Alpha Moguls: Next Wealth-Creation Cycle Won’t Start Soon, Says Ravi Dharamshi
The correction in Indian equities is mostly done but the wealth creation cycle won’t start soon, according to Ravi Dharamshi, chief investment officer of ValueQuest.
India has been lucky that crude-led macros have become kinder again, but global liquidity for emerging markets is still in a receding mode, Dharamshi on BloombergQuint’s special show Alpha Moguls. He doesn’t expect the markets to hit new highs in such a situation.
India’s benchmark indices hit record highs in August but have since erased most of the year’s gains. That rout was first driven by rising crude prices and a weakening rupee, and then a credit crisis triggered by defaults by IL&FS group companies.
“Stock pickers are so focused on individual stocks that sometimes we miss the macros and they hit us hard every few years,” he said. “And 2018 has been one such scenario where macros led to a sharp correction.” Most people didn’t anticipate such a correction, especially in the broader markets, according to him. “A large part of the drawdown is done, but that doesn’t mean that a wealth creation cycle would begin soon.”
Crude prices have now fallen from their highest level in four years and the rupee too has strengthened. The Reserve Bank of India is also providing liquidity support.
Still, Dharamshi doesn’t expect the markets to rise dramatically in the near term. But, according to him, Nifty 50 could hit 11,700 levels in the short term. Investors, though, would need all the patience, conviction and courage to hold on to their portfolio, he said.
Here’s what he advises investors:
Dharamshi expects the growth drivers to change. Consumer and non-bank lenders’ stocks will see a slowdown. “Both are intertwined and there is going to be a one or two-year period where these sectors are likely to not provide great returns on a relative basis.”
Conversely, corporate lenders will likely provide good returns, he said. Among these, he is size-agnostic. “A bank having liquidity, reach, balance sheet strength and ability to grow will come up trumps.”
The capital goods sector too has a good probability of throwing up winners in the next 12 to 24 months, he said. It’s a sector which the market has largely ignored and needs only the private capex cycle to revive to throw up winners, according to Dharamshi.
He is bullish on liquor stocks because of the changes in distribution, lower raw material costs and price hikes.
Selling drugs to China is going to emerge as an opportunity in the next five to seven years, he said, adding that the nation is keen on having India as a second source of supplier of generics. “This may well enable pharma exporters to compensate for the lack of growth and lack of profits in the U.S. market.”
Watch the full interview here
Here’s is an edited transcript of the interview.
Last year, you mentioned that there was an absence of volatility in 2017 and 2018 will see a return of volatility in a meaningful way. It has brought about volatility in stock prices.
Volatility looked like an obvious thing at that point of time. Some of the things were not as clear. We had nine years of pull marketing U.S. The U.S. 10-year rate went from 1.6 to 3.2. Crude shot up to $85 per barrel. Bond yields in India went from 6.4 to 8.23. There was ample reason for the market to pause. But the action which panned out shook the confidence of the best of investors. With that backdrop, the foreground conclusion is that volatility will come back. Now the question is, the top that has formed recently is for 6 months or 12 months? Or will it be prolonged or elongated?
What’s your gut feeling about it?
The macros were bad. Combined with that, the valuations in some pockets were very expensive. So, there was a legitimate reason for the markets to pause. There were a couple of things missing, like a euphoria. There has been a lot of inflows from retail into the mutual funds. But I wouldn’t classify that as euphoria. The leverage cycle in India is yet to begin. We are still deleveraging our balance sheet. Due to this, it is more like three, six, nine months correction rather than 12-18-24 months kind of correction. It is restricted to a pocket where the valuations got a little more expensive, like consumers and non-bank financial lenders.
Is probability of a sharp drawdown more currently, or do you reckon that a large portion of valuation drawdown has happened for India and probabilities of us doing better are more pronounced?
Large part of drawdown is done. But that doesn’t mean that we are going to have a wealth creation cycle soon because there are still some events lined up. We are lucky that some of the macros fell in place for us. Crude dropped dramatically which has led to a stabilisation in rupee and bond yields. Thankfully, that is out of our way and should provide some sort of a flow in the market. At the same time, there is uncertainty in the U.S.-China trade war. Globally, liquidity is still in a receding mode because U.S. economy is strong, and Europe is still recovering. Incrementally, liquidity is receding. In that scenario, we cannot be making a new high. Going forward, in the next 6-12 months, we are more likely to be on neutral grounds. There will be ups and downs and we must take advantage of that volatility rather than clear trend suggesting that we are done falling and we will make a new high, or we are in top and will fall another 20 percent.
A very bottom up stock picker like yourself is talking about market cycles. Did Howard Marks’s book have some influence?
Yes. We are so focused on companies that we are invested in, that sometimes we miss the slightly bigger picture and that hits us hard every few years. 2018 was one such scenario where macros came in and we had a sharp correction out of the blue. Most bearish of people could not have expected this drawdown. In a couple of months, only the large caps corrected. The midcaps have been correcting since the beginning of the year. Over and above the 30 percent kind of fall, another 30-40 percent fall in midcaps hurt a lot of investors.
How does one create a portfolio in the current market scenario?
Behaviourally one needs to mentally adjust to be okay with subpar returns for a period of time. You cannot time the market precisely, saying “I will sell here and buy here.” Going back to the book of Mastering the Market Cycle by Howard Marks, essentially, you have to be in neutral mode at the point of time. The book talks about where you must be in a market cycle to understand where you are in the cycle. By cycle, I mean economic, market or leverage cycle. If you are aware where you are in the cycle, you must adjust your behaviour to that portion of cycle. Today, we should be in a neutral zone rather than being aggressive or very conservative. There were some concerns about overvaluation. The two months of market correction took care of it, though. We are at a neutral range. That is the behaviour that should make one ask if you should be allocating more towards equities. If your percentage allocation is not too high, you should think of allocating. At the same time, it is not a rising tide. Every company or stock will not necessarily do well. It will be a very nuanced market, volatile and stock pickers’ market. You will need all the patience, conviction and courage to hold on to what you have. For creating wealth, one must stay in equities through this volatility. Some amount of pruning and getting out of stocks that you believe are deadwood in your portfolio and getting into new themes which are emerging. That should be the strategy. As to where to find those strategies, it is a moving target.
In case of a correction, would you stagger out your purchases in opportunities that appear attractive right now, or would you believe that if the opportunity presents at the valuation that you want, you don’t mind buying the whole chunk at one go currently?
Whether to buy in a staggered phase or as a chunk is also a factor of portfolio manager’s personal style. If I find an opportunity, I will not hold back, or fear that there is only a 10 percent downside possible. If one survived August-September(slide) then whatever comes up ahead, we will still be okay. We will not be committing the error of buying something expensive at this point of time. There are land mines and one must be careful. If you find that opportunity, I would deploy.
You don’t seem to be unduly perturbed by the election calendar lined up in India, the volatility that it could bring, the potential downsize that it could bring (if at all there is an outcome), if the U.S. Fed were to be on a tightening spree faster than what they anticipate right now and the resultant correction that it could bring in.
For politics, I have no idea (of the outcome). It is way above my paygrade to know that what the electorate of this country will do. I can only paint scenarios. If the current dispensation were to come back and the market were to go into euphoric stage, then I will look to create cash. If the reverse were to happen, it doesn’t pan out and market correct sharply, I may think of buying more. It is an unknowable variable. In the past, we have seen that immediate the reaction is not necessarily the correct one for the eventual pan out. Whichever government comes in, we are at the bottom of the economic cycle and we will turn around. The next government will reap the benefit of all the structural changes that have happened in the last four-five years, whether we like it or not. Something similar happened in 2004. The NDA government was out but 2003-08 was one of the best periods. History rhymes, but it is not exactly the same. We are on a wicket where it will be an improving economic trend for the next few years.
In a span of a year, the U.S. Fed and the European Central Bank combined are going to reduce their bond buying to the extent of a trillion dollars in the next 12 months. That is playing its role out. For over eight-nine months, FIIs have been constantly selling in India. Markets are positioning themselves to the possibility that the U.S. Fed rates would be higher than anticipated. The valuation will provide the bottom. It is not like we cannot have a rising market in up trending interest rates. If the rates are going up because the economic strengths are good, then it is good thing. We will adjust to the fact for higher rates. We will ask for more risk reward in our favour and that’s how we need to adjust. We need to adjust our expectation of returns.
It was an unusual Samvat. Volatility made a comeback. There was no HDFC bank, Kotak bank, or Maruti-like company in the list of top 10 gainers. Anchored stocks for portfolio were not doing well. How do you think the next 12 months will be like from that perspective?
The market performance was carried on the shoulders of a few stocks like HDFC bank and Marutis of the world. So, the market was positioned in that defensive before the volatility started. There could not be a safe haven which one looks out for. For other banks, there was severe underexposure and that is why those are the ones where money has flown into. They are providing returns. The nature of the market is going to change. Consumers and the NBFCs, which were the darlings of the markets three months ago, were priced for perfection and there will be a growth slowdown. Both are intertwined with each other to that extent. That growth slowdown will reflect in the coming period. There is going to be a one-two year period where these sectors are likely to not provide great returns. I am not sure on absolute basis, but on a relative basis, they will not do well. If that is the case, then the mantle needs to be picked up by something else. There was a time 12 months ago when the expensive stocks kept getting expensive. The cheap stocks got cheaper. So, the expensive stocks have now started correcting but the cheap stocks are not yet back into the up-cycle mode. Capital goods is one space where the profit pool has shrunk dramatically in the last decade. It provides for a happy hunting ground. If private capex cycle picks up, and there is a good probability of that happening over the next 12 months, then there will be good winners coming out of this. That is a sector which the market has ignored for a long period of time.
Are you looking at investment-led themes, picking up the mantle of growth, stock price performance for the next 12 months?
I wouldn’t say it is a 12-month perspective, but it is a three-month perspective. It is tactical. For me, over a 10-year period, consumption in India remains the backbone of Indian market. No one can deny that. With a two-year point of view, that theme can correct itself. In a 10-20-year bull market, you can have two years where those stocks don’t do anything. We have entered a phase like that where some price correction needs to happen. In the meanwhile, there is another major theme with lot of listed companies in that theme, which is emerging, and which provides a better risk reward. It is not a one-year call. If it does pan out, then the cycle will last for three-five years.
But you are not off financials as you like banks.
Within financials, I am avoiding NBFCs for obvious reasons. Public sector banks don’t have the capital. NBFCs don’t have the liquidity right now. Banks have the liquidity as well as growth capital and they also have product offering. The NBFCs took advantage in last five years by capturing the market share, the banks have that runway available to them with less competition. If private cycle capex cycle is picking up, then early movers will be corporate lenders.
Would you be size agnostic or bet on large ones?
I would be size agnostic. Whoever is best positioned, who has the best liquidity, liability, reach, they should do well. There are smaller companies which can do well. But I will go with looking at balance sheet and willingness and ability to grow.
Have you seen the willingness and ability to grow in small size bank’s balance sheet, too?
Small size banks are not out of their asset quality problems with respect to regional private banks. They are still struggling with getting asset quality in place. But they have the liquidity and capital required. Once the cycle becomes apparent and their asset quality problems are taken care of, they also provide a very good risk reward. They are valued like PSU banks at this point of time even though they might be private companies. They are all at a sub 1-1.2 price to book. That is where outside returns over five years can be made. One more space is small finance bank. They are not exactly corporate lenders. Right now, they are suffering because of technical issues which have cropped up. Also, the NBFC crisis would have led to liquidity tightening and capital being an issue to them. Though on the ground, it is not an issue. The perception about them being a full-fledged bank or their ability to raise funds in markets is still under question. Market will adjust to the fact. Once they get their liability side in place then they will have good runway to grow. Their size is much smaller. So, they will have much faster growth.
Is this technicality not big over hang to your mind?
Market is pricing that in. It is an issue. At this juncture, the market is saying it is sure to happen and value is going to be destroyed. In case, if it doesn’t happen for whatever reason, then there is a double upside. Couple of them that are listed are thinking about giving 60 percent of banks’ shareholding to existing shareholder and 40 percent being held by the listed holder. If that is the case, then assuming a 50 percent discount to the whole core, one is able to salvage 80 percent of the value. This is also a period where the costs have been initially absorbed via these banks. The growth is still up ahead of them. It is a huge operating leverage which will pan out once the growth comes back. We could be a quarter or two away from that happening.
Lot of people didn’t bet on exporters as they bet on import substituters. Specialty chemicals came out as a big theme on import and export substitution side. It is a space which has seen multiple years of growth. Are you constructive here?
I am definitely constructive on the specialty chemical space. But I must caution that specialty chemicals is not one sector but probably has 50 sub-sectors under it. You need to be sure of the chemical you are investing in. The likely threat of substitute or neighboring country or where we are in that cycle. Lot of gains are price led and not necessarily volume led. When those prices reverse, we don’t have an idea about it. One needs to be diligent about what kind of companies they pick. Not everything is a specialty chemical company. From a long-term point of view, there is a window of opportunity that is available to Indian companies. Thanks to the pollution issue in China, trade war and combined with the fact that labor is becoming expensive in China. We have a base of manufacturers in India who can take advantage of it. The European and American customers are looking for an alternative to China. In that broad theme of import substitution and being the second supplier after China to the developed world, then that theme is panning out. You need to be careful about what stock you pick. It is not a black and white thing.
So, within chemical space, bulk chemicals, Agro chemicals, you are selectively bullish.
The strength of the company in that particular chemistry, their ability to produce at a competitive rate with China, or ability to compete at a scale with China, all that will ensure the longevity and sustainability of the opportunity that they are able to encash.
What are your thoughts on sin companies?
In the consumption space, this is one space where there is some value and growth which has not been priced in yet. I like liquor companies. The largest one which is listed came out with good numbers though it had some patchy quarters. So, the ability to extrapolate that is missing at this point. These are the kind of companies which you want to buy and leave for your grand kids. No amount of disruption is going to hurt them. Only they can hurt themselves. There is a regulatory risk present on these companies. Government is known to kill the bird that lays the golden egg. If you believe that sanity will prevail then this is the biggest contributor to the exchequer at state and central level.
There are a few reasons why liquor companies are doing well and will continue to do well. The route to the market changes that have happened in various stages, whether it is through a franchise route or directly through government or too many distributors, has led to a big expansion in the market and it has been favourable for the industry. Raw material prices are in favour. They have seen prices increase in the last year which they had not seen for four years in a row. The growth is coming back after a long time. The competitive intensity has also decreased after the exit of the Indian promoter and the entry of the MNC. So, the competitive intensity has reduced which is leading to growth as well as margin improvement in this space. We do own some of the companies. This space is poised for very good growth over the next two-three-year period.
Is it safer to bet on larger sized sin companies even if they are more expensive?
I would not distinguish by size, but by brand. You should look for a demand pull the particular product creates or if it is just a commodity being sold. If there is a brand which is being created, then those are consumer companies in the right sense. Or if you are just selling country liquor and you don’t have a brand pull and if you are just a beneficiary of the cycle, we would go with branded players. Within that there are only two-four companies. So, the size doesn’t matter. Whichever is positioned with best brand in best geographies works. The north based states are witnessing some hyper growth. There is a lot of business off the books which is coming back on books.
The Uttar Pradesh government, last year, collected excise worth Rs 16,000 crore from liquor and this year they have budgeted Rs 28,000 crore. So, if the government is witnessing that kind of a growth in excise collection that is coming from the manufacturer, they will witness huge growth. That growth will continue for some time. There was a monopoly distributor and that monopoly has been broken as the profits are being redistributed between the government manufacturer and distributor.
How do you approach the auto sector or auto ancillaries which have an export element attached to them?
I am avoiding auto stocks at this point, especially the passenger vehicles. I believe that a lot of growth was fueled by the NBFC lending. There is disruption of electric vehicles which is approaching. Markets are forward looking and there is something that we might feel right now that it is 10 years away. But the market might start factoring in that today. We are witnessing this disruption in the media space clearly today. One of the large broadcasters is about to sell 50 percent stake. That is a submission of the fact that the tech is hitting them. They might have other reasons like balance sheet issues in group companies. At the same time, the disruption risk is real. We can argue on the timeline. When markets have trouble understanding what terminal value to give, valuations start tapering off. Also, this festive season was not that great. I don’t see a reason why one should be rushing in it again.
What about the ancillaries?
For the fact that they are manufacturers and some of them are exporters and there is a probability of being an outsourcing hub, then I will go with those kinds of ancillaries. If there is an over dependence on passenger vehicles in India, then I would be careful. Commercial vehicle cycle is still continuing. So, commercial vehicles-focused auto ancillaries will still be okay.
Do you think that the merry run is over or paused for export companies or do you reckon that the market will believe that if you are a cash generating company of growing 13-15 percent then there is no harm in giving you the price to earnings multiple?
India is very entrenched in the global supply chain in IT. It will not change. India increasing its market share in IT outsourcing space and within that service is a secular trend which will pan out. A year ago, this stock was factoring in a possibility of 7-8 percent growth. When the 7-8 percent turned out to be 10 percent, re-rating happened. Midcaps which displayed 15-20 percent kind of growth got rewarded disproportionately. To that extent, the reversion of mean trade is done. Now, with some consolidation when the market gets it confidence back, that this kind of trajectory can sustain over a period of time, I don’t see a risk that these companies will face. There are a lot of technological changes happening and relevance of Indian IT company is when they have to keep themselves updated and be at the edge of technology. If they manage to do it, then the opportunity is there for them to take. When you put an exporter growing at 15 percent compared to consumer company growing may be 20-25 percent but valued at 40 percent, then IT companies are okay. May be after a round of correction and consolidation, they will still go back up. It is not all dooms day.
What’s your approach to the pharma sector?
We must accept that the attractiveness of the U.S. market has reduced for good in oral generic space. There are still pockets of profitability where there is inhaler, bio-similar, specialty. Those profit pools are difficult to capture. It requires higher investment and much in advance. These generic companies have gained in size. All of them are quoting a Rs 30,000 crore to 40,000 crore market cap. They are not small. They do invest a lot in research and development. There is a transition phase for them to make the next move, they have the diversify away from the U.S. and away from oral solids into specialty devices and many other sectors where the profit pool is available for grabs. Valuation wise, we have corrected substantially. The companies which grew 25 percent plus have now come down from profit growth of 10-12 percent. They are running hard to grow by 10-12 percent or stay in the same place. That is why there was de-rating in the sector. Until the market sees that 10-12 percent going back to 15-20 percent, I don’t think valuations are going to change dramatically. That kind of a growth can only come if they have a special product or if they manage to crack a new geography. China as an emerging opportunity It is new to Indian market. Selling pharma to China is going to emerge as an opportunity in the next five to seven years. A company took seven years for their product to get registered in China. The second approval took them 18 months. China is very keen on having India as a second source supplier of generic. They want to bring their healthcare cost down. This will be an interesting opportunity. May be to some extent we will be able to compensate for the lack of growth and lack of profits in the US market. But we are still in a transition phase.