Investment Philosophy: Mr.Prashant Jain, Mr.E.A.Sundaram & Mr.Chandresh Nigam

These are the personal views of the respective persons and need not necessarily be official use of Zurich Asset Management Company.

CIO : Thank you for giving us the opportunity to speak with you, for agreeing to share with us your investment thinking and for bringing to the table your investment experiences and the selection of your companies. Mr Prashant Jain, could you briefly tell us about your overall investment philosophy?

Prashant Jain: When we talk of Zurich Asset Management Company, there are essentially three things that run across funds.

One is that the respective funds’ product sanctity must be maintained at all points of time. If you say that this is a diversified equity fund it must remain diversified across sectors that are not linked to each other. At no point of time can it become a sector fund no matter what the pressure.

Two, we believe that diversification is a tool for reducing risk. So, all our funds, unless you have the mandate to invest within a particular sector, will remain diversified to the extent reasonable and practical.

Three, we always try and invest in sustainable businesses and companies, which have a reasonably strong competitive position.

I think these are the three elements that are common across the company, across various funds. Beyond this, it is up to the respective funds. Some funds are focused on growth while others may be focused on providing regular income. Some have a perspective of one to three years while some have a longer-term perspective of three to five years. These are in a way also driven by the individuals who manage the funds.

CIO: What about your own investment philosophy? I mean yes, you have to stick to the mandate of the fund, you believe in diversification and you look at businesses that are sustainable. But what else figures in your investment selection process?

Look for a credible management

Prashant Jain: I think the issues are really quite simple. I look for a management that is credible, that I think is fair, that works for the growth of the business and that is focused on whatever core competency it defines.

I look at the nature and the quality of the business. What kind of growth the environment will support - I don't believe in buying a company at replacement cost or things like that. I look at buying a share because of growth potential. A related issue is of whether that growth will be profitable, what kind of ROCE can it sustain and for how long. What are the entry barriers or the competitive advantages that the business enjoys, which will support profitable growth.

The price you pay for a stock is critical

Lastly, one needs to examine the valuations. Everything might be good but if you do not pay the right price you might not make money. My time frame of investment is usually three to five years.

Identify the key factors that drive a business

By and large, what I have seen is that if you get the key driving forces behind a company right, then the other things fall in place. Most – 90% of a fund’s energies should be focused on identifying these one or two factors because these are typically what drive the company either upwards or downwards. Unfortunately, when you start working on a company you get so involved in the nitty-gritty - quarterly growth numbers, percentage market share, capex - that at times you tend to miss the key driving factors.

CIO: Can you illustrate what you just said on one or two companies that you have invested in? What are the valuation parameters that you use for gauging whether a company is cheap or expensive?

Prashant Jain: In equities it is extremely difficult to pinpoint a value because you are always working on future cash flows.

You could look at the price to book value ratio and the sustainable return on equity. You could relate sustainable growth to the price to earnings ratio I typically look at the pre-tax sustainable return on equity and relate it to the price to book value ratio and to the prevailing interest rates in the economy.

Let’s say a company’s sustainable pre-tax ROE is 20%. In the current environment you might be willing to pay two times the book value. However, if the interest rate itself were 20% then that valuation benchmark might change. I mean you might move more towards bonds. Three-four years ago, you could buy AAA bonds at 20-24% YTM. There was really no need to get into equities at that point of time.

CIO: You said you link the sustainable growth to P/E. What kind of numbers would you be willing to pay for a given sustainable growth in terms of P/E?

Prashant Jain: Around 1 for 1 growth is fine. The lower the better. As I said, I don't put a value to it but I look for significant buffers. I don't buy a company just because I think it's 20% under priced. I would like to buy a company which is 50-60% undervalued because I could always make an error of 10-20% in estimating the value of the company.

Valuation is linked to the prevailing interest rates

Valuation, I think, is definitely linked to the prevalent interest rate in the economy because that is where your opportunity of alternate investment lies. So, in the current environment one is willing to pay higher for growth though actually the market is paying much less than what it was paying four years ago. To that extent, I think either the markets four years ago were a bit overvalued or today they are significantly undervalued.

CIO: You said that when the market loses focus on the key issues and you just stick steadfast to these three or four issues, then attractive opportunities often present themselves. Could you give us an example from your experience?

Prashant Jain: Let's look at paints for example. There are two changes taking place in the industry. One is the excise rates have come down. So what is happening in the air conditioner market is happening in the paints market as well. These are sectors where the unorganized players have a strong presence but there are issues of quality and delivery. With lower excise rates, the organized sector can grow at a significantly faster rate.

In air conditioners, however, the competition is still very intense and organized players are not making money. In the paints market, Asian Paints is coming out to be more profitable because of different competitive dynamics in the industry. The company is changing the delivery system and is trying to reach out to the retail client directly. It is trying to build brand equity with retail clients. It is putting up things like call centers and is trying to associate Asian Paints as a one-stop shop whenever you need to paint. It is trying to do away with the scenario where the painter decided which paint to use. I think that's a very significant move and will improve the company’s standing.

I think Asian Paints is increasing prices at sub-inflation rates. The company is improving its working capital by putting up paint mixing machines that generate the hues and tints desired by customers at dealer locations. I think this is a fundamental shift that brings down costs significantly and takes you on to an entirely different orbit. Companies with poor balance sheets, poor brand equity and poor confidence of trade cannot deliver this system. No dealer would be willing to invest for a company in which he does not have confidence.

So, with increasing disposable incomes, I think consumption should continue to grow. Consumers are also becoming quality conscious. Even managers of cooperative societies, who are bulk buyers and are price sensitive, would not buy paint just because it is cheap. They would prefer to buy a reputed brand as that purchase decision is less likely to be questioned by the members of the society. More so, because the cost of the paint in the overall painting job is typically just around 30-35%. You spend a lot on labor.

This gives reputed companies like Asian Paints some pricing power and the ability to withstand competition from the unbranded segment or even Chinese imports as and when they occur. In any case, the market has been very competitive and the unbranded segment has a significant presence. It's true that Asian Paints' profits are not growing at a rapid pace but that's because it is trying to gain as much market share as possible in a highly competitive market. However, if you were to take a slightly longer-term view, higher profits would ultimately begin to flow in.

CIO: You talked about valuations changing quite significantly especially in the context of the changes in interest rates. How has your investment philosophy changed over the last 4-5 years?

Prashant Jain: I have been looking after a balanced fund. Till about two years ago, although we were overweight on bonds. That was because bonds were giving you 18-24% return and P/E multiples for reasonable quality companies were in the mid-20's. So, there was no incentive to invest in equities. There was hardly any scope for significant appreciation in the value of an equity portfolio given the high P/E multiples and given that earnings growth was slowing down because of high interest expenses. So, we were overweight on bonds and we bought longer-term bonds.

From Jan 99, the fund has been overweight on equities. Although interest rates are still declining, there is little room for a further decline - they could fall further by 50-100 basis points. But that won't really give you lot of money. On the other hand equities are quite cheap and companies are focused a lot more today than they were 5 years ago on issues like ROCE, shareholder value, getting more out of assets, improving productivity, improving efficiencies. I think the environment for equities has certainly improved.

However as competition across all segments of the economy has gone up one has to be extremely careful about where you are investing and that is where sustainability becomes extremely critical. Competition will continue to increase and only companies that can withstand rising competition or have some competitive advantages will perform. That is why you see, for instance, that the whole profile of the group-A shares on the BSE has changed. Half of the companies that were thought to be successful five years ago don't even have a meaningful existence in today's markets.

CIO: How do you go about determining your portfolio allocation? You said you are sometimes overweight/underweight on equities - on particular sectors in the equity market. How do you go about allocating funds?

Prashant Jain: Our starting point is obviously the benchmark. We look at the distribution of stocks in the benchmark. The main idea behind investing in equities is long-term growth. Although you might feel that you could add value through active portfolio management, you need to be realistic about your limitations and accept that you might make mistakes. So, I think the benchmark is certainly the starting point.

CIO: Which benchmark do you use?

Prashant Jain: We follow the Crisil-500. However, I have not shied away from taking aggressive bets. For example, in January 2000, I sold off our technology shares and our allocation to the sector came down to almost zero - close to 2-3%. The sector constituted almost 40% of the benchmark. I have not invested in the financial sector and the fund is underweight in the financial sector. Right now, cement is significantly overweight.

CIO: How do you control the risk in your portfolio? How would you, for instance, evaluate its risk-return performance?

Prashant Jain: I have not evaluated the portfolio beta internally for the fund though it is available from other organizations. I think risk reduction primarily comes from diversification across sectors. It reduces the risk arising out of the mistakes you might make. Secondly, risk is a factor of the quality of the businesses you buy and the price you pay for them. I think if you stick to quality and don't significantly overpay - I mean if you don't buy an Infosys at Rs15,000 or continue to hold it at that price - risk is significantly curtailed in the portfolio.

I typically look at the potential upside and the potential downside when I decide to buy or hold on to a business. At times, the downside has been much more than what one had bargained for. The idea is to be invest in stocks where the upside to downside is say more than 1:1. Today Infosys is nearly Rs4,000. What can be the upside? What can be the downside? Maybe the answer is 1 for 1 though it could vary across different scenarios or different individuals. But that is one way to try and improve reward to risk.

CIO: What returns do you think are achievable in the present interest-rate scenario? What target have you set for yourself?

Prashant Jain: If you remove Hindustan Lever, ITC, Infosys and Reliance from the Sensex, which is a widely followed benchmark, I think stocks are available cheap. The Sensex is trading at 11 times one-year forward earnings. Going by the historic growth rates of the economy - of the manufacturing and service sectors - I think a 15-20% profit growth is sustainable in the Indian context. I think the growth rate should actually improve going forward because interest rates are low, domestic demand has been by and large quite stable and tax rates have come down this year.

Commodity prices have become relatively stable and a number of companies have improved their efficiency dramatically. If you look at a Tisco or the cement companies, they consume far less power and employ fewer people than they did earlier. I think the upside is quite significant. Most importantly, companies are focused on getting the maximum out of their assets. I think profit growth for the larger companies should be good even in a fairly competitive environment because the environment clearly does not support the unorganized sector. The organized sector should continue to gain market share. I think a multiple of 15 to 20 is fair for the Indian markets.

CIO: You talked about the various entry criteria like the quality of management, the sustainability of the business and so on. Could you also talk about your exit criteria?

When you make a mistake, admit it and exit

Prashant Jain: I think that there are four conditions that prompt you to sell a stock. One is of course that you are getting over exposed to a stock. Second is when you realize that you have made a mistake. There was either a violation of a discipline or you got carried away by the prospects of a quick return or you understood the company or the environment wrong then I think historic cost is of no consequence. You just go ahead and sell.

When you have made the right investment decision you sell a stock if you think that it has crossed your price target. Last, you sell a stock if you feel a better opportunity is available. Let's say you're holding onto a SmithKline Consumer and suddenly you find that even Lever is available at the same P/E. Then you might decide to switch to a more liquid, more visible and a larger company.

CIO: How often do you rotate your portfolio? Do you trade actively?

Prashant Jain: The last one year has been a period of fairly high turnover. That is because the volatility in the markets was quite high. Obviously, the less the turnover the better it is but I think last year one made some mistakes that had to be corrected. Maybe one acted under market pressure, got carried away by the prospect of quick profits or simply that the investment premise went wrong.

Otherwise, over the last few years, the average holding period of a stock would be between 2 –3 years.

CIO: How much of portfolio management do you think is an art and how much is science?

Portfolio management is not an abstract art

Prashant Jain: I think it is an art to the extent that you are dealing with something that is not definite. I mean you have to anticipate the future. Ascertaining the quality of the management and the sustainability of the business is an art. But it is not an abstract art in the sense that the management's past track record and the company's past performance can guide you significantly in assessing the quality of the management and the value of the business.

It is a science to the extent that you have benchmarks available - you have equations and formulae that help you to arrive at a particular value. There are various scenarios that could materialize and you don't know which is most likely. Determining that is an art. But once you have done that arriving at specific values is more of a science.

CIO: Could you start by articulating your investment philosophy?

E.A.Sundaram: In terms of investment philosophy, I think it's rather straightforward what the Zurich India Capital Builder Fund tries to do. The accent is on the quality of the businesses, on the quality of management and on a reasonable price. This fund gives less importance to the index weight of a particular stock. Many stocks in the portfolio are not part of the major indices. So what matters is the quality of the business, some competitive advantage that others will find difficult to emulate and good quality people. Basically, we are looking at companies with a track record that are currently not very hotly favored by the stock market. That's the philosophy.

CIO: What are the valuation parameters that you use?

Look for businesses that have predictable cash flows

E.A.Sundaram: There are four but all of these criteria will not necessarily be met in all the investments that I make. For businesses where a reasonable degree of prediction can be made in terms of the free cash flows, we work out the discounted cash flow valuation. If it is higher than the current market price by at least 20-25%, then it's considered a reasonable buy.

The second criterion is the P/E multiple in relation to the expected growth rate in earnings over the next 2-3 years at least. This is what everybody normally uses. The third is market capitalization by revenue. I use this criterion because I have increasingly come to realize that earnings as defined in the accounting sense don't really give the full picture. So, in some cases market capitalization by revenue is the better indicator.

Let me give you an example. There are two industries - one is a highly capital intensive business and the other is a less capital intensive one. Now, in my opinion, accounting gives an unfair advantage to the capital intensive company. Let's assume that one company has capital expenditure of Rs100 and revenue operating expenditure of Rs20 and the other has revenue operating expenditure of Rs100 and capital expenditure of Rs20. If they both earn the same kind of revenues, the first company will show a much higher amount as profit in the P&L account.

Assuming that the cap-ex is written off in three years, the first company will show about Rs53 as total expenditure - about Rs33 as cap-ex write-off and Rs20 as revenue expenditure. The second company, on the other hand, will show Rs107 as expenditure. If this is a one-off case and there is capital expenditure only in one or two years, it is okay. But, there is definitely a problem in case of chronically capital intensive businesses.

In my opinion, if your sales by capital employed is just about 1 or 1.2 then you are not showing your full profit. Profit as defined in the accounting sense is not the right interpretation of profit. I believe that in many cases, market cap by revenue gives an alternative way of valuing companies. The fourth criterion is P/E as compared with the sustainable return on equity. Like I said earlier, all criteria may not be met in all cases.

CIO: What exit criteria do you use?

E.A.Sundaram: If exposure in a particular stock comes close to 15% of the portfolio, I start selling. Recently, exposure to Hindustan Lever reached nearly 14%. So I exited from the stock partially. Now it is below 10%. Secondly, as Prashant said, if I am convinced that a mistake has been made then I sell irrespective of the price. Besides, if the market price is far higher than our discounted cash flow valuation, or if the P/E multiple is very high as compared to historic rates, we think of exiting a stock. But I should clarify here that I'm far from being anywhere near perfect as far as sell-discipline is concerned.

CIO: How do you go about allocating your portfolio? Are there any specific percentages that you have pre-determined to allocate a given sector or to a given company?

E.A.Sundaram: No, there is no conscious decision to restrict to any particular sector. However, we like to keep exposure to a particular sector under 30% to ensure prudent diversification. I must confess that there is no hard and fast rule about this. But we like to keep the portfolio diversified across at least seven or eight major sectors.

CIO: What typically is the time horizon that you think is appropriate for investing in the Indian environment?

Hold a stock for at least three years

E.A.Sundaram: While this might sound quaint and old-fashioned, I think it's a minimum of three years. Any equity investment should be for a minimum of three years.

CIO: But when you are doing a DCF calculation…

E.A.Sundaram: About 10 years. I take 10 years. But not all companies are amenable to DCF calculations.

CIO: How do you view the risks involved in investing?

E.A.Sundaram: I don't define risk as volatility vis-a-vis the index. I don't think that is relevant. There are three risks that I look for. One is business risk - how vulnerable is this company in its own business. If the business dynamics are changing because of something new, say technological innovation, business risk is paramount. Then there is management risk - is the management honest? Will it treat the minority shareholders fairly? Third is price risk. If these three risks are taken care of, the portfolio will perform better than the broad market indices.

The whole problem arises when the fund manager gets fully involved in trying to beat the index on a continuous basis. When this happens, the fund manager’s investment decisions are more often guided by what he thinks the short-term price performance of that stock would be rather than on the quality of the company. In many cases, this leads to the dilution in the quality of the portfolio. This fund is built on the premise that at times the portfolio will underperform the market. But we will not dilute the quality of the portfolio merely to ensure that it always outperforms the benchmark indices.

CIO: Having invested in a stock how frequently do you reassess your decision?

E.A.Sundaram: Although we take stock of our investment decisions every three-four months on an average, this is an area where we need to further improve. We need to carry out this exercise on a more regular basis. Again I want to make one thing clear. We choose a company carefully and after we invest in it, we stick to it through thick and thin. It does not matter if a particular quarter is bad for the company. As long as the long-term story based on which we made the decision to invest in a stock is valid, we continue to remain invested in it.

CIO: In your view, how much of portfolio management is an art and how much of it is a science?

E.A.Sundaram: I tend to agree with Prashant that it is a bit of both. If it were purely a science, all portfolios would look exactly the same. There are some unique individual inputs that go into the construction of a portfolio as well. That makes it an art. Yet, we all look at some fundamental things like the financial performance and arrive at similar conclusions. To that extent, it is a science.

CIO: Could you articulate your investment philosophy?

Chandresh Nigam: Basically, I look after two funds. One is what we call the Progressive Growth Fund, which invests in growing companies. There are two kinds of opportunities that I look for. One is, companies with excellent managements and excellent businesses, which will grow over long periods. Experience shows that such companies have returned 30-35 times the amount invested in them over the last 20 years. The other opportunity is to be found in special situations where you get good, established companies cheap.

So, you can look at into a company which has solid fundamentals, a tremendous competitive advantage, a favorable industry position, and which is likely to sustain growth for a long period of time. If you stay invested in such companies for a long enough time, you are certain to make money. Alternatively, you could look out for some established company that is facing temporary problems and is not being valued fairly by the market. Such companies may not necessarily be able to grow their business very fast but they will still be around for a long time.

Irrespective of the kind of opportunity, we look for good managements - managements with proven track records. We look for businesses that have long term potential. They should typically be in the sunrise category, not the sunset. The companies we like to invest in are those with a competitive advantage that is difficult to emulate – it may be in terms of brand, technology, low-cost distribution, or anything else. They should either be the number one or number two in their respective sectors or should hold the potential to reach those positions.

More objectively speaking we are looking for companies that will achieve a minimum 20% compounded annual growth rate in profits without taking on additional debt. Also, we consider industry analysis important. We would like investing in companies that are in an industry that will allow them to grow. We look into issues like: is the company an early mover in a particular industry or is it just a follower? We would rather be in company that is aware of its product innovation cycles – that is ahead in whatever is the real dominant success factor in that particular industry.

Before we decide to invest, we look at the valuations more closely. We don’t look at investing as just a way to make money on the stock market but as prospective owners willing to buy the entire company. What is the reasonable valuation would you give to own a company? It will definitely be different from what somebody who is just looking at buying today only to palm off to somebody else in six months. Suppose the company were to go private, what is the kind of reasonable valuation somebody would be willing to pay? Those are some issues that we examine.

CIO: What are the factors that influence the valuations of a company?

Chandresh Nigam: The valuation of growth companies depends on three things. One is, how much confidence you have in the management. If the confidence is high, obviously you'll pay high. Second is the quantum of returns possible. Companies that have higher discounted cash flows deserve better valuations. Third is things like technology. If you are looking at P/E multiples to growth rate, obviously you're trying to pay a P/E on the long-term sustainable growth. The ratio should be less than one.

CIO: In your exercise of growth investing what is your time horizon? It is one thing to get an actual growth of X% but to say that they will be sustainable over a number of years is very difficult. Would you say that growth investing is different from any other form of investment?

Chandresh Nigam: As a fund we are saying that we are looking at companies that will grow at a sustainable growth rate of 20%, which is not something extraordinarily high in the current context. For a large number of companies even this growth may not be achievable but not for the kind of companies we are looking at. Forget about the new economy, there are lots of companies in the old economy that will achieve this kind of growth easily.

Ultimately nobody knows what is really going to happen. We look at the management quality, its track record and opportunities available in the business, and make a judgement accordingly. Typically, you would find a number of growth companies that are priced very high in relation to their current financials. You have to be extra careful that you don't over pay because if the growth numbers or the profit numbers don't materialise, you get hit on both sides.

The basic thing is that over a five-year basis if I think that the company will meet my growth expectations of say 30% then I am willing to pay 25-30 times its earnings. I am not willing to pay 100-150 multiples.

CIO: What are your views on top down and bottom up investing?

Chandresh Nigam: Although we do have sector norms in a sense, this fund is predominantly bottom up. We add companies that we like. Yes, we certainly look at the overall exposure and our internal criterion is that we have to be invested in a minimum of 4 to 5 uncorrelated sectors. At a macro level, we invest in businesses that have different drivers but we build our portfolio stock by stock. Primarily, we are an aggressive fund holding 15 to 20 companies. We keep building the portfolio keeping in mind SEBI guidelines and our comfort with various companies. When we do not see suitable investment opportunities, we are not averse to holding cash for small periods.