Engineering R&D's Rapid Growth Similar To IT In Nineties: Piper Serica's Abhay Agarwal

Abhay Agarwal: We have been tracking China, especially for the last six months, for a couple of reasons. One is that whenever China's local consumption gets into distress, we have seen that the Chinese large manufacturers try to get into cash by dumping at cost or below cost their products and that creates a deflationary cycle, unintended globally. And I think, Indian companies, a lot of them in the chemical space, agrochemicals, metals have suffered because of that over the last six months.

But whatever research we did, we also started seeing over the last quarter, starting January onwards, that dumping has ceased and stopped being a problem. The pricing power was coming back in a lot of categories, especially for metals, chemicals, and agrochemicals.

So I think, the data now coming out of China's PMI increase and to be followed by better domestic consumption and cleaning up of the real estate exuberance, if I may say that, I am happy to make a bet that is behind us now. So all the pain that the Chinese economy, Chinese domestic consumption, and Chinese exporters had to go through are largely behind them and now we will see the Chinese economy recover.

The good thing about the Chinese economy is that it's not so dependent on foreign flows. Unlike India, where foreign capex and capital formation is still dependent on international global flows, China has a lot of domestic capital. So I think, China will grow this year at a level that will surprise the analysts, probably driven by domestic consumption.

As for your bigger question—will the global growth outlook be better than estimated, my guess, my bet is yes, it would, because I don't see any reasons for the consumption falling off, interest rates are going to trade down and when that happens, if consumption goes up, the macros continue to improve, especially for India. So I don't want to be sanguine or careless. But I would bet that the global growth of global macros will improve from there on.

Abhay Agarwal: That is a natural outcome because there is limited supply of metals in the global markets and the Chinese exporters have been the largest ones there and they have had no pricing power because they have to keep the factories running and that puts pressure across the board.

In a down cycle, we saw last year where global consumption of metals didn't fall off the cliff, but at the same time, it wasn't growing in a manner that people were used to, and at the same time you had supply coming in continuously.

I think that is going to even out and the natural implication will be that commodity prices, specially metals, will firm up from here on. However, I don't think it will be a very sharp uptick. It could happen in some commodities because we don't really track the exact monthly demand and supply data.

But barring some, I think, there will be gradual recovery. So if anybody is going to make a bet about sharp recovery in metal prices, they would also be wrong. But at the same time, the recovery over the next 12 months will be on the higher side. Generally, for metals as a commodity basket, it will not be surprising to see a double-digit growth in pricing from here on, over the next 12 months.

Abhay Agarwal: I think, these are exclusive things you know. So, when you look at metal space by itself, most of the Indian metal manufacturers have not shown any performance over the last 2-3 years. So I think, this maybe the year that is driven by the volume growth and plus pricing growth. The margins may expand and the balance sheet may improve.

The only problem, I see in this sector, is that it is a highly consolidated sector, not just like cement. So anytime there is a volume and price pick-up, the companies start working on the next capex cycle to grow. And they have this—all of them, rightly so, probably—passion for continuously using capacity. That is why, this industry goes through ebbs and flows where supply comes up right at the time when the volumes are tapering off or pricing pressure is there. So that is the nature of this industry.

So with that caveat, if somebody wants to play a recovery cycle in this space, for next 12 months, you have to look out for those purple patches... But I don't think that these are for long-term investors because these are very cyclical industries.

Abhay Agarwal: It is a mix of both, because I think Adani is an exceptional manager of ports business. They really get it and that can be also seen in the ‘String of Pearls’ acquisition strategy that they have come up with where they have been acquiring some of these strategic ports, and then turning them around by increasing cargo.

So I think port management is a very, very complex business. It's a lot of heavy engineering, constant capex, constant improvement in operations, trying to get bigger and bigger ships closer to the port. So I think it requires a very big player that understands that complexity and there are very few players in the world who do that like Dubai Ports and Maersk and some of the other guys, but I think Adani is almost at that level.

So, the fact that their numbers are improving, I'm not surprised because I think they're a good operator and in a macro environment, where trade into India and outside India is going to grow, they will benefit more than other operators. At the same time, other operators will also grow.

But from an investment perspective, it's not a buy recommendation. We may have the stock in our portfolio. With that disclaimer, I would say that in an environment like this, one needs to look at the best operator, the balance sheet strength, technical capability, ability to attract talent, get customers, vision, etc.. I think, Adani Ports rates right up there and you know, on top of that. So I think it's a mix of both—Adani being a great operator of ports, plus the macro pickup in the trade business.

Abhay Agarwal: No, I think crude is a red herring. It has always been. In the last 30 years that I've been investing, I've heard this many times that crude is going to touch 150-200-250. And then, just when people are gearing up their portfolios for very high crude prices and it corrects. But I think, crude has an automatic mechanism like most commodities where the large suppliers understand that it is dysfunctional to break the market by charging too high a price. So I'm not worried about crude prices. It will always spike. That's the nature. I'm not worried about commodity price spike. Geopolitical risk—unpredictable, always there.

To answer your question, what I'm looking at more closely is the interest rate correction or you know, fall globally. Once that happens, I think that will start a virtuous cycle of capex, which will further lead to demand and then further lead to consumption and further capex.

So I think we can, and people are not budgeting for it frankly. Driven by interest rate cuts, we can get into that virtuous capex cycle over the next 2-3 years, which will see the risk assets also perform well.

Abhay Agarwal: I think the ER&D companies are exactly what the IT services companies were in the late 90s, early 2000s—growing very rapidly, acquiring customers, and customers are looking at them not only for saving cost or saving prices, or you know, reducing cost arbitrage but for getting talent, which they could not get in their country, as it is not available as easily.

So I think in the ER&D play, investors need to look at it with a 5-10-year perspective and look at it as a space where near-term valuations will stay elevated. But it's not a value buy but it's a classic growth space where the bets you make will make you similar returns that IT services companies made for 10-15 years, starting in the early 2000s.

I think it’s a secular growth path. The whole world is looking at Indian talent in this space. And the companies that can manage that talent, get bigger and bigger contracts. I think they'll all win. So we are very bullish on this ER&D space.

We're also bullish on the whole EMS space because that is also mimicking, in terms of growth. So I think, it's something that investors should definitely look at with a longer term perspective.

Abhay Agarwal: On the staples side, we have had a different view. Personally whatever data I've looked at, I don't think that there is any slowdown in growth of staple consumption.

What has happened is that there are very competitive, domestic players, regional players who have come in and have taken market shares in some of these staples categories across food, personal care, and other such categories. The larger companies have been slow in reacting to that competition and I think it is now that they have started reacting to that competition.

So I think, the overall market is still growing in terms of volume at close to 7-8%, at least across categories. It is just that the larger companies that are listed are not able to get a large part of that group. They're getting a smaller part of that group. So they have gone back to the drawing board in terms of optimising their cost structure, optimising their products to cater to this new competition as well as the new demand from customers.

So I think, we are in that adjustment cycle and I think in another quarter or so the volumes for the larger players will again start picking up. That is the bet that we are making. So we are not in a hurry to add any large staple or FMCG or personal care company to the portfolio right now. We'll probably wait for a quarter or so to see how they are redefining their competitive strategies.

Abhay Agarwal: Absolutely. I mean, any which way we look at it. You know, I was in the Middle East the whole of last week and travelled through multiple airports and it was remarkable that at all airports, the largest buyers of any product in the duty-free shops and in the city were Indians and they were just lapping up stuff. You know, it was like flying and this is across. It's not restricted to alcoholic beverages. I was busy observing it.

So what is happening is that is this premiumisation is very evident and companies like Ethos have been hard at work for many years, but it's only now that they have come to the forefront and are being recognised for the work that they are doing and they are all category creators, you know. So when these category creators will continue to grow. The good thing is that these industries are consolidating very fast, even at an early stage. So some of these companies will benefit a lot more than the new entrants as they build their brand and try to explore newer sub-categories like in case of Ethos, used watches, trading in second-hand premium watches.

I think this is a big space that will continue to grow. This premiumisation story is aspirational. As a country gets richer, it is going to aspire for better and better quality stuff.

Abhay Agarwal: Some of these positions, we are in the process of annual rebalancing of our portfolio where we cut the allocation to some of the stocks that have run up over the last one year and have gone higher than our model portfolio.

So our number one hoarding is Jio Financial Services right now. Then we have CDSL, Maruti, Reliance, Dr. Reddy’s. These are some of the stocks that have done well for us. So their weights have gone up. What we are looking to do now is that last year our model portfolio indicated the next 12-month return of 40% and we did about 57%. But now, the new model portfolio we have is forecasting a return of 18.5% for the next 12 months and which is expected because a lot of return has already been made last year.

We are overweighting large caps in our portfolio from 30% to 55%, reducing the small and mid caps to about 40% and keeping 5% cash in the portfolio. So that is the portfolio strategy now because we see more value in large caps that have gone through time correction over the last 3-4 years, especially in the insurance space and some of the other spaces.

Pharma will continue to be a large part and in terms of contrarian bets, it continues to be agrochemicals and some chemical names. So that's the overall portfolio tilt at this point of time.