India’s Economy Firing On Two Out Of Four Cylinders, Says Hiren Ved

I think so. It so happens that you had a very strong rally in the last few months. It probably, it surprised people on the upside. At some point in time, bull markets also go into a correction, and they always look for alibis to say that it’s the geopolitics of North Korea or it’s the India-China standoff. But these are all just alibis for a normal correction to set in. And that’s what’s playing out in our markets right now.

These markets has been searching for earnings growth for a long period of time, which has gotten delayed. Earnings were likely on an uptick in the second quarter last year. But because of demonetisation and now the GST, things have gotten deferred. Hopefully, the big disruptions are out of the way, and hopefully earnings will catch up in second half of the year provided there are no major geopolitical events or disruptions.

For retail investors, we are at valuations where they need to take a 3-5-year view. From a very secular perspective, this is not a good time to book profits. We are in the early stages of a multi-year bull market. To my mind, we are almost in mid 2004 of the 2002-2008 bull market cycle. It’s not 2002, so we are not cheap. We were that cheap in 2013, but that’s when the macroeconomic condition was the worst. Typically, when you have weak macro, there is a massive risk off and that’s when the markets are at the bottom. When things improve, the PEs expand and then earnings catch on. Then you have a virtuous circle of earnings coming in and PEs correcting.

There is a worry that private investment is not picking up. The engine of our economy is basically firing on just two cylinders out of the four. Typically, we have private consumption, public investments, private investments and exports. It’s the classical C+I+G and then it’s the export minus imports. Of all the four engines, the only two engines firing right now are government spending and private/personal consumption. Exports have recovered from the absolute lows but there are still challenges because global growth is not as great. Now we have headwinds of currency and certain large exporting sectors in India are going through their own phases of difficulty like technology and pharma. So we are left with two engines.

There are two things: One is the near term and one is the more medium term. My own assessment of the market cycle is that the first phase is always like climbing the a wall of worry, which is happening right now. In the next 2-3 quarters, earnings should look strong because the base is low. You will now be hitting the quarters were there were demonetisation - the third and the fourth quarter, and then subsequently the GST quarter. If you have back to back 2-3 quarters of strong earnings growth on year-on-year and quarter-on-quarter basis, then the market will take the support of earnings and climb higher. Typically, in the early stages where businesses are not doing well, we have liquidity. Especially in our case we have extra liquidity due to demonetisation. That liquidity is not being used by businesses because they have not yet taken off. So, that liquidity typically goes and chases returns in assets. This time, it’s not the hard assets. It’s equities. Because fixed income returns are low and nobody wants to buy real estate and gold. All that liquidity is chasing returns. Therefore, when the actual number starts to improve from economy perspective. IIP and GDP starts growing and credit flow starts to reflect that. And the markets would have already discounted it. It’s at that time when market does into a correction and consolidation phase. The beauty about the market is, when everything is visible, it’s already discounted. Right now, earnings are not visible and people are saying it’s liquidity driven. But it’s always liquidity driven. You need money to buy stocks and you can’t get higher levels out of thin air.

We have been seeing that volume growth is not there in the economy. Partly, some of these resets that have happened, whether it is demonetisation or GST, is impacting a certain category of businesses and consumers. Consumption and growth is also about confidence. If the feel good factor does not come back, if you are constantly battling a completely new paradigm in your life - suddenly you don’t have access to cash - then your mindset is not about going on holiday or spending money, you are constantly battling something. Now, suddenly there is GST, so you are trying to adapt to a new business environment. But after a period of time, you need a period of stability, where there is visibility. The consumer needs visibility, the producer needs visibility. A lot of that is likely to be more qualitative. If people feel confident, if there are not too many variations going forward from the government policy perspective or international global events. If the government focuses on just implementing what it has already done and does not bring one more major disruption and people can get on their lives, and there is no major global event which creates a risk-off sentiment then you are setting the base for a good earnings recovery. Otherwise, those are the things which are at risk. Tomorrow if they say now I will change this, then it’s another big disruption. In that case, you may have a situation in which earnings growth gets delayed even further. So I hope that now that we have started utilising the benefits of the big reforms that we have done, money starts to flow, that creates demand and confidence both for industry and as well as for consumers. If that happens, then you will see earnings growth coming in. If that doesn’t happen, you have a problem.

For the retail investor, the trend which is going well is putting money in systematically, put money in diversified mutual funds so that you could get exposure to broad sectors of the economy. There are several good mutual funds which have very good long-term track record. If you are a very savvy investor, you could come to a portfolio manager like us where we create a compact portfolio of high conviction ideas for the long term. The way we are looking at markets right now is that there are certain secular themes which everybody likes - private banks, NBFCs, auto companies and a few select high quality companies which continue to compound on the consumer side. So, every long-term portfolio will have some exposure to these sectors. But at the same time, you should now start looking at companies where the balance sheets are good, but where the revenue traction was not there until now. And you believe that with some of these reforms and growth coming back, traction would also start to come in, and those are not yet reflected in their valuations. I am not talking about very leveraged companies or companies which had broken business models. There are several companies which haven’t done as great in the stock market over the last 2-3 years because the rally has been concentrated in a handful of companies. So you start building your positions in some of those companies - the bucket were the balance sheet is good but the P&L was still struggling, and you believe that the P&L will start to grow. Once that growth comes in, there is operating leverage and the market recognises it and you start getting the benefits of valuation. You have to play a little contrarian, not just for the sake of being contrarian but you have to start looking at domestic-oriented sectors where you think the growth in infrastructure or volume growth will drive this companies. Then, there are at least 2-3 large sectors which are going through tough problems. You will find opportunities in the next six months to be the contrarian there. Pharma stocks have corrected almost 50 percent from their peaks. IT hasn’t been doing well. It’s not that this is going to be the situation for the next 3-5 years but this is a temporary blip. It might continue for couple of quarters. But it will also give you an opportunity to buy into some of these names. You take a lot of this and combined it into a portfolio and you still have opportunities to make more money. The problem is so far the visibility is restricted to a very few companies. That’s why all the money is chasing those names and those valuations have become expensive in the marketplace.

You have to differentiate between one unsecured lender and another unsecured lender. While valuations are very expensive now and I can’t argue that it’s a cheap stock anymore. But I wouldn’t worry on their credit underwriting standards. It was because their credit underwriting standards were so strong, that they are where they are today. That’s the reason why markets are giving them high price-to-book. If they had higher gross NPAs as many NBFCs...Mahindra & Mahindra [Financial Services] has almost reached double digit of 8-9 percent gross NPA, many public sector banks had reached there, several specialised NBFCs also have high gross NPAs. They have never gone there. Their systems, processes, credit underwritings standards are a class apart. We have to also understand the absolute size of the balance sheets. No longer are they as they were five years ago with just one or two revenue streams. They have several revenue streams. They have diversified their book substantially. Secondly, if you study their business model, they don’t give unsecured loans to anybody or everybody. It’s a cross sell to an existing customer. They understand the customer, have his or her credit history. Only when they are comfortable with the customer, do they give unsecured loans. And thirdly, the absolute size is still very small. For example, HDFC Bank’s balance sheet size is Rs 8.5-9 lakh crore. This year the asset size of Bajaj Finance is going to be Rs 65,000-70,000 crore. It’s less than one-tenth. And this is not a direct comparison but you are still a sub-Rs 1 lakh crore balance sheet size. So, there’s enough room to grow and there can be several Bajaj Finances which can come in. But the whole idea is not about secured lending versus unsecured lending. It’s about what your credit underwriting standards and processes are. You could still make money in unsecured book provided you run that business very carefully. On that front, I am confident about Bajaj Finance. But valuations are a different issue. One could argue that it’s very richly valued.

The recent rally in the Nifty or the Sensex is driven by sectors where there is gross under-ownership. For example, I don’t think people own as much of oil and gas as they own a HDFC Bank, for example. People don’t own so many metal stocks because it’s a cyclical industry. And this does happen in markets that there may be parts of the market, which you don’t own, which go up. That creates short-term pain for investors like us who don’t invest in cyclical businesses.