NAFA Asset Managers: Insights on the small and mid cap stocks and investment strategies

PMS Bazaar organised a webinar titled "Building Resilience Through the Certain Times," that explored NAFA Asset Managers' journey, investment strategies, and insights from Balaji Vaidyanath, Director, Fund Manager, CEO, & CIO of NAFA Asset Managers.

19 Aug 2024
NAFA Asset Managers: Insights on the small and mid cap stocks and investment strategies

NAFA focuses on the mid-cap and small-cap segments of the market, leveraging its expertise to navigate complex financial landscapes. Their flagship fund, the Nafa Emerging Blue Chip Strategy, is set to celebrate its ninth anniversary in March 2025. This fund has successfully navigated multiple market cycles, including the booming phase of 2017, the trade war and financial crises of 2018, the COVID-19 pandemic in 2020, and the ongoing geopolitical tensions from the Russia-Ukraine conflict. Through this webinar, one gets to understand NAFA’s stocking-picking approach, analysis, strategies employed and outlook on the market. 

Three-Pronged Stock-Picking Approach

Vaidyanath started the webinar by explaining about the stock-picking approach: 

CapEx Mispricing Approach: This strategy focuses on companies undergoing significant capacity expansion in sectors projected to grow at 1.5 to 2 times the nominal GDP growth. For example, in an economy with a nominal GDP growth of 12%, NAFA seeks sectors expanding at 15% to 20% annually.  This approach hinges on identifying businesses that align with changing consumer preferences and growing at a rate above the nominal GDP, aiming to capitalize on revenue potential increases.

Market Share Gain and Consistent Compounders: This approach focuses on companies gaining market share due to superior leadership, product offerings, or operational efficiencies. Examples of such companies include Safari Industries, which has gained market share over VIP Industries, and KEA Industries, which has outperformed Finalex Cables.

Special Situations and Temporary Headwinds: This strategy involves identifying undervalued stocks facing temporary challenges, aiming to capitalise on market inefficiencies and the potential for normalization over time. 

NAFA structures its portfolio with roughly one-third of investments in each of these categories. This balanced approach allows the company to leverage opportunities across various market conditions and maintain a diversified portfolio.

Debt Reduction Strategies

Vaidyanath emphasises the importance of debt reduction in enhancing shareholder value, highlighting that reducing debt often leads to higher market cap growth, especially in small-cap companies. For example, if a company with Rs 100 crore in debt repays Rs 10 crore, the debt reduction is 10%, but the market cap can increase by a much larger percentage. This is particularly true for small-cap companies, which show a 1.8x market cap increase relative to debt reduction.

Quadrant Analysis

Vaidyanath explained the investment quadrants based on sales growth and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin expansion over two years, which helps evaluate stock performance and identify investment opportunities.  The four quadrants are:

First Quadrant: High Returns with Growth and Margin Expansion (sales growth greater than 5% and consecutive EBITDA margin expansion over two years).

Second Quadrant: Sales Growth without Margin Expansion (sales growth greater than 5% but no expansion in EBITDA margin).

Third Quadrant: Moderate Sales with Margin Expansion (less than 5% sales growth but shows improvement in EBITDA margins).

Fourth Quadrant: Declining Sales and No Margin Expansion (declining sales and no EBITDA margin expansion).

Vaidyanath emphasises that investing in the fourth quadrant is not inherently disadvantageous if the stock price is attractive. For example, if a company in the first quadrant is trading at a high price-to-earnings (P/E) ratio, a company in the fourth quadrant at a significantly lower P/E ratio can still offer value.

Identifying Potential Multi-Baggers

Vaidyanath explains that significant wealth creation often comes from shifts in consumer behaviour and market transitions. For example, the rise of PVC and CPVC pipes over traditional galvanised iron and copper pipes led to substantial growth for companies like Astral. Similarly, the shift in the furniture industry from traditional carpenter-made pieces to ready-made factory designs has benefited companies producing medium-density fibreboard (MDF).

Diversification and the Importance of the Tail

Vaidyanath believes that diversification is crucial in managing portfolios, particularly in emerging blue-chip stocks. He posits that holding a diversified portfolio can mitigate risk and generate returns.  He also highlighted the importance of the "tail" in a portfolio, which refers to the smaller, less prominent holdings. According to him, the tail often contains multi-baggers—stocks that increase in value many times over.

Case Studies

Balaji Vaidyanath explained all his pointers with a case study, to illustrate NAFA's investment strategies. Here are a few: 

Heritage Foods: NAFA invested in Heritage Foods during a challenging period. Despite the company’s struggles in the retail business, NAFA saw potential due to a change in management and the company’s strategy to increase its share of value-added products. Over time, Heritage Foods showed improvement, increasing its share of value-added products and leading to a rise in EBITDA margins and quarterly turnover. This growth and margin expansion led to a significant re-rating of the stock, showcasing the value of patience and strategic investment.

Just Dial: This company faced challenges during COVID-19 but showed a significant recovery, with improving EBITDA margins and substantial cash reserves. Its stock price doubled after Vaidyanath’s investment.

Castrol: Perceived as a sunset industry stock, Castrol was acquired in early 2024.  Despite the initial decline, the company’s strategic adjustments and strong dividend yield made it an appealing investment. Castrol’s market performance improved, and the company adapted to new opportunities.

Global Market Trends

While NAFA does not invest directly in global markets, Vaidyanath tracks over 100 international companies to gain insights into potential trends affecting the Indian market. For instance, he observed profit growth and guidance from machine tool companies in the US to gain insight into the performance of related sectors in India. Similarly, he tracked multinational companies like Linde and Hitachi to understand global technological trends and priorities that could impact the Indian market.

You can watch the video for more case studies and insights on the small and mid cap segments. 

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Disclaimer: The stocks mentioned in this blog are for educational purposes only. This blog does not constitute financial advice. Please consult with a qualified financial advisor before making any investment decisions

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