Speciality chemical stocks have taken a sharp hit since their October 21 market peak, with some of them losing up to 50 per cent. Valuations, too, have corrected 25-59 per cent in the period. While prospects still seem intact, headwinds from high input prices and demand slowdown can be a concern. For this analysis, a basket of 15 companies, including a mix of larger peers (SRF and Aarti), vertical speciality companies (Navin Fluorine and Deepak Nitrites) and recently listed companies (Clean Science and Tatva Chintan) have been considered.

Purple patch until market peak

From trading at valuations of around 20 times one-year forward earnings prior to Covid, the sector has gained from supply chain diversification away from China and accelerating post-Covid disruptions. As a result, compared to 52 per cent growth in the broader Nifty-50 index in the period (from January 1, 2020 to October 18, 2021), these companies have returned 375 per cent (in a range of 82 per cent for Fine Organics to 979 per cent in Balaji Amines).

The sector had the twin advantages of both earnings as well as valuations assigned to those earnings, expanding. But only a smaller portion of the change in stock price (135 percentage points out of 375 per cent returns) is attributable to valuation expansion in the sector, which grew from around 20 times forward earnings, to 50 times in the period. Growth in earnings expectations for the next one year explains the rest of the change.

RM pressures, a headwind

However, currently, the stocks have declined 21 per cent on average from their October peaks. This fall is higher than the 13 per cent decline in Nifty-50. More importantly, the valuations assigned to companies in the sector have shrunk in line with prices.

Thus, while earnings expectations so far seem to have remained intact for the sector, the change in valuations (50 times in October 2021 to 30 times now) can be attributed to the changed macroeconomic scenario, i.e. expectation of a demand slowdown in the face of macro headwinds such as high inflation and interest rates.  

Whether this will curtail future expansion plans is a monitorable. But the primary risk which may still need to be factored into stock prices is that of earnings downgrades from high operational costs. The cost of base chemicals derived from crude have inflated along with supply uncertainty from China, which is under bouts of localised lockdowns. With inflation of raw materials expected to persist in the face of global headwinds, in today’s scenario, companies with better pricing power may be better bets.

Cherry picking stocks

In the spectrum of speciality companies are commoditised manufacturers, including nitric acid, phenols, caustic soda and so on; on the other end, are made-to-order manufacturers classified as CRAMS operators or low competition market leaders backed by process or product innovation. The latter, including Clean Science, Navin Fluorine and SRF, offer better margin protection. They offer a larger revenue contribution from a non-commoditised portfolio, with price pass-through agreements, albeit with a lag, compared to portfolios of the former, which derive strength from a volume-based play.

But, with valuations still hovering around 50 for Clean Science and Navin Fluorine, the risk- reward may not be on an even keel. SRF, Atul, Gujarat Fluorochemicals and Aarti, which are trading at around 30 times one-year forward earnings, should be attractive in the current context. These offer softened valuations and are positioned along the supply chain where pricing power is still available.

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