Resilience in a Volatile World

In continuation of the trends witnessed over FY16-21, the Rising Giants (RG) companies continued to post healthy performance in 9MFY22 (revenues and PBT up 46% and 28% respectively for the portfolio) driven by continued market share gains and addition of growth drivers through capital allocation initiatives. The investee companies’ acceleration in investments in products, distribution expansion, technologies and acquisitions through the Covid-19 crisis gives us confidence regarding the sustenance of absolute and relative fundamental performance in the coming years. Whilst the significant increase in input prices may impact near term margins, the long track record of high pricing power and healthy margins, cashflows and RoCE will help RG companies to turn near-term headwinds into longer term opportunities.

Performance update for the Rising Giants PMS
The Fund intends to invest primarily in high quality mid-sized companies (less than INR75,000 crores market-capitalisation, predominantly in the INR 7,000 crores – INR 75,000 crores range) with: 1) Well moated dominant franchises in niche segments; 2) A track record of prudent capital allocation with high reinvestment in the core business and continuous focus on adjacencies for growth; and 3) Clean accounts and impeccable corporate governance. From a universe of ~450 companies in this segment, a portfolio is constructed of 15-20 companies which make it past Marcellus’ proprietary forensic accounting & capital allocation filters as well as our bottom-up stock selection & position sizing framework.

Source: Marcellus Investment Managers. Note: (i) Portfolio inception date is December 27, 2021. (ii) Returns as of February 28, 2022. (iii) Performance data is net of annual performance fees charged for clients whose account anniversary falls upto the last date of the performance period. Since fixed fees and expenses are charged on a quarterly basis, effect of the same has been incorporated up to 31st December, 2021. (iv) Returns shown above are net of transaction costs and includes dividend income. (v) Total returns index considered for BSE500 above.

Rising Giants companies continued their healthy earnings compounding in 9MFY22
The Rising Giants (RG) portfolio companies, on a portfolio allocation weighted basis, delivered Revenue and PBT CAGR of 16% and 20% respectively over FY16-21. In the first nine months of FY22, the RG companies continued their path of earnings compounding at an elevated pace. The YoY Revenue and PBT growth were 46% and 28% respectively (on an allocation weighted basis) for the portfolio in 9MFY22. Further, similar to the FY16 to FY21 period, the performance of RG companies in 9MFY22 were in sharp contrast to that witnessed in the broader corporate landscape as can be seen in the exhibit below.Source: Company, Marcellus Investment Managers, Ace Equity
Note: *Median YoY growth computed for companies in BSE500 for each year and then CAGR is calculated for the FY16-21 time period

The key drivers of these absolute and relative healthy performances of RG companies are market share gains and new growth drivers (through their capital allocation initiatives) built by these companies in the recent years. In general, the persistent economic slowdown in the recent years marked by disruptive events like demonetisation, GST introduction and the recent COVID-19 crisis has only served to widen the gap between stronger and weaker companies. Market leaders helped by their superior return on capital employed (RoCEs) are able to generate healthy cash flows and in turn deploy them for strengthening their franchises further through investments into products, people, and technology, expanding distribution networks and gaining market share from weaker players.

We highlight some specific instances of how our RG portfolio companies have been able to outperform their sectoral peers in the following sections:

 .  Chemical stocks in the portfolio (Alkyl Amines, Galaxy Surfactants) have been able to post much better growth than chemical industry peers: The outperformance is across all key fundamental parameters of growth, profitability and free cash generation, thanks to success in new products, timely expansion of new capacities and scale benefits. We explain the key reasons in the below exhibit.Source: Company, Marcellus Investment Managers, Ace Equity
Note: *Median YoY growth computed for chemical companies in BSE500 for each year and then CAGR is calculated for the FY16-21 time period

.   Auto ancillary companies viz. Suprajit & Endurance have been able to partially mitigate the impact of the auto slowdown: Despite the Indian automobile sector witnessing one of the most brutal slowdowns in it’s history over the last couple of years (FY21 two-wheeler production volumes were down 25% compared to FY19 volumes), both Suprajit and Endurance have been able to mitigate the slowdown impact (and the associated impact on margins) to a large extent. This is primarily driven by acquisitions, new client additions, entry into new products and geographies.

Source: Company, Marcellus Investment Managers, Ace Equity, SIAM
Note: * Median YoY growth computed for auto ancillary companies in BSE500 for each year and then CAGR is calculated for the FY16-21 time period; ** Suprajit FCF was negative in FY16. Hence, we have computed FCFF CAGR over FY15-21 using FY15 as the base year above.

.  The lenders in the portfolio (Aavas and Cholamandalam) have outpaced peers in loan book growth thanks to their well capitalised balance sheets

Source: Company, Marcellus Investment Managers, Ace Equity, Crisil, ICRA
Note: *Median YoY growth in loan book computed for all housing finance companies in BSE500 for each year and then CAGR is calculated for the FY16-21 time period

In some cases, though, the RG portfolio companies’ growth has been lower compared to the peers – for instance in the case of ICICI Lombard where its premium growth (ex-crop) has been slower at 7.7% CAGR during FY19-21 while the industry growth (ex-crop) has been at 8.7% CAGR leading to some market share loss (ex-crop premium market share down from 8.5% in FY19 to 8.3% in FY21). However, we believe this is mainly on account of cautious stance taken by ICICI Lombard towards the motor segment where competitive intensity has heightened impacting the profitability. Meanwhile, ICICI Lombard has continued to maintain vehicle mix within the motor portfolio better than competition and its loss ratios are better than the industry. Similarly, Page Industries’ revenue CAGR of 4% over FY18-21 has lagged the median revenue growth of 5% recorded by its listed peers viz. Lux industries, Dollar and Rupa & Co. However, Page has made a strong comeback in the recent quarters with 9MFY22 YoY revenue growth of 42% YoY (vs median of 26% for Lux Industries, Dollar and Rupa for the same period).

The pace of consolidation has only accelerated through the Covid-19 crisis
Thanks to their strong balance sheets, the Covid-19 crisis has helped Rising Giants in accelerating market share gains by stepping up the investments to strengthen core business, expand capacities or in some cases acquiring weaker peers. We highlight some of the instances in the exhibit below:

While we have highlighted some specific instances in the above exhibit, more details for each of the portfolio company can be accessed in our 20 January 2022 Rising Giants webinar.
Consequently, thanks to this accelerated market share and growth initiatives, we expect the pace of outperformance of RG companies vs the broader corporate landscape and more particularly their industry peers to continue in the coming years.

Why we remain sanguine about our portfolio companies’ prospects amidst input price inflation
While we highlighted above that RG companies witnessed very healthy growth in revenues and PBT in 9MFY22, there are a few portfolio companies which did see some deterioration in margins in 3QFY22 due to the significant increase in the input prices and supply chain issues as highlighted in the exhibit below.

Source: Company, Marcellus Investment Managers

Several of the Rising Giants’ inputs are volatile raw materials like steel, aluminium, basic chemicals, etc. Furthermore, due to the recent geopolitical events, there has been a significant uptrend in the prices of these raw materials. While these may have some near-term impact on the margins of RG companies, we don’t expect it to have a longer term or structural impact on RG companies’ margins due to the following reasons:

.  Portfolio stocks, including the cyclicals, have exhibited a high degree of pricing power: Rising Giants companies have historically exhibited a high degree of resilience in the face of volatility in the prices of their underlying inputs. For instance, as can be seen in exhibit below, RG companies have been able to post YoY increase in gross profits (we believe change in absolute gross profit to be a better measure of pricing power than gross margins which get impacted due to the pass-through impact on revenues) for more than 80% of all the quarters in the last ten years (even when we consider time periods as a short as ‘a quarter’). This ratio further improves to nearly 90% if we base the analysis on rolling four quarters. Further if we remove the two Covid-19 impacted quarters viz. 4QFY20 and 1QFY21 (where raw material price inflation was not an issue), the ratio further improves to 93%!

Besides the resilience in gross margins, what also gives us confidence regarding the pricing power of the RG portfolio companies are:
.  Presence in resilient end-user industries: A significant number of portfolio companies (GMM Pfaudler, Alkyl Amines Chemicals Ltd., Galaxy Surfactants Ltd, Dr Lal Pathlabs, Relaxo, Page Industries) cater to end-use industries like pharma/healthcare, personal care, low ticket consumer purchases which typically exhibit high degree of resilience to price hikes.
.  Turning crisis into an opportunity: Most RG companies command market leadership in their respective businesses which also helps them in passing on the increase in their input prices (relative to their peers who operate on wafer thin margins due to lack of scale and higher overheads). The RG companies with their stronger balance sheet and healthier RoCEs are better able to weather the near-term inflationary headwinds. Furthermore, just like their ability to turn a crisis into an opportunity, the RG companies with their strong balance sheet, superior margins & RoCEs and constant endeavour to generate operational efficiencies may tactically choose to absorb the price hikes to stifle their weaker peers resulting in further opportunities for market share gains. This underlying attribute of dominant franchises – to use an inflationary environment to suffocate their competition and deepen their competitive advantages – is discussed in detail in our June 2020 Consistent Compounders newsletter.

Regards
Team Marcellus
If you want to read our other published material, please visit https://marcellus.in/

Copyright © 2022 Marcellus Investment Managers Pvt Ltd, All rights reserved