Saurabh Mukherjea: Invest in recreation, but don’t get caught up in low-quality small caps: Saurabh Mukherjea

People should be careful when investing in quality. Invest in recovery, but don’t get caught up in low-quality small caps, broken balance sheet finances, or broken balance sheet companies in the power, infrastructure and real estate sectors Saurabh Mukherjea, Founder, Marcellus Investment Manager.

It turns out to be quite a standout market after the Monday slide. How do you view the situation with the new strain of Covid in the UK and the many global problems? It seems like the Indian markets aren’t getting too much attention?
We need to realize that vaccinations around the world will take a long time. I have spoken to my friends and relatives in the UK but it’s moving very slowly and it doesn’t look like we’ll be through with all of this effort to vaccinate the world in the next 12 months. It will likely take the majority of two years and we will be prepared for the momentum of two steps forward and one step back. This time it’s in the UK, so maybe next time we wouldn’t be so lucky!

In this context of two steps forward and one step back, it makes sense to invest in companies that will benefit in the early stages of this economic recovery. You have been very emphatic since March that we are at the beginning of an economic recovery. The recovery of the Indian economy is being driven by cheap money and cheap oil that we both have. We are in the early stages of recovery, but because of this two step forward and backward momentum, people should be careful about investing in quality, and definitely play the high quality financials, good auto companies are playing to benefit from the recovery , but don’t get caught up in poor quality smallcaps, broken balance sheet finances, or broken balance sheet companies in the power, infrastructure, and real estate sectors.

What is the pecking order for the IT shopping cart and your stance on its future?
Over the past 20 years, the leading Indian IT companies, particularly TCS and Infosys and, to a lesser extent, HCL Tech and Wipro – the four largest Indian IT companies – have shown themselves to be very capable and adept at changing their businesses accordingly changing needs of western customers. When the infrastructure management was going well, HCL Tech made a lot of money from it. After moving into a world of remote working and the cloud, it is relatively clear that Indian companies have adapted very well to Covid and the world of cloud computing.

The four largest companies have proven to be very adaptable. Obviously, western technology trends are changing and therefore one should be careful about narrowing the market cap spectrum. In the past we have long been investors in TCS in several of our portfolios and our trust in TCS remains. Like everyone else, we recently got the bumper number from Accenture. It’s noteworthy how strong the Accenture numbers are, and we hope TCS will do some of that business too.

Don’t get carried away and run through the market cap spectrum and start investing in monoline IT services companies. Stay with the giants, stay with TCS. Over the past 20 to 30 years, the company has proven to be a scale gorilla in Indian IT. It is almost as big as the number two and three companies in India combined. At 30% ROC, almost the entire pack was paid out as dividends. What to complain about when it comes to delivering scalability, profits, dividends and growth?

Is it the right time to revisit some of these consumer games?
Let’s break down the consumer games into staples – classic FMCG stocks like Nestle, which has long been Marcellus’ favorite. Depending on your taste, you would put an Asian color and a pidilite in the same basket of classic compounding companies whose products are part of everyday life in our country and whose point of view has long been very simple. These are dominant franchise companies that have very little practical competition on the daily market level and therefore achieve a very high return on investment, which gives them a high free cash flow that they reinvest and steadily put together 20% over long periods of time.

The more exciting piece about consumption that will start your pulse racing is when the business cycle accelerates. In my view, Auto does very well in the first three, four, five years of an economic recovery. We are in this phase, so it makes sense to have frontline auto stocks like Maruti Suzuki and Eicher Motors part of our portfolio.

The next part of consumption is discretionary consumption and the ecosystem that builds on it. So tiles and sanitary ware and laminates and so on. We tried to work a lot and find good companies in this area. So far, Astral Poly is the only one we have been able to build trust with. This company can give us a multi-year compounding if we are in a three to four year economic recovery. So Astral Poly is our main game. I see Asian Paints and Pidilite as FMCG – very reliable, very stable compounders.

So if you split the consumption up between those constant staples and more exciting consumption games, we’ve committed the auto piece, which we loaded pretty well from March, April and June, to the car because I think at least the next two, three, four Years. The building materials room, where more work has been done so far, was Astral Poly our main investment.

Would you add to your shopping cart when it comes to pharmaceutical and health names?
There are several good pharmaceutical companies in our country, and I have been a great admirer of Cipla for a long time. I never bought the stock, but you can only admire what Yusuf Hamied and his family have done for the Indian pharmaceutical industry. It’s a remarkable company. However, one challenge with classic Indian pharmaceutical stocks like Cipla, Lupine, and even Sun Pharma is that there are so many moving parts that it is difficult for people like us from the outside to understand exactly where the competitive advantage lies.

In this regard, we realized a few years ago that there are two other pharmaceutical companies that are making it a lot easier for us to understand the demand dynamics. One is Divi’s lab. I’ve discussed it extensively on your channel over the past few years. Divi’s is the world’s largest manufacturer and we’ve worked a lot on who exactly Divi’s customers are. We estimate that the six largest pharmaceutical companies in the world generate 80%, maybe even 90% of Divi’s profits.

This is how you can see the monopoly and the base. You can understand the business and commit to making a long-term investment like you did at Divi’s. The other pharmaceutical company where we got a very good understanding of the business and were able to add significant parts to our portfolio is Abbott Labs. In some ways it resembles Nestle. They sell important products like Vertin, Thyronorm and Cremaffin to the Indian public.

If you look at these categories and speak to general practitioners in Mumbai, Delhi, Bangalore, they will tell you that it is very difficult for a general practitioner to consider why they should recommend Thyronorm or Vertin as a competitor. These are high quality drugs that generate high free cash flow for Abbott. We can’t really see a lot of competition and that’s why we bought Abbott.

Aside from these two, we find that most other pharmaceutical names are speculative in nature, with too many moving parts and very large regulatory uncertainty. I would like to say that we would build a larger pharma portfolio beyond these two, but we tried to build a belief beyond these two. We also have names in our small and midcap portfolios such as Alkyl Amines and GMM Pfaudler that feed into the ecosystem and the supply ecosystem, which leads to Abbott and Divi making their drugs. But at the forefront of the pharmaceutical names, Divi’s and Abbott Labs will sit in our portfolio.