Alpha Moguls: Ayaz Motiwala On Why Consumer, Financial Stocks Trade At Higher Valuations
A strong portfolio must comprise companies that have withstood the test of time because high valuations that are also sustainable aren’t built overnight, according to Ayaz Motiwala.
Stocks of certain consumer and financial sector companies trade at stratospheric valuations for a reason, said the senior fund manager at Hong Kong-based Nivalis Partners. The reasons can be attributed to the companies’ performance relative to their counterparts, he said in the latest episode of BloombergQuint’s special series Alpha Moguls.
One of the key reasons consumer stocks trade at rich valuations, Motiwala said, is that investors have tried their hands at other themes and burnt their fingers, while the portfolios of those trading in the richly valued names have grown.
Watch the full interview here:
Edited excerpts from the interview:
You sit offshore and invest in India, probably have India interests now as well and therefore the returns you get might be different due to the currency impact. Taking all of that into account and looking at what we have done over last 18 months, how are you looking at investing in India currently?
It was a big relief to get high returns in the last 18 months, especially coming from the ‘pedestal’ gains witnessed in 2015-16, with some money being made in 2015 and some negative annual performance in 2016. So, now people thought that the economy was indeed turning around. There were also global cues. All the markets went up in this region, anywhere between 15-40 percent, which was in line with some of the Indian indices, especially the small cap funds. The large cap indices also did well.
This led to Indian companies getting expensive on headline valuations, both for large-cap stocks, and more particularly for small- and mid-cap stocks. The market was not discerning. But in the first six months of this calendar year, markets became discerning again. You could attribute it to specific events such as the Budget bringing back long-term capital gains or the lag effect of Goods and Services Tax, saying the revival is indeed not there, the tax collection was not as high as expected. Investors took action and booked profits. This led to separation of a deserving businesses from a not so deserving one.
We often get asked about why certain businesses are so expensive for a long period of time. Now, we are getting into the 10-year anniversary of Lehman as we speak. September 2008 may sound either distant or very recent to people depending on how they got impacted by the whole event. If you look at the 10-year numbers of the same theme of deserving versus non-deserving businesses, we had periods in which the market was excited and then it was aghast at not getting what it expected to get. Similarly, it is back to the deserving and non-deserving phase for the Indian markets.
Do you think the market has been correctly discerning?
Participants always move into the sectors, where we saw a little bit of shuffle, along with the technical factors. We had India-specific issues such as SEBI’s re-classification of mutual funds on what is defined as a large, mid and small cap stock. Overriding those technical factors, investors held back a bit on to see the numbers for a bit and let valuations show up a little bit of discount to what was prevalent in January-February. And now we have got numbers for two quarters for some of the businesses which were expensive and indeed got corrected by 20-30 percent where the market participants said it was enough.
Or there’s the relative option on two levels. First is equity in relation to other asset classes which is the motherhood argument of financialisation about mutual fund trends in India because real estate, fixed income did what they did, and were not attractive in relative terms.
Or there’s the relative argument in businesses itself in stock market and equities where for long periods you can clearly see whether it is financial stocks, consumer, pharma, or IT services, or a host of other businesses which have growth opportunities, they are self-funded, they are quality in nature, they have clean balance sheets and those have created serious long-term wealth. We have enough data and studies which show that over long periods of time these have created serious wealth for investors.
These businesses that you talked about are self-funded, tax paying, with good cash flow generation in most cases and have created clean balance sheets. Do you think that trend of market rewarding such good businesses disproportionately will continue five years hence as well? Are you betting on such businesses?
Yes, because if you were to look at a forward scenario, talking about external macro headwinds that we have talked and read about, in that scenario if you were to take some headline negatives such as the U.S. rates and thus the world rates which are going up, oil being in a challenging situation and so we have this imported inflation as a function of rates and currencies. You would want to own businesses which are less challenged.
In a construct over the next 12-18 months, where you have an impending election too, looking at a past 20-30-year pattern you know that the government in power would be focused on finishing the existing business and not taking on anything new. That's a lull scenario as far as big policy announcements and measures are concerned.
With such a picture in place, you would want to be in a better boat to ride up upstream in a challenging macro situation. This means managers would look for businesses which will not be much affected by these external factors, and can achieve the same kind of cash flow and margins. We have to go down from these high-level discussions to the brass tacks which we are focused on as bottom up investors and find out businesses which meet that cut. That is a constant exercise that we do where our philosophy is to own companies which are self-generating high cash flow, have clean balance sheets and a growth opportunity. And what we are paying to purchase those type of names.
The market is characterised by one particular behavior. Around 15-20 stocks in India, if not the world over, wherein there is substantial premium, be it financing companies or consumer companies where the PE multiples are upwards of 50 times. Also, the money which is buying these names is not necessarily short term or hot money. They have thought about why are they investing in these companies. Does this get build over a long period of time, and therefore, one is comfortable parking this money?
Yes, it does gets built over a long period of time. Around 10-11 years ago, some of these businesses had the most attractive points in relative terms, even just before the global financial crisis in mid-2007 where the consumer businesses as an aggregate was always trading at a premium of 1.5-1.7 times the Sensex multiple. To put that in numbers, if Sensex traded at 12 times earnings, these traded at 18-20 times of earnings, which were the expected numbers then and now we are 60-80x, and people are flinching on it.
Other businesses which were the flavor of that bull market of 2004-2007 were real estate and infrastructure businesses. That was the best relative opportunity at an absolute basis where the premiums had contracted more like 1.5 versus 1.7 and post which, we had the Lehman related sell off in the market where everything got painted with the same brush. Most of the stocks, including the consumer and IT services type names, fell 40-60 percent and non-deserving businesses fell a bit more. That was the less attractive opportunity versus where your money was better placed looking in hindsight on a 10-year basis.
As you rolled forward from there, we are sighting history 10-11 years back, you had the recap year whether in region or Indian context where lots of real estate and infrastructure companies of the big names raised a ton of money. The investors got excited. Some of these stocks made a comeback. We had this pause because every time people want to see the delivery and the macro vacuum and the upcoming elections overtime did not really happen and we went into lull.
Regionally, we had a massive sell off in 2011-12 but India started recovering early 2012. Again, we had a low point before the announcement of Narendra Modi as a Prime Ministerial candidate for the BJP up to August 2013. If we look at that and overlay what the investors did, I don’t think these Indian businesses, the 20-40 names, which are aggressively valued were pushed to these numbers on an immediate basis from point one to point two. It has been a process of gradual outperform or relative outperform and get valued.
So, there are a lot of forces at play. We had one massive force from March 2009 till today, which people call it QE Infinity, etc., where the interest rates have gone to zero globally for a long period of time. That force has been a constant add factor to that multiple expansion where financial asset prices whether in India or internationally have been pushed up. It was meant to be for industrial action like infrastructure and investments in America but that didn’t happen.
The second is the relative option for investors on equities which have kept drying up and we became a very narrow market. Investors have been pushed to corners saying where are the earnings, if indeed, and where are they growing. So we obviously had IT services coming off from 20-25 percent, but they still have 8-12 percent earnings growth. They have high ROE companies and services companies, so are consumer companies which have high dividend pay outs and outsourcing model in place.
The pharma had another beat to it in intrinsically high ROE companies. So, you have some consumer-facing financial companies doing very well. In their case, you have wounded state-owned bank infrastructure and not lending which has come to bear later but you could make out intrinsically that the business was challenged. To name some big names like HDFC Bank and others, they have constantly lent and grown book at 20-25 percent earnings in that range because they have effectively taken market share. There was a ready market to be taken up on the corporate banks and consumer facing other businesses within these banks where they have gained again.
Second is relative search for earnings that push investors into bumping things up. Third is, you bet on some things during that five-year journey from 2013 to 2018, and the recovery has been elusive. In May 2014, we have euphoria and you have another bout where investors painted everything with the same brush, you again had a relative opportunity, looking in hindsight, where if you have betted on these 40 companies, four years later you could be smiling like roses, whether it is HDFC Bank or Bajaj Finance, all these are names in hindsight or some of the mortgage finance companies, or you look at Britannia or some other such names which have done exceptionally well. They have done well and got earnings growth from 15-20 percent in a very challenging economic environment where consumer volume growths have disappeared or come down to 2-5 percent.
Investors have rewarded these firms because they have seen nothing else being there on deliveries. I think its been this long period where there is built up of hope and then people bet on it and then they have been disenchanted as the numbers don’t come through. Like they bet on state-owned banks, real estate recoveries. There are always arguments that these recoveries or break out or the RERA have come and volumes had disappeared.
With that argument these businesses have constantly been pushed up over the past 10 years. If you take a consumer pack like Dabur, HUL, Godrej Consumer and the MNCs included such as Britannia, Nestle, etc., they traded at PE multiples and PE premiums of 1.5-1.8 times or PE multiples of 18-25 back then. Now they have clearly doubled the number, if not more, in one year forward or two year period.
If you were to take a large serious bet right now, would you take that on these companies?
It will be bottom up combination to start with as an argument. We will work hard to search out for values within that. We are trying to do it in two-three types of buckets within the businesses which have delivered. We think we have the luxury of quarter of the portfolio which can be very long dated, and we pay up for it. So, we buy some of these names expecting that they are expensive, but we trade it off with the surety of achieving earnings growth and achieving certain RoE and dividend payout. It is one way to do it. That would be a third of the bucket.
The other end of it where we are saying that we will put new names into our portfolio which we are assessing, they mean the basic cut being certain return of capital criteria or return on equity criteria or a return on equity criteria of saying that these businesses cover in the cost of capital and are good to cover growth capex which is self-funded.
So, they meet their criteria but have shorter reported history, either they have recently come out with an IPO, or they are coming into that fold of higher return of capital only recently. So, we put them on the sword and buy with the faith that these will make it beyond the 40 businesses. If they deliver, then we are onto something big. These are sort of upcoming businesses which have the potential and have come to fruition which are turnaround to base. So, they were earning sub-par which is why there is relative valuation opportunity at the other side.
It could be two quarters or two years, where the numbers have come through. But it is a flicker of hope, a two-year phenomena, which is a short period to be getting excited and carried away by it. It has its own risks and challenges. Effectively saying that there is a turnaround on returns in businesses which were making below cost of capital, let’s say, 12-18 percent and are now making 18-20 percent. We have done assessment that it is not because of favorable external commodity or a macro situation or drop in interest rate on EPS, but because the businesses improved meaningfully, and they have done things like launched new products, etc., and so we want to bet on them that they will carry on this with good work. So, they come to a high perch and remain there. That’s the second bucket.
The third bucket is more challenging with businesses which delivered good performance in the past. They have had challenge on growth and the best example is the IT services companies. You have got that opportunity.
I will classify this opportunity in that 12-month bucket like you have got the pharma opportunity again. You have the largest pharma company halving (returns) within a short period of 18 months or less. Those are stand out opportunities for us...These stocks came out because people who were doing long dated discounted cash flow was suddenly wondering where the growth and the terminal value is because margins were collapsing. These are businesses that have done great stuff in the past.
Partially, some of the old heavy-duty consumer names such as HUL were struggling to deliver numbers. They are doing phenomenal volume growths in early double digits and cranking more, recently in the last two quarters. That opportunity is there which is some sort of turnaround which you are playing. But the baseline would be that even in tough times, the growth of Infosys, Wipro, TCS might have come off but their baseline RoEs meet your 3-5-year minimum track record...
The big guys are now getting modelled at 12-15 times and the midcap names which are trading at a premium seem to be back to growth years because their sizes are under a billion dollars and they have a growth opportunity. Those guys are trading at mid-20s now. The market keeps giving you these opportunities. Some of these names on a one to one-and-a-half-year basis in August have more than doubled. Some of them are recent IPOs. They were at 10-12 times earnings, 30-40 percent RoE companies, great pedigree slightly smaller in scale.
And the question was will it be able to pull it off. Now, it seems that the markets have gone to the other end, whether they are saying not only they are pulling it off, but they seem to be the digital champions. So, if you talk about L&T and the Mindtree of the world, those are trading at premium.