Investors need to have a selective approach to get the best returns from frothy market conditions, according to SageOne Investment Managers LLP Founding Partner and Chief Investment Officer Samit Vartak.
“The confidence and resilience in earnings growth is the biggest measure of the quality of a business,” he said.
Vartak added that he prioritises earnings growth or resilience while picking a stock compared to the management quality of the company.
“So you have to be confident about the earnings growth and against that what is a comfortable valuation, that you have to pick,” he said.
The ace investor said that it was okay even if the investor bought a stock at a higher valuation in this scenario.
“If the earnings come through, you may have some time correction, but in the long run, you will make those returns. In the short run, valuation multiples may be the bigger drivers of return but in the long run, it is the earnings growth,” he said.
“These are not extraordinary conditions where you think that the markets and the economy are at peak, banking systems and corporates are over-leveraged, companies are finding it difficult to collect cash—at that point, the market is trading at an all-time high. Those environments are risky,” he explained.
Vartak suggested that an investor may face two bull markets in a lifetime and missing out on one of them could be expensive.
“Sensex has gone up 670 times since 1979. If you rank all the 10,500 days during these many years, and if you look at the top best 112 days, those are the ones that contributed towards the entire 670 times,” he said.
Samit Vartak said that if an investor missed out on those 112 days, or 1%, their returns would have been zero.
“The opposite is also true. If you missed out on the worst 1% days, then your returns would have been 4.6 lakh times,” he added.
However, with the return line being uptrending at 14–15%, Vartak believed that it’s always more expensive to miss out on the best days rather than the worst.
Watch The Conversation Here
Here Are The Excerpts
The case for a chat that I'm making today for Samit Vartak, quality over value amidst life highs, or does value triumph over quality or is there a mix there. Non-banks better placed amongst BFSI or can banks make a bit of a comeback and global headwinds persist for Metals or can that change as well?
All of this is happening Samit Vartak, because, since March, I haven't read a memo from you. Otherwise, it just becomes very, very simple to know how to structure the conversation. I miss your writing Samit, so it's a cue that you write one more memo soon.
Samit Vartak: Yes, within the next fortnight, hopefully.
But Samit, without giving up too, too many takeaways from your memo, just trying to understand, how do you think about this because at various points of time in the past, when people have spoken about excessive valuations, you have pointed out the dichotomy in looking at market wide valuations, which is what's happening at the broad end of the spectrum, specific buckets, etc, and how value was there and that's proven right thus far.
So, I'm trying to understand, amidst the most common narrative of markets across the board being expensive, what are your thoughts on the numbers based on history or otherwise?
Samit Vartak: I think the most popular metrics used for valuations are P/E multiples or EV/Ebitda, those kinds of metrics are more P&L based. I think the game changing event for India, which happened post-Covid was the improvement in the balance sheet. You know, the balance sheet has improved and in the previous decade, we saw median debt to equity of point 6, point 64, you know, today it's at point one four, and that's a huge draw, and that's the improvement.
Plus, if you see the P&L profits are supported by operating cash flow. It's not still above 100% and the return on equity, return on capital metrics, are near all-time highs. So that's a big difference. Now the ratio that I look at basically incorporates P&L as well as the balance sheet, which is enterprise value to operating cash flow. Now, enterprise value opening cash flow, basically, you know, has ranged, I mean, up to 25-26 times during 2018-19 as well as in 2008 you know, today we are below 20 times. It's about 19 and a half. So, which is not suggesting, and this is for the top 1,000 companies. This is the weighted average.
So, of course, there are pockets which are more expensive, and especially once you go towards the smaller caps, or you go towards anything to do with capital goods, anything to do with government incentives. You know, those kinds of pockets are expensive, but overall, broader markets are not that expensive and this is excluding financials. The financials, as you know, the banking stocks, are cheaper. I'm saying beyond just financials, because you can’t look at the enterprise value to operating cash flows for financials. So I'm excluding that. Even that universe is the median over the last 20 years is about 17.1 times.
You know, we are at 19.4 and hence, you know, some overvaluation probably the market deserves, given the fundamentals of the balance sheet, the fundamentals of the banking system, you know, the kind of capex the government is putting and more importantly, is even the private capex. You know, I think we keep on focusing on the corporates for private capex, but there is so much capex going into real estate.
Real estate today is one of the biggest drivers of the economy. It percolates into a lot of, you know, different ancillary industries. Today, real estate inventory is the lowest. You know, if you look at the top eight cities, there's an Axis report, it shows that since 2010 we have the lowest inventory today, you know. So there could be a lot of projects which have been launched, but we are still sitting at the lowest inventory and probably we will have a few more years of real estate boom, that kind of capex, which comes, and the government itself, you know, is putting up significant capex.
You know, their rate of spending has, has gone up. So, government capex, strong balance sheet, strong cash flow, private capex in terms of real estate, as well as the general corporate private capex, you know, in terms of building factories or putting up new capacity, even that's picking up. So these are pretty positive things, and you got to look at the overall valuation in this context.
Got it. If you had a choice to sit on cash, etc, would you do that, or would you wear the portfolio, maybe towards more safety, if you were, if you are, maybe not as constructive? I mean, what are you doing right now and given a choice, if you had a choice of taking cash, would you sit on cash right now?
Samit Vartak: I think I've learned through multiple cycles, you know, since 1999 that taking a macro for cash is extremely risky and it's very, very expensive sometimes if you get out at the wrong time, because it's not just taking a cash call one way. You also need to get it right, getting in, you know, a lot of people do, did take a cash call during Covid time, but then pullback was so sharp. Within a couple of months, things were back to normal, at least in terms of the stock prices and very few people could get back. So, getting it right one way is not good enough, and then getting it right both ways in multiple cycles is almost impossible.
I mean, I have presented this statistic previously, but I think it's always worth repeating, and, you know, sort of updated the analysis. If you look at Sensex, Sensex has gone up 670 times since 1979. If you rank all the days, there were about 10,500 days during these many years and if you rank from the top performing day to the bottom, and if you look at the best performing 112 days, those are the ones who have contributed towards the entire 670 times. You know, that means if you miss out on 112 is roughly about 1% of the 10,500 days. If you missed out on the 1% best days, your returns would have been zero.
Of course, the opposite of that is also true, if you had missed out on the best one or worst 1% days when your returns would have been 4.6 lakh times, you know. So both are true. But I think one has to look at the market, and it's not a zero sum game. The long term, historical returns have been in that 14 to 15% that means the return line is up trending. So when the return line is up trending, it's always more expensive to miss out on the best days rather than missing out on the worst days.
So even with those statistics, you know, mathematically, it doesn't make sense to sit out unless you can exactly time the market. So from that perspective, I never did a top down call, but bottoms up is very important. In such a time when everything looks frothy, you need to be even more choosy, and you need to pick pockets where you're very confident about the earnings growth. Now, earnings growth, I feel, is the confidence in earnings growth, or the resilience of earnings is the biggest measure of quality of a business. So, you know, I don't believe in just looking at the management quality or sort of the modes of the business.
You know, there's no earnings, and if there's no resilience of earnings to what's the use of that kind of a quality. So you are being very confident about the earnings growth and against that, what is a comfortable valuation you are able to pay. Even if you pay a higher valuation, it's okay. You know, if the earnings come through, you may have some time correction, but in the long run, you will generally make those returns. I mean, everyone knows that in the short run, valuation multiples may be the bigger driver of returns, but in the long run, it's the earnings growth and if you are able to pick companies with high earnings growth or whatever hurdle rate that you have, and you pay reasonable valuation, they may not be cheap. In the long run, your returns will match the earnings growth.
So there's no reason to move away from that discipline and from that process, you know, these are not extraordinary kinds of conditions where you think that the markets or the economy is at a peak. The banking system is over leveraged, the corporates are over leveraged. You know, companies are finding it difficult to collect cash, and at that point, the markets are trading at an all time high. You know that that kind of environment is risky.
But today, I think we are at the start of a capex cycle on the private side. Government has just started a huge capex over the last two or three years. We had that missing since 2012 and, you know, I think if we are in an investor's life, maybe you will get two big bull markets. You know, maybe it's once every 20 years. So if you miss out on one, it can be one of the most expensive decisions. So it's not worth sort of taking that kind of macro call.
By the way, Sensex is at new highs yet again. Are we in the midst of one such bull market? What's your hypothesis?
Samit Vartak: See, given the condition of the balance sheet, given the prudency of corporate India, given where the banking system is, and given the real estate cycle, given that the capex was missing for the last, you know, since 2012-22 it's possible that whatever missed out, probably we compensate for that beyond the average, you know, over the next 10 years. So, if your historical growth rate has been about 13-14% last, you know, 2012 to 2022 was in single digit. We may make up for that, you know.
So instead of 13-14% we could grow at 16-17% not the 32% that we grew in 2003 to 2008 and because at that time, there were multiple cylinders which were really firing the global market. You know, the government capex, private capex, real estate, infrastructure, a lot of those things were picking. China was, you know, starting into a big capex cycle. We are missing the global factor, but the domestic factors are way better today than what they were. You know, we are going in a measured way, in a much more efficient way. So we may not have that kind of a cycle, but it could be a long, prolonged cycle where there could be short-term corrections in between.
But we have to ride this cycle, you know, it looks like an India decade, you know, not just from a story perspective, but just to just look at the numbers. It is highly possible. It's very difficult to predict such cycles. But when the fundamentals are so strong, you know the valuation cannot be the only reason why you get out of the market. You need to pick your pockets right, because there are, you know, 1,000 stocks, even for a fund manager to pick, and if you're looking for 15-20 stocks to build a portfolio, you generally need to find those. If you are not able to find those, okay, you know, you can sit in cash, but it has to be bottoms up, you know, reason and if you're not able to find opportunities, whatever you find is extremely risky, then okay. You sit on cash until you find something which is comfortable to you. But I think if you do enough hard work, you are finding enough opportunities and there are multiple sectors which are offering that.
Okay, so we are in the midst of a bull market, and some hypotheses around potential returns that could come in as well. It's a hypothesis, viewers, you need to build your own if you're an investor yourself. So bear that in mind. Samit, just before we get to pockets, which are giving you the opportunity, I want to understand about pockets, which were the crowd favourites until about three months ago, and since then, the pullback has happened. Some of the naysayers would say that we told you so that trees don't grow to the sky. Valuation excesses get corrected, and stocks don't bounce back.
Samit, what happens in these because the sound bites of order book growth all stayed true even now, stocks have come off. That is not to say they will stay here. My question, therefore, is, will a showcasing of earnings growth revive the fortunes of some of these because it does look very likely that the earnings growth in some of these pockets will look very strong in the quarters to come?
Samit Vartak: In the last interview, I think, you know, I had sent out a table where railways and defence were the top performing, and then you look at their earnings growth, it was completely missing, and then the stocks had just multiplied and just didn't make sense. See, I think again, you know what I defined by quality, as I said, is earning growth, as well as resilience and predictability of that earnings growth and defence whether it's Railways, these are, you know, the life cycle of these products, whether it's the railway wagons or some defence equipment, sometimes, is very long. You know, it can be 30-40 years.
The longer the life cycle of the product that you cater to, the more volatile it becomes, because it depends completely on the capex. So, railways can have a great two, three years. But who knows, in case the government changes, or in case the government policy changes and suddenly the order book stops. You can have a really one bad year, and during that one bad year, you know, the market has no idea and then it crashes. Hence, if you look at these kinds of stocks, whether defence stocks or railway stocks, thrice in the last 15 years, it has corrected by 80-90% just because of the uncertainty. It can have a great run, but then one or two bad years where there is no visibility going forward can correct these stocks. So such stocks cannot be valued like a resilient, high-quality business.
One has to know that it's highly cyclical. These are highly cyclical stocks, and accordingly you need to value them, because the risk associated has to be compensated by the cheapness of the valuation, whereas a lot of these stocks are trading at almost FMCG kind of valuation. So, it doesn't make sense. So, I think it's again, bottoms up. You need to understand those businesses, the risks associated with those businesses and how resilient is the earnings growth as well as the earnings quality, and if you find such businesses. See, in investment, it's always important that you reject most of the businesses and only you know, bet on businesses where you're confident about earnings growth, earnings quality and bet on those. Paying higher valuation is a much less risky decision than betting on low valuation and extremely low-quality business in terms of earnings growth and earnings resilience.
Tell us, where is it that you're finding a mix of quality of business or quality of earnings and resilience in the current context, and are some of these pockets available at good valuations or the valuations are stretched?
Samit Vartak: See, again, it's bottoms up. Some of the pockets which are offering reasonable opportunities, I think, are niche NBFCs, you know, where the return on equity is high, where assets are extremely secure. There are, you know, CDMO spaces, there are specialty chemical spaces which are more related to, maybe electric vehicles. You know, there are a lot of building materials which haven't gone anywhere in the last one, one and a half years, and they are exposed to the biggest capex, you know, whether it's real estate or a factory builder or government capex. So, they will definitely benefit from it.
Some of them are going through maybe some down cycle of the Chinese pressure on metals during those times. Some of these companies do go through inventory losses, and hence, you know, investors don’t want to touch them during such times. But those are the times when you have an opportunity to get these long-term good businesses at reasonable valuations. So, I think those are the opportunities which are available in these kinds of sectors. Sometimes a sector may not be that great, but you will find one of opportunity in those you know, even expensive sectors, which is something that you like, or you know, which is trading at pretty uncomfortable levels. So again, bottoms up is a very different story. Top down can give you some direction, but still, your stock picking has to be bottoms up.
Okay, stock picking has to be bottoms up, but you mentioned some pockets, Samit very difficult to figure out what would be the right valuation to pay. So for example, let's talk about real estate. You have some investments there. You bought into them earlier. That sector has run for a bit, right? Would you pay top dollar currently for real estate? Do you believe the cycle will last and is a better way to bet on real estate through pure play, real estate companies, or through ancillaries?
Samit Vartak: So ancillaries are, you know, if you find them with good valuations, also are great plays. You know, either you can bet them through housing finance, you can bet it through materials which are used in real estate. See, real estate is more bottoms up because it completely depends on that real estate company. The location, location, location is very important where their projects are, and real estate is very difficult to value in terms of a lot of metrics. You know, the metric that I use is that whatever is the market cap of that company, look at the operating profit that the company will make over the next six to seven years. If that operating profit is higher than the market cap, today's market cap, you know, I find it reasonably valid or cheap.
So, if you want reasonable value, you can stretch it up to maybe 10 years. But whatever projects the company has under their development and over the next six to seven years, if the operating profit makes up for the market cap, it's generally a great investment. It's worked out, you know, for me, multiple times and that's the metric that, you know, I use. Now again, it's very company specific. I can't talk about the overall sector, but the overall sector itself is, as I said, it's at lowest inventory levels in the top eight cities and urban real estate makes up for 2/3 of the value of India.
So, it's a big, big contributor towards real estate and real estate does contribute almost 1/3 of the capex of India. So, it is a big contributor. So, depending on your understanding of the businesses, your comfort, you can bet it through multiple ways.
Okay, you spoke about Housing Finance. There is this big housing finance listing that's happened, trading at a substantial premium market cap, equal to or more than the 10 next housing finance companies. Is this a sign of excess in that space or do you believe that after a high test that space might start working again, because NBFCs or Banks per se, haven't quite gone anywhere, if you will?
Samit Vartak: It's such a market way that, you know, anything new, you know, gets more attention and attraction, and many it's in the you know, it's for the short run. So, the older similar businesses are boring, and no one is interested, because it comes in with historical performance, you know, baggage. But I think this is a time when you need to identify which businesses, which were delivered in the past, in terms of protecting its assets, in terms of delivering close to 20% of return on equity are well managed. You know, management in finance is extremely important. It's one of the biggest factors, and that's where, you know, Bajaj Finance, Bajaj Housing, gets that kind of valuation only because of the management and then the belief and confidence in that management that they will be able to ride through the cycles protecting capital.
But there are many companies which are available at probably 1/3, 1/4 the valuation with similar kinds of better metrics. There are a lot of options in that space and again, haven't done too much over the last you know, compared to what you know, a lot of these pockets have done. too much. I think there are a lot of opportunities in this space. This also includes building materials, you know, building materials. You can bet it through PVC, pipes, structural pipes, you can get it to MDF.
I mean, there are so many ways where, you know, you don't need to bet on the entire sector. But if you find a player which sometimes is really attractive, you know, those with the industry tailwind, I think they will deliver over the next 3-4-5, years and rather than focusing on sectors which are sort of in the story, and you know, where there is lot of talk, he always would look at sectors where no one is talking about will seem very boring. Maybe the stocks haven't done anything in the last one, two years, and hence, no one is interested in them. You know, unfortunately, the better the stock does, the more interest it generates and stocks which haven't done anything, you know, they're completely abandoned and that's the opportunity.
That’s true. Samit, one final word. I mean, a sector that is a bit complex to understand. But while you say that, you know, maybe look at sectors which maybe it might be a good idea sometimes to look at sectors which are not in vogue. A CDMO is in vogue, especially because of the BioSecure Act, and suddenly people are talking about how fortunes will change. It's not an immediate thing, anyways.
But because it's such a difficult one to track, because each company might be doing things differently, and there is this whole USFDA piece around them, etc. How constructive are you? Are you taking a large bet on CDMO and are you spreading bets, or have you chosen it? I mean, are you playing it via maybe just one company or two companies because you know the companies very well?
Samit Vartak: Again I'm completely playing it through just one company in each portfolio, so not really betting on the, see, people's Biosecure. It's a very niche segment, and not all the CDMO players will benefit, you know, from the US ban on China, you know. In CDMO, it's also important that whether you have the capacity already built up, you know, no U.S. company is going to continue if you don't have the capacity. Sometimes it takes years to build up that type of capacity and China is a big, big supplier, and to replace that will need a huge capacity to be built up. It may take time.
But right now, because of sort of the macro story, people will get excited about all the CDMO players which have no relationship with the ban and so again, it's, you know, completely bottoms up is very important. You need to know exactly the earnings growth potential. You know, they should be delivering at this point. It should not be just based on hope that they will benefit from this China plus one story. It's always better to, you know, understand that right now they have triggers. Right now they have the capacity and they're already delivering. Better to pay a little higher valuation. But, you know, have high confidence in that earnings growth and again, resilience of that earnings growth.
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