How is India prepared for the post-covid era? Do you think India would surpass major economies to emerge as an economic superpower by 2030?
Younger countries are naturally better placed than older countries in the post-Covid world as there is abundant data which shows that impact of Covid is greater, the older the victim is. Secondly, countries with efficiently executed massive vaccination programs are better placed than countries which face vaccine shortages. On both counts, India seems in a good place after the traumatic events of the second wave.
Leaving aside the current hype around Covid, if India can continue improving the standards of healthcare offered to its people then we will continue to be in a healthy economic climate where clean, well run high-quality companies will continue to make wealth for our clients at a growth rate of around 25% (as they have done over the past 20 years).
Indian equity markets have been touching all-time highs recently. In fact, the market has been trading at a very high valuation. How do you read equity markets in the medium term and how comfortable are you with the valuations?
Fundamentals of Indian equity markets compound at no more than 8%-12% over the long term. More importantly, there is significant volatility in the rate of compounding over the short term – for instance, Nifty50 EPS went up by only 1% CAGR over FY15-20. Hence, timing entry and exits from the stock market becomes important for an investor to generate outsized returns. However, timing entry and exits from the stock market is one of the most speculative and risky parts of equity investing.
What are the major triggers and risks for domestic stock markets?
There is a long list of potential triggers for the domestic stock market – economic growth, capital flows, investor sentiment, political developments, regulatory announcements, black swan events etc. However, it is worth noting that the correlation between these triggers and the stock market appears to work only in hindsight (because our mind chooses to ignore the instances where the correlations did not work). For instance, in March 2020, domestic stock markets crashed massively when there was not much of Covid-19 pandemic spread in India, and they bottomed out exactly when the national lockdowns were announced (and hence their adverse impact on economic growth)!
Similarly, during the second wave of Covid-19 in April / May 2021 stock markets kept going up, when a much smaller 1st Covid wave of 2020 led to a 40% drawdown in the stock market. Hence, the linkages from events to economic growth to stock market to an investors’ portfolio are not as obvious as they appear to be.
What should investors do in the current market scenario? Should they deploy incremental flows in equity markets or simply invest in fixed income funds?
Investors should deploy incremental flows only in specific high quality companies – for instance, those that are beneficiaries of the last 18 months of crisis either because their competition got crippled or because they undertook certain business initiatives or capital allocation decisions to benefit from the opportunities thrown up by disruptive impact of the pandemic. A portfolio of such high quality companies – we call them ‘consistent compounders’ – is likely to outperform against fixed income funds over a 12 month time period, even if there is a stock market crash.
You have been in investments for decades. What are the three things that investors should follow to grow their wealth through equity markets?
Firstly, a clear understanding of how to filter out companies which have red-flags in their accounting quality. Secondly, deep understanding of sustainable competitive advantages of the underlying businesses. And thirdly, a scientific approach towards portfolio construction and position sizing in order to avoid subjectivity and personal biases while making investment decisions.
While equity markets give attractive returns to investors in the long run, very few investors actually make healthy money as most people react hastily to market conditions. How should investors understand their own biases and overcome them to make healthy money from equity markets?
Investing decisions based on myths or one’s personal beliefs expose an investor to more luck than skill. Forecasts of the growth prospects of any business are based on several factors, many of which are qualitative in nature, such as management quality, capital allocation discipline, the ability to disrupt rather than be disrupted by unforeseeable events, etc. Investors who arrive at these decisions based on their personal beliefs or myths expose themselves to subjectivity in their stock selection and portfolio construction. Such subjectivity often weakens the risk-reward outcomes of their portfolio due to biases, inability to scale up research efforts and inability to forecast the risks (rather than just returns) of the portfolio. A rigorous hunt for mathematical and scientific tools helps the investor reduce the contribution of luck and enhance the probability of success. Investors need to quantify the qualitative aspects of the companies under their coverage to make investing a more scientific process which can be improved over time.
You have written a book titled ‘Diamonds in the dust’. Tell us about the book. What are the three key takeaways from the book?
In this book, we elaborate on the key elements necessary for crushing risk to generate steady and healthy returns from equities in India. Our approach is to buy clean, well-managed Indian companies selling essential products behind very high barriers to entry. We call this approach to investing Consistent Compounding and have seen both in theory and in practice, that it works. This approach has three key elements—Credible Accounting, Competitive Advantage and Capital Allocation.
- The first pillar, Credible Accounting, uses a set of forensic accounting ratios and techniques to identify companies with the least accounting risk and the highest reliability of reported financial statements. We use case studies of three prominent companies who have each stolen billions of dollars of shareholders’ and lenders’ money to explain how investors can use annual report analysis to identify corporate frauds before the rest of the market latches on to them [and before the stock price collapses]. We also provide a forensic accounting checklist that investors can use to shield themselves from such companies.
- Competitive Advantage is the search for companies that possess strong and durable pricing power, enabling them to be leaders in their markets and consistently earn returns higher than their cost of capital. This mitigates their revenue and profit risk. We not only use detailed case studies of how great franchises have been built in India over the past two decades, we also refute common myths about competitive advantages – for example, the strange notion that ‘brand’ is a competitive advantage.
- The third pillar, Capital Allocation, is about finding companies that make the best use of their excess returns (the difference between return on capital and cost of capital, akin to free cash flow) in order to grow their business as well as to deepen their competitive advantages. Knowing what stocks to buy using the three pillars is what we call the Consistent Compounding approach. We provide a checklist that investors can use to gauge the quality of company’s moats and its capital allocation.
