Smallcaps, metals will do well in next 3-4 years: Parag Thakkar

Parag Thakkar of ICICI Prudential – PMS says quality midcaps and smallcaps are likely reward handsomely over the next 3-4 years. Edited excerpts from an interview with ET NOW:

ICICI Pru AMC's big call which was very often discussed in the market was when you called out the peak for smallcaps and midcaps. What were those signs that made you say this is time to stop investing? And now have you changed your stance back to lean towards them?

We looked at the PE multiple of the smallcap index. The PE of smallcaps in January 2018 was 25, and it was at a premium to largecaps and midcaps both. And if you see from August 2007 to January 2018, all smallcaps were rallying madly. There was a crazy run, and it was complete euphoria with many stories getting sold. So that was what I called a perfect top. Of course, I give this credit to my entire team, my colleagues and other fund managers. It was a collective call to return Rs 700 crore to investors and after that we saw 42 per cent correction in smallcap index. So, PE multiple which was 25 times came to 14 times recently in August-September. Then we said that okay now this is a hatred space of the market, so let us focus here. There are so many good quality companies which have corrected 30 per cent, 40 per cent, 50 per cent while profit decline is hardly 10-15 per cent. So from October onwards, we started looking at companies where business cycles were going wrong, the corporate governance and leverage was under control.

What is the core philosophy of your stock picking framework for 2020? What is your outlook? Do you think this polarised nature of the market that has started to normalise will continue?

We call our core strategy Focussed Four, where we focus on corporate governance, which is a key criterion. So there should be an alignment of interest with the promoter, where a promoter also believes in creating shareholder value for the minority shareholders. The second is return ratios. We look at ROE of above 15-18 per cent, and clean cash flow generation and do not like companies where working capital leakage is very high. Then third we look at net debt to EBITDA which is our key parameter. So, net debt to EBITDA should not be more than say 3.5x and last is valuations. This is our Focussed Four strategy on which we actually construct all our portfolio strategies depending upon the theme.

The year 2020 has started on a good note for the broader markets. Do you think this will be shortlived or do you think it will continue?

We are of the view that smallcaps, metals, and those kinds of sectors where investors were not ready to invest will start doing well over the next three to four years. But the recent run up in smallcaps has been very fast, so there can be some consolidation which is okay.

Let us talk about your schemes and funds and contra funds. Why the name contra? Is it because you take contra calls only over there and what qualifies as contra calls? Data shows it has quite nicely outperformed the benchmarks. Do you find it fearful to get into places where people are heading to the hills?

Contra is a strategy that is very close to our heart as a house and it has worked very well for us. How we structure contra is that we do not necessarily buy absolutely cheap names, we actually buy quality companies at some reasonable discount to their fair values. So, we buy a quality company that becomes cheap due to some sort of temporary problem either in the markets or in that particular sector. To give an example, when crude oil goes up see paint stocks correcting, auto stocks correcting, even banks correcting. That’s because when crude goes up there is a fear of inflation, and rising interest rates. So, banks also go down and that is the time we start buying quality franchises in those sectors.

Talk to us about some of the themes which have really worked well for you. How do you choose them and how did you arrive upon those kinds of themes, which led to a sharp outperformance?

We cannot discuss stock specific things any good quality, genuine business which undergoes a long period of consolidation or underperformance catches our eye. And if we see an inflection point in that company or we see some triggers that the company has started to change the strategy and results are visible, then we try to be first in that particular space. So if every parameter is moving in the right direction, then we catch up to that theme.

Metals is one area where you had taken a contra call. What is the thesis behind it?

Metal is a day to day need and because of the trade war which was continuing from the last one year, the metal stocks were trading at below book values of 7-8 PEs. It was a very attractive valuation and this time in this cycle, unlike in the 2015 cycle, metal companies had a very good balance sheet.

So if you see net debt/EBITDA, net debt/equity was very comfortable. It was very easy to take a call on metals this time while during the trade war was going on. For example, during the Demonetisation it was very easy in my view to buy FMCG stocks or paint stocks. During the trade war it was slightly difficult because you do not know where the tunnel ends. But because the valuations were in your favour and the balance sheets were good and cash flows were robust, it made sense to buy metal stocks during the trade war.

Talking of your contra call on telecom, it has been handsomely rewarded. What was behind that, because it was a very brave call at that time but now it is working out very well?

I would attribute this to our house view. And it was a great call because it is an industry which is of day to day need. One can live without food for one time but without a mobile one cannot. So, mobile is a day to day need; it was the most competitively priced in India than in the world and there was undue competition and now the survivor has emerged. It was a call to bet on a healthy company in a sector which is of a day to day need, where the balance sheet is not highly leveraged and cash flows are very robust.

Moving to the Pipe fund, that is an area where you actually do much deeper stock picking in the smaller areas. The valuation, corporate governance matter over there. What is your strategy for the Pipe fund?

In midcaps and smallcaps, corporate governance becomes the most important criteria. Leverage is another very important criteria. We look at companies with operating cash flows and where working capital leakage is not there. For instance, in construction space, most of the companies where debtor days are above 100, we have companies where debtor days are less than 60 and the corporate governance is top of the class. I would say that makes a lot of sense. Recently, because of a good rabi crop and water levels in rural India, we have seen very good numbers from agri companies. We have to buy those companies where there is an inflection point.

Talking about this agri theme, you have some speciality chemicals names, some agrochemicals. You are quite tilted towards the agri theme. For the last two-three days, fertiliser companies, agrichem are doing very well. Do you think this is a durable kind of a theme?

Yes, it appears that at least this rabi crop season, which is Q3 and Q4, these companies are likely to do very well. It is a seasonal business so you cannot say whether next year these things will repeat or not.

There are many pharma names in a couple of your schemes. Pharma is also at a five, six-year low, and nobody wants to touch that space. What is your thought on that one?

So across the theme, as I told you, we focus on companies. We do not go by how much return they have generated for shareholders in the last five years. We go by genuineness of the business. If the business is generating very good cash flows, very good return on capital employed but say the growth is missing, then there is an inflection point which comes and we start seeing growth also. So those are the companies which we have focussed in the pharma space also, in Pipe funds and in small caps

What is the outlook for the area where you specialise in, midcaps and smallcaps, for the next two-three years? Do you think companies that are doing well on the earnings front have a runway ahead of them? Can alpha be created versus the space benchmark?

Absolutely. We clearly believe that. We are up by around 15 per cent so there can be some retracement, some consolidation but the belief is that over the next three to four years this is the space which is going to give you higher returns. This is the space where if you buy good quality companies, where earnings traction is there, then you are going to get handsomely rewarded.

So some of the stocks in our portfolios are up by 30-35 per cent in the last two months. If earnings come in a good-genuine business where promoters are good, balance is debt-free or less leveraged and return ratios are good, then there is huge liquidity that is going to chase them.