Best Buys Worst Picks-2017

KN Sivasubramanian

His experience with HDFC Bank taught him the merit of sticking to winning companies to create long-term value, while his bet on overleveraged Lanco Infratech went all wrong

Post the euphoria of the IT boom, the focus was shifting away from technology stocks to other sectors. That’s when we started looking at private banks seriously. However, we didn’t get in as early as we did in tech stocks. It took some time for us to understand that the retail banking story in India is going to be huge. The retail banking segment was clearly underserved and in terms of service quality and product offerings, government-owned banks had a long way to go. So in that sense, we realised that the retail banking opportunity was still nascent but a very lucrative one to ride out.

The late 1990s saw the emergence of a whole host of new banks after RBI granted new licences. Financial institutions like ICICI changed their DNA from being a development finance institution (DFI) to a private bank. HDFC Bank got its banking licence in 1994 and got listed a few years later. Banks are a good way to play the growth in the economy and it was clear that government banks would slowly lose market share to private banks. By then only foreign banks were active in India, but we didn’t see any foreign banks scaling up, because they already had issues in branch banking. They were focused on the metros and affluent customers only. So the field was wide open with the government-owned banks not doing a great job as far as retail banking is concerned and foreign banks not stepping up. We met many banks that came up during that period, such as the Times Bank, GTB, UTI Bank, IDBI Bank.

Around the same time, in early 2000, our salary accounts were shifted from ABN Amro to HDFC Bank. This gave us an inkling of the kind of services HDFC Bank offered and clearly they were way ahead of the others. So we got an early idea about how the bank worked. 

UTI Bank which subsequently became Axis Bank was equally focused on project finance and retail banking. ICICI Bank was struggling with a lot of legacy issues because the transformation from being DFI to a retail focused bank was not easy and the entire balance sheet had to change. HDFC Bank was the only bank with a laser focus on retail banking.

Thus, we invested in HDFC Bank in July 2002 at Rs.212 a share (adjusted stock price Rs.42), when the market cap was around Rs.6,000 crore through our Bluechip fund. The bank had a deposit base of over Rs.17,650 crore and was trading at a price-to-book value of 3.41x.

HDFC Bank ensured that they fufilled all the retail banking needs of their customers — they had at least four to five touch points including credit cards, wealth management, savings accounts, personal and auto loans. When it came to credit cards they went hell for leather and ensured all their customers had their own credit cards. But unlike most banks that burnt their hands offering unsecured loans, more than two-thirds of their credit card were issued to their existing customers. They were also early to expand to wealth management and unlike the foreign banks, they didn’t cater only to the affluent. They went ‘mass affluent’ even before the term became fashionable to use. Hence, the bank was not only able to retain its customers, but could also rapidly add new customers. And the deposit base grew from Rs.17,650 crore in 2012 to over Rs.367,000 crore in 2014 when I eventually left Franklin Templeton Asset Management (India). 

When it came to corporates, the bank never focused on long-term lending, instead it focused on fulfilling their working capital needs. Also it didn’t lend just to Tata Motors, it would look at the entire value chain. The bank also looked at the ancillary companies and ensured it was servicing everybody who was part of the value chain. The other smart thing that HDFC Bank did early on, was becoming bankers to the stock exchanges, which meant it became the end-to-end service provider to stock market participants and grew with them as they scaled up their business. Early on, given their deposit base, the bank focused on capturing the transactional and cash management businesses of corporates rather than lending long-term loans, which helped build strong relationships with them.   

A lot of companies may have their strategy in place but in terms of execution, HDFC Bank was way ahead. There is nothing glamorous about banking products. It is all about acquiring funds at a low cost and selling them at lucrative rates as loans to customers. HDFC Bank did both without compromising on quality and focusing on profitability. Even as advances grew from Rs.6,814 crore in FY02 to over Rs.303,000 crore in FY14, it managed to bring its NPA levels from 0.50-0.27% during that period. The focus on retail banking and its ability to consistently grow that business meant that it kept away from lending to the troublesome infrastructure and power sectors. HDFC Bank was the first bank to have a centralised online banking system, much ahead of the others. Robust back end processes and IT systems that were way ahead also helped them execute well. 

What helped HDFC Bank, was the fact that its leadership team has largely stayed, since inception. Deepak Parekh is credited for a lot of things, but in terms of identifying the right people to head the business, he was spot on. He brought in Aditya Puri from Citibank, who has been the bank’s CEO since inception. I think he was with Cititbank Malaysia then and Parekh not only convinced Puri to join HDFC Bank but also gave him a free hand to run the business. Puri has led much of the bank’s strategic thinking and ensured its execution. Not only was he very good dealing with the various stakeholders, he was also very good in the rough and tumble of the business.   

Today HDFC Bank is bigger than HDFC in terms of market capitalisation. Despite getting into the business nearly two decades after its parent, HDFC Bank’s market capitalistion is 60% more than its parent. What’s more the bank managed to do it without participating in one of the largest retail banking product — mortgages — for the longest time. As investors, we always felt that HDFC Bank was slow getting into mortgages. Even when they forayed into home loans and couldn’t go after that segment aggressively, they managed to grow faster than most private banks.

Whenever we met Puri, we would voice our concern on whether the bank could grow on a sustained basis. But the management was always confident of sustaining growth and had great clarity on how they would do it — they managed to demonstrate it quarter after quarter and year after year. Despite its increasing size, the bank’s interest income and profit grew by 31% and 33% on an average every year since 2002 to 2014.  

Despite the sustained outperformance, we reduced exposure to HDFC Bank and got into other banks. Those days the fund sizes were not too large. The first fund to hit Rs.1,000 crore was Bluechip; all the other funds were tiny. Given that the stock gained faster than the fund size, holding on to our original exposure meant that the stock would form 20% to 30% of the portfolio. So from a risk management perspective, we had to cut exposure. 

But more than that, in our bid to find stocks that will do better than the existing ones in the portfolio, we thought we were being smart in selling HDFC Bank to buy an ICICI Bank stock. But in hindsight, these were all mistakes. If we held on to our original exposure, the funds would have done much better. But it was a learning for us on how to evaluate companies from a long-term perspective and what to do when you find a good quality company.

Between 2000 and 2010, some companies like HDFC Bank outperformed substantially and created sustained long-term value for shareholders. In the race to beat the benchmark and shuffle our portfolio, we missed the bigger picture. In October 2002, ICICI Bank’s market cap was larger than that of HDFC Bank. However, today HDFC Bank is more than 2x the market capitalisation of ICICI Bank. That is the kind of value creation you would see if you stuck to the right stock. 

I have never been comfortable with investing in expensive stocks. While I am well aware that you have to pay more for quality, I have always been more of a sceptic when it comes to high growth companies because in a spreadsheet you make whatever projections you like. Whether those projections will materialise in reality is anybody’s guess. So I have been wary, and in many cases I have been right. But in some cases like HDFC Bank, I have been proven wrong since it has continued its outperformance even when it has grown fairly large in size at a rate that even smaller private banks are finding hard to match.

We were still holding on to HDFC Bank when I left the fund in 2014. The market cap was around Rs.250,000 crore. Even today, it is the largest holding of the Bluechip fund making up nearly 10% of the fund. I still remain bullish on private sector banks because I think there is a long way to go before we hit saturation levels as far as retail banking products go. While the penetration of retail products may be higher, the demand for retail banking products will grow as people become more affluent. 

Investing lesson

We realised that good quality management matters and when you find one, staying with your conviction is important. If you look at our portfolio, we have stayed invested in tried and tested stocks even in the mid-cap space. Not that we haven’t made mistakes — we have backed managements that have failed to deliver, but over a period of time, a substantial part of the portfolio has been in stocks where the management quality has been good. Although, it may seem boring we always stuck to the same stocks across funds. Instead of reinventing the wheel, if we identified a good company, we remained invested in those stocks. There was a lot of pressure to change our strategy when quality underperformed in the run-up from 2003 to 2008, but luckily we didn’t succumb to the pressures. This helped us outperform when the markets recovered in 2009.

They say those who forget the past are condemned to repeat it. In my case, it was my experience with infrastructure stocks. Infrastructure was a sector that took some time for me to understand, so we made our fair share of mistakes. Between 2003 and 2008, infrastructure was the flavour of the season with huge investments coming into the sector. It was a sector that was hard to ignore since much of these investments were driving economic growth. But luckily, our largest investment was in Larsen & Toubro (L&T) so we emerged mostly unscathed in the end. L&T also took a hit but the damage was much less, compared to the other companies since it managed its various businesses much better. Yet, my experience with infrastructure stocks left me a little wary of them. 

During the infrastructure boom, while the sector continued growing, in terms of use of capital, I think the entire sector was totally inefficient. Most of the companies did not have the balance sheet size to take on large projects since their net worth was insufficient. Many of them were often overleveraged and we missed to see it in the overall euphoria surrounding the sector. Their ROE always looked good because of the leverage, but from a return on invested capital perspective the entire sector was a disappointment.

Post the financial crisis, the Indian economy bounced back faster than expected. In fact, it emerged from the crisis as the second-fastest growing economy. With the recovery back on track, banks were lending to infrastructure and power projects with the government stating its intention to boost infrastructure and power spending. 

Lanco Infratech was a Hyderabad-based infrastructure company that was riding on its strong order book in the construction and engineering procurement construction (EPC) business and was making huge investments in the power sector across 16 projects at various stages of development. Revenue increased from Rs.1,594 crore in FY07 to Rs.6,072 crore in FY09. Given the company’s projections based on its strong order book position and the government’s push to increase power generation capacity, it looked like the company would continue to do well. While we were wary of infrastructure companies based out of Hyderabad, given our past experience, we still decided to go ahead and invest in the company given its strong performance and the opportunity in the power sector in February 2010 at an average price of Rs.48 per share. 

In FY10, revenue increased by 35% to Rs.8,210 crore while profit increased by 43% to Rs.643 crore. The order book position almost doubled to more than Rs.25,000 crore. The company had a portfolio of 9311 MW of power projects with 1349 MW in operations and the rest under construction. Things did look rosy for the company. Almost all of this growth was being fuelled by debt. The company’s debt increased from Rs.3,165 crore in 2008 to Rs.8,361 crore in 2010. On paper, the company’s cash flow projections were not only enough to service the debt, but also repay debt. Only in reality things didn’t go as per the plan. We were monitoring the progress of the projects and it wasn’t going on projected lines. The problem is if you are highly leveraged, the meter starts ticking from day one and if projects get delayed and cash flows don’t materialise on time, then you find yourself sinking deeper in a debt trap that you can’t get out of. 

The problem was that there were cost overruns and delays with almost every project that it undertook. The company either underestimated the overall costs or low balled the numbers to bag the projects, but the delays cost them dearly, since the company was highly leveraged. Part of the overruns were because of government approvals being delayed. In many cases, land parcels that were promised to them were not given at the right time, pushing up project costs. The business itself is a difficult one to execute in India. The margins look good on paper, but when the project is finally complete you end up with negative margins and these companies posted huge losses in the end. It was difficult to see if Lanco was making profit at every stage since companies were booking revenue on the basis of the progress made in the project and the business was prone to accounting issues. Only closer to the completion of projects, it became apparent whether they were actually making money.Besides,these were long gestation projects so predicting the profitability was even tougher. While it needed to be conservative in recognising revenue, in a bid to bag new projects and raise funds for the existing ones, the company was actually aggressive in booking revenue. 

We were definitely wrong about the management and their risk management capabilities. They did not limit the risk, but went all out and bet the house if you will and that blew up in their face. The company was very aggressive in bidding for projects. It was more a double or quits kind of strategy which made them take risks that eventually resulted in the company going belly up.

I was kicking myself when I realised the premise of my investment was wrong when I started assessing the investment after a couple of quarters. The good thing is that as a rule, we don’t shy away from cutting our losses once we realise we made a mistake or when the premise on which we made the investment changes. We exited the holding in March 2011 at an average Rs.36 a share, losing one-fourth of our investment value. The company ended that year with a 6% dip in revenue and flat growth in profit. Debt had ballooned to over Rs.11,000 crore. In hindsight, it worked well for us because by December 2012, the stock had fallen to Rs.14 per share, losing more than 60% since our exit.     

Investing lesson 

We need to understand a business really well before we start investing in them. When you get in without a clear understanding, thinking you will figure out the pieces as you go, more often than not, you will not. There is no need to reinvent the wheel and switch from quality to other stocks because they are cheap or the sector they are in is suddenly the flavor of the season. Even when the markets collapsed in 2008, quality held on to value much better than other stocks.