Value traps. (Source: BloombergQuint)

How Basant Maheshwari Avoids ‘Value Traps’

When equity valuations are relatively low, investors tend to get allured by “value traps”—stocks that look cheap but never rebound. For market veteran Basant Maheshwari, only one thing differentiates value from value traps: return on equity.

“If a company has got a low return on equity, like 13-15 percent, there has to be a problem somewhere,” Maheshwari, co-founder of Basant Maheshwari Wealth Advisers LLP, said on the sidelines of the BQEdge event in Kolkata. “Because your cost of debt is generally 12-13 percent, if you are generating 13-15 percent on your business, you are doing a 2-3 percent spread,” he said.

Value trap is a stock which cannot do a return of equity more than 15-16 percent.
Basant Maheshwari, Co-Founder, Basant Maheshwari Wealth Advisers LLP

Return on equity is the “gayatri mantra” of investing in stocks, Maheshwari said. “You buy a company at 100 percent return on equity. With some growth over the next 10 years, irrespective of price earnings ratio, you will not lose money.”

Another important factor to watch out for is whether the company is a leader in its sector or not, he said, citing the example of Durgapur in West Bengal where a decade ago “everyone who made money” was setting up steel rolling mills. “Eighty percent of those business went bust as there was big brother Tata Steel,” he said. “If you have any business who is not a sector leader, which has got a big brother somewhere, it will squeeze.”

Maheshwari suggests to aim high while picking stocks. He likened investing to West Indies cricketer Chris Gayle’s explosive batting style.

You have to look at stock markets like a Chris Gayle six.
Basant Maheshwari, Co-Founder, Basant Maheshwari Wealth Advisers LLP

“If Chris Gayle is batting, he never thinks of making the ball just tip over the boundary line. He thinks if he can hit it in top tier stand,” Maheshwari quipped. “You have to look at stocks which go up 20 times. If it doesn't go up that much, at least you make 5 times, 10 times or double. If you are focused on making 20 percent, then you will end up losing 20 percent.”

Watch the full video here:

Here are the edited excerpts from the interview:

Is this the good time to focus on value companies or value bets?

Normal cliché is that you can buy a stock anytime. In the next two months, the election results are being built in. The present government, through its action in Pakistan, whether deliberate, intentional, consequential, time phasing— it has confirmed itself another five years in Delhi. Post-election rally will happen pre-election. Once this government is voted back, I don’t think there will be too much flurry in market as it was already there. There is a great time, in the next two months, to buy stocks and position yourself in case you are waiting for elections. But you don’t have to wait for election. If you are buying fundamentally, then you would have already bought them. So, there is no reason for you to wait. On broad scale, a person like me who is always invested, we are invested, and we are not doing anything special because PM Modi is coming for the next five years. But for someone waiting for election, you should stop waiting and get in.

If you have money, then is this a good time to seek value within the broader end of the spectrum? Would you think that good quality has taken a premium and there is no value available?

The argument of Nifty is driven by 15-20 stocks. For example, Tata Motors stocks have been there for 20 years and they have not yielded even fixed deposit returns. So, what blue chips are we talking about? It is fashionable to say I have bought Tata company stocks. But anything which comes with Tata brand need not be as good as the quality of product.

The stock is different from the product. There was a study done long time back that 85 percent of Indian stocks don’t yield even the inflation adjusted returns over a 20-year period. So, you have to get in and get out. So, what yields do they return? On a Nifty scale, 40 percent Nifty earnings are globally oriented like IT and pharma. I don’t think IT will do any magic. TCS and Infosys won’t go down because companies are doing a buyback. They won’t go up as there was a dollar rally, Trump thing. So, there were too many things. What is left to Nifty is to prop it up. It is the same typical level financials which is consumer names. So, it gets narrowed down. When everything is going up, it is normally six months before the top. If you are saying that only a handful companies in Nifty are going up, then it is good. If everything is going up, in four-six months you will hit a top and it happens all the time.

It is fashionable to say, “I am a stock picker; I do selective stock picking, I am cautiously optimistic.” But there is no message in those statements or phrases. You have to be a stock picker, you have to phase out what you want from life. The company is growing, and you want good return on equity, sectoral leadership, you want company which takes market share away from its competitors.

Good things in life never comes cheap and markets are life. You have to buy it at a little expensive in the hope that over the next six-nine months the earnings could come in and your stock will become cheaper not because the seller is in distress, but because earnings could come in and that could make your stock look cheaper. That is the broad theme. You missed lot of companies trying to buy them cheap.

We always wanted to buy that company 20 percent cheaper, not thinking that over the next five years, this company can grow three times. You buy 20 percent expensive, wait for six-nine months, let the earnings come in and let the stock become cheaper. You have to be sure about earnings because if there are no earnings, then stock will come down. But for companies generally, the format of investing should not change just because something has gone down or up. At the end of a bull market which we saw last year, many still don’t agree that bull market ended, but I believe that it ended last year in January. Everything was going up and when it does, it is before the end.

Are you saying that whatever value is available right now, a lot of times it is a value trap because the market is so widespread that true value is bought on very quickly?

How do you say this stock is a value trap or a value buy? If a company has got a low return on equity like 13-15 percent, there has to be a problem somewhere. Because your cost of debt is generally 12-13 percent. If you are generating 13-15 percent on your business, you are doing a 2-3 percent spread. Value trap is a stock which cannot do a return of equity more than 15-16 percent.

For those companies, the argument could always be these are turnarounds. But we have always seen turnarounds seldom turn around. If you have company which offers low return on equity, which is not a sector leader. In Bengal, 10 years ago, everybody who made money from its business, said let me put a steel rolling mill near Durgapur and 80 percent of business went bust as there was big brother Tata Steel. So, if you have any business who is not a sector leader, which has got a big brother somewhere, it will squeeze. Ten years back, there was so much fanfare about Justdial. As long as you are doing business in your own locality, nobody bothers. But the moment you reach an all-India presence, Google says you are making lot of money and let me see if we can do same thing or not. So, your Justdial business goes down not because there is problem in business model but because you have suddenly started to look big.

A small company, the moment it starts doing something fashionable and become big, it will always have a problem with a large brother. It has two things. First is return on equity and second is that you need a sector leadership. Management is still third. I don’t think Tata thought about putting a B-grade management to manage its steel business and best management to manage software business. Just the inherent nature of business didn’t work out. I am not saying Tata Steel is bad or good. I am saying, over last 20 years, they have not yielded even FD returns. But everybody wanted to buy Tata steel at Rs 450 and sell at Rs 550 by making 20 percent. Eighty percent of those who try to make 20 percent in a stock market swing lose money.

If Chris Gayle is batting, he never thinks of a ball tipping over boundary line; he thinks if he can hit it in top tier stand. So, you have to look at stock market like a Chris Gayle six. You have to look at stocks which go 20 times, if not then make 5, 10 times or double. If you remain focused on making 20 percent, then you will end up losing 20 percent.

Return on equity is the gayatri mantra of investing. You buy a company on 100 percent return on equity with some growth over next 10 years, irrespective of price earnings ratio, you will not lose money. Unless, there is business model failure. Price-earnings ratio is a function of growth and return on equity.

Value for me is like god. So, god can be anything and similarly there are different ways of looking value. So, value can derive itself from growth, dividend yield, free cash flow. When there is growth, nobody cares about free cash flow.

So, during 2003-07, you had, Nagarjuna constructions, IVRCL which went up 50-100 times. There was Unitech which went up 100 times where there was no regular business. There are different facets of value. Depending on the market condition, we convince ourselves of a perfect value. If it is a bear market, we will say ‘low-PE’ with divided is perfect value. If it is a scorching bull market, everybody looks for growth, but ultimately, market pays for growth.

All of us thought that asset management companies were great businesses. HDFC AMC listed. From Rs 1,900, the stock fell to Rs 1,400 because regulator decided that they are making a lot of money. So, you don’t want to be with any company, irrespective of value metric where there is a big brother looking upon you. They are saying you are making lot of money and I won’t let you do it. That’s why you need to get rid of regulated businesses.

Return on equity, a business model which is not regulated, a non-cyclical business, then the next part comes in of opening the balance sheet. It is for long-term investing. For short term, you buy CG Power at Rs 36. Someone says the management wants to sell it off. For those things, Rs 36 stock will go to Rs 60. Most Rs 36 stock come back to Rs 25 before going back to Rs 60 and that is the time when we chicken out. Two-three months is a different game but if you have two-four years view, the plan should be simple of buying the best and that is how I will approach it.

If I want to make an investment which enables one to buy a stock and hold it for next five years, what are the things that it should meet?

Checklist will vary from person to person and it is influenced by what has worked for you. For me, the growth is the number one thing that has worked. Market pays for growth. We come to market for growth, otherwise we could be happy compounding money at 8 percent CAGR pre-tax in an HDFC Bank fixed deposit. Why buy the HDFC Bank stocks?

There has to be above average growth of 25 percent plus. In India, there will be 10 companies growing above 30 percent. Out of 10, four wouldn’t fit your investment criteria because of liquidity or other things. Maybe 50 companies are growing between 25-30 percent. There will be 200 companies growing between 18-25 percent and the rest grow sub-18 percent. So, those 10 don’t get paid 20 percent more. They get paid two-three times more in terms of valuation. There are handful of companies growing fast in the market and those companies get bid up. In 2009-2015, we had abnormally high valuations for stocks like Page industries, Eicher Motors because there was no option.

The moment you have 50 companies growing up of 30 percent, there is no premium. Premium goes up in bearish times and goes down during bullish times as money gets spread out. Second part is, the sector in which you are operating. I would put sector below growth because when sector is in flavor, even worst sector gives you the best returns. The sector has to be non-cyclical and not influenced by government. You don’t want to run a television company only to be told that your licence is not operative.

You want to be away from government as much as possible. Government companies like HPCL, BPCL—suddenly some minister decides that HPCL will take a Re 1 hit on its balance sheet, which can be great for a company and the masses, but it is not convenient for the stockholder because it is our money. When a 51 percent holder decides for 100 percent ownership, it is not always economic set works but has also social factor at play.

There is great research done by Jeremy Siegel where he has compiled returns over the last 100 years of U.S. companies, and he concluded that the number one sector which was providing returns for shareholders was the pharmaceuticals space in America. Number two was consumer and number three was financials. Indian pharmaceuticals are normally copying. Like, you make something for $2 and we will re-engineer it at 30-40 cents and sell it at 50 cents. But, American pharma has a novelty aspect. Market pays for newness. There has to be something new. In 1992, cement and steel were decontrolled which is a new thing and ACC went through the roof. In 2000, Infosys, Wipro went up as software was the new thing. In 2003-2008, infrastructure was the new thing. Between 2009-2015, you decided these bunch of companies were new. So, something new has to happen.

Our problem now is that because of the private equity space, you won’t get enough opportunities in these kinds of companies. If there is Flipkart, it will first be bought by Sequoia. If there is some other company in India, it will first be bought by private equity players. So, we don’t get the opportunity. So, it has something new. If I can find something which is new, obviously it will be in a new sector and that’s why that sector will always have growth because a new thing means that you are getting new market share. If I had a chance to invest in America, which we don’t, I would like to look at Lyft which is competing with Uber.

A year and a half ago, when we were there, and we couldn’t get Uber on our phone, two people on the street asked us to try Lyft and it was better. The guy who tells you what is better as a product, you should look into it. So, I would look at growth, sector, it shouldn’t be cyclical, shouldn’t be affected by the government. I don’t want a third-party big brother to influence my stock. There must be a return on equity. But if there is growth and if it is good sector, you are sorted.

How should I buy at the bottom? Is it possible to do at the bottom if I haven’t, then what do I do next? How do I know at that point of time, when the news flows aren’t the most promising, that this might end soon and let me take small bet and I won’t lose money? Essentially, the difference between value available versus a value trap. How do I distinguish between the two?

My learning is that money which you bring to the market, if you are willing to lose it, you will end up losing it. That money must be very dear to you. It must be like part of your family which you cannot lose. Then you will automatically take decisions which will maximize returns. When you buy a stock of Rs 20,000 and let it go, then you will definitely lose it. You look for bottoms if you are buying cyclicals like steel, sugar, or a shipping company.

If you are buying a secular growth, multi-year compounding monster, you shouldn’t look at the bottom as it will keep moving up. Then you should look at it if it is looking down 15-20 percent from top. My experiences has been that for most wonderful companies in India, they don’t fall more than 18-20 percent unless there is an external impact on it. When there was the IL&FS scare, the best of NBFCs fell 30 percent and worst went down 70 percent. But what was the signal that the bottom had been made? When a new phase of bad news on worst of companies didn’t impact the best of companies. Everybody knows what the best NBFC is in India. You know that this company is not going down even while DHFL is falling another 5 percent from previous day’s close. That is the first indication of a bottom.

If you are searching for a bottom, you should do it in a cyclical business, business which is influenced by government or external or global event like sugar, steel or even an auto. if you are looking for bottom in a secular growth business, most of the time you will miss it as bottom keeps moving up.

Don’t worry more about bottoms and tops. Worry about whether the earnings will come back. Earnings to stock market is like a ventilator to a dead man. It will keep it alive and the stock will come back. Most of the time we can’t figure out whether earnings will come back or not. If the price is down 60 percent, then earnings will not come back. If earnings come back, the worst stocks which are down 70 percent, the best stock will be down 30 percent and it will stop falling after a time.

The moment it stops falling there is first indication that everything is fine. That is the way to approach it rather than looking at bottoms and tops. Most of us call ourselves ‘value investors’ and we become price fixated because we look at bottoms and tops and become value investors. As value investors, look at price but also look if the earnings are going to come or not.

What does you do when your stock is down 50 percent from the price that you bought it at and it doesn’t look great, but it is difficult to cut your losses? Why should I book a loss on my portfolio?

It had happened to us. Most of the times, 20 percent of your portfolio will take 80 percent of your analysis and the problem lies in that 20 percent. You will be calling the company, investor relation officer, analyst. From our experience, if you are spending too much time on certain company or a set of companies, then that is a problem area. If a stock is down 40 percent, you are left with 60 percent. At that time, it is more important to recover, retain that 60 percent, rather than recovering that 40 percent which is lost.

We have bought useless companies in 2015 of small caps where we made 3-5 percent allocation thinking that digital transformation could come in. Soon, we realised it was not working out. We sold most of them at 30-40 percent below cost price and not below all-time highs and moved on with life. Every day, when you look at your losing stock, you will get a new ray of hope. Don’t average, irrespective of how the good company is as the market generally knows something more.

I got nothing against DHFL, and it is not a recommendation. The stock was down 30 percent one day and didn’t recover that day or the next day. There is then a problem. Zee was down 30-40 percent one day, recovered next day, recovery happened the third day and next day we were buying Zee. This is how you evaluate stocks. Don’t look at the balance sheet. Look at what the big brothers are doing. If a stock finds a buyer when it is down 30 percent, that means the story is not finished. If a stock doesn’t find a buyer even though it is down by 30 percent, you have to not think of buying something at Rs 400 because Rs 700 was all time high.

If the stock is down suddenly and it doesn’t find a buyer, had we had DHFL we could have sold it to Rs 400, irrespective of results, returns. You can’t have Rs 2-4 crore volume of stocks which is collapsing 40 percent and still the price is not recovering. It is better to take the money and run. It takes 10 years to understand that all times highs have to be bought and another 10 years to implement what you have understood. It took me 20 years to understand that you have to buy all time highs and not be afraid of them. It takes similar amount of time to not buy all-time lows. Price and fundamentals cannot be divorced, and they have to go together somewhere.

You said for Tata Steel, the product may be good but not the stock price. And for Lyft, you said the product is good because you heard it. So, how do we choose?

If the steel prices go up, you will have 200 different people thinking of putting up steel plants. So, there is no supply and the price will come down. If steel prices come down, everybody will not get bankrupt because world needs steel. You will have 200 people exiting the business and price will go up again. So, it is the cyclicality of business.

Lyft prices wouldn’t go. Uber rates don’t change or in worst cases you may have surge price. So, you must look at pricing stability of the same thing. You cannot focus yourself on one aspect of investing.

Steel companies are convertors. They buy raw material from somewhere. Even in 2003-2008, all cyclicals do well because iron ore prices were going up. So, people who held iron ore mines made a lot of money and the ones which were converting didn’t make as much money. So, you have to look at it from that angle.

How do you track a company which was not Flipkart but was Flipkart-like 10-years ago? How do you track competitors who are not in the listed space?

This is known as scuttlebutt where you go around checking companies. A company which we bought held and sold because for a lot of time, it was not doing anything which was Hawkins cooker. Beyond a point this habit of going and checking everybody out doesn’t create too much of a help. As an individual, you can check once or twice, and you cannot do it all the time. You do not need to check all the companies. If a product is good and you are not buying something from the unlisted space and buying only from listed space, then you are fine and well.

For example, there was talk about how Patanjali will disturb Dabur, Marico and Emami as they have ayurvedic product. But nothing happened. All of them survived. Beyond a point, trying to look at everybody else doesn’t help. You can do it once or twice. If there is something in the unlisted space, it is small, and shouldn’t impact you because if it were big, it would have been in the listed space. If listed companies were small, it wouldn’t have been listed. If you got a leader in your hand and how do you know if it is a leader? Check the revenues. You can check revenues of any listed or unlisted company. If your listed company’s revenue is Rs 10,000 crore and the company in unlisted space is Rs 100 crore, then you are a leader there. If you have got a leader and it is doing fine, then it is good to have a sense.

A company which we had earlier which is Page industries, it is doing okay. The Van Heusen model, they are selling Rs 100 -200 crore every year and it is in unlisted space. All these smaller companies in the unlisted space are selling Rs 100 crore worth of things every year. So, the growth of the main company gets impacted because main company has a Rs 2,000-3,000 crore sale because the unlisted space is cannibalising the incremental growth. In such cases, it is okay to see what the competitor is doing but if your company is doing fine then there is no worry.

Can you take us through sectoral allocation?

Too much of good things can be wonderful but there are pitfalls to it. If you decide to buy 10 stocks in a portfolio, the average would be 10 percent. You should not go 1.5 times of this average. Your number one stock should not have more than 15 percent allocation. If you have decided to allocate your portfolios in five companies, your average could be 20 percent. So, your number one company should not be more than 30 percent, to start with.

Let’s assume you have a portfolio where you have one Infosys, and one TCS with 20 percent in each. For some reason, you get Infosys completely wrong and the stock goes to zero, then you would need your TCS with that 20 percent allocation to just double up or go as much as Infosys has fallen. It is much easier. If one Infosys is at 20 percent and you have rest 100 stock portfolio with rest 99 stocks making up 80 percent, then all those 0.8-0.9 percent allocations will never able to recover the Infosys loss for you. For one wrong decision, you don’t expect to get five right decisions to recover this for you. You should have one wrong and one right decision. For one wrong, one right is enough from the same space or sector.

For sectoral allocation, if you are a fund manager, you have to see what that sector has in Nifty, if financials contribute 40 percent of Nifty. At an individual level, you should cap your allocations to 40-50 percent if you understand that sector very well. I have made all my money buying and holding just two odd companies. It is all about how much you know and understand a company. It is okay to be 30-40 percent into a sector, as long as sector is doing well. If the price is doing well, results are coming in and if fundamentals are fine then you are okay.

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