Don’t Try To Avoid Value Traps, Says Kenneth Andrade
Veteran asset manager Kenneth Andrade on how to identify stocks at the bottom of an up-cycle.
In a bid to invest in stocks that give the maximum returns, investors often fall into a value trap—where a promising stock fails to rise as expected or falls further. But don’t try to avoid them, says veteran asset manager Kenneth Andrade.
“As far as value traps are concerned, don’t try and avoid them. They will be part of the processes,” he told BloombergQuint in an interview.
A value trap is defined as a stock that appears to be cheap because it’s trading at low valuation metrics such as earnings multiples, cash flow or book value for an extended period. But often, the stock continues to languish of drops further once investors have bought into them at low prices.
Andrade also spoke about reviewing portfolios, why large-cap stocks will dominate the market in financial year 2018-19 and how to play the rural theme.
Here are edited excerpts from the interview:
Do you think the investing climate and the way people would invest over the course of next 12-24 months would be vastly different from the last 18 months?
You are moving from euphoria to uncertainty, from a period of surplus liquidity to slight caution. The two situations are completely different. The mindset will change. The mindset today is to not look for pockets of opportunity, which was the mindset 18 months ago. The mindset today is to navigate these pockets of uncertainty. High price earnings multiple stocks are giving way, slightly dodgy business models are not doing too well. All of this comes in once the liquidity is slightly uneven in the entire system. That’s what we are seeing over last couple of months.
You must be loving these times? You said that you like stress in the system.
From an investment environment, it is great. But no one wants to see their own NAV go down. That’s the absolute truth. We have been used to, over last 5-6 years, unidirectional movement in indices and NAV and ability to make money. Today you are getting a consolidated move. Whether you are a great fund manager, or you are a good stock picker or not, you have those pockets which exist in your portfolio which you want to revisit at points like these. So, it is business as usual and it is a little bit fun right now. You get time to do what you wanted to do and in a practical sense make your portfolio more robust in a couple of quarters or years.
When you say you get the time to do what you want to do, is this because there is price and time correction happening and the opportunity is not running away?
In past experiences, we have seen lot of markets correct themselves and come back. But in most portfolios what you have will be material and you have to wait for it to come back. You can’t go into a cycle. In the last cycle, you had this large infrastructure rally which took place and in the next cycle infrastructure refused to come back. It’s nothing to do with stock prices. It happens in any industry or business where you have massive euphoria taking place and a lot of capital gets accumulated in that entire system. The guy who gets capital, uses it most efficiently. But at that moment the valuation is stretched out. Once the environment consolidates itself, some of the bottom end of the businesses refuse to come back.
What is important is where your portfolio is positioned for it to come back. Most professional investors make a mistake of staying with legacy companies. That is the only way to navigate an environment like this. We rely on arbitrage of capital efficiency. So, any business that requires enormous amount of money to grow or it demands incremental of capital to grow, is going to be less efficient as time goes by which means that return on capital employed or return on equity will go down because the denominators bloated up any expected returns of over a period of time. That is the space which we try to avoid. That is the space where lot of investors have polarized capital around. When I say we need to revisit most of our portfolios or try and establish incremental amount of conviction in most of the portfolios, that is necessarily why you have to open up entire portfolios. There is high probability that you will still like them. That’s why you increase the conviction and ride into the sunset, as they say.
The macro is not looking favourable because of what oil has done. The GDP numbers seems encouraging. The GST collections have missed the mark but have shown a trend of improvement. How are you looking at this piece of the puzzle for the next 12 months?
We have come from an environment where the macros were extremely good and micros where weak. Today,the micros are better than what they used to be in last five years. There are hiccups on the macro side. But that is not unexpected. Last year, everyone talked about the elections. When we went into Budget this year, we slipped on the fiscal. Then you have the joker in the pack – oil. This is something which we need to navigate through. And it’s a commodities cycle and commodities do weaken over a period of time. This is just the process. I am not worried about the macros in near term.
In the near term, you have got elections coming up. Even if you have fragmentation at the centre, the worst-case scenario that takes place, it will still be stretched by a year or two. Unlike past, the micros are very robust. Banks are cleaning up their legacy assets from 2013-14 and there is nothing new which has come up in their books. Companies don’t have too much debt on their books and they can navigate. First thing you do is to look at company balance sheets and they are sounder than they ever used to be. So, that is the opportunity which we look at. How we will price this asset is the question which we are looking to establish. Last year, micros were trading 21 times forward. Today if you look it is close to 18.5-19. So, you have seen derailing of equity as asset class. Growth coming back to cycles, markets are de-rated themselves. So, this may be a 2-3-year process.
It is very important to look back at what is your portfolio construct. Are you in a business opportunity which is consolidating? Incremental growth of ROE will be superior with enough growth. All of this will come if the industry is not competitive or it is not fragmented.
Are you echoing the same thing that I have heard from so many people that financial year 2018-19 will be the year of large caps and just forget the small and mid caps? Why bifurcate companies through market cap and why not look at balance sheets, return and how the return ratios would work?
Even in the large cap space, it is not uniform across the world. So, you take 20 companies in large caps which are doing well and 20 companies in mid caps which are doing well. Large caps will dominate because you will have a slight polarization or recalibration of companies. But opportunities still lie in the bottom end of the market. The growth momentum, balance sheets are there. All you need is to give it time.
Somebody said recently, 60 percent of stocks have corrected by 20 percent at least. Some of this correction is due to the recalibration process that SEBI has imposed on the mutual fund industry. That will reverse when this whole recalibration is over. Would you subscribe to it?
It is always difficult to predict liquidity. Last time, everybody did expect liquidity in mutual funds to continue. For last 4 years, everyone predicted that earnings growth will come back and it never did. Now, all of it is coming to play. At the end of the day, you have to look at numerators of equation which is profitability. If profitability comes back, then you see demand coming back. As investors whether we are smart or not so smart, we all look for efficient assets. A 10 percent interest rates yield is better than 8 percent. We understand that characteristics. Earnings have actually bounced back, and profitability is there. It doesn’t matter whether you are in small, mid or large cap. You will essentially come back.
Are you deploying your gunpowder in stocks which are likely to give higher dividends, or buyback because of free cash flows? Or you will be happier to look at businesses wherein the free cash flows are moving up, but they are also investing some of the money back into capex because business momentum will be taking shape in 4-5 years?
The best business is the company that grows, deploys capital and is still free cash flow. That is the ideal scenario. Hopefully it ends at 10 times earnings. But that’s not the case. So, you have to segment the ratio to figure out where is your comfort level. We like growth. Our business is about taking smaller companies that be scaled up. We have to buy them at the bottom of the industry cycle. When you get in that environment, you want growth to kick back. Otherwise, we can buy a very valuable company and if growth doesn’t come then there will be value trap for a very long time. So, you need growth to kick back for value to emerge. That’s the underlying basis of why we try and pick scalable industries and participants who are going through that downcycle to form a part of our portfolio.
When do you get the conviction that I am very comfortable putting the money to work in small, businesses because they will compound capital over a period of time? The common refrain could be that the larger business is more reliable as they have proven track record of performance which some of the smaller ones might not have. How are you getting this conviction?
What we need to do is buy companies will low price earnings multiples and buy companies which are growing. Once growth gets established, assuming the company grows at 25 percent in five years, that is 20 percent CAGR that you expect on the stock price. But if you look at 20 percent CAGR in earnings, your multiple starts moving. If your multiple starts moving from 10 percent every year and you earnings are compounding by 20 percent every year, you have both levers working for you.
Industry should absorb this kind of growth rates and the company should be able to get incremental amount of market share every year into that vertical. So, you establish the size of the business. You invest in the company which gets incremental amount of market share every year, which means they have got a product, client base which is growing very fast and probably more than the industry is. That’s how we work it together. To address this situation, you need to balance this growth which is why we look at cash flow positive business before we get there. Because growing balance sheet, market share is the easiest thing to do. You can always buy market share.
You said that one more pattern that you are looking to do is the identify leaders of a cycle and pick them up when the next cycle is coming about and when they are just starting off. Are you doing that actively?
Both are correlated. There is very little difference between the two. You get a small company in small industry and then the industry goes mainstream and it grows significantly large. In numerous situations, we have seen something like this happen. The guy who is tiny as the part of the format becomes industry leader with a sizable business opportunity.
You mentioned that the good business industries which are large are hitting fresh lows currently. Can you explain it? Do you believe that there are some investing opportunities at all? As they are large industries and they are hitting lows right now, then there must be some problem which the company and industry is facing.
We have mainstream businesses and they are all capital-intensive businesses post 2008 hitting lows for almost a decade. You have the pharma business stocked about three years back and we are all waiting for the revival to take place. The corporate lenders have not seen anything happen for extremely long period of time. The new construction or engineering are completely news businesses from what we have seen in the last two decade. So, this is the evolution of business from the last decade to this decade and it will continue to happen to the next decade. At the top of it, we have found that 80 percent of entrepreneurs are very capital inefficient. They effectively destroyed their balance sheets.
Are they any of these which will make value trap? With the fair degree of conviction, do you think that the turnaround might be underway or will start very soon?
You have to look at bottoming it out and then watch them as they turn around. As far as value traps are concerned, don’t try and avoid them. They will be part of the process. As far as the catching of the cyclical part of the entire market, last year you had lot of commodity [stocks] form the bottom. For last 3-4 years, the pharma business is going through a rough patch. My sense is there are some years where lot of capacities will give up into the system. Then you will find some stability as you turn some metrics around. Technology is at mid-point. So, they have based out getting market share incrementally which started happening back again. So, you have got elements of all of this happening. We have done large portfolios of companies with large rural footprint. That has also mainstream. There are some very small businesses which are at bottom of cycle. We continue to look at venture out there with incremental amount of capital allocation. On the large ones, we did mention corporate lenders are still at the bottom.
You don’t like financials, right?
We stayed away from it.
Are you looking to turnaround that for corporate lenders or something?
For financials, it has become a stock picking market. Either everything is in distress or everything is high in terms of price earnings. We find 1-2 companies sitting in the mainstream with opportunity to scale. We are actively pursuing it. From allocation point of view, it won’t become material difference for the underlying portfolio. It is the company which sticks out in the portfolio, but it will not make material difference in portfolio.
Is the hunt for compounders still on to put large sum of money to work or do you believe lot of that part is done?
You will get large franchises coming up in this country and in lot of spaces where we have not scaled up dramatically. Over a long-term period just because of sheer size of population, the consumer franchises will go from strength to strength. I can see myself participating in some kind of markets. There are lot of industrial names which will join that part of the market. I can’t see us not being there. You got to build in blend of both these businesses. At some point they will be large compounders also.
How will you put incremental sums of money to work? Are you taking a particular theme or are you happy investing in high multiples too?
I look for safety in valuations and may not look for safety in companies which are good companies and trading at high valuations.
Did you sell some of the agri-related exposure?
No, not a significant chunk but there is incremental churn that happened.
So, you are bullish on rural theme?
There is lot happening there. We have to see how these companies execute.
How are you now looking to play rural theme?
It is not different from where it was 1.5 year ago. Our underlying premise of that environment is if you believe in secularity of growth in India at 6.5-7 percent of GDP growth, the large beneficiaries over the last three decades have been 30 percent of population which is urban, and the 70 percent is left to manage on subsidies and weather gods. The metrics could change in next decade.
You bring 70 percent of the population in mainstream consumerism because you have higher income growth which will get into it. So, that is the big picture scenario. In India, we have got such a large population that anything and everything will sell out. So, there is demand for everything. But we believe that without income generation you can’t have sustainable growth of the economy between 6-7 percent. You have to push that part of the world to grow at 10 percent plus. Then you have to start investing in it and it is going from government balance sheets. So, government balance sheets will fund that economy to create a regular income stream. For it, there are number of policies. If you break each of them, you will find tiny opportunities.
We have seen some which has potential to be 3x and 4x per year. But the numbers all add up. The companies that are existing in that ecosystem might be fairly priced. But they have got financial muscle as they have non-leverage balance sheet and they have existing capacity on their books. If everything falls in place, then India’s 6.5-7 percent sustainable GDP growth can continue. Others will have cyclicality which have been there historically. You do very well some time, then you fall off the cliff and you come back again.
Watch the full interview here.