Inflation is back and on the other side, there is a visible recovery in growth and demand. If you have to balance growth and inflation, valuations and opportunity, how would you map things?
The last 10 years have been marked by under investment in the core industries in India. and globally. When you do not invest in a particular sector and demand keeps on growing, a time comes when there is a mismatch between demand and supply. I think we are probably looking at that stage. It is hard to say if inflation will grow year on year because the base effect always tends to reduce inflation the next year. But the sharp underperformance that we saw in capital spending, in commodities, probably is behind us. Also ESG funds have impacted the supply side more than the demand side and that is not a very good thing to have happened as large corporations in the world are now shying away from opening up new supply sources. There could be a period of demand supply mismatch, It could lead to some inflation and also a change in direction of the stock performance.
When we started the year the view was that we have recovered smartly from the first wave while globally, the world was still struggling on the medical front but post April, the view has changed. On the medical front, the world is doing better and we have our own struggles and challenges because of the second Covid wave. Does that change anything?
The crisis seems to have abated. The societies and the governments are extremely resourceful and whenever there is a crisis, you bring in a lot of focus, energy and effort in dealing with the crisisWe seem to be winning the second wave and interestingly the world over, the markets did not fall during the second wave and that again shows the optimism going ahead.
You always focus on assets which are available below the intrinsic value. That call is now working. is outperforming , is an outperformer, the value in PSU oil companies is getting recognised. Do you think value investing is back ?
We want to clarify one or two things. There are some misconceptions about value investing, at least the way I look at it. Value investing is not about buying companies around book value or below book value, buying only old businesses or buying businesses that do not grow. I do not think that is value investing.
According to me, value investing simply suggests that I will price whatever is my assessment of the growth going forward and I do not want to pay a very aggressive price and what is justified by the current and future prospects. Despite growing well, if a great business is overvalued, it may not turn out to be a good investment. That is how I look at value investing. We have invested in growth businesses at different points of view. Over the last few years, some sectors became extremely expensive and they were not even growing that fast in India while others continued to underperform. It certainly appears that the cycle is changing. It took a while too long this time around.
Even earlier, we have seen similar periods but this time, it got a bit extended. But I have also seen that the longer the period of underperformance the more sustained and the sharper should be the outperformance. So value is coming back and what is supporting that in India is the fact that the corporate NPA cycle is clearly behind us. Everyone agrees on that now and also the bank’s balance sheets of the asset mix have converged between various leading banks in terms of retail and corporate loan books.
Going forward, the big divide in valuations that we saw over the last couple of years may not sustain and as we move ahead, what has happened is that as a reaction to the lockdown and economic conditions last year, interest rates have hit the bottom and governments across the world are focussing on infra. As I said earlier, in the last 10 years, the world has invested very little in capital intensive or core businesses. We are looking at a situation where demand could possibly exceed or supply may not be able to keep pace with demand and that is why you are seeing a sharp increase in commodities across the board.
Interest rates are also bottoming out and I believe rise in interest rates will be more negative for the very expensive sectors because the more expensive the sector in the longer term, the higher the growth in the future in cash flows as any rise in discount rates impacts those businesses far more. I do feel and I also hope that considering the changes we have seen in the last few quarters, the quality and the sustainability of the business are important factors. Price has a very important bearing on the future returns at least over the medium to long term.
Short term of course is extremely hard to predict.
How would you then assess the future of PSU stocks? Are they fairly priced or are they still at the beginning of a growth cycle and new capital allocation policies have just started?
PSUs as a group have been misunderstood across the board. PSUs have not been perpetual underperformers in the stock market. The underperformance was very stark in the last couple of years. Also, that is not backed by the financial performance of these companies. In last five years, the profit growth of PSUs was more than the broader markets.
I believe this underperformance was possibly a result of the ETFs. The government has hinted that they are unlikely to adopt ETFs as a divestment tool. The focus is now shifting to strategic sales. The real value of these companies will come out and that overhang of ETFs is no longer there. To that extent, from a stock market perspective, the environment has turned positive.
The second and more important thing is what is happening in the broader economies and what is happening across sectors in the PSUs. In the Indian context, there are no PSUs in IT, pharma, FMCG, retailing, chemicals etc. PSUs are concentrated in banks, oil and gas, energy, coal, mining and in the power sector. The bulk of the PSUs are in sectors which were also underperforming but since almost all PSUs were in these sectors, one thought that everything is bad. Both these factors did not go in their favour.
But now, even the sectoral outlook has changed. Look at what is happening in the energy sector, look at the way oil and coal prices are moving. Coming back to profitability of the core sectors of the economy, the changing outlook towards these sectors, the end of the corporate NPA cycle, a sharp improvement in the profitability of banks carrying the burden of corporate NPAs and the business performance have been supportive going forward.
Finally, when the underperformance was so stark, so acute and almost everyone was extremely negative on this sector, such situations lead to deep undervaluations and that has been partly corrected. But I still think there is significant room in many of these sectors because even the current valuations are significantly below long-term averages. We still have cases where even the dividend yields in quite a few of these companies meaningfully exceed the borrowing cost of these companies. They are growing successful companies and there is room to be optimistic on this.
For the next couple of years, in which part of the market do you think we are in for a growth surprise and where do you think we are in for a growth disappointment?
The current valuations in the consumer space are the highest versus the last 10- year averages. This space represents extremely high quality companies but I believe this is not a high growth sector. The offline sales growth of most of these companies over extended periods has been in high single digits or very low double digits. The profit growth has been somewhat better supported by significant expansion in margins, supported by indirect and direct tax cuts. Going forward, from the current high base of markets, it appears even significant margin improvement should be less likely and in any case we are seeing broad-based inflation and tax cuts again. So while there would be some profit growth in this sector, I do not think it justifies the multiples this sector is trading at.
A more important point to be kept in mind is that most other sectors were struggling for a variety of reason; capex was weak, commodity prices were low, corporate profitability in core areas were weak, NPAs were high and pharma again had a challenge of a very high base margins about six, seven years back. So that also was mean reverting in a way.
Various sectors like pharmaceuticals, commodities, capital goods companies and banks were struggling and these are large segments of the market and in an environment like this, even medium growth or low growth of consumer companies was richly valued because there was nowhere else to hide. Going forward, one thing which has decisively changed is the revival in profitability across the board and it is surprising and ironic in a way.
Last year saw the highest ever growth in Nifty EPS and it is fairly broad-based. Metals, capital spending, banks, chemicals, textiles, paper — the core sectors of the economy are doing very well. Corporate profitability has revived very strongly and that makes a fit case for a significant revival in private capex. We have been hoping for the last several years that private capex will revive but I think now the environment is more conducive and one feels far more confident about it happening in the foreseeable future simply because the corporate balance sheets in the core sectors of the economy are extremely healthy, the cash flows are good and profitability is good.
When we look at companies that we cover and when we look at the announced capital expenditure plans over the next few years versus what these companies have done over the last few years, there is definitely a significant increase in the planned capex. That is one sector where we could expect meaningful acceleration.
A lot of disruptive changes are happening. Fuel is moving from thermal to solar; the combustion engine is moving towards EV. All these will have an impact on the way normal commodities are consumed. How are companies in the construction and EPC getting their revenue?
The energy field is undergoing a lot of change and I do not think anyone will argue that there is both a need to resort to cleaner forms of energy and also that over time the share of clean energy should and will go up. But it is very simplistic to consider that conventional energy has no future! Many companies have taken that view and they have stopped investing because of either this view or because of concerns around ESG. The only point I want to make here is that demand will take its own time to come and no one is sharply incentivising. Consumers simply want to buy energy at the cheapest price.
So till the time, there is parity and green energy is available round the clock and storage is economically viable, conventional energy will continue to play an extremely important role. Look at what is happening in China. Look at the growth in coal demand, the growth in thermal power and please bear in mind that in the last 10 years, even in a country like India how many thermal plants were set up? I cannot think of any new thermal plant that have been planned but demand continues to grow at 6-8% a year. How are we going to meet that demand?
So whether we like it or not at least in the Indian context, it may happen even outside but I will not say that because I do not know for sure but in the Indian context we will need more conventional energy. But the supply has dropped faster across the world. There is hesitation in investing in new oil fields but demand continues to hold up well. I think it will be very interesting to see how the energy prices are impacted over the next few years. One cannot take this view for 10 years but quite some time we may have to contend with higher energy prices.
Even though the capex cycles are bigger and higher because of the base of the economy, the number of players are less. What does that mean?
It is said history rhymes, but it need not repeat. That is an apt phrase to describe these two points of time. There are similarities between 2001, 02, 03 and now. During 2001-03, growth was very expensive but it was tech-led. Today, again growth is very expensive but in my limited understanding, it is represented by the consumer sector. That time the commodity prices were extremely low and at the beginning of the cycle. Today, we are not in that phase.
Today many commodities are significantly above the cost curves. We were somewhat closer sometime back but if you look at the steel prices today in any part of the world, the spreads are unbelievable. It took almost six-seven years from 2001 till 2007 for commodity prices to keep on rising. But we were at the bottom of the capex cycle in India then both in infra and industrial private capex.
Today we cannot say that for the infra capex because we have had a fair bit of focus on that in the last few years but in private capex, we are at probably the bottom and to that extent, in the next few years we should see a significant revival in industrial capex.
Last but not the least, in 2001, markets had fallen to almost 9 PE. That was also a year when retail interest in equities was probably the lowest ever. That year saw a net inflow in mutual funds of just Rs 142 crore. It was the lowest ever in a long-long time. People used to tell me that look you are selling equities just because you work in a fund but for 10 years, markets have not given any returns. I think equities were deeply out of favour then,
Today, the multiples are not low and the retail interest in equities is completely different. So I would argue that while there are similarities between then and now, there are quite a few things which are quite different as well.
For the next three to five years, are equity investors in for double digit returns or that will be a tall order?
We are in a situation where markets in aggregate terms are fairly valued. If you look at India’s market cap to GDP and I focus on fiscal 23 and not on fiscal 21 because last year GDP contracted the base to look at the market cap to GDP ratio. We are in June. In three months’ time, everyone will shift to March 22-23, fiscal 22-23. Based on that, as per my memory, markets are at around 90% market cap to GDP which I think is neither expensive nor cheap. It is just about right.
The moment you bring in the current low cost of capital, this appears quite reasonable. Please remember that today you are buying government 10-year bonds at 17 PE (6% translates to 17 PE). In these days of low cost of capital, one can work with slightly higher multiples. Of course, the risk is to what extent and how fast the cost of capital can or will increase. I am not too unduly worried because let us remember that it is the US interest rates which have collapsed. Interest rates in India are not the lowest.
In 2005 the Indian 10-years yield was 5% and the US 10-year yield was roughly there as well. So there has been a sharp fall is in US but if those yields go up, it could lead to some corrections in the markets but in a fast growing country like India, capital markets can take in their stride some increase in cost of capital as the outlook for profit growth is quite positive and fairly broadly-based this time around.
In the next few years, returns will also be a function of inflation because if the market cap to GDP is fair, then what becomes the key is the nominal GDP growth going ahead. Maybe real GDP growth of 6-8% and 4- 6% inflation brings you to 10-14% and one can make a case that over the next few years, medium term return should be in line with those numbers. But the returns across sectors could vary significantly and portfolio returns will also be a function of how you are positioned. Stock markets represent a duality of opinion as every trade represents the same company, same time, same price, same everything, two opposing opinions. While I have my opinion, I am sure there are others who think completely differently.
