Higher valuation of mid-caps result of higher cash generation and return ratio post-covid: Sage One’s Samit Vartak

The biggest change now has been that the cash flow from operations growth has been about 16 percent, almost double what earnings growth has been. The balance sheet is probably the best that you have seen, not only at the overall level but especially in the small and midcap space. The debt to equity ratio, if you net off the cash that's on the balance sheet, is probably close to 0.1x or 0.15X which we’ve never seen earlier. The ROE and ROCE of the small-cap space today are as good as that of the large-cap. Those are the big changes which have happened. And out of those last nine years, the initial six to seven years were spent cleaning up the system. A lot of reforms were implemented, such as GST, tax cuts, PLI, labour reforms etc. But reforms take time to show results. Because of that, there was a slowdown in earnings. Plus, Covid took away a lot of momentum. But, there has been huge capex from the government side. Even if you look at the growth pre-Covid, a three to four-year average, was almost 16 percent, which is pretty high. During Covid, it did slow down. In short, fundamentals look better but valuations are a concern. Valuation is the reason we would get short-term shockers, like what happened last week. To get a valuation correction, a 10 -15 percent kind of cool-down helps the market to weed out the excesses. That's what's happening now.

Also read: Look for pockets where earnings are depressed to find value buys: Sage One’s Samit Vartak

What are the underlying factors that have changed the complexion of the mid and small-cap space? 

One definitely is capital deployment. Earlier, getting project finance was easier and people did that by following “not-so-good practices”. That is not happening now; money is not going into large projects now. Secondly, before Covid, a lot of companies were always hesitant to reduce their payment terms.

For example, building material companies would always give 30 to 60 days’ credit period to the distributors. But when Covid hit, things got so desperate that people were just trying to survive, and they wanted to protect whatever cash they had. That forced them to reduce their risks. I know so many building material companies who said, we will not supply any new material unless the previous cash is paid off. And that happened across many industries. Post-Covid, that was the highest amount of cash collection that the companies did.

I thought in a few quarters companies would go back to the previous normal, and extend higher credit terms, but it hasn't happened. It's been almost three years, and companies have been very disciplined and that is the reason the RoE and ROCE are high. It's not just supported by the P&L profits, but also cash flows; growth in cash flow from operations has been significantly higher. The CFO to PAT ratio has also improved significantly. From the lows, it has almost doubled. So these things, have sustained for three years. In other words, these changes are getting into the culture of companies, and hopefully, they will last.

You said that ROEs are now increasing. Is this because of a fundamental change in our credit dispersal system because banks are now wary?

Yes, it is. As I said, seven to eight years back, that's the reason we had the huge banking crisis, which actually ended up resulting in 2017- 2019 banking crisis. At that time, gross non-performing assets were just building up due to poor lending practices. These practices have significantly reduced, and that's why the easy money, which companies used to get is history, and I don't think it's going to come back. And that's why the companies have become much more frugal now.

If you see the recent capex that companies have announced, it is happening through internal accruals because a lot of companies who are doing capex have reasonably good ROC, ROCE, closer to 20 percent. If you make that kind of money, generally that should be good enough to create growth through capex, or growing through expanding capacity by 18 to 20 percent. So, leverage is really not required. And that's what I'm seeing across many companies.

As I said, as companies become more frugal, ROE and ROCE are going to go up, and this is not temporary. The management's attitude has changed, so markets are starting to value such companies differently. I think any company that has a better return on incremental investments does get a way better valuation than companies whose incremental return on capital is poorer than their existing return on capital.

How do you differentiate between good and bad stocks?

In a good market, many companies do exceedingly well. If you're analysing any company within that industry, weed away the ones that, during bad times, see their margin profile and ROE and ROCE profile really deteriorate. Focus on the ones that are really good or do relatively much better during the bad times. Secondly, cash flow is the king. I know a lot of people who like to focus on free cash flow, which is also important, but in a high-growth company or economy, you will not see much free cash flow, because a lot of that gets reinvested back. Look at cash flow from operations because that is independent of the investment. You don't want that cash flow from operations to be inferior or reduced when the net profit is improving. Thirdly, especially in a good economy, everyone is going for capex and there is a lot of money flowing into companies. So, there is easy availability of money, at least from the equity markets. Look at increment. Whatever the new capex they're going for, or the recent capex that they have done, look at what's been the return on equity or return on capital on that incremental part. For example, you don't want a company that is generating 35 percent ROCE going for a project that is 20 percent ROC.

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There are a lot of other things that you can always look for, such as, whether they are growing business by loosening their credit terms. You don't want the working capital days to be ballooning, as they are growing, because that itself will have an impact on the cash flow from operations. These are important things you need to look for beyond just looking at the EPS growth.

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