AI bigger risk to IT workers than companies, says Marcellus’ Pramod Gubbi
Edited excerpts from a chat:
Marcellus had reduced cash in its small-cap strategy from about 40% to 13% earlier in Feb-March. Since then, how has your assessment of valuations and risk-reward changed?
The sharp rebound from the March lows have meant that valuations are not as compelling anymore. Whilst the earnings cycle seemed to have bottomed out, continued tension in West Asia and the resultant effect on oil prices pose risks to a sustained recovery in earnings. Hence, from a valuation and earnings combination perspective, risk-reward trade off is not as compelling as what we saw in Feb-March.Are you still deploying capital, or have the market’s recent gains once again reduced the number of attractive opportunities?
Yes, in line with the above, opportunities are few and far between. Whilst we aren’t deploying fresh capital, we see opportunities for rebalancing given the non-uniform nature of price action in the portfolio.
Marcellus has traditionally backed high-quality compounders. Has the valuation premium for quality stocks now corrected sufficiently?
Absolutely. Given the broad basing of the market post Covid, compared to the very narrow nature of the market in the decade prior, valuation premiums of quality stocks have corrected meaningfully and now are at attractive levels. Furthermore, quality stocks thanks to superiors moats and RoCEs and low leverage, tend to be far more resilient in a relatively weaker macro environment, challenged by weaker demand as consumers fight inflation and a weak job market and rising raw material prices favour companies with pricing powerSeveral companies once regarded as consistent compounders have struggled to deliver expected earnings growth. How do you distinguish temporary weakness from a broken investment thesis?
With the exception of a few, the quality basket hasn’t disappointed much on earnings on an absolute basis. However, on a relative basis, post Covid the rest of the market benefited from the demand recovery post lockdown and massive govt capex post Covid, thereby narrowing the earnings superiority of quality from the previous decade and in turn narrowing the valuation premiums. Having said that, some pockets of the market hitherto bracketed under quality such as FMCG and IT have seen structural changes. The former due to the dent to brand and distribution as they lost market share to private label brands of retailers and mushrooming D2C brands thanks to growth in digital marketing, further exacerbated by growth in e-commerce and quick commerce nullifying distribution advantages. Similarly, IT losing share to GCCs and now AI disrupts the business model through deflationary effects. Those need to be seen differently than any temporary weakness.
Has the risk-reward improved more meaningfully in large-caps or in selectively chosen mid- and small-cap companies?
Whilst large caps might seem cheaper on the surface, if you adjust for sectors such as IT facing structural challenges and private sector banks at low earnings multiples given the capital intensity, it is no different from small and mid caps. So opportunities are market cap agnostic and more bottom up for those looking for growth-value trade offs. It is a stock picker’s market.
Which sectors are you most bullish on in your funds and why?
Healthcare is a large exposure for us across all our funds with diverse plays across hospitals, diagnostic labs, pharmaceuticals and APIs providing export exposures as well. We find the opportunity quite structural for reasons not limited to growth in health insurance and supply constraints. Having said that, we wish valuations were more compelling for us to increase allocations. On the other hand, whilst a rising current account deficit and shrinking capital account surplus have created balance of payment issues and a sharp depreciation in the Rupee, we see opportunities in Indian manufacturing exports, thanks to growing competitiveness from a cheaper rupee and FTAs lowering tariff barriers and opening up new market opportunities.
Do you think that the market is underestimating the risk of a weak monsoon and El Nino?
Depends on how bad it will be. But I reckon there are offsetting factors in the form of plenty of food grain stocks and a plethora of centre and state led welfare schemes, which should mitigate the impact. Furthermore, resurgent competitiveness of Indian manufacturing should keep the non-farm rural economy relatively more buoyant from a jobs perspective compared to urban white collar jobs under threat from AI and automation.
When it comes to IT, which side are you on? Do you believe that AI will decimate the need for IT services or do you think enterprise adoption will drive the next round of growth?
I think decimation is too strong a view. It does pose risks to the extent that the basis for Indian IT was labour arbitrage (albeit the industry has come up the value chain to a large extent), AI’s effect on reducing the labour intensity of services does have a detrimental effect. That doesn’t mean the need for IT services will be eliminated. Enterprise IT tends to be a complex web of infrastructure and applications tied to business workflows and incumbent service providers tend to retain significant knowledge of the same making them hard to get rid off. It won’t be that simple for a CIO of a Fortune 500 company to say they will manage all of this using Claude, at least not overnight. Furthermore, Indian IT companies who align with this new paradigm of delivering the output using AI and less humans will continue to be relevant. However, the short-term effect is bound to be deflationary on existing work whilst savings can be ploughed back to new streams of work in due course – it is not clear when and whether this will be big enough to offset the deflationary effects. So, AI’s risks to workers in Indian IT are far greater than that for the companies themselves.
