Monday, December 6, 2021
HomeMarket Live UpdatesIndia Inc margins under pressure for next few quarters: Pankaj Tibrewal

India Inc margins under pressure for next few quarters: Pankaj Tibrewal

Companies are flagging that there are margin pressures and our sense is that in the third and the fourth quarters, further margin pressures as high cost inventory of raw material starts to get consumed in and there is a limitation of what you can pass on to the end consumer, says Pankaj Tibrewal, Sr Equity Fund Manager, Kotak Mutual Fund.

How should one read this week’s reversal in some of the ranked midcap stocks? Some of them had become Humpty Dumpty stocks and now they are seeing a great fall!
We had a remarkable run in the last 18 months and it is now on record that this is the third longest run without a 10% correction in more than 250 days. So clearly, some correction is needed in the markets and the last three months, the moves in many stocks made us a little cautious that things may not be in the right order.

Clearly on one side we are seeing frothy valuation in some quality names and on the other side, low quality companies which have not made a double digit ROE for a decade are also moving and trading at price to book of three times, four times. Clearly markets are in a zone where they have clearly forgotten what valuation stands for and that is a bit of a concern. Let me share a couple of data points which will probably make things clearer where we are standing today.

Look at NSE 500 companies and just remove the financials out of it; in that universe, 20% of the stocks are trading at price to sales of greater than 10 and the contribution of those companies in daily turnover is more than 20%. We saw such excesses in 2007-08 also when there was frothy valuation in certain pockets and clearly that is again reflecting this time around.

The second data which I wanted to share with you is to give some sense on valuation. If one looks at the 90% of the investable universe in India, and do a rolling five year stock returns, about 70% of the universe has doubled over the last five years and clearly that is again reflective of the fact that the best of the market breadth is behind us.

Normally, at these points, markets tend to take off on the valuation side. We need to be a little careful right now and need to be a little cautious. Our view is that over the last 10-11 months, not only in India, but in Asia and globally, the earnings momentum which helps stock prices or the earnings upgrade cycle which help the stock prices probably are showing signs that it will pause over the next few quarters and one of the main reasons is the cost inflation side.

Companies are flagging that there are margin pressures and our sense is that in the third and the fourth quarters, further margin pressures as high cost inventory of raw material starts to get consumed in and there is a limitation of what you can pass on to the end consumer.

The second is the supply bottlenecks. Across companies, logistics have become a major challenge. Supply bottlenecks are a major challenge which will be on either the top line or the margin. Early indication suggests that there could be some pause on the earnings upgrade cycle which we saw for almost four quarters now and where markets will probably take a fresh look at the valuation, fresh look at the growth over the next few quarters and that is very healthy from a market perspective.

Do not forget that in the previous bull market of 2003-2007, we had various mini corrections of 10% and if my memory serves me right, three times we had 30% correction as well. These are part and parcel of any bull market. Over the medium term, we are extremely positive that the earnings cycle compounding or the earnings growth which is coming in corporate India after a long time seems to be quite robust. The investment cycles are showing signs of pick up which has not happened for almost a decade now. These are medium term positives but in the near term, valuations have run ahead and we need to be careful about that.

Is it a good idea to compare historical valuations and assume that what has happened in the past will happen in future because the scenarios are different, the debt levels are different, RBI tolerance towards inflation is different and productivity levels are different?
I am a great believer in history that history may not repeat itself but history may rhyme. In April, May of last year, when everybody was negative, we came on records and said that this cycle resembles the 2001-2003 cycle. We did not even say 2003-2007 because there was a sharp decline post 2001 following 9/11 and from there on, the broader market did extremely well for the next two-three years before the actual bull market took off.

We saw many stocks multiplying very fast and that laid the seeds for the next big upturn in the economy. We saw those similarities last year but do not forget that valuation is something which you cannot ignore for a long period of time. If 20% of the NSE 500 companies ex-financials are trading at price to sales, forget price to earnings. Prices to sales of more than 10X these are signs of froth in certain pockets of the market. So I am not saying that the market is crashing or collapsing but is intermediate correction possible? Answer is yes.

For 18 months, there was almost no 10% correction and that creates excesses in its own way. So history may not repeat but history always rhymes. There are enough cues from the past we should not ignore. It always looks different but trust me, we have seen enough cycles to suggest that valuation is an important parameter and you should not ignore it.

The second point which you have flagged off is high cost pressures and demand supply constraints. High cost pressures are going to impact companies’ profitability but there is a new profit pool which is getting created in steel, cement and metal companies. Can that make the aggregate picture very different?
In an inflationary situation, upstream producers benefit and the downstream companies and the consumer of those commodities suffer. In India, a large part of our basket is mostly the second part not the first part and obviously earnings expectation built into that basket shows that there will be a strong earnings growth on the producer side, which will negate the pressure on the downstream side. That built into the expectations.

What markets like is an incremental base from here on for the next two quarters. Are we seeing an earnings upgrade cycle which happened for the last four quarters? My hunch is the probability is quite low and the reason is that last year from the third and the fourth quarter, there were very strong margins from corporate India. There was low cost inventory, low cost of raw materials, low feedstock, salary cuts had not been fully reversed, travelling had still not started, marketing cost was low. In the December and March quarters, all these things which aided the margins of corporate India will probably work against us and probably there will be a base which will not be so low. So my hunch is that margin pressures on a year on year basis comparisons will start looking quite severe.

The second point is that a part of top line growth will negate the margin pressure but still the way commodity cost has gone up is something which we need to be a little worried about. Few of the cement companies reported their numbers and they are clearly saying that Rs 500 per tonne of incremental cost on power and fuel will flow into the third quarter and an equal amount can flow into the fourth quarter.

So with that kind of increase, you need to pass at least Rs 35 to 40 per bag on the cement pricing to the end consumer. That is the story across the board. Things might change over the next two months but the pipeline inventory which people are booking now at high cost will get consumed over December, January, February and March. So, costs not passed on to the end consumer will be on the margin.

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