Most self-sustaining pockets of liquidity come with a heavy price tag

In 2Q12, Globe Minerva Underserved was up +1.4% and Globe Minerva Undervalued was flattish, with no change in net exposure. That compared with a flattish quarter for large-caps and -3% and -1.3% declines for mid-caps and small-caps respectively. Over trailing 12 months, Globe Minerva Underserved and Globe Minerva Undervalued were up +4.7% and +7.7% respectively, vs. -6.5% and -10.2% declines for large-caps and mid-caps respectively.
It’s hard to take anyone seriously who claims to confidently predict EMU’s future in 2 years. For what it’s worth, there is a broad consensus (and for good reason) that India would be relatively lesser impacted in case of continued pressure on EMU. At current valuations (within the universe we are looking at), we think it makes little sense to materially cut exposure. Instead, we are selectively betting on names that are more likely to tide through a potential liquidity crunch than the broader universe (and are available at significantly more attractive valuations).
Backwaters of liquidity. We don’t believe it’s an aggressive expectation to factor in either a flattish capex cycle or an incremental capex cutback. It’s been a while since Indian Gross Fixed Capital Formation was under 30% of GDP. In fact, bottom-up estimates suggest that F2012 GFCF could be worse than government’s reported top-down estimates . Capex in the most land-intensive industries was off sharply (Cement, Hospitality, Power and Industrials all saw materially lower capacity expansions in F2012). To make matters worse, certain recent events related to taxation and Telecom Services auctions haven’t helped and may actually impede FDI in the near future. Note that no industry contributed more towards last decade’s capex growth than Telecom – Contribution of Telecom within BSE 500 capex has more than doubled since F2002 (see Exhibits 2a and 2b). That said, potential FDI-related impact is still marginal (excluding re-investment of earnings and share acquisitions, green-field FDI in Telecom accounted for barely more than a tenth of industry’s capex). Nonetheless, in such times, we believe it’s critical that we focus on businesses that have the discipline and ability to deploy capital wisely and are able to generate operating cash flows that are significantly ahead of their capex requirements (largely within India). If one plots change in capital deployment efficiency vs. the extent to which operating cash flows are channeled into capex, it would be helpful in identifying pockets (subject to valuations) that are more likely to ride out a potential liquidity crunch, should the EMU situation turn out to be a black-swan event (see Exhibit 1; grayed area highlights industries where capex deployment efficiency has improved and operating cash flows have been enough to fund capex). That said, we do note that most industries aren’t facing capacity constraints (on paper). Such exercises need to be supplemented with extremely thorough bottom-up clean-ups. Given the uncertainty, while we haven’t played overly safe on our net exposure, both of our strategies continue to be nearly as concentrated as our internal limits allow us.


Source: Internal Research, Reuters, Company Reports, Factset, RBI
Note: Only BSE 500 constituents with substantial listed history, which is a large majority, have been included for the purpose of Exhibit 2c; F2013E earnings outliers were excluded; Appliances include all Durables and Agri-chemicals are included within Chemicals; To exclude any impact from changes in tax-rate, F2009 comparisons were made off of changes in pre-tax earnings at the time.
We believe that most of our high-conviction bets are solidly positioned to withstand a potential liquidity crunch (i.e. fall in and closely around the highlighted area in Exhibit 1). In context of this exercise, we would like to highlight two key observations:
1. No easy place to hide – Nearly all industries that appear better positioned to tide over a potential liquidity crunch have estimates that are dependent on a strong recovery. While, on the surface, valuations don’t appear stretched for Autos (12x F2013E) or Energy (11x F2013E) names, those are based off of sharp earnings rebound expectations in F2013 (see Exhibit 2c). So, if one assumes repeat of F2009 pre-tax earnings performance, Autos names are trading north of 20x. However, this growth is off of easier F2012 (Mar) comparisons and is only slightly ahead of past 5-year average earnings growth for the industry. Still, unless one expects a material softening in steel prices and rates (which most analysts seem to be banking on), very few Auto names could be categorized as ideal places to hide. Of the two scenarios mentioned above, one can safely bid the latter goodbye if we do witness a liquidity crunch.
Similarly, Consumer names are trading at about 27x F2013E earnings, nearly double the valuation for BSE 500. And that high multiple is off of arguably stretched estimates – F2013E earnings estimates for Consumer names suggest 27% growth, >3x F2009 and 1.4x avg. pre-tax earnings growth for the industry. Effectively, Consumer names are trading at 31x F2013E, assuming repeat of F2009 pre-tax earnings performance, suggesting that such names are expected to witness earnings acceleration in F2013 (how can relative immunity be confused with counter-cyclicality?). At a time when there is a legitimate doubt surrounding any sustainable drop in food prices, such estimates appear particularly at risk. We remain highly skeptical on the value such “defensive” names bring to any long book at such expectations.
Nearly all industries that fell within the “suggested safe area” in Exhibit 1 have F2013E estimates that cannot be viewed as conservative (based on historical evidence). The only exception is Chemicals, where projected F2013 growth trails F2009 and prior industry growth (see Exhibit 2c).
One critical distinction that shouldn’t be lost however is the extent to which an adverse event (defined as a F2009 pre-tax earnings repeat performance) is priced-in in these industries – While headline multiples for Consumer names appear high, there is little contention that they deserve a relatively higher multiple. Our concern though has more to do with our view that, fundamentally speaking, the safety trade can’t be extended any further. Even assuming everything goes well (i.e. no repeat of F2009, when Consumer pre-tax earnings growth was 20 points below where analysts are aiming right now), we estimate that multiples for Consumer names need to compress by 25% just to get them to a level where one could be indifferent. On the other hand, look at Chemicals, where valuations haven’t run ahead of themselves, even though there doesn’t appear much room for further multiple expansion.
2. Land prices continue to drag down capex deployment efficiency. Half of all industries we studied have seen their capex deployment efficiency in last 3 years deteriorate vs. the prior 3-year period. 70% of such industries had one thing in common – Their land requirements were significantly above average. The most land-intensive of these industries (Cement, Logistics etc.) saw their capex deployment efficiency deteriorate significantly vs. others. What choice do cement companies really have ? – They need limestone rich areas for setting up plants and, given the high logistics cost, are unable to engage in inter-regional trade. Therefore, expanding in a new region invariably involves setting up new capacity.
Despite clearly visible challenges across land-intensive industries, there is lack of major policy initiatives to cool down real estate or aggressively improve rural and semi-urban infrastructure. On the contrary, we continue to naively view rapid rural ~ urban migration patterns as beneficial in the long-term and continued rise in land and real estate prices as yet another facet of underlying economic growth. In sharp contrast, China has been actively taking air out of real estate through various initiatives such as imposing penalties on land hoarders and by instituting provincial purchase limits.
It’s critical to understand that the above exercise is purely top-down in nature and could invariably miss outliers. The purpose is not to provide top-down investment recommendations. Exhibit 1 needs to be viewed in the context of immediate capacity requirements – Take Cement, for instance. While Cement capex budgets have been significantly ahead of operating cash flows in recent times, more than a quarter of industry’s capacity remains idle. Somewhere in the middle of the highlighted area in Exhibit 1 lies Pharmaceuticals, where a name like Ranbaxy is in no hurry to add capacity but Abbott India might have to. Broadly speaking however, we don’t see capacity constraints across industries and therefore pricing power is as critical as positioning to tide through a potential liquidity crunch. Any way we slice it, it’s hard not to agree with the contention that this is possibly as much of a bottom-up stock picker’s market as any, C1Q12’s valuation-influenced rally notwithstanding.
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Piyush Sharma, born and raised in India, is investment manager of the Globe Minerva Fund. Having spent time with Citigroup and Bombay Stock Exchange in India, he moved to United States in 2002, where he covered stocks within Business Services, Autos, Consumer Products and Financials with Sanford Bernstein, Longbow Research and Avondale Partners, working in teams that received accolades by leading institutional research arbiters , including Institutional Investor (II) and Greenwich Associates. Piyush received an MBA from University of North Carolina at Chapel Hill, MS from MNNIT, and BS in Accounting from University of Allahabad.  Piyush will be sharing his fundamental views periodically.