We first looked at Berger Paints five years ago during my stint at ChrysCapital. We liked the company but felt the valuation was slightly expensive, so we gave it a pass. In December 2015, Mylen Capital was set up by raising 660 crore.
Berger Paints was on our radar again. It held a lot of promise thanks to the improving dynamics of the Indian paint industry. Valued at about 43,000 crore, decorative paints make up three-fourth of the paint market while industrial paints make up the balance. The sector receives 85-90% of its business from replacement demand and was expected to reach 70,875 crore by FY20. With higher disposable income, the average paint cycle in India has dropped from 15 years a decade ago to 10 years now, thus driving up replacement demand. In a developed market like the US, it is once in four-five years. Higher dependence on replacement demand means that one is protected from the vagaries of real estate. Over the past couple of years, demand from real estate had been on a decline due to fewer launches and growing inventory of unsold properties. However, we expected some recovery in demand given the benefits to first-time home buyers under the government’s initiatives to push for affordable housing.
On an average, the growth of the paint industry has been about 1.5x that of GDP. Since we expected the Indian economy to do reasonably well, our bet was that the industry would ride that growth wave. While it does not see periods of super-normal growth, the paint business brings in a consistent cash flow. There are not too many surprises barring the monsoon when growth slows down.
Over the past five-six years, there was a significant shift from the unorganised to the organised market (58% to 70%). This worked to the advantage of Berger Paints as it all comes down to a consolidation play between two players — Asian Paints and Berger — that have a combined market share of over 70%.
The Kolkata-headquartered company had been steadily gaining market share over the past five years. From 12-13% in 2011, its market share was close to 20% in 2016. There were a couple of factors that worked in the company’s favour. It has largely been a player in the economy segment. Some years ago, it began increasing its presence in the premium end of the market through its brand Silk. The higher-end of the segment is known to grow faster than the economy one. Prices are at least 20% higher there. And Berger’s efforts were reflected in its rising market share.
It improved its visibility by strengthening the distributor network. Depth in distribution goes a long way in building brand familiarity among key influencers and that is half the battle won. Berger had also invested more in advertising and brought in Katrina Kaif as a brand ambassador for Silk in 2012. It understood distribution well and built strong relationships with key influencers like painters and interior decorators. The company came up with innovative solutions and products such as Berger Express Painting, where it would offer to paint customers’ homes in three-four days compared to the average six-eight days; and ‘Weathercoat Anti Dust’ which is a dust-resistant coating for exteriors specially developed for the dry regions in India. These products helped Berger differentiate itself from competition.
In our mind, all this meant the company got it right on the key ingredients. In India, there are 50,000 dealers. Over the past five-six years, Berger added 800-1,000 dealers each year reaching out to about 18,000 dealers. The market leader, Asian Paints, reached out to approximately 40,000 dealers. While Asian Paints was a strong player across India, Berger drew strength from a dominant presence in the west and east.
We weren’t too worried about the gap between Berger and Asian Paints as it was a well-run company with stable revenue and earnings. Berger’s revenues had moved from 2,341 crore in FY11 to 4,223 crore in FY16, growing at an average of 12.52% every year. Net profit, for the same period, moved from 150 crore to 365 crore, at an average of 19.46% every year. Net profit margins improved from 6.44% to 8.64% due to higher contribution from premium products and falling crude prices. We also liked that the company was improving its capital efficiency and ROCE surged from 26% to 31% during the same period.
It was no surprise that Berger was trading at a higher discount than rival Asian Paints — a P/E of 30x compared to 42x. Asian Paints with a market share of over 50% had a larger presence in the premium-end segment. We felt given Berger’s increasing portfolio of products for the premium and industrial segments and its expanding distribution network, the valuation gap between both companies would decline in the future.
Also, interactions with the promoters assured us that they were not just competent but also extremely focused on the business. The Dhingra family that owns the company now holds nearly two-thirds of the company, which meant that they have enough skin in the game and had a sound management that supported them well.
So we made an investment of 40 crore in Berger Paints in March 2016 at 174 per share. Much to our delight, the stock started to rally soon propelled by stable earnings growth and margin expansion. For the April quarter, revenue was up by 8.5%, while net profit went up by 60%. The company also announced a bonus issue in the proportion of 2:5. The good performance continued in the June-September quarter where revenue grew 10.6%, while net profit was up by 54.6%, both on a YoY basis, on the back of higher growth in premium products and softening raw material costs.
The stock price moved up by 50% since our investment. Our return already stood at 50% against our policy of a 25% return for the full year. Much of the success in investing comes from discipline. Sticking to your investment thesis is easier said than done. A lot of thought process had gone in when we formalised our investment strategy. So we were determined to stick to it and exit when it met our return requirements. Since Berger Paints did that, we sold the entire holding on October 18 the same year at 265, fetching us 60 crore, a 1.5x return and an IRR of over 120%.
If you have made your returns before time, it is a good time to leave. I learnt the importance of “discipline of exit” from Ashish Dhawan and that is with respect to walking away when the returns are great, especially when it has done well in the short-term.
Technology was a sector that was hugely rewarding for us at ChrysCapital. We invested in Infosys and HCL in mid-2008 and exited in November 2010 with over 2x returns. We did better in HCL Technologies where we entered around the same time and exited with over a 4.5x return in FY15.
Post the financial crisis that imploded in 2008, Indian tech companies proved that they were resilient despite more than one-third of their revenue coming from banking and financial services sector, which was most impacted. They had shown that they could adapt to a changing demand environment bouncing back faster than the market expected them to. The depreciating rupee helped their cause as well. Clearly when we invested, the valuations were beaten down to unreasonable levels. When the market bounced back, tech stocks were huge outperformers.
Naturally, tech was one of our first choices when we started investing in Mylen. There are very few sectors or companies in India that have achieved global scale or can boast of such strong execution capabilities. Besides, the business continued to throw up a lot of cash. Of course there were challenges such as waning demand and increasing cost pressures, newer technologies that were eating into some of the traditional services and changes that a potential Trump administration could bring. Like 2008, we felt the market was factoring a little too much negativity into the valuation of tech stocks. We continued to believe in the robustness of their business model. So we did exactly the same thing — invest in Infosys and HCL.
We bought into the Infosys stock in February 2016 at 1,110 per share. It was quoting at 17x its FY17 earnings, which was its lowest multiple in the past three years. The long-term average for Infosys has been around 22-23x 12-month forward earnings. Shortly after our investment, the company announced its quarter and year-end results in April. Things were starting to look up for the IT major under the leadership of Vishal Sikka. It was the third quarter that the company had managed to beat analyst estimates after grappling with growth issues for some time. It added 89 new deals and revenue from large deals increased to over 5,180 crore during the quarter. While the revenue grew by 4.07% on a QoQ basis, consolidated profits grew by 3.81%. What enthused the markets further was the fact that Infosys had indicated that its revenue would grow between 11.5%-13.5% during the current year compared to an average industry growth of 10-12% driven by its effort to increase revenues from digital and automation, and reduce overall costs.
But the good run didn’t last long. In fact, it ended on the day the company announced its June 2016 quarter results. The stock fell almost 9% on July 15, the day the quarterly numbers were announced. Net profit was down 4.5% on a sequential basis on a muted revenue growth of 1.4% (QoQ). The company was quick to lower its guidance to 10.5-12% from 11.5-13.5%.
It seemed like a lot of punishment for a bad quarter. We bought a small quantity again in July and August after the stock price fell thinking the situation would correct. In all, the outgo was 20.48 crore. But there was something else brewing within the company. That became evident as its peers did reasonably well. We were still holding HCL, so we knew.
Soon that something came to the fore when one of the founders raised an objection to the unusually high severance package to the CFO. The severance package was just the starting point when things started to unravel between the CEO and the promoters. A lot of decisions including a couple of the company’s acquisitions were questioned. This couldn’t have come at a more inappropriate time as the external market environment became extremely challenging. We sensed that the differences weren’t going to get sorted in quick time. Lack of management focus had led to its under performance in the past.
So we sold a part of our holding in October 2016 at 1,050 per share. We decided to cut some of the short-term losses even as we hoped for an improvement. That was not to be and so we sold the rest of the holding in March 2017 at 990 per share which turned out to be the right decision since the stock is quoting at even lower levels today. Our profit in HCL (a gain of 22%) partially offset our losses in Infosys. We still remain convinced about the Indian IT story, which we believe will start to look better.
Both our bets on HCL and Infosys were an educated guess based on the external environment that affects the sector. We felt the valuations were factoring a lot more negativity than what the situation was in reality. In the case of Infosys, we got swayed by its improving performance in the previous three quarters. We clearly didn’t see the flare-up between the promoters and the management coming, so it was a call that didn’t quite work out the way we thought it would. It is better to exit investments when a call goes wrong rather than holding on to them and hope for a reversal in their fortune.