Saurabh Mukherjea on how to play recovery

Our preferred way to play the cyclical upswing is high quality financial services, auto and auto ancillaries and increasingly the speciality chemicals plays which are in the global cycle rather than local economic recovery, says Saurabh Mukherjea, Founder, Marcellus Investment Managers. We have had a great ride and a great post Budget rally but since then, the juggernaut has really gotten derailed and this heightened volatility is a little unnerving? What is your take?If we cut through the noise, the underlying economic picture is quite clear not just in India, but globally as well in the sense that shortages are showing up. There are shortages of semiconductors and shipping containers, It is showing up in electricity demand in our country, in car demand, in housing loan offtakes. But the global picture is one of reasonable and robust recovery in the wake of Covid. Whether it is in Europe or in India, we will go through these waves of Covid. We have seen this for 13-14 months but leaving that aside, the economic recovery pattern is pretty steady and robust. Day-to-day market volatility doesn’t have any great value for us to focus on. We focus on the fact that large well run companies in our country are growing earnings at around 25% to 35%. That was true for the December quarter and my reckoning is the March quarter numbers will also show 25% to 35% earnings growth from large well-run companies across various sectors. That is a pretty good place to be in the early stages of an economic recovery. I get your point that long term we are intact, but given that we track the market on a daily and hourly basis, would you be tempted to buy this decline? Are these good levels to add to the positions in the names that you already hold in your portfolio?On March 12 or 13, 2020, I was on one of your shows and I remember running out to speak to my colleagues about how much we wanted to buy when the market went gap down. So over the last 12 months, we have put around Rs 20 crore to work incrementally every day. So, in the course of 12 months, we have put Rs 4,000-4,500 crore to work in the Indian market and we are continuing to do that. We honestly do not lose sleep about whether the market has fallen a percent, couple of percent or 5%. We follow this policy both in terms of domestic investors who are Marcellus’s clients and increasingly foreign investors who are coming to us asking us to deploy their money in the Indian market. Our view is that the next two to three years will bring further flows into India. As we get more money from investors, we keep deploying that money. We are not going to lose too much sleep about day-to-day market volatility. What do you think IT as a pack can do going forward what is already not priced in? Where could we find the dark horses?I am not so sure Indian IT has been fully discovered. There is this bizarre notion in many parts of the Indian market which sees IT as a defensive sector. I never quite understood how in the age of technology, Indian IT services can be a defensive sector? I think the Indian market is still getting accustomed to the notion that Indian IT is the world’s cloud kitchen. Accenture’s blazing result last week will be a good precursor to the Indian heavyweights posting further jumps in their order books. TCS is in several of our portfolios. Over the last three-four months, we have also started building up positions in L&T Technology Services because we are seeing a significant recovery across the world in capital goods and machinery and L&T technology services is a rare Indian IT company which is specifically a play on technology going into capital goods and machinery. There is a significant upside in IT over the next two to three years. Scale gorillas like TCS have for long been a part of our portfolio. The recent addition is L&T technology services. Are there any hidden gems that you have identified in the mid and small cap space which in this correction you have been tempted to buy?For a good part of two years, we have been talking about how Indian specialty chemicals is coming of age, my reckoning is Indian specialty chemicals today is where the Indian pharma sectors stood in the mid 90s on the cusp of a golden 20-year run or where Indian IT services stood in the early 90s. Both in terms of supplying the burgeoning domestic market and in terms of becoming large exporters, Indian specialty chemicals has real potential. One would argue we actually have world-class process chemistry skills in our country and both China and the west do not want to make it anymore for environmental reasons. Increasingly this would come to India. A company that has researched diligently over the last couple of years and then built a significant position over the last 12 months is called Fine Organics. Your bread or biscuits this morning are highly likely to have contained fine organic emulsifiers and there are antifungal agents. We are a market leader in this. Majority of India’s emulsifiers and antifungal agents in baked products come from Fine Organics. The market cap is around a billion dollars, the return on capital employed is 35% odd and there are high barriers to entry. Fine Organics has a marquee clientele consisting of leading Indian FMCG and global companies. There has been consistent reinvesting back in the business. I think 20-25% earnings compounding over a long time should be feasible for Fine Organics and therefore we have built a substantial position in the small caps and specialty chemicals companies. Auto companies are reworking their strategies. For instance, Ralf Speth is now with TVS Motors, looking at a very strong global presence over the coming years. How are you seeing this story unfold when it comes to autos? Let us break it into two parts. One is the one or two-year outlook which is about dealing with input cost inflation — be it steel inflation or the shortage of semiconductors and containers. Market leading companies such as Maruti are pushing through multiple price hikes. Maruti is about to take its second price hike and Maruti is in several of our portfolios. So the one- or two-year outlook is largely about are you a category leader and have the pricing power to push through price hikes? Or are you a number two, number three player and hence you will suffer margin pressure? I would be very wary both in auto OEMs and in auto ancillaries. I would be very wary of buying the number two, number three players. Buy the leader who can push through price hikes because cost inflation will only get worse as the year progresses as economic recovery takes hold, we will see further cost inflation coming through for the auto and the auto ancillaries. We are playing market leading auto ancillaries such as Lumax in the headlight space and Maruti and Royal Enfield, Eicher Motors in the OEM space. The trickier call is three, four, five years out, how meaningful does EV become? I am no expert on this. We are trying to get our heads around it. It does look like that over the next three, four, five years, we will start seeing low cost electric vehicles come to India and therefore we are trying to figure out to what extent are companies like Maruti exposed to that. Royal Enfield and Eicher Motors has less exposure to that. Of course a bike like Bullet is simply not substitutable through an EV bike but in the car space, we are trying to understand how quickly Tesla comes to India and can Tesla launch a $5000 car in India four, five years out? Leaving Tesla aside, large EV, electric battery manufacturers are also looking to move to India. So there is a lot happening that we are trying to research and understand better. How are you approaching metals? Does it continue to be a meaty investment?We all understand the nature of the metal rally globally which started in March last year and we understand that if you buy Hindalco or JSW Steel you can profit from that global rally in metal prices. But I have never quite understood why people buy the stock rather than the commodity itself because there is a high correlation, 70-80% correlation between the stock prices of metal stocks and the underlying commodity. If you are buying a company which is a proxy for a commodity, then effectively you are buying the volatility of the commodity cycle. Since we in Marcellus have no expertise in predicting commodity cycles, we have stayed away from investing in the metal sector whilst admiring the rally in the commodity prices and the stocks. If global recovery continues, then metals and metal prices will rise and there could be a further rally in the steel prices. But I do not see what competitive advantage they will bring to the table and as I never quite understood where exactly is the risk adjusted return for our clientele. While you are continuing to adopt that approach of sticking to the leaders within most of the sectors, would that strategy hold true when it comes to even infrastructure and real estate?There are clear signs based on recovery in heavy truck demand, recovery in genset demand, recovery in demand for heavy cranes. The engineering capital goods infrastructure cycle has started moving up but again the challenge is where can one find companies with comparative advantages. I have never seen a real estate developer, infrastructure company, engineering capital goods company which is able to show a return on capital that is above the cost of capital. Therefore all we are buying is the cycle. And I have always been very wary of that. Why should we just buy the cycle? You are just buying into an economic upswing cycle which could turn south without warning and furthermore, if all your buying is the upswing, then over time as the economic upswing proceeds further, new entrants will come in and take away business and profitability from even the market leaders in engineering capital goods! So we have tended to give these sectors – engineering capital goods, metals and mining as well as real estate a wide berth. Our preferred way to play the cyclical upswing is high quality financial services, auto and auto ancillaries and increasingly the speciality chemicals plays in our country which are the coming plays in the global chemical cycle rather than just a local economic recovery.

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