The return of order book investing
Something that was forgotten and given up on more than a decade ago has made a resounding comeback. Not many who are following the tips & gyan channels on social media and telegram would have been around to invest in the 2003-10 era. That was the “build India” era when exports, job growth, equity market, real estate prices and rupee appreciation were all on a tear. India was the next big emerging thing and the shining star, investors had just then started to understand who FII’s were and how global money flows worked.
The pace of infrastructure development was fast, those building roads, bridges, houses, ports and factories were in a hurry to get things done. Corporate lending teams at banks had a different swagger about them. The most aggressive private sector lender then would start meetings with “we have the willingness and the ability to write large checks within a short period of time”. A few corporate bankers I know would decide at 9 AM in the morning to fly down to Mumbai for a post lunch meeting and close deals within the same week. The entire ecosystem was geared focused on growth and winning deals, no one really gave a damn about risk then.
The stock market would then value businesses based on the order wins they announced. Execution risk was a non existent element then, since investors saw over quarters that order announcements would show up in the P&L and earnings. Very few would pay attention to debt building up on the balance sheet or receivables steadily creeping up. Any voice that raised an alarm about these things would be shut down the minute the next quarterly earnings showed a 25%+ PAT growth and new order wins announced.
If you are below the age of 30 and are gung ho about what is happening in the economy facing sectors right now, do take some time out to read the history of how things built up through 2003-10 and eventually came to a screeching halt. These themes may be novel and new to you but old hands in the market have lived through that era, nothing new or novel about this for them.
Is it time to start worrying about froth in these pockets?
Short answer – Yes, to some extent in a valuation sense, but not yet in a business sense. Every long cycle is made up of multiple short cycles where valuation extends a bit and then corrects, before resuming its journey higher and discarding the non-believers aside.
We have many voices cautioning on order book investing right now, but the thinking needs to be a bit more deeper than that. History rhymes but rarely repeats in a predictable manner. Order book growth is very welcome, what is not welcome is when the market starts to price in the growth in the order books much before there is enough confidence on timely execution. Timely execution is usually determined by the macro environment and the commitment of the parties involved in the projects. Execution rarely slows down when there is intent in the Govt and private capex channels. Execution usually happens at a good pace when there is no shortage of liquidity, it doesn’t lead to unprofitable deals when inflation is under control.
Signs of excesses usually show up across the value chain and not just in isolated instances. In the initial phases, utilization improves leading to abnormal profits as businesses come off a low base. Once this phase is done and order books continues to grow, businesses embark on capacity expansion to service the new orders. This is where credit offtake starts to show a tangible increase, developmental projects needs to be funded by either equity or debt. One should logically expect to see equity dilution or a steep spike in term loans to the core sector at this stage. Most businesses here don’t have the intrinsic cash flow generation to fund 30%+ growth since their ROCE is much lower. The largest wealth managers and structured credit fund managers start becoming very active since it is a very good way of pocketing high spreads in a short span of time. We are seeing early signs of this, especially in the QIP and private placement activity to the HNI segment. Greed shows up much before balance risk starts showing up.
One should also start seeing heightened competition in the bidding for projects at aggressive prices, usually led by newer businesses who don’t yet have risk thinking ingrained in them. Do remember that L&T came out of the previous infra cycle healthy and safe while the “next L&T” of the previous cycle did not live to tell the tale.
We don’t yet see signs of tangible business risk emerging though, execution for projects booked so far appears to be happening at a good pace right now and excessive leverage isn’t yet visible. We don’t yet see corporate lending teams at banks speaking of 20%+ growth for the next few years.
At the same time, we are wary of extrapolating the healthy trends given that an election year is coming up. The whole ecosystem can sometimes go into a “no incremental decisions” mode when there is the possibility of a change in their political masters. We see this as a bigger near term risk than the possibility of organizations over extending themselves on execution towards the end of FY24. Our take is that many businesses are still being priced in for aggressive FY24 earnings growth rather than getting valued for the order book 3 years into the future. If the rally continues to pick up steam that day may well come sooner than expected. Cautious but not yet worried.
Please be choosy about where you deploy incremental capital. We think it is better directed towards segments where there are muted expectations while the medium term outlook is slowly changing for the better rather than in the sectors and themes that are hot right now. Consensus in the market is a devil that draws you in easy but hangs you out to dry when you are most vulnerable.
We’ve been issuing more exit calls than buy calls over the past few months, especially in counters that are a bit too popular right now. As they say – booked profit apna, baaki sab sapna