Saurabh Mukherjea is gung-ho on 2 pharma stocks; adds Prudent Corporate. Here’s why

Saurabh Mukherjea, Founder, Marcellus Investment Managers, says ROC and free cash flow are proxies. While ROC can drive, Divi’s promoter has distinctive capabilities. One has to look for unique businesses and unique skill sets that nobody else possesses and if one can identify them, one should go and build positions there. Just make sure the promoter is an honest person, because if he is not honest, then he will scheme away the upside from the unique capabilities for his personal wealth rather than sharing it with you.

Further, Mukherjea says that rather than playing the mutual funds per se, he prefers to do it through an intermediary like Prudent Advisory. An unlisted company like NJ and a listed company like Prudent have competitive advantages and are the gatekeepers who stand between the mutual funds and the broader investing public.

Let’s discuss a couple of your holdings in the Consistent Compounders portfolio, the likes of Divi’s Labs and Dr Lal PathLabs. Divi’s specifically because it has not done much for a while. What makes you confident about these two stocks?
Divi’s revenues today are 30% more than what it was in pre-Covid days. So, strip out Molnupiravir and even then, Divi’s is 30% larger, the firm has grown by a third through COVID. They had a gross margin hit in the quarter to December. My reckoning is much of that will unwind, especially the raw material cost issues that were there in the quarter to December. There is inventory destocking happening across the pharma industry across the world. Some of that will still carry on in the March quarter. I doubt that the March quarter will be a booming one. But the company’s top line has grown steadily over 20 years and has grown steadily even through Covid, stripping out Molnupiravir. As gross margins recover, this business is in good shape. Their key customers are six of the largest pharma companies in the world.

We speak to them quite regularly and the view is this company has come out of Covid with their credentials burnished, their credibility is at an all-time high and with western pharma companies looking to reduce their dependence in China, we see Divi’s incredibly well positioned. So, through November, December, we doubled our position in Divi’s.

Coming to Dr Lal PathLabs, the situation is somewhat similar. The operating margins are higher today than they were before Covid. This talk about competitive pressure is a lot of nonsense. If a company is under competitive pressure, you should see that pressure on operating margins. You do not see that here. This company’s free cash flows are more than the rest of the path lab industry put together. Excluding Covid, business growth is around 12-13%. A couple of percentage lower than what it was before Covid.

But as we come out of Covid and get back to our old routine of perhaps not being as hygienic as we were through Covid, as we lose the habit of using sanitizers and washing our hands, I think it will go back to 13-14% top-line growth that Dr Lal was accustomed to seeing before Covid. So competitive intensity is reducing in the sector as private equity and venture capital funding dries up and we see Dr Lal nicely positioned. In July,-August, we doubled our stake in Dr Lal.Where are you putting your incremental money to work apart from the fact that you have doubled positions in a couple of these pharma companies? Which are the spaces or the recent additions that you have made to your portfolio?
We have added Tata Elxsi to our midcap portfolio. That was our last big addition. We got out of Relaxo and added Tata Elxsi around three months ago. The other addition we have made in our financial services portfolio is in the midst of this mayhem around income tax on debt mutual funds. We have added Prudent Corporate.

Prudent is a wealth management platform for the IFA community. We have added that to our Kings of Capital portfolio. We see this space as being very attractive. We think the mutual fund story in India will play out amongst mass affluence. Prudent has built a platform which has 25,000 IFAs. The IFAs bring in mutual fund business, insurance business and Prudent gets a slice of action. We will monitor Prudent over the coming months to see whether it merits additions in any other part of the Marcellus Investment Universe.

Would it be a good idea to buy the stress in AMCs? A year ago, Rs 4,000/share was the price for HDFC AMC, Now the same business is 20% higher in terms of the AUM size but is available at Rs 1,600?
I think the debt industry and more generally, the mutual fund industry has a good runway ahead of it. Yes, the Finance Ministry will tighten tax loopholes; but given the sheer quantum of financialisation that lies ahead of us, I reckon something like a trillion dollars will come into financial services products over the coming 10 years by insurance, mutual funds, AIFs, PMSes. We need to have investments in this industry.

Rather than playing the mutual funds per se, we prefer to do it through an intermediary like Prudent Advisory. Our view is that competitive advantages that say an unlisted company like NJ and a listed company like Prudent have these competitive advantages are formidable and in fact, they are the gatekeepers who stand between the mutual funds and the broader investing public. Wealthier people go through Kotak Wealth and IIFL and so on, but for the less wealthy people, firms like NJ and Prudent have been very effective low-cost platforms for the masses to access mutual funds.

This is our straightforward way to play the epic financialisation that lies ahead for India in the coming decade. Just one disclaimer, I am an investor in all of these stocks through our PMS products, so are my parents and so are my 10,000 clients.

Thank you for the disclosure. Coming to some of the internet stocks, today, they look expensive and do not make profits. But if you have to extend the timeline by three to five years, the businesses could be different, the demographics would be different. So do you think there is merit in buying some of these stocks?
I think there is merit in doing that but we need to look out for companies with distinctive capabilities because there are lots of clever coders in our country and lots of clever entrepreneurs. If tomorrow morning, Saurabh Mukherjea starts a pizza delivery business it is difficult for me to tell you that I have built a moated pizza delivery business or I have built a moated business for delivering cabbage to your house. Therefore, the search should be for companies which have distinctive capabilities and can do something that their rivals cannot.

I have said in the past, we keep looking at Nykaa and asking, “Are they in that space? Has Falguni Nayar and team built a platform which is distinctive, unique?” There are elements to what Nykaa does which we think are very clever, very unique, but I also think they could do more on the tech platform and we are keeping an eye on that. Our focus has typically been on understanding the business fundamentally. What does the business bring to the table that nobody else can and if we find such businesses, given that valuations have come off, we would look to invest.

But as yet, that search continues. We are yet to find too many digital businesses in India which have distinctive capabilities. InfoEdge remains in our midcap portfolios as one such business. I think the Naukri platform is utterly unique and the business that Sanjeev Bikhchandani and team have built using the cash flows from the Naukri platform is a very clever way to monetise the free cash flows coming out of Naukri. If somebody else out there builds a Naukri or builds something akin to a Naukri, a distinctive, unique business, we would love to invest.

You are investing but you will never look at companies which do not generate free cash flow. You will say, look that is a no-no for me?
You can turn my Divi’s bull case around and tell me rightfully that 20 years ago, Divi’s did not generate much free cash. Around the time it went public 20 years ago, Divi’s ROC was not particularly higher than cost of capital which means it did not generate free cash flow. If I had the brains 20 years ago, I would have turned around and said, Murali from Divi’s is an uniquely talented chemist, he is building a high quality franchise. Mr Divi has unique capabilities. Let us build a position in Divi’ Lab. As we get older and we become more capable of identifying businesses where ROC apart, free cash flows apart, a promoter brings to the table distinctive capabilities, it becomes easier for us to build positions in such companies.

In a way, ROC and free cash flow is a proxy. We are saying that because ROC can drive. This promoter has distinctive capabilities but fundamentally what one is looking for is unique businesses, unique skill sets, skill sets that nobody else possesses and if you can identify them, you should go and build positions there. Just make sure the promoter is an honest person, because if he is not honest, then he will scheme away the upside from the unique capabilities for his personal wealth rather than sharing it with you.

You do not have a very big allocation to consumption. Of course, you have allocated through Asian Paints and Page Industries etc. but there are no hospitality companies, no big auto names, not even FMCG for that matter. Is there a reason you are sticking away from consumption, even durables for that matter?
I think it is the distinctiveness point. In our country, I think increasingly the moat of the FMCG franchises is being eroded by direct to consumers (D2C). Direct to consumer itself does not make a lot of money but hey one can get hair oil, cooking oil, a whole range of FMCG products directly on my app, even though the D2C provider might not make money, it erodes the competitiveness of the standard FMCG players. That’s something we have been very wary of over the last couple of years.

Our only conventional FMCG player is Nestle because it is not possible to sell baby milk powder on D2C. It is a difficult industry to enter, there is licensing, there is restricted selling and therefore Nestle remains our core FMCG player. For the rest of the FMCG players, the moats are eroding as D2C comes of age in India.