by Agam Vakil
Shraddha Babla
October 28, 2016, 8:19 pm
This week on Thank God It’s Friday, we spoke to Hiren Ved, director and chief investment officer of Alchemy Capital on how he has seen the equity market evolve over the last two decades, the stocks and sectors that he is bullish on, and how he sees the current Tata Group versus Cyrus Mistry spat to play out.
Q: You have been tracking the Indian markets for the last 25-26 years. Just wanted to understand how have things changed over the past two decades in terms of corporate governance and investment opportunities. Was it easier to make money back then?
A: Yes. When markets are imperfect, there is more opportunity to make money. Over time, access to information has improved substantially. You have the concept of quarterly results, you have conference calls, you have analyst meets. You did not have any of those in the early days. In those days you had to go to the stock exchanges to put half yearly results up on the notice board and take them down later. And then probably come back and analyse them in the office. And to get access to companies we had to go and attend shareholder’s meetings of these companies because that was the only time that we got facetime with the management and you could ask relevant questions, try and make friends so that you can reach out to them later. So I think the speed of information and the access to quality information has gone up by leaps and bounds. Obviously, as the market gets more perfect, and the number of players increases dramatically, it becomes tougher and tougher to make money. But I still feel despite that, India is a great land of opportunities. 5,000 listed companies, our economy is still evolving, and for a curious mind, and a person who wants to work hard, there is still money to look at.
Q: Which phase is the Indian economy is in? Are we still in the recovery phase, are we in the trough or are we climbing the path towards an economic recovery? Has the expansion phase already begun? And is there any scope for further PE re-rating from here on, like the kind we saw in February?
A: I would say that we are in the early phase of the recovery. Clearly, there are parts of the economy that have begun to show some growth, and there are parts of the economy which are still lagging. We all know that private investment is still lagging substantially. There are areas in consumption that have done well and government spending is picking up. So if you look at what drives growth, I think consumption and government capex are driving growth. Private capex and trade or exports is still very slow. India may still take market share in certain areas on exports but, on the whole trade, growth has been very slow. So I think it’s like of the four engines you are running on two and the other two are yet to fire off. So I think you are in the early stages of recovery. And that is probably also reflected to some extent in the market valuations because what happens is that when you are going from trough profitability, usually the PE of the market goes off first and then earnings follow. Earnings is always a lagging indicator. PE is a leading indicator. Similarly, in 2008 when the market started to correct, and you would ask a company or management, they would say, ‘no my business is going fine but I don’t know why the stock price is falling’. But the market is smart. In 2008, the PE contracted first and the earnings fell later on. You only realised it in March 2009 when earnings de-grew. Expectations were very high in 2008 that earnings would keep growing and growing at 20-25 percent plus. So I think we are in a reverse situation right now where margins are at 15-year-low, capacity utilisation in many sectors is very low, so you are not on your normalised profit growth. But at the same time, there are a few things which have started to turn around. And obviously, the easy liquidity that we have seen around the world, and the fact that cost of capital in India is falling, means that we have got a lift-off in PE first. And hopefully the earnings will follow.
Q: I am sure you are following the ongoing issue with respect to the Tata Group and the ouster of its chairman. And this is going to be in the run of speculation because we do not know what is going to happen but if the Shapoorji Group were to move out of the Tata Group with respect to shareholding, would you have any guesses what could happen? And secondly if there is a correction right now, we have seen some correction in all the Tata Group stocks, would you buy some of these companies?
A: First of all, we have to understand that the Tata Group is a group which has been around for many years. So it is not the last 10-year or 20-year phenomenon. It is a last 100-year phenomenon. When you have such deep rooted history...a group will never crumble just because something happens. Now obviously the group has become fairly large and complex. And it is going through its usual metamorphosis. So typically groups that survive have to change. Sometimes that change leads to friction. It causes things to unsettle for a while. But then things will get back in shape. If you ask me, will it dent the reputation of the Tatas as we see it? Probably a little bit of the sheen has worn off. People are a little surprised at the manner in which things have been done. But having said that, I think that it is a large institution. And now things will sort themselves out over a period of time. As to whether I would buy on a correction, we have to realise that some of the things which have come out in the open are not necessarily new revelations. I think the market was very smart. And if they believe that Tata Steel Europe was a bad decision than the market discounted it in that manner. It is not something new. The fact that the overseas properties of Indian Hotels are not making money, or are RoCE dilutive, the market is much smarter, it discounts this much quicker. From here on I think what investors would want to see is that now that many of these issues are out in the open, how some of these capital allocation decisions that were taken in the past. You can always in hindsight question some of the decisions. But it is not about the history, it is about the future and what the managements of each of these companies decide to do in order to improve the profitability of their businesses is to my mind more relevant from a future stock price perspective. These shocks can keep coming and you will see a downgraft and then obviously you will see things coming back to normalcy. The longer-term trajectory of the valuations of these companies will solely depend on the fundamentals and the future action that managements take to grow these businesses’ profitably. So if you ask me, I would still say that they would have a stellar reputation despite what has happened. Investors are likely to give them the benefit of the doubt and some more time.
Q: Do you think there is a case for reshuffling as far as the senior managements of some private banks are concerned? You’ve already seen some of that happening in PSU banks which have seen a big pile up of bad debt. Should managements really be made liable for some of this?
A: In India, the equity market adjusts to the new reality very quickly. So if a company is highly indebted, and it is not able to service its debt, you see a massive drawdown on equity value. In the enterprise value what remains is dead. Equity value becomes a very small part of the enterprise value. So the market in its own wisdom penalises. But our structure was not amenable to fast change, as in banks could not easily take out a management and take in a new management. And therefore there was a flaw in the laws and regulations governing change of management. The Bankruptcy Law is a seminal regulation that has been passed in India. Obviously you still have to iron out and see how this is implemented. But I think that just like any other developed market, companies should be free to be bankrupt. Lenders should be free to sell their assets and recover their money and if required, even change managements. Have we reached there in India? I think we are far from there. Have we taken the first few steps towards that? I think so. And I think that today more than at any point of time in the past, I think investors are looking at governance as a very very important pivot around taking investment decisions. So whether the law does it or not, the investors will penalise you if they believe that your governance structure is not right. And I think it is going to be increasingly difficult for some of these companies to go and raise future capital for growth. So the market mechanism is taking of care of a few things, but I think for sustainable growth and to attract foreign capital, we definitely need the ability to change managements if required, to sell assets if required more freely, and not have these judicial interventions all the time which take years and years to be resolved. I think some managements have taken advantage of the fact that they could block any of these things because of where the regulations are today and the judicial system is not geared to take such decisions.
Q: Bajaj Finance has been a multi-bagger for you. It has been one of the best performing stocks in your portfolio. Just wanted to understand what your stand on the stock is? What have you done with your allocation and secondly which is your next bet as far as the NBFC space is concerned?
A: I think we have had a very good experience as investors in Bajaj Finance. They were there at the right time, at the right place with an excellent, cutting edge management team. And I think they have been able to exploit the opportunity to the full. I still believe that from a long-term perspective, there is a lot of growth ahead. All said and done, it is still a Rs 50,000-60,000 crore balancesheet. The balancesheets of most of the large banks are almost 10 times that of Bajaj Finance. So I think that the market is growing. Financial services in India is fairly underpenetrated. So if you ask me, long-term growth is still there. Obviously because of the stellar performance that was shown in the last 4 years, the market has rewarded them with a very high price to book ratio, high PE ratio. It is hard to argue that there is further upside as far as valuations are concerned. So I think as investors now you will probably get the earnings compounding. Possibly if you bought this 3-4 years ago you have got a combination of earnings growth and multiple growth. You can’t argue for a multiple growth from here onward. Will the multiples remain high? I think the multiples will remain high because of the sheer quality and growth opportunity that is ahead of it. On the whole, I think I am still bullish on NBFCs in general. We are in the unique situation where the economy has to grow and therefore financials is a great way to play the growth in the economy in several sectors, whether it is through corporate landing, whether it is through retail landing, whether it is through selling or distributing financial products. I think the biggest opportunity in financial service is, the way I see it today, is at the bottom of the pyramid. The fact that this government has rolled out the UID program, the previous government and then carried forward by this government, and the whole DBT framework, I think they have laid the basic infrastructure on top of which many financial services will lie. What was supposed to be the mandate of the public sector, which is to go into the hinterland where the private sector is not going to go and deliver banking services, to some extent they have been able to fulfill. To a large extent because of the structure of PSU banks they were not able to fully exploit that opportunity. That is today being done by some smarter private banks, largely by the NBFCs, and even more importantly by the microfinance companies. So I think that is where I see a future opportunity for growth.
Q: What trends are you picking up with respect to consumption, specifically in the discretionary space?
A: As I said, discretionary consumption is a big driver of growth in India. But it’s been a winner-takes-all strategy. If you look at four-wheelers, for an instance, I think that other car companies are not growing as well as Maruti. This despite the fact that Maruti has capacity constraints. But that tells you that, yes, there is demand, but it’s not a secular demand for everybody. So you will see differential growth rates within sectors. If your product is good, if your pricing is good, if your distribution and reach is there, then you have a better chance of attacking the consumer’s wallet. We have to keep in mind that while consumption is growing in India and will continue to grow, the big challenge I see is creation of new jobs to get consumption growing. Some of the consumption growth that we’ve seen in India has been driven by consumer debt. Right now, it is not alarming as consumer debt in India is much low. But we cannot take our eye off the ball. We have to keep at the back of our mind that the more sustainable consumption is one where you create more jobs and income and not take on more debt. That is a big challenge in front of the government, which they do realise. The problem is that 10-15 years ago, a lot of tech companies offered high-paying jobs and that created a consumption boom due to high salaries and employee stock options. You now need either manufacturing or high-quality service jobs to maintain that consumption. The tech industry is itself going through a metamorphosis. They are focusing on growing employee productivity than just growing the number of employees. They are not hiring as many software engineers as they were 10 years ago. Therefore that’s a challenge. The investment cycle needs to kick in for creating high-value jobs. For example, the construction sector, one of the largest employers of unskilled labour, is lagging. A lot of those things need to start to kick in if we want to sustain consumption. The good thing is the monsoon was very good this year after two consecutive bad monsoons. That’s likely to give a boost to rural consumption this year. But what about the next year and the year after and so on? Yes, consumption is a bright spot driving the economy but we need to start creating jobs to make it sustain.
Q: Are you seeing any contrarian bets in underperforming sectors like industrials or commodities which have run up?
A: I think the time to bet on commodities was earlier this year in January and February. Commodities have rallied, oil prices have rallied $25-26 to almost $60 plus per barrel. Commodity prices were so battered down that we had to see a rebound, and we’re seeing that now. In some sectors we see oversupply in China and that’s why we see coking coal and iron ore prices go up. Is it a secular rebound? I don’t think so. I think global growth is still very challenged. The people I speak to in shipping and logistics tell me they’ve never seen days as worse as these in international trade. It’s more about supply being managed in the short run which is leading to a run-up in prices. It’s not about demand growing at a very heavy clip. I wouldn’t bet on commodity companies in general. I don’t think this is an area where you’ll bet and say ‘I think commodity prices will keep going up’, although I could be wrong there. On a contrarian basis, I think money can be made in some of the stressed sectors. Some of the large PSU banks can be a contrarian play. Or maybe some infrastructure companies which are able to deleverage their balancesheet. We know there is business happening in areas like roads and so on. So there could be some pockets of good EPC companies that might do well. There will be pockets in manufacturing, infrastructure and some of these beaten-down sectors where there could be a turnaround if the company is able to resolve some of their balancesheet issues.
Q: What is your stock selection criteria and what style of investment do you relate to the most?
A: At Alchemy, we are growth investors. The market is willing to give good valuations to sustainable and high quality growth because there is underpenetration in many areas in India. Does value investing make sense in India? Yes, but money has been made in India by investing in growth, whether it is HDFC Bank or ITC or the generics pharma industry or the private banks. In absolute terms, the big money, the big market caps have been made because these companies have compounded at 20-25 percent growth for several years. At Alchemy, our framework is that we look for a large external opportunity which is expanding. We look at companies with competitive advantage. If the opportunity is large then everyone can take a shot, but why is one company performing better than the other. You need to have competitive advantage to exploit the opportunity better than your rival, and that differs from industry to industry. In a consumer business it could be brand and distribution. In a manufacturing business like cement it can be your cost leadership and logistics capabilities. You have to look at every industry to see what is the competitive advantage. The other factor is scalability. Can a company have the same or better profitability with a Rs 5,000 crore turnover than what it has with a Rs 500 crore turnover? Scalability is important. Niche businesses are exciting. But if it can’t grow it’s not going to create absolute market capitalisation and therefore wealth. Then you need a good management team. Subjects like governance and so on are equally important. And lastly, all of these should come at reasonable valuations. So I think our framework is – large external opportunity, a competitive advantage, scalability and operating leverage in the business, good quality management and all of these at a reasonable price. If we find an opportunity that falls in this broad criteria then it becomes a potent universe for us to invest in.
Q: How often do you come across potential opportunities which fulfill these critieria?
A: As I said, if you look at domestic consumption stories, India has had large opportunities in many categories. You have to look at companies which have that competitive advantage and who exploit the opportunity. Take Maruti for example. There’s so much of opportunity for four-wheelers in India because we have one of the lowest cars per 1,000 people. But the opportunity is so big that every other car company from the U.S., Japan, Europe have come into India. Yet Maruti still has the No.1 position. I remember when there was a lot of competition people said, “oh you should sell your Maruti because they are going to lose so much market share due to competition.” But why has Maruti after losing market share regained it? Because of its competitive advantage. The other guys came but they don’t have the volumes. They don’t have the dealership and distribution network. Maruti had a natural advantage of being in India for so many years. They’ve built a massive network. That was its competitive edge. The opportunity in India is big. In India, across the consumer markets, the number one player has an outsized market share and the others are way below. So take liqour, United Spirits has over 50 percent market share. Take beer and United Breweries has 51-52 percent market share while the next guy is at 15-16 percent. So when you have a lead that is so big, especially in a complex country like India where the consumer in the north thinks differently from the consumer in the south, it takes time for a new person to come in and establish themselves. Obviously the advent of e-commerce and the internet is going to make things difficult for incumbents. Today if you’re a third party seller you could go on Amazon and sell your product. But not every product will be amenable to that. I think that this is an interesting juncture in India where in some cases the strong will become stronger while in others the strong will be challenged due to new business models that come in with e-commerce. But there’s still lot of opportunities.
Q: Tell us about three of your favourite books?
A: The book I’d read early in my investment career was Peter Lynch’s book. The other book which I liked was Edwin Lefevre’s Reminiscences of a Stock Operator. On a very different take, I like to read books on Indian philosophy, Bhagavad Gita being one. But over time I’ve read several books on the Vedic philosophy which I find very interesting. It’s amazing to see such sophisticated thoughts almost 5,000-6,000 years ago.
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