In the Indian market that is neither really attractive nor expensive, where does one find value? Among those undertaking "pretty large" capital expenditure, says Samit Vartak of SageOne Investment Managers LLP.
That may range from capital goods to building materials followed by real estate and ancillaries, and niche pharmaceuticals, Vartak said on the Alpha Moguls series.
This is “because the capex is picking up there and will continue until we have that 15% tax rate by March 2024,” Vartak, founder and chief investment officer at SageOne Investment Managers, told BQ Prime’s Niraj Shah.
Vartak remains confident on India’s valuations, which have been consistently high, over the next two to three years. He highlighted the "pretty large" capital expenditure in especially niche areas, the success of production-linked-incentives, clean balance sheets, and strong banking system as the drivers.
There is also opportunity from China-plus-one strategy, he said.
However, a correction of 15% cannot be ruled out if there is slight disappointment in India, he said. As such, Vartak prefers companies that will double their earning over three to four years.
Top Themes
Vartak said the domestic-oriented portfolio is geared towards capex, while export-oriented include the “niche” pharmaceutical segment and real estate. The valuations, he added, for these segments are pretty reasonable.
“I wouldn’t say that they are really attractive or really expensive, they are somewhere between, which is fine," Vartak said. This because the fundamentals are "way better that average, so average multiples are okay for that", he said.
Vartak said that his highest conviction is for any business which is capex-oriented, such as building materials or capital goods. He positioned real estate and its ancillaries in the second, while API and CRAMS were his third choice.
The active pharmaceutical ingredient segment and contract research and manufacturing segment, which is anti-consensus now, is getting reasonable valuations and the growth hasn't slowed down, Vartak said. “API and CRAMS players could see sharp earnings growth over the next couple of quarters.”
There is a long-term potential for API players given what is happening in the Russian and Europe, he said. The two important qualities that customers ponder on while giving order to API makers are -- efficiency and competence, and capacity. Vartak pointed out that there are only two-three players in India that have both these qualities. Those type of companies could see a lot traction, he said.
For real estate ancillaries, Vartak said, the valuations are not factored in versus the overall market. Plywood, MDF and tiles imports are almost down to zero, so that's where demand has gone up, he said.
Views On Defence, Automobiles, Specialty Chemicals
On defence, Vartak remains “skeptical” as there has been many “fake starts” in the past 15 years. The defence orders may flow through, he said, but the kind of profit generation is a question mark.
The government as a customer is a worry, Vartak. It is not clear that the recently broached talks about the Europe-plus-one strategy is a structural story or a short-term blip, he said.
Specialty chemicals, on the other hand, is a “good theme”, the investment manager said, but there is a need to be picky as they have become expensive. “It is important to ensure that the specialty chemicals are not just getting benefitted by global circumstances like what is happening in Europe of China,” he said.
"If you are convinced that they are the most efficient player, I think then that theme has lot of room to play out, especially if its niche specialty of niche pharma like API, CRAMS."
With underperformers, Vartak said, “Investors need to be patient as it may come in the short-term for these themes, and take the risk.”
On automobiles, the investment expert prefers the consumable part, the ones which has potential for the next three to four years. Vartak said he stays away from players that offer one-time purchases such as engines.
“While in segments such as tyres or tyre ancillaries, lighting side, has potential over the next three to four years driven by electric vehicles push, the valuations are attractive,” he said.
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What is your basic portfolio construction strategy? Are you top-down or bottom-up, are you thematic?
Samit Vartak: We are completely bottoms-up. It is just that we do have some risk parameters that we follow. So, for example, if through bottoms-up, you figure out that okay, you bet a lot of stocks from just one sector, we limit that exposure to 25% or if you find that you are getting too much exposure to one promoter group, so we limit that to 20%, which is completely bottoms-up. What we look for is basically looking for companies which will double your earnings in three to four years because that's our goal, that we should try and double our portfolio in three to four years, not every year it will happen, but at least if you consistently deliver those earnings growth, and in the long term, you know, the earnings growth should mirror what your returns are and that's what has happened in the last 10 years. You know, if you look at the last 10 years, our portfolio earnings growth has been 30% per year and our portfolio returns have been 27-28%. So, net of fees, you know, you did have a couple of percentage from there, so it almost exactly it has mirrored earnings growth, and that's what we target it. Completely bottoms-up.
Whatever valuation multiple benefits come in the bargain is all an upside over and above earnings growth?
Samit Vartak: Yes, I mean, valuations sort of attractiveness happens maybe once in you know, three, four years. It's more and more getting difficult because valuations, especially in India have been consistently high. I mean, if you look at maybe 2012-13, 2012 was the low valuation time after that, you know, 2014-15-16-17-18, those years were all way above the average value chain and then we had that you know, 2019-20 period where we got really attractive valuations, but again, after 2013, almost five, six years it took, and again, now we have sort of towards the higher end of the valuation, and hence the only thing you can control is earnings growth. If you keep on waiting for the right valuations will never happen, as a fund manager. As an individual investor, you probably have that flexibility, but if you keep on getting money and on a continuous basis, there is a limit to which you can delay your buying.
Are you wanting to delay your buying under the current landscape, for the portfolio simply because the world seems to be I mean, it always is an uncertain place...?
Samit Vartak: You are right. I mean, it’s a very tricky situation, I will tell you for sure because I have been very positive on India and as I have been presenting my thesis of how India's has deleveraged and presented the kind of debt to equity ratio which has come down to the lowest ever, the cash flow generation to net profit ratio at the highest level, and also the return on capital improving a lot again today it is at almost 10-year high. So those kinds of parameters gives me the confidence that India should be an alpha story and it should not be looked at as a beta story, which happened in 2012-13 or 2008-09 kind of period and that fortunately, you know, it really played out well. Well, beyond of what I thought of played off. But problem is too much of a consensus. Everyone is talking about, you know, India is decoupled... so, whenever there is such a big consensus and the way some of the stock prices are reacting, I mean, as a fund manager, you know, since I have a luxury to buy and sell on a continuous basis, I get to see what is the liquidity situation in the market and you could see that if there's something that you need to buy, the impact cost these days has significantly increased, that means the sellers are much less than what I have seen, even you know, last year and if you have to sell something, it flies off. So, there is too much liquidity which is thrusting into the market and looks like, not too many people are worried about the market and it's more generally a good sign and as you said, you know, there are too many uncertainties around in the world and whenever the world is uncertain, and at the same time because of the confidence in India, the valuation sort of gap has just sky rocketed and if India disappoints in any way, or if certain things play out, you know, there is very little room for error that we have left. So, I would say that's the problem with India, the way I mean, I am seeing more and more companies in my portfolio, getting to a level where you find it's very uncomfortable to hold on to such valuation. So, you tend to sort of hit your exits and that is happening more and more and so that's what I have to say. I think just the consensus and too many people excited doesn't give me too much of comfort.
Are you more worried about potential downsides as opposed to the prospect of missing out after selling? Would that be a fair assessment?
Samit Vartak: Of course, there is you know, the long-term confidence. I am pretty sure about the next two-to-three-year kind of time horizon, India looks really good, you know, because the way the capex, which is been planned by many companies, it's a niche area, but you know, there is a pretty large capex which is happening. Of course, we have seen the success of the PLI scheme, and the balance sheet is really clean. The balance sheet quality, I have never seen this, this good banking system, pretty strong and I think there is an opportunity away from China Plus One, of course, we are looking over Europe. So, those kinds of opportunities are presented to India. So, I am pretty sure two-three years down the line, the earnings growth will come through. So, I don't expect that there is going to be a large correction, you know, so question is you get really worried when you think that there's going to be more than 15-20% kind of correction. So, that possibly I think seems very, very remote, but 5-10 up to 15% correction can easily be possible, if there is any slight disappointment, you know, in India. If say, in the next budget, India goes for putting long-term capital gains or increasing long-term capital gains or increasing those, you know, those kinds of disappointments when everybody is so confident about the situation in India can easily create that because it will take away that premium that we have built in the competitive world because after all, it's all relative attractiveness where global investors will look for and in case of disappointment, that's a real possibility, but I don't really expect 20%, 15% correction.
I was talking to somebody who was making this point about how India versus EM looks expensive and also because China valuations have hit a bit of a bottom currently and therefore, that piece has gone down, as opposed to India really moving up dramatically relative to others and therefore the differential looks very large, but earnings growth should support these valuations. FII flows seem okay, the domestic flows are strong as well. Can we sustain these valuations, or do you reckon that should be a course correction?
Samit Vartak: Just to give you a reference, you know, I generally look at large-cap valuations or small-cap valuations and mid-cap valuations. Today, the top 100 median price-to-earnings multiple is at 35 times, which is a highest that I have seen, the mid and large evaluations, I am not talking about the Nifty weighted average and for me as a fund manager mid-term makes more sense because I am not going to allocate the largest company not if I probably have an equal chance of getting across. So, the median valuation base is 35 times which is, I think, really, really high and if you look at the 400 to 500 companies, so if I am looking at the BSE 500, the top 100 is 35 but the bottom 100 is about 24 times. So, there is a big gap between that. I mean, that 30% gap is very normal. It's always been the case, if you look at last, you know, 15-20 years, that absolute level itself is pretty high. 35 times multiple, probably is closer to 24-25 times as a normalised multiple even if I look at say the Modi Era, you know, let’s assume that this is the different era, say pre to the 2014. Even compared to that, there is a premium of 35% of the averages. Now, you would question that, okay, the fundamental itself are also way better than, you know, enriched. So, India deserves those kinds of multiples and that's fair, but there is an extent to which fair valuation needs to be there. You know, the PE multiple is sometimes very volatile, so I would also like to get the enterprise value cash flow from operations and operation ratio. Those kinds of multiples are not as high compared to averages, but they are still at 15 to 20% premium. Last year, they were reasonably okay. You know, they were near average, I presented an analysis saying that they were just about average or near average. Now that premium has gone up. So, I mean, they are nowhere close to say for the small cap and mid cap what we had reached in 2017 or what we had reached in 2008 peak. So, the cash flow of the operation, the enterprise cash flow from operations, or the price to book, they are just about average, so that's, I think that's something that you need to be aware of. So, it's not a worrisome sign for sure. But one needs to be careful with the world market has become cheap.
If I am not misunderstanding, you seem to be suggesting that a bunch of the broad end of the spectrum companies, there the valuations may not necessarily be as big a worry as the medium valuations seem to suggest?
Samit Vartak: Exactly.
So, then therefore, what is the current portfolio construct? I mean, how are the AUMs scattered across themes? Are you sitting on a bit of cash because you are a bit worried and because you mentioned that in some cases, valuations are hitting the exit valuation levels as well?
Samit Vartak: So again, we are bottoms-up. So, wherever we find value and growth, mainly the first thing is growth and that is the reasonable valuation which is what we look for. Where we are finding growth is in API kind for pharma play, capital goods, real estate, the real estate ancillary place, real estate financing, or building materials which we were talking about which are used in construction of various warehouses, your factories because that capex is picking up and that will continue at least until we have that 15% tax rate by March 24. So that plus PLI scheme, there is an end bound plan, you know, if we apply for a PLI, then you have to put up capex. So, I think there are a lot of triggers for capex. So, our portfolio is more geared towards, if it's domestic oriented, more capex oriented and if it's export oriented, with more to do with you know, the niche pharma, not the generic pharma, but the niche pharma and the real estate. Those are the themes where we are finding pretty good growth. Valuations are good, I wouldn’t say that they are really attractive or really expensive. They are somewhere in between, which is fine, because I think the fundamentals are way better than average. So average multiples are okay for that.
A lot of portfolios are also starting to bite into stories like defence, after a lull and because of this Europe Plus One observation as well. There is again, a move towards specialty chemicals. There is some exposure that people are taking to autos because they have had such a long underperformance over the last five years. Did you like these at all?
Samit Vartak: We generally do not pre-empt themes. So, defence, we have seen so many fake stars, in the past maybe 15 years that we are still skeptical. But that's okay. If the defence theme really plays out, you know, I am sure it will last for multiple years and even if you miss out on the first year or so, it’s okay but when you get in at least you need a high probability kind of company where it will play out in a long term structural story, it shouldn’t be just the expectation which plays out and then we realise that they are really not making profits and I am sure alternates will get through, but what kind of profits they will generate is still a question mark. Whenever there is a government as a customer, you know, that is a worry and you know, it generally doesn't fit into our kind of style, right now. Europe, a lot of people are talking about it, but you never know, is it a structural story or is it just a short-term sort of a blip. Speciality chemical is a good theme and we have played it for many, many years. It just didn't have become expensive, so you need to be very, very picky, where you need to make sure that they are not just getting benefited by, you know, what's happening in Europe and what's happening in China and then assumption downs, and they need to be the most efficient player irrespective of just you know, having your lucky periods because of some shutdowns somewhere that they just making more profit. If you are convinced that they are the most efficient players, I think that theme has a lot of room to play out. So, whether it's the niche specialty chemical pledge or niche pharma API CRAMS are kind of players, and we are sticking to those themes and you know, with that comes in underperformance sometimes in the short run, you got to be patient otherwise if you keep on running at each and every themes that keeps on coming out, yes, maybe you will get good performance in the short run. But in the long run, you pay for it because you are just jumping around from one boat to another. It is better to stay in a very steady state boat, which you know that it will reach the final destination much faster than jumping around and that's what we try to stick with.
Therefore, autos also is not something that you are very comfortable with currently?
Samit Vartak: We do generally like the consumable part of autos, so anything which is sort of one time, you know, like engines or camshaft where you just need that for once in the life time, we stay away from something like tyre stocks or ancillaries. Recently, we have added something on the lighting side, where you can see at least a three-four year kind of a journey, which could be driven by electric vehicles in the two wheelers, four wheelers and then where the valuations are very active because in these themes, which may not last for 10 years, but even if they last for three, four years, the valuation needs to be in your favour because just in case if it doesn't last for three years, and then slow growth starts, then you losing money is the chances are very high and many times you get such a place, you know, pretty 20% plus return on equity, where you know that this the potential of doubling earnings in four years is really high and you get such companies that 10-11 times trading multiples and if you get that it really makes sense.
So, suffice to say that, maybe where you are anti-consensus currently might be defence, because a lot of people are bullish, but you for the right reasons, you are not quite that enthused to go out and take the bet?
Samit Vartak: Not so far. I mean, we will wait and watch and see how it plays out. We are okay even if we lose out a year, if it is a long-term story.
Okay, so that is defence where you might be anti-consensus. Let me ask you, where is it that you have the highest conviction that when you spoke about real estate, you spoke about building material and real estate, of course, and that packet, you spoke about capex as well and capex driven themes and API in cramps, where is the highest conviction?
Samit Vartak: The highest conviction is related to the building materials which are used, anything to do with capex, the capital goods, that’s where we have the highest conviction. A lot of capex may seem like it's a domestic theme, but maybe you are using it for factories which are export oriented so whether it's for the PLI scheme, a lot of niche engineering good companies also aggressively making India's as their exports hub—companies like these bearings companies, or really high-end engineering kind of companies. They are making India as their exports hub and also even they are probably pretty large capex, you can bet directly on those, you know, themes or you can indirectly bet through the building materials. So that is our highest conviction. Next is real estate and its ancillary place and, and then the API CRAM space which sort of is anti-consensus today, so you are getting reasonable valuations there, you know, and then the growth hasn't slowed down. I think there were a couple of quarters where because of the growth derivatives being the input, they did face some margin contraction, I mean, across the board, if you look at that space the margins got contracted by 300-400 bps during that time... So, next couple of quarters, you could see them coming back to normal or some even going beyond the normal margins because they are not going to take back some of the price increases that you have seen. So, you can see pretty sharp earnings growth, and then slowly the markets will again jump into that kind of a boat, and you continue in that same. So those are the companies where we are finding high growth opportunities where valuations are reasonable, and you continue betting on them, and you keep looking for new emerging themes. Defence will be one of them you know, something else but you got to get really convinced about the long-term story of that growth, as well as the valuation.
Quick follow ups on all of these on APIs for example, there's this whole conversation about how because currently Europe has these issues, some of those plants are shutting down, some of those buyers are looking for long term alternative suppliers, even if smaller in size as a smaller percentage because they have realised that they don't want to be fully dependent on one geography, which is say for example, Europe and my question is, is there a long-term structural opportunity for API players because of what's currently going on between Russia and Europe?
Samit Vartak: Yes, exactly. There are a couple of things which are important for a customer to consider while giving the order, most of them would come for long term in nature, even these are long-term contracts they come in with. So, one is of course, their efficiency and competence, whether they can deliver, you know, reliably, and second is the capacity whether do they have a large enough capacity to deliver the size of order they are looking for. So, in India, there are not too many players, there are only two or three, who have both of them, where they are consistently shown and executed, you know, timely delivery of these and they are also paid orders of our capacity for the next three years. So those types of companies will definitely see a lot of traction. I mean, some customers may come in for the short term, but once they experience that, you know, the quality and the cost is way better than what they probably get in Europe. You know, it's pretty comparable to what they get in China. They will stick with them. But I think over the years, the efficiency of many of our players and the capacity is pretty comparable to the best thing in the globe.
We were talking to for example Century Ply, and they are saying that they have embarked upon the next two-year capex which is larger than what they have done in their history thus far, and how growth for the next 3-4-5 years maybe a CAGR of 20% and they said that they want to be conservative, they don't want to be aggressive and yet he is talking about five years growth of 20%. So, is this a theme which is completely well discovered, or do you reckon that as growth comes by the valuation, multiple arguments could also come to the fore simply because real estate is not a sector that has had now 6-7-8 years of tailwind behind it ,it's just been a recent phenomenon?
Samit Vartak: I think compared to overall market, I don't think the valuations is factored in, in order to kind of growth that you could see because I think things have changed structurally in these whether it's plywood, MDF players, or tiles, the imports into India whether it's tiles, MDF, plywood is almost gone down to zero, you know, so that's where that demand from the Indian players and have gone up and at the same time, there are countries outside, so U.S. has put an end on duty on tiles and India has completely benefited out of that. Recently, the Tiles Association players were saying that the annualised export of tiles are most recent 17,000 crore you know, which is which is phenomenal. I mean, which wasn't even close to 5,000 crore three years back. So that's the kind of growth we have seen and at the same time because of the energy situation in Europe, Spain and Italy has been large players in this. Their cost of manufacturing has just gone through the roof because you need a lot of energy for manufacturing say tiles and hence, they are also out of the market. So, there is India growth story plus added benefit of export opportunities and if you are one of the players who can do both, you are in a great position to take advantage of both and the valuations, especially in the tiles players it's I think it's long consensus play because people are worried about the gas prices, even in India the gas prices have gone up, you know, whether you look at north or south and hence their margins have got impacted. I mean the stock prices haven't changed in the last couple of years. That's where they are at and I believe that the valuations may look as high as what the others are, but I think it's because of the margin compression that sometimes in the short term they superficially look high but as soon as the margin expands and most of them have taken huge price rise, almost every quarter they take 2-3% of price rises. At the same time hopefully, in the next six months or one year, maybe the energy, especially the natural gas prices in India, may come down and whenever that happens, and if it doesn't happen even then they will have already taken up the price enough to come back to normal prices. If the prices go down, most of the time they will not take the prices down and their margins will expand way beyond their normal margins and then that the PE multiples would start looking attractive at that point. So, I think that's pretty interesting theme, building materials in real estate ancillary plays, which I don't believe is frothy.
So, if I am not wrong you were in a structural company as an building ancillary play, now it has expanded to tiles and some others. Last couple of questions. One, you have manufacturing of, you know, conversation with SKF some time back, but the MD mentioned that as he looked out at the decades, he mentioned that if I was an Indian manufacturer or capex oriented or B2B player, I would be very happy because it seems to be my decade. You kind of echo that. So my question is, are these MNC players that you really like because they have to export opportunity out of India, or do you like Indian players wherein some have proven their mettle, some haven't, but valuations might be capturing that or are you looking at ancillaries which supply into this theme?
Samit Vartak: I like the MNC players as well as the Indian players you know, the problem with MNC players first of all, they are very illiquid and secondly, because of that they are very expensive. You know, so that's a big problem. So even though they may play out, most of them trade at 60-70 times multiples, so you can't have too much allocation to them. There are Indian players making compressors, those kinds of players they are reasonably valued because that completely makes sense, but most of them are still illiquid companies. So, we do buy them in the small-cap portfolio, and they have been really well for us. But those are the way you can do it or indirectly, like the structural steel tubes would be used across whether a Timken is putting up a factory or an SKF is putting up a factory or you know someone in the compressors player putting up a factory or the government is going for infra you know the PLI scheme picking up and whether you are building textile plants or semiconductor plants, so I feel that so much better out of indirect way, where you are getting reasonable value, mostly half the valuation of what you would pay for, you know, the Timken or the SKF of the world and probably you will get higher growth, you know, compared to just betting on say one industry, you know, so if that part of the same theme, you know, you can think direct or you can think maybe second or third level and try to figure out what is the best way to position your portfolio and off course you got to think longer term like where is the longer term, like what will happen in the next three or four years. That is where you need to be, you don’t need to be what will happen in the next three months or six months.
Samit, I know you mentioned that your starting point is growth and then you come down to valuations, but given a choice currently, looking at the way the valuations are, would you go for a company which is better on valuations, even if the growth is slightly lower than the threshold that you mentioned or would you not mind paying top dollar for a company which is growing above your thresholds?
Samit Vartak: It depends on the extent of valuation, but you know, I have never paid super exorbitant valuations. So, you know, we are rarely in companies which are, you know, 50-60 times kind of multiples. So, but even if I say I am looking for 25% growth, but some companies only delivering me say 18 or 20% growth, but I am getting at 10-15 times multiple you know, that makes complete sense to me. See, my successes historically, the largest multi-baggers have come in because of I mean, I don't remember a single multi-bagger of mine, where the earnings multiples haven't rerated, you know, whether you look at Bajaj Finance, PI Industries, you know, if you look for Amara Raja Batteries, LaOpala, you know, Solar industries, Sundaram, Finance, you know, Cera, I mean, across the board, Deepak Nitrite, these kind of play. I have seen that the multiples have gone on by two or three times and the earnings have gone up by two or three times. So that results in you know, in 10 times multiple, so that’s when you don't find an opportunity then then you try to find the best bet you can. It's very difficult to find earnings multiple getting rerated two or three times. You know, it can happen in one of these, but that's these are not the times it comes in. As I said, you know, once in three, four years, those kinds of opportunities. When they come in, you have to grab it and have a good time location to those kinds of companies.
Any interesting book or a blog or an article or something that you have been reading, which viewers can benefit from?
Samit Vartak: There is no extraordinary new book that I have read, which really comes to my mind, but whenever I sort of need to get a little more motivated, I go back to some of my old time favourite like, you know, Investment Gurus and have where you get to read stories of so many different fund managers, traders, all different styles, you know, it does motivate you, how they have come up, you know, and what kind of things they did. So, I go back, and you know, you don't have to, you can go back to just one or two of those fund managers and see how they have done, it always keeps motivating you, so that really helps and I keep on going back to Michael Porter’s book, understanding Michael Porter kind of book and do that and then I spent probably half the time really reading the spirituality kind of listening to those kinds of talks because on the investment side, you know, after a while there is very little incremental knowledge that you get, it just that you find them entertaining, if you actually evaluate what is the real value addition that you got in terms of actually helping you in delivering higher returns. It's very, very incremental, you know, by reading just few bytes, 10 of those really good books, when you are learning. You have enough knowledge to give it's more about us, you know, execution capabilities, your temperament and just staying, you know, calm and focused, so that spiritual aspect actually, you know, helps much more with that to keep your mind open, clear and otherwise, this is a pretty stressful profession where people do judge you based on, your three months performance when your performance and you just need to keep your head down and, you know, go through those sentiments, without getting affected otherwise you can get affected and then you know, it disturbs you in your actual world. So, whatever you can do to keep your sort of head and mind grounded, you know, that is much more helpful, once you have covered a lot of critical aspects of investments.
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