SBI Investment Strategy

Few of your schemes are doing exceptionally well, so how do you discover stocks among the hundreds available in the market? What is the star performing stock selection process from the universe of stocks in the market?
As a house we have two separate philosophies, one for large caps and the other for mid caps. The large-cap philosophy is based on a one year perspective but the mid-cap viewpoint is longer, say for around three years. We define large-cap stocks as the top 100 companies in terms of market capitalisation and look at four essential variables. The first one is positive fundamental change (sales, margins and profitability); then we look at market expectations since there is no point in buying when the news has already been factored in. The third variable is valuations and the last but not the least is momentum. This is in addition to our regular due diligence on the business. We also take into account the recommendations of our research teams as they too have their own models of identifying a stock. Based on these parameters, we rank the stocks and decide where to be actively over-weight or under-weight.
For mid-caps we adopt different parameters on account of liquidity constraints and a longer time perspective. We consider five factors for mid-caps. The first factor is a ‘right to win’ or a core competency which can be defined objectively, for example in terms of market share, gross margins, technological edge or a brand franchise. We find a lot consumer companies with some high brand franchise such as Hindustan Unilever. Second is the return on capital and its consistency over a time period. Then we look at the growth expectation as you don’t want to end up with single digit returns in a growing market like India. Our fourth factor takes into account the management capabilities and their integrity which is followed by valuations.
A combination of these five factors helps us make a buy decision based on the relative intensity of each factor. Fortunately, for mid caps we are not benchmark oriented which is unlikely in the case of large caps and hence can afford to ignore what we do not like.

After going through all the process, how do you choose a stock that is best suited for a fund and avoid the bad one?
Well, for example, we run a mid-cap fund called Magnum Global where the fund needs to satisfy three factors such as competency, consistently high returns on capital and fairly high growth expectation. So we consider a stock if it meets this criteria and follow this strategy for more than 75 per cent of our equity funds. This approach narrows down our universe of stocks to around 150 odd scrips. We then make the selection decision based on management assessment and relative valuations.
Due to this philosophy, this fund is typically high on ‘quality’ and stocks may come expensive relative to the index or the peer set. We have seen this philosophy work well in secular markets but not during sharp swift rallies. So, last month, we got hammered badly against the benchmark.
The Emerging Business Fund, on the other hand, could happily buy junk if the valuation comfort is high. In other words, we might compromise on companies that have no core competency or where returns on capital are low just because valuations are attractive. Take McDowell Holdings, for instance, which is trading at an 88 per cent discount to the value of its underlying which ironically, is also a holding company trading at a huge discount. Not to say it is low risk but one needs to weigh the probability of a one-zero event.

Can you tell us about some stock calls that have gone right or wrong while managing the fund?
Page Industries is definitely one stock that contributed substantially to excess returns last year across a number of funds. Manappuram General Finance has done well for us and so have Hawkins as well as Goodyear among the mid cap bets. Likewise, Redington India is something we bought for its ‘right to win’ (market share and business model), consistently high returns on capital, valuations and most important out of all, its management, and it paid off handsomely as it has almost doubled in a bear market.
Buying Bajaj Holdings, we thought, was a no brainer as we liked the underlying, Bajaj Auto and there was a 65 per cent margin of safety. We got a meaningful lot at Rs 400-odd, I think, at a time when the management itself was doing a preferential at Rs 450 and made decent returns on them.
Clearly, we’ve gone terribly wrong on a few others. Dhanlaxmi Bank for example, where we betted on the new management coming in and picking up low lying fruits similarly we got it wrong with Centurion Bank. We had bought a meaningful quantity in the Emerging Business Fund but lost more than one-third of it before we exited and the stock crashed even further. We had bought that stock for around Rs 180 levels and exited later when it came down to Rs 120-125 and booked some losses there.
McDowell Holding is another example which we still hold. The stock is at half the price we bought it for. I had thought it was a doubler then; now, obviously, I think it’s a four-bagger (smiles). It is down because of the problems with Kingfisher. Did we see it then? Yes. But, we thought and still do that the stock sufficiently factors in the concerns based on the reasonable event probabilities.
Essentially, we run an investment thesis on the stocks we hold which we revisit every once in a while and then revise our view when the thesis changes. In Dhanlaxmi Bank, we had an investment thesis which changed when the bank got into a vicious cycle rather than a virtuous one. When we saw that, we exited irrespective of the cost price. I think, in the investment business, one need to swallow a lot of self discipline and as a house, I think, we have been alert on cutting our losses on the wrong decisions and made more right decisions.

Mid-cap stocks come with a set of risks, how do you manage the overall portfolio balance?
There is risk in mid-cap stocks because it comes with high beta and it is apparent that when markets are negative mid-cap stocks fall more. While managing a mid-cap fund, we are obviously benchmarking it to other mid-cap funds and the mid-cap index, so in that context there is no relative risk. On an absolute basis, risk effectively emerges out of volatility. I personally think, volatility is a boon and presents an excellent opportunity to buy businesses you like at your price. In the Emerging Business Fund, for example, we don’t bother about volatility for a significant part of the portfolio but we do communicate to our investors that this is a high-risk, high-return fund. But, having said that, in all the other funds we run clear internal mandates that controls risk and limit the fund manager’s flexibility to the given mandate. Say for instance, Magnum Equity which is a pure large-cap fund that can invest only in the large-cap space of top 100 companies wherein we also run a minimum benchmark coverage and active sector and stock limits. SBI Bluechip can buy mid caps only to the extent of 20 per cent and similarly we have limits for every fund that cover not only market cap risks but also benchmark risks along with volatility risks.
But, in a way you are right, mid-cap companies are more prone to basic business risk because they are small. But, like I said, we try to focus on leaders within that smaller space like a Page Industries or a Redington or even a Divi’s Laboratories.

Given this kind of scenario how do you sustain your conviction on the stocks or the sector you hold?
One should have done enough work on the company before getting into the stock so that the market momentum does not change your conviction. In a stock if one has a high conviction, you should be happy if it comes off because you can accumulate more stocks. That’s especially true for a large fund house like ours where you have more money chasing fewer ideas. Simply speaking, a stock falling shouldn’t affect the conviction as all the stocks are not going to perform during all periods. But again as I said, our five pillars in selecting a stock are very important. Even in mid-cap stocks we are looking for some core competency, we are not buying a small company in a space that is dominated by larger player. One has to, I guess; wait for its time to come.

But some times do you try to avoid some stocks and what are the reasons behind it?
We don’t have any specific reasons for avoiding stocks, but typically we stay away from stocks which have larger concerns on management side. As a house, we don’t have a particular philosophy for not investing in a company because finally we are looking at the risk-adjusted returns. But it could be that some times we might not buy a sector due to fundamental reasons. So, today we don’t own much in Construction as we feel that the balance sheets are still quite stressed.
Personally, real estate has been a no-no for me since long time. I didn’t participate even in the DLF Initial Public Offering (IPO). I have bought only two real estate stocks, one is Phoenix mills and other is Godrej Properties. So it does not mean we don’t get into real estate stocks.

Who has been your investment mentor?
I have read many investments books, but I really like Philips Fisher’s ‘Common stocks with Uncommon profits’ which was introduced to me by Raamdeo Agrawal of Motilal Oswal. And mostly, people from real life whom I have worked with have added tremendous value knowingly or unknowingly.

So many investors across the globe also look at investment strategies of famous investors like Warren Buffet. Have you any time looked at investment strategies and replicated it while buying a stock?
Yes of course. Frankly, nothing we do is original. Ours is a glorified copy-and-paste industry (smiles). There is definitely a lot to learn and whatever I say here would seem clichéd. But, yes, as much as possible you try to read up and copy-paste effectively. The most we learn, however, is from our interaction with company managements who unfortunately tend to get less credit than money managers for the performance of their own companies. Having said that, a typical ‘Buffet’ philosophy does not work naturally for a mutual fund since the focus is on relative returns and the consistency of that relative performance given that investors are getting in all the time.

So what kind of strategy do you follow in investments as volatility is part of the equity markets?
It is like running on a treadmill and we need to keep evaluating the portfolio all the time. We did well in a lot of funds last year as we had a defensive approach. Towards the end of last year we moved incrementally into higher beta, but unfortunately it wasn’t good enough. So, a few funds that were doing well last year have lagged the benchmark (year-to-date) while some others are doing much better. Apart from that we have active churn in the portfolio, there are many stocks which we buy and hold again where our thesis are bang on. When we think our price targets are achieved or the thesis is getting shaky we churn, eventually we rank our preferences all the times and buy what looks best. Fortunately or unfortunately, one thing I have learnt in this profession is not to respect one’s views too much.

IPL Model

After the emergence of the Indian Premier League, BCCI secretary Niranjan Shah had grandly announced: "Indian cricket is now worth a billion dollars every year." So where is all this money to come from and where will it go? What’s the ‘business model’ of the IPL? Is there any way the franchisees who have bid millions of dollars a year can make money?

To get a fix on the answers to these questions, let's start from the source of the river of moolah. The IPL - read BCCI - has four major sources of revenue. The first is the sale of media rights for the matches, which will fetch the board $1 billion over a 10-year period. The second includes things like title sponsorship of the tournament, licensed merchandise and so on. Put together, these form what the IPL calls "central revenues".

From the sale of media rights, IPL will keep 20% for itself, give out 8% as prize money for the tournament and distribute the remaining 72% evenly between the 8 franchisees. These proportions are valid till 2012, after which IPL’s share goes up in two stages by 2018, with the shares of both prize money and franchisees declining.

The second stream - other central revenues - will be shared between IPL, franchisees and prize money in the ratio 40:54:6 up to 2017 after which IPL’s share will increase to 50%, the franchisees’ share will drop to 45% and the remaining 5% will go for prize money. The third major source is, of course, the amounts bid by the franchisees. The fourth stream comes from the revenues generated by the franchisee rights, of which 20% will be given to IPL.

From the franchisees’ perspective, while the share in central revenues will be a given, they can raise money on their own by a variety of means. These include selling advertising space in the stadia for home matches, licensing products for their team like T-shirts, getting sponsorship for the team uniform, advertising on tickets and so on, apart from the gate money. As already mentioned, 20% of all of this will then go to IPL.

What do the players make? Apart from the annual fee contracted with the franchisee, they get a daily allowance of $100 through the IPL season, which lasts about a month-and-a-half. The total amount spent on player fees for an IPL team cannot be less than $3.3 million each year and is actually expected to be significantly higher. In other words, players will earn about Rs 80 lakh or more per season on average, though the amount would vary from one member of the team to another.

Players could also get bonuses from the team owners and perhaps even the prize money that the team wins by virtue of where it finishes in the tournament. But it is for each franchisee to decide whether these payments are made to the players or not.

Even in the case of the annual fee negotiated between a player and the franchisee, not all of the negotiated amount may actually go into the player’s pocket.

This is because the IPL is reaching two different kinds of agreements with players when it gets them on board. Under one arrangement — called the "firm agreement", the IPL commits a certain fee to the player. If a franchisee bids more for that player in the auction between franchisees for different players, the IPL gets to keep the excess. Under the other - the "basic agreement" – the player gets whatever is bid for him. Not surprisingly, most players so far have opted for the "basic agreement".

Now that we have the broad structure of the flow of money in place, how does this translate into actual numbers? The bottomline, acknowledge BCCI officials as well as franchisees, will depend on whether the IPL as a concept takes off and captures audiences.

As things stand, the expenses committed by franchisees are more than what they are certain to receive as income from IPL or from sale of their own rights. The UB Group, which acquired the Bangalore franchise, says the idea was to use it as a vehicle to promote its brands. "We are not looking at making money. But revenues will be in excess of costs," said Vijay Rekhi, president of United Spirits, the spirits company of the UB Group.

Some franchisees said that if everything goes according to plan, they will break even and perhaps even start making some money after about three years.

Sources say IPL is guaranteeing $7 million per franchisee from central revenues. But what will come from the local level is anybody’s guess. Even with the right to market just about everything connected with their teams, the industry is not expecting to raise more than $2 million per franchisee each year. BCCI expects the franchisees to earn $1.5 million from gate money in every IPL match, but insiders say the figure is "exaggerated" and that the franchisee will be fortunate to get $1.5 million from 7 home matches at home. In fact, highly charged India-Pakistan one-day matches make around $3 to $4million.

However, based on IPL’s calculation, tickets will have to be sold for Rs 750 to Rs 1,000 per match for gate money to be of the estimated levels. Will the fans pay that much? Apparently, there is also a suggestion from IPL that franchisees could have some "business class" tickets for Rs 10,000 each. Again, will there be takers for such expensive tickets? There are franchisees who are planning to sell tickets for Rs 200 to Rs 300 to keep them within the reach of the middle class, without which making the IPL a success would be difficult. But then, they cannot expect huge revenue from the gate money.

Assuming the gate money is around $2 million for all seven home matches, this means the franchisee in the first year can look forward to total income of about $10 million after paying 20% of local revenues to IPL.

Against this, the franchisee will have to spend at least $8 million. To this must be added the bid amount divided by 10. For Mumbai or Bangalore, that means another $11 million. Even if it’s lower for others, the franchisee's expenditure will be anything from 1.5 to 2 times of what his income is, at least in the first year.

What can change in this equation to make the business financially rewarding for the franchisee? If local revenues really rise, things could get better. It all boils down to whether the IPL teams can make their cities identify with them. That’s the billion dollar question.

Reference : Times Of India article