This time around, there is not one overarching growth model like during the 2003–08 rally, and one needs active stock picking to benefit from a potential surge in the emerging markets, according to Swanand Kelkar, managing partner at Breakout Capital Advisors.
During the 2003–08 golden period for EMs, there was one EM growth model and that was predominantly exports, Kelkar told NDTV Profit's Niraj Shah in an interview. "There will be different countries that will have interesting drivers, but there is no single model that will lift all countries together."
There will be a domestic demand-driven model in counties like India, Indonesia, while Vietnam will be export-driven. There will be markets where there is a value angle to them, Kelkar said. "This is a very diverse EM model versus what it was in the last cycle. Which is why you need to have active stock picking."
Swanand Kelkar. (Source: NDTV Profit)
Swanand Kelkar. (Source: NDTV Profit)
There are multiple headwinds that are setting the stage for a rally in the EM. One among them is that EM have got their balance sheet act cleaned up over the past decade, according to Kelkar.
Most EMs today are running positive interest rates and will start cutting rates after the action by the US Federal Reserve. This will set the base for an EM cycle again, he said.
Valuations in these asset classes have been ignored the past decade, Kelkar said. "The balance sheet is light and clean, there seems to be some growth angle that can come up, and valuations are cheap. This is the time you start looking for opportunities."
The India Picture
According to Kelkar, India will have many growth drivers than just a single one, and one of the few places that have a large domestic consumption base.
With a diverse set of portfolio themes existing, India today is the "prom queen of emerging markets". Most emerging market portfolios will be overweight on India, Kelkar said.
Tilt of the portfolio remains towards the investment side of economy rather than consumption. Almost a third of India's top 100 stocks are trading above 40 times above their one-year forward earnings, he said.
Watch the full conversation here:
Edited excerpts from the interview:
Just give us how somebody who invests across emerging markets looks at that space currently, and then we'll get to whether India can break out from the EM basket, if you will?
Swanand Kelkar: I think I cannot bring any expertise to a two-week trend either. Let me get out of that first. So I'll talk a bit about Emerging Markets and what's really happening because in India, sometimes you're so preoccupied with what's happening within our vibrant markets that you don't look at what's happening elsewhere and rightly so at times. But what's been happening in EMs is it's a very diverse asset class, multiple countries, there are two or three things. One is that over the past, maybe over a decade, EMs got their balance sheet act cleaned up, and that's across households, corporates, and in most cases, even the public debt. So I'm not talking about China here. I'm talking about most other EMs apart from China, which is a very good thing for starting a new cycle. That your balance sheets are much more clean and much lighter than what they were, let's say 10 years ago. The other advantage I feel for EMs is that the inflation experience in EM has been much more benign than what it has been in the developed world and that's a divergence from what it was maybe two decades ago. So even if you look at the quantum of rate hikes that have happened in the developed world versus what has happened in the EM. If you look at where the inflation numbers are, most EMs today are running positive real rates, which means that inflation is much lower than the policy rates in those countries. Again, a good starting point that eventually when things fall in place, Fed starts is rate cutting cycle, a lot of EMs will follow and that will set the base for for an EM cycle again and the third thing of course, is valuations which has been one of the most ignored asset classes as you will know for the for the past decade or so many we had the 2003 to 2008 EM rally, and since then, not much has happened really speaking within that asset class.
Some justifiably so some not so justifiably because all eyes were on the U.S. People have made what has been the U.S’s decade in the last entire 10-12 years. So that's the starting point for an EM if you are a stock picker, if I tell you that okay, the balance sheet is light and clean. There seems to be some sort of growth angle, which can now come up and valuations are cheap is the time that you start looking at such a stock and that's exactly what is happening. So we have seen some money trickling into EMs over the past maybe 6-12 months, not in a big way. But there is at least some attention coming back to the asset class. India of course within that whole thing has stood out remarkably for the growth characteristics that the country has and the differentiating characteristic of the domestic flows, which are not present in most other EMs at least in the quantum that we have had in India over the past five to 10 years.
Do you foresee a probability that in this decade, we will have an EM rally wherein all EMs could move up at the same time and would a global rally be necessary for something like that?
Swanand Kelkar: Interesting question. So, if you go back to the 2003 to 2008 golden period for Emerging Markets, there was an EM growth model and the EM growth model predominantly was about exports. It was about exporting to the developed world and there was commodity exporting emerging markets, which sort of fed into what China was doing with their huge fixed asset creation which was happening in that country. So those were the two EM models, which could synchronously take the entire asset class up. India then if you remember the index weight for India and MSCI EM was mid single digits, it's almost 18% now. So it's a very different EM as an asset class that you are looking at today, but you asked a very valid question. I think this time around, there isn't one overarching single EM growth model. There will be different countries which will have different interesting drivers, but there isn't a single model, which will lift all the countries together.
So there will be a domestic demand. driven model, in places like India, Indonesia. A country like Vietnam is still pursuing the East Asian Tiger model of exporting to the developed world. There will be countries where there is sort of a value angle to them. I said that EM is trading cheap. There are at least four or five large emerging markets which are trading at single digit P/Es where you get the basic inflation growth dynamic on an even keel, and you get some sort of a country re- rating. So there is a very diverse EM model now versus what it was in the last cycle, which is why you need to have a bit of active stock picking. I'm selling my book here, but that would need to have a bit of active asset allocation at a country level as well as stocks level, this time around.
Would select markets like India and others be chosen by an EM fund manager for the domestic demand that it brings to the table or also because of this whole conversation of the last 24 months about what China plus one, Europe plus one, etc.?
Swanand Kelkar: So again, when an asset allocator allocates money to a country, it's rarely a single bullet point sort of rationale. So you don't allocate money even to Vietnam only for the export model. Vietnam has a very buzzing tourism sector, as you know, so there are always multiple growth drivers in a single economy. Having said that, India is one of the few places which has a large domestic consumption base, which also still has a fairly large cap catch up to do in terms of the capital stock within the country.
There will be phases, places where exports China plus one, Europe plus one manufactured exports services exports, even which is done much better than manufactured exports, I would argue, would be part of that rationale, would be part of the portfolio. But I think that single factor model which drove growth of some of the East Asian tigers, I think India will have many more growth drivers than just a single economic factor.
But it is not purely, largely domestic demand, or that's not the overarching majority overweight for which you might choose India? Is it a combination of domestic demand plus export prowess plus some of the other factors?
Swanand Kelkar: So it's all of these put together. In fact, some of the listed domestic consumption names, now since we're talking about India, and you know, those names haven't done well at all, versus what the country's growth numbers have been. So people have allocated capital, even within the country, to diverse growth models, which is just one being the capital investment model, a bit of the manufacturing export model that you talk about or even the services exports model. So I think it is a very diverse set of portfolio themes in every large foreign investor's portfolio, rather than just one single theme driving the entire portfolio.
Now because you have a choice of investing across markets, do you still find value as a global investor? I'm saying to put money into India at these valuations because of all the promises that India has, or are there better options in the EM basket growth versus valuation argument?
Swanand Kelkar: So you take a step back here. Again you do not run an Emerging Markets portfolio, allocating 60-70% to a single country. There are different flavours that you have within your entire portfolio and that's true even if you think about your individual portfolio. There will be a growth darling and there will also be a value pick or a turnaround pick which you have in your personal portfolio. When you think about it from an emerging market standpoint, you do exactly the same thing. So the blue chip prom queen of emerging markets, today is India and most emerging market portfolios will have overweights on the Indian… I mean those who are linked to the benchmark, will be overweight on the India weight in their respective benchmarks. But having said that, a lot of people tend to also ignore some of the turnaround that is happening in some of the smaller emerging markets and the valuations at which some of these things are possible.
I don't think we'll ever say that this market is 20 P/E so we will not put in any money there. We are not big fans, frankly, of looking at index level P/Es. if you ask me that. Is there anything different than I'm doing about India? I would say no, it is business as usual. I'm looking at business models. I'm looking at valuations, I'm looking at growth prospects, what I would do or have been doing for the past almost 15 to 20 years now. It's become slightly harder to get stocks for the valuation that you want them at. Yes, true. But this has been our operating state in India for a long time. what you like, and what's discovered is priced very quickly. So I don't think it is any different from that sort of a scenario. It is business as usual. It is a bit harder to pick stocks than maybe it was 12-18 months ago, but you keep at it. That's what you're paid for.
Let's say you're not a passive investor, would you be over that weightage looking at the current valuations? Would you still go over that 18% benchmark weight on India or would you be under?
Swanand Kelkar: We don't compare ourselves with the benchmark but we are overweight in our portfolios, we are overweight above that 18% number, although that is as I said we are absolute return investors. So we don't really look, we have been able to find enough opportunities that meet our investing philosophy to deploy anywhere between 20 and 25% of the portfolio in India. That’s where we are at. I don’t know about others but that’s where we are at.
The question is, would you believe that India is indeed in the 'Amrit Kaal' of growth, if you will? Can this decade be a decade of secular growth? It may be a percentage shade here or there or whatever? But is it a secular growth story?
Swanand Kelkar: So I've always shied away from taking decadal calls on things. I always say that as an investor in any country, your investing horizon typically when you talk about a stock is somewhere between 18 to 24 months, that doesn't mean that you sell a stock in two years. What it means is when you write the rationale for buying a stock or allocating money to a country, you typically write an 18 to 24 month rationale. We have written those 18-24 month rational and kept holding stocks for 10 years because you revisited this rationale and have done well and done well. So it's very hard to do a 10-15-20-25 year sort of prediction. But India's valuation premium also comes from the fact that people feel that growth here is secular. I mean, there are certain markets where they peak out at 15 P/E.
They peak out at 15 P/E because they are by nature very cyclical markets, growth is very, very cyclical or the composition of the index is very, very cyclical. That's not true for India and there are very, very few other markets in the emerging world which will have that secular nature of growth where you can say with some degree of confidence that even five-seven--10 years from now, the broad growth metrics or the broad growth engines will still be intact. Anything can happen, but this is investing is a game of probabilities and if you think about those probabilities, one of the reasons why you get that P/E premium is just because the ROE is higher versus rest of the world,, yes, but also the longevity or the perceived longevity of that growth while the returns number gives you that higher multiple, which answers your question I mean, do you think that group sustains for the next the market is telling you yes, you're paying that multiple because the market feels that this growth is long lasting and will sustain, for a longer time and some of the other very cyclical markets.
No, because you don't have a very large India portfolio because your portfolio also has a lot of other Emerging Market stocks. You will be choosing your ideas even more carefully. I'd love to understand where it is that you find the most favoured, from a 24-month perspective?
Swanand Kelkar: So I will tell you the framework that we employ first. So we think about quality growth and valuation in that order because we are an absolute return fund. 100 going to 95 gives us nightmares. Even if that 100 doesn't go to 150 it goes to only 120. We are still okay with it, because the agreement that we have with our investors is to provide an absolute return for their liabilities or for their commitments. So that becomes the framework of stock picking, where we are very concerned about what are the downside risks. Are there any stroke of the pen risks, can anything change overnight, which will cause the stock to be down 20-25%. Even if there is a 5-10% probability of such an event happening, no matter how promising the growth prospects, we will steer clear of those stocks.
This isn't an investment philosophy that everyone has. A lot of people look at equity markets almost like lottery tickets. There is a 99% probability of losing everything but there's a 1% probability that I'm going to become a millionaire. Good luck to them. No comments or no judgement on that way of investing, but our way of investing is where we want to first protect the downside. Having said that, the last time we met, I said that the consumption side of the economy versus the investment side of the economy. We have been very clear on the investment side of the economy and that includes Real Estate, that includes the Public sector spends that have happened in multiple areas.
That still remains the tilt of the portfolio. Where we are more focused on the investment side, rather than the consumption side of the economy. We have also engaged into these New Age companies, which have now swung their metrics more towards convincing people that we are profitable. That swing to profitability mantra or the focusing on profitability mantra, a lot of these New Age companies have realised and realised very quickly and that's a function of I think, they're beholders changing.
When they were in the private world, remember, TAM was the buzzword. Everybody talked of Total Addressable Market, because that's what the then beholders cared for. After being listed, the now beholders care for EBITDA, and they care for cash flow, and they care for profitability and the smart companies I think nicely pivoted their business models to align to these new set of beholders and we have taken note. These are more value shifts sort of plays rather than a fresh value creation sort of plays across a supply chain or across a chain of where value gets captured. The digital beneficiaries are sort of making the most of it, that is a thing like Telecom as a space. I still think it's a fairly non consensus thing to like, even today, which is where we are saying that okay, we are getting a 15% growth sort of a sector where price repair is still ahead of us, which is still not happened with the lowest rates in the country, etc, etc. and a very supportive regulatory environment, at least for now.
So the sector has come like emerging markets after a decade of, you know, being at the receiving end of a lot of things and I think that repair is underway. So we like that space, as well.
So, service provider or ancillary or pure play Telcos?
Swanand Kelkar: Pure play Telcos, I mean, you can guess there aren't too many out there.
There are a lot of people in Emerging market funds which have taken bets on the one that is coming up or the tertiary beneficiaries as well?
Swanand Kelkar: So I think that is one pocket of consumption, which we think has gone through a decade of I think underperforming on multiple metrics, which is now looking better, which is what we like. In the investment side of the economy, we are still not absolutely sure whether private capex has picked up. The public sector capex has done really well if the numbers are there in front of you to see. But I think private capex we almost feel like as a market we are willing with the private capex to to look up.
So if you zoom a certain chat, you might see some uptick, but it's not there yet. That's something we keep watching because there is a limit to which the public sector capex can take the country, the private sector capex has to sort of step in its place. So I think those are the areas where the portfolio is aligned. I think conspicuous by absence would be private sector banks, which are, I think, a mainstay of a lot of portfolios. So it's a bit of a longer term reason where we feel that given the rate hikes that have happened across the world in the past two, three years, the easy advantage of CASA is that some of these banks had that you basically got money for free. That is under challenge, because people are switching money from there on to multiple other avenues which are yielding better.
So your raw material as a bank has just gotten more expensive. On the lending side, I feel that the lending in India over the past few years has become very lopsided, which is more towards the consumer even though they're more towards the unsecured and the regulator is telling you that please look at it. It's being cautious on that side of things. In the last 12 months, I would say it was the best of multiple worlds for banks. NIMs were at their best, Credit quality was at their best, Credit growth was in double digits. From here on some of these things start turning at the margin, and that can't lead to a re-rating from here. So that is why private banks, which I think means to have many portfolios, don't find a lot of space in ours.
There's a chalk and cheese behaviour wherein some with a technology mode or a client mode or process mode… My question is if the private capex were to come, and if you had to take a bet, would you take a bet on those qualities and since the valuation parameter comes third, would that be your preference or would you look at the valuations because some of these are also not doing bad work?
Swanand Kelkar: I agree. So when it comes to valuation, we ran this analysis some time ago that almost a third of India's top 100 stocks, were trading at more than 40 times multiple for one year forward, that number might have gone up as well now. This 40 times one year forward is a number where we kind of had our hands start shaking as investors, when we are not very used to it. We are not very sometimes as they say read experience sometimes in bull markets is a liability.
So sometimes it happens to us that we have seen some of the same names trade 10-15 P/E and fundamentals have changed . I can understand all the arguments. But that is something that given we have, I wouldn't say a value mindset, but we are at least we are mindful of valuations where we kind of baulk at buying some of these names. That also means that you have to then make a forecast of where you think private capex is picking and where who will be the beneficiaries and we have opted not to do it at this juncture. We own a large EPC company in the portfolio and if you have seen recent results, you will realise that bulk of your orders are coming from overseas and coming from the Middle East and coming from hydrocarbons. So that basically tells you that is widespread private capex that you were expecting to come out at least in the Bellwether companies numbers you're not seeing it. So again, the last time we met in the Alpha Moguls (show), we discuss this. I mean themes and trends are multiple going around at different points in time and some of these themes if they play out they are multi year themes, you're happy to miss out the first couple of quarters of that, but we would rather look at a validation of that theme before getting something into the portfolio.
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