What earnings commentary tells us?

BizNotes_Aug20

In this earnings season, ironically, most of the earnings commentary are less about earnings and more about evolving trends. With not much to offer on earnings for the current and next quarter, the management discussion is more about how the business would survive first (cost cutting, cash conservation, strengthening balance sheet etc.) so that it can revive later when the normalcy returns. For someone who wants to listen and track management commentaries, there is plenty on offer. In normal times, they come only in every three months. But now, because of April-May lockdowns, one gets to listen to the managements (vide earning calls) twice in the last 2 months, one for delayed March quarter results and another for June quarter earnings. In that sense, it is hectic times for fund managers and research analysts. As investment managers, we relish that.

Listening to the managements, there seems to be a pattern that is emerging across these calls. The objective of this note is to capture the common thread that cuts across these earning calls and present it in a curated form for better understanding of the Covid impact and the emerging outlook for many businesses, esp. in the broader small and mid-cap segment.

First, on the broader trend, every management is highlighting about the impending consolidation of stronger players in the market across the spectrum (small, mid and large-cap space) when the businesses revive. Marginal players with weak and questionable balance sheets (high debt) are likely to get weeded out (will not even survive to see the revival in the economy), paving way for the stronger ones to gain significant market share. Similarly, unorganized players will witness a huge churn with market shifting towards organized players in many segments. This is primarily arising from the inability of unorganized sector to get access to shrinking labor pool and its inability to overcome supply-chain and logistics challenges. What DeMon couldn’t achieve, Covid seems to be driving this shift. These two themes together (consolidation and shift from unorganized to organized) are likely to have a huge positive impact for strong listed players across the spectrum including small-caps.

Second trend is more interesting. Barring few, every management is talking seriously about China+1 strategy accelerating for global supply chains and about the trend of de-risking China imports in domestic manufacturing. While former will help in pushing exports in globally competitive industries like specialty chemicals, Industrial products, APIs, select niche garments etc., the later will help the import substitution industries in India. It will be interesting to watch how this will play in the coming years.

The third significant trend which is visible across the calls is on the rural theme. Various factors have miraculously come together to fire the rural economic engine. With bountiful rains, increased kharif crop acreage and Govt’s thrust on rural schemes (increased allocation for rural schemes like MGNREGA rural employment etc.), rural India is taking the lead on the recovery over urban and metros. Lower incidence of lock-downs and return of migrants have also added to the strength of rural story. Be it seeds, fertilizers, agro chemicals or any such rural related sectors, they are likely to be insulated from Covid impact.

In summary, there is a hope of resurgence next year for strong businesses across the spectrum of small, mid and large caps (with high quality balance sheets with low debt and cash surplus) after painful period of survival this year. This revival will be driven by above discussed consolidation and global China pushback, besides organic growth in the domestic economy. Hope this will bring huge rewards for patient long term investors in high-quality businesses.

Happy Value Investing!!!

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Importance of staying invested

BizNotes_July_20

There seems to be no end to the surprises the year 2020 can bring. Whether it is in pandemic breakout or in stock market recovery, 2020 refuses to play to the script. If one looks at the past down-cycles, they have always played out as per good old script. That is, in down-cycle, economy goes through a huge deleveraging cycle with far reaching impacts on corporates balance sheets and investors risk appetite. Highly levered corporates find the going tough in a risk-off environment with many of them folding up. Over time, once the leverage risks completely play out (after many bankruptcies and blow-outs), risk-appetite returns to turn the cycle back. It took anywhere between 8 to 12 months for the entire deleveraging cycle to play out. This is how a typical down-cycle transpired in earlier occasions. But no longer so. With its progressively innovative back-stop, Fed has provided such a vast safety net (even to the extent of buying junk bonds from the market in its new QE avatar (Quantitative Easing)) to risk takers, there is a new fancy curve (deleveraging) that is getting flattened ferociously. While one can debate whether US Govt. has successfully flattened the Covid curve or not, when it comes to this deleveraging curve, there is absolutely no debate on the Fed’s success on flattening this one, at least for now.

Now, coming to the more interesting part of this thread, that is, the impact of this innovative flattening on the stock prices globally. While the Governments, across the world, seem to be treading carefully on the dreaded disease with its phased unlocking, in the stock market, there is a new spirit of unlocking that is unfolding in an adventurous manner, driven primarily by the Fed’s flattening. Globally, stock prices made a stunning comeback in this quarter with most of the indices up by over 35 to 40% from March lows (including all emerging markets). To appreciate the power of this renewed surge, one doesn’t need to look far beyond what is happening to NASDAQ. It is now trading near all-time high.

While one can debate whether this liquidity driven rally can sustain or not, esp. in this Covid driven economic disruptions, when Fed’s safety net stretches to “Whatever it takes” shape, one has to reconcile to the fact that this humungous money tap will find its way to stock prices before it finds its ways to the economy. Having said that, while one should respect the power of liquidity, one should not trust it completely. Needless to say, liquidity can be very fickle.

Moving beyond, let us talk about an interesting shift one is sensing in this turnaround rally. It looks like a fundamental shift in the structure of the rally. For the first time in the last two and half years, one is witnessing a broad based rally in the current turnaround. In earlier occasions, whenever the market rallied on liquidity support, it used to be limited to few narrow stocks in the top-end, leaving the broader small and mid-cap segment languishing. This is not limited only to India. Globally, one is witnessing such a turnaround for small-cap stocks after a long lull for over two years. Looking at Russel 2000 – the US Small Cap Index – has come back in this global rally with a 50% spurt from lows after two long years of under-performance.

Does this signal a very material turnaround globally for small-caps (including those in Emerging Markets) and points to a structural turn for small-cap space in India? Of course, while the short-term economic disruptions on account of Covid will continue to be an overhang for the overall markets, this structural shift in small-caps will lead to substantial sequential returns over next few years (once normalcy returns to economy) as we have seen in the past such cycles i.e. Small-cap index surged by whopping 124% in 2009 after the downturn in 2008 and similarly, in 2014 recovery, it delivered a stunning return of over106%.  Similar level of upside in the small-cap index can’t be ruled out over next one year period (or max two years), esp. when most of the weaker hands are out during the panic March fall from many stocks that suffered indiscriminate selling.

If the past three months rally had shown anything, it is this: One can never over-emphasize the power-of-staying-invested, as markets will always surprise.  Investors who rushed to exit citing the Covid narrative, during the March mayhem, are frustratingly waiting for better entry points after the stunning rally in much of the broader space.  Just to share the data-point, BSE small-cap index is up by over 33%+ while the Sensex is up by over 25%+ from the 31st March level.  This doesn’t mean that the risk of markets touching another low in the short-term has gone away. But, taking a longer view, the upside from current level could surprise even seasoned investors, esp. in the smaller end.

Stay the course and stay invested for reaping the full rewards from the longer-term turnaround.

Happy Value Investing!!!

(This article of mine was published in the online edition of Financial Exp. on 17-07-2020. Glad to share the link: https://www.financialexpress.com/market/cafeinvest/sensex-small-caps-rally-up-to-33-since-march-check-how-staying-invested-for-long-term-may-beat-covid-woes/2027075/

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Sell-on-rallies to Buy-on-dips?

buy-the-dip

 

In the contest  between liquidity push (driving up the prices) and economic pull (downward pressure on the prices), liquidity seems to be winning hands down for now.  Given the “what-ever it takes” approach from Fed, the nature of this contest is unlikely to change anytime soon.

More importantly, the come-back of small-caps globally after a two year lull marks a major milestone for the structure of the ongoing rally. With small-Caps doing better than large caps (for the first time in the last 30 months) in the current rally, are we in for a decisive turn for the broader markets? If so, what is driving this change? Liquidity alone can’t fully explain this changing dynamics. Because, in earlier occasions, during liquidity driven rally, markets have spared the rally for small-caps (globally) with a sinister design. So, if it is not liquidity, what else?

First and foremost, all directional shifts start from Uncle Sam. It is no different for the structural shift in small-caps. Small-cap index in US (Russel 2000) has taken a decisive turn after the March correction. It is up by over 50% from March lows. As many veteran investors are alluding to, this sharp bounce in small-caps in US is a key factor responsible for the global rally in small-caps across emerging markets. India is no exception to this global phenomenon.

Of course, there are other factors that have worked in the periphery to fuel the rally in small-caps here in India such as:

  • Most of the weaker hands are out during the manic fall in March leading to reduced selling pressure in small-cap space.
  • Some level of reversion from “priced-to-bankruptcy” level of distressed prices in March.
  • Indiscriminate selling driven by redemptions in PMS/HNIs have more or less played out.
  • New buyers emerging on the back of decisive turn in global small-cap segment.

While liquidity can be fickle, some of the above factors could provide a major support to the broader space from hereon. With the visible confidence coming back to broader segment, structure of the market is slowly changing from sell-on-rallies to buy-on-dips. This doesn’t mean that the volatility will not come back to haunt the markets again. With Covid overhang, that risk is unlikely to go away anytime soon.

Should you heed to the popular narrative on small-caps?

When going is tough, it is “easy” that gets sold. If the story is simple and eloquent, it becomes easy to sell. This is precisely what the investment advisors do in every cycle. In down-cycles, they can make a good story out of “long-on-large” theme as investors seek refuge in safety. As investors perceive small-caps as risky, it is easy to sell the story of large-caps in stressed times. Investment advisors, in their rush to sell the easy ones, unfortunately they end up painting the entire space with the same brush i.e. sensationalize safety in large-caps and trash the small-caps as toxic ones. How should investors respond to such a narrative? Does the risk come from the size or from the balance sheet quality? The other spin the advisors give in their eagerness to sell the easy ones, is that, the large caps will lead the recovery first while the small-cap space will struggle for longer time. Is that true? How did this play out in past cycles? Let us look at these in little more details as follows.

Reality Check1:

As one veteran banker eloquently put, in this pandemic crisis, there is going to be no winners, only survivors. But those who get to survive, can hope to gain from the huge wave of consolidation (market share gains) that will be triggered by weaker hands getting out. While investment advisors, dictated by the large-cap narrative, may try to project “Size” as key to survival, in reality, it is the quality of balance sheet that will determine who survives and who doesn’t. Quality of balance sheet will become the biggest differentiator in this crisis. It will not be limited to only small-caps. It will be across the spectrum including large caps. Large companies with weak balance sheet (high gearing ratio with unsustainably high debt) are likely to be weeded out as much as the weak ones in the smaller end of the weighing scale. So what one needs to worry is not on how large are the companies in one’s portfolio, but how good they are in terms of quality of balance sheet and quality of cash flows. Even some micro-cap minions who are leaders in their own niche market-space with zero debt and positive free-cash flow business (so many names come to mind) will emerge stronger from this crisis. Strong-will-become-stronger will be the over-arching theme across the spectrum which will include the much maligned small-cap space as well, contrary to the ongoing narrative that puts emphasis on safety of large-caps.

Reality Check2:

The next question that springs up spontaneously from advisors is, if quality is the key differentiator, why not stick to large caps, esp. when they are likely to lead the recovery? Here is where pattern of past cycles can help us understand the nuances of recovery. Both, in 2008 and 2013 down-cycles, while small-caps lagged the large-caps by few weeks (weeks, not months), the quantum of recovery in small-caps was substantially higher than that of large-caps in both these cycles. Looking at the data-points, in 2009, within 3 weeks of large-cap rally, small-caps turned and followed. The surprise is where both ended in Dec’09. Sensex delivered 81% that year while Small-cap index surged by whopping 124%. No one can deny that the trade-off of 3 weeks is a small price to pay for the additional 43% returns. Similarly in 2014, with a few weeks of lag, small-cap index delivered a stunning 106%+ returns while the much touted larger one delivered less than one-third of small-cap index returns (Sensex delivered 30% in 2014).

It doesn’t stop here. Even the 2020 short-term data is not siding with the ardent advisors, however much they try to de-sell small-caps, as can be seen from below chart (Small-cap index up by about 25% against 18% rise in Sensex in this quarter from Ist April to 15th June 2020).

Sensex Vs Smallcap New

Hard-sell: A Better Bargain:

In investment business unlike other businesses, what is difficult to sell makes more money for investors in the longer term. Money works harder in hard-sell products. Easy ones, of course, appeals in the short-term, but hardly a bargain in the longer run. Next time, when investment advisors push you to switch from small-cap schemes to large-cap ones, esp. in a down-cycle, you know what to say. Of course, in small-caps, one has to digest higher volatility. That doesn’t mean higher risk (permanent loss) as long as one stays put thro’ the crisis.

Happy Value Investing!!!

Market View: Push & Pull?

Globally, there are now two camps when it comes to market direction. One camp believes that the pandemic cycle will play out very similar to past down-cycles. As per them, the economic and fundamental news-flow will be so negative in the coming months that the market cannot escape from testing March lows. This camp believes that the current global rally will fizzle out at some point of time. The other camp believes that unlike past cycles, this cycle will play out differently because of Fed’s unlimited back-stop. The reason markets retested lows in the previous cycles is much to do with credit events (blow-out of funds, corporate defaults and bankruptcies etc.) than economic or fundamental news-flow. With Fed ready to even buy non-investment grade junk bonds (unheard of in past cycles), where are the chances of credit events in this cycle? Fair question. Boeing’s ability to raise 25Bn from markets during this unprecedented crisis without any bailout from US Govt. is a case in point. As per the second camp, given the remote chances of credit events, upward bias may continue, thus ruling out the possibility of markets testing March lows.

As always, the reality must be somewhere in between. This means, markets will be pushed and pulled by these two opposing forces without breaking out on either direction until the world comes out of this crisis. In other words, volatility is likely to continue with downward bias, but with remote probability of retesting March lows, though one can’t rule that out given the unprecedented nature of the current crisis (notwithstanding the current rally in the global markets). The story for emerging markets like India, is unlikely to be any different, given their penchant for following the footsteps of US markets. Having said that, EM specific credit events if any (Fed backstop doesn’t come to the rescue in such cases) can still rattle the markets, thus the overall caution for EMs. Investors should use this volatile period to re-balance their portfolios, increase allocations on stronger ideas in a gradual manner so as to benefit from the eventual turn.

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In Search of a Silver Line in the Dark Cloud?

Even if you find one, the world is likely to look the other way in the current mood of gloom and doom. But if it is bunch of lines, it becomes hard to ignore, however dark the mood is. India’s macro seems to be in one such a silver spot. The credit goes to our policy makers. We manufactured a crisis much before the pandemic crisis hit the financial world. Ironically, that is coming around to help us now. It may now seem strange that our macro is relatively stronger precisely because we accidently prepared it with self-inflicted blows (credit and NBFC crisis triggered by ILFS) during the boom times when global markets were going through exuberant times. Looking ahead, such manufactured blows (or self-goals as ardent critics of this govt. would like to call them), might ironically soften the pain from the pandemic crisis. Who says, mis-steps always end in misery and mis-fortunes. Sometimes they surprise with positive outcomes. Look to India’s relative macro advantage in this pandemic crisis as a piece of evidence for that.

Let us start with India’s macro position in the earlier crises. Every time India hit a crisis in the past, it faced the crises with a weaker macro in terms of high inflation, high interest rates, low forex cover, high current account deficit etc. Since India was in sync with the global top in the earlier cycles, most of its macro metrics were stretched (economy was overheated) when the crises hit. This is unlike the current pandemic crisis. In this cycle, India did not participate in the global boom by being out-of-sync with the global growth for an extended period of time (two years+) because of self-inflicted pains (or mis-steps). As a result, our macro metrics are more moderate, not overheated or stretched. That gives a lot of elbow room for both fiscal and monetary stimulus. To understand this more, let us go back in time and look at GFC in 2008 (Global Financial Crisis) in particular for few data points:

  • Inflation at CPI level hit a high of 10.45% in Oct 2008, with inflation averaging around 8.8% level in 2008. Current CPI is at much more comfortable level and is hovering around 5%. That points to lot more head room for monetary policy actions for RBI in the current crisis.
  • In 2008 cycle, India’s forex reserves were barely adequate for two years of trade deficit. But now, forex reserves at $475Bn+, can cover over four-and-half years of trade deficit. One reason why Rupee is more resilient in the current crisis compared to peer country currencies is on account of this strength. Currencies like Mexican Peso, Rand (South Africa) and Real (Brazil) have crumbled by over 25%+ in this calendar year (since Ist Jan 2020). In contrast, Rupee, with the fall of just over 7%, is standing tall among its peers.

It may not be out of place to share the chart (below) from Economist which puts India on the top quartile along-with China when it comes to strength of Forex cover i.e. reserves as a percent of external financing needs in a stress scenario. This chart is quite revealing and reflects relative strength of India’s macro in the current pandemic crisis among peers.

BizNotes_May20

So far so good. If one adds crude oil dynamics, the whole macro metrics will get a booster shot. Crude connects all of them through its wide reaching linkages i.e. positive impact on inflation, twin deficits (fiscal and current account), forex cover, interest rates etc. In 2008 during GFC, crude was hovering between 60 to 90 dollars a barrel. Now it is at one third. If this level sustains, it can add another one year to the forex cover (trade deficit cover) discussed above, besides extending a huge headroom for both fiscal and monetary actions (thro’ lower inflation and lower twin deficits). Add to that, Met’s encouraging forecast (initial) for a normal monsoon this year couldn’t have come at a better time.

Going beyond macro, India could also be looking at long-term gains from global push-back on China. If that push-back, in terms of developing alternate supply-chain, gets accelerated, it could help India’s growth immensely even if the small part of diversification flows through India, given the very small and meager base.

To summarize, for anyone who can see beyond few quarters, there is not one silver line, but bunch of lines for India in these dark clouds. It is hard to miss them. This doesn’t mean that India will not have a tough and painful slowdown in FY21 or some hiccups in macro, esp. fiscal stress in Govt.’s budget etc.

Happy Value Investing!!!

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Stress Ahead, Distress Priced-in?

BizNotes_April_20

Private Equity and Public markets are far-cry from each other when it comes to marking down valuation. For PE industry, protective masks in the form of “marked-to-myth” come handy during pandemic outbreaks. Without the access to that mythical protection, public market funds, where valuations are marked second to second, start dancing to the sound of every sneeze and wheeze. If one is marked-to-myth, the other is marked-to-madness. This note is not about myth versus madness, but to discuss more about the myth behind the ongoing mayhem.

No one can argue about the stress that is ahead for the economy on account of lock-downs across the globe. The stock prices need to adjust for the impending recessions across developed markets. Whether the recession will be shallow or deep is difficult to say at this point of time. The debate is not on whether the stock prices need to adjust, but on how orderly or disorderly it can be. No assets in financial markets adjust orderly for the new information or the new situation, be it equities, currencies or commodities. The nature of the beast is such that every adjustment, upwards or downwards, are brutally dis-orderly. It is no different this time. But the new fancy features of the beast, such as, algo trading, passive ETF bubble (more in US) etc. are adding fuel to the fire of familiar old time suspects like margin-calls, speculative unwinding etc., This fancy combo has conspired with other panic sellers to wreck a brutal bloodbath in markets, that too in a very short cycle time of few weeks, which would have normally happened over few months in the past crises. In such dis-orderly adjustments, deep under-shooting is inevitable. Though screen may look scary, investors shouldn’t resort to selling during under-shooting as it will make the pandemic losses (notional) permanent.

Going beyond the technical context for the correction, what about immediate fundamentals? Easy to see that there will be a washout for earnings in this and the next quarter for many businesses. In our view, no business will be spared because of second and third order impacts across the economy. For many businesses, it will be a survival issue, esp. if they carry any balance sheet related risks. Debt can become a great de-railer for many companies. Across the spectrum (large to mid to small caps), companies with higher gearing (high debt to equity) may face survival risks. On the flip side, companies with low debt and high cash surplus may come out stronger from this crisis as they equip themselves to gain market share from weaker ones that will battle for survival. This will be the case across the spectrum including quality small-caps.  Portfolios built on conservative approach with stocks with low debt will have much less to worry.

But what about medium term?

Right now, market is in the mode of scoot and run. First sell and then think later. In such mayhem, it is easy to lose sight of anything that is not in the immediate vicinity. But when the dust settles, market may start looking at some of the India specific opportunities (listed below) that are arising out of this crisis.

  • The Covid crisis is now expected to accelerate the china-hedging process that has already begun post US-China trade war in many of the global corporates. Reducing china dependency is no longer a cock-tail discussion for many companies worldwide. It is a serious issue facing many boards today. When it is translated into action, India is likely to be one of the potential beneficiaries, esp. in industries where India is globally competitive. This is likely to incrementally boost growth in the medium to long-term, esp. with the new concessionary corporate tax regime of 15% for the new investments in manufacturing.
  • Amid the rising fears of global slowdown and recession, it is important to remember that the following factors that are likely to alleviate the impact on India.

 

  1. India is coming off from a deep deleveraging cycle and a decade low growth. Since impact from global recession is mainly fed thro’ credit crisis, given the deleveraging that has already happened in many of the balance sheets, impact from global recession is likely to be limited (on relative scale) on this aspect, though there will be a collateral damage.
  2. Being domestic and that too consumption driven economy, India will be relatively insulated. Since it is coming off from a low base, any incremental growth that can potentially come from low oil prices and from china hedging, will make it look respectable for global investors, esp. if the Indian Govt. contains the covid crisis successfully (initial signs do give hope on this). In such a scenario, out-performance of Indian markets (after the dust settles) can’t be ruled out, esp. when India has more headroom in both fiscal and monetary policies in comparison with global peers. Recent RBI bazooka is a case in point (75bps cut in repo and other large liquidity measures).

At the moment, the consensus view is to wait for clarity. But, as past cycles show, one has to pay a heavy price for clarity. When cloud clears, prices will be already up. For those who are already well invested, it is not the time to panic, but to add to the portfolio by taking advantage of the pandemic prices. For those lucky few who are sitting on high cash, no better time to start deploying than now.

Happy Value Investing!!!

 

 

Scared of small-cap investing? Here’s how one can avoid landmines in small-caps

FinExpress_Mar20

There are two ways to look at small-cap investing. One, take a very conventional view that it is a highly risky space and avoid it all-together. Goes with that, is all the potential reward as well, as one says no to the alpha generation (higher returns that come from small-cap space). The other is to take a more contrarian, but an objective approach. That is, take the pain to understand the various risks in that space and build a process to mitigate those risks. This is more demanding, but rewarding in the long-run, as the whole game in small-caps investing is all about weeding out bad apples. This piece is an attempt to cover the critical steps (below) that are required in the stock selection process to mitigate the risks in the small-cap space.

Nature of risks in small-caps:

Small-cap is not a sexy space, notwithstanding the seduction of spicy returns it promises to lay investors. It is a space which is infested with lot of risks. They are many, but the prominent ones are,

  • Sub-scale and unproven business model
  • Poor governance
  • Key man and succession risks
  • Leverage and balance sheet risks
  • Management depth
  • Client concentration risks

These are mighty risks and the process to mitigate them may seem herculean at the first look. But the good news is, it can be distilled with few basic hygiene filters which, surprisingly, can surmount much of the risks in this murky space. Though these filters are simple, sticking to them in a disciplined manner when spirits run high (bullish time), is not easy. That is what makes this process fascinating.

Let us look some of the most crucial ones.

Debt: The great derailer:

There is a twin side to the debt story. The same debt that is greeted with cheers in bull market, turns into a dreaded one in the bear market. While it can spruce up returns in the upturn, it has the lethal power to turn a liquidity issue into a solvency crisis in the down-turn. In that sense, it is a dangerous beast. This much is well understood. But, what is not that understood and appreciated is the extra-ordinary influence the debt has on the overall governance standard. One thing that constantly pops out from our extensive experience in small-cap investing is this – if the business doesn’t need debt to grow, there is less likelihood of mis-governance in that business.  At the first sight, this co-relation may seem odd, but every down-cycle has shown that the real catalyst for corporate mis-governance is rooted in debt. When debt puts additional pressure on the management in a down-cycle when the business is already under duress, there is extra-ordinary incentive for the management to pursue the sub-standard governance practices. In this case, the debt pushes the otherwise okay management into below-board practices (Zee Entertainment is a classic example – group debt in the promoter entities). What about managements/promoters who are inherently unclean and with bad motive. For such managements, debt is a convenient alibi for siphoning money out. Hence one will find such managements loading up debt more than what the business might need as debts are taken with the intent of not repaying. In both the cases, debt is a very accurate indicator of potential governance issues that may be lurking under the radar. It leads to a surprising simple filter, that is, avoid excessive debt to avoid much of the risks in small-caps. To put it differently, look for businesses that hardly require debt to grow or more ambitiously, look for those that has the ability to throw free cash-flow after funding its growth capital.

Long operating history:

This is another critical metric to weed out the bad ones. Longer operating history essentially means that the business model is tested under many down-cycles and hence more robust. If it has survived down-cycles without facing liquidity issues, it also reflects stronger long-term financial position.

Sticking to Knitting (Focus):

In this era of mega expansion and diversification, talking about focus may seem odd. But, hardly anyone can over-estimate its importance, esp. when it comes to its impact on both quality of business and also on quality of management. As we have seen from our extensive research, sticking-to-knitting in a given segment over long period of time leads to solid specialization which in turn builds a durable moat in the underlying business. Focused management has less need to expand empire. With that comes less risk of unrelated diversification, either thro’ promoter pledging  or thro’ diluting balance sheets (loading up with debt). Both such actions have always led to deteriorating governance standards in addition to solvency risks as many examples have shown in the current down-cycle (many reputed groups like Eveready, Zee, Emami etc come to mind).

Conclusion:

The list of filters can go on. But what is explained above covers most part of the requirement. If one adds the other hygiene factors such as, management compensation, related party transaction, capital allocation track record, capital efficiency (high return metrics like ROCE/ROE) and skin in the game etc. along-with bit of scuttle-butt work on management’s quality/track record (channel checks in analyst’s parlance), one pretty much gets to size the overall management and business risks. Small-cap investing is much like “road-less travelled” poem by Robert Lee Frost – “Two roads diverged in a wood, and I – I took the one less travelled by, And that has made all the difference”.

Happy Value Investing!!

(as appeared in the online edition of Financial Express dt. 24th Mar’20)

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Luck Has Still Not Run Out For Bears?

Mailer_Mar_2020

No hiding from the fact that we are going through an extraordinarily difficult time for the market. Precisely when we thought that the luck has run out for bears in the broader space, market has been hit by a double whammy of COVID and Oil price war. This is after a glimpse of hope (from the first signs of momentum in small and midcaps in Jan-Feb) that things may be turning after a long and painful bear phase in the broader markets. The light at the end of tunnel turned out to be that of a speeding train. It does test the tenacity of last few standing value investors. Outbreak is not limited only to COVID in this social-media-driven frenzied world. Everything is an outbreak, but with a short shelf-life in such a wacky world. After this final (hopefully), but a painful lap of capitulation, as one may call it, with more or less everyone throwing in the towel, is there a hope for the few who are left.

In the short-run, what would happen is anyone’s guess. On one side, COVID news-flow will keep the markets edgy while on the other side, the talk of stimulus from Govts and the hope of co-ordinated actions from central banks will keep the market’s hope alive.  Push and pull forces from these opposing news-flows are expected to keep the markets extremely volatile in the short-term.

But what about medium term?

Right now, market is in the mode of scoot and run. First sell and then think later. In such a mayhem, it is easy to lose sight of anything that is not in the immediate vicinity. But when the dust settles, market may start looking at some of the India specific opportunities (listed below) that are arising out of this double whammy crisis i.e. boiling corona amid plunging oil.

  • Oil price, if it is sustained at this or around the current level, will give a huge headroom for both fiscal and monetary stimulus. RBI, constrained currently by inflationary challenges, will have more elbow room to cut rates. Similarly, with reduced oil price, govt. will get the additional leeway to hike spending or pass on the benefits in oil price to stimulate consumption.
  • Covid crisis is now expected to accelerate the china-hedging process that has already begun post US-China trade war in many of the global corporates. Reducing china dependency is no longer a cock-tail discussion for many companies worldwide. It is a serious issue facing many boards today. When it is translated into action, India is likely to be one of the potential beneficiaries, esp. in industries where India is globally competitive. This is likely to incrementally boost growth in the medium to long-term, esp. with the new concessionary corporate tax regime of 15% for the new investments in manufacturing.
  • Amid the rising fears of global slowdown and recession, it is important to remember that the following factors that are likely to alleviate the impact on India.
      • India is coming off from a deep deleveraging cycle and a decade low growth. Since impact from global recession is mainly fed thro’ credit crisis, given the deleveraging that has already happened in many of the balance sheets, impact from global recession is likely to be limited on this aspect.
      • Being domestic and that too consumption driven economy, India will be relatively insulated. Since it is coming off from a low base, any incremental growth that can potentially come from low oil prices and from china hedging, will look respectable for global investors. In such a scenario, out-performance of Indian markets can’t be ruled out, esp. when India has more headroom in both fiscal and monetary policies in comparison with global peers.

It may sound cliché if we conclude this communique by saying that the darkest hour is just before the dawn. Many false dawns have come and gone, as we all know. But, is it not a mystery that the darkest hour in the night is not “mid-night” as anyone would intuitively think? The jury is still out there on why it is darkest just before the dawn. Is it a known-unknown?

Happy Value Investing!!

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Value Investing: Back to the Future?

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In 1985 Hollywood flick “Back to the Future”, the protagonist needed the time machine to travel back in time. Value investors rarely use such sophisticated machines to back-test in time. Simple travel back in time in memory would do. It was year 2013. Going back there was like travelling to the future of 2020.  It was like setting the clock back to the future. Scanning the headlines in financial dailies back then, it exactly feels like 2019 and 20. What is fashionable now, was fashionable then too. Take for example the headlines that screamed – The Death of Value Investing; Is Bubble Building in Quality? Flight to Safe Haven Stocks etc. – they equally reverberate now in financial and business headlines. But what is interesting is, in the interim between 2014 and 2017, this fashionable theme quietly lost its fancy when small-cap story rose from ashes like a phoenix to dominate the narrative for three successive years.

How does one take the current headlines that are flashing in the financial dailies? As one headline goes, the well-known veteran value investor has succumbed to his self-doubt and become a neo-convert who has fallen for his new found love for quality. Of course, in the social media, there is a huge chatter that yells ills about value investing. That begs the question whether value investing is dead for the second time or forever?

Fundamentally, value investing doesn’t stand in isolation. If it is only value for value sake, it deserves to be deserted. But, if growth is embedded in value, then, that value investing is very much valuable and it will continue to vault, though with hiccups here and there. Similarly, “quality” is not the exclusive possessions of some coveted coffee-can-clubs or the neo-converts or privilege of much fancied large caps. It is equally relevant in small-caps. Nothing to beat the value that comes from trying to buy “quality-cum-growth” at a discount, be it large-cap or small-cap. Of course, in small-caps, such spicy opportunities spurt more often, because the space is under-researched and under-covered (also more volatile).

To borrow a phrase from one of the seasoned stock pickers, value investors are like a group of beasts now that is being hunted to extinction. Why? It is not difficult to fathom the reasons. Value as a strategy has been under-performing for an extended period of time since early 2018, because of flight to safety and polarized market dynamics. Even the last man standing out is being tested for his tenacity. Should the last few standing be worried? No. If one sets the clock back and look at the past 2 decades, one would find that neither this narrative (that value investing is dead) is new nor the crowded trade in quality is new. There has been only one thing that has been constant across cycles. That is, every strategy has a day under the sun and only thing that has always worked all the time is “reversion to mean”. It is a question of time before market takes its fancy to value, though it is difficult to predict the time of the turn.

Seasoned investors understand that every strategy has its time of out-performance and has its time of under-performance. The key is to stick to a strategy and not to flirt around with the flavor of seasons. Stay the course to smell the roses, however hard one is being hounded.

Happy Value Investing!!!

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