Red hot molten steel stands in an arc furnace in the steel smelting shop at a steel mill in Russia (Photographer: Andrey Rudakov/Bloomberg)

Metal Stocks Attractive Despite U.S. Tariffs, Says Kotak Mahindra AMC

Metal stocks look attractive at current levels despite the run-up last year, even as these companies come to terms with U.S. President Donald Trump's import tariffs.

“One will have to be stock-specific looking at what could be the possible impact in terms of the likely tariff wars,” Harsha Upadhyaya, chief investment officer-equity at Kotak Mahindra Asset Management Company told BloombergQuint. “We think that at these valuations there is some merit in looking at metal companies.”

U.S. has imposed an import tariff of 25 percent on steel and 10 percent on aluminium early this month, raising concerns of a tariff war. Canada and Mexico have been exempted from the tariffs. According to a Bloomberg report, President Donald Trump is set to announce about $50 billion of tariffs against China over intellectual-property violations on Thursday.

Watch the full interview here.

Here are the edited excerpts from the interview:

What’s your view on trade market set up? Are you seeing any kinds of worry because market seems to be little nervous?

We believe that in the immediate short term the market is in consolidation phase. We have seen less volatility in 2017. We are of the opinion that volatility will increase in 2018. Also, the return expectations should be more moderate than 2017 for this year for next 12 months. We believe that immediate short term will be consolidation base. It is to worry from long term investor perspective. But if somebody is unable to take this volatility then there is problem. Last year everyone felt that equity is one way were volatility is less and you can make money at daily level. That couldn’t have lasted longer. Now, we are in phase of consolidation clearly.

When we talk about extreme short term, would it be dependent on the results? Are you talking about 1-2 months or could the volatility persist or slightly longer than that may be couple of quarters?

Definitely couple of months until the earnings season. It will give us some sort of indication although I don’t say it will give full indication of how next year is going to pan out. There are ifs and buts that are going to be there post June quarter. Until June quarter we had lower base which was because of demonetization and GST transition last year. That’s going to go away.

Post that we will see provisioning numbers increasing on the corporate lenders in the banking space. So, for FY19 numbers you won’t get confidence by looking at March quarter numbers this year or June quarter numbers next year. To that extent, earnings alone will not help the market. As we move into the second half, the news flow will be more from a political setup. That’s what will drive the sentiments then. But until then, it will be the earnings trajectory which will drive the market.

How will Q4 shape up? Are you bracing yourself for some unpleasant news in earnings front because of banking or do you think it is muted but just there is conversation happening around?

At this point of time, it is very difficult to predict the kind of provisioning that will require in Q4. There could be some upfronting that some banks will do,since they know that six months down the line more has to happen. There may be some delay in some cases. We don’t know how the earnings number will pan out for the PSU banking space. For rest of the market, we don’t think there will be too many disappointments.

The disappointing sectors are known. For example, telecom will disappoint in form of earnings, Pharma, PSU banks, so this are the space where we have no clarity of how much will be the drag and for overall earnings. But for rest of the markets we are fairly confident that, we will grow at mid-teens. So, overall numbers will depend largely in terms of how this drag is going to pan out. If the drag is more than what everyone is expecting, then we are going to have muted set of numbers. Otherwise, it will b similar to previous two quarters.

What’s your view on metals as overall metals have been corrected significantly globally? How does this sector pan out now?

We were of the opinion that the valuations are run up much ahead of the fundamentals from entire 2017 from metals pack. Now, that has corrected significantly. Global growth seems to be catching momentum. There are positive expectations of how the global growth will pan out over the next 12-24 months. Given the valuations, there is some merit of looking at metals companies. But one will have to be stock specific of what will be the positive impact in terms of likely tariff that will come out and also how will it display some of the region capacity and supplies. That is what we need to see and take stock specific investment opportunities.

What about oil companies? Crude is again back at $70. How will that play out for the oil marketing companies?

We continue to hold some oil marketing companies (OMCs) in our portfolio. As of now, there have been market determined pricing. There has been no interference in terms of not adjusting the prices to market reality. As long as that continues, even if the crude moves up to higher levels the profitability will be maintained, and we won’t be worried about that segment as of now. In case there is change in mechanism in terms of adjusting the prices on regular basis happens, then we have to see how it will impact profitability. In last 4 years or so, we have not seen that kind of impact. As we are getting into election year, some things could change. That is not we need to see. Other than that oil marketing companies looks attractive on valuation basis.

How does NCLT augur for what happens to the metal space after some of these assets where operational but not operating at full capacity come into stronger hands and there is natural augmentation of increase in capacity that comes in for India steel sector? What does this do as the space was the biggest outperformers over last 12-18 odd months?

As far as the capacities which are at NCLT today, they are running because they need cash flows to service their interest burden. To that extent they are not looking at earning anything over and above debt servicing. Once the resolution happens there will be more economic sense that will prevail. That’s our belief. Hence, you will not see re-adjustments in terms of demand supply. But from a pricing perspective it will be lot more sensible is what we believe. If that where to pan out, then there is no risk for metal stocks per se. But as you feared, if the buyer starts to ramp it up in terms of more capacity additions or sweating it much more than what they were doing earlier then that could have impact on prices in short term.

If Arcelor Mittal will come in or JSW picks up Essar or Tata Steel gets Bhushan steel and they start operating this capacities at much higher capacity utilization level. Wouldn’t that increase the supply and therefore compromise on prices over the medium term? Is that not a worry?

Without getting individual cases and companies, who where is getting part of the entire process they are already present in those sectors in those countries and region. To that extent they have invested to keep everything at a balance. I don’t think there will be indefinite ramp up of capacity and prices coming down. We don’t visualize that at all.

Does it concern that we had a fall but there is room for bunch of this companies to fall to if need be without being considered cheap?

Yes, that is possible because when you look at overall valuations of Nifty today then they are 10-15 percent higher than long term averages. To that extent, there are pockets within Nifty too apart from midcaps and small caps which anyways have been very expensive relative to large caps. Even within the large cap space there are companies and sectors which may have been trading at higher valuations than in the past. So, those are the space where you need to be more watchful. If earnings start to disappoint in some of those pockets, then there is room for further fall. At this point of time some of these names are pockets where earnings growth seems to be better than the rest of the markets. So, to that extent there is no fear of correction in these names, but we have to wait to see how earnings will pan out.

One side of the market discussion would be to think that where do investors or fund managers park money. Second part is where you completely avoiding any kind of investments based on the news that we have in the valuation picture that we have at hand.

We are focusing more on visibility of earnings growth going forward. So, there are pockets where we can’t be confident in terms of future earnings trajectory. Those are the names where we are circumspect or have been avoiding the spaces. For example, we hardly are in telecom sector, PSU bank. So, this are the pockets which we believe that we are in pressure in terms of profitability. Pharma is sector where lot of fortunes of the sector is dependent on US FDA approvals where you can’t predict timing or outcome of those approvals. Again, we are not in a clamp to take any blind bets in that segment. So, this are pockets we are avoiding.

Apart from this, we are cautious on NBFCs sector where we have seen significant growth in business in past. Interest rates were very conducive for wholesale borrowers. As we move forward, there is going to be pressure in terms of cost of funds and also the kind of growth we have seen in recent past. There could be asset quality issues coming up in NBFC sector at some point of time in future. As of now, there is no risk. Given the kind of growth that we are seeing in past, one needs to be cautious. Especially, at these valuations where some of this is trading even higher than some of the private sector retail XX. So, this are the sectors where we have been cautious. Otherwise, we continue to hold same view on markets. There is economic recovery which s visible, although the pace could have been higher than we have witnessed. At least, its visible. There is large amount of excess capacity in country and operating leverage will pan out over the next 12-24 months. That’s what we will provide profitability boost for Indian corporates. Those are the bets that we are taking in portfolio as well.