Many experts believe that the index may not really give you much higher levels for the balance of the year and it would be individual stocks and sectors and stock rotation that will keep the market going. What is your view?
It has been the case in the recent past as well as over the last 10 years, that a handful of companies have actually delivered bulk of the wealth creation in the stock market. So it is a bit pointless to be looking at the index if the whole idea is wealth creation. In future also, we will continue to see concentration of profitability and free cash flows in the hands of a few companies. Therefore we maintain our stance. We own all of the 10 to 15 stocks in each of our portfolios and therefore we only look at a very small segment of the market that has demonstrated a track record of consistent growth and profitability as well as free cash flows.
We have shown in our latest news letters, that even in the BSE 500, barely 15% of the entire index has managed to deliver any free cash flow growth over the last 10 years and therefore the investable universe remains small at least for investors looking at franchises with long term capability of delivering free cash flow growth and therefore I think I would tend to agree the index not really interested nor do we have a sense of which way it is going. Even in the benchmark indices, we do not find too many franchises having that consistent track record of delivering free cash flow growth. It has to be a bottom-up stock pickers’ market. There are plenty of opportunities for those who can put their minds to it to understand the strength of these franchises, focus on governance and comparative advantages which in turn underpin their ability to generate free cash flows. So yes it is going to be a bottom-up market.
What do you make of the prospects of Zomato for long-term investors and the slew of Indian internet companies which are slated to come out with their IPOs this year?
Technology is changing quite rapidly and it is disrupting several industries. There is no doubt about it and having said that, within Zomato’s experience, we have seen that the food delivery business has received a boost in terms of accelerating adoption thanks to Covid. Like many other industries, digitisation has been accelerated by a few years and the opportunity has also been brought forward for the likes of Zomato for a few years.
It is coming at a time when the whole food take industry has been consolidated. We started off with a whole host of food delivery players which has now boiled down to two players who are cornering most of the market. Having said that, the risk of technology is that disruption could affect anyone. We have seen that a company like
came back and gained market share again at a time when these players were around.
In technology, it takes a very deep understanding of the sources of competitive advantages to make a bet particularly when they are coming at high valuations. In any case, for us as investors at Marcellus, it does not tick the box because we generally look at companies with at least a decade long profitable track record and Zomato has been around for more than a decade but the profitability track record is still not there. Therefore it is outside our purview,
But having said that, watching companies and franchises like Zomato helps us understand how technology is playing out in various fields to the extent that even some of our portfolio companies could be subject to this disruption. So from the overall technology boom or the spate of IPOs in the technology sector, we have always been a bit circumspect when it comes to IPOs. IPOs always have a sense of asymmetry in terms of information.
Clearly there are promoters as well as pre-IPO investors who are selling out. They clearly are privee to a lot of information which otherwise we are not and therefore we do not mind missing a little bit of listing gains because we tend to look at franchises from a long-term perspective.
If indeed these businesses are worth holding for the long term perspective, there will always be opportunities to buy into them even after that listing. So it is interesting to watch this space more for understanding the world that we live in. Technology is affecting our lives, affecting the traditional businesses that we have invested in. But we are in no hurry to buy into these IPOs any time soon.
What are you working with when it comes to earnings within the capital goods space? Could the likes of L&T, Cummins, continue to stand out and deliver a strong set of earnings?
We generally do not look at too many cyclical industries because of the patchy track record in terms of free cash flow generation. Having said that, it is important to understand that it is an important sector from an economy standpoint and we have been through a fairly good period of deleveraging in the big capital heavy industry space, particularly in the commodity space, metals and mining. Even in real estate, there has been relief of sorts where the last six to nine months has been a decent period allowing cash flow generation to deleverage their balance sheets.
So given the deleveraged nature of these balance sheets, if these sectors start building capacities back up again, it augurs well for capital goods equipment suppliers after a fairly long hiatus in terms of demand for capital goods in the country. But yes, the Covid second wave has also thrown a spanner in the works in the sense that there is further demand destruction happening in small and medium enterprises. We have heard about job losses there.
This will all feed into the possibility of many of these industries building capacities again. They do that only if they see demand coming back and that is where there is a bit of a question mark. But from a cycle perspective, there is a reasonably higher probability that we will see a capex cycle in the country over the next three years and that should augur well for capital goods manufacturers.
The market in the next three years is going to be dominated by more cyclical recovery and capex will pick up. Steel demand is also making a comeback. Some of the stocks you own like Pidilite, HDFC Life, Asian Paints may grow but the stock prices may remain stagnant for the next two, three, four years?
It is a matter of relative performance. There are periods in which such franchises have perhaps underperformed for brief periods of time. It is quite possible. I do not think there is any strategy in the world which outperforms in every time period but we tend to measure ourselves from a three-year perspective and we reckon it is not a zero sum game. It is not that the capex cycle is going to take away consumption demand. In fact, if at all, the capex cycle recovery in the country is going to create more jobs that augurs well for income generation, disposable incomes and consumption demand.
In fact, it is good for a lot of consumer and retail oriented companies if the investment cycle in the country picks up. So while there might be question marks about relative performance, the sort of outperformance these companies have exhibited over the last five, 10 years has been stupendous. So, it may not be the same level of outperformance but at the same time the absolute returns and the absolute earnings and cash flow growth for these companies are only going to benefit from a recovery in the capex cycle. Therefore it is very unlikely that these stock prices should stagnate.
Over a three-year timeframe, these companies should deliver an earnings growth or free cash flow growth of 20-25% depending on which way the cost of capital moves across the world. There are lots of moving parts there. The returns could be slightly higher or lower than this underlying free cash flow growth and that has been the trend over the last 20-25 years as well. Our portfolio companies have delivered a free cash flow growth of 25%, the stock price returns have been pretty much thereabouts.
Why are IT midcaps trading at a premium to large cap IT? The PE multiples of Mindtree, Mphasis, Coforge and even L&T twins they are higher than of Wipro and HCL Tech now.
It is difficult to assess what the market is thinking. There is a bias towards midcaps given that a low base tends to offer a better growth trajectory, although we do not tend to agree with it. I think the bet the market is making is based on the fact that this digitisation is impacting industry after industry across the world. The pace at which digitisation is being adopted by Fortune 500 companies has just obtained a new scale which means the outlook for IT services in general is going to be pretty strong and that too over the next decade. It is not just a one, two or three year story.
The assumption is that the midcap IT companies will be far more nimble given their lower bases to be able to adapt and build capabilities in these technologies. Having said that, ultimately it boils down to scale. Some of the larger Indian IT companies like TCS and Infosys have had long track records of not just hiring but also training large numbers of engineers and IT services personnel over new technologies. It does take time but once they do it, they are able to capture the larger volume market because this is just the beginning of that digitisation trend and over the next few years, the demand for a large pool of engineers will just ramp up and that should put the larger IT companies on a stronger footing.
The deal sizes are already increasing. We have seen Accenture announce something like 20 deals above a $100 million in just one quarter and that would require companies to train large numbers of engineers on the new technologies which the large guys have an edge over as far as track record is concerned.
What is the view on the energy space? We have already seen petrol demand cross the pre Covid levels and as of now renewables as well are likely to become a part of the energy basket. What are you looking at when it comes to this pocket?
We have never invested in energy, partly because it is a bit of a global commodity and therefore our edge in this space is nonexistent. Therefore we tend to stay away from large commodity sectors which are macro driven. Of course, some companies do better than others but the scope for differentiation through bottom up capabilities is much limited. Most of the companies tend to move as a pack. It is better suited for more macro investors who have a better understanding of global macros. Unfortunately, we are not in that bracket and we tend to stay away from such sectors.
