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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

Alpha Moguls | Falling Cost Of Capital Will Revive Private


Capex, Says Kenneth Andrade
Niraj Shah
t @_nirajshah

Published: Jul 12 2019, 11:10 AM


Last Updated: Jul 12 2019, 2:11 PM

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

Falling cost of capital will resurrect private sector investments in India over the next
couple of years but government spending will have to fill in the gap till then to boost
growth, according to Kenneth Andrade.

“If we have to be excited about anything in the near future, or even the medium term,
the lower cost of capital is the one interesting change to the macro,” Andrade, founder
and chief investment officer at Old Bridge Capital, said on BloombergQuint’s special
series Alpha Moguls. That, coupled with increasing capital efficiency of corporate
India, augurs well on multiple counts for any investor.

The global central banks have maintained a dovish stance for sometime. The Reserve
Bank of India has also cut rates thrice this year. Besides, the government’s proposal to
issue sovereign bond in foreign currency would ensure that yields in India stay soft—
all of which point toward lower rates and lower cost of capital.

Andrade cited how March 2018 exit or year-end return on equity—a measure of how a
company is using assets to generate profits—of BSE-500 companies (excluding
financials) was 14-15 percent. The first 100 companies where the full financial
statements have been disclosed show an RoE of over 16 percent, according to Old
Bridge Capital’s calculations.

“Efficiency on the ground is improving and is also pushed by higher utilisation levels,
and we have not had meaningful capex,” he said. “Couple this with the cost of capital

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

coming down, and we are heading close to a private sector capex recovery, which has
been absent thus far.”

But Andrade expects that to happen over the next 24 months, not in three to six
months. If government capex comes in, the capacities run out faster, maybe in the next
12 months, he said.

Business-to-government stocks, or companies providing products and services to the


government, form the larger part of Old Bridge Capitals current portfolio, unlike its
business-to-business and business-to-consumer focus in the past. This stems from the
belief that if the economy has to be stimulated, the only balance sheet that can make a
material difference is that of the Government of India, Andrade said.

Some of the private sector balance sheets are stressed, and industries like power and
metals have a fair amount of capacities lying idle, and don’t inspire confidence, he said.

Andrade is optimistic on select power generation businesses. “There have been a lot of
false alarms in power. That was because any potential turnaround never showed up in
the balance sheets.”

This time, the cost of capital has been lower than the return on capital employed—a
measure of how well is a company generating profits from its capital—according to
Andrade. The arbitrage between the two leads to creation of significant profit pools.

An inverted structure of higher costs and lower returns, as in power in the past, leads
to large bankruptcies. 2017-2018 saw some correction in this inverted structure
because some power plants started earning higher than the cost of setting up the
projects, he said, adding 2019 saw them earn a higher return on capital employed as
the cost of capital fell further.

According to Andrade, if bond yields correct further, it adds to the lustre in this space,
which makes it a sector to watch. An environment like this is ideal for “releveraging
balance sheet” (taking on more debt), and companies that have deleveraged balance
sheets stand to benefit the most, he said.

Watch the full conversation here:


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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

28:02

Alpha Moguls: Kenneth Andrade

Here are the edited excerpts from the interview:

The elections are behind us, and a party is in power with a large majority. The
budget is out of the way too. What is your prognosis as to what the next 12
months will look like?

Like is the case of most events, especially an election followed by a budget, it is usually
a consolidation period for any government that comes in. If you look at the previous
year, it was a phemonenally big year—from the government spend, economy and the
corporate point of view. Flip it over to 2019-20, this is the year where you will see
consolidation of everything which is happening on the ground.

Given the limited time in which the government had to come up with the budget, it
focused on how to consolidate the balancesheet, saw from where revenues could be
mopped up and talked about longer-term focus of how to invest this capital.

I think a lot of that was laid out with no specific details as how large it can get. Look at
this year’s budget as a direction. I don’t think you got any specifics, except where from
the incremental amount of revenue can be generated.

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

So, a few surprises and a case of past continuous, that was the belief post-budget
as well? Do you think this was the case?

Yes, the past is continuous. There is nothing really to add. There was probably one
mention (in the budget) on the government increasing its access to international
markets for borrowings. For a debt, it is 5 percent of India’s GDP. They have given a
number between 10 percent and 15 percent on incremental borrowings. That will push
down bond yields.

That is probably a very interesting event because if you lower the cost of money, then
a lot can be done. If you have to be excited about anything in the near future or in the
medium-term, this could be one event which could be an interesting change to the
macros.

One of the messages from the government seems to be to keep the cost of capital
low. Did you get that sense too? What will be course over the next 12 months,
with the world also playing its part? Does your way of portfolio construction, or
picking ideas, or looking at the economy change materially?

Nothing changes materially. We also talk about how efficient Corporate India has been.
Capital efficiency is the moot point around how growth will shape up in the future.

In March 2018, our Exit ROE (return on equity) on BSE 500 companies (manufacturing
and services businesses, effectively non-financial business) was somewhere between 14
percent and 15 percent. The first 100 companies, where we have full financial
statements, ROE is upwards of 16 percent.

So, you are seeing efficiency on the ground improve. The efficiency is being pushed by
higher utilization levels, which is also factor for no incremental supply coming
through. All of these three have tied in together. There was a capex freeze, which has
resulted in higher utilization and that has resulted in higher return on equity.

The bigger moving point is the cost of capital coming down. If you see that trend line—
cost of capital moving lower and return on equity moving higher—it increases the

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arbitrage between cost of capital and return for industry. If this moves higher, you are
pushing very close to a private sector capex cycle, which has so far been completely
absent.

If you look back to 2005, 2006 and 2007, this was the period when the same subset of
companies (non-financial companies) in BSE 500 whose DROs were at ~20 percent. The
10-year G-Sec was down to 6 percent. Fourteen percent was the number when the
private sector capex cycle commenced.

That is the number which seems very favourable—apart from the fact that in the next
1-2 years you will also run out of capacities on ground. We are heading towards that
direction. So in 1-2 years, we will have all the answers.

Do you sense that the next 12 months could see a slowing down of government
capex compared to what we have seen in the previous two years?

We all try to search for growth. The only part of the economy that can drive growth is
the Government of India. We are done with the first quarter and we are starting with
the second quarter...there will be hardly two quarters left after that. Post that, we will
have to see how the finances of the government actually shape up to drive growth.

But keep growth out of this for a minute. Even if Corporate India has to grow by 4-5
percent, it puts incremental amounts of demand pressure on existing capacities, which
are close to running out. Just concentrate on the fact that you have no new supply
coming in. If the economy remains status quo, you are still pushing up the utilization
levels. This is cash creation cycle for a lot of companies.

I would tend to look at this avenue of the market.

Second is how does one exhaust those capacities faster. That’s where the government
spending has to come in. If the government spending comes in, then you run out of
capacities far earlier. Otherwise, it will take two years to run out of capacity. Either
way, you have to wait for 12 months for these events to unfold.

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

Would you reckon market will start discounting those events faster and will the
market will able to do this time around?

I will wait for the last six months of this financial year. I don’t think anything will
happen as quickly as September.

Why are you sticking to only industrials and farm economy in your portfolio?

When I look at the portfolio in construct, you have a fair dominance of businesses that
address the government at this point in time. There are no B2B or B2C businesses, as
the case has been for the bulk of my portfolio prior to 2016.

If the Indian economy has to be stimulated and stimulated higher, then probably the
only balance sheet that will make a material difference is the stimulus given by the
Government of India. That (stimulus) will be driven by policy or balancesheet, which
will drive the economy forward.

When it comes to private sector capex, which is essentially B2B business, there is a fair
amount of stress on some balancesheets which has driven corporations previously.
There is fair amount of surplus capacity available with some of the large industries, be
it power or metals. So, there is fair amount of capacity sitting idle.

The thing with B2C businesses is that we are apprehensive of investing in businesses
that have high multiples. The high multiple is driven significantly by leverage that was
created by the consumer cycle over the last decade. Those are the two probable macro
points we look at, which is why our portfolio is constructed in a very different manner
at this point of time.

Every industry maps the GDP 1X, and to get higher growth in the industry, you have to
leverage it. As we can see from both sides of the balancesheet, beneficiaries of growth
over the last decade are the consumer businesses—whether it is auto, consumer
durables, FMCG and the like. Their balance sheet expanded dramatically.

That created leverage, which is fed on the consumer cycle.

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

The reason these companies grew faster than the GDP is the significant amount of
leverage they had—that helped along the way.

It also happened in the last decade when we had real estate, infrastructure, capital
goods, metals and minerals do well with little help from corporate banks and public
sector banks in terms of leveraging their growth levels.

That’s what transpired over last two decades. For the next decade, we’ll have to find
the part of the economy which is deleveraged, or which has low leverage, who will
expand their balance sheets. The beneficiaries of those businesses will reflect in
market capitalization or growth. That’s where portfolio is effectively positioned.

There is lot of unutilized capacity in power. The proponents for power seem to
suggest that if the demand were to pick up—the government is trying to make
sure that power is available to all—this capacity will get exhausted in a hurry,
new capacity will take some time coming in, and therefore rates will move up,
and therefore earnings could do well. Is that the theory you subscribe to as well?

Our point of view essentially maps the outcome, which you have laid out pretty well.

The basics of this is going back to the financial statements. Infrastructure, historically,
has not done well because cost of capital was higher than return on capital employed.

When any business has an inverted structure, where you are paying more than you are
earning, you have large bankruptcies on the ground. In 2017-18, you had the first
element of this inverted structure playing out, correcting itself. A lot of power plants
have started earning higher than the cost of setting up the power plant.

In 2019, this ratio improved in favour of Return on Capital employed. So, Return on
Capital employed improved and Cost of Capital came off. If bond yields continue to go
southward, and Cost of Capital goes down and utilization goes up, then the balance still
gets tilted in favour of Return on Capital employed.

So, you take a financial statement, and look at Cost of Capital going down and Return
on Capital employed going up. That stimulus is the next phase of capex. That’s exactly

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what is happening in power generation.

Everyone said there’s false alarm in the power sector and that infrastructure will be
back, capex will be back. But that never really showed up in financial statements, until
now. If you continue to push your Cost of Capital down, then arbitrage between Return
on Capital employed and Cost of Capital makes it favourable for significantly large
profit pools.

If you were to raise a fresh fund right now, what would be a good theme to have—
a set of companies or industries that will benefit from falling Cost of Capital?
Could that be a good starting point?

In an environment like this, the ideal is for re-leveraging your balance sheet.
Unfortunately, companies which have deleveraged balance sheets can releverage
them. The falling interest rate regime is interesting. It is ideal for equity shareholders
into this business. As far as raising a new fund is concerned, the dynamics have
changed dramatically over the last couple of days.

Is the auto sector slowdown cyclical or structural? If it is cyclical, then do prices


provide an opportunity even if you can’t time when the cycle will turn around?

The auto sector slowdown has a lot to do with apart from cyclicality. It is also due to
the disruption that is taking place on the ground. I don’t know if the industry is geared
to shift quickly to electric vehicles, but there will be massive loss in profitability. India
is already one of the largest exporters of two wheelers. If you have to replace the
internal combustion engine of a two-wheeler with a battery, it makes sense to do in the
domestic market (first).

But given that volumes will fall sharply for legacy bike makers (if they go electric), you
might become uncompetitive in the export market. This is a business of volumes. If the
domestic market evaporates, then export market costing will fly through the roof,
which makes you uncompetitive globally.

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7/13/2019 Falling Cost Of Capital Will Revive Private Capex, Says Kenneth Andrade

The industry is going through a transition and we as analysts or portfolio managers


will not be able to comprehend what the outcome will be.

So, it (auto sector slowdown) is more than cyclical and the change in dynamics are too
dramatic to take a call on what will be outcome for this business.

Is it as difficult to comprehend when and if the turnaround in sentiment, and


therefore consumption, in staples would happen?

I was surprised to see even pharma data fall off the cliff in the last quarter. So, it is not
just staples. It has been dramatically bad June quarter.

As for slowdown, I feel its credit availability at the stockists’ end has something to do
with it. It is not that consumption has fallen down, but the inventory wasn’t there with
stockists or distributors. They are essentially not stocking as much as they used to,
which brings us to credit availability in that cycle.

If there is no pickup anytime soon, what happens to the market-wide multiples in


a scenario like this?

I think over breadth of market, except for a few companies, there has been significant
correction in the last 15 months or so. Till March 2018, everything was quite hunky
dory. From April 2018 to June-July 2019, things have slipped dramatically, economy
and market-wise. That’s where we are in the market cycle.

If we look at the last 15 months, if you push back even three years, returns have been
low double-digit CAGR (compound annual growth rate). FY 19 is a complete washout
year in terms of returns. That’s the cycle we are in.

There is a sense that valuations are still high in staples, consumer & financial services
businesses, and those financial services businesses are essentially the liability side of
private consumption. That is where the valuation is a little bit on the higher side. They
are undergoing a slight structural shift downwards in terms of growth rates...they are
normalising.

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If you eliminate that, then the rest of market seems fairly okay. You might say public
sector banks are distorting valuations because they have no denominators out there. A
lot of large balance sheets with no market capitalization and explain debt as part of
their entire yield is also distorting some part of valuation.

Otherwise, valuations are comfortable. Balance sheets are in good shape. There are
question marks on longevity of this business for next 2-3 years, but we should be okay
as far as valuations are concerned for some of these businesses.

So, we might finally over next couple of years see turn in midcaps and small caps.
The headlines numbers and those 5-15 stocks could not be too much if growth
doesn’t come back. But the rest of the market, because the valuations are good,
will perform better relatively.

We are hoping that some of those events turn around. We need lot more of positive
sentiments and little bit of growth kicking in. I think everything will come back.

BloombergQuint

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