Disclaimer: Please note that the views expressed in this interview are those of Mr. Basant Maheshwari and do not necessarily represent the views of, and should not be attributed to, Safal Niveshak.
Safal Niveshak (SN): Do you believe in the importance of maintaining an investment checklist? If yes, what are the most important points on your checklist?
Basant Maheshwari (BM): Let’s take an example of, say, a company like ITC. The first question I will ask is, “Is it cyclical or non-cyclical?” It’s not cyclical. So, basically it means that you can predict.
I assume that I don’t know anything about ITC. Now, I will open the company’s annual reports and see the fourth year figure. So if I’m in FY14, I will see how much revenue it earned in FY10.
From FY10 to FY14, in four years, it has got to double. If the revenue has not doubled in four years, then I don’t get excited. I am just looking at revenue at the moment. I have not yet dabbled with profits.
I will then look at the return on equity (ROE). ROE should be more than 25%. Then, if I find the ROE to be above 25%, I will look at the dividend yield.
Then I will look at the profits. So if the revenue has doubled in four years, and if the profits have quadrupled, and if the EBITDA margin is sitting at 30%, I’ll say that margins can’t expand from here on.
So if the EBITDA margin is at 30% and the revenue is not growing at more than 18%, there there’s some risk involved. Then I will look at similar businesses across. I will also look at the management – how much dividend it pays, and does it pay taxes or not. Then I will ask whether the industry is growing or not.
You see, this is just a two minute check on how I do it.
SN: While they are very critical, “competitive moats” are also tough to define. How do you define a moat, and assess whether it is sustainable or fleeting?
BM: See, some moats are good only in the textbooks. For instance, look at Container Corporation. It has got a good moat. Indian Railways has a fantastic moat, but it does not make money.
So, I don’t agree that moat investing will always make you money. Moats that give you the right to increase prices at will – at will is the important term here – those are the only moats that are relevant from an investor’s standpoint.
Take for instance, Horlicks (Glaxo Consumers). It increases prices by 6% every year at will. So that is a moat.
The textbook definition of a moat is that you put up a lot of capital, and there’s a network effect etc. etc. But the moat which really works is pricing power. This is because prices can increase 100%, but costs cannot be cut by 100%. Costs can be cut only up to a point.
So I think the definition of a moat is good to debate, but all moats don’t translate into prosperous shareholders.
If you have pricing power, you will have competitive advantage, you will be dominant, and you can skim the cream out of the consumers. And in a bad environment, you can get around the situation as well.
How many companies would have survived an excise rate increase like what ITC has done? They would have gone bankrupt in the second or third year.
Of course, we’ve learned a great lot from these American investors like Warren Buffett, but you also have to consider that maybe Buffett talks about moat in a different way. He gives us a definition. And Buffett also does not say that you’ve got to invest in all the moats.
Facebook has got a big moat, because it has got the network effect. All my friends are on Facebook so I won’t go to any other social media site. I will remain hooked on Facebook. But Facebook is slowly losing its challenge to Whatsapp.
That is what we have to actually look at – the sustainability of the moat and whether it will translate into higher ROE.
Why? You see, ROE has got three components – net profit margin, asset turnover, and leverage.
Let’s leave ‘leverage’ aside for a moment. So if you’ve got a low capex business, your asset turnover goes up, and if you’re making higher margins, your pricing power comes into focus.
If you’ve got a pricing power, and you’ve got a high asset turnover, you’ll get a higher ROE, which is the best moat to have.
So you look at the ROE and just try and segregate it away from the incremental addition it has seen because of excessive use of debt. That’s I think the best indicator of a moat.
If you don’t want to get into the confusion of moats, just look at the ROE. But you’ve got to break up the ROE and see.
Like, let’s look at net profit margin, which is “Net profit / Sales x 100”. What happens is, between sales and net profits, there are so many expenses – like employees, raw materials, advertising, distribution, etc.
One thing that nobody talks of is that there is a certain amount of moat called “distribution”.
All FMCG companies have lac of touch-points. How do you translate that?
You can sell all the products that Dabur sells. But how do you go to the remotest village and get in relation with a guy who has a small 20 square feet store there. It’s very difficult. So that is one point that nobody talks about. Distribution is also a big moat. That distribution helps you again in making more money.
See, a company can grow in three ways – new products, new geographies, and new distribution. A company that does well on all these accounts should have a high ROE.
SN: Value investors generally tend to buy and hold for long periods of time and literally marry their portfolio. Assuming that we have been rewarded for our efforts by a few multi-baggers, how and when should we exit when we are sitting on huge gains and emotionally attached to the stock?
BM: First is, you’ve got to love your family and not your stocks.
I love the stock only till the point the stock loves me – in doing what I wanted to do. If I find that my stock is not rising at the rate I wanted it to rise, or is facing headwinds, then this is not a place I got to give it a lot of time.
Because if you relax a little bit with a stock that is not acting in your favour, then you might lose a lot of money as well.
Talking about when I would sell my stocks, first is when I will get a better idea. If there is a better relative opportunity, then I will sell.
Let me explain this with an example. Till 2006, I held Pantaloon and TV18. I sold Trent because TV18 was doing a spinoff, and I had read in this book called “ You Can Be a Stock Market Genius ” how spinoffs make money. So I was sure this stock would do well for me. So there was no big reason to sell Trent but still I sold it and bought TV18. And Trent, even after eight years, is still at the price I sold it.
So there has to be a better opportunity when you sell.
Second is when the present discounts a great future. You can look it from a market cap angle also. When I sold TV18 in 2007, it was trading at a market cap of more than Rs 5,000 crore, which did not make too much sense at that point of time. The company had no cash flows, it was diluting equity, and it was raising a lot of money.
So at that time, the present was discounting a great future ahead. And that is why I sold.
Third, I sell when the trend finishes. Take, for instance, Pantaloon Retail. I did not sell it at Rs 875 and the stock fell all the way to Rs 300, when I sold it.
I was a little late to react that the trend had finished because Pantaloon was trying to do its spinoffs at that time. So I thought that once it does its spinoffs I would get a higher price like I did in TV18. Recency bias got into me.
I was willing to give it some more time, and then some more time, and then some more time. By the time it was clear to me that this trend was finished, I sold Pantaloon.
Then in 2009, I got into a lot of these cyclical names like Voltamp Transformers, Blue Star, Thermax, etc. They were all cyclical businesses. So I sold because I made 2-3x in 2-3 months, because with cyclical, the moment you make money you’ve got to sell. You can’t take a long term view with these.
As an investor, I am always trying to maximize my last rupee. I don’t have a concept like, “Okay, I bought it at Rs 200 and now it’s at Rs 600.” What difference does it make?
My cost price is the last price that is displayed on the screen. When I do my excel, I have no column for my cost price. So when people ask me, “I had bought this at Rs 50 and now it is at Rs 150. What should I do?” I say, “Forget what you bought it at!”
If I had put Rs 10 lac in a stock and today it is Rs 16 lac, I need to see what I can do of this Rs 16 lac.
I can’t say that because I came in this world with nothing, I can afford to lose everything. Whatever money has been made in the market, I have to take it from there.
Anyways, I also sell a stock because, for instance, there is a government regulation. For example, I sold Titan. Of course the stock has gone up from there, but my decision to sell it took just about thirty minutes. For a stock that I had held for six years, thirty minutes were enough for me to sell it because there was a regulation that gold companies can’t get gold on lease.
Then you sell when the management does something that you don’t want them to do.
But basically, if you can get just one thing right, sell for a better opportunity and you’ll be saved from all the problems in this world.
If I may give you an example, for an equal return, assume there is a cyclical company with a spinning mill in Tirupur and is on a turnaround path. You tell me that this stock is going to double in three months. I’ll tell you that HDFC Bank will double in four years at most. Why take that headache?
But you see, there is a great kick in buying an unknown company. That is what most people do.
I think it’s more about how sure you are about making money rather than the absolute amount of money you can make. This is because the latter is dependent on so many variables. And if you can cut down on a few of them, then you are through.
SN: You do a lot of scuttlebutt before investing in a stock. Is there a process to it?
BM: There’s no need to do scuttlebutt with every company. What scuttlebutt can I do with Nestle? Scuttlebutt has to be employed when there is not too much of management information, or where there is very little operating history, or where the company itself does not tell you much about what it is trying to do. That is where it helps.
But beyond a point, scuttlebutt does not help you too much.
There are companies that have passed the scuttlebutt barrier, if you may call it. With them, you can’t add any incremental value doing the scuttlebutt.
Let me give you an example. In 2003, I used to stand outside Big Bazaar (Pantaloon) to see how many people were coming out with bags. I also used to stand outside Westside (Trent) to see how many people were coming out from there. For every 10 people out of Big Bazaar with bags, there were not more than 2-3 people coming out of Westside.
So that scuttlebutt helped, because Pantaloon was an untested company at that time. Today, you don’t need anybody’s confirmation that Big Bazaar is a place where people go to buy.
Now, the best scuttlebutt will come from consumers, or from distributors. You should make friends with distributors of companies which you have bought, and an easy way of doing that is to go and regularly buy something.
For instance, if you have bought shares of Page Industries, look at the business outlet near your place, go to the store, once every month, and buy a pair of socks. It’s a Rs 120-150 cost, and you get to know what the company is doing.
So many times the guy at my nearest Page outlet tells me, “Sir why don’t you buy a pack of three?” I tell him, “I want to talk to you regularly. I don’t need the socks!”
So this is how it helps actually. That’s it! But as I said, beyond a point, scuttlebutt does not help much.
There are companies where scuttlebutt does not help at all. If it’s got a cyclical element to it, then no matter how much scuttlebutt you do, it’s not going to save you.
SN: How do you evaluate a company’s management? Is there a specific process to do this?
BM: There is no specific process that I follow, because management is an intangible thing.
But a company that is paying taxes, paying dividends, generating a high ROE, and is a sector leader, will normally not be stealing from shareholders.
Like Infosys was a high quality company while Satyam was the deceptive guy. So people lost a lot of money in the latter and not in the former.
Similarly, during the 1992 era, there was an ACC and there was Kakatiya Cement, and Kalyanpur Cement, and so many such companies. All these second liner cement companies were washed away but ACC remained.
So if there’s a company you are planning to analyze or you have invested in is a sector leader, then you can be more or less sure that the management is good.
Of course, you have examples of companies like DLF and Unitech. But here there are other checks. Like Unitech’s management always wanted to go into diversification like telecom and those things. With DLF, before the company came with its IPO, there were suits filed against the management for not having actually given shares to people who had applied for the shares long time back. So you had enough information there.
Secondly, look at high ROE. A management that steals from shareholders can do it in two ways – over-invoicing its plant and machinery, and under-reporting revenues and profits.
If you under-report revenues and over-invoice plant and machinery, you will never be able to generate a higher ROE. Higher ROE can be generated by having a higher net profit margin, and lower capex.
So if the ROE is high, obviously without debt, and if the company is paying you dividends, and pays taxes, the management is often good.
Now, a great management in a great business creates tremendous value. Like Narayana Murthy with Infosys.
A great management in a bad business will lose value. Like Tata Sons with Tata Steel.
A bad management in a great business will lock value. Take, for instance, Vijay Mallya with United Spirits.
A bad management in a bad business will always blow up value. Like Vijay Mallya with Kingfisher Airlines.
You can’t get a great management and a great business combination every time. But remember – you must not partner someone you are not sure about.
Of course, there are people who won’t tell you too many things about them. But then, their actions have to speak – like in terms of dividend cheques and taxes. Like most of these MNCs don’t talk too much. For instance, 3M is a company that never talks, except on the AGM day. But 3M has the reputation of having had a long history in the US.
A management which does too many conference calls, you are not going to make too much money out of them. This because it is sharing its best with investors beforehand. Markets pay for surprises and not for the predictable.
SN: There are several giants in the value investing field who profess the use of patient capital (no borrowed capital or debt), whereas you profess taking loan for a stock just as taking loan for a home. Can you throw some light on this aspect of investing?
BM: My first borrowed capital was from my grandmother in 1992, during the Harshad Mehta days. And from there on, for nine years, I lost money on borrowed capital.
So I used to make money and give it back, then make money and give it back. But that was not a primary work for me as I was into my family business. Thus it did not hurt me that much at that time.
You see, borrowed capital must not be looked at in isolation, because you are buying an asset that can rise multiple times.
If you buy a car, which is a depreciating asset and which loss value over time, with borrowed capital, nobody objects. But what you do with that borrowed capital is more important than whether you’ve used borrowed capital or your own capital.
So if you’ve bought a stock that goes up 40 times, then if you would have used borrowed capital, it would have actually expanded your gains.
Most investors, in their initial days, can’t allocate too much to investing. If you start with a capital of Rs 5 lac and you grow it 10 times, you go to Rs 50 lac. If you grow 10 times, you reach Rs 5 crore.
But instead of Rs 5 lac, say you had started with Rs 10 lac, if you move it up 10 times, you will reach Rs 1 crore. You move it up 10 times more, and you will reach Rs 10 crore.
So the effect of capital comes into force because in the initial days you don’t have too much of a surplus capital of your own. So you have to take help from borrowed capital.
But most investors generally don’t like borrowed capital because they are not focused on buying only high quality businesses.
I can’t buy a turnaround steel company with borrowed capital. I can’t buy a cyclical copper-mining company with borrowed capital.
With borrowed capital, I can only buy companies where, if I get it right, the stock should at least get me 30-35% per year. And if I don’t get it right, then at least the current price should hold itself.
You do an excel calculation. If you grow any amount of money by 30% for 10 years, and you pay 12% interest on that money, then at the end of the 10th year, you don’t make 30% minus 12%, or 18% CAGR. You make 26% CAGR. This is because the spill-over also grows by that amount.
If you are smart and have concentrated positions, it is possible to grow at 30%. But to grow at 30%, you have to be on the lookout for selling at the first sign of trouble also.
I am not saying I have to buy a stock that will grow at 30% for 10 years. I will buy a stock that should grow at 30%.
But keeping the stock selection process aside, with 30% growth and 12% interest payment, you will make 26% every year, on a CAGR basis. So why should you not borrow?
SN: But that’s in hindsight. When you look ahead, isn’t there this risk of permanently losing money, which can multiply your pain when you are on borrowed capital? It’s only after 10 years that you realise that you’ve earned a 30% CAGR.
BM: I agree, but you are not borrowing two times your capital. You are only borrowing maybe 20%, 30%, or 40%.
This is how you have to look at it. In this market, there is nothing called a bad thing or a good thing. People have made money in Suzlon. People have made money in Unitech. Just because I couldn’t or didn’t buy Unitech, I can’t say Unitech is bad. If it’s made money for someone, it’s good.
I won’t say betting is bad, but obviously it’s a question of probabilities. Why people get is wrong is, if you are on borrowed capital, and if you are on borrowed conviction, then that’s a bigger problem.
Borrowed capital is less dangerous than borrowed conviction. If your conviction is original, then capital can be borrowed. But if your capital is original, and the conviction is borrowed, then there’s a problem again. This is because if the stock goes down, you won’t know what to do of it.
If I met somebody at the airport and he whispered into my ear, “Why don’t you buy this stock?” and I go and buy it, and then if it goes down, where do I find that person?
And if I look on TV and buy a stock, and then that expert isn’t available on TV when the stock price is going down, where do I call up?
So, conviction has to be original, capital can be borrowed.
But the problem originates when people use borrowed money on borrowed conviction. Most people who have used borrowed capital with original conviction have made money.
SN: So you still use borrowed capital to invest?
BM: Oh absolutely! If you have surplus to lend, I am there!
To be continued…
Value Investing Workshop in Bangalore: I have my next Value Investing Workshop in Bangalore on 1st November 2014 (Saturday). If you want to be a part of it, just click here to register now .