UTI Midcap Fund - Reversion to Mean (Theory & Practice)
In theory, there is no difference between theory and practice. In practice, there is -Yogi Berra
In the UTI Midcap Fund, we attempt to build a margin of safety by buying above average companies (in terms of past track record) at a weak phase in their operations. The core rationale, of course, is that the company’s operations would eventually revert to mean on business performance. The necessary conditions to support improvement would include a mix of ingredients including among other things, internal factors such as the leadership style, restructuring or change in capital allocation, external factors such as industry cycles or changes, a structural shift in the business or regulatory environment or some other unique characteristic. Any of these can set up an expectation that in due course the company would attain not just a better level of performance but a performance above the trajectory presently baked into the beliefs about its long-term prospects. If all goes to plan (the theory part), the internal metrics such as profit margins and capital ratios should eventually recover and at the least revert to mean. In our experience, the actual path to recovery (the practice part), can be somewhat frustrating; often punctuated by false starts as the change manifests slowly while the market takes its time recalibrating its view. On these occasions, the journey requires patience and may have us re-examining our original assumptions. There are also times when we can get lucky and the improvement in trajectory is not just widely recognized but then gets extrapolated, with the overall sentiment on the company’s prospects getting a significant boost. At these times, the earnings and sentiment (read valuations) working together, can even get us a premium valuation.
As real-life examples usually help better understand any theory, we look at a few cases, which illustrate this line of thought; a few where it worked and one where it did not.
Case 1 – Internal consolidation & RM cycle helps reversion to mean:
At the time of entry, this branded biscuit maker was facing headwinds around its leadership even while on the RM cost front pressures were high as agri-commodities were in an upcycle. The incumbent CEO was battling on many fronts, including cleaning up after a predecessor who had to leave abruptly. Things were not quite coming together for the company. Return ratios were depressed (RoCE~15%) but quite clearly not par for the course for the company in historical terms and even versus its industry cross-section of FMCG players. Eventually, the company got its act together even as input prices corrected; the Head of Sales who was much more hands-on took over as the new CEO, topline growth picked up and operating leverage drove margins recovery, and more importantly, cash flows and return ratios(RoCE~38%) reverted to mean.
Case 2 – Leadership change boosts energy, market share and margins
When we first invested in this tractor company, it was trying hard to bring down legacy costs in terms of vendor inputs as well as staff expenses, and trying to stem a continuous market share fall over several years. Leadership at the promoter level had moved to the next generation, which was perceptibly more willing to get its hands dirty in order to set the business back on its feet and work closely with distributors and professionals managers. Segment margins (EBITM ~7%) were at a huge discount to bigger competitors and a reversion in approachable distance to industry average was not a huge ask as company had reasonable scale (market share was ~10% in a ~10 player market). While the cost-efficiency improvements were on, two successive weak monsoons hit demand and the cost savings were therefore not prominently visible in the financial results. However, there seemed to be tangible improvement in efficiencies, which helped us increase our investment commitment. Eventually, the monsoons recovered, the northern markets, which were a traditional bastion for the company, saw a higher growth and the market share fall began to reverse. The cost savings kicked in even as operating leverage rose(EBITM ~ 13%),profits consequently recovered as did valuations.
Case 3 – Exited as recovery weighed down by acquisition drag
This is a mid-sized cement company, which had demerged from a diversified unit. It showed promise in terms of cost efficiency due to access to linkage coal, proximity to limestone deposits and a depreciated plant. Prices in Maharashtra, a key market had been depressed for a prolonged period due to rural stress affecting profitability (EBITDA/Ton ~Rs 400), lower than their historical average. Traditionally a western India market play, it had just built a new integrated plant to help it service demand in south India and was burdened with increase in fixed cost due to the new plant. There was scope for improvement in profitability and sufficient room in valuations to believe that the company would converge to sector valuations.However, even before efficiencies could recover, the company announced the acquisition of a majority stake in a grinding unit where the arrangement for raw material supply was unclear to us. Operational performance continued to suffer and we felt if the company had focussed on brownfield expansion, close to 18 months of performance and earnings would not have been lost and return ratios would have recovered sooner. While it is possible that this issue would eventually be resolved, but at the margin, we felt it was better to exit. A difficult decision but we moved on to what we felt were more potentially rewarding opportunities.
Case 4 –Headwinds of structural shift changed to tailwinds
This city gas distributor in the NCR was facing headwinds on pricing as also pressure on marketing margins from the regulator. A change of government in the city meant that price increases would be difficult. But the long term case for increased gas use in transport and industry was strong as pollution concerns were rising with successive winters. A utility with low utilization rates and thus suppressed margins (EBITM~15%), its reasonably healthy execution record of accomplishment meant that the option value of a change in fuel use was not fully recognized. Judicial pronouncements on both i)the jurisdiction of the regulator with respect to marketing margins and ii)the compulsion to switch commercial vehicles to gas radically elevated the narrative. Increased volumes, some pricing power, and new geographies, meant improved earnings growth prospects, a sharp rise in margins(EBITM ~23%) cash flows and better valuation multiples on the improved opportunity available to the company.
RM: Raw material
RoCE: Return on Capital Employed
EBITM: Earnings before interest, taxes margin
EBITDA: Earnings before interest, taxes, depreciation and amortization