Saurabh Mukherjea is busy picking stocks in these three cyclical sectors

Earnings growth to power the rally on D-Street. Auto and financials best way to play economic recovery, says Saurabh Mukherjea, Founder, Marcellus Investment Managers.

Nobody is complaining but everyone is worried about the pace and the force with which markets have come back post Budget. Do you think the fundamental context of this market has changed because of the strong earning season and the Budget?
It will be very hard to stop this market. Even through that one month lull that we had going into the Budget, where people were losing sleep about the Budget, I kept highlighting that in an environment where earnings growth is going to be 25-35% consistently for several quarters to come for large companies, it will be very difficult to hold back the market. The only circumstance in which this market can see a pullback is if inflation comes back strongly and interest rates are hiked both in the western world and in India.

Barring that scenario, for anybody out there, waiting on the sidelines worrying about valuations, life will be difficult. For the next four quarters, because of the YoY comparisons turning favourable, we will get even better earnings growth than the bumper quarter that we saw in Q3. So, it is difficult to see what will hold the market back barring a strong inflation and interest rates.

There was a time when markets used to worry about pristine quality and great capital allocation but as the economy is opening up very differently, could the market also be looking for different indicators?
We will be going into that part of the economic cycle where capex after being subdued for eight-nine years, is clearly picking up. Whether it is power consumption, truck sales, sales of residential housing units or mortgage disbursals or steel demand, we are in the early stages of a two-three-year capex uptick. There are two ways to play it. One way is the traditional value investing way of going and buying steel and metals, mining, power, infrastructure, construction and real estate stocks. The other is the Marcellus way. We know that in heavily regulated actors like metals, power, infrastructure and real estate, it is very difficult to generate return on capital above the cost of capital. So, at Marcellus, we play the economic upcycle, through three cyclical sectors. The first one would be auto and auto ancillaries; second would be the lending construct in our banks and NBFCs to a lesser extent; and the third way to play the macro upcycle is to look at the building material sector, in the sense of tiles, pipes, paint adhesives and so on.

In the December quarter, they are having a bumper run but my reckoning is the building materials sector is set for a two-three years bumper run as the real estate cycle turns down. So play the cycle through sectors where you know there are clean well run high quality companies with a long track record of high quality capital allocation. Do not get suckered by low PE multiples into getting into sectors which are capex friendly but which have a really troubled history of broken balance sheets and poor governance.

Could you give a few names which surprised you on the upside over the kind of growth that we saw? Anything new that you are taking a note of even if you have still not added it?
Let me start with financials. In the past, I have discussed that we are adding second run financials and mentioned AU Small Finance Bank which we have added assiduously over the last six-seven months into our portfolio.

We are continuing to look at this theme of second run lenders which are well run and have a good balance sheet tier one ratios north of 20% and over 30% in some cases. In that context, we have also started adding Aavas Financiers. This is an affordable housing finance play primarily focussed on north western India. They have ticket sizes of Rs 8-9-10 lakh and used to be part of the AU Finance table. Subsequently, AU Finance had to sell its stake and it is now owned by two private equity firms for the most part. So, Aavas Financiers is another small financials name that we are adding and we will carry on doing this.

We have been very clear through last summer that over the next three, four, five years, there is a lot of money to be made in India by investing in high quality lenders and high quality savings plays. AU Finance, Aavas are part of that strategy for Marcellus. We also obviously have the traditional lenders HDFC Bank, Kotak Bank, Axis Bank and so on. We are adding the second run lenders.

The second space where we have very enthusiastically increased our positions through 2020 was auto and auto ancillaries. We have added familiar names like Maruti Suzuki and Eicher Motors but we have also added smaller auto ancillaries and we have fairly substantial positions in companies like Sterling Tools, Suprajit Engineering, Lumax Industries and so on.

That is this theme where we are very confident that over the next one or two years, even if EV makes a meaningful entry into the Indian landscape, these firms will do well. We are adding these stocks. You will need car headlights and hence you will need Lumax. Even with EVs, you will need fasteners for your car and hence you need Sterling Tools. So auto and auto ancillaries remain an exciting space.

The third area is something I have earlier also but we have been surprised by the upside in specialty chemicals. It is increasingly evident that the west and China want to reduce production of specialty chemicals because they believe there are environmental hazards associated with it. That production will have to go somewhere and a big part of global specialty chemicals production is coming to India. In our portfolio, we had names like Divi’s in the API space and Alkyl Amines, GMM Pfaudler. We are looking to add a few more names, we are doing some more research. Give us another month. We are trying to figure out what other names we can add in this specialty chemical space. There seems to be an enormous demand. The most obvious way to play this is to play the main supplier of this industry GMM Pfaudler.

In the next one-one-and-a-half years, demand and production pipelines are full for the special chemicals industry and we are looking for other ways to monetise this. Yes, the traditional ways of cement and road construction and real estate are there but for long, we have had concerns and there are competitive advantages to be built in sectors like that. There are governance issues as well which I hinted at a couple of minutes back. So our favoured way is to look for good quality lenders, auto, auto ancillaries, specialty chemicals and building material companies. Astral Poly, Asian Paints, Pidilite, Berger Paints are traditional Marcellus favourites and we continue with those.

While the API theme is continuing, what about pharma? What kind of opportunity do you continue to see in some of these pharma majors?
So in pharma the two companies where we have had meaningful stakes over the last couple of years -- Divi's Lab and Abbott Laboratories. In Divi's case, it is more a play on API rather than pharma per se. Divi's does not make the formulation. It supplies APIs which go into formulations. This was already a well run firm even a couple of years back. In the last couple of years, they have consolidated their position as one of the leading API suppliers in the world. They have announced further capex just three months ago. A steady 20% compounding in this company should be possible over the next five, six, seven years. Among the export centric pharma plays, Divi's would remain our chosen play.

Amongst the domestic pharma construct, Abbott is the most moated company. The stable of products that they have had for the last eight-nine years led to their revival. The stable of products that they have had has been without comparison in the domestic landscape and the main challenge to try and deal with here is that FII holding is capped out at 75%. So already the FIIs ceiling has been hit and obviously with FII money will not be able to come in. The stock has flat lined over the last eight-nine months.

Ironically that means that domestic like us can buy more than the foreign investors can and we have taken full advantage of that. Whilst recent results have in quarter was basically a flat quarter, our reckoning is that the Abbott franchise in India has enormous potential and it will keep bringing better products from their western stables and adding into the formidable line up they have in India.