The Outperformers 2013

“The biggest mistake is to misallocate capital”

IDFC Mutual Fund CIO Kenneth Andrade on why it’s all about survival of the fittest

Kenneth Andrade believes in taking regular breaks from the market as it helps him keep the noise out. That is what he chose to do this time as well when the market went south. The 43-year-old chief investment officer, who oversees assets of over ₹39,000 crore at IDFC Mutual Fund, recently resumed work after a 10-day break with his wife and two daughters. Having spent more than two decades in the market, Andrade tells V Keshavdev that he is far from intimidated by volatility. The proof of the pudding: his fund (IDFC Sterling Equity) tops the mid- and small-cap category with 16% CAGR returns over the past five years. Though for FY14, it is down 15%, Andrade is not too worried.If anyone needs further proof: Andrade has gone ahead and launched a new mid-cap fund (IDFC Equity Opportunities) in April this year even as aversion towards mid and small caps crept in. His reasoning: it is a one-time opportunity to go fishing in the mid-cap space. 

You have spent about two decades in the market. Over the years, have you been able to develop any kind of template to identify outperforming stocks?

To begin with, you cannot identify an outperformer at the very outset. At best, you can only identify good businesses. “Outperformance” is a market term but, really, it is a derivative of how well a company performs on the business front. Is there a scientific way of predicting tomorrow’s leaders? No, there isn’t. But our stated approach of investing is to buy consolidators of businesses, companies with low leverage or those that are cash-flow positive or where cash-flow visibility is amply clear. Any company that deviates from these norms does not form a part of our portfolio.

Let me explain the challenge of picking the winner with an example. If you go back to the early 1990s, India had only three bike manufacturers: TVS Motors, Hero Honda and Bajaj Auto. Yamaha was a fringe player at the time. Which of the three did you think would have come through? Bajaj was selling scooters, which was a dying product; Hero Motors was a relatively new entrant. Nobody knew who the Munjals were, plus there were corporate governance issues, and also Hero sold four-stroke bikes, which everyone questioned at that time.

Down south, TVS Motors with its engineering prowess and two-stroke engine reigned. Back then, southern companies were considered models of compliance and good corporate governance. In such an environment, which of the three would you have thought would make it? Logically, you would have bought TVS Motors, followed by Bajaj Auto and then Hero Motors. But towards the turn of the century, Hero Motors was the largest. Hero Motors also turned out to be the best performer in the stock market over the years. 

Therefore, your approach at any time — and especially in a category that is growing — has to be to keep looking at incremental data points and keep moving money based on that information. A close look at important data points will show which player will be the ultimate survivor.  

What does this mean in today’s turbulent times where growth is slowing and you don’t have too many categories that are really booming?  

Yes, the economy is contracting, and growth is clearly out of the window, with experts now talking of just 2-3% GDP growth. In such an environment, as market share gets consolidated, you start looking at survivors and see which company is accumulating significant market share. In the absence of capital, and diminishing competition, the big will only get bigger and stronger, and the last entrants or players with a high-cost structure will be the first to go. When that happens, it will lead you to the next round of companies that will outperform. 

Again, take the case of telecom. It was the first industry to get into trouble. Today, which player has pricing power? Only the top three operators in a sector that had as many as 15 players with licences. Now, within the existing pack you have to look at which companies are outperforming and then allocate capital. Do not worry about stock prices because you will never be able to catch the bottom; instead, focus on what’s at hand. Just pick the survivors and once the environment improves these are the players that will be left standing. 

Are you suggesting that big is always better in challenging times?

That is often true, but not necessarily true all the time. Consider Asian Paints — it makes twice the money the entire paints industry makes. In a bad year, the company can spend a year’s worth of cash flow and obliterate everyone else. Now take the case of Hindustan Unilever (HUL). Zydus had created a niche for itself with its Everyuth skincare brand, but in the last two years HUL went on an advertising spree nearly the size of the entire category and now the niche category no longer matters. But, in a shrinking economy, will HUL do a repeat? Perhaps not, because it has bigger battles to fight in 90% of its core business. When that happens, you could possibly see new companies coming in and creating newer categories.

But, then, you have to remember that while this sort of behaviour may be peculiar to consumer businesses, it may not hold for commodity businesses, such as steel or telecom. In the capital goods space, look at Larsen & Toubro. Last quarter it had operating margins of 8-8.5%, just slightly above its historical low of 7%. Now, if the biggest player is making such margins, then the rest of the industry might as well not exist. 

What do you think drives outperformance — is it the quality of management and execution or the business itself and other external forces?

The company’s track record is key. Look at tyres. Which company has survived through the past several years of good and bad times? It’s only MRF. Apollo has its hands full now, Ceat is too small, Birla Tyres doesn’t matter, Goodyear is non-existent and the two new MNC entrants, Pirelli and Bridgestone, are yet to make a significant presence in the market. MRF, on the other hand, has created a really strong brand in India and it is the No.1 brand. It will be debt-free in a year, so there is no stress on its books. Now, Bridgestone and Pirelli have made billion-dollar investments in India, which will, naturally, create hurdles for MRF. But even if the tyre market ends up becoming a three-horse race, it can easily accommodate the competition. 

So it’s not just about the survival of the biggest; you also need to build a moat around your business. Most businesses, say 90% of them, need just one moat — the lowest cost of manufacturing, lowest cost of production, lowest cost of service or a strong brand. Once you have established your moat, even if you are the smallest in the industry, you will still be the outperformer.  

What kind of mistakes lead to companies losing their winning streak? 

The biggest mistake an outperformer can make is to misallocate capital. That may seem like a no-brainer, but let me explain. We are financial investors. What do we buy? Not cement, tyres, petrochemicals or banks. We buy efficient capital: whoever delivers that efficient capital in whatever way he might do it. In that sense, every sector can throw up a good performer, as long as the company is conscious of the fact that the return on equity has got to be significantly higher than the cost of capital. The best businesses do not consume capital but keep throwing up profitability every year.

So would you agree that what happened in infrastructure companies was essentially a case of misallocation of capital? Or would you say that it is simply because business conditions turned against them? 

It is a mix of everything. But I think everyone was too overambitious. In fact, in 2011, when the markets went into a tailspin, we expected huge consolidation in the infra space. Unfortunately, the liquidity tap was so open that banks refinanced all these players and they never consolidated. The problem of 2011, throwing good money after bad, is coming to hit the banks in 2013. There is too much debt in the system.

The government has it, companies have it and the banks have it. The situation will take time to turn around. But, by the way, this irrational exuberance is nothing new. The markets made the infra guys think that they could deliver superior return. That happens all the time — and the market will continue to behave that way. It happened with technology stocks, then with infrastructure stocks and now you are probably seeing that in consumer stocks.  

What is your portfolio strategy in today’s environment?

Our portfolio approach is based on a set investment process and well-defined criteria. When you do that, you do not look at what is the underlying industry you are buying. What is important is whether the company is meeting your criteria. Currently, we have 55 companies in the new mid-cap fund, of which 25-30 meet our investing criteria. Some of them slipped up in the past six months in terms of execution, balance sheet, etc. Over the next three months, we will fine-tune the entire product so it will be homogeneous. What I mean by homogeneous is that today, a large part of corporate India has got cash on its books. Not debt, but cash in books. But, cash is getting zero value; you do not attribute a multiple to cash held by a company, but earnings are getting a multiple of 6-10 times. Once the environment changes and if these players are able to leverage the business, they can consolidate faster. There’s no telling when and how that will play out. Even if we have a bank or a financial services company, the leverage in that business is the lowest in the industry and its profitability and return on equity is the highest. That is how we construct the portfolio.  

Going ahead, what is the biggest risk to your portfolio, what would work against you, even adjusting for the fact that it is constructed based on stringent criteria? 

Well, the macro environment obviously poses a risk.  Second, a number of companies can slip up on execution and we have seen a number of companies do that. When I talk about execution, these companies go and say acquire companies that are very large or misallocate capital — that’s beyond our control. 

Some companies in your portfolio are part of the outperformers list. Do you foresee any risk to their performance? 

Blue Dart is the only player with its own airline fleet business and controls 65% market share. So, in business terms we can’t see anything that will challenge it. In terms of valuation, it might stay here for a long time. Again, Asian Paints is well placed in terms of business, but in terms of valuation, it is very steep. So many of these companies have good businesses and if they fall, it will be because they are expensive. There is a value that you pay for earnings and if they do not repay that value, then you will have a problem.

So, even good companies could fall, but there is no business mortality risk. In the case of Asian Paints, as I said earlier, if the company takes one year of cash flow and puts it into the existing distribution system, every other player’s profit will be wiped out. Not that the management will do that, but that tells you how powerful that company is in its industry.  

Would you buy into companies that will gain from the recent rupee depreciation?

Right now everyone is hitching on to the export bandwagon, since currency depreciation means you will end up making far more money in rupee terms. But that is not a sustainable advantage, because that will just about manage to keep your capital where it was in dollar terms. Second, massive import subsidies will come through. But then is India geared up for manufacturing? I am not too sure about that. Next is IT and pharma. We have already seen what the two sectors are capable of. How much more they can expand and what more specialisation they will end up doing is still not clear. 

Can you share some of your recent investment learning? 

One thing that we tried to do was to buy leverage and stress in the economy. But I don’t think that works in an economy that is contracting. You have to identify where you are in the entire cycle and build your portfolio accordingly. If the business or the economy is expansionary, then you have to revisit your flight to quality. But even in the expansionary phase, if the companies we are talking about are the only dominant players in the industry, they have to lead first. This applies to all sectors.  

Would that apply to real estate as well? 

It is not an industry. Who are the participants out there? That is why we don’t like it. But there will always be one or two companies that might exist. I wouldn’t waste my time on them.