Pratik Gupta, CEO & Co-Head, Kotak Institutional Equities, says “while we are quite positive on the long-term and medium-term outlook for the Indian economy, for the businesses in general, one also has to anchor their investment portfolio to valuations and what is already priced in and the risk of disappointments and you still have a lot of geopolitical events, risks out there. In general, largecaps appear far more attractive to us versus small and midcaps”.
How have you divided the largecaps versus the midcaps? Do you believe that the risk-reward looks better when it comes to largecaps, even though some of them have been slightly underperforming as compared to the broader markets?
Yes, I agree with you. The largecap valuations have become far more attractive compared to the midcaps. Just to put some numbers in perspective, the Nifty year to date from January till now is up about 7% whereas the small and midcap indices are up anywhere between 28% and 30% and obviously individual stocks have done far better.
So while there is a lot of excitement around small and midcaps given their recent performance over the last six to nine months or so, one also has to keep in mind the valuations and what the stocks are already pricing in. So while we are quite positive on the long-term and medium-term outlook for the Indian economy, for the businesses in general, one also has to anchor their investment portfolio to valuations and what is already priced in and the risk of disappointments and you still have a lot of geopolitical events, risks out there.
Potentially right now the markets are celebrating what is going on with the US Fed and thinking that the rates have peaked. One never knows inflation is still running quite high and they may actually be forced to hike again. And in India, we have the election risk. One never knows which way that might go. So there are still risks out there, but the more important factor is valuations. At Kotak, we cover about 250 odd stocks and we are seeing a lot of the small and midcaps are trading well above their pre-Covid valuations as well which is not necessarily the case in all largecaps. But in general, largecaps appear far more attractive to us versus small and midcaps.
Within largecaps, is it just the financials and the private banking names that have been underperforming and look a bit attractive?
Private banks are definitely one of the areas that we still like. Again, as you rightly pointed out, partly because of this year’s underperformance, the valuations are still quite attractive. We still believe we are in the midst of a very strong banking sector upcycle for the next two-three years wherein loan growth will remain quite robust.
In double digits, you will see NIMS coming off very slightly and the credit costs will still remain quite low. There will be an upside from faster than expected loan growth as and when the private capex cycle picks up. So in that context, private banks, especially those with a strong liability franchise, the deposit franchise, look quite attractive to us, especially given their valuations and how these stocks have underperformed the market over the last six to nine months.
So that is private banks, but we also like a couple of the leading PSU banks. There is a similar logic – attractive valuation, strong banking upcycle, low risk of credit costs going up very sharply. But other than the banks, we also like the insurance companies, especially the life insurance companies, the real estate sector.
Let me just talk about the real estate sector briefly. This is one sector where companies have generally deleveraged quite aggressively over the last two-three years. Their net debt to equity has come off very sharply. The pre-sales, which we have been seeing, especially in the last few months, have been picking up. The cash flows are looking strong and interest rates have also, in our view, at least domestic interest rates are close to their peak. If not, they may have peaked already.
The outlook for the real estate companies, the residential real estate companies is quite strong so that is the other sector that we like. And last but not the least is consumer staples. India had a sort of a K-shaped recovery post-Covid, and now finally we are seeing the bottom end of the K gradually picking up, and we think there is upside over there. But yes, private banks, insurance, real estate, consumer staples, these would be the sectors we would be focused on.
In consumer staples, we have seen down trading across the segment in lieu of an upscale in inflation. What makes you bullish in consumer staples?
That is correct, but that in our view is more backward looking. We think the worst of the downturn for the consumer staple companies is behind us. We believe first you will have the usual pre-election boost, typically government spending or political party spending; that is one.
Second, the consumer is gradually recovering. We are seeing signs of the post-monsoon pickup and rural recovery.
Third, raw material prices have come off.
And fourth, our preference for consumer staples is against consumer discretionary, where demand is still quite weak. From a valuation perspective, we find consumer staple stocks still relatively better compared to say the discretionary names.
Given that the expectation is that we are seeing a strong capex boom, how do you believe investors should really play on that theme for the long haul?
We believe that we will see a long capex cycle, but capex has to be divided in our view in two-three different buckets. First is the government capex which is central government capex, then there is state government capex. Then there is PSU capex. And then there is private capex and then there is also what we call MNC capex, which is a smaller part of the overall capex plays.
Now, as far as central government capex is concerned, despite all the excitement, one needs to keep in mind that it is more backward looking. In our view, given the fiscal constraints, it is going to be difficult for the central government, whichever political party comes in next year after the elections, to sustain the growth in central government spending the way what we saw was happening in the last few years.
Just to give you some numbers, the central fiscal deficit, which is budgeted at 5.9% this fiscal year FY24, has to be brought down to 4.5% by FY26 so that is 130 on basis points of a reduction in central fiscal deficit. In that sort of a constraining environment, we do not see the scope for a dramatic increase in central government spending.
It is almost a similar situation with most states. Most states are running large fiscal deficits. Again, over there, after the elections, there is going to be pressure on them to try and reduce their spending. So as far as government capex is concerned, we think the growth rate is likely to slow down. And again, a lot of the stocks are already pricing in that this sort of government capex will sort of carry on forever which we think is unrealistic.
As far as private capex is concerned, obviously we have seen some pickup and we are seeing green shoots all around and the order books are picking up, but the pace of the pickup is a bit slower than expected. So that is where companies which are uniquely positioned or have strong balance sheets, have strong cost controls, they will be better positioned, but again, we would not be carried away and recommend that you need to look at valuations also.
One cannot completely ignore valuations and just say, it is going to be fantastic next three years, no matter what happens. But even over there, you do have all kinds of external and domestic risks to keep in mind. Companies are being somewhat cautious. So it is going to continue picking up, but perhaps not at the pace at which the stocks are implying right now.