Free cash flows of cos drives investment decisions for Sonthalia

Sonthalia also shares insights on some of his early-bird picks like Page Industries and Eicher Motors which gave blockbuster returns.Below is the verbatim transcript of Manish Sonthalia’s interview to Ramesh Damani on CNBC-TV18.Q: There is a very popular book ‘All I Really Need to Know I Learned in Kindergarten’. You learnt investing from watching your dad’s portfolio? A: Yes, the story began some 25 years ago after I passed out of class 12 and I was a science student obviously inquisitive about the how and why of things. My dad is a practicing chartered accountant so had some stocks in the portfolio which always did well. He used to get good dividends and good dividends increased every year and at the same there were some stocks like Tata Iron and Steel, very cyclical, they went up but they came down, dividends were erratic or not there. That made me wonder as to what made stocks move. Q: Let me take you to 2004, the Motilal Oswal of Motilal Oswal called you for a job? A: That is correct. One fine morning sometime in July or August of 2004 I got a call from him asking me whether I was keen to join them. Q: Did you think it was a crank call? A: No, I didn’t. The serious voice that spoke on the other side convinced me. He wanted me to come over to Mumbai and face an interview with Raamdeo Agrawal and himself and if I could have cleared that, obviously he was willing to hire me. So, I came, I gave the interview, got selected and now I am here. Q: The early part that shaped your investment philosophy was where is the cash. How did that shape the first years of your investment business? A: I must say that whatever I am today so far is all been due to the learning’s of this organisation. Motilal Oswal, that has created the foundation. Ultimately numbers don’t lie and what matters the most is the free cash flows of companies, not the P&L account, profit balance; that is the determinant to the free cash flows and if you are able to gauge how much cash flow the business is going to earn over lifetime or maybe next 5-15 years, it is nothing but the present value of the future cash flow. So, that is what we focused on and of course Rammdeo Agrawal, he is a great teacher, how he creates, how he goes about explaining how businesses are and what matters and what doesn’t matter and that created the foundation, made me perfectly believe that if you got to get stock prices right, you better get a handle on the cash that the company is going to make over long period of time. Q: As you progressed in your job, I have heard a lot of abbreviations in my time, SOS, IOU, GOI, PMO but you guys believe in a different abbreviation, tell me about it.A: The term is called QGLP. This is nothing but the margin of safety. QGL is the value piece, P is the price, difference between value and price is the margin of safety. The value component has been broken down into three that is Q, G, L where Q is the quality as measured through quality of business and quality of management, G is the growth part -- we want to buy growth businesses so we are following a growth at a reasonable price (GARP) method of investing and longevity of growth is understanding whether the moat or the competitive advantage of businesses are structural or cyclical.Q: Give me a couple of qualitative and quantitative factors that are very important to you? A: Quality, we have two components, one is the quality of business as measured through return on capital employed and free cash flow. At the same time, the quality of the management is quite important. A good business run by a bad management or a bad business run by a good management, answer is a not for you. Only if a good business is run by a good management we will have a winner. So, understanding and gauging the quality of the management is equally important and that requires a lot of experience and whole lot of methodology and we have evolved and developed few of the forensics that we use quantitatively to gauge whether the management is of high quality. Q: You don’t think it is beating the return on capital right, the cost of capital? A: In India the cost of capital is pretty high. We have very few businesses -- 65-70 percent of the businesses in India don’t even earn cost of capital, just about meets cost of capital. They should be trading at maybe one time price to book. Q: And don’t deserve a place in your portfolio according to you? A: You won’t be beating the markets. Q: In certain stocks you have not only doubled but you made 40 times your money. One of them is Page Industries. Tell me how did you chance upon that stock?A: I had some understanding about the hosiery businesses. Coming from Kolkata you have some of the old names – and if you went through the Draft Red Herring Prospectus (DRHP), we bought into the stock just about after the IPO came. So, if you have gone through the DRHP, you understood how the businesses actually were very successfully managed by them in the Philippines. If you did some internal research, desktop research for yourself, you would have been able to figure out what they were intending to do. Then it was all about going to be factories in Bangalore and understanding what they are wanting to do and obviously it was an aspirational brand; you knew it because American brand (Jockey) -- 100-year-old product -- here they were positioning the product at a very reasonable price point so they were offering value for money. Market was expanding, they were doubling every five years, he was present in the mid-premium and the super-premium category which was growing faster than the market. Q: What was his moat?A: His moat is his distribution according to me. This distribution advantage, which he has will be there even today for the next 10 years. Q: Despite the stock doubling and doubling and then doubling some more what gives you the confidence to stay on? Is it the sheer numbers that come every quarter? A: Long-term is made up of many short-terms and if the short-term, the numbers do come, you just got to figure out what should be the terminal value and terminal value to determine you understand the nuts and bolts of what will make that much. As long as you are confident about these numbers coming, then it is just extrapolating what is the price to earnings multiple that should be for that business. Q: Another stock that has been very successful for you, let us go to their strategy. Eicher Motors has been a fabulous stock, one of the great winners of the 2007 bull market. You spotted it young, tell me the exciting story behind Eicher. A: Eicher had been a fascinating story but we looked into Eicher initially for their trucking business, when they tied up with Volvo. They opened the joint venture (JV) but it was not doing that well. They were going about it but slow and steady. Then I happened to read an interview of Siddhartha Lal and he was also equally optimistic about the Royal Enfield business. However, it was doing meager numbers those days, 50,000 units. In a category of motorcycles, where numbers were big even those days, the entire category was growing, doubling every seven years. So, growth rates were 10-11 percent in volume terms. Here we were talking about company which was setting 50,000 units but it was an aspirational product owned by the British Navy Royal Enfield and the Bullet and the Classic 350 which is the best selling bike just kept on ramping numbers and margins kept on increasing. Q: He is in a sweet spot in terms of segmentation you say? A: Absolutely. He has created the segment for himself. He does not compete with scooters, he does not compete with commuting motorcycles, he does not compete with ultimately ultimate leisure biking.Q: He owns this segment?A: He owns the segment and even today there is no major competition that is coming through. If he has priced its product very sweetly between Rs 1,00,000 to Rs 1,50,000, that range, he will continue to be a winner. There is of course competition trying to position their own products within that segment but he is miles ahead of them and to get latent demand in the system for these sort of bikes is roughly around 2 million units. Today he is at 60,0,000 units. Q: Lot of headroom?A: Lot of headroom to go and the market hopefully should be growing at about the motorcycle category growth rate for long period of time. Q: When you first buy a stock, Page, Eicher, anything else, is there bit of heart pounding goes on, are you unsure, do you know that is going to be a winner, is there something that your bloodstream tells you? A: Mentally I try to figure out the P&L account model at least for the next three years. Looking beyond that is difficult to take a call on but based on my understanding about the business, what would make money for those businesses, just try to figure out how much money this business is going to make in the next three to five years. Q: So it comes down again to numbers and cash flow? A: 100 percent, nothing else works. According to me, value investing is understanding growth investing as far as India is concerned. Benjamin Graham’s definition of value, the strictest definition of the term would not apply to India because bulk of the businesses are earning less than cost of capital, how does low P/E stocks would make or create wealth for you. It is about growth, understanding growth and how much cash flow these businesses are going to make. Q: The way India is shaping up, there are and there will be a lot of structural stories coming through with good quality management. So, investors, I have missed Page and Eicher, can either buy Page, Eicher again or some other stocks, do you feel that opportunity is still there?A: Today bulk of the value is getting captured in the private equity space. However, at the same time we will have umpteen numbers of opportunities even in the listed equity space. So, one thing which I look forward to also, is to understand how much the profit pool is going to grow and how many players this profit pool is going to get shared with. So, if you have consolidated sectors, I as a fund manager try to figure out whether company A is going to do well or company B is going to do well or company C, if they all fit into the QGLP framework. My job is easier if there is a growing profit pool and a consolidated space.