Ajit Dayal, Founder, Quantum Advisors (Source: BloombergQuint)

Demonetisation An Economic Failure, But A Political Success, Says Quantum’s Ajit Dayal

If demonetisation was meant to be a political move, aimed at wiping out the “money power of opposition parties”, it succeeded, but it was a bad idea on every other front, Ajit Dayal, founder of Quantum Advisors told BloombergQuint on the weekly special, Thank God It’s Friday.

With demonetisation, the domestic consumption story crumbled and could not recover with the implementation of the Goods and Services Tax soon after, he added.

Here are edited excepts from the interview.

In a recent article headlined ‘Demonetisation was a dumb idea’, you suggested that the government has wasted a windfall. Can you tell us more about it?

I will first say that BJP lovers should not take my statement as a pro-Congress statement. I think the Congress UPA-1 and UPA-2 were the worst governments India has ever had. So, if I say something, I am looking at data points.

When you look at the reasons or the rationale presented to us as a nation for demonetisation..initially there were a few, the main one was getting rid of black money and counterfeit notes. Everything else – digital India, cashless society came much later. When the government saw that it was failing in its primary supposed reason for demonetisation, it created a whole bunch of reasons to do it. We should ask ourselves whether demonetisation was a political move to try and win elections and ensure that the money power of opposition parties was wiped out – with Uttar Pradesh elections scheduled for just months later – or was it a rational economic move to weed out black money. If it’s the first reason then it was a great success because BJP did win UP, it did not win every other state. And if it was economic reasons, I think it’s a huge question mark. As I indicated, it was a bad idea.

If you look at where India stood as an economy, we were just about to pick up on a cyclical recovery. You talk to anyone selling any product, between the October 1 to November 7 period, there was a phenomenal growth in volumes. We had a decent monsoon, we had Diwali, optimism was coming through.

What happened with demonetisation was that the one thing you can guarantee in India to a large extent, the domestic consumption story, was completely sucked out and everything fell and crumbled. So, we had the 3-4-month delay as people had to start getting cash to begin the consumption pattern. And before they could recover from that, we had GST which is another angle.

For demonetisation, if the objective was to get black money out and if the objective was to root out the funding going to terrorists, I think it did not succeed, at least from the data points that we have seen so far.

The Saudi Example

Is there an alternative method by which the government could have tackled these issues?

There are many. I am sure you have a list in your head of people in the country who have black money. I am sure the government too has the list and maybe they should have gone and raided those 10-20 people who are huge people and set an example. That could have been a less expensive way of trying to ensure that more people pay taxes.

What the Saudi Arabia Prince did recently in Saudi Arabia is fascinating. He has gone after his own brethren, he has gone after examples showing that these people may have looted the country, I am putting them under house arrest in a fancy hotel, including the Prince Alwaleed who is known as the Warren Buffett of the Middle East. So they put big people, who were very powerful, effectively under questioning. They announced it. The next thing they will probably do is announce VAT and taxes for the rest of the Saudi people so that the common man does not feel that I am the only one who pays taxes. There was someone else there who was not paying taxes and they have been caught and I will make sure that I start paying taxes. Maybe that was the less expensive way of getting black money out.

Please don’t get me wrong. I think getting black money out is very important and getting a higher tax base is very important. We are discussing whether demonetisation, where the whole country was effectively shut down for a period of time, whether that was the correct way of doing it.

Demonetisation: Worst Over?

Then would we say that the impact of demonetisation has been completely absorbed, or not yet?

Suppliers, manufacturers say that cash is back in the system. The Indian mind is sadly creative and does all these things in a negative way. You should not assume for a moment that corruption has stopped, corruption still exists. I asked people during a recent conference,  do you believe corruption has stopped, are you paying fewer bribes. In general, the answer was no. We are actually paying higher bribes because the risk of getting caught for taking a bribe has increased. So, this is a common man sharing his example that he is still giving bribes. And you don’t give bribes in cheques but in cash.

We should not fool ourselves to imagine that corruption is eradicated, it is not. People may be more fearful of taking money. Therefore, in a risk-return reward situation, there is now a higher risk of taking a bribe. So I want a higher price for the bribe.

Economy Vs Market

Is there a growing disconnect between the economy and Indian stock market?

There was a disconnect. If you look at the quarterly numbers that came out from December right through now – and September numbers are not all out – there was certainly a dip in quarterly profits. If I step back a bit, when Prime Minister Narendra Modi came to power in 2014, we had begun every financial year with a very high estimate. But by the end of the year, it was a very low reality. There are of course companies which did very well and companies that did horribly. On an average, on the index there is no growth in earnings and there is an increase in price. Therefore, the PE ratio of the market has increased. To justify this high PE ratio, for the next year or so, you need to see 30-40 percent increase in earnings per share.

And while we see some recovery now, post demonetisation and GST, I don’t think we are likely to see a 30-40 percent increase in earnings.

Therefore, as a value investor, we are wrong as we have said that the PE ratio should not be high, but they are. As a value investor, we are getting nervous to buy in this market because of these valuations.

Moving back to the macroeconomy, which also affects the stock market, where India was in November 2016, we had interest rates around the world definitely low. Now they are rising but very gently. We have had a situation where oil prices have gone up about 40-50 percent compared to where they were a year ago. India imports $100 billion worth of oil and now it is $70 billion, so we have got a huge benefit from low oil. All of these factors make us more vulnerable to external factors compared to where we were pre-demonetisation.

What demonetisation and GST have done in succession is made the economy more vulnerable to external factors after having built a nice little mote around the economy, as Warren Buffett would call it because we built our domestic consumption, forex reserves and we were moving down on the inflation interest rate curve. Now, we could be destabilised because of the self-inflicted bane of demonetisation and that is something which the market has not been talking about. You have seen some reaction recently because oil prices and interest rates are going up.

There have been comments from international investors that India is the best place on the planet to get into bonds which is a powerful statement. But if inflation picks up because of high oil and domestic reasons, and interest rates pick up, the foreign bond investor will run for the exit door which is not good for currency and the stock market.

So, the two successive acts have very good long-term desire to get black money out, to have a unified tax structure but the way they were implemented, and the timing have opened up the economy to potential repercussion from external shocks that we may not be able to withstand, given where we are today.

Domestic Flows To Continue?

How long will domestic liquidity support current market valuations?

If you were Mr India and went to a financial planner and said ‘I am 27 years of age, so what should be my allocation to the savings pool’, every financial player will tell you, rightfully so, that you should have 40-60 percent in equity and Mr. India has less than 5 percent in equity. So, there is that massive allocation from household savings over the decades that, deservedly, will come into stock markets. I strongly believe that in the long run, stocks are a phenomenal way to make great returns to outpace inflation. So, there is that driving force. We have seen $5000-6000 crore, about a billion dollars worth of flows coming into stock markets from SIPs and domestic investors. But if you look back at the data of March 2016, there was a massive withdrawal. In Feb 2016, a year and a half ago, the stock market in India fell because of China, the retail investor saw massive losses and in March they pulled money out of the stock market. While there is a wonderful positive trend, please recognise that retail investors will respond to market price action if things are at an extreme. So far, SIPs have worked beautifully but you give the market a couple of negative weeks and you bring market prices down, you could have a reaction as you did in March 2016 from the retail investor. So foreigners have been cautious on India and the retailers have been optimistic on the domestic market. If retail stops to putting in money and starts taking it out, how much can LIC keep buying? They have been buying everything from the government, they have bought Coal India. So, you have to be careful about this assumption.

Long-term domestic money will support the market but in the near term, you will see mismatched inflows. There is this myth that demonetisation has spurred money into domestic retail mutual funds. It may not be a primary impact but a secondary, tertiary impact. Every other asset class is dead, whether it is real estate or whether it is fixed deposits. So, if you are a local investor you have four choices - you go to SBI for FD, you buy property, buy gold or buy stocks. Out of these four asset classes, two have given you useless returns. FDs are bad and real estate is negative. Gold has given you no return as such and it is flat. The only thing moving is the equity markets. So, automatically your money and allocation will move there. I don’t think it is demonetisation effect, but it is just that other classes have not done as well. You put FD rates back at 8 percent and you see how the money floods back into FDs.

Eye On 2019 Polls

How does the government play its cards as we move towards the 2019 elections?

The government knows that they got only 31 percent of the votes and that 31 percent was lower than the number of votes that Vajpayee got during his tenure when he won the elections for the BJP in 1999. Vajpayee got 34 percent. So, although Prime Minister Modi got 282 seats, he got a fewer percentage of votes than Vajpayee because the fragmented opposition got a lot of votes and because they are fragmented the BJP got more seats. So, this is known by the Prime Minister and the BJP, and hence they are trying to get to a 35-40 percent vote share so that they can win the election.

The other part is, the fact that they won on the development agenda. They want to get India out of the junk rule of the UPA-2. UPA-2 was one of India’s worst governments, please don’t have them back in power again if you can avoid it. Having said that, the BJP has not fulfilled expectations over the last three years. So, a combination of, yes I need to to win an election but focusing on development, infrastructure spending – which is what they have been doing recently – those are very good things to go on. And if you continue focusing on that then development will again take the forefront. But it should not be things like bullet trains. I don’t think bullet train help and people have done calculations that a bullet train between Gujarat and Bombay is not going to benefit the whole nation too much. If the money was judiciously spent on infrastructure and other projects that have bigger impact, then you could see a win for everyone, that is, the people of India and the government.

Room To Ease Rates?

How much more leeway does the RBI have to ease rates further?

Given where India is in terms of inflation, reported numbers are low, but one doesn’t know what the agricultural output is. We opened ourselves to whether the rainfall will be good or not, whether food production will be good or not or food prices will be move up or not. So, we have that risk coming in. On the international side, we have seen a substantial swing in oil prices. We have had the benefit of low oil all these years and there is now high oil prices.

The RBI’s ability to cut rates is very limited. In fact, people should start fearing or factoring in that can RBI raise rates and under what conditions they are likely to raise rates. If they did that, it could be a shock.

I don’t think anyone expected at the start of the year for RBI to raise rates and they are worried about it. But the general consensus is still very clear that RBI, while they speak hawkishly, they are not likely to raise rates. They may keep rates where they are, and they may reduce them over time.

So, India has to be careful on the inflation front, fiscal deficit, which includes the stress that has been caused by demonetisation in rural India shows up in two numbers. One is NREGA and other is farm loan waivers. As of now, the amount of money on loan waivers is two times that spent on NREGA year to date. Since we are in election mode in many states one can expect that state governments will announce more loan waivers. You add the two up – NREGA and loan waivers – you come to a number which starts to impact the fiscal deficit. If fiscal deficit is getting impacted, then I can imagine what Moody’s, S&P, Fitch are likely to say. They will put India on negative watch and if you put India on negative watch, that’s how you scare away bond investors, maybe not equity investors. If bond investors sell, that weakens the rupee. In the last year and a half, bond investments in India have been more than foreign equity investments in India. So you are more susceptible now to what bond investors are likely to do than what foreign equity investors are likely to do.

Watch the full interview here.

Avoiding Mid Caps?

A growing number of investors are getting increasingly wary of mid caps given their valuations and the way that they have run up. Historically, mid caps have always outperformed the large caps. Your thoughts on that?

If plot do a graph from January 2005 till today, you will not find the outperformance of the BSE Mid-Cap Index, BSE Small-Cap Index to the BSE 30 Index. There are periods when people lose rationality and everyone rushes in. In those periods, mid caps and small caps have done very well. You saw it in the BRIC environment when everyone said India was going to be a super power and the small and mid-cap indices and mutual funds did very well. Come to Lehman, the small- and mid-cap indices collapsed by 80-90 percent. Again, you have gone to madness since 2013, so they have had a phenomenal run compared to the BSE 30 or the NSE 30 index. To that extent, it looks good. When you look at a longer period, for the risk that you have taken for being in a relatively less liquid small-cap fund or a relatively less liquid mid-cap fund, you have not received the return or the reward for being in a higher risk category.

We did a study, we took 10 large funds, and HDFC mid-cap funds are the largest. If there was a massive redemption, it will take over 220 days for them to liquidate their largest holding. And the assumption of this is if you look at the trading patterns of the last year and you assume that the manager will not sell more than one-third of the average daily volume – because if he sells more than a third, then he may have a negative impact on the price. So making that assumption, the portfolios of all these mid-cap funds by and large are very illiquid. Not to scare people, but please look at the charts, look at what happened after Lehman to small- and mid-cap funds. If there is a situation like this, then liquidity plays an important role in getting the money back. If a manager sells too much stock too quickly, he hits his own share price and therefore hits the NAV and we have seen that cycle before.

In a similar way, the big thing going on is balanced funds. Most fund houses have a balanced fund where at least 65 percent of that money is in equity which is very unbalanced. Look at what happened to balanced funds between January and March of 2016. The indices were down about 8 percent, balanced funds were down more than the indices. A balanced fund is not supposed to fall more than the index but less than the index. But if the balance fund has equity-like characteristics then it may fall more than the index. When an investor is told to take money out from an FD and put into a balanced fund, he is being misled. He needs to be careful and understand the characteristic of the instrument that they are buying. Quantum Multi-asset fund between January and March of 2016 had a decline of 2.5-2.8 percent. It fell less than the index, it fell because we have exposure to equity, but not that much that it behaves like an equity fund.

So, your balanced funds are not balanced but they are extremely unbalanced. Investors need to be more and more careful about what they are buying, and the risk associated with what they are buying. The returns we know from the papers and the index, but the risk should be understood before investors plunge into markets and into instruments.

Top Themes

What are the themes that you think will outperform over the next three-four years – NBFC, brokerages have done well. What’s next?

There will be flows into financial sectors from household savings. So that is great for brokerages and mutual funds. Some of these financial companies are trading at 5-7 times price to estimated book value which is a fairly steep valuation by any global metric. Everything is priced to perfection as if nothing could go wrong and maybe nothing goes wrong. But if it does go wrong then you see corrections in valuations. So, we were very nervous about that sector.

As a value investor, we tend to buy which is not necessarily liked by the market. Technology and pharma shares have not been liked by the market for legitimate reasons. In the case of technologies, it is the Trump visa issue. In the case of pharma, it is the U.S. FDA internationally and potential pricing pressures set up in India to sell their products here.

We like companies which do not have too much debt. We like companies that have cash and we like companies which have business plans which, for next few decades, can show positive cash flow. Pharma and IT companies, while they are risky, on a valuation and risk-reward basis they look very attractive.

If you look at the Quantum Long-Term Equity Fund, they have inched up the allocation to these two sectors within the fund.

Giving Recent IPOs A Miss?

Do you think that a lot of these retail investors should consider themselves lucky if they missed out on recent IPOs, especially the insurance ones?

I think they should. Please recognise, a company does not hire an investment banker to be a lead manager if that investment banker walks in and says that Rs 100 is too high a price for a share and Rs 60 is good for the retail investor. You do a roadshow. In the beauty parade, it is the investment banker who offers the company the highest price that wins the mandate. If I walk in and say that ABC insurance company, you are worth Rs 60 and I am going to offer your share at Rs 60, someone else says that I can give you Rs 100 because the market is great, then I am not going to get the mandate and maybe the investor will pay Rs 100 when it is worth Rs 60. So, I am talking about value and price.

Value is the intrinsic earning potential of the company and business. Price is what at a mad moment you feel like paying or at a depressed moment you do not feel like paying. So, the price will go all over the place, but the value remains here.

In general, IPOs are to be avoided in bullish times because they are priced against the investor and for the company. Nothing wrong with it but recognise that investment bankers are not hired by retail investors, they are hired by the company to sell shares to the retail investor. So, be careful.