In the second episode of Coffee Can Investing, Samit Vartak, founder and chief investment officer of SageOne Investment Advisors tells Saurabh Mukherjea about his life’s journey so far and the filters he applies when selecting a stock to invest in.
Mukherjea is an independent market expert and author of the best sellers ‘Gurus of Chaos’ and ‘Unusual Billionaires’
Vartak recounts how his father, a farmer in rural Maharashtra, struggled to give him and his two brothers a decent schooling.
While investing, Vartak says he prefers to speak to the professional managers of a company, and not the promoter, to get an idea about that firm’s culture and competitive advantages.
Among other things, Vartak speaks of his decision to shift base to Pune, which has helped him take better investment decisions as he is far from the noise of the Mumbai market circles.
(Read part 1 of the Coffee Can Investing series: An interview with ICICI Prudential AMC's S Naren)
Edited excerpts of the interview.
Q: You have built for yourself a reputation in the last 5 years as one of the smartest investors in small caps. But from what I understand, it all started very far away from the stock market. You are a farmer’s son and your years in school were years of hardship. How did those early experiences of childhood and schooling shape you and make you the investor that you are today?
A: My father is still a farmer and I grew up on the farm and as most of the farmers in India, it's very difficult to meet the ends. And same was the case with us; my father was really different in terms of trying to put us in a better school. Most of the schools were free there, the government schools, but he put us in a private school and there the fee was high.
Q: This was in Maharashtra, right?
A: Yes, this was in Maharashtra just a couple of hours away from North of Bombay and the fee used to be 30 rupees per month, which was really high at that time. This was the 1980’s. And I remember times when my father - because you had to pay the fee monthly – and he didn’t even have that much to pay because most of the farmers, they borrow the next one year or two years of income through their society, they have local village cooperative society and most of the income that they make goes just to repay that.
So, I remember, really tough times, in terms of trying to borrow money to pay the fee, the school used to send reminders. So, I have gone through that kind of a phase where I really valued money. I knew the value of money, little money which for most cities, wouldn’t even matter, but it helps educate a student in the village for the entire year.
Q: It's yourself and your brother, right?
A: My two brothers
Q: Two brothers, three of you went to a private school in rural Maharashtra?
A: Yes, and the fees weren't that much, but for a farmer it’s a lot. So, with that background, I luckily got a scholarship to go to the US to do my MBA and I went to do the MBA. Fortunately or unfortunately it was the timing of the dotcom boom, I joined the MBA course in 1997 and then passed out in 1999.
That time it was a crazy bull market in the US; every stock used to double or triple on the listing day itself. Everyone was excited, money making was so easy at that time and I caught that bug. That was my first experience, until that time I had really no idea what stock market. After I completed the course, I got an offer because the job market was good. I got a signing bonus which was pretty large compared to my background. So, I got the job with PWC as a consultant.
Q: This was straight out of business school?
A: Yes. Then the time was so good and I invested. MBA doesn't prepare you at all for investments, it just prepares you with just basic theory and that too maybe, 1 on a scale of 10 on what you need to be a real investor. I started investing and because it was a bull market. Wherever you invested, you made great money and by the time you hit 2000 the markets got really tough. And because it was such a bullish market, you could invest by borrowing money.
So, I did the same thing and as the markets got tough, you just read analyst reports or just see who has the best recommendations and just invested in that. It was the wrong approach because I ended up investing in most of the crowded stocks, the most highly valued. By 2001 because of the margin funding and leveraged positions, I was completely wiped out. All the money that I got, including the signing bonus. That was painful because the money that I lost were few lakhs but that money meant so much.
Q: In the context of how you have grown up.
A: Yeah, to some of the farmers. The money I lost was large enough to fund the education needs of the entire village. It was so painful that I said, this was completely gambling what I did. And that is when my real education of stock investments started. I enrolled for CFA, I bought all kinds of books that I could and the next 3 - 4 years were the real learning experience for me in the stock market. The main thing was that I promised myself I will never go through this kind of a pain ever in life.
It helped that this education came to me really at the start of my career itself. If I had a great 7 - 8 years of bull market, probably I would have gotten completely wrong investing lessons and if I had hit the 2007-08 kind of a financial crisis with that kind of a wrong education, I would have been wiped out. Because, I became much more prudent, I did much better than most of the investors in 2007-08.
Q: You mentioned you did the CFA around the turn of the century; 2001-2003?
A: Yes
Q: You also did a whole bunch of very interesting jobs in America. I read somewhere that you worked in GAAP’s strategy team. That sounds very interesting. Could you just take us through that piece as to these employment opportunities that the United States gave you, what did you take away from that, what did you learn from that which later proved to be useful in your investment career?
A: Yes, I am an engineer. I worked with the Mahindra and Mahindra for a couple of years in Mumbai. So, right after my MBA I got hired for consulting, where I advised companies—mostly manufacturing companies in the Midwest, based out of Chicago—on their cost optimisation, on their growth strategies. I got to work in different industries.
At that time even though Midwest was mostly manufacturing, some dairy farms, there were some Toyotas, Chryslers of the world. But there were also some dot coms at that time. So, when you work with the corporations you almost become part of the management. You get to know how they think, how they strategize, how do they plan their growth. Most of the companies in the US have global ambitions.
So, just sitting with them, understanding different perspectives of different kinds of managements and then working on different industries helped me a lot. I got to think about businesses from inside, rather than just looking from outside as a stock market investor. That experience really helps even now when I look at a business. I tend to think from a management perspective, whether they are taking the right decisions, whether they are positioning themselves appropriately compared to what the others are doing in the industry.
So, that was the first part of my experience. Anyway my passion was to become an investor. So, my next step was to lean towards finance. So, I jumped into valuation with Deloitte, did it at PWC and then GAAP, the strategy part and then again with Deloitte in San Francisco. Valuing options, valuing the venture capital investments on the private equity deals, all kinds of complicated valuation of even the IPs (Intellectual Properties) and then the brands. So, I think that the corporate experience and then the valuation experience were two important facets in investing
Q: So, you clearly had very high-quality work experience in the US, your career was going places working in world-class firms. What prompted you to come back to India?
A: Coming back to India was a plan which I had set while going itself. So, there was no question whether I was going to come back. It was just a matter of when and actually I should have come much earlier but then you also want the kids to be born there and those kinds of things and by 2006 we were all set and I had done my CFA and the stints at consultancy firms. I may have been 2-3 years late but I always intended to return. I mean, at that time, it was more patriotic that I want to come back and do something for the country. I tried to do whatever I could but that was the driving force behind the homecoming. It wasn’t a professional call.
Q: So, initially when you moved back from what I understand you came to Mumbai. But soon you realised that there were better places to build an investment company than Mumbai and then you move to that lovely office in Pune which I visited, how did that shift happen? Most people who would want to build an investment firm tend to do it in Mumbai or in Lower Parel where you and I are having this discussion. Where did the decision to move to Pune arise from?
A: My wife was from Bombay. I did my college in Mumbai itself. So, there was no question that this is the only city we will ever live in after coming. But my office was in Nariman Point. I used to live in the suburbs and travel used to take me almost 1.5 to 2 hours each way, it was one of the most frustrating phases, because you are sitting in this kaali peeli taxi. At that time there was no Ola. You couldn't read anything, it was just a waste of time and that too sitting in pollution. At the same time, there were few of our friends who had moved to Pune and before that I had never visited Pune ever in my life. So, we used to go for, it’s like every Bombayite, you just want to get out of Bombay for a while.
Q: Go to Lonavala and come back?
A: Right. Initially I went for the weekends with the kids, and then looking at much greener and much peaceful life, I considered shifting base. For me as an investor, staying in the midst of too much of noise, you become part of that crowded space. However hard you try to isolate yourself you get swayed, when more and more people talk about the same idea. You then get more and more confident investing in that. So, Pune has helped me workwise. But wasn’t the primary decision for me.
Q: The quality was the primary decision?
A: Yes, quality of life was the primary decision, but the side benefits have been that I can focus on my work, I don’t talk to the stock market participants much. I rather talk to the companies and just focus on that learning about different businesses, their strategies, their positioning, and different evolving businesses. That is time well spent rather than trying to talk stock market where most of the people just talked about timing in the market, whether it is the right time, whether the valuations are right or not. It doesn't really help in actually taking the investment decisions
Q: So, that brings me to the next question. You clearly have a lot of time in analysing a company thoroughly. How much time do you take to analyse a company or a stock before you actually start building a position, and if you could you just take us through what are the layers of diligence that you apply before you start building a position?
A: Layers of diligence vary a lot depending on the industry. For example, I was researching on a structural pipe manufacturer. When you meet the management - my diligence always involves the management. I definitely want to meet the management, visit the plants, and talk to the operational managers. My main goal is not to get insights into the financials of the companies; it is more to understand the culture.
When you meet some managers, you realise they are too much of micromanagers. They try to control everything in the company. There are certain managers who try to delegate and empower the next level of leadership. I need to see that because that is the only way you can scale up that operation. Otherwise you will just become a regional player.
So I like to see that culture across different layers of management because that is where you get real insights. If you just end up meeting the promoter of the company, he is too smart.
Q: He will give you the PowerPoint presentation.
A: Yeah, and then he would know much more about the business and you will definitely get biased.
Q: So, for someone like me, I don't have a background unfortunately in engineering or in manufacturing. So I find it very hard to understand what to ask plant managers or foremen type people at the plant. How do you strike up a discussion, a rapport with say middle manager at the plant level in a manufacturing company?
A: Before I visit a plant, I spend a lot of time studying the critical drivers. For example, a steel pipe manufacturing company. Here the value addition isn't that much. Raw material cost itself is 75 to 80 percent of total costs. So, the net margin that this company makes, is going to be just 4 or 5 percent.
So, then the cost savings matter. Whether they are from sourcing the raw material, getting the best interest rate for working capital, or having the most efficient manufacturing process. Even if it adds up to one or two percent of your sales, it’s a huge competitive advantage.
For example, there was pipe manufacturer which had a big advantage in raw material sourcing because they used to buy 10 percent of their inputs from JSW Steel. At the same time, most other companies in this industry were near bankrupt. So, they didn't have the buying power this company had. Again, because the balance sheet was so strong their working capital interest cost was much lower. They brought in a new technology which allowed them to make pipes in a way that helped save on material.
The other difference is the change over time. In the conventional setup, it used to take 24 to 48 hours to change over and here they used to change it in 2 - 4 hours. So, you can just take even small orders, which otherwise you had to reject even if it was a profitable order because the change over time was so high.
So, once when you understand which are the critical factors of the business accordingly you have got to answer those questions. Sometimes you don't know technology and you don't know whether what the management is claiming, say the cost saving or price advantage, if that is true. So, I hired consultants, I paid them lakhs to do surveys at the distributor level. You talk to distributor across states, see how and what is the pricing advantage that they have, what is the time to delivery that they have. So, based on the industry if you don't have the skill set to understand you hire people. There are people who are experts at a lot of things but we try to do that.
Q: Clearly, you are doing a huge amount of rigour on management process, production process, manufacturing process but clearly in small and midcap companies a big call is the promoter. Is he able, honest, hardworking how do you reach a judgement on the promoter?
A: I rarely try to take a personal call on the promoter. I try to see if he is delegating, whether the people under him are fearful of him or they are empowered. The second thing is about his strategy and positioning. You got to hear his vision. For me the most important thing in any business is that I would never invest in a business where they are not taking market share away from the competition.
Irrespective of what you call moats,--they can be the widest moats in the industry--but if they are not taking the market share from the competitor I will never invest in that business. Because taking market share from rivals shows me that the strategy they have is working. Moats alone are not good enough. There are brilliant moats like the Hawkins, what have they done with it - they have lost market share. Just having a great brand doesn't mean that it's a great moat and you got to pay higher valuation for them.
Q: CFAs like you and me we are told that assessing financial statements is a big task. A big part of the CFA charter courses is the financial statement analysis. What are the critical aspects of financial statement analysis that you focus on?
A: Obviously, the real analysis goes on evaluating the profitability of the company. Profitability in terms of comparing, because each industry has a different set of parameters that you look at. You can't just analyse the company in isolation, you got to understand the differences between that player and rest of the players. That difference is the most important for me.
So, I try to look at different parameters within the financial statements, whether they are differentiating themselves and whether those factors are sustainable or not. That’s the main thing, but obviously the other ways of looking at it whether what they are presenting in the financial statement itself, whether it is true or not.
Q: Return on capital employed (ROCE), company X with the peer group, is the ROCE sustainable going forward?
A: Correct, and you got to look at various expenses items, most of the expense items are comparable. So, if you look at whether it’s the working capital as a percentage of sales compared to the others, whether it is the power cost, whether it is the raw material cost, how much value addition, you got to make sure that the value addition is the highest even though at the industry level it might be less. But comparatively it has to be the highest.
Q: You mean, compared to the peer group, they have to be the highest?
A: For me the margins that they make for example, the steel pipes their EBITDA per ton that’s the factor that you look at, because the steel prices can go up and down, so the top line can go up and down just because it’s a pass through and again the EBITDA margins can keep on changing. So, you can't look at that EBITDA percentage margin but you got to look at EBITDA per ton and then compare it with the rest of the group, there is no one else who is even half of what they do.
Q: It sounds like you are doing 6 to 12 months of work before you are reaching to a conclusion on a company.
A: Right, I mean sometimes it’s 3 to 4 months work and sometimes it has been 3 or 4 years. So, you can do the work, but sometimes you just don't get that comfort.
Q: So, once you have the comfort, you go out and build the position, or is there a question, you take a small position, your work some more and then you gradually build the position?
A: I generally start very small, so I do not mind paying higher prices. I am not a falling knife catcher. I like to pick great businesses which I feel their competitive advantage is going to last over the next five to 10 years. So, even if I buy at X price I have bought at 6X price. You know 3-4 years down the line I am completely fine. For me, if the management is delivering, if the competitive advantages are lasting and over the next foreseeable future I just keep on building that position.
Q: So, let’s assume you have done the diligence, built the position and then you spot something in the annual report that worries you, let’s assume you spot in the annual report that the promoters had paid his spouse the best part of Rs 2 crores as a consultancy fee -- how do you then deal with that, do you sort of take the point of view that well the stock prices hasn't moved so I shouldn't worry or do you actually take it up with the management?
A: If it is a new finding which I did not catch before, obviously you got to re-evaluate. Whenever I have invested, I have invested in companies where they pay their spouses or the promoters take really high salaries, but at least it is disclosed, it is already deducted part of the net profit, so actually they are paying for it because if the company is going to be valued at 30 times, they are reducing the valuation. It is not an acceptable thing but there are different shades of grey.
For me, at least they are representing it rightly in the annual report and I can take a calculated call and if it fits into my valuation. The most important part is the business and the strategy whether their focus is right, they can do lot of these things for tax savings and they can pay some other family members, those are fine if they are disclosed and they are transparent in it, but for me the business strategy if they are not good at it then that is something where I will not touch.
Q: Your newsletters are exceptionally good. People like me who earn a living writing, for us it is really high-quality stuff to read. But one of the things you keep pointing out is very high small and midcap valuations, you are one of the most eloquent commentators on very high and small midcap valuations. How has that observation that you made impacted your investment process?
A: One thing which I have observed – you are exactly right – the midcap and small cap valuations are at more than historical highs because I have done the comparisons with the 2008 peak. At that time the large cap valuations are comparable to the large cap valuations now, 27-28 times around that. But the midcap and small cap valuation then were all at 18 times at the peak in January. Today they are close to 30 times, which is something that people don't really talk about. I believe that whenever there is too much hope of the future, the benefit of the doubt goes to all kinds of companies. People don't discriminate between high quality and low quality. And that is what happened that with rising tide everything has gone up.
My experience has been that everywhere the 80-20 rule plays out, whether it is the GST benefit, from unorganised to organised, 80 percent of the benefit would be sucked away by the top 20 percent of the companies who have the right positioning who have the competitive advantage because the remaining players do not have the capability. Everyone cannot take the market share away. And those one or two players, they would justify the valuations they are trading at now. But the remaining players, they will come back to their historical valuations which most of the history has been in single digits but at least closer.
Q: And hence your strategy of focusing on market leaders?
A: Exactly.
Q: You are one of the few fund managers who has raised money domestically in the last 5-6 years and also, you have gone abroad to raise money. This valuation issue is this the greater concern amongst the investors you meet abroad or is it a greater concerned at a domestic fraternity?
A: I think it is a much greater concern in domestic fraternity. What I have seen is that offshore investors, most of the institutional investors, they have real robust asset allocations. So, when they invest in India, it is a very small portion of their net worth which they end up investing in India and they understand the risks of valuation as well as the kind of volatility that a market like India can go through. Whereas domestically, what I have seen is that people tend to invest the most when everyone is positive.
Because, when I was raising money last time people were concerned about valuations. But then the valuations kept on going up until December and January we had shut taking new subscriptions and the most demand came in January when the markets where at the peak. So people were concerned but then after a little while they get too much confidence that now nothing can go really wrong, exactly at the wrong time.
Q: You have lived through 2000 and you have lived through 2007 and 2008 so I can see the memory flashing back in your head. Three books or three investors whose styles, whose philosophy have influenced you deeply?
A: I would like to categorize the books into something which really helps me in my investment thesis, which is understanding the business. For me, Michael Porter's books, whether it is the Competitive Advantage, there are books written by others too, have helped me the most. For any serious investor, if he has to read a book, that is one.
Second category is more which helps me, just like your Coffee Can Investing, helps me filter and narrow down the universe. So, for me Joel Greenblatt books, he has a phenomenal history. Magic formula book. He has beaten even Warren Buffett, over his history and very simple formulas but I design my own formulas.
Q: So basically a mixture of ROCE and price multiples, to weigh up.
A: I have three or four parameters which I use to filter down and make sure that I need to eliminate most of the stocks so that I can focus on the right one. So that Magic Formula book has helped me a lot. And then the third category is more motivational, entertaining, where you read about various fund managers and how they have generated alpha. Like Investment Gurus by Peter Tanous because he talks about different fund managers, he has interviewed different fund managers and they talk about what is the strategy they have used to generate alpha. And you will see varied ways of doing that and it takes you through their life how they have developed that passion and what they have done through their life. So, motivational book maybe not that useful in actually creating the hypothesis but it just helps you just to go pump up and do more work and try to do as good as what they have done.
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