Sanjeev Prasad on why it is still not time to turn buyer in the broader market

“In the case of FMCG companies, valuations and prices have corrected, but I do not think they have gone to a level where you can make a strong buy case for the companies. They have just got back to March ’19 levels,” says Sanjeev Prasad, Managing Director & Co- Head, Kotak Institutional Equities.

There is a silver lining out there that commodity prices have started reversing, crude is down from its high. Do you think now markets are getting reassured that the bulk of the inflationary fear is behind us?
It is too early but I would say definitely positive developments over the last fortnight or so in the form of some recovery in monsoons. Now we are getting into normal monsoon territory but we will have to wait another two months to get more confidence on that.

The same way, commodity prices have corrected a lot, especially metal prices while oil prices have moderated from high levels. All that is good news and expectations are inflation will not surprise negatively on the higher side and in the second half of FY23, we will see a big decline in inflation just because of the very high base effect of the second half of FY22.

Since inflation was very high, assuming we do not see any negative surprises on either food or fuel inflation linked to either subnormal monsoons or something going dramatically wrong on the whole Russia energy supply situation, hopefully inflation comes down and because of that, we will get some more confidence that the RBI may not raise interest rates dramatically.

Our expectation is that by the time we exit FY23, inflation should be in the range of 4.5-5% which means the RBI probably needs to raise rates another 60-85 bps from where we are. So 5.5-5.75% is as of now the limit that we are looking at as far as policy rates are concerned. That is pretty manageable in the context of the fact that we are at the bottom of the cycle. We are looking at about a 150-175 bps rate increase similar to transmission if we assume interest rates in general. The impact on the economy is pretty limited in that case.

There is a challenging macro environment where the micro of the market has become better. While we can focus on interest rates, inflation, commodity prices, where do you think the micro is looking good now?
If you look at parts of the economy, especially urban poor and the rural economy which were quite badly affected by Covid because these are typically people who were employed in high contact or physical sectors, a combination of construction, hospitality, retailing, travel and tourism and transportation – just because of reopening and the economy activity rebounding – we are starting to see income levels if not at pre Covid levels, at least significantly higher than what they were in days of lockdown. So clearly a lot of recovery over there.

On top of that, we have seen a fairly smart recovery in domestic food prices and vegetable prices have gone up very sharply because of seasonal factors. It is contributing to inflation on one side but clearly it is positive for the rural especially the agri part of the rural economy. So things have improved over there.

Over the last fortnight because of commodity prices cooling off, particularly metal prices, it is clearly a big positive for autos which consume a fair amount of metals and we have seen a significant rally in some of the auto names and also oil prices to some extent. So those are the segments where at least the macro seems to be getting better linked with the micro factors also.

How should one approach FMCG? If one takes ITC out of the equation, FMCG stocks are down 15-30%. Now commodity prices are getting softer. Is there an opportunity here?
From a valuation perspective, the stocks are still very expensive. If one compares the multiples on a 12-month forward basis for any of the consumer staple names or even discretionary names say in March 2019, which was a similar macro environment with similar levels of bond yields, multiples are pretty much at the same level if not higher in some cases.

In the case of Asian Paints, Marico and Godrej to some extent, the multiples are higher compared to March ‘19 level. It is not as if we have seen a big correction in the multiples. We have seen some correction in the stock prices from the peak levels but the valuations had become totally absurd in February, March, April.

So yes, valuations and prices have corrected, but I do not think they have gone to a level where you can make a strong buy case for the companies. They have just got back to March ’19 levels. I do not think you can take a very positive call on the consumer names linked to valuations at least.

I was reading a report you had put out on June 24th where you found broader markets to be still quite expensive, especially if one were to look at the bond markets. Why are you still not impressed with the valuation of broader markets and what kind of levels will you wait for to become a buyer?
The broader market Nifty 50 index is about 18 times on a one year forward basis. It is clearly a lot more reasonable compared to somewhere about 22-23 times in which Nifty was trading in the second half of calendar 2021.

So yes, multiples have come off but the problem is the bond yields have gone up pretty sharply over this timeframe from less than 6% to now closer to 7.5%. The challenge still remains that if we look at the gap between earning yield and bond yields and when I say earning yield, that is nothing but the reverse of PE multiple on a year forward basis, that gap is still on the higher side.

The 10-year bond is at about 7.5% or 7.4% as of now and the earning yield on a one year forward basis could be somewhere around 5.5%, that is 1/18 times. So that gap is somewhere about 190-200 bps, which historically is on the higher side. I am talking about the negative side and if the yield gap is so negative, the markets will struggle to perform.

From here on, hopefully there is not much risk of bond yields going up further assuming we are right on the inflation part and things have cooled off and the inflation has more or less peaked. We still have an upside risk but assuming that is the trajectory of inflation going forward, hopefully you would not see the negative surprises on the bond yield part.

Do we see any positive surprises on earning? It looks unlikely. I do not see earnings upgrades happening in this point in time and so the only way this market could go back to normal levels of yield gap that is between earning and bond yield could be through a process of either time correction and hopefully that is what plays out or through a price correction which obviously means there is upside risk to the market in that case.

Our view is that if inflation has more or less peaked and inflation starts coming off from the second half linked to base effects and no negative surprises on food and fuel inflation, then it looks like most of the bad news is there in the market. The valuations are still not very attractive but at least there could be some bottom for the market at current levels.

IT stock from their pre-Covid levels are still 60% higher even though IT was the first to crack in this global market selloff. But the buzz is still extremely strong. The demand parameters and levers seem to be so strong but IT stocks are not performing. However, valuation wise they still have not cooled enough. What is your view on IT?
I have a more or less neutral view on IT as of now, neutral to slightly underweight. On the positive side, demand is looking good but we also have to contend with a possible slowdown if not recession in the US. As of now, most people are of the view that we will probably see a recession in the US sometime in 2023. That will definitely weigh on demand for IT services.

The bigger challenge in that case would be also margin pressure because if there is a recession and God forbid hopefully I am wrong on that one, then I do not think IT companies, the buyers of IT services will be in a big hurry to close deals, etc. They will take their own sweet time. They will negotiate the hardest they can, squeeze margins of the IT service providers to the best they can.

So we will definitely see some margin pressure coming in. How much of that is also by the rupee, time will tell but I definitely think even if there is not a big cut on top line of the IT companies, the bigger risk is coming from the margins assuming this whole recession scenario actually plays out in the US.

The second challenge for the IT companies is valuations have corrected pretty sharply from March levels but they have not gone to levels where I feel very comfortable and where all the negative news is getting priced in. Infy for example, was a stock which used to play at about 15 to 19 times on a one year forward basis on a pre-Covid timeframe. It is somewhere about 24 times on a one year forward basis.

Maybe the pre-Covid multiple is not correct because at that time, there was a lot of negativity associated with the IT sector in general and in particular with the Infosys stock and maybe that 18 was not justified. But we are at 24 and I think we still need some correction over here. So, hopefully there will be time correction and assuming stocks do not go anywhere over the next six-nine months – which I suspect is the case for the market also – multiples will start looking a lot more palatable after a period of time correction.

The other interesting thing what one is seeing and that is only a very recent phenomena since last week is this massive revival in autos. M&M scaled new highs and now the buying seems to be spreading across Hero MotoCorp and Bajaj Auto where the street is finally excited about the buyback meeting happening today. Maruti also finally scaled Rs 8,000 per share mark.
It is broadly linked with top-down positive developments in the form of sharp crack in metal prices which is obviously good for profitability of the auto companies because at a month back levels of metal prices, auto companies are seeing a lot of pressure on cross margins and profitability. So, that fear has now gone away. So there is a big positive in the form of not that much negative impact on margins as to how the market was faring a month back.

Oil prices have also come off although it probably does not matter that much in the Indian context because we have not changed prices for a long time but at least the worries about big increase in pump prices, etc, has probably receded because ultimately the whole cost of ownership matters as far as auto demand is concerned.

There are positive tailwinds arising from commodity price correction plus specific developments in some of the companies. In the case of Maruti for example there is excitement around the new Vitara Brezza launch and hopefully that will result in Maruti regaining some of the lost market share in the SUV segment. We will see how that plays out but that is what the market seems to be focusing on as of now.