Noisy promoters, information overload make spotting mid, small cap winners tough: Jatin Khemani

In conversation with Moneycontrol, Khemani talks about his investment strategies, how they have evolved over the years, and why spotting opportunities in mid and small cap stocks have become more difficult now though the amount of information available publicly is much more today.

There is a lot of interest in small and midcap companies all of a sudden. You have been investing in this space for over a decade now. The current crop of investors could do with some perspective on how things have changed over the years and what they need to be mindful of. Tell us about the early days when mid and small caps were still unknown commodities.

We have mostly looked at interesting small and midcaps because it's very difficult to make money from large caps. In 2014-15, when I first started in this space, it was quite tough because there were hardly any investor presentations or conference calls, and annual reports were sketchy. Also, with debt-free companies, there was not even a credit rating report to rely on. So I would try to attend as many Annual General Meetings (AGMs) as possible. I have to thank my mentors for this training. I bought one share in many companies and then travelled across cities to attend the AGMs. Often I was the only person in the AGM. The starting point itself is great, because the management takes you seriously; they know you have taken the effort to travel all the way. It helps even more if you ask the right kind of questions.

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What was the earliest bet, either a stock, or a theme that paid off handsomely for you?

Back in 2014-15, I was focused a lot on consumer focused companies, FMCG. And the reason was very simple, because they were easier to understand and research. I would extensively spend time on high streets in malls, in expos, and talk to dealers and distributors, retail outlets, suppliers, and I would get a lot of insight as a consumer, as a layman, just by doing this simple scuttlebutt process. That’s how I identified companies like Amrutanjan, Tasty Bite. Essentially, I was looking at sectors still dominated by unorganised players—mom and pop outfits, small manufacturing outfits—these sectors had very few organised players with the advantage of brand, economies of scale, distribution, efficiency, and a good balance sheet. I focussed on opportunities like Titan, Apollo APL in steel, Relaxo, Thyrocare, Page Industries.

Things changed after demonetisation, GST happened. Organised players were able to gain market and grow much faster as the smaller players struggled. Suddenly everybody wanted to own these companies.

That would have also made these stocks very expensive and over researched. Did that lead to a change in your investment strategy?

Yes, because I realised that there was too much competition for researching FMCG companies and if it was easy for me, it would be easy for everybody else too. So we majorly shifted from FMCG to FMIG, Fast Moving Industrial Goods. These were consumables, essential consumables used in industries like steel, cement, glass, infra. And while we were bullish on the user industries, they came with a lot of volatility in terms of earnings, in terms of carrying a very leveraged balance sheet, and associated risks. So, we did not want to get directly exposed to those risks and chose to have proxies to play those industries.

Like which ones?

So we got into a company called Gujarat Ambuja Exports. It makes starch and derivatives from maize, and supplies to pharma, textile, paper, and FMCG. So their products would constitute just 1-2 percent of the cost of the overall product. But the quality is very critical for the end consumer, because these are B2B businesses. So we realised there are parts in the value chain, which are very small, but they add a lot of value, and they have some pricing power.

That's how we stumbled onto another company, RHI Magnesita, which makes refractory products for steel companies. Refractories are only 1-2 percent of the cost in steel making. Even in a bad steel cycle of 2015-2017, when steel firms were making losses, this company continued to grow, reported a 40-50 percent ROE, and was debt-free.

Similarly, we invested in a company called Sanghvi Movers, India's largest and globally the sixth largest crane rental company. Whenever you have to put up large infra projects, you need a crane. And it doesn't make sense to buy a crane just for a project. So everybody relies on crane rental companies, and it's a fixed cost business. In a good cycle, when your utilisations go up, you make tonnes of money. Usha Martin is one stock which we bought three years ago. It's a classic FMIG special situation we got invested in. The company was on the brink of bankruptcy after taking on too much debt. It turned out to be a seven bagger for us.

What are the filters you use while deciding on the companies to invest in?

It works on the rule of elimination. We don't know what will work, but know better what will not work. Of what remains, we dig deeper. And our elimination is very wide. So we're actually able to eliminate 90-95 percent of the companies. There are certain sectors we don't touch at all, like tobacco, liquor, gambling.

We completely avoid balance sheets which are overly leveraged either through term debt or through elongated working capital cycles. We completely avoid IPOs as we believe they are a seller’s market. Also, promoter groups and companies with either governance or capital misallocation issues. We like to invest in high quality businesses in sectors growing faster than GDP and gaining market share.

The last category in particular, would be on everybody’s radar. You wouldn’t get those stocks cheap. So how do you make money on such bets?

That is true. In such cases we wait patiently for a market crash or for when these companies are facing trouble. And once in a while you do get an opportunity. For instance, Divi’s had a plant approval issue, Maruti had a strike etc.

The other basket with alpha opportunities is mean reversion plays. For instance, Mrs Bector’s Food. It was expensive at the time of its IPO, profit margins were fat. Next year, the margins crashed, and the stock halved. We bought it on the hunch that margins would recover. That’s because one of its key rivals, Britannia was focussed on margins and not market share. That allowed a smaller player like Mrs Bector’s to regain its footing. Had Britannia been focussed on market share at any cost, Mrs Bector’s would never have been able to make money.

We look for businesses which have incurred a lot of fixed costs, but the utilisation is low. As utilisation improves, the money flows directly into the bottomline. We played the whole Wonderla Holidays cycle this way.

You mentioned asking the right kind of questions to management, give us some examples.

To understand not what's happening this year or next quarter, but to focus on the core parts of the business, like what drives value? How do they add value to their customers? What are they doing differently? How do they intend to maintain that? Are they investing in capex? Are they investing in R&D? How hungry are they for market share? Are they innovating? And how's the management’s bandwidth? I mostly like family run businesses, first generation entrepreneurs. So the questions are also around how the second generation is, the second line of management is. Then about their focus on quality, through questions about rejections, if they have lost any customers over the years. What has been the churn, talking to employees, finding how old are they in the system? What are they saying about the company, about other competitors they've worked with before joining this company. So, a lot of qualitative inputs go into forming an opinion about the quality of the company, and not being too focused on just numbers.

So, you would say the qualitative aspects matter more than the quantitative?

Both go hand in hand. Of course, numbers are important. The gross margin itself gives a good idea about the kind of value addition a company is doing in converting its raw material to finished goods. The working capital will tell you what kind of bargaining power it has with its suppliers and customers. Numbers reveal a lot. But to know why they are the way they are, interacting with them helps a lot.

But how do you know that the management is being honest? They would try to put their best foot forward, wouldn’t they?

Valid point. Back then, most of these companies did not even ever publish an investor presentation. And they were not really after market capitalisation, they were holding AGMs in a remote area, sometimes at their plants; not in some city where they could attract shareholders. They were low profile promoters just going about their business. But yes, you do come across a lot of promoters who talk fancy narratives. It is only when you track them over the subsequent quarters or even a couple of years that you can see if they deliver on their talk. You can’t immediately find out if a promoter is genuine or not.

It must have gotten even tougher now, given that every small and mid-sized company is trying to project itself as world class firms.

Oh yes. Now you almost have a situation where everyone is trying to sweet-talk investors into investing in their companies. At present, some 600-700 companies do conference calls. Thousand plus companies come out with investor presentations, you have fancy investor relation firms writing annual reports and investor presentations for them. They write precisely the things that investors want to hear. There is information overload, and lots of noise. The other issue now is AGMs are happening in online mode. So now you can't notice the body language, you can't meet the management in person, it is difficult to ask questions because managements can now avoid uncomfortable questions by choosing who can ask questions.

Even after the best of research and efforts, some ideas don’t play out the way you had expected them to. Tell us something about your disappointments.

The mean reversion bet on Goodricke India did not play out. Unorganised tea growers continued to gain market share as their operating costs were lower. Organised players like Goodricke were bound by the Plantations Labour Act, and that kept their staff costs high. We invested in GE Power as the government’s rule making flue gas desulphurisation (FGD) process compulsory for fossil fuel plants would benefit the company which was a leader in that technology. We thought the Indian arm would be immune to the problems its parent was facing globally.

That was not to be. We lost out on Alkyl Amines because we researched it for too long and also because of anchoring bias. Once the price took off, we could not bring ourselves to buy the stock, having seen it at much lower levels. Then there was a building products company, where we took a bet on its capex plan. But the company returned the land it had been allotted by the government, and started looking for another piece of land. We lost patience and sold at a steep loss.

Later we realised the promoter was not happy with the Vaastu of the original land. To add insult to injury, the stock went on to become a multi bagger after we sold it.