Commodities are India's Achilles' heel: Nick Paulson-Ellis
It has been a liquidity-driven rally for global equity markets in 2012. However, the Indian markets seem to have been stuck in a range. Nick Paulson-Ellis, country head (India), Espírito Santo Securities, tells Puneet Wadhwa breaking out of this range will require a turn in the earnings cycle. Most emerging markets, except Mexico, are trading at or below their five-year average price-to-earnings (PE) multiple, he says. Edited excerpts:
There has been a lot of optimism built in the markets around hopes of a further stimulus. Have they rejoiced a bit too early?
The optimism around the European Central Bank’s (ECB’s) ‘big bazooka’ shorter-dated government bond-buying is justified in the short term, given that the unlimited nature has driven down yields sharply. But in the longer term, the jury is out; ECB’s record so far in sustainably controlling yields is poor. Ultimately, convincing structural reforms in Euro zone economies, alongside ECB support measures, is the only sustainable solution, and there is much still to do on that front.
While the third round of quantitative easing (QE3) would be good for flows, the problem is that commodities, and specifically oil, are India’s Achilles’ heel in QE. And the big difference between the start of QE1 and now is the level of crude ($40 odd then vs $113 now), especially in rupee terms. So while the emerging market (EM) flows are likely to benefit, it is hard to see India receiving a disproportionate allocation given oil prices.
How does India compare to its Asian and emerging market peers in terms of valuations? Do investors here need to be cautious now?
India is in the middle of the pack. It is trading at a discount to its five year average P/E multiple, but China is at a much wider discount. Most emerging markets, except Mexico, are trading at or below their five-year average P/E.
India appears to have been largely stuck in a broad trading range (Nifty 4,500–6,000) for a couple of years now, trading at the top of the range when domestic reform expectations build and at the bottom of it when Europe looks like it will imminently implode.
We think breaking out of this range will require a real turn in the earnings cycle, driven by a turn in the investment cycle. That is not visible yet, so, investors need to be cautious and selectively stock pick within that trading range. The key thing we’re watching for a break out is signs of recovery in the investment cycle, with an uptick in project clearances the lead indicator to watch.
The ‘Coalgate’ controversy has yet again dashed hopes of reforms getting back on track. Will the key reforms ever see light of day? What about the sectors and the companies involved in this space?
Yes, the ‘Coalgate’ controversy resulted in much of the monsoon session of parliament being de-railed with little achieved. Initial optimism around reform momentum picking up post Presidential elections and the new Finance Minister has again been put on hold.
Several companies/projects (in coal, power) are again mired in further uncertainty with an unwillingness to take decisions at the Central or state level, resulting to question marks on project economics and business valuations. While the inter-ministerial group (IMG)’s recommendations will offer some interim hope, the air of uncertainty will continue for some time.
How do you see the metals sector shaping up over the next few quarters? Is China slowdown a worry?
Regulatory uncertainty, illegal mining issues, slowing domestic consumption, Chinese economy, etc, have all conspired to put the resources sector between rock and a hard place. However, we take a bottom-up approach and have selective buy ratings on the stocks like JSW Steel and JSPL, where we recognise the issues, but we now see value.
What are your top contrarian bets (stocks) from the large-and the mid-cap space at the current juncture? Why?
Our big contrarian bet is our consumer sector downgrade. Slowing GDP (gross domestic product) growth, negative real wage inflation and weakening employment opportunities are creating structural risks to consumption.
The current decoupling of consumption and the investment cycle has never lasted before, and we don’t see it lasting now. Initial stress in discretionary spending suggests that a breaking point may be approaching. Consumer stocks at current levels are priced to perfection and simply don’t discount these risks. This triggered a raft of downgrades, with Marico the only Buy, Sells on ITC and Nestle, and Neutral on Emami, GSPL (Gujarat State Petronet Ltd) and Colgate-Palmolive (India).
Companies will be announcing their July quarter results soon. What are your expectations from the banking and information technology (IT) sectors?
The key trend to watch in banking will remain the asset quality deterioration in public sector banks, which we expect to continue, given that the restructured advances are 4.68 per cent of overall advances for public sector banks. Where we see the biggest problems is in slippages from restructured assets into NPAs (non-performing assets), which we expect to be at the 20 per cent this cycle. Punjab National Bank (PNB) is most exposed to this.
We expect the divergence in performance between the individual IT stocks to continue. Business operations will remain the key horizontal driving growth. Pricing is a key area to watch, especially for Infosys.
Are the heydays of companies like State Bank of India (SBI), Infosys, Reliance Industries Ltd RIL, Larsen and Toubro and Bharat Heavy Electricals (Bhel) are over?
SBI might have another choppy quarter or so, but it is the most conservative among the oublic sector lot and has classified most of the problem assets as NPAs. It remains a default long-term play on structural credit growth in India.
Infosys, on the other hand, has had a dreadful few quarter. But we see signs of greater flexibility in pricing and less risk aversion, which should drive improved volume growth.
Given a weak investment environment, L&T’s order inflow growth will be constricted, but this is reflected in the discount to its long-term rating. The recovery will be gradual but the pervasive negativity towards the sector means that L&T, with its sustainable competitive advantage, sound governance and broad based model, is available at a sensible price. We consider it the best investible idea in the Indian infrastructure sector.
Against the backdrop of rising imported fuel costs, uncertainty over supply of fuel from Coal India, and power producers/miners alleged scams, it is highly unlikely that any private player would entail major capex in the power sector. Additionally, increasing competition from domestic players (L&T, BGR and Thermax amongst others) and Chinese/Korean players means weak pricing discipline. Given this, BHEL’s operating margins are likely to get impacted. One can avoid it.
Can you highlight the companies that could outperform?
The results are likely to remain polarised, with sectors like Real Estate and Industrials continuing to struggle, as will the mid-and small-cap companies in general, as they are struggling with a lack of pricing power, with margins under greater pressure than large caps, and revenue growth slowing faster.
Public sector banks are likely to struggle with asset quality, notably PNB. The IT sector should continue to see pockets of outperformance, with HCL Technologies continuing its recent performance. We also expect an improvement from Infosys. The Pharma space remains solid and we see significant room for earnings surprises from Sun Pharma.