Macros for Indian business in YTDFY22 are a case of glass half full

The first half of 2022 has passed so it will be worthwhile to study performance of Indian equities, understand the key trends and develop an informed opinion of how the rest of the year may pan out for equities. It will be an understatement to say that it has been a difficult and volatile phase for Indian equities since start of 2022. The large cap benchmark BSE Sensex has corrected by ~8% in YTD2022 while BSE Midcap and BSE Smallcap indices have corrected by 10.3% and 14% respectively. The drawdown is even higher when considered from the all-time highs achieved by Indian equities during Q3FY21. In our view, the correction has been mainly driven by global macroeconomic factors like: 

• Decadal high inflation in commodity and energy prices mainly due to global supply chain issues; key ones being ongoing Russia-Ukraine war and lockdowns in China till recently because of its stringent zero covid tolerance policy.
• Heating up of the US economy due to liberal fiscal and monetary policies as well as inflation is driving US Fed to hike rates. There is a fear that Fed will have to hike rates sharply inducing a recession in US in 2023. 
• High inflation forcing all central banks including India to hike rates resulting in subdued consumer spending and ensuing fall in global GDP leading to fears of stagflation globally.

While global macros have turned negative since start of 2022, India has witnessed several positive macro factors in last 1 year:

• Indian corporate profits are at multiyear high while corporate leverage is at a decadal low. Cumulative profits of top 500 market cap companies as a % of GDP hit a 11-year high of 4.3 per cent in FY22. As per India’s leading credit rating agency CRISIL, the number of credit rating upgrades to downgrades reached a decadal high in FY22.
• Indian banking sector NPAs have fallen significantly from their peak in FY18 and will reach decadal lows by FY24. Indian credit growth is witnessing a revival after subdued growth for past several years.
• In FY22, India achieved highest ever merchandise exports of US$ 418Bn, a 43% increase from FY21 and a 33% increase from FY20 (pre-covid year). What is even more positive is that there has been a significant improvement in exports mix towards more value added products. Share of conventional goods like gems/jewellery has reduced from 16% in FY17 to 9% in FY22 while share of engineering goods, which has become India’s top exported product, increased from a meagre 5% in FY17 to 27% in FY22.
• Monthly GST collection hit an all-time high in April 2022 and have remained above the key level of 1 lakh cr/month since July 2021. A portion of this growth is due to stricter tax compliance and stronger anti-evasion measures but this is also being driven by strong economic revival.
• After a decade long slump, there are early signs of revival in urban real estate demand. Housing prices as well as sales have seen good growth in most of the key Indian real estate markets.  

Negatives seem almost priced in; incremental positives can drive a strong rebound

Equities globally have seen significant correction to the tune of 15-20% or more in the last six months with several markets entering into a bear phase. Indian markets have also witnessed similar levels of correction due to fear of global macros worsening and relentless selling by FIIs while we believe most of the Indian macro positives have been overlooked. There is no doubt that high inflation and consequent rate hikes pose risk to Indian economic revival while global slowdown will definitely have an impact on Indian exports. Moreover, rise in crude prices is already leading to higher trade deficit and further price rise can worsen the situation. 

However, we feel that significant correction in Indian equities since start of 2022 has factored in most of these apparent negative macros. Any incremental positive indicators on inflation can lead to strong rebound in the markets towards the end of 2022. There are already signs of inflation peaking with prices of agri commodities and metals cooling off substantially from their highs in last month. This resulted in significant outperformance of auto stocks as auto sector is a large consumer of commodities. Nifty Auto has gained 6.4% in last 1 month compared to just a 0.12% rise in Nifty 50. Crude, natural gas and energy prices have not shown any meaningful signs of correction so far but our sense is that inflation may top out in next 2-3 months. If that happens, then there can be a meaningful rebound in Indian equities post that especially if Indian corporate earnings growth remain strong.

Moreover, valuations have become quite attractive after the 15-30% correction in several high quality businesses from their peaks in the last six months. Historically, Indian equities have delivered healthy returns over 3-5 year period following a correction of 15-20% over a six months period so there is no reason to believe this time will be different. This correction has brought about a sanity in valuations and taken out the froth from the market that was evident in the unjustifiably high valuations of IPOs, especially of new age cash burning tech businesses, and of certain fad sectors last year. In the last six months, this correction has brought back a focus on business fundamentals like cash flow generation, pricing power and sound capital allocation. Despite the substantial overall correction, there have been several strong business from sectors like capital goods and engineering, auto, agrochemicals, etc, which were neglected by investors over last few years, that have delivered exceptional returns in last one year. We believe it is time to invest in quality business that are available at attractive valuations to generate healthy returns over next 3-5 years.

Time to be stock specific

Post this correction, valuations are attractive but it is essential to do proper research to invest in quality businesses with strong growth prospects. We believe that certain sectors will outperform in the next few years and it is important to invest in quality names from these sectors. The first sector that looks quite attractive is capital goods and engineering. After almost a decade, there are early signs of capex revival in India as capex heavy sectors like metals, cement, power, etc have plans of significant capacity addition over next few years. In the overall engineering space, there are segments in which unorganised players as well as weak players with poor financial practices have been weeded out during the prolonged downturn of last decade. As a result, there are several niche market leaders that have gained significant market share and are poised to benefit in a big way from revival in Indian capex cycle. Moreover, some of these leaders have significantly increased their exports business because the downturn in the domestic market forced their quality management to increase their international business by spending considerable money and effort on R&D, market development and relationship building with international clients. We believe it is a great opportunity to invest in such niche segment leaders in the engineering and capital goods space that have been able to diversify into international markets as well.

The second sector we are quite bullish about is auto ancillaries. Indian auto sector has been through a very challenging phase over FY19-22 because of multiple issues like multiple Covid lockdowns, semiconductor shortages impacting production, weak demand due to significant increase in vehicles prices due to regulatory changes, etc. The result is that India auto sales in FY22 is either at same or lower level than FY17 sales. However, factors like cyclical revival in economy (especially positive for commercial vehicles), significant improvement in semiconductor supply, preference for personal mobility, etc are expected to lead to a meaningful revival in sales of cars and commercial vehicles over next few years. Even though auto OEM valuations are not that attractive, several quality auto component manufacturers are available at cheap valuations. What is also interesting is that quite a few ancillaries have also been able to meaningfully increase their exports and are suppliers to several global OEMs just like select engineering players. Moreover, several ancillaries were early in identifying opportunities presented by the transition to EVs and in developing solutions for EVs. It is difficult to place a bet on which OEM will make the most successful transition to EV. However, there are several ancillaries that are vendors of EV specific solutions like suspension components, bearings, LED automotive lights, etc to several EV OEMs not just in India but globally. Such players might have several competitors in the ICE space but in the EV space they are sole supplier of their respective components to EV OEMs. Select auto ancillaries that have been able to meaningfully increase exports over last 2-3 years or are ahead of their competitors in developing solutions for the EV space will be able to grow faster than Indian auto sector, which anyway is poised for strong growth. We believe now is a good time to invest in such auto ancillaries when valuations are attractive.

Lastly, we are quite bullish about the agrochemical space because prices of agri commodities remain quite healthy even after the recent correction. India has witnessed normal monsoon for last 3-4 years and this year is also expected to receive normal monsoon. Farm economics are quite healthy globally so agrochemical demand is expected to be strong. We are especially bullish about agrochemical exporters as international markets are less price sensitive making it relatively easier to take price hikes in these markets. Since prices of several intermediates mainly imported from China have significantly increased since last year due to lockdowns and other supply chain challenges, export focused agrochemical players have been able to better protect their profitability compared to domestic focused ones as the Indian market is more price sensitive making it difficult to pass on input cost inflation. FY22 was a strong year for export focused agrochemical players and we expect the demand prospects to remain buoyant this year. 

In summary, we believe this correction has presented an opportunity for long term investors to invest in quality business at very reasonable valuation. It is impossible to predict a market bottom but we believe investors should start investing gradually to take advantage of the current drawdown as healthy returns are only generate by initiating investments in a bear market.

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