What to buy in a year of populism, fiscal expansion and possibly rising rates

Year of elevated valuations

However, the growth engine was in slow gear in India. Between Q2FY17 and Q2FY18 the Nifty’s earnings rose by 5.5 percent. As a result Nifty is trading at trailing price-earnings ratio of over 26 times, while mid- and small- caps are trading at PEs above 35 and 53 times, respectively. Hope of a rebound in earnings have attracted more funds into the markets.

The themes for 2018

As we attempt to crystal-ball gaze at 2018, three key themes beckon our attention. Politics will take centrestage as the ruling Bharatiya Janata Party gears up for Lok Sabha election in 2019. Eight states – Karnataka, Chattisgarh, Madhya Pradesh, Rajasthan, Meghalaya, Nagaland, Tripura and Mizoram are to hold assembly elections.

The imperative of electoral victory coupled with the need to plug the absence of private capex and an expansionary fiscal policy will be another hall mark of 2018.

A global recovery and firmer commodity prices including crude and expansionary fiscal policy are all pointing to hardening rates – our third theme for 2018.

Rural pump-priming in focus – consumption to gain

Given the strategic importance of rural economics to India's political economy, we see a very high likelihood of policy action aimed at addressing the unbalanced terms of trade that have shifted against rural India.
In our view, the stress in the farming economy has reached a level where near-term solutions may be needed including a modest fiscal response and pump-priming of the rural economy.

Policy needs to recalibrate the challenge of keeping inflation under check but without making farming non-remunerative. A calibrated increase of MSPs (minimum support prices) over the next three years to a level which takes margins higher may be needed.

Historically, in years when the government has taken steps to mitigate pain in rural sector, say in form of higher MSP, sectors like consumer staples have responded positively and outperformed the broader benchmark.

Source: Ace equity, moneycontrol, Reuters

A spur in demand on account of similar measures in future can aid FMCG sector companies having a higher rural India exposure. HUL and Emami are among those having 40 to 50 percent share of sales from rural region with a well-entrenched distribution network and an increasing contribution from direct reach vs. wholesale. We see companies like Dabur and Manpasand Beverages getting positively impacted.

The other consumption category to benefit would be entry-level electricals and brown good makers like Bajaj Electricals, Havells, CG Consumers, Veto Switchgear, V Guard, Dixon Technologies, TTK Prestige, Hawkins, Butterfly Gandhimati Appliance etc. Higher purchasing power should impact jewellery companies like PC Jeweller and Thangamayil Jeweller.

The strength in the rural economy will also boost demand for two-wheelers (2W) and four-wheelers (4W) and help companies like Hero MotoCorp in the 2W segment and Maruti Suzuki and M&M in the 4W segment.

Housing for all by 2022 is definitely a pet project of the government that should continue to get disproportionate attention. Rural housing forms 40 percent of overall cement sales in India, which is largely supported by agricultural income and rural wages. We see gains coming for cement, asbestos and housing finance companies and identify HIL, Visaka Industries, NCL Industries, Sintex Plastics, Star Cement, JK Cement, Dalmia Bharat, and Ultratech. The financiers to participate in the theme are the likes of Gruh Finance and Repco.

Improve farm productivity and raise farm income

Another issue that could merit the government’s attention is fragmented land holdings, which depress productivity and prevent mechanisation. The Modi administration has articulated its strong commitment to doubling agriculture incomes by 2022. However, the strategic quest to double farmer incomes cannot be successful until all state governments cooperate, as agriculture constitutes a state subject. Given the significant benefits of this initiative in improving farmer incomes, the central government may not be averse to amending laws that override the state APMC (Agricultural produce market committee) laws, creating a national common market for agriculture.

Any move in this direction will aid companies that are involved in farm mechanisation and improving productivity. The list is long and the prominent names are M&M, Escorts, Swaraj Engines, Shakti Pumps, VST Tillers, Coromandel, Rallis, Finolex Industries, Jain Irrigation, Garware Wall Ropes, Kaveri Seeds. The finance companies to benefit are M&M Finance, Muthoot Finance, and Shriram City Union, with a significant rural presence.

While FDI in multi-brand retail has been a contentious issue, it has the potential to significantly enhance agricultural incomes by allowing farmers to sell directly to retail chains. It will also result in a potentially explosive increase in demand for supply chain infrastructure which will be beneficial for large as well as small and medium enterprises. The move could be very significant in terms of job creation, given the wide linkages across the supply chain, from farm to fork.

One of the expected focus areas for the government is also to address the farm-to-consumer value chain so as to increase additional avenues for farm income, lower food wastage and improved infrastructure. Among staples, ITC seems better positioned in this value chain of farm sourcing and processing and could be a preferred company to look at.

Source: Ministry of Food Processing industries

Fund allocation for food processing industries has increased in recent years with focus on infrastructure (food parks, cold storage chains, food processing industries). While some of the unlisted players like Patanjali are expected to benefit in particular, the category itself is expected to expand from here.

Companies from the farm allied sectors like animal feed and dairy could benefit from the government’s thrust towards doubling farm income by 2022. Investors should keep Avanti Feeds, Godrej Agrovet, Apex Frozen Foods, Parag Milk Foods on their radar.

Benefits from DBT to be channelled to rural infrastructure

DBT (direct benefit transfer) could help the government achieve considerable savings on account of fixing leakages, with saved funds channelised towards higher expenditure on roads and railways and increasing allocation towards quality of life issues – sanitation, healthcare and water. A look at year-wise progress shows that the amount of funds disbursed under DBT has increased year after year.

Capex – revival in selective pockets

While overall the private capex cycle will remain a non-starter in 2018, we definitely expect government-led capex to continue, led by rural infrastructure, roads and railways.

To play the theme we like Dilip Buildcon and Titagarh, which are relatively strong in terms of earnings visibility and capabilities. Further downstream, we also like Tata Steel, which has got strong distribution network and branded retail products, and so would be the largest beneficiary.

In power, more than generation, T&D (transmission and distribution) sector will be in focus with the government augmenting the T&D capacity to evacuate power. That apart, the focus is on connecting the rural markets with the grid and providing excess of power to deprived regions and villages. The government recently announced it would electrify all the villages by the end of December 2018 with an  outlay of Rs 16,320 crore. It is expected that the implementation of Soubhagya, the scheme to electrify all villages, could lead to an additional demand for 25,000 MW of power. We expect companies like Rural Electrification Corporation, ABB, KEC International and Voltamp to benefit.

What to avoid in 2018?

We would avoid companies with excessive leverage. For financials while the hardening yields do not spell good news for wholesale financing companies, we would avoid entities earning thin spreads and stick to a handful of rural focused differentiated asset financing companies as mentioned above. For public sector banks, in is a tale of two halves with the stronger ones likely to get capital, but the end of the NPA resolution is still a year away, so patience is warranted. Efficient private banks will continue to garner market share and will have their evergreen appeal.

We are a bit circumspect on the oil marketing companies, given the inflationary headwinds. For upstream companies crude remains a joker in the pack too as a sharp rally may bring back the ghost of subsidies.

Export-oriented sectors – be selective

Turning to the defensives, we continue to remain positive on the auto ancillary sector given the secular growth outlook for the automobile sector. However, we are turning more selective in light of the impending disruptions from electric vehicles. Names like Motherson Sumi, Jamna Auto, Lumax Industries, Minda Corp, PPAP Automotive, and Gabriel India lend comfort.

With increasing pace of approval from US FDA, the outlook for pharma companies is definitely looking better, although a regulatory hangover with respect to US FDA clearances of Indian facilities remain. We are selectively positive on the space with names like Sun Pharmaceuticals, Cadila and Torrent.

Information technonogy is undergoing a painful technological transition and will produce only a few winners in the long run. Our preferred bets in the sectors are the companies that we see weathering the storm like Cyient, Mindtree and L&T Infotech.

Overall, we see challenges in the heady earnings growth of the broad index and would monitor this closely.

While we expect modest return from broad markets, we definitely see pockets of excellence outside of the broad headline index. Do stay tuned to Moneycontrol Research for all our “alpha generating” ideas through the year. Wishing you all a great year of rewarding investments.