Rural is the big theme as capital is going to people
Kenneth Andrade, Founder Old Bridge Capital
Oct 13, 2017 | Source: ET Burea
Corporate earnings are not coming back, and secondly markets are at high valuations. In such a scenario, markets tend to correct on negative news and there is volatility. If I look at how corporate India has emerged over the last decade and where we are in the cycle now, there are a lot of positives. The last decade saw a massive investment cycle where corporate India grew its balance sheet, fiscal deficit of government went to an all-time low and you had good corporate health in 2006-08 before they started investing in the economy. From 2007 to 2010,balance sheets expanded, companies effectively picked up a lot of debt and that is playing in the decade.
If you look at the BSE 500 from 1999 to 2017, remove the financial companies and look at the investment cycle, the ROEs (return on equity) peaked in 2004-2007 which coincided with the stock market highs and you also had an all-time low in debt: equity ratio. High ROE, low debt-equity ratio and high capacity utilization, all three happened together. The last three years were important to us as we saw bottom of ROE. Interestingly, the debt-to-equity stagnated and has started coming off, which shows corporate health is getting better. Absence of private sector capex for me is good as any balance sheet has to create capacity to leverage back again. When debt-to-equity is high at 0.95, you cannot leverage again. So it has to come down, create capacity on balance sheet and you have to go all over again. Companies are using their cash flow to repay debt and build their balance sheet to take advantage of the next cycle.
We have moved to a capacity utilization of 70%. If India continues to grow at 5-6% in four years, companies will run out of capacity, before the start of the next investment cycle. That's how the cycle is moving. Corporate India is throwing lot of cash but has no growth. The growth will come, once companies have been able to stabilize balance sheets, which is what banks are struggling with and then you flip on to the next cycle. If you maintain this profitability, we should be good to start a cycle in 2019-2020. This in turn means Indian markets can hold on to valuations.
We are positive on the rural theme, given that there is far more transfer of capital in hands of individuals now, coming through multiple socialist schemes, which focus on the rural part of the economy. Today 65% of the population stays in rural India contributing 30% of GDP. The35% of the population that stays in urban India account for 70% of GDP. If I have to play the next 10-15 year cycle and if we believe that India has a demographic dividend, India cannot grow as an economy till you do not even out this imbalance. If you look at a farm loan waiver or subsidized insurance policy or subsidized loans for housing, all of this is going to enhance per capita GDP growth of people in rural India. Hence rural is the big theme. It's a transfer of capital, which is not going to corporate India to grow balance sheet but to individuals this time.
We run a portfolio without any bank stocks. It's not that we don't like banks but we are very valuation conscious. In banks, there is no comfort level in terms of valuations. While in certain aspects of the business in financial services there are growth opportunities, but these opportunities are fairly captured in the way the market has priced it. Though PSU banks may appear cheap, there is nothing structural about them. If you take a consolidated 10-year ROE of a public sector bank across a cycle the average ROE is less than 10%. So these stocks tend to be cyclical and I can’t fathom why over a cycle you should pay significantly over book for some of them. You have an established two-decade track record for most of these companies.Over this period, they have demonstrated the best and worst. The average is fairly mediocre.They have good asset models, large reach, large distribution and franchisee but all that doesn't lead to above average capital efficiency. PSU banks are not very cheap and the model is not changing to be more efficient and dynamic.