A mixed bag on expected lines
Till FY20 end not many investors cared about this sector, once the price run of FY21 began too many started caring all of a sudden. My experience has been that it takes an investor 2-3 years to truly understand the quality of a business, the ability to differentiate between a good business and an average business in a sector requires a price to be paid.
In a sector like chemicals there are some basics that we need to understand and appreciate –
- Supply chains are integrated at a global level. Either customers are outside India or the suppliers are, pricing is determined by global demand-supply factors and not just local factors
- China continues to be the gorilla in the room, huge capacity to the extent most products are reduced to bulk deals at the cheapest possible price
- End industries are usually agrochemicals, pharma, FMCG, printing, dyes, ink. The first two have their own cyclicality though the rest are more predictable in terms of demand
- Inflation that spiked for the first time across the developed world has taken many businesses to the cleaners, that this followed the COVID pandemic has stressed supply chains like never before. Businesses stocked up in FY22 worrying about further supply shocks that did not materialize, then were hit by muted demand due to inflation
- Chemicals businesses are secular in terms of volume growth but rarely in terms of value growth. Even steady businesses here see their RM price fluctuate a lot, just see the EBITDA/MT trend for even the good businesses here, it has been a very wild ride in FY21, 22 & 23
- Plant shutdowns in some parts of the world can cause flutters for a business in India that does not even export. This risk is inherent in this sector
The market is clearly worried about volume slowdown across product lines right now given that agrochem and pharma sectors have had their own set of challenges. Agrochem supply chains have seen overstocking in the value chain which is coming off right now, pharma has seen pricing volatility and a normalization of the product portfolio in favor of non COVID related drugs. With raw materials prices falling steeply in FY23, the market is worried about the double whammy of muted growth and muted realization going forward. EBITDA/MT is set to come down for many businesses, it remains to be seen if volumes can grow to the extent absolute EBITDA can show a +ve YoY number.
There are pockets of quality that stand out either due to their competitive position, industry structure, business visibility or product portfolio that is geared towards emerging areas. While a business like Aarti Industries has proven its ability to scale, the muted demand environment keeps pressure on the stock price. A business like Fine Organics has excellent unit economics but doesn’t have growth visibility for FY24 due to capacity constraints. The fluorine chemistry players are far better placed but are priced in to this extent. A player like Gujarat Fluoro is investing big money into emerging areas that don’t feed off the usual end industries.
The big learning from the FY23 experience is that we are better off sticking to businesses that have relatively higher gross margins and higher asset turns rather than buying something that has 2x asset turns at 16% EBITDA margin, once growth falls off the second business will see its stock price get taken to the cleaners. This applies to buy and hold investing over 2-3 years, one can always take tactical bets in the average businesses; they are the ones that can offer the highest price delta once margin starts to mean revert.
With many other industries showing both businesses momentum and price strength, one should be very choosy about adding incremental allocation here. At some point of time in FY24 some of these will become value bets with a medium term horizon but there is no point in rushing into this trade.
Portfolios are up 20%+ since April, this affords us the luxury to remain choosy and not rush into value bets in a sector where there is still no sign of life, in a technical trend analysis sense. Happily make money elsewhere until we either see life springing back here or we see cheap prices.
