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Could Alembic Pharma be the next Pharma Multibagger?

Blog on Alembic Pharma – May 2020

Every crisis brings with it, changes, and some of those changes spell OPPORTUNITY. Of course, not all opportunities pan out the way we intend them to. But what if we manage to ride one such opportunity and manage to benefit from it.

This is my first attempt to understand a Pharma business and I started deep diving only after the Covid19 situation started evolving, since I thought it might be a good idea to expose my clients’ portfolios to fast growing companies from an industry which is basically, recession proof. It would be fair to say I am quite new to this industry and have been trying to understand a very complex business. On the other hand, from my interactions with several value investors, over the years, Pharma as a sector, is a black box in a lot of value investors’ minds, due to the complexity involved, and that exactly, makes it a bias worth exploiting.

The purpose of this post is to be able to come back a few years later, do a post-mortem and understand what worked and what didn’t. My views are biased and what follows is, how I look at the situation today. My opinions could change rapidly, depending upon how internal and external factors play out over time.

On 21st March, Donald Trump tweeted this.

There are quite a few listed companies that produce Hydroxychloroquine & Azithromycin. So here’s what differentiates Alembic Pharmaceuticals, a company that I started investing in, in Sep 2019. My initial reason for buying was the company was growing well, was run by a fantastic management team and the price was attractive, given the growth numbers.

What the company sells..

What are Generics / Generic Drugs?

Generic drugs have a similar chemical composition as branded drugs. They are accepted globally and are of the same quality with a lesser cost as compared to branded drugs. Along with no compromise on quality, they are also cost-effective as the cost of R&D and drug discovery is not included in the case of generic drugs.

Generic drug manufacturers like Alembic fall in the latter category because they help reduce prices of essential drugs vs companies like Valeant Pharmaceuticals which work to increase prices. We all know what happened to Valeant and some of it’s very savvy investors, a few years ago.

Below is an old news article that shows staggering price differences between Generic & Branded drugs

An old article shows Pharma Firms Sell Common Drugs At 10 Times The Cost: MCA

And here’s what happens when a company creates win-win situations for itself and it’s customers, by selling drugs at a fraction of the prices that branded drugs sell at. The company wins by increased sales and customers are happy to buy the same unbranded drugs at unbelievably low prices.

Contribution of US Generics business to Alembic’s overall sales is increasing

Branded drugs – A company develops a drug over several years, secures approvals from FDA or equivalent regulatory bodies, secures patents for it and then milks the cow. Medical patents typically last for 17-20 years after which other companies are legally allowed to manufacture the same drug using the same ingredients. Since the company manufacturing the generic drug, has not incurred R&D and related costs, it sells the drug at a fraction of the branded drug’s prices.

API Business

API (Active Pharmaceutical Ingredient) means the active ingredient which is contained in a drug. API and raw materials are often confused due to similar usage of the two terms. An API is not made by only one reaction from the raw materials but rather it becomes an API via several chemical compounds. In layman terms, Medicines are composed of APIs, and APIs, in turn, are composed of raw materials that go through various manufacturing processes before they turn into APIs. To give you an analogy, let’s take Coca Cola.

Peter Lynch once said “When there’s a war going on, don’t buy the companies that are doing the fighting; buy the companies that sell the bullets.” In the current context of war against the virus, one can equate APIs with bullets being used to fight the war against Coronavirus. Effectively, Alembic is fighting the war (through their Azithromycin drug) as well as supplying the bullets (APIs) to MNCs like Pfizer.

Icing on the cake – Azithromycin shortage in the USA & other countries

As per the US FDA website, there has been continuous shortage for Azithromycin all the way until 8th May, 2020 and the shortage continues as of the time of writing this blog. Only 3 companies out of 10, seem to be in a position, to supply the drug. And because, Alembic manufactures the API as well as the end product, it seems to be better placed to continue supplying the drug vs it’s competitors.

Alembic has the capacity to manufacture 10 Crore tablets a month. Retail price in the USA is between ₹120 & ₹174 per tablet. This price does not exclude retailer / distributor’s margins and how much of an upside this situation brings for Alembic, is hence open for debate. I believe there could be significant upside from this opportunity for the company, this year, and leave it to your judgement as to how much of an upside there is.

Capacity expansion

The company has been investing a good chunk into expanding their production capacity and this should take care of the next leg of growth for the company. The company’s balance sheet shows Capital work in progress has grown by 17x between 2016 & 2020. Sales has grown by 1.5x during the same period.

Potential to increase sales per rupee of assets, from 1.4 in FY2020 to a higher number, once the company starts monetizing the R&D & Capex spends it has done over the last 3-4 years

There is no denying that the company is capitalizing some of it’s R&D and related costs. On the other hand, the purpose of the above graph is to roughly understand what kind of an upside potential there could be. Before the company started expanding capacity in 2016, it used to have sales of ₹4 for every ₹ of Fixed assets and CWIP. Even if we were to assume, the company moves to ₹2.5 of sales for every ₹ of fixed assets and CWIP, coupled with increased assets in the future, from the current ₹1.4, the upside could be significant.

Earnings quality check

In FY2020, Alembic earned a return on equity of 26% after incurring high R&D expenses. While ROE can be used to measure a company’s efficiency, it is also my hunch (based on number crunching several fraud cases), that companies with 20%+ ROE in some industries are less likely to give us things to worry about vs the ones with lower ROEs. Barring exceptional cases, companies with ROEs above 20% and high cash flows are less likely to result in permanent loss of capital for minority shareholders. In most cases where there are corporate governance issues, you’ll either find low ROEs or low cash flows as compared to PAT. This is a shortcut that I use to filter companies quickly.

What are a few things that can kill this idea?

Exporter risk – Early in March 2020, the government of India, banned exports of APIs and some basic chemicals. If the situation changes, and exports are banned again, for reasons (unknown-unknowns) that we can’t anticipate, this would adversely impact the company.

Infection risk at plants – At least 2 other pharma companies have reported several of their employees got infected, recently, possibly at work.

Pricing power risk – The company may not end up being able to pass on the increase in API costs or other raw materials to it’s customers. We will need to wait and see how this plays out over the next few quarters. This risk also applies to their generics business. Other generics players producing the same drugs may result in margin erosion for the company.

For example, data from an article from the US FDA site states, higher the number of generic players, lower the drug prices.

So if the branded drug sells at ₹100 and there is just 1 generics player, then the generic drug would sell at ₹61. However, if there are 6 Generics players, then the generic drug gets sold at an abysmal 5 bucks.

Other risks include Macro risks due to uncertainty around Covid19, Opportunity cost risk, Logistics / Raw material risks & Dilution / Leverage risk (The company has been growing faster than the ROE it delivers)

Valuation

Why investors are likely to pay top dollar for pharma companies in the near future?

  • The markets hate uncertainty and given the current uncertainty around earnings prospects of most companies, one sector that is recession proof is Pharma. This is because, no matter how the Covid situation impacts the economy or no matter how long it takes scientists to develop a vaccine, patients are not going to reduce consuming medicines. For example, I looked up sales numbers for pharma companies between 2008 & 2010 and a majority of pharma companies’ sales went up, although every other sector was hit by a recession. I believe it is reasonable to assume that pharma companies (and other sectors with good earnings visibility) will see better valuations in the near future, compared to sectors which have low or no earnings visibility, such as Oil, NBFCs, Real Estate or Auto, etc. Moreover, if lockdowns are extended or reintroduced, Pharma companies are less likely to have a production impact since they serve an essential human need which cannot be deferred to a future date. Unlike most other industries, there is no concept of pent up demand in the essential drugs business and patients cannot postpone consuming drugs to a later date.
  • Scarcity of high growth companies in the current environment is likely to drive up valuations for the ones that promise growth in tough times. Some investors may perceive 17-18 PE as expensive but I disagree with that notion, and believe we should buy growth and not PE. For example, in 2009, Page Industries’ stock was selling at 17-18 PE at some point and some people considered it expensive and fell into the statistical cheapness trap. They ignored the fact that Page had grown revenues at 45% CAGR between 1996 & 2009 and PAT had grown at 68% CAGR between 2005 & 2009. We all know the outstanding returns it subsequently delivered for the ones who looked at growth instead of PE.
  • In his wonderful blog on VST industries, Prof. Bakshi mentioned this

I believe, at my buying price, this would apply to Alembic too. At 17-18x TTM reported earnings, for a company with high R&D exp and one that’s rapidly growing, the downside looks limited, whereas there is option value embedded in the stock in the form of an upside from the Azithromycin opportunity as well as the other approvals that the company hasn’t monetized yet. In other words, I may be wrong on how much upside there is from the Azithromycin situation, but I don’t think I have paid too much for the growth I anticipate from it. My average buying price is a little less than 700 bucks, which is marginally higher than, what the market was pricing this company’s stock before the Azithromycin opportunity knocked the company’s doors.

If the Azithromycin situation plays out as I expect, then it’ll result in a significant growth in earnings for the company.

If it doesn’t play out, then there is a high chance the company might still continue to grow well, as it has demonstrated over the last few years.

  • Besides, economic earnings are higher than reported earnings because the company spends a fortune on R&D. A high R&D expense shows that the management is willing to forego immediate benefits, in order to ensure future growth and has the deferred gratification gene. The management team mentioned they are looking at 700+ Crores R&D Exp in FY2021, on their latest concall & this increased R&D Exp is in a year where most other sectors are announcing layoffs, cost cutting measures, etc.

How did the company fund it’s massive R&D program?

The company spent a total of 2900 Crs on R&D between 2012 & 2020.
In the same period, their debt increased by 1420 Crs.
Out of this 1420 Crs, 847 Crs were paid out to shareholders as Dividends.
So these guys went to the bank, borrowed 1420 Crs from the bank and out of this 1420 Cr loan that they took, they passed on 850 Crs to Shareholders as dividends.
So that left them with 573 Crs which they could now use to fund some portion of their R&D.
So, this means the company funded 2300 Crs or 80% of it’s R&D exp from cash flows that the business generated and 573 Crs or JUST 20% of R&D from debt.
Was it funded by diluting equity? No, because no new shares were issued.
So that leaves us with the only other source of funding which is Cash Flow from Operations.
So 80% of their R&D exp was generated by cash that the business generated.

The co. funded 80% of R&D Exp from internal cash flows and 20% from debt

The outcome of all this R&D expenditure can be seen in the new approvals that the company receives from the US FDA.

Some folks I spoke to, raised concerns about high R&D expenses (investments?) by the company. Lets think about what happens when, a company has a lot of approvals.

By securing more approvals with potentially huge payoffs, the company gets more exposed to positive black swans. A case in point would be Alembic’s opportunistic plays at 3 different times. Alembic,

  • benefited from the opportunity in Abilify drug back in 2016 or thereabouts
  • is benefiting from the ongoing opportunity in Sartans drugs in 2018 (expected to last until Dec 2020 or beyond)
  • has the potential to benefit from the ongoing opportunity in Azithromycin in 2020

Was it a case that company got lucky thrice or was it because the company had so many approved products / approvals in place, which ensured they were (almost) exclusive sellers of 3 products that were in solid demand? Were they thinking “Heads I win big, tails I don’t lose much”?

In my view, Alembic seems to be taking the approach outlined by Jeff Bezos – Given a 10% chance of a 100 times payoff, you should take that bet every time.

Here’s what somebody somebody wrote about ANDA filings elsewhere. And this is one hell of a way, to think about the big number of ANDA filings this company has, in comparison to other companies of similar sizes.

I personally think of filing ANDAs as Making Dices which the pharma company gets to roll once. If you roll and you get “6”, you get a windfall. If you roll the dice and get “4” or “5”, you get a reasonable amount. If you roll the dice and get “1” or “2” or “3”, you get nothing. The more dices you manufacture, the more number of times which you can possibly roll. There is a role of luck, but for that to happen you have to have a dice in your hand. And possibly as many dices as you can. Abilify was one of the dices which alembic rolled and luckily got a “6”. With the money from this, Alembic is now manufacturing many more dices . We don’t know which dice in future would be a jackpot, but what we know is that Alembic is surely producing many more dices to roll in future.

From the book – 100 to 1 in the Stock Market by Thomas Phelps

Imagine Nifty was a single company. Which of the following companies is likely to have better prospects?

Here’s a good way to think about High R&D expenses. From Prof. Bakshi’s Relaxo lecture.

As stated earlier, Alembic earned a return on equity of 26% after incurring high R&D expenses in FY20. And here are the managements’ thoughts on R&D exp, ROE and Free Cash Flows in the next few years.

Addendum – Writing about some questions I was seeking answers to – 26th May, 2020

Why are margins high?

The company’s FY19 annual report states – “A good supply chain helps protect margins and also provides us with some room to improve our pricing.” I believe the reasons for higher margins could be the company’s supply chain + their US front-end marketing team + some pricing power due to the Sartans issue.

With this I conclude my investment thesis on the company.

Disclosure – I and my clients have substantial positions in this company and my views are certainly biased. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above business anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

-Barath Mukhi

13th May 2020

Selling before it’s too late- The delusion of paper profits in a bull market

Selling stocks is exponentially more difficult than buying. If you sell a winner at the wrong time, you could have the financial regret of a lifetime. On the flip side, there were times I ended up kicking myself for not having sold losing stocks in time, thereby magnifying the somewhat inevitable smaller losses I would have otherwise had.

It takes quite a few trials and errors before one figures out how to sell stocks in time. And even after one thinks he’s got it, could still go wrong.

The context is that like a lot of my peers, I was anxious about how this current bull run will play out. Will we experience another bull market like the one we experienced between 2009 and Feb 2020? Or will the market correct from here? If yes, then I shouldn’t be repeating the mistakes from the last cycle and convert paper profits to cash.

Bear markets sneak in when most poor mortals aren’t expecting them and not when there is a lot of debate on Twitter about whether it will crash this week or the next or the one after that.

While I am no expert at timing the markets or the macros, let me give this a shot anyway. In the aftermath of the 2008 housing bubble, the US Fed’s balance sheet expanded multi-fold and all those newly printed dollars chased equities and markets, the world over, shot up. Will the same story play out yet again over the next decade or so? A layman’s guess would be yes.

And here’s what somebody who has a good handle on macros, said about liquidity. Stanley Druckenmiller (left), one of the guys who famously broke the Bank of England, along with his mentor, the legendary, George Soros (right), in a highly leveraged bet, once said,

“Earnings don’t move the overall market; it’s the Federal Reserve Board. Focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

With liquidity, earnings and the several moving parts that work in the background to keep the market engine running, it is hard to make a sure shot prediction about market direction. Think about how many people got out in time before the March 2020 crash and whether the same set of people had the nerve to get back in time before the markets ran up so suddenly.

I don’t think there are easy answers to when a bear market will come or if at all it will be in the near future. While I have been dealing with this uncertainty in my mind, I’ve simultaneously been reading How to make money in stocks by William O’Neil. For somebody like me, who loves reading financial history, this book is an absolute delight.

O’Neil is a genius. He collated fundamental and technical data of historical multi baggers, as early as the year 1885. And he put them into his mainframe computer in the 1960s to analyze what works on Wall Street. So this guy got his hands on a mainframe (remember there was no Windows then) to analyze stocks much before Bill Gates was famously dozing off on his desk, working on computers, in 1968. Woah!!

How O’Neil collated and analyzed so much data at a time when computers used to work like the ones below is quite fascinating.

Anyway, like a lot of other things in life, one naively ignored idea is that of looking at history and seeing how others solved the same problem I am facing today. And here’s how O’Neil solved the problem of being able to sell winning stocks in time. He wrote –

“Have you ever analyzed every one of your failures so you can learn from them? Few people do. What a tragic mistake you’ll make if you don’t look carefully at yourself and the decisions you’ve made in the stock market that did not work. You get better only when you learn what you’ve done wrong. This is the difference between winners and losers, whether in the market or in life. If you got hurt in the 2000 or 2008 bear market, don’t get discouraged and quit. Plot out your mistakes on charts, study them, and write some additional new rules that, if you follow them, will correct your mistakes and let you avoid the actions that cost you a lot of time and money.”

Hmmm.. so he looked at his past trades and so should I. I have this excel sheet where I note down all my buy/sell trades. And here’s what I figured out by doing a post mortem of my past trades from that sheet. There is a bit of hindsight bias here but we’ll just need to work with what we have.

Relaxo Footwears

  • I initially thought the stock will not do better than 15% returns per annum, and did not buy.
  • Big opportunity loss due to not averaging up. I was anchored to low valuations or my cost price perhaps.
  • Position sizing was not sufficient. Should have bought a lot more.

Nesco

  • Prematurely sold due to fear of losing out gains already made.
  • Did not apply second level thinking. Should have trusted management would fix the issue, because they would have solved the problem with their business sooner or later.

Kitex Garments

  • Should not have bought the stock in the first place. I wasn’t looking hard enough.
  • Averaging down did not help.
  • Should have sold when EPS fell down. Did not cut losses quickly enough.

Bajaj Finance

  • What worked – Buying when others were fearful.
  • What didn’t – Process gap. Not adhering to my stop loss.

Alkyl Amines

  • What worked – Experimental bet although it was outside my circle of competence.
  • What didn’t – Not following up. Not averaging up.

The way I look at it is, my journey has been through 3 phases.

Phase 1 – Where I was neither buying nor selling correctly
Phase 2 – Where I was buying somewhat correctly but not selling correctly
Phase 3 (Hoping I am in phase 3 today) – Where I am buying correctly [High allocation bets like Alembic Pharma (exited), Laurus & RACL have done well since March 2020] and hoping to sell correctly.

It is foolish to keep repeating mistakes and I now have pre-determined stop loss prices for all my long term bets and I am hoping this kind of a process allows me to convert paper profits into real currency. Having pre-determined stops also helps get rid a lot of bias and inaction that comes when the stop price actually arrives. I am hoping this helps me to transition from phase 2 to phase 3 smoothly unless I figure out there are more holes in my process.

Perhaps there is a phase 4 too, that I can’t visualise today. Having said that, I am glad to have made it this far, the future seems exciting and there’s a lot more yet to be accomplished.

Note to self:

  • Not backing up positions with enough capital, is a costly mistake. How many of your bets go right is less important than how much you allocate to the ones that go up. To quote Jeff Bezos, “Big winners pay for several failed experiments.” I seem to have fixed this mistake, by allocating 25% of my portfolio to Laurus Labs, last year.
  • Avoid slow or non-growth businesses altogether. Just doesn’t work for my investing personality type.
  • Not cutting losses quickly is a lacuna to be avoided.

Barath Mukhi
26th July 2021

A potential multi-bagger from an unexpected industry

Imagine you are a senior employee, at a company, with several years of experience and you know things are going like this.

By year 6, you know that the company’s equity has been wiped out and it goes into BIFR, a fancy name for potential bankruptcy proceedings.

Once it is clear that the chances of survival are almost zero, in most cases, employees are the first ones to flee a sinking ship because it is easier to switch to a different job than to go down with the ship. To understand the scale of losses incurred, there were no employees in this co. earning more than a lac a month, in year 6, at a time when it incurred a loss of 5.4 Crs.

In this context, I present to you the story of an entrepreneur who managed to save a business from dying. The above numbers are of RACL Geartech, an auto ancillary company that was about to go belly up in 2001 (Year 6). But, due to one employee and his team’s persistence, managed to survive.

A few years later, due to a stroke of good luck, he met a potential client (Kubota, a leading Japanese player in tractors) on a flight and convinced them to give a small order. And that resulted in a domino effect of being able to thrive in a sector that is famous for a lack of pricing power.

Gursharan Singh
Turnaround was led by current promoter, Mr. Gursharan Singh

The company came out of BIFR in Nov 2007. And here’s how they’ve turned around a business that had almost gone to the grave.

Sales have grown at 12% between 2016 & 2021, despite Covid lockdown impact
Profits have grown at 42% CAGR between 2016 & 2021

Higher margins were led by exports growing faster than lower margin domestic sales.

Higher exports also led to better returns on shareholders’ funds.

Clients

Most of the company’s growth has come from BMW, Kubota, KTM & Piaggio, which are all giants in their respective businesses.

Clients Piaggio Yamaha Kubota BMW KTM Honda

Typically, in such situations, the supplier gets squeezed. But this is not what happened in RACL’s case, indicating there is something more to this business than being just an also-ran auto ancillary player.

What would a new entrant need in order to compete with RACL?

Moat # 1 – Peer Margins & ROE

I ran a screen to check which auto ancillary companies have the best margins in the industry. RACL is the only growing co. which showed high margins coupled with high ROE over the last 2 years. In an industry with low or no pricing power, high margins and high return on equity are good indicators of a presence of a sustainable advantage over competition. Why else would no other names show up on the list?

Moat # 2 – Technical know-how

Lets think about it. Why would multi-billion dollar companies let a tiny supplier like RACL make high margins and high ROE, when they might as well go to other auto-ancillary co’s and give them lower margins?

Thomas Phelps, in his wonderful book, 100 to one in the stock market, said “Know-how is a competition reducer. The longer it takes to learn how to do what your company is doing, the fewer competitors will be around to do it for less.”

And here’s what management said about technological know-how in their maiden concall in Feb 2021.

Basically, they were saying, employees at their manufacturing plants have built their skill set over several decades. Plus, the machinery is prohibitively expensive. Even if another ancillary co. does put up the money to buy costly machinery, they will need to go through a learning curve, which could take many years. The other option is to poach a ton of employees from RACL, which is less likely because a lot of RACL’s employees have been around for decades and seem to be quite loyal to the co. I speculate, this is perhaps because the co. went through potential bankruptcy at some point, and led to a closely knit team.

To a potential new entrant, this would be like a chicken and egg problem. “Do we spend a ton of money on the machinery first or do we poach employees first?” I am not saying a new entrant can’t accomplish that. I am saying chances are less. Another thing to note is that the count of employees has been more or less the same over many years, despite all the growth, which possibly indicates very few employees leaving the co. for better and potentially risky opportunities.

Moat # 3 – Plant location

This is from the book “The Unusual Billionaires”.

“In the 1980s, Maruti used to give its suppliers thirty days of notice for the components it needed. Now, it instructs the supplier the previous night about the specific two-hour slot the next day when the components have to reach Maruti’s assembly line. It takes a new entrant into the Indian auto market many years, sometimes decades, to create a supply chain as efficient as this. That’s the power of architecture— it brings different companies together into a common network with a common goal in mind.”

The supply chains of global customers are considered super-efficient. A BMW or a Kubota, would want their suppliers’ plants to be in and around their own plants. But that is not the case with RACL. Forget being close to the customer’s plants, their plants are not even close to the port. RACL’s plants are located around Delhi, which is hundreds of kilometres away from the nearest port. If large OEMs are okay with a gear vendor being located hundreds/thousands of miles away (which is reflected in RACL’s growth over the last few years), it tells us something about RACL’s competitive advantage. No?

Gears for High end bikes

Moat # 4 – The gears that RACL makes require very high precision

This is based on hearsay and from another video made by somebody I haven’t interacted with, and hence I don’t know the source. So, take it with a pinch of salt if you want to 🙂

In 2014, KTM decided to launch a bike by 2017. RACL was given orders in 2014 and they delivered parts the same year. Before launch, KTM planned to run a bike for 50,000 KMS. The part failed after 47,000 KMS. This led to a delay in launch by 6 months. So, instead of KTM saying, we’ll fix it as we go, they said, we will wait until RACL fixes the issue, which they eventually did a few months later. Given this level of clients’ focus on precision, a new entrant is likely to encounter several technical roadblocks, over several years, before he cracks a contract to make high precision gears for a BMW, a KTM, a Kubota or any other large player.

Risks

The buzz word in auto nowadays is electric vehicles. This is perceived as a major risk for auto ancillary companies. But is EV a real risk?

Imagine you are a European who aspires to buy a luxury bike that costs several thousand Euros. Even in Europe, most salaried folks, can’t afford such high-end bikes. If you’re spending a bomb on an expensive luxury bike, what are you more likely to consider? Would you even think about the fuel economy that the bike provides? Would you not prioritise style and power and thereby not even consider an electric bike? I would imagine, somebody who considers spending that kind of money would almost certainly not worry about whether the bike is electric or not.

That being said, consumer preferences can change faster than we expect and EV adoption would stay a key aspect to track while staying invested in this co.

Another risk is that of high receivable days. RACL’s receivable days have trended in the range of 90-110 days, over the last 5 years, up from 27 days in 2016. Although 3+ months is a long time to recover cash from their clients, the good thing is that the trend has been flat, since 2017.

As per management, one of the reasons for receivables being high is that their plants are not located close to the port and that adds 15 days to the number. The usual number for exports is in the range of 60-70 days.

Typically, when receivables are high, businesses have trouble converting profits into cash. However, that is not the case here. RACL has been comfortably converting it’s reported profits to cash. Had receivables been taking a toll on the business, we would see much shorter orange bars, in the below graph.

Cash flow from operations
CFO vs PAT

Addendum –  I missed to add a key risk yesterday. Debt to Equity is on the higher side and is another risk to this business’ future prospects. Also, the co. plans to take on more debt to fund Capex in the next year or so and one will need to watch how well the co. is able to monetize the additional capacity they will be putting up, most of it using debt.

Debt to Equity

The icing on the cake is that current debt is equal to 2 years of FY 2021 cash flows and has been trending downwards. I don’t expect the co. to pare down debt in the next few years, given the huge growth expected. The only case where I foresee debt being reduced is either, when future cash flows are better than expected or the management decides to increase equity by issuing new shares (Equity Dilution).

Debt to Cash Flow

Scalability

RACL has several multi-billion dollar clients. BMW, for example, sold bikes worth 21000 Crs in 2019. And RACL’s annual sales is a paltry 1% of BMW’s. And this is just from one client. Will RACL be able to scale up their business multi-fold across geographies and across clients? Time will tell.

Another interesting thing that happened was that Kubota recently did a JV with Escorts and despite Escorts being the local partner did not bring in their own gear manufacturer. Instead the Japanese partner, Kubota, roped in their supplier, RACL. This is important because RACL’s big client is taking them along, into whatever newer markets they are going into. This opens up a very wide range of possibilities for RACL.

Capacity expansion during an industry down cycle

The co. announced Capex worth 50 Crs in FY2020 AGM. This is at a time, when their fixed assets were 100 odd Crs. Why would a co. that sells non-compulsory goods, increase capacity by 50% during a pandemic? It is not like they are selling roti, kapda, makaan, or anything close to that.

I think it is because they have high visibility for future orders, from clients, which is why they are taking such a huge risk of putting up 50 Crs, that too, 3/4th of it through debt.

Valuation

When it comes to valuation, the best thing one can do is to keep things simple, instead of using fancy excel models. I like to compare the earnings growth rate to P/E and here’s how it looks.

RACL vs NiftyRACLNifty
EPS growth – 5 years37%9%
P/E1429

RACL compares well to Nifty and most other indices in terms of earnings growth as well as it’s valuation.

Disclosure – I have a position in this company and my views are certainly biased. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above business anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

Barath Mukhi
25th June 2021

Why is selling more difficult than buying stocks?

I have high regards for Peter Lynch’s investing wisdom. His investment track record was one of the best, of his era. An important thing that is most often missed, is that he achieved a 29% return over 11 years, despite having a big big handicap of not being able to invest more than 5% in his highest conviction bets, due to prevailing mutual fund rules, at that time.

And he was an investor who advised not owning more than 5 stocks in a DIY individual investor’s portfolio. Had the rules allowed him to back up the truck, to say 20% of Fidelity Magellan, chances are, he would have outperformed his peers by an even better margin.

Here’s what he wrote about his highest conviction bet, in the early 90’s.

During my final three years at Magellan, XXXX was the biggest position in the fund—half a billion dollars’ worth. Other Fidelity funds also loaded up on XXXX. Between the stock and the warrants (options to buy more shares at a certain price), Fidelity and its clients made more than $1 billion in profits on XXXX in the 1980s. This was the year I backed up the truck. Backing up the truck is a technical Wall Street term for buying as many shares as you can afford. Now 4 percent of Magellan’s assets were invested in XXXX, and toward the end of the year I reached my 5 percent limit. It was my largest position by far.

I’ll reveal the name shortly. Just stay with me.

Fannie Mae stock price

These kind of returns happened, because the company’s earnings per share grew at 18% CAGR over 15 years, from 50 cents in 1986 to $5.60 in 2001. Btw, he called this the best business in America. And, this came from an investor who compared it to thousands of other American businesses.

And yet, he seems to have lost money on this 27 bagger. The stock was that of Fannie Mae, which was the American equivalent of HDFC Home Loans in India. In a Sep 2008 article published in the Wall Street Journal, Lynch was expecting the beaten down Fannie Mae’s business to bounce back by 2011. By the time this article was written, Fannie Mae’s stock price was already down from a peak of $86 in 2001 to $2 in 2008.

WSJ article published in Sep 2008
Fannie Mae stock price

But then, just like with most hope based investing situations, Fannie Mae’s diluted EPS never recovered post GFC, and so did it’s stock price.

Basant Maheshwari Pantaloons - Bought at 7
went to 875
Sold at 300

Whether or not he ever sold his Fannie Mae position eventually, is not known. If an experienced investor as smart as Peter Lynch did not sell a winning position in time, it tells us how difficult endowment bias can make it for us to sell our ex-winners.

That led me to thinking what if he had sold his position much earlier, when the company’s growth had slowed down? Fannie Mae had not been doing well since 2003 anyway, as seen from their blue EPS chart above. Assuming he was holding a big position in Fannie Mae from 2003 to 2008, he would have saved a fortune by getting out of the stock once the company’s business had slowed down, say by 2006 itself, much before the price tanked all the way.

Now let me tell you a story of somebody who did not make the same mistake as Peter Lynch, and sold Pantaloons because the price had started tanking. He’d started buying Pantaloons at ₹7. The stock went up all the way to ₹ 875 and then when it came to ₹300, he sold the stock, a price it never went back to, ever again. Below, he explains his rationale.

What if I had stuck to selling at pre-determined stop loss prices, in the past?

Well I used to be this “buy and hold and forget” investor a couple of years back. But not any longer.

Kitex Garments mistake

I’d started buying Kitex Garments at 500 levels in Oct 2016 (not adjusted for splits) and then averaged down at 400 levels too. It is easy to hide under the garb of “buy and hold” despite the market giving you enough signals that you are wrong. Here’s what I had written in my trading journal, in Feb 2018, at a time when I should have been selling.

Journal

The same pattern has repeated for me in stocks like Bajaj Finance, Manappuram Finance, etc. and when I should have been selling these stocks, I didn’t – A mistake I am almost certain, not to repeat in the future. I now have a process wherein I set pre-determined alerts for stocks that I own. This takes out a lot of bias, when trying to cut losses quickly. So if and when the price of stock goes down below that level, I force myself to sell. Sometimes, it makes sense to think Mr. Market is smarter than you, control your risks and protect your limited capital.

Unknown Unknowns

Thinking about it, such a strategy could potentially protect my portfolio, from potential black swans in the future, such as the world wide web going down all at once, or a nuclear attack or a bio attack, another pandemic that is way deadlier than we are experiencing today or the US dollar blowing up or some freakin’ unknown unknown that nobody ever anticipated to begin with. I really hope none of these scenarios ever materialize but one can never know.

My own experience has been that problems in companies come from areas nobody anticipates. From 2014 to 2018, I had been invested in Nesco, the company that owns the lucrative Bombay Exhibition Center and a couple of IT buildings, which it leases out to MNCs. The problem eventually came from their exhibitions causing several hour long traffic jams outside the Bombay Exhibition Center. The problem was compounded by the fact that there was metro rail construction (an unknown unknown that no research analyst had anticipated) going on at the Western Express Highway and I got rattled out of my position despite having held the stock for 4 years. You could blame this failure on a lack of my thinking about second order effects. What I did not foresee was that when their kingdom was at stake, the management would use its contacts and all its liquid resources to resolve the problem quickly with the Bombay City Corporation.

Nesco sale

The other unknown that nobody anticipated for this otherwise foolproof business was Covid19. Not one analyst had predicted that a pandemic would put off returns for some this company’s oldest shareholders, by a few years, resulting in huge opportunity costs.

And here’s what Morgan Housel wrote about unknown unknowns in The Psychology of Money “Beyond the predictable struggles of running a startup, here are a few issues we’ve dealt with among our portfolio companies: Water pipes broke, flooding and ruining a company’s office. A company’s office was broken into three times. A company was kicked out of its manufacturing plant. A store was shut down after a customer called the health department because she didn’t like that another customer brought a dog inside. A CEO’s email was spoofed in the middle of a fundraise that required all of his attention. A founder had a mental breakdown. Several of these events were existential to the company’s future. But none were foreseeable, because none had previously happened to the CEOs dealing with these problems—or anyone else they knew, for that matter. It was unchartered territory. Avoiding these kinds of unknown risks is, almost by definition, impossible. You can’t prepare for what you can’t envision.

Some more anecdotal evidence

Here’s what Mark Minervini wrote in one of the Market Wizards books – “Were there any other major pivotal points in your transition from failure to success? After I had been trading for several years following my initial wipeout in the markets, I decided to do an analysis of all my trades. I was particularly interested in seeing what happened to stocks after I sold them. When I was stopped out of a stock, did it continue to go lower, or did it rebound? When I took profits on a stock, did it continue to go higher? I got tremendous information out of that study. My most important discovery was that I was holding on to my losing positions too long. After seeing the preliminary results, I checked what would have happened if I had capped all my losses at 10 percent. I was shocked by the results: that simple rule would have increased my profits by 70 percent.”

To conclude, this article is not to question a very smart investor’s wisdom but to understand how difficult investing in stocks, particularly selling, can really be, at times. And more importantly, how critical it is to cut your losses quickly rather than slowly. The difference between both can be night and day.

Barath Mukhi
30-May-2021

Buy and hold investing in India

Remember the market cliché about some of the best track records coming from those of dead people’s inactive portfolios? This comes from a supposed study that was done by Fidelity, in which they noted an internal performance review on accounts to determine which type of investors received the best returns between 2003 and 2013. The customer account audit revealed that the best investors were either dead or had forgotten about their portfolios.

From Business Insider

This happens because emotions and opportunity costs are not a factor in dormant portfolios. Does that mean, one should not try to maximize returns from one’s portfolio by switching to better ideas? I don’t think that would be the perfect thing to do, considering the dormant portfolio data. I’ll tell you why. Imagine you were an investor in Wipro in Feb 2000 and somebody told you about inactive portfolios doing better than the active ones and based on that you’d decided not to sell. You’d have had 20 years of zero returns while the indices ran up multi-fold.

Very few companies survive the relentless onslaught of competition, technology, changing consumer preferences, changing government regulations and various other factors. See for example, the below list of top 50 companies by market capitalization in 1992.

Most of the above got replaced by better, sexier, smarter companies. And, most of the ones that did survive in today’s top 50, did so because of issuing new shares. Take State Bank of India for example. From a market cap of 22900 Crs in 1992 to 318,000 Crs today, SBI’s market cap grew at a pitiful 9.5% CAGR. I am not even getting into equity dilution which would chop shareholder returns down to much lower single digits.

Or take ITC, a much debated hot stock. ITC’s market cap went from 9000 Crs to 2.6 Lac Crs, delivering a return of 12% CAGR, excluding dividends. That ITC would grow at a faster clip, 2021 onward, when it is 28x bigger, and is likely to be much more bureaucratic than it was in 1992, will possibly become a case study in hope based “long-term” investing, in the future.

Going back to 1992, as investors who believed in the India growth story, and who wanted to maximize their ROI, why would we have stayed invested in SBI/ITC when there were much better fish in the pond, provided one knew where to look? Shouldn’t we have been looking for faster growing high ROE companies, than the below large caps?

Company19922021CAGR (excluding dividends,dilution,spin-offs)
State Bank of India2290531878710%
Tata Iron & Steel13793863857%
ITC912825959412%
Reliance Industries6654131061620%
HUL636954460617%
Tata Engineering & Locomotive 5287N/AN/A
Associated Cement4924N/AN/A
Century Textiles400352251%
Grasim Industries36609249512%
Tata Tea3516N/AN/A
Tata Chemicals2986189587%
Larsen & Toubro294119633916%
Gujarat State Fertilizers Company2886N/AN/A
Colgate Palmolive27664186010%
Master Shares (Unit Trust of India)2699N/AN/A
Cochin Refineries2619N/AN/A
Industrial Credit and Investment Corporation of India (ICICI)2475N/AN/A
Chemical and Plastics India2133N/AN/A
Hindalco21047350013%
Bajaj Auto206910417414%
Brooke Bond India2060N/AN/A
Indo Gulf Fertilizers and Chemicals Corp1814N/AN/A
Gujarat Narmada Valley Fertilizers & Chemicals177944563%
Jaiprakash Industries1779N/AN/A
Shipping Credit Corporation of India1762N/AN/A
Bombay Dyeing168614680%
Essar Gujarat1683N/AN/A
Great Eastern Shipping Company166145134%
Tata Timkem153094476%
Nestle India150115977817%
Castrol India1479121668%
Century Enka1461549-3%
Indian Aluminium1452N/AN/A
Motor Industries1445N/AN/A
Britannia Industries13798441515%
Apollo Tyres1328142809%
Madura Coats1308N/AN/A
Gujarat Ambuja Cements11605855714%
Indian Rayon and Industries1144N/AN/A
National Organic Chemicals1134N/AN/A
Raymond Woollen Mills1124N/AN/A
Birla Jute Industries1120N/AN/A
Oswal Agro Mills1112132-7%
Ingersoll-Rand (India)110421162%
Mazda Industries1095N/AN/A
Siemens India10386444915%
Ashok Leyland10283348013%
VST Industries101710170%
ITC Bhadrachalam Paper1003N/AN/A
SKF Bearings (India)963107579%
Data not available for companies marked N/A

Suppose an investor forgot about his large cap portfolio in 1992, 29 years later, in 2021, he would have realized what a poor idea it was, to leave his portfolio dormant. The top performer, Reliance Industries, delivered 20% CAGR, excluding dividends, while most of the remaining companies either ceased to exist or delivered single to lower double digit returns. I am not getting into what happened to companies where data is not available. And I am not inclined to calculate dividends either because we want to look at the most efficient way of calculating returns quickly. My hunch is that, at best dividends would add 2-3% to the above returns. It is not rocket science to understand that active investors who kept learning about companies did much better than the cumulative returns delivered by this dormant portfolio, including dividends.

Conclusions

  • The answer to Buy and hold vs Buy and forget lies somewhere in between. Continue to hold companies that keep executing. For the ones that don’t, switch to better alternatives, because opportunity costs are real.
  • Buy and monitor beats Buy and hold any day. As Ian Cassel says “Fall in love with companies that execute but be prepared to divorce quickly.”
  • The above data is only for large caps. People typically invest in large caps for the certainty and clarity, the big companies provide. I agree with Ken Fisher, who once said “Clarity is almost always an illusion—a very expensive one.” As ROI focused investors we are better off investing in mid and small caps, even after adjusting for the risk involved in smaller companies.
  • Most things in the market are contextual. What works in the west doesn’t always work in India. Buy and hold may have worked in the case of Fidelity’s investors who forgot/were dead. It certainly has not worked in Indian large caps.

Barath Mukhi
30th-March-2021

How depressed markets can cost you money

This is a case study of how a lot of investors missed a big trend in Indian markets, costing them a 25+ bagger and how we can avoid falling prey to such a trap, ourselves.

Bull markets can delude one into believing that good times will continue. Likewise for bear markets. In bear markets we may start to believe that things around us are gradually getting worse when they could actually be getting better. This notion is compounded by the fact that everybody around us is bearish and negative about the future state of the economy and the markets. As investors, it is our job to keep our eyes on the ball (data) and not lose focus by believing what everybody else is saying.

Imagine what might been on investors minds, after reading scary headlines, such as these.

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Economic Times article from May 2002

Imagine that the Sensex goes down from 50000 to 31000, over the next 3 years. What effect will it have on your psyche?

Sensex – March 202150000
Sensex – March 202237500
Sensex – March 202336750
Sensex – March 202431973

Yet, this is exactly how it played out in the 500+ trading days between 2001 & 2003, in percentage terms.

March 31, 2001-25%
March 31, 2002-2%
March 31, 2003-13%

Most investors are likely to have lost both, the money and the confidence in the above kinda market. Some of us may think, yeah the market rises, every time it falls and we might have just kept buying, had we been investors back then.

However, this ignores the psyche of most investors of that era. In 2000, just when the market was starting to forget the Harshad Mehta scam of 1992, and investors would have been less worried about manipulation, came another blow to their faith in the markets, in the form of the Ketan Parekh scam of 2001. And after they or their peers lost money, some of them are likely to have believed, Indian markets will never change and there will always be scams like these.

Also, in 2001, FIIs started to pull money out, after the Sep 11 attacks on WTC. Back then, FIIs were considered the major drivers of stock prices in India, because collectively, they had the muscle to move markets whichever way they wanted and FIIs selling could mean just one thing.

Investors were perhaps twice bitten, thrice shy (First Harshad, then Ketan). This was an era where the internet was still a luxury and wasn’t considered too important. Information flow wasn’t as smooth as, it is today. Perhaps, not many would have foreseen the impact, the introduction of demat and online trading would have, on making it harder & harder to manipulate the markets at the scale of previous scams. Even today, some old timers believe the market is a gambling den, thanks to historical scams like these ingrained in their memory and to a genetically programmed human emotion, called loss aversion.

Enter, the era, when mobile phones went from being a luxury to becoming a need, and landlines were still the norm. To put things into perspective, this bulky phone, the Nokia 6600, a rage back then, thanks to it’s relatively lower price tag and the all new camera feature, was launched in India, only in Oct 2003 and it took some years for it to be widely accepted.

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So, in the middle of all these things, in 2003, why would you want to put your money into a company whose losses had kept increasing for 4 years? It also had a seemingly insane market cap, of 5000 Crores.

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Investors were also expecting this company to continue making losses for the next few years.

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Yet the stock price started moving up and went on to become a multi bagger over the next few years.

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This is a story about Bharti Airtel. And here’s how one very smart investor kept his ears to the ground, thought differently and made solid money from this stock.

Raamdeo Agrawal’s investment thesis “Bharti Airtel was a big investment for us. It was a combination of two frameworks – value migration from fixed line to wireless phone and the network effect. In network business, the winner takes it all. The number one player makes 80% of the profits and the number two player 15%. I had read this in Michael Mauboussin’s book. In 2003, Bharti was making losses. In Jan 2003, Bharti’s CMD, Sunil Bharti Mittal, announced on the analyst call, that they had started breaking even. I did a five year excel spreadsheet analysis and deduced that they will make Rs. 28 thousand crores, cumulative PAT, in the next 6 years. The cash flows were expanding, the operational cost was fixed and there was a ten year tax holiday. The market cap was just Rs. 5000 Crs then. In life, you get very rare opportunities like these when the market is blind to the numbers. The market was also very depressed in 2003, which contributed to the under valuation. We bought the stock at Rs. 12.5 (adjusted) and it went to Rs. 590 within 3 to 4 years, but I did not sell then. I sold the stock at Rs. 325, when they bought businesses in Africa. So, it was still 25x. Investments like these give you the confidence that your frameworks work. In earlier times, just buying stocks at cheap valuations, made money. But the world has changed. You cannot just buy cheap and do well. You have to buy quality stocks with growth at cheap valuations.”

His investment thesis was a lollapalooza, where multiple mental models came together, which isn’t practically easy to do, by the way. Perhaps there are more models, but here are the ones that come to my mind.

  • Network effects (Pat Dorsey)
  • Loss to profit company (Ben Graham)
  • Using spreadsheets which are frowned upon otherwise (Mr. Agrawal projected a PAT of 28000 Crs. Actual number 22000 Crs)
  • Focusing on the story and not on numbers (RK Damani’s HDFC Bank example?)
  • Operating leverage once fixed costs are covered
  • Focusing on Cash flows (Buffett)
  • Mr. Market was depressed (Ben Graham)
  • Focusing on quality + growth and not just cheap valuations (Munger)

Focusing on cash flows instead of profits

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Conclusions

  • Depressed markets can impact investors’ judgements, even without they realising it. Why else would somebody ignore a massive change in consumer preferences, that was very evident (in hindsight)? If there is a multi-year bear market in the future, keep your eyes and years open. Do not forget that, things will eventually get better.
  • Do not underestimate the effect, negative news flow from social media, can have on your psyche.
  • Buy what you see isn’t always easy.
  • Keep an eye on companies which are reporting losses, yet are cash flow positive.
  • Growth + Quality + Reasonable valuations due to Mr. Market’s bias = Multi baggers.

Barath Mukhi
1st April 2021

Strategies to get lucky in equity investing

Many experienced investors are likely to tell you the role of unexpected pleasant surprises aka serendipity in their investing careers.

The idea that I am trying to explore is how much of equity investing is luck and how much is skill. And, if it is luck, are there game plans which can help us get lucky.

Here’s Peter Lynch “Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up five fold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is. I remember buying Stop & Shop as a conservative, dividend-paying stock, and then the fundamentals kept improving and I realized I had a fast grower on my hands.

Hero Honda’s (a 150 bagger from 1994 to 2016) early investors had no clue, (at least initially) that they were capitalizing on a massive shift in consumer preferences. Here’s Mr. Taher Badshah’s interview on Wizards of Dalal Street “I started to flesh out the story in my mind and I used to have these repeated sessions with Raamdeoji late into the evenings and that is how it came about that this is a story, not about the capacity expansion, but this whole element of mobility, mobility was so constrained at that point in time in a country like India and especially in the rural markets. Scooter was only a largely urban city led phenomenon. So, we tried to rationalise that this is a product which can become large. How large, even we did not really have the vision to think that what was a 90:10 scooter-motorcycle market would become a 10:90 scooter-motorcycle market.

An astute investor like, Mr. Basant Maheshwari for example, thought Pantaloons won’t do well and it subsequently became a 40 bagger for him. He explains this in this short video.

Ayush Mittal, an investor I admire for teaching us the value of turning over a lot of rocks, nailed this idea in one of his presentations, “Many often the stocks where we worked very hard, where we thought we knew enough, gave the worst returns. While many others – not our favorites – gave extra-ordinary returns. Often stocks where we did lot of work haven’t worked out well. Plus they performed best when undiscovered. It’s like a backbencher performing well – he gets rewarded more.”

Sometimes, even founders/promoters don’t know

And here’s a leaf from the legendary investor, Charles Akre “According to Bill Gates’ first book, The Road Ahead, he and Paul Allen tried to sell the company to IBM some years earlier and they were turned down. And so… hindsight my inescapable conclusion is that neither party of the proposed transaction understood what was valuable about Microsoft. In my mind it’s a huge irony at least because in my point of view Microsoft became the most valuable toll road in modern business history. But here again, even the people running the company at an early stage did not understand what it was that made it valuable. And it wasn’t even visible to them. So my point here is simply that the source of a business’ strength may not always be obvious.

Sam Walton’s biography “I’m always asked if there ever came a point, once we got rolling, when I knew what lay ahead. I don’t think that I did. All I knew was that we were rolling and that we were successful. We enjoyed it, and it looked like something we could continue.”

What’s in it for DIY investors

Given that it is difficult to predict high CAGR stocks, here are some ideas that can help bypass the human limitation of a lack of foresight.

Strategy # 1 – Average up – So what you really need to do is to size positions based on a Bayesian approach. Kill small experiments that you thought would do well but failed, and allocate more and more capital (by gradually averaging up, based on subsequent quarters of good results) to bets that are working in your favor contrary to what you initially thought. Relaxo Footwears was one such bet for me. When I first bought the stock, I thought 40 times earnings is too high a price to pay for this company. Nevertheless, I invested despite what my intuition kept telling me at that time. And the price kept going up, and I kept buying.

The best example of averaging up I have seen till date is Mr. Maheshwari buying Page Industries from 350 to 5600. So he keeps buying the stock until 16x his initial buy price & beyond. No price anchoring. No excuses of the price running up. Just plain execution on his strategy of averaging up on a winner.

A critical part our position sizing process should be to let the validation of our thesis (reflected in business performance subsequent to our initial positions) determine the position size. When we first spot a stock, we shouldn’t pre-decide we’ll allocate 5-10-20-30 or even 40% of our portfolios to a given stock. Every time the management of a company executes on it’s stated plan, by delivering growth and ROE, we should be buying more of the stock. If it doesn’t do as well as we’d expected, we get out of the stock (unless the slowdown is temporary) and add to stocks that are doing well despite what we originally thought.

Strategy # 2 – Basket approach – The second strategy is taking a basket approach. So if you think a sector is going to do well, allocate more of your portfolio to a potential winner, at the start. At the same time, invest small sums into other counter intuitive bets from the sector. Let me give you an example beautifully articulated by Mr. Kenneth Andrade, in an interview from 2013.

So if you were bullish on the 2 Wheeler market in India, in the 90s and 2000s, what you should have done is allocated a lot more to TVS Motors initially and when consumers were starting to accept Hero Honda’s 4 stroke engines, paid attention to disconfirming evidence like a true Bayesian, and moved money from a TVS & Bajaj to a Hero Honda because clearly it was outperforming it’s peers. Hero Honda deserved your capital more than Bajaj or TVS did at that time. The opportunity cost of staying invested in a Bajaj or a TVS was skipping Hero Honda, a subsequent 150 bagger.

Strategy # 3 – Businesses with multiple possible futures aka sidecar investments

I’ll let David Gardner explain this for you.

With this I’ll call it a wrap. Hoping good luck finds you soon 🙂

Barath Mukhi
18th-March-2021

Why investors didn’t buy Infosys when it was a small cap

Let’s do a thought experiment. It’s August 1997 and you are in the trading ring at the Bombay Stock Exchange. In between the chaos of that place, there are thousands of listed companies. An investor friend, tells you “Buy Infosys”. You are unconvinced and don’t buy because you’ve burnt hands buying stocks recommended by others before. And you forget about the co.

The question I am seeking an answer to is – If Infosys subsequently became a mammoth wealth creator, why didn’t a lot of investors buy it in the early 90s? What biases were involved in causing the massive opportunity loss that followed, due to not buying the stock of this co.?

Let’s go back in a time machine. Here’s what it looked like in mid-1997.

*PAT Data not available for 1992

ROE for all 5 years kept increasing YoY and ranged between 21% and 33%.
The P/E ranged between 15 & 25.

Infy also had a 15 year track record of growing sales at 28% CAGR from 1982 to 1992. So even in 1997, it was not some microcap co. with no track record. It was a fast grower for 15 years, with decent credentials.

Let me quote what some veteran investors have said about Infosys and other technology companies of that era.

Basant Maheshwari – “Between 1994 to 1998, Infosys came right under my nose. We saw their good results, but there was always these thoughts like – “Who would buy Infosys if you take away all their employees tomorrow?” or “It only has computers and chairs and what are those worth for?” or then “I can create an Infosys by hiring all those people.”

Anil Goel – “I had never invested in IT companies. I didn’t understand that business and I did not understand the valuations. The valuations just did not make any sense. The market cap of one Computer Education Company exceeded the combined market cap of the few large conglomerates at that time. That saved me from technology crash of 2000.”

Here’s how the company’s market cap went ballistic, 1997 onwards.

1997 to 1999 – 19 x
1997 to 2000 – 127 x (not excluding new shares issued)

What would have happened if one had purchased the stock in 1997 or prior to that?

Assuming most people could not sell Infy at it’s peak, they would have still done well, had they bought the stock prior to 1997 and sold it post-crash, in 2001.

The point I am trying to make is, just like one cannot be right all the time, one also cannot be wrong all the time either. What was a growth stock for 6 years (1993 to 1999), became a bubble stock in 2000 and most people who bought in 2000, were likely to have been nastily injured. Had one purchased the stock any time between 1993 and 1998, they’d still have done well.

Ramesh Damani, who understood Infy, due to his technology background and made a ton of money from it’s stock, said “Lot of the old hands in Dalal Street didn’t understand technology since there were no physical assets, and all the real assets walked out at five in the evening. They had no idea how to value these companies.”

Would it have been easy to buy this stock without a tech background? No. As a wise investor once said “The risks of this trade always appear lower, after the rewards have been made.” Here’s what Infy’s website looked like in 2000. No investor relations. No annual report PDFs. This was the world back then.

Now let’s look at the situation from the perspective of an investor who had NO tech background.

I am not trying to find fault with investors who didn’t invest in Infy. I totally respect the wisdom, the investors I’ve quoted, have. I am just trying to present the situation from various vantage points, as investors saw it back then.

Here’s what Raamdeo Agrawal’ investment thesis in Infy was, in 1997 (I have shortened & rephrased this a bit). He had NO tech background, just like most people of that time.

“In the Y2K boom, we made Rs. 100 crore. We were 80% invested in technology, 40% of which was in Infosys. Mr. Narayana Murthy taught us that Indian cost was unbeatable. What Americans were doing in Boston for the last 20-30 years, Infy was doing for 1/5th or 1/6th the cost. Due to a friend’s suggestion, to learn about globalization, I started reading The Financial Times, The Economist, Business Week and Fortune. Somewhere in 1997, I read about the effects and challenges of Y2K. It explained what problems would occur when the systems would change from 1999 to 2000 and how it will need to be changed in computer systems for continuity of various industries. I could see a big elephant approaching and that the gate is small. And that it is a dated event. In the market, you rarely get to know about a future event that is dated, that this transition has to happen in just 3 years. The demand was high and the supply was not as much. The IT companies were growing at 100%, but were still available at 20 P/E in the beginning.”

Y2K as cover page on the Time magazine

Selling a bubble stock

Ramesh Damani – “When we saw that the 2000 Technology, Media & Telecom (TMT) bull market was getting over, I realized that these values wouldn’t hold. Infy was trading at 150+ forward P/E. Even if you try to hold the stock, the markets rattle you out of the position. Infy went up three straight circuits to Rs. 13,000 and then started falling. So when it fell to Rs. 8,000-10,000 levels, I sold it, as I could not handle the stress of holding it since so much money was involved.”

Raamdeo Agrawal -“When these companies were trading at 100-200 P/E, we did start selling. I started selling Infy at 11,000 per share. And I sold the last bit in September 2001, at around 2,500.”

Rajashekar Iyer – “My 1995 experience had taught me that when stocks are highly overvalued and start declining, the safe course is to sell them and not be a ‘long term investor’. All IT stocks were tremendously overvalued by Jan 2000 and so when they started falling in February, I sold them as quickly as I could. I could not sell at the peak, mostly 15% down from the peak. One IT company’s stock that I had bought at Rs. 60, came down from Rs. 510 to Rs. 360 by the time I could sell. I sold it almost 30% down from the peak, but it finally ended at Rs. 12.”

Conclusions:

  • For most investors, it takes a lot of time to adapt to new business models created by the arrival of new technology. Learning about these new business models quickly is sometimes the difference between great returns and mediocre returns.
  • Holding such investments is never easy. Think how difficult it is, to own Bitcoin today, given all the noise. I don’t own it btw.
  • Having bought early, if you find yourself invested in a bubble, stay put. Booking some profits intermittently and keeping trailing stop losses may be a good strategy, although stop losses may not help at times, given that there could be severe gap downs and no buyers.
  • Cut losses quickly. If you don’t, you may find yourself holding a loser for 8 years. (It was not until 2008, when Infy crossed it’s 2000 high price).
  • No matter how good a business or a management team is, at some price it becomes stupid to buy it.

Barath Mukhi
6th-March-2021

Case study – How one investor made 25 Crores in 4 years by investing just 7 Lac rupees in a real estate hot stock

A few months ago, I watched this very humble interview of a celebrated investor, Mr. Rajiv Khanna, husband of Mrs. Dolly Khanna.

Mr. Khanna bought Unitech’s stock in 2003-2004, when it’s market cap was ₹100 Crores. His investment thesis was simple. Unitech’s business was being valued by the market at ₹100 Crores, a price Mr. Khanna thought was abysmally low. Just their Delhi office was probably worth more than that, he thought.

This is the functional equivalent of walking into an Infosys’ branch and telling it’s owners, “Sell me your business for the price of this office building.” Insane.

Yes, these kinds of absurdities occasionally show up in the market. When Mr. Market is in such a distressed mood, he throws the baby out with the bathwater and creates bargains for investors who can separate the wheat from the chaff.

This video got me wondering. What causes a stock to go up 350x & beyond in just 4 years. Here’s what I found.

From 1989 to 2002, Unitech was an unheard-of company, an also-ran. And then the bull market in real estate began. In 2002, they were selling the same amount of goods, they’d sold 5 years back.

Profits were down in the dumps, too.

And then began an unprecedented bull market in India’s real estate sector. From 2003 to 2008, the market leader in this sector, other than DLF, turned things around at a scorching pace.

Unitech’s total # of outstanding shares went from 1.2 Crores in 2003 to 162.3 Crores in 2008. To remove the impact of equity dilution, I have taken EPS numbers instead of PAT numbers because EPS & not PAT is what matters, from a minority shareholder’s perspective. BTW, PAT went from 46 Crs in 2003 to 1669 Crs in 2008.

Unitech’s promoters were a celebrated lot. The title of this article read “India’s most investor-friendly companies”

What these developments did to the market cap, starting 2003, was unimaginable.

Led by scorching growth, investors were made to start looking at valuations differently, so the high prices could be justified somehow. Valuations were no longer based on earnings but based on land bank. Consensus was “Buy landthey’re not making it anymore.”

BubbleValuation based on
DotcomEye Balls
Real estateLand bank
Infra companiesOrder book
E-CommerceGross Merchandise Value

And here’s what happened when the party was over.

Would it have been easy to buy the stock of this company? No. The sheer number of subsidiaries of Unitech’s would make your head spin, besides teasing the forensic analyst in you. In 2008, this co. had 337 associates/joint ventures/subsidiary companies.

Info about Mr. Khanna’s exit from Unitech’s stock is not available but my guess is that he might have exited before or after the peak, once the stock fell beyond a certain threshold. (In the same video, he talks about exiting when positions go down by 15-17% from his buy price.

Conclusions:

  • Ride the bubble but make sure trailing stop losses are in place. Usually 20-25% from the top is a good enough warning signal. However, let, stop losses not give you a fake sense of security. Like most things in life, this strategy isn’t fool proof.
  • Not watching your portfolio for a few years may sometimes, do wonders for your portfolio.
  • There are bull & bear markets in real estate too. Returns before and after the real estate boom have sucked. Without the kind of growth experienced between 2004 & 2008, most people are likely to have had low to medium range returns.

Barath Mukhi
12th-March-2021

Case study of a 33 bagger whose sales grew at just 6% CAGR over 5 years

I love biographies. Particularly, those of investors who have experienced Mr. Market’s mood swings, over the years.

In this pursuit, I am currently reading the mind blowing book – Masterclass with Super Investors. There’s an investment case study of a co. between 2003 to 2008, by Mr. Raamdeo Agrawal of Motilal Oswal.

I started the book with the assumption that sales growth is important for a multibagger to happen. This assumption was based on sales growth of multibagger businesses, that I had analyzed in the past, which had some tailwind going for them, in a particular phase of their long journey.

CompanyPeriodSales CAGRStock Price CAGRStock Price went up by
Avanti Feeds2011 to 201753%106%83 times
Page Industries2008 to 201735%74%35 times
Bharti Airtel2003 to 200855%97%29 times

Based on the above table, it looks like, there is some correlation indeed, between the top-line of a company and the stock price, which is what we all are interested in.

Or so, I had assumed.

Until, I ran into the story of CESC Ltd. in the book.

Just 6% CAGR in sales. That sucks, some investors might have thought!

But surprise surprise. Here’s what happened to the company’s stock price.

Here’s the investment thesis given by the legendary investor himself.

“Another investment was in CESC. They had a monopoly in power generation and distribution in Kolkata and had done a wonderful job in terms of operations. Yet the whole company was available at a market cap of Rs.90 crore. The reason was that they had very high debt and were paying an interest of Rs.400 crore. Still, they weren’t generating loss but were making meagre profits of Rs.7 crore. I saw that the interest rates were falling. I had read Security Analysis by Benjamin Graham, and knew that equity is always some kind of option value. With the crash in interest rates, the interest cost fell from Rs.400 crore to Rs.200 crore, so the profits jumped 30x. You get these kinds of opportunities only when markets are very depressed.”

Despite a stagnant top line, the co. was able to turnaround it’s business and deliver a profit growth of more than 300x, thanks to an improving balance sheet.

Here’s how things turned around for this business.

Interest rate reduction coupled with lower debt levels, resulted in money flowing directly to the co’s bottom line.

Total interest paid reduced by 281 Crs
Profits increased by 470 Crs

In other words, a big chunk of earnings per share in 2008 was funded by interest that would have otherwise been paid out to banks.

2002 & 2003 not included because the co. was not making profits

Sometimes, it’s not about ROE, but about growth

At most times, both ROE and Growth are equally important to achieve high returns. Yet, there are times when ROE doesn’t matter as much as growth. Despite having single digit ROEs in a high interest rate environment, this co. turned out to be a multibagger for investors who were smart enough to recognise this anomaly. Had one focused on ROE, he’d have lost out on an 80% compounder.

Conclusions:

  • Sales growth is almost always important, but not always important and a good investor recognises the difference between almost always and always. A golden rule to follow in the market is never say never.
  • When interest rates are going south, they are disproportionately beneficial to highly leveraged businesses.
  • Do not assume that a power generation and distribution business cannot deliver a multibagger stock.
  • Do not assume a low ROE business can never deliver a high CAGR stock. An 8% ROE business whose profits are growing fast could still deliver better returns than a 20% ROE business with no growth.

Barath Mukhi
2nd-March-2021

The growth story of Laurus Labs & it’s promoter

Let me start with a story of a fanatic who creates a 20 thousand Crore company from scratch. How does he do it? Where does he start?

The story begins at Andhra, which by the way has produced quite a few successful first generation entrepreneurs in the Pharma space. The ones I know of, are Dr. Reddy’s, Divi’s & Laurus. I don’t know if it is plain randomness or there was something in that environment that led to creation of multi billion dollar pharma companies by people starting from scratch. I speculate, one of the factors, may have been the way chemistry was taught in those colleges, was better than other places.

Or maybe it was about being in the right place at the right time with the right skills. Maybe, in an alternate universe, the same set of entrepreneurs may not have done as well as they have. Too many things needed to fall in place for this kind of, what some people may call, coincidence. Reminds me of the experiment which is widely known on the net, through the article about Justin Timberlake.

One of the key ideas in this article was that too many things need to fall in place, and more importantly, at the same time, for a knockout success story to happen. For example, imagine what would have happened if the exact same set of people were to start Infosys today. Would they be nearly as wildly successful as they have been? Or what if Bill Gates was born just 5 years later? Would we nearly have another giant monopoly like Microsoft or anything close? You get the point.

Will Laurus (20k Crs Market cap) follow the same trajectory as Dr. Reddy’s (75k Crs Market cap) & Divi’s (1 lac Crs Market cap)? In my biased view, chances are it will.

So after finishing his education, Dr. Chava,

  • Joins Ranbaxy as an R&D management trainee.
  • Moves to Veera Laboratories in 1995 and runs the R&D dept.
  • Moves to Vorin Labs which merges with Matrix Labs in 2001.
  • Becomes Chief Operating Officer of Matrix in 2004.
  • Starts Laurus Labs in 2005 due to differences with the chairman of Matrix.

How Matrix Labs strengthened it’s R&D – From Matrix Labs 2000 Annual Report

In 2000-2001, Matrix entered into drugs that treat the deadly AIDS disease. Here’s a snippet from Matrix’ 2001 annual report.

Matrix Labs 2003 Annual Report

Matrix Labs 2004 Annual Report

And here’s what happened at Matrix Labs during Dr. Chava’s tenure. Back then, this kind of growth might have been possible due to a mix of factors such as a growth in the overall industry + the management team driving the company’s focus on to the right products in the right markets, at the right time.

Now, let’s get into the current and future state of Laurus’ business.

In the past, growth was driven by sales of Antiviral APIs. This is the division that sells APIs for AIDS drugs, primarily in low and middle income countries through the Global Fund, PEPFAR and the WHO. A majority of ARV API sales growth came from 4 HIV/AIDS products – Tenofovir, Lamivudine, Efavirenz and Dolutegravir.

As per their latest concall, doubling sales in the HIV segment (APIs + Formulations) is going to be impossible. Having said that, they also mentioned, they should be able to deliver growth in their overall API business in FY22 as well. Based on whatever little info I could find, the largest player in ARVs seems to be Mylan (which acquired Matrix Labs in 2007), and has a 40% market share, in this space.

The other 2 therapies that management is bullish on, are Cardiovascular and Diabetes.

Some part of the growth was also driven Laurus’ Custom Synthesis, CDMO & Ingredients businesses. Custom Synthesis is the segment that has potential to do well over the next few years because the total sale from this division over the last 4 quarters is a minuscule 491 Crs.

Transforming into a full fledged Pharma player

Formulations / FDF showed up for the first time in 2020 Annual Report.

Q3 FY 2021 Concall – “See, if you look at the evolution from 80% to ARV APIs, in the five years we moved to 38% of ARV APIs. Similarly, our revenue dependency on ARV formulations currently is very high. But in the next five years, we will also diversify our revenues coming from non-ARV formulations significantly and the dependence on ARV will come down. Because there are no new formulations to be developed in the ARVs, we are almost done with developments. So, development focus is shifting from ARV to non-ARV. And also, we are adding very large capacity in Vizag and we have taken land for formulations expansion in Hyderabad as well. So if you want to look at where we will be in say, three, four years down the line, I am sure we will be discussing on non-ARV in five years from now. If you look at the calls one and a half year back, half of the times people were asking questions on Efavirenz. Now nobody asks questions on Efavirenz. Two years from now people will not ask questions on ARV APIs. And maybe another two years from then people will not ask about ARV formulations, people may talk about what is we are doing in our Laurus Bio?, what growth we have in Laurus Bio?, what other therapy areas we will be focusing?, what kind of delivery dosage forms we are doing?. So, company s in the transformation phase, so we need time and we are very confident to expand our portfolio beyond just ARV.

The SMILE pattern

This is a pattern noted by the famous investor, Mr. Vijay Kedia. He believes multibagger companies exhibit the following characteristics – Small in size (at least it was small when I started investing in this co.), Medium in experience, Large in aspiration and Extra large in market potential. I am of the opinion that the company has all 4 ingredients and is likely to scale up to the next level, from here.

Regarding aspiration, here’s a person who starts with a salary of a few thousands, moves on to lead the R&D division of another co. and goes on to create a $2.5 billion business in less than 2 decades. If this is not aspiration, what is?

Disclaimer: I have stayed invested in Laurus Labs from lower levels. These are my views and are not to be construed as investment advice. As always, please do your own research before proceeding to buy/sell.

Barath Mukhi
26th-Feb-2021