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Alpha Moguls | Place Your Bet On A Quality Management, Says Sumeet Nagar 

The Malabar Investments Founder shares his investment mantra including his two top picks right now. 

A man carrying a briefcase walks in front of the Bombay Stock Exchange. (Photographer: Prashanth Vishwanathan/Bloomberg)
A man carrying a briefcase walks in front of the Bombay Stock Exchange. (Photographer: Prashanth Vishwanathan/Bloomberg)

Quality of the management is one of the key aspects to consider before investing in a business, advises Sumeet Nagar from Malabar Investments.

The investment adviser, who bets on small businesses and manages assets worth $600 million, says he looks for four things in the management: strong operating capability, good capital allocation discipline, integrity and a strong second rung.

Malabar Investments backs small- and mid-cap companies with good managements over a long period to get returns. Over 5-10 years, well-run companies end up outperforming the larger peers as they grow faster and their earnings growth reflects in market valuations, he said.

“We are not buying a stock that we think will sell at 20-50 percent profit later. We want to buy the best small and mid-cap companies in India that we can own for 5-20 years. That is a very different mindset,” he said on BloombergQuint’s special show Alpha Moguls.

Here’s an editted transcript of full interview:

How was 2017 and how do you feel about 2018?

2017 was a good year, but it is one of those years when you had a rising tide. If you haven’t done well, then there is a problem. But in a year like that, what tends to happen is all companies move up, all boats rise, and sometime the leakiest boat rise even more. You find that the marginal companies, the more leveraged companies would end up move moving up a lot.

In a year like that, the quality doesn’t matter as much. But at the juncture where we are, and as we look forward, I think the quality will start to matter a lot more. In a year or two, returns may not be as easy to come by. We will not see a run up like we have seen in last year, not with out an earnings revival. Valuations have gone up and you need to digest it. In the 1-2 years, you will see earnings growth might outpace the performance which is healthy and not bad because the valuations become reasonable. In that time, you will find the higher quality companies which are able to deliver better earnings growth are the ones that will perform better.

Do you think the next 12-18 months are the period when the tide moves lower and the leaks are exposed in those boats? Or will the tide stay stable and companies may not fall off too much, but choicest ones will rise?

It is very difficult to predict in the short term. In last one-two years, there are a lot of things that are happening, both globally and domestically, in terms of global macro factors which are happening in the context of change in liquidity, rising interest rates and domestically there is an election coming up. These are some of the concerns, but to offset that we have a domestic economy which is doing well, and global economy which is doing well. So, these competing factors will come into play. What is likely to happen, the volatility which was almost gone because of liquidity infusion will start to come back. You will have these competing factors jockeying for influence.

Do you think the average PE multiple for the markets would come off a bit?

For that, you need to take a step back and look at what has happened over the last 10 years. After the financial crises, you saw an unprecedented amount of liquidity infusion that happened across the globe. So, they infused a lot of liquidity and in many ways, it supported the economy which helps inflation perk a little bit and not allow the economy to go into deflation.

That experiment continued for almost 10 years. It was not a one-shot quick medicine. It is something which went on for 10 years. This year might be the first year when you start to see the liquidity reverse where central banks start to pull out more liquidity than they could in which have an influence on interest rates. That’s why you are seeing global rates or interest rates suddenly rising. It will likely continue and will have its impact on India. If the liquidity infusion and lower interest rates resulted in all the asset prices moving up, then the reverse of it is also true. When you pull on the liquidity and the interest rates move up then maybe the asset prices and valuations come off marginally. Some of that is offset by a stronger global economy. But this tug of war between the two factors will continue.

Can investing in the mid or small cap space yield results that people typically desire?

Investing in equity, particularly in small and mid caps, we have to do that with a very long-term perspective. It won’t come around in the next 1-3 years. We need to have a very long-term perspective. It doesn’t mean that you ignore the short-term risk.

You have to keep an eye on them and respond to them. But the money that you allocate to this, you have to allocate with a view that it will be for the next 10 years. That’s the view you have to take.

Over the very long-term like 5-10 years, the smaller companies would end up outperforming the large companies because they can grow faster. Over the long term it is the earnings growth of these companies which will reflect the market valuation. So, over long period you will see the stronger outperformance.

Even when you look at it from the previous market top which was in January 2008, from the peak the small and mid caps have completely crashed. But even then, if you look over the last 10 years, the small and mid-cap companies have been outperforming. As per last five years’ chart of small and mid caps, when you look at the market bottoms, the small and mid-cap stocks were beaten down at that point of time. Since then the economy and markets have recovered.

The smaller companies tend to outperform and normally quite significantly. We can see massive outperformance. But this is only when you are invested in the bottom of the market. When the stocks are really beaten down, when in the bottom of the market, you want to put more money and time in general, that’s when they outperform in the long run.

But we are not at the bottom of the market, what did you do then?

Even if you look at the previous top of the market, 10 years ago, the small and mid caps were very expensive, probably not the best time to invest. But hypothetically, even when you have invested at that point in time over the last 10 years, they were volatile and went down very significantly.

But eventually they caught up and they outperformed the large caps again. So, over the last 10 years again you will see that outperformance. But you have to be more careful. When the market tops smaller companies and retail investors participate, and lot of emotions get there which is why you see massive bump up in valuation. The reverse is also true. When things go down, it is like a pendulum which swings a lot. You want to be able to respond to it. When you see valuations are very high and you want to dial back a little bit to reduce exposure. Similarly, when the markets are beaten down, there is lot of concern, pessimism and you want to increase exposure at that point of time.

What differentiates you in investing based on research?

The research and its quality, you have to orient to yourinvestment philosophy. So, you have to come up with research, qualities orsystems which are very well aligned to the way that you see the world evolvingand the way you like to invest. We like to see ourselves as owners ofbusinesses.

We are not buying a stock that we think will sell at 20-50 percent profit later. We want to buy the best small and mid-cap companies in India that we can own for 5-20 years. That is a very different mindset. When you keep that time horizon in mind then you focus lot more on quality and the quality comes in form of quality of the business and you understand that business really well and also in quality of the management team. We are looking at companies that we think can compound at above average growth rate for an extended period of time.

They can keep compounding and grow at 20-25 percent year-on-year without needing much outside capital. For that they need to generate enough cash from their own operations, and why would the competition allow you to do that. The only way you are able to do that is that you have some sort of competitive advantage, you can not only sustain but hopefully widen over a period of time and then you can generate enough cash through it. Then you need to be in business which doesn’t require too much capital. That’s where fixed capital and working capital comes in, you can fund that through your own cash flow generation. Then if you keep growing you can re-invest the cash that you generate and that will be a self-propelling machine. What matters is what is the runway of growth that you have. When you have longer runway for growth then you can keep re-investing that capital which can be a fantastic investment for you in next 5-10 years. That’s just the business.

It needs to be managed by the high-quality management team too. For us, in high quality management team we are looking for four things. One is, they need to have very strong operating capability. They need to understand their businesses. The people, the entrepreneurs that we invest in, these guys are so passionate about the business that they run. You want to be able to see it. They need to see how the industry is evolving, what the competition is doing, how I will stay ahead of them.

Two is, they need to have very good capital allocation discipline. It is all good that you are generating a lot of cash but if you don’t have that discipline to deploy that at the right times, and amount then you are not going to generate value.

Third is, integrity. If you don’t have the integrity, then it’s not going to be good long-term investment. You have to find people who have utmost standard for corporate governance. You can see yourself partnering with them for next 5-10 years.

Last is, it is not just one person or one family, but the next level of management also strong enough. They are capable enough and compensated well and given enough responsibility. These are sort of things that we look for and you have to find this combination at reasonable valuation. So,that’s what we look for.

Why did you bet on the business of Safari?

In India, the aviation industry has just started. We are still 1/10th the size of China. So, there is a long way for this industry to grow. People always debate over investing in airlines. But this is a great way to look at the ancillary sectors. As people travel by air and they want to make sure that they are carrying nice bag, so they will buy a nice luggage and take it with them. Then there is tourism, both domestic and internationally which is increasing. There are the drivers of growth for the luggage industry. Also, weddings. Many of these drivers are helping the industry grow at something like mid-teens year after year.

Then you have extra bonanza in the form of backpack. This is the second order effect of the two-wheeler revolution that happened in this country in the last two decades. So, people started travel more by two-wheelers, they realize that unlike the old Bajaj scooters that could put things in front but in motorbike there is no space to take things in. So, the only way to take it was from backpack. Suddenly, over the period of last 5-10 years, the number of backpacks is actually rising rapidly. If you look at numbers of backpacks today, the are an order of magnitude more than what was in 10-15 years ago.

So, that transition is happening. From buying very basic simple backpacks, people are moving to more sophisticated better-quality backpacks which are branded backpacks. All the three players Samsonite, Safari, VIP, all are taking advantage of that. This is a very early stages of happening. Thanks to GST and preference of getting better products, we are seeing unorganized to organized conversion happening in backpack. So, the organized backpack may grow up to 30-40 percent year-on-year. That’s the massive tailwind which the branded players have. Industry is growing at 15 percent year-on-year.

That kind of tailwinds can allow companies to do a lot. Generally, we always tend to invest in industry leader because they are the ones who are most advantaged, have better economics. But in select cases we have picked a number 2 or number 3 player when we find that they are hungrier, they want to grow more, they have something unique and as a result they are able to take market share away and grow faster. We have seen the same thing happen for Sera, they are number 3 market player and solely getting market share. You are seeing same thing happening in luggage industry.

Safari was a number 3 player, it was a distinct number 3 and many years it was languishing. From 2002-2012, there sales didn’t grow but the industry was growing. So, they were losing market share. In 2012, Sudhir Jatia came and took over the company. Sudhir came with lot of experience. Before he took over Safari, he was CEO of VIP, and before that he ran Aristocrat which was acquired by VIP. So, he is the most experienced person in the industry.

He is the one person who knows the industry inside out, whether it is product design, product procurement, manufacturing, distribution. He knows it, he has lived through it. He wants to grow this and make it into much bigger brand and much bigger company. When you come with that hunger, you can see that the company which was flat for 10 years has been growing at 30 percent annualize in the last 5 years.

In last few quarters, it has also started showing in their margins.

It is always bound to happen. There is an operating leverage that comes in a company. When you have a countrywide distribution, there is a lot of costs involved with it. Once you cross a certain level, your margins will start improving and that’s what you have seen in the last few quarters that operating leverage has started to play out.

Do you think this can improve further?

It can improve further. If you look at VIP and their margins, they are still much higher than Safari. When VIP was this size of Safari, the margins of Safari were still lower and now they are catching up and caught up to that level. If they keep growing at 25-30 percent, you will continue to see margins inch up.

If the company is growing at 30 percent, then it is able to increase its margin. Your bottom line can increase quite rapidly. That’s the example of a company where the industry is growing. It is a concentrated industry. So, globally in any country or any region, you only find 2-3 players.

Even in India, the three branded players control 90 percent of branded business. The reason is because it needs lot of space. If you have five different products, with three different sizes, then you have hard and soft luggage, suddenly, you have 30 different luggage and you have to put somewhere.

No shopkeeper will give you that space unless your product sells. So, the branded players have a deep advantage in this space. That’s why globally this industry is very concentrated in any region or country that you go through.

So, you bet on the promoter quality because of the change in management, as well as the growth in the industry at a nascent stage.

So, the industry provides the tailwind. It provides a good backdrop, but then you need somebody who is able to harness that, and I think Sudhir is able to do this well. When you see this type of growth and passion coming from the CEO and see energy across the organization, it galvanizes everybody. It also attracts the better talent of the company too. Over time you build up better and stronger team which can deliver stronger growth in future. That story is playing out for Safari.

How did you end up choosing Hatsun Agro?

India is a very unique country. It has the highest percentage of vegetarians in the world. Even non-vegetarians have a very high vegetarian diet. Milk forms a very important source of protein. As a result, India is the largest producer and consumer of milk in the world. So, milk is a very important industry.

For a long period of time, this was an industry controlled by the cooperatives. The biggest is Amul and they have done a fantastic job. But in many different states you have different cooperatives, they are operating at a different efficiency level and capability level. But the demand continued to expand, and they could not keep up. Eventually, that created an opportunity for companies to come in and start up a business.

Hatsun stood apart as they understood very well that to be able to sell better quality milk, you need to have control of it end to end. So, you have to procure it from the farmer, bring it to your processing center and sell it to consumer. You need to be able to control all of it. Only then you can deliver the quality. Milk with every passing minute before its quality keeps coming down. So, Hatsun had set up the biggest network of any private dairy company in India to procure 4 million litres of milk from 400,000 farmers across southern region, predominantly in Tamil Nadu but also in neighboring states. That’s a lot of milk.

Every single day you have to procure, process and sell. Once you have that kind of network, you have much advantage than anybody else. The denser that your network is, the cost per litre to procure that milk is much lower than anybody else. You can pass on that benefit to the farmer at higher price which attracts even more farmers which makes networking even denser and makes strong network course even further. They have played that game well. As a result, they have the best network of private companies. It keeps developing that network further and keep increasing the advantage further.

This is a company that build an amazing franchise. They have great plans across milk and ice creams, yoghurt business. These are higher margin businesses. As they keep expanding outside of the state, there volume growth is up 15 percent, plus there is milk inflation and other higher margin products. As a result, this is a company which will keep going every single year. People can’t think of any other company where they have this sort of comfort that they will deliver double digit growth for every single year for next 10-20 years.

Do you believe that there is a scope for this to happen for the next 10-15 years?

They have 15 percent of market share in the state of Tamil Nadu and 2 percent market share across the country. They have started from Tamil Nadu, and slowly gone like concentric circles around that. You don’t see them going to Delhi or Gujarat. They are slowly expanding their network from the epicenter.

So, it is like to go from edge of the network, set up a processing plant and in 200 km of radius you get to build a network around that area. That’s how you slowly keep expanding and that’s the strategy that they are following.

Mr Chandramogan is fantastic. He has build this business from the scratch, brought it to this level and even today he has the minute detail of any project that he is undertaking. He can tell you in 2 minutes the amount he is investing, how much time will it take, per litre benefit, and the result of that at the bottom line. That control and ability to understand the business and passion behind it, that’s what we look for.

Are there any new themes that excite you enough to look at them?

Professional staffing is a great industry. On the supply side, you have almost a million people coming to work every single month. Most of them don’t have the skill set to directly get employed in the organized sector. On the other side, you have corporates who are growing, and they need people, but they are concerned about hiring permanent people, especially for non-core operations.

So, there is a classic exchange formula. You have very fragmented supply, very fragmented demand. So, in between, there is a role for an exchange to play. You can get these people, train them and skill them. You can find a way to effectively deploy them and meet the needs of the industry. I think there is a tremendous value which we have there. Then there is skill advantage. To be able to roll this professional staffing services, you need that minimum level of investment in people and systems. But the bigger that we get your operating leverage starts to come in. Over time larger players will continue to benefit from that. So, that’s a good thing.

You are clearly betting on mid-size and small size companies growing multifold over the next 10 years.

Yes. We are focusing on small or midcap companies. We think that companies can go from significantly faster pace than what the market is growing. All of these players even though they are small but in the small nation they are operating they are very strong within it. Those niches are growing at a very rapid rate. As a result, these companies have a strong tailwind and they are able to do a bit better than the industry that can grow faster. As they do that operating leverage comes in, the margins could keep increasing and those are the kind of companies that you will bet on. In many cases, you have first generation entrepreneurs, young management team. They want to work hard, prove something, show results and we want to partner with them.

Do you think that the growth in business will ensure that the return on investments is good enough, irrespective what happens to the market in the short term?

Small-, mid-cap and equity investing, in general, is always volatile. That’s why you only invest money if you think you can invest in long-term. There will be volatility on the way. But over the long term, there is no other asset class which will give that kind of returns that equity can do. Within that, if you are disciplined then you can pick the right companies. Small and mid caps will provide better returns than anyone else. That’s why we are investing in this place.

(Updates an earlier version after Malabar Investments clarified that it manages $600 million in assets and is backed by partners who manage $15 billion)