There Is Something About Mary

 In the past two months, I have received numerous communications criticizing me for being overly cautious on markets and questioning the premium Indian equities have historically enjoyed. The primary and common theme in all such communications is that the incumbent government has taken many innovative, unprecedented and revolutionary steps for the upliftment of the poor, farmers, women and youth; supported the small and medium businesses and promoted manufacturing and innovation.

I would like to close the discussion on this topic with the following reproduction of a conversation from the popular 1998 Hollywood movie “There Is Something About Mary”:

“Hitchhiker: You heard of this thing, the 8-Minute Abs?

Ted: Yeah, sure, 8-Minute Abs. Yeah, the exercise video.

Hitchhiker: Yeah, this is going to blow that right out of the water. Listen to this: 7... Minute... Abs!!!

Ted: Right. Yes. OK, all right. I see where you're going.

Hitchhiker: Think about it. You walk into a video store, you see 8-Minute Abs sittin' there, there's 7-Minute Abs right beside it. Which one are you gonna pick, man?

Ted: I would go for the 7.

Hitchhiker: Bingo, man, bingo. 7-Minute Abs. And we guarantee just as good a workout as the 8-minute folk.

Ted: You guarantee it? That's - how do you do that?

Hitchhiker: If you're not happy with the first 7 minutes, we're gonna send you the extra minute free. You see? That's it. That's our motto. That's where we're comin' from. That's from “A” to “B”.

Ted: That's right. That's - that's good. That's good. Unless, of course, somebody comes up with 6-Minute Abs. Then you're in trouble, huh?

Hitchhiker: No! No, no, not 6! I said 7. Nobody's comin' up with 6. Who works out in 6 minutes? You won't even get your heart goin, not even a mouse on a wheel.

Ted: That - good point.

Hitchhiker: 7's the key number here. Think about it. 7-Elevens. 7 dwarves. 7, man, that's the number. 7 chipmunks twirlin' on a branch, eatin' lots of sunflowers on my uncle's ranch. You know that old children's tale from the sea. It's like you're dreamin' about Gorgonzola cheese when it's clearly Brie time, baby. Step into my office.

Ted: Why?

Hitchhiker: 'Cause you're fuckin' fired!”

The point being, you may find a small improvement in the status quo, a transformative development, but I disagree. I want much more evidence of the growth and development than mere headline statistics.

Paying silver for the dust

Powerful people have always fascinated the media and the film industry. The drug lords of Latin America, the mafia families of the United States, the warlords of Africa and the Arab world, the Russian oligarchs, the media barons of Australia. They have been as popular on screen as the spy agencies, the CIA, the KGB, Mossad and MI6. By most accounts, many of them had a say in how politics, courts and financial systems worked in their own countries, and at times outside them too.

Business having a say in foreign policy is not new either, at least in the developed world and in countries that are not fully democratic. The East India Company ran an empire. American fruit and oil companies influenced how their government dealt with other countries. Russian business magnates helped re-elect their president in 1996. What has changed is the form. After the global financial crisis, a few owners of technology infrastructure, such as satellites, platforms, cloud services and chips, came to hold something that governments depend on. When a businessman decides where a satellite network will work in a war, as Elon Musk’s choices on Starlink in Ukraine showed, he is making a call that once belonged to the state. The media is in love with them.

Governments are pushing back, each in its own way. China has put firm limits on its large private groups, technology platforms in particular. Russia had done much the same with its oligarchs early in the 2000s. Europe is trying to bring big technology platforms under stricter rules. India is also tightening the screws on global social media and ecommerce companies. In my view, Elon Musk’s purchase of Twitter, now X, should be seen in this context. When one person can own the place where a large part of the world argues in public, governments are bound to take notice.

India is different, and this part is new

Large business families have always carried social and political weight in India. Tata, Birla, Bajaj, Modi, Shriram, Singhania, Goenka, Wadia, Kilachand, Dalmia, Lalbhai, Sarabhai, Murugappa, Thapar and Kirloskar were respected names. They built schools, hospitals and temples. Patriarchs from several of these families took part in the freedom struggle. After independence, though, their influence stayed mostly on policies relating to trade and finance. Foreign policy belonged to the government and a small circle of diplomats and politicians. Business did not decide it, and did not seem to want to.

In the last few years that line has become blurred. Some Indian business groups have become very visible abroad. They are building or buying ports, power plants, mines and airports in countries that matter to our diplomacy, and the announcements often come around the time our leaders visit. At least one foreign minister has described such a deal as something close to a government-to-government arrangement.

I see two ways to read this. One is that business is steering policy: the group sets the agenda and the government follows. The other is that the government is using these groups as its overseas arms, the way China uses its state-owned firms, because our own public sector lacks the money and the appetite for risk. The facts in public view fit both stories. I do not have the evidence to choose, and I doubt that anyone outside the room does. I am also not naming any group, because the question is bigger than any one of them.

The costs are easier to see than the motives. Some observers believe a few of these projects have strained our relations with neighbours, and local politics in host countries has turned against some of them. Whoever is steering, that risk is real.

How the market saw them

In the old days the financial markets were small. The Indian equity market started taking shape in the late 1970s, when multinationals were asked to dilute their holdings under FERA. It was around the same time that Dhirubhai Ambani took Reliance public. For a decade or more after that, the market was ruled by multinationals like HUL, Nestle, ITC, Castrol, Colgate, Cadbury, Glaxo and Reckitt. The next big step came in 1992, when foreign portfolio investors were allowed to buy Indian shares in the secondary market.

By the late 1990s, professionally managed technology companies and private banks had taken the lead, and they held it for almost two decades. In that period the business was the story, not the person behind it. Many of the older families had already faded after the 1991 liberalisation, when competition arrived. Those who stayed on, like Tata, Birla and Bajaj, and later Ambani, did not always keep pace with the multinationals, technology companies and private banks, at least in the returns they gave to investors.

There was one exception, and I have not forgotten it. In 2006 and 2007, promoters of infrastructure and power companies were the darlings of the market. Many investors who bought at the top of that boom waited years to get their money back, and some are still waiting.

What is different now

Over the last few years something new has been happening. The market has started valuing the person more than the business. It hardly seems to matter what the business is. It could be commodities like coal, copper, aluminium, steel, oil or gas. It could be power, retail, automobiles, financial services, food processing, textiles or ecommerce. If a particular promoter is behind it, the stock gets a premium.

The argument behind this is simple. “This man can turn dust into gold, so paying silver for the dust is not a bad deal.”

I do not want to dismiss that argument. Some promoters have genuinely built big businesses out of very little, and a record of execution deserves some premium. But I keep wondering how much of the premium is for what the person can do in business, and how much is for being seen as close to those who matter. The first can be tested in the numbers. The second cannot.

The promoter is not the only name that gets a premium. Something similar is happening with some large investors and fund managers. Every quarter, when companies publish their shareholding pattern, many retail investors rush to see which well-known investor has bought what. If a famous name turns up in a small or mid-sized company, the stock often runs up within days, and the only reason offered is that “he has bought it”. Fund managers get the same treatment. A manager who has had a few great years finds money flowing in, and the stocks he holds get a bid along with it.

I understand why this happens. Most retail investors do not have the time or the tools to study a company, and borrowing the homework of someone successful looks like a sensible shortcut. But there is a lot we do not see. We do not know at what price he bought, which may be a fraction of today’s price. We do not know how big this holding is in his total portfolio, or how long he plans to stay. We do not even know why he bought it. The disclosure also comes after the event, so by the time the news reaches us, a good part of the move may be over. As for fund managers, a few good years do not always prove skill. Sometimes a style or a sector was simply in favour.

It is the same pattern again. The name is being valued, not the business. The investor may well be very good, but paying more for a share because of whose name is on the register is also paying silver for the dust.

Why this matters to me as an investor

A premium built on earnings and a premium built on closeness to power carry different risks. The second depends on goodwill that can change with a government, with a host country or with a legal case abroad. It also depends on one man, and one day he will not be there. None of this shows up in a quarterly result until it is too late.

Where I stand

I will be honest. I am confused by this change in the market. It is something very new for me, and I am not sure how it will end. Whether the dust will turn into gold or the silver will turn into dust, we will know only in hindsight.

For now, I am sticking to my old method, which is to look at the business first. The person behind it matters to me only as far as his record shows up in the numbers. Here is what I check:

·         What does the business earn on the capital employed, and how much of that comes back to the shareholders?

·         How much debt does the group carry, and how much of the promoter’s holding is pledged?

·         How many deals are done with related parties, and are minority shareholders treated fairly?

·         How does the valuation compare with other companies in the same industry? If there is a premium for the promoter, I want to see it and put a number on it.

·         How much of the growth depends on the goodwill of governments, at home or abroad? That kind of growth can disappear quickly.

·         What happens to the business if the promoter is not there? Key-man dependence is a real risk.

If a well-known investor or fund is on the shareholder list, I take it as a reason to look at the company, not as a reason to buy it. Would I still like the business if his name were not there?

In our folklore there is a stone called paras, which turns iron into gold. Investors today seem to believe that some promoters carry one in their pocket. I would rather own businesses that make money without needing one.

 

Glass Half Full or Half Empty?

 

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The table above presents the equity returns of some of the world’s largest markets since January 2001 against their nominal GDP growth (in local currency) over the same period.

The idea is to examine whether over long periods, equity returns that track nominal GDP growth are an optimum outcome an investor can reasonably hope for. Listed companies ought to, broadly, grow with the economy that hosts them. Returns far above GDP growth would usually mean valuations have expanded or profit margins have stretched, and neither can go on forever. Returns far below GDP growth usually mean something has leaked between the economy and the shareholder: poor capital allocation, dilution, a shrinking share of profits, or economic growth that happens outside the listed universe.

By that yardstick, the picture is mixed.

The lagging majority

Thirteen of the twenty-three markets have delivered equity returns clearly below nominal GDP growth. In several cases the gap is wide. China and Hong Kong, the UK, France, the Netherlands and Italy have all delivered less than half of their respective GDP growth. China is the starkest example. Nominal GDP compounded at over 11% a year while the Shanghai Composite returned about 2.2%. The economy grew enormously, but very little of that growth reached the owners of listed equity.

The divergence could be a result of a multitude of factors. For example, growth can be captured by the state, by unlisted private firms, by foreign investors in other markets, or by the workers and consumers who benefit from it. It can also be consumed by years of poor returns on capital. Shareholders get only what is left.

The leaders, and when they led

Nine markets have beaten GDP growth: the US, Japan, South Korea, Taiwan, Canada, Germany, Mexico, Thailand and, narrowly, India. On the surface this looks like vindication for equities.

Look at when the outperformance arrived, though. In the US, Korea, Japan, Germany and Taiwan, most of the excess return has come in the post-Covid years, and much of it in the last one to five. These are the markets carried by AI, semiconductors, and a general re-rating of earnings.

Japan’s ratio of 7.47 is partly an artefact. Nominal GDP growth of 0.8% a year over 25 years is a very low base, so almost any equity return looks large against it. Much of Japan’s return also came after decades of going nowhere.

A long-run average can hide a lot. For most of the period, these markets did not outperform. They have recently caught up, and then some, and that recent move can be read two ways. It may be a durable re-rating driven by real changes in profitability. It may also be a stretch that will gradually revert.

Only two in sync

Across 25 years, only India and Brazil have logged equity returns in line with GDP growth. India’s Sensex compounded at about 12.0% against nominal GDP growth of 11.5%. Brazil’s Ibovespa compounded at about 9.8% against 10.0%.

I would call this the optimum outcome: equity holders broadly participating in the growth of the underlying economy, no more and no less. It is neither a bubble nor a disappointment.

The question for India

This brings me to the question that matters most to the investors.

Equity returns have lagged nominal GDP growth in most European and ASEAN markets over the past couple of decades. The question is whether India’s recent relative underperformance is a temporary phase, with returns catching up and perhaps overtaking GDP growth, or the start of a longer period in which our market looks more like Europe or Southeast Asia’s.

I don’t think valuations or earnings cycles alone can answer that. My view is that the answer lies in how India’s industrialization progresses. Specifically, it depends on whether we can meaningfully raise our share of global trade, especially in engineering goods and merchandise exports.

The reason is that the markets that kept pace with or beat their economies over long periods, such as Korea, Taiwan and, in recent years, the US, have had globally competitive listed companies that earn high returns on capital. A consumption-led economy can post impressive GDP growth. But if that growth flows into low-margin, domestically focused, or capital-hungry businesses, shareholders may see only part of it. Competing in global markets disciplines costs and capital, and it lets listed companies grow beyond the size of the home economy. If India’s manufacturing and export base deepens, equity returns can plausibly keep pace with GDP growth, or exceed it. If it doesn’t, the European and ASEAN experience is a real possibility.

Some caveats

·         Price indices understate returns. Apart from the DAX, which is a total-return index and so not strictly comparable, these are price indices. Including dividends would add perhaps 2–3 percentage points a year in many markets, and would move several laggards much closer to parity.

·         Endpoints matter. Starting in January 2001 means starting near the peak of the dot-com era in some markets and before several others had rallied. A different start date would change several rankings.

·         Index and economy don’t match. A listed index doesn’t mirror its home economy. The FTSE 100 and the CAC 40 earn much of their profits abroad, so measuring them against UK or French GDP is imperfect.

·         The data is approximate. The GDP numbers are broad estimates, so I’d read the table for the shape of the story and not for the second decimal.

None of this, however, changes the central point. Over a very long horizon, equity returns that track nominal GDP growth are a healthy result. Returns well below it suggest value leakage, and returns well above it should make us ask what has changed and whether it will last.

By that standard, India is currently in a good place, but not a guaranteed one. Whether it stays there depends less on the next few quarters of earnings and more on whether we build an industrial base that can compete globally.