"IT sector has corrected from its recent high leading to valuations coming down. While there would be near term uncertainty on growth and margins, I think it makes sense to look at the sector from a medium-term perspective," Darshan Engineer, Portfolio Manager at Karma Capital said in an interview to Moneycontrol.
Apart from IT, the recent market correction which has been brutal and swift, has definitely led to more sectors looking attractive now, he feels.
"We believe, Pharma, Auto, and BFSI sectors look attractive from a medium-term perspective, especially after the correction. Rate hikes will have a positive income on the margin profile of BFSI companies depending on asset and liability mix. Similarly, select Pharma companies have a healthy growth profile, with strong balance sheets and cash generation profile," Darshan Engineer said.
What are the implications if the inflation risk sustains and oil prices remain elevated for the rest of the year 2022?
A key reason for higher inflation is crude prices. If oil prices remain higher for longer, it would have a cascading effect leading to sticky and higher inflation. Normally, high crude prices and inflation cause a natural slowdown in the economy leading to lesser demand and correction in prices back to lower levels.
However, higher prices in recent months have been due to supply disruptions on account of the Ukraine war, and unwillingness of other producers to increase their production to fill the gap. If not brought down, it could lead to even more rate hikes by central banks including the RBI, which can further slowdown and delay the still nascent economic recovery. We are already seeing the adverse impact of high inflation on smaller countries such as Sri Lanka and certain South American nations.
Given the elevated inflation risk and weak global environment, do you think the Reserve Bank of India will cut the repo rate by 50 bps in June? What are your broad expectations?
Re-opening of the economy, the related pent-up demand, and huge liquidity infused by central banks in the past few years, have translated to strong offtake for various goods and services. This coupled with various supply chain disruptions on account of COVID and geopolitical factors, has led to elevated inflation in recent quarters which has not come down despite various fiscal actions by governments across the world. This can result in high inflation expectations getting entrenched in the economy which can be detrimental to the spending power of the population and consequently the economic recovery. Hence, it becomes critical for every central bank to ensure that inflation expectations don’t go out of control.
Even though governments are quite aware of the detrimental impact of higher interest rates on the still-nascent economic recovery, hard decisions are needed to be taken regarding rate hikes, while balancing between growth concerns and inflation. Hence, despite a weak economic environment with increasing concerns on recession & stagflation, they may have to raise rates further till the time inflation comes under control.
Hence, RBI too decided to go for an unscheduled rate hike in early May 2022. The bond markets had already anticipated the same and 10-year G-Sec yields had already breached 7 percent before the announcement.
In a recent interview, the RBI governor has already indicated further rate hikes in the coming monetary policy meeting in June. However, it remains to be seen how many and how much cumulative rate hikes will the RBI take going ahead. This is because the government has also taken several fiscal actions to tame inflation and bring relief to consumers. It will have a small adverse impact on its balance sheet but given the circumstances, it seems justified.
Do you think the Reserve Bank of India will lower its growth forecast further in the June policy meeting and will that be achievable in FY23?
Predicting growth forecasts is a tough task as it is dynamic in nature and gets influenced by various sudden external unpredictable factors. However, all data points indicate that the USA is likely to slow down in the near term on account of various factors. India is no exception and remains linked to the global economy in various ways. Hence, it will also see a slowdown in growth rate going forward. Already, several economic experts have downgraded their growth forecasts for the current year (FY23/CY22). Hence, it is likely that RBI may also revise its projections downward.
Technology is the worst hit sector in the current calendar year, losing 25 percent despite weakening rupee. Is it the time to bet on this space for a portfolio?
Disruptions from COVID benefited the Technology sector in a big way in the past 2 years. Spends on several areas of technology such as digital, expected to happen over a longer time frame, were accelerated and brought forward by their customers. Naturally, they have reported their strongest growth rates in recent years on a high base. Apart from that, profitability also got a boost due to muted marketing and travel spends, Work-From-Home environment, and other factors. Thus, the sector got re-rated in terms of valuation multiples.
In recent quarters, there have been increasing concerns on the sustainability of these beneficial factors. First, due to the strong demand environment, there is an increasing pressure on profitability due to rising wages and increasing attrition. Now, the latest concern is regarding the growth outlook as the probability of a recession/stagflation in developed markets increases, which may lead to delays/deferrals/cancellation of certain tech spends from customers in these markets.
Hence, considering the same, the sector has corrected from its recent highs leading to valuations coming down. While there would be near term uncertainty on growth and margins, I think it makes sense to look at the sector from a medium-term perspective. I would go for a stock specific bottom-up approach to investing in this sector. Companies with strong growth prospects and reasonable valuations can be considered now.
What are the pockets that are looking attractive now to buy with a medium perspective, and why?
The recent market correction has been brutal and swift, spreading across most sectors and market caps. In fact, it has helped valuations become more reasonable. This has definitely led to more sectors looking attractive now.
We at Karma Capital as per our evaluation believe, Pharma, Auto, and BFSI sectors look attractive from a medium-term perspective, especially after the correction. Rate hikes will have a positive income on the margin profile of BFSI companies depending on asset and liability mix. Similarly, select Pharma companies have a healthy growth profile, with strong balance sheets and cash generation profile.
Further, they have been reasonably valued for quite some time now. Auto and related ancillary companies have gone through a tough time such as de-growth in volumes, lack of demand due to secular price rise, and pressure on margins from high commodity prices, in the past few years on account of various reasons. Most of them are still to cross their peak in FY19. Hence, we expect the auto sector to report strong growth on various metrics, on a low base in the coming years.
Energy has turned out to be the best sector in the current calendar year, rising more than 12 percent. What are your thoughts and is it the time to stay away from the sector?
Higher crude prices and supply disruptions have benefited the energy and related commodity sectors the most in the past few quarters. In global markets, they have benefited immensely. However, in the case of India, the benefits are less evident as the sector is heavily regulated and serves as a public utility function thereby preventing the generation of super-normal profits for long.
Hence, Indian companies in these sectors are unable to take the full benefit from global trends. This was most evident recently when PSU oil marketing companies faced margin pressure in their marketing segment, as they were not taking regular price hikes, despite the high crude prices and the perception that they are now free from government control. Fortunately, they have been saved by the strong refining margins in the refining segment. Similarly, upstream oil producers also are unable to take full advantage of higher crude and gas prices as pricing is fixed and regulated in India. Downstream companies such as gas distribution companies are faced by margin pressures in such periods and face volume demand challenges.
The only comforting factor for this sector in this situation is that valuations are generally reasonable and supported by strong dividend and cash flow yields. Hence, we would be very selective in stock selection in such sectors.
What are your thoughts on corporate earnings announced so far? Do you think the risk of more downgrades is rising?
It has been a mixed bag as far as Q4 FY22 results season is concerned. Several consumer facing sectors have had to face higher raw material prices which they have not been able to pass on easily to their end consumers. Most companies took a call on balancing between volume growth, market share, and profitability. We have seen instances of companies who lost volume growth and market share to protect profit margins and vice-versa.
Overall, on a net basis, we have seen more downgrades in Q4FY22 than upgrades. This is a reversal from past few quarters which have seen more earnings upgrades than downgrades. However, there are always silver linings in each earnings season. Some sectors see a turnaround in their fortunes like Auto and Auto ancillaries who are seeing revival in volume offtake and receding pressure on raw material prices.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.