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Discipline is the Key

Bharat Shah, Executive Director, ASK Group, shares his views on the current state of Indian markets with a new government in place

A stable government at the centre has pushed the markets to new highs. In this scenario what do you see happening two-three years down the line?
I believe we are at the point of inflection, where, for the very first time, Indian markets will experience a real, long-term compounding and transformational wealth-creating rise over, maybe, next five to ten years. This period will be marked as qualitatively one of the best rises ever in the Indian markets.

So far, markets in India have never witnessed a real bull-run. All the phases of the market that have witnessed a pronounced upturn in the past, have all been characterised with being shallow (short-term), narrow (confined to a very few businesses) and inadequately supported by the fundamentals. The period ahead promises to be different for several reasons.

One; it is almost axiomatic that long-term growth in profits (for any business or market) is a pretty good substitute for the underlying longterm investment returns (subject, of course, to a few things). Two, this equation alters if the initial valuation is higher or lower than what it deserves to be. That requires us to look at the current valuation. Both Nifty and Sensex are presently valued at just a shade over 15 times, while the 10-year average is 16 times. So, even if valuations are not cheap, they certainly are not expensive, and are in a fair range. Therefore, logically speaking, profit growth ahead should convert into matching investment returns or better.

Three, it begets the question of what is the expected profit growth? At the peak, the real GDP growth touched over 9 per cent while it came down to 4.5 per cent last year. As a corollary, the corporate profit growth, declined from a scorching 30 per cent plus to a bare singledigit last year. I believe the GDP growth will rise, over next five years, from 4.5 per cent to 7.5-8 per cent at the least.

Four, if we observe the past correlation between the real GDP growth rate and the corporate profit growth, it has ranged between 2.5 and 4 times. This, when applied to, the expected GDP growth rate, translates to the expected profit growth of 12 to 32 per cent. If I narrow it down to a more modest range, it still will mean 15-20 per cent compounded annual growth rate (CAGR) of profits.

Five, one of the most important determinants of the valuation is the quality of growth, and not just the growth itself. The quality of growth is nothing but capital efficiency or return on capital employed (ROCE). Coinciding with the peak GDP growth rate of 9 per cent was the corporate ROCE of 24 per cent, which last year came down to 16.5 per cent.

Six, as the character of the economy and growth rate improve going ahead, so will be the corporate ROCE, which I believe will rise over next five years to 21-22 per cent. That would, normally speaking, imply improving valuations from the present level. Let me not count the benefit of the same. Therefore, if we sum up all of the above, it will imply at least 15-20 per cent CAGR of corporate profits and hence, at least the matching investment returns over next five to ten years. That kind of long-term compounding holds in its throes a dramatic wealth creation, without it appearing dramatic at any point in the journey.

That was well articulated, but is the economy not facing concerns and challenges?
Concerns are the alter ego of the markets. There will always be concerns and challenges, in life as well as in the markets. But in markets, everything is not mathematical. One has to make rational judgments and wise choices. If so, chances of the decisions being right, rather than wrong, are far higher. And good investing is all about making the probability in your favour.

The principal macro-economic challenges before the country are the twin deficits (fiscal and current), the resultant high inflation (with the attendant high interest rates), removal of the supply side bottlenecks and keeping the demand stimulated without the prop of excessive subsidies, while ensuring judicious delivery of the subsidies and reviving the capex cycle. Certainly, the challenges are many but solvable. And there are good reasons to believe that as the above issues are beginning to get addressed, the economy will spur ahead on a higher growth path.

Even if inflation gets tamed, that fact in itself will improve the real GDP growth rate, even if nominal GDP growth remains the same. As the implementation of various steps occur, fiscal and current account deficit will get into manageable shape, which in turn will have implication on inflation and currency. That in turn will soften the interest rates, and there already are early incipient signs that capex cycle is indeed reviving in true earnestness. I remain hopeful that the challenges will be met with and surmounted.

So, do you believe that economy has rebounded?
I firmly believe that worst is behind us and there are strong reasons to believe that the Indian economy will spur ahead on all the key parameters. Having said that, some variables might take more time to improve while others will recover faster. Quick policy formulation, efficient administrative decision making and clearing of various projects are a low hanging fruits.

This can happen much faster even if its impact will take some time to show results. But if it is done and implemented with rigor, positive outcomes are sure to follow.

I believe that interest rates have peaked out and in a relatively shorter term, we will see them decline. Even on the subsidy front, oil subsidies can be dealt with in the shorter term, fertilizer subsidies may require a medium term formulation while food subsidies require long-term plans and efficient, actual delivery of the subsidies. But, issues of improving agriculture and manufacturing competitiveness will take longer time. And so are the issues pertaining to improving infrastructure and power deficit. Formulating a long-term energy security plan remains an agenda of critical importance.

BLURBS
Capital allocation and distribution skills are the hallmarks of good management, while integrity, vision and execution are of quality management.

Everything is not mathematical with the markets and one has to make rational judgments, which could be right or wrong.

Discipline lies in investing only into quality businesses and the temperament of not getting carried away by the fads of the markets.