The whole notion of trying to guess how markets will read elections is a little bit more interesting than trying to figure out whether India will win the World Cup or not in England. Market is obviously pretty poor at reading election results. I mean even after the election results have come, the Indian market has not been able to figure out what to do with the results.
Back in 2004, when NDA lost, the market went down circuit and then we had the biggest bull run in the Indian history in the next five years. In 2009, when UPA won, the market celebrated and then we had five years of no returns. So the Indian market’s ability to understand what the political outcome means for the economy and for the market is pretty poor.
If we look back at India’s history over the last 40-50 years, there is very little evidence that politics have any meaningful impact on the economy or on the stock market. For the last five decades, our GDP growth has been better than the decade before, Obviously, it will be hard fact to convince ourselves or others that over the last five decades, India has had some enlightened version of economic leadership which has resulted in five decades of trending up.
Second, if you look at our country, there is very little proof or evidence that government X changes the policy of government X minus one. Since 1991, there has been a great deal of continuity in economic policy of various governments. Whatever policy the previous government promulgated, the next government have taken it through. There are obviously ideological differences between our political parties but those ideological differences are not with regards to economic policy.
Third, if you look at the pressing problems facing the country such as job creation, it is not evident that any political party or indeed a apolitical party has any great success in making our country more competitive in the global economy. How do we create jobs? That hopefully answers from the government policy and indeed no political party can claim to have clear answers on these pressing issues. For a variety of reasons, the less focus you give to elections, the better off you are as you are. If you want to play a game, you might want to concentrate on second guessing the result of the cricket world cup rather than the coming elections.
You have recently said that Nifty does not clearly reflect the state of the economy, which indices or what do you think would be a better play on the state of the economy?
It is not just the question of the Nifty. Two things have happened in parallel over the last decade; the first is that readers have become more prosperous and increasingly large percentage of our spending is being devoted to items which are not part of the listed world at all. So this phone on which I am talking to you and your phone as well, the PC or the laptop on which you are going to write the story up, the websites on which your readers will read the story, the servers or the cloud on which the story will be hosted — increasingly your and my life is about products with have nothing to do with the Indian market and that itself makes the market a pretty poor play on economic growth.
The second challenge is that private equity has emerged in India as a far more aggressive, far more reliable provider of growth equity than the Indian stock market and therefore the provision of growth capital to our economy now primarily comes from private equity than from the stock market.
So, in both regards, we have a challenge facing our country. The challenge is accentuated by the composition of the Nifty or the Sensex reflects old fashioned smokestack economy whereas the growth in our country — whether in consumer or in financial services –is anything but smokestack industry. Both Nifty and the Sensex are loaded up in sectors like power, infrastructure, metals, mining, oil and gas, engineering, construction for reasons which are not quite easy for me to understand because the economy itself or our GDP itself is not heavily biased towards these heavy industrial sectors.
Yet for some reason, the Nifty and the Sensex gives disproportionate representation. There are challenges with the composition of the Nifty and the Sensex but leaving that aside, there are broader structural issues which are increasingly making the stock market a poor play on India’s economic story.
For investors, which are the proxy plays that they can use for the unlisted space?
People like us at Marcellus say just look at the last 10 years. Let us look for companies which are consistently growing revenues in double digits, consistently generating return on capital above the cost of capital and therefore we call these consistent compounders. Therefore, these companies are a reliable trade on India’s strong economic growth just by doing evidence based investing. Just by doing evidence based investing, we are saying look here is the data, here are a dozen odd companies which are consistently growing faster than the Indian economy whilst generating free cash flow, reinvesting the free cash flow back into the Indian economy and generating faster growth for years ahead.
If you want to participate in India’s economic prosperity and its economic growth, invest in the consistent compounders. We are not waiting for some capex cycle to start day after tomorrow morning at 9 am, nor are we waiting for the election results to trigger a capex cycle. We are not making any funds in the dark that companies who have not generated return on capital for a single year in the last 10 years, they will suddenly miraculously generate return on capital in the next two, three years. That sort of speculative investing is unfortunately encouraged by the composition of our frontline indices which is one of the reasons that the frontline indices are no longer doing justice to the Indian economy.
Think of the Nifty and the Sensex as the shop window of the Indian stock market. If I go to a shop — whether it is a online shop or a physical shop — the shop window is supposed to entice us to enter the shop by showcasing the best about the shop. If it is a clothing shop, the best dresses, the best clothes will be on the shop window, if it is a bakery, the tastiest and most attractive looking cakes will be in the shop window. The Nifty and the Sensex are not performing that function anymore for the Indian stock market. They no longer contain the glittering jewels, the best that our country has to offer and they are doing a disservice to the stock market.
The stock market itself has challenges because the best growth opportunities are being taken up by the giant PE funds which have large aggressive PEs in Mumbai and Bangalore now and more generally because our growth is increasingly coming from unlisted parts of the market, It is a multilayered issue but people who run the stock market could start deviating matters by revisiting the composition of the Nifty and the Sensex.
There’s a lot of optimism in the market right now. We have had people raising their targets on Nifty. What are your thoughts on this optimism and is it here to stay?
In our investment style, we have never really bothered about optimism or pessimism. Our investment style is always focussed on buying high quality compounders and staying invested for years. We typically buy when client money comes in and we build the portfolio for that but never really understood why people get so swayed by short-term factors. That being said, if one were to understand why people are suddenly optimistic around the world on markets in India, first the Fed in December and now ECB in March have basically said that the economy is slowing down and therefore we are going to keep monetary policy relaxed and not hike interest rates. That has made investors more optimistic about the prospects of equity going forward.
Similarly, in our country, the rates have been cut twice. Around the world, the desire of central banks to stimulate growth in a slowing economic climate has made investors more optimistic in the near term. But we need to be mindful that these waves of optimism or pessimism really are little bit more than entertainment for stock market participants. Fundamentally, high quality companies keep compoundin. In a year like 2017 when the market rose 30% or a year like 2018 when the market fell and thereby the market was flat. Great compounders keep compounding and also ran in years of 2017 where they run up and years like 2018 when they crumpled. Since our focus in our investing is on the great compounders, we never lost that much sleep on the short-term noise.
You have been pro consumption theme for a while. What are your thoughts there?
The filters that we use are needed to assess where to put our money, where to put our clients’ money. Filters have dragged up for us companies which are growing consistently, generating good return on capital. It so happens that these companies are primarily from the B2C domain or from financial services. These are the companies which have consistently over the last decade participated or more than adequately participated in India’s economic growth. It is not that we start our day at 8 in the morning with the view to be pro consumer. It is just that sort of evidence based investing that we do — the quantitatively oriented investment I do, finds itself aligned to the consumption theme in our country.
What are your thoughts in the auto space currently given the fact that it is going through its own headwinds.
If you look at the data, the auto sector is doing what the data historically suggested it should do, which is that auto sector goes through cycles. It goes through four-five years of good sales growth, volume growth and then it goes to two to three years where volume growth becomes weak. We are in the midst of the first year of what could be the first year of three years where volume growth is weak. To that extent, people like us look for consistency in historical compounding. The auto sector has not been able to provide that because of this off-on nature of volume growth. The volume growth is switched on for four-five years, switches off two-three years. As a result, the auto sector has not been able to deliver consistent compounding that people like us look for.
What are your thoughts on the paint sector?
The paint companies, not just an Asian Paints, even the next two players BergerNSE 0.20 %and AkzoNobel have had very long track record of return on capital being above the cost of capital for several decades now. That is the first criteria if you look at paint, Asian PaintsNSE -0.16 % has 50% market share, Berger Paint around 20% market share, Nerolac and Akzo each with around 5% to 10% market share. Each of the top four players has return on capital above cost of capital for extended periods of time, multiple decades we are talking about. Within that –the two leading players Asian and Berger have had double digit volume growth pretty consistently for the last decade or so. In case of Asian Paints, you have more like the last 30 years. Berger’s case last 20 years. These characteristics obviously lend themselves very nicely to our philosophy of consistent compounding. Asian Paint stocks are up 1600x or 1700x since that IPO in 1983. So you are getting 10x in 10 years, 100x in 20 years, 1000x in 30 years quite comfortably with Asian or Berger.
The auto sector does not give you this sort of compounding. So what happens in the years like 2017 is the auto sector looks far more attractive than the paint sector and those who get swayed by short-term data and noise, get sucked into the auto sector right at the top of cycle in 2017 and then obviously the sector comes down in 2018 to what is historically done, it does again in 2018 where after three-four years of strong volume growth, the volumes drop. We are going through that and obviously auto sector investors are struggling with their 2017 investments in this sector.
What are your thoughts on the recent L&T-MindTree saga?
It is relatively clear to all concerned that consolidation in Indian IT is long overdue and logically the consolidation will have to come in the mid-tier companies . The big four are too big for others to consume but the mid-tier companies are possible. It is high time they consolidated because if they do not consolidate, they tend to have very one-dimensional growth stories. Either they have a specific skill set or they have this one sector or one geography that they focus on. They tend to be volatile if that specific skill set or that geography is not working at that point in time. It is high time that we saw consolidation in Indian mid-tier IT, midcap-small cap IT and this could be the starting run for that wave of consolidation.