From valuation to growth: Unearthing the investment playbook

Authored by Samit Vartak, Founding Partner and Chief Investment Officer of SageOne Investment Managers LLP.

In this article, I plan to briefly explain the strategy we follow at SageOne Investment Managers and what’s the hunting ground for our investment management team to find targeted companies. 

Before we decipher our strategy, the following are a few common investment strategies followed by active fund managers:

1. Pure value investing (low valuation multiples) where the majority of the returns are driven by valuation reverting to fair value

2. Growth at reasonable/fair valuation where a majority of the returns are driven by earnings growth

3. High-quality consistent compounding companies where entry valuation is less relevant as the holding period expected is very long (10 years and above) and returns are expected to be less volatile (similar to earnings growth) but generate wealth by compounding over a prolonged period. This is also called “buy and hold” investing.

4. Some combination of the above

There are many more strategies and all can generate alpha if executed well. All strategies tend to be cyclical and may not work at all times. E.g. value investing has worked really well in the post-COVID times and a high-quality quality consistent compounding strategy worked magic for 7-8 years until 2019. It’s almost impossible to find a fund manager who is good at all strategies and can switch to the right strategy at the right time. Most focus on what they are good at and what has worked for them.

Even though growth is the most important factor, entry valuation is also an important factor in selecting a stock for the portfolio. Ideally, we would like to get returns from valuation re-rating as well as earnings growth. In our experience, stocks which have turned out to be multi-baggers had both of these factors playing out during our investment holding period. It’s common to see valuation going up as the company delivers growth and becomes bigger.

When we started in 2012, valuations were very attractive and it was easier to find companies with high growth at a significant discount to fair value. During the Modi era, valuations have generally been much higher and hence one had to rely more on earnings growth for alpha. 

How does one find high-growth companies? To start with it’s important to find a pond with a lot of fish which are of high-return variety. In our experience, we have found the small/Mid-Cap universe to be a good pond with many potential opportunities.

If you analyse the period from FY14 to FY23, the earnings growth for the top 750 listed companies (by market capitalisation) has been subpar compared to our longer historical growth rate which has been around 12-13 per cent CAGR. Even during this slow earnings growth phase, many companies compounded their earnings above 18 per cent, but the per cent hits in the Large-Cap universe (largest 100 companies by market cap) were significantly lower than in the small/mid-cap universe (next 650 companies). Only 11 per cent (or 11) large-cap companies delivered earnings growth of above 18 per cent from FY14 to FY23, while close to 20 per cent (or 128) did so from the small/mid-cap space. Even if you analyse the recent 4-year period since FY19 (pre-COVID), there were 23 per cent of large-cap companies delivering 18 per cent plus earnings growth vs close to 30% for the small/mid-cap companies.

Since 2012, our portfolio companies have compounded earnings at 28 per cent vs single-digit growth for Nifty or any smaller indices. High earnings growth does provide a cushion during market falls. The key is to find companies which can deliver irrespective of the economic environment. In the current environment where many Small-Cap companies have run up sharply in FY24, there is increasing and loud chatter on whether we have reached frothy valuations. While there is no question that the valuations are above the last 10-year average, that’s not the only determinant to trigger a crash in the market. Other factors such as earnings growth and whether we have excesses in the economy or the banking system are also important to understand. 

I believe that Indian corporate balance sheets today are the strongest ever and it’s relatively easier to find 18 per cent plus earnings growth companies today compared to finding them in the last decade. The economy and banking system looks strong. Having said that the markets can correct 10-15 per cent (which occurs very often even within a bull cycle), but I believe that a crash looks unlikely. If you successfully can find companies with high earnings growth potential with reasonable valuation, such companies would fall much less during downtrends and I believe it’s one of the best ways not only to protect your capital during market falls, but also to grow your capital in the long run.

(We are a SEBI registered PMS and AIF with over 11 years of performance track record in the Indian listed equity space.)

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ