What are you advising your clients? What should be the positioning ahead of the election? And looking at the market setup right now, what to your mind is in the price and what is not in the price?
It is not like we are taking election related or election as a trigger for what we are telling. We do not know what will happen and nor are we too prioritising it. I mean, I am not downplaying the importance of it, but it is not like we are very clear about it and we are not telling investors what to do relating to that. But at a broader level, what we are saying is this market, the way the valuations are, the way the earnings trajectory is likely to play out going forward, we are advising clients to have some bit of caution and have a higher proportion of cash and be positioned towards quality stocks, quality managements.
Do not be too aggressive in how your portfolio is constructed. That is our broad tone. There are multiple reasons for it. And if you go through why India has done well over the last four-five years and pretty much from COVID to now, the key reason we think is it is a combination of two things. One is industry consolidation was a very important driver. In multiple sectors, you saw a few players disproportionately gain market share and that led to very volume growth coming from market share gains.
It led to an oligopoly kind of pricing power and as commodity prices eased, that translated into margin expansion last calendar year and then that led to operating leverage, which led to huge cash flows.
In fact, the year ended March 24 was the best year on operating and free cash flows for pretty much the entire listed universe that we have ever seen and that led into debt repayment, which meant valuation shifted from enterprise value to equity value.
This has led to a very positive capex cycle, likely to start private sector capex cycle. This very good profit growth also led to strong government capex because tax collections were buoyant. So, it was a very strong demand, supply, earnings and valuations cycle. We will be a little naive if you were to extrapolate all of this going forward into FY25 and even FY26 earnings, we think the Street should start seeing some downgrades, some moderation in expectations and at the macro level and at the micro level, we think there should be some reasons for us to keep some gunpowder dry for moderated earnings growth and returns expectations going forward.
Are you ruling out the possibility of a good monsoon and the multiplier effect, what this RBI dividend could do because what we are assuming is that monsoon effect, which hopefully should kick in, nobody thought RBI would give you this one lakh crore more, which comes back into the economy and yields come down. Are you ignoring these two aspects or that is built in according to you?
No, the monsoon, again, like elections, we do not know how the variables, but what we have seen over the last decade or so, the importance of monsoon has generally kept coming down because government’s rural infra spend is actually a bigger driver for rural economy than agri was or monsoon dependence was.
So, not sure, not that we are too prioritising monsoon as an outcome. The dividend is an important one. I think it is an important positive.
This gives government some shock absorbers in case tax collections were to moderate, which is actually one of our expectations that in the coming year there could be moderated tax vis-a-vis expectations and I think this can be a buffer.
So, we are seeing it as an important positive development which has come yesterday, which can come back to help us a fair bit and that can help government’s expenditure to sustain at reasonable growth levels.
I still think it will be sub-10%, not just FY25, but FY26 as well we should expect government expenditure to moderate vis-a-vis the high teens to maybe even excess of 20% in some year over the last four years.
So, vis-a-vis that in spite of this dividend, we will expect government spend to be sub-10% growth.
The other thing is this entire sequencing of demand, supply, earnings valuation cycle and how is it that in the current phase one should set the context for your stock selection, portfolio?
So, I think when we build all of this, the likely supply coming from a private sector capex cycle, look at sector like say paints or even banks. During the last 24 months, nothing is wrong with earnings. Paint stocks earnings have grown 75% in the last three years.
Stocks have gone nowhere. Banks’ earnings have been very strong over the last three years after FY21.
Nothing wrong with the earnings. But stocks have gone nowhere. Why? Because if you are coming after a period of strong oligopoly-led industry consolidation and then you see new competition come, there is expectation that the economics of the business, the competitiveness will increase and that can moderate your earnings expectations going forward and that is why we are looking at demand, supply put together and its impact on earnings and its impact on valuations.
When you construct it together, we think some bit of euphoria needs to be curtailed and that is why if you look at how our top picks are positioned, we are recommending an underweight stance on financials, underweight on consumption, underweight on IT, or the entire commodities pack.
Overweight is on pharma and industrials. Because as I said, private capex, this is actually in our expectation over the next 24 months that remains the largest hope expectation.
The stocks are very expensive. They have been multi-baggers over the last 24 months. So, there is less margin of safety in the stock prices, but those earnings will continue to compound at 20-odd percent over the next 24 months. So, our top picks continue to have a bias towards industrials and the second sector is pharmaceuticals.
I distinctly remember we had a conversation on banks and you said, look, this unsecured category which is growing could be a time bomb. But looks like Reserve Bank of India has managed it very well. I mean, I have been speaking to a few bankers and you look at the numbers, there is no alarm bell so to speak. So, how would you approach this entire banking space, which in a sense is one pocket, which is subdued despite economic growth?
So, if you look at the way we are looking at the banks and specifically NBFCs, which are more retail, especially mass retail segment, we remain cautious and I will tell you this whole thing about unsecured loans, there is moderation especially on banks funding NBFCs which are in that segment, a lot of fintechs, liquidity slows down its telling effect will be seen on categories where these unsecured loans went into.
So, we will keep our eye out and typically what we have seen is this as long as the systemic liquidity is in comfort territory, lenders do not cut because deposit growth is reasonably good so credit continues and liquidity can be a kind of a panacea in some form.
If we see a scenario where the BOP turns negative for whatever global reason or if deposit growth remains weak and many banks, if you see the private banks, their CD ratios are high so they will be forced to slow down and where will they slow down?
We do not think they will slow down corporate lending. We think they will slow down retail lending.
So, till then, we will not see it, and maybe we will not see it at all. If the bond inclusion related flows are $30-40 billion beginning next month, maybe we will not see it at all, but we cannot build expectations of only blue-sky scenarios when you buy into stocks.
You need to prepare for what if scenarios play out and when you do that, you look at whether there is margin of safety in the stock prices and that is the scenario we are saying the Street is ignoring.
I am not saying that will indeed play out, but you cannot ignore such scenarios.
The other thing is always this debate about whether to bet on compounders or cyclicals because the market throws up so many opportunities at every given time. Where is it that you are leaning?
So, three years back we said decisively be biased towards cyclicals and those stocks have done very well. What we are telling now is, do not be polarised, more a balance is needed.
We have increased the proportion of compounders because many of them have not done well.
Some financial, some in consumer, some in IT. So, clearly for us, we have increased weights of some compounders, some private sector capex-led cyclicals we still remain very positive, though they are expensive and we have a bias towards that, there are some cyclical characters, say two-wheeler companies or even some banks who are gaining market share and so we will continue to say, though they are cyclicals, they are market share gaining companies so for sure hold on to the faith.
But if not, we will slow, moderate it, say government capex names or some of them even in other categories of autos like commercial vehicles dependent. So, we are kind of slowing down or reducing the proportion of such names.
So, it is now not biased or heavily tilted towards cyclicals or compounders, which is what it was say in 2015 to 2016 to 2019. No, we are more balanced currently than we were over the last many years.
So, let us say three years out if you are looking at a basket of outperformers and underperformers, do you think cyclicals may actually underperform?
I do not want to say that they will underperform, but they are not going to kind of outperform the way they outperformed last three years. The returns have been upfronted. A lot of earnings expectations have already got built into the stock price. So, I will not expect the level anywhere close to the kind of outperformance which we saw.
I will not reduce my proportion of industrials, manufacturing sector bias that stays.
When we called for it in 21 we said it is a decadal view and I think somewhere midway in the cycle we hold on to that view though the stocks factor a fair bit of the upside, but we will not be too quick to reduce the weights in that space.
