Quality at any price?
Client Update - December 2022
“I am not aware of us getting into EV chargers, actually. I really don’t know where you’re getting this information. At this point of time, these are all in the developmental category. We have not come to a stage where we’ll be able to report anything solid. [..] There are no products, no revenues, nothing!”
That was the exasperated CFO of an Indian electric motor company trying to tell the sell-side analysts who were attending his company’s recent quarterly update that, despite their vehement assertions, his business had little to do with Electric Vehicles (EVs). At least, not for the foreseeable future. However, this didn’t deter the brokerages who seemed determined to fit the company into their narrative about the upcoming exponential growth in the EV sector — whether the company’s management agreed with them or not!
In a missive last year, we wrote about the bubble we were witnessing in the initial public offerings (IPOs) in India, where business models that had some sort of comparable peer in the US or China were being touted as the “XYZ of India” (where XYZ was inevitably a massively overvalued, profitless business). That mania has since subsided and we are seeing the detritus float around now. Apparently, in just four of these newly-listed companies, there are around USD 11bn worth of shares that will come out of the IPO lock-in period this month and that is after share prices have fallen 50% from their recent peaks — happy holidays!
We are waiting for the other shoe to drop now, in companies such as the electric motor business mentioned earlier, which has now been bid up to an eye-watering prospective price-to-earnings ratio (PER) of 60x. This is a different type of bubble — in these cases, the business is often a proven one, with a strong track record and high return profiles. The management teams running these kinds of businesses are also of high calibre. In short, these are mostly our kind of companies. Over the last few years, several such stocks in India have been catapulted into the rarefied valuation orbits that are usually only inhabited by the latest SaaS1 wunderkinds (or EV start-ups). A water pipe company, notwithstanding its amazing return on capital employed (ROCE) profile and strong compounding track record, is now valued at an incredible 64x PER. India’s leading adhesives manufacturer, who we have long admired and have been shareholders of in the past, trades on 73x PER. One of the country’s best grocery retailers, one that we were sufficiently impressed with that we made the rare exception of becoming an anchor shareholder five years ago but sold on valuation grounds, has gone up another four-fold since then and now trades at a scarcely believable 90x PER. India’s largest Non-Bank Finance Company (NBFC) is no longer the trusty HDFC Corp, but rather one that trades on an incredible 8x price-to-book (PB). We could go on and on.
As in the case of the IPO bubble, we are staying disciplined. We believe there is substantial downside in these companies if (when?) shareholders head for the exits. The important difference with these “high-quality bubbles” is that we would happily own them on behalf of our clients for the long term after the valuations come back to earth.
But this not to say that we’ve drawn a blank with regards to finding interesting new investments in India. The market is huge (over 5,000 listed stocks) and the watch-list of companies that meet our quality criteria keeps growing (over 200 now). For example, instead of the pipe company that trades on 64x PER, we own one of India’s leading air-conditioner manufacturers. Given the low penetration (only 5% of Indian homes have an air conditioner vs. more than 90% in developed markets like the US2) and its track record of market share gains, we think the opportunity for this company over the next decade is even more compelling. More importantly, its valuations are far more reasonable. The mania that has resulted in the electric motor company (supposed EV beneficiary) trading on 60x PER, has also thrown up opportunities at the other end of the spectrum, e.g. India’s leading engine lubricant company, Castrol India, which has been de-rated significantly because investors are certain that its entire franchise, based on Internal Combustion (“IC”) engines, is ending imminently. However, this is a business that depends on the stock of vehicles rather than sales of new ones. For decades to come, we believe the composition of India’s vehicles will still remain overwhelmingly in favour of the traditional IC type and Castrol’s volumes will likely grow at a steady rate. Meanwhile, the company has already launched a full range of EV fluids and is contemplating forays into EV charging stations — i.e. this is a management team that is likely to transform the company over the long term. For now though, Castrol India seems a bargain — it generates over 200% ROCE, has a net cash balance sheet, grew earnings per share (EPS) at 7% CAGR3 over the past decade, pays a healthy dividend (5% dividend yield) and traded at 11-12x PER when we first invested. There are several such examples in our portfolio and watch-list.
In fact, as noted in our recent letter (Aug 2022), the portfolio has, over the past decade, never looked in better shape as it does now. With portfolio-weighted earnings growth in the range of 18-20% over the coming two years, average ROCE of more than 35% (3-year average) and portfolio PER at 21x, we feel confident about the portfolio’s prospects.
2 IEA, Percentage of households equipped with AC in selected countries, 2018, IEA, Paris https://www.iea.org/data-and-statistics/charts/percentage-ofhouseholds-equiped-with-ac-in-selected-countries-2018, IEA. License: CC BY 4.0
3 Compound annual growth rate
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Source: Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at 30 November 2022 or otherwise noted.
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