The Economic Times daily newspaper is available online now.

    Small, midcap stocks to benefit most from rate cut, improved liquidity: Nilesh Shah, Kotak AMC

    Synopsis

    Clearly, there is some amount of slowdown and despite that, the market is running up, says Shah.

    Nilesh-Shah-1200ETMarkets.com
    If the liquidity improves and if rates are cut and transmission improves, the biggest beneficiary will be small and medium enterprises i.e. small and midcap stocks. These are the stocks which are bearing the burden of tight liquidity, said Nilesh Shah, MD, Kotak AMC, in an interview with ETNOW.

    Edited excerpts:

    We are close to election. Flows are back and the global narrative is that interest rates will only go lower instead of higher. Is all the news baked in or is there a genuine scope for markets to go higher because of earnings recovery?

    There are three things which drive the market. One is flows. Second is sentiment and third is fundamental. From a flow point of view, since December 22nd, 2018, when the economist wrote an article on why investors are leaving India, one could be reasonably sure that FIIs will come back to India and from 31st of January 2019, roughly about 30 days after that article, FIIs have been continuous buyers in India. My guess is this trend is likely to continue even post-election.

    Unlock Leadership Excellence with a Range of CXO Courses

    Offering CollegeCourseWebsite
    IIM LucknowIIML Chief Operations Officer ProgrammeVisit
    IIM LucknowIIML Chief Executive Officer ProgrammeVisit
    Indian School of BusinessISB Chief Digital OfficerVisit
    On the domestic mutual fund side, we have seen flows slowing down from second half of FY2019. My guess is that there are people waiting on the sidelines and once election uncertainty is over, they may come back to domestic investors. Anyway, there are not many large scale issuances and so the market remains well bid and that is why it is at the current level.

    The second thing is sentiment. Certainly markets in the near term will be driven by election outcome. Today, the market is pricing in a stable, economic-reform-oriented government. As long as those expectations are met, market will remain supportive. But the most crucial thing is fundamental. Results matter on the day of the election but post that, it is the work of the government which makes a difference.

    Fundamentally, there is one optical fundamental and a real fundamental. Optically, auto sales are down in February by more than 7%; FMCG companies are talking about deceleration in consumer demand; auto component companies are also talking about deceleration in demand.

    Clearly, there is some amount of slowdown and despite that, the market is running up. The market believes that three factors were partially responsible for this deceleration in demand; a) tight liquidity; b)high real interest rates; and c) transmission of credit which will get resolved over a period of time.

    On high interest rates, today the Government of India itself is borrowing at 3.5-4% real interest rate. SMEs are borrowing at 10% real interest rate. There are very few countries in the world where nominal interest rates are so high. There is an expectation that the credit policy will see a rate cut. The alignment of real interest rate towards rational level and towards normal level will create profitability growth.

    The second thing is related to shortage of liquidity. The OMOs by RBI and the FX swaps done by RBI is lesser than the FX intervention of RBI, the currency in circulation increase and CRR increase. So, there is some amount of tightness or deficiency in liquidity. Post election, normally currency comes back into banking system. Hopefully, that will create sufficient liquidity to ensure that economy gets supported.

    The third thing was related to limited transmission. Earlier, PSU banks under PCA were not lending freely. Post IL&FS default, NBFCs stopped lending. Now the expectation is that there will be reserve transfer from RBI either before election or after election and that will help in recapitalising PSU banks and result into starting back of transmission of credit.

    The NBFC sector is slowly but steadily getting its act together. Over the next 6-12 months, they will be back into lending business and this combination will create transmission of credit.

    Another factor which also resulted in a slowdown was related to a little overvalued rupee which allowed Chinese trade deficit to cross $60 billion. Nowm rupee is near fair value and hopefully Chinese dumping will not be as large as it was in the previous years and that will support growth. The market today is ignoring the optical headlines in terms of deceleration in demand and looking forward to solutions which can remove these constraints and hence is trading at current valuation.

    Do you think the rally in banks would spread across and be a more lateral rally rather than only ICICI Bank, Axis and HDFC Bank leading going forward?

    The bank index has been significantly up in the month of March itself and to expect similar performance in the days to come will be a little bit out of place. If the liquidity improves and if rates are cut and transmission improves, the biggest beneficiary will be small and medium enterprises i.e. small and midcap stocks. These are the stocks which are bearing the burden of tight liquidity. Their working capital is stretched, they have orders but they are not able to complete those orders for absence of availability of credit.

    My guess is the biggest beneficiary will be select small and midcap stocks which today are bearing the brunt of tight liquidity and high interest rates. Financial services undoubtedly will do well if liquidity improves and rates come down but this will be a little bit selective rather than across the board because drivers for different segments -- be it corporate-focused private sector banks, public sector banks, retail-focused private banks or NBFCs -- are totally different and all these four segments will be driven by different factors.

    There is an attempt by the companies to get out of the debt trap. Do you believe that cases like GMR, the Essel Group, Emami, DLF etc brings about a sense of rerating for some of these companies?

    Undoubtedly, the market values a company as an enterprise value which is equity plus debt. Every reduction in debt will result in increase in equity value even if enterprise value remains the same.

    The second factor peculiar to India is that many a times, promoters pledge their shares in order to raise capital to fund other investments. Whenever the business does not do well and share prices drop, there is always a pressure of lender selling the shares and putting the prices down.

    Clearly, when promoter leverages come down, that anxiety goes away and that also supports share prices. IBC is one of the biggest reforms. It has given power to the lenders, it has disciplined borrowers and today we are seeing borrowers, instead of evergreening their loans by borrowing from the same banks and financial institutions, are looking to deleverage their debt by selling their assets. It is a very welcome move where the level playing field occurs where lenders and borrowers are now on the same stable.

    You have seen liquidity coming back and how that will kick-start the system because the liquidity machinery was broken down. A lot of reversals could happen, which will obviously be a challenge in earnings?

    Undoubtedly, but again there is optical earning and real earning. Optically, three of the corporate focussed banks -- two in private sector and one in public will report better numbers in FY20 compared to FY18 numbers. From collective loss in FY18, they will move to maybe Rs 50,000-crore collective profit in FY20 as per street estimates.

    The pharma sector, despite rupee appreciation should be able to show decent profit growth. There are companies with significant presence in Europe having global businesses and they had one-time losses this year and are unlikely to repeat in next year.

    If there is improvement in business, those companies could also deliver significantly higher profitability. There is a massive competition going on in telecom sector which has resulted in losses for many of the telecom companies. If at some point of time there is rationality in pricing for telecom sector, even those companies could move towards profitability.

    Optically, there could be better earnings growth coming from corporate-focussed private and public banks, pharma companies and telecom companies. If this competition comes to a halt from global companies having exposure to Europe, that will support earnings on the positive side on an optical basis.

    In the real sense, while we are talking about deceleration in consumer demand, it is not negative growth, it is below potential growth. At 6.6% third quarter GDP growth, India still the faster major economy which is growing but what we are worried about is that instead of 7% or 8% or 9%, we are growing only at 6-7%. So, it is not negative growth, it is the below potential growth which we are talking about in the form of slowdown.

    Most of the countries will be more than happy to achieve our growth rate, it is just that we want to grow faster than the current level of growth.

    Let me construct the election scenario; A) Scenario number one nothing changes and the current administration comes back in the current avatar. B) Current administration comes in with outside support; and C) There is a change of guard and coalition government. What do you think markets are pricing in? If there is a fourth scenario, you can also explain that.

    Currently, the market is pricing in scenario number one. It is pricing in an economic stable government which will carry forward economic reforms in the next term. Again I would just like to reiterate that the market is not a good predictor of elections. In 2004 and 2009, it was not correct in predicting election results.

    In 2014 it was lucky but what is important is that elections matter only for the result day, thereafter it is the work of the government and we have seen different kinds of government -- coalition, majority over a period of time and by and large markets have continued to move ahead despite different governments.

    Let us also talk about the valuations. Liquidity will come back and interest rates will remain low. How much of that has already been captured by the bond market and by some of the corporate banks? Do you think a lot of good news is already in the price?

    To a great extent, a lot of the positive news is priced into the market. The series of rate cuts, improvement in transmission, improvement in banking liquidity, rupee remaining fairly valued and not allowing Chinese dumping. The beneficial impact of GST and demonetisation is finally coming into play. A government which maintains the path of fiscal prudence and hence leaves enough room for private sector to borrow -- all these things are fairly factored into the market at current valuation.

    But the point is once we build the momentum, people will start discounting a few years forward if that momentum is strong and lasting. So, we could see a scenario where markets can remain supported if we see the momentum building up for almost last three-four years because of the telecom sector losses. This is because NPA is getting cleaned up, the burden of higher real interest rates being carried, the corporate profitability by and large remaining at about Rs 4,50,000 crore give and take few 10,000 crore here or there.

    Now, can we make a break in that orbit from Rs 4,50,000 crore to may be Rs 5,50,000 or 6,00,000 crore? Once that break occurs, people will start pricing in higher profitability.

    The other way to look at it is, today in corporate India EBITDA level margins are higher than average. The last 10 years’ average EBITDA margins was roughly about 18% and the current number is 18.2%. The profitability is significantly lower than historical average. Between EBITDA and profitability, you have depreciation, interest, and taxes.

    Tax rates have actually come down for corporate India from 35 to 25. Depreciation has not increased in a major way because people have not invested enough. Obviously, the gap between above average EBITDA and below average profitability is explained by interest and if that interest cost gets reduced, people will start factoring in further momentum to support market.

    What happens if crude goes higher or RBI does not cut rates?

    If crude price goes up, it will be inflationary in nature. Globally, if central banks accept their limitation, food and fuel prices would not be influenced by interest rates. If you fall ill, then you need to be supported by supplement. When rising oil prices impact Indian economy and weakens it, we need to support it by way of lower interest rates rather than higher interest rates. We should understand that if we raise interest rates in India, it is unlikely to impact global oil prices but it is more likely to impact Indian consumers.



    (What's moving Sensex and Nifty Track latest market news, stock tips and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Download The Economic Times News App to get Daily Market Updates & Live Business News.

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more


    (What's moving Sensex and Nifty Track latest market news, stock tips and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Download The Economic Times News App to get Daily Market Updates & Live Business News.

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more
    The Economic Times

    Stories you might be interested in