Don’t Sell Stocks That Are Doing Well Because Of Higher Valuations, Says Swanand Kelkar

So, if you look at the high-frequency indicators, that’s something we’ve looked at for the past many months. it’s difficult to find a bright spot there. You might get a few bright spots here and there but on an overall basis, it is very difficult to see something which is trending up. Be it auto sales, or even some of the other consumption indicators, I think all of them are indicating some sort of slowdown and that’s evident in the GDP numbers that came out over the weekend as well.

I think within the GDP numbers which were weak of course, the number that I found shocking was the consumption growth number. So, I think it’s difficult to find growth spots out there. But having said that, it is not as if you have abandoned growth investing. I mean, you’re still looking for growth stocks and at places where you can at least make a case for growth which is higher than the nominal GDP growth over the next 12 to 24 months.

Sure. So that’s an interesting point you’ve made. What’s different about this slowdown is that it’s difficult to put an “X caused Y” kind of analysis to it. In 2008, there was a financial crisis globally which caused a slowdown to happen. 2013 experienced a taper tantrum, wherein you had a twin deficit which was fairly high. The money flowed out, but you had to run on the currency. That caused a slowdown. Demonetisation caused a slowdown.

But if you were to ask me today what is it that one cause X which triggered this slowdown, I think it’s very difficult to put a finger on that one thing. Krugman has a great term for it; he calls it the ‘Smorgasbord Recession’, which happens when a host of factors individually, while not very big, come together and cause a recession. In the U.S., Krugman talks about the 1990-1991 recession as a Smorgasbord Recession. Multiple factors came together to cause a downtick.

So, if you look at the reasons for this slowdown, I think there are multiple reasons. It started a year ago if you have to date this slowdown. It started with the liquidity and the funding crisis in some of the NBFCs. Obviously, there have been price increases in some sectors which have been very steep like the autos. The fallout of the NBFC crisis has been seen in sectors which are overly dependent on NBFC credit, which tend to be very employment heavy in terms of the employment that they generate. They are facing a slowdown which is causing job losses and causing lower-income growths. All these things put together, you can ‘back fit’ and reason as to why we are here. This I think is very unique for this slowdown. It is very difficult to point to one factor which caused the slowdown.

Let’s address the point you made on consumption. So, what causes consumption growth? There are a lot of factors. A lot of people spend a lot of time analysing the income growth, what kind of jobs they are getting, created, etc. But there is a more important component of consumption: the marginal propensity to consume. It is a fancy way of saying if you are earning a rupee, how much of that are you likely to spend on consumption?

When we wrote in 2016 about “Loan peh phone, Phone peh loan”, the NBFC boom, I think the marginal propensity to consume then was more than a hundred. I mean you were earning 1, but you were willing to spend 1.1. I think that has turned. I think income growth not being great apart from job creation at whatever numbers we get, not being great. I think whatever numbers have turned up in the last 12 months are about that the marginal propensity to consume, your willingness to spend a rupee of your income that you earn on consumption has gone down. We only get anecdotal data for this right? A lot of auto companies will tell you that footfalls are not getting converted into sales. I mean, that’s a classic sign of the marginal propensity to consume going down.

There is uncertainty which causes people not to spend so freely especially on discretionary items like cars, which you hold back. How does it come back? Does it come back? The answer is in the sentiment, right? The answer there is why is there a marginal propensity to consume? Why did the marginal propensity to consume go from 1.1 to 0.8?  And how does it go from 0.8 back to 1? The one thing I feel fairly confident of is that there is not going to be a ‘V’ shaped snap back. So, the confidence comes back slowly, you have some sort of income growth going. If you had to retrace the cycle, the last time an auto company talked about not being able to convert footfalls into sales was probably in 2013. And I think after that, through 2014, 2015, 2016 and 2017, you got a nice recovery come through at 2017. You can assume or argue that it was because of the pendulums swinging the other way, in terms of consumer behavior.

Having said that, have some of the basic things like income growth and job creation have materially and drastically changed over the six odd months? I would argue no. We were in this low growth kind of a phase be it jobs or be it income levels even earlier, and you’ll broadly give or take a percentage point here or there. I think what’s more important and what’s changed now is this your willingness. Your marginal propensity to consume which is directly linked to sentiment.

Sure, I mean as I said, I don’t expect a V-shaped recovery in consumption here. It is a difficult thing right because we are not talking economic indicators here. We are largely talking sentiment, we are largely the consumer’s ability, the consumer’s more than the ability, the willingness to go there and spend. But having said that, I look at it from the perspective of my day job which is, to invest in stocks. So, even if let’s say the nominal GDP print is not great it is like 8 percent of the nominal GDP print but the advantage you have in a place like India is that this is happening on a base of $2.7 trillion. This 8 percent is happening on a base of $2.7 trillion which means that somewhere beyond $200-225 billion of GDP is getting created. Albeit, It is not a great number because you have grown at 12-13 percent in the past, but it gives me enough opportunity to look for spaces. That’s the only thing I’d want to say. So, let’s say, if this had been an 8 percent nominal GDP growth on a $300 billion economy, it’s tough-going for a guy like me you know. For a growth quality investor, where do you find these opportunities? But, coming back, I think there are places. There are bright spots and one of them that I see is this mixed-shift that is happening towards organised ways of selling. Or maybe, organised retail. Be it in apparel, be it in grocery or even pharmacy, you are seeing a couple of data points that we get on an organised pharmacy chain. Sales growth there is fairly robust. So, what that shows you, is that, within a pie, a consumption pie, which might not be growing very fast, there are mix shifts, there are mixed changes which are happening. Every FMCG company today will tell you that the salience of modern retail in their sales, has gone up. Modern retail now contributes much more to the top-line growth to what it was contributing two-three years ago. So, you will be able to find those some spots here and there where you can deploy capital. But I am not expecting a roaring recovery on the consumption side because one sentiment takes a bit of a knock. It does not come back very quickly or very sharply. I mean, that is just human nature, right? If you have begun to be cautious, your friend who are deferring their vacations, for them to say, yeah okay, good, this looks great, let’s get out. I mean, it will take a few months if not more.

So, if you think about earnings growth in FY20-FY21 were supposed to be big growth years based on concerned earnings. There was one factor that was driving growth in a big way. This was the change in the corporate asset quality cycles. That was the big delta in earnings for FY20 or FY19. There were these corporate banks who were going through their asset quality issues. They were either recognising them or increasing their provision coverage on these assets all through FY19. They will not have to provide so much and from 2021 onwards, that thing will swing.

I think one of the reasons that the market didn’t do poorly despite the fact that the earnings growth numbers were tepid all through FY17, FY18 and FY19; was precisely due to this reason that the markets were looking through this provisioning asset quality cycle. The markets acknowledged that this is not really current stress but a provision for the stress of the past and that’s a good thing. Which is why the markets were not going down in a big way, especially in the financial space, despite the fact that large banks were posting loses or very miniscule profits. The markets opted to look through.

My biggest worry from a market and an earnings growth standpoint is that asset quality, you can call it an aftershock, has started over the past 12 months. When you call something an aftershock, by definition it is smaller than the main earthquake but nonetheless, it is an aftershock. If you think about it broadly, I would say four or five large accounts with hundred thousand or a lakh crores of outstanding debt, each give or take, which is what’s causing the uncertainty. How much are we going to recover? Is it 20 cents to the dollar? Is it 50 cents to the dollar? Is it 90 cents to the dollar? After a long time I am seeing adjusted book s for a lot of private sector banks; which used to be a preserve of the SOEs, the public sector banks where you just have a book to think that there is more stress coming or you have inadequately provided for current stress. That is not a happy place to be. This means that the corporate asset quality cycle which is priced in for people to be recovering fully by now and credit costs actually going below long-term averages may not come to fruition by FY20.

We look at FY21 and what is required for that thing to get solved is, we need to see resolutions. We need to see resolutions on some of these large cases. I mean, the one that triggered the whole thing and we are almost at the one-year anniversary on that one. And even today, I would say, we don’t have a sense whether we are getting 50 cents, 70 cents or 30 cents. If you think of the last corporate asset quality cycle, right? It actually turned. The corporate banks turned when you started getting some resolutions on the IBC cases. Some steel names got through, cement names got through, you could crystallise losses. You could provide what is needed to be provided and you moved on. That’s how that cycle, the aftershock and there is a mini-cycle that is begun over the past 12 odd months, there are names in the vortex. I think, a faster resolution of these things.

I mean, resolutions don’t mean that you go back to, but you crystallise. You get on with it. I think that will help get confidence back on some of the book numbers, some of the people being able to give a multiple on a stable book . From a market earnings standpoint, that is the one thing that I have been watching for. I mean, how are these things coming out on the other side? How quickly are they coming out on the other side?

No, I totally agree with you. What happens in these scenarios is that we’ve seen this in 2013 as well. Money seems to congregate on a few large-cap names which also happen to be heavy on the index with respect to weights in their respective entities. I call this label buying, right? You’re not buying the underlying fundamentals of the company but you just want to park in a very safe place and since most of the money in India or a large proportion of money in India is relative money, you also want to protect yourself against index woes. Which by definition means that the index remains well-bid, right? Because you’re trying to buy the large 10 odd names in the index. Despite the fact that there might be a lot of pain lower down the cap as we are seeing for the past 10 to 18 months that you tend to congregate in a certain stock. So, index level might remain in a zone because of this phenomenon, but I think because of earnings and markets to do really well, I think one, the resolution of this is very important and second, we obviously have to track and this is basically, playing it by the year. You’d have to track how the consumer evolves. Is this a blip? Is this something which is temporary? It’s hard to believe that is structural. The word structural has been thrown down so many times. But when I say structural, I mean, it is hard to imagine that at 18 cars per thousand, India’s car penetration is saturated. It sounds very unlikely for the per capita income country that the number that we have, with the normal GDP growth that is.

I don’t see it is structural from that standpoint but how quickly the consumer comes back is a thing that you’ll have to track and anything. I don’t think anyone has the a clear idea. I mean, what got us here, is only a back-fitted answer. What got us there, hence, can’t be a very conclusive answer, right? Because if what got us here is a laundry list of 10-12 things, or what gets us there is probably is a mix and match of several things. So, I am sure there are experts telling you different things, making different suggestions to the government which has a huge gamut of prescriptions. But I think it is a tough one because it is very difficult to pin-point what has got us here. It is a multitude of facts.

Yes, sure. So, what has happened in the past couple of months I would say is the fact that somebody who is not an India dedicated investor, who has opportunities to invest globally or in EM. That’s evident in the FY numbers, the money has gone up. People have opted to take money out and deploy it elsewhere. So, that is one option that people are following.

The other option is that you get very close to the index. As you rightly quotes that stack that a lot of people are now in those names; money is on those top five-six names and the portfolio starts resembling in the index. At where your active shares go down so that has happened. We have opted to do neither. We have stuck to our investment philosophy. We are going to look for the growth quality names which is has been our approach all through. The only change that we have made, is the stock that we talked about in 2016-17 is, I used to always talk of growth as 15 percent. I used to say that 15 percent growth and 15 percent ROE, that is the benchmark or that’s the cut off that we use. But for an 8 percent GDP ROE economy, I have got that number down to 12. It became on the growth front, right?

Even though it is 12 percent earnings with a reasonable degree of low standard deviation, I am willing to engage. So that is some of the gas utilities that are there in the portfolio, right? They are steady and have 10-12 percent earnings growth but they have all the other characters to look for, there is balance sheet, ROE, reasonable valuations, that’s how I am much warmer to tech than I was two years ago. I mean, the tech earnings profile is broadly in the same ballpark. I mean you can give or take on the dollar top-line, the currency helps or hurts. Two years ago, that didn’t seem attractive given the kind of growth that was available at other places. Today, I am much warmer to tech than I was two years ago, not because tech by itself has changed fundamentally but it is also a relative call that we have taken. So, we have opted to do a couple of things. One, we have no tried to dilute the investment philosophy. We have diluted it to this extent. We have gotten down to the growth cut-offs that we have looked for. Of the five or six large names of the MSCI that we follow, we are zero-weighted on four of those large five. The only game in town to buy are those five or six names. But the principle that I had followed as an investment manager is, if you like something, you are overweight. If you don’t like something, you don’t own it. I haven’t for a huge part of my career gone underweight. I don’t understand the concept of underweight. What is underweight? In your personal portfolio, are you underweight a stock? You aren’t. You like a stock you buy it. You don’t think of weights and stocks. That is a bit later but that is the philosophy we’ve run with and what you like you are overweight; what you don’t like you don’t do it and in times like these, when it is really tested. It is very easy right, to get a half weight on a lot of things or get yourself underweight on a lot of things. Save yourself the pain. I think that would be doing disservice to our investors because that’s not, you’re not doing what we promised.

So, the place that we’ve engaged in, for the past six odd months has been life insurance. So, when all of these things IPO’d, I was very sceptical because they were priced like secular growth stories. They were like a happily ever after stories and people were extrapolating the AP growths into the future but a lot of it was capital market-related. A lot of them were the Unit Linked Insurance Plans.

Markets did well, your AP did well, your VNV did well.  So fundamentally, I liked the characteristics of the business, but I think they were just priced as a secular story when they were actually cyclical. So, when valuations corrected towards the end of the last year, we got into a couple of those names. What we liked there is the shift; the mix shift that is happening away from ULIP type products to more protection type products which are very beneficial on margins. So, despite the fact that the AP growth might not be going gangbusters, the VNV growth, which is equivalent to the Ebitda growth just to simplify terms, that is growing much faster because the mix is improving in favour of protection. We have played that part. I still remain cautious and sceptical on general insurance, gas utilities as I mentioned.

So yes, it will depend upon; you have to look at valuations, what it means. But I think, most life insurance companies in India if all goes well will double their EVs. The embedded s which are equivalent or embedded or parallel book for a bank over the next three to four years. So, that implies a growth rate if you use the rule of 72. That implies a growth rate of somewhere between 18 to 24 odd percent. Very few pockets out there which are giving me that kind of a growth opportunity. So, what I think is, I’ve learnt the hard way is that the operating momentum is in your favour. If you are going to go well in terms of growth, don’t sell stuff just on valuation. Otherwise, India’s most respected bank would never be in anybody’s portfolio if we just sold it on valuations. So, that’s been the learning. That’s the principle that I have stuck by that if operating momentum is in your favour, things are broadly moving and meeting the kind of thesis that you wrote. You hand onto stuff despite the fact that valuations on a 12-month forward basis might be looking expensive.

Interesting question. So I call these, this section of the portfolio a ‘one day, someday’ portfolio. Which is that today you cannot write a 12-18-month rationale on how things are going to improve. But the basic building is to keep the market share, keep the ROE, keep the balance sheet intact are in place but we don’t know how and when the growth is going to revive. And let’s hope that someday, the growth will revive, and these stocks will do well quickly. So, the one advice as an investor is that the ‘one day, someday’ portfolio or the ‘one day, someday’ portion of your portfolio should be restricted to only a certain percentage of your portfolio. It can’t be 60 percent of your portfolio, right? The ‘one day, someday’ things will go well. Since you’re okay, I am restricting this to 10 percent. I am going to have three stocks which tick the building blocks, which tick the basics. But growth today is a challenge and I am going to wait it out. I have the patience to wait it out on those stocks, but you have to contain. Keynes said that markets can remain irrational longer than you can remain solvent. So, you have to maintain. There are still areas where you can still. Credit markets are differentiating where there are NBFC’s at the cost of funding. I think there are many NBFC’s which are painted with the same brush in terms of valuation. I think in one place, nothing is going to happen tomorrow, probably nothing is going to happen six months out. As I said some of these issues resolve, this aftershock, I think these will do well because the inherent opportunity is there, the ability to lend in those spaces is there so I think that’s what I find interesting. I am still doing work on some of the home-improvement side of things, right? As you know the construction, private capex, real estate has been in a downturn for a long time and it’s a big employment generator. So, if some kind of help is forthcoming, I think most people have opted this far to play it through cement but I am looking at a few other names on that space but not yet concluded on that piece. But there are a few good names there which have proven market share, which have decent balance sheets, which can go through a downturn. So, the kind of screens that we run to get these stocks is what has been in the past 10-15 years? What has been the worst ROE number? Right? But which are the companies that are navigating through uncertainty by keeping their balance sheets in place? Not letting working capital go haywire, ensuring that within a slowing market even the relative market share is fine. So, the two screens we look for is market share retention and balance sheet which still has a good ROE for you. You’ll find some interesting names there and then your guess is as good as mine so as to what comes out faster in the growth sectors from this growth front. If you have the right names there, I think they’ll make up for the performance of the past 12 to 18 months.

Not really. I think I’ve spent more time on stuff that I am likely to be interested in.

Not too huge but I think there were companies which I felt that were still not attractive enough from a valuations standpoint but I don’t think I have discarded businesses saying that incrementally, these are not worth it.