'The mind is far more open to contrary ideas when you are not doing well'

Over the past few years, the stock markets have displayed something like the ‘beauty pageant’ effect, as defined by economist John Maynard Keynes. One of the greatest economists, he compared the stock markets to a beauty contest organised by a newspaper for its readers. In it, the readers had to send in their votes and if they made a choice that was the majority’s, they won a prize. So, to win, the reader had to align his or her choice as close as possible to the most probable popular choice. Exercising independent judgment would be a bad strategy, and guessing popular perception and voting accordingly would be the smarter way. While this may work well for the reader-voter, it may not work as well for an investor. In the stock market, this beauty-pageant phenomenon causes great polarisation in stock returns — the money flow favours some stock disproportionately and ignores the others—further feeding into the perception story and polarising the prices. The only thing that can break this vicious loop is sensible independent thinking by exceptional contrarians like Prashant Jain, CIO and executive director at HDFC Mutual Fund. In Outlook Business’ Investment Summit 2021, he tells editor N Mahalakshmi how he remains confident about his convictions, and about the ‘Price and pain of being a contrarian’.  Edited excerpts from the interview:

Mahalakshmi: Prashant, you’ve been in the markets for close to 30 years now. From the time you started till now, what aspects of the market and investing do you think have changed and what has remained unchanged? You can probably talk about it from 1996-97 onwards because that’s when the private sector mutual funds had come into the country.

Prashant: This month I completed 30 years in investing, and it’s been an exciting journey and a period of tremendous change. When I began my career, the earlier era was ending — the era of jobbers and physical scripts — and we moved over to screen-based trading, DEMAT and so on. Information back then was extremely difficult to come by and we used to spend most of the time just collecting information. We have come a long way from there. Today, information is a commodity and we have more information than what we can handle. Sell-side research used to be few and far between, and today, we have more research than what we can handle. Mutual funds have grown tremendously in scale, size, diversity and range. If you look at it from a distance, a lot seems to have changed, but to my mind, all of this is nothing but packaging. More of the market is much the same as it was. Markets are as hard to forecast in the near term today as they were then. Sentiment is as fickle today as it was then. The human emotions of impatience, desire to make quick money, desire to avoid pain and greed for more returns stay the same. So, in a way, I feel a lot has changed but I think not much has.

Mahalakshmi: You said the ability to forecast near term is as difficult today as it was in the past. But has the ability to forecast the medium term become more difficult?

Prashant: One can forecast directionally. But to forecast exact numbers was extremely challenging then and it remains so today.  If you look at the significant capital-allocation decisions taken by the corporates, especially in M&A situations, you will realise that most of these have gone wrong. Even the people who are running these businesses find it tough to forecast the future. You are faced with events such as 9/11, demonetisation, Brexit, tapering and COVID-19 once in a while, and they make forecasts quite redundant. One does have a view on the short to medium-term direction of the economy and businesses, but stock markets are extremely hard to forecast in the near term. It becomes easier to forecast markets as you think slightly longer. What I have observed is that the best indicator of future stock market returns is the valuations at the time of investment — the more attractive the valuations, the higher the returns are likely to be and vice versa.

Mahalakshmi: Is there a substantial change in the way you approach markets, between then and now? Of course, the size of the fund you manage is substantially larger, but apart from that, what else has changed?

Prashant: To be honest, not much has changed. I continue to follow a bottom-up investing style, focusing on sustainability of businesses and on managements that are of acceptable quality with a clear preference for growth, focus on effective diversification not overdiversification and on value. Over long periods, the entry point of investment has a substantial impact on return, so value is extremely important. I am patient with my investments and have the ability to handle pain if there is near-term underperformance either by the business or by the market. So, I don’t think much has really changed. As far as fund size is concerned, it is overemphasised in the Indian context. Of course, funds have grown in size and there is no denying that, but so has the market. Even today, if you look at some of the largest funds, they are about 0.1 or 0.2% of the market. Fund size in absolute terms is not relevant. To that extent, I don’t think even size has impacted my style much.  When the funds are smaller, one would manage portfolios with 25 to 30 companies, when they are bigger, there may be 40 to 60 stocks. 

Mahalakshmi: Would you agree that in a large fund, your ability to move the needle by buying unique non-index stocks is limited and much of the returns will have to be driven by a view on stocks that is different from the index? In essence, do you have to necessarily take a few contrarian views to create alpha?

Prashant: I think contrarian investing is highly misunderstood. It is not me who decides whether I am contrarian or not. I am trying to look at businesses that are sustainable, that have reasonable management managing them, that have decent growth prospects and are available at a reasonable value from a long-term perspective. Now, if the market thinks like that, I am not contrarian. If the market thinks differently, I am not contrarian. Let me emphasise that my reasoning has been consistent and, when the market agrees with me, I am not contrarian and vice versa. So, I am not contrarian for the sake of being contrarian. Many a time, value is there in contrarian thinking and, many a time, there is value when there is no contrarian view.

Let me give you a few examples here. Corporate banks — there was a time when one was a clear contrarian (for holding them) and there was good value, but today, if you look at the target prices or recommendations or even portfolios of many people, you will realise that they are no more of a contrarian view but that there is decent value in these stocks. Of course, I am not shy of taking a contrarian view. If the market thinks in one way but to my mind, it does not make sense and I’ve arrived at that conclusion after careful evaluation, then I am not shy to bet against the market. Some of the best investments I have made have been contrarian.

The reason is very simple — when the whole world dislikes a theme, it is likely to be cheap and when the whole world likes to buy into a theme or a stock or a sector, it is likely to be extremely expensive. There is one fundamental difference between investing in elections. The majority decides the outcome in elections but in investing, the majority can be wrong.

Mahalakshmi: Even in election outcomes, you don’t know whether the majority is right or wrong. The majority just has its way.

Prashant: I disagree. You can’t say my opinion is superior to the majority’s opinion.

Mahalakshmi: I’m not saying the majority is wrong. I’m saying there is nothing to say that the majority is always right or wrong. 

Prashant: At least elections are won or lost on the basis of the majority opinion, and who am I or you to say that the majority opinion is incorrect?

Mahalakshmi: One of your approaches has done exceptionally well for you in the past. I recollect the first time we met in 1999, when you had already exited all the tech stocks maybe a year before they peaked out. That really worked out well. Again, you did the same thing in 2008, when the power infrastructure stocks were really rising. You didn’t participate in that trend and went through a pain period for a year or two. That worked out beautifully. This time around, it’s taken a bit longer. Your cycle seems to have been longer and you’ve had a longer pain period. Now, apart from the valuation differential compared with the growth prospects, which you talked about, are there any other factors that you look at to evaluate whether and when a polarity can get closed? So, do you have a sense of the pain period and the kind of pain you will have to endure, and if at all there needs to be a course correction, when should that be done?

Prashant: This is a pertinent point that you have raised. I’m reminded of a couple of thoughts from Howard Marks (writer and investor). What he says is that there is a fine line between being too early and being wrong, and I’m fully cognizant of that. He also says that a decision cannot be judged only by the outcome of the decision because, over time, the environment and the information available both can change. Let me add a third dimension to that — it may still be premature to judge the outcome of the decision because what looks wrong today may look right tomorrow and vice versa.

Coming to the issue of corporate banks, it is true that the pain has been much longer (than expected). Whether one could have estimated this or not, it’s a matter of theoretical debate. A few points — the IBC (Insolvency and Bankruptcy Code) said that the resolutions should be reached within a year, but they took three years. Whatever the reasons, merits or demerits, I don’t want to get into that. So that certainly delayed the process. COVID-19 — it took one more year away. Now, your investment approach has to be such that it is able to handle these unforeseen developments or rough weather. It will happen once in a while. That’s why I emphasise the sustainability of a business foremost.

In the same period, there have been many businesses which have destroyed wealth permanently. When you talk of underperformance, here at least wealth has not been destroyed. They may have given lesser returns than the market, but there were a lot of businesses that were mega caps a few years back and have now disappeared.  I think we have maintained a discipline by avoiding most of these businesses because they did not pass the test of sustainability. In the businesses that we have invested in, the rough weather has been extended and it has delayed the proper price discovery of these businesses, but the businesses have grown in value over time and that value will be evident whenever normal profitability returns. I hope it happens this year.  Along with the growing franchise, the scale, the size, the competitiveness of the core banking businesses, you can also see how much value has been created in the non-banking businesses of these banks. So, I would say yes, there is a price that has been paid in terms of active performance. Things have improved significantly in the last few quarters. I hope over the next few quarters, these businesses get a fair value and, if that happens, it would justify the entire holding period.

Mahalakshmi: Now, when your calls start going wrong and for a longer period of time — now it’s been seven years that a large corporate bank has delivered anything at all, being at pretty much the same level that it was many years ago — how do you think about the return math, because you’ve lost five-seven years with a large investment, maybe 10-15% of your portfolio, not delivering anything. So now, in the next few years, it will not only have to give returns commensurate with the market’s but also have to make up for the opportunity cost.

Prashant: The market cycles are often much longer than the typical investment horizon of many of us. That is a challenge, and that is what makes this job both exciting and challenging. If you look at the opportunity cost with the benefit of hindsight, there would be hardly any investors without regrets or who have not made such mistakes. I am not so much worried about businesses whose price discovery has not been proper as much as about businesses whose intrinsic value has been destroyed. Definitely, this particular bet (on corporate banks) that I had taken has not worked out so far, but what reassures me is that these are businesses that have stood and come out of period. The profitability of these businesses is evident, and price discovery will justify the entire holding period.

There are many examples in capital markets where a business has not done well for five to seven-eight years and, in the following two years, it gives a return that justifies the holding period. I think and I hope that these are such businesses. Again, in this industry, people always look for what you have owned and what has not worked. But what is equally important is what you did not own and what did not work. 

Mahalakshmi: Do you think there can be a possibility of J kind of returns in a large-market-cap company with so much coverage?

Prashant: Of course. We see that every day. Look at the metal space today. Look at pharmaceuticals between 2008 and 2014, at consumer stocks in the last few years… I think it is happening all the time. You look at Maruti and go back 10 years. What happened to technology between 1995 and 2000, what happened to capital-spending commodities between 2000 and 2008. I have seen large engineering companies go up 20-30x, we have seen consumer companies go up 10-20x. On the way down also — haven’t you seen large companies vanish and lose 90% in value? Whatever sector comes into focus, it can do extremely well, and if things are overvalued or unsustainable or very expensive, they can use huge amounts of value.

Look at companies that moved out of Nifty, and observe what happened to them before they moved out and after they moved out. In many cases, you will see that such price movements are possible and do take place even in large caps once in a while.

Mahalakshmi: With the size of funds that you manage and also with the funds being open-ended when your stocks don’t perform, I’m sure there is a lot of pressure. What are the questions that you ask yourself when things go wrong when the market is not responding and you hold on to your conviction? Of course, we know what you do but what do you think?

Prashant: When you are not doing well, that is when the mind works much better. That’s how it is for me at least. The mind is sharper and is far more open to contrary ideas, opinions and it is practically working 24x7. Most of my good learnings or insights have come in periods of underperformance or from mistakes. Someone has said that success is a lousy teacher. One tends to become complacent and confident when things are doing well. So, when performance is weak, I do something very simple — go back to the basics, look at the business.

Mahalakshmi: Are you suggesting that you had become complacent?

Prashant: Yes, if everything is working in your favour, I do think that most people become complacent or more confident of their views and I am sure that happens to me as well. When things are not working, you go back to the basics, check your assumptions and seek an alternative opinion. If you feel that what the other person is saying is either incorrect or only relevant for the short term, then I think you are reassured about your views and conclusions. That is what gives one the confidence of enduring the pain and I think I also have an advantage of experience. I have been in such situations three or four times. On every occasion, wherever our understanding of the business has been right, things played out as we had expected. 

Mahalakshmi: Who are your sounding boards with respect to investing?  When things go wrong, whose views, opinions and analysis do you trust the most?

Prashant: Sell-side research has evolved over time and it has highly experienced analysts across most sectors. We have a discipline of seeking out, talking to and documenting the opinions of these highly rated, experienced analysts who think differently from us. I think they are the primary sounding boards for us and, of course, it goes without saying the internal colleagues, who are also highly experienced, their opinions are also extremely important. But more often than not, since the internal team meets frequently, we know what the other person is thinking. I think at times like these, the external opinion, primarily of sell-side analysts, is what we seek. In the end, a portfolio manager’s job is to listen to everyone but do what he thinks is right.

Just imagine what would have happened if we had cut exposure to some of the underperforming stocks one year back and you will have your answer. Then we would have done permanent damage to our returns to customers and I don’t think that would have been right after enduring so much pain.

Mahalakshmi: Are there any Indian investors or sell-side analysts whose contrary opinion you really fear? If they have a stance that is opposite to yours, it makes you question yourself? 

Prashant: I deeply respect all contrary opinions. That is what has helped me survive but, at the same time, I am also confident that the majority opinion can be wrong and I can give you any number of examples. Can you tell me how many people were negative on technology in 2000? Can you tell me how many people were positive about the old economy? In 2007, I think practically everyone was positive on the power utilities, the non-banking finance companies and the real estate companies and what happened? In 2014, practically the whole street was positive on pharmaceutical companies.

That’s why I said there is one fundamental difference between elections and stock markets. Here, the majority opinion can be wrong over time. That’s why it is important that while there is the risk of being wrong, people like me don’t have a choice of not investing according to our understanding.

Mahalakshmi: How do you view unquantifiable negatives such as perception issues and how do you factor these into your valuation? You know there are stocks that you hold that are solid in terms of businesses, but they are perceived poorly because of government ownership, ESG and things like that. 

Prashant: You must have heard this often — investing is both a science and an art. I am better at the science part of it and am still learning the art part of it, which relates to timing. Timing is more difficult because sentiment is prone to changes without notice and I have experienced it too often. But, at market extremes, when there is too much pessimism and the risk perceived is too high, and on the other hand, when there is too much optimism and there is no risk perceived at all, the distortion is easy to identify. But, between the two extremes, it becomes more challenging.

There are opportunities created by perceptions. What happened between 2000 and 2007 was perception. Whenever perception diverges from reality, there is an opportunity. So, something gets overvalued and something gets undervalued. Again, you understand a business, go back to the basics, and if your assessment of the business is different from the perception, then you may time your entry or exit to take advantage of a particular direction in which the markets are moving. Over time, at least a person like me would like to do what one thinks is right from a long-term perspective.

The cash flows will not change. The reality of the business is what it is and over time it will be evident to everyone. Perception is what brings uncertainty to this business. As you gain more experience, you try and appreciate these issues a little more, otherwise, there is no exact science to reading perception or to knowing when it will change.

Mahalakshmi: Looking at your approach, I believe the way you think about markets is more long-term than what most common investors would like to see. But you manage open-ended funds. Why has HDFC Mutual Fund not launched ten-year closed-ended funds or something similar? Won’t these be more amenable because the investor is also sure about the commitment in terms of time? This way, your thoughts and timing are more closely aligned with investor expectations.

Prashant: I don’t agree that most investors are short-term investors. If you look at the size of some of the funds that I run, they don’t suggest that. But yes, many investors do not think that long. I agree that my investing style is more partial to a long-term approach, and I am glad that it has worked. Even if you look at the last few quarters, I think we have covered a whole lot of ground in a fairly short period of time. This is one interesting thing about investing that, what you lose over three years or four years when it returns, it does so in a few months. I have seen that happen two or three times, and hopefully, it will happen once again.

Mahalakshmi: Close-ended funds seem to have gone away for good because of trouble over the discounts at which they trade and liquidity. But there still seems to be a lot of merit in the product. Being a large fund house, why is it that you have not championed the idea?

Prashant: I have to connect with my colleagues in sales and don’t have a ready answer for that. But nothing prevents an investor from staying put in an open-ended fund for ten years. You have the flexibility. My investing style would not be too different between a close-ended fund and an open-ended fund.

Mahalakshmi: Won’t investor behavior make a difference to your performance? If a large majority of your investors don’t feel the same way about close-ended funds like you do, then it can make a difference to your returns.

Prashant: I don’t think so because these are fairly large funds, and they are marked to market every single day. Equity AUM is mostly retail and people coming in or going out won’t impact performance. As I said, even the largest fund in the country is just about 0.2% of the markets. Even if 5 or 10% of the AUM goes in or comes out, I don’t think it is going to impact returns.

Mahalakshmi: You have large bets on power producers. How grave do you think the problem of cash flow is for them this year with the pandemic and government’s deteriorating finances, both at the Centre and state-level? Can it freeze liquidity? We didn’t envisage that even early this year during the Budget. In the absence of cash sales, how credible is their business and earnings growth? I think this is a major concern that the market also has.

Prashant: There is no absence of cash sales.  You are right that last year was a challenging year. Let’s recollect what happened. When the lockdown was announced, the power demand in the country dropped 30-40% for a few months and, as you know, the distribution companies have a huge fixed-cost structure. When your throughput drops, your losses will go up. To that extent, they were unable to pay the power producers and that’s why the receivables of the power companies went up last year. But with initiatives taken by the government, the receivables position has come back to pre-COVID levels.  So, I don’t think it is fair to say that they are non-cash-sales-taking companies.  It is true that the power sector is in need of reform. But, compared to the way we were subsidising or managing the oil and gas sector, we have come a long way. There was a time when there were subsidies on petrol and diesel, and today, that is not the case. I am confident that, over time, since we have the ambition of supplying quality, uninterpreted power to residences and to commercial, industrial establishments, we’ll have to bring this sector to speed, to improve the viability of all the investments. I think we are moving in that direction if you look at the pending Power Bill. I remain quite optimistic about this.

Mahalakshmi: We’ve seen a lot of value erosion and value destruction in public sector companies, in which you have significant holding, in the past. How real is the risk of capital destruction in the power sector because of vested interest?

Prashant: There are a lot of misconceptions here. There is an index called the CPSU index. If you look at the performance of that index between 2000 and 2017, the return was virtually the same as that of Sensex. So, for 17 years, the CPSUs did not underperform. It is true that, in the last three years, they have underperformed sharply. When something has underperformed sharply in a three-year period, if you look at the trailing 10-year period also, it is possible that you may underperform over a 10-year period also. The counter is also possible, i.e., if you underperform for 10 years and sharply outperform over three years, you may end up outperforming even over 10 years. 

This underperformance of the last few years is not because of the financial performance of these companies. Based on public data, over the last five years, from 2015 till 2020, the profit growth of non-bank PSUs has been higher than the broad market. I think the reason for the underperformance, therefore, is a particular disinvestment approach the government had followed. I think the government (Department of Investment and Public Asset Management or DIPAM) has understood that and they have taken corrective steps. The DIPAM secretary has emphasised time and again that, going forward, the focus will not be on exchange-traded funds (ETFs). It will be on strategic sales and occasional waivers.

I think a significant opportunity has been created here because of the underperformance of these companies. Most participants in the market base their view on recent price performance. But, whenever I am faced with such a situation, when the price underperformance has not been due to the business underperforming, I think there is an opportunity. Therefore, we have stayed put and, wherever possible, we have even increased our exposure within a prudent limit. I am happy to say that, if you look at the performance over the last few months, you would have noticed how these stocks are coming back in favour.

There is still a big gap between what people feel about these businesses and reality. Let me give you one example here: I think the current approach of ESG investing of exclusion — for instance, thermal is bad — is fundamentally flawed. If thermal is bad then what about the gasoline cars, the automobile industry, the cement companies, the steel companies and the chemical companies that are burning coal? And how can you say burning coal in these industries is good but burning coal for power is bad? This exclusion-based investing doesn’t make too much sense to me and I don’t think it will make any change on the ground as well.

Is your act of excluding making any change on the ground? I don’t think so. If you starve a sector of investments, then what will happen? Over time the prices of the output of that sector will go up sharply. What is happening to metal prices today and why are metal prices going up so sharply? One reason is that in the last 10-12 years, you have not created new capacities.

The power demand in the country continues to grow. Are you aware that just 5% homes in India have access to air conditioning? What happens when electric vehicles come? They will need power. India’s power consumption is a fraction of the world and will experience continuous growth, significant growth in power demand. How are you going to meet that? On a daily basis, the demand for power in India peaks between 5 and 9 in the evening. There is not enough sunlight during this time. Storage costs Rs 7-10 per unit. Who is going to pay that extra amount per unit of power?

These are issues are extremely serious. The approach of exclusion will be counterproductive, it will not work. ESG will serve the interests of the community, society and countries better if we promote ESG investing that encourages people to invest in companies that are improving their ESG scores. Why not encourage a thermal, steel, cement or car company to become more efficient and reduce its carbon footprint? I think that would be a more proactive, productive and rewarding approach to ESG rather than this simplistic way of investing in which one sector is considered good and another bad. 

Mahalakshmi: Globally, a few trends have emerged strongly over the past few years. We talked about ESG and the triple-bottom-line approach, and there are also digital businesses, where companies are building their fortresses by over-extending their P&L to ensure that their market position is secure in the future. Do you believe this has permanently altered the way we think about earnings and stock valuations, or is this just a temporary trend and finally the quantifiable part of the hard earnings will prevail?

Prashant: Fundamentally, I don’t think there is absolutely anything different in the valuation approach (of digital businesses). But what makes this job far more challenging and difficult is the huge variability in cash flows and outcomes that is possible. If you are successful, you may make money which is beyond anyone’s imagination and, for every one such outcome, there could be 10 or 100 failures.

So, I think it is a lot of hard work, a lot of luck at the right place and the right time but I think the fundamental approach to valuing these businesses isn’t different. But since cash flows are so unpredictable, so non-linear, I think forecasting them becomes extremely difficult. There is also a lot of luck involved.

Mahalakshmi: So, for a person like you who believes in sustainable businesses and hard earnings, what does this opportunity really mean? Because, especially from this year, a whole bunch of internet businesses is likely to go public. How will you look at these businesses?

Prashant: I am keen to evaluate these businesses. I am glad that many start-ups and these new-age businesses are coming up in India and some of them have global aspirations. I think India has significant advantages in terms of technical skills and in capital not being a constraint. So I think this internal environment of a lot of cheap capital is highly conducive for such businesses to flourish. I think my job is a little easier than the venture funds or the private equity funds because by the time these businesses come to listing, valuations apart, they would have established a certain degree of leadership in the space they operate in. They would have moved ahead of a lot of competition. To that extent, I think the sustainability of these businesses would be a lot more and the risks would be a lot less. But, of course, valuation is a slightly different issue. Whether it has been overvalued or undervalued, only time can tell.