You are well known as a value investor. In fact, your value fund recently completed 10 years. But there are different styles within value investing. The Graham-and-Dodd style looks at statistical bargains, risk arbitrage and other such factors. Buffett looks at moats. Tell us what style you adhere to and how it came about.
When I started off I was very influenced by Graham and Dodd. At this point of time I am more under the influence of Howard Marks and James Montier as they advocate a contrarian approach which is also a type of value investing.
What brought about this change was the experience I had in 2007 when the market was on a roll. I was invested in a number of low valuation stocks which underperformed, pushing me to re-think my framework. When you are managing other people’s money you cannot afford to have a style which may not work for years. I admit, it worked in 2009 but in 2007 it was difficult to work with the Graham-and-Dodd style.
How different are the two styles?
Pretty different. The Graham and Dodd style is cigarette butt investing- where you try to find a very cheap stock, keep buying that stock and wait for the environment to change. Whereas when you buy contrarian or quality oriented stocks, the cycle change happens faster.
A classic example is the telecom sector over the past 5 years. It is in favour 3 months of the year and out of favour for the remaining 9 months. If you follow the contrarian style, you may end up buying telecom stocks during those 9 months and earn returns in the remaining three.
So in the case of the contrarian style, you can find periods of time to earn your returns. In a mutual fund environment, one is better off operating in a framework that allows for these kind of returns to come rather than waiting for years.
Can’t these two styles be combined?
If you have a cushion in the form of past performance, it allows you take longer term decisions. If this cushion is not there, taking a very long-term approach does not work when you are managing other people’s money.
You said you are under the influence of Howard Marks. Marks looks at “good company, bad balance sheet,” which is different from a bad company which is challenging to turn around. Do you follow in those steps?
Yes. I have believed in it very strongly. For example, we kept adding the stocks of a chemical company to our portfolio as it came down; as the stock went up we gradually reduced its weightage. It is important to feel comfortable with the company.
Do you think it is difficult to find value picks in India?
Not at all. My experience has been that while the bulk of the market is still either growth or growth at a reasonable price (GARP), it is always possible to find pockets of value. The problem is not so much as finding pockets of value, rather it is to have the emotional reserve to pick that stock. What you buy should be something others detest; which can be emotionally draining to some extent. To buy something in trouble, the fund manager requires courage.
Patience is the key skill set for investors in order to have a good investment experience, whereas the fund manager requires courage.
When the market is in the throes of a bull run, like 2007, is it not difficult to find value?
We believe in a concept of relative value. In 2007, we found significant value in consumer, pharmaceutical and technology. Therefore, at any point of time, we will be able to find value in something at least relative to the rest. In our opinion, given the way markets have got integrated, there is lot of scope to find value at all points of time. What is required is the intrinsic approach to buy value while others don’t like it; in the first place, it becomes value because others don’t like it.
In 2007, there was a problem with one pharma company- there was a view that the exclusivity that they previously had on one of their products would be lost. The stock got de-rated substantially. So, while in 2007, valuations of the rest of the market had expanded, a pharmaceutical franchise with a good management was trading at 10-12 times the earnings due to a temporary problem and we saw this as a potential opportunity for investment.
You gravitate a lot towards mid-cap stocks in ICICI Prudential Value Discovery. When mid caps run up do you see value in large caps?
If you see the period post 2006, there has been only a short period where mid caps have done well - after 2009 and also parts of 2010. Mid caps tend to be out of favour longer, therefore one gets better opportunities in the mid-cap category for such a fund. To an extent we do see value in large caps. In fact, the current top two holdings of ICICI Prudential Value Discovery are large caps.
Have you experienced value traps?
Yes. Going by cigarette butt investing, we bought certain paper and fertilizer stocks which turned out to be value traps. Therefore, we believe one should not go for very cheap, low price to earnings (PE)/ low price to book (PB) sectors. Instead, it is better to buy a quality company where you may have to pay a higher valuation, but at least it is less of a value trap. For example, we avoided oil marketing companies in 2007-2014 and they turned out to be value traps for most of the period because the policy on subsidies resulted in their earnings not growing at all. So, periodically, one may get into value traps and learn from our past mistakes.
But do these companies or sectors remain value traps forever?
There are sectors like paper which have become value traps because the tablet revolution has resulted in people using the internet as a mode of news rather than a printed newspaper. Frankly, investing is not about getting everything right, rather it is about getting most things right. If you choose to avoid making a mistake, you may end up taking no decision. It is to an extent a percentage game, where you try to identify the right decisions, and one or two decisions may go wrong. It is not something like arithmetic where there is one correct conclusion; it is more like an art.
We are finding value in select large caps- in fact, some of the technology large caps. That is because relative to the market they have become reasonably cheap i.e. their valuations have not expanded. There are also opportunities in companies in the public sector area where investors have got disillusioned with past performance.
You mentioned above that it is better to buy a quality company to avoid a value trap. How do you define quality?
Quality stocks have a good return on equity (RoE) and return on capital employed (ROCE), while at the same time paying a higher price to earnings. To give you an example, a prominent automotive battery company had underperformed for the last 3 years but since the industry does not have too many players, the business has a reasonable ROCE and RoE. Naturally we found it to be a good investment opportunity and the stock has done pretty well.
How do you know a stock is an investment you want to hold?
There is a certain end point of valuation, and that end point has been defined in our investment research process as the target price range. We have a higher end of target price. We have seen that when the stock reaches the higher end of target price range, we are able to find a way to book profits. But one has to wait till then. In the fund management process, there are times when you don’t manage to catch the entire move. The other framework, which we believe works for us in the case of mid-cap stocks has been that you sell slowly rather than decide the peak price. This framework helps us participate in the upside.
