Old Bridge’s Kenneth Andrade takes a contrarian bet on IT services, pharma

Is that a good thing?

Too much of debt has its problems and so does too much of equity. It is good from a solvency perspective. No company is going to go insolvent. There is hardly any corporate risk on the balance sheets of banks anymore, because companies have managed to clean up theirs. This is stark contrast to the situation in the west where there is only debt all around. When a contractor (firm) comes on a business channel and says that it is going to be cash flow positive, it is something that I have not heard in my career till now. And despite textile companies having gone through a tough phase in the last couple of years in terms of a dip in utilization rates and sales, they have hardly taken on any debt. They have emerged from a downcycle fully solvent.

Read: Not worried about capacity addition in chemicals, FDA red flags in pharma: Kenneth Andrade

That is where we are in the corporate cycle. Too much equity, no debt, capex needs are met largely through internal accruals, so banks are struggling to increase lending, and because corporates do not have a huge appetite to borrow, it is not very profitable doing corporate banking.

What does this mean for banks?

A large part of the business is now centered around SMEs and SMEs are in a good financial position. Their growth has been decent, they have opportunities, but access to capital has been limited. So banks are looking at this segment as an opportunity.

Are you bearish on banks?

There are individual business models that will hold out. The top three banks are doing well, but try picking from 4 to 10, and it is a hit and miss. Financials as a sector stopped doing well sometime back. The index (Bank Nifty) is doing well and a couple of banks within that index are doing well.

What are the pockets that you are looking to put money into in this kind of a business environment?

We are looking at segments where valuations are reasonable, catering to industries that are growing, the product is acceptable and you have fair degree of pricing power. IT, for us, ticks all the boxes. The sector is going through a downcycle, but it is still better placed. You have companies that are cash flow positive, have cash on balance sheet and are now available at attractive valuations. Of course, there are debates about AI and India losing IT jobs, but at its core, Indian IT is a pure play on wage inflation. Roughly, the cost of a mid level executive in India and a fresher in the US is the same. What we are doing is importing US wage inflation. Growth will be softer this year, but from the earnings commentary, it is clear there is no major risk to the industry. We won’t see the kind of growth rates seen during the pandemic, but even the normalized growth rates will still be in the low double digits, which was seen pre-pandemic.

But (IT) management commentary has been cautious, the wage arbitrage has always been there and with inflation and interest rates expected to be high in the US, there are concerns of slowdown in discretionary IT spending by (US) companies. So why IT?

The slowdown in discretionary spending is what is leading to the cautious commentary. There was a spike in discretionary spending during the pandemic as companies rushed to embrace digital, which is now normalizing. The decline you are seeing right now is also because of the spike. Remove the excesses, and you are again seeing normal growth rates. The difference is that you are now getting Indian IT companies are very acceptable valuations for a mature business. As for the point on wage arbitrage, US wage inflation has been the fastest in the last two years than it has been in a decade. So that makes even more a compelling case for outsourcing to India.

So IT is the big contrarian bet, what about other sectors?

China is back in the market, and you had prices across all chemicals collapse, which has also led to a moderation in stock valuations. Going ahead, this will lead Indian companies to invest in processes, in becoming more competitive and developing strong customer franchises. So you pick the survivors in the downcycle and run with them. This is an ongoing cycle though and it (downtrend) is yet to play out fully. One place this trend is apparent is in the pharma sector. The commentary has been largely buoyant but that is not yet reflecting in the performance. The trough performance was in September 2022, and since then there has been a gradual recovery. But over the next few years you will see Indian companies increasing their dominance in the west. If you look at the financial metrics, Indian pharma companies are solvent, they have cash and are willing to invest in capacity and to invest in growing market share. On the other hand, pharma companies in the west have too much debt, that debt is expensive, and these companies are now vacating some of their strongholds giving an opportunity to Indian companies.

Then you add a swathe of Indian commodities companies to this mix, I see steel companies doing well. If they can get their carbon footprint right, then Indian steel companies will dominate the global market for steel as well as downstream products emanating from that.

There is huge capacity addition happening in chemicals. Conventional wisdom has that the downturn in the chemicals sector starts when excess capacity starts coming on stream. Some analysts have already flagged this as a concern for the sector. What are your thoughts?

Chemical companies have tasted success, that success has led to new capacities, with the new capacities, you have China getting back into the game and dumping its surplus into the world markets. In a situation like this, you have peak profitability behind you and higher competitive intensity ahead of you. In short, it might just be an adjustment phase for chemical companies in two things-build scale in a way that helps lower the cost of manufacturing (and hence the products), and use the lower costs to expand your client base and enter into long term contracts and become the go-to market for clients. There is nothing such as country + 1. There is no such thing as China + 1, there is either China or there is no China. You can see that in the effect on prices when they decide to comeback with a vengeance. India is in a similar position of strength in the steel sector, where we have now become the lowest cost producer of steel.

Pressure in the US generics space may be easing because of the problems being faced by rivals. But one of the big concerns for pharma has been periodic red flags from the USFDA. How do you balance these two opposing trends?

Unlike chemicals, pharma is in the late stage of the cycle where there is already plenty of capacity. If you look at India’s manufacturing capacity in generics, we are 30 percent by values. In terms of volume, I think it will be closer to 60-65 percent. More the number of plants we have, the more scrutiny you will attract. If the number of plants being shut down in India rises, so will prices of medicines in the US. So that will create a problem for the US as well. Investors in pharma companies will have to deal with regulatory pressures. Despite all the regulatory pressures, this is a quarter where (export of) pharma generics to the US is hitting an all time high in terms of profitability. You can’t wish the FDA away, they will ensure that the standards of production are met, and over time you will see Indian companies improving their manufacturing processes.

What are your thoughts on the consumption space, what is the theme that you are looking to play there?

In demographic trends, you are now seeing a sharp north-south divide, with the replacement rate in some of the southern states below 1. Many of the cities/states in the west and south are now clearly moving away from the developing zone and close to becoming a developed zone. You can see that with manufacturing companies, services companies…and India clearly is a services economy. And that is one of the factors driving per capita income faster in some of the urban centres compared to rural India. You will se that with all consumption spends. So you have got premium vehicles, premium watches, top end mobile handsets selling more, while you have toothpaste as a category degrowing This is a global trend, but showing up more pronouncedly in India. A lot of product categories which are non-discretionary, you are seeing some downtrading happening there. The discretionary part of the market or the premium end will hold well and the rest of the market will continue to struggle. I am bullish on real estate. Home loan rates are pretty much the same today as what they were in 2013.

But house prices have gone up at least twice if not more, depending on which market you are looking to buy.

Yes, but that does not mean income levels have not kept pace. If you look at the strength of the property market in specific geographies, especially the south and the west, a large part of it has to do with the services economy. And the services economy strength is mainly coming the West. We are doing nothing but importing wage inflation from the West. So, when you import wage inflation, the (upward) pressure on salaries is higher than they are everywhere else, and that’s what is happening with real estate. The other big structural change that has happened in real estate is that developers now have better access to capital because of instruments like REITs that are investing in the sector. That said, real estate assets are reasonably inflationary, they are an inflation hedge.

Which is the big macro theme you are betting on?

Our hypothesis is that over the next few years most economies will remain inflationary. What I mean here is that inflation will stay high even if the pace of rise slows down, not just in India, but globally too. That will be mainly driven by government spending on infrastructure, as countries look home to bring their manufacturing to the job economy. In India, we have the PLI scheme, the US too has something similar. Everyone is building semiconductor plants, bringing back their automotive infrastructure back home, relooking their energy infrastructure. Europe is talking nuclear, renewables, US is doing something similar. When that happens, your manufacturing metrics will look extremely good, because you will need steel, cement, transportation, fuel etc to build it out. Between In 2008 when India and China were building out their power and infrastructure projects you saw what it did to commodity prices. The rest of the world is now doing that to us. But there is a dichotomy right now. Commodity prices are low even though inventory levels are low.

How do you see the weakness in China’s economy affecting commodity prices?

The popular view was that when China reopened there would be strong demand coming out from there which could boost the global economy. Nobody expected that when China reopens, the first thing they will do is export their surplus production. So you now have a situation where nobody wants to hold excess inventory because there is always the risk that prices could fall further, so everyone is moving back towards just-in-time inventory. We will have to see how things play out here on. If the overall trend is inflationary, which I feel it will be, India is the best market to be in and our corporates have the best balance sheets to capture that. And if our companies can capture market share globally, then we will be completely home. Most of the emerging markets minus China, which is India, Indonesia, Vietnam etc…all them will have companies with strong balance sheets and financial systems which are robust.

What is the overall sentiment towards equities right now? What is the sense you are getting from your clients as well as others in the market?

It has become a competitive market for capital between equities and everything else. Unlike in the past, returns on fixed income have become much better, and in some cases you are getting upwards of 8 percent annually. Not just on bank fixed deposits, but also on some of the structures there are out there, and which are reasonably safe as well. Also, in an inflationary environment, gold and real estate are doing reasonably well. Equities are not cheap, but they are not terribly expensive at about 20 times forward earnings. Lot of these earnings are now transitioning into cash flows because of lack of capex opportunities, and you will be between 3-5 percent of cash flow yields. I am an equity manager and so I am biased towards equity. Given the health of corporate balance sheets, it is a good place to be in. I would say 2023 will be a good year for equities, and I am reasonably sure that 2024 too will be a good year.