Covid-19 is leading to rapid consolidation across a range of sectors in India, including those in which well-run smallcap companies participate.
While the ability of consistent compounders like Asian Paints, HDFC Bank and Page Industries to consolidate market shares during times of economic distress is well known, the rise of smaller consolidators like GMM Pfaudler (market share: 80-90%), Alkyl Amines (mkt share:50-55%) and Garware Technical Fibres (market share: 60-70%) and DCB Bank (disclaimer: we hold these stocks in our Little Champs Portfolio) has been a revelation over the past six months.
Little Champions surprising us
In business circles, it has long been a cliché to say “When the going gets tough, the tough get going.” Over the past six months, as Covid hammered the Indian economy, the performance of some of the champion franchises in our country has been reassuringly strong. Powerful well-run franchises like Asian Paints, HDFC Bank, Nestle, Titan and Bajaj Finance have all performed way better than their rivals.
The more positive surprise came from far the smaller firms mentioned above. The ability of these small firms – with sub-$ 1 billion market caps – to protect their balance sheets and franchises in the face of a sharp economic downturn suggests management talent is now spreading beyond the well-known consistent compounders and percolating into the better-run small companies.
For example, GMM Pfaudler’s capital allocation in recent years has been almost exemplary. Thanks to strong barriers to entry (around reputation and world class technology), the company has been the preferred supplier of glass lined vessels to the premier Indian pharma and chemical companies. As a result, its pre-tax ROCEs tend to be around 30 per cent, well above its cost of capital. That, in turn, implies that free cash flow generation has not been a problem for this company. In fact, entering this current financial year, the company had net cash of Rs 110 crore. In spite of the sustained entreaties of investment bankers, GMM Pfaudler had carefully cultivated this cash pile over several years. Then, when the Covid crisis created the perfect opportunity to deploy this cash, the management rose to the occasion.
The number 2 player in the market, Die Dietrich, a German company, exited India and GMM stepped into to buy its plant and order book for Rs 53 crore (implied
P/sales multiple on the deal on 1 times). Post this acquisition, GMM has an almost complete hammerlock on an essential B2B product, which is in short supply and where the barriers to entry (around regulation and technology) are very high.
Gradual economic normalisation
Channel checks and recent management commentaries suggest demand recovering quickly across a significant number of smaller firms in India. For example, in the pharma and chemicals sector, our channel checks and recent management commentaries suggest companies in pharma, agrochemicals and personal care segments have witnessed significant normalisation of operations.
Examples of what we have heard from well-run companies in these sectors:
- “We had an order backlog of Rs 350 crore on April 1, which is 40% higher than previous year” – A leading supplier of process equipment to pharma/agro-chem industries (a portfolio company) in 4QFY20 results conference call;
- “In the pharma industry, more and more intermediates that go into the API could be manufactured in India (shift from China). That can give good long-term growth to the industry” – Executive director of a raw material supplier to pharma/agro-chem industry (a portfolio company).
We have received similar inputs from the better run auto ancillary and light industrial manufacturing companies. While it may be still early days, we also hear news flow (from the media as well as from management of credible lenders like Bajaj Finance and HDFC Bank) about more and more MSMEs opting out of the moratorium particularly in the southern part of India.
Similarly, our checks also suggest banks and NBFCs are starting to lend in sectors where they are gaining confidence about the recoverability of the loans – for instance, the tractor segment.
The strange world of Indian smallcaps
If we take a step back from company-specific commentaries and look at the big picture, a very interesting picture emerges regarding Indian smallcaps.
Small firms’ revenues and profits tend to be more volatile than those of larger firms due to dependence on: (a) a single line of business; (b) a small group of people running the show; and (c) limited free float and trading volumes, which accentuate the good or bad impacts of any macro/company specific developments.
Naturally, therefore, investors expect higher returns from smallcaps (relative to larger caps) to compensate for the higher uncertainty involved in smallcap investing.
However, an analysis of the BSE SmallCap Index’s performance over last 14 years shows that it does NOT provide this extra return that investors expect to get for the extra risk they are taking. From September 2005 to December 2019, the index delivered a total return CAGR of 8.9 per cent compared with Nifty’s 13 per cent and BSE500’s 12.5 per cent over the same period (these returns include dividends & buybacks).
These challenges in the broader smallcap space do not mean that there is no money to be made in smallcaps. In fact, there is an enormous amount of money to be made by investing in high quality smallcaps. So how does one identify high quality smallcaps?
We use the following two quantitative frameworks to arrive a shortlist of companies:
- Evaluating the accounting quality of a company needs to be a cornerstone of any investment process in India. We have developed a set of 12 ratios that help to grade companies on their accounting quality. The selection of these ratios has been inspired by Howard Schilit’s legendary book on forensic accounting called Financial Shenanigans. We use this framework to eliminate around half of the small cap universe.
- Our competitive advantage/capital allocation framework uses financial parameters like revenue growth, consistency in gross margin, consistency in interest coverage, improvement in working capital and improvement in fixed assets turnover to rank the companies which clear our forensic framework explained above. We then select companies which score above average on all the above five individual parameters and deliver metrics above our thresholds on latest year RoCE and net debt-equity levels.
This framework has delivered for us: our smallcap portfolio delivered a PBT growth of 1% in FY20 compared with the BSE Smallcap’s median decline of 10-15%, RoCE of 19% (pre-tax) and debt levels at 0.1x of net cash equity in FY20.
(Saurabh Mukherjea is the CIO at Marcellus Investment Managers (www.marcellus.in). His next book, ‘The Victory Project: Six Steps to Peak Potential’, will be published in August by Penguin.)