How Samir Arora Identifies Alpha-Creating Stocks

Samir Arora: There are a lot of stocks in the market, around 100-200, but technically, I would say, around 400 stocks. So, first, we weed out bad stocks on the basis of eight factors. Earlier we used to pick stocks with very high valuation saying it is high quality. But, over the years, we have realised we veto on any one of these factors — if the theme is bad, if the history is bad, if there is a potential disruption, if it has high valuation, if it has bad financials or bad examples of corporate governance, if there is expectation of bad results in the next three, four or five quarters.

Any of these we will reject, but once in a while, we may accept, say, a bad theme, saying "this stock doesn’t define the theme or the theme doesn’t define the stock". For example, we do not like commodity and PSU companies as it is a bad theme. But once in a while, we might take it if that stock is better than the theme in a very significant way.

Broadly, the idea is to first reject. And from the stocks that cannot be rejected on these parameters, we will look for the positives. This works. To say something is good, there is no end. For bad, one line is enough — It doesn't matter what else is there, we don't like this fellow's history. Now, someone may say they like it because it is cheap. Okay, but it also has a bad history or many such bad examples. Or many may say the valuations are not just high but they are unprecedented, but then it is a very good company. These are the places where tradeoffs are made.

Initially, everybody tries to make a formula saying — I will give so much weight to this factor or so much weight to the other factor. But with time, they realise that so many stocks didn’t do well. That there is no need to make the tradeoff. Still, among 35 stocks, we may say one stock is very expensive but it doesn’t matter. The idea is that nothing is 100% black and white. It should be at 80-90% black and white, with 10% still a choice to be made.

Samir Arora: We found 80 stocks that we say cannot be rejected on any factors. That means it doesn't have a bad history, it doesn't have a bad theme, it doesn't have very high valuations relative to sector on its own history. If we don't know anything bad about them, then we look for the goods.

For example, you are trying to buy a relatively new company, which had its IPO recently. Suppose it has some private equity history. Now, if the management is not bad and is qualified, if it has some skin in the game and has grown. So, there is only one bad, but there are other things which are very good. May be the industry is very good, the financial position is good, or the numbers are good in general and hence the management is also good from that angle. So, we just keep them separate. That is why we bought stocks like Bajaj Finance. In 2011, Rajeev Bajaj was a relatively new guy. Clearly not the big hero that we discovered or even Kotak when it became a bank.

We had 5% of the bank when Kotak turned from a broker to a banker. On what basis were we supposed to say that this is a good bank or a good management. So, we said not bad on management because there is nothing bad, but very good on the size or market cap. And very cheap or on the theme that it is competing with state-owned banks early-on, or very good other income because they had only other income in terms of broking investment banking, but also no actual banking business. The point is that everything is never good. Some things have to be not bad. Even an expensive company, say, some company, consumer staple company normally has a 30 multiple, and today they have the 35 multiples. What can you say? It's all in the same range? There's no formula that 33 will make it good, but 35, we will say is not bad, even if it is 40. But, if it is 60, then you can call it bad and rejected.

It is mostly of been few not bad and the rest good; very rarely everything is good. 

Samir Arora: In bad cycle, nobody gives us money to buy. Secondly, it is a bad cycle at that time for some reasons? So, do not confuse when I give examples of all stocks in September 2008 and the next in March 2020. It does not mean everything was good. Actually, it was not good. The hotel industry was closed. How do you buy saying I buy ROE and ROC. So, we could say the results were not bad considering the industry was closed. But everything else is bad or something in similar note.

Samir Arora: It is not backdated, not modelling. It is the actual difference with some fellow who came with a model. We have actual 26 years history. We charge even a performance fee and net performance. We return nearly every fund in India after charging a performance fee. The net is only in the 60s and these guys are over 100, and they charge mutual fund fee, nearly every one or two would be better.

Samir Arora: We might say everything else is good, but we don't want to buy five-six quarters ahead of time.

Samir Arora: Cyclicals we reject, if we don’t like the theme. Such theme we mostly will not buy only because cyclicals need a completely different game. The cyclical’s game is independent of all these factors. You have to get the macro global factors right, because cyclical 90% of the time is the price of that commodity, rather than it demand. Everything is dominated by the price, and you need to worry about what is happening in US and Japan and Brazil including Russia these days. It's very conscious. We are not rejecting it for results. We mostly reject it as we consider it a bad theme.

We have been nominated for the Best India Fund in 14 of our 17 years that we have operated. The idea being we don't want a strategy. I do only this and then wait for the whole country and the market to fall along with it which might happen every five years. Therefore, seeing five years I had been in the market, I want to broadly be up there every year. Once in a while, though, we have bought one or two commodity companies which might be 4-5%. But at that time, we make sense of China or India has got protection or this is happening that is happening. It might work for a year or two.

In the end, most have not worked for us. But we needed it, to go through that phase. When we feel that if we just cover this angle, we can concentrate on the balance 95% of the portfolio. The other everyday Tata Steel is going up. We know it is going up, why are we not having it. Buy 2-3% and move on in life.

Samir Arora: We are totally into macro, but we are not in this macro where the steel company has closed down. I am not a fund manager who says, well, I only look at stocks, but I don't look at economy and I don't look at marketing. Whoever says that either is too lazy, or has got wrongly influenced by Warren Buffett and Peter Lynch.

When Warren Buffett says “if you spend something like five minutes on economics, you have wasted five minutes” or something like that. The point is he had 100 of unlisted companies and he get their reports every month. That is the economy. He has all the stocks, which are representing the economy. But, if you don't get those things, we have to talk about the economy. He talks whether the consumer is doing well or road is doing well or broker is doing well, housing, semi-carpets and he is selling houses. So what does he need, he already has it.

But Peter Lynch can say on time waste as he is on Fidelity. Fidelity has and had and will have 10s and 20s or 100s of economists and those big picks. He has them. They give him something he has not read. They have registered in him because of Fidelity. He was the head; he was the CIO at Fidelity. My point is because this is the way they put it into context a little bit of which sector or which listing for the next few years. Where is the priority, if interest rates are going up, one should know that. That is part and parcel of even projecting a company's next few years. It's top down a little bit, and bottom up. But commodities are too specific and too narrow for us.

Samir Arora: Top view is that India is relatively very well placed, because there are three or four pools where equities are invested which is the U.S., Europe, China, India, and Japan. But broadly, Europe is doing very badly and everybody knows why it is doing badly. China is doing badly not just because of its own macro reason but also micro, in the sense that the government's policies have directly hit many listed and unlisted companies. Therefore, they can feel the pain. And the U.S. is actually doing well but the Federal Reserve says it has to slow down because inflation is part of that doing well.

So, India is relatively well placed, but to make absolute money, if this year has not been made because the market is flattish. You need other markets to fall, at least the U.S. I think the U.S. will never fall. If falls, it balances off within the quarter or we say it’s discounted. As there are three rate hikes and more commentary, whatever has to happen Is more or less now as it will take second- or third-rate hikes for inflation to cool.

So, after two or three months, either the U.S. market would have fallen enough or it will be said it is discounted. That we have gone through the worst possible hikes and maybe even the commentary are less hawkish, then you can move on and think next year will make absolute money.

Samir Arora: I don't even agree with that because one reason is that India’s relative valuation looks high is because China, which is a big part of our emerging market indices, has fallen some 30-40%. However, the indices have not fallen 30-40% as the general flow of money is going in there. China has fallen because it has actively changed its policies.

It is like saying if a company in India is caught for let's say corporate governance and after one hour, one day, or one month, you say it is very cheap. No, you know why it is so cheap.

By the way, India has not become more expensive simply because the market is not up this year. So, at a market level, how could it have become little bit centre-wise. It is because Europe is specifically hit, with its own problem. So, if it didn't become little cheaper, who knows? Maybe the earnings also fell. China too has done major, not minor, corporate governance country type issues. Corporate governance means where the policy changes has directly hit and hurt investors. So, if you come in randomly and change policies which hurt for whatever objective you may have, which might be good as a country, obviously that cannot be considered.

The bottom line is that we haven't gone up for a year. So, we could have gone much more expensive unless you say that earnings are falling, which haven't.

Samir Arora: It has changed quite a bit. So, for example, three big picture themes have left from the theme angle. They are in practical terms, financials, consumer and tech. Actually, it is Tech, pharma, and specialty chemical which we put in one group which is exporter. Then consumer is middle-class consumer and financials are private financial though we own State Bank of India in a big way. Since January, we were “underweight” on tech.

But one month or so, we made zero because the idea is that there are so many other things which are doing very well in India. Consumer and financials are doing well, we have hundreds of these. So, an IT might go up, but it's unlikely that IT will outperform the other two groups for the next six to nine months because of the news coming from the US. There is engineering of a slowdown in the U.S. They are unlikely to have the same level of growth compared to Indian companies particularly Europe which is hardly 15 -20%.

Broker CLSA is saying that they are very bullish or sort of bullish as Indian companies told them that they are still seeing strong demand up till at least second quarter FY 23. And we have just 11 days left for the second quarter of FY23. The report quoting these companies are saying there is no problem of visibility in second quarter.

Samir Arora: We have specialty chemicals and pharma. SRF Ltd. has done okay this year. That stock we have made four-five times. But we have held it from 2018. Pharma is much we have. It's an issue of IT because it is mostly US listed companies and those listed companies are under attack mostly from these private equity or VC funded companies that spends on IT during their initial days. The big picture is that there is a slowdown. I have seen in 2000, when companies do not know anything about their six months later business. They can only see the second quarter, which is like over and the report is from today, not yesterday, so why the old report? Point is, nobody knows, not even that fellow who is giving the business. Even the valuations are still higher than what they were pre-Covid.

Samir Arora: The big picture is this is actually for Europe; it can be India. You can make them because India at that time was less environmentally sensitive. So that could be one reason. Second is how do they do transition between the company? Then you want an India-wide advantage and once it is clear that it can sustain, a companywide advantage is very confusing. So, IT is very good that way, pharma is also good. You see there are tens of companies, how can they all succeed. India did not have advantage; Speciality chemical could be getting there. We are not used to multiple valuation that we had more than IT, more like consumer companies that we don't like.

Samir Arora: Not mid cap but middle-class consumption. It is actually right because the consumer staple guys who are selling to a billion consumers are large caps or extreme large cap. This low ticket consumer means not those guys who go out to eat or buying some shoes or seeing a movie or getting an ethnic wear, all these are not for the 70 crore, and will definitely not for the first 50 lakh guys, who want to go abroad, will be considered low ticket Indian consumer middle-class. Leave out the one end, and 70% of the other end.

Samir Arora: That is structural because the big picture, the middle-class itself, we know is underpenetrated. It does not mean that 1.4 billion people are underpenetrated but underpenetrated in say 300- 400 million people. So, it is simple to understand where these guys pool will go and they still have to open more outlets. In the medium term to short term they should grow not at 10-15% but at 25%, if India's GDP is growing at 10-12% in rupees. The large guys they grow at 10-12%. That is no fun. 

Samir Arora: That's the proper time for Lemon Tree and Indian Hotels. Their logic is that it is driven by supply. It is lots of foreigners will come back one day soon and they are already there.

The big picture is that they are saying that the cycle will be longer because new hotels have not come online and the capacity to be around 12% per annum and now it is up to 2-4% per annum, therefore the cycle can continue for the moment. Yes, next one year all looks good because your RPUs are going up and the number of foreigners and business travel and conferences all have just started. I think these days conferences may not be like the first conference post Covid. It will be in a big way.

Samir Arora: It is going on likewise. People say that how can consensus do well. Some of these things are like everybody broadly agrees that Google is a good company in the U.S. and every year it outperforms.

We also have bought a few smaller banks. We were the early ones to buy IndusInd Bank. We like financials. We are just going into it because you already have the big ones, the three big ones. 

Samir Arora: Our logic is we have 35 names, if you buy 10 names, you will be confused over whether you should get that much conviction. But the whole idea of buying all 35 names is that we are buying 10 big odd regular names HDFC Bank, ICICI Bank and we have 20 of these smaller positions of 2-2.5% each where there are eight factors. Then you are betting on some positive and some hope also. So, in that we have Bharat Electronics which has not done well this year. It's become 2.8% itself. Every year some six to eight stocks have to do much better than the market, the rest can be either plus or minus or break-even with the market. We overrode PSUs, but we have two PSUs, State Bank of India and Bharat Electronics.

Samir Arora: The book you guys should read is Halo Effect. It will tell you why you should not look at price of a stock, to say, it is good. The basic logic of that book is that when you see a company is good or bad, basically you are looking at the price and there are hundreds of examples and logic that is given that you will be convinced that just because the stock has done well for about ten years and therefore it has good management, it has good and motivated employees, cost reduction is good, everything is good just because the stock is doing well.

In terms of building a portfolio, we would say one thing, don't think that you are smarter than the world by saying I will buy five stocks. The odds are that some 30% of the companies, 40% will do very well, and the rest with plus minus.

Look at Prashant Jain, one of the most successful fund managers. Of course, I was bigger than him in 2003 when I was in Alliance, but he just wrote a letter, in which he said that he bought 469 stocks in 19 years. If initially, let's say, he bought 60 stocks and then you got 400 more stocks in 19 years. So, he bought more than 20 new stocks a year and then many of them worked. Rakesh Jhunjhunwala made his money from 10 stocks, big money. What do you think he bought about 15 stocks? No, he bought 100 stocks but what we also say is we are buying 20 new names every year, not new every year, 20 names with five to six kept aside that makes you feel that it’s a good buy.

In 2013-14, you buy five or 10 stocks and then say one more year or three more month and if you are disappointed, you sell out. So, buying five stocks, makes no sense. So, be humble and buy a little bit more names and you also learn more. Otherwise if you are buying five stocks every day, you will over analyse those companies and it cannot be analysed beyond a point.