Lion Hill’s Krishna Kumar on his investment style, filters, valuing stocks, and diversification

Also, incorporating a top-down filter provides a better understanding of timing, like if it's the right time to buy or if there's a longer cycle before undervaluation corrects itself.

For example a shipping company may stay undervalued for an extended period. However, undervaluation doesn't necessarily correct itself unless there's a change in the global macro environment, such as an upswing in freight.

What are your key filters while selecting a stock?

I use what I like to call the 5S approach.

The first S is simplicity of business. I avoid buying complicated business. For me, a business has to be easy to track, else it becomes hard to value. If a company is into multiple lines of business under the same roof, it is hard to figure what exactly you are paying for.

The next S is that the business should be scalable.

Third is the strength of promoter/professionals running the company. Look at the track record of the founder, if it's available, track record of what he's done in the past. If he's a professional CEO, then see what he has done in his previous stint, whether he was able to make a difference or does he keep frequently hopping jobs.

Fourth is strength of competitive advantage. For a midcap that advantage could be a collaboration with a foreign partner, it could be prime locations for a hotel, and a strong brand for an FMCG company. You need to see if it is already there or is the company trying to create one if it is not there. This is very important for the sustainability of margin, growth, return on capital, cash flows, more so in an era where business models are getting easily disrupted.

The fifth is strong cash flows. I focus on operating cash flows rather than free cash flows. It is a cliché to say I like free cash flow companies. (Free cash flow is the cash left after all expenses including capex). In a growing economy like India, to accelerate growth—particularly for small and midcap companies—you will need to raise equity, debt. As long as your business throws up positive operating cash flow, that is fine. Because we are a growth economy, companies need to invest more than what they generate. Else their growth will slow.

How does one get all these qualities at a reasonable price?

Equity investing is about paying for growth. If you pay too much, you will have to wait longer for the rewards. One has to try and predict the future and bet on the probability of that future playing out. So a bit of top down approach helps. Where can the industry go, where can your company get to, what is the potential revenues, profits and what would the market be willing to pay for it. You don’t need to be 100 percent right. What is the kind of return you have in mind and what how much do you stand to make even if, say, 70 percent of what you predicted comes true.

To give an example, PVR and INOX had around 100 screens back in 2012, 2013, and were trading at fancy valuations. I did not buy the stocks then.

But someone looking to bet on these stocks would have done well to look at trends globally. How large chains have consolidated the industry, how the viewing pattern are moved from single screens to multiplexes, how consumption and demographics is changing here also. What are these guys trying to do? Globally there are three, four companies everywhere who are controlling the entertainment screens. Is that likely to happen in India as well?

PVR's ability to raise funds for its business, far ahead of its competitors indicated a clear vision and a plan to scale. Considering India's potential with 7,000 to 8,000 screens, even reaching 2,500 screens could reshape the market cap significantly.

Then there is the matter of profits. Here, one will need to get a good understanding of the company’s operations, and figure the dynamics of screen additions and their impact on the bottomline. Initial years may witness low occupancy, but profitability kicks in with time. What is the minimum occupancy at which the screen won’t make a loss, what is the occupancy for a decent profit? These are things you will need to figure out. By the time the old screens start making money, the company adds new screens and that weighs down profits. At some point, there will be a balance where earnings from old screens will be able to offset investments in new screens.

So, investment is not merely about looking at current financials, but taking a bet on what they are likely to be in the next 5-10 years.

Do you believe in taking concentrated bets?

No, because I have been schooled in running a diversified portfolio in a mutual fund. We have been taught to think where a 30-40 stock portfolio at least helps in risk mitigation, diversifying yourself, etc. My portfolio construction has been all about keeping diversification intact, having most sectors of the economy, barring a few, which you would probably have reasons not to be there.

One may argue conviction is what shows up in concentration, but I'm saying you can be still convinced about 25 stocks, it doesn't have to be that you only have 10 stocks or 5 stocks. At the same time, one is also able to mitigate specific event risks. It could be an adverse US FDA report, a key management personnel resigning, loss of a contract or some such. When these events hit, you see a dramatic fall in the stock price, more so if it is widely-owned by big investors.