Proxy Investing

"Know what you own, and know why you own it."

- Peter Lynch

Now when we discuss about wealth creation and profit maximization through investments. Broadly there is an argument as to which is a better choice- Value investments or growth investments? (Written in-detail in our previous post- "Investments 101"). Well both have their own pros and cons, but factor common to both is that they do not help in doing away from volatility.

Now what does exactly proxy investing mean and how it benefits an investor? Well it is a way of investment often not talked about and results in Google would be near to imperfect.

Coined for the first time by Peter Lynch, it refers investing in stocks that get positively affected by the underlying main trend.

Peter Lynch is an American Investor, fund manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return.

Proxy investing is an interesting framework proposed by Peter Lynch. What I observe here as a fundamental difference when Proxy investing is compared with any other thesis of investment is that, if you are a conservative investor and cannot tolerate volatility, this way of investment helps you do away with it. As you do not directly invest on the main theme, you invest in those stocks that are the biggest beneficiaries of the underlying main trend.

Explained in detail with examples below:

Exhibit 1: Auto Sector

India had become the fourth largest passenger car manufacturer in the world. With a production of 29 million passenger cars in 2017. This was a period of growth for the auto sector, as many factors acted as a tailwind to make it flourish.

This shows that the total trend for the auto sector has been bullish, where total production, domestic sales and export numbers have been steadily increasing. If closely noticed, there has been a major jump in numbers from 2016-17 to 2017-18.

The tailwinds being, India not only became a hub for companies to meet local demand but also a market for exports. Large scale upgradation and automation, not only helped in manufacturing faster and meeting demands quicker than competing nations but also helped in increasing quality of vehicles.

Now after looking at this growth, one must think the auto sector to be a good bet for a investment horizon of say 5 years. Right? Well not really.

• I have presented a comparison chart, where I have compared the price movement of TATA Motors a well known company from the automotive industry, to SKF India, a auto ancilliary giant present across the globe which primarily deals in the manufacturing of bearings. To give a little background of what bearings do and how they work: Bearings are basically small cylindrical shaped, which help in reducing friction and smooth functioning. These get placed in bicycles, bikes and cars as well. Help in movement.

• As I previously mentioned, proxy investing means to invest in the indirect beneficiary rather than the main trend. This helps one to do away with volatility. Tata Motors has seen a lot of volatility and the journey has not been smooth, but when we look at SKF the journey has been steady and slow yet in a positive trajectory and not that volatile.

Tata Motors:

SKF India:

Now the compounded annual growth rate and return on equity both have also been relatively better for the indirect beneficiary here SKF, when compared to the main trend here TATA Motors.

Exhibit 2: Metals

Now we all know, how metals is a cyclical sector. Proxy investing works perfectly in cyclical sectors such as metals and real estate. Now, prior to the export duty of 15% on 11 types of metal products and raw materials this sector as a whole had been doing good. The demand for metals had been very robust and international steel prices had been increasing. This being one of the main reasons because of which steel manufacturing companies were in a continuous growth momentum. And India has the positive "China +1" effect, too.

Now to understand the cyclicality of this sector, I have depicted the chart of the BSE Metals Index.

It is very clear, that how range bound this sector has been.

Now before going further, one of the biggest beneficiary/proxy for the metals sector is refractories.

What is refractories? Refractories are basically a lining which is used in furnaces, used for manufacturing of iron and steel. These are resistant to high temperatures, so furnaces where liquid metal is transported or mixed, it is commonly used there.

Example of refractoring:

Now why do I feel playing the metals sector through refractories is a better method than the main trend of metals itself

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Now as we know, the metals sector is cyclical in nature, so invariably it's EBITDA margins too would fluctuate with the phase of the cycle.

Now the reason why refractory companies have stable-range bound ebitda margins is because their replacement period varies from 1-2 weeks to 2-3 months depending upon the demand. And because these are hardly 5% cost of steel plants, which makes the steel companies price insensitive towards these refractories.

ROCE Of TATA Steel

ROCE Of Refractory Companies

Now when we compare the ROCE of TATA Steel to any of the top three refractory companies mentioned above, either the trajectory of ROCE has been consistently increasing or it has been above 20-22% even during the worst times of the steel sector. This again is a proxy play to the steel sector.

RHI Magnesita seems to be the top pick in the Refractory sector.

Now in this exhibit when we compare the chart of RHI Magnesita to TATA Steel, notice how the volatility disappears when we look at beneficiaries chart. This again proves my point right of how, proxy investing goes right without volatility.

Hence, the valuable learning from this thesis of investing is that wealth can be made and money can be compounded consistently by investing in the beneficiaries rather than the main trend!

Shivam M. Dave