Alpha Moguls | Index Composition Makes Valuations Look Expensive, Says Prateek Agrawal
The indices, at present, look expensive with standard deviations above historical trendlines, but higher growth and “a new normal in valuations” can resolve the issue, according to Prateek Agrawal.
It’s important to recognise the changes to the composition of the benchmark index, said the chief investment officer and head of ASK Investment Managers, which manages assets worth Rs 35,000 crore. The stocks and themes that constitute the index are expensive, and thus, he said, overall multiples of the index cannot be compared to historical averages.
Once new-age consumer tech companies make their presence felt in the market, investors are expected to adapt to the “new normal in valuations”, Agrawal told BloombergQuint’s Niraj Shah on Alpha Moguls.
While growth in the recent past has been propelled by consumption, in the future, it is likely to be household and private capex that keeps the momentum going, according to Agrawal.
For generating alpha, Agrawal looks to stay invested in high-quality companies with growth longevity. Over a 24-36-month period, such stocks deliver better returns than cyclical themes, like commodities or short-term earnings growth companies, which can’t sustain earnings dominance, he said.
Agrawal is upbeat on select financials, jewellery, export themes like textiles and chemicals, as well as healthcare themes like diagnostics and pharma.
Dips in share prices of chemicals and the banking, financial services and insurance firms are welcome, as they give investors an opportunity to add quality stocks to the portfolio at reasonable prices, he said.
Agrawal advises investors to pick companies that are adding capacities in the chemicals segment. The competitive advantage of the Indian chemical and pharmaceutical sectors places them in a favourable position, he said.
Watch the full interview here:
Here are the edited excerpts from the interview:
As we hit a period of multiple central bank meetings, the year-end, as well as a newer variant of Covid, what’s your sense of how are you approaching investing in general, in the current scenario? Are you trying to be a bit cautious? Are you trying to be defensive on cash or are you all out aggressive because the economy may show healthy growth? What’s your basic construct?
Prateek Agrawal: So, we are fully invested, we believe that markets will sustain. We believe that there is double digit or slightly better returns to be made, on a compounding basis in the market. And all completely logical explanations to follow, to practice. We do believe that the economy is growing well. Yes, there has been some amount of slowdown post festival season and we have our eyes there as to post-festival season every time it happens and then it pops up again. So, we need to watch that. But the good thing that is happening in India is the first round of economic increase after the Covid dip, was led by consumption but now it seems like both household capex and private sector capex could take the baton and keep the growth story going for longer. Something that is being attempted in the U.S. as well, can be said for many countries globally. Second, this is the period when you know Indian fiscal situation is standing out. Economy is larger in India, richer in India, the Western world handheld their populations quite a bit during Covid. People were sitting at home, still getting cheques and all of that which impacted the fiscal in those countries quite badly versus (the fact) that Indian fiscal in a good situation. In fact, the government had confidence enough to roll back some of the duties and maybe talk of giving some more leeway going forward. So it is very different in India versus the world. So that is the backdrop. We do believe growth continues for longer. And that is something to start (with). Second, if we look at valuations. Yes, valuations are higher than the long period average, no two ways about it. But we are at a market high and every market high valuation would be higher than long period average. At a high in the market, to compare with the averages is not going to get anybody anywhere. So, the point is, if you go back to pre-Covid i.e., November, December, January you know, that period of 2019- 2020 valuations were higher than the present. Between that period and now markets are up 45% to 50% and earnings are up actually more than that 15%, 2021 over 2020, 35% or more 2022 over 2021 and a further 15-16% 2023 over 2022. So, earnings themselves explain the move up in the market, quite well. And on top of it, versus then and now, we have got a percent decline in interest rates, which to my mind increases the value of the same form, same cash flows up by 15% to 20%. You may take half a percent away saying the monetary policy will normalise. So, coming down to your lot of noise on monetary policy, monetary policy will normalise. So, you know, if you believe it is 20% for 1%, 0.5% means 10% more. Okay, but still, we are cheaper versus the December 2019 kind of a period. At that point in time, if you see the indices, they were nicely sustaining, had it not been for Covid, which caused a sharp dip in the month of March, we would have probably sustained, which then leads me to believe, at the current juncture, we are eminently sustainable. Sustainable for our double-digit kind of growth. You know because I have built in the discount rate-related benefit for my conversation. So, the expectation of future returns should also be pared down. And given the fact that today alternative investing spaces do not offer any significant returns, okay, the hurdle rate is lower. If you look at a parameter like bond yield to earnings yield, you are actually fine, your averages. And that again, makes it very frustrating. Lastly, just want to leave one point, which is, the complexion of the index itself has changed. Now, a lot of times I hear people saying index, one standard deviation and higher than long period average. But in the long period, the index has changed completely, only the name remains the same. So, to give you some sense, the so-called expensive part of the market or the consumers in the NBFCs -- when I say NBFC, it is HDFC Ltd. and Bajaj Finance, Bajaj FinServ kind of tough retail insurance, consumers etc. which used to be either not there or just 12% in the index 10 years back is now 50% of the index. So, if you compare this changed index wins long period averages, it needs to be higher than the long period averages and which is how you will reconcile that a house which says index is high, higher than averages and should go down, as a lot of buys from the index themselves. That is what it is.
Are you trying to make a point that the next few years will likely have an average multiple which will be higher than the long-term averages for good...? So, would we typically have much higher valuation benchmark and therefore we shouldn’t be flustered if those numbers look higher?
Prateek Agrawal: It will take some getting used to and its true for everybody, including myself to start a conversation saying things are looking expensive. We end it differently, but you know the thing is, if you believe that the rate cuts are there to stay, then valuations will be higher assuming similar growth rates. Interestingly, you know, interest rates could be lower in India going forward, let’s say, three years from now. So, we are at 6.5% fend off rates you can borrow for homes at that rate, G-Secs would be lower etc. versus the 2002-2003 period when one section of the population did not like rates to be so low, the savers, the elders, who wanted that income. This time around people seem to have taken this very well. You have heard no noises of people wanting interest rates to be higher. So, on the social side there is an acceptance towards these lower rates. And secondly, if you look at the stability of the rupee, look at our inflation differential versus that of the West and any other parameters, chances are that our interest rates, they might take a step back, increase over the next one year by itself. But over the next three years, it could be lower than what they are today. Over the last 10 years, that has happened, our rates have declined overall by 1.5%, going up sometimes, going down sometimes but as of now versus 10-years back, that’s the situation while that of the U.S. may have declined by less than half a per cent in the same period. So that deferential is definitely reducing and that should be expected going forward as well. Now typically, interest rates decline when your growth rates of the economy also decline. Like China, the big hope is that Indian growth rates will continue to be strong, deep into the future. People say this is the decade of India, I believe this is the decade of India. So, you have good growth rates, lower interest rates, which means valuations will be sustainably higher.
What is the risk to this double-digit growth in the markets?
Prateek Agrawal: So, this is long period compounded that I shared with you. Obviously, it is not going to be a straight line, it will have its dips and ups, so the immediate risks are when you increase rates, you reduce the liquidity, surplus liquidity in the system. But like I said before the pricing in the market today is such that half-a-percent kind of increase in the interest rates should be absorbed without an issue. The taper tantrums that we saw in 2013 should not repeat themselves. Now one, they are doing it much better this time. Second, our forex reserves are much better versus then. Third, in this period, we simply did not get to commensurate foreign buying, like we did in the pre-calendar 2013 period. So very different kind of situation and you know, Indian markets that could be held up by Indians, rather than foreign money. So as long as the confidence of the Indian investing public has maintained I think the thesis stays strong. Yes, if a disease crops up and causes disruption, well, we try to price that as well. You know, versus the first period of Covid when the country was shut down and it was not sure as to for how long we stay in the lockdown situation. In the second round, it became very clear that lockdowns would be the last instrument of control, we will stay open for business. If that happens, then you can price it, a quarter of disruption in business, if you survive, is less than 1-1.5% of impediment to value so that is what it is. Today what is happening is, a lot of these things are happening simultaneously and hence, the market is having to digest it, but give it time, I think, these levels are levels which are sustainable.
How do you propose to generate alpha over the broader end of the spectrum? I am guessing your portfolios are flexi-caps in that sense and not necessarily benchmarked to have a larger set. Do you believe that there are certain themes which might have a valuation rerating versus certain themes which might actually move as per the earnings growth?
Prateek Agrawal: Sure, so to my mind the way to generate alpha in a situation like this, is to have high quality businesses, so we stay in the quality space. I need not repeat that. In that space, the higher the growth and for longer, the sustainability of that growth is what will provide alpha. In the index for example, different parts of the index will provide growth at different point in times. In this year, for example, commodities are providing large delta on the EPS that cannot sustain forever. Maybe next year, some other parts will do. But for our portfolios if you see, you will probably see the same company delivering strong growth for a sustained period of time. And of a quantum which is in the best case for the index like investment is lesser than index, but generally speaking over four five-year CAGR basis, higher than the index on a non-diluted basis. So practically, no company that we hold would go to the equity markets to fund a 20-25% kind of growth. So that is the key thought that we have, now to achieve it does require a lot of tailwinds, its not (going to) be easy. Tailwinds could be an 'organised- unorganised' kind of shift that we are seeing very strongly in the country. Business after business is benefitting from that. In fact, if you look at it, it started off 3,000 companies and you divide it into deciles, it is the top three deciles where things have turned around and profits are really coming, that is what markets are cheering. The bottom five, six deciles are still showing a lot of pain, pointing to a shift in business towards the larger names. So, in spaces where we have unorganised presence is large, we do believe this move will provide a lot of tailwinds. This could be for example, in the jewelry space, we have names there, it could be in the footwear space. Second, of course, is China plus one. Now both the things are happening, China is getting richer. It also wants blue skies and voluntarily it is not wanting to expand certain capacities. While many businesses are going elsewhere, some are coming to India, textiles for example, after going to Bangladesh, Vietnam, I think now our guys are also getting positive. For pharmaceuticals and chemicals. You know, for everything else I believe we will have to jostle with the competitive world. But for pharmaceuticals and chemicals, I think our businesses are in a superb position. There is no other country with an ecosystem like ours. So, there is a lot of tailwind for these spaces. So, we have names from these spaces. Yes, Covid has changed behaviours, I think many of them may be changed for keeps. So, for example, diagnostic change, people will go there more to get themselves tested. They are benefitting from an unorganised-organised shift as well, consolidation, as well. So that is an added space to look at. Third, is the net-based businesses. We do believe in a while many of them are not cheap. And we have looked at them, spent a lot of time on them. A lot of them are not cheap but this is a space where growth will be there, higher quantum of growth and for very long. So again, this is a space where we have got some exposure, not very high, but some exposure.
The street after a rewarding, let’s say, some of the spec-chem companies quite nonlinearly in the last six odd months, both on spec-chem and pharma, there has been a sharp pullback. Do you believe that the growth story is so long that you would use these dips to buy or how would you approach this, because suddenly the space after having seven-eight years of fancy, seems to have just lost its footing a little bit?
Prateek Agrawal: Yeah, so you are saying more about chemicals, pharma, after the first round of participation, last year has been consolidating. The diagnostic themes have done well. Now for chemicals, two things have happened. One, the bottom numbers did not show growth, let me put it this way. While the stock price had shown a lot of growth and that may have disappointed people while it was known that second quarter will be weaker than the first quarter given the way commodity prices were moving. So, chemicals at the end do have an element of commodity, the prices, the margins move up and down. And that has to be taken into stride. What is going for them and what we believe will continue to be on their side is the strong capacity expansions deep into the future. The makeup of the market that we account for is 3% of the global capacities. The global demand growth is of similar order odd-3%. And if no other country in the world wants to do more of chemicals, then theoretically speaking, our guys if they were able to expand capacities could have doubled up every year. As we speak, they are doubling up every three years. And this is something we believe, we will continue to see for the next six, seven years, at the minimum. So, you know, if you get a dip and dips are good, because if you are convinced on a space and convinced on a name, dips are when you can actually build the portfolio. Otherwise, when the names are in the strong upward momentum, maybe the upside gets lesser and it becomes difficult to build the portfolios, for such times. So, such small bearish phases are completely welcome-friendly, otherwise you can’t build portfolios.
I know you invest in businesses for the long term, but there are some businesses which did not even exist and were not fancied, let's say, 18 months ago and some PLI beneficiaries may be out there. The whole ethanol play out there. You would probably consider the EV space and the fancy that it has taken. Where is it that you find, figure if you do, within these newer themes?
Prateek Agrawal: So, we looked at all of these spaces, all of these spaces have a presence in the portfolio. So, for example, in the EV space very difficult to play through OEM just now, but auto ancillaries are a good way to play that. And we have an auto ancillary exposure and it has done well for us. You can also play through, let’s say, chemicals space. There are some of these new listings which are focused on the EV space. We haven’t really gone there while we have looked at these names. Ethanol we latched on very early, but while the size of the opportunity is large, but it is divided between lots of companies, you know, and it becomes more like, one short kind of returns rather than a compounding nature of returns and it did not help that at the same time global sugar prices, so you know all the sugar mills will put up ethanol plants, de facto, the ethanol pricing will dictate sugar pricing at some point of time because ethanol is market-linked while sugar prices are still controlled. Now that is how the control, will go away. That is at least the quantum of sugar that the country produces will be market-linked rather than policy or regulation. But then you know, with so many mills putting up their ethanol capacities and at the same time sugar prices moved up also, the stock prices moved up sharply and did not give a juicy enough opportunity to get in. The equipment manufacturers we looked at, there is one very good equipment manufacturer, frankly, even on a global basis. But there, it seems like the three to five year kind of opportunity, we are still not accepting that, it can be a decade-long opportunity. Or what happens is sugarcane gets over, that’s easy, but it gets over pretty quickly in terms of sugarcane-to-ethanol mix. Then comes broken gains of stuff that people don’t eat, animals don’t eat. Instead of rotting you make ethanol out of it, which is also easy, not very difficult. Economics are not as good. Then comes ethanol from cellulose, husks and all of that, the wheat chaff etc. That again the pilot has been made but economics, I don’t know. If that succeeds, it can really be a long period opportunity. So that’s how it is. We looked at this but are not invested in this space.
In PLI, there are some 15-16 sectors. Are you are enthused by any, because some of them have run up quite a bit ?
Prateek Agrawal: PLI, if you see the biggest investment where the government is, in is electronics. You know under three or four heads, so club them all together. So, telecom equipment would also be done by the same electronic company as would probably an AC or a washing machine kind of stuff and a cell phone. So, that is where we have seen names emerge, of a meaningful size. And that’s something we are positive upon. We do believe ‘Make In India’, that’s a great initiative. It will last beyond the PLI benefit period of four to five years. And we have investments in that space.
What about the other key opportunities, our new fancy, consumer tech. Nykaa and Zomato are showing that even in a bad market, even though there’s not much history out there, what is perceived to be expensive is not cracking really. So, there is appetite for these themes. And there are some more to follow. Are you enthused, are you circumspect about the opportunity?
Prateek Agarwal: Well, let me give a slightly long and rounded answer to it. These are things that the next generation uses more than the current generation. Okay, just making a small point, one old man today drank Coke, bought Coke and made money. Times have changed, times are changing. If the next gen is going to do more of these companies, probably they could do well, I have looked at these companies. It requires perfect execution, a lot of tailwinds and blessings of God for them to justify the current price, for me meaningful returns.
Somebody told me that he would look at it if it corrects by 50% and he said that I know that it won’t, but that’s what I look for. Are you of that opinion? If not the exact percent but you need a sizable correction in those themes for you to look at them.
Prateek Agarwal: For a sizable correction, yes, we will look at them. We are looking at them. It’s not as if we are not looking at them, which I mean almost every day, these are new spaces; you really want to understand them well before you commit large monies for long term. We don’t play momentum, by and large. There are many variables, the Covid situation for example, has influenced many of the cost factors quite substantially. It does require a period; I am just talking of one which is human cost. The behavioral change that people had, people did not want to go out as much, so every one of these businesses have seen a bump up in some part of the Covid, maybe not the first one but may be the second one, costs has moved down. For example, if jobs were not available, then maybe you could get people cheaper and did not have to pay what you are having to pay now, so we really need to see what numbers we have seen in the run up till now, which is till the Covid period sustaining post-Covid because the valuations are extremely sensitive to growth. You know, margins, contribution margins, Ebitda will take a long time and discount rate. So, all three and hence, you know if interest rates go down that is basically when globally you see a large correction. So, with so much variability that is possible. I think it is a must to be sure of what you are buying, why you are buying. A lower theme-based approach and I can tell you today, there is a spectrum, large spectrum of thoughts that we have in some cases, maybe 30-40% drop itself would not justify the price we are looking for. So, because at the end of it, if you believe that the economics that was seen in the Covid will revert to the pre-Covid period, and then improvement starts from there on, the numbers will look very different.
What is lending and non-lending? What is your thought on the whole thing? How do you approach it from an investing perspective?
Prateek Agrawal: So yes, if this is a space which has not relatively worked or rather worked less in this bump up in the market, it’s because maybe people are thinking that fintech’s could cause some amount of disruption in the lending space as well. So, few thoughts there. We believe why some of the names may not be working is more because they may be expensive to start with, point one. Point two, many of them may be seeing the regime changes. So, you know regime changed in HDFC, may change over the next two years in Kotak and so on... Very few of them actually raise their own money, it all depends on the banks for the money. Now when you are in that kind of situation, the bank can simply stop that flow. It is unlike other places where they raise money and lend money, Indian fintechs have to cover quite a bit of ground. Its good to see them as a symbiotic relationship between the banks and them, you know, helping banks go to spaces where they on their own would not. And lastly... you got UPI pretty quickly and payment as an instrument does not make money for anybody. Everybody makes money in lending. So, the cakewalk that many of these fintechs had in payments probably wouldn’t be very different in lending. There will be stiff competition. I think as of now, finance is reaching a very small part of the total population. You know, we can have a lot more people come in and make finance reach a much larger part of the population. And that leads me to believe that both NBFCs and retail focused banks could continue to do well, for quite some time, actually going forward. The current lull in the market could be a great buying opportunity. You know, we are looking at things normalising that it costs reducing and business growth is getting stronger, as we speak. So, it could be a good opportunity now except for the regime change etc. that we spoke about.