How do you read the market based on valuations and earnings? Even though the earning season was not wow, markets seem to have digested it. On the banking front, NPAs went higher, markets are saying move forward. On the pharma front, margins were okay it’s time to look forward. Do you think markets are running ahead of themselves or is it okay?
The conclusion is, it is fine, it is okay. Markets are interlinked all around the world and the multiples to the valuations in India are a function of where equity markets are globally. It is not that only the markets in India are trading near the high end of the long term valuation multiples, the US itself, which is the ultimate benchmark in terms of equity markets is trading towards the high end and that in turn is benchmarked to the US long bond rate which is what every asset in the world is eventually benchmarked against.
The US long bond rate is towards the very high end of its multiples. The 10-year bond is at 1.17% today. Until the mid 90s, it was at 7% and before that in the mid 80s or early 80s, it was 15%. So we have gone from a 15% long bond rate to 1.2%, which in terms of multiples, if you were to invert would suggest that the bonds have gone from a seven multiple to 80 multiple while the US market went from maybe 15 multiple in the mid 90s to 21-22 multiple.
I am not suggesting they ought to go to 80 but you have to see it in the context of where the bond markets are. When it comes to earnings in India and how this market has reacted, the analysts may talk about this and next year’s earnings or even this quarter’s earnings and what impacted the market. Markets in the end and rightly so, present value of future cash flows perpetually. Markets never move on this quarter or this year’s changes in earnings unless those changes imply a structural change in longer term cash flows. In this case, it is very evident to everyone that Covid 2.0 is a one off. The risk of another wave remains but it is not something that is structural, that there will be wave after wave in perpetuity.
Since the anchoring is centred around where the 10-year paper is and that in a sense gives valuations for underlying PE multiples, then some would imagine the valuations can be justified because even if the 10-year paper or US 10-year paper goes to 2, US markets can justify a PE multiple of 45-50 which means we still have a long long way to go?
Again no one knows and certainly I do not know what is the right justifiable multiple for a particular interest rate. What I am saying is that when you think of a multiple moving from 15 to 22, you have to keep in context what the benchmark or other asset classes, most particularly the bond market has done. It is like if you think of real estate in Mumbai and if you are comparing prices of Altamount and let us say Borivali and the prices go up 50% at one place, you have to keep it in context of what the prices have done all around Mumbai in terms of real estate. You cannot look at it in isolation.
So to your question on whether at a 2% bond yield, a 40-45 multiple can be justified, I am not saying that it cannot be justified. I am saying let the market reach there. If the market gets there, then maybe it is justified. What I am saying is you cannot logically expect to get the market at the same multiple today as it was as an average over the last 40 years when the bond yields today are not at the average, bond yields are at the lows so how can you expect the market to be at the averages unless the future is really dire or has worsen tremendously which is not the case.
You run a portfolio which in a sense has been centred around private banks, consumer companies and they have done well. In the last couple of years, growth was very narrow and cyclical and industrials were not doing well. Some of the fund managers like you bought for growth and now growth is opening up. Commodities and capex dominated sectors are coming back. What happens to your portfolio positioning when the options are plenty?
Let me clarify a few things. One is, the theme runs the portfolio. Second, we do not run narrow portfolios at all. We are in fact at the other extreme. I have been asked all throughout my investment career, why do we run such broad portfolios? We go out of our way to ensure that we are not dependent on any particular theme or set of themes leave alone a particular sector or set of sectors.
The portfolio that the theme has been running for the last several years is not focussed on any particular sector and certainly not focussed on financials. Having said that, yes we have always found abundant, strong, alpha opportunities in the financial sector because there is a large number of very well run private sector financials where the team usually invests in.
Furthermore, the last two years have been very challenging for the financials. Even this year, financials, year to date, has been one of the worst performing sectors and so was the case last year as well because the pandemic hit affected the financials more than other sectors. Despite having the exposure that it has to financials, the team has performed as well as it has. Over time, various sectors have come into play and gone out of favour. The team has continued to manage a very broadly diversified portfolio that is built stock by stock from a bottom up perspective.
What happens to macro in a top down perspective — be it at a market wide level or sectoral level — is highly unlikely to affect the performance of the portfolio. But what you are saying might be true for some of the other participants in the market who tend to have more narrowly defined, sector focussed, top down thematic funds.
When a particular theme or sector goes out of favour, they might face challenges but we have gone out of our way to minimise the risk. The risk cannot be eliminated but the team has gone out of its way to minimise this risk, not just this year but it has been the case forever, by design.
Where do you see the potential for alpha generation?
We find opportunities across all sectors from a stock selection perspective and have almost every sector represented in the portfolio, barring some exceptions where we do not find alpha opportunities. Coming specifically to your question, one area where at this point in time we are finding many opportunities is new age technology. Some are listing right now but there are some which have been listed for over a decade and have listed during the last decade. They might not be loss-making but they are new-age technology companies and they have been in the portfolio and the team has done very well identifying the winners in that segment and will continue to do so going forward as well.
Secondly, the team has always found a good number of great alpha generating opportunities in the private financials. I underline private financials — be it private sector banks or private sector non-banking financial companies or insurance companies or otherwise service providers to the financial sector.
Thirdly, we are finding and have found over time, very attractive, underappreciated opportunities in the IT services sector. These are traditional technology companies. These continue to be amongst the fastest growing and have the lowest valuations in the market in large cap, but also particularly in the midcap IT services sector. I have often repeated that many people mistakenly have long believed the IT sector to be a mature ex-growth sector and the reason is they are just focussed on what companies and Nasscom says about growth prospects in US dollar terms rather than converting it into rupee terms. There is a 4% odd conversion depreciation of rupee that you have to factor in. So when Nasscom and companies talk about 7% to 9% growth, it is actually 11% to 15% growth when it is translated into rupee terms. That makes it one of the fastest growing sectors in the market and the valuations are not commensurate with them. These are highly cash generative companies and we continue to find and that is at the industry level.
Some of the midcap companies that we own are growing at 15% to 20% and even higher over the next five years post the benefits of accelerated technology adoption after the pandemic.
Fourthly, we are benefitting from China plus one opportunity. This is a real structural shift that started several years ago, not just post pandemic. It started five to seven years ago and could last over decades and it is not necessarily focussed on only one sector but in chemicals, over the last several years, particularly speciality chemicals. It is where Indian companies have strong IP and engineering capabilities and the shift is happening from China, there we found great winners but also in some of the manufacturing related sectors have been great winners and we continue to see the opportunities there.
You mentioned IT midcap and large cap. We are expecting to see strong growth over here but my question is most of these stocks have run up more than 100% in the last one year. Don’t you think the prospects of strong growth are priced into these counters? Where do you see the correct valuations for these counters?
I want to emphasise that this is not like a top-down sectoral call but these are sectors where we still find a great number of opportunities that are undervalued for growth prospects. So while overall as a sector, over the last 15 to 20 months there has been some relative rerating, the market itself is up more than 100% from the pandemic lows and small caps particularly are up from the March 23rd low of last year small cap, BSE small cap index is up more than 200% and midcaps are up nearly 150%. Some of these midcap IT stocks are up 200% even. But relative to the midcaps, they are up only 33% and all valuations are relative. There is no such thing as absolute value.
If I were to talk about IT services or even some of the companies that we own in the portfolio, we believe it is nothing compared to what they ought to be. There is a long way to go because to begin with, they were highly underappreciated and while today there is greater appreciation of the growth prospects post pandemic for IT companies, it has still not caught up with the structural long-term growth opportunity that these companies have ahead of themselves.
has in some sense marked the FAANG moment for India. There is also the other big debate on how to value these companies as they are loss-making right now. Is valuation the right way at to consider investment in these new age internet companies?
For any investment you make, you have to look at valuation because no matter how good a company or business is, it is valued a certain amount. Nothing is valued with infinite or indefinitely high sums of money. So valuation is an extremely crucial leg of our investment process and the same is applicable not only to traditional businesses but also to new age businesses.
Now how you value is important, we for one never look at PE multiples. We focus on the cash flow based approach — so DCF value. We have our own variant of it or a framework which we call OpcoFinco Framework. Now one can argue DCF is garbage in, garbage out. You can justify anything. Yes, but then it is the job of the investment theme to make sure that they do not put garbage in. DCF is a powerful tool and like any other powerful tool, it can be dangerous in the hands of the unskilled, but can be very useful in the hands of the skilled person. So DCF would be the right approach to value this.
Secondly, just because a company is making losses right now, does not mean the present value of future cash flows is zero or negative. Amazon is one such company and I myself missed it and has been one of the biggest learning lessons in my investing journey.
From the late 90s and 2000s, for eight years from 1998 to 2006, I was managing US money in US equities. While I got Google right and invested in it on day one because it was profitable from day one when it came with an IPO. I missed out on Amazon all along because I felt the business does not make sense. More volumes mean more losses but that was too myopic a view. When I analyse my thinking now, I find I was focussed too much on just this year’s and next year’s cash flow. Even then I was focussed on cash flow but only the near term cash flows.
What really mattered in the end game is cash flows in perpetuity or over a longer term and that is how you will have to look at these new age companies even in India. I am not saying everyone would be successful like an Amazon and everyone would make money. Hence you have to invest in every company that is making losses. Remember for every one Amazon, there are hundreds of companies in the US that went bust or whose name we do not recollect and hence do not even bring it up. But selectively, companies would make huge amounts of money. There will be other companies that would make very strong and decent amount of money and then the others that would go bust. So selectivity would be of ultimate importance. We think it is a great area for alpha generation because greater the inefficiency and uncertainty, the greater the potential for alpha generation if you get it right.
Any other misses that you regret? A stock that you did not get on in time or completely missed?
Many of those to really keep count of and not appropriate to mention specific names in the Indian market context. But if I were to think of a particular sector, without taking names, I would say consumer staples, which has been on a tear for the last 15 years or at least since Lehman Brothers consumer staples, has been one of the best performing sectors and from a valuation sensitivity perspective even on a cash flow basis perspective, we have not been able to capture as many opportunities as we could have.
We have several names in the consumer staples sector as we do not ignore any particular sector but from a valuation perspective, it was more challenging to invest in many of those and we ended up being too selective if you will. If I look back over the last 13-14 years since Lehman times, I would say that would be one of the areas where I personally and to some extent the theme also missed out on some of the opportunities.
