Status quo has been disrupted; both globally and locally
Events of the last few months starting with Brexit, followed by the US presidential elections and more recently the referendum in Italy clearly point to a change in the political landscape globally. Years of stagnation in living standards of the majority of developed world population has resulted in simmering discontent which is now coming out in the open in the form of radical political choices. The merits of these choices can be debated no end; however, its impact on the economic landscape can’t be wished away. The extent of impact on the global economic linkages will become clear only after a few years; however, the direction and the import of the same will become apparent as the new political dispensations start taking policy decisions over the next few months and quarters.
Closer home, after taking incremental but effective steps to improve the Indian economy for the last 30 months, PM Narendra Modi has opted for the big gambit, possibly realizing that incremental steps will have only incremental benefits and that radical changes in the Indian economy can be brought about only by disruptive steps like that of ‘Demonetization’. While the jury is still out on the success or otherwise of this huge gambit (though almost everybody agrees that implementation could have been better), it is clear that PM Modi is willing to up the ante and go for the jugular in his quest to change the economic landscape of this country.
World moving to ‘de-globalization’ and India to ‘formalization’!
The change in political landscape in the United States and the upheavals being seen across European Union is unambiguously telling us that the phenomena of ‘globalization’ has hit a massive road block. Indeed, global trade data has been pointing in this direction for some time now and the political discourse on economic policies favoring a less ‘connected’ world is growing louder by the day. It is probably a foregone conclusion now that the Trans-Pacific Partnership (TPP) will be buried even before it sees light of the day and that many other global trade pacts and policies including NAFTA will come up for debate and renegotiations.
While some of these changes (for example falling apart of TPP) will be good for India, a less connected world economically will certainly impact some segments of the Indian economy as well. However, the defining change of this decade for the Indian economy will be the shift in business from the informal (unorganized) to the formal (organized), led by the demonetization drive and the impending implementation of the GST bill. The immediate economic benefit of ‘Demonetization’ to the government is unclear today and will become more apparent only on March 31st, 2017, the deadline for the second and possibly the last VDIS; however, it is clear that PM Modi will do his best to ensure that business practices of the informal economy doesn’t return to status quo going forward.
We at Quest believe that both carrot and stick will be used by PM Modi to push the informal economy into the formal system over the next few months and quarters. Not every small business will be able to successfully make this transition but India will definitely end up with a much larger organized sector and possibly a much smaller unorganized one. This change will also reduce the tax disparity that currently exist between the organized large businesses (most listed businesses fall in this category) and unorganized small SMEs (who will slowly become part of the formal economy) thereby improving the relative competitiveness of the organized large businesses in the medium term.
However, the disruption caused by ‘Demonetization’ and possibly closure of a section of the informal economy will have a short term impact on demand for products and services, thereby resulting in lower GDP / GDP growth for the next couple of quarters. More importantly, the movement from ‘parallel’ to ‘formal’ economy will have profound impact on both the consumption pattern and savings / investment pattern of Indians. While it is relatively easier to project the change in savings / investment pattern in India going forward (shift from cash / real estate / gold / jewelry to financial instruments), it will be much more difficult to project the change in the consumption pattern of the Indian middle, upper middle and rich class. Undoubtedly, this change in consumption pattern will have a major impact on the relative operational and financial performance and therefore stock prices of companies / sectors in India in the medium term.
Where do we go from here?
Any kind of transition is painful (only the degree of pain varies) and clearly India is undergoing a transition of moving its parallel economy into the formal system. There are interlinkages between the two (be it in the supply chain or in the form of demand for products and services) and to this extent, performance of the organized sector too will be impacted in the near term. However, if we step back a little and forget the pain inflicted by ‘Demonetization’ for a moment, India has come a long way over the last 30 months both in terms of its perception in the global community and in terms of macro-economic parameters (fiscal, current account and monetary conditions are all vastly better today) as well as actual on the ground situation. If the union government continues with the good work that it has done till date on liberalizing the economy, reducing corruption and leakages, increasing allocation to the infrastructure sector and improving ease of doing business, India will undoubtedly be a much stronger economy two and half years from now when we have the next general elections.
Global disruptions in the form of capital flows, changes in trade pacts and policies and volatility in commodity prices are likely to continue going forward as well. Fortunately, India has a large domestic economy, rising domestic savings (that is increasingly finding its way into financial instruments) and a vigilant government to fall back upon during these uncertain times. Advancing the budget by 27 days is symptomatic of the lateral thinking of the present union government. We expect more bold steps in the ensuing budget; lower effective tax rates (for both corporates and individuals), higher tax collections through widening of the tax base and significantly higher spending on rural, infrastructure and social sectors almost seems to be a given. We believe that with PM Modi at the helm, the efficacies of the policies from a longer term perspective is not a question mark; only the extent of transient pain is. However, let us not forget that PM Modi is a very astute politician and he is aware, more than anybody else, that we have general elections looming again in less than 30 months!
QuestPMS has done well since inception. While its performance has been more or less in line with the market in the short term, it has outperformed the market in the medium and long term. The outperformance has been more pronounced in the 3 to 5 year time frame. The same is reflected in the numbers listed below:
(Returns above 1 year are CAGR)
|PORTFOLIO||SENSEX||NIFTY 50||BSE MID-CAP INDEX||NIFTY MIDCAP 50||BSE SMALL-CAP INDEX||NIFTY SMALL 100|
The Above returns are of a Model Client as on December 30, 2016. Returns shown above are post fees & expenses.
Returns of individual clients may differ depending on time of entry in the Strategy.
Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.
We believe that shift to ‘formalization’ and changes in the consumption pattern of the Indian middle, upper middle and rich class will have a lasting impact on the Indian companies. The degree of this impact will differ from one sector to another and within the broader sectors too, certain sub-segments will be better positioned than others to benefit from this change. India over the last couple of years was becoming a stock picker’s market and now it is even more so given the recent changes. Here we believe our experience of almost 3 decades in capital markets will come in handy in identifying stocks that are better positioned to benefit from the changing dynamics of the Indian economy.
The India stock markets off late has seen wild swings between optimism and pessimism. Outflow of FII money consequent to the changing economic outlook and rising interest rates in the United States has further accentuated volatility in the markets. Some of the good quality names / scrips which were out of reach in terms of valuations are suddenly seeing their prices being corrected to more reasonable levels. This moderation in valuation is indeed providing an opportunity to those who are alert and vigilant to align their portfolio in line with the new undercurrents in the Indian economy.
We at Quest have been monitoring our portfolios very closely and have been working with a single minded focus of tuning it towards companies and sub-segments that we believe will be positively impacted by the rapidly changing business environment. Majority of the stocks in the QuestPMS portfolios are already well positioned and we are taking advantage of the current volatility to make incremental changes that we think are required and will hold us in good stead in the medium term. Quest PMS portfolio is expected to deliver earnings growth of ~28% CAGR over the next 3 years i.e. FY16-FY19. Still, it is trading at a price earnings ratio of 15.5 and 11.9 on FY17 and FY18 basis giving us confidence in the strength of the portfolio and its ability to outperform the market in future as well.
The Indian economy that was picking up momentum over the last few months has clearly been hit by the demonetization roadblock. While there may be a debate over the extent of impact, even the Modi government accepts that there is short term pain. This is important as recognizing the problem is the first step in addressing it. PM Modi off late has shown inclination towards taking bold decisions (starting with surgical strikes on the border and then ‘Demonetization’) and we expect the same to continue going forward as well. Indeed, a strong push will be required to put the economy back on its growth path and we believe that the government is fully seized of the matter. Implementation of GST too can provide that push; however, the initial stages of GST implementation will be disruptive as well.
As an investor, it is important to visualize where India is likely to be in 2 to 3 years from now rather than focusing only on the situation over the next couple of quarters. Ability to see through the maze and see far enough will be important in identifying the winners of tomorrow. This will require one to keep one’s ears close to the ground to identify new trends and not be influenced by the noise that is all pervasive today. We at Quest are focused on diligently following our investment process, closely monitoring our portfolios and making changes where required in line with the changing business dynamics. We firmly believe that the challenging markets of today bring with them ample rewarding opportunities as well and that those who are alert and vigilant will profit from these opportunities in the coming quarters and years.
On this note, I would like to wish all our investors a very happy and prosperous new year!
December 30, 2016
DISCLAIMER: This communication does not constitute or form part of any offer or recommendation or solicitation to subscribe or to deal with QuestPMS. The views expressed by Bharat Sheth, Portfolio Manager QuestPMS are his personal views as on the date mentioned. These should not be construed as investment advice to anyone. This communication may include statements that may constitute forward looking statements. The statements included herein may include statements of future expectations and, are based on the author’s views, observations and assumptions and involve known and unknown risks and uncertainties that could cause the actual results, performance or events to differ substantially or materially from those expressed or implied in such statements. The author does not undertake to revise the forward-looking statements from time to time. No representation, warranty, guarantee or undertaking, express or implied is or will be made. No reliance should be placed on the accuracy, completeness or fairness of the information, estimates, opinions contained in this communication. Before acting on any information contained herein, the readers should make their own assessment of the relevance, accuracy and adequacy of the information and seek appropriate professional advice and, shall be fully responsible for the decisions taken by them.