Contra view: Pharma overvalued sector now, says Dharmesh Kant

Talking about the Nifty 50, it is expected to end FY24 with an EPS of around Rs 1,050, give or take 25 points. So based on that, the index is trading at around 20.2 or 20.3 times forward earnings multiple. Historically, it has always been 22.5 to 23 times when the bubble starts creeping in. So we are far away from that. Extrapolating this multiple, that would be around 23,000 on the Nifty.

So, why does it look like a bubble?

What’s happened and why it looks like a bubble is that for all public sector undertakings, stock prices have run up quite hard and they are being valued at the PE multiple at par with private sector undertakings. Earlier, in spite of a good order book and earnings visibility, valuation multiples assigned to these companies were around 30-35 percent lower than their private sector counterparts. There were many problems – delayed execution of orders, delays in payment, etc. Now things have changed and are being priced in.

The speed at which the stock prices appreciated created a sense that we are entering a bubble, which is not the case. They are just being marked compared to their private sector peers. So we are fairly well, but not highly, valued.

For example, Hindustan Aeronautics gives you an RoE of around 27-28 with a PAT CAGR of around 25-26 percent. With the kind of order flow they are getting, I won't be surprised it will give a profit CAGR of 30 percent. So, there is plenty of scope for Hindustan Aeronautics to get rerated. However, companies like Data Patterns do look to be on the higher side of the valuation multiple.

So company-specific, there are challenges out there on the valuation front. Sector-specific, I don't see any challenges, except from the pharma space.

Why do you think pharma is overvalued?

I don't see pharma companies coming out with an earnings growth number of more than 10-12 percent for the next two or three years on an annualised basis. The reason is price correction is still happening in the US, even though the pace has decelerated quite a bit. Back home, every time a national pharma policy comes out, there is a downward price revision  – this will keep on happening as more and more drugs come out of patent. Add to this the fact that input prices are already low, so the margins will be in a declining mode. Thus, to me, pharma does seem to be overvalued at current multiples.

How do you see the Nifty panning out from here on?

We are going with a year-end target of 21,000 on the Nifty. And that is purely on the fact that Q2 numbers… will surprise most analysts.

The good side of the lower end of the monsoon is August has been a completely dry spell, and during this dry spell… most of the construction activities have picked up, which was not the case last year. So one month additional incremental benefit will play out for construction companies, which includes materials suppliers – all these companies will report a very good set of earnings.

Moreover, if you look at the automobile numbers for August, all companies reported a great set of numbers. Thus, automobiles, metals, infra, construction – these companies will report much better numbers in Q2.

Small and mid-caps have been buzzing a lot lately. Are you a buyer, seller or waiting on the sidelines?

Depends. As far as our research goes, first, we do a top-down approach where we select the sector and the pockets where we see traction coming, and then we go by a bottom-up approach. And we go by a sector-agnostic kind of an approach. Whenever we find value in mid-, small-cap, we are out there.

There is opportunity in this economy. If you look at the GST collections, or e-way bill collections or even the IIP numbers – all these numbers all are pointing to the same direction – that there is an underlying strength in the economy. You just have to be in the right basket, right company selection. So there you have to be a bit careful if you want to protect your capital.

What you're saying is you don't see any exuberance or any froth, broadly speaking, at least in mid cap or small cap?

Of course, yes. There is not too much froth, broadly speaking. Though the rub-off effect does happen. When a particular stock moves up, the underperformers also tend to catch traction. Heavy retail participation has also fuelled this trend. But largely, all meaningful companies, under the BSE 500 umbrella, froth is not there as of now.

The metal sector has seen a lot of buying in the past month. It is perplexing because China has slowed down and prices have stabilised. What’s cooking there?

You have to look at the metal sector from a domestic consumption point of view. So the companies which have run up in the last one month have been domestic-centric companies – Jindal Steel, JSW Steel, SAIL, NMDC. They have no concern with what is happening in the international market.

The China factor becomes important, say in the case of Vedanta, which exports iron ore to China, and they are seeing a slowdown. Other than that, be it Hindustan Copper, Hindustan Zinc, they are doing phenomenally well.

So, our suggestion when it comes to playing the metal basket is keep aside Tata Steel. There are better domestic-centric plays like JSW Steel or Jindal Steel or even the Steel Authority of India.

Banks have been underperforming for a while now. Logically, when the economy is doing well, banks should also grow, no?

Optically, it does look like the economy's growing and banks should be growing much faster… But you have to look at it with a more microscopic lens. For example, what happened last quarter… if you look at the AUM growth of all these financial companies, including NBFCs and banks, the growth came from the unsecured side. Credit card business and retail lending were where the maximum growth came from. Even home loans did not see the same kind of growth it used to see a year ago.

Most of the companies that are doing brownfield or greenfield expansion are sitting on very strong cash flow. Most promoters and managements say they don't need debt – internal accruals are good enough to cater to capacity expansion. So, this is the challenge that banks are facing.

Add to that the fact that we are sitting on a rainfall deficit of 12 percent in a high inflationary condition, so there is a fear that there may be slippages because of the slowdown in the rural and semi-urban segments, where financials have been very aggressive. There may be a 10-20 basis point uptick in gross NPAs (non-performing assets) in Q2 and that is scaring market participants.

You mentioned a slowdown in home loans. It’s a bit puzzling because real estate firms say there are record bookings. So what is the disconnect here?

In real estate, only the premium segment has picked up in a very big way. So very high ticket sales are happening and those are not financed by banks. Right now, whatever new launches are there, you have to pay only 10, 15 or 20 percent to get the booking done. Those buying a Rs 5 crore, Rs 10 crore, Rs 15 crore, Rs 20 crore house – they already have that kind of money.

Any stock picks from your house that you're focusing on? 

There are a few. From the power sector, JSW Energy, Tata Power, and NTPC can be accumulated. The other thing which we feel is likely to do well in this upcoming festive season is the automobile industry. Bajaj Auto remains our top pick out there, followed by TVS Motor.

We have been a buyer in the metal space as well, just on the back of good infrastructure spending, which is happening out there. So Hindalco, though it has run up, is still a good buy, followed by JSW Steel and Jindal Steel. Similarly, in defence, Hindustan Aeronautics still looks a very good buy to me. In railways, IRFC, RVNL or Ircon are great companies to stay invested in.

One caveat is that these should be investment buys and not for 15-20 days or two months. If you're willing to hold it for one year, 20 percent kind of stock price appreciation is very much on the cards.

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