Alpha Moguls | One Factor That Kenneth Andrade Sees Driving Profitability This Decade
Even as the Covid-19 crisis is expected to hurt earnings for at least another year, market veteran Kenneth Andrade sees one factor driving India Inc.’s profitability this decade: lower costs.
Till 2022, there will be a reversal of profitability and volumes to a very large extent, according to Andrade, founder and chief investment officer at Old Bridge Capital Management, which manages Rs 916.3 crore in assets as of July. But in the rest of the decade, lower costs will lead to higher profitability, he said.
Asia’s third-largest economy is second only to the U.S. in the number of confirmed Covid-19 cases, but the government has eased curbs to allow most economic activities. Yet, the nation is headed for its first economic contraction in decades after the GDP declined nearly 24%, the most among major economies, in the April-June quarter. Indian companies, however, aggressively cut costs to cushion the impact of the lockdown.
According to Andrade, three key corporate expenses are energy costs, which includes power and fuel; wages; and interest. All three, he said on BloombergQuint’s Alpha Moguls series, are showing no signs of any inflation.
According to Andrade:
- Power, which accounts for about 8-10% of industry’s costs, is showing deflationary trends.
- Wage inflation has hit a peak and wages will either remain static or come down as automation continues to drive processes.
- Interest costs, too, have been falling.
These moderating three large elements, comprising of almost 20% of the corporate balance sheet expenses, will dictate the trend of profitability in the next decade, he said.
If the two biggest cost elements for corporate India—financial costs and commodity costs—are going to be benign and corporate volumes or industrial volumes come back, there's a fair amount of profitability that can come back, he said.
That’s not to say all’s well. Andrade sees volatility rising. The simple reason, according to Andrade, is that globally governments along with central bankers are holding up asset markets with liquidity, but in the real economy, the news is not very positive to justify whatever is happening.
Still, investors in India need not worry, unlike in the U.S., he said. While some of the large tech stocks in the U.S. may be in bubble territory, the rally in India is still driven by very conventional businesses, according to him.
“If you have to value markets, don't look at 2021; look at 2022 because if corporate India even returns to 2020 numbers, we are in a fairly priced market right now.”
Andrade also sees lack alternatives feeding the equity market sentiment. “Gold effectively counters the volatility, but if you look at fixed income and if you're seeing that there's going to be a little or no return from the fixed income market or from the commodity market, then people may like equities.”
Businesses In Focus
To take advantage of better potential returns in equities, Andrade is focusing on stocks that have a global scale. If companies know their costs well, they can take the risk of actually putting together a fairly scalable business model which starts to take on the competition globally—catering to 100% of the world GDP against just 3% when focusing on India.
Given the global realignment, Indian companies can play a fairly large part and can fit into supply chains across the world in a number of new industries, not just the conventional information technology, pharma and chemical sectors, he said. According to him, the firms engaged in the automotive supply chain, large scale businesses with a global footprint in manufacturing, engineering businesses all in this category.
He’s not convinced about investing in telecom stocks because, even globally, companies using such networks have a much higher market caps than the owners of networks, and Andrade sees that happening in India as well. While IT companies will remain service providers, he said there could be business models that will grow faster, and thus the sector may do better than others.
Watch the full show here:
Here are the edited excerpts from the interview:
Do falls like how they happened yesterday worry you because I was looking at a statistic which showed that this happened in June when the SPX dropped about 6% and even post that we are up 15% from that point of time.
I do expect the level of volatility to be significant. Now when I say volatility, it extends both ways. There is a simple reason for that, and that is, that globally governments along with central bankers are holding up asset markets with all the liquidity. But on the real economy, the news is not very positive to justify whatever is happening. When you’re on the defensive given the level of new participants in the marketplace, this volatility will extend itself for quite some time. So my sense is it will continue to be there, but I’m not sure if you need to be too worried about it. At least in the Indian context, may not be, there is some kind of a bubble that is there in U.S. stocks or some of the techniques that are there in the U.S. India still is very much of an old style economy or a stock market widget driven by the very conventional businesses that we’ve seen in the past.
Is that the reason why you say in Indian context there might not be a bubble territory because everybody keeps on throwing data about how the GDP growth is and how the earnings growth is likely to lag and therefore valuations are just too steep for comfort?
The top earnings growth will keep lagging for some period but just remember that it is just a period of one year. If you have to value markets don’t look at 2021 to value the market, look at 2022, because if corporate India even returns to 2020 numbers in 2022, we are in a fair-priced economy and market right now.
Would the other factor driving this is also that other asset classes are offering fairly meager return opportunities and therefore stay in equities otherwise, I mean for two years if the earnings growth is not necessarily going to come back, you could look at alternatives too but that would not be an option currently?
So when you take a look at alternative asset classes, remember the alternative asset class is fixed income, it is commodity markets and to an extent, it is gold. Gold effectively counters the volatility that is there but if you look at fixed income and if you’re seeing that there’s going to be a little or no return from the fixed income market or from the commodity market, effectively they are deflationary in nature. They’re deflationary even if they are constant. Now those are the two biggest cost elements for corporate India; financial costs and commodity costs and if they are going to be benign and corporate volumes or industrial volumes come back, I think there’s a fair amount of profitability that will come back to corporate balance sheets.
Is that your premise of how you’re going about portfolio construction that some spaces will see a revert to mean of volumes and profitability or is it different? What’s your investing hypothesis?
2022 you will definitely see a reversal of corporate profitability and volumes to a very large extent. But if you try and push it a little further, you can argue the rest of the decade out – what probably is the biggest trend that is shaping the next decade? Now, I just reduced this to a quantitative look into corporate P&Ls over the next decade. What we come across and what we’re seeing actively on the ground is that the three large costs that exist in corporate profit and loss accounts are—one is power, electricity, fuel costs; second is wages, and third is interest costs or cost of capital. All three are showing no signs of any inflation. If you just look at power trends that are happening in India and also globally, you’re seeing a huge deflation on that one line. Power costs account close to about 8 to 10% of industry costs. I can say that this is definitely not going to go up if at all is coming down. Wages, given what has happened in the world over the last two or three years, I think you’ve hit the peak of wage inflation for some period of time. If at all it will remain static and in most cases, it will come down as automation continues to drive processes now or manufacturing now. The third is interest costs. I think the biggest problem the banking system might face over the next decade is corporate India deleveraging too fast. So, you’re in the final leg of it all and corporate India is deleveraging at a pace that we probably haven’t seen before. That effectively means they don’t need money to grow. So, if you take these three large elements of cost of corporate balance expenses and that is almost 20% of the total expense, then if that’s moderating it, I think that will dictate the trend of profitability or affordability in the next decade.
I want to pick up the point number two that you mentioned first and then we’ll talk about the others as well, the wage inflation point. Now, that could be happening due to two reasons right? One, we could have a factor of automation taking in jobs and maybe if wages are not moving up as well; my question from an investing perspective is that would you look at companies which are the tried and tested one but having lower wage inflation and therefore profitability moving up? Or would you look at the newer sectors or newer themes that are cropping up which are substituting the way manpower used to work and automation is substituting that? How are you approaching that portfolio construct?
So, you can play it at either ends of the entire spectrum. You can play it because corporate India’s costs are coming down and that will contribute to profitability but the more efficient way of doing it is effectively trying to pick businesses that are actually bringing wages down. So, the businesses that dominate automation, companies that are contributing to incremental throughput of the manufacturing process without the need for labour, I think those guys will offer a reasonable amount of growth because it’s a decade of play. They should do very well. The other extreme I think everyone will benefit, so I’m not too worried about that.
You mentioned in the first few answers that you’re looking at the next decade. So when you’re looking at the next decade and with an assumption that India Inc. at large is reducing manpower costs, power costs and interest costs etc., it would benefit everybody. So therefore if that is a constant across, how are you then picking up the winners? Are you picking up themes which are likely to do better based on pure business fundamentals or because some of these businesses were leveraged and they are coming back and not leveraged and therefore the beta may be high? Can you give us a sense of how you’re building a fresh portfolio if you were doing that?
Companies in India will be competitive in the global context and that’s your biggest opportunity subject as you go forward. Second is the scale of opportunity that you are seeing. If you are just an India-centric business, you are targeting about 3% of the world GDP but if you extrapolate it to the rest of the world and target 100% of the world GDP then you open your horizons, open a significantly large market out there. So, if you know your costs, then you can take the risk of actually putting together a fairly scalable business model which starts to take on the global economy. And that’s how I would like to believe that the portfolios will need to be built out. So, you’ll need to be globally competitive to build a global franchise and given the realignment of the global stance, Indian companies can play a fairly large part of it and can fit into supply chains across the world in a number of new industries that are there than the conventional IT, pharma and chemicals businesses. So, that’s a small domain that we will probably be looking at and when we actually started this entire process, we just looked at what gives us the competitive advantage.I think all of these little things that are falling in place are giving us the competitive advantage.
What else is there? Is it some bit of manufacturing that comes in because we’re seeing backend manufacturers in India for the Indian market doing well but what aside of the three themes that you spoke about (IT, pharma and chemicals) you believe can succeed on a global scale?
You’d have to look at niche opportunities out there. Quite obviously India hasn’t done very well, as a country we haven’t done well in mass market products. In the automotive chain, we’ve got good companies out here in the automotive supply chain. We have got really good and really large scalable businesses with a global footprint in manufacturing and not just an Indian footprint in manufacturing. You’ll see some have come up in the engineering businesses. These are manufacturing businesses; some of them are not really listed but they are manufacturing businesses which have established the first leg of dominating niches in that space. So, the engineering business that is there and you have a number of MNCs who’ve also put capacities in India and a lot of them are interesting, their international subsidiaries. I think it is necessary to look for niches and companies that have really established themselves. Some of them are category leaders also globally but they’re very small industries by themselves. So I think you’ll have to look at it on a case to case basis rather than making a general assumption and everything in it.
So you are saying this is a lot more bottom up, unlike IT or pharma or chemicals, it is not an industry wide thing, the major opportunity that you’re seeing, is my assessment correct?
Everything starts bottom up. You had one success in the company and then the peer group actually follows. So, we need to go there and get one company out there on an established scale and then the rest of the peer group actually follows the business model. It started with IT in the same way and it started with pharmaceuticals in the same way. They didn’t have 10 IT companies going to the same client and asking them for business on day one. It started in minute increments. What we need to look for is, do we have the DNA and do we have the advantages that will drive this? I think that’s all falling in place. During the realignment of manufacturing or the requirements of another source of global supply, a lot of countries will come in. Entrepreneurs from India will also put their best foot forward.
Kenneth, a small follow up or a small clarity. Almost everybody seems to be betting on house as because of the Make In India push, companies which are catering to import substitution are going to do well. Your major theme seems to be quite the opposite of that. You are looking to bet on companies which will actually cater to the global landscape. Where’s the dichotomy here?
There is no dichotomy. I’m just saying that India is 3% of the world demand and if you go out, you’ve got 100% of the world demand. You can’t be profitable internationally without being profitable in India. So, if you create the scale in India you can take the capacity globally. I mean, look at India’s largest four-wheeler manufacturers or two-wheeler manufacturers. You are profitable in India and you’ve generated your cash flows. Those cash flows will help you get the dominant franchise and foothold in the different parts of the world and then you build the momentum of capturing a higher global market share. The evolution of every industry which is globally competitive comes from a domestic cash flow.
In which case then the size of the pond that you’re fishing in is essentially comprising of larger mid-caps or large-caps in that fashion or am I wrong that a company which is too small in nature might anyways not able to compete on the global landscape, right?
Not necessarily. If you look at the tire manufacturing process and you look at all the intermediates that go into tires, we’ve got very dominant global companies. If you look at chemicals; we’ve been talking so much about chemicals but they’re in a very specific segment of the market which is agrochemicals. We’re fitting into the supply chain very effectively. Not all of these companies are extremely large. Three years ago, they were non-existent in terms of size, today they’re mid-size but there are newer and newer companies coming through. So it’s a white canvas of all of that; that is available.
You’ve always told me that one of the ways of investing, there are thousand ways to skin a cat, but one of the ways to do it is to look at companies which were leaders in the previous cycle, have survived that cycle and now, try and identify when to bet on them when the cycle is turning around. Are you still doing that and what are the factors that you use to identify the change of a cycle?
So there’s no change in the way we work and there’s no change in trying to identify where the cycle is at weak and where the cycle is strong. If you look back, I’ve been in the system since 1990s, a little before that. If you put two or three decades that you spent in the market cycle, every decade throws up a new characteristic or a new bubble that gets created in the economy. So, it was technology, capital goods and materials and then it was consumers and financials, and consumer franchises that recently happened. So if you don’t participate with all of that, you’re probably not making significant return but the entire effort is to try and anticipate it.
So, how do you do that? Maybe it is like revisiting the 90s all over again. That’s not just a bad thing some of the most competitive businesses that got set up in India came from the 90s. Hopefully we’ll create a number of new ones that come through. So let’s go back into capturing last companies at the bottom end of the cycle.We are not doing anything new. I mean if you’re looking at a chemical business you look at a chemical business that’s alive for 20 years, established all the competencies that were there and to an extent is scalable, which was built in it but did not have the opportunity size. You just have to wait for the opportunity to come in. So when we look at all of this today, you have to just scale the size of the opportunity and companies which are waiting for this opportunity to materialise, they’re all there already. So, you’re not looking at anything new. You’re looking at the bottom end of the manufacturing cycle probably; you are looking at the bottom end of the utility cycle–nothing has happened in the power and utility for an extremely long period of time and you participate with the most competitive or the largest in that entire sector.
While you may say that there is nothing that has changed, I’m just wondering if the nature of the liquidity or the nature of the new businesses coming in change this or add some factors for identifying the cycle or picking up winners in the cycle in any fashion whatsoever?
I mean technology will come in. There’ll be technology disruption in every business that is there. So, when I first highlighted those three costs, they are actually coming down for corporate India. Those three costs are coming down because there are new companies out there that are driving those costs now. Costs are dropping below the historical averages significantly, that is because there’s new utilities that are driving costs cost that low. That’s going to mean a case in point, then obviously you’ll have to adapt you investing style to pick up those opportunities up. So there are new age businesses that will also come in but the older companies need to adapt to those new businesses and make it a part of their business model as a they build it going forward.
So first, with new age businesses, everybody believes that TMT is like the discovery of the Covid-19 period and Telecom, for example, hypothetically is looking very strong. It’s a highly capex-intensive business; the ROI may not be as strong as some of the other businesses. So, there is promise here but there are some issues over the capex and the ROI over the lifetime of the business. How do you take a decision whether you want to be in telecom or whether you don’t want to be in telecom?
It’s not a new industry, it is just the way that the industry has transitioned forward. So, even if you align it to something that has been in the past, you had companies that built the roads but the guys who put the cars on it or the automotive manufacturer made more money. If you’re a shareholder in the automotive company over a period of time you’d make much more money than the guy who built the roads. When you look at a network company, a network company can only price productive things but everything that goes through the network is going to price it at a significantly higher number. That’s what is typically seen. I mean, none of these large tech-enabled businesses globally own the networks but their market capitalizations are gigantically higher than what the networks are. So, to what extent do you want to go? At the end of the day it is happening, that the network is in place but content or the enabler of the network will create much more content out there for you and will be much more profitable.
Are there already existing players like that which are sizable in nature in India which are taking advantage of the network?
There are, obviously.
The other thing has technology in it and while the common refrain is that Silicon Valley is doing all the innovation and Indian IT service providers are kind of derided for being just that – service providers and not product companies and therefore will always be the second-round players. Do you believe there are possibilities of scale, size and substance here, in Indian IT?
Service companies will remain service companies. That’s what they are built to do. They have never claimed that they were the cutting edge of innovation but they’re going to help the process of innovation and they’ll get a fair value of whatever is there on the table. So they’ll commoditise businesses. They will not show you significant volumes. There will be volumes which will switch on and switch off at times but they’re fairly steady and stable businesses and they’ll have their bouts of growth. Some of them will grow faster than the market while some will lose market share.
I would presume that being too early in the cycle could be as damaging as well maybe. So, is there a way to identify of being too early in the cycle, how to make out the difference if it is even remotely possible?
No, you can’t. You have to have the patience to go through the cycle with these companies but when you use it as a portfolio approach, you probably have three or four industries some of which or all are already doing something. You’ve got to be extremely unlucky but at times that also happens. When you have probably invested in four industries and all of them are not doing well. But like I said, you have to be extremely unlucky to do that because every industry has its own life cycle. If you diversify across three or four industries and not more than four, then you will be in very different lifecycles of these businesses and you will always get things right. It takes about three years for these kind of portfolios to stay stable.
You spoke of course of, of the profitability metrics looking okay, but a lot of people speak about the near term being riddled with so many potholes on the GDP front that even if the markets and the GDP may have no correlation, but top line of companies and the GDP would have a correlation. Simultaneously, there is a thought that a lot of Indian companies are now outward facing and don’t necessarily depend only on the Indian GDP. What is your view here?
See if I can answer that in two parts, we are close to an all-time high. So, it’s just past that thing. We want to overcome those problems and entrepreneurs in India are likely to overcome it. Two, there is a correlation between sales growth and GDP and when you see a decline in GDP and there is a decline in turnover, remember the positive aspect to all of this is, you got a very low base to start from the next year and in the next two years we can even come back to normal. So, you should be quite okay. Look at the numbers but just don’t get overly influenced by the near term because when you look at the numbers and anticipate a 20% drop in GDP or market cycle, the market and market valuation might already be there. So, if any indices did decide to correct, and quite significantly at that and some other small-caps and mid-cap won’t give away completely, remember at the end every single company has got an entrepreneur who wants to survive and wants to grow and he will do everything for it to comeback. So, there is a value for the underlying business. As long as the financial characteristics are right you will find value. So, you want to be a little brave when the tide is against you because a lot of us will come back.
My question is a bit of a follow up to what you mentioned in the earlier half of the interaction that Indian banks will have this issue in the next decade because companies area lot less leveraged and therefore that’s a bit of a thing that goes against business. Would you therefore reckon that this whole narrative of the big banks getting bigger and more shareholder return- friendly might be a bit of a bogey, and there are better investment opportunities, even if they might grow and give returns there might be better returns from a portfolio perspective in other spaces?
Firstly, I’d like to clear the air that I don’t invest in financials. What we like to do is, we like to see cash flows and identify the cash flows. Financials are really a leveraged business and unless they come at a significantly deep discounted value. I would want to say that I like cash flows and I like deleveraged businesses and then I go and buy a financial services company or a lending business. So, I just like to clear the air on that. It is not like I don’t like it, there are opportunities that will come out there. There are large customer franchises but we take our time to decide where and how we’d like to build a portfolio. The system will comeback, it’s going to take it’s time for it to come back and there will obviously be a consolidation before. The big banks will become larger. So there’s an opportunity in that space for the larger companies to grow larger and there is enough of capital and we see when in a bank. Whenever we see a business that is going out to leverage itself or to raise capital, they’re getting capital intensive. So that’s the advantage that you have in that part of the world that companies are making a lot of capital and when the opportunity comes, they will consolidate. So, I’d stick with the larger companies and once things settle, they will deliver reasonable amounts of returns.
The other thing from all the portfolio managers that I’ve spoken to in the last few years you’ve looked at the agrarian space maybe the closest compared to the rest, at least in my knowledge. Now I was listening into a recent interview that I think Pronab Sen gave on one of the portals wherein he likened the agrarian reforms in the last three months to 1991. Now, I’m not saying that that is the case or that is not the case I’m not an expert out there. I’m wondering if you believe that the investment case in agrarian, rural, exposed or focused businesses has become stronger over the last 12 months or no.
So what you are seeing is near term data and while the reforms were genuine and large, the near term data just suggests that the entire economy has a limited amount of capital that the government had pushed into the rural space. What you are seeing out in rural India is a surplus of cash flows that have come to the farmer. It’s just keeping that economy fairly buoyant. There are also addresses that the reverse migration that is taking place just to keep everyone employed and content, the cash flows are prevalent in the system. Agriculture by itself will never pull India out of despair, agriculture has to be profitable by itself which it is not; and you have to get the reforms down there. So, the reforms are there, the implementation on the reforms, we will see that happen over the next two or three years and hopefully some private sector participants will emerge which are fairly strong in that part of the world. There is too little private sector participation in rural India at this point in time except for probably the FMCGs, the consumer and consumer participants out there but apart from that, there’s not too much that is happening in that part of the world. So, it is an opportunity that is there but I would say that it’s going to be a significantly large investment. Agriculture comprises of 15% of India’s GDP, it will come down as a percentage of India’s GDP and the rest of the economy will grow.
Would the companies exposed to that space be more profitable than what they have been in the past and therefore attract attention, just wondering?
The companies that are there are very profitable and the profitability will be larger. It’s also the last domain after the banking system which is still dominated by the public sector.
So despite the sector’s contribution to the GDP pie, would you presume or believe that the investibility of select spaces in that pocket still exists or is strong?
Remember that it’s a part of the world that has seen no reforms, no investment and still depends significantly on labour and labour arbitrage between urban India and rural India to drive that economy.If you reduce the entire agricultural economy in terms of profit and loss or numbers, the opportunity that is staring in your face is almost 2X the size of what it is. It is not that I don’t think that is there but the number of participants in that part of the world are so few, that you can actually count yourself as to who owns the profitability matrix out there.
Any companies that have emerged and surprised you because I mean for a few market participants, Tesla mow has been a bit of a surprise and for a few it hasn’t because they see it as a pointer towards maybe like what you said an indication of what could happen to the energy market or something but anything that has happened in theIndian or the global context that has surprised you in the last six odd months?
In the last six odd months, I don’t think so. I mean, what’s happening in the U.S., there have been some five or six businesses that are there but that’s been happening for a while. The scale and size of opportunity of those companies are significantly large but why those numbers and profitability of those companies are large, I don’t know. I don’t know if it’s a bubble but it’s in continuity, I’d be a little wary of extrapolating what’s happened in the past to those companies into the future.
One final question, one very popular thing that wealth teams across the country are talking about is if Indians should, can, ideally take some exposure to global equities as well and not just remain in the Indian pond? Are you a proponent of that in any fashion whatsoever?
Yes. If you know your markets abroad you can very well invest in that part in that part of the world for sure. As an equity investor, if you know your markets out there well, then yes.
Presuming you do know most markets very well that you would invest in. Are you taking that choice of investing in global stocks as well?
There is a little bit of it all over the world.