Investors are willing to bear GST pain for long-term gains, says Nandurkar

Interview with Mahesh Nandurkar, executive director and India Strategist, CLSA

With the introduction of the goods and services tax (GST) Bill round the corner, a tax that will have an impact on how the economy and corporate earnings shape up over the next few quarters, MAHESH NANDURKAR, executive director and India Strategist at CLSA, tells Puneet Wadhwa that he expects an earnings growth of more than 15 per cent in FY18. Edited excerpts:

How should investors approach the markets now? Is it time to book profit given that goods and services tax (GST) bill will bringing in uncertainty for the economy post its implementation?

We recently did a demand – supply analysis for Indian equity markets, where we studied the overall demand and the supply of paper – i.e. paper by corporates in terms of qualified institutional placements (QIPs), initial public offers (IPOs) etc. Our analysis suggests that we have a healthy surplus of demand over supply, which is around $5 billion on an annualised basis. I think the current market valuations will sustain and don’t advise investors to sell just yet even though the market looks expensive. 

Where do you see the markets in a year’s time?

One can easily expect around 10% return from the markets over the next one year. Though this return may not appear to be very high in context of the over 20% returns that we have seen in the last six months alone, one should not hope for a repeat of such super normal return and invest. Given the fact that we are also in a relatively lower risk-free rate of return environment, we need to tone down our equity returns expectations as well.

But hasn’t the likely implementation of goods and services tax (GST) bill created some nervousness in the markets as regards the economic outlook and corporate earnings?

Yes, I agree. June quarter numbers will definitely see an elevated impact. What we hear and understand is that a lot of companies, traders, distributers and dealers are de-stocking inventory. The inventory levels have to be brought down in order to be ready for GST implementation / transition. As a result, this will have an impact on the June quarter reported earnings and revenues. The impact can possibly flow into the September quarter as well. However, gradually during the course of the year the inventory levels and businesses will normalise. 
 

A lot of investors that are investing at India are willing to look through some of these near-term disruptions. The markets trade at 18x one-year earnings, it is not based on what will happen in the next six months-to-one year. One can’t justify the valuations on that basis. Investors are now looking beyond FY18; and from that perspective, the near-term disturbances that will be caused by the GST will only have a small impact on the investor sentiment.

Do you think India Inc is ready for GST implementation on ground? Should the government look at deferring the implementation?

Technically, one can argue that since things on ground are not ready and the implementation should be deferred, but the nervousness will remain even after three months as well and we will still be not fully prepared three months down the line. It is better to go ahead with its implementation in July. 

What are your takeaways from the March quarter results season and estimates for FY18 and FY19?

The March quarter earnings continued to be weak. While the overall earnings growth was in double digits due to the low base for metals and banks, if one looks at the other domestic businesses on a like-to-like basis, the earnings dipped by around 5%. There was a lingering impact of demonetisation as well. For the first time after several quarters, Ebitda (earnings before interest, taxes, depreciation and amortisation) margins also dropped on a year-on-year basis. Since the past two years, companies were enjoying the benefits of low commodity prices that helped shore up margins though revenue growth wasn’t that great.

Going ahead, we should see some buoyancy in revenues to come through in FY18. We expect an earnings growth of over 15% for FY18. There is some risk on the downside in these estimates on account of GST bill implementation. Even then, a growth of over 10% is very likely.

What is your view on the mid-and small-cap segments?

From a valuation perspective, the large-caps look much better than the mid-cap segment. We have seen the mid-cap index trading at a premium to large-cap index, which is not normal. In this backdrop, I would prefer large-caps to the mid-caps.

What has been your investment strategy over the last 6 – 12 months? Which sectors are you overweight and underweight on? 

One of the sectors we like is financials. One reason why we like this space is that it will be one of the biggest beneficiary of the upcoming housing boom that we expect to happen. This augurs well for the housing finance companies. We like private players within the broad financials spectrum. The other sector we like is materials, which includes cement and steel. Valuation in the steel sector are quite reasonable. There is visibility on the pricing and the margin front as well, which is unusual for a commodity related sector like steel. That apart, we also like select consumer discretionary stocks, including autos and the household sector.

Any contrarian bets?

The contrarian bet are stocks related to the capex cycle recovery. Therefore, we are overweight on the corporate-oriented banks and the industrial sector we well. 

How are your foreign clients viewing India as an investment destination? Are they willing to put in more money going ahead?

Foreign investors did invest in India, especially after the outcome of the assembly polls – especially in Uttar Pradesh – in March 2017. Barring that, we haven’t seen much inflows from them. Their key concern has clearly been the valuations. While the Indian markets have given reasonable returns, they haven’t really been the best performing markets globally. Within the emerging markets (EMs) as well on a year-to-date (YTD) basis, Korea, China, Turkey etc have done much better. That apart, earnings revision in many other Asian markets has started to happen on the upside, which is missing here. On the contrary, we still continue to see earning downgrades. Once we see earnings estimates stabilising and the expected double digit growth coming through, we will see greater participation from the FIIs as well. 

Stocks from the auto and fast moving consumer goods (FMCG) sectors have seen a good run in calendar year 2017 (CY17). What is the road ahead?

We clearly like the auto segment between these two. On the consumer staples / FMCG side, we are very selective as the valuations look steep. Besides, the growth prospects are not that bright. I remain underweight on the FMCG space.

While the government, on one hand, is recapitalising PSU banks, on the other, it is doling out farm loan waivers. Is there a solution to the NPA mess the sector is grappling with? What should investors do in this backdrop?

We are at crossroads as regards the banking sector. While the farm loan waiver is really the risk and we may see more states join in, we will have to see how the states manage the overall fiscal situation. If this translates into the overall fiscal deficit widening, it will not be viewed positively by the rating agencies and the markets. This will also impact the inflation outlook, and in turn, the possibility of a rate cut. Having said that, the resolution of the NPL issue will have a far higher leverage. If the government is able to get that part of the equation correct, then the positives will outweigh the negatives.

Should one avoid PSU banks then?

Within the PSU banks, one should look at the banks that have capability to raise money from the markets. Alternatively, the private corporate lenders can also be looked at where one will get a similar benefit in case the NPA problem gets resolved. One should not be adventurous and invest in small public sector banks (PSBs) for sure.

What's your view on pharma and the information technology (IT) sectors? Both again seem to be battling problems.

Between the two, I prefer the IT sector to play the bottom-fishing game. If anyone wants to play contra, this is the sector to bet on from a 12-month perspective. Valuations appear more attractive in this sector than pharma. Having said that, IT will only be a tactical trade because the long-term growth story in the IT sector has been damaged. We are not looking at long-term compounding story to be played out here.