Focus on businesses with strong cash flows

By Ravi Samalad |  04-08-20 | 
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About the Author
Ravi Samalad is Assistant Manager - Editoral for

Pankaj Tibrewal is senior vice president at Kotak Mahindra Asset Management Company. He is also the fund manager of Kotak Small Cap Fund.

He believes that businesses with strong cash flows, and companies that rely on domestic growth are the ones that will outperform in the near future.

What are the main parameters you consider when picking stocks?

There are four broad parameters we consider while picking stocks:

  • Business: Good and sustainable.
  • Management: Good and honest.
  • Pricing: Growth at a reasonable price. The companies should be available at an attractive price from a margin of safety perspective.
  • Capital ratios: Focus on cash flow and balance sheet more than the profit and loss account.

We normally avoid companies which have weaker balance sheets, very high fixed costs, inferior cash flows, high leverage and have had corporate governance issues. Companies which don’t earn a return on equity over cost of capital tend to destroy value for shareholders.

You use the word “good” twice with respect to business and management. Explain it a bit.

A good business is one which has competitive advantage and can generate high return on capital for a sustainable period of time.

We believe businesses which can grow their profits along with cash flows could probably generate sustainable returns for investors. Markets tend to be less charitable in giving multiples to businesses which are only growing their profits but not cash flows. Companies which have sustainable cash flows are scalable.

In mid and small cap companies, promoters and management play an important role in scaling up the business. Hence, we look at the track record of management in terms of integrity, longevity and capability. Promoters who have skin in the game tend to do things which are in the interest of minority shareholders.

When do you decide to exit companies?

We don’t churn portfolios often across our schemes. Our philosophy is Gorilla to King Kong. We own about 40-60 stocks which can be termed as Gorilla. Some of them may turn into King Kong.  They will make mistakes also, but they should not be large enough to drag down the portfolio.

Every company goes through a life cycle. Our philosophy is to see them ride over the lifecycle. There is never a company which is perpetually into a growth mode. Even growth companies don’t keep growing till perpetuity. We need to understand where in the lifecycle of the company it is currently positioned. If the company’s market share has saturated, then you may not get multiples which are very high. So there are many trigger points to sell.

We also exit from companies where we see any corporate governance issues or balance sheet and cash flow deterioration.

Kotak Small Cap has 56 stocks in the portfolio as on June 2020. Is the large holding meant to cut down risk?

This is to make sure we make less mistakes. It also helps from a diversification perspective. In small caps, the risk of mortality is high. Some calls may go wrong, but they should not be large enough.

Diversification is also important to generate liquidity. Around 70% of Kotak Small Cap portfolio is in small caps and the remaining is in a mix of large and mid-caps. So this helps mitigate the liquidity risk. No stock in the portfolio is so large to make an impact on the price when we trade. We have internal risk model to ensure our portfolios are invested in liquid stocks.

Which kind of businesses/sectors in the small cap space are likely to bounce back faster when things return to normalcy?

The FY21 earnings will be impacted by the lockdown. A broader recovery in earnings will be visible in second half of FY21 assuming the COVID situation comes under control. Beyond the near-term volatility, the markets will focus on the long-term sustainable earnings growth of companies.

The earnings will be resilient in sectors such as rural, agriculture, fertilizers, tractors, chemicals, specialty chemicals, cement, IT and Pharma even in FY21. Across mid and small cap sectors, the market share shift is happening from smaller unorganized players to organized players at a rapid pace. We are seeing this trend in products like tiles, plywood, cement and specialty chemicals.

Whenever the economy stabilizes, these companies will emerge much stronger. Those who survive this pandemic will emerge stronger provided they have the right balance sheet and cash flows to support their growth.  Our portfolios are positioned to take advantage of this trend.

In mid and small cap space, the China substitution is a large theme that is in the making in the country. We think India will be self sufficient in assembling and manufacturing electronics.

Real estate stocks in the mid and small cap space have run up despite slowing sales. What is your view on this sector?

The sector will bottom out in the next six to twelve months. The property prices have remained stable over the last six years. During this time, the affordability of consumers has increased.

Post Real Estate Regulatory Authority (RERA) and COVID-19, many builders could go out of business due to paucity of funds. Non-Banking Financial Company (NBFC) was the main source of funding for the mid-sized builders. NBFCs have their own trouble. This will lead to consolidation in real estate business. A lot of supply which we are seeing on paper may not materialise.

The home loan rates offered by public sector banks is around 7%. The rental yield is around 3 to 3.5%. The gap between the home loan rate, adjusted for tax benefit and the rental yield is around 3%. This gap was around 5 to 6% earlier. So now there is a larger incentive for people to buy houses.

The rupee has depreciated significantly from 45 to 74 while the real estate prices haven’t gone up. So NRIs will also contribute to the demand growth. In the near term, there will be pain due to lack of funding for real estate players. From a three to five years perspective, real estate stocks are in a sweet spot right now.

Having said that, there are not too many real estate companies which fit our return on capital requirement. The return on capital is lower than cost of equity in most cases. So we are playing it through ancillary sectors like mortgage lenders, tiles, plywood, cement, paints, etc.

BSE Small Cap Index is up 34% from its March 2020 lows despite earnings not coming through. Are you cautious about this liquidity driven rally?

The small cap segment has been facing headwinds since January 2018. Since then the mid and small cap segment has seen a pullback. The current downturn in this segment is the deepest and longest, especially in small cap. From January 2018 till March 2020, when the markets bottomed out, 80% of the top 1,500 companies by market cap had already corrected by 50%. 70% of them had corrected by more than 60%. We had seen such price damage in the 2008 crisis.

Even prior to COVID, we had weak economic conditions for the past few years.

The pain in mid and small cap was not long in the 2008 financial crisis. But this time it has been more than 30 months. This segment was underperforming large caps significantly.  The current divergence between the performance of large versus mid and small caps is at historical extremes.

The relative valuations in mid cap versus Nifty is at 2014 levels and in small caps it is at 2011 levels. History suggests that such divergence will not exist for too long. Post such underperformance, small caps tend to outperform large caps over 18 to 24 months. In a crisis like COVID, one would expect mid and small caps to correct more than large caps due to the economic conditions. But it has not happened this way. There are many companies in the mid and small cap space which have strong balance sheet and are likely to emerge unscathed post COVID. FY22 will be a normalised year for economic growth.

Whenever the economic conditions improve, mid and small cap firms will benefit the most because they are biased towards domestic growth rather than global growth. Bottom up stock picking will be rewarded in this space going forward.

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