6 May 2016

Why are IPOs Overpriced & come in Rising Markets?

ipo overpricing underpricing

Another IPO got oversubscribed few days back – that too 70+ times oversubscription - I so wish that I was the seller ;-)

In recent times, the number of IPOs coming out has increased and more importantly, many of them are witnessing significant oversubscription – clear signal that appetite for IPOs is returning to the markets.

This optimism is fueled primarily by the recent upmove in secondary markets.

IPOs are known to generate a lot of emotions - both good and bad depending on how previous few IPOs have performed.

Why are IPOs Overpriced?

Now if I own a company, which is about to go public with an IPO - which means I need to sell my shares to get money - then I will make sure that me and everyone else in my team, will do everything to ensure that I get the highest possible rate for each and every share that I want to sell.

This is not greed. This is what any normal person will do.

Isn't it?

And that is exactly what a promoter (original Investor) does during an IPO.

Now lets turn around the table.

The ‘above mentioned’ promoter is selling his shares to new investors (i.e. you).

As already mentioned, his primary aim is to get the maximum amount of money for his shares.

He, with his investment banker friends sets the issue price. Remember that he still has his primary aim in mind, while setting the IPO price band.

Now as an IPO investor, you end up paying as much as the promoter wants - i.e. a lot more than what is financially necessary.

This is how IPOs work.

Few weeks ago, I read the news about how L&T had decided to withdraw the DRHP for its subsidiary L&T Infotech’s IPO. Among others, one of the reasons quoted for this withdrawal was that the valuations of company were very expensive and did not suit current market conditions.

Now just think about it.

Even the company felt that it had overpriced its share sale! :-)

Had the company decided to come out with the IPO instead of withdrawing, the investors would still have paid the expensive prices for the shares on offer.

Atleast in this case, the company withdrew its application. But in most cases, companies go ahead with their overpriced IPOs. Why say no to money coming in?

The result?

Most IPOs fail to give good returns to investors. Most promoters tend to price their public issues in a way that leaves little or almost nothing on the table for long-term investors.

I recently read in a business daily that for most IPOs, listing day gains are better than one-year returns. If that is true and my guess is that it is - then it speaks volumes about how IPOs are priced.

Talking in reference to the mistake people make in IPOs by ignoring ‘Base Rates’, noted value investor Sanjay Bakshi said:

‘Base rate’ is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money. But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run?

If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks! It’s that’s the case, not just in India, but also in every market, in different time periods.

Now I remember that in 2014, Indian Oil’s disinvestment was being deliberated by the government.

But eventually, the Petroleum Ministry rejected Department of Disinvestment’s idea of the stake sale. The publically acknowledged reason being the huge undervaluation in share prices.

But think about it.

Would it not have been a good time to buy shares of that company? I thought so it was (Read why)

The promoter’s representative (Oil Ministry) was unwilling to sell shares due to undervaluation – even when the government (actual promoter) was forcing it to (for reasons ranging from trying to reduce its fiscal deficit by selling stakes in PSUs to what not…).

The stock of the company was then trading close to Rs 190. Now the same is above Rs 400. Ofcourse low crude oil prices helped as the company belonged to the downstream sector. General rise in markets too acted as a solid tailwind.

But what I am trying to highlight here is that when promoters are not willing to sell (unless absolutely necessary), then that is a good time to think about buying. It’s a sort of corollary to the idea of stocks being undervalued (in eyes of promoters), when promoters are buying back shares.

Exactly opposite is the case during IPOs. Promoters are willing to sell their shares. So they would want to get as much money as they possibly can. This is against the interest of long term investors.

ipo overpricing jokes


Now I already said this in a post few years back and I say it again: the very purpose of a company to do an IPO is to raise as much money as possible. They are not here to do any favors to anyone. They need money and want to have as much of it as possible.

For a moment, let’s digress from IPOs and assume that you want to sell your house or real estate. You will definitely try to get the maximum price for your house, isn’t it?

You are not concerned about the buyer at all.

Don’t feel bad about it - it’s natural.

Everyone wants to get more when they are selling.

But you don’t want to be at the receiving end of such a seller’s transaction. Isn't it?

That’s common sense.


Why IPOs come in Rising Markets?

If you have been in markets for last few years, you would have observed that the number of IPOs increase, when markets are in an uptrend.

That is quite obvious as during bull markets, the perception of stock markets being a place of easy money becomes strong. This in turn helps IPO sellers to sell the IPO as dreams to potential investors. Investing in IPOs during bull markets can still be a profitable endeavour. But then again, IPOs during those time get hugely oversubscribed and allocation is pretty small. At times as low as being negligible, when considered in comparisons of overall equity portfolio.

Many people suffer from the Fear Of Missing Out (FOMO) syndrome, which pushes them towards IPOs. They put money in IPOs with the hope of making some quick gains and then boasting of high CAGRs. But for most people, hope is not a good strategy. If you are lucky, you might make money. But odds are stacked against common investors in IPO.

Older investors tell that the scene of IPOs has completely changed in India. Earlier, it was possible to make decent profits as issuers were not free to set IPO pricing – which was controlled and decided by the Controller of Capital Issues.

But now, its another ball game.

Though there is no strict IPO overpricing definition, fact is that majority of IPOs are not priced fairly – from IPO investor’s perspective. Or to put it simply, the scale of underpricing and overpricing of IPO, is skewed towards overpricing.

IPOs are built around hype and stories. And many are fairy tale stories. ;-) As the bull markets go higher, almost every story is able to excite the investors. Compelling stories allow expensive price tags to be attached to these IPOs.

But most of the (IPO) stories are not true – just like in real life. But problem is that these stories and hypes disrupt proper investing behavior.

Stories alone cannot keep the prices up. One day or the other, business does catch up with the price. Or rather, prices come down to levels of the real story behind the business. :-)

And this is not something new.

Hype was that caused Tulip Mania in the 1600s. Remember Reliance Power’s IPO? The company was selling the hope that it will construct power plants and change the power sector forever. It was a one of the biggest IPO overpricing example in Indian history. Very few even bothered to have a look at NTPC, which was available way more cheaply and had actually set up large power plants!

It is amazing how people will not do simple things to make money!

Start early, invest regularly, do not interrupt the compounding process... but will continue to do stupid things.

In general, IPOs are only launched keeping in mind the interest of existing promoters and investment bankers. There is a reason why they tell you to read the offer document carefully before investing. ;-)

If you are a long-term investor, you are better off looking for good stocks in already-listed stock space.

In fact, one of the big incentives for an IPO is so that previous investors – founders, venture capital firms, and large individual investors – can “cash out” at least a portion of what they’ve invested. That is why most IPOs are often expensively priced.

Now Warren Buffett has been quite vocal about his distaste for IPOs. This is what he had to say in a letter published in 1993:

…intelligent investor in common stocks will do better in the secondary market than he will do buying new issues… market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public…

11 years later (in 2004), he had some more wisdom to share about the IPOs:

“An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.

The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.”

At the end of the day, it comes down to the need for investors to understand - that IPOs are designed to benefit promoters more than investors. If they don’t understand this, they will eventually end up loosing money.

And as Late Parag Parikh said: If consumers are irrational it makes sense for companies to cater to that belief rather than eradicate it.

Sounds logical to me. :-)

Now its possible that going forward, markets might show signs of further revival. This in turn, would mean that companies would become ready to come out with their IPOs and FPOs.

The IPO sellers will start projecting these new companies as investments that can take you portfolio to the sky.

But remember, that the IPO sellers have the luxury of deciding the timing of the sale, i.e. they can choose to sell only when they get high prices for the shares. And that is what they will do.

Now for a moment, give it a thought. Why don’t IPOs come in Bear Markets? Or why does the number of IPOs hitting the market fall down when markets are not rising?

Mr. Parikh once said: “Companies don’t want to sell their shares in a bear market because they won’t be able to get a good price. But then where is the logic for investors to buy these shares in a bull market, when valuation is high?”

I am sure that many people will still be interested in investing some money (say sin money) in IPO.

I am not stopping you.

Please go ahead and do it.

But just remember that you are buying shares from someone, who knows much more than you about what he is selling, has done everything (right and wrong) in last 1-2 years to make the financial statements look good, paid good money to merchant bankers to spread good words and stories about the company.

As IPOs in initial phase come out and start trading at significant premiums to their offer price, this gives a confidence boost to the next line of not-so-good companies, waiting to tap the market.

So the momentum continues to build up unless it stops. And as noted professor Aswath Damodaran says, the IPO game is a subset of the momentum game. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers.

So keep you eyes, ears and place where common-sense resides, open. :-)

To be fair, there have been some good issues in the past and its possible that good companies might come up with an IPO that is worth investing. But identifying the ‘goodness’ of the company in itself is a very big task.

Most IPOs are not good for most investors – and hence, there is no reason for common investors to try and portray that they know the value of company better than the person who is selling his stake in the IPO.


Suggested Reading:

The Economics of IPO (and other) Markets (by Sanjay Bakshi)

You can read the full article here. Or can go through some IPO relevant extracts below:

---

Any kind of rational comparison of long-term returns in the IPO market and the secondary market would show that investors do far better in the latter than in the former. Indeed many such comparisons have been done which cover data taken from several countries spanning over decades. The conclusions are always the same: that IPOs are one of the surest ways of losing money in the long run.

There are certain characteristics of the IPO market, which makes it unattractive for long-term investors.

---

The IPO Market It is only to be expected that in a bull phase of the stock market, there will always be a sector, or a group of sectors, which are viewed extremely favourably by the investment community. These favourable views of the investment community are expressed by it in the form of high price/earnings, price/book value, price/sales and price/cash flow ratios commanded by the stocks of publicly owned and quoted companies.

At this time, privately-held companies in such sectors find that they possess an unlimited supply of extremely desirable "merchandise" i.e. their own shares.

Naturally, merchant bankers scramble to advice these companies on how to raise a large sum of money from the equity markets at inflated prices. (The recent development of book building for IPOs is nothing but an artful form of pitting one bidder against another in an attempt to create a high clearing price for the shares being offered).

---

Four characteristics of the IPO market make it a market where it is far more profitable to be a seller than to be a buyer.
  • First, in the IPO market, there are many buyers and only a handful of sellers.
  • Second, the sellers, being insiders, always know more about the company whose shares are to be sold, than the buyers.
  • Third, the sellers hold an extremely valuable option of deciding the timing of the sale. Naturally, they would choose to sell only when they get high prices for the shares.
  • Finally, the quantity of shares being offered is flexible and can be "managed" by the merchant bankers to attain the optimum price from the sellers' viewpoint. But, what is "optimum" from the sellers' viewpoint is not the "optimum" from the buyers' viewpoint.

This is an important point to note: Companies want to raise capital at the lowest possible cost, which from their viewpoint means issuance of shares at high prices.

That is why bull markets are always accompanied by a surge in the issuance of shares. It is true that often hot IPOs list at incredible premiums. The reason is simple: the demand for the shares being there, the merchant bankers ensure that only a limited supply is released to ensure a high price on listing.

Super profits are made by those who get shares allotted to them in the IPO, so long as they sell them at, or soon after, the initial listing.

This is where the trouble begins. Everyone wants a piece of the hot IPO cakes. Everyone thinks that he will get out at the top. Mathematically speaking, obviously this cannot be true. Moreover as time goes by, the investment quality of the issues tends to deteriorate.

2 May 2016

Health Care Inflation: Are Your Prepared for this Future Horror?

Rising cost of healthcare is not a new thing. But since most people in present generation are young, they don’t discuss it often. But still, the idea of health care inflation cannot be ignored now.

Health Care Inflaton India


Lets see why?

Suppose you have a health insurance cover of Rs 5 lac today.

But after 5 years, if you still have the same policy, i.e. with coverage of Rs 5 lac, then does it make any sense?

If you can answer this question, then it means you know what are the risks here.

But if you can’t answer, then have a look at the example below:

A small surgery costs about Rs 4 lac today. Now considering a very conservative medical inflation of 15% (yes, its conservative), the same surgery will cost more than Rs 8 lacs after 5 years.

So the difference between the cost of surgery in future (Rs 8 lacs) and your insurance cover (Rs 5 lacs), i.e. Rs 3 lacs will have to be paid out of your pocket. And that is assuming that your health insurance provider pays 100% of the sum assured amount.

A Rs 4 lac surgery can be covered easily with Rs 5 lac cover today. But like everything else, price of healthcare is also rising with time (due to inflation). So cost of this surgery will also rise in future.

health care inflation india chart


This sample health care inflation chart clearly shows that given a health insurance policy with fixed sum assured, chances are high that your health cover might not remain adequate with time. And this is a very important point that most people forget.

Not buying a health insurance is not an option for most of us. Ignoring health insurance can easily set you back by a few lacs!

And even if you can afford to pay the medical bills, why do you want to spend several years’ saving on it? Why do you want to dip into your savings and disturb the process of compounding?

Health insurance allows you to transfer the risk of paying large future medical bills from yourself, to the insurance company - that too for a very small price (premium). It makes perfect sense. Do read why Health Insurance is your Wealth Insurance if you still have doubts.

Lets come back to the discussion of health insurance inflation.

A policy bought today might not be sufficient tomorrow.

Another unfortunate truth is that medical inflation in India is much greater than regular inflation. Some estimates put it at 15%.

But health care inflation definition (%) can differ as treatment costs of different medical ailments increase at different rates - depending on individual ailment-specific medical advancements and various other factors. It can be 30% in some cases and maybe 10% in others.

But in general, the cost of medical treatments is going up. I couldn’t find but there are bound to be some healthcare or medical cost indices, which track the rise of healthcare costs in India. My guess is that these index would be based on parameters like Hospital charges (which includes room rent, other expenses), doctors and  technicians fees, drugs, equipments, nursing, etc. Do let me know if you find one.

Another point to note is that government hospitals (which have the potential to offer cheap healthcare services) are in pretty bad shape. So most people (in middle class) prefer going to private hospitals, which in turn increases the cost of treatment for obvious reasons.

It is for these reasons that one must prepare to deal with rise in healthcare costs.

What To Do Then?

So what should you do if you now understand that your current health insurance cover might not be as helpful to you in future, as it is today?

Lets see…

I think building multiple levels of protections is the key here. It might sound strange but hear me out:

Step 1

Ensure that you have a Health Insurance plan, which preferably covers you for lifetime. If you do not have a policy till now and are solely depending on the medical insurance cover provided by your employer, then you are making a big mistake.

Don’t do it. Don’t take chances.

Go and buy a policy for yourself (and your family) immediately. And don’t worry about finding the perfect policy. There are many health insurance plans in India and you will easily find a good enough policy for yourself and family.

Step 2

Next is to ensure that your cover rises roughly inline with rise in medical costs (inflation). Some policies allow increase of coverage for every claim-free year. This can work to an extent. Better would be to go in for top-up or super top-up policies. They are cheaper and financially efficient. (Read this detailed post on same by Manish)

Step 3

Purchase some critical Illness cover too. Such covers payout lumpsum amount in case of critical ailments like cancer, heart diseases, etc. This can be of great help and offset the loss in income, in case the insured person is unable to remain employed in future. You should also consider buying accident (partial/complete disability) covers.

Step 4

Once you are through with above steps, think seriously about building a medical emergency fund. Yes. This is not the same as your regular emergency fund.

Its more about creating a backup to deal with unexpected medical expenses in future, which might not be covered under plans bought in steps 1 to 3.

Health Insurance Portfolio

Where to put this fund is the question now. If you think that current plans will keep you adequately covered for next few years (ideally more than 5 year), then you can consider investing small amount every month in some well-diversified large cap or index mutual funds.

This will act as a health corpus, which if not disturbed in near future, can help you save up a big amount for your health-care needs in post-retirement years. Now this might not fully cover all your medical costs in future. But it will help you cover some of the costs anyway. This effectively means that you are indirectly reducing your dependence on your health insurance policy, which is a good thing.

Note – You might want to use your regular emergency fund in case of requirement. Though you can do it, I suggest you don’t - unless it really is an emergency. If you can manage without dipping into this emergency fund, then its great. And if you plan well and in line with steps 1-4, then you can actually do it.

That’s it about how to layer your medical costs contingency plan.

You should also make sure to check actual costs of various surgeries and medical procedure in your city/locality to get an idea about the adequateness of your current coverage.

And please don’t think that since you are healthy today, you don’t need a health insurance. There is absolutely no guarantee that you will remain healthy in future. Though I pray that you and me do. :-)

This brings me to another suggestion, which is ofcourse a no-brainer.

Stay healthy. More importantly, understand the importance of being healthy. That way, you can enjoy the life as it is meant to be enjoyed and ofcourse, it won’t hurt you financially too. :-)

So take some time off and call up your doctor friends / clinics / hospitals. Get an idea about current medical costs. You will immediately know whether you are on the right track or not.

Medical inflation is a reality that cannot be ignored now. And we are not in a country where healthcare is free. Isn't it?

So every man for himself and God for us all.

Go and do what is necessary.

1 May 2016

State of Indian Stock Markets - April 2016

I regularly update the State of Markets section (link) on Stable Investor. This time when I updated it, I took a step further and decided to try and publish heat maps for 3 popular ratios (P/E, P/BV, Dividend Yield) of Nifty 50, on monthly basis.

The numbers are averages of P/E, P/BV and Dividend Yield in each month. The maps don't show the maximum and minimum ratios of each month.

As with any such 'average' indicators, its worth saying that you should not make any investment decision, based solely on just one or two indicators. At most, these heat maps should be treated as broad indicators of market sentiments.

So here are the Heat Maps...


P/E (Monthly Average)

Nifty Historical PE Ratio
P/E Ratio (on last day of April 2016): 21.24


P/BV (Monthly Average)

Nifty Historical PBV Ratio
P/BV Ratio (on last day of April 2016): 3.27%


Dividend Yield (Monthly Average)

Nifty Historical Dividend Yield
Dividend Yield (last day of April 2016): 1.37%

For detailed analysis of what have been the historical returns for investments made at various P/E, P/BV or Dividend Yield levels, I suggest you have a look at these 3 posts:
I am planning to see whether I can also bring in data for some other mid-cap / small-cap indices from next month. Do share your feedback and help me improve these monthly State of Indian Stock Market posts.
 

26 April 2016

Interview With Mid-Cap Mogul Kenneth Andrade

Kenneth Andrade Interview Midcap
Image Source: Livemint


I recently had the privilege of talking to Kenneth Andrade, who is widely acknowledged as one of the best fund managers in the mid-cap space in India.

Most people already know this legend and many refer to him as the ‘Mid-Cap Mogul’. Hence, an introduction is not necessary in Kenneth’s case. But for those who don’t know, he was the fund manager of IDFC Premier Equity Fund - one of the most popular and best performing mid-cap funds ever.

Ability to think out-of-the-box to identify the big theme, build investment hypothesis around it and most importantly, convert it into winning investments. This was and is his expertise. Now he has moved on from IDFC MF and turned into a private investor.

In this interview, he answers my questions about investor psychology, investing in stocks for the long term and mutual fund investing.

So here it is...


Common Investor Psychology

Dev: One of the biggest problems of common investors is their inability to sit. So how does an investor stay put even if (say) markets have moved from 10,000 to 20,000 in just a couple of years and he/she wants to book profits?

Kenneth: Investors do stay put in investments; except in equities. This probably is associated with the volatility of the asset class and the lack of a fixed return or physical asset.

Also no one likes negative returns and the equity asset class can't promise that every year.

The western world has found a way around this with their pension plans. India still needs to get there. As a discretionary investor they will always give into greed at the top of the markets and fear at the bottom of the cycle. Hence the only way out is to package products, which eliminate or smoothen out volatility. Manufacturers in India have been experimenting with hybrids. They tend to cushion the volatility of the markets. Maybe that’s one way to keep the investor interested. It may not be the most efficient way of equity investing but the yields across market cycles would still be higher than mere fixed income products.


Dev: It is said that in investing, it’s very important to avoid making big mistakes. Even someone like Charlie Munger believes, that not making big mistakes is a huge determinant of whether one will have financial success in life or not.

How does a common investor identify his limitations, create a simple mental framework and more importantly, implement this framework to avoid making big mistakes?

Kenneth: The way I would address this is to invest in what you know. I am very apprehensive in putting money to work either in a company or an investment, which I don’t understand. I guess the same would apply to any investor.

One way of avoiding mistakes is to understand what you do, that way you can identify and correct it when and if it does go wrong. If you don’t know the investment, you would never know if things are going wrong in the first place.


Dev: What according to you is the biggest reason most investors don’t succeed in stock markets?

Kenneth: I guess most serious investors do succeed in markets. The longer you stay invested, the better are the results. Investing needs to be passive and rather than focus on prices investors should concentrate on the underlying. This is a learning process. And being persistent is the key to long-term success. A lot of investors give up in the short term.


Dev: How important it is for investors to have reasonable expectations? Many investors start believing that markets will continue to perform well, just because they have done so in the past. How does one correct this perception?

Kenneth: In the beginning of 2013, 10-year index returns converged with liquid fund returns. There is no set rule that equity or any asset class will deliver an above average return in perpetuity. Sure if you play with statistics, we can prove otherwise.

In the long term, any manager or fund with a return over 5%-7% (post tax) over the risk free return is a job well done. If that is the benchmark, then it is fairly important to anchor investor expectation around this number. Of course at times this could be significantly higher if a couple of asset classes do extremely well. 


Dev: Volatility is one of the most recognizable and hated aspects of equity markets. And because of volatility, most investors do the exact opposite of what needs to be done. They buy (on fear of missing out) when markets are high and sell (out of fear), when its low.

This seems to be driven primarily by the perception of volatility and risk being same things. But that is not correct as per my understanding. So how does one start believing and also, convince others about the fact that volatility is an aspect of risk and it is not 100% same as risk.

Kenneth: I guess the latter part of the question can only be experienced with time in the market. In one of my presentations lately I made a point that you need to use volatility to your advantage. Markets overshoot in both directions, and if you take advantage of this it could be extremely profitable. But one needs discipline to take advantage of these extremities.


Mutual Funds

Dev: The best time to invest was yesterday. Next best is today. Though its easier said than done for most people (who invest for long term goals), how does one go about convincing people to stick with to long term mindset when it comes to investing?

Kenneth: It’s the discipline that’s very important for that. And more than convincing, it’s the investor experience in the product category that matters. If any consumer has had a good experience of a product or a service, chances are he will stick to that regime. So it’s important that a habit is cultivated. 

A lot of investors like to see markets trend up so that their money is multiplied everyday. Logically if I had a steady income – I rather want to invest in a market that is sideways to down for even maybe 5-7 years. (Read I Pray for Bear Markets) That keeps my average holding of my investments low. Then if markets doubles or trends upwards, which they normally do once in 5 years, it’s a very profitable trade.

If you do the math investing in a market, which is trending upwards is very inefficient. You have a very high weighted average cost of holding and a relatively lower return than the former.


Dev: It is said that apart from returns, one should also consider many other factors while selecting a mutual fund for investing. Which factors according to you should form the key criterias for fund selection?

Kenneth: Investing in any portfolio should be a long-term commitment. Likewise the long term is also associated with durability. So if one needs to buy a MF scheme for the long term, the portfolio also needs to be in sync. There are a lot of funds out there, which promise long-term returns with the top stock undergoing tumultuous changes. Portfolio churn is never good for the long-term investor. If this were so with the underlying fund, at most the best return would be index linked. One needs to watch for this.


Stocks

Dev: Inspite of MFs being the best option for common investors*, people do get attracted by the glamor of investing directly in stocks. As per my understanding, this is human nature and people will continue to do so.

But when they do it, it also makes sense to invest only in companies, which dominate their industries with no-to-moderate debts and positive cash flows (atleast for non-professional investors, these criterias should be good starting filters).

How can an investor go about finding such companies? Another problem with finding such stocks are the perennially high valuations, which they are assigned. How does one go about investing in such companies?

* neither has the time nor expertise to analyse individual stocks.

Kenneth: MFs reduce volatility and at the same time offer participation in the growth of the capital markets. Their models are largely disciplined with managers allocating money across a number of companies. Individuals can replicate this off course by buying stocks directly. The error that most investors commit is the discipline of diversification. If this were managed well the outcomes would not be very different from diversified mutual funds.

The second part of your question resonates around investment styles. And no one style fits all. But by sticking to what you understand best will give you more upsides than downs. Don’t diversify your style.

As an investor I have always shied way from levered companies (excessive debt). And I consistently look for stocks and business that are out of favour. That way you know you are getting in at the ground floor.

An example of an ideal investment case would be a loss making company with a shrinking balance sheet in an industry that is under stress. So go one step backward on what creates capital efficiency – higher profits and capital employed (RoE = Net Profit/ Shareholder Capital). The former is the function of the environment; the latter is the function of the management. Look out for the latter, this should not be bloating. Chances are these stocks will come extremely cheap because of the cycle they are in.

As investors we all consistently focused on return. On the contrary we should be risk managers. A bull market gives you the return because all stocks participate; a manager has a very little role in that. It is the downside that counts.

You have to have a framework that works in a market offering you negative returns and measure your successes by buying companies that survive an economic slide.


Dev: In one of your interviews, you said that it is very important to go for companies, which are in a space that is scalable and significant. But as Graham said in Intelligent Investor, “obvious prospects for physical growth in a business, do not translate into obvious profits for investors.”

How does one think on those lines, so as to avoid the pitfalls of investing in the wrong company in the right space? Is it that the predictability of understanding the environment that a company operates in, and the ability of the company’s management to actually execute in that environment is the most critical aspect of decision making?

If yes, how does one be sure about the management here?

Kenneth: A company profit is limited by the size of its industry. Hence my fetish for scale sets in. Off course once this scale is established, the execution has to be profitable market share growth.

In my framework any company that loses market share raises a red flag, the cost of building back market share gains is ridiculously expensive. It is an easy parameter for most investors to track. (This framework may not strictly apply to commoditized business, but it works in most cases)  

Getting back to the scale question, I love excesses. I always am on the look out for the next stock market bubble and the reasons that would cause it, but I would rather preempt them. Else like every one else I end up being the follower. If this is the context, I would necessary need to find scalability in the business and in the mid term markets extrapolate these numbers creating these excesses.


Dev: Most people say that India will continue to grow for years to come. As investors we need to be optimistic about future prospects. But as I read in one of your interviews, you said that it is very important not to go into an expanding economy with the wrong portfolio.

Most people are looking at the same set of sectors, which have done, well in recent past. But to outperform over the long term, one needs to know what can drive the next bull market. Though its tough for common investors to do it, what would you advise a person who is willing to put in place a mental-framework to think on those lines?

Kenneth: That’s an easy one. Demand creates profitability, which creates market caps which in-turn creates the need for fresh capacity. So in this framework, companies, which were growing 15%-20% per annum, set up capacities to grow between 30%-50% using near term historical numbers to justify the capital investment. This creates excessive capacities. Which is why the same sectors get very capital intensive and never return to historic levels of capital efficiency and then valuations.

If the above is true, we would need to let go of the past and look at industries where supply constraints or competitive intensity is low. Chances are they hold on to their profits and efficient capital allocation. One way of tracking this is leverage. Banks usually are arbitragers of high capital efficient business and low interest rates. They usually fund excessive creation of capacity based again of near term historical numbers, which they extrapolate into the future. So look for what these institutions fund, it may be the beginning of the next economic bubble; and excessive lending may end up being the end of one.


Dev: I know that you like buying companies, which are efficient with their use of capital. How can one analyse companies to find efficient use of capital. And more importantly, how does one create a list of such (prospective) companies in the first place?

Kenneth: Go one step behind. In one of the question above I alluded to two components of the capital efficiency ratio – the numerator and the denominator (ROE = PAT/ Shareholder Capital; ROCE = PBIT/ Capital Employed). The numerator is profitability, which largely is the function of the economy; I don’t believe I can predict a complex subject of growth.

The denominator however is the function of the management and efficient capital allocation. A lower denominator is all I look for and you don’t need a model to predict that. This is already in public domain. Just look for the latter. If you buy a portfolio of 20 companies that meet this criterion, the probability of going wrong is well zero!


Others

Dev: Few books which you would ask everyone to read, to get their thoughts about investing and money ‘corrected’ and streamlined. And what will you suggest for someone who is interested in doing deeper analysis of the actual businesses behind the stocks?

Kenneth: I have always identified with the Peter Lynch style of investing, which is what makes his two books my all time favourites. i.e.


And nothing beats company annual reports if you want to deep dive into an analysis of a company.


Dev: How do you avoid noise and information overload, which are so prevalent these days? How does an investor focus just on what is important?

I feel that noise is generally made up of opinions people have. And I may be wrong, but most people don’t know what they are talking about when discussing about future. How does one stop oneself from becoming influenced by such noises?

Kenneth: As an investor I am always looking at a right price to buy a good business at. So noise is welcome if it gets me to that objective. Else, file all the information you get in some remote corner of your grey cells. Chances are you will need this sometime in your investing journey.


Dev: That's all from my side Kenneth Sir. I thank you for taking time out of your busy schedule to answer my questions. It was wonderful to have you share your insights.

Kenneth: Thanks Dev.

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