Widely known for his specialisation in mid and small cap stocks, Kenneth Andrade, Founder and Chief Investment Officer, Old Bridge Capital, explains which sectors he is bullish on, and why.
What are the things investors need to be cautious about while picking small-cap stocks?
The mortality rates of these companies are extremely high. So you have to be careful about the longevity of any business.
I would suggest a focus on:
- The ability of the company to remain solvent.
- Leaders in the segment. Every industry goes through a cycle. When the cycle turns against you, the company has to come out unscathed.
- Price to Earnings Ratio. Look at valuation. While evaluating PEs, you will always find companies that are relatively cheaper than others. But PE is not necessarily a good filter while choosing stocks from a long-term perspective.
How do you identify leaders in the segment?
Market leadership is about getting a higher amount of market share while being solvent and profitable. So strong cash flows. Once you have been able to establish market share with profitability into a downcycle, when the industry emerges, the company should be able to clock incremental market share with higher profitability.
In your investing career, what have been your notable investment learnings from investing in small-cap companies?
Never use relative valuation. It is not a sustainable metric. In a market cycle, any industry that does well, the largest and the smallest companies are very comfortable. You also have to recognise that when the industry is not doing well, everyone loses money except a few companies. That will define the peak of a bubble and the other extreme when there is recession in the entire industry.
Investing is about buying low and selling high. Usually, you get a valuation of a business cheap when the business cycle is against it.
In my investing career, I participated in the tech bubble in 2000. When it collapsed, I believed it would not go away and it went away. The mortality rates of the companies were very high. When we went into 2008, we saw the valuation profile of some of the larger consumer cyclical firms being cheaper than some of the smaller infra material firms. So you had large caps in an industry trading at a cheaper valuation than the small caps in another industry. That helped us navigate that cycle.
What we are seeing right now is very similar in the market place.
I have spent decades as a research analyst and a money manager, and I have seen that the market moves in polarisation in certain categories of businesses, it doesn’t matter if they are small or large. You have to anticipate it before it becomes large and when you have to get out.
How is your current portfolio positioned?
From Old Bridge perspective, our investment strategy has not undergone a change.
We anticipated the overvaluation in financials and some part of the consumer economy. We stayed out of it. So while 2018 and 2019 were challenging for us, things are not so bad now. So investing is about not being in places you don’t like as much as being in the place which you like.
If we shift that cycle forward from 2021 to 2030, and go back to history, you have decadal changes that have taken place. Technology towards the end of 2000. Materials and Infrastructure in 2008-10. Consumers and Financial Services now. We like asset-light and efficient companies. Our portfolios are getting polarised towards export-driven companies rather than the domestic economy.
So we have a bias towards companies that have established their global footprint, have spare capacity and have cash on the books. Most of these companies will be part of the global supply chain. From 2021 to 2030, we have relatively weak domestic macro. The government expenditure has been diverted towards defence and social sector. The industries are left to fend for themselves. This situation could be similar to 1990s.
There are some sweet spots in the domestic market but the most scalable part of the opportunity comes when you address 100% of the world’s GDP.
Which theme looks promising?
We are looking at companies that have a global footprint, have spare capacity and have costs in their favour. It cuts across a few commodities, services (IT) and pharma sectors. It is fairly diversified.
The second level is the utilisation of capacities that are already sitting on the ground. If manufacturing takes off and if everyone gets plugged into the grid, the utility business looks good given that valuations are at historic lows.
Are you bullish on the automobiles sector since there are expectations of increased demand for private vehicles due to fear of Corona virus?
This business is fairly cyclical. The commercial vehicle market is at an all-time low. The auto ancillary sector is suffering from a lack of demand. It will be a one time opportunity in personal transportation segment as people transition towards owning vehicles. I don’t think it is a secular trend. But there are some automotive manufacturers that are very competitive globally. These companies will leave a large footprint behind. We are apprehensive of participating in any company which is purely domestic driven.
What makes you bullish on manufacturing?
In India, we have spare capacity. We have a tremendous amount of operating leverage that companies can exercise over the next decade. All of that will be converted into cash flows. We are heading into a decade where costs will be completely under control. Capacity is sitting on the ground. There’s needs to be an alternative to the world’s largest manufacturer. When it comes to costs, besides raw material costs, it is power cost, interest/finance cost and manpower cost. All these three costs will see deflation in the next decade. There is no wage inflation. Interest rates are collapsing. Electricity costs will also come down in the next few years. These factors bode well for manufacturing companies.
Banks are still wary of lending. When do you think credit offtake will pick up?
Wages are not increasing. If defaults increase post moratorium, the credit rating of a lot of consumers will be adversely impacted. This is going to lower the number of solvent borrowers in the system. You have financial services firm sitting on cash wanting to lend to creditworthy borrowers. If you have a large Non-Performing Assets (NPA) post the moratorium, the number of people in the lending pool will be fewer. There could be a challenge to grow the balance sheet in the same industry in the next few years.
You describe your strategy as buy and hold. How long do you typically hold the stocks?
Companies are created over multiple cycles. When they acquire market share and grow in line with the industry. We run a thematic fund. We will exhaust four years now in this theme. We have invested in companies involved in the farm sector. From 2016 to 2020, some of these companies in our portfolio have become significantly larger. And today the market environment favours such companies. They are at an all-time high in terms of profitability, market share and growth levels. So there will be a shift in that strategy. We are looking at capturing a new cycle that will emerge.
