Note to self on the current Chinese disruption – Big Vision Investing

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Let me just start by saying that my views are positively biased because I have stayed invested in this company since much lower levels.

This post is an attempt to articulate what I have learnt so far, about Indian Pharma.

We have all read recent news reports about the Chinese government cutting power to polluting factories in certain areas. These power supply cuts mean that the factories operating out of such provinces will have lesser capacity to produce goods and operate at a much lesser scale.

This change could mean that if Chinese manufacturers are unable to produce as much chemicals or APIs (active pharmaceutical ingredient) or Key Starting Materials, as before, there would be a shortage of these products across countries. This could possibly lead to higher prices of these products for whoever is able to make them and thereby result in increasing sales and margins. These manufacturers could be from China, India, Timbaktu or anywhere else.

In our case, it could either be beneficial or not, depending upon which side of disruption, the companies that we are invested in, are on.

What are Key Starting Materials (KSM)?

The textbook definition of KSMs – Critical input used in the manufacturing of an essential generic medicine, as well as ingredients or components that possess unique attributes essential in assessing the safety and effectiveness of such essential generic medicines, including excipients and inactive ingredients.

From Mr. Sajal Kapoor’s Twitter handle

From what I have understood so far, KSMs include stuff like Amines, Solvents, Reactants, Acids & Salts. Maybe there are things beyond this too.

With this background, let’s define the problem now. Raw material supplies for Pharmaceutical companies are likely to get hit and these shortages will lead to spikes in input costs.

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Question – Who will be impacted negatively and who will be impacted positively, by this change?

There are certain products where Indian API manufacturers are completely dependent on China for APIs and KSMs. For instance, fermentation-based products like anti biotics, statins, vitamins etc. These players may see cost escalations in input costs of fermentation based products and some of them will pass it on to their end customers over time. Conversely, Pharma players without pricing power won’t be able to pass on these increased costs and their margins will get negatively impacted.

Since I am interested in Laurus Labs, I was worried about this angle and decided to deep dive.

What will happen if Laurus Labs is not able to pass on these price increases to their customers?

Here’s what I found.

This China problem is not new. It keeps cropping up every once in a while. They had a similar issue in 2019 as well.

And here’s how they handled it.

Let’s go back another year now. The year is 2018 and they were having the same troubles. Prices of key raw materials had gone up and Laurus was able to convert a challenge into an opportunity.

Based on the above events, one gets a gut feel that even if there are challenges in the supply chain, here’s a team that can do things, to resolve the issue.

Now let’s look at the situation from the vantage points of various stakeholders involved.

The Chinese factory owner: Last week it was the pollution control officers. This week it is the damn power cuts. How am I gonna pay my bills? How am I to pay salaries to all those people working on the shop floor? I am not sure how long I can sustain in this business.

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The Indian Entrepreneur: There’s a plant closing down in China. I am sure there are opportunities out there for me to go out and grab, and thereby grow my business. While that happens, my margins could take a hit and let me keep my eye on the ball and focus on the long term.

The Customer: Everything was going so well and then thanks to all the polluting factories, I need to find another skilled guy in another business friendly geography where my supplies are guaranteed with equal or perhaps better quality.

Mr. Market: He is swinging in between what will happen in the next quarter and what will happen over the long term. On days when he is worried about the next quarter, he offloads his stake. And on days when he is focused on the long term economics of the business, he thinks “This China + 1 thing is real after all. More and more business could fall into this company’s lap. Let me just hold on to this business. Better yet, let me increase my stake in this business.”

Let’s look at some disconfirming evidence too. Below is one instance wherein they were unable to pass on price increases to their customers.

That being said, here are my conclusions.

  • Equity investing is not a science. Sometimes, we just need to stomach the volatility, the uncertainty & the self-doubt that accompanies falling stock prices. Particularly so, if the entrepreneur has a decent, execution track record.
  • Disruption in APIs isn’t new. It’s been there for a couple of years and is here to stay. And entrepreneurs who have handled it successfully before, could possibly handle it well in the future too.
  • What Mr. Market perceives as disruption, is perceived by the entrepreneur as an opportunity. There are times when blind belief in the entrepreneur is foolhardy. Yet there are times, when you need to go with your gut feel and just trust that the jockey will make things right.
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You don’t want to be that guy who calculates too much and thinks too little.

Disclaimer: I have been wrong with my thesis in the past and could be wrong this time or in the future too. These are my thoughts today and could change as and when the situation evolves or whenever disconfirming evidence presents itself.

Barath Mukhi
11-Oct-2021





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Barath Mukhi

Barath Mukhi

Barath can talk all day about fundamentals-based investing | He is passionate about learning and teaching equity investing | Small and midcap stock ideas.
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