Saurabh Mukherjea: Link between economy & market breaking

There is no obvious link any more between the Indian economy and the Indian stock market and that really puts 68213571 68212956 68202648 the onus on folks like us to stock pick intelligently for our clients, said Saurabh Mukherjea, Founder, Marcellus Investment Managers, in an interview with ET Now.Edited excerpts: can start with the block deal as to what is the future for insurance companies. We can talk about geopolitical tensions or we can talk about a multi-bagger idea from your side.Let us get the geopolitical tension addressed. Obviously, what is happening in the border is far more serious than my or most other people’s portfolios. We are a $3-trillion economy now. Even if matters were to escalate, the financial hit to the Indian economy is very tractable. It is the world’s sixth largest economy now and even in case of a conflict in scale of Kargil, the financial hit can be dealt with but obviously the human cost is on a different level. That is why the market is relatively sanguine about the serious matters taking place up north and let us hope the market stays that way and the matters decelerate. The Korea-America matter has been brewing for several years now. The global financial market has learnt to live with it and China-America tensions, if anything, seem to be settling down. So the geopolitics is not something we should have foremost in our minds. It is very interest to talk about but I am not so sure how relevant it is to your and my portfolios. But you also mentioned that there is a disconnect between the opportunities and the earnings expansions. Could you explain that? It has been a good ten years now. The nominal GDP growth in India has been around 12-13% over the last decade or so. In only one out of the last 10 years, has the Nifty earnings growth been commensurate with India’s GDP growth. Overall Nifty earnings growth has been miserable for five-six years. My reckoning is this is not going to go away easily. It is not a question of the Nifty suddenly recovering one year.What is increasingly happening as we become more affluent is that a bigger part of our consumption pie is coming from imported goods that is at the B2C level, at the B2B level, increasing spend on capital goods is imported robots, automation, mechanisation lines. So, the link of the Indian stock market as a play on the Indian economy unfortunately is getting broken. Our economic growth no longer seems to feed into stock market performance which means that stock picking, building an intelligently constructed portfolio in India is becoming ever more important. There is no obvious link any more between the Indian economy and the Indian stock market and that really puts the onus on folks like us to stock pick intelligently for our clients.Telecom turns out to be that contra bet. Jio has really set the cat amongst the pigeons. But now it seems that Bharti is upping its game. An Africa listing is in the pipeline. There is news about a sizable fund raising. Does it seem like at least some power is coming back to the incumbents too?Generating high earnings growth for sectors in India which have heavy regulatory construct , has always been a challenge. It is not just telecom. It also includes power, infrastructure, real estate. Wherever a sector is surrounded by regulation, the regulators basically suck the profits out. In telecom, initially it used to done through auctions. Now, it is done through rule changes. So I am not optimistic about that sector. If you ask me, the best chance the Indian market has of finding sectors which consistently give earnings growth better than GDP growth are sectors where there is low regulatory intervention and capital intensity is light. So, light industrials, traditional FMCG consumption type plays, IT, pharma. My reckoning is over the next one to two years, consumption-oriented light industrials, export-oriented IT-pharma type plays will have a decent run. Capital intensity is light in these sectors. The currency is weak. The currency is likely to weaken further over the next 12 months and those sectors give us the best chance of generating EPS growth ahead of GDP growth of say 11-12%. The only other area is private sector banks as the NBFCs and housing finance companies lose market share, given what is happening in the wholesale market. As NBFC and housing finance companies lose market share, the top four or five private sector banks should be able to pull away from the rest of the BFSI pack.The closer we get to elections, everybody will have a view on it. But from the market standpoint, this is just conversation narrative and nothing more, nothing less. When election verdicts have been on expected lines, markets have moved. When election verdicts have not been on expected lines, markets have come down and then moved. Eventually what matters is earnings.The Indian stock markets’ track record on elections is not great. It is probably as bad as the opinion pollster track record on elections. In 2004, when UPA won, the stock market went circuit down and then it had the best bull run ever in the next five years. In 2009, while the UPA won again, the stock market thought that it was a good result and then we had a miserable run for the next five years. So the Indian market’s ability to read political outcomes even after the election is done is fairly patchy and hence my reading is best to ignore it from a portfolio perspective. It is a big human interest story. Looking at powerful people jockeying for great power is always fascinating. But I am not so sure it will make me wiser and wealthier if I obsess about who will win the election. Part of the reason is there is no great ideological difference when it comes to economic policy. It is not as if politicians are sitting up late either reading Karl Marx or Adam Smith, losing sleep on matters of economic theory and economic philosophy. Their job is somewhat different in the Indian context. We leave them to do their jobs. We do ours which is to buy well run companies which generate good cash flows consistently.When it comes to pharma space as a whole, do you believe that there are select opportunities here? There are expensive valuations as well. What exactly is driving your conviction here?Let us us be clear. Sectors like IT and pharma do not have companies in those sectors which are akin to an Asian Paints or an HDFC Bank. An HDFC Bank and Asian Paints have core competitive advantages. It is in none of the IT or pharma sector companies. Those two sectors are far more commoditised. They are competing in a global market, with low differentiation in their products and that is why a currency tailwind is immensely helpful.I reckon the rupee will go towards 75 over the next 12 months. The rupee sliding to that extent gives sectors like IT and pharma which are inherently commoditised sectors. It gives them a real kicker. We have seen the IT companies benefit from that, not just in terms of earnings but also in stock prices. You can see in pharma’s Q3 results the currency benefits coming through. The US numbers are turning around and whilst the FDA issues will continue, it is also clear that the leading pharma companies are getting a better grip on how to deal with the FDA issues. A combination of currency pulling back with further currency depreciation ahead of us, decent Q3 numbers from the pharma companies and in a way the worst of the FDA issues being behind us, my reckoning is there is a good pharma recovery ahead of us over next 12 months. I said the same about IT 18 months ago and I am sticking to my IT call. I would like to add pharma to that list of currency beneficiaries as we continue to exist in a phase where the rupee is heading downwards.Do you stay with more of the same? Do you continue to buy the top four, five Nifty names which have performed in the recent past, or do you think the time has come to tactically move yourself and start nibbling into the small and midcap names or even some of the largecaps which have been beaten down?The way I think about portfolio construction is I have a core in portfolio say 10 to 11 stocks which I call structural compounders. These are well-run companies with core competitive advantages, clean accounting and good corporate governance -- the Asian Paints, HDFC Bank type plays. I sit with them for very long periods of time and I will admit that I personally own these stocks. Then there are another eight, nine stocks where I take a tactical view. For example, my tactical view is that the housing finance companies and NBFCs will cede market share rapidly to the private sector banks. So I will add a couple of other private sector banks to my portfolio. They might not be of the quality of HDFC Bank. but they will be able to benefit from the shift in market share. Similarly, I am not saying IT and pharma are structural bets for me but given the extent of the rupee weakness, IT and pharma companies will tactically perform for me over the next one to two years and therefore I will have a couple of stocks from each of those sectors in my portfolio. As I try to blend the two, perhaps a little more than majority of the portfolio is in structural plays and something like 40-45% of my portfolio on tactical plays. Obviously all of these companies have to have clean accounts. If the accounts are believable, then I am whistling in the wind. But leaving that aside, on the tactical play front, there are opportunities in private sector banks, opportunities in IT and pharma, small ticket consumption which do not require borrowing money and these are in good shape in our country. We are seeing that for the last three sets of results.Consumption will continue roaring ahead. The recent budget that the FM announced is very pro consumer. So there is plenty to play for. It is not just largecaps, there are some midcap plays, one or two smallcap plays as well, but the primary focus has to be underlying quality in the financial statements, strength in the franchise and consistently good ROCs, without which you really find it very difficult to make money in India.Howard Marks in a Google talk said if you bought the classic blue chip stocks in 1960s which is GE, Kodak, 3M -- the 1960 classics -- you did not make money because those were fully priced. My only fear with classic compounders is that their businesses will continue to grow but in today’s market are they pricing in next three, four, five years of growth. Is that the risk for some of the A quality great moat franchises like Asian Paints or an HDFC Bank?One fundamental difference between American investing and Indian investing is exactly this subject and that is the reason I write books in India. In America, you will find it possible to find a company. In America, you will not find companies which have return on capital massively above their cost of capital for decades on an end. You would not find companies like Asian Paints, Britannia, ITC, HDFC Bank, Marico in America. American firms that we are all familiar with say, Walmart, JP Morgan have return on capital pretty close to their cost of capital because America is a far more competitive economy. Ours is the only large economy in the world where a) companies continue to dominate sectors for decades on an end and b) they have return on capital well above the cost of capital. So I am sure Howard Marks is right in the American context but that message does not apply to India because unfortunately or fortunately, whichever way you look at it, an Asian Paints or a Britannia is able to maintain return on capital, way above the cost of capital for decades on an end.Asian Paints is 1600x since their IPO in 1983 and 1600x in a pretty smooth line. It is not that Asian Paints had a good run and then suddenly stagnated. I reckon that continues. I am not saying that this is true for lots of Indian companies. I would say barely 1% of Indian companies fall in the category of Asian Paints on 99% of Indian companies Howard Marks is absolutely right. But there are 1% Indian companies, the structural compounders, the classic compounders, which are able to continue dominating their sectors for decades on an end, in a way which is not possible in the United States.As a result, these companies give you 10x in 10 years and 100x in 20 years, 1000x in 30 years. It is a shame to not have those companies in your portfolio. It is like an ATM machine you stand in front of it and collect the Rs 2,000 notes.

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