Kenneth Andrades Top Sectoral Bets

Markets will continue to struggle on account of macroeconomic factors, before they make a comeback in 2023, according to veteran investor Kenneth Andrade.

While the numbers will not go below the lows of 2020, the levels will drift sideways with a downward bias, declining around 10% in the worst case scenario, Andrade, founder and chief investment officer at Old Bridge Capital Management, told BQ Prime's Niraj Shah

He advised investors to look at the textile exports space to wait for demand to recover. This season is over and they can crawl back in the next season on the back of healthy balance sheets, he said.

According to Andrade, the valuations framework is strong in the metals space, and it is also extremely competitive in terms of cost. Price stability for metal companies will be established once volumes show up, he said.

In terms of IT exports, Andrade expects the global meltdown to lead to a lot of information technology budget cuts, especially from clients like banks and companies funded by private equity. However, development work across governments and other companies broadly will not be part of this trend, he said.

Valuations in the space have become cheaper, with some large companies already trading at 5-6% dividend yields, he said.

Andrade expects any volume cuts in the sector to only last for a year.

The power sector, where the market expert sees capital expenditure happening in the near term, had a good cycle in 2021 and a tepid one in 2022, he said.

He expects "green shoots" to start appearing within a year, and he considers the space to be one of "the lowest hanging fruits" in the market.

View the entire video here:

Edited excerpts from the interview:

How difficult is it to gauge the current landscape?

Kenneth Andrade: From the time we left our last conversation, I don’t think the number of moving parts has come down, it still remains the same. So, in the near-term it's always a guess-estimate, but we will continue to struggle with everything that is already there as far as the macros are concerned.

We almost got a stagnated market for all of this year, stocks that actually lost reasonable amounts from their highs. So, I would just tend to believe that 2023 should be a lot better. But still, it is going to take some time before we see signs of that actually coming through.

Before the markets at large were to start getting better Kenneth, just wondering if the combination of the macros at hand plus technical factors, do they ensure that the markets get a bit worse from where they are right now? Do you reckon that things would get uglier before they get better?

Kenneth Andrade: It depends on what you actually say (is) ugly, because it's not going to be anywhere close to what we saw in 2020, it will just probably drift sideways.

The change, looking at the marketplace in 2022 compared to what we had in 2020, is that we have completely defined what downside in terms of numbers are.

You take the worst scenario that happened in 2020, where we almost lost two quarters of turnover and still, we were able to deliver so far. So, you define the bottom of your earning cycle, and it is not going to go below that. From there, you have to figure out how much higher it will go.

My sense given where the marketplace is, and the way the interest rates are moving, what you are seeing is the valuation of equities as an asset class coming down, because the cost of capital is going up and that's something happening globally.

It's also been represented somewhere in the Indian context. So, we have gone through that adjustment phase on that side. My sense is all will fall into place somewhere in 2023.

When the world seems to be moving into a slowdown/recessionary phase depending on which region you look at, therefore, can it get really bad from here or would it be a drift/sideways move?

Kenneth Andrade: I think a drift-to-sideways movement, with a bias towards going down. My sense would be if you asked me a worst-case scenario, I think it will go down to about minus 10% from here, maybe a little more but that is where it should be okay.

Markets are not rich in pricing, but they are not very cheap either. We are sitting somewhere in the middle. The answer to that would be whether it will become cheap before it goes higher again; I will not be able to answer that.

So therefore, in such a scenario, what is the portfolio construction strategy currently? How are you thinking through things?

Kenneth Andrade: Nothing very different. Our sense is that we are still in an inflationary move and right now, the world has seen some levels of stagflation if not destruction of demand that is there.

It also comes from the fact that a large part of the world, which includes the European Union, has to go through winter. After that, I am a little cautious because they come out of the next two quarters with one of the most competitive currencies in the world.

So, the carrot to that is if they come through with one of the cheapest currencies in the world and go into a manufacturing cycle to come back, as far as the economy is concerned, they could rebuild their economy all over again. The U.S. will do it because of the strength of the dollar, the Europeans will do it because they have the weakness of the currency.

So, these are two global engines that will start working and that is where countries like us will necessarily have to find ways to feed into that part of the economy.

So, this migration you are seeing China to India, from Europe to India probably hit that cyclical hub this quarter, which is the September to December quarter, and maybe January and February will also see some really large exports going out of India and lot of companies manufacturing.

That should be a cyclical high because when manufacturing resumes with the weaker currency across the world, a lot of currencies are much weaker than us, could see that shift going back again. So, enjoy the cash flows for a quarter or two but I will be wary on the other side.

Yet, I hear you say that 2023 will be better than 2022.

Kenneth Andrade: Yes, it will be. I think pockets of opportunity will always be like this because most of the Indian companies are already finding their footing in a large part of the world.

Our domestic economy is... you don't have a broad-based consumption that is going on, it's very infrastructure, government-related consumption and also non-discretionary consumption is reasonably good.

So, those are the things that will hold us together and we will also come off a significant tail, I won’t say significant lows, but we will also come off from the lows from the market standpoint.

So, 2023 should be marginally better than where we are standing right now.

If I am understanding this correctly, you are saying that the next two quarters or next few months, we might see the market make lows for 2023 or the ensuing 12-15 months. Selectively, export-oriented themes might have issues, but domestic themes might actually hold in good stead?

Kenneth Andrade: I don't think export-oriented themes will have issues. They will continue but they will not be as broad-based as they are now.

Okay. So, it will become very selective?

Kenneth Andrade: It will narrow down to how well you are placed in the global competitive list. ...Until India actually exhausts capacities that they have, because you can look at data the way you want to, your capacity utilisation is still middling 75%.

I am not of the opinion that we hit a significantly high capex cycle just now. If the capex cycle happens, it will happen more because we found newer markets, global recoveries have started to happen, etc.

I think that's where we are anchoring our portfolio that there is a global recovery that will happen. A lot of Indian companies will feed into that.

We will also have some benefits of the domestic environment because employment generation starts taking place and that is how economic cycle for India will start off.

A bunch of people are anchored towards how the great Indian manufacturing theme and the great Indian capex cycle is about to begin. It’s been there in the thought process for the last six months. I am hearing you say that you don't believe the capex cycle will start just as yet. Is this a lot of quarters away?

Kenneth Andrade: The manufacturing cycle has to exhaust its capacity first. So, if you look at data, your utilisation levels have to cross 85% and that is not a bad thing, because at 85% your domestic cash flows are at all-time high and that is good for the markets and good for evaluation and good for growth.

The cash flows will then have to go back to generate the new capex cycle. I would tend to believe that it is some distance away. Capex is happening in a very narrow band right now, so it will happen in power, it will happen in utilities, but that's the only space I actually see that happening. Otherwise, we are fairly well-entrenched with existing capacity.

I think most commodities on the ground have got enough and more capacity. If you look at capacity creation, if you look at the chemical sectors, part of the pharmaceutical sector, IT expansion is taking place, steel expansion that is taking place, all of these capacities that are coming on stream. They are coming with the premise that the global economy will open up and we will be competitive there.

So, that 97% of the world economy, because we are 3%, absorbs some exports from us, to basically absorb material that will create a reverse flow of capital profitability and the new cycle products.

But that may be under a bit of a cloud because in other countries the currency is depreciated a lot more than India has.

Kenneth Andrade: You will not be as competitive as you are, or you were probably a year or two years back and you also face the demand destruction that is taking place.

Right now, if you look at some verticals that are there, imports into India have started, shipping rates have collapsed, the logistics chain is easing itself out and there is no demand in very large part of the world. When Europe doesn’t grow then China gets affected, China gets affected then demand from there cools off. I see a deflationary cycle in the next six months.

Do you reckon that the bogey of inflation is already behind us?

Kenneth Andrade: Yes, a very large part of it is already done.

The refrain that I get is that you have the headline grabbing capex numbers coming in from the very large corporates and at the middle end of the spectrum are all the PLI-led capex for 13 or 14 sectors, and five or 10 odd companies is a sizable enough thing. If you throw in what's happening on the cement side and a few others, then there is a decent capex cycle underway, just that it is not getting reflected. What is your sense?

Kenneth Andrade: The numbers are really not material. Now, if you look at PLI, it is over $60 billion or even if you top it up with another 10 or 20, it is not that significant. Cement, we will have to see, there is a lot of brownfield capacity on stream that's already very capital-intensive.

Steel is the only place where some green shoots are happening, and there’s visibility around that and obviously the infrastructure and road building. So, here we can slice and dice those numbers on an overall context. It may not be as large as it should be given the size of the balance sheets.

So therefore, domestic-facing economies and select global opportunities—would that be the theme for the next 15-18 months?

Kenneth Andrade: Our portfolio is still geared towards the global economy. If that revives, it will be okay for the rest of the world also.

So, you are saying despite that theory, you still anchor towards the global economy?

Kenneth Andrade: You just have to find places which are extremely competitive, obviously using the bottom of the pharma cycle that is taking place. Chemicals in bits and pieces will continue to do well and that is a permanent shift that is happening. Some commodity-oriented businesses and a lot of soft commodities will be there, so, those are the few places we are there.

On the domestic side, I think urban consumption will continue to be pulled up especially in places where wage inflation is higher-than-normal GDP growth, wage inflation in IT is still a problem.

I would anchor myself into any of the consumer economies feeding into that cycle which is actually down south India. So, those are the few places which will remain buoyant.

Where is it that India is gaining versus where is it that India is not able to gain on the textile exports front, what is your sense?

Kenneth Andrade: It is fairly simple, you have the best balance sheets you ever had since I know these companies, we just have to figure out how to find the right company in the right space and you have to wait for the demand to recover for those guys.

Okay, what are conversations telling you Kenneth, what's your sense of when you analyse the cycle, will the demand recover in a hurry or take time to recover?

Kenneth Andrade: This season is gone, in the next season you will crawl back. So, basically you made a low in terms of the numbers, and next season you will be back.

The thing with most of these industries and companies, this includes the metal cycle you are going through, and all you need is a good, great solid balance sheet. Because when growth comes your way, you can financially leverage into the cycle. There is no point in having a debt equity of 100% then you get growth and then you have to leverage your balance sheet higher to capture that growth.

Today, you have got no debt on books, the financial cycle comes in, you can leverage your balance sheet or take debt, build-up your market share, and then get your cash flow and deleverage again and that's what the commodity cycle did to most of these companies.

Okay, and which prompts me to ask you one final question on this space, are you constructive on Indian metal companies as well?

Kenneth Andrade: Yes, we are there, the price-to-book multiples are at one. So, purely on valuations framework they work well, they are extremely competitive in terms of costs. Now we just have to wait till the volumes actually show up, not pricing. When volume show up you get elements of price stability, we are back.

You reckon that will happen in the few quarters down the line?

Kenneth Andrade: I got the valuations were right. So, you have to wait till it gets right.

What is your view on IT exports, because again management commentary thus far has not been shaky, we are waiting for the IT companies this earning season to talk about the second half, what is your sense?

Kenneth Andrade: So, there are two ways to look at it. The global meltdown will push a lot of cuts and a lot of companies will cut a lot of IT budgets; we can see that with banks. And you will see that happening to a very small set of companies which are funded by external capital which is private equity.

So, there you might have a cut in budgets but the rest of the development work that is there across governments and across companies shouldn’t get really impacted. Everyone has got focus on the bottom line, they have to cut cost and if they have to cut costs, outsourcing will be their best bet, so I am not too sure.

I am reasonably sure that volume impacts if at all, will probably be there for one year, it won’t be longer than that. They will get pricing hike and they may not be able to pass on all the cost inflation, so they are on a fairly good wicket.

Valuations-wise they are not as expensive as they used to be, and you could get a company or two or a business or two to do reasonably well. Some of the large companies are already trading at 5-6% dividend yields.

My question is, is that attractive enough or do you reckon that because of this volume down tick and possible margin squeeze because they will not be able to pass on the costs? You might get them at better valuations?

Kenneth Andrade: I don't think that will sink the boat. We are not going to get them 15x or 16x valuations, I don’t think that is possible. There is a company that's already trading there and there is a company giving 10% dividend and one of the large ones, but you are not going get them as cheap as you actually want them to be.

Have you tried to think through the new themes that are coming up let's say, green hydrogen, electrification of vehicles, green energy? have you tried to think through this and if there are options available, within India?

Kenneth Andrade: That is something that is moving very fast. I would rather come in at second cycle till the profitability is established, till the companies are established in that segment, till the capex is all done, because these are all significantly capex expenditure projects. So, while we keep revisiting all of them, I don’t think for us they are actionable.

What about defence?

Kenneth Andrade: We are not really participating in any of them. A large part of it is public sector and we have stepped away from that entire space.

What about power, you seem to be talking about capex there, there seems to be reforms happening there materially but there are always issues with a space like power. What is your thesis here?

Kenneth Andrade: So, in power, we have emerged from the bottom in the last decade of huge underperformance these companies had, both in terms of earnings as well as their participation in the marketplace.

I think, a large part of that has already been overcome, they have done extremely well over the last two years. So, there are no low hanging fruits out there, but we have anchored ourselves to just one exchange, and we have been waiting for volumes to come back.

So, we had a good cycle in 2021. 2022 has not been very good for this business. Probably, a quarter or two or maybe a year, and we should see green shoots happening. These are very high RoE businesses, low capex requirement and some of them get established as monopolies and remain monopolies, that's the structure of the exchange business.

So, unless there's something very dramatic that comes out of that path, a policy framework change for power exchanges, it seems to be one of the lowest hanging fruits.

Okay, and therefore power ancillaries, do they fit the bill?

Kenneth Andrade: The same thing holds true for them. They're fairly well priced-in, India has to double power capacity to justify some of the valuations that are sitting out there, but some of the businesses targeting the offshore or export market could still have a fairly long cycle of opportunity.

A lot of urban discretionaries have risen quite a bit, do you find valuations attractive for any of these to warrant a fresh look at?

Kenneth Andrade: We do hold some of the names, the alcoholic beverage places is a nice expanding marketplace, globally it is one of the most profitable places to be in. Real estate is something that's up there in terms of higher allocations.

Some of the retail plays, if at all, that's only space where valuations are not compelling enough for investors like us, if something we can anchor around that, then we will seriously look at it.

What about hotels?

Kenneth Andrade: No. That’s too capital intensive.