Over last three months, we have seen an excruciating fall in midcaps and smallcaps. Do you think in next three months we could see that reverse and absolute gains?
I do not foresee absolute reversal. We have given a higher valuation to the midcaps and some parts of the market while ignoring the overall market trade. Active investing is facing its worst crisis today — be it largecap or midcap stocks. I only expect the crisis to get worse as active investors and managers — me included — will face challenges in trying to decipher and realign our actions towards the macro changes that are happening in the economy.
Clearly portfolios are not prepared for the kind of macroeconomic changes that we are seeing now and in the next three to six months, the portfolio change has to happen. When that happens, there will be impact cost on portfolios large, small or medium and only after this impact cost is absorbed and the performance starts to show in the realigned portfolio, you can have positive returns. I do not see much scope for that over the next six months.
What is going to be the nature of this continued fall? Is there more price damage left in the broader markets or is it going to be a time-wise correction and the large part of the damage is already behind us?
We are heading towards a phase of disclosure damage, not price damage. The valuations have been given to businesses without measuring governance very tightly. The disclosures will send us back to the table to measure governance with a stricter yardstick and this will definitely soften valuations in several companies which have been market favourites over the past year or two. I expect that to impede returns.
I know there is this entire thought that money should move towards passive investing and, active investors are underperforming. On a 10-year basis, most of the active fund managers or worst of the active mutual funds have done much better than the Nifty. There is right now a huge crack in the mid and the smallcap space and the pain is back and gains are gone. Do you think it is too early to assume that there is going to be a big systematic change?
I am not expecting a systemic change. I agree that active managers will do well over the long term but what I am seeing is that in the next six months, active fund managers have challenges which they cannot overcome in such a short span of time. However talented a manager may be, active investing has gone a little too far. It has to come back to a certain midpoint and then go in a new direction. My simple point is we cannot ignore the impact cost of this. If you look over the next three years, I am quite sure that several active managers will widely outperform whatever benchmarks they may take. But over the next six months or one year, I do not expect this to happen. The challenges are far higher.
Even today the active managers who seem to be outperforming are doing it on the strength of two factors: one, they still have flows which help them to support their portfolios or their investee companies in their portfolios.
The second is they have invested in companies which are rather illiquid where the valuation does not fall so easily. These two are likely to change. Flows can change and liquidity can arise in a company all of a sudden. That is why we are seeing several companies fall by 50% after going up several times. If liquidity emerges suddenly, then you have issues that shake the confidence of people and valuation cracks. This challenge is going to show up in several portfolios of active managers and there is no escaping from this. That is why I feel in the near term, active managers are unlikely to outperform their benchmarks.
Valuations are looking rich now in private banks. Everybody keeps talking about why HDFC Bank is nearly at four times book but the appetite for that bank in the market continues to soar. Should one switch from private banks to corporate oriented banks, PSU banks or NBFCs or rather continue to buy private banks as they offer certainty of growth?
I look at banking very differently. What gives private banks premier position is the fact is that they had very good fee-based income. They have grown this fee based income tremendously over the last decade.
Over the next decade, I expect the companies that give them this fee-based income to do better. They are all going public. Today you have asset management companies, insurance companies, stock exchanges. There are several options before you to play in the same team. I would rather play the themes through those entities than through the private banks.
Second, private banks have their own capital raising imperatives. Take HDFC Bank and Kotak. They have specific imperatives of raising capital or reducing promoter stake. These things significantly satiate the appetite for their stock. That is one aspect.
The second aspect is that the active managers have been holding these stocks up and that will also not be so easy going forward. When there is supply, these stocks will soften in valuations. So, I do not see any need for being euphoric on private banks, I would rather shift my focus to other businesses which the private banks have benefited from and which also have similar growth in fee-based income. Those themes are the ones that one should look at going forward. I would play the same financial theme very differently that is my basic point.
How do you propose to do that?
I told you there are several new companies that are going public in the space of asset management. You already have a few. You will have more. These companies will see their prices being discovered on the stock market and will stabilise at some point in time. At that point, I would look to scale up my investments.
I also mentioned insurance as a play. There is life insurance, general insurance, health insurance — three spaces which are relatively nascent and which are going to be very strong growth engines going forward. There are stock exchanges, commodity exchanges — businesses with big networks and long runways. There are a number of such opportunities in the financial space. I would think that banking is relatively unattractive when compared to these opportunities.
The Shriram group is regarded for its corporate governance. The way Mr Thyagrajan has conducted business, have been admired by markets both for his approach and for his consistency . Yesterday, the market discovered that Shriram Transport is no different. In order to make up for their infrastructure/EPC businesses, they were also obliged to give a bank guarantee. What is your view?
Without getting specific about the transaction, let me say this; we should not mix up personality with governance. In the end, an NBFC lending to truckers is a subprime business. So, it does not matter who does this business or what are their personality traits or what are their personal values. Their business is bound to have its challenges. Leveraging that business to get into other unrelated businesses is again a second level speculation. That speculation is bound to come back to hurt some time.
In the end, even if assumed that the company was very good at one business that does not make it a candidate to enter other businesses where it does not have any history or domain expertise.
In that scenario, institutional investors have oversimplified their assessments and not really paid heed to what were the structural risks of the group.
I would only advise to look closer at the structural risks of a company with strengths in one business which is actually a subprime business leveraging it and entering several other businesses. Who the owners are, what the board is, what is their personal standing, these things really should not influence our judgment. We have to look at it as a generic situation and then clarity will emerge.
Will that apply to other so-called south Indian conservative groups — the Sundaram Group, the Murugappa Group? All of them have SME exposure, exposure to the CV cycle. Do you think we now need to look at concerns which could emanate from some of the stronger names also?
I would look at any company from the point of view of disclosure, transparency and business mix and their core competence. These are some of the things that you need to look at. If you look at Sundaram, they have not really gone into businesses which are not part of their core competence. They have taken a long time before entering any new business and it has raised the ire of shareholders saying that they are too slow.
Cholamandalam had one bad experience earlier from which they have come out, now they are going into the next phase of growth. You should constantly watch what business is bringing in the money and what are the structural risks in that business.
You cannot take financials as one business, I think you should see the subsets within financials and see how the risks are panning out and then form investment judgements. I would not like to say that south Indian business groups are conservative or that you cannot expect anything to go wrong, these are all generic judgments which do not have any basis except your perception of people. I think that you have to look at governance and risks in every company dynamically. I do not think we should have such generic judgments anymore. We do not live in such times anymore.
You say ITC and Bata are the largecap consumption stories. However, the market has not been able to capture the kind of upside potential that there could be in these businesses. Do you think the market will really capture that transition?
I do not agree with your view that market has not captured this. Two years ago, Bata was Rs 430, today it is Rs 840. So, the market has definitely captured it. It is just that we have started noticing it late and that is all there is to it. If the average realisation per unit of sale goes up Rs 100, it can really create a massive multiplier in the P&L of these companies. I am talking about Bata specifically. However, at this point, the valuations definitely look a bit stretched and I would watch out for any other market situations which will give the stock at a relatively lesser valuation to enter.
It is a fantastic company with great scope and can be a very good compounder over the next five to seven years. GST is again something which will benefit this company enormously and I see that migration and social mobility is going to help this company. The company is also taking active steps to rearrange its store portfolio. They are shutting a lot of stores in bad locations, opening stores in newer formats, the real estate market is also very conducive to expand the business. They are not even there in the digital, I mean, in the online retailing so that is another segment where they need to do a lot of work.
It is a lot of heavy lifting for sure but the size of the opportunity is simply enormous. In the case of ITC, the market is not going to easily take cognisance of ITCs problems. That has been the history of ITC. In the last three decades that I have been an investor, ITC always has its challenges and the markets for a very long time never believed the company would overcome them.
When it was convinced that the company had overcome them it quickly rerated the company and that is how it has grown from a rather moderate valuation in 1990 to what it is today. The company has a very solid core business. It is not going away and it is investing in several businesses which are also reasonably great opportunities for growth and the company is in a good position to stabilise this and prove that it can run those businesses.
You have said that you like commodity stocks. Of late, there has been a bit of crisscross on which way the commodity cycle is headed given that the trade war is no longer a fear. The trade war is real and directly-indirectly it will have impact on global demand. There is a case of disruption at global level. The demand indicators could slow down. What happens to commodities in this kind of environment?
We have to understand what will be the stand taken by government in the event of a trade war. It is amply clear that the Indian government wants to be self sufficient in its need for metals — both ferrous and non-ferrous. Post resolution of the larger NCLT matters, a lot of capacity will come into production. We do not really need to import with the floor price being already set for imports. I do not expect the government to play is soft and allow imports to come and affect the prospects of domestic industry. This is as far as the ferrous metals are concerned.
In case of non-ferrous metals, demand is definitely going to be strong and we are going to see a macro growth and better rural growth leading to a lot of spending. A lot of investments can be expected across the spectrum. The demand for ferrous and non-ferrous metals is going to be strong. I expect the government policies to be supportive.
The problem with the market is that we trust the government when you should not trust it and we distressed the government intensely even after the government made its intent clear. It is us who need to learn from our post mistakes and try and reset our expectations from government and move on.
The biggest thing with commodities in the last one year is that market has shown very poor judgement of what is governments intent. If this judgement improves, our investing in commodities will improve and there is a lot of money to be made in them. The problem is that we want to rush into the wrong judgements and then stick to them that needs to be changed.