Beating the Market 70% of the Time | Vinay Paharia on Quality Investing

0:06 Hi everyone, welcome to this episode of the LA Street to Wall Street. With me is Vine Pahara who's a very experienced investment professional and I look forward to a wonderful chat with him. Vine, welcome to the show. >> Hi. >> I know you've had deep experience in growth investing. It's an area you're passionate about. And recently you had some amazing research that you published about how investing in highquality growth companies versus lower quality growth companies gives you a significant return differential over the long term.

0:32 Right? 21% to 15% if I quote the headline of the story. If you can shed more light on this and just talk about what your insights are from this and what you would recommend to normal investors that would be fantastic. >> First of all, thank you for having me on the show. so the objective of this study was exactly to give some very very simple yet very powerful insights for investors who are actually practitioners of long-term investing. so what we did is we looked at long-term data for companies which are listed in Indian markets for the last 20 25 years and looked at very simple metrics like what has been their historical sales growth what has been their historical returns on equity something which is very much available from basic financial data and we tried to create portfolios out of very simple conclusions which is that what if we are able to buy companies which have better than average sales growth historically and better than average returns on equity over the previous 3 years.

1:42 what would have been the the returns of such a portfolio and and the results were phenomenal. The insights were extremely attractive. I told what what was discovered is that if you create a diversified portfolio of companies which are growing at a better than average pace and which have returns on equity which are better than average. Such portfolios deliver superior returns over a longer period of time. And not only that, we saw that such portfolios are able to deliver a better batting average as well. What do we mean by that? It means that if there are 20 years, such portfolios have outperformed almost 14 out of such 20 years. So, so I think such superior batting average is also what clearly highlights that such a strategy has has good potential.

2:38 So, good news for fundamentals based investors who looking for simple metrics, right? I think you also believe in making sure that you're not overpaying for companies, right? So, and you have a strong view in that. So it would be good to talk about that especially in today's age where momentum and acceleration are you know words that investors are used to hearing and betting on talk about sort of value investing in your view. >> In fact I think valuation is the most misunder misunderstood part of the entire investing jigsaw puzzle. Most people think valuation is the published price to earning or price to book. A low price to earning multiple means cheap companies and a high price to earning multiple company means an expensive company. I think that is a myth.

3:27 Companies which are able to earn a superior return on equity >> should have a higher price turning >> and which are able to deploy that capital for future growth. Such companies can necessarily or should necessarily command a higher multiple. And you this is based on a very simple financial theory right. So which means that a rupee in hands of a company which has these good qualities should be worth let's say 20 times versus a company who doesn't have avenues to invest or which is producing very suboptimal returns on equity such companies a rupee in hands of such company would be just worth five five rupees or 10 rupees. I think importantly what investors should understand and should try to devote more time on is what should be the fair worth of these companies. Fair worth is driven by four factors based on our understanding. It is what is the forward return on equity? What is the forward growth?

4:32 What is the riskiness in the business and ultimately what is the risk-free rate of return in the economy. So that is same for all companies in India but it would be very different for companies in let's say US or Argentina or some other country. So all of these four factors together produce a fair multiple for each company which is like a fingerprint. No two companies will have a same P multiple or fair P multiple. So I think value is buying companies at a discount to their fair multiples not just the optical high or low P multiple >> which most investors mistake. Right.

5:08 Absolutely. Let me ask you one important question. You talked about how historical data on growth rates, right? Above average growth rates, above average return on equity were a good predictors of performance. How do historical returns predict future returns, not stock market performance? Because you have to pick companies where you believe there's going to be upside, right? So, what do you think? Are there similar markers when you're looking at forward projections? so you mean the fundamental data?

5:40 >> Yes. So >> absolutely I think historical data is very very important and I think what we have been fed into is future is disjoint from history. I think that is a myth. Many times future is just an extrapolation of what has happened in the past. Not necessarily but future depends a large to a large extent what to what has happened in the past. So studying the past historical data gives us clues into the future. So for example, companies which have very very strong returns on equity in the past potentially can produce similar strong returns on equity into the future. In fact we have done more studies on that. What based on those studies what we have discovered is that high highquality companies seldom become lowquality companies and lowquality companies seldom become highquality companies. So the nature of the business quality seldom changes.

6:42 >> So how do you identify disruptors in a world where there's not that much crossover? >> Absolutely. I think disrup disruption is is to be understood on a realtime basis. You have to devote time and effort to understand the nuances of business and absolutely bang on these are disruptors and disrupted are are set of companies where you need to be extremely cautious on and historical data may not be very useful. What we also need to remember is companies which are in their infancy or are in the early phases of their growth they may be incurring losses in the initial phases of growth. as their characteristics are not set in stone. They're not immutable.

7:24 >> Exactly. But as investors, we need to understand the power of operating leverage. A new business has got high gross profit but has also got a reasonably large chunk of oper operating expenses which means probably the reported profitability is low. But as the business multiplies, scales up, the fixed costs or the operating expenses do not grow at the same pace, which produces the power of operating leverage, which at times is missed by most investors. And that is a very crucial link in investing into many of these new age growth companies. Got it.

8:01 So let's talk about one more piece that you highlighted at the beginning of this talk, which was diversification, right? So I think you have a view that hey let's make sure that you don't have single stock exposure more than 15% or thereabouts. Let's make sure you don't have sector exposure more than 30%. But there are only so many good companies and sectors that are you know doing well right. So how do you deal with liquidity constraints or allocation constraints and still stick to your diversification markers? Isn't that a challenge?

8:30 >> Sure. So before I answer that question we must first understand what is diversification. Once again a very abused concept. >> so to explain diversification probably we need to understand it using a very simple example. Let's say you have a simple coin which is slightly loaded in your favor which is let's say the coin has 60% probability of getting heads versus and 40% probability of getting tails. Now you have this coin.

9:04 I'll ask you that will you bet your entire net worth on getting a single flip and getting ahead on it? >> No. Despite the fact that the probabilities are tilted in your favor, you'll not do that, right? If I tell you do it on two flips, once again probably you will worry. But what if I tell you that you have the ability to get,000 flips and you can divide your entire net worth on this thousand flips?

9:33 Absolutely, you will bet on it. For the simple reason, the dice is loaded in your favor. And because of this reason of this diversification, you are able to get a superior outcome for your overall bet. And this is the concept of diversification. You need large number of coin flips. You need coins which are tilted in your favor and you need uncorrelated flips. >> Yes. >> So the next flip should have no relation with the previous flip. three very important principles of diversification.

10:11 Applying this to stocks or to portfolios, what you need is maybe a reasonably large number of assets stroke stocks. You need investments which have a probability of winning in your favor. So the riskreward should be tilted in your favor. And third very importantly each of these assets which you have accumulated in the portfolio should be should have limited correlation with each other. Now when you build a stock portfolio it won't that won't be the case but diversification is going to be useful and fruitful as long as you start creating uncorrelated or limited correlated assets. So coming to investor portfolios that is why we we advocate building portfolios for different asset classes for example stocks and gold might be very uncorrelated to each other. similarly if you let's say if you are building portfolios of stocks if you build the entire portfolio of large cap stocks it would be very very highly correlated with each other compared to a portfolio of let's say large cap midcap small cap something like that. So the point which I'm trying to explain is build diversification using the principles of diversification and not just by including a large number of stocks stroke assets. We try to incorporate similar hypothesis in many of our portfolios while being true to mandate. So for as you rightly talked about few of our funds we do not go beyond a particular limit in some of the funds for example in the large cap funds we don't go beyond the 10% limit which anyway is the regulatory limit >> but even in the midcap fund we don't go beyond the 5% limit for each single security so that we are able to achieve the benefits of diversification and also no single stock can materially change the fortunes of the entire portfolio.

12:17 >> Right? So let's stay on diversification. Right? You talked about the important piece being not do I have 10 stocks but what is the actual correlation between them because you could have 10 stocks that are extremely correlated. Right? Let's say you took you know six auto majors said hey I have different stocks but they're very correlated. So right so the increasingly what we seeing is correlation across different markets is falling. So if you look at US India correlation was quite high 10 years ago now increasingly lower. What's your take on driving international diversification especially in today's day and age where there's much more information right so you can understand how these stocks are doing etc and there's ease of access right and there's actually reduction in correlation right across markets. So what do you think about international diversification as a must-h have tool for today's investor in India? So I think clearly international stocks give one more asset class for investors to diversify their portfolios. We talked about gold, we talked about Indian stocks. Similarly, international stocks are one of the other tools to help diversify an investor portfolio. And while the correlations have reduced recently I would not extrapolate it for a long period of time and historically the correlations have been a little wider apart and hence that is the reason why this diversification is expected to work and and I that's the reason I think every Indian investor also needs to have some exposure to international stocks.

13:58 >> Yeah. if you think about another form of diversification right which is how do I diversify across duration of my portfolio right so do I hold everything for 5 years do I hold something for you know a year what do you think about investors also thinking about time duration based investments right and having different time duration investments in their portfolios >> I think if you are talking about equity investing ing equity investing cannot be done for short duration of time. The biggest myth which investors have is that you can generate XY Z percentage returns from equities over XY Z percentage of time. Remember equities is a nonlinear asset class. Sometimes you borrow returns from the future, sometimes you postpone returns into the future. There is no guarantee and hence please do not make any timebased investments into equities.

15:06 However, if you wish to make time based investments, there are other hybrid instruments. There are fixed income instruments. Feel free to include them into your portfolio to make them more time based. Got it. So, let's talk about you know investor myths that you've talked about, right? you've identified seven types of microbubbles that you believe are happening. Say a little bit more about that and how should investors look to avoid them. >> Sure. So I think we have talked about these microbubbles since the last one and a half to two years and since about year back some of these bubbles have started to deflate.

15:50 What were these bubbles? prominent amongst them were Indian capital goods stocks for example the railway stocks which were exposed to railways or power equipment or solar businesses stocks which are present in the real estate sector. So these were another set of stocks which are in a bubble and I'm talking about residential real estate. the third set of categories was companies which are small and midcap companies in lowquality low growth segments of the market. Once again these were quite in bubble. fourth a bubble which continues is the IPO wholly framed. So that continues. and fifth which not many people are exposed to is the theme stocks. I think that's an area where investors need to be very cautious of. If you are able to find a needle in the haststack, great please do that. But plus but you need to tread with caution in that area. So these were four or five areas where we thought there is sort of unrealistic stock price expectations which are built up and and potential returns in these segments of the market could be very very limited. And what's your take on the global you know bubble everyone talks about which is the AI based runup in valuations. Do you think that is simply a recognition of you know the potential of the space which is immense or do you think it's bubbly?

17:30 So I think as far as we while we do not officially track lot of companies globally but from what we read and understand the stock prices have multiplied multiffold in the last three or four years but so has the earnings. So this time when you look at stock prices they are not skyrocketing without any earnings the multiples are are virtually constant. So the earnings are going up and so are the stock prices.

18:09 However, if you are if you think and believe and if you have any special insight that artificial intelligence is is going to see some sort of moderation in terms of capex or in terms of acceptance probably there could be some slowdown or if you have a view that this continues or this would continue on the upside >> then the earnings will will may not crash but at least they may plateau out. So, so I don't think so that there is a irrational exuberance but but definitely there is there is a very very high level of growth in a very short period of time sometimes which is prone to some sort of a recalibration or a correction of some sort of correction >> yes but not tulips it's not a tulips okay let's come back to India right you've talked about how Indian corporate profits are approaching north of 9% of GDP and how you know that is clearly you know documented but may not sustain right. what's your view now with sort of you know the next set of earnings around the corner in a few months.

19:16 >> Sure. So the way we as investors look at long-term returns. So if you have to think about equity returns over the next 5 years how would you think about it? The way you would look at it is let's say I buy a company at let's 100 rupees today which has an earnings of 10 rupees today and pay multiple is 10. If the earnings move to 20 in the next 5 years, potential stock price could also be 200 and I make 100% return over a 5year period which means a 15% chair.

19:57 Right? So it's all based or predicated on what is the potential return I can make and second is what is the P fair P multiple which I can get. As we sit in today the potential earnings which we can envisage for the next five years is not more than on an aggregate basis not more than 12%. And the multiples at which we are trading is higher than historical average. So there is a potential for some multiple correction and the profits at best can sustain at 12%. And how do we get this 12%. This is the maximum potential nominal GDP growth rate which we can go to. we we would be growing at 7% real plus 5% at the max inflation. Remember today the inflation rates are running lower. So the nominal GDP today would be somewhere closer to 10%.

20:57 Now if the GDP grows at 12%. And corporate profits as a percentage of GDP are already at a historical high you cannot expect the the corporate profits as a percentage GD to go up. So the best case outcome which you can expect is corporate profits to grow at GDP rate. So let me ask you this right that assumes that different sectors non-corporate sectors perform at par right if you have a dip in let's say agricultural performance which has you know been sort of middling couldn't you expect to see corporate sector doing better and the agricultural sector not doing as much especially as you see price aileration etc which is typically offset through subsidies so is so I'm not saying that it'll fundamentally change that and suddenly you can expect double the rate but you could at least 4 to 5% additional potential right or are you not of that view >> it may happen but generally the fabric of the economy has not materially changed over the last 20 years so for example the last time when corporate profit as a percentage of GDP went up to 8% was in 2008 >> m >> that was the peak and after that we have touched 8% only very recently >> yes so so while we May we may believe that the structure of the economy would have completely changed. There would be some companies which are growing very fast but remember there are some companies which are also going to grow slower pace. Right? If there are disruptors there are also companies which are disrupted.

22:34 >> Yes. >> So the profit pool is shifting from one to another. I'm not saying it's a zero sum game. It's maybe a positive sum game but it's not a vastly positive sum game within the economy. >> So, so as an investor I should be able to pick the pools that are going growing faster. Right. Right. >> So let's come to that. Right. You are positive on certain sectors which you believe will grab more share versus others. Right. Healthcare consumer sort of you know sectors telecom. So why don't you talk about maybe your top three and the thesis behind that and how should people check if your thesis is playing out or not right because it's in the future it's uncertain.

23:18 So our u one of the first sectors which we are very bullish on our portfolios are significantly overweight this sector is consumer discretionary. What do we mean by consumer discretionary? let's take a simple example as a consumer you always have two choices to buy the basic necessities which is roti kabra makan and to buy things which are beyond your necessities >> these days roti kabra makan and cell phone so we'll come to that little after that either that's the sector that malaysia so so if you look at history of economies over long periods of time as the GDP per capita goes up >> the share of >> consumer staples keeps going down >> and the share of consumer discretionary keeps going up as a percentage of the total expenditure.

24:18 >> So your earnings might even if your earnings remain the same >> as you keep going up the income ladder the exposure to cons your discretionary buying would keep on increasing. So as India's economy is growing there is a disproportionate share of expenditure which is going to this discretionary items and this is where the growing profit pool or the revenue pool is also located. So when I'm talking about the GDP growth of 10 to 12% I have to buy something which is going to grow at a faster pace and this is a segment which is definitely going to grow faster because of the nature of the economy. the second sector is is health care services especially hospitals.

25:04 So in the last 3 or 4 years we have got a lot of chains of hospitals which have got listed. >> Correct. >> and a characteristic across most of them they are belonging to different parts of the country they are localized. Some of them are national >> but some of them are localized. the unique part is that all of them have got very high returns on equity. The business is very it's I have to call it a business.

25:34 >> So it is yes >> so it is it is very scalable which means that if you have thousand beds you and and you generate let's say 15% or 18% returns on equity you deploy this capital more in in setting up more beds >> more beds and it's a very scalable >> and it keeps on scaling up. So it is a scalable business generates very high returns on equity and very importantly organized healthcare is highly underpenetrated in India even today. So this is a segment which can absorb a lot of capital has nonlinear growth potential and is still available at reasonably attractive valuation.

26:13 >> third sector I know you're going to talk about telecom now. >> Yeah. So the the third one is telecom. telecom is just like an infrastructure sector most parts of the world it is treated like a utility but if you look at telecom in India and incrementally other parts of the world companies which are providers of telecom services are also big beneficiaries of the digital boom which we are seeing so for example people are moving from 3G and 4G to 5G G correct their data consumption is going up and this incrementally has a big driver for the arpoo for many of the telecom companies so I think it's a long journey for disproportionate growth in arpoo and and while we have almost all of India on telecom so there is no penetration which is left but there is clearly a huge headroom for our to go up and these companies are big beneficiaries of the digitization book and remember there is a very limited capital expenditure which they have to incrementally >> correct because the capex is already done in fact I'm equally bullish on this because tell me if you agree right because what's going to happen is as you move from voice to data the monetization ability not only on data plans but on services linked to data go up because these telecom companies are also household brands >> absolutely and they haven't quite figured it out yet so you don't see that in their strategic plans yet It's primarily a voice to data switch but ancillary services that are database I think is going to be significant add-on revenue.

27:56 >> In fact, you will see in the next 3 to 5 years a lot of other ancillary businesses will start showing up like for example payments banks or people are are setting up various apps which act as aggregators. Exactly. So, so bound to happen and massive upside >> and remember we we are in a completely consolidated telecom market. So, so a great place for investors to be. >> Yeah, it's an oligopoly for all practical purposes mandated by regulation, right? It's a great place to be.

28:29 >> So, so an extremely attractive sector, reasonably attractive valuation, remember and most of these companies are are are already past their big capex pays. In fact, their dividend yields are going to be very very strong forward. >> Yeah. So, let's come to that, right? Because you talked about penetration of mobile devices, increasing user of data. What we're seeing is that tier 2, three, four users are becoming avid consum consumers of content. >> Yeah. >> Right. >> And what's that's and that's content across movies, songs, but also education, right? Awareness of what should I do for my whole financial future, right? So you're getting more and more investors from these tier 2 3 four cities right if you look at investors into mutual funds a large number of investors are now being sourced from smaller towns and cities whereas let's say 20 years ago it was a metro gale in fact we recently met a company which is an online tutoring company they said that just because we are available on as an app to on tier three and tier four towns the number of registrations for UPSC has gone up.

29:35 >> Exactly. So you are creating so much of opportunity. >> So much of opportunity. So on investing in particular, right? The other thing that's happening is the push by many mutual funds to get lower you know sort of transaction sizes. Right? For example, on appreciate we just introduced 11 rupees daily SIP, right? So what do you think will happen as three things collide? Usage of data and awareness of a multitude of things including personal finance 101 etc.

30:04 Right. the accessibility of easy digital transactions again you know enabled by data and people saying that hey I have lower transaction values and it's now affordable so it becomes a part of your discretionary spend story right not on capital goods or physical goods but on financial goods how do you think that will change the investing landscape and how should people think about that right with this new influx of investors >> I think what it will do is it will bring in a a very important change from a behavioral investing perspective.

30:40 if you introduce daily sip or monthly sip or anything which introduces a regular saving habit >> discipline discipline I think that's a huge behavioral hack because investing is is not so much about intellect as much is it about behavioral discipline. So the more you reduce the friction, the more you introduce behavioral discipline, the more it is beneficial for the end industry.

31:11 >> Exactly. Most people don't realize, so we often do this like when we do walks popular, we ask people could you become a kurati, right? Could you like have 1 k of savings? And what most people don't realize is if you started investing at 21, 3 years after you turn an adult, maybe first job versus if you started investing say 35, which is when most people get up and say, "Okay, now I have to think about retirement." That 14-year window, right, is often if you invest every month at a reasonable sum, is often the difference between already being having a corpus of 1 cr by the time you're 35 versus not.

31:44 >> Absolutely. >> So the power of compounding as people start understanding it, right? And as we use telecom access to data and reducing transaction size, I believe will fundamentally change the investing landscape >> which means lots of potential upside for us as an economy, right? Because that's contributing capital. >> Yeah. It it's it's great for everyone, the entire ecosystem. >> Yeah. so look, you know, you've now run a mutual fund in India for a while, right? As a chief investment officer. How do you think Indian investors should think about concentration, market risk, right? Like you talked about discipline being more important than skill. So what's your message to the retail investor that's starting out, right? On a,000 rupee monthly SIP or a 10 rupee daily SIP, right? What are the two or three mantras he or she should have in mind as they start their investing journey?

32:39 So the first thing I would say is that you don't operate on yourself when you are having an injury because you are not a doctor. You don't go and fight your own case when you when you are in a dispute because you are not a lawyer but you attempt to do that with investing. So I would definitely recommend investors to take the services of qualified professionals whenever they think of investing because investing is a serious business and it needs serious investment professionals.

33:16 That's point number one. Point number two is is all about discipline. So while you can always engage the services of a professional the discipline is something which you bring to the table. So investors need to be very disciplined about both their savings habits and their investing habits. And finally don't treat investing as a game. there has been lot of gamification of investing. it is not gambling, it is not gaming, it is serious business and and treat it seriously. Lovely Vet, it was wonderful having you. Thanks for being on the show and folks, we'll see you next time on the next episode. Thank you.