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Stock multiples looking pricey due to under-trend earnings: Rahul Bhasin

Valuation distortions need to be seen in the context of cost of money, says Rahul Bhasin.

ET Now|
Last Updated: Jan 24, 2020, 04.49 PM IST
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Rahul Bhasin, Managing Partner, Baring Private Equity, says valuation distortions in the current market need to be seen in the context of cost of money, which is lower in the whole world today than what it was in last 1,000 years. Excerpts from an interview with ETNOW.

The market is at an all-time high. Economic indicators at a record low. Nobody is excited about spending, yet consumption stocks are trading at PE multiples, which are highest in the world. Will the economists get it right or will investors like you get it right?
My experience has been that markets are far smarter than people give them credit for. Of course, there are distortions and people get carried away at times, but you have to look at valuations in the context that the cost of money today in the whole world is lower than what it has been in last 1,000 years. Look at any of the reserve currencies in the world, whether it is the US, Japan or most parts of Europe, you will find everybody has got very strong monetisation programmes going in some form or fashion, and interest rates are at very low levels. If you have the cost of capital that low, driven by policy, then you will have a situation where asset prices will look pricey in any historical context.

But if you discount that cost, you will find they may not be that unreasonable.

In the Indian context, it is quite interesting that we have had the highest cost of capital in the world, probably, in real terms over last five-seven years, and for those companies, those stocks and that part of the economy which run on the domestic cost of capital, you will find that valuations are cheap. That is largely midcaps and smallcaps and that whole segment. But the part which is fuelled by the money from ETFs and from global capital, which has a far lower cost, you would find the multiples very expensive. I think that is the dichotomy that you are seeing in the market today, and that creates opportunities for all kinds of players, whether you are momentum player or a value player. I think it is a market for everybody at this moment.

The purist would say that if you buy stocks at PE multiples of 50, 60, even 100 times, the returns will not be great. The new theory I am hearing is that if you are in a low interest rate environment, you cannot value stocks because if earnings are going to be there and if interest rates are low, then do not get trapped into valuing stocks based on PE. Do you think we need to understand that something different is happening in the world because you bought stocks that cannot be called very cheap and yet you have made money in Manappuram, Marico, Mphasis?
In a market like India, where you can have compounding growth over many periods of a very extended period, you can see or work with companies to gain market share significantly. So that is organic growth, growth which comes from gaining market share. There is also growth in income which accrues because of productivity gains, and from essentially working with companies to reduce cash cycles. You start combining all of these gains together, then what looks nominally expensive can organically work out quite reasonable in the long run.

I am very lucky and fortunate that I have long-term capital available. Because when you start doing any of these activities, what tends to happen is that you depress earnings in the short term, which is why most of our activities tend to be more in companies that are private, not public. If you work with a company to increase its brand, you increase expenditure. If you put new IT systems in place or ERP systems in place, you increase expenditure; you increase their quality processes, you increase expenditure, you increase entire HR processes and bring in more talent, you increase expenditure.

So if you buy what looks nominally expensive, you make it even more expensive from a short-term multiples perspective, because earnings get depressed. But if you have a perspective that is long-term enough, you get the payoff from these kinds of businesses and these kinds of companies, which is why for more than two decades we have compounded money at over 30% a year.

So there are a number of opportunities of this kind in India. You talked about Manappuram, for example, it is extraordinary. The company has phenomenal distribution. If you look at the number of transactions it does in a day, it is larger than most banks in the country. And it has distribution around the country. Its return on assets is 5.5 per cent, and if you look at the growth rate, it is almost double of its PE multiple today.

Obviously, such businesses will do well. But it was a long journey for us. We have been there for a long time, working with the company to increase the platform of different businesses, which have been built over the last five-seven years. It is a journey that takes a lot of investment, takes a lot of patience, but you come out of it on the other side right. You tend to get a lot of returns and it generates a lot of value for all stakeholders.

So what is happening in the IT space?
My belief is, even a lot consumer companies have become very expensive. A couple of things will happen now. Demand has been very artificially depressed at the moment. You are going through a transitionary phase; you are going through a lot of cleanup in the economy. You had this negative wealth impact of real estate. The real cost of money has been extraordinarily high, and that has depressed consumption. And long-term growth is actually way below trend.

So you are not looking at peak earnings right now; you are looking at earnings that are probably under trend. So, multiples tend to look higher. On top of that, you had a lot of cleansing of the tax system, because of GST etc, which will benefit those players which are better organised and better compliant at the cost of those who were doing business in a non-complaint manner. I think a lot of these businesses will benefit. You will see a similar trend even in real estate, where you will have a handful of companies doing very well. We have investments in the listed environment in Prestige, in Brigade which have done extraordinarily well for us. We felt most of the weaker players will disappear from this sector in one or other fashion and larger players will actually gain market shares and have very robust growth and that hypothesis has worked out correctly.
A very narrow strip of the market is priced to perfection, and that is really because of the arbitrage in cost of capital, which is driving that phenomenon.

-Rahul Bhasin

Let’s take a look at the IT pack. I want to get your views on whether you feel midcap IT, in particular, is starting to look attractive given that the heavyweights are actually not showing that kind of robust performance?
Most of the midcap IT players, which have not been rolled up, are quite well managed and that the opportunity in the global IT world is still very large. Indian companies still have a very robust cost advantage and they have access to good labour. Those fundamental competitive drivers have not disappeared. So these companies will do well. You will not see that tear-away growth, which was there 20 years ago in this sector, where a company would double every year or every two years, but for an investor looking for a 10-15% kind of organic growth over the next decade, these companies, especially the better-managed ones, will provide that kind of growth. I do think the bigger opportunity is from the disruption being caused by AI applications in different industries and you are already seeing disruption using these kinds of technologies in companies like Bajaj Finance, which has built a huge market cap in last decade or so by using and incorporating a lot of insights from these technologies. The winner and loser will get determined in this fashion. If you look at Tesla, a company which runs on an operating system. If something goes wrong with the car, somebody in central Tesla can actually rejig the car and rejig different functions in the cars to better optimise its performance. They actually capture the data of how the car functions in the conditions where it functions and can finetune the car in that situation.

Now this kind of activity, the capturing of big data to actually understand how you can optimise your profit margins and your business model, these are the disruptions. This is where large value creation will happen; not in the traditional IT services kind of business. Having said that, they will still give you your steady 10-12 per cent kind of returns over the next decade or so.

Do you think there is going to be a big earnings pool or a big growth sector, which will get unlocked this decade? To add to that where do you see a combination of earnings growth and PE growth, because that is an ultimate combination for investor? Do you see that happening anywhere in the listed space at all, or everything is priced to perfection?
I did allude to some of the companies in our portfolio where price-to-earnings multiples are significantly lower than the growth. So you are inevitably going to get PE expansion and the value of the growth that inevitably happens. No, I do not think everything is priced to perfection. A very narrow strip of the market is priced to perfection, and that is really because of the arbitrage in cost of capital, which is driving that phenomenon.

A lot of the small midcap companies are not priced to perfection, of course. It requires stomach of a long term for some to have a long-term exposure, but there is tremendous value that we find all the time. Also a lot of opportunities are arising today from the government’s very stated intent to divest a lot of the public sector companies. A lot of them are very rich in terms of assets, and poor in terms of productivity. So if you make a call, greater clarity emerges as to which assets might get sold down. If there is half decent management that takes over, which is better aligned, you will find massive value creation in that ecosystem over the next decade or so. I think that will be fantastic for the economy.

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