Buying good companies going through a bad cycle is one of the strategies in Jatin Khemani’s investment playbook, betting they will emerge stronger when the cycle turns. Khemani, the Managing Partner & CIO of Stalwart Investment Advisors, a SEBI-registered Research Analyst and portfolio Management Services Firm, is taking that approach with shares of agrochemical companies, many of which were underperformers during the recent record-setting stock market rally.
The chemical basket comprises many segments with varying operating environments. The outlook for the sector in general has turned bearish over the last couple of quarters due to the double whammy of weak customer demand and falling prices as a result of dumping by Chinese firms. The subpar monsoon has also been a drag on sentiment for agrochemical stocks.
Khemani’s favourites are pure-play manufacturing companies carrying out contract research and manufacturing (CRAM) for global giants. His big picture call is that while India is the third largest agrochem market in terms of manufacturing, its global share in trade is in single digits, which is both an anomaly and an opportunity.
He sees the $60 billion global agrochemical industry maintaining its current pace of growth because of the rising world population, the decline in arable land and climate related disruptions.
“The largest (player) is China, but it has been losing market share of late. If a small percentage of the global market share shifts to India, the industry can grow multifold in the coming years,” he said.
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Business model
According to Khemani, the CRAM business is all about building trust over the years.
“These collaborations typically span 10, 15, or even 20 years because many of the products involved may be patented. The innovator companies trust you only after a decade or two of a proven track record, where you become a reliable, consistent supplier, offering the right quality at the right price,” he said.
In some cases, the partnerships evolve into joint ventures, leading to firm orders for dedicated manufacturing plants.
“This business model offers excellent visibility because these orders span the next 10, 20, or even 30 years. The nature of this business is highly favourable, with strong entry barriers that make it difficult for newcomers to disrupt the market overnight,” he said. Among the stocks, Khemani owns in this space is Hikal. And while he is bullish on PI Industries given its stellar financial performance over the last many years, he does not own the stock in his portfolio because of expensive valuations.
Price drops unsustainable
The reason for the current downcycle in the industry is that customers are trying to reduce the excess stock they had taken on during COVID as a safeguard against supply disruptions.
“So, you have volume pressure because of channel destocking. And then you have margin pressure because of China dumping,” Khemani said.
The signals he is picking up from interactions with industry people is that the price drops are unreasonable, and hence unsustainable.
“A lot of products are either making no money or making losses. This is obviously not sustainable, even for the Chinese. For how long can they sell at unreasonable rates,” he said.
The road ahead
Khemani’s positive outlook for the sector contrasts with that of some broking firms, such as Jefferies. “Falling crop prices and rising farm input costs impact farm profitability and limit visibility on a sharp turnaround in the agchem cycle. Elevated Chinese exports in CY2023 will likely weigh on pricing,” wrote analysts Bhaskar Chakraborty and Niraj Todi in their note last week.
But Khemani is not betting on an immediate recovery. Investors will need to be patient.
“We’re not saying it’ll turn in the next month or next six months. But we’re very close to the bottom and it could turn in the next six to 12 months. And whenever that happens, we’ll have volume growth; we’ll have margin normalisation; and then you’ll have that steady growth.
Companies continue to incur capex and their relationships with these multinationals will continue to grow over the next 5-10 years. So, it’s a decade of opportunity, probably longer. And from a top-down standpoint, it seems a very interesting space to be in,” he said.
Agroprocessing stocks
Similarly, Khemani feels that the downcycle in the agroprocessing sector may be nearing the bottom. Since the COVID-19 pandemic, many of these companies have seen their realisations face pressure and raw material prices surge due to factors such as the Russia-Ukraine war and adverse weather conditions.
“This price imbalance has affected basic agricultural products such as maize, soya, and wheat. So, production costs rose while revenues have decreased, causing profit margins to shrink, and in some cases, even turn negative,” Khemani said.
He is now expecting an upturn over the next couple of quarters. “For instance, Gujarat Ambuja Exports, which is into maize and agroprocessing, has been seeing the lowest profit margins in a decade in the agro sector,” Khemani said, adding, “we’ve held this investment for the past five to six years, and it’s been a five-bagger for us.”
Similarly, he sees nascent signs of a recovery in the livestock feed and dairy segments.
“Feed companies have had a challenging time over the last six quarters due to the significant rise in raw material costs. But the situation is now normalising, with some companies managing to pass on these cost increases. Overall, profit margins are gradually improving.
Dairy companies have also endured difficulties over the past eight quarters, said Khemani. But looking at the Q1 results and management commentary, most have recovered well and the next couple of years look promising, he said.
One risk, however, is if raw material prices rise again because of deficient rainfall and food inflation, but Khemani feels it may not be so much of a problem this time.
“In the short term, it’s bad if raw material prices go up again. Because it takes a while to pass on the costs, because of competition, and customers being price conscious. For example, for a cattlefeed company or an aquaculture shrimp feed company, your end customer is a farmer,” Khemani explained. “It’s difficult to pass on the hike immediately because they don’t have the paying capacity. Also, it’s very competitive; you’re up against unorganised players. So, it’s a problem if it continues, but for a lot of industries, it’s already played out in the last two years. And for those specific inputs, right now, things are not looking bad,” he said.
