You have been shopping a lot in IPOs and typically IPOs have a reputation that they never leave anything on the table. These are priced to perfection stocks. The promoter wants to do, merchant banker convinces him to sell higher. You have been shopping and some would say that value investor shopping in an IPO?
We have been, see 0.25%, 0.5%, 1% of the fund. There is very high discipline with regard to that. When a company is good, even if valuations are expensive in 0.5-1% of the portfolio, we can participate but if you look in percentage of portfolio terms, you will see it is actually insignificant.
I would like to draw attention to a sector which you. In 2016-2017, it had become a mature sector. Do you remember which sector you told me about? See, I remember it?
In 2015-2016, we had a conversation. You said IT had become a mature sector and now there is a reversal for a sector which went through massive re-rating post Covid is going through de-rating. What is happening there? The order books are very fat but that is not translating into revenue.
What one probably meant by maturity is that the growth rates are mature. So, the growth rates have stabilised and we can see that. In the last 5-10 years, growth is in high single digit in dollar terms and those growth rates will sustain over time, but what happened in the Covid year is that there was slight de-growth because corporates pushed back on discretionary spends and the moment the world opened up. There was rapid digital adoption and Indian companies did exceedingly well in terms of adopting to work from home which probably some of their global counterparts did not do as well.
So a lot of business came their way and the growth was pretty high for maybe two odd years. I think that high growth markets extrapolated that and at the peak, these companies went up to almost 40 to 50 PE.
Yes midcap IT was at 40-50 times.
Yes, it was wrong because high growth was due to very specific circumstances and it was an error on parts of the markets to extrapolate that growth and growth is now normalising due to the high base of or the big digital catch up has probably happened. Again we are back to 6-8% dollar revenue growth for the next few years. Those multiples have gone.
The template for IT is that it will grow at a rate which is lower than India’s GDP and there are companies which can give 12 to 14% visible growth for three to five years. Now, IT companies may defend and say our return ratios are great. We will keep on doing buyback, but if the growth rate is going to be low and if markets always focus on growth, then why should one own largecap IT at 6-8% growth when the economy is growing at a much higher rate?
I think 6-8% is in dollar terms. You can add rupee depreciation to that.That will make it 10-11%.
10-12% but India is also a lower inflation country now. Our nominal GDP is growing at 11-12% only. So, to that extent IT is growing in line with rupee GDP growth and what we can say to their credit is that the capital allocation is one of the best. The good companies, large companies pay out 90% odd of profits, all of free cash flow. If a business is growing at 12%, it needs capital, it will be valued lower but if a business can deliver the same growth with no incremental capital, it will trade at a higher multiple. So, I would say IT is now coming round to near fair multiples. This business can deliver moderate returns especially if you add back the dividends over medium to long term.
So, IT is not part of your portfolio, but it is there on your radar.
We are underweight. It is there in the portfolio, but we are slightly underweight.
We have also seen an interesting trend in the IT space. You know, for the longest time the criticism was that Indian IT was all about body shopping and IT services. But a lot of SaaS companies, a lot of niche IT companies, design companies have now taken birth. Good quality, great entrepreneurs have gone public. Any thoughts there, anything which looks interesting?
No, actually I am not on top and there are some good product companies which are there, but they are very small and few. That is one space where India still lacks. But Indian companies in some cases have developed good products. But that is not enough, that is just the start. To make this product, to sell these products for consumers to adopt, is altogether a very different challenge and that needs a very different magnitude of resources, time horizons, executions. I would say hopefully one day Indian companies will have products that will be adopted globally. So far, we have very small companies which have very niche products, nothing meaningful.
You know it is a coincidence that your firm’s name is 3P and one sector which you identified also starts with P which is power. You have been talking about the power sector pre-Covid, during Covd and post-Covid, It is just that markets are recognising them. They had become the ugly ducklings. This sector needs a constant dose of money unlike IT. You said one should like companies which do not raise capital, Power has a different story. It needs to grow, it needs capital and it is a regulated sector. Return ratios are not impressive yet you like it.
No, there is a fair price for everything. So a business which is generating all free cash flow also has a fair PE like at 40 PE an IT company becomes very expensive. At 16-18 PE it starts looking attractive. So at 2 or 3 PE a business which is generating 12-14% ROE and needs lot of capital to sustain that growth. At 2 PE it is very cheap and probably at 16-20 PE it is very expensive. I think you have to pay a price. That is what I said earlier that the right price is relative to what business you are talking about. Simply a high or low PE does not mean much. A business can be very expensive at 12 PE and it may be cheap at 80 PE.
India’s power demand will grow at a fairly decent pace because adoption of ACs in India is only 5% and as our income levels grow, discretionary spends grow, air conditioning will consume a lot of power, manufacturing will consume a lot of power as the economy is growing in any case. This electrification will consume significant amounts of power. So power demand in India will grow at a decent pace and in the last 10-12 years, we have not invested in new thermal capacity. The mix will continue to shift towards solar and wind but the markets anticipated the shift to be much or expected the shift to be much faster than the reality.
In India, demand for power typically peaks in the evening. At that time there was no sun. See renewable power is not 24×7 power that is the big disadvantage. So unless storage becomes cheap, we will need more thermal and India is planning maybe 50000 or 80000 megawatts of new thermal capacity. I have been saying all along that this sector was misunderstood and the right to win in the power sector is with companies that borrow at the cheapest rate.
If there are three companies and all put up solar plants or all put up wind plants, the cost of panel, the land, everything is practically the same. The difference can come from the cost of borrowing because these are projects that are typically 70-80% funded through debt. So someone who borrows half 1% or 2% cheaper is likely to be a winner. The ROEs will be higher. That is why the public companies which borrow at the cheapest rates. That is the reason those companies have come back in favour and why they continue to grow well and to do well. The whole narrative around ESG, bleak future of thermal and PSUs – all came together and it created deep value in that space but slowly all those things are correcting.
You are the only fund manager who has called spade a spade unlike a lot of fund managers who come and say okay long term bullish, medium term stay invested, short term we do not know. There are periods when you have come out saying the market is rich and will give you no returns. For the next three years, what could be the returns?
I think in India the largecaps – Nifty, Sensex can compound 12% longer term. I do not see a challenge in that. Markets are now close to historic multiples, slightly higher but I think there are three reasons why Indian multiples may settle higher than the past.
A)Our growth is likely to be higher. In the last 20 years, we have grown around 6%. I think we should grow 7% or even higher in the current decade and next. So, higher growth means higher multiples.
B) The cost of capital has come down. India has moved from a high inflation to a low inflation country. In the last 9-10 years, inflation is sub 5%. The gap between Indian and US yields is shocking. It used to be 6% 15 years back. Today it is 2.5%. So, lower cost of capital, higher growth means higher PE multiples.
C)The volatility of Indian markets is slowly trending lower and that is because of the improving share or improving flow of local savings towards equities. So faster growth, lower cost of capital and lower volatility. Even though these multiples are not cheap, I think one should not remain in cash in the largecap space. So 12% or may be slightly higher returns are possible. The US yields have touched 5%. They may go to 5.5% or 6% in six months to one year. But the move from 1% to 5% has been digested by the markets which I think was a hanging sword all along. So to that extent I think there is greater comfort in these markets.
So every year in your previous avatar your firm used to come out with a year book indicating where investors should invest, what is the macro set up, where the valuations are. Now to your existing investors in 3P, if you have to write a Diwali note talking about the lay of the land, how will that note start, how will that note end?
We publish quarterly and what we have said is.
Please put it on the website, everybody wants to read.
Okay, minus the portfolio we will do that. I think the growth rates will accelerate. See one thing which we did not discuss, this remote working has brought huge dividends for India. Global companies are now shifting a lot of jobs to their India offices across functions, accounts, taxation, legal, back office, HR, engineering, payroll. The net exports of services ex software, that number was flat for 8 years. It is now going up fast.
So whichever company you talk to, whether it is a bank or engineering company or an automobile company, the number of jobs in India is just shooting up. There will be more jobs, more purchasing power and it will reduce India’s current account deficit. So the current year current account deficit is likely to be 1.5%, which is lower than the past. Growth rates will accelerate, one because of this and two because of manufacturing.
One slow change in India has been the vast improvement in infrastructure. Leave city life out of it. Cities in India are very crowded. The inflow of people to cities makes infrastructure always a challenge. But think of a business, ports, airports, power, telecom, intercity roads, these are good. So infrastructure for business has improved. Infrastructure for citizens is still always catching up because the cities are growing so fast. The digital infrastructure in India is probably one of the best in the world. I think business conditions are good, external environment is supportive, growth rates will accelerate.
The economic growth outlook of India is strong. Corporate leverage is at a 15-year low. Bank NPAs are not there. One can tick literally all the boxes as far as macro is concerned. Companies are making money. Corporate profit to GDP is back to 5%, which is where it was post Lehman. Net-net, India is in a very good space. Many other EMs are out of favour for some reason or the other.
Some are sick or some are unwell, but nobody is very fit and healthy globally.
Or the behaviour of some is disliked by the world. We are looking quite good. Markets are fairly valued. Fairly valued means no multibaggers in this market but these markets offer you compounding opportunities. So if you remain invested…