Alpha Moguls | Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

Falling cost of capital will resurrect private sector investments in India over the next couple of years but government spending will have to fill in the gap till then to boost growth, according to Kenneth Andrade.

“If we have to be excited about anything in the near future, or even the medium term, the lower cost of capital is the one interesting change to the macro,” Andrade, founder and chief investment officer at Old Bridge Capital, said on BloombergQuint’s special series Alpha Moguls. That, coupled with increasing capital efficiency of corporate India, augurs well on multiple counts for any investor.

The global central banks have maintained a dovish stance for sometime. The Reserve Bank of India has also cut rates thrice this year. Besides, the government’s proposal to issue sovereign bond in foreign currency would ensure that yields in India stay soft—all of which point toward lower rates and lower cost of capital.

Andrade cited how March 2018 exit or year-end return on equity—a measure of how a company is using assets to generate profits—of BSE-500 companies (excluding financials) was 14-15 percent. The first 100 companies where the full financial statements have been disclosed show an RoE of over 16 percent, according to Old Bridge Capital’s calculations.

“Efficiency on the ground is improving and is also pushed by higher utilisation levels, and we have not had meaningful capex,” he said. “Couple this with the cost of capital coming down, and we are heading close to a private sector capex recovery, which has been absent thus far.”

But Andrade expects that to happen over the next 24 months, not in three to six months. If government capex comes in, the capacities run out faster, maybe in the next 12 months, he said.

Business-to-government stocks, or companies providing products and services to the government, form the larger part of Old Bridge Capitals current portfolio, unlike its business-to-business and business-to-consumer focus in the past. This stems from the belief that if the economy has to be stimulated, the only balance sheet that can make a material difference is that of the Government of India, Andrade said.

Some of the private sector balance sheets are stressed, and industries like power and metals have a fair amount of capacities lying idle, and don’t inspire confidence, he said.

Andrade is optimistic on select power generation businesses. “There have been a lot of false alarms in power. That was because any potential turnaround never showed up in the balance sheets.”

This time, the cost of capital has been lower than the return on capital employed—a measure of how well is a company generating profits from its capital—according to Andrade. The arbitrage between the two leads to creation of significant profit pools.

An inverted structure of higher costs and lower returns, as in power in the past, leads to large bankruptcies. 2017-2018 saw some correction in this inverted structure because some power plants started earning higher than the cost of setting up the projects, he said, adding 2019 saw them earn a higher return on capital employed as the cost of capital fell further.

According to Andrade, if bond yields correct further, it adds to the lustre in this space, which makes it a sector to watch. An environment like this is ideal for “releveraging balance sheet” (taking on more debt), and companies that have deleveraged balance sheets stand to benefit the most, he said.

Watch the full conversation here:

Here are the edited excerpts from the interview:

The elections are behind us, and a party is in power with a large majority. The budget is out of the way too. What is your prognosis as to what the next 12 months will look like?

Like is the case of most events, especially an election followed by a budget, it is usually a consolidation period for any government that comes in. If you look at the previous year, it was a phemonenally big year—from the government spend, economy and the corporate point of view. Flip it over to 2019-20, this is the year where you will see consolidation of everything which is happening on the ground.

Given the limited time in which the government had to come up with the budget, it focused on how to consolidate the balancesheet, saw from where revenues could be mopped up and talked about longer-term focus of how to invest this capital.

I think a lot of that was laid out with no specific details as how large it can get. Look at this year’s budget as a direction. I don’t think you got any specifics, except where from the incremental amount of revenue can be generated.

So, a few surprises and a case of past continuous, that was the belief post-budget as well? Do you think this was the case?

Yes, the past is continuous. There is nothing really to add. There was probably one mention (in the budget) on the government increasing its access to international markets for borrowings. For a debt, it is 5 percent of India’s GDP. They have given a number between 10 percent and 15 percent on incremental borrowings. That will push down bond yields.

That is probably a very interesting event because if you lower the cost of money, then a lot can be done. If you have to be excited about anything in the near future or in the medium-term, this could be one event which could be an interesting change to the macros.

One of the messages from the government seems to be to keep the cost of capital low. Did you get that sense too? What will be course over the next 12 months, with the world also playing its part? Does your way of portfolio construction, or picking ideas, or looking at the economy change materially?

Nothing changes materially. We also talk about how efficient Corporate India has been. Capital efficiency is the moot point around how growth will shape up in the future.

In March 2018, our Exit ROE (return on equity) on BSE 500 companies (manufacturing and services businesses, effectively non-financial business) was somewhere between 14 percent and 15 percent. The first 100 companies, where we have full financial statements, ROE is upwards of 16 percent.

So, you are seeing efficiency on the ground improve. The efficiency is being pushed by higher utilization levels, which is also factor for no incremental supply coming through. All of these three have tied in together. There was a capex freeze, which has resulted in higher utilization and that has resulted in higher return on equity.

The bigger moving point is the cost of capital coming down. If you see that trend line—cost of capital moving lower and return on equity moving higher—it increases the arbitrage between cost of capital and return for industry. If this moves higher, you are pushing very close to a private sector capex cycle, which has so far been completely absent.

If you look back to 2005, 2006 and 2007, this was the period when the same subset of companies (non-financial companies) in BSE 500 whose DROs were at ~20 percent. The 10-year G-Sec was down to 6 percent. Fourteen percent was the number when the private sector capex cycle commenced.

That is the number which seems very favourable—apart from the fact that in the next 1-2 years you will also run out of capacities on ground. We are heading towards that direction. So in 1-2 years, we will have all the answers.

Do you sense that the next 12 months could see a slowing down of government capex compared to what we have seen in the previous two years?

We all try to search for growth. The only part of the economy that can drive growth is the Government of India. We are done with the first quarter and we are starting with the second quarter...there will be hardly two quarters left after that. Post that, we will have to see how the finances of the government actually shape up to drive growth.

But keep growth out of this for a minute. Even if Corporate India has to grow by 4-5 percent, it puts incremental amounts of demand pressure on existing capacities, which are close to running out. Just concentrate on the fact that you have no new supply coming in. If the economy remains status quo, you are still pushing up the utilization levels. This is cash creation cycle for a lot of companies.

I would tend to look at this avenue of the market.

Second is how does one exhaust those capacities faster. That’s where the government spending has to come in. If the government spending comes in, then you run out of capacities far earlier. Otherwise, it will take two years to run out of capacity. Either way, you have to wait for 12 months for these events to unfold.

Would you reckon market will start discounting those events faster and will the market will able to do this time around?

I will wait for the last six months of this financial year. I don’t think anything will happen as quickly as September.

Why are you sticking to only industrials and farm economy in your portfolio?

When I look at the portfolio in construct, you have a fair dominance of businesses that address the government at this point in time. There are no B2B or B2C businesses, as the case has been for the bulk of my portfolio prior to 2016.

If the Indian economy has to be stimulated and stimulated higher, then probably the only balance sheet that will make a material difference is the stimulus given by the Government of India. That (stimulus) will be driven by policy or balancesheet, which will drive the economy forward.

When it comes to private sector capex, which is essentially B2B business, there is a fair amount of stress on some balancesheets which has driven corporations previously. There is fair amount of surplus capacity available with some of the large industries, be it power or metals. So, there is fair amount of capacity sitting idle.

The thing with B2C businesses is that we are apprehensive of investing in businesses that have high multiples. The high multiple is driven significantly by leverage that was created by the consumer cycle over the last decade. Those are the two probable macro points we look at, which is why our portfolio is constructed in a very different manner at this point of time.

Every industry maps the GDP 1X, and to get higher growth in the industry, you have to leverage it. As we can see from both sides of the balancesheet, beneficiaries of growth over the last decade are the consumer businesses—whether it is auto, consumer durables, FMCG and the like. Their balance sheet expanded dramatically.

That created leverage, which is fed on the consumer cycle.

The reason these companies grew faster than the GDP is the significant amount of leverage they had—that helped along the way.

It also happened in the last decade when we had real estate, infrastructure, capital goods, metals and minerals do well with little help from corporate banks and public sector banks in terms of leveraging their growth levels.

That’s what transpired over last two decades. For the next decade, we’ll have to find the part of the economy which is deleveraged, or which has low leverage, who will expand their balance sheets. The beneficiaries of those businesses will reflect in market capitalization or growth. That’s where portfolio is effectively positioned.

There is lot of unutilized capacity in power. The proponents for power seem to suggest that if the demand were to pick up—the government is trying to make sure that power is available to all—this capacity will get exhausted in a hurry, new capacity will take some time coming in, and therefore rates will move up, and therefore earnings could do well. Is that the theory you subscribe to as well?

Our point of view essentially maps the outcome, which you have laid out pretty well.

The basics of this is going back to the financial statements. Infrastructure, historically, has not done well because cost of capital was higher than return on capital employed.

When any business has an inverted structure, where you are paying more than you are earning, you have large bankruptcies on the ground. In 2017-18, you had the first element of this inverted structure playing out, correcting itself. A lot of power plants have started earning higher than the cost of setting up the power plant.

In 2019, this ratio improved in favour of Return on Capital employed. So, Return on Capital employed improved and Cost of Capital came off. If bond yields continue to go southward, and Cost of Capital goes down and utilization goes up, then the balance still gets tilted in favour of Return on Capital employed.

So, you take a financial statement, and look at Cost of Capital going down and Return on Capital employed going up. That stimulus is the next phase of capex. That’s exactly what is happening in power generation.

Everyone said there’s false alarm in the power sector and that infrastructure will be back, capex will be back. But that never really showed up in financial statements, until now. If you continue to push your Cost of Capital down, then arbitrage between Return on Capital employed and Cost of Capital makes it favourable for significantly large profit pools.

If you were to raise a fresh fund right now, what would be a good theme to have—a set of companies or industries that will benefit from falling Cost of Capital? Could that be a good starting point?

In an environment like this, the ideal is for re-leveraging your balance sheet. Unfortunately, companies which have deleveraged balance sheets can releverage them. The falling interest rate regime is interesting. It is ideal for equity shareholders into this business. As far as raising a new fund is concerned, the dynamics have changed dramatically over the last couple of days.

Is the auto sector slowdown cyclical or structural? If it is cyclical, then do prices provide an opportunity even if you can’t time when the cycle will turn around?

The auto sector slowdown has a lot to do with apart from cyclicality. It is also due to the disruption that is taking place on the ground. I don’t know if the industry is geared to shift quickly to electric vehicles, but there will be massive loss in profitability. India is already one of the largest exporters of two wheelers. If you have to replace the internal combustion engine of a two-wheeler with a battery, it makes sense to do in the domestic market (first).

But given that volumes will fall sharply for legacy bike makers (if they go electric), you might become uncompetitive in the export market. This is a business of volumes. If the domestic market evaporates, then export market costing will fly through the roof, which makes you uncompetitive globally.

The industry is going through a transition and we as analysts or portfolio managers will not be able to comprehend what the outcome will be.

So, it (auto sector slowdown) is more than cyclical and the change in dynamics are too dramatic to take a call on what will be outcome for this business.

Is it as difficult to comprehend when and if the turnaround in sentiment, and therefore consumption, in staples would happen?

I was surprised to see even pharma data fall off the cliff in the last quarter. So, it is not just staples. It has been dramatically bad June quarter.

As for slowdown, I feel its credit availability at the stockists’ end has something to do with it. It is not that consumption has fallen down, but the inventory wasn’t there with stockists or distributors. They are essentially not stocking as much as they used to, which brings us to credit availability in that cycle.

If there is no pickup anytime soon, what happens to the market-wide multiples in a scenario like this?

I think over breadth of market, except for a few companies, there has been significant correction in the last 15 months or so. Till March 2018, everything was quite hunky dory. From April 2018 to June-July 2019, things have slipped dramatically, economy and market-wise. That’s where we are in the market cycle.

If we look at the last 15 months, if you push back even three years, returns have been low double-digit CAGR (compound annual growth rate). FY 19 is a complete washout year in terms of returns. That’s the cycle we are in.

There is a sense that valuations are still high in staples, consumer & financial services businesses, and those financial services businesses are essentially the liability side of private consumption. That is where the valuation is a little bit on the higher side. They are undergoing a slight structural shift downwards in terms of growth rates...they are normalising.

If you eliminate that, then the rest of market seems fairly okay. You might say public sector banks are distorting valuations because they have no denominators out there. A lot of large balance sheets with no market capitalization and explain debt as part of their entire yield is also distorting some part of valuation.

Otherwise, valuations are comfortable. Balance sheets are in good shape. There are question marks on longevity of this business for next 2-3 years, but we should be okay as far as valuations are concerned for some of these businesses.

So, we might finally over next couple of years see turn in midcaps and small caps. The headlines numbers and those 5-15 stocks could not be too much if growth doesn’t come back. But the rest of the market, because the valuations are good, will perform better relatively.

We are hoping that some of those events turn around. We need lot more of positive sentiments and little bit of growth kicking in. I think everything will come back.