Three reasons why JP Morgan‘s Iyer is bullish on cement

The third driver for cement could be very low input costs;we have seen a very meaningful reduction in coal costs,” he says.

On the broader market, Iyer says the risk to the Indian market is more from external factors like crude and global liquidity, than any internal problems, 

He says urban demand has bottomed out and is even showing a slight recovery, but not good enough to offset the weakness in rural demand.

He does not see a recovery in private sector investment anytime soon, and says much of the capex spend will be by the government, with a focus on roads, railways and defence.

"Companies that are geared to these opportunities should be very good to pick on," he says.

Iyer says the market has already discounted weak June quarter earnings. He expects aggregate corporate earnings of 10-12 percent for this fiscal.

He says there was a disconnect between valuations and the ground situation at the begining of the year, but that has narrowed with investors toning down their expectations.

He sees limited scope for rate cut till monsoon is out of the way. If rainfall is adequate and crude prices are stable around USD 50 a barrel, there could be one rate cut in the last quarter of this fiscal, he says.

Iyer is bearish on two wheelers and tractors as he feels rural demand will be under pressure for another year. He is bullish on passenger cars, but not trucks as he is till cautious on the investment cycle.

With consumer discretionary stocks, Iyer is more bullish on FMCG because lower input costs will provide some relief for operating margins.

He feels IT is still a reasonable investment bet from a two to three year perspective, except that one should focus on the better managed companies. 

Below is the transcript of Bharat Iyer’s interview with Latha Venkatesh and Sonia Shenoy.

Sonia: First a bit about what the market setup is looking like because so far the going has been good but now reality hits us with the weakness in earnings, etc. How are you wading through all of this?

A: Earnings are a near-term distortion as far as the markets are concerned but you will appreciate that earnings estimates have been coming down for 12 14 months and that has not been a dampener for market. The market have held their own, they have done well and as we see it the market basically is been driven by two factors, one is from a local perspective – progress on reforms and two is from a global perspective – global risk appetite. So, as long as these two stay supportive, no one needs to worry about the market. 

Coming to earnings specifically, our own call is that you perhaps have another couple of quarters of weakness but going into the second half we should see things pickup.

Sonia: You said progress on reforms and that is interesting because the monsoon session of the parliament kick starts tomorrow. I don’t know whether there are too many expectations because there is a lot of work being done outside parliament as well but what is your own view?

A: I think the government in terms of the job they have done so far, I think that has been fairly positive. We have seen meaningful improvement in governance, in the kind of clearances they have given out, we saw both telecom and coal auctions go off without any hitches and they got very good money for it. If anything the private sector complained that they had to pay a lot. We have seen foreign direct investment (FDI) limits in defence and insurance being increased.

We have to concede that they have a binding constrain in terms of not having the numbers in upper house of parliament and reforms that require legislative reform will need consensus building.

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Latha: I heard you speak about global liquidity, in the last two to three weeks we have got some positive foreign institutional investor (FII) flow, there appears to be a short crude, long India trade playing out. Has that trade got more legs?

A: I believe so because it was not just the short crude, long India trade, it was a combination of factors. We saw global risk appetite in general cool off a bit on the back of events in Greece and China and what we have seen is there has been a fair bit of relief in those two places as well. So, it is a combination of factors – Greece and China have settled down, crude has come off and we are also seeing locally the monsoon is a little better than expectations. So, I guess it is a combination of reasons and what we are seeing is more of a relief rally in that sense.

Latha: Let me read a bit of your note, I am given to understand – this is a paraphrasing of your note, not verbatim that at a sector level capital goods, telecom, utilities and consumer staples are expected to see relatively healthy earnings growth. I have some worries about couple of those sectors. Consumer staples, is really urban demand picking up enough to counter rural growth? We understand that rural demand has been still quite bad.

A: I agree with you. I think urban demand has bottomed out decisively and is showing some signs of picking up. However, by itself is it enough to offset the weakness in rural demand? Not necessarily, not at this point in time which is the reason the preferences for picks of companies are more geared towards urban demand rather than rural demand.

Latha: Utilities, that also kind of had me wondering, you would have to be very picky isn’t it in utilities?

A: Absolutely, the preference will have to be for the central government utilities as well as couple of the private sector utilities which even in the last quarter you would have noticed had a very good free cash flow operating environment. So, you have to be picky; absolutely right on that.

Latha: Capital goods - what would be the pick of the pack, how should an investor go discerningly about this pack because capex at least is not taken off?

A: As far as the capex cycle is concerned, one has to view it from the prism of the fact that private sector capex is not going to pick up in a hurry. The private sector has constrains, they see a very iffy global environment, leverage is very high there. So the onus is largely on the government and from the government's perspective it appears that they are focusing on three areas roads, railway and defence. So companies that are geared towards these opportunities should be very good to pick on.

Sonia: What kind of performance do you expect to see from the index for the rest of the year? Are there any more gains that one can expect or do you think the best of the news is already in the price?

A: What we like about the market at this stage is that they have consolidated for the first six or seven months of the year and there was a meaningful discord between reality and expectations at the beginning of the year and that discord is meeting up right now. The expectations have come down meaningfully. In terms of prognosis for the year, our base case still is that there is about 10-12 percent to be had in terms of broad market returns to the end of the year, largely driven by earnings growth because valuations at about 17 times forward earnings, leave very little scope for rerating. So earnings will have to do the heavy lifting. We believe that we should end this year with about 10-12 percent of earnings growth and that's where we are expecting the market returns to come in from.

Sonia: Additional 10-12 percent?

A: Yes, an additional 10-12 percent through to the end of the fiscal year._PAGEBREAK_

Sonia: Going through your report, another space that you like is cement and there is a large population that is hopeful of a recovery in cement sector but that has not played through just yet, you can see it in ACC's numbers. Would you still be bullish?

A: I would still be bullish because the call on cement is predicated on two things. One, a meaningful cyclical pick up going into the second half particularly as the government's efforts to kick up road, construction takeoff, I think that can be a very meaningful demand stimulant and also we must appreciate that setting up capacity is going to be a problem now. So utilisation levels can trend up very meaningfully and with no capacity coming up, I think that should be very positive for pricing and second driver for cement could be low input cost, we have seen meaningful reduction in coal cost.

Latha: Coming to interest rates - the way crude is trending, what are you all giving by way of space for rate cuts or at least rate falls in the market and therefore what would be your sector themes?

A: As far as the rate cut environment is concerned, the call right now is, there is very limited scope until at least the monsoon is out of the way because given the guidance, given that the Reserve Bank of India (RBI) expects inflation at 6 percent by January and also the guidance on wanting risk free real interest rate of 1.5 percent. I think it is going to be very difficult over the near term but if the monsoon is out of the way and it pans out okay and if Brent settles down around USD 50 per bbl mark then perhaps you do have scope for one rate cut perhaps sometime late in the last quarter of the financial year.

Latha: Would you tank up on non banking financial companies (NBFCs), real estate companies, those who benefit from lower interest rates?

A: Not necessarily, not at this point. I think it is too early in the cycle to do that. The preference even now remains for high quality financials with a very strong capital and liability franchise. The wholesale funded entities or those banks which need to grow their way out of trouble, I think it is very early in cycle to start going after them. Typical tend to be late cycle plays.

Latha: What do you like in auto space?

A: As far as the auto sector is concerned, if I could divide it into three parts - two-wheelers and tractors, cars and commercial vehicles, we are underweight the two-wheelers and the tractors. We think that the rural discretionary consumption cycle is seeing serious cyclical pressures and that could carry on for another year or two. We would be more positive on the passenger car segment which is geared towards the urban demand as far as commercial vehicles which is geared towards investment demand. So the preference is for four-wheelers both cars and commercial vehicles in relation to two-wheelers and tractors.

Sonia: Most of these four-wheeler makers whether it is Maruti Suzuki or even some of these luxury two-wheeler makers like Eicher Motors, etc are sitting at record highs so would you still back these names despite the stratospheric valuations?

A: I think the theme going forward is going to be visibility and sustainability of earnings growth. As far as the names you mentioned are concerned they have both of those. Whereas what I suspect will happen is for the two-wheelers and tractors we still need to see earnings come down, I think there will be cuts. So, the market will continue to bid up names where there is visibility and sustainability.

Sonia: Let me talk about some of the big numbers that are expected this week. There is Hindustan Unilever (HUL) from the FMCG space and in FMCG we have seen a slowdown, a grind down in demand, single digit growth for many of these players, is that something that you will continue to see in the quarters to come?

A: Even FMCG will perhaps see muted demand for another two to three quarters at least but that said in terms of making relative preferences, we would be more positive staples as compared to the consumer discretionary pack. However one must appreciate that as far as the staples are concerned, they are seeing a lot of raw material deflation because typically their raw materials tend to be either petroleum derivatives or food derivatives.

So, they have that much more leeway in terms of margins or in terms of pricing which unfortunately the discretionary pack does not have. So, on relative terms we would still prefer the staples to the discretionary. However, in absolute terms, will they both feel the pinch? Yes.

Sonia: As we wrap up our conversation on the sectors, you remain overweight on the IT services space and that one has come back into action in the last couple of weeks. However, we have seen unimpressive numbers from the likes of Tata Consultancy Services (TCS), etc. Is that fine or is that something that would bother you in the quarters to come?

A: Not necessarily, when we talk to investors the big concern expressed is, are we going to see a very serious slowdown in growth, on a medium to long-term basis? Our thesis there is growth has trended down, what was 25 percent is perhaps going to be 8-10 percent for the next two or three years. However, the better managed companies will take market share, they will have some leveraged benefits and add to it three to four percent rupee depreciation every year and I still think there is a very reasonable investment case there.

Add to it that most of the smarter companies will look for the next driver of growth, the next engine of growth and they will focus on what are buzz words today – digitisation, artificial intelligence, cloud, etc. If they can make it then those arenas then there is no reason why they can’t grow at 15-20 percent. So, broad scenario, the sector still grows at 8-10 percent. Those who can do well, can still grow at 15-20 percent. So, we remain positive.

Sonia: You don’t think it will be hard for these companies to catch up on their digital wave?

A: It is going to be more selective. Unlike the plain vanilla services businesses where anyone and everyone could make it, as long as they had the basic skill sets, this is going to be that much more challenging which is the reason you will have to be a little more picky than you were in the past.

Sonia: You were telling us about how you expect a 10-12 percent growth in the market say by the end of this year. Do you believe that now the global worries are completely out of the way because now come September we will start talking about the Fed lift off as well, its impact on emerging markets. How much credence would you give global worries now?

A: Those are the two biggest risks for me, for the Indian equity market. I don’t see too many internal risks but the external risks are – if oil stages a V-shaped recovery or at some point in time global central banks realise that they are running behind the curve on inflation and have to tighten faster than expected. Those concerns remain, we hope that they do not play out but we have to be vigilant and watchful for those.