It could sound boringly cliched, but it’s complicated: R Srinivasan on SBI Mutual Fund’s investing philosophy

“It is as cliched as it gets, you’re going to get bored,” he said, before elaborating further.

He said, “The core philosophy essentially effectively tries to buy a good business run by good guys at reasonable valuations. The satellite philosophy essentially looks at incremental change. You're looking for positive change, fundamental change, upgrades, technical momentum, and valuations… The difference between these two philosophies is that the satellite philosophy is supposed to outperform the benchmark consistently, so you can look at it as a relative return philosophy, while the core philosophy is more like an absolute return philosophy, where we're targeting some returns over a longish period.”

He said that the differentiator between the two investing styles is largely the time horizon that the two consider.

When asked if every fund follows this structure — of having a core and a satellite portfolio of stocks — he said that different portfolio managers would use the two styles in different intensities to run their funds.

The core philosophy is made of the usual checks but, more importantly, it is about trying to avoid taking a lot of missteps.

He said, “It's a lot more complicated (than it sounds). It sounds cliched because nobody wants to buy a crappy business. Nobody wants to bet on fraudulent management. So, isn't everybody trying to do the same thing? But the point here really is that by not trying to do a lot of the other stuff,… you just make that whole process a little better.”

The crucial element of their investing style is to look at the three things — business, management and valuations — in tandem and not in isolation.

There is a list of around 29 checks that his team has, to assess a business model, though not all checks will be relevant to all businesses.

This includes questions such as whether the business has a competitive advantage; whether they are investing in it; whether the moat is wide; whether it generates cash flows; whether the return on capital invested is reasonable enough, higher than the cost of equity; even if return on capital employed is not reasonable enough and even if they're losing money, are unit economics attractive, so that at a scale this business could make money; who is the addressable market and what is the longevity of that growth.

“You might not necessarily want the business that is number one. You want a business that is also number one in terms of profitability,” he said.

To assess the management, Srinivasan said, you could check their track record, meet them, try to figure out whether they are focused and so on.

Then valuations must be seen beyond just price-to-earnings and price-to-book multiples, according to Srinivasan.

He referenced a suggestion made by Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, in his book about putting your investment thesis into a cash-flow model, “which is very different for different businesses”.

Srinivasan elaborated, “You will have a three-year second stage for some businesses, while you will have a 20-year second stage for certain other businesses such as DMart or P&G hygiene… so a 55 PE stock maybe actually cheaper than a 10 PE stock, depending on how your thesis fits into that. These things are nuanced.”

While it is easy to define the checklist, “the real problem is combining these factors to decide… because stocks are second-level derivatives.”

“What you expect is almost always in the price, not always, almost always,” he added.

Srinivasan said that an investor has to respect the collective wisdom of the market and still have to believe that he/she has an opportunity, that there is some gap between what can potentially happen (and what the market knows) that he/she can exploit.

He pointed out that a good business and good management will always trade expensive, but the complexity and art of investing come in when you have to combine these two factors and decide what your cut-off price will be.

“These three variables (good business model, good management and valuations) are directly proportional to making money. A good business will always make you money, good management will always make you money, and an attractive valuation will always make you money, but they don't operate independently. They operate together. Because a good business can be expensive, it may not make you money,” he said.

He compared good investing decisions to creating life. That is, the parts of the whole are simple and easy to procure, but it is in their coming together that the magic happens.

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“What constitutes life, you can get it for a few bucks… it's water, chalk, carbon, coal, oxygen… but we haven't figured out how to create life,” he said.