SageOne Investment Advisors followed the same wealth-creating formula through the decade and plans to continue that in the post-pandemic era—spotting companies with outstanding earnings growth potential.
The portfolio manager is looking for companies that will double their earnings in the next three to four years, Samit Vartak, founder and chief investment officer of SageOne Investment Advisors, told BloombergQuint in the latest episode of the special series Alpha Moguls. “Earnings growth is the best defensive mechanism in investments."
The biggest risk comes from picking a poor quality company, he said. So how to avoid than and spot the ones that offer multifold returns?
While the bottom line is earnings growth, “It’s not just earnings growth which will give you that 10X or 20X or 30X returns,” Vartak said. “It’s also the earnings re-rating or the P/E multiple re-rating.”
Companies such as Bajaj Finance Ltd., La Opala RG Ltd., Cera Sanitaryware Ltd., PI Industries Ltd. or Amara Raja Batteries Ltd. have all seen valuation re-rating of at least two to sixfold over five years. They also clocked three to four times earnings growth, generating 15-20 times returns, he said.
Another factor is investor interest. Most of these companies—while maintaining their financials, return on equity and earnings growth— now command a higher valuation than before because of the market expectations and interest from large investors.
Vartak looks for companies that will command similar investor interest five years down the line. “I try to find companies where the interest of these larger investors is very low and maybe five years down the line, we’ll expect that it will become a darling,” he said. “So that makes a huge difference in what kind of returns you make, irrespective of what the characteristic of the business is.”
His task, however, has only been getting more difficult over the last few years with the country battling one economic disruption after another. First demonetisation, then GST, and then the banking frauds, all affected credit flow into the economy, he said. There were still a number of companies that doubled their earnings during the last three years and SageOne Investment Advisors was fortunate to have a number of them in their portfolio, he said.
Yet, the unprecedented disruption during the pandemic poses another big challenge. Vartak sees the manufacturing sector a potential growth opportunity—an area most investors are banking on as the government champions its 'Atmanirbhar Bharat' push.
There are multiple ways of investing in India’s manufacturing future, Vartak said, whether directly in contract manufacturing, pharma and API companies or into material companies in anticipation of the infrastructure and factories that will have to be built. In any of these approaches, he advises investors to look for companies that are dominant in their area by a large margin so that they can grab market share.
“Right now manufacturing is a very small portion of India," he said. Even if it picks up 5% of what China does by attracting specific industries where India has the strength, if you do the second or third level of thinking, you will find huge multi-baggers in that."
Three Red Flags
If the core requirement of investment is high profitability, finding red flags in a company is an easy enough task, Vartak said.
The first is to compare a company’s cash flow with its profit and loss statement. “If you just look at the cash flow from operations and compare it with the net profit which is collected by the company and if the efficiency is at least 60-70%, that itself will save you from a lot of fraudulent companies,” he said, adding that a lot of companies show book profit because that’s what the market focuses on.
Second, is to check the profitability of a company’s expansion plans. A number of times, because of the pressure from the market and the pressure of growth, the expansion goes more towards incrementally lower return on equity or return on capital, he said. Vartak advises to avoid such companies and look for those that look for addition as much as opportunities to expand. This feature is most common in small-cap companies where they grow without spending money, he said.
Third, return on equity has to be ahead of the expected return, otherwise it makes sense for these companies to pay out the dividend to investors.
Lastly, Vartak warns that the best way to make a safe investment is to understand the business and its market position.
Watch the full conversation here:
Edited excerpts of the conversation:
So, let’s start off with talking about whether you are changing your strategy even one bit from what you have done in the last 10 years because I was looking at data from the PMS AIF world, which said that your SageOne core portfolio scheme has been the best performing PMS scheme over a 10 year period.
So in terms of what we do, nothing is going to change because that’s what our passion is. So what we look for is basically earnings growth, that is not going to change. We look for earnings of companies which will double their earnings in the next three to four years. That’s something which is possible in India and if you’re an equity investor in Indian markets, I think that’s what you need to do. Valuation and all of those factors are good to have but sometimes it’s not in your control. But if you find good earnings growth companies even if you pay a little bit higher in terms of valuation, the risk definitely reduces. I think earnings growth is the best defensive mechanism in investments. If you end up entering into a really high valuation cycle and even then if your earnings tend to double but say your P/E multiple goes down by half you would maybe end up losing two three years of returns. But in the long run it’s highly unlikely that you end up investing in the highest of cycles. Hence we continue with the same, our strategy would be that whenever we are at the peak, we just stop taking money so that the investors who enter into the market at that point will not have two three years of no returns. Now, it did happen last time, we did stop taking money in mid-2017 but there were few investors who still insisted that whatever it is we would want to come to the market and their experience wasn’t that good. So, we will continue with the same strategy, AUM is not our end goal. Returns are what we look for and we will do whatever is the best for the investors and not for us.
So, let’s try and put this into perspective from the answer that you gave me at the current point of time even in a Covid-disrupted world, are you looking out for companies which will double their earnings growth in the next three or four years and how are you able to predict that when the structure is so high around us?
It is definitely getting difficult by the year but, yes, we have had pretty large disruptions in the last three four years. It started with the GST and then with the demonetisation, then added all the banking frauds which came out and that definitely put a lot of brakes on the economy and in this environment because after all, all of these things affect the credit flow into the economy as the investors and the banks become risk averse. Even during those times which were very difficult in the last five years, I think there were many companies which doubled their earnings in three years and we were fortunate to find many of those in our portfolio. That is what has protected us from big losses or big drawdowns in the portfolio even though we were in the small and micro-cap and the mid-caps during those years – from the peak of December 2017 to March 2020, small-caps went down by almost a two-third, the median loss was almost two thirds and that’s a huge drop. The portfolio didn’t go through that kind of a loss at all, nothing compared to that, mainly because of the earnings. I believe the next five years are going to be much better than the last five years because it’s very difficult that you’ll have – for a country like India which is a high growth country – such a stagnant period twice and back to back for five years. I think that one good thing is that five years ago, there was too much hope about the government and the reforms and delivering of the reforms and that’s where the prices went up too. much. Right now, even though people may call that the markets have gone up too much, in December 2017 the small-cap and the mid-cap valuation if you look at the median valuations were in the mid-30s. Today they’re at 16-17 times, half of where they were. So even if you assume that your earnings growth will be similar to what the last five years have been, at least your starting point is much more attractive. So, there will be disruptions, Covid kind of situations are very temporary. I think there were many temporary things affecting the market over the last five years and hopefully the next five years will not be as disruptive.
Let’s try and assess this whole thesis that you have. Why do you believe that presence in the broader markets is a must currently? Are there some anecdotal evidence or examples and is the current move by SEBI on the multi-cap funds also an enabler of sorts of that theory?
So, one is let’s talk about the theoretical aspect of why the broader markets especially for an investor who’s a bottoms ups stock picker. It is 10X easier to find doubling of earnings in three to four years in the non-large cap space compared to the large cap space. Most of these large caps, the top hundred are extremely large so they have that high base effect and if you look at the best of companies within those top hundred – meaning that they have really high ROE, ROCE and less debt to equity – they are dominant players in their own space. For them, to deviate from the nominal GDP growth is extremely difficult because those are the ones who are making up the nominal GDP. So it’s very difficult for those large caps who are almost 75% of the market cap of India to deviate too much from the nominal GDP. If you assume that the nominal GDP will be in that 10-11% kind of range, that means it will take you almost six-seven years to double your earnings. So if you are trying to find stocks in there without the help of re-rating of multiples, it will take you six to seven years to double your returns. Whereas, if you look at the smaller space irrespective of whatever the starting point is, it has been much easier to find companies because they are much smaller. It is very difficult for companies to remain dominant over even a decade. So you need to find which companies are going to be dominant over the next decade. When you start with your top hundred, you’re already starting with companies which were dominant in history and as an investor if you are a stock-picker, you need to find which are dominant companies over the next 10 years and that is highly possible in the broader space than in the large cap space. Secondly, the valuation in the broader space today is half of the large-cap space. So you have a huge benefit of higher earnings growth as well as a lower starting point where most of the time if you find good companies and again that’s a big IF because I’m talking about investors who can pick good stocks and good companies and we will talk about that later. I’m not talking about blindly investing in the small-cap space. If you find good companies, doubling their P/E multiple as well as doubling their earnings over the next three to four years is very possible. So, you’re talking of 4X kind of multiples, I am not saying that all the companies will do that, but if you find such parameters in the company that you’re looking for and if you have a portfolio of say 15 or 20 stocks, I’m pretty confident that you can find at least a couple of such companies. If these two companies which give you 4X returns in three years or four years, if you are able to find them – that means 10% of your companies do that and the remaining just gives you market returns – your returns are generally double of the market. You’re talking about almost 25-26% kind of returns and that compounding is humongous. Here you are talking of almost 10X in 10 years versus when you’re looking at the large cap space you’re talking of doubling in six to seven years. That means probably you will do 3X in 10 years. So, it’s definitely worth taking the risk if you have the capability of finding good companies in that.
Now let’s talk about this data because I think the way institutional shareholding comes about in the broader end of the spectrum would also probably determine returns.
Absolutely. I think that’s what determines the valuations. So, there were SEBI’s regulations which were enforced in 2018 wherein they were adverse for the small and mid-cap space, I’m talking about the institutional holding mainly.
(Presenting from slide) So you would see that this is the institutional holding data across large caps which are the top hundred, the mid-caps which are the next 150 and the small caps – I’m considering only the 1200 odd companies which are in the small-cap, there are thousands more. So, you could see that in December 2017, almost 10% of the institutional holding was into small-caps; that means they held almost 4.7 lakh crores out of the total they held in December 2017. Now, look at one and a half years down the line, which is December 2019, when the entire reclassification of the Mutual Fund Schemes played out. What it did was, basically forced institutional holders to get out of the small cap space and get into the large cap space. You’d see that by June 2019, the overall institutional holding actually had gone up from 48 lakhs to 51 lakhs. But at that time, the small cap valuation or the that they held went down from 4.7 lakh to just 2.9 lakhs. That means the dropped by 39% during a time when the overall valuation or the overall of the institutional holding went up. So, it’s not just that the markets had gone down. So this was enforced basically by the regulation change. What I’ve done is that the drop in which is 1.85 lakh crore was the drop in the small cap that the institutions held. l have tried to break up that into two aspects. One is how much was the actual outflow of the institutions as well as because there is an outflow, the market of the companies also dropped because when you try to exit of course the stock prices go down. So if you break up that 1.5 lakhs loss of the institutional that they held, roughly only 12,000 crore was the actual outflow but it resulted in the market drop off the small cap space by 1.7 lakh crores. Almost 15X was just the drop in the share prices compared to how much they exited. So, this is a basically forced exit just because of the regulations and this was just in one and a half years. On the next page, we are talking about what happened until March 2020, which is 23rd March, which was the low of the market. Here if you look at the small cap institutional holding, it dropped to 1.65 lakhs. Remember in December 2017 it used to be 4 .7 lakh crore which has now dropped to 1.65 lakhs – which is a drop of 65% from what they held in December 2017. That means almost two thirds were lost. So, just going back to December 2017, you’ve got to triple the institutional holding. Now, again this has dropped to almost 5% of the overall market cap. Remember, the small cap space today makes up almost 10% of the overall market cap. So, it makes sense to at least have institutional holding which is proportionate to that. My logic is to see what is good for the economy and what is good for the country. Now, if you look at the large cap space, these are dominant top hundred companies which really do not care as they don’t have the need of fundraising. They are mostly profitable and good quality companies, at least where the institutional investors are holding these are huge cash flow generating companies who do not really care what their valuation is. Whereas if you only look at the small cap space, you’re talking about 1000 companies, more than 10X of the companies that are in the large cap where they find it very difficult to get debt funding. So, any environment which is less risk averse helps them. I think regulators should probably favour this space because it will benefit these thousands of companies. I mean we need animal spirits in the economy and why should there be regulations which are against animal spirits, especially in an environment where there is no credit growth available and it’s very difficult to get debt funding. So, logically it makes sense for us to have an environment which will aid animal spirits. I feel this small cap institutional holding should be at least taken to the same proportion as what the market cap of the small cap holding is – which is double of where we are at now. We are just at 5% of institutional holding in small cap space. There is a market cap of 10%. I mean even today, after such a big rally, the institutional holding as of September is 41% below what it was in December 2017 and I feel we are in an economy of great entrepreneurs which are mostly in this small cap space. They need to be held. I mean look at the U.S. economy, the Silicon Valley is thriving mainly because there is risk capital available. So regulators there are helping this space, so it will definitely have a lot of these entrepreneurs and they are the ones who will create growth. The large gaps are not the ones which are waiting for any debt funding and I feel logically this definitely makes sense to favour these companies.
I think the opinion is divided about whether telling the multi-caps to forcibly invest into mid-caps and small caps was the right move or should there be some other way to do it. Your point is well taken, but why force a fund to necessarily invest 25% into mid-caps and small caps wherein a fund may not feel that that’s the need? So, therefore, let’s presume that due to the regulatory changes or whatever other factors, we’ve established that if you can pick stocks, the broader end of the spectrum is the right pocket to be in. So, how does one avoid the big mistakes in the mid-caps and small-caps because I think that’s where people get stuck? So, how do you avoid the pitfalls?
I think the biggest risk comes in from picking a poor quality company. Now again, let’s think about what a poor quality company is. A poor quality company can’t be looked at from an absolute perspective, it is all relative. By that I mean how dominant are you in your own industry because in the small cap space you will have many such smaller industries which at an overall scale are small and hence, all the companies within that space are small but the gap between a leader in that space and the rest of the pack is pretty wide. It is as wide as what you will find in the large cap space. So I think you bet on such companies where the competitive advantages of this company are way superior to the competition, because they are the best managed companies, they are very efficient and they keep on taking away market share from the rest of the competition. That’s what will deliver the 25% kind of a CAGR growth. It will not be that these industries will be growing in that space. So if you figure out which are those companies in each of those segments, you will at least avoid making broad and gross mistakes. So that will be the core behind avoiding those companies because what you avoid is more important than what you really pick.
Are there some common red flags, some key red flags that come up? How do people avoid a Manpasand or any other? I’m not saying those companies are bad companies necessarily – some of them were and some of them weren’t – but how do you avoid these mistakes? Are there some common red flags?
So, if you are looking for high growth companies, one of the core requirements is that they need to be highly profitable companies in terms of return on equity and return on capital. So, that’s very easy to do. I am looking for a 20% plus kind of return on equity and on return on capital but it is very easy to manage your P&L because P&L profit may not be exactly supported by the cash flow in the company. So if you look at the last 5 years or 10 years, you look at the efficiency of cash flow accumulation compared to what is booked on the P&L side. If you look at just the cash flow from operations and compare it with the net profit which is collected by the company and if that efficiency is at least 60-70%, that itself will save you from a lot of fraudulent companies and lot of companies which just show book profit because that’s what the markets generally focus on. Second, expansions. Look at any company, it’s very important that whenever a company announces an expansion project, you evaluate what is the profitability of that expansion. Many times because of the pressure from the market and the pressure of growth, the expansion goes more towards incrementally lower return on equity or return on capital. You need companies to grow at a much higher profitable level. So, I like companies which go for expansion but they also go for more addition. So, that is very important because in the small-cap space, you will not find companies which will just grow without spending money. There has to be CAPEX because of which there has to be reinvestment, because of which these companies grow. So, the incremental return on equity on the reinvested capital is very important to know. Thirdly, even if you say that the incremental return on equity is not way higher but maybe as good as the current one; then, whether that incremental return on equity is better than the expected return – I’m not talking about cost of capital because cost of capital could be as good as say 8, 9-10% for many of these companies – in the small cap space, the expected return from a foreign investor would be at least 17 to 20%, if not more. So the return on equity has to be ahead of the expected return, otherwise it makes sense for these companies to pay out the dividend to the investors. If you’re a large cap company, the expected return for that large cap company generally tends to be 12-13%; whereas in the small cap space, it is much higher. So, the return on equity from an investment has to be way higher than what it is, otherwise it’s not worth taking that risk. So those are the factors that you need to definitely evaluate and understand that the business is the bottom line and there is no shortcut to it. You can’t just put it on an Excel and try to use your history to forecast the future. It is very business specific, you have to understand the business as well as the competitive dynamics because if the company is dominant, generally they will try to take away the market share and they will be able to generate much higher returns. So, understanding the company and the business dynamics within the industry is very important. Only then you will get the right assumptions to forecast a lot of these things.
Are there some common characteristics of companies that you’ve picked in the last 10 years which have been multi-baggers for you? How do you find these multi-baggers?
The bottom line is earnings growth, there is no deviation from that. Any multi-bagger that I have had in the past, earnings growth is the core. Generally, for a multi bagger it’s not just earnings growth which will give you that 10X or 20X or 30X kind of returns. Mainly, it’s also the earnings re-rating or the P/E multiple re-rating of the company. So, whether examples like Bajaj Finance, La Opala, Cera, PI Industries or Amara Raja batteries – all of these had at least 2X-6X of the valuation re-rating that they went through and during those five-six years, they had almost 3-4X of earnings growth and those are the ones which create those 15-20X kind of returns. For example, if you look at Bajaj Finance in 2010 and if you look at it today, the ROE hasn’t changed much. If you look at the financials, it hasn’t changed much. Two things which have changed is that they have delivered in two good cycles – one say from 2009 to 2013 and then 2013 onwards to now. What happens is that the risk assessment of the business completely changes. As I said that expected return is a very important factor in a business and in valuation; if you assume a company which has the same cash flow and if you discount the company at a 12% expected return versus an 18% expected return, the valuation differential can be 6X. If you discount the company at 12%, the P/E multiple could be 60 times and if you discount the company at 18% the P/E multiple could be 10 times. That’s how big the differential is assuming the cash flow and everything else is exactly the same. So imagine Bajaj Finance in 2010 where because of the last 10 years, it was considered to be a very risky business with personal financing which was pretty unsecured. But the growth that Bajaj Finance delivered was getting into a very diversified set of businesses and that itself reduced the risk assessment of that business. Hence, if the expected return from Bajaj Finance from an investor who wants to invest in Bajaj Finance in 2010 was 18% by 2019, it had probably dropped to 12%. Hence, a larger company with much less risk gets a much higher valuation multiple even though the business returns, cash flow generation or ROE remains the same. A similar characteristic you will see in La Opala in 2012, trading at nine times multiple and 2016-17 trading at 60 times multiple. Not much change in terms of return on equity, return on capital; it’s just that it delivered growth and by growth the market identified that. A lot of FIIs, the P/E funds came into that company and the larger investors whenever they come into a company, whether it’s a La Opala or a Bajaj Finance, their expected returns are much lower than for an investor like me, who is looking for 20-25% kind of returns. So, a larger investor whenever they come into a company tends to result in a huge re-rating of multiples just because their expected returns are much lower. So if you have a company where the FIIs don’t want to touch today and five years down the line, it will be a darling of the FIIs, the FII’s expected returns are lower. It will be at 12% kind of returns, you will get a much higher multiple for that company. So my try, of course I won’t succeed all the time, would be to find companies where the interest of these larger investors is very low and maybe five years down the line, we’ll expect that it will become a darling or the people will think that this business is much less riskier than what they thought five years ago. So that makes a huge difference in what kind of returns you make, irrespective of what the characteristic of the business is. They may not change in the next five years, they’ll just continue to deliver the same but how an outsider views that company has a big implication on what valuation that company gets.
In the post-Covid, where do you find the possibilities of multi-bagger creation? Would it be in pockets which are temporarily disrupted due to Covid and if so how do you predict that it’s a temporary disruption and not a permanent disruption. Part two of the question is, if that is not the case, which are the themes where you believe in a post-Covid world there are a lot of possibilities of earnings growth as well as multiples’ growth?
I am a bottoms up stock picker, so I would look at the stock level but still there has to be some direction in which you look. So, I will tell you what my thought process is when I start looking. It may not be exactly themes but I feel seeing for India to resolve its growth issues or the issues that we are facing, there are two things that are needed. One is we need to create employment, otherwise the rate at which we are producing a lot of these highly educated engineers and even the education level is going up, so you will have a large workforce that we need to employ and that can’t happen unless you attract more industries into India which may not just be manufacturing for India but for the world. This Covid pandemic has pushed the government into a corner and forced them to act. That’s where you’re seeing a lot of incentives given to multiple manufacturing industries in the country. At the same time, without anyone knowing, there are huge labour reforms which are happening at the state level, which was something that was missing. So, if you try to connect the dots, they are trying to basically ease manufacturing in India. So I think that’s a theme which seems to be the focus and which is the need of the hour and at the same time if you make things attractive, there will be huge capital which is available in the world which can flow into India. So, even if you think there are 3, or 4-5 industries which will maybe pick up in India, how do you play it? Either you can directly think of okay I want to get into contract manufacturing, that’s a theme. Maybe I want to look at API kinds of themes or Pharma or the intermediaries which are supplying them. You can think second or third level also, so I would think that okay if there are so many of these factories which will need to be built, there will be building material which will be used. Now, again within the building material, you can evaluate if you want to get into cement or tiles or maybe the roofing systems or you can go into structural but even in that I would evaluate how each of those industries which will be providing the building material – where there is biggest gap between a player and then the rest of the competition. That’s where they will be able to get the entire benefit or more benefit out of the overall growth. If you’re an industry which is highly competitive, each of them will try to kill each other out and then the profitability will drop and you’ve also got to look at where the capacity can easily come in or where the capacity would not be able to come in for the next five years. So I think this is the directional way in which I’m thinking and in which you will find huge multi-baggers because right now manufacturing is a very small portion of India – even if it picks up 5% of what China does by attracting specific industries where India has the strength. If you do the second or third level of thinking, you will find huge multi-baggers in that because these are small companies and in 10 years they can multiply their earnings by 10X or more. So, I’ll think in those terms. This is the broader theme and you can go for individual industries or you can go for the ancillary plays which are much more generic and already have their existing business – which is India’s infrastructure story or the building material story, but this is an added trigger. If it plays out, the companies which are already growing at 15-20%, will start growing at double the rate. So, that’s where I will completely focus on.
You’re so bullish on the mid-cap and the small-caps, then why start this scheme, which is offering this large-cap offering? I presume it’s at a very low cost but why do this at all?
See, it’s not something that we practice but it’s a passive strategy. As I said, I find it very difficult to add much into the large cap space. I can’t do much of the groundwork and it’s extremely difficult to add much into it. You can add whatever you can based on what you look for in companies – whether it’s high return on equity or high cash efficiency, those are the parameters where we just did the back testing of 19 years and said, this is just a passive product that we offer to our investors. When you do it as a business, almost 82% of the investments are into the large cap space. So, the small-cap, mid-cap players are only playing in that remaining 17%, which is a very small portion of the overall investment field. So when I try to market it to anyone, I tell them that this is a space which is extremely expensive and here, doubling the earnings will take six to seven years but still some of the investors do not like small and the mid-cap space. So for them, this is an alternative which is very low cost, where we say that we will not charge you any fees if we don’t beat the Nifty or we will not charge you any fees even if we do not deliver positive returns. So, zero fees. I feel if you are not adding much and if your expenses are not that high, why charge higher fees compared to in the mid and small-cap space where we need to travel a lot and spend a lot of time talking to people doing groundwork. There, the expenses are much higher whereas that’s not the case in the large-cap space. So it’s just an option available to our existing set of investors. Sometimes if the small cap space becomes too heated, I don’t want them to be invested forever. This small and mid-cap space, sometimes in five years there are times where you want to take profits because the valuations are too high. So, during that time they have an easy option to move some of their allocation into the large cap space without having to go somewhere else. So, that is the only rationale, it’s not an offer that we try to push. It’s just an alternative for someone who is in the large cap space and they want to be in the mid and small-cap space.
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