4 investment themes that are offering value in mid and smallcap space: Pankaj Tibrewal

“Manufacturing and industrial capital goods looks to be a very sweet spot to be in. We have seen a very strong performance by financials. For the next couple of quarters at least, the financials seem to be in a good space and both large private sector banks and large PSU banks are well positioned in a rising interest rate scenario as well. The third is the auto pack and pharma can be the dark horse but there has to be a stock specific approach,” says Pankaj Tibrewal, Senior EVP & Fund Manager (Equity), Kotak Mutual Fund

Nifty is 500 points away from 18,600. Who would have thought we would be here when there is war in the world, when rupee is at 82 and there is a problem in terms of what is happening to Europe and US but the Indians market is holding on?
Absolutely.

Where do we go from here? Should we focus on macro and valuations or not? It is momentum and liquidity which is making all the difference?
The Indian market is very resilient and in an environment of a perfect storm when global markets are down 20% to 30% calendar year to date in dollar terms, the Indian market has been a clear outperformer. The valuations today versus emerging markets and the rest of the world are at all-time high now. So valuations clearly are one or maybe two standard deviations above the long-term averages. The flows have been positive.

In the last six days, we have seen FIIs buying to the tune of Rs 14,000 crore, In the last two months, the selling intensity has come down. From here on, for the next six to eight months, it has to be a bottom-up approach rather than a top-down approach and look for companies which probably can weather this global storm.

In India, there are a couple of points to note. On the macro side, one concern which is emerging is that liquidity is getting tighter. Across the board on the conference calls also, managements are alluding to working capital cycle elongation. Deposit rates have started to move very fast. We are seeing a credit growth of 15% but deposit growth is not keeping pace and our sense is that banks over the next six to eight months will raise deposits aggressively to fund their credit growth. So liquidity which was in surplus for the last three years, has started to come down and that is a matter of concern.

Second, the global interest rates can remain higher for longer and this is something we need to watch out for because if you look at two-year US treasury, you are getting 4.7% and add to that 2.5% of rupee depreciation on a normalised basis. So you are roughly getting about 7-7.25% on a US treasury asset which is not a bad yield for any global investor. My sense is that it will weigh on the flows at some point of time going forward.

The third point to note is geopolitics. Clearly the China side and the Ukraine-Russia war is not giving us any respite and we need to be a little careful. These are some of the concerns which are emerging incrementally but the positive point is that after a long time market participants are cautious on the market but corporate India is extremely bullish and they are seeing a very bright future over the next two to three years.

We traveled all across the country and the sense we are getting in the engineering belt is that the order books are full for the next few years, mainly led by orders from China and Europe. The PLI scheme is doing a good job as well as the capex intensity in the domestic market is picking up. I have not seen entrepreneurs as positively as they are today for the last many years. That is reflecting in the market being so resilient in a land where growth would be scarce going forward. India could be a bright spot in that scarcity.

Some of your thematic ideas within mid and smallcaps where you find value?
We believe that the medium term thesis does not change from the last time. Industrials and manufacturing is one space where we are seeing good traction. Order inflows continue to be strong and we believe that if you look at the cycle, first the order inflow starts coming in which reduces the pressure on companies and managements to take orders at any price and then revenue growth follows and then the margins.

This time, the cycle is not looking very different. Order inflow for the last few quarters have been extremely strong and that is the sense we are getting going forward as well that it will be followed by top line growth and then margins will flow down from the cyclically low levels today. So manufacturing and industrial capital goods looks to be a very sweet spot to be in.

We have seen a very strong performance by financials. For the next couple of quarters at least, the financials seem to be in a good space and both large private sector banks and large PSU banks are well positioned in a rising interest rate scenario as well.

The third is the auto pack, especially the passenger vehicle and the commercial vehicle segments. We believe that the traction there has been extremely strong. Even the festive season has been very strong for most of the automakers – both on the passenger vehicles and the commercial vehicle segment. These are some of the spots or the themes which we are liking from a medium term perspective.

One dark horse which has started to look good from calendar 2023 perspective is pharma but that has to be a stock specific approach. Incrementally, in this earning season, after a long time, most of the large pharma companies have reported either in line or better than expected results which is a deviation for the last four-five quarters.

So the worst in terms of US pressure is behind us. Domestic market in pharma is doing well. Valuations are in our favour and there is very little to lose. In this market, the question we should ask is where we should not lose money rather than where we should make money. We are at a point where we need to assess risk also and not get just carried away by the momentum.

Banks is a very generic word. There is HDFC Bank, big, large, growing and there is a Karur Vysya Bank small but impressive set of numbers. For an investor, which is the best pocket to park money and generate absolute returns now?
Our preference lies with the larger private sector banks and larger PSU banks and the reason is that deposit rates have started to move very aggressively and the banks which have large CASA balances will finally be the beneficiaries. Many of the smaller banks are wholesale funded or NBFCs and we have seen in some of them, the pressure has started to reflect on their NIMs already.

Our sense is that Q2 or maybe Q3 will be the peak in terms of NIMs for most of the banks in the sector and hence banks with better retail franchise on deposits will probably gain disproportionately as you move ahead. Do not forget that many of the large good private sector banks are raising one-year CDs at 7.5% now and that is not still reflected. The average cost of deposits today in the system is 5.5% and the two-year G-Sec bond yield is 7.15%. Do not forget the average tenure of deposits in the system is about one-and-a-half, two years.

It cannot be that the Government of India is borrowing at 7.15% and the average rate of deposits in the banking system is 5.5%. There is a very large gap and I think that gap will narrow down over a period of time and hence our preference lies for banks with strong CASA which can weather the rising interest rate scenario.

You talked about the sectors and segments that you like but let us talk about the spaces to avoid at the moment. Which are those pockets that you think will likely underperform? Is it IT and consumption staples?
Yes absolutely. We have been cautious on IT for a while and I think the commentary coming out of either global or Indian IT companies are not giving us any comfort. There is global macro uncertainty. We have seen that layoffs have started by large companies in the US and that will weigh down the IT budgets as we move into 2023.

We believe that one round of downgrade is still pending and that will weigh on the valuations of most of the IT companies because they are still trading one standard deviation above the long-term averages. We continue to have a cautious stance on IT as we speak.

The second sector to avoid is consumer staples. It is quite amazing to see that the consumer staple three-year CAGR growth is either flat to negative. That means that the bottom of the pyramid has been hit very hard and most of the consumer staple companies even in their call mentioned that things incrementally may look better but not compared to the pre-Covid days. Our sense is that valuations are not supportive there to the growth which these companies are offering and our sense is that consumer staples is something which one should be incrementally cautious about.

The only thing out there is that margins may likely improve because commodities have started to correct whether it be palm oil, wheat, flour and that should aid margins incrementally but demand is something which has been hit very hard at the lower end of the pyramid and the low income households and we need to have a careful view and that is also showing that the economic recovery is not in full steam as market is pointing out to be.