Budget 2020: Fails to deliver on elevated expectations

The context:

For many years now, weeks heading into the Budget Day gives me adrenaline rush and excitement on what could be the key announcements, both for professional and personal reasons. This year too was no different, and given the sharp macro slowdown (FY20E real GDP of 5%) that called for a greater need of growth revival through fiscal measures, investors expectations had risen. Although, everyone was well-aware that the scope for stimulus was limited given the fiscal situation (just 3% YTD tax collections, & corp tax cuts already announced), nevertheless, high hopes had built-in for: a) lowering personal income tax rates, b) increase in rural/agri spending which is being hit substantially, c) some market-friendly measure (like abolishing LTCG/ DDT/ STT/ privatization, etc.) to boost sentiments, d) higher infra/capex spending, and d) some path for NBFC/banking stress resolution.

The event:

Are Fiscal deficit number credible? 
The headline fiscal deficit is now targeted at 3.8% for FY20RE (+50 bp vs earlier targets), & 3.5% for FY21E, both bang in-line with the consensus expectations. While the headline numbers suggests macro stability, quite often than not the devil lies in the details, based on projections assumed by the govt., and off-balance sheet financing. While the nominal GDP growth assumed at 10% (after 7.5% in FY20E), and projected tax revenue of Rs 16.3 trn (increase of 9% for FY 21BE) is realistic, the catch is it still assumes high FY20E tax base (+14% growth is assumed, 2x of GDP growth vs general 1.2x buyancy) on assumption of collections from the dispute settlement scheme. Further, on the revenue-side, disinvestment targets of Rs 2.1 trn appears optimistic (3x of FY20RE, forming 10% of govt. total income), and telecom spectrum/AGR revenues of Rs 1.3 trn (2x of FY20) may be tough to achieve (as the industry already has high debt).  On the expenditure-side, it will grow at 13% and the focus on rural India has stayed - albeit MNREGA allocation is down and higher agri spending is likely for PMKY (Rs 6k/ yr as transfer to farmers). Further, while fiscal deficit came at Rs 8 trn, the more keenly tracked number by investors is govt.’s bond borrowing program, which at Rs 5.4 trn for FY21E is again broadly as expected, and the remaining deficit is largely funded by the increase in national small savings fund (NSSF, Rs 2.4 trn, 2x jump already in FY20RE, and expected to remain flat next year).

Although the fiscal math remains challenging in my view, but then every year there are always some nitty-gritties like above that makes the assumptions look aggressive. However, with govt. having more data points than investors, we can presume that they have done their homework while setting these targets, and from bird’s eye perspective I see there is no out rightly very aggressive assumption (will await more details from brokers tomorrow). Further, govt. revealed off-budget financing details (again need to understand this better), at a time when some doubts were being raise on the relevance of the official deficit number, which should possibly help to bring transparency. 

Will personal tax new regime boost consumption? 
The budget introduced a new optional tax slab structure (that could save taxes up to 75k for income up to Rs 15L) if the assesses let go of deductions/ exemptions (HRA, LTA, 80C, 80D, Int. on housing loan, etc). This in govt’s view should help to simplify taxation for lower-end income-earners (say 3-10L), and thereby give assesses a “choice” if they want to save for the future or use these tax savings for consumption. While the salaried-class individuals are unlikely to shift (barring few who are currently not able to utilize their exemptions), what is more worrying is that the new system no longer encourages longer-term investments (ELSS, insurance, home loans EMIs), and gives option to those, who are generally ill-equipped to take correct decision. Also, this comes at a time when household savings rate is already falling, when India needs risk-capital to fund its growth, and when govt needs funds through NSSF to meet deficit targets. The more annoying part is FM’s statement in post-budget media conversation, where she believes new regime to be eventual path of taxation in few years (they are testing waters now), which implies to me that taxes will go up (rather than widely expected cuts) for the higher middle class in the subsequent years.

Dividend distribution tax abolished: Apparently, we were among the last few nations to remove this tax, which now allows dividends to be taxed in hands of recipients (at their respective tax rates) rather than at corporate-levels at 20%. This should benefit FIIs and MNCs who are located in low tax countries, apart from small retail investor. Thus, a small sentiment booster for the markets. However, promoters with large stakes will be negatively impacted (as their dividends will now be taxed at their rates, say 42%), and therefore such companies will now do more buybacks (taxed at 20%) rather than dividends, and might also announce one-off special dividend this year, to take out cash. Also, DDT removal could be seen with corp-tax cuts already announced, as it incentivizes companies to undertake capex spending rather than paying out dividends. Further, MFs until now use to levy dividends for equity funds at 11.5% and debt funds at 29%. For investors in high tax bracket, it now makes sense to switch to ‘growth-option’ MF rather than ‘dividend-option’, and do SWPs. 

                                     

Doing LIC IPO might actually open Pandora’s box:  Govt’s ambitious disinvestment target relies on LIC IPO, IDBI sale, BPCL, Concor, SCI, Air India, among others. The largest proceed is expected to come from LIC IPO, which will not be an easy task, as it requires legislation change, favorable market conditions given its large size, and will face stiff opposition from political parties & unions for selling the perceived ‘jewel’ of the nation. With Rs 27 trn in AuM and market leadership (66% share) in a high-growth potential sector, it could command valuation of 8-10 trn, and thus investor’s demand could be very high. However, contrary to popular belief, I have had my doubts for long on LIC’s governance, their unknown investment management team, and often joke about them being the biggest Ponzi scheme in India. I say this because LIC has been bailing out successive government’s unexciting disinvestment programs in the past, has been a lender of last resort for PSU banks capitalization, and few reports suggest its equity fund performance is very poor in the recent years. Yet, it continues to reward policy holders/ agents through attractive returns, albeit with limited transparency & through govt support. As it undergoes IPO, we could possibly see more skeletons coming out here.

Infra boost: To attract foreign investment in infrastructure, govt has announced sovereign wealth funds will get 100% exemption on income, FPI limit in corporate debt market is increased to 15% (prior: 9%), and there is also some proposition to have some gilt series being traded without any FPI limit, that will allow Indian govt bonds to be included in global bond indices. The govt has not compromised on capital expenditure (18% in FY21BE), albeit expenditure spending growth is low in Defense and Railways, but solid on roads and smart cities. 

Conclusion: No stimulus, lacks out-of-the-box thinking

While many believe that Budget is unlikely to be the only place to announce big steps, and quite often govt. has announced reforms outside the Budget day, nevertheless, I still look up to the event as it likely lays out the path on which govt. is heading. The broad message this time seem to be: a) the higher middle-class (income >15L) and rich will continue to be taxed more on all its income avenues, so as to meet govt. obligations towards farmers/agri which is a large section of population, b) focus remain on supply-side measures (corp tax cut, DTT, govt. spending, PPP infra, etc) rather than the demand-side (consumption boost), and therefore GDP growth is poised for possible medium-term recovery rather than on short-term revival, c) fiscal prudence and macro stability is given due importance, and d) more willingness towards foreign flows for infra-building. The biggest disappointment to me is the new tax regime, as it complicates the structure rather than the stated objective of simplification (at least until the compulsory full transition comes into effect), and the lack of urgency in govt.’s action - if we do not pull the growth trigger now, then when is the question on my mind.

On markets, the bond market should heave a sigh of relief (they were closed for trading yesterday) as fiscal deficit and FY21 bond supply has no negative surprise, and we should see some rally in bonds, in the near-term. Though this could fizzle out, if progress towards budgeted numbers for disinvestment is slow. On the equity side, Nifty corrected 300 points on Budget day, and is down 6-7% from its recent highs at 11,650. The budget has lost opportunity to give any boost to revive economy, and lacks any reformist/ radical announcement, and therefore broker’s GDP growth estimates might be pushed further ahead. And with so many expectations building up until the budget day, I will not be surprise to see another 3-5% downside from here for Nifty to hit 11,000 immediately next week, on ceteris paribas basis (coronavirus developments, global markets performance, geopolitical developments, etc). The only savior could be lower bond yields, which should support banking sector,  lack of any big negatives for FIIs (unlike the previous July-19 budget), and possibly any indication from FM/ secretaries that more steps are coming. 

Key sector winners: None in my view, but market might reward IT and Staples on risk-aversion, high dividend payouts (on DDT removal), and perceived boost to lower-end consumption (new tax regime).

Key sector losers: Real estate/Autos/ Infra (vs rising expectations), Insurance/ AMC on no tax exemptions (though it corrected already 10% today, and could be interesting to evaluate the actual impact), cigarettes (on excise duty hike). 

Being ‘Actively Passive’ vs. ‘Passively Active’

In few months from now, I will be completing a decade in Equity Investing- a journey that has not only given me steep learning curve (much more than any academic book could possibly impart), but also grown my wealth. During this period, I have actively indulged in whole gamut of Equity trading/investing: starting with earnings-based investing (straight out of MBA I believed that financial models, DCF, P/E are the only truth), than style-based investing (Quality, Momentum, Size, etc.), to trading based on technical charts. Further, the approach was sometimes complex and institutional-driven, when I indulged in derivatives (F&O) or say special situations (Buyback, Spins, M&A, Event-play), and sometimes as simple as going the mutual fund way.

Interestingly, if I were to write my blog consistently across the last 10 years, then you would have seen how convinced I was on each of these approach, which I was pursuing then. Yet, no specific strategy for wealth creation lasted for over 2-3 years for me, which some may classify as a sign of incompetency, but I would rather define it as a constant evolution of myself. Now which of these techniques is best suited to grow wealth is an open-ended debate, and there is no one size fit all recipe here- you could be a good trader, or a patient investor, or just brilliant with risk mgmt., or combination of everything. One has to evaluate it for himself, as to what works for him to grow his money.

But what astonishes me is how every individual in this field tends to overestimate his abilities to find a multi-bagger winning portfolio idea. Every new entrant, be it a professionally-qualified person (CAs, CFAs, Engineers), or say a guy with family-legacy in equities (generally belonging to say Gujrati, Marwadi communities), or say someone who has just learned some basic concepts through some hearsay, enters this equity world with a belief that he can easily outperform market returns consistently over a long period of time. When I advise my friends or colleagues to invest through mutual-fund (MF) route rather than doing the stock-picking themselves, I am looked down upon, with some even doubting my aptitude & skills. They counter me with a theory, which says MF investing is good if the objective is to grow wealth ‘steadily’ and broadly in-line with market returns, but MFs are lackluster if someone wants to grow their wealth at say 25-30% cagr.

My only question to them often is: “Is your portfolio return expectations rationale?       

Since we do not have dataset on number of retail/HNI individuals who pursue active stock investing, and further we do not know how many of them have actually outperformed the markets consistently, I therefore rely on institutional (MF) data to see the kind of returns that are generated by professionals.

The fact that Nifty has delivered just 8.8% CAGR return in the last 10 years (even when both starting & ending point are in favor) and that only 13 funds (out of 171 MF schemes) managed to deliver over 15% returns, with highest being 18% cagr, I really doubt if return expectations of 25-30% are rational. Especially because retail/HNI individual lacks access to real-time information, interaction with company management, and time to analyze annual reports, as much as these professionals do. And further note, 20% of fund managers have failed to even outperform Nifty, despite all the resources.

Obviously, there will be exceptions, few retail/HNI do make supernormal returns (Damanis, Jhunjhunwalas, Chokhanis, of the world), as they do not need to mimic benchmark, and that they can take disproportionate risks, but then they will be few and far between. And to assume that you are among that few, without any credible track-record is a far-fetched thought, in my view.  It is like believing you can be next Tendulkar or Kohli, just because you can play cricket (which millions other can do as well).

Do you really have a portfolio-approach?

The other characteristic of retail/HNI’s Active Investing is that they spend lot of time in researching a new winning idea, but pays little attention in tracking development of their existing investments i.e they are Active on new stock ideas but Passive on their broader portfolio monitoring. They feel immensely satisfied to see how their latest stock pick have done well, while in overall portfolio context, it might have little significance, and at many times the other broader portfolio could be losing ground everyday. Further, while there are lot of techniques available to find a ‘multi-bagger’ stock, there is very little academic literature on when to exit. Quite often it means, these active investors tend to exit, when there is a big negative event/ fall in price, rather than selling at highs. In other words, possibly great entry point, but terrible exit.

Therefore, increasingly I am getting convinced that individuals should not attempt to do Active Investing (stock-selection) and rather leave it to professionals. This is not to say that Professionals are more capable than any single retail/HNI, but given that Professionals have institutional approach, the risk element and portfolio sizing is better managed.

So how does one keep himself intellectually simulated on markets?

All said and done, then how does one satisfy the deep intellectual urge to build opinions regarding economy, company management/ strategies, earnings expectation, etc. How can these retail/HNI individual satisfy their ego and prove a point to their peer group which they often claim, ‘I had told you that xxx stock will rise /fall….” At many times, for most, it is less about making wealth, but more about getting due recognition from your peer group on your wisdom.

My solution to them is that use all the energies and analysis to take a view on market direction, and decide on your Asset allocation- no fund manager will be able to do that for you, as it will vary depending on your risk capacity, time horizon, liquidity needs, etc. Once you are decided on this allocation, give it to ETFs or professionals (MF, PMS, etc) and let them take care of stock-picking and portfolio risk.

Conclusion

As you would have seen, this post is not about Active vs Passive approach to fund management – a debate that has grown rapidly in the last couple of years. But this post is for every individual investor who starts with stock-picking, but at many times, cannot give adequate time and energy that is required to build a portfolio over a long-period, and in most cases they lacks the skills, too (albeit no one admits despite their losses). I would say it is best to be Actively Passive (i.e being Active on framing/deciding asset allocation every quarter, and Passive on stock-picking, risks framework, etc), rather than being Passively Active (i.e passively monitoring your active stock portfolio). Always remember, "Investing is a Marathon", and not one-time process of finding undervalued stocks. 

So what is my Equity allocation now?

Personally, I started going Underweight Equities at the start of 2018 (Nifty at 10,800 than) as valuations appeared to be dislocated considering it was late-cycle and tariff news started gaining momentum. My belief got strengthened after US recession fear gathered pace in Q4 2018 (trade war, yield curve inversion). But in reality it turned out to be a lost opportunity, as H1 2019 had a sharp rebound globally. Particularly from India perspective, things were just looking to come in my favor post July-2019 budget, with increasing investors starting to doubt the 'India Story'. But with the unexpected corporate tax cut in Sept (see my previous post on it for more details), the bulls are back in the market.

I have continuously increased my underweight stance (just ~30% of my savings are in Equities now vs. ideal 50% that I want to keep, which I had prior to 2018). This equity allocation is the lowest I have held since I have started following asset allocation principle 4 years back, and is being achieved not necessarily through selling equities, but doing lesser incremental investments each month of my savings. Today, I am slightly disappointed to not participate in this up-run for over 2 years now. But, I am not a fund manager who has to prove on 3m, 6m, 12m returns, and therefore can afford to still wait for the better opportunity, as time horizon is very long. The objective is to enter at levels that are comforting enough to see 12-15% index CAGR for the next 5-7 years, which I doubt will be achieved from current Nifty levels at 11,900.  That said, the market strength remains solid, with every minor correction getting bought heavily, adding to my frustration.

Corporate tax cuts: Context & Consensus opinion

Amidst all the gloom & doom in the last few months over Indian economy, and FM Nirmala Sitharaman’s frequent press conferences (to an extent that it might have given complex to even TV anchor Lata Venkatesh’s time on air) to calm nerves in the last few weeks, stock markets were sinking and Nifty had closed at 7-month low yesterday at 10700- down 11% from all-time highs hit in Jun-19. The pain in broader market was significantly worse than what was being represented by Nifty (which was helped by IT stocks & few big gainers), with Midcap & Smallcap index down 29% and 44%, respectively, from their peaks they had hit in Jan-18. This performance appeared particularly miserable when compared to global stock markets, which are holding remarkable gains (20%+ YTD), with US markets kissing all-time highs. And it has come despite BJP govt. (perceived to be more market-friendly) getting re-elected with an overwhelming majority in the recent elections (May-19).  

     

To note, Q1 FY20 real GDP growth was 5% (slowest since 2013), and nominal GDP growth was only 8% (17-year low), courtesy low inflation. Also, recent government messaging (FM & Economic advisor to PM), has been that 'socialized losses & privatized profits' is no longer an option to revive economy.   When it was just about time for even hardcore bulls to throw the towel (at least for short-term), in a surprise move, FM has announced corporate tax rate to be reduced from 30% to 22% to revive the economy. And as smartly it could be, this positive news was announced by FM during market trading hours at 10.30am (vs. most of her other announcements post-markets), triggering animal spirits of investors in stock markets, and resulting in 5%+ move today, making it the biggest single-day move (+570 points on Nifty) in the last 10 years, with overall market-cap of BSE-listed firms rising by $100 bn today. Importantly, the reduction in tax announced had no caveats, no hidden clause, no preconditions attached, with a clear intent to revive growth. 

Given sudden change in investors’ sentiment, with some renowned voices (Vallabh Bhansali) calling it ‘the biggest step since 1991’, or few other calling it as ‘bold move’, or as turning ‘vicious economic cycle to virtuous cycle’, or with fund managers (Samir Arora) saying this can drive 10-15% stock market gains swiftly, I thought it is time for me to evaluate the facts closely, appraise the optimism, and ‘try’ to be rationale amidst this euphoria. Tuning into TV debates, or checking into my analyst friends/colleagues, I could not hear even one voice believing that markets might go down again, with most calling new-highs in the next 3-6 months (ceteris paribus in global markets). 

For the beginners, details of tax reduction announcement, and some preliminary questions are well explained in the link here . In simple words, lower taxes →higher corporate net profits →higher EPS → P/E valuation looks low, so market rallies. Further, higher profits can kick start the economy, as more money is now available to plough back/ reinvest in biz. → higher capex spending → more jobs/wage growth → more income in hands of consumer → more consumption demand. And even the least optimistic person will assess it saying corporate (especially in more competitive industries) could pass the tax benefit through lower prices for consumers, who might now consume more than before (i.e. higher volumes offsetting lower prices). 

Amidst this rare consensus among all, I try to split-up the impact of this announcement, with more emphasis on what can go wrong in my next blog, as the positive side of the debate is well-known to all. Like always, my attempt is to not to follow the herd mentality blindly, and check the realistic possibilities. For those, who could comprehend this basics well, I suggest reading the next part. 

Corporate tax cuts: Another hope for the markets!

Now that we have laid the basics in part-1 of my blog before, let’s try to structure our thinking given how financial institutions could evaluate such events i.e. getting into the details, understanding the possibilities:

What do lower corporate taxes mean simplistically?

When govt. lowers taxes, it is nothing but transfer of resource (capital) from one hand (Govt.) to other (in this case, Corporates). Both, Govt. & corporates, when given additional capital tends to sped on economic activities that boost the GDP. Now the key question is who can do a better job in spending effectively: In India, the govt. mechanism hasn’t worked well (corruption, bureaucracy, political compulsions, etc.). Further, in the past, we have seen large productivity/efficiency gains in the sectors/ services which have been privatized. In other words, if money is to be spent on reviving economy (and not towards socialist agenda), then it probably makes sense to have hands-off approach by govt. 

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What does this measure indicates of govt. intent?

Say now that Govt. had decided to transfer resource, it had 2 options: a) to give it to individuals directly by lowering personal income taxes or GST cuts, triggering ‘Consumption cycle’, or b) giving it to corporates triggering ‘Investments cycle’. Going by past experiences, Option A would have immediately instigated short-term economic momentum, and Option B, might not benefit short-term, but should hopefully revive capex cycle in the medium-term. Amidst the current backdrop of “Growth Recession” and prevailing negative sentiments, anyone would have been tempted to choose Option A, and show quick fix. But Govt. selected option B, probably bcoz: a) their vision to bring large longer-term impact through ‘Make in India’ campaign, b) compared to major & competing economies, tax rates in India were higher on corporates side (thus making them less competitive on global manufacturing), but broadly in-line with the world on personal tax rates, c) no political pressure as elections were just behind us.

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Will corporates spend on capex or will it be lost in pricing, or paying dividends?

Say now that corporates have higher resource and that IRRs of new projects will appear attractive, the key debate is: a) will they use it to spend on capex, or b) will it be retained by them and given back to only shareholders (through dividends/ buybacks), c) or will it be lost in lowering prices to retain market share. Over the next few weeks/ months, markets will increasingly look for evidence to see where the trend is, and will increasingly make or break the sentiment.

While some could argue that corporates are unlikely to spend on capex when demand environment is so-weak, the other side could say that with corporates spending on capex, demand will eventually pick-up. This therefore is classic chicken & egg dilemma i.e. whether Demand drives Capex, or if Capex drives cosumer demand?

My sense is for most large-size capex projects such as Refining/Energy, Steel, mining, the demand situation is more global in nature, and therefore we are unlikely to see major capex revival (as expected by many), given weak global economic momentum (I will not be surprise to see a Global recession in the next 12 months, unless again cycle is extended by Fed, ECB, etc.) But then, we could see some capex on manufacturing side (as India is incrementally more competitive) or from sectors that are domestically-driven (power, cement). Specifically, sectors which have historically seen lower competition, and higher return ratios (such as consumer, pvt. banks, pharma, autos, in that order) are likely to retain the tax benefits for shareholders, and spend on capacities as appropriate, while few others hyper-competitive sectors (airlines, infra companies, telecom, power) will eventually lose these added benefits. In other words, I do not think this move will see shift in leadership of companies in the index i.e. near-term the beaten down stocks might rally, but over 12 month period, we will see the same winners (high-quality, high PE stocks). 

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Will this step make India more competitive to China & Asian countries?

Amidst the backdrop of US-China trade tariff tensions, which has escalated in the last 1.5 years, it appears Mr. Trump is being keen to bring manufacturing back to US, or at the very least shift it away from China, so as to curb China’s rising influence on global economy.  With many Asian countries as contenders, India with its large labor-force, improving labor laws, and ease of doing biz do stand a chance, especially after these tax cuts. But is it enough to challenge the peers and see a shift in production is unknown. My sense is this is just the beginning, and we will need follow-up measures (factors of production i.e land & labor reforms, speedier approvals & lower bureaucracy, faster judiciary system, etc.), and this alone will not make India more competitive. We are at least 2-decades behind global manufacturing cycle, and catching up isn’t that easy, in my view. 

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Will it drive over-capacities in India?

As tax rate for new biz is even lower at 15%, there is high-probability in my view where existing companies could change corporate structure to create new company/ subsidiary and setup a new plant & shift productions there to avail these benefit. I read that cement companies did something similar in Rajasthan when taxes were reduced for new plants. This might create a problem of excess capacities (especially if demand doesn’t pick-up).

What is the impact on fiscal deficit?

The only, & obvious negative aspect from lower govt. revenues is higher fiscal deficit (budget target of 3.3% for FY20), and as a reaction we saw India 10-yr bond yields shot up by 15 bp yesterday to close at 6.8%. However, economist/ strategist who until yesterday were saying govt. doesn't have fiscal space, are now suddenly projecting only 20-40 bps slippages (vs. 70 bp of lost revenues) as they assume: a) some lost revenues will be borne by State govt. (40% share)., b) better tax compliance, and c) lower than planned spending in PM Kisan scheme, in which small farmers are promised 6k per year, and is being budgeted at 800+ bn with 140m beneficiaries, but disbursements so-far has been slow as finding farmers with proper land-records is increasingly difficult.

I think the market is under-estimating the impact from double-whammy of lower GST collections (+6% YTD vs. budgeted 14%) & now lower corporate tax cuts. While govt. might manage to dress-up the issue (through RBI dividends, borrowing from FCI & other PSUs, rather than on govt. budget) and manage to show only marginal increase in the fiscal deficit, I think sooner or later it will bring credibility issue on govt. accounting practice. Or we could see slower spending on govt. driven capex programs (roads, railways, etc.)

What is the impact on Inflation and interest rates?

With rate-cut cycle already in-progress, the risk often of higher fiscal spending, is a) higher inflation, & b) crowding out effect, resulting in higher borrowing costs for all. My sense is inflation is lesser of a concern when fiscal spending is through corporates, rather than consumption booster. And with RBI governor (Shaktikanta Das) coming from finance ministry, he will continue to move rates lower, and increasingly force banks to pass this rates to end-borrowers (from MCLR to external benchmark borrowing). Thus, borrowing rates will still continue to fall, in my view.

Although, I have tried my best to give straight answers to key questions on investor's mind now (without beating round the bush as typical analysts do), for those who cannot comprehend this economics above, but are looking for an answer to simple, straight-forward question- whether to buy equities now, or stay on sidelines, or sell the rally? 

Quantifying the impact:

Brokers say Nifty EPS will benefit by 6-7% over the 12 month period, as only 20 Nifty companies paid more than 30% effective tax rate in FY19. With FY20E Nifty EPS at Rs c.600, this 6-7% EPS upgrade (assuming all tax gains are retained by corporates & not passed through, which is optimistic assumption) translates into an additional Rs35-40 of EPS, and with P/E 20x, should translate into 700-800 points higher level on Nifty index. With today’s 570 point move, it means bulk of the adjustment is already done. If markets inches further swiftly, than it means it will be pricing-in added benefit from economy revival,  or P/E re-rating on expectations of FII fund flows, upwards earnings revisions, pick-up in demand, etc.  

Another elementary way to look at it could be if govt. forgoes 1.4L crs of tax revenues, and assuming all of that comes to listed companies profits (as lower tax rate were already applicable to smaller companies) and with P/E of 12x (lower bcoz of higher share of profits will flow to low P/E sectors like Energy, Materials, etc. & not all mid/small companies will be able to retain this lower taxes into profitability) than it translates into market-cap gain of 17L crs (17 trillion). The market-cap of all BSE-listed companies stood at 138 trn yesterday, and addition of 17 trn on this figure represents 12% move from the yesterday’s close. (note: 7 trn, or $100b, was already added today).   

In simple words, based on my preliminary calculation and few assumptions, I would expect Nifty to hit 11600 soon, but we might then see investors getting more realistic based on my discussion above.  

The Conclusions

In crisis lies the opportunity, and Indian govt. typically have taken big steps only when the 'going is bad'. We have seen it yet again, but I would classify it as 'fiscal stimulus', rather than 'mother of all reforms' as quoted by many (still believe demonetization was the boldest step, but unfortunately it did not bring desired outcome). Whether it will revive the much-need capex cycle, my initial assessment is no, but then I am no economist, and am hearing big corporate leader/voices who have more wisdom than me, saying this will bring back the 'risk appetite' and 'animal spirits'. I hope they are right. 

For stock markets, this is another 'hope trade', which like other reforms of last 3-4 years (demonestisation, GST, RERA, faster resolution of NPAs under NCLT) will give analyst/strategist fodder to write long research reports and make everyone believe in India's GDP potential, Modi's leadership, and longer-term high returns for stock markets. Unfortunately, I am not one of those perennial bulls, who believe in the heavily-marketed 'India Equity Story', and therefore am not a fan of monthly SIPs, which makes investors buy at all levels. I rather believe that Equities are to be bought when they are cheap and when there is fear, rather when there is euphoria like today- though it is easier said than done. 

I would trade this event with long call (as upside will come quickly in 1-2 weeks) rather than with any long cash positions. Before we get to face the reality (whether good or bad) of this announcement, the hope alone can attract lot many investors & drive market-returns. 

Kewal Kiran- It is not always about growth

For the last three years, I am invested in this apparel company that has hardly grown its core profits and yet share price has doubled during this period. Quite often, my friends question my investment rationale on a company that has not been offensive in its approach to expand (despite having relevant opportunities) and available at high valuations (30x trailing P/E). I say high valuations, because most investors compare P/E with growth (popularly known as PEG ratio) and for a company that is not growing its earnings this mean PEG ratio of 30 (a very high number)

I thought to review the investment case after its full-year FY17 numbers were released last week. Before I get going with financials, let me explain the business profile for the beginners. Kewal Kiran Clothing Ltd. (KKCL) designs, manufactures and markets branded jeans, formals, semi-formal and casual wear for both men and women under 4 brands- Killer, Integriti, Lawman and Easies. It is largely a branded jeans player (65% of revs.) and deriving majority of its revenues from its flagship brand Killer (51% of revs.)  The branded apparel sector growth should be driven by usual investment case (i.e. rising per capita income, growing fashion consciousness, aspiration value, etc.) and within the branded apparel sector, denim wear provides a stable long-term growth opportunity driven by the timeless appeal of denim amongst the youth. The largest section of the market is still catered by the unorganized sector and the transition to the organized (so easy to plug-in GST word here) and branded segment has lured many domestic (Flying Machine/Wrangler from Arvind Ltd, Spykar owned by PE fund.) and MNC players (Levis, Pepe).

However, it is not the biz profile that drives my attention, but accompanying financial strength that keeps me invested. Let me explain some numbers here- For FY17, company reported Rs 5 bn in revenues and with an impressive ~20% EBITDA margin (Rs 1 bn in EBITDA), minimal depreciation charge, virtually zero debt and tax rate of ~30%, it reported adj. net profit (excl. other income) of Rs 0.65 bn.    This net profit is generated on net worth of Rs 3.6 bn and capital employed of Rs 3.75 bn, translating into RoE of 18% and RoCE of 17%. But what fascinates me is how this capital (Rs 3.75 bn) is employed into biz – it has Fixed Aseets of 0.75 bn, non-current assets (excl. Investments in MFs) of only Rs 50 mn and working capital (excl. cash & ST inv.) of Rs 0.4 bn. In other words, the actual money employed into biz is only Rs 1.2 bn and rest is cash equivalents (Rs 2.5bn). Therefore, the point I am making here is KKCL’s return ratios are much higher than what appears at first sight. My calculations suggest that it has RoCE of whopping 55% (NOPAT of Rs 0.67 bn / CE of Rs 1.2 bn). Company claims for RoCE in operation are even higher at 65% for FY17. To confirm if P&L numbers are not inflated, I look at cash flow statement where I see that reconciliation between reported earnings and cash flows is excellent as EBITDA to Op. cash flow is at ~100%.

Thus, its financial strength is impeccable with sector-leading margin of 20%, net cash of ~Rs 2.5 bn, RoCE of 55%, strong cash flows and payout ratio of ~50%. Such financial strength is unheard among its peers (except Page Industries which owns Jockey brand) and is a result of KKCL’s successful brand, pan-India distribution, asset-light franchise biz. model, and most importantly it is a reflection of conscious strategy to not run with the crowd and chase market share, but indulge in steady race. Further, I find solace in the fact that promoters have ~75% of total ownership and no pledges or dilutions in the past.

The next question is at what price such financially strong biz is available- I would put that in context of theoretical RoE and P/BV relation which states that P/BV = RoE- g/ Ke–g. Assuming cost of equity as 12%, growth at 5% and RoE as calculated above at ~55%, theoretical P/BV should be 7x. Whereas stock at CMP of Rs 1700 and Mkt-cap of Rs 21bn, trades at 5.9x. In a market where most other companies are trading at frothy valuation and some making new highs everyday even disregarding basic P&L risks, I think this discount in valuation for KKCL should be pounced upon.

Key risks:

Some investors doubt how KKCL generates such margins and return ratios and have failed to understand the moat in the business that drives the strength: My argument will be that financial irregularities and P&L fancies generally do not last wrong, but KKCL has delivered consistently for last 5-6 years now with reasonably good dividend track record. Also, I have mentioned moat above- franchise based biz model, pan-India distribution network and efficient manufacturing setup.

Can denims continue to grow in the longer run: Maybe not as strong as other fashion-wear category, but certainly denims have timeless appeal among youth. 

Conclusion:

The branded retail segment has seen few success stories and quite often wealth-erosion (Koutons, Canatabil, Zodiac) companies due to over-bloated B/S and super aggressive strategies that lead to encompassing excess risks. KKCL's biz. strategy on the other hand is a classic example of slow and steady to win the race.

The dilemma of investing in Education sector

I always wanted to buy some credible company in education sector, given that the sector is benefitting from exponential inflation in fees and inconceivable willingness of parents from all socio-economy stature to provide the “best” education for their kids at “any” price (even if it means sacrificing other desires).

What I paid for my MBA course 10 years ago (Rs 0.3mn), is now annual school/tuition fees for student in class 1, and I cannot even imagine the share of our savings that will flow into our kid’s education expense over the next 15-20 years. As a hedge against this inflation (which no insurance seems to cover other than their flashy advertisements to protect child dreams), I wanted to own some company in this space that would grow its profits exponentially and give us capital appreciation that will atleast partly offset the burden.  

Till few years back, I always thought that with such super-normal growth in the sector the beneficiaries should be many in the education value chain- i.e pre-schools, private schools/colleges, tutorial classes, publishing houses, and digital content provider. However, as surprising it may sound too many, there has been hardly any listed company that has been able to reflect this benefit on their P&L. In fact, the sector has given one of the highest disappointments to investor community and sharp downfall in shares when expectations did not materialize. This includes unimaginable 99% fall from its peak in Educomp and Everonn, who were once thought to be pioneers that will change the way of learning through their digital content; Treehouse Ltd. which was easily believed as relatively asset-light, high-margin scalable pre-school biz, but has already fallen from grace; NIIT and Aptech who have tried to diversify their biz. model but have achieved little success; and finally Career Point and MT Educare in coaching classes segment who have failed to prove that they can scale-up their business to drive strong profitable growth.   

The reasons for this downfall in post-facto analysis are plenty- highly capital intensive businesses, long payback period, bloated balance sheets, poor corporate governance, competition with trust owned institutions, etc.  I can probably have endless discussion on company-specifics issues, but I will restrict those thoughts for some other day.

Conclusion

The situation has turned out to be similar to classic joke flowing around about liquor consumption- the drunkard, owner of the liquor company (Mr. Mallya) as well as banks lending to Mallya are all losing money- so the big question is where has the money gone? I think education sector has given a similar dilemma to most of us.   

The key learning to me from this sector has been that reality can be materially different that what is perceived. What appears to be money machine for a common man on the street, company’s P&L has categorically different result. The hypothetical new winners in education sector have failed drastically, while publishing house like Navneet which is believed to be in mature or declining stage of business has hold out reasonably well.

The hunt is on for some interesting biz. model in this space that can prove its mettle with financial strength. So far, only Zee Learn and Navneet Education have been able to hold strong; MT Educare had good prospects, but has given away its B/S strength recently.I will have sleepless nights till I found a good hedge.  

Century Ply: Peaking investments, to reap benefits now??

Key details: Price: 215, M-cap: 47.9 bn

While investing in consumer-driven building products sector (which includes paints, ceramics, pipes, bathroom-ware, etc.) has been a no-brainer in the recent period, I am skeptical on valuations for this group (avg: 28x FY18E earnings when steady-state growth is around mid-teens). However, the below opportunity in Century Ply (CPIL) appears interesting in the context of multiple triggers that lies ahead for this company and can be a low-volatile good long-term investment bet.

Key positives:

• Peak capex phase is almost behind us: Out of budgeted capex of 600 crs, Century has already incurred 370 crs of capex since FY16, and by end of this quarter it has plans to complete ~500 crs, which represents overwhelming 30% of FY17E revs. This capex includes commissioning of Particle board facility in FY17 (capex: 66 crs), new MDF facility which will start in next 3-4 months (capex: 330 crs by FY17E, see below as why MDF is important), and will increase laminates capacity by 50% in H1FY18 (45 crs). As these capacities ramp-up, growth will be stronger over the next few years. (Bloomberg estimate of 22% EPS CAGR in FY17-19E vs CAGR growth of 7% in FY15-17E).
• Stellar margins and return ratios: Strong retail brand (90% sales are retail driven), wide distribution network is resulting into industry-leading margins (17.5% EBITDA margin vs. Greenply at 15.6%) and stellar return ratios (RoE: 30% vs. building products company excl. paints avg. at 20%). In fact, its return ratios appears similar to paints industry (Asian paints is at ~35%).
• GST beneficiary: During its concall mgmt. noted that in plywood sector there are ~3,300 units under small scale industries (SSI), of which 2,500 enjoy 100% duty exemption and ~700 are partially exempted. However, SSIs will be stripped of all exemptions under GST which would narrow the taxation/price gap with organized players. Further, the GST rate on plywood sector is expected to come at lower rate (<20%) than the current incidence of tax (26-28%) and this should help to lower plywood prices and revive demand which has been weak recently due to demonetisation.
• Backward integration ensures long-term sustainable availability of timber, its key raw material: It has set-up veneer processing and plywood manufacturing units in resource-rich Myanmar and Laos. Also evaluating option to setup facility in Indonesia.
• Why demand is shifting towards MDF: Low-end plywood prices have increased over the past 2-3 years as face veneer prices have gone up after Myanmar restricted their exports. This gave a strong boost to MDF consumption in India as the price differential between low-end plywood and MDF declined to just 5-6%. Globally, MDF’s share in plywood is much higher (65:35), while in India MDF share is currently very low (6:94), which provides a great opportunity. MDF’s low-cost, better utility (can be easily moulded and painted; but less strength) and increasing preference for ready-made furniture provides good prospect for MDF.Note: 100% of MDF is controlled by organized players due to high capex requirement, so as MDFs penetration increases in overall plywood sales, organized players will automatically increase.
• Valuations are cheap: Based on FY17E EPS of 8.5, CPIL trades at 25x P/E which might appear little expensive to some of us, but if we assume that fruits of recent capacity addition will drive growth and operating leverage in the next two years, this P/E drops to  15x FY19E EPS of 14.3 (assuming 30% CAGR). This valuation to me looks cheap in the context of its high-return ratios and growth potential. 

Key risks/ challenges:

• Low capital requirement and less R&D intensive makes plywood industry highly fragmented. Branded players together controls over only 25% of the plywood market and this industry has always been highly cash driven. While most investors view it as a great opportunity since demand could shift from unorganized to organized sector post demonetization and GST, I would view it as a risk until tax compliance increases and more level-playing field is generated.
• Century’s mgmt. was behind its key peer Greenply in understanding the increasing consumer preference for MDF. While Greenply setup the its MDF plant 6 yrs bk, Century has only now initiated India’s largest MDF plant (~0.2mn cbm); but Greenply’s capex plans to triple its MDF capacity in the next two years (~0.54m cbm) could mean Century’s capacity would still lag its main peer. Also, increasing capacity across all players could mean risk to pricing/margins in MDFs.
• Working capital days is over 2x that of Greenply (similar receivable days, but higher inventory and lower payable days); and net debt to equity at 0.9 is higher than Greenply as well as other building-products companies.

Business profile:

• Century Plyboard is the largest seller of multi-use plywood and decorative veneers in the Indian organized plywood market (25% market share of organised and joint leadership with Greenply), and with recent addition of doors, particle board and MDF its offerings covers entire wooden interiors infrastructure products. 
  
  
• Industry dynamics: Of the total plywood/panel industry, roughly 2/3rd is made of plywood, laminates constitute 16%, and veneers/particle broad/ MDF makes up about 6-7% each. With organised sector's share at 25% in plywood, and Century/Greenply share of 25% within organised, both of them roughly hold 6.5% stake each of the plywood segment. Important to note is that in the other sub-segment of plywood, organised's share is much higher- i.e in MDF 100%is organised, in laminates  and veneers organised share is >50%, and in particle board it is ~35%.
• Its portfolio comprises brands across the luxury (‘Architect Ply’, ‘Club Prime’), premium (‘Centuryply’) and economy (‘Sainik’) categories, but lacks product offering in low-end of plywood market. It has plywood manufacturing capacity of 210,000 cbm (cubic meters per annum), and MDF capacity of 198000 cbm, spread across six manufacturing facilities. CPIL is also a significant player in laminates (7.2m sheets by Sept-17, it is already third largest in India), commercial veneers (largest player in India).
  
  
• Indian plywood industry has grown at a 6-8% CAGR in last five years, whereas the organized players, especially CPIL and Greenply, have clearly outperformed industry growth. 

Conclusion:

Market seems to be ignoring long-term benefits of CPIL's entry into MDF (which is high-growth and potentially game-changing moment for plywood/panel industry) and GST benefits of shift from unorganised to organised. Despite similar return ratios and growth prospects of Asian paints, CPIL trades at 1/3rd the valuation of Asian Paint. While I am not debating that it should trade at similar valuation, but I think CPIL could potentially double in the next 18 months as growth picks up.