BQEdge: Investing In Debt Better Than Buying Some Of The Consumer Stocks, Says S Naren
The top fund manager at India’s second-largest mutual fund considers investment in debt better than buying stocks of some consumer companies.
When consumer stocks were trading at 35 times their earnings, S Naren, executive director and chief investment officer at ICICI Prudential Asset Management Company, considered them expensive. But the valuations rose to 50-60 times.
Interest-rate arbitrage helped consumer stocks in 2008 and the valuations are so expensive now that there could be a time correction, Naren said on BQ Edge, BloombergQuint’s on-ground initiative. There is no clarity that the products made by consumer goods companies can be replaced because the pace of change is lower in this sector, he said. But since debt is giving you 10 percent-plus returns in A+-rated paper, investing in Indian debt is better than investing in some of the consumer stocks.
For an investor to make money in any stock, Naren cited Edward Chancellor’s book Capital Returns that suggests investments in sectors with low supply. Bharat Heavy Electricals Ltd. was the monopoly in power equipment till about 15 years ago, he said, adding that after that a number of new entrants came in and the sector did badly.
But he admitted that best also get it wrong sometimes. “How many weathermen get everything right? Fund management is the same. The only fund managers who got it right the next day were Harshad Mehta and Ketan Parekh, and both of them went to jail,” he said. “So I don’t think it’s possible.”
Naren considers an asset class that becomes “irritating and loses favour” as an investment opportunity. The entire debate on credit funds has become an irritant, and they are very cheap because yield to maturity has gone up significantly, he said. “Equities are currently not an irritating investment, and therefore you can make only average money if you invest in now.”
Naren’s three key principles for choosing an undervalued class encapsulate this approach:
- Look at trailing price-to-earnings multiple.
- Current price to book value.
- Dividend yield.
If the goal is to make money, and an investor is unable to identify stocks that could return 100-fold gains, then these principles would help avoid big mistakes, he said. Naren cited examples of Infosys Ltd. and Wipro Ltd. in 1999, or Reliance Power Ltd. in 2007 or Bharat Heavy Electricals Ltd. and Larsen and Toubro Ltd. in 2007 to illustrate that investing in companies with PE multiples of 50 or more, even if they are quality stocks, didn’t generate wealth.
By contrast, he said public-sector firms are trading at single-digit PE multiples, 4-5 percent dividend yield and close to the book value.
Watch the full conversation here:
Here are the edited excerpts from the interview:
How should the approach of a full-time investor be right now? Should she look at Indian economy move to $2.5 trillion to $5 trillion over the next five years and keep that in mind and ignore the noise?
I am opposed to the word full-time investor. These full-time investors have a challenge. They can be full-time investors while investing as a hobby. They can be part-time investors.
I spent six-and-a-half years of stockbroking in Chennai. Full-time investors want to make money every month. My experience of watching all of them wanting to make money every month wasn't pleasant. As Warren Buffet said that investing is a profession where impatient investors gave all the profits to patient investors. A full-time investor does not have patience because he says that I have to make money every month.
The equity market is not a market where you make money every month. It’s a market where you make money over a 10-year period in a large way. That money is made out of impatient investors.
I used to see people coming and sitting before the terminal, watch market morning to evening and I don’t think their experience was good. I would advice such full-time investors to do something part-time. You can paint, sing, dance, play cricket and teach. And I think that model will work very well.
Just think about the next 45 days. Is it possible to predict what will happen to the market in the next 45 days? Can anyone be 98 percent right on elections? Then the answer is no. So, how do you make money in the next 45 days? To make money in 45 days is actually luck. Everyone wants to think that it is not luck. Does any political party know how many seats they will get? I don’t think so. The challenge with investing is that you say you want to make money in the next 45 days. It is a completely incorrect strategy. In the next 45 days, you make money or not depends on you get the election right or wrong. To get the election call right or wrong is luck.
If an asset class becomes very irritating and loses favour and valuations become cheap, look at that asset class. Look at the entire debate on credit on this point of time. The entire debate on credit funds is becoming irritating. It is an asset class which provides enough fodder to you. It is cheap because yield to maturity has gone up significantly. That is the challenge.
I had a property in Chennai which I sold about five years ago. I used to tell that Chennai property looks overvalued. I told the builder to bring leverage down to zero. They didn’t listen.
The real estate in Chennai five years back was opposite of irritation. Everyone was in it. Almost everyone I know bought property in OMR in that phase. Right now, the rental markets have improved and people are happy. But in between, they had a sub-optimal experience. They had a flat and they didn’t give on rent. The challenge is can you invest in the irritated asset class. Can you invest when valuations are low?
Equity is not an irritated asset class. Everyone is completely in love with equity relative to what I have seen in 1990s and 2002. Equity is not an irritating asset class. If it is an irritating asset class, then you can make big money. It is not an asset class where valuations are very cheap. So, you can make only average money.
Is there euphoria today? The answer is no.
Ask wealth managers that how easy was it to sell equity and small-cap alternative investment funds 18 months back. Many of them made small-cap and mid-cap AIFs. They were the only product and never invested in a mutual fund. They used to tell us that it is a dull product. Now it’s not an irritated asset class. At that time, it was a fond asset class. If you have invested in a fund when valuations are high, you will suffer. But today it is not a fund asset class. Every wealth manager is struggling to add AUM now. Then it is not a euphoric phase. We are in the middle zone.
While someone who does a job but also wants to take advantage of short-term fluctuations that could happen as a result of volatility due to elections, due to global markets or otherwise, how does he approach this asset class which is not irritating right now?
About six months back, I realised that PSUs were very attractive. We felt that it was an irritating segment within equity. I have a simple principle. You look at trailing price-to-earnings, which means you take this year’s earning and calculate price-to-earnings. Then you take the price-to-book of that balance sheet which is based on this year. And the third thing you look at it is dividend yield.
If your goal is to make money and you don’t have the ability to judge that this will become a Google or a Facebook, then that is there for the set of people. I don’t have it. There are a few people who can guess this is the next Google or Facebook or Apple. That is the skill set which is different. Otherwise, you use these three frameworks. You can avoid big mistakes.
If you go back to 1999, Infosys’ PE used to be 100, Wipro’s used to be 200. If you invested in stocks at that PE, you finally didn’t make money. Go to 2007, Reliance Power’s PE was infinity, BHEL’s was 50, L&T’s used to be 50. If you want to access whether there is irritation, just look at current year price-to-earnings.
People in 2007 looked at the 2012 earnings of BHEL and say it is very cheap. If you look at some of the power IPOs, they look at 2015 earnings and say it is very cheap. That’s why you move that and say it is the current year.
Six months back, PSUs were trading at single-digit PEs. They where trading at 4-5 percent dividend yields and most of their price-to-book was 1. I went to my sales team and said I want money in PSUs. They said if I launch a PSU fund, no one will give me money. You call it a special situation and today that special situation is PSU. At another point in time that special situation can be another sector and then it can be sold. Therefore, we launched one special situation fund.
You have to look for pockets of irritation and where something is being cheap. It is not like that reverse doesn’t work. Our foolishness is in the consumer. I used to look at 35 times and say the consumer sector is overvalued. Then it became 40, then 45, then 50, 55 and then 60. Only in the last three months, they have underperformed. But they have not come down much. They have just gone up. I tell people that fund managers can’t get everything right. There are only two fund managers in India which got it right the next day—Harshad Mehta and Ketan Parekh who went to jail. You won’t be right always. People have a fancy thing that what they do will be right. It is like predicting the climate. How many weathermen get 15 years right?
What do you think will happen to consumer stocks?
They have to go through the long sideways movement. We didn’t understand the initial part of the rally but could rationalise it later. Suppose you are a Japanese, U.S. or Europe fund, you have zero percent interest rates. When you have zero percent interest rates and you know that in India soap, toothpaste and detergent demand will go up then it is very easy to bet that this will grow, and you are getting funding at zero percent.
So, you are getting money at zero percent and you are investing in Indian consumer stocks, you are taking zero percent money to invest in something which will surely grow. I didn’t realise it in 2008 but after it outperformed for five years people explained it to me and I accepted it.
But in the last two years, the U.S. interest rates have gone up. Still, this sector has gone up. I don’t know what the reason is. Then we looked at the shareholding pattern and found that FIIs have stopped buying those sectors. The local mutual funds and others have started to buy.
We are still underweight. There are some people who said that it kept underperforming for about eight years and looked foolish and so let’s not look foolish.
If you look at the next 20 years, then there is no clarity yet that soaps can be replaced. If you 10-12 years back we were depending on Blackberry which became history, and we used to depend on a landline phone 15 years back. Around 15 years back, people believed that the internal combustion engine car will be much smaller than where we are today. The pace of change, which Warren Buffet keeps talking about, is lower in this sector. But the current valuation suggests that you should invest that money in debt. Invest in debt whatever money you want to invest in consumer stock. Debt is giving you in India 10.5 percent for taking single A+ credit. So, why can’t you invest in debt instead of consumer stocks?
That is what I am thinking. We have gone wrong not for one year. We used to advise one fund in Europe. Every year, we could ask if they want consumer stocks and they said no. They said it is now six years that you said you want to be underweight for consumers. I said look at the valuations of your companies and our consumer companies and see the difference.
What are the pockets which could outperform mean?
If you look at power as a sector, do I see in any country electricity being replaced then the answer is no. For the last 10 years, there has been no returns in most of the power stocks. In the last 10 years, the demand has gone up 50 percent.
There is an interesting book on investing I read written by Edward Chancellor. The name of the book is Capital Returns. He said that for you to make money in any stock, you should have fewer supply. If you apply that theory to the power equipment manufacturer, 15 years back there was a monopoly for BHEL. After that JSW, Toshiba, L&T came in. After that, the sector did very badly.
If you look at power 2007, you have 25 new entrants— out of that 20 are bankrupt. So, the sector didn’t deliver. Now there are no new entrants. So, Chancellor said that if there are few suppliers, you bet on that sector. In power, we all agree that we will use more ACs, TVs or any other thing. Power demand will not go down in India for the next 25 years. So, if you look at other models of price-to-earnings for the stock, they have all come to 10-11. Dividend yields are comfortable. That becomes a very easy sector at this point in time to invest.
We haven’t made money in the last 2-3 in the telecom sector. So, what Edward Chancellor has said in the book is like when Jio entered, you shouldn’t be buying the sector. But now there are no entrants possible. Whatever exits needed to happen, happened. Can we have a world without smartphones in the next five years? Doesn’t look like it.
I travelled by the Rajdhani Express. Because of the Gujjar agitation, the train reached in the evening instead of the morning. I was in a coupe of six people. There were four other people. Those four people, from morning 9 till the time train reached, were working on their mobile phone. One of the guys repaired CT scan machines. He would continuously get photos of that CT scan and he could give advice. It was fascinating. Mobile phone for eight hours was their manufacturing tool. The other guy was trading cotton and he said what boom we have created. I was on my iPad sending orders.
This sector has changed well for India and this is the sector which will be well for the next five years.
I have a principle that if the sector has not done well for 10 years, then you turn very positive because people have given up. In 2012, we launched the U.S. fund. I used to tell people that the U.S. has no return and you have to invest. People laughed at me but after that, the fund did very well.
It could be very difficult to believe that two—electricity and phones—are the products we are totally subservient to. Just imagine you didn’t have electricity and mobile phone; how would you be? These are the two simple sectors.
What is your view on the automotive sector?
My view has been 10-year bull run. The opposite of telecom and power, here you are at good times. There was a time when people used to say you can’t make money in autos as auto companies will never allow. But in the last 10 years, the auto has done very well.
From a cyclical perspective, there is more pain. But many of my colleagues don’t believe that there is a pain for some other companies. Some of the companies have to keep upgrading technology. Whether they have upgraded themselves fully on technology is another question. I am not in a the positive camp tactically. But structurally, there is no problem because India will grow. But 10-15 years from now, what will happen to EV? Tactically, you have to be careful.
One of the other lessons which I have learned in the last 10 years was sometimes a sector peaks. People then want it to bottom in one year. In 2015, pharma peaked. Somehow after 2016, we always thought that pharma has bottomed. But it bottomed at a much lower level in 2018 than where it was in 2015. Metals peaked in 2008 and we wanted it to bottom out in 2009 and it bottomed out in 2015. We want cycles to be short where we can sell, buy and make money. But the cycle is long. The peak seems to be one year back. Should the bottom be in one year?
What are the three parameters that investor should look at?
The three things which we are using is cycle, valuation and sentiment. Where are you in the cycle? At times, you will know that the cycle is very extended. There is a time when you will know that the cycle is extremely bearish.
Second is the valuation where you use a mix of factors like PE, ROE, price to book, market cap or whatever any other factor you want to think of.
The third is the sentiment. It won’t work at the level of stocks. But sentiment in an asset class is extremely good then you be careful. When the sentiment is extremely negative, you are very bullish. If you take sector like sugar, the sentiment oscillates between extreme bullishness to extreme bearishness. You get once in three-to-four years the extreme bullishness and extreme bearishness. I would use these three.
The fourth in which I have seen my younger colleagues do better is seeing trends. Sometimes you don’t realise that scooter is completely taken off from the bike. You don’t realise that people going to multiplexes is such a big trend because there are no good parks in India. People go to multiplexes every weekend. So, this type of consumer trends, which Peter Lynch talks about in his book, have helped in identifying and watching what younger people do. It’s a good way of making money.
On corporate governance, we are cyclical. Any stock with very good corporate governance, those stocks are very costly relative to the rest of the market. Corporate governance in India is cyclical. There are companies where the industry does very well, they start saying that they have good corporate governance. When the sector does badly, they go back to their older ways. I have spent 15 years as a fund manager, and I have seen cyclicality in the corporate governance of a set of companies.
Then there are a set of companies where corporate governance is always good. Then there are a set of companies where corporate governance is always bad. In 2007, companies with bad corporate governance did as well as the ones with good corporate governance. Today, the companies with good corporate governance have done very well and companies with bad corporate governance have done very badly. The challenge is in the middle. Corporate governance changes. Now they will tell you that we will not do any mistake. In the bear market, they will again do something.