My biggest bet has been on the chemical space, says Shankar Sharma

Shankar Sharma, VC & Joint MD, First Global talked about smallcaps, stock market, chemical space and a raft of other topics in a wide ranging interview.

A: When I say I like small caps, let us get one thing clear I have always said that smallcaps are not an index bet meaning that you can take largecaps as a proxy in the Nifty or the Sensex, in smallcaps it is a collection of very bottom up companies. When I say I like smallcaps, the reality of that I don’t like a smallcap index, I like 10-15 smallcaps that is the basic premise on my smallcap thinking goes. Don’t say small cap index is down 30 percent, there are any number of smallcaps I own which are at all-time highs. So for me it is not down, some are down but on a broad basis it has been a decent year and a decent 18 months.

Now, if you talk in aggregate of smallcaps, I think the last 18-19 months have been obviously very brutal for them and as a result of that the sentiment on small caps have become extremely negative. If you see a revival in the market on a technical basis even if not on a fundamental basis even on a high beta end of the market it usually does well and what is the high beta end of the market it is obviously smallcaps because if you go back to 2008; 2008 was a cataclysmic year for equities in India and globally. After that if you look at the performance of smallcap index relative to the Nifty, it just was a secular downturn till 2013. So for five years people did not want to hear about smallcaps it was only stick to comfort, stick to quality, stick to Levers, stick to Marutis, all the quality end of the markets, sentiment went to an extreme point. After that from 2013 the bull market in smallcaps started and they beat the Nifty handily over the next four years - now you reverted that back to a complete negativity because again we have had a big economic crisis in India. When you have such situations people then say HDFC Bank I want to go an buy, Lever it is the exact same repeat of post 2008 sentiments, just aversion to risk, aversion to any kind of smallcap - I don’t think promoters are good-bad, I think that it has reached some degree of extremism right now.

Q: When you said obviously it is not about the index and it is about the portfolio, are you saying that your portfolio never took a big hit?

A: No, it did not.

Q: Then I would want to know the portfolio.

A: The biggest bet has been on the chemical space. I have said that to you, in the last two to two and a half years. You go and look at the list of 7-8 stocks in that space. They have done phenomenally well. They don’t look like a smallcap index at all. There have been other names as well. So you will lose some money. If you are going and playing boxing, you will get hit as long as you win the entire match. The point I am trying to make is that smallcap – I have always said this, smallcap don’t attempt it on your own to anybody who cares to listen, it is a very tough game to find a good company, it takes a long time, it is a very labour intensive efforts, it is not within the capabilities of an average individual investor listening to this interview to go and replicate that. We know how difficult that is and we will still make mistakes.

Q: You have said once that most people want the meat but cannot stand the heat, right?

A: Exactly. The other thing of course which is something that I like to say is that people say I lost money in investing etc. My responses are two. One is, if you look at a player like Virat Kohli or Sachin Tendulkar. Are they going to get hundred every innings? It is not possible. Okay. Their average is 50. What does that mean? That in the other innings, they will have a low, you will have a zero, you will have a five, you will have a ten and you can have a whole series also in which you won’t anywhere get close to your averages. That is the nature of the beast.

The second thing is that the way to look at the losses in the market – you can look at it in two ways. You can look at it as a penalty, you can look at it as a fee.

So think about it as an entry price, if I take you to an amusement park and the guy tells you Rs 500 entry fee, you will happily pay but the guy at the ticket counter tells you, it is a Rs 500 penalty, you will never go there.

The price remains the same. It is just how you look at it. If you took it as a penalty, you won’t enter it, you won’t have fun inside. If you look at it as a fee and you enter it, you will have a lot of fun inside. So it is only – najariye ka fark hota hai.

Q: Last time you told me that if you were in a stock like Manpasand, just have to say bad luck, nothing else. So if someone was in Indiabulls Housing or a YES Bank or an RBL Bank, what is it, fee, penalty, bad luck? How are you going to describe it?

A: Don’t look at it stock by stock. Overall it is a fee for learning – and I have always said this – leverage businesses and this is a leverage business, banking or non-banking financial companies (NBFCs) are businesses of pure leverage, it is essentially a bad business and I am not pointing names. I am not taking names.

As a category, banking or NBFC is a bad business, pure and simple, because the risk and the reward are never going to make sense, which is why worldwide, no bank consistently over decades makes –- or it is a very small list. They also go through a huge amount of crisis because you are making a wafer-thin margin, a wafer-thin return on equity (RoE) and you are amplifying that with a use of large amounts of leverage.

Hindustan Unilever Ltd (HUL) doesn’t need to do that. It has no leverage and yet it will make a 40-50 percent return on equity. To make a 30 percent, you are leveraging yourself 10 times.

The quality of the business is back. In that quality of business being bad, you will have some standout performers like HDFC Bank and Bajaj Finance.

A: Now, you will have exceptions. But that is a point, they are exceptions, they prove the rule.

And then people say that communist form of government has delivered great growth in China. I said how many such communist governments you know in this world? You need democracy, rule of law, liberalism because the western growth is all based on this. So there will be an exception to that rule in China. So every rule will have an exception and HDFC Bank is an exception. Remember that this game is still unfolding. What is good today, may not be good tomorrow.

There were many banks which were good six months back, there were many NBFCs that were great one year back.

Q: RBL Bank was thought of as the next HDFC Bank.

A: Exactly and great management – I know at least one of them very well, they are very good people but you cannot tell when something which is leverage can suddenly go bad because of one bad quarter or one bad asset.

Q: The other issue is that because of this whole NBFC crisis that had an impact on the overall consumption. Do you think we are now past that, the worse of that, we are beginning to see some of the consumption stocks again make a big come back, so numbers from Parle or Britannia or some of these other companies, they have been quite good now. So do you think we put the worst behind us?

A: I don’t have a clear view on that because I like to look at more evidence. HUL numbers have been good but the commentary has not been good, so you can manage one quarter but I want to see at least one more quarter before we make that conclusion.

Q: This corporate tax that happened that was described as a game changer, your good friend Samir Arora said bigger than the last ten budgets and I think you had also hailed it - do you think government should come out with more measures, do you expect more measures which will help financial markets?

A: I absolutely think so and while in the context of things since we are discussing corporate tax rate cut it is addressing the supply side, which is  you put more money in the hands of the companies - then spend or invest and boost supply but is that what the problem is

Q: We need more money in hand of consumers.

A: We need a demand push which I hope should come.

A: Personal income tax cut should definitely happen and I want the 42.7 percent……(doesn’t complete the sentence both laugh).

A: I think it should go, as simple as that. I am very clear that by letting it revert back to its original shape, which was 12 months that itself will work a lot in terms of stock market sentiment changes, I think that worth a lot. They might make it two years or might make it three years or something while all that is good, I am saying it is pointless to tinker…. again one of the biggest problems in India is you don’t have continuity of policies. Why not let it remain what it was, what was the problem that you were trying to solve by imposing capital gains tax, just leave it, let it go back to its original shape you would have removed a big cloud over the market.

Q: So overall is the market looking healthy again because while I take your point that smallcap investing is all about individual stocks we had a big rally and after that a decent correction and the rally which started again barring Friday was again narrow because Friday we had good advance-decline but it is again being led by HDFC Bank and Bajaj Finances of the world, Lever is leading it but the other stocks are struggling?

A: Oh yes of course but remember one thing about smallcaps they can collapse without warning and they can rally without warning. If you look at technicals for example largecaps will make move after making formations whether on the top, on the bottom, it is fairly easy figure out that this is a topping out situation or this is a bottoming out situation in largecaps. In smallcaps, I have done this a long time it can be a vertical fall or a vertical rally with no formations, no chart formations, nothing at all. So, they have lagged but on Friday they had a pretty good move, so there is little bit of change.

Q: Yes, on Friday it looked like midcaps were making a comeback the screen was telling you that?

A: Yes the screen was telling you that - it is a far healthier screen than what I have seen for a long time.

Q: When I walked into your office, so tell me the next big stock that Shankar Sharma is betting on?

A: You came too soon.

A: No, it is getting there. In the next few days’ time, one will have pretty clear mind but I do believe that if one believes this rally has legs then this beaten - and again remember sentiment has gone to an extreme on the smallcaps. I think they are due for a comeback.

Q: Any broad theme looking good?

A: The worst part of the market has been the industrials, so there are companies in the smallcap or even in the midcap space, which are into some degree of let us say the pipes or plumbing of the economy. So those are again a pretty high beta end and if the government has to boost capex in the economy because you do need that – index of industrial production (IIP) at minus 1.1 is clearly telling you and again within that capital goods was the worst minus 7 percent or something. If the government is looking at a data and I am sure they are, there will need to direct stimulus to those problem sectors and if they do that then you have beneficiaries.

Q: The sector which did well on Friday because of this news about Bharat Heavy Electricals Ltd (BHEL) divestments so that could be --

A: That could be a catalyst so capital goods - I am making a call here, so please don’t get me wrong, I am still formulating or forming my thinking, but I am just saying that could be a potential area even looking at the economic data that has come out. That is a sector that has been hurt the most and then you have the BHEL news there may be a beginnings of trade there.

Q: Is the optic fibre and chemical trade still on?

A: I think so, they are - again chemical is an international theme, there is nothing to do with India, and the fibre theme is again - we know India is still, it is not just fibre remember, pure commodity fibre is not what I like. Around telecom there is still a lot of activity ahead of us assuming the government gets sensible on 5G spectrum prices.

Q: Which is what they are hinting at.

A: It is a 2 person industry - if those two people sit out what are you going to do, nothing. So there are lot of ways, in fact I was discussing with somebody that if you look at the broad theme in the last couple of years what has happened in India, you have had large or at least reasonable parts of Corporate India going bust or about to go bust or they may go bust whether it is telecom or in banking or in NBFCs and even in industrials what that has done is it has actually sort of polarised the market and market shares with just a handful of players.

Q: The overall market cap has remained the same.

A: Correct, it has just gravitated towards the handful of players. I am not saying that is necessarily a good thing. In my view concentration of economic power is never a good thing. You have seen that in the debate in the US where just a handful of technology companies control everything about everything, trade data and how you look at things etc. They can mould political opinions it is just too much power being concentrated in the hands of few companies. India is actually getting there. It is not necessarily a good thing. One of the things about India has always been a diversity of companies, but here you find, some banks go out, the depositors still need a bank, they will gravitate towards that. So that theme if you think about it, is a structural theme.

Q: Getting back, since we have discussed BHEL, your thoughts on this renewed vigour of the government to do strategic sales whether it is Bharat Petroleum Corporation Ltd (BPCL), Container Corporation (CONCOR), now we know it is BHEL, even NMDC is being discussed how do you view that as a strategy?

A: I have a very different view from all, from what the consensus is.

Q: What is that view?

A: My view is that you cannot sell or you should not sell these assets. It is an admission of failure as a manager, if I sell my company. Who is the manager of public sector undertakings (PSUs)? The government. It is a clear admission of failure. We voted this government to power because of their ability to manage not just economy, but to better manage PSUs with better governance, with better transparency, less corruption. Are you saying you have failed in that endeavour?

A: I disagree, I don’t think - in businesses there is nothing called legacy issues, you have to surgically eliminate those legacy issues and remodel companies. It is like saying that if you become a manager of a company, tomorrow, you become CMD of a company what will you do? You will go and sell that company.

Q: They are trying to that, whether it is banking crisis, the non-performing assets (NPA) crisis, there has been a bit of a surgical strike?

A: What has been done, I don’t understand.

Q: Whether it was National Company Law Tribunal (NCLT).

A: NCLTs, we all know that banks hate NCLT the way it has been done.

Q: Whether it was successful or not is debatable, but at least there was an attempt.

A: NCLT was already done in the previous government, it was done in the United Progressive Alliance (UPA), it was pending legislation. So let us not get into that. I want a narrow point that I don’t believe that you should be selling strategic assets.

Every country is built on the platform of their strategic assets. Is China selling strategic assets? Why can we not manage them better? That is where your question - selling is the easy part. Get the world class managers. If the same businesses by private sector can be run well, what suddenly changes if it is a public sector?

Q: Perhaps if the BPCL is privatised then Hindustan Petroleum Corporation Ltd (HPCL) has more competition, Indian Oil Corporation (IOC) will have more competition so perhaps they can be also more efficient that could be one way of looking at that?

A: I am just saying they are great franchises, selling it to a buyer I think is negating the whole purpose. As a good manager, I would hate to sell my business.

Q: Couple of sectors are bouncing back, Tata Motors had a big move in the last 3-4 days, Maruti Suzuki from Rs 5,500 has moved to Rs 7,000 plus. TVS Motor has made a bit of a move is the sector making come back or do you think the best is now way behind us and we should not be looking at these?

A: Remember these are quality companies and it is just a tough business right now. But maybe the market is thinking that a minus 30-35 percent sort of decline cannot remain permanently so. So at some point you might see a sequential bottoming out, I think that is what the market is betting on.

Remember there has been general change in the last 10-20 days. So obviously the beaten down end of the market will do pretty well, usually that is the case and that is when people get left out because they have exited Maruti so these are now under-owned, small caps are under-owned so obviously when things turn, HUL won’t necessarily do as well as it did. It will all be these beaten down companies so these are pretty normal moves in the market.

Q: Tata Motors is up so much, have you bought any new Jaguar?

A: I think I need to.

Q: Any other theme which is looking good right now, in this market?

A: I do believe that the rupee is an overvalued currency and my view is to get the economy - remember stock market doesn’t mean economy. I think we have seen that, it is a huge diversion.

Q: Because of cue?

A: It is a huge cue, because of companies going out of business, market shares coalescing towards a handful of companies so the Sensex looks pretty good.

Q: On the days of the works of the bank crisis the Bank Nifty hit the new high because HDFC Bank goes up so that point is taken?

A: Let us not mix up two things. I do believe the economy is still hurting, there is enough data out there and I think one of the ways you can re-stimulate this economy is through bringing some degree of inflation. I think this war on inflation has actually resulted in a war on growth.

I do not believe that an economy like India can grow without an inflation that is my core belief. In any case some inflation is good. Excessively low inflation in a growth economy - that is a developed market thinking. That is for them, that is not necessarily relevant for an emerging economy like India because through inflation producers gets pricing power, through pricing power they can have better margins, through better margins they can reward employees better. There is a whole downstream virtuous cycle. I think you need to bring back inflation to some degree - by chance or by design it ought to happen. Only then you will have nominal gross domestic product (GDP) growth go back. Earnings growth is a straight function of nominal GDP growth. One of the reasons why earnings growth has been very tepid is because your nominal GDP has collapsed from 15-18 percent to like 10 percent.

I do believe that this 5 percent print on the GDP growth number is probably not the end of it and by the looks of it even Reserve Bank of India (RBI) has downgraded, International Monetary Fund (IMF) has downgraded and lot of agencies are still on the downgrade cycle.

I think we have a problem there, we need to bring back inflation and if you do bring back inflation, it can be done through the currency. One of the easiest ways is through the depreciating currency. I do believe the rupee is overvalued. I think the government should do something to fix that. Look at the export situation, I think it is abysmal, merchandise export is at a multiyear low, $26 billion a month that is like peanuts. We need to fix that because without net exports, you can’t fix the economic growth.

Q: So rupee sensitives could be the next theme, right so that would mean that in the past you were bearish on IT, would that view change?

A: Yes, that was a long back. Nothing is permanent, as I always say I don’t look at 5 year view, I look at a four quarter view that pretty much is so strategically I think rupee sensitives, beneficiaries of a depreciating rupee should be very much in play.

A: I don’t understand pharma, I never have. I don’t think even the US FDA understands what the Indian companies do. I don’t want to go there, I just don’t get that sector. I don’t get the complexities, I don’t get the problems.

Q: So in IT you first have the largecaps, which have done fairly well and then you have the midcap IT pack as well, where there has been bit of divergence, so more opportunities in the midcaps then you reckon in the IT pack as well?

A: Midcaps the only problem is always the governance, so as long as you are comfortable with that because remember IT is one of the easiest sectors to fudge accounts (not sure) as long as you are comfortable with management in question (not sure) midcap IT has done pretty well, at least the good ones.

Q: Overall for the market you reckon the worst is over?

A: I hope so, we all had a very brutal 18 months but you need to fix the economy. I just come back to this the tax rate cut fixed the Sensex or fixed maybe 25-30 companies because as per MAT  credit if you look at it the benefit is not Rs 1,50,000 crore it is more like half that number. People are better off taking MAT rather than paying 26 percent.

I think we should focus more on getting genuine growth rather than a two square mile growth, so this Fort, Nariman Point, BKC can take care of itself, and we need a 2 million square mile bull market for the rural poor, for the hurting sectors of the economy. I think the government should and it will focus on those sectors. If it does that, I don’t care whether the Sensex does well or not, it will follow, it has to follow if the economy does well.

Q: Do you see the animal spirit getting revived anytime soon, are you sensing that?

A: I think it is too early to say that. I think it will take a lot more robust numbers for that to happen and remember, animal spirits have anyway now become centered around a handful of companies. If you look at the rich list the top two companies are telling you what the animal spirits are in India, so it has become a narrow set of billionaires, in narrow set of companies. Whether they can build a big economic growth…

Q: Which is what capitalism does - worldwide if you see, more and more wealth gets concentrated - the big gets bigger right, that is the concept of capitalism?

A: Which is okay when you are $60000 per capital GDP when that happens at $2000 what happens to the rest.

Q: That point is well take that is the side effect right of capitalism?

A: Side effects can be very brutal.

Q: Yes, I take that point and we have seen some of that play out. Are you sensing that we could be on the cusp of the same post 2013 phase in the broader market? We have gone through a two year of underperformance - 2017 was a great year, 2018 was a brutal year, 2019 has also been a brutal year - do you think that would change over the next two years?

A: As I said I don’t make views which are not backed by data. So I am better off looking at some data better being a little late rather than being too early because in stock market and my business is investing. In investing you don’t need to be the first guy in trade, you don’t want to be the last but you definitely don’t want to be the first. If you are the tenth guy, which means the stock has moved and the sector has move, market has moved, it is okay because you are buying with data in your favour.

I don’t think the corporate data or the economic data right now merits such wild optimism. We are always cautiously optimistic, it is a safe term. We had a brutal time, we had little bit of bounce back which was already due but whether that is sustainable based on what we see still in terms of rural distress, even urban distress, job losses etc I am not going to go out there and say bottom is in and worst is over.

A: December.