Motilal Oswal: Taking the long view

(This story was originally published in the February 2020 issue of the magazine.)

The Indian stock market gained 13.8% in 2019 despite high volatility. Making gains in 2020 doesn’t look easy with indications of domestic and global headwinds: slow growth in India, and geopolitical tensions between the U.S. and Iran. However, Motilal Oswal, managing director and CEO of Motilal Oswal Financial Services Ltd (MOFSL) which he co-founded with Raamdeo Agrawal in 1987, is optimistic about the world’s seventh-largest stock market. In an interview with Fortune India, the 57-year-old Oswalsays the stocks of many companies, mostly with good quality businesses, are trading at a discount to their long-term averages. It is a great time to construct a well-diversified equity portfolio for long-term wealth creation, he says.

Edited excerpts:

Economists say India’s gross domestic product (GDP) needs to grow at over 10% to make the nation a $5-trillion economy by 2025. How realistic is this goal?

The government’s vision of the nation to become a $5-trillion economy by 2025 is definitely challenging but not impossible. We believe India is well on its path towards achieving this target, albeit it may get there a year or so later. India’s economy crossed $2.6 trillion in 2018-19 and would need to grow upwards of 10% on a nominal basis over the next five years to reach the $5-trillion mark.

While the near-term growth has been slower than expected, the long-term growth prospects continue to remain sanguine. Some of the key components of the economy which would be contributors to this growth would be consumption, private investment, and exports, as government expenditure alone cannot help in achieving this mega target.

The government on its part has supported [the goal] through various measures, including the commitment to spend ₹100 lakh crore over the next five years on building infrastructure across the country. It also cut the corporate tax rate and offered a lower rate for new manufacturing firms to boost private investment and attract global capital.

India has several positive factors supporting its long-term growth potential. Hence, we believe India has the potential to achieve this ambitious target. The economic slump has deepened and business confidence has declined, but the stock market has scaled lifetime highs. Do you expect markets to correct because most analysts believe a pickup in the growth cycle may take longer than anticipated earlier?

While the economic slump is a big concern, there have been multiple reforms over the past few years such as demonetisation, implementation of goods and services tax (GST), the RealEstate (Regulation and Development)Act, [and] bankruptcy law under the Insolvency and Bankruptcy Code, leading to the resolution of a few large non-performing assets (NPAs). Apart from these, the government in 2019made the historic decision to cut corporate tax along with providing incentives for manufacturing in India.

In the New Year, we remain optimistic that many of these measures will play out positively for the economy. Additionally, liquidity is expected to improve, as banks have recognised and provided for a large part of NPAsin the system. Furthermore, we are seeing abundant liquidity globally, as most central banks have been accommodative in 2019 and are also resorting to quantitative easing. This should lead to liquidity flowing into emerging markets with India being one of the key beneficiaries. Also, the government has hinted towards working on rationalisation of personal income tax/taxes related to equity markets, which would help boost demand and economic growth.

Only a handful of stocks are driving the index, mid- and small-caps are trading at historic low valuations, and credit quality is a concern. Across asset classes, where do you see the opportunity for value investing?

While the economy continues to remain in a slowdown phase, the benchmark Nifty 50 is hitting new highs, which has created some confusion in the minds of investors. This situation can be clarified by understanding: first, the Nifty 50 does not always act as an indicator for the entire market; second, liquidity through systematic investment plans and exchange-traded fund flows from foreign institutional investors (FIIs) continue to be strong and are allocated to large-caps; and third, large companies, being market leaders, tend to perform comparatively better in tough times, and hence, act as a risk aversion trade. In addition, FIIs’buying streak (net inflow of ₹95,000 crore in 2019), which touched a seven-month high in November, has been a major support for the markets. Returns from equity markets are a function of two things: growth and valuations. At present, while growth may take some time to revive, the valuation of the broader market is still quite attractive and there are only a few pockets of excess valuation. After the recent rally, we believe that the Nifty 50 at approximately 18x FY21E P/E [price-to-earnings] captures the expected earnings recovery. While the upside from the current levels may be capped, the current momentum can continue in the near term on the back of strong liquidity flows and positive sentiments.

The market has rewarded stocks with steady business performance and quality growth, irrespective of their market capitalisation. A major theme for 2019 was corporate governance. Companies with good, clean managements were rewarded handsomely by the markets—a theme which may well continue in 2020. A lot of sectors/stocks with good quality businesses are trading at a discount to their long-term averages and can potentially participate in growth recovery. Overall, we believe it is a great time to construct a well-diversified equity portfolio for long-term wealth creation.

With many new sectors opening up, what’s the next big investment theme to drive wealth creation?

India is on the cusp of an inflexion point, where we are targeting to reach a $5-trillion economy over the next five-six years. Globally, very few large economies can offer such growth along with stability. Hence, India would attract a lot of global investments, both financial (FII) and strategic (foreign direct investment or FDI). From an investor's perspective, some of the key themes that would play out in India over the next few years would be: increasing formalisation of the economy; financial inclusion; financialisation of savings; increasing per capita income leading to higher discretionary spend; and increasing focus towards the environment, health, and safety.

Given these trends, investors can look towards sectors like insurance, which is in a sweet spot in India with strong structural growth potential, as it is still highly underpenetrated. Asset management is another sector which could emerge as a megatrend with increasing access and financialisation of savings. In the case of infrastructure, sectors like renewable energy and water conservation are likely to see a lot of focus from the government. Electric cars are likely to spread throughout the transport sector though it could coexist along with internal combustion engine vehicles. E-commerce and social media will continue their expansion with higher Internet penetration; and5G should further assist its growth.

We are at the dawn of a new decade. What are some disruptive ideas that will shape the next decade?

The new decade will bring along with it a lot of new developments and changes for the economy as well as businesses. We are already witnessing disruption in many sectors, which should not only continue but also accelerate, going forward. One of the major factors that would determine the long-term viability of businesses would be the ease of doing transactions, be it in products or services, the traditional or contemporary businesses. Another major overhaul that we would see in India would be the formalisation of the economy(i.e. trade structure in favour of the organised sector) with the government’s initiatives like demonetisation, GST, etc. Unorganised trade accounts for a significant proportion of India’s economy. However, with rising per captain come and aspirational buying, theshare of unorganised trade is gradually reducing. The shift will also be driven by better tax administration and compliance. Sectors like consumer, homebuilding, light electricals, auto ancillaries, healthcare, logistics, and metals are crowded with unorganised players and can witness a gradual shift to-wards larger organised players.

A lot of industries are adapting to an environment of digitisation and robotics. Fast-moving consumer goods (FMCG) firms are changing their product mix towards more healthy and herbal. Traditional media is being challenged by digital distributors like over-the-top platforms and live-streaming apps. In addition, financial inclusion categories like micro-credit and digital payments would also witness high adoption as digital will solve the access problem.

What are the key financial risks and asset class bubbles that we need to be wary of in the next decade?

It is generally difficult to predict financial and economic events that could play spoilsport in future. However, it is prudent to acknowledge areas of concern as well as risks for the market. A sharp global macroeconomic slowdown is the biggest risk for the financial markets. Another risk in the current environment of global trade hostility is a full-blown trade war, leading to a global economic recession. Geopolitical issues are another source of risk which may increase volatility as well as uncertainty. Environment and climate change is fast becoming a global issue, which needs to be addressed by fast-growing economics and businesses to remain relevant in future.

Major technological advancements are likely to disrupt existing norms and the way businesses are done. Hence, entrepreneurs need to consider how to adapt their businesses to the effects of technological changes. With the Indian economy expected to be among one of the fastest-growing within the emerging nations, it would require adequate capital flows to sustain and fund this growth. Inability to attract and sustain capital flows could restrict it.

India's household debt has increased at an annualised rate of over 13% in the last five years, while consumption has seen a steep decline. Are you concerned?

Over the past seven to eight years, driven by easy financing from non-bank-ing financial companies, consumption has been on the upswing even as the pace of wage growth, both urban and rural, declined to single digits. The household savings rate, which was around 23% at the beginning of the decade, has fallen to 17%. At the same time, the household debt burden has increased in recent years and may well have begun to strain consumption.

Physical savings (largely real estate) of households declined from 15.9% in FY12 to 10.3% in FY18. Financial savings declined too, from 7.4% to 6.6%. And that’s a major concern because households are traditionally the net suppliers of funds to the private corporate and public sectors. Put another way, the excess of household savings over their investment is used to fund the saving-investment gap of the other two sectors. At present, the level of financial savings is just about enough to finance the combined fiscal deficit of the Centre and the states. A continuation of this trend will shrink the pool of savings available for private investments or result in crowding out.

The government’s resolve to push growth up is evident. And with a softer monetary policy stance, investments are likely to increase in the future. But if savings do not rise commensurately, India’s current account deficit couldcome under stress. Clearly, it is time to reignite the virtuous cycle of high savings, investment, and growth, if the economy has to be pulled out of its current downswing and restored on the high growth trajectory.

We have seen some grave cases of fraud and corporate governance failure at leading companies. What measures need to be undertaken to protect the interests of stakeholders?

Corporate governance has become a very pertinent topic in recent times.We have dedicated our 24th WealthCreation Study on this topic. The culture at the top level of a company’s management should be very strong and they should focus more on the long-term picture, rather than short-term results. They should be able to build a good culture with deep values within the organisation. The board of directors should be competent along with high integrity and should not be there just for compliance purposes. They need to be more effective in the discharge of their fiduciary responsibilities. The corporate governance framework should be effectivelyimplemented and stringent action should be taken in case of any wrong-doing. There should not only be satisfactory compliance procedures but also effective escalation and accountability processes. Apart from these, a few other points we highlighted in our study were that companies should be asked to present a simplified free cash flow statement, as the P/L [profit/lossstatement] is easier to manipulate. Also, auditors must be made more accountable to minority shareholders to avoid misconduct by the management.

What is MOFSL’s outlook for asset allocation in the coming year and what are the key milestones you aim to achieve?

Historically, equity has been viewed as a wealth-creating asset class and debt and gold being inflation-beating asset classes. Over the longer term, equity is the best asset class in terms of returns. However, it comes with its own risks. Diversification always helps. One needs to decide his/her individual asset allocation based on his/her risk-taking profile, investment objective, financial goals, age profile, etc. There are multiple factors that define the risk tolerance level such as investment horizon, liquidity needs, investment goals and so on. An investor with high risk tolerance may allocate a higher percentage of the portfolio towards equity while on the other hand, an investor with a low risk profile has to allocate higher towards fixed income securities. Thus a portfolio diversified across asset classes would have the ability to generate superior risk-adjusted returns.

Within equities, we believe a multi-cap approach would provide a favourable risk-reward scenario where the portfolio would have stability from large-caps and potential alpha generation from mid-caps as and when earnings recovery happens in the broader market.