Stock Selection: Focus on the India-focused

Many Indian companies, in the past few years, have witnessed increased offshore revenues. I do not know whether it is a good thing for those who invest in the shares of such companies. There are reasons why I prefer a purely domestic-focused company. For instance, in developed economies, the automotive industry is not hot because its growth is a function of business cycles and how often people junk their cars. Most citizens in developed countries own a car and, therefore, fresh demand from first-time buyers is insignificant. On the other hand, the automobile sector is booming in India. At the worst, there are small, albeit temporary, slippages in sales. Valuation tends to be high as fund managers’ exuberance in the search for investment opportunities change evaluation standards.

However, Indian companies that acquire businesses in developed markets, such as Tata Motors, Tata Steel and Hindalco, become victims of business cycles and low intrinsic growth rate which also makes it more difficult to forecast their earnings. Why should one take risks and buy shares in such companies? Companies usually acquire cheaply on the basis of replacement cost or exploit synergies in technologies. I have seen companies acquire global companies in sham transactions. For instance, someone will set up a fancy sounding company in South America or United States. Then a domestic company will ‘acquire’ this offshore company at a fancy price. Eventually, the acquisition fails and gets written off, siphoning off money in the process. There is a company which has done a dozen acquisitions in 10 years! When it is so tough to manage even one acquisition over 10 years, this company must have some super-normal skills.

India is growing at around 5% to 7%, in real terms. If inflation of around 7% to 10% is taken into account, the nominal growth will be around 12% to 17%, on an annualised basis. Maybe we will maintain this range for the next 10-30 years, depending on the extent of economic governance. Would you rather bet on the Indian or the global consumer?

The kind of businesses that are interesting are solid MNCs that set up and designate India as an export base. One such name that readily comes to mind is Cummins India. In addition to a growing domestic market, the company also addresses global markets for certain types or range of motors and engines which are solely made in India. The other type of business that attracts a lot of attention is the Indian information technology (IT) industry that is yet to exploit niches in the domestic market. So far, they are nothing but sweat shops built around labour cost arbitrage. However, these businesses still have potential for above-average growth, so long as wage differentials between India and overseas markets work to our advantage. Beyond this, these companies have done nothing to protect long-term earnings.

In fact, it is rare to see any Indian product in the growing tech business worldwide. There is also the myth of the depreciating rupee that is helping these companies. Local analysts tend to attach a very high valuation based on EPS growth which, they think, will not diminish. I prefer to believe that these companies should not trade at more than 8-10 times earnings.

Global earnings impart volatility which means that stock valuation tends to be conservative. For instance, Tata Motors cannot be valued at more than 5-6 times earnings in a good year. In a seven- to 10-year cycle, there may be two or three good years, coupled with two to three terrible years. The average returns on capital employed over the long term will be barely above borrowing costs. If you see Hindalco, the return on equity has been in single digits for the past three years. Is it because of global weakness in aluminium prices, high energy costs in India or is it because of the high cost of global acquisitions? Whatever it is, why should I risk money on uncertainty? Be desi, buy desi.



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