There is a second Covid wave in India and particularly in Maharashtra and Mumbai. From a market standpoint, could this derail the momentum in economic growth and could that be an indication for markets to hit a pause button or to retreat?
If you look at our past experiences with the marketplace, everything has been postponed. So even if the infection spreads, we need a hiatus for a month or two before it moves on. We have been through a number of years and we have come down to a phase where vaccinations are getting administered across the world. It will take some time before we hit a critical population that has been vaccinated. We will probably see another six months of this uncertainty there the world normalises a little bit more.
For the marketplace, things have bounced back, valuations have come back, momentum has come back, inventory channels are getting full, trade is almost normalising. So things are okay. I would not say that they have gotten significantly better from where we left off, but things are okay and markets have responded to that.
Today steel stocks are higher because steel companies are enjoying one of the best patches in their history.. At what point in time would the inflation and margin compression concerns take over? Do you think that the market should not continue to ignore the rising raw material prices — be it steel, copper, paper or even plastics?
I look at it a little differently. There is always a pool of profitability in that value chain. For a very large part of the last decade, that belonged to all the users of the commodity. What we are seeing out here is a transfer of that profitability from one end to the other extreme. So the aggregate profitability may not change and it would not. It will just shift from one company to the other. It just moves up and down the value chain and over a period of time, supply has gotten constrained in steel and demand has been at a steady clip. I would not say that margins will come back for the automotive companies but definitely that shift in profitability has moved towards the commodity business. In all likelihood, it will stay for some time till new capacities come up not just in India, but globally.
How exactly will the template play out? Could this trigger a fresh capex cycle by cement, steel, industrials and cyclicals? Are we on a cusp of where big corporate houses will start increasing capex and will commit to both greenfield and brownfield projects?
Well that does not happen immediately. We will have to wait for a year or two and see how these events play out. Everyone wants a significant bout of cash flows and everyone wants a high return on capital invested. Remember, a significant amount of these commodity businesses have not earned anything for the last decade. The reason why that happened was because the excess supply came in between 2008 and 2011.
It was not that demand fell off the cliff. Demand continued to grow at a single digit which it always does but supply came in at double digits. We had a situation of oversupply and now that the entire supply is being consummated, we would have a shortage of supply and that is where the transfer of pricing takes place. That is where the transfer of profitability happens in the cycle. Some of these companies or a lot of them will enjoy this period for a couple of years before new capacities come up.
Look at the brownfield capacities. Everyone in those industries that we are talking about have non-brownfield capacities. When they get exhausted, then you will have greenfield capacities. But critical to all of this and the best part of all of this is that these companies will leverage into an expanding cycle.
Earlier, last decade, we have been able to pay back most of our debts. What is there on the ground today is that none of these capacities are financially unviable. Most of them that have survived the cycle are now financially viable and can become extremely profitable. Then we will have the start of a capex cycle. But it may not be as large as we have seen it in the past.
Are you still focussing on a two to three-year outcome? Which would be the themes that you would look at immediately given that the markets have already topped out and uncertainty may follow?
Well profit pools and the profitability of the entire marketplace or the economy will continue to grow. If that is going to be the situation, then I cannot see why we need to be defensive? What we need to look for is where is the build up of all this profitability or earnings growth. That is the template that one needs to come to at this point in time.
The marketplace, over multiple cycles, has always moved from industry to industry. Whenever one industry has hit peak profitability, the probability of that continuing to do very well into the next decade is less likely. This has happened on multiple occasions. So the same thing is working out today.
I think the capex cycle that we are undergoing is something called de-carbonisation worldwide. The normal power plants that are there in the world which are based on fossil fuel are giving way to alternatives. Now this is not because of any other reason but very simply economically these alternative modes of manufacturing electricity are very profitable and have reasonable amounts of ROIs. We have seen that happen in India too.
The underlying fuel basket has moved– shifting towards gas. Incrementally most of the capex is coming up in renewables. You never hear about a company setting up another thermal asset. Now that is a lot of replacement demand coming on the ground, including the transmission or changing of fuel. That also incurs a very significant amount of capex on the ground.
When you come out on the other side, you will see costs actually come off the cliff. It is reasonably well known what the cost of power is from renewable sources versus a thermal source or a fossil fuel source. It is clear what the cost of running an automobile on gas is versus liquid fuel and so on. So large parts of those buckets are seeing significant changes which will lead to the next round of capital investment.
When it comes to the other extreme and we go into the consumer economy, in the last 18 months (most of it under the pandemic), employment rates were down and may not come back to near normal very soon. Even if it comes back, it is going to come back at the bottom of the pyramid where the spending powers are not going to be significantly large. This is going to be the case at the top of the pyramid and at the bottom of the pyramid. Volumes will continue to grow but in an industry like this, there would be too much pricing power. The pricing power and the profitability is shifting to commodities.
Our sense is that in the consumer economy when the growth is at the base of the pyramid and you get a significant amount of volumes, it may not come with pricing power and that would impact margins as well as capital efficiency. Those companies that have a fairly large run till now may not be able to continue that growth in profitability or those capital efficiency ratios that we have seen before.
So, it is not about being defensive in the environment like this because back in 2008-09-10, when we are coming out of the infrastructure cycle, the normative assumption was if India does not invest in infrastructure, profitability cannot grow and this decade has proven completely different.
Let us focus on staples. Is it the least exciting part of the market or do you still see some merit there?
Well, I did mention that there will be volume growth there. I am not too sure about pricing and so companies will grow in single digits and profitability will keep pace. But the growth will be in another part of the market. It is not going to come in consumer staples for sure.
Should one be underweight on staples right now because of the inflationary pressures across the board? They will only have that much bandwidth to pass on the raw material cost to consumers?
When we run a product and we have been highlighting this for a couple of quarters or probably a year or two, we basically see a shift in the profitability that exists in the industry. It is going back to basic materials, it is going back to the capex cycle and industry profitability starting to grow. This is going to be at the expense of something else. When I put all of this together, it is hugely inflationary and that is going to come at the cost of the consumer. We are sitting at a point where the profitability in the consumption cycle which has grown all the way from 2010 to 2020 is seeing a shift and that is because of inflation.
Inflation is very good for corporate profitability but it is not good for the consumers. The consumer is going to consume the same quantum at a higher cost. This is not only happening in India, it is probably happening across the world. So yes to a level, we prefer the capex cycle and the manufacturing cycle, companies that are building a global footprint.. We are a little apprehensive about the consumer and the domestic consumer cycle say and we do not have a very large exposure out there.
