“I do not take the market’s view as gospel truth, but I also do not assume it is foolish or stupid”

Bharat Shah has seen it all. With three decades in the Indian stock market, Shah has lived through enough market cycles to figure out what will strike gold and what will turn to dust. So, if the market defies gravity or stays inexplicably depressed, he knows not to ignore the sentiment. He keeps his ear to the ground and treads carefully. The tactic has served him well. With assets under management (AUM) of Rs.250 billion as on August 31, 2020, under ASK Investment Managers, his Indian Entrepreneur Portfolio has delivered return of 16.6% over 10 years and seven months against BSE 500’s 7.9%, while his Growth Fund has delivered 19.9% over the past 19 years and seven months compared to Nifty’s 11.5%.

But investing and its brilliance cannot be captured in numbers, if you go by what he says. According to him, the complexities involved in investing make it more of an art than science. Therefore, over the years, he has sharpened his ability to grasp the intangible. A whetstone he uses for this is reading. “I read every day, like I brush everyday… you just can’t procrastinate,” Shah had mentioned in an earlier interview to Outlook Business. The bare minimum reading, according to him, is two books a month which makes 24 a year. If you are not reading, you are condemning yourself to intellectual death. Well, it sounds harsh but anyone serious about investing as a career should pay close attention.

What do you make of the sharp recovery since March?
In all probability, COVID-19 is a transient problem. I believe while it is not a minor challenge, it is not an intractable or insurmountable problem. The world has seen such challenges in the past, and we have overcome them. Technology-wise we are in far better shape than we have been anytime in the past. So, there are reasons to believe it will be short-lived. Near-term earnings can only be a small part when you estimate the overall value of a business. Anyway, nothing is cast in stone. You have to constantly be on the watch for new facts and data.

There is a tendency among observers to pass a verdict on the behavior of the market: ‘Markets are bizarre and crazy’ or ‘They are driven by money flow’. These things may have a ring of truth, but when we make such judgments, we implicitly suggest that we know the whole truth and market does not know the reality. But, I bow before the market. That is not to say I take the market’s view as gospel truth, but I do not assume that the market is foolish or stupid. That’s my guidepost.

That said, investing is a lot about the future. Past and present do not account for more than 5-10%. That does not mean you make grandiose projections, but broadly, it is about what you believe is the shape of the future, and that belief has to be examined to see how much of it is flight of imagination and how much is real.

While examining our beliefs, we must remember that as human beings we tend to lean more on tangibility and immediacy. But, the value of any stock is in the intangibles. Price is a tangible real number but value, which is distant and amorphous, is what determines wealth creation. Price is only a dancing reflection of value.

Even otherwise, we should not be dismissive of the market. Value today compared with price today is definition of margin of safety. Value tomorrow compared with price today defines possible compounded return over the period concerned. We need to use both, not just chase gratification with margin of safety but also appreciate compounding of return.

March was tough. Prices were falling every single day. Such a fall breaks an investor’s resolve and you capitulate. During this time, fear was at its highest and so was value. Therefore, people either go with immediacy and become very short-term oriented or they make grandiose forecasts about the future. For instance, they may make a case that sanitisers will be the only and best business to buy, or they may make projections on how things will change forever. We must be wary of both extremes. 

What is your reading of the comeback we have seen in stocks? Is the market really looking at business beyond COVID?
Businesses, which have hit new highs, are really businesses that have not got disrupted such as telecom, delivery, data and digitisation. Then, there are businesses that may be not seeing any immediate benefit, for example, the business of healthcare, diagnostics or pharma. But, these will ride a long-term tailwind.

Events like the pandemic shake people and they take a relook at things, asking if they are adequately insured, for life or for medical and so on. The ripple effect of this can grow into something bigger, and the gains from this have to be factored in.

Finally, some businesses will be affected deeply for a long period of time, such as aviation, hospitality and entertainment. They may have to change their business models and this may mean additional cost.

Where do you see value now?
There was a lot of value in March, but it has reduced since. Still, there is margin of safety (MoS) in some pockets. For example, in insurance, MoS was more in the range of 40 to 60% in March, but it is 20% to 40% now. Even in a beaten down sector like non-banks, the MoS was steep at around 75%, but now it has contracted to less than 40-50%. Still, there is good value even now.

Other segments I find attractive are pharma, healthcare and diagnostic chains, for which the MoS is around 10-15%. Here, the bigger attraction is the possibility of future compounding; ditto for chemicals, specialty chemicals, API and agrochem. These businesses are gainers because of the shift of production from China. Company after company says projects are moving from China and, over three to five years, even if a small part of the production shifts from China to India, there will be a sizable opportunity. China accounts for 30% of global chemical output while India accounts for 6-8%, so you’ll see a big impact.

India had been stuck in a primitive mode in manufacturing. Under the assault of imports, it had kind of surrendered. But that has begun to change, starting 2017, and the process is speeding up now.

With the shift in production to India, agrochem particularly looks attractive. There are a couple of players in agrochem, for example, which are doing cutting-edge chemistry and which supply to global majors. In agrochem, the research payoff does not take too long because the testing cycles are shorter unlike in pharma.

Combine these with the fact that these companies have built strong relationships with global clients and have been investing in research wisely, and they have good visibility on future growth. They earn good margin and are capital efficient. The market has obviously sensed this opportunity and stocks have seen a huge surge. But, the possibility of compounding in future will mean there is still possibility of value.

Pharmaceuticals is a Rs.1.7-trillion industry in India at the retail level, and exports constitutes another $20 billion, of which APIs comprise $5 billion. The domestic portion can safely grow anywhere from high single digit to double digit on a long-term basis, especially as health insurance penetration goes up and the entire chain can support faster growth.

Now, APIs are the key building blocks for drugs. For quite some years, we have been importing key starting materials from China. Somebody was willing to dump and we lazily allowed ourselves to become dependent. But that is set to change. APIs have done well over the past couple of years because of China clampdown, and we should continue to build on that growth as there is a long runway ahead.

For generics exporters, the past five years have been tough because generics pricing has been under pressure with buyers consolidating in the US. There has been a reduction in drug pipeline as there were fewer new generic opportunities; there were hardly any new blockbuster drugs coming off patent.

Looking ahead, some of the companies are focusing on specialty and new molecule development, which is tough. The other area of focus is branded generics, which again can be rewarding but is a painstaking exercise. Overall, the US market is key for pharma players as it accounts for 45% of the world’s pharma market. But right now, if you ask me, I would be more bullish on companies focused on the domestic market. 

How do you see the China+1 manufacturing opportunity?
China was becoming a concern for a number of global companies and this transition started in 2017 as buyers started developing alternatives. Post-COVID, that sentiment has only intensified, and buyers are also looking for replacements (for China).

The real point is that our manufacturing got hollowed out because of Chinese dumping. Now, we are getting it back. A key driver here could be the Production Linked Incentive Scheme (PLIS). The allocation for Electronic Manufacturing is Rs.400 billion and the average incentive is about 5% of incremental output, which means an overall opportunity size of Rs.8 trillion, which is significant.

Now the PLIS could be extended to other areas — it could be for pharmaceuticals, API and even agrochemicals. Then, these can become very powerful models. So the manufacturing opportunity is knocking at our doorstep once again. I believe this could be renaissance.

Think about it, air conditioners were imported till about seven years ago. Now, they are not, but the components are still imported. This could change. Some of the companies in the consumer durables space such as Dixon or Amber Enterprises could be exciting opportunity from this perspective.

What is your view on FAANG stocks? There is a lot of exuberance around Reliance as it emerges as a FAANG-type stock. How do you read this?
They are not fantasy businesses. They make real profit and have serious cash flows. Plus, they are loaded with cash on the balance sheet. That is the first thing going for them. Secondly, digitisation is real and its pace will only accelerate. Even pre-COVID, the world was moving towards greater digitisation. Without digital payments, there would have been greater chaos during this pandemic.

Third, there is the question of sustainability of cash and profit: Will these companies remain ahead of the curve? Will they create new needs that did not exist earlier? So far, they have been good at both. Amazon touches 75% households in America today. Clearly, based on these observations, the market is not getting carried away.

The only digital play we have in India is Jio, which is a play on telecom, data and e-commerce. Jio is entering devices, which is a huge space in itself, and then it will be the first to offer 5G. It will also host a whole array of consumer businesses, which will flow through its e-commerce platform, including medical, entertainment and education. In e-commerce, Jio’s model involving the kirana may be unique.

There is a lot of investor activity in cement. How do you find this space from a value perspective?
Cement is surely a significant opportunity, although there is no MoS. The industry has transformed itself. This is one industry where India is still world class and cost competitive. Companies have innovated and cost structure has improved dramatically. One, companies have been able to increase output without adding capacity, by enhancing the clinker-to-cement ratio.

Two, they have improved on the command-area economics by having plants at reasonable proximity to consumption centres and figuring out alternate routes to catering to demand, which has helped lower freight and logistics costs. For example, Southern cement-makers have used coastal routes to transport cement to the East, which was inconceivable earlier. Three, energy costs have reduced greatly. Freight and energy constitute nearly 50% of costs for cement, so it has made a huge difference. On top of this, the sector has consolidated. There were a number of small and mini cement plants, which have disappeared, reducing poor competition.

With scale, intelligent investments, well-managed costs and pricing discipline, some of the companies such as Shree Cement and Dalmia Bharat have done remarkably well. A cement company operating at a 30% return on capital employed (ROCE) is quite extraordinary. Growth in infrastructure and real estate, especially homes, will be a big driver for cement. This is an opportunity one can’t ignore. By the way, this is one of the three industries where the price of the product has remained the same for nearly 30 years. Yet, companies have improved their return ratios.

Which are the other two sectors? Telecom is one for sure. In fact, it has declined.
Telecom, of course. The other one is software services, where billing rates have more or less remained the same. Earlier, margins were 30-35%, but now they hover around 25%. But, per hour dollar billing has roughly remained the same ranging around $24-30. Some companies may do better or worse.

That’s quite remarkable for an industry where people costs are 50% of total costs and obviously that part cannot remain stagnant over long periods. This has been possible because of efficiency gains — better employee productivity, more offshoring, more readymade solutions, apart from scale benefits and operating leverage. In a world where so many things are changing, these companies have managed to deliver with remarkable consistency and maintained very healthy ROCE.

How about the auto sector? Our penetration in two-wheelers is fairly high, so won’t growth be a challenge?
That’s true. Overall growth will be modest, in high single digits, over the next three to five years. Within that, lot more will have to come from replacements. In two-wheelers, value migration will be the key driver. If you look at bicycles, sports bicycles and those used for fitness are already selling in fairly good numbers and at far higher prices. Similarly, in two-wheelers, demand will move from commuter segment to one that is more aspirational.

How competition will play out is clear (Hero Moto, Bajaj Auto and Honda will be the dominant players with Eicher Motors catering to the aspirational segment). Exports is a significant opportunity, where Bajaj has been successful, and now others are also headed the same way. The opportunity now lies in premiumisation. 

Compared with two-wheelers, cars have not run their course yet. People may look at personal ownership once again, thanks to COVID-19. Car penetration in India is only 9%, so demand is not the issue. The problem for carmakers is more to do with the economics. Customers are no longer happy to have their products for a long period of time. Each new product requires capex and opex.

Henry Ford once said, “You can have any colour so long as it is black”, but those days are gone. When you grow with a single product, profitability is higher. So, the question here is who has the scale to remain profitable, through which they can continuously offer what the customer wants and yet remain profitable. A host of unlisted carmakers are loss-making. Even for Maruti, it will be critical to maintain 50% market share to ensure it can stay on self-perpetuating mode.

But then, it is not only about customer expectation, the overall customer profile is also changing in India with people moving up the income ladder. Maruti has remarkable offerings for the lower income bracket, but as demand moves up the escalation curve, we need to watch how they do.

Looking at the overall growth potential in autos, I believe that some of the big and efficient auto ancillary players will be fairly attractive bets, too.

What about financials? Retail delinquencies have not started to show up yet. This a complete unknown, and therefore, would you think of this as a big risk? 
Financials have been pushed down badly. Lending is about borrowing capital and making money out of it. Therefore, in a rising tide, these businesses do well and, on a falling tide, they tend to suffer. With their response to COVID-19, the government has postponed the problem. The first moratorium was required because people needed time to adjust. The second time, it was not really required; it should have been left to the lender and borrower. But I am glad they did not extend it again, because otherwise it would have impacted the credit discipline and created a bigger mess. I think, by December quarter, we will have a better handle on retail delinquencies.

While the possibility of bad loans rising exists, I do not believe retail delinquency is as big a risk as is made out to be. That is because, Indian households are better behaved. Indian individuals are more cautious about borrowing because this is about traditional value, which is ingrained in us, that borrowing is not a good idea. Maybe it is changing with the younger generation but, for the large part of retail, jumping a loan is not a matter of convenience. Much of our problem with big businesses was because there was no such conservatism or guilt with respect to borrowing.

There is another important point to bear in mind. Delinquencies will also depend on each lender’s efficiency and ethics. A player such as Bajaj Finance, for example, has wisely invested in systems that maintain high level of credit diligence even while ensuring speedy delivery to the customer. For the past 10 years, they have been investing 3-6% of the interest income on building their data analytics and other systems.

But there is a lot of concern over their flexi-loans, post-COVID. Is that an unknown that makes you nervous?
They have been offering flexi-loans for seven to eight years. These are given essentially to professionals such as doctors, chartered accountants and the likes, and these are non-standard products, meaning you can alter the way you structure these in terms of principal and interest repayments. So far, their strategy has worked. There may be some concerns because of COVID, but they have made aggressive provisions over the past two quarters.

Normal NPA last quarter was 1.6%, which is below their long-term average. Their core credit cost during the quarter was better than what it was in March quarter, which itself was an improvement over the number in the previous December quarter. But, they made a COVID provision in the March quarter of Rs.9 billion and in June of about Rs.14.5 billion, amounting to a total of Rs.23.50 billion. This a telescopic provision based on their assessment of the situation. They also took a write-off on some pending accounts such as IL&FS.

Only time will tell how the loan losses will play out, but the important thing is that their balance sheet is water tight. In November 2019, they did a QIP of Rs.85 billion and then they raised public deposit, which they have accelerated as it is a much more stable source of liquidity. As of June, they had liquidity of Rs.230 billion.

Does the overall macroeconomic environment today make you optimistic?
Yes, very much so. First, the cost of capital has declined materially. Good corporates were borrowing at 12% a few years ago, and now that rate is below 7%. This is dramatic. The government has taken the path of fiscal prudence, so there is nothing that is going to hit us hard in the future. Crude price is low, so are other raw material costs, which is good if it lasts. If you look at competition post-COVID, the bigger and stronger players will grow and take away share from weaker players, and we need to factor that into our strategy.

Another thing I am optimistic about is the reforms related to agriculture. APMC, which has lacked transparency and bred inefficiency, will be dismantled over a period of five years. Corporate farming may get a leg up, and these measures together will enhance farmer-level economics. They will have the liberty to sell to whoever they want to rather than being forced to go through a certain channel.

Also, fertiliser subsidy being given directly to farmers will mean better choices. Urea, for example, has been overused and abused over the years because it was highly subsidised. Usage of SSP (Single superphosphate) and DAP (Diammonium phosphate) and their subsidies have been lower. But, we need to create a more balanced nutrient ecosystem with urea, phosphates and complex fertilisers used in judicious proportion for better crop fertility and soil quality. With DBT (direct benefit transfer), you will not subvert market economics and drive the whole system towards better choices. But then, these measures won’t change things in the short term.

What are you reading now?
I am reading The Behavioral Investor by Daniel Crosby, A Psychological Analysis of Adolf Hitler: His Life and Legend by Walter Langer and The Secret Teachings of all Ages by Manly Hall.