Alpha Moguls | Prashant Khemka On Key Investment Themes And How To Deal With Macro Shocks
Trying to make gains out of macro events would amount to a punt, according to Prashant Khemka, founder of White Oak Capital Management. But he has a strategy for it.
The firm, managing around $5.9 billion worth of investor money, prefers to keep a balanced portfolio approach that can withstand the unfolding effects of macro shocks, while helping the portfolio outperform in a good market, Khemka told BloombergQuint’s Niraj Shah in a special series Alpha Moguls.
White Oak, he said, didn’t have to and didn’t make very large changes to the portfolios it manages during Covid-19 or even as the pandemic recedes. “Yes, the team had done some changes, but they were not more than 3–4% of the overall portfolio.”
Khemka lists corporate governance as the biggest factor that determines the companies picked by his portfolio management firm. That results in the portfolios being heavily overweight on technology and private financials. And while he is positive on real estate, valuations and corporate governance issues mean White Oak has picked only one stock from this sector.
Khemka also likes the renewable and electric vehicle push but doesn't see too many companies with the right valuations yet.
Watch the full interview here:
Read the edited transcript here:
Uncertainty seems to be the name of the game. How are you looking at the current landscape, where for an investor, aside from the tapering and rate questions, the advent of newer Covid-19 variants are also adding to the pieces of the puzzle?
PRASHANT KHEMKA: Our view is that these macro-market-related factors are completely unpredictable. There are two ways of addressing it.
One way is to try to make some money out of this situation. So let me position the portfolio like this: Covid-19 is going to get much worse, so let me get defensive; Covid-19 is going to get fixed, so let me get aggressive. In our firm belief, all these don’t add any value whatsoever, over time.
In the near term, they’re like coin flips and in the long term or short term, they’re like the coin going in your favour or going against you. You can make a lot of money or lose a lot of money, but in the long run, over 100 such events, you are likely to get 50 heads and 50 tails. If you’re trying to chase coin flips, you are basically standing still in a world with no transaction costs, no taxes, no other impact cost.
When you add all these costs, you have made it like playing Seven Up Seven Down (betting on numbers more than or less than seven) in a casino. You would, over a period of time, end up losing the seven to the house.
So, that’s one way of chasing this macro which does not add value. It actually loses value over time and introduces a lot of volatility in the near term and losses in the long term. And that’s something we consciously avoid.
The other way to address these risks is to make sure that your portfolio is not unintentionally exposed to any such major event evolving in one direction or the other. Let’s say your portfolio is extremely conservative or defensive, then it would benefit if Covid-19 gets much worse or the Fed increases the rate in an unanticipated manner or inflation expectations spike… Or, let’s say if the U.S. 10-year bonds yield goes from one-and-a-half to three or four in no time, in a month or so. If such things happen, the market may be down in double digits; and if your portfolio is very defensive, then it will benefit from such situations.
But it will also get hurt in the reverse direction. If the market were to rally or if the U.S. bond goes to zero instead of 10-year bond yield going to 3%—in such a market, your portfolio will suffer. So, how do you safeguard your portfolio? We safeguard the portfolio by making sure that it is well-balanced.
Balanced portfolio means that in case the market moves, it does not lead to outperformance or underperformance. So, in this case, giving a hypothetical example, let’s say you managed to have a perfectly one beta. Our aim is not to neutralize all these numbers, but we won’t be 0.58 or 1.5. Let’s say if you are around 0.8 or 0.9, which is what we end up with, then you neutralised the market risk, even if market risk is one form of macro risk.
Then, there are more specific risks like currency risk. So, if you have a portfolio that is completely made up of export-oriented companies like the IT or pharma sector, there is a risk that if currency appreciates sharply in a year, your portfolio would substantially underperform.
Now, some people make it as a proactive bet that currency is going to appreciate and so, let’s avoid investing in IT and pharma. We don’t have a clue what currency is going to do. Nobody does. So let’s make sure you are not taking an unnecessary risk on it.
The portfolio should have a good balance between export-oriented companies as well as domestic focused companies. In that way, you can neutralise the (uncertainty around) currency. Covid is also an individual risk factor.
So, for most of these factors, the folio tends to be in good balance. It will never be perfectly balanced, unless you are indexing. But you can be in good balance with a very high alpha potential.
Have you changed the alignment of your portfolio considerably, at some point of time? Are you doing that considering there is a risk of taper in interest rate plus the Omicron variant?
PRASHANT KHEMKA: My comment and our team’s viewpoint on this is two times is the best alignment at all times or the best positioning for the consumer. The best positioning for a portfolio to be in, is that which never requires repositioning. Now, that’s easier said than done.
Does that mean that you did not alter the portfolio strategy too much or at all in the last 24 months?
PRASHANT KHEMKA: That’s true. And “too much” is an important point. I can’t say the team has done zero, because there was never perfect alignment. It can’t be a perfect alignment especially when (there are) risks like Covid-19.
For taper and the Fed, we were in perfect alignment. We don’t care if it doesn’t taper, or interest rates go up or down. It won’t impact our portfolio. Any differential in the market, we can outperform in either environment. But Covid-19 was the first time a risk appeared in our lifetime that was never imagined.
But when you are in good balance to a variety of different factors, you would end up being in decent balance to enter even if a new risk factor emerges. But not in as good a balance as you might want.
When Covid-19 emerged, the team felt that in certain pockets, we have a greater degree of exposure. If Covid became a doomsday scenario, our portfolio would be more exposed in that direction potentially. We are talking about 2-4% changes to the portfolio and not 20-30%.
The best quarter for the team, in terms of performance, was the first quarter of 2020. Over the last 4.5 years, stock selection was extremely strong. January and February were super-strong even before Covid-19. And in March, the team did not lose, did not underperform even when the markets nosedived. It might have slightly outperformed, but January and February were very strong. It was the best quarter in the team system, so it wasn’t a big shift that the team had to make.
Covid-19 is now a known risk, unlike in February-March 2020 when it struck. So, the team had to move 3-4% of the portfolio. Now, since it is a known risk, the team didn’t make a change for the risk related to Omicron.
With the responsibility of $6 billion of investors’ money and countries moving to impose travel bans as the fear of Omicron looms, what is the mental model for dealing with it?
PRASHANT KHEMKA: Our effort is to outperform everyone else but we can’t see what everyone is doing or outperform every individual in the peer group over a short period of time. In the long term, the market is the average of the (performance) of peer groups. The client can invest with anyone in the market.
We have to deliver the highest returns to the client over time. It’s highest returns, not higher returns. There’s a subtle difference between the two. Like in cricket, it doesn’t matter whether you score 500 or 200. What matters is whether you scored more than the other team. So, the task is to deliver higher returns compared to others which also includes the benchmark. The benchmark is the average.
So, our focus is on outperforming the market. These headlines may or may impact the market. The question is whether the impact on our portfolio is greater than the impact on the market. You cannot care for outperforming during such macro events because that’s just pure luck and that’s okay.
During such macro events like Covid-19, we make sure the portfolio is in balance. Most of the time we find that the portfolio is already in balance as the structure is designed to be in balance for most of these outcomes. In case inflation shoots to the upside or to the downside, it’s already balanced for such risks.
For us, macro is about risk management. It has nothing to do with performance or alpha generation. But if you ignore macro, you may unintentionally subject yourself to inordinate risk which can hurt you big time or help you big time.
How have the economic forces in the last 18 to 24 months compelled you to change the construct of your portfolio?
PRASHANT KHEMKA: We invest in almost all sectors. There are structural imbalances and the value that we tolerate. We are never in perfect balance. We may not be willing to be perfectly balanced because that’s the investment theme’s philosophy.
Let me take an example. Corporate governance is first and foremost an analytical process. So, the first thing we assess is whether corporate governance is adequate in nature. We avoid companies with average or below average governance. For example, in the IT service sector, historically, 80-90% of the companies have above (average) corporate governance. Whereas, it is commonly believed that 80-90% of real estate companies listed have below average corporate governance. Hence, we will have less exposure to some sectors where it is difficult, by nature of the sector, and there are not a large proportion of companies with good governance.
We are not saying they will underperform but there is no way for us to value them appropriately and generate alpha as we can’t value this cash flow.
The fundamental approach to investing in valuation is the present value of the future cash flows which is an important element of decision-making. The business’s present value of future cash flows has an underlying presumption that these cash flows will be shared with us, the minority shareholders, in fair proportion. However, in companies with poor governance, that’s not the case. Poor governance means that the fruits of the business, which is cash flows ultimately, might not be shared in fair proportion. There is no formula that 20% would be taken out. It can fluctuate and could be anything. Hence, there is no sanctity of the formula for present value of the future cash flows as there is no sanctity of valuation. There is no decision-making possible with companies with poor governance.
We invest in areas of the market where we are confident of outperformance. In the last two years or even before that, (it’s been) sectors like IT services and private financials. And lesser exposure to some other sectors. They are not necessarily an outcome of what’s expected of the Fed or Covid-19. There could have been a minor fine-tuning of 2-5% or 2-4% that the team had at the time when the Covid-19 risk emerged.
Over the last 18-24 months, the IT sector benefitted out of the world going digital. There were also factors like the China plus one policy. What is your view?
PRASHANT KHEMKA: Yes, IT services sectors across the board have benefitted from some acceleration in adoption of technological trends that have been underway. China plus one is definitely a significant force that is playing out in the real economy in certain sectors, more so than others.
India is a beneficiary but I wish it was a bigger beneficiary. Certain sectors do a very good job of identifying fantastic opportunities like chemicals, particularly specialty chemicals. We have certainly benefitted in the past and continue to have a good exposure in that sector.
Does the EV and ethanol push in the last 12 months excite you?
PRASHANT KHEMKA: For portfolios which do not have these as the core business investment, it is an opportunity for business in specialty chemicals. EV batteries-related businesses may not be the core business of the specialty chemical company but they may be doing some research and development or undertaking some trials which may lead them to succeed in that field. So, those kinds of exposures to some extent, could be there in the portfolio as pure play
There is no such pure play that we can find in the Indian market that has the makings of a winner in that segment, and one which is available at a valuation that provides substantial upside.
What can you say about MNC companies in India because their corporate governance standards will be very strong? I hear a lot of murmurs about how the capex theme would come back and benefit a lot of MNCs who have got technological edge on a global scale. Are you enthused by this and believe that Indian capex will pick up in terms of valuations?
PRASHANT KHEMKA: Yes, MNCs by and large have above average governance. Some of them can have AAA (rating) governance but just like a bond fund manager won’t be able to fix income from anyone… able to perform or outperform when only invested in (papers) that’s widely recognized as AAA.
Similarly, our goal is not merely to look at or invest in companies which are AAA. The bond manager may make a lot of money through companies which are rated A or BBB or AA but are AAA quality.
We invest in companies that may not necessarily be widely recognized or are AAA in governance, but also those whose governance is as clean or close to as clean to AA or AAA.
The capex, first of all, it is getting steam is somewhat of a like, you know, what is the analogy of wolf, the boy crying wolf or something like that… right now and then whenever the market rallies, high beta stocks rally more and the sell-side strategists are out with the (statements) capex is back, capex cycle is back, right?
I recollect the same happening in the U.S. when I was a fund manager from 1998 to 2006. After 2000, the TMT (technology, media and telecoms) bubble burst, the telecom capex went out of the window and other forms of technology capex, hardware, slowed down dramatically.
There were some similarities in what we see in the organic cycle. We remain ambivalent on whether the capex cycle was to indeed come in a very strong fashion. We may not have outsized exposure and we might not be similar to someone who is not backing that capex cycle is coming. So, let me buy all these infrastructure and industrial capex companies.
And that individual would have already done half a dozen times over the last dozen years, at least once every other year have drawn half a dozen times, eventually such a manager has to be right, someday. I mean like December is right every once every twelve months and that’s fine, but we will just don’t bat that way.
And we have made some including MNC names, which are exposed to the capex cycle and very well, if I can make segments on spectrum that’s very much part of balanced portfolio, need that you don’t want to have a portfolio that is, you know, so different and this aspect to the market, that if they are working on capex cycle, be left behind.
So, we have some exposure there but I won’t say we press the bet as people say.
The final question is on the real estate sector — a theme you mentioned has poor corporate governance but seems to be, as per the numbers, something that is different from what the last decade has been. My question is the model that you would have or weightage in the sector.
PRASHANT KHEMKA: I know many managements and real estate companies and we do own a company in the sector.
There are fine companies in the real estate sector. It’s a minority, but some companies have extraordinary corporate governance. The reason is because they recognise that this sector is marred with this (bad) perception. They have gone out of their way to make sure of governance and transparency.
Having said that, why don’t we have a lot more exposure to that minority? Let’s say we have one company in the modest side. The market is also recognising that this small minority is one with clean governance and so there is a big crowding effect in that small number of needs. So, we find that these names, which are in real estate sector, have great valuations, you know.
And so these companies, unfortunately from a valuation perspective, aren’t palatable at this time and have not been palatable over the last 12 to 24 months. But we’re happy with the exposure that we currently have.
It has been a good year for sectors where it’s a struggle to find companies with good governance. The sectors which have done the best this year—at the risk of generalisation—because there are some other sectors where this does not apply, including IT services.
In general, the best-performing sectors are those where we struggled to find large proportion of companies with good governance.
So, the stock selection element can be powerful to offset and mitigate some such imbalances that we have in the portfolio in the near term. Those imbalances end up doing very well, in aggregate.