In every country, the market has rallied in the last 16-17 months — be it India, South Korea or Taiwan. Which market do you think holds the most potential now?
We have always believed that in the very near term, the market is impossible to predict and is hardly any different than a coin flip. When people say it is very difficult, they mis characterise the problem because very difficult is something that can be still done, but impossible is something that just cannot be done.
Over the long term, markets worldwide have tended to deliver returns that are more or less in line with nominal GDP growth rate plus dividend yield. India’s nominal GDP growth rate is expected to be low double digits going forward and similar would be our expectation for the market return in rupee terms.
What makes India such an exciting market is that it offers the highest alpha generation potential compared to any sizable equity market around the world. While there are strong opportunities across the market capitalisation spectrum, India has a diverse mid and smallcap segment which is relatively less well researched and hence more inefficient, thereby providing higher alpha generation potential.
When one thinks about the total return of a portfolio, it is a sum of market return and the outperformance or alpha. While market return is more or less the same across every market, in India’s case, the potential to generate higher alpha or outperformance is higher. Since total return is the sum of market returns plus outperformance, India offers the potential for greater total return than the developed world and a lot of the emerging markets as well.
How risky is it to enter the market or stay in the market right now?
Equity markets always have risks, and currently it is no different. The nature and kind of risks may vary from time to time. Just because the market is at an all-time high, that does not mean it is expensive.
Valuations are very important while investing, but in our view, all valuations are to be assessed in relative context. Indian equity valuations are correlated with US equity valuations, which in turn are the function of US bond rates among other parameters. This relationship between the equity market and bond market is very fundamental in nature, since interest rates used for discounting long term equity cash flows are a function of long bond rates. If we contrast the evolution of long term bond yields and PE ratio in the US over the last few decades, it provides some interesting insights to understand the increase in equity market multiples in the US and globally compared to the past few decades.
For instance, the US 10 year bond yields have been steadily declining from a high of mid-teens in the late 1970s following a decade of high inflation and elevated inflation expectations. Even in the mid-90s, the 10-year bond yield was 7 per cent, implying that the bond was trading at a multiple of approximately 14x.
At that time, the S&P500 in the US was trading in mid-teens. Today the bond multiple has gone from 14x to 75x (current 10-year bond yield at 1.33 per cent), whereas S&P500 PE has moved to low 20s. I am not suggesting S&P should be 75x, but just putting it in context that equity markets have not become expensive relative to other asset classes, particularly the bond markets, which is the largest asset class and also the benchmark for all other asset classes.
If for whatever reason, the US long bond yields were to shoot up to 3-4 per cent or higher, then the bond multiple would correct from 75x to 25-30x or lower, and in such context, it is possible that equity multiples globally might also come under pressure. We are not suggesting that bond yields are likely to move higher any more than they are likely to move lower, but we are only highlighting what is the most obvious risk to global equities at any point in time, all else being equal.
Can you tell me a bit about your portfolio? What kind of stocks do you hold which have existed in the near term and other information on that?
At White Oak, our investment philosophy is that outsized returns are earned over time by investing in great businesses at attractive valuations. To be considered great, a business should possess the following attributes: (a) have superior returns on incremental capital, (b) be scalable and; (c) be well managed in terms of execution and corporate governance.
Our team is very stock selection driven. We do not make top down thematic or sectoral calls, as those are drought with risk without adding to returns in our view. Having said that, given our philosophy, there are certain sectors where the team might find more attractive opportunities compared to other sectors from a bottom-up perspective. At present, the team finds a greater number of opportunities in private sector financials, IT services, speciality chemicals and certain consumer discretionary industries.
In private sector financials, there is this debate on choosing between corporate focussed banks and retail banks. What do you lean on?
In our view, it does not matter whether a bank is corporate focussed or retail focussed. In banking, what matters more is whether the lending business is being conducted in a risk-prudent manner and in doing so, whether superior returns on assets and on equity are being generated on a risk adjusted basis.
If you look at the larger private sector banks, the perceptions on retail or corporate focussed have become stale and irrelevant. Besides understanding the asset side, it is very important to focus on the liability side. The strength of the liability franchise often determines the business you can drive on the asset side. If you have a weak liability franchise, then your cost of funds would be higher and to earn a reasonable margin or spread, you would have to do riskier lending whether retail or corporate. The financials that our team owns, typically tend to have the best-in-class liability franchise.
Do you recognise cryptocurrencies as an asset class or do you see it just as another mania? Are you invested in it?
We have not invested in cryptocurrencies, personally or for clients. Five years ago, I would have completely dismissed it as a fad. It has thrived for much longer than I thought it would survive. It does make me wonder whether we are missing something and whether we should make a greater effort to understand the asset class. But from what I know today, which is dangerously little, I continue to believe that the prices of these crypto currencies are driven by speculative activity rather than fundamental value.
What about smallcaps? Where do you stand on them?
Some pockets of the market, especially in the small cap segment are being driven by the heightened retail activity. At the risk of generalisation, it seems to be particularly the case where the quality of corporate governance is weak. The more volatile a stock and weaker the governance quality, the greater seems to be the retail investor interest in some of these names.
In the recent IPO boom we have seen some loss-making companies like Zomato, Devyani International landing on Dalal Street and they have generated huge investor interest. Is it a sign of maturity in the market or a sign of exuberance?
There is still a lack of familiarity among Indian investors when it comes to evaluating loss- making initial public offerings. It is very different from the US, which has a long history of loss-making companies going public. However, the Indian market is gradually evolving to a stage where it can assess and evaluate IPO companies which may be currently loss making.
One must recognise that just because a company is making a loss in the near term does not mean it is worthless. For example, now everyone seems to think it is a no-brainer to invest in the FAANG stocks. But the majority of FAANG stocks were loss making when they got listed.
In the US, in the last 20 years, there have been more than 2,000 IPOs. As per one study, nearly 60 per cent of those IPOs have been for loss-making companies. Moreover, they listed at an average gain of 18 per cent compared to profit making companies which listed at a gain of slightly under 15 per cent. I am not suggesting that all IPOs of loss-making companies are good investments and investors should jump at them. But just because a company is loss making is not a sufficient reason to ignore or rubbish it.
So you would not be afraid of investing in the likes of Zomato and Paytm?
Our team evaluates every company on its merits and would not discard an opportunity just because it is loss-making currently. The fundamental valuation principle does not change regardless of current profitability. The value of any business is the present value of future cash flows. What really matters is the long-term cash flow generation potential; near term losses have less meaning. Therefore, a thoughtful, bottom-up consideration of expected future cash flows of each individual company is of paramount importance rather than a top down approach of discarding loss making companies currently.
To be more specific, our team has invested in the past and remains open to evaluating companies that are loss making at the time of investment. This is true as long as such companies possess the attributes of a great business mentioned above, where our analysis suggests that current losses are temporary and long-term cash flow generation more than justifies current valuation.
