Date & Time: 16th July 2021, 05:30 PM – 06:30 PM IST
Samit Vartak Founding Partner & CIO, SageOne Investment Managers
Moderator: Kamal Manocha – Founder & CEO, PMS AIF WORLD

Building a superior portfolio of names less known today, but giants in the making

PMS AIF WORLD has taken the baton to shift investor’s perspectives in Equity markets, away from risk, towards returns. It recently organized a mid-year event, a confluence of Top Portfolio Managers in India and highlighted the same theme. The event was a grand success, and in case you missed the live sessions, you can watch the recordings on our YouTube Channel.

With the primary focus intact, that the next decade will be all about returns, PMS AIF WORLD recently organised a webinar with Mr. Samit Vartak– Founding Partner & CIO, SageOne Investment Managers, who has a track record of having generated 30% CAGR returns. Mr. Raamdeo Agrawal (Chairman, MOFSL) sees Sensex at 2L in 10 years from now, given that it grows at a CAGR of 15%. Such a CAGR for the broader market definitely implies that there will be individual businesses that will grow at a CAGR of 25% and above, which would ultimately generate 10x wealth for investors in 10 years. This is the central idea of this webinar—how to build a superior portfolio!

The focus of SageOne Investment Managers is creating a high conviction, concentrated, and a balanced portfolio in Mid & Small Caps. Mr. Samit Vartak mentions that it is really important to have an overall good build of portfolio as for instance, in a portfolio of 10 stocks, over a period of 10 years, if only 2 of them give 30-40x returns and the remaining give a return in line with the market i.e. 10-15%, the overall portfolio will give a return of about 25%, which is about 10x in 10 years. Typically, it is very rare that the top line grows by 10x in 10 yrs— even for fast growing companies, the top line grows at 17-20%. So, to begin with, one can start looking for companies wherein the top line has the potential to grow 5x in 10 years. Couple this with margin expansion and that adds to the overall return. The third and the most important element is valuation. If you get the business right, the valuation itself goes up by 2x-5x.For instance, Bajaj Finance in 2010-11 was barely 1-1.5 times P/B valuation; today it stands at 9 times P/B.

“Where you start and where you end is what will drive returns.”

A lot of people tend to focus on the demand side. Mr. Samit Vartak believes that since demand is easier to estimate, given the rate of population growth and potential expansion of certain parameters that play a role, the difficult part is to estimate the supply side. Taking the example of the most popular multibagger, Amazon, he explained that demand did not grow up by that size, but rather, competition was destroyed, and the business verticals were expanded. The point of being heavily invested in small and mid caps is to realize the growth potential over a 10-year period and unearth a multibagger which is difficult to replicate with a large cap firm.

In the context of Indian equities, Balkrishna Industries (BKT) has been a multibagger capture for SageOne. The Company manufactures off-road tires (tires used for agricultural/mining/construction equipment). This space was completely dominated by the big international brands, so BKT inherently gained a cost advantage. The need for customization in orders restricted a lot of players from entering this space. BKT, which initially started with off-road tires, slowly started expanding, got bigger in size and started selling to the OEMs directly— today, 25% of sales come from OEMs. BKT has been a disruptor in its space and has grown at almost 23-24% for the last 10 years.

The industry may not grow but if you have a disruptor, that will take away the market share from others and create growth.

For instance, if we look at APL Apollo, a biz. that deals in the space of structural steel pipe, an industry which has not grown much in the past couple of years. But the biz. itself, drove technology in its favour and disrupted the space by filling orders much sooner than its competitors. Put together a low manufacturing cost, the technology to support it, and the brand to go along— all of that gives you a pricing power that marks you as an outlier in the positive space in markets. The same was noticed between Amara Raja Batteries Ltd. and Exide, wherein the former had 15% lower cost price than the market leader. It decided to tap the unorganized sector and the replacement segment while growing at 20%-25% from 2012 to 2017. Moreover, it spent heavily on branding and advertisement which helped it gain control over the market. The growth majorly stemmed from the supply side rather than the demand side, leading to a sustainable advantage.

To take another cue from a market player, Deepak Nitrite dealt in specialty chemicals, performance chemicals and normal chemicals business. However, the launch of the phenol plant in Dahej, Gujarat, led to savings in importing of phenol. Yet again, the supply chain was disrupted leading to sustainable growth for the company.

Being a Founder himself, Mr. Kamal Manocha (Founder & CEO of PMS AIF WORLD), made a pertinent point that management quality in terms of passion, skillset, and integrity is important to look at while making long-term investment decisions in a company. But there are several other factors also that play a role in such decisions— what is the overall thought process of SageOne in building such a portfolio for investors? Answering Mr. Manocha’s thoughtful question, Mr. Samit Vartak elucidates the fact that there are very few companies with a market cap of ₹30,000 crore that are poised to reach ₹3 lakh crore market cap. Hence, he is heavily invested in the small and mid caps with a positive outlook for them over a 2-3 year horizon only as beyond that, how the business plays out, only time will tell. No one can predict the growth of any business for the next 10 years— a continuous revaluation and reassessment is needed. If the company still fits the growth potential after 2-3 years as well, they continue to hold it; but the horizon is always of a 2-3 year period as continuous reassessment is what builds conviction over time.

A promoter’s execution skills come into action while looking at various factors for building a sound portfolio. Mr. Rajiv Jain from Bajaj Finance had the execution skills as the firm only dealt in unsecured lending for personal finance and the two-wheeler segment. Furthermore, he had the ability to align his interests with that of the minority shareholders which led to the business entering mortgage and consumer financing segments. In order to search for a viable opportunity in the market, an investor should target the ₹5,000-₹10,000 crore market cap segment. A suitable investment horizon period would be 3+ years with an expectation to double your money within the same time frame.

With a portfolio comprising of 15-16 stocks, expectations should vary from 8x returns in 3 years or 10x returns in 5 years if most of them turn out to be correct. A 20% growth for the top line, margin expansion, growth potential varying between 5-6%, and correct entry at a cheap valuation are the major factors to be kept in mind to create a portfolio. However, the last point is not in the hands of the fund manager or the investor. If the earnings double in the next 3-4 years combined with a 30% decline in valuations, an investor stands to earn decent returns. It would be safe to exit the market if the first criteria is not met i.e. doubling of earnings in 3-4 years.

Investors have had the misconception that if the company doubles, one should book half of the profits and believe that the remaining is a risk-free investment. They need to evaluate whether earnings growth potential is still there or not before buying the stock or booking just half the profits. For example, La Opala grew 5x in one year itself, however, a major trigger rose when the government imposed dumping duty on opal glassware imports from China and UAE which hit the business adversely. Another example taken during the webinar was of Kaveri Seeds and its competitor Nuziveedu Seeds. The former’s market share was 5% as compared to 15% of the competitor. SageOne invested in Kaveri Seeds as they felt that it should have a similar market share due to a better product on offer. The fund realized 3x returns within 3 years and decided that it was ideal to exit as there was no further growth that could take place.

Companies have de-leveraged considerably over the last year where the debt-to-equity ratio has fallen to 0.3 which gives a sufficient cushion to investors. Secondly, the cash flow generation is high, especially the CFO to net profits which is hovering around 120-140%, which used to be below 70% three years from today. Banks did have significant amount of NPAs in their balance sheet in 2017.  It would be commendable to say that the balance sheet of banks have improved considerably when compared to corporate balance sheets today. Although most companies do not require credit due to sufficient profits generated, credit availability has improved over the last 4 years. Today, there are less chances of a company going bankrupt when compared to 2007-08 or 2017 as well.

You need to be invested in companies that can double their earnings in 3-4 years.

During Covid times, on an average, an investor’s portfolio did decline by 20-25%, which states that investors need to take the pain before they can see returns in the 3-4 year horizon period. An upward trending earning line will be the biggest protection of your capital as against valuations. The latter does not provide protection due to tumultuous times like Covid. Mr. Kamal Manocha rightfully stated that earnings growth has a part to play in valuations but new investors in India around the age of 25-56 have also increased in numbers. For experienced fund managers, it does become difficult to manage sentiment of a large group of investors and stay away from momentum. Large caps have rallied from 2017 to 2020 but delivered almost zero returns due to the pandemic. Over the same health crisis period, small and mid caps have returned 10x in a one-and-a-half-year period. When the quality of stock is determined by the rise in price, it instills confidence in the investor about the quality of business. There are companies which might go up 30-40% due to a stellar upcoming quarter but they are also desires or pleasures that one should stay away from. Investors should stick to those companies that have the potential to deliver returns irrespective of the movement of interest rates over the next 3-4 years.

There are times when greed is stronger than the fear of making losses.

Investors need to stay invested for at least 10 years to even predict what might happen in the next 6 months or 1 year horizon. There is a tendency to jump in momentum stocks because the speed at which they are increasing is enticing. People cannot stay away from this temptation of making quick gains until and unless their wealth has been eroded a couple of times. The core of investing carried out by Mr. Samit Vartak can be explained by investing in those companies whose earnings is poised to double within 3-4 years. Moreover, it is important to see the way they execute the strategies and implement them. Investing in mid and small caps is understanding the business qualitatively, the existing market competition and whether the company will be the market disruptor. Studying in depth about the business verticals, the supply chain and background knowledge about how companies strategize for various kinds of events is crucial. The speaker laid down the fact that valuations are important but the choice and strength of the business should not go wrong. The compromise on the valuation part is sufficient as long as a company valued at 25 times is being paid 30-35 times but wrong selection of business might lead to losses of permanent capital.

Mr. Samit Vartak has a 4-5 year experience of conducting professional valuation in Silicon Valley at renowned organizations like Deloitte and Ernst & Young. His experience has led him to understand that it is tricky when PEG ratio is compared for a cyclical company with a consumer-oriented company. Cyclical companies trade at 10-12 times multiple as against consumer oriented companies that trade at 60-70 multiples along with a growth range of 11-12%. However, it should not be concluded that such consumer oriented companies do not have a fair value. There are two factors which need to be kept in mind during valuation— duration of growth and the kind of investor a company attracts to its table. For example, Bajaj Finserv’s expansion into seven verticals led to its yield increasing to 17-18%. The expansion led to the business becoming much safer and even attracted investors looking for a meager 12% returns from the stock. Reliable earnings growth and business expansion are crucial for sufficient gains. Similarly, APL Apollo’s inventory days have reduced significantly to a couple of weeks and hence less volatility in earnings. Once the company has come out of a tough cycle stronger, it will attract investors looking for stable returns and will skyrocket the PE multiple.

Understanding how valuations work will lead to answering the question of whether the PE multiple will be re-rated or not. The investors that the company is currently attracting versus those it will attract five years down the line speaks volumes about the organization. Returns are concentrated in a short period of time under the current market levels but timing the market is very difficult under any scenario. It is difficult to bet on earnings or PE multiple re-rating, and more difficult to find PE multiples of 12-15%. Expectation of returns have to drop when an investor enters the market at a peak, however, earnings will lead to returns of 15-16x even if the valuations crash. Momentum stocks pose a serious risk to capital as earnings stagnation over 3 years will lead to the PE multiple crashing by 30%.

You will have to do whatever best you can in every kind of a market.

The fundamentals of the business are in your hand as the PE multiple moves up or down. The core should be to find fundamentally strong companies, not necessarily the quality companies that are usually sought after but those that have the potential to be called quality companies 4-5 years down the line. It is imperative to say that investors need to spread out their bets and diversify their risk as much as possible. The webinar provided insight into Mr. Samit Vartak’s trading strategy of identifying companies with factors that have potential for future growth. The strategy is unique and Mr. Kamal Manocha wished the speaker good luck for an upcoming AIF. The webinar would be incomplete without talking about the IPO frenzy where the guest speaker highlights that Zomato’s P/S ratio is currently 30x whereas the global competitors in the industry have a P/S ratio of 4-5x. Even if the valuations fall to 6x, Zomato will have to deliver a top line of 5x to compensate for the drop in valuations. It is mathematically difficult to make 10x returns in 10 years but unique businesses do attract investors that have a liking for such valuations. Lastly, good quality IPOs apart from the tech industry have entered the market that are profitable and have been in the respective industry for quite some time. The IPO frenzy has been a major boost to employment in India as their expansion has given rise to more jobs. Towards the end, it is suffice to say that better the quality of a business, higher is the price commanded for it. Mr. Kamal Manocha, during the webinar, articulated many real questions that investors have in their mind, and this brought about the best out of Mr. Samit Vartak, making this session a remarkably interesting one. Mr. Manocha wrapped up this insightful discussion meaningfully by concluding that a high conviction approach combined with quality companies in the mid cap space that have a horizon of 10 years might lead to 10x returns for investors.

RISK DISCLAIMER: Investments are subject to market-related risks. This write up is meant for general information purposes and not to be construed as any recommendation or advice. The investor must make their own analysis and decision depending upon risk appetite. Only those investors who have an aptitude and attitude to risk should consider the space of Alternates (PMS & AIFs). Past Performance may or may not be sustained in the future and should not be used as a basis for comparison with other investments. Please read the disclosure documents carefully before investing. PMS & AIF products are market-linked and do not offer any guaranteed/assured returns. These are riskier investments, with a risk to principal amount as well. Thus, investors must make informed decisions. It is necessary to deep dive not only into the performance, but also into people, philosophy, portfolio, and price, before investing. We, at PMS AIF WORLD do such a detailed 5 P analysis.

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