Udayan@Moneycontrol: Weak macros, corporate governance concerns weighing on Indian markets; Q4 earnings to chart direction

He listed two factors that were weighing on sentiment for equities: worsening macros and recent news flow over corporate governance issues in India.

“We are facing many macro headwinds. GST collections remain stuck around Rs 85,000 crore while crude has been on the rise. Soon the markets will start fretting over Karnataka elections,” he said, while pointing to the alleged lapses in the Nirav Modi-PNB case, and recently, the ICICI-Videocon case.

The spate of bad news for banks means the Nifty Bank would likely continue to grind lower, Udayan said. “Public sector banks are going to continue to struggle with provisioning for calendar year 2018. The corporate private sector banks such as Axis and ICICI will also underperform,” he said, terming the latter as “quasi PSBs”, alluding to the tempered valuations the market has always assigned to them.

The perceived solid private sector banks, such as HDFC Bank or Kotak Mahindra could be beneficiaries of a portfolio switch but they too suffer from lack of valuation comfort. “I think the medium term peak for banks in the index – they commanded as much as 33 percent in the benchmark – has been seen.”

Overall, for the market, the global market may provide some comfort, after showing signs of taking fears of a global trade war in sight.

But Udayan was sanguine in his overall view, saying that fiscal year 2018 earnings could come in at 5-6 percent, way lower than what the market was pencilling in earlier during the year.

He also talked about the slowness in the IPO market lately, saying the HNIs are redeploying their “opportunistic money” from IPOs and small-cap stocks to largecaps.

“They realise the wind is blowing in the other direction."

Below is the verbatim transcript of  the interview:

Q: What do you see as the key factors impacting market sentiment in the short term? We had the Nifty falling below 10,000 and then making a fairly good bounce back from those levels

A: From a technical point of view, the price action is quite interesting right now, because what was visible over the last couple of months was a clear loss of momentum on the way up because you could see throughout February and March that the upward momentum of the market that was visible till before the Budget, has been completely disturbed. We just do not have that momentum any longer in the market.

However, while that is true, it is also true that over the last 10 days, the market is also probably dissipating some of its downward momentum because we are going down to those 10,000 kind of levels, but every time we go there, we seem to sort of bottom out when we are bouncing back a little bit. Not with a lot of gusto, we are still struggling to have powerful bounce backs, but what is going on is, we are not making fresh lows or fresh lows by a big margin. That tells me that it is conceivable, though not certain, that after two really bad F&O series for the market, February and March where the Nifty lost nearly a 1000 points, it is now trying to consolidate because it has spent some of its downward momentum.

As you would be aware, markets do not fall in a single line; sometimes they go up for a couple of months and then they stall. Similar is on the way down when the markets have fallen a lot over the last two months, and now it is stalling a little bit. So, as we see earnings season unfold throughout the month of April, it is possible that the market tries to form some kind of a trading range and then looks for fresh triggers to resume its journey whether on the way up or on the way down, though more likely on the way down because the macro is still not supportive for the market.

There are many macro headwinds at this point in time, offset only by a modest improvement or recovery in earnings. So the micro-news on the margin is not too bad, but the macro is just getting worse. So, Goods and Services Tax (GST) collections are very weak for the last couple of months, getting stuck around Rs 85,000 crore, crude is indicating a fresh breakout technically, which is very bad macro news, and as we get through the month of April, the market will start fretting about the Karnataka elections in May as well. So, the overall environment I think is not still greatly conducive for major rallies in the market. However, the downward fall might get arrested just for the moment till the market rediscovers momentum and fresh triggers.

Q: How do you see the global trade war affecting near term sentiment, both in the local market as well as in the global markets?

A: The global outcome will be the most important I feel. However, what is clear is India is underperforming the global market; markets go up a little bit, but India does not go along completely with it and that is perhaps because of two factors – one is the quality of our macro is worse than many other global markets at this point, and b) we are not helping our own cause with the kind of news flow on corporate governance that has been coming out of late and that matters because through the last month, month and a half, we have been embroiled with this Nirav Modi and Punjab National Bank (PNB) headlines.

Just when we seem to have put it behind us, we have got this fresh outbreak of news surrounding alleged issues with ICICI Bank and Videocon. We do not know the truth of that yet, but it has certainly affected sentiment which is clearly visible in the ICICI Bank stock and partly in Axis Bank stock as well. So, I think the news flow on the margin is making people or large investors quite skittish about India. They do not know what will blow up in their face over the next few weeks. So I think it is a combination of our worsening macro and the poor quality of news flow with corporate governance that has put India at a slight disadvantage compared to other global markets.

However, I still think the global outcome will be the key in forming the overall direction of the market and that may not necessarily be bad news because over the last few days, we have seen some attempt by global markets to pullback. Maybe the price action globally is suggesting that they are not as worried about the global trade war outcome as they might have been a fortnight back because the thing is a lot of it is posturing it will not become a full blown war though China has responded with many items on the US list. So this is again an evolving situation which will led to volatility. However, our best hope at a pullback rally frankly at this point in time is to have a situation where global market stabilise in April and give you a temporary pullback which sort of negates our negative momentum at least temporarily.

So, I would say that it is something that is potentially a big negative trigger, the global issue, but just in the short term, it may actually alleviate some of our trading momentum issues if there is some possibility of a short term pullback there.

Q: How do you see the ongoing controversy at ICICI Bank affecting sentiment for the private sector banking space in general?

A: My sense is that the corporate private sector banks will underperform now because it is clear that over the last many years ICICI Bank and Axis Bank; ICICI Bank particularly has been seen as a quasi public sector bank, not quite as bad but it is somewhere between a public sector undertaking (PSU) bank and a retail private bank, the valuation at least and if State Bank of India (SBI) was trading at one time book or just above then ICICI Bank would be trading at 1.5 times book, net valuation but never quite at 3 times and 3.5 times which was reserved for the HDFC Bank and Kotaks of the world or IndusInd Banks of the world. So in a sense the market always knew that the quality of governance, the quality of issues of the book which might come up at a later stage was such that the market needed to keep tempered valuations for ICICI Bank particularly.

The one thing you can say for ICICI Bank now is some of it is priced in because in January before the Budget the stock was trading at Rs 350-360; now it has come down to Rs 270. When a bank like ICICI Bank loses about third of its marketcap, it is a serious damage. A lot of damage has already happened to the stock price and it is not an easy call to say that from here traders should go short and everybody should sell but having said that ICICI Bank is a very well owned stock. If you look at most mutual fund portfolios, if you look at foreign institutional investors (FII) portfolios, ICICI Bank because of its near 5 percent weightage on the index actually is a very well owned stock and if there is scare on governance or the finger of suspicion lingers, it is conceivable that a lot of people might actually want to pare down their weightage in this bank and that will keep the bank under pressure as we are witnessing today.

You asked the question about what it means for the private sector banking universe. I think it is quite interesting and not a coincidence that on a day like this when the mood on private sector banks is not great, stocks like Kotak and HDFC Bank are actually going higher. This reminds me of Satyam scam day when the day it erupted one of the biggest gainers on such a bad in the market was Infosys in the same sector. It was the market’s way of saying that whatever else happens we do not expect a corporate governance issue with Infosys of the like of Satyam and the money moved out from Satyam to Infosys on that day, which a lot of people voted with their feet. I think something similar might be but not of that scale because ICICI Bank is no Satyam and so there is no clear parallel but the point that I am trying to make is that something similar in terms of sentiment might be playing out where investors might be saying – I do not know how this thing will play out but for the moment let me pare down my weightage in ICICI Bank and use that money and deploy it to accumulating more of Kotak and HDFC Bank because I do not expect any governance issues to erupt in those two banks at any point in the future.

So it is a bit of a switch, if you will, which is playing out in the private sector banking universe which is not to say that these retail banks have valuation comfort because they are very expensive but still in a day of bad sentiment, I think money is switching from one to the other.

Q: Overall it has been reigning bad news in the banking sector for quite some time now and we have seen the Bank Nifty falling very sharply. Is there any opportunity in public sector banks at this point?

A: My fear is the Bank Nifty might continue to underperform for some more time. It has corrected quite significantly but the more you think of what will happen over the next one year with many of these banks, the retail private banks aside, you are going to see public sector banks continue to struggle with their loan book issues, with the quality of disclosure and I think the fact that there is far greatest scrutiny in the non-performing asset (NPA) accounts right now might lead to some more disclosures over the next few quarters. Recent RBI’s circular mean that the amount of provisioning in many of these public sector banks and the corporate private sector banks will be elevated for 2018 calendar which means the reported number may not be great. So it is difficult to make a case right now for the Bank Nifty to go higher from here. It wouldn’t surprise me. Temporarily you will get pullbacks that always happens but eventually it wouldn’t surprise me if the Bank Nifty continues to grind lower.

Retail private banks might continue to do well but there is an issue of valuation out there because you are talking about three or four banks or three-and-a-half banks out there. How much more will you take them higher given that the rest of the banking sector is still struggling? So I have a feeling that retail private banks, their outperformance will be capped by valuations, they may not fall but they will not go up significantly from here through the year but the PSUs and the corporate private sector banks may actually underperform and that doesn’t mean good news for the Bank Nifty.

Finally, I would say that we may have seen a medium-term peak not a long-term peak but a medium-term peak in the weightage of the bank sector in the Nifty, it often happens; sometimes you will go through phases where the weightage of a particular sector will go up disproportionately compared to its history and sometimes it will fall disproportionately to its history. I remember the same thing happen with the auto sector many years back when it fell to some 2 percent of the Nifty – that was unsustainable and we have had a massive comeback in the last 10-12 years in autos. I think banks over the last 10 years became 30-32 percent of the index and that level that we saw in the peak maybe in January 2018 might remain the peak which is the Bank Nifty weightage or banking sector weightage on the index which may not be crossed for some time maybe even a couple of years.

Q: The last few issues in the primary market have got a very tepid response. Do you think this is a case of expensive valuations or generally the outlook on the market as a whole is becoming weak?

A: A bit of both. IPOs generally do not have great post listing performance in a situation where the overall secondary market or the underlying secondary market sentiment has turned weak and clearly over the last couple of months the listings are telling you that the kind of HNI money which was chasing IPOs for post listing performance, has become skittish because the IPOs are not delivering as they were in 2017 after the listing. This is a function of performance. You see five good listings and thousands of crore move into the IPO game and people want to just chase and sell on listing. The moment three IPOs do not do well after listing, people become wary and they say this is not working any longer. So this is opportunistic money in a sense. This is not long term investor money which is playing the IPO game.

I think generally the mood among HNI investors right now is one of caution and you can see that in smallcap performance. If you look at the smallcap index performance over the last two series, it has actually been a big underperformer compared to the Nifty which tells you that high networth investors have been stung by the market correction and for the first time in the last 18 months, they are probably trying to pare their weightage in this risky, high risk business of IPO investing, smallcap punting, and some of their money is a) getting out of equities into maybe the bond markets, b) they are coming out of smallcaps and IPOs and moving to the relative safety of some of the bluechip largecaps because HNIs are not stupid.

They were chasing momentum throughout 2017, it was working for them, but they have realised after January that this game is now turning a little bit, the wind is moving in a different direction and they have been quick to adjust. I think primary market issuances might face as you could see with the ICICI Securities, it is a pedigreed issue, did not do very well. They had to cut down the size of the issue also. So I think it is just the first sign that things may not be as easy going with the primary market with IPOs as they have been in 2017.

Q: The fourth quarter earnings season will be getting underway shortly. The third quarter numbers broadly were slightly better than what market was expecting. Do you expect any kind of outperformance in the fourth quarter numbers as well?

A: I do not expect numbers to be too bad. However, it is all in the price. If you look at aggregate numbers for the third quarter, they were not great, because State Bank of India (SBI) marred and therefore as a composite set of numbers, the overall growth was not great. However, if you take SBI out, which I am not a great fan of doing, you could see that many sectors have been showing a fairly significant improvement. In a sense, therefore, third quarter was not a bad set.

I think fourth quarter will be similar. You will see some sectors, notably autos, etc. will do quite well, maybe some of the infrastructure companies will do well as well, but overall at the reported level of the Nifty, you will find that some of the banks, etc. will hold back any major reported composite growth in net profit and I still think that FY18 will end with no more than maybe 5-6 percent kind of a net profit growth which is much lower than what we started off FY18 with in terms of expectations.

So if you do not throw out individual companies, you would still have to say that FY18 net-net has still been a marginally disappointing year with earnings. However, having said that, it is true that there is some recovery momentum in earnings. The point is that the market priced it all in, in 2017. How many times have we seen in the past this same phenomenon which is that stock prices go up six months ahead of reported earnings. When the reported earnings actually come through, which are not bad, the stock prices do not move any higher, they are actually stuck in one place or if the market environment is not so supportive, then they actually come down which is the markets way of saying, we saw it coming, we priced it in, and therefore, there is no justification to go up after the news has been delivered.

So it is buying the rumour and selling the news in a sense and I think that is the same story in the corporate earnings right now. In a sense it is supportive for the market because they are improving in the margins, but it may not be a sufficient condition for prices to move higher because the pricing in of this expected recovery actually happened in 2017 and you could see that after the January earnings, stock prices have not been able to move higher. Arguably as you said, Q3 earnings were not bad, but the stock market is 10 percent lower than it was at the end of the January earnings season, which is there have been other reasons, but it is one way of saying that this modest recovery in earnings may not be enough to propel stock prices higher necessarily.

Q: Coming to specific stocks, we saw big sell-off in the Fortis share. What is your view on the stock at this point and also on the deal?

A: I think it is disappointing. Fortis is a good asset and you would have expected the TPG Manipal Group to actually put in a much stronger offer. I think they are being opportunistic. They probably think it is a promoter problem, people are very worried about how it will pan out and therefore even if you make a half good deal offer, then people will actually sell in relief. That may not necessarily be the case because investors also know that while the promoters may not be great, erstwhile promoters, the asset is good. Therefore, at this Rs 7,100 crore of valuation for the hospital business, it may not fly.

If I were a minority shareholder of Fortis, I would have great reservations about tendering or selling at this kind of a price. I would be quite unhappy frankly at the offer which has been made particularly in light of the fact that at the kind of valuation at which SRL deal might be going through, which means that minority shareholders are actually being shortchanged from what they could get from the SRL cash generation plus the core value of the hospital’s business.

I think TPG Manipal will have to sweeten the deal if they want it to go through. Last week’s 14 percent fall in the stock price is indication that the market is unhappy with the deal. They believe it does not do justice to the quality of the Fortis assets and therefore, I expect that TPG Manipal will have to raise their offer by Rs 1,500-2,000 crore if they want this deal to go through, else I do not think it will see the light of the day. I do not think it deserves to go through at the current kind of valuations despite the promoter issues lingering around the company.

Q: Auto sales numbers for March were once again slightly better than expected and overall FY18 was a fairly good year for the sector as a whole. What is your outlook on the sector for this year?

A: Some of these companies are reporting good numbers, like Ashok Leyland particularly is seeing some momentum on the commercial vehicle (CV) side. I think it stripped off the stuck in transit numbers, export numbers from Bajaj Auto, the overall numbers do not look bad. However, it is once again a case of we knew it earlier and it is in the price and therefore, the price is not moving higher; the point that I was making about corporate earnings because if you look at autos, they have outperformed a lot through 2017 and that is partly pricing in this recovery, this momentum in monthly numbers.

Also, it is a very well owned sector, so, how much more of the three or four auto companies will you buy because not all of them are doing that well; there is disappointment with Tata Motors among a large group of investors. So basically, you are talking about Maruti, Ashok Leyland, TVS Motors, probably the other two two wheeler companies, and a bit of Mahindra and Mahindra (M&M). So these five companies are very well owned now, they have outperformed handsomely, most of them, and now I think given the amount that people already own of these names, and the way the valuations are positioned, it is difficult for people to go on loading up on them.

Frankly speaking, if you ask investors on the street where they are hiding in the midst of this flux or upheaval in the market or volatility in the market, I think most people will tell you that they are hiding in IT and auto. IT because it is considered defensive and safe, and auto because the numbers have some momentum. So most of the money is treating this as a safe haven, IT and auto, and therefore with so much money already invested in these two sectors, it is difficult for auto stocks to react too much more. You can say that they will not fall because the numbers are good, but they will not go up significantly given how much they have already outperformed.