Don't fall for India growth proxy narratives: Karma Capital's Rushabh Sheth

Karma Capital, an independent Mumbai-based investment management firm, was founded by Rushabh Sheth and Nikhil Desai in 2005. With over ₹6,200 crore in assets under management, the firm primarily handles the India allocation for the largest Norwegian and Scandinavian sovereign wealth funds, as well as several India-dedicated funds and pension funds of multinational organisations. In a free-wheeling interaction, Rushabh Sheth, co-founder & co-CIO, shares his investment philosophy and explains why he believes the India growth story is on track.

There is a general sense of optimism about India's economy. What is your reading of this exuberant environment?

On the ground, the situation indeed looks good. We're experiencing a rare convergence of economic growth and political stability, which historically has not often occurred simultaneously. It's either been one or the other. There have been times, like during a few years under Vajpayee's government, where we saw both factors align briefly before diverging again at the end of his tenure. Currently, we're in a 'sweet spot'.

On the geopolitical front, the scenario is complex yet opportunistic. The global shift in seeking alternatives to China's supply chain has placed us in a geopolitical sweet spot. This shift isn't just about diversification strategies but also emerges from a necessity, making it a crucial time for strategic investment decisions. We are beginning to capitalise on this new geopolitical landscape, which, while largely driven by the needs of others, presents significant opportunities for us. Thus, despite the general optimism, we approach this environment with a balanced strategy, leveraging the current stability while preparing for the inherent uncertainties of global politics and economics.

How do you see the Production Linked Incentive (PLI) scheme changing the contours of Indian manufacturing?

Structural changes in manufacturing, particularly through initiatives like the PLI scheme, are indeed underway, but these transformations will take time. The PLI is not an endpoint but a starting point. It's about initiating a cycle of investment and job creation in the manufacturing sector, which traditionally evolves over many years. For example, the success of the Vande Bharat trains has shown us that once a model proves effective, scaling it up can lead to broader changes. The PLI aims to kickstart this process by incentivising investments in specific sectors, fostering both domestic activity and exports.

While the scheme is relatively young, about 3 to 5 years old, we are beginning to see some positive outcomes. Major unlisted MNCs and some larger domestic companies have started to deepen their manufacturing capabilities under this scheme. It’s a gradual process; the full impact of PLI, including significant job creation and enhanced sectoral revenue, will likely unfold over the next few years.

But isn’t domestic capex spending sluggish? Besides, traditional business houses too are increasingly becoming consumer oriented.

At the end of the day, companies need to make money and size up market opportunities. Currently, the opportunity is on the consumer side because India is still predominantly a consumer economy. Traditional conglomerates recognise this and are reconciling their strategies to capitalise on this consumer demand. However, they are not completely abandoning their industrial investments. For instance, Tata is investing in semiconductor fabrication. This indicates that while there is a significant focus on the consumer market, there is also experimentation and investment in high-tech manufacturing. This dual approach allows these conglomerates to maintain a balanced portfolio, catering to immediate consumer market opportunities while also building capacity for future industrial and technological advancements.

So, how do you go about investing? What is the guiding framework?

Investing is not too complicated. You don't need to be philosophical or get bogged down by Return on Capital (ROC) metrics. We are bottom-up investors. Our focus is on finding good companies with sustainable businesses, run by people who have a deep respect for capital allocation and some degree of ESG (Environmental, Social, and Governance) awareness.

The problem for us often is that what looks obvious might not be obvious. Until proven otherwise, we have to believe what we're seeing. Our matrix is not fixated on having a 20-25% ROC. Instead, we look at how significantly the current ROC can change or expand. For us, a starting point of 20% is not necessary, even 10% or 8% will do, as long as it has the potential to grow to 25%. If we get it at 8%, it will come at a reasonable price.

There's a lot of breadth in India. For instance, two years ago, there was a mad rush for chemicals. Today, it's the Public Sector Undertakings (PSUs) that are in demand. Two years ago, nobody cared about PSUs. The narrative keeps changing, and our job is to stay away from the narrative and look at the fundamentals—what businesses are doing well at their core.

Five years ago, none of us were using services such as Zomato or Swiggy. Many things we take for granted today were not part of our routine back then. This illustrates how quickly consumer behaviour and technology can evolve. As an investor, it's crucial to anticipate where the economy, spending, and money will go in the future, rather than relying solely on past trends. As they say, follow the money.

Where do you see the money flowing?

The narrative keeps changing all the time. Currently, pharma is our largest holding, and we believe that healthcare will be one of the biggest beneficiaries of consumption over the next 5 to 10 years. There is significant consolidation happening in the healthcare market because it is still very fragmented. In pharma, the top 20 companies control 55-60% of the market, and there is still a long way to go. It’s a slow consolidation, similar to what FMCG consolidation was 10 years ago.

We, as investors, need to figure out where the next opportunity or phase of growth will come from. That’s why pharma is our largest holding. There is a huge domestic opportunity and a reasonable global opportunity, but we are not big fans of just generic plays. We prefer companies with specialty plays globally, but mainly focused on the domestic side. We believe this play will be secular in nature, with at least three to five years for this story to play out. Ownerships are low, and the weight in the index is very low at 5-6%. So there is a long way to go as ownership changes and more people hopefully invest in it over time.

Similarly, communications or telecom is another large play we have. We think connectivity and networks are the future. Everything is getting connected, from your cars to household items. The more things get connected, the more critical networks become in your life. Even factories are now getting fully connected, with 5G networks within factories to ensure faster connectivity. Networks and connectivity are big themes for us over the next three to five years.

We also see the media as a significant theme. Incrementally, people will spend more time in front of their screens and spend more money on it. That’s where the world is heading, and we are no different in India. The medium of entertainment here is primarily through screens due to relatively lower participation in outdoor sports. So, media consumption through screens will continue to grow, and this is a big theme we are focusing on.

Is the "big getting bigger" narrative turning all-pervasive?

Yes, we are seeing this trend across various categories. Take airlines, for example, or look at what's happening in life insurance. Smaller players are selling out—Exide sold to HDFC, and Bharti AXA wants to sell out. This trend is evident in almost every industry, where larger companies are consolidating and smaller ones are being absorbed or exiting the market.

Where do you see value in the market today? There is a growing acceptance about new age companies such as Zomato even if there is no cash flow visibility.

The day we start accepting businesses without cash flow as valuable is the day we should be concerned about the market. There's no business without cash flow. Confidence can't come just from having cash in the bank. For instance, having ₹9,000 crores in the bank and incurring losses for the next two years isn't sustainable. Everyone will eventually have to justify cash flows, which will be the differentiating factor. The issue is how quickly and how large the cash flows can become.

The bet is on whether companies such as Zomato can achieve significant cash flows quickly. For example, if Zomato can reach ₹2,000 crore of cash flow over the next 3-5 years, then the current valuation might be justified. But as soon as Zomato hits ₹1,000 crore of annual cash flow, there will likely be two other players entering the fray, seeing the opportunity. There will be enough private equity and venture capital firms ready to try and crack this market.

I recently heard about someone toying with the idea of starting a service employing only ex-servicemen, doing the same thing as Zomato and Swiggy but with a different narrative. So narratives can change, but at the end of the day, cash is king. It doesn't matter if the business is old or new; cash flow is essential. Without it, you're deluding yourself.

Where do you see the margin of safety?

My focus is on businesses where we see strong, steady cash flows and reasonable valuations, as that's where the margin of safety lies. Currently, I believe pharma offers that. These businesses have very strong cash flows and are quite stable. Even if there is a significant change or crisis tomorrow, like a war, the cash flows from pharma are unlikely to be dramatically affected. There might be a slight impact, but not a substantial one. Additionally, the valuations in pharma are still not excessively high.

We also see telecom as another area with a good margin of safety. The sector is critical as connectivity and networks become ever more essential in our daily lives and industries. So, while the market might present various opportunities, we find the most comfort and margin of safety in sectors like pharma and telecom at the moment.

What about banking? Given the premise of the big getting bigger, such as with HDFC Bank, are you not a buyer in this space?

In my opinion, large banking players such as HDFC Bank and State Bank of India are hitting a glass ceiling. These institutions already hold a significant percentage of the market—SBI, for instance, has a 20% market share. They haven't lost market share, but they haven't gained any either. At this point, they are essentially the market.

Take Reliance Jio as another example. Jio cannot gain significant market share anymore because it already dominates. When you reach this level of market saturation, the growth prospects become limited. You're at peak margins and that can't improve much further, even credit costs are already at their lowest. This is why we don't have a substantial position in banks.

It's not that they're bad investments, but they're not aligning with our criteria for significant market expansion. Banks can be tactical plays when they are very cheap, offering 10-15% bounce. However, for a long-term strategic investment, we're looking for opportunities that offer much larger market expansion potential. However, there is still a lot of potential in the broader financial services sector.

What about Jio Financial Services?

We don't have a position there, but we do own SBI Cards.

Isn't that risky given the uncertainty of creditworthiness beyond a certain threshold in India? Also, doesn't RBL Bank's ₹800-crore credit card exposure sale to Kotak Mahindra Bank at a 97.5% haircut tell you something?

That tells you how challenging the business is! For those who get it right, there's a huge opportunity, but it's not easy. Kotak Bank has been trying to break into the credit card business for the past 15 years. They've succeeded in other areas but not this one. That's why Axis bought Citi's credit card business—Citi's quality was far better than theirs.

But the growth is inorganic. Where is the organic growth?

Organic growth in this segment is incredibly challenging.

So, that is the point — the penetration story is oversold because there is no credit history beyond the 20 crore?

Okay. Let’s consider the number that you are talking of [20 crore], the market will still double from here! We are at 10.8 crores now (December 2023), and if it goes to 20 crore, that's doubling of volume. Show me another business in India that can double its volume in five to six years. Except for new age businesses selling online insurance, you won't see this kind of volume growth. Even if that happens in the next five to six years, it's a huge opportunity. Your spending will continue to increase at least at the rate of your nominal rate of GDP of 11-12%, and you have 10% volume growth. The market will double in seven years. Assume 10% volume growth, 13-14% nominal GDP growth, and 23-24% spend growth. How many businesses have visibility for 24% growth for ten years? It's a phenomenal business.

SBI listed the business. Ideally, this business should have never been listed. No bank will ever list their credit card business, ever. Please look at it, a player of the scale of Axis Bank had to buy the credit card business from Citi, and Axis Bank is different from Bajaj Capital. The strength on the ground is very different for an Axis Bank compared to a Bajaj Capital. That’s why credit cards are a difficult business to crack. SBI listed it because of their historical problems and issues. Otherwise, why would they list a 5% ROI business when they don't even earn 2% ROI? You're getting an opportunity here. Same was the case with ICICI Securities. Why should the bank have listed ICICI Sec? It's a 40% margin business with no need for capital, distributing 40% of their PAT every year!

Is this why Kotak Bank is not spinning off its business? Uday Kotak told Fortune India that the bank is the best proxy to play India’s financial services -- all businesses rolled into one.

Their ROIs on other businesses are significantly higher than the bank itself. Uday is a very shrewd banker, and even he couldn't do much in the credit card business. You can imagine the difficulty of this business.

So, is there a premiumisation story in the credit card business?

Absolutely. American Express has set up the whole business on that premise.

But where is Amex growing in India?

That is what I am explaining. It's very difficult to grow this business. Branding is very important. You and I know what American Express is, but ask the common person, and they might not recognise it. We might talk about American Express and Netflix in our circles, but that doesn't reflect the rest of India. Indian credit cards often offer better deals than Amex.

But we are seeing now some premium credit cards no longer offering lounge access as they are losing money?

The card no longer needs to offer premium access. The banks are now confident that they can sell the card without lounge access. Even if the access is withdrawn, it will not prevent people from using the card. Also, consider how many flyers there are in India. If you need lounge access, you can even get it on a flight ticket. That's why we first bought GMR Airports. First and foremost, you need an airport to fly, right? Without an airport, you can't even get to the lounge. There is need for capacity building,

But isn’t banking India’s biggest proxy play, and if that flounders, what does it mean for the broader market given its heavy weightage?

Nothing happens. The India growth story will continue. There is no single proxy for the India growth story. The idea that banking is the proxy is flawed. Proxies change over time. Thirty years ago, Ambassador, Maruti, and Premier Padmini were the proxies. Bajaj was then the proxy. In the past, they used to say cars, bikes, and briefs were the proxies. Now, that has changed. It's a nice narrative-building exercise that makes for great cocktail conversation. But at the end of the day, the fundamentals of India's growth story are what matter, and they will continue to drive progress, irrespective of the proxies we choose to focus on.

Do you see retail flows proving to be a strong counter to FPI flows?

Obviously. We've seen it in the last few years. But the issue is that the stickiness of these flows will get tested at some point. And we'll have to see how it behaves when that happens.

But it was tested during Covid, right?

It was a very quick recovery, in a matter of six months. My sense is that the markets in the last three years have been very kind. So, everybody thinks that making money is becoming easy, which always worries you. Because that's when you forget what luck is and what skill is. So as the market starts to become challenging, people will realise that this is not easy.

But there is enough dry powder waiting to be deployed?

We are talking about two different things. One debate is about outside flow, which is different from domestic flow. Domestic flow will be tested in two ways. One scenario is if the market goes sideways for a year, people will get restless if money isn't being made. Will the flows continue at that point in time or not? I don't know; I'm not being judgmental about whether it will happen or not. I'm just saying this is something we have not seen before. So, we'll have to wait and see how people behave when that happens. This is the first time we are seeing such humongous retail flows, there's no precedent.

You mentioned about media - is the play in print, broadcast, or digital entertainment?

Newspapers are not on the screen. A newspaper that gets on the screen, I'm very happy about. But anything that cannot get on the screen, the next generation will have zero interest in. I don’t see even my 23-year-old daughter ever picking up and reading a physical newspaper. For her, everything comes on the screen.

Will traditional media be a permanent value trap or a tactical allocation?

What is conventional media? If it’s newspapers, then yes. But if the news goes to the screen, it can be very valuable. The Wall Street Journal, New York Times, and Financial Times have made a phenomenal transition to digital and are doing very well.

Everything that can make the digital transition, whether it’s providing news or entertainment, will do well. These are basic needs of human beings: you want to know what’s happening in the world, and you want to be entertained. So, any media company that successfully transitions to digital and meets these needs will have significant value.

But one glance at Reliance Industries’ annual report shows media listed the last among its businesses. Doesn’t this suggest that media is more of a good-to-have business rather than a must-have?

That’s the status of the business today. Let's talk about it five years later and see which business figures on top of its segments. Today, the media is the smallest of their businesses, so naturally, it comes last. The focus is first on oil, then retail, then Jio, and finally media.

As an investor, I'm looking at what will be in three to five years. Media is getting fragmented, which is why we are seeing consolidation. This is why Reliance Disney is combining, and why Sony Zee wanted to combine—they understand the need to become big and to be large platforms that can appeal to a broad audience. Small players will slowly fall off the radar because they won’t have the sheer strength to stay in front of people.

So, consolidation is happening, and once it's done, consumers will have fewer choices as those choices will shrink. This pattern is seen in many new industries. When Swiggy and Zomato started, there were four other players. Eventually, it becomes a duopoly, and maybe a third player will emerge over time. As these companies become profitable, new entrants will come to break their monopoly.

The same thing is happening in the media. At the end of the day, India has 1.4 billion people and 20-30 languages. India is not like the US, where if Netflix puts something in English, everyone will watch it. My mother will only watch content in Gujarati, and similarly, others will stick to their regional languages. You have to cater to a diverse audience, which is not easy. Very few countries in the world have to program in 30 languages.

So, how are you playing the media?

The only listed media companies we can play with are broadcasters and digital companies, as they have evolved into large digital businesses. Unfortunately, Meta and Netflix are not listed in India, so we can't invest in them directly. Many traditional newspapers in India are still struggling to make the digital transition successfully, unlike some international counterparts.

Right now, our focus is mainly on broadcasters and possibly cable companies—essentially the companies that provide the infrastructure, or "pipes," for content distribution.

Pipes are going to be equally critical; without them, it's not going to work. However, we'll have to see how the landscape evolves. There might be more players coming over time.

What is your big prediction in the market?

The market will continue to do reasonably well, but you can't project the last three years and expect the same for the next three years. It's ridiculous. We've already discounted one or two years of growth in many cases. Look at the banking space -- HDFC Bank was the flag bearer for the past two decades, but the narrative has changed. Maybe it’s telling you something.

What happens if the current government doesn't come back? Will it be a good opportunity to buy?

I am no political analyst. I have no vision about what is going to happen in the election. Democracies have a funny way of behaving. So, we'll have to wait and see. But India's story will still continue. Everything else is secondary to us as investors. I remember selling India in 2001-02. Not a single investor was willing to buy into the story—it was that bad. So, we are far better off now.

But if consensus is bullish, isn’t that a problem?

There will be a shock. What difference does it make? Don't miss the wood for the trees. If the market goes down by 10% or more, what will happen? Will the growth story change? You should be confident that India's story is on track, and not worry about short-term aberrations.