Avoid Herd Mentality While Investing, Says Samit Vartak | Alpha Moguls

Samit Vartak: Yes, you are right Niraj. I think these days things move too quickly. You know, and especially we have seen, two periods of 18 months each post-Covid. So, post-Covid if you see, there are so many of those export-oriented sectors like pharma, chemicals, IT, which were doing exceedingly well.

And then, we have the past 18 months when most of them have taken a significant beating and many of the domestic-oriented sectors have done well. So, 18 months is too short a cycle for things to play out. Things move too much towards the extreme. So, if you look across the board at a total market level, valuations—especially after the run-up in the past couple of months—are back to way above average.

So, though valuations are definitely not that attractive, there are in pockets. You need to find those pockets, where there is not too much herd and not too much excitement.

I think that's the key, especially when cycles are so volatile, swift and sharp. I think if you really want to beat the market, there is no option but to deviate from the herd and you definitely need to be a little contrarian. It's even more important these days, with the kind of efficiency in the market and the speed with which information spreads so quickly. Even a new investor gets the same information that fund managers get on a real-time basis, which probably wasn't the case earlier.

So, a lot of data is completely commoditised. The spread of data, the spread of research and today, most participants have access to any research report that they want. So, everyone gets the information at the same time. Unfortunately, that probably boosts the herd mentality. As everyone gets the data at the same time, everyone gets bullish at the same time and money flows into those pockets very, very quickly. So, if you are part of the same herd, it's very difficult and it's getting more and more difficult to beat the market, especially for fund managers, where there is a pretty significant impact cost. If too many people buy at the same time, the impact cost probably takes away whatever alpha you were trying to make. So, I think post-Covid, things have moved towards the extreme and one needs to definitely take that into consideration when building a portfolio.

Samit Vartak: You are right, but I really don't differentiate too much between new money and existing money because even existing money has that opportunity cost. And, you can get out and get into a new stock. For me, it's important that you optimise your returns going forward. For that, history is sunk. It has no meaning for the future.

Of course, you would look for extremely attractive opportunities and add new opportunities. But for me, because I am operating more on the smallcaps and midcaps side, there tends to be much more volatility as well as many more multibaggers. So, the risk is higher, but the potential to make outsized returns in stocks is also possible. Hence, in multibaggers, time period or time horizon can be long. Sometimes, it can play out in two years, or sometimes in five years or 10 years.

So, in your portfolio, there are going to be stocks, which are somewhere in the middle of that multibagger cycle. They may not be as attractive as they were maybe when you bought it, but, you know, things also change. So, something which was available at a valuation of 10 times P/E after two or three years when the company has matured, has become much less risky. It has become larger, liquidity is higher, but that doesn't mean that 25 or 30 times multiple is expensive.

So, you tend to hold those stocks because there are going to be older stocks, which you expect to become bigger or multibaggers as part of the portfolio. But then, on the other side, you would be churning some part of your portfolio. So, if you have 20 stocks in the portfolio and your churn rate is 20%, then you would have four stocks that you would be adding, or exiting during the year. Those are the stocks in which you look for outsized divergence, whether it is between the peers or even compared to their own historical averages. And that's where when you add new positions you need to be a little more contrarian. You can take your time to build that position, but that's where you have the opportunity. If you keep on adding the flavoured stock, which everyone likes, that will definitely not be adding an alpha, especially if you are a little late to the party. You need to be maybe a little early to the party and build your position slowly. That's where you can make outsized returns.

For multi bagger returns, you need three ingredients: One is a low-valuation starting point. Second is high earnings growth. Third is basically rerating of the multiples, where you expect that multiple definitely is not going to depreciate, it will improve going forward. So there has to be rerating of multiples. In my last 11 years of history I don't remember a single multibagger where the starting P/E multiple was 30 or 25 times. Mostly it has been closer to the single digit. So that's the starting point and the P/E multiple would rerate by 2x or 3x.

So, if the starting multiple was 10, and over three or four-year period, the multiple itself is sort of a multibagger and then you have earnings growth of 70% where the earnings will double in say, three or four years and that's how you do get multibaggers.

If you already enter at 35-40 times kind of multiples, then you can’t expect to be a multibagger. There are going to be exceptions for sure. There has been Bajaj Finance where it was a multibagger even when you bought it at a much higher value. But those are exceptions. That's one in 2000 stocks and if you try to pick or if you try to cue that benefit to all the stocks you will make many more mistakes just to get that one. And that's not how you improve your probability of finding multibaggers. So, for improving your probability, you have to have those three ingredients when you enter. And that is only possible if you have a little contrarian view, you are early to the game, and you wait for the cycle to play out over the next two to three years.

Samit Vartak: When a fund manager talks about his strategy, it will be about trying to find multibagger. But, it's almost impossible to have all the 20 stocks as multibaggers, at any point in time, whether during the Covid lows, or the excited markets like today. So, I have seen that in a three to four-year investment horizon, out of our 20-stock portfolio, even if you get two or three multibaggers and the rest of the portfolio delivers you an average market return, that itself creates 5-7% alpha.

So, over a three to four-year period you find at least two to three multibagger stocks. So the goal is to be able to find that stock, which more than doubles during that time period, typically—at least for most multibaggers—be at least 3x to 4x in a three-year period, sometimes even in much lesser time.

Out of the 20-stock portfolio, there would be at least 50% stocks which are older where they are actually not at the start of their multibagger journey, but they are somewhere in between. They are also not towards the end of the multibagger journey. But then, the remainder 10 is where you look for those two or three stocks. So, your hit rate, even if it's like 20-25% that's reasonable enough. So that's what you try to find but at least those 10 need to have that potential of those three ingredients—low P/E multiple, high earnings growth and potential of rerating of the P/E multiple.

Samit Vartak: No, what I am saying is that you may think that there is potential for you know, certain percentage of your portfolio to become multi baggers, targeting two to three stocks out of the 20 to be multi baggers.

Samit Vartak: Yes, so that proportion typically is going to be seven to eight stocks, or sometimes you seven to 10. Out of those, I would expect two to three to become multibaggers, because not all of them may turn out to be that.

Samit Vartak: See, there are pockets where I believe those will become multi baggers. Surprisingly, there are extremes in this market. Some are extremely expensive, but there are pockets which are extremely cheap in the market. You may think that the markets have run up quite a lot. But if you remember, even in 2018, the smallcap index had reached 9600. Today it's somewhere around 10,500. So in a five-year period, it has gone nowhere.

So, overall, long-term returns for the small and midcaps have been extremely meager. In my recent memo, I have written about the three-year cycle. The cycle has repeated every three years. The peak of smallcap index has repeated every three years. So, whether you look at 2005, 2008, 2011, 2014, 2015 and then 2018, 2021. Next peaks would be somewhere in 2024, and the multi baggers typically, occur more often during the up cycle.

So, in that three-year period, the first 12-15 months is the correction period and during that period, you know the correction or an average in these last six cycles has been about 45%. So, there is a sharp correction in the smallcap. This time, from the peak in end of 2021 to the bottom towards late 2022, it was about 33% drop. And from the bottom to the next peak, typically the run-up is 2.7 times. This is for the Nifty smallcap 100. So that means the index itself becomes a multibagger. So, during that phase, it's possible that you will find many more multibaggers compared to the correction phase.

So, I believe we are in that upcycle phase, from here on, till the start of 2025 and hoping that same kind of cycle repeats. There is no reason why it shouldn't happen. Even today, if you look at the top 100 stocks, the smallcap index which I say from the 251st stock to 750 stocks, those 500 stocks, and even today the discount of this smallcap universe is about 25% to the top 100 stocks. And that's the average discount over the last 10-year period. The discount is 25% to 30%. But the key difference is the return on equity today of that smallcap universe which is about 15% compared to the largecap of 16%. So, there is very little difference.

Historically, if you look at the last 10 years, the smallcap index’s return on equity has been around 12% and then the largecap is around 16%. So, largecap RoE is similar to what its last 10-year average is, but that of a smallcap has improved significantly. The average discount of RoE of the top 100 and these 500 stocks has been about 35% to 40%. So, today the difference is barely 7%. So, you would expect that and still the price-to-book of smallcap index is trading at almost, 30% discount to the largecap universe. I am talking about the median values here, which I believe it doesn't probably deserve. Even the debt-to-equity ratio for the universe is below 0.2 times for these 500 stocks.

So, significantly improved balance sheet, significantly improved profitability, but the valuation gap still remains as historical. A lot of things have changed. There's been a lot of cleanup promoters, management have become much more prudent in protecting their businesses this time. Even if there was a down period they did not compromise on the margins. So, there is significant improvement in the business and valuation, but I don't think it is reflecting as much as what's in the largecap space. So, I don't know about returns for the entire index, but I think in the smallcap space, there are significant opportunities which are still available and I believe we are in the right part of that two-year cycle.

Samit Vartak: Right. I mean for example, in power finance, or power equipment side or even, you know, small, midcap metals play. Many of these are in terms of their balance sheet at the best historical levels but trading at a significant discount to their last 10-year average. So, these are really good businesses we are having. Forget the power finance company, but even power equipment, some metals play where it's very difficult for competitors to come in because they have long-term licences, they are debt-free, and the valuations are way below average. Most of them trade at significantly below one time price-to-book or single-digit kind of a P/E multiple, where I believe given that their balance sheet has improved and the growth has returned there. I don't think given their balance sheet it is going to be as cyclical as what it historically has been.

So those are the pockets.

I am seeing in auto ancillary players where they are incrementally putting growth on the electric vehicle components. That's one. Power finance companies, gold finance, microfinance kind of companies, significantly below their long-term averages and metal space, smaller metal space where they might be slightly vertically integrated, but in the last down cycle, they have significantly improved their balance sheet and people still are valuing them as extremely risky commodities, which isn't the case given their balance sheet and the prudent management. So those are the pockets where I still find I think there are going to be multibaggers in this space.

And then, you know, what we talk about is that reasonable valuation, but there is pretty huge potential. Those are the spaces like you know, the building materials that I've been talking about for a long time, whether it's, fabrication pipes, electrical cables, bearings going into railways, industrials. There are many other building materials like stainless steel which go into wagons or there is a monopoly in India for stainless steel. So, those are the plays where they may not be cheap, but they are fairly valued, but significant growth is ahead of them. Overall, if I were to put it into a theme, I would say it's either build India, whether you're building factories or airports or bridges or railway, metros, roads, data centres, factories. So, either build India or build in India. So any foreigners who are coming into India, where obviously, they would also need to put up their capacity.

So, niche again, one needs to be very careful, if you are just trying to bet on basic building materials where there is no limit of how many competitors can come in. So there is there has to be huge caveat that look for this kind of demand drivers, but the manufacturers or the service providers or the product providers, they need to be very limited. The number of players shouldn't increase. Whatever growth potential that you see the benefits should go down to these two or three players and you need to bet on some of those dominant players. You know, if that is the case, I think, for some of that, we are at the start of that kind of growth cycle. India has gone through a pretty significant cleanup whether on the financial side, whether on many key industries like real estate and there have been a lot of regulations. And the kind of improvement that you have seen on the power side, in terms of defaults, losses, the cross NPAs on the power finance companies is I think, missed by many investors and we will reap the benefits you know, going forward.

Samit Vartak: Yes. So, real estate, building materials, you know, that side I am extremely constructive as before. On the chemical and pharma space, we definitely were a little late to exit. S we got it wrong in terms of exit. We did benefit from chemical and pharma space for a long period of time. The first chemical company that I bought was in 2011-12. So, we did right, but then again, we do keep on getting investors on a daily basis. So, that benefit is not occurring to the newer investors.

So, on chemical, pharma space we were very constructive until the middle of last year, but then realised that things have completely changed.

A few other things changed in the chemical space. One was, post-Covid, there was pretty significant stocking up of them because of a lot of logistical issues. So, many pharma or chemical companies stocked up on inventory. Suddenly, there was a lot of demand and then because of shortages, the margins that these companies made were all-time high. And, they also made a lot of cash. So many companies ended up putting up new capex and then after things normalised across the globe, there was re-stocking. At the same time, there was overcapacity, which is a double whammy and margins contracted. P/E multiples have contracted and because there is oversupply because of overcapacity, even though the demand may normalise, but still, there will be margin pressure because of overcapacity.

So, you know, that's something where we completely got it wrong, in terms of exiting early. Right now, we don't have too much chemical other than you know, one-off plays that we have, but the portfolio is more geared towards the building materials, the power infrastructure, power finance side, gold, microfinance side and then completely sort of bottoms-up plays, wherever we are finding those pockets or one-off stories. So, that's how the portfolio is constructed. Overall, the valuations have significantly dropped because the newer additions that we have done, I feel, have those three ingredients to become multibaggers. Not all of them are going to be, but at least from what I see now, there is potential to that. Of course, we can go wrong as we went wrong in terms of exiting chemical from our space.

Samit Vartak: No, we are absolutely not doing it because I think those are really long cycles. You know, that's not like a three, four, five-year kind of cycle. I think such cycle predictability is more from a 10, 20, 30-year perspective and I am not even sure if those are the right numbers, where there is a pivotal jump. I mean, we can bet only on things we are seeing.What we are seeing on the ground is that there is a significant buildup of India by the government, by private players, and there is also significant interest of building in India.

So, there are foreign players who are coming in. So, any sector which will benefit from that, whether in building materials, power, etc. You would need much more power. So, in finding place to play that kind of theme is what we are betting on because I feel those are much higher conviction when there is much higher growth even if there is significant improvement in demand side, on the consumer side, but generally it's late in the cycle.

Once India builds the infrastructure, when the factories come in, and then there is employment which gets created and that is when salaries will go up. And then, consumption will pick up, but I think that's much later in the cycle. I think right now, it's too early for that to happen.