Piper Serica's Abhay Agarwal Isn't Worried About High Valuations Of One Set Of Stocks

Abhay Agarwal: I was surprised personally by the commentary of Bharat Forge. It's a very strong player. So, it came as a bit of a surprise. But it is also quite natural that the environment that we are in, with a lot of global influx in shipping and inflation rates, interest rates, corporate earnings in the U.S. and Europe. I don't think we are in a situation where any company can come in and say that look, I have absolutely clear visibility of growth for next two years. I think there is expectation and optimism, but still till it translates into orders, nobody is going to go out in this market and say that…because we have also seen that you underperform in one quarter and what happens to your stock price…

Management of most companies are not willing to go out, make a very aggressive forecast and then underperform because the market will punish them. So, I think it's just the nature of the market right now. The corporate commentary just reflects that nervousness, but that also gives astute long-term investors opportunities to make their own bets among this noise that we are going through.

Abhay Agarwal: So, you're absolutely right, towards the end of the third quarter of the last calendar year, we had bought into cash because we were nervous about the whole trajectory of Fed interest rates and normally, we don't take cash calls. But this, we thought was an extraordinary event and we also had made good money in our small and mid-cap bets, so we wanted to book some profits and get into large caps and get a little defensive because we thought that the environment globally and in India was a little volatile.

However, things changed pretty quickly. We were surprised how fast-paced change stands to keeping the rates where they were and indicating the cut in the middle of this year. So, that gave us confidence that we don't need to sit on this much cash and then we can deploy it…

But what we have done is that since we have a very long-term approach, and we're not really looking to churn portfolios very often, what we are looking at is backing the long-term opportunities that we see will make the kind of returns that you mentioned for our portfolio.

We're not trying to do anything extraordinary. We don't want to take too much risk. Our investor profile is such that they are already wealthy. They are family offices or ultra HNIs and their mandate is that you grow the capital at a sensible level without trying to take too much risk. So, we like keeping the portfolio de-risked as much as possible, can't escape the market volatility but we have cut down our allocation to large banks and NBFCs. We are just about 20% there.

We have a large segment in our portfolio that we call financial services companies, which are not lender companies like Angel One, CDSL and CAMS. We see these as very long-term plays. We are not looking at them for one quarter, five quarters or 10. What are we looking at is for the next five years and 10 years.

Then we have added agri chem in our portfolio, and right now that is flatlining. But I think with the focus that the government has on boosting the agri economy, there are companies out there that will do well. Large-cap pharma has been a contra bet for us for the last six months. You know we added three names there and they have actually already done well. So, we are quite positive on large-cap pharma because of various reasons.

In autos, we have one bet, so that's the portfolio construct. We don't have any IT names. A lot of people are surprised but I think IT, we still see struggling for growth for one year. So, once we see positive commentary, we'll probably add to that. So, that's the broad portfolio construct, I would say—it's a mix of small caps, mid caps; we have a flexi-cap strategy and about 30% is large cap, 20% mid cap, and almost 50% is small caps.

Abhay Agarwal: No, in pharma, we can clearly see over the last three months, we have seen multiple things happen that make us believe that trough has been reached in the cyclical business of generic pharma exports. One is that the extended supply or dumping from China has ceased to a large extent, and in generic pharma companies were struggling because the pricing power was lost and they were making money but barely any money to cover costs. So, we see a margin improvement...

The second thing we are seeing is that raw material prices coming out of China have dropped. Third thing which we have seen, which is again a very good long-term macro play, is that the U.S. FDA has become friendlier. I don't know the reason for that. I mean, is there a political overtone to that or is it because the U.S. is running short on generic supply for its domestic market or whatever it is, the U.S. FDA is not as competitive. I think large credit should also be given to our companies, our large pharma manufacturers that they have learned how to comply with U.S. FDA standards, they have learned how to come up with the best of the manufacturing facilities in the world in India. So, we are not at all worried about U.S. FDA actions that used to destroy value a lot earlier.

Another interesting thing is the new launch in both the U.S. and India. I haven't seen that kind of pipeline, so if you look at companies like Dr. Reddy’s, Lupin, Sun Pharma … these are not my recommendations, but across the board, you will see a very strong pipeline of launches. So, that has given us the confidence that these companies are trading at very low valuation compared to their upcycle multiples. So, there is enough good money to be made over the next three to five years is what is our bet in this case.

In IT, we're not making that bet because we're not seeing any signs of recovery. We're not seeing any increase in customer demand. We're not seeing any innovation coming out of IT services companies in India, that is leading them to increase their margins. So, once we see that, we will definitely consider adding those also.

Abhay Agarwal: In the current environment, yes, it's a very competitive market and unfortunately, the Indian companies seem to be caught like a deer in the headlights when it comes to innovation and adopting new technologies like AI to drive efficiencies for their customers. I think some of the recent losses of large contracts is probably because of the reason for that their pricing is not able to match what the customers expect them to do.

Abhay Agarwal: So, we have three companies in our portfolio in the agri chem space. They cater to Indian farmers. One is Dhanuka, and the other is Bayer Crop, and then we have a large play in the form of UPL that we recently added, though the commentary as you said is still pretty weak.

But I think the kind of extended downcycle these companies are gone through, we would like to believe that we are towards the end phase of that, maybe a quarter morem maybe two more quarters, but again, we can see some of the key product prices inch up as the dumping from China is reducing as we speak and I think that is what will help them increase margins.

The domestic companies like Dhanuka is a small-cap company, just expanded capacity, has a very good product portfolio, new launches. Bayer needs no introduction, you know, one of the best players in India, top players. So, we believe that these companies will get volume growth, will get higher margins because the government is very focused on making sure that the farm level income increases.

The BJP has a stated objective of doubling the farm income over the next five years and I think that is going to be a big focus area for this government. But leaving that also aside, you know, just the economics of it, that the farmers will need a better yield on their farmland and the farmland is not increasing. So, all that can do is increase the yield and for increasing the yield, you need herbicides, agro chemicals, fertilizers, crop protection, all kinds of chemicals.

That is where these companies with a very solid value chain will play that upcycle when it comes, so you're right. We may be a little early in the cycle. But we know that the valuations will spike pretty quickly once the numbers actually start hitting. So, that's why we have a 13.5% allocation to this space which we are happy to hold for the time being.

Abhay Agarwal: There are two reasons for that. One is a structural business issue that these banks are now struggling for two things. One is access to cheap deposits, which drives their margins. I think that access to cheap deposits in the form of constantly increasing CASA (current account, savings account) has probably hit its upper level now and I think incremental gain if any is going to be pretty small. So there is going to be a cost-side inflation as depositors want a higher return for the money that they put up in these banks.

The second thing is that the opportunity space on the credit-side is very competitive. If you want to go and lend to very good quality corporates you know, that's become very competitive with PSU banks also becoming very competitive. In fact, SBI and Bank of Baroda are giving all the private banks a run for their money as far as corporate finance deals are concerned.

So where do you go? So then you go to retail and retail is a large franchise, but again, as long as you're going to do mortgages or secured lending, the margins are limited. And then, willingly what you're left with to drive aggressive growth in the book and margins is to drop down to unsecured lending or close to that. Now that is a space that is infested with microfinance companies, small NBFCs who do a very good job at that.

So I think the large private banks, most of them, are really struggling for growth right now because either they sacrifice credit quality or at the same credit quality the growth is going to be not equivalent to what it was and that is the fundamentals part.

The other part is the technical part. Now look at the valuations. As you mentioned, they are probably (at) one of the lowest end of the valuation range, if we go back to last 15-20 years. But at the same time, if you're an FPI investor, if you are a foreign investor, who doesn't really have to invest only in Indian banks, you would look at Indian banks and say, ‘Wow, these are the most expensive banks in the whole world you can buy.’ You look at Citibank, Bank of America, JP Morgan, all these are trading also at almost single digit book value 1-1.5 times book value multiples, international level franchises that are fairly de-risked, because of their global nature. So, as an FPI investor, you always toss up and say, ‘Look, instead of buying a very expensive Indian bank, may be I could just buy a Citibank, if I need to increase my banking allocation.’ And you look at some of the Chinese banks, which are trading at ridiculous 0.3, 0.5, 0.25 times book value.

So,if you look at the technical factor, and if you look at the fundamental factor, I think the question is what kind of return can you generate backing these big banks now. Are they going to go into a business restructuring technical valuation correction zone for some years before you start looking at them again.

Abhay Agarwal: You said it so well. You know, the short-term outlook drives valuations, but long-term perspective drives returns. That's the truth. The longer you can see, the farther you can see, the better is your probability of making returns. I've seen that you know, the investors that we have, they are looking for compounders that will compound at a sensible valuation. We pay a lot of attention to valuation. We are not investors who would like to buy quality at any price. For us, returns come when we pay a fair valuation and let the company's compound growth.

So some of these companies—like CDSL, CAMS and Angel One—look expensive, and they have been historically expensive. We have them in our hands since their IPO time and they have delivered excellent returns for us. The reason that we are backing them is that as the financialisation of savings takes place, more demat accounts, more trading accounts, more mutual fund accounts, folios are getting created. These are companies that are completely driven by technology now. Their margins keep improving because they don't have incremental costs as much as the revenue growth.

So you're in a beautiful space where you have a highly consolidated industry, with two players or at max three players in these industries. And, you don't spend any money in marketing because your business is all inward, it's all inbound. And with that, as India becomes from a $4-trillion market cap to an $8-trillion market cap, these businesses will triple or probably quadruple in size just to support that size.

So, if you take that five-year view or eight-year view and say that these companies can become, four to five times their current market cap, then I think the attention goes away from their near-term PE multiples to looking at what is the wealth that I can create. So, I think that's the bet that we are making in these companies.

Abhay Agrawal: Absolutely. They don't have the cost structure and they can scale up very rapidly. They don't need to build new offices, they don't have any capex, they don't need to hire as many people because technology is driving their entire business growth.

Abhay Agrawal: We had Lemon Tree in our portfolio. Post Covid, we had added and then we exited the same recently and the reason was exactly what you said.

I think a lot of their valuation is now well into the frothy zone because of populism of these stocks right now and also the fact that there is some scarcity. So if a large investor wants to allocate a reasonable amount of capital into the hotel segment, there are very few names that are available. So I think that is driving some of these frothy valuations but I think the earnings are not going to be as high as people expect them to be because these are businesses that are driven by very high capital inflow. Every time they grow, which is either by acquiring a hotel or taking a contract of a hotel, they have low-margin, high-capital businesses that will struggle for growth beyond a point. So I think, it's a good secular theme going forward, but the valuations are not that attractive anymore in this whole segment. I think the returns have been made whatever was to be made within Covid.

So in the hospitality sector, if you look at travel, there is Indigo, which is probably the only airline that one could invest in and then there are you know, restaurant stocks, but they have also disappointed. Most of the QSR (quick service restaurant) companies have struggled for growth in the last one quarter because of seasonality and some other factors. Then you have movie chains. PVR is probably grinding towards its 52-week low. So, what is happening is that, while the whole tourism space is a good and attractive theme, the problem is that there are not enough players in this that investors can look at. I think that's one of the reasons that whatever is worth investing in is already so expensive, that you wonder, what kind of return would you generate by investing in them at current prices.