Stick to market leaders, recovery won't help second-rung stocks: Saurabh Mukherjea

Saurabh Mukherjea, Founder, Marcellus Investment Managers, says that investing in market leading franchises remains a very durable proposition in the second wave of Covid. Edited excerpts from an interview:

Metals continue to be a rip-roaring theme. Is the best of the rally behind us?
I am not an expert on commodity prices, which is actually driving the share prices of metals and mining stocks. We can sit here and try to quantify earnings growth of Indian metals and mining stocks but the main engine of share price of metal stocks like Tata Steel or JSW Steel, is the price on the London Metal Exchange or in the global commodity markets. They are on a tear because of roaring economic recoveries in America, Europe and China. To that extent, we are in the early stages of a global economic recovery. It could be that there is more steam left in metal prices, but I am no expert in that.

What always foxes me a bit is why investors choose to play metal prices through stocks, rather than buying the underlying commodity. Inherently, you are buying a company which is producing a commodity and if you have such clarity on commodity prices, then by all means invest in the commodity rather than the stock. So I do not think the Indian economy has that much to do with the super show that metal stocks have posted. The global economic recovery looks likely to continue over the next couple of years.

What will be the impact of high commodity prices on consumers? Companies like Maruti and Pidilite are feeling the heat because of high raw material prices.
This is where the power of barriers to entry is very useful. In a roaring economic recovery situation, you are bound to see input cost inflation. In the next 12 months, wage cost inflation will also come through. Now if you are a market leader with very powerful barriers to entry, the competition cannot really punch on a level footing with you. You will be able to push through price hikes to protect your margins. You might take a operating margin hit for 3-6 months. If you look at franchises like Pidilite, Asian Paints and Maruti their operating margins go down very rarely because of input cost inflation. That's because they have the muscle and the barrier to entry to push price hike on to the consumer. That is why investing in market leading franchises remains a very durable proposition.

We have had a 50-55% rally in the last 12 months. It is so difficult to call it anything other than a bull market. In a bull market it is very tempting to go down the market cap spectrum and buy lower quality franchises, but they cannot protect you from input cost inflation. The champion franchises give you that protection and allow you to benefit from the economic recovery with top line benefits. So the economic recovery does not flow to the bottom line of the second-rung franchise.

How badly can the second wave of Covid hit retail franchises?
This quarter will be a very difficult one. Barring pharma and FMCG, probably all other types of consumption will see a pretty significant hit. I do not think people are rushing out of their houses to buy clothes or washing machines or cars.

If out of the next 20 years, you take away 6 months of earnings you are locking off the stock's fair value by 2-3%. If Maruti, for example, gains 10% market share during the period then the math reverses as that market share becomes permanent and the fair value of Maruti actually moves up because of the crisis.

I think it is that counterintuitive piece that a lot of people did not understand last year and this is why they are so reluctant to sell them. They have figured out that in times of stress the market leader might have 3 months of zero earnings, but the market share gains it makes becomes a long lasting one. This gives a fillip to the next 5-10 years of earnings growth and boosts the value of the franchise rather than suppressing it.

So the near-term consumption could be under pressure, most likely it will be in this quarter, but it will not relinquish those market share gains. You are pushing up the fair value of these franchises on a permanent basis and that is what investors like us are trying to benefit from.

A lot of your investors must have made money in Alkyl Amines and Garware. What's your next bet?
We have been steadily building up our positions further in Fine Organics over the last year or so. They make emulsifiers and anti-fungal agents that go into breads and baked products which we all consume. It is the largest player in that market of supplying food emulsifiers and anti-fungal agents for baked products. They also have a very strong presence in supplying specific inputs which go into aerated drinks.

Increasingly, they have turned into not just a market leading domestic franchise but also into an export franchise. These products are also called oleo chemicals. They base their need from palm oil derivatives that do not have petrochemicals or animal fats in them. Therefore, Fine Organics is finding a global market where environment conscious western consumers do not want to have products with animal fat and petrochemical based inputs. My reckoning is beyond the domestic monopoly which gives them 30-35% ROCEs and consistent growth of 20% in their business. I think it is a powerful export franchise as well. Indian promoters have build this up with lots of hard work over 50 years. This could potentially become a multibagger play in our portfolio. It is a well-run and debt-free company listed for the last 3 years.

Has there been any change in your view on IT stocks?
I have a very positive outlook on both IT and pharma. This is probably the strongest IT demand environment that we have seen in our country in the last 11-12 years. You can see it in the numbers of TCS and Infosys. In pharma, we have Divi’s Lab in our portfolio. It continues to do well.

Speciality chemicals is in a 10-year boom, very similar to where IT was 20 years ago. The world wants to shift its speciality chemicals to India. Thankfully, we have got a big population of skilled process chemists. So these sectors face very little pandemic impact. Their numbers will continue to be very healthy. In a nutshell, therein lies the story for the broader economy. We are all part of the global economy, which is coming out of Covid. Hopefully, we too will be in a similar position after 3 months.