Changing the rules of investing

The effects of demonetisation are still reverberating through the system. Most Indians are feeling avenged and validated, while a minority of undeserving rich are putting up a brave face. Many of us have become instant economists and many more are now conspiracy theorists. While the general public plays guessing games about Modi’s next move, investment managers are confronting an excruciating dilemma.

The law of unintended consequences has kicked in and overturned the rules of investing in India. Let me explain how. Until recently, a good investment had many or all of the following attributes — the company should be selling to end-consumers (B2C); it should ideally not be involved with or owned by the government (not B2G); it should be into retail sales and not into bulk sales to industrial customers (not B2B) and it should have pricing power (negligible working capital). Therefore, consumption-oriented companies, financial services companies, private sector banks etc would do very well in the stock market. However, over the past three trading days, an entirely new paradigm is evolving.

In this ongoing cash crunch, payment channels have got clogged, and this is leading to demand curtailment. In an environment of uncertainty, threats and conspiracy theories, people prefer to lie low. What we need to ascertain is whether this is a temporary demand deferral or something more permanent. We broadly agree that most of the current logjam is merely demand deferral.

What we are unclear about, however, is the extent of permanent demand destruction. Think about a scenario — bulk of Indian manufacturing is in the informal sector. Almost all of the jobs that were created in the past decade have been in this sector. It operates on thin margins, often using tax arbitrage (unpaid taxes) as its competitive advantage.

With tax avoidance becoming difficult, many of these SMEs would go out of business. If such a scenario comes to pass, then would it not lead to widespread unemployment? If yes, then wouldn’t the business of consumer goods companies suffer? With many of these recently unemployed people returning to their villages, rural demand could take a hit.

So what the market fears is some level of demand destruction at the top and bottom of the pyramid. Amid this kind of uncertainty, the equity market is taking the less-risky approach of selling stocks of companies operating in these spaces. As the market waits for clarity to emerge, few changes are already becoming discernible.

Investors seem to be changing their orientation. Infrastructure companies are expected to do well, betting on judicious use of the confiscated black money. Long working capital cycle is no longer a deterrent, as it gets balanced against a bulging order book. Dealing with the government is desirable now, since government is the only source of demand in these difficult times. Capital goods or engineering goods suppliers are becoming more attractive, since they serve the burgeoning infrastructure sector.

Within financial services (NBFCs), companies that deal with other corporates would do well, while NBFCs that deal with retail customers are expected to suffer demand destruction. So infrastructure-focused NBFCs are holding on to their share prices, while retail-focused players are seeing steep fall in value. Even within banks, those owned by the government are doing well, while shares of blue-chip private sector banks are declining. Export-oriented companies in the organised sector still remain attractive, while smaller and labour-intensive exporters face headwinds.

Less than ten days ago, nobody imagined that B2G and B2B would become desirable, even as B2C becomes suspect! Welcome to a brave new world.

The writer is CIO, Edelweiss Global Asset Management. Views are personal

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