Power sector for compounding ideas? Here’s why

Ashutosh Bhargava, Fund Manager and Head of Research, Nippon India Mutual Fund, says “a lot of EMS companies would perhaps keep delivering very high growth. We are at the very initial part of the long-term journey. Some bit of extra work is required in terms of identifying which are those companies which have a serious long runway as far as earnings are concerned. At the end of the four-five-year period, the number of winners would be very selective and there would be 2-4 winners in these categories.”

What is your outlook in terms of what the markets hold in store? How are you looking at overall corporate profit growth when it comes to earnings?

In the last couple of months, there has been high uncertainty related to the war which is going on in the Middle East and also related to Fed tightening, etc. In the last few weeks, I would say those concerns have abated and the entire focus has come back to the cyclical recovery. And the good news here is that globally, the worries related to hard lending, the data which is coming, the earnings which are coming, are turning out to be better than most people’s expectations. So this is how we are at a global level, we are going into 2024, which to my mind is going to be a relatively more boring, slow recovery kind of year for the global economy.

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As far as domestic earnings are concerned, we have just seen the conclusion of the second quarter earnings and here also on a relative basis, earnings have been better than expectation. We have seen overall upgrades in Nifty EPS. Yes, there has been a difference in terms of where the earnings are coming from, and most of the earnings surprises are coming from domestic cyclical sectors. But on an overall basis, this is an environment which looks more stable as far as macro earnings related news flow is concerned and this is how we are entering the next calendar year.

The big sector which has not participated is banks and for a sector which has not participated, there seems to be a double whammy. NIMs are coming under pressure and growth will come under pressure after Reserve Bank of India’s diktat on unsecured loans. So do you think banks could be the biggest bugbear?

Obviously, RBI is a bit concerned only time will tell whether these concerns are overdone or there is some truth behind whatever the actions they have taken in terms of risk weightages. But to our mind when we look at banks in general, what has happened the last two-three quarters, there has been better than expected earnings performance. This is a sector where credit growth has surprised positively, NIMs decline has been much lower than what people were worried about six months ago. And asset quality concern, barring this small unsecured piece which is close to 4-5% of the overall banking sector book, there is no asset quality concerns as such.

If you look at the next two years as well, we are talking about only 12 to 13% kind of earnings growth. Despite this action by the RBI, which can lead to a 2-3 percentage point earnings cut overall, I do not think there is going to be disappointment in running as far as banks are concerned. This is a sector where valuations are also very reasonable versus their own history and particularly versus the rest of the market. So there has been a good consolidation, there has been some bad news. But I think price wise banks are not looking unattractive to us.

Is that the reason why you have actually as a house trend, some of the largest NBFCs from your portfolios?

In the case of NBFCs in general, the valuations were a bit stretched in general. The NBFCs which we are liking are less into the consumer segment in general, but more into infrastructure power sector lending related NBFCs or those NBFCs are into auto lending. But in general consumer specific lenders in the NBFC space, we are in general underweight. We are in that point of the cycle where the liability side would matter a lot more. We favour banks or NBFC in general, beside the pockets like, as I said, infrastructure lending, bit of micro finance and some bit of auto lending.

So where are you picking your spots now? Where are you looking at some compounding ideas, where there could be scope of PE expansion and earnings growth?

One theme is the power sector theme. Right from equipment companies to financing companies, to utility companies which are generation as well as transmission companies, we are in a multi-quarter to multi-year up cycle there. And there, if you look at the visibility and earnings in general, are improving and valuations also remain reasonable. Therefore, there is still some scope of rerating, given the fact that a lot of institutions were underweight in these names going into this cycle. We think this sector has outperformed. But there is still more scope for a) earnings growth estimate to be met and perhaps better than expectation and some more scope for multiple rerating across the value chain in the power sector.

Within the power space, will you go for power financiers? There is enough fancy for big power financiers, in fact, one of the IPOs also in the same space getting good interest. Your transmission companies, wires and cables or even some of the legacy power companies, which are at multi decade higher than NTPC. Where do you find better risk reward out of all of these?

What we have seen historically, market rewards, earnings and earnings, positive earnings, surprising upgrades, the whole value chain, which we have talked about, we have very high confidence that there would not be much disappointment in any of the value chain, be it financiers, utility companies, equipment companies and so on.

One has to look at it holistically; make a portfolio where you are participating in all sorts of names, rather than picking one over the other because within the bigger team, there can be rotation that would keep happening. But if you are thinking from a two, three year perspective, I think the entire value chain should benefit.

Where do you think there is a serious mispricing in the PSU space? Power, we have discussed, but what about railways, defence? Is there any mispricing there?

Obviously, there could be some double counting as far as revenues are concerned because at the end of the day, a lot of these sectors depend on government spending, and if you do the bottom up it becomes a bit difficult to justify that there would be so much of spending over the next four, five years in all these pockets, including renewable, railways and defence as a sector.

So one has to be selective from here, we are at that point of the cycle where a lot of these things have been discovered over the last 12-15 months. And from here on, one needs to be selective, have to focus more on the bottom up work because not all of these stocks in the overall, each of these themes would really deliver in terms of revenues as well as profitability. So here on, we are more confident, honestly, over power and defence as two of the infrastructure themes, versus other themes like railways. This is our house view. And we would advise investors to be incrementally more discerning as far as some of these comeback themes are concerned.

The other space where I would like your opinion is the entire EMS space. One is the actual manufacturers but then the argument is that they are no longer cheap, though there are a lot of new PLI also being opened up by the government. Then there is the software part of EMS, engineering R&D type. There is a big IPO around it. Would you play R&D, engineering manufacturing from the software route or by these new age EMS guys?

This is a new theme but the reality is we are already seeing a big shift in terms of work which is coming as far as these services exports are concerned, some part belongs to the space which you are talking about. A lot of these EMS companies would perhaps keep delivering very high growth. We are at the very initial part of the long-term journey.

Again, the same point here also that some bit of extra work is required in terms of identifying which are those companies which have a serious long runway as far as earnings are concerned because at this point of time, you are seeing each and every company in this space is getting rerated. So we need to see because at the end of the four-five-year period, the number of winners would be very selective, two, three, four winners in these categories.

One needs to definitely participate in this theme because the runway is very, very long. But again, one has to be choosy in terms of the right management and within the EMS space, the right segment where you think the revenue runway could be strong over the next four-five years.

Harry Byrne

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