Stock picking & not basket buying is the need of the hour: Rakshit Ranjan, Marcellus
I don't think the market has bottomed out, says Rakshit Ranjan, Marcellus Investment.
Do you think a firm bottom is in place? Can one say with certainty that the bearish way of the last one and a half year is over?
At market level, I would not want to say that because honestly speaking, over last four years we have had earnings compounding barely 1-1.5% when the market’s index level performance has been 8-9% CAGR.
I would say the gap between fundamentals and valuations was at least 25-30% or maybe 20-25% if not more as of 2-3 months back. We are only about 5% off the highs and the tax cut which has been the recent reason for a bit of a recovery in the markets, will benefit only a part of the listed universe, not every company. More so, it will only be oriented towards the highest quality companies which are a minority in the overall market space.
I do not think it would be fair to say that the market has bottomed out at Nifty, Sensex at the largecap level. But yes, if we talk about great companies which have clean accounts, which have good corporate governance and no top of it and which are monopolies that cannot be disrupted, then for those companies, the recent tax cuts as well as fundamentals might bring in a lot of better earnings. That will also compound in the future. So stock picking, rather than market buying is what I would call out here.
In 2018, January, the broader market -- the midcap and the smallcap end of the market -- started getting traded at a premium to the benchmarks. But in the last one and a half years, the smallcap and the midcap valuation difference has gone back to seven-year lows. Would you say that at least a semblance of value is emerging in parts of the broader market?
Yes and I would definitely agree that in the parts of the broader markets, semblance of value is emerging. Provided they are extremely beautiful in terms of their fundamentals, the last 18 months of crash has brought some very good entry points in some of these smallcap and midcap companies.
What are your thoughts on some of the select players like Godrej? They are at multi-year highs and the management commentary is very confident?
As I said, stock picking is the way to go about investing in this market though at a sector level, real estate certainly does not look very good. I do not think basket buying in the real estate sector is going to make any money over the next couple of years or longer. However, select plays where market share gains are the reason for the possibility of fundamentals to be good, are definitely worth buying.
In the real estate space there are only three developers that I think are good in terms of quality, accounts and corporate governance and they are Godrej Properties, Oberoi Realty and Sobha Developers.
Apart from these three over the last decade the country has not seen clean accounts and any competitive advantages being held by any of the businesses in a sustainable manner. Within these three, one can play the real estate sector.
What are your thoughts on infrastructure and metals space, steel companies which are providing mostly to domestic markets?
In these types of sectors, where the cycle plays a massive role in making investors generate returns, for anything higher than 14-15%, the timing of the cycle plays the most critical role. We believe that there are very few investors who can time these cycles very well because underlying fundamentals of any of these commodity players are not able to offset the cyclicality that the external environment throws on them.
We always try to stay away from such sectors and hence we do not have any exposure to the commodity space. However, you really need to time the cycle. Whether over the next two years demand comes back or not, our view currently is wherever you have got debt-laden companies, the cost of borrowing might go up over the next few months. As the fiscal deficit comes under a little bit of pressure and the government’s requirements for borrowings increases, then the cost of debt might go up.
On top of it, if there is excess capacity, it may take more than a couple of years in many sectors for the excess capacity to get absorbed and hence in those sectors, it is better to be very careful with timing the cycles.
Our approach is that as long as the country as long as the markets offer a very consistent compounding of earnings, it is not worth taking the risk of timing any cycles in India because you can get pretty healthy compounding of say 20% there or thereabouts on the sustainable basis regardless of the cycles, regardless of the external environment. As long as that type of company is available to invest in, it is a no brainer to go for lower risk and healthier return rather than take higher risk for the same healthy return.
In your interaction with large clients in the last one and a half years of this corrective phase, have you been persuading them to add to holdings? How is their reaction to this correction and where do you see more value emerging?
My answer to the first question is that we have all sorts of investors. Some whom are very well educated on the psychological as well as fundamental aspects of investing. Others might not be very well versed on the subject. We try our very best to help our clients understand the product before they decide to jump in. The last six months have been particularly interesting because markets have given several reasons for clients to either get too worried or to get too excited.
The year began with the whole overhang of the elections, before that the IL&FS crisis and the broader NBFC crisis, the crude oil price rally which we saw late last year. Then came the elections, then the budget, then there were a couple of global macro events so on and so forth. There has been a never ending series of news flow which has gone to investors from the market side.
Our positioning is that there are certain companies. But there are hardly a couple of dozen companies in the entire listed universe which has the ability to deliver in a very consistent manner. They have healthy fundamentals and 14-15% earnings and revenue compounding over a two-three-year period at the worst case scenario and maybe 25-26% or high 20s earnings and revenue compounding in a high case scenario.
If that is the band in which these couple of dozen companies operate regardless of the external environment, then it is ideal to gravitate towards a portfolio composed of only such companies because this sort of portfolio not only will it give you a healthy return but it will also give that healthy return with a very low degree of risk involved.
Remember risk is the most underappreciated aspect of investing for many investors because if you do not take risk, then getting a healthy return without taking risk means not only will you avoid sleepless nights, but you will also avoid getting in and coming out from your investment portfolio at the wrong times.
News flow which will bring about uncertainty is going to be there for the foreseeable future in the market and hence stick to low risk and healthy way of compounding in a consistent manner over long periods of time. That is our approach.
Now coming to your second question which are the areas where we are finding more value than we used to. So the best example is the recent tax cuts announced by the government. The optical or the superficial impact of these tax cuts is an increase in earnings for companies paying higher tax rates. Now that is a very superficial reason for that. Although a high tax rate tells you which of the companies will be able to reduce the tax rate numbers, but whether they will be able to retain the incremental earnings because competition will definitely try to eat into it and also what a company which is able to retain these incremental earnings, will do with it. Will they redeploy that capital back on to the balance sheet and generate an incremental return on capital? If they do and if this incremental return on capital employed is very high, then you are talking about a snowball effect, a compounding effect of the reduction in tax rates for such companies.
Now most of our portfolio companies which are monopolies with high rates of re-investment of capital back to the balance sheet and ability to sustain a high percentage of return on capital employed. These companies will find even better earnings profile going forward given the incremental earnings that they will generate out of doing the same business.
Pretty much our entire portfolio, thanks to the recent move by the finance ministry, will see a lot more value going forward. We are quite optimistic about investing in our portfolio companies at these levels.