Alpha Moguls | Three Key Things Samvitti Capital Focuses On To Build A Resilient Portfolio

We are based out of a place called Mulki, it’s almost a village so we are operating out of a very small place. It is close to Mangalore. We have been in the business for about five years now. The firm is promoted by about three of us—me, Atul Kudva, and Shugram Kamat. All three of us have known each other for a long time and in the earlier avatar, Atul and I were involved with technology with a firm called Omnesys, which was later sold to Thompson Reuters. Post that sale, we started Samvitti Capital. So, it’s been five years since we started this journey and we started with a base capital of about Rs 40 crore. We started with one AIF and today, we are managing two AIFs and one PMS under the PMS license. We have Rs 650-700 crore asses under management.

The last couple of years have been some of the toughest times that a lot of investors have seen because every little mistake has been amplified by the markets. Even if you made a very small mistake, that has been amplified and punished by the markets. So, in this backdrop, I think we have done reasonably well. I don’t want to talk about exact numbers, but I think we have outperformed the benchmark consistently in this period and we have done much better than the benchmark. The Nifty has been the toughest benchmark to beat in this environment.

So, we have successfully managed to do that, and we have done that consistently over the last 48 months. Our investment framework and our attitude towards alpha are slightly different than what you generally see. So, generally alpha is trying to pick stocks that will do really well, look for the future winners. But having seen or studied the market cycle, the conclusion that we have come to is that enduring alpha is created in bear markets. In bull markets, everybody can beat the index and do well. But, most of those returns are lost out. So, the alpha is fleeting in bull markets but enduring in bear markets. So, if you can manage to fall less than the index than the peers, then you can’t help but generate alpha.

So, the whole stock picking is based on that core principle that you have to look for stocks that will be resilient to corrections. So, if you manage the downside, so to speak, the upside generally has taken care of itself because we are operating in an environment where there is growth. So, the growth is easy and there are several companies which are doing very well, which are growing fast but the trouble with the Indian markets is that, when we fall, we fall very badly. The corrections are very severe. So, if you can build a portfolio that can withstand corrections and then you will be able to retain the money you were able to make in the bull market. So, we believe that is the key to outperformance, that is the key to alpha.

The goal is not to generate alpha. We don’t chase alpha, so we typically look for companies with three or four key characteristics. One is creation. Second is, predictable growth and third is, market share capture. Mathematically, what creation means is a high return on invested capital.

These could be a consistently high return on investment capitals or companies that are undergoing changes that will allow them to earn higher ROICs into the foreseeable future. So, the delta in ROIC is one play and consistent high ROICs—they both form a part of our universe. Then you look at the sector in which they are operating should have predictable growth. What that means mathematically is that the demand growth has to be faster than the supply growth and the sector in which they operate. Then if you are looking for that incremental growth, you need to look for companies with characteristic one, characteristic two and the ability to capture market share. So, they should be doing something which is slightly different, which is allowing them to take away market share from peers. So, these are the three characteristics that we look for and then comes valuation. So, people generally start with valuation. There are different styles that work in the market. Our style is to identify these three characteristics, high prospective or current ROICs, the sector that is growing and market share capture. That forms our universe. From there, we drill down and look for other characteristics and build our portfolio of stocks.

The most important parameter is the ROIC. There is a study that is done and even mathematically, one can do this on an excel sheet. So, if you buy a company with an ROIC of 20 percent and another company with an ROIC of 10 percent, the first one you buy at four times book and the second one at two times. You hold them for 20 odd years. The first company goes from four times to two times, the second goes from two times to four times. The valuation expands for the lower ROIC one and the valuation contracts for the other one. I am taking the worst case here. Even then, the price CAGR of company A will be much higher than the price CAGR of company B.

Even in the worst-case scenario, where the valuation has contracted by half, but because of the higher ROIC, the compounding of earnings takes care of the suppression in valuation. This is pure math. The ability to consistently generate higher ROICs and our ability to foresee that are the clinchers. Even (as far as) the delta in the ROIC (is concerned), there are several (factors) at play here. The current ROICs may be mediocre but they (the portfolios) are doing something different which allows them to earn higher ROICs in the future. So, those are the so-called multi-baggers. If you go back and study them, (for example: a Bajaj Finance or an Avanti Feeds) or anything that (goes from a) lower quality to a higher quality, the multi-baggers are always those cases where the ROICs have expanded across one cycle. So, both of these types of companies are a part of the portfolio. Having said that, portfolio construction is not just about identifying companies. The key thing is allocation. When allocation comes, you have to differentiate between the companies which can maintain these higher ROICs across cycles. So, to repeat the same example of Bajaj and Avanti.

So, what I was saying was Bajaj Finance or HDFC Bank, for example, are companies which have been resilient across cycles. So, they have seen multiple business up-cycles and down-cycles and maintained their ROICs. But something like an Avanti Feeds has seen only one cycle playing out. The next cycle is starting for it now. So, one has to size the bets according to that. If you foresee the company to have a sustained high-return ratio across cycles, you can give it a higher allocation. But something that is a one-cycle play that is doing well in this cycle, should not be missed out on (either). In the 2000s, you don’t want to miss the technology boom, whereas, in 2008, you don’t want to miss the infra boom. Money has no color. So, you want to play both the current cycle and also the enduring names. So, the portfolio is the mix of these where the higher allocation is towards the enduring businesses and obviously there is some allocation to the current cycle plays (high-performing names) also. So, that’s how we structure it and put it together.

Generally, these are very sector-specific or company-specific factors. Like I told you, the second parameter in my checklist is looking at what is happening in the sector. (One factor is) whether in the sector, the demand is outpouring the supple or not. So, I believe that any business can be explained by four factors: demand, supply, market share capture and regulation. So, put together these four parameters you can explain any business.

In Avanti Feeds, what was happening was there was a supply disruption. These people were able to come up with a new type of feed for which there was a lot of demand. So, the demand was taken care of and they were able to enjoy some pricing power with the dealers because of their brand and they were able to capture some market share also.

So, if you look at these four variables, you will be sort of able to identify what is driving the ROIC. So, you can break down the demand, supply what is happening with the demand in sector, how are they capturing the market shares and if there are any regulatory worries. That is how you should look at it.

Having studied the market for a while now, one has to understand that the valuations of some of these names have always been high —HDFC, Kotak, Nestle, Unilever or Asian paint—the only problem people had with these companies was that their valuations were high so they did not buy it. Having done they have probably missed out on a big profit opportunity which was sitting right in front of them. So, we have to learn from our mistakes and we have to study what has happened in the past.

The same arguments were being made about Bajaj Finance five years back, two years back and even today. Some of these very small numbers of companies will remain expensive (the argument cannot be extended to all companies) and typically investors look at only one parameter that is growth. People look at growth and they say 20 percent growth (would mean) 20-30 P/E, 30 percent growth (would mean) 30-40 P/E etc. People are never able to understand why Hindustan Unilever is growing at 10 percent but enjoys a P/E of 50 percent.

So, clearly growth is not only the factor. So, there are several other factors and a lot of them, ROICs and growth are the two factors. But there are other things also which people sometimes doesn’t recognise. Number one is resilience across cycles.

So, if something has been in existence for 100 years then it is likely to be in existence for another 100 years. So, these companies have endured across cycles which markets respect. That plays a small part in the valuation that they enjoy. Then obviously, the predictability of growth, though not the quantum of growth, for NBFCs and banks are very high. So, if you are doing the job right then growth is not going to be a problem for you.

Next, these people typically play games which is different from their peers, which allows them to consistently do well. So, if you look at an HDFC Bank, when everybody was doing corporate lending, they focused on retail. Even with Bajaj Finance, when nobody wanted to touch consumer durable financing, they were there. So, today nobody wants to touch HFCs and they are expanding in a big way there.

If you look at something like a D-Mart, people want to be retailers for anything and everything: clothes, electronics, etc. D-Mart is very focused on food and allied items, which is where its profits are. So, they are playing a different game than their peers. They all may be in the same sector, that allows them to really profit from their own niche. And then, of course, they straddle across industries. The winner such as Bajaj Finance and HDFC Bank are no longer only financers. They have become technology companies also. And if you speak to them today, the language that they speak (shows this). If look at Amazon aboard, it started out as a retail company but it was never a retail-only company, it was a retail and technology company.

So, these companies straddle across industries. So, whenever you see the companies straddling across multiple industries, to the normal eye it may look like (the company is operating) in just one space. But actually, if you look at it, they are operating across different industries. There is something special happening there.

The most important thing is optionality, which people are not able to judge. All of these companies, because they keep running these small experiments, they don’t believe in the status quo. There is huge optionality of new revenue streams coming in. So, to take example of an Amazon, it is always a high-paying stock. But nobody thought that it will go into AWS or other things. Some of them failed, but others did well.

(Similarly), Bajaj Finance started with consumer durables lending. Some people make fun of them today as they are getting into all sorts of lending. But these are experiments. This is the culture that we have to respect. So, we don’t know what will come out of where. Look at Titan. They launched skin and fast track. These are all brands worth several hundreds of crores which you could not have envisaged looking at the numbers of Titan 5-6 years back. That inherent optionality which some of this things or names bring to sustain that growth cannot be put in a number, which is why the whole exercise of looking at the P/E ratio cannot be done. You cannot objectively come to a number and say that this is the right P/E for this stock. because there is objectivity for this, there is optionality and you are straddling between the industries. So many of these parameters go into making this PE ratio. So, I think, one has to spend time and look at these companies from a different vantage point to be able to sit on them and benefit from the opportunity they are serving.

Selling is generally dictated when one of these parameters starts to fall apart. So, either the growth starts to slow down because if the growth is slowing down that is telling you that some underlying parameter is broken. If there is a management change, you know something is changing there in terms of culture. Again, it is not something that can be put into a single factor. There are multiple factors that will tell you that there is this engine, which has been running on these pillars or legs, then something has been falling apart.

So, those are telltale signs. It is quite easy. It is not that difficult. But generally, you don’t sell out because of the valuation. You sell out because something is falling apart. You don’t just sell out just because the valuations are high. If you speak to any number of veteran investors, they will tell you that the biggest mistake has been selling just because of the valuation. So, if you want to sell out, sell out because something in the business is falling apart. Then your focus has to be on the business, the valuation will take care of itself.

I will talk about Avanti Feeds. We had it in a few of our portfolios. It was operating at super-high margins. The reason why Avanti Feeds went through with a margin expansion was that they did a large capex at the same time they got their demand. So, everything really fell into place for them. So, generally, margins are a very good indicator because they tell you a lot of things. They tell you about your pricing power, your operating leverages, which in turn driven by the sales. So, if you have a super-high sales growth, operating leverages comes into play.

If the growth of the margins is steady, you can still be assured that things will be okay. But if you see super high margins in an industry that is not supposed to have super high margins or super high margins which are not earned by some of the much better sectors. So, if you see such things, then you have to start questioning your thesis. I think this has been the key indicator for me to be able to come out.

With Hawkins, I did quite well with that stock (around 2013 period), which went through that phase of super high operating leverages. The sales really took off, the aluminum prices had fallen, then margins expanded significantly and the profits that they made in 2014-2015 are just surpassing it now. The sales have been consistently growing but the margins they saw then and the profit they saw then just fell off a cliff and that number are now just coming back.

I believe there is a large opportunity in the corporate banking space. It’s already started to play out (when I say corporate banks in the likes of ICICI and SBI) because in the same thesis the return ratios which was subdued because of provisioning are now coming back as the provisions have come off, the NPAs have peaked out, the management has changed, the cultures have changed. They have seen the worst of their cycles, so the business cycles have already begun to sort of turn for them. I think, there is a large opportunity in PSU. (This is not the case) with the second-rung, but I would play it out with SBI and ICICI sort of things.

There is one large opportunity there. Of course, there are opportunities in some of the names in private banking. I am also bullish on consumer durables. That boom has just not happened yet. We have been waiting for it for a long time. Nothing much has played out. These are multi-decade kind of themes. So, we cannot view them on a quarter-on-quarter basis or on a one-or-two-year basis. But a lot of these companies are building capacity, building the brands to be able to become much larger than what are they today.

It generally comes down to the numbers. The growth obviously and that’s what I said the growth has to be accompanied by an increase in the ROE. If you just see growth and the ROE is falling, you have to be worried about such companies because a lot of what happened in the 2007 cycle, where there was rampant growth but ROEs were actually falling. So, the growth was coming at a cost. So, when we run our screens, we look for companies that are growing with an incremental increase in the ROEs. Then that tells you that there is something wrong happening in this space.

So, in the smaller names (again, no recommendations but we may be owning some of these stocks) an Oriental Directorate and a Borosil are very small companies today, but they have been allocating likewise and have been building franchises and brands. The market caps are so small, the opportunity is so large in front of them, they are operating in their own niches.

Borosil, for example, is really benefiting from the no plastic theme that is going on right now and they are doing the right sort of branding, restructuring the business, and expanding their margins. So these are the things which we look for to identify them, that doesn’t guarantee that this will go on to become winners, because, in business, a hundred things can go wrong. So many companies just don’t have the DNA to scale up.

So, while it looks easy in the credit space because so much opportunity is there, that scaling up itself is a matter of the DNA. Not everybody can do that. So, these companies have to be in your portfolios and you have to watch them. See how they are performing on a quarter-on-quarter basis. Do not judge them on a quarter-on-quarter basis, but you can see how they are navigating different phases. Then the conviction builds up and that’s how the allocation goes up slowly.

The corporate banks, the SBI, ICICI, fit that theme. Since bombing out, they have not gone anywhere in the last decade or so. If you look at SBI, it has been in this range for the last 10 years. So, I think there is definitely a play there, but in the likes of the infra, they have also bombed out, along with the valuations.

This is not a question about not being convinced. There is also a concept of the circle of competence right. So, I have no competence to judge what will the numbers look like two to three years out. So with a lot of these companies which I told you, I can tell you what these numbers may look like to a fair degree. This is what the profit may look like because there is a fundamental momentum that is already underway. Here (infra), I don’t have the competence to (tell you any numbers) because it is so messy. The whole infra business is so messy, so politically involved, and so execution-led. So, that’s an area where we don’t go to.

I think as far as autos are concerned, the future is hazy. So, everybody has this question, Maruti is corrected from 11,000 to 6,000-7,000 now. So, is it cheap or is it expensive? But again, it goes into my bucket of I don’t know. How the whole EV thing will play out (is difficult to predict). As a discussion, we can all make conjectures but when you have to invest money, you have put in where there is a degree of certainty because you need to have an edge.

Today, even an Elon Musk does not know how the story will play out, even for his own company, leave aside the industry. So, these are buckets where one can’t take a long-term call. My universe is very small, it is where I can with some certainty project the numbers out. Here, I don’t think we are in a place right now (to do so). May be five years back, these were the industries which was quasi-consumers, and you could make that bet. But now you have to understand that the whole game has become very fuzzy as far as autos are concerned. So, I don’t know how they will play out so better to (stay cautious). There are so many stocks there, then why do you have to (invest in these)?

Telecom definitely looks interesting. The businesses have become much stronger than what the story was five years back. So, there are two players and both the players are in some amount of cartel. If you look at price hikes if somebody is not following the dues and just looks at the price hikes that have happened. These elements are good for a capitalist. So, we have to see how it plays out because on the one hand there was a lot of government intervention also in this whole game. Telecom definitely looks interesting; data is the new cocaine! It definitely looks interesting in that sense, it will be interesting how these players milk out the whole opportunity.

Traditionally, we have not ventured into this space because it is very opaque. But like you said, regulations have changed now. But again, like all of these things which look to be ‘’, there is a reason why they are ‘’: because they are so fuzzy. Do you want to take a business risk or a valuation risk? Our question is always that. We always choose to take a valuation risk because the whole edifice is built on business, so you can’t take a business risk. So, valuation has so many elements that if you choose a good business you can come out of it. You may unknowingly also do well because the business is good. Like I said about optionalities, so many good things can happen. But here, what looks like a , it’s so fuzzy that you are actually making a 50/50 kind of a bet and you are betting on the valuations again. And if the business deteriorates, nothing can stop a 10 P/E stock from becoming a 20 P/E stock because the earnings so far have become half. So, as you said, that is an area where there is a circle of competence again. So, we don’t get into those spaces. If they give me that predictability, maybe in the future, one can look at it. But currently, (we don’t get into that).