Why this investor doesn't care for dividend paying stocks

By Larissa Fernand |  20-08-19 | 
 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Parag Parikh Long Term Equity is a multi-cap fund. The interesting aspect of this offering is that it is a true go-anywhere fund. It is not restricted by any sector, market cap, or geography.

While the 5-year return is an impressive 11.11% per annum, ahead of the category average, it can be a volatile performer It was fourth quartile in 2014 and 2017, and top quartile in 2015 and 2018. Having made that clear, it must be viewed in perspective. This fund also invests in global stocks (up to 30% of the portfolio), making a blanket comparison difficult.

The global universe is huge, so the criteria is to select companies with a) English language reporting, b) from countries with a good legal system, good accounting norms, history of protecting minority shareholders, c) global multinationals and names which are familiar in India.

RAJEEV THAKKAR, the chief investment officer and manager of the fund, discusses his investing philosophy.

You have a penchant for tech stocks. Alphabet, Facebook, Amazon, Mphasis. Why such a prominent high infotech exposure in your portfolio?

It would depend on how you look at it.

Is Amazon a technology company or a retailer? You can view Amazon as a retailer, but thanks to its seamless, frictionless transaction technology, among many other things, one can debate if it’s a technology company.

Is Apple a technology company or a consumer company? Three months ago, Tim Cook on CNBC explained that Warren Buffett probably views it as a consumer company. When asked for his take on that, he said: “We’re in the tech industry. But we work at that intersection of technology and the liberal arts and the humanities. We make products for people and the consumer is at the centre of what we do.”

Is Uber a technology company or a transportation company?

Is Netflix a technology company or a Media and Entertainment company?

Is Zomato or Swiggy or Uber Eats a technology company or a food company?

Is HDFC Bank a technology company or a Financial Services company?

That is stretching it. Why would that confusion arise with HDFC Bank?

It provides services through its app. Just like Amazon. HDFC Bank has brick-and-mortar branches and staff that clear financial transactions. Amazon has football ground-sized warehouses that funnel merchandise and staff who organize delivery. 

What is the point you are making?

The point I am making is that you cannot paint with a broad brush all companies from Facebook to Amazon as being similar. I agree that all technology serves real human needs but both address a very different need. Both are very different companies. One way or the other, all of them use technology to address a need more efficiently, yet each address a diverse set of needs.

Under this wide umbrella of technology, what is the one thing that makes you narrow down on a company?

I choose companies where the consumer preferences are shifting.

For instance, earlier people purchased the newspaper to get their daily dose of news. And you could get the stock prices there, obituaries, birth/marriage/death announcements, advertisements for jobs, and matrimonial advertisements. With digitisation a lot of that has moved online. Google is the new Yellow Pages.

What made you avoid NBFCs?

NBFCs do wonderfully on the lending side but have zero to very little franchise on the borrowing side, or when it comes to raising money. In this area, they are dependent on the wholesale debt market. Which, in turn, depends on the kindness of strangers; every 3 months or 6 months, or whenever a rollover is due.

In many cases, they raise money from their competitors. For instance, DHFL will raise money from SBI, and both offer home loans.

There is hardly any segment that banks cannot directly tap into. Of course, they may refrain when it is at the risky end of the spectrum. Their USP is that they can play on the speed of disbursement or convenience, but that is the only factor. If banks catch up here, the advantage goes.

So instead of NBFCs, I would prefer buying a private bank – I get to participate in their banking business, maybe even asset management and insurance businesses, investment banking, stock brokerage, current and savings account franchise which is low-cost deposit.

Not public sector banks?

No.

Management is not there for long time periods. The individual at the helm of affairs is selected for a few years and then replaced. There is no consistency or stability on that front.

Also, working for minority shareholders is not a priority, but the majority shareholder, the government, takes predominance. Hence, they may be forced to take over another bank in trouble or take haircuts on their NPAs. Their business priorities are not driven solely by profits.

PSU banks and NBFCs are highly levered where the smallest mistake can take down the company.

Is leverage bad?

Per se no. All banks are leveraged companies.

What it does is that it reduces the company’s staying power. The smallest downcycle and they get hit. If funded by equity, an entity can withstand a downturn in sales. But if % funded by debt, the interest has to be paid irrespective of whether the business is doing well or not. When principal payment is due, you are forced to give up the company to the lender.

Recently you changed the way you look at dividends. Explain with an example.

A company earns a profit. It has to pay 30% tax + surcharge + cess. It then chooses to distribute the profits to its shareholders. Now it is forced to pay dividend distribution tax (DDT). India is the only country with this tax.

A consequence of this tax policy is that the effective tax rate for a dividend paying company is higher than that of a company which retains the earnings to re-invest. We explicitly bump up the tax rate for dividend paying companies when we calculate the valuations of the companies that we own.

Now you cannot just value the company on the reported earnings per share (EPS) because there are taxes after the reported EPS, which is primarily DDT and, in some cases, additional tax.

If the dividend payment is zero, then that is real money without any leakage. So it’s of more value to shareholders than company paying out tax. When looking at earnings numbers of a dividend paying company, I would explicitly reduce DDT from the EPS to value the company.

How would you prefer capital allocation in the companies you invest in? 

1. Re-invest in own or allied line of businesses

2. Invest in a new line of business

3. Undertake share buybacks

4. Pay dividends

The last one, for reasons I mentioned, we don’t really prefer it anymore. Some of the companies that we own, do not pay dividends -- Alphabet, Facebook, Amazon -- and we are happy with that. We would be happier if some of our other investee companies, like HDFC Bank, eliminated dividends given that they have to periodically issue additional shares. It would be more efficient to retain the earnings and issue fewer shares.

You have also changed the way you view conglomerates.

Yes. Conglomerates tend to be shunned. And with good reason. There are plenty of vivid examples of wealth destruction. Say a liquor group getting into airlines. There is even a terminology for the valuation fall this results in called the “Conglomerate Discount”.

But we have realized that there are equally vivid examples on the other side. Berkshire Hathaway traces its roots to textile manufacturing. Wipro would have remained Western India Vegetable Products Ltd. if the promoter had taken the advice against diversification too seriously. Amazon has gotten into retailing and cloud computing. Alphabet, Tata Group and Bajaj Auto prior to the finance division spin off are all conglomerates.

We now view conglomerates as neither inherently good nor inherently bad. An additional line of business may create tremendous wealth for its shareholders or be wealth destroying. We will evaluate each company on its own merits.

You can view the portfolio of the fund here

Earlier interactions with PPFAS Mutual Fund:

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