Why Shyam Sekhar thinks irrational smallcap valuations may continue, and stays bullish on logistics

Shyam Sekhar, founder of ithought Financial Consulting

It is a case of ‘this-time-it-is-different’ in midcap and smallcap stocks, though not in the positive sense. Unregulated advisors and a trend-chasing mob are fuelling the frenzy, and the situation is completely out of control, says Shyam Sekhar, founder of ithought Financial Consulting, an investment advisory firm managing around Rs 1,400 crore of client assets. There is a fear of missing out (FOMO) among investors, and this could drive valuations even higher for some more time before sanity returns, he said in a telephonic interview to Moneycontrol. Sekhar is bullish on shares of logistic companies, financials and firms that make industrial consumables.

Excerpts from the interview:

We see massive demand for shares of mid-cap and small-cap companies. The frenzy is more pronounced in shares of micro-cap companies. What is your reading of the situation?

It is not new to see money chasing one sector or one theme. We have seen it happen in smallcaps in 2018, we have seen it happen in infra in 2008, we have seen it in pharma and in banking multiple times. What is different this time is that the speed is much faster, the number of people creating the trend is higher and the trend-chasing mob is much bigger now than ever before. And the way in which the trend is fuelled is now out of control. The trend is completely in the hands of the mob. You are not able to regulate it, you are not able to build public opinion and you can only watch. So, I see this more as a helpless market now than ever before.

Could you expand on it a bit more?

Today, people who make others buy stocks are almost entirely an unregulated lot. They are seeding opinions, seeding judgments, then catalysing people, calling them to action, and everything happens in some kind of a parallel opinion universe, which is social media. And, there is no way for the people who receive their opinions to hold the opinion maker, or decision manufacturer accountable. And the liquidity that is available in the system is so high that if you put an opinion, the liquidity chases it instantaneously. It is like a forest fire.

Sebi has ruled that brokers should not associate with these unregulated advisors or the so-called finfluencers. To what extent do you think that will help fix the problem?

It should, to an extent. We will have to wait and see how it plays out and how people try to sidestep the rules. If a broker engages an advertising agency which in turn engages an influencer, will there be a trail? If you layer the engagement, I think the engagement will still be out of the eye of the regulator.

What’s your advice to retail investors who are bent on buying shares of mid-cap and small-cap companies in this market?

The merit of aggressively investing in these two spaces right now is very limited, especially through mutual funds. If you do it directly, you would identify individual companies. You need only four or five companies which the market is not looking at. With effort and some luck, you may spot them. But your prospect of doing it sensibly through the mutual funds is very limited because the mutual funds are constrained by the actual ground reality.

What is the ground reality?

I think that everybody is chasing the trend. And once trend-chasing starts, the number of people who hop on to trends progresses geometrically as the price moves up. I am not seeing any levers to regulate this. How can you stop people from buying something?

I think people are looking at 10-year returns in a space where there can be huge volatility every two or three years. So, you are looking at two convenient time points and measuring returns when people don't even hold their investment for two years. If in two years it goes down 25 percent, all these people investing now will be out. That is a risk.

In other words, you are saying that investors have not really been tested by a harsh market...

I don't wish it happens, but it is inevitable.

How do you see this cycle in the small and mid-cap space playing out? Do you see a 2018 like meltdown at some point?

Things can become very irrational and then the market will suddenly turn. That is my sense. I am not expecting a very rational move in the market from here. Because the primary need of people is not to be left out of this activity. People want to be a part of the action. And the anxiety to be part of the action is unabating. The illiquidity in stocks is becoming more frustrating. Or, scary.

Trading in options contracts has seen an explosive growth after the pandemic, despite an overwhelming majority of traders losing money in derivatives trading. Why is there so much attraction for an instrument in which it is hard to make money?

I think this should be controlled at the point of exchanges, not at the point of intermediaries or investors. The regulator needs to tell the exchanges they cannot incentivise derivative trading. The entire derivative trading income of a brokerage should come from the investor only. There should be no conflict of interest between the exchange as a platform and the exchange as a regulator. You control only two people (exchanges), and you can control the whole system. Yet there appears to be limited will to control those two people. So the platforms are heavily incentivised to grow the tribe of retail speculators.

Passive investing (index funds, exchange traded funds) has caught on in a big way. You are seeing a lot of index reshuffles frequently as well. Your thoughts?

The number of changes in them (indices) is only going to increase the volatility further. See, they make changes, something (stock) goes out, something comes in. So, there will be very high volatility in the shares which go out and shares which come in. Whenever there is a change, periodically there will be these phases, and bouts of volatility.

Are you a believer in passive investing?

I think passive investing is a way of investing which suited the west (western markets). Not in a country like India where you have so much divergence in corporate governance. The corporate governance standards has hardly reached even a semblance of uniformity within the Nifty. What do you think will be the divergence, let's say, in a microcap 250 index? It makes no sense to mindlessly copy what is working in the West. In India, a good investment opportunity is like a oasis. So, packing yourself with too many investments is not the solution.

But corporate governance standards have improved significantly over time, haven’t they?

True, we have much higher standards of corporate governance than say in the 90’s. Disclosure has improved on one side, but on the other side, I think annual reports have become unreadable. Earlier, annual reports were far more readable, they gave data in a way which even a non-financial expert could read. Right. I'm not seeing it in today's annual reports.

What needs to be done there? What should a good annual report be like?

I don't know. In the name of creating more disclosure and transparency, they are only obfuscating what could simply be understood. And I think this has got to do with the institute that sets the accounting standards. See, it's become very, very technical and far more complex today.

You think there is an excess of disclosures today?

No, no. There is a deficit of what should be disclosed and excess of what need not necessarily be disclosed.

Tell us something about your own experiences as an investor in small-caps. How has it evolved over time?  

When I started investing in 1990, the standards of corporate governance were very, very low, so you could be cheated. One needed to be extremely vigilant. In fact, you were schooled to reject more businesses than to accept. It was a reject-99-select-one kind of game. That was important purely to survive. Because if I chose wrong, I would lose my capital and have to leave the market. The scenario has changed a lot now. Actually, it's not 99-1, but it is still probably 90-10. That’s why I feel if you start investing in very large baskets, you will inevitably land in avoidable companies by virtue of their being present in the basket.

What were your mistakes in the initial phase of your career?

I would think that I made more decisions than I needed to. So, if I had 25 decisions, I would have five outstanding decisions, 15 mediocre decisions and five bad decisions. Had I focussed only the really good ideas, then I think my investing would have been much better. And it was very easy to get trapped in bad decisions in those days. Even today, it is quite easy to get trapped in a bad decision once in a while.

What are the filters you use when trying to identify a company for investment?

Visibility of growth, predictability of cash flows, impact of leverage, stability of margins, and visibility of future business potential. That is, whether they are going to create capacity, whether they have enough capacity, when the capacity will get utilised, when they would need to create fresh capacity, such things form my regular check list.

I guess you would then be looking at a reasonable track record. Does that automatically exclude a lot of businesses that have not been around for long enough?

No, it does not. We now start studying companies as soon as they come in. We look for peers in that industry to benchmark or we go and look for global peers. For example, to understand a cold chain logistic company, I have to go abroad. I have to go to US and understand that business.

Have you done that?

Yes. We understood how the large companies in the US grew over the last 15-20 years.

But you said India is slightly different in many ways. So, will those industry dynamics be applicable here?

But we are building the same downstream industries that use these businesses. There is no difference. You are using the same format, the same QSR, the same conditions for storing medicines, the same systems to sell ice cream, the same principles to grow dairy supply chain. You are mostly using what is in the West. Right. Except we eat more fresh meat than processed meat. That could well change in the future.

What are the businesses in your focus now?

I like most of the businesses that benefit from financialisation. So, I like companies which are going to participate in this financialisation by making the lives of people better. It could be an AMC, it could be an insurance company, it could be a wallet, something that is extending from being a wallet to being a solution provider. It could be a lender. It could be many things, actually.

Insurance would typically fall in the large-cap category, right? So are you agnostic to market capitalisation?

I do not think capitalisation of a company will matter if you are going to have a 20-year runway. Right. So, today you can have a Rs 10,000-crore company which you will buy now and it can become Rs 2 lakh crore after 20 years.

Which other businesses do you like?

I like a lot of consumption-oriented industries in digital commerce and e-commerce. I like logistics as a business. I like industrial consumables as a business, as a category I think industrial growth will definitely be good and industrial consumables is a segment in which you do not see too much change in players over time.

What makes you bullish on logistics?

In a fast-growing economy, efficiency is the source of profits. Today, if you are able to move goods from one place to another at a much faster pace, it creates so much efficiency, your lead time is shorter, your inventory is shorter, your cycle time is shorter, it all translates into money. And any industry which is going to bring this transformation to so many other industries has to be a good industry to bet upon. It becomes a very, very central part of the economic transformation.

But logistic shares have not done well over the last couple of years? What can change?

The industry will have to get more organized. In logistics, I am seeing the unorganised to organised shift just starting to play out. The industry should become more and more formalized in this decade. So the real impact will be seen only after the formalization reaches a certain advanced stage.

You mentioned industrial consumables, what exactly are they?

Industries like cement, steel, then you have engineering which all extensively use consumables on a continuous basis. These consumables have to be bought in high volumes, they have to be replenished continuously. So, the economies of scale in the consumables industry will go up significantly over the next decade.

Typically, how long does it take for you to build a position in a stock you are convinced about?

I can take anywhere between 3 months and 6 months when I do it fast and much longer when I do it slowly. Sometimes even 2 to 3 years. It is a function of my conviction and supply in the stock.

What is one thing you feel all newcomers to investing must follow?

One must read the management discussions of all the companies. Then one must read the management discussions of companies which are global players in that industry. You must have benchmarking without which, it is very difficult to identify an opportunity. And the size of the opportunity can be estimated only if you have some solid benchmarks.

Your broad outlook on the market, considering general elections are less than a year away.

I think it is going to be a choppy phase. The situation will deteriorate a little bit before it improves. Probably the next monsoon is what holds the cue. In the interim period, we could see volatility.

What about interest rates, do you see them rising further?

If they (government) are not able to control inflation, then interest rates will have to be raised. But we can never predict inflation. We never saw it coming in in 2011-12. Similarly, in 2018, we were fearful that inflation would get out of control, but it kind of managed to hold up better than what we expected.