Alpha Moguls | Prashant Khemka Has A Unique Way Of Valuing Companies
Weighing Scales | Photographer: Angelos Tzortzinis/Bloomberg

Alpha Moguls | Prashant Khemka Has A Unique Way Of Valuing Companies

Prashant Khemka looks at cash flows in a company to arrive at a valuation, but not like everyone else.

He relies on what he calls an asset-light cash flow to value businesses, sectors and countries, said Khemka, founder of White Oak Capital Management LLP that manages Rs 8,300 crore in assets. Khemka splits a company into two: the part which houses the assets and the working capital; and operating company that uses those assets.

The operating company would pay the asset-heavy company the cost of capital, he said on BloombergQuint’s special series Alpha Moguls. “Once you can project the excess return on invested capital, the present value of the excess capital would help in determining the value of the company.”

This model, according to Khemka, helps in correctly valuing the capital intensity of a business and judging the capital structure. And he doesn’t use price-to-earnings multiples. “We may investigate a company, invest in it, for years own it and then sell out without looking at PE multiples at all.”

The PE-based investing is faulty, he said, because it can be distorted and is misleading as the multiple neither normalises for capital structure of the balance sheet, nor for capital intensity. And a lot of times, he said, White Oak found that a company that may appear expensive based on PE multiples but looks reasonable on the asset-light cash flow model.

Bets On Growth

With the elections out the way, Khemka said the backdrop for earnings and growth was in place.

“Earnings growth mirroring nominal GDP growth is a very normal occurrence in a lot of major economies, and therefore 12-13 percent earnings growth is not abnormal,” he said. “Getting back to the corporate profitability cycle would itself lead to earnings growth pickup.”

This is because the normalisation of return-on-equity of corporate banks will take care of the earnings growth delivery, he said. The time is ripe for earnings growth to exceed the last five-year average and it should be front-ended when measured over a period of the next five years, according him.

The Sectors He Likes

Khemka said non-bank lenders and select consumer companies provide reasonable opportunities at valuations which are selectively comfortable. Consumer staples present several opportunities because the consumer in India is consuming lesser than most emerging peers. Moreover, if India would stick to its current growth rates, a lot of services like travel and tourism are saturated in the world but are at a very nascent stage in India, providing multiple years of possible earnings growth.

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Here are the edited excerpts from the interview:

Now the big event is out of the way and we know the finance minister. How does the medium-term, long-term, and near-term look like?

One of the best outcomes of the election is that at least the risk of having an unstable government is out of the way. And definitely with this government one can expect continuity of the last five years and continuity of the reform process. I think the backdrop for the equity markets for corporate earnings is benign. The micro was already in good shape as it concerns fiscal deficit or current account deficit, inflation. Yes, there is a bit of a slowdown, but I think with the political backdrop stabilising or settled now for the next five years, those should improve as well. And we would expect finally after 10 years of earnings lull—mid- single-digit growth. As I have been saying for the last five years, we are at the cusp of earnings acceleration. But I do think, for corporate earnings, the backdrop is solid to accelerate from here and at least exceed the long-term average of 12-14 percent that we have experienced over the last 25 years.

Front-ended or back-ended for the next five years?

For the next five years, I would say it should be a bit more front-ended because we are coming of a 10-year lull. Earnings will probably end up in high single-digit to low double-digit. From here, if most expectations consensus is for 20 percent-plus, it sounds very high but half of that is just normalisation of corporate banks like the leading large corporate banks and normalisation of their return-on-equities from zero or close to zero level. So, that itself should contribute about 10 percentage points and that is lot more certain than the rest of the non-corporate bank’s earnings. If the rest grows even at the mid- to high single-digits, we should get low double-digit earnings growth next year. Our expectation should be around mid-teens and from there I think we can build further in the mid- to high-teens range. And while it sounds fairly optimistic and bullish but remember our 25-year average is 12-13 percent which is in line with nominal GDP growth rate. So, it’s not anything heroic. Being in line with nominal GDP growth rate is also the experience of many major economies or markets. So, it’s no different in India. It has been the case for last 25 years, but it doesn’t come as straight line like nominal GDP. You go through years of mid- to low single-digit earnings growth and then years of 25 percent-plus earnings growth. And in India at least in last 25-30 years, the lull period has been longer, but you had three to five years of very strong earnings growth. In 2003-2008, the Sensex earnings growth was 25 percent which was preceded by six to seven years of low single-digit earnings growth. So, expecting mid- to high-teens is not a big stretch when you put it in that context.

You have seen many global markets as well because you used to manage global portfolios. How does it happen that in some of the other economies when post a long period of earnings lull the earnings bounce back if the indeed GDP growth is more or less stable? Let’s work on assumption that GDP does not go up to 9 percent but keeps on rendering at 6.5-7.5 percent. After 10 years of earnings lull, do earnings bounce back very swiftly? There is a lack of direct correlation between what economy does and what Nifty earnings show, because the last portion of economy is not reflected in Nifty in any way.

Each case is different and many times you would find earnings jumping sharply. But if you take emerging markets, few of them are very closely tied to the commodity cycle. So, if a commodity cycle turns around sharply from down to upturn, you will find these economies or corporate sectors in those economies do very well and the earnings growth accelerates because it’s not just the weight of the commodity.

Look at Brazil. Weight of the commodity sector in the benchmark or markets is not very high. Vale and others are not very large companies but it’s not like Russia where commodities might make up 75 percent of the markets. But even in Brazil, the banks supply credit to the commodity companies. There are large numbers of industrial and transportation companies which supply industrial equipment and services to these companies. When you add those up, 40-50 percent of corporate sector earnings may be highly co-related with the commodities sector. So, commodity iron ore prices going up from 30 bucks to 75 bucks not only improves the corporate earnings for Vale and others, but also helps the banks and the asset quality of the banks. That’s because those banks are lending to many of the smaller companies in iron ore business or companies that are supplying iron ore.

So, there is that cyclical linkage in some economies. Similarly, other economies may have different cyclical factors... Again, depends on what’s the universe you look at. I looked at the broad corporate sector. The average, if we have any kind of mean reversion even to 4-5 percent range, that’s a 50-60 percent recalibration of earnings from their current levels. On top of that, you have 12-13 percent nominal GDP growth rate. So, let’s say there is one percentage point increase in corporate profitability— if and when that happens that would add 33 percent cumulatively to the 12-15 percent nominal GDP growth rate. Now if that recalibration happens in three years that would add 10 percentage points each year and if that happens in five years it would add 6-7 percentage points each year.

Let’s assume the backdrop is set and the market will grow earnings at a satisfactory pace. What do you—as someone seeking alpha for clients—do in such a scenario? How do you go about picking those winners in order to do much better than ideally the benchmarks?

If you beat the benchmark but every other peer group has beaten you, you are no good. I would say what we do in is no different in the scenario we talked about than the scenario we talked about in last 10 years. Even over the last 10 years, what we talked about is the averages of low single digits. There have been companies which have set themselves apart and been untouched. If you see those companies, you will feel like we went through a sluggish earnings environment.

The team has stock-selection driven, bottom-up investment philosophy, which is—simply stated—that outsized returns are earned overtime by investing in great businesses at attractive values. Now two key elements in this are— business and value. Where we see as most powerful combination of the two is where we want to invest or stay invested. Otherwise stay on the sidelines and look for other opportunities. At all times in markets, there are these opportunities that are available. Some might be more obvious, and most are less obvious. Now everyone says great business, attractive values—which sounds simple. It is in one way very simple, yet to execute is extremely difficult.

But coming back to what we consider as great business, it the business, among others, that has these three attributes. One, superior returns on incremental capital, which is a pre-requisite to generate free cash flow sustainably and hence, we talk about incremental capital. So, sustainable free cash flow generations as an outcome of superior returns on incremental capital. Second, scalability—whether business can be much larger, multiple times larger than what it is today, relative to the economy or other companies in the sector or broadly the corporate sector. So, can relative size of the business be much larger compared to the rest of the corporates. Third, well management in terms of execution so that the potential for superior returns and growth are delivered. Execution has to be with a long-term value creation focus. For example, there were at least more than a dozen banking licences given out in mid 90s. One of them has grown to become a $100 billion of value creation, while others floundered along the way or went bankrupt or had to be bailed out by better banks. So, execution is very critical.

Management may be the most critical of all. If governance is not adequate, then the cashflows that we talked about, they don’t truly belong in their fair proportion to the minority shareholders and ultimately, we are minority shareholders. So, all the attributes are present but if governance is lacking then it is a great business but only for the controlling shareholder and not for the minority shareholders because there is no sanctity to valuation. Because we as minority shareholders don’t know how much of cash flow we are going to receive. If all these are present in terms of attributes, it’s critical to buy at a prize that is substantially lower than fair value. Otherwise it’s a great business but may not be a great investment. When it comes to valuation, our framework is very cash flow-centric. The two key matrix that we use in our assessment is DCF and asset light cash flow multiples.

Now, asset light—not to go into details— but basically, we look at every company comprising two firms. One is the asset heavy component, which is where all assets and working capital rose and others which uses those assets and operating company pays the appropriate cost. This breakup is how we would access. This forms the basis of valuation input for every decision that we make. We don’t look at PE multiples at all. We may investigate a company, invest in it for years, own it and sell out without ever talking or mentioning PE multiples.

How do you judge if a company is looking expensive or otherwise?

It is on the asset light cash flow multiples. Let’s take a manufacturing business or a tyremaker. It has a manufacturing plant. It would need working capital as well. In our analytical framework, we will house those in a so-called ‘Finco’ of the company. The ‘Opco’ would be asset light in our construct and for the use of this assets would pay a cost of the capital and the amortisation over the economic life of assets. From the ‘Opco’ flow of the overall company, once the operating company pays the cost of capital for use of net block in working capital and then after paying taxes what is left is what we call— asset light free cash flow. So, the business or the entity is effectively broken into the invested capital, which is the Finco and the asset light cash flow since the cost of capital is already paid is nothing but it reflects the excess return on invested capital. So, it is tied back to the first attribute that I talked about, that we look for in a business superior return on incremental capital.

So, asset light cash flow reflects excess return on invested capital for any given year. Once you take it out and project it for future years, the present value of those asset light cash flows would reflect the overall value in the enterprise of excess return on invested capital. The sum total of invested capital and excess return is the enterprise value.

You use this framework for more than 90 percent of your businesses.

All the companies, without exceptions. It is something which the team adheres to in a very disciplined manner. It provides multiple insights, including the mix of how much is the value of invested capital it sells. If a tyre company or any company dumps a billion dollar of capital into plant and machinery, a billion dollar is just from capital. What does the value added by management, by brand, by network affect whatever is captured here? Asset light cash flow is a lot more comparable like apples to apples. When compared within the sector or across sectors and lends useful insights rather than PE multiple which can be distorted and misleading. Because PE multiple is neither normalised for the capital structure of the balance sheet that equity makes, nor does it normalise for capital intensity of the businesses even within the same sector. Whereas, this construct normalises for capital structure of balance sheet as well as normalises for capital intensity.

How do you go about choosing non-manufacturing financial businesses. You buy businesses with good valuation and you have model for selecting companies.

When you look at PE multiples or price to book, financials are a little different. The same approach can be applied to financials as well. If you do it then the distinction between valuations will not be as much as you would think when looking at PE multiples or price to book multiples. Same is true for non-manufacturing or manufacturing companies. This is even true at a country level valuation. So, if you apply same approach to China as a whole or India as a whole, after cost of capital the multiple between the two on an asset light basis would not be different as it may appear on a price to earnings.

Let’s go back to the tyre company example. So, there may be two tyre companies. One that is very low return on incremental capital and the other with high return on increment capital. Now the PE multiple of a company that has low returns on incremental capital would be very low and the PE multiple, likely, of a company with a strong return on incremental capital will be higher. On the surface it will look like this is cheap and other is expensive. It is good but it is priced very expensively. When you break it down on asset light multiple basis, it is possible, on an asset light multiple it would turn out to be a lower multiple. I am not saying universally that it is the case but the company with high PE multiple is actually lower asset light price to free cash flow multiple, whereas, the company on surface may have lower PE multiple is higher on asset light multiple.

The two components, you look the investment capital and excess return. Invested capital is a very low multiple component and the excess return is a very high multiple component. So, a business that is dominated by the low component element, which would be the case if the return on investment capital is low, then the overall multiple of the combined ought to be lower. And a company where it dominates— the excess return element—there the overall multiple ought to be higher, deservedly so. It’s not that it is expensive, it is just two different components that you are valuing and ought to be valued differently.

When you see business in India with that prism, how does the optically expensive companies look like?

There is no standard answer. Within our construct, there are companies which are expensive and there are companies which are attractively valued. In staples, most companies trade between 40-60 multiple. Within that, some companies would look attractive on asset-light basis whereas others may not look attractive in that asset light construct. In Sensex, the asset-light multiples are in 30s. When you look at PE multiple of a consumer staple company at 50 compared to PE multiple of Sensex at 19-20, it is 2.5 times or more and it looks very expensive. When you compare the asset-light multiples, it may be that the Sensex is in 30s or 35 and the asset light multiple of the staple company is still 50. It is at a premium for various other reasons like better business models, sustainable return from capital, well governed compared to average Sensex. But the disparity goes down from 2.5 times to less than 1.5 times. Premium goes down. On a PE basis what appears like 150 percent premium goes down to less than 50 percent premium.

Would you believe that optically, HDFC bank or Bajaj Finance may look expensive or via your model they look considerably less expensive?

I will not make a universal statement but several names which you have mentioned will look lot more attractive than when looked at PE multiples which are misleading.

Until the IL&FS crisis happened, you stayed away from NBFCs. What is the current stance and why has it changed?

Pre-IL&FS, the NBFC sector had become the most-fancied industry and the valuations had become extremely stretched when looked at any model including ours. So, we struggle to find any attractive opportunity. Whatever the team had, they exited over the months leading into September. There were half a dozen people I knew who had applied for an NBFC license and they had nothing to do with NBFCs. It was reminiscent of the 2007 real-estate boom or 2000-boom where everyone was starting a dotcom. That was an anecdotal but strong indicator.

In September-October, it brought down valuations of all NBFCs and presented an attractive opportunity to the team. When an industry corrects like this, it may be beneficial to some NBFCs. Prior to the crisis in June-July, our worry was that so many NBFCs are coming in and so much capital is being raised and chasing similar lines of business that even the best house in industry would likely suffer when so much capital is chasing. Valuations are high and there is some deterioration in competitive outlook. Whereas post crisis in October-November, valuations had sharply corrected in most cases. At the same time, the competitive outlook for the better run companies had tremendously improved because capital became scarce. So, lot of existing competitors and most new competitors would not see light of the day or be lot less of a competitor. Hence, the team was able to find some of the names that it always believed were attractive and great businesses, but they also were able to find valuations attractive after that.

Do you have view on consumers and what that space will do?

We don’t have top-down sectoral views. In any sector, there are companies which you can find to invest in. In NBFCs, we had a lot of investment and even in private banks our team always has high exposure. So, broadly the financial sector is very well invested.

Similarly, in consumer, like any other sector, there are always great opportunities available at attractive valuations. On the other side, there are companies with bad models and are overvalued. So, we are trying to find attractive ones.

At an industry level, India is consuming a lot less than most emerging markets in the world. As standards of living improve, one can argue with the pace of standard of living but we can more than double the standard of living every 10 years in real terms if we grow at 7-8 percent real GDP. It leads to an increased consumption. A lot of goods and services which are well saturated globally are at nascent stages in India. Travel is an example. Your viewers may be well travelled but when you see an average Indian consumer at more than $2,000 standard of living level, their travel is very limited. For most of the times, it is for family emergencies, or pilgrimages. The discretionary travel element is very minimum—empirical evidence suggest for 100 or more countries around the world. As standard of living measured by per capita income starts moving upwards, the $2,000 goes to $3,000 and to $8,000, which we will see in next 10-20 years.

You will see spending on the services grow exponentially. You have to find which are the companies that can generate sustainable superior return on capital... When a company is beaten down and the valuations is low, nothing else is different. But the valuation is low, people think there must be something wrong and it is not a great business. If nothing else changes but the multiple doubles, people may say that it must be a great company because it is trading at a very high multiple. So, great business does not necessarily mean high valuations.

How do you think the global investors wants to put money in other emerging markets looking at India right now? Because the common refrain we hear is that India is expensive.

I would agree that there is merit to look at them because the earnings are depressed. Price-to-book will be the better option. Let’s look at other times. Historically, that refrain has always been there and quite likely always will be there because India is quite different in this case and far superior as a mix of underlying assets. When people say India multiple versus China multiple, they are referring to MSEI India and MSEI China and MSEI Russia and other MSEI EM. Now these are apples to lemons in comparison.

There are many differences. One is the extent of government ownership of the market and the market being MSEI indices. In China, the government ownership is about two-thirds of the MSEI China. In India, it is high single digits. EM average is close to 30 percent. Globally, for good reason, government-owned companies trade at a small fraction of their privately-run counterparts.

Take banking sector for example in India and China and everywhere. Globally, government-ownership, from Korea to Mexico and Russia to South Africa, is synonymous with sub-optimal governance. Companies with poor governance, be it private or government, trade at a fractions of multiples. So, if you adjust this one factor, the apparent headline or superficial on the surface difference between multiple of India and China would more or less be eliminated. So, compare a well-run private company; let’s say a well -run private sector bank in India with a well- run private sector bank in China which doesn’t exist. In China, 30 percent is government-owned. So, if you just adjust the banking component from the overall index multiple, that would chop off four multiple points difference between India and China out of apparent 9-10 multiple. Then you do the same in other sectors.

Technology as a sector is the largest in India after banking in which is at 15-20 percent. In India, the technology sector has a very high return and is a steady cash flow growth industry. The earnings to cash flow conversion are more than 80 percent and deserving of a lot more multiples and to trade that way globally and in the ADR market as well. In Taiwan, Korea or China, the technology industry is very hardware intensive and capital intensive where returns on capital are muted and barely in double digits and highly cyclical. That compares to India where you have high returns on capital. Let’s say 2008 global financial crises, Indian IT industry grew in earnings while Taiwan, Korea got decimated. So, they deservingly trade at different multiples. So, there are many nuances which you have to correct. Otherwise it is the same as comparing Google versus Exxon and I am being somewhat generous when I call some of the other EMs Exxon and when I call India as Google, but it is apples to lemons.

So, may be optically high PE multiple is not a concern and the situation seems to be set for earnings to come back and therefore good time for investors for next five years in India.

It’s always a good time to invest in India but now even more. The alpha component is potentially much bigger in India and that’s what sets India apart compared to other EM’s or developed markets for sure.

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