Market environment, Feb ‘22

Rajinder: Hi and welcome to matrix moments. Today’s podcast is titled market environment. Avi, i’m not sure if this is still be relevant by the time this gets posted, because the markets already up 4% yesterday and China was up like 8-10% yesterday. But, you know, just taking a step back, we did a bubble podcast in July 2021, where we discussed that finally, you know, this bubble would burst and, you know, FOMO investing would be gone. And, you know, some money would be lost, but lasting digital businesses will, we’ll be here to stay and, you know, expand over the next decade. Are we finally there yet?

Avnish: So first of all, great to be back first podcast, i think we are doing in person, post a very interesting start to 2022. i think we have discussed this before, you know, the key to forecast is not give it time around it. So even a broken clock is right twice a day, right? So i’m just kidding. So the reality is, when something will burst or not is unclear. if you remember, i think you and i did the fear podcast post the il&FS crisis we did a fear & greed podcast also because the environment was exactly the opposite.

We have discussed before, velocity, velocity value, meaning valuation and volume are the key signs of a bubble. Was it there throughout 2021? Globally, maybe except China? Absolutely. i mean, there’s no doubt about it. So i would say, the bigger question is, does history repeat itself? Are we? Are we in a situation where a lot of factors are in play, that will make things you know, potentially correct? Absolutely. But if you remember, second wave, people were thinking will become a trigger, this whole China thing will become a trigger. Now maybe the Russia thing will become a trigger. Now we’ll talk about inflation will become a trigger. if we knew the trigger, it won’t be a trigger. Right? The whole thing about these things is that, you know, uncertain event that gives a negative surprise. You said markets have already bounced back strongly. You know, if people expect VCs to be able to really actually project the future, we will be doing a different business.

But i don’t think it’s over and i think today’s what we should put a date to it Feb 1st, Feb 2nd, whatever it is and probably this will go out in a few days, we’ll see where we are a month or two from now. i’ll tell you what’s different. There is slowing growth with rising inflation, which means that interest rates are going to be increased.

Second, for me, what hasn’t played out yet is the behavioral aspect of it. There is a new generation of investors that came in during lockdown of COViD, who think that you can only make money in the markets, they haven’t lost money. By the way in the correction, they have lost the gains. But they haven’t lost principal yet. How will they react when they lose principal if they lose principal. So you know, there’s a joke in the market, which is because this is a lot about behavioral investing, that you can keep buying the dips till it till zero, you can dollar cost average to zero, don’t catch a falling knife, a lot of these comments which are basically telling you this is human psychology and behavior. And that’s where i don’t think we have seen a real what is called a capitalization and the capitalization when it happens, we’ll all know where it feels like the world is over. And this was happening in late 2018 in the market. The other point i would say is what individual investors do not realize is that they are up against very sophisticated computer programs and people who are doing technical analysis, you may be thinking it’s down 10 15% i should buy. There’s somebody who’s looking there at the chart and saying at this place, it’s still a falling knife and at this place, a number of buyers will come in, right. So Warren Buffett says it well- Well, you know, you can say a stock is down 80% or 90%. What’s the big deal? And he says a stock that is down 90% is down 50% from when it was down 80%. So i think some of that has not yet played out and again today and  it looks like it’s all turning around. So we’ll see how it plays out. But it does look like this inflation, slowing growth, increasing interest rates. i think it’s a big deal.

Rajinder: Yeah,  i agree with you, the markets are always volatile and we may not read the real, you know, the separating the signal from the noise is always hard. But you made a comment, which is that structurally inflation is going up. Yeah, structurally growth is slowing down. interest rates, however will, you know go up. So sounds like the market has to correct right and but

Avnish: Why? i guess the question is and i think i think in one of our podcasts, maybe it was marginal value and we had covered this. But you know, what people don’t understand is the correlation between interest rates and we have all you and i have done it at business school, this capital asset pricing model and stuff, but very simplistically, P E, just reverse a P is a price to earnings ratio is e by P, which is the yield that a stock is giving you. if your risk free rate is 5 6 7 percent, right, if it goes up by 1%, what is what is the US Fed saying five increases foreign reserve that’s 1% 1% on the base of 2%, that’s a 50% increase, your mortgage outgo EMi  will go up by 40 50%. Your when you say earnings yield should be correlated to interest rates, those PE’s have to go down by 30 40%. That’s what happens with the markets. And i do i think people don’t understand that. How big a deal that is. Because ultimately money is chasing returns. And when returns change in the debt markets, and the yields go up. Now the question is what i struggled with is even this is now factored in. Right? So markets always priced This in fact, they already priced in five increases. But then the math has to play out because you can’t have a 36 P E was just reading in the market the other day, NASDAQ at this level is still 36 P and steady state is 27. How far does it have to go? 30% now, right? Well, yeah,

Rajinder: 13 14%

Avnish: i’m saying after that it’s 36 after that. Okay, so not to scare people. But i think that that some of this is not fundamentals and what i wonder, which is why i’m saying i don’t sometimes understand this, that the smart money starts talking this language, but you see markets going up. So then the question is, is the retail trade taking it up? i don’t know. i’ll tell you, i think india is different. Versus yesterday, the Survey estimates came out, we will be the largest, largest, fastest-growing economy in the world. Right? i think that’s a big deal. People will change Chase growth, we may be actually free. if i don’t know, if you saw the revised estimates, pre COViD, the growth rate was revised down to 3.7%.  COViD, minus 6.6. This year, nine next year, eight and a half. So i think people will look for the haven of growth. And a lot of CapEx cycle, you and i’ve been working on some slides. A lot of indicators are looking positive government has never collected this much tax, they are going nuts. Fiscal deficit is down digital, i really believe i mean, you are in org business, you’re in bunch of these companies Razorpay. it has inflicted like anything. So it may be here to stay. But recognize that most of the money comes from the top US, you know, Europe, largely US. So that will be a liquidity driven correction in india, my view. i don’t think it will be a secular, you know, bear market or anything like that. Just because growth and a lot of a lot of things that are looking negative for others are looking positive for us. We had our you were telling me highest ever exports, the internet 250 to 300 billion for five, six years and our run rate now is 400 450. Yeah, it’s a big deal. Yeah, very big deal. What do you think?

Rajinder: No, i think on the i think the framework is simple, right? if you say 30 35 times PE that’s, you know, earnings yield, you can do the math. it’s like sub 3%. Yeah and if interest rates long term yields are in the one and a half percent range goes up, like 100 years. it’s just normal that the equity markets have

Avnish: But look at india, we can get if interest rates in india go up. We even today, you can get FDs at 6%. So what should the PE be? 15 16? What is it?

Rajinder: Yeah, but then 35 to 40? i think people are basically pricing in the fact that we have a very long runway of growth, growth

Avnish: Growth, growth. So if you asked me the biggest risk for us in india, including in general, is this growth real? if this growth is real, we are good, because corporate profits increase at three to four times the nominal GDP growth rate. So that then can justify a 30 PE 35 PE in our businesses, we are seeing the growth rates you’ve been doing. You should talk about the capital efficiency piece also.

Rajinder: Yeah, no, i think that that data is, you know, everyone instinctively understands it. But if you just think about the amount of capital that went into building many of these internet businesses for almost like six, seven years, and then you look at the incremental capital to the incremental GMV, the efficiency of that incremental GMV is many times that of the First, you know, period of time and these businesses are getting built so and their burn ratios are declining, companies are actually getting towards profitability, return on capital characteristics are showing up actually, it’s very interesting all the money show no, no, but i think the the other piece of it, which you know, is long term one, of course, is just overall economic growth. But the other thing is digital growth within that economic growth. And i think it’s completely,

Avnish: it’s the digitization of the economy, right.

Rajinder: it’s completely within, you know, the realm of imagination to expect that Nifty 50 by 2050 will be 50%. Tech. Yeah. And if that’s the case, then tech will likely grow even faster than the overall corporate profit rate. Right. So maybe the volatility of the tech earnings as well as the long term growth of these tech earnings, not just in india, having global M&A india, of course. But even globally,  Apple results were great Microsoft results were great. These are all like, trillion dollar companies. So sounds like tech, there are still large pockets, which are, you know, kind of looking good for the long term.  But, you know, taking a step back, like the macros clear, what about a business like ours, like some of this is going to liquidity is going to affect, you know, businesses like ours, right. We are fundamentally a long term investor, and our business is not as, you know, liquid as you know, people who invest in public markets, right. So so why should we why should we care about what’s happening in the public markets?

Avnish: Yeah, Because our investors care, right, so our investors, for them, they have allocations, and rightly so that have come up over decades of experience, that you put this much in private markets. Within that you put this much in Venture Capitall, you put this much in public markets, you put this budget in debt and does that, and you have guardrails, let’s say 25 to 30%, in each asset class, what has happened over the last year is that the valuations went up so much in private that that 25 30% got blown, went to 40 45.

But they have to come back there is no, they don’t have any discretion on it. it’s a mandate. it’s like a debt covenant, you have to do this. Now, obviously, you don’t have to do it overnight, but you have to slowly rebalance. That’s called the numerator effect, then public markets correct. Now what happens? Denominator shrinks? So what was 35/40 becomes 50 plus, so it’s not easy for them and if you ask me, and we talked to some of the investors, they’re loving the performance of Venture Capitall, so much distributions, tech is going up. They’re like, how do we manage this, it’s like a beast, which they cannot, you know, correct quickly. So it does affect actually, in my view, a slowdown is good. if it happens, we’ll see and we’ll talk later about, you know, early stage we plan to continue as as as is, but i think a slowdown is great, but we need to understand that the ultimate source of capital does care. And the ultimate source of capital is, you know, Universities, Family Foundation, so on and so forth. The other thing is, as interest rates are going up, they also have to potentially increase their debt allocations, right? Because ultimately, they are doing a modeling of we need to on 7- 8% and the minute the debt, the interest rates are going up, they have to allocate more to debt and so it does affect

Rajinder: Ultimately, but slow down, understood, where do you think it will be more pronounced? Will it be more late stage more early stage? Do you think early stage will bounce back?

Avnish: So i guess the agenda, if we were not doing this, what would we be doing?

Rajinder: We would be doing early stage period like

Avnish: So we the VCs in the country are living and dying by the country. The people who are investing in latest stages are not necessarily living and dying by the country, their dollar is fungible and rightly so.

We’ll see and we’ve heard this so many times earlier, india is too expensive compared to China is too expensive. Now, what have we heard lately, US public markets have corrected so much that we would rather invest there than here, why will we take private risk. So later stage will be affected? it is already affected. Some of that will play out over a period of time.

That said, if you look for the last six, seven years, there used to be this thing about tourist money, hot money, running away. if you look at i don’t mind naming even some of them right whether it’s Tiger, which gets talked about a lot Falcon, Softbank , these are all weather people. They dial up and down depending on you know, the market conditions, which is also correct, because their dollar is fungible. But they have now been in the market six, seven years and if we really believe and in some cases 15 years like Tiger, right, and if we really believe that the growth has arrived with better business models. i think they’ll be back. But they may be a phase they may need to navigate and we need to be respectful of that early stage, we are going to continue a pace. it’d be nice not to meet a team on Friday and be expected to give the termsheet by Friday midnight. That’s not how this business works. it only in that situation, there’s only one answer that ends up which is, you know, the return goes away. But early stage is here to stay. i think thoughtful founders will find that this is a better environment for them.

Rajinder: And not hearing why. So for founders, it sounds like doing a meeting on Friday and getting money on Monday is like fantastic. So how should they be thinking about navigating us investors

Avnish: because the investor has invested in FOMO? Right, the investor doesn’t have conviction. You cannot build conviction in a few hours.

Rajinder: But what about valuations, valuations are…

Avnish: Valuation is all notional i have i’ve said this before, or we you and i have discussed this before that valuation is notional, dilution is real. Focus on dilution. By the way, i’m having chats. And i know you’ve had chats with founders right now saying, in this environment, raise the money you’re getting, don’t over optimize, if the investor has conviction in you, respect that conviction, and focus on dilution - raise less. Right. So i think that is the better way to navigate, i think it will play out and there were a couple of articles floating around even yesterday that these high velocity decisions that have been made, also play out badly for the founders. High velocity by the investors, right. So i think i think long term, if you’re building this for 10 years, this is the environment, this is a better environment. Then the other one, your competition, when you start a business, five other businesses are getting funded. Same, same.

Now, if you believe you’re a differentiated founder, market is not differentiating.  Capital is available to everybody. i would prefer to build well, first of all, we don’t know if this environment will last but i would prefer to build in this kind of environment.

Rajinder: And as investors,

Avnish: just backing up, sorry, Rajinder was looking at my notes. i think companies bunch of companies have raised a lot of capital. So you’re in good shape, don’t blow it. Companies are on the cusp of raising capital, raise it very fast. Those who haven’t raised. And if they feel they were going to be in the market in three, four months, i think you should test the market now. Otherwise, you will need to go back to the basics that we have discussed in other situations.

Focus on your runway, focus on your business model, cut costs. in my view, infinite runway always gets funded. Because you control your destiny and i think those founders should be thinking about some back. You know, the basics.

The other thing, maybe it would come up later in M&A. But i have found. So if you look at the old business houses or industrial houses, i think i used to always say this openly that they don’t get it. They understand the internet is disruptive. But they and they understand they don’t have the capability and they want to play but they want to be bottom feeders, right? They only want to buy distressed assets, distressed assets only cause you distress and you get monkeys for peanuts, right? i have seen that change. And that’s a big change. Now all the top- Tata is in the i mean, it’s well known they bought a bunch of companies Jio is well known. Aditya Birla is being talked about, right? it’s very good, it’s very good. And they are ready to pay market price, maybe slight discount to market prices, i think that’s becomes a real option. PE guys, by the way, there are a lot of value PE seekers. So i think just recognize the change in the environment and navigate towards that. i think that’s important.

Rajinder: And also all amongst the sources of capital, one source of capitalists, for course, these large industrial houses who are now becoming more active. The other is actually some of the private equity groups, which were really focused on profitable companies, kind of in the last three, four years basically felt like they were missing out on this growth journey that everyone in the tech ecosystem was seeing. Many of them have actually set up teams in the last year and that can be an important source of capital.

Avnish: i think you had mentioned this before. it’s very important because the traditional indian PE is not to be named. They find it hard to fund negative unit economics. i find it hard to fund negative economics, but also negative EBiDTA or no path to positive EBiDTA, ah, that’s changed the businesses are deeper. So they will be Probably licking their lips saying this is the time for us to get in.

Rajinder: And, you know, going slightly off topic, i guess the the inflection point in everyone’s thinking probably was last year’s iPO.

Avnish: Zomato credit to the Deepinder, Nykaa, even the ones that haven’t done well. Balanced market is a good market. Right? if everything was going up, it would be a problem. So i think they have done a service, bunch of our companies are hopefully going to go public this year. That’s the part that worries me the most, by the way about the market.

it’s a little bit irritating, that we have just started and iPOs can’t happen in volatility. Yesterday, some company went public, it’s down, goes down. 10%. Right. So that’s a little bit annoying, but otherwise, it’s here to stay. And actually, it is a slight digression. But to me, having lived in the US in the 90s, the question people ask is, is this 99 2000? in india, right? it’s not. it’s the 95 when Netscape went public 96 Amazon, and it’s just the first set? Yeah, it’s a long way to go might be volatile along the way.

Rajinder: Through this volatility, any advice for investors? How should they think about navigating this environment?

Avnish: Look, i am an investor. i can’t give other investors advice. But i was i would only say, if the founder and the story was great till December, it cant have changed in January. So keep that perspective. So i think remember, you can have persistence in the belief in the person, even if you don’t have can’t have persistence in your capital support. Right? and business development, intros financing intros, budget help, M&A Help. So i think, just keep the broader perspective in mind that the story couldn’t have changed so badly. it was never that good and it’s not going to be this bad.

Rajinder: Yeah. i was just reflecting on something you said earlier, which is, india digital story was just taking off and you know, this iPO market seems to be a little bit, you know, unclear now, some stocks are actually, you know, off 50% from their highs, which is, you know, i was wondering, like, is this just too much correction? What do you think the future near future at least holds?

Avnish: You are putting this together and one of the deck so why don’t you tell? Do you think

Rajinder: They i think the market is, frankly, from a public market standpoint, i think the market will open up and the reason is, the growth is the growth is real. So if you just look at across the digital digital section, whether it’s Jio whether it’s, you know JAM whether it’s Demonetization, GST, tech, all of these things are just long term secular drivers of digital adoption. And that will lead

Avnish: To that. Let’s pause there because i think what is getting missed is that this has been building over five years, six years, it started with Jio, in our view de mon, it helped the whole payment infrastructure. UPi may be more than that. GST brought one national market. What else? Jam architecture we have spoken under NADA and China. How much China Brexit tick tock tick tock adoption, then tick tock ban. Right. WhatsApp, this was all building, then COViD. Just put it on the next level. Right. i think the digitization of the economy we are seeing this in razorpay or business deal share, like so many companies, companies are getting off the ground much faster than you’ve ever seen. Go quick, far mart, captain fresh, like we can go through so many examples, right? it’s because the offline economy has become digital. So if you believe that india is going to grow digital is going to grow at a order of magnitude higher. But it is still irritating because i don’t know if the i agree with you that at some point. Tech iPOs may be the only iPOs that that can happen. in fact, there was a senior banker i respect who said 2022 mEdtech You in. Right. Because of the growth because of all these changes everywhere else things are going up and out. i have a bit more optimistic. i think the india story at least if these numbers that the government is talking about plays out and a lot of the analysis we’ve been doing on all the things that are changing. i think the india story itself may come back in three to six months. The only if it is not already back. The only caveat is like we discussed before ultimate global liquidity matters. Right? if that gets sucked out. People don’t have the money.

Rajinder: Yeah, fair enough. i guess the other, you know, theme, which seems to have worked in our favor, which we’ve talked about internally is that there seems to be an india versus China story, which where the narrative is actually changed? Yeah. You know, for a long time, we kind of always looked at, you know, the market there and said, you know, these guys are just, you know, a ahead and we just, you know, the gap is widening. Yeah. But finally, it seems like, whether it’s, you know, COViD, whether it’s, you know, manufacturing, relocation, whether it’s capital reallocation, there’s just multiple drivers, which are actually cracking down

Avnish: On consumer businesses. i was just reading a report last night that the, the nature of Startups and Venture Capitall in China has changed completely, right, because there’s been a big crackdown on consumer. So some of that sentiment obviously helps india digital. The other thing we haven’t spoken about is these experienced founders. That’s the other thing that’s different, right? They have seen cycles, we have discussed this before, big focus area for us. These are people who have somehow or the other built businesses, whether they were founders, or they were l minus one, right, they have seen cycles, and they are building businesses for 10 to 15 years, they’re playing the long game. And i think that’s the thing that if all else fails, makes me the most optimistic, because ultimately, these people will figure it out. They’ll write it out and figure it out.

Rajinder: You know, one asset classes everyone is talking about these days is crypto it seems to mirror what’s going on in the broader public markets, complete euphoria, like you know, call it three months ago, and now everyone is basically talking about it in a completely different light. We had also a look back episode, you know, we had spoken about how we would, you know, explore this space more deeply does the recent change in the market worry you ?

Avnish: it excites me. i was very worried till December. Because there was a sense of FOMO internally in the form and externally, and crazy practices were going on and at some point, we may have felt compelled to play in that environment. This is the real environment. i think this will this sector in particular, it goes out of favor and comes back in favor every two, three years. it’s very nice to our 2 -1- 2 year window, we are we are going to probably we are likely to invest more because of this, then than before. And you know, one of the if you read or listen to some of the experts in the crypto world, they say, unless you have lost money in crypto, you don’t have a right to invest. i didn’t have a right or we didn’t ever i have lost money now. So so we have a right to invest. And the second thing is, volatility is your friend in crypto, you have to just learn to live with that. Right. So i think so that’s one aspect. Second. i think it’s a bit overhyped to everybody knows. i’ll tell you where i think differently. i was trying to say, web three crypto. You There was web one, web two, web three. So is everything going to move to web three, and i have now at least a penny has dropped for me that it’s just a new technology. New business models are going to be built on it. And let’s take examples. Web one was PC based. So you had a bunch of Amazon this that. Could you have had Ola and Uber in web one. No. You needed the mobile and you needed location based now with Blockchain and with all that, crypto is a very wide term, you know, and it gets confused with cryptocurrency. it’s actually web three. i think a bunch of new business models will come and this D5 has been talked about. First, it was hype. Now it’s in depression. But game five, which is gaming and you know, tokenization if there is one place where all of this comes together two places, gaming and Metaverse, and i didn’t when meta was announced, i didn’t even get it. i’m like, what is all this? But actually, we could be doing some of these things in the metaverse two three years from now. So

Rajinder: They also shout out to our matrix US colleagues for their investment in Oculus

Avnish: Yes, it is so early, so early. Unbelievable. So i think you know, if you look at cloud computing, if you look at 5g, by the way so people are talking about new applications based on 5g which didn’t exist before and quantum computing. This blockchain is a technological disruption of similar or higher order. Right? But it gets more hype than these things but i have been reading Ai based like surgery is says that like especially in health tech, a lot of stuff around  5G quantum computing, lots of stuff. So absolutely huge trend. We will be investing. This is the best environment to invest in when the hype is gone. Now. The bubble is burst. No, no. And i know you’ve been tracking so you should add

Rajinder: Nahi Nahi. i think the the, frankly, on crypto, we should actually get some of our colleagues. Yeah, to do a podcast or expert with these guys are actually, you know, neck deep in it. So i will call on them to do i think they’re up. Another thought that, you know, we’ve been, you know, kind of thinking about, you know, how we play this differently is really how the seed stage explosion and the number of angels, the number of micro VCs and you know, just the way the early stage ecosystem has just rapidly evolved and , frankly, to some extent it you know, makes it a little competitive for for VCs like ourselves. Yeah.

Avnish: No, and huge respect to our competitors. Right. So if you look at what Sequoia has done with Serge, i think it was transformational. i think XL has already always excelled. in seed, now they have a program called atoms. So the question is, and Lightspeed does lights and so on and so forth. Everybody’s doing it. Then there are all these emergence of micro VCs and angels. So what should we do? What should we do?

Rajinder: Well, it sounds to me like, eight, if you do something, you play with the trend, and actually back some of these angels and micro VCs and really enable them to succeed.

Avnish: And that’s also more more in line with what we do. Right? We are, we tend to work closely with founders and closer and try to i can’t say bring the ecosystem together. But that is an aspiration. Right? So yeah, i think we’ll do that. Some version of that i don’t think we can compete with some of our colleagues on the C program, because it doesn’t play to our strengths. i think we work better collaboratively with some of these angels and

Rajinder: Yeah. Just reading through the notes, there was one other topic that we should have covered, which connects back to something we were talking about earlier, which is the M&A environment. How will that likely play out this year, just given that companies have raised so much capital?

Avnish: i think it’ll be brilliant, by the way, in our own portfolio. And this is Vikram used to say this three, four years ago that in the US, if a company and for a founder, it’s great in the US if the company’s doing average it gets bought here, you have to be exceptional and win, or, you know, you’d be toast. it’s changed. it’s changed and that’s great. So i do believe we have discussed before the industrial houses, they are real options, they are a real option because they have digital FOMO they have some level of short and fluid watching the current you know, okay, we were saying the bubble will burst. But they are also saying, maybe this is the time, we should not sit there on our high horse and we should jump in. That’s a very big deal. Large companies will look to consolidate. So i actually believe that the overall maturation of the indian VC ecosystem comes from exits, iPOs have happened, but not much M&A happened last year because capital was very abundantly available this year. This year if if capital is not abundantly available, the second pillar will also fall into place and then the fly will start to stop.

Rajinder: Fingers crossed. Excited.

Avnish: Alright. Thank you

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