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How to Pick Great Stocks with Rajeev Thakkar

Apr 9, 2018

Kunal Thanvi, Research analyst

I hope you enjoyed reading the first part of our discussion with Rajeev Thakkar of PPFAS mutual fund. In case you missed it, please click here.

Before we jump in to the second part, I would like to share a small incident with you.

When Rajeev agreed for the interview, I was excited.

But while preparing for the interview I got nervous. There was so much about Rajeev all over the internet. Rajeev has given multiple interviews on various platforms.

My only concern was how to make this useful to you, dear readers. I prepared hard and avoided asking things which Rajeev has already addressed.

And I'm glad to report, there were quite a few things we discussed that were unique.

They say, it doesn't matter how many times you read the old classics - you will learn something new everytime.

The same holds true for meeting super investors. I always learn something new.

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Now, let's get straight in to the second part of the interview...

Kunal: Value investing is easy, but it is tough as well. There is a gap between text and practically applying it. How would you look at this situation? How can our readers help themselves applying it practically?

Rajeev: This is a somewhat difficult question to answer.

Charlie Munger has said that you don't need to pee on an electric fence to figure out that you should not do it. Learn vicariously; learn from other people's mistakes.

So, that is what a subscriber to Equitymaster is already doing. They have already read interviews of various people. They have already read various books. But there is also this element of experiential learning.

Now let us say of the people sitting in this room, one person does not know how to swim. Now, you show that person 5,000 hours of video of people swimming in the pool, you give that person various textbooks on what is the physics of a person floating on water with different kinds of motion. After that, you get in an expert swimmer to give a lecture. After all that training, unless that person has actually dived into water; will you be confident that when you throw him in the pool, he will be able to stay afloat? The answer is no. So, there is always this element of experience.

In Vipassana meditation training, they say there are three kinds of wisdom. One is what is called received wisdom where you say this book or this scripture or an intelligent person says this...and that's why it's true.

The other kind of wisdom is intellectual wisdom where you can reason things out. So, one can intellectually prove that trading is a zero-sum game minus taxes minus transaction cost. Net-net, it's a losing game because someone's gains have to come from someone else's losses. As a group, traders can never make money in the market, which you can argue intellectually and prove it.

Whereas investing, if all people became investors and if corporate profits grew, if security valuations rose over a period of time, everyone can make money from investing. That's intellectual wisdom.

Experiential wisdom comes only from actually doing it. So, if people listen to Charlie Munger and run extremely concentrated portfolios of let's say three stocks. Charlie Munger doesn't give you that experience of that churn in the stomach which comes from deep draw downs. You look at the investment track record of Munger's partnership now. That has to be experienced. By looking at that table you'll never realise the emotional stress that people go through.

So, the last part...neither I nor Professor Bakshi, nor Charlie Munger, nor Warren Buffett can guide people. You have to jump into the pool to learn swimming.

Kunal: Any themes or patterns that you look for in businesses that you shortlist?

Rajeev: I'll mention some of the things that we would avoid. I've mentioned the things we look for, for example high return on capital, low leverage, good quality management; all of those are the characteristics we look for.

Things we would typically avoid is even companies that are doing well or otherwise are well regarded, but if they are B2B businesses where trends can be difficult to ascertain or where one loss of a client can mean a significant damage to the earnings, then we would try and avoid such companies.

So, for example, Apple has this ecosystem of suppliers. Now, a rumor saying that they are looking to develop their own chip or their own screens can suddenly drive down stock prices by 20%-30% of some of their suppliers. As an outsider, it's difficult to figure out whether that will happen or not and so, we would not be in very fast changing spaces in B2B where it's difficult to analyze the sector from the outside.

Sarvajeet: Anything else that you avoid?

Rajeev: Anything that is very technical. So, pharmaceutical is one space, pharma companies are companies where we take relatively smaller sized positions given the uncertainties in individual companies. So, very technical businesses or B2B businesses, we are a bit cautious.

Sarvajeet: One thing that I've noticed is your ability to pick holding companies specifically, Maharashtra Scooters and Bajaj Investments. They are a proxy to Bajaj Finance, Bajaj Finserv, and Bajaj Auto.

Similarly, you bought Nestle's parent company. We understand holding companies trade at a discount While it may not be the case always, companies like M&M and Tube investments of India continue to trade at discount. So, how do you go about picking holding companies?

Rajeev: So, firstly there is a difference between Nestle and Suzuki, which we own versus Maharashtra Scooters and Bajaj holding.

Maharashtra Scooter, Bajaj Holding are pure holding companies. Nestle is an operating company, Suzuki is an operating company. They are actual businesses.

So, it's no different from buying Tata Motors in India which has a subsidiary in Jaguar Land Rover. So, I wouldn't term Nestle and Suzuki as holding companies. Those are operating companies.

Now, let's come to the holding companies that are there. So, holding companies you cannot start with discount to market value. That cannot be the starting point. If you were to do that you will come across various kinds of companies in India. So, you will have Pilani Investments, or you will have Tata Investment Corporation and various others.

So, we are not looking at holding companies as a space to pick up investments. Investments in Maharashtra Scooters and Bajaj Holdings came out because we liked the underlying businesses of Bajaj Auto and Bajaj Finserv.

The investment started in 2003. It's a holding we have held for 15 years. When we bought Maharashtra Scooters there was no Bajaj Holding. It was one company at that point in time. The de-merger had not happened in Bajaj Holdings, Finserv, and Auto. It was just a proxy to earning Bajaj Auto. Later on, given liquidity characteristics and given the huge amount of weightage that was in Maharashtra Scooters we converted part of that to Bajaj Holdings.

So, that's the only background to it. At the time of the first investment, the discount was as high as maybe 70-75% to the underlying Bajaj investment.

Kunal: When you say discount, you are talking about the market value?

Rajeev: Market value. That time shares themselves were undervalued, but even on top of that you were getting a further 75% discount. Globally what has been seen is that the discount between the underlying value and the market price of the holding company is not that large.

Typically, these are in the range of 5%-10% kind of thing. Now in India there is a context to these large discounts. In the earlier age promoters could buy shares themselves, issue fresh shares to themselves at a market price for diluting the other shareholders or people could merge, de-merge and reduce the underlying value. So, one is if the promoter were to be unscrupulous then they had possibilities of doing all these things. Over a period of time the laws have got tightened.

A new Company's Act has come in 2013. Again, SEBI regulations are there. Today the legal regulatory situation is such that on a related party transaction the promoters cannot vote. You need an approval of the minority. So, doing those things is not easy today. So, logically the discount has also narrowed, but not closed down or we have not gone to the international levels.

So, the starting points for these investments, and this is a 15-year-old investment and it was in Maharashtra Scooter, was that we like Bajaj Auto - there was no other reason for this.

Sarvajeet: In case of global Nestle and Suzuki?

Rajeev: As I said, those are operating companies. Those are not just holding companies. Now, Suzuki owns 56% in Maruti. Their investment in Maruti itself is worth about 26 billion dollars. Now Suzuki would trade at a market cap of let's say 29 billion dollars. So, for 3 billion dollars you are not only getting the 56% stake in Maruti, you are getting the royalty income which Maruti pays which does not go to minority shareholders. You are getting the Gujarat plant which will also export which will have that JV for battery then motorcycle business, marine power business, their Asean business, European business, China business, and Japanese business. It's a no-brainer in terms of which one to buy.

Kunal: Recently, public sector banks have been in limelight for all the wrong reasons and so there has been this value shifting from PSUs to private banks in the last one decade.

And with NPAs, banking frauds happening, the public sectors banks stand to lose even more. Private sector banks and NBFCs will again be the winners of the future.

But when we see your portfolio we do see private banks, but we don't see any NBFC per se. So, do you think only private banks will be winners of PSUs falling down or you feel it will get distributed among select NBFCs?

Rajeev: So, a lot of NBFCs have done well. Bajaj Finance for example has done well and we own that thing through our Maharashtra Scooters and Bajaj Holding. So, that entire Bajaj Finserv business of general insurance, life insurance, NBFC we have through our proxy holding on that.

So of course, some companies have done well, some companies will continue to do well, but structurally the well-established private sector banks do have a cost advantage over the NBFC counterparts. If they are having good CASA and low-cost deposits in terms of even FDs they are able to raise at lower cost than the other players, then on the lending side, virtually all sectors are open to banks as well. If someone is doing gold loans or housing loans or consumer finance, it's not that banks cannot do that.

Arguably, if the bank has a large enough customer base, they have better early warning signs or a better knowledge of a customer than what an NBFC would have. Let's say you want to give a personal loan. Bank A has that customer's salary account whereas NBFC B is just going by CIBIL rating for example. Now I would think that bank A has a better risk management mechanism in place if they do things well. So, our preference is towards the private-sector banks and we also have presence in proxy holding in Bajaj Finserv.

Sarvajeet: What are your views on microfinance businesses? To be very specific about companies like Bandhan?

Rajeev: I will not comment on things that we do not own or talk too much about but in microfinance per se, I remember the statement of ex-RBI deputy governor K. C. Chakraborthy. He had mentioned in passing that, the RBI is tolerating microfinance companies.

They said these companies are good because they are replacing the money lenders in the village or someone who is a complete loan shark but they are not the ideal situation. So over the period of time, you would want the banking system or the formal financial system to reach most customers.

This plays again - maybe it is my bias talking - but it again is a space where populism can play a role in business economics which has happened in the past, either in terms of interest rates or in terms of what recovery mechanics can be employed and things like that or if there is a region wide problem in terms of a failed monsoon or agricultural distress, do you suspend recovery, or do you write off loans or things like that.

So, it has a bit of element of risk and right now we are not invested in that space but may be some people will do well. It works well in some countries.

Kunal: One of the biggest influencers I've had in my life was Prof. Sanjay Bakshi and the idea of buying quality stocks.

But when I write to my subscribers, they always ask me that they are buying stocks at some premium because it is a quality company, it will give subdued return for some time. It may outperform in the longer run but right now it's not performing, and there is an opportunity cost for it. So how would you look at it and how would you help me answer them.

Rajeev: Professor Bakshi I think the first presentation he made on this subject was at one of our events, he was talking what happens when you buy quality and what happens when you don't.

Somehow, a few people have interpreted it as buy quality at any price, or just go on buying quality, don't look at the price at all. The argument again people bring up this Munger statement that if you bought a business with good return on equity and expensive looking price, return would be decent whereas if you bought a bad quality business and that kept reinvesting money at subpar return capital you will end up with a lousy return.

So, these two, this presentation and this statement are taken together in-taken to mean as buy at any price. I don't think that's correct.

At least in my limited personal view I don't think that's correct at all. So, Infosys in late 90s or early 2000 was a quality company. Wipro was a quality company, but if you bought shares at those prices for maybe a decade you would not even break after that or you didn't even make what a savings bank account would make you. What one would want is, one would want to buy high quality companies at reasonable prices rather than outrageous prices.

So, when Buffett says, it is far better to buy a great company at a fair price, than a fair company at wonderful price, he says, great company at a fair price, he does not say great company at any price.

You cannot pay any price. He has said that if you are an investor, and not a speculator, then after you buy those stocks you shouldn't care if the market shut down for five years.

Now whenever people talk about buying quality businesses, the question is that, would I buy this quality business as a private investor at the current market price and if you are buying, just for the sake of argument, D-Mart at 100 times earnings then the earnings today on your purchase price is one percent.

Now if your target return from equity is 20%, and we are saying that the market will shut down, then essentially you are saying that the earnings are going to grow substantially because I am buying this at 100 and if its earnings are Re. 1 today, someday it may earn Rs. 20 for it to make 20% return on my purchase price.

Then you are betting on a 20-fold increase in profit, whether it is said or unsaid.

If you again reverse it out, if you say that your investment returns can come on account of your dividend yield, your earnings growth and re-rating. The combination of these three is the realised investment return. So if you are buying it today at a 100 multiple, the dividend yield over next five years is going to be negligible. Earnings growth will be some number and then you have to estimate the exit multiple. Now from 100 the chances of earnings multiple to increase dramatically at least to my mind is not significant then you are betting on earning growth or you say what is the expectation that the market is built in to this company at this price and define your investment.

I am just saying that I am going to buy this, and I am going to hold it for 100 years and after 100 years this company will be this and it will be the Wal-Mart of India? Yeah.

If you have that horizon it is okay, good for you, but I don't personally have a 100 years investment horizon. I have to work on investment horizons of five years or slightly more than that. I am not in the camp of buying quality at any price. I would be mindful of what value I am paying for something.

Sarvajeet: I have one specific question on pharma sector. So recently we have seen pricing pressure in the US market, because this is a challenge or concern we are getting and there is also increase in competition as well in generic space, and in India we have seen pressure from USFDA when it comes to inspection.

So how do you see this sector evolving going forward? What is your view on that? And do you see any value at current valuations in the pharma sector?

Rajeev: The opportunity side looks good overall given that a lot of value is still in patented medicine globally; a lot of shift is likely to happen to generics. The pricing pressure is affecting not only Indian companies but even international competitors. So all the pharma companies all are undergoing stress and somewhere you can see that bottoming out given that it doesn't seem to be a very sustainable game to just going under cutting prices and India in some aspects is a price leader in terms of cost competitiveness that our companies have.

The other head winds that you mentioned are there as a fact and that is also reflective in terms of the stock prices. If you look at the overall market cap of Indian generic companies, it's far lower than what it used to be and as a sector it's almost a sector which no one wants to own and everyone has shunned the space. So I think overall there would be opportunities, there would be company specific risks, still lingering in terms of some FDA inspections yet to happen or some import alerts and things like that. As I mentioned earlier, we are not taking very big company specific positions but we do own small positions in the basket of Indian players.

Kunal: Thoughts on averaging up, have you ever averaged up?

Rajeev: We do, if we are convinced of the company and its business prospects, you average up. It wouldn't be averaging up at a very significant valuation premium so for the same earnings we wouldn't go on paying more and more expensive price. If over a time earnings have grown, and stock prices grow that is fine.

Sarvajeet: How do we decide upon the exit multiples, as you rightly mentioned, there are key aspects and one of the important aspect is the exit multiple that you give to a business, so what are the small checklist that you have in your mind when you think about exit multiples?

Rajeev: The way I think about it is, even the very strong company may not have very great exit multiples because in the future more competitors may have entered, there may have a technological change, there may have been a change in how people consume stuff. Various things would change.

There would have been a change in the management etc. Ideally, one should be conservative on what exit multiple one puts in a business. The other thing is that given that arguably in the world the rate of change has increased over the years. The visibility far out in the future is hazy.

You can probably see what happens in next five years seven years saying that this will happen with confidence 10 years from now, 20 years from now is becoming more and more difficult. That logical way is lowering the entry price because seeing further is that much more difficult, I think that's the way to go.

Kunal: In one of your online presentations on YouTube, you talk about the Falling Knife. That was the presentation.

So, you spoke about identifying patterns of falling knife. So, if current market continues to correct, we could see such kinds of falling knives in various sectors, various stocks. How should an investor protect himself or herself in such situation?

Rajeev: I will break this into two parts. One part is where people would have bought into an absolute fancied company and with benefit of hindsight, in late 90s one would have bought a .com at extremely highvaluations.

In 2007 if people would have bought a real estate companies or infra companies at very high valuations. Now, if after let's say a 10%-20% fall, if the company is still not at reasonable value, then it may make sense to not buy or to sell what you have what you own.

Because that thing can still correct, and you cannot look at the peak price and say oh it's already corrected so much. So Nirjhar was fond of saying that a stock which falls 90%, is a stock which corrected 80% first and then halved.

So how much it has fallen from peak does not tell you anything about its true value. So that's the general market correction or general correction in a sector. It's essentially people who are playing the momentum, whether they have specified it as such or not. And if the momentum has gone then exit it because you are anyway a trader, you did not buy with an intrinsic value perspective.

The presentation that you are talking about catching a falling knife is not from a market perspective or not from overall crashes and things like that, this was more from company specific troubles.

So in that presentation, I spoke about, let's say American Express which Buffett invested in and Valeant which Bill Ackman invested in. So people who favor concentrated investing, people who say buy on declines, would give example of Buffett. So that worked and the other one did not work. It sank the people. So people who bought Valeant or Bill Miller who went on buying financial stocks in 2008-9, they got it wrong. So my presentation was in the second category which was in terms of problems which an individual company faces on its business side. Import alerts in the case of pharma, PNB fraud, Russia's political meddling in the US in the context of Facebook.

So, these are company specific issues, where the company is in trouble in its business front for some reason or the other. This has nothing to do with the market correction or valuations or anything like that where the stock sees a sell off.

What to do in that context? Is it falling knife where if you try to catch it, it will cut your hand, or is it something which is potential multibagger in the future.

So what I pointed out was - would the government intervene to protect the company? That is one criterion. The US government did not want the auto industry to die, so many jobs would be lost and so they wanted to protect GM, Ford, and Chrysler.

Do the customers still trust the brand, love the brand, and would miss the products is a problem, a near term pain but not fatal or is it fatal? So, these are some of the criteria, as I had mentioned in the presentation, a lot of these have to be put together to figure out whether you should buy the company after a steep fall or not. So this is a separate category as compared to market decline or a valuation correction. I don't have too much to say on market declines or valuation corrections that people figure out for themselves and anyway the market cycles keep going up and down.

Sarvajeet: Any views on Indian economy and the government. Further on the global trade war?

Rajeev: The readers of equity master would read the same newspapers as I read, or you read. I have no special insight on macroeconomics and I don't put too much weightage in our day to day investing as well.

Kunal: One question I have is on active versus passive investing. In the US, we have seen a lot investment done through the passive mode. Do you see such a trend in India going forward?

Rajeev: Sure. HDFC Mutual Fund is going for a listing. The HDFC Asset Management Company. They have just filed their prospectus. I was just reading that today and that is an interesting number. What is the value of assets managed by the asset management companies as a proportion overall market cap. So if I remember correctly it's about 4% in the Indian context.

Given that it's a small portion, there is a possibility to make extra returns on active investing. If this number were to be higher like say the US of 42%, it would be much more difficult for the active managers to outperform.

So where the mutual fund industry becomes too big then it becomes difficult to outperform the market. As a thought experiment, let's say the mutual fund industry were to manage 100% of the market cap in the country, can they outperform? No.

Because their returns on an average will be market return minus the expense ratio. But if they are only 4%, then what they have to do is to be smarter than some of the other players.

So let us say Indian asset managers sitting here, running around all the day, attending all conference calls, analysts meets, reading annual reports versus some people sitting maybe 3,000-4,000 km away managing offshore money, doing macro, trend buying selling, probably Indian guys have a small advantage, it's debatable but maybe they can eek out that alpha or extra return because they are relatively small.

As a size of industry grows bigger mathematically it becomes more difficult to outperform because then the asset management industry tends to be the market. You cannot outperform yourself effectively. So right now, I think there would be some scope. Again as some of the fund houses become too large or as the industry becomes large, it becomes difficult to be nimble footed to make that.

Sarvajeet: You have used portfolio allocation, number of stocks and how one should size in.

Rajeev: I think this was among the earliest discussions I had. The insight was from Mr. Chetan Parikh, if I am not mistaken. And another person who used to work with him, Karthik.

So, as you add the number of stocks to your portfolio, your risk comes down. So one stock portfolio is very risky, when you add two stocks and let's say you have 50-50 weightage to both stocks, risk comes down. When you add one more, one-third, one-third weightage risk comes down. It's a steep line initially, but then it gradually flattens out. So most of the risk reduction benefit comes around 14-15 stocks.

Then adding more stocks does not reduce the risk that dramatically but it dilutes your best ideas as you go on adding number of stocks to your portfolio. So I think beyond a number of let's say 25, it really does not do much in terms of risk reduction, it only adds clutter to the portfolio. So, our sweet spot would be somewhere in the range of 20-25 stocks. We would have meaningful allocations of 4%-5% most positions, in some cases higher, in some cases lower. But this would be on an average. It does not dilute our best ideas as well it does not take too much risk and is reasonably diversified.

Well, that's how our session with Rajeev came to an end. We learnt some good lessons which will live with us forever.

We hope you enjoyed this conversation as much as we did.

We would like to thank Rajeev for answering our questions with great enthusiasm despite his busy schedule.

Hopefully we will meet him again soon.

    I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. - Charlie Munger

Until next time.

Chart of the Day

We asked Rajeev about some of his successes when it comes to picking right holding companies. One of best bets PPFAS made was in Maharashtra scooters ltd.

Holding Companies Can Outperform the Index

In last eighteen years, on an absolute bases Sensex has grown 7 times, while Maharashtra scooters has grown at whooping 53.6 times.

Rajeev picked Maharashtra scooters because he wanted to invest in Bajaj Auto. The holding company discount at the time of his investment was as high as 75%.

As Rajeev correctly mentioned, higher is the holding company discount higher is the margin of safety.

Regards,
Kunal Thanvi
Kunal Thanvi (Research Analyst)
Editor, Smart Money Secrets

PS: The best investors in India do all the hard work required to pick the right stocks - all you need to do is watch what they are doing. Follow India's top 40 super investors here.

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