SMIDs Are Future Of India, Says Sanford C. Bernstein's Venugopal Garre

Venugopal Garre: I think India is now in a pretty unique situation. There is a global excitement growing towards India for a lot of right reasons. Part of that is the fact that macro has, you know, seen a pretty good recovery off the lows. And India stacks up pretty much as among the best performing emerging markets globally, in terms of overall GDP growth as well.

But the reality is that if you were to just look outside of India, normal comparables usually happen with China, which has been the one dominating a lot of these emerging market funds and also in terms of global allocations. Valuations there have compressed quite a bit in the recent years and (that) has been an ongoing process for the last year as well. So the gap has expanded fairly widely. Normally, valuation calls itself are usually not taken as a gesture in terms of how to approach investing in a particular country because you do tend to look at the structural and cyclical practice as well, which is where India's still favoured. But I would probably argue that compared to where we were 12 months back and where we are right now, and even on relative since, valuations very clearly look excessive.

There might be still pockets of opportunity, but across the board, it is becoming a bit more tougher to argue even the growth angle. You have to really discount a lot of things into future, expect and be a bit more imaginative in terms of how to look at price-to-earnings multiples or build probably an earnings growth, which might last much longer into the future. So these are the challenges that I see.

You know, one characteristic way I sort of represent that is that over the next 15 -20 years, I guess at the top line, top down index level, the large-cap index has to deliver anywhere from 12-13% earnings growth, on a sustained basis. That's a pretty large compounding that one has to expect, and for SMID caps around 17-18% over the long run. These are not very easy to achieve, when you look from a long period of time. Of course, you could achieve that over a shorter period. So this is where I guess is a challenge that somewhere down the line, we have to see some form of a flatlining of the markets, which is what we believe should happen this year.

Venugopal Garre: The very simplest way I look at it is that India at the end of the day is an emerging market. It is always better to, you know, compare ourselves with how emerging market constructs work. The funds are very different as well. You can't have an emerging market fund investing into Japan, for example. Japan has its own story, but look at the currency as well. So, if you weren't really well-hedged, you would have lost a lot in currency as well.

But the reality is that, if you compare with Latin America for example, where, growth rates are still very meagre, for a lot of these countries, or outside of that, even in Asean, which are a bit commodity-driven or even China, India might look up really well in terms of overall macro construct, not just for history for last year, but for today as well. But the reality is that, the question simply is number one, is it priced in? Number two is that, you know, from an international fund flows’ perspective, if you're not going to see some of these larger countries do well, which is, let's say, China, you know, tends to see a lot of redemptions happen. So it automatically restrains the ability to sort of see a fairly large FII flow happening into India from that perspective.

Now India as an own asset class is something they could talk about, but we are still too early to be in that situation where you can raise money, let's say, a billion-dollar raise just for India alone. I don't think we are in that situation right now. I could argue that 10 years later that could happen. So that's where the challenge is. The constraints of FII flows and how you approach investing… May be a retail investor globally has a choice of investing everywhere and anywhere, but it is not the case for funds. So you need to be cognizant of that.

Venugopal Garre: It is a fair point. Believe me, all of us like telling stories, and you actually raise a lot of money through storytelling. Of course, storytelling needs to have a fundamental background in backing as well. If you go wrong, you were wrong after a few years. So that's the part and parcel of how investing works. But if you were to think of China, a lot of money did get pulled out over time. I think some of it was an early call people took on the cyclical aspects of China. Some consider it as a structural challenge, but I call it cyclical. So whatever it's, some took an early call and some capitulated. Later on it, if performances were not good and you have to capitulate and then of course, you know, funding was getting pulled out. Now these are large funds, which are primarily funded through, let's say, endowment funds and others. So these are asset allocators, who take a call. When you pull out that money, the simplistic thought process is that you are primarily either investing and reallocating that to fixed income or to the developed world or to something else, it could be another asset class, you know, maybe crypto, whatever. So that's basically the way these things work. Now, the reality is that a lot of this money, which is allocated by these asset allocators, also goes into private equity. Public market is only one phase that we see. A lot of challenges are being seen in a private market—the VCP market, for example—in some of the established countries like China. It is very difficult to get your next round funding, come closer to IPOs, or raise money, or list. So when you get the opportunity, you basically use public markets primarily to create liquidity for yourself. That's why that money which is creating liquidity for these asset allocators is not coming back to India.

I mean, if that was the case, in the last two years, if you would accumulate FII outflow and inflow, you're not really seeing any inflow. If it's an India Shining story, why haven't we talked about $30 billion inflow every year for the last two years? It's actually 30% of outflow and we probably got some inflow which probably neutralised it. So that is a reality right now.

Venugopal Garre: What comes to help normally, at times, is a cycle. So what a cycle actually means. Cycle means a string of EPSs or earnings growth of a certain level continuing for a longer period. So this is not about 18% growth for two years, and you go back to 6% growth. So that's, of course, you know, a very challenging situation, but you have a slightly longer cycle, where you have 7-8 years of, let's say, a 15% growth. So what does happen is, after some point of flatlining, you tend to again start to see that earnings growth, you know, give you the return. So, in a very simplistic way, if price-to-earnings for an index or any stock does not change from here, and let’s assume this is the new normal, based on India's positioning in the world or the ROE perspective, asset-light companies, and let's assume this is the right multiple. Thereafter, ideally, you're going to get your earnings growth as your returns. If you are going to get 14-15% returns per year, let's say from the compounding aspect, that's not a bad idea to be in equities in general.

The challenge for us is that we have risen very swiftly, in terms of price-to-earnings, and this level itself looks unsustainable. So you do see flatlining as a broader concept from a market level, which is what we have been arguing for this year. I am expecting 8% returns for Nifty for example. And my argument is you get that much for fixed deposits in general. Of course, their taxation aspects might be different, but then what's the fun of being actively involved in equities. But then, you get the bottom-up ideas. Bottom-up ideas are relevant across every cycle. So that doesn't matter. That's not a unique aspect to it. So that's the situation that I see. But the only positive aspect, as you mentioned for India, is that we do believe that we are in a macro cycle, which could last for a couple of years—may be not 2003 to 2008, or 2003 to 2010. Supercycle—we've probably seen 25-30% earnings growth on a CAGR perspective. But can you deliver 15% growth over 6-7 years? The answer is, yes.

Venugopal Garre: I would say that the importance of SMID—as an area to invest and look for opportunities—is increasing every year. In the last couple of years, it was primarily about retail investors and domestic mutual funds, which are again funded by retail.

Internationally, it used to be sort of a very niche process. Certain funds would probably look at alpha by investing in some set of mid caps. Now, we are actually starting to hear pretty tremendous focus from a lot of funds globally on seeking and trying to understand the SMID cap opportunity. But I have always been of the view that it is very difficult to invest at a broad-based basis in SMID, if you don't really have capability. So the first thing you need to do is hire people, build capability, and understand stocks. That is how bottom-up investing works. Sitting somewhere in the U.S. and having somebody who's in China for 20 years, you suddenly want to invest in SMIDs. It does not work. It's a recipe for disaster because SMIDs can be very dangerous as well, when it comes to bottom-up picking. You have to be very careful about the business model and governance. May be large caps you can scrape through because what are large caps? Large caps basically were SMIDs which delivered over time and that's why they became large caps. The risk element is usually lower.

So one thing I want to highlight here is, we started our India SMID portfolio, for the first time ever, this year at a hefty SMID valuation, because we really wanted to basically build this portfolio over time because I think this is the future of India.

Venugopal Garre: I'll just tell you that it was a big struggle, to identify stocks. I can assure you that when you try bottom-up, you realise how tough it is.

So what I did is that, I realised firstly, that there is no point allocating everything to equity. It's a slightly long-term portfolio. I want to basically build it over the next 12-18 months, or 24 months. So I have 80% allocation basically to somewhere down the line to non-SMID, which is fixed income, which is almost 50% allocation and 30% allocation to large caps, through a separate India portfolio, which I run. So technically, 80% is not SMIDs.

(For) the remaining 20%, we thought the first theme that we're going to choose is where there is an opportunity for non-linearity, as I say. So this is basically manufacturing, where I felt that while valuations are steep 50-60 times P/E, but there is room for earnings growth and sudden surprises to come in because this is a phase where businesses are getting built for those companies. So there are four stocks out there which are primarily linked somewhere down the line to manufacturing—one is an EV-linked company, moving from a normal traditional to EV, which is not an auto component company. One is an EMS (electronics manufacturing services) player, one of the largest in India. One is again an EMS component player, more towards PCBs (printed circuit boards). And the fourth one is a logistics company, which has in my view also a linkage in manufacturing. So there are four stocks, allocated 5% each, right now on the SMID portfolio.

Venugopal Garre: When I looked at the broader market, I wanted to get certain things like certainty of near-term earnings streams. How do you get a certainty of near-term earnings streams? There are two approaches, actually two sets of business models which give you that certainty. One primarily is let's say capital goods-linked companies which have order backlogs. So you have an idea of what revenue growth and what margins they will deliver. So they won't suddenly disappoint you, meaningfully. And the second one was emerging sectors such as, primarily manufacturing where there are order backlogs and you have visibility of very high growth, at least in the near term. But then, between this, manufacturing was critical for me because I think this is at least a 10-year theme. Number two, as there are a handful of companies like these which I have selected who have access to production-linked incentives, which primarily means that they have become a conduit for any foreign company thinking of setting up, you know, capacity in India. These guys already have an advantage of 10% plus, on the table for you. So, which is the reason they tend to gain market share in that process. So think of another laptop company coming to India. Which is going to be the natural company they would go to? Somebody, who has a PLI, who has the ability to gather labour, and has some skill sets. So I felt that, you could see non-linearity. By non-linearity, I mean, a 50-60 times company, which is trading at that level, even a high growth usually tends to be discounted. But then the reality is that, if you have let's say, you are generating $100 of revenues today. And suddenly, let's say Apple comes into India, incrementally, of course, in terms of new lines and says, let me just allocate some part of my volumes now to you. And suddenly what happens is, 100 becomes 150. It's not about a specific case. What I'm saying is that when opportunities are abound in that area, you have a tendency for a disproportionate scale-up for some of the companies. And that's the reason I decided to digest extremely excessive valuations for that set and still keep it in the portfolio.

Venugopal Garre: I think policy continuity is already priced in the markets. And you know, much larger than expected mandate might lead to some euphoria, where you get even more excited, you know, in terms of what all the existing government can achieve in the next five-year term, but that is the only element of surprise left. We're not even thinking about a negative surprise right now. It doesn't look like that's going to be the case in this election.