Find value in businesses with no growth: Kenneth Andrade

f you are a value investor like Kenneth Andrade, Founder of Old Bridge Capital, certainly is, where you find value in a market which is up 25 percent this year and at all-time highs.

In a market like this, you effectively find value where there is no growth or where the industry has been to a level where they earn lower than the cost of capital. That is a happy hunting ground for us, he said.

Below is the verbatim transcript of the interview.

Q: Where do you find value in a market which is up 25 percent this year and at all-time highs?

A: In a market like this where do you find value? You certainly find value where there is no growth or where the industry has been up to a level where they earn lower than the cost of capital. These are also times where market actually consolidate or industries consolidate to two-three businesses and in their sectors. That is a happy hunting ground for us.

Q: Businesses where there is no growth, returns which are lower than the cost of capital?

A: In some cases yes. So these are the two places we like to go hunting for and in the past, we have been able to find some of those and today if I open the opportunities that are there, we still incrementally are able to find small pockets that are available.

So basically as an investor, what we essentially look for is low valuations and these are the two places we usually find low valuations and we find industries which are consolidating and then you wait for a cyclical recovery in the business.

So low valuations essentially means low price earnings multiples and price earnings multiples will look upwards, if there is earnings growth, so you get an earnings growth momentum and you expanding valuations and that is how we compound capital.

Q: Where is market headed?

A: If you adjust corporate India’s balance sheet for current profitability, you are going to a historical low near debt-equity ratios in 2019 balance sheet. So if you adjust two years of current cash flow which is 2017 cash flow, you go back to a historical low in debt equities. So what is happening on corporate India’s balance sheet is that you have created a lot of space or you are going to create a lot of space to restart the next capex cycle. But the one big thing that is missing is where is growth going to come from because when I talk of all these numbers, these are numbers ahead of 70 percent of capacity utilisation.

Q: You don’t need more capacity if there is already unutilised capacity, so where is it going to come from?

A: Yes, you are going to go to a cycle where you have very large cash flows, low capacity utilisations and enormous amount of ability to leverage should you see an opportunity or two.

I would pay a multiple for all of this happening which is why probably the market may not correct very significantly from here.

The second element on valuations is that currently if you take BSE 500 manufacturing businesses basically the non-banking businesses, you have got an average return on equity (ROE) of about 12.5 percent and that bottomed out at about 11 percent back at about 12.5 percent. We have increasing capacity utilisations and you have a deleveraging balance sheet, your return on equity is going to grow up quite significantly. I won’t be surprised in 2020, maybe 2021 we will surpass our previous highs in terms of ROEs, which was at 23 percent.

Like I said, I won’t be surprised because you have got a lot of capacity to spare. If you get incremental amount of pricing on the ground and the demand kicks back, that number is a possibility. Now on the demand side, I think what is happening and it is not happening in India but globally the demand cycle is kicked up. So you have got a confluence of a lot of events happening.

Even if it doesn’t pick up here, you have got avenues to export the products out of the country if demand continues to remain as robust as it is. So your target segment of companies that are there will probably be completely different. So if you put the cycle together, we have never been as good as we are today over the last ten years.

It is probably what the markets also – probably one of the reasons why markets also priced themselves where they are pricing themselves right now.

Q: If I look at your portfolio, I don’t see any bank private, public, non-banking financial companies (NBFCs), why is that?

A: If I put it this way, I could play the economy through the liability side or I could put my mind to work on the asset side of the balance sheet which is manufacturing sources, consumers etc. or I could buy the financial services side of the business. I traditionally like the asset side of the business because there are many leverages that is created on the liability side actually transfers demand growth to any of the brick and mortar businesses that are there. So that is historically where I have been.

It is not that I don’t like financial services or banks at any point in time because in my career, I have owned them multiple periods of time. It is just that their valuation framework just doesn’t suit mine in the point of time of putting our portfolio to place.

Surely, there are one or two companies out there that fall into the valuation framework, they are always on the radar but they haven’t made their way to the portfolios yet. They are always on the radar but they haven’t met their portfolios yet.

Q: They have been compound already last couple of years, they have been the leaders of the bull market, NBFCs especially.

A: Sure, like I said I have owned all of these companies at some point in time in my career and they all fitted the valuation parameter when we did buy the cycle. A lot of these companies do have tailwinds as far as their businesses are concerned and it is just that they may not just suit my valuation criteria.

These are great companies but they are not great stocks.

Q: Let me instead of asking you what else do you find value, let me ask you where do you find absolutely no value, what are the other sectors that you think and the financial services is one, as you are pointing out but what else?

A: We have been struggling with consumers so that part of the world is fairly close to my heart in terms of secular, structural.

The entire consumption or consumer basket forms the part of it all. So a lot of these businesses do exist. Only part of that cycle is that consumption might be back-ended and you are paying a lot of price upfront for back-ended growth.

It is across the board. I might be wrong on that but I am happy to look elsewhere for the time being.

Q: You don’t own very much of that either in your portfolio?

A: Nothing. I own very few companies.

Q: But you keep looking.

A: We do get opportunities, it is not that we don’t get opportunities.