Formalisation in Indian economy: Invest in good quality, clean companies; don’t look at valuation in isolation

Over the course of the next two years or so, you will hear a lot of divergence between what you hear on the ground and what you see in Nifty companies reporting

stock market, investment, coffee can companies
Invest in quality, i.e. Coffee Can companies, “Good and Clean” companies

By Manish Jain

The present political dispensation came to power in May ’14, and since then two things have been fairly high on the agenda – formalization and digitization, and quite rightly so. The fact is that both are in some ways linked to each other and do tend to complement each other.

The long term benefits are multifold:

– It helps expand the tax base. Reported only 1.08% of the total population pays taxes and that’s one number that definitely needs to go up
– It helps expand many legitimate benefits to millions of workers like EPS, medical etc. The way the unorganized sector employees are left open to exploitation is to be seen to be believed
– It helps reduce tax evasion
– It would help many products find the right markets directly, reducing the imposing middlemen
– It would also help reduce the gross inequality in income, one of the things our country suffers from

If we are to achieve our dream of being in the top three economies of the world, then this agenda is not just paramount, but also non-negotiable.

In the last few years, we have seen a number of efforts being launched by the government to give this dream a shape of reality. This includes tax law changes, GST implementation, Demonetization etc. However, for a very long time this remained a pipe dream and looked like it would never be achieved anytime soon.

Quite unexpectedly, something changed dramatically in 2020 and formalization in the economy picked up in a big way. Across sectors we are witnessing this trend unfold right in front of our eyes. So, the key question is – what changes? Believe it or not, it was COVID-19. As they say, every dark cloud has a silver lining.

Three things happened, which pushed the economy towards both formalization and digitization in a big way:

a) Technological changes: Logistics, as we know, has changed in a big way only to never remain the same again. Today, things like Robotics, data integration, automation have crept in such a manner that smaller businesses are going to struggle. So many consumer companies have now started touching the retailer directly, cutting out the middlemen completely. This saves cost and time. Changes like these are expensive and sudden, something the MSMEs always tend to struggle with.

b) Extended lockdowns: With extended lockdowns across the country, now twice over, money stuck in working capital is starting to become a big issue, which impacts the survival of many of these small businesses, which tend to function on thin margins but a quick turnaround.

c) The rise of eCommerce: As barriers of physicality get broken and more and more people move towards ecommerce, the availability of brands is suddenly no longer an issue. Bigger brands tend to benefit out of all this more than anything else.

So, in the end, the ultimate question is – how do we benefit from this, as investors. Well quite simple. Over the course of the next two years or so, you will hear a lot of divergence between what you hear on the ground and what you see in Nifty companies reporting. So, don’t get confused and invest in quality, i.e. Coffee Can companies, “Good and Clean” companies. As formalization picks up quality play in stock markets will become more pertinent. So, don’t look at valuation in isolation, look at the delta this formalization play can add. Risk-reward still hangs in balance.

(Manish Jain is Fund Manager, Ambit Asset Management. Views expressed are the author’s own.)

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