After a great 2003 and good 2004, what can equity investors expect in 2005?
Predicting the markets from a short-term point of view is not easy. But there are many drivers for the market at this point of time.
From a global macro perspective, there is more interest in emerging markets and among the emerging markets, it is the BRIC (Brazil, Russia, India and China) countries. China and India provide relatively more opportunities. According to the BRIC Report by Goldman Sachs, if India and China maintain such rates of growth, by 2050 they will become among the top three economies in the world with the fourth economy way behind. The US, China and India will become the three pillars of world economy. If infrastructure issues are addressed, it can come true. More and more of the smarter FIIs are realising it. When people will see more work on the ground in terms of infrastructure, the confidence will improve. If you look at the composition of the global markets, Asia ex-Japan accounts for less than 5 per cent, while US accounts for over 50 per cent of the world market capitalisation. If you look at the growth opportunities, a lot of the GDP growth will come from China and India. There is a big disconnect between the GDP growth and market cap and if both countries continue to grow, there could be a lot of money coming in. Both currencies are also undervalued and if they get fairly valued, then there will be a surge in liquidity as people want to park money in stronger currencies. So from the global perspective, India looks promising.
From the Indian economy point of view, there are signs of acceleration in the GDP growth rate. If you look at the last ten years, agriculture has been growing at 2 per cent, industry at 5-6 per cent and services at a higher rate. At that time, agriculture had a higher weightage, which has come down now. Even if these sectors of the economy maintain their current growth rate, the overall increase in GDP will be healthy. There are also signs that industry can accelerate the growth rate if some of the infrastructure issues are tackled. Services can be a very big opportunity. Though in terms of the domestic GDP, the contribution of software and BPO has not been dramatic but going forward, we expect it to improve in a big way.
Going forward, the impact of the growth in these businesses will be felt in a more substantial manner. Take the example of Infosys five years ago when it had a base of around 2,000 employees. A 50 per cent-addition on this base is good but it is only 1,000 people. Today, if they are at 20,000 or so, even a 25 per cent addition will mean 5,000 people. In BPO, these numbers are pretty huge. If a company has 9,000 people and is increasing its head count by 70 per cent, it is 6,300 people. So many jobs are being created which were never created even in the glory years of the public sector. These are also more high-paying jobs than the traditional jobs that India has been creating in the past.
The other interesting point is demographics where India will see a big bulge in the 21-35 years age bracket in the next 10 years. This is a great bracket from an economic point of view as they are a young workforce. Because of the change in demographics, the dependency factor will go down, which means that the number of people who are dependent on a person earning wages will become lower. This will result in a higher savings rate and consumption will increase dramatically.
Coming to the corporate sector, Indian companies have started created a lot of value add as defined by the difference between the return on capital and the cost of capital. This spread was not good in the late nineties, but it has improved now and I expect it to remain respectable for the next few years. With better spreads, you can afford to pay a higher multiple, specially considering that the economy is strong. So valuations can move up.
The private sector insurance companies are also coming of certain size. In the first few years they do not have much investable surplus but as they grow, these too will rise. They too can become major players. Overall, the demand for equity can increase substantially. We have strong fundamentals, equally strong technicals both from a global as well as domestic perspective. While we cannot predict what will happen year to year, we have the ingredients in place for a fairly good bull market. Of course, things could go wrong but it looks like fewer things can go wrong.
If such huge sums comes in, will there be enough supply of shares to match the demand?
The government will continue to disinvest though it may not be a strategic sale, but they could disinvest in the secondary market or the ADR market. Besides unlisted companies, some good companies will also be raising money as the capex cycle is also accelerating. So the need for capital is going to be more than what it was in the past seven-eight years. But this will not be big compared to their market cap as these companies are having free cash flows and their balance sheets are not leveraged. Nevertheless, when companies have the opportunity, they tend to raise some capital. So some supply will be there, though it is not going to be that huge. The demand in general is likely to outstrip supply and push the price-earnings multiple higher.
Why are mutual funds unable to attract more money?
We have taken the low hanging fruits in the last two or three years, primarily the bank distributors. They have been tapping the high net worth individual segment. That money has already come in and probably now they are trying to get out as they think a Sensex level of 6,000 points is high. That is one reason why there is pressure on the fund industry. But there is a huge potential for the middle class and the upper middle class, where the distribution is not reaching today.
The second way is to have tie ups at the payroll level so you can inculcate the principle of systematic investment planning so that it becomes a monthly habit. It cannot happen overnight as it is concept selling. But once the concept is sold, lots of people will come in.
What will be Templeton's growth path?
Our growth path is to improve the reach of our products, getting them distributed among a wider demographic profile along with advertising, continue to maintain performance in terms of investment management and improve customer service. These things are not esoteric but they remain the fundamental building blocks of our business.
The fund management team that started in ITI Pioneer remains more or less the same.
You have fund managers who have stayed here for 10 years, which is uncommon. What is the secret?
I think it is the value system where things hinge on simplicity, openness and there is a certain common level of commitment to achieve targets. People are not here purely for money; their purpose is to achieve success for investors. Some of the team members believe that we are working for our investors. They will not shift for more money as long as they are able to achieve their goals. We also have a culture where people can criticise each other openly.
All the funds have had some bad days if you look at the performance. There may be a year or two when the performance was not good. But we learnt from those mistakes. For example, we had a lot of mid-cap exposure in 1995 and many of those stocks underperformed large-caps for so long that the fund performance got hit. Our second mistake was that we were too focused on valuations, and ignored the wealth creating ability of certain companies. We realised that and rebounded strongly by getting into companies like Infosys. We also had another advantage that no philosophy was thrust upon us. We were allowed to develop a philosophy that works.
Since it is a home-grown philosophy, our mindset is also to experiment and refine the investment strategy as market conditions, levels of efficiency, etc change.
What was the logic behind lau-nching Prima Plus at that time?
Bluechip was a closed-end fund while Prima was open-end. In Prima, there was no intention of declaring a dividend at that point of time. Prima Plus was the Prima Fund with the provision to declare dividend. However, the timing was unfortunate and we took a few years to generate the surplus for dividend. We then converted Bluechip also into an open end fund. By that time, the market was getting more sophisticated and we needed more differentiation between the products. We also had to do something more consistent with what the funds were already doing. We then decided to maintain Prima as a mid-cap fund and changed the focus of Prima Plus to mostly large-caps and some mid-caps with a growth tinge.
How expensive is a fund of funds for investors considering that there is an expense for the FoF as well the funds it invests in?
An investor would have anyway incurred the expenses while investing directly in the mutual fund schemes. The additional expense that an investor can incur is a maximum of 0.75 per cent that FoF is permitted to charge for meeting out its expenses such as audit fees, statutory disclosures etc. We believe that the convenience that a FoF offers should more than make up for this marginally extra cost.
What is your view on the technology sector considering the appreciating rupee?
We are positive on the long-term prospects. The rupee appreciation can have some impact on the margins. We are expecting a margin compression from a longer term point of view so what the rupee appreciation will do is make it happen earlier. The wage differential is still huge and the supply base of people is also expanding. With people getting good opportunities, the engineering colleges are also upgrading. With more supply, the wage increases will also reduce.
What about demand? Is there a possibility that US technology spending will decline?
Maybe on a cyclical basis it may happen, but not on a longer term basis. See technology is having an impact on every business process. An accountant's job is getting more automated and contains less work for an accountant and can be called an IT job today. Similarly, it is happening on the shop floor or the medical field. A guy working in a top Indian software company would be an accountant or a chemical engineer, depending on which vertical he is working for. His job has just got shifted from a manufacturing company to a software company. As long as Indian companies are competitive, they will gain market share. In services, I am very positive. If you look at the composition of the US economy, 78.7 per cent was services. Manufacturing industry was around 19 per cent and agriculture is the rest. China has been able to create a huge export basket by playing in the 19 per cent part of the US economy. India is going to play in the 79 per cent part. The companies are flexible; they say they will do the job you want them to do. If they need to become SAP consultants, they will do that. Or, even write equity research reports.
People have been saying that it is risky, but you can realise that it is risky being in other tech stocks, which have gone down. We have been maintaining that weightage for more than four years now. The total risk to the portfolio is not just by the weightage of the stocks in it, but also by the risk to the underlying businesses of those companies. I can have 10 other companies and say the risk is lower but if those companies are going to fall and this is the only company that will stand up, my risk would have been higher by diversifying. That is why we have always maintained that we would be in top quality companies, irrespective of the size. It is a coincidence that the better quality companies are also the bigger companies. We have had smaller companies like Hughes, which was top quality. We believe that when the industry consolidates, people will go to the top-tier companies. The cost structure of the second-rung companies is not much lower than the top-rung companies. Large companies squeeze their vendors as their volumes are large. Top companies pay 10-20 per cent more in terms of salaries, if you see the offshore salaries as a percentage of total salaries. The big companies can easily charge 5 per cent more to their clients. They have a competitive advantage and today we stand vindicated.
What is your view on the pharma sector and the Franklin Pharma Fund?
The pharma industry has huge opportunities and Indian companies have competitive advantage. In multinationals, big pharma is a big bureaucracy. They are not agile. They are spending too much for too few discoveries. At the same time they are doing well as they invested substantially in the past. With users feeling the cost pressures, there is reform happening across the world. It has become easier for people to challenge some of the patents. I think the basic patent should be there for 15 years or whatever, but drug companies have created artificial barriers like getting extensions, without investing more and that should be subject to litigation, and people are litigating.
In our pharma fund, we are in the same type of situation as we were in the Infotech Fund in the past. Because pharma stocks have been rising, people are thinking that every company will make it big in the US or the UK. People are re-rating all the stocks that have a generic strategy. But I think it will be a similar story to IT and all companies will not be able to succeed. Only a few companies will succeed and move up the value chain, while the rest will fall by the wayside, and it will take two years to realise that.
Prima is almost a Rs 1,000-crore fund. Are you comfortable managing such a large fund?
The challenge has increased in the short term, not necessarily for the long term. We are in the initial phase of widening of the basket of investment opportunities, which Prima has participated in. But that is not institutionalised, which is a risk. A lot of people have come for short-term considerations and it will affect all companies in the mid-cap space, irrespective of these companies being good or bad. But in five years, mid-caps will become much more resurgent and more institutionalised. Five years later we will not face this challenge. We have to see how we cope with the situation in the next two years as the size increases. So far, portfolio manager Sivasubramanian and co-fund manager Sathish Ramanathan have done a very good job. To cope with the situation, we would increase the number of stocks in the portfolio - say from 40 stocks to 50 or 60 stocks. For this, we will need more people to expand the team and so we are hiring. If we think that it is growing beyond the bandwidth we can increase, then the option may be to shut it for new investors.
You have more than one person managing each fund. Doesn't it create a conflict?
Last year, we entrusted the co-portfolio management responsibility on three of our senior analysts. There were three reasons. First, it gives them variety in their work. Second, when they try to execute some of the ideas, they know the actual challenges. Third, we need to transition them and have more home-grown talent as the opportunities will increase substantially in the next five-ten years and we will need more people to take on the responsibility.
In our system, people are not rewarded purely on one fund's performance. It is the team's performance which is more important. There will be more weightage on their stock ideas than on how the fund has performed. To a large extent, our systems are macro based. We do not want to make it too individualistic as it will create an individualistic culture. Our reward system is based on creating a team culture. As I told you, some of our members are not even so bothered about rewards. To that extent, we do not have any pulls and pressures at this point of time. While recruiting, we choose team players over brilliant-but-individualistic people.
Also, people in our investment team are fairly mature about taking criticism. We know that even if we do the right thing, the right thing may take a long time to show up. In the interim, say for a quarter, people will say you are in a stock that has not moved when everything else has moved. Even last quarter, some of our funds have underperformed. We do not want to venture out in stocks that are moving because there is market activity. It might look stupid on the upside, but if things go bad, we have to protect the investors' interest. This business is not about trying to be a superman; it's trying to do simple things consistently. Ultimately, it does not matter whether you provide returns of 25 per cent or 30 per cent returns. Even if we can make 25 per cent over the long term, it is a lot of wealth creation for the investor. We want to produce stable returns; our idea is not produce superlative returns, as it might not be possible to replicate every year.
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