Large assets do not fascinate me if there are no returns
Mr. Chetan Parikh: Mr. Sreesankar, it's very nice of you to have given us the time to share your investment experience and your wisdom with us. Could you tell us something about your broad investment philosophy?
Mr. Sreesankar: There are two schools of thought in investments. One look at value and the other at growth. I tend to believe that it's not growth alone, it's not value alone. I tend to look at this from a perspective of both value and growth. Large assets alone do not fascinate me. It is simply because If those assets are not able to generate a reasonable return then it's as good as having no assets. For example, there are huge asset plays or traditional brick and mortar companies as you call it, whose assets may be worth Rs.5 billion or Rs.10 billion. Today, those assets may be returning Rs.50-100 million. To me, this particular investment doesn't make sense at all. I'm not buying a stock for the purpose of getting a return from it after the company is liquidated. Given the circumstances and knowing how much time it takes to sell off properties and realize your share I think it is going to be a long wait… So, book value or the net asset value of a company doesn't fascinate me to any great extent. This is more glaring in the last six to seven years in the Indian context when a number of companies probably have raised more money in the form of share premium than ploughed back profits.
Return on equity and cost of capital are the lodestones
For my investments, I look for companies having a return on equity above it's cost of capital, and the incremental capital employed in the business should be able to generate a return above the cost of capital and above the ROE in the previous year. Only then will I believe that the company is adding value. Having said that, this is more applicable to companies established in that business over a period of time.
Qualitative judgements when looking at the future
When one looks at companies that have just started the business, that are in a growth phase, or beginning to implement a change in strategy; one has to make certain kinds of qualitative judgments while taking an investment decision. I do look at the companies from this angle too. Such investments may not necessarily have the ROEs right now, but we believe that ROEs in these investments will be implicit in the performance of these companies going forward.
Return on equity should be predictable and durable
The second part is how do we look at this ROE. Is it a mere function of one year? I believe it should be a consistent and sustainable model. When we find the ROE of one company to be good, then we analyze some of the peers in the industry too. This helps you to differentiate between companies even within an industry. There might be many companies that I like in an industry, but my favorites need not necessarily be in my portfolio for various considerations. But I like these companies because of a specific reason. All my favorites have got something very special about them.
For example, Hero Honda has been a company making losses probably in the early '90s. The company came out of it, but the way it grew subsequently and the kind of return it generated over its cost of capital, the returns that it generated over its incremental capital employed, and the productivity increases and the working capital efficiencies were excellent. I think they have set a standard for themselves. The way they gained market share and the acceleration of earnings they achieved even while their ROE kept on rising. After the initial IPO to my memory they had been to the capital market only once with a small rights issue. It's a beauty that today it may be crossing over 1million units of sales for the year ending March 2001.
Multiple valuation tools should be used
The broader philosophy doesn't undergo a change. I believe that on their own that P/E, book value, ROE is never a tool for investment. I think these are all different variables that we use, and we have to create a function with all these variables in place. More than ROE, I always stress on the return on the incremental capital.
One such company that comes to my mind is MICO. Although it doesn't form a part of my favorite five, I believe that MICO’s return on its incremental capital has been excellent. This company had been a very dominant player in its industry. It never had any significant competition, and it has grown phenomenally well in terms of ROE and return on incremental capital.
Indian capital markets have learnt the importance of capitalization
In the beginning of the '90s, we all had some great learning experiences. When I came to the capital market after my studies somewhere in 1985 or so, there was no differentiation between small cap and large cap stocks. A distinctive change happened in the capital market probably post 1993 when the institutional investors entered the market. After the first run of FII investments in '94, we clearly saw a differentiation developing between small cap and large cap. From an institutional perspective, we need to look at larger cap stocks with fair amount of liquidity much more closely.
Perhaps the only stock pick of mine that has been an exception to this in the last couple of years is Visual Soft. Though it was just a Rs.180 million company when I bought it, today it's probably over a $1 billion plus company. This kind of difference has happened because the company was focussed, the strategy was clear, the vision was there, and the business model was different.
Criteria for stock selection
The trigger that I look for in a company is as follows:
- The company should have something extra that results in a long-term advantage for the company.
- A sustainable long-term growth story should be developing.
- It has to be a very dominant player in that particular sector, or be a trendsetter.
- Return on incremental capital should necessarily be greater than the cost of capital.
Automatically, with each quarter passing by, the results will show that there is an effect of the above factors happening. If you look at all the five companies that I am going to talk about, you are going to clearly see a thrust from this particular angle.
If one looks at the '98 annual report of Visual Soft, what stood out clearly was the statement that it's not the number of additional engineers that is important but the productivity that is going to make a big difference. Mr. Raju said he doesn't believe in adding number of engineers. It was showing a completely different business focus, strategy, and vision. I think of all the software company balance sheets in '98; the only one that talked about e-commerce was probably Visual Soft. Product development was the path that they chose at that point of time, knowing very well that they don't have the financial muscle or even the marketing ability to go and market a product elsewhere.
Dominance detracts while competition complements
When I look at companies, a sustainable longer-term growth strategy is a key driver. I had mentioned that a company needs to be a dominant player. Having said that, I don't think the dominant player criteria is to be used in isolation. The problem is that most dominant companies tend to become complacent to a great extent. It is competition that creates that extra something in companies to survive.
I personally believe that many of the old companies in the Indian corporate sector have not done well over a longer period of time. This is basically because they got protected to a great extent during the pre-1991 days. So there was no need for these companies to become efficient, there was no need for these companies to be facing the open market system and face competition.
I think that is one of the reasons why we see such changes. The companies that have progressed, or most of the leading companies in the capital market today, are companies that have come to the capital market after 1991.
Strong institutional investment process in place
Mr. Chetan Parikh: Mr. Sreesankar, how do you choose the population of companies? You have talked about quantitative measures and qualitative measures, but how do you select the population of companies that you are going to keep on your radar screen? You are clearly adopting a bottom-up approach. Do you use any top-down analysis or use economic growth rates to a very large extent in your investment decisions?
Mr. Sreesankar: We want to be a top quartile performer over a longer term. To achieve that, we believe that we need to have a strong institutional investment process. We have a five-stage investment process. In that investment process, we try to create a liquidity screen. This first stage liquidity screen reduces the target population to 300 stocks from amongst 3000 traded stocks. From there, you try collate a lot of information about these stocks, and bring the population down further to around 100 stocks. In the third stage, once you have complete data about them, you finally reduce the population to around 75 stocks. That is the universe that we keep on tracking regularly. We try to create a portfolio of around 30 stocks out of these 75.
Focus on bottom line, not top line growth
Mr. Utpal Sheth: Could you elaborate on the screens between stage two and stage three?
Mr. Sreesankar: Let me give an example. Globally, Levers is a food company, but in India it is more or less known to everybody as a soaps and detergent company. Yes no one will ask for vanaspati, but most will ask for Dalda, which has become the synonym for vanaspati in India. But, the beauty of Levers is that it has probably given to the corporate world more than 200+CEOs of various companies. That speaks volumes in terms of its management capabilities. My simple logic is that if the company has got good ROE, good ROCE, and a good return on incremental capital exceeding the cost of capital, then the company must necessarily have a good management in place. And if a good management is not in place, it will be very difficult for these numbers to fall in place. So Hindustan Lever is a classic example. It has been here for many decades, but still it keeps on growing at 20-25 percent bottomline. I think it's a very healthy growth rate. What is more important is the way they have tried to get into the foods market. They are trying to concentrate on the atta market today. I think less than 1% of the Indian atta market is in the organized sector. If you want to get into the food chain of the Indian consumer, you have to get into a segment, which is used the most by the Indian consumer – atta and rice. They are into vanaspati, saturated fats and now into atta. They are also into a number of products but none like the must use category like atta. But the main ingredient now is staple food. They have got into it slowly and have probably just scratched the top of the surface. Most other companies wouldn't have thought about creating a new market. There must be quite a few companies trying to piggy ride on the back of the Hindustan Lever initiative. But to me the Hindustan Lever efforts and their approach are very impressive.
A couple of years ago, they said they had linked their entire communication network to VSAT. Their working capital efficiency and reduction in inventory have driven their RoCE dramatically. They are clearly leveraging technology. They have done their homework well. Most MNC companies try to launch their international products here. But Hindustan Lever has a different approach. Atta is not a product for Unilever anywhere else, yet atta probably will become a very important component of the Hindustan Lever food product basket. It is an exceptional company, which in my view where the parent learns a lot from the Indian subsidiary. Look at the number of people sent from India to their international operations. Finally, take a look at their amazing return on incremental capital (60-70% plus consistently over a long period of time). Yes, it's a steady performer. Top line growth at around 6-8%. I'm happy with that kind of a top line growth. I don't like companies who try to grow top line for the sake of top line. What I would ideally look at is only the bottom line. It all boils down to only two things, ROE and return on incremental capital, nothing else.
Investment objective is absolute returns
Mr. Navin Agarwal: Mr. Sreesankar, what is the investment objective that underlies this investment philosophy? I mean, if you want to dissect it into the risk part and the return part, for the investment objective, what are those targets?
Mr. Sreesankar: My personal objective is that I should always be able to give an absolute positive return to the unit holders. Irrespective of the market or index movements, there have been many stocks that have given impressive absolute positive returns viz. Hind Lever, Nestle, Cipla, Infosys etc. But there is a catch. This nice and simple model is not a momentum-based. Hence, my feeling is that you will tend to underperform in bullish markets with excessive speculative activity.
Mr. Navin Agarwal: So basically you are looking at absolute returns. You are not looking at relative returns. That statement means that you will not accept any permanent capital loss. What you want is steady returns irrespective of bull markets or bear markets.
Mr. Sreesankar: Yes, underperforming the benchmark in bull runs is a risk. If you look at the 99-00 scenario, where barely anything except technology stocks moved, the likes of Hind Lever, Sundaram Fasteners and Hero Honda underperformed. Yes exactly. In short term phases you will tend to underperform the markets when you have an aggressive growth portfolio and the momentum is lost. What you want to achieve is a sustainable outperformance over a longer term of 12 months. But today we tend to look at the NAVs on a daily basis.
ROEs of Old Economy and New Economy
In spite of my reservations about this terminology, today we tend to speak about two types of stocks. The new economy stocks and old economy stocks. Whether it is the old economy or the new economy, I don't think the capital that you use is different. The capital is the same. Simple underlying fundamental principles of investment - return on equity and return on incremental capital exceeding cost of capital, don't undergo any change. When the fundamental premise itself doesn't undergo a change, then why should we change the whole thinking process? I don't see a reason for this.
Let's say that a hypothetical company has 100 engineers and Rs.100 million turnover currently. Next year, it has 200 engineers and Rs.200 million turnover. Third year, it has 300 engineers and Rs.300 million turnover. What is the value addition in the company? Nothing! In fact, a company like that, with salaries going up by 25 percent and other costs going out by 5 percent, is actually losing value even if it's earning growth is there. For companies of that sort that, the business model is fragile. Unless such companies earn a per man-hour realization which is at least ten percent higher every year, they are not even earning the realization per man-hour of the previous year in real terms. To maintain the operating margins, they will have to increase the per man-hour realization by at least ten percent. This is how I look at it.
Valuation differentials will increase in the software sector
Mr. Utpal Sheth: Does that mean a macro level preference of product companies within the IT sphere rather than service companies?
Mr. Sreesankar: Yes and no, for two reasons. Yes, if the product companies can deliver that particular return. No, if you look at service companies that have been able to generate consistently higher revenue. Maintain and improve ROE. Assume that a service company earlier charged $20 per man-hour. If they're able to go to $26, then that issue is solved. Look at this chart about the positioning of some Nasdaq companies. We have to look at companies that can make the transition from a lower value added spectrum to a higher value added spectrum. Probably Andersen Consulting is at the top end of the value added spectrum. Those companies that continue to remain in the lower side of the spectrum will not see their valuations improving over the next five years. Within the software services companies, you will see companies quoting at 50x-70x earnings on one hand and probably companies at 5x-10x earnings on the other. At some point of time, every investor is going to look at where these companies are placed, what is the kind of valuation, what's the kind of advantage these companies have, where are they positioned in the value chain? These things have to happen and that's what the market is all about.
Coming back to product companies, the risk associated with product companies is extremely high. If someone comes out with a better product that is more efficient, then you are bound to see this particular company losing its market share. A classic example could be comparison between Netscape and Explorer. You had to pay for buying Netscape, but Explorer came bundled with Windows. So I don't know how many people would buy Netscape even if people find it more attractive. Thus, product companies are exposed to greater risks. To that extent, one has to naturally look at the kind of product that they're having, what are technology trends in that particular product segment. We have all seen the evolution from elementary dbase to the latest Java. So that's the domain on which to work on.
I wouldn't differentiate between a product company and a service company. If such companies can change according to the circumstances, fine. Service companies, if they're able to go up in the value chain, are good enough
I believe there is no use for developing a great product if it has got no commercial use. At the end of the day, our objective is to generate a positive return to the unit holders. If that has to happen, the product companies that we are to invest in should necessarily to have a product of great commercial value and it should succeed by itself.
Components of five-stage investment process
The five-stage process is as follows:
- Liquidity screen
- Company profile - shareholder value, strategies, focus
- Sustainable long-term growth, management capabilities
- Portfolio conception
- Opportunity cost of an investment
Competitive considerations make me believe that I may have to think otherwise.
If that's the case I will even think in terms of an opportunity cost which finally the portfolio company have to have.
Disciplined selling is also important
Mr. Navin Agarwal: Mr. Sreesankar, you clearly highlighted that return on incremental capital is your reason to enter a stock. Could you tell us what typically could be the reasons for your exit from the stock? Is it only valuation driven or are there any other factors that trigger an exit from a stock?
Mr. Sreesankar: I love that question because it's a part of a process. I always say that sell when value is realized. What is this value? When do you think that proper value is reached? There are two ways of looking at it.
Let's put it up this way. Mature businesses and growth businesses. I think the FMCG business is a steady growth business, a mature business. Why do I say so? We can assume that soaps and detergents will grow at 4-6%. People do not change their habits just because the economy has recovered. One does not brush his teeth ten times a day or have a bath ten times a day just because the economy has recovered. This is a stable model. One can use a discounted cash flow model in mature businesses.
Whereas, I feel software services business is not a mature business. This is a fast growing business. The earnings growth has been and could be quite exponential. To my mind, the cash flows of a business that is not mature cannot be predicted well. Software, for example, has tremendous earnings growth. I love software companies ploughing back 80-90% of profits into the business and still showing 40% ROE. I wouldn't like them to pay higher dividends. If they can plough this money back to the business and again make similar returns, nothing like it. When I see fast growth companies suddenly increasing payouts to unrealistic levels, it is an indication to me that they are not confident of their growth and that the speed at which they are growing cannot be sustained. And if that is true, then the valuations that they are getting are not sustainable since the higher valuations are for the higher growth.
Don’t buy anything that you don’t understand
At the same time, a company may be in a very good business earning very good returns. I obviously wouldn't like the company to suddenly go into a completely unrelated business. If I don't understand the synergy of the new business then I try to exit from that particular stock. Don't buy anything that you don't understand however lucrative it is.
Global factors increasingly affect local valuations
Today, we have gone global to a great extent. You may have a great company with good ROE and a growing business. If the global environment changes adversely, and it has got a large impact on this company, you're going to see its valuations suffering badly. A classic example will be the way our commodity companies; especially metal companies have behaved in the stock market over the last few years. Despite good earnings growth momentum, look at the volatility that has taken place in this market.
Disciplined long-term investing is the right choice
At the end of the day, I can have my philosophy in place, but the fundamental objective is to generate a positive return to the unit holders. I have to accept the market realities.
In a bull market any small news or rumor can take stocks into an altogether different orbit. If the markets are going to behave differently I will have to change my thought process at least temporarily. I will have to take a different view at that point of time - a word of caution. At the same time a word of wisdom - immaterial of these things, if you invest in the companies with the same principles that I mentioned earlier, you should still outperform over a two-year timeframe. These scenarios keep on happening in the bull market, and abnormal changes take place. But, in the long term, such fundamentally strong stocks will keep on outperforming.
Diversification necessary to contain volatility
Mr. Utpal Sheth: You mentioned that your return benchmark is absolute returns. What is your risk benchmark? How do you measure risk? More importantly, how do try to control that risk by the process of diversification?
Mr. Sreesankar: I believe that mutual fund is a savings product. It is unit where money is pooled from the unit holders i.e. savings and invested. Why are they trying to do it? Because they have neither the time nor the skill to invest directly. So, we should try to do the investment in the most appropriate manner, which means that ideally they would not have liked to see a huge volatility in their returns. Also, they would love to have a much broader, diverse portfolio, which in turn will minimize the risk. Now, how do you try to achieve this? You try not to concentrate investments in any single sector. Let us put this in perspective. We try to restrict our exposure to any one industry to the extent of a maximum of 15 percent over the sector weight in the benchmark index. I personally believe that I should not go and expose myself into any sector to 50-60 percent. That's definitely not a prudent way of thinking. For those who want to take that risk they should go into the sector funds.
We also believe that we should not have more than 15 percent in any stock. Anyway, the regulator permits you to have only 10 percent of amount invested at any point of time. So it's 10 percent investment in a good stock.
If I have 30 percent in one stock, when the going is good for the 30% stock, my NAV will go on zooming. I probably will come out as a wonderful performer. What happens when the reverse happens, and when there's no liquidity for the stock? Then I'm a sitting duck. We try to manage a diversified portfolio and monitor it daily.
From our angle, we believe that we should be very clear in terms of a risk return profile. And, we do not want to have any extreme leverage in terms of exposure to the stock. If there are investors who do want a higher risk appetite, then we have specific products to cater to them.
Statistical risk measurement has yet to come to India
Mr. Chetan Parikh: Mr. Sreesankar, do you use any statistical measurement of risk i.e. something like the Sharpe ratio? Do you use any of those measures to gauge what the risk is? You talked about the control of risk, but what about the actual measurement of risk?
Mr. Sreesankar: Internationally, these things are available. In India, it has still not caught up. Even organizations like Barra do not have risk parameters for most Indian stocks. Going forward, all these are bound to come to the Indian market. Whether we have Barra, or Sharpe ratio, or tracking error on the index, a lot of people will still not be able to implement it. I believe that this will happen as and when institutional investors say like the pension funds start investing in the equity markets. When they start looking at such things, they will definitely evaluate risk parameters from these angles. I think we are still in an evolutionary process, and have not yet caught up with these things. In a bull market you try to talk about risk I am certain that no one wants to hear about. Only when the market turns south people start thinking about risk.
Investment Flexibility is key
Mr. Utpal Sheth: What is the time horizon that you envisage for your investments? In your presentation, I saw one of the points saying that there is no minimum stipulated time horizon.
Mr. Sreesankar: Yes, one of the reasons is the way the market has performed over the last one year. To a great extent there has been a momentum that has been built on certain periods. Sometimes, you may deviate yourself slightly from your own set parameters to look at certain stocks. If one were to look at any capital intensive industry over the last 20 years, there would be hardly any companies which have exhibited ROE exceeding cost of capital and return on incremental capital exceeding cost of capital. A report in financial Times sometime back said, only in two years out of the last 17 years or so have capital intensive earned a return over its cost of capital. That's the international scenario that we have had.
When you look from this angle, there are some industries in which you will never invest. We take exceptions to that. If there is faster growth coming up, there's going to be valuation increases i.e. a PER expansion. Besides my bottom up approach, given that an industry is going to do well, one has to use a top down approach and concentrate on the larger, liquid ones. Sometimes you feel that everything is looking good and suddenly a drought like scenario happens. That will make even the most optimist bull on the sector to become a bear or a pessimist. If that happens, your stocks are bound to underperform. One has to then determine whether one wants to persist with the stock and underperform. That's why we said that there is no minimum holding period. One has to consider the opportunity cost of an investment and look at the risk-reward ratio. If you make a mistake, accept it, and never say that you'll not sell this stock at a loss. I am marked to market daily. My NAV is at stake.
Portfolio allocation determines investment time frame
Mr. Utpal Sheth: While I take your point on having no minimum holding period, what is the time horizon over which you evaluate the company that you invest in? Your expectations and the company's performance take some time to play out. And there must be some expectations that will be playing out for years together.
Mr. Sreesankar: I would definitely distribute my portfolio in a certain manner. There will be companies that I know will take time for the story to unveil, and develop itself into a greater explosive story. That will probably extend towards 12 months plus. There will be companies whose performance probably may happen in six months plus. There will be companies that would be unwinding themselves in a steady manner right now. So I'll definitely have a mixture of all these kind of stocks. Sometimes you go and participate in unlisted securities. The listing itself will happen within a period of six months to 12 months. So I think you try to construct a portfolio keeping in mind that all these stocks are about to perform in systematic manner, and that's what you track on a regular basis. You know we expect all this performance to happen in due course. If you see some changes in the performance schedule, one needs to revisit the stock yet again from scratch.
Mr. Utpal Sheth: So you've got a duration and maturity profile of your equity portfolio too?
Mr. Sreesankar: Let me give you an example of this. There was one stock recently - BFL, that went to Rs.2000 after the merger. And it was only Rs.413 the other day - less than 25 percent of the valuation that we had seen just 2 months ago. What has gone wrong two months? The company had given a presentation. We would love to look at it. If we find that a great story is developing, and even if we have to wait for two quarters, we will definitely have a look at it. At the end of the day, this market is giving an opportunity because somebody doesn't believe and someone else believes in the story. That's how I look at it. As I was saying, in markets, profits are transferred from one person to another.
Themes don’t matter if cash flows are not in place
Mr. Chetan Parikh: Globally, people are saying that geography now really doesn't matter, and what one should invest in is ‘themes’. Can you give us some comments on this?
Mr. Sreesankar: I agree that today geography doesn't matter to a great extent. But there are some riders to it, so to speak. When the going is good, it's like selling dreams. But, at the end of the day, any business over a longer-term will be respected only by a one particular word that we use in every part of our analysis and that's cash flow. Theme is fine. Probably, the theme is also based on a cash flow coming at some point of time. If that doesn't happen, then I think the theme is also going to go out of the window. This is my personal perception. And I think this will be the story going forward. Probably we have seen the theme. Dotcom has been a great theme and many dot coms have surfaced. I have no clue as to know how many of the dotcoms will actually come out with positive cash flows. I'm not talking about India. India is too early in the cycle to even think about the cash flows. Even in established markets, we have seen the state of many companies in this space. So long as the companies have the cash to spend when they do not have any positive cashflow there is no problem. The moment funding stops and still the companies are losing cash my estimate is that questions will be raised about the expected cash flows and at that point of time themes will be forgotten.
The second question was about geography. Yes, the tariff barriers have come down. We have seen lots of changes happening in the marketplace. Just because international cement prices come down does not mean that cement is going to be imported and dumped in domestic markets. There are logistics issues involved like port constraints, infrastructure facilities and so on. So one has to look at a case to case basis. But I do agree that to a great extent geography does not matter.
Continuous updates are an investment necessity
Mr. Utpal Sheth: Mr. Sreesankar, what is the process of reviewing the companies that you are invested in, and those that are on your radar screen? Besides the process, could you also share with us the frequency and parameters that you use in the process?
Mr. Sreesankar: Some of the parameters are already mentioned in that particular slide that we have. We always try to keep ourselves updated about what is happening in our targeted universe. We try to meet up with all the companies in our universe once a quarter. More follow-ups are required in case of companies, which are not actively followed by analysts. As a general rule, at any point of time I think we probably know only 5 percent of what is happening. I don't think that there's any substitution for learning and knowledge. The more you update yourself, the more you know about it.
We always try to keep in touch with the industry in which we have invested. If someone comes out with another technology that makes production easier, or which reduces the cost, then companies with the older technology will have no meaning. Classic example is caustic soda manufacture. The technology has undergone a sea change from mercury cell to membrane cell technology. One has to be focused on the changes. I also believe that, as far as possible, go and visit and meet all analysts meetings and all AGMs. You always get to know something in these places. Whether you are an investor or not, any opportunity to meet the company's management and discuss and understand should never be missed. Besides, one should try to keep abreast of seminars on industries and technologies and exhibitions like the auto exhibitions where you can see new products and people's reaction to them.
Warren Buffett says that when everyone sold American Express (Amex), he went and bought Amex after the big collapse. Why? Because, when he registered for a flight, he could see people buying airline tickets still using Amex. They are not bothered about whether Amex is bailed out or not, because at the end of the day, the credit card usage is what is more important in that particular case. I don't think that there's any substitution for continuous monitoring of companies.
Yes you may go wrong in certain estimates but that's the risk. I don't think there's any substitute for continuous follow-up and meeting with the management, trying to get convinced about what you have seen, realize what the management talks about is possible finally how the business is developing.
Experience is the biggest teacher
Mr. Navin Agarwal: Mr. Shankar has your investment philosophy it been significantly influenced by any major global or local investors? I mean you just quoted Warren Buffett giving some example.
Mr. Sreesankar: We all learn and keep learning by investing in the market, making mistakes. The one factor that I have learned is the principle of ROE and return on incremental capital. I like reading books of the likes of Warren Buffet and Peter Lynch. There is something that we always learn from their own experiences. You can say that I have taken a leaf out of every book that I have read. I try to understand what pitfalls they fell into, and what mistakes were committed. I analyze what are the mistakes that I myself have committed. In hindsight, how I could have avoided them. A whole lot of international experience cannot be transplanted straight away into Indian markets. But the central premise of ROE doesn't change. That never undergoes a change irrespective of market sentiment. Over the longer term that alone is the focal point.
Investment objectives of Pension funds and retail investors are different
Mr. Navin Agarwal: Is there any global or local investor whom you admire in terms of what he has achieved or in terms of his performance or in terms of his investment philosophy?
Mr. Sreesankar: I really like Warren Buffett's investment strategy.
Mr. Navin Agarwal: That's where you draw your concept of absolute performance from?
Mr. Sreesankar: International institutional investors tend to manage quite a lot of pension money. There the target given to you is to outperform your benchmark. What you are asked to do is not to go beyond a tracking error to your index.
Here, it's a set of retail investors who put money into your schemes. When retail investors come into the mutual funds I don't think they are bothered about your out performance over your index. What they are really looking at is an absolute performance.
Large Changes have taken place in investment analysis in the recent past
Mr. Navin Agarwal: You mentioned that liquidity is one thing that differentiates today's markets from the markets in India five to seven years back very substantially. I mean that's a very dominant criteria in terms of your investment process and it cannot be ignored today, while it could have been ignored five to seven years back. Are there any other major changes in terms of the investing approach or investing philosophy that has evolved over the last five to seven years?
Mr. Sreesankar: Oh yes. I mean five to seven years ago I have not seen any research report talking about ROE, return on equity, return on assets etc. Even international brokers didn't talk much about ROE at that point of time in '93. The evolution of the markets from around '91 to 2000 has been a great experience by itself. In '91 to '93, we had such typical situations of heavy demand and supply not being there. In '94-'95, supply came, and demand slowed. Suddenly two terminologies that went out of the window at that point of time - book value and P/E ratios.
It was a great learning experience for me in '95-98 when we met a lot of companies. Companies that were supposed to be the bluest of blue chips, have told me that equity is free money and there's no cost to premium collected. Today, I can only pray for such companies. If anyone has done an analysis somewhere in '97 or so, one would probably find that the premium collected from fresh issues of shares would have been more than the reserve that is generated through plough back of profits. When equity is raised and you replace debt with a huge amount of premium, the EPS number is vitiated. So I think the P/E ratio also lost its relevance when rampant issues at high prices were done.
Another wonderful phrase that does the rounds was the theory of replacement cost. My analysis is that when one cannot find any argument for buying any stock, then he comes out with the replacement theory. And once the replacement cost theory is advocated, I think it's a perfect launching pad to sell the stock. For I think that you come out with the replacement cost theory only when you exhaust all other avenues to convince people that it's a buy. So it's clearly a huge fib that we have seen in the market place.
And some positive changes. Today, we are looking at sensitivity to international price fluctuations, and what products are coming into the market and what is going to happen. What is a global view for this particular product pricing? Is it is going to be a commodity? How is the market expected to look like over the next few years? Is a secular earnings growth story going to be there? I think these are all big positives that we have seen over the last four years. In '92-'93, we only used to say what is the next year's earnings. We never even used to go two years down the line or even think about it. I'm not saying that today we can predict two years plus. I think changes have really happened in terms of analysis etc.
No single tool for valuation
Mr. Navin Agarwal: To analyze the last decade, you said that we moved from a phase of P/E, P/BV and replacement cost theories to a phase of ROE and ROCE. The return ratios came into extreme focus where you started equating your ROEs with your P/E ratios. In the latest phase, these are not really the focus area in the last two years both in the local and the global markets. People are increasingly getting obsessed by growth and give high valuations. Would you like to look beyond these three phases into what could be the next major theme for investors going forward?
Mr. Sreesankar: Not only growth but another interesting thing is PEG ratio or price earnings to growth. I'm not fascinated by the PEG ratio to a great extent. Let's assume a price earnings ratio is 100x, and growth is 100%, then your PEG ratio is one. If price earnings is 15 and growth is also 15 your PEG ratio is still one. So I don't know how PEG ratios alone can differentiate this particular variable. I don't think that there is a single tool for us to look at. The market always evolves value.
In the late '80s and early '90s, a lot of MNCs and some Indian companies were assigned very high valuations. With hindsight, that was because these companies had high ROEs and ROCEs. Even now, lets take the case of an interesting angle to Infosys. From '96 to '99, the profits grew 6.5 times, whereas the market cap grew 87 times. Probably it would have changed quite a lot from then. Why did it happen? I think this is a function of these two aspects. In '96 they ploughed 83% back into the business. Their ROE then was 29%. In '97 it was 99% plough back, but ROE still increased. In '98, it was 88% plough back and ROE was higher. After '99 plough back, ROE dropped, but that was because of the ADR.
In such high growth and high ROE businesses, there could someday be a problem. If the plough back drops to 50% all of a sudden, it could be an indication that growth at that high pace maynot be there. All the fancy valuations of 100x and 150x then go out of the window. If the growth is going to be affected, then the P/E drops along with it.
My personal feeling is that there's not a single tool that you can utilize and say that this will make you buy a stock. Now let's look at from a different angle. Market loves high growth. At the same time market also likes high return on equity and high return on incremental capital. As long as these things are there I think market is going to keep giving a very high valuation. The moment your growth is going to be saturated, my best estimate is that the market will give you much lower valuation. It may happen all of a sudden. This can happen to technology stocks also if the growth slows down.
Then you may probably see interest coming back to FMCG stocks quite a lot. The valuations that these stocks have reached are probably at their four-year lows. They may get re-rated. ITC may be quoting at 18x its earnings. Last 10 years its ROE has been going up. Then suddenly people will realize and find it interesting. Today a lot of people believe it's a tobacco story. They believe there is no significant volume growth. Are we looking at topline growth or at earnings growth? In the past we have seen managements saying we will be a Rs.2 billion or Rs.5 billion in assets and turnover. But today, managements talk about RoE and RoCE - a complete change.
To me, something like this is more important than a PEG ratio.
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