How These Portfolio Managers Defied The Rout

Soumil Zaveri: At the risk of saying something relatively generic, we put it in three pieces. The first is bottom-up approach to pick up stocks carefully and high conviction ideas which allow us to build on the concentration on these businesses.

The second is size. If you are managing several thousand crores as oppose to a couple of hundred or thousand crores, you have a distinct advantage. You go in niches and pockets which you otherwise can’t explore. These are structural advantages which hold anyone managing less than billion dollars in good stead at times like this. You take position specific ideas, scale them up and be agile which you can’t do with larger pulls of capital.

The thing which is under-d in our community is quality of investor base. Having a small set of investor base which understands the investment approach gives you the way to diverge from what broader markets are doing over shorter periods of time. It is very critical. Those are three things which are very fundamental to our approach which held us in good stead which otherwise was a turbulent year.

Jinal Sheth: It was not effort in 2018 but more so before. The seeds were sown in 2016-17. We were telling our clients that small- and mid-cap space valuation was getting out of comfort and it got worse in 2017 when the markets did well. On an absolute basis, we were fine but there were attempts to fare well in a bull market. In 2016-17, we started identifying high-quality businesses which were not doing well. That’s where you were getting and comfort. So, we built up over there. We were okay underperforming in a bull market. The client base is important in this business, if they believe in you, they stick by you, then it becomes easier for fund manager to do its job. It helped us in 2018 where we stood ground because of bets we have taken in 2016-17. It helped us to outperforming 2018.

Gaurav Awasthi: From our perspective, the focus on risk is very high. The valuation for small and mid cap is going through roof. Late last year and early this year, we were completely out of mid and small caps. In large caps, we have become quality conscious and quality-focused. It helped us get out of the volatility in good shape.

Gaurav Awasthi: A lot of quality packs also did not do well. Even in quality packs, valuation matters. The NBFC crises that happened recently. Everybody in world knew that there was asset liability mismatch happening. It was just that the risk was not out in the market. Until, one day it came out and suddenly everything collapsed. A lot of high PE companies, till the growth is there,valuation will sustain. As soon as growth started dipping off, for lot of this names find valuation far cheaper. Quality for us was not in terms of high PE but low debt, where in expensive market you will not lose money.

Gaurav Awasthi: Even in debt, the pricing which was happening in debt market in terms of how credit was being priced was extremely mispriced in India. The kind of yields which we were getting for a lot of players, the spread between AAA and AA (rated stocks) was hardly there. While for the entire world, single A is shot through the roof, in India it is reversed. Over the last three months, if you look at valuations, the spread in India is decreasing. This poses a question that there is more damage to come in that part of credit market.

Jinal Sheth: In small- and mid-cap space, in 2016-17, they have surpassed plus two standard deviation in terms of PE historically. There was re-rating rather than earnings growth coming through. It was liquidity driven. So, in our sense the small and mid-cap space mix by 2017 had come down to sub 30-40%. Whatever position we had in those hadn’t done well and there was some valuation comfort. We believed that over next three-four years earnings growth will come through and you will have expectation of return.

But some of the bets in 2016-17, if you take IT sector, which was considered a complete dud. People had given up on sector. There were certain cyclical issues and structural issues. We believed that even if you factored the structural issues, the valuations pricing in large companies even then it was as if they were priced for no growth. It was highly under-owned as well. We didn’t mind taking that contrarian bet.

We had some domestic pharma names which were okay to go with. But we are seeing some valuation comfort coming in generic space today unlike few years back. The pricing was stabilising in the U.S.

Then their other contrarian bets, more like niche bets, which we have taken. We believed that down side was limited, balance sheets were clean. So majority of positions, if you look into balance sheets, either they have net cash or minimal debt to their extent.

That’s how we were placing ourselves and portfolios knowing that we were not comfortable with what’s brewing in 2017. You will be caught by surprise. When we were getting portfolios in 2017, by November-December, we were deploying only 20-30 percent in equity and remaining was in cash. So, we do take that asset allocation call too. Equity position and cash that helped us.

Soumil Zaveri: We are 50 percent financials, 25 percent platform businesses or market places and other one-fourth is consumer business now. That was more or less the case in 2018 too.

Returns have been exceptionally lumpy. When you own 10 businesses, 5-6 businesses can be 80-90 percent of portfolio. Someone in top 10 can find them up in bottom 10 the next year. It is not function of something they did wrong when they have multi-year horizon. Lot of quality investors, great allocators find themselves having a tough time in the past year. That comes natural and comes with turf.

That said, one of things which we take pride in is qualitative arbitrage. It is appreciating type or aspects of business, which don’t translate on spread sheets. Sounds little romantic but the essence is very simple. There are aspects associated with great owner operators, with purpose-driven organisation, which have very low market share or adoption rates. It buffers them of what happens in that sector or industry, political scenarios or macroeconomic scenarios. We try to get in insulated zones.

We stay clear of blind spots; we don’t understand IT, pharma and we stay clear.

The combination of having deep qualitative on underwriting businesses combine with staying clear with stuff which we don’t get.

Soumil Zaveri: For everyone that speaks about quality, one of the things which is a real steward of quality investing case study stands for is Bajaj Finance Ltd. We still own it and it is poster boy.

For us, a lot of growth and opportunity is in windshield as oppose to the rear-view mirror. If you look at the size of industry—more than trillion rupee of potential banking sector credit—then one lakh crore is very large market opportunity for somebody of Rs 85,000 crore of AUM today. When you have long runways, you can’t say opportunity is great. You have to be case-specific. You have to choose owner operator, you have to choose the duo of a Sanjiv Bajaj and a Rajeev Jain. These are very exceptional entities they build in terms of underwriting credit in very short periods of time at retail outlets, underwriting cautiously while doing that. You are straddling these things which are opposing forces. Grow at scale but maintain underwriting discipline. These are very tough things for others to replicate. People who have these edges are likely to enjoy them for long periods of time if they continue to invest in them. Bajaj Finance is the poster boy of it, planning three-four years early of where they want to be.

Jinal Sheth: In pharma, the competition and pricing is stabilising unlike what we saw in two-three years. We are seeing a consolidation in purchasers in the U.S. They were seven players, which shrunk.

When we look at export plays, they are taking a longer-term call in capital in allocation. They are taking longer term call of three-four year call on how and where they are placing their bets. Therefore, when you look at entire cycles in past these companies have played—looking at the capital employee and balance sheets—we are okay at this point of time, considering what valuations are, taking those bets.

Along with that we were taking the bets where in domestic pharma plays—the MNCs—where there were a lot of negatives in the last few years. You had pharma policy in play and regulatory concerns. That’s where we found some ideas. We believed that look that this are more like FMCG plays and they don’t require capital. Growth isn’t very high but if they are able to grow 12-15 percent, which is possible over the next decade, we are okay taking those plays and for the valuation which were getting them. That stood ground in this particular year. That is something more on pharma side.

We took a API bet. It was a custom synthesis play on Divis Lab. We always liked that business, but we never enter in terms of valuation point of view. Only when they were hit by import alert, we came in. At that point, we just asked few questions. The kind of relation they had with global innovators were exclusive. They have been with them for last 25-30 years. You will see consistency there. So, we believed that there was matter of time like two-three years that things will be out of the way. We got lucky that import alert resolution got done in less than a year. No pharma companies have seen it. They were not competing with innovator.

Another play, which worked for us was in the consumer space: Jubilant FoodWorks.

A couple of years back the industry was going through a slowdown. The wallet share had share had expanded for consumer where there was Zomato and Swiggy available at your doorsteps.

From that angle, we have studied the businesses from global level. In Domino’s globally, it is most profitable restaurant businesses in world. It was matter of time that we thought the same-store sales growth will come back to normalcy. Even if you take developed markets today like U.K., the sales are in higher single-digit. In India, there is growth opportunity and profitability. So, again we were playing contra bet that at some point people will be negative on these names.

Gaurav Awasthi: In the beginning of 2018, the view was emerging world is growing. If you look at ex-U.S., the rest of the world was gradually slowing down. The U.S. was the outlier, which continued to grow because of policies of President Trump.

The other view was interest rates are on the way up because of what is happening around globe, tightening and you don’t know when the cycle will end. Crude was not there as base case at that point of time. The fact that you expected interest rates to go up, the fact that you expected global growth to slow down and it went out to allocation. Anything which is linked to global economy, for example commodities, which you will want to start avoiding. Also, what is very linked to interest rates—so the NBFCs.

While we can’t claim that we saw the NBFC crises [coming] in any way, the point is if you expect the interest rates to rise then the kind of competition the NBFCs would be giving to banks will start subsiding. Banks will be competitive going ahead. If you look at housing finance companies, the underlying real estate market is not doing well. So, at some point the growth has to slowdown. We all know where the real estate market is right now from sales velocity perspective. Unless that picks up, the growth which is riding on top also has to slowdown.

Gaurav Awasthi: Yes. The front view was we thought interest rates were going up in the economy. If my two broad views are the world is slowing down and at the same time interest rates are going up, the first allocation bet is anything you are to do with global economy want to start getting out. Anybody, who has taken advantage of this entire down swaying of interest rates, on the upswing they will get hurt. That for us played out.

Soumil Zaveri: We follow audacious, outlandish and unconventional approach.We are not tending to minutely focus on what interest rates will be over a year and it is very fundamental to the approach. We are in it for element of time arbitrage when others are focusing on three to six months which will have meaningful impact on some of these businesses. It is not to deny it or dismissive of it. Some of these businesses have scalability prospects which are not being measured in those time frames.

Take businesses like Eicher Motors. We take stewardship of that brand and business. When they get monthly sales numbers, it is comical tome. You look at Sherwin Williams, the paint business in the U.S. over the last decade, they published details of paint sold every month. If anyone wants to pass action judgements on it, it will be a real folly. The story played out over a multi-decade horizon.

Because we have a clear mandate, we view ourselves as a family for very limited number of families and the approach is very simple, by irreplaceable asset with irreplaceable capital. We just want to mute out the things which we are not qualified to comment on, whether it is our view on interest rate cycles. We zone out of these things. It is a zone of expertise that we can’t curate. It is not a zone of expertise which we can cultivate. So,let’s operate in zones where competencies aren’t critical.

Gaurav Awasthi: The view sustains that global growth continues to slowdown and now the U.S. has also joined the pack. Anything which is outwardly looking not still be a great idea. Even from market capitalisation point of view while mid and small caps are corrected substantially. Valuation on mean are still higher which is true. We remain cautious in our stands, but we are not over bullish right now. We don’t think we will have substantial returns. We may, in best case, get lower double-digit returns. It is our sense, especially with lot of volatility we have.

The key is earnings have to revive. People hope every year that the first quarter will come in and you will come in the second half. If earnings come up, if capex cycle is reviving, capacity utilisation is going up,if those things played planned, then we will have huge swings where capex and related sectors may start doing well. Rather than jumping into it, it is great to wait for evidence.

Jinal Sheth: We are cautiously optimistic. Although we had a correction in small- and mid-cap space, we are not comfortable yet. We focus a lot on valuation. We consider what is being priced in. We are finding some valuation comfort in IT and pharma. Some of it is emerging in the two-wheeler space. We believe that most of the things are not priced for growth. We are talking about trend growth and not high double-digit growth. That is one avenue where we are finding .

We are identifying micro trends. There are certain pockets of opportunities like air pollution or waste water treatment. We are seeing certain shrinkage of foundry capacity globally. That has an impact on India where foundry makers and niche players supply. We are taking one view of it and are finding . It will be hard work but that is where expertise will come in to try and survive.

Soumil Zaveri: We think there are a bunch of businesses which are emerging and are no longer in core sector as much as they are in technology companies which happen to be in business of staffing or how power is traded in our country. There are long runways which are present here. These are very nascent opportunities. If you look at the short-term power market in the country,power traded on exchanges is 3 percent of total electricity traded in country. When you think of runways which are possible here, the market places which emerge or are emerging, we are optimistic on it. The seeds that we have sown or businesses that we think will be substantial larger contributors to our portfolio overtime.That’s why we are seeing them like platform-style or tech-enable businesses.

Soumil Zaveri: Bad Blood by John Carreyrou. Just great insight of how much you have to think of corporate governance irrespective of who your other shareholders are.

Jinal Sheth: Market Moguls by Indian investors. It is useful as you are trying to get understanding of different investors which we have seen in India.

Gaurav Awasthi: Thinking, Fast And Slow by Daniel Kahneman. If you are able to control emotions, they you will make far more money in market.