Stuck with defence stocks? Ravi Dharamshi explains how he spotted the downtrend early

Even fighter aircraft Tejas-maker Hindustan Aeronautics Limited (HAL) is down around 25% from its 52-week high value.

ET Markets caught up with ValueQuest Founder and CIO Ravi Dharamshi on the sidelines of CFA Society India’s Value Investing Pioneers Summit held in New Delhi recently.

In this chat, he spoke about why he exited defence stocks but is still not bearish on the theme.Why did you exit defence stocks? Was it primarily due to valuation concerns?
We enter any particular sector with a rolling 3-5 years view to earn minimum compounded returns of around 15%. So either it doubles in five years or if we are much better at catching the trend, then it would be compounding at 25% – which means doubling in 3 years.

So the point at which we are unable to justify that the stock can double from here in 3-5 years, it becomes very difficult for us. The second thing is that the ordering, in my opinion, has kind of peaked but the execution, sales and profits will continue to grow.

That’s because it is a totally central government capex-driven business and the pace of growth of capex has peaked.

A top-down view is developing that the government is going to move from capex towards revex. Or in the capex cycle, they are leaving the space for the private sector to pick up the gauntlet.

One has to be careful over there. So a combination of valuation, macro changing and the fact that market pricing is in picture perfect execution made us sell. So now there is a risk of time delay or material prices going up and down which we don’t want to take. And that is the reason why we exited.

In short, near-term underperformance. In our time horizon of three to five years, we feel earning outsized returns is going to be a challenge in defence.

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But you’re not still bearish on defense as a theme.
No, we are not. I have a private equity fund as well, and we are doing some investments in the private space. The smaller defence companies are getting orders from HALs of the world. Growth is percolating down to the downstream value chain and we are capturing that because valuations over there are not so bad and the size of the companies are still very small.

There are many companies in the downstream defense value chain which will come to list in the market.

You’ve been a proponent of megatrend investing but in a heated bull market some investors also get trapped in narratives.
If you are going to base your investment decision on a narrative and not do the hard work of going inside each of these sectors, understanding the business, understanding what the drivers are, then obviously you will not know when things have turned.

Like it happened in the case of defence also. Stocks are down 30-50% from the peaks. And I’m not saying the narrative is wrong. There is some truth to the narrative. For you to make money in the next three to five years, you have to disassociate from the narrative and focus on what the numbers can be delivered on that in that 3-5 year horizon.

Do you think that the froth that we say building up in defence stocks was largely because of the over exuberance of retail investors?
It doesn’t make me happy to say that, but it is usually the case.

Popularity is the opposite of what we look for. We look for themes when they are developing and nobody is looking at them.

I would advise that most retail investors should come through institutional mechanisms of either mutual funds or professional fund managers, rather than trying to do DIY.

Even professional fund managers also make mistakes, but at least hopefully they will correct their mistakes and will not make fatal mistakes. A DIY investor can end up making a fatal mistake and that can end their investing journey at that point of time.

A sort of similar story has also happened in the case of solar. You bought Waaree much before it got popular. How do you see this solar space evolving?
I would say solar is slightly different because over here is the reverse. I won’t say it is a very popular theme on the institutional side but it is very popular on the retail side for sure.

There are many companies in this space which are yet to get listed. So from that perspective, I don’t think we have seen the last of solar. The story is still evolving – backward integration into cell wafers and capturing other parts of the energy transition. Value chain is also still ahead of us, so it’s too early to say that.

It has at least a five-year window, who knows, it could be longer also. The objective is to diversify away from China in the renewable space. If we don’t, we will end up being at the receiving end, just like we were in the case of fossil fuels.

If you want to reduce that dependence, this is our chance. We have ample sun, we can generate our own energy. We can in fact export energy. And if we harbor this kind of aspirations that we will export energy 10 years down the line, then we don’t want to be beholden to our arch rival neighboring nation.

From that perspective, the profit pools will remain protected for a period of time. And the companies over here will use the cash flows generated to seed other businesses.

Once the big boys like Ambanis and Adanis enter solar space, how will the market evolve for smaller players like Waaree?
The solar sector is an ocean. India is going to go to 530 GW from 50-60 GW. We’ll have a 10x growth in the next 7-8 years.

You think only one or two conglomerates can build the entire capacity? Impossible! Everybody will contribute. This is not a winner takes all kind of an industry. In the case of technology-driven sectors, food delivery has evolved to a duopoly and the search engine market has become a monopoly.

This is not that kind of a business. This is a business where competition will always exist. And we have a reference point in terms of China, where there are five big players. We will also have 4-5 big players and so, I don’t think it is going to be a monopoly business.

Talking about the current market scenario, do you think double-digit return is possible in Samvat 2081 given the kind of valuations and the earnings growth that we are seeing?

I am never good at it and one year has a lot of noise built into it. Since we are coming from a point where the markets have rallied four years on the trot, there is a good likelihood that in the next 3-6 months, we might correct or digest the gains that we have had in the last 4 years.

But the real question is, is this going to be only a correction? And there is still a lot more wealth to be created. I have no doubt about that. The cycle has barely begun. The little valuation discomfort will correct itself by either the market going down or not going anywhere for a few months.
And then we’ll be ready again for the next 3-5 years where the returns will be made. Corrections are part and parcel of the market and we should embrace it. We should not try to run away from it.

If you get too obsessed about the correction, you’ll miss out on the opportunity. Nobody over here who has made any significant wealth in the market has managed to avoid all corrections. So why even attempt to avoid that correction? So rather stay focused on where the opportunity is unfolding and try and capitalize on that.