Top 5 stocks in the mid & smallcap space could be hidden gems for value investors

Nitin Bhasin, Managing Director and Head of Research at Ambit Capital, prefers Lemon Tree Hotels, Geojit Financial Services, Alkyl Amines Chemicals, GMM Pfaudler and Mold-Tek Packaging from the midcap space.

Excerpts from his exclusive interview with Moneycontrol’s Kshitij Anand:

A) Beyond a few large public sector banks (PSBs), most banks are still low on capital and large provisioning is yet to be made. Hence, we recommend investors stay away from PSBs despite their cheap valuations.

We recommend banks with superior earnings growth such as IndusInd Bank and City Union Bank. Among NBFCs, we prefer auto NBFCs as they would benefit from a rural recovery.

We are negative on housing finance companies (HFCs) as we foresee net interest margin (NIM) compression and asset quality risk.

Apart from banks and NBFCs, we also like the financialisation of savings theme, wherein companies like select life insurance companies such as Geojit Financial Services and Motilal Oswal Financial Services stand out. However, MOST’s housing finance company (and the risks associated with it) takes the sheen of it.

A) Early this year we turned positive on the IT sector given taxation changes in the US, risk of automation concerns overdone and valuations turning attractive.

We expect leading companies in this sector (Tata Consultancy Services and Infosys) and a few mid-sized ones such as L&T Infotech to achieve industry-leading earnings growth from rising investments by their clients and measures to improve productivity and capital allocation.

Within autos, there could be a slowdown in the commercial vehicle (CV) segment (and related segments) due to high truck inventory, rising costs for fleet owners (increase in diesel cost and rising interest rates) and the recent 20-25 percent increase in axle loads.

Within autos, passenger vehicles (PVs) and two-wheelers (2Ws) should be better performers as demand remains steady with a pickup in the economy.

A) Rising yields in the US and a strengthening dollar-rupee are impacting FII flows. This could continue unless crude reverses or earnings growth sharply recovers in India. Political uncertainty too could add to these as well.

A) The elections and their outcome are on everybody’s mind now. The recent bypoll indicates that BJP’s support base is dwindling, especially among the farmers and the downtrodden.

The three big state elections (Rajasthan, Madhya Pradesh, and Chhattisgarh) in November will be watched closely to ascertain the ruling party’s position. All 3 states are currently ruled by the BJP and the election verdict there will be an indication of the ruling party’s position in next year’s general election.

Investors will start worrying if there are indications that the ruling party’s support base is dwindling. All this political uncertainty comes at a time when the economy has just started recovering, albeit with emerging signs of rising inflation and cost of funds alongside a weakening of the rupee viz-a-viz the dollar.

A) A few thinly covered mid and smallcap names which we prefer at present valuations are Lemon Tree Hotels, Geojit Financial Services, Alkyl Amines Chemicals, GMM Pfaudler and Mold-Tek Packaging.

The stock is a bet on the turnaround in the hotel industry and a play on the strong growth prospects of the mid-scale hotel space. The latter is seeing strong growth in demand (pickup in leisure and commercial) as well as prospects for consolidation (high fragmentation at 95 percent of room inventory).

Lemon Tree is the fastest growing hotel in the mid-scale space and best placed owing to: i) Its focus on costs efficiencies; and ii) Operationalisation of hotels in strategic markets at a time when industry profitability will improve. Current valuations (at 27 times enterprise value-to-earnings before interest, tax, depreciation and amortisation) while not cheap does not factor in upsides from high growth over FY18-22e.

It is a play on rising systematic investment plan (SIP) culture in the country. SIP inflows continue to grow despite market volatility as rising financialisation of savings improves the minuscule penetration of SIPs in India (at only 2 percent of India’s population).

The company is our preferred bet as its high granularity of investor base and strong positioning in higher yielding beyond 30 cities drive increased market share in SIPs.

As Geojit evolves from a brokerage company, with volatile earnings and low return on equity (RoEs) to a financial products distribution company, its earnings sustainability and predictability will improve, which will drive the re-rating.

The company is India’s second-largest aliphatic amines manufacturer and has 40 percent market share. Strong management pedigree, superior technical capabilities and a strong research and development team are Alkyl’s key strengths.

Foray into specialty chemicals aided a 370 basis points/456 bps EBITDA margin/pre-tax return on invested capital (RoIC) expansion over FY13-18. We expect the company to report strong earnings growth over FY19-21e led by capacity expansion at Dahej (increase in methylamines capacity from 16,000 million tonne per annum to around 30,000 mtpa) and rising share of value-added products.

Current valuations (21.3 times trading 12 month’s earnings) remain attractive given the favourable industry dynamics (duopolistic industry, huge import substitution and high fixed costs) and potential to report strong earnings growth.

Mold-Tek is a pioneer in the in-mold label (IML) packaging and plastic pail packaging for paints and lubricants. Penetration continues to expand led by the food segment, with EBITDA/kg up structurally (expanded by around 10 percent YoY in FY18).

Our thesis hinges on: (i) Uptake of premium packaging, driving EBITDA/kg (steady-state) higher; (ii) Improved visibility in legacy paints segment (new plants in FY19: About 20 percent of existing capacity); and (iii) Ramp-up in the UAE plant, which we believe justifies the around 31 times TTM P/E.

GMM Pfaudler is the largest glass-lined (GL) equipment manufacturer (55 percent domestic market share). We expect the company’s leadership to continue, significantly expanding the non-GL business.

Higher exports (from parent Pfaudler) will aid business mix and materially expand the opportunity. Further, margin/returns should benefit from high operating leverage and lower capex intensity.

We expect growth momentum to continue (FY13-18 EBITDA CAGR/average pre-tax RoCE: 31/18 percent, respectively) and hence feel the punchy 30 times FY18 PAT is justified.

A) Our analysis suggests that year-to-date, quality stocks have declined lesser than the relatively fewer quality names, a reversal from last year. Amid the carnage, high-quality names, especially within midcaps, haven’t corrected that much.

While valuations of smallcaps and midcaps have reduced, sharp downward revisions to earnings in the smallcap and midcap space is keeping valuations punchy.

Rather than focusing on stocks which have declined sharply and optically offering a value or bargain, we advise investors to hunt for quality businesses which are investing for building competitive advantages for long term growth, irrespective of the near term business environment.

A) While volatility will affect flows, if the markets fail to deliver returns (stagnant for five months) over the next quarter or two, equity flows could stop growing or decline on the high base of last year.

Outflows are also possible but unlikely given the rising acceptance of financial savings among Indians after the structural changes over the last couple of years.

Our checks and analysis suggest that a few alternative investing vehicles such as portfolio management schemes (PMS) are not receiving inflows to the extent that they did a couple of months back. Thus, indicating emerging fatigue among those investing mostly in mid- and smallcap dominant schemes.

That said, SIP flows remain steady, implying that the retail investor continues to invest in equities.

A) We expect India’s current account deficit (CAD) to widen to 2.8 percent of GDP in FY19 from 1.9 percent in FY18. The expansion in CAD is likely to be driven by a steep increase in petroleum imports due to rising crude oil prices.

Non-oil and non-gold imports are also expected to record healthy growth in FY19, given the recovery in GDP growth. Ambit expects 7 percent GDP growth in FY19 as against 5.8 percent in FY18.

We are moving towards a scenario where India’s twin deficits (fiscal and current account) are likely to expand. In such a scenario, a global risk-off event could trigger an attack on the rupee. Rising yields in the US and a strengthening dollar can keep the rupee under pressure.

Increase in merchandise exports and steps to increase FDI could be the only saviours given the weak portfolio flows.

A) A weak rural economy (as evidenced from very low rural wage growth) and a faster-than-expected rise in input cost and interest rates pose risks to a recovering economy.

Ahead of the elections, the government could set fiscal prudence aside as it tries to pump-prime the rural economy. Fiscal misbehaviour, coupled with rising inflation, could lead to a further rise in borrowing costs, which is already visible for companies borrowing from the short-term.

The rise in interest rates (and hence deposit rates/yields) relative to stagnating (or negative) market returns could impact flows, if yields continue to rise, which is highly likely.