Is there a disconnect between the market and the real economy?

I don’t think so. To begin with, a stock represents the discounted value of profits for a long period. So, let’s assume, if the economy was not doing well and profit was hit for a year, at best, it would have impacted not more 5% of the fair value of a business. We haven’t seen any meaningful impact on profits barring for a few sectors. Instead, FY21 was a unique year which saw a strong resurgence in profits. Banks witnessed the end of the corporate NPA cycle. Businesses such as IT, pharma and FMCG did not experience significant disruption. Utilities also did not experience any major pain. Metal prices shot through the roof. Auto, multiplex, retail, restaurant, airline, among others, were the only sectors that were impacted, but these account for a small part of the market. Finally, the most critical aspect, the cost of capital has come down in response to the pandemic. If you bring down the cost of capital, why will asset prices not go up? So, I am not surprised by what has happened, and I don’t think there is any disconnect between the market and the economy.

Among the several measures taken by the Centre to pump-prime the economy, how would you rate the PLI?

The outcome of an initiative is a function of its timeliness and PLI (production-linked incentive) is a timely step. What has happened over the past few years is that the wages in China went ahead of India meaningfully even as the concern for environment increased from where it was 10 years back. So, Indian companies in many sectors are now able to compete reasonably well with Chinese costs. Second, the lockdown disrupted the supply chain in China, resulting in a keen desire among companies to develop alternative sources. And, in any case, their costs are not lower anymore. So, PLI should improve India’s market share in global manufacturing and contribute to private capex.

So, when do you see a recovery in private capex?

I think a bigger trigger for private capex should be the sharp revival in the profitability of the manufacturing sector. Sectors such as paper, sugar, textiles, chemicals and metals have done well. Corporate leverage is near all-time lows. When you have solid profitability, low leverage, good exports, initiatives such as PLIs and interventions such as anti-dumping duties, it is reasonable to assume that private capex should come back fairly quickly. Though, we must bear in mind that there is a reasonable gap of four-six quarters between intent and putting money on the ground. I think credit growth may take a bit longer as companies will first utilise their equity capital and then resort to borrowings. In due course, however, we should see both revival in private capex and credit growth.


Are we in the midst of a commodity super cycle?

I really don’t know. My approach to investing in global cyclicals is simple—buy low-cost producers when the cycle is weak because that is when you will get these companies below replacement or book value and wait for the cycle to turn. In a downturn, margins tend to be lower, resulting in slower capacity addition. So, when the cycle turns, cash flows improve and so do stock prices. But those margins are not sustainable in the long term as these are cyclical businesses. Hence, these businesses should be bought at high PEs and sold at lower PEs. We have kind of moved out of this space. There is a chance that the current upcycle may continue but then there are other opportunities where our confidence is higher and uncertainty is lower.

In which pockets of the market do you see over-exuberance? Is speciality chemicals one such sector?

I have had no investments in the chemicals space for a while now It’s a good sector and India has all the right attributes—our capital costs are low, we have the right skill sets, we are cost competitive. Besides, it’s a growing business both locally and outside India. But I do think these businesses are very richly valued that can deliver high ROCE only in niches. The moment you try to scale up these businesses, in most cases, the ROCEs will be capped because it’s a capital as well as working capital-intensive business. I am in a way surprised at the valuations that these businesses are trading at. In the past we have seen similar situations. In 1992, old economy was over-valued; in 2000, tech was overvalued; in 2007, infra and power were overvalued, in 2013- 2014, pharma was overvalued. So, I don’t know how long this sector will do well, but I do feel the risk-reward is not in favour.

What about the consumer space?

This is the other segment where I find valuations expensive and where I have been wrong for the past few years. Consumer companies are good businesses with solid entry barriers, sustainable businesses, good free cash flows but they are growing at a moderate pace. If you look at the past 10 years, their topline growth was in high single digits in many cases, but the multiples they trade at are anywhere between 50x and 100x. The reason for that probably lies in the margin expansion which was partly on account of the GST cuts which, probably, were not passed on to consumers. This sector also has some pricing power. Also, if you recall, almost 10 years back, the Standard Weights and Measures Act was modified and post that the grammage was not standard anymore. Thus, companies could continue to reduce grammage and keep the unit price the same. The corporate tax rate cut in 2019 has also aided profitability. And of course, the space, which is the least cyclical, enjoyed the maximum benefit of the current low cost of capital. Going forward, many of these factors are in the base and so profit growth should moderate and, thus valuation multiples appear to be relatively high.

Post consolidation, will government banks gain over private banks?

All the old banks in the country have been heavy on corporate loans and the newer banks pioneered retail loans. Over the past few years, when the corporate NPA cycle deteriorated, older banks—both in public and private sector—suffered. But the predominantly retail loan-oriented banks did not suffer; all these were private banks because no public banks were set up after 1990. So, over the past few years, corporate-focused banks suffered. But, today, the divide between corporate and retail banks is practically non-existent. In my view, retail loan is likely to become a commodity—driven by data, analytics and artificial intelligence. So, a bank which has a good tech platform and can offer loans at a reasonable rate should be able to compete. The corporate NPA cycle has also now ended and, hence, the ROE divergence seen between these two sets of banks should converge now. Corporate-heavy banks have grown faster in retail loans to derisk, while retail-focused banks have grown faster in corporate loans because competition has increased in retail loans. As a result, the balance sheets of both these category of banks look a lot similar in terms of asset mix. In future, the divide in banks should come from technology, and not from retail or corporate assets. Banks that are fit and contemporary on digital, on technology, or on AI, will be able to compete in the future and banks—public or private—that lack these are likely to fall behind. The strong public banks are already doing well—up almost 3x and some of these banks have successful non-banking subsidiaries as well with large market values.


Should investors focus on margin of safety or worry about the opportunity cost?

That’s a very apt question but I think margin of safety is a concept that is relevant at all points of time. The big question today is: what is going to be the long-term cost of capital? How long will these interest rates sustain, or do you move it up by 1% or 2-3%? I believe the cost of capital is unlikely to move any lower. We can always debate on “how much” and “when”, but it should move up at some point of time. In my view, the market today is fairly valued, and around a fourth of the market still offers good value. So, one should moderate their return expectations [from equities] and think long term.

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