If there is significant capital, once the NPA issues are over, the balance sheet can be rebuilt, says Pramod Gubbi, MD & Head of Equities, Ambit Capital. Talking to ET Now, Gubbi says consumption, financials and IT are the three sectors he is betting on for driving earnings growth in next 2-3 quarters.
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As a house you have been of the view that one should avoid buying into mid and small cap stocks. The correction has been very severe and steep. Are you now telling your clients to put money to work?
It is a difficult period to paint all stocks with the same brush. The important thing to note is whether they are large-cap companies or small-cap companies, to establish if you have pricing power. It is clearly evident that inflation is on the rise across commodities. We are just not talking about crude but metal prices as well.
We are already witnessing that in this earnings season, several companies while demonstrating strong growth have seen margins collapse simply because the input costs have begun to hurt. This would be a commodity buying cycle or an inventory build-up cycle which happened in Q3 or perhaps Q4 last year, given that we are still higher on the commodity price front. I guess another two, three quarters of pain on the margin front is clear.
In that scenario, generally one would tend to believe that small and mid-cap companies are not sector leaders and hence more exposed to an inflationary environment. But I would not like to paint all stocks with the same brush, generally looking for companies with strong brands, which have the pricing power, the ability to pass on the input cost rise through price hikes and keeping their margins intact. The earnings growth is commensurate with the sort of top line growth demand that we are seeing in the economy broadly.
There are a lot of Nifty earnings today, whether it is the oil marketing space, pharma names, Dr Reddys, Cipla or SBI. Where would you be watching out for a directional trend?
We are well into the earnings season and certain trends have been established. The most striking is the inflationary trend and the impact of input costs increases on the margins of various companies.
To that extent, typically towards the end of the earnings season, you will see some of the weaker companies coming through. I do not expect any major turnaround in that trend, if at all, that will just get confirmed. But the other dynamic is the cost of money going up as well. In the bond markets, with the yields going up, we have seen trends getting picked up by financiers who are able to pass on the cost of liabilities on to asset price increases. That is something worth watching out for. Wherever it is — for financiers, money is the input and again that inflationary trend on interest rates should be watched out for.
What has been your biggest takeaway from the earnings season so far? It has been an interesting set. Are you convinced that earnings revival is on its way for FY19 and that we could see earnings go up to early double digits?
Yes. In pockets, that is right. We have been waiting for that recovery in earnings. Certainly, the demand scenario is pretty strong in the economy and that is reflected in healthy across-the-board top line growth. Where the dynamic breaks down, is in terms of the margin level because of the input costs going up. The not-so-great companies with no pricing power have clearly not been able to translate the strength in the top line growth towards earnings growth and that is where the broader dynamic of an earnings recovery played out.
But in pockets of consumption, particularly Indian consumption, there have been very strong companies with strong brands. They have managed to use the strength in the recovery in rural consumption and being stable to stave off much of the input cost rise.
Keeping their margins relatively stable and delivering earnings growth is likely to continue as we proceed towards election because the macro for rural remains strong. On the private sector financials, again because of their strong liability franchise, the private sector banks with strong CASA will clearly become more and more competitive as we go on. As interest rates rise, their asset side goes up but the cost of funds remains largely anchored and that allows them to expand their net interest margins. The earnings growth recovery will be quite visible there.
Third, in the tech sector, we are seeing demand improving as the US economy improves but also the investments put in by some of the Indian IT companies are bearing fruit now. Add to it, the tailwind of the rupee and I guess there is one of the pockets where earnings growth is visible. These three sectors perhaps should be the driver of earnings growth this quarter and for the next two, three quarters as well.
Big gains are made in the market when you buy something when the news is bad. You think it is temporary in nature and that is the time you buy good stocks and make money. Where do you think the news flow is seemingly bad but eventually it would lead to improvement?
Corporate banks is where you would see this dynamic. Unfortunately, we have not had too many pockets of value where both earnings recovery and valuation support is there. But I guess the corporate banks would fit the bill. That is where maybe we are near the bottom.
Here again, you have to be a bit discerning and figure out which ones have the structure or fabric to come out of the rut. I would look at the capital structure. If there is significant capital, once the problems of the NPAs are behind you, you will be able to rebuild your balance sheet and start growing. That is when the benefit of growth and the depressed valuation will add up giving you disproportionate returns.
One angle that has really stood out in the market is what is happening with real estate and infrastructure engineering companies? The debt laden space is just seeing no light at the end of the tunnel. Is this space to be completely avoided? I am talking about companies which are trying to reduce their debt and come back to life. Is it still a risky bet?
Hardcore infrastructure development is something that we would still stay away from. These are not particularly good for equity investors. The sort of funding these projects need, are long dated and terms of their duration are slightly different and companies will be better off tapping those sources of funding. So, we would generally stay away from the development side of infrastructure.
However, the EPC side of infrastructure is something that is more of a P&L play. They need working capital debt and so on but where you have the end applications — be it roads or government buildings — are the two areas that are picking up. Any EPC company which is exposed to this dynamic where order books are strong and debt is reducing, will be an attractive place although I am not sure how much of value remains there.
Most of these companies are already trading at 15 to 20 times which is perhaps the higher end. Assuming we are still at the early stages, the earnings pickup cycle still envisages a couple of years of growth runway ahead of you. EPC companies within infrastructure are worth playing. Real estate, is that much harder. You need perhaps a three-year plus horizon to look at and certainly not the short -term perspective.
There are several moving parts, A lot of it is structurally positive for some of the better managed companies to consolidate and take market share away from the unorganised sector but the pace of change will be a lot more slow and maybe we will see some hiccups but I would not recommend that for people looking at it from a short-term perspective, but rather a three-year plus horizon.
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