Ridham Desai And Hiren Ved Think Cyclicals Can Make Your Diwali Happy Next Year

Ridham: Last Diwali I said that it is going to be a good year so let’s put a disclaimer because it didn’t turn out to be such a good year. Last Diwali it was looking so well with the caveat that we may get a bad election result. But when the election result behind us, no one would have thought that this is what would have happened within days or weeks of the election results. So, I think we have probably got to a point where, as we’ve been discussing since July-August, I think the price in the market has become very attractive. I don’t know how long the economy takes to turn because there are a lot of imponderables just not at home but also abroad and I think those are far more important right now which is what’s happening with the U.S.-China trade war. It may determine whether the U.S. gets into a recession or not which may in turn determine global growth and that will have its implications on India’s growth rate. But the price is at a level where I think if you are patient, then come next Diwali, or a few months after that, I think you should be rewarded. Because at some point in time, the cycle turns and you look back and say, ‘Oh yes, that was a good moment to buy’ and I am referring to July-August. Since then, the share prices have come back a little bit, but the broad market is still looking very attractive to me.

Hiren: So, I think this is the deepest deleveraging cycle that India has witnessed, right? We keep talking about the economy and I am not an economist, but deleveraging and growth cannot go together. I think you need the credit creation cycle to come back to drive growth in the interim. I use this analogy that you had a water tank and pipes carrying water into the fields, the water tanks were empty because the monetary policy was too tight. I think that has turned. They’ve now put water into the water tank, but the pipes have corroded. We need the liquidity to start moving into the fields and once that happens, we need to see nominal GDP growth and real GDP growth, both to start coming up again. I think the broad markets are cheap and I agree with Ridham that the broad markets are cheap. There’s a small section of the market which is expensive which I think in the current context will remain expensive. I think we’ve seen the worst as far as the broad markets are concerned. From here on, we should see a steady improvement going forward.

Ridham: I’ll just echo Hiren’s point that the monetary policy has been dried and this goes back to June 2018 and now we know this by hindsight. So, June 2018 I am not saying that there was a mistake made because that time, economic growth was actually accelerating, people have forgotten about that. So, growth was accelerating but it peaked in June 2018 for a variety of reasons and we won’t go into the reasons but there were a variety of reasons. The lagged effect of demonisation, GST, global growth etc. a lot of those things kicked in. After that peak, while we were not aware that it was peaking, it were two rate hikes; one in June and one in August. So into the growth slowdown, we had two rate hikes and it wasn’t until February this year that the RBI actually cut interest rates.

So, for eight months, the economy was bearing interest rates which we could not bear. In the meanwhile, IL&FS happened which was in September which was the corroded pipe analogy. IL&FS at that time, it didn’t seem to be such a large problem, but it actually started swelling in size and it probably became four-five times larger. So, that’s what kind of happened and of course, the RBI has made liquidity in the banking system surplus, has cut interest rates so we have unwound some of that monetary overhang tightness but if look at monetary aggregates to simplify things like broad money growth, it is actually not there. Broad money growth is the lowest that it has been since Independence. If you look at the money multiplier, it has collapsed. I am just echoing Hiren’s point. There is no credit creation of note happening in the economy. It’s going to take a while before all of this gets fixed. The government has put capital in the SOE banks, RBI has made liquidity surplus, interest rates have been cut. So, a fair amount of repair work has been done but it does not immediately get reflected into credit growth. I think it takes a little bit of time, but we will get there.

Ridham: So, there is a very big change in the mindset that has taken place with the tax cut. For a moment, do not underestimate the potency of this, okay? We’ll forget about the tax cut and there was a time about a couple of weeks ago that the market had actually forgotten, and the Nifty was threatening to go back to the level that it was pre-tax cut. At the big macro level, it is a transfer from the public sector to the private sector. It’s exactly what the doctor had ordered because the private sector is in pain, the private sector saving largely the corporate saving has collapsed, which is because corporate profits have collapsed. So, you needed to do something to bring corporate profits and corporate savings back. Unless the corporates save and going back to Hiren’s point, you cannot actually start leveraging your balance sheet, because you have the absence of equity. You can only take debt if you have equity on the balance sheet which is, if you have equity on the balance sheets, you need more profits. So, this is the fastest and the surest way to get profits back which is, you cut taxes. So, it is a very potent move and inside that potent move, there is that 15 percent manufacturing tax thing which I think is killer. I think that has the ability to push people to doing capex. We have done some calculations, the net price and of that relative to the ongoing tax rate is almost 20 percent. So, in a reasonably comparative sector if A company decides that I am going to set up a manufacturing unit, company B will have to in that sector will have to respond because otherwise company A walks away with the 20 percent price advantage, or marketing or ad advantage or whatever advantage it wants. So that I think will set the advantage for a bigger capex cycle. What the government has done is actually fixed the problem that was ailing the economy on a structural basis. I don’t think consumption was the problem. From 2010 to 2019, the single factor that has driven GDP growth down to 9 to 6 percent is the collapse in corporate investment rate from 17 percent of GDP to under 6; one single factor, corporate investment rate. How do you get that back? You lift corporate saving. How do you lift corporate saving instantaneously? You cut taxes. So, I think that is very potent.

Hiren: I think what has happened is that, a large part of the capex was in the capital-intensive sectors like metals, power, infrastructure, right? Where I think that there is because of the slowdown, there is additional capacity that is there. Secondly, the healthy corporate balance sheets have got a choice of make versus buy. So, because of the bankruptcy code that has been put in play, right? Let’s say an Ultratech has a strong balance sheet, they have a choice to put up a green field plant versus buying out JP. A Tata Steel went and bought out Bhushan, a JSW energy is buying out some another plant, right? Until this excess capacity moves from weak hands from stronger hands, and today because its so difficult to buy land and start a new green field project, cutting tax was a very important element of that. Land labour are other reforms that you need to know. But for healthy corporates, there’s a make versus buy today. They are buying versus making. But, that’s not bad in itself because the ROI on the asset that you buy is shorter and quicker than a green field project is, right? So, I think eventually, the capex cycle will pick up but we have to see a lot of this de-leveraging cycle getting over and these assets moving from weak to strong hands. Once that is done, I think the new capex according to me and I could be wrong will largely be driven by FDI because they don’t have the baggage of the past and therefore they are liberalising FDI rules and now with the new tax rate cuts I think you will see new manufacturing and new capital investments coming via FDI. If they go through with privatization, which I think they will, that is another filler that you will get to the capex cycle.

Ridham: Privatisation is the other way in which you transfer resources from the public sector into the private sector. So, this is a big change; it wasn’t the thought process in the last five years. So, they have done one, which is, I am saying this for an illustration purpose, you have taken money from the RBI as dividends and you have given that to the corporate sector as a tax cut. The amounts match. Now the next thing that may happen is that, you’ll privatise a few large scale public sector entities and there will be a healthy amount of resource that the government will have and it can decide what it wants to do with it, maybe cut personal taxes for example or whatever but that’s is another transfer to the private sector. So, there is a mindset change that has happened, there is no dearth of public resources in this country. If you do a back of the envelope calculation, it’s not like the government has a large amount of net debt. Gross debt is 70 percent of GDP but then, they have a lot of assets underneath where they have got the market and they’ll discover this when they try to do these privatizations and these bids will come much higher than the ongoing share prices in the market.

Ridham: Go back to Hiren’s point, there is massive interest from foreign investors. So here to date, look at the private equity fund flowing in the country. I think the number up to July is adding up to $40 billion. So, you bring a reasonable asset to the table, get a clean deal and there is a bid out there. It’s so simple. So, selling assets in India is not a problem. In fact, the problem in India is that the domestic entrepreneurs have turned shy for whatever reason because they have seen a dip pressed probability for too long a time and the recent tax cut feeds into that. Going back to the tax cut and I will not hesitate to over-emphasize on this; it completely alters your required rate of return. The biggest cost for a company or for a business after raw materials is the tax you pay to the government.  It used to be 35 percent, you suddenly halved that. So, imagine, the biggest cost item has gone away. So instead of requiring a 15 percent return, now you can do a 12 percent return. It changes the dynamics of the project. This all will come through in the next few months. The market anticipates all of this. So, to a certain extent, you can get the bid in the market ahead of all these changes. I reckon in 2020 you’ll see some of these shifts happening in terms of capex, in terms of investment, in terms of corporate profits.

Hiren: I think earnings is a lagging indicator. If the market goes up and stays there, then earnings will go up because earnings is a lagging indicator. You can already see some of that in the Q2 itself. Just look at Bajaj Auto. The top line has fallen, volumes have fallen, top line has fallen but realisation has gone up and PAT has gone up. Now this is when top line is degrowing. Just imagine when it starts to grow and the operative leverage. I agree with Ridham that we have been too myopic to say that the back of the envelope weighted average calculation of tax cut is say, 8 percent growth in Nifty earnings and you bid it up. That’s not the end of the story. This is at the current subdued level of growth. If growth steps up, operating leverage catches on, which it will, and then the impact of the tax cut. If you take the present or future tax savings, the Delta is much more than 8 percent. What it does to the behavioural change of capital allocators is very significant. What you need in the economy, I don’t care whther the domestic guy puts in capex for us or the FDI. Somebody has to pick up that stimuli and start doing it. According to me, it will be the FDI this time and the foreign capital which will step up and say, I will take advantage of this.

Ridham: There is bound to shift. It is not going to continue with the same set of stocks. Right now, obviously the highest taxpayers are driving the market because they have that immediate benefit. But that’s the immediate benefit. The point that Hiren makes is a very important point. The present or the future gains recover in terms of profits. Your required rate of return actually drops. So, there is a big shift that happens for businesses. Eventually, cyclical businesses will come back. Now, we are in our moral portfolio, focused on buying cyclicals and not defensives. So, we’ve been underweight IT, we’ve been underweight healthcare, we are neutral on consumer staples, we are not underweighting there but we overweight discretionary; we are buying autos, we are buying industrials . We like the large banks so we’re clearly cyclical oriented. We think that this is the time to buy cyclical and more the beaten up the name is, the more attractive it is and therefore it deserves scrutiny which is a lot less than what the highly priced, high performing stocks require. Those require much greater scrutiny because you have to be absolutely sure that they can sustain the earnings momentum otherwise that P/E ratio will come down very quickly and it could cost you a lot of money.

Ridham: Its not that easy job actually, its lot harder because, you know, human psychology is to buy winners and momentum is the best strategy in the market. The winners of the past continue to win till they fail, we don’t know when they are going to fail. So, its lot harder for these bidders of failures to come back and today also the bid is only on the erstwhile winners. It is not easy. What I am saying is they requires less scrutiny. My thresholds are going to be much lower. If I am comfortable with the balance sheet, I am comfortable with the management, the promoter and I have the half good business then, I am willing to look at that compared to very high-quality company which of course has very high multiple on stocks. You have to be more careful there, because you are probably overpaying for that business.

Hiren: I absolutely agree, but it depends on time frame. What is it that you are chasing? If you are going to be worried about the next one year’s return, then I don’t know, maybe quality still performs for a long period of time. But if you are taking a 3-5 year view I think at some point in reversion has to start, in the cyclically oriented sectors and you can already see that in the larger sector which is banking and financial services, incrementally the returns that an Axis or an ICICI bank has given from the loans is significantly for higher order than let’s say of HDFC bank or Kotak has given.

The question is therefore that what is your time horizon and if your time horizon is slightly longer then I agree. For example, I am of the belief that what happened was that essentially because of the tax cut the existing high visibility sector where the growth and the cash flows were already there, they got re-rated. It is very easy to re-rate them first very quickly. But the longer-term impact will be much deeper in the cyclical names than in these names. So, you need to move a little bit away from an all-consensus portfolio if you want to generate Alpha is my feeling.

Hiren: It is little bit of a nuanced answer and I will tell you why. There is some merit in holding quality in the short to medium term because I think what is happening is that if we have to use the analogy of GDP as a cake, the cake is not growing very fast but there is a lot of movement within the cake. When HDFC bank grows at 17 percent they have a formula of GDP+ 5 percent, now its GDP+ 9 percent. You are growing much faster than the system because you are able to outgrow the other people. Titan used to open 30-35 stores a year. They have decided to ramp that up to the 70 stores because they have an opportunity of a lifetime because after Nirav Modi nobody is funding any jeweler. They have an outsize opportunity over next 2-3 years to capture market share from other people. So some of that, which means that the growth will be faster than the system to compensate the higher valuation, but you take a little longer time frame. I think, if you want to make slightly higher Alpha you need to move a little bit away from the non-consensus trade also. Now, how you make that transition is each portfolio manager or each investors risk appetite and risk reward in appetite and time frame.

Ridham: I will tell you one more reason why you cannot give up on quality at this moment, that is not actually a domestic reason it’s a global reason. Which is that we are still dealing with the spectre of the trended trade war. It is not yet resolved, it is bit of a pause there but it is an uncertain pause if this pause proves to be false one and things again hot up in December then global economy is not able to take more of this already things are slowing down. So that will then come to play in India’s GDP growth as well. 20 percent of India’s GDP gross is exports. Take down 5 percent, that is 100 basis points gone down from GDP growth then. Whatever you do to please here, it will still take your GDP growth down so it is not game over for quality. It’s not even for a moment but it is nuance shaped – a time frame and return thing. Quality I think still will still give you your reliable 10-15 percent return, if you are gunning for 30 then that’s may be not the place you want to be again risk appetite, return and time frame.

Hiren: I mean the weighted average portfolio has to look a little different than just being completely lopsided, it’s the only point. I agree with him. Nobody is making the case that you need to sell down all your quality stocks and you know.

Hiren: Yes we have, as I said we also have a larger proportion of consumer discretionary and cyclical in our overall portfolio than we used to have but we are very bottom up so, I don’t think micro top-down and then try to do things. But yes, if I just look at the snapshot of the portfolio then I think we have more discretionary, more cyclicality in the portfolio today than what we had let’s say two years back.

Ridham: I think they are still upside. I think the price is still okay and the fundamentals is still turning. So, I think auto is still good. We still some bunch of auto names in our focus list.

Ridham: I don’t know a CV, car, a two-wheeler name, tractor name.

Hiren: Financial services is a very different business. Specially in financial services I will stay with the leaders or let me put it the other way if you can raise money in this environment at a reasonable credit cross, then you are in the game or else you are out of the game. It is very simple, if you raise capital and if your credit cross is higher than the normative cycle then forgets it. I would not go and try bottom fishing there at all. It is a very dangerous game. See, the NBFC stroke banks is a leveraged game and very few people know how to run that game so I would stick there, I would. No adventure as far as financials are concerned.

Ridham: No, I completely agree. I think you cannot compare a manufacturing business with a lending business. I will nuance it further because financial business includes non-lending businesses- for example like the exchanges looks very good. So that’s a financial service. Property looks good, so that’s a financial service. But lending businesses are very tricky and it is all about confidence and we have seen that confidence goes your business is worth nothing, you can do whatever it takes, it’s worth nothing. When you are ten times leverage or a seven times leverage, you have just no scope for even a small error. So, I don’t think price there plays such an important role.

Hiren: Well I think, there is an opportunity that we have because of the U.S.-China trade war and again I am not a global strategist so I would let Ridham answer this bit, but it’s important to ponder here that every developing nation that has become developed has not done it without creating a globally competitive edge in a few industry. Japan did it in automobile and electronics and it was followed by Korea. China did it in light manufacturing. I think, India has done it in IT services, they have done it in generic pharmaceuticals, though there are structural problems right now. We have done it in auto and auto components and in now in specialty components.

I think, India is competitive but this kind of geopolitical and trade war shifts gives you an ability to take a little more market share away if you are smart about doing that and again tax cut to that extend was again very smart move to get global supply chain to start coming in because you have a natural market of 1.3 billion people at an inflection point were consumer discretionary demand will have a J-curve over a period of time. So, I think we have only net gain to happen. The only imponderable is in capital flows, because typically when the globes slow down, as he said, GDP will go down. I don’t know what happens to global capital flows, but I think, slowly Indian savings and Indian flows to financial markets is buffering that quite a bit. I think, we are less sensitive to FIF flows today. I am not saying its unimportant. It is very important, but we are less sensitive then what we were let’s say 5-7 years ago.

Ridham: A couple of years ago, I was asked to state India’s biggest problem in single line, now that’s very hard to say because there are so many points and the point that we made was that export sharing, global export has stagnated at 1.7 percent for five years now. If you don’t trade with rich people, you cannot become rich. You don’t get a transfer of terms of trade, transfer of terms of trade. It only happens when a poor person trades with rich people. If poor people trade among themselves then there is no wealth transfer right. In the previous decade, I mean the first 15 years after the liberalization, we had a big surge in export share. So, we got a big transfer from the world. So, he is in absolutely spot on we have an opportunity and I think the tax cut actually underscores that is to gain export share in global export. If we can take that 1.7 to 2.5, I think, we will get a big upside surprise in GDP growth.

So, the good news is, we shipped our first iPhones, made in India iPhones few days ago and the total iPhone capacity, what I understand in India is 4 percent of what is there in China. So, we have a long way to go. We can take this to 20 and I think a lot of global managers would love to shift out of smaller countries in Asia in right environment and it seems that they are quite happy with what they are getting right now. So, I think this can happen. The global remains challenged, Morgan Stanley thinks that there is a risk, not an even risk but less than even risk that we get 30 percent recession in what we get next year in the U.S., so we have to be alert to that. The Fed is cutting the rates and usually when Fed is cutting the rates, it’s in acceptance that there is recession risk out there. So, let’s see how that plays out. That I think, is the overarching risk on India or in the domestic growth environment.

Just one last point, I just came across this data and I think almost everybody knows it and I think everybody knows it, it stuck me quite a lot when I came across this yesterday. India’s market cap as of last week is $2.1 trillion, the same that it was ten years ago, it is unchanged. GDP, by the way, has doubled. Our market cap to GDP has collapsed and given that the top 50 companies have gained shares, they have gained almost 15 percentage point share. The rest of them, those companies have really shrunk. The price is very attractive, reminds me of my opening remark.