Kenneth Andrade, Founder & CIO, Old Bridge Capital Management, says “I will be a little cautious about saying that foreign portfolio investors are going to continue to put money into a marketplace where valuations are trending high and there is a very low margin of safety. I will be a little cautious this year because I tend to believe it will happen and there are other markets around the world which have underperformed quite dramatically, which would get their fair share of capital also.”
You are on the minority side of the market which believes that metal converters or the Indian companies are a good bet. Some of the metal counters are coming out with good results, Tata Steel for example. Is it the improved balance sheets you are betting on or is it the India demand story, what exactly is the hypothesis there?
Kenneth Andrade: When you look at the entire commodity basket and specifically steel, balance sheets are not what they used to be or the financials are not what they used to be in say 2015- 2020 period. A lot of these businesses have been generating enormous amounts of cash and also expanding capacity at the same time. It is a volume game and we remain competitive across the world in terms of profitability per tonne. The only call that needs to happen right and this is through 2024 and some part of 2025 is steel prices moving up and if steel prices actually move up, one can cash in on the next recovery of these prices. So, valuations are as cheap as you can get them in a down cycle with a completely solvent balance sheet.
It is a matter of time and patience. We are not taking a call on the cycle because we do not know when steel prices will actually rebound. In CY2024, you will get a reasonably depressed environment as far as commodity pricing is going but this should be the low point in the company’s profitability. They are still reasonably valuable or should I say very valuable.
You have recently added one name from the premium liquor segment which is making a lot of waves. This part of the premium liquor or some of the other premium categories of the consumption basket have been doing phenomenally well even when the rest of the mass’ segments are doing badly. What is the hypothesis behind adding a premium liquor segment in your recent editions? Is it company specific or do you like the category?
Kenneth Andrade: It is company specific but the category is trading upwards. India is amongst the top countries in the world in per capita consumption of alcohol. So, to believe that we will consume more alcohol is not the right way to go. Once you have been able to get that base of users, you basically have to ride on the per capita rise in income which will create a premiumisation trend that is there. So, what is happening not just in the liquor market, but the rest of the categories also is everywhere where there is a premiumisation of the category and that category has done reasonably well. At the bottom end of the consumption pyramid, we are seeing the reverse working around. The reverse in that sense is people are downgrading. They are consuming the same amount of volume but at a lower price point and that is happening at the bottom end of the pyramid.
So, consumption in India is broken up into two extremes. The top end of the consumers are premiumising with volumes and the bottom end of the entire population pyramid is consuming higher volume but at a lower price point, which is creating a margin pressure for a lot of businesses at that end of the consumption spectrum.
Given that we were really banking on support coming in from the FII community, Rs 30,000 crore, though is what we have seen in terms of net sales figure over the last few trading sessions, is unnerving or is it a precursor to what could transpire for the rest of the year? Or are we banking on FIIs coming right back?
Kenneth Andrade: India is doing well as a country and there are a couple of other emerging markets that are also doing well as countries, but out here for any investor, valuations where Indian companies trade is a very big pushback because there are some other larger businesses and opportunities that exist across the world wherein the valuation trade is almost at 50% of where India trades at this point in time.
We tend to believe that we will get continuous flow of foreign capital when they have other choices. I am in the camp where I will be a little cautious about saying that foreign portfolio investors are going to continue to put money into a marketplace where valuations are trending high and there is a very low margin of safety. I will be a little cautious this year because I tend to believe it will happen and there are other markets around the world which have underperformed quite dramatically, which would get their fair share of capital also.
So, India is dependent a lot on domestic capital flows right now and we have shown in the last two or three years that domestic cash flows or domestic investors are far larger than what foreign portfolio investors can be and that structural change which has taken place is here to stay.
One thing which I find missing from your list of the holdings at least what I am seeing is the lack of largecap financial names, that is the private banking names. Have you been averse to that for any specific reason?
Kenneth Andrade: It is not a trade that we have participated in for a very long time. Actually, in the last five or six years, we have not participated in that trade. We have got a large lending name out there but it is more of an NBFC and to that extent we tend to like the NBFC space a little more than the private banking space. The opportunities as we see and as the entire industry also sees is that it is in unsecured lending and that is the book which is growing significantly fast and there is some amount of demand plus a higher yield on lending as long as you can control your risks. So that is where we are tending to navigate our portfolios or tending to look at companies or businesses in that spectrum.
So, lending businesses are on the table, but as portfolio managers we will stay out of the banking space at this point in time.
A two-part question, what will make your view on largecap financials change? When you see value on the table, will you be looking at that and secondly, unsecured lending being the growth driver, are you looking at adding some microfinance names which have been doing well?
Kenneth Andrade: We are not looking for anything to recalibrate our thought process out here and it is not that banking as an industry is doing badly or lending as an industry is doing badly because you have to go stock picking in that segment of the market right now.
We have a bank which is doing very well and hitting 52-week highs and another large bank which is hitting 52-week lows. So, it is basically a company problem and it is not really an industry problem. So, category profitability is growing and we just got to move towards a place where the profitability is growing at a significantly faster pace than the broader GDP. That is where we are moving. So, to that extent, we have got one large financial NBFC which is there, but we have opened up the entire category to see what really fits our investing profile.
How can investors unleash the opportunities within the power space as a whole? Renewable energy stocks have been in the spotlight and schemes have been announced by the Prime Minister. Can you give us your take?
Kenneth Andrade: That is a difficult one. If you want to invest, and this is not really in our domain right now, because virtually every business out there is coming at a price point and on a promise of the future. So if you have to put a portfolio together, you have to play in the direction of the news flow or the projected news flow and figure out companies and categories that will participate in that part of the growth of the economy.
Power as an industry is going to be very large. It has always been significant. Energy cost as a percentage to total sales would be anywhere between 11% and 15% of individual companies’ cost lines. So it is a large industry but now you have to play in the direction of that entire industry. But one thing is very sure that power costs are going to be inflationary. Inflation is very good for company profitability.
Profitability is very good for cash flow. Cash flow is very good for incremental capex. So you are in a virtuous cycle and because you are in a virtuous cycle, these companies are priced at where they are at this point in time. I mean, obviously there is a space or two in the energy space, which is reasonably priced. A lot of it is trading like it is a sunset business, and I am just highlighting it. I mean, a lot of it is in the oil and gas space and that is probably the only opportunity that is around there. But you have got to tread a little carefully because valuations of those industries depend upon what you would assign a terminal value to those businesses. And if it is really a sunset industry then you would not get a real price-earning re-rating like you see in the rest of the power companies or the contractors that address the power companies.
I see that you have added a lot more pharma names as well, whether it’s Glenmark Life, Marksans Pharma, even Syngene, Aurobindo for that matter. What is the thesis when it comes to the pharma names?
Kenneth Andrade: A lot of it is already playing out, like step back to the last quarter numbers or even in 2023 numbers you have hit the trough as far as the profitability is concerned, and now it is all incremental amount of growth that is there. All of this growth is coming at incremental market shares that are happening across the world. All these names that you did mention and probably a lot more of them that are there are addressing international markets or the rest of the world, including the US. And that is where the profit and that is where the pricing will emerge for a lot of these companies. So that has been with us for a while.
We think balance sheets are completely thin and cash flow generation is at an all-time high. For all the companies that are addressing the West, volumes have started picking up. Now we have got to see how margins come through. Margins also are not too much of a problem because we are starting on an extremely low base, which was in 2022. So margins will also come through. How large can these guys get? I think what you are seeing with numbers coming through is all companies are reporting a very good growth in volumes.
We have got a margin pressure out there, but that is just the pricing environment that is there. All incremental capacities that these companies have also set up and they have been setting up all capacities. They have been through a capex cycle over the last three, four years. They have to get utilized. So in CY2024, a lot of Indian businesses in pharmaceuticals have the largest capex cycles going on stream. Incrementally from 2024 onwards, you will see volume growth. We have not been able to get a handle on how profitability will grow but that will also have a similar growth compared to how the top line on the turnover actually grows with these companies. So we are fairly constructive.
It is also our largest holding in portfolios right now. And they do not trade at very abnormal valuations. They are higher on their baseline but they do not trade at very abnormal valuations.
I mean, not going into the names which you have actually added, but one of them has a very big valuation-rerating opportunity, which we saw because the debt reduction happened. One of the few pharma companies which had big debt, has seen that coming down. Plus there was value unlocking. The other one is seeing very sharp outperformance on the EBITDA generation. Do you see these two play out from here also?
Kenneth Andrade: So yes, For the companies and the stocks to do well, now the denominator has to start moving, which is basically EBITDA earnings. And for those two to do well, you should have had capacities on the ground and you should have gone through a capex cycle. I think the latter has happened. The former now has to play catch up in terms of the profitability has to, the capex is already on the ground in the former, which is where profitability growth should start happening. It is not going to be a company or two, it has got to be an industry that grows profitability.
Then if the industry’s profitability pool is expanding and we think it is going to be quite sizable between in the next five years, the Indian companies or all Indian companies, all companies domiciled in India, which also have a few operating companies across the West, they will play into this profit pool expansion that is sitting out there. That is where the opportunity is and that is why it has one of the largest exposures in our portfolios.
Congratulations for the foray into mutual fund space. I am told that there is a big dearth of quality talent. I am sure the competitive landscape would be slightly stronger. What are your plans there?
Kenneth Andrade: Well, we have been in the asset management business for the last seven years with license. This was in the portfolio management space and we did a few alternative investment funds also. This is just an extension of our product profile into the mutual fund category. Now, with the mutual funds, we can address investors from Rs 100 investment all the way to the HNIs, where we do have portfolios or family offices who are investors in our funds. I think that is the only extension.
Yes, it is a very competitive landscape across the world. It is also getting reasonably fragmented. So we have to find a niche and build an investment style or investment team and concentrate on what we do best. So someone like us, who have always been investment led, would not build out a very large distribution base. We will lead with an investment style and investment portfolio and take it across the marketplace. Once the thought process is built through, then organically, like we have seen in our other asset management vehicles, the investors would hopefully align with someone like Old Bridge.
