Originally published July 27, 2016
SN: Is there a mechanism in Mutual Funds where you repay cash to shareholders if you're not finding opportunities for a long period of time?
RT: Some people do it by the way of dividend payouts. Another mechanism is that you can shut the doors for the inflows. What you can say is that I'm not getting opportunities now so I wouldn't be buying anymore. Lot of people have done that also. So you shut the door and say I'll not take any more inflows from this date onwards. And you can open it as and when the opportunity arises. You can keep it shut for may be 3-6 months or 1 year or whatever period you deem fit.
SN: Being a fund manager, what are your thoughts on indexing?
RT: Indexing has a very important role to play but you can't overemphasize it. People typically fall into two categories. One category of people are completely pro indexers. And the other is people who are completely against indexing. I am someone who is in between. So at one side indexing acts as a huge control on excessive fund management fees. Since indexing is a low cost mechanism for people to participate in equity markets. It's a fact that if all the money were to be managed by professional managers, the aggregate return that they give to investors will be market return minus fees. They can't outperform themselves as a group. So mathematics is fine and I appreciate indexing from that point of view.
At the same time, there is a very interesting piece written by Seth Klarman on indexing. He asks us to do a thought experiment. Let's say that the entire market moved to indexing and there are no active managers left in the marketplace. So there was one giant index fund operating at absolute low cost and whatever was the market return was the return to the investors.
In such a scenario, that fund house should have logically fired all the fund managers and all the analysts because only one person is required who is allocating the money as per the index weights. In such a scenario, there would be no one left to vote for shareholders because it wouldn't matter what salary the promoters are paying themselves, it wouldn't matter whether they are doing shareholder friendly or unfriendly mergers and acquisitions or spin offs. There would be no buyers of IPOs because at the time of IPO the share isn't in index so no fresh capital raising would ever happen in the economy. There would be no relative variation in prices of various companies irrespective of how they are doing in terms of profitability.
So if Company A tripled its profits and Company B fell by 90% they would continue to get inflows from the index funds in the proportion of market weights. That would be a completely illogical market where everything is formula-driven and mechanized.
The role of active managers is to act as a watchdog for the company management and to allocate funds to more capital efficient promoters and management, to channelize funds to the right direction. At the same time, they can't be too greedy for charging excessive fees because ultimately they have to deliver good return after fees and they have a strong competitor in terms of an index fund which is doing it for low cost. I think both will co-exist and as asset sizes grow there will be pressure on managers to reduce the expenses in the system.
SN: How do you think about valuations and how do you address the complex problem of differentiation between paying up for quality and overpaying?
RT: I think the first decision in any business evaluation that I make is - how many years out can I see the business. So when Prof. Sanjay Bakshi says about Cera that its business would not change much with technology or Internet, I tend to agree. Making basins and toilet pots isn't going to change dramatically. But if you're a cable TV operator or a satellite channel then streaming video could change things dramatically. If you are a newspaper, then you are aware of the threat that internet poses for your company. So it depends on the horizon that you can project into, or where you can have some reasonable visibility, and in most cases, it would be not more than 5-10 years and in some cases, it would be shorter. Shorter the visibility, lower the valuations.
The characteristic of the moat is that it either widens on a continuous basis or it reduces. It's a continuous widening or reducing action. It doesn't remain constant. If the moat is not going to be around, then paying a very expensive multiple doesn't make sense. If you're paying 40 times for a business, ignoring the growth part of the business, then you're saying that it will take 40 years for the business to earn back your initial investment. And if your visibility is not beyond 5 years then how can you pay that valuation.
It's a very rough heuristic. If you are paying 40 times earnings and next year the profits grow four-fold it'll be a 10x P/E. I'm not saying P/E is the be all and end all of valuation. But it has to be in conjunction with how strong you think the moat is. And if one is humble then he would realize his own limitations and also the fact that humans are a bad predictor of the future.
There is this great piece by James Montier on fallacy of forecasting. If you do a google search on the "famous incorrect predictions," you'll realize that even the so-called experts in the field don't get it right most of the time. For example, IBM (NYSE:IBM) thought that there was no market for personal computers and that's why they gave away the DOS to Microsoft (NASDAQ:MSFT) and allowed Microsoft to dominate the Operating System market.
So given that track record, I am not confident of looking far into the future for most businesses. Because of that, I am most stingy in terms of paying too high a price. Stephen Penman, in his book Accounting For Value, has given a good framework for this. It says that you calculate something called true intrinsic value and you calculate speculative value.
So what is true intrinsic value? Let's say you are able to see somewhat confidently for the next five years. You discount those cash flows to present value, that's the true intrinsic value. And then you say this terminal value based on some assumptions is the speculative value. So the bigger the portion of intrinsic value, the bigger the comfort. Otherwise, you are just making a wild bet. One of the reasons I am not able to pay far too much, at least it's my personal opinion and people have different views on it, because my view of the world is that it's changing faster than it used to change in the past.
Look at history. In the initial years, the lifestyle and technology didn't change much from one generation to the next. The rotary telephones we had, the same instrument would last for 10-15 years. Till it broke you wouldn't throw it away and get a new one. Whereas these days, people change their cell phones every 1 or 2 years as new models come in. Given the fact that change is increasing its pace, you should shorten your horizon to that extent. True that you can't pay the same price for a high quality business vs. a low quality business. But there is a limit. I don't know if that answers your question.
SN: It does and it actually gives me another question about things changing very fast. If businesses are changing, I think the valuations should be changing. In such an environment, how do you look at this concept of 'moats'? You said it's always increasing or gradually decreasing, right?
RT: It could be a sudden increase or sudden decrease.
SN: Right. Now, people give high valuations to FMCG companies and to big banks with brand power. Big companies with deep pockets can easily erode the existing moat of others. You also said that government regulations and patents couldn't be a moat. So how do you figure out if the moat is sustainable or fleeting?
RT: You have to be extremely wary and keep your eyes and ears open. There is this signal vs. noise thing. Sometimes you may mistake a noise as a signal and get scared out of a company which has a good moat, whereas in some cases you would assume it as a noise where it is a signal and not come out of it before it's too late. So you have to balance both the factors. But again some of the things that used to be strong moats earlier may not be moats anymore. You mentioned one, which is brands. So most of the brands, historically, have been built by financial muscle and dominating media for a long time.
If you were a Hindustan Lever at that time, then you went down saying "lifebuoy hai jahan tandurusti hai wahan" repeatedly over decades on television and you kept bombarding your audience with that message. And that was a brand, that was a moat. For someone else to come in was very difficult. Because you'd have to have financial muscle to buy the television advertising for all over India on such a scale and have that kind of distribution network too. But those days of broadcasting of one-way media is now giving way to two-way interaction between businesses and consumers and things like social media and 'narrow-casting'.
So earlier a shop owner gave you a shelf space and the consumer had seen that brand repeatedly on TV so he thinks that it's a good and reliable brand and buys the product. That is giving way to things like, different people have given reviews on Facebook (NASDAQ:FB) or Twitter (NYSE:TWTR). On an e-commerce website like Amazon (NASDAQ:AMZN) you'll have consumer feedback and reviews. And if customer feedback is not strong your product will fail. Whereas something, which has not been heavily promoted but has good user feedback and good word of mouth, that brand could take off in a big way.
Some of the people who have gained a lot of market share, for example Samsung (OTC:SSNLF) is a very heavily advertised brand whereas Chinese companies like OnePlus or Xiaomi as phone makers are not that heavily advertised but they have a good price point, they have word of mouth recall, they get positive reviews in newspapers and magazines and that is enough to gain market share and gain customer loyalty.
So it's a changing world and I don't know how things will be in the future. So today "fulfilled by Amazon" or an Amazon quality guarantee or Amazon saying that we'll take back the product if you're not satisfied is as good as brand for me. Even if it's an unknown company selling to me, as long as Amazon is in between and they promise to make good any defect, I would be willing to try out new things. So things are changing fast. A brand and a distribution network was a big advantage in the past, may not be true today.
SN: This is where Graham comes into picture where you have to have the margin of safety of whatever high quality business you are buying, because you never know that the moat or what you are paying for is coming down or whether it will exist for the next 5-10 years.
RT: I would have thought that Dabur is a great moat and a great brand but I didn't know that Patanjali would come with someone who is a Yoga teacher and has a wide following. He's right in terms of following traditional Indian products and Ayurveda but I would be very worried if I am selling Dabur Chyavanprash or Dantmanjan.
SN: What about risk? You talked about different kinds of risk to business - moats deteriorating, valuation going haywire. How do you think about risk apart from a general definition of having permanent loss of capital? And how do you employ that mindset of keeping risk low in your investing?
RT: It's here that, to a small degree, there is a difference between managing public investments and managing your own money. When you're running an open-ended unitized fund, any person who comes in and invests money in your scheme is buying shares at today's market price, not at your historical cost. That's why you have to be wary of not owning too many companies which are at the upper end of the valuation bound or beyond. Even though your original purchase price is quite low.
Second is, the way Buffett defines permanent loss of capital saying I'll hold it for 10-15 years it will eventually work out. If your client's investment horizon is 5-6 years, you have to make sure that within that time period you don't lose capital rather than 10-15 years. Volatility isn't risk is true as far as daily or weekly volatility goes, but for 2 to 5 years' volatility you have to be aware of those kinds of volatility saying you shouldn't have a big drawdown in 4 to 5 years.
Again, some people are big fans of very concentrated portfolios. I understand that you can't have 100-200 stocks because that will dilute your best ideas, but at the same time, one wouldn't be too comfortable having let's say 10-12 stocks or a very limited portfolio. You'll need to have a reasonable amount of diversification say, 20-25 names so that anything going wrong in one or two businesses doesn't affect your investment too heavily. You have to come at something like a golden mean, not excessively diversified vs. not too concentrated, where one or two things going wrong could upset your overall returns of your capital.
SN: What's your advice for an investor who wants to improve his/her decision-making? Is reading enough?
RT: Reading is a hygiene factor. You have to do it. But it alone may not improve quality of decision-making. Two things come to mind to improve quality of decision-making. One is to keep an investment journal. Jot down your thought process when you are buying something or rejecting something and then periodically revisit that as to how things have panned out and what are the things you missed out originally. That improves your decision-making.
The second is make fewer decisions. This thing I have seen very strongly in Mr. Chandrakant Sampat. He would stick to an extremely small set of companies that he would cover and understand or decide upon. Again, number of trades in a year would be very few. At most times, there are thousands of cons to either buying or not buying, selling or not selling. Whereas at some point, it's blindingly obvious. You can't miss it. It screams at you that this should be done. When you act at such a time, the quality of decision-making will be far superior.
Buffett has also talked about it in terms of a punch card where you have 20 investing decisions over your investing career. So fewer decisions you make the better. You'll put that much more time and effort into arriving at that decision whereas if you're making a decision every day or every hour then seriousness doesn't go into that decision. So just like most people get married once in their lifetime, you give a lot of thought to it - most people do. Marriage is an extreme example. Even when you take a job you plan to spend at least a few years in that company. People give serious thought to it. Why should it be different for stock investing? You can't be on a train and some guy sitting next to you says that this stock looks good and you go out and buy it. It can't be that.
SN: It's good to be positively optimistic about the world but if you remove the angle that you are managing money and were a personal investor, what's your thought about where the world is headed in terms of money and finance, given the way that central banks globally are turning the entire planet into a zero cost kind of thing. How do you think this is going to play out in the long term?
RT: I don't give too much thought into it. Very recently Charlie Munger has said that he's surprised that so much money printing is going on, interest rates are so low, and yet inflation is not there at all in most of the world. This poses a greater risk to fixed income investments or the currency notes that you and I have in our pockets than to the businesses. Buffett has said this numerous times.
If you are the best heart surgeon in town, irrespective of what the currency is, whether the US dollar was up or down, whether people moved back to exchanging gold coins or shells as currency or bitcoin, your service will be valuable to humankind and people will be willing to exchange goods and services for your expertise. Same thing carries over to businesses that provide good or services to the population. So if you are pharma company making life saving drugs, whether interest rates are zero or 20% or negative, people will still be willing to give up their time, labour, effort and capital to get your product in return.
As long as you have that business view right, focusing too much on macro may not make much of sense. However, there is one thing that confounds me. Switzerland for example, their 10-year bond is at negative yield and Nestle (OTCPK:NSRGY), which is a Swiss company is about 22 times earnings where earnings is equivalent to cash flow because there is not much capex, etc. So if we could borrow money in Swiss currency or government bond for 10 years and buy a Nestle, this one will at least give you may be 50% of your principal amount in earnings over 10 years and you just have to repay what you have borrowed effectively or even less because the yields are negative.
Interest rates, even long-term interest rates, are so low, hence the opportunity cost for equity investors is that much lower. If you are a pension fund or endowment fund, where do you put your money today? In a low inflation environment, you should be prepared for a lower nominal return. When Indian inflation was closer to 10% and we were getting 15-18% equity returns, if our inflation were to fall to 5%, you should be happy getting 10% equity returns.
We should be prepared for lower nominal returns. So I don't worry so much about macro as long as the business is right. It's not that I predicted that in 2009 there would be a crash. I was clueless. The reason we held on cash was because we were not understanding DLF, Unitech, GMR or GVK. It's not that we had any foresight that Lehman Brothers would go bankrupt. I hadn't even heard of subprime mortgages or what is CDO or CMO etc.
SN: What's your quick advice to someone who wants to get into value investing? What are the pitfalls that he or she must be aware of?
RT: The only pitfall is that you'll not enjoy the riches of youth. Raw material of investing is money, so if you start with Rs 100 and make a 25% return the first year, you can't go out and consume that Rs 25. You require Rs 125 to compound next year. In your youth, you have to live a frugal lifestyle to really compound wealth to become wealthy.
Lot of people come to investing with expectations. Unfortunately, lot of advertisement on mutual funds also say that invest now and ride in a Mercedes. Most value investors I have seen are frugal people who don't splash money around. They can retire comfortably and achieve financial independence rather than a flashy lifestyle. If you've inherited a lot of money you can live a flashy lifestyle as well as be a sensible value investor. Otherwise it's a long-term game. You can get financial independence and you can retire wealthy. You can either leave behind a large legacy for charitable or philanthropic work but if you're expecting to suddenly become a billionaire, it doesn't work that way. Even Buffett made most of his wealth in old age. It's the nature of compounding.
SN: I think compounding should be taught in school. More important in compounding is that it's back ended. You have to have time on your side. Great! So what are some unconventional books and resources you would recommend to a budding investor?
RT: Rather than a book or a resource, it's an activity. I think someone who has parents who have been salaried employees and who does conventional education like MBA, CFA, Chartered Accountancy or Engineering and then straight away comes to investing, starts with a big disadvantage. Buffett has said this numerous times and it's absolutely true. He says I am a better investor because I am businessman and I am a better businessman because I am an investor. When you have an experience in running some kind of a business or a professional service it gives you unique insights to investing. Being in business and actually being an entrepreneur gives you that multidisciplinary thing.
Let's say you're a sole proprietor starting out. You have to understand finance, you have to raise money and figure out whether that will generate adequate returns or not. You have to understand accounting to see whether your business is making enough profits or where do you stand on a continuous basis. You have to have human resource capabilities to recruit, motivate, monitor and compensate people. You need sales and marketing capabilities to be able to go out and get customers and grow your business. You need some legal expertise for clearing all the regulations.
It may be a simple thing like a municipal permit for a restaurant or a shopping establishment license for your store. It also gives you that perspective that running a business is not linear. There are ups and downs. And in fact sometimes I laugh when I see brokerage reports by well-renowned people, which say that we ran a screener and only these companies grew profits in each of these quarters.
Business doesn't run that way. You can't have a linear growth in each quarter. Why should it grow every quarter? When you run a business on your own you get that approach to investing in a company as a business. Otherwise your knowledge of this concept - buying an equity share is partnering in a business, it's not buying something which is quoted on the exchange and goes up and down every day - is only at a superficial level. You don't get an owner's perspective.
Another thing is, if you have done accounting or auditing for these large corporates as a chartered accountant or as an auditor, that enables you to take those quarterly report or even annual earnings numbers with a pinch of salt. I don't know how you can place so much reliance on one quarter's or one year's accounting estimate for an entity like a bank or even some of the manufacturing companies. It's an estimate. Effectively, you should have a view of the business as an unfolding movie rather than a snapshot. That comes only after running a business or understanding how that accounting happens. Otherwise people know it only at a superficial level.
SN: But for most people who neither have a business background or running a business?
RT: I have not run a business in a traditional sense. But today we run PPFAS. It's not linear. We have periods like 2007 where we underperformed severely where we don't understand the fancied sectors for a period. Where we see client outflows. We have periods like 2009 where markets are down and out so growth doesn't happen and people are reluctant to put in money. We face challenges in terms of recruiting people and creating awareness.
Let's say you run Safal Niveshak. You will face challenges in terms of how to make the website well known among people. How to get more people to sign up for the programs and seminars? It could be small things like that. But unless you have actually implemented something and you have understood the challenges of human resources, marketing, finance and you really know how a real life organization or business works, you will understand things only at a superficial level.
In a lot of conference calls and analyst meets that I attend as an investor, the whole question is on this quarter's number or guidance for the next quarter or projections. Things don't work out that way. Let me ask you - how many people do you predict will sign up for your course in the next quarter. That depends on so many factors. You may not have a precise number. If you give a precise number, then you are just making things up or it's your best guess. A lot of people don't get it.
A lot of people don't understand business at an intrinsic level. They only understand at a superficial level. Also when things go wrong, how long will it take to rectify? If a pharma company gets a FDA notice, people say by when will this be resolved? A lot of these things are fluid. Lot of interaction has to happen with a regulator. A lot of bureaucracy is involved. Timelines are usually underestimated. These things are known only if you have experienced something similar in your life. Otherwise you think everything is cut and dried and everything becomes a point estimate for you.
SN: I think running a business helps you empathize better with the promoters.
RT: You asked me a very good question. What happens if you don't have a business and you still want to become a better investor. Become a secretary of your cooperative housing society. It will give you challenges like dealing with the municipal corporations, how tax notices come out of the blue for retrospective taxes, how dealing with other members of the society becomes challenging, or how to make compromises. It tells you what the real world is. Otherwise we are sitting in our air-conditioned offices in silos, and only looking at spreadsheets. If all you've looked at is spreadsheets in your life, you can't be a good equity investor.
SN: That should also be an advice for someone who wants to get into value investing that you need to have the sense of business.
RT: Business or any organization. You could be your class representative in your college. That gives you a sense of how many variables are involved, that things don't go exactly as planned, why the concept of margin of safety is required, why do you over-engineer things so that there are fall back mechanisms. All those things come only when you have experienced it.
SN: Which investment thinkers or investors do you hold in high esteem?
RT: The usual suspects. Apart from Buffett and Munger, Prof. Bakshi is someone who I follow quite regularly. I have mentioned about Mr. Chandrakant Sampat and Parag Parikh.
SN: Coming to a hypothetical question. There are two questions. Let's say you are going to lose all your memory next morning, briefly what would you write in a letter to yourself so that you could begin relearning everything starting the next day.
RT: One is, associate with good people. Applies both to personal life as well as investing. Then the concept of inner scorecard. Also, the idea of envy being the deadliest of the sins. What matters is how you are doing absolutely in terms of your mental well-being, physical well-being, financial well-being, rather than what someone else has earned or what return someone else has achieved. The biggest trap that people get, even in investing, is trying to catch up with someone else who has done better than you rather than being happy with what you have earned.
SN: Another question, if you could do anything other than managing money for a living and make twice as much money as you do now, what would you do?
RT: Manage my own investments rather than managing for other people. Apart from investing, I would pursue other hobbies that I have.
SN: What are the other things that you currently do apart from investing?
RT: Playing chess is one. Reading fiction, listening to music, karaoke singing, travel and watching movies.
SN: Great! So that's all I have. Thank you so much Rajeev for all the insights and your time.
RT: You're welcome Vishal.