Nilesh Shah | Third wave of Covid: is the market assessing the possibility of a third wave of Covid?
Let me make the headlines for you. The main headline is the disruption in demand due to medical news, from crude to $ 70 and companies are indicating that there is going to be a drop in demand due to what is happening on the ground. If the headlines aren’t favorable, why are the markets holding?
Headlines may not be our favorites, but there are several things happening. There is a surge in world prices for several commodities and India is a producer of some of these commodities, which will lead to inflation. But inflation is somehow positive or accretive to earnings for many companies in India. Crude is at $ 70 and some of the other commodities are obviously at multi-year highs, but that’s inflation and so it’s going to lead to profit growth. This in turn will release the animal spirit of the producers and they will embark on a capex ride. They are going to increase capacity and we are going to see increased economic activity. It sounds counterintuitive, but it’s going to trigger some kind of heightened economic activity, which bodes well.
Currently, we are facing the challenge of the second wave of Covid and it has certainly had an impact on feelings at the level of individual consumers. A lot of discretionary spending will be postponed. That said, it is highly likely that in a few quarters, towards the end of this calendar year, a significantly larger share of the population will be vaccinated and business will return to normal. This quarter will likely be weak. Maybe the first half of this fiscal year will be relatively lukewarm but we’re going to see demand return in the second half of this fiscal year and it looks like the market is probably more focused on the two-quarter scenario than on what it is. reading course.
In addition, the global liquidity is still there and that is something that matters in the very short term. I believe it’s a combination of all of those things that are gradually positive and reflected in the market.
Much will now depend on the medical field. While the second wave seems to be peaking, there is talk of an inevitable third wave. What is the market pricing?
The market has been very resilient in the very short term. The third wave is a known unknown, which means we know it can come in. Unlike the second wave which caught us all off guard as we had underestimated its strength. But the third wave is a known unknown. Between the first and the second wave, we had the remedy which is essentially the vaccines. What will happen now between wave two and wave three is that hopefully a large majority of the population or the urban population will likely be vaccinated within the next three to six months.
The question is, when does the third wave arrive? If it happens a month later, then we will have challenges of a different magnitude and a different proportion, but if it comes with a gap of maybe three to four months, the impact of the third wave will be a lot. less and hopefully a lot of lessons would have been learned from the first and second wave experiences.
Are we ready to repeat the same playbook we saw, around the same time last year? When the reopening started, the demand surprised us. Or is it going to be different this time?
I would be surprised if the demand really surprises us and in an area where it seems a bit offensive, but my opinion is that we are going to see a huge demand for residential real estate and the reason is that there is a consensus on the makes us progress. in an inflationary environment and one of the best hedges against inflation is real estate.
Prices haven’t budged for almost a decade now and when there is fear there is a tendency to flock to financial assets. Traditionally, money is turned into durable assets in India. Globally, real estate prices are falling. Real estate prices are skyrocketing in the United States and Europe. I wouldn’t be surprised if something like this happened here.
Of course, it may not go like this, but even if there is a slight increase in demand, even if it is a demand for real estate prices in the residential space, induced by investment, you will actually see an increase in demand there and if there is a bit of it. increase or improve the demand for houses and other spaces, it still fuels in a way the demand for many others. I come back to the same thing and believe the demand environment will improve from now on. Maybe it’s only a few quarters, but I see it coming back.
It’s a big point that commodity inflation is back and real estate demand is back. If you are bullish on metals, why not buy metals on the futures market? If you are optimistic about real estate, why not buy a house? Why indirectly buy a stock from or DLF?
Yes, if you are generally bullish on metal prices, then of course there is nothing wrong with going out there and buying those metal futures and stuff like that. But we have to keep in mind that historically the underlying stocks give much better returns relative to the prices of the end product, which means that if iron ore prices increase by 20%, the ore producer iron or steel stock can increase disproportionately.
Owning the stock or owning the company is a higher beta game and the ability of the delta from a 10-20% spike in iron ore prices or metal prices results in a much higher delta in terms of profits. because that leaves the producer with a lot more cash flow. It uses that cash flow to eliminate debt and there are huge savings on finance costs.
Therefore, income growth is disproportionately higher. I believe owning metal producers, owning iron ore producers and all that pack is much better than just owning the futures. Second, to get back to ownership, you need to keep liquidity in mind that owning a real estate developer or owning a real estate developer or owning any other type of building material for a business is much more liquid than owning a house. It is much more liquid. It’s more tax efficient. These are some of the things that essentially favor owning a stock over owning the underlying asset.
The automobile is a problem. Demand has been shattered and margins are under pressure, but auto stocks have done pretty well. Why is that?
It’s probably due to belief or faith that the demand will come back and this is a temporary lull. It’s good if volumes are down 10-15% in April, May and maybe this quarter. In general, demand for automobiles or demand for vehicles should basically come back and you will see that 10-15% drop in volume being offset by mostly pent-up demand that might essentially come in.
Second, while the rural economy or rural areas seem to be affected by the second wave of Covid as well, it should be borne in mind that there is a forecast of a very strong monsoon and that 70% of the population lives always in rural areas. A normal monsoon will therefore mean that agricultural prices will rise again, which will lead to a considerable increase in agricultural incomes and the incomes of people living in rural areas.
This extra or extra income is going to be passed on to a lot of discretionary things like houses, cars or vehicles. It seems that in the very short term there has been an impact in terms of demand and volumes, but maybe in two quarters this demand should normalize. This should bode well for OEMs. The question is, of course, how to play with all this automotive demand? You are either playing by owning OEMs directly or you might be better off owning auto ancillary companies which aside from OEM demand have a few additional demand factors namely replacement demand and export demand.
So there are different ways to play, but it is clear that demand should return in the second half of the year.
has been a phenomenal wealth builder over the past month or so. Are you following this one?
Yes, I watch him pretty well. The magnitude of the price movement is a bit surprising and it has essentially happened with many other pockets of the market, especially those related to commodities. Praj is somehow directly, indirectly linked to the sugar cycle which is again linked to ethanol.
In a way, they’re all pretty much related to each other and so the surge in share prices in sugar stocks and everything else spilled over to a player like Praj as well. The beauty of Praj is that he’s pretty much a winner who takes it all in the sense that it’s a real opportunity and has massive support from policymakers. Praj ends up being a disproportionate beneficiary and this was reflected in their last quarterly performance.
That said, the surge in stock prices has caused a disproportionate rise from current levels. As a company they will continue to do well as the traction on the order front is fantastic and they continue to be leaders. But at this kind of current stock price, I don’t expect it to produce massive returns as we’ve seen the kind of returns unfold in the last month or two or maybe even the last month or two. over the past year.
You have to be careful with this and moderate expectations. I believe a lot of the strength of short-term performance is roughly reflected in the current stock price.
How is this market different from 2017 and 2018? We saw some euphoric moves in mid and small cap stocks and the endgame wasn’t great.
The only difference I would say is that in 2017-2018, a lot of shoddy stocks – companies that were almost bankrupt or whose management quality was really, really bad – managed to come together and have gave good returns. This is because there was a group of investors who probably believed that reforms like demonetization, the GST and the bankruptcy code would help all kinds of businesses to be fundamentally sound and solvent and that there would be a huge transformation in governance standards. Based on this premise, many low-quality stocks have performed very well.
This time around, small and mid caps are doing well, but the big change from yesterday to today is that I think quality is first and foremost in the minds of investors and traders and for me it is. is an extremely healthy sign. It doesn’t mean we can’t have bubbles yet, but quality bubbles can be around valuations as well. So I find the big difference between 2017-2018 and now is basically that investors and traders are much more aware of the quality of the underlying companies that they are trading or investing in.