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Alpha Moguls: What Will Make Morgan Stanley’s Swanand Kelkar Confident About India Again

Morgan Stanley’s Swanand Kelkar is “slightly cautious” on Indian markets even as they trade at record highs. And his view on the country would only get better if two specific macroeconomic factors improve.

“I would want to see a couple of months when neither oil or the rupee make the headlines,” Kelkar, managing director at Morgan Stanley Investment Management, said on BloombergQuint’s special series Alpha Moguls. “When you get those two months, that is when I’ll get more constructive.”

His concern stems from his view that despite India’s “fairly strong” domestic growth story, macroeconomic indicators such as inflation, fiscal deficit and current account gap aren’t at levels that he would like them to be. “The environment is not very conducive given the macro-factors that are at play here,” Kelkar, who oversees $3 billion worth of India investments, said. “Within India, while the domestic story seems to be strong for the country to do well, some of the macro indicators really need to stabilise.”

India’s record stock market rally hasn’t given him enough confidence either. “This is not a roaring bull market kind of a high. It is an uneasy high. It is a narrow market rally, led by a few stocks.”

It is a very weird market. We are talking as if the markets are 10-odd percent down, but in fact they are at a record high.
Swanand Kelkar, Managing Director, Morgan Stanley Investment Management.

Kelkar said for the markets to remain here, India needs to deliver up to its potential on the domestic growth front.

Yet, he said investors looking to build their portfolios shouldn’t rely too much on macroeconomic factors. Instead, he suggests having a “bottoms-up” approach of picking companies that can deliver 15 percent annualised earnings growth and not look for particular sectors.

The biggest mistake I’ve made over the past five-six years is making pure macro calls. When I made those calls, the transmission into specific stocks wasn’t that strong.
Swanand Kelkar, Managing Director, Morgan Stanley Investment Management.

Below is the edited transcript of the interview

Are you worried or sanguine about the prospects? It doesn’t seem like it is an India-specific problem, but one gripping emerging markets across the world. Also, add to that the trade spat is not doing us any favors.

If you look at India’s performance for the past nine months, there have been two phases. The first phase of 2-3 months was that India materially underperformed emerging markets. And it is only around the time that the discussions around trade started heating up, India started picking up in terms of relative performance against EMs. If you look now, India is outperforming others by 5-6 percent in the U.S. dollar terms. So, India is relatively insulated from the trade war narrative which is taking shape versus some of the other EMs and has a fairly good domestic growth story. That seems to be borne out by high frequency indicators.

Even if you adjust GDP numbers by two years’ CAGR given that the base was weak, etc., seems to show that there is a fairly good domestic story, which seems to be fairly strong and that attracting attention towards India. Even if you look at it from fund flows standpoint, the FII flows were steeply negative for the first 2-3 months of the year. When I last checked them, they were marginally negative. So, that turn has happened within this year in terms of India’s relative standing within the EMs.

Having said that, domestically, the three macro factors which we talked about that peak macro is happening in India in last 2017. The three indicators, inflation, current account deficit and fiscal deficit were going to deteriorate from here. It was the view which we had last year. That doesn’t seem to be stabilising as of now. If you look at any of these three metrics, inflation is clearly above 4 percent. Even if you look at RBI’s forecast for the second half of this year or early FY20, there is 4.7-5 range. So, the debate on monetary policy is when is the next hike. But the word hike is cemented. So, it is now or later is the discussion. With oil at $78/bbl, the inflation and the current account deficit problems are clearly there. They haven’t gone away.

On the fiscal side, you can look at two standpoints. The positive way of looking at it as despite this is an election year, there has been a reasonable amount of fiscal discipline which has been followed in terms of not letting the fiscal deficit blow out. That’s the positive way of looking at it. The negative way of looking at it is you have oil-related tax collection windfall from 2015 to 2018, when you could hike the duties and excise of petroleum products and shore up the revenue numbers, it is unlikely to repeat. Despite that your fiscal deficit number is still flattish that you were not able to capitalise on that windfall by reducing the fiscal deficit. When that windfall is not available for the next 2-3 years, then the deficit slips back. On all these three parameters, the narrative has not improved. I hope that it will stabilise a bit by now. That part is clear that this is not 2013. The markets are telling you the levels that which they were.

I would be slightly cautious because the environment is not very conducive given the multitude of macro factors which are playing globally, be it trade war, dollar strength. Within India, while the domestic story seems to be strong for India to do well or be confident then some of the macro indicators need to be stabilise. I would want to see a couple of months when neither oil nor rupee makes the headline. When we get those two months, then it will be little more constructive.

If both stays and do not improve materially from here but the micro is showing improvement, does that provide a downward cushion aided with the strength in domestic flows which thus far seems to be okay. Do those two yardsticks help cushion any kind of major downfall if it were to come back?

The strength of domestic flows is a good trend. I am happy as those numbers remained positive despite the fact that markets have been what they have been. So, it is a very weird market as we are talking as markets are down, but they are at new highs. It is different market and not roaring bull market kind of high, but it is an uneasy high. It is narrow market lead by very few stocks.

Domestic growth story provides a cushion. But it provides a cushion versus the expectations. If you have FY19 or FY20 EPS growth numbers for Nifty and MSCI at 20+, then the cushion is provided if those numbers are met. It is already in the numbers that you are trading on 20 PE on a 20 percent earnings growth numbers. I am not a big fan of looking at market-wide earnings number. For the markets to remain here, domestic story has to deliver. If there is even a slight weakness in the second half of the year, it will be difficult for markets to hold, especially given the fact that market rally is very concentrated and narrow for now.

Does your portfolio construct, if you had the levy to do, change materially of what it has been in last 9-15 months, in that you also keep some room for cash anticipating a correction whether led by global or domestic factors like elections?

Having talked to a lot of cement companies, the three metrics that matter is volume, price and cost. The one metric which every cement company unequivocally seems to be confident of for the next 12 months or so is volume. Everybody seems to be telling that double-digit volume is a given, and its primarily being led by infrastructure projects. This could be a rush ahead of busy election schedule to get stuff finished. The question which is not being answered is whether things would cool off after 12 months of frantic activity.

But as of now, the volume growth is strong. The only thing on making a broad comment on infrastructure is that public expenditure is the only piece which is driving the sector. The difference versus 2005, 2006, and 2007 is that the buyer in that cycle was dispersed because you had housing, private and public capital expenditure doing well. But now, it is one large disproportionate buyer for cement companies which makes the pricing equation a bit difficult to negotiate. In a diffused buying environment, you can raise prices easier. In a single large dominant buyer, raising prices is not easy as it is in a diffused environment.

For building portfolios, I will give two approaches. One approach is macro top down approach where you can say oil is at X, and rupee is at Y, hence current account deficit, inflation, and fiscal deficit are at these levels, which means these are based on external facing sectors. You go overweight on sectors like tech, pharma, etc., take a broad top- down view, align your portfolio into this pocket of the market and say that you will stay away from the remaining part.

The other view is that these same factors stay here or reverse from here in which case inflation pulls off, you get benign monetary cycle, cost of funds goes lower. You buy wholesale funded financials who get money from the wholesale market. But it is a short-term way of constructing portfolio. This portfolio you are constructing for next 1-3 months and it is always a difficult game to play. The way I have looked to construct portfolio is to look bottom up. To find 15 percent earnings growth, ROE and not look for sectors or look for macro calls. The biggest mistake that I made in the past 5-6 years was when I made pure macro calls saying that I think rupee is going to X level, the corporate asset quality cycle is over and made those calls based on these factors. That is when the transmission into specific stocks hasn’t been that strong. I still stick to my bottom up way of investing. I still find domestic sector growth is fairly good. I am finding 15 percent growth and earnings opportunities in those spaces.

The only change is that we have reduced our underweight view on technology stocks. We were deeply underweight on tech. We have reduced the underweight over past six months. The original thesis was that FY19 from topline growth standpoint is better than FY18. But there are some mid-cap companies where I am able to convince myself that they are meeting my 15-percent growth bar. As facts have changed, I have changed my opinion. I have added some technology names. But this is not a rupee driven decision. This is a decision driven by the fact that six months ago I thought that company X was going to grow topline nine percent but now it will grow 12-13 percent.

The rupee will help margins, and hence, there will be a better EPS outcome. Those are the kind of companies where I have engaged in. There is a fundamental change in the business dynamics. We are still underweight on tech. I don’t think it is a widespread acceleration like the one we saw in 2009-10. This is an acceleration for sure versus the last year. It might be 2-3 percent points. But within that there are winners to pick.

By definition of 15 percent growth numbers, you are looking at mid-cap tech stocks. But then for large-cap technology stocks, there is probably one name which is talking of 15 percent?

There are a few mid-cap and some large-cap names which could meet that number, and those are the ones we have moved to. But the portfolio is extremely biased towards domestic growth names. That’s how I have stuck through these. I feel the market has taken the top down view of investing. If you look at the sectors which have done well for past 8-9 months, its IT and consumer staples. This reminds me of 2013, when IT and pharma companies, again exporting sector and staples, which did well. Everything else was underperforming. So, this is like a 2013-kind of reaction that the market has taken by taking the top-down view. Consumer staple is a a defensive sector. You have bought the label, not the underlying business fundamental. That is what has happened. As and when it would reverse, it will be a very sharp reverse.

My dream scenario for the portfolio is that oil and rupee are not in the headline for two months.

If you have that leeway as a personal investor, will you sit on some percentage of cash to be deployed a bit later on when the opportunity arises?

As a personal or a professional investor, I have rarely taken cash calls. But my adjustment filter there is how sticklish I am on valuations rather than taking a cash call. I have tightened the valuation metrics to provide some cushion and margin of safety. In a go-go market, I might loosen it a bit. In a market like this, I want to be extremely sure of what I am getting into. To get into those kind of stocks, you have temporary amount of cash, then so be it. I have not taken a cash call saying that I want to sit on cash.

If you take 10 percent cash which is the maximum allowed, and a market corrects by 10 percent from today’s level, i.e., go down from 10,700, you make 1 percent alpha, 10 percent to 10 percent cash. It is not a big number. I am not as certain as this is going down 10 percent to meet that kind of alpha. I have refrained from taking cash calls. On an overall balance, these things even out. So, I would rather tighten my valuation parameter. I will tighten what gets into the portfolio rather than taking cash calls.

How do you play auto sector?

We have remained engaged in commercial vehicles. After the July and August volume numbers, due to overloading restrictions being removed, the CV guys are telling me that the demand for CV is very high. Freight demand is running strong.

In the passenger vehicle space, we are engaged with one company and plan to continue that. This is not so much of a call on passenger vehicle growth as it is on the attractive industry dynamics that you have in India. There is one car company which has the market share comfortably in excess of 50 percent and has no incremental competition left to come because everyone has tried the hand here.

Think of the last couple of years and name a non-50 percent guy model doing well. You can probably name one or two. The top 5-6 selling cars belong to one company. Even if the passenger vehicle growth is in single digit, I am confident that the dominant market share player will have two times that growth and the remaining industry will be flat. That is the call which we have made on the industry structure more than the passenger vehicle growth which remains okay and a decent number.

With presumption that autonomous driving or aggregation driving is going to become bigger, the car industry would move from being B2C to the extent of moving B2B as well. Does that also set the stage for a low-cost dominant player to extend its strength and dominant position?

These numbers are not in public domain but the the passenger car sales made to cab aggregators peaked in FY17 as a percentage of total passenger vehicle sales. That number has come off a bit in FY18. As you try to shore up your P&Ls as cab aggregators, either induced by private equity or you want next round of funding or you have some issues happening at mothership, etc., the profitability for the individual cab drivers is not as great as it was. This is the trend which will continue but I think it has come off its peak.

The car of choice is the one which will give you best economics because this is a commercial venture and not a personal one. So for a commercial venture, you think of buying a car with the same metrics or in the same framework as you would think of buying a commercial vehicle which gives you best mileage and returns. So, that will drive your decision.

Do you expect a steep correction, or do you believe that because of growth momentum within the economy, it could be a shallow one?

An idiosyncratic correction, which is an India-only correction, is unlikely to be very deep. If you get a correction which is emanating from global factors, it is very difficult to hazard a guess on what kind of a correction you will get because of those factors. That’s where I stand at. The macro factors are well telegraphed. I think the India only correction seems a bit difficult, a steep one, but you don’t know how steep a global market driven correction could be. I still remember John Templeton’s lines, “a lot of people have lost money waiting for the correction than in the correction itself”.

I am not a person to make big market calls because that is not my forte. I know friends who have a great sense of market, but I don’t have it. I would rather spend time analyzing companies and sectors and react to prices rather than spend time thinking a lot about whether this looks over extended or extended on the charts. Not that it is incorrect, that’s not what I have done but why dabble into things of which you are not good at.

Where are we in the lending super cycle? Do you think we are pricing in the change adequately?

In terms of where we are on the cycle, we are getting started out. I don’t think the cycle has matured. If we see the metrics of India’s household debt to GDP, what percentage of two wheelers are sold on finance, it is just starting out, may be 2-3 years. If you look at what kind of loans are being extended by banks in these spaces, we are just getting started. This is the trend which can get over extended quickly. I remember meeting a financier in 2006-07 cycle who was lending unsecured loans, and I asked what was the criteria for lending and the answer I got was traceability. I should be able to trace the guy who I have lent to and if I am sure of it, I will lend, and it scared me. Traceability cannot be a criteria for lending.

The industry has come a long way over the last 10-12 years from traceability being the only criteria. In 2006-07, if you came out of the airport and had an economy class boarding pass, there could be somebody standing out to give you a credit card: you just handed over your boarding pass and you got a silver credit card. If you had a business class boarding pass, you would have got a gold credit card. So, it was a very surrogate way of lending.

But now it has become a lot more scientific. You have credit information bureaus which are now able to give information on borrowing history of a person. There are institutions, banks, NBFCs, etc., who are now tapping into data of their own customers much more effectively than what they were doing earlier. Thus far, this cycle seems to be on a good footing and evidence for that is the segment wise asset quality numbers that we get from some of the independent data providers. The cycle has legs to run. But I will watch this very keenly. I am not saying this time it is different, but it is the same. But the thing is we are getting started out on this cycle and there are still enough legs to run for it but you have to keep watching signs of the over extensions very closely.

Is it because all the incremental credit growth has been retail led and that’s why it is a sign of getting it into an over extension space or as would bear would say it is already over heated?

Bulk of the incremental credit is not retail getting over heated but other parts of lending not doing much like agri,corporate, etc., are flattish. If you look at the retail growth numbers, those by themselves are in the 18-20 percent YoY growth range, which is not over extended from the economy which is growing nominally by 12-13 percent. It’s the other parts of credit growth not growing as fast which is making retail stand out for its contribution to the overall credit growth. I will not say that it is getting overheated. You will always find pockets even at the beginning of any cycle, and naysayers will always point to these pockets. That here is the affordable housing company whose NPA has gone from 1 percent to 7 percent, or here is this X company whose asset quality experience has been really bad. I will treat them as isolated incidents.

I will look for commonality. Are all companies in that sector reporting similar asset quality experience? If not, then you have to look for reasons which are more specific to what has happened in those individual places. If you find that the entire segment, which happened in a certain segments, is reporting asset quality issues, then it is time to be cautious. For now, there are a lot of proliferating NBFCs. These are fintech-enabled small tech companies who are also lending. Watch that space very closely. It is good for now, and it’s extremely easy to grow 20-30 percent here, but keep watching the collectability. One of the CEOs of an NBFC said that bank and NBFCs make money in the last EMI of a loan. So, see the ability to collect that last EMI. See if the last EMI is coming through. Today, the naysayers are basically fearing the unknowns and the older generation thinking that loan is a bad word, but we have to watch how the credit cycle pans out, especially in this space. For now, I am not seeing signs of overheating.