Sumeet Nagar's Small- And Mid-Cap Bets—Alpha Moguls

SUMEET NAGAR: Sure. I think the portfolio approach, we have been making concentrated bets, I think that continues to remain the same because if you are too diversified, your performance will resemble that of the market, right? So, if you want to outperform, you need to make concentrated bets and the whole notion that you never have all the ideas of the same quality, with the same level of conviction. So, you ought to put most of your capital in your highest conviction ideas. So, that approach continues to remain the same. Having said that, with size, there are challenges in terms of deploying capital into small and mid-sized companies. So, it does result in building positions slowly over a period of time but the idea is to eventually get them into a concentrated place in our portfolio. So, if you look at the top 10 to 15 positions, would always have more than 75% of capital. So, that’s a very concentrated approach to investing. On your second part in terms of churn, our view always has been to be that of a long-term investor. So, when an investor company comes in with a long-term horizon, we are very supportive of those companies. We know that companies never move up in a straight line so there are periods when they face challenges and we want to be supportive, if anything, those things give you opportunities to add along the way. Having said that, as you pointed out over the last year and a half, you have had such violent movements in the market, first on the downside, then on the upside and those movements were not uniform. So, we found a certain set of opportunities that moved first and a certain set of opportunities that moved later and so, as a result, it is incumbent upon you as a fund manager to see, where you see the best prospect of returns—not in the near term, but again, from a three to five-year perspective, where is the best prospect of returns and to ensure that you allocate capital to those and sometimes as a result, you have to be very disciplined about taking capital out from some ideas, which honestly, are good companies and good ideas but the challenge as an investor is not to differentiate between good ideas and bad ideas. That’s very easy. The challenge is to differentiate between good ideas and great ideas and that’s where the real challenge is. Very often it’s not about the company, it’s also about how these landscapes are evolving, how will these companies would grow, what is their runway for growth, what is their current valuation compared to the intrinsics—so it’s not easy to prioritise or characterise them into good, very good and great. So, you have to make a lot of subjective calls, It’s not easy, but just because it’s not easy, it doesn’t mean it’s not important. It’s very critical that you re-look at the portfolio and ensure that even the companies that have done well for you on a prospective basis, are they able to give you the best chance possible returns and if that’s not the case, then the answer that tough question is, where you can allocate that capital.

SUMEET NAGAR: So, we are always focused on small and mid-caps. So, we don’t invest in that area because it is topical, because we think that over the next one year or two years, it will give us better returns compared to large-caps. The reason why we focus on that space and I am not saying that’s it works for everyone, but there is a rational case for investing into small and mid-caps and that’s three fold. So, number one, smaller companies just have the ability to grow faster, right? They can grow faster than larger companies, and its just the law of large numbers— larger companies can’t grow percentage-wise as fast and that’s what gets reflected in the performance. So, if we take most five-year period and pretty much any 10-year period, you will find that the small and mid-caps would outperform the large-caps. Obviously, they are more volatile along the way but if you have that long-term investment horizon, then actually investing into small and mid-caps works but because they are more volatile, you have to be a bit more sensitive about where in the cycle you really are, what valuations you are investing in but that’s true about any equity investing and you have to be mindful of that. But it’s just a little bit more acute in the case of small and mid-caps but the longer your time horizon is, the less important the entry or exit valuations become. They are still important, they still matter but not as much. So that’s the number one reason that over long periods, small and mid-caps outperform, that’s why we invest in that. Number two is that there is a lot more inefficiency in the small and mid-caps as compared to large-caps and it is possible to find some great companies at a fairly reasonable valuation just because there is not enough research done on them or if it is done, it’s not done in-depth and the true appreciation for quality in those businesses is not apparent and so that inefficiency as an active investor is what you can take advantage on. Number three is your temperament; the longevity of your capital and the skill sets that you have as an individual or as a team. If it’s geared towards that in-depth research that you can do on your own, you are not relying on somebody else, then this combination actually works. So again, as I said, it may not work for everyone but we believe that for us, with the longevity of capital that we have, with the long-term approach that our team has, we can actually unearth these inefficiencies and find some great ideas to invest in the small and mid-caps.

SUMEET NAGAR: I think, what we saw during the Covid period, is that besides the disruption, I think there were not really new trends that came up. It’s just the trends that were already taking place. They were brought forward or they got accelerated. So, for example, that option of technology or adoption of e-commerce or digital transactions, these were trends that were already happening before, it just got accelerated during this period. I mentioned this in the past too but even before Covid, we had two or four significant investments in companies like Apple or in Indian markets with technology led-businesses and it was surprising to us how they took a hit immediately post-Covid. Our assessment was that these companies would be able to navigate this change quite well if not actually benefit from them. So, as a result in those immediate months of March, April and May, our biggest find was in companies like those where we felt that the disruption is actually beneficial to these companies and yet, like everything else, they corrected by the same 30-40%. So that was the inefficiency in the market that was available back then. Similarly, if you think about sectors like specialty chemicals or electronic manufacturing and so forth these trends were anyway taking place, it’s just during that disruption, in case of specialty chemicals, I think most companies around the world realised that they had an unhealthy level of reliance on China, and they needed to diversify away from that and in sectors like specialty chemicals, where you need a well-entrenched chain, you need feedstock coming in which becomes input into something else which become byproducts of that and that can become an asset to our company. So, unless you have an entire ecosystem you can’t compete in that and other than China there is no other country that has as wide an ecosystem as India has. So, when people are looking to diversify away, which by the way, which they were already doing for the previous three, four or five years, that trend just got accelerated in the last year and a half and so, that’s what we witnessed, during the period of that nothing new per se but that trends—what would have taken us four or five years, has started to happen in two or three years.

SUMEET NAGAR: Honestly I think that’s one part of our work, that we missed quite a bit during the past year and I am glad that has restarted to some extent now and I think the feel that you get of companies and their ecosystem, and the suppliers and the distributors and dealers, meeting them, face to face, is just different from doing it remotely. Having said that, I think the one thing that we learned quite well is that using technology, you can supplement or augment what you can do in person. So, while in-person visits, you can do only x number of them in a day, and you should do that but then you can use technology to reach out to a lot a greater number of people to get a broader and diversified opinion. So, we started to do a lot more of that, during the past year. We started to find data sets, industry-specific data sets that you could analyse to understand what was happening. So again, use of technology and what you can do remotely, and I would say that those things are a welcome change and some of those will actually remain. So, I think, while we welcome this opening up of things and being able to travel and meet people in person, some of the things that we have learned in the last year and a half will continue to remain with us and that’s actually a good thing.

SUMEET NAGAR: So, I will start with the caveat that we had never been big investors in IT services because we felt that this is really not a platform play. Their businesses, the economies of scale can be hugely beneficial and in services you don’t get that, so what you want to see in the platform businesses, the great thing is that each piece of incremental business beyond a critical mass doesn’t add to your cost and that results in an accelerated return on equity and capital—that doesn’t happen in services. So, with that bias in mind I would say in the early stages, we did look at this space, we did make some investments in Happiest Minds—that is the most important one that comes to mind in that phase but it may be the case that the trend has run. If you look at IT services in the very long term in India, they have followed the cyclical pattern. While there should not be much of a cyclicality to the business but if you look at the valuations they have always followed that cyclical pattern and that’s because the growth beyond a certain level becomes difficult. I think, in the last one and a half years, people have seen how much dependence the world has on technology and as a result, the need for IT services is a sort of in your face but the level of growth that you would see there is still limited, and it doesn’t lead to that accelerated return on capital. I am sure people are able to find good ideas in that space but we find that there are other places where we can get a better return on our investment so we will be focusing on that.

SUMEET NAGAR: We do believe that in businesses, winner takes all and where there’s a clear winner, it is incumbent upon that winner to keep expanding the market and to become more and more entrenched and if that results in higher deployment of capital upfront, then that’s a rational thing to do. But if all that starts on that big premise upfront, is this a ‘winner takes all’ and is the company you are betting on, really the winner? If the answer to those two questions is correct, yes then you could perhaps take the path of saying that you can defer the profitability for longer but in the vast majority of the cases, the answer to those two questions is not a yes and then it just becomes an easy excuse to invest in companies that don’t really have a path to profitability and to justify a higher valuation. So, I would say that in our case, our overwhelming preference has been to invest in companies that have clearly demonstrated profitability, and just we know that you are missing out on certain opportunities as a result but that conservative approach has done extremely well for us. So, the two tech examples that I mentioned to you, Apple and IndiaMart, both have been highly profitable businesses and yet they have been able to deliver growth that is far above what the overall market is delivering and many technology companies are delivering. We also had invested recently in a company called TrueCaller, which everyone in India knows about, they use the app, but the company is incorporated in Sweden and got listed there, even though 70% of their business comes from India, but it’s a phenomenal business. Its user numbers are only behind that of Facebook and WhatsApp. If you look at their gross profit generated, it's higher than that of most other consumer technology companies in India, and because it was in Sweden, where people did not understand the proposition, it was available at a very reasonable valuation. So that’s an example of a company that has done extremely well, it is a consumer company, an internet company, and yet it's highly profitable. So, our bias has been to find companies like that and invest in them, and that way you are not taking the risk that eventually at some point, you wake up and you realise that either the company continues to get the need of funding to grow or the market starts to them differently.

SUMEET NAGAR: I think that’s a preference. Why don’t you always want to make sure that you are able to buy something at a discount to its intrinsic and so this notion of price is what you pay, and is what you get, is a very important one and while, I have no doubt that over the course of the next decade, there will be some great winners in the internet economy in India. But I think you will have to be very careful in terms of the valuation at which you are investing in and I would say there is probably sometime in the future that you may be able to find these companies at least at a better valuation, if not an absolute price. You just need to be a little bit patient in terms of pursuing that but if you do reach this assessment, that there is a company which is in a ‘winner takes all’ market, then maybe, there is a clear winner, then maybe actually if you do your work and if you can actually justify the valuation based on the future , it is a worthwhile thing to say.

SUMEET NAGAR: I think as investors, you always have to be forward-looking and so you have to visualise the world, sort of 12-24 months down the road. Obviously, you can look back in the last year and a half, as you pointed out, the financials took the brunt of what happened as the borrower’s earnings capacity got impacted, the repayment got impacted too. The growth was not there, the asset quality was affected too—so a whole host of reasons financials have taken it on the chin and that’s what is getting reflected in the market, but if you look forward that in 12 to 24 months, to an environment where Covid is hopefully behind us, in that environment, these companies—the growth can resume, as you are seeing that inflation coming back the demand for credit is increasing and as the demand increases you would see the top line of the companies continuing to increase. There is a sense around the world that the central banks have been very cautious in increasing interest rates and so as a result, the cost of funds should continue to lag the demand or interest rates in the market. So, the spreads can remain healthy but the biggest hit that the financial companies have taken were in terms of the provisions they had to make and that provision in a post-Covid world, in a world where people learn to live with Covid should not be there and that has a one-time impact. So, the profitability of many of these companies can improve quite substantially and that’s the rational case that you can make for investing in international companies have been beaten down but even more interesting than that is that the companies they mentioned about the mid-sized companies, that are differentiated and if I may take an example from our portfolio, there’s a company called Aptus Value Housing Finance, we’ve owned this company for the last several years but this is a company that in FY21, think about FY21, it is probably the worst year that I can think of for financials in the last many years that I have seen. In that environment, Aptus was able to grow its earnings by 40% year-on-year. That’s phenomenal performance in that phase and in that very tough environment and if you look at its financial numbers, if you look at their ROAs, it is not 7%, very limited leverage. This company can grow its earnings by 25% compounded for the next many years. They got listed about a quarter ago in an environment where there was a lot of public listing. There was maybe an IPO fatigue to some extent and because there is a general pressure on financials, it hasn’t done much but if you look at the fundamentals, like the only two companies in India that I can think of financial companies that have had fundamentals comparable to this, is Gruh Finance and Bajaj Finance in the past and you have seen how those companies have created for their shareholders and we think that Aptus has the ability to do something like that and because there is an overhang on financials, it is not getting reflectively priced but as it keeps on delivering the numbers, if nothing else, at least you can see a 25% appreciation in earnings that should get reflected.

SUMEET NAGAR: I would say with a caveat, right? So, if you are thinking about your normal home finance, like if you were to go out and get a home loan there will be 20 lenders out there, lining up to lend to you, right and obviously when that level of competition comes, it becomes very difficult to earn margins that are significantly above what the market is living by. So, if you are a mid-sized player in financials or an NBFC or an HFC, you must operate in spaces, where you are not competing with banks because banks have a cost of funds that you cannot compete with. So, you need to operate in areas where banks find it very difficult to operate in and affordable housing finance is one such area. So, when you are talking about lending to a local painter or a local mechanic or a Kirana shop, where you may not have tax returns, you may not have a prepared balance sheet and cash flow statements, that’s an art and Mr. Anandan, who founded Aptus, has three decades of experience in doing that and has done it so superbly well that in the decade-plus history, they have had zero loss given in the data. There is hardly any financial company that can boast a record like that. So, I think it’s because they have a skill set to underwrite these very well, they underwrite these very conservatively. So that a typical loan to at the time funding is about 50%, on the book basis it will be probably just over a third and so that is a very conservative underwriting and if you are able to do that consistently well, your costs of funds are lower compared to the competition, your spreads are high, your asset quality superb and with the ended FY21 with a GNP of less than 1%. Most home loan companies have numbers that are much higher than that.

SUMEET NAGAR: So, I would say luckily for us, we have been looking at this theme for some time. As I said, this was a theme that was there pre-Covid as well as it has accelerated and for many of our bets in the space that we have made in the early part of that journey at valuation levels that thankfully were much more attractive compared to where you see them today. Having said that, I would say that while in the near term, maybe the returns could be muted because of valuations being high, it’s always about the long term and we believe that in specialty chemicals, you are seeing the trend unfolding, which is a very long run and because it is an ecosystem play because I think India is getting more and more advantages and once you have that, it becomes even more difficult for somebody else to replace you and so, you find more and more companies coming to India to look for alternatives, once they have comfort with that they will also double down on that and we see that trend to continue for the next many years. So just like IT services started in the 90s, Y2K gave it a fillip and even 20 years later, it’s running on strong legs. We think that specialty chemicals similarly so started, three, four, five years ago, it got momentum because of Covid and has a long runway. If you can find those differentiated players who can take advantage of this trend and keep expanding the addressable market and compound at a high enough rate for the next 5 to 10 years, then you can still generate very good returns in those select companies from the levels that we see today. So, when you see the kind of appreciation that you have seen in the last year, you have to become even more discerning in terms of where the true quality is, which are the companies that have that very differentiated offering that allows them to keep compounding or pinpoint it for the next five years, 10 years at a pretty high level and we can find companies like that, then it is worth investing in them and again, it’s not that you will put all your capital in those and all of the investment there today when you can start building your positions in companies like that.

SUMEET NAGAR: I think that the truly differentiated players are getting d highly as a result of what has happened but again, I think it’s really about not what we see today, but what these companies can become five years down the road.

SUMEET NAGAR: Yes, but when you are investing at high valuations, it becomes even more acute and the growth rate that you need to sustain the current valuation just becomes that much higher. So, can you conservatively underwrite that? What is the visibility that you have? What is the comfort that you have? Have you spoken to customers who are saying that, listen, I am willing to give more orders that the company had more capacity? I have seen clear bounds in terms of adding capacity down the road and if you are seeing tangible evidence of them expanding their addressable market by getting into other areas where they are right to win. So, if you can find things like that, then yes, you can still justify either investing or holding onto those positions but in our view, as long-term investors quality is always very important. So, you want to be with companies like that but you want to make sure that you are investing at a valuation that is reasonable, given the growth profile and capital efficiency that these companies have.

SUMEET NAGAR: I think the PLI schemes have obviously provided a very strong impetus to domestic manufacturing, and I think they have been reasonably well thought through and I think if you think about most other Asian countries have succeeded well, in exports, they have done well on the back of similar schemes that came up in those countries. So even though belatedly, I am glad to see that we are seeing this happening in India, as well. So, I think our approach has been to look at sectors where there is a reasonable level of domestic demand, and the demand is going quite well especially if that’s leading to import substitution. That’s a very easy thing to bet on and once you create an upscale with that then you can start to become competitive in exports, as well. So, electronic manufacturing is an example of that, and we are invested into a post-pandemic index, and you know it quite well. More recently we invested in a company called Xpro. Again, it’s a derivative of electronics manufacturing—Xpro, makes these thin films, that you are metalised, and it becomes the dielectric material that goes into capacitors and capacitors go into pretty much any electrical or electronic application that you can think of and as the demand for electronic manufacturing in India is continuing, they are effectively a beneficiary of that and moreover, when EVs start to come through the capacitors that go into EVs are significantly larger and the dielectric materials you need is also significantly higher and the demand for that is so huge in India today that even at this stage, Xpro was the only manufacturer of this film in India, is catering to only about a third of the demand. So, even if they double their capacity, they would still not be able to leave the existing demand in the country and the demand itself is growing quite rapidly. So again, if you find examples like that, where there is already enough market in India, there is a clear import substitution theme, once you capitalise on that then your cost basis becomes quite good and then you can compete in the exports market. That’s a great place to be in.

SUMEET NAGAR: That’s a great part of being in an investing business. We are always learning new things and there’s excitement and the reason why most of us do what we do today is that we can find companies like that, the thrill or excitement of unearthing something that you did not know about yesterday, I think that’s great and that’s what gets you excited and that’s what gets you to the office or gets you on the road to learn about these companies and the industry.

SUMEET NAGAR: You see that happening in many cases when a new trend starts, and people believe that this is a very powerful trend and there is a temptation of extrapolating significantly comes in but the reality comes out different. So, again, I think we have seen cases after cases where people say, per capita consumption of XYZ is so low in India, as compared to other countries, but I think on that metric, you can show pretty much anything and say it’s just about a huge potential but that doesn’t make it an investable opportunity, right? I mean we are investing in automobiles quite a bit over the years, but we go with an open eye, I think people say that China is manufacturing 25 million cars and we are producing two million, we are going to go to that. No, you cannot go to that, because look at the landmass, the size of China, look at the density and the road system. I think you have to temper those assessments by what the ground reality is and, on that basis, you can still make an educated estimate of where the future would be and make an investment with those realistic assumptions. If things don’t pan out as you anticipated, you keep reevaluating. That’s part of investing, I think, what we talked about earlier, you have to always introspect, what you have done, what has worked out, what hasn’t worked out, and if it hasn’t worked out, whether it is short term or long term, if it is structural change, then you need to correspondingly reform your views.