Investment lessons from the past

Vinay Agarwal

First Sentier Investors

Over the last few years, valuations have generally become expensive in our universe of quality companies. Valuations reaching these levels remind me of the mistakes I made running into the 2008 crash. While it is hard to predict a market turn like that, some of the signs look eerily similar.

I have been keeping a close eye on my own behaviour with regards to the changes I have made in the portfolio recently; and have asked myself whether I am committing the same mistakes I made ten years ago.

When I think back to that tumultuous time, I think I made three kinds of mistakes back then:

  1. Sold some great businesses on valuations which seemed high on near-term earnings projections;
  2. Went down the quality curve looking for cheaper valuations; and
  3. Held on to mediocre businesses on high valuations by getting caught in extrapolating a spark of brilliance long into the future.

I was wet behind ears then and walked into all three of the above traps unaware. Ten years later I find myself struggling with similar challenges.

Selling too early

Three years ago, we reduced our position Eicher Motors, a 2-Wheeler (Royal Enfield) and Commercial Vehicle (Volvo-Eicher) manufacturer that we had known for over a decade. The stock had been the top contributor to portfolio performance, rising ~200% in US$ terms during the year. But at the time, we felt valuations were stretched, even after taking a long-term view.

As one might have guessed, over the subsequent FY15-FY18 period, Royal Enfield’s volumes have doubled, while its larger peers like Bajaj Auto and Hero MotoCorp have grown their sales by circa 5%. Eicher’s EBITDA per motorcycle has also increased by around 25%. As a result, its share price increased by over 50% over the period. Eicher’s runway for growth remains quite long. Its market share in the overall Indian motorcycle market is still only 6%, and management is now focused on building an international business, where it has a negligible presence.

As it builds a stronger supplier eco-system and gains scale, profitability has scope to improve. We rarely find businesses which combine Eicher’s quality of management, a brand as strong as Royal Enfield and its growth potential. However, given that it now trades on very expensive valuations (22x 2021 earnings) on aggressive growth estimates (more than 25% 3-year earnings per share (EPS) CAGR) and profitability is at a life time high (23% net margin), we feel that the risk reward trade-off is unattractive.

This is a business we would love to buy back (although arguably, we shouldn’t have sold) when the margin of safety reappears.

Holding on

“We come from a low margin, B2B business mindset; cost and capital consciousness is all we know. So we do not chase market share, we chase profits.”

Vir Advani, the 3rd generation of his family to lead Blue Star (an air-conditioning products and projects company), was laying out his vision for the future of the business. The Indian air-conditioner industry is at an inflection point. Penetration of air-conditioners in India is only 3% and industry volumes are expected to double over the next 3-5 years. While every competitor is chasing volumes, Vir’s focus is on increasing Blue Star’s profit share. After a long downturn in their projects business, new orders are more easily available here. But, he stressed the learnings from their past mistake of taking on too many low-margin contracts. His focus is to improve return on capital employed (ROCE) of the segment by focusing on profitability instead. He also described his intention to enter new, fast growing categories like water purifiers, air purifiers and air coolers. But this expansion will happen in a cost- and capital-conscious manner – he will not bet the farm. After every interaction with Vir, our conviction in Blue Star’s long-term potential has grown. Our discussions with him often remind us of those with a young Siddhartha Lal and our experience with Eicher Motors. But, as is our wont, we ask ourselves every now and then – is Blue Star really that good or are we making a mistake?

We find Blue Star to be at a similar stage today as Eicher was a few years ago. The turnaround at Eicher Motors was driven by generational change. Blue Star is at the early stages of such a change – Vir Advani was appointed group managing director in 2016. Both businesses have a long growth runway. Eicher achieved this by creating a new market segment. Blue Star benefits from the dismally low penetration rate of air-conditioners in India and has doubled its industry market share over the last five years. Based on 1-year forward earnings, Blue Star is also similarly valued as Eicher was in 2015 (at 35x forward price-to earnings).

However, based on EV/Sales, Blue Star is valued at only 1.3x vs. 7.5x for Eicher Motors. The difference is due to its lower profitability. At its peak, Blue Star’s net profit margin was 7.9% in 2007 and 2008 vs. only 2.9% in 2017, as the profitability of its projects business declined along with the weak economic cycle. Vir’s focus on gaining profit share in air-conditioning products and improving profitability in the projects business should help the company achieve a step change in its net margins over the coming years.

Combined with strong industry volume growth and its consistent market share gains, profits could grow multi-fold over 5-7 years. Our experience with Eicher has taught us that selling a high quality business run by an ambitious and committed steward due to expensive near-term valuations is a mistake.

We are under no illusions that we won’t make any mistakes with our investments. Neither are we ashamed to admit it when we do; rather, we look to learn from our mistakes. Analysing our past mistakes does not automatically futureproof our portfolios; but, constantly questioning and testing the quality of our companies takes away the worry of trying to predict the future, of which we are thoroughly incapable.


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Vinay Agarwal
Director, First State Stewart Asia
First Sentier Investors

Vinay Agarwal is a Director of First State Stewart Asia, part of Colonial First State Global Asset Management. Based in Singapore, Vinay has more than 14 years of investment experience, with a focus on Indian and Asian equities.

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