This can be a detailed content note by itself, but I will keep this post simple enough to focus on a few takeaways that investors can use when they are analyzing a business.
Breadth of analysis over time can lead one to some generic rules that work well in most scenarios. While the field of equity research and business analysis should be bottom up and focus on the specifics of each business, a few high-level rules can always be used to place the business within the right context. As investors we ideally should not have sector preferences at all, we should focus our efforts on the ideas that can give us the best bang for our buck. But in practice sector preferences always exist.
A more practical approach is to have some high-level rules that can help us decide between seemingly equally decent businesses that operate in different sectors.
This post is oriented towards this scenario. While it is not practical to cover all sectors in a single post, I will attempt to summarize how I view some of these sectors and why I have the preferences I have.
IT Services
I am yet to see an IT Services business that loses money consistently. The average business here makes enough profits to keep the show running for another 10 years. The difference between the best and the average businesses reflects in higher growth rates over time, maybe higher margins and better corporate governance at most. Even the worst business here can make money and offer a decent return for investors. Large addressable market size (USD 1 Trillion+), healthy margins (20%+ OPM), low balance sheet risk (most are debt free) and free cash flows are there even for the average IT Services business.
But very few have a moat in the true sense of the term. An Infosys and a TCS will essentially work with the same set of customers, hire the same kind of people and make similar kind of margins for the most part. Culture matters, but not to a great extent.
Outsized gains made by investors here will never be limited to a single business, it is industry tailwinds that determine the return and not how good a bottom-up equity analyst one is. IT Services is not like banking where PSU bank stocks languish for a decade while private bank stocks do well.
I would minimize time spent on understanding each individual business and instead focus on sector growth and earnings over a 3–5-year horizon and pick the most reasonably valued business.
Lenders
The average lender can make for a bad investment. When you have a business that levers up more than 6-7 times of its net worth, all it takes is 10% of the loan book to go bad and the lender can go under. Leverage and stretched balance sheets are the norm and not the exception in this sector. The difference between a good lender and an average lender can be massive over time. A lender also has a reflexive relationship with the capital markets, the stock price tanking can affect business prospects as depositors/capital markets take their money elsewhere. This problem does not plague an IT Services business or a pharma business.
Culture matters a lot, the biggest screw ups in lending have happened when professional management loses touch with the ground reality and starts to live in La La land building personal connects with promoters. It is also much easier to pull off accounting jugglery in a lender than in any other business. Till 2010 the way banks would classify and report NPA’s was a joke, I was selling core banking software then and I know the inside scoop on how standards did not exist for NPA reporting then. What Subba Rao started in 2010, Rajan took to the next level by ensuring that account X could not be an NPA for Bank 2 while being a normal account for Bank 2.
Most investors don’t understand the risks involved in holding lending stocks. Even if you spend the next 12 months doing scuttlebutt and accounting forensics on your favorite lender, you still can’t be fully sure there are no cockroaches.
Investors should focus on those lenders that have shown a history of prudent underwriting and a culture of thinking about risk first and return later. Those that aggressively chase loan growth will eventually be caught in a vicious cycle, some may survive to learn their lessons but many go under.
Focus on those banks that have a cosmopolitan culture where talent can join and rise through the ranks in 15 years. You do not want to hold a bank where meetings are conducted in a regional language, unless that bank is dominant in only a particular region. In which case you don’t want to hold that in the first place. Very few regional banks have gone on to become pan India banks where one can buy the stock as a mid-cap and exit as a mega cap. The next HDFC Bank is usually a mirage that runs away further the more your chase it.
Focus on stories where the risk inherent in the lending book and business model is being brought down through a series of well planned and prudent steps. By the time metrics like ROA and ROE get better, the bulk of the story would have been priced in. Once the core part of the franchise is set, a bank with the right set of talent can cross sell products for decades. Ideally an NTB (new to bank) customer should start with liabilities and not assets.
When in doubt, stick with the largest banks that have the lowest cost of funds with a hygienic spread over it. One can jack up the spread but not without increasing the risk. A tail event can hit the book and net worth retrospectively, this happens in very few industries. Choose wisely.
I compounded my portfolio at 30%+ p.a. over 10 years without holding a single lender. I bought a bank for the first time in 2020, it is still not a large position for me.
Cyclicals
Needs a different skill set and a completely different way of thinking. The range of outcomes here is so wide that wrong timing can set you back by a decade if you are unlucky. Cyclicals are all about lead indicators rather than growth and earnings, once the numbers come in the smart investors are already exiting. Good luck with tuning in to listen to conference calls after good results, the successful investors in this segment have their ears to the ground and not to the conference calls. In some trading circles I have seen seasoned investors focus on just the sugar sector and kill it with 4-5x return in a very short period of time, then invest proceeds in an FD until the next cycle.
The game here is to get all three right – thesis, price and timing. Not a high probability endeavor for the average investor.
Which is why the returns can be very high in a very short span of time, but they accrue only to those who play the game very well. Secular returns across a cycle rarely accrue here, don’t become a disciplined long-term investor in a segment where the best investors are short term oriented.
A complete avoid for the average investor. Better off taking your chances elsewhere.
Consumer
One of the safest bets for the average investor in India. Much easier to do scuttlebutt and ensure genuineness of products since we consume these regularly. Large addressable market, well known brands, healthy margins and cash flows, secular growth patterns and good corporate governance are a feature of this sector. Total no brainer as to why this segment has created wealth with the least amount of volatility and risk in India.
But risk always lurks in one form or the other.
In this case the biggest risk has been valuation since 2016. Consumer stocks have never been cheap but they have reached stratospheric levels post 2016. What we sometimes fail to take into account is that growth has been hard to come by in India post 2016, so taking the sure shot 10-12% PAT growth was the smart thing to do in that context.
The biggest risk for investors here is the prospect of India going into a decent growth trajectory where 12% p.a. growth becomes the norm for the broader market. Suddenly the sure shot 10-12% growth loses its luster when every other business is able to do the same with some of the sectors doing 15%+ reliably, if that happens.
Consumer discretionary appears to be a better bet right now rather than consumer staples. If one can buy a 15% growth decent quality business that trades at 30-32 times earnings, I would not hesitate to make that bet. But I would surely hesitate to buy a 12% growth business that trades at 75 times, even if the 5-year average multiple has been 65. The same business saw its stock price underperform the indices for a good 7-8 years in the 2001-10 decade, who’s to say it won’t happen again? Maybe it won’t but I am not willing to make that bet so long as other decent alternatives exist. We should not be guilty of assuming the past 5 years are a good representation of how the market has always been.
Will cover some more sectors in the next post.
One of the things that is starting to concern me is the narrative that the context does not matter too much for a few chosen businesses in India. Over a 10-year period this might be right but this can be a painful journey in the medium term. Try underperforming the index 2 years in a row and see if you can stick to your convictions. When narratives meet numbers, the numbers prevail most of the time.
One can always buy these chosen few businesses after 5 years, if the narrative that timing and entry point does not matter is true, isn’t it? In fact, one should buy them after the microcap focused 40% p.a. return brigade starts taking pot shots at the high-quality brigade regularly. Building a portfolio with an over reliance on a single theme can work against you in the medium term, even if it does work over the long term.
See the long term as a series of medium terms with a few course corrections.
Stick to practical considerations wherever you can rather than relying on lofty ideals and the illusion of perfect businesses whose moats are everlasting.
Probabilities over possibilities. Numbers over narratives.
