Alpha Moguls | Why ValueQuest’s Ravi Dharamshi Thinks Falling Valuations May Drive Markets

Clearly, we are in tough times and creating alpha is a challenge. Absolute returns are a bigger challenge—of course, you can create alpha by falling less than the markets.

But having said that, like you mentioned, Howard Marks’ framework for market cycles. It is very important for a person to understand where we are in the cycle. In terms of economic cycle, we could see the slow trainwreck coming our way, that the economy was coming to a grinding halt. Till the post-election budget, markets were still hopeful that we will see some amount of stimulus being given to the economy and that would have rekindled the spirits, but I guess lack of that is really what is hurting—one is the continuation of the credit crisis and the other is the lack of stimulus.

So, I don’t think if you ask 10 people on the street who are in markets or businesses, anybody will tell you that times are tough. So, it is very clear that we are in downturn of the economy.

Where in that downturn are we is the challenge. We started slowing down in terms of passenger vehicle sales since September 2018, when the credit market also froze up a little bit. We are now almost 12 months into that cycle. In terms of market cycle, I think midcaps have been correcting for the last 18 months. In the last two decades of my career, I have not seen a downturn which has been more prolonged than this. We have to go before 1999-2000—1994 to 1997 were the three years when the market, in terms of midcaps and smallcaps, was really worse than the past 18 months.

That gives you sense that this is not something new, market cycles have been worse.

But there were still some hiding places, till this budget. People were getting more and more committed to the top 30 stocks, but there’s no more scope to hide there as well. Maybe, from the large caps’ point of view, the downturn has just begun, but from the midcap point of view, we are way into it.

The upcoming festive season is likely to be a bad festive season, and I think most market participants—be it businesses, corporates or investors—are aligning themselves to the fact that there is a slowdown coming.

If that is the case, in terms of valuation and in terms of market cycle, we can probably say that we are probably a quarter or two away from bottoming out. But the last bit is the most challenging always, and that tests your conviction to the core.

The reason why markets might turn, despite the economy doing badly, is that we will reach such valuations, we will hit such a trough in valuations, that people will stop thinking about the next six months and start thinking about the next 3-5 years. Usually, that’s how the bottoms are made in the market. In hindsight it will so turn out that you would’ve have bought at multiples of single digits for the business that can do well over the next 4-5 years.

The economy may be grinding to a halt, but markets and economy are not 1:1. The markets are moving ahead. Markets have been falling for the past 18 months because of bad news after bad news, but at some point it will outrun itself. We will have excesses on the downside as well—right now, that looks like the scenario. The floor will be provided by absolute valuations and not by economic news.

Before you get into the question of portfolio, you have to think about asset allocation levels. A lot of people are frozen because they are seeing 30, 40, up to 50 percent cut on the stocks they have bought. But first you have to ask—‘Am I over allocated to the equities or am I under-allocated to the equities?’ If I am over-allocated, then I need to bring down that allocation. And if I’m under-allocated, then I don’t need to worry about a company that is probably giving me a quotational loss.

Then check whether you are going to face any kind of permanent capital loss in any your holdings. To avoid permament capital loss, I’d say you have to get rid of CRAP in your portfolio. That’s an acronym I have come up with. CRAP means any company that is facing corporate governance issues, or any company that is facing regulatory issues—basically, an average business or average management that you have overpaid for thinking there is a bright outlook—or if there is a permanent disruption happening in that business.

So, if you are holding such companies, I think it makes sense to get out even at this point of time. This is not to cause panic and I am not saying this is a cash call. This is basically to strengthen your portfolio for when the next upcycle happens. You have to get rid of the dead wood, water your flowers and weed out the bad. You have to get rid of CRAP and bring in companies that are built to last—provided they are available at good valuations.

Now, what do I mean by lasting companies? They are those that have a long runway—they have some kind of advantage in terms of business, their (business) model is scalable, and the issues they are facing are temporary. So, growth issues or margin issues are not going to scare me out of a company just because the next 3-6 months are bad. I think we have to start looking beyond that.

All of this (is) in the backdrop of valuations being reasonable—if you are carrying high-valuation companies (in your portfolio), then you have to think twice there as well.

You should prepare youself for bad headlines over the next 3-6 months. Markets are a forward-looking animal, they have already seen it (economic downturn) and that is why it is behaving the way it is. But if you are not allocated to the extent where only that amount of money is invested in the market, then it is not going to matter to you.

Okay, so your compounding is going to be delayed by a couple of years, but it is your permanent allocation to equities that can withstand your lifestyle over the next 2-3 years. Then it doesn’t matter, right, if the stock prices are going down? You have to be able to live with the bad times, if you want to enjoy the good times.

At the same time, you can start strengthening the internals of your portfolio rather than staying with the losers of the last cycle. You can try and realign your portfolio to, hopefully, the winners of the next cycle. That is easier said than done, but that should be the endeavour.

And if look at it that way, then you will not feel bad about selling off a stock, which is 50 percent down from your cost price. The exit decision has got nothing to do with the price at which you bought (the stock).

Price is only a trigger. You should investigate it further. Is the stock facing existential issue due to some regulatory issues or because of some leverage or disruption? If it is not an existential risk and just a temporary blip and the company has 10-20 years of growth ahead of it, then you might have made a mistake in your entry point. But if you have not made a mistake in your company selection, then it is definitely one you should be buying.

As I said before, the economy turning around would be a lagging indicator. I don’t think it would be leading the market.

The first indicator will be valuations, and those kinds of mouth-watering valuations will be accompanied by some big event somewhere. It can be a Lehman-like moment at home or a global crisis panning out somewhere. At this point of time, it is very difficult to imagine what that event would be, but valuations would bottom out alongwith a major event happening.

RIght now, we are in the mode of preparing ourselves for something of that sort, and it could happen over the next six months. I think, along with that, we should bottom out. And suddenly, those old valuation parameters will come back, whether you are talking about replacement or multiples, which will be way lower than what you have been accustomed to over the last few years.

All we need is one good quarter and suddenly prices and everything will come back. So, be on the lookout, don’t anticipate. But I think it will happen and the markets will behave that way and some markets will bottom out.

Everything, all of those, are contributing factors—no doubt about that. But as I said earlier, if I come back to this budget, I don’t think this surcharge on FPIs or some of the other budget announcements were the main reasons for the market fall. I think it was more to do with the lack of stimulus for the economy and the continuance of the credit crisis. These were the two issues that the market was keen for a resolution, but that did not happen.

The government has been a little too nonchalant to concerns of market participants and I think I am disgruntled at a personal level rather than at the market level.

So yeah, those are the things that are adding to the issues.

Not necessarily asset quality issues, but definitely growth issues are affecting the perceived large-quality private bans, which have declared their earnings. They are definitely sounding cautious on outlook, and that is contributing to growth slowing down.

While others, for example the public sector banks, they do not yet have growth capital. They still have only survival capital. The budget did provided them with Rs 35,000 crore from the total of Rs 70,000 crore. We can only presume that the Rs 35,000 crore will be growth capital—as that’s what Arundhati Bhattacharya mentioned.

See, right now, there is a credit freeze. My money is stuck in working capital or some projects and we still are in the develeveraging cycle. This cycle needs to turn around, and for that to happen, banks need to go out and start lending and credit growth needs to pick up, essentially.

Right now, leverage has become a bad word. RBI has done its bit by providing liquidity, but what we need to do is build confidence in small businesses, confidence in terms of lending to NBFCs. That confidence is missing.

Over the next few months, we will get to get to see whether the likes of DHFL and Yes Bank are able to raise long-term equity. That’s the only way out of this. If they manage to raise equity, and even corporates like ZEE are able to do so, that would provide some kind of bottom to the market temporarily because the confidence will start coming back to the market.

Finally, if you have equity then you can leverage on that. Those are some of the signs that I would look out for—whether the markets are bottoming out or not.

From the banking space point of view, corporate banks are the ones to watch out for. Corporate growth has not picked up for a while. These banks do not have that kind of liability-side issues. Everything is pointing towards them. They are growing upwards of 12-13 percent in the foreseeable future. If they grow 12-13 percent topline, then they end up growing their bottomline anywhere between 15 percent and 20 percent. The Return on Equity can start moving upwards of 1-1.5 percent. From the next-two-years point of view, I will position myself for corporate banks versus retail banks.

Absolutely, because the cycle is a downcycle. We are still trying to gauge whether the asset quality cycle has peaked or not peaked. May be there is a new round of NPA cycle which is beginning. Smaller banks have lot of chunky accounts. One of those accounts can cause big turbulence in their overall balance-sheets. The slowdown itself can trigger a new wave of NPAs and that is worrying markets at this point of time.

A two-part view—one on capex cycle and one on cement.

I don’t know whether we are going to see a capex cycle like the one we had in 2003-2010. Steel, power, telecom and cement drove that capex cycle. Thermal power is not coming back, neither is steel. The steel sector just went through big rounds of merger and acqusitions. So there will be no fresh capex. There will be some maintenance capex. In telecom too, besides 5G, companies need only enough capex to maintain quality levels and subscriber shares. If that is the kind of situation, then overall capex cycle is not going to be easy to revive.

Having said that, there are pockets which can do well.

For cement, even if the sector grows 1X or 0.8X of India’s GDP, then that is okay with us. Even if it degrows from hereon, then that is also okay. The bigger factor in cement is pricing. Last year, they had a double whammy as the costs went through the roof and they could not raise prices. This year it is reverse. The costs are coming down and companies have managed to raise prices. They increases the price by Rs 80-100 around February of this year. More than 50-60 percent of price hikes have been maintained.

We are now in the lean monsoon season right now. If the cement companies are able to maintain that 50-60 percent price hike through the lean season, then post the lean season when demand picks up, cement companies will have a fantastic time because profitability will go through the roof.

Even in the current quarter, a company like ACC Ltd. has reported the highest-ever Ebitda per tonne in the last decade or so. ACC attributed that to the north market. There are other companies, which will report fantastic numbers in this quarter, precisely because the pricing has done well, and the costs are down.

Volume will be a lesser factor than the pricing.

Within the capex cycle, there will be pockets that will do well. You have to see where the focus of the government is on spending its money. If private capex is not going to revive, then it is government capex or quasi-government capex of companies like Power Grid and NTPC or regulatation-driven capex that is going to dominate.

The government has taken a lot of anti-pollution measures. So, the power plants are upgrading themselves. They have a deadline of December 2022 before which they have to install the anti-pollution equipment. That is the bunched-up opportunity that is coming in the next 3-4 years, and there are very few players addressing that opportunity. That can be an interesting play.

The other is water, which is emerging a potential opportunity, and here as well there are a few players who are addressing this space, whether is water distribution, water availability or water treatment.

Since manufacturing has not done well for a while now, these are the topdown sectors where the government’s focus will be. One has to keep an eye out. For me, as a stock picker, I still have to do the job of finding out the best of the lot, in terms of where can be the maximum delta and sustainable benefit. That remains a challenge. From the topdown point of view, these two opportunities look interesting.

The third is railways. It can be a mix of platform redevelopment to Metro, to broad guaging of railway lines, or electrification. There are many things even within railways.

These are the three pockets where capex will be done. I would be inclined towards looking at plays in these areas.

There is no denying that fact. There was a large presence of the unorganised market and government usually goes with the lowest bidder. That tends to spoil the market. But in some of the spaces that I have mentioned, the presence of the unorganised market is lower, like in pipes, pumps, water treatment units. There are few players addressing that segment. If that is the case, then essentially the pie will be shared between these guys only.

Some amount of competitive intensity will increase. If I can see the opportunity, they can too. The larger guys will also tie up with some foreign players to bid for projects. The pie is large enough for some of the small guys to become large in next five years.

It (auto) definitely falls in that category where you have to think hard whether there will be a permanent disruption or not. There is a double whammy over here—that the consumption came to a screeching halt because of the IL&FS crisis last year. Currently, it seems to be a temporary issue. It is not like cars will not get sold. And I don’t think electric vehicles are coming in a major way for another 10 years or so.

On the margins, you have to consider the fact that there are headwinds against the products that are being sold. Companies will have to replace their product portfolio with EVs, and they will have to do capex for that. That transition phase can keep a cap on where these companies can go to.

There is always a question of what terminal growth to be given to these companies, right? We have seen what happens when the industry get disrupted. The can get completely destroyed. So, nobody is suggesting that we’ll have no cars in the country.

In the U.S., the incremental growth in the auto sector has gone towards EVs. Not that those EV companies have created wealth but they’ve been a disrupting factor for the existing players, and thus the incremental growth came down. It is good enough for them to be a cap on the valuations.

For me, auto remains in the basket where there is a serious question mark, especially in auto ancillaries which cater to internal combustion engines. They have to make that transition. If they don’t, they will be kidding themselves. There will be a boiling frog syndrome if they think nothing will happen for 10 years and they can rest on their laurels. You will have to take steps to adjust to a new reality today so that you can address the opportunity 10 years down the line.