Looking at a Goldilocks scenario for corporate earnings? Mukul Kochhar is betting on 3 sectors

Mukul Kochhar, Head of Institutional Equities, Investec Capital Services, says he is bullish on financials, auto and pharma sectors. Financials include some very high-quality banks, regulated banks, small finance banks trading at very affordable multiples; in autos, there are OEMs, two-wheelers and some four-wheelers also at this point they have become attractive in terms of valuation. Finally, in the third sector, we have a very strong counter consensus call in pharma where the rest of the Street and some of the companies also are quite bearish overallIn your daily conversations with your clients, you are never short of great ideas to tell, but is their conviction now becoming shaky? Everything seemed to have run up, there’s froth in the market. Will earning growth oblige if they get into new names? Is that a bit of an issue?

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Mukul Kochhar: There are definite signs of froth and typically at times like these, you need to be cautious in the lower quality smaller companies because that is where you will see some malpractice when there is retail excitement and there can be permanent loss of capital. So, when markets are frothy, be very careful where you are investing, so that is one advice definitely to investors that is important at this time of the cycle.

Having said that, the broader fundamentals in India are exceptionally positive and this is something we have been talking about for some time now. There are three strong positives for the Indian economy on a fundamental basis. The first positive is we expect India to become a current account surplus and this happened in the last quarter, but structurally we should get there in the next couple of years which will increase our cross-cycle GDP growth, and make growth more stable and sustainable.

The second positive is high profitability in the corporate sector which will lead to a substantially strong private capital cycle, with the elections out of the way I think that trend should start playing out.

The third positive is the premiumising consumer, a consumer in which a lot of the basic needs are already being met, and a premiumising consumer leads to higher distributionally consumption, that is the third trend or third fundamental positive in the market today. So, the economy is very stable, and there is excitement in the market as well as froth where you need to be a little cautious in what you are investing, but definitely, you can get ideas today as you mentioned in the beginning.You have raised a very interesting point. One is price run-up versus valuations in isolation. But the second is current account surplus plus fiscal deficit under control and last evening at the 188th Bombay Chamber of Commerce kind of anniversary, the RBI Governor made a very important comment. He is saying that India is at the cusp of a structural shift in growth. He is making a case of 8% sustainable growth. If we couple moderate inflation and 8% sustainable growth with other points which you said, we could be looking at a kind of a Goldilocks scenario for corporate earnings, is it not?
Mukul Kochhar: You are right and it will be reflective of the economy. From what we are seeing and the first point you raised, a lot of the stock run-up is based on earnings. Earnings have been super strong over the last four years, five years. We have seen earnings triple or more than triple, actually three-and-a-half times for BSE 500 companies in the last five years and that is reflected in the price run-up, so that is something one should keep into account when one looks at the market, and takes the market in perspective.

But to the second point, I say that growth will be structurally higher by a percent, percent-and-a-half and one factor is the current account surplus which should get us into a more stable economic growth cycle. I feel that the private capex cycle is going to be very strong and going to focus a little bit on manufacturing where, as you increase the manufacturing output, the country has been weak on that, it should contribute to the second level GDP growth and creation of some employment.Well, one point that I want to talk about which is making me and many others quite uncomfortable right now is the supply of paper. Earlier tops of the market we have seen with mega offerings on the IPO side, but this time the consistent supply from PE guys, from promoters, all of that does it take away a lot of liquidity which otherwise was meant to be coming into the secondary market?
Mukul Kochhar: More than liquidity, it is the ease with which this supply is getting absorbed points to a certain level of exuberance. It is a great time to invest as any investor would know is when market sentiment is down in the dumps, when these things are very difficult to get through and on the other hand when market sentiment is very positive, you need to step back and see what you are investing in.

So, yes, that is a definite sign of concern, the ease with which these things are happening. But a lot of time you have to see the promoter selling in the context of them having this source of liquidity to fund their private sort of lifestyle, so that is not all bad.

But the timing and the frequency with which it is happening certainly points to a level of exuberance in the market which one needs to be cautious about. The IPO, by the way, is just one small point I would want to make about this cross-cycle IPO quality and we have been in the market for roughly two decades, cross-cycle IPO quality today is excellent. The quality of companies that we see that are coming to IPO, we have not seen this kind of quality companies coming to IPO, so that also should be put in context. But yes, the supply of paper, and the level of exuberance is a cause of concern.

Some of the areas of the market show a lot of cushion because earnings are there, valuations are still not out of whack and management quality is very good because maybe we are in a mature bull run and where one tends to be in safer quality names. Even on pullbacks, the drawdowns would be limited.

Mukul Kochhar: Absolutely, it is not like the entire market is so expensive and it is not investable. So, yes, banks typically are well managed in India, and RBI is a good regulator. There, the valuation comfort is fairly reasonable and there we like autos, and auto components stories. We also like pharma, all these are very, very good, high-quality stories, high-quality sectors available at reasonable valuations today at this point in the cycle.

What are your thoughts on auto, especially on two-wheelers? Do you think the story has played out or do you think there is juice because the tier II, tier III, rural is coming back?
Mukul Kochhar: I think two-wheelers have been structurally undervalued in India for many years. If you think about it and we have been positive on them, maybe for the last six-seven years, it is not just now. But let us just talk a little bit about the quality of the business. So, this is one business where India is globally competitive. It is a very large home market where two-wheeler companies have built economies of scale, they are competitive on quality as well as price, and they are major exporters globally competing with the best in the world. There is very little risk of disruption.

In four-wheelers, there is autonomous driving and a lot of use of technology-connected cars. In two-wheelers, all that trend is you can imagine autonomous driving, while some people are talking about it how difficult it will be for a practical purpose. So, if I look 5-10 years out, the current two-wheeler companies globally will probably be the ones leading. So, we have a high-quality global industry in India. This industry, by the way, has negative working capital, a very high return on invested capital, 50%, not very good marketing companies, and historically traded at a multiple that was sub-20.

Right now, they have gone slightly higher but that is also reflective of the second point you made that they are at a good point in the cycle where there is some replacement demand. In addition, more consumption money in the market means more demand for two-wheelers. So, we are very comfortable given the high-quality business that they are, despite the run-up that these companies have seen.

You do have beyond the mega caps as well, largish midcaps, in that category what are your high conviction bets where you see aggressive management growth, and capital allocation policies are in under check?
Mukul Kochhar: We are unfortunately barred by compliance from talking about single stocks, but the three sectors I named – financials, banks, some very high-quality banks, regulated banks, small finance banks trading at very affordable multiples, autos, OEMs, two-wheelers we like, some four wheelers also at this point they have become attractive in terms of valuation.

Auto components are a good sector play right now given China plus one; we can see the numbers coming through for auto comp companies spectacular and valuations also are relatable. So, many names to hunt over there.

Finally, in the third sector, we have a very strong counter consensus call in pharma where the rest of the Street and some of the companies also are quite bearish overall and specifically on US growth and we have a very strong counter consensus call around the US business of these companies which makes us positive. These three sectors are very broad, all cap heavy, so you can select some midcap names as well as largecap names there.

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