Let’s first talk about the valuation of the broader market after the correction. From October, the correction occurred. and The conflict in Russia has only accelerated this correction. Small caps and mid caps were both hardest hit. Some of them have corrected 40-50% and even more have been affected. After that, do you see a case for revamping in this area?
What’s happened over the past five to six months in the mid and small caps has pretty much washed away all the foam that had been building over the past two years. We believe that on the valuation side, midcaps and smallcaps, especially the midcap index, are now trading almost in line with largecaps. Opportunity exists in all space. Second, and most importantly, mid caps definitely outperformed Nifty 50 in FY22.
But if you look at the slightly older data, over the past five years, mid and small caps were still underperforming. Over the past five years, the underperformance is as acute as 16-17%. There will be a lot of catching up happening in the broader market and, more importantly, we understand that there is a very strong correlation between how the economy is doing and how the broader markets are doing. There is a very positive correlation.
Once we see the economy coming out of it, the unlocking is in play. Going forward, mid and small caps will do very well. We all know that many of these sectors especially unlock themed like QSR or restaurants, hotels, airlines, luggage – most are available in the midcap category itself and we must not forget that when you put highlight Russia-Ukraine and in the last two quarters, the maximum impact on earnings has been visible in the broader market.
Earnings growth will be even higher in midcaps and smallcaps compared to largecaps over the next two years. We think any investor should have a very decent allocation given the valuation comfort given the higher earnings propensity and should be able to make good returns over the next two to three years. in this category.
In the past six to eight months, what are the areas and companies in which you have studied or strengthened your positions. Where do you see age-old arguments about growing businesses intact and robust?
We are positive on the prospect of India’s economic recovery at least. We believe that this unlocking theme should move forward very well and that the sectors that will benefit from the economic recovery should be the focus of investors’ concerns in this particular regard. We are very positive about BFSI as a unique industry. If you see, over the last two years the theme that really played out was deleveraging. A majority of these companies, the cement companies, the metallurgical companies, were getting out of debt. We are now entering a point where the re-leveraging will begin.
Bank balance sheets are at levels we haven’t seen in a decade. Most of these banks are currently over-provisioned. They have a very strong capital adequacy and the last quarter which resulted in the majority of profits was supported by the banks. This will happen over the next two quarters. We think private banks and good NBFCs are the players to consider.
Apart from that, the Russian-Ukrainian war changed the whole narrative of geopolitics. Over the past 20-30 years, the theme that has played out has been globalization and interdependence. But what happened after the Russian-Ukrainian crisis was that a lot of those countries were left behind and weren’t able to get the key things needed to make the economy work.
We believe de-globalization may eventually be a theme that could play out over the next couple of years. A lot of these manufacturing units especially in the pharmaceutical, chemical, textile, paper space – the theme of manufacturing plus capital expenditure – can play for this country and India will not exception.
Apart from that, the sectors that will benefit from the opening of the economy, such as cinemas, airlines, luggage and even QSR, are expected to do very well in the next couple of years. We got into names like this, we increased our allocation to BFSI from last year and we remain quite confident about that
What did you buy from the BFSI, apart from the banks?
At BFSI, we love private banks the most. But we believe that opportunity is still present in the NBFC space, especially on the housing side. Housing growth has not been as high. It lingered around 5%, 6%, 7%. But we believe the situation is good. So anytime there’s a very strong stock market, we think it’s playing out in a very strong real estate market.
We’ve seen a lot of data on a lot of real estate players. The type of growth we are seeing is unprecedented. We think the more housing-related NBFCs should do well. Auto, which has been a dark horse and related things can also pick up well. So we are buying more NBFCs for housing and autos. It may be a bit too early to tell, but even mid-sized banks could be looked at at this point. It is essentially a waterfall that occurs. When credit growth picks up and goes from 8% to 9-10%, the majority of the gains will go to the big banks. But when valuations start to rise, investors turn and start looking slightly down the curve. Today might be a good time to look at mid-sized banks where there is two to three years visibility.
Your wallet has some weight in the chemical space. We were just looking at the data that even chemical names have worked wonders over the past two weeks. Where did you increase your weight in regards to chemicals? Do you see concerns about margin pressure fading or can they persist or extend beyond the next two quarters?
Chemistry has become a difficult sector today. We were early investors in the chemical sector in 2016-2017, when valuations were trading around 13-14 or 15 times the forward PE. Now those valuations are 30 to 40 times higher and on top of that we have this fear of inflation because a lot of the commodity inflation has been around 10% to 30% which will to some extent be visible on the fringes of many of these chemical companies.
Overall, we remain very selective in the field of chemistry. So while we hold a decent amount of chemicals as exposure, the key thing to watch is whether these companies have very strong pricing power and are able to maintain their margin.
There might be a bumpy quarter or two, but overall for the next two to three years if margin is something they can really improve and valuations are comfortable in conjunction with growth.
Even if a business is at 30 times price to earnings, if it grows at 35-40 times, we’re fine with that. So there will be a handful of companies like this and you can’t just go and spray money on the chemical sectors. You have to be very selective and there are still stories to follow. We are very positive on a plus strategy which, due to the China problem and de-globalization, can help India to become a major player in the chemical sector. So in the long term, we are very positive. In the short term, this could be a blow and you have to be very careful what they have in the chemical space.
Would you like to look at offbeat open trades beyond hotels and exhibit companies – the shoe line, the luggage line and all that? Or even paper companies that deal in stationery or office paper or if the kids go to school and all that. Is this something that interests you?
Yes, we are very positive about shoe accessories. We have a few names in our portfolio that we think are not just about open economy trading, but look like companies that are doing incredibly well. Similarly, there are sectors such as textiles and even paper, but there are very few names that fade with a rigorous filter.
The investor should be open to owning sectors like this. Textiles could be the next big thing and play like chemicals.
Likewise, we are seeing enormous traction in the paper industry. It will also be the next big game. But investors need to stick with the best and stick with the players who have shown price power and have the ability to stay tough when the going gets tough with inflation, but we really like those areas, other than luggage and exhibits and all that.
I’m also excited about consumer discretionary. This is the retail part where we think a theme would play very strongly. Consumer staples are under pressure due to the rural downturn as well as the inflationary impact. But consumer discretionary will do just fine. Many retail businesses that are into merchandising or possibly apparel and fashion can also do well over the next year or two and should be taken care of. .