'Market valuations are not disproportionately expensive, they are fair'

Who's scared of an imminent correction in the equity market given the fear that it is in a bubble zone? Of course, not someone who has been dabbling in the market for 30 years. Kenneth Andrade, founder and chief investment officer of portfolio management firm Old Bridge Capital Management, has been through all the equity market cycles in the past – including his time as fund manager for 10 years in IDFC Mutual Fund managing money of retail investors. Neither does he believe that valuations in the markets are too high nor is he scared of a correction. Here's an extract of his interaction with Dipak Mondal of The New Indian Express.

With states now unlocking and the vaccination drive finally picking some pace, how do you see the economic recovery from here?

I think this time the opening up of the economy is going to be slightly slower. I don't think India is very enthusiastic about opening up, but I think we will all crawl back to offices in the next two to three months. Urban India is obviously faster, because a significant part of the rural population still has to get vaccinated. Some parts of corporate India will be able to vaccinate most of their staff over the next two or three months. I think capacities will be up and running. We will just have to address the demand side of the problem.

What are the challenges on the demand side?

Discretionary expenses never really bounced back quite significantly, and that is true for both urban and rural India. This trend will continue in the next year or two, probably. The demand in urban India could be okay, the demand from salaried employees could be okay, but the pandemic has damaged a significant part of the self-employed.

So, that's where I think the demand will show a little bit of a lag. We clearly need to get per capita GDP up, we really need to get people back to the earnings cycle, before we actually start up the economy. Till then in the interim, I think inflation and international demand will help us. Sectors like fintech, pharmaceutical, chemical, metals and agriculture etc. are doing well on the back of strong international demand.

So, international demand will help us domestically...

To a very large extent that (international) demand cycle will also percolate down to the Indian environment. Our steel companies are exporting, our aluminum and metal companies are exporting, a lot of industrial companies are exporting. Tech is internationally-linked. Pharma is internationally-linked. So, I think all of that is meant to be coming back. The trade, at least in the near to medium term, would be boosted by global demand and urban consumption (there could be some revenge spending that could take place). 

One question everyone is asking nowadays is, why the equity market is growing despite so much negative news? Some say that the equity market is in the bubble zone...

Just from a corporate standpoint and where these companies are, I will take stock prices and valuations differently. We had one of the most difficult years since independence with negative GDP growth and still, we closed the financial year with a positive profitability report. And this is not one or two companies, it is across a number of companies. So that shows you the resilience of corporate India.

Now from a line-item perspective, what corporate India did was it tried to get back to turnover basics. So, while turnover degrew in line with GDP, profitability grew extensively on the cost line. Inflation helped a lot of commodity businesses, which got them back in terms of profit margins. But lack of demand, especially from the domestic environment, actually sunk volumes. We exited a year where volumes were still a question mark, but profitability overall was squeezed through with a lot of interesting things coming through the system.

Now fast forward one year or two years, if we run the enterprise with the same amount of efficiency, and the top line and volumes come back, then the income statements of a lot of companies will look very robust.

When you have this large liquidity in the system, some asset prices are bound to go up. Even if there is a gradual reduction of liquidity in the system, I think if corporate profitability holds, there is a fair chance in a number of spaces you will still be able to make an absolute return. Like it always happened in the past, there is always a pocket or two or three where you will make an absolute return.

To be more specific, valuations are not disproportionately expensive, they are fair. Some segments of the economy are expensive but what has not moved really is the denominator, which is the earnings number (Denominator in the P/E ratio) even though P has already moved.

Now what could help the denominator (earnings)? Volumes and inflation. Inflation is a very large contributor to near-term profitability.

If inflation remains robust -- we are seeing inflation across every single commodity on the ground except for oil -- it will be very good for near-term profitability, and if near-term profitability kicks in then the balance sheet will look good.

In some industries, inflation-induced profitability will take care of the capex. If you have that large cash flow, it will take care of one or two years of capital expenditure and all that capital expenditure will be met through internal accruals with no recourse to borrowing.

That means the corporate balance sheet is now strong and India Inc may not need too much leveraging to grow or do capital expenditure.

Yes, you got that right.
 
So, in a way, the pandemic has come as a boon for the corporate sector because before that we used to hear that most corporates had a weak balance sheet. What changed during the pandemic?

No, during the last decade, the companies were always on a deleverage cycle. I think we are into the last leg of deleveraging. Cash flow has been enormous and inflation is actually helping. There has been high inflation last year, this year will also be the same. Inflation contributed to some part of the profit. In the next cycle, volumes will come back and if inflation plays out, then that will contribute to profitability. It will contribute to significantly higher profitability than it has.

It is an interesting point that inflation is helping profitability. So, do you think the market has factored in the fact that some part of the profitability was contributed by inflation?

I won't put up the emphasis on inflation that much, I think inflation is the icing on the cake, it's not the cake. Inflation over a longer-term period destroys demands, and that's not what we want. Neither does the government want it, nor do corporates want long-term inflation. But in the near term, it does help in saving up some part of the financial structure.

You said that the companies won't need to borrow to do their Capex. So, do you think the credit uptick would be moderate next year also?

I don't think it will be very different from what has happened in the past. But the recipient of that credit growth will signal which part of the economy will do well in the next decade.

So, low-interest rates may not significantly contribute to the profit growth, something else would?

Low-interest rate makes it easy for operations. Finance cost as a percentage to total sale never really crossed between 9 and 10%. It has never been that elevated. Say if you have to save on financial cost, you save over 200 or 300 bps. But the availability of capital at the drop of a hat is much better and easier for people to access.

Everyone is hoping for a correction. So, are we going to see a very sharp correction or should investors be wary of the correction?

I won't be worried too much about that. I mean last time also the market collapsed almost 50%, and came back all over again right. You will always get corrections and that depends upon where you are located, how much patience you have with your investments, with the investments you already have on the book.