Expect a range-bound to volatile market that could do well in H2: Vikas Khemani

“The first three to six months could be fairly uncertain and a volatile period and that will depend on how policymakers respond. Post that and depending on data, one could have a view. The way I would like to characterise this year would be some headwinds, some tailwinds and a situation where the markets are fairly valued,” says Vikas Khemani, Founder, Carnelian Capital Advisors.

Khemani says Aditya Birla Capital can deliver 20-25% growth over the next two, three years. This is a kind of setup, which at Carnelian is called “magic basket stocks” where one can get both earnings growth as well as the valuation rerating.

So what is it looking like for this year?
This year we will have a little bit of a mixed kind of sentiment. There are headwinds for sure coming both from the global market as well as the local economy. The way I see it, this year we will have some of the global headwinds playing out and which will have some implication on the domestic economy as well.

The first three to six months could be fairly uncertain and a volatile period and again that will depend on how policymakers respond. Post that and depending on data, one could have a view. The way I would like to characterise this year would be some headwinds, some tailwinds and a situation where the markets are fairly valued.

The market tends to be volatile and so the impact of steep Fed rate hikes and quantitative tightening always happens with a lag and the economic impact of that we will begin to see in next two, three, four months. We have to keep all those factors in mind and markets are at a fair valuation and we will see a reasonably range-bound to volatile market, which could do well in the second half of the year.

We are not off to a great start for this year. Commodities have melted. The recession fear is back. China has started stabilising, The meltdown in big tech is also having an impact on the financial market per se. What to your mind are the chances that this year while India will grow, the fear of recession which is more dangerous than high inflation, could actually lead to a financial dislocation in next two or three quarters?
Financial dislocations happen for a few reasons. Leverage is always a big reason. Whenever there is a tightening or sudden shocks happen in the system, then the leverage leads to a big financial dislocation. Fortunately this time around, despite such a sharp correction in the market, such a sharp loss of the value of the assets across the board – fixed income, crypto and equities – we have not seen any rippling effect across the board. The key reason for that is the banking system this time around is not leveraged. The balance sheets are very solid and so the pain is sitting somewhere else.

Where that pain is sitting in the complex world is very difficult to guess. My guess is that it is sitting right now in the balance sheets of the government and pension funds which are fairly long dated. So one could never know the timing and how it will come and whether at all it will come. The good news is that the leverage in the system is not there right now, but at some point in time, it has to play out in its own way. Whether it will be slow play out or sharp play out nobody knows but my sense is that the probability of that should not be very high given the fact that it has not traded out so far. How the Fed reacts is important. But I do not think that in the next three-six months, the Fed is going to give any dovish outlook till they see a very strong conviction around inflation.

So the next three to six months would be uncertain. I would not say a very big sharp fall or steep kind of situation is visible but in markets, risk always comes from unknown directions. When there is a tentative environment, one has to be a little bit careful about the risk and that characterises this market. In the next three to six months, one has to be very watchful.

What does that translate into for an investor? Where should one be underweight and immediately go into capital protection mode? Should one keep some powder dry or continue to buy the dips?
Whenever this kind of scenario comes about, it is always advisable to keep some powder dry. Whether that dry powder should be 10%-15% is anybody’s guess. It depends on individual strategies. Of course, some bit of defensiveness should be built in the portfolios.

Having said that, we also know that right now this worry and anxiety is also in some sense pretty much a consensus . So, one has to be watchful of that and everybody knows that recession is coming, there are problems and there are pains. One does not know how much of that is already factored in. So one has to be careful but I personally feel that some amount of dry powder would be a good thing to have right now.

Let us also discuss some of those underlying themes that you would have spoken about in the past that can really be beneficiaries of the manufacturing and export growth that is going to play out. There are specialty chemicals, auto components, textiles, defence. Can you elaborate a little bit more on some of these themes?
Sure. Manufacturing continues to remain a very big theme. Nothing changes from a 5-10 year perspective and we have seen whenever any big trend plays out over a long period of time. There will be intermittent volatility, there will be intermittent downturns which will come and be part of it. We see that there is a big opportunity. If I were to go back to IT when it played out in the mid 90s, we see that it was never one way. There were many drawdowns to the extent of 30-40% in most of the large good tech names.

We will see a similar kind of thing happening now but the good thing is that this is a structural trend and it is not changing. It is not a technical opportunity and we would see this if any correction happens more to deploy money or buy some of those good businesses rather than getting worried about it.

Your top holdings include names like L&T, Laurus, Syngene, Bharti, for me what stands out is that if I look at your declared portfolio out of the top 10 holdings two are pharma names, this is a call which is completely against the street, why?
It is not a call against pharma per se but both business models are very different. Syngene is not a pharma company, it is a CRO and CDMO company. It is a very solid company. In an environment like this, their business model is good, they have done a lot of capex in the last two, three years and we think that delta of that is going to come in this year or next one, one and a half years. It is not at all dependent on anything happening in this environment. According to me, investing in players like this at this point in time provides a lot of risk reward comfort and downside protection.

Similarly, Laurus has corrected 50-60% from the top. The business model is good and we have just increased our stake in that. We have done some sort of portfolio alignment.

We think that in an environment where globally things are uncertain, locally also things can be uncertain. Telecom is one sector where ARPUs are growing. I do not think there can be any slowdown in the consumption of data or subscribers and the industry remains robust forever. In my opinion, it is one of the best consumer plays one can have where the industry has consolidated only two, two and a half players market and rates going up. Nothing changes because of the environment. These kinds of situations tend to help in markets like this.

For me a standout name is Aditya Birla Financials. It has done very well, it is in a good spot. There was a time when we spoke about how ICICI Bank could really reboot itself after a change of guard and that has happened. The same could happen to Aditya Birla Capital. Is it fair to compare ICICI Bank management change with Aditya Birla Capital because that was a bank and this is an NBFC?
Both are very different in size, scale and franchisees, no doubt about it. But both are incredible franchisees and the reason why we bought Aditya Birla Financials is because it is a good NBFC, there are no major problems. One of the biggest things in an NBFC is the liability side franchise. They borrow capital at a similar cost as Bajaj Finance.

Vishakha Mulye coming in as CEO, according to me, adds a lot more energy or drive to the whole platform. We think this stock is a completely ignored stock by the market. The institutional holding is almost close to zero right now. If you take out the two private equities which own the NBFC, it is under owned. So, a big change is happening in that and it is similar in that sense to ICICI Bank when it was under owned. Then changes happened and over the next two, three years, I think it can deliver 20-25% kind of growth. The valuations are clearly in our favour. This is a kind of setup, which at Carnelian we call “magic basket stocks” where one can get both earnings growth as well as the valuation rerating.

Let us say the current valuations when we bought were around Rs 100, the book value was one time book. If it goes to two times book and 25% growth happens, then there are supernormal returns. That is the kind of setup we constantly keep looking for and that is where you see the disproportionately large position in our portfolio.

What is the outlook in the entire metals space? The latest view seems to be that China reopening is going to be a key driver for that space?
Frankly speaking, we do not have too much handle on it and we keep hearing from experts that China opening up will drive the demand for metals, When we did a little bit of channel checks, more from sensing what impact it can have on inflation, we are seeing China importing a lot of steel from India. We do not have a strong view because China is a sort of a black box in terms of how long they will do, what context they will do, how it will play out etc.

We do not have any exposure in the commodity space. The only reason we are watching it is that if it goes up, it has an impact on India inflation. So both energy prices and commodity prices will have an impact on India inflation and that is the input we are looking at from these indicators.