Investment mantra | Allow companies to come to you rather than seeking them out, says Utsav Mehta of Edelweiss

Equity investors, both new and old, have had it simple and easy in the last 18 months. An investor, on average, has a 50 percent chance of picking up a NSE500 stock that would go on to beat that index in that financial year (using today’s NSE500 for simplicity).

In FY21, the figure was 56 percent, the second-highest in the last decade. You had a 73 percent chance of picking a stock that went up by at least 50 percent and an unbelievable 40 percent+ chance of picking a stock that doubled in price if bought on March 31, 2020.

Earning these returns perhaps says more about the investor’s mental fortitude to buy in the 2020 dip than of their stock- picking capabilities. Drawing conclusions on the sustainability of returns, investing quality and style is difficult purely on those experiences.

History shows that there will be worse times—times when success ratios will fall below a third. As we progress towards what hopefully is the end of the pandemic phase into judging the economic reality, this may become more apparent.

Three things could lower that success ratio over the next two-three years. One, earnings growth surprises are behind us – NSE500 companies grew earnings at 30 percent+ in FY21, much ahead of expectations in April-May 2020; FY21-23e EPS growth expectations of 27 percent CAGR leaves little room for surprise.

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Utsav Mehta

Fund Manager-Alternative Business|Edelweiss Asset Management Limited

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Two, as valuations increase and hopes of economic revival intensify, a “narrative” for all companies starts to build, resulting in a wider universe of companies to consider.

Third, valuations– the Nifty trading at a PE of 21x is higher than one-year forward multiples of the past of 16x. So how does an investor sift through a wider universe for winners when success ratios are likely to fall?

Picking the winners

Sticking to “quality” and “long-term growth” is easy to espouse but difficult to execute. Moreover, stats suggest a woeful tale for what may be today’s fancied stocks. For instance, Nifty loses 40 percent of its constituents in each decade (Source: Marcellus Inv Adv).

For us at Edelweiss, our proprietary catalyst investment framework comes to the rescue. We have identified five salient themes that enable us to identify companies early in their earnings cycle. Key equity events such as (a) acquisitions by the company; (b) promoter changes through acquisition; (c) major private equity investors buying a meaningful stake in the company and finally (d) promoters buying their own stock through the open market or buybacks form the backbone of our fund. Our experience of identifying winners within these themes has been highly encouraging.

What are the advantages?

For one, it strongly aligns the interests of minority investors with the promoters. Data indicates that many of these events prophesise outperformance. They may indicate potential earnings upcycle in the industry or in the company. They also tend to be more reliable commentaries on fair valuations.

For instance, March-May 2020 saw more than 40 announcements of promoters increasing their share by more than 0.25 percent in their own company. Compare that to March-May in 2021, when valuations have skyrocketed from a year earlier, there were only 10 insider buying instances.

Moreover, it allows us to focus on a much narrower but equally rewarding set of opportunities rather than spreading ourselves thin chasing mythical dragons across more than 500 companies.

In certain M&A and PE deals, earnings milestones are announced with the event thereby allowing investors to track delivery. Finally, and perhaps more pertinently, they also tend to pay off handsomely when identified correctly. While western market-centric research indicates M&A tend to be value destructive, less is spoken of the successful ones.

In India, investors have created sizeable wealth of well-made acquisitions such as UPL-Arysta and TechM-Satyam. Since these acquisitions, both companies delivered 30 percent/ 58 percent CAGR returns over the next three years.

India Inc’s cash balances are higher than ever as of March 2021 and with the magnitude of tech-based disruption, lack of avenues to invest in fixed assets, M&A is likely to accelerate, thus expanding the pool of such opportunities.

Watch your steps

However, investing in catalysts is also fraught with dangers. One can’t blindly follow these. Our internally developed frameworks help us identify potentially successful ones. As we progress through the valuation cycle, the investor’s worries may be no different from the Rime of the Ancient Mariner. “Water, water, everywhere, nor any drop to drink.” Life can be made easier by allowing these companies to come to you rather than seeking them out.

(The author is Fund Manager-Alternative Business of Edelweiss Asset Management Limited.)

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