Mukherjea, who has a Master of Science degree in economics from the London School of Economics and Political Science, was among a few experts who predicted the 2007-08 financial crisis that originated in the US. While he believes in prioritising quality, covid presented him with a unique learning: overpaying for quality can backfire.
“To find companies like HDFC Bank or Asian Paints at these valuations, you would have to look back quite a while,” he said in an interview with Mint, adding: “While the broader market is likely to correct, I expect large caps to face smaller declines compared to small caps.”
Edited excerpts:
How has your investing style evolved over the years as you gained experience?
Throughout my 20-plus-year career, each stage has brought its lessons. I’ve learned, applied, succeeded, made mistakes, and used those missteps to refine my approach.
In my UK years covering small caps, I followed Peter Lynch’s principles of growth at a reasonable price, which served me well and even led to my 2007 prediction of the financial crisis. But as markets crashed, I realized valuations can be misleading—only true quality endures in crises.
After moving to India, I embraced the ‘coffee can’ investing philosophy: prioritizing quality, especially in markets where corporate governance and institutions might be shaky. Paying a premium for quality helps weather tough times. (The ‘coffee can’ investment strategy involves buying and holding a portfolio of high-quality shares for a long term.)
However, post-covid, we learned that overpaying for quality can backfire. Marcellus struggled in 2022 and early 2023, teaching us once again to balance quality with prudence. We refined our approach and it’s paid off, with strong returns over the past 18 months. Each phase brings new insights, and I see the charm of this job in adapting and improving as the market challenges us, making us better investors along the way.
So you kept plugging in the leaks?
Yeah. So, you have got a boat, and you are in the high seas. Every few years, the boat will leak; you plug it, and the boat moves further in the deep seas of investing.
Now, the Nifty 50, it’s been in a very tight range. What’s your take on the markets at these levels? Do you also see a correction looming around the corner?
Before we get to the valuation of corrections, it is worth highlighting that we had a supercharged economic boom in India post-Covid. From 2022 to early 2024, India experienced a strong economic recovery, becoming the world’s fastest-growing large economy.
Markets move in cycles, and a strong economic recovery cannot last indefinitely. Unlike China, which had 20 years of continuous growth, India has now entered a cyclical downturn. The results for the quarter ended June were weak, and I expect the results for the quarter ended September to be even weaker.
In this context of the economy entering a cyclical downcycle, the valuations at the Nifty level appear rich. I would suggest a correction at the overall index level over the next six months or so.
In the past month, broader market indices have mirrored the Nifty’s narrow range. But over the year, mid- and small-cap indices have nearly doubled the benchmark’s returns. Some areas in the broader market appear overvalued. What’s your view on mid and small-cap stocks? Do you see any value?
A correction in the broader market is more likely, especially considering that the economy appears to be entering a cyclical downturn. It is reasonable to expect that small- and mid-cap stocks will experience a greater decline than large-cap stocks, given that small- and mid-caps have seen larger gains.
That said, our focus is on identifying clean, high-quality companies, and we have been fortunate in that regard. Throughout 2022, 2023, and even into the early months of 2024, up until six months ago, quality was not performing well at all.
Since the Russian invasion of Ukraine in January 2022, we’ve observed a two-and-a-half-year period where quality stocks took a backseat, allowing low-quality companies to perform exceptionally well.
As we move into this economic downturn, high-quality companies are now more reasonably valued than they have been in the last four years. To find companies like HDFC Bank or Asian Paints at these valuations, you would have to look back quite a while.
In summary, the economy does seem to be softening. The earnings reported this quarter indicate a clear trend of weakening. Thus, while the broader market is likely to correct, I expect large caps to face smaller declines compared to small caps.
Furthermore, across both large and small caps, I anticipate that quality stocks will decline less than low-quality stocks, which enjoyed a stellar performance throughout 2022 and 2023.
Which investment option would be smart among large-cap, mid-cap, and small-cap stocks?
If you were to compare like-for-like quality investments, I would advise avoid investing in anything that isn’t of high quality right now. You can interpret quality in your own way, but steer clear of companies with unclear financials, questionable promoter track records, poor capital allocation, or weak balance sheets.
If I had to choose among three portfolios—large, mid, and small caps—each consisting of high-quality companies, I would definitely recommend large caps in the current circumstances.
But would you still see the same growth potential compared to mid- and small-cap stocks? And if large caps have been delivering double-digit returns, do you believe that trend will continue?
In many instances, high-quality large caps are currently trading at record low PE multiples. For instance, HDFC Bank, one of our largest holdings, is at a historic low PE multiple. From a valuation rerating perspective, I believe high-quality large caps have greater potential for a steep rerating compared to high-quality small caps.
Additionally, many large caps in our country remain relatively small within their respective sectors. Take Titan, for example. Its market share in the jewellery sector is under 10%, despite compounding 1000x in 20 years, all while gold demand continues to surge in India. Likewise, HDFC Bank, although it is twice the size of Citigroup, holds only a 12% market share.
Many large caps still have significant room for growth within their colossal sectors. Therefore, I’m not convinced there will be a substantial growth discount. It appears that the valuation rerating for many high-quality large caps is likely to be steeper than what we anticipate for high-quality small caps.
Since you mentioned financials and Asian Paints in consumer discretionary, which sectors are you bullish and bearish on for Samvat 2081?
I expect a classic pattern to emerge. In India, during economic slowdowns, IT services, pharmaceuticals, and FMCG generally perform well, and currently, these sectors look solid. In IT, the US has started its rate-cutting cycle. In FMCG… the government has become more proactive with subsidies and sops for the poor. For pharmaceuticals, strong demand from the West and lower raw material costs due to Chinese price reductions create favourable conditions.
In an economic downturn, IT, pharma, and FMCG should be reliable safe havens. Focus on high-quality companies with strong capital allocation records within these sectors.
You said the economy is entering a cyclical downturn. Could you elaborate on that?
Structurally, India is in good shape. Our book, ‘Behold the Leviathan: The Unusual Rise of Modern India’, discusses this structural rise but acknowledges that economic cycles will still occur.
First, rising interest rates—felt after a one to one-and-a-half-year lag—slow down the economy. The (US) Federal Reserve raised rates throughout 2022 and early 2023, with the RBI (Reserve Bank of India) following, leading to higher NPAs (non-performing assets) in banks and NBFCs (non-banking financial companies)—a trend likely to continue.
Second, fiscal stimulus. While Western governments provided substantial support during covid, they began withdrawing it as the pandemic eased. Our government offered less significant stimulus but still provided support.
As these fiscal buffers are removed, economic momentum is likely to decrease. Tightening monetary policy exerts downward pressure, while tightening fiscal policy contributes to deflation. The job creation cycle also plays a role; we saw notable growth post-covid, especially in 2021 and 2022-2023.
The recent slowdown in job creation presents a significant opportunity for long-term investors. If the economy continued to rise unchallenged, chances for strategic investment would diminish.
However, India’s strong fundamentals—robust corporate balance sheets, a stable banking system, and financially secure households—remain promising.
A downturn allows for investments in high-quality companies at reasonable valuations. Our recent results reflect this strategy, showcasing numerous opportunities for generating alpha. By following our investment approach—focused on quality, good governance, and solid growth—you’ll see that alpha has been strong over the past six months.
Talking about trends, we are observing some sector rotation. Do you see anything intriguing emerging?
I think one trend that we are likely to see in the next couple of years is the amount of retail money coming to the market; I think that feels a little over the top.
Recent Sebi (Securities and Exchange Board of India) data shows 170 million demat accounts, but only about 20 million individuals file income tax returns.
I find this disconnect suggesting that a huge ecosystem of first-time retail investors without particularly deep pockets has come into the market, and I suspect they would come into the market, into the most overheated stocks. I suspect they’re going to pay the price for that. And, therefore, in that regard, there will be churn in the investor base that drives the Indian market.
Are you hinting that domestic and foreign institutional investors (DIIs and FIIs) could take the baton from here on?
I will be astonished if retail investors take the baton from this point. Four years ago, there were 30 million, and now it is 170 billion—a 6x increase. That feels excessive for a country where only 20 million pay income tax.
What kind of returns should investors anticipate at this stage, particularly given the impressive performance we’ve seen in the years following covid?
Depending on your investing style. Consider this: the Sensex has compounded by around 12-13% over the past 40 years, while the Nifty50 has been around for 30 years. After experiencing phases of 25% returns, a degree of mean reversion seems warranted, especially with the Indian market at record levels.
Currently, the large-cap index trades at 23-24 times forward PE, suggesting a potential reversion. Conversely, high-quality companies have seen steady earnings growth in the high teens over the past three years, but share prices have only compounded at low single digits. This discrepancy may also lead to mean reversion.
At the index level, we can expect low-teen returns while the economy faces a cyclical downturn. However, for high-quality companies with mid-teen earnings growth and potential re-rating, there’s a good chance of achieving high-teen returns.
Since you mentioned a cyclical downturn, should investors focus on steady returns or superior returns?
I think the tortoise versus hare story is the best parable for investing. While you can try to be the hare, the team at Marcellus prefers the tortoise approach. The fable reminds us that, despite appearances, the tortoise ultimately wins.
Since Marcellus began investing clients’ money on 1 December 2018, we have had both good and bad years, but net of fees, we have outperformed the index by nearly 100 basis points, even during the tough times of 2022 and 2023.
Companies like Titan and Asian Paints exemplify this tortoise style of investing. Titan has compounded 1000x in 20 years, and Asian Paints has compounded 24,000x in 40 years, while the hare is nowhere to be seen.
We call these tortoises “consistent compounders”. Those seeking superior returns often overlook them, but during an economic downturn, tortoises cross the finish line first.
