PSUs will disappoint, packaging could be a contra bet, says this leading AIF manager

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Kunal Bhakta, Co-Founder, First Water Capital Fund, thinks PSU stocks may deliver mediocre returns over the next two years as they have run up a lot. In a conversation with Moneycontrol, he explained that while certain defence PSU stocks have large order books, they are not generating enough cash.

With 43.94 percent returns over a three-year period, First Water Capital Fund is India’s (added) second-best alternative investment fund (AIF). It is a category III, long-only AIF. The company manages Rs 700 crore with its offshore and domestic AIF vehicle.

Edited excerpts from the conversation.

Your thoughts on the current IPO scenario?

We’re very unlikely to participate in initial public issues (IPOs). There is a lot of fashion-parading involved in IPOs, where numbers are padded up ahead of the issue to portray a better picture of the business. Miraculously, in a lot of cases, growth of the company tapers post listing for some or the other reason. We are not happy to give an exit to a private equity investor or a promoter doing an offer for sale. Specifically at this time, the IPO markets seem to have a lot of froth and we don’t see much being left on the table for investors like us, who’re not looking for just a listing pop.

It is also unlikely for us to participate in qualified institutional placements (QIPs) or block deals because companies are looking for investors who keep their float passive, and we are active investors. Also, fund managers are offered a lot of incentives, like discounts on the market price, to participate in the lofty growth stories.

Do you feel PSU valuations are expensive?

Valuations are not expensive in and off itself. A considerable amount of re-rating has already played itself out in PSU stocks and the P/B has more than doubled in most cases. Valuations have a tendency to revert to the mean. So from here on, the easy money may be off the table and some moderation in P/B will be seen. This will lead to a more time-wise correction rather than just a price-wise correction. Some PSU stocks may end up with mediocre returns over a 2-year time frame from here on.

So are you scaling down on PSUs?

We are paring down some of our exposure in PSUs. They have run up more than our comfort level. While the initial re-rating was driven by excessive undervaluation, what we are seeing currently is that the rhetoric ‘Modi hai to mumkin hai’ has seen PSU names, especially central government owned-PSUs scaling to unprecedented heights. Some of the PSUs have run way ahead of fundamentals due to the defence theme such as shipbuilding stocks, which we have completely axed from our portfolio.

What are certain red flags in a company?

Companies which don’t have adequate cash flows, which are continuously growing but not generating cash. This is true for certain defence stocks which have larger order books but their working capital is too stretched.

Another red flag is companies whose value is overly attributed to the perception of people at the helm, rather than intrinsic worth of the underlying business. In the past, we have seen that some CEOs have had a rockstar image which led to premium valuations and there was a substantial de-rating when they left; Vishwavir Ahuja of RBL Bank and Ramesh Sobti of IndusInd Bank are cases had a great influence on the extrinsic values of these companies.

The business should have hard assets. We do not invest in new-age companies. If companies say that they have a user base and maybe three years down the line, they will monetize that user base, we are not interested. We will never invest into a Zomato or a Paytm for example. Likewise, we don’t invest in companies which have perennially been overvalued based on the fond hope that they will someday achieve something which they have never achieved. For example, VIP stealing the march from say a Samsonite.

Any contra views?

Packaging. We continue to like packaging over the years and the market hasn’t given its due to is packaging films companies like Uflex and Polyplex. And there was pain in the sector for the last two quarters because oil prices were going up and their margins contracted. Now, milder oil prices are a positive for this sector. Packaging is a proxy for the whole consumption theme. Rather than paying 60-70 times earnings for an FMCG company, we are happy to pay single-digit multiples (adjusted for cyclicality) for packaging firms.

Also, Indian packaging films players have created businesses of truly global scale with manufacturing plants across the globe. Therefore the story is not just domestic but also gaining market share from the higher cost local manufacturers.

Your thoughts on the pipes sector?

Some pipe companies on the PVC side such as Astral and companies on the construction side such as APL Apollo have grown manifold. But 2010-2020 was a lost decade for saw pipe manufacturers like Jindal Saw, Welspun Corp and Man Industrie. They were operating at low levels of utilization and struggling with margins.  But we love situations where companies are at an inflection point. Then the embedded operating leverage will create a very high alpha for investors.

What kind of  inflection point?

One has invested Rs 1,000 crore to create a million tonne capacity, but because the industry is in a slowdown, the company is operating at only 4,00,000 tonnes. Then, when the industry picks up, the company does not have to invest fresh money because it already has a capacity of a million tonnes. This will translate into earnings. I am not happy to invest in a company operating at a high efficiency level and high capacity utilisation, Because if something is doing well, then where is the lever (for further growth)?

What sort of companies do you prefer?

Companies with a potential to invest relatively lesser amounts than a greenfield expansion interests us. Brownfield expansion happens at a fraction of greenfield. If a company sets up a new facility at Rs 1,000 crore, a brownfield will happen at Rs 500 crore because it doesn't invest in land. The company will probably add another building, block, or line.

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