We will not go all-out to buy now; here's what to avoid in this fall: Pankaj Tibrewal

“When one combines the three portions – the government, private and household capex -- the manufacturing sector and the investment cycle looks poised for a revival, says Pankaj Tibrewal, Senior Equity Fund Manager, Kotak Mutual Fund.

Mid and smallcap stocks have corrected. Every major midcap sector has seen a 15% to 25% drawdown. If the starting point is February 22, 2022, are we in for decent returns given that a correction has already kicked in?
It is still some time away before the stocks become extremely attractive and the basic premise which we have been talking about is that in the near term, we believe that the earnings upgrade cycle has peaked out and we have been saying this for last couple of months. In the third quarter, we saw a glimpse. In the fourth quarter, while listening to the commentaries by the management and doing our channel checks, it seems the demand momentum is still very weak and margin pressure is sustaining across different companies. As a result, as we move into the fourth quarter, my sense is there could be an earnings downgrade in the fourth quarter number as well.

So once the Street adjusts itself to the new reality on margins and top line growth, that will be the time to reassess the stocks at a new valuation point and till that time volatility will continue. We may have different distractions like Russia-Ukraine, China-Taiwan or maybe US-Fed at that point of time and this volatility will give us enough opportunity to buy good quality franchises at right prices and valuations. So we still believe this is some time away before we go and buy the market full-fledged.

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When you say that markets need to perhaps correct or we should spend some time so that there is consolidation, what is the basis for this criteria?
There are a couple of things. One, this is a year of transition from lower interest rates to higher interest rates, from excess liquidity to adequate liquidity, from early cycle to mid cycle and from a very high earnings expectation to moderate earnings expectation. Whenever you transit in a year and the year is of transition, you have to navigate it well and that comes with a lot of volatility. Our base assumption is that the bull market continues but the breadth of the market will become narrower as we have seen over the last couple of months and that makes me believe that the easy money making which has been there for the last two years is behind us. This year will be men versus boys. This year will be extreme bottom-up stock picking and people who can pick the right sectors and right themes probably will be the winners.

The dispersion which I am seeing in the first 40 days globally across sectors is crazy to say the least. On one hand, the written-off oil gas majors are up 20-25%; on the other hand, the top IT or tech companies are down between 30% and 40%. So there is a dispersion of 50% to 60% taking place in two sectors in just 40 days time. Think about a public manager who is positioned on either of the sides and the dispersion in returns will be very different. So this year, we need to navigate the market quite carefully as this is a year of transition to higher interest rates and tighter liquidity.

I was scratching my bottom-up stories. What are you talking about?
There are a few themes which we have been bullish on. The first one is on the revival of the investment cycle and the domestic-facing economy stocks and there we are seeing traction coming in. Order books are at an all-time high and that gives visibility on top line growth for the next couple of years.

If you look into the past cycle, this is one sector where the top line growth comes in and the operating leverage could be very high in terms of margin. So there is a reasonable scope of margin surprise as we move into FY23 and FY24. We believe that the capacity utilisations are running quite high across various traditional sectors and that gives us a belief that the capex cycle is beginning to revive after a decade or so so.

That is one very interesting space where we believe that over the next couple of years, we will get a decent opportunity. The second one is on financials. Banks and private sector banks especially are looking very well poised in this cycle and that is one space where valuations have corrected over the last 12 to 18 months and that space is also looking good.

The third space which we have been talking about for more than a year now is the revival of residential real estate and the entire home improvement space around it. We believe that a three-four year cycle is beginning to start and we are liking the space.

Last but not the least, the export opportunity where the demand momentum seems to be extremely strong as companies diversify their supply chains ex-China and across sectors – when we are speaking to companies – be it light engineering goods, auto ancillaries, home improvement or speciality chemicals – everybody is saying that the demand momentum seems to be quite good. The export opportunity is there and we need to go bottom-up and select the leaders, the companies with strong balance sheets and cash flows.

This volatility will give us an opportunity to do that.

Of late, a lot of froth has come out of IT and the entire new age tech IPO space. Nykaa and Paytm have been battered. Is this a pocket you will be looking at now from a long haul perspective?
Yes, we have been very selective in the new age IPOs because we we could not understand the valuations at that point. The companies which we believe will do well have a good business, overlaid by a digital architecture. There are a few companies in that space in the edutech world which we believe has a long runway for growth. We have a right to win and there is probably an inflection point coming in over the next couple of years where any new addition of subscribers will flow directly to the bottom line.

I would be interested – maybe not all of them but very selectively in this space and look for the right price points where we can make money over the next three to five years.

In your February 2022 presentation, you have written that in the last five years, the Nifty manufacturing index has underperformed the Nifty 500 and the odds for an outperformance is 68%. How exactly are you playing this theme?
We recently have been positive on the revival of the entire manufacturing sector. First of all, the balance sheet of corporate India are the best in two decades and the companies we are interacting with are saying that they are looking to deploy the cash flows back into the business. So after a long time, we believe that the animal spirits are coming back and people are looking to expand their operations and balance sheet and cash flows are supporting that that is the first starting point.

Second, if one divides the gross capital formation into three parts – one is the government, the second is the private sector and the third is real estate, which is household capex. The government has been doing its work for the last four-five years and this Budget also, we saw a very significant increase in the capex expenditure.

The private sector has been silent but we believe balance sheet cash flows plus the PLI opportunity and the China plus strategy will help them expand their operation and many sectors – be it electronics, API chemical or pharma, the entire ecosystem around green energy will see massive amounts of investments coming in.

Companies we are speaking with are saying that the entire ecosystem around them has started to build around and probably that may take two, three, five years but we will see that momentum gaining and so that is the private sector.

The third part is the household capex, which has been subdued for almost seven-eight years. Real estate is showing early signs of revival. Across the top 10 metros, the unsold inventory is at an eight-year low. We have started to see price uptick also and probably the launch cycle will determine more and in our view GDP growth will after six to eight months. When one combines these three portions – the government, private and household capex -- the manufacturing sector and the investment cycle looks poised for a revival.

What to buy in the recent fall and what to avoid also?
I think in investments, what not to do is more important than what to do and if you are clear of what you will not do, the list of things to do becomes shorter and one will be surprised with the outcomes. In this market and as our investment philosophy, we have stayed away from leveraged companies ex financial.

We always believe that one should look into the history rather than the future and avoid companies which cannot generate return on capital (ROC) or return on equity (ROE) above cost of capital for a considerable period of time. Also, stay away from companies where there is a huge cyclicality across the board and they do not have pricing power. Also, if you can stay away from companies which have very high valuation and low floating stocks, that will be another space. These are the three-four things which we will advise investors to avoid because things are very volatile and this will be a year of volatility. So please follow a basic investment principle while selecting stocks, sectors or funds. This will help you navigate this volatility quite well.

Why do you like the consumer durable story so much right now?
We believe that on the consumer durable side, the basic thought process is that as you transit from a $2 trillion to a $5-trillion economy and as you move ahead of the breakeven point of $2,000 per capita GDP, the incremental money spent on food or food staples starts to come down and discretionary expenditure starts to move up. We believe that appliances in India are a very underpenetrated category. For example, air-conditioners as a category has grown in double digits, almost equal to what paints have done and we believe that now ACs are no longer a luxury. It is a necessity at every house, at every office.

With the real estate cycle picking up, demand for consumer durables will see a very sharp upturn and in the entire consumer durables category, small appliances are very well positioned and the runway for growth over the next three-five years seems to be very strong.

However, we need to be very selective in the companies in the space and look for companies with strong distribution, strong brand power, innovation capability and the ability to also export to the world market from a cost competitiveness perspective. The companies which are ticking those boxes are part of our portfolios. With a three-five year runway for growth, the sector is very well poised and we are positive from a mid and smallcap perspective in this sector.