If you remove the top 100 companies of India, there are 4,900 companies that can form your mid- and small-cap universe. The universe may be large, but in the last 20 years, only 5% of the small caps became large caps and only 9% of mid caps became large caps. So, the mortality rate is extremely high. That is why you need a solid process in place when investing in small- and mid-cap stocks.
Management
In India, more than the business, what is most important is management.
When we identify a company, we always go to the local chartered accountants. The kind of information you can get from the local CA about the lifestyle of the promoter, and if there is anything hanky-panky is very crucial. Because the promoter’s lifestyle is not isolated from the company's balance sheet and cash flow. It's important to know if the promoter is leveraged in a personal capacity or not.
This is becoming an important issue in India. The first and second generation are retiring and passing the baton to the next generation. I think it's most important for all of us not to interact with the first and second generation. They have done whatever they wanted to. Look at the generation that has been born with a silver spoon in their mouths, and drive BMWs. Do they have the same integrity and passion to take the business to the next level?
I think in the next five years, my sense is that a lot of new wealth creators will be created, and the old wealth creators probably be on their way down. And I think, again, it comes down to identifying the right set of people who are running the show.
One of the reasons why companies in India don't mature or fail is because they are driven by individual promoters and moneylenders. And they can't think big, they can't delegate. Hence, beyond a scale, they struggle to grow. If you can identify that mindset over a period of time, it will help you identify whether to hold on or let go.
Once you get a market cap of Rs 5,000 crores or 15,000 crores, there will be various advisors surrounding you, telling you what the flavour of the town is and what business to get into. The focus here is very important. The moment you lose your focus, you have lost the plot. There are many groups also who have successfully diversified, but the examples are very few.
Ecosystem
The ecosystem matters a lot. What do the suppliers have to say? What do the employees have to say? What do ex-employees have to say? A tiger doesn’t change its stripes. If the past is not good, if the intentions are not good, you'll see it coming in the future. Trust is very, very important if you are going to be a long-term shareholder, as liquidity is very low.
Balance Sheet
Top line is vanity, bottom line is sanity, cash in bank is reality.
A lot of mistakes have been avoided by following cash flows and balance sheet rather than P&L. The P&L can lie, but cashflows or balance sheets don't. If you track the company over long periods, you will understand the psyche of that company, whether it's a cash-flow or top-line driven.
Growth
Does the company understand the incremental return on capital change? A lot of people chase growth just for the growth. Very few promoters in the mid and small cap space realize that growth at any cost is not good. Once you understand that return on capital has to be 17%, 18%, 19%, or your first improvement should be return on capital rather than chasing growth, I think you are on a solid footing.
Valuations
Valuations are very, very important. We have seen that companies which were trading at crazy valuations in the year 2000, even after two decades, if you look at their CAGR, they are underperforming the NIFTY. Growth is the horse and valuation is the cart. Keep a close eye on the growth assumptions over a period of time.
The biggest mistakes for me have been errors of omission, even more than errors of commission. In error of commission, 90% of the time the stock goes down, but in error of omission, the stock can multiply 10x, 20x, 30x, and that actually hits you and pinches you a lot. My mistake was looking at headline valuations and assuming that it’s done, but the growth kept on surprising, and the valuation remained elevated for many, many years to come. Growth is the horse, valuation is the cart, not the other way round. We always make a mistake of looking at the valuation first, growth second.
Patience
A look at all of the above and the opportunity of the business will tell you whether or not to invest. Once you do so, be prepared for the long haul. There are phases of growth. You need to sit down with the company or hold it patiently for a longer period. And I think rewards come in a very short period of time. A lot of stocks which have multiplied 25x, 30x, didn't do anything for 2-3 years. People got tired and sold those. Those who didn't sell really benefitted when the company emerged stronger and just killed it in terms of market share over longer periods of time.
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All the above views were shared during the Morningstar Investment Conference India, September 2022
