Towards the end of CY 2021 many were convinced that inflation was just transitory, they soon pivoted to a narrative that said inflation is here to stay. With the latest developments across commodities and bond yields, the narrative is now changing to that of a short lived recession in the US and of inflation cooling off significantly by the end of CY 2022.
Every macro forecast should be taken with a pinch of salt and teamed up with a tub of popcorn. The strike rate of macro forecasts has been poor, that still doesn’t stop us from crystal ball gazing every now and then. Purely because it is fun, if not anything else. Enough macro, let’s talk meatier stuff.
Certain pockets of industrials have been strong even as the NIFTY 50 fell ~10% over the first quarter. Multiple stocks within that cluster are close to 52w highs and some are on the verge of taking out their all time highs.
Project executors (EPC) have made for risky bets in the Indian market, with the exception of a well diversified, professionally run behemoth like L&T. An EPC company signs up to execute a project over a long time frame through a tender process and multiple risks like commodity price risk, legal and Govt interventions and the risk of unit economics changing markedly over the tenure of the project. However the core technology components underpinning these projects can make for steadier bets. For the simple reason that such segments are oligopolies where MNC’s rule the roost and the unit economics more stable. Observe how many companies make power substations for data centers and traction transformers for metro rail projects.
You will see a similar trend in real estate too where real estate players valuation can swing a lot but the building materials players trade at steady and often higher valuations. Leading sanitary ware, tiles, ceramics, kitchen appliances, housing wires and pipes makers are valued better than real estate players. In a city like Bangalore, you may find 15 decent real estate developers but just 4 pan India tiles and sanitary ware brands. A small lesson in here, always study the industry structure and ask why things are the way they are.
A lot of the Govt spending and private capex feeds into the revenue funnel for these few component makers. So when you see ABB, Siemens, Honeywell, Schaeffler India, SKF India trade at steady valuation across market cycles, you know why. They have technology leadership, market dominance and visibility of continued business for years. In such stories rerating possibility isn’t high, an investor will need to focus on getting the medium term demand and earnings trajectory right.
In general any decent industrial story that can generate 18%+ ROCE during a bad cycle is worthy of detailed study. A below average business in IT Services can eke out 25% ROCE because that is the unit economics of the industry itself. In industrials only good businesses can make 20% ROCE across cycles. It is futile to base investing decisions solely on ROCE and FCF for this very reason without adjusting for the unit economics of the specific industry
Very few industrials make 15%+ operating margin, at an EBIT margin of ~12% a business cannot afford to have an elongated working capital cycle. The average business which works at a 150 day working capital cycle will need gross asset turns > 2.5x to even make 15% ROCE at good utilization. Unless the competitive position is strong, it is difficult to optimize working capital in an industry where project executors and the Govt have perennial cash flow issues.
Business enablers (key component makers in an oligopolistic industry structure) often make for better investments than business drivers (EPC & project executors) over longer time frames.
Our preference is for businesses that make differentiated products where revenue growth relies on capacity utilization and not just capacity addition. Industrial consumables will be an obvious choice in that sense, of course at the right valuation. We like stories where one can bet for 3-5 years rather than playing for a cyclical uptick in the order book that may not last beyond an year. Stories where the business is emerging as manufacturing hub that can serve demand across countries might be in for an interesting phase even at the current level of the INR.
New stock market leaders reveal themselves at the beginning of every cycle, this time should be no different.
Breadth of industry coverage should be a priority for every investor right now.