India Can Handle External Shocks, Says ValueQuest's Ravi Dharamshi

Ravi Dharamshi: Everyone likes to put on a hat of either a value investor or a growth investor, I don't like to put on that hat. What I try to do, what we try to do is identify companies that are going to change scale, and that identification is done with the combination of top-down as well as bottom-up approach. We are neither only top-down nor only bottom-up.

Having said that, we don't take too many top-down macro calls, where what the market is going to do, what market is not going to do. However, that ends up being the bulk of the conversation that I have with most of the media people is about where the market is heading, though we pay very little attention to what the market is going to do and more attention to which is the company that is going to benefit from the trend that is unfolding. So, in a nutshell, scale change is where we focus and that is usually backed by some amount of tailwind from the top-end.

Ravi Dharamshi: No, we don't take too much of tactical cash calls. Having said that, today we are sitting on 10% cash, but again that is not a cash call, it is divestment out of opportunity, which we believe has played itself out and we are probably leaving something on the table for somebody else to make the money and waiting for the next opportunity to deploy the money.

It is just a coincidence that usually, these things happen at a time when you know, markets tend to be a little overvalued in the short run and gets corrected. But it has nothing to do with our view of global recession or India undergoing any kind of challenge due to that. It is purely getting out of one track and waiting for an opportunity to get into another track.

Ravi Dharamshi: In the parlance of weather analogy, so you know, we cannot predict the daily weather, but what we can do is predict season, so are we in the winter or summer, I believe we are entering a winter scenario. So, from that point of view, you have to be little bit careful about where you are deploying your funds or what kind of opportunity you are going in for. So, our macro analysis is restricted to the fact to understanding, in the case of cricket parlance, what kind of weather condition is there, what kind of pitch condition is there, and should we be trying to preserve wicket or should we be upping our striking rate. So, I think this is probably a condition where we will try and keep our wicket rather than trying to up the ante and play T-20 style of cricket.

This is the time where not too many very obvious opportunities are available. So, we will wait for that opportunity but at the same time we are not taking any cash calls. We are staying invested because a lot of the themes and opportunities that we have identified in the last 6-12 months have not yet panned out fully. So, we are staying invested with those because from a three-year perspective, it still looks a fantastic opportunity, and we should be generating 15% plus kind of CAGR in those opportunities. So as long as that remains true, we continue holding on to this stock.

Ravi Dharamshi: I forgot to address the previous question in terms of what the weather conditions are, I ended up giving a pre-match commentary, but I have to tell whether the pitch will bounce more or whether it will swing more.

I think India is actually in a very sweet spot as compared to the world. We did not stimulate the economy as much as some of the western developed economies did and because of that they are facing tremendous inflationary pressures. India actually did well too. People like to play the game to give credit to, so I am not going to do that. But for whatever reason, we did not over stimulate and because of that today, our economy is in a good shape. Our debt-to-GDP ratio is not bad and most of that is still domestic, our forex reserves are upwards of nine months in terms of number of months of import, our tax buoyancy is very high. Some of the high frequency indicators are still indicating that there is still a lot of buoyancy in the economy.

The festive season is just ahead of us and there is a lot of chatter that this is going to be one of the best festive seasons in a long, long time. Everything said and done, India is in a very different situation from where the world is, where inflation is going through the roof, where the profit margin for the corporate world were at a peak and they are coming down. Valuations on those peak margins was very, very high. So, there is a kind of valuation correction happening which is far deeper in nature in the world than compared to India.

So, I would say in a scenario where the interest rates are rising, coming back to your question about the PE multiples on the valuation, India is still not in the same boat as the world is, where the 10 years has gone from almost sub 1.5% to almost 4%. For us it has gone from, you know, maybe 5.8% to 7-7.5%. So, it is a scenario where the money is becoming expensive, but at the same time it is not such a scenario where India cannot handle the external shock.

Infact, we have been using some of the shock absorbers and kind of protecting the economy as well as the consumer, for example, even in fuel, we did not face the brunt that we saw when crude went to $130 (per barrel) and at the same time right now, I don't think if crude were to fall to $80 or $70, we are very close to that, we will probably not get the benefit of that also, most of it will be returned by the government.

But that is actually not a bad strategy from an overall economy point of view because you actually use those reserves when the going gets tough. RBI has ended up spending almost $95-100 billion to defend the Rupee at 80 level and now since the last week or two it seems that they have let it go. They are not trying to defend a particular level. I think Rupee is also a tool to control the imported inflation.

A little bit of inflation is going to creep through so this week when RBI is there, we will see RBI raising rates, so that is another tool available for them to control inflation. So, I think currency is being let loose just a little bit and interest rate hike is coming. So that is why India is witnessing the kind of, you know, damage in the last two three days as compared to what it was witnessing earlier, because in the trilemma of inflation, current account deficit and currency, RBI is still trying to find that sweet spot.

So, that is where we are, it is a challenging situation, but it is not dire. We should very soon reach a stage from where we should actually be looking to invest more into the market.

Ravi Dharamshi: I don't think we are going to reach kind of March ‘20 evaluation level or for that matter 2013 currency crises valuation levels. We will get like, slightly more attractive compared to what we were. I think what is happening is we are like our cutout has been, you know, held on before the gates open up and we are allowed to ball. Right now, it is more of a situation where we are raring to go, but there is no tailwind, there is a global recessionary headwind.

So, we are biding our time. What we have to ensure is whatever global accidents that are to happen, does not impact us as a country and our portfolio in particular. We are in kind of, again, continue to an analogy, but we are in the middle over. We need to ensure we take single, doubles and don’t go all out and just ensure that you are at the wicket and soon the picture is going to be very attractive to start playing your shots.

Ravi Dharamshi: I don't like to put any kind of label on the company that I buy whether it is cyclical or defensive or structural. Having said that, what we do prefer is a portfolio that is structural in nature, which is aided by cycles, so something that has a tailwind at its back is what we would prefer. Today, I would say that kind of tailwind exists in the domestic economy and not in the global economy.

We are heavily allocated towards domestic, if I were to say sectors, financial, capital goods, the manufacturing, real estate. Real estate includes some ancillary as well and there we are clearly not invested so much in IT, pharma and may be some chemicals stocks. Those are the places that we are trying to avoid even though they are structural in nature, but I believe they were kind of a beneficiary of bunching-up of a lot of business during Covid time and there were unsustainable growth and margins, unsustainable valuations from the next two to three-year point of view.

I believe there is still some correction to be done before they become attractive. So maybe another two or three quarters some margin pressure will be there in chemical companies and also in the IT companies. But at the end of that time, those sectors will again become attractive from a three-year point of view and maybe we should try to allocate at that point of time.

Ravi Dharamshi: Clearly some amount of impact will be felt. Today, I feel that we are at a stage where bulk of the investment demand is out of the real estate market and there is more or less consumption demand. In the previous cycle, the component of investment demand was probably 80% and consumption demand was 20%. Today, it is probably the reverse, consumption demand is at 80-90% and maybe 10-20% of investment demand. Investment demand is the one which is more sensitive to interest rates going up.

The consumption demand yes, there will be an impact as but as long as, see what has happened for seven-eight years it just kept going up, the supply kept coming down, affordability had reached a very attractive level. So that's some amount of affordability, it is not so that the prices are going through the roof.

Most of the real estate companies are doing well because it is less because prices have picked up. Prices have picked up probably in a specific project or bulk of the tail has happened, you know where only last 5-10% of the inventory is left. That is where some amount of pricing power to the developer is coming back. But if a new project is launched, if there is enough supply that prices are not going up, but if a good product is being offered to the market, there is a demand for it.

People are coming and buying whether it was work from home which made people realise that they need bigger houses, they need to stay in a place where they can work also or whether it was the incentives that drove in the short run, which was provided by the state government in the terms of stamp duty concessions and all.

The demand has stayed up now good four-six quarters after those concessions have also gone away and while those Covid concerns have also gone away. So, the demand has sustained and actually the festive season and I believe that the festive season will be a good one. So, I don't think for us the repo rate has probably gone from 4% to 5.5%, maybe it will go to 6% also but the home loan rate probably it had gone to 6.5% today probably at 7.5% so you are not going to postpone your decision to buy a house because you are paying 1% more EMI, it is still within the range. See, we have seen interest rate so high in our life in the earlier stages, that this does not feel high at all.  

We have always been used to it. I will just give you a perspective, I was in the US three months back, over their home loan rates have gone up from 2% to 6% that is something that pinches. For us, it has gone from 6.5% to 7.5%, even if it is 8%, we have lived in that kind of an interest rate scenario. 8% still feels very, very attractive, for anybody who is buying home. 

So, I don't think interest rates is going to have so much of an impact. Though real estate stocks are interest rate sensitive that way, some amount of valuation impact can happen in the real estate stocks.

Ravi Dharamshi: Absolutely, I think real estate ancillary is the far better way to play the real estate theme than the real estate developers, purely because the industry structure is better over there.

There is a multiple tailwind in terms of unorganised becoming organised, so the larger and stronger guys are gaining more market share. That is leading to consolidation, that is leading to some amount of pricing power being better. So, your returns are going to depend on the absolute price of the industry, how much it is growing, what is the structure of the industry and which player you have bought into. So, from that point of view, see no one real estate player can ever be a leader, even the leader will never have more than 5-10% of the entire real estate market.

While it is possible that in building material space, one particular player can have 30-40-50% kind of a market share. So, in that kind of market share gives you dominance in the market, which a real estate developer will never have. So, from that point of view, the industry structure is far better in building materials than the real estate developers.

Ravi Dharamshi: In fact, valuations have corrected recently because a lot of that was driven by the raw material price increase. Now, raw material prices have kind of a dual effect. It leads to increase in their sales because they sell on a fixed Ebita margin and when I say fixed it is not the percentage margin.

I am talking about let's say, for example, PVC if I have to take, PVC is available today at let’s say Rs 100 a kilo, I am giving a rough example, if the price goes from Rs 100 a kilo to Rs 120, it leads to an inflation in the sales, at the same time the margin is compressed because you are still making Rs 10, just an example, Rs 10 for what you are making on 100, now you are making Rs 10 on Rs 120. So, your absolute Ebita will remain the same but as a percentage it has gone down.

Now in a falling scenario, Rs 120 comes back to Rs 100, you are making Rs 10 on Rs 100 now, your margins optically look like they are expanding, but what is happening is actually just sales that is compressing.

Now, we are in a scenario where some of the raw material prices are actually coming back down, and they will stabilise somewhere around here and the volumes will pick up, so now the ensuing growth will be more volume-led rather than price-led, which was the case earlier which is a far more sustainable thing.

Ravi Dharamshi: We do have a presence in defence, and we are looking to increase that allocation as well. I tell you, most of the money that we have made in this market over the last 20-30 years has all been on identifying themes.

When an idea’s time has come nobody can stop it. Defence manufacturing in India is one such theme and we are against the confluence of factors. Just like I explained in the geopolitical term for the broad manufacturing. Similar thing is happening in defence also and we could have foreseen those things happening in chemical sector also, five to eight years back.

Today off course, we are way overvalued as compared, and lot of growth was because of margin expansion and prices going up. Coming back to defence, I think the last move that the government did was to ban the import of some 400 odd items, like final confirmation that we need in terms of you know what, now today, if Army needs an equipment or Navy needs something, they have no choice, they cannot import it, they have to procure it locally.

So, most of these even the MNCs have gotten a lot of defence orders are now actually facing a penalty in case they don't have the offset clause. The offset clause ensures that 35-40% and in some cases 50% of the manufacturing is done locally with a partner over here. Now if they don't do that, they have to pay penalties and now that penalties are eating into their margins, and which is why the offset clause is actually benefiting the local players. So, what was a pipe dream, say six-seven years back, today they are a reality, and we can see it in the order books that some of these defence companies are getting.

We can see that right now there is a rush to book their capacities, not only are they getting orders, they are getting good advances also. Otherwise, see they are a small cog in the whole wheel and there is not much value in that we will go into defence at this juncture but the scale of lot of these companies are going to change and you can judge the importance of offset partner in the whole chain from the kind of advances and concessions that their clients are giving them and they need them more than the local vendors need the client. It's a win-win situation actually. But there is a demand, there is a firm demand, and this is visible for three-four-five years.

A lot of these companies are going to change game in terms of three-four and five years, so this is an opportunity to look out for three to five years point of view for sure.

Ravi Dharamshi: We have a mix of both. I would say that over a 10-year period 15% CAGR might not very attractive. But what will happen is that we might have 20 or 25% CAGR for the initial five-year period and then a slowdown which may lead to a 15% CAGR  because 25% CAGR in a large company is actually a fantastic number, so I would not kind of discount the opportunity size or the growth that some of these companies are going to witness.

Now, the good part about some of these smaller companies, see, what are the bad part about this defence business was one, your client is government and second is because your client is government, because your client is government, there is no visibility. The biggest problem was the visibility. There was a lumpiness to this business, you will not know when you will get the next order, if you will get the next order, what kind or what will be the size, when will you get the payments.

The second problem is when you will get the payment. The working capital used to be fresh to 1-1.5 years. Those two problems to a large extent at the current juncture haven't taken care of, as I mentioned to you that they are getting advances, that tells you that the pressure on the working capital is coming down.

Now if you are an offset partner to some of the larger guys, actually, your client is not even a government, so to say, you have far better visibility in terms of what business you are going to get for the next three-five years and your payment terms are not as bad as they are with government, although, even that is getting better. But also some of the structural issues on the business are getting addressed and we are in a phase where some of these companies are going to go up big time and we have seen this, even though some of the wealth created in the previous cycle and capex was transitionary you know, when small players run companies of 1,000-2,000 tons turnover of  20-30,000 crores and now that is the kind of case you are going to witness.

Some of these companies today whatever their market cap are, they will end up probably having an exit part of that kind of topline will become their tag in five-six years, the rerating is absolutely bound to happen in those kinds of scenarios and one cannot be stuck up in the past that it has not happened in the past. So usually, in times of such rapid change, analysts tend to get stuck with the old way of looking at things.

Ravi Dharamshi: I have seen the IT companies over the last 20-25 years and the change they have gone through tremendous metaphorical, I don't know if you recollect, but in the heydays of Nakamura, the company used to grow 100%. So, obviously, at that point of time their valuations were different, and today we are at a far more mature phase of the industry, expecting these companies to grow more than 15-17% over an extended periods are also not a right thing.

I think some of the larger ones are going to grow 12-15% over a longer time period in between, they can have 2-3 years of Covid like we had in the last few years, where actually we had slightly higher growth than that and most of the growth actually was during the margin expansion, profit expansion and in PE rating and that has what led to fantastic returns. Most of the stocks were anywhere between 5 and 10 kinds of return over the last few years, but now their margins are under pressure. Suddenly, you realise that they are in a more mature phase, in terms of industry.

Some of the smaller players can probably still grow 20% plus, but the largest player cannot grow more than 15% over a sustained period. So, their valuations have to adjust to that and at the bottom of March 2020 Covid time, the market was you know, factoring in 5-7% growth.

Today, the market is factoring in at the peak was factoring in 20% kind of growth, this is not scaled down to 15-17% fair value is reached in IT and some more downside and it will become attractive again because now people start saying that no, they cannot do it 15% also. That would also be an unfair assessment.

So, I will say that IT is a mature industry, IT services okay, but at the same time, there are some new areas coming up whether it is IT products that companies although private domain and they are not yet in the public domain. So, we will wait for these companies to come but that is where the real fact growth is happening.

Ravi Dharamshi: The space is attractive. We don't have any bets currently and you know, I feel incommensurate, a slight bit of challenge compared to some of the new newcomers because their way of doing business is completely different.

I think new business models are emerging and they are going to challenge some of the incumbents which might have the advantage but in a B2B business is very challenging to maintain your market share. You will see new players taking on because finally, the nimble is going to win and not the larger one in the IT space, I strongly believe.

Ravi Dharamshi: Coming to defining the investment thesis, so I would say our investment thesis depends on single word tail/sale investment. What we are looking for is confluence of stock band factors which is leading to a tailwind in the industry and at the same time a player that is best positioned to take advantage of that trend, which is going to last 5-7-10 years.

A combination of good balance sheet, a great management with alignment of interests and educational capabilities that is what you want to achieve. Most of these companies when they change scale, they undergo a big rerating also. I would say scale investing is what defines our investing appetite.

Coming back to the books. I don't have a particular investment book for you today. We have discussed many investment books in the past but the one that I am reading currently, which is probably a path-breaking book in that sense is one of the self-help, self-improvement book 'Atomic Habits' by James Clear and it's a fantastic book because it actually gives you small tips on how to keep on improving that 1% every day. How to bring in that discipline in your thought process, in our habit. Essentially what he is saying is that first of all, you have to visualise yourself how you will be 5-10 years down the line and then you have to take small steps to becoming that person. Even if you are moving slowly that's fine but move in the right direction and don't move backwards at least. So, persistent incremental steps are required to reach your destination, reach your goals.

Everybody starts off with the same but the difference between somebody achieves the goals and somebody doesn’t achieve the goals is that consistency and motivation is actually an overused term. It is very difficult to maintain motivation over a long period of time. The only way out is for you to develop a habit, be it motivation any day and the way to go about building habits is to make these small changes rather than trying to take a big leap.