Earnings surprises to continue, Nestle resilient: Raamdeo

He also sees some greenshoots with the economy recovering and a spike in government spending.

Taher Badshah, senior vice-president and fund manager, Motilal Oswal, too says that with the rotation in asset classes, equities will benefit. According to him, domestic household have started to understand the opportunities in the market. There is enormous headroom for retail investments and a lot of action can be expected in the coming days. He says many mutual funds are also getting into shape. "We are heading towards a time when market will be less reliant on FIIs," he told CNBC-TV18.

One thing that stands out is the fact that Motilal Oswal AMC is bullish only on State Bank of India in the PSU banking space. Manish Sonthalia, senior vice-president and head equities - PMS, says there is still a lot of distress in the banking space. He does not think that the worse is over for PSU Banks.

Below is the verbatim transcript of Raamdeo Agrawal, Taher Badshah and Manish Sonthalia’s interview with Latha Venkatesh and Anuj Singhal on CNBC-TV18.

Latha: What did this earnings season tell you? Is the economy recovering at a micro level? Did more companies tell you that they sold more? Did the Emamis, Daburs tell you they sold more sachets? Did the power equipment or the capital goods guys tell you that they sold more volume, not revenue?

Agrawal: I do not think that is the story. I think this quarter, of course, we were expecting some surprise in the earnings side, but I am really surprised by the extent of margin expansion because of the collapse of the commodity prices, oil and other lot of soft commodity, hard commodities which have fallen and the pricing power has been fully used by the companies, starting with Maruti, Britannia, your Pidilite, Asian Paints, you name it, all the companies had pricing power. Their margin expansion has been almost 400-500 basis points which is staggering. On a 12-13 percent kind of business, you go to 18 percent, it is like a 50 percent expansion on it. Then you do not care whether top-line is growing or not.

So, that is the kind of surprise. And it is not the lowest oil price. Still after the results, they have fallen further. So, for the next 2-3 quarters, September, December, for the whole year, this segment is really going to do very well.

Anuj: Is this not a risk as well because if the top-line does not grow, then this is a bit of a one-trip pony?

Agrawal: No, we are talking about right now. Right now the situation. These are all dynamic situation. Economy is recovering, government has started spending, they are spending to the extent they can spend, so clearly, I am hearing some green shoots from the automotive markets and all. But it has not become very strong, but I am quite sure as a cumulative build-up once the government expenditure happens, this is three months, six months, nine months and then the revenue pick-up because it is a circular kind of thing. You spend more, you get more revenue, you spend even more.

Latha: Actually, I wanted to take Anuj’s question further. I mean, should not fund managers now stop worrying about top-line and worry more about volume of sales? Because, there is a secular fall in the realisation, in the price. But that does not mean the company is not making money. They are able to cut prices probably because they are buying their inputs much cheaper. So, as fund managers or even as stock pickers, is top-line going to be ignored and you will look at volume in margins?

Agrawal: No, nothing will be ignored. I mean the fund manager is going to look at in specific company, everything.

Latha: No, no. Are you going to be put off just because revenue is like five percent but, volumes and margins are making up.

Agrawal: No. It is individual stock. I mean every company has a different story. A company say, Britannia, they have expanded the margins, they have got the volume, they have got the sales, they have got everything going, but good volume, good top-line and terrific margin expansion. So, you can get all types of colours of the companies, but if it is associated with volume growth, pricing growth and margin expansion, that is the dream run. But, then there will be a lot of companies where there is no margin right now. But, your volume is going to just explode. So, all kinds of stories will come. So, this is an opportune time and it is all going to happen in the next 6-8 months. New stories are going to just start.

Anuj: Indeed, in fact, Britannia is up 200 percent in the last one year as Raamdeo pointed out. Almost everything going in its favour. So, USD one billion in your funds, what is the next target? You know we say USD one billion is a lot, but given the kind of equity culture that is now beginning to take place in India, anecdotal evidence of a lot of gold investments, real estate investments, shifting into equities. What kind of domestic flows do you think can come into equity markets?

Badshah: It is a great time. This whole rotation in asset classes is clearly going to be beneficial to equities and we are significantly under invested in equities from household perspective as we all know running into single digits in terms of exposure. So, there is always a lot of head room which is available and market has probably started to realise that opportunity in front of them now with the new configuration of the government as well as the whole economic configuration that we have right now. So, the future is clearly exciting, if you look at the statistics on mutual funds itself, I mean we have got a flow of USD 4-5 billion in the last 12 months and we have got an equal amount in the last 10 years. So, that is a staggering number and we are still significantly below what we can probably be in terms of potential.

So, the headroom is enormous and many of the mutual funds are getting into shape. We are getting up very well, performances are improving, so I think we will see a lot of action as far domestic mutual funds. I hope we are come to a stage where a dependence on foreign institutional investors (FII) and talk about daily slows based on FII numbers, etc. probably becomes much more muted going forward than we have been in the past.

Latha: I am dying to come to the stock specific lessons that you got from the first USD one billion. The big power house or at least one of the big power houses in the last few weeks have been public (PSU) banks. I have gone through all your lists. Barring State Bank, there is nothing. You do not like this idea?

Sonthalia: There is a lot of problem is the PSU banks.

Latha: Yes, of course. But I thought buying in distress was what the market is doing.

Sonthalia: But is it the end of distress? That is the moot question. The government has announced that Rs 70,000 crore would be infused over a period of next 4-5 years, but is the problem not much more than what this Rs 70,000 crore would do? Of course, it would alleviate a bit of the position, the stressed position, but the size of the non-performing assets (NPA) is just too big. Within the PSU banks, a lot of NPAs according to me is still hiding within the restructuring thing.

Latha: Now, it is going to be refinanced as well.

Sonthalia: So, do you play valuation or do you play the earnings growth, what sort of earnings growth is going to play out over the next 3-5 years.

Latha: So, not your cup at all?

Sonthalia: I really do not think that we are at the end of the NPA cycle as yet.

Anuj: There was a grin on Raamdeo’s face when we spoke about PSU banks and I remember the Central Bank story that Raamdeo told us. But, that apart, you have made a lot of money in some of these so-called high priced stocks whether it is Eicher Motors, Page Industries, Bosch, Bajaj Finance. Some of these stock are stocks where retail investors would not want to venture because optically the price is too high. There is a bit of a scarcity premium in some of these stocks. But valuation-wise these are very expensive stocks now. How do you justify some of these stocks as a value picker now?

Agrawal: Taher has picked all the stocks.

Latha: Why would you want to sit on? Are you not tempted to book out?

Badshah: Not really. We have done a little bit of rationalisation wherever we have felt that the growth is significantly less than what the valuations are actually calling out today for. But then there have been many others despite the run and probably despite stretched valuations in the near-term, have a lot of headroom for growth.

Latha: So, what is the number that you look for? Price/earnings to growth (PEG)? How would you decide Eicher is too expensive or Bosch is too expensive?

Badshah: If there is a stock at 50 profit/earnings ratio (P/E) and probably it is still good enough for a growth of around 30-40 percent, at least visible growth over the next 7-8 quarters, then that is something which is reasonably, we know that there could be a downside, we could probably see 5-10 percent come off. But, we know that the underlying growth is supportive of higher valuations in general.

But if there is a dichotomy to the extent that there is a stock which is trading at 90 P/E and probably growth is more like 10 percent, then that is something which going a little over the top. So, there you would probably feel the need to rationalise and maybe try and see if you can correct that position despite the longer-term franchise, attractiveness of the franchise of that business.

Sonthalia: Just to add out here, without taking specific names, you take weighted P/E of the portfolio also and then the earnings growth and the return on equities (ROE). And there is nothing to say that we should only be looking at FY17 numbers. Markets are fixated about FY17, it is, the valuations are expensive. But the business of the company would continue even beyond FY17. And we are nobody to tell to the market what they should be looking at.

Anuj: So, are you convinced by their business models that this kind of earnings growth that we have seen as the base goes higher, that kind of earnings growth will continue?

Sonthalia: That is what it is. Stock prices are nothing but evaluating the earnings growth and what is the longevity of earnings growth. That is if you get both these things right, it is a matter of time when the markets get it wrong as far as the longevity of the earnings growth is concerned.

Latha: So, you will not trade HDFC Bank for some of the new private sector banks?

Sonthalia: Absolutely not.

Latha: Why not?

Agrawal: He said, longevity of growth. One is Quality, Growth, Longevity and Price (QGLP)...

Latha: Because, I guess you are going to get a lot of private sector banks now.

Agrawal: Yes, we will open to it.

Latha: I guess a Ratnakars and all also will be it level and you also have IDFC.

Agrawal: We are open to any company which makes us money.

Latha: Shows longevity.

Agrawal: Yes, longevity, company’s high quality business, high quality management, growth, longevited growth, not eight quarters growth. I mean eight years, 10 years, 15 years, 20 years growth.

Latha: By that time the company proves it also becomes expensive, how would you guess the longevity before you get in?

Agrawal: That is an art and that we are practicing.

Latha: Yes, give us some lessons.

Agrawal: Lessons in the sense that I am telling you the factors to look at it. Every single company has to pass through QGLP process. Quality of business, quality of management, if both are not 10x each, it does not go through. We do not look at price. You start with the price. The biggest problem in the market, in my opinion is that, people don't understand the values. So, QGL is about the values. If you do not know the value, there is no point in looking at the price. If you do not know this is a banana, how do you figure out what should be the price?

So, I think we are spending 90-95 percent time understanding the value and once we know the value, then price is very easy. And everybody’s own money is also stuck with this So, it is not that we are speculating, we are investing. Seriously, we are investing.

Latha: Let me come to another sector – oil and gas – which has made a lot of money for you. You very correctly have invested in Hindustan Petroleum (HP), Bharat Petroleum (BP) and not the upstream companies like Oil and Natural Gas Corporation (ONGC), Reliance Industries (RIL). Why would you do that and why would you stick with it? Will you stick with it?

Badshah: The idea was very simple that the downstream companies is where the franchise value is significantly higher. If you look at these retail franchises like HPCL and BPCL, etc, they are the ones which are the most durable. I mean, as we discussed internally as well that these are businesses, actually retail businesses that you would like to be in. There are no alternative kind of businesses, real brick and mortar retail, but no option, you cannot actually do on line buying of petrol and diesel.

And then there are only three or four players in the market and these are the guys who are now seeing a significant transformation in the business value because earlier they were denied the due profitability.

Latha: But, you would not ever go upstream? You do not see too many positives in those companies?

Badshah: We still have the issue of the whole oil price, the under recovery burden which is still going to sting them and we need to see a situation where they get completely off it. If that happens, then of course there is a good amount of franchise value especially at current levels even for some of these upstream companies.

Anuj: You have Cummins in your portfolio. It came out with numbers yesterday and after a long time we saw the kind of rally but overall as a space would you stay invested in names like Cummins, Voltas and you think the earnings recovery that we have started to see is that sustainable?

Sonthalia: One of the themes in the PMS that we are playing on is the Make in India theme. India will move towards a self sufficiency in the past situation that could mean that Cummins as primary back up power, the volumes would take a beating and their lower HP would have lower margin. However, Make in India theme means that they can manufacture here and outsource to the rest of the Cummins subsidiary all over the world. 60 litre engine is now being exported to China that is seeing the huge amount of traction. The mining segment, that is just about, you know what Coal India production targets are for the next five years, doubling of products. It is consumable engines. So, as opposed to what the market believes, what is the growth trajectory we significantly deviate from that opinion.

We have seen the numbers how they are playing out. In spite of a gross margin contraction the volume has just taken care of the entire growth trajectory. It has been very strong. Similarly, consumer discretionary now 21 percent in the market share in the room AC business you have seen the margins what we have seen. In spite of the industry going through a slowdown. FY17 for the industry as a whole should be a pent-up demand both from FY16 and moving into FY17 so at least I am convinced about the growth. Let us see what the numbers are, till now they have delivered. We will evaluate the situation how it goes.

Latha: What we are now seeing is a fairly broad based midcap rally. You all have preferred to choose in your fund 50 stocks which you all monitor very closely? Will you change that philosophy or change the stocks?

Agrawal: These are focused strategy; it is a part of the QGLP process. As a fund manager you can know very few stocks. It is impossible to know 70-80 stocks.

Latha: So that will remain your philosophy?

Agrawal: That is a core of the philosophy; in fact if you see the names we have chosen a name focus 25, focus 30, focus 35. It is a focus series. So, though we have taken permission for 25-40 stocks, we don’t invest in more than 17-18 stocks. 20 is absolute laxman rekha. We are going to maintain that and that may constrain that may bring some kind of capacity constraint how much money we can take till the performance gets hurt. However, still the promise is that will remain focused, will have fewer companies and will have chunky allocations to them. This is because if you have convictions on the stock you have to buy eight–nine percent.

Latha: Why are you getting out of Power Mech? You had 22 percent; you are now only two percent?

Agrawal: That is a different question. That is not part of the mutual fund. That is in private equity and that fund is coming to an end. The tenure is on extended period.

Latha: You have to wind up the fund?

Agrawal: We have to wind up the fund by December 2016. We are going to line-up 10 more IPOs in next one year. These are best pieces of the business which we are selling right now. So clearly I am under compulsion to sell it off. Good that markets are little warm so that we can offer to the public. However, it is under compulsion that we have to sell.

Anuj: Your biggest stock has been Maruti Suzuki. You have been bullish at all levels on Maruti. Is this still a Yen story playing out or do you see a volume growth story as well or the next few years and would you stay invested in a stock like this or would you add more at current levels?

Badshah: We are up to our limits as far as Maruti goes in our funds. Unfortunately we can’t buy beyond that 10 percent limit we have almost gone to 9.9. We remain extremely positive. The company has done its bit in terms of insuring a very healthy product pipeline. They have benefited out of, they can’t see much more than many others in the business. However, now going forward the story is going to be more about the topline, growth and volumes.

Plus market will be keenly watching their success in the higher end because till now it has always been perceived that Maruti is essentially about small cars and compact cars and yes it is and for the next ten years it will remain so. Clearly they are adding on to the new piece. They are taking steps in the right directions separate brand, separate set of products coming up. It remains the most profitable enterprise.

Anuj: I was reading somewhere its market cap is now higher than Suzuki’s itself.

Badshah: Suzuki itself is all about Maruti India so it is not surprising that stock is hitting new highs and we are seeing what is happening to Maruti Suzuki India. It has always been so but now the true colour of the value of the business is emerging. So, we were fortunate to get a lot of it in the distressed of the last two or three years when a lot of problems were happening to the company. So it this buying some very good companies in distress and then you make some super normal return.

Latha: Your most interesting stocks for the next one billion opportunity or one trillion opportunity. You have DCB would you prefer it over Kotak Mahindra? You have Speciality Restaurants would you prefer it over Jubilant FoodWorks? Why these?

Sonthalia: A company has a breakup value, a franchise value and growth value. Out of these three values, if there is a less than fair value that is coming out in the stock price, there is an opportunity. So, at Rs 600 crore odd market cap whether Speciality does have the room to go, does the franchise value represent a value much superior than what the market cap is. It was traditionally his return on equities (RoE’s) and return on capital (RoC’s) have been quite good so it is a play in consumption space dining out this has gone through a slowdown that creates an opportunity.

If you talk about a DCB is it the next HDFC Bank in the making. Everything begins with a small – Rs 10,000 crore books, Rs 3,000 crore market cap. Their credit appraisal is their chief competitive advantage. It is the Aga Khan Foundation which is the promoter and which also promoted HDFC Bank. That learning is there; and you are able to grow your balance sheet 25 percent with minimum non-performing assets (NPAs) that is all that we need for a bank to do right and if that comes market is oaky about it.

Anuj: How do you play a story like Nestle because this whole scarcity premium of course in terms of equity but 25 percent of your business is going through the kind of mess that it is going through? Good opportunity right now for Nestle or would you rather let is pass and look at it later?

Agrawal: I am surprised by the price movement of Nestle. Despite the once in 30 year kind of a loss and here the brand is not back on the shelves. I mean now there is much higher moves, I can see much more sympathetic statements in the headlines today. Yet the permissions are not come, brands are not back and it hurts a lot this kind of brand out of the shelf for long period. Despite that it is almost all time high. So, market has voted with full confidence. With the current valuation it will be a very average return even if the company does very well. However, longevited if you want 15-17 percent return for next 20-25 years you can buy even at current price.

Latha: So a pension fund should buy?

Agrawal: Yes, essentially it is fit for pension fund and probably it will a Index returned. If Index has done 17 percent for last 34 years clearly it would match or probably be a two –three percent higher because you are buying at 65-70 price to earnings (PE) even if you talk about PE. So, it is a very long-term, very good investment but it is not a multibagger by any stretch of imagination.