Dear Investors,
The following chart depicts our returns viz BSE 500 TRI:
In this Investment Memo we will try to cover two broad topics:
How we are mitigating risk of high valuation companies in our portfolio.
Sectors where we are seeing growth and are investing in at reasonable valuations
Topic 1: How we are mitigating risk of valuation in our portfolio
Referring to the chart below, our portfolio's Trailing PE multiple is 31.4x, when compared to the 28.1 multiple for the BSE 500. As you may see, we have moved from trading at a discount to the index to trading at a premium.
The trend is indicative of the run the small and mid cap stocks have seen with respect to the Index. The above thought may trigger a question on our capital deployment strategy for the near term.
We are first protecting returns and preserving capital. We are exiting past investments which are expensive in valuation.
In the last 3 months we have exited/partly exited the following portfolio companies: TD Power (Exit at a TTM PE range of 45-50x), Bharat Bijlee (Exit at a TTM PE range of 40-45x), Ajanta Pharma: (Exit at a TTM PE range of 45-50x), Gabriel:(Exit at a TTM PE range of 35-40x), and RPG Life Sciences (Exit at a TTM PE of ~40x).
The capital generated from exits and the capital of new clients is being deployed slowly and gradually in new names. The deployment of capital is slow and the timeline of deployment of capital is 6-9 months.
Topic 2: Sectors where we are finding investment opportunities:
Theme 1: Rural demand is turning around
In our Oct 2023 Monthly memo, we had highlighted that rural demand was slowing down and had proven the same with some leading indicators. In this memo, we have updated those drivers and have added a few more. It is important to note that for our country to demonstrate ~ 7 p real GDP growth (recent IMF forecast), the rural demand has to lead.
2-Wheeler sales, which is a leading indicator of rural demand, are reviving:
FY 23-25 have been good years for a recovery in 2W demand. Both ICE and EV 2 wheelers have shown a rebound in demand. In FY 24, the overall domestic sales of 2W has grown by ~ 14%. ~ 70% of 2W sales is to non urban centres.
Our deployment strategy: ~ 20% of our fund is invested in Auto ancillaries and in particular ~ 13% of our fund is invested in auto ancillaries having a direct exposure to the domestic 2 wheeler market. The median PE multiple of our auto-ancillary portfolio is 24.7x. We have invested in these companies at a reasonable TTM PE multiple of 15-20x
Rural wages are improving, inflation is tapering, fuelling consumption growth:
Post COVID, the rural inflation remained in double digit while the rural wages went up by early single digit. This led to a significant compression in rural demand. Since the last 18 months, the rural CPI has shown signs of reduction (around 5-7p) and the wages have also gone up by late single digits. If this trend continues, we could expect more disposable rural income. Rainfall also plays a key role in rural demand. With two full years of good rainfall in most of the regions except the North, we are seeing good crop sowing by farmers.
Commentary of Leading Industry Players on Rural Demand:
Our Deployment Strategy: We have been investing in consumer businesses since the last one year. Around 10% of our fund is invested in consumer businesses that have a rural/tier 2 footprint.
Theme 2: Banking has bottomed out
Just like rural, the banking sector took a big hit in asset quality during COVID. Peak NPAs of SCBs went up-to 7-9%.
MSMEs in India have been fragile since demonetization and COVID prolonged the recovery. The situation of MSME banks was no different. Leading MSME banks were running at ~ 10% of their books as stressed. Just like rural, MSMEs are the backbone for a 7% plus real GDP growth of India. Last 2 quarters have seen a pickup in the MSME sector and hence a pickup is MSME credit. MSME is a credit hungry sector for both working capital and expansion credit. We are invested in 2 banks which lend to MSMEs and agri. Both banks have demonstrated remarkable credit and collection prudence during the last 5 years of stress. We have been investing in these banks at a reasonable valuation of 1.3-1.5 x Price to Book.
Another segment in Banking we have been investing in since 2019 is housing finance. We see a longer term secular growth trend in assets of housing finance companies that are responsible/conservative lenders to the non urban population. A reduction in repo rates in the next 2 quarters and the same to provide a fillip in growth to the affordable housing finance companies. The valuation of some of the top quality lenders are near their 50% percentile range and hence are investable at current levels. For more, refer to our June 2024 memo.
Theme 3: Speciality chemicals & agrochemicals are showing a sign of recovery
Post the supply squeeze during COVID, the last 18 months have seen excessive global dumping of speciality/agro chemicals. This has led to reduced demand and a sharp drop in margins across all speciality chemicals companies. Refer to the chart below to indicate the trend:
Based on inputs by industry experts and management, the excess inventory levels have bottomed out and growth in sales and margins is expected to return by H2 FY2025. We faced headwinds of margin contraction in our portfolio companies during FY 24. With companies' balance sheets intact, we believe that the worst is behind us in specialty chemicals. We have an exposure of ~12% of the fund to the speciality and agro chemicals.
To sum up, we are very valuation conscious and the importance of this trait gets magnified in a bull cycle like the current one. If and when correction happens, our portfolio will correct too. The macros for a large part of the economy are strong and hence the rebound should be sharp. Our prudence in promoter selection and valuation will help us avoid any permanent dent in the portfolio.
Please feel free to reach out if you have any questions.
Regards,
Prescient Capital