Financial Services Industry May Be Facing Its U.S. FDA Moment, Says Alchemy's Hiren Ved

Hiren Ved: I've been saying this from the beginning of the year that because we have had such a strong run-up in the markets, it has almost become fashionable to be cautious going into early this year. And I'm not saying for a moment that one should throw caution to the winds. Obviously, you know, we have to be cautious in terms of where we are investing. You are absolutely right. We are not cheap, but we are not expensive either.

I think we have been saying this for a while that whether you look at the last nine months of this fiscal, the way the broader market earnings have panned out, or if you look at a four-year picture from Covid till now, it's quite staggering how earnings for the top 500 companies have grown. They've almost compounded at 38% a year. So if you take the Nifty 500 companies and the four-year compounding, if I were to annualize the first nine months and then look at March ’20 to March ’24, we've seen a pretty staggering compounding of earnings. So, to that extent, the fundamentals of this bull market are very solid. They are based on earnings.

Now, obviously in any bull market, we do see excesses which build up. There can be pockets of exuberance. We are seeing in this market that a lot of the returns—because of the high visibility over the next few years—could be front loaded. Therefore, obviously you know, this market can be susceptible to both, price and time-wise direction. So it's quite possible that, that may happen. And to me, it looks like that there is, as you mentioned, a coordinated regulatory action to kind of preempt any bubbles, or so called excesses that might happen in any part of the market.

So I think, these kinds of cautions, breaks within bull markets are actually healthy because then you know, people tend to dial back and you know, if there is unbridled fear and if every day or every week the markets keep going up. You know, it's a sure recipe for building up bubbles. So I think, occasional cautions, whether it is external intervention or corrections because of whatever global macro, or whatever, is actually good in a bull market. But I think, this bull market is alive and kicking.

Yes, we should all be responsible and cautious. But I don't think that it's going to change the basic direction of this market. I think, we are very clear. We are in a solid bull market.

Hiren Ved: I think, you're absolutely right. All the recent actions by the regulator point to the fact that they want to preemptively cool down unbridled, unsecured lending. Now, whether it comes by way of soft advice, whether it comes by way of strictures, when it comes to adhering to certain operational processes and risk-management processes, I think that this will definitely take the focus of the lending institutions away from growth, to sort of look at their internal controls and processes and it may impact growth in the short to medium term.

In the long run, it's all good because, you know, strict regulation is painful initially, but it's always beneficial in the long run. But unfortunately, there is a cost to be paid. And the cost for that would be in terms of growth? We don't know, we'll have to watch the fourth quarter numbers and then look at it. But certainly, I think, all the players will be focused on getting their house in order, relooking at their systems and processes. I do believe that this is an environment in which it is quite difficult for the sector to deliver returns in the near to medium term.

You know, I use this analogy that the financial services industry may be going through its USFDA moment. So if you know what I'm saying and in 2015 and 2016, when similar regulatory interventions were done in the pharma industry, first we thought, oh, it's just a one-off plant, one-off company. And then, one after the other, you had almost every pharma company coming under very severe scrutiny. Obviously,the intensity was different. In some cases, they got an import alert and now something similar is happening. The RBI is actually asking you to stop a certain line of business. Obviously, that's going to impact growth, and to some extent in the near term, it could even impact the sentiment of the sector. You know, as I said, in the longer run it's all good. But in the short to medium term, I do believe it will have an impact.

Hiren Ved: Well, I think, you know, they also got a wrap on their knuckles at some point in time. So I hope that it's not one versus another. But for funds, which to some extent, have to be benchmarked to a certain weight in the sector and they can't go completely underweight or zero weight. There will be some rotation away from let's say, the NBFCs to the bigger banks, because there might be a perceived safety there.

But you know, I mean, my big point has been that I think overall, you know, private financials were the leaders of the previous bull market. And that's a space, which had done quite well between, let's say, 2010 and until Covid. And then, obviously, because of Covid, there was a disruption. But, you know, most of them had to make heavy provisions and had to raise capital. But broadly speaking, if you look at it, that entire lot has underperformed the market. My sense is that, you know, their sheer weight in the index kind of has peaked at 37-38%. While I'm not making a case by saying that they won't deliver returns, I think they will, you know, quality financials will deliver returns.

But if I take a slightly longer-term view, my sense is that their relative weight in the index will keep on falling and some of the other sectors in the index whose weight was highly compressed, will actually relatively rise. So I think that there will be bouts where these companies will deliver both absolute and relative returns. But if I take a slightly, you know, five, seven-year picture, my sense is that they will broadly underperform the market.

Hiren Ved: You know, this is a very potent time, especially for any sector that reaches the end consumer like a B2C sector. The government would want that if there are any input benefits, or other benefits, then those should be passed on to the end-consumer.

We must understand that usually, during election times, the tolerance for inflation or anything that is inflationary is very valuable. While in general, this government has stayed away from intervening, I think this is usually a very sensitive time where pre-election, they don't want any flare-up in inflation anywhere. Look at a series of things that they've done. For example, it's quite possible and it has happened so many times that you will see that if there are certain agri commodities, which are likely to see an increase in prices because of either weather issues or production issues, they will ban exports. They did it for some variety of rice. Then they came up with an ethanol policy, where they said that you can't use sugarcane to make ethanol because they realised that sugar prices could go up.

I think if you look at the sum total of the picture, it is very clear that when it comes down to B2C industries, and when it impacts the common man, I think the government would want any benefits that arise, whether because of taxation, whether because of input costs, it needs to be finally passed on to the end-consumer. So all of that is what I look at, is part of the same theme that they want the impact of inflation to be felt lower on to the general populace.

Hiren Ved: You're absolutely right. So if you look at the weightages from 2003 to 2019-20, the weight of financials went from 15% to almost 40%. And now they are receding. While the weight of so-called cyclicals—you put four or five sectors in that which includes power, energy, capital goods, autos, real estate, infra, cement—what you call as industrials or cyclicals or energy, the weightage of all these sectors put together had fallen from 67% in 2003 to almost 30%. And this had happened when the markets had gone up seven times.

So I think the time has come, when weightages of these sectors are likely to slowly and steadily move up in the indices. Therefore,I think with the theme that I've talked about with you in the past, the whole manufacturing renaissance, the fact that this time the growth is not led by consumption, but it is led by the capex cycle, initially triggered by government capex post-Covid, which continues till date. Every year, the central government is spending more and more on infrastructure, coupled with the PLI schemes, coupled with the supply-chain diversification that is happening globally, coupled with the demand for power that is rising. To me it looks like those neglected sectors—which we all shunned during the previous bull market cycle where it was essentially financials and consumption that did very well—are all going to come back.

So I think that power, energy, cap goods, auto, real estate, hotels, infra, cement, all these sectors—to my mind—will see an increase in their weightages over the next couple of years. But you must understand that it's a slow, steady change. It happens in a very stealth manner. You know, slowly but surely people realise that what they are owning is not really delivering returns, because we all have the biases of the previous cycle. And because in the previous cycle, when Nifty earnings growth was in single digits and these high quality franchises were delivering double-digit earnings growth with high ROEs, that's where all the money gravitated towards. And then, eventually, these sectors became over-owned, which means that their relative weight in all the benchmarks went up, while the relative weight of the benchmarks in all the so-called cyclical or dirty sectors went down dramatically.

I mean, real estate, for example, was 7% and it went down to almost 0.7%. And now, from 0.7%, it's just gone up to 1.2%. So many of these sectors are likely to come back and I think that what most investors and managers are doing is, they are grappling with this transition that is happening. Suddenly, the PSUs and the real estate... Actually, if you see from Covid, it's the PSU banks and the real estate that are two best-performing sectors and which is where people have the least exposure today. So I think, this is a trend. As long as this trend persists, there are some early adopters and then over time, everybody catches on to the trend by which time the trend has significantly played out.

So it's always interesting, in markets, how these things happen. But I think this is what we believe is likely to happen. That's why, you know, you'll see that people keep justifying, owning private banks and financials endlessly. And they're all great franchises, nothing wrong. Even the great consumer franchises. But on a relative basis, they keep underperforming and the underowned area of the market keeps outperforming.