Rathi says 20% to 30% CAGR can come from two factors: Demand, and operational efficiency.
You are talking about growth companies and one of the growth areas of late has been manufacturing, capital goods, and industrials, which have seen quite a bit of momentum, even electronics manufacturing. Is that a theme that you would still recommend betting on because that is set to be the next decadal theme.
Rahul Rathi: Absolutely. While all these themes will play out, what we like as a theme and what we are playing out is energy. We think that India’s energy basket, capex, has not been done. There are quite a lot of monopolies in the energy sector and especially in renewables and other places, balance sheets are clean. There is a quick return on investment and there is a huge pipeline of orders that there are. So, for us, while we like sectoral themes and we like some of them, what we also have a discipline of is seeing that they fit into the drivers that we want.
There is something of a bottom-up approach, which is much higher than the top-down approach that we have. And the bottom-up approach, all the boxes have to be tick-marked.
How would you value defence, railways, or for that matter, shipyard companies? Everybody is of the view that these are multi-year trends. These are businesses that are backed by the government. For the next 5-10 years, the size of the pond is great.
Rahul Rathi: So, let us go top-down. Think about defence. If you have to put capacity for defence, would you put capacity based on wartime efforts or would you put capacity based on peacetime efforts?I like to draw your attention to what Buffett says are consumer monopolies and moat businesses and every business needs to have a moat around itself. Which are some of the companies or businesses that you think have a general moat around them or a unique advantage? This is one of their favourite questions for every investor.
Rahul Rathi: Any business that has a certain level of distribution is beyond a tipping point has a moat. Because in India, distribution is an extremely expensive affair and you have to throw in a lot of money to build distribution. If you have a distribution that has a certain history, legacy and a certain amount of performance, that is a big moat and you can see it in the numbers.
Any challenges to certain distribution moats will continue to require large amounts of money and if they can buy assets at a certain price, we will see that moat in finance. We look at distribution as a large moat, but even more is a certain capex, that is very important to building the moat.
So, if there is a certain ROCE and we see that reinvestment of that particular ROCE is 20% or 15%, it means that they are not reinvesting in continuing to have a moat or build that moat. We look at reinvestment rates very carefully when we are evaluating moats.
You alluded to the fact that the box has to be ticked when it comes to bottom-up stories and I am wondering where are you finding those stories in this kind of a market.
Rahul Rathi: I am fully invested. There are so many opportunities that are there. India is growing at 6-7% GDP growth and it has a large market cap. There are pockets of underperformance for the last three years and you start seeing that it ticks up all the bottom-up boxes and then you start overlaying a certain environment to it and you will start seeing that yes, it makes sense to look at these companies. There is a structural story and you are getting it at a good valuation. GAIL was something like that. Tech Mahindra is something like that. we picked up when it was around Rs 20, was exactly similar to this. So, look at the bottom-up. It has to tick all the bottom-up boxes and then you start seeing whether there is a runway that you can play. We have a concentrated strategy and it is easy for us to cherry-pick versus be aligned to an index.
Is it a coincidence that you keep on buying all Pune-based companies like Bajaj Finance, Suzlon?
Rahul Rathi: Pune has some great entrepreneurs. The entrepreneurial capability here keeps you always searching for good things. But no, a lot of our returns have come also from non-Pune-based companies. So, while GAIL is not a Pune-based company, Suzlon is, Bajaj is, but the others have not been. And Finolex also is Punr-based.
Where according to you in the next three to five years, in either companies or themes, a 20% CAGR earnings growth could come? Let us look at some ideas. Forget what happens to stock price, that is a function of technical, flows, and macro.
Rahul Rathi: A 20% to 30% CAGR can come from two factors. One is demand, and the second is operational efficiency. Companies’ operational efficiency does not require a demand environment to be good. If you buy companies where you see that the operational efficiency is at its lowest and you start seeing a direction of greater operational efficiencies, you will start seeing a certain amount of earnings CAGR that starts coming up.
So, the first factor is that you look at more than external demand. If you are looking at 20% to 30% and ticking the boxes, you see whether there are internal efficiencies that will drive up a certain operating margin expansion.
Once you know that there is a certain amount of confidence in why there will be an earnings CAGR and after that, if demand gets overlaid, you have a certain multiplier effect that also comes in. So, I think that when I was looking at ticking all the boxes given the interest rate environment today, I was looking at margin expansion as a driver along with volume growth and at a reasonable valuation. I think most of the companies that we have picked up, are seeing operating efficiencies that are internal driving up earnings CAGR or a reasonable part of the earnings CAGR, not all of it.