Better to focus on business as stock price tells us nothing: Saurabh Mukherjea

“If a business is growing conservatively 10x in 10 years, 25% cash flow compounding means 10x growth in 10 years, even if the PE multiple moves a little bit here and there, we are not going to lose sleep. Our focus is on businesses which can do 10x in 10 years in terms of free cash flow compounding,” says Saurabh Mukherjea, Founder & CIO, Marcellus Investment Managers.

The new hot pack at the moment is the metal story. You have added some new stocks but the metal story is missing. Are great franchises not being built, with decarbonisation being the theme around the world? I know the jury is divided when it comes to this story?
Not just in India, but the world over, metals and mining companies find it very difficult to decouple from the global commodity cycle. Typically the share price of these companies has a 70% correlation with the underlying metal prices on the London Metal Exchange. So effectively, when one buys a metals and mining company, one is basically betting on the LME metal price which to my mind is not an area where we in Marcellus have any competitive advantage. How are we supposed to predict metal prices 6 months hence, 12 months hence? We cannot do that and so we cannot take our clients’ money and invest it in these stocks.

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You have spoken a lot about the great franchise of HDFC Bank. But whether in 2021 or early this year, the signs have not been very encouraging. On the other hand, a public sector bank like SBI has outperformed the market and in fact the PSU banks are expected to outperform. Will you be making adjustments in your portfolio?
I have lived in India for 13 years now. I have looked at SBI’s numbers for the last 20 years going back 20 years, I have not seen them deliver a return on equity above their cost of equity in this century. When they do so, we will be happy to have a look because staying with fundamentals, it is difficult to take money from hard working families and invest in a bank which does not deliver return on equity above cost of equity.

On the other hand, let us focus on HDFC Bank. They have gained more market share than the entire private sector banking space plus SBI put together in the last three years. Three years ago, the market share was 7%, today it is 10%. Add up all the private sector banks, add up SBI in the three years they have not got remotely close to HDFC Bank. Asset quality, net NPAs are all in a different league from any other large private sector bank or SBI.

The net interest margins are obviously very good because of their famous CASA franchise. So unless I am very obsessed about short-term movements, I do not see why we in Marcellus or indeed anybody else holding HDFC Bank shares out there after they showed impeccable operating performance quarter after quarter and gained 3% market share in three years. I have not seen any bank gain 3% share in three years anywhere in the world. It is phenomenal.

At this scale to go from 7% to 10% through Covid and through the disruptions that we have had is phenomenal. Just to put it in perspective, Kotak Bank’s market share is 2.5%. That means in the last three years, HDFC Bank has added a bank much larger than Kotak Bank but obviously those who focus on the work in the stock market focus on noise and news flow. We do not do that. We focus on the fundamentals and keep our eye on the ball.

There is nothing wrong in buying good quality businesses but good quality businesses may not be a great stock. There was a time when Unilever went into a 10-yar time wise correction. The company was growing but the stock did nothing. Could that be the story for HDFC Bank because in the last two years, the stock has underperformed in a bull market and last one year’s returns are negative?
People keep citing these theories. Another story I keep getting is that Infosys share price in 2008 was the same it was in 2000. We keep hearing these stories. In the Indian market in the last 20 years, we will struggle to find any company where PAT grows at 20% year after year and the share price does not grow for obvious reasons. If a company is delivering PAT growth of 20% year after year, then every four years basically the company is doubling the business, doubling the PAT and it will be crazy for the stock market not to take heed.

I completely admit that if a great franchise becomes a mediocre franchise, a great franchise underperforms from a business perspective – the PAT stops growing at 20%, the PAT becomes single digit PAT growth – then obviously the share price stagnates. So the point we all have to recognise is from an investment perspective, if we get the quality wrong, if we thought this is a great franchise but actually it is a mediocre franchise, then of course it will underperform. That is the main risk to our style of investing and it is a risk we have to be very vigilant about.

We are generally investing in companies which continue to be producing great results and if the results are mediocre over an extended period, obviously we will underperform and that is the reason I focus on the business rather than focussing on the stock price. The stock price tells us nothing. It is one of the biggest ironies of investing. The stock price has zero information value.

How will LIC IPO change the dynamics for the life insurance sector? You own HDFC Life. This is one sector where you had Covid pain and this is one sector where insurance companies are struggling to increase premiums also?
LIC’s market share losses vis-à-vis the private sector life insurers are a very similar story to say how public sector lenders have lost market share to the private sector lenders. It is a repeat basically of the same paradigm in life insurance. We are seeing a replay of what happened to the public sector banks over the last 20 years but as we are also discussing, SBI remains a formidable lender and therefore by the same token, LIC remains a formidable life insurer.

I am not so sure the LIC IPO will change the operating dynamics in the life insurance industry, the interactions that the manufacturers have with their distribution and with the dealership community and I do not think the public perception of LIC will change. The public perception is that LIC is a sound insurer, a reliable insurer and that perception will sustain very nicely for the years to come. Vis-à-vis HDFC Life growth in embedded value, growth in premiums has been solid and even in January, which was a pretty soft month for other insurers and we were alluding to the fact that recent quarters have been soft for other life insurers. HDFC’s growth in embedded value and in profitability in business has been very steady around the 20% mark.

We have nothing but admiration for the way the operations of the business have been run by Vibha and the broader team at HDFC Life. Amitabh Chaturvedi in his HDFC Life years did a fabulous job. I think Vibha and team have taken it forward, operating metrics are impeccable and to our mind HDFC Life is a class apart in Indian life insurance much like HDFC Bank in the context of private sector banks.

We have seen the third quarter numbers. Inflation is on the rise. There is all this talk of PE compression. Are you still going to bet on the consumer stories?
Again the performance is self explanatory. In the case of Titan – even if you take a two-year CAGR, even if you look through Covid, I think the business is seeing top line and bottom line growing at 25-30%. Remember Titan has grown free cash flows at 30% CAGR for 20 years. It has been a similar case for Pidilite also. Interestingly, the two firms you mentioned have grown free cash flows at 30% CAGR for 20 years and that means, they have grown free cash flows around 150x over the last 20 years. This is just incredible.

I doubt too many companies in the world can claim what Titan and Pidilite can claim that they have grown 150 fold in 20 years. Pidilite operating performance is solid. They are around 20% excluding that position, they are gunning out around 20% growth in operating profitability. Yes, there is input cost pressure on Pidilite but that is again transient. I do not think VAM prices will carry on sustaining at these levels. The input cost pressures are transient, the market share gains, the efficiency improvements are structural. That has really been Pidilite’s story for the last 10-15 years. With consistent improvement in working capital cycles, improvement in operating cash flow driven by underlying efficiency improvements, it is a fitter business than it was 10 years ago and that is what makes us money.

If a business is growing conservatively 10x in 10 years, 25% cash flow compounding means 10x growth in 10 years, even if the PE multiple moves a little bit here and there, we are not going to lose sleep. Our focus is on businesses which can do 10x in 10 years in terms of free cash flow compounding. Let the PE multiples focus on their PE multiples.