New-age tech giants need to show pricing power, says Kenneth Andrade

Anointed the midcap mogul by Forbes magazine in 2011, Kenneth Andrade has made a living out of hunting midcap and smallcap stocks that eventually morph into largecaps.

In an interview to Moneycontrol over a video call, the founder and chief investment officer of Old Bridge Capital said new-age technology companies need to exhibit pricing power before they become investible for an investor like him.

“Some of them are really good in terms of what they do and how they've been able to execute so far but I'll give it some time. Actually, I'll give it a long time,” Andrade said.

For Andrade, the new-age tech sector needs to see more consolidation and pricing power.  “Remember, pricing power is the only thing that distinguishes good franchises from bad franchises,” he said. Edited excerpts:

I will start with the tough question first: is this the most difficult investing environment you have seen, given what is happening to different markets?

No, I don’t think so. I think we have had multiple instances like this in the past. It’s difficult right now because it's something that investors haven't encountered for a very long period of time. So I think one just have to look to the past to figure out what happened in phases like this but it's not very difficult. That said, things will remain volatile going ahead.

We are seeing a tectonic shift in policymaking across the world, especially on the monetary policy side. Does it require any adjustment to your portfolio strategy?

Certainly. If I just look into my career history, the biggest barrier to entry used to be the availability of capital. Today, capital is no longer a barrier. I think what will happen is that with interest rates going up capital will be critical. Companies will have to dip into their cash flows to make sure that they are not spending someone else's money or creating losses.

I think a lot of the companies we have invested in have already gone through multiple such cycles with capital and without capital. I'm not saying rising interest rates are good but rising interest rates are something that investors need to get used to.

Some of them are really good in terms of what they do and how they've been able to execute so far but I'll give it some time. Actually, I'll give it a long time.

I will answer it a little differently. Lower interest rates lead to higher price-to-equity (PE) multiples and higher rates cause lower PE multiples. So if you're going to buy it at a price and the cheaper it is, the better it is—your portfolio will not be volatile.

Obviously, you have to be a lot more careful about how much you pay for a great business or a good business.

Midcap and smallcap investing is difficult. Could you shed some light on what is your investment process when it comes to identifying potential bets in this space?

Investing in midcap and smallcap stocks is not very dissimilar to investing in largecaps. I mean if you invested in Tata Steel in 2008 to 2015, you never made money.

When it comes to midcap companies, a lot of midcap companies do grow up to be large. The only thing about all of these companies is that one has to buy the most efficient of the lot when they are small.

We usually buy the largest company in their product category. We check for the efficiency of capital and profitability and we make sure that through multiple cycles they've been able to generate a reasonable amount of cash flow to stay afloat and grow market share. I will pay very close attention to where the business cycle is.

We buy monopolistic businesses in an industry which is consolidating. All businesses have to adhere to certain capital efficiency, that is they don't burn capital to stay in business.

The most important part is that they should not have too much debt on their books because that's a killer track to be on.

A lot has been said about new-age technology companies. We have now seen a substantial decline in their valuations, with some of them becoming midcap companies from largecap companies. Do you see any value in that space?

We still have to get used to the new-age technology companies. Some of them are really good in terms of what they do and how they've been able to execute so far but I'll give it some time. Actually, I'll give it a long time.

One has to go back to what happened in 2008 when real estate companies were the flavour of the market and half of the real estate companies that came with an IPO at the time are no longer there. So for some of these new-age tech companies to be worthwhile, we would need a lot of consolidation in the space.

They need to exhibit an ability to have pricing power. Remember, pricing power is the only thing that distinguishes good franchises from bad franchises.

Remember, pricing power is the only thing that distinguishes good franchises from bad franchises.

These companies have definitely developed a global footprint. So, they will always be on the radar. Our investing format is, as I said, buy them when they have low margins and sell when they have high margins. Now, some of these companies are not able to pass on the inflationary pressures, which means that they have weakened their ability to price the product. Right now we will wait for the second coming of the industry.

Every business that I know of including many consumer-facing businesses are cyclical in nature. Commodities usually go through very long-term cycles and I believe chemicals will also go down that path.

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