Alpha Moguls | Prashant Khemka Says This Is Key To Generating Consistent Returns

For one of India’s best-performing portfolio management firms, a very strong and focused investment culture is a prerequisite to generate and sustain consistent performance. And that’s what it suggests investors should be looking at while picking stocks rather than betting on macro events that are chance-driven.

“This means we must deliver the highest returns for our clients. It is founded on four pillars, or there are four elements to it—philosophy, theme, process and portfolio construction. Each one of them plays a very crucial role,” Prashant Khemka, founder of White Oak Capital Management, said on BloombergQuint’s special series Alpha Moguls.

Instead of betting on macros, White Oak Capital, he said, has a bottom-up stock selection approach that outsized returns can be earned overtime by investing in great businesses at attractive valuation. Besides, it looks at a balanced portfolio as it ensures that the portfolio’s performance is an outcome of stock-picking rather than leaving the performance to chance.

Macro factors are top-down, be it market timing or sector rotation or thematic bets, those are more chance-driven, he said. “The more macro you go, the more it becomes a coin flip. The more micro you are, the more it remains stock-picking."

White Oak Capital, which manages more than $2 billion of India investments, gained 4% so far this year compared with the Nifty 50’s 9% drop. This comes despite massive volatility in India’s equity market as it recovered from the worst selloff in more than a decade triggered by the coronavirus pandemic. The portfolio management firm recently took over the mutual fund business of Yes Bank Ltd.

The best positioning of portfolio, according to Khemka, is one that doesn’t require any repositioning due to macro events. When panic is the highest, people end up exiting their investments, which is the worst time to do so. Investors, he said, are sitting on the sidelines and waiting for a correction, which is like “doubling your mistake”. Just because an investor makes one mistake of getting out, say, in the Covid-19-induced panic in March, they have a psychological block of not getting in, which ends up harming the portfolio more, Khemka said.

At White Oak, he said sensitivity to valuation is very critical and that discipline around valuation adds those crucial extra few percentage points. But it’s very “insensitive” to multiples like price-to-earnings and Ebitda multiples. “They are distorted and misleading. What we focus on is the DCF (discounted cash flow) value and cash flow multiples,” he said. “One of the things we look at is cash flow conversion. That says a few things about the governance of the company as well.”

The portfolio management firm, Khemka said, also monitors the rate of cash flow conversion relative to the peer group in the industry. Often times if there is a disparity for one company, then that should raise questions. Not necessarily always it is a bad business model or bad governance, but it should mean that a certain follow-up is required, he said. “The only ratio worse than a PE ratio is the PEG ratio.”

Inflation Expectation

Inflation expectation, according to Khemka, is a critical trigger to monitor. Overall inflation expectation is very low and that’s what is likely driving the bond yields lower, he said. A spike in inflation expectations, according to him, can correct bond yields or it can cause correction in equity prices globally as the abundant liquidity can get sucked out of the markets.

Watch the full show here:

Prashant, consistency takes some doing. It’s probably an outcome of processes and not just the flair of a fund manager. How is it that you go about constructing your portfolio and are you doing something different in the current times?

If I were to split the question into two parts. It’s not possible to be top one percentile in each of the years, but collectively for the last 13 years for the last various rolling periods, you are right. So, in my view, to generate and sustain strong and consistent performance is a prerequisite to have a very strong and focused investment culture, what we call ‘performance first culture’. This means we must deliver the highest returns for our clients. It is founded on, if you will, four pillars, there are four elements to it—philosophy, theme, process and portfolio construction. Each one of them are very critical and play a very crucial role. Now you might say yeah that’s generally what you hear from everyone, but investing is a centuries-old game and there’s no silver bullet. Therefore, you have to do a few essential things. For centuries what has not changed is how to have a healthy body, you need to eat well, sleep well, exercise, and have a stress-free life. Now, these are very simple things to follow in theory for what is most important in your life and in practice very difficult to do beyond first few days of January. Similarly here, it’s very crucial to get these four things right— philosophy, theme, process and portfolio construction. So, we have a stock selection based bottom-up philosophy of buying great businesses at attractive s rather than betting on macros. To go with that philosophy, we have a theme, which in my subjective opinion, is the most outstanding theme out there. Implementing a time-tested process that has been developed for more than two decades at the core of which is our analytical framework that we’ve talked about earlier and I can collaborate further here. And all along, we maintain a balanced portfolio construction approach. This portfolio construction, some may call it risk management, I like to think of it as more of a balanced portfolio construction. It ensures that the performance of the portfolio is an outcome of stock-picking, which is where the skill of the team is or where the skill can be developed rather than leaving the performance to chance. What I mean by chance is macro factors are top down, be it market timing or sector rotation or thematic bets, those are more chance-driven. They can work really well when you get them right and they can destroy your performance when you go wrong. In my view, the likelihood of success of those is almost, if not exactly, as good as coin flips. On more macro you go, the more it becomes a coin flip; the more micro you are, the more it remains stock-picking.

If indeed there are events that are macro events in nature, would you not try to take advantage of those conditions at all?

There is no way in our view that you can take advantage of such macro events. You have to recognise those as risks, risks to be guarded against. Performance of the portfolio needs to be guarded against those risks which is possible by having a portfolio that is balanced. So we often say when clients ask, how are you positioned for this or that, or Covid-19 or post Covid-19? We say the best positioning of portfolio at all times is one that doesn’t require any repositioning. That’s a Nirvana situation and you almost never are in that perfect balance but we continually strive towards that balance. What it means is, if tomorrow you tell me that markets are going to be up 10% or down 10% because of whatever reason, because a vaccine is invented or not invented; we should ex-ante have no belief how our portfolio would do good tomorrow merely because of the movement in the market. That we would consider as a balanced portfolio. If you tell me that the market is going to be down 10%, I’d feel very excited that we will be outperforming by 200 basis points; then that is not a balanced portfolio or vice versa.

Prashant, let’s assume that we were 11,500 odd for argument’s sake, in the first hint of Covid-19 being a real problem came about, and then everybody realised that you can’t price in what lockdowns could do and therefore the beliefs were in the market to correct substantially. You would have been in a balanced portfolio. Did you not get tempted to take off some of the money out of the balanced portfolio and sit on cash to maybe try and take advantage of a further correction? I’m not saying you timed it to the levels but probably, you may have guessed by your experience that the markets are going to go down and it made sense to be on cash. Did you not get tempted?

There are a few assumptions in your comments. First is, that you develop the belief that markets would go down before the markets actually go down. Often times, you develop the belief after the market has gone down. Even if you do sometimes, it’s like a coin flip. Sometimes we have a strong belief and a strong gut feeling that the coin was to flip heads and it does come heads. Do you feel like you can predict a coin flip? In reality, it was just a fluke and the next time doesn’t mean anything. So that is one aspect of the comment you made.

Now second aspect – even if we have such gut feelings, we have developed over time a discipline to ensure that we don’t let our portfolio be driven by such coin-flip-like beliefs. That discipline is crucial in delivering the consistency of performance that we talked about over time. The second element of the question was, you somewhere alluded to the experience and that is a common myth. People, ordinary investors and even smart investors – possibly because they watch media and they just listen to this so often, that they’re led to believe that fund managers, smart investors and people who’ve been very successful investing over time; they must know where the market is headed. It is no different than if I were to give you my favourite Captain Dhoni just retired. If I were to give you an example of the cricketing world, it is like expecting a good captain who can win games to know how the coin is going to flip at the start of the game. At the coin toss, he’s no better than you or me or anyone out there in the street. He can win the game no matter what the outcome of the coin would be. Similarly, for us, investing is about identifying the right businesses that can generate superior returns over time. In our view, all this- expecting the market to go down and sitting in cash and then expecting it to go up and coming back in high beta stocks, all that is entertainment and that should be kept limited to talk. If you start implementing it in a portfolio, you’ll have to pay entertainment tax, just like you pay the tax when you go to Vegas. Similarly, if you start doing that; going in cash and coming out you’ll end up tax. In my experience, for the last three to six months and a lot of people who are dialled in, they can probably relate to it- at least a majority of them can relate to it. In my experience, most people got out close to the bottom around March 25 because that is when as the market kept going down, the belief became stronger and stronger. You would remember all your friends and colleagues whoever is invested like a doomsday scenario. We’ve seen nothing yet. Spanish Flu in 1920 killed how many percentage of people? Lehman crisis in 2008, when markets went down 60-70%, we are not even halfway there. Panic is the highest and people exit at the worst time and now they’re sitting on the side-lines waiting for a correction, which again is like doubling your mistake. Just because you made one mistake getting out now you have a psychological block of not getting in because if you get in now, you’ve locked it at a certain 25-35%. Just like the dialogue, “Don ko pakadka mushkil hi nahi, namumkin hai”. “Don phir bhi pakda jata hai, in my view, market ko time karna bilkul namumkin hai”. It’s a bit of disservice; when you say it is difficult, it suggests it can be done but in reality, you can do a PhD from Harvard or MIT in probability theory, which is like coin flipping, or you get a PhD in market timing. As soon as they finish their PhDs and come out on the street they’re no better than the layman in predicting the next coin flip or predicting the next market move.

Then obviously there is a guiding philosophy here. I mean, there will be a few things that will work for you; I’m guessing the kind of theme that you alluded to is one and which is great that you’ve been able to build this but the theme in order to operate in a particular way probably goes by some investing methodology and some philosophy. Can you tell us a bit about what is doing that and have you altered it at all in these last three or four months or in 2013 however, it maybe- during big events, have you altered it or kind of tailor fitted to the situation then?

Great question. So, the core philosophy is pretty much the same overtime but it evolves with learning and you learn everyday. Covid also taught us that such risks exist, which consciously or unconsciously have an impact on the philosophy. So, it evolves over time and there are no dramatic changes. Let’s say over the last two decades plus or more than two decades, it has evolved without necessarily any dramatic change from day to day but considerable change when you think over time. What is the philosophy? It is bottom up stock selection base that outsized returns are earned overtime by investing in great businesses at attractive valuation. The two key elements are business and . It’s simple, but not as easy as it sounds. The team is looking for most powerful combinations of business and . The devil lies in details and execution – how you do it versus others will determine whether you can set yourself apart. How we think about a great business is one that has these key attributes if you will; superior returns on incremental capital. So, importantly, it should be forward looking, not backward looking. To give you an example of the difference between superior returns, incremental capital versus superior returns and invested capital, when I started here at the Goldman India Business & Strategy, some of the leading telecom names were the market darlings and they were the top holdings in many portfolios because backward looking, they had very strong ROICs. However, having made the mistake of investing in Vodafone during my days of managing global portfolios, to me those returns on invested capital didn’t seem sustainable forward looking because of all the new competition that was coming in, whether weak or strong. So, it is very essential to not just run screams on backward looking ROICs in my view. The same way today, the ROIC’s of some of these telecom companies to survive is very poor when you look backward but could be very strong forward looking as things have changed now, industries have consolidated to two or three players. So, one is superior returns on incremental capital, then scalable – the business should be able to multiply overtime relative to the economy or corporate world or the industry if you will. That is very important because that drives the sustainable growth. Both these and even the third element if I will, is the well-managed; when you have room for scalability and cash flow generation or superior returns you need management that can execute to deliver those. These are all derived from the fundamental equation which is equal to present of future cash flows which can be written as, ‘ is equal to cash flow divided by R minus G’. To generate cash flows sustainably, it is imperative that return on incremental capital is higher than cost of capital. Only then, you have cash flow generation. The sustainable growth – the scalability aspect is the ‘G’ in the denominator. The higher it is, the more valuable the business is. When you have the potential for these two, you need the management as I was saying to execute it. Let’s take private banks. Many of them got licences in the mid-90s. Less than a handful have been able to capitalise and create lakhs of crore of franchise . A lot others have disappeared or fallen by the wayside or just muddled through. So, the execution DNA of an organisation is very critical to assess. First and foremost, it is the governance DNA of an organisation because even if all the other attributes are present, but the governance is lacking, then it’s a great business only for the controlling shareholder not for us minority shareholders because those cash flows generated over time, minority shareholders would not get their proportionate share. Hence, there’s no sanctity of those cash flow equations if you will. So, the best way to make money from such businesses is to avoid them altogether. That’s one of the most successful outcomes over the last 3 or 13 years, that the team has achieved where they managed to avoid some of major disasters. Governance is the only screen we use if you will as it is a subjective screen. When all these attributes, let’s say are present in good measure, then, it is very critical to have a logical framework to them and the discipline and patience to buy them when there is substantial upside to fair . There are investors and managers who will say when you have great businesses, you can buy them at any price and you will outperform over time. There’s probably a lot of merit to that but as we keep reminding on our team that our goal is not merely to outperform the market but to outperform the best performers. When the Indian cricket team goes to the World Cup, the goal isn’t for people to qualify for the quarterfinal or semi-finals. The goal is for them to win the cup and it remains to be seen them what happens. That should be the goal and if that is the goal, sensitivity to valuation is very critical and that discipline around valuation adds those crucial extra few percentage points that sets the team apart. When at valuation, the team does not look at the P/E multiples. We are very valuation sensitive but very insensitive to multiples like P/E in Ebitda. P/E multiples in Ebitda has many flaws. Many times they are distorted and very misleading and hence harmful if you use them as inputs for decision making. So, on the team we may evaluate a company for years and finally decide to buy, own it for years and then sell out without ever mentioning the word P/E ratio. The only thing worse than P/E ratio is the PEG ratio – which is exponentially a useless thing in our view. So, what we focus on is the DCF and cash flow multiple as derived from our proprietary, a clear framework, or what we call it as the Opco-Finco model as well. In prior discussions we discussed where any company for analytical and valuation purposes can be split into two entities or subsidiaries – Finco and Opco. So take any company, let’s take an auto tyre manufacturing company. It can be split into Finco and Opco. In the Finco, we house the plant and machinery and all the fixed assets as well as the working capital of the current company whereas the revenue and Ebitda are assigned to the Opco. From those, the Opco is deemed to pay an operating lease cost for the Finco for use of fixed assets. This is like paying a car lease payment when you buy a car on lease which includes an amplification element and a financing element. Then you pay a working capital financing cost. When these two costs are paid and the taxes are paid out from the remainder, what is left in Opco is the capital light free cash flow. Capital light because all the capital is in Finco. This capital light free cash flow is nothing but quantification of the excess return on invested capital in the business because the cost of capital has been paid out. What this process does is, it helps you quantify the of excess return on invested capital because you have a stream of cashflows for Opco which you can present which is a of excess return on invested capital. The Finco is simply the dumb capital, invested capital.The total enterprise is, the Finco+Opco which is IC plus of excess ROIC. So it’s like if you have a pot of curd and you want to it and if you can churn it to see how much is the butter and how much is water, you can it more appropriately. And, this is the churning process. Then when you rearrange the terms and substitute the formula what you also get then is the capital light price to free cash flow which is nothing but the market implied of excess ROIC in that equation, divided by the cash flow for Opco for any given year. This capitalised cash flow multiple provides a more apples to apples comparison between companies within a sector as well as across sectors because it normalises two very big flaws besides, others. Two very big flaws of P/E multiples – one is the capital structure of the balance sheet that is normalised in this process and the capital intensity of the business model is normalised, which P/E multiple fails to normalise. This is an example to give you the magnitude of difference in some companies, collectively at Sensex if you look at today. On FY20 our team’s estimates suggest that Sensex is at 23 times P/E multiple but the capital light cash flow multiple is 43 times. Now, 43 should not suggest excessive valuation of something remember, its cash flow multiple after paying cost of capital. Having done this in earlier times across countries in emerging markets and even U.S., even in China also it tends to –in my recollection always remains in the mid-30s or even higher 30s. Even now, where the valuations it might be in the 40s around the world. I was saying that it was actually no big invention or anything, it’s just a different perspective and applying the very basic financial equations along the lines of this perspective that you want to quantify the excess ROIC in a business.

The common parlance, whenever we talk to people in all reports or everywhere else; is that what is the P/E and is the P/E high or low? It is used for the markets at large, it is used for stocks at large, it is used for companies where in the P/E holds no until the P/E is used, right? My question to you is, if you are a ready reckoner and if you just want to kind of pick and choose things that you will eventually study, if the P/E is not a reliable metric at all, how do you do first set of filtration because surely, in the first set of filters you probably don’t go through all of this. You probably use something in order to weed out or bring in certain ideas that are presented to you. How can people do that?

One of the things I like to look at is what cash flow conversion is. That says a few things about the governance of the company as well. Also, what is the cash flow conversion relative to the peer group in the industry? That is very important, let’s say if you are you looking at the Pharma sector or even the consumer staples sector. You’ll find that most of the good companies like say Unilever, Procter and Gamble, Nestle, Colgate and even like Britannia, and so on, most of the companies tend to have nearly 100% cashflow conversion. This means if they have reported a thousand crore or ten thousand crore of profit depending on scale over the last 5 to 10 years, you can look at the cumulative number. About that much has gone to the bank in terms of free cash flow which might be then used as dividend or buybacks. Oftentimes if there is a disparity for one company, let’s say if this is a very different number than the rest of the industry, then that should raise question marks. Not necessarily it is a bad business model or bad governance, but it should mean that a certain follow up is required. Whereas, if it is a 100% conversion, that suggests it’s a potentially good business model. The scalability still remains to be seen but should have superior return on incremental capital and governance should be potentially good. I say potentially because there’s still a question mark with what is done after the cash comes to the balance sheet. To be honest, a lot of it goes to the experience and the knowledge of the team. The average experience on the team is 15 years with several people having more than a couple of decades worth of experience. On the governance part, we’ve seen many companies overtime to screen that out. So, the first thing is screaming out for poor governance and then the preliminary model and this framework helps us assess. Obviously, collectively as a team there are 2,000 meetings over any given 12-month period with not only company managements that we’re looking to invest in but also their peer group at various levels, divisional head levels, in CFO and all those besides the CEOs, listed and unlisted peers, suppliers, distributors and industry experts like in IT services, Gartner experts or FDA experts for pharma, ex-employees and ex-employers to gain a 360 degree understanding of the execution and governance DNA of the organisation besides the scalability of the business as well as the sustainability of superior returns.

What if Prashant Khemka was not running White Oak and therefore will not have access or the ability to do all of these but what if he was an agent, I am not saying just one small capital retail investor; the rules of the game per se would be the same for a retail investor who has low capital or another retail investor unlike me has slightly higher capital or an HNI who has a lot of capital. So, what do such people do? You have the advantage of doing a lot of these things but some people don’t. Not everyone has the access to the things you mentioned, like meeting managers etc.

Earnings calls are fairly and readily available right and that provides insight as well. So that’s why I asked whether it is full time investor or someone who is doing it on the side. Someone who is doing it full time, can do a lot of this. Someone who is doing this full time is no different than someone on our team. If you do it with passion, you’re doing it with drive, you’re putting in the necessary hard-work, if not 100% then why not 95% or 99%? It’s not that difficult.

Let’s kind of drive in your model and your expertise into the current scenario because the current scenario is as much local as it is global and because you’ve managed global portfolios, what does the global market scenario tell you what could possibly be the root of the markets over to the near or the medium term? I know you said it’s impossible to predict the market but I am still taking the chance.

I think we can only rationalise. So, the widespread concern around market valuations is whether we overd it or not, for most of last 11 years, that has been the concern. Since 2009 bottom for the global markets for most time globally, whether the markets are ahead of themselves has been a concern. Sooner or later that might be right but that’s like even a broken clock is right once in 12 hours. So, if you write once in 12 years, it’s kind of like that. How I think about it is, what might justify the current valuations? If I think of what might justify current valuation, you look at going back to the basics of the equation that I mentioned. Value is equal to cash flow divided by R minus G. Cash flow is the numerator, and then the remaining equation which is one divided by R minus G that is the cash flow multiple and then a derivative of that gets you to the P/E multiple if you want to look at it for the markets as a whole. One divided by R minus G – the denominator is R minus G where ‘R’ is the discount rate and ‘G’ is the growth rate. Now, what has happened over the last 25 years if you see, I picked 25 years because in the mid-90s the ultimate benchmark for all valuations in the world was the U.S. dollar long bond yield. The long bond is somewhere between 10 to 30 years. When I went to the U.S. to study my MBA, the long bond was between 6% to 7%. So, the inversion of that is 14 to 17 multiple. So, bonds were trading at 14-17 multiple and when we would do our DCF in college, we take the risk free rate of let’s say 6% and tack on top of that the 6% equity risk premium. So, let’s use 12% for a company with beta equal to one as the discount rate. At that time, S&P 500 in the U.S., also happened to trade about 15 multiple, more or less in line with where the bond multiple was. Fast forward to today, the bond yields are close to 1%, or 1-2% on the longer dated ones. The multiple for bonds has gone to 50-100 times. I’m not suggesting equity market multiples ought to go to 50 to 100 times but, when you think of the equity market multiples you have to view them in that context. The S&P in the U.S. has gone from 15 multiple to 20 multiples or so. So, where is the bond multiple, 15 to 75. You can argue that the bond yields are very low and the bond prices are too high. They should come down as well. You have to see what bond yields reflect usually. They are an outcome or a reflection of the inflation expectations. One of the key inputs that drives bond yields is the longer term inflation expectations. Inflation expectations have structurally come down in my view over the last 25 years. In 1995, the generation of professors and market participants that taught us in the MBA schools were the people who had the hyperinflation in the U.S very fresh in their memory in the 70s, 80s and the oil shock and all. This was when the central banks around the world and governments around the world were preoccupied with containing inflation. So, the inflation expectation and worries about inflation was still high back then. Today, a large number of banks and governments are more worried about deflation than about inflation. There’s a big fan following now about Fang stocks and Nasdaq stocks. If there is any merit to the prices of these stocks then they are very deflationary and that’s just a very deflationary environment. To quickly add some substance to what I’m saying here – I’m not an economist but just a layman’s understanding if you will – the two primary sources of inflation are commodity inflation and wage inflation. Commodity inflation expectations have structurally come down in my view because of substitutes for the biggest commodities such as fuel or fossil fuel. So if you believe that Tesla’s stock market valuation of 350 billion or anywhere close to it, that means there is a substitute coming down the line which could be a battery which could be fired by solar energy. So, that is renewables and commodity prices are determined by demand and supply on the margin. So, if there is a new supply of alternative form of energy, besides fossil fuel, and even for within fossil fuels, there is a huge supply that’s come on board now with the advancement in technology, shale gas and shale oil. Now, that is not part of the cartels. Cartels can control and drive up prices. You have thousands of shale oil producers who would not let that happen. So, there’s a permanent lid I think in people’s expectation that’s come up with commodity prices and crude in particular which is the largest commodity and drives the prices of other commodities as well to some extent. And this lid might even be a declining lid, a declining cap. So, the commodity inflation of the two components is more or less in expectations dead. I may be wrong but in expectations they are dying or dead. Wage inflation again if you believe in all these technological advances about drone delivery and autonomous driving and artificial intelligence and robotics and all, a lot of which is driving up the prices of a lot of these stocks, then all those are deflationary and it’s partly because of that I suppose that the U.S. pre-Covid despite having historically low unemployment rates still had hardly any wage pressures. So, these inflation expectations on these two contributors to inflation have died or are dying, then the overall inflation expectations are very low and that is what is likely driving the bond yields lower rather than what excuse a lot of the macro experts give to hide behind for the incorrect calls for the last dozen years on the market is that it is purely the liquidity that is driving up valuations. It could be that the cause is actually the dying inflation expectations. What can change all this, for whatever reason, its inflation expectations. A spike up can correct bond yields or it can cause corrections in equity prices globally as well.

A final question to you since you have a different method of figuring out what the multiples of a market will look like. What’s your sense of this whole conversation around the disconnect between the economy and the market because you did mention that the economy is not looking all that great but the markets are a different beast. So, markets can do well even if the economy doesn’t.

The market looks well beyond horizon. What I was talking about economies not doing well is here and now, today. With consumer behaviour as of today, reflects what he feels here and now typically and also obviously what he thinks of in future. So obviously the consumer by buying automobiles at least he’s just not thinking that the world’s going to come to an end. The markets always look beyond the horizon and they may be wrong very often but they are always looking beyond the horizon. In 2009 if you remember, when global markets started bouncing up from March 2009, in India we had the election outcome which muddled the situation; so hard to say because of elections or whatnot, but globally markets rallying and every market guru was scratching their heads that this is so much to worry about all around. Why are the markets going up in a straight line and some of them still continue to scratch their heads. At that time, people had said U.S. is going to be the next Japan. Some of the macro gurus said that the U.S. dollar’s in the long term is zero. And since then, like I’ve kept saying that the U.S. has been the best economy, best equity market and the best currency. So, the markets in 2009 saw ahead of what anybody else could see and the same is true today as well. So, let’s hope the market is right and things indeed are very good beyond the horizon.