Indian Equities: Invest in “Quality” but….

While globally the trend is clearly in favour of ETF’s or passive investing, emerging markets like India still offers plenty of scope for stock selection and active management.  Investors can take a cue from bellwether indexes like Nifty 50 or Sensex and develop strategies around them to gain alpha. In this context, the recently launched index by National Stock Exchange (NSE) 2015 attracted my attention. . It is titled as “Nifty 30 Quality Index” comprising 30 best Indian companies evaluated across three important parameters i.e., Return on Equity (RoE), Debt to Equity ratio (D/E) and Net Income growth. It is normally understood that highly profitable companies with low levels of debt perform well over time compared to medium to low profitable business with high leverage. True to this logic, the Nifty quality index returned 16% annualized during the last three years compared to 13% for Nifty 50. Definitely some alpha here for chasing quality.

While index investing is a good idea for lay investors, professional investors can do more in terms of deciphering some strategy around these indices. Any index is always a combination of great, good and poor stocks. Buying the index (in the form of ETF) means not only buying great and good but also poor stocks. This article attempts to improvise the quality index by focussing only on great stocks and see if we can perform better than the index.

The 30 companies in the quality index can be broken down into three groups viz., , great, good and poor based on their stock performance since the launch of the index.

While great group are super performers, the good group eked out decent performance while poor group actually performed poorly true to their name. The poor group pulled down the overall performance of the quality index as they enjoyed higher share of the index by virtue of their size. Here is the summary of the three groups:

April, 2013 to September, 2016	Great	Good	Poor	Total
No of stocks	14	9	7	30
Market cap weight (%)	33	31	36	100%
Average. RoE ( %)	28	45	27	33
Average D/E ( %)	44	10	2	18
Annualized Net Income growth (i%)	27	2	0	7.4
Portfolio Performance	34%	17%	8%	16%

Dissecting the 30 companies constituting the quality index, we can see that 14 of them are star performers, 9 good and 7 companies draggers with more or less equally divided weights among themselves. It is interesting to note that all three groups enjoy high return on equity. However, the great group has the highest debt to equity ratio while the poor group has the lowest. However, the key among the metrics is the net income growth. The great group show a robust net income growth of 27% annualized while the good group show only 2% growth. Worse, the poor group show 0% growth. If you carve out these three groups as distinct portfolios, the great group portfolio returned an astounding performance of 34% annualized, the good group 17% (equivalent to the quality index performance) while the poor group returned only 8% severely underperforming the overall quality index.

In each of these groups there are surprising entries as well. For eg., in the great group we have companies like Emami and Tata Motors recording negative income growth but stellar stock price performance. The poor net income growth can be attributed to latest quarters and hence they may be penalized going forward. In the good group category, Tech Mahindra enjoys high RoE, low D/E and high NI growth but performed average relative to index which is surprising. In the poor group, we don’t see any surprises as all of them report poor net income growth.

Caveat: This analysis looks at the past performance and extrapolates into the future. There is a good possibility that companies in the great group can drop down to good or poor and vice-versa. Hence, it behoves to revisit this strategy annually to make changes to portfolio.

PS: The author thanks Rajesh Dheenathayalan for data assistance

GCC needs monetary policy independence

This Article was Published in Gulf News,  Arab Times, Akhbar Al Khaleej and Alqabas

Typically, the topics in the business section of a newspaper in the GCC will almost always focus on issues such as the budget, deficits, subsidies, investment, etc. Meanwhile, a publication in the United States will dedicate more time towards speculating on the Fed’s imminent actions. Global financial markets gyrate to every move made by the Fed and hence are constantly trying to guess what its next one is likely to be. The GCC spends most of its time on fiscal issues since it has effectively outsourced its monetary policy responsibilities to the US Federal Reserve and therefore they are compelled to mirror the Fed’s policies regardless of its domestic economic underpinning. Fortunately, for most part of the arrangement, this worked reasonably well with business and economic cycles of the US and GCC being roughly synchronized. Additionally, strong oil prices throughout much of this period enabled GCC governments to build reasonable reserves; which also thwarted any occasional challenges which would pressurize the pegged currencies.

However, the recent drastic fall in oil prices and oil revenues (on which the budgets are heavily dependent) and the near unanimous consensus of the new low oil price reality going forward has changed that scenario. Given the high and growing break-even oil price (the oil price required to balance the budgets), GCC governments will now either have to draw down on their reserves at a faster rate or resort to borrowings to fill the gap. Being modeled as welfare economies, the restructuring process to rationalize subsidies and stop providing pseudo-employment in the public sector can be painfully slow. Hence, GCC governments will focus on reducing their role as the main investor in their respective markets and dedicate resources towards diversification strategies. The private sector will be encouraged to play a larger role in this diversification effort, especially in sectors such as healthcare, education and transportation where the government is currently forced to commit significant funds and capital. Also, research and innovation will rightfully be granted a higher priority as it can quicken the transition from public to private sector-based economies.  As the shift happens, maintaining a positive business environment will take precedence over government expenditure. Improvements in ease of doing business ranking will have to be achieved in swift time as the economy faces liquidity shortfalls, increase in cost of capital and higher risk premium.

In such a scenario, where government spending and employment will reduce and private sector led diversification process takes center stage, an outsourced monetary policy model may be counterproductive and costly. The ability to set short-term interest rates in order to manage domestic cost of capital and inflation will become important in order to orchestrate the transition. Monetary policy independence would be a necessary requirement for this to be possible. Otherwise, a pegged currency dictated by US monetary policy, where the interest rate curve may be sloping upward going forward, can create serious frictions in  the GCC’s low economic growth environment.

GCC monetary policy independence is also warranted in an environment where the Fed is running out of ammunition. According to The Economist, in the 3 most recent US recessions the Fed slashed rates by 675 bps, 550 bps and 512 bps respectively. However, what is interesting to note is the time taken for rates to return back to normal levels. The Fed took 2.5 years and 3 years to return to normalcy in the first two recessions respectively. However in the most recent recession of 2008, it is 8 years and counting. Should another recession occurs, the Fed will not have the necessary tools at its disposal. It is generally opined that long-term problems which are enveloping in the global system like low economic growth, deflationary concerns and lack of business confidence cannot be solved using the Fed’s short-term monetary tools. For a variety of factors, sooner or later, the Fed will lose its role as the financial market’s sole saviour. Such factors include the fact that its short-term interest rates have already hit rock bottom, an inability to move back to normal rates for a long stretch of time and the long-term nature of many problems that the Fed do not have resources to provide solutions with.

It is therefore time for the GCC to have an independent monetary policy framework like its fiscal policy framework. Such monetary independence will provide the GCC with the ability to set short-term rates and help guide the capital allocation process more cost effectively. It will also enable better control of inflation and will reduce friction in a challenging low growth economic environment. 

GCC M&A: It’s Shopping Time!

This Article was Published in The National

GCC Investment Bankers (IB) should be the most stressed lot! Too much work and too little rewards. The fee based investment banking business has four key components going for it i.e., syndicated loans, equity capital markets, debt capital markets and Mergers and Acquisitions (M&A). While in other markets we can witness activity across the four components, in GCC the IB advisors solely depend on syndicated loans for their survival. (On average 50% of total IB fees) Equity capital market is dull thanks to poor performing capital markets and related dull IPO environment. Debt capital market looks promising given the slew of activity expected from sovereigns and corporates. However, the sticky point seems to be M&A, which can be erratic and suffer from some idiosyncrasies.

The fallout of Global Financial Crisis and the recent oil price crash has dented the stamina of corporates leading to weaker balance sheets for many companies. The operating environment has turned difficult with stagnating earnings and increased cost of capital. After hitting peak of $70 billion in 2014, our research expects corporate earnings to touch $62 billion for 2016. This should be a dream environment for M&A advisors as difficult environment forces corporates to restructure, improve efficiency and productivity, hive off non-core assets and concentrate on strategic business. In other words, corporates need the help of M&A advisors to do all this.

However, the value of announced M&A transactions reached $18.7 billion during the first half of 2016, a decline of 29 percent compared to the first half of 2015 and the slowest first six months for deal making in the region since 2014 according to Reuters. What can explain this conundrum?

GCC market is dominated more by private companies than public companies. Scouting opportunities in the private market is onerously difficult due to lack of transparency and family control. This prevents deal flow even though there may be genuine need for M&A. Even assuming healthy deal flows (cases where companies express interest to hive off non-strategic units), the actual consummation of transaction can be low (poor deal closures) as poor information can prevent meaningful negotiations and conclusion of transaction. Take the case of Emaar Properties buying a stake in Americana (Kuwait Food), a deal that was in the making for years with multiple parties. There are several such examples like Etisalat ending talks with Zain, Kuwait or EFG-Hermes agreement to create the largest Arab investment bank with Qatar’s QInvest collapsing in 2013 after the deal didn’t get Egypt’s regulatory approval.

GCC M&A environment is also characterised by dominance of “mega deals”. Take the recent acquisition of Emaar Properties chairman Mohamed Alabbar’s buying of 9.9% stake in Aramex or his recent acquisition of a USD 2.36bn stake in Kuwait Food Company (Americana) along with a group of investors or the recent merger of National Bank of Abu Dhabi (NBAD) and First Gulf Bank (FGB) which  is expected to create a mega bank with total assets of around USD 171 billion (only bettered by Qatar National Bank whose assets stand at USD 190bn) or the celebrated Emirates Bank and National Bank of Dubai merger to form Emirates NBD in 2007. Domination of such mega deals can “crowd out” other transactions and can also create league tables (rankings of Investment bankers) that can look very different and distorted from one period to another (making it difficult for comparison).

How will things be going forward?

Given the low oil price environment, corporate stress levels are bound to increase going forward. Need to restructure, enhance productivity and efficiency and hiving off unnecessary non-strategic assets will be pursued vigorously by private and public players. This should certainly be good news for IB’s. Also, companies are unusually sitting on very high levels of cash as measured by data available for publicly listed companies. At the end of 2015, total cash levels reached nearly $250 billion with financials (read banking) accounting for $155 billion. Hence, banking related M&A transactions will continue to see action followed by energy and telecom. “Mega deals” may continue to dominate the scene but given the oil price impact across the board, representation from mid-level segments and SME’s can also increase. This will help to improve the ratio of “pipeline to closure” which should be good news for IB’s. Political climate will also play a role in Mena ex GCC countries. Volatile political situation, large scale currency fluctuations and lack of lending and underwriting experience in those regions could increase the risk that could outweigh any potential gains and hence this may shift the focus back to GCC. 

Nifty Top 10, How will it look like in 2025?

This Article was Published in Market Express

Though the Nifty index comprises 50 stocks, the top 10 enjoys a lion’s share. In 2005, the top 10 constituted nearly 60% of the index (in terms of market capitalization) while in 2015 it comprised 48%. Obviously the performance of Nifty itself will be impacted by who is on this coveted top 10 list and funds flow from institutions (both domestic and foreign) that track this index will also be skewed towards these top 10 companies. Hence, the curiosity to study this in greater detail and try and figure out how this top 10 list will look like say in 2025! Also, a look from 1996 to 2015 for Nifty 50 shows that more than 115 companies have been part of Nifty 50 with average age of 8 years. In other words, if a company has been in the Nifty 50 index for more than 8 years , its probability to continue in the Nifty 50 reduces. In this context, the race to top 10 gets even more interesting.

How the sands have been shifting?

Back in 2005, ONGC was the top company in Nifty followed by Reliance and TCS. Fast forward to 2015, the coveted top slot has been taken up by TCS with ONGC pushed to 7^th spot though Reliance managed to keep the same 2^nd spot. However, the attrition rate of top 10 between 2005 and 2015 has been 50% in that only 5 of the top 10 in 2005 made it to 2015. Wipro, Bharti Airtel, ICICI Bank, Satyam computers and State Bank of India dropped out in the 2015 Top 10 list. HDFC Bank, Coal India, HDFC, Sun Pharma and Hindustan Unilever replaced them in 2015. 

The rise of TCS from the 3^rd position in 2005 to 1^st position in 2015 is impressive as its market cap compounded at an astonishing rate of nearly 20% between 2005 and 2015. While it had a market cap of just $18 billion in 2005, it jumped to $72 billion by 2015 making it as the most valuable company in Nifty 50. The saga of HDFC Bank was even more impressive. Back in 2005, it was at 18^th position with a market cap of just $5 billion. It then moved 15 places up to become the 3^rd most valuable company in 2015 where its market cap compounded at an astonishing rate of 22.5%. The rise of Sun pharma is also credible whose market cap grew nearly 10 fold between 2005 and 2015 moving it from 31^st position in 2005 to 9^th position in 2015.

Getting to 2025

While it is useful to know changes that happened in the top 10 coveted list during the last 10 years, it can be challenging to figure out how this list will look like say 10 years from now. On a perusal of growth rate performance of Nifty 50 companies during the last 5 years, I see a normal distribution ranging from a positive +30.7% (Lupin) to a negative -22.7% (Vedanta). However, positive performers (companies with positive rates of growth in market cap) outnumbered negative performers 35:15. In other words, 35 companies enjoyed positive growth during the last 5 years while 15 suffered negative growth rate. The top 25 stocks organized in terms of CAGR shows that companies have grown at a hectic pace during the last five years. The CAGR among top 25 ranged from 30%(Lupin, HCL Tech, Indusind)  to 10% (Mahindra and Mahindra). Going forward, I believe maintaining such high growth rates may be difficult given the headwinds blowing across the world. There is a recent Mckinsey study that says that long-term equity returns for the next 20 years will be nearly half of the last 30 years average for US and European equities. While US and European equities clocked 8% annualized growth in the last 30 years, they are expected to clock a growth of 4-6.5% in the next 20 years. Also, in the next 20 years, Mckinsey expects inflation to rise, interest rates to remain the same, and weaker GDP growth. More importantly, it observes that emerging market companies and new tech competition could cut margins. The story is the same on the bonds side where the last 30 years produced a bond return of 5% in US, the next 20 years will produce a return ranging from 0-2%. Welcome to a world of diminishing returns!

Hence, it may be prudent to assume that going forward the CAGR for Nifty 50 companies could be just half of what it enjoyed during the last five years (excluding negative growth companies). While this may sound conservative, in my view it is more realistic since compounding at a very high rate for a period of 10 years can produce extraordinary numbers. Given this approach, here is the list of Top 10 Nifty 50 companies by 2025.

Who makes it?

6 out of the 2015 Top 10 makes it to 2025 with TCS continuing to remain the most valuable Nifty 50 stock. TCS would have improved its market cap from  $72 billion to $158 billion implying a CAGR of 8%. Sun Pharma would have moved from 9^th position to 2^nd position while HDFC Bank will retain its 3^rd slot even in 2025. Notable new entrants to the Top 10 list would be HCL Tech that was positioned at 22 in 2005, 19 in 2015 and would be 6^th by 2025. Impressive indeed! Maruti Suzuki also has a similar ascent (21: 2005; 13: 2015; 7^th:2025). Kotak Mahindra Bank moves from 16^th position in 2015 to 8^th position in 2025 while Lupin moves from 23^rd (2015) to 10^th (2025) with its market cap improving to $52 billion.

Who loses it?

Notable exclusions in 2025 from the Top 10 include Reliance, Infosys, Coal India, and ONGC. Reliance will move to 11^th position from 2^nd, while Infosys will move to 12^th from 5^th. Coal India will move to 15^th from 6^th while ONGC will move to 16^th from 7^th.

Sector Shifts

While Oil and Gas dominated the scene in 2005, it is nowhere to be seen by 2025. Telecom has already lost it by 2015 while tobacco holds on thanks to ITC. Financials will see continuous growth in the Top 10 while automobiles will be a surprise entrant by 2025 (thanks to Maruti). However, the most important ascent is noticed in pharma whose market cap will explode from $30 billion to $160 billion courtesy Sun Pharma and Lupin. IT will still be a big part with TCS and HCL Tech leading the way.

Investment Implications

The jostling for space in the Top 10 can be important to make investment decisions. Firstly, it will have huge impact on the index per se. If you are investing in ETF’s, you will mostly track the index which is heavily skewed in favour of top 10. Index investors will also navigate this process of churning given the shifts in weights. Index realignment happens over time and hence investors in ETF’s will underperform active managers especially in emerging markets like India where ability to add alpha is very high.

If you are in stock picking, this study shows sectors to avoid (oil and gas, Telecom) and sectors to embrace (pharma, IT). You may even want to deep dive attractive sectors (by dwelling into mid-caps) to bet on future winners. Automobiles and auto ancillary are good examples.

The market cap of Nifty 50 will increase to say $1.6 trillion in 2025 from $824 billion at the end of 2015. That is a modest 7% annualized growth between 2016 to 2025. However, if you focus on the top 10 list likely to be in 2025, your investment performance should definitely be better than 7% at the least. However, what is crucial is to keep an eye on this transformation as even stable companies can spring surprise on the negative side.

PS: The author thanks Rajesh Dheenadayalan for data assistance

FINANCIAL CHALLENGES FOR GCC

This Article was originally written for CFA Institute and published in several newspapers including Gulf News and Arab Times

The GCC is witnessing a period of rapid transformation as oil prices, which were once at a cushy $100 per barrel, has fallen below $50 over the past 18 months. The stable oil prices between 2012 and 2014 enabled GCC to earn more than $3 trillion in export revenues. Thanks to that, GCC governments are now sitting on strong cash reserves.

However, that is only a short-term comfort. Given the extremely high dependence on oil revenues of GCC governments and their lack of economic diversification, the depletion rate of those precious reserves has been highlighted as a major cause for concern. GCC countries now require the oil price to be much higher than $50 in order to balance their budgets. Since prices are still significantly lower than that rate, the region’s governments will face successive years of fiscal and current account deficits; which they will have to plug through additional reserve depletion or through borrowings. Given this context, I would like to specifically look at the financial challenges this period of low oil prices will pose to four specific stakeholders: Government, Banks, Corporates and Individuals.

Government

The biggest pressure is on governments, who face a bloated bureaucratic structure and increasing levels of expenditure largely comprising of salaries and subsidies. Therefore, there is little flexibility for them due to the current social welfare model and the strong social contract with nationals. While rationalising subsidies and reducing wasteful expenditure can be prioritised, this may not reduce deficits within the urgent time frame that is required. Hence, the biggest financial challenge for GCC governments will be funding growing deficits. The IMF estimates GCC countries to pose a fiscal deficit of about 12% of GDP or $150 billion in 2016. I expect this to be met through a judicious combination of reserves, local debt and foreign debt. Research estimates by Marmore point to the cumulative debt increasing from $250 billion to $390 billion by 2020, a significant jump from $72 billion raised cumulatively between 2008-2014. Such a massive growth in debt raising is bound to have an impact on the overall economy in multiple ways. Saudi Arabia, for the first time in eight, had to secure a loan of approximately $26 billion from domestic banks in 2015. It is also in talks to raise $10 billion from a consortium of international banks in an effort to address their growing budget deficit. Most notably the credit rating will be lowered as a consequence of the increasing Debt to GDP ratio. Sovereign ratings of Bahrain, Oman and Saudi Arabia have already been downgraded recently with further downgrades expected in the future. Another point of impact will be the Credit Default Swap (CDS) spreads. In the last six months, CDS spreads of Abu Dhabi, Qatar and Bahrain have doubled while Saudi Arabia’s has tripled. The current macroeconomic conditions will also increase the cost of capital for governments.

Banks

The financial challenge for banks will come in the form of lower levels of liquidity. Banks, to a great extent, largely depend on government deposits for their liquidity; which have experienced significant decreases. With stagnating growth in deposits, banks will have lesser amounts to lend at a lower spread; which will have a negative impact on their profitability. On the other hand, the sovereign bond issuances will see high levels of subscription by banks because of the attractive yields and their risk free nature; this will crowd out lending to the private sector. The pressure this will introduce to the margins of banks will result in lower profitability. Additionally, the financial challenges for corporates will mean deteriorating asset quality and a rise in Non-Performing Assets. As a result, the credit rating for banks will remain on the downward trajectory.

Corporates

Banks being crowded out will directly impact the private sector, since fund raising will be increasingly difficult and expensive. Many companies have solely depended on government spending for projects. In this climate, project delays are inevitable and may affect working capital. Advance payments for projects have been slashed from 20% to 5% of contract value. Since corporates access banks for most of their short-to-medium funding requirements, access to funding may become difficult and expensive given the pressures banks face resulting from lower liquidity and tighter margins. Debt markets may be an attractive source of funding for governments but not for the corporate sector due to wider spreads demanded by lenders. We have already noticed a weak corporate issuance of debt due to the drying up of liquidity. Where funding is absolutely necessary, it will come at higher cost of capital which adds additional pressurise on margins and profits. Introduction of VAT may also impact corporate profitability. These developments will have a substantial impact on Small and Medium Enterprises (SME’s); who will be crowded out the most.

Individuals

Financial challenges for individuals will come in different forms. Firstly, the generous government policies in the form of subsidies will see cuts; especially for the three most highly subsidised amenities which are petrol, water and electricity. As subsidies are reduced, the cost of services will increase and lead to higher inflation. Individuals will also have less access to financing options from Banks as lending procedures are tightened. Simultaneously, borrowing costs will also increase. Such market conditions may lead to increased debt defaults. Also, governments employ a majority of citizens in the public sector more as a social contract rather than genuine need. The absorption rate will come down as a consequence of growing federal deficits.

Opportunities

As many experts say, challenges can also be viewed as opportunities. Increasing government debt will induce financial discipline, better management of fiscal expenditure and more importantly, the much needed development of debt markets and improvement of the yield curve. Efforts to reduce wasteful expenditure will improve productivity levels across sectors and banks will look for overseas expansion opportunities to improve profitability. The current economic conditions will also encourage the adoption of advanced technological products and services to reduce the cost of service offerings. Corporates will focus heavily on efficiency and productivity gains and align corporate planning with thoroughly researched market needs. Mergers and Acquisitions will be on the rise along with alternative financing avenues such as private equity, crowd funding and sukuks. It will be a period of financial reform to navigate through this challenging period for both the government and private sector!