What Best-Performing Portfolio Managers Of 2019 Did Differently

Paresh: So incidentally, this strategy hasn’t changed since 2007 which continues to focus on highly profitable consumer franchises- run by ethical and passionate managers with a record of wise capital allocation application and incidentally bought at fair valuations. What obviously you saw in 2019 was very difficult economic circumstances and interestingly, many of the companies that we’ve invested into continue to do operationally and financially very well. Many of them have been market share gainers as well and they obviously have very little debt in their balance sheets, they have high degree of pricing power and a pretty good corporate governance system. So, I think a combination of these aspects have come to the fore and you continue to do well. So, all the heavy-lifting was done by this set of companies.

Pramod: Yes, absolutely. I think I tend to agree with what Paresh mentioned. This is an all-weather strategy and I don’t think you can change it based on the state of the market. Ultimately you have to buy clean companies because there is no for corporate governance that you can put because you need the creation to accrue to the minority investor as well, which is our clients. Secondly, you need franchises that have strong competitive advantages so they continue to grow even in difficult economic circumstances simply by taking market share. Thirdly, you need exposure to goods and services which have a secular demand, which are relatively immune to the economic circumstances. As a result, most of the outperformance we’ve delivered is perhaps coming from the fundamental outperformance. For example, the earnings growth for our portfolio was north of 30 percent compared to the earnings growth for the index perhaps which was 5 percent. In fact, our share price outperformance is not even as much as our earnings outperformance.

Bhavin: So what we do is, we pay a huge emphasis on understanding in each and every company we invest in. It actually prevented us from owning some of the very great large-cap companies we earlier had in our portfolio. We actually had to sell out because we no longer could justify holding them. We had to work harder and, in this market, some great and mid- and small-size companies also were priced at a discount. In fact, some good IPOs came, people and the market kind of ignores them because I think the investor is still trying to test the waters in some of these new companies. If we do our own work it was then we found that this company actually had a great potential.

So, it’s a combination of those factors and sometimes there are large-cap companies which market doesn’t understand how to them. Those opportunities were also there for us.

Bhavin: Absolutely. In fact we have found that when you try to buy smaller company, accumulating a position itself is quite a challenge. So, divesting it is an even bigger challenge. So, we have some liquidity criteria. We don’t want to have a name which will take another six months to divest for example. So that pushes us to have a large number of companies in the portfolio.

Sushant: I think what worked brilliantly—both in 2018 in 2019—these have been two of the toughest years in the equity markets that I have seen in the last 20 years. We haven’t seen such drawdowns for such a long extent and the polarisation which is happening. What has worked is, we haven’t changed our strategy. What has worked is, buy good and clean businesses with coffee-can component. You enter into great and good franchises and stay on invested.

We have been churning probably industrial lows. Our churn ratio in last two years have been a single digit across all our three strategies. So, without churning those companies, delivering those returns I think shows the quality of the businesses you have bought in. People say that large cap really hurt the most. I think large cap sort of delivered the negative performance the least. If you ask on the positive performance, it’s the mid caps which have given the best returns—both in 2018 and 2019.

There were 15 mid-cap companies which delivered more than 50 percent returns in 2019. Similarly, even in 2018 there were five mid-cap companies which delivered more than 50 percent returns while there was just one large-cap company. So, midcap did deliver. It’s just that select ones. It has been the story so far across mid, small micro-cap, large caps. Quality businesses have delivered. Those who have got high-quality corporate governance and those who have been giving earnings in these two tough years as well. They have been rewarded the most for shareholders in this market.

Pramod: I would like to disagree. I would like to agree with what Sushant is saying. I think there’s a lesson for all of us and including your audience here that this whole myth about large cap doing well is not really true, right? Quality lies across the market-cap spectrum. Sushant gave out the numbers and that’s what we find as well. To start off, our strategy is market-cap agnostic. It’s not like we start off with the large cap.

Ultimately, we’ll look for the quality parameters that fulfil our investment strategy. It so happens that some of them are skewed towards the larger companies and I think we’ll come to that explanation as to why the larger companies are getting larger and larger. That’s a global phenomenon as well and not just in India. Consolidation for various reasons is driving the dominant companies to continue to take market share and I think if your question is that, that trend is here to stay. You will see the dominant companies take more and more market share going forward. The guys with the competitive advantages, the environment is so favourable for them because we’re becoming a unified market across the country because of breaking down of barriers from telecom networks to road networks to GST—a unified market.

Technology disintermediation mean that the national guys will wipe out the regional guys fairly quickly. For various reasons, the dominant guys can become larger but having said that, in the market-cap spectrum of midcap and small cap as well, you will see champions—dominant forces albeit that there are dominant forces in a smaller industry. Their industry itself happens to be niche and hence there are mid and small cap—although they are market leaders in that.

If you can identify these market leaders, not just leaders but dominant market leaders, almost a quasi monopoly, irrespective of the market cap, they will do well and there’s a second aspect I would like to emphasise again for your audiences’ benefit. Sushant mentioned is the low churn. I think it tends be very under appreciated. The cost of churn can be fairly significant. Our churn is also in single digits—roughly about five percent. I think industry average churn is 50 percent. Just this difference can add 100 basis points to your outperformance.

Often when you pay your broker 10 basis points, you reckon how much difference can it make but if we keep churning, remember it’s not just brokerage. There is a securities transaction tax on top of that and there is the price impact—particularly if you are dealing with small and midcap stocks. On top of that, capital gains tax whether short term long term and all of it adds up to a large number.

I would reckon about the two points that Sushant mentioned. Forget about market cap, focus on the dominant players in each of these market-cap spectrums and second, stick to low churn because dominant forces don’t change that frequently.

Bhavin: The best scenario is obviously to look at the dominant company. For example, we call a portfolio ‘all-star’ and the definition of an ‘all-star’ is typically for a company to do well across market cycles. So obviously when we do research, we spend at least 20 years to understand how the company is done. This is including the 2008-09 meltdown. For instance, how the financial position, how the operational position of such companies has been.

Just to add to what Pramod as well as Sushant has eluded, we obviously look for dominant companies. What we have also figured out is that and seen through with the data as well, is that companies sometimes you get lax, especially the leaders, and it is the second company which kind of has a faster growth and they end up being far better wealth creators. For instance, we would also want to add that we actually focus on market share gainers. To give you a couple of examples so that the audience can relate to it. Think about the difference between Castrol and possible, a Gulf Oil Lubricant. Castrol has been a very dominant lubricant player for very long period of time, but if you see over the last 20 years the focus has largely been on profit margin preservation at the cost of volumes. If you see Gulf Oil Lubricant on the other side, it has continued to gain market share and continued to drive volumes three to four times industry growth and therefore has been a great wealth creator. Over a long term, please understand that the returns will come from obviously what the companies’ underlying earnings are and that is exactly going to match with what the shareholder returns are. The only caveat is we obviously want to look at the dominant company and many times the dominate companies end up getting market share, thanks to technology and all the factors that Pramod alluded to, but sometimes also, the second in the race are actually doing better than the leader.

Sushant: So, difficult to say or growth. Value at times becomes a trap and similarly growth at times becomes suicidal. You’re assuming a 50 percent growth rate for last five years which will continue for next five years and suddenly, it’s the economy which ultimately delivers the growth. If the economy isn’t recovering in a hurry in which I don’t think anybody has a clue as to when will it recover. It has to recover but whether it has bottomed out also, we don’t know.

There’s no need to change the strategy as such because we’re buying quality businesses and there are enough opportunities available. In each space you would want to say that these now look relatively better compared to other portfolio companies, so why not get into these businesses. They’re doing better but they have been pushed to the shore because of liquidity reasons.

Sushant: If you do an analysis of where the conceived is, the sectors mostly which are non-secular, which are more depending on macros. That’s where probably the utilities, the capital goods and infrastructure everything lies. Now, this is a very grey area as to when will the macro improve. We have historically seen a V-shaped recovery in the past but looks like it will be a U-shaped recovery this year or in this cycle. Now, whether the U will become visible on the upper side this year, at the end of this year and next year we don’t know.

So, it’s difficult to take a bet at this point of time as I would say, it’s better to stick to secular businesses. See, there have been several hits to this economy. One is the financial crisis where nobody has any trust on anybody else in this country. The other part is the GST-led consolidation and third is more importantly which we expect in the next one-two years is the corporate tax rate cut consolidation which will take place whereby the leaders in each segment will use these profits to shove out their competitors either by giving more margins to dealers or by spending on advertisements or by price cuts. All the leaders generally have cost leadership, so they lose less while the second or third of fourth player lose probably everything of their earnings. So, this year is of consolidation and probably next year as well. So, the leaders are the challenges in any category if you want.

Bhavin: We never want to pay a premium for growth. We understand that a growth company in a good cycle with its margin expansion or high growth, market will reward it with a much higher multiple. When that growth goes away, that stock and multiples can crash as well. By our philosophy, we’ll pay for whatever we can explain, it’s five years of growth or 30 years of growth, we want to be able to explain it through our model. So, in that respect, our strategy from last year this doesn’t change but going back to what you said about in finding in some of these non-secular sectors, Yes, we look for opportunities there as well.

Bhavin: If we understand the company well, if we understand the management well and if there aren’t too many complicated moving parts of the business, then we are willing to take a chance, in the sense that, invest and be patient with the investment and eventually that pays off.

Bhavin: My rough guess is that it would be 20-25 percent of the portfolio.

Pramod: Yes and no in the sense that we tend to look at it differently. We don’t distinguish between growth and investing. For us, everything is investing. It’s just that the growth tends to be mispriced because of the extent of research. Our conviction in how long the growth will sustain is far higher than what we think that the market understands. The fact that something is trading at 50 times PE, doesn’t necessarily mean it’s expensive or cheap. If the growth can sustain for 10 years or 20 years, a 50 times PE could actually be much cheaper than what the intrinsic of the company is. So, for us, everything is investing at the end of the day; the growth tends to be mispriced. What you are alluding to is, the cyclical versus the secular. There I tend to agree. I think I would rather prefer secular growth stories because our challenge, I’m not saying it’s the general challenge, others perhaps are far more skilled in investing in cyclicals and getting the timing right. Because at times it will look like cyclical stocks are delivering super-normal earnings growth. Usually, they come from loss-making to profit-making. So, the earnings look overpowered. On a cross-cycle basis, we don’t see any evidence where cyclicals actually delivered a superior earnings growth. If you acknowledge that you don’t have the skill to time your entry and exit from cyclical stocks, you’re better off playing the secular stocks where demand for the goods and services for the company in question is secular in nature with very little volatility so, you don’t have to go through the gyrations of the market and you’re focused on dominant players in each such product category which tends to sort of keep its earnings growth even less volatile because even during the economic stress they continue to grow albeit slowly but simply by taking market share from the weak.

Pramod: Simply put, all our companies, at least based on our expectations of growth, are trading well below their intrinsic . So, nowhere are we paying a premium to their intrinsic . In fact, we are buying it with a fairly handsome degree of margin of safety with these companies. Where the debate arises is, the assumptions of growth itself. Not just growth, the longevity of growth, the low volatility of growth. The longer the growth sustains, the higher the of the company and because we are choosing companies which essentially make essential goods and services, the volatility of growth is also fairly low. The volatility deserves a higher as you can expect because there is a lower discounting rate even if you were to do a cash-flow based evaluation. So, these three factors tend to be misunderstood by the market, both ways. Some companies tend to be perceived as high quality, but they are actually not. Some companies are generally high-quality whether they can sustain current earnings for the next 10-20 years or not. Because the market doesn’t go deep in terms of assessing the competitive advantage or hence doesn’t build conviction that this growth can sustain for the next 10-20 years, it’s not willing to pay anything close to its intrinsic . So, we are happy to believe that a company can be trading at 100 times PE and yet be trading at a discount to intrinsic .

Pramod: Absolutely. We reckon that the sustenance of growth is there. We might be wrong in the assumption but that doesn’t mean that a stock can be overpriced simply because it is trading at 50-60 times PE. So, we are happy to have a debate. We in fact question our own assumptions on the company’s competitive advantage and hence, the sustainability and the longevity of growth. But we aren’t the ones to say that the company seems too overpriced based on PE and hence, let’s not go near it.

Paresh: So, before I answer that question, I must go back to what you just asked—what would work in 2020 or what worked for us in that sense. I have always gone back to saying that we’re doing exactly what worked for us since 2007 and that has worked for us in 2018 and 2019 as well. A wise man, Singapore’s former premier Lee Kuan said, “repeat what works right” and that’s exactly what we’ve done. The only difference is, while we continue to stick with the all-star portfolio, we have begun to feel the heat of the extended valuations that we’re seeing and very highly profitable consumer companies, right?

What we try to do is that we try to be on cash. For example, every new client who comes on board currently with us over the last three or four months, we are almost 70 percent cash for every fresh investment. Because we learn from history. For example, what happened way back in 1970s, in America, we had this phenomenon where you had companies like Coca-Cola, Xerox, IBM, Kodak, Polaroid. All these companies were trading between 50-60-70 times earnings multiple. And then, you had a bear market, which came because of the oil crises. The oil prices moved from $4 dollars to about $12. We had President Nixon moving from gold standard and then, you had ensuing inflation where you had Paul Walker increasing the interest rates dramatically. So, our end objective is that for any client that gets associated with us, we need to ensure the capital is protected and therefore we necessarily need to buy it at a discount.

Therein sometimes, there lies a problem. We’re very focussed that these are the kinds of companies we need to buy but we have to pay marked on price. We don’t like paying for growth. Therefore, when the opportunity comes, which comes typically rarely— once or twice in a year—we tend to make bigger allocations. That’s why most of our portfolios are limited to about 11 names. Top five names occupy almost 75 percent of the portfolio and on a weighted average market-cap basis, as we speak it is closer to Rs 1,89,000 crore or roughly about $26 billion. Their incomes, because most of these companies tend to gain market share. Therefore, already are big and they are continuing to do well. The question is, we’re very disciplined in terms of paying a price. So, our concept was buy big at fair valuations, till then, hold cash. But we know what we have to buy.

Sushant: One clear-cut theme is the consolidation era in most of the sectors because still in the financial sector, the trust is not back in the system. I think the economy will continue to languish. The other thing we can look at going forward is a rural-based place, because rural economy has been getting into stress for last five years. If you look at food inflation, it has been at historical lows for so many years now. So, the farmers’ incomes haven’t increased. Coupled with that the monsoons which have been so erratic in the last five years. In 2019, we had a great monsoon across the country. At some places, it was in excess and destroyed monsoon crops. But the Rabi crop looks to be really great. So, rural is something which we believe will be a great play in 2020 and 2021 because we have seen wage inflation having a high correlation with food inflation. And as we see in last three months, food inflation is inching up and inflation should also inch up. So, the combination of both will lead to a greater income in the end of rural India and that’s fair, actually.

The growth—if you see the consumption slowdown—it has hit the most because the urban consumption has held between 10 and 15 percent for a long time and the country should do so. Probably 15 has become 10 but the rural which was going at 20-25 has come down to 5-10. So, once the rural picks up, the economy will probably pick up, but it will be more of a rural play I think, to begin with.

Sushant: The government’s actions don’t do much to the economy. The government comes out with announcements and schemes but if you ask how much it reaches to the consumer, it hardly does, as a fraction of the economy I would say.

Bhavin: I agree with Sushant on the rural economy probably showing a clear improvement. I think there’s a general sense that the reservoirs are full. In the past, it tended to support multiple good crop seasons and so on. So, that I think there is some opportunity to play that. Beyond that I think we stick to our philosophy of finding opportunities across sectors on a bottom-up basis.

Bhavin: I think strong financial companies because of what has happened in the financial crisis. The financial companies that were able to raise funds, the valuation also has tilted a little bit towards them and in general, they have also delivered better numbers. That might also continue. I don’t think we’re out of that environment yet. I think that would be another place to look at.

Pramod: I think it’s going to be more of the same. So, we are sector agnostic, we are thematic agnostic. In fact, we tell our clients to come in with a three-year horizon when they invest with us. So, there is no point in looking at it on a calendar year basis or a 12-month basis. It will be unfair to them. The reason we say three years is, whether they invest with us or in the market directly or with other fund managers, Indian equities have a peculiar behaviour in terms of the risk and the volatility. We have seen the past data— the past 25-year data, even for the Nifty or the Sensex, the standard deviation on a one-year investing rolling basis is as high as 35 percent. This falls steeply all the way down to mid-teens if you are doing a three-year investing. The longer, it continues to fall further but the fall is much more gradual. If you want to eliminate risk which is all about investing, it is not just about returns, it is risk-adjusted returns— you need a three-year horizon to deliver a supreme risk-adjusted return. We sort of step away from looking at it from an annual basis which is why, we reckon in any three-year period, the cycle will be by and large taken care of. And the dominant franchises will deliver a superior return over the three-year period. Within this three-year period, maybe there is a 12-month period where the will run up, the commodities will run up.

Pramod: I think more than the sectoral themes, I tend to agree with Sushant. This theme of consolidation is real, and we’re witnessing through our field visits across the country. We can see it happening day to day. The stronger franchises in every sector are becoming stronger and stronger and they will take share. It doesn’t matter. There could be smaller industries were the dominant leader is a small-cap company, but it will continue to take share from the weaker guys and eventually, the country will be consolidated into a few hands, a few companies which will create immense amount of . You’d rather focus on that dominance or the quasi-monopoly as we call it rather than trying to figure out which theme will work this year, which is, at least, beyond our skill sets.

Paresh: I keep saying that repeat what works. For instance, when I was born in 1978, the per capita about $200 per person. Today it’s about $2,200 per person. We have seen a 10-times rise essentially and we see that, there is going to be a lot of secular headroom for many of our kind of companies to grow for the next 20-30-year period. Therefore, it’s very important for us to stay focused in our kind of companies only and therefore we don’t look at cyclicals. Typically, we don’t look at commodity companies for instance because these companies seldom give you opportunities to buy them cheap and we really need to be focused, disciplined enough and we need to be patient enough that when these opportunities come, you swing them big.