Midcaps set for huge rally in May: Dron Capital

The midcaps index, which has underperformed the benchmark Sensex by 11-12 percent in the calendar year through April, is set for a big rally in this month powered by earnings momentum and attractive valuations, says Pathik Gandotra, partner, Dron Capital.

"If the market sticks in the 6,050-6200 range, then we will have a big rally in midcap in May. The rally will happen in sectors, which have seen quality earnings growth. Non-banking finance companies (NBFC), midcap IT and midcap pharma are doing very well," he told CNBC-TV18. Also read: Nifty to hit 6100 soon; bet on pharma; shun IT: Dimensions
He expects banking stocks to recover in the next few weeks once there is more clarity on further rate cuts by the RBI.
"Stocks in private banks, consumption, pharmaceuticals, IT sector will continue to perform well and are likely to post 15-20 percent earnings growth next year," he says. However, he sees stress in cyclicals and metals stocks.
All in all, he expects earnings to improve and enter low double-digit number in FY14. Below is the edited transcript of Gandotra’s interview to CNBC-TV18. Q: What you have seen of this PSU bank lot so far and whether you think there is more devaluation in stock for some of these banks?
A: I think these stocks are anyway very cheap. There can be some result reactions to these stocks, but given the way that the private banks are moving, it does not look like there is too much of downside from hereon for PSU banks as well. The moot point here is the asset quality problems. It is different for PSU banks and private banks. That is what is showing in the stock prices. It is one country, so eventually if the non-performing loan (NPL) cycle is close to peaking over the next few quarters, everything will settle down. For PSU banks to rally, they need one clear message and clear understanding that interest rates will fall in one direction over the next 12-18 months. Once the market gets a sense of that, then that is when those stocks will do extremely well. Q: We have now seen most of the influential bunch reporting at least on the indices what is your take away from earnings season so far and what would be a reasonable estimation going into the next financial year in terms of earnings growth you think?
A: The good part. The growth part of the index has reported earnings so far, not the cyclical part of the index. One has to take a call after you get all the earnings put together. I think what is growing will continue to grow, which is the private banks, consumption, pharmaceuticals, IT. All those stocks will still continue to do well and report 15-20 percent earnings growth next year. The problem is in the cyclicals, metals, etc, where one is not sure about the way the commodity prices are going to move. So there, there is still going to be stress on earnings. Overall, for next year I would expect very low double digit number of earnings growth. Q: What is the next trigger that this market should watch out for, which could take to new highs? Will it continue to be the global liquidity that will spur our market higher or is there anything domestic that you would watch for?
A: One of the main reason would obviously be globally liquidity. Another one could be if the technology sector gets a comfort around the fact that technology spends are going to increase. The US economy is on its verge of recovery and US economy numbers keep on doing well, then what happens is that people start building in expectations from the technology sector.
The management commentary, in these results, were pretty cautious. But, progressively, that commentary will change if the US economy recovers. I am a firm believer that these stocks don't run on rupee, they run on dollar revenue growth and if there is comfort around dollar revenue growth accelerating, then these stocks should do well. That is one trigger.
The second trigger could be Reserve Bank of India’s (RBI) cutting interest rates every time and still sounding hawkish. The message that the governor is tell us is that, he is going to wait for data. If one sees the consumer price index (CPI) numbers coming down in the next week or ten days and if one sees the wholesale price index (WPI) numbers also sliding down and with soft commodity prices, there is some comfort around the current account deficit (CAD) as well. He has no choice, he will cut again. He may still sound hawkish but he will cut again because the message that we took back from the policy this time was that he is saying that there is limited space if the data remains the way it is. If the data changes, then obviously the scope increases. Q: Some people believe that this is a good time to buy good quality midcap stocks based on the positive earnings momentum and the attractive valuations that many of these stocks are sitting on – would you concur with that view and if yes, in which pocket in the midcap space would you look at?
A: Absolutely. If one looks at it, the midcap index is still down 12 percent from its January peak. It is up 8 percent. The smallcap index is down 20 percent from its peak, it is up 7-8 percent so, both these indices have underperformed the broad market indices.
I think if the market even sticks here at 6,050-6200 in that range, one will have a big rally in midcap which is going to come in May. I think where the rally will come is where one sees quality earnings growth. If one sees there is quality earnings growth in finance companies, one will see non banking finance companies (NBFC) etc doing very well, midcap IT doing very well and midcap pharma doing very well. So, wherever one sees every strong earnings growth one will respond to that.
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While it is not clear whether RBI will cut again or not as the governor is saying, what is clear is that, there will be transmission of this monetary policy. There is 75 basis points repo rate cut that has happened, but transmission has not happened. The next trigger will also be transmission of this monetary policy into the real economy. Then all the people, all the companies which are leveraging will start benefiting. That is where one has a whole host of midcaps which is available. Q: Up until now, the strategy that has worked is to play defensives in terms of whether you are buying consumer goods or pharmaceuticals -those kind of spaces, high valuations but earnings comfort – are you saying for the second half the tactical shift should be towards high beta now that is where the greater performance will come from?
A: I would start buying a bit of high beta. I would still not let my guard down on defensives, it is still very unclear. One cannot say that the global risk has totally vanished because if something happens globally which is negative then one is back to 3-4 percent correction again. One should start nibbling at beta and as one gains confidence and as the stocks perform, one should keep on adding to it. It is not a very easy thing. Otherwise, you buy beta and forget about it because eventually, one will make money from these prices. You may go through one more dip but eventually, you will make money as the prices are just too attractive. Q: On the point that you were making about midcaps – one space that has had fairly disparate moves is this entire non banking financial companies (NBFC) lot – the micro finance institutions, the NBFCs what could you pick from there if you had too?
A: I would pick all the stocks which are delivering strong earnings growth. There is Bajaj Auto Finance, Mahindra Finance, IDFC. One could look at this whole space where one sees strong earnings momentum still continuing. The point is one hasn’t reached a point in the economy where consumption has slowed down materially. There is a big shift in market shares which is happening from the state owned lenders to the NBFCs and the private banks. So, they are thriving even on the market share gains. Those are the stocks that I would look at.
 
Q:  Some people have actually pointed to single digit earnings growth going into FY14, you were talking about doing something in the low double digit region, at this point would you say there is greater risk to underperforming over the next couple of quarters or have you seen anything in the quality of earnings this time around to suggest that there is an improvement underway?
A: There is one more sector which has joined the party- telecom. Telecom earnings earlier were very suppressed. Telecom earnings which are a big compound of the index will surprise on the upside.
I also think IT earnings will surprise all the analyst estimates for this year, because the US economy as it gains traction, it will result into strong top-line growth for IT companies. These are two sectors which are pretty obvious.
On cyclicals, there is still scope for some disappointment. We haven’t seen those earnings coming out as yet but I won’t expect them to be great. That is where one would look at more of a second half kind of recovery, kind of bet. Q: Hindustan Unilever Ltd (HUL) continues to move higher. What are you guys recommending in terms of subscription to the open offer and how do you see this stock move from here?
A: I don’t recommend anymore. The only thing is that I would subscribe to the open offer. It is a very-very good price. One might obviously see that they have some big game plan in mind if they have taken up such a big position in the stock, but I would subscribe to the open offer. Q: How do you approach the entire auto space now because on one hand the original equipment manufacturer (OEM) are not doing so well in terms of earnings but if you look at the tyre makers or the tractor makers all of them are reporting good set of numbers – What would the approach be by and large?
A: As far as the OEMs are concerned, the volume recovery is still about six months into this year, so around Diwali, one will see recovery happening in OEMs. That is where those OEMs would look interesting. For tyre, there is a whole benefit of rubber prices which those companies are reaping, but it is not so much volume growth. Q: From amongst the heavy weights on the index which is basically a clutch of faces like Reliance, Tata Steel, etc, which one would you say is the dark horse candidate going into FY14?
A: I think it could very well be Reliance because the problems around its exploration and production (E&P), around its KG-D6 gas pricing issues should get resolved during the year and if they get resolved the market is not pricing any of that. Hence, that is something which can be very a big kicker. Mind you, there is also serious risk involved there which is why we could call it a dark horse.