Utpal Sheth is the CEO of Rare Enterprises, an asset management firm founded by Rakesh Jhunjhunwala - an Indian Billionaire Investor and Trader. Recently, I attended a conference held by CFA Society India at New Delhi where he was one of the speakers. His presentation was insightful and delved into the topic of identifying/investing in megatrends and what it takes for some companies to attain the pole position in their respective sector. As you read the summary of his presentation, you will realize that most of the attributes that he talks about are nothing but the Intelligent Fanatic way of doing business. Please note that his presentation is centered around businesses operating in India but the key takeaways from the talk are universal.
Megatrends and Leadership are the two most under-appreciated yet the most important drivers of value and wealth creation in the markets. These are usually overlooked because they aren’t too obvious.
There are some sectors like private banks that have consistently outperformed the broader indices over the long-term due to some structural (none mean-reverting) changes which we call the ‘Megatrends’ and within these sectors, the top three players have taken up 70% of the market cap of the whole sector establishing their ‘Leadership’. This implies that not only were they large in market cap a decade ago but they have incrementally gained market cap over the proceeding ten years.
The leaders within the megatrend create most value across sectors over many cycles.
- Megatrends ;
– Structural shifts that are long term (30-40 years) and have irreversible consequences for the world around us.
– Picking them requires a broad perspective and narrow focus. One needs to see the big picture but a narrow focus as there are very few true megatrends.
– They reset the rules, throw up opportunities and threats along with new winners and losers.
– They transcend geographies, generations, and governments.
– Some of the Megatrends include –
- IT Revolution
- Demographic evolution
- Consumption boom
- Women in the workforce
- Financial deepening
- Digital transformation
- Unorganized to organized shift
- Culling of ‘Dwarfs’ i.e the companies that have not grown due to ‘n’ number of factors despite being in business for the last ten years or more.
- IT Megatrend – A case Study :
– The IT megatrend had a confluence of factors driving opportunity size and longevity such as benign supply-side conditions, fall in the data storage and transit cost, changing demand dynamics with more focus of the west on outsourcing and evolution of innovative business models like global delivery models, offshore dedicated centers, master service agreements, infrastructure management service, etc. This evolution of the business model was necessary to sustain the megatrend. All the three components were necessary to have an IT megatrend in India.
– Once the megatrend is in place, two things are needed to sustain it ;
- Granularity – Eg: Addition of more and more verticals in the IT services offered by top Indian companies. It gives the businesses inherent strength to develop different revenue streams which reduce client dependence and helps in de-risking the business.
– The Concept of Displacement – for any megatrend to reach it’s potential, a lot of displacement is needed. For example, in the early 90s, the IT outsourcing spend by global IT companies was almost zero but now it is consistently 30% of their global spend. It is this displacement from 0 to 30% that has created this opportunity. Within the outsourcing, it’s the offshoring that has driven the profits higher.
– For megatrends to sustain, the sector also needs to show resilience.The IT megatrend persisted through the dotcom crash, through the financial crisis and demonstrated adaptability and innovation with people discussing things like AI, analytics, cloud computing, etc. This has helped sustain and elongate the megatrend.
– The concept of resilient value creation: It is difficult for any company to deliver a ROCE more than the cost of capital for a prolonged period of time along with growth that’s higher than the GDP growth over the long term. These two factors are critical for the sustenance of the megatrend and the success of the companies within that sector. The Indian IT sector and its top companies have been able to demonstrate this consistently over a long period of time. Factors such as the size of the opportunity, quality of leadership and scalability have made sure that the outperformance in the industry has continued over the years.
- Leadership ;
– Leadership attributes are more intangible than tangible as they are not always quantifiable.These include;
- Culture – most important yet most underappreciated in the investment process.
- Strategy and execution – Strategy is quite important but it’s the execution that’s the hallmark of good leadership.
- The leaders must be able to demonstrate profitability,scalability, and durability. These attributes contribute to the longevity of the business and its leadership position.
- These leading companies are battle-tested through multiple cycles.
- They demonstrate resilience and adaptability .
- Have prudent capital allocation and capital structure.
- Possess depth in management quality and their ability to transition the company into an institution.
– Here are some examples of such companies and their key leadership attributes:
A) Quantitative attributes
- Market share → Asian Paints (53% market share in the paint sector)
- Delta Market share → Bajaj Finance (gaining market share on incremental sales)
- Least cost player → Shree Cement
- Share of profit pool in that sector → Page Industries
- Share of cashflows of that sector → Maruti Suzuki
- Leadership Durability → Nestle (has sustained its market share in each of its product categories over a long period of time)
- Leadership in new segments → HDFC Bank (as and when new segments in the industry emerge, gradually it ranks in the top 3 in each of those segments)
B) Qualitative Attributes
- Culture → Titan (besides culture, it has also institutionalized along with management transition)
- Innovation → Nestle (at the product level, packaging level, distribution level)
- Execution → TCS
- Expanding the total addressable market (TAM) → Bajaj Finance
- Elongating the competitive advantage period (CAP) → D-Mart
- Embracing disruption → Infoedge
- Redefining competition → HUL
– Economic cycles amplify leadership:
A) Macro perspective of cycles
In each cycle, there is ‘creative destruction’ where the leaders redefine and expand their leadership. These are ‘non-linear’ shifts one cycle after another. Currently, India is going through one of the most acute economic cycles in recent history.
There is a 4D framework of economic cycle drivers :
- D ebt
- D isruption
- D isplacement
- D is-intermediation
The economic cycle durations are shrinking now, as a result sustaining competitive advantage period (CAP) for companies is also shrinking. This change has huge implications on the investment decisions that we make going forward. It also challenges the valuation multiples of companies.
B) Micro perspective of cycles
- In each cycle, men are separated from the boys as new challengers emerge to take on the incumbent leaders. So, investors need to make sure whom are they backing and why.
- The treadmill speed and incline keeps rising i.e the bar is raised in each cycle. What was good in the last cycle is just not good enough in the next cycle. That’s why managements need to keep re-inventing and redefining themselves.
- The value paradigm evolves in each economic cycle.
- Value migration accelerates with each cycle.
- Each cycle gives the opportunity to expand the total addressable market but only the adapters can take advantage of that.
- How to value megatrends and leadership?
– There is no fixed formula.
– Must value the intangibles and not just the numbers.
– Value is reinforced and magnified through economic cycles. So, the classic value investing strategy of mean reversion will be challenged here.
– The intersection of Megatrends and Leadership is a multi-sigma event. Hence, standard valuation metrics cannot reflect this ‘Outlier’ event appropriately.
– The terminal value impact of megatrends and leadership is disproportionate that cannot be captured in conventional valuation frameworks as it’s an event that’s far in the future.
– Favorable value migration that happens during each cycle is difficult to capture in a conventional valuation framework.
We overestimate change in the short run and underestimate it in the long run – Bill Gates
- How to inculcate these megatrends into your portfolios?
– Focus on 3-4 megatrends in which you have high conviction.
– In each megatrend, identify & focus on 2-3 players who are showing leadership attributes. They may not be clear leaders at that point in time but should demonstrate leadership attributes.
– Among these, classify them into;
- Clear leaders – companies that have shown most of the leadership attributes discussed above. They form the bulk of the portfolio.
- Near leaders – companies that are not clear leaders but demonstrate quite a few of the leadership attributes. These form the aspirational component of the portfolio.
- Emerging leaders – the probability of these becoming clear leaders 15-20 years down the line is quite low, hence they form the high-risk component of the portfolio.
– Market cap is not the criteria while identifying these company, this framework is based on leadership attributes.
– Finally, have a high concentration of these in your portfolio as it should reflect your conviction in Megatrends and the Leadership.
- The concept of Gorilla Investing
- There are many monkeys in a jungle and very few gorillas – Rare
- Gorillas are outsized as compared to monkeys – Dominant
- Gorillas are not challenged by monkeys – Moats and Knights
- Gorillas have lifespan double that of monkeys – Longevity
- Find the right jungle where the Gorillas live (Megatrend) and then find the right animal (Leadership)
– Over time, the portfolio will have few gorillas and some monkeys which one thought would turn out to be gorillas but didn’t. The gorillas over a long period of time will keep outperforming and become a larger portion of the portfolio plus the monkeys once identified will be eliminated from the portfolio in order to invest more into the gorillas.
It is difficult to correctly value these leaders in megatrends because valuation is done to calculate the price that we are willing to pay today for the value that we will get in the future i.e we are trying to figure out what the terminal value of the business is going to be but in these companies the change in that terminal value is so large that no matter what number you put on valuations today, it will become insignificant in the future. Such companies usually don’t revert around the means, so that makes it difficult for us to value them by the typical valuation frameworks.
These companies become a sell only when your hypothesis of the megatrend and leadership is at risk. Simply moving in and out of them based on a temporary change in valuations isn’t a prudent strategy.
Unorganized to organized shift is a megatrend, contract workers/consultants/temporary staffing is a megatrend as the business cycles are shrinking, the frequency of newer business models disrupting the old ones is increasing and automation is on the rise. The need for certain skills might be temporary, so re-skilling or temporary hiring of the workforce will be a major trend going ahead.
Money managers should say no to misaligned capital i.e the capital which doesn’t concur with your investment philosophy and time horizon.
One rupee of aligned capital is worth hundred rupees of misaligned capital
Your state of mind is your most valuable asset and things such as misaligned capital can disturb your state of mind which might lead to sub-par decision making on your part.
CFA Society India has shared the video of the complete presentation on their youtube channel for the benefit of the larger audience. Here’s a link to the same.
Disclaimer: None of the content of this article should be construed as investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view and is for educational and informational use only. The author/website accepts no liability for any interpretation of the article being used for making actual investments. This is purely an information service and any trading done on the basis of this information is at your own risk, sole risk.