Dear Carnelian Family,
Hope everyone is safe and fine at your end.
In our last month’s newsletter, we have highlighted a couple of mega trends emerging out of the current crisis – manufacturing led boom and IT sector boom.
While the first order beneficiaries are obvious, there are significant and far reaching compounding opportunities of the above themes which are beyond first order consequences of the above mega trend.
As Ray Dalio quotes, “Human brains are designed to overweigh the first-order consequences and ignore second and subsequent order consequences”.
Our research is cognizant of the above psychology and is consistently engaged in identifying potential beneficiaries (first, second and third level “SHIFT Beneficiaries”) which qualify within our MRFG and CLEAR framework as well.
Second order impact of growth in IT:
The Covid pandemic has fast forwarded the adoption of digital technologies, making it an area of primary focus across the world. Generally higher technology spends by developed markets have had a strong positive correlation with the outsourcing growth and we believe, this time should be no different.
The digital segment of India’s IT service exports is expected to grow at a CAGR of 22% over the next five years from ~USD 60bn in 2020E to ~USD 150bn in 2025E leading to incremental revenues of ~USD 90bn. Employee costs is ~50-55% of revenues of which ~60-65% are offshore employees, thus translating to ~35-40% of an IT company’s revenues flowing to offshore employees. This results in an incremental ~USD 33bn flow to offshore employees (existing & new) translating into ~INR 45,000 crs average p.a over 5 years. Further, this growth will entail a ~USD 8-10 bn spend on other operating expenses including travel, real estate, etc. thereby giving a push to the overall economic activity.
Second order impact of growth in Manufacturing:
India’s manufacturing GDP is expected to grow from USD 450bn to USD 1tn+ (more than double) over the next five years, leading to significant job creation. Currently, the sector employs ~56mn people, which can well double over the next five years. Moreover, there is a multiplier effect in play – as per various studies, one job in the manufacturing creates additional 3 jobs in related services. Furthermore, it also leads to a push in the investment cycle both in manufacturing plants and the required infrastructure to support such growth. Investment cycle in turn again creates jobs.
Multiplier effect of drop in interest rate & tax rate:
The current pandemic has also resulted in significant drop in interest rates across the globe including India. The Government has also reduced Income Tax on new manufacturing units to 17% and stamp duty on new house purchase; GST on most items is at 18%. The recent cut in direct taxes has improved the IRR economics of various projects.
A drop-in the interest and tax rates will boost the spending power and capital creation in the economy.
1. A drop in EMI by 10% on account of 150 bps reduction in interest rates improves housing affordability. The outstanding inventory of INR 2,80,000 crs can find velocity not seen in the sector for long.
2. A drop in the corporate hurdle rate by 150 bps will result in a drop of 9% in payback period thereby improving the competitiveness and spurring a growth in the investment cycle.
3. The recent reduction in direct taxes has improved project IRR by ~525 bps, this again improves the competitiveness and spurs the investment cycle.
4. Assuming all other factors constant – a 150 bps reduction in interest rates will lead to a P/E expansion by 25%. This delta is well understood in Fixed Income instruments but not as much in case of equities, given the complex valuation framework.
We expect the above will have a far reaching impact on disposable income & consumer spending creating a snowball impact on the economy.
We foresee significant rub-off effect of all the factors put together on various sectors including:
· Consumer Discretionary & FMCG
· Insurance – Life and general
· Logistics & Business ancillary services
· Auto and Auto Ancillaries
· Real Estate
· Real Estate Ancillaries
Due to all these factors put together we anticipate an accelerated investment cycle, consumption cycle and export cycle.
When several forces combine in one direction, we get the desired amplification --- “Lollapalooza Effect”, which one can’t get through simple addition – “Charlie Munger”.
We believe that the COVID crisis has hurt all of us in the short term but has created several catalysts as mentioned above, which will spur India’s economic growth. We see outsized opportunities across the segments which will lead to significant wealth creation opportunities over the next five years. We are constantly evaluating the first, second and third order impact of the above mega trend withing the Carnelian risk-reward framework.
While we are enthused by these developments and hypothesis, our research team is consistently assessing the emerging trends and opportunities, objectively free of biases. However, there is no alternative to finding bottom up right businesses managed by great managers. We will keep that quest on.
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