Capex cycle to continue despite challenges: Karki

Synopsis

“Our models and our frameworks tell us that when we have sharp drawdowns in the stock market and if the overall demand environment is not too bad and there are no huge financial risks, post a sharp correction the expected returns should be higher. Anything can happen but the higher probability would be for, even by this year end, reasonable positive returns from these levels.”

ETMarkets.com

“Heavy industrials which include commodities and the other sectors are finally turning in terms of their cash generation capability and demand outlook. These are the two key things which are required along with animal spirits,” says Vinod Karki, Equity Strategist, .





At the beginning of the year there was a hands-down consensus that a capex cycle like never before had started and Mr Birla said that a capex maha kumbh has started. But if I look at the recent headlines of drop in energy prices, high inflation, impact coming on global demand trends, do you think the capex cycle is off track?

Our reading when we look at data and what we have experienced through cycles is that these cycles have false starts but if the conditions become right, then rising costs and inflation is not a deterrent.

In fact, if you look at the breakup of the gross fixed capital formation, especially within the private corporates, the heavy lifting is being done by most of the commodity companies and heavy industrial companies and even telecom and others which were under pressure in terms of cash generation over the last several years.

We have seen initial signs of improvement and we have seen that it does not get reversed within a year or so. These cycles are long-trending and in between, at times some slowdown hiccups come up but the cycle continues on its trend despite some of these short-term challenges.

In 2011-12, we peaked out in terms of the capex cycle and if I were to just break it up, not all components were dragging it down. The main components or the heavyweights which were dragging it down were industrials and real estate investments basically. While what was giving it a lift was services sector corporates like communications, IT services and the PSUs share was rising..

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The point is that real estate and industrial corporates had almost a 60% weight in the gross fixed capital formation in 2012 and that share has fallen to 40%. Even if the government tries and services sector tries, their weight is not enough to lift the gross fixed capital. But what we are observing is that it is heavy industrials which include commodities and the other sectors are finally turning in terms of their cash generation capability and demand outlook. These are the two key things which are required along with animal spirits.

The cash flow in some of the companies stands at unimaginable levels but can I say that given how commodity prices are coming down, maybe there is a thought that recession is round the corner and if prices come down another 15-20%, one is better off delaying these capex cycles?

The point is that although commodity prices might correct, the level is still high compared to what we have seen over the last decade or so. The bigger thing is under investment. Over last seven years, there was under investment in some of these industrial sectors like utilities, metals, telecom. The latest capacity utilisation was around only 74.5% as per the RBI and that was in Q4. In Q1, we have seen further traction in terms of demand.

I would not be surprised if this number moves to 75-80% capacity utilisation. If we were to just extrapolate it over the next year or so, demand can slow but it will still be there and at these levels of capacity utilisation and cash at their disposal, in some of these sectors, capex is possible. but the ones which matter – infrastructure and real estate – are the heavy lifters. I am saying again real estate does not come on a balance sheet of a company, it comes on the balance sheet of the household and that sector is turning.

In 2012, real estate investment by households was 37% of the gross fixed capital formation which fell to almost 25%. And we are seeing very strong signals that the absorption is rising and new projects are being launched. Eventually there will be a problem of over enthusiasm and misallocation of capital but these are the one or two years of expansion of the real estate cycle. One cannot immediately say that this will go and that is a large pie of the investment cycle. That is where the positivity comes in.

The government was anyways pulling enough and they are going to pull more. Going by the tax to GDP number, we are confident. So from a cash generation and capital expenditure perspective, we feel confident about both the government and the private sector companies.

Capacity utilisation nudging up above the 75% level and the years of under investment in some of these heavy industrial sectors is the key for me. That will play catch up rather than doing a one to one correlation between immediate demand and investments, these sectors which have seen years of under investment are catching up.

About a fortnight ago, ICICI Securities gave a target of 19,000 for the Nifty by the end of this financial year but for a shorter term. What are you telling your clients and what should our viewers brace themselves for – negative returns, neutral returns?

Our models and our frameworks tell us that when we have sharp drawdowns in the stock market and if the overall demand environment is not too bad and there are no huge financial risks where balance sheets can go bust, post a sharp correction the expected returns should be higher. Anything can happen but the higher probability would be for, even by this year end, reasonable positive returns from these levels.

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