Here's Why OysterRock Capital's CIO Is Biased Towards Small And Mid Caps

Mehul Bhatt: We are not big fans of forecasting. But just to put things in context, some of the changes that are happening in India, if we can contextualise into the portfolio, it will help you and the viewers a little better.

So, there are a few things at work here. One is that you know, the tier 2-3-4 towns are actually now exploding and doing really well. The second wave of course, also is, you know this whole India being included in the bond indices, and you know, the credit rating agencies, I mean U.S. with its debt has a rating which, you know, asks us many questions, but India's ratings also eventually will improve.

One of the important things is the cost of capital converging with the U.S. in the long term and with even some of the Asian peers, and that actually puts, you know, a very different angle to this whole story, which, you know, we underestimate. Add to that, the fact that, you know, SIPs are India's 401k is now so if you're a 30-year-old guy, your parents have influenced you to save all your life and you're putting money there, so it may not be as flaky or as dicey as a lot of us, who have been doing this for a long time may think. In addition to that, you meet a lot of young guys, who're incredibly smart. So, many more pairs of eyes are looking at Indian markets now, and companies specifically, that the inefficiencies have become far fewer. And when you see a bad quarterly result, the action is immediate. You see a good quarterly result, the outcome is immediate.

So, I think putting all these together markets, you know, are not necessarily cheap right now. And you know, the small is more expensive than the mid and the mid is more expensive than the large. These things are what we've seen in the last at least 8-9 months. We'll have to see now that fundamentals catch overvaluations, not the other way as we are used to.

But if you see many, many buckets are doing very well. So you don't find, you know, mouthwatering opportunities. But if you look hard and deep, there are opportunities to hunt in. So we look at it in three buckets. One is value, which is cheap companies, the second is undiscounted change, and the third is long-term compounders.

So you know, value is companies that are conventionally cheap, you know, 40- 50-60 cents to the dollar. PSU banks three years back. Many of the PSUs, all these defence guys were single-digit earnings. Those don't exist right now or whatever exist is where there is a problem and the danger for people like us at a time like this is because we are value-conscious, we are not value investors. We'll end up compromising on quality and go into lower tier businesses for the valuations. That's something that we are constantly guarding against. So, the value bucket is actually quite unavailable right now.

The second bucket is perception variance. So, either you see a bad result, a good business going through a troubled time, and the markets don't give it, it's due for a longer term basis and, you know, that's a bucket we love to hunt in. If we've done our homework, we are ready with what we think is the limits of buying and selling. Then we obviously act on those decisions where we think that we have a differentiated view against the market. That comes with being prepared—when you have a bad result, or a CEO changes, or any of these one-off things. But the second bucket where we had great success and we like to hunt is transition or undiscounted change. So, one is, you know, the constant change in India of, you know, small going to medium or medium going to large. The other bucket is, you know, like B2B to B2C. So one of the names we own was an institutional business, selling a consumer product. They have launched their brand in India. Since the last 3-4 years, it's like a Rs 200-crore brand going to Rs 500 crore in the next 3-4 years, investments being made and transitioning into other consumer categories, like mini QSR, and some of those ancillary areas. And that's a bucket where, you know, there are a lot of interesting opportunities, not just the one that I'm talking about and interestingly if you look at the consumer space, as a sector, the large names are reasonably priced compared to the historic numbers, but right now, the trade off is between cash flows and growt. And the markets believe that some of these may suffer from growth. So there is actually a revolution in that space. I mean, look at your own ordering, for example, how many times have you ordered a pizza or a burger or something from a big box retailer because you trust the quality of the smaller guys. It's artisanal. It's not, you know, just a templated product that they're giving you.

Mehul Bhatt: That's right and you know, with the whole tech thing coming in now. So for example—we don't own Mamaearth or we don't have any interest—but this is a company formed in 2017, Rs 12,000-crore market cap, Rs 1,500-crore revenue last year, probably Rs 2,000 crore this year, I don't know the number. But I'm saying that, you know, something like this was created in 5-6 years. It's come from nowhere and, you know, it's a reasonably large business and we'll see many more of these whether it's sugar or you know, Swiggy, many of these unlisted companies coming into the market and challenging the current incumbent. So, there are two ways of seeing it. One is from a consumer angle and the other is from an investor angle.

Mehul Bhatt: So, our approach is that I mean, we are agnostic to the capitalisation of the company, but naturally, we veer towards those areas, because that's where the change or the transition that we are seeking is very high. So, one is this B2B.

The other is, you know, for example, commodity to value add. So, five years, 10 years back, a lot of Indian companies were N minus nine and N minus 10 steps away from the final product. Take chemicals for example, or auto ancillaries. You know, like auto ancillaries would only do forging but not machining. Today, a lot of these guys have invested in high-end equipment, they are actually selling the final product, or as close to the final product as possible. So, you are two steps or three steps away from the final product, and you are at global scale. So you're no longer a price-taker by some guy in China. You're also a price-setter yourself and combine that with better margins, it's a very potent combination.

The other bucket for example, that we like is, you know, import substitution. And we own a medical consumable business, for example. These are companies where multinationals were large, very large import component. At the end of the day, India has strengths in these areas with this whole wave of manufacturing, Make in India, and incentives. Not only are these guys now strong in India, but they are exporting to Europe, I mean, India branded products in Europe and you know, trying to make headway in the U.S. So there are many of these opportunities that may not be mainstream. And that's why our strength is to make idiosyncratic investments. We are not necessarily looking at whatever is just mainstream, but, you know, if you go out of that mainstream and you know, find these opportunities.

So, if you look at our portfolio, we are, you know, sector-agnostic. I mean, if I run a large fund, like in the past, you know, there has to be some index alignment and stuff like that… Portfolio construct is just an outcome of what we like. And we don't want to have a very homogenous portfolio. So, even in financials or consumers or engineering, capital goods or power equipment, for example, where we have reasonable interest, we are looking to invest in businesses that, you know, give different angles to the portfolio.

Mehul Bhatt: Sure. Unless the mega caps are going through some sort of transition or change, like one large media business which was large, became mid, now again became large.

Mehul Bhatt: No, I'm just saying that you know, there are some of those names. We don't own a lot of commodities, but a large steel company, for example, can potentially fit in that bucket. We don't own it, but those are much more complicated to understand, which is why I'm just giving you examples of mega names that potentially can fit our bucket, but we have not hunted there yet.

Mehul Bhatt: Yes, that's correct. That's a fair statement to make.

Mehul Bhatt: Sure, we have like engineering, if you bucket the whole thing into one, which is engineering, capital goods, and power equipment. We have interest in that area and that is because, it's gone through 10 years of pain. If you see balance sheets, you know, companies that were, Rs 300-500 crore of debt have actually repaid now and are net cash positive. Obviously the whole infrastructure investment, done by the government in the last 3-4 years, is an important source for that growth that we are seeing. But there are some interesting developments that are happening.

So, if you go to Europe, there are so many small companies in the range of 10-50 million, run by people who are 70-75 years old, (with) no successors readily available. A lot of our investments are actually buying these companies. So it's not an insanely large risk they are taking, but they are building a product business or getting a product capability that didn't exist earlier and you know, that actually has become a very good engine for growth.

Of course, India is doing well and will continue to do well as you know. So far, it's been government. And now, private sector as it kicks in with capacity utilisation wherever they are, whatever number. We assume it's now at a place where at some point that kicks in. So, India is one leg. And this is not pure global because you're not leveraging up insanely and you're buying very niche product businesses—whether it's valves, pumps, motors, I mean, pick an area and there are interesting names that I can throw out which I can't talk about on TV.

Mehul Bhatt: So growth always takes care of higher valuations and all the mistakes we make as investors. And if the growth doesn't come, then the mistake is amplified and if the growth comes, then our mistakes get hidden and you know, that's an honest confession.

So we do believe that in many of these names, growth is an important criteria. So most of these are trading between let's say 20 to early 30s. So they are not insanely expensive. But they are not cheap, either. In these businesses, because of the cyclical nature of the underlying profits, typically you're not going to find them very cheap in upcycles, as we are seeing now. And the interesting part is that, you know, one is the capex that we've seen by the government, we will see by the private, but a lot of these guys are going out now and they have already built or are building capabilities to sell to the world, which didn't exist. So whether it is like I said in pumps, motors, gears, whichever product you take, power equipment, turbines, etc. So, there is an opportunity, one, to win market share overseas and you know, I mean we know about the U.S., Europe growth, etc., and I don't want to delve a lot on that. So they're actually acquiring some of these smaller businesses, not putting their balance sheets at risk by doing so and of course, the balance sheets are much more healthier than they were even four or five years back. And in addition, all these guys have, you know, actually cut muscle dramatically in the decade that went by from 2010 to 2020 because they were all suffering very badly. So they have all deleveraged and even from a cost standpoint, I think a lot of these guys are absolute bare bone right now. So they've got to now, you will see them adding costs, building muscle to actually fulfill some of the growth that we are seeing. So right now, you know, profits are also looking very good because they are bare-bone structures in many instances. So we'll see, you know, profits growing at a healthy clip and not so many of them, you know, for example, were in projects and now they've transitioned to only selling products, which is their core. They meandered in the late 2010 and 2011 into doing stuff that they were not good at because they foresaw growth, which never happened or in fact went into, you know, losses in many instances. So now they've actually corrected their businesses and those are very interesting opportunities to hunt in. So they're not necessarily very cheap, but growth hopefully takes care of that. And, you know, obviously we'll make some mistakes as we go along in some of those names, but on aggregate, if we are fine, then you know, we'll be okay.

Mehul Bhatt: So we like the equipment guys the most because they suit our investment approach where there is a change. Either capacities have doubled or capacities are increasing by x%, or they're building capabilities in ancillary areas that didn't exist in the past, by acquiring you know, something in and around that space. So a guy who makes turbines will do something else. Basically, they are going into ancillary areas and not creating a large risk on the business, like they did in the past most importantly. So that's one bucket.

We also like the power financiers and some of them are interesting. Many PSU banks also do it. So we do like a couple of those names. And I think most of them will do well, or even the banks that have exposure to that area will do well. As we go into summer and the anticipated power situation will benefit, you know, more investments in that area. So whether it's in new energy or in old energy, we're going to see a lot of that coming in. And we don't necessarily like the annuity type businesses though they've done very well in the recent past. This is a cyclical thing and you know, some parts will do well, some parts won't do well and by and large when the underlying growth engine is at work, most people will benefit out of this. So we like to play it through the shovel makers, as opposed to the gold diggers. So we are more focused on that zone.

Mehul Bhatt: So actually, you know, in that space, the shovel makers haven't done very well. Only in the immediate past, like in the last 4-5 months, they've done okay. They've had a rough time preceding that. Our belief is that they will obviously come in when the keys are handed over to the buyers, and the market obviously was concerned around that.

But having said that, you know, real estate is an important source of growth for the country and the economy. A lot of growth that we're seeing is also an outcome of that—the real estate cycle having done well in the last two-and-a-half years or so.

Mehul Bhatt: Hard to say, I don't know. But right now, at least, in the higher end of the market seems like there is some slowing and we've got to be a little cautious on that front. But we don't know that business very well, if you go outside the areas we know. And it's a very local market. So you got to get that and unless you get that, making a general statement is very risky.

Mehul Bhatt: I don't think defence is a newer theme, but they are the ones which have done well. We do have investments in a couple of these areas.

But we are also worried. So, you know, in both defence and railways, we've seen in the past that orders, which people thought would get executed in three years, or four years or five years, actually took 10 years, 12 years and commercialising many of these products—and by commercialising, I mean to actully make 60-70-80 missiles of something—took much longer. So, you know, we come with a hangover of that and if this time, they actually execute in the timeframes that we are hearing about in terms of the execution cycles, then I think they are not necessarily as expensive as they appear to be, but you never know these things.

Growth has its own way of disappearing. So we don't want to overpay for growth, at most points in time. And in the defence and the railway areas, you're paying for growth and you know, I mean, of course, you can see that right. They were all trading at you know, single-digit valuations or very low two-digit valuations. And today, they are all significantly higher.

Mehul Bhatt: If the growth comes, then you're not overpaying. But right now, based on our experiences of what's happened in the last 15 years, we would be skeptical. But, I'm sure that people will do well. It's just that it's very hard to figure out which projects out of those very large ones will actually see the light of the day in the time that they are talking about.