Alpha Moguls | Three Filters Saurabh Mukherjea Uses To Identify Companies To Invest In

I would say, it’s not just me but there’s a group of us who work together. This co-group has been together for the best part of 15 years now. So, for most of our lives, we’ve been working with each other. As a result, what’s happened is whatever we do is an amalgamation of our skill sets. I have some strengths, I have some weaknesses. Pramod has strengths, he also has weaknesses. Rakshit has strengths and weaknesses. So, if you put the group together, and not surprisingly, I’ve talked in the victory project about this part that collaboration is the essence of success in highly creative and competitive industries. Therefore by working together for over 15 years, we’ve been able to build a unit where each of our strengths comes together and creates a sum which is greater than the sum of the parts. So two plus two is five, not because of anything great I am doing but because all of us have come together and pooled our strengths together which makes for a unique style of investing.

The second thing is all of us, I suppose to some extent are birds of a feather who flock together. So all of us are more bent towards reading, more bent towards a slightly intellectual turn of mind and it so happens in this job that orientation actually is quite helpful. So just like if you want to be a great basketball player, it helps to be six feet five or above. Similarly, if you want to be a successful fund manager, it helps to be a person who likes reading endlessly because what the stock market across the world does is; the stock market over emphasizes short-term factors and under emphasises longer-term factors. If you’re therefore someone who naturally cuts out noise, if you’re someone who’s naturally introverted who just likes reading and thinking, you’re able to play to your strengths and the stock market’s weaknesses.

Let’s just use that prism of reading to sort of think through why reading is so powerful. So, let’s start with this observation, Charlie Munger made this observation famously. Charlie Munger says that he has never met a smart person in his life who does not read non-stop. Now, why does he say that? So reading does three very powerful things from the context of an investor. Firstly, it develops your neural networks and the development of the neural network allows you to think deeper. So for example, if I take my colleague Tej Shah, the depth at which Tej is able to think through forensic accounting of Indian lenders arises from not just the fact that he’s a chartered accountant, but also from the fact that is a chartered accountant who reads decade or more of annual reports of lenders before Marcellus takes positions in those lenders. So, it’s a combination of someone doing the reading, doing it over long periods of time over several years, the neural networks and the brain strengthening allowing my colleague to go deeper and to think deeper about accounting of the lenders in whom we might take stakes. So, that’s the first benefit of reading. It forces you to develop your mental muscles, so to speak. Just as a gymnast who sort of goes to the gym and works out for decades on and ends up with an exaggerated upper body, similarly a reader who reads non-stop, the brain expands, thankfully you and I can’t see the expansion of the neural networks.

The second benefit of reading is, if you’re going to be allocating a heavy duty part of your time to reading, necessarily you’ll have less time for the noise. You’ll have less time to sort of ponder over the P/E multiple and say P/E is less or more, you have less time to figure out what is the latest Covid death count in India and how do we compare to Brazil and China and so on. You’ll have less time to figure out what is the latest from the RBI or the Federal Reserve. So, by focusing on reading you’re de-emphasising noise and by de-emphasising noise, you’re reducing portfolio. We are all human beings right? If I sit in front of a trading terminal all day long and I keep looking at prices and P/E multiples and the latest news flash from central banks and latest earnings announcements, obviously my mind will get more inclined to trade and go with the market opinion. By reading you’re cutting yourself off and not only is your brain getting stronger and your neural network is getting deeper but you’re also focusing less on the news flow which is driving the herd. That’s the second benefit.

I think the third benefit of reading is if you’re able to see a company’s numbers or its annual report over 10-15 years, if you’re able to see long cuts of data, the world reveals itself to you in ways that others can’t see and I’ll give you a simple example of this in the context of cricket. So when I was a 17-18, 19-20 year old I used to work in a betting shop over the weekends to earn some money for my college education and I used to notice that there was a small group of betters who would come first thing in the morning at 9 o’clock. They would come into the shop and place their bets for the day and then they would go home. Then, I won’t see them and the next morning they would come to collect their winnings. I used to notice that there were a couple of these guys who used to win every day at a very high hit rate. They would bet once and have a very high hit rate. The rest of the fellows would be standing there all day in the betting shop but would not get money. So I asked one of these British guys I remember I was 17 or 18, I asked him how do you do it? How come you know which bet to put on in the morning and you win with a high degree of certainty. So he taught me something I’ll never forget. He said, I follow the same routine every day. I wake up at five or six in the morning, sit down with a big cup of coffee and I read the sports pages of newspapers. I’ve been doing this for 20 years. So as a result I’m able to see simple patterns that others can’t see. So, one pattern he taught me was, he said whenever India plays England at Lord’s in a test match, if Dilip Vengsarkar plays, you should always bet on him getting a century. So the logic was simple. I’ve seen him play for the last for the last 10 years. This conversation took place around 1992-1993. He said, I’ve seen Vengsarkar come to England over the last 10-11 years. Whenever India plays England in Lord’s and Vengsarkar plays, he gets a 100 and it’s actually true. I checked on Cricinfo, it is true. That taught me that just the simple fact that this guy’s been reading the sports pages for 20 years allows him to make money. Similarly, if we read or your viewers read the same company’s annual reports for 10-15 years, they will spot stories and patterns that even the most seasoned fund manager can’t see. That is the benefit of long cuts or long sweeps of reading.

So there are two ways to do channel checks, right. The industry euphemism is channel checks. One is to say, “Dhanda kaise chal raha hai?” (how’s the business going?), what will happen this quarter, that’s the typical channel check most fund managers do. Our preference is to do a different type of channel check. So, let’s take an example of a stock we have in some portfolios – Maruti. To do Maruti channel checks, we would not be that interested to know what will happen to Maruti this quarter or indeed this year. That has very little but we’re more interested in, over the last 3, 5-10 years, what systems and process improvements has Maruti put in place which you as a dealer are benefitting from. Compared to what say Hyundai is doing, has Maruti done some things fundamentally better or worse over the last three or five years. In terms of the quality of Maruti staff who come to engage with you Mr. dealer, what have you seen? Has the quality of staff improved or has the quality of staff deteriorated? In terms of the degree of support you get from Maruti – whether it’s tech support or financial support or support for the rental cost of the dealership –has there been a fundamental change in view over the last three or four years. Those are far deeper insights into Maruti’s competitive advantages than knowing what will be the sales number for Maruti in October–November or indeed this year.

One another interesting thing is we don’t ask about “maal bika hai ki nahi” (if the inventory is sold or not) but we make a note of which companies’ dealers are really focused on telling us that maal bik raha hai ya nahi bik raha because that itself tells you a big part of the mindset. A company which is just focused on showing the numbers and running the stock is something that our channel checks tell us to get wary about.

"One of the most interesting things about living in India and investing in companies over long periods of time is, you realise that some companies end up with incredibly good dealer networks. Talking to the dealer is almost like talking to the CEO of a BSE small cap company."

The quality of the dealer is so good in some companies’ cases and actually Maruti is a good example. Some of the Maruti dealers are so evolved in their thinking that it’s almost like talking to the CEO of a small cap company. That tells you far more about the company than that quarter’s sales number will tell you.

Let’s just step back a bit. I don’t think anybody can, you can’t go to one shop and say, sell me completely different types of investment products right. In our case, our investment philosophy is identical across all products, which is look for companies – whether they are large-cap, small-cap, financials, FMCG, pharma – that satisfy three broad criteria.

The first criteria is the books have got to be clean. That’s the 10-15 years of forensics.

If the promoters are stealing money then we have no interest regardless of how hot the sector or the stock might be. If the promoters are stealing money as per our forensics, then we’re going to be running away as far as possible from the company.

The second is we try to, as much as possible, focus on investing in companies which are selling products or services which are essential for life in our country.

We try to avoid sectors which are commoditised in the sense of metals, cement, real estate, infrastructure and cyclical sectors with heavy commodity orientation. We also try to avoid luxury oriented sectors. So, as much as possible, essential products and services.

And the third criteria is that we look for monopolies. Whether your market cap is half a billion or 100 billion, we need you to be as close to being a perfect monopolist for us to take a large position.

So, we find that, that if you apply this philosophy, you can do this in large-cap, small-cap and mid-cap. For instance, in Aliphatic Amines, Alkyl Amines is as much of a dominant position as say a Pidilite or Asian Paints has in the context of paints. Similarly, in glass line vessels, GMM Pfaudler has as much of a dominant position as Nestlé has in baby milk powder. Now yes, Nestlé’s market cap is $23 billion and GMM Pfaudler is a billion dollars, but they are fundamentally the same franchises and therefore the investment philosophy is consistent.

"Now, if the investment philosophy is cleanliness, essentiality and dominance, therefore it stands to reason that the checking which is the primary data work, the discussions with distributors, dealers, ex-employees, competitors and management consultants will also be very similar. "

That actually allows us to underpin a common investment culture across the whole portfolio, across all our analysts and fund managers.

So most things get eliminated in our country. So, like I said, we are looking for essentiality products which are essential in day-to-day life and we’re also looking for dominant franchises.

No, we still would not be interested. There can be as many upticks as they want in a sector. Let’s take three sectors where upticks can be non-stop but it’s not going to be of interest for us – airlines, steel and telecom.

None of these sectors have produced companies which can generate a return on capital above cost of capital on a steady basis. So it’s entirely possible that there will be an uptick in the airline sector as we come out of Covid, but it’s not in our skill set to second guess that. There might be really smart people out there who can second guess the airline sector but we can’t; and similarly with steel and telecom. So, we’ll stay away and we’ll focus on our strengths. You play to your strengths right, while other people have other strengths, let them play to theirs.

So, that distinction is very specious. So that’s a devastating distinction and I think it destroys a lot of people in our country. So the good business-bad stock distinction only applies to people who don’t really figure out what is a good business. Let’s take two examples. Let’s take an extremely simple business – Nestle. The bulk of their cash flows, we estimate that 80-85% of their cash flows come from selling infant milk powder. The infant milk powder business in our country grows at around 15 to 20% per annum, has done so for a long period of time and looking at other countries that are twice as rich as us or thrice as rich as us saw some per capita income is also very tangible evidence. They are all the way up to $10,000 per capita income – 5X of where we are. This baby milk power market continues to grow twice or thrice as fast as GDP. So the growth runway is clear. One company has 95-96% share, Nestle derives 85% of their cash flow. So clearly, it is good business. Even at 220 times P/E multiple, Nestle is a good stock and it’s quite easy to actually show that math. So, let’s assume that Nestle continues gunning out dividend yield plus earnings growth. Let’s assume it stays in the vicinity of 20-22%, been like that for a long time. Even if the P/E multiple halves on Nestle, so if dividend yield plus earnings growth is say 20-22%, then even if the P/E multiple halves on Nestle in the next 10 years, we will still take home 15-16% returns on Nestle, which is higher than my cost of capital for a typical client.

So, this is one example where a good business is a good stock even at P/E multiples significantly north of where we are today.

Where a lot of people get stuck in our country is on names like Maruti Suzuki. Maruti Suzuki while it’s dominant in the small car market, if you take market share they have 50-55% of the small car market. In a 10-year cycle, Maruti will have four rough years. It’s an auto company and can’t help it. In those four rough years, obviously the P/E multiple halves in those four, five, six years and then in those four rough years, the earnings growth also disappears. So obviously if you buy Maruti in the sixth year of its six-year bull run or the seventh year of the seven-year bull run, in the next three-four years the earnings will tank off and the P/E will half.

Then you will turn around and say, I told you it is a good business but not good stock. So, as this takes us back to what we were discussing five minutes ago, there’s around 20-25 companies in our country whose dominance of their industries is such that even if you buy these companies at a substantially higher P/E multiples than they are today, we still make money. Unfortunately, the rest of the stock market 90-odd percent of the stock market is such that, you can buy them at any P/E multiple you want, it’s close to impossible to make money for any return because for the vast majority of listed companies, 80-90%, return on capital will never exceed cost to capital.

So investing in these stocks is like putting petrol in a car without an engine because there’s a kind of a hood over it you don’t realise and you just keep pumping life savings into these stocks.

It’s like putting petrol in the car with no engine and the money is going into a gutter. That’s the most devastating aspect of investing in our country. A lot of people and a lot of pundits go and hog this investing dogma taken from Benjamin Graham and taken from the American stock market but it works over there. What Ben Graham did, works especially in the Great Depression era in America at work. Warren Buffett amended it for the more prosperous America of the 80s-90s and made his name on it. What a lot of people in our country have done is, taken that and implemented it without understanding that in our country the economic landscape is fundamentally different.

So let’s start by focusing more generally on life. Whether you’re buying a shirt, a car, a stock or a house; whenever you find yourself obsessing about price, that’s an immediate sign that you don’t actually understand what you’re buying. Now, why does the human mind look at price as a determinant of what to buy, because the human mind is implicitly telling the buyer that you don’t quite understand any other inherent characteristic of the shirt or the car or the house or the stock you’re buying and hence, you’re defaulting. You’re defaulting to use the price for the heuristic. So, whoever is out there, you’re investing or you’re buying a house or a car or a shirt – remember this, this has served me great – whenever I find myself thinking too much about the price of whatever I’m buying whether it’s a stock or a shirt, it’s a signal to me that I don’t know how to buy shirts. Now, I agree and I confess I don’t know, but my wife does and therefore she does the shirt shopping. Neither of us know how to buy cars so we don’t buy cars and we have the same clapped out car for the last 12 years. So, that’s the first thing to sort of realise.

So there’s two ways to look at it. One way is to say that diversification is a good thing we should all do it and I have a degree of sympathy with that view, especially if, like me, you are at a stage in life, when you might have children going abroad to study and so on. So it might make sense to have, depending on your corpus and your stage of life, say perhaps, 10-15% of your portfolio in overseas stocks. So, that’s the sort of the financial planner in me. I’m no great financial planner but if I was one maybe on that basis maybe I’d have 10-15% but I certainly wouldn’t do it myself. I don’t think anybody in India should be going and punting on these stocks themselves.

You’re out of your mind if you think you can sit in India and punt on global stocks and make money.

Find a really high quality global fund. In our office we found a couple of funds outside India which are very similar to what we do in India; which are clean companies, monopoly franchises, essential products and we and some of our colleagues are getting our money to these fund managers.

We think ITC is an incredibly powerful franchise. Not just because of cigarettes, which is probably one of the greatest monopolies ever built in India, but also because of the way that ITC has scaled up FMCG in the last six-seven years reflects very well on the company and their execution competence.