“The crucial role of cycles is missed out in outperformance”

Sankaran Naren’s contrarian move to stay away from infrastructure stocks during the go-go days of 2007, except in thematic funds, has been amply vindicated over the subsequent five years. The 46-year-old chief investment officer at ICICI Prudential believes the sector is paying for its excesses and that the worst is far from over. A value investing practitioner and a connoisseur of carnatic music, Naren tells V Keshavdev that in these lean times only solvent companies will live to see another day. An added word of caution: investors need to gird up their loins as we are headed into an exceedingly volatile 2014.

What drives outperformance, especially in the kind of disruptive environment seen over the past five years?

Whenever we raise a toast to outperformers, we tend to forget the role of [business] cycles. Companies become outperformers because of the sector becoming an outperformer. That part is forgotten by people very often. In the 1990s, we were in an export cycle. After that, there was a very strong boom in technology. Between 2001 and 2003, there was a lull phase and then from 2003 to 2006, there was a mid-cap cycle, followed by an infrastructure cycle that went on till 2008. Post that we had a consumption rally. The discretionary part of the consumption cycle — that is, automobiles — has deflated and the non-discretionary part is showing signs of slowing down. Now, we are entering an export and import-substitution cycle, similar to what happened in the 1990s, given the high current account deficit. Once this plays out, we will need an infrastructure cycle to prop up the economy and markets. 

The problem is that when you’re in an upcycle, investors get swayed into believing that cycles last forever. That is never the case. But sectors can make a comeback. After the technology boom of the 1990s, the sector went into cold storage till 2007. But now, over the past one year, technology is back in vogue.  So, as renowned value investor Howard Marks of Oaktree Capital says, if you are able to get the cycle right, many things starting working in your favour.

Knowing the all-important role of cycles, how do you pick stocks — would you just go with sectoral bets or can bottom-up stock picking work, too? 

If you go back to the NBFC cycle in 1994-1995, the companies that came out of that are all very successful today, even as the other 90% perished. In 2000, Himachal, Global, DSQ and Pentafour were perceived as big outperformers. But when the cycle turned, these companies went down the tube. In fact, some of the IT names of today were actually considered to be stodgy at that point of time. Similarly, if you look at the road or real estate or construction sectors, there are only a handful of companies that are solvent.

I would say that the few companies doing comparatively well in the construction or roads business today deserve to be called massive outperformers because they have managed to survive in a negative cycle. The market doesn’t give them any credit because it says that their performance is nothing compared with a consumer goods company, which has done extremely well over the past six years. So, a key criterion for me is to look for companies that can hold their own even in tough times. You need to always remember that for every Amazon or Google, there were several others that went bust. Our job, therefore, is to spot these survivors.

But how do you pick these survivors? What do you look for in these outperformers?

Since we focus on long-term outperformance, we look at an outperformer from one up-cycle to another up-cycle or from one bottom-cycle to another bottom-cycle and see which are the companies that have survived the whole cycle. What happens is that when an industry experiences growth, margins rise and you see earnings multiple rising for the sector. Naturally, as these stocks gain favour among investors and stock prices rise, they become a bigger part of the index. The reverse happens when a sector goes out of favour: growth rates tumble, margins are squeezed, price-earning ratio falls, and the weightage of the sector in the index goes down. All these things — growth, margins, earnings multiples and index weights — happen simultaneously. In 2007, the composition of the benchmark was tilted towards infra stocks; in the year 2000, it was tilted towards technology-oriented stocks. At this point, we are slowly moving towards an export-oriented benchmark.

When the cycle is on an upswing, it doesn’t really matter if a company is great or not — companies in the sector outperform because of the upturn in the business cycle. For example, in 2008, every steel company was seen as a superstar; not because steel companies were walking  on water, but because the cycle was supportive. Today, the same craze is being seen for consumer or healthcare companies, mainly because of the environment that has existed between 2007 and 2013. 

What we like to do as investors is to identify a particular sector in trouble and buy a company that we think will do well in the next up-cycle. So you have to go through the pain. Only a month back we had massive weightage in metal stocks, even as others were bearish on the space. The stocks were dirt cheap, but the general consensus was: avoid metal stocks as there is no hope. But in the past one month, metals have outperformed consumer stocks. And we believe there is good potential for outperformance over the medium and long term. 

What do you look for in companies when you look at sectors in distress?

Ultimately, it is only companies that are sensible both at the bottom and top of the cycle that turn out to be outperformers. One of the prominent groups in the country went and bought a metal company at the top of the cycle. The company is struggling and it is a relative underperformer. Another prominent group went and bought an auto company at the bottom of the cycle. Now, that company is a star. In other words, the decision taken by a company at the bottom of the cycle has worked out very well and the one taken at the top of the cycle has proved to be disastrous. 

At the top of the cycle you will get easily carried away, but at the bottom of the cycle it takes a lot of courage to actually stay the course. Also, at the top of the cycle, one has to be very careful about allocation, especially when it comes to acquisitions, because companies have loads of cash and when you are cash-rich, you can make mistakes easily. On the other hand, only a handful of companies will have the capital to make acquisitions in a downturn. How managements behave in up- and down-cycles is their true test and it determines their long-term performance. Therefore, look for managements that have seen cycles. Be sceptical of managements that are overtly bullish in an up-cycle and extremely pessimistic in a down-cycle. Also, sound financial management is critical to survival, especially if it is operating in a cyclical industry. 

What is your view on infra companies and do they hold potential for outperformance at current valuations? 

Generally, as value investors, we avoid over-leveraged companies. Right now, a number of infrastructure companies are over-leveraged, so we are not keen on them. What’s the point when you don’t even know whether it has the ability to pay its bills or survive? One would instead look at companies that are in a solvent position even today. Among the things we have learnt is that at the bottom of the cycle, it is enough if the company is solvent; how much money it makes is secondary. Similarly, at the top of the cycle, valuations look very good from an earnings perspective as they appear cheap. Today, in the construction space, you need to look for a company that has a comfortable consolidated debt-to-equity ratio and a reasonable credit rating. If a company has those, then you don’t need to consider earnings, as that will flow in when the cycle changes. 

Do you see consolidation in the infra space as it is largely  banks’ largesse that has kept the pack afloat?

There’s unlikely to be consolidation as over-leveraged companies are unlikely to fetch buyers and their only option would be to go in for asset sales. And that is a way of ensuring that the residual company is able to meet its debt obligations. So, we would rather look at buyers of distressed assets because they are the people who are comfortable today. The good thing is, five years back, companies went for very aggressive bids; today, they are bidding cautiously. That is because they haven’t forgotten the experiences of the past five years. That means they are less likely to make mistakes. 

Which sectors are you bullish on right now?

We are looking more at ancillary sectors such as cement and telecom, where the balance sheets are clean. So, when the sector cycle finally revives, cement will stand to benefit as it is used in almost everything. In telecom, the sector hit the bottom of the cycle last year. People threw in the towel and reduced the quantum of circles that they operated in. We continue to hold telecom stocks simply because the sector has got nowhere close to the top. In fact, the top is, perhaps, many years away. Telecom may not seem to throw up an outperformer today, but the story will be different over the next five years. Unlike in infrastructure, the leaders in the telecom business are solvent and that gives investors credible opportunities. 

That apart, we are looking to bet on low leverage companies in down-cycle sectors. But for the actual return to play out, we need to have an acceleration in growth rate. You can’t have 4% GDP growth and expect a big booming equity market. Till the current account deficit goes into surplus, any sector that is engaged in exports and import substitution will be in focus. For example, textile stocks, usually the underdogs, have delivered 30% return in the past one year. That is another hunting ground one can look at. 

How do you see the coming year and how are you positioning yourself? 

If you look at the immediate term, over the next one year, there are enough negatives to worry about. Historically, election years have been pretty volatile. 2004 was a volatile year on the downside, while 2009 was a volatile year on the upside. Unfortunately, we now know, in retrospect, that March 2009 was the bottom of the bear market. 

Similarly, next year, besides the elections, you also have the world’s most powerful nation thinking of unwinding its easy monetary policy and making the cost of capital higher. In other words, you have a perfect recipe for volatility. Now, I can’t be sure which way the markets will swing. Also, in times like these, you steadfastedly try to avoid mistakes. As Howard Marks says, at any given point in time, and more so now, we have to decide whether to save money or make money. We are still in the saving money phase. Having said that, as far as portfolio strategy goes, past performance helps you to take good long-term bets in stocks, and that is what we focus on.