Divi’s Labs Most Admired Family Business In India: Madhu Kela
This week on Thank God It’s Friday, we spoke to well-known investor Madhusudan Kela, the chief investment strategist at Reliance Capital on what's in store for the Indian equity markets as earnings season picks up steam.
The Case For Equities
In one of your tweets you said “Compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn’t..pays it. A powerful force as per Einstein.” What message do you have about people between ages 25 years and 35 years who only want to invest in debt, realty, and the likes?
The message is, first, you have to learn from history. First, you see what has happened to various asset classes in a 5-year, 10-year, 15-year, 20-year and 25-year time frame. And 25 years is a very large time frame. A lot of thing which you cannot imagine happen in a 25-year time frame. You’ve had the Iran-Iraq war, you’ve had Hurricane Katrina, you’ve had oil prices moving from $40 to $150, the 2008 crisis of the stock market, the Lehman crisis. So there are many events which happen. But the reality in spite of that, is equities have compounded at 15 percent plus in the last 25 years. Gold has compounded at less than around 8 percent and fixed income is 8-9 percent. And that’s what I meant, when I said ‘compounding at 15 percent’. Anyone who has a calculator must do this exercise. Just take Rs 100, compound it by 8 percent, compound it by 10 percent, compound it by 15 percent, compound it by 18 percent and then you see that it’s not a difference of 5 percent but a difference of crores of rupees, over a period of 25 years. I am saying that the case for equities is pretty simple – it is the only real asset which keeps earning. A good company, let’s say HDFC has kept compounding at 15-18 percent yearly. So every five years, my earnings double. If I buy gold, does it yield any return? If I take silver, does it yield any return? No. A lot of these assets are going up because of other reasons. But equities are an inherent earnings story. If you invest in a good company where earnings are growing 15-18 percent per year, I believe that kind of inherent return is possible to be made. The only catch is that most people end up asking the wrong questions about equities. So the question says “Main kya lelu?” (What stock should I buy?). People want a tip on what to buy and when to buy. That is not the answer. The answer lies in how much should I buy and for how long. Do I put 5 percent or 10 percent or 20 percent? Eventually people will have to realise that water will only flow where the slope is. So, the money will eventually come. It is a painful point for someone like me who has been preaching it for 25 years. In spite of that, the equity participation by local Indians is very low. It’s time that you do your homework daily. If you’re a young person who’s going to be alive for the next 30-40 years then it’s better to invest week by week. It’s not a big technical subject as people make it out to be. It is something which can be easily understood by any one and once you understand that, you have to ensure that you start from somewhere, be it 5 percent or 10 percent of your assets...you start investing. And over a period of time you discover yourself that it is a good investment.
Bottom-Up Approach To Stock-Picking
Then let us talk about some of your favourite stocks. Now some of your largest positions are in stocks like UPL, HCL Tech, Muthoot Finance, Divi’s Labs, United Spirits. Has there been any change in your holding/allocation to some of these stocks? Do you still like them at current valuations?
I will not comment on specific stocks due to compliance reasons. All our portfolios are disclosed every month. But we are bottom-up stock-pickers so from time to time we keep discovering new stocks and ideas and keep investing.
Let’s talk about sectors. In this list I do not see any metals or energy names which have done well in the recent past, whether you talk about steel companies or non-steel companies.
In our recent portfolio disclosure, you will see some of these names. If they have done well, then you will see them.
So you bought some of the energy stocks?
Yes, some of the metal companies, of course.
Pockets Of Value In NBFCs
The non-banking financial companies have been overvalued but this is one sector where there is a lot of growth. But within NBFCs, do you see a smaller theme where there is some value left?
I have spoken very publicly about it, that this is one sector where there is a lot of flexibility, the cost of funding is coming down. And they are far more agile, they are private owned, so the owners are sitting on top of the companies. So their ownership is very strong and I think some of these NBFCs will do very well in the longer term. So you cannot generalise that I will not buy this sector because some companies are trading at five to six times book value. Neither can you say that I will buy everything regardless of valuations. Selectively you have to be very sure and hold it for a longer period.
Within the NBFC space, what is your preference between say, housing finance companies or consumer credit or gold financing.
We have investments in gold finance companies, housing finance companies. We have investments in a consumer finance company as well. So what I am trying to say is its basically a bottom-up approach. If we like the valuation, if you like the promoter, then you buy it. So we are not saying that we are bullish on only one space. We are saying that we are bullish on the entire NBFC space. We should have an idea where we can put in the money.
‘IT Must Learn To Live With Low Growth Rates’
Coming to the IT industry, we hear the word disruption very often these days. At some point, your traditional businesses stop giving you the kind of growth which has been seen historically. What would you like to see in IT companies which you think can accelerate growth to the levels seen earlier.
I don’t know whether those growth rates are going to come back..the kind that we saw in previous years..30-35 percent kind of growth rate. It doesn’t look like those growth rates will come back, at least in the near future. Obviously five of these companies are also expanding. Managing 50,000 people and managing 3 lakh people are a very different ball game. Maybe a lot of the growth will come from products, maybe from technology disruption. So I do not think that those growth rates which you are talking about are possible at least in the near future. You have to live with low growth rates. Also to be fair, the valuations are also corrected for these companies.
'Money To Be Made In Select PSU Banks’
What is your view on the PSU banking space? If in the second quarter companies were to say that the pace of fresh addition of banks’ bad assets has stabilised, would that change your view on PSU banks.
I had said in February that the public sector banking space is looking interesting, and from that point, a lot of money has been made in the last 6 months. I still believe that you cannot generalise the entire sector. There are selective opportunities for investors who are willing to go that way because there is a lot of pessimism that’s been factored in. These banks have a lot of inherent advantages, a lot of assets which are not valued in the book, like their investments in real estate, their investments in life insurance companies, asset management companies. Some of them hold positions in the National Stock Exchange. So a lot of it is not reflected in their books. Bad loans are reflected in the book value; a lot of things are not reflected. So in due course, as it gets unlocked, and as the economy improves, let’s not forget that it is not the first time we are seeing this economy challenged. So today, normal gross non-performing liability ratio for the whole decade, is about 3 to 4 percent. Today, it has gone to 8 to 10 to 12 percent. This cannot be normalised. We are coming from a period of extreme challenge. So if you have a long-term view, which is what I have for my investments there is money to be made here.
But all the reasons you spoke about constitutes other income and are not related to their core lending operations. We are seeing that PSU banks have lost market share to private banks.
They might continue to lose some market share because that is again a reality. Some of them may not have enough capital to grow aggressively. Some of them may not have the management expertise which is required to grow in particular sectors. There are those challenges, but the size of the opportunities is large enough. In India, even in the NBFC space, the size of the opportunity is so large that selective people will be able to find customers. I think in 2 to 3 year time frame some of these factors will start playing out.
High Valuations In Low Interest Rate Environment
Shifting focus back to the global environment and low interest rates. Considering currently prevailing rates in the U.S., Germany and Japan, we are expecting money to flow into equities. Under these metrics, should we start getting used to high valuations in India?
Till the liquidity situation remains, not only in India but world-wide the metrics are changing. Which is why traditional investors are finding it extremely difficult to invest money. They are used to buying companies at price to earnings (PE) of 4 to 8 times. Now nothing is available and a lot of these companies are going at PE ratios of 25 to 35 times because of the extremely low interest rates in the world. It is very simple; I have the choice to put money in a bond or equity. A fifty-year bond in Switzerland is trading at negative interest rate which means a sure shot way to lose money in a fifty-year time frame is to go and buy this bond. Now if I have to invest in an FMCG company in India which can grow at even 5 percent per annum for the next 50 years and even if it has a 50 PE multiple, it might still make a justifiable case to invest in that company which has a 50 PE multiple versus investing in a Swiss bond. Which is why looking at it traditionally, when the interest rates were at 2 percent, I would have made a lot of money if I compounded my money at 2 percent for 50 years, but they have now gone negative. So valuations are never absolute and actually nothing in life is absolute. It is all relative. So equity valuations are to where bonds are trading.
The Lurking Risks
We are all assuming a very rosy picture for Indian equities but what could go wrong for the market, at least in the near to medium term, especially in the backdrop of global events?
Yes, there are many events. Lot of things can go wrong. Most of the times, many things go wrong which we can’t comprehend or anticipate...the ongoing geopolitical events, whether it is India-Pakistan or Syria or tensions between U.S and China, represents one risk. Secondly, this low interest rate environment itself will be a risk to the world at some point because of the deflation it is causing or can cause; interest rate cannot remain here forever. So whenever these interest rates go up, the central banks’ ability to pump in more money will be important. Third, specifically for India if there is a spurt in oil prices, it remains a key concern. So if it goes back to $70-80 or $100 per barrel it will be a risk factor, though I am not making a case that it will go there. Fourth, from a market perspective, we have had a case for earnings improvement for the last six quarters but it has not materialised. The market desperately needs earnings to catch up now. So its important for earnings to come through.
Your favourite business family in India – or any corporate group that you admire?
Any other fund manager that you admire?
Julian Robertson (American billionaire former hedge fund manager)
Your investment guru or somebody who has inspired you?
Your next best asset class after equities?
Real estate given the steep correction in some pockets.
Hillary or Trump – who do you wish to see as the next U.S. President?
It’s a million dollar question. I would not like to hazard a guess.
One favourite sector or theme that you think will become the next NBFC.
From a 5-10 year perspective, I think there is a lot of money in the travel and tourism industry which has not yet been discovered. We are all talking about consumption but the absolute market cap of this sector, including the hotel companies, is less than Rs 50,000 crore. I think there is some money to be made here.