Good time to allocate high capital to equities: Edelweiss

About 17 years ago, Rashesh Shah started as a small three man unit in a small room in South Mumbai, a firm that he hoped would become in his words the Goldman Sachs of India. Today, Edelweiss Financial Services is not quite the Goldman Sachs of India, in fact, in a way, it is far more diversified but it also competes with Goldman Sachs in India.

Below is an edited transcript of his interview to CNBC-TV18. Watch the accompanying videos for more. Q: It’s been quite a journey in the last 17 years.
A: I think 17 years looks like a long time. Q: You quit a job from the corporate world, launched a company which that time seemed a very, very good idea because the country has just opened up. But as you were launching it, the country was hit by a number of issues. One, interest rates went up. We saw the Asian crisis hit us. We saw the currency under pressure. We saw all kinds of trouble that happened. Somehow your partners backed out and you had to depend on your father to give you money to start the company. So you are used to difficult times. How does today look? That time, it was a small company looking at a very difficult economic environment. Today, you are large profitable company also looking at a difficult financial environment. When were you more nervous?
A: I think it was a lot harder at the start-up stage, because you are small. You don’t have the resources. You don’t have the people. But I think in a way the scale has its own issues. Now we have 3,000 people. We have so many businesses. What I have seen in India is we have always had three-four good years and three-four bad years. I think we are now getting used to this three-four year, three-four year cycle that goes on.
So after we started the first three years were very bad then the four years after that very good, then we have another three bad years, then another five years were very good. Now I think the last three-four years have been bad. But each time, I have seen one thing that if you start things in a bad time the foundation is a lot stronger. You are more conscious of cost, you are most conscious of quality. You really make your resources go a lot farther. So in a way, it is good experience, but I think you realize only after it’s over, you don’t realize it when you are going through it. Q: That brings me to an interesting point. You said and I quote that to you from an earlier interview that, “Interestingly, almost every new business we got into was, in a sense, during adverse markets or regulatory conditions.” What is the new business you are looking for in this adverse market or are you already fully invested?
A: About four years ago, we were largely a capital markets firm. When we started, the hypothesis was that capital markets in India will grew. It has grown a lot. But I think in the last four years, we saw the cyclicity of the capital markets and the inherent volatility. We said we need to be more broad based, because now we are listed, we are outside investors. So we expanded into credit, insurance, asset management, housing finance.
Now, we have a clutch of businesses which are non-capital market related which are more retail oriented. Each of them has a large opportunity space into which you can grow and capitalize upon. So I think idea of basically broad basing has been in the last three-four years which also hasn’t been a good time. Q: Let me just go back. In an earlier interview, you said, “You can't have faith in an India story without robust capital markets. So, we keep our faith in the bridge.” The bridge being the capital markets. So in the sense, has your faith in the capital market subsided a bit or is it that you think to be more robust you need to diversify?
A: I think in order to be a lot more robust, lot more scalable, a lot more stable, because capital markets, especially after the credit crisis, I think there is a lot more cyclicity that will come in. I think the regulatory oversight on capital markets has increased a lot. Initially, we were seeing that credit and a lot of other products were going through capital markets. We think that growth might be slow, still in India capital markets are so small that we will still see growth in that.
But if you see India, as a whole, capital markets, insurance and banking are the three channels on which household savings flow into investments. Currently, if you see almost 70% of the financial services go through the banking system, another 25% goes through insurance and only 5% comes through capital markets. Q: Is the pessimism in the environment today justified or are we focusing only on the bad headlines and in a sense making that pessimism self fulfilling?
A: In a way, the growth slowdown always has fuelled pessimism because growth gives you that kind of optimism whether it’s at organization level or at a country level. When there is growth, there is a lot more optimism. The good thing is we are still growing. India has not gone into an economy that is not growing at all. We are still growing but by our standards our expectations has gone up a lot.
I wouldn’t say glass is half full-half empty. I think glass is slightly emptier because of the current slowdown largely because of Indian factors and international factors and few things will have to change structurally. So there is cyclical element to this and there is a structural element to that so the cycle will come back. Q: What is your sense of the quantum of capital flows coming in today? Is it anywhere near 1,000 crore?
A: No, I think if you see the first quarter, it was still good. I think first quarter we were able to get good USD 11-12 billion. I think we need about USD 5 billion a month both foreign direct investment (FDI), foreign institutional investor (FII), euro commercial borrowings. I think we are somewhere about half of that now but for the year as a whole even now we will be getting to 70-75% of that and that itself is bad. Hence, the rupee is under pressure because the markets are anticipating that because our current account gap is also fairly priced because of oil imports. So we have to woo investments, we have to get FII, FDI into the country.
About a year ago, we felt that the foreign investors need India more than India needs foreign investors. I think we have proven wrong and the realization in the government and all is coming around to that that we need to woo investors. Q: Should the smart investor be getting into equity at this time or should he prefer bonds because equity is looking undervalued but is the risk still too high?
A: It’s completely a function of who you are and this not an easy answer to give but it’s not just in India. I think if you are a contrarian investor, it is as good as a time as any. Equities are cheap, not just in India; everywhere in the world equities are very cheap as compared to bonds. So in India equities are cheap, they have attractive valuation. But you have to be a contrarian investor and have the stomach of a contrarian investor because the next six-eight months will be very challenging. You might have to see even more correction in the prices that you buy. However, if you are not a contrarian investor but generally a growth investor then you may want to wait for growth.
One of the things that we tell our investors is that you should watch two things; one is you should start watching uptrend in corporate earnings growth rate and second more importantly in India your GDP growth rate should be higher than inflation for at least couple of quarters. We have almost couple of years where the inflation has been much higher than the GDP growth rate. Once the inflation comes down and the GDP growth rate is higher than the inflation rate for couple of quarters, you can start factoring optimism around growth in India. That is usually a good time to increase your allocation to equities. Q: If you are not going to increase your allocation into equities there is no worry that suddenly going to run up so fast that you will miss the boat?
A: Absolutely. Either you are a contrarian investor and you want to buy things, which are becoming cheap or you want to wait and you will get a chance to buy. I think if you wait a couple of quarters for the signs of growth coming back and then invest you will be able to catch a fairly good trend. It is usually a good time to allocate your high capital to equities and even institutional investors will be reallocating at that point of time. Q: When you started the company 17 years ago, you said you wanted to become the Goldman Sachs of India now. Clearly, the focus is now moving away not moving away also going on to the Indian retail consumer. You have launched an insurance company, you have home loan company – how risky is this business because there are lots of people who you are competing with banks, you are competing with other NBFCs what do you bring to the table that others don’t?
A: Originally, when we started capital markets in India was very small. Online trading had just started, option, futures were not there so my hypothesis was that capital markets will also factor in India’s growth as the economy started opening up. It has happened; India has grown a lot, capital markets have come a long way from where we were 17-18 years ago. But what we have also seen is the opportunity in financial services in India has also grown a lot. Things like credit and insurance are fairly capital intensive so when we were young and when we were small company, I think the advisory business like capital markets and broking were easier ones to enter because of smaller capital no brand name and all. I think now at a stage we looked at the opportunity space that is there in India and things like housing finance, home loans it is a large business and we will continue to grow and the scale is huge in that.
The same thing on insurance, currently, I think about 40 billion dollars a year, 200,000 crore a year of household saving goes into insurance within that 40 billion we will become 100 billion over the next 5 years. So India’s households are saving more and more as India’s economy is growing. The savings are so large that some of the saving goes to through the banking channel, some will go through insurance channel and some will go through the capital market channel but as a whole savings is growing and each of them the credit opportunity, the insurance opportunity is very large.
_PAGEBREAK_ Q: When we meet, you said how am I going to beat, the reach that the others have – is it because the regulations are good enough that regulatory overlook or the regulation ensure that there is a level playing field for everybody or is there something else?
A: What happens is that any market that becomes very large and grows also rapidly there are segments in the market that open up so if you get into home loan there are various segments in home loan and you have to find the segment which you can cater to the best and in a large opportunity even that particular segment can be fairly rich. So it’s the same thing in broking, when we started the institution in broking we initially focused on F&O business, on futures and options which was a smaller segment as compared to the cash equities. But it has grown faster and we as an institutional broker leaders in the future and options space so you have to find our own market segments and then grow into them.
As long as the market size is large even that is a good entry strategy and everybody gets a chance to compete. I think even today if you look at all industry consumer products and all there are lot of Indian firms which are competing fairly aggressively with global names and the opportunity is very large. The household savings in India in the last 11-12 years that I have been tracking them have grown from USD 80 billion to USD 600 billion now. This USD 600 billion will become 1.5 trillion in the next 8-10 years. So there is a huge growth in savings. Unfortunately, in India, the financial sector reach and the capacity is not actually growing as fast as the need of the investors. Q: This USD 600 billion currently today banks would account for, handle about 70% of this?
A: Out of this 600 almost half of it goes into what we call hard assets like real estate and gold. Half of it goes into financial saving which is USD 300 billion, out of 300 almost 140-150 goes into banks, another 40-50 goes into insurance, another comes into capital markets and the balance is currency, cash, small savings and PPFs. Q: But do you think each segment is large enough for it to look attractive for somebody who wants to tap that?
A: Absolutely because it was USD 80 billion earlier out of which 60 was in hard assets so only 32 billion out of that 80 was coming in financial assets, that 32 has become almost 300 now – this 300 will become 700 – 800 in the next 8-10 years so household savings in India are getting channelised into financial, into financial investments for the long term is where there is a huge opportunity and the capacity is not growing as fast as we think the household savings are growing. Q: In insurance, you have tied up with a foreign partner because you had to in that case. All the time while you were growing, as you were saying India was an attractive market for foreign capital market players to come in and they did come in. You never tied up with any of them. Why was that? Was it because you kept in mind your mentor, someone you call your mentor Narayan Murthy has said that never sell equity cheap and were you offered too cheaper price for your equity or were you not offered at all or did you not consider them?
A: Actually over the years, we have always had offers. As you remember 2004-2008, India was very hot and almost everybody in India would have got offers from the foreign players. But I think earlier we were mainly on the wholesale side and we have found that trying to do a JV or partnerships on the wholesale side is not as easy and we have seen a lot of other wholesale JVs. Q: In valuation terms or in operational terms?
A: I think from the opportunity point of view, from the execution point of view. Retail is a lot easier to do a JV because you can bring the best of both the parts and market is very large. What happens in wholesale when the market is small and you own only half of it and the partner owns another half and you both want to grow and increase the share and as you have seen in the investment banking a lot of the global JVs ultimately broke off, because in wholesale your execution style is very important, so two partners executing becomes a problem. The scale is not as much for each one to feel that they are getting enough out of it.
After sometime, wholesale JVs in financial services we have seen are not going to work for a long time. However, retail needs capital, brand, reach and has a lot of scale. In almost every part the retail is about 5-7x of the wholesale size, so given the size and the depth. Also in retail foreigners will find it very easy to penetrate India, while wholesale I think the foreign firms can actually come on their own also. Almost all the global banks in India are largely on the wholesale side, whether it’s corporate credit or investment banking or broking. But retail is a much harder game to play and for that you need an Indian partner. So I think on the retail side it makes a lot of sense to have a foreign partner and a JV partner but wholesale if you do the economics and the math, it won’t anyway make sense. Q: As you have said, you have invested a lot of capital now in the new retail investments which are all very capital intensive. When will your shareholders start seeing a return on these investments?
A: As we start scaling up all the businesses as each of them has a real clear path to profitability. We have also made sure that we have allocated enough capital like in insurance which is very capital intensive. We have a JV partner who has invested money at a premium, who has capitalized it very well. So we have made sure that there is adequate capital for each of these businesses to get some scale and get to a stage where they will be profitable. So I would guess over the next two-three-four years, each of these businesses will start hitting scale and profitability along with that. Q: Is there a pro and a con for a banking license? If you get it now, would you grab it and go ahead with a bank or are there cons also to becoming a bank?
A: I think almost in anything there are pros and cons and you will always weigh the two. If you look at the overall opportunity in banking, it is a very scalable model as compared to either an NBFC or capital market firms. The largest NBFC might have Rs 40,000-50,000 crore of assets while the smallest bank will have Rs 40,000-50,000 crore of assets. So from the scalability point of view and from the regulatory oversight point of view, because what happens if you are a large financial services company ironically you don’t want to be actually regulated as strongly as possible. I think the banks are regulated very strongly in India, because it will give confidence to the investors and your customers. So in a way, I think banking is a mainstream business.
It encompasses all the other business models underneath that. It’s a fairly elastic business model, fairly flexible business model. On the whole, I think eventually if you look at a country like India it would make sense from a scalability point of view. Are there cons on that? I think there are a lot of restrictions on that. There are lot more things you can’t do. Your flexibility for going after growth opportunity can get curbed. Like for example, I think for quite a few banks increasingly to invest capital into insurance subsidiaries is getting curbed. So the restrictions will also go up. So along with the opportunities some restrictions will also come and I think on the whole for scalability and given the way India is evolving, India’s household savings are evolving I think banking would make sense for a large financial services company. Q: Would it make sense for you not right now maybe at some point?
A: It would make sense at an appropriate point of time, because currently as I said we have opened up insurance and housing finance and all of that. It will take us another couple of years 2-3 years to consolidate all of that. Get the businesses up to a scale. Get our infrastructure and leadership pipeline in place. I think there is no hurry and India opportunity in financial services is going to be for the next 18-25 years. So a couple of years here or there is not something that is extremely critical. So for us, it would be ideal a couple of years from now is when we should start thinking about it.