As the Indian market scales fresh highs, investors are looking for new opportunities to generate returns over the benchmark performance. However, veteran investors like Prashant Khemka don't see a relationship between market levels and investment opportunities.
The alpha opportunity is more or less the same through time, said Khemka, founder of White Oak Capital Management.
Regardless of where the market is, there are always going to be some names that are overvalued, relatively overvalued, and relatively undervalued, said Khemka.
According to him, "mispriced opportunities" through the relative overvaluation or undervaluation do not change as compared with the market levels because they are relative in nature.
The alpha opportunity is more or less the same through time, said Khemka, founder of White Oak Capital Management.
Regardless of where the market is, there are always going to be some names that are overvalued, relatively overvalued, and relatively undervalued, said Khemka.
According to him, "mispriced opportunities" through the relative overvaluation or undervaluation do not change as compared with the market levels because they are relative in nature.
Watch the full video here:
Edited excerpts from the interview:
Prashant, seldom do all-time highs, get accompanied by mouthwatering valuations or normal valuations. So, when building a portfolio in order to generate Alpha over the next 12 to 24 months, how do you go about it?
Prashant Khemka: So, we take the market as given. Our assumption always is that the market is faring well, for better or worse. What we are looking for is relatively, attractively valued businesses. So, the market can be high or low. We would only know with hindsight. But regardless of where it is, within that market, there is always going to be some names that are overvalued, relatively overvalued, and some names that are relatively undervalued. So, it is the relative framework with which we proceed to identify investment opportunities.
Let us say, over the next 12 months, or 18-24 months, do you reckon generation of Alpha over the benchmark would mean just about performing at par? Or do you reckon the markets themselves from where we are looking at earnings growth, looking at geopolitics, looking at everything, other technical factors, that the markets could be higher than they are currently, and therefore, the Alpha generation would be a particular number, which portfolio managers like yourself or teams such as yours will have to deliver?
Prashant Khemka: Very interesting question, something that I do get asked often, by clients as well. Whether the Alpha opportunity is particularly higher or lower at this time? See, the answer that I have always given is that the Alpha opportunity is more or less the same through time. The mispriced opportunities through the relative overvaluation or undervaluation that I spoke about, that does not change compared to the market levels because we are talking about relative valuations.
Let us assume for a minute. In hindsight, we can all agree that 2007 or the year 2000 was a high point in the market valuations. Still, at that point in time, there were many names that were way overvalued compared to that market level, which in subsequent years, got decimated. At the same time, there are other companies, which obviously went up as well as many which went down but they didn't go down as much. So that is relative outperformance. If the market goes down 60% and certain names go down only 20% that is a massive, relative outperformance.
On the other hand, if you take 2003 or to a lesser degree 2013, when markets were at cyclical lows, and at those points in time, after that, most stocks, a lot of companies, vast majority of the companies had a sharp move upwards. But within that, some go up multifold, and again, outperformed the market by many times, whereas others can't keep up with the market. So that is again relative outperformance based on variety of factors. And at least I haven't found a way of distinguishing that outperformance of Alpha opportunity in different market environments.
In hindsight, one would argue that if you had the guts, March 2020 was a market that was teeming with opportunities and maybe in 2007 was a market fraught with risks even though the sentiments were completely polar opposites at those times. Currently, do you feel that the market is full of opportunities because of this whole India positioning in the geopolitical world and the cynosure of all eyes, or is it a market teeming with risks because there is just too much money chasing very few global assets?
Prashant Khemka: So, those facts point in time as you pointed out to 2020, and the other one was in 2007. As you can see, those points come far and few between almost once in a cycle. Do I think whether we are at such a point in the cycle one way or the other? Certainly not at a low point, because you can see historically where we come from. But remember, about 20 months ago, or 18-19 months ago in October 2021, the market was just slightly lower than where we are.
Yes, we climbed an all-time high. But, it is not an all-time high after rising 50% to 100%, or multifold over the last couple of years or like it was in 2007. So, we have had certain time consolidation over the last 18-20 months. So at this time—not that I am good at picking these tops or bottoms, and not that I found anyone else to be good at picking these tops and bottoms with any degree of consistency other than what can be associated with luck—my view is that we are in one of those normal times, which is neither at one extreme or the other, and somewhere around that.
Is the construct of the portfolio currently geared more towards high growth opportunities, even if they might be priced at a premium to your own framework, or are you very, very conscious of the average multiple of the portfolio, even if it means that you are settling for slightly lower growth?
Prashant Khemka: First, I would just like to comment on what you just said Niraj. It is not that the macro is unpredictable, but it is the implications of the macro on the market, which are completely unpredictable. Right now, it may be predictable to a certain degree, what the Fed is going to do. They orchestrated it so well. It also maybe predictable to some degree as to what the U.S. and the global economy would do, what the Indian economy would do.
What are the implications of those macro outcomes on the market? Are they any different than what the markets have already priced in? These are what are unpredictable. Now, coming to your point on growth, which is valuable only as an element in the value equation. So, if after factoring in a certain projected growth, if you don't see any material upside in a company, then you are better off not investing, and staying on the sidelines. And we have so many companies in the market which are among the fastest growing companies, but our team has not invested in them. Some of them have turned out to be prudent not to invest, even despite their valuations, they have continued to sustain and go higher. Valuation is of crucial importance, whether you are looking at companies, which are in the hyper growth phase, or high growth phase, or moderate growth phase.
Our team looks for opportunities in those segments of the market, where, first and foremost there is a strong business model. Growth in and itself is of no use unless it is accompanied by superior returns on incremental capital. In fact, a company that is growing very rapidly but not generating and not expected to generate costs of capital is going to lose money at an accelerated pace. A lot of wireless and technical companies did that at the turn of the century globally, and in India afterwards.
So, first and foremost, superior returns and incremental capital and then companies that are growing faster with superior returns on incremental capital. They are growing faster because they are gaining market share on the back of strong management execution. When such companies are available with good governance, adequate governance, all these are the attributes that we look for. And then, finally or alongside, we also look for something that is attractively valued. Otherwise, it would just be a great business and for which we can you know, stay on the sidelines till we get the right opportunities.
Are you getting opportunities that satisfy most, if not all the reasons currently, at these current valuations?
Prashant Khemka: Yes, definitely. So obviously, we have a light portfolio, we are investing. So, there are companies that we find in the current environment as well which relative to the rest of market are on these parameters that I just talked about, the team finds to be very attractively poised to deliver out from.
Many people are looking for opportunities in companies, which are domestic, focused, and which will gain out of the growth in India over the course of the next 3-4 years because the globe may be a shaky place. And then there is a set of people, who are looking at global opportunities because they are playing the slightly longer game and saying that valuations in a bunch of these pockets are, “bombed out” and they are factoring in the worst and the worst may not come. Are you looking at both, or are you favouring one over the other?
Prashant Khemka: We are very much looking at both and pretty much at all times. I can't recollect a time in the past when the team was not looking at opportunities in both these segments, because if you look over time, over long periods of time, through the cycles, both these segments have created tremendous wealth for investors.
If I give you two examples—banking, which is as domestic as it can get that created tremendous wealth. And let us look at I.T. services, cash machines that have created tremendous amount of wealth, over the years, for decades. So, the second question could be that can you from time to time enter and exit one or the other depending on where you see faster growth in the near to medium term, or whatever extent period of time. That element, we believe, is inherently unpredictable. That is the macro that is inherently unpredictable beyond what is already priced in the market.
So, as an example, right now, it is already evident to the market participants that global demand for I.T. services is a bit of a struggle, the demand environment has slowed down. Demand environment domestically, because of robust GDP growth, is favourable to many of the capital goods and domestic cyclical companies. So, these are well-anticipated and well-factored in our view of the market from an aggregate perspective. So, there isn't a lot of undiscovered value or performance to be gained by moving from one segment to another from time to time. Sometimes, you can get lucky, because even with a coin flip, half the time it would come in your favour. But it is about half the time that in the market we believe by making such macro calls, you can make money. The other half, we lose. Generally, we tend to be invested and look for opportunities at all times in both segments of this point. There are multiple ways you can slice and dice the market. This is one way, domestic-focused versus global-oriented. And at all times, our portfolio has good representation, balanced representation from both segments.
Where are you most constructive on Prashant, whether for the existing money or comfort of putting in even new money to work?
Prashant Khemka: If there are structural changes in the market, then there will be change in this as well. And it happens, because of technological changes and other changes in the society. But otherwise, for a long period of time, we have found attractive opportunities in the market. These are some of the things that are representative of segments of the market that we find a lot of opportunities. Governance, you can find a large number of companies or large, mid and small, entrepreneurially driven companies as against let us say, primarily government-owned companies or so.
Private sector financials are a segment of the market where as long as I can remember we have been able to find a lot many attractive investment opportunities. These are not talking about just private sector banks, but private sector NBFCs and private sector non-lending institutions. Obviously among non-lenders, there are insurers and capital market intermediaries and so on. And there are some very well-known companies in this segment growing, not only well ahead of the industry economic growth, but well ahead of their peer group with strong execution. Similarly, I.T. services—the two sectors that we are talking about, domestic and global-oriented. In I.T. services also, there are companies which on the back of strong execution are able to maintain a very wide margin compared to the industry average growth over a very sustained period of time. And I.T. services, most companies unless they are doing something (nonkosher?), they tend to generate very strong cash flows and tend to have superior returns on incremental capital. These are segments where the team has routinely found and there are other segments in consumption, both consumer discretionary as well as consumer staples, healthcare and allied sectors, and chemicals. The team has been very successful in finding opportunities that pass the hurdle from an investment approach perspective.
The past performances of some of your portfolio's chemical companies have been exemplary. The recent one month has shown a number of global chemical companies sounding the bugle of low growth, no growth, degrowth as the case may be across segments and it is probably too for both, specialty chemicals and commodity chemicals as well. Is that exporting opportunity, a bit of a no-no currently, or even within are there pockets of opportunities available?
Prashant Khemka: Within that there are pockets of opportunities. And over time, if we look at the banking sector, just as something that everyone is a lot more familiar with. We had demonetisation, we had Covid, we had global financial crisis. We had other crises in between that we might not be able to remember. Obviously, Fed increasing rates, decreasing rates and all those are usual, inflation rising, inflation declining, RBI raising rates.
Can anyone really make more money than by identifying the right banks 20 years ago and staying invested or identifying new opportunities along the way? I am not saying that if they will do any valuation, you stay invested. But could anyone have made a lot of money by getting in and out of banks at each of these crises times or in each of these macro inflection points? I don't think so. A lot of people probably have lost a lot of money by exiting right after global financial crisis or exiting after Covid struck. When any such crisis happens a bank seems to be the first one going under the bus, because the leverage is 1:8, or 1:10. So, when the regulator announced moratoriums there was lot of concern. So, when in those environments it would seem very prescient to get out of these names, or unload these from the portfolio, but then in hindsight, they were all the very wrong targets and the wrong reasons to exit.
Similarly, in I.T. services also, there have been a number of times, including GFCL and Covid. Initially, when Covid hit, I.T. services business was expected to collapse because all the global demand would stop. However, they turned out to be big beneficiaries. So, it is not possible to predict these macro factors to any great degree than what the stock prices are already factoring in at the time.
So, the money we seek to make is through identifying companies in these industries. Let us say chemicals, which have a certain right to win, either due to strong technology, strong process knowhow, strong chemical chemistry skills. They would weather the ups and downs like others, but do a lot better than others and over time end up gaining market share in a very profitable manner.
The other thing is a lot of newer opportunities or maybe opportunities of companies or businesses that were always existing, have found a new lease of life maybe due to the government focus or otherwise like the whole defence, railway pack which has come. As you run global portfolios, you might be looking at what has happened in other emerging markets, whether it is due to the per capita GDP moving up or GDP itself moving up, and coming across opportunities of a similar nature back home in India, which might do well because it has happened in the world and set a replica. How are you thinking about these? What goes in your mind when you think about such things?
Prashant Khemka: These are very important ones and these are macro of a different kind that are important from stock selection perspective as well. With the advent of the internet, some 25 years ago—which has completely changed the way we live— came a lot of opportunities to a lot of sectors. New sectors were born, existing sectors benefitted, and other sectors got demolished, like some of the media sectors. So, those are things that we have to, as a team, continually stay on top of. Technological threats, technological obsolescence, which provide opportunities as well as risks, those are things that we may not have all the answers at any point in time. Many times nobody has the answer.
For example, over generative AI. There is a lot of debate. Everyone agrees that it is a very big thing. Many have compared it to as big as the internet. So, when internet came, it was supposed to demolish a lot of various industries. It did demolish a few, but others that it was expected to destroy, actually ended up leveraging it and benefiting a lot.
Just 2-3 years ago, if you remember, BNPL (buy now, pay later) was supposed to be a big threat to traditional financial companies, both banks as well as non-banks. Today, hardly anyone mentions BNPL and to the extent that the existing companies have benefitted from it. So, there would be opportunities for generative AI. It is not clear to us right now, how much of a threat, how much of an opportunity it is. We continuously as a team try to stay on top of the developments. To some companies, we believe it will end up being a big opportunity, which are well prepared for this and have the necessary skill sets, or have developed the skill sets in a timely manner. The slow movers can be left behind. So again, execution capability is of primary importance.
Similarly, the other big change that has been going on for longer than generative AI is this whole energy transformation. In many countries, it is accelerating. It has been accelerating and post Covid it has accelerated further. In Norway, 80% of new vehicles sold are electric vehicles and other countries are riding the same wave. It has implications for very large segments of the fossil fuel chain, as well as the overall society. So, those things also the team continues to evaluate. It is not necessarily that at present time we may have opportunities in India that are listed and appropriately valued to benefit from these—the most direct opportunities. But, there are second order, third order effects, the positive and negative.
So, you can make money by avoiding those that are impacted by negative effects. So that is what the team is on top of, but these are certainly risks. You can call them macro risks, I would say these are macro risks of the technological obsolescence, of technological opportunities that every now and then present a lot of opportunities as well as pose risks to the existing players.
Where does your team find opportunities, in any of these newer landscapes, which you may have already invested in because some of these might be private in nature, but defence, PLI?
Prashant Khemka: So, one of the things that I only talked about was only technological phenomena. One of the things that is evolving and has been evolving and gaining momentum is the whole diversification away from China. It is imperative for global corporations worth their name. The board members are asking managements, the investors are asking management, what is your risk mitigation strategy, if China were to face disruptions that we saw during Covid or those caused by the Russian-Ukraine war. So, there are already disruptions right now that the team has in the portfolio and has had for some time. They are in manufacturing sector.
And defence—it is not directly related to China plus one— but yes, also several defence names also that the team has identified are beneficiaries of the indigenisation of defence equipment that has been underway over the last 2-3 years. So, these two, if I were to say somewhat distinct. The China plus one, which also has helped, PLI is one of the elements that is helping it. But there is a major overarching force tied that is helping that and PLI is one aspect and on defence in particular, it is the indigenisation effort that is helping. And there are opportunities in both, which the team looks for and has also already identified more opportunities that we have invested in.
What are the risks to be in the current form? What are the risks to having a good run over the course of the next 12 months—maybe market-wide risks, or maybe something that portfolio managers will need to carefully weigh?
Prashant Khemka: See, one of the risks in the Indian context is the central elections that are less than 12 months from now. The market is expecting a certain outcome. Like every election, the market expects a certain outcome. The market is more comfortable with that outcome which it is expecting, which maintains continuity in a way. We have seen in the past that sometimes this gets surprises while right now, that does seem a very low probability event. But it is a low probability, very low probability but a high consequence event. So that is one of the risks that is more India-specific that one has to look out for. Obviously, there are other risks like El Nino, inflation, GDP, growth slowing down and others which are very well-known and well-discussed variety.
Obviously, I am not saying elections are not well discussed, but I think as we move closer to the event, this will start occupying more of the investors’ mindshare. This risk would start occupying, because there are certain state elections along the way as well, those outcomes will have a riding on what market expectations are for the central election and so that is something to be mindful of.
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