The market may be in a multi-quarter slowdown, driven by monetary and fiscal tightening, and global factors, according to Saurabh Mukherjea, founder and Chief Investment Officer (CIO) at Marcellus Investment Managers. Amid this challenging business environment, he believes that eventually, men will be separated from boys.
Mukherjea explains who will emerge stronger, what will give them their right to win, what are the themes to play and what are the risks to consider.
He made these observations while speaking to Moneycontrol as part of the Diwali Special Samvat 2081 conversations.
Watch the full conversation here
Edited excerpts from the interview:
Over the last four years since the Covid-19 pandemic, the value trade has been back in play. PSUs (public sector units) went through the roof. Investment led stocks did well, everything to do with government expenditure did well. Do you see that trade reversing?
Post Covid-19 pandemic, we had a blockbuster economic recovery. Financial year (FY)22, FY23 and FY24 we saw 7.5 per cent GDP (gross domestic product) growth in India, 20 per cent EPS (earnings per share) growth at the market level. Naturally, under such circumstances, the market found Marcellus-type stocks very expensive.
2022-2023 were blockbuster years for PSU-type trades but, over the last six months or so, the economy has started slowing down. The post-Covid-19 pandemic recovery was cyclical, it wasn’t structural, and now it is ebbing.
We are entering a cyclical slowdown, which is evident in June quarter and more so in September quarter earnings. We are entering a multi-year quarter slowdown. In that earnings slowdown, the usual stalwarts that Marcellus has backed for many years, Asian Paints, HDFC Bank, Titan, Divis' Lab, their earnings are holding up far better than the broader market.
The market is oscillating away from PSU-type names to the sorts of names that Marcellus has had in consistent compounders for the last five years. It's not so much that value is out of fashion and growth is in fashion. As the economy slows down, the market is going back towards the consistent compounders.
How long do you see the slowdown last?
Whenever a central bank hikes rates by 200 to 250 bps (basis points), with a year to 18-month lag, the economy slows down. The hikes of 2022 and 2023 are biting in 2024. Consumption growth has slowed down pretty much across the board, not just a big ticket, even small ticket consumption growth has slowed down.
The second piece was the government stimulus, which was massive during Covid-19. Over the last three years or so, (the Finance Minister) Nirmala Sitharaman has reduced the budget deficit and the fiscal policy also has turned contractionary. So, you have a monetary policy which has turned contractionary, a fiscal policy that has turned contractionary and the global economy also has slowed down, naturally the Indian economy is slowing down as well. In the September quarter, I suspect, at the market level, we'll end up with close to zero earnings growth.
Until the monetary policy turns expansionary again (and I don’t think the government is suddenly going to be fiscally expansionary)… so if the RBI (Reserve Bank of India) starts cutting (policy rates) in say December this year, we could be looking at the economy recovering at the middle or end of next year. Towards Diwali 2025, we could see corporate earnings growth picking up again.
It is quite remarkable that you are saying that we are going to see zero percent earnings growth this quarter. Analysts’ consensus estimates also have it that we will see only 2 per cent earnings growth this quarter, the lowest in 17 quarters. What is creating this level of stress? Of course, one reason is the high base.
The forward P/E (price to earnings) of the Indian market will be around 23, 24. Long term average P/E for the Indian market tends to be 16, 17. We are a good one-third or even 50 per cent above the long-term average P/E.
Bloomberg consensus (on earnings growth) for the year ending March 25 was 15 per cent. I think that's highly, highly unlikely. If earnings growth is more like 4-5 per cent. It means a meaningful market pullback over the coming few months.
On why are we seeing the slowdown at all? One part is of course explained by the (high) base. The other is that, post-Covid-19, private capex (capital expenditure) hasn't really kicked off in any meaningful way and it was largely government capex. For reasons I can’t fully put my finger on, government capex seems to have throttled off big time. Also, consumption has been weak for a couple of years and it seems to be weakening further. A combination of factors such as weak job creation in the private sector, especially in the IT (information technology) services sector, although it (job creation) seems to be reviving; interest rate hikes causing households to spend bigger and bigger portion of their income paying EMIs (equated monthly instalments) rather than spending it on consumption; and the government fiscally consolidating…
I think this is the first I can remember for many, many years, India's elite institutions, including say the IITs (Indian Institute of Technologies), not being able to place a good third of their students. That gives you a sense of how weak the private-sector job creation market is.
I think all of this is cyclical, we are a free-market economy. You've had three years of tremendous growth. You're bound to see a cyclical lull for a year or so.
As monetary policy turns constructive, hopefully by Christmas, in the second half of next calendar year, we'll see the economy perking up again.
Has the trend of business moving from unorganised sector to organised sector played out?
There are two developments and perhaps they are neutralising each other. First is formalisation of the economy, which means that companies that didn't pay tax, are now paying tax. That’s still playing out. Direct tax collections are still robust; in FY24, the collections were growing at 16-17 per cent and, in the first half of this fiscal, F25, direct tax collections have also been very healthy, with mid-teens growth. Direct tax collections growing considerably faster than nominal GDP would suggest that more businesses are coming into the ambit of the formal taxpaying economy.
The counteracting force is black money, there’s plenty of that in India. Wherever I'm traveling, I'm seeing a plethora of unorganised sector brands. Distributors and dealers say that cash is back big time and not just in real estate but generally in the country. This black money is allowing unorganised brands to flourish. Therefore, there is very much a reversal of the formalisation trend that we had seen under the NDA and NDA-2 (National Democratic Alliance)-led governments up to say 2021.
But, with direct tax collections growing at a rapid clip, I would still say that we're moving in the right direction.
Is this observation on the expansion of black-money in the economy based on anecdotal evidence or are there any hard numbers pointing that way?
For one, you see organised FMCG (fast moving consumer goods) companies reporting absolutely dire numbers. Their numbers have been unbelievably weak for the last two to three years. You don't expect to see a Dabur having negative growth, right? That makes no rational sense or an HUL (Hindustan Unilever Ltd) having 2 per cent volume (growth). Quarter after quarter, you're seeing undergarment companies such as Page Industries reporting zero growth in a country where population grows at 2 per cent. That’s when we realised that we are seeing a revival of unorganised sector brands.
In places such as Haryana, Punjab, Uttar Pradesh, there are shops that will say Havells or a Polycab on its board but every single item in it will be a brand that you and I have never heard of. Often they'll tell you that these are made in Tamil Nadu, shipped all the way across to the other end of the country where it's doing booming business and being sold in cash.
Black money is back also in the property market. If we speak to our friends in Delhi-NCR (National Capital Region) or in Gujarat or in Madhya Pradesh, they'll give you the ratio of black to white and the ratio is skewed in favor of black once again.
Therefore, there are two pressure points to deal with: one is a slowdown in tax collections and the other is taking away market share from listed companies. This is causing stress in the private sector and reducing government’s revenue streams.
Just to clarify, direct tax collections are holding up, but the GST (Goods and Services Tax) piece is flagging. The GST piece flagging seems to correlate with the revival of a cash economy for black economy, which in turn is robbing the exchequer of revenues. If tax collections falter on account of this (the build-up of black money), then that has a bearing on the government's ability to spend on capex, which in turn has a bearing on the whole contractor economy spanning defense and railways and roads.
All of that being said, I'm still perplexed at the scale of the government capex pullback that doesn't sort of square off with the numbers in the budgeted allocation that Sitharaman announced on July 23.
This (the capex pullback) in turn is contributing to the earnings slowdown because a big part of the index's earnings growth was PSE (public sector enterprises) and this whole contractor economy showing EPS growth.
A lot of the readers would be interested in the trend of unorganised-to-organised conversion, which was one of the pillars of growth in small and mid-cap companies. What does this trend (reversal) mean for that segment of the market when several investors already believe that valuations may be a little exaggerated?
Valuations across the market are exaggerated but it's true that smid (small and medium) cap valuations are more exaggerated than large cap. If the smid cap earnings slowdown is more pronounced than large cap, then it stands to reason that the smid cap share price pullback will be sharper than large cap share price pullback.
Large caps, especially on the quality end of the large cap spectrum where you have names such as HDFC Bank, which are trading at 20x or less on PE multiples, so the concerns are less there. The concerns are most acute in small cap and specifically in what would be called the small-cap value.
On how to think about this, one should worry a little less about large caps than about small caps. Small caps, especially the ones that have had a sharp rally in the last two, three years, potentially could see pullback that is sharper.
What are your thoughts on consumption and the various pockets of consumption such as staples, discretionary, rural versus urban, mass versus luxury?
The view till a few months ago was that, in the K-shaped recovery, the uparwala danda (the upper arm) of the K (which captures growth in the premium/luxury segment) looked to be more insulated than the lower danda of the K. But I think with the weakness in job creation in IT services, weakness in job creation in the formal sector, even the uparwala danda of K is under a little bit of pressure. You can see that in passenger vehicle sales and in consumer discretionary sales... So, across sectors, we are seeing pressure on consumption.
At Marcellus, we made a call seven to eight months ago that the polity will have to swing towards helping rural India from an electoral perspective by extending subsidies, higher MSPs (minimum support prices) and so on. Therefore, seven or eight months ago, we built a position in Godrej Agrovet and it still remains a large position for us. We entered at valuations which were pretty undemanding. We entered at 20x earnings and it’s pushing towards 30x earnings now.
Tata Consumer (TCPL) also emerged as a candidate that we have invested in. In TCPL, the valuation is high and therefore we're being a little cautious. But given the more prosaic nature of what they sell, we're hoping that the consumption slowdown won’t bite.
To add a disclaimer here, all the stocks I'm mentioning are part of our portfolios. I'm invested in our portfolios. My parents and our 7,000 clients as well are invested.
Are there a few luxury plays?
We stay invested in Titan, which is more a play in gold than watches, but gold is doing well. The watch's piece of Titan is barely 10 to 15 per cent of profit, but as a jeweller Titan is holding up. It remains a big chunk of our portfolio.
We stay invested in Royal Enfield, Eicher Motors. Other than Bajaj, with their Triumph, none of the new entrants have been able to pose a meaningful challenge to Royal Enfield. Their export piece is also doing well, Volvo Eicher’s trucks are continuing to gain market share.
You said Titan is a play on gold prices. Are gold prices doing well because of geopolitics or is there anything else?
It’s a very good question, on what is driving this blockbuster demand for gold.
Demand for gold is very strong in India. In Titan's case, we are pretty confident that they follow all the rules and regulations, and therefore the gold that they're selling is being bought with white money.
But gold demand is strong and part of it could well be because even affluent Indians are saying we need to continue saving a significant chunk of our money through gold, whether it's because of their innate skepticism of financialisation or whether they are also trying to hedge their bets given where the stock market is.
What about stocks such as Zomato, Paytm? Many of these have run up sharply because there is greater level of confidence in them. What is your take on their fundamentals, is there more headroom?
We are longstanding shareholders in InfoEdge, which has a substantial stake in Zomato. We've benefited therefore.
A big part of Zomato's success has been that the funding ecosystem dried up completely for everybody barring Zomato and to some extent Swiggy. Therefore, we ended up with a duopoly in the food delivery space.
Credit to Zomato and credit to Deepinder (Goyal, CEO of Zomato) for having the clarity of thought to buy BlinkIt. I hadn't figured this out (then), it's only with the benefit of hindsight (that I have come to appreciate it). It’s a great play on affluent Indians wanting things fatafat (in quick time) and you've got low-cost labour who can deliver things to affluent Indians.
So, the quick commerce piece, again, there's only so many players who can get funded. Reliance is backing a quick-commerce (q-com) (but) there's only two other players properly financially backed q-com plays in the country; one is owned by Swiggy, one by Zomato. You have ended up with a duopoly sector until the funding winter for venture-capital continues. Funding winter could continue for a year or a couple of years more.
You have always been bullish on HDFC Bank but private banks have been overall a disappointment of sorts. Is there a turning point in sight?
I think the turning point is the RBI's announcement recently. There's a lot of funny stuff happening in the financial system and the central bank is trying to clamp down on them as evidenced by the four lenders that the RBI ordered cease lending.
When the economy is booming and asset quality is benign, then you can't separate men from boys, women from girls. It's when the economy starts softening as it has that you will see sharp demarcations in asset quality. HDFC's asset quality is on a different planet to any other private sector bank. In the coming quarters, that discipline, the ability of this large bank to lend at scale and still keep asset quality strong in a soft economy will become very apparent. In parallel, RBI will clean up what's turned out to be a fairly unruly lending ecosystem.
In micro-finance, you can see unsecured lending, NPAs (non-performing assets) are going up pretty much across the board.
We remain large investors (in HDFC Bank) and the fact that it's cheap has emboldened us to build a large position. I think that our largest holding.
Is it only HDFC Bank or are there others? For example, you have also been extremely bullish on not a bank but Bajaj Finance for a long time. Is that changing?
Our big holdings and lenders are HDFC bank and then Axis Bank, which is a smaller holding. Bajaj Finance is a significant holding but we have pulled back on it because asset quality is going to be under pressure. The NBFC (non-banking financial company) has greater exposure than the banks to unsecured (loans) and will face asset-quality pressure. In smaller lenders, we have Mas Financials, which I think will hold up. They are experienced at smaller ticket sizes, very high interest rates (segment).
Overall, I expect the men and the boys to separate sharply. As the PSUs come under pressure to oblige their political overlords, their asset quality could also come under pressure in the coming quarters.
Over the last seven months we anticipated the IT sector bottoming out, so we built up positions in HCL Tech and in R Systems, one in large cap and one in small cap. L&T Technology Systems (LTTS) has been a long-standing holding.
We broadly hypothesise that when the rate cutting cycle begins in the US, the US companies will start spending on IT services. There's tonnes of work to be done on AI (artificial intelligence) and cloud, and the Indian companies will get a chunk of that. We continue to look for more investments in that space.
I mentioned the piece around rural (consumption support from government spending). So we built a position in Godrej Agrovet, a small position in Dodla Dairy based out of Hyderabad and in Tata Consumer. In one way, Eicher Motors is a play on rural (consumption) because Royal Enfield has a big following in the farming community.
We've also built a position in Escorts Kubota. We think the Japanese are doing a terrific job there.
Thailand is Kubota's current global export hub. Kubota's now announced a Rs 3,500-crore project in western UP, where they want to set up their global export hub. So, Escorts Kubota India becomes Kubota's global export hub and Kubota is a superstar in the tractor industry globally.
Kubota is famous for Kaizen. They potentially shave off 200 bps of Escorts’ cost and thus boost margins. Then if the farming sector comes to the party in the wake of the government doing more reforms for the farming sector, then so much the better. That's our second favourite hunting ground after the IT piece.
We've continued with large holdings in Divis Lab because we believe that it will be a play on China-plus-one (theme). It's a world-class API (application programming interface) manufacturer and has been so for 20 years.
Alkyl Amines remains a substantial position in our smid-cap portfolio. It's a well-run company, acetonitrile sales are booming again. And as and when the government decides to put anti-dumping duties on acetonitrile, I think I'll start to see a sharp rally.
Where do you stand on specialty chemicals as a whole?
We've tried to separate the ones which are in the firing line of Chinese dumping, from the ones which are more insulated from the dumping. Broadly speaking, if it's a spec-chem manufacturer, we think of Divis as a spec-chem manufacturer and it can hold up to whatever the Chinese do because of its enormous pricing power.
Alkyl Amines wasn't quite able to do so because acetonitrile is a commodity to some extent and therefore Alkyl suffered on account of that. We have lived through a 50 percent drawdown in Alkyl (Amines) and we hope now that the drawdown corrects. The import data that we get suggests that Chinese dumping of acetonitrile has kind of maxed out and Alkyl's own record sales of acetonitrile also suggests the same.
We've also stayed invested in Clean Science because it is the reverse. Clean Science exports to China rather than being at the receiving end of Chinese dumping.
We left Paushak a year ago because I made a mistake. I thought it would be insulated from Chinese dumping. It wasn't. Once I saw that the phosgene derivatives that Paushak makes were being dumped by the Chinese, we realised that we needed to cut our losses and get out.
It could well be that this is the bottom of the cycle, but even if it isn't, the Chinese stimulus that's being injected by Beijing should mean that 2025 brings better news for Indian specialty chemicals.
Tell me about your take on autos because that's a motley bunch. Each company has a different complexion. Some are in EV (electric vehicles), some are a non-starter. Now, there is Ola, which had a huge listing and then the drawdown happened. Then Hyundai came to the market. So, where do you stand on the EV play versus the non-EV play?
Barring Eicher Motors we don’t have an auto OEM (original equipment manufacturer).
There are a couple of reasons. One is that we are not sure if we can spot who will successfully transition from ICE (internal combustion engine) to EV. Secondly, whether it is ICE or EV, it is not clear to us that we have companies with competitive advantage. If you look at Indian auto OEMs, you'll struggle to find one which on a cross-cycle basis grows at more than 14-15 per cent, which signals that it’s difficult to generate competitive advantage. History suggests that it's difficult to find Indian auto OEMs whose cross-cycle growth is rarely more than the index in terms of EPS growth.
What do you think are the three biggest risks?
The fiscal situation seems a little fluid. If GST collections are going to slow down at this rate for the next few quarters, then there's probably a steeper fiscal belt tightening than perhaps we had reckoned with. If the government has to spend more on rural (population), on farmers, then there’s even less left for the capex piece, which in turn poses a risk to the stock market because a big part of the stock market is driven by government capex today.
The third would be the situation outside India. I haven't seen this level of volatility in my career. I can't remember too many years in my career where there were two big wars underway in strategically important regions of the world. The Middle East and Ukraine might not be massive economic centers, but strategically these are important. The risks of a broader conflagration and therefore (on dampening) the investors' risk appetite (cannot be overlooked)… Alongside that, you have elections coming in America. If the politics stays under control outside India, the Fed keeps cutting, then that will give the Indian market a strong support. In 2025, we will need external support. We will need FII (foreign institutional investor) flows to hold the Indian market up.
What is the best way to describe the past year and how would you describe the coming year?
The last few years, Covid-19-year itself, I was pleasantly surprised to see India's resilience, how our authorities dealt with it, how the people dealt with it, and how society came together to deal with the pandemic. The post-Covid-19 boom has been a joy to watch. And I would call that the last four years, the unusual rise of modern India. I still remember Western pundits denigrating India, painting all sorts of apocalyptic scenarios that they believed India would go through. Well, we didn't go through that. Instead, what came out of Covid-19 was a resilient, high-performing economy, and we pulled away decisively from China.
The next few years will be the Western world realising finally that this is a mega economy, the world's fourth biggest market, fifth biggest economy, and it's here to stay. The imbalances that the West has historically sort of maintained in its relationship with China versus India--the Western economies have invested $3 trillion (Rs 252.27 lakh crore) in the Chinese market versus only a trillion in India — these imbalances will be corrected with trade flows and financial flows over the coming few years.
Is there a movie or a song or a dialogue to describe the past year and the next year?
If you take the last four years, it's been a break up into good, bad and ugly. The good has been the post-Covid-19 recovery, the stock market boom, formalisation and financialisation. The ugly was obviously the depths of the Covid-19 crisis was sad, was ugly, but the whole world went through it. The bad piece in a way we haven't seen yet. Bad in the sense that we're getting a resumption of what we had seen for many years, which is the black economy takes off, the default narrative that India had built of progress or prosperity potentially gets challenged.
We’ve got a little bit of bad coming up in the coming quarters. We need the RBI to cut, the sooner it does the better. The sooner the Western economies revive, the better.
What’s the one contrarian high conviction bet you have? This is Diwali, so make a bet.
It is highly likely that, in 2025, the old-fashioned IT-pharmaceutical-FMCG troika is coming to the party again big time. Pharma has been doing well because China's banged down the prices of pharmaceutical raw materials. IT has only just started its recovery but it could sustain pretty powerfully into 2025, especially if the Fed continues cutting. FMCG could once again become glamorous, if the government rolls out the red carpet for rural India.
Where do you expect Nifty to be next Diwali?
Over the next 10 months, over the next 12 months, if the Nifty does even high single digits, I think we should be very happy.
Now coming to your book. First of all, congratulations on the new book. What can investors hope to learn from it?
One of the most noticeable aspects of the post-Covid recovery was female employment, female education, and female earnings. That became one of the five planks on which we built this book. What can investors learn from the book?
A lot of what's actually happening in India is largely unknown to Indians themselves. We live in large, relatively prosperous, relatively advanced cities but the transformative changes are really happening in the smaller towns such as Coimbatore, Tirunelveli, Trichy, Indore, Kolhapur, Sholapur, Kanpur, or Ludhiana.
The first is the rise of women, the fact that they now have more money in the bank than men, they have more bank accounts than men, their default rates are half of that of men and increasingly women-run SMEs (small and medium enterprises) are doing better than many male-run SMEs.
The second is that the nature of the Indian elite is changing. The people who are running India are local graduates. If you see the data on Indian boardroom composition, non-IIT, non-IIM (Indian Institute of Management), non-overseas directors now dominate the boardrooms of corporate India. This transformation of the elite has bearing on what items they spend on, how people show status… That again has a bearing on how investors should think about investing. Finally, south India is now a quarter of India's population, half the GDP and two-thirds of the GDP growth. It's the fastest-growing region in the world. It's been like that for the last decade.
I would submit that south India is going to be the fastest- growing region of the world for the next decade. And therefore, over indexing on companies who have a disproportionately high exposure to South India would make a lot of sense.
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