Alpha Moguls | Alchemy’s Hiren Ved Identifies The Winners Of Next Growth Cycle

2018 has been a tough year. Somewhere, by the end of 2017-2018, we got a sense that the markets were getting a little euphoric, especially valuations in the small- and mid-cap space were just completely out of whack. We look at this gauge regularly. We look at the trailing PE multiples of the Nifty and compare it to the CNX Midcap. Not the future multiples, but the forward multiples. The expectations could be high or low in the future but trailing is all in the numbers, and it just gives you a sense of where the risk-appetite is and what the valuations, etc. are. Long-term averages are like 200 basis points premium to the Nifty, which was trading at 10 times at that premium in the beginning of the year. So, something was clearly wrong and we systematically reduced our exposure to small- and mid-caps very early into the year. Not like our small- and mid-caps did not correct for everybody else, but they corrected less than the average and some of them which have corrected, have bounced back pretty well.

We changed our positioning a little bit, thinking that the small- and mid-caps have had a phenomenal four to five year run from the bottom in 2013 to the peak in January 2018. A lot of money has been raised in small- and mid-cap funds in 2016-17, largely in 2017-18 and all in close-ended strategies. There was a little bit of self-fulfilling prophecy that went into people liking the long-term stories in some of these companies, keeping in mind the same stocks at higher and higher prices. We’ve seen these cycles before. We’ve seen several bull and bear market cycles before and so we don’t tend to make the same mistakes. Our setup in 2018 was something very similar to what we saw in the 2013’s second-half—the rupee depreciated, current account was in stress, small- and mid caps got smashed, there were elections in six months, we had a new Reserve Bank of India governor (Raghuram Rajan); and then you switch to 2018’s second-half where you have something very similar—the Fed raising rates, small- and mid-cap overvaluation which started to come down, and the trigger point came when SEBI changed the reclassification of the mutual funds, then the ASN framework was brought into place, but those were just alibis. There were a couple of stocks which were too overvalued, so they had to correct and so they did that. The nail in the coffin was the IL&FS crisis. If you really look back at 2013, the low point of the market was in August-September, very similar to this time.

I think, to some extent, that context which we saw in 2013 was something which was in our mind in 2018. Even though we have a fair-share of mid caps in our portfolio but wherever we saw a chance of at least a near-term overvaluation, we took some money off our table, reduced our exposure, and incrementally, sort of invested in some large-cap, non-consensus trades and I think that has helped us. It’s our view that every cycle is different and I think, post this correction, the new cycle that would emerge over the next two to three years would be led by large caps and larger mid-caps, and not by micro caps and small caps.

If you really want to be a long-term investor in small and mid caps, you should know how to manage volatility. All our strategies are cap-agnostic. We have large, mid and small exposure. We restrict the small-cap exposure to a very small amount because of liquidity issues. But because markets keep changing character, for example: small and mid-caps were very cheap in the second half of 2013. They were trading at a 700 basis points of discount to the Nifty. And in January, they were trading at a 2,200 basis points premium. That’s a massive re-rating that they had gone through. So no matter how much you like them, everything is good at a price. You have to look at the risk-reward for investors. We’ve remain invested for five to 10 years in some companies. But in the interim, you have to manage the volatility. We do a lot of concentrated investment, sometimes it makes sense to reduce our weight but still hold a core position in a stock that we like. That’s what we did in many of the stocks that we owned in the mid-cap space.

It’s very difficult to predict if we’re at the end of the correction or if the correction is already behind us. My experience has shown that usually the low-points in the markets is when the macro is at its worst. And I think the macro has been at its worse, when the oil prices peaked at $85 to $86 a barrel. So from there, we’ve seen oil correct very substantially. That’s like the natural stimulus to the economy. And I think the peak of the crisis was IL&FS and usually the highest aversion is at the peak of any crisis. While it’s hard to predict what the exact bottom is, and if I were to go by past experiences, I think we may have seen the worst in the markets just a couple of months ago. And I think that the behavioral consensus is that nothing is going to happen till elections. Whatever has to happen will happen post-elections. My view is a little different. My sense is that you could see a small rally here, which might surprise people, and that’s because, going into the elections, we might see a little bit of a monetary and fiscal stimulus being given into the economy. Because of the IL&FS crisis, the RBI and the government have stepped in to infuse liquidity into the system. And, if not in the past, this time the RBI has had some room because inflation is running very low, so they can afford to give a bit of monetary stimulus. The government is talking about infusing new capital in PCA banks. We might see a cut in GST rates, which is like a cut in excise. Let’s say, after the 2008 crisis we aggressively cut excise duty to stimulate the economy, and then the farm loan waivers and so on and so forth. I’m not justifying farm loan waivers, but I’m just saying if you take the drop in oil prices, bond yields and inflation, the new liquidity injections, potential GST cuts, and farm loan waivers—this is nothing but a combination of fiscal and monetary stimulus that is being given to the economy. And that might help to raise asset prices. I don’t think money’s going into real estate but it might find it’s way into the markets. While the consensus trade is that nothing is going to happen till elections, my view is that you might see a little bit of a rally pre-elections itself because of all of this. Again, I could be wrong. All of this doesn’t matter in long-term investing, but that’s just the context that I think might play out in the short to medium term.

I think more than the domestic factors, what could queer that pitch is what happens globally as well. I think even the U.S. markets (the kind of volatility we are seeing). Usually, this kind of volatility is seen when some kind of a top or bottom is formed. So, we have seen a severe correction from the top in the U.S. Again, it is not our job to predict tops and bottoms. But I think, usually this kind of volatility precedes settling down and some kind of a bottom being formed. But, there are imponderables going into 2019. We don’t know what is going to happen. Whether China and the U.S. would settle the trade dispute, they have a March deadline, whether the Chinese economy will slow down dramatically.

There is an after-effect, whether the Fed will finally relent and talk the language that the markets want them to talk. But these are all imponderable going into 2019. As portfolio managers, our focus is to cut out all this noise and focus on companies which have durable earnings growth and where the risk-reward is still favorable for investors to make money.

There are certain secular growth stocks that we want to continue to own. Now clearly, these are stocks that everybody knows are doing quite well. Therefore, it is hard to assume that any PE multiple expansion is possible there.

What you’re playing for is earning growth. And if you believe that there is visibility for earnings growth in those companies, those companies will compound at the rate at which earnings are compounding for them in over the next couple of years. The real interesting challenge is to find companies where we think the balance sheets are very strong. These are relatively larger companies but where they are doing something very specific or we believe that the external environment for them is getting a little favourable. And we think the rate of change is likely to be significantly different.

Let’s say corporate banks where we think that they are trading at cheaper multiples than retail private sector banks. I’m not saying retail private sector banks won’t do well (They will continue to do well), but they are priced for the fact that they didn’t have an NPA cycle. And the corporate banks were priced for the fact that they had to go through a very severe provision cycle in the past. That’s where the rate of change would be different. Or, for instance, we recently invested in a capital goods company where the company’s last peak earnings were in financial year 2012. Thereafter, we’ve only seen a trough in earnings. We believe that probably, over the next two years is when they will potentially cross the previous peak that they achieved six years ago. So, you have to look for companies which are generally well run but have gone through a tough cycle and where the external environment is likely to improve for them or they are doing something very specific to their strategy, where we think that the rate of change could result in a re-rating and earnings growth momentum. I think the challenge now is to find those ideas because what is already growing at 25-30 percent is discovered and priced for it. Therefore, for you to make incrementally significant alpha might not be that easy. But, at the same time, if there is a long-term growth in those companies, you want them in your portfolio. The challenge now is to be a little more innovative and look for certain non-consensus ideas in the large caps and larger mid caps where you think incrementally money can be made.

So the one stock in large cap where we’ve taken a slightly contrarian view and which looks interesting is Bajaj Auto. In the two-wheeler space, people have preferred TVS or Hero Motors earlier. Bajaj has not done anything in the last several years in terms of stock price performance or incremental growth in profitability. If anything, they lost market share.

Early this year, they changed their strategy. They have gone after market share and we are beginning to see that play out in the numbers where their domestic sales are picking up at the entry level. Plus, they have a fairly good exports market franchise that is also growing quite nicely. The three-wheeler business is a cash cow. They may be one of the first few early entrants to introduce electric vehicles, two-wheelers as well as they have mentioned, and the stock was trading at 13-14 times one-year forward when the entire market was trading at a substantial premium to that right.

Now, nobody priced the stock for growth and there are people who are still skeptical. If your thesis is right, your hypothesis is right, your probability to make money is much higher in something like that than to bet on a consensus trade today and hope that you will make disproportionate money with quality. I think, whether it is things like Bajaj Auto or whether it is the corporate banks, you have to have a good mix of the portfolio. They say that the leaders of every cycle is different. You don’t have to be stuck with the leaders of the previous cycle.

There are some stocks which lead in every cycle. But, those are a few exceptional companies. For the rest of the portfolio, you have to think hard and look at companies that will leave the next cycle. I just used Bajaj as an example.

Disclaimer that we own it and they should consult their adviser and do their own research

For us, we don’t think top down as to what weight we want in financials or consumer or whatever. It’s the aggregation of what we have in the portfolio that shows up as the weight. We may have reduced exposure in private financials but added some other exposure in them. So, the net exposure probably remained the same but the structure might have changed across names and that continues to be a large opportunity. There has been such a big dislocation because of PSU banks that it’s a golden opportunity for some of these companies to take away market share, which will continue. We are still an under-leveraged economy. Corporates were over leveraged, but consumers were still under leveraged. They are getting more leveraged now as we go ahead. Corporate leverage life cycle might also restart again, once the NPA cycle is away. So, financials do offer a lot of opportunity. There are a lot of companies which are very interesting, and it’s a natural area of growth in India. So, there will always be some secular bets that you will continue to make there. In industrials again, when you think that there is a new area which is going to emerge, the idea is not to go head long. You test out your hypothesis, and if the trend is long enough, it doesn’t matter if you get in a little late. You don’t have to be early all the time. But we think there is a chance that selectively, in capital goods, in industrials there is money to be made because all other sectors have been overweight. For us, its purely a bottom of stock call rather than a top down sector call.

The NBFC story is no different than other significant thematic moves that we have seen in the market from time to time. So, I think the version 1.0 of the NBFCs is over. It culminated with the IL&FS crisis. You have a sector where every player is growing, and the people in the initial stage do not differentiate among the good, the bad, and the ugly. To give you an example— pre-2007-2008, when retail was a new industry in India, everybody wanted to set up retail stores and the market was giving valuations based on how many square feet you have. It’s like giving you valuations on eyeballs, or on square feet, nobody bothered about inventory returns, margins, free cash flow. And then the sector went through a very difficult time period, from which emerged version 2.0, which is the winner. So, the guys who were doing the business the right way, who didn’t get busted because of too much leverage on the balance sheet, and after a brief period of consolidation, the next survivors broke out and then started to grow again. I think something like this is likely to happen in NBFC as well. Version 1.0 is over, where the growth was the single biggest factor, under premium, nobody focused on what the liability makes, whether there is a mismatch, what is the underlying credit quality, nobody was asking those second-level questions. Now that the crisis has happened, I think the men and the boys will be separated. There may be a period of consolidation after the sector corrects severely, but from there will emerge the leaders and they will continue to grow. I think the sector will still grow, like technology has grown post 2000. Just imagine how many tech companies were there pre-2000, when 1.0 was being played out and how many have survived and grown post that? The same, as I said happened in retail, the same is going to happen in NBFCs.

Everything. It’s just not one variable.

Yeah, that’s always the case. I think you get to understand these things only during a time of crisis. As Buffet put it, “When the tide turns out, you know who is wearing clothes and who’s not.” Also, what happens is that, through successive cycles, whether these are regulatory headwinds or external headwinds, that is the time when these things show up in numbers, and that is the time when the strategy, the execution is different than the vision because everybody has the same vision. If you look at a powerpoint presentation of any NBFC company, they will say. “Oh, you know there is a massive growth opportunity, there is so much under penetration.” But the difference is not in the opportunity, everybody understands that the opportunity exists. The differentiation is that how do you execute the opportunity, and how do you not get busted by the time you go from being a small player to a significantly large player in that business. The beauty is that, in India, the external opportunity for all the businesses is so great, whether it is retailing, financial services or the consumer markets. But it is only over time that you are able to differentiate who is executing on that opportunity, not getting busted, maintaining a certain growth rate, a certain discipline in capital allocation, in free cash flow. I think to some extent, these are times when you have to look in the mirror and say, if you have the right bet or is it is still not late to change your bets because version 2.0 will go on for a very long time. The better you are sitting on the right horses, than the wrong one.

Absolutely! And its good that you brought this up because when a stock falls, people tend to do one of the two things. Either they freeze and don’t do anything about it or they add to their investments. But there is a third thing that you could do and these things typically happen when you have a secular fall in the market—where the breadth of the market corrects like it happened recently and then you have alternative choices. So you say that my stock has fallen but there is something else that I didn’t own which has also fallen. Now, can I do a risk-reward and say that probably this is a good time to switch from A to B; you don’t do it for all the stocks but you certainly do a critical analysis because something that you liked may not have been cheap at that point of time therefore you bought something else. But now that everything has fallen, so you have an opportunity to say both A and B have fallen; you wanted to buy B but you have A and this is the time you can probably switch if not all, in some of them. That is what I call a reset mode. You have an opportunity to reset your portfolio as well. Where you think you have the conviction, you hold on, you add to your positions and ride the volatility and that’s the way to play it.