Since dollar denominated revenues make sense at this point of time, IT, barring TCS, was quoting anywhere between 11 and 12-13x or so on. Midcap ITs were going for 8 and 9x and this is less than a month ago and IT stocks continue to outperform.
Bank stocks continued to fall significantly through last week. Dipen Sheth, Head-Institutional Research, HDFC Securities, does not see a change in the trend. In fact he says the skew in valuations looks like it is at an extreme point, maybe close to a tipping point of sorts. But a reversal does not seem to be in sight. According to him, the temptation to buy PSU banks is huge, but the leaning is still towards private sector banks.
In an interview on CNBC-TV18, Sheth says IT sector looks good and investors must look at it. But consumer, especially FMCG, looks very costly. And in auto, investors should wait for a cyclical rebound which may not happen anytime soon.
In PSU companies, Sheth sees a further 20-30 percent downside for BHEL because of the kind of capacities that they have now and the kind of capacities that are required over the 13th, 14th or even 15th Plan period and the kind of pain that is prevalent in the power sector.
He further cautions against L&T. He suggests doing some deeper down study of L&T before jumping at it just on the basis of order inflows.
Below is the verbatim transcript of Dipen Sheth’s interview on CNBC-TV18
Q: Last week was a curious phenomenon of the banks falling significantly, but the market being held out by a few defensive sectors. Do you see that trend persisting?
A: I do not see any reason for this trend to change soon, although I must confess that the skew in the valuations is now not just worrisome, it looks like it is at an extreme point, so we maybe close to a tipping point of sorts. Even near the tipping point I would look for triggers and sadly those triggers are not happening. You have Fast Moving Consumer Goods (FMCG) stocks at 30-35 plus valuations. You have PSU banks at half book and so on. So you are right, there is skew. I think the skew has gone to extreme levels, but sadly I still do not see a reversal.
Q: Which way do you think this skew will start giving way? Will people start showing some interest in the broken, beaten valuations of many sectors like industrials etc. or do you think some of these very expensive defensives are set for an explosion?
A: Last week when I met a very senior and respectable fund manager, he said this half in jest but I could understand where he was coming from, he said that the job of brokers right now is to identify the next big Punj Lloyd or Jaiprakash Associates or Himachal in the consumption space. While it sounds hilarious, but that is the thing. People simply cannot digest these valuations anymore and like I said I do not see a tipping point happening soon, but we are getting increasingly close to that tipping point.
Q: What is your sense on how to play a sector which is not that expensive like consumers; IT where valuations are still in that Rs 15-20 kind of zone. Do you find those valuations being able to expand somewhat more?
A: If you look at our strategy note of early July we have said that dollar denominated revenues make sense at this point of time in our economic cycle. Hence, IT which was as a pack, barring Tata Consultancy Services (TCS), quoting at anywhere between 11 to 12-13x or so on. Midcap ITs were going for 8 and 9x and this is less than a month ago and IT continues to outperform and I think it still makes a lot of sense. If you ask me over the last 15-20 years if there is one industry at which this country has beaten the rest of the world, it is the IT and hence any trouble that IT goes through whether it is in the form of Immigration Bill and so on, I think these are opportunities to buy into a very capable sector.
Consumer, I do not think I would agree with you. Like I said within the consumer vertical the FMCG space definitely looks very, very costly. There might be little bit of value picking on the sides, but in things like auto you have to wait for a cyclical rebound and I do not think that is happening anytime soon.
Q: What are you comfortable purchasing from the banks especially after the kind of carnage there was last week?
A: The temptation is to pounce on the public sector undertakings (PSU) banks. We like them when they were 1x book or adjusted book, we like them more when they were 0.9x or 0.85x and now things like Oriental Bank has fallen to 0.5x adjusted book. This could be illusory, I am not specifically talking of Oriental Bank, but what can happen is that as the economic cycle toughens in India over the next one or two years, I suspect it will, we are in a different growth trajectory now.
So some additional non-performing assets (NPA) accretions could happen to adjusted book value, which might make the current price by adjusted book values revise significantly upwards and the same price levels for the banks. So, I would still say that private bank should be bought on decline. There are some very capable names there. Not all PSU banks are relatively incapable, nor are all private banks relatively capable. But with some intelligent stock picking I think the leaning should be still towards private banks.
Q: A lot of institutional holders have been distressed by the way some of these big names like Tata Steel, Bharat Heavy Electricals (BHEL) have continued their downward drift. In which of these names do you see the even further potential for derating after the damage or carnage that has happened already?
A: One structural story of derating could obviously be BHEL. Last week we published a note in which we said that we just do not see any hope of a turnaround for the stock, not that it is an incapable company by any stretch of imagination, but simply because the kind of capacities that they have now and the kind of capacities that are required over the 13th, 14th or even 15th plan period and the kind of pain that is prevalent in the power sector, if you look at BHEL on a price book basis and that is the way to pick industrials at the bottom of the capex cycle, we still see valuations as being at a significant premium to what they used to be in the last down cycle.
So just because BHEL has fallen and just because it looks very cheap maybe about 11 or 12x you should not be buying into this and I see a further 20-30 percent downside for BHEL. Frankly, I would buy the industrials, I would buy the interest rate sensitives, I would buy the guys who are dependent on a capex cycle only once I see some hope on the policy front which is not happening yet.
Q: Conversely though you would go in bullish on Larsen and Toubro’s (L&Ts) earnings?
A: I would be a little cautious here. They have recorded some superb order inflows recently and I would wait for some kind of understanding on how profitable these orders are. As we know the order environment or the bidding environment in the last few years whether in India or even in the Middle East has been terribly competitive. So, comparing order inflows over 2012 and 2013 with order inflows over 2005 and 2006 and ascribing similar margins to these order inflows would be a little reckless. I want to see a little more delivery on the part of this company. They have been showing declining margins though not terribly so.
They continue to be easily the most capable infra company or construction company in this country. I am also worried a little bit about the funding for their infra assets, which is going to be required over the next few years. So, I would actually do some deeper down study of L&T before jumping at it just on the basis of order inflows.
Q: How are you approaching the Non-Banking Financial Companies (NBFC) space? It is less discussed compared to banks, but that clutch of 10-20 stocks has also taken a big beating over the last month or so?
A: That is right. What has happened is that, courtesy the Reserve Bank of India's (RBI) recent tightening short-term interest rates have shot up. I think what the RBI is doing is to punish the drunkards in the bar and it is getting too late and I think the toughs are throwing out the drunks so to say and that is having an adverse impact on the NBFCs who are dependent on wholesale funding. So whether it is a stellar name like LIC Housing Finance which has taken a beating. Lesser names of course have fallen even more.
So I would wait for some clarity to emerge on the direction of one year and two year paper before I take a call, but that said some of these businesses are very, very solid businesses. They do not have asset quality issues especially the likes of LIC Housing Finance and I think the current spike in short-term interest rates has actually afforded us an opportunity to accumulate some of them.
Q: What has the experience been with some of the midcap funds that you hear of? Have they been struck by large redemption pressures or are people mostly numb to the kind of losses they must have faced on some of these midcap funds in specific?
A: For the midcap funds I guess most investors who have bought units of these funds have settled for the fact that there is going to be volatility and there is going to be an underperformance during a down cycle. So, I am not too worried about those. Infact quite a few of the midcap funds are doing admirably compared to their largecap peers and there is some very intelligent stock picking going on out there.
So, whether at the top of the pack if you see Supreme Industries or an Ipca and so on, people have made a lot of money on midcap funds. Their returns have not been too bad. The panic button or a rush for the exit is really not happening in some of these funds atleast. So, I don’t think that is a worry.
Q: One of the midcap stocks that did okay this earning season around was Exide Industries, how would you approach that one, given the fact that it has recovered quite a bit as well in terms of stock price?
A: It is easy to overshoot on sentiment on both sides of the argument. On Exide Industries for the last couple of quarters or so, we have been constructive on the direction of their margins after some two years of almost continuous decline in their margins simply because they were losing market share in the replacement market to Amara Raja Batteries and they were getting beaten down on their auto original equipment manufacturer (OEM) supplies who were asking them for lower and lower prices as their own business cycle began to harden.
We called for a bottom in their margins the last quarter not this quarter at around 13 percent and we said this is where the cycle is turning. Our channel checks suggested that they were gaining market share in the replacement market and low and behold this quarter, they have done very well, 15-16 percent in margin. I don’t think 16 is going to sustain especially since costlier led mark to the dollar is entering their inventories from hereon. But to remain constructive from a 13 percent kind of level to 14.5 percent and thereabouts makes a lot of sense.
Capex is going to be a concern for us because at 75 percent capacity utilisation, I don’t see why they should be doing about Rs 200-250 crore of capex every year. Surely, there is value in the stock at this point of time.
Q: You were speaking about public sector banks but two of the smaller private sector banks have got bashed up a lot over the last week or fortnight, Yes Bank and IndusInd Bank, do you find any of those two attractive?
A: IndusInd Bank’s tilt towards truck financing and Yes Bank’s aggressive tilt in the corporate market would make me cautious on them. I would like to maintain that these are both very capable banks. Valuations at IndusInd had run ahead of realistic levels. So a little bit of punishment was not uncalled for so to say and the spike in short-term interest rates did the trick.
So both of these banks are going to aggressively build out their deposit franchise over the next few years, particularly Yes Bank. But for both of these banks, there is going to be a period of consolidation and the kind of supernormal returns that we got from them over the last one-two years may not play out. That said, they continue to be very capable managements and you should be looking to buy them on declines.
Q: Would you pick anything from the midcap basket because there have been some aggressive recommendations even on faces like Hexaware etc. Would you say it is time to look down the chart a little bit on IT?
A: Yes, certainly it is. We were quite disappointed for a couple of quarters with what Hexaware was doing and they seem to have clawed their way back. I think a little more demonstration of business traction will do them a world of good. We continue to retain hope in this space and I think if Hexaware does not spoil too many things from hereon, I think we can still have – there is about four percent dividend yield, valuations are still around 10x or a little more. So, I don’t think there is too much to be lost there. The stock had cracked to Rs 70s when they posted a disastrous quarter the last time around.
On the other hand, Mindtree has been much more consistent in its delivery and this quarter too we saw a pop that we hadn’t anticipated, somewhat driven or inflated by currency gains. But I think there is another very valuable story emerging at Mindtree as well. Even after the recent run up I think the valuations are still around 10x. So for companies which have clean cash flows, very high management quality, return ratios in the 20s and higher, I think paying 10x makes an awful lot of sense at this point of time. You can’t lose money, especially when you have currency tailwinds in your favour.
Q: Would you buy anything in some of the spaces which people are not looking at today, which include metals, real estate, these kind of sectors, which are completely out of favour?
A: No, I would stay away from these sectors. I don’t see anything materially different or changing in the macroeconomic cycle which will tempt me to buy these sectors. Real estate, there are clearly issues of overpricing in some of the key markets and hence volumes may not move the way you might want them to, volumes sales that is.
On metals, I think globally commodities are going through a little bit of softening, barring oil I think there is hardly any commodity where there is a significantly high level of hope in terms of pricing. There are significant structural deficiencies in the way this country manufactures steel for example, our complete dependence on external coking coal is only one of them. So, I don’t think I would go out on a limb and buy these just because they have cracked.
Q: A word on telecom though and whether you would buy anything from there, because that is emerging as a bit of a dark horse candidate. All three names Bharti, Idea, Reliance Communications ofcourse have been strong on the deal news?
A: We really don’t understand Reliance Communications so well. We are skeptical of the way their balance sheet is structured and other issues at the company, but that okay. I think they are a very aggressive player and they are going to define some changes in the market from hereon. So, I like the way they are behaving with respect to their customers’ atleast. That said we don’t have them under coverage.
Between Bharti and Idea I think the latest concern on Bharti has been its leveraged balance sheet and dollar exposure with respect to its Africa operations, some offset will happen because not all currencies are falling against the dollar or some of the African currencies may even rise against the rupee. So, there is a little bit of internal hedging, for every rupee change in the price of the dollar, I think Bharti’s net present value (NPV) cracks by about Rs 2 or so. So, it is not so bad as you might imagine.
On the other hand, on the domestic market they are clear leaders and they have signalled their intent to come back into a little bit of aggression. So, I think the others especially Idea and perhaps Uninor will take note of this. I think adjusted for inflation a minute of telecom is now the cheapest it has ever been in the history of this country and there can only be pricing power, which comes in from hereon, barring what disruption Reliance Jio might do.
So, I think there is an opportunity to buy telecom. The worst of pricing pressure, competition, bad regulation, and controversies I think they have all taken their toll and this is probably a very good time to look at telecom.