Stocks Benefitting From GDP Growth Are Good Picks, Says ITUS Capital Founder

Naveen Chandramohan: So I think if you allow me, I would like to tune out a bit before I then go into the question. I think I've always believed in the value of cycles and that comes again, from studying history a lot. So I think the cycle that we are in is what I call the GTP beneficiary cycle. It's quite contrary to what we saw in terms of global markets, as well as Indian markets between 2010 and 2020. So effectively between ‘10 and ‘20, you didn't see GDP expand not just in India but globally and post Covid, post the inflationary regime that we are in, which I think we will continue into over the course of the next three to four years. I do believe that GDP facing sectors should show better growth. 

So within that broad framework, I would want to position portfolios towards those areas. So if you look at the portfolio from a top-down perspective, we would be overweight on capital goods, we would be overweight (on) power, energy, autos and auto ancillaries. We have been underweight banking, and we have been underweight on Consumers. We don't have any I.T. exposure and effectively that is how our portfolios are constructed. So the I.T. services the only company that we have is (in) an E R&D services company. So it's not the typical service based company. It's mostly an engineering R&D services based company that we own there.

Naveen Chandramohan: So again, I don't know how we qualify aggressive and defensive. So for me, a portfolio construct where liquidity is taken into effect and earnings growth is roughly between 18 to 20%, is what I would look for.

Naveen Chandramohan: So the valuation if you look at a trailing the perspective of our portfolio, it's roughly 12 months TTM is around 27 and a half. So in order to get an 18 to 20% earnings growth, you have to pay up a bit, you're not going to be able to buy at today's valuations a TTM of 10 to 12 P/E, that doesn't exist. So the question is, how much are you willing to pay up? You can go into the consumption space where you have to pay up a lot more to own these businesses. We're not willing to do that. You can go into cap goods, you can go into power, where I still think the valuations are reasonable. So we don't think about it in the traditional sense of saying I.T. and pharma are conservative and the rest of the businesses are aggressive.

To me, equity is aggressive. So the question is equity means volatility. My job as a fund manager is to reduce that volatility. If I can do that consistently across time, returns are an outcome. So we still own pharma. We are still overweight on pharma.  Does that mean that's a conservative but I don't think so. That's not defensive to me. That still is aggressive.

Naveen Chandramohan: So at the end of the day again, auto has and will continue to be an extremely cyclical sector. Now, if you go back 10 years in the past and when you study auto ancillaries you have very few scaled up businesses in auto ancillaries. Auto ancillaries  don't lend themselves into pricing power at all. So they always have a cost plus business margins if you can get to a 10% EBITDA margin. That's like a dream come true because you get squeezed day in and day out. Now with manufacturing moving here, there are a lot of technopreneurs who have been in this business for the last 35 years. They either have been playing in the back of import substitution, or they have a unique niche R&D that they have established, which has lend itself into what you call deemed exports. These two put together tend to have characteristics of giving you a high teens EBITDA margin with a sensible debt profile. If you can get these, that's the space I will be overweight on. So I'm not saying we own businesses across the board. It's a technopreneur that we are backing. It is R&D ability, there is a lot of import substitution. So you have the ability to expand your margins. Today's ROEs would roughly look at 16 to 17%. Many of them have actually put up Capex on the back of import substitution orders, which means they can expand from 16 to 17% to closer to 20 to 21%, and that's the space that we are backing.

Naveen Chandramohan: So for example, if you go back in time, let's say seven years back, and take an M&M, when most of the power trains that we manufactured would actually stay in house because the machining requirements of a typical IC (internal combustion) engine, the powertrain that you manufactured mostly are commoditised. 

So at the end of the day for you to scale, there was no powertrain manufacturer in India, who was generating more than Rs 1,500 crore of top line seven years back. Today, you actually have companies doing north of Rs 5,000 crores in top line, doing powertrain both for the exports as well as if you're transitioning into an EV, you cannot have the same machining requirements. The machining requirements in terms of precision, the torque transfer requirements are going to be a lot higher. So you have niche components in the South that we are backing, that we are heavily overweight on. When I say heavily overweight for us 3% in a particular company would be overweight, considering as you rightly pointed out auto ancillaries by their very definition in India are low mid to small caps by nature. The largest auto anc company in India is a market cap of Rs 24,000 crore. 

So, historically auto ancillaries haven't lent themselves to scale. As auto exposures go up in terms of market caps going up, you will see certain auto anc with an R&D component behind it expand too.  Those are the companies that we would want to pick. So it's purely bottom up. It's purely balance sheet driven, and that's what we would back. It's a mix of both four wheeler and two wheeler as well.

Naveen Chandramohan: I wouldn't call a Bharat Forge certainly as an auto ANC and they have a much wider portfolio and a lot of what they do is an EBITDA margin of what they do is machining plus precision. So that's not the space that I'm looking at. Normally they should do well as well. 

Naveen Chandramohan: I think if you look at the last 10-year volume growth of two wheelers, it's been 3.2%. For a country that actually relied on saying that two wheeler volume is the go to market. The actual data points tell you completely otherwise. So today for the first time in the last three quarters, you're seeing two-wheeler growth after a 10-year period.

So the question then becomes where did, let's say Bajaj Auto or TVS Motors, growth come from in the last five years? It came from two aspects: it came from exports and it came from pricing power. So many of these companies who actually up the model, in terms of where they went up the value chain, that's how their revenue growth came from. Today for the first time after a period of 10 years. You're seeing volume growth come through. So I think two wheelers can surprise on the volume side, that space that we would want to own and four (wheelers) we continue to be bullish on.

Naveen Chandramohan: Autos (are) one of the components. So Engineering R&D will lend itself into capex driven businesses. It could be Oil and Gas. It could be Aerospace, Auto, Telecom. So all of these sectors, if you look at it, didn't have great volume growth between ‘10 and ‘20. All of these sectors basically had degrowth and as the capex cycle revives and it's one of the things that I keep saying, I think we are in an inflationary cycle. We are not in a rate cut cycle. Maybe you will see because of political pressures, one, maybe two rate cuts. Two is already an over extension as far as I'm concerned. 

But I think we are in an inflationary cycle and not a deflationary cycle. So at the end of the day, I think in an inflationary cycle, GDP facing sectors should do better. You look at what happened in the U.S. between the 70s and 80s. I don't want to use the India example between ‘03 and ‘09 because the base effect as well as the growth that you saw was extremely nonlinear and I'm not sure you're going to get that level of growth in this cycle. But I think the U.S. between the 70s and 80s is a better example of inflationary driven growth. So metals, oil, energy, these are the sectors that should do well.

Naveen Chandramohan: I think, rather than get into the price, for me the question is, am I seeing visibility of growth and I don't see that yet. Today, the reason margins look creative is because many of them have managed their employee costs much better. For me as a core business, what I want to see is top line growth, translating into operating leverage and hence margin profile, and you not just running efficiency in terms of your cost base/space well, and getting an EBITDA margin expansion. So broadly, for me, I would put my hand up and say I would rather stay underweight because I don't see any green shoots of growth. If growth does surprise the upside, I'm happy to relook at it. But for this growth, I don't think the valuations are cheap.

Naveen Chandramohan: Absolutely correct. Cap goods with a power angle is where the conviction is. So a lot of capital goods which actually manufacture for the power sector and the energy sector. That's where the higher conviction is, because today, capital goods don't come cheap and your nonlinearity has come in between ‘21 and ‘24, in terms of growth. So the growth from here is going to come on a higher base. So I would pencil in 15 to 18% growth from here, which is not trivial growth either. But the valuations that you're paying for that growth is not cheap. So I would want to build in starting exposure today, with the ability for me to size up higher over time if I can get more volatility.

Naveen Chandramohan: In terms of large caps for example, we own an ABB, we own Cummins, we own Thermax.

Naveen Chandramohan: See again, we use this word very loosely in our conversations. because let's take ABB for an example. Right and again, I'm not saying someone needs to be buying ABB today. It's not a recommendation at all. But you go back to ‘21. ABB was available at our TTM from a P/E perspective, assuming P/E is the easiest metric for someone to relate to. It 65.  

So was that cheap for the company, which actually had a three year growth of 11% or are you going to say that when I'm getting a 23% CAGR and growth with a future growth potential of 15 to 18% or 75 P/E multiplicity is something that I'm okay to pay off. So my question is not starting off by saying what is cheap. My question is starting off by saying where am I seeing growth and where am I seeing sustainability of growth and for that, what is the valuation I'm paying? I'm not saying these valuations are cheap, but then the question is, how do I position this in order to ensure if I'm going to pay up at an overall portfolio level, my portfolio construct doesn't get affected. So it's not one name that's going to drive my returns. It's basically saying, for this valuation for the visibility of growth that I'm seeing, do I want to be staying out of this sector? The answer is no because that's where I see visibility of growth.

Naveen Chandramohan: So let me play both sides of the coin. I'm going to make a fairly tall claim by saying that you are going to see over the next cycle, maximum number of Solar bankruptcies that you've ever seen, because the cost at which and the IRR at which some of these projects are getting bid up, and some of the smaller companies are setting up solar capacity doesn't make any sense on the ground.

So at the end of the day, obviously there is going to be enough and more supply that comes in because demand for the first time after a period of 12 years is growing at a CAGR of 9%. End of the day, power in terms of supply side will and should grow at the cost of GDP. Now, basically over 2010 to 2020 when you kept setting up supply and GDP was at three and a half % over a good part of the decade, you had excess capacity and hence a lot of the companies went into significant debt on their balance sheet and you saw a huge amount of value erosion over the last 12 years. For the first time you're in a power deficit cycle and that deficit basically means because you've not invested for a good part of 10 years in an aggressive way because demand didn't come, for you to set up a greenfield in thermal does take four years. 

Whereas if you go into Solar it takes 12--14 months. So it's a lot easier to set up solar capacity, than it is to set up a thermal capacity and I don't one of the reasons that India is in a much much better position is we didn't take this ESG tall headed claim of saying that we will not burn coal because coal is extremely essential and today many of the countries in Europe are realising that. They did that and now they've gotten killed on the other side. So, if I am going to bet on Power, which we are I would much rather bet on a large portfolio, which has a good mix of Thermal on one side and an element of Renewables and the other side because renewables it's good they will see growth, but at the same time I am not really as bullish on renewables where the IRRs will be close to mid teens on a sustainable basis because these are all what you call plugging the gap. Wind energy is not going to be self-sustaining, Solar energy can be, but the kind of bidding that is happening on the ground is not very comforting. So I still back a thermal lead portfolio into renewables rather than a renewable led portfolio into thermals. 

Naveen Chandramohan: I mean, I think we don't own power financials. Today, we find them a bit expensive, they still can do very well. But that's not the space that we are looking at from a lending perspective. Power generators is one space we are bullish on and hence that will translate into power transmission also, because at the end of the day, in order for power to get into the grid, the transmission capacity has to go up in a significant way. So I think transmission and generation is going to benefit as a result of this. Financials could, we don't own them. So I'm not. I don't have a very strong view. The easy thing to say is valuations are expensive, but I don't think that's a prudent statement to make. 

Naveen Chandramohan: I think today, many fund managers have dissected Pharma in a beautiful way, so I'm not going to break it down. Indian Pharma pretty much works like an FMCG business. It's a branded business. Everyone would want to own that. No one wants to own U.S. generics for all the right reasons because it's a commodity play. You don't have pricing power. But I also feel that that cycle, in terms of the rate of change of price, erosion is reduced. You still don't have a price increase, and I don't think that's coming back anytime soon. So in terms of what we like in Pharma, we like product portfolios with an Indian facing angle, as well as CDMO manufacturing. That's a space that we think has significant tailwinds. 

You're seeing businesses which have no background in CDMO, acquiring deploying capital and getting involved. Capital misallocation does happen at a time where capital is abundant, and free cash flow of many of these quality corporates is abundant. So you're going to see a lot of capital allocation on this basis. So the companies that we want to be owning are those that have 10-15-20-25 years of track record in manufacturing, they've done this, they have sticky B2B businesses. We also do have businesses which have a U.S. genetic component as well, because that cycle has not played out, could play out in the next two, three years. It has played out from a margin expansion perspective in the last year and I think in the next six to eight quarters, you could see more runway for that. So broadly, we have a mix of CDMO manufacturing, Indian branded play as well as a US portfolio as well.