Interview with Sahil Shah, Fund Manager, Edelweiss Asset Management

Radhakrishnan Chonat : Good day ladies and gentlemen for our Fund Manager Insights Series, we are thrilled to have Sahil Shah, a distinguished fund manager join us today for very insightful interview. Sahil has been an integral part of the Edelweiss family since 2007, when he began his journey as a Research Analyst specializing in in-depth coverage of, I believe, automobile stocks within the mid-cap — small-cap, mid-cap space, right? So with a solid foundation in finance, Sahil’s dedication and expertise have led him to become the fund manager at Edelweiss Asset Management since 2015.

Sahil has accumulated a wealth of knowledge and experience as both a Fund Manager as well as a Research Analyst in his remarkable tenure of over 14 years in this industry. Sahil holds a Bachelor’s Degree in Commerce and has obtained the Prestigious CFA from ICFAI, Hyderabad, which exemplifies his dedication to continuous professional development, right? So today, ladies and gentlemen, we have the privilege of delving into Sahil’s expertise in managing small-cap funds and I’m looking forward to gain some valuable insights from his vast experience. So Sahil, great to have you here.

Sahil Shah: No thanks for hosting and thanks for your kind words.

Radhakrishnan Chonat: So Sahil, to start off, can you share your journey from, let’s say, being a Research Analyst to becoming a Fund Manager? How has this transition influenced your investment approach and your journey in general?

Sahil Shah: Absolutely, absolutely. So I think — I think the journey started before 2007 being part of a — I was a Gujarati businessman family and a lot of people surrounding you were into different kinds of businesses. That kind of always kept me intrigued in terms of how businesses are run, how businesses scale up, how they fail, why do some businesses do much better than the others? And I think that was the — I think the first or the seeds that very sown during that point of time.

And over a period of time, I kind of realized that being good in math or accounting, I mean that would help me to do kind of financial analysis and that is the reason why I kind of chose the profession of being an equity research analyst and then finally transitioned in the — on the fund management side. So since you asked the question in terms of what has been the — I mean how the transition has been from an equity research analyst to being a fund manager, I think the horizons completely widens.

I mean being an equity research analyst you cover a handful of companies, maybe one or two sectors where you kind of specialize in. But what I think helps investing is kind of cross-leveraging what you’ve learned from different sectors. I mean, I think is very, very helpful. Also I think fund management is a slightly different ball game as compared to just being [Indecipherable] with the foundation has to be research-based, it has to be equity research based.

But I think it has a lot of more things have to be done as far as fund management is concerned that is developing conviction, staying put during bad times in a stock, understanding the thin line between when to sell, when to hold up in a particular stock. So those are the new aspects I would say, which I came across as I kind of transitioned from being a research analyst to a fund manager.

Radhakrishnan Chonat: Nice, nice. So Sahil small-cap stocks — are often considered riskier investments and in the Indian context small-cap stocks are often associated with — we keep talking about the higher volatility, right? So how do you navigate the challenges and how do you capitalize on the potential opportunities in this segment? Or to put it differently, how do you manage volatility, right, and maintain a balanced portfolio at the same time?

Sahil Shah: Yeah. So I think the approach towards more consistent returns in small-cap and obviously — I mean we don’t hedge as a long only investor in the small-cap space. But I think what we can do is to have more consistent returns over a longer period of time. And I think the most, one of the most important things is that we don’t take macro calls or cash calls, only focus only in bottom up investing. The second thing that we do is that we don’t take any major sectoral bets, right?

So for example, we will not go overboard on a particular sector thinking that over next one or two years that sector is going to be extremely well. While we will have a view about the sector, which will be also be more driven bottom up but we’ll never go overboard a sector. Typically our range of underweight, overweight is typically between 5% plus-minus. And I think we’ll stay completely away from a particular sector, right, because you never know when things turn around and typically people I’ve seen are always late when it comes to — if they have avoided a particular sector and if they want to get into a particular sector, they are typically late.

I mean very few times you get it right and you will get it right always. So I think managing volatility, I think, I mean the only thing that we can do is kind of stay invested for long term, diversify, not taking macro calls and more importantly over a period of longer period of time if you want to take or generate more consistent returns it has to do with being sector agnostic as well as style agnostic.

Radhakrishnan Chonat: Excellent, sector as well as style agnostic, right? So India has a diverse and you know very dynamic small-cap universe and identifying potential multi-bagger stocks among these small companies is the challenge fund manager faces. Now what factors do you consider when selecting stocks to your portfolio, right? And also if you could explain the investment philosophy and strategy you follow while managing the small-cap fund that you manage at Edelweiss Asset Management, in that way, icing on the cake.

Sahil Shah: So I think as far as the — I mean, see, multi-baggers, I believe that multi-baggers are not known beforehand. It turns out to be a multi-bagger over a period of time. But I think what matters more is the investment process or investment philosophy which kind of results into finding handful of multi-bagger within the overall portfolio that we run. So I think there are two or three major things, which — where I have seen stocks becoming multi-bagger.

First of all, multi-baggers more than earnings growth, multi-baggers are a function of PE-rerating and PE-rerating or the valuation rerating is driven by earnings rule, but it is driven by more — even if a company is doing faster than the industry or faster than its peers or it is — the quality of the company is good I think these are the factors, which is faster earnings growth and quality of the business, quality of the management, which drives valuation rerating and that is where multi-baggers are kind of — we see multi-baggers returns in some of the companies. So the investment framework that we have is what we call as FAIR Framework.

It’s an abbreviation for F stands for forensics, A stands for acceptable price, I stands for being [Indecipherable] informed and R stands for robustness of the business. So forensics, I think is the most important thing as you said that there are almost 350 to 400 companies which qualify as small-cap and which has a market cap of more than INR2,500 crores to INR3,000-odd crores. So to kind of filter out those ideas, I think forensics is the first filter that we kind of put in. Now nothing is black or white, I mean there will be different Shades of Grey and with experience you know where to draw a line in terms of what to choose and what not to choose.

So that becomes important and I think robustness of the business where we kind of look for companies as I said growing faster than the market, faster than the nominal GDP growth rates which are market leaders. And finally it should translate into return on capital and cash flows. So I think the Holy Grail for company giving very good compounding returns is basically one is the earnings growth and the quality of earnings growth should be very good.

Radhakrishnan Chonat: Excellent, quality of earnings growth. So you mentioned corporate governance as one of the key factors. It’s always — what do you call a subjective in nature. So how do you evaluate the corporate governance practices of a company that is part of your portfolio or you’re looking at adding? So are there any separate benchmarks other than the forensics that you do?

Sahil Shah: I think accounting quality checks are the most important of everything. And within that, I mean when we look at the expense ratios of companies, whether it is gross margins, employee cost — breakup within other expenses, even the — how much tax is company paying, what is the conversion of profits in reported profits into cash flows at the capital allocation decisions of the company, those things kind of gives us skews in terms of whether the companies are under-reporting earnings, whether they are over-reporting CapEx. So I think those are the parameters on which we kind of filter out companies.

Radhakrishnan Chonat: Excellent. Sahil, if I were to ask you to discuss just broad — specific or broad, anything, sectors or themes — within the small-cap space that at this point you find particularly promising or in general have a positive outlook with regards to Indian context, what would they be?

Sahil Shah: Yeah, sure. So in our portfolio, we are overweight on the housing CapEx theme. In fact, when I look at our portfolio and if I do a sum total of housing financiers, cement companies, building material companies, which are kind of — which falls under the housing CapEx theme, we are quite overpaid compared to the index. So that is one theme that we like and I think — we’ve seen almost a 10 to 12 year lull in the housing — on the housing sales side, which has now picked up over the last one, one-and-a-half years.

So I think this growth in the housing sales is likely to continue for a longer time. More importantly, the inventory levels in the housing space which were getting more to closer to four years, which were very, very high has now come down to more comfortable and to a long term average of around one-and-a-half years. So I think these factors plus the affordability because the prices of housing has not materially gone up, but the income levels have gone up at least over the last five to seven years. So the affordability has increased. So I think that is one of the reasons that we are quite positive on the overall housing as a theme.

The second is the capital goods space; again, we are overweight there. I think the CapEx cycle again here the CapEx cycle in India was, I would say absent or it was at a very low intensity for a very long period of time because of various issues that we have seen in the past and now that that is coming back. So I mean when we look at some of the larger capital goods companies, we are seeing very good order book growth, which provides us a leading indicator in terms of how the CapEx will pan out in India. So that is another theme that we are quite positive on. And within consumer discretionary space, we like automobiles as a theme and if I talk about sub-segments like QSR as a theme, the quick service restaurant as a theme.

Radhakrishnan Chonat: Right. So the tomato prices are not going to affect the QSR segment, right?

Sahil Shah: I hope so.

Radhakrishnan Chonat: Excellent. Segueing a bit, Sahil, if I were to ask you to share an example of a successful investment stock — that you’re happy about that you have done and exited, right, and what factors if you self evaluate contributed to its success? And are there any lessons you learned with that investment or you can even pick an example of the worst investment you have made and the lessons you have learned?

Sahil Shah: Sure, sure. So I think one of the stocks where we have been investors for the last almost more than five, six years and which has delivered outsized returns or you can say multi-bagger returns is a steel tube manufacturer. I think what the learnings have come out from that is that once you have a very, very, capable, a very, very aggressive promoter who is at the helm and he’s trying to do things very, very differently especially in a space where I mean because of his drive and the products that they are launching, the new use cases are coming up where there is a conversion from cement to steel or from wood to steel.

So those kind of things when promoters do or when they kind of try to expand the overall addressable market is when there is a significant rerating that happens in the stock along with earnings expansion that we have seen over the last five to seven years. Obviously, the starting point when we talk about very outsized returns of the multi-bagger returns it has typically to do with markets kind of ignoring that particular space or that particular stock because of X, Y, Z reasons. But ultimately once the numbers come in and once people see cash flows and return on capital is when the stocks get rerated. So I think that is the key learning that I would say I had from the experience of investing in that particular.

Radhakrishnan Chonat: Excellent. Excellent. So Sahil, you have this very envious position, right, when it comes to large cap and all that when you are talking about indexing, but small-cap is something that actually needs active investing and fund manager skills. So how do you stay updated with all the evolving market dynamics and changing trends in, with regards to the small-cap space?

Sahil Shah: I think I mean, obviously we start — I mean, I start my day by reading newspaper. There are a lot of business magazines which are available plus I mean there are a lot of conferences that we attend to kind of stay updated about what is happening in the business. From the news flow side, I think there is more information that comes through obviously more than what we can chew. So I think information nowadays is not a problem. In fact, I mean let’s say 10, 15 years back there were maybe large cap companies, which used to do quarterly interaction with investors. Now, I see that most of the small-cap and mid-cap companies also kind of interact with investors on a quarterly basis and quite regularly. I think information is not a problem, but I think information overload and how do we filter that out is a challenge nowadays.

Radhakrishnan Chonat: Excellent, excellent, filtering the noise. If I were to ask you right now, small-cap is the flavor of the season and I believe some fund houses have like stopped taking in — I mean we are at a historic high levels. What advice would you give to individual investors who are looking to invest in small-cap funds or who already are in the SIP process, what factors should they consider before either making an investment decision because the risk volatility so what kind of an advice do you generally give investors who are looking at picking a SIP or a bulk investment in your fund?

Sahil Shah: Typically we always tell investors to do an SIP as far as small-cap fund is concerned with an investment horizon now more than three to five years. And the reason is that we can’t forecast what is going to happen on the macro variables, whether it is inflation or what that is going to say tomorrow or whether there is some SVB bank like crisis that is going to happen so those things are not predictable and SIP becomes the best [Indecipherable]. As far as the valuation of small caps are concerned, as far as the level of indices are concerned, I would say that we are somewhere in the mid of the cycle.

So when I look at the history and more importantly, we are not in the euphoric zone that we have seen in 2007 and ’17. So in 2007 and ’17, the valuation multiples of large caps used to be 25 to 27 odd times. On top of that small-cap, mid-cap stayed at 20% to 30% premium almost at 30 to 35 times. In the today’s context that valuation multiple is more closer to around 18, 19 times as far as the small-cap is concerned, right? And so is the case with large-cap index with the growth that is looking quite robust over the next two years.

So that makes me believe that while we are not at the bottom of the cycle for sure, but we are not also at the top of the cycle as far as the valuation or euphoria is concerned. In fact, once — I mean at least in hindsight in late 2021 when small-caps kind of picked out, they did not perform for a very long period of time, right, there was an under-performance compared to the large-caps for almost an year. It has been just three months when this small-cap rally has started. So that makes me believe that we are somewhere in the mid of the cycle and I think once you stay invested, once you continue to do SIP in the small-cap side.

Radhakrishnan Chonat: Excellent. So Sahil, when you’re not filtering the noise, when you’re not actively picking — or when you’re not actively looking at forensic audit and stuff, what are your hobbies or how do you chill?

 

Sahil Shah: So I mean I like to kind of play some sport so that is one and second is reading books is another hobby. Obviously, when markets are doing very well and when we have to kind of look for new ideas the time that I can dedicate to reading was less and when I mean we are just sitting on great ideas my time for reading goes up, so that keeps changing. But yeah, I make sure that I’m reading something or the other.

Radhakrishnan Chonat: Excellent. And that perfectly segues to final question that I always ask all the fund managers that I get to interact with. Recommend three books for my listeners.

Sahil Shah: I think if one has to understand behavioral finance, which is very important as far as investing is concerned I think The Art of Thinking Clearly book is — I found it would be a good read. A book by Morgan Housel has been a good read for me. On the business side or to understand how businesses have evolved over a longer period of time there are a whole host of books. There is Shoemaker, a book on Nike which is there or 100 Bagger, which is another book which is there. So I think these are the books I would recommend.

Radhakrishnan Chonat: Excellent. So Sahil, it’s been a pleasure picking your brain and I look forward to more such interactions in the future. Thanks for taking the time out and catching up with us.

Sahil Shah: No, no. Thank you so much. Thanks for hosting us. It was actually a pleasure. Thank you so much.

Radhakrishnan Chonat: Excellent. Thank you, Sahil.