shares to buy | RIL RIL share price: Defensives will be relevant as it is a year of sector rotation: Vikash Kumar Jain

“FII money will be important and could be more important if this DII liquidity dries up due to improving short-term debt yields,” says Vikash Kumar Jain, Investment Analyst, CLSA.

In one of your recent notes, you mentioned that you expect banks as well as year-over-year market earnings growth in FY23. Where within Reliance do you think that the greatest disturbance occurs? What makes the case stronger for the greats to get bigger and better in the years to come?
I wouldn’t want to be stock specific, but it’s clearly one of the few conglomerates that isn’t really impacted by the disruptions; if anything, he could be the beneficiary because he’s there in every theme out there. So longer term, if you look at most of the important themes that are playing out – whether it’s technology, e-commerce, organized retail, green energy as well as green inflation – that could benefit generally.

It is therefore in this title that simple short-term earnings growth is progressive. There are about 10 names that make up only about a third of Nifty and contribute 80% of this additional earnings growth and that include some big banks as well as some commodity names. In fact, five of these names feature in our targeted portfolios. We have a focused portfolio where we look at around 12 stocks, including three banks and three commodity names. There is therefore a very clear preference to be overweight on banks and commodities. This is very clearly an underweight in IT and Consumer.

What are your thoughts on what is happening in the Indian pharmaceutical space, including healthcare services? In India, pharmaceuticals have taken a step back and are no longer the crème de la crème they used to be and as sought after as they are in 2020?
It is clear that an element of sector rotation is at play. These are the stocks that were doing very well at the start of Covid, being seen as big beneficiaries of Covid. Some of them have gone up in hopes of cures and Covid vaccines which could be a great beneficiary for them. Sometimes, when there is so much excitement, stocks go into overdrive, and then there is a period of consolidation. We think we may be nearing the end of that consolidation for some of the pharmaceutical names. We have one of the pharmaceutical names and through that we are overweight in our positioning in the pharmaceutical sector.

Also read: What will boost the market in 2022?

Among defensives, we like pharma and utilities much more than IT and consumer staples. We must not forget that we start the year with things that are not on our side. This is not an equivocal year where we can tap on the table on what will happen. This is a year where there will be a balancing act. Right now, the big worry is that Nifty’s absolute and relative valuation is at levels that historically haven’t given us great returns.

With consumer sentiment not being so correct, these are the two big risks at the start of the year. The balancing factor is that Nifty has the best earnings growth story among the big markets in the world other than the Philippines, which is not such a big market and should kind of offset some of those valuation issues. So there will be times when defensives become relevant because it’s going to be a year of big sector rotation and not really a runaway on the benchmark and if we were to look at defensives, pharma would be a favorite for us .

Your team made a counter call on real estate. Do you think a 50 or 75 basis point rate hike will change the affordability factor and the uptrend of the housing cycle?
The call is more about expectations, basically looking at the type of registration data etc. that we saw last year, which were also stimulated by the tax advantages granted by the State. We must therefore be more selective on certain names, where we see a net benefit of consolidation and new launches or new markets helping them rather than a call to the cycle. We don’t believe we are in a booming real estate cycle that will accelerate dramatically, but yes, real estate and investments in general are going to experience a gradual recovery that we favor. So that’s our thought process.

Sometimes, like in the pharmaceutical industry, some of these names can get ahead and that’s where we see periods of consolidation. It really has to do with that call rather than saying the cycle will turn prematurely because that’s not what we’re saying. I understand what you’re saying from an affordability perspective, but some of these interest rate sensitive topics may take a back seat during the time that rate hikes are happening and yields are rising and more now that there is a clear link between repo rates and home loans. So there could be more of an inventory reaction rather than a slowdown in activity per se.

Can we say that you don’t really have to worry about a lot of withdrawals or liquidity contractions because 2021 has not been a year where FII liquidity has dominated. Rather, it was domestic liquidity that made all the difference. So while the money may have come in the IPO market, the FII’s liquidity wasn’t huge and we shouldn’t be worried about that?
Well, that’s true, but I’ll tell you why we can’t ignore it. If I were to look at the last six months on a rolling six month basis, at the end of December net FII outflows were the lowest we’ve seen in the last 15 years, other than maybe two months after IL&FS and may -to be a month in January 2016. So apart from these three months, you have to go around the GFC level to find this kind of sale by the FII.

Unlike previous periods where the rolling six-month exits would have meant that Nifty’s rolling six-month returns also turned negative, that hasn’t happened and it worries me that it will bounce back from here because generally what happened when FIIs sold was Nifty also used to become more attractive relative to its peers. But that hasn’t happened so far. So I would say that just blind liquidity won’t help because valuations come into play and that’s where I would bring the argument from the domestic side.

We have to appreciate this kind of steep yield curve. We will have to go back to 2008-2009 when it was so steep because of the RBI crunch. With a general tightening of liquidity as well as rate hikes, perhaps short-term yields will also improve and as that improves, if one were to make a simple comparison of bond valuations by versus equities looking at earnings yield and 10-year bond yields, we’re at levels that have historically led to Nifty’s sub-5% return. So clearly it’s not in our favor.

And so, what is the worrying environment for the coming months? As short-term yields go up and if we see a few months of negative returns in the market, some of the domestic money could start going back to debt and a lot of it has come because there had very little return to make in the short term one year, two years of investments in the form of debt. That will change as liquidity tightens and if short-term returns in equity markets aren’t so great, then that money could start flowing out.

Anyway, if I were to look at a simple graph of the percentage of equity held by Indian households, we have already reached an all-time high at levels above 2007. We cannot take our eyes off this valuation of equity. As this changes, FII liquidity will be important for us to support the markets and more so because this could also be the year that the primary markets could get even busier with plenty of lockdowns to come.

We estimate that quite a bit of the lockdown could come out and there could be more stake sales as well as the normal primary IPOs. FII money will therefore be important and could be more important if this DII liquidity dries up due to improving short-term debt yields as well.

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