Monday, December 31, 2018

Themes for 2019

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Here’s wishing everyone a very happy 2019 ahead. 

Calendar 2018 provided a reality check to all who weren’t aware of Newton and gravity. And even more, it busted the myth of mid-cap and small cap stocks always giving huge returns year after year. While it is true that such stocks gave huge returns in the last 2 years, they also were hammered anywhere between 20-90% this year.

The unprecedented rally in mid-caps that started in 2014 went on unabated for four long years, delivering a 29% CAGR return (Nifty Midcap 100 Index from Jan. ‘14 to Dec. ‘17). The lure of earning easy money attracted many investors to this category, leading to excessive valuations towards the end of 2017. Midcaps that generally traded at a discount to large-caps till 2013 started commanding huge premium over large-caps. During the first quarter of 2018, the Nifty Midcap 100 Index was trading at 40-45% premium (in PE terms) over large-caps (Nifty 50). The worsening external environment, weakness in global markets, rising oil prices, noise around the election outcome (states and central) led to significant correction in mid-caps, starting August 2018; this was more pronounced in small-caps. With this fall, some sanity has returned to the mid-cap valuations. It still continues to trade at a premium to large-caps; however, the premiums have reduced to about 15%.

Liquidity crunch for NBFC is the buzzword on D-Street these days. And there is no sign of it easing anytime soon. That has also caused the whole NBFC sector to be under the lens. Stocks like DHFL which had run up 3 times in 2 years came down to the same levels they were 2 years back, and even lower.

We are in an election year which should happen in the next 4-5 months, if not earlier. So the focus of the govt. would be more on populist schemes than economic sense. And they have only about 3-4 months to implement such schemes.
Obviously with the govt. loosening its purse strings for the general good, the sectors which can look forward to good demand would be housing/real estate/construction (led by PMAY scheme) and of course agriculture. Having bitten the dust in state elections recently and the agrarian crisis staring in the face, the govt. is faced with little choice but to cater to the farming community in whatever way it can, and fast. So expect fertilizers, tractor makers, seed companies to do well. For the other theme (housing/real estate/construction), demand would be strong for govt. financial companies (for e.g. HUDCO, NBCC), and the sectors that provide inputs to the construction sector (cement, building products – plywood, paints etc.).

It would also be prudent to temper one’s expectations of the returns from the markets. 20%+ returns would be an ambitious target; 10-12% would be more realistic, at least for 2019. There would still be opportunities at individual stock levels where good returns can still me made, as is always the case, but one has to be really choosy. Even though the mid and small caps have been beaten down, they are not yet cheap on the valuation front, mainly because their earnings are still suspect. It may therefore be a good idea to keep away from the small and micro caps, which would be the most impacted, and look at the relatively larger mid-caps and diverse large caps which could withstand the sectoral churn.However, this can't be a blind rule to be followed. There will always be opportunities in mid and small caps which show promise and are attractively valued due to the collateral damage they have suffered.

The key theme in 2019 would certainly be Infrastructure, govt’s move towards affordable Housing, and the agri sector, which again covers everything from fertilizers, seeds, and tractors to small-ticket financial companies/NBFC which have a prudent model. These sectors would certainly benefit from the govt’s thrust in this direction. So, most of my choices this time around are centred on this theme. I would also look at stocks which are consumption-based as 2019 is an election year and this category of stocks generally benefits in such years.

Everest Industries (EI)
One of the leading building-solution providers in India, Everest Industries’ range of products comprises ready-to-install building products (BP), roofing solutions (RS) and pre-engineered buildings (PEB). It offers products and solutions for the commercial, industrial and residential sectors. It has diversified from roofing to various value-added products such as cement boards and panels for ceilings, walls and floorings. It has six building-product plants and three pre-engineered building plants, with 32 sales depots and over 6,000 dealer outlets, serving more than 600 cities and 100,000 villages.

With the GST rollout, all its major products (roofing, boards, panels, PEBs, “smart” steel buildings and metal roofing) have come at the18% GST. For roofing and boards, the tax rate has come down 8-9%, resulting in rendering its retail range more affordable, aided by other expected benefits such as logistics costs and the shift of business toward the formal (or regulated) sector. The company continues to expand its geographic footprint by increasing its distribution and dealer network. Everest continues to improvise its portfolio offering through the launch of new products. Everest Super, coloured waterproof roofing sheets launched earlier this year, is gaining traction among customers.

EI is working on value-added products to improve its margins and also focusing on brand development through marketing activities. The management has guided to a topline growth of 20% on the back of a healthy order book which needs to be executed over the next 12-18 months.

The GST implementation and mounting demand due to the shift from kuccha to pucca houses, spending on infrastructure in India, e-commerce growth, increasing warehousing and govt’s focus on the rural economy would drive overall growth. On the cost front, the company continues to focus on internal business efficiencies through better working capital management and debt reduction
Currently trading at about Rs. 505, this could provide handful returns over the next few years, whichever govt. comes to power as housing is now a set theme.

Mold-Tek Packaging (MP)
A packaging company, MP is involved in the manufacturing of plastic moulded containers for lubes, paints, food and other products. It started the business in 1986 as a supplier to Asian Paints and has seen remarkable growth in the past three decades. The company diversified into other industries through an expansion of product portfolio - paint buckets, lubes & grease packs, ice-cream tubs, retail packs, q-packs and it now caters to marquee clients from the paints, lubricants, pharma and Food & FMCG space. While paints and lubricants remain MP’s largest revenue contributor, the clientele list now includes other sector heavyweights such as Unilever, ITC, Ranbaxy and Cadbury.

MP’s foray into the FMCG packaging business has been the key revenue driver for the business in recent years. Innovative packaging along with deeper penetration has helped the company scale up this segment at a rapid rate. Food & FMCG segments are likely to play a key role in improving its volumes.

The company has a total manufacturing capacity of around 33,000 metric tons spread across seven plants in India and one plant in the UAE. While the domestic business has been performing well, the UAE-based 3,000 metric ton RAK unit is operating at sub-50% capacity utilisation and continues to be a drag on the business profitability. Given the weak demand scenario in GCC, the company has decided to shift 1,200 tons of machinery capacity to India for packaging of ghee and edible oils. This will lead to better utilisation of the company’s assets in the coming time.

The company has a strong focus on R&D and was the first company to introduce IML (In-mould labelling) technology in the country, which has witnessed steady industry adoption. This now contributes more than 55% to Mold-Tek topline. The company is enhancing its capacity by setting up new units for Asian Paints in Vizag and Mysuru.

In all the right segments (Paints, FMCG, Food) at the right time (election year),  this integrated packaging manufacturer with a consistent track record of execution currently quoting at Rs. 264 , MP is surely to provide healthy returns in the coming years.

IDFC First
This is the new entity formed post the merger of Capital First with IDFC Bank. With credible CEOs at a premium in private banks (Axis Bank and Yes Bank went thru a lot of turmoil on this count), IDFC First is lucky to have someone of the calibre of Vaidyanathan to helm it.  The new entity has a head start with 200 tech savvy branches already in place( IDFC Bank’s contribution). BV of the merged entity is just 38, so share is ruling at a P/BV of just 1.15, which is dirt cheap in the current market where 2+ is the norm, even after the latest crash, especially for an entity with this pedigree.

The merged entity has a retail loan book of 32-33% of its overall portfolio. Gross NPA is 1.6% and net NPA is below 1% which reduces the default risk significantly. Capital First brings to the table a retail growth of 30% which the new entity would continue to carry forward. This coupled with a credit growth of another 20% in other sectors, the overall growth would be in the range of 23-24% which in current times should be considered excellent.

All in all, a pedigreed management, established tech savvy infrastructure and a good growth record should ensure that this is a credible NBFC in times to come.
Currently quoting at Rs. 43.4 this should easily conservatively cross 50 in the coming year and more. And this would not be impacted by a change in govt, if that were to happen.

Amber Enterprises (AE)
Amber supplies ACs and parts thereof to 8 of the top 10 AC brands in India, and enjoys client stickiness too. The number of AC units manufactured is estimated to increase from 1.9 million in FY18 to over 2.5 million by FY20-end.

AC models based on the IoT platform, which yield better realisations than regular ones, are being developed. Customs duty hikes announced by the government on some crucial AC components should help the company bag incremental orders, as import substitution initiatives by AC brands gain momentum.

Amber derives close to 75 percent of its annual revenue from original design manufacturing processes. Utilisation rates at its manufacturing facilities are slated to increase from 50 percent in FY18 to around 70 percent over the next 2 fiscal years. Debt repayments from IPO proceeds will de-leverage its balance sheet. To facilitate backward integration, manufacturing of new specialised components will gain scale.

The stock, after witnessing a sharp post-listing rally in January 2018, has corrected significantly. This makes it a good buy for those who missed the IPO bus, considering that the price of Rs. 904 is close to the upper end of its IPO price band (Rs 859).

Parag Milk Foods (PMF)
PMF is one of the leading dairy products companies in India selling the entire gamut of dairy products from milk, ghee, curd cheese, paneer and others. The company has been successful in creating strong brands like GO, Gowardhan and in introducing new products like Whey Protein. It has become the 2nd player in processed cheese (after Amul) in a short span of 10 years and commands 33% percent market share.

The dairy sector is driven by two vectors: trend in milk prices and share of value added products (VAP). Since milk prices have been subdued in recent times, plain vanilla players were impacted, even as companies with higher share of VAP were better off. PMF falls in the latter category.

In FY18, PMF registered 12.9% revenue growth. Consumer products revenues registered 15.7% growth. Value-added products comprised the maximum share with 65.6%, followed by fresh milk at 19.9%.  Better product mix, with VAP constituting nearly 66% of sales helped expand margin. In addition, benign input costs and operating leverage have been advantageous. Distribution expansion and traction from new launches (whey protein, protein powder etc) have also aided earnings growth. PMF plans to add about 9,000 retail outlets per month. As of now, its distribution stands at 2.6 lakh outlets. In the recent quarter, the management attributed 30% growth to expansion of its distribution channel. As per the Department of Animal Husbandry, co-operatives and private players procure 20-25% of the milk produced. Around 35% is still sold in the unorganised sector. The department expects milk handling by organised sector to grow from the present 20 to 50% by 2022-23.
The organised sector in the dairy business is looking ahead to increased exposure to high margin VAP in the milk value chain. This improves the margin profile and helps in reducing sensitivity to milk price volatility. Additionally, efforts are also on to enhance both distribution reach and backward integrate the procurement of milk. PMF recently forayed into the north after acquiring Danone's Haryana facility at Sonipat. While improved margin profile would be moderated by increased competitive intensity, the recent decline in stock price offers an interesting opportunity to look at the dairy consumption theme.

PMF currently quotes at 248 about 13% higher than its IPO price of Rs. 215, but that was 2 and a half years back. So it is now nearly back to square one from the time of its IPO. However, it is just about 11% higher than its 52-wk low and nearly 40% lower than its 52-wk high, thus making for a profitable risk-reward ratio.

Let’s now pause a bit to see how my last year’s picks did.

Price as on 31-Dec-17
Price as on 31-Dec-18
Century Ply
MIRC Electronics
Dredging Corp
Kridhan Infra

This time the performance has been nothing short of disastrous with the portfolio nearly halving. This is also a reality check on a small-cap tilted portfolio. While this category is the fastest gainer, the fall is equally swift. Other than Multibase, which is an MNC, most of the stocks have fallen half or even more in value. That they will bounce back, I have no doubts. The best option in my view at this juncture would be to buy more of these and average out the holding cost, so that when the next bounce comes, you would have recovered all your capital (including that lost this year), and more. But this is a view most experts would strongly discourage you from pursuing. I can say for sure that this has worked for me, more often than not.

All in all, the year has indeed been a huge disaster. However, as I firmly believe, India is a stock picker’s market and the small cap ones take time to give any meaningful returns. So this portfolio should ideally be judged after at least 5 years, for a start, and not yearly. Only then the real performance will be visible.

While the BSE Mid cap index gave a return of -13.37% and Small cap index returned -23.5% this year, the mid-and-small-cap heavy portfolio of 2016 (consisting of ICICI Bank, Sterlite Tech, Bharat Electronics, Engineers (I) and NBCC), has returned a CAGR of 10.07% over the last 2 years. Yet, over this period, it has swung from one end to the other with an eye-popping return of 61.63% last year and a depressing return of -25.05% this year. This compounding is what will enable such portfolios to give a meaningful return over a longer timeframe.
Similarly, another small-cap heavy portfolio of 2015 (consisting of Axis Bank, Sun TV, Sterlite Tech, MCX, Jamna Auto, Surya Roshni and DCB Bank) which returned a great CAGR of 26.2% last year (over the 2-year period) has also returned a CAGR of 8.15% this year (over a 3-year period), while the carnage in mid-and-small-cap stocks was on this year. So it is all a matter of getting into a stock at the right valuation and holding on to it thru ups and downs as long as you have faith in it.

As I have said many times before, equity is a long term game with a holding period of at least 5 years (and much more in the case of mid and small cap stocks), if not more, to get any meaningful compounded returns. This year has only proved this theory.

Here’s wishing all investors a very profitable 2019.

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