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Tilting towards ‘Cash flow generators’

In our August 2021 update, we had put forth our view of SMID outperformance (versus large caps) peaking out. Apart from reiterating this, we now look at history (since 2002) and point out that during periods of SMID underperformance (especially the ones after post-crisis rallies), consistent OCF generators outperform massively. Based on this, we highlight a list of stocks across BSE500 that pass muster on our consistent OCF criteria coupled with earnings growth.

We are also now tilting our 30-stock SMID model portfolio towards ‘Winners’ (market leaders with strong cash flows). Overall, our top SMID picks are: Gujarat Gas, Quess, Birlasoft, Blue Dart, Jubilant Ingrevia, Sobha, Varun Beverages and RHI.

SMID outperformance peaking; head towards CF generators

In our August SMID note, we had argued how SMID outperformance may have peaked out based on historical mean reversions (Exhibit 6 & 7). We reiterate that view and further point out that the market gets narrower towards cash flow generators during such periods of mean reversion. Consistent OCF generators (with positive OCF year-after-year and EBITDA to OCF conversion of at least 50%) have outperformed during such periods. On the other hand, during strong rallies such as 2003–07 and 2014–17 and recovery rallies such as 2009–10 and 2020–21, returns of non-consistent OCF generators tend to be superior (Exhibit 1 & 2). During sluggish market phases, pharma, IT, consumer, durables and cement show up as resilient.

Consistent CF generators now warrant higher weights

In light of the context set above – the SMID rally so far, likelihood of mean reversion, earnings upgrades drying up, etc – we believe, apart from earnings growth, it is time to focus equally on cash flow generation. With that in mind, we have built a screener that not only captures historical OCF & EBITDA growth and OCF conversion, but also future earnings growth. We have screened for 15% earnings growth and RoCE, 50%+ EBITDA/OCF conversion and similar future earnings growth. We screen BSE500 universe and present the results in Exhibit 10 (this is a customisable screener).

‘Winners, Warriors & Value’ model portfolio: Beefing up ‘winners’

We have kept our ‘Winners, Warriors & Value’ SMID model portfolio quite dynamic. Till early 2020, our model portfolio leaned more on structural plays (Winners), which we tilted towards cyclicals/recovery plays (Warriors) and Value (re-rating) around mid-2020. This held us in good stead, with the WWV model portfolio beating Nifty Midcap 100 index by 23% since mid-2019 and 15% during the past six months.

Now, we are beefing up the ‘Winners’ bucket of our model portfolio again (refer to Exhibit 12 for new entries and exits). We are adding Varun Beverages, Jubilant Ingrevia, PVR, Supreme Industries, RHI, Timken and Redington. At an overall level, our top SMID picks are: Gujarat Gas, Quess, Birlasoft, Blue Dart, Jubilant Ingrevia, Sobha, Varun Beverages and RHI.

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