In any country, how do economic reforms lead to wealth generation?
Economic reforms typically come with a short-term cost. If there was not some sort of economic pain associated with economic reforms, those obviously would have been done a long time ago. If we look back at 1991, after Manmohan Singh and Narasimha Rao announced those reforms, growth slowed down for a couple of years. Growth slowed down because Indian companies which had benefited from tariff barriers from the licence raaj obviously suffered as the economy got opened up.
Similarly, after the GST announcements, it is clear that there was a slowdown in the economy. The economic reform typically comes with costs over the first one to two years and thereafter, the benefits start coming through. By my reckoning, the benefits of reforms should come through from FY21-FY22.
I also believe we will see more reforms come through in the remainder of this fiscal. The finance minister has been pretty clear on that. There are further reforms on the anvil. What is even more interesting is how the stock market discounts the benefits of the reforms, even before the economy starts showing them. But then, that is what the stock markets’ job is! The stock market is not perfect, but it tries to figure out who are beneficiaries of the reforms and the stock prices of those companies start discounting the benefits.
What is interesting is economic reforms do not typically help the entire stock market. There are winners and losers in it. If we take the example of the recent tax cuts, clearly companies with not just high tax rates but also very high cash generation, very high ROC and high re-investment rates are the greatest beneficiaries.
On the other hand, companies with broken balance sheets, without market leadership, without pricing power really do not benefit. They will have the benefits of the tax break which they will have to pass on to the consumers because if you do not have pricing power, you would not be able to hold on to the benefits of the tax rate. So economic reform is not a panacea, it is not a remedy for all companies. It helps a select subset. The stock market discounts the benefits before the economic benefits come through and typically the economy slows down in the wake of economic reforms. That is the way it has been the world over and that is the way it tends to be in our country.
You are expecting more reforms to come through. What is your wishlist on these reforms?
It is not a wishlist. It is a list that the government used to be relatively candid about. Firstly, if you announce 15% tax rate for companies who set up new factories, it logically stands to reason that you have to make land easy to acquire. There is no point in giving lower tax rate if they can’t get the land. So, land reform should logically follow in the remainder of this fiscal, probably the Winter Session or perhaps the Budget Session.
Secondly, once you get land, you build your factory. If hiring and firing labour is a problem, we are not going to build that factory. We build the factory but we pump it with robots. If you want to see job creation after the factories are built, labour reforms should be on the anvil. Now labour reforms is a holy cow in India, nobody has touched it since 1971. I suspect the way the BJP will deal with this is they will ask the states to take the lead. They will pass the hot potato to the state governments.
Given the extent of corporate tax cuts, it would be anomalous if income tax rates are not cut. Otherwise it will look very strange. So my reckoning is in the Budget, we will see income tax cuts for the broader Indian population.
Thirdly, given the manner in which these reforms have been announced, which is typically Friday evening at 5 pm in front of the press, I have a strong hunch we might see something before Diwali. As we know, reforms is a way to underscore to the country whether the government cares about the economy or not.
Coming to markets how does the market outlook look for the rest of the fiscal year?
The economy clearly is in a bad place. We all know that it is not just the PMI data. Also, sitting in Mumbai, we can see the core of the NBFC community struggling to get funding. This morning’s headline in various newspapers was a HUL CFO talking about a severe liquidity crunch. It is evident to everybody now that we are in a fairly difficult economic situation and it is unlikely that this fiscal, we will quickly get out of the troublesome economic situation. But as I said, the stock market’s job is to discount economic growth to three-four-five years out and in that regard, the discounting of future benefits or reforms has already begun.
If the FM continues the way she has announced reforms over the last couple of months, the stock market will benefit from that. The stock market therefore is contending with two opposing forces. One is a weak economy and the second is a reforming finance minister.
Considering where the market is, how do the mid and smallcap space look like at this point of time? What are your top picks?
I have never really thought about the market in terms of market caps. Over the years, we have used a structured process of looking for companies with consistently double digit revenue growth and return on capital above 15%. I have never really cared whether they are smallcap, midcap, micro cap, infinite cap or mega cap. Those are useless labels. Our job, I think anybody’s job should be to look for companies whose promoters are clean and that should be the first priority.
About 80% of the listed market has got dodgy promoters, bad corporate governance. So step one, look for clean companies, clean promoters. Secondly, look for companies with deep comparative advantages, strong moats, very high barriers to entry and thirdly look for companies which have been able to show a track record of generating stable cash flows, stable earnings and sensible capital allocation. So three different facets – cleanliness, barriers to entry moats and stability. We are investing other people’s money, we have to be responsible about that. We cannot take people’s money and punt it on companies which have crashed by 67% but a goddess told me that they will recover by 89% in the next 12 months! It does not work like that. Be rational about it, rather than getting lost in these false labels of large caps, micro caps, mega cap.
So ESG is clearly very important right now?
I am not sure ESG also works because if you give me money, my job is to compound your wealth. My job is not to prioritise saving the planet over compounding your wealth. Now if compounding of wealth also means that I need to look for companies which are responsible about pollution and responsible about how they treat their staff and ethical about how they deal with the government, sure I have to do that, but the priority has to be to look after clients’ money. Do not come up with these marketing labels such as ESG. You do a disservice to a lot of lot of people, this whole bandwagon around ESG is a disservice to our people, including the causes that the ESG funds purport to support.
Are autos an attractive bet at this point or not?
First,, just look at the discourse. We are talking about bets. But we are managing peoples’ life savings and obviously we cannot bet. I do not think anybody can or should. You cannot pick as well. We are investing, we have a fiduciary responsibility to take people like your money and invest it in a conservative low risk product so that we preserve your wealth at the outset and then see if we can give you a little bit of compounding. So betting and picking is out question here.
Focussing on the specifics of the auto sector, I do not know whether the de-growth cycle that we are seeing in volumes has bottomed out. Some people are saying that October data suggests the de-growth has stopped, I do not know.
I doubt if one or two months’ data is good enough to give us a clear hint or clear picture on whether de-growth has stopped. But what one has to concede is given the quality of these franchises, given their ROCEs, given their cash generation, given their track records of growing at a stable steady pace over the last 20 years, the valuations look extremely tasty.
In that regard, I do have to confess that we are building positions in some of our portfolios in some auto stocks. I cannot give you the names for obvious reasons but the quality of the franchises, the sheer financial strength of the track records coupled with extremely attractive valuations, has led to some position building by us.
What is your take on PSU stocks at this moment?
My views on PSUs have been uniform in the 11 years I have lived in this country. PSUs are owned by the Government of India; the Government of India serves the people of India and PSUs therefore serve the people of India. I do not think PSUs’ job is to look after the interests of minority shareholders and hence it is illogical for me to invest my clients’ money in PSU stocks.
What are your thoughts on divestment through the privatisation route?
We hope that disinvestment and privatisation happen. It would be a step forward for the country. The Government of India is involved in too many activities where it does not bring great competitive advantages to the table. So, whether it is Air India or the much-talked about BHEL disinvestment, bring it on, the more the merrier and the sooner the better.