 "I see more opportunities than headwinds: Bharat Shah")
Even as Indian markets are at all-time highs, BHARAT SHAH, Executive Director, ASK Group, which has five funds managing over Rs 10,000 crore in equity assets, remains optimistic. In an interview to Vishal Chhabria, he says that there are incipient signs of the economy turning for the better and shares his thoughts on the investment avenues in the current market scenario. Edited excerpts:
Given the various headwinds, how has it been for your company and are your investors putting in more money?
Can't complain. Clients have been investing more money every single day. You talked about headwinds. However, I see more opportunities than headwinds. In my opinion, economy is turning for better. Incipient signs are visible. But, of course, economists will dispute that!
Aren’t clients concerned about growth not picking for a long time from the perspective of Sensex earnings being a case in point, as well as shorter term issues like demonetisation, etc?
Investing cannot be based on a projected number for an index or a group of stocks. Such projecting has no real meaning or utility. Investing remains the art and science of the bottom-up stock picking. If I am selecting a microcosm, out of the macrocosm of the whole market, I am more concerned about that microcosm as to how it is behaving or performing. Secondly, you can't talk about only earnings growth without talking about the quality of growth. Whether growth is achieved with superior capital efficiency and improved balance-sheet, or otherwise, is equally critical. If you observe, in several cases, even if earnings growth has not been as robust as you would have liked it to be, the quality of the growth has improved. Markets recognise any real value creation and value quality of growth and its durability, not just brute growth (and, not to forget the margin of safety). The third point is, even if the overall index earnings may not have grown significantly, if you remove the sectors in which balance sheets are under grief for a variety of reasons—internal as well as external, though a lot of it has got to do with really the internal issues-- then, the rest of the growth is pretty healthy. But, if you are looking for just the headline growth, then yes, it will take longer time to get better. But I don't think that this, in itself, without the overall context, is of as much critical importance. If out of some 6,500 companies listed in the market, I am a buyer of only a few, my fate or portfolio performance is really linked to how those few are doing. Attempts to invest, or draw broad inferences, based on overall market earnings growth or valuations, is a lazy form of investing. Macro factors are not unimportant, but one should not over-emphasise them or draw a very close parity with investing. Investing remains a disciplined and focused pursuit of finding good, capital-efficient businesses, enjoying a large size of opportunity, run by quality managements of capability and integrity, ensuring that the businesses have meaningful, durable and quality earnings growth and buying them at a favourable price, compared to their intrinsic worth.
Which are the other areas where you see similar productivity improvement trends beginning?
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There are quite a few firms today, which you can call as globally benchmarkable, in terms of their efficiency of operations. In textile industry, for example, there are many pockets of excellence across the vast value chain, having made remarkable improvement in their cost competitiveness, branding and marketing processes. If you look at the quality finance franchises or quality banks, you will see the same phenomenon: reduced cost of operations, superior use of technology, larger scale and improved customer service.
Any sectors which investors can look at for quality growth?
Auto and auto-parts makers represent a great local and global opportunity. The Indian firms, have displayed great capability and strength, both in the domestic and international markets. Leveraging the burgeoning domestic market, many firms have built enviable international franchises as well. Cost competitiveness, quality, scale and capital efficiency define good automobile and auto-parts firms from India.
Good banks and finance firms have a terrific opportunity. We are not even scratching the surface here. The most important, positive and transformational effects of demonetisation will lie in the long-term shift away from physical assets (gold and real estate) to the financial assets. For years, India has been importing an unaffordable (about) thousand tonnes of gold, every year (!), essentially spending valuable forex reserves of $55-60 billions, on an asset with zero economic utility, and bulk of which then gets traded in cash in domestic markets! For long, real estate investment has been viewed as if it were an automatic substitute for generating returns, skewing household assets in its favour. This is slated for a change. Demonetisation, along with many other initiatives, has changed this narrative. The entire financial sector is poised for the transformation, what with, the long term shift from physical assets to the financial ones, from informal financial sector to the formal one and the fact that the financial inclusion in this country, has seriously begun, over last three years.
Third is the consumption opportunity. For a country of 1.25 billion people, our consumption is at a paltry $1.5 trillion. If we believe this country is going to grow well, as I do believe, for a sustained long period of time, consumption businesses, if well chosen, with underlying value proposition and quality, will have phenomenal multiplier opportunity. And an important change has been that consumption in India becoming more aspirational, even while demanding value.
Indian pharmaceuticals have tremendous strengths, though there are recent challenges at individual company level, mainly due to FDA plant approval issues. Like in automobiles, pharmaceuticals enjoy very large domestic market, growing at a healthy rate, plus, a global market of $1.2 trillion. I see great opportunity for quality Indian pharmaceutical firms.
With the ushering in of GST, Logistics is set for a fundamental reset, causing consolidation from weak logistic firms to strong ones. Logistics will more from in-sourcing to out-sourcing model. So far, businesses have managed it within, to tackle the complexity of myriad tax laws and multiple local stocking points. Now, it will be one country, one tax. Even the e-commerce opportunity will benefit from GST. One broad inference, in general across all sectors, is that the compliant, transparent, law-abiding and formal businesses will gain, over tax-evading, non-transparent and doggy businesses.
Agriculture per se is an important opportunity. The serious efforts of the government clearly indicate that it is slated for an overhaul, though over time. A lot of opportunities will be unlocked in that space as the Government has committed itself to the daunting ambition of doubling of farm income in five years.
India presently is the fastest growing energy consuming nation and with reform steps more or less completed in removing administrative controls, oil marketing and fuel retailing businesses represent a strong, sustained, long-term growth opportunity, still available at value prices.
Pharma and IT are two segments where there are good quality companies, but they have seen many headwinds recently. How do you see these things playing out for these two?
Issues are different for both the businesses, though they may seemingly be converging with the anticipated US policy stance changes. These likely business environment changes are not extra-ordinary and the business managements have to find ways to overcome them. However, software industry faces many structural faultiness which are not limited to mere recent US policy concerns (which are not, in my opinion, fundamental or major issues). These concerns are essentially manageable issues. The real challenges are different. Fundamentally, the software business is not evolving much beyond cost arbitrage. Trouble is, cost has the tendency to go up. But, the customers are denying the software vendors higher price for two reasons: one, they are going through their own business challenges. Second, and the critical issue, is that our software firms are not adding enough verticality to their technology solutions. Therefore, price has largely stagnated or even worsened while costs perennially tend to move up. Clearly, there is a pressure on the margins, which they have tried to tackle by greater offshoring and by raising productivity, etc. But, there is a limit to that, which has been largely exhausted. The only ways to break the glass ceiling is by either being able to innovate fundamentally new technology (which the firms are attempting half heartedly but I suspect, it is not in their DNA) or by becoming business domain specialists (which software firms are attempting but without much success). So, even though the overall opportunity remains large, companies are fast reaching a stage where they are unable to get a predictable and meaningful growth rate. Hence, while business continues to be high quality (they still are cash throwing machines, enjoying high return on capital employed and are run by some of the finest managements), sustained, high growth is a question mark.
It’s different with Pharma?
Pharma is a completely different ball game. Pharma is a superior business of greater intellectual capital. You are creating innovative solutions (unlike software industry offering only applied technology solutions). The India pharma industry has evolved up the value chain: from largely being a maker of active pharmaceutical ingredients (APIs), to maker of copycat solutions (helped earlier by weak IP- intellectual property- laws) to becoming compliant (but not innovative) manufacturers, to research-backed, incremental/improvised innovations of patented drugs through altered routes/first-to-file post-patent generic opportunities, with Indian firms having among the biggest ANDA filings around the world. Alongside, we have seen, some sporadic but notable, successes in developing original new chemical entities (NCEs). This is a risky business, entailing upfront large investment, for a prolonged period, with uncertain prospects. That requires courage, evolved capability, ability to foresee well and a balance sheet to afford this. Even if successes are fewer, the picture is positive and evolving well. Now, we are witnessing the trend towards building a pipeline of higher-end specialities, which are harder to make or copy and, often, novel. This a part in which the leading Indian pharmaceutical firms are investing heavily. It is research driven and the efficacy of the R&D in India is much higher than in Europe and US.
So, I won't say that the pharmaceutical situation is similar to that of software. In fact, far from that. It is backed by higher intellectual capital and has not been stuck in a rut like software. It is revealing that, of the total drugs consumed (in physical volume terms) in the US, more than 40 per cent comes from India alone. Global pharma is a $1.2 trillion opportunity a year, growing at 5-6 per cent, and India has demonstrated, over time, material success and resilience. Can all this be easily taken away by local US firms? Impossible. Challenges emerge but are meant to be overcome. To that extent, I am not worried about the fear psychosis which recently seems to have gripped the minds.
The US FDA issue has been haunting Indian Pharma with best of the companies not able to solve it. What is your reading?
There is no question of not solving them. But these are challenges for sure. US FDA doesn't offer a prescriptive checklist. It sets and evolves the regulatory standards by practice, rather than through precise prescribed standards. Observations offered, on a particular inspected facility, become the new benchmarks, for others to follow. Therefore, companies are constantly under pressure to know what is being evolved elsewhere all over the world and quickly adapt. What may have been considered acceptable, audited and certified practice some time back, may suddenly become unacceptable, creating compliance challenges. The other challenge is that of the human element. How much ever you train humans, there is a tendency to deviate, and with Indians, it is even more so. But having said all this, I believe Indian firms (barring some black sheep) are generally compliant and high on quality standards, operating top-notch facilities. Companies have realised the challenge and upping their game and improving the practices. The current FDA challenges, while significant, are transitory. Indian firms will eventually emerge stronger.
Global commodities have rallied in the last few months. What is your view on the prices?
I have no clue. When least expected, global commodities may jump up and when least expected, they crash. I can display wisdom only after the event is over. It requires agile, and at times fortuitous, skills to succeed here.
But, there are some businesses which are transitioning from commodity, to semi- brand and to brand/speciality businesses. One is seeing that kind of improvement, to a varying degree in cement, tyre, chemicals and textiles. Instead of remaining commodities, many have evolved and become superior businesses on which one can take a long-term view and not treat them entirely as commodities. Therefore, the valuation of many of these businesses has improved, while still holding more promise.
The government has made several attempts to improve the business environment for infrastructure sector. Has it become conducive enough for you to look into this sector for investment in companies?
Infrastructure investment appeals to those investors who have a mind-set to look for returns superior to fixed-income but with a fair stability and for long haul. Infrastructure, no doubt, is very vital from the nation’s perspective, but given its relatively modest returns, we prefer to be customers of, rather than investors in, infrastructure. To put it colourfully, our efforts are to find plumbers and masons and electricians for the infrastructure sector rather than invest in a pure infrastructure play. We prefer to leave it for more patient capital, having reasonable return expectations, rather than superior returns. We find businesses which supply to these infrastructure projects, either a service or supply equipments and material, more attractive. They benefit from the infrastructure growth without undertaking the challenges that these businesses go through. For example, project design and implementation monitoring firm like NBCC doesn’t invest in capital intensive part of the infra projects but earn healthy fees (and good ROCE) by designing and implementing the projects.
The demonetisation was a big surprise and has impacted many companies. But many including yourself see it as a big game-changer. GST is also set for implementation next fiscal. Which are the key sectors that will stand to gain from these measures?
I indeed see the demonetisation move as a game-changing, audacious and cleansing move. Debates and criticism abound, but I see it as a first serious effort to eventually cleanse our nation of various ills that have crept in over time. It will also be a rather narrow application of mind, to see the demonetisation in isolation, of many steps precedent to it, and many more in the offing. Over time, along with these other initiatives, it will bring about path-breaking changes: a long-term shift from the physical to financial assets (raising capital efficiency), a shift from the 'informal' to the 'formal' segments, less-cash than before will help in bringing inflation structurally down, and so will be the cost of capital. Money-under-mattress, as it comes in circulation, will improve the velocity and productivity of capital. Most importantly, a long-term shift will happen towards a more compliant and transparent society and businesses, raising tax collections and unburdening the societal conscience. In some sense, the demonetisation move is a precursor to the GST. In so many spheres of economic activities, informal (which is a euphemism for tax-evading and non-compliant) entities dominate. In these sectors, the pendulum will swing in favour of the transparent entities. Compliant firms, for example, in building material sector (paints, ceramics, plywood), plastic processors, a host of consumer durables, chemicals etc should gain over the others.
Indian bond yields are up sharply in recent times and economic growth is expected to be lower next fiscal. US bond yields are also expected to move up due to Fed rate hikes. What is your view on Indian fixed income markets?
The control of twin-deficits (fiscal and current account) over last three years has enabled a structural control over inflation which had become stubborn. The supply-side steps will supplement this further. Many initiatives underway for improving the ease of doing business and attracting FDI are beginning to bear fruits. I have a feeling that we are somewhere near the vantage point of witnessing a surge in FDI. Energy costs, hopefully, will remain range-bound. I, therefore, believe that we are going to see progressive decline in the cost of capital. Somewhere between a year and two from now, we might witness 10-year bond yield testing 6 per cent threshold. This is likely to happen despite US rates rising. The economic narrative of the two countries is today different and a blind coupling with US Fed rate is unlikely. India easily remains, as one amongst the more attractive large economies, with high growth and stable/improving macros, as a top investment destination. We are looking pretty good.
With election results through and government is becoming stronger, do you see it will have a favourable impact on financial markets?
Indeed. A host of economic and reform initiatives, unveiled over last few years, are beginning to combine together well and appearing to be reaching towards culmination. As an investor, my effort is to find good investments, rather than trying to predict market levels or to 'time' the markets. But having said that, I have a palpable feeling that all the various events seem to foretell or presage that the coming period of next 5-10 years is going to be very defining phase for our economy, businesses and (hence) markets.