What makes Karma Cap's Rushabh Sheth bullish on pharma, ports and media?

Surprisingly, the market has been resilient to rising interest rates, unlike in the past…

That’s because our system isn't heavily leveraged. Corporations aren't heavily leveraged, banks are in good financial standing, and the government isn't highly leveraged either. Of course, there are exceptions, like some parts of the retail sector, but broadly speaking, leverage isn't a major concern. So the impact of higher interest rates isn't as pronounced this time. In contrast, during the 2010-2012 cycle it was much more painful as many companies had taken a lot of debt because of the strong capex cycle in 2007-08.

Have you increased the proportion of cash across your portfolios?

We don't take much of a cash call. Of course, we have increased our cash position, not because we are worried about the market but because we booked profits and don't see other interesting opportunities to deploy the cash. If the idea is good, then it does not matter to us even if the market is high. What we are seeing right now is a scarcity of ideas.

Pharma is one of the sectors you have significant exposure to in your portfolios. We have seen a few false dawns in the sector over the last few years. What are the drivers you are betting on?

There are multiple drivers as we see things. As (India’s) per capita income moves up from $2,400 to $5,000, we see a big increase in healthcare spending. Also, the Indian pharma industry is very fragmented, there is ample scope for consolidation. We believe this consolidation trend will persist over the next 3, 4, 5, or even 10 years, like what FMCG experienced a decade or more ago.

Also, capital allocation in the sector has improved over the past five years. Many companies have expanded their presence in the US and other markets through sensible capital allocation strategies. So balance sheets have improved. Take Cipla for instance, a company we own. From a net debt of Rs 3,500 crore five years back, it now has a net cash position of about Rs 6,000 crore.

Other companies we own, such as Alchem and Zydus, have seen similar transformations, though not to the same extent as Cipla. Our investment thesis is simple. These companies are already dominant players in their respective sectors. In the current cycle, mature businesses generate profits in the range of Rs 4,000-5,000 crore, and have substantial market share and healthy margins. While new competition is emerging, these companies have room to grow because the current market share of each of the players is low. Sun Pharma, the number one player in the industry has just an 11-12 percent market share.

What about Indian pharma companies having a poor track record as far as US FDA inspections go? Also, the competitive pressures in the US generic market have abated for now, do you see this trend sustaining?

The issue with the US FDA is faced by pharma companies across the world, not just Indian companies. And competitive pressure is something of a moving target. Anyway, we prefer companies with higher domestic exposure. Our thesis is based on domestic the domestic market, not offshore.

Within communications services, we see that Tata Communications is the top holding in one of your schemes, and Bharti Airtel is the other big bet. What is the broad theme that you are looking to play here?

Connectivity and the connected network are emerging as big trends. And it will grow exponentially because data usage is skyrocketing. Consider a country with 1.4 billion people, where everyone loves to stay connected, whether it's through social media, watching videos, or following sports. This trend is set to continue and expand over many years. Tata Communications is different from other telecom players because of its global focus; as it has clients across Europe, the US, and various parts of the Middle East and the world.

They primarily cater to enterprises (B2B) and are into connected networks for businesses in a big way. Nowadays people work from anywhere, and enterprises need both security and connectivity, especially when many of them have employees scattered across the globe. Also, Tata Communications is deeply involved in the media economy. For instance, the entire Formula 1 operation, from what you watch on TV or online to the real-time communication between cars and their engineering hubs worldwide, runs on the Tata Communications Network. They also handle production for nearly 700 live events, including major global gatherings.

Tata Communications is seen as an enterprise solutions player but their scope is much broader. Connected cars are on the rise, and every vehicle needs round-the-clock connectivity. That is a big market for a player like Tata Communications. So, in both Bharti Airtel and Tata Communications, data is a significant driving force for growth.

You have a sizeable exposure to media. That is a sector that has not delivered good returns in recent times. What do you see changing there?

I believe consolidation tends to occur when viability or challenges arise in an industry. Typically, consolidation happens when the top three players control roughly 75 percent of the market, which is the case right now.

Over the past three to four years, companies cut back on advertising because of COVID and high inflation, to save costs. But to achieve volume growth, companies must invest in advertising and promotions, whether it's on TV, OTT, or digital platforms. The competitive landscape in India is intense, so someone needs to capture the market. But there are limits to how much you can extract from this avenue. The real potential lies in subscriptions.

Our bet is that as disposable income rises, people will be willing to pay for content. Right now, Indian OTT platforms charge anywhere from Rs 500 to Rs 1,100 for a year's subscription while Netflix charges Rs 500 a month.

Here's the thing, what you and I enjoy watching may not be what the rest of the country watches, and vice versa. In my view, subscriptions will be the next major driver of growth in India's media industry. Subscription services are set to explode. Many people are willing to pay even small amounts, say Rs 15-20, for content. With TV subscriptions, you can access top channels for as low as Rs 20 per month.

As the concept of premiumisation catches on, from clothing to cars, people will likely be willing to pay slightly more for premium content. For instance, if companies can get people to pay Rs 50 more, it would result in a big boost to profitability, as most of this revenue flows directly to the bottom line. This shift is happening, albeit gradually.

Ports is not a sector that you find in too many portfolios. In fact, it seems to be one of the unloved sectors, what makes you bullish on it?

Everyone is betting on the growth of India's manufacturing sector. The one critical element there is logistics, and within logistics, the lynchpin is our port infrastructure.

Without efficient ports, manufacturing can't thrive. Manufacturing typically involves adding a percentage of value to raw materials, and to do that effectively, you need the capacity to import materials and export finished products. This is where ports come into play.

In India, particularly on the western seaboard, especially in Gujarat, we've witnessed a game-changer with the Dedicated Freight Corridor (DFC) becoming operational. It has significantly reduced travel time between the interior regions like Dadri, Ludhiana, or Dewas to the ports. Travel time has been slashed by almost two-thirds, going from 80 hours to approximately 25-26 hours. It allows for efficient double stacking and fully electric operations, making it highly efficient.

The DFC, which is expected to be fully operational in less than three years, is a major catalyst for manufacturing. When you combine this with the importance of ports, it becomes a no-brainer. In India, you don't have a wide array of choices for ports. In the private sector, there are primarily Adani and Pipavav, while much of the rest is operated by various government entities.

What's your take on the financial services space, banks in particular?

We're bullish on financials; we see a lot of action in this sector, and we anticipate even more in the future. Bank balance sheets are solid, and growth is on the horizon. It's a terrific scenario for them. However, there's a catch – we're not seeing a substantial influx of larger buyers. Because banks are in such good shape, it means there are plenty of other opportunities opening up in the broader economy. The overall economic picture is rosy, and corporate balance sheets are also robust. We expect other businesses to grow at a faster pace.

The issue with larger financial institutions is that they might not be as agile as we would like them to be. Even the best-performing banks like HDFC Bank or ICICI can't push their return on equity (ROE) much beyond 18-19 percent. Given this, we believe there are better opportunities outside of the banking sector.

What are the filters that you go by when deciding to invest in a business?

We try to identify change, catalysts, and shifts in the business environment. We look for instances where the business is benefiting from external changes or actively driving change within.

As for our criteria for selecting stocks, we typically seek market leadership, or at the very least, a position within the top 3-4 companies in the industry.

Another crucial factor is the management's ability to execute on opportunities. India offers a wide array of opportunities but it's a challenging landscape due to various hurdles. Effective execution and business scaling are key. Sometimes, everything seems great but there might be concerns related to government policies or other issues. Balancing this with execution capability is crucial.

There are always the usual flags like balance sheet, return on capital (RoC), and the rate of change. We assess how they approach long-term capital allocation across different facets of their business. So, it gets progressively detailed from there.

Disclosure: Karma Capital holds shares in TV18 Broadcast, part of the Network18 Media and Investments group.