What about the new-age start-ups which are hitting the bourses — everything from Zomato to Paytm to Nykaa to Policybazaar. How do you justify the frenzy and the kind of valuations that some of these companies are hinting at (or trading at in the case of Zomato) given that they have not seen profits yet?
This is always going to be a challenge when you analyse a new business, but think about it this way; we are seeing one of the largest companies in India create a massive telecom business which now accounts for maybe a third of the total valuation of the company and they were giving the service away for free for almost one-and-a-half or two years. So it is not so unusual for us to see companies which do not make losses in their early years but as they scale up their business to a more sort of higher scale, they are able to bring in the profitability. So I would not get carried away just by looking at the red in P&L. We have seen this in many businesses in their early days.
Now the way to think about this is are they able to make money at a positive contribution level and are we able to see an addressable market whereby over a period of time, they would be able to generate significantly positive operating cash flows. What we are missing in some of these businesses is that they do have such an opportunity. Now to be very fair, these are early days for some of these businesses. We do not know how many of them will actually go to take leadership positions in those businesses so we got to be cautious in terms of identifying which of these companies we might choose to put into our portfolios. But I think there is a case for investment and one will have to look at some of these in the context of the overall market opportunity and whether these companies are close enough to getting to a stage where EBITDA is positive and cash flow is positive. That is very important.
We want to see positive operating cash flows. Forget the reported P&L being negative, the operating cash flows need to be positive and as long as you can scale the business, eventually your profits will start to come through. So, those are the elements one has to keep in mind, the addressable market, the contribution margins and the ability to scale that EBITDA. Profitability will come in due course and we have seen this so many times in the past.
You do not think it is a good idea to buy into IT but do you think that this could be a multiyear IT cycle where the earnings will continue to surprise us?
It is possible, I am not a soothsayer. I loved IT in 2017-2018 when I could get them and free cash flow yields were higher than what bonds could pay me. We always knew that these were some of India’s most competitive companies. They had proved their ability in the global environment. How many sectors do we have where we have world champions from India? So this is clearly one of them and therefore we have been positive about this entire area for a very long time.
But there is a price at which you are happy to be positive, there is a price at which we are happy to be holders but no longer willing to allocate additional money in that sector. That is where I am coming from. Growth may be strong as companies have been telling us about this for a while, but it eventually remains a B2B business and arguably the run up in valuations is already telling you that the market is starting to price strong growth that could come in the near future.
Our thought process as value investors is to hold back when the market is looking at near term growth because it is no longer concerned with valuation. But given that their valuations moved dramatically in the IT sector over the last three years, it is not something where we want to deploy additional capital.
We own quite a few companies, we are happy owning them and we will continue to own them but we would not put more capital.
One thing which puzzles me is that why markets are still not very excited about owning banks. The historical template is that the economy will be back, banks will do better,. But that somehow is not the template right now banks or markets are working with?
That is a fair point and I would agree with you that if you are bullish about the economy then eventually you have to believe that credit growth will happen. Maybe I am not so positive about the capex cycle, but what if I am wrong and the capex cycle does kick in with a vengeance and you combine that new job creation and income.
There is absolutely no reason to not believe that there will be a strong credit cycle as well which should benefit the financials. So hard to put a finger on it say why the financials have been the way they are; I think a part of it is historic. In the past, many of the financials have disappointed in terms of their ability to navigate credit cycles. But I take a lot of comfort in the way we have seen companies behave through this entire pandemic cycle.
Once they preempted and started providing for potential losses in their books in the past cycles, many of them actually waited till much later in the cycle to provide. Secondly, they were also pre-emptive in terms of raising capital early. So I believe that at this point of time, the market is not excited about financials. So be it, it does not concern me. That is actually giving me an opportunity to keep nibbling away at a handful of banks which we think are very well placed. They have got a strong balance sheet and when the opportunity to grow comes, these banks will be able to put their foot on the accelerator and surprise in terms of growth. It is literally a mirror image of the kind of view I described on IT where when there are so many concerns about growth and valuations, they start to look cheap. We are far more comfortable deploying additional capital to work in that sector as compared to IT where we have seen the valuations go through a very different cycle.
We talked of a similar environment in 2014 when Prime Minister Modi got elected, everyone thought a new capex cycle has started and it will be a multi-year phenomenon. Markets got it wrong. How is this time the promise of a new capex and investment cycle different?
I have not really been very bullish on a strong capex cycle in India for many years now. I think we just had such a massive capex build out in the previous cycle and positive factors to drive that same cycle do not exist at this point of time. Also, look at the data. Today the power sector is still operating below capacity and therefore there is no large investment required there.
There is also a shift of technology happening and so many contributing factors which perhaps result in a situation where the traditional capex is unlikely to happen with the same vengeance that we saw in 2003 to 2008. I also think we are guilty of anchoring.
The 2002-2010 cycle was very different, it had some unique characteristics and what we should not do is continuously anchor to that to look for the same cycle this time around. Every cycle is different and I think one of the interesting things that I see is that this time around, when we see capex, when we look at the data for FDI, India seems to have done extremely well. Massive amounts of capex are coming in but it is not coming in infrastructure, heavy industry areas. It is coming more on the services side.
It is actually quite interesting because we want capex as we want physical infrastructure. The construction of that physical infrastructure creates a lot of jobs for low skilled people, now we are creating those jobs for low skilled people in the services arena. So when you look at all these internet and these unicorns that have come up, they are not necessarily using highly skilled manpower. They are using the same kind of manpower which historically may have been used in the construction side in these business models.
So we have to be a little bit careful here. If we keep looking for capex in the way that we understood it 20 years back, we are missing the fact that the nature of the economy itself is changing. So I would not look for the same kind of large investments in physical capex as they happened in the previous cycle because every cycle is different and the nature of the capex is different.
