World’s Mightiest Financial Services Investor JC Flowers Very Keen To Invest In India: Mukerjea
The bulk of the upside in the market is now in stock selection, says Saurabh Mukerjea.
This week on our weekly series Thank God It’s Friday, we spoke to Saurabh Mukerjea, the chief executive officer - institutional equities of Ambit Capital on the markets, the global setup and his new book The Unusual Billionaires, which was published earlier this month.
Stock Selection is Key
What is your view on the Indian equity markets, more specifically, what do you make of current valuations, given the GDP data and earnings growth that we saw this quarter?
There is no clear relation between earnings growth and market movements from quarter to quarter. So I don’t think we should try to link them with one another. Around four months ago, we turned positive on the Indian market. We had a target of – still have – 29,500 on the Sensex. Markets have rallied radically from 23,000 six months ago to 28,000 now. My reckoning is this that there is still some upside in the market over the next six months, of around 5-10 percent. But the bulk of the upside is now in stock selection. I don’t think playing the index, per se, is going to make you a great deal of money here. The money to be made is in stock selection and that has been the Ambit house view for the past six years – buy good and clean stocks of well-run, sensibly-run companies with believable accounts, credible managements, and good cash generation. That is also the context in which the book was written. Clean stocks, sensible investing is how you’ll make money here, not necessarily by buying the index in India.
Limited Impact of U.S. Fed Hike
In the backdrop of the global environment, with U.S. Federal Reserve chair Janet Yellen suggesting a rate hike at the last Jackson Hole Symposium, what is your call on the kind of fund flows we can see in India?
What we’ve seen with India in the last decade is that it doesn’t really matter at one level whether the Fed hikes or doesn’t hike interest rate. There is a core constituency of large long-only investors who are always interested in India. For example, we were hosting an event around The Unusual Billionaires last evening, and legendary financial investor JC Flowers was speaking at the book launch. He said they are very keen (on India). The world’s mightiest financial services investor JC Flowers is very keen to invest in India. He sees the Indian economy as a fundamentally sound growth story and he is interested, therefore, in putting money to work in India. That’s been the case for the last decade or so. What can happen quarter to quarter is some of the hot money, some of the hedge fund money might come and go but I don’t think viewers should lose sleep over that. The fundamentally-oriented average retail investor should just focus on the fact that we have a healthy economy, with a core constituency of large long-only investors who keep investing in India, lending support to the market.
Focus On High-Quality Stocks
Long-only investors will usually only look at volatility which could potentially rise on the back of a Fed rate hike. Would you use spikes in volatility as buying opportunities, or would you rather wait and watch? What is your stance?
In my experience, what the markets have shown is that there is absolutely no point in worrying about what the Fed will do, or what the RBI will do, or what this quarter’s results will be. It’s good TV, but from a fundamental investing perspective there’s actually zero value in it. They main way you make money in any equity market is you buy fundamentally high-quality stocks and you hold them for a long period of time. Those are the two central tenets of equity investing success in any era, in any country. So talk to any of the gurus, whether in the west or India, they’ll say buy high-quality equity names and hold them for a period of time. What I’ve tried to do in The Unusual Billionaires is turned those two tenets into actionable strategy, where my point of view to the investors is, buy companies which generate at least 10 percent revenue growth over a decade, at least 15 percent ROCE (Return on Capital Employed) for the same period and sit tight for a decade. You’ll make a lot of money and you’ll do it regardless of the year you are in, which quarter you’re in, or whether the Fed is hiking or not. So that’s the way to think about it. We can all read the daily newspaper, but the best strategy will be to forget the short-term noise and focus on the underlying fundamental issues which make some companies great and 99 percent companies very ordinary.
The Investment Mantra
How long did you take to write your book?
My previous book, Gurus of Chaos, took me three years to write because I was a first-time author then. Because I learnt from that, The Unusual Billionaires from conceptualisation to publication was roughly a two-year journey. The intent of the book is to help the investor who gets completely lost in the sea of interest rates going up, the rupee, some corporate announcement. All of this has very little to do with actual investing. The point we have tried to make to the investor is to keep it very simple. Look at basic financial metrics – revenue growth and return on capital employed. Take long periods of time, and then once you invest in those stocks, sit tight for a decade. The astonishing thing about India is that this is a country where even though its been 25 years since liberalisation, the economy has “pentapled” in size. The way our financial market works still remains very inefficient. So if you buy fundamentally high-quality companies, of the sort highlighted in the book, and you sit tight for a decade, you will get compounded returns of around 22-23 percent. So you will make 10 times the money in 10 years’ time, provided you show the necessary patience.
‘Don Bradman Of Corporate Life’
Why just these two filters – 10 percent revenue growth and 15 percent ROCE – what about other criteria like dividend payouts, corporate governance? How did you arrive at these two filters?
You want to capture two facets of corporate life. One is you want to capture an element of growth because franchises which grow bigger obviously make you more money but second, you also want to capture protecting or guarding a franchise. So revenue growth captures the growth element and ROCE captures the ability to protect and to guard the franchise. In ROCE, the EBIT (earnings before interest and tax) captures a whole lot of other elements such as cash flow, working capital profitability, which are necessary elements of corporate success. So by combining revenue growth and ROCE you actually pull in all that is relevant. By using a 10-year period, you are factoring in the economic cycle. Over a 10-year period, you have a mixture of recession and boom, so you are evening a cycle out. The interesting thing is going by those metrics, 10 percent revenue growth and 15 percent ROCE, there are barely 15-20 companies which pass those metrics. I will tell something further which we haven’t put into the book. If you take a 20-year period – in the last 20-year period if you use these 2 filters, not one Indian corporate passes the 20-year filter. And remember there are 5,000 listed companies in India. The company that comes closest to that 20-year filter is Asian Paints. They passed the filter in 19 out of 20 years. As I highlight in the book, Asian Paints is the Don Bradman of corporate life in India. So what Don Bradman is to cricket, Asian Paints is to corporate life. This incredible company, over the last 60 years, has compounded revenues at 20 percent per annum. Over the last 40 years, its profitability has improved, and over the last 30 years, its ROCE has improved. I doubt there is any company, even globally, which has produced this sort of results over the last 60-70 years. So the benefit of this approach where you are taking a longer-term perspective to understanding corporates is that you are identifying outstanding franchises who are then able to compound your wealth in the next decade or so at a frenetic rate – 10 times in 10 years. Day trading is not going to get you there, and obsessing about when the RBI will hike rates or not hike will not get you there either. By backing companies like these, you are more likely to get there.
Role of Promoters Versus Management
Another question that I have for you, and you have mentioned it in your book..it has to do with tight-fisted promoters who are reluctant to give management more powers, more authority as against other managements. To use Marico’s example, the promoter has given almost everything away to the management. According to you, what roles should each play – the promoters and the management?
I think what we are seeing in India, and I think it is evident elsewhere in the world as well, is that the day-to-day operations of a company is best left to executives – what should be the pricing policy, what marketing plan you should launch, which geographies to enter – those sorts of operations decisions are best left to the executive management team. The promoter’s forte, his strength, should be capital allocation, and to the extent its required in India, the interface with the regulator/political community. Unfortunately, the interface with politicians still remains a necessary aspect to corporate life in India. Basically, capital allocation and political interface should be the promoter’s forte, and the executives should be left to run the company. That demarcation works very well. It also works very well in the American context. There’s a lovely book if someone wants to read about this in the global context. The book called The Outsiders by this guy called William Thorndike. He highlights the demarcation in the American context. I have tried to do something similar in the Indian context. As you said, a Marico, an Asian Paints, a Berger Paints...they are handing over the charge of the company to the executives. The promoter is saying my main job is to help you allocate capital in a rational manner.
Avoid The Cyclicals?
There are seven companies that Saurabh has mentioned in his book. You have Asian Paints, HDFC Bank, Axis Bank, Marico, Berger Paints, Page Industries and Astro Polytechnic. What I really noticed Saurabh is that all of these are retail consumption-related, defensive stocks. Would that really imply that commodity stocks or cyclical stocks are not going to be outperformers in long-term because they are cyclical in nature? Will they not generate wealth for a long term investor?
In most countries, banks are very cyclical. So the fact that in India some banks are not cyclical – take HDFC Bank in particular – is a testimony to their quality of management. Banks are necessarily supposed to do really well when the economy is booming, suffer when the economy is in recession. But the fact that HDFC Bank doesn’t do that is because it has an outstanding management and outstanding capital allocation. Secondly, not all the franchises are retail. A big part of HDFC Bank’s book has commercial in it. The majority of Axis Bank’s book is corporate lending. You could argue Axis has suffered by dint of that in the economic downturn. Which they have. But in spite of that, if you look at Axis over the last 15 years, they are compounding at mid 20s. Mid 20s compounding for a commercially focused bank in India is outstanding. At one level Axis’s success in that regard is even more laudable than HDFC Bank because HDFC Bank quite rationally said that I’m not going to take too much corporate risk. Then we come to the most fundamental issue which is a fair one. If you buy a commodity, you buy real estate, construction stocks, steel stocks in India, you are not going to get these sort of returns. The reason is the cost of capital in the country is high. Historically, in the last 10-20 years, the bulk of our savings has gone into gold and real estate and as a result financial markets haven’t received the bulk of people’s savings. As a result, the cost of capital is high. With a high cost of capital in the country, you go into sectors like steel, real estate, construction, it will be difficult for you to generate shareholder value. Which is why those sectors haven’t made money for retail investors, or any investor for that matter. My point of view for investors out there is that if they don’t make money then there is no compulsion forcing you to go and buy stocks in this sector. Focus on sectors where cash generation is high and if the company itself is throwing off so much cash that they have got resources to compound your wealth in the years to come. A professional fund manager might perforce have to have some real estate, steel exposure. The viewer of this programme doesn’t need to have that and shouldn’t have it. It’s his or her money, my money and I can maximise returns from it.
Identifying Growth Stories
You have also mentioned HDFC Bank and Axis Bank and highlighted how these companies have tackled challenges over the years and transformed themselves. But my question is based on historical or past data. How does a person identify new growth stories or new unusual billionaires in the making? How will you identify some of these newer stocks?
So I’ll try to answer the question at two levels. The first is, the future is unknowable. In fact, it is just as unknowable for me as it is for you, as it is for the people watching the programme. So if it unknowable, there is no point trying to predict it and behave as if I know it. I might get it right once or twice but fundamentally, consistently, I am not going to be able to get the future right and anybody who claims she can or he can, you have to be a little sceptical of that. Since I can’t predict the future, I should look back as far as possible. Identify companies which have a great track record, and then say that given the track record, do I believe that the track record could be sustained going forward. So If I, for example, identify 15 companies which have a great track record, I might sit here and say although there are 15 here and 10 might sustain, that and other 5 new entrants are coming in and whacking the margins down. So that to my mind is the most sensible way to invest. You look back, identify high-class companies and then applying a process of elimination, you knock out a few of them where you know there are obvious disruption threats.
The second point is that, if you look at India at any point in time there are barely 30 companies which are investible. It’s a tragedy but it is what it is. With 1,500 companies and Rs 100 crore or more market cap, there are barely 30 companies which are doing a good job of putting more money to work. Therefore, to assume that outside the super set of 30, new challengers will emerge is also a little bit over optimistic. It rarely happens. If you see Appendix 2 in the book where we have re-created coffee can portfolios going back 15-16 years. You can see that the names are very similar here year after year. You can also see that the strategy has delivered for 17 years now. In fact, every single year, the coffee can strategy, and just to reiterate the coffee can strategy, you are looking back at the previous 10 years, revenue growth 10 percent, ROCE 15 percent. You are identifying the stocks. You are holding them for a decade. Every year, for the last 16 years, this strategy has delivered substantially better than Sensex returns at lower risk levels. So if it has worked in the past, there are reasonable grounds for believing it will work in future and that is what I am telling the retail investor out there to focus on. It’s like the difference between modern medicine and quackery. We can believe quackery, it gives us hope that if I have something which is unconventional medicine, alternative medicine, I might suddenly get better, but science is in favour of conventional modern medicine.
Creating Shareholder Value
There are also some names like Sun Pharma, Infosys, Bajaj Auto, some of these have created a tremendous amount of shareholder wealth over a past few years. They did not clear your criteria or double filter. Are these not good business or you feel you have missed out on any such names. Also, why are there no IT companies in your coffee can portfolio?
Let me answer the easier question first on why IT or pharma companies aren’t there. I would refer to Chapter 1, where I have addressed some issues. The criteria of 10 percent revenue and 15 percent of ROCEs is very demanding and the only IT company which really made it was Infosys. The reason I didn’t include Infosys is in the book. Infosys’ sales growth went from 5 percent in FY10 to 24 percent in FY14 and dropped back to 6 percent in FY15. Since my criteria says at least 10 percent revenue growth the drop in sales growth of Infosys, unfortunately, disqualified it from making it to the book. There are two pharma companies which came very close to making it to the book but failed. One is IPCA (Labs), ROCE halved from 28 percent in FY14 to sub 15 percent in FY15. Again 15 percent is my cut off. In IPCA due to a bunch of U.S. FDA challenges, the ROCE plunged and I had to take it out. The 15 percent threshold is sacrosanct. Similarly, a major ROCE plunge in Cipla over the last three-four years disqualified that company. Sun Pharma surprisingly, doesn’t actually need the filters over the last ten years so let’s come to the other point you are raising that do you have to meet the filters to make money? No, you don’t have to.. Kotak Mahindra Bank, for example, doesn’t meet my 15 percent filter, Motherson Sumi doesn’t, they’ll make money. What I am saying is I want to identify the company which consistently have the basic techniques of shareholder value maximisation right. That is what I am betting on. The difference is, using cricketing analogy, I want to identify players like Rahul Dravid, classical technique, right temperament, the right mindset and the right grit for outstanding cricket success and then I’ll back them and say I’ll bet on your career. What I don’t want to do is watch the latest IPL, watch your player doing well in a couple of IPL seasons, two IPL seasons and say let me back you career. I am looking for people whose fundamentals are solid rather than people who had a great few years because the latter is where I could get trapped, whereas the former is where, if I get my fundamentals correct, I’ll back a good player who’ll become a legend.
Hunt For Value
Which sectors/themes are catching your attention right now? Where do you see value currently?
There are three things that are happening in India and for those who want to take a more creative approach to investing rather than The Unusual Billionaires approach, there are three things that are happening in India. The first is that there is a massive squeeze on black money. When I travel extensively to small towns in India, it’s reasonably clear that real estate and jewellery or gold are casualties of this and a lot of that money will come into the financial system. When it comes into the financial system, small banks, private sector banks will do well; smaller lenders, NBFCs could also do well. But consumption could get a boost. Consumption will boom as some of that black money savings could potentially become consumption in higher-end cars, consumer durables, doing up of homes. So there’s a big shift towards saving through black money into savings through white money and/or aspirational consumption.The second big trend in India clearly visible is the decline in public sector banks – they don’t really have the money to lend more, and as a result, there’s big market share gains for private lenders, whether banks or NBFCs. There’s a whole gamut of well-run, private sector lenders that you can invest in, that allow you to play the consumer credit theme. As consumers spend more money, they will borrow more as well. And consumer credit providers can play that theme.The third trend is the slow but sure, almost guaranteed death of Indian Railways and the migration of freight from rail to road. So the Railways is consistently having to cross-subsidise freight – they charge high charges on freight so that they can keep the passenger rates low. But at the same time, diesel prices are down, roads are getting better, trucks are getting more powerful so road freight is dropping sharply in price. And freight is migrating. So roads is a big opportunity, trucks and truck-financing are big opportunities, and there are many different plays around that. These are the three trends that one can play out there. So viewers can judiciously choose companies associated with these themes as well.
Saurabh’s Investment Guru
You have mentioned William Thorndike earlier and have also mentioned John Kay in your book. Can you tell us more about these two guys?
William Thorndike’s book, The Outsiders, was referenced by Warren Buffett in his Berkshire Hathway 2012 or 2013 annual report. It’s an outstanding book worth reading. What he does is identify seven American companies which outperformed GE by a big multiple, I think 20 times or so in the last 30 years. And what he highlights is that in those 20 companies, the central trait that the CEO or the promoter showed was the ability to allocate money rationally, clinically, coldly over a long period of time. John Kay is the person who taught me most of what I know. He was my first employer after I graduated from the LSE. I then set up my company when I was 27 and John invested in my company and became the chairman so I continued to learn from him. I have learnt from John about how to assess great franchises. John has a framework called innovation, brands, architecture and strategic assets. His view is that a company’s competitive sustainable advantages can be assessed using the framework. In the same industry, say truck companies, one company can radically pull away from the other if it is able to come up with better quality trucks, better distribution or marketing or better training processes for its staff and better branding processes. His book Foundation of Corporate Success has a chapter called Sustainable Competitive Advantages – that chapter has formed the spine of my career.
Challenges Before Urjit Patel: The Bad Debt Mess
Urjit Patel takes office as new RBI Governor on Tuesday. You had previously said that you were not surprised by Raghuram Rajan’s exit given that his thought process did not match with the finance ministry’s. What are your expectations from Urjit Patel?
As Urjit Patel has himself said, in his own extensive commentary in the past, he’s an inflation hawk, he believes inflation in India needs continuous check. He has played a central role in creating the Monetary Policy Committee (MPC) framework in India. So I am sure on that front, he will be reasonably predictable. He will take a hardline stance on inflation, and I doubt in the next six months we got more than one rate cut coming. Whether it was Raghuram Rajan or Urjit Patel, their views on inflation seem to be similar. Where I am completely in the dark is what Mr Patel’s views on the banking system are. Our banking system is in a mess. The PSU banks seem to be in a downward spiral to doom. I am not sure what exactly can be done about that. Remedies don’t appear particularly obvious to me. I suspect there might be major announcements in the next few months on the banking front. I don’t know what those announcements will be but that in a way is the big unknown. Our banking system is in really bad shape and the new governor’s ability to fix that, or the lack thereof, will have a major implication for the economy in the next 2-3 years.
Midcap Bet: Astral Poly
Why aren’t there any midcap or smallcap companies in your list?
So Astral Poly is there in the book as a very credible company and passes the two filters. And then there’s Sandeep Engineer’s story of losing almost everything he had twice over and then becoming one of The Unusual Billionaires in the book. There are some prominent midcap names in the book in Appendix 2 which you can mull over.
On Saurabh’s Weekend Reading List
Three or four books that you would recommend reading?
Foundation of Corporate Success as I had mentioned has had a defining influence on my career. One specific chapter, The Sustainable Competitive Advantages has been the spine of what I do in my professional context. Two other useful books are India – A Million Mutinies Now – a book by VS Naipaul published in 1990 to understand how India works in one book. To learn how to articulate complex arguments, there’s a book called Pyramid Principle by Barbara Minto. These three books have had a big influence on my life and my thinking about the world.
Aviation: A Crowded Space
What’s your view on aviation stocks on a long-term basis, especially Interglobe Aviation?
It’s a sector that’s present in every large economy, and in every large economy, the challenges are identical. Barriers to entry tend to be modest, and as a result, on a cross cycle basis, it is very difficult to generate a healthy return on capital employed. It is obviously a capital intensive industry but the bigger challenge is to generate a return on that capital. It’s hard because entry barriers are low. So you are seeing that in India already. Because fuel prices are low, airlines are making a bit of money, but as soon as airlines make money, three new guys come in and crush profitability for the incumbents and the share prices sag. So it’s a tough sector to invest in. There is only one airline globally which seems to have defied norms - Southwest Airlines. Maybe someone else in India will defy the norm. But I am a sceptical guy and I try to focus on the tried and tested rather than the new and speculative.