There are a few big winners under the Goods and Services Tax (GST) regime, but many small businesses, over the next couple of years, will probably down their shutters, Saurabh Mukherjea, chief executive officer at Ambit Capital told BloombergQuint on our special series, Thank God It’s Friday.
Here are edited excerpts from the conversation.
Is the Street really overestimating GST-related disruption?
The Street is overestimating the extent of the near-term disruption, but I think the market is also underestimating the extent to which our country is changing. It’s not just GST, it’s a whole package of changes, package of reforms that the NDA has thrust upon the economy – the black money crackdown, the Real Estate Regulatory Act, Benami Transactions Act, demonetisation, GST. And what all of this is going to do in totality is change the economy more fundamentally, more profoundly than even the 1991 reforms did. The winners will be big and few, and the losers will be many and small. And that sort of rebalancing of the economy, I don’t think the market’s really understanding that. In all fairness to the market, it’s tough to figure out at the moment.
There are a few winners who will win big time out of this, but there are lots of small businesses who over the next couple of years will probably down their shutters.
Is it too difficult right now to try and figure out which businesses will gain and which won’t. You speak to any retail store owner or otherwise, in Mumbai, or Kolkata or Hubli for that matter, the answer is the same, “pata nahi hai kya hoga (we don’t know what will happen.”
So we understand the broad dimensions of the change. What’s very hard to do, is to calibrate the dimensions. For example, in the plywood sector, we know that the listed market leader will consolidate market share and amongst say the 3000 plywood manufacturers in India, we know that the bottom third, between 700-1,000 companies, will have to wind down. They’ve never paid taxes before, neither do they have their IT systems or processes in place. Both from a profitability and from an administrative standpoint, over the next three-four-five months they’ll go out of existence. If they go out of existence, the market leader gets more market share. He presumably gets better pricing as well, because the lowest-cost guy is out of the equation. However, remember that as this happens in hundreds and hundreds of firms, you have small business owners whose income dwindles or disappears, and you have large scale unemployment. So when you have large scale unemployment – remember 90 percent of Indians work in companies with less than 100 employees – so as the small and medium enterprise goes out of existence and the owner lays off workers, demand gets hit. So, I benefit from my market share gains as an organised sector market leader, I benefit from pricing gains but I also might have a smaller market to cater to, at least over the next couple of years, when demand could stay muted in the economy as a whole, and the calibration of the positives versus the negatives is still not very easy to do.
A lot of people are saying there will be disruption in the short term. Is that difficult to figure that out?
No, that I think is reasonably straightforward. Straightforward because the extent of administrative changes obviously are epic here. For larger companies, they’ve obviously got consultants…
Sectors At Risk
What about sectorally or thematically?
So, thematically, the impact on the SME sector, the impact on the informal sector, the ripple-on impact on lenders to the SME sector, some degree of consumption slowdown in the short-term, I think those are reasonably easy to foresee. What’s harder to foresee is the extent of the positive and the extent of the negative and which one outweighs the other. So for a quarter or perhaps for a couple of quarters, we will see the demand slow down and then administrative hassle. And companies therefore necessarily will tell the market to look through the first three quarters of FY18. What companies don’t know themselves is will the slowdown be one or two quarters or will it be three or four quarters. Nobody really knows at this juncture.
GST-Related Correction Likely?
If we see a significant hit on revenue within the first two quarters, in first half of FY18, is there a possibility of a correction?
If you look at what has happened in India over the last five years, we haven’t really seen any meaningful earnings growth. We haven’t seen any double digit earnings growth for five years now. And in that five-year period, investors were concerned over the lack of earnings growth and for the last year or so, especially the last six-seven months, investors have abandoned their concerns over earnings growth and they were looking through and hoping that the earnings will fructify. They are buying in hope rather than buying on the basis of earnings. Now there is a chance that investors continue to buy stocks in hope and valuations both in the bond market and the equity market.
It is possible that the investors look through the near-term slowdown and keep buying. But I think the bond market is in a fairly fragile state and is also overstretched, bond valuations or spreads have crunched to such a level that are simply not tenable to believe that in a country where the banking system is as stricken as it is, where beleaguered promoters are borrowing as much money as they are from bond funds, it’s not credible to believe that bond funds can carry on, can continue to go through this without the hit on their NAV. So if the bond funds start seeing hits on their NAV, if investors start losing faith in bond funds, that’s where I think the equity market knockoff impact will happen. So it is possible because of the demonetisation experience investors say, let’s just ignore the near-term pain and the near-term noise, and keep buying through this. But I think there is a high possibility that the combination of global factors and local factors will bring a fair bit of realism back into investment behaviour. And therefore, a correction in valuations starting with the bond market and going all the way to the equity market I think is more likely than not in six months.
RBI’s Latest Bad Loan Salvo
The pace at which RBI has moved about has surprised a lot of people, positively if I might add. Do you believe this process will finally help bad loan resolution?
I think what the authorities are saying in Bombay and Delhi is that take the pain now rather than waiting for next year. Whether it’s the economic pain associated with GST, or with respect to provisioning, and the hit to the bank’s balance sheets. Let’s take the pain now, rather than waiting forever. Now coming to whether it will work, of the 12 companies that have been prioritised I fear that there is very little value left in them. So, I don’t doubt that the bankruptcy process will be applied, the insolvency process will be applied, the waterfall structure, secured creditors, unsecured creditors, I think there will be attempt to apply that. My fear is there is very little value left in these companies. And the reason is, there has been such a long time that these companies got into trouble, and because of the sort of delay in holding them accountable, and whatever had to be stripped out of these companies, has long been stripped out. Be that as it may, the fact that it is happening, powerful corporate interests are being held accountable, money that they didn’t repay, for loans that they didn’t repay, I think that sets a very powerful example, sets a very powerful precedent. So far in India, my analysis suggests, not a single bank has done profitable commercial lending on a cross cycle basis. Public or private, profitable commercial lending on a cross cycle basis, has been a fiction rather than a fact. I think these current developments might change the construct.
Contrarian Calls In Pharma, IT?
How do you see the beaten down information technology and pharma stocks? Do you see any value or contrarian calls in these?
Can’t say that the entire sectors are worth buying. In the pharma sector you have names where the companies have very low dependence. In fact, if you leave aside top four pharma names, rest of them have low dependence on the U.S. Several of them have high return on capital (RoC), good cash flows, healthy operating margins, no debt at all and their valuations are at 16, 17, 18 times. I think there is value there in those sorts of names.
Low U.S. exposure, good financial position, high cash flow generation – I am a fan of those sorts of pharma names.
In IT one has to be little more selective, because there U.S. exposure is almost a given. But even in IT, the earnings per share (EPS) growth expectations of some of the larger IT name is one or two percent, and if you take some of the premium names in Indian IT, RoCs are approaching 30 percent, there is strong commitment to return cash, and just on the basis of returning cash alone, some of them are trading at effective dividend yields, high dividend plus buyback of around six to seven percent.
If you give me six to seven percent dividend yield on an Indian IT stock, and I am able to get it at 15 times earnings, I think I am interested.
‘Look For High-Quality Names’
The opinion is divided, a lot of people say that mid caps and small caps trade at frothy valuations. I rubbish their argument primarily because it is such a wide space that you will always find companies which are not trading at frothy valuations but they get branded in the same pocket. Is it a good time to fish around for non-Nifty, non-BSE 200 names?
There is never a good time to fish around for names, in the sense that, that there are only 30 to 50 investible stocks in the country. That effort is always bound to be a little speculative. If you buy high-quality names – companies which are consistently generating healthy RoCs, healthy revenue growth, with good corporate governance practices – and you are willing to be a little bit patient, it doesn’t matter what stage of the market you are buying at – bull market, bear market. On the other hand, if you are a speculator and you want to make a quick buck, you are better off doing that when valuations are cheap. For speculators cheap valuations are very important.
Clearly, valuations today are not cheap. For investors who are fundamentally oriented, investors who want high-quality names and are willing to be patient in holding stocks for three-five-ten years, the entry period valuation is not really that relevant.
We can flip that argument and say, for example, that CDSL which has listed today is a high-quality name but it’s not in the top 200 names...
With any of these companies or IPOs it’s very hard to know whether they are high quality or not until the track record comes through. I am the sort of conservative person who looks for a 10-year track record. I’ve never really put money in a company until I have seen its 10-year track record. I have never quite understood how people are able to participate in IPOs, especially retail investors with the sort of enthusiasm I am seeing. They clearly have far more faith in the institutions of our country than I do.
The Next Big Bet
Where do you see the next set of multi-baggers coming from?
It’s interesting that you ask that question because when we sat in your studio seven months ago and we published The Unusual Billionaires, what it says is that, all you have to do is, look back at the preceding 10 years’ worth of financial performance and look for companies which are able to pass two tests. Test one is, at least 10 percent revenue growth each year on CAGR and the second test a company needs to pass is at least 15 percent return on capital employed each year. Typically, in India, 15 to 20 companies pass the test. If you buy them as a portfolio, sit tight for a decade. Compound it between 22 to 32 percent. That’s what the book says. Thankfully people have gotten the message. But it’s as simple as that. You just look back, find companies which have delivered. They might be expensive but don’t kill yourself thinking about the PE multiple because you are giving this time, a 10-year run. There is a high probability that you will make money from the quality of the fundamentals that you are buying. The other type of investment we were discussing a minute ago is that you look at IPOs and you try your luck. The reason I am saying you try your luck is if you look at IPOs in India over the last 10 years, only 15 out of 100 IPOs have given returns higher than inflation, forget market-beating returns. That’s broadly representative of the broader market as well. Ninety percent of Indian stocks don’t even give returns comparable to the rate of inflation. So, I am in the conservative investing camp which wants to make money rather than speculate and hence The Unusual Billionaires style of approach.