Short Call | ITC comes a full circle, smart money leaving small, midcaps, buzz over rail stocks, Indus Towers

In investing, rarely do more than three or four variables really count. Everything else is noise. - Martin Whitman

Invest first and investigate later - that seems to be the mantra right now for investors zooming in on mid, small and micro-cap stocks. News flow in terms of order wins, corporate restructuring, deals and collaborations has been positive, but the stocks are now pricing in earnings that is likely to be seen two or three years out.

In the months following the Covid lows, rookie investors fared better than experienced players because the new entrants asked fewer questions and blindly bought into a rising market. But now it could be the turn of the battle-scarred veterans. Investors who have seen the mid and small-cap meltdown of 2000, 2008, and 2018 have turned cautious on the rally in second line shares. They are willing to let go of the potential 10-15 percent gains from these levels, only too aware of how it will all end.

The strategy of many of the HNIs/operators have been to hold on to the good names, gradually liquify positions in iffy stocks and veer that money into large-caps. With fund managers already slowing their purchases of mid and small-cap stocks, the support of smart money for these stocks is as good as over. But with the overall mood still upbeat, the large investors are now turning their attention to large-caps that have underperformed so far.

The more things change…

“It is a win-win situation for all shareholders, the timing of the amalgamation is particularly appropriate as the travel and tourism industry in India is poised for rapid growth,” former ITC chairman (late) YC Deveshwar had said back in August 2004, when ITC had merged its subsidiaries ITC Hotels and Ansal Hotels with itself. The market cheered the move briefly and investors moved on.

Cut to the present day: the hospitality sector is again in the midst of a major boom that looks to persist as the ITC board has given an in-principle nod

for the demerger of the hotels business. The market greeted the news by knocking the stock 4 percent lower as the re-rating story now appears to have climaxed. Besides, the contours of the proposed demerger are not exactly what the market had been looking forward to, though it partly addresses shareholders’ grouse of ITC not generating enough returns on the money it was pumping into the hotels business. But more importantly, the ITC story is now fully priced with its market capitilisation not too far from that of industry leader Hindustan Unilever. To argue for a valuation higher than HUL at this point looks to be a stretch.
View on the street is that hereon ITC is a compounding story and no longer a rerating story. In other words, gains will be steady than spectacular. The derating began in 2014-15 when the ESG (environment, society, governance) fad began to take hold and some FIIs started paring stake.

That no longer seems to be a concern, considering that FIIs have increased their holding in the stock by over 10 percentage points over the last six quarters. In market parlance, the stock is now ‘widely-owned’ by institutions.

What could drive the next round of re-rating, if at all. “Possibly the company announcing a demerger of some of its other businesses as well, like FMCG. But if the hotel demerger has been in the works for five years, it is anybody’s guess how long the next demerger could take,” a long time watcher of ITC said.

Rolling stocks

Shares of railway companies are on the move once again as order flows remain strong. Titagarh Rail’s top boss Umesh Chowdhury said his company’s quarterly revenues should stabilise around Rs 900 crore, going forward. Just a couple of years ago, it took the company two quarters to gross that much. Choudhary expects margin in the passenger train business to improve significantly, and the order pipeline to keep on building.

The street is hanging on to every word as it pushed it to a fresh record high on Monday. Domestic fund houses have so far been cautious on the rail story as they feel over-dependence on a single customer comes with a high risk. But foreign investors seem to be slowly warming up to the story. The Smallcap World fund recently picked up a 6 percent stake in Titagarh. The narrative for rail stocks in general is that the cycle has decisively turned for the railway sector.

But investors would do well to have a look at the long-term charts of railway companies going back 10-15 years. These companies have been the flavour of the season, but it was then followed by a long spell of brutal price correction. For instance, Titagarh shares plateaued in the 150-180 range between 2015 and 2017 and then corrected more than 70 percent over the next couple of years even before Covid struck.

A similar trend was seen in Texmaco as well, which is yet to regain its highs seen in 2015. There may be a compelling story in rail stocks right now, but investors should also realise that risks have also gone up significantly after the recent run-up. A lot will depend on how well the companies are able to execute and how fast they are paid.

Indus Towers

A group of HNIs led by the Silent Operator have piled on to Indus Towers over the last couple of months. Shares of the country’s largest mobile tower installation firm, whose fortunes are closely tied to that of Idea Vodafone, has been a underperformer for a while now, in line with Idea’s poor financial health.

With Kumar Birla having rejoined the board of Idea, a section of the market is betting on a fund infusion in Idea. The story is that if Idea does well, it will be able to repay its dues to Indus Towers. The longer-term picture for Indus Towers looks a bit hazy given that its business model is under threat from the new technology that will reduce reliance on mobile towers for expanding connectivity.

Old school players are betting that the transition could still be some way off, and there are gains to be made in the interim

The recession debate

The US economy may have surprised investors with its resilience to high interest rates, but a section of the market remains convinced that a recession cannot be ruled out entirely. JP Morgan AMC’s head of fixed income Jonathan Liang said in an interview to CNBC that he expects the US economy to tip into recession either by the end of 2023 or early 2024.

The main driver, according to Liang, would be the balance sheet problems at regional banks. These banks will need to first repair their balance sheets that took a blow during the banking crisis in March and this means credit costs could get tighter, hurting small businesses.

Liang may have a point. According to a WSJ report, regional banks are cutting back on lending as it eases the pressure on them to raise deposits in a high interest rate scenario. A smaller loan book also means lower capital requirements. These moves helped stabilised earnings in the quarter gone by, but they also have repercussions.

“This puts things like auto loans, home mortgages or commercial-real estate financing in banks’ crosshairs for cutting back. That could be felt by banks’ customers and ripple through the economy, affecting car dealers, home buyers or big-city office districts.”