Demonetisation Is Like A Speeding Car Hitting A Wall, Says Kenneth Andrade

The currency curb won’t change the long-term pattern of how the economy grows.

Traffic passes the Chhatrapati Shivaji Terminus railway station in Mumbai, India (Photographer: Dhiraj Singh/Bloomberg)
Traffic passes the Chhatrapati Shivaji Terminus railway station in Mumbai, India (Photographer: Dhiraj Singh/Bloomberg)

This week on Thank God It’s Friday, we speak to Kenneth Andrade, founder and chief investment officer of Old Bridge Capital on the impact of the government’s currency purge on the market and the economy, the themes we would now invest in, and whether Indian equities have already discounted a potential Fed rate hike.

Cash Curb: Temporary Blip?

A lot of noise has been made about the impact that demonetisation will have on India’s GDP and corporate earnings growth. In your opinion, is it a temporary phenomenon or could it extend beyond the 2-3 quarters that everybody is talking about?

It’s a temporary phenomenon. Though it depends on how you define ‘temporary’. When a speeding car hits a wall, it comes to a standstill before it gets repaired and moves on. So that’s the only analogy I’d like to use for something like this. So you brought this entire economy to a grinding halt because capital flows or liquidity in this cash entire system actually came down quite significantly. So you’ve got to take a pause, you’re going to take a long pause before you start rebuilding it all over again. And a significant part of that economy is affected. My sense is it will take at least a year, 1.5 years before you see some kind of stability.

Economic Impact

The prime minister indicated that there is a lot more to come with respect to tackling black money and corruption. Are you anticipating any more surprises that could derail or slow down India’s economic growth story?

I am not anticipating anything. And this doesn’t change the long term pattern of how the economy will evolve. It depends on how you define ‘temporary’. My sense is 18-24 months. Post that it would be quite okay. Also from point of view, I would look at the data first and see which part of the economy gets impacted and then move forward with the analysis. So as an organisation or as an individual, I am not going to pre-empt anything that’s going to be dramatic for this economy. When the data comes through, if we think it’s going to be dramatic and it’s going to slow down, then we will build it into our future estimates.

With respect to this exercise, there are all sorts of numbers thrown in. People are talking about break-even points. When does one decide that this exercise is going to be fruitful and what is the best case and the worst case scenario from the government’s point of view and in your opinion?

I think wait till December or January. We will get a fair sense of what is happening on the ground. It’s a fairly expensive exercise, apart from just the printing of the currency notes you also have a revenue loss for this quarter. The revenue loss is from taxes, both direct and indirect. There will definitely be a dent in sales volumes and incomes. So the break-even on something like this can be fairly high. So let’s wait for the data to come through but the number is fairly high for this exercise to break even.

But you don’t want to give us a number right now?

I will be with the consensus. The banking system is talking about Rs 5 lakh crore of currency which will not get back into the economy through bank deposits, which extinguishes the liability side of the RBI. Some parts of the capital markets are sitting at the other extreme where the number is between Rs 1.5-2 lakh crore of currency which will not get deposited. In either case, it is not very positive for the way this economy will shape up in the near-term.

Fed Rate Hike Impact

The consensus believes that there will be a Fed rate hike in December. Has the market already discounted that? And after that is underway, what would you expect from the Trump administration?

On a Fed rate hike or any rate hike, we have seen a trade that’s played out in the last 40 years in the U.S. and across the world. Rates were at higher double digits and then were reduced virtually to zero. And price earnings multiples were at low single digits which have gone to high double digits. So early teen yields in the U.S. went down to zero and a 7-8 times price earnings multiples went up to 20. Now if you see a reversal or you do believe a reversal of trade takes place, it is not very good for equity as an asset class. So that is the trade that will play out. So if you are looking at reversal in interest rates anywhere in the world, I think that is the way the market will play out – in a significant de-rating of price earning multiples of equities.

RBI’s Next Move

Traders and economists seem to be divided on the RBI’s next move with respect to interest rates. Again does demonetisation change the trajectory in any way?

It’s clearly deflationary and interest rates would…at least interest rates should be on the downhill rather than going up. So if an economy is deflationary – I think India should see this case for at least next year or two – interest rates can’t go up.

But given that interest rates are already on a downward trajectory, the RBI governor will probably want to wait and watch how growth pans out for a quarter before he hikes interest rates.

Well, nothing much to wait for in the next quarter or two because everything is going to fall off quickly.

Investment Themes

So you indicated that it is going to be a while before things get back on track. In such a situation, what themes would you absolutely avoid and which would you consider buying?

Let’s look at it the other way round. Let’s look at how corporates in India will shape up in an economy like this. In the first sense, your companies with robust balance sheets and no leverage will continue to get higher market share in the segment that they operate in. Because this economy or marketplace is going to move from a cash economy to a credit economy. The only guys who can provide credit are the guys who are organised, aligned with the credit system and are deleveraged. So imagine a business which is operational, with a market share which is high and a zero debt balance sheet, you can grow your market share disproportionately because the weaker section of the industry is going to collapse. So you’re going to consolidate business significantly faster than you have ever seen before and this is not just because of demonetisation, but also because of GST.

The second is what happens with the government’s balance sheet. We very clearly see on the expenditure side, interest rates are going to come down and government is the largest borrower in the entire system, provided the expenditure levels are going to come down. On the other end, they could choose to get a capital receipt from the RBI. So you’re getting a company or a government which is getting a capital receipt plus it has lower expenditure so you have a balance sheet which is shrinking. Now that is my best case scenario for buying a company. And in this case it is the government of India. So not everything is negative. It is a huge positive but the situation of timelines could be completely different in both cases. Near term, I think it is a long pause for capital markets but in the longer term, everything is falling into place.

Your third level is your tax-to-GDP ratio. If all of this cash comes into the system, your cash-to-GDP ratio is only one way which is higher which again goes back to the government’s balance sheet. The government becomes a very integral part of this entire economy. This one balance sheet has to do a lot of heavy lifting for the next two years. You’ve got to define as to where to put this money to work. And that is going to be the place where this economy will flourish. So you’ve got the makings of a very big “spender” in terms of the government. At the other end of the extreme you’ve got consolidation of the corporate environment and once you’ve consolidated at the corporate environment you have few corporates targeting bigger spends. So it makes the case simple in terms of where you want to be. So let’s look at it on a quarter to quarter basis, you’ll know exactly where the government is going to spend.

Thing to avoid? It is simple. From an investment framework, avoid everything which is expensive. That is my sense of how a portfolio needs to get constructed. From a segment point of view it is reasonably bad for consumers and the consumption economy. But I’m not the first one to say it and I won’t be the last one to say it. By the time December results come, you will see a lot of managements will be saying something very similar.

‘Markets Still Over-valued’

So we have seen some correction in the large caps but you still don’t think the Nifty is reasonable valued right now?

It’s not cheap, still.

‘Avoid PSU Banks’

So lets move onto public sector banks because that is one sector which has seen a very strong rally driven by low cost deposits treasury gains but do you believe that markets are overestimating the benefits of PSU banks? How would you move your allocation between private sector and public sector banks?

I am actually the wrong person to ask on PSU banks. I don’t believe they are very efficient allocators of capital. So there is always a trade in something which is cheap. There is always a trade in something which is completely smashed down. But I don’t think there is anything structural with these companies. So if the only thing that happens with these companies is that the government bails you out at every point in time as they did at the end of the last industrial cycle, over periods of time they continue to suffer from a loss of market share and I believe the loss of market share in retail and consumer is far higher and they virtually don’t exist in the consumer segment. So there is nothing really structural about these businesses. They are part of the economy and if the economy does well, these companies do well. But over a long period, they have just destroyed capital. So I would rather look at a well-run financial services company than play a valuation bet in some of these names.