Formalization in the Indian economy: investing in clean, good quality businesses; don’t look at evaluation in isolation

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Invest in quality ie coffee can companies, “good and clean” companies

Through Manish jain

The current political regime came to power on May 14, and since then two things have been quite important on the agenda – formalization and digitization, and rightly so. The point is, the two are somehow related to each other and tend to complement each other.

The long-term benefits are manifold:

– It broadens the tax base. Reported that only 1.08% of the total population pays taxes and this is a number that absolutely needs to increase
– It helps to extend many legitimate benefits to millions of workers like PSE, medical services, etc. The way employees in the unorganized sector are left open to exploitation must be considered
– It reduces tax evasion
– It would help many products to find the right markets directly, reducing large intermediaries
– It would also help reduce gross income inequalities, one of the things our country suffers from

If we want to realize our dream of being in the top three economies in the world, then this program is not only essential, but also non-negotiable.

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Over the past few years we have seen a number of efforts by the government to make this dream come true. This includes changes in tax laws, implementation of GST, demonetization, etc. However, for a very long time this remained a pipe dream and never seemed to be achieved any time soon.

Quite unexpectedly, something drastically changed in 2020 and the formalization of the economy accelerated dramatically. In all sectors, we are seeing this trend unfolding before our eyes. The key question is therefore: what is changing? Believe it or not, it was COVID-19. As they say, every dark cloud has a silver lining.

Three things happened, which strongly pushed the economy towards formalization and digitalization:

a) Technological changes: Logistics, as we know, has changed a lot, never to stay the same again. Today things like robotics, data integration, automation have crept in such a way that small businesses are going to struggle. So many consumer companies have now started to reach out to the retailer directly, cutting out the middleman altogether. This saves time and money. Such changes are costly and sudden, which MSMEs always tend to struggle with.

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b) Extended lockouts: With prolonged lockdowns across the country now twice as much, the money stuck in working capital is starting to become a big deal, impacting the survival of many of these small businesses, which tend to operate with low margins but quick turnaround.

c) The rise of electronic commerce: As physical barriers are broken and more people turn to e-commerce, brand availability is suddenly no longer an issue. Big brands tend to take advantage of all of this more than anything else.

So, at the end of the day, the ultimate question is how do we profit from it, as investors. Well quite simple. Over the next couple of years or so, you will hear a lot of discrepancy between what you hear on the ground and what you see in reports from Nifty companies. So make no mistake and invest in quality ie coffee can companies, “good and clean” companies. As formalization resumes, quality play in the stock markets will become more relevant. So, don’t look at valuation in isolation, look at the delta that this formalization game can add. Risk-reward is always in balance.

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(Manish Jain is Fund Manager, Ambit Asset Management. The views expressed are those of the author.)

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