Saurabh Mukherjea is the Founder and Chief Investment Officer of Marcellus Investment Managers. At the Morningstar Investment Conference, he explained how he unpacks some of the companies with a strong internet digital play.
Can I comprehend the accounting?
We could set up a power plant in Tamil Nadu and generate cash from that, then set up a power plant in Maharashtra. We would report the Tamil Nadu power plant as cash generative and operating cash flows positive, but since we're doing CapEx in Maharashtra, therefore overall the company's consuming cash. An investor can see that the Tamil Nadu company generates power profitably while in Maharashtra a new plant is being set up.
Unfortunately, that distinction is not possible with these companies. If I was a naughty promoter of a tech company, I would keep saying, “believe me, I am making money in Tamil Nadu. Trust me, I'm making money in Tamil Nadu. The new cash that you're giving me as a VC or as the stock market is going to finance the Tripura expansion.” A fair bit of our diligence around these companies will look at whether they actually made their original areas of dominance cash generative. Or, do they actually have no cash generative elements of operation? The more transparency we see from the companies in this regard, the greater will be our faith in their future prospects. I'm sure everybody's happy to keep giving money to a company which has shown that it can conquer a part of the country before it goes forward.
Why do they need the cash?
Historically, the best tech businesses actually don't need much capital. Sanjeev Bikhchandani and team made Naukri.com cash generative as little as I think a couple of million dollars. The Nykaa team come to profitability on well below $50 million. I was listening to the PolicyBazaar promoter say that they build the company on $70 million. So whenever we see any tech business asking for a tonne of money, obviously the scepticism meter moves up and then it links back to the first point.
Is the leadership stable?
A lot of these tech companies seem to resemble revolving doors, where every two, three years they've got a new pack of people come in and have a go, somebody cashes in, somebody cashes out. We need to see stable leadership. Very good discipline around cash generation. Very good discipline around capital allocation. A stable leadership team which over a decade has built what is fundamentally a sound operation. It just happens to be in the tech space, but it's fundamentally a class business with strong moats, and with corporate governance, hygiene, succession planning and team dynamics nicely in place you can go ahead and invest in it knowing that the business actually has moats.
The opposite extreme is what I call putting lipstick on a pig; businesses which are fundamentally unviable, but they polish themselves up and present themselves to the stock market as a tech business. Nothing wrong with that. That's the nature of free market capitalism. As data shows that only one out of six of these players will actually make money. Out of the other five, some will be pigs putting lipstick on themselves. And some will be honest triers who didn't quite get the business model right.
Can you grasp where the money is being made?
Standard old-fashioned scepticism works, and you just have to realise that business rules very rarely change. This don’t think this notion that tech fundamentally changes the rules of business is true. You just have to re-understand the accounts and ask the company for help. You have to understand where they generate cash and where they are using cash; the standard IFRS or Indian accounting standards are not going to help us there.
When I meet a promoter, my simple point is, mere ko paisa bane ke dikhao malik. Whether it's sticky, unsticky, network effects, show me where you make money. And the moment you sort of start hearing that it's unit economics, to my mind it is a red flag.
So, just to sort of link back to good old-fashioned fundamentals. When we first moved to India, 2008 Info Edge was a tiny company then. I think listed in 2006, but already naukri.com was generating cash flow. We realised that Info or Naukri was a national dominant player. So whether you are a HR head in Bangalore or a HR head in Noida, you subscribe to the Naukri database, and therefore, whether you are a youngster in Delhi or in Bangalore, you put your CV into Naukri, right. And because Naukri built a national dominance within its first 10 years on very little money, subsequently, it's been an unchallenged player, it's been difficult for whether it's Monster or LinkedIn or others, to really give Naukri a run for its money. In contrast, many of the tech players today are building local dominance. And as a result, you know, you might be great in Mumbai, but somebody else usurps your turf in Hyderabad, because your Mumbai dominance gives you zero benefit in Hyderabad.
So, if you're able to find frugally run companies building national dominance on the back of technology, on the back of a high-class team, of course, you and I should invest in it. And usually, such teams are able to very clearly show you how the dhanda makes money. On the other hand, if you and I are running into teams, who are building local place that too with sketchy unit economics, and they're using further money to build out other markets that immediately suggest shallower moat, a weaker moat and more questionable future prospects.
Will price to sales valuations be the norm going forward?
Price multiples - be it PE, PV, price to sales - have no utility at all, whether it's old economy or new economy, whether it's Bulgaria or India. Those who invests basis price multiples make life difficult for themselves. What any investor has to do is build a picture of how long the investee company can sustain a strong cash-flow generation.
For example, take any company, anywhere in the world. It can grow cash flows at 25% for the next five years, and thereafter, the cash flow growth fades to a perpetuity of 5%. You shouldn't be paying any more than 25x current earnings.
If the same company can sustain strong cash flow growth for 20 years, say 25% cash flow growth for 20 years, then it is a different story. Incidentally, several companies in India have done it – Titan, Pidilite, Asian Paints.
The fundamental job of an investor is to try to comprehend how a business can generate cash flows. 5 years? 15 years? 25 years? The job of an investor isn't to look at price to sales or price to book or price to earnings. And as soon as someone does that, they're on a slippery slope.
