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August 2022 Newsletter

Aug 22, 2022

Quality check of the Sanctum Indian Titans (Titans) Portfolio

The result season has concluded, and all our portfolio companies have come out with their earnings. As expected, the raw material price pressure kept eating into the margins of the bulk of companies, despite which, the performance has been quite promising. The commentaries are also comforting given that commodity prices are now cooling off and price hikes of end products have helped to pass on the current price inflation.

Here is how the aggregate earnings of Titans portfolio fare as compared to that of Nifty 200. The robust revenue growth in the index came from Oil Market Companies (OMCs), which, however, dragged the index earnings as the OMCs posted losses despite high revenue growth. Titans’ earnings performance was relatively consistent and stable as we stayed away from metals and government-owned OMCs.

The recent past has been extremely turbulent for companies. The corporate world had to deal with a whole host of headwinds. The rampant rise in commodity prices, a steep increase in freight rates, interest rate hikes, and the ensuing demand destruction from high prices, especially in rural areas. Though all was good for commodity producers, commodity users were mainly at the receiving end.

Times like these are the litmus test for equity portfolios because such headwinds are temporary blips for strong companies but a major blow for weak companies. Therefore, in this commentary, we decided to showcase a quality check on our Titans portfolio that assesses the portfolio’s ability to withstand current as well as future shocks and emerge stronger on the other side of the storm.

The themes we are betting on

In the Titans strategy, we follow a mix of a top-down and bottom-up approach to identify investable stocks. A bird’s eye view gives us a broad theme we want to be a part of, and a worm’s eye view leads us to the strongest of the companies in the theme.

A quick glance at the theme allocation below shows that the Financial Services theme holds the largest weight in the Titans portfolio as we believe that the worst of NPA troubles in lending are behind us and the credit cycle is at the cusp of turning up. We are playing the theme through the strongest of the names and best of the franchises in the sector.

Titans portfolio split across themes

The second largest theme in our portfolio is Manufacturing, which includes manufacturing companies across different sectors. We believe that India will continue to benefit from the decent edge many companies have developed in certain manufacturing industries like chemicals, pharma, and auto ancillaries. In addition to benefitting from the capabilities that these companies have built, they are further expected to gain from government support for these sectors through PLIs, and the China+1 sourcing strategy of customers across the globe.

The next big theme in the Titans portfolio is Housing, where we have adopted a pick and shovel strategy to focus on companies that have established brands catering to the housing sector. The names that we own in the sector not only benefit from the housing demand but also from reconstruction and renovation demand. Further, there is a massive formalization underway in this sector, which is leading to a shift in business from unorganized to organized players.

We also like Industrials and hold ~11% weight in the theme as we see capital expenditure picking up across sectors led by buoyant economic growth, government support to the manufacturing industry, and rising export opportunities. We hold the best of the mid-caps in industrials, where we see significant capabilities and robust growth potential.

The other theme that we have exposure to is IT. Though the returns in IT might be moderate hereon in the short run, we feel that demand for digital and cloud transformation will continue to drive growth once the short-term concerns are gone.

The earnings track record

In all our portfolio strategies including Titans, we focus on companies that have a respectable record of historical earnings growth and a similar or better outlook of growth going forward.

Here is how the portfolio companies have grown over the past five- and ten-year horizon and its comparison with the aggregate CAGR of Nifty 200 and Nifty 500 Index. The Titans portfolio has handsomely outperformed the indices’ earnings growth over both time horizons.

Notwithstanding the healthy growth of the past, the Titans portfolio companies are expected to continue growing decently over the next two years. Here is the table showing the expected earnings growth of the Titans portfolio in the coming two years.

Reinvestment Rate and Shareholder Payout

As past growth is no guarantee of future growth, all the companies need to keep investing in the business by plowing back profits to maintain their competitive position and expand their moats. The Titans portfolio companies have maintained a robust reinvestment rate, investing close to half of their profits back into the business and at the same time also rewarded the shareholders immensely through dividends and buybacks. These investments do not factor in the investments done by the companies through their income statements like expensed R&D, employee upskilling, and capability building. Adding those P&L expenses the reinvestment rate will be much higher.

Here is how the reinvestment rate and shareholder payout stack up for the Titans portfolio (ex-financials) over a 5-year and 10-year horizon.

All the companies in the Titans portfolio continue to invest in their businesses to expand and explore newer avenues of growth. The consistent investment in businesses augurs well for future growth and shareholder returns.

Return Ratios

The mean and median return profile of the Titans portfolio has been quite decent over the 5- and 10-year horizon (as shown in the table below), despite these companies continuously reinvesting in growth. The data vindicates our view that these companies continue to remain structural bets as most of them are catering to huge markets with large opportunity pools that help them keep generating high returns even on larger bases.

Our focus is mainly on companies that can continue to garner decent returns on each rupee of incremental capital deployed. This check while selecting stock ensures that the newer projects and expansions are not returns diluting and come with a similar or better return profile than the company’s existing return profile.

Cash flows

The Titans portfolio companies have been consistent cash generators over the 5-to-10-year horizon, with an operating cash flow-to-EBITDA ratio of over 75% and operating cash flow-to-net profit ratio of over 110%. Such high ratios indicate the cash robustness of these businesses and their ability to withstand turbulences without a significant long-term impact on business.

High cash flow ratios also signify the quality of earnings is top notch and the companies are able to convert most of their earnings into cash, a trait that’s hard to find in low-quality businesses.

The health of the balance sheet

Apart from the robust cash generation, the Titans portfolio is also quite decently placed on the solvency parameters with low debt levels, high interest coverage, and comfortable working capital ratios. The banks in the portfolio have also adequately provided for the bad loans with the net NPA ratio placed comfortably at 0.71x.

Soft Factors

It’s not only the hard data that determines how the portfolio companies will perform going forward. A large part of the growth and returns depend on soft factors like the management pedigree, capability, and integrity. At Sanctum, we look for managements who have a good grip on their businesses and are looking for stable, sustainable, and profitable growth.

Most small businesses fail and falter midway because managements become overconfident about their businesses and take decisions that turn out to be detrimental to the business. Some managements are also outright dishonest and take the businesses down with them sooner or later. It generally happens when the management has too less ownership in the company.

Therefore, to be better placed in this parameter, we look for companies with high promoter skin in the game. To be safe than sorry, we would any day go with boring management talking stable growth than with aggressive management overtalking unsustainable growth.

All the Titans portfolio companies are backed by solid people who take calculated risks to grow the business with an eye on profits. The past track record speaks volumes about these managements and their ability to execute. Despite that, we don’t rest on our laurels and relentlessly assess managements on their growth plans and execution.

Portfolio Performance

performance is calculated using Time Weighted Returns, net of fees, and expenses. Returns over one year are compounded annually; returns for less than one year are absolute. Please note that SEBI does not verify the performance information provided above. Please note that past performance is not a guarantee of future performance.

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