Continued from Part I
A small note on a blind spot I see with Indian investors. We are too inward focused and don’t understand global markets all that well. “Mera Bharat Mahaan” is good at nation building but not necessarily the best approach for portfolio building if you have the ability to invest across geographies. Tech behemoths in the US are growing at high rates, have dominant market positions, generate free cash flows and are reasonably valued. Their ability to build USD 10Bn lines of business within 5 years is amazing, see what Microsoft has done with the cloud line of business.
On the other hand, when Indian businesses do category expansion that can do a grand 500 Cr incremental revenue in 5 years, our market hails the management as visionary and rerates the stock price to 70 PE. Of course, longevity and predictability of growth may be better in a few of these industries compared to tech but overpaying for these is a serious risk. Many investors who give gyan of holding for the next 20 years will cut their positions if the stock does not perform for 3 years.
While one can debate both sides of the argument here, the point is to consider data points across the world before paying premium valuation for something in India because you do not have a wide enough lens. In many SEA markets, the best banks trade at less than 2 times book while in India we think 4 times book is very reasonable. Maybe it is, but don’t accept this narrative at face value. Do your thinking and understand what you are signing up for.
“It is different in India” is a sales pitch for many fund managers here.
Do not make it your core investment strategy unless you are fully convinced about this.
Pharma Industry
Complicated stuff for the most part. For the 5-year period up to 2015 the Indian market believed these would keep compounding at 20% p.a. for the next decade or so, without getting into the intricate details of how distribution in the US works. Healthcare costs are a drag on developed market economies, one cannot keep raising prices for basic drugs. Bulk of Indian pharma makes off patent generics, price erosion there has been significant and will likely continue to see pressure. Patented and breakthrough drugs are given a free run on the pricing for a period as an incentive for innovators to do R&D and find newer drugs.
Pharma industry in India has ~30 listed companies that clock annual revenue of 2000 Cr and more. All of them make healthy profits since the cost of making API and basic formulations is much cheaper in India. The worldwide pharma market is more than USD 1 Trn in size with the US market alone accounting for more than USD 450 Bn. I am yet to meet a decently run pharma company that makes losses since the unit economics are favorable – large TAM, good asset turns, healthy margins and free cash flows. This is the easier part to understand for investors, what is tougher is to keep a tab on launches in the US, market dynamics and regulatory upheavals.
For the market dynamics of pharma businesses in India, we will never have a winner takes all industry structure. If that were the case, we would not have so many listed, profitable and successful companies in India. In my opinion, running after a multibagger return here is futile since market dominance is unlikely. A better approach for the average investor is to identify a basket where risks are lower and the growth rates good at reasonable valuations. For this reason, I prefer businesses that have a higher reliance on the domestic pharma market (INR 1.2 lakh Cr+) than on a regulation heavy and dynamic market like the US.
Unless one understands the intricacies of molecules, Para IV filings and supply chains, one is better off with a basket approach than with a concentrated approach. If you understand these aspects well, you can take a different approach.
Read more at my valuepickr post here
Financialization
One of the no brainers out there in my opinion. For the past decade or so deposits with scheduled commercial banks in India have been growing at 10%+ p.a. The MF industry growth rate generally is at 1.3-1.4x of this growth rate, this holds up on a rolling basis across 15 years. The newer segments like PMS and AIF are growing at 2x the baseline deposits growth rate.
This pretty much gives us the possibility of the industry growing at 15% p.a. across segments like mutual funds, wealth management, insurance (which is still primarily an investment product in India rather than a protection-oriented product) and the transaction processing architecture like exchanges, depositories and registrars. The only odd segment out here is broking which will grow in volume terms but is unlikely to grow too much in value terms.
Unit economics are very favorable. Healthy growth rates at low incremental investments, low balance sheet risks (with the exception of a few insurers), high profits and free cash flows. Transaction processing layer will be a 2-3 player oligopoly at most since the addressable market size is lower at high regulation costs, while the players at the front end like mutual funds (38 lakh Cr), Insurance (7 lakh Cr premium per year), wealth management and broking will have a longer tail of organized players.
Industry sizing and broad segments can be seen in my valuepickr post here
I think this is one of the few sectors in India where investors can buy leading businesses and hold them for a decade without worrying too much. While the transactions processing segments (exchanges, depository, registrar) and richly valued right now, the other segments are more reasonably valued and give many options to choose from.
One is unlikely to lose money by buying businesses that have asset light balance sheets, come from well known brands and parentage, grow profits at double digit rates p.a. and generate free cash flows every year. Even if the regulator can tighten things up once in a while.
For all the volatility in the equity market, equity SIP inflows have grown from 8,500 Cr in 2019 to 11,500 Cr today. Large AMCs continue to grow their AUM while private insurers continue to win market share. Medium term trends haven’t changed too much even if newer players have been entering the market.
Chemicals
These were viewed as below average quality businesses till 2015 and rightly so. Double digit growth rates at 15-16% ROCE when the 10-year G-Sec yield was 8%+ made for a tactical investment at best. These businesses need continuous capex to grow thereby needing capital in the form of debt or equity every 3-4 years.
However, the competitiveness of this industry at the global level has improved over the past 3-4 years. Not because of any great innovations we have done but because of China’s clampdown on industries that consume a lot of power and pollute their metros. As the cost of manpower and environmental compliance went up in China, Indian businesses started providing alternatives to the global behemoths who wanted to source raw materials at a good price with reliability. Right place and right time but only after becoming very good at process productivity over two decades. Hemendra Kothari (founder of DSP financial group) was the more prominent of the two brothers till 2019 but looks like Yogesh Kothari (founder of Alkyl Amines) has seen a sudden upswing in his fortunes since then. He became an overnight success after spending more than 20 years in an industry that no one cared about.
These businesses (especially the ones that aren’t into bulk chemicals) have good medium term growth visibility and are putting up capacity at a scale never seen before. The growth trajectory here is likely to be healthy (volume growth of 15%) over the next 4-5 years but one needs to be choosy about valuation and the predictability of earnings. Even the best businesses here have limited control on pricing as can be seen from the Q2 and Q3 results in FY22 so far. On a 4-5 year rolling basis though, the good businesses here might deliver 15% revenue growth at 18%+ EBITDA margin without stressing the balance sheet too much.
What is the catch here? These are unlikely to be 25%+ ROCE businesses since their gross asset turns are below 2, EBIT margin at ~15% and working capital cycle can stretch up to 150 days.
Participate at a valuation that is favorable but be clear that the business quality will never be very high barring a few exceptions like the CSM businesses of Divis Labs and PI Industries. Investing when the margins trend down for 2-3 quarters might provide the best opportunity since RM prices and margins eventually mean revert to their long-term averages. One needs to play the cycle well here.
Avoid bulk chemicals makers that have a very wide range of outcomes on margins. They tend to put up their maximum capacity at the point of peak realization only to struggle with poor unit economics and average balance sheets for the next 3-4 years. Understand supply chains well and prefer players that are focusing on a differentiated product portfolio. While selling to large global players offers the possibility of committed growth visibility, selling niche products to many players offers the possibility of better margins though at lower addressable market size.
Once again, a basket approach should work better here since there are many options to choose from.
Auto Ancillaries
I’ve already covered things in this thread in good detail here
Worth a read if you are looking at this segment with a long-term horizon, in my opinion very few businesses are worth our time with a 5 year+ horizon. Very few businesses have managed to break away from the cyclicality and pricing pressures inherent in the industry. It is not easy selling to concentrated buying centers, the balance of power will always be skewed in favor of the OEM barring exceptional circumstances.
Will cover a few more sectors in the next post
