Dear Investor
We cover the following topics:
- Valuations
- New emerging spaces may offer alpha potential
- Growth offers a great opportunity to invest
On the first topic of valuations, let us try and look at it differently. Let us take two examples:
- Many investors believe that low PE is more favourable as compared to high PE which is considered expensive
- And, if a company traded at 20PE once upon a time (for a long time) and is now traded at 15PE it is assumed to be low valued.
- Is a 20PE valuation good for a company whose terminal value is in question?
- What is the terminal value of the business?
Generally speaking, it is not wrong but there can be a different lens to this view.
- In the first example, we see several instances, particularly in global commodities, where a plant set up in an emerging market where there is growing demand for it, starts to command a higher multiple vs a plant put up in another location, say the developed world where the demand growth is less there. Here, very simply what has happened is a plant bought for say USD1bn (all by equity money) but put up in two different locations, where the land and other costs may be similar, has a very different market cap outcome. Some part of the different outcomes can be explained by margins and growth that one geography offers vs others. However, particularly in global commodities, where global trading volumes are meaningfully large, these advantages don’t sustain for too long. If we see many of our undervalued spaces, say in commodities like cement, steel etc, in many instances we would find domestic valuations higher than global and on this point of view, these may not be undervalued spaces to be in. Similarly, global banks no longer command a high valuation and most trade at similar to our PSU bank valuations. Hence, is banks, as a space undervalued? Frame of reference is hence very important.
- For example, in the second example, if the growth delivered by the company was say 30% when the valuations were 20 PE, would it not need to reflect the new reality of a lower growth of say 10%. The point is that the valuations should be growth adjusted. Also, in the same space there may be entities which always grew at 10% and had a 10PE for example. In this context another view could be that the true value of the 20PE company could be just 10PE i.e. it is still expensive. We have tried to keep the example simple for ease of understanding. Frame of reference is hence important.
Most investors use only a one-time static domestic frame of reference of one indicator per space, mostly PE and hence this narrative of cheap vs expensive becomes very difficult to explain.
- In the 3rd example, today there are a large number of industries which are getting disrupted in the world. Mostly, we are moving away from fossil fuels, we are adopting EVs, etc. Now when such a trend is happening new investment mostly would not occur in these spaces. This means that many of these spaces may see higher margins and profits for the remaining part of their existence. This may make them seem cheaper on PE. Moreover, investors end up doing sum of parts where a declining business is offered a PE (low by historical standards) and the new business is valued separately on strong growth outlook. This is mostly not correct because the new business would actually, simply overtime, replace the existing business (if one believes on say only EV outcomes, only OTT outcomes for media, etc). There is no new net value getting created unless the new business has a higher margin which in most cases may not be true.
- Terminal value has a very significant, mostly, single dominant impact on valuations. For example, in a declining industry like steel in certain countries where capacity shutdowns are occurring, there’s a probability that the lowest-cost producer will retain some terminal value. However, the likelihood is high that a producer further up the cost chain may only hold a terminal value equivalent to the scrap value of its plant. This would result in sharply different PE outcomes for both of these entities.
Overall, we believe that growth and its sustainability, is the biggest variable impacting valuations. Higher growth industries command higher valuations vs lower growth ones. A 1% difference in compounded growth, over 10 years, has an impact of approximately 5% on valuations. Spaces witnessing value migration and headed by focussed managements may hence be valued significantly higher than head winded spaces.
New emerging spaces hold alpha potential
Alpha is excess returns vs the benchmark. Also, market ultimately follows earnings growth corrected for valuations. A stock/ space with a higher sustained growth quotient vs the index, especially with valuations close to index, may hence be expected to deliver alpha. If the space is new, it would take some time to be part of the index and this helps. For example, Software offered this combination in the 1990s and private sector bank offered this combination in the 2000-2020 period. Managers, created some spaces in their substantial legacy portfolios for the new spaces for alpha.
Growth offers a great opportunity to invest
Let us look at various kinds of FPIs and how their actions may be. We divide the FPIs into the following 4 types.
- Arbitrage seeking funds
- Hedge Funds
- Alpha seekers
- Long only funds
The month of January and first half of Feb has seen a sharp cut in the high earnings growth part of the market. Our understanding of the situation is that the cut was because of currency movement induced sell off, of the performing part of the market in the prior period of Sep to Dec 24. The sharp currency and debt yield movements caused a sharp unwinding of global arbitrage and hedge fund positions which resulted in the selloff. A round of panic, rumours, margin calls etc caused further damage. Threat of US import duties increasing also caused anxiety.
However, now currencies seem to be stabilizing. INR has been below 87 for some time now and for 3 weeks our forex reserves have also increased. This raises hopes that the new level may be the new equilibrium. If this sustains, hedge funds could be able to take risks again. This may help market find its fair level.
The USD yields have also cooled off after crossing 4.7. As US yields cool off, funds will make a large mark to market gains there. This prompted debt (arbitrage guys) to pull back to the US. Since Arbitrage can only offer yields and no mark to market gains, this can continue for a while till US yields reduce and stabilise.
An offshore investor would want to invest in arbitrage in India if he is assured of a yield higher than this as this trade is essentially riskless. Typical assumptions would be say 7% arbitrage returns from which one subtracts a 3% INR depreciation (assumption) to arrive at say 4% net yield. Hence when US 10 year falls to 3.75 or lower, arbitrage chasing money comes gradually and it seems like a strong FPI buying interest. In this period, i.e. just after a strong currency depreciation, if the currency holds, some managers may subtract a lower number for currency depreciation and we could see some new FPI arbitrage driven flows, reducing the intensity of FPI sell off.
The third variety of FPIs are alpha seekers. They bet on a manager for alpha. Manager goes long Indian equity and the FPI shorts the Index (eg MSCI). While this variety of FPI is slow to react, yet after a sharp correction, chances of alpha as the market achieves its fair level is high and on the margin, the current managers could see some extra flows.
The FPIs money taking a long only call on India, like our domestic MFs is significant but only a part of total flows. Most of this money comes from EM funds. India dedicated funds are a small part of total. We saw outflows back to US and also to China on sharply different valuation considerations. This has happened in the past as well. Now that China has had a outperformance, and relative valuations have improved, move away from India and other geographies to China should also subside.
The above thesis on FPIs shows that odds of FPI selling intensity reducing is high. We have seen that FPI sales of around Rs.2-3K cr a day or lower, the market is able to withstand and perform ok.
Valuations have cracked in general and in growth spaces in particular. A crack in valuations make equity more attractive vs debt. Funds which allocate assets such as BAF category in India, seems to be increasing the equity allocation. This further provides support to the market.
Lastly, the fears of US and its duties is manageable. We have to bridge the USD35bn of trade gap. This is a tad over 1% of our GDP. This gap can be bridged by buying some more oil and changing our oil mix and weapons. Duties are being reduced in some spaces. There is a very small space where western products are cost competitive vs what we do on account of our lower labour costs. Impact on domestic industry could be expected to be limited. Preferred access to their large western markets could be beneficial to us. Our cost structure offers a competitive edge compared to others. Preferred access to the west vs other geographies should be supportive for make in India. Also, any action could create both winners and losers. Higher import duties on say base metals could create great opportunities for value added players. The problem today is that of high uncertainty and high risk perceptions. As it subsides, the present period may seem to have provided a great entry point. Jan and Feb 2025 have traditionally seen slower months for Indian equities for a variety of reasons. March to December 2024 has usually more than reversed the losses of Jan and Feb 2025 and chances of the same happening this period, going by the past 16-year track record, is high.
Growth as an investing style works best when money availability is good and low valued. This is because growth requires money. We have seen interest rates drop in the world and in India. As equity markets normalize on account of factors described above, the growth investing style may come back.
We have stress tested our portfolios for
- export linkage to the US
- spaces which may get impacted on larger access to US companies
- cash on book and near term and long term growth visibility
On these above counts, we find only around 15% of any portfolio exposed. Here again outcomes can be beneficial as well. Spaces like EMS, renewables, capital markets, NBFCs and banks, Luxury consumption, defence, etc are all domestic focussed spaces and are not impacted by global events.
We think the risk reward presented by equities at the current juncture and growth stocks in particular is compelling at the current juncture and ask the investors to take advantage of the same.
Thank you
Happy investing
May the Good Times Continue 😊
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