Investing in small and mid cap companies can be fraught with risk but if you get your thesis right the potential for growth could be humungous. Samit Vartak, Founding Partner and Chief Investment Officer of SageOne Investment Managers LLP, talks about his stock-picking style, the companies he avoids, and his hits and misses so far.
You like to invest in companies that are gaining market share. In the current scenario, where are you finding opportunities?
We scout for companies that have the potential to double their earnings in three to four years at a 20-25% growth rate, either from gaining market share from competitors or by entering into newer product categories. Market share gain is a reflection of competitive edge. However, it is not that easy to gain market share consistently. They need to have the right strategy for capturing incremental customers. Having a competitive advantage and moat is not just enough to protect market share. You have to be aggressive. If you don’t take the market share, someone else will.
Which are these companies?
Today, a lot of export-oriented companies are gaining market share from countries like China and European nations. There have been some catalyst like the tax rate cut announced in September 2019. It has made Indian manufacturing extremely competitive.
Alongside, there were supply chain disruptions around the world. It started with Donald Trump going into a trade war with China. Companies in India have gone through extremely challenging times like the trade war with China, and supply chain disruptions. There was a shutdown in China too. The pandemic and the ongoing Russia-Ukraine added to the woes. A lot of companies have learned that there is a huge risk of relying on one or two countries and they need to diversify.
Historically, we have witnessed many decades of globalization. Now, we are going through deglobalisation. I think India is going to be a beneficiary of deglobalization. This is because companies will move away from just sourcing from China and India will be one of the prime destinations for those companies with better profitability and lower taxation and other measures announced by the government. This makes India a competitive market to manufacture compared to five or ten years back.
Export-oriented manufacturing companies are likely to see huge capex. We are also positive about the building materials which are required to construct factories/warehouses. They are available at reasonable valuations and not super expensive like what we find in low-growth consumer-oriented companies.
White goods manufacturing, defence, specialty chemicals, other industrial goods, and agrochemicals should do well. Most of them are growing at a 25% - 30% rate. These companies are deleveraged. They are able to expand without taking debt.
What filters do you apply while picking up mid and small cap stocks given that these are under-researched stocks?
When you're looking for 20% plus growth you don't want that to come from huge leverage on the balance sheet. So your Return on Capital Employed (ROCE) and Return on Equity (ROE) should be better than the growth rate. We look for ROE (25% or above) or closer to the growth rate.
We look for stable margins which indicates that it is not a commoditised product. The firm needs to sustain its margins through the ups and downs in the economy. A sure sign of a commodity company is that they don't have control over the top line. Their pricing is driven by global pricing while the input costs are fixed. For instance, the input cost of a steel company is fixed. It will make good profits when steel prices go up. They can make losses when steel prices go down. We tend to avoid such companies because we don’t have control over these variables.
Rather, we take structural calls which are long term in nature. The company should be able to navigate through any kind of macroeconomic environment. One key variable which we look for is Cash flow from operations/Profit after tax which should be more than one. You want the incremental Return on Equity to be high as well as better than what they are doing right now. The expansion should ideally happen with higher value-added products.
What kind of businesses do you avoid?
We tend to avoid companies where the pricing is not in management’s control. Public Sector Enterprises are one such example. They face regulatory risk. It becomes difficult to get a reliable Earnings Before Interest Depreciation Tax Amortisation (EBIDTA) margin in such businesses. Change in the government can have an impact on their business. Many of these companies fall into commoditised business model where the top line is governed by government policies or global prices while the costs tend to be fixed. Such businesses never get a good valuation. You can have ten years with zero profit and you have one year where profits go up to 5X. The timing of entry and exit is important in such companies.
Have you invested in any of the Initial Public Offer (IPOs) which were listed in the recent bull run?
We have not found the valuations attractive. We liked Nykaa (FSN E-Commerce Ventures). We didn’t like the business models of the remaining tech IPOs. Most of them are loss-making and we don’t know when they will turn profitable.
If we are expecting 25% growth from an already existing listed player then we would expect 30% growth from Nykaa. That means you need to generate 3x in the next three years. We arrived at a fair value of Rs. 1.2 lakh crore market cap three years down the line. But this was the valuation of Nykaa when IPO came out. If we have to make 3x, the entry point has to be at Rs 40,000 crore market cap. So we did not invest in Nykaa. We would like to participate in such businesses but valuations have been a concern. You rarely find good valuations in an IPO.
How do you protect the downside when the tide turns against you in mid and small caps? What are the risks involved when investing in small and mid cap companies?
Most of these businesses are relatively new and you don’t have the hindsight of multiple business cycles. You need deeper insights to understand how they will evolve.
Even if there are companies that may have existed since the 1990s, their business in the first 15 years was completely different. Business models completely evolve. Initially, it may be a one-product company but over the years it has multiple products and is a much more sophisticated company. In mid and small cap companies, it is extremely important to understand the current business and its potential going forward.
Understanding the risk of the business is important because these are under-researched stocks. During a downturn, when a fund manager wants to get out of small cap stocks, the impact cost can be 30-40%. So evaluate the business risk and enter stocks that provide liquidity. If you get this right, you will protect your drawdown as compared to the index. When Covid hit, our Small Cap Fund fell by 25% versus the 38% fall witnessed by the Small Cap Index. This was because we held businesses that were resilient in that environment and they had ample liquidity.
When you're evaluating the business, many a time, it's easy to understand the demand side of the equation but it is more important to look at the supply side.
For instance, there is no doubt that ethanol demand is going to be very robust over the next four or five years. But you need to understand how many companies will be set up which will start manufacturing ethanol. When the supply exceeds demand, investors don’t make money. That’s what happened in the infrastructure during 2003-07. The demand for infrastructure has been there forever in India. But how many investors have made money in infrastructure? This is because the entry barriers in infrastructure are low. So get into segments where demand is robust. You need to see if the company you are investing in can meet most of this demand or there will be many other players who will enter the market and eat into its sales.
Often, investors tend to fall for the demand side. The initial two years are great for such themes but then other players enter the fray. It takes time to build capacity and then the capacity hits all at once and the profits are vanished because of the competition.
What have been some of your hits and misses?
There have been times when we anticipated a few structural stories, but they turned out to be cyclical. In a structural change, the growth, margins, and valuations multiple sustain. If you get the thesis wrong, you get hit with lower profit and lower Price to Earnings Per Share (PE) multiple.
One such mistake happened in Indocount. They were exporting into the U.S. and Europe. They were just doing export in the bed linens. They were planning to get into fashion linen, bed toppings, and pillowcases which had higher demand.
We visited New York wholesale stores a couple of times as part of our due diligence. But it turned out that Amazon kind of players came in with huge offerings at lower prices from 20 different countries. This ate into the market share of Indocount. There was margin pressure as it started losing market share and the PE multiple crashed. If you sold it through Amazon, you don't end up making even half the margin that you make you know by selling to these customers.
In our history, we have invested in 80 companies in the last 10 years out of which we have got almost 12 companies wrong. It was probably because the valuations were exorbitant or the business was faulty. We have exited positions in losses. Around 50 investee companies that we have held have delivered more than 25% annualised return.
We have identified many multi-baggers. Among them was Bajaj Finance which we entered in 2009. Kaveri Seed also went up 14 to 15X. PI Industries, Sundaram Finance, Solar Industries, Amara Raja Batteries, La Opala, Aarti Industries, Balkrishna Industries, Page Industries, and Cera were a few other examples that multiplied. In recent times, the biggest success has been APL Apollo, Apollo Tricoat, Deepak Nitrite, Navin Fluorine, KEI Industries, Polycab, Balaji Amines, Gujarat Ambuja, Laurus Lab, Sequent Scientific among others. In small/mid cap winners, the key is to get the exits right.
What is your view on Information Technology (IT) and real estate sectors?
We have limited exposure to IT as valuations have been expensive. IT is one of the biggest drivers of real estate growth. IT salaries and real estate growth go hand in hand. The real estate sector has been stagnant for ten years. The cost of mortgage is low. The real estate inventory levels are the lowest in last 10 years and the absorption rate of new launches is the highest in the last ten years. Real estate market is akin to a stock market. It is observed that when the prices go up the demand comes up. Builders will pass on the hike in construction price to consumers. It can be played through some developer stocks and ancillary companies.
So I think it's going to be a good start for at least four or five years kind of a cycle. One has to stay away from places where inflation is going to be a huge drag, for instance, FMCG companies. It will be difficult for them to pass on this 30 - 40 % kind of rise in wheat, corn, sugar, and other commodities to consumers.
You don’t need to be diversified across and present in all the sectors. Focus on sectors where you find growth and valuations attractive.