The scope for an earnings downgrade is increasing given that most of the drivers have already been played out, according to Ganeshram Jayaraman, managing director and head of Avendus Spark Institutional Equities. There are about eight drivers for growth when the earnings profile is broken down, Jayaraman said. "When you weigh them all, almost all other drivers have played out, with the exception of the industry-led volume growth driver."
According to Jayaraman, there may be some room for downgrades in earnings and valuations, but it's important not to leave too much room for moderate downgrades. The challenge with markets today is that there are plenty of conundrums, he said. "On one hand, the big picture in India is quite good, but the multiples are quite expensive and can present earning challenges."
Within the portfolio construct, the fund has been very decisive over the last three years, the Avendus Spark MD said. He recommended a decisive tilt of the portfolio towards cyclical, industrial real estate, financials, and autos, while steering away from IT, consumption, and consumer financials.
However, Jayaraman noted that, given the potential policy changes brought about by the election mandate, there could be some room for revival in the consumption space.
The private capex cycle is poised to pick up, and so far it has been a government capex cycle and a property capex cycle, he said. According to Jayaraman, PSU companies can lead the cycle, which could begin in the next six to nine months. "I think it will go into the private sector capex next year, and that will bring supply."
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Here Are The Excepts
Are you caught between a rock and a hard place, Ganeshram?
Ganeshram: Of course, we are caught because the challenge with the markets today is you know, as we had mentioned in the note, there are plenty of conundrums which are there. On one hand, the big picture on India is still very good, but the multiples are quite expensive and there can be earnings challenges and within the portfolio construct, we have been very decisive over the last three years, maybe about three and a half years, pretty much from Covid onwards, that the tilt of the portfolio decisively should be towards cyclicals, towards industrials, real estate, financials, autos and you know, the domestic cyclical manufacturing. They have been the clear, decisive tilt and away from IT, away from consumption and even consumer financials. That has been a very, very clear one call over the last three, four years.
Should you change, that is the first question and that question is coming because we think the policymakers, the government will have questions asked, due to the election mandate and not just election mandate, but even prior to that, you had questions around the nature of consumer recovery. Last 18 months and including in our assessment based on channel checks, even including the June quarter, it's now 21 months where consumption has been slowing down and the K- shape recovery has been impacting mass consumption.
Now, when will the nature of the election mandate, will it make the policymakers change their stance and I'll give you some numbers. Over the last four years, the government's capital expenditure has tripled, not on a low base, it's tripled, whereas the government's subsidies, or you can call all the rural spend, that's actually been flat. So this has impacted the nature of recovery and clearly, you see multibaggers and defence, railways, even cables, all the industrial stocks which benefited from government capex
But consumer stocks have gone nowhere over the last few years. Should you change, will the government's policy makers change their stance, what will be the second order derived impact of that, will it lead to inflation, because we have always seen in India if there is a government push towards, you know, consumption or trying to get the mass end of the consumers pyramid, if you take the income profiles higher invariably lead to inflation. Then how will the central bank behave, react to that. So that's why we call this whole note as caught between a rock and a hard place and that has implications for our portfolio managers and fund managers or anyone managing money into the markets, clearly because how should the portfolio be constructed with that, not just next six months or 12 months. But over the next 36-month view, what should be the decisive tilt and it's not as black and white as we would have wanted it to be.
What do you think if indeed as your note says that there is a middle path with a bias towards fiscal consolidation. What's the resultant impact from an equity watcher's perspective on portfolio and on multiples?
Ganeshram: I think, you know, there's another layer to it, which is the private capex cycle. We think, private capex cycle will pick up. It has been a government capex cycle, property capex cycle, but not yet a private capex cycle. We think that will pick up over the next 18 to 24 months, maybe even in the next six to nine months. It can start. But it will start with PSU companies. Be it in refineries or steel, you will see PSU companies beginning capex, I think it will go into the private sector capex next year and that will bring supply. So, if you look at demand, supply, earnings, valuation, there are four drivers for stock prices to do well over the medium term, say maybe 24 to 36 months and when you look at it, we think supply will go up. We think demand can remain, especially on the consumption side. We think it can remain sluggish.
We think valuations can moderate because let's take an example of say paint stocks. Now it was a cosy oligopoly club for 10 years or more, one new entrant was coming with a reasonably large capex. The incumbent's earnings have shown no problem. In fact over the last three years, their earnings have grown 75% cumulatively, but the stocks have gone nowhere because market knows that if your oligopoly business characteristic of a sector starts undergoing a change, it can have impact on margins, pricing power, market share, operating leverage, it will come with a lag, but markets don't wait for earnings in a well-discounted market like India, well-understood economy globally by institutional investors.
People will be early and that's why my fear is that there can be an angle and add the angle of the election mandate lead, not just mandate as I said it was coming and over the last few maybe a few quarters. This character of consumption will need some kind of intervention and to kind of channel the flows and the economy in a different direction. What should we do? Should we be too early? Can we be too late? Those are real questions to be had and implications of all of this on earnings will come maybe not the next six, maybe not two quarters but thereafter.
Okay, based on your assessment of where within this private sector capex will be the first inkling show because, you know, we've seen select industries do this. It's not uniform, but you know, data centres, new age parks etc. The capex is happening at the private end too. Within the others, where is it that you believe we hitherto haven't seen meaningful private sector capex, but we are likely to see that. I mean, based on either capacity utilisation levels or the industry turning or what have you, private sector specifically?
Ganeshram: Power, steel, maybe semiconductors
But that's what's happening as we speak in which ways.
Ganeshram: Power has not been happening, Steel has not been happening in the last many years. Cement has been happening and semiconductors announcements have come. We think that announcements cannot, the rubber has not hit the road yet. The capital goods company has still not seen any order book coming from any of the announced semiconductor projects.
So have we all baked it into, have we built a semiconductor industry-led demand potential for a capital goods company or transformer or a voltage-related management company. No. We have not pencilled it in as growth opportunities for these companies. So clearly, it is somewhere baked into the multiples, but not yet into the earnings.
Noted. I thought I saw some stray announcements around Power for sure. But you're right. Some of these things have been baked in as well.
Ganeshram: I will give you numbers. For the next three years alone, our assessment is India will do about Rs 10 lakh crore of capex in power alone. This number was nothing, literally nothing, in any of the last 10 or three-year periods.
Do you reckon that the plans, as we understand from the government documents and the stated intent from many companies as well, is that there's a lot of renewable capacity added up, but at the same time, thermal isn't going away and maybe near-term thermal capacities might get added up because we are looking at some serious power deficits in 2024, and maybe in the very near term. So will the capex be led by thermal power capacity addition, or will it largely be led by renewable? I'm just trying to understand for the viewer currently, to know which ecosystem will flourish more over the course of the next 24 to 36 months?
Ganeshram: All of them, but thermal is always scale.
Okay, can you explain why?
Ganeshram: It has much more impact on Indian companies. The supply chain has more Indian suppliers supplying for thermal, and it has bigger implications on markets. Renewables have a large imported element.
Okay, so all will do, but thermal will have a larger impact on the Indian ecosystem versus renewables per se. That's the point you're making. Fair point and I heard you mention steel as well. Will the steel capex be dependent grossly on how well China turns up its numbers or could it happen independent of that?
Ganeshram: You look at India steel prices, they're way above Chinese prices. So, I think it can be independent because you know, there is some level of protection which is being given to the Indian steel manufacturers and their capacity utilisations are quite high. So, we will see the steel sector capex come almost independent of how it can play out from China. But we will watch China too, no doubt but I think capex decisions can be independent.
Let's shift focus to the banking space. HDFC Bank reported Q1 numbers, and they looked a bit soft from what our expectations were. I'm not asking for a call on HDFC Bank. But could the performance of one bank be isolated to that one bank? Do you expect banks to come out with a decent quarter or is it difficult because a lot of hope at the current valuations that we have is also laid out on earnings momentum continuing, whatever the number may be, but the momentum continuing?
Ganeshram: So, we think credit growth will slow down, for the system and for the large banks. Over the course of this year, we think a further slowdown in excess of 15–16% credit growth is unlikely to sustain even in the current year. Deposit growth can pick up especially because the system will now start seeing that the accumulated government's cash balances till elections are now spent out, coming back into the system as deposit growth that can. So, deposit growth in the second quarter and thereafter can start picking up.
But we are still quite cautious on margins. Even if credit costs can be unsustainably low currently, it can mean revert. So, we think the best of ROA profiles of most banks possibly has been seen and the valuations are not demanding, which is again another part of the you know, caught between a rock and a hard place because banks are opposite of what we normally like stocks to be, which is we generally like lowballed earnings and high valuations. That's the construct we like because we know earnings will catch up.
Now we are at opposite, we are actually seeing earnings are high and valuations are attractive. So that can be kind of a pull and you might want to say that things can get weaker, but it's in the price and we may fall into that trap on banks. With that, that can be a live risk but still, we do believe that the earnings picture, growth margins, credit costs, ROAs, ROEs, the March quarter was possibly the best.
From a pure valuation perspective, just trying to understand, are you a bit circumspect or do you reckon that valuations themselves might come under question and earnings might make the valuation seem a lot more expensive than what they are right now?
Ganeshram: For almost every other sector than banks, that is actually the truth because when you break up the earnings profile, there are maybe eight drivers. You can say: Will it be market share-led volume growth, will it be industry growth-led volume growth, will it be a pricing improvement which can come? Can it be, you know, a product mix improvement, can it be raw material prices further going down? Can it be operating leverage, can it be financial leverage, is there anything hidden as some subsidiary loss-making segment which can turn around?
When you weigh all of these, across our entire coverage of 250, 270 stocks. What they are coming to is almost all other drivers have played out over the last three years except industry led volume growth. Market-share gains, we don't see too much upside RM prices, basically gross margins or pricing power, consolidation-led benefits, played out, operating leverage largely already in the base. Now, the industry needs to show volume growth pickup. Can more cars be sold, more houses be built, more capex be done, more two-wheelers get sold? So, you need the industry growth dynamics to pick up. For that, you need a very strong macro and for that, you need strong credit growth, for that, you need, you know, the government's capex to be quite high or government's spend to be high.
Given all the first points I mentioned, I think there can be some scope for downgrades in earnings and the valuations don't leave too much room for even a moderate downgrade. You know what many evaluations are pencilling in you know, almost error free earnings expectations built in. So that's where the confusion is coming from. There isn't a lot of margin of safety in this market and there can be a need for margin of safety inbuilt into the character of earnings profile. That's why we have kept our portfolio construct, where quality management has been there, we have been increasing the proportion of them and increased proportion of cash in the construct of our top picks and also have cyclicals like industrials or autos or property-related stocks, some segments of financials as well. We've kept the proportion. So we are trying to keep this barbell approach, keeping this kind of likely scenario. So we need to prepare for either kind of a binary look actually.
Okay, my final question and your note speaks about that welfare tilt as well. I'm not calling it welfare. But if there is a government thrust on rural and agri in order to revive it ahead of three key state elections or, however, what is that resultant impact because one is for the macros to do well, but not in our hands. Two is for a specific set, which is a policy for a particular sector or a theme working from the government, even if the macro by and large is not all right. So, if the government gives this thrust to rural and agri spend, can it have the potential to change the lifeline for select pockets within the equity markets?
Ganeshraman: See, don't just look at it as rural. I think the lines are blurring between urban and rural. It's no longer as black and white as it was before Covid. So I think we could easily fall into a trap because we all thought over the last four years that you would have thought rural has not done well. But tractor sales were very good. So, it has not happened in the past. So, it's not as straightforward as you might want it to be, but as a broader-level consumer, after searching for answers, we still believe that the mass household, I'm not worried about the top five crore households, I think that household balance sheets are in great shape.
I'm not too worried about the bottom 10 crore households also, where I think the government will always take care and it's not like consumer companies heavily depend on that segment for growth also. My concern is the middle, the 15 to 20 crore households in between. That segment has not seen incomes more than expenditure and I see debt has gone up there in that segment and especially in the last three years, unsecured personal loans and credit card outstandings. That segment has seen leverage levels on the rise and in my view, that's going to slow down and that's why I said credit growth will slow down and lenders will moderate their bank lending to NBFCs, banks lending to retail is moderating. So, this can have an implication on mass consumption in that category.
I'm also watching how the IT sector or in general, the whole GCC IT sector, jobs play out because the trickle effect of IT hiring is very high. Especially in urban consumption in India, you know, in Chennai, Bangalore, Hyderabad, Pune, maybe even in NCR to an extent, not Mumbai. So, markets you can look at Mumbai and I will have different answers, but these cities and maybe even the trickle effect next to towns like Coimbatore or Vizag. There is a lot of IT hiring led to a trickle effect into the economy. For every job in IT, three, four jobs get created outside IT. So, IT has not been adding jobs, you know, six quarters, maybe now seven quarters in a row, where IT might have shed jobs. So, I'm watching that to figure out what can be the implication of this as well.
We also watch as a crude proxy BSE 500 employee cost. It is growing at the weakest pace and if you adjust for some of the pension provisions that state-owned banks made last year, if you exclude that, because it's not cash in the hands of people. It's actually quite weak and so for us, even though there can be a narrative starting in the markets that the government might now want to take a more measured stance, there can be an increased tilt towards consumer benefit. We still think the household balance sheet needs to be, I'm not saying repaired to make it sound too much, but it needs some bit of improvement before consumption starts picking up. So, we still remain wary of mass consumption households expanding or discretionary spending coming from there, especially unlevered consumption.
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