Portfolio Management Diary Jan 2020 - Small and Midcap Portfolio - Portfolio Management Services - Small ...
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Portfolio Management Services
Portfolio
Management Diary
Jan 2020
Small and Midcap Portfolio
Darkest before Dawn:
Time to Add for robust returns over the next 3 yearsDear Investor,
At the outset I would like to wish you and your families a Happy, Healthy and Prosperous New Year!
The year 2019 reminded us of the uncertainty surrounding India in the year 2013. India was clubbed under
the bracket of “fragile five” in 2013, with inflation touching 10%, Fiscal Deficit touching 5%, GDP growth
of under 5%, Banking NPAs on the rise and business sentiment in the dumps. To top it all, there was political
uncertainty with the incumbent PM not expected to do well in the general election. As a result of these
uncertainties there was a flight to safety in the markets and various indices performed as follows:
Index CY13 CY14
Ni y 50 (Large Cap) 5.9% 31.4%
Ni y Mid Cap 100 -6.2% 55.1%
Ni y Small Cap 250 -9.3% 67.3%
As we can see in the above table, there was polarisation in the markets in 2013 in favour of the large
caps and away from Small and Mid-Cap indices. Thereafter in the year 2014, without any material
change in economic parameters, the markets delivered stupendous returns. Additionally, the underper-
formance in Small/Mid-Caps in 2013 was turned on its head and they outperformed large cap indices by
a large margin in 2014 (36% outperformance in Nifty Small Cap v/s Nifty 50). This happened with the
advent of a stable reform oriented government, as hope for a better future started getting built. India
attracted large global capital as a result, which took the markets higher
Fast forward to 2018, while India did not have the same problems as 2013 but macro concerns raised
their head. We witnessed an interest rate tightening cycle globally. The US Fed raised interest rates 4
times and the Indian Central Bank raised rates twice in 2018. Additionally, liquidity was taken out of the
system by the US Fed through a Quantitative Tightening program, wherein it lowered its Balance Sheet
size by USD 800 Bn to USD 3.2 Trn. This contraction in liquidity for risk assets led to global
underperformance in Emerging Market Equities, Cyclicals, Small/Mid-caps & Value stocks in 2018. In
India the situation was exacerbated by a large credit event i.e. IL&FS failure. This event froze capital
markets and further intensified the tight liquidity situation. Near freezing of the capital markets and
sagging consumer sentiment led to economic parameters deteriorating through 2019:
GDP Growth slowed down to under 4.5% in the Sep 19 quarter (a six year low)
Tax collections have remained flat for the year. Indirect tax collection declined by 1% y-y while
direct tax collection was up a mere 3% y-y
Fiscal deficit is at the risk of over shooting the budgeted number of 3.5%
RBI indicates NPA problems of the NBFCs and Banking sector are not yet over
This weakness in economic activity, combined with weak global liquidity trends led to markets polarising
in CY18/19 as well as shown in the below table:Index CY18 CY19
Ni y 50 (Large Cap) 4.1% 11.5%
Nifty Mid Cap 100 -15.3% -4.4%
Ni y Small Cap 250 -27.2% -9.8%
As we can see, large caps have significantly outperformed small and mid caps. We have witnessed over last
two years a flight to safety, wherein investors have moved toward large & liquid companies to the detriment
of smaller companies. With the price determining perception, it is now commonplace to believe that only
Large caps where price action has been favourable have quality businesses. All other stocks, are believed to
be low on quality. Nothing could be further from the truth. Periods where Risk-Off trade plays out, Small
and Midcaps tend to underperform Large caps. Thereafter, over long periods of time, Small/Midcaps tend to
give a robust performance. Consider the following table:
Mid Cap returns Small Cap returns
Next 3-yr Next 3-yr
Years Returns Next 1-yr Years Returns Next 1-yr
CAGR CAGR
2001 -30% 24% 55% 2001 NA NA NA
2008 -59% 99% 18% 2008 -71% 107% 17%
2011 -31% 39% 27% 2011 -34% 37% 25%
These were three periods of small/midcap underperformance. Performance over the ensuing 1/3 year
periods was robust for small/mid caps. Over the five year period 2011-2017 small caps delivered 20% CAGR
returns.
In light of this, let us address some of the many concerns about Small/Midcap companies in this note and
share our point of view about the same.
Concern 1. Small/Midcap companies are Small, because they have weak businesses
Many small/mid cap companies are leaders in their respective businesses and are on track to becoming large
in size. The spaces they operate in may be small but fast growing due to a variety of reasons like:
Market share gains from the unorganised sectors e.g. Jewellery/Footwear
Share gains from Public Sector e.g. Banking/ Insurance
Strong Sectoral Growth e.g. Innerwear/ Water Pipes
Shift in preference to alternate products e.g. Plastics Pipes/ LED Lights
Consider the example of Britannia Industries (wherein we had an investment till 2017) and its 5 year
financials:
Rs Cr FY14 FY19 CAGR
Revenues 6,913 11,055 9.8%
EBITDA 627 1,732 22.5%
PAT 395 1,159 24.0%
ROIC 57% 36%
Net Debt/ Equity 3% 3%
Stock Price 460 3,000 45.5%As we can see the company’s stock price rose exceptionally from Rs 460 to 3,000 over a five year
period i.e. five year CAGR of 46%. This was supported by a robust 10% revenue CAGR, 24% Profit after
Tax (PAT) CAGR, exceptional Return on Invested Capital (ROIC) of 36% and Net Debt/Equity of only 0.03x.
The company witnessed this strong growth due to the industry growing at a healthy 10%+, supported by
strength in own business. The sector is benefiting from a shift away from the informal/ unbranded sector
towards the formal/ branded space. The company has built a strong business around brands, manufacturing
facilities and distribution network, which allows the company to benefit from favourable industry trends.
Due to its business strength and industry dynamics, Britannia transitioned from a mid cap to a large cap,
delivering nearly 7x returns over a 5 year period.
This is an example of size not being an indicator of business strength. Current size may just be a
function of industry dynamics or stage of growth cycle. The right businesses, identified when they are small,
have the potential to offer substantial upsides over the ensuing few years.
Concern2. Corporate Governance is bad
Good Corporate governance manifests itself in a combination of the following ways:
Policies that keep minority and majority shareholders at the same pedestal i.e. no actions are taken to
the detriment of minority over majority shareholders
Interaction is fair with all stakeholders - suppliers, customers, shareholders, employees, etc.
Rules based and not discretion based decision making
Clear division of management responsibilities
The impact of corporate governance on financials looks somewhat like the following matrix:
Strong Corp Governance Weak Corp Governance
Return on Invested Capital High Low
Balance Sheet Strong Weak
Good businesses having strong corporate governance are expected to have a high ROE and strong
Balance Sheets. This is an indicative, but not a necessary condition:
Many times, despite having high ROE and a stronger balance sheet corporate governance may be
sub-par e.g. Information Tech companies not distributing cash to shareholders
The business may have weak ROE, despite strong corporate governance e.g. capital intensive
businesses like Cement/Steel
Despite these shortcomings, ROE and Balance sheet strength are good indicators to filter strong corporate
governance. We filtered the top 1000 mid/small cap companies (non-financial) by market capitalisation for
Debt/Equity under 1x and ROIC over 15% and the results were startling. 495 of these companies fit the
said criteria of having low Debt and high ROE. By deduction, many of these small/ midcap
companies would have robust corporation governance.
While identifying stocks for our portfolios, Balance Sheet strength and ROE trajectory are given prime
importance. This not only serves the objective of identifying companies with strong Corporate Governance
policies, but also helps identify robust businesses.These metrics for our portfolios are as follows:
FY19
Net Debt/Equity 0.2x
ROE 18%
Some of the measures we undertake to assess corporate governance are as follows:
Understand financial drivers of the business and compare them to the current numbers
Peer analysis and comparison of company’s numbers with those of peers
Meet and speak with various stakeholders (employees – current and ex, distributors, customers,
competitors, etc.) to understand their views on the company
Promoter meeting to understand their alignment with minority shareholders, etc.
Concern 3. Valuations of small/midcaps will not expand
Equities are fractional ownerships in the businesses of companies. Perceiving equities to be participation in a
listed ticker is akin to speculation and it exposes oneself to behavioural biases, which are detrimental to one’s
own interest. On the other hand thinking of oneself as a business owner, protects one from biases caused by
movement of the ticker. In the latter mind set, investors focus on price they would be willing to pay for the
business, if it were not listed on the exchanges. What becomes more relevant in this scenario is calculation
of business value and comparison of the same with the offer price. If value of the business is greater than the
offer price, the said trade-off is attractive.
The same assessment should apply to all equity investing, irrespective of market capitalisation of stocks. If
anything, this differential between price and intrinsic value can be substantial in small and midcaps, due to
relatively lower interest from market participants. For this reason small and midcaps offer great opportunity.
Some examples from the past of the small and midcap opportunity playing out are as follows:
Name Mkt Cap (Rs Cr) PBT (Rs Cr) Remarks
1 Jan ‘10 1 Jan 2020 FY2010 FY2019
Ramco 2,640 19,400 530 880 One of the most efficient cement manufacturers
Cements in South India
Bajaj Finance 4,130 255,480 134 6,035 Strong growth with low NPAs
JB Chemicals 475 3,600 119 252 Sold Russia OTC business in 2012 and rewarded
shareholders through Dividends/Buyback
TCPL 42 270 8 41 Has grown revenue and profitability at 18% CAGR
Packaging
Nilkamal Ltd 350 2,100 73 165 Market leader in Plas c Furniture and Material
Handling
Inox Leisure 670 4,050 18 220 2nd largest Mul plex Chain operator
Transport Corp 330 2090 65 180 Core business has grown profitability at 15%
of India CAGR. Demerged Express logistics business and
rewarded shareholders
NBCC* 1,140 6,600 289 569 Growth picked up and valua ons expanded
*20 Apr 2012 to 1 Jan 2020These are some Small and Midcap companies which over the last ten years have witnessed valuation
expansion across diverse sectors. This has been on account of business fundamentals being appreciated by
the markets and valuations trending toward intrinsic value. It has been proven time and again,
difference between intrinsic value and current price does get bridged over time. Typically, it takes 3
years for the markets to notice this differential and bridge the gap. The key is to be right on assessment of
intrinsic value
Concern 4. Prices of Small and Midcaps are volatile
Small and Midcap investing is volatile for many reasons like low traded liquidity, relatively low institutional
interest, Greater correlation to cycles, etc.
Consider the following example
Capital 100
Returns %
Investments Year 1 Year 2 Year 3 Total
Debt 7% 7% 7% 122
Small/Mid Cap -7% -7% 41% 122
The first is a Debt investment, where cash flows are pre decided at 7% returns per annum. After a three year
period, return of Rs 22 is generated over an investment of Rs 100 for a total of Rs 122. In such a debt
investment there is no ambiguity in cash flows. The risk in this trade-off is that of default of Interest, Principal
or both.
On the other hand, the second investment is in a Small & Midcap oriented portfolio. Here, the portfolio loses
7% in the first two years and then generates 41% over the third year to give the same Rs 22 return over
invested capital of Rs100. Most investors would choose the first investment over the second, given that there
were periods when they were exposed to loss of capital. Also in this example the 3 year return is the same,
so investors would not see the point of choosing a volatile investment. There could be many scenarios that
play out in this example.
Scenario 1. Consider small/midcap equities continue their run over the Years 4 & 5
Capital 122
Returns %
Investments Year 4 Year 5 Total
Debt 7% 7% 140
Small/Mid Cap 25% 15% 175
In the case of a debt investment, due to a fixed interest rate the next two years will also have 7% upside.
However, in the case of the small and midcap investment there is a likelihood of 25% and 15% returns over
the next two years. If this scenario plays out the return on debt investment would be Rs 40 over 5 years, while
that in the Small/Midcap investment would be Rs 75 i.e. 12% CAGR. Investment in a debt instrument to
avoid volatility would have incurred compounded opportunity loss of 5% or Rs 35.Scenario 2. An additional investment of Rs 20 is made at the beginning of Year 3. In this scenario
returns over 5 years would look something like this
Capital 100 (AddiƟonal investment of Rs 20 made beginning of Year 3)
Returns %
Investments Year 1 Year 2 Year 3* Year 4 Year 5 Total
Debt 7% 7% 7% 7% 7% 165
Small/Mid Cap -7% -7% 41% 25% 15% 216
In this scenario the total debt investment of Rs 120 would yield Rs 45 over the five year period. However the
small/midcap investment would yield Rs 96 over the same period.
Seasoned investors see opportunity in volatility and for precisely that reason they are drawn to
mid/smallcap investing. Warren Buffett in his 2013 letter says, “The true investor welcomes volatility. A
wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses”.
Here Buffett suggests that due to volatility a gap is created between intrinsic value and traded price of
equities. While small/midcap investing is volatile, the volatility balances out over time to provide superior
returns. Further, times of volatility should be considered as opportunities to add.
We believe that small and midcap investing is lucrative and the key to make money in this segment
is to remain invested through volatile periods. We have over the last two years witnessed one such
period. Valuations have corrected meaningfully with the recent small/mid cap rout. Promoter of these
companies see value in their own businesses. Over the last year, 114 promoters of companies between
Rs 100 Cr- Rs 20,000 Cr market capitalization have purchased stake over Rs 1 Cr in own companies
(Source: Emkay Institutional Equities). Promoter buying is always a good indicator of insiders seeing value in
own businesses. Some of our portfolio companies have also seen Promoters increasing their stake and taking
advantage of depressed valuations.
We believe global and local macros are in place for small/ midcap outperformance over the next few years:
- US Fed has moved from a Quantitative tightening cycle to an Easing cycle
- Over 30 countries lowered rates last year
- Domestic economy is at a cyclical low
- With monetary and fiscal stimulus, we expect an economic turnaround over next 2-4 quarters
Given this, we reiterate that this is the time to add to Small and Midcaps. Given that our portfolios
are focused on this space and that portfolio companies offer robust fundamentals, we would recommend
adding to our portfolios at this time.
.Our Portfolios
The composition of our portfolios looks something like this
FY19 Rev FY 19 PAT EPS CAGR
Security Name FY21 E RoE D/E FY21E PE
Growth YoY Growth YoY FY19-21E
JB CHEMICALS & PHARMACEUTICALS LTD 16% 40% 18% 15.3 -0.2 13.1
WELSPUN CORP LTD 42% 40% 56% 21.4 0.1 6.6
ESSEL PROPACK LTD 11% 12% 18% 15.9 0.4 18.9
PNC INFRATECH LTD 67% 45% 7% 21.8 0.9 12.3
RAMCO CEMENTS LTD 17% -9% 19% 15.1 0.3 23.0
TCPL PACKAGING LTD 17% 43% 11% 11.6 1.3 6.6
INOX LEISURE LTD 25% 16% 23% 16.8 0.1 19.1
TRANSPORT CORPORATION OF INDIA LTD 17% 17% 18% 17.9 0.4 10.1
JMC PROJECTS (INDIA) LTD 18% 185% 57% 16.8 2.5 8.9
PERSISTENT SYSTEMS LTD 11% 9% 9% 15.8 -0.4 12.8
PSP PROJECTS LTD 40% 36% 30% 23.0 -0.5 11.7
SIYARAM SILK MILLS LTD 5% -11% 25% 17.2 0.5 7.0
ANUP ENGINEERING LTD NA NA NA 17.0 0.0 8.6
STATE BANK OF INDIA 11% 150% 253% 12.4 NA 10.4
NILKAMAL LTD 11% -5% 12% 13.0 0.0 13.2
COLGATE-PALMOLIVE (I) LTD 7% 15% 8% 54.0 -0.2 43.6
ORIENT PAPER & INDUSTRIES LTD 7% 106% 1% 6.6 0.0 5.4
DHANUKA AGRITECH LTD 2% -11% 13% 19.2 0.0 13.5
KIRLOSKAR FERROUS INDUSTRIES LTD 22% 158% 22% 16.0 0.2 6.0
APAR INDUSTRIES LTD 37% -6% 27% 14.3 -0.2 6.8
KPIT TECHNOLOGIES LTD NA NA 32% 18.3 -0.3 10.8
VST INDUSTRIES LTD 16% 25% 18% 35.3 -0.9 20.8
FEDERAL BANK LTD 17% 41% 25% 14.2 NA 8.5
HIMATSINGKA SEIDE LTD 24% -2% 23% 14.6 1.6 4.1
SOMANY CERAMICS LTD 0% -34% 38% 12.2 0.6 10.2
AVANTI FEEDS LTD 3% -39% 24% 27.4 -0.7 18.8
ACTION CONSTRUCTION EQUIPMENT LTD 24% 8% 17% 14.7 0.0 11.4
Equity 19% 33% 30% 18.3 0.2 12.8Key Developments Essel Propack Blackstone has recently acquired a majority stake in the business. The new management is bringing in operational efficiency which along with operating leverage is leading to an improvement in EBITDA margins. The company aims to increase the contribution of Personal care segment which is a better margin business. Further, the company has enough capacity to grow revenues at 15% CAGR over the next 2 years without needing incremental capex. Consequently the dividend payout should increase going forward. Inox Leisure Over the past two years, the company has closed the gap on operational metrics vs. the leader PVR. The company should add ~70 screens annually on a current base of 600 screens providing strong revenue visibility. The company is taking steps to improve its Advertising revenue per screen which should aid margins. Incremental screen addition should happen from internal accruals and consequently the company should remain largely debt free. Avanti Feeds The company has increased its market share in a weak environment. We expect international shrimp prices to have largely bottomed out at these levels and incrementally should improve from here. Company has commenced export of shrimp feed to Bangladesh thus potentially setting up a new avenue for growth. Shrimp processing segment should see a strong 20% growth for the next few years as Avanti improves its market share in this segment. Persistent Systems Persistent specializes in software product development and technology services. It helps enterprises to transform their business to software-driven business in North America, Europe, and Asia. Mgmt expects to outperform industry-growth rate with double-digit revenue growth starting from 2020 supported by healthy traction in digital business. It is aggressively focusing on newer technologies such as machine learning, block chain, IoT, data and digital which should elevate its growth trajectory. The company is debt free with close to INR 1,200 cr in cash and cash equivalents on balance sheet. We believe most of the disappointments are priced in; and think likely positive surprise on revenue growth and improved margin trajectory could re-rate the stock over the next 1-2years.
Risk Disclosure Investments in securities are subject to market risk and there is no assurance or guarantee of the objectives of the Portfolio being achieved or safety of corpus. Past performance does not guarantee future performance. Investors must keep in mind that the aforementioned statements/presentation cannot disclose all the risks and characteristics. Investors are requested to read and understand the investment strategy, and take into consideration all the risk factors including their financial condition, suitability to risk return profile, and the like and take professional advice before investing. Opinions expressed are our current opinions as of the date appearing on this material only. We have reviewed the document though its accuracy or completeness cannot be guaranteed. Neither the company, nor any person connected with it, accepts any liability arising from the use of this document. The recipients of this material should rely on their own investigations and take their own independent professional advice. While we endeavor to update on a reasonable basis the information discussed in this material, there may be regulatory, compliance, or other reasons that prevent us from doing so. Investors and others are cautioned that any forward - looking statements are not predictions and may be subject to change without notice. This document is not for public distribution and has been furnished to you solely for your information and must not be reproduced or redistributed to any other person. Persons into whose possession this document may come are required to observe this restriction. This material is for the personal information of the authorized recipient, and we are not soliciting any action based upon it. This document is not to be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Statutory Details: Portfolio Manager: Kotak Mahindra Asset Management Company Ltd. SEBI Reg No: INP000000837- Registered Office: 27 BKC, C-27, G Block, Bandra Kurla Complex, Bandra (E), Mumbai - 400 051, Principal Place of Business: 2nd Floor, 12 BKC, Plot No. C-12, ‘G’ Block, Bandra Kurla Complex, Bandra East, Mumbai – 400 051,India. Address of correspondence:6th Floor Kotak Towers, Building No 21 Infinity Park, Off W. E. Highway, Gen A K. Vaidya Marg, Malad (E), Mumbai 400097. Contact details:022-66056825 .
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