The chase of high growth has led to valuation skewness in the sectoral order of India's stock markets. So much that while investors have been out on a limb betting on NBFCs, they have been most downbeat on the IT sector.
But according to Dipen Sheth, Head of Research at HDFC Securities, the opposite strategy makes more sense now.
"IT has been grappling with a shift but the story is not over by any stretch of imagination," he said, adding that the transition to newer, digital business models will happen over the course of a decade. "[In the interim] there is cash flow and sustainability of earnings."
On the other hand, NBFC companies, who Sheth reckons have each found a lending niche in which banks were lacking, are doing a great service, he said. "But they are in bubble territory," he added, pointing out that stocks such as Bajaj Finance, Bharat Financial, Chola, Capital First, Ujjivan Financial and M&M Financial were all trading between 4 and 7.5 times adjusted book value.
He also talked about the broader market, saying that the benchmark indexes could overshoot fundamentals. "But you do not argue with liquidity. The PE ratio is sub 20. Can it go to 25? Yes. Will it be a good thing? Maybe not."Below is the verbatim transcript of Dipen Sheth’s interview to Sonia Shenoy, Latha Venkatesh & Anuj Singhal.
Sonia: You were listening in to the argument that Sunil Singhania of Reliance Mutual Fund was making. What are your thoughts?
A: I would completely agree with him. We are certainly not in bubble territory but here is the thing about pendulums. They rarely spend time in the middle although we know that is the equilibrium position. So, it is with market. We are on the verge, not exactly having overshot, but we are on the verge of overshooting substantially and there are good reasons for my saying that. So, you don't argue with the momentum when you see the gush of money coming in and Sunil is completely right when he says that 30x is a number that didn't rattle investors at one point of time and they burnt their fingers. I don't think we are at 30x we are sub 20x. Can this go to 25x, yes. Is that a good thing to happen - maybe not. But when it goes from 20x to 25x the guys sitting on the sidelines begin to panic buy and that is what makes it look frothy at 25x and you don't know whether it is going to reverse at 23x or 25x or 28x or even 30 for that matter. So, I hate to sound philosophical but yes, the money is coming in and we are going to get a ride is the sense I am getting.
Latha: Where will you then dip in? Let us start with IT. Those are the stocks that have not run away but with a reason. So, is that the space to buy?
A: Yes, the big picture in IT is that they are grappling with this big shift that is happening in the industry. Traditional services giving way to digital services. Application, development and maintenance (ADM) yielding more and more ground. You can see it across the banks, financial services & insurance (BFSI) space to products which is why of course companies like Majesco and Intellect Design Arena have got investors attention. So, it doesn't mean that the Tata Consultancy Services (TCS) and Infosys and HCL Technologies of the world are doomed at all. This shift is going to play out perhaps over a decade is the sense we are getting from my friends in Silicon Valley at least.
The people who are aligned with this shift will do well. So, you have a Mindtree. You have Infosys which is of course now lead by a transformational leader and having stumbled a bit this quarter I would say. So, these two steps forward and one step back will keep happening in IT. The IT companies in India represent the cream of our talent. They have been at the forefront of innovation and I don't think they have lost that game at all. Look at the resilience in TCS for example and on such a large base.
So, I don't think the IT story is over by any stretch of imagination. If you are getting the stocks at 12x to 15x look at their clean cash flows, look at their sustainability of earnings and I don't think the digital disruption thing is going to eat into their profits as fast as we might think.Anuj: Reading your report is there a bubble in Non-Banking Financial Company (NBFCs), answer that. There is one argument which says look at the return on equity (RoE) for example for Bajaj Finance and look at the compounding story and then of course we have price to book value?
A: Look at Bajaj Finance and Bharat Financial Inclusion or SKS Microfinance as you would call them from their earlier name. They are both at something like 7.5 times trailing book value. That is unnerving. Fortunately or shall I say unfortunately, we don't have them under coverage and I really wouldn't know how to value them right now, but what they have been rewarded for, and they are not isolated. We have Cholamandalam Investment and Finance Company Limited (Chola) under coverage and Chola is trading for a shade under 6x trading book. Capital First also under coverage is trailing at something like 4x, Ujjivan Financial Services and Mahindra & Mahindra Financial Services that is at almost 4x.
Now, why are they getting this kind of multiples? There are two or three reasons. To my mind they have mastered the art of specialised lending in a fast growing niche and each one of them has their niches. Bajaj Finance has a whole lot of niches of course. And if you look at a Mahindra, if you look at rural, you look at a Chola, then you look at the top of the bottom of the pyramid in terms of up country vehicle financing and then he has punched that with a very interesting home equity business. So, each one of these guys is doing things that traditional lenders have failed at or aren't good enough at. Otherwise where was the need for NBFCs in this country?
So, to my mind, they are doing a great service to the borrowers. Some of them are lending at apparently usurious rates but that doesn't matter because anyways they are replacing even higher priced lenders. However, if you look at the microfinance guys for example and two of the microfinance guys are converting into small finance banks. The large financial companies, the banks, even some of the private sector banks have been caught napping if you look at the growth that some of these NBFCs are doing. So, is there are bubble, valuation wise yes, reward wise and salute wise certainly not.
Sonia: Very interesting, in the consumer space the stocks that you have, Maruti Suzuki and V-Guard Industries are the stocks you like the most. Maruti Suzuki, okay understandable because of the way it is growing. But V-Guard is a stock that has doubled since the month of March. Is the growth compounding as well?
A: If something doubles doesn't mean it can't double again, and then it can't double yet again. So, we have seen that happening for an Eicher Motors, we have seen that happening for Bajaj Finance, we have seen that happening for Shree Cements. It is at Rs 16,000. I have seen the stock at two digits and I am going back two decades of course.
Latha: But is V-Guard in that league?
A: I will tell you what is right with V-Guard. They have a superb brand name which they have built and it is not a brand that has been created out of fancy full page advertisements in newspapers, with venture capital money. It is a brand name that has been built out of top class product quality in something very critical such as voltage stabilisers and voltage stabilisers which were a fraction of the cost of an air conditioner or a fridge that you had bought and you bought it along with this and you were thankful that you bought because your neighbour's fridge burnt out or his AC broke down or something and he had to blow a whole lot of money. Now they have extended the brand equity across, a whole lot of other electrical products and home appliances, so that is one.
The second, they have got a very strong footprint in southern India but they are still to build out a substantial network in northern India which of course they have started and they are gradually picking up there. Third, it is not just the monsoon but the percolation of real incomes across midtown India away from the metros and that is a 10-15 year story if you ask me and as soon as the first bits of income begin to percolate down. So, India's demographic/macro story is completely or V-Guard's business is completely aligned with that story. Look at basic penetration of household appliances like even fans, is still low; forget the toasters and the microwave and stuffs like that. So, there is growth ahead of V-Guard and 20-30 percent growth. So, if we are valuing them at funny multiple and giving them 24-25-28x I am not ashamed to do that.
Latha: Coming to the sector that Maruti Suzuki represents. On Friday we saw Bharat Forge's numbers being taken in their stride by the market and the market giving them actually a 7-8 percent gain after the numbers that disappointed. How do you look at this space? Are these the guys to look forward - those that seem to be the laggards in the race but are potentially good companies?
A: Nobody is a laggard forever and nobody leads forever. Unless there are very good reasons for that and there are structural reasons for that. So, Maruti Suzuki has been the leader, Maruti Suzuki will continue to be a leader and the leadership is based on excellent product quality, great product line coming up, super research and development (R&D) and new product pipeline so to say over the next few years completely in alignment again like V-Guard with India's macros. Car ownership still remains abysmally low even seen in the light of comparable economies let alone the higher income economies.
In the case of Bharat Forge let me flip an old adage from the markets which is that in the case of Bharat Forge people sold the rumour and bought the news, if you know what I mean. So, it was in trouble, it was very clearly in trouble and to figure out that Bharat Forge is in trouble you don't need to look at Bharat Forge's numbers. All you need to look at is class A trucks or whatever it is in the US and people have been crying hoarse over this for some time. So, yes the numbers were bad but everybody knew they were going to be bad. And can they turn now is the question. So, 1.2 percent headline macro growth print in the US but a very strong jobs number, so the jury's out whether the truck market will revive or not but certainly the US economy is not as soft as what Europe or Japan might be. So, there is some amount of hope being placed there.
Anuj: My mind keeps going back to Navin Fluorine International Limited. Two or three quarters back you identified and that has had a stunning run. On that space, Navin Fluorine, SRF and all and anything else that you spotted in the midcap markets where there could be such parabolic rise?
A: Yes, I wish I could tell you with some conviction. So, despite the run up in V-Guard for example we think if something is good enough to grow for five or six years or even 10 years then assigning at a 25 or 27 multiples doesn't look like a bad idea. Gulf Oil Lubricants came out with fabulous numbers last weekend, confirmed our thesis and indeed our preference for Gulf Oil Lubes versus let us say Castrol where volume growth is not so evident and the new plant coming up and distribution getting more rationalised with it and of course not to mention the salutary impact that Goods and Services Tax (GST) will have on a company like this. High return ratios, good pay outs, there is no reason why even here on Gulf Oil Lubes cannot grow.
Sonia: Since we are talking stocks, let us come back to that argument you made about IT and you have been contrarian in a way you have chosen a downtick in sectors to buy into individual stocks and you mentioned that in midcap IT Mindtree is a stock that you can buy on any dip. What is the story there?
A: The thing in Mindtree is that for a midcap of its size it has got disproportionately large revenue from the digital revenues stream which bodes very well for its growth in the future. Now, the last quarter was an absolute miss, let us not mince words here. So, we love it when good companies go through tough times and it gives investors an opportunity to buy them and it gives us an opportunity to re-recommend them as it were. They are having some kind of an analyst meet today and a lot of their troubles are going to get dissected painstakingly I suppose, but what stands out in my mind on Mindtree is one, it is leaning towards the digital space, two, it is very efficient mining of top client accounts. The last quarter was certainly a miss, they suffered on pricing, they suffered on effort mix in terms of offshore onsite and they suffered in terms of Bluefin and their exposure to Europe and particularly UK. They are good folks; they will get it right over a period of time. This is a time to build faith in guys like Mindtree.
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