We're in stage 2 of the current bull market: Stellar Wealth Partners India Fund's Gautam Baid

Stellar Wealth Partners India Fund Managing Partner Gautam Baid's latest book, The Making of a Value Investor: What a bear market taught me about investing, grew out of the writer's experience during the bear market of January 2018 - March 2020.

A book about investment that reads like a ship captain or adventurer's log is unusual, to say the least. Yet the short, bullet-pointed format also makes Stellar Wealth Partners India Fund Managing Partner Gautam Baid's latest book, The Making of a Value Investor: What a bear market taught me about investing, fast-paced and interesting.

The Making of a Value Investor grew out of the writer's investment journal from January 2018 till March 2020, a 27-month bear market before Covid-19 spread quickly and fatally across India. Entries range from the author's thoughts on particular stocks, from Bajaj Finance to Bandhan Bank and Rajratan Global Wire, to human nature and how it affects the way we invest.

The true path to success in life and in the investment world is through authenticity; you have to open up yourself up, share your vulnerabilities... this helps you get feedback from people and also use that feedback to improve yourself.

Tell us about the title of your new book: The Making of a Value Investor: What a bear market taught me about investing. Were you not a value investor before, or did the bear market of 2018-20 change you in some way?

To be honest, I used to be an overconfident investor during the December 2013 - December 2017 roaring bull run in small cap and mid cap stocks. The thing is that when stock prices are going up, your portfolio is going up rapidly, then you start to think of yourself as a very astute investor. But it's merely a rising tide lifting all boats. And the reason why I decided to write this book is that the greatest lessons of investing are realized and learned only during a bear market. And those lessons bear fruit for an entire lifetime.

It was only in hindsight that I realized that I was investing the wrong way prior to 2018. I used to invest primarily in small caps, micro caps, deep cyclicals and commodities because I was looking for statistical cheapness, statistically cheap securities, instead of focusing on the quality of the business, and the quality of the management.

But this bear market, which was a very long bear market of 27 months, from January 2018 to March 2020, ingrained in my mind the significance of resilience and longevity, which are the key to compounding. This bear market brought about a profound shift in my thought process as an investor, henceforth, I would focus on return of capital, before return on capital, capital preservation and a focus on quality would take precedence for me henceforth, and that is where the title actually comes from. Because this book covers the journey of my evolution as an investor during that bear market and my reflections and learnings along the way.

Could you give an example of return of capital over return on capital - and how it played out in your decisions over these 27 months.

When you're investing in statistically cheap securities of mediocre or bad quality businesses, then during an industry upcycle or during a market upcycle, you will make a lot of paper profit. But once the going gets tough, and the economic conditions worsen, and the economy starts slowing down, then those businesses start incurring losses, and their earnings simply collapse, and you end up with permanent loss of capital.

But if you invest in a very high quality, strong business, which is enjoying sectoral leadership, then as I've written in this book, those managements tend to capture market share from their weakened competition during bear markets and tough economic conditions and they become stronger. And this market capture is a source of great value creation for shareholders over time. So this was a big learning from this bear market that you can make temporary paper profits by investing in a poor-quality business during a bull market. But sustainable long-term wealth is made only by investing in quality businesses with healthy growth.

You don't have to aim for hyper-growth because any business which is targeting hyper-growth with a return on capital which is far below the cost of capital, will eventually just destroy shareholder value, even though the stock price may temporarily surge during a bull market. But long-term sustainable wealth is created only by focusing on the quality of the earnings of the business and the durability of the growth for the company.

Throughout the book, you also share specific examples of stocks that you picked keeping this in mind. Could you share any one example.

I've talked a lot about Bajaj Finance throughout the book, as you must have noticed. As the bear market progressed, I began to appreciate why do investors in the Indian market hold this company in such high regard.

To understand that we need to understand the history of this business: Bajaj Finance started as a single product company. It started in a single geography and then diversified into multiple geographies and developed a pan-India presence. It also diversified into multiple product lines. So it de-risked its business model. It also demonstrated the discipline to get out of product segment when most of its peers acted imprudently and tried to chase growth at any cost. The company achieved good growth across economic cycles with low NPA and good asset quality. And the owner of the company, Mr Sanjiv Bajaj, chose a great CEO, Rajeev Jain, to run the business, and he was completely hands-off when it came to day to day operations - this kind of approach helps cultivate middle and upper level management. These finer nuances, you only get to realize once you've actually gone through a tough economic cycle, like Bajaj Finance did that time, and it was almost as if it was Bajaj finance on one side and the entire NBFC industry on the other side.

There will be a few small cap and mid cap stocks in every kind of market which are poised to grow earnings per share at 25 to 30 percent over the next three to five years. And they're bound to create wealth for you in the long run. All you need to have is the conviction to back them.

No, I invested in Bajaj Finance during 2018, not before 2018. Because before 2018, like I mentioned, I was primarily investing in commodities and cyclical businesses.

Coming to the second part of your title: what a bear market taught me about investing. Can you crystallize this in, say, four-five points, when you think back to this period.

This book is dedicated to all my investor friends and colleagues, because without their helpful feedback and guidance, and constant moral support, I would have not been able to do as well as I did during that long bear market. And there were certain pieces of wisdom from them which I received, which I've shared in this book, as well. And I would like to share a few pieces of those wisdom with you right now.

The first advice which they gave me was that if you want to make it big as an investor in the stock market, you need to be detached from stock price fluctuations. Because during bear markets, it becomes extremely tough to endure such severe notional losses - that was the first big piece of advice from them.

The second piece of advice and learning from them was that India will grow at a healthy rate, and Nifty stocks may have earnings growth of low double digits, but there will be a few small cap and mid cap stocks in every kind of market which are poised to grow earnings per share at 25-30 percent over the next three to five years. And they're bound to create wealth for you in the long run. All you need to have is the confidence and the conviction to back them.

The third piece of advice was, in the long run, what ultimately counts is earnings, earnings, earnings. If the earnings growth comes in, the stock price eventually will go up. So just focus on the earnings growth and ignore most of the noise around you.

And the fourth and very important piece of advice from them was that sanity will eventually prevail after every bear market or market crash, just like it has always done in history.

So these four pieces of advice were very, very helpful for me. And I think they will really serve me well for the remaining part of my investing career.

You end the book by saying that you got your first 20-bagger after this 27-month period. Did that change how you saw the learnings from this bear market?

The last line of the book is a quote by Peter Bernstein that survival is the only road to riches. Because I was able to survive that bear market and not sell my stocks in panic, and because I was in the market by the time that bear market ended, it allowed me to participate in the subsequent bull market.

And the stock which I was referring to there was an auto ancillary company named Rajratan Global Wire, which I purchased in June 2020. And it basically was purchased at a trailing PE multiple of less than five times with a big capacity expansion in place. After the NBFC crisis broke out in September 2018, the Indian auto industry entered a severe downcycle. So even though this auto ancillary company had a very good prospect, since this entire sector was out of favour, investors' attention on this particular stock was low. That's why you were able to buy it at such a cheap price. But as soon as the initial signs of recovery in the auto cycle started coming in, after mid-2020, and the earnings from the new capacity expansion started kicking in, you got the benefits of both valuation rerating and earnings growth and you got a big multibagger. So this is how big multibaggers actually happened. Valuation rerating is often a key ingredient in multibagger stocks.

You also written that fundamentals aren't exactly what decides the price of a stock. Can you explain that?

Correct. So, fundamentals do not decide the price stock price at any given point of time; supply and demand does, and supply and demand for a stock in turn is driven by the prevailing investor sentiment. And there are certain gauges which you can use to understand what is the prevailing investor sentiment in the market.

The first is the use of the IPO market to understand the prevailing risk appetite in the market. There are three stages in an IPO cycle. During stage one, good companies come out with IPOs at cheap or reasonable valuation. During stage two, good companies come out with IPOs at expensive valuations. And during phase three, loss making companies or companies which do not have the earnings come out with IPOs at ludicrously expensive valuations and which are heavily oversubscribed by retail investors whose surging presence in the markets is a late cycle indicator. Very high levels of margin funding in the primary and secondary markets by retail investors is a predominant characteristic of the final blowout phase of a bull market. So, these three stages will basically help you assess the prevailing risk appetite.

The second way to assess the prevailing investor sentiment is by looking at the quality of the investor portfolios, and the kinds of stocks being discussed on WhatsApp groups or telegram channels or Twitter. As a bull market matures, investors tend to move from stocks having healthy growth and high returns on equity to stocks of companies with inferior management and business quality, but having faster revenue growth. Then they move to commodities and cyclicals, then to turnarounds which are currently loss-making then to micro-caps with limited history of operations, including SME stocks, and finally to highly leveraged companies with projections of rapid revenue growth. At this particular point, the bull market usually tops out and by the end of the euphoric phase, most investor portfolios have got only junk stocks left in them. And after that, you know, the bear market which follows, stocks are returned back to the rightful owners and we again have a start of a new bull market. So, this is how markets have always been and because human nature has not really changed much in the last few centuries, I think the cycles will keep on repeating.

Given these two criteria, where do you think we are in the bull versus bear market phases?

Every bull market goes through three stages. During stage one, stocks across the board get revalued back to fair valuation because we are starting off the low valuations post a bear market and sector rotations happen very fast and furious during stage one, because the market is trying to figure out which sector or industry is going to lead this new bull market.

During stage two, you have a narrow and selective rally in which only a few select sectors and stocks with very good earnings visibility and good growth, only they do very, very well.

And stage three is when you know high quality underperforms and junk stocks - deep cyclicals commodities microcaps SME stocks - go parabolic. And finally the bull market comes to an end.

I think stage one has just gotten over on September 12. If you notice the market breadth has only worsened since September 12. And even though the small cap index is in the positive, since 12 September, the median stock price performance in the small cap index is negative, which means that the entire market has become very, very narrow. So I think from here on for the next two years, we may have a very narrow and selective market. And in the book I've written about this, that narrow markets and selective markets are where you make the maximum amount of wealth, if you're a good stock picker. So I think right now is a great time to be a stock picker in the Indian stock market, and really generate a lot of alpha for your clients.

Tell us about the format: the book grew out of a journal?

The practice of journaling has helped me greatly in learning about myself, and improving both as an investor and an individual. I receive a lot of valuable feedback, and I use it to correct my personal biases. I also maintain a personal archive of investor behaviour and media commentary during various episodes of market panic during the last nine years. I purchased the journal in late 2014. And I consider that to be one of the best value investments I've ever made. So since that day, I've been keeping track of my investing decisions, and my observations and learnings in an investment journal. So I think this is a practice which most of us investors should have, because all investors make mistakes, but the great investors tend to repeat old mistakes less often. And by having an investment journey with you, in which you have actually documented all your past mistakes. You will obviously not repeat the same mistake twice.

Tell us about a mistake that you've made in the past.

I'll share both a mistake of omission, that is a missed opportunity, as well as the mistake of commission which is mistake because of poor judgment as an investor. So the first mistake of omission was a stock called Polyplex. Basically, it was trading at dirt cheap valuation, very high dividend yield, strong balance sheet, massive capex plans all executed, good track record. And I just failed to pull the trigger. I just basically engaged in what Buffett and Munger called thumb-sucking - just kept thinking about doing something but didn't do anything about it. So missed on a multibagger there.

The big mistake of commission I made was a stock of Bandhan Bank. And the reason for incurring big loss in that stock was that I failed to consciously separate the economics of the business, from the personality of the promoter at the helm of the company. What had happened was that I'd read a book by Tamal Bandyopadhyay titled Bandhan, The Making of a Bank. And I was very emotionally attached to the founder, Chandrashekhar Ghosh, because of his life story of hardship, struggle and perseverance. And that drove lagging bias for him, which in turn drove confirmation bias and I started to search for positive aspects of the business from its past, instead of focusing on the worsening fundamentals in its present, like over leverage among its borrowers in its core markets of eastern and northeast India, and the socio-political risks inherent in the macro finance business. And I also was ignoring the worsening asset quality issues in the business and that's why I incurred a very big realized loss on that particular stock.

One of the things I've learned from one of my investing mentors is that the true path to success in life and in the investment world is through authenticity; you have to open up yourself up, share your vulnerabilities or weaknesses. And this helps you get feedback from people and also use that feedback to improve yourself.