If you do not treat me well as an investor, I do not care what the macro story is for India: Ajit Dayal, Quantum Advisors

Ajit Dayal, Founder, Quantum Advisors, asks: “Should you be in smallcap funds? Of course. Should you have 40%, 50%, 60% in your smallcap funds? Probably not. Should you have 5-10% in smallcap funds? Probably less. Yes, and you should have smallcap funds that are declaring liquidity on a proper basis, not this 20% illiquid stocks are exempt, that is a bit crazy in my view.”

Dayal further says: “The macro story for India, irrespective of which government comes to power, in our opinion, since 1980 over the last 11 governments remains constant, 6% to 6.5% rate of growth of GDP on an annualised basis long-term. India looks fantastic. India is a place to invest. But we need to ensure that governance remains and misgovernance at the corporate India level is eliminated.”


First of all, let’s talk about this latest trigger which impacted the market sentiment to some extent – the rally in US yields, the rally in DXY and then the war crowds also coming in over the weekend. That has eased a bit. How much risk do you think these kinds of issues have for emerging markets, particularly India?
Ajit Dayal: So, when the Fed started announcing in 2023 that there was an interest rate hike cycle, the markets paused and were not sure what that meant and then, of course, the strong economy kept the markets moving with an assumption that at some point in time as inflation tapers around the world, central banks will cut interest rates and reduce them to certain levels that a generation of new investors from 2008 have been used to which is low interest rates and what has really happened is that as you correctly pointed out while sales in America and the GDP has been strong, there is now the concern in the US particularly that will they actually start increasing interest rates.

Interest rates are extremely important for the entire world allocation. Because if a pension fund, if a foundation can earn 5%, 5.5% in dollar terms from a fixed deposit in their local bank account, they do not have to put a lot of money to the external world, like India, to stock markets like India or PE India or real estate India or infrastructure or venture capital. Their target rates of return are roughly between 6.5% to 7% at max. And if you can get a chunk of money at 5.5%, you will only invest 10% or 20% of your total allocation to get a high rate of return in foreign markets so that US interest rate is kind of the guard to determine what happens in allocations around the world globally, that is very important to recognise.

As you correctly again said, as interest rates now are likely to increase, what we worry about as people sitting in India should be, will there be enough allocation to India in a higher than longer interest rate environment from the US. The European cycle is very different. The European cycle is inflation is being tamed and therefore, interest rates are likely to head down. So, you may have this divergence where in western Europe, you will find interest rates being cut may not be at a fast pace but the signal and the action is on a downward trend. In the US, it is uncertain. European capital for India is also important and European capital is increasingly trying to find alternatives to be in other nations besides China.

So, this is tale of two continents if you will, one side of the Atlantic you have got this fear from our side that interest rates will remain higher and therefore allocations to India may be a bit slower and on the other side of the Atlantic closer to India, where in the European area you have got chances of lower interest rates – more interest in India, and therefore more allocation to India, that is the way we should look at it in general.

On the one hand, there are external issues or factors which are keeping markets on tenterhooks and traders and investors. But on the other hand, there are also developments such as the IMF raising the growth forecast once again for India and good commentary coming in. How does the macro look on a more structural basis as far as India is concerned?
Ajit Dayal: The Indian investor and the international investor investing in India should focus not so much on GDP, but there are certain factors at the macro level which are positive for India. If you look at CMIE’s employment data, it is looking a little better. But there still is, in some sense, a K-shaped recovery in the world and in India. One of my colleagues who was flying in from Bombay to New York was saying, the flights in business and first were full and the flights in economy were not so full. So, you are finding that sort of K-shaped recovery where the rich have gotten richer, the poor are getting poorer. You see that in the FMCG sales, not much volume sales are coming out of rural India, but there is massive consumption happening within urban India.

So, you are seeing that mix all around and therefore when you look at GDP numbers, I would not say ignore is the wrong word because GDP has a lot of constituents to it and therefore, we would not rely too much on GDP. It is a headline number. We would like to know where the demand is coming from, which sectors are likely to benefit and most importantly, as we have seen in the ICICI Bank case. what is the level of governance or of misgovernance, will impact my returns as a minority shareholder.

We have this strange situation where I-Sec, the securities company of ICICI Bank, a listed entity, so far has had a 66% growth in profit and any company with a 66% growth in profit would have a surge in share prices and yet the I-Sec board members and ICICI's board members have stolen I-Sec shares from the minority shareholders. The share price will not surge to a market level. It is trading at a PE ratio of 13 times compared to 33 times and 25 times for the indices. So, this is what upsets any international investor and a local investor.

It is not the uncertainty of US Fed rates, it is not the uncertainty of what is going to happen when 300 drones cross different continents and different borders, it is not macro politics, it is not macro GDP in India, it is how I am respected and treated as a minority shareholder. That is the straw that can break the camel's back – misgovernance – and I really want to focus a lot more on that in future discussions that we have. The macro story is nice. But if you do not treat me well as an investor, I do not care what the macro story is for India.

What are your thoughts on the valuations of the market right now, especially the broader market because a very decent correction played out in midcaps and smallcaps ever since commentary on broader market valuations came in from the regulator. The entire stress test issue from the AMFI side also was a bit worrying for the market. Now, the smallcap and midcaps are coming to terms. How do you see that factor playing out?
Ajit Dayal: For the smallcap space, the regulator was and is in a top mind. If you look at 2008, smallcap funds were 2% of total equity AUM. when Lehman went bust. And in 2008, smallcap funds, international and domestic, the few that were there, declined by 60% to 80% from January 1, 2008, till December 31, 2008. Fast forward to this era that we are in, smallcap funds are roughly 8% of total AUM in equity.

So, we have gone from 2% to 8% of a larger share of equity. On top of that and I do not have data on this but I know the regulator definitely will have data on this, the people who have entered the market post COVID from 2020 onwards, trading on their apps and on their laptops from home, my gut and my guess is that, are a younger generation by age and also taking more risks because they are mostly novice to the world of investing.

So, my gut feeling is that their allocation to smallcap funds is not 8%, as is for the universe of all investors of total equity AUM, it is probably more likely 40%, 50%, 60%. And God forbid, if there were incidents internationally or locally, which causes a 2008 kind of rate of return, i.e., a 60%, 80% fall in smallcap prices, what could happen is you will have a lot of discontent. In 2008, there may have been one million people owning smallcap funds. Today, that number is probably 10 million. So, you will have a lot of 10 million people who are angry with SEBI and it is not the fault of SEBI, like SEBI correctly said the job of the regulator is to frame the market, not to tell you whether shares are expensive or not.

So, SEBI has done the smartest thing possible. They have sent a torpedo, not towards the ship, but across the bow of the ship and they sent a warning for those who care to listen and for those who wish to listen, that listen, be careful, valuations are a little stretched and illiquidity is a massive concern in smallcap funds. We had done our own analysis.

Actually, personal FN had done it and we have looked at the data. When personal FN did this analysis on smallcap funds, they found and I will give a name here, Nippon, one of the top five, we did of all the top five funds, Nippon is the largest smallcap fund. They manage roughly 45,000 crores. One of their top 10 holdings would take 3,000 days to exit, 3,000 days of trading, which translates to roughly 15 years of trading to exit one stock in their top 10 and if you look at it for all of them, HDFC, Kotak, SBI, Nippon, I forget the fifth one, but look at all of these five, they all have got a lot of illiquid stocks.

SEBI has not set the guidelines to determine what is liquidity or illiquidity. They left it to AMFI. AMFI, of course, is a protector and is an association of the manufacture of mutual funds. Quantum AMC is also part of AMFI by law. We have to be, but not in spirit and when we do our own stress test, we use different criteria. What AMFI has used is, take 20% of the portfolio which is most illiquid and just pretend it does not exist and then tell me what your liquidity is. Now, just think about the sense of this. When there is a redemption, therefore, the smallcap fund if and when there is a redemption, will sell its most liquid shares to those who are leaving and the people who are staying in the fund, I imagine will be left holding more and more illiquid shares in the fund.

So, you are basically building up a time bomb where you are forcing retail investors, those who remain, those who are committed to hold more illiquid shares, that is the illogic sort of calculation that has come out of AMFI and therefore, there has been that bounce up again in smallcap funds, in smallcap valuations, in smallcap prices because everyone now says, aha, AMFI has done its great calculation and there is calm in the market. Not at all!

Smallcap funds are a time bomb that is going to blow up. I have no idea what the catalyst is. I have no idea what the time period is, but it is massively dangerous and for those who remember history, please look at the smallcap fund graphs from January 1, 2008 till December 31st, 2008 and you will realise that we again do not know the timing and do not know the catalyst, but if things go bad smallcap funds are going to be the worst place to have a big chunk of your allocation.

Should you be in smallcap funds? Of course. Should you have 40%, 50%, 60% in your smallcap funds? Probably not. Should you have 5-10% in smallcap funds? Probably less. Yes, and you should have smallcap funds that are declaring liquidity on a proper basis, not this 20% illiquid stocks are exempt, that is a bit crazy in my view.

Everybody is talking about the next generation reform the government may take. Parts of the government are indicating the next generation reforms which lie ahead. Any thoughts there?
Ajit Dayal: So, I wrote an article in 1990 February, so 34 years ago, about how India will reform. Loosen The Reins on the Bull Market was the title of the article for the Asian Wall Street Journal way back when. Since 1990, we have seen a bunch of reforms. 1991 were the big reforms and since then we have had a whole bunch of reforms.

This government over the last decade has continued with that pace of moving India forward and it has the massive advantage of what happened under UPA 2 which is Aadhaar, technology, smartphones, lower telecom costs. A lot of the digital-based reforms, banking, financial services, etc, reporting reforms were something that started 11-12 years ago and this government too, has carried on and maximised them. I think that the hard reforms, which are hard infrastructure reforms, have also been accelerated by this government.

It started with Vajpayee. He had the golden quadrilateral triangle on road infrastructure, hard infrastructure. It did carry on during the UPA 1 and 2 but they got embroiled in all sorts of discussions on corruption and coal mining and coal ore and iron ore, all that stuff. So, it kind of got derailed for the last few years of UPA 2. Whereas in this government, there has been no discussion in the press on corruption and we have just moved ahead with the sort of hard reforms, which is important.

So, you have got the soft digital reforms which build the platforms and the hard infrastructure reforms that are allowing the trucks and the roadways and the electricity to move through and help us grow. In my opinion, India continues to be for the last four decade on a phenomenal wicket and India can only be its own worst enemy and governance and CEOs can be India's sole and worst enemy and which is again why I spoke about ICICI Bank and I-Sec because what will ultimately determine whether an individual investor or a foreign institutional investor in India makes money or not is not going to be the big reforms, it is going to be how do you treat me as a minority shareholder?

At the end of the day, if you were an investor in Alibaba, in Jack Ma's company and the Chinese government makes CEOs disappear, that is misgovernance. Here, you have private sector managements, like ICICI Bank, evaporating my profits that I could make from a stock that I picked because they choose through the help of proxy agencies, board members, and their hundreds and thousands of their sales people calling up I-Sec shareholders telling them how to vote apparently, that sort of misgovernance is the one that people will be most, most upset about.

So, the macro story for India, irrespective of which government comes to power, in our opinion, since 1980 over the last 11 governments remains constant, 6% to 6.5% rate of growth of GDP on an annualised basis long-term. You may have spurts, as you had under the UPA 2 of 7%, 7.5%; you may have spurts like you had in India at the time of Covid when there is a slump in GDP but India looks fantastic. India is a place to invest. All we need to ensure is that governance remains and misgovernance at the corporate India level is eliminated.