Stable profit margins indicate a company’s moat: Swati Kulkarni

Yes, I look for companies that offer competitive advantage and also growth at a reasonable price. Despite the slowdown, there are opportunities within consumption where I do see a long growth runway — categories with low penetration levels, those that can benefit from formalisation of the economy, a shift from the unorganised to organised sector and so on. Now the question is, how much of this is in the price. High valuations do rule out some of the consumer categories today, but I hold positions in consumer discretionary stocks with strong drivers.

Well, as Pat Dorsey has said, it is important to differentiate between temporary competitive advantages and durable competitive advantages. If you overpay for a temporary moat, you will suffer value destruction. The assessment of moat or competitive advantage differs for different businesses. In capital-intensive or B2B businesses, you judge a company’s moat by its cost efficiency.

The buyer is a hard negotiator too and you won’t get pricing power. You can look at fixed costs per unit of capacity compared to peers, whether the company is moving up the value chain, its R&D efforts, its de-risking strategy and so on. In B2C businesses, you assess pricing power. Often, people talk of brand value or market share, but I’ve found these to be transitory. A brand can lose recall and a company can lose market share. So, unless the company is able to charge a pricing premium on the basis of its brand, the moat isn’t durable. One way to assess the moat is to see if the company’s profit margins remain within a tight band. This is indicative of its ability to pass on input costs. If a company manages growth while rarely diluting equity, this adds to return ratios. These are the key numbers I would look at to assess moat.

If you see in the Nifty500, the top ten stocks have a 43 per cent weight in the index and contributed 40 per cent of the returns from January 2018 to October 2019. Whereas if you see the bottom 250 stocks, they have delivered negative returns. So, there is polarisation.

The market is preferring the handful of companies because of the dearth of growth elsewhere. Even today, growth managers vouch for the compounding characteristics of companies such as HDFC or a Hindustan Unilever. Yes, these companies are trading at a premium to their historical valuations. This I ascribe to the uncertainty about growth and earnings visibility in the rest of the market. So, GARP (growth at a reasonable price) gives me a framework to spot opportunities that balance both. While I do own some Nifty companies that have delivered returns, I balance it out with positions in sectors such as two-wheelers quoting at low valuations.

These are long-term measures aimed at reviving the investment cycle in the private sector. But these dole-outs do curtail the ability of the government to do capital spending in the near term. Also, capacity utilisation in the private sector is still well below 80 per cent and the demand outlook is weak, so new investment plans may take time to fructify. On the tax cuts, the corporate sector will need to evaluate how much it can retain versus passing it on. But these measures are definitely positive in terms of improving India’s long-term competitiveness. We need to think of this as sowing the seeds of growth, which will take some time to materialise.

Yes, there was criticism that something should have been done on the demand side instead of this corporate tax cut. But my view is that when you have this NBFC slowdown, a trust deficit on bank lending, mutual funds going risk-off and so on, a demand-side boost may not work. Handling the investment side can pay off with a time lag. Consumption has been the engine we’ve been exploiting for too long. The investment side of the economy also needs to eventually pick up, to generate employment and income growth.

It just highlights the futility of timing the markets. One should remember that GDP growth is a lag number that captures growth for the previous quarter. The markets are always forward looking. The market may well be looking at two-three quarters down the line where some recovery is possible. The de-stocking issue may be behind us after the March quarter, and there can be a cyclical demand upturn from consumers who were postponing purchases.

So, what the market is signalling is that the GDP growth may be bottoming out. But I do not expect a sharp recovery because we have serious issues in terms of slowing rural incomes and a falling share of industry in the GDP pie. Earnings growth needs to pick up to justify current market valuations which are at the higher end of the fair value zone. As fund managers, we have a mandate to be fully invested and handle this through position-sizing and sector allocations.

Yes, from a below 20 per cent weight in the Sensex, financials have grown to this weight. But if you dissect this further, the market cap gain is mainly driven by private sector banks and NBFCs while PSU banks have hardly participated. Today though, PSU banks are capital-constrained to expand their balance sheets. For some large PSBs, management bandwidth is occupied by mergers. Therefore, the recovery in their Return on Assets and Return on Capital may be quite slow. I think the shift in business fundamentals in favour of private sector banks will continue. Many of them are also addressing their cost of funds issue through CASA growth. So, I believe PSBs will also face stiff competition on the deposits side. I think this is what is driving valuations.

At the headline level, yes. Compared to December 2017 when mid and small-cap indices were trading at a 30 per cent premium to the large-cap indices. But today the valuations have reverted to a normal 20 per cent discount. To that extent, I have been increasing my mid cap allocation within scheme mandates.

But indices often don’t tell the full story. We find that there are only a few mid-cap stocks that meet our frameworks on returns and cash flow generation. The growth expectations from such stocks are quite high even today. Even large-cap companies in the Nifty have been struggling to deliver on growth expectations and we are seeing earnings estimates being repeatedly downgraded for the last 5-6 years. The expectation of a 20 per cent earnings growth from the Nifty50 appears high even for the next year. Interestingly, after the recent corporate tax rate cut in September, you would have expected Nifty50 earnings estimates to be upgraded by 7-8 per cent. But in reality, we saw analysts taking this opportunity to correct their estimates downward.

So, I would hesitate to make a generalised comment that mid-caps look attractive today and I would prefer to be selective.

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