Nilesh Shah, managing director, Kotak Mahindra Asset Management Company. (Source: BloombergQuint)

Market Corrections Drawing In Investors Instead of Deterring Them: Nilesh Shah

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  • This week on Thank God It’s Friday, we spoke to Nilesh Shah, managing director of Kotak Mahindra Asset Management Company on whether the correction seen on Thursday (September 29) was just a routine one or the beginning of weakness in Indian equities, the possible impact of a Fed rate hike on India, and the stocks and sectors which will drive markets going forward.

    Here are edited excerpts from that conversation.

    Correction Or Mayhem?

    I’ll start by asking about Thursday’s mayhem. Was it just a case of investors taking the opportunity to book profits, just a routine correction? How would you term it?

    Markets are a little bit ahead of fundamentals. Valuations are a bit on the higher side. Obviously, investors are looking for reasons to book profits. Yesterday (Thursday), the strikes provided an opportunity, it could’ve very well been some other reason. I don’t call yesterday’s correction a mayhem. And when you’re up 20 percent and fall 2 percent, that’s a correction, that’s not mayhem.

    Did you also use the opportunity to buy?

    I certainly would’ve bought. I was in Kanpur and Lucknow, and tried my best to tell investors that this is the time to invest in mutual funds or the equity market. Invest on a long-term basis, don’t expect a miracle in the short term. Yesterday’s correction was a pointer that markets are markets. You can try to predict as much as possible but there will certainly be that one event that’ll take you by surprise.

    Foreign Investors Betting On India?

    How are some of your foreign investors looking at India given current valuations?

    By and large, in our interactions with foreign institutional investors across Japan, across Europe, across the U.S., across Middle East, I think the guys who have not yet got any India experience, are regretting that decision. The guys who have India experience and who’ve invested in India are looking to increase their allocation. Some guys are looking at lower levels, some guys are looking at current levels, but by and large, everyone is looking to increase India allocation. So overall, I find foreigners more bullish on India, than probably some of the local players.

    Fed, State Elections: Key Risks

    In the past you’ve spoken about a few risks that India faces, one of them being interest rates and the other being upcoming elections in a few key states. I’d like you to elaborate a bit more on these risks and any other risks that you see coming into play.

    So some of the risks which we can foresee today are related to the U.S. Fed rate hike. We all grew up on the story of the boy who cried ‘tiger’. Fed is like the tiger in that story. Like the villagers, we now believe that the rate is not going to go up, even when the Fed chair says it will. So far, we’ve been proven right, that’s why markets are where they are. But indeed, when one day, the tiger comes, when the villagers believe that the tiger is not going to come, that day will create mayhem. The Fed has warned about a rate hike multiple times in the past but hasn’t followed through so far, which is why there could be some miscommunication between the Fed and the market. In that scenario, our market could see some correction. If the Sensex is at 30,000 and the Fed hikes the rate, and gives the impression that they’ll go on another four times, certainly the market corrections will be bigger. If we’re at 27,000 and the Fed says that we’ve hiked once and we’re done with it, then there will probably be no correction. So you have to view the Fed in that context. The second thing is the state elections. We’ve seen markets correcting post the Bihar elections, we’ve seen markets correcting post Assam. At this level of valuations, the market is pricing in continuity of economic policies. These policies are associated with the current government. There is hope and belief in the market that same policies will continue. If the state election results give an indication that these policies will change then certainly there could be some correction.

    ‘Future Hikes Matter’

    Will a 25 basis point hike by the Fed, even if it comes in December, really make much difference to Indian equities?

    It is not the 25 basis point hike that will make or mar. But it is the post-25 basis point hike, the roadmap that the Fed gives that’ll make a difference. So in December 2015, after a gap of 10 years, the Fed increased the interest rate and gave an indication that it’ll raise the rate four times in the next year. Now that was too much for the market which was not expecting the Fed to raise rates that rapidly. Finally, the market was proven right, but in the intervening period of January and February, the market corrected. So it’s not the 25 basis points hike, it’s how much more they intend to hike thereafter which will drive what happens to prices.

    Consistency In Policies

    What kind of probability would you assign to the continuation of the BJP-led government?

    I have no idea. Voters are too diverse. 2019 is far off. Even April 2017, when the state elections will be held, is too far off. In six months, anything can happen. Today, the market is pricing in pro-reform government policies that have helped improve India’s current macroeconomic situation, which has given confidence to investors. For example, on February 29, 2016, the finance minister honoured his commitment to fiscal prudence. The world was telling him to forget prudence and spend money, create growth, and create jobs. The finance minister said no, I want to honour the fiscal commitment, the promise which I made to the market, I will honour it. That one act of honour created a bottom for the stock market for some time to come. We have not fallen below that level even once. On February 29, many people were questioning the Budget. But the market ignored all those pundits and consistently moved up thereafter. This is the impact of government policy, and this is what the market wants to believe will continue. Now if because of state elections there is some change in these policies, the market will react to it.

    ‘Retail Investors More Mature’

    Do you think retail participation has picked up as per your expectations?

    If I looked at mutual funds, I feel extremely satisfied and proud of what we have done as an industry. I have 1.1 crore SIPs (Systematic Investment Plans) that bring Rs 3,500 crore a month, I have 5 crore folios, I have delivered fantastic returns. Elderly people come up to me and say, “Beta, tera fund accha kar raha hai”. I am sure this is happening to many other people in the industry. So when I look at the past I feel very happy. After 20 years of hard work, you have visible results. But when I look at the potential, the possibilities, I am terribly disappointed. I have 5 crore folios, if I assume an investor has 5 crore folios, that’s 1 crore unique investors. My potential is 25 crore. How will I reach 24 crore? When will I reach those 24 crore? When I look at my equity AUM (assets under management), it’s roughly about 5.5 crore across the industry. Now, in 1990, Unit Trust of India had raised Rs 8,000 crore in Mastershare. When did we raise Rs 8,000 crore in one fund even in 2015, 2016? So compared to our own glorious past, the potential for the future is probably 35 times more and we still need to work hard. We haven’t even begun looking at the potential.

    Where are the retail inflows being directed? Has there been any change or shift in the mix as far as equity versus income funds are concerned? And does that mean that the debt market is more favourably placed than the equity market right now?

    W e are not a homogeneous country, we’re a heterogeneous country. So first-time investors come more towards fixed income funds, but experienced guys are happy to lean towards equities. Yesterday, we ended up collecting 2.5 times more than what was the normal day collection. So a correction in the equity market, instead of deterring people, as in the past, is actually bringing in more flows into the market. There was a time when if there was a correction, you’d go on a call with the distributor and you would be told ‘don’t worry things will get sorted out, everything’s good in the long term.’ Now our distributors call up and say “Nilesh bhai don’t worry everything will go well”. So there is a tremendous amount of maturity in retail investors, especially the guys who have experienced equity mutual funds. They’ve seen the benefits of SIPs, they’ve seen benefits of long-term investment, they’ve seen the stupidity of trading, they’ve seen the stupidity of going into direct investments and losing their pants, shirts, hands, and mouths. There is one class of investors behaving with tremendous maturity. They are able to take volatility in their stride, but I must mention, this is probably 4-5 percent of my universe. I still have to teach the other 95 percent on how to make equity investments. What is an SIP? How is volatility their friend and not an enemy? Why we tell people to be a long-term investor and so on. So, depending on how you feel, the glass is either half full or half empty.

    The Best Returns?

    Are debt markets currently more favourably placed than equity markets?

    If you have a 3-5 year horizon, my guess is that equity markets are far more favourably placed than debt markets. When I started my career, bank deposits used to give 16-18 percent. Then it fell to 13-15 percent, thereafter it fell to 9-10 percent. Today they are available at 7-8 percent. I have no doubt that 3-5 years down the line, bank fixed deposit rates could be 4-5 percent. Now that’s going to be far more superior than zero percent to negative interest rates in some markets. But will you be happy with 4-5 percent returns? Today people assume that bank fixed deposits are the safest instruments. They don’t realise that they carry a tremendous amount of reinvestment risk. Your only solace is in taking risk because that’s going to give you returns. There are no free lunches. If there’s no risk, there’s no return. Equities, real estate, commodities are all areas where you’re probably going to get better returns than fixed income.

    ‘Avoid Gold’

    What is your outlook on gold and how do you pitch it against other asset classes?

    We are the largest holders of gold in the world. When will Indians start selling gold and who will buy from us? When I started my career, an uncle told me a story. A broker received a call asking for the price of stock X. He said Rs 10. He said why don’t you buy 1,000 shares. Next day he calls and asks for the price, he says Rs 50. He buys 5,000 shares. Third day the price is Rs 100. He says buy 10,000 shares. Fourth day, the price quoted is Rs 150. So he asks to sell off all his shares. The broker says who will I sell to? We were the only buyers. So in gold I foresee a similar problem. Everyone is feeling happy with the level of gold prices but who’s buying that gold? Indians are buying gold. If we want to sell, who will buy it. My feeling is that gold does not create value, it does not give dividend, it does not give bonus. Of course, it matches inflation. From an investment point of view, every Indian who can require gold in his portfolio has more than the sufficient amount. So let’s avoid investing in gold, and instead invest in golden entrepreneurs – they are going to create far more opportunities than gold. And by buying gold, India is exporting money overseas. India doesn’t mine any gold. In the last 10 years, we have exported $220 billion overseas for import of gold, silver or diamond on a net basis. We need that money to be invested in hospitals, schools, colleges. So if we love our country, I think we should avoid gold.

    ‘Indian IT Needs Complex Products’

    The IT sector has been beaten down as client spends have come off a little, at least according to managements. What do IT companies need to do right now for sentiment on these companies to improve going forward?

    Simple – they have to introduce a Pokemon Go kind of game. When Pokemon Go came, the market cap of the company went up by few billion dollars. On a serious note, Indian IT will have to move from infrastructure management, application maintenance, simple programmess and simple products to complex things. We will have to move into the digital space, product space, consulting space, we will have to provide solutions, gaming, a product like Facebook, WhatsApp, Twitter, or something like that. We will have to go into data analytics. Indian companies are already venturing there but the contribution of all these exciting activities is far lower than the contribution coming from the other parts of the business. So we are in the samudra manthan kind of scenario where there is a churn happening, for a few companies there will be poison, and for a few, there will be amrut. Any Indian IT company which can move into the digital space, product space, consulting space or gaming or data analytics or artificial intelligence will create value for their shareholders. Indian IT companies which will continue to remain in infrastructure management, application maintenance etc will find it difficult to create value for their shareholders.

    Cyclicals Versus Industrials

    Cyclicals/industrials are cheaper on a relative basis, and on the other hand, consumer-linked stocks have had a great run-up but are looking expensive now. How would you allocate your portfolio between the two?

    Life will also give you this problem – that what I like is not cheap, and what is cheap, I don’t like. The stock market has a similar problem. In consumer-related sectors, valuations are on the higher side but this is the sector where we have seen earnings growth of 15-20-25 percent over the last 2-3 years. On the other hand, for industrials, valuations are cheap for extremely leveraged companies and valuations are still reasonable for many other companies. But then this is a sector which is not showing any earnings growth. They are not increasing their order book, they are not able to convert their existing order book into sales or not able to recover their sundry debtors. Hence industrial companies today are on a backfoot. Consumption-related companies are on the frontfoot because people are expecting good monsoon to revive rural demand, seventh pay commission to increase employees’ consumption expenditure. So between employees and pensioners, more than 1 crore people will spend Rs 75,000-80,000 per family and that is going to boost consumption. There is also some amount of confidence now in urban consumption courtesy many things that are improving sentiment. So consumption today is expensive, but there is earnings growth. Industrials are cheap, but then there are concerns. In our opinion, for the foreseeable future, it is worth being overweight on the consumption sector rather than on industrials. The time will come for industrials but that’s probably 18-24 months away. Right now, let’s focus on the consumption season that is witnessing a bumper festival season. In Onam, Kerala automobiles witnessed good growth, In Odisha, people witnessed good consumption growth, in Mumbai probably because of Bombay Municipal Elections and partly also because of overall growth, we saw a number of pandals becoming double the size. So my guess is the festival season, starting with Dussehra to Holi, should boost consumption and that should support current valuations.

    Electrical Vehicles: The Next Big Shift?

    In auto, I came across some interesting statistics recently. The penetration of 4-wheelers in India is set to be 9 percent and the penetration of 2-wheelers is set to be around 3 percent. I’m uncertain about the accuracy of this data but if this is true, it took me by surprise. So what’s the preference here?

    This calculation does not look appropriate. We have a total of 25 crore automobiles of which 4-wheelers, my guess is, will not be more than 2-3 crore and this includes motor cars, commercial vehicles, agricultural tractors etc and the rest are all motorbikes. The number of motorbikes that Hero and Bajaj sell in a month is what car manufacturers sell in years. So the 9 and 3 figures don’t look appropriate. There is some serious error there. Today in automobiles, the longer-term call is fossil fuel automobiles being replaced by electrical vehicles. Global warming is going to put pressure. Today, the pressure is on the developed world, tomorrow it will come to the developing world. In the longer term, I want to invest in companies which will be able to capitalise on electrical vehicles. And that day is not too far. I was in Kanpur yesterday, I saw it in Jaipur, there are already electric rickshaws which are moving quite seamlessly in those cities. So electric vehicles are not operating only in the U.S. but also in India. So we have to take this longer-term call that automobiles - 2-wheelers, 4-wheelers, commercial vehicles - are geared for electrical vehicles. Other than that, we believe that the easy availability of finance as well implementation of the Seventh Pay Commission will lead to spurt in demand for automobiles. The Sixth Pay Commission came in 2010. It’s quite likely that within 6 years, people will replace their cars. If they had bought a Maruti 800 in 2010, it is quite likely that they will buy a Zen rather than a Maruti 800. So you will see some upgrade from entry-level bikes to premium sport bikes, from entry level cars to mid-sized sedans, and so on. But within that segment, automobiles will do well. Also, the auto components will do well. There is already an increase in the base of automobile units and that’s how automobile component guys will make money because they have to provide replacement parts to those units.

    Cement Sector: Building Gains

    Are cement stocks overpriced right now?

    If you are looking at the short term, yes it might be. But if you are taking a longer-term cycle, then I don’t think so. One, you cannot import cement. It is too bulky, we don’t have that kind of cargo or port facilities to import. So it is a pure domestic story. Second, the demand for cement is going to go up because now there is availability of water, and barring certain areas, most parts of India have sufficient water to carry out construction activity. So for two years we had depressed cement demand because of lack of water and now we will see that suppressed demand spurt. Third, the newer capacity additions for cement manufacturers are coming under pressure. If you were able to set up a cement plant in about 2.5-3 years in the past, it has probably risen to 4.5-5 years now because of land acquisition laws, mining etc. Demand is expected to go up, you cannot import so now you know what’s going to happen to cement prices and what is going to happen to profitable cement manufacturers. So my guess is that in the short term, it is difficult to say whether cement companies are overvalued, but over the longer term you will still end up making money in the cement sector.

    Assessing Company Promoters

    So I want to talk about understanding managements. Right now we have everything from growth rate to debt equity to return ratios at our disposal. What is perhaps hard to gauge is whether a management is reliable or suspect. How do you decide that?

    When you have to choose a ‘jamaai’ (son-in-law) for your daughter, how are you going to go about it? It’s not that you are going to get data. At least for some promoters you have past record and historical performances but for a ‘jamaai’, such things will not be available. You will make a calculated guess. You will probably visit him, talk to him. You will check with neighbours or some relatives and you will arrive at a conclusion. Now by-and-large in India, most people, whether they are literate or illiterate, educated or otherwise, have been able to find a good ‘jamaai’ for their daughter. Our divorce rates are not comparable to some developed nations. If an illiterate person knows how to choose a son-in-law for his daughter, I think you are smart enough to pick a good promoter. How do you pick a good promoter? It is all about past performance and record. Why is Tata a golden brand? Because when Tata Steel was in trouble, Dorab Tata, Ratan Tata pledged their wives’ jewellery to take a loan for TISCO and they survived. That’s how the Tata brand is built. There are so many such examples where we have seen promoters go out of their way to protect their companies, to protect minority shareholders. They have worked hard to create value for shareholders. There is always a caveat that past performance is not an indicator of future performance but in terms of governance, past performance IS an indicator of future performance. Obviously, if some ‘Mallya’ can become ‘Valmiki’, it does not mean that every ‘Mallya’ is going to become ‘Valmiki’. That’s an exception to the rule. The rule remains that if the promoter has been a saint in the past, he will remain a saint in the future. If he has been a crook in the past, he is unlikely to become a saint in the future.

    The Next Big Stock Idea

    Ajanta Pharma and Eicher Motors - two of the biggest outperformers of the last decade. How can you look for the next such idea over the next decade?

    Ajanta and Eicher were small cap companies that have now grown to become large cap companies. That is where you make maximum money. How do you pick up winners from small caps and large caps? It is the strategy of ‘Monkey to gorilla to King Kong’. In hindsight, I can say that I was smart with this stock and it became King Kong. In reality, everyone has to nourish so many monkeys. Some of them will die, some of them will grow. They will become gorillas. So I have to invest more money with gorillas. And out of those gorillas, some will remain gorillas, some may come back to being monkeys and some will grow to become King Kong. So if I have carried this strategy, with the benefit of hindsight I will be able to tell the world that look, I was visionary enough to pick up the King Kong. I won’t tell them that I have so many monkeys and one of them became King Kong. But if you are going to target only one monkey becoming King Kong then please consult your astrologer or you should be tremendously lucky.