This week on Thank God It’s Friday, Manish Chokhani, director at Enam Holdings says if a 2008 or 2001 like shock occurs in the financial markets, the “easy come” money will be “easy go”. He, however, does not see such risks on the horizon and believes that world is in a sweet spot right now.
India, he says, is the last big economy which can see unit volume growth as consumption rises. Therefore, even if investors believe they are paying a slightly higher multiple today, it might not look that like that high a multiple three to four years down, he adds.Here are edited excerpts from the conversation.
Benchmark indices are currently at 22 times. In 2007 peak we saw benchmarks around 23 times and in 2009, around 25 times. The difference, however, is that interest rates are lower now. We are looking at more economic and political stability, more legs to run. Are you skeptical or you comfortable with the kind of levels we are seeing right now?
I am always hopeful. When you are in equities, you always have to be optimistic,. Valuations are at near historical highs and the difference is capacity utilisation is very low. We are probably around 70 percent as opposed to 90 back then. So we do think there is operating leverage in the system if indeed demand comes back. If I recall, back then our profit share to GDP was somewhere around 7 percent and we are currently at 4 percent.
We think there is room for profit to come back as capacity utilisation goes up.
Money is far cheaper and has been far cheaper for longer than I have ever known. Mr Buffett said that if interest rates remain so low, the reciprocal of it is really that the price-to-equity (PE) multiples may remain higher than what we are used to or comfortable with.
You think Indian markets are not pricing in any risks that could emerge from global events?
It’s true across the world. The fact is, there is surplus capital all over the world. There is no return on fixed income pretty much anywhere in the world. There is the whole Schumpeter cycle going through, where the developed world is really ex-growth. How many more cars can you sell to someone who already has four cars, how many more TV sets can you sell them, how many more Starbucks can they buy? The markets, even in the West, are basically pricing growth. So you take the top four companies, like Google, Apple, Facebook, etc, they didn’t exist in 2002 and today their market cap is greater than the whole market cap of India. The top five companies in the world are no longer energy or auto stocks or retail stocks, it is really tech stocks and it’s really growth which is being priced.
Similarly, if India falls into the growth bucket…we are the last big economy which can have unit volume growth and, therefore, logically if you look at the consumption stocks here, you think barely 2 percent or 3 percent of India is consuming today. There is a long road, ten years ahead, for these people to consume.
Therefore, even if I pay a slightly higher multiple today, it might not look like that high a multiple three to four years down.
When I juxtapose that with the cost of capital of an investor overseas and he may be, at 3-5 percent kind of opportunity cost, for him the reciprocal multiple of 30 is the base case. Because I look at it as 15-20 percent ratio in India, I think I want sub-10 multiple to feel comfortable. And that’s what the dichotomy is. Therefore, the risk to our market is more global than local. That if an exogenous shock occurs like 2008 or 2001, and this money becomes expensive then the way it has come in, “easy come”, will be “easy go”. A lot of these flows are now ETF or programmatic money. Therefore, in some sense, it has become price agnostic, so as they are price agnostic on the way up, they’ll be price agnostic on the way out. But having said that, I don’t see that on the horizon. Even the fear of the French coming out of Europe are fading. Things seem to be in a sweet spot for now.
The rate of change today, especially with respect to technology, is really fast. So which do you think are going to be emerging sectors of tomorrow?
So I just attended a programme at Singularity University in California and the dichotomy and the dilemma in my head is really that. That at one level interest rates are so low that they seem to suggest that PE multiples should remain high. Though I believe interest rates are manipulated and so they may not be sustainable for long. The flip side is because there is so much much innovation coming in the world, and disruption in so many sectors is imminent, the terminal value I would want to pay for several businesses in my mind is shrinking very rapidly. So while the PE multiples look like they should be elevated because of cost of money, the reverse, in terms of terminal value going down because of disruption coming in is also occurring. And what’s the fine line there, I wish I could answer. But that’s the thing I fear the most. Just to illustrate, we know the way the cost of solar is going. So we know what’s going to happen to the cost of energy. So if we, therefore, think oil prices are headed down over a five-year trajectory – you may have a 1-2 month cycle when it goes to $60-70 per barrel, basically it is headed for $25. If that happens, it has an enormous implications for India’s balance of payment and rupee strength, for competitiveness and power costs. It has an enormous implications on what happens to refining and margins. The flip side is, if it is going to have that depressing an effect on large market cap companies, does the market go up, does the market go down, does the stock go up or does the stock go down, it is a dilemma. You think of medicine and the advances made with the gene, effectively the whole chemical-pharma industry is obsolete in 10 years. I am not sure if biology survives because it is all going to be gene-splicing and CRISPR can basically go change your DNA. How do I buy pharmaceutical stocks? In theory, I could argue I don’t need the doctors and the surgeons, the robots can do it. It might reduce operating costs in the hospital but how many people now end up in the hospital? I don’t know. All I’m saying is it’s an interesting question to have in the head but it is certainly one of the most challenging times to be an investor. Sometimes ignorance is bliss, it’s better you didn’t know. Or you say autonomous cars and electrical cars are coming, the whole internal combustion engine goes in five years, the PE multiples decay. I have a holding in Maruti, I don’t think it comes to India in five years but will the PE multiples for Maruti in five years be the same. I don’t think the answer is yes, so it’s a challenge.
Yes Bank has reported a seven-fold difference between what the bank thinks is its NPA and the RBI thinks is its NPA. And this might not be a Yes Bank-specific phenomenon. Does this raise questions on private banks under-reporting their asset quality?
I don’t know the specifics of any bank nor do I sit inside any bank. I would suspect the RBI knows what it is doing. I can’t think a bank is saying I have a difference with my regulator, in terms of what I recognise or don’t recognise. Having said all of the above, I think the way the market is looking at the opportunity in the financial services space is something that balances off the current fear of NPA because that’s really past. And when you normalise and say all these NPAs are in some sense extraordinary hits which one is taking, and at some point it has already ended maybe. When you normalise and look out three years from now, does it look like these profits are 2-3x. If you say FY18 earnings for the index, I suspect lot of the earning growth may come out of the public sector banks, the way it last year came out of the public sector refining companies. Which is not to say that everything is over and is hunky-dory, it just means that the base was so low that they are rising from there.
But the larger opportunity set in India on a $2 trillion economy, lets say its a 25-30 percent saving economy, there is $500 billion of saving, of which only half goes into financial savings, and the other half is going into real estate and gold. So you now have so many levers in your favour.
That $2 trillion economy is going up, therefore the $500 billion savings number is going up. Let’s say in five years it will be $1 trillion worth of savings, then the $250 billion of financial saving doubles. So you are already looking at $800 billion of financial savings coming. Of that the share of private banks is 25 percent versus 75 percent for public banks, and that might flip.
So now you have 75 percent of $800 trillion, so if you have a $560 billion kind of opportunity for private banks and non-banking financial companies (NBFCs) as opposed to 25 percent of $500 billion today, so $125 billion goes to $560 billion, so 5 times expansion for your addressable market. There will be four to five players that take the opportunity. So when I am taken with that size of opportunity, it’s very hard to worry about what’s this quarter, what’s next quarter, what’s the last NPA cycle. If I look out three years, you will repent not looking at the current prices. And that’s seems to be what the market is pricing in as well.
You spoke about the shift towards financial savings that’s inevitable In the stock market. If you leave the private banking sector out, what are the other ways…
There are banks, there are NBFCs, there are now insurance companies, in some sense you play the stock exchanges. They are all a manifestations of that. At some point you will get a mutual fund that will get listed. So there are so many different ways in which you can cut the whole space.
I want to address crypto-currency now. The idea of bitcoin was that it will be a currency without any regulations. This will come into play in the near term. It’s already into play right now. There will be many crypto-currencies that will come into play. What does it mean for traditional financial systems?
Cryptocurrency is small part of the larger ecosystem called the blockchain. Which is really a distributed ledger. I would like to describe it as..we used to have a mainframe computer, then you went to client server which is the PC on your desk, then you went to cloud. And if you see banks today being the distributed architecture of the client-server architecture, having bank branches and so on, if you swipe your credit card today, it goes to the bank for verification and comes back. The bank is basically the medium of trust, and the central mainframe PC is the central bank. The blockchain is a distributed ledger which is, in a way, the cloud. Because it’s a distributed ledger, and nobody can now hack each others’ computers, because all of them need to be working together, it takes the element of trust from one central repository to a distributed architecture. So the architecture of banking, the way we know, will change. The bitcoin is just a tiny aspect of it, because that is more a question of regulation and how we want currencies to take away the power from the central bank.
Bitcoin, by the way, is probably 90 percent traded in China. There are already 90 other crypto-currencies. Some countries will, at some point, make these cryptocurrencies legal. It’s a battle between technology and regulation. So which central bank or government will readily give away power to the currency…we will see how that plays out. It’s still really a market for smuggled goods or informal market for drugs and stuff like that. It will get mainstream by and by because every fashion gets mainstream.
But it’s a challenge and opportunity for the bank, because now if I can harness blockchain…take the whole example of SME, the whole element in SME was based on trust and verification. So unlike a large corporate where I can get a AAA rating, or in retail lending where I can go to CIBIL and get a credit score, how do I get one for an SME. A lot of them remember are wholesalers who trade in cash in India, how do I get a digital imprint? If I start getting distributed trust verification from using blockchain technology, from across the whole SME space, the vendors as well as the customers, it might make the whole verification process easier. So it could be an expansionary possibility for banks in India. At the same time you may think I don’t need the bank branch, I have a block chain and do away with the bank. So it’s a question of which element of trust do you want more. Similarly in the past when ATMs came, we thought that’s the end of banks – you go to the ATM and you don’t need to go to a bank anymore. And the reverse occurred. Because wherever you put in an ATM, the consumer thought, hey my cash is here, it’s secure here, I can trust this bank. And perversely if you track ATMs and the deposit growth of CASA in banks, it actually correlates perfectly. So wherever you have an ATM, CASA growth is high. So I think this is fun evolving, and India is ahead of the game.
Take all our leading private banks, Kotak or Axis, HDFC or ICICI, they all are playing the tech game much better than what I see in the West. Because they are sitting on legacy systems there, and we don’t have so much legacy to deal with. So I see this as an opportunity for ourselves.
I am going to shift focus to the real estates. The NSE Realty is up 35 percent since November 8, against Nifty run of above 10 percent. The demonetisation wasn’t a dampener and likewise for the Real Estate Regulation Act. You have been tracking the sector closely. What are your thoughts?
It is a positive act. Honestly, real estate is the most unorganised and deceptive sector. The maximum amount of consumer money went into it and maximum badmashi [wrongdoing] happened over there. What you are buying, you don’t know. Till the day you get possession, you don’t know. Whether you will get possession, you don’t know. Coming of the Real Estate Regulation Act (RERA) is a bit like the change in the old days of Bombay Stock Exchange. We had this vyaj badla [indigenous carry-forward] system. But the system was made transparent–with time stamp, dematerialisation and so on—and investors were attracted to the market. In some sense, I am hopeful that RERA does that like for example organised players like Godrej, Oberoi or Raheja or whoever start gaining more attraction. They can put up the information—like for the first day I saw Naman Builders putting all the information up about the RERA on the net. It would be natural that the more transparent and the organised players gain in this. You may start getting a lot more joint developers. As a buyer I now feel a lot more confident because like I see my company’s results every quarter with the balance sheet and all the disclosers, I now can see the whole project online as well —what I am getting, when I am getting and what is going on etc. I suspect a lot of money will now come both for actual users and for investors in this space as well. Like you saw the investment trusts coming for utility assets, I won’t be surprised if real estate trust coming as well. It is a large source of fixed income for people all over the world. We have lacked access to it. Like we get a share of business for buying one stock, can I hedge myself in real estate if I want to buy a larger house by keeping or buying units of houses of reputed developers. I think this business will evolve. Like I said, even today we probably do more than $200 billion to $250 billion of real estate in India every year. People still love to own that physical real estate. It was seen as a store of value because the rupee kept deprecating and inflation eroded while at least real estate held its value. If I get a chance to do that directly with a reputed person in a regulated framework, there are good times ahead for the good players. So, there will be these big winners and big losers and I think market is rewarding that. For example, you said real estate index, but as it is seen when a sector booms the best and the worst both move. So, you will see Godrej Properties moving on result spectacularly but you will also see the worst stock [moving] because you would probably have Rs 8 stock and it would go probably Rs 15 and it looks like it doubled—that’s how it is.
Warren Buffett has said his favourite holding period is forever but then business models, managements and regulatory environments do change unfortunately. Is there an ideal holding period for you and when do you think is the right time to make an exit?
I agree that the ideal investment period is you find a great business which can keep earning incremental return on capital at a higher rate and therefore I have to never sell it because of what I have invested in, I know a lot more than what I have not invested in. So when you sell something, it is very painful because you have to then get familiar with something that you are less familiar with. Having said that, the rate of change is so fast in this world that you don’t have a choice. The buy and hold for 10-20 years doesn’t hold anymore. Even if I look at Mr Buffett’s portfolio, he used to own Coca-Cola, Wall Street Journal and a lot of those businesses aren’t relevant anymore and he is making changes to his investment style as well. We are just students of the master and if the master is changing, the student must change as well. Like I said before, disruptions coming at such a rapid pace, I can’t say that 10 years from now, the stock I am holding today will still be in my portfolio. I will be foolish to not always be paranoid about what I am holding. I hate selling things because I have very few stocks. I typically don’t have more than 20 stocks in my portfolio. But as I become more and more worried about the impact of technology, the solution of the ignorant is to diversify but it doesn’t solve the problem. That just means I have to learn and investigate harder. That’s the best I can offer at this point.