Below is the verbatim transcript of the interview.
Q: How does it feel at the end of what has been a really good three months? Do you think valuations are justified right now?
A: The valuations, if you look at it, on the face of it, it looks a bit on the expensive side, but then you have to look at the potential to deliver growth and we are very bullish on the growth that is possible, primarily because the starting point is quite low. After a long time, under a very stable political environment, we see reforms happening which will have far reaching impact. So therefore, the growth potential of this market over medium to longer term looks very good. Therefore, although the valuations looks a bit on the fair side, buy we would pay up for it.
Q: When is the starting point of that growth? I speak not about gross domestic product (GDP) growth, but earnings growth. Last 2-3 years have not been great. Every year, we think this is going to be the year of 15 percent plus. Are you optimistic that the tide turns with this current year?
A: It should turn in the current year. In fact, if you look, the global environment is quite supportive. If you look at the global profits, since 2016, they are growing. Now, when we look at India, we must also highlight, if you look at Nifty, about 40 percent of Nifty’s profits are linked to global profits. That should do well.
Now come to the domestic part of it. Now domestic part, because of the large banks and they have been facing a lot of non-performing loan (NPL) issues, their profits have been subdued. But hopefully, by the end of this, when this quarter results come out, hopefully most of the resolution issues at least will be behind us.
Q: For even the corporate lenders? You think banks like Axis Bank and ICICI Bank will draw a line at the end of this quarter?
A: It is quite possible that they recognise those NPLs. Therefore, we would not expect slippages to go up from here. It is already very high, the stock of NPLs. However, what might not happen is that recovery and upgradation might not happen. That is probably towards more like FY19. But in the meanwhile, there are certain pockets in the market where we are very optimistic that those can take over and I can about a few.
For example, one of these reforms that the government is pursuing, the end result is formalisation of the economy and the most large impact you are seeing in the financial savings part. So, the financial saving part. So, the financial savings is going up. As a result, a lot of bank deposits are flowing into the mid-sized banks. Now mid-sized banks will have lower cost of deposits. They do not have legacy issues. So, they can grow their loan book aggressively, particularly even the large banks are struggling. So that is one spot where we think earnings can grow.
Q: Mid-sized private banks?
Q: Not public sector banks?
Q: So, the DCB Bank , RBL Bank , Federal Bank , those kind of banks?
A: We are looking at slightly bigger mid-sized private banks. Because of compliance reasons, I will not be able to name any banks, but slightly bigger than those mid-sized private banks.
The second segment where we think although it is not a part of Nifty as yet but where we think earnings can grow quite strongly, a lot of money is going to bank deposits, but if you look at the delta, most of the money is flowing in mutual funds and insurance. So we are very bullish on wealth managers, asset managers, some of the slip brokers and insurance companies. We do think the earnings will recover very strongly there.
The third opportunity is in formalisation like certain sectors like jewellery, apparel, plastics where the informal sector is very large and very fragmented. Because of this formalisation initiative including goods and service tax (GST), we do see the listed corporates where are already organised, they will have a heads-up, they will not only gain with the market, but they will also gain market share.
And of course, last but not least, this came out recently on this new circular in affordable housing. Now of course, we need to wait and see how much government really allocates in those schemes, but potentially, it could be a game changer because real estate is about 10 percent of GDP and real estate was not moving. That was one of the main reasons why capital formation and the capex cycle was down. But if this scheme is expanded, government allocates more, this can set off a construction cycle and the construction value chain you can then play and you can also play housing finance companies, you can play construction companies, cement companies. You can also play select real estate companies with balance sheets who can potentially benefit from this.
Q: What about housing materials like ceramics or these kind of names like plywood and paints?
A: Absolutely, you can absolutely play those segments. In fact, those segments will have twin benefits. If this scheme really takes off which we think it will, not only the demand side gets a boost, but particularly ceramics, plastics, cables, wires, light, electricals, in these sectors there is also a lot of informal businesses are there which we think may have a tough time dealing with GST at least transition wise. So, the organised companies, the listed companies sector will benefit not just a market growth, but also they will benefit from market share growth.
Q: Do you see GST as an opportunity? Do you think it will throw up opportunities in these pockets in terms of even temporary aberrations?
A: It could because GST frankly, we do not know what the rates are going to be. So, depending on what rates, what is classified, what is expected in the market, we do expect there can be short-term aberrations. Also there could be certain de-stocking, re-stocking depending on where the rates are classified. So, there could be short-term opportunity. Our view is that GST, if you take a slightly medium to longer term view, 6-9 months view, it is a big positive. Therefore, we would just probably ignore those short-term noises that may happen.
Q: So, these are two big clusters, one is organised to unorganised and another is basically the financial inclusion space.
A: That is right. And also construction related to housing and the finance of that.
Q: Any other major theme in India which you can play with some degree of certainty?
A: These are the themes which we are incrementally more positive on. The other theme which we have not always been playing in India is about aspirational consumption. And with rising income levels, rising middle class that is the most talked about and most owned story, but that story still remains intact. Therefore, if you look at something like a passenger car penetration in India, still very low. White goods penetration, particularly air conditioners, washing machines, still very low. So, the consumer discretionary part, where particularly we are looking at passenger cars and white goods, that is one segment we have been bullish and we continue to remain bullish more so because of all this fundamentally positive things that is happening.
Q: What about the global plays where you started off by saying they will contribute to earnings because of the global waves. But if you had to play between commodity related plays, IT and pharmaceuticals and chemicals, four different clusters, which ones would you be in that pecking order be more bullish?
A: If we take a next 6-9 month view, one has to be more bullish on commodities because if you take a step back from what is happening in India and look at Asia or the world, a lot of this reflation trend is happening due to China. In 2016, when the world was not such a great place, it is China who stepped up the stimulus and in this year, they have kept the world going by doing supply side reform. So, therefore, commodity prices are inflating and that will obviously be reflected in the results of those companies who are listed in India. That is number one.
With respect to IT and pharmaceuticals, frankly, in IT we were bullish at certain lower levels, but since then, the rupee has appreciated a lot. In fact, even our expectation we were not thinking that rupee will be this strong so soon. So, that will have some negative impact on IT as far as concerned, but still IT is not expensive. There is certain level of value in IT. I do not think results will be blockbuster, but return wise, although they will give returns, but they might underperform the markets.
Coming to pharmaceuticals, that is actually where we are quite negative on the large-cap pharmaceuticals, particularly the largecap pharmaceutical companies which are exposed to the US, not just because of regulatory concerns, those are there, those will be there, we cannot take a call on it, but if you take a look at US generic pricing, those have been under pressure and that will reflect in all the numbers. This problem is compounded by this regulatory uncertainties. That said, within pharmaceuticals, there is a small space where there are certain pharmaceutical companies predominantly midcap companies who are exposed to India as well as other emerging markets where they sell branded generics. That space is still alright.
Q: And chemicals, the last one?
A: Chemicals, I would look at it as a part of the commodities value chain. With chemicals in particular, where China has clamped down the most. So we do think we will see good earnings accretion in that space as well.
Q: Any other niche domestic spaces because I was looking at your portfolio and I saw a rating agency. Something like that which does not have a very large stock universe footprint, but can you identify some smaller spaces like that?
A: I will go back to the second theme I mentioned because when we talk to our peers or investors, we do think that this theme is not as well recognised as it should be and this is where we believe we also kind of differentiate ourselves. We mentioned that about financial savings growing and bank deposit is more of a known story. Of course, the benefits can still play out. But this savings is also going into mutual funds and insurance.
So, one needs to play the wealth management companies. One needs to play the asset management companies. Now, wealth and asset management companies, these are smaller companies with market cap of USD 2 billion thereabouts, they are not part of any index. The beauty about them is let us say, think about a wealth management company, maybe they have 100 relationship managers (RM) and maybe they have USD 10 billion under management. This USD 10 billion can be USD 20 billion with just 110 RM. So, look at the profit accretion that is possible.
Similarly, for asset management companies. Maybe 5-10 member team managing USD 5 billion today. It can be USD 10 billion tomorrow. So, those are the very exciting spaces. They are positively levered to our positive view on the market.
And insurance, because we think that in certain insurance companies there could be potentially quite large upside to margins particularly the ones who are selling more Unit Linked Investment Plans (ULIP) today. As they start diversifying the product mix, sell more production related policies and we do think the market will mature to those extent. Their margins can move quite substantially. Thus powering their earnings. So, that is one segment, a niche segment in the sense they are not very popular, they are not into any indexes as such, but that segment going forward will do very well.
Q: I have to ask you about telecom because that most asset managers did not like to own for the last many years, but it has come back on the discussion table at least. How do you feel about it?
A: Telecom is one domestic sector where we continue to remain quite negative. Telecom any other day to us, I know that there is the Bharti brand and Idea brand and Jio brand, but to us it is a commodity. It is about who can produce how many minutes. So, right now, there is a capacity war. The new players are coming with a lot of minutes and at the same time, your usage of course cannot grow that much. There was some hope in data, but the pricing has gone for a toss.
So we see for telecom companies there will be a lot of pricing pressure and to keep good customer service they have to keep investing. So, we see falling margins, higher capex resulting into lower return on equity (ROE). And some of them may be good value according to some people, but we are predominantly growth investors. So, that value does not excite us as much. We need to see a long runway to growth where we can buy stocks and sit quietly for the next 2-4 years, telecom does not give us that comfort at this level.
Q: You do not think this current wave of consolidation will help in anyway?
A: It will help marginally, but capacity needs to go out of the system. I will give you an example. Think about aviation. That market was struggling big time. It took one player to shut down and go away, no takeover, no consolidation, shut down and go away for the market to come back. So, we need capacity going away. Because of the merger of A and B, the capacity is still A plus B. So people are not really walking away. So we need capacity going away for us to have a more constructive view on telecom.
Q: How do you feel about aviation since you mentioned it?
A: Aviation is too hard for us actually because if you do go through the when you try to predict financial of aviation companies they are so sensitive to utilisation, oil prices, US dollar that you can expect USD 1 earnings and they can end up giving a minus USD 10 or plus USD 10, you would not even know. So, it is good for people who can take that kind of volatility. We certainly cannot. We would rather like more businesses which are more predictable where we have hang of the business, where we can predict the financials to a certain degree of accuracy. Airline is just volatile, the financials. As a thematic, it may be alright, the markets are consolidated, there are only few airlines now left, but the inerim financials for us is just too volatile.
Q: Let me ask you about oil and gas separately. Downstream companies, where do you stand on that now?
A: The downstream companies are actually doing quite well. Within the downstream we do think they have done a good job by maintaining their marketing margin and refining margin of course, it is a global thing. But global refining margins have been holding up. The good thing about these companies are there was apprehension in our mind also that can they sustain with these kind of marketing margin. To our surprise they have. They are generating good cash flows, they are paying good dividends, the stock valuation is not as expensive. So, the oil marketing companies provide some sort of stability in your portfolio.
You need certain companies which will provide you very stable returns. Of course, their reported earnings have been volatile, but if you look through the inventory losses, just look at the core recurring earnings that has been very stable and valuation is reasonable, good yield. So that is for the stable part of the portfolio.
Q: Are you a supporter of this mooted plan apparently which is doing the rounds of upstream plus downstream merger or does that scare you?
A: I have to admit that neither me, most people do not know the contours of the plan, but based on what has been talked about that Oil and Natural Gas Corporation (ONGC) buys out Hindustan Petroleum Corporation’s (HPCL) share or something like that, if that happens without any management change, in that case, I do not see that as a big issue because HPCL operates as an independent company and so does ONGC. It probably helps government’s fiscal balance at the end of the day.
So, currently our sense is that all this merger and acquisition (M&A) or consolidation talked about is more like investment wise, not so operational wise. Therefore, that should be alright. If it were to be operational wise, then we need to step back and think it afresh.
Q: And what about gas? Things like Indraprastha Gas (IGL) or Petronet LNG , do you track that space?
A: We do track that space, but our sense is that the valuations in those spaces are quite expensive and let me just spend a minute on this point because I mentioned earlier that we are growth investors and valuation, even if it is expensive but the growth is there, we will pay up. Now, we note that if you look at the companies that you named in the gas space, these are utility businesses. They have to deploy significant capital for the next leg of growth. So, in our investor framework, we will pay up if the asset turn keeps growing. In those businesses, by nature of that, that may not be that easy. So, therefore, gas businesses, we were bullish. We played them for some time, but currently in that space, the valuation looks very expensive in the context of the capital they need to put for future growth.
Q: We have spoken for about 15 minutes on India and we have not said a word about infrastructure. That whole space, capex related, corporate capex, is it an avoid or can you still take bets saying that maybe four quarters down the line, things will start moving.
A: That is the tough one, because the corporate capex has been also poor, not just because of domestic environment, but also global commodity prices were low. That has changed about a year back. So, as people get back confidence that this is going to sustain, we can see some amount of corporate capex comes back, but having said that, there is a lot of capacity already in the system. We mentioned about the imperial issues, those need to get resolved first. We hear from time to time that there several committees working on it. So, we will see what happens. But even if you look back into the last bull market, 2003-2004, what really sparked the capex cycle was the household capital formation, the physical real estate part. If we had this interview about two weeks back, we wold have said, real estate also we are not seeing anything. But now that this scheme has come, are very hopeful that it is the real estate that will kick-start the capital formation cycle. Therefore, if you want to play infrastructure at the construction companies, first one could start with playing that real estate value chain. That is somewhere we are quite bullish and real estate has a huge multiplier impact. That fuels demand of a lot of things. So, maybe that going forward, maybe in 2019 maybe in 2020, can fuel further capex. And for big ticket capex to come back in steel and in refining, these global commodity prices need to be sustained. And for that, one needs to take a call how far and how serious China really is about this consolidation. We think it will continue, we think prices will remain quite solid, but it is the Indian corporate sector who needs to take that call.
Q: So, you would be more bullish on construction related to real estate rather than infrastructure spaces like roads and ports.
A: We are bullish on roads, on ports as well as housing. We would stay away from the listed corporate capex driven stocks, sectors or companies so far because so far, there are no signs that they are making a comeback because firstly, deleveraging needs to happen. After that we can think of releveraging. If anything with higher risk appetite wants to play that space, they need to look at deleveraging plays. They need to look at NPL resolutions how that happens. After that, you can think about releveraging and corporate capex coming back.
Q: What is your take on cement?
A: Cement has been a very favourite sector. It is a great play on infrastructure and the roads and the housing that we were talking about. At the same time, corporate capex not happening is a bit of a drag. Therefore within segment also, we look at companies which are somewhat cheaper which have good regional exposure, the region that we like. We also look at companies which can have certain operating and financial leverage. Those are the kind of cement companies that we like. Certain cement companies, especially the top ones by now are quite expensive.
Q: What is your preferred solution to this NPL problem because if the market got a realistic credible NPL solution today, the chances of a rerating are far higher? What do you think would be the most acceptable solution because there are two or three which are being spoken about?
A: The solution hinges on one key point. You can form asset management companies and whatnot, but what is the valuation of those assets today? And if the valuation is 80, not 100 as in the books, who takes that haircut? That needs to be decided and how the haircut is split between the promoter, the bank and other stakeholders. That needs to be very well understood.
But our sense is that once that happens, the situation after that can be quite good actually. What we are not sure about, if there is a write-down, how the PSU banks will handle it, because they are already quite weak on capital and they would definitely need more capital. So, it is the government, the government is the ultimate owner of those banks. So, they need to take a call on it. But should a call be taken and those problems are ring-fenced, haircut taken, after the banks are recapitalised, then the deleveraging play we spoke about, that will be like on in its full force.
Q: So, after such a strong start to the year, what is the biggest risk fear that you have? What could derail this kind of momentum that we have on hand right now?
A: If we think about the global level, if we go back to November, when the US election happened, the fear was that we will protectionist policies from the US. So far, we have not seen that, maybe the probability of those policies of reduce has not gone away. So one has to be mindful of that and if that happens, that will not impact India so much fundamentally but sentiment of the emerging markets can definitely sour. So, that is number one we have to watch out for. Domestically, for around the GST implementation we do expect some teething trouble to happen depending mon which good is classified and which basket, there will be destocking and restocking, so that is something one has to watch out for.
And then of course, every year, around June-July, we look towards the sky and watch how the rains are going to happen. Although we have to say that the importance of rain to the Indian economy has been diminishing, but still at the end of the day, after such a good run, it is going to be a sentiment driver. So these are the three things that we are watching out for. But having said that, the themes that we mentioned, whether it is mid-sized private banks, whether it is wealth asset managers, whether it is organised sector gaining market share or housing and road related infrastructure companies, they have a very good long growth runway. So, there may be some volatility from time to time, but we do not think any of these events, the risk factors that I mentioned, alters the big picture, 3-5 year growth outlook.