Why CLSA’s Mahesh Nandurkar is bullish on property developers

From a valuation perspective, the EPC, the contractors and also infrastructure companies look attractive. There should be a shift in the investment portfolios away from the expensive consumer names to the bottom of the cycle plays like property developers, cement etc, said Mahesh Nandurkar, India Strategist, CLSA, in an interview with ETNOW.

Edited excerpts:

CLSA India strategy market outlook headline says a strong verdict for Modi government. The fine print is not really indicating that you as a house feel that despite such a resounding mandate we could be in for a very sharpish earnings recovery or a market re-rating. Why is that?
What I want to highlight is political cycle, economic cycle and a market valuation cycle. These three are different things and yes, one is correlated to the other but there does not have to be a 100% correlation. Political strong mandate will definitely translate into better policy making and will definitely have a bearing on the economic cycles for sure. That correlation will be played out over a medium term.

However, we still have to contend with the near-term issues like liquidity-related issues for NBFCs, the consumption slowdown that we are facing, the housing market showing some signs of improvement and that is on the economic cycles.

On the market valuation cycles, clearly the domestic flows hopefully will now begin to start improving. For the last seven-eight months, we have been seeing a declining trend and with the strong mandate, the domestic investor sentiment has definitely improved.

From my discussions with the foreign investors, the sentiment over there for India relative to the other emerging markets is better at this point in time. But there is a broader global concerns on the US-China trade war, etc.

Also MSCI rebalancing will probably cause some outflows from the Indian market as far as foreign passive money is concerned. Keeping all these things in mind, while on a relative basis India looks very attractive in the emerging market, Asian market space. but how much of that gets translated into a large amount of foreign money coming in will be decided by other external factors.

Do you think that the government’s 100-day agenda is going to address all the economic agendas that you just highlighted? The election mandate back in 2014 was about development. This time around, it is focussed around nationalism. Do you really think the economy would be top of the government’s mind this time?
You have rightly identified the key differences but the other big difference between 2014 and 2019 is that in 2014, there was a change of government, a change of bureaucrats at the top level and so on. But in 2019, the prime minister, the key ministers in the cabinet and also the top bureaucrats are going to be the same. They already know what the problem is. They have already started working on for the solution.

My sense is that the government will clearly be hitting the ground running this time as against back in 2014. Also the disruptive and yet long-term positive oriented reforms are more or less done. GST, demonetisation, RERA, bankruptcy law all are done. Now, we are getting into the more operational level issues. All those things were disruptive, with positive long-term outlook but came with a short-term growth disappointment. All those things are behind us. I do not really expect too many disruptive changes going forward. I would say that the growth outlook definitely should be improving and the government should be able to take adequate steps.

Your note says you are fairly confident that it is the midcaps that are going to be back in favour. What is driving this confidence? Is it largely driven by the fact that the overall flow situation is likely to improve and where within midcaps do you believe there is value?
There are two reasons for our confidence. One is definitely the flows, as I highlighted for the last seven-eight months. The inflows into the domestic equity mutual funds have been coming down and one of the probable reasons for that was the political uncertainties weighing on the minds of a local investors. Now that it is out of the way, the local flow should improve and that should be a positive for midcaps.

The second is also the valuation. The gap between the midcap valuation and the largecap is at a reasonable level and that is the second factor which gives us confidence to be pushing midcaps here. Now within midcaps, the segments that we really like are the property developers, the cement companies, some of the other cyclical names like the EPC contractors, infrastructure, hotels and medical services. Those are broadly the segments that I would like to own in the midcap space here.

When NDA-1 came to power, the underlying narrative for India changed. The view on earnings changed, sectors like mining construction, road, railways got completely rerated and there was an entire rerating moment for some of the PSUs also. But the challenges of private sector capex, liquidity are still there. Do you think one should get excited but not euphoric?
Yes, that is the right way to describe. It is definitely a reason to be excited about but not really that euphoric because even the starting point on the market valuation is different. Right now, we are sitting at 18 times one-year forward earnings. It is not really one of the cheapest market levels that we have seen.

Also, if you look at the global developments, there are shadows of the trade war, Brexit and a few other factors. Back in 2014, we were coming out of the taper tantrum environment and so there was a positive tailwind from the global side and also from the valuation side. That is not really the case at this point in time. So yes, there is no need to be euphoric on the markets. What can definitely be expected is the relative outperformance of India vis-à-vis the other markets.

Do you expect a huge consolidation happening in the PSU banking space? The process started with Dena Bank, Vijaya Bank and BoB? Do you think that is one space where we are in for a pleasant surprise?
Yes, the PSU bank consolidation is already happening we are already down from 26 different state-owned banks to 19 as we speak and the government has said their long-term goal is to bring that number down from 19 to 6. But does that mean that one should be going all out and buying some of these state-owned banks blindly? I would probably say no because when we talk about M&A, there are some uncertainties that come to the fore.

There are some weaker banks that will be merging with somewhat stronger banks and what that makes to the balance sheet and the P&L of the stronger bank also becomes a question mark. I would rather go with a couple of large state-owned banks where the consolidation has already happened and so to that extent there is a lesser amount of uncertainty may be that probably a better place but I would still say that even on the private financial side, the private bank side, the valuations are still reasonably good so my first choice would still be that.

Do you think the groundwork has been done and now with NDA 2, is there a greater chance to be on the cusp of earnings recovery? Where do you think is the natural course correction is already behind us and it is time to start plucking the fruits?
One of the biggest drags for corporate earnings’ growth over the last two-three years has been the NPL recognition, the provisioning for it by the corporate banks and the state-owned banks. That has been the single biggest drag and the worst over there is clearly behind. The NPL ratios for the banking systems have already declined in the last 12 months in each of the last four quarters and the P&L impact has also peaked out, the provisioning for those NPLs has also peaked last year FY19 and FY20-FY21.

We will now be looking at provisioning cost going down considerably which will mean that the banking and the financial sector earnings growth will really be at a very high level in FY20 and also FY21. So you are right to that extent we have gone through the painful process of taking those write offs etc. and the time has now come to reap the benefits those benefits would mostly be seen in the corporate banking space.

When you talk about benchmark indexes, up until now it has been a very restrictive move. It has been only the HDFC Bank and Bajaj Finances of the world which have given outsized performance. Are you betting on any new leaders or do you think these two big ones will become bigger or gigantic after this?
I would say that over the last five, six years, the investment cycle has been quite weak. The gross fixed capital formation as a share of GDP continuously declined for the last six years. The economic growth was broadly driven on the consumption theme with the private consumption expenditure as a share of GDP rising consistently. Now that is beginning to change. The consumption ratios as a share of GDP are topping out in my view.

It is time we start looking at investment cycle improvement. I want to be very specific that we are talking about the housing market recovery because that is the one segment of investment side which has been very weak which I think is showing some initial signs of improvement.

I would probably say that some of the expensive staples and consumption names where we have already seen some element of slowdown where the valuations are anyway on a higher side. The investor should be going underweight on those names and the investment side of the story which is like the corporate banks and more so the housing related names like property developers, cement. Even the housing finance companies, notwithstanding the NBFC problems if we just focus on some of the best names in that space appear attractive.

One does not really need to go down the curve in the housing finance space. That is broadly the segment that looks interesting. From a valuation perspective, the EPC, the contractors and also the infrastructure companies look attractive. By and large, there should be a shift in the investment portfolios away from the expensive consumer names into the bottom of the cycle plays like property developers, cement etc.

But you are not ignoring or rather denying the fact that financials will still be at the top slot, is it?
Yes, I would say that financials still look very attractive and within thatm the corporate banks appear more attractive. I would actually be going underweight on IT and pharma. Pharma has been weak for quite some time but IT has been doing pretty good for most part of the last five years. But that is also a space that I would probably now look to underweight.

Do you add autos to that list because you have spoken about a consumption slowdown especially within the auto space?
True. Autos is definitely a part of the broader consumption theme. As investment activity and job creation pick up, it will eventually lead to improvement for auto demand as well, but that will probably take some time.

For now, we would be underweight on autos as well. Within that, the four-wheelers as a category looks more attractive from a longer term perspective although may not be just as yet. But two-wheelers is not really a category that I would be looking at from a longer-term perspective. Yes, there is a possibility that if the government were to review the GST rates on autos, especially, the two-wheelers, there can be some near term up move in those names.

I do not think the two-wheeler as a category really offers long term growth opportunity. Four-wheelers definitely look better but as we discussed, maybe there is some time for demand to pick up in autos.

If you have to bet on NDA-2 and allocate disproportionate amount of capital apart from private banks, which is the second segment you will choose? How best to make money during NDA-2?
I would say apart from financials, the one space that I would look to be overweight with a lot of confidence is the property developers because that is really a bottom cycle play at this point in time. We have seen five, six years of very weak trend, we have seen a lot of disruptive actions hitting that segment such as demonetisation, RERA, GST then the NBFC slowdown etc.

Yet, if you look at the data over the last six to 12 months, the new housing unit sales have been rising consistently quarter over quarter and the affordability levels are at very attractive levels I would say. Within that, the listed developer space is clearly seeing the benefit of industry consolidation.

Even if the property markets do not recover, the listed developers are definitely gaining a lot of market share and that looks like a very attractive space to me.