Why is investing in India so challenging?

With so much negative news about PE/VC returns in India, it begs the question - What has gone wrong?Talking to a couple of my banker friends reinforced what most veterans in the PE/VC industry in India  have known for long.  Bankers are privy to both sides of the transaction, companies raising money and VC trying to get their hands on companies, more recently trying to exit these companies - which is proving to be much tougher

The venture capital/PE industry that started in India in 2004 saw great returns in 07(mostly on paper) which attracted more firms; firms that had been successful in the US and wanted to replicate the model in India. The macro analysis that started with the $1bn population and 15-20% growth looked great on paper; however, what most of the PE firms missed was placing a higher than normal emphasis on  execution capability and promoter intent.

In India, the companies that have done well are the ones which have been able to execute and pivot on their ideas - it's not just the idea, but how well can you do "jugaad" to make that idea work. Right from the start, whether it be setting up an office space to hiring talent, the parameters are very different in India. There is no "plug and play" center nor, do newly minted grads have the grit to work in a start up. It takes more than an average person to work through the logistics, at the same time have a burning desire to execute on the idea. On ideas, the ones that actually succeed are the ones that are "indianized", no point doing the macro math and assuming that the next  expedia and amazon idea will be billion dollars exits. Its all about execution at the end.

Innovation is rare to find, when the executive pay sucks up 25% of money raised. The income gap between the developer and CEO cannot be 10x. The executive has a cushy lifestyle with the options being "good to have".  Interests with investors need to be properly aligned.

In the more traditional industries, promoters will seldom dilute at the bottom of the company's valuation. For them, these are family jewels that are meant to be passed on the next generation. If a company has lower than 51% promoter ownership, hard to see why the promoter would be motivated. The company would in most cases be the channel for raising money for other promoter entities. Hard to compete with the promoter, where his interests are not aligned with the investors.  Most of the PE firms have been burnt by this, not to mention that the stocks are so illiquid and  exiting a 10% ownership is likely to drop the stock price by 90%.

No wonder, most of the VC firms are having a hard time finding exits, which is discouraging new money, not to mention the actions of government which have caused the rupee to devalue to 61 from 40 in 2008.

But as Warren Buffett says "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”. A strategy that has proven to work - look at  companies with wide and deep moat and good corporate governance and stay invested for the long run. 

So is it a good time to buy?

Last week, the Nifty had the perfect setup to break the resistance of 5200 - panic of pledged shares hitting the market, global cues not looking so great with the Greek overhang. However, it pulled pretty smartly from those levels. Not a technical analyst by any means (i tend to be a more bottoms-up person), I do have a lot of respect for what the market tells you. So, what exactly is the market telling us -

For one, the market has a strong resistance at 5200 and now people can go back to trading in the 5200- 5600 range. It would be crucial to see whether the market stays in this range or breaks the next resistance level of 5600-5700 on the upside or 5200 on the downside.

My view is the market would stay in that range till the Q1FY2012 results are out. If the results have a positive bias, very likely the range of 5700 can break. Companies like SBI, BHEL, L&T need to have better than expected results to carry the NIFTY to the next stage. If current leaders like Bharti and HUL, ITC disappoint, the rally could be shortlived and we would have more downside pressures. However, we cannot analyze Indian markets in isolation, as we noticed just couple of days back with oil prices being the single most important factor to rally the markets.

In terms of external factors, oil prices is certainly a big factor to watch out for. My sense is given that oil prices is also a big issue for the Obama adminsitration, it will not go pass 110. This being an election year, the Obama administration will try its level best to have a feel good factor for the US public. This means, Oil prices will not rise nor would US markets end lower this year (read risk trade still ON). The release of oil reserves was just one example of such an intervention by the Obama administration.

So, coming back to the question - is it a good time to buy. In general, i would hold on until Q1 results are out. I would also look at a number of niche industrial companies which seem to have fallen off the cliff due to rise in commodity prices and/or policy decision paralysis, however, these are niche companies and market leaders in their space.

Short DM, long EM

The trade for the rest of the year is "Short DM, long EM".

With QE2 coming to an end and the Euro land falling apart, there are no positive triggers for the DM part of the world. The DM market is still pondering whether the recent slowdown in the job market is a sudden skittish stop in the economy or couple of months of slow job growth. People have still not fully factored in the lack of QE3 in the coming months.

On the other hand, the EM market has gone through the pain of correction in the first half of the year with most of the indices correcting 10-15% and now have reasonable sub to mid teens valuations. Also, prices of crude oil have moderated to sub 100 levels and central banks have taken measures to curb inflation. More specifically, for India the current rate hike may be one of the last few rate hikes.

For emerging markets, a key question is where the next margin improvement will come from. If improvement does not materialise, we could see a trading range for emerging market equities, but if the market realises that company margins over the next few quarters are sustainable, the stock prices should start rebounding gradually and consistently. I think there will probably not be a huge uptick, but more a steady improvement for the rest of
2011 on an absolute and relative basis. This should compare favorably in comparison to DM's which are bracing for lack of liquidity, high unemployment rates and possibly inflation (the dreaded stagflation phenomenon)

Another company under the "scam" radar

Isn't it interesting that a company's stock falls 30% in a single day over allegations on the promoter's brother being involved in a scam, with no apparent correlation as to how this news might directly impact the company's operations. Now, i am certainly not commenting whether this is justified or not. What i find noteworthy, is that when analysts analyzed the said company, they got excited by the near monopoly the company enjoyed in its markets and super normal returns. Clearly, one of the moat(now risk) highlighted by many buy side analyst before numerous Investment Committee's was the "political closeness" the company enjoyed.

Clearly in the last several months "political links or being on the right or wrong side of the aisle" has become an increasingly important factor when analyzing companies. In the past, analyst use to shrug this factor as the way business is done in India or cost of doing business in India. However, in the last 6 months or so after the 2G scam and Anna Hazare and Baba Ramdev's fasting episodes, I think it has become a very important screen and probably the first screen a company has to pass to guarantee long term sustainable returns for its investors. What we are witnessing here is growing maturity of the indian markets and even though this might be a bump in the short run, longer run the move by institutions and retail investors to punish companies with poor corporate governance records paves the way in making India a safer and sustainable place to invest.

Clearly the findings of Mckinsey's survey bears greater significance
A premium for good governance
https://www.mckinseyquarterly.com/A_premium_for_good_governance_1205

On another note to my fellow investors - would love to hear any frameworks you have to analyze "political closeness" or is it just better to not invest in such companies.

Can the sensex see 16000 again?

I saw the commentary by Mr. Mukherjee of Ambit Capital - his prediction is that Sensex could touch 16000 by end of June. Very interesting.. he is of the view that the current climb is on the heels of FII inflows with no change in fundamentals. Clearly the DII's are not buying. So is this sustainable or we slated for another correction? I will draw you two scenario's -

Firstly the bear sceario that Mr. Mukherjee paints - the FII inflows could stop if Bernanke turns off the liquidity tap. Bernake could do that if inflation fears are real - the unemployment rate is falling and their is an increase in real wages. Clearly, that does not seem to be the case. More likely, the sensex could see 16000 if Indian companies disappoint on earnings due to margin pressures (increase in input costs and increase in wages). The FII's in that scenario are likely to see India as a more risky asset class in comparison to the US where economic recovery seems to have real legs and hence move money out of India.
However, there is a 50 percent probability that companies might just deliver and more money could flow in.

So in the extreme bull scenario - the FII's continue to pour money due to better than expected company results, morever the Indian policy makers shift gears after the state elections and actually make investments in the last year of the five year plan - infra sector which has been the lagard until now starts performing and the gdp grows due to investment spending.


I will let you decide, which scenario is the most likely?

Technical Analysis - a misunderstood topic by fundamental analysts

Technical Analysis is a much less understood subject by fundamental analysts. It is considered more of voodoo than being an art based on science of patterns and trends. Lets try and dispell some of the myths so technical analysis is treated more of a friend by most of the fundamental analyst community.

Technical analysis gives you a view to how other market participants have reacted to the stock in the past. This is an important data to understand and interpret as humans tend to react the same way in times of greed and fear and hence likely to repeat such behavior. In essence, a technical analyst believes that patterns repeat themselves and hence tries to find patterns in the stocks previous prices and volume charts and extrapolate the same in hte future. The basic tenet behind technical analysis is that human behavior is repeated whether it be greed or fear. Hence the knowledge of market behavior participants in the past gives you another data point to consider ascertaining the stocks future performance. Technical analyst is based on human behavior be it greed or fear and people tend to react in the same manner no matter what security or what time frame and hence the concept of symmetries and patterns.

There is a saying in the Indian market “bhaw bhagwan hain” meaning price is god. Prices by themselves convey a lot as is taught to us in basic economics. Technical analysts take it to the next level by looking at open, close, high and lows of a security in one day, one week or one month. By looking at patterns they can tell whether bears or bulls rule the market.
As is with fundamental analysis, it is more of an art than an exact science. For a fundamental analyst a P/E of 10 can mean overvalued as well as undervalued depending on where the market, the sector and the company has traded historically and his future expectations. Similarly for a technical analyst it is the subtle art of deciphering patterns and symmetries can make all the difference whether a particular stock is overvalued or undervalued.

The basic advantage that a fundamental analyst gets is to get a sense of the entry and exit levels of the stock.

A word of caution - Technical analysis does not work on illiquid stocks as in such stocks it is not the behavior of the masses but that of a select few that have more often than not insider information. Hence, technical analyst is most useful on liquid stocks.

Time for capital market participants to look at emerging markets more closely?

For the last 30 years, growth in financial assets was primarily driven by rapid increase in equities and private debt securities in countries such as United States, Japan and Europe. The world’s financial assets – including equities, private and public debt, and bank deposits rose from $11 trillion to $194 trillion, becoming four times the size of GDP.

The United States has the dominant share of the global financial markets with $50 trillion(385% of GDP) of assets. The eurozone is second, with nearly $40 trillion (314% of GDP). Japan ranks third with $26 trillion(533% of GDP) and the U.K. market has less than $8 trillion(325% of GDP) of financial assets. Asian financial markets remain fragmented and have very different characteristics. Japan has a huge government-debt market, whereas China holds 75% of its more than $12 trillion(270% of GDP) in financial assets as bank deposits. India's financial system is tiny, with only $2 trillion( 160% of GDP) in assets -- possibly ranking as the global dark horse in the decade to come.

However, after the 2008 downturn, the drivers of future growth have likely shifted. There is a growing consensus that going forward, growth in financial assets would be led by emerging markets such as China and India. There are primarily two reasons cited for this – one, the fundamentals support it; second, there is enough room for them to grow.

Equities have been the fastest growing asset class in mature markets since 1990, as corporate earnings and price earnings ratio increased. But now, earnings growth has slowed and valuations fallen. In developed markets, GDP growth is likely to more modest due to aging population and mounting government debt- little reason to believe that corporate earnings would grow, if at all from domestic growth. On the other hand, emerging economies will likely grow much faster on the back of better demographics and high savings rate. India alone would have 270mm net increase in working age population (almost the size of the US) and middle class would nearly quadruple from 22 mm to 90mm. Subsequently, consumer spending would increase by four times to $1.2 trillion by 2025. Secondly, these countries lack basic infrastructure and hence massive amounts of financing will be required to build them. India alone would need about $1.2 trillion capital investment to build its roads, metros and cities.

Thirdly, the growth of the equities will also be driven as more state owned enterprises are privatized and as existing companies expand. It is commonly believed that only about a fraction of the companies are listed in emerging markets, while about 70% of the companies’ trade on the exchanges in the US. Similarly the corporate bond markets and other private debt securities would grow with significant legal and financial reforms.

The third big factor contributing to the growth of financial assets would be bank deposits. Currently 2.8 bn people in emerging countries are unbanked. For instance in India, more than 50% of the household savings are pooled into hard assets such as housing and gold. Bank deposits would grow significantly as more of the unbanked are brought into the mainstream financial system. As more and more people open savings accounts and household savings grows, deposits would grow.

More importantly, if we compare the size of financial assets in terms of GDP, more commonly known as financial depth, most emerging markets are tiny compared to the US and other mature markets. The total value of all emerging market financial assets is equal to just 165 percent of GDP – just 145 percent if we exclude China – well below the 403 percent financial depth of mature economies. Clearly there is a lot of room for the assets of these economies to grow.

Clearly, all these factors combined would lead to substantial growth of financial assets in the emerging markets in the next twenty years; their relative share in the global capital markets would only gain further prominence. It is simply too glaring to be ignored any longer.

IMF raises India's target GDP growth to 9.5%, is it sustainable?

The IMF revised India's target GDP rate to 9.5% with many brokerage houses following suit. It also reported that growth would be largely consumption led . Clearly this is great news, where growth in US and China seems to be losing steam. But is the "largely consumption" led growth sustainable? Lets break down the numbers -
GDP growth has three components -
1. Due to Investment growth
2. Consumer spend
3. Net exports
In the case of US, where lot of core investment has already been made, the growth is largely consumption led. China is largerly export oriented economy and hence most of its growth is derived from exports and investments.
India differs from the two -
India has net negative exports and hence growth in India would be largely investment and consumption led. Also, since it is still a developing economy, investment growth forms a major component of GDP growth. Now, lets look at the two numbers broken down -
1. Investment - The investment to GDP growth is 34% which is quite good. However, this might largely be projects getting completed rather than new projects being started.
2. Consumption - In an economy such as India, where organized retail forms 4-5%, it is hard to track consumption growth. Consumption is tracked through quarterly GDP estimates - household expenditure. Secondly, we can use IIP data as a proxy. We break IIP data into consumer durables and consumer non-durables. Consumer goods data is very healthy at 6-7%, but if you further break it down - consumer durables is 20% and consumer non-durables is 2%. My index of sustainable consumer growth is non-durables growth. The reason being - consumer durable growth is driven by interest rates (one buys an automobile, as they feel interest rates might go up). Consumer non-durables is lifestyle augmentation - once you start consuming these, you can't really roll them back - they are not one-off purchases.

To maintain an 8-8.5% growth, we need consumption to grow at 6%. If you look at the historical pattern - it tends to lag and is more robust. Household consumption is also more stable than investment spending. When things go down, households preserve their consumption expenditure until their incomes start getting strained. On the way up, household expenditure does not go up all of a sudden, it gradually does. In the 2000 cycle, investment hit rock bottom in 2000, then gradually recovered by 2002, however consumption response to income growth came in late 2004 and gradually picked up in 2005.

Is it going to be the morning after?

In a span of 15 months, i have seen a black Monday(Sensex down 1000 pts) and a golden monday (sensex up 2200 pts, upper circuit hit, mkts closed for the rest of the day). Indeed markets have very short memories. On March 9th anything and everything was getting sold. On May 18th anything and everything was getting bought.
What would explain this irrational exuburance ?? The markets seem to think that the UPA govt will change the face of India. To some degree they would, but the market has conveniently forgotten about the budget deficit and that the current government was in power for the last 5 years as well. A 7-10% surge was warranted, but the kind of franctic buying - $1bn of FII investment with PE of 15.4x (above the long term average of 14.5x) . FII's can very easily pull out money as they put money in, so for a retail investor it would be key to look at fundamentals, rather than sentiment. Surely, it seems the momentum is huge - it remains to be seen how long this rally will last

Venture Capital Industry in India and Bay Area - a few points of comparision

A lot has been written about venture capital in India and US, and here is my take on it from the perspective who has lived in the bay area for 9 years, went through the dot-com bust and helped sell a company , worked at one of the internet darlings only to be working at the best investment bank of the world.

The industry in India and Bay Area is vastly different

1. Stages of investing - Bay Area as you can imagine is the incubator of all technologies and the venture capital ecosystem is mature and setup with firms specializing at each stage of the company starting from seed stage investing to late stage firms. However, in India most venture capital firms have morphed into late stage growth capital private equity shops. My personal take on this is that over a period of time they would see a dearth of deals as the venture funding required at the seed stage or early stage of investing is missing.
   
2. Succesful exits - Most venture capital firms have not witnessed the kind of exits that they have seen in the valley - the likes of Google, Yahoo!, Electronic Arts. It is going to take some time for venture backed companies in India to see such exits.
   
3. Environment of innovation - I see a lot of development, especially in the IT hubs of Bangalore and to some extent in Mumbai where the young folks are leaving their cushy jobs to become first generation enterpueners. Also a lot of venture capital firms are visiting universities, colleges and having enterpuenership meets to create budding enterpueners. Such efforts need to be appreciated, however, it is still in a nascent stage and would take some time to develop.
   
4. Business Models - I think this point bears a lot of thought. There is a lot of difference of how the early stage companies are set-up. India is still trying to solve basic logistical problems like bus ticket inventory (bus travels is an unorganized sector with most operators having 2-3 buses with little incentive to bring inventory online) or yellow pages where the carpenter in the neighborhood is listed on the web. So, most business models that get funding are either models that have been successful in the US and are being replicated in India.
   

Trends in BPO/KPO industry in India

From the hey days of IT outsourcing which put India on the world map in 2000-2001, this is a successful and tested model. This model has contributed almost 3-4% of India's GDP in the past.

The Indian IT-ITeS sector (including hardware) grew by 33 per cent in FY 2008 to reach US$ 64 billion in aggregate revenue. Of this, the ITeS/BPO sector contributed US$ 12.5 billion as against US$ 9.5 billion in FY 2007, an increase of 31 per cent.

The Indian ITeS-BPO exports grew significantly from US$ 8.4 billion in FY 2007 to US$ 10.9 billion in FY 2008 while the revenues of domestic BPO grew to US$ 1.6 billion in FY 2008 from US$ 1.1 billion in FY 2007. The sector provided direct employment to 700,000 in FY 2008 up from 553,000 in FY 2007.

This business model is based on labor arbitrage and works on two conditions being fulfilled- one, wage disparity between different countries and secondly, tasks that can be performed off line using a predetermined set of instructions. My personal take on this is that wage discrepancy will exist in India so long as India keeps churning young eager high caliber talent from its numerous engineering and management schools ready to work for less than $500 a month. According to economists, India would have the largest population in the world in the age group of 20-50 by 2035.
The two new trends in outsourcing are legal process outsourcing and with the demise of banking system in the US - banking and research KPO. However from my experience working at a services company, for the long term success of such models - the model down the line needs to maintain Service level agreements (read Quality) as well as provide value addition to the process/task ( read move to being a product company in addition to a purely services company or be able to provide on the ground research/intelligence not available to the foreign outsourcer). Some of the emerging financial services companies are Amba Research (Helion Ventures), Copal Partners, Evalueserve, UnitedLex (Helion Ventures), Pangea3 (Sequoia Capital), Mindcrest (Ganesh Natarajan), and JuriMatrix (Jerry Rao) to name a few.

How do Venture Capitalist value your startup

There are generally two ways VC's do their Voodoo !!

1. Early Stage start-up - This is more of an art and less of a science. To calculate the exact value of a business is tough, since a lot of assumptions used can change over time starting with from the definition of the market the startup is going after. However, the general method used is - start with the market size, estimate as to how much of the market share this startup can potentially capture and then multiply these two with the profit margins. This would generally give you an idea of the value of the startup. But as you can imagine there are a lot of variables and most numbers are best a gestimate firstly because there are no published authoritative reports on how big the market size is or would be and secondly, over time how would the competitive landscape change - meaning, how much market share and the startups' profit margins might be. Hence, frequently you would find a lot of Venture capital firms focusing on the sectors they know best(so the assumptions/variables have been tested and verified against) and investing money with people they trust (so they are reducing at least one variable/risk - the management's ability to deliver.

2. Late stage start-up with some cash flows - Again, you would use the same methodology as you would with early stage start-ups, the only difference is the variables/assumptions are more grounded in reality. Firstly because the company has been in operation for a while so you can judge from past performance as to market share and profit margins. Secondly, hopefully you are in a sector which seems attractive to other enterpueners and you see competition - you a benchmark to compare your startup both in terms of precedent deals that other VC's have done as well as market share and profit margin numbers to compare.