, chief executive officer and managing partner, ASK Raymond James Investment Management, has seen the best and worst in Indian stock markets. For him, every day in the markets is a new lesson to be learnt. Shah's theoretical moorings come from his chartered accountancy and cost accounting degrees, apart from an MBA in finance from the Indian Institute of Management, Calcutta.
Starting off with a career in corporate finance, Shah moved to Apple Mutual in 1992 and to Birla Mutual in 1994 and finally to ASK RJ in 2002. ASK manages five PMSs (portfolio management schemes) with a total corpus of Rs 1,000 crore.
Shah, 44, looks to Warren Buffett - and his own experiences - for investment lessons. One understands why he is an ardent fan of Buffett. The influence of Buffett is evident in the kind of businesses he chooses to invest in and the price he likes to pay for a stock. Shah's key strength lies in identifying growth stocks early.
He loves travelling, especially trekking. An avid reader, he also likes to listen to western classical and old Hindi film songs. His favourite books: Zen and the Art of Motorcycle Maintenance by Robert M Pirsig and The Ascent of Man by Jacob Bronowski. Shah talked to The Smart Investor about his investment approach. Excerpts:
Can you explain your investment philosophy?
We aim to preserve and grow capital. Long-term sustained growth in earnings of any business is not as natural as most investors assume. It depends on the character of underlying business and the management.
Globally, there are limited examples to show how companies sustained high growth for a long period. Therefore, it is important to tread with caution, while assuming growth in future.
Hence, I like to buy companies which have outstanding businesses and are run well, but would like to buy with a margin of safety. The key is to understand the character of the business and its value and buy at a price lower than its value.
The size of the opportunity is also very important to me. From that perspective, I don't find debates about large-cap and mid-cap businesses appealing. To my mind, the important thing is not whether the business is mid-sized or large-sized today, but whether it has the capability to be much bigger tomorrow or not.
How do you value businesses?
People see value and growth as two different things. To me, growth is a subset or a part of value. In a growing economy like India, one can find several companies which can deliver out-sized growth for a fairly long period.
So, the idea is to buy businesses with enduring power to grow earnings, which generate superior capital productivity yet are available at cheap prices so that growth comes for free. That is the ideal scenario.
The value of any business is the sum of values of past and future. The value of past is more straightforward to judge and compute. Over time, businesses build useful advantages like physical assets, processes, brands, distribution network and knowledge base. These provide a foundation for stable and recurrent cash flows in future. One can easily convert them into a present value.
The second part is the value of future growth: how much the company may grow and earn in future. That depends on the size of opportunity, the character of business and the ability of the company to harness that growth while enjoying superior capital productivity.
What would be your investment theme for the next couple of years?
I am looking for a combination of factors - some relating to the nature of business and the others relating to the quality of management. So here it is:
The size of a business opportunity must be big. There is no point in wasting time in shallow waters of a small pond. A small (but capable) fish in a big pond is better than a big fish in a small pond.
The business must represent enduring opportunity, rather than one-time, transactional gain. That will allow power of compounding to work.
Businesses in which India in general and the company in particular enjoy compelling advantages.
The firm must have displayed capabilities to comprehend the space in which it is operating. It may be small today; the key is whether it can harness the opportunity and get bigger tomorrow.
The company must have demonstrated commitment to globalise its business while not losing sight of local markets. It's good to have both engines firing.
The firm should display frugal and efficient usage of capital. Based on these, there are some themes that we continue to like:
A. Infrastructure-related businesses will be big beneficiaries. Political consensus on infrastructure development, the gaps present in the system and availability of local skills and cheap capital provide the right framework. So it is fair to assume that infrastructure will grow. Infrastructure-allied businesses are an interesting investment opportunity, not because they represent superior businesses per se, but because growth will be overpowering.
So companies engaged in building plant machinery (capital goods), laying roads and ports, supplying material for them, generating power or making power equipment, and supplying capital (banks) will see sustained rise over the next few years. Logistics service, rural infrastructure and real estate are also potential areas.
B. Businesses which will benefit from the rapid expansion of income. Financial services, select consumer businesses and services fit the bill.
C. Global outsourcing: The pressure on large foreign companies to cut flab, improve quality and scale up will drive outsourcing. Thanks to cost advantages and the specialised skill sets that some Indian businesses have, there are compelling reasons to believe that India will dominate the scene in select high-end/low-end manufacturing and service businesses.
FAVOURITE SECTOR I:
Auto ancillary
Firstly, the size of opportunity is really big. There is a strong domestic engine and a global opportunity. Secondly, there are huge India-based cost advantages to be exploited. There are global customers who need these supplies for their survival.
These global auto firms have little choice but to outsource components, given the skill, quality and cost advantages. Thirdly, auto ancillary companies have gone through the learning curve as they have been supplying to auto majors in India.
Companies need to invest in capacities before getting business. Because buyers won't give orders and then wait for a company to build capacities and supply.
In this respect, not all companies have demonstrated the ability and conviction to manage the transition and grab the opportunity, though they are not short on quality and capability.
We have bought Rico Auto from Rs 22 or so and continue to hold the stock. Similarly, we bought Mico from Rs 800 and Motherson Sumi from Rs 30. Bharat Forge has been one of my favourites since it was Rs 150. These businesses are still faring well.
The companies that came and made it big in the stock markets over the past 10 years hail from infotech or pharma sectors. Auto ancillaries, on the other hand, is an old business and these companies have been there for quite a while. What has changed for them now?
Inspiration begins only when perspiration is through. Auto ancillaries are today at a stage where they can get seriously large. Indian auto ancillaries are recognised far more than ever before for quality, cost and skills, though not for scale.
They have earned their reputation by becoming cost competitive and maintaining high quality standards and flawless delivery through several cycles.
Some have positioned themselves as global hubs. Some have created a set of customers who can give 50 times more business than what they have been giving. They enjoy superior capital efficiency, and a great lock-in with clients provides formidable entry barriers. Having achieved that, now it is only a matter of scaling up.
FAVOURITE SECTOR II:
Global pharma
This is a large opportunity. Not just companies producing generics, but those in custom synthesis, global R&D, branded generics, and specialty pharma and APIs (active pharmaceutical ingredients.
Indian pharma majors are adding to a formidable pipeline of molecules and expanding geographies and customer base. If you disregard some quarterly performances, the progress that some companies have made is breath-taking. Companies like Dr Reddy's, Ranbaxy, Glenmark and Sun Pharma have remarkable strength.
Why not MNC pharma companies?
MNCs are focused only on Indian market which is much smaller compared to the global opportunity. So, it's simply a question of size. Local subsidiaries of MNCs are less focused on innovation/R&D and manufacturing; they are focused on marketing and sales.
What about Indian IT services?
The value proposition (cost, quality, scale, global delivery, etc.) is still intact. The key concern is that these are horizontal business models, and not vertical ones. They don't enjoy non-linearity. Over-dependence on USA and rupee-dollar parity are also concerns.
In the case of global pharma and auto parts businesses, vertical business models are good. Though they are global, they are not so US-centric.
To the extent that they are well diversified across geographies, the risks are lower. The issue is not whether software businesses will grow or not. That is settled. Debate is needed on valuation and business models.
FAVOURITE SECTOR III:
Capital goods
Many Indian engineering businesses are poised to be major outsourcing hubs. The global opportunity available is large. The business enjoys some inherent advantages: low capital intensity, superior return generating capability, scalability, skill intensive activity and high margins.
What was missing earlier was adequate order book. With that in place, many businesses should continue to surprise pleasantly, if you believe that Indian economy is going to grow at 7 per cent plus.
What about textiles? Does it fit the bill given the huge size of opportunity post-quota?
Textile as an industry will grow. But it has been a guzzler of capital and delivered low return on capital. Most businesses haven't generated adequate cash - forget free cash - even at the operating level.
So, while Indian textile industry will grow due to the huge global opportunity, I am not sure if this growth will translate into better cash flows and rising capital productivity for most players. Sheer growth in the size of a business and the amount of profits earned may not necessarily mean improvement in its value.
THREE BEST PICKS
South India Credit Agency: The company is engaged in logistics business (but has many other unrelated businesses, too) and manages specialised cargo solutions, especially for port-based logistics. It has decent capital productivity in the core business and good cash flows.
Over the last five years, its operating profits have been substantial though its balance-sheet has been impacted due to the high leverage arising from investments in unrelated businesses. Now it is going through a financial restructuring and with lower interest cost, it should be able to post superior profit growth.
Given the growth in domestic and international business activities, its future growth prospects are bright. We have invested from the levels of Rs 25 onwards.
We think topline growth will be modest for the next couple of years, as the company is engaged in consolidating balance-sheet; but bottomline growth will be better. Business growth should accelerate thereafter. It is still modestly valued at about four times historic operating profits.
Visaka Industries
The company runs two businesses - asbestos and textiles. It is run by an efficient management. This, coupled with high operational efficiency, judicious capital allocation, strong capital productivity and attractive growth prospects, makes the business attractive. Currently, it has an asset turn of little less than two but we expect this to improve.
Visaka is growing both of its businesses in a way that it does not compromise on capital efficiency. With the construction and industrial activity growing, asbestos sales should be good. Rising cement prices also favour the asbestos business.
The company is known for its quality products. It sells its specialised yarn in fashion conscious Italian markets and enjoys a dominant share. Visaka's yarn commands a premium over its competitors' products. This is an example of a relatively mid-sized company with a management which is ambitious and has a global view, without losing sight of domestic opportunity.
Last year the company produced a return on equity of around 20 per cent. I expect the company to improve this to over 25 per cent in a year from now. We expect earnings to grow by 30-35 per cent over the next three years.
Bharti Shipyard
Bharti Shipyard is an engineering skill-intensive ship building and repairing business. It enjoys the advantages of a growing capital goods business, without the negatives of cyclicality of shipping activity.
Its strengths are good engineering skills, a sound customer list, efficient delivery and reliability, low capital intensity and high asset turn, and a healthy order-book. It has no net debt.
The company generates good cash flows and return ratios are excellent. Operating margins are strong at around 15 per cent. We have been positive about the company and were the largest participants in the IPO at Rs 62.
