Take long-term view on sector market leaders: Saurabh Mukherjea, Ambit Capital

There is a lot of jitteriness not just because of demonetisation but also because in America we can see which way US interest rates are headed, said Mukherjea.

| Updated: Nov 21, 2016, 04.06 PM IST

Take long-term view on sector market leaders: Saurabh Mukherjea, Ambit Capital

In a chat with ET Now, Saurabh Mukherjea, Ambit Capital, says the informal sector will shrink as a lot of businesses go belly up following introduction of GST.

Edited excerpts:

Just a perspective on the way the markets are behaving these days. Every intraday move on the upside got sold into, expiry week and we have started off Monday with almost a percent downtick, getting ready to break 8000 as well. What is the near term thought? I mean do you think this one way slide will continue over the course of the next couple of weeks at least if not more.

Clearly there is a lot of jitteriness out there not just because of demonetisation back home which we can discuss threadbare but also because in America we can see which way US interest rates are headed. Janet Yellen was very clear last week with regards to her intentions. US bond yields are rising. Let us talk about the 30-yeara bull market in western bonds ending. So there is plenty of reason to worry both for DIIs and for FIIs. So not surprising therefore that you are seeing downside pressure on the market. My reckoning is at least until the next Fed meeting where most likely the Fed will hike, at least until then this pressure will continue.

Everyone is calling the demonetisation move as the biggest reform unleashed since 1947. On paper, we can argue that yes this is a greatest reform. But this reform is coming at cost and this reform is coming at a cost when the Indian economy had just about started accelerating.

That is to be expected. Our whole Modi-Rajan technology reset theory that we started propounding for March 2015 was that. There is a whole bunch of things that need to be done to fix the economy. Those fixes will entail short-term pain, short-term cost for longer term gain. So Raghuram Rajan did his bit by forcing the banks to come clean on their balance sheets, by reforming the bond market. We can see the benefits of Rajan’s reforms. We got a whole clutch of new banks coming through. These will help the country and the bond market has also become more liquid.

Prime Minister Modi’s attack on black money which I have discussed extensively on your programme over the last year will continue. I do not think demonetisation is an end of it. I think the risk is we focus too much on demonetisation when it is the broader attack on black money which matters. This is an attack which had to be undertaken on black money. Good thing is he is doing it. Clearly, it means an economic slowdown, probably GDP contraction in the current quarter but benefits of this will come through over FY18 and FY19 through lower cost of capital and lower cost of real estate which will help all of us and help Indian manufacturers become more competitive.

What is it that you are telling your clients right now? How should one position ourselves for say the next one year because you still do not know the quantum of the damage because the currency demonetisation is going to persist in the economy? What sectors do we stay away from? Where do we look at buying opportunities?

The advice we have been giving over last year and pretty similar to the advice we are giving now is we are asking clients to look through the damage, look through the pain because there is very little we can do about the damage. Yes Q3 numbers both on the economy and on corporate earnings will be pounded. There is very little investors can do about it. What we need to look out is a year out, year-and-a-half out and say who are the big winners out of this and our unequivocal take is the winners out of this are sector market leaders.

Whether it is an electrical, whether it is in sanitary ware, whether it is in the financial services, the sector market leaders will win as the informal sector shrinks and dies away. So with my friends, with my colleagues, relatives and friends, we have been discussing extensively over the past three or four months as to how a lots of SMEs plan to shut down their businesses over the next year or two because they saying that if we pay full tax, we simply would not make any money. Hence, might as well wind up our business. As we go through that process of that informal sector winding up, you will see the formal sector market leaders gaining market share and my reckoning is from Q4 results onwards, this talk will gain momentum of market share gains by leading franchises in the listed world.

We are pushing our clients towards those franchises, buy them maybe 5% to 10% lower than where they are today but what is unquestionable is we have to build an Indian portfolio out of sector market leaders rather than trying to play second rung, third rung names or names with broken balance sheets.

What pockets out there because if I just look at informal versus formal, they exist in the distribution space, they exist maybe in gems and jewellery, they exist in the brokerage names, they exist at multiple pockets. What are the favourite themes?

The one distinction we are drawing is we want to look at sectors which overall do not get structurally damaged by the attack on black money. So for example, our take is that there is a good chance the real estate sector does get structurally damaged by the attack on black money.

It is logically not possible for the real estate sector in our country to continue at 2% rental yield. It makes no sense at all. So even though in real estate as well, there will be sector market leaders who will gain market share, we would rather steer clear of that.

In something like kitchenware sector, you have got a couple of companies which dominate the sector. As the informal
part of the kitchenware industry dies away, the market leadership will consolidate around that. Ditto in electrical. You have got two to three companies who dominate the electrical sector in India and again as the informal sector whose market share is as much as 50-60%, dies away, the formal sector market leaders will gain market share. So this will happen and it carries on and on, stock broking, jewellery, restaurants, this will happen in several places. It is incumbent on investors to identify the market leader, take a position and then sit through the turmoil. There is no point waiting for the share price to bottom out. Neither you nor I will really know which is the day on which share prices bottom out and my take is overall most investors will be willing to look through the damage. They will say cost of capital falling, fiscal stimulus coming, India moving towards more efficient economy, let us look through the pain and buy now.

How long would this pain period last? Do you think the market reaction which typically comes in ahead of the event, could be short lived for three to four months or do you sense that this could get stretched over a one-year time?

It is a little hard to gauge the extent of the period of pain is because by the time the chaos around demonetisation the uncertainty around GST will start accelerating so if indeed the government is planning to meets its 1st April deadline of GST launch then this will almost become two shocks in quick succession. So we have got a period where it is very difficult to see how the next 12 months, we have anything but uncertainty at the macro level in India. However, again I think what investors are planning to do is they are saying that look demonetisation, GST be that as it may we want to understand what is the impact on corporate earnings and if the impact on corporate is not particularly negative especially in the year to March 2018, if the impact on corporate earnings is not particularly negative in the year to March 2018 let us look through the pain and buy market leading franchises and some my clients are saying they are happy to buy market leading franchises even at elevated multiples. I was talking to a client last night and he was saying I am really not that (12:29) about the short term correction, I just want to get in into the market leading franchises and stay there for the next couple of years because I think see the long term benefits to the country of this.

What will happen to NBFCs because that is where the confusion is there, there are some NBFCs which will get rebooted because the way you were collecting cash, the way you were distributing cash will change. Eventually when the dust will settle down, which are the NBFCs you think will emerge out as winners?

You got a whole spectrum of SME lending in our country, you have got the prime SME lending industry which is catered to by the HDFC Banks and Kotak Banks to take two examples of banks which are largely prime SME books. By prime I mean high quality collateral. By and large, those SME cash flows are white money cash flows and hence the scope for disruption is modest.

The other extreme we have got the LAP books of the housing finance companies where the collateral might not be prime, it might be something like commercial warehouses and where the underlying SME client’s cash flows might not be white money cash flows and hence the scope for disruption is substantial. So you got a whole spectrum of prime SME lending at say close to the bank’s base rates and subprime SME lending with iffy collateral and uncertain cash flows where exactly in that spectrum you draw a line is hard to say.

We are telling our clients to focus on buying the smaller bank shares, well run smaller banks which are available at say around 1.5 to 2 times price to book. Let us look out for those bank’s shares even of those banks have SME books. Let us look through the pain and buy smaller banks shares on the premise that as the cost of capital really plunges for these smaller banks. They are disproportionate beneficiaries of the change that sweeping across the land. We have to confess we are not that confident that you should go out there today and buy NBFCs shares given the sheer extent of uncertainty as to what is transpiring out there smaller bank shares is where we feel more comfortable.

Banks are in the business of lending. Whereas the liability part, the cost of capital will be taken care of because more money comes via CASA all that excess CASA would be either sitting in government bonds or that would be lying idle. The problem with banks is that they always had capital at least the big ones, they do not have opportunities to lend?

Yes. One of the reasons for highlighting the smaller banks is what the smaller banks are doing. Are they replacing wholesale market funding which came in at say 6-7%, 8%. replacing wholesale market funding with low cost CASA. So yes the lack of opportunities is the common problem for everybody but the NIM hit is bigger for the adverse NIM hit from not being lent out money is potentially bigger for the well established market leading CASA franchises whereas for the smaller banks the extra CASA is an outright boost to their NIM but on the broader issue of lending opportunities it will take time. There is no question it will take time for the lower cost of lending to translate into loan book growth. Even in the western economies it takes three quarters for lower interest rates to translate into economic growth. It is unlikely in our country that we will see a growth spurt anywhere before the next three to four quarters. So cost of lending is said to fall in the next 30-60 days. The benefits of that loan book growth will take three-four quarters to come that is how economies work we got to learn to live with that.

Post currency demonetisation hopes are only getting higher about what this time’s budget could be and considering it is going to be early as well on Feb 1st while it is a given that there would be perhaps income tax cuts coming in what else could we actually expect from the budget this time do you think there are going to be enough and many freebies for various sectors autos, consumption, what have you which have been hard hit this time because of the currency demonetisation?

Just as we had highlighted in our research in October that demonetisation was around the corner, we have also been talking about universal basic income. The reason we have been flagging off the possibility of universal basic income being introduced in the budget is our reckoning that GST is a potential creator of unemployment. GST hits the informal sector which hitherto did not pay tax. GST hits the informal sector very hard and thus renders big parts of the informal sector inefficient and puts them out of business. The informal sector employs 5x more people than the formal sector . Combined GST and demonetisation will almost certainly have the grounds for a big upsurge in unemployment over the next couple of years. My reckoning is the government is alive to that and hence something along the lines of universe basic income in the 1stFebruary budget I think is likely i.e. direct benefit transfer of money into low income peoples bank accounts perhaps in his mid-year economic review in December the Chief Economic Advisor will give us some clue as to what the government is thinking on this but what is very clear is we do need some sort of palliative, some sort of remedy to buffer the hit for unemployment which I think will rise over the next couple of years as we formalise the Indian economy.

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