Budget 2017: Nilesh Shah says FM must take risks, ease fiscal tightening plan

With just two more years at the government’s disposal to reinforce growth, Nilesh Shah, MD and CEO of Envision Capital, hopes it does not stick to the path of fiscal consolidation in the upcoming Budget. "It is worth taking the risk and providing incentives to bolster investment and consumption," he says in an interview to CNBC-TV18.

On sectoral trends, Shah says he will be surprised to see the commodities uptrend continuing in 2017 after the terrific run during the last year. Similarly, he sees it wise to wait for further correction before considering investments in the consumer staples sector due to high valuations.

However, public sector companies could enjoy some good tailwinds like a pick-up in the capex cycle. Likewise, the worst could be over for information technology stocks. Considering cheap valuations despite good cash flows and strong balance sheets, Shah does not see a better time to enter the space. “IT looks attractive from 2-3 year time horizon,” he says.

Sharing his take on the BSE IPO he says the exchange’s biggest challenge is entry into high growth areas like currency, commodities etc. "Also, it will be tough for the exchange to make a significant impact or increase share on the F&O side where bulk of the volumes are," he said. Core operating earnings have not grown much over the last 5 yrs, which makes it tough to justify valuation for long-term investors, Shah said, talking about the BSE issue. While he expects listing gains, it would be more prudent to wait to make an investment bet, he says.Below is the verbatim transcript of Nilesh Shah’s interview to Latha Venkatesh, Anuj Singhal, and Sonia Shenoy on CNBC-TV18.Anuj: What are your first thoughts on the way we have seen couple of sectors really standout, you have metals which has had a big run and commodities in general have had a big run, do you think that could be the story of this year, commodity producers doing well? A: I think it is pretty much unlikely. I think we have had a terrific run for commodities. Commodity prices have been on a run and virtually the whole of 2016 belonged to the commodity producers and you name any kind of commodity and it has done well, right from agri-commodities to metals, ferrous, non-ferrous, I think the whole pack has done very well. So, I would be really surprised if it continues given the fact that we are seeing a scenario of a stronger dollar, interest rates going up in the US and by and large commodities are global plays. So, it looks very unlikely that the surge that we have seen in actual commodity prices in the consequent surge in the prices of commodity stocks, I would be very surprised if that kind of rally continues even into 2017. Latha: The obvious big news of overnight results is Hindustan Unilever (HUL) and Asian Paints. Broadly in the FMCG space, should we look through the demonetisation woes and now start picking these stocks in distress? A: The challenge I think for most of these stocks is valuations. The reality is that if you look at the last five years or so, the first three to four years have been strong volume growth and strong revenue growth. The last one year has been more about margin expansion which is clearly been the earnings driver. What we are going to now see is sobered down volume growth and even a further sobering down of margins. Even despite the fact that some of these stocks have corrected 20-25 percent from their highs, the valuations still continue to be very high. For some of these stocks, the valuations are as high as almost 40 times on a trading earnings basis. So, I think one should probably wait for still a further correction in some of these consumer staples before they actually become meaningful buys from a medium term horizon. Sonia: What about your first love, IT, how did you read into HCL Technologies numbers; it didn’t look so bad?A: I think so, I think across the board for most of the technology companies, by and large the results are in-line and some of them have reported numbers which are marginally ahead. I think the good part is that right now the expectations are very low, there are general perceptions that the headwinds are very high both from the actual ground realities in the US as well as what the new administration could do in terms of the visa regime. So, these two continue to be challenges but I think by and large these companies seem to be on track. Yes, growth rates have come down from the low double digits to high single digits, that is essentially and that is what probably the street is factoring in. Our sense is that perhaps the worst is over. Our view is that I think when these companies come out in April, my sense is that they would probably again come in again and say that FY17-FY18 may not be as bad as what the street is expecting. I would actually be surprised if the Trump administration just really goes ahead and actually implements whatever they have been saying on the campaign trail. If that were to kind of really not happen in terms of all those kind of restrictions, I think there could be a potential upside in the sector. So, I honestly think that the technology sector today presents of good investment opportunity. I think that from a two to three year outlook, I think these are still outstanding companies. Sonia: What is your pecking order then? A: The larger companies have become more attractive. If you look at each one of the larger companies, I think you should just kind of look at what their aspiration is, look at what they have set out to do in next three to four years be it Infosys, be it Wipro, any of these companies, I think even if they get to even 50-70 percent of that aspiration, I still think they will end up being fantastic investments over a three to four year opportunity. Latha: Are they still your first love? A: I think as a sector it continues to be. Not getting into individual companies, but as a sector look at it, these are companies even on this size, they are still growing at almost 8-10 percent. On one hand, we keep celebrating when Asian Paints or Hindustan Unilever (HUL) keeps reporting 8-9 percent growth and we say what companies and what wealth creation, but look at the size of these companies, they are really competing with the big companies out there like Accenture, and all of that and still growing, they are throwing cash flows, they are still kind of having a fantastic balance sheet, they have been able to make successful transitions from one management to another management, if you really look at it, these are truly global companies and these have come down to valuations which perhaps are at a decade low. I can’t see of a better opportunity than where they are today. Anuj: The other big mover has been the PSU space. The move started with oil marketing companies but Engineers India (EIL), you have BEML which is surging now, do you think this is a real bull market for some of these PSUs and would you put some money here? A: I think some of these PSUs I think are enjoying some nice tailwinds. If you really look at the marketplace, there are four broad kind of segments in this market. One is of course the technology side, the second is the consumer side, third is the capex side and fourth is commodities. Most of the PSUs are in the latter two segments versus the former two segments. It is clearly technology and consumer where there are tremendous headwinds either in terms of valuations or in terms of growth prospects and you flip over to basically the capex side and the commodity side. These are the two segments which are doing extremely well and it is quite possible that especially on the capex side you could still continue to see an upside coming in because of investment led demand if the government honestly does something really worthwhile in the Budget to kick-start the investment cycle, then some of these companies which are interesting plays on defence, on specialised engineering, on the power sector, could essentially end up doing very well. So, I believe that yes, there is value in the PSUs. However, I think one area which the street is not yet factoring in is the impact of seventh pay commission. I think for a lot of the companies, especially companies in defence and some of the very routine kind of businesses, the impact of the seventh pay commission could be reasonably high coming in from Q4 and then the rest of the next financial year. So, that is one factor which one needs to keep in mind as far as the profit outlook for these companies is concerned. However, leaving that aside, by and large, most PSUs look to be on a pretty strong wicket. Latha: There will be new sets of stocks for you to analyse. Will you buy BSE? A: I think we kind of evaluated it and the challenge for BSE essentially is going to be if it is able to kind of get into some of the other high growth areas. I think it is going to become very difficult for BSE to make a significant impact on the F&O side, the derivative segment of the equities. That is really where bulk of the volumes reside. It is going to become very difficult for it or challenging for it to kind of make a serious impact there and walk away with some market share which finally is profitable as well. So, it really will depend on how BSE will be successful in many of the other segments like currencies, like commodities as and when the regulatory environment allows it to do so because from the core operating earnings, I think over the last five years I don’t think they have been growing the core operating earnings. Of course you add back other income and of course there is growth, but I think core operating income, I am not quite sure if that has been really growing at a steady pace. So, it will really depend upon how the BSE is able to branch out into some of the other areas. The good part is the regulatory regime is very clear that at some stage they would be allowed in commodities and some of these other segments. The question is how distant that is. So, yes, if one has a long term view, I think exchanges can be very good well creators in the very long run. However, in the short term, I am not too sure if the valuation at the current prices is attractive enough for a long term investor. You could have obviously that popup on listing and you could make some listing gains. However, over the very long term, it might probably be more prudent to wait before making an investment bet. Sonia: What about your view on the Budget now? For the government to stick to the path of fiscal consolidation, it seems pretty daunting given that there are elections right up next, should we expect a lot or are you keeping your expectations very low?A: My only expectation is that I hope they don’t stick to the path of fiscal consolidation this time around. That is what I think they should be doing. I think it is worth taking the risk, it is worth taking the gamble at this stage because we clearly have now honestly just two years left for the current government in which growth needs to kick-start and if it means that you need to in a way compromise on the fiscal deficit target for a couple of years, I think the government should do that so that basically the investment cycle kickstarts, the consumption cycle kind of renews its growth trajectory so that the overall economy can kind of grow in a more significant manner for the next two or three years. Latha: If you want to comment on L&T Infotech itself and if you move on to pharmaceutical as well, you have spoken about IT but as pharmaceutical also priced in most of the damage now? A: Coming to pharmaceutical, yes, there has been a lot of price damage undoubtedly. The challenge in pharmaceutical is that you have got to post two questions. One is here are a set of companies who have already faced the regulatory challenges, the US FDA and I think the big question out there is how long will that linger on. There are some of the pharmaceutical companies which had regulatory challenges as way back as four years back and still have not been able to resolve it. So, I think wherever there are issues of data integrity, I think those are really the kind of companies you should necessarily avoid. I think just taking a call on them would nothing be but just a punt saying some day it will resolve it. However, I think data integrity are very serious issues. I think then there are whole set of companies where there are no data integrity issues, there are process related issues which can still be resolved and we have seen the US FDA coming back and saying okay fine now go ahead, you are good to go. I think those are the kind of companies to bet on. The third is the kind of companies to bet on who have a meaningful India presence, who have a rest of world presence and then only have a small presence in US and Europe and maybe they have better headroom for growth versus rest of the pack because they do not have legacy of the past. They are tuning their current systems, processes, and their physical infrastructure to comply with the new US FDA regime. So, I think that is really where the bulk of opportunity in pharmaceutical rests. So, look out for companies which do not have over dependence on the US but can have headroom for growth again from regulated markets like US or Europe.