What is your opinion on the economy, given the fact that neither the non-oil imports nor the non food credit have grown dramatically and overall a consensus seems to be emerging that the interest rates have bottomed out. Are we in the same stage where we were last year or is there a dramatic change taking place...?
Not a dramatic change but I think the changes are not very positive. I would say that the external front is weaker than before but it is not anything to worry about. But certainly I think the pressure on the rupee would continue to be there. Crisil has predicted that the rupee would go to Rs 46 to a dollar by the end of the year. We have also been predicting that the interest rates would go up and it looks like there would be some uptick in the interest rate both because of the external pressure and the fact that the foreign inflows that were expected have not been as strong as they were envisaged to be. So I would say that this year I see interest rates going up, exchange rate ending up somewhere between Rs 45.5 to Rs 46.0, the fiscal deficit widening because when interest rates go up the cost of borrowings to the government also goes up. And inflation will certainly be at a much higher level than last year. Some part of the oil price hike that has been absorbed by the oil pool would be ultimately passed on and this would also increase the inflation.
So for commodity industries overall, no respite from pain...
What has happened is that the margins have been squeezed and there is overcapacity in most of the industries not just in metals and oil. Across the commodity industries we find that the capacities are still very high for the current level of consumption. So the pressure on margins will be there for at least the next one or two years. And investment is also not picking up as a result of this.
So, at the economy level the investment led growth that we were witnessing in the past will not happen now. And that slack has to picked up by the services sector and by the consumption led growth. For the latter, this inflation is not very good. So if the consumption led growth does not come, the entire burden comes on the services, which are still showing a lot of promise but whether that will be adequate to overcome the slack in the investment led growth is difficult to say. More importantly, agriculture is still moribund. So we have become extremely concentrated and vulnerable to what services will do.
Services, be they telecom, banking and software are showing promise and they certainly have a lot more to deliver. But the thrust has come from the export market (for the software industry) and there competition is catching up. We've also (because of our success) gone up the cost chain and there are other emerging countries that are beginning to compete. So on a sustained basis over the next two years how well we maintain this growth rate will be crucial and the challenge really is that the services sector, which is growing is still very small compared to problem that we have. So whether they would be able to catch up and solve the problem remains to be seen.
You've spoken in the past about ratio of rating upgrades/downgrades ratio being a lead indicator of economic growth. Could you elaborate on that concept?
This was based on what we've witnessed over the past four years. After the liberalisation and deregulation in 1991 we witnessed a huge upsurge in economic activity and investment activity. And all the indicators, including our rating activity, were absolutely on the upswing. I remember over three years from 1993-94 to 1995-96 the number of rating upgrades (including the no changes) we did, amounted to 90% of the total ratings i.e. around 60% were upgrades and 35% were no rating change and may be 1-2% were rating downgrades. In 1995-96 after seeing a sustained uptrend we became bullish. In 1996-97 our rating upgrade/downgrade ratio started dropping. It became somewhere around 50:50. We were surprised by three things at that time.
First, by the huge amount of capacity that was being added. Till 1995-96 even we didn't get a full appreciation of the capacity being added whether in steel, cement etc. A lot of announcements were made but even we were sceptical whether all of those would be followed through but by the end of 1995-96 we were surprised that all those were being constructed on the ground. Then we were clear that industry would not be able to absorb all those capacities. What was unnerving at that point was till the end of the eighties we were adding capacities in discrete proportions say 10,000 tonnes but by the mid nineties capacity additions were of the order of 5 m tonnes. So, that actually put a brake on our enthusiasm with the industry. At that time we were more worried about the tightness in the market and we started making rating changes to reflect that. I clearly remember IPCL was one of those cases where we had to bring down the rating change and they were saying in this huge upturn why are you downgrading us, but we could see the capacity build up and the tightness in the market and margins becoming an issue.
The next year we actually saw the IIP fall purely as a result of the tightness in the market and as the IIP fell, the GDP also fell and the market's honeymoon for giving funds to anyone who wanted to set up anything ended. We saw debt equities go out of bounds. That year was the first year when a huge amount of downgrades (almost 75% of our rating actions) compared to upgrades took place. The next year was a total wash out with almost 99% downgrades and hardly one or two companies were upgraded. And what was interesting was that while at that time each one of these companies were individually reviewed, when we put all that together there was a strong correlation that emerged between the ratio of rating upgrade/downgrade and indicators such as the GDP and the IIP growth rate and amount of equity money raised from the IPO market. The latter is also an important indicator for us since debt equities balance must be maintained. Ratios such as debt equity and interest cover play an important role in our understanding of how comfortable the company's coverage is for repayment of debt. And as we saw debt equities shooting up the rating downgrades were significantly higher.
Last year we saw somewhat of a steady state being achieved where the downgrades still predominated but it was not as widespread as the year before last. And that was a surprise us in the light of the complete lack of revival of the equity market. This year (i.e. calendar year 2000) we have seen somewhat of an uptick in the upgrades more predicated by the fact that some of the stronger companies came out as great winners or consolidated and deleveraging their risks. One company that comes to mind is Mahindra & Mahindra. They reduced their debt equity, they got rid of their car project, they improved productivity norms, forex loans were repaid. This is just one example. There are a host of companies most of whom have been upgraded this year that have followed very strong derisking measures.
Concerns still remain on three issues: margins are still low and we feel that they will continue to remain low in many industries for some time to come. Hence the abilities of the individual companies to compete in thin margins would be of paramount importance. We are still hoping for the revival of the equity markets and we felt that maybe the feel good factor would permeate to the other sectors as well. This has not happened, so far. A lot of these companies would be able to come out of this situation only when they infuse equity in their balance sheet and retire the high cost debt that they contracted during the 1994-96 regime. In retrospect, the interest rates hardened at a time when massive investment was taking place because of the credit squeeze that was imposed in order to rein in inflation. That looks like a major cause for the downgrades that have taken place because interest rates shot up and huge investments have taken place at those very high interest rates (since many companies were caught up in the middle of the expansion when the interest rates shot up). That needs to get out of the system if these companies are to survive. Hence they need equity funding. However, the markets don't seem to be any mood to give the required funding. So these companies will have to look out for partners.
What has happened is that more than 45% of the rating that are outstanding today are still below investment grade. And for them to come back to the mainstream would require balance sheet restructuring. If it's not going to come from the equity market, they'll have to look atů some of them have sold property, they've sold divisions, they've begun to move in the right direction but it's going to be a long haul.
If you look at this from another perspective, what happens to the equity market till these companies finally get back on the rails?
The equity market has got clearly bifurcated between two dimensions. One dimension is clearly what they have been talking about, the new and the old economy stocks. The other dimension pertains to the divide between good and bad companies. Those two divides seem to be very strongly etched. I have always respected the market so you have to take my comment as a pure observation rather than a criticism of the market. I have not been able to find empathy or the analytical backing for making such a strong distinction between what they call old and new economy stocks. Certainly, I can empathise, I can understand the sharp distinction between good and bad companies. It's been done logically also. But somehow I have not yet been able to convince myself that there is a completely different paradigm under which the new economy stocks operate. And that everything they do will be good and everything the so called old economy stocks do will be bad. I have a feeling that there has been some bit of correction and there has to be a lot more correction.
I am quite willing to accept the market's judgment when you say that there are stocks between 0 P/E to 100, 150 P/E, even 250 P/E is fine with me provided there are continuous data points. If you say that there is something (some stocks) at 500 (P/E) some at 100, a few at 30 and the remaining all at 5 P/E, there is a no continuum. After all, the software industry has to sell software to (say) the petrochemical industry. If you saying that the latter is absolutely dead and gone, then they are not going to be able to buy software also. It may be a tenuous link but there is a link and you cannot disrupt that.
Now (after the recent correction) we can start to talk a little more sanely about why this (software) is 150 P/E and this (old economy stocks) is 2 P/E. I still have a lot of issues on that and I feel that over the medium term that will also get corrected. I have no doubt that the software companies in this country will do very well, they have a lot of upside potential and they will grow tremendously. Clearly, keeping software companies at the highest level of valuations is something that I am very comfortable with. I have doubts on some companies' abilities to ramp up their output in tune with the market's requirements. They are growing continuously and strains will tell, managerial controls will weaken at some point in time and good managements would not like that to happen.
They will themselves put a restraint on their growth and say 'Let me consolidate, I've grown fast enough, at the fringes I am not able to maintain quality, there are customer complaints.' Companies are already employing 8,000-9,000 people and if you expect them to grow 100%, next year they would have to add another 8,000 people. This is not a joke, it's a huge managerial challenge. Then next year they'd have to add another 16,000 people. That I'm worried about as to how companies will have to cope with that. To some extent they will get value appreciation. If today some of the leading Indian companies are getting $ 55/manhour, they may get $ 70 per hour, that will bring some growth, some amount of acquisitions will also be happening that will also bring growth. But I cannot see all this happening all the time to continuously feed the market expectation of 200% growth on a CAGR basis. If that doesn't come even these valuations are dicey. Because for these valuations to sustain you have to do three things. One you have to continuously acquire companies or continuously increase the value or continuously increase the throughput. All three are fraught with tension. To be able to do this all the time on the run would be superhuman. If some of them (software companies) succeed in doing that I would salute them. Already what they have achieved is amazing and cannot be easily replicated. So considering the pressure on the management to perform at these levels, I would be cautious.
But on the other hand I very strongly feel that many of the so called old economy companies are doing well but are not being given their due. And have, in my opinion, a lot of upside potential. At some point in time investment managers would have to make a determination as to what the potential upside is on these two types of stocks.
I feel that before the end of this year there would be a little more of rebalancing in values and somewhat of a more level headed continuum on valuations.
Read the second part of the interview