With the Indian equity markets continuing to scale new highs, the big question is what is the road ahead. What should one invest in? How will earnings pan out going forward?
Vikram Kotak, Managing Partner, Crest Capital and Investment believes that on an overall basis market is still cheap and says the only place to deploy money is equities.
Although the domestic inflows have continued to support the economy in the last two years, according to him, Indian retail is still very much under-invested into equities. Compared to the domestic savings of about USD 500 billion only about USD 2 billion comes into the market every month. So, even if 10 percent of that comes into the market it would great. Therefore, equities an asset class should be an investment destination.
“Market looks very good from a 5-10 year perspective,” says Kotak.
Within equities, he is very upbeat on financials. With about 50 percent of India still being unbanked, there is tremendous scope for growth for financials. Moreover, the demography of the country that is young population is also an advantage but the only problem is they are still not taking credit and the mortgage penetration is still one-tenth of the world.
So, within the sector look for companies that have a mix of growth and risk-management. Companies like HDFC Bank, Kotak Mahindra Bank have done wonders. The house is upbeat on Yes Bank, Edelweiss Financial Services, and Fortune Financial Services etc.
However, he is very sceptical of IT industry because of various headwinds that they face. The biggest threat to the industry is its huge size, he says. The other headwinds like digital transformation, automation, rupee appreciation, Trump policies, visa costs etc., will continue to remain a threat to the industry.
From an earnings perspective, he expects a 15-16 percent growth going forward in the next two years. He says the market is also currently trading at 16 times PE multiple one-year forward, so it is not extremely over-priced.
Below is the verbatim transcript of the interview.
Q: What are you expecting from the market going ahead?
A: If you look at the market overall, it looks cheap, it does not look very expensive because you look at FY19, 16 P/E multiple, but when you really deep dive like you rightly said, smallcap, midcap, it is super expensive. 5 times price to book value for most of the stocks in the midcap, it looks expensive. However, why is it expensive? If you further deep dive into why it is expensive, because there is opportunity.
So when you have a scenario where globally things are lull, nothing is happening globally, you have domestic flows which was completely staying away for last two decades in this market and suddenly in last two years you are seeing a strong inflow coming back, investors don’t find any other opportunity with lower interest rate, bank deposits are not even covering inflation, gold and real estate looks like be on the side for some time, I think the only place to really come and deploy your money is equity.
Now the return expectation is an important point and the markets are actually running ahead of the time, it might give you 40 percent this year and then give 20 minus next year. However, if you have 5-10 years horizon, this market is still looking extremely good.
Q: About the midcap and smallcap, how long this whole theory of domestic strong liquidity can drive this particular space because as you rightly pointed out some of the stocks are at crazy valuations?
A: It is a big debate and we can carry on for long. However, my summary is that I have seen 22 years of market, I had not seen this kind of retail flows coming in. Because of three reasons it is happening, one, people are under-invested big way into the equities.
You look at today what is the flow in India and still you are getting close to USD 1.5-2.7 billion a month or maybe USD 2 billion a month. You have USD 500 billion of domestic saving; even if you get 10 percent of that, which I think will happen in five years of time, you will be a USD 5 billion a month which is USD 60 billion of flows into India. We have not seen this kind of a number and this number is gradually going to go up.
Q: Do you think earnings are going to surprise on the positive from here?
A: I have seen some brokerage report having 20 percent earnings in FY19 and FY18. However, I am in the middle camp. I agree with the 15-16 percent number because you have some headwinds from the IT sector which was supposed to do X and now they are going to do X.
So, we will see some kind of earning negative surprise on some of the sectors, but more or less I see 15-16 percent earnings is very much doable because you have many sectors which are bouncing back, like PSUs have started doing well, PSU banks, private banks, all are showing a steady set of earnings. Auto is one sector, cement is one sector which is showing a good positive trend.
So, these sectors will drive the earnings side of it, and some of the sectors will kind of let down on that. However, overall, 15-16 percent earnings in next two years, what we think is possible and markets are trading at almost same levels. So, 16 times a P/E multiple, one year forward, so, we are not extremely overpriced as of now.
Q: I know one sector which you are probably negative on is Indian IT for a long period of time now. Most of the stocks are at 52 week low, everybody is sitting on cash, they are looking at buybacks, they are looking at special dividends, you think it is right time to buy or it is still an avoid?
A: I think I will avoid. I will not touch IT for long time and I believe IT is in a bad shape. I will tell you why. The biggest problem is the size of the sector which has been. India, 15 years back, BPO market was USD 2-5 billion market, today is USD 110 billion market. You have USD 110 billion India BPO industry. Now, world is going through digital transformation and automation. This itself is the biggest threat to the BPO, forget about Trump policies.
I am saying the size itself is big and the labour arbitrage -- why has the size happened because labour arbitrage and good policies. Labour arbitrage is coming down because our cost is going up and second, you are not able to do value addition on that. So, you are doing the work which companies give to you, you are not putting the other way round. So, I think that is BPO.
Overall Trump policy is going to be very important and I think the cost of visa is going to go up, there is no question about it and everyone wants to protect their own economy, like we have Make In India, people have make in US or make in China. So, I think that is going to be one threat always going to remain for IT. I think the way Indian balance sheet is shaping out, the macro balance sheet, rupee is going to be in appreciating trend for long period of time and there is going to be headache for IT industry.
So, how do you on this scale grow at 20 percent? I am not saying they will de-grow, but I am saying that at a scale which you are already, a size which you are already, in a mid-tier value addition job which you are not going to improve, how do you really grow your balance sheet from here? So, you will see either flat, or single digit growth.
Maybe some selective companies can do better, but overall, I am not seeing in the world of digitisation and automation you continue to do a labour arbitrage job for too long period of time. So, I think you have to seriously rethink what strategies you have to follow and I am really worried about IT.
Q: The big sector which you are bullish on is financials, that probably constitutes 40 percent of your core portfolio. What is your view there because I was looking at the holdings, you hold Yes Bank, you hold Edelweiss Financials, and you also hold Fortune Finance – over 2 percent stake, so, it looks like you are biased towards financials and the financial sector. So, what is the story there?
A: Financial sector is very simple. As we always discussed that Indians keep money in the bank all the time, in cash, in gold, in real estate. Now, we are seeing that is changing slowly. Your savings rates are so high, it is one of the best in the world and this money if starts flowing into other assets with the young population understanding of equity market, SIPs, all these things, what will happen to financial sector -- I am talking on investment side of it and this is what exactly is happening right now for last two years and I think the trend is going to accelerate going forward. It is not going to come down for sure in medium-term.
Second what about the urbanisation, demography, young people, more penetration -- mortgage penetration is so low India, it is still one tenth of the world. You see credit, on auto side, or consumer side, people are still not borrowing. Still the banking is 50 percent of the country, 50 percent of the people are still not banking.
So, opportunity in the banking financial is going to be crazy, very solid. Only thing you have to keep in mind is the companies which are doing the mix of right balance of growth and risk management, I think those who have done that, they have created a solid market cap, like HDFC Bank, or Kotak Mahindra Bank, they have done really great jobs in the past many years and I see companies which I am holding has the same kind of risk management capability and growth capability.
Q: What are the plans for your financial services business going ahead?
A: I started this business two and half years back and the whole idea was starting a business to start with investment book which was my passion - managing money for yourself not for others. So, this is what I started and I am doing good there.
At the same time we also felt that lot of people who want to come in ask you that, why don't you manage my money? When you run a prop book you can't really run others money. So, you need to keep a Chinese wall. So, we kept our PMS business, I became promoter and director in the PMS company which is separately run, it is completely managed professionally by a separate CIO and I really don't participate on day to day.
We also have built up the fixed income trading company with the joint venture with Fortune Financial which is doing quite well. Also we have taken a strategic stake in the company called Credence Family Office which is doing pretty well, almost USD 1.7 billion of assets. The whole idea is to stay around financial services because that is an area which I think is going to really prosper in next 20-30 years' time because that is the area which is underpenetrated. The awareness and the returns are so good, so people are going to come here.
Q: The agri space and the fertiliser space, you have a very strong view in that space. You are also holding some of the fertiliser stocks in the portfolio, what is the story there and why do you think fertiliser as a space will do well for investors?
A: Fertiliser what is important is what is the bottleneck in fertiliser. One, you don’t get energy, gas linkage and second subsidy. Now if you have subsidy outstanding for 18 months, how can a business be managed with such a shady working capital cycle. Now, with new government coming in and what we talk to companies, the cycle has come down from 15-18 months to three to four months and that is also in my view in next three years will replace by a zero subsidy.
You will have direct benefit transfer (DBT) coming in, you will have farmer getting money in the bank account, going to company and going to retail outlet and buy the fertiliser at the market price. Now, that will reduce the working capital cycle for the companies. I will give examples without naming; one company which has Rs 1,000 crore of debt and Rs 1,000 crore subsidy, if you remove that subsidy and debt, assume that becomes zero, the Rs 120 crore is the saving on a market cap of Rs 600 crore.
I think the opportunity in fertiliser is huge, plus the consumption is going to go up because this country is still agri-economy. If you reduce the control and if you ease out the way of doing business, I think there will be more marketing, there will be more distribution, there will be more capabilities by the companies which is going to ultimately penetrate further and create awareness for the agri and the fertiliser side of it. So, we remain very bullish on the sector.
Q: Is that going to be the big theme, the affordable housing which probably even Narendra Modi has been talking about, by 2022 everybody should have homes, is that going to be the big theme to play over the next four to five years from now?
A: I think the valuations are expensive there, no doubt about it but that theme remains a 25 percent compounder because your growth is in excess of 20 percent and the way I think the shortage of housing overall is there in India and if you have such sops coming in from Modi on the affordable housing side, you will see the consumption of ancillary items like cement, tiles, paints, durables, I think it is just going to shoot up.
Where are we in terms of penetration compared to global? I would say we are one fourth of China, one fifth of China, and we are one tenth of anywhere in the western world. So, if you look at Indian washing machine, ACs, or TVs, we are still at 10 percent, sub 10 percent penetration which is too low, abysmally low. I think there is opportunity there whether you take tiles, or paint, everywhere we are one fourth or one fifth of China and one eighth or one ninth of the global consumption.
Q: As you rightly pointed out, the valuations are not cheap in that space, many of the stocks are probably quoting at 35-40 times FY18 earnings. So, pretty much discounted right, so, how do you play that theme with valuation in mind?
A: The growth compounder on the business is say 18-20 percent year-over-year and with efficiency playing out, if they deliver 25 percent, do you want to sell this investment right now or will you wait for -- new investor can buy in a correction. However, it is like that you need to hold these companies because they are going to show that growth and growth always gets a price in the market, so, we will continue to hold that, maybe as I told you, I may not buy now, we will hold our capital right now, not deploy at this moment but in any correction you get a demonetisation kind of correction when everything was available at half of this, again it is all 70-80 percent up. So, that is opportunity where you actually can build a long-term portfolio.
Q: We are just chatting about how early you have been into Maruti. What is the broad sense in that auto space, you still like that space and what about auto ancillaries because that is where probably larger money is made in the last two years?
A: Auto ancillary selectively has been good but with the change in technology, change in the way world is going to – the new theme of the world for auto is lighter car, pollution free cars, and the electronic gadgeted car, so GPS driven car. So, you have to really see which auto ancillary will benefit but overall as a theme you are right, auto ancillary is a good theme but I still believe the companies like Maurti which is a great brand in this country, which has a strong product cycle, which has a strong distribution network and most important which I love about Maruti, that is my first car, is that the service is at very cheap cost.
You can go anywhere in the country and you find a service center. So, I think that is a standard home car, whether you move to BMW or something else but you will have one Maruti car at your home for your family, for your other stuff. So, I think Maruti remains a strong company for long and a great management. I look at two things in a company, one is scalability and most important is management. I think Maruti has been the world class company in the country.
Q: What about infrastructure because that is again picking up, some orders have been given to many of these companies off late.
A: Couple of high quality management companies in infrastructure which is in transmission lines and water segment and we think that that can be opportunity because I think this sector has been again lagging for long time and the cycle has been -- listening for long time that cycle will revive but slowly I think we are seeing the road momentum in road transmission is playing out. So, I think there is opportunity there.
Q: When you talk about infrastructure, it is a larger space, what do you look at?
A: I like transmission lines as a sector, or transmission line manufacturers as a sector, we like road selectively -- again very few stocks we understand and water is one segment where we have the investment and we think that is the opportunity.