Chemical stocks trade at high valuations. What should be your strategy for the sector?

“Post-COVID19, several downstream MNCs that used to import the bulk of their chemical requirement from China are now contemplating to supplement this supply from India and other countries to reduce their dependence on China," said Yogesh Patil, Senior Research Analyst, Reliance Securities.

“Capacity expansion and heavy investment by specialty chemicals on the R&D front and backward integration have boosted the segment," said Patil.

Most players reported better-than-estimated numbers for the June quarter of the current financial year, and managements are sounding optimistic, anticipating a strong domestic demand and export opportunities. Valuation concerns prevail but the sector is poised for gains in the long run.

Stellar gains of the stocks from the sector have given rise to concerns over lofty valuation.

Big wealth creator in last five years

Santosh Meena, Head of Research, Swastika Investmart, pointed out that the chemical sector has created great wealth for investors in the last five years and most stocks have risen manifold.

However, he underscored there is a concern about valuations in many such counters.

“Opportunities will be manifold over the next five years, thanks to an increase in outsourcing and divestment in the developed world due to rising cost pressure, better availability of feedstock, and import substitution," Meena said.

“This will lead to a meaningful increase in India's share in global chemicals but the sector can see some volatility, depending on how the pricing environment moves. Investors should remain selective because most companies will not be able to enjoy the current level of growth and margin," said Meena.

‘Near-term upside will be limited’

According to Likhita Chepa, Senior Research Analyst, CapitalVia Global Research, by 2025, this industry is expected to grow at a CAGR of 12 percent. The primary growth drivers for this sector will be robust domestic demand, rising import substitution, and strong export growth as global MNCs increasingly follow the 'China-plus one' strategy.

She also underscored that many stocks from this sector are trading at very high valuations which might limit near-term upside.

However, the long-term outlook of this sector appears to be stable, Chepa said, as the Asia- Pacific region is expected to dominate the market in the coming years, largely attributable to the huge production base concentrated in India and China.

Indian specialty chemicals space predominantly comprises products that meet the demand of pharmaceutical and agrochemical industries.

"With the consideration of long-term structural tailwinds for the specialty chemical sector in India, we have a positive view on the sector," said Patil.

Brokerage firm Edelweiss Securities is positive about strong growth across specialty chemicals players, driven by a solid sector tailwind and visible structural changes in the long run.

However, it also pointed out that valuations across the sector have been continuously getting expensive.

“As our long-term view on the sector remains positive, we have been continuously raising our valuation framework to capture favourable growth scenarios across the industry. In Q1FY22, post results, we have raised the P/E target multiple to 38-48 times from 38-42 times," said Edelweiss.

Stocks to buy

Meena's top pick from the sector is Deepak Nitrite, despite a sharp run. That’s because growth visibility is there with some comfort in valuations. SRF, Aarti Industries and PI Industries may also continue to do well, Meena said.

Chepa is positive on Deepak Nitrite and Navin Fluorine.

“One can expect a further upside of 12 percent in Deepak Nitrite in 15-18 months while Navin Fluorine can rise about 15 percent in the same period," said Chepa.

Aarti Industries and SRF are strong beneficiaries of capex-driven growth, while Galaxy Surfactant offers sustainable growth at a reasonable valuation, said Edelweiss Securities which has a buy call on all these three stocks.

It has a 'hold' call on PI Industries and Fine Organics.

"Though PI Industries will benefit from the recent acquisition of Ind-Swift Lab, the current stock price factors in large synergy benefits. Fine Organics will continue to face margin pressure over the next 2-3 quarters," Edelweiss said.

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