Are new big trends going to emerge next year or is it going to be a continuation of what has happened in 2020 as themes?
There are three things that we are hoping to benefit from at Marcellus. a) We think we have not even begun a proper recovery yet. This is still the closing stages of the unlocking process. As gradually the fear of Covd is shed in 2021, we will see a much sharper pickup in consumption and demand, especially in sectors like auto, building materials, consumption, consumer durables and so on. We have not seen anything yet in terms of demand pickup.
b)We will get very sharp operating margin improvements because companies were able to crush costs during Covid. As the demand recovers next year, the benefit of the demand recovery will be nonlinear and it will have a disproportionately positive impact on the bottom line. If you believe what most people are saying that in the next fiscal we could grow GDP in real terms at 8-9-10%, it means in nominal terms, GDP growth could be around 15%. One could expect lots of good companies to be doing 20-25% EPS growth in the next fiscal and therefore we are trying to position our portfolios to benefit from good earnings growth in the next fiscal.
c) The polarisation in the financial space. It is obvious to us that the majority of lenders have not provisioned properly for Covid. They will feel pressure on their balance sheet. Already when we are doing our channel checks, it is evident that several lenders have been all but squeezed out of lending, they have not got the balance sheet, they have not access to funding. The polarisation in financials, especially in lenders will become very apparent in the next fiscal.
How do you treat financials now? Month to date, Nifty Bank has given a 1% uptick as opposed to Nifty IT’s 11%.
We have launched a portfolio in mid July called Kings of Capital and we stuffed it full with the best banks, the best NBFCs and best life insurers, general insurers asset managers and brokers. Around 60% of Kings of Capital is lenders, 40-45% are savings plays. Now let us discuss the lenders first. What is very interesting is that the top five-six lenders have provisioned super heavily for Covid, the top five-six lenders have stashed away a huge amount of provision.
If you take the top three PSU banks – SBI, BOB, PNB — and top five or six private sector lenders like HDFC Bank, Kotak Bank, Bajaj Finance, Axis Bank, it shows Covid provisioning is six to seven times more for the private sector lenders than for the PSUs. The cumulative loan books of top three PSU banks and top five or six private sector lenders are similar in size but the private sector banks have provisioned six to seven times more and therefore to use a popular aphorism, the Queen’s Gambit move, is load up on the top private sector lenders who have already provisioned super heavily for Covid.
The leading private sector lenders are assuming heavy NPAs in their moratorium books, heavy write-offs there and are already provisioned for that. The PSU banks are saying we do not really have the tier I so we cannot really provision, So, it is like waiting for lady luck to play out on the PSU side. Therefore, it is a straightforward story – buy the top PSU banks. The provisioning disparity is very stark and it is obvious that there will be Covid NPAs and COVID write offs as we get into 2021.
Coming to the savings side, you have heard how 60-70 lakh brokerage accounts have been opened in the last six-seven months. We are trying to play that dynamic by investing in good brokers. We think private sector life insurance will have a super run because this whole dynamic around Covid is driving demand for life insurance. You can see that in the data and we have bought HDFC Life there as our main play across several portfolios.
We have built positions in HDFC Life. So good private sector lenders, not just the frontline names but say even smaller banks like AU Small Finance Bank, City Union Bank. which are well provisioned lenders and asset management, broking and life insurance on the savings side have several good years ahead. HDFC Life is our chosen play on the life insurance piece.
One of the big juggernaut — Reliance Industries — has stalled. You have earlier said that you do not see merit in holding on to Reliance for too long. What happens next as it is struggling in sub 2,000 levels?
I have twice said that we cannot quite figure out where the free cash flows will come from. We cannot but admire how adroitly they are pivoting this business away from the traditional chemicals and oil refining business into retail and telecom but the challenge in all of this is where do you generate the free cash flows from? Indian retail is a tough game — be it Flipkart, Amazon. Beyond a DMart or a Titan, not too many people have generated free cash flow there.
Coming on to Indian telecom we have not seen anybody generate free cash flow there either. So to the extent we are a classical investing shop, we look for free cash flows, we look for dominant competitive advantages. We have been a little bit at a loss as to how to build that thesis? We completely understand the scale of the transformation this company has pulled off and I am sure the transformation has a long way ahead to go but the lack of clarity on future cash flows and specifically lack of clarity on future free cash flows has kept us away from putting this in our portfolio.
