Choose the volatility you are happy to live with: Kenneth Andrade

Image: Mexy Xavier

Kenneth Andrade says a capex-driven revival led by corporate India may not happen

When Kenneth Andrade moved out of IDFC AMC, where he was the head of investments since September 2005 and managed Rs 8,000 crore as a portfolio manager, in September 2015, it was not to join another similar venture or enter the private equity business. Instead, he decided to take time out to research new businesses in a changing market (even as he paid some attention to his vinyl collection—which includes Adele and Simon & Garfunkel records).

Though he does not reveal any ideas about his next venture, Andrade, 45, says that he will be back in the Indian markets as a money manager in the next few months. He believes that moving out of the institutional space has allowed him to become more objective—he doesn’t necessarily need to have a positive or an optimistic bias about the markets when he analyses data. And based on the data he has analysed, Andrade feels that Indian corporates are in a debt-reducing mode and mid-cap companies have been leading this trend. At the same time, they are adding and building assets through existing cash flows with no recourse to external capital.

According to him, 2016 will see an acceleration of this trend, which would be beneficial for Indian investors. In fact, he expects the year to be more challenging than 2015, one in which sanity would temper the current frenzy in second-line stocks.

Excerpts from an interview:
Q. What have you been doing over the last few months, since you moved out of IDFC?
Organising thoughts, collecting data and meeting up with old friends. You know, there is actually a lot to learn if you don’t look at investing as a job. You then look at data without having to be bullish all the time. You break down companies not in terms of market capitalisation but on their ability to generate profits from existing infrastructure. This, in an institutional framework, was a bit difficult to do since there was always a size bias. So it has been a very refreshing break.

Q. As an investment philosophy, you have stayed away from debt-laden companies. But over the last few years, Indian companies have been over-leveraged. How do you look at it?
At a macro level, I can’t say I look at things very differently from where I left off at the institutional framework. The bias towards companies with zero or low debt continues.

I go back to the ’90s where except for a handful of cement companies, Shree Cement and Ramco Cements notably, and probably the Jindal group, not too many businesses flourished after building their business through excessive debt. These are the few that made it through when the cycle revived; however, the probability of a significant number of debt-laden companies making it through the cycle has historically proven to be low.

Today, interestingly, there are a lot more choices than before, increasing the investing universe. Companies have been very diligent in reducing the size of their balance sheets. Indian corporates are finally and firmly getting into a de-leveraging mode. It is starting to show up across a breadth of companies.
 
On an aggregate, however, it is still a concern since, overall, the debt-equity has not come down. For the BSE 500 companies—and specifically for the non-financials like manufacturing, etc—the debt-equity number is still at 100 percent. This is its all-time high since 2000. Now what the market expects is a big recovery in capex but I continue to say I can’t see where corporate India can further leverage to kickstart the economy. A capex-driven revival in the industry, driven by corporate India, just might be a non-starter.  

The assumption that the government will chip in with funds to start this cycle is plausible. But it will be measured and there is unlikely to be anything big bang about it all. The economy, at least what balance sheets tell us, has expanded almost seven-fold in 10 years.

There is little scope for this kind of expansion through the same conventional sources again. Any financial stimulus has to be routed differently if it has to have a multiplier effect. Else a lot of this perceived stimulus will go down to repay corporate debt.

Q. You have seen that returns on equities (RoEs) are at a 15-year low. What does it imply? Can you talk about government securities’ (G-secs) yields and RoEs and how they changed direction in extreme cases?
The argument is that because of low RoEs, the incentive to invest by any entrepreneur is non-existent. When your return on invested equity by an entrepreneur is close to a risk-free return (like in the case of G-secs), expansions of balance sheets (business) are normally very illogical, unless you are a super contrarian.

For BSE 500 companies, RoEs have inched as close to 10 percent now, with the aggregate profit actually lower in 2015 than 2014, or close to FY2011 levels. So how does one even take a decision to invest? All this is showing up in credit growth, de-leveraging and a very anaemic IIP growth number.

I think we are in that zone as an economy where expansions will be measured and a lot of entrepreneurs will look for payback/profitability on already incurred capex before they commit anything incremental to the business.

Q. Are we getting into a green zone then? Where growth is catching up and we don’t have to worry about external issues?
The good news is that the worst has already happened. The downsides are known. For the first time, we are seeing a convergence of corporate sales growth and GDP growth numbers. Anything lower is incremental and would not be significant in the near term. The risk on financial markets in the domestic context is low. The bear market in commodities is probably the best thing any Indian can ask for. Domestically, the entire system seems to have acknowledged the problem of inefficient capital and high debt, and is dealing with the same. This could signal the recovery of capital efficiency in the system. Thus I’m not too worried about out-performance of Indian markets but an absolute return in the near term could be a challenge.

External volatility could be an issue that markets would have to deal with. India is a participative economy. The boom-bust cycles in equities have coincided with the regional markets. I am not sure that has materially changed even now. So we do need a stable external environment for any material cycle to emerge.

Q. How is the current cycle placed compared to what happened in the last two decades?
India pulled through in the last cycle because of the global recovery. The capacities [in the 1990s] around textiles, metals and other commodities gave companies the ability to price products in the international market in dollar terms. I remember steel prices going all the way down to $160 per tonne between 1998 and 2000 and then rally to $1,000 per tonne midway through the last decade. This, plus the rupee depreciation, helped these companies/assets become financially solvent in 2008, a recovery exactly a decade from where these assets got laden with financial excesses (high debt and low equity). Large commodity companies, notably Tata Steel, had RoEs in excess of 40 percent for almost two years, something they had not seen for a very large part of the company’s history.

In short, India depreciated itself out of the problem in the last cycle.

However, power and fertiliser plants set up in that era did not see as much benefit compared to export-oriented companies or firms which manufactured commodities, which linked their prices to landed costs. Power and fertilisers were sold in the local market which was rupee-denominated and they clearly could not make supernormal profits to get through the excesses of the ’90s.

We have a larger part of the latter problem this time around. Infrastructure assets have to earn revenues based on the earning capacity of the domestic economy. They are rupee-linked. So even if there is depreciation of the currency, a lot of these companies will not see a rise in turnover or asset prices connected to the fall.  

Another thing that does not help is that India again had a number of commodity companies that acquired assets at the peak of the cycle, and all through debt. This plays out very negatively at a time when commodity prices have virtually halved in value.

Q. So is there a silver lining?
While that is just one element of the aggregated number, what is happening at the other end is very bullish. If you break down the BSE small-cap index, over 50 percent of these companies are either debt-free or paying back debt at an aggressive pace. So the clean up has already been done. Even if markets go nowhere, anyone who is shrinking capital employed is an interesting play, especially if you have a universe where 50 percent of the companies are doing the same thing. You can be sure that analysts will have a fair amount of work to sift through this data.

Q. Which are the companies that will benefit?
I tend to give higher weightage to a cash flow positive nature of business rather than the focus of a pure EPS-driven model. The former has more longevity. Secondly, if the nature of the business is cash flow positive, in a no-growth or a low environment, this also has to have large rewards when the economy does turn.

Growth, I don’t think, is a predictable number, so as an investment style, I would rather concentrate on companies building up capital efficiencies by reducing the denominator with regard to capital employed.

What we are witnessing now, in the form of strength in the small- and mid-cap part of the market, is not backed by data to ensure its sustainability. This might just go into bubble territory if there is even a slight bounce back in the economic environment.

Q. Was it the same thing last time around?
I can’t say I have seen anything like this in recent memory. In early 2013, it was a valuation market. Stocks were really cheap; 2015 corporate balance sheets are deleveraging and creating financial capacity to leverage the next cycle—you just need to pick them right. Timing growth will always remain a challenge.

Q. For large- and mid-cap investing, how have the cycles moved?
All these indices move together. As an investor, you need to choose the volatility you are happy to live with. On the upside, small-caps are historic outperformers and the reverse is true on the downside. If you are happy stock-picking, I would not worry about capitalisation; just choose the company that addresses a large market and has financial discipline. That’s half the battle won.

Q. When do returns converge for large-caps and mid-caps? What should investors do at that time?
All of this converges at the bottom of the market or economy. But it is difficult to time it. As an investor, I keep reminding myself that if you have them—the different categories, index, small-cap and mid-cap—in the right ratio, little can go wrong. The discipline is to reset the weightages and not get carried away by the historic momentum.