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00:00Thanks for tuning into Talking Point. I'm your host, Neeraj Shah. A case for a chat.
00:17And while I'm bringing this up, I might end up talking something completely different
00:21because the nature of our guest is such today. However, the case for a chat that I'm making
00:26today for Samit Vartak. Quality over value amidst life highs or does value triumph over
00:32quality or is there a mix there? Non-banks better placed amongst BFSI or can banks make
00:37a bit of a comeback? And global henwinds persist for metals or can that change as well? And
00:44all of this is happening, Samit Vartak, because since March, I haven't read a memo from you.
00:49Otherwise, it just becomes very, very simple to know how to structure the conversation.
00:55Good morning and thanks so much for joining in on Talking Point today, Samit. Hope all
00:59is well. All well, Neeraj. Always a pleasure to be here. Thank you so much. I miss your
01:04writing, Samit. So it's cued that you write one more memo soon. Yes. Within the next fortnight,
01:10hopefully. Within the next fortnight, hopefully. Okay, good. I'll look forward to reading that
01:14and maybe talking about it a bit later as well. But Samit, without giving out too many
01:21takeaways from your memo, just trying to understand how do you think about this? Because
01:25at various points of time in the past, when people have spoken about excessive valuations,
01:30you've pointed out the dichotomy in looking at market-wide valuations versus what's happening
01:36at the broader end of the spectrum, specific buckets, et cetera, and how value was there.
01:42And that's proven right thus far. So I'm trying to understand amongst the most common narrative
01:48of markets across the board being expensive, what are your thoughts on the numbers based
01:53on history or otherwise? Sure. Yeah, I think, see, the most popular metrics used for valuations
02:01are P-multiple or EB-beta. Those kind of metrics are more P&L-based. I think the game-changing
02:09event for India, which happened post-COVID was the improvement in balance sheet. The
02:15balance sheet has improved. I mean, the previous decade, we saw a median debt-to-equity of
02:200.6, 0.64. Today, it's at 0.14. I mean, that's a huge drop, and that's the improvement. Plus,
02:29if you see, the P&L profits are supported by operating cash flow. It's not, so they're
02:34still above 100%. And the return on equity, return on capital metrics are near all-time
02:40highs. So that's a big difference. Now, the ratio that I look at is basically incorporates
02:48P&L as well as balance sheet, which is enterprise value-to-operating cash flow. Now, enterprise
02:54value-to-operating cash flow basically has ranged, I mean, up to 25, 26 times during 2018,
03:032019, as well as in 2008. Today, we are below 20 times. So it's about 19.5, which is
03:12not suggesting, and this is for the top thousand companies, this is the weighted average.
03:16So of course, there are pockets which are more expensive, and especially once you go towards
03:22the smaller caps or you go towards anything to do with capital goods, anything to do with
03:28government incentives, those kinds of markets are expensive, but overall broader markets
03:33are not that expensive. And this is excluding financials. Financials, as you know, the banking
03:39stocks are cheaper. I'm saying beyond just financials, because you can't look at the
03:45enterprise value-to-operating cash flow for financials. So I'm excluding that. And even that
03:52universe is the median over the last 20 years is about 17.1 times. We are at 19.4. And hence,
04:02some overvaluation probably the market deserves given the fundamentals of the balance sheet,
04:09the fundamentals of the banking system, the kind of capex the government is putting.
04:15And more importantly is even the private capex, I think we keep on focusing
04:21on the corporates for private capex, but there is so much capex going into real estate.
04:26The real estate today, real estate generally one of the biggest drivers of the economy. It
04:34percolates into a lot of different ancillary industries. Today, real estate inventory
04:43is the lowest. If you look at the top eight cities, there's an access report, it shows that
04:48since 2010, we have the lowest inventory today. So there could be a lot of projects which have
04:58been launched, but we are still sitting at the lowest inventory. And probably we have a few more
05:03years of real estate boom, that kind of capex which comes. And government itself is putting up
05:12significant capex. Their rate of spending has gone up. So government capex, strong balance sheet,
05:23strong cash flow, private capex in terms of real estate, as well as the general corporate
05:30private capex in terms of building factories or putting up new capacity, even that's picking up.
05:37So these are pretty positive things. And you got to look at the overall valuation in this context.
05:46Got it. Okay. So Samit, have you given a choice, if you had a choice to sit on cash, etc,
05:57would you do that? Or would you wear the portfolio maybe towards more safety if you were,
06:02if you are maybe not as constructive? I mean, what are you doing right now? And given a choice,
06:08if you had a choice of taking cash, would you sit on cash right now?
06:12See, Neeraj, I think I've learned through multiple cycles since 1999, is that taking
06:19a macro call on cash is extremely risky. It's very, very expensive sometimes if you
06:27get out at the wrong time, because it's not just taking a cash call one way. You also need to get
06:33it right getting in. A lot of people did take a cash call during COVID time, but then the pullback
06:41was so sharp, within a couple of months, things were back to normal, at least in terms of the
06:46stock prices. And very few people could get back. So getting it right one way is not good enough.
06:51And then getting it right both ways in multiple cycles is almost impossible. I mean, I have
06:58presented this statistic previously, but I think it's always worth repeating. And I have sort of
07:05updated the analysis. If you look at Sensex, Sensex has gone up 670 times, 670 times since 1979.
07:16And if you rank all the days, there were about 10,500 days during these many years.
07:23And if you rank from the top performing day to the bottom, and if you look at the best performing
07:29112 days, those are the ones who have contributed towards the entire 670 times. That means if you
07:36miss out on, 112 is roughly about 1% of the 10,500 days. If you missed out on the 1% best days,
07:43your returns would have been zero. Of course, the opposite of that is also true,
07:47is that if you had missed out on the best one or worst 1% days, then your returns would have been
07:564.6 lakh times. So both are true, but I think one has to look at the market and it's not a zero-sum
08:03game. The long-term historical returns have been in that 14 to 15%. That means the return line is
08:11uptrending. So when the return line is uptrending, it's always more expensive to miss out on the best
08:18days rather than missing out on the worst days. So given that statistics, mathematically,
08:24it doesn't make sense to sit out unless you can exactly time the market. So from that perspective,
08:30I never take a top-down call, but bottoms up is very important. In such times when everything
08:36looks frothy, you need to be even more choosy and you need to pick pockets where you're very
08:41confident about the earnings growth. Earnings growth, I feel is the confidence in earnings
08:47growth or the resilience of earnings growth is the biggest measure of quality of a business.
08:53So I don't believe in just looking at the management quality or sort of the modes of
08:58the business. If there's no earnings growth and if there's no resilience of earnings growth,
09:03what's the use of that kind of a quality? So you want to be very confident about the
09:08earnings growth and against that, what is a comfortable valuation you are able to pay?
09:15Even if you pay a little higher valuation, it's okay. If the earnings come through,
09:20you may have some time correction, but in the long run, you will generally make those returns.
09:26I mean, everyone knows that in the short run, valuation multiples may be the bigger driver of
09:32returns, but in the long run, it's the earnings growth. And if you are able to pick companies
09:37with higher earnings growth or whatever hurdle rate that you have and you pay reasonable valuation,
09:43they may not be cheap. In the long run, your returns will match the earnings growth.
09:48So there's no reason to move away from that discipline and from that process. These are not
09:55extraordinary kind of conditions where you think that the markets or the economy is at the peak,
10:01the banking system is over-leveraged, the corporates are over-leveraged, companies are
10:05finding it difficult to collect cash. And at that point, the markets are trading at all-time high.
10:11Those kinds of environments are risky. But today, I think we are at the start of a CapEx cycle
10:16on the private side. Government has just started huge CapEx over the last two or three years.
10:21We had that missing since 2012. And I think if we are... See, in an investor's life,
10:30maybe you will get two big bull markets. Maybe it's once in every 20 years. So if you miss out
10:36on one, it can be one of the most expensive decisions. So it's not worth taking that kind
10:43of a macro up. By the way, Sensex is at new highs yet again. But Samit, are we in the midst of
10:49one such bull market? What's your hypothesis? I mean, given... See, given the condition of
10:57the balance sheet, given the prudency of corporate India, given where the banking system is,
11:04and given the real estate cycle, given that the CapEx was missing since 2012-2022,
11:13it's possible that whatever missed out, probably we compensate for that beyond the average over
11:20the next 10 years. So if our historical growth rate has been about 13%, 14%, last 2012-2022 was
11:30in single digit, we may make up for that. So instead of 13%, 14%, we could grow at 16%,
11:3517%. Not the 32% that we grew in 2003-2008. Because at that time, there were multiple
11:43cylinders which were really fighting the global market, the government CapEx, private CapEx,
11:50real estate infrastructure. A lot of those things were picking China was starting into a
11:58big CapEx cycle. We are missing the global factor, but the domestic factors are way better today
12:04than what they were. We are going in a measured way, in a much more efficient way.
12:10So we may not have that kind of a cycle, but it could be a long, prolonged cycle where there could
12:17be short-term corrections in between. But we have to ride this cycle. It looks like an India decade,
12:26not just from a story perspective, but just look at the numbers. And it is highly possible,
12:32it's very difficult to predict such cycles. But when the fundamentals are so strong,
12:38valuation cannot be the only reason why you get out of the market. You need to pick your pockets
12:45right because there are a thousand stocks, even for a fund manager to pick. And if you are looking
12:51for 15, 20 stocks to build a portfolio, you generally need to find those. If you are not
12:57able to find those, then okay, you can sit in cash, but it has to be bottom-up reason.
13:05And if you are not able to find opportunities, whatever you find is extremely risky,
13:09then okay, you sit on cash until you find something which is comfortable to you. But I
13:15think if you do enough hard work, you are finding enough opportunities and there are multiple
13:20sectors which is offering that. Okay. So we are in the midst of a bull market and
13:27some hypothesis around potential returns that could come in as well. It's a hypothesis,
13:32viewers. You need to build your own if you are an investor yourself. So bear that in mind.
13:36Sumit, just before we get to pockets which are giving you the opportunity,
13:40I want to understand about pockets, which were the crowd favourites until about three months ago.
13:46And since then, the pullback has happened. And some of the naysayers would say that we told you
13:50so that trees don't grow to the sky, valuation excesses get corrected and stocks don't bounce
13:55back. So viewers, here's a chart. This is the defence aggregate market cap in lakh crores,
14:00of course. And if you look at it, it peaked in July. Since then, it's about a 21-22%
14:05downtick in defence and similarly for railways as well. Big jump in the last three years peaked in
14:11July. Railways will also come up on your screen. And then there's a dip that came in. So both for
14:17defence and railways, the dip has been fairly swift and it's not showing signs of turning
14:22around. Sumit, what happens in these? Because the soundbites of order book growth all stayed
14:31true even now. Stocks have come off. That is not to say they will stay here. My question therefore
14:38is, will a showcasing of earnings growth revive the fortunes of some of these? Because it does
14:45look very likely that the earnings growth in some of these pockets will look very strong in the
14:51quarters to come. Yeah, I mean, in the last interview, I think I had sent out a table where
14:58the railways and defence were the top performing and then you look at their earnings growth,
15:02it was completely missing. And then the stocks have just multiplied and just didn't make sense.
15:06See, I think, again, what I define by quality, as I said, is earnings growth as well as resilience
15:14and predictability of that earnings growth. And defence, whether it's railways, these are
15:20the life cycle of these products, whether it's the railway wagons or some defence equipment,
15:26sometimes it's very long. It can be 30, 40 years. So, the longer the life cycle of the product
15:36that you cater to, the more volatile it becomes because it depends completely on the capex.
15:42So, railways can have great two, three years, but who knows, in case the government changes
15:47or in case the government policy changes and suddenly the order book stops, you can have a
15:54really one bad year. And during that one bad year, market has no idea and then it crashes.
16:02And hence, if you look at these kinds of stocks, whether it's defence stocks or railway stocks,
16:07thrice in the last 15 years, it has corrected by 80 to 90%. Just because of the uncertainty,
16:14it can have great run, but then one or two bad years where there is no visibility going forward,
16:20can correct these stocks. So, such stocks cannot be valued like a resilient, high-quality
16:27business. One has to know that it's a highly cyclical, these are highly cyclical stocks and
16:34according you need to value them because the risk associated has to be compensated by the
16:39cheapness of the valuation, whereas a lot of these stocks are trading at almost FNCG kind
16:44of valuation. So, it does not make sense. So, I think it is again bottoms up, you need to
16:50understand those businesses, the risks associated with those businesses and how resilient is the
16:56earnings growth as well as the earnings quality. And if you find such businesses,
17:03you know, see in investment, it is always important that you reject most of the businesses
17:11and only, you know, bet on businesses where you are confident about that, you know, earnings
17:17growth, earnings quality and bet on those. Paying high valuation is a much less riskier decision
17:25than betting on low valuation and extremely low-quality business in terms of earnings growth
17:30and earnings resilience. Okay, fair point. Now, Sumit, tell us where is it that you are finding
17:38a mix of quality of business or quality of earnings and resilience in the current context and
17:48are some of these pockets available at good valuations or the valuations are stretched?
17:55No. Right. See, again, it is a bottoms up. Some of the markets which are offering
17:59reasonable opportunities, I think, are niche NBFCs, you know, where the return on equity is
18:05high and where assets are extremely secure. There are, you know, CDMO spaces, there are
18:11specialty chemical spaces which are more related to maybe electric vehicles, you know, there are a
18:18lot of building materials which have not gone anywhere in the last one, one and a half years.
18:23And they are exposed to the biggest capex, you know, whether it is real estate or a factory
18:32buildup or government capex. So, they will definitely benefit. Some of them are going
18:38through maybe some, you know, down cycle of the Chinese pressure on metals, you know,
18:47during those times some of these companies do go through inventory losses and hence, you know,
18:52investors do not want to touch them during such times. But those are the times when you
18:57have an opportunity to get these long-term good businesses at reasonable valuations. So,
19:03I think those are such opportunities, you know, which are available in these kind of sectors.
19:09And, you know, sometimes a sector may not be that great, but you will find one-off opportunity in
19:14those, you know, even expensive sectors, which is something that you like or, you know, which
19:19is trading at comfortable value. So, again, bottoms up is a very different story. Top-down
19:24can give you some direction, but still your stock picking has to be bottoms up.
19:29Okay. Stock picking has to be bottoms up. You mentioned some pockets,
19:33Samit, are very difficult to figure out what would be the right valuation to pay. So,
19:39for example, let us talk about real estate. You have some investments there,
19:43you bought into them earlier, that sector has run for a bit, right? Would you pay top dollar
19:51currency to real estate? Do you believe the cycle will last? And is a better way to bet on real
19:56estate through pure play real estate companies or through ancillaries? So, ancillaries are,
20:04you know, if you find them with good valuations also are a great place, you know, either you can
20:09bet them through housing finance, you can bet it through the materials which are used in real
20:16estate, you know. But see, real estate is a very, very, it is even more bottoms up because it
20:22completely depends on that real estate company, the location, location, location is very important,
20:29you know, where their projects are. And real estate is very difficult to value in terms of
20:34lot of metrics. You know, the metric that I use is that whatever is the market cap of that company,
20:39look at the operating profit that the company will make over the next 6 to 7 years. If that
20:45operating profit is higher than the market cap, today's market cap, you know, I find it reasonably
20:51valued or cheap, you know. So, I mean, if you want reasonable value, you can stretch it up to
20:57maybe 10 years. But whatever projects the company has under, you know, under their development
21:04and over the next 6 to 7 years, if the operating profit make up for the market cap,
21:09it is generally a great investment. It has worked out, you know, for me multiple times.
21:16And that is the metric that, you know, I use. Now, again, it is again very company specific,
21:21I cannot talk about the overall sector. But the overall sector itself is, and as I said,
21:26it is at the lowest inventory levels in the top 8 cities and urban real estate makes up for two
21:32third of the value of India. So, it is a big contributor towards real estate. And real estate
21:40does contribute almost one third of the capex of India. So, it is a big contributor. So,
21:47depending on your understanding of the businesses, your comfort, you can bet it through multiple
21:53ways. Okay. You spoke about housing finance, there is this big housing finance listing that
22:01has happened trading at a substantial premium market cap equal to or more than the 10 next
22:07housing finance companies. Is this a sign of excess in that space? Or do you believe that
22:12after a high test that space might start working again? Because NBFCs or banks per se have not
22:18quite gone anywhere, if you will. Yeah, I mean, it is such a market today that,
22:23you know, anything new, you know, gets more much attention and attraction. And maybe it is in the,
22:29you know, it is for the short run, you know. So, the older similar businesses are boring
22:36and no one is interested because it comes in with the historical performance, you know, baggages.
22:43But I think this is a time when you need to identify which are those businesses which are
22:49delivered in the past in terms of protecting its, you know, assets, in terms of delivering close to
22:5520% kind of return on equity. Well-managed, you know, management in finance is extremely important.
23:03It is one of the biggest factor and that is where, you know, Bajaj Finance, Bajaj Housing
23:08gets those kind of valuation only because of the management and then the belief and confidence in
23:14their management that they will be able to ride through the cycles protecting capital, right.
23:21But there are many companies which are available at probably one-third, one-fourth the valuation
23:26with similar kind of or better metrics. And, you know, there are a lot of options in that space.
23:34And again, have not done too much over the last, you know, compared to what, you know,
23:38a lot of these markets have done, have not done too much. And I think there are a lot of
23:44opportunities in this space. This also building materials, you know, building materials,
23:49you can get it through PVC pipes, some structural pipes, you know, you can get it through MDF.
23:57I mean, there are so many ways where you don't need to bet on the entire sector. But if you find a
24:05player, you know, which sometimes is really attractive, you know, those
24:13with the industry tailwind, I think they will deliver over the next three, four, five years.
24:18And rather than focusing on sectors which are sort of in the story and, you know,
24:23where there is a lot of talk, I think always good to look at sectors where no one is talking about,
24:28which seem very boring. Maybe the stocks haven't done anything in the last one, two years and hence
24:33no one is interested in them. You know, unfortunately, the better the stock does,
24:38the more interest it generates. And stocks which haven't done anything, you know,
24:43they are completely abandoned and that's the opportunity.
24:48Yeah, that's true. Sameer, one final word, I mean, a sector that is a bit complex to understand,
24:52but while you say that, you know, maybe look at sectors which are, I mean, maybe it might be a
24:57good idea at sometimes to look at sectors which are not in vogue. CDMO is in vogue, especially
25:02because of the biosecure act, suddenly people talking about how fortunes will change. It's not
25:07an immediate thing any which ways, but because it's such a difficult one to track because each
25:13company might be doing things different and there is this whole USFDA piece around them, etc.
25:18How constructive are you? Are you taking a large bet on CDMO and are you spreading bets or have
25:23you chosen it? I mean, are you playing it via maybe just one company or two companies because
25:28you know the companies very well? Yeah, again, I am completely playing it through just one company
25:34in each portfolio. So, not really betting on the... See, because biosecure, it's a very niche
25:39segment and not all the CDMO players will benefit from the US ban on China.
25:46You know, and in CDMO, it's also important that whether you have the capacity already built up,
25:50you know, no US company is going to come to you if you don't have the capacity.
25:54And sometimes it takes years to build up that kind of capacity. And China is a big, big
25:59you know, supplier. And to replace that, we'll need a huge capacity to be built up. It may take
26:05time. But right now, because of sort of the macro story, you know, people get excited about
26:10all the CDMO players, which have no relationship with the ban. And so, again, it's, you know,
26:17completely bottoms up is very important. You need to know exactly the earnings growth potential,
26:24you know, they should be delivering at this point. It should not be just based on hope
26:28that they will benefit from this China plus one kind of a story. It's always better to,
26:33you know, understand that right now they have triggers, right now they have the capacity,
26:38and they're already delivering. Better to pay a little higher valuation, but, you know,
26:42have high confidence in that earnings growth and again, the resilience of that earnings growth.
26:48Point well noted. Samit, great talking to you today. Thanks so much for taking the time out
26:53and being with us. Looking forward to talking to you once more in or around the festive season.
26:58Thank you so much, Neeraj, for inviting me and always a pleasure.
27:02So Samit Vartak writing a memo in the next fortnight or so, we'll talk about that
27:06and get him around Diwali as well. But with that, it's a wrap on this leg of Talking Point.
27:10Thanks so much for tuning in.
27:28you