‘Return on capital matters more than PE’

Aarati Krishnan Chennai | Updated on November 18, 2019

Ajay Tyagi, a strong votary of the quality style of investing, weighs in on why he’s sticking to this style and whether there’s a buying opportunity in mid-caps. Excerpts:

Today, we’re getting evidence of an economic slowdown from practically every sector be it in products or services. As a growth investor, where are you finding pockets of opportunity?

When I look at constructing a portfolio, growth is important to me but what is even more important is quality. By quality, I refer to businesses with strong cash flow generation and high return on capital employed. Over time, it is businesses with strong cash generation and ROCE that also generate high and sustainable economic value. If you find these businesses in the growth pocket, that’s great because then you not only have quality, but you also have their earnings compounding at a high rate. But growth or quality in this context is not to be gauged over six months or one year, it needs to be gauged over a full economic cycle.

We don’t worry too much about whether the company will deliver growth over the next few quarters, we’re only worried about the long term. So right now, we’re not doing anything very different. We continue to look for businesses that can generate long-term economic value. Today, a Maruti, Nestle or a HDFC Bank may be delivering slightly slower growth as the economy is in a downturn. But as we emerge out this period of gloom and doom, we are confident these quality firms will see a pick up in growth. Our philosophy is to stay focussed on quality while we keep testing our hypotheses on each of our companies.

We’ve seen a very polarised market in the last couple of years with just a few stocks leading much of the index and market gains. Is the market likely to broad-base once growth picks up?

Frankly, I think there’s nothing new about this. That’s why you have the 80-20 rule which says that 80 per cent of the gains will come from 20 per cent of the stocks. If I ask anyone to name 100 wealth creators in India, they may struggle, but if I ask them to come up with 20, the names immediately come to mind. The truth is that there are only a few companies in India that have been able to grow across economic cycles.

I see the current phase as a reversal from a very indiscriminate rally that we saw from 2013 to early 2018, which saw all kinds of poor-quality stocks gain. We’re now seeing a return to normal. But yes, the polarisation seems stark now because the stocks with the three highest weights in the index have been doing well and are having a disproportionate impact on the benchmark. In the long run though, this is how it has always been — 90 per cent of the companies fall by the wayside and the other 10 per cent create enormous wealth.

You clearly look at the quality of the business first and assess valuations later. But there’s a prevailing view that there’s now a bubble in quality. What’s your view?

For people who would like a layman view and do not want to get into technical aspects, I would urge them to look at how expensive HDFC Bank was twenty years ago and how expensive it is now, and whether the stock has made money. The same argument would apply to a Kotak Bank or Nestle India which are believed to be ultra-expensive stocks. If they do this exercise, they will find that these stocks have generated huge wealth from high starting valuations.

I would also urge them to look at stocks that were cheap ten or twenty years ago, and they would find that many of them haven’t delivered. This begs the question — Are returns only a function of buying cheap and selling high, or are they a function of some other business characteristic? To me, what makes a difference to wealth creation is the ability of a business to generate economic value. If you get such stocks cheap, you are lucky and will make exponential returns. But if you don’t, that’s still fine; you will make very good returns.

For the more fundamentally inclined, valuations are a function of ROCE/ROE and growth rates. It is important for the ROCE to be high, more than for the PE to be cheap. ROCE is really the key because it decides how much profits a company makes for every rupee of capital.

Are mid- and small-caps attractive after the correction, relative to large-caps?

My approach, managing a multi-cap fund, tends to be purely bottom-up. I am quite agnostic about the market-cap of the stocks I buy. I simply go by the most compelling ideas I can find for my portfolio at any given point in time. Even in 2017, when mid-caps were expensive, I bought a mid-cap company in the diagnostics space and off late when large-caps have been relatively expensive, I have increased exposure in a large retailer.

On valuations, I think mid-caps had gone to a very unsustainable premium of 40 per cent over large-caps in 2017. In the long term, on an average, they have traded at a 5 per cent discount. So the correction needed to happen. But I wouldn’t say mid-caps as a category are great to buy as yet. Often when the pendulum swings in the stock market from one extreme, it seldom stops at mid-point. It swings to the other extreme.

Behaviourally, a market theme ends only when there is absolute frustration and capitulation on the part of investors towards that theme. Today wherever I travel, investors are still asking me about good mid-caps to buy. So, I don’t think we are at the capitulation stage yet. I could be wrong, but this is a soft indicator.

At the market level, the earnings projections of 15-20 per cent have been made repeatedly for the last many years but never seem to come good. When do you think a turnaround is likely? Is the corporate tax cut likely to help?

The Nifty earnings are important as an indicator of what is happening to the largest stocks in the market. And yes, I don’t see the earnings recovery, particularly on the operating front, happening over the next one or two quarters. The impact on earnings from corporate tax cuts may be selective. Some companies will be able to retain much of the benefits owing to strong pricing power, others may not. On the whole I do see the tax cuts accruing to corporate bottomlines because the pass-through to consumers will be gradual and may be even partial.

What is your approach to the equity portfolios in hybrid schemes such as UTI Regular Savings and UTI ULIP?

We try not to reinvent the wheel and the equity portfolios are exactly the same as that for UTI Equity Fund. I believe in maintaining a low beta multi-cap equity exposure in these schemes to ensure that the return kicker from equities is available.

Published on November 18, 2019

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