We are spending a fair bit of time looking for consistent compounders down the market cap spectrum, well-run
small cap companies with good franchises, Saurabh Mukherjea, Founder, Marcellus Investment Managers, tells ET Now.Edited excerpts:It has not been a bad year for India 2018 even though the midcaps gave us a rude surprise on the downside. Can 2019 be rewarding despite the elections? As I have been saying for the last 12 months, the Indian market still remains overvalued in totality. 9,500 is roughly where the Nifty should be. Whether it will get to fair value or not is a different matter. If you ask me, this is again going to be a year for stock picking. It is difficult to see why there will be a broad-based rally in the market. I know everybody will obsess endlessly about elections but as I have said before, I am not so sure politics really has that much of a bearing on our stock market as people think it has. So, it will be year of stock picking and specific segments which I think looks very interesting for making money continue to be exporters who benefit from a weaker currency, private sector banks who benefit from the slide in the NBFC fortunes and more generally, the consumption story especially small ticket consumption where you do not have to borrow money to buy the products. There will be pockets to make money but I am not so sure that the Nifty as a whole will bring you that much joy in the next 12 months.You are bullish on exporters because of weak currency. But don’t you think the currency arbitrage which worked very well for IT and pharma companies, may not be a trigger for 2019?There are two parts to it – one is that we know on a factual basis that a year ago we were at say 63-64 on the dollar. We are now around 70. Most of the IT services companies fully hedge their currency exposure. So the last 12 months they have not really seen the benefits because they have hedged their exposure out. The benefits of the weaker rupee only now will start fructifying for the IT services firm. My reckoning is even without any further depreciation, even if the rupee stays at 70 to the dollar, you will start seeing the benefits of the weaker rupee flow through now. Second, it is relatively clear looking at the gyration in the rupee that for exporters to be competitive, you need around 75 to the dollar and that obviously suggests that there is further tailwinds for IT companies, the pharma companies, the export pack as a whole. It is very difficult to see how our current account deficit will go back to semblance of normality without rupee reaching 75 to the dollar and the fact that the FPI inflows (bond and the equity inflows) are moderating as the cost of capital rises in America. This make it even more imperative that the CAD goes back towards say 1-1.5% of GDP level rather than the current levels closer to 2.5%. So 75 to the dollar feels like equilibrium, which suggests that there is further juice in playing the export story around IT and pharma.The slowdown in the lending has taken its toll on auto sales as well. This played out in December sales figures. Would you say that the worst is already priced in and is it time to start buying on dips, or maybe keep it to names like Bajaj Auto?It is not just the slowdown in lending, It is specifically the challenges facing the NBFC sector which have hit auto very hard. Because of the nature of their business model, the NBFCs are far more enthusiastic financiers of trucks, cars and bikes than the typical high street banks are. My reckoning is that NBFCs stay under the pump through this year. Whilst the worst of the IL&FS scare is behind us, there are reasons to believe that money will stay dear, cost of capital will stay high for the NBFCs and market share will shift to the banks. So, while the auto slowdown will abate as the year progresses, seeing 15%, 20% growth in truck volumes and 20% growth in car volumes is not something we should expect to see in 2019. That was a specific feature of the early part of 2018. It will probably go back to high single digits growth on cars and trucks but the high teens, early 20s numbers that we were seeing in car and truck volume growth will be a long time coming. This is year of a high single digit growth in auto volumes rather than double digit growth.You have been making a point, stick to the compounders’ list. In 2019, has there been any additions to your classic compounders list?Abbott Labs is a company we have been looking at quite carefully for a while. It seems to have all the classic characteristics of a great compounder, strong proprietary technology, proprietary IP, superb cash flows. It is a company we are looking at quite carefully, perhaps we will add it to our portfolio at some stage this year. The other element to think about is the fact that what you are seeing in largecap consistent compounders, firms like say HDFC Bank or Asian Paints and so on. There is a reasonable chance you can see the same phenomenon on getting repeated lower down the market caps spectrum. I think there is a good chance that well-run smallcaps can have a very good year. Raw material price pressure, raw material cost pressures have abated and that typically is a great time for smallcap stocks to see improvement in operating margins. So well-run smallcap companies will find 2019 to be a fertile year and we are spending a fair bit of time looking for consistent compounders down the market cap spectrum, well-run small cap companies with good franchises.We may hope to catch the next smallcap but in reality it is very difficult, isn’t it?There is a very peculiar feature in the Indian markets. The Sensex churns by around 25 to 30% over a 10-year period. But the BSE 500 churns by almost twice as much over a 10-year period. What that suggests is it is relatively easy for a well run smallcap company to enter the BSE 500, have a good four-five-year run where growth is say 20-25%. The companies enter the BSE 500 and then they struggle big time to get anywhere close to the Nifty. So our stock market is a play of two halves, on the one hand you have giants like Asian Paints and HDFC Bank with formidable competitive advantages cranking out huge shareholder returns over long periods of time and then you have well run small cap companies who are able to grow rapidly to a point but not beyond that. And in between these two extremities there is a sort of whole load of mediocrity which is basically the bulk of the BSE 500. My job in a way is to think one of the HDFC Bank and Asian Paints consistent compounders, great companies which can crank out superb returns over long periods of time but on the other hand, look out for promising small companies who can have a four-five-six-year run and end up dominating the small niche in the Indian economy. So I was referring to the smaller strategy of looking for companies which can dominate small niche in the Indian economy. They might never be an HDFC Bank or an Asian Paints but they will have a four-five-year good run and that is what I am trying to also discover, This is a good year for that because raw material prices have abated and that is typically a good climate for smaller companies to have a decent run.Where else within smallcaps do you find value? The other area to look at quite carefully is playing a capex recovery but rather than trying to do it through say an L&T type of construct or buying Axis Bank shares, one can look for B2B companies which will benefit from a revival in the capex construct in our country. To give an example, take a company like GMM Pfaudler, which makes glass line vessels. Their vessels are used by the chemical industry, the pharma industry and therefore if we have an economic revival and chemical demand spurts upm then GMM Pfaudler with experience should experience a revival in top line growth.Similarly, if you look at a company like Alkyl Amines which makes aliphatic amines, again if you have an industrial revival in our country a dominant supplier of a niche chemical could see a good run. So try to look for well run small cap companies which dominate a niche in our B2B economy and our industrial economy might be a more interesting way to play a potential capex recovery on the other side of the election rather than trying to buy the sort of the no-brainer type of stocks which is what the typical investor will run out to do.How would you be looking at the exporters this year? They were a big play into 2018 especially the IT stocks. How would they fare in 2019?IT remains a prominent part of my portfolio. I had turned bullish around 17-18 months ago and as you were just discussing in the early part of this interview, if the currency remains at 70 and perhaps goes towards 75 to a dollar, there is good reason to believe IT exporters will continue having a decent run in. I would add pharma to that list. A stock price recovery in pharma is long overdue. Domestic demand has been very robust for the last four, five years. The worst of the FDA action is behind us and if the currency stays at 70 or indeed moves towards 75, there is a long overdue recovery in Indian pharma stocks as well.We have seen a massive outperformance in the Nifty because of TCS and to a large extent Reliance. They have done well and there was a macro scare. This kind of factor played out in 2013 when rupee went down, crude was volatile, interest rates went higher. We saw a very strong rally in midcap and smallcap stocks. But now mid and smallcap valuations are not cheap. So will only experts like you be able to get few midcaps right? But but that is only 15% of the market?I am glad you brought this point out. I think there is two different ways in which you can think of a small and midcap rally; the first way the classic small and midcap rally in any market is typically when money becomes really cheap, cost of capital drops, everybody gets really excited, the animal spirits come out and people start looking for exciting small and midcap companies even though the fundamentals of these stocks might not be the greatest. I do not think 2019 is going to be a year for that sort of a rally. The cost of capital keeps going up in our country and maybe we will get the odd RBI rate hike before the election but by and large, the cost of capital globally will carry on grinding up and we too will be part of that journey and hence it would be difficult to see a small and midcap rally driven by risk appetite. The other reason that small and midcap companies can more selectively have a good run is their fundamentals improve either raw material prices abate or demand picks up a little bit and they see operating margin expansion. On the back of operating margin expansion you see selective small and midcaps rallying. I think this is more the latter sort of year, not the former sort of year. I find it difficult to believe that suddenly we will see cheap money sloshing around India and everybody will start having a punt at small and midcaps. It feels more like the latter sort of year where well run small and midcap companies have a good run on the back of better profitability, better profit margins in 2019.Will you buy two-wheelers if there is right now only gloom and doom in a Hero MotorCorp or Eicher Motors? If interest rates which is a raw material for consumer to buy cars and two-wheelers remains low, will auto demand come back?Let me answer the easier question first. FMCG is set for another good year, partly the demand base for FMCG is in good shape, election oriented spending and so on. But also raw material prices abating is good news for FMCG stocks. I know valuations are elevated there, but I do not think FMCG stocks will suffer on account of rich valuations. If I had to buy a two-wheeler stock, if someone held a gun to my head and said you have to have a two-wheeler stock, I would go for Bajaj because the export-oriented element of the Bajaj franchise puts it on a better wicket than Hero or indeed Eicher.If I had to buy a two-wheeler stock I would look at Bajaj. For a long time now, TVS Motors continues to be a company which has gone from strength to strength, their BMW bike is shaping up pretty well and I think TVS will continue to be an interesting stock to have. But amongst the frontline two-wheelers, if someone held a gun to my head, I will look at Bajaj Auto. The export franchise could be the main thing which draws investors towards them. The domestic piece on two-wheeler consumption will remain challenged as cost of money stays high in our country.
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