Portfolio Construction: Part 4

Lets move down the pecking order!

Part 3 of my blog can be found in the link below, do give it a reading if you are seeing this for the first time.

Over the last 3 weeks we’ve shortlisted 20 companies with a market cap INR 10,000 crores and above. There are quite a few reasons why I pick companies that are upwards of INR 10,000 crores.

A few of the reasons are:

1. “Size means Safety” - though this borders on “too big to fail” phrase, there is a lot of truth to this. Companies that are big automatically (usually) form a “MOAT of irreplaceability” in the segment that it operates in. For example - NTPC & PGC. You wouldn’t be able to imagine a world without them. To a large extent even FMCG Companies like HUL & Colgate.

2. “Size means pricing/bargaining power” with its customers and suppliers. For example - FMCG companies like HUL & ITC, Telecom companies like Bharti Airtel & RJio, Asian Paints (till the competition intensified recently)

3. “Size means lesser concentration of revenue/customers” - For example - TCS, Infosys and Larsen & Toubro

4. “Size means diversification of raw material suppliers” - For example - Eicher, Hyundai and Other auto companies that have a long list of tiered suppliers

5. “Size means larger economies of scale” - For example - Cement, Iron & Steel and other commodity companies

Considering all of the above it is usually prudent to pick companies that are big if you want “normal returns for abnormal period of time” (isn’t that how you build wealth?). But every now and then there would be a “pocket dynamo” that would do an outstanding work of managing its business and deliver returns that will far outpace that of the biggies. This company is the ace in the pack and will deliver the “alpha” that any investor wants.

As simple as this “alpha” creation might sound, this is an exercise fraught danger (especially when you want to employ mid and small caps) because when the size is small, the “margin of error” is equally small. In the case big companies, “Size is a friend”, but it becomes exactly the opposite in the case of smaller companies. (there are always exceptions to this rule so don’t hold me to it :))

The problems that small companies usually face are:

1. Concentration of revenues

2. Concentration of suppliers

3. Lower bargaining power

4. Lower pricing power

5. “Key man” risk

6. Lower economies of scale

All said and done, if these risks are managed well then there is a higher probability of these small companies delivering super-normal returns. So, our endeavor should be to identify companies that can potentially manage these risks better. We’ll try to do this using the same quantitative parameters and short-list a set of companies for in depth research.

The parameters that I would use here would be slightly more stringent as safety is paramount. (again these parameters will apply only to non-BFSI companies)

1. 4 year positive Sales & EBITDA CAGR - We are focusing on companies that have grown post COVID-19

2. Positive operating cash flow for the last two consecutive years and a 5 year cumulative positive Operating Cash flow - We are looking at companies that have managed working capital well during and post COVID-19 and the interest rate hikes

3. Ability to convert accruals to cash flow over the last two consecutive years (Operating Cash flow/EBITDA > 0.5)

4. Debt/Total capital < 50% for the last 2 consecutive years - shows the ability of the company to maintain a prudent capital structure

5. RoE > 12% for the last 2 consecutive years

What we are looking for is companies that display growth, good accrual conversion & cash flow generation along with prudent capital structure and good return on equity.

The list of companies are as follows:

A few observations:

1. 10 out of the 14 companies are more than 10% away from their 52 wk high

2. The market cap of all the companies are < INR 13,000 crores; the smallest being INR 591 crores

3. 5 out of 14 companies have delivered a returns upwards of 50% over the last 12 months

4. 13 out of 14 companies have grown their PAT at a CAGR of 10% or more

The final list of stocks that seem interesting are:

1. Sula Vineyards

2. Craftsman Automation

3. Archaen Chemicals

4. Elantas Beck

5. Foseco India Ltd

6. Epigral Ltd.

7. Kriti Nutrients

8. Procter & Gamble Health

9. Nelco

This is my first set of Mid and Small cap companies. I intend having a tracking universe of ~35 companies (Mid & sml cap) that could potentially provide my portfolio with that much needed “alpha” Vs a benchmark.

In terms of portfolio construction, we have selected ~30 stocks and are half way through the stock selection process. It is protracted and rightly so, as you need to be careful while creating a universe of investable companies that would survive the test of time.

In my next piece I would be performing the first iteration of constructing my portfolio.

Stay Tuned!

Disclaimer : I am not a SEBI registered investment analyst; none of the securities discussed here are investment recommendations; the views expressed are my own and are not that of my employer or their associates; I can not endorse the veracity of the data that I have pulled out from databases