In an interview with IIFL's Devansh Mehta, Sachin Trivedi said, “The pockets that we think could see a decent momentum would be of course those that are directly affected by the current currency depreciation.”
Here are the excerpts from the interview.
Bond yields have been rising and higher crude oil prices have led to a widening CAD. Inflation is also expected to harden further. Do you believe that these factors pose a significant risk to the Indian growth story?
Yes, these factors would effectively run into CAD-negative situations. India is expected to touch 3% CAD deficit; this could also mean a subdued amount of inflows from FIIs or outside investors, potentially leading to a significant negative balance of payment situation. There are some estimates that put this number as high as $30bn. This will effectively eat into our savings, i.e. less consumption by us. Logically, we would be consuming less because the lower inflow of capital will create challenges. The other drawback right now is that when your currency depreciates, it naturally creates inflationary pressure; until now, we have not seen that because food inflation has been quite benign. But when you look through some of the corporates, some challenges have already started to creep in, which will escalate going forward. Hence, the inflation expectation could remain slightly on the higher side, which would create another challenge. There would be some amount of moderation in the short-term but with the right policy (now that the RBI policy mandate is to anchor the inflation expectation), these things should be under control. So in the medium- and short-term, there will be some amount of challenges as far as the markets are concerned. As I said on consumption, there will be some amount of challenges as far as the top-line is concerned and plus raw material pressures will hit your margin expectations. So, over a period of time, we may see some amount of moderation in earnings growth. This is what has been happening for the last couple of years: we start with high expectations and then earnings don’t actually materialize. This may again happen this year. So there will be some amount of challenges as far as growth is concerned.
So will we overcome these challenges in the next one year or will it take longer than that?
Yes, of course, if we find the right solution, because, for the last several years, we have just not been able to find the solution for the oil deficit. So it would be a challenge; and because of the shrinkage of the balance sheet by the US Federal Reserve and the hardening of interest rates, there would be medium-term challenges. So maybe a year or a year and a half for growth to actually come back. Nonetheless, just because there would be temporary challenges to consumption, that does not mean that we would stop consuming; we are a growth economy and will continue to grow. Of course, the growth will come back and people will take time to adjust, which is why we will spend the next 1-1.5 years in a consolidation phase.
What will the next financial year be like for the Indian equity markets? Which sectors do you think are the right place to be in right now?
The pockets that we think could see a decent momentum would be of course those that are directly affected by the current currency depreciation. In the past, we have seen that export-oriented sectors have done reasonably well. Then again, you will find IT and pharmaceuticals within this pocket, two large sectors which will see a pick-up in volume momentum according to historical data. We think that they should be the main beneficiaries of this currency depreciation.
If you look at the fundamentals of IT companies, they have been saying that the volume momentum is returning because the de-growth that was being witnessed in their traditional business has decelerated. At the same time, digital and newer technologies have started kicking in for them and they have started getting a decent chunk of volume, which should be more profitable on an incremental basis. That’s one pocket that we find attractive.
The other area is pharmaceuticals, wherein some of the headwinds that were related to price pressures or pressure with respect to approvals of new drugs have also started to wane. Moreover, plant-level approvals have started to come through. Also, some of the larger companies have spent a good amount of time on developing some specialized drugs. That’s one area where the fruits should start getting visible soon. Also, there are pockets within the domestic sectors where you can definitely see that the volume momentum continues. Of course, they will start to face some amount of margin pressure going forward with respect to raw material pressures kicking in, but at end of the day, these companies have pricing power on their side. Hence, over a period of time, the right matrix to focus on would be EBITDA growth rather than EBIDTA margins, and there we are quite confident that these companies should be able to actually hold up their performance.
Other segments are the private and corporate lenders and some of the large private banks with a corporate focus. Our expectation there is in terms of provisioning cost or the credit cost, which has more or less peaked out for them and somewhere in the next year onwards, that cost should gradually start to go down. Anyways, these companies have now been focussing on growing their balance sheet so this is another sweet spot we find. Of course, some amount of re-rating has happened to their valuations, especially in some of these banks, but we still feel confident that the improved performance should result in a decent growth from these companies.
As you spoke of private banks, what do think of the crisis in the NBFC sector, especially after the IL&FS fiasco?
As far as NBFCs are concerned, the issues started to crop with the IL&FS default but went on hit housing-related NBFCs more than other NBFCs. The contribution of some of these NBFCs in the entire banking space in terms of profitability has improved in the last couple of years. Now, the basic model which these guys were running is that some of the housing NBFCs, which are naturally into asset-based lending, were relying on mutual funds for short-term borrowing or on wholesale borrowers. But, even the RBI has stated its unhappiness about this situation, and hence, some amount of correction is happening here.
So the natural outcome of this is more likely that people will have to go back and ensure the right amount of asset liability management, which would mean that some of these NBFCs, which were lending long and borrowing short, will see a de-growth in their balance sheet. That’s one area which is not favorably placed and these companies will find it hard to grow on an incremental basis.
But among the NBFCs, which were also hit hard, some are actually lending on a short-term basis. For example, NBFCs financing for short-duration products, say a two-wheeler or a TV or some other consumer durables, will actually see a bounce back. Another example would be some of the asset finance houses that are in the business of financing commercial vehicles or two- or four-wheelers. They will find the right solutions and there will still be pockets of opportunity. So, we will have to distinguish between these two buckets.
You specialize in the auto and auto ancillary sector, and we have seen a correction in this space over the last few months. So what’s your take on the same?
Auto has been hard hit and if you see on a year-to-date basis, I think auto shares have corrected nearly 20-25%. This implies that peak valuations have gone through a revision. But naturally, the other adjustment that has happened here is that demand has been slower and market reports say that there is some amount of inventory built-up that has happened.
Now, a couple of factors that added to this are some regulations that kicked in, including the one which mandates that personal insurance be taken compulsorily while buying a new vehicle. Initially, there was some confusion about this; i.e. some thought it was for five years, but it has since been clarified to be for one year. The other issue that cropped up here is third-party insurance, which again ranges from 3-5 years: for two-wheelers, it is five years, and for four-wheelers, it is three years. So, in the case of some two-wheelers, the cost of third-party insurance is as high as 10% of the vehicle cost, while the raw material costs are anyway building up. Last year, we had migrated to the BS-IV emission norms. This was also an additional cost that crept in. So, there is a continuous cost pressure, which has resulted in an increase in the cost per vehicle. So the few regulatory hurdles that I mentioned and the added cost pressure on the prices of vehicles has resulted in some amount of softness.
On the demand side, we’ve already seen the headwinds in some of the areas. Let’s say, for e.g., Maharashtra has witnessed a drought situation in certain pockets, which has hit the demand. Furthermore, there’s also the Kerala floods and some regulatory changes in West Bengal which mandate that one should have a driving license to purchase a vehicle. All these factors have come together and have resulted in some amount of demand challenges as far as this sector is concerned. CV, to date, has been doing well, but we will have to see how it goes forward. So as far as the auto industry is concerned, there are these challenges that come into play, but this is short-term in my view. Naturally, valuations have corrected.
We should keep in mind, which I also keep telling my investors, that auto is one area where we believe that complete market penetration, both in the two-wheeler or four-wheeler segments, still has a long way to go. Moreover, premiumization is happening within the sector, which means that there is ample room for revenue growth of these companies. But currently, there will be some challenges from the NBFC sector that will temporarily impact demand; however, there is also the pending demand, which is not just going to go away. And this is just a short-term adjustment; we remain quite bullish as far as the long-term is concerned.
We should also keep in mind that when we talk about auto original equipment manufacturers (OEMs), these are companies that are actually very profitable and are high cash-flow generating companies, with most of them available at 10x the EBIDTA. So, of course, temporary challenges, but attractive valuations post correction; and these are high-quality companies. So we are quite confident that they should keep doing well in the future.
The Nifty has corrected almost 15-20% in the last few months while mid- and small-caps have also witnessed a good amount of correction. Do you feel that these valuations in the mid- and small-cap sectors are attractive and should one start investing there?
Typically, what we have seen in the past is that whenever there is a currency correction, i.e. the rupee depreciates, the mid- and small-cap segments take some amount of beating. You should keep in mind, on an average, mid- and small-caps trade at a discount to the large-caps. However, in the last few quarters, mid- and small-cap companies were at a premium compared to the large-caps on the back of performance and re-ratings. The premium had gone as high as 30% over large-caps. Now, post correction, in the case of mid-caps, this premium over large-caps has corrected and they have gone back to trading at a 5% discount. We found that there is some amount of correction that happened somewhere. So our expectation is that over the medium-term, some amount of consolidation can happen in the mid- and small-cap sectors. Meanwhile, large-caps may continue to outperform the mid-caps. Of course, stock-specific opportunities and sector-specific opportunities always exist.
What is your investment philosophy? How do you select stocks?
As far as my thought process is concerned, it is clearly a bottom-up approach. I continue to believe that companies that can achieve healthy cash flows and return ratios are the ones that will survive in the long-term. So the thought process is to keep investing in companies that generate healthy ROEs and have the right management that focuses on the right areas. Also, we are not averse to investing in companies that are currently facing challenges with respect to some of these metrics, but there has to be an underlying belief that they will go back to their potential. But if there is no such potential left, it is not a “go” for me.