Sticking to the script

It doesn’t matter to me how many bags of cement are sold per month or how many tyres are sold. We at Quantum look at companies that have sustainable businesses, strong corporate governance and are worth their valuation.” Atul Kumar still remembers this comment by Ajit Dayal, who had then just received a licence to set up a mutual fund house and was putting a team in place. “By then, I had already heard that Quantum followed the value investing philosophy, but hearing this comment in person only reinforced the fact that I had come to the right place,” recollects Kumar, who has completed over a decade at the firm, managing close to Rs.500 crore in assets under Quantum’s Long Term Equity Fund and Tax Saving Fund. With a CAGR of 13%, the 39-year-old is today one of the top three fund managers in the country, with an exceptional track record in terms of return over the past decade. 

It was during his ICFAI days around 1999 that Kumar got hooked on to investing, especially after reading Roger Lowenstein’s book Buffett: The Making of an American Capitalist. “It was like an eye-opener about the magic of investing,” says Kumar, as he sips tea at Quantum’s head office in Mumbai’s Nariman Point business district. But Kumar had to bide his time working as a consultant for Deloitte for nearly two years before making the switch to the market, landing a job as an analyst with KR Choksey in 2003. It was under Jigar Shah — the-then head of research at KRC — that Kumar got his hands dirty by tracking stocks. Back then, Kumar used to track Thermax, and still recounts how conservative he was in his assumption of growth for the capital goods company. “I was assigning growth rates of 15-20%, whereas the sector was growing around 35-40%. Jigar was clearly not impressed with my target [a 7-8% upside on the-then prevailing price of Rs.46 (adjusted)] and wanted me to rework my estimates by revisiting the assumptions I had made.” The stock went up fourfold to touch a high of Rs.196 in 2005, by when Kumar had moved to Quantum as a buy-side analyst. After working for a year, he moved up the ladder as a fund manager in 2006. The switch over to the buy-side proved to be yet another learning curve for Kumar. “On the sell-side, it’s all about momentum and extremes. If a business is doing really well, you don’t mind extrapolating growth into the future and assigning higher multiples. Similarly, in a downturn, you’re ruthless when it comes to slashing multiples. You saw that happen with infra and real estate companies,” says Kumar. But at Quantum, it was all about valuations and finding good businesses at the right price. “By taking a long-term view, you can normalise growth rates both on the upside and downside,” he adds. To begin with, Quantum screens stocks by taking into account four key assumptions: first, India’s GDP will grow at a sustainable rate of 6.5% to 7%; second, inflation will hover in the range of 5.5-6%; third, the long-term G-Sec rate of 8%; and fourth, the currency will appreciate by 2% over a longer term. Putting this in perspective, Kumar says, “So, if we assume that the economy is going to grow at 6.5-7%, you won’t go overboard in estimating the long-term growth of the cement or automobile sector, which tends to happen on the buy-side. And, more importantly, we assign a predetermined multiple to each sector, and if there is no distinct change in the fundamentals, we will buy/sell a stock if it hits the predetermined valuation band, irrespective of the market momentum.” 

Value-conscious
In other words, the fund buys a stock when it believes that a company’s valuation is cheap relative to its long-term earning potential and historical valuation and sells the stock when it believes the price is expensive based on the same metrics. The other trigger to sell stocks would be limited upside from the current level or an equally exciting alternative. This investing approach pretty much ensured that in the cycle right up to early 2008, Kumar did not buy any of the darlings on the Street, which was going overboard with the infrastructure story. “It was hard to justify the multiples that were being assigned to stocks such as BHEL and L&T. In the euphoria of global liquidity, the Street was oblivious of the fact that at the end of the day, these were cyclical stocks and not defensive ones,” says Kumar. So, while the market was buying momentum stocks, Kumar was tanking up on consumer, discretionary, pharma and oil stocks between 2006 and 2008. “It was a painful period of underperformance, as one such stock that we had bought into was HUL, which hadn’t moved since 1999 right up to 2009.” It sure was, for when Quantum bought 63,000 shares of HUL in early 2007, it was trading at Rs.200, and when the fund exited its position by October 2008, the stock was still trading at Rs.208.

Unlike other funds, which tend not to take cash calls, Quantum has no qualms in taking money off the table if it finds the going too hot to handle. In fact, Quantum chose to sit on a cash level of around 20% by January 2008, when the market had hit an all-time high. Eventually, as the euphoria gave way to mayhem by the end of the year, Kumar deployed the cash into buying capex and infra-related companies that were beaten down. “That was the only time we had a large number of stocks in our portfolio, numbering around 37. It was quite a diversified portfolio,” recalls Kumar. When the 2009 election results came in, Quantum outperformed the benchmark by a huge margin, even as its peers, which were sitting on cash, missed out on the rally. It happened yet again in 2014, when the fund raised its cash level to 30% by September, the highest ever in its history. Of course, Kumar had to pay the price, since his fund underperformed, even as the market took off on Modi mania. “We couldn’t figure out why these stocks were going up. It was more hype and less substance,” remarks Kumar. From early 2015 onwards, Kumar slowly started reducing his cash and as on date the cash accounts for just 7% of assets.

What makes things easier for Kumar and team is the fact that the top management is willing to bear the price of underperformance. “All it means is stocks that we believed were originally expensive have turned even more expensive as they continue to rally, increasing downside risk,” he wrote in his latest market outlook. That’s but natural because the value investing philosophy itself means staying clear of market mania. While HDFC Bank, for example, is common across the portfolios of most mutual funds, Kumar sold the stock nearly two years ago and his portfolio features names such as Kotak Mahindra Bank and SBI, instead, both of which account for over 6% of the fund’s assets. “In the case of HDFC Bank, while there is no doubt that it has been a good compounding machine, we did not see merit in owning the stock given its rich valuation commensurate the expected growth,” explains Kumar. 

Going against the flow
Then what explains a stock like Kotak Mahindra Bank, which, too, is not trading cheap? Pointing out that the position in Kotak Mahindra is by virtue of the fund’s holding in ING Vysya Bank, which was taken over by Kotak Mahindra earlier last year, he says, “When we bought into ING, it was trading at a P/B of not more than 1.2x, but after the takeover, we reassessed the prospects and were very comfortable about the bank’s future growth trajectory. Also, the RoA that ING made was substantially lower than Kotak Mahindra. Having said that, we are not holding Kotak because we view it as the next HDFC Bank; it’s just that the valuation is still reasonable.” As far as SBI is concerned, Kumar believes that even if one were to consider the downside of a substantial write-off, its relatively inexpensive valuation seems to go in its favour. Before taking a final call on whether to junk a stock or hold on, Kumar and his team also make it a point to revalidate their own assumptions and estimates. 

When things haven’t gone his way, Kumar has chosen to exit rather than let the problem linger. It was in early 2006 that the fund picked up 3i Infotech, which it found to be an interesting IT products company. But over the years, the company’s penchant for inorganic growth unnerved Kumar. “We made a mistake in judging the management’s capabilities,” says Kumar, who sold off the stock in 2011. Another instance was when the fund had to sell off Arvind in 2009 after having bought the stock in 2006. “We were expecting the whole denim story to play out. But leverage issues and the fact that we had begun looking at another textile stock — Raymond — prompted us to exit Arvind. Though we made money on Raymond when we sold it in 2011, we missed out on Arvind’s gravy train,” laments Kumar. The stock has since surged to Rs.270.

Exits are not driven by valuation consideration alone though. The fund also dumped shares of Ranbaxy after the Daiichi-Ranbaxy buyout ended up giving a raw deal to minority shareholders. While Malvinder Singh and his family got to sell all their shares at Rs.737, all other shareholders got to sell only one out of three shares at that price. In fact, a peeved Ajit Dayal went public about the deal when he mentioned in a newspaper article that “The Ranbaxy saga is intriguing: it brings to light the “us” and “them” mentality of founder shareholders (what we call “Promoters”). The question to be asked is: how much of this negative news flow was coincidental “and how much was known or anticipated? If anticipated, was the sale by the founding family a case of reverse engineering “maximising the price to the founder shareholders in a future negative environment? Or are the minorities “like us — just plain unlucky to have taken all that risk and not received a fair share of return? Ranbaxy has reminded us that, for all the exciting investment opportunities that exist in India, we swim naked much of the time.” Not surprising that the fund sold off its entire holding of 28,500 shares by mid-2008. 

Currently, banks, auto, IT, gas, financials and energy stocks dominate the company’s portfolio. While Kumar believes that Bajaj and Hero both have a strong theme going for them, one is a pure urban play while the other is rural-focused. “In the case of Bajaj, it has strong export potential and growing RoE and operating cash flows. More importantly, their valuations are still not expensive.” However, the fund has slowly started paring its stake in Maruti, as it believes the near-term trigger of new launches and market share gain has already played out. In the case of the energy sector, where ONGC accounts for over 3% of the fund’s assets, Kumar feels that the PSU’s EV of $5 per barrel is cheap if one were to normalise crude prices to $55-60 per barrel. “While we believe a bounce-back in crude prices will happen six months or a year down the line, we will reassess our assumptions if things don’t play out as expected,” he adds. 

As things stand, Kumar’s fund is down 6% YTD compared to Quantum’s Sensex Total Return Index which is down 7%. His fund is ranked 51^st by Value Research among the 200 funds that constitute the multi-cap category. However, Kumar is optimistic about Indian equities in the long run as the recent market correction has made the valuation of many stocks attractive on selling by foreign investors, who bought on hopes of big bang reforms post elections. They sold over Rs.11,000 crore in January, the highest ever since 2008. The early third-quarter result season has begun and continues to show subdued topline growth, a clear indication that the economic recovery that has been talked for at least year-and-a-half, is still to pick up. Kumar believes India is unlikely to be impacted much from the unfavourable situation in other parts of the globe. “In fact, it has been a beneficiary of fall in commodity and energy prices. Investors can significantly add equities given the above reasons. We feel the risk-reward situation is attractive.” Though the fund takes a sector-agnostic approach, banking and engineering stocks such as Larsen & Toubro have entered the fund’s portfolio over the past few months, an indication that the fund is finding some of these names attractive, in terms of valuation.

In these uncertain times when most fund managers are wary of sticking their neck out on which way the market is headed, Kumar too is no exception. On whether he will be able to repeat his 10-year performance, Kumar chooses to play it safe: “I surely cannot thump the table and make a claim but I am 100% confident of the efficacy of our investing philosophy in helping us meet that goal,” sums up Kumar, as he heads back to his work station.