Value Investing Principles Estimate Sensex at 33000 to 35000 By End 2015
A Fund Manager, handling the Alpha L50 (India) at Arthveda Fund Management Dr. Vikas Gupta is responsible for understanding the investment ecosystem and creating the strategic opportunity matrix for the AMC across different asset classes including, traded markets, infrastructure, real estate, private equity, unlisted equity, agriculture and debt. His value-oriented research framework transforms data and information into alpha-generating products and fund constructs. He has formerly served as Professor and research faculty at IIT Kharagpur and University of California and has co-authored a book on Corporate Governance. In conversation with Dominic Rebello he espouses the belief that investments to be successfully handled need a value-oriented investment philosophy, which emphasizes “margin of safety” to minimize risks before focusing on maximizing returns…
A little background about your company and yourself?
ArthVeda Capital is a top-ranked global Asset Management firm managing global, developed and emerging market equities specializing in creating investment solutions designed to generate high risk-adjusted returns for global Ultra HNIs, Family Offices and Pension Funds. It has been structured as a differentiated fund house through its team, investment philosophy and most importantly, the path-breaking structured value investing framework, Smart Alpha. This is a sophisticated innovation on the rules-based approach to investing called Smart Beta which has $500bn of assets globally tracking it, is fast-emerging (Financial Times expects an extraordinary 60% p.a. growth, with AUM levels reaching ~$6 trillion in the next 5 years) and has already attracted several international and renowned players on-board (such as Goldman Sachs Asset Management, Man Group and Legg Mason). I am EVP & Fund Manager at ArthVeda Capita having more than 20 years of experience in research, strategy and operations and my capabilities lie in strategic value creation by understanding the interplay of valuation drivers and sources of risk through in-depth research and analytics.
At what point had you given a thought of making a career in the financial markets?
This thought has been in the background for more than 2 decades but, it got formalized about 10-12 years back. This was after a long stint running entrepreneurial businesses and realizing how value is created in the economy by an entrepreneur. The eye-opener was the realization on reading Benjamin Graham’s Intelligent Investor and Warren Buffett’s Letters to Shareholders of Berkshire Hathaway that making money in listed stocks is based on exactly the same principles. The concept of intrinsic value of a business, in the sense of a business owner, combined with financial analysis and valuation and the concept of “buying below intrinsic value” with a “margin of safety”. These formed the basis for a whole new approach to investing based on value investing principles.
How do you pick your investments? Do you use technical analysis, or employ fundamental data?
We only look at historical fundamental data and comparison of market price to intrinsic value. If a company is available significantly below its intrinsic value it is a “buy” and if it is close to or above its intrinsic value it’s a “sell”. Beyond this concept we have created a whole new value investing approach called “Smart Alpha” which we systematically apply these principles on an “industrial scale” and hence “mass manufacture” value investing. We are able to dredge through the whole market and create value-oriented portfolios which are likely to yield market-beating returns with much lower risks.
How would you describe your methodology?
Ours is a structured value investing strategy which can scour the whole investment universe, whether Indian markets or any global markets and create investment portfolios which have much lower risks and potential for much higher returns as compared to the market. We systematically buy below intrinsic value and sell above intrinsic value on a long-term basis with high tax efficiency and low transaction costs. The concept of how to buy “below intrinsic value” is based on the principles articulated by Buffett for decades. We have literally created a “Smart Alpha” engine based on Buffett’s principles. This engine can sift through thousands of companies and select the ones which are promising based on value investing principles.
What appeals to you about Investing? The short side or the long side?
Our focus has so far been on the long side since intrinsic value is created in the economy and a company over the long-term by investing actual capital in creating assets. There is a possibility to generate alpha on the short side as well. However, value investors typically don’t like the short side since it entails much higher risks and has lower margins of safety.
Is there any applicable lesson to trading/ investing?
Yes our whole approach is based around this edge. The lessons are encapsulated in Warren Buffett’s two principles of investing: Rule number one is “Don’t lose money” and rule number two is “Don’t forget Rule number one”.
How much of what you do is gut felt?
Nothing. Everything is systematized, structured and put into the form of rules. We follow a 100% “rules-based approach”.
Do you try to anticipate or follow market trends? What is the basis?
Not at all. In fact, we believe that one cannot predict market trends and an investment technique based on that is bound to end up losing money over the long-term. The only concept which works is estimating the intrinsic value of a company. Buy it when it is trading at 30% or more discount to intrinsic value and sell it when it is above its intrinsic value. Intrinsic value estimation should be based on conservative cash flows.
When you put money on a trade and it goes against you, how do you decide when you’re wrong? What do you do next?
If one has bought below intrinsic value and the price falls further, one can consider buying more if there is no change in fundamentals. However, if one finds out that the company was misreporting financials or the company’s economic value creation is impaired and hence intrinsic value estimates themselves have to be changed, then it might be time to sell. So in summary, if intrinsic value is intact and price has fallen, buy more. If intrinsic value has fallen and is below market price then sell.
Any positions you ever lost sleep over?
No. A value investor sleeps peacefully since he or she has already evaluated the intrinsic value and intrinsic value doesn’t change overnight, except in rare cases of fraud or financial misreporting by the management or promoters. So typical market or price volatility is not something which bothers value investors negatively. Rather it is an opportunity to see what more is now available below its intrinsic value. After a volatile event in the market the fundamentals of most companies have not changed at all.
What would make you wary about an Investment?
Dishonest promoters or management, opaque financials, highly leveraged balance sheets, and value-destroying business models in that order, bother us and we will steer clear of such companies.
Do you have a scenario about how the current bull market will end? Where do you see the Indian markets five years down the road? Any number for the Sensex in 2015?
Our most likely expectation is that earnings will continue growing at a CAGR of 20% to 30% over next 3-5 years. We are at a price to book value of 3 which is a median valuation. Assuming that there is no re-rating this still leads to a market which is about 3 times of current value over 5 years due to earnings and book value compounding at 25% CAGR over 5 years. For Sensex at the end of 2015 our estimates show a likely value of 33000 to 35000. Of course, our investment strategy is not based on that scenario of Sensex value at the end of 2015, but on the earnings growth over 3-5 years.
Of the tens of thousands of investments that you have done, which was your best ones?
In past 2-3 years Infosys, Hero, Cera Sanitaryware, National Buildings Construction Corporation and Relaxo footwear have been some remarkable investments giving multibagger returns in the range of 2x to 10x.
What was the story there?
In all cases, these were companies with high quality business models with huge sustainable competitive advantages. They had rock solid balance sheets with nearly zero debt and mostly large amounts of cash. Further, they were available at prices where the worst case scenario in terms of returns was better than fixed income returns assuming that the market and company valuation ratings did not change much. The sheer fundamental performance while maintaining same valuation ratios would provide one with higher-than-fixed income returns. But in the optimistic scenario one was looking at multi-bagger returns. Cera, NBCC and Relaxo have all been 7-9 baggers over this period. Infy and Hero have also doubled in a year’s time.
What makes an investor successful?
Stick to strong business, strong balance sheets and buying at a discount to intrinsic value with a margin of safety. Create a diversified portfolio of at least 10 and ideally 25 companies. Re-balance infrequently (say, annually) to save taxes and transaction costs.
Any final words?
Read Intelligent Investor and Buffet’s letters many times until you really understand them. Then apply with small amounts of money so that you build confidence in the approach and learn in practice. Then scale up the operations.
What is your take on the current scenario, Indian as well as global?
India is perfectly placed with fair valuations and strong economic prospects. Global markets as a whole also offer lots of opportunities. Specially, many large companies are available at a discount. For Indians, this global hard currency based exposure is good for diversification.