India’s Best Fund Managers 2021

“We may see two or four multinational, chemical companies emerging out of India”

Kotak Mahindra's Pankaj Tibrewal on the structural shift in specialty chemicals and why portfolio construction should trump stock picking

Faisal Magray

Caution could be Pankaj Tibrewal’s middle name. The Senior Equity Fund Manager at Kotak Mahindra Mutual Fund says they are paranoid about bad balance sheets and run a mile away from companies with corporate governance issues. In the current market, he is betting on a leaner corporate India’s impressive recovery over 2022 and 2023 with specialty chemicals industry and manufacturing taking off, and real estate picking up. From such a conservative fund manager, these seem highly optimistic predictions. He tells Outlook Business why he stands by these views

Is there a feeling, after the pandemic, that market leaders are gaining disproportionate market share and therefore profits, and therefore valuations? What does this mean for mid- and small-cap investing?
One of the themes we have been advocating for the last couple of years, post demonetisation and goods and services tax (GST) rollout, is that big will get bigger. Post-pandemic, it has become clearer that companies with strong balance sheets and cash flows will weather a crisis better. But, the myth is that bigger companies mean only large-caps. We did an interesting exercise, in which we studied companies ranked 101 to 650, according to their market cap. We were surprised that more than 50% of them are market leaders in their respective segments. So, there is a large universe of category leaders in the mid- and small-cap segment across sectors. For example, in the entire home-building segment, except for cement, none of the categories leaders are large-cap. This is true whether it be tiles, plyboards, wires and cables or consumer durables. If you put your money in these category leaders, which are mid- or small-cap, your money would have multiplied quite a bit and outperformed the market.

Most fund managers say they take a bottom-up approach. But with mid- and small-caps, isn’t it difficult to take high-conviction calls on individual companies?
We don’t label any company as large-, mid- or small-cap, but as great, good or gruesome, based on the quality of business and management, and finally based on valuation. Good and great businesses are those which generate a return on capital (RoC) higher than the cost of capital, thus giving a higher return on invested capital for longer periods of time. Secondly, a business needs to have a competitive advantage, such as better distribution or a superior product. Once these two criteria are met, we try to figure out the growth opportunity in the sector. If the company is a large fish in a small pond, it will be limited in how much it can grow.

When we evaluate the management, we rely more on historical data than forward-looking data. A leopard cannot change its spots. In this qualitative check, we interact with the ecosystem in which they operate, such as talking to vendors, customers and ex-employees, and try to understand the culture and intent of the company. Finally, with valuation, we want growth, but at a reasonable price.

We are focused on minimising our mistakes and don’t try to be No.1 in any category; instead, we focus more on consistency. Gruesome businesses, we won’t touch.

Let’s take your last point first, valuation. In your Emerging Equities Fund, barring a couple of names, there are no companies that trade below 30x earnings on a trailing basis. How do you justify these prices? Do valuations guide your exits as well?
You are right that, when you are looking at the trailing P/E, nothing in our portfolio looks cheap. But we are seeing the largest gap in many years between the trailing EPS and forward EPS. The third quarter of this fiscal has been the best quarter in many decades for corporate India. In the broader market, that is of 1,000 companies, in the second quarter, market reported almost Rs.1.7 trillion in profit though the expectation had been somewhere around Rs.900 billion and Rs.1 trillion. Corporate India has come out far stronger than what we all expected during June-July-August. That’s why there is such a chasm between trailing EPS and forward EPS. For next year, market is expecting growth of 25 to 30%. If companies deliver that earnings growth in 2022 and 2023, then the market does not seem too expensive.

Secondly, many of the companies in our portfolio have delivered earnings growth that they have not delivered in the past five to 10 years. That is because post-pandemic these category leaders have actually become stronger and leaner in their cost structure. A lot of them have reset their margins.

As for valuation, I see growth as the horse and valuation as the cart. If the company can deliver higher than market growth, or higher than industry growth, the valuation seldom becomes cheap. I have made errors in the past of selling businesses very early on.

On the selling strategy, I have a few guidelines. One, looking at balance sheet and cash flows gives me an indication whether the company is moving in the right direction. If it is not, we get jittery. Any corporate governance trouble is a red flag for us, it is non-negotiable. I think of myself less as a fund manager and more as a risk manager because, in India, stock picking is overrated and portfolio construction is underrated. Portfolio sizing becomes important. If after a strong performance, a stock becomes a large portion of my portfolio and doesn’t fit my risk matrix, I would like to take money off the table.

You have large exposure to specialty chemicals. How do the growth runway and valuations look now?
Specialty chemicals is still small in India and there is huge, untapped potential. Earlier, India used to be competent in chemical engineering but now we are getting better at chemistry too. Many companies are working with global companies to innovate molecules, as opposed to earlier when they would focus only on low-cost production after a molecule went off-patent. This is a structural shift. In this decade, we may see at least two or four multinational, chemical companies emerging out of India.

What is worrying is that many commodity chemical companies are clubbed together with high-end, specialty chemicals companies. Also, after the five-year run, we do need to consider that valuations are no longer cheap for the sector as a whole.