With Dalal Street's Diwali sparkle being dimmer than the last couple of years, Saurabh Mukherjea the founder of Marcellus Investment Advisors, has one advice for investors: “don't invest in anything which is not quality right now.”
Speaking to Mint on a recent episode of ‘How To Invest In Samvat 2081’, Mukherjea says he thinks we have entered a cyclical downturn — and why this is actually a good opportunity for investors. He also spells out which sectors he thinks are going to bounce back in the upcoming year.
Hi guys. We have with us Saurabh Mukherjea. He's the founder of Marcellus Investment Managers. He's well known for his coffee can investing style that focuses on high quality companies for long term investment. Hi Saurabh, how are you doing?
Hi, I'm fine. Thank you very much for hosting me.
Thanks for making time for us.
My pleasure.
Q. So, let's dive right into it. So you've you come across as an introvert. How do you balance it with your work?
A. Well, look, the introversion was a very painful thing to deal with. I remember in school, in class eight, there was a, I think a debate where you had to stand up and speak in front of the whole school or the entire class, 250 boys staring at me, and I had stage fright. I couldn't open my mouth. And, you know, it was this was I think I was 12 or 13 years old.
And that's when I told myself that, however much, I have this problem with introversion, what I've trained myself to do is speak clearly in front of other people. I think I was 13 years old, and I created the sort of, goal in life to be able to speak clearly in front of large audiences.
So, ironically, the introversion itself led to this desire that, you know, through my teenage years, through my university years, I kept looking for public speaking opportunities to get over the stage fright. I think so far, so good. I think I managed to get over the most of it.
But even now, the introversion gets in the way of, you know, building relationships with say, other people in the industry, building relationships with management teams. Because, partly related to introversion is my social skills probably aren't as good enough as good as I would like them to be.
Thankfully, I married a woman who's got superior social skills, so at least when we have to go to parties, my wife takes care of this, to a significant extent.
That's quite interesting. How did you get introduced to the stock market? And, I mean, is there any incident that stood out for you?
So, believe it or not, I didn't really know about this whole concept, about equity research and and fund management. I really had no idea about it.
I graduated from university. I was working for, one of my professors, Sir John K, and, a friend of mine, told me that there's this thing called CFA. So she showed me the CFA website, and I enrolled for the CFA program. I passed a couple of levels, and this is 2001, 2002.
That's when I realized there's something called equity research. That's when I realized something called fund management. So it was it was, I think at the age of 22 or 23 that I became aware of the possibilities of of analyzing companies and then investing in them.
And had it not been for, Nikki Arnold, perhaps I would have never come across this whole concept at university. I was very much a geeky student. And then, as I said, I graduated from university and started working for Sir John K, who's a prominent economist.
So the introduction came to the stock market in early 20s, perhaps, if somebody had introduced me to the stock market when I was 11 or 12, perhaps, you know, I would have been a better investor, A very early investor, actually. Early investor. You know, practice makes perfect. So 10 more years in the market might have given me other points of view.
Q. Yeah, yeah. So I mean, talking what about your investing style, how has it evolved over the years as you gained experience?
A. So, so I think in every stage of your career, at every stage of my career, if I look back, I've been doing this now for roughly 20, 22 years. Every stage of my career, I've learned something, implemented it, done well out of it, then made some mistakes and then the mistakes, then help you finesse what you do.
So if I look back at my years in the UK of covering UK small cap stocks, I was very much a disciple of Peter Lynch. Right? And Peter Lynch's books are about, growth at a reasonable price. PE ratios and so on and so forth. And I, you know, I drank that Kool-Aid and became well known in the UK for doing that.
Thankfully, I was able to predict the Lehman crisis. So there was February 1st, February 2007. We wrote a 50 pager on how the British financial system will blow up. But as the financial system blew up both in Britain and America, that's when I realized that valuations are often deceptive. This whole notion that something is looking cheap on or growth at a reasonable price. It's deceptive because ultimately, under deep duress, it's only quality which holds up.
And then the refinement of that took place after I moved to India, that's when the whole coffee can investing construct arose that quality matters, especially in a country where institutions are weak, where, corporate governance can be, uneven, you overpay for quality because that helps you, go through tough times better.
Then then we learned post-Covid that if you overpay for quality, then you suffer, right? We suffered badly through 2022 and the first three months of 2023, Marcellus suffered badly. And that then taught us again that, yes, you want to be you want companies which are high quality, both from a corporate governance perspective and from a franchise perspective. But you also have to be careful that you don't get overinvested in quality, because if you do and interest rates go up 5%, you will be taken out on a stretcher.
So you then we have refined again over the last 18 months. And that's borne fruit, we're outperforming again. So every stage of your life you learn something, you build it, you tweak your philosophy, you do well.
But inevitably the market is clever. It catches up with you. You make a few mistakes and you correct again, I think that's part of the charm of the job. If you see that as the charm of the job, you're able to learn from your mistakes and make yourself a better investor.
Q. So you kept plugging in the leaks?
A. Yeah. So you sort of you you've got a boat, you're in the high seas every few, every few years. The boat will leak, you plug it and the boat moves further on in the deep seas of investing.
Q. Nicely put. So also, so now that we look at Nifty, it's been in a very tight range. So, what's your take on the markets at these levels? Do you also see a correction looming around the corner?
A. Before I think we get to the valuation of the corrections, I think what's worth highlighting is we had a supercharged economic boom in India post Covid. Right. So 2022-23 and the opening months of 2024, for the best part of two and a half years India has a really strong economic recovery.
As everybody knows, we became the world's fastest growing large economy. And free markets move in cycles. You're not going to have a strong economic recovery endlessly. This is not China where you'll have 20 years of 9% growth nonstop. Right. So I think we have entered a cyclical downturn. The results for the quarter ending June 2024 were weak. I think the results for the quarter ending September 2024 are going to be weaker still.
In that context of the economy entering a cyclical down cycle, In that context, the valuations of the Nifty level do appear to be rich. And I would suggest a correction at the overall index level over the next six months or so.
If we talk about the broader market, in the past one month, although Nifty is in a very narrow range, even the broader market indices have been in that same tight range, though if you look at the, past one year performance, the mid and smallcap indices have given almost double the returns of the benchmark. Also, there are pockets which are quite overvalued as well in the broader market.
Q. So what's your perspective on the mid and small cap stocks? Do you find value there as well?
A. I think as we discussed, if you're going to have a correction in the broader market, which I think is more likely than not, given that the economy seems to have, entered a cyclical downturn, if we have a correction in the broader market, it stands to reason that small and mid-caps will correct more than large caps, given that small and mid caps rose more than large caps.
Right. That being said, our job is to find clean, high quality companies, and it's been a in a way now I turn to the good luck that we enjoy. Because, through 2022, 2023 and, even the early months of 2024 and until six months ago, quality really wasn't doing well.
So you basically had a two and a half year period starting with the Russian invasion of Ukraine in Jan 22. Quality took a backseat and and low quality companies had a great run as a result.
Going into this economic downturn, high quality companies are actually far more reasonably valued than I've seen them, in the last four years or so. I think to find HDFC Bank or Asian Paints at these valuations, you have to go back a long time.
So my reading is, yes, the economy seems to be softening. I think the earnings, that have emerged in this quarter so far clearly point to a softening in the economy. And yes, therefore the broader market seems likely to correct, but I think large caps will correct less than small caps. And across the PEs, across large and small caps, quality I think, will correct less than then low quality names, which had a blockbuster run through 2022 and 2023.
Q. So if I ask you, what would be a smart investment option? Among, large cap, mid-cap and small caps, you would go for.
A. So if you said like for like quality, so you say I create three - so first I would say to whoever is watching, don't invest in anything which is not quality right now. You can you can interpret quality your own way Mr. or Mrs. Viewer, you can interpret quality your own way.
But don't invest in companies where the books aren't clean, the promoters track record of high quality capital allocation isn't well established, and the balance sheet isn't rock solid right now.
If you then say, look Saurabh he has three portfolios large, small and mid, each of them high quality, which one would you go for? I would unquestionably say go for large caps in this sort of circumstance.
Q. But then would you still see the kind of growth potential, as compared to like the other mid small cap stocks? Or also if large caps have been giving like double digit returns, do you see that continuing in large caps? If you're saying let's choose large caps?
A. So I think two aspects to understand that firstly, in many cases high quality large caps are trading at record low PE multiples. Right. So for example HDFC Bank which is one of our largest positions is in a record low PE multiple. And therefore from that perspective, from a valuation rerating perspective, I think high quality large caps potentially have a steeper, a steeper valuation rerating ahead of them than high quality small caps. Right.
Secondly, given that, many of the large caps in our country are still relatively small in the context of their sectors, right. So, for example, Titan's market share in the jewelry sector would be less than 10%, right? Titan's compounded 1000x in 20 years. But even today, its market share in the jewelry sector is less than 10%. And as everybody knows, gold demand is ripping through in India.
Similarly, HDFC Bank, even though it's twice the size of Citigroup, today. HDFC bank's market share in India is just 12%. So many large caps are still very small in the context of colossal sectors. So I'm not so sure that there is going to be a massive growth discount. And I think it's reasonably clear in many, many of the high quality large caps, the valuation rerating that lies ahead of them is potentially steeper than what you see in high quality small caps.
And as a quick disclaimer, all these stocks are parts of our portfolio. I'm invested in our portfolios. So are my parents and obviously so are our clients.
Q. So since we spoke about financials and Asian Paints consumer discretionary, which are the sectors that, you know you are bullish and bearish on for the upcoming Samvat year?
A. I think we will see a classical set up again, classical in India if you go back ten years, 20 years classical in India, going into an economic slowdown, you tend to see IT services, pharmaceuticals and FMCG do well. I think for a whole bunch of reasons, I think these three sectors are in good shape.
In IT services case, the American rate cutting cycle has begun. In FMCG's case, I think, the government, after the 4th June verdict, the government has become far more proactive in giving SOPs and subsidies to the poor. And in the case of pharma, both the demand coming to the Western world and the fact that the Chinese are banging down the prices of raw materials which go into pharmaceuticals, puts pharma sector in a good place.
I think IT, pharma, FMCG going into a classical, economic downturn should be good safe harbors. And within those sectors, again, look for well-run, clean, high quality companies with stellar track records of capital allocation.
So, I mean, it's very interesting that you pointed out that the economy is going, into a cyclical downturn. Could you elaborate a little more on that?
Because, so from what we've heard so far and what people are speaking about is that the transformational phase of India and that's it is only going to go higher from here. So, I mean, your view is slightly different from what others are saying.
Q. Can you elaborate?
A. Structurally, India is in good shape indeed. We've actually published a book, which is going to get published in 21st October, called 'Behold the Leviathan: The Unusual Rise of Modern India'. And that's your copy. Hopefully you'll enjoy reading it over the Diwali break.
So we have published a book on India's structural rise that structurally India will be ascendant. But remember, in a structural story as well, there will be an economic cycle around that. And the reasons for economic cycles are always the same.
Classically, three things drive economic cycles. Firstly, if you have interest rates, which have gone up with a one, one and a half year lag, the higher interest rates slow down the economy. So if you think about it, the the Federal Reserve hit rates through 2022 and 2023. Even the early months of 2023, the fed was hiking and RBI also followed suit. Thankfully, not as much as the fed that the RBA also hiked up meaningfully.
And therefore, with the 12 month lag you're seeing, the effects of those higher rates feed through already in the first quarter results, you had banks and NBFCs reporting higher NPAs. I think that will continue into the second quarter. Right. So that's the first reason to dampen economic growth, central banks hike rates. And then with the lag the that has a dampening effect on on growth.
The second piece is fiscal stimulus. Right. So through Covid the Western governments gave massive fiscal stimuli. Then as we came out of Covid they removed the fiscal stimuli. And similarly, our government didn't give as big a fiscal stimulus as the Western countries did. But supported the economy through various measures. So if you remember there was a nice measure to support SMEs as those fiscal buffers, as those fiscal stimuli would support, which help the economy up, they get taken out quite rightfully, fiscally also, you take some steam out of the economy, right? So a monetary policy, tightens exerts a down force on the economy. Fiscal policy tightens, it exerts a deflationary force on the economy.
And finally, the job cycle, you're bound to go through cycles. You know, in a free market economy, have lots of job creation. We have that in the early years after Covid, I thought 2021, you know, 2022-23 were super for job creation. The job creation cycle seems to have tempered a little bit in the last few months, and all three factors, I think are contributing to a cyclical slowdown.
And these are great opportunities, I think, for long term investors. If an economy kept rising every year. Right. Your ability to figure out when to get in is lower. But if you can see that fundamentally the country is in great shape, fundamentally, India is in great shape because corporate balance sheets are in great shape. Banking system balance sheets are in great shape. Affluent households, are financially in great shape, Financialization is afoot in the country. Structurally, India is in great shape, but cyclically we're going to go through a downturn.
I think that creates lovely opportunities to get into high quality companies that, at sensible valuations, which is exactly what we are, what we are doing, which is what we have done. And thankfully in the last few months,the results are coming through again.
So you see ample opportunities in terms of creating alpha right now. Yeah. I think if you ask me that, for that style of investing like ours, which focuses on quality, which focuses on high quality governance, great franchises, and steady growth, I think for our style of investing, in fact, the alpha has started coming through nicely over the last six months.
And both my hope and my reading of the situation is the next, two years bode well for Marcellus.
Q. So, there is a bit of sector rotation that's happening. Are there any other interesting trends that you probably may have observed?
A. I think one trend that I think we're likely to see in the next couple of years is the amount of retail money that's coming to the market, I think feels a little over the top. So I think the latest SEBI data is saying, 170 million demat accounts in the country and the latest income tax returns data suggest 20 million Indians up being income tax, the filing filers or more I think filers 80 million. But people paying it is around 20 million.
And I find this disconnect between 20 million people paying income tax and 170 million demat accounts suggests to me that a huge ecosystem of, first time retail investors without particularly deep pockets has come into the market and I suspect they would come in into the market, into the most overheated stocks. I suspect they're going to pay the price for that. And therefore, in that regard, there will be churn in the investor base that drives the Indian market.
Q. So basically now you you probably are hinting that DIIs and FIIs could take the baton from here on?
A. I'll be astonished if retail investors take the baton from this point in, I think they've done a great job, but it just feels that the number of retail investors, I think we four years ago, we had 30 million. Today we 170 billion. That's 6x explosion feels a little excessive for a country where just 20 million actually pay income tax.
Q. So what should investors expect in terms of returns at this point in time especially, you know, that the returns have been quite stellar in the past few years after Covid, specifically.
A. So depending again on your style of investing. So if you let's take it step by step. Remember the nifty over the last 40 years has compounded not Nifty50 is only been around for 30 years, but say Sensex over the last 40 years has compounded by around 12-13%. So have been through a phase of, 25% returns. Then naturally, a degree of mean reversion there feels feels warranted, right?
The Indian market is trading at at record levels. Therefore I think a mean reversion from 23-24 times forward PE at the large cap index level back to would seem warranted. But by the same token, if you reverse the argument, if you invested in high quality, high companies whose earnings growth has been pretty steady around high teens, mark over the last three years, but compounding has barely been, low single digit low, low double digits. Right. Earnings were compounding at 19,20, but share prices were compounding at 10,11. I think there'll be a degree of mean reversion there as well.
So I think at the index level we're likely to see, you know, at best, at best low teens returns for a while while the, the economy, sort of the economy goes through a cyclical downturn. I think the index level low, teens returns. But for quality companies, I think, with earnings compounding being mid-teens, combined with some re-rating, I think there's a high possibility that for high quality companies, you'll see high teens returns. And that's the alpha that you referenced a few minutes ago.
