When betting on small caps, track capex decisions closely: Arvind Kothari

“More than the business cycles, I keep an eye out for the decisions relating to companies’ capital allocation. If they are off, we would exit the stock even if the business cycle is looking good,” he said.

Edited excerpts:

Q: What were the early days of your venture like?

A: Tough. I had a background of industry research, but to be able to attract clients, you needed to connect that to specific company research. My employees were largely part-timers and students studying for CA and CFA. I initially focussed on 6-7 ideas. Whenever we stumbled upon an interesting company, we would create a note on it. My colleague Gunjan Kabra introduced a structured approach to writing notes about the businesses we were researching. Fortunately for us, most of these companies were not covered by any brokerage firm. Gunjan took some of these notes and compiled them into a blog. These blog posts turned out to be our calling card, as nobody had written about these companies in ages. In fact, they became the only available notes about these companies.

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Q: What was the turning point?

A: Our note on Rain Industries was noticed by Mohnish Pabrai in the US, and he liked the idea. He reached out and we met up. Similarly, our notes on Garware Wall Ropes (now Garware Technical Fibres) and Jamna Auto were noticed by some high-networth individuals who manage their own capital. We were finally in business.

Q: Which are the sectors that you focus on?

A: We mainly look at various manufacturing sectors—whether safety equipment, capital goods, or textile machinery manufacturers, among others.

Q: Are you an engineer by background?

No, and that is one of my regrets in life. An engineering mindset does help get a better understanding of capital goods business. But then, I try to learn through regular interaction with the people in the sector that I am tracking. Also, my family was in the textile business. So I had an idea about equipment as well as the business cycles.

Q: How do you select the analysts in your team?

A: We currently have a team of around 19 analysts, and the majority of them come from business families. Interestingly, none of our analysts have previous experience in a research role. We intentionally avoid this because we want to cultivate a culture that doesn't rely solely on exchanging views with other analysts. Instead, we look for people who are willing to get out in the field and find out things firsthand. They should be prepared to travel extensively, often dedicating 10 to 12 days for this purpose.

Additionally, we regularly visit unlisted companies. This practice remains consistent, particularly with SMEs and MSMEs in South Gujarat. Many of these entities are either suppliers or involved in similar lines of business. Their insights provide valuable context. For instance, when they face supply chain disruptions leading to price hikes, we dig deeper to see if there is a wider opportunity in there.

Q: What process do you follow for identifying investment opportunities?

We look at industries that are emerging out of a downturn. We then dig deeper into how these industries work and try to identify the companies that make essential equipment. When industries are going through tough times, the companies that make equipment for them also struggle. This is because there's already too much equipment available, and not enough is being used. But when an industry starts doing well for a couple of years, the existing equipment gets used up, and new demand appears. That's when the companies we've invested in start getting orders.

So, the equipment makers start doing well with a lag, and that gives us lead time to study them well. And these companies will do well for a while even after the main industry has started to slow down. That is because the orders placed during the boom time will take a while to be executed.

We form deep relationships with the clients who invest in our fund, and because many of them are business people themselves, we get to learn about industries that may not have been on our radar at all.

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Q: Can you give an example of that?

A client of ours is a leading player in their core business, but they are also into construction materials and real estate on the side. They're a significant player in medium-density fibreboard (MDF). During our interactions with them in 2019, we learned that MDF imports were shrinking. Later COVID worsened the situation by affecting supply chains, as did the anti-dumping duties. So local players formed a cartel and raised prices.

We also found that how MDF in India was gaining popularity, especially in metro cities where the entry of global players like IKEA also influenced this shift. Getting to know about the fall in imports was crucial. The major risk factor was the potential return of imports, which eventually happened in 2022 as supply chains normalised. We got to know about that as it was happening, and so were able to exit our positions in time.

Q: But even companies that supply equipment would be going through brutal downcycles? In such a scenario, won’t market start punishing the capital goods suppliers the moment the main industry’s fortunes start to wane?

We've had mixed experiences. Sometimes, the market behaves just like we expect it to, but there are times when it's hard to predict. Take for instance RHI Magnesita. This company is in the refractories business and makes brick linings for steel makers. Brick linings in steel furnaces have to be changed every two to three months.

In the latter half of 2021 and early 2022, steel stocks corrected sharply as earnings peaked. But the RHI stock did well. That’s because while the profits per ton for steel companies dropped, big companies like ArcelorMittal, JSW, and Tata Steel kept investing a lot in making their businesses larger. Even though they were making less money, they still spent a lot on growing.

Even though these companies were making less profit, they didn't stop their plans to get bigger. The government also supported their efforts to grow. This was really important for traditional engineering companies to keep expanding and to make sure there's always enough metal available. Also, RHI Magnesita bought another company in the same field and combined their private businesses with the one that's publicly listed.  This led to a further re-rating of the stock.

Q: But how bad is the downcycle for these companies when it does set in?

A: Our observation is that when an entrepreneur makes flawed capital allocation decisions, cycles can significantly impact their business. However, when a business's quality is strong, the cycle's adverse effects are tempered. For instance, HLE Engineering faced a significant downturn, exacerbated by capital allocation issues. Yet, their business retained a substantial order book. Similar patterns can be observed in companies supplying to the speciality chemical and pharmaceutical sectors, where capex activity persists. In contrast, EBIDTA (earnings before interest taxes, depreciation and amortisation) margins of businesses dealing in refractories tend to have narrow ranges. Unlike other sectors, refractories do not experience the extreme lows of negative EBITDA margins. These large, quality-driven businesses focus on market leadership. While they endure tough cycles, their expansive strategies aid them during prosperous times.

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Do you always bet on the market leader when it comes companies that supply key materials to the main industry?

Not really. Our strategy revolves around comprehending the industry's capex initiatives. By talking to their bankers and understanding their funding plans, we ascertain that orders are indeed on the horizon. However, it's a matter of guesswork where these orders will go. But all companies have more than one supplier. For instance, if Deepak Nitrite has a large capex, it will source glass coatings from both GMM Pfaudler as well as HLE Engineering. This approach reduces risks should one of the suppliers have a shutdown for plant maintenance, or any other issues.

When we invested in HLE Engineering, it had a far lower market share compared to the top player GMM Pfaudler. However I was confident that a certain percentage of orders would flow to HLE, given the management’s negotiation capabilities. The merger with Swiss Glasscoat further enhanced their offerings. While the precise extent of market share gains would vary, my bet was that if HLE just managed to maintain its market share, the capex upcycle could potentially yield substantial gains. In general, we look at the market size, and market share, and then try to figure out how much those can change.

More than the business cycles, I keep an eye out for the decisions relating to capital allocation. If they are off, we will exit the stock even if the business cycle is looking good.

Q: Tell us something about your bad trades

A: There was an Ahmedabad-based dye firm that ventured into food dyes at an inopportune time. And to make matters worse it set up a plant for making intermediate dyes for the food dyes when it would have been cheaper to outsource them. Their production faced delays, and simultaneously, China started dumping similar products. We exited the stock at a loss after having scaled up our positions just a few months earlier. ILFS Transport was another lemon. Despite its international transport business and potential, the company suffered due to severe capital misallocation, further exacerbated by the ILFS crisis. Time Technoplast expanded extensively, primarily in plastics, albeit with a greed-driven approach that overlooked potential financial ramifications. Our investment in Titagarh Wagons resulted in a loss due to a challenging cycle and ill-timed acquisition. While some stocks flourished after our exit, we were early investors, encountering market downturns before the eventual turnaround.

Q: How has your research process evolved over time?

While we don't strictly adhere to a standardised process, our experience has led us to certain practices. Importantly, we've leveraged the network of investing circles that has grown within our country. I have many friends in the industry whose judgement I trust. Since it is not possible to interact with every company that shows up on our radar, these trusted contacts offer valuable insights, having either tracked the sector or met up with the management. This helps us build a comprehensive understanding of various businesses.

Even now, when we collaborate with successful business leaders, we make it a point to understand what makes their businesses tick.

Some of our clients were interested in reducing energy costs through solar projects, so we tried to understand the bidding process for these solar initiatives. We also teamed up with friends and experts in the industry to explore setting up solar plants. In this process, we learned a lot about the entire solar industry, from transformers to specialised cables for different environments.

Through investments and getting involved in various projects, we learned a lot about industries like transformers and the demand for specific types of cables. These experiences, along with time spent with entrepreneurs, have helped us understand businesses and business leaders better. It's given us insights into their decision-making processes, which are quite different from what regular analysts do, focusing mainly on short-term financial results.

Q: Your area of specialisation is small and micro caps, so liquidity would be a challenge whether you are building a position or getting out of one.

Agreed. It takes months to build a decent-sized position in a stock after we have identified it as an investment opportunity. In micro caps, liquidity can completely disappear. However, based on our experience and observations, we have found that when our thesis is proved right, exiting is not a problem

At the same time, losses are part of the game. If we invest in 10 companies, there will be three or four where we go wrong, possibly even more. Ideally, if out of 10, we are wrong in only three or four cases, we consider ourselves fortunate. Even if we do go wrong, we attempt to limit our losses to around 50 percent through timely exits. We are prepared to accept a 50-60 percent capital loss if our decisions turn out to be incorrect.  But if 2-3 stocks do very well, they often make up for the losses in other stocks.

Q: How did your firm survive the meltdown in midcap and small stocks in 2018?

That was undeniably brutal. No matter how much you tried to explain to your clients the need to invest in these times, the problem was apparent. Every quarter, earnings only reinforced the gloomy picture. Management commentary was weak, and liquidity concerns loomed due to issues with IL&FS and DHFL. These circumstances were so dire that even convincing clients to put more money in became an insurmountable task. Furthermore, in such scenarios, your fees typically dried up. This was especially challenging if you managed a large team, as it compelled you to liquidate your portfolio due to insufficient cash reserves to sustain the firm. Selling at valuations when you intended to buy was perhaps the most challenging period in the market. To be candid, it was emotionally draining when I had to sell winning positions solely to keep the business operational. This action went against the fundamental approach, yet it was necessary.

However, some clients stuck with us. These individuals, being seasoned businesspeople, understood market cycles better than we did. Despite being unable to encourage investments across the entire portfolio, we managed to convince them to invest in three to four companies.

There were some promising signs in the December quarter results. However, before long, COVID-19 emerged. This triggered a precarious situation, causing confusion for the following five to six months.

Q: What was the turning point this time?

We gained insights into Borosil Renewables and its links to the glass cycle. We noticed a significant increase in glass prices in China, something that most analysts hadn't really caught on to. This made us realise that sharing this kind of insight with people involved in importing glass and in solar projects could have been really valuable for them. Surprisingly, during a conference call after the 2021 results were out, analysts didn't ask about the glass price increase at all. This made us realise how much of an edge our direct interactions with entrepreneurs give us in understanding various industries.

Yet, the initial two months of the pandemic were equally stressful. Having just convinced clients to commit capital, the emergence of COVID-19 created a dilemma in persuading them to invest more. Many may claim to have invested at the bottom, but to be honest, we couldn't as we were short of funds. The market recovery brought relief. Borosil Renewables played a pivotal role. Its success attracted attention and endorsement from industry insiders, drawing more investments.