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Coffee Can Investing | S Naren's biggest contrarian call: Betting his house on a real estate crash

In the inaugural episode of Coffee Can Investing series, Saurabh Mukherjea talks to Sankaran Naren, Chief Investment Officer of ICICI Prudential Mutual.

In the inaugural episode of Coffee Can Investing series, Sankaran Naren, Chief Investment Officer of ICICI Prudential Mutual takes Saurabh Mukherjea through his journey in the world of financial markets, his investment style, hits and misses, and the investors he looks up to.

Mukherjea is author of the bestsellers Gurus of Chaos, and The Unusual Billionaires, and is an independent market expert.

The idea of the Coffee Can portfolio traces its roots back to the American Old West, when people would put all their valuables in a coffee can and then forget about them for a long time.

Naren tells Mukherjea that one of his big contrarian calls he got right was outside of the stock market. And that making money in the stock market was relatively easier in the late 80s and 90s when information on companies was scarce.

Edited excerpts of the interview:

Hi there, welcome to Coffee Can Investing. My name is Saurabh Mukherjea and it’s my privilege today to be able to interview one of the leading fund managers of our generation, the CIO of ICICI Prudential Mutual Fund, Sankaran Naren.

Q: So when someone sees a fund manager from Chennai, the immediate curiosity is that typically, the superstars of Chennai go to IIT and then pursue a career in engineering either in India or abroad. From that world, how did you get pulled into the world of stocks and stock market?

A: Stock market is something which was always very dear to me. Actually, my mother passed away when I was 14. And it was a two-person household because I did not have any brothers and sisters. So, somehow, cricket and stock market were the two conversation points between me and my father in those days and my father would make some small investments in stock markets. Actually the whole process was pretty fascinating and that got me very interested. We are talking about 80s here. At that point of time, very few people invested in equities. So, making money in equities was actually much easier, particularly in public issues in those days and that’s how I got started.

Q: So, this is well before you went to IIT. In your school days you were actually an active investor in the market alongside your father.

A: I would say I was more an advisor to him when I was in 11th or 12th. When I cleared the IIT entrance, my father told me, “You have to join IIT” and he didn’t give me any choice. And it’s very interesting, JEE in those days was a test of mathematics and not the test of engineering at all. And I got in and my father said, “This ensures your middle-class status. So, go in and join.” and it was not something which I wanted to do. But I ended up getting (an admission in IIT) which was then very good. So, I said OK, let’s join.

Q: So I presume that from IIT, you were very clear. After you finished IIT, you wanted a career in finance and that’s how IIM Kolkata came about, right?

A: Absolutely. I was very keen to move out of engineering to finance right from those days and that process and getting MBA from IIM Calcutta was actually best way to get myself into what I always wanted to do, which was finance and stock markets.

Q: So, if my memory serves me right, around 1989, 90, 91…in those days, working for SBI or SBI Caps (SBI Capital Markets) was seen as sort of the big finance job in our country. Is that the path you also wanted to take?

A: Yeah, I actually wanted to go back to Chennai and SBI Caps was a Bombay-head quartered entity. So, I actually picked what was my dream job; ICICI in 1989. I got project finance, which to me was the closest to equity research in retrospect. What people don’t realize in 1989, there was nothing called equity research. There was nothing called FII (foreign institutional investors). There was nothing called research report. There was nothing called CNBC. So, it’s a very different world. So, in that world for me, project finance was the closest to equity research.

Q: One of the most fascinating aspects your career, especially in mid 90s is this Chennai club that you have mentioned in several of your interviews. And recently I took the pleasure to meet Mr. Chaddha who ran the club in the 90s. Could you just take us through what role the club played in the evolution of you as an investor?

A: It was very important because we had made a number of big investing mistakes in 94, 95. When the bear market arrived in 98, all our investing mistakes showed up clearly. What was interesting was you realize that you were not the only person making the mistakes and that there were many others who had made similar mistakes.

So, what I guess Mr. Kamal Chaddha did was he got together a set of people like alcoholics anonymous. These were all people who made mistakes in investing. And it was anonymous at that point of time and got us to discuss our sorrows of losing money. What interestingly came out of that is the realisation that in investing, you sometimes go wrong, sometimes get it right.

When you go wrong, you need the equivalent of support system. A formal organization provides such a support system by the virtue of the number of people in the team, but when you are investing on your own, you don’t get that. So, a group really works. So, it’s like some kind of a psychiatric help which is required to... or a coaching, you can call it either which will help you to make very good investments decisions over a period of time.

Q: So, after that, you didn’t get caught out by the dotcom bubble or the 2008 bubble?

A: No. See, in each bubble, what happens is because of the mistakes of 94, 95 you are trained to be cautious ahead. So, instead of losing money after the bubble, you tend to miss opportunities. So, in 99, you asked yourself, why did you miss Himachal Global, DSQ, Pentamedia, and said that’s part of it and you have to agree that you can’t make all the money.

But in 2001, you were just laughing all the way because you had not made any mistakes. So, what I learned out of it is, you will be earning, you will then find that you have lost some money-making opportunities but after the cycle ends, you find that you are actually a big winner.

Q: One of the striking things about your career is you both before you joined the fund managing profession and since you joined, you were very willing to take contrarian calls, and you were willing to talk about it publicly.  Once you have made visible, high-profile contrarian calls, doesn’t that exert a fair degree of pressure on you? What role does the rest of your support system say, people at home, how do they help you deal with that pressure which arises running this sort of amount of money and with taking contrarian calls?

A: See, it’s very interesting that my family doesn’t know much about stock markets. And my son is a special child who doesn’t understand what is fund management or anything to do with money. So, I think when I go home and talk to them, I don’t realize anything on the stock market. So, that’s a very different kind of an environment. Actually, in this whole contrarian style what I have seen is when you do it the first time, you go through intense pressure.

When you do it the second time, you go through even the same kind, but as you keep doing it and as you have successes, you will find that it’s part of your daily routine. Of course, taking pain is not easy but that has to be part of a contrarian style.

And you get used to it. So, that’s how I have actually learnt it and there are people also now who do follow contrarian style and they are also in the same pain. So, you again take pleasure from participating in the pain with some other people whom you may know or you may not know.

Q: I guess I can see why you keep visiting Chennai to meet the club again and again. On the question of pain and contrarian style, one of the intriguing developments in the last 6, 7 years has been that apparently everybody in India or at least majority of the investors I meet now are value investors, right? They are all equities of Warren Buffett if I believe what they are saying and value investing seems to be proliferating in the country and yet we have a stock market trading act at 23 times forward earnings. When you meet other investors, when you assess fund managers who you are trying to interview, how do you gauge whether someone’s really a value investor or whether it’s someone who has read too many books from the American school of investing?

A: I think one is when you meet people in the midst of a bull market, you can’t judge who a value investor is, who is not. I mean Warren Buffet says that it’s only when the tide goes out that you knowing who swimming naked. So, I think from that point of view, today is not the time to judge value investing. But I have seen for example, there was a big real estate bull market, how many people had the ability to say that this bull market is very very extended and real estate won’t do well for many years? Very few. So, what I believe is that the time to judge value investing is not in the middle of a bull market, it’s to judge when you are in the midst of a bear market.

That’s why I would say that the process that we have followed is by trying to train people into fund management and not recruiting experienced fund managers because the moment you recruit experienced fund managers, they always come with the view, “I know how to create alpha”, whereas our model has always been we are trying to teach people how to create alpha, how to take pain, how to stay out of a bubble, how to make money over a cycle. These are things that we are continuously learning.

Q:  If you look back at your last 15 years of your investment management career, I am sure you will recall instances where you took a deep contrarian position. I am sure you will be able to recall at least one in this episode, where you took a contrarian position and it didn't work out. Could you just talk us through one example of each type, one where it worked out in a contrarian position, in which you made plenty of money, and one where it didn't?

A: Let me take an example what hasn't worked out, so you know there is a big boom in real estate. So, I said let's try to see which is the cheapest way to buy a real estate. So, I looked and found out that the tea plantation per acre was one of the cheapest ways to buy land anywhere in this country.

Q: …this is 2003-2004?

A: No, 2013

Q: Wow.

A: So, I went to Assam and happened to see some of the fantastic tea plantation companies, I came to know that land is found for a lakh or two per acre. So, I said let me now buy a tea plantation company. It is after all the cheapest way to buy tea, I don't think you can manage to get a land in Assam so cheap. So we went to buy tea plantation stock and I have been waiting for returns from it for 5 years. My colleague said how many more years will you wait, I said it is still the cheapest way to buy land in India, I don't think land in India has become cheaper, but there is no sign of returns. What worries me after looking at it is maybe it is the fate of lots of farmers in India. Because if I am not able to make money out of a tea plantation stock, that’s the state of the farmers of India as well. So, that was interesting case of a failure.

Q: Why do you think the market hasn't seen the logic? Tea plantation is giving you so much land and the land is not reflected in the share price and hence the share price should get rerated. Any reasons why the market is not seeing the logic?

A: Somehow the tea plantations are not growing 20 percent a year; tea demand grows by 1-2 percent.

So, while we all think that there is a high food inflation, the reality from what I can see from my tea investment is tea prices are not going up so significantly because the population growth is just one and a half percent and then tea is a mature product. So why should tea demand grow much higher than population growth?

Q: On the converse side, you took a contrarian position and it worked out like a dream.

A: I think the most contrarian position I took was actually outside equities; in real estate. I used to see everyone buying real estate between 2007 and 2013, and you know I had seen in 2007 most of the infra stocks was pricing in 2014 earnings.

So, when you approached 2012-13, I saw a number of people buying projects under construction real estate, what could come 4- 5 years later or 7 years later, from builders whose antecedents were not clear.

I could see there was a reasonably large bubble in real estate and I said I don't need to stay in my own house so I ended up selling my flat in Chennai and Bombay, and I have been very impressed that in 5 years that the real estate prices have gone nowhere, and people ask me how did you come to the conclusion. I said I used a simple equity technique for valuation.

No one understands the valuation of real estate. So I looked at rental yields and at mortgage interest rates. In the US, at the same time when Indian property prices were high, rental yield was much higher than the mortgage interest rate. Whereas in India there was a 7 percent gap. That means the mortgage interest rate was nine and a half percent, rental yield was 2 percent. I said the seven and a half percent gap can't continue.

So, that was a fairly good contrarian call because it was a scale call. Because the number of people who made mistakes in India in real estate, in that period is not small

Q: Yeah, it is very interesting, if someone had, anyone had in a way, sold their Mumbai or indeed Delhi residential real estate in 2013 after the 10 year boom and bought the stock market in September 2013 when Raghuram Rajan became RBI Governor, that would have been the ideal asset allocation strategy to follow. Given that you know, at one level it is as easy as you just explained do value investing; you have a look at what is the ragingly popular asset class that everybody and their father, mother are buying, and you do your homework as you become a little sceptical of the asset class and you try to find less popular asset class, given the simplicity of it, why is this sort of value investing so hard to do, what stops people from becoming investors like?

A: The problem with the best investing decisions is that the near term is very painful. When Warren Buffett invested in Goldman preference shares or GE preference shares in 2008 the near term was very painful. The long term was very good for him but the fear of the near term is a big problem. So, recently my company did something in December, January of returning money in small cap PMS (portfolio management schemes).

And this was the decision my CEO and head of PMS took. They came and asked me, “Can we do it?”  I said,” It's a perfect example of a contrarian in decisions, so I will support you.”

At the end of the day, small caps have gone up from 2013 to 2018 by 200 percent. If you had asked anyone 3 to 4 months back whether it was easy to believe small caps had peaked, the answer would be  ‘no’. Because everyone was very clear that small caps are the way to go, so, I would say that the fear of the decision going wrong in the near term, the inability of the people to time the market correctly, makes this decision very very difficult.

 Q: None of us wants to take the pain in the short run and hence we like to go with the momentum strategy and go with the popular decisions. So, if you had to take a step back and say, it turned out to be a good principle which you used to figure out where we are in the stock market cycle or the bond market cycle. How do you figure out using broad thumb rules, where are we in the cycle, is it a question of looking at the RBI rate policy, do you look at my stock market multiple times, how do you figure out where we are in the cycle?

A: Actually I must tell you how flows happen, so, if you look back at the last 20 years, which were the best years to invest in equities, it was when both FIIs and local mutual funds were sellers. The worst years to invest in equities was when both of them were aggressively investing.

Go back in 2002, neither locals nor FIIs were investing, they were selling. It was one of the best years to actually invest, in 2007 both local mutual funds and FIIs were investing aggressively and that was the best year to take out money. So, if you look at it, if you had to use one metric, I would say, look at the scale of local inflows and the scale of foreign inflows. Similarly, look at the scale of foreign outflows and the scale of local outflows from mutual funds, which gives you a perfect indicator and it is a very difficult indicator sitting in a mutual fund to follow. Because what I am trying to tell you is that money will come to you when the market is extremely expensive and money will go when the market is very cheap, that is not an easy thing.

Q: Yeah, absolutely. But in that context, basically the mutual fund manager’s job in India is the opposite of the central bank. In India, the mutual fund manager’s job seems to be to... just as the stock market parties getting really wild…go to people and say put even more money in the stock market. You said you prefer to recruit talent from scratch rather than hiring experienced hands, as it allows you to build an ecosystem in this house of other value-oriented fund managers. If you see that culture, would you say that across equities, you have been able to create a stable of funds, which is able to give an investor steady returns regardless of where we are in the cycle.

A: Clearly, I have been surprised because in 2007, 2008 and2009, I actually went through a heart-wrenching process, where people invested in 2007 lost money in 2008, did not invest in 2008 and missed a big rally in 2009.

So, we end of the day based on that experience we created two things,  one was we created a category called balanced advantage,  whose job was to sell as the markets go up and buy as the markets go down. And I didn't expect it to be successful but the company made it successful, which was something, which was unbelievable.  The second is, in August, September 2013 we went out and told people to invest in close-ended funds and at that point of time people said close-ended funds can't deliver a good investing experience. So, we have been continuing to raise money in closed-end funds but today when we raise money in closed-end funds, we actually put a good part of the money that we have collected in cash or hybrid portfolios because at end of the day markets are not cheap.

So, we came up with two models what I called the closed end model and the balanced advantage category and we have been trying to do the same thing in debt. Truth is that that the market is not yet as developed as it is in equity. So, we are trying the same kind of construct as balanced advantage fund in debt as well and we are trying that. In my broad view, it is impossible to change behavioural finance, it is impossible for you to collect money at the bottom. It is impossible for you to take out money at the top. So, it is very imperative that the mutual fund has to that job because behavioural finance tells you that everyone can't do it. So if you can do it, the investor can't do it. So, if you do it you can give a very good investor experience over the long-term.

Q: Leaving aside the Chennai club, any other Gurus any other bosses, colleagues from you have learnt a lot from in the Indian context?

A: In the Indian context, we all watch everyone, many of them are your peers, your competitors. It was the 1999 to 2004 cycle, where I got to see what Birla Mutual Fund was. What Alliance Mutual Fund was. These were all big mutual funds in that phase and we watched what they did right, what they did wrong, obviously, you know, the gurus like Nemish Shah and Mr Jhunjhunwala, this is where all people again you could track their portfolios.

Once they became famous you could track their portfolios that give you additional insights, so,  these were  clear leads and I think the advent of the date and the advent of the data being available, so many companies and their shareholding patterns gives you such valuable insights over a period of time but I tell my colleagues, in the 1990s, we had nothing and that's why it was easier to make money whereas today you know what every big investor has done, every quarter because his shareholding is very visible to you.

Q: So, if you suggest taking that construct for the thing Michael Mauboussin came up with, this simple formula that the amount of alpha a fund manager would generate is the fund manager’s ability multiplied by the efficiency or lack thereof, in that part of the market. So say in small caps, if the fund manager is reasonably able, there is enough inefficiency in the Indian market to generate lots of alpha. By that same token in BSE 100 the efficiency is less, and even if the fund manager is skilful, the alpha is presumably modest. Is that a framework that you have used because as a CIO you have to figure out where to allocate scarce resources to generate outperformance. How do you make that resource allocation decision?

A: It is very complicated, the problem is part of what we are measured by is measured on a 1-year basis, sometimes to take the right investment decisions you will have to actually invest with a much longer-term view, and if you are keen on trying to deliver alpha in the short run, you can't make the best decisions. I was lucky with my bets on metals in 2015 and telecom in 2016 as returns came quickly, surprisingly. But good investment decisions can take 3 or 5 years to show results.  Increasingly the market is going to be more efficient, making it much more difficult for people like us, which is the reason why I believe that multi-asset construct where you are selling equities as the market goes up and buying equities as the market goes down is a much better way to try to create alpha for the customer because it is in pure equity funds, where actually this problem of Michael Mauboussin calls, efficiency is going to become more and more a problem

Q: Beyond Mauboussin, any other gurus in the world of investing either in India or outside India?

A: Clearly, two more, James Montier and Howard Marks and I would say James Montier has written some of the best research papers as a research analyst and we have all learnt from him, … there is a very famous research report called 10 tenets of investing, which I think is one of his best pieces and Howard Marks has completely demystified investing as something very simple in his website called Oaktree Capital. In the 1990s, barring a few Warren Buffett books, there was nothing available for us to learn on investing. Today there is so much information available freely on the internet. But the practice is still difficult, so it appears very easy because you have access to the resources but to practice good investing techniques is not as easy as reading about them

Thank you Naren, thanks for your time and thank you to our viewers hope you learnt a lot from listening to Naren, we appreciate your time and look forward to seeing you again on the next episode of the series.
Saurabh Mukherjea , is the Founder of Marcellus Investment Managers.