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The joy of rowing downstream

LiveMint logoLiveMint 17-07-2017 Swanand Kelkar

Newton’s second law of motion, that force is mass times acceleration, is easy to intuitively understand. Imagine a large wrecking ball accelerating towards a concrete wall, the outcome is force. No, this is not a physics lecture but a framework to think about growth investing. At $2.3 trillion of nominal gross domestic product (GDP), India is the seventh-largest economy in the world and with an average nominal GDP growth of 11.7% over last five years, it’s easily the fastest growing. This is the Newtonian winning combination of size (mass) and growth (acceleration). Over the past 14 years, there hasn’t been a single year when India did not grow in double digits in nominal terms and this ability to skirt big booms and busts despite high levels of growth should make it a top destination for any growth investor.

Before this seems like a happily-ever-after story, an investor must appreciate that composition of India’s GDP and indices is very different. While we have had consistent double-digit GDP growth, Nifty earnings for the past three years have grown at a rate of just 1.8%. Outward-facing companies constitute a large chunk of the indices. By outward-facing companies we mean export-oriented sectors such as technology and pharmaceuticals, companies linked to global commodity cycles and those that derive significant value from their overseas subsidiaries. Brokerage firm CLSA estimates that almost 49% of Nifty earnings are derived from such outward-facing companies. Thus, investors convinced on the India growth story who quickly jump to buy an index-linked passive fund, do themselves a disservice. The index is not the best representation of domestic growth opportunities and one is better off looking for an active manager who can sift through them for superior returns.

A large macro opportunity for growth transforms into a profitable micro opportunity for investors only when there are a number of listed companies that operate in these growth spaces. An ideal filter would be to look for sectors that are growing faster than nominal GDP. Within those sectors, look for companies gaining market share, i.e. growing their revenue faster than the sector growth. If such companies are doing it profitably and with right capital structure, it will manifest in profits growing faster than revenue. In our experience, markets normally re-rate such attributes, which means investors are willing to pay more and more for the same cash flows and earnings, implying stock returns could be higher than profit growth. Think of this as a pyramid with nominal GDP on top and stock returns at the bottom. When the top of the pyramid itself is easily growing in double digit, expecting higher growth numbers as you progress down the pyramid is reasonable.

To test this, we ran a simple back test. We looked for companies that have compound earnings growth rate of 15% or better and an average return on equity in excess of 15% and we did this for last three and five years. Two things stood out—the opportunity set for investment and the returns it produced. Three years ago, there were 166 companies in India with market capitalization in excess of $1 billion. Of these, 31 companies satisfied our criteria and they had a cumulative starting market cap of almost $130 billion. If with the benefit of perfect hindsight, you invested in an equal weighted portfolio of these 31 companies, you outperformed the Nifty by a whopping 19% each year. Similar analysis for a five-year period yields an excess return of 9% (see charts). Of course, one is quite likely to get a few calls wrong but with a disciplined growth philosophy and large opportunity size, the odds of generating good absolute as well as relative returns are in your favour. Also, we have restricted the analysis to only those companies whose starting market capitalization was in excess of $1 billion. There are many more companies that satisfy these criteria lower down the capitalization curve and are a fertile hunting ground for the growth investor.

One thing we are clear about is that when looking for companies and sectors to further probe into, our primary filter will never be valuations. We will not focus our energies on stocks and sectors trading at low valuations just because they are trading at low valuations. Brokerage firm Ambit Capital did the numbers and their conclusion is that for time periods in excess of three years, there is no correlation between starting point valuations and subsequent returns. However, we take a slightly nuanced approach here and describe our investing style as “valuation aware”. While bulk of our time goes in looking for superior growth and capital self-sufficiency characteristics as outlined above, we try not to pay top-of-the-range multiples. Also when looking at valuations, we pay a lot of attention to the assumptions implicit in those numbers and try to zero in on metrics where we differ versus the consensus opinion. This approach has two benefits—if you get your growth outlook for a sector or company wrong and this will inevitably happen once in a while, you will have to bear lower or no losses than when you pay top dollar.

Second, if indeed your growth conviction is vindicated, having got in at a sensible valuation, opens up opportunity for re-rating gains along with underlying growth.

None of this means investing is one smooth upward sloping curve but if one can shut out all other noise and focus on unearthing companies and sectors that meet these criteria, the possibility of making disproportionate returns is much better. With a favourable current taking you to your destination, this is as good a time as any to get your canoe out or to find a good oarsman and get in his or her boat.

Swanand Kelkar is with Morgan Stanley Investment Management. These are his personal views.

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