Investors cautious, reforms agenda not firing: Ambit Cap

Another roadblock is infrastructure. Mukherjea says though the government is placing more order in infra-related sectors - roadways, railways, etc. But execution continues to remain an issue - perhaps it will happen only in FY17, he says. So as a driver of earnings growth or economic growth, it won't be much helpful this fiscal year, he adds. Even in FY17, the pace of execution will be key, he told CNBC-TV18.

Below is the verbatim transcript of Saurabh Mukherjea's interview with Sonia Shenoy & Anuj Singhal on CNBC-TV18.

Sonia: You have been meeting a lot of clients in London lately do you get a sense that investors are losing a bit of patience’s towards the Modi government because there are reports suggesting that the land bill will not be tabled in the monsoon session. Some other fears as well. Are investors losing a bit of patience now?

A: I would put it like this, when I attended our same conference exactly a year ago, the talk largely was around should I buy Indian largecap or smallcap, should I buy cyclical versus defensive? This year the talk, the core of the investors' questions to me are around should we actually cut our exposure to India fairly meaningfully? Some of the largest investors attending our conference, their most tricky question to me growth isn’t quite firing.

Specific initiatives led by the PM apart it is not clear that the reform agenda is firing and it is not clear that the Black Money Bill while it is good for the county in the short run is particularly good news for India in the current fiscal. That is what would I say is the big shift. Year ago the question was what should I increase my exposure with respect to India - largecap, midcap, cyclical and defensives. This year the big question is should I cut my exposure to India quite meaningfully?

Anuj: Let us talk about stocks then, IT has started seeing some cracks, we have seen profit warnings from companies, Gartner has cut growth guidance, what is your call on the sector?

A: I wouldn’t go as far as to say that. I think the way we look at sectors like IT is you are bound to have ups and downs as these Indian IT companies are now hugely or largely dependent on western economic growth. As we go through where we had a phase through 2013 and 2014 where economic growth in the west especially America was surprising on the upside and those surprises on American growth were resulting in faster growth than expected in our IT companies topline, their new business wins.

Now, as America itself faces a degree of challenges on its growth trajectory, as the western world faces some challenges on its growth trajectory it will ripple onto us. However, as Accenture's number show, Accenture posted 10 percent revenue growth year-on-year (YoY) in its latest quarterly results, there is no reason to suddenly believe that IT services as a sector has fundamentally weakened. So, I would say companies such as Tech Mahindra which posted a fairly dire set of, companies like Tech Mahindra with its profit warning are actually well run companies. Tech Mahindra if you look at the last seven-eight years has been a stellar company, a profit warning such as the one posted yesterday are good opportunities to look at this company and say I should buy here.

Similarly HCL Technologies to our mind remains a first rate remote infrastructure management and engineering services franchise. I think it is worth buying HCL Tech as we approach the result season. So, I wouldn’t go with these sudden fads and fashions which develop in the Indian market where suddenly the market decides that the large sector which has done well for 20 years suddenly has lost its mojo; I don’t buy into that sort of thinking and my sense is specific Indian companies are worth buying even going into slightly choppy set of results.

Sonia: In the midcap IT space, are there any stocks that look exciting to you now?

A: In the midcap IT space I have to confess we have turned more circumspect. Some of the stocks which we had buys on say MindTree has done exceptionally well that we did have take our buy calls away a month or so ago. So, amongst the IT pack I would say Tech Mahindra and HCL Tech would be where the vast majority of our faith will be placed. Midcap IT many of the stocks we had buys on have already gone through our target prices. MindTree was part of our good and clean index till a month ago when we took out because of valuation concerns.

Anuj: We are very close to earnings season where do you see the biggest disappointment cyclical, cements, PSU banks I mean what sectors?

A: It will be cyclical; I have a very little doubt in mind that sectors such as cement where you still have the vast majority of the large cements stocks trading at almost record enterprise value per tonne (or EV/tonne) and EV/EBITDA valuations sectors such as industrials, such as private sector banks. That is where the bulk of the disappointment will come. So just to take it sector by sector, in cement volume growth will disappoint. There is a great deal of over optimism baked in to consensus estimates of cement volume growth.

In industrial, order flow and revenue growth will be a challenge as it has been for the last couple of years. Moreover, industrials profit margin will come under pressure. In private sector banks, asset quality deterioration will spring a nasty surprise. Loan growth has slowed down but that is well known. Asset quality deterioration will be a nasty surprise for a private sector banks.

Sonia: From an earnings point of view then what are the sectors to hide in right now where you expect relatively stable earnings this quarter?

A: I don't think it is as easy as that, I don’t think this is as easy as saying let us buy defenses and shy away from cyclicals. I think the thing where we are is that there are specific stocks, some largecaps, some midcaps where you have earnings visibility. So, for example Coal India you have earnings visibility, you have got fairly clear point of view from the government that volume growth will double digits, operating margins will be pretty firm and the free cash flow that Coal India has will go into more capex in the years to come.

Similarly, Power Grid Corporation has got a fair bit of visibility because it is a regulated return on equity (RoE) company, 15.5 percent regulated RoE company, order wins are very public, SEBs and central government is giving T&D business to Power Grid as a result with our regulated RoE order wins coming through, we have got good earnings visibility on Power Grid.

Similarly, in the midcap space a company like say PI Industries, 35-40 percent earnings CAGR over the last five to six years, return on capital (RoC) have gone from 18 percent to 25 percent, PI continues to do well. I saw them at our conference and I can see how impressive they are in front of world class FIIs. So, it is more stock specific now, some largecap, some midcap, you have earnings visibility and my hunch is the market will flock towards these few stocks with earnings visibility over the next six months or so.

Anuj: Infra stocks at least some of them have seen some buying. What is your call on the sector? Do you see some signs of government spending improving?

A: We have discussed this subject sort of thread bare with both, policy makers in Delhi and with corporate in the sector. And my sense is what is happening is reasonably clear and the market’s optimism around this is probably a little overblown. What is happening is the government is placing more orders, so whether it is roads, transmission and distribution (T&D), railways, it is very clear that order flow activity in these three sectors has picked up very materially. But, if you speak to the corporate and indeed, even to policy makers, there is still a big question mark on execution. It is not at all evident that execution will actually happen in this fiscal. It is more likely than not the bulk of execution and indeed, the vast majority of the execution related to these order flows will happen in FY17.

So, as a driver of either economic growth or earnings growth in the current fiscal, the pick-up in infra orders is helpful but not really a big driver of earnings growth or economic growth in the current fiscal. It is more a FY17 event. Second point I would make is even when we look forward to FY17, one still has to wait and watch to see what is the pace of order execution. Remember, this is the first time in this government’s life that they are ramping up order flow. Do they have it in them to facilitate the necessary clearances for T&D, for roads. We know that the land acquisition bill is stuck. But that apart, the other myriad clearance is the environmental clearance (EC), forest clearance (FC), the utility clearances that are required to facilitate road building. Can the National Democratic Alliance (NDA) provide those? Can they work with State Governments to provide those? That still remains a question mark. It is good to see the order flow pick up, it is good news, but I am not still yet counting my chickens, I would rather wait and watch and see what happens on execution before I start making it into earnings and economic growth.

Sonia: You have spoken to many midcap companies during the conference what is the key feedback and which sectors you reckon will outperform from hereon?

A: If you look at India there are three segments of our country which should do well as the resets that Narendra Modi government is pushing through as those resets bite. First is as they have attacked on black money bites flows of money into the financial system should improve quite radically over the next 3-5 years. As flows of funds into the financial system improve cost of funds for banks will fall. Particularly benefited by this would be midcap banks, small-cap banks whose current account- saving account (CASA) ratios are around in the mid-20s. Two - good examples are that would be our conference attendees, City Union Bank (CUBK) and DCB. So, CUBK with respect to South India, DCB with respect to Western India are both banks with regional franchises, mid-20s CASA. So, if the attack on black money that the NDA is engineering results in flow of funds out of real estate into the financial system, these sorts of banks with mid-20s CASA are natural beneficiaries.

The second area where the government seems to be fairly active is pulling back the subsidy regime, introducing direct benefit transfers in the context of subsidy regime and then gradually liberalising the whole subsidy regime. So, this week the NDA government is trialing cash for food. So, rather than giving food to below poverty line people, they are giving cash and the trials are being conducted in three Union Territories, Pondicherry, Chandigarh and Delhi. Now, this is the beginning of a process, we are gradually, the whole food ecosystem, the agricultural ecosystem will get liberalised in our country. In that context as you gradually agriculture, you liberalise the farmers ability to become a more commercially oriented economic agent. A company like PI industries, 40 percent rural revenues comes from supplying herbicides, fungicides, pesticides to Indian farmers is a natural beneficiary. PI also has a world class export franchise, 60 percent of its revenues comes from exports to global chemical majors. So, companies like PI who have a link into domestic agri ecosystem will also have a good export franchise I see as natural beneficiaries of the NDA's resets.

And the third grouping I would say are consumer discretionary plays. As we go from being a USD 2,000 per capita income country to a USD 4,000 per capita income country over a 10 year period, consumer discretionary sector, discretionary consumption will blossom in India and in that context companies like TTK Prestige would be natural beneficiaries.

So, that is how we have actually tried to construct our conference at Ambit. We look at macro themes, we try to identify good and clean companies in the context of the themes and then we try to take them around the world to meet the leading FIIs.

Anuj: You did an interesting exercise in terms of new stocks getting added to the Sensex by 2025. Can you give us the stocks which will get replaced?

A: I will just link it to the previous question you asked and what we did was we looked at how the Indian economy has changed over the last 20 years. We also looked at how other emerging markets changed when they made the move from USD 2,000 per capita income to USD 4,000 per capita income. There is at least a dozen emerging markets who in the last 20 years have made this jump; USD 2,000-4,000. It is a very significant jump. And what typically happens when a company makes this jump is financial savings rise quite radically and as a result, financial services sector becomes much better represented in the market. So, just to carry that theme forward, we see the Sensex 10 years hence, having in it banks such as Kotak Bank, IndusInd Bank, we also think life insurance companies will initial public offering (IPO) and ICICI Prudential as the largest life insurer in our country is likely to be a Sensex constituent 10 years out.

Secondly, as I was saying a few minutes ago, consumer discretionary blossoms as an economy takes off from USD 2,000 to USD 4,000. So, 10 years hence, we see in the Sensex not just companies such as Nestle and Page Industries but we also see in the Sensex e-commerce companies such as Flipkart and Paytm. The casualties of this change, I have just discussed some of the beneficiaries of the change, the casualties of the change would be what would be called traditionally old economy companies So, metals and mining, power and infrastructure, chemicals, petro chemicals, that is where the exits will arise from. So, in the context of our country, Vedanta, Hindalco, ONGC, that is where we see where the exits arising from whereas the entries come from the FSI and consumer discretionary.

Sonia: With the Sensex now at 28,000 if you had to crystal ball gaze for us what could the target for Sensex be say 10 years from now?

A: That was reasonably easy one to answer. Over 10, 20 and 30 years the Sensex has compounded by 17 percent. So, I am not that good at math's to compound 17 percent over 10 years in my head. The more useful number I can give to your viewers, is the Indian market has been very steady in spite of the many different waves of reforms that we have seen through the 80's, 90's and noughties the decadal return from the Sensex are pretty steady at around 17 percent. I doubt that will change going forward.