Three factors Saurabh Mukherjea tracks to identify stocks to invest

His firm's strategy is to first identify companies with clean financials, then narrow down to those with a return on capital consistently higher than their cost of capital over a 10-year period, along with prioritizing companies with pricing power, said Mukherjea, founder and chief investment officer at Marcellus Investment Managers, in an interview.

Sectors with significant government involvement—like real estate, infrastructure, and metals—rarely meet these criteria, leading Mukherjea to avoid such investments, he said. Besides, he also avoids getting involved in sectors such as defence, power and infrastructure, and metals and mining.

Edited excerpts from the interview:

What is the most important lesson you've learned from the markets in your journey so far—something that investors could benefit from?

Life has taught me that investing goes through phases. There are times when making money seems easy, and you must stay grounded. And then there will be times when returns are elusive, where you shouldn't lose hope. When things are going well, think about what could go wrong; when things are tough, focus on what could go right. Especially in a volatile market like India, this mindset is crucial to deliver stable long-term returns.

The second thing I have learnt over the past two decades is to try to diversify across uncorrelated asset classes. For example, the Indian and the US stock markets have very low market correlation. Over the past couple of years, we have diversified our investments, including our clients' portfolios, between India and our Global Compounders Portfolio to lock into this low correlation effectively.

When diversifying, the goal isn't to lower returns. Many in India invest in government bonds for diversification, but while they offer low correlation with the market, they also significantly reduce returns. Instead, diversifying with assets–such as American equities–that are equally attractive in terms of long-term returns but have a low correlation helps maintain strong returns while reducing risk and volatility.

What lessons have you taken away from the challenges in your career?

I have learned that true diversification within a country portfolio requires more than just spreading investments across sectors. It’s essential to mix both established leaders and emerging challengers, not just different sectors.

For instance, having companies from 10 different sectors in your portfolio might seem diversified, but if they all share the same style—like being growth-oriented with high ROIC (return on invested capital)—you're not truly diversified. It’s like owning the same stock 10 times, just from various sectors. I learned this the hard way when a market correction from January 2022 to March 2023 caused a 15% decline in our portfolio, as all these similar companies suffered simultaneously. This triggered a bout of introspection in Marcellus and the result of which is that today our portfolios are diversified not just across sectors but also across different types of companies. For instance, Narayana Health is an emerging player in healthcare with ROCEs in the mid-20s, whilst Tube Investments is on its way to becoming an industrial powerhouse with ROCEs in the high teens.

Anything interesting ahead, in your view?

The next 12 months could be quite interesting. If the government shifts its focus from capital expenditure to revenue expenditure, as indicated in the Union Budget in July, it would mark a significant change. Unlike the interim budget in February and the previous three union budgets, which prioritized heavy capex, the July budget saw a 17% increase in Capex. This is a reduction from over 30% increases in the earlier budgets, signalling a potential shift in spending priorities.

With several upcoming assembly elections in key states – including Haryana and Maharashtra – the results are likely to influence the budget decisions on 1 February 2025. We may see a significant pullback in capital goods, power, infrastructure, and defence sectors in the wake of these elections.

Given the political developments since June 4 and the government’s clear focus on social development, including support for the poor, women, and rural areas, the current enthusiasm for defence and public sector investments seems misplaced. The government's recent budget clearly outlined its priorities, making the current push for defence and infra-focused new fund offerings appear untimely.

Do you think the manufacturing theme might also fall out of favour?

While the success of the PLI scheme in smartphones and the EV sector is notable, and sectors like APIs are benefiting from reduced western dependence on China, there’s limited evidence of a broad-based manufacturing revival in India. The government's China+1 strategy has yielded some results, especially in mobile phones and two-wheeler EVs. However, beyond these areas, a significant manufacturing boom is not apparent, as reflected in recent quarterly results and in the weak private sector capex data.

A byproduct of this is that manufacturing companies haven't seen explosive growth. While electrical companies have performed well due to high demand for air conditioners, coolers, and fans during the hot summer, the overall manufacturing sector remains underwhelming.

How have you avoided getting involved in sectors like defence and capital goods?

After reviewing 10 years of annual reports of companies in these sectors, we found that defence, power and infrastructure, and metals and mining sectors often lack clear thinking (in terms of the promoters in these sectors having to change course whenever our policymakers change course), purposeful strategy, and effective capital allocation. As a result, we have avoided investing in these areas.

Have you completely ruled out these sectors?

We don’t blacklist sectors upfront. Our approach focuses first on finding companies with clean financials; and then amongst those companies with clean financials, looking for the companies with return on capital higher than their cost of capital over a 10-year cycle. We also look for evidence of pricing power, often indicated by stable gross margins.

Companies in sectors with heavy government involvement, such as real estate, infrastructure, and metals, rarely meet these criteria. Consequently, our investment philosophy naturally leads us to avoid these sectors. Our reluctance to invest in government-owned companies is due to the political risk involved. As governments change, their policies and priorities can shift, impacting these companies. Investing in firms with government as a major shareholder means accepting this inherent political risk.

What’s your outlook on equities at this point?

Just as our Global Compounders Portfolio is significantly underweight the "Magnificent Seven" tech giants in the US, and yet we've outperformed the S&P 500 by 10 percentage points over the past two years, we're seeing a similar dynamic in India.

Many of the PSU stocks and sectors like power, infrastructure, and real estate appear significantly overvalued. Conversely, high-quality, long-term compounders are trading at attractive valuations. In the US, mid-cap companies with strong fundamentals are undervalued because the market has heavily favoured giants like Nvidia. Similarly, in India, while investors flock to sectors like power and infrastructure, we are seeing undervalued opportunities in companies like HDFC Bank, which is currently trading at a lower multiple relative to its book value. This divergence underscores our focus on quality investments despite prevailing market trends.

If the rally continues, which sectors might lead the way?

Now that the focus seems to be shifting towards spending on the poor, rural areas, and women, in a country with high inequality, such redistribution isn’t just populist; it’s necessary. The recent budget and state schemes, like those in Maharashtra, reflect this trend. With Covid's impact easing and good rainfall expected, a consumption revival is likely in the next year. This shift away from heavy infrastructure investment should benefit retail lending, building materials, healthcare, and pharma sectors.

You have a book coming out in October, what is it about?

My book explores the remarkable and unconventional rise of modern India. It highlights how women are outperforming men in various sectors, the efforts of educated Indians to improve their standard of living, notable trends in South Indian states, the China-plus-one strategy, and the growth of outsourcing to India.

How do you turn these insights into actionable strategies for investing in listed companies?

Let’s take Trent as an example. Zudio is Trent’s play on affordable fast fashion. Zudio’s strategy of providing affordable, quality clothing has capitalized on the increasing purchasing power and aspirations of India's middle class. By focusing on women’s apparel and expanding across various regions, Zudio has proved its model and is on track for profitability. Similarly, Star Bazaar caters to the newly educated, middle-class consumers who desire high-quality products at affordable prices.

This insight into evolving consumer preferences and regional growth helps identify promising investment opportunities. For instance, companies like Zudio and Star Bazaar align with the themes of affordable luxury and rising living standards.

Disclaimer from Saurabh Mukherjea: I am personally invested–via Marcellus’s PMS offerings–in all the stocks mentioned in this article. The same applies to my parents and to Marcellus’ clients.