global perspective

Missing the Forest for the Trees

We are in an ambivalent investment environment globally. Risk assets find themselves in a strange conundrum. While low interest rates have ensured that there are no cheap bargains out there, the feeling increasingly among capital allocators is that everything is fully priced. Animal spirits seem to be confined in a few individuals like Elon Musk and Jeff Bezos and it seems like not much else is happening elsewhere. The excitement around emerging markets has disappeared and the feeling among investors is that plus ca change, plus c’est la meme chose (the more things change the more they stay the same).

I don’t think I am qualified enough to make a statement about every single asset class and every single geography in the world, however, I do believe that I have a good handle on things on the ground in India.  The narrative among investors allocating to India is that it is fully priced and that the risk-reward has become inverted. Markets have done well while the real economy remains sluggish.  In my investing career of 18 years, I have remained obsessively focused on asymmetry and protection of permanent losses of capital. I can tell you that investors are completely missing the forest for the trees.

Something transformational is under way in India. It is hard for me to explain what is happening on the ground without sounding hyperbolic. Let us discuss two very significant changes underway and their transformational impact on India.

Movement to a rules based system: This is unprecedented in India’s history. The law in India has always been optional and has been enforced differently for different people. Discretion is slowly being weeded out of the system and the leadership at the top has embraced decentralization and non-interference. While skeptics will quickly point to continuing grass roots anomalies and corruption, the change at the top is undeniable. If one were to assume that the current leadership will govern for seven more years, the fabric of India’s civil society will be transformed forever. While this derails the gravy train for the beneficiaries of the current system, it creates exponential growth and value creation opportunities for those playing by the rules.

De-bottlenecking India: India has been divided by its rulers and leaders for centuries. This policy of division continued after Independence. Division is very lucrative for those in power as it increases the value and hence the tolls for access and decision-making. Giving up power and discretion is very difficult even for the most benevolent. Unification increases transparency, reduces friction and reduces the ability of those in power to collect tolls. India has been undergoing massive re-unification and integration at a fundamental level for the last three years.  It started with the dismantling of the planning commission and the devolution of revenues to the states that strengthens the federal architecture envisaged in India’s constitution and continues with the implementation of the Goods & Services Tax (GST). Low cost information technology and ubiquitous mobile telephony has enabled the government to undertake rapid large scale deployments of e-initiatives. The mobility of the people in the United States has always amazed me. Mobility of people and workers has been severely restricted in India and people have remained unwillingly chained to opportunities in their immediate ecosystem. Initiatives like mobile employee provident fund accounts (EPFO), low cost Jan Dhan bank accounts and biometrics based Aadhar numbers have empowered migrant workers and reduced their bondage to employers. Initiatives like jurisdiction free income tax assessments and digital national agri marketplace (e-NAM) are likely to further unchain individuals from their immediate geographic ecosystem.  

The number of initiatives under implementation for the decentralizing and integration of India’s social and economic systems are too many to list here. Let us instead focus on what this means for India’s economy and for investing in India.  This integration completely disrupts existing business models of companies that have profited from the inefficiencies of a divided India. One can already hear the cacophony of complaints from business people who are seeing their margins compress and their businesses disappear. The old order has changed forever and the sooner companies accept it and take corrective action, the more likely they are to survive and thrive.  While the old order based on inefficiencies is getting disrupted, new opportunities for scale from servicing a national market are emerging. Companies have to invest in people, management and technology and have to improve access to organized capital to survive and thrive in this environment. For companies that manage to embrace this change the opportunities are unprecedented. This entire change is resulting in (good) deflation and is empowering the Indian consumer. Over the next decade, India is likely to see gigantic leaps in productivity growth and increases in purchasing power and standards of living. 

The equity markets in India offer a range of investing opportunities second only to those offered by the US markets. There are a large number of companies in India run by competent management teams with good standards of corporate governance and sensible capital allocation policies.  Many of these companies and their management teams are cognizant of the new emerging order and the opportunities it presents. They are hard at work transforming their companies to capture the emerging opportunities and to catapult themselves higher. For companies like these, trailing valuations are irrelevant.  The challenge for investors of course is the fact that not every company has what it takes to change leagues.  However, given the magnitude of the change underway in India the universe of investible companies is fairly large.  

Opportunities to invest in economies, markets and companies like these emerge once in a generation. It is inevitable that there will be setbacks and missteps along the way and it is true that there are no roads paved with gold in India. However, as a tour guide at Ellis Island in New York once told me, the exciting part is that the roads are getting paved rapidly and that investors (immigrants in the case of Ellis Island) have the opportunity to participate in the paving of the roads. It is therefore important for investors not to lose sight of the forest while evaluating the trees.

Systemic Risk from Passive Investing:

The active investment management industry has earned itself a terrible name. Two thirds of all equity mutual funds in the US underperform the S&P 500.  What is worse is that, as a group, investors in mutual funds underperform the funds themselves because of mistimed entries and exits.  Fees on actively managed funds including entry and exit loads are high. Their fees have made asset management companies and their star investment managers rich while delivering mediocre performances for investors. One is reminded of the title of a popular book about Wall Street called “Where are the customers’ yachts?”  When one looks at what is going on in the hedge fund industry, the situation is even more appalling. Hedge Funds on average have underperformed consistently and failed to deliver value despite charging egregiously high fees. No wonder then that there is a big backlash in the public pension space against allocations to hedge funds and a push toward passive investing at much lower costs.  

Warren Buffett in his letters to investors calls people in the investment management industry “helpers” who are out to take the wealthy “Gotrocks” family for a ride. He recommends that investors should fire (i.e. redeem) all their active managers and instead allocate a fixed amount periodically to a low cost index fund like Vanguard that replicates the S&P 500 index. It seems like the investing public is listening. Over the previous ten years, assets under management in actively managed mutual funds have declined as investors have shifted assets to passive funds like Vanguard and Exchange Traded Funds (ETFs). Interestingly this has put into motion two negative self fulfilling cycles. As more money heads into passive strategies, index stocks outperform non index stocks leading to further underperformance and consequent redemptions from active management. Also, as active managers become more obsessed with tracking error and benchmark underperformance, they start closet indexing their portfolios to reflect pseudo-index funds. With interest rates near zero and flows into equity markets continuing unabated, it appears like investors have discovered a new alchemy in passive investing.

It is important to stop for a moment and think about the staggering nature of the shift underway.This has very large consequences for investing and investors. If investing is all about flows and all about supply and demand of a particular security then the underlying and fundamentals do not matter. This would then be the anti-thesis of the fundamental value investing hypothesis proposed by Benjamin Graham that the market is a voting machine in the short term and a weighing machine in the long term.  

If there is any truth to Benjamin Graham’s hypothesis, the weighing machine will eventually overpower the voting machine. Given the size and duration of the passive investment trend, it is inevitable that equity indices and their linked passive investors will endure very long periods of underperformance. On the other hand, disciplined active investors who know what they are doing (a dwindling lot) will likely outperform the consensus for an extended period.

Indian Infrastructure - A decade in the making:

The global investment landscape today looks quite unexciting. Consumers in developed countries have been maxed out for the better part of a decade. Notwithstanding the recent optimism in the US, it is highly unlikely that consumption growth will reaccelerate. The best scenario one can hope for is that consumption growth settles at a 1% to 2% rate and that fears of contraction subside.

Emerging markets face a completely different problem: China. China has been the engine of growth in emerging markets for the last two decades but the Chinese engine is now sputtering. China made a miraculous transformation of its economy by building infrastructure that is the envy of even the developed world. It fueled this growth with massive amounts of debt (most of it domestic, thankfully) and by borrowing growth from the future by conspicuous overbuilding. The problem with a capital or fixed hyper-investment model is that one cannot stop. If one stops then the entire economy stalls and crashes.  

China has been adding capacity in roads, railways, ports, power, steel, aluminum etc. Each of these sectors depends on the other sector’s “growth” to keep itself going. If one sector stops adding to capacity, the feedback loop stalls capacity addition in all other sectors. China has reached the point where the discourse has shifted from growth of capacities to utilization and shut down of capacities. For example, Chinese steel capacity exceeds 1 billion tonnes or about 50% of global installed steel capacity. China produces 825 million tonnes of steel. Chinese aluminum capacity exceeds 45 million tonnes which is once again more than 50% of global installed aluminum capacity. China produces about 30 million tonnes of aluminum a year. While steel capacity growth has completely stopped, China added 7 million tonnes of primary aluminum capacity last year. This year the discourse in aluminum has also shifted to capacity utilization and shut downs.  Chinese consumer spending is a sideshow compared to its fixed investment juggernaut. Discussing Chinese consumer spending as a driver of China’s economy is like discussing the restaurant industry in the Bay area as a driver of Silicon Valley.

I am not necessarily calling a bubble or a crash in China. The only point I am making is that the Chinese economy of the next decade is going to be very different from the Chinese economy of the previous two and that it will have major consequences for the world economy, especially for emerging markets. China will import a lot less of the primary commodities it had been importing during the previous decade.  The buoyancy in commodity prices since the China scare of Feb 2016 appears to have been driven more by speculative activity in China than by a meaningful resumption in fixed investment or capacity growth. A resumption of the global commodity meltdown experienced in early 2016 will be devastating for emerging markets. China will also dump a lot more of its manufactured goods on the world market despite protectionist safeguards and duties. This will keep a lid on global capital investment and capacity expansion.

This brings me to my main topic: India. I have always maintained that India is a bottom up economy and unlike China, it does not have the ability to execute state diktat while ignoring popular opinion. Therefore, it behaves a lot less like a focused corporation and a lot more like a feuding extended family. India is an emerging market and will get materially affected by the goings on in China. However, India is also emerging from a gut wrenching five-year slowdown and a clean-up of its banking and political systems. India will remain a bright spot (albeit a small one) in the global investment landscape during the next few years. What then is likely to do well in India and what is likely to not do well?

The financial services and financial inclusion story in India is a little long in the tooth. It has been so difficult to deploy money in the Indian real economy in the recent past that all investment dollars have gone to the easy business of leveraged lending. Anytime financials start trading at more than three times price to book value, the risk reward asymmetry becomes inverted. When the entire financial system starts to trade at valuations of more than three times price to book value, investors should be prepared for a very long period of underperformance. It is possible that the economy keeps growing but financials underperform as their economic realities catch up with expectations built into their stock prices.

The non-cyclical consumption story in India also looks a little over extended. The problem with consumption in India is that it is 100 small countries inside a large sub-continent. Purchasing power and consumer behavior and preferences are so heterogeneous that the addressable organized opportunity for individual players is relatively small. This has been anecdotally experienced by investors in Indian listed consumer stocks. Companies experience high double digit and even triple digit growth from small bases and their growth tends to taper off as they reach $250 - $300 million in revenues. Unfortunately for investors, valuations continue to climb and it is not uncommon to find non-cyclical consumer names trading at between five and ten times multiple of revenues. Often managements find themselves under tremendous pressure to grow to sustain market valuations and expectations.  This often results in sub-par decisions and diworsefications to capture unrelated and dissimilar lateral markets.

Large core industrials like steel, power, mining, chemicals and textiles are in unenviable positions. They are suffering from large domestic as well as global overcapacities in their respective sectors and the resulting absence of pricing power. This is unlikely to change even if the India economy grows dramatically. Global (Chinese) overcapacity is going to ensure that investors in these companies make sub-par returns on investment even in a growing economy. Manufacturing is therefore going to lag the economy and will not be a driver of economic activity in the first few years of the Indian growth rebound.

What will do very well in India then is anything that is cyclical but domestic and not influenced by global overcapacity. I believe that the Modi government’s thrust on infrastructure building and housing for all by 2022 is going to become the engine of the Indian economy. This will liquefy the market for land in India and will create a real estate boom. A boom in land and real estate both in transaction volumes and prices is essential to create a wealth effect in the economy and to rekindle animal spirits. The wealth effect will result in explosive cyclical consumption growth in durable goods. This imminent boom in infrastructure and real estate has been a decade in the making. These sectors are however prone to excessive leverage and systemic corruption.  They will eventually succumb to excesses like at the end of every economic expansion.  Hopefully these sectors will be able to put in a few years of high quality growth before they succumb to excesses.

Indian markets will therefore remain volatile and large sections of the market will suffer with contagion from other emerging markets. The markets will be a paradise for stock pickers who can stomach volatility and who can find idiosyncratic names that benefit from the growth in the Indian economy while remaining fundamentally insulated from global overcapacity.