Canary in a Coal Mine!

True to its name, securities firm First Global has operations world over. Not only is it a member of the BSE and NSE, but also of the London Stock Exchange and the National Association of Securities Dealers.

The firm researches and trades stocks across the world for its institutional clients and has to its credit many seminal calls on the markets, such as the end of the tech boom late 2000 and the start of the Euro rally against the dollar late 2001. In December 2007, the firm turned negative on India. The rest is history.

Shankar Sharma, speaks to Larissa Fernand on why he thinks India is in a bear market and what made him make the call ahead of the rest.

In September 2007, you said you saw a market situation over the next six months where index levels would get taken out successively. And you also said you saw the Sensex moving to 20,000 and 30,000 levels. When did you change your view?

Around August-September last year the Sensex was at around 14,000-15,000. When the P-Note incident took place we were at 16,000. So from there we were certain that the market would move to a significant level. It did hit 21,500. So the market did rally around 50 per cent from there.

When we comment on the market, we take a view at a point in time. So at a point in time I may take a view that the Sensex may move from X to Y. Now when it reaches Y and the factors that contributed to the rise are still intact, then I would continue with it. But if I notice that various changes have taken place and it has already moved significantly, then I may be forced to reconsider my view. We turned negative in December 2007. In the first week of January 2008 we wrote to our clients and informed them about our change in view.

What were the factors that forced you to change your stance?
Valuations in the Indian market. The over exuberance attached to the market at 21,500 was completely crazy. The current account deficit. Now the price of oil too is a concern but we looked at it ahead of the market and it made us cautious.

Around December 2007 and early January, we said that this year would witness around 7 per cent GDP growth. The finance minister was still saying 8.5-9 per cent. In fact, that was the street consensus. But now with the inflation, interest rates, rise in crude oil price and deficits surfacing, the consensus is moving towards 7 per cent. But if we change our view after the numbers have become real, we are too late anyway. We have to be one step ahead.

You also changed your view on the US market.
We were negative on the U.S. for the past two years. But in the last couple of months we turned positive, particularly in the U.S. technology space. Now we think that the people generally have an extremely negative view on the U.S. and this is creating opportunities.

At a time when there was an extreme view of optimism on India and China, we changed our views on these markets. In November 2007 we said that China was going to be a huge problem market and from there it has been down 50 per cent.

What is it about the India story that scares you?
The macro view is extremely disturbing. In fact, it is a very scary situation. Besides deficits on the fiscal side, we have deficits on the oil, food and fertiliser subsidies. All these deficits were at a moderate level. Now because of price inflation of crude, fertilisers and agricultural commodities, these deficits have swelled to account for 10 per cent or so of GDP. This is besides the current account deficit of 3.5 per cent of GDP. So we have moved from a well managed fiscal and external account situation to a dangerous one. A combined deficit of 14 per cent - fiscal and current account - is a scary number. With such deficits, it is not possible to reduce interest rates. Since the government needs that much of money to fund that deficit it will be a borrower in the market. With such demand, interest rates will rise. That in turn means that the benchmark for corporate and individuals to borrow has gone up. And that was precisely the problem we had in the Nineties. Despite a lot of good things happening — liberalisation, Manmohan Singh's budget of 1991-92, the market went nowhere for 10 years. We never saw the highs of 1992 taken out till 2000. That was because the macro picture had become bad. My fear is that we are going back to the same situation.

There has been ample talk of the "consumption story" in India. What's your view on that?
This consumption story could have been played up any time in the past too. And it probably will be spoken about in 2020 too. India has always had a young population. I remember studying geography in school about the ownership of bicycles and wrist watches per person in India. And India was so pathetically placed, half a watch for every 100 people. And I remember thinking that India is so far behind that it can only catch up. And that must have been around 30-35 years back. So this story could have been played way back then and it would have gotten you nowhere. On all parameters India is way behind and hopefully it will catch up. But that does not mean it has to catch up tomorrow or even by next year. We don't know when that will happen.

We talk so much of this "young population" but is it that a great thing? A huge percentage of this population is very poor. You can't just look at the big number, you have to go deeper. If a huge portion is from the lowest strata of society, how good is that population going to be towards contributing to the consumption story? They need to get jobs before they start to consume. That means they have to get educated. India has not invested enough in primary education. Sure we have IIMs and IITs. But we lack good primary schools in India. Neither do we have a good healthcare system. These foundations — the building blocks of the economy are missing.

India today is running so short of manpower — be it in banking, financial services, technology, power sector, whatever. There are not enough good quality people available despite a nation with so many young people. Why is this the case? Because these people are not employable. They are not "educated", in the strict sense of the word. So many young people with MBA degrees cannot write a paragraph of good English.

India's wage inflation is 35-40 per cent. You cannot remain competitive with that kind of wage inflation. In the U.S. and U.K., employees have virtually no salary increases for 10 years. The increments come only by way of performance bonuses and incentives. Our wage hikes are not sustainable. They are high because we do not have quality manpower.

What must be done for India to increase the GDP growth?
A number of things actually. Still, the impact will be felt years down the line, not next year.

At the very least primary education, for reasons mentioned earlier, and basic healthcare. These two issues are so fundamental that I cannot over stress its importance. The physical infrastructure is a huge mess and I don't think we have done enough on that front. And of course, judicial reforms. Governments change and when that happens, policies change. I may invest on the basis of certain policies and a new government may come with a reverse stand. What do I do if I have already invested $1 billion? If I go to court, it will not get resolved for a decade by which time the project has lost meaning. In India's democracy there is no continuity of policies. It all changes with who is in power. So an efficient court system is mandatory.

What's the key risk to our domestic market? Global concerns, earnings deceleration, higher interest rates, political instability?
All of them. Our take is that the global concern over time will lessen. We don't see any big bankruptcies happening in the U.S. It will slowdown and probably even go into a recession but we do not view that as a real risk to India. The local risk is the Indian macro problem that I have outlined above. The second risk is the political issue. Elections will take place and no one knows what will happen after that. There is no saying if the same government will return to power and whether the government that comes to power will have a majority and will be a stable government. Instability in politics is never good for the equity market. More than earnings, it is these two factors that will cause a problem.

If you believe we are in a bear market, do you have a view on how long it will last?
I do believe that we have entered a bear market. I reckon it could be a year or two. I don't see it changing next month. The only thing that will change my view is if oil goes to $50 per barrel. That is the only caveat to my view. If that happens, we are in for a reasonably good ride. My view is that in the long term, oil should go back to $50. But it might reach $200 before it drops to $50. So if oil shoots up to $200 levels, then our market will drop to 10,000 levels. Then if the price of oil drops to $50, you can expect another great run of the Sensex moving from 10,000 to 20,000. So the bull case for India will be a bear case for oil.

If the price of crude drops, would you consider aviation stocks?
Never! It is one of the dumbest businesses in the world, the fuel price notwithstanding. The airline company will buy or lease its aircraft. It is a fixed cost on the P&L. If the flights have a great load factor, the company will make some profit. But by the time the company begins to get profitable the aircraft need to be replaced. So the entire plant and machinery have to be replaced after a fixed number of years. So the capex cycle starts again. In no other business that I know of does the entire machinery have to be scrapped and replaced with new stock. So when you hit some level of profitability you are running an obsolete fleet. When that happens, travellers will not want to fly on your aircraft. So you have to replace the aircraft which means depreciation and interest. So one cannot make money on a sustained manner in this business unless there is a monopoly on a route. So unless the government gives some protection, then it is not feasible. It is a perennial capex cycle business in a free market.

You had once said that NIIT was your favourite tech stock. What's your view now?
That was way back in the late Nineties and 2000. NIIT has lost its way so I no longer think it is a viable name. It used to be a good company and a reasonably valued one too. Now it's hard to pick the best one. There are 3-4 good ones which one can buy as a pack. But our bet is on Satyam Computers. On operating parameters it is still behind Infosys and TCS. So there is room to catch up — Return on Equity, EBITA margins. So in this stock you could get bang for your buck.

Are you bullish on technology?
4 We have been bullish on tech from December 2007 onwards. That was our single biggest buy in the market. We were clear when we upgraded tech in December 2007. Our view was that the rupee would weaken and given what we saw in the non-technology sectors like infrastructure, construction and capital goods, we found this sector to have far more reasonable valuations and a lot of defensive characteristics. A lot of these companies have 30 per cent of their revenue coming in from non-U.S. markets. If the rupee weakened, the U.S. problem would get mitigated.

Technology has been pretty flat this year, while the market has been down 20 per cent. Not losing money in a falling market is a good thing. So we think technology is a sweet spot.

What about pharma?
We like pharma in India specially second-tier firms like Glenmark Pharmaceuticals. We had been negative on the sector for the past few years and upgraded the sector in February 2008. We think it will do incrementally well. It's not a great sector but relative to the rest it is fine. From the options, it is the one of the least worst.

Why did you change your view on PSU banks?
We liked PSU banks last year. But ever since we changed our view on the macro-economic scenario, we changed it on the banks too. If we have an economy with high deficits and high interest rates, then it will definitely hit these banks since they hold a lot of bonds. High interest rates will mean that these bonds will suffer losses. Last year we were bullish on them, this year we are negative on them. We are negative on banks as a whole because we find them way too expensive.

What contrarian bet did you take in this market?
We bought sugar because we believe it is a good long-term story. Even though the companies are loss-making or close to it. We think that the world will turn more towards ethanol because of high crude prices and more of it will come from sugarcane rather than corn which is causing a lot of controversy. So this will create some level of shortages in sugar worldwide. So we think that is a good trade to get into.

What about steel?
We liked steel a year back but that's not the case now. We think it has entered a territory where the risk-reward has become really adverse. Steel goes into automobiles and construction, all of which are hurting. So when your end customer is hurting, how can you make money?

You once said that real estate is a great investment. Do you think real estate funds are good options for investors?
I made that comment on a general basis. It was not an implication that you should buy real estate today. I said it because real estate is an investment that does not require brains and analysis. You just have to buy it and hold it. In stocks you have to constantly track the quarterly results, the annual figures and other such factors.

As for buying real estate funds, it depends on which part of the cycle you are getting into. If it is already hyped up and highly priced, it would not be a good time. You cannot get into real estate at the peak because it is not an asset that is easy to sell.

You seem to be ahead of the rest in your views on the market. What's the reason?
We like to be completely unbiased and neutral about the way we analyse the market. Most people inject a lot of emotion into the analysis. So if you are an Indian, you want the India story to be a great sell, Indian companies going abroad to buy other companies, foreigners flocking to India and so on and so forth. You begin to believe the headlines. This is certainly not a good move for an analyst. I don't need to read the newspapers to form my view. If I did that I would be no different from the guy who reads the Business Standard or Economic Times to form an opinion. I get paid to analyse facts and data, not to believe in stories. Stories are for children, not for adults.

So we like to take a neutral and dispassionate view on the situation. Just because I want India to do well does not mean that India will do well. Or the world owes it to India to do well. There is no such thing. So at a point in time, I may have a particular view. But later, when the prices have readjusted and fundamentals have changed or you think they are going to change, then obviously the view one has will also change.

There is no point in injecting your belief into your analysis. We don't get paid for fixed views. There is a price that is right and there is a price that is wrong. There is a price at which everything is already discounted. And there is a price which has already factored in the bad news and just a bit of good news can trigger a revival. So when good news hits the market, what investors may not realise is that the stock price may have already factored in the good news.

Can you give me an example?
I can give you no better example than Indian telecom which we are currently bearish on. In the second quarter of 2007, we turned negative on Bharti Airtel and Reliance Communications, despite being positive on them for a number of years prior. And we did so because of data and facts. The market was already paying $1,000 at Enterprise Value per subscriber. All over the globe, specially in emerging markets, mobile companies trade at $300-$350. Maximum, barely $500 per subscriber. And that $500 is a function of the revenue per subscriber. In India people bill Rs 350 per subscriber on an average, it could even be lower than that. In Egypt it would be Rs 800.

So an Egyptian company should logically, rest everything being equal, trade at twice the valuation per subscriber because the subscriber is paying twice the money per month.

Nobody is denying that India is a growth story where telecom subscribers are concerned. India will grow to 40-50 crore subscribers when 50 per cent of the country has mobile phones. But that does not mean the stock is a great buy because it has already accounted for all that growth. So even if the market grows to 50 crore, it has already been discounted. So despite strong subscriber growth over the past 12 months, Bharti which was at Rs 1,000 then is at Rs 800 now. India has added about 7 crore subscribers out of which 20-25 per cent go to Bharti. About the same has come to R-Com, yet the stock is down 40 per cent from there while Bharti is down 20 per cent. This despite record breaking subscriber additions and the numbers being good.

So the market and the stock price are two different things. India will still grow but the question is how much of this has already been factored into the stock prices.

What do you look for when you pick a stock?
We are not big believers in great management. We try to keep an open mind. We would rather buy a low quality management at a lower price rather than a high quality management at a very high price. We basically like stocks which are out of favour. For instance, power utility stocks like Tata Power and Reliance Energy.

We were the first to upgrade the sector a year and a half back. So we like to take an opposing stand to the market, not always but often. We believe that over time this is the way to outperform the market. If we do the same as everyone else, how would we ever outperform.

And have your calls turned out to be right?
Yes. The only time we went wrong was when we thought oil would correct from $80-90 levels. It is now at $132. Other than that we do get most of the cycles right, bullish or bearish. And we also use a lot of quantitative research. Our model has moved away from the traditional one of meeting companies, understanding management and stuff like that. It is still important and we do it, but we are very quant driven and that takes the emotion and bias out of our decisions. We get a more neutral picture.