Meet the Manager. Pick-up in urban consumption is visible

“For 2016, bet on domestic cyclicals with low financial leverage and high operating leverage,” says Harsha Upadhyaya, Chief Investment Officer-Equity, Kotak Mutual Fund. Here are excerpts from an interview with BusinessLine :

Economic growth is still not broad-based. On the investment side, things are yet to move at the desired pace. Where do you see growth picking up?

There are a couple of areas where growth may pick up. One is urban consumption. We have already seen some patchy growth here. That’s going to gain more momentum as we see the Seventh Pay Commission awards being doled out. While the extent of increase this time around has been much lower when compared to the earlier one, it must be remembered that the average salary for government employees has gone up over the last 10 years. So, that will help consumer discretionary demand.

Auto, auto ancillaries and banks — which are enablers for these purchases — will also do well. When the earlier Pay Commission recommendations were implemented, banks were not so much focused on consumer lending. Also, last time the Pay Commission report was delayed by almost two-and-a-half years. So, there was a large component of arrears. This time, there is unlikely to be such a delay. So, there is less chance that big money comes into the hands of consumers for down payments and so they have to look at financing options. There is also promise of growth where the government spending has begun already — roads and railways. There, it is better to play some of the companies where leverage is not high and where management bandwidth is strong. Cement or some select capital goods companies, such as those focusing on defence, will probably participate in the initial leg of growth.

Will December quarter earnings be any better than what we have seen so far this year?

The industries which did better in the second quarter will continue to do well. So, auto, cement, and private banks that are strong in retail lending — these are some of the areas where earnings growth will be better than the market. The earnings momentum itself should be slightly better than the first half for the Nifty and the Sensex baskets.

In the first half, there was a marginal year-on-year fall. I think it will be a positive number in this quarter. At the same time, it will not be as high as what the market is expecting. The market is expecting 10-12 per cent earnings growth for the full year. That can happen only if earnings for the second half grow 24-25 per cent. This is unlikely. A 6 per cent growth for the full year may be possible, if the second half shows at least 15 per cent growth.

Have corrections of 2015 created more buying opportunities?

Yes. At the beginning of 2015, markets were entering a fair value-plus kind of zone. After seeing 12 months of corrections, valuations are more reasonable now. That suggests that the downside now is less than what it was one year ago. Also, we have seen close to eight years of subdued earnings cycle. At some point in time, this will have to get normalised.

Our belief is that it should start inching up from hereon. If you see corporate results, the gross margins have improved because of raw material benefits. That is not translating into higher net profit margins because either the pricing power in the industry is less or because interest cost has eaten up most of the profitability. These will start to resolve. We have already seen 125 basis points rate cut and a transmission of 65-70 basis points.

Are commodity stocks value buys now?

On the fundamentals side, there has been no change in this space. There is this question mark in terms of Chinese growth, and it is very difficult to predict what will happen in a short time frame. Until and unless you see some change in fundamentals, these can also be value traps.

Look at the way public sector banks have behaved over the last few years. You may feel that it has value compared to the market or private sector basket, but as long as fundamentals don’t improve, on a sustained basis, you won’t see any change in valuations.

Funds such as Kotak Select Focus and Kotak Opportunities are overweight relative to the benchmark on sectors such as construction and engineering. Is there value in this space now?

The strategy is more bottom-up. Even within construction, we are not looking at stocks that have large amounts of financial leverage. We are focusing on the immediate outlook for earnings for that particular stock and then taking a call. So, to that extent, we may be paying a little higher than what the market is paying as a whole.

But this is because we may be looking at stocks which have earnings growth potential compared to the market.

If you compare the global and domestic growth scenario, global growth seems more vulnerable.

So, we are looking at domestic cyclicals, where there is comfort in terms of financial leverage as well as ability to withstand some of the shocks.

The operating leverage is what we are trying to focus on. That way, where there is even a small pick-up in volumes, we may be able to see better earnings growth.

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