The moving variable to look for is whether growth exists in the system and how profitable the growth is. You will get that from a smattering of large companies and the gigantic listed universe of small and medium enterprises.
There are no defensive businesses, says the contrarian Mr Kenneth Andrade, Chief Investment Officer, IDFC Mutual. There are only shifts in capital allocation based on the earnings growth of sectors vis-à-vis the index. Not wanting to view opportunities based on market-cap segments alone, Mr Andrade, throws up quite a few interesting ideas for investment based on global changes in an interview with Business Line.
Excerpts from the interview:
Indian markets have outperformed most global peers on a year-to-date basis. Are markets taking less note of global risks?
Markets are not less concerned about the global risks that exist except for the fact that, if you look at a couple of trends that have been happening in India and in a significant part of the emerging market, it is contrary to what's happening in the West.
So, that resilience itself is holding out. When I say contrary trends, you've got the US and probably Europe heading into stagflation while you still have inflation in the emerging part of the world. And that, by itself, attracts a reasonable amount of money because inflation is a derivative of growth. So that will hold out in the near term.
What do you make of the current Indian market valuations compared with peers?
We are not expensive; we are not cheap. We are very close to the long-term median line. Added to this, stimulus withdrawal has been happening across the world. In a way India has already had a roll-back of some parts of the excise duties and now the realignment of petrol prices to some market-driven formula.
These are all very good from a macro-point of view as it helps the fisc significantly. And, if growth still does not stop then somewhere you will justify the premium valuations that you trade at.
But we have been seen growth moderation in sectors such as cement or telecom with profit margins too compressing. Could that extend to other sectors?
That will always happen in any industry where there is fragmentation of capacity or introduction of new players. When capacity grows significantly faster than the demand, you would see near-term contraction in margins. The contraction is also essential to make sure the strongest survive.
It's very prevalent in real estate and in some phases in infrastructure where the pricing power just does not exist with the contractor anymore because there is so much of fragmentation. You will start seeing it in the commercial vehicle and automobile market because India has moved from duopoly to probably 10 companies manufacturing four-wheelers andwe have more lined up.
Going forward we will see more segments actually fragmenting and that will lead to contraction in margins, competitive price points and product innovation to stay ahead of the curve.
In the recent rally we saw the traditional defensives pharma and consumer goods outperform. Are we seeing a shift in the classification of defensives?
What is defensive and what is offensive! Let me put this in perspective. You had an FMCG business at the turn of the century which was steadily growing at 15 per cent per annum and then there was this sector that turned up — technology — which grew at 50 per cent per annum. So you simply had a capital allocation choice. So you took that money and allocated it to technology. And yet the FMCG businesses continued to grow at 15 per cent per annum.
At the turn of the century, technology collapsed and FMCG grew at 15 per cent per annum. And so, FMCG was a defensive. But you have to remember one thing, when technology contracted, your index earnings contracted and the (index) growth levels went below the FMCG earnings growth levels. Then the investment economy picked up. You had the same scenario – FMCGs grew 10-15 per cent, while capital goods grew at 30 per cent. Again, there was a capital allocation choice and everything went into capital goods. You had polarisation of capital, so FMCG was overlooked.
Today you have a scenario where the index earnings is significantly below the earnings of the FMCG companies. So you now have a capital allocation which is moving steadily towards the consumer part of the economy as the latter is now growing faster than the investment economy and probably faster than even the outsourcing economy.
And that's playing itself out in the index. So I don't think there are any defensive businesses, expect that while growth has always been there, they trailed the markets; the growth has actually stepped up now. This is true of pharma as well. While domestic formulations businesses have stepped up in growth , the export-driven businesses suddenly have flush, large tie-ups coming from MNC companies, wanting to take the manufacturing capabilities of the local companies to their countries.
The valuation gap between mid and large-caps has shrunk. Where does the opportunity lie for investors? I would not want to go with the bias of market capitalisation. The moving variable that we need to look for is whether growth exists in the system and how profitable the growth is. You will get that from smattering of large companies and since you have such a gigantic small and medium enterprise universe that is listed, you would also get it from some part of that market. So you just have to look at opportunities and there are plenty of them out there.
The consumer story is probably one of the biggest that's setting itself in India. And when we talk about the consumer story we are not saying it in isolation because all emerging market economies are focussing on the fact that they would try to get the consumer back to revive their economies. So, China is no longer looking at the American consumer, it is looking at its own for growth. India or Latin America or some parts of Asia are all doing the same thing.
Two, on the outsourcing front we still enjoy the arbitrage in the standards of living between the West and this part of the world. But, more importantly, with wage inflation between 20-30 per cent in China this year, our economy would tend to be a little more competitive in this space. So we will take market share in some of the low value-added items, such as textiles.
Three, there will also be a shift in technology, in the sense that we are moving away from the desktops and networks are getting increasingly more bandwidth-intensive. So you will see a lot of capex happening on the technology part, which does not necessarily mean just software.
Four, Europe is more competitive than China now because Euro has depreciated vis-à-vis the dollar and China is going to peg vis-à-vis the dollar. So Europe goes into being one of the largest (manufactured) exporters in the world all over again. And they have got a very large ancillary base out of India. So, these are all opportunities that exist in the entire system.
Now you can play it through the engineering companies of the foreign MNCs in India, which are large-caps. Or you can play the outsourcing stories on some players in the technology space which are large-caps.
In manufacturing if we need to go back to textiles, which are low value-added, it can be through mid-caps. If we need to play with the entire consumer gamut, we get them through discretionary spends, such as automobiles, which are large-caps, or through domestic appliances, that are either mid- or small-caps or FMCGs, which are available across the entire spectrum.
So, look at the opportunity and if there are large and mid-caps, then they both should go together.
However, small and mid-sized companies carry the risks of being hit by any hike in borrowing costs. Does that make them less attractive?
What is relevant here is to note that the mid-caps are actually much better financed than the large companies. Not too many of them are actually over-leveraged. A lot of them are setting capacities; despite flat top-line they have not made losses.
Some of the very large companies are completely over-leveraged. So, on a structural basis, I think the smaller part of India is a little more resilient than its larger peers. Again, by definition, this does not mean that the smaller part is going to overtake the larger part. All the large companies that we know of are in commodities, engineering, banking and some part of technology.
Of the four, technology is the only one that is deleveraged. On the other hand, if you look at mid-caps, you've got contractors, which are working-capital intensive, so no significant leverage; which is the case in the engineering space as well. Then you have consumers, who are free cash-flow and then pharma companies, that do not need very high cash.
Q. Would the recent deregulation call for a re-rating of stocks of OMCs?
See there is an opportunity in the entire space and the opportunity is that this sector is the largest part of India's GDP and of all them fall in the services part of the GDP. Now, if you look at that and say that private sector does not realise that there is a huge opportunity in addressing this space I think it is very wrong. So I would not put these companies at a significant premium to the existing petrol stocks or oil marketing companies listed elsewhere in the world or in India. Sure they have got depreciated assets, to that extent it is fair, over and above that I am not too sure we will have a sustained re-rating over the next 12-15 months.
Q. One more topical issue is the introduction of base rate – would it impact borrowing costs of corporates?
You may see a hike in short term financing costs but let me also qualify that statement. There has not been a very large build-up of inventories in India. And working capital is probably the largest part of any company's balance sheet. Project finance is relatively a smaller part. So I would not say that the increase in cost would dramatically affect the P&L account of companies. In some cases, you might see an increase by 1-2 percentage points. That's the range in which a lot of companies may report an increase in borrowing costs. But at the same time it also increases the opportunity of creating a very vibrant bond market. It also means that Corporate India would look at alternative sources of funding which includes going overseas.
Source: http://www.thehindubusinessline.com/iw/2010/07/04/stories/2010070450950500.htm
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