“My first decade as a full-time value investor”: Key learnings by Mr. Jatin Khemani, CFA

Contributed By: Dr. Udai Cheema

Recently, CFA Society India had invited Jatin Khemani, CFA, Founder & CEO of Stalwart Advisors to speak about his experience of being a full-time investor over the last 10 years. The session held at the Holiday Inn, New Delhi was full of insights from a young man who has become a trusted name in the Indian Investing landscape. He has also given us a wonderful platform for learning in the form of indianinvestingconclave.com.

Interestingly, Jatin designed his talk based on a twitter thread that he had published a while back regarding his learnings after going through his first ten-year market cycle as a full-time investor. He took each of the tweets from that thread and elaborated upon it. We are going to follow the same layout for our post. Here are some of the highlights from his talk.

Tweet 1):“In the beginning, everybody thinks bottom-up stock picking is the holy grail, I thought so too. Whereas, in reality, sectoral tailwinds/headwinds immensely matter and should never be ignored.”

• When there are headwinds, the aircraft burns more fuel and still reaches its destination late. A pilot can’t really do much in such an environment. Similarly, there is only so much growth a company can manage if the external environment is hostile.
• The example of Jeff Bezos and Amazon.com is a good one when it comes to riding the tailwinds. The internet usage was increasing at 2300% a year and Bezos was the right man at the right time with the right product to ride the wave.
• Investors should try to identify sectors that enjoy such massive tailwinds. Even with decent management, the sectoral tailwinds will make sure that the company does well. Also while looking at the past performance of a company, try to figure out whether the superior performance has been due to sectoral tailwinds or management competence.
• Some sectors that are currently enjoying tailwinds and could have the longevity of growth include;
  • Asset management industry
  • Life and Health Insurance
  • Staffing companies
• Some sectors that are currently facing headwinds include;
  • • Traditional Media
    • Automobiles
    • Highly regulated/Govt. related sectors

Tweet 2)– “I always thought technical analysis is all gas and what matters is ‘just’ the business behind the stock. I was wrong. Price-action, volumes, delivery data, liquidity/flows, index inclusion, etc. also matter & can add value even for fundamental/value investors especially for timing and optimising entry/exit better”

• In today’s world, more than half of the flows are decided by algorithms and the majority of the flows are passive via ETFs. These flows have no human intervention and run on certain guidelines. This can lead to massive inefficiencies and bubbles. You can either sit out such bubbles or can participate in them only if you understand what is driving them.
• If you have invested in a stock based on fundamentals and the price has gone ahead of the fundamentals, it might be a sell but the stock might be destined to enter a major index in the short term which could further boost the valuations and make the stock even more expensive then based on this information one can ride the momentum and time the exit better based on technicals.

Tweet 3)– “Value stocks without a catalyst are value traps. It’s okay to wait for the catalyst and board the train 20-30% higher, but at least it will be a moving train and not a stationary one with an indefinite wait, capital is finite and opportunity cost should always be considered”

• There are about 4000 listed stocks, out of which 1700 are actively traded with more than 100cr market cap. 75% of these actively traded companies are value traps. For example, holding companies have always traded at a massive discount to intrinsic value and historical data suggests that these companies have always traded at such discounts. Stocks trading below cash, trading below book value/replacement cost, conglomerates – all such companies are value traps if there is no trigger in sight otherwise the wait could be endless and most investors would run out of patience. Conglomerates need a demerger to unlock value or else they will always appear to be cheap based on the SOTP valuation method.
• Without a trigger, having a lot of such stocks in the portfolio will kill the CAGR. The opportunity cost in such cases can be huge.

Tweet 4)– “It probably makes sense to have a stop-loss in terms of time, not every management can execute. In fact, even if the past execution track record is great, it could falter in an evolving environment, changing competitive dynamics, regulations, etc. If our thesis doesn’t play out for 3-4 years, something is wrong and it makes sense to switch but continue tracking “

• Investors should consider a ‘time-based’ stop-loss on their investments. Even Ben Graham has suggested in his book Security Analysis that if the thesis doesn’t play out in two odd years then he would exit the stock. So, there should be a pre-defined time that one has to give his investment to work out in his favor. Exit, track the stock and if you see the thesis finally playing out, there is no harm in buying the stock 20% higher.
• Management teams that are able to execute and that are able to show consistently profitable growth command the highest premium. So one needs to find out and exit the companies in the portfolio that are not able to do that and 3-4 years is a good time frame to make that judgment.

Tweet 5)– ” In small & micro caps, entry during a bull market is easy & smooth, however, there is no exit in a bear market as volumes dry up or exit has to be at a huge impact cost. This is like Abhimanyu’s Chakravyuh.”

• When we talk about multi-baggers, we are discussing companies with a few hundred crore market cap or even less that have the potential to become big over the years. They can practically grow by 10-20-30x, whether they are able to or not remains to be seen. Besides the potential upside, the process of unearthing a hidden treasure can be quite intellectually stimulating. Small size, negligible institutional ownership, minimal analyst coverage of the company are a few reasons why such companies turn out to become multi-baggers as they keep delivering and then eventually the institutions start to take notice.
• All isn’t as rosy as it seems. Small and Micro-caps have a significant downside as well compared to some of the bigger and more well-known names. These companies possess a huge concentration risk in terms of their product portfolio, number of clients, geographical concentration of operations. All these factors add fragility to a small scale business model. For example,  all these risks are evident in the way cement companies across various production capacities are valued by the market. Larger and well-diversified players get a much higher premium compared to more regional players with small capacities with 1-2 plants.
• Lack of scale and experience can put such companies in a spot of bother when the going gets tough in the company itself or the economy as a whole. Keyman risk is also a concern in such companies. Their inability to keep up with regulations can put the business at risk as well.

Tweet 6)– “In cyclicals, exit criteria should be defined at the time of entry itself and should be adhered to, no matter how rosy the fundamental performance in the upcycle is. A timely exit is all that matters. Otherwise, you would be back to square one. While exit strategy should be triggered based on some fundamental criteria like a reversion to mean in valuation/profitability margins, however, the actual exit could be on the way down, maybe 10-15% from the top.”

• All industries are more or less cyclical. Some being more cyclical than the others, these can be divided into 3 buckets;
  • Low Cyclicality – FMCG, IT and any other consumer-facing businesses.
  • Medium Cyclicality – Industrial goods. Consumable items such as refractories, bearings, abrasives, etc.
  • High Cyclicality – Industries with 2-4 years of high growth and 3-5 years of de-growth. These include the auto industry, lending businesses (NPA cycles invariably put them through years of degrowth), capital goods which are highly linked to the shape of the economy, commodities such as graphite electrodes.
• Criteria that can trigger a buy in cyclicals include company selling below cost, the entire industry is bleeding, the survival of majority players at stake, weak/leveraged players on the brink of bankruptcy, old capacities going out of the system and new capacities are not coming up and one expects that demand-supply will get restored going ahead and profitability will come back going ahead. The time to enter such businesses is when the P&L of the company makes you feel sick. The traditional valuation metrics might not work here as the business might be losing money. Some important metrics while valuing such businesses can be price/sales, replacement cost, price/book.
• It’s important to book the gains in cyclical stocks before the stock price is back to square one. When the cycle is in an uptrend the earnings go up and markets tend to re-rate the company and de-rating of PE occurs in the downcycle. The exit can be triggered by reversion to mean valuations or reversion in operating margins. When the company hit the mean valuations/margins of previous good times in the industry, one should start planning their exit. One can never predict how far the exuberance can take the stock, so a more prudent way would be to ride the momentum and sell it 10-20% from the top. Peak multiples along with peak margins is a strong signal to exit a company operating in a cyclical industry.

Tweet 7) – “Certain investing styles are best suited for individual investing & not for managing/advising public money. The role of money manager isn’t maximizing returns but optimizing them with respect to risks. Drawdowns should be minimized even at the cost of sacrificing some returns. Drawdowns that last long enough could be considered permanent loss of capital.”

• Certain investing styles like deep cyclicals, deep value, turnarounds can really test the patience of investors. They can take much longer to perform while in the meantime, they can show a 50-60% drawdown in the portfolio before eventually going up 4-5x. As an individual investor, one might be able to handle the volatility based on personal conviction but as an advisor, at times it can get difficult to convince some of the clients to hang in there until the story plays out.
• Some clients tend to misconstrue drawdowns and volatility as risk rather than opportunity and therein lies the problem. The impatient ones exit at just the wrong time when they should be buying instead. The underlying problem is that when someone is not interacting with the markets on a daily basis and invests on borrowed conviction then a 50% drawdown in the portfolio can be scary, he thinks it might go to zero if the company turns out to be one of the rotten apples as we have seen with certain companies in the recent times with all the corporate governance issues. Even if the stock goes up 5 times, later on, the investor would have sold out early at a loss, thereby,  losing confidence in his advisor.
• The focus should be on minimizing drawdowns even if it is at the cost of sacrificing some percentage points on the returns. For example, in the advisory business, a 25% CAGR with a 25% drawdown is worse than an 18% CAGR with a 10% drawdown. So when you are advising the public at large, a lower return with much lower volatility/drawdowns is a much better option. Consistency of returns is more comforting for the clients than a rollercoaster ride. Even though massive wealth is created in small undiscovered names/cyclicals compared to the large efficiently priced companies but this is a trade-off that one has to make as an advisor.

Tweet 8)- “If there is froth in a particular segment of the mkt, even if your stocks from that segment are at a reasonable valuation they will still get affected badly when there is a sell-off in that segment.”

• Small and Midcap space, in general, was quite richly valued in 2017 but some of us must have thought that our stocks which haven’t participated in the rally would stay isolated from any significant drawdowns if the market as a whole corrects. Ironically, that was not the case. Even fairly valued, good debt-free companies bore the brunt of the subsequent meltdown in the Small and Midcap segment.
• The learning has been that the index valuations of the space in which your portfolio fits must be tracked. It makes sense to switch to some cash/other less richly valued segments of the market/defensive names in times of over-exuberance.

Tweet 9)– “Diversification is crucial no matter how deep your understanding of the business is, coz shit happen”

• Even though we have some great examples of people who concentrated and made it big but for one such hero there are thousands of zeros but you never hear about them as nobody writes books on them.
• It’s extremely difficult to come out of the financial and emotional turmoil when that one/two concentrated position in the portfolio starts to go against you. Even if we were able to diligently exclude all companies with doubtful financials/management, there can be good companies that can fall into hard times due to XYZ reasons that nobody could have predicted at the time.
• The sweet spot could be anywhere between 15-25 positions with allocations ranging anywhere between 3% to 10%. Sectoral and geographical caps of 25% can also be applied to the overall portfolio as part of risk management.

Tweet 10)– ” While formal education like CA/CFA/MBA can set the foundation right, there is no substitute for own experience; it is the biggest teacher in the market. Vicarious learning is also not enough, one has to be invested in the market to go through those emotions. It takes one or two market cycles just to understand own psychology, mass psychology and to determine ‘what works for me’.”

• Investing is like swimming, no matter how much you read about it or watch tutorials, until and unless you take the plunge, almost drown – you won’t learn how to swim or protect yourself from drowning.
• There are plenty of ways to make money in the market. Each style requires a particular skill set, psychology, and temperament. One has to figure this out by themselves as to what works for them. There is no single right way. Knowing yourself and figuring out which investment style suits you is the most crucial aspect of successful investing. Feedback loops are longer especially for investors compared to traders. So, it might take some time to figure out what works for you but you must keep at it.
• Charlie Munger says;
  • “You dont have to pee on an electric fence to learn not to do it”

Unfortunately, in real life, we need to get some electric shocks to learn and evolve as an investor.

In conclusion;

When someone decides to share their decadal experience with you, it’s always a pleasure especially when it’s someone like Jatin Khemani. Here’s hoping that Jatin will deliver a similar bi-decadal presentation in 2030. A day packed with learning and great hospitality by the team of CFA Society India. Looking forward to the future events by the Society, till then keep learning, keep evolving and happy investing to you all!