2022 was a year of reckoning with interest rates going up and lots of businesses got derated, lots of excesses in the market got weeded out and realisation has kicked in that growth is not the only factor needed to have profit more than market share gain. What will be the dominant theme for 2023?
The trend that we have been seeing over the last year or so will continue. While interest rates have been rising in the last one year, we have to see it in the context of the fact that they have fallen for 40 years systematically. The reversal now does not mean that this is short- term or transient. It might be, we will get little heart attacks every time there is a slowdown in the global markets or there is the economy shrinkage but structural inflation is not going to be that easy to get rid off simply because it is not only the monetary factor it is also because of the supply chain shocks and under investment in the entire commodity value chain for a long time.
On top of all of this, we also have got dislocation and will intersperse this with bouts of falling prices, largely because demand is coming off in places or because very high debt levels will lead to distress selling. So we are in for interesting times.
But like in any other situation, we will always get the disruptive plays which are going to be available in terms of investment opportunities and will also always get the bottom up companies which are going to benefit from disruption and from harder times. It is not a pretty world. India is a very good place to be in relative to the rest of the world. The only issue in India is that a lot of that upside is already priced in and as our premiums to the rest of the world keep increasing, it is very hard for the Indian market to give very strong systemic returns.
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So would you call out that for 2023, we could be in for a low return or no return kind of a patch?
Overall, that may be a correct statement to make but different sectors might do very well. Very strangely, in most parts of the world, higher beta is getting trashed but in sectors like banking and financials services, we are at the cusp of a fairly long upcycle in terms of both credit growth and in terms of no NPAs and strong credit growth. We are in that stage of the cycle now and we will get that kind of upside.
But again, long-term investors need to keep their eyes on the fact that while there is a cyclical uptrend right now, longer term you have to step back and say how this whole industry operates. Since we are talking about banking, what is going to happen is that banks have distributed ledgers, they have a user interface and a lot of that will become digital.
Banks which crack a very good user interface digitally, are going to do a lot better. Cyber security will become a bigger and bigger issue. Risk management and governance is going to also matter a lot because ultimately banks are a regulatory arbitrage because governments want to protect depositors’ money and governance architecture matters a lot.
Now if you put these components together, what should the banking system look like in today’s technology? Today’s digital stack and architecture may be very different in terms of cost structures etc. than what existed in the past. In the short term, the PSUs will benefit and everybody will benefit because we are on a cyclical uptrend but longer term, it is the people who transition into long term winners.
One can do this kind of analysis, industry after industry and one would get a good sense of it. The other issue is when the cost of capital is close to zero, then cash flow 20 years out versus the cash flow today is almost equal in value but as rates go up, near term cash flows matter much more. Therefore paying for growth which is going to result in free cash flows 10 years from now becomes a lot more expensive. Therefore there is an obvious correction in dynamics between value and growth parts of the market.
I think nearer term cash flows are going to get valued much more. Again, if the interest rates were not going to be so high, simply looking at interest rates and saying when I should stay away from equity markets is probably not sensible. We still have inflation which is an issue and if you stay in fixed income or bank deposits, you are going to lose purchasing power.
So, one will have to judiciously stay in equities but one should expect that near term may not give you any kind of outsized or exciting returns anyway. I would not get out of the equity markets from any medium to long-term perspective. I would be very much invested.
We have spoken about why EV is going to be the next big multi-year trend but if I look at the Tesla, the ultimate pivot stock and look at some of the other EV related stocks, all are down. Is that a pointer that EV stocks have peaked out in terms of the valuations?
This always happens in technology. When there is disruptive technology, we have a hype cycle and things get overhyped that the world will change. That is all right. You may change the world, but will you capture the economic value? I think that is the important part, which the people have not focussed on.
For a company like Tesla which is valued more than the next 10 largest auto companies put together, I think it is only incumbent upon us as investors to look at the other auto companies and say what is their EV game and are they really that far behind Tesla and is that much for a differentiation at the end of it.
Yes Tesla has its competitive advantages in terms of its own battery technology. The fact that they thought about the car is an extension, as a sort of physical arms or wheels to speak of a networked computer and designed it from there whereas the auto guys have come from totally different parts and are trying to integrate technology into an already existing platform.
They both have their advantages and disadvantages and it is not clear that Tesla is the runaway winner. They might get challenged by BYD out of China in different markets. So yes, the stock was very overvalued but Tesla is a great disruptive company and the bottom line is that EV is here to stay, it is not going away anywhere.
EV has more efficient technology and energy consumption. In an EV vehicle, 95-98% gets converted into momentum and motion, whereas in an internal combustion engine, that ratio is 25% to 29%. We will inevitably move to an EV regime over the next 20 years.
I think that is a given but how do you go there? Do you go through the hybrid groups which the Toyotas of this world are pushing or do you go to the direct pure plays like Tesla and BYD? Are there other alternative fuels which are a good part of the mix and here to stay – maybe compressed natural gas or green hydrogen kind of vehicles? Personally, I am a little sceptical of the green hydrogen part of it.
While you are saying that FAANG and tech have been overhyped in 2022, a few months ago when we spoke, you also said that is focussed on generating profit and can become a valuable franchise. Do you believe that there is merit in relooking?
In terms of their stated intent, it merits a closer watch but I believe that when a company spends so much time being happy with not making money and burning cash, then the cultural transition takes a little longer than people expect it to. I would like to see that there is a shift in the actual belief system and that is something which is important and they want to accomplish.
My belief is that if they want to accomplish it, they can and the question is whether that really is an imperative they believe in even now. I think that the statement would be true of a lot of the tech companies. Culture is not that easy to pivot and if the culture in an organisation is growth at any cost and just acquire customers and do not look at the economic value of that customer, then making that change operationally or in terms of management directives sounds easy but is very hard to overcome very subtle cultural things embedded in businesses.
I believe that the Zomato management has it in them to make this change happen but it might take a little longer than most people expect.
What about old school tech companies, the software consulting names like , , etc. Do you believe they will return the benchmark gains in 2023 or do you see a bit of outperformance within IT itself? Is there a case to be made to look at the niche companies like , , etc?
I would normally look at niche companies. If you look at their valuations, you would find that there is no margin of safety there and larger tech should be fine. It is very hard to say what happens in the next 12 or 18 months in such a volatile world, but if I take a five- year view, most of the IT sector should be just fine. They generate strong cash flows and are very efficient utilisers of capital. Their demand is here to stay. All they need to watch out for is that they do not spend time, energy, attention in trying to disrupt their own business models and trying to enhance their own productivity using the tools that they create themselves.
My sense is that most of the Indian IT companies are very well managed with very competent folks at the top. But the returns in this sector like in most other sectors are going to be volatile going ahead. It is not going to be a simple, secular growth upwards although I am very
about their long-term prospects.
Let us understand the investors here. In India, consumer demand will always grow but consumer staple stocks are not the best stocks to invest in. They are expensive and consumer stocks which are trading at PE multiples of 70-80, will grow but they are not the best investments. Do IT services fall in that bracket?
I think they definitely make a case to be a part of the portfolio. Are they the ones which are going to generate you alpha? Probably not in this stage of the cycle largely because a lot of the markets in which their customers operate might go through some degree of turmoil and so one needs to be a little bit careful there.
But if you look at the valuations in the rest of the market for the kind of ROCEs these businesses generate, 20 times is still below the ROCEs of most of these businesses. This means they will spit out a lot of cash and on an absolute basis, if you are confident of that 8-12% growth with a 30% plus ROCEs that many of these businesses generate on their operating businesses.
They should be alright as an investment but the real issue is the volatility ahead of us because uncertainty is high and risk premiums will start to reflect that in some form or fashion. In consumer businesses, it is a big challenge and at 60-70 times earnings as an investor, one baulks at that. It is not going to generate decent returns but what is probably is what does this market look like five or 10 years from now? Who wins?
If one makes those bets right, then paying a slightly higher premium is not such an issue. I would advise non professional investors not to try that. Sticking to your very diversified index funds is probably a smart thing for consumer investors to do in spite of all the volatility ahead.
In 12 to 18 months or let us say 18 to 24 months, which is about two to two and a half years, where do you see the scope for alpha generation?
When we look at alpha generation, we have always had a blended strategy where we can operate in the listed markets or in the private markets. We are finding all the alpha generating opportunities much more in the private markets in the last 18 months in spite of the fact that even in the private market there are some bubbles.
As far as the listed markets go, if you were to look at the next 12-18 months, the alpha will get generated from the financials. It is just because of where they are in the stage of the cycle, no other reason but that is where you will get alpha relative to the rest of the market. You might also get it to some extent in the PSUs but I would be very wary of that trade, very honestly.