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BW Businessworld

The ‘Real’ Route To Big Returns

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Once upon a time in India people believed in a "story", a story of 9-10 per cent economic growth. Of inexperienced promoters turning cash-consumptive enterprises into muti-billion dollar market-cap plays with help from politicians. And, a story of banks growing their loan books forever at 30 per cent per annum by lending to companies which had never generated a rupee in cashflow.

Investors subscribed to the primary issuances from such corporates. Such was the mania that between March 2009-August 2009, at least half a dozen energy utilities, nearly as many large real estate developers and an equal number of construction companies, raised close to $10 billion with little to show for other than stretched balance sheets and close links to the political establishment. The banks were then happy to back the equity raised with large long-term loans.

All good things in life have to come to an end. So sometime in late 2010-early 2011, this story died and there continues to be much public breast-beating. However, there is another corporate India which quietly continues to function efficiently and effectively. This India produces cashflow by selling real products to the Indian public. It reinvests this cashflow into building new manufacturing plants, and thereby enters a virtuous cycle of steady growth while keeping its financial leverage low. This India accounts for around half the market-cap of the BSE100 and this is the India I focus on when I advise our domestic and foreign institutional investor client base.

When you look at India over the last three years, what has and hasn't worked for investors is clear. What has not worked is investing in corporates whose main competitive advantage is political connectivity. Ambit's index of 75 politically-connected corporates has underperformed the BSE500 by 30 percentage points since the 2G scandal broke a year and a half ago. Furthermore, investing in highly indebted, cash-consumptive companies hasn't worked either, as capital has become scarce and expensive, and has thereby limited the ability of these companies to finish their projects. What has worked is:

  • Aspirational consumption: Indians are buying goods (cars, coffee, noodles, facewash, undergarments, etc.) which, over and above their underlying utility, signal to the world around them that they are upwardly mobile. Such consumption has meant that a basket of "aspirational stocks" (with no particular regard to quality) has outperformed the BSE100 by 14 per cent per annum over the past decade.

  • Cash generation: Since the cost of capital in India is the highest amongst major emerging markets, Indian investors are increasingly putting a premium on cash-generative companies rather than buying power, real estate, construction and infra companies with little experience of complex project management, weak contract enforcement rights, and almost no visibility on cashflow generation. As a result, cash-generative companies in sectors such as FMCG, consumer durables, auto and auto ancillaries, IT and light industrial goods have outperformed by wider and wider margins as we have moved from FY08 to the present day.

  • Clean accounting & decent governance: In India, as in other emerging markets, the quality of accounting varies widely across listed companies, with the most common accounting fudges being revenue overstatement, expense understatement and cash pilferage. The good news is that in the three years post the Satyam episode, the India market has started differentiating between companies based on their accounting quality. The telecom sector has seen the biggest decline in accounting quality; other sectors with poor accounting include real estate, conglomerates, construction, mining and retail. Naturally, the sectors with the cleanest accounting tend to be those with strong underlying demand dynamics and cash generation: FMCG, consumer durables, auto and auto ancillaries, IT and light industrial goods.

For the discerning investor who is willing to look within the cash-generative sectors for high- quality companies trading at affordable valuations, the Indian stockmarket will continue to yield double-digit returns. For the rest — those who either go by the index or focus on cash guzzling or banking plays — the story of the stockmarket being a route to riches is dead.

(This story was published in Businessworld Issue Dated 28-05-2012)