Why these rural plays make sense now: Dipen Sheth

Below is the transcript of Dipen Sheth’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.Sonia: It is a flat day today, but the index has seen a pretty good performance so far. What is the sense you are getting about the themes that one should look into now?A: We do not live for a day-to-day movement of indices. We are really not in that business and I will never tire of saying this. But from a longer term and even if you call 3-6 months longer term compared to what people are saying, a couple of years out and so on, here is a reformist minded government, struggling admittedly after two years in power, but having ushered in a plethora of reforms, here is a country which is the single largest destination for foreign direct investment (FDI) in the world ahead of China. This is probably the lone bright spot in the global economy right now. The US is struggling with presidential elections, macro data is unsteady, the rate hike is off for now, China is slowing down, Eurozone going nowhere. So, if you are still not gung ho on India and lead indices over the next two years, when will you be bullish? So, I do not know whether I can thump the glass here, but yes, we are constructive and indeed more than averagely constructive. India will always be a struggle, the path is not going to be linear going ahead, but this is probably the only economy in the world which can do 7 percent plus consistently for the next few years.Latha: I was also enthused by the April indirect tax numbers – came in 41 percent higher. You have to remove all the excise hikes for fuel and stuff like that, but even then it is showing some resilience.A: Look at the volume data on power, on coal.Latha: That is what I was coming to. The numbers that you have seen so far in the fourth quarter, for some, maybe I should say January-March quarter. What has enthused you? Any of the midcaps? Some of them have played out already like cement has played out, probably sugar has played, I do not know if it will play out further. But what did you like in the results so far?A: Two stocks come immediately to mind, I will pick a midcap and I will pick a largecap and the largecap has been actually a boring stock for a while for many people, but it is not necessarily so. Look at Hero MotoCorp and here is a stock at 15x two years out. I am looking at volume growth of something like 8 percent compounded annual growth rate (CAGR) for the next two years unless something disastrous happens to the rural economy and the monsoon. So, they have done less than 3 percent CAGR in the trailing two or three years on volumes. This is a company where five years ago, people were sceptical about whether it could survive without the Honda parentage. Scooters was a stumble for them and we are looking at 25 percent growth in scooter volumes this year to actually drive their numbers. In three quarters their market share in scooters is up from 12 percent to about 20 percent.I do not know what say. If you get a stock like this for 15x with 3 percent dividend yield, why should you not be buying it? So, this is one of those absolutely safe bets to play and nothing can go majorly wrong from here on. So, I know you have the sceptics who say that how much will two-wheelers grow in India, I think you will be surprised if you look at rural incomes pick up and the kind of demand that might unleash for motorcycles.Sonia: That is the largecap, what about the midcap?A: The idea number two is a much battered and maligned midcap over the last week or weekend, shall we say – Inox Wind.Latha: Yes, but they came out with their clarification.A: They came out with their clarifications and quite frankly, that working capital bloat-up is admittedly, an optical illusion. Because what happens when you book a disproportionate amount of revenues in the last quarter, then the exit debtors must be seen on the basis of the revenues you booked in the last quarter and not the entire year which drags down the denominator and then makes the exit receivables look optically high. So, that thing I will forgive them for and I do not think that is the worry. They have gone up to 580 megawatt of volume this year in FY16 and we are expecting them to do 1,000 megawatt plus and then maybe 1,200 megawatt plus in the following year which is FY18.The real worry in this stock is the rising exposure to group companies, specifically, Inox Renewables which is in the business of – it is an independent power producer (IPP) of sorts and it owns wind assets. And obviously, many IPPs are under stress because of the lumpy payments which come in from state electricity boards (SEB) and they are kind of, they have put in more than Rs 200 crore – Rs 260 crore is the number that I think I have in mind for the exposure there. There is informal or even stated commitment from the management that they are going to bring down this exposure. They are in a wonderful space, they are the number two player now in India and there is no reason why you should not go and buy this stock at under 8x anticipated FY18 earnings for a company which is at 22-23 percent return on capital employed (ROCE).Sonia: You have also picked up a theme that everyone loves these days – the non-banking financial company (NBFC) theme. In that, Cholamandalam Investment and Finance Company has already hit a new high. So, is there more value there and Mahindra and Mahindra Financial Services, I agree it has been one good quarter, but would you not want to see some more quarters of evidence to go gung ho on that stock?A: What we have realised from our experience with Chola Finance is that sometimes, you have to go out on a limb and place faith in the management. Chola Finance, we published what was clearly an aspirational target price at least for the short-term for them after the results, but they have already exceeded that. The stock has run up some 10-15 percent after the results as well and right now, it is at 3.3x two years out adjusted book value (ABV). So, what is the lesson to be learnt here? I think many of the NBFCs, the swing back in asset quality and the ride-backs to their ABV which happened when asset quality swings back is remarkably faster than what it is for their cousins, the larger cousins which are the banks. The reason for this sounds like a little bit of a virtuous thing that actually, in rural India the incidents of default, real default, people running away with your money is very low. The loss given default (LGD) as they call it. So, the minute the farmer or the small borrower, the small transport operator has the money, it is actually in his interest to go back and pay up and repossess his vehicle or at least get his business going. So, these are people who, this is the classic description of the segment that Chola lends to. They say we are at the top of the bottom of the pyramid. They have got 520 odd branches across the country at the top of the bottom of this huge pyramid. The opportunity for them to take their Rs 17,000-18,000 crore vehicle finance book, grow it at 25 percent CAGR for the next 2-5 year is undeniable. The bank simply cannot do this and then, their Rs 8,000-9,000 crore home equity book, as they call it. So, look at the number of SMEs which still do not have access to bank credit and the kind of opportunity that exists there. So, DCB Bank is chasing that space, City Union Bank is chasing that space, Bajaj Finance, God knows, is chasing that space. And so will Chola and all these are wonderfully run businesses.Latha: That was my point. In this NBFC space, the tide is turning in their favour because wholesale money is getting cheaper. That always benefits them. But look at the number of options you have. You have Bajaj Finance, you have M&M Financial Services, you have Shriram Transport Finance Corporation, Chola Finance, Ujjivan Financial Services, Equitas Holdings, SKS Microfinance, Magma Fincorp, broadly NBFC. And Equitas is NBFC as well as microfinance. Money cannot come for everybody. So, what is your pecking order?A: The pecking order should be in order of which managements are likely to scale up and run stable operations. Let us start this by first saying that if you will remember basic high school geometry, the bottom of the pyramid is much bigger than the top, first of all. So, the opportunity to go and find granular lending, to establish a granular lending business with a national footprint, spread over thousands, lakhs, millions of borrowers is very much there.Latha: So you buy all is what you are saying?A: Maybe you do not buy all. From time-to-time, you will see shifts in strategies, shifts in positioning, shifts in the kind of segments that they are attacking. So, it is not that the ING Vysysa Bank slice in Kotak is lending to the same guy that Bajaj Finance is lending on the same segment. So you will have to look around for how they do over a period of time, but yes, the rural focus guys – if you look at the commercial vehicle business of Chola, if you look at the rural slice and I think it is entirely rural so far as Mahindra Finance goes, these guys are well set because there has been 2-3 years of stress out there in rural India, National Rural Employment Guarantee Act (NREGA) allocations have gone up, the monsoon should be good. We are actually in make or break territory on the monsoon, I must confess right now.Sonia: In fact, on that subject I wanted to quickly squeeze in the agriculture focused stocks. You like Coromandel Agro Products and Oils, you like Rallis India, UPL. Tell us more.A: Some of these are hope trades. Coromandel and Rallis for example are hope trades and Coromandel is built on a thesis that earnings will see a breakout over the next two years after two bad years, driven by the pickup in the fertiliser demand driven by the pickup in their unregulated or non-subsidy business. Will that necessarily happen? I think the monsoon triggers, the anticipated goodness in the monsoon, if I can say this, has already played out partly for Coromandel and news here on will be crucial to determine how they go forward. On the other hand, in Rallis, the story is actually that of being able to build out their custom synthesis business which has been under wraps for the last two years and I think they are at some kind of threshold now. If that happens, then you will see about 20-25 percent earnings CAGR. And it is a very high returns ratio business which can become even higher as you move forward. So, 14-15x multiple really does not worry me. The upsurge in the business, something like what played out in Navin Fluorine International when they made that foray into speciality chemicals over and beyond their Contract Research and Manufacturing Services  (CRAMS) business which went over and beyond their fluorochemicals business. So, if something like this plays out in Rallis, I would not be surprised if the stock rockets.