‘Buy large-cap stocks, but be selective about mid-caps'

Among the beaten down sectors, auto could benefit



It is not yet time to chase mid-cap stocks but large cap stocks should be bought after recent market declines, says Mr Pankaj Pandey, Head of Research, ICICIDirect.com. Mr Pandey also believes that today's markets favour companies that deliver growth over those that offer value.

Excerpts from an interview:

In the last two quarters, the market has been sliding due to worries about earnings downgrades for Indian companies. How has ICICI Securities changed its FY12 earnings estimates recently?

At the beginning of the year, we had a Sensex EPS expectation of Rs 1,209, one of the lowest estimates in the market where the consensus was Rs 1,250-1,300. Given the shaky global and local macro scenario, we have downgraded our EPS for FY12E to Rs 1,165, implying a 3.6 per cent downgrade.

For FY13, we have projected 17 per cent growth to Rs 1,374 versus our earlier EPS target of Rs 1,414. In case the scenario persists, we could see a further pruning down of FY13 estimates. We will review our estimates again in the second half of the financial year.

What sectors would you prefer to buy today?

We had been positive on three sectors — banking, IT and pharma. We believe that these sectors will do better than the Sensex in terms of earnings although caution is warranted in the IT sector given the global concerns. We prefer chasing growth and not value because valuations are now attractive across sectors.

Among the beaten down sectors, auto could benefit as valuations have factored in multiple headwinds. Volume growth for the sector has come down and the cost of ownership is higher year on year with fuel costs up about 17 per cent.

It is also suffering from higher interest rates and commodity prices such as rubber. Once the rates peak out, investors can look at this sector. In addition, Tier-1 engineering or mid-cap cement companies appear attractive from a risk return trade-off and revival of capex perspective.

Is the commodity price decline sustainable? Does that create some opportunities to buy?

In commodities, it is difficult to take a call because the demand and supply is polarised towards China. China accounts for between one third and half of production of most commodities. As of now, there is still uncertainty about whether the Chinese economy is headed for a hard landing or a soft one.

It is also struggling with high inflation. Given all this, it becomes too difficult to take a call on commodities. In steel, high coking coal prices and weak demand are problems.

In the oil and gas sector, higher crude oil remains the biggest concern for oil marketing companies. At the current prices of US$110 per barrel, the under-recoveries are expected to be Rs 1,17,588 crore for FY12 and Rs 1,04,615 crore for FY13 compared to Rs 78,000 crore last year.

In the short-term, the release of 60 million barrels of crude by IEA may curb the speculative element to some extent, but hopes that the Fed may announce QE3, may keep crude prices at elevated levels. However, in the medium term, crude oil prices may slide as there is little logic for crude oil to be ruling high as more than half of the global GDP is expected to grow at a sluggish pace compared to the pre-crisis period.

With RBI remaining aggressive in hiking rates, which are the companies under your coverage doing to cope with their debt?

One of the sectors that has been badly hit by interest rates is infrastructure and construction. For the construction segment, we witnessed a six per cent increase in top-line and a 54 per cent decline in profits this quarter. Interest costs expanded to 1.9 times compared to the past year. In a high interest rate scenario, these companies tend to execute fewer projects as they tend to be working capital intensive. It is in their interest to slow down the pace of execution.

The order inflow has also slowed down for these companies in the first quarter compared to Q4 of last year. However, we expect the order inflows to revive once the capex cycle picks up.

Are you seeing a revival in the capital goods segment?

Tier-1 companies usually tend to be better managed and have better balance sheets. They usually do not get impacted by the slowdown to the extent that smaller companies do. That is why you are seeing companies like L&T retaining 20 per cent growth guidance for their top-line. Hence, frontline companies will do well but smaller capital goods companies will suffer in a scenario of high interest rates and tight liquidity.

A key variable to watch is the improvement in macro variables, which directly impacts the order flows for the sector. Hence, till the time clarity does not emerge on government policies for infra, decline in inflation and interest rates, the sector may languish in terms of financial performance and valuations.

Consumer stocks have been much in favour during the past two years and this has taken their valuations to a huge premium. Do you see the consumer theme continuing to dominate markets?

There is nothing new about FMCG companies delivering profit growth. They have been growing at reasonable rates and will continue to do so. However, once you look at the overall universe, these are the only companies where growth visibility is there. Investors have been chasing these stocks. As a result of this, stock prices have risen sharply.

It is not as if earnings have grown at a faster pace. Valuation multiples have expanded. Most of these companies now trade at 24-26 times on a FY13 basis, which is quite expensive. Hence, what we are advising clients is that they should not buy these stocks from a 12-18 month perspective as these stocks may get neglected once overall economic growth returns. However, if they already hold the stocks, they can continue to ride on the momentum.

Do you think the market is now more focussed on who can deliver growth rather than value?

Whether you can chase value depends on your investment horizon. If you have a longer perspective you can, for instance, look at mid-cap stocks. They are trading in excess of 32 per cent discount to large caps against their historical discount of 21 per cent.

However, then again, it does not look as if interest rates or inflation have peaked out. Therefore, mid and small sized companies will suffer in the short term. That is why you will need to buy these stocks from a long-term perspective.

I don't believe that people can go the whole hog chasing mid-caps as yet, as there could still be some downside. We are recommending mid-cap stocks selectively and investors need to have a long-term horizon to buy them today.

Will you recommend that investors should have some cash positions to take advantage of opportunities?

We expect more of a time-based correction and the markets to oscillate in a broad trading range till the time reasonable clarity emerges from the various local and global macro headwinds. In case of a negative event, the markets may fall further in the wake of panic selling.

However, we do not expect the markets to sustain at such levels. Therefore, in such an environment, timing the markets would become extremely difficult.

We believe that any sharp cuts should be bought into from a 3-5 years perspective. Buying is recommended in large-caps and selective quality mid-caps.

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