April 2021 Investor Memo

Dear Investors,

Hope you and your dear ones are doing well. 

Below is our newsletter for the month of April 2021: 

This is a very difficult time for all of us as we face the biggest crisis of our lifetime. The Covid-19 crisis is a generation defining crisis for us just like partition, war, famines, etc would have been for our previous generations. We sincerely hope that all of us are able to navigate this challenge successfully and emerge unscathed. Even though the crisis is taking a big mental toll, all of us are trying to carry out our responsibilities as best as we can. As an investment adviser, that for us means working to deliver the best investment outcomes for our clients during this challenging phase. In order to do that, we are trying to gauge the impact of this brutal second wave of Covid-19 pandemic on Indian equities and managing the risks to our portfolio as well as possible.

Overall our sense is that this time Indian equities should not correct to the same magnitude and as quickly as it did in March last year because of couple of factors:

• We have seen that equity markets correct sharply and irrationally when there is sudden emergence of a risk whose impact is unknown. If a risk is relatively well understood, then the reaction is generally not that severe. Unlike in March 2020, when the business impact of the Covid-19 pandemic was not clear at all and equities globally reacted with the sharpest and quickest fall in decades, this time the market has seen the impact of the crisis on businesses in FY21. So, the risks from this second Covid-19 wave is relatively much better understood by investors compared to last year and it is highly unlikely that there will be a knee jerk and widespread correction in equities this time. This is already evident from the fact that since the onset of the second wave in late March this year, Indian equities have been volatile but have not witnessed meaningful correction till date.

• It is clear from the last time that just like any crisis, the impact of Covid-19 crisis is not uniform on all industries. In fact, this crisis has even created unexpected opportunities in many sectors. There are few sectors like travel & hospitality, retail, media, movie theatres, etc that were and will continue to be severely impacted. On the other hand, there are several other sectors like insurance, pharma, IT, metals & commodities, etc that have actually benefited from the crisis. Most other sectors like banking, auto, consumer durables, cement & building materials, engineering, agri inputs, etc did not witness any significant earnings impact in FY21 because of the crisis. These sectors were seriously impacted in Q1FY21 (April-June 2020) due to the imposition of the nationwide lockdown. However, these bounced back very quickly from Q2FY21 itself and few sectors like auto, consumer durables actually enjoyed significant growth due to release of pent up demand in the rest of the quarters last financial year post Q1. Thus leading companies in these sectors ended FY21 with minimal degrowth as is clear from the sales data of leading auto companies below. Even within the auto industry, it was one of the best years for tractors because the rural economy remained healthy and resilient last year due to lower incidences of Covid-19, strong support by government policies and normal monsoon.

So, it is rational to believe that the second wave of Covid-19 crisis will have a different impact on different industries as was the case last year. Travel & hospitality, retail, aviation, etc, which were beginning to show some signs of recovery in H2FY21, will again suffer significant business loss. Our expectation is that select companies in pharma, ITS, etc will witness some benefits. For example, now that Indian drug regulators are approving vaccines for Covid-19, some pharma companies like Dr Reddys, Cadila, etc that have Covid-19 vaccines in their portfolio will see meaningful earnings from this vaccination opportunity. However, the same sector and companies will not witness identical impact as last time because circumstances in this second wave may be different. For example, we don’t believe agri plays like fertilizers, agrochemicals and tractors will witness the same tailwinds as last time as the pandemic’s impact in this second wave is much more widespread and tier 2/3 cities as well as rural areas have been much more impacted this time compared to last year. It is precisely our job as your advisor to identify sectors / businesses that will do well and also those that will suffer significantly due to this second wave and make investment decisions accordingly.

• It is abundantly clear that the central govt. as well as most state governments clearly do not want to impose months long stringent nationwide lockdown like last time. Several states starting with Maharashtra and followed by Delhi, UP, Karnataka, Haryana, Bihar, etc have imposed localized lockdowns / restrictions of varying intensity this time. However, manufacturing or construction activities have not been banned anywhere like it was during Q1 of last financial year. All states have come up with standard operating guidelines for these and the common feedback from ground is that even local authorities are not interfering arbitrarily with manufacturing or construction activities. Moreover, this time till date there has not been a mass migration of labour like last time. Even though there may be specific instances of some factories being shut down temporarily due to spread of Covid-19 among workers, there is no blanket shutdown of plants and factories this time. So, if conditions deteriorate meaningfully from here on, there is a chance that a highly restrictive nationwide lockdown is imposed like last year but our sense is that the government will only do it as a last option.

• Most of the economic indicators till end of April have not shown any meaningful deterioration:

o   Monthly GST collection was at an all-time high in April 2021 (https://www.business-standard.com/article/economy-policy/gst-revenue-collected-in-april-2021-is-at-a-record-high-of-rs-1-41-trn-121050100471_1.html )

o   Manufacturing has held up in April despite the onset of second wave and local lockdowns (https://timesofindia.indiatimes.com/business/india-business/manufacturing-activity-steady-in-april-despite-covid/articleshow/82380158.cms )

o   Both exports and imports picked up significantly in April this year. Since manufacturing was completely shut down in April 2020, so a y-o-y comparison is not correct but April exports were higher even compared to April 2019 (https://www.thehindubusinessline.com/economy/indias-exports-in-april-rise-197-per-cent-with-growth-across-sectors/article34462983.ece ). Exports growth is expected to remain strong as several international markets like the US, UK, Asia, etc are now out of the Covid crisis and witnessing strong economic rebound.

o   Both IMD and Skymet have forecasted a normal monsoon this year which is a relief for India’s agri economy.

o   Metals, especially steel, are witnessing the best pricing as well as capacity utilization in over a decade. The pricing and utilization levels of Indian steel industry is further expected to improve due to Chinese policy actions like removal of export incentives on steel, curbs on export of specialized steel alloys as well as intense environmental clampdown on highly polluting steel plants, etc. The improving business prospects of the steel industry will have a significant trickle down effect on other areas of Indian economy like power equipment, engineering goods and consumables, power consumption, etc. This is because it is expected that a phase of substantial capex in Indian steel industry will begin due to the onset of the current upcycle. Steel sector is one of the biggest capex spenders in a manufacturing economy. So, the upsurge in metals should have a substantial positive impact on manufacturing especially engineering & capital goods.

• The impact of the Covid-19 crisis on large organized Indian businesses across industries has been much less compared to MSMEs and the unorganized players. Due to strength of their balance sheets, large scale, significantly better management quality, etc most sector leaders in industries that have a large share of unorganized segment were able to wrest away market share from unorganized players in FY21. So, even though the Covid-19 crisis has led to large scale unemployment, severe stress for India’s MSME sector, MFIs, small NBFCs, etc the impact has been nowhere as brutal on listed sector leaders across industries and leading listed banks / NBFCs. Below are a few examples of such listed companies:

Lastly, investors have seen the massive rally in equities from the bottom of last March and are well aware that even if businesses get impacted for a few quarters, they will eventually bounce back and in fact are much well prepared to handle this challenge compared to last time. So we believe that whenever there is a meaningful correction of like 10%, investors would rush into buy into equities providing support to the market

In summary, our assessment is that Indian equity market will not suffer a drawdown as large and especially as quick as the last time but it will definitely remain volatile as long as the Covid-19 crisis persists and even witness 5-10% correction on inflow of any unexpectedly bad news. We will request all our investors to remain calm and not lose faith in equities during such short phases of correction. Also, we believe that markets would undergo time correction due to current levels of relatively high valuation in several pockets and one should expect a much muted market return in FY22 compared to FY21. Moreover, it is highly likely that there will be subsequent waves of Covid-19 pandemic until 60-70% of Indian population is immunized and herd immunity is possibly achieved. So, Indian businesses and equities may be facing a long period of uncertain and challenging environment and our job as your advisor is to manage your investments well through this phase.

Given this phase will most probably be a long and volatile one, this is a much more difficult task compared to last year when the markets recovered from the lows in March very quickly and then witnessed an unidirectional rise over the next 7-8 months. Obviously we have our task cut out this year but we believe that our strategy of investing in quality businesses with good earnings prospects at attractive valuations should help us deliver better than market returns in the medium to long term. We will continue to focus on keenly tracking the impact of the Covid-19 crisis on our portfolio companies and rebalance the portfolio to increase allocation to positions that are less impacted or can even possibly benefit from some opportunities thrown up by the crisis while exiting positions that are materially impacted by the crisis. We will of course also be on lookout for new investment ideas that will do well despite the challenge of the Covid-19 crisis. We might miss some opportunities like we did even last year but we believe if we stick to our time tested strategy of patiently investing in quality businesses run by competent and honest management, we should be able to do a good job for our investors.

Hope you all stay safe and healthy and please feel free to reach out to us in case of any queries / concerns.

Regards

Sonal / Anubhav

Prescient Capital

March 2021 Investor Memo

Dear Reader, 

Hope you and your family are doing well in these testing times.

Below is a chart detailing our performance viz major indices: 

The last one year has been an unpredictable roller-coaster to say the least. In this investor update we wanted to do an annual review of the markets, the underlying sectors and how behavioural biases played a role in shaping the returns the markets have delivered. 

One Year Review

The lockdown came into effect on March 23, 2020 and led to a correction of ~35% in the broader indices. Zoom out one year, the index is up by ~100% from its lows and by ~25% from its pre-lockdown peak values. During the peak of the lockdown, we heard narratives ranging from a 25-40% contraction in GDP, to a 2-3% mortality of the Indian population due to the COVID-19 pandemic. Some experts forecasted a complete collapse of real estate, auto and the travel sectors. While we are not delving into whether the government did a great or a poor job of managing the pandemic, we surely wanted to write about why some of the biases and perceptions were wrong and the economic impact of the pandemic was far less in comparison to what was estimated by analysts. 

1. During phase 1 of the lockdown, the impact of the pandemic spread was restricted to Tier 1 cities. The Semi Urban and Rural India did not see a significant spread of the pandemic. Apart from disruption in movement of migrant labor, COVID did not impact the crop sowing and production. India saw its 5th successive year of record harvest of wheat/rice (up at a CAGR of 4% for the last 5 year) during this period. As a result, the sales of Agri inputs (3 year growth CAGR of 14%) , tractors (yoy sales growth of 20%), 2 Wheelers (yoy down by only 3%) saw a sharp rebound.

2. As countries around the world wanted to de-risk and beef up their drug supply chains during H1 of FY 21, exports of both the formulations (up 18% yoy) and the API (up 9% yoy) saw a sharp upswing in demand. 

3. The lockdown also caused a disruption in the organized and unorganized labor force during its peak (24% unemployment rate in April 2020). The impact however lasted for 3-4 months as a strong demand rebound in auto, chemicals, pharma and IT led to a revival in demand for the workforce. The unemployment rate in March 2021 is lower than its pre COVID value in Feb 2020 (at 6.5% compared to 7.7%). 

4. Almost all of the listed companies saw their overheads (rent, travel, power) come down by 5-15%. A benign raw material pricing further created a cash cushion. This created surplus cash for the companies and reduced the pressure on wages. 

5. During the lockdown, people saved on discretionary products and services. It is estimated that domestic savings went up to 21.4% of GDP in Q1 FY 21, when compared to 7.9% in Q1 FY 20. This savings formed the base for spending in the subsequent quarters. 

6. We had seen a growth of passenger vehicles in China post the opening of the lockdown, as people found it safer to travel in their own vehicles than shared mobility solutions. India followed the same journey as higher savings and lower cost of funding helped people buy new vehicles. If we consider the two months of the lockdown where people could not buy cars, passenger vehicle sales is down by only 3%. 

7. Between March and August 2020, the RBI imposed a moratorium on both principal and the interest payments due during the same period. They also rolled out extra  lines of credit for the MSME and the unorganized companies with a good credit history. Markets initially feared that the moratorium period will permanently alter consumer behaviour and the NPAs in the banking sector could be between 10-30%. As we see the situation right now, and at the cost of not overly generalizing the argument, banks/nbfcs that had prudent lending and collection practices pre-covid, have come out stronger post-covid. Their peak NPAs are expected to be in the range of 2-5% and they have gained a significant market share. 

8. During the same period, the Indian economy also consolidated its fiscal and monetary position. The forex and gold reserves of the country have been up by 22% and 5% yoy respectively. This has helped stabilize the INR. The GST collected is seeing a sharp uptrend and has been down only by 7% (given the economy contracted by 25% in Q1 FY 21). 

Markets & Portfolio Deployment Update

As equity fund managers, we wear the hat of an optimist when the world around is a pessimist, and a pessimist when the world around is an optimist. During the peak of covid, we tried to be an optimist and continued to invest in sectors where growth hadn't been hampered by COVID. In all honesty, while we could forecast and invest in companies/sectors whose businesses were resilient to COVID (in the IT, Pharma, BFSI and Chemicals), we lagged in fully understanding the revival in auto, consumer durables, metals and capital goods. 

The table below shows sector returns and growth during the COVID period. We have taken the BSE/NSE sector indices and companies constituting the index as a proxy for the growth in the sector and the returns delivered. 

Key observations from the above are: 

1. We prefer to invest in sectors with a positive demand outlook. If you look at the chart above, we have invested in sectors (Pharma, IT, BFSI, FMCG) where the demand has been robust or is least impacted by COVID. 

2. We do not understand some sectors (metals, real estate). They have delivered 30% and 10% returns in the last two months, compared to 8% for the broader index. These sectors typically have a low ROE/ROCE profile and are highly cyclical in nature. 

3. Our medium to long term buy and hold strategy generally requires patience over a 1-2 year period, hence switching between sectors and companies to follow a momentum in stock price is tough for us.

4. We continue to focus on sales/ earnings growth and quality of earnings and believe that the same is a leading indicator of sustainable wealth creation.   

April 2021 Onward Lockdowns

We have been keenly monitoring the ramp-up of the second wave of COVID-19. The ramp up has caught the healthcare infrastructure providers and pharma companies by surprise and hence lockdows have been the best counters. While the situation on the ground is changing rapidly, we do not believe that this government can bear the economic impact of one more complete lockdown. From the investing perspective, any uncertainty in this regard will and have led to a correction in the markets. Headline indices are down by 2-3%. From a portfolio perspective, we continue to deploy capital in sectors that are least impacted by COVID. Our incremental deployment has been in Auto, IT and Consumer staples. 

On the portfolio front, we continue to be cautious in our capital deployment and have created reasonable cash reserves in both old and new accounts. We continue to exit companies where valuation has hit top quartiles and the trade off between growth and valuation is not in our favour. Over the course of the next 2-3 months, you will see us exit more such companies in our portfolio. The cash generated will be redeployed gradually into new ideas. 

Prescient Capital

Second Guessing Promoters

Investing sometimes is a tight rope walk between what we think might be true based on our outside in knowledge and what the promoters think is true based on their inside out understanding of the opportunity in hand. In investing in small caps the walk become interesting as the companies one is dealing with are low on public information, and often not clear about the opportunity in hand due to their niche business or their rank in the supply chain. To add to the ambiguity, analysts often seek QoQ guidance from these companies, leading to often heartburn and random pump and then dump decisions.

This blog was triggered by one such discussion on a company that overachieved its growth projections by 18 months. The founders are not super communicative, but are very conservative. As investors, we often tend to stick to a number shared by a founder, and when the company over or underachieves that number, we are in unknown waters. Not many sophisticated market estimate studies or projections can help: A) due to the lack of availability of market data for such small niches or B) just too many moving parts in the business for anyone (including the founders) to understand it linearly.

Such a situation triggers two behaviours amongst us, and this note is more a self-reflection:

1. We think we know this better and start fitting conservative projections and valuation. For me, 4–5 years back, the perfect way to find an entry multiple for such a situation was to project the earnings of the company 3–5 years hence and then back calculate an entry price for a 3x return. Surprisingly enough, that entry price was always 20–30% lower than the current market price, no matter if I do this assessment over a gap of 1–3 years.

2. We shorten our investment horizon to hedge our risk from such ups and downs in the performance.

What I have realised from such mistakes of selling early or not buying at all is that I was not willing to give time/rope to my winners. This is where the non-quantitative part of investing kicks in. I have tried to counter (still learning) such behaviour by asking myself some questions:

1. The promoter is more aggressive than you and will find opportunities beyond the current expansion/ product segment to grow over the longer term. In the longer run, great promoters always pleasantly surprise you.

2. Also ask yourself, given today’s day and age, how can someone small have an insight to his business beyond a 2–3 year horizon. This leads me to ask myself, is this question appropriate for the scale of a business? Can I invest without knowing the answer to my question?

3. It also sometimes helps to start with a little lower allocation to such companies but not shy away from averaging up as more answers come our way. Have learnt this the right and wrong way, your winners ought to be >15% of your cost allocation over time. Else, stop wasting your time romanticizing that some company in your portfolio became a multi-bagger with a 5% allocation. Or you lost a multi bagger, but you would have only put 5% of your capital in it.

4. Lastly, a bit of sanity check is the balance sheet prudence. Even during these periods of ups and downs/consolidation, promoters who do not lose their balance sheet prudence, get a much longer rope than those who don’t.

The balance between procrastinating and reacting in investing

When I joined investing a decade back, I asked a friend what should I do to succeed, he answered wisely “Don’t get killed, because others will”. “With this, you will land in the top 95% percentile”. No complaint, but the balance 5% is where it starts.

The balance 5% honestly is the most difficult and the lonely part. There is no textbook to teach that part. Quite like other professions, the 5% defines you. I haven’t heard a surgeon say, he/she is better than others because he has done no operation and hence has zero fatalities. Unless you don’t act, you don’t act right. The balance 5% makes or breaks you as a surgeon. You are either a good surgeon or you are not one.

The point I am getting to is that, one has to decide what to do as much as what not to do. It’s like one has to invest in 5 things along with rejecting 95 things. It is easier to reject than to select. In this article, I will cover what helps us act and act wisely.

Trust how you feel after talking with an entrepreneur:

Our analytical mind is wired to find holes in an argument to taper things down. True value creators in public markets are the companies that have changed their return profile over a 5–7 year period and hence require an understanding of the founders. If you feel an entrepreneur is different in his approach and execution, it will show up in his discussions and actions. Never let a good feeling die down. Work on it, till the timing and valuation to invest is right. Companies that I have liked have a.) honest and professional management, b.) track record, c.) MOAT and longevity of the business, d) valuation. In a subtle way, they add up and follow one another. No maths here, things just add up. So talk more with entrepreneurs. The ability to stay invested for long with an entrepreneur is a mix of both subjective and objective observations. The same way, never overrule a bad feeling or vibe by valuation. That is wrong. Work on it, to convert it into an objective data or an observation.

When the outlook looks gloomy, find positive data, and vice versa:

Something I have learnt from the last two cycles, when you in the middle of a bubble or a crash, you feel rational. Whereas the baseline of our rationality is by default siding towards optimism or pessimism. During this time, it’s important to take baby steps, reduce your bite size, but don’t exit. More wealth has been left on the table by those who time the market than those who stay invested. As a Private Equity professional, in 2008, we were given instructions to be on a standby on all deals. Not do anything at all. Gladly, I didn’t follow the advice on my personal finance. Have spoken with a few friends post covid who exited the markets at the peak and entered again around the trough and were happy to make 20–30% return in 3 months. While the returns are good, two things happen when you dig deeper and reinvest in the companies you like, a.) your conviction to average up and down improves b.) you concentrate your portfolio towards your winners; both of these improve your IRRs.

The next risk in a business will be the one you would not have factored in, so relax and build some margin of safety:

It’s wrong to be in the virtuous loop of cursing yourself on not being able to predict negative/black swan events. One might lose time and money. Best to absorb it, chin up. Assess if the initial thesis on the business is still intact, if yes, average down, else exit. There are no marks for romanticizing with an idea and your constant brooding will not help a penny in recovery of a company. I was recently speaking with a MFI company, and the promoter nicely summarized his business as the first to get hit come what may, by a new factor every time. He has built his business in a manner to work in crisis every quarter. On the contrary, I also remember having invested in a steel company that couldn’t execute much over a 7 year cycle. We kept the faith in the management, whereas the learning was that between a bad sector and a good management, the sector wins.

People will show splendid returns for 100 companies, don’t feel pathetic, you can only choose a few:

With all due respect, post covid, have been seeing charts on 50 odd companies that have more than doubled since March 2020. Sometimes it makes me feel miserable to have only 2–3 names of the lot in our portfolio. I have, but learnt to ask: if there was a fund manager who had 8o percent of his/her portfolio in these multibaggers, he/she would be god’s gift to mankind. We are limited by our perception of loss (read sunk cost), risk, price and circle of competence. This limits the options and creates an in-action bias. My take: Its best to know your winners and double down on them over time. That will make you successful.

Entry price should be the last thing one should work on:

In my early days as an investor, I used to prioritize companies based on the valuation multiples. While it created inaction bias for the ones which were expensive, it created an action bias for the ones that were cheap or value traps. Dig deeper on the sector, growth opportunity and the management quality before a valuation discussion. Valuation first approach leaves out a large part of the investable universe. I believe that one only gets a really good thing cheap once in 10 years, for the balance one has to pay up.

Pharma: Prospects Turning Bright

If you track Indian equities, you would be aware that the pharma sector has outperformed the broader markets as well as benchmark indices like NIFTY50 in the last few months. The table below compares the performance of the pharma sector represented by NIFTY Pharma index against the main index NIFTY 50 and the more broader index NIFTY 500:

This outperformance has been driven by few factors. The most important one is that demand for drugs has not been hampered in medium to long term because of the Covid-19 crisis. In fact, Covid-19 pandemic being a healthcare crisis has only increased the demand for affordable drugs both in India and globally. There was a slight disruption in drug demand in the domestic pharma market in April and May as patients couldn’t go for doctor consultations during the nationwide lockdown. However, the demand improved drastically in June when the country started to unlock as is shown below:

SOURCE: IQVIA

Moreover, India being one of the largest exporter of generic drugs globally has stepped up to its role of being the world’s pharmacy during this Covid-19 crisis. There has been a surge in global demand of drugs like HCQS, Azithromycin, Paracetamol, etc, after it was found that these might be effective in treating Covid-19. Indian pharma companies like IPCA, Cadila, Alembic Pharma, Granules India, etc, which are one of the largest manufacturers of these drugs globally, were able to meet this increased demand and thus witnessed good growth in their exports. Covid-19 has also thrown up new product opportunities for Indian pharma companies. Some have collaborated with MNC innovator pharma firms to manufacture and sell their novel drugs for Covid-19 in India and other emerging countries. Some are even working to come up with their own novel drugs or vaccines for Covid-19.

So it has become apparent that the impact of the Covid-19 pandemic will be minimal on the pharma sector. In fact, the crisis has benefited select Indian pharma companies by presenting new business opportunities. Compared to this, the impact of Covid-19 is much more structural and pronounced on other sectors like travel & hospitality, movie theatres, consumer durables, auto, NBFCs, etc. Due to superior prospects of the pharma sector, investor money has flown into pharma companies partially driven by reallocation from other sectors. This has resulted in recent appreciation of share prices of pharma companies and has driven the current outperformance of the pharma sector.

However, an important question is whether the pharma sector can deliver further gains from this point on? Specially given that prices of most pharma companies have appreciated considerably so is there room for further upside. Also, is Covid-19 crisis the only factor driving pharma outperformance? If that’s the case then the performance of pharma sector  from here on should be in line with or even below market as the economic impact of Covid-19 starts waning. We believe that the outperformance of the pharma sector during this Covid-19 crisis is just the beginning of a long term bull run for the sector. We see several tailwinds for the sector that can help it deliver good returns over the next 2-3 years.

However in order to understand the medium to long tailwinds for the pharma sector, one will need to look at how the pharma sector has done in the past 4-5 years. The pharma sector has performed well recently but if we look at a longer time frame then it underwent a phase of substantial correction over 2015 to 2019. The underperformance of pharma is even more stark if we compare it against the performance of another sector like financial services over this period. This is highlighted by the charts of NIFTY Pharma and NIFTY financial services below:

This correction over 2015-19 was driven by the poor business performance of pharma companies during this phase. This was due to a couple of factors impacting different business segments of pharma firms. Firstly, the Indian pharma market was impacted by the implementation of GST in 2018 because GST led to pharma channel disruption for a long time as pharma wholesalers and retailers reduced their inventories. In FY18, the domestic sales growth for pharma companies slowed down considerably and the impact on profitability was even higher as typically the domestic business is the most profitable segment for Indian pharma companies.

Secondly, exports to US for several Indian pharma companies was impacted over 2015-19 due to increased scrutiny from US drug regulator called FDA (Food and Drug Administration). US is the largest export market for Indian pharma and exports of generic drugs from India to US had been growing considerably. Prior to ~2015, US FDA officials would come down from US to inspect Indian pharma plants and companies would be intimated well in advance about any upcoming inspections. So, companies would have the time to prepare the plants so that these could meet US FDA standards during such inspections. However, from ~2014-15 US FDA began increasing its local presence in India with several FDA officials settling down here. These inspectors started conducting surprise inspections at Indian pharma plants dedicated for manufacturing and supplying drugs to US. They would show up completely announced at plants so companies wouldn’t get time to spruce up their facilities at last moment. Moreover, the number of inspections conducted as well as the scrutiny of the inspections both increased drastically as shown in the chart below:

Most Indian pharma companies at that time did not have the manufacturing standards to comply with this increased scrutiny by US FDA. As a result, FDA either banned exports completely from few firms like IPCA, Wockhardht, etc or stopped any new product approvals from the non-compliant plants of others like Dr Reddys, Sun, etc. This severely impacted US exports for several companies leading to poor earnings performance over FY15-19 because US generics is typically a large segment contributing anywhere between 30 to 50% of sales and net profit. The table below mentions few pharma companies that were flagged by US FDA for not adhering to its manufacturing standards during 2015-2019:

Lastly, emerging markets in Latin America, Asia, Africa, etc which are also large drugs export destinations of Indian pharma companies were also impacted by general economic slowdown and currency depreciation. So, almost all key business segments for most Indian pharma companies were impacted due to different factors leading to poor business and consequently poor share price performance over 2015-19. There was a loss of investor confidence in the sector, which is best reflected in the falling contribution of pharma sector to the main benchmark index NIFTY 50. As shown in the chart below, the share of pharma sector in NIFTY 50 fell from 5.23% in Mar-2014 to just 2.42% in Mar-19 compared to an increase from 27.45% to 38.85% for financial services sector during the same period.

However, the prospects for the pharma sector started improving around a year back due to a confluence of factors. Firstly, Indian pharma companies worked on improving their manufacturing standards for US exports over the last 3-4 years. They put in place the necessary processes, automation as well as trained their workforce to ensure compliance with US FDA regulations. All these efforts bore fruit as most of the Indian pharma companies, whose plants were deemed non-compliant by US FDA during 2015-19, were able to regain regulatory clearance from FDA in the last 1 year. The US FDA itself acknowledged that the quality standards of Indian pharma plants dedicated to US generics have improved drastically. Also, the Covid-19 crisis has been an impetus for US FDA to increase the pace of clearing such plants in order to ensure sufficient supplies of essential drugs as has been covered here and here. Moreover, there have been several instances of drug shortages in US, especially injectables, over last 3-4 years even before the onset of the Covid-19 pandemic in March 2020. The Covid-19 crisis has just been a tipping point that has prompted US FDA to support the growth of India’s generic exports to US. In fact, prompt clearance of Indian plants has become a priority for US FDA as it looks at alternative ways to inspect them even during the Covid-19 crisis as physical inspections are not possible.

The much improved culture of regulatory compliance at Indian pharma plants as well as the supportive stance of US FDA are a big positive for India pharma’s prospects for US generic exports. Being one of the largest business segment for Indian pharma, US generics should drive strong earnings performance for the sector over the next 2-3 years at least. Similar to the US business, the prospects of the domestic business has also improved drastically over the last 2 years. The impact of GST on the domestic pharma market has waned and the market has grown a healthy double digit of 11% in FY20. The Covid-19 crisis has further added an impetus to the domestic pharma market growth as spend of Indian govt. on healthcare and purchase of drugs is expected to increase manifold. Driven by all these tailwinds, the pharma sector should deliver strong earnings growth over next 3-4 years. 

This high earnings should translate into higher than market average returns for the pharma sector over the next few years. This is also because the pharma sector is trading well below its long term historical median P/E valuation. As can be seen in the chart below, NIFTY pharma is currently trading at a P/E of 31.2 that is at a substantial discount of 28% from its long term historical median P/E of 43.2.

Many people believe that the Indian equity market is expensive currently as it has pulled back substantially from the bottom formed in mid March when the markets corrected sharply due to fear of unknown business impact of Covid-19. This belief is well supported by the fact that NIFTY 50 is currently trading well above its long term historical median P/E multiple. As can be seen in the chart below, NIFTY 50 is currently trading at a P/E of 27.9 that is at a substantial premium of 29% from its long term historical median P/E of 21.7.

So, it is very stark that the NIFTY pharma is trading at 28% discount to its long term median valuation even though its prospect amid this Covid-19 crisis is much better than that of the broader market, which is clearly overvalued, as is evident in NIFTY 50 trading at 29% premium to its long term median valuation. We believe that the undervaluation in NIFTY Pharma will correct in the medium term especially driven by the fact that pharma sector will do well while the broader markets will take 1-2 years to revert to pre-Covid level earnings. This is because other sectors like financial services, auto, travel & hospitality, consumer durables, real estate & construction will take long time to recover. We have strong conviction that outperformance of pharma sector during the current Covid-19 crisis is just the beginning of a long term bull run for the sector driven by reasonable sector valuation and multiple business tailwinds for the sector.

Not all is well…

Last one month has magnified what we have felt for a long time: there has never been a wider divergence between the real world and the markets. India is grappling to keep the bottom 30% of its population away from dying of hunger. Our national unemployment rates are peaking at 25%. Still, the markets are up 25%!!

This contrast between the real world and the markets often disillusions us and is tougher behaviourly than anything else we see/read. It reminds us of a quote from the movie “Big Short”:

“This business kills the part of life that is essential, the part that has nothing to do with business”

…And the more you stay out of this bubble and gaze at the real world (read essential), the greater are the odds that you will end up questioning what is so wrong.

We think, markets and desktop warriors hate to think about bad things happening so they always underestimate their likelihood. Indian markets are underestimating the impact of the lockdown on peoples income and their purchasing power. They are busy making the V, U and W shaped recovery. Just read a report from UBS that showed a V shaped rebound !!

While we are no better at guessing the alphabets that best represent the rebound (if at all), we know from the past data that the recovery is going to be slow. We will try to capture this through a series of charts and sum up with our investment strategy:

GDP Growth Vs PE of the BSE 500 index

Source: BSE and RBI

1. Our GDP growth for the next year will be closers to zero, which side of it is anyone’s guess.

2. Markets typically have a lag in response to GDP growth data. Maybe starts reflecting in company performance with a time lag.

3. GDP bounce-back is gradual, albeit 2008–09, where it was more global and less an Indian crisis.

4. If India’s real GDP is going to grow between -3% to +1%, markets haven’t yet corrected to factor this in.

5. If PE is a real reflection of the future earnings, it shld be between 12-15x for the benchmark index than at 18–19x now !!

   

Unemployment likely to skyrocket

Source: CEIC

1. We are inching towards 25% unemployment rate. As a reference, we were at 9–10% unemployment rate during demonetization.

2. From what we know, startups/MNCs have either slashed salaries or are cutting their manpower.

3. Travel, hospitality, real estate, infra and small scale manufacturing, which employ a large part of the labor force, are dented for at least 6–9 months.

4. IT and tech companies are preponing their automation drives as this is the right time to fire without giving much justification.

Household debt as a share of income continues to rise

Source: RBI

What we are staring at is a customer who typically:

1. Has financed his personal expenditure through short term debt, largely due to easy access and the lure of zero cost EMI.

2. Has financed his/her her home, which has depreciated in value by 20–25% over the same period. Likely to depreciate more in the future.

3. Hasn’t seen his income grow as much as his expenses.

Refer chart below, both overall consumption loans and in-particular credit card outstandings have grown at 20% and 23% respectively between 2012–2020. During the same period, personal income has grown at a CAGR of 11%.

Source: RBI

Consumers economic and employment sentiment is at an all time low

Consumer sentiment on economic situation, Source : RBI

Consumer sentiment on employment , Source : RBI

How does this translate into investment recommendations for the next 12 months:

1. Stay in cash and debt instruments if you don’t understand what is happening.

2. Have said this earlier too: personal fin companies will see headwinds. Expensive multiples are a trap and carry an illusion of growth. Will stay away from pure-play personal fin businesses.

3. Stay away from consumer stories where expenditure can be postponed or can be replaced by lower cost substitutes: ACs, brown goods, Auto.

4. Consumer businesses that have utilitarian consumption demand such as staples, education, healthcare, gas, communication are more predictable and secular. Demand has held well in these segments.

5. Businesses that have heath/wellness as demand drivers are interesting at a reasonable price. Look for: OTC consumer businesses, health/general insurance, domestic pharma.

6. With an average per user data consumption growing 10x in the last 4 years, keen to look at businesses that are riding the communication/data consumption story. Eg: OTTs, internet infrastructure, hardware/software, digital brokers, banks that are using digital interface well to get customers.

7. Companies will de-risk marginal supply away from China. Will be interesting to look at speciality chemical companies. However, we acknowledge that these companies already trade at FMCG type multiples.

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Never loose capital, no other rule counts…

When we started our private equity investing career around 2008, we were told that it is ok to have 2–3 winners in a portfolio of 10. The winners will make up for the losses in 3/10 duds. Just return capital in the balance 5. In hindsight, this framework was so VC’ish, to say the least. In India, owing to difficulty to scale, smaller addressable markets, rich entry valuation and promoter integrity issues, the winners could never hit the ball out of the park, but the duds could take your investment down to zero, albeit very quickly. Profitable growth was and remains difficult.

Another framework that we had to quickly unlearn was super natural growth projections. Owing to high valuations and best in a decade margins (which never came back), private equity investors were forced to make models that had their top-lines and bottom-lines growing at 20–30% yoy. Why not, this was the only way to justify crazy valuations and white space market assumptions. Give capital to companies and then have them on steroids. Needless to say the survival rate of those on steroids is pretty low. Pretty low for even the 100 mts globally competitive sprinters. In fact for some sectors like lending, this is a recipe for failure (will dedicate a full blogpost on the failed banks in my portfolio).

The reality is however, very very far from this. If these hyper-growth assumptions and portfolio success theory were to be applied to the public investing, one could loose his shirt very quickly. What we learnt from returns made in public equity are as follows:

Phenomenal topline growth rarely translates to commensurate returns. What however does translate is sustainable good quality of business. To prove this hypothesis, we studied listed companies with a time frame of 3/5/10 years. We classified companies into two buckets, those that grew >15% yoy and those that had a sustainable return on equity of >15% (proxy for quality) for the same period. To de-noise, we considered companies that had a market cap of >200 cr 3/5/10 years back.

What we witnessed is as follows:

Companies that had a sustainable high quality of business (ROE> 15 %), returned higher return than the cohort of companies that were growing fast (sales growth >15%).

The deviation in returns of high growth companies is much higher than the deviation in returns of companies that have a predictable quality record.

In investing it is very important to understand and quantify the risk one is taking for a return. One can make infinite returns but also loose ones shirt. Some risks are not worth losing capital. As shown by data, chasing growth also means one could lose capital permanently.

So investing in high quality business doesn’t only give higher longer term returns, it also significantly reduces the risk of losing capital.

If we were to the same analysis for a lower sales growth rate (10%), the findings do not change.

Over the longer run (10 y), high growth and high ROE converge in returns. This also implies that people are looking for more predictable businesses.

A good analogy we are borrowing from a recent blog we read from Nalanda capital: public investing is like playing a test match. One has to only play balls where you know you can hit high quality shots, something like what a Dravid/VVS would do. If you are always racing to a 50/100 score, you better be a god like Sachin/Lara or a maverick like Sehwag.

In the next post will be taking a deeper dive on some characteristics of good quality businesses that can be dug up bottoms up: free cash flow generation, dividend yield, change in promoter stake and management compensation.

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How tech help in building a execution driven org.

As an amateur Investor, I could rarely accept and appreciate why some orgs. could execute and some couldn’t. I use to think its more a pitch to impress investors and hence had a linear scale than a binary scale to like/dislike managements.

Zoom out after running a start-up and having seen some tech driven orgs. from inside out, understand that companies that last long have a sustainable internal MOAT. They implement tech/systems for customers, staff and vendors (in that order). Good orgs. are those that:

a. Can connect customer experience to internal orgs.

b. Does the above in the most transparent manner.

For our food tech startup, we had an objective function: We wanted to have a simple and transparent org that is customer-centric and responds to exceptions. We scaled up our tech to make sure we were true to our objective function. While executing, we zeroed on some ground rules:

Build an org/tech to catch bad customer feedback and exceptions than to reporting good data:

Orgs. that respond to bad feedback more proactively, are on a treadmill. We didn’t know what exceptions we will face or where we will screw up, but just wanted to catch that exception and build a tech module around it. What this paranoia did was to build a standard response to problems and secondly, minimized any human interaction and cost. What this also did was to signal to our customers that we are listening. This amplified the feedback we got from our customers. Around 60–70% of our customers gave us feedback. This helped us collect statistically significant data on each internal metric to set up KPIs for staff from top to bottom. For scaled up companies such as Flipkart/Amazon, customer experience may be solved by tightly controlling supply and delivery manpower. Asking a customer for a feedback might cause leakage in the conversion funnel at that scale, I still think that systems built to identify whether a customer is happy with a product are more fruitful than pushing for the next sale. If I have bought a ball from amazon/fk, and am looking for another ball in next 10 days, there may be issues in the last purchase. Or if I am checking the same category after the delivery of an order, there may be an issue. Customers rarely mind, bad news delivered to them proactively. Or blend the reward program with getting customer feedbacks. Trust me you will not have to discount to red or answer to investors what you stand for.

Completely map staff performance to customer KPIs:

A bit difficult to execute given HOs and distributed systems, but this helped us align 90% of the staff to good and bad times in the company. This is something we check for even as a public market investor. The trick is to keep it simple and make people believe in the power of a statistically significant sample set of feedback. How do we get a statistically significant sample set: build a culture where a customer knows we will respond to exceptions/bad ones more proactively. Even for large orgs, blend customer feedback on frequency of late deliveries to delivery staffs performance which in turn maps to the performance of the category team. Even, for roles that are distant from the customer, aligning the conversion funnel to staff’s performance helps. Show it live, show the incentives to good and bad behaviour.

Improve the frequency of visibility of staff performance data, so bad news gets known first:

Small point but helps correct staff behavior. We didn’t like surprises as employees and wanted the same for our company. This keeps noise level down. If someone is not performing, show it upfront.

Equip your staff to take decisions with customers, create buffers :

We shamelessly learnt this from Amex. The authority with which their execs execute, is remarkable. Empower your staff to take decisions that suit customer, even if it means giving them a long rope. This also helps weed out the middle service layer in mature/large orgs. Make a cost center, a loyalty/perk center for an employee, you will see savings without blinking an eyelid. Have seen this for travel, logistics, delivery cost, food cost and reporting.

Lastly, invest in dashboards. We built our own with views and access like a tree. Consolidated at each level for the data relevant. This kept the noise low and focus on the top 2–3 that we as entrepreneurs wanted to focused on. On a lighter note, I often use to ask an an amateur investor to an entrepreneur “What are the top 2-3 things you want to focus on”. After a startup and some grounds up experience this has now changed to “How do churn out your top 2–3 things and what do you do to only focus on them”?

How this helps in public investing

For pubic investing, we rarely have access to this granular a data, but what helps in on-on-one interactions and scuttlebutt on the managements running consumer facing service businesses is to get to know the following:

1. How does a founder capture and check the primary velocity of his product/service. We try and understand how much a promoter is on top of the signals from the consumer. Whether be new product launches or be it after sales. Does a promoter deal fairly and equally with his channel. Have seen case of a listed apparel company run by one of the most conservative and smartest founder, but he does not respect his channel. The only thing that matters is how to clear the inventory of the shelf, if it takes making their channel unhappy, so be it.

2. How is this velocity linked to long term metrices such as churn/repeat. A listed classified ads company often talks about how their traffic is growing, how their listed MSME base is growing, but rarely talks about whether any one is repeatedly using their app/website. Traffic is a vanity metrics.

3. What is the escalation and tolerance mechanism of the org. and what level of information reaches the top management.

4. Lastly but most important, whether a promoter likes to hear and give bad news first. This paranoia mostly translates into a mindset, that don’t know a lot, let me adapt. It also creates a responsibility to not only customers but also minority shareholders.

Good governance breadcrumbs for Public Investing

When we started investing around a decade back, markets were on a dope. Steel strip suppliers wanted the valuation of telecom tower companies and bold cross-border acquisition plans were fancied by investors. Most of the corporate governance checklists were thrown out of the window to strike a deal.

Then came 2008, and the standing orders were to not close any deal, question everything from promoters salary to his/her personal P&L. Needless to say that either ways were extreme.

Zoom out a decade, the frameworks have become more rational and “test the intent than the action”. Getting answer to two questions is most important during our diligence:

1. Is the promoter’s wealth creation aligned with mine, or has his wealth creation already happened, or will happen through the leaks in the company?

2. Is the company’s best days behind it or in the future? If the best days are behind, it creates adverse incentives to stick and defend the legacy.

As secondary investors we cannot influence anything but can pick up breadcrumbs of the promoter’s behavior. This is where the most difficult, subjective and interesting part kicks in. Its a mix of analytics and diligence outside the business.

Will cover both the analytics and subjective part with relevant cases, obviously with no names.

“Less salary is bad news”

Look for Promoter’s salary as a % of overall PAT. While Company’s acts best cap is 10% of PAT, the calculation is more wholistic and subjective. We have come to learn the “less is bad”. A promoter who discloses and takes a flat high remuneration, is far better than the one who draws less and then finds ways to create leakages in the company. Leakages are in the form of movable assets, related party businesses, inducting more than reqd. family members, entering new businesses that match promoter’s lifestyle.

Same applies to the salaries of the Key management. Less is bad. I remember this from an apparel portfolio company. The salary on the books for two business heads was low. We were invited to a new store launch and to my surprise saw them both getting out of their own BMWs. When we asked the promoter in a casual manner, how nice their cars were, the promoter in a sheepish manner, mentioned “They work hard, have given them cars to rest well on the way back!!”. We didn’t know how to respond!! Needless to say, that company and promoter was a big CG fraud!! Everything on the BS was cooked up.

“Speak with the Auditor if you can”

Not a big fan of Big 4 or Big 10 in the Indian context. But questioning something like: how can an auditor audit a 1000 cr + topline company in 7 L of fee, is critical. Sometimes, it just doesn’t add up. This is a huge problem we grapple with Pharma, Building Material and Consumer Durables Companies. Auditor’s salary just doesn’t add up. How can one audit a multi location plant, sales, distribution set up having a 1500 cr plus topline in less than 25 L !! Not saying these company’s are bad, but one needs to find ways to get comfort that they are professionally managed. Same is the problem with some traditional sectors like building materials, consumer durables.

Speaking with auditors or someone in the team is a good to have. We remember speaking with the auditor of a leading bags company. We had called them up to get a meeting with the promoters. To our surprise, the lady on the other side told us, “Why are you wasting your time, they are going be busy in a sales tax fraud” !! The company was imitating complete assembly of bags in a tax free zone. The only assembly step that was however happening in the tax free zone was sticking of handles!! :)

Having a good CA network helps. They know the personal reputation of some of the business groups that we sometimes do not have access to. One company I remember thorough this interaction was a leading home/kitchenware company. The CA whom we were using for leads, insisted that we meet this promoter group as they are very conservative/fair in their business dealings. Not sure how aggressive they were, but were good people to meet. We ended up liking the promoter group for their sharp focused and long term approach to the business. Needless to say, the company is a multi-bagger in last 5 years.

“How distracted is the founder”

We started this as an informal exercise. But soon realized that this is core. What we are digging for is “How distracted is the founder”. Will not delve into specifics as it is a very subjective point. We use this for elimination, than for selection. But can tell you, this helped me knowing that the MD of a leading durables company was contesting for Lok Sabha elections. Or the MD of a leading men apparel brand was more bothered about his sports and snow cars than how he plans to turnaround/grow his business in the next 5 years. Or the MD of a mediocre ceramic tiles company was a close buddy and had similar habits as of one of the promotes mentioned above. It’s important to gather these breadcrumbs to know where Promoter’s attention is.

Its also important to speak with industry experts or competitor top managements to know what they like about the promoters. We were evaluating an upcoming wellness company and spoke with a competitor. The competitor highlighted the headwinds in the sector and how they were diversifying. When we asked the same question to the company we were evaluating, we got arrogant answers around market share and half baked answers of selling their products through mobile app. As if mobile apps were a magic wand that could sell anything!! Needless to say, the company we were evaluating, could not make the shift. Its at the same market cap as it as 5 years back.

“Look for events of shareholder wealth creation”

This is a litmus test that is above all. Prior behavior of founders to distribute cash reserves, not dilute minority shareholders, high dividend payout, not participate in buybacks, and no event of a pref allotment are all very strong indicators of a good governance. Another event to measure the same is the terms of merger of a group entity. Have never liked promoters who merge/de-merge group entities too often. If done too often, its usually good only for founders.

Also, a promoter who pledges his stake for equity infusion in another business is a big no. Usually such companies, are not left with much juice and your wealth creation (already a low prob) is not aligned with that of the Promoters. No matter how good their business is, this is an absolute no.

Have been in some promoter meeting where after the usual Business Q&A is over, promoters ask so what do you find interesting to invest in public markets. That’s a slippery slope, I love this question as a bait. Needless to say, Promoters who find some other stock more interesting than theirs, need a double check.

Another bait is to ask, if you were to raise [YY] cr of primary capital, what would you wanna do with it. Good ones, do not need me or my money, whereas the bad ones have interesting answers: own more stores, get a brand ambassador (most usual), go online (easy right !!). Best companies (even including banks) are non-dilutive. They don’t need us or our money. Promoters who are not keen in our money or chivalry, are good.

“Look for volatile changes in the Current assets and liabilities in the balance sheet”

Most of the current account are sticky and don’t have huge swings. If you these accounts changing too often quarterly or half-yearly, dig deeper. Ask the management on the reason. Have seen good managements change their accounting policy during bad times. Best to assume anything transferred from short term to long term is lost. Again, a leading B2B company had a great execution track record. But when projects started getting delayed, the receivables and loans/advances started moving from current account to long term account. While the cosmetics of it looked good, on the overall basis, the accounts were swelling and so were losses.

Also, ask simple questions such as, how do you write off your inventory. Or if you have sent 10 types of suits, how many do you expect will sell and what do you do with the balance. For some consumer companies (mainly apparel) PAT and EBITDA are an outcome of how they value their inventory, so is completely subjective.

“Try to get as close to the answer to why is he doing this?”

Have been surprised, that the root cause has been often a very simple urge. Sometimes it is linked to social status with peers, sometimes it is a better lifestyle and sometimes just the urge to be the decision maker than being an employee.

The answers are not that difficult to justify for a first-generation founders. Things become complex for second and third gen founders (something u find a lot in public companies). A good reason sometimes is that the next gen cannot run the business the same way as his pop has run. Hence, he changes the shape/form of the company to make it more modern. We have also seen, some well educated promoters taking time to assess whether he/she is interested in taking the baton.

What we think is a clear red flag here is lack of education, or mediocre education, and a sense of entitlement. Next gen Promoters are often advised well to not commit silly mistakes, what they however need time for is to know how they want to express themselves. Groups such as Eicher Motors, Blue Star, Birla have done a phenomenal job of grooming their next level of leaders.

As per us, its ok that a promoter is not articulate or sure about the answer to this, as long as he has the humility to explain his own thoughts and is at it, it works well in the longer term.

“Is a company’s best days behind it or in the future?”

While the answer to this question is party summed up above, it always helps to know from a founder, what led to the success in last 3–5 years. Replicability is a function of inputs not externalities. Good managements attribute success to both internal inputs and external factors which are non-replicable. So they discuss the future with a word of caution or just focus on the inputs. Success is often a function of both inputs and tailwinds in the sector. Only schmucks can predict or pretend to predict the next tailwind. We are wary of founders who define future in terms of valuation, sales growth or market share.

“Burn Baby Burn”, “Burn More”

Am an ardent Bear and believe that one needs 3–4 bear markets during his/her professional life to retire. I saw my first one in 2008. Since then , I have hummed to myself: “Burn Baby Burn”, “Burn More”, just like The Beat Of McConaughey’s Drum.

From an Indian context, a steep correction in the markets in the next 12–24 months looks likely. While the Indian economy has sound fundamentals, a large part of correction in the markets is due to FII hot money being pulled out. What may be a trigger event is unknown, but one can make sound portfolio strategy basis the data available.

Based on the comparison with the last two down-cycles: 2000/2008, it seems likely that a correction is pending at a global level.

Excessive liquidity has thrown caution out of the window in the global markets.

Govts, round the world (except India) have used debt to justify their spends.

Narratives of private equity fund managers, equity analysts and bond yields are looking more like pre-2008.

I follow Howard Marks. This publication of his is a more elaborate vision of whats happening on the ground.

US corporate debt is piling up to the levels seen 2008.

CLOs are at an all time high

Debt to equity of the US is nearing the last trough…

Share of BBB-rated debt in US IG universe, % is at an all time high:

Fed interest rates are moving up, indicating money will taken away from the markets.

Tech bubble is compounding the problem

Tech Stocks’ health is frothy. We are near the peak if not there yet, will lead to a major correction in cap markets. Last 3 corrections in the markets (2000, 2008, 2014) are related to things heating up in the tech world in particular and in markets in general ….

Expensive listings for tech stocks is not sustainable.

Number of Tech IPOs also indicating that markets are beginning to heat up:

Why Consumers in India are not buying?

We started looking at the Indian listed consumer space ~ 2011 and found some of the great multi-baggers of the current days reasonably/cheaply priced. Needless to say, that was a great time.

As an amateur investors, we use to first look at price/valuation and never question the growth. Why, because in our Private equity world, a deal wouldn’t work at at >30x PE entry multiple and a <15% sales CAGR. So sales/earnings growth in excess of 15% was a given. That created a bias to extrapolate the same growth assumptions for listed consumer companies. While the assumption worked for a few, it was mostly wrong. We were lucky to make money in a few of them, but largely due to multiple expansion.

1. The 5 year sales and earnings CAGR of the top 25 listed consumer stocks is 8% and 15%. Earnings CAGR was partly better due to a benign raw material commodity cycle.

2. A lion share of the consumer stocks were at rich multiples, which became even richer with time. Average PE of these stocks was 37x 5 years back. Its now ~45x.

Forget the fascination of the capital markets to still stay invested at these multiples, what I really want to talk about today is how/why demand for the listed consumer universe is looking edgy and why their moats are not as solid as they were maybe 5 years back.

Rise of Debt

In the last decade, a large segment of consumption growth has been driven by personal finance. The charts below highlight the drift I want to take in this blog:

Refer to the personal fin loan growth in key segments. Consumption driven loans (durables, vehicle, credit card loans, other personal loans) have grown at a CAGR of >20% over the last 5 years. Analyse this with the backdrop that the household income has grown at 10% during the same period.

Y Axis in INR Billion, Source: RBI

Household debt as a % of household income has been rising fast.

Source: CEIC

What we are staring at is a customer who typically:

1. Has financed his personal expenditure through short term debt, largely due to easy access and the lure of zero cost EMI.

2. Has financed his/her her home, which has depreciated in value by 15–20% over the same period.

3. Hasn’t seen his, income grow as much as his expenses.

Weak Sentiment to spend

What we are looking at is a consumer whose macro sentiment has been largely tepid.

Consumer sentiment on economic situation, Source : RBI

Consumer sentiment on employment , Source : RBI

The same is also highlighted through the expenditure basket:

Volume growth for the discretionary segments such as eating out, beverages, recreation, furnishings/decor, clothes and shoes, durables is muted to say the least.

Sectors that have done well are utilitarian in their consumption: healthcare/wellness, communication, education. While business models are subjective and may vary based on segments, predictability of demand is a plus.

How does this translate into investment recommendations for the next 3-5 years

1. Personal fin companies will see muted growth. Expensive multiples are a trap and carry an illusion of growth. Will stay away from pure-play personal fin businesses.

2. Stay away from consumer stories where expenditure can be postponed or can be replaced by lower cost substitutes.

3. Consumer businesses that have utilitarian consumption demand such as education, healthcare, communication are more predictable and secular. Demand has held well in these segments.

4. Businesses that have heath/wellness as demand drivers are interesting at a reasonable price. Look for: OTC consumer businesses, diagnostics labs, health/general insurance, domestic pharma.

5. With average per user data consumption growing 10x in the last 4 years, keen to look at businesses that are riding the communication/data consumption story. Eg: OTTs, internet infrastructure, hardware/software, digital brokers, banks that are using digital interface well to get customers. Will cover this more in the next blog.