portfolio breakdown | investment strategy: Rising crude oil prices, fears of stagflation? Here’s how to make your wallet less fragile
Market anxiety appears to be receding from the war despite crude prices remaining high. A new concern is whether growth is slowing and inflation remains sticky, a sort of stagflation scenario. How do stocks as an asset class fare against this? What are your thoughts?
Most markets around the world, including India, are higher than the levels that existed before the outbreak of the war. This in itself clearly tells us that the market can withstand war and these cases.
In the last couple of years economic growth has been very weak due to the lockdown and most businesses were struggling and despite all of that and a very weak economic environment the markets have been doing very well and so is for the last month. Although crude is up nearly 20% from pre-war levels, markets are at levels above pre-war levels. This means that some of these impacts which are likely to be short-lived on the economy can be absorbed by the markets as long as the funds flows and the interest rate environment are very good.
So far, the flow of funds has been very favorable to the domestic market. Domestic investors were net buyers in a big way despite the FII sales that were there. Going forward, what is important to watch is that over the past couple of years the Fed and other central bankers around the world have been supportive of stock markets or capital markets and the economy with ample liquidity and keeping interest rates low. The most important factor we need to watch over the next three to six months is how this liquidity is withdrawn.
Given the type of inflation measures we are seeing, I think this will have an impact on the markets. The Fed and central bankers have kept the markets at these levels for the past two years and they are at such high levels that only the withdrawal of this liquidity will impact the markets and not war or the outbreak of the pandemic. .
Due to the sheer size of your portfolio, I’m sure you have a very keen eye on macro development as well as the business models of the company you follow. How serious could this risk of a slowdown that the war could have triggered be? How bad could it get on the growth front, in your view, over the next 12 months?
Over the past five to six quarters, we have always been positively surprised by the growth in Indian corporate earnings. It’s clearly behind. The positive earnings surprise that we have seen in recent quarters will not be there.
With commodity prices rising across the spectrum, starting in the fourth quarter we’ll see the pressure on margins across most businesses, but the good thing is that the bulk of our earnings are coming from the financial services sectors. , followed by IT services, then of course Reliance and oil and gas. These three segments, despite this pressure on margins, may not have much impact in the current slowdown or commodity-driven inflation.
The only sector that could have an impact on earnings is consumer companies or consumer discretionary companies, automotive and other general manufacturing sectors. Steel and cement will come under pressure on margins, but the composition of these sectors in the overall index and aggregate EPS is not very high. I would say that 65% to 70% of our Nifty 50 earnings are virtually unaffected or have little impact, while only 30% of the earnings mix would be affected by rising inflation. We are relatively less affected in terms of earnings, the positive surprise that we had seen in recent quarters will not be there. Most general manufacturing companies will also face margin pressure in the fourth quarter and the first quarter of next year. It’s worrying.
This is not 2013 when the market was taking off, nor 2016-17 when small caps had a good 24 month run to 2018. How should the portfolio be and what selection strategy do you follow to make your portfolio anti – fragile over the next 12 to 24 months?
Only crude appears to be the major risk to Indian corporate earnings. This will impact inflation in India and will also impact margins in most manufacturing sectors. As I mentioned, the bulk of our earnings are relatively less affected by the current commodity-driven inflation, particularly aluminum and steel. We are net exporters there and we have fully integrated upstream businesses. There you could only see the positive impact.
In India, the situation is not so worrying. Despite the war and despite the fact that crude is 20% higher, we are higher than pre-war levels, largely because of the composition of earnings and not only, the biggest worry for the markets Going forward is how global liquidity will be withdrawn and overall what impact this will have on PE multiples and valuation.
From a sector perspective, we still like metals as a segment. At current prices, most companies in the metals sector generate 12-month free cash flow equivalent to approximately 25-30% of their market capitalization. So they are quite attractive as cash-intensive companies. They use this cash to deleverage the balance sheet.
IT services are again one of the strengths of the Indian markets which, with the depreciation of the rupee and the strong demand, remain relatively unscathed. The BFSI sector is relatively unaffected by commodity-driven inflation.
The four to five leading banks in the sector are very well capitalized and very well positioned to capture their growth. So there are good investment opportunities despite the volatility and the overall market valuation may come under some pressure over the next three to six months, but from a longer-term investment perspective there are many opportunities.
If market volatility continues over the next six to eight months, where would you want to expand your positions, increase your weightings?
Mainly IT, metals and BFSI space. These are the segments where we hold the bulk of our investments. Pharmacy is also a sector that we have enjoyed for some time. We will also look for some of the small and mid cap themes where we might find growth opportunities such as electric vehicle. We are looking for players either among component suppliers or among OEMs.
I would like to know a bit more about your portfolio strategy in the areas of engineering and capital goods, mainly manufacturing, and not just for the domestic export market as well. Value-added manufacturing and engineering, where does the China plus one strategy work?
Even on the engineering side, there are quite a few multinationals. Fortunately, most of the multinational companies present in India are listed and offer a very good opportunity to participate in the capex story. Most of them are small cap companies, be it KSB Pumps, AI Engineering or Linde. A host of multinationals listed in India for legacy reasons provide an attractive way to play the investment payback cycle.