Investment style revolves around looking
for stocks with a strong moat or competitive franchise. In today’s market, with
a consumption slowdown, look for companies that offer competitive advantage and
also growth at a reasonable price. Despite the slowdown, there are
opportunities within consumption where there is a long growth runway with low
penetration levels, those that can benefit from formalisation of the economy, a
shift from the unorganised to organised sector and so on. Now the question is
how much of this is in the price. High valuations do rule out some of the
consumer categories today, but hold positions in consumer discretionary stocks
with strong drivers.
As Pat Dorsey has said, it is important to
differentiate between temporary competitive advantages and durable competitive
advantages. If you overpay for a temporary moat, you will suffer value
destruction. The assessment of moat or competitive advantage differs for
different businesses. In capital-intensive or B2B businesses, you judge a
company’s moat by its cost efficiency.
The buyer is a hard negotiator too and you
won’t get pricing power. You can look at fixed costs per unit of capacity
compared to peers, whether the company is moving up the value chain, its
R&D efforts, and its de-risking strategy and so on. In B2C businesses, you
assess pricing power. Often, people talk of brand value or market share, but
these to be transitory. A brand can lose recall and a company can lose market
share. So, unless the company is able to charge a pricing premium on the basis
of its brand, the moat isn’t durable. One way to assess the moat is to see if
the company’s profit margins remain within a tight band. This is indicative of
its ability to pass on input costs. If a company manages growth while rarely
diluting equity, this adds to return ratios. These are the key numbers I would
look at to assess moat.
If you see in the Nifty500, the top ten
stocks have a 43 per cent weight in the index and contributed 40 per cent of
the returns from January 2018 to October 2019. Whereas if you see the bottom
250 stocks, they have delivered negative returns. So, there is polarisation.
The market prefers the handful of companies
because of the dearth of growth elsewhere. Even today, growth managers vouch
for the compounding characteristics of companies such as HDFC or a Hindustan
Unilever. So, GARP (growth at a reasonable price) gives a framework to spot
opportunities that balance both. While doing some Nifty companies that have
delivered returns, balance it out with positions in sectors such as
two-wheelers quoting at low valuations.
At the headline level, compared to December 2017
when mid and small-cap indices were trading at a 30 per cent premium to the
large-cap indices. But today the valuations have reverted to a normal 20 per
cent discount. To that extent, we have been increasing mid cap allocation
within scheme mandates. But indices often don’t tell the full story. We find
that there are only a few mid-cap stocks that meet our frameworks on returns
and cash flow generation. The growth expectations from such stocks are quite
high even today. Even large-cap companies in the Nifty have been struggling to
deliver on growth expectations and we are seeing earnings estimates being
repeatedly downgraded for the last 5-6 years.