'When market is at record highs be sure of not trading high-quality businesses for low-quality ones'

When we look at the basic core industries like steel, cement, housing, power, and auto among others, we see an all-round pick-up in volumes and a decent amount of demand buoyancy across sectors.

This leads us to believe that the economic revival is around the corner. From that perspective, the undertone in the equity markets should remain fairly buoyant over the next couple of years.

Q) Market is focusing on the unlock trade. But, will the scenario pan out the same way as last time considering that was a total lockdown and we are in partial lockdown?

A) You are right in saying that this year we are in a partial lockdown and therefore most of the industries are not severely impacted as supply has been constrained but not come to a stand-still, therefore a good part of the demand has been serviced even during the partial lock-down unlike the complete lockdown of last year where an absolute non-availability of supply led to huge pent-up demand.

This year it’s different as most of the demand is being met, albeit with a lag and therefore there is no bunching up of demand beyond a few weeks in most of the product categories.

But, there will be a few selected sectors in discretionary spending, which may see a spurt in demand as ground-level scenario normalises, for example, industries linked to Travel & Tourism - Airlines, Hotels, Travel Luggage, Shopping Malls, Restaurants, Movie Exhibition Halls, Business Exhibitions, Commercial Real Estate all of which have come to a standstill may see a huge pent-up / spurt in demand.

Q) What should be the ideal strategy now - should one book profits and then deploy cash at lower levels?

A) There are two certain things about markets – 1) they will go both up, and down in the short-medium term, and 2) they will always go up in the long term.

The strategy is to SELL/Book Profits and BUY later at lower levels sounds like a great thing, but in most scenarios it’s easier said than done.

The key to figuring this out is the direction of the primary trend of the markets/economy over the next two years and if one believes that the primary trend is pointing northwards, then trying to sell and buy-back for a gain of less than 5%-15% is not only tax-inefficient but also risks a high probability of missing out on the big upside that’s lying ahead just a few quarters away.

In the process majority of the investors tend to trade their good quality stocks/businesses with low-quality stocks and eventually get stuck with them almost perennially.

Q) Which sectors likely to lead the next rally on D-Street? Time for sectoral rotation and look at sectors that remained underperformers?

A) The current market rally has been very broad-based. For the first two quarters of FY21, it was largely Pharma & IT, followed by Banking, Auto, Real Estate, and Engineering in Q3 FY21 and now for the last two quarters, we have seen Metals, PSUs doing very well.

Effectively there has been a very natural, and systematic sector rotation over the last 14-15 months and this mature movement in the markets with all-around participation gives us more confidence about the sustainability of the market’s rise and a strong indication of revival in the economy.
Q) Which are the key risks that the Indian market faces in the year 2021?

A) As aggregate demand in the economy increases, one of the key challenges is to keep up the pace of increase from supply-side as to maintain the demand-supply equilibrium, which otherwise could lead to short-term hyper-inflation in most cases.

Managing such distortions not going out of proportion is key, as sharp spikes in commodity prices do not match with purchasing power and lead to the destruction of demand.

Q) With markets at record highs have you increased or reduced your cash position compared to last month?

A) In an up-trending & broad-based market like the current one, it does make sense to remain nearly fully invested. Nevertheless, it is in such markets that at times certain stock prices do tend to rise much ahead of fundamentals due to over-excitement of new investors in the markets.

Therefore, there are stock-specific opportunities to book partial profits if not fully, but as I mentioned earlier be very sure of not trading high-quality businesses for low-quality stocks.

Q) Companies or stocks which stood out in the March quarter earning seasons according to you?

A) Quite a few companies in sectors like Auto-ancillaries, Banking, Insurance, Cement and Pharma were able to maintain the profitability and registered decent growth in Q4 FY21 results.
Q) What is the thought behind EIML's investment framework E-QUAL, how is it unique?

A) More than a decade back when I and my colleague were introspecting our portfolio decisions of the previous two years, we quickly realised that some of the learnings (errors) were related to non-financial (P&L, Cash Flows) parameters and were more qualitative in nature, particularly to do with management intent & acts.

To keep those learnings ingrained in our investment process, we decided to list down all the non-financial (P&L, Cash Flows) management action-related parameters, which we believed would help us in understanding the intent and impact of management actions.

Simultaneously, we were also contemplating multiple (trial & error) valuation methods to determine a Great Purchase Price (High Margin of Safety) as we experienced that although our stock selection was right most of the times, we ended up making sub-par returns as more often than not we would have paid more than adequate consideration as Purchase Price.

During those deliberations, we realised that the market tends to have much higher volatility for mid & small-cap stocks v/s large –cap stocks, and even within the large-cap (or within mid-small caps) volatility was much higher in companies with lower quality  v/s the strong, well-managed ones.

We, therefore, concluded that our purchase price needed to capture this differentiated volatility for earning higher returns.

We first shortlisted the five heads that would summarise our exercise on Management Quality –

1) Management Integrity

2) Management Capability

3) Wealth Distribution

4) Investor Communication

5) Liquidity

Our next step was to evaluate each of the above very objectively, with publicly available data points mandatory for all listed companies, at regular (quarterly / yearly) intervals. Only then was it possible to have a like-to-like comparison across companies and generate a score-card by assigning weights (%) to each of the parameters short-listed by us.

The very first score-card (Nifty stocks) distinctly highlighted the companies on high corporate governance (Infosys, HDFC Bank) v/s the others at the bottom of the list (JP Associates, Reliance Infra).

The scorecard led us to build a Risk-Reward Matrix in terms of differentiated expected returns from each of the companies based on their above-mentioned qualitative factors.

Simply put, the returns expected from Infosys will be lower as compared to a Mid/Small-cap IT stock, which still has to walk the path of Infosys and prove its managements’ intent and mettle. This truly helped us to achieve our long quest of determining the Right Purchase Price.

It’s more than a decade since we are using the model for each of our investment decisions and today we can very confidently say that it has truly steadied us through the thick & thin of the last decade - a period where a large number of companies have wiped-out investors’ wealth owing to serious corporate governance challenges.

Looking back, we feel very pleased that owing to the discipline of our E-Qual model, we have had a decade-long track record of No Blow-ups with any of our investments.

It is imperative for every model to refine and upgrade itself, with the times and with new realities and realisations. We promise ourselves to remain committed to further fine-tuning the model with every experience in our journey of investing.

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