#6th VIPS – IN PURSUIT OF ALPHA by ROSHI JAIN

Roshi Jain aptly titled the session In Pursuit of Alpha, to reflect her journey. Like any astute portfolio manager, Roshi began her session with a simple quote which goes, “Success in the equity market is 30% market analysis, 30% risk management, 30% emotional control and 10% luck”. The percentages might vary for people, Roshi here highlighted that with a “sane” investment philosophy and framework which is focusing on market analysis and risk management, emotion control becomes easier. Focus on the 90%, the 10% will follow.

The focus of her session was on establishing and following a framework.

Why a framework?

• It brings discipline to the process: Hit rate is better, also brings consistency in performance, and takes care of the emotional management
• Build a framework based on your convictions/ philosophy, make tweaks as required however not too frequently. Changing too frequently is as good as not having a framework.

Two broad approaches to active investing: fundamental based (growth, value, blend) and behavioural based.

Good to know where our leanings are, so there is clarity. Roshi has been trained to be a fundamental based investor and hence leans towards fundamental investing and considers it to be the 1st principle of investing. Fundamental analysis is the bedrock on which behaviour is overlaid. Fundamental investing sets the trend and behavioural (technical) investing accentuates it.

Value is at the core of fundamental investing, inherently we are looking for a company which is lower than its intrinsic value. The following four broad questions are important and which a fundamental investor should seek to answer, according to Roshi. Basis on which comfort zones can be formed i.e. growth, value, contrarian and so on. Understanding value and the catalysts lead to an investing style.

1. How to determine intrinsic value?
2. Why is the company trading below the intrinsic value?
3. What could lead to value unlocking?
4. When can value be unlocked?

Why is the company trading below the intrinsic value? and What could lead to the unlocking of value?

Growth company is traditionally perceived to be a company that is growing very fast and a value company is considered to be a “cheap” to buy i.e. low P/E, P/B. This is a very simplistic way of investing and perhaps leads to suboptimal investment choices, shares Roshi. Company that is cheap may not be because it is ex-growth, it could be due to a poor business/ economic cycle. A company could be cheap according to traditional ways of estimating and it need not be value. Let us not equate “cheapness” with value emphasises Roshi as we continue.

She provides a few examples of value unlocking:

1. underestimation of growth by the market, what would lead to value unlocking is performance by the company. Growth underestimation, unlocking by growth delivery.
2. Company not generating cash flow, misallocation of the capital, unlocking: change in management.
3. Cash distribution uncertainty, unlocking: change in strategy or confirmation by the company/

You can’t delineate growth and value. You can’t have sustainable growth unless you are focused on things like governance, capital allocation. Value investing also requires that there be value in the first place. These are style drifts: as long as we keep in mind that there is value to be unlocked.

Growth cannot be linear. Components of Growth

• Structural: Large TAM and low penetration, Company specific factors
• Cyclical: economic cycle linked, industry cycle linked

Roshi shares that she sees this as a common mistake in the industry: Avoid mistaking cyclical weakness for structural weakness and cyclical strength for structural strength. Growth rate will not be so high in perpetuity Ex: FAANG stocks.

When can value be unlocked?

Time is of the essence in value unlocking. Company may be trading below value, but unlocking may take a while which might destroy value. Company trading cheap may still be a fair valuation. Value traps are mathematically proven, important to remember that maybe it is cheap for a reason.

Ignoring the “when” can lead to value destruction. Value unlocking also has to come with a tenor and only then can we make right valuation choices.

How to determine intrinsic value?

Important to understand the style drifts and the reasons for their success

1. Growth investing

• Availability of capital and cost of capital.
• Robust macroeconomic drivers for growth.
• Disruptors of growth: privatisation, tech, digital

2. Value/Contrarian investing

• Patient capital and a strong stomach due to uncertainty involved
• Ability to time
• Regulatory Framework (facilitate management) / event driven (board changes)
• High risk-reward

3. Yield Investing

• Need for regular income + capital preservation/ appreciation (demand side)
• Lesser reinvestment opportunities (supply side)

“Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive” -Warren Buffett, 1992 newsletter to shareholders

Two takeaways that Roshi highlighted: 1) Growth and Value investing styles should not be seen in silos.
2) Sometimes growth is the factor that unlocks value. If a company continues to grow in unsustainable fashion that need not be value: no visibility on ROE exceeding ROIC or on cash generation.

Determining intrinsic value is more an art than a science. P/E or P/B are not the only criteria to check for cheapness, there is a reason for that, so do not make that the only criteria for assessing value.

Roshi’s go to tool to identify intrinsic value is the Discounted Cash Flow. Cash is King. Helps in identifying the:

1. Growth tenor and quantum
2. Cost of capital
3. Value of stock
4. Reinvestment needs

Key elements of robust framework

Value is at the heart of the framework and value creation requires compatibility with mandate.

Durable value creation requires sustainability (replicability and consistency) and scalability (large enough opportunity). Governance is at heart of sustainability, ESG > has to be brought into the framework

Business depends on externality. Capture interlinkages and dependencies in value creation, no business operates in a vacuum.

Roshi’s Investment Philosophy

1. Focus on sustainable growth (especially for India)
   1. Fundamentally strong companies with growth drivers
   2. Competitively placed in the industry
   3. Consider stage and trajectory of industry cycle
   4. Track record of good management, corporate governance and sustainable strategy
2. Valuation discipline
   1. Emphasis on valuation to assess risk-reward and provide reasonable margin of safety
   2. Holistic approach to valuations without relying solely on traditional parameters like P/E or P/B

Roshi’s Learnings in practice

Negative stance on Infra in 2008/09

• Unsustainable growth
• Overleveraged
• Overvalued

Positive stance on select Banks in 2015/16

• Adverse asset growth quality cycle
• Business models improving
• Market factoring in poor profitability for extended time

Positive stance on Cyclicals in 2020/Covid lows

• Not a call on when lockdowns end
• Consolidation opportunity for good quality, healthy balance sheets
• Attractive valuations

Mistakes largely stock specific

• Growth was not self-sustaining, underestimating capital needs
• Behavioural

The speaker shares that the objective has been to learn from these mistakes and to reduce some of the overriding/ behavioural aspects of it, continue to work on strengthening the framework, understanding sector linkages,

Risk Management – why?

We don’t know what we don’t know! VUCA world with lots of interlinkages – hence the need for risk mitigation. It is important to first survive. Always scope for getting carried away, whatever the experience level.

Approach to risk management

Process

• Compliance with regulatory and internal risk guardrails.
• Robust Investment Process

Portfolio construction

• Diversification: part of the Investment Framework and helps in risk management. Quantity is not the criteria for diversification. You do not have to dilute your framework to diversify. She further adds diversification is about uncorrelated bets. Having correlated stocks will not help in diversification.
• Position sizing should be based on risk appetite. Risk no more than that you can afford to lose, but risk enough that the win is meaningful. Risk is key, all the work will come to naught if you do not. Can be linked to the fundamental analysis.
  

Equal weightage to risk management and investment framework/philosophy.Roshi ended her session on yet another Buffett quote: “The best investment that you can make is an investment in yourself”. We need to keep learning from our successes and our failures.