Picking stocks that can deliver consistent returns year after year can be challenging for portfolio managers, especially with slowing consumption and economic growth sputtering to a six-year low. To solve the problem, Samit Vartak channelises his bets on the “right kind” of mid-sized companies.
The partner and chief investment officer of SageOne Investment Advisors LLP said one needs companies that aren't large to achieve annualised returns of around 20 percent. “If a large company is going to deliver you 10-11 percent earnings growth and if it's already trading at 70-80 times the multiple, that means there's no upside room of that re-rating happening,” he told BloombergQuint on the latest episode of Alpha Moguls.
Explaining his logic, Vartak said that in the past eight years, nearly 85 percent of the companies that generated the highest return were focused on commodities, and all but one firm were mid-sized with market value of lesser than Rs 10,000 crore. Companies that are large today may still deliver earnings growth of over 20 percent, but from today's valuation, there's little room for re-rating, he said.
They may trade at high valuations, but Vartak, who manages assets worth about Rs 970 crore, expects financial sector stocks to “last the test of time”. That's because stocks from the sector have figured among the top 50 companies delivering the highest growth, he said. “If you look at a 10-year growth phase and if they (stocks) look at anything above 20-25 percent, you will find it 40 times or 45 times PE (price-to-earnings ratio) to be cheap.”
On the other hand, most Indian consumer goods makers don't have “the long runway” to capture markets as they focus on domestic markets, he said, adding that their earnings would be close to the nominal GDP growth rates.
Non-lending financial stocks, despite trading at rich multiples, can still grow at a healthy pace and deliver returns, because some of them have only scratched the surface of growth.Samit Vartak, CIO, SageOne Investment Advisors
The strategy of “buy and hold” may not necessarily do well anymore, he said, adding that investors must react quickly to troubles at any company.
WATCH | SageOne Investment's Samit Vartak On Midcaps, Financials And FMCG Sectors And More
Edited transcripts:
Do the last 30-odd days seem remarkably different than what the last 18 months have been?
Absolutely, one of the biggest differences was that, if you look at the results, they were aided by the tax writebacks but if you look at the operating results, they were pretty bad, especially on the auto manufacturing side. Even the worst of earnings weren't met with a big drop in stock prices.
It was a big difference but fundamentally itself, I think now, at least the perception is that the government is genuinely trying to resolve issues. Initially, the perception was that they almost seemed anti-capitalist which definitely has changed since September since the tax cut and there is some aid given to the real estate, telecom industries.
I think the biggest problem for the markets as well as industries was the credit cycle getting stuck. That's oil for the engine and that is slowly loosening, and we are getting that. So, last-mile steps that they are doing for real estate, some of the NCLT cases getting resolved— that will bring money into the system and allay a lot of fears. Plus having Yes Bank almost saved and the tail events where one bank failing and having a domino effect and systemic risk, I think that kind of fear seems to be gone and you can feel it in the market.
The reactions in the market are much more logical and reasonable compared to those knee jerk reactions which happen in a fearful market.
Divestment announcement has triggered a rally in some of the stocks... Shipping Corporation gained 150 percent in a period of 3 months or thereabouts. This is some remarkable reaction to possible events or some post-events as well. A lot of underperforming sectors are starting to move up, pharma, metals, etc. Are these tell-tell signs that some risk appetite might be coming back?
They were beaten down so much. If a Rs 100 stock comes down to Rs 10 and then by going 150 percent up, it goes to Rs 25, we are still down Rs 75. So, I think those are the kinds of reactions that you are seeing. I think divestment in itself is a big reform. Its just not selling the stake but it's also change in management control. We have seen historically that there are multiple examples where huge value has been created. So, I think investors are definitely sensing that. These may be very small steps, but it shows the direction in which the government is going.
The big incentive that has been given to the new companies which will be set up, I think it's a huge step. One is, you are only getting that four-year window. That means the capex process has to start now. You'll have to at least get the approvals and it is the matter of ‘how much' is the capex coming. There are reports that the government is actively talking to more than 300 global companies. That shows you that they are very serious in attracting the capital. See, one way that the government could've gone was, maybe cutting the personal taxes. That would've ramped up the consumption side.
I like this direction because they are trying to expand the pie. It may be a slower process but to get more industries in, it's a very short window to attract companies who are getting out of China. Once industries are set up, the economy itself gets bigger. They will employ people and the employment itself will start the consumption cycle which will be much more long lasting.
By cutting the cost, by people spending more or maybe leveraging more, it will be short term. So, I like the direction in which the government is going.
How would you as a portfolio manager, look to generate alpha? Just wondering, have you made some changes to your portfolios?
I think it's a really important question because the last couple of years have been really difficult for most of the fund managers. You always try to introspect: Did you go wrong somewhere? Was your hypothesis itself, wrong? Or was it just that you hit a pocket which any market can hit, and you were right in your process. As an investor, you exactly need to know what you are looking for. It's a long, 10-year journey. The question is, at what pace do you want to complete that journey? You can drive at a 15 kilometre/hour pace or you can drive at an 80 kilometre/hour pace. In general, you will finish the journey much faster even though the chances of accidents is higher at a greater pace.
Whatever you do in the long run, the earnings growth of your portfolio will drive the returns. Now, I target 20 percent earnings growth which in itself over alpha would be what the Nifty's growth earnings would be. If you assume that nominal GDP growth is 13 percent or even lower because of inflation going down, that 20 percent in itself is 7-8 percent alpha. Now, the question is, what kind of companies will generate 20 percent earnings growth? I just looked at the history because the last 8 years is a very good history to look at given that until 2011, the consumer-oriented, commodity-oriented companies in the general market used to grow at a similar pace. They did grow at that 13-14 percent kind of earnings pace over the last 15-20 years. Even their valuations weren't divergent, they were still trading at 20-25 times.
You look at the history of consumer companies versus the commodity companies. The divergence started in 2011 and that was mainly because the rest of the economy - the non-consumer economy's growth just faltered. It dropped from that 11-13 percent to 5 percent whereas the consumer-oriented companies continued to grow at 11-13 percent. That's where the inventors huddled into those companies. That was the only pocket where growth was available and their valuation just shot up. From that 20-25 times, it crossed above 50 times as an average. So, I said, let me look at this last 8-year period, and see which are the companies which have delivered the highest growth. Not only in terms of earnings growth but also in terms of the returns.
So, I set a benchmark for myself, saying that I need to do 10 times in 10 years that is 26 percent on an average annualised growth which I am looking for in terms of multiplier of returns. There were 70 such companies and I only looked at companies which today, at least half a billion that is with a Rs 3,500 crore market cap currently and which are those companies that have multiplied. So, they could've been Rs 350 crore 10 years ago, but they were at least Rs 300-400 crore at that time.
Now, in these last 8 years, there were 70 companies which did that. That means, we had 70 companies which have grown at more than 26 percent annualised rate. The average growth for these 70 companies was 37 percent in terms of share price return. That means, you do 23 times, in 10 years compared to 10 times in 10 years. So, you had such a large pool of companies which qualified, and their average earnings growth was about 21 percent. That means, they delivered more than 20 percent growth and because of that, there was a re-rating in these companies.
Now, when you look at what were the profiles of such companies, almost 85 percent of these companies were commodity oriented. So, I think it's against the general perception. The major contributors were chemical companies, pharma companies and there were a lot of financial companies. You can't charge 20-30 percent higher premium compared to the rest of your competitors.
Which one was this? The Rs 12,000-crore company?
I think it was IndusInd Bank. Bajaj Finance itself was Rs 2,400 crore at that time and it has crossed Rs 2-lakh crore now. So, as an investor, you need to know what will constitute your portfolio. If you are looking for such returns, it's impossible to do that by getting into whatever quality of companies that it could be, if it's a large cap. So, once you are clear, then it helps you filter out which are the companies which will qualify in my portfolio. Absolutely the companies which are larger today, can deliver above 20 percent growth in earnings but from today's valuation, there is very little room for re-rating. Most probably, on an average, the valuation multiple should contract. They can't sustain at these levels especially the large quality companies.
So, if your eventual portfolio target is northwards of 20 percent, you are saying that naturally, the bent of the portfolio would be towards non large-cap names?
Absolutely. Practically once the size is so large, other than few financials where the market in itself is humongous. If you go to non-financials, there is not enough market size to deliver that 20 percent plus earnings growth over the next 7-8 years. So, majority of times, the earnings growth will be closer to the nominal GDP. So, you think from a normal investor perspective or from a foreign investor perspective.
If a large company is going to deliver you 10-11 percent earnings growth and if its already trading at 70-80 times the multiple, that means there's no upside room for that re-rating happening, most probably, it is going to be down. This is gross returns that you will get. The best gross returns. Deduct the portfolio manager fees of 2-2.5 percent, you drop to almost 9 percent and from a foreign perspective, there will be 3-4 percent of rupee depreciating. You are talking of 4-5 percent returns and paying 70-80 times the multiple.
I just do not understand why a foreign fund manager should be coming into India to get such a growth because I am pretty sure, in dollar terms, you will get such a growth in many markets that may be one-third or one-fourth of the valuation you are paying here.
The argument made is that, some of these companies for the last 7-8 years haven't had quality growth. The revenue growth, the bottom-line growth for the consumption names at least haven't been spectacular. Your thesis also suggests that the run-rate growth hasn't been there. Maybe we are looking at higher volume growth number coming up and the higher return on capital employed etc. and the low capital and therefore, the returns these companies give is just so high, that it justifies the premium valuations. Where are you on that argument because I hear both sides every single time?
No, that's the perception. As I said, the last eight years were an extremely difficult phase for an earnings growth. Even then, you found 70 such companies which delivered that. So, I am pretty sure that the next eight years won't be as bad as the last eight years. So, you should have more probability finding such companies.
So, put in the hard work and try and find that in those pockets?
Yes, you might have more accidents but that's what happens if you are driving your car fast. Again, are you trying to get that 10-11 percent returns minus the portfolio management fees? I don't think its worth the risk to come to the market for getting those kinds of returns.
Have you re-aligned your thought process in the 24-odd months in terms of the quantum of returns that you want? I would presume that the starting point for you at any point of time when you re-align your portfolio, is the target return you have in mind?
Yes.
I believe that is your starting point, right?
Yes, that is my starting point and that is the only way I can construct my portfolio. If I don't have any idea what my target is, I'd be completely blind about what to put in my portfolio. So, that is my starting point. I think in the last 24 months or so, you've got to introspect because I think its how fast you react once you see some signs of trouble. You hold on to that because you are conditioned that you should think really long term, hold onto the stock. You hear stories of people taking an 80 percent drop in Amazon and then, still recovering. Kotak taking an 80 percent drop and still recovering. But those are one-off cases.
The question is, you've got to correct your mistakes very quickly. In a down market, you get the opportunity to do that because there are many good companies which also correct sometimes equally. So, you use that times to get off the peak position which has given you a lot of stress and get into a lot of stronger companies. So, that is what I have done, and I‘m trying to do.
So even if you have taken a hit on some of your portfolio holdings in the last six months, you are happy to swap them? Book that loss, because there are opportunities available elsewhere - you are going out and logging in there?
Yes, and I think the next few months will be critical to do that because you will see signs of improvement because you don't want to be preempting a lot of things. Just track it much more closely. I think your depth of work will be much more important because this is a turning point. Things are recovering from the bottom. That's the most important time to build your portfolio. So, even if you are hanging on to your weak positions, this is the time to do it - over the next five to six months.
For the next 12-24 months, are you playing an equal part for a valuation uptick for some of the beaten-down spaces or are you largely positioned for earnings growth?
So, for the first criteria, I'm positioned for earnings growth. I can't compromise on that. Post that, if you have multiple options where somehow the perception in the market is much worse than the reality, you get such a company at a much lower price.
We were talking about the steel pipe company versus the CPVC pipe company. The CPVC pipe companies are perceived to be a brand and a consumer-oriented B2C and it trades at 70 times the multiple whereas the steel pipe company, if you look at its last 10 years' history, its earnings growth is much higher. Its top-line growth has been much higher than that. Its return on capital is almost equal, and its cash flow generation is almost equal. The trailing 12-months profit after tax is almost equal to both the companies. One company you are getting it at Rs 4,000 crore market-cap, another company you are getting at Rs 17,000 crore market cap. For me, this is a huge dislocation in the market, and these are the opportunities you buy because they have delivered. It's just the perception that one is a much more commodity-oriented company and another one is a brand. Whereas if you look at the numbers, they won't suggest that.
Would that be the case across multiple sectors and maybe a way to play the next leg according to you , the market leader trades at say X PE multiple and the number two or number three player trades at slightly lower and there could be a fair way to play this wherein the number two or number three player will not be number one but even if it improves, it will do better than the leader moving up slightly?
Not necessarily. Think its completely different industries but having slightly similar profiles of profitability
Not just for this. I am saying across spaces.
No, I am not playing that. For me, I need a dominant leader because the 20-percent earnings growth has to come from market share gain. The industry is not going to deliver you that kind of an earnings growth. Generally, a leader, I mean by his cost efficiency, market positioning, his product profiling depending on his industry, you want to analyse it differently. But the differentiation of that company versus the rest of the competition is more important.
If I find that, it can be a number one player, it can be number two. You bet on that and if you are getting it at a much cheaper value, the probability of you getting a re-rating is much higher. You cannot bet on that re-rating but at least if the earnings are delivered, you are at least sure that in the next 10 years, you will get that 20 percent kind of returns and looking at history, any company which delivers that kind of a returns over a long period of time, significantly gets re-rated.
The last 18-odd months have also seen industry leaders in their own sectors where growth didn't seem to be a problem. They have hiccups and have seen significant erosion. It has happened in the largest four-wheeler passenger vehicle company, it has happened to the niche two-wheelers company, it has happened to the undergarments company. All these have come down quite dramatically. How do you think investors should approach pockets like these?
Because, when you hear any big numbers, imagination PDF or when you see that, it almost seems that India is such a high growth market, and yeh sector meh growth toh hai (there is growth in this sector) But, have you seen hiccups and the valuations have got de-rated?
That's the problem. The expectations built in are too high. I mean, if you compare this to 1972 in the U.S., the Nifty50 bubble, even at that bubble time, they traded at half the valuations that they are trading in India. You are talking about a lot of the consumer-oriented large companies; J&J, Merck, McDonald's, Kodak and Xerox and these companies. People thought the same thing. People thought they will continue their growth for the next 25-30 years. If you look at their drop, some of the companies drop by 70-80 percent in the next four to five years. For the next 10 years, as a group, it delivered negative returns.
Then, there is professor Jeremy Siegel who has done an analysis and he showed that in 25 years, they have delivered better returns than the S&P 500. So, when your horizon gets longer, the starting multiple is really irrelevant. If the earnings are going to be better than the market earnings, then you will get returns. Again, you know, are we in a similar position as in the U.S.? Because post that, there was huge inflation during the period; especially during the 1980s. U.S. had global companies, so they had the global market to capture. Most of the Indian consumer companies are local so I don't think they have that long runway for keeping on capturing the markets. So there, the earnings will be pretty close to the nominal GDP growth rate. If you look at the U.S. GDP growth rate, it was much lower than these consumer-oriented companies' growth because they entered into many countries.
So, I don't think that is a possibility for India. So, you got to factor that in, even if you have a 25-year horizon, can you see your stocks underperforming for the next 5-10 years? I don't think so. You can say it easily, it is extremely difficult. If a fund manager tries to do it, he will no longer be in the business.
The non-lending financials— essentially insurance and asset management companies. The debate out here is that, the runway for growth here is long because the market is there for them to capture. So, the growth rates in all probability should be great and it is the leaders which are available right now. The listed space only has the leaders. It doesn't have the number 10, number 15, number 20 player anyway. So, the only way you can bet on that would be, arguably buying the top five companies but they are priced to perfection and beyond. The question that I have for you is, do you believe a 10-year high growth formula is possible and if so, does it take care of the entry price at such high valuations?
So, one of the small pockets which has gone against the trend of continuing to grow on that rate for multiple decades is financials in India because you see the 2000-decade and the 2010-decade. Look at the top 50 companies which delivered the highest growth. The only common stock that you will find is the financials. With that in mind, I cannot bet against that. Even though I find them expensive, if you look at a 10-year growth phase and if they look at anything above 20-25 percent growth, you will find it 40 times or 45 times PE to be cheap.
So, you do believe that the non-lending financials do provide an opportunity for a long-term investor?
Absolutely. The size is too small, there is a huge market to capture and I think that will happen in the next 9-10 years.
Therefore, people should do their homework, but the higher multiple should not deter them.
Absolutely. Because I think it's still not a mature industry; it's probably going to take it couple of decades to mature.
For the last 8-9 years, I have heard enough, and more people talk about this private sector banks taking the game away from the PSU banks and starting to do well. While that has played out in part, it has still not played out fully. The size of this industry is large, and we can't call them at a nascent stage. They are mature banks. Do you believe that theory or that practice will still continue and despite the higher multiples - you can debate the multiples, but would the growth landscape still be available there?
Even if you consider the largest NBFC or the largest bank, the largest NBFC talks about their market share is barely 1.5 percent or so. Many of them can target to reach at least 5 percent. The industry itself is growing and then you are tripling your market share. So, you have a pretty high growth phase which is possible for these. The PSU gives you the opportunity of 65 percent of those buckets that are available for people to keep on pulling the water from the well. So,
I think finance is a space where the growth might even surprise you on the upside, given that we have had 8 years of really low growth credit period.
Let's talk about the speciality chemical business. Now, the reason why I bring this up is, I know you have been selectively bullish in the past and I have had enough people who have told me while you call them speciality chemicals, they are commoditised businesses and therefore, the multiplies should also be questioned.
One, do you believe these companies have it within them to compete in the global arena, some of them are already doing that but can that continue? And two, would you debate the multiples that some of these companies get for what some people call them “commoditised businesses”?
You are right. I think even though some companies may call them speciality chemicals, almost two-third plus of their business is commodity business. The important thing in that is, you have to be very selective and you have to track what is happening globally because you have to differentiate between luck and the competence of management. There have been many companies which have been lucky because of some Chinese plant shutting down and they have done really well in the last two to three years.
You have to differentiate between the companies that have started doing well over the last 10 years. There you can be fine paying a little higher multiple but for most of the other chemical companies, I don't think you can pay double-digit valuation. You probably should pay higher single digit or extremely low double digits. If you are getting such valuation multiples and you still see 20 percent plus growth, it definitely makes sense, but you can't be a passive investor in these companies. You have to track at a product level, how the pricing moves, whether those margins are sustainable, whether those spreads are sustainable and be an extremely active investor and be ready if things change and the valuations go up, you should be able to get out of these companies quickly.
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