Metal stocks are down; where to bet now: Rakesh Arora

"My pecking order for metal companies would be PSU steel companies followed by larger steel companies followed by aluminium companies," says Rakesh Arora, Founder, Go India Advisors.

The metal sector has been an underperformer in the last couple of months. Has the up cycle ended or would you say there is more to go?
Obviously it had a very sharp run up in the last one-and-a-half years and now stocks are kind of consolidated. I do not think they have crashed but they are consolidating and underperforming the market a little bit. This is a smaller cycle within the larger cycle and when I look at the larger cycle, I have good demand visibility.

Apart from China, the rest of the world is actually growing very strongly given the monetary stimulus as well as the fiscal stimulus. One might recall the trillion dollar infrastructure boost has been provided in the US. India itself is going very fast on infrastructure built up so we will move from monetary stimulus to fiscal stimulus in most of the countries. The hiccup has come because of China which has slowed down dramatically in the last three to four months and was not expected.

Everybody expected China to cut production because of pollution and winter Olympics coming up in February but they did not. I expect that demand will also collapse simultaneously, faster than the production cut and that has pulled the metals down but there has been a big change in China’s stance towards exports. So despite the slowdown in demand in China, exports of steel, etc, have not really picked up. They have also cut 13% rebate that they used to give on export and there are a lot of market rumours that if exports pick up, they might put in 10% to 25% export tax. So that is a big policy change. So supply which normally used to come is not coming and that is why commodity prices are largely stable. We expect China to start growing back post the winter Olympics in February and that is the time the market would start to relook at metal stocks again because valuations are extremely cheap.

Is it time to accumulate selectively or not quite?
One has to look at sustainable earnings to identify whether the stocks are cheap or not. Companies like Tata Steel, SAIL or JSPL are all trading around three to four times on sustainable earnings on EV/EBITDA multiple and historically they have traded around six times. So they do look cheap based on sustainable earnings and the current earnings also. Obviously current earnings are very high and they are looking incredibly cheap but they are deleveraging very fast. So the recent upgrades in metal stocks by consensus is largely driven by deleveraging happening at a faster clip and than what we anticipated.

The valuations are absolutely cheap on sustainable earnings and higher commodity prices remain. Deleveraging is happening even faster and once demand starts to revive, which I expect will do from February next year onwards, it is a good combination to have.

What is the right way to look at metals in the light of the debt profile? The debt profile for metal companies have changed in the last one year. They have generated so much cash that some of these companies have retired 30-40% of debt. How does the market factor that in?
When one looks at EV/EBITDA, the debt component goes down and market cap component goes up. If one is trying to do so, market cap may not be the right indicator. People are saying okay the stock is up 4x, but they had a large amount of debt which has been retired. So when one looks at EV, the stock does not really move much. That is where EV/EBITDA comes into play and that is a better indicator of the health of the company and the balance sheets.

What are the chances that because of ESG, supply will remain under constraint, inflation will come back and central bankers will be forced to move which automatically will have an impact on demand? For inflation watchers and central banks, could ESG create an inflation nightmare?
Absolutely correct. So ESG is inflationary because it is increasing costs. Tomorrow if governments force companies to capture carbon, then it is going to increase cost. And add to that the under investment in the mining sector over the last one decade. Supply is not coming through. Overnight also we have seen companies cut their guidance for the current year. So clearly supply is constrained and it will remain one of the factors and is one of the reasons why we are so bullish.

Coming to central banks raising interest rates, that does not really change the supply equation. But it changes the demand equation. Now at the same time, fiscal stimulus is coming and that is driving the demand. I am not too worried about the demand supply balance for commodity companies, specifically as the main supplier, China, is not exporting with the same enthusiasm that it used to earlier. So China is not there to export disinflation into the rest of the world and commodity prices are going to stay stronger for longer and that is the theme which is yet to be discounted by the market.

The market has discounted a pop up but they have not discounted a stronger, longer theme for a few years.

In this light, what is your pecking order within metals and what is the ideal buy list?
It depends. PSU companies are the cheapest and they have the highest dividend yield and they have also managed to deleverage very fast. Take the example of SAIL. SAIL has announced that they will be debt free by the first quarter of the next financial year and for the first time, they have given Rs 4 dividend. Looking at the guidance which the government has for PSU companies for dividend, they have to dole out almost 30% of their profits.

So SAIL’s consensus EPS estimate is around Rs 40. We can expect Rs 12 EPS and so that is more than 10% dividend yield and the company becomes debt free to boot. So what kind of rerating can it actually attract? PSU companies are the cheapest followed by steel companies. Steel companies’ margins have gone down because of the sharp rise in coking coal and that is what the market has factored into their valuations.

But coking coal prices are coming off pretty sharply and margins are going to be restored for steel companies by Q1 or Q2 next year. So steel companies have a better chance. Aluminium is the third in pecking order. Here Vedanta has outperformed given the corporate action that we have been seeing and the promoters have been buying and that has kept the stock popped up. Hindalco seems to be a better play and Nalco is the cheapest of them in the aluminium space. So my pecking order would be PSU steel companies followed by larger steel companies followed by aluminium companies, here again PSU companies look better on valuations.