How to play financials and IT now? Kenneth Andrade answers

IT has the biggest challenge coming up. It may not be visible this quarter but definitely next quarter onwards, the cost and the turnover and employee turnover factors are going to be a critical thing to watch out for, says Kenneth Andrade, Founder & CIO, Old Bridge Capital

How far into the IT rally are we? With the kind of growth visibility that we have in the IT sector for not just today, tomorrow, one or two quarters, but for the long haul, would you say that the valuation metric does not really apply to IT?
IT has the biggest challenge coming up. It may not be visible this quarter but definitely next quarter onwards, the cost and the turnover and employee turnover factors are going to be a critical thing to watch out for. Going into the June results, a lot of companies will be highlighting these challenges. Growth is fairly there in most of the company valuations that some of these companies have. I guess all of them have to surprise significantly on the upside. It is an unknown fact because all the large companies have guided for almost a 100% or almost doubling of turnover in five years. This time, it is on a very large base. They are talking about doubling the size now. It is significant and if they can do that and maintain some level of competitive pricing, the market will reward them fairly well. So, even if they are expensive, these numbers would continue to be elevated.

Raw material for banks is cash and if the cash cost is going higher because of inflation, banks should underperform. What is the right way of looking at banks and especially corporate banks?
I always believe that financial services or lending business is a late cycle play. We got to have the first initial round of capital investment and get it established. All the companies that are there on the ground, have got significant cash generation and the cost of capital is coming down. It happened in the previous cycle also. Only towards the end of the cycle with more participants coming in, financial services or the lending business gets pricing power. I will bide my time on this one. I have been doing so for a pretty long period of time but this was more on the retail lending companies. Till now we have had the retail assets growing to probably all-time high even as percentages of the banking system. There will be a pause there. I think the corporate books will start expanding but it will take some time before banks would be able to establish significant profitability.

I bide my time on the banks. They are late cycle plays and will establish profitability when the business gets fragmented. Today in the steel industry, there are six participants on the ground compared to what we had in 2000 when numerous smaller companies were setting up steel capacities. Today all of that is consolidated into six companies. When fragmentation of an industry takes place, that is when banks start getting pricing on the ground and profitability increases. So, that is our framework of investing in the financial services business. For us, it will take some time before we actually get into that trade.

How are you resisting the temptation of not buying into internet, platform and network companies because that is where the market cap is getting created?
I cannot say we are not participating because when some of these companies brought out IPOs, you could have explained their valuation with the cash they generated on books or the franchise. But yes, at this time and at these valuations, I am not too sure what to expect from some of these companies that are getting listed.

We are staying away from that but let me just rewind a bit on these internet companies and platform companies. While they are new in the way of delivery of the product. To the end user, it is not a business which is very new. The bigger business which has platforms based in the country or across the world is the banking system and that is the biggest platform that is there. It is just debt to a legacy system. Here you have got a different mode of communicating with the end consumer. Over a period of time, even that will get commoditised.

When I look at it right upfront and you have got a number of individual companies that are sitting out there in various lines of business -- be it financial services or telecom providers or retail B2B assets -- all of them started with very large access to the end user, but their margins are way far thin.

It is not that the competitive intensity is not there in these companies. The competitive intensity is significantly there. What advantages these companies do have is that the incremental amount of capital investment in the business is reasonably low and so they can survive at these margins.

But yes if it continues with these high valuations and such high ROEs, over a longer period, they will correct themselves. So you just have to bide your time and the second round of investing in these businesses are much larger than the first round.