With a market rally that has surprised most(not all) we are today in a situation where a number of Large Cap stocks that have decent balance sheets are no longer extraordinarily cheap. This has happened at a time when the domestic investor participation in Indian Equities is at the lowest since the end of the last boom. Essentially most of the Indian investors have missed the move up in the markets over the last 2.5 years. The apathy towards equity has continued to remain high even as the economic activity has bottomed out. News flows on persistently high inflation, strong tax free returns from tax free bonds, volatility in the markets due to the volatility of the Indian Rupee have been contributors along with the negative news flow generated due to the economic slowdown and the various scams in the UPA2 regime.
Now to potentially see the best value creators of the next economic boom in India, which can be delayed but not denied we need to see and cull out the companies that have either learnt the hard way from the previous downturn and now recognize the risks they took and that those risks were not worth it or the companies that handled the downturn well by being wary of taking big risks upfront and are now in a strong position to ride the next move up.
I have typically been a bottom up investor. The reason my approach to investing has been typically bottom up is that I have observed is that such an approach typically ends one to the same results as a top down approach but in a more efficient manner. Because here one is focusing first on micro research and then trying to evaluate the same in a macro environment. Let’s look at an example from the past. One of the key sectors where I invested at the beginning of the last bull cycle was the automobiles sector. After meeting a whole series of companies in the sector in early 2002 I realized that all these company had restructured substantially over the last five years and were seeing significant volume growth coming in. Volume growth combined with on capex and consistent cost cutting was a potent combination in an industry such as auto with high operating leverage. For example a company like Mahindra and Mahindra which used to break even only at a tractor production level of over 100,000 at a time when they were unproductive had brought down their break even levels to 30,000. My key picks at that time were M & M at Rs 100 levels and Tata Motors at Rs 75 levels. An overweight position in these two stocks based on bottom up research finally led me to the same result, as a top down positive view on the auto sector would have resulted in.
Lot of these companies had learnt from their overinvestment in the last cycle, which created stress and took these companies into losses. A very good example of this leering from the past in the current cycle has been that of Cement Companies that went into huge losses in the late 1990’s and early 2000’s but handled the current downturn of 2010-14 very well.
My essential point is that the last boom in India created a lot of first generation companies that had never seen a severe downturn. Now a large number of them have taken a huge amount of pain over the last 4 years. The aim of my company meetings at this time is to identify those which are now prepared to operate with a lower risk model in the next cycle and have got good business models. The second part of companies to buy into are those which never had balance sheet stress, however the macro environment hit them badly. These companies also never focused on productivity during the boom years and now will have two things playing for them. A lower cost base and hence higher operating leverage combined with better top line growth. These companies will see a significant uptick in valuations. One of the best examples of such a company where I had made huge investments during my tenure as Fund Manager in SBI Mutual Fund in the year 2004/2005 was Kajaria Ceramics. The company had low return ratios and low operating profit levels. Over a period of time the company deleveraged, added capacities via tying up with stressed units rather than investing of their own, focused on cost cutting, developed superior products etc. This led to a rerating of the company from a 5 P/E ratio to over 25 P/E today.
In my experience stock prices move on the following two major factors.
The up gradation or downgrade of earnings vis a vis consensus earnings forecasts – Let me try to explain this in a simplistic manner. The stock markets discount news flow very fast and as such the price at which a particular stock trades are dependent on what the expectations in the markets are. At the beginning of the last bull cycle of 2003 every one was very negative on growth prospects and in general expectations of earning growth were very low. Under the circumstances as the economy revived most companies came out with results better than expectations and stock prices moved up sharply. On the other hand at the peak of the bull cycle at the end of 2007 earnings growth expectations had moved up very sharply and subsequently there was an economic slowdown and most companies started delivering results much below expectations. This led to stock prices falling sharply.
The movement of the direction of the return ratios of the company rather than the absolute values
– Measures like Return on Capital Employed and Return on Net worth are used to determine how well the company is using the money it has to make profits. Typically it is believed that higher these ratios the better it is. Although this is true, the actual movement of stock prices depends more on the direction of these ratios rather than their absolute value. That is the reason why turnaround stocks which go from losses to profits give huge returns as the return ratios go from negative to a positive value. Examples of these are Automobile and commodity stocks in the early part of this decade where they went into profits after years of losses and most stocks in these industries went up multifold.
Will write more on my thoughts later as this piece is becoming too long. We are at the threshold of a new economic and market cycle as I pointed out at the beginning of 2014.
Key is to ride it or walk by the side and be left behind.