Please find below our key excerpts from a investor memo published by Solidarity Investment managers. In this wonderful memo through case studies they have explained the key trigger point required to select a stock in portfolio. It also includes point of view on Zomato and telecom as a sector. (Emphasis Ours)
- Response to the 2008 economic crisis worsened inequality. While the Banks got saved, employment in the US did not reach 2008 levels till 2017. At the same time, money printing did not result in inflation. This encouraged policy makers to keep interest rates lower for longer to prioritize employment creation. This has elevated valuation multiples across the board as it lowered Cost of Capital and has also created tail risks of very high inflation down the road.
- Corporate India has significantly de-leveraged and the pandemic has also resulted in lower fixed cost structures. However, we are also in a “two speed world” in consumption where a segment of consumers like us are unscathed by Covid while many our fellow countrymen need to repair personal Balance sheets – hence, one cannot take strong consumption growth for granted Private Consumption is ~56% of the economy). There are also head winds to Earnings from rising inflation.
- Valuations in India, for the market in aggregate, are high when examined vs historical averages. MCAP/GDP at present is approx. ~105% vs ~80% (last 15-year average).
- One sees wide dispersion in valuations from Euphoric (Digital, Consumer) very rich (IT Services, Specialty Chemicals) to reasonable (Life Insurance, Banking, Steel Pipes) to attractive (Telecom).
- Prospects for non- linear Earnings growth, and small changes in terminal value assumptions can make one miss a decadal story if one obsesses excessively on near term valuations. Over-paying by 15-20% for exceptional franchises is a risk worth taking when longevity is high and when price declines can be used as opportunity to build up positions. One however needs to have discipline that these cases are exceptions and not the rule and we use this approach only when there are both prospects for non-linear growth and longevity.
Why they don't prefer IT?
- Our hesitation to participate is because we believe that bottom line growth will be more in the range of 10-12% over a decade as IT Services companies will face margin challenges from large deals which tend to be margin dilutive, wage inflation driven by talent shortages in Digital, the need to invest more in on site customer facing roles and as cost benefits from Covid 19 are either priced away or return (e.g. travel costs).
On Zomato & Optional Value in businesses
- Zomato has a strong value proposition
- When buying into mature growth, and where there is no Option value, one must be more careful on valuations as there is less room for error.
- Digital business models have significant market opportunity, tend to be winner take all and have significant option value of future business lines. Many of them are loss making, however, for some, losses are helping them build deep moats which will turn the business model hugely profitable at scale.
- However, it is not clear to us what the steady state economics of the food delivery business will be and at what scale/timeline break-even will be achieved.
- Additionally, competitive intensity has not reached equilibrium. If Jio’s big bet is on an interconnected eco system between a smart phone and a retailer, its needs a last mile delivery to fulfil that. Amazon is piloting food delivery in Bangalore.
- We consider Optionality in valuations only when a company is Free Cash flow positive and can use that cash flow to enter new markets. In the absence of Free cash flow, the above approach is that of a Venture Capitalist whose mandate permits them to embrace significant uncertainty for a much higher upside.
- As the scarcity of Digital business models declines, investors will start focusing more on absence of cash flows (numbers) rather than on narratives.
- De risking of supply chains from China is now a consensus bet. However, this sector is early on the growth cycle and offers significant longevity of growth and opportunity for companies to transform into higher ROCE business models over time through both margin expansion and increase in Asset productivity
- ROCEs of Specialty Chemicals should expand as the useful life of Assets tend to exceed time horizons over which Assets are depreciated. Macro tail winds, domain expertise, reputation for reliability and willingness to re-invest for growth can create a value creation flywheel.
- Multiples tend to sustain if the growth narrative is credible and backed by strong execution.
- We should not worry about a stock not performing if its Operating performance is improving and the industry is not in decline. Prices can stay muted for a long time and then suddenly give 3 years’ worth of return in a month.
On Airtel & Telecom
- It is very hard to regain lost market share. For VI to survive without capital infusion, we estimate that ARPUs must inch up to 190/subscriber from 113/subscriber today to meet its Capital expenditure and financial liabilities. If ARPUs go up, the entire industry will benefit, and Airtel’s EBITDA will also expand leading to a re-rating. The more VI fund raising is delayed, or ARPUs stay muted, the more the competitive position of the other two incumbents gets strengthened with very-positive implications for long term value creation.
- Additionally, if the tail risk scenario of very high inflation plays out, Telecom is a good sector to be invested in. One can increase prices in line with inflation while a significant portion of costs (depreciation) are in yesterday’s prices.
On business characteristics & Operating Leverage in staffing business
- Scale is critical to success as costs of core employees, technology and SG&A is largely fixed. Hence, the staffing company which achieves maximum scale and productivity will be able to offer the best pricing in the industry.
- The above aspects create a virtuous cycle:
- Increasing scale leads to market share gain
- Ability to lower pricing for customers with improved scale without compromising account profitability.
- Ability to further invest in technology to improve productivity, increase presence across India & improve service quality resulting in further market share gains.
- The Govt at present provides the sector Income tax benefits under section 80JJA of Income Tax Act. According to this section, if the company employs more associates than in the previous year, it gets to claim a deduction of 30% of total employee salaries from its PBT in that year as well as next 2 years. Given that employee expenses are >90% of revenues, 30% of this implies deduction is greater than PBT and hence company pays zero tax.
- TL made statutory remittances of ~Rs 1400 crores in FY21 and they have a miniscule share of the flexi staffing industry. Governments stand to gain if the share of organised players goes up over time and hence should continue to encourage formalisation of the sector.
On Turnaround of MAN Industries
- MAN has lost a decade, primarily due to internal challenges. Inter promoter group disputes have now been resolved with one set of promoters firmly in control post court rulings. Over last few years, MAN has reduced its debt and its Debt/EBITDA is now < 1.
- MAN has announced intent to divest their real estate division to focus solely on core steel pipes business.
- Promoters have demonstrated confidence in the business by issuing warrants to themselves. While we believe a rights issue would have been better governance, promoters are demonstrating skin in the game at the same time as related party transactions are reducing and promoter pledged shares have also reduced materially from 41% to ~5%.
When it makes sense to buy Low P/E?
- However, excessive focus on the past can lead one to miss situations where the historical narrative may not extend to the future. The key question in any such situation is “what are the expectations embedded in the price”? we should focus not only on what can go wrong but also on what can be the size of the upside if things work out right. When one is buying a stock at a PE of ~4x, when there is visibility of growth, we believe it is highly unlikely that we will lose Capital. However, if the management can execute well, we see this as a 4-6x opportunity over 5 years as growth with higher ROE and improving investor perception can result in a 2x increase in the valuation multiple ascribed to the company.
- Investing is a game of probabilities. This explains why we have a 3% initial position and will track execution and how management walks its talk before increasing the position weight. A company can be a better investment at a higher price when there is more certainty on improvement in prospects.
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or from their website: https://www.solidarity.in/