Is P/E relevant or a relic?

It may be just a number but it causes heated debates. One side says that it takes too much but gives too little, while the other swears by its miracle-working power

Published 3 years ago on Jul 26, 2021 27 minutes Read
Marcellus Investment Managers' Saurabh Mukherjea and Abakkus Asset Manager's Sunil Singhania.

The relevance of P/E multiple, from when Benjamin Graham taught the world how to make a killing by investing in low-P/E stocks, has waned. Investing strategy has evolved and become more sophisticated, by looking at earnings through a prism of quality, predictability and durability, as professed by Warren Buffet, and the people have become accustomed to paying a quality premium for good companies. With the heightened uncertainty over the past few years, the low interest rates and the way technology is disrupting traditional businesses, the debate on the utility of P/E and if it is a magic number is back. Is P/E relevant as an investment metric? That is the topic of discussion at Outlook Business Investment Summit 2021, and there are two eminent panelists to help us crack that mystery. One is Sunil Singhania, a familiar face in the Indian investing scene, having spent the last 40-plus years managing funds for Reliance Mutual Fund, which is now Nippon India Mutual Fund, with great success and is now running his own PMS called Abakkus Asset Manager. The other is Saurabh Mukherjea, with a remarkable career trajectory. He started out 13 years ago in the Indian markets, built a broking business for Ambit and now manages his own PMS, Marcellus Investment Managers. The conversation is anchored by editor N Mahalakshmi.

Edited excerpts: 

Mahalakshmi: Mukherjea, I am going to start with you. If we consider technology stocks in the US, of companies that have built a solid moat for themselves, they are being rewarded generously by the market with higher and higher multiples irrespective of their earnings. The market has an eye on their future profits. But in India, where the old economy of the brick-and-mortar companies with predictable earnings and a linear growth trajectory dominates, how justified are high P/Es? 

Mukherjea: Thank you for inviting me Mahalakshmi, it’s a privilege being here and it is a privilege being on the same panel as Singhania, a man I have learnt a lot from. Whilst these 13 years in India have been great fun, it’s been so because people like Singhania have taught us a lot. 

With P/E multiples, there are broadly three areas where ‘E’ or the denominator of P/E doesn’t do justice to the franchise. The first area is accounting and governance. For example, if we take two housing finance companies, Diwan Housing Finance and HDFC, I don’t think anybody in the right mind would compare earnings of both on an equal footing. Deepak Parekh on the one side and Wadhawan on the other, it’s chalk and cheese. So the E does not capture the difference in accounting quality and governance between two companies in the same industry. The second challenge is around capital intensity. In franchises where capital intensity is low, E captures basically the free cash flow. It does not tell the whole story. Let’s take two companies from the same corporate group, TCS and Tata Steel. The first generates around $2.5 billion of free cash flow in a given year, while the second has generated this amount over the last 10 years. But TCS has profits only 5x that of Tata Steel while its free cash flow is around 11x of the others. So, the two companies are from the same corporate group, following equal standards in accounting and governance hopefully. But one is cash generative while the other is capital intensive, and therefore, the E doesn’t tell you very much. The final and third challenge is that E does not capture barriers to entry. If we take two high P/E stocks, say Jubilant FoodWorks and Nestle. While I am a great fan of Jubilant FoodWorks’ product, and I shouldn’t be of Domino’s Pizza at my age, I don’t think Domino’s has the sort of monopoly in pizza that Nestle has in infant milk powder. The P is not going to capture the barrier to entry Nestle has. So, in the end, a low P/E stock could be a bad investment and a high P/E one could be a good investment. Then, what sort of price metric can we use? 

The metric I found works beautifully in India is not P/E or P/B or EBIDTA (ratios) but is the free cash flow growth. If you or I or Singhania can predict the next 10 years of free cash flow growth, you can capture 60-70% of what you need to capture as a fund manager. It is easy to do free cash flow growth in old-style manufacturing and steel companies, where the underlying variables are quite simple. It’s hard to forecast free cash flows in companies where technology plays a big role or where intellectual property plays a big role, such as TCS or Dr Lal Pathlabs. Among these franchises, the best ones have a return on capital just shooting into the sky. So even a franchise like Pidilite ROCE is risen now for I think 25-30 years at around 35%. Right. And again, if you do the backward maths, if a company can grow-ups at say 25% for five years, and after that UPS escapes, it should have paid around 25-30x earnings, the same company, if EPS growth is 25%.for 15 years, the warranted P/e is 80 times, same company EPS growth is 25% for 25 years, the warranted is 250 times. Pidilite has been growing free cash at 25% for 25 years, it should have been 250x at the turn of the century. It wasn’t therefore whoever bought Pidilite, Asian Paints or Nestle then obviously made a huge killing and this is where the job gets hard. 

We understand where P/E works, we understand where P/E doesn’t. We all understand we need to get a grip on free cash flow growth. But because of the power of technology and intellectual property, getting a handle on free cash flow growth has become a much harder job over the last five years.

Mahalakshmi: Singhania, how do you respond to that? 

Singhania: Thanks, Mukherjea, for the good words. There are two or three things. One is that we started by saying P/E is irrelevant but ended by saying the P/E of a company should be based on free cash flow. So, somewhere down the line, we all agree that P/E is not the only parameter, but it is an important parameter. The second thing is that I completely agree with what Mukherjea says that P/E for different sectors and different kinds of companies and management would be different. Third, again I completely agree that any multiple you assign a company, P/E or otherwise, will depend on its growth rate. Therefore, while agreeing completely that P/E is not the only parameter, I would say that it is a good, simple parameter. Ultimately, the growth has to justify the price. The trouble is that, in hindsight, we can always see which was the worst period in a company’s life or the best, and therefore, we should have given that kind of a P/E, but we cannot know that a company is going to provide 25% for the next 25 years or the next 15 years, or even the next five years. Our lives would have been so easy if we could. Also, competition is getting more and more intense. The millennials and other younger generations are much more open to experimenting than any of us were. When the younger generations are choosing, say, a T-shirt, they will simply go by the design and won’t care whether it is an XYZ brand. Therefore, stickiness or longevity of growth and sustainability of growth have changed quite dramatically. Keeping all of this in mind, P/E is not the only factor, but it is an important factor. 

Finally, on the point about businesses that are capital-intensive versus capital-light, let me give you an example. If there is a company that has a market cap of Rs. 1 trillion and there is another with a market cap of Rs. 500 million, the second company can grow 3x and the first cannot even grow 2x. But, how much money can you deploy in a Rs. 500-million company? On an absolute basis, you can make Rs. 50 million from this company, but you can make Rs. 50 billion from the Rs 1-trillion company. So, companies that require big investment are also an opportunity to make big gains. With companies that don’t require big investment, the opportunity from an investor’s perspective is limited. Ultimately, every type of investing works. That said, there cannot be an unlimited P/E multiple (growth), that is valuing a company at 20x, then at 50x, then 100x… 200x. If that was possible, then portfolios which were made in 1960 should have worked even now. 

Mahalakshmi: Singhania, that is a point very, very well made. You can’t keep increasing the P/E multiple for any company without an end. Mukherjea, all your points are well taken, but if we look at the set of high-quality companies such as Asian Paints, Pidilite, Marico and HDFC Bank, they were well-established even five or 10 years ago. HDFC Bank, even in 2000, was seen as having an agile and reliable management or Marico as an innovative company. So why revisit their multiples now? What has changed? 

Mukherjea: So let me first get back to what Singhania is saying. He is absolutely right that an investor’s job today is much harder than it was 10 years ago. Firstly, as Singhania rightly said, because technology has made it so easy to set up a new business and, secondly because the millennial customer is so open to trying new brands that give them convenience, affordability and such. It’s become much easier to dislodge an incumbent. In my 13 years in India, I’ve seen businesses being created, disappearing, being acquired or being reduced to zero. In 2008, there was Zipdial that helped brands set up a call-back service for their customers. Its clients included even P&G and Unilever. By 2013 and 2014, it was a hugely popular service and, in 2015, the company was acquired by Twitter for $70 million. That year, Jio launched to offer that was basically giving away free mobile phones, and soon the call-back service died out. In seven years, a company went from zero to leadership to acquisition by a leading MNC, and then back to zero again. There are many other examples. Technology has made it much easier to attack new markets or takeover markets and, at the same time, technologies have also made it easier for companies such as Asian Paints, Pidilite or Nestle to scale up their businesses with minimal reinvestment. In the hands of high-quality management, modern technology allows a business to expand with incremental expenses. 

The best example of this is Dr Lal Pathlabs. It has been around in Delhi since the eighties when I was growing up, and it is listed in the market today. It got listed around five years ago. For three years, the stock didn’t move because people thought it had an expensive P/E. What people hadn’t realised was that, over the last five or six years, Dr Lal Pathlabs had added a whole range of wellness products that had twice the operating margin of their conventional products of blood or urine tests. By burning minimal extra cash, Om Manchanda and team raised their operating margin and ROIC over the last seven or eight years went through the roof, I think at 40-45%, the return on invested capital went to 90%. That’s the power of technology combined with a smart management team. So if it’s a lazy management team, which is not awake or alive, the company’s margins will be destroyed in few years. Another example is Pidilite. Between 1970 and 2000, its wealth came from the Fevicol business, but over the last 20 years, they have been building new businesses and their cash compounding engine is running well, at 25% free cashflow compounding over long periods of time. 

Singhania: But I defer here. I don’t think any of these companies have had 25% compounding (free cash flow) for 25 years. There’s a huge difference in numbers by our calculations. Asian Paints has grown at like 11-12% over the last 10 years. So, I don’t know where these numbers are coming from.

Mukherjea: I will be happy to do a session in which we publish our numbers and you publish yours. Pidilite has seen a free cash flow growth of 26% over the last 20 years. Therefore, it’s no great surprise that the ROIC has gone from being 20 to 23% at the turn of the century to 48%. In 2000, they bought the two waterproofing businesses M Seal and Dr. Fixit, and used the Fevicol distribution channel to sell both. 

Singhania: I have absolutely no problem with higher P/E multiples given to companies that grow at 25% sustainably. In fact, we had come out with a paper towards the end of 2019, in which we had listed companies that had reserves and so gave the perception that they were growing at 25% when they were actually growing at 10 to 11% CAGR over the last 10 years. Also, if we have taken the base year at 2001, which was a terrible period that saw a massive recession, then the picture we get is very different from what we would get in other times. If a company is growing at 25% year after year, and if the view is that the growth is going to be there for the next 10-15 years, then we can always justify a higher multiple. But, most of these companies are not growing at those levels. They have been growing at the low, nominal GDP growth rate of 11% CAGR. If these companies are so great, they would show a significantly higher growth rate. 

Mahalakshmi: I think the only company that has grown earnings at more than 20% CAGR for 20 years is HDFC Bank. I don’t think any other company comes close to that. But that apart, Mukherjea, these companies are bigger in size today, in many of the product categories the penetration levels are higher and technology is disrupting these sectors. So, even if these companies have grown 20-25% in the last 20 years, how can we assume that they will grow at such elevated levels for the next 10 to 20 years? 

Mukherjea: So that’s exactly the point that I’ve been trying to make, through my books over in my books and so on. In the last 10 years, nominal GDP growth has been around 10-11% and we all know that, over the same period, Nifty EPS growth has been close to zero. So clearly, GDP growth has disproportionately benefited a small set of companies. If you delve deeper, you see that over these 10 years, the top 20 to 25 profit generators in India accounted for 30% of the nation’s profits. End of FY20, these top 20 to 25 profit generators accounted for 90% of the country’s profits. So why has GDP growth disproportionately gone to a small set of companies? It’s because, in many industries, the smaller players are getting crushed and the market is consolidating. For example, our number-crunching suggests Pidilites’ profit share will be around 90% in both waterproofing and adhesives. That wasn’t the case 10 years ago. So, smaller companies are getting crushed because they don’t have the technology or don’t have managerial expertise to benefit from a more competitive landscape. Now there are problems with this type of investing (heavily in high-performing companies). Firstly, if I say 10 companies will grow like this for the next five years, I might get five wrong. But on the other five, even if I get 50% right, I can more than make up for the mistakes. Secondly, say I buy a low P/E stock, sell all when the price goes up within a short span of say two to three years and get double the price I paid. On the other hand, if I hold on to the five (high P/E) stocks that I got right for 10 years, I can make around 8x to 10x with around 20-25% compounding. Yes, if we can find a Pidilite at low P/E nothing like it, no one will complain about that. 

Singhania: No, Mukherjea, just to add here, we are not advocating that we should only buy low P/E stocks. The only point I’m trying to make is that the P/E you pay has to justify the future cash flows from the company. The challenge in India is that these (high-performing) companies trade at the highest level anywhere else in the world. The largest paint company in the US grows at a rate higher than the largest Indian company and, despite its higher ROE and higher cash flow, it trades at one-third the valuation. So the point I am trying to make is that the growth rate has to justify the price. Obviously, if a company is growing at 50% every year and you have the view that it’s going to grow like that for the next five to 10 years, you’re not going to get it at 5x, you’ll have to pay 50x-60x. But, if a company is growing at 10% and you’re paying 70x and, if to meet the return expectation of 10% that company will have to trade at 70x for the rest of its life, it is not going to happen. That hasn’t happened anywhere in the world. You can dig out the data. There is not a single company which has traded at such high multiples for 10 to 30 years.

So, Pidilite might have done 20% CAGR, with whatever cash flow, but a lot of the other companies including the best of multinational companies have not done that.

Mukherjea: So the multinationals are actually the valuation trap if you ask me. A lot of Indian investors make the mistake of thinking that Google trades at this (high) valuation so other multinationals should also trade at such levels. If we take the example of Colgate Palmolive or Castrol, both have high PE and both have very high ROCE, I think between 100% and 110%. Now, for different reasons, their sales volume is low. If you have a low growth engine, then the ROCE is pointless. You may have strong barriers to entry, strong brands and a strong franchise, but as an investor, I’m not getting anything in return for that. Just because you have high ROCE, why should I care? I need ROCE to generate growth. So, where you see ROCE without underlying growth, Singhania’s point is bang on.

Singhania: That is exactly what we are advocating. That someone with a 100% ROE will trade 100x is a big fallacy. If they have 10% growth, you can’t trade at 70x to 80x.

The other thing is, to invest big sums of money, you might get a financial-services company that generates higher ROE, but you can’t invest $100 million or $500 million in it like you can in say an HDFC Bank or an ICICI bank. You’ll also have to see how much capital that company can absorb. And, what has happened over the last five or seven years is that these companies don’t need capital. In fact, a lot of these companies have even done buybacks and thus the number of shares available has reduced. Proponents of quality have increased. They have been buying more of these companies, pushing up the prices even further. When funds do well, they get even more money and they end up buying even more. Besides such funds, there is ‘dumb investment’ in the form of ETF, and I call them dumb because they don’t take a view and buy however the index is moving. Then, 20% of the return generated by these companies is thanks to the Finance Minister reducing corporate tax. In one day, the stocks went up 20%. If you remove that day, for the last two years, a lot of these companies have made zero returns. 

Mahalakshmi: Are stock prices getting lopsided because of money flows?

Singhania: You take the example of Hindustan Lever, it stopped moving the day its $3-billion float got sold in the market. Hindustan Lever stopped moving because whoever wanted Hindustan Lever has $3 billion of Hindustan Lever, and from that day the return on Hindustan Lever has been zero. We don’t have HUL in our portfolio. 

Mukherjea: My colleagues and I have noticed a pattern here, and I have written about this in The Unusual Billionaires and Coffee Can Investing. If you do this across a portfolio of 13-14 stocks, that is, looking for champion franchises, good accounting, re-investment of capital and an underlying engine growing at 20-25%, in a given year three or four stocks do really well. It could be for various reasons including the ones Singhania mentioned, such as an ETF buying it or a finance minister making an announcement. Another three to four stocks are on a valuation holiday and the last three to four stocks give you index return. Of the total portfolio, we were able to get 20-25% return. The next year, the same portfolio’s identity changes… we keep a low portfolio churn. So, the same portfolio’s identity changes for reasons that are not predictable. The three to four that were on a holiday start moving, the three to four that were doing well now go on a holiday and the middling guys keep chugging along. The way we see it is, rather than agonising endlessly over one stock and its P/E, let’s focus on the totality of the portfolio and make sure that every company has an underlying compounding engine of around 20-25%. If every engine is tuned to the best of our ability, then from the total portfolio, we will get an earnings compounding of 20%.

I wish every year all the stocks compounded, but that doesn’t happen. Every year, three or four do well, three or four are on a holiday and three or four are middling. We have looked hard to see if we can change this with similar quality and lower P/E, and we have realised that P/E by itself has no predictive power. We can’t disregard P/E, and no one managing money should disregard it. But the multiple by itself has little predictive power, whether the P/E is 70 or 20. The RBI said recently that high price-to-book banks tend to do better than low price-to-book banks, and I felt like calling up and saying ‘Shaktidasji (the RBI governor Shaktikanta Das), sir, price-to-book does not have that much of a predictive power’. Yes, high-quality banks do better than low-quality banks. But, if it was as easy as looking at price to book, the regulator could go to sleep.

Mahalakshmi: Mukherjea, one follow-up question before we bring Singhania in. With this set of companies, with proven management, stable earnings and a growth trajectory over long periods of time, there is no surprise left. So, do you forego any opportunity for rerating in the future?

Mukherjea: That’s critical. I think we shouldn’t reach out to the public and say, ‘Trust me with your money. I’m going to invest in a company that will rerate.” Honestly, that is beyond my remit. It’s beyond my purview. How am I going to do that?

Mahalakshmi: That’s exactly my question. To complete it, do you forego the opportunity for any rerating?

Mukherjea: When I say the stocks don’t perform, I mean that they perform on earnings but their share price doesn’t shoot up. So, just to be clear, there are 14 stocks in which three or four are performing on earnings and stock price, and three are four see earnings coming through but their stock prices are going nowhere. For example, HDFC Bank, in the run-up to Puriji’s (Aditya Puri, former MD of the bank) retirement, earnings were up 20%-25% but the stock was going nowhere because the market was worried. But, if the business is firing, I have no business saying, ‘The stock is not moving and let me check out right now.’ 

If we have a portfolio of 14 such stocks, will we make a mistake on one or two franchises? Absolutely. But what I shouldn’t be doing is telling a client that I can rerate the stock, because that is absolutely beyond my purview. Furthermore, P/E is a mean-reverting metric. Even if I rerate the stock, some of the stocks which have derated could rerate. 

Mahalakshmi: In fact, this is exactly my question. When you say you cannot rely on P/E, because it’s a mean-reverting metric and you’re relying only on earnings growth, you forego any opportunity for the valuation upside but risk any valuation downside, then how do you build a margin of safety? Or, for that matter, how do you build any offsetting mechanism in your portfolio to better your odds?

Mukherjea: I’ll explain again. The reason why the P/E debate is interesting is that traditional value investing around low P/E stocks resides in the reversion-to-mean phenomenon. So, investors buy low P/E stocks thinking they’re underpriced and, when their P/E ratios go up, investors will say the valuation gap is closed, that juice is squeezed out of the orange and they should now sell and move on to the low P/E opportunity. I used to see this often in my brokerage days. This method of investing, however, does not work for high-quality franchises with good management teams, who are able to scale opportunity after opportunity, decade after decade. 

If you’re one of those investors who set target prices and sell when the TPs are hit, you will be dead wrong when it matters the most, when you are dealing with exceptional franchises. Whether it is Warren Buffett, Charlie Munger or little Mukherjea, all of us make most of our money on a few exceptional franchises, such as Coke in the eighties and nineties, or Microsoft and Apple for Buffet in the last 10 to 15 years. If you apply a mean-reversion framework around P/E to off fade-defying franchises, you will be cutting your winners prematurely. And if you ask me, that’s the greater danger from the P/E obsession. 

It’s not so much that I will buy a few crap stocks, at least the downside to that is modest. The biggest damage of this obsession is you cut your exposure to champion franchises, because you fail to appreciate the ability of the management team to keep rerating the stock, not because they’re doing something extraordinary but because they’re using modern technology to run industry after industry. And this is the central point. And this is why technology has changed the way investing works. This is why investing is harder than it was 10 years ago.

Mahalakshmi: Well, I have my own take on this. When you talk of extraordinary companies and that they stop to revert to mean, one can think of several examples, but what is on top of my mind is Infosys. It took five to six years to climb back to its 2000 levels. Another example often quoted is HUL, which didn’t move for 10 years. But let me get Singhania’s view on this. Singhania, do you believe that extraordinary companies stop being mean-reverting. More importantly, can you count on that as a strategy?

Singhania: I do not believe that. We go back to the 1980s when there was a similar phenomenon in the US when all these quality companies traded at 50-60-70 multiples, and then for 20 years gave zero returns. You mentioned Infosys from 2000-2012, it gave zero returns. From 2001 and 2011-12, Hindustan Lever gave zero returns. For the last 10 years, ITC and Castrol have given zero returns. All of these have been messiahs of corporate governance, quality, so on and so forth. So, quality is crucial when we are investing. Our first check is on the management and if we are not confident about that we don’t invest. But how we do assess the quality of management, who are we to give certificates that this kind of management is the best and another kind is not good, I don’t know. The largest paint company’s profit from 10 years is lower than the largest steel company’s profit from six months. In such a situation, I am not saying that we put everything in steel, but should we ignore it? I don’t think so. There are cycles, and we have to consider that as investors. 

There is always a point at which we say that a company is priced beyond perfection, and this is determined by a lot of things such as fear of missing out, a lot of dumb money coming in, and so on. In the last five years, the economy was not doing well, so investors were hiding in certain companies. Even when the Nifty was not doing anything, these companies were growing at 8-10%, so it was a good place to hide in. These companies did not have auditor issues, investors were comfortable with these names, and these companies were high-dividend paying. Then, the tax cut happened and these companies gave 20% more. 

In the US, there have been only five companies in the last 10 years, which have traded at more than 50x for more than five years, and that includes companies such as Google, Apple and Microsoft. All of them are trading now at 30x and still people are saying there is a kind of bubble around them. No company can keep trading at 70x or 80x forever. The other thing is that, when the interest rates were going down, there was some reason to believe that the P/E multiple will go up. Now that interest rates have started to go up, the P/E should begin to go down. 

The point I am trying to make is that quality at any price never works. It has never worked in the last 300 years in the US and it is not going to work in India. In other parts of the world such as China, Europe, Indonesia, Brazil and Mexico, it has not worked. India is not unique. So, I don’t believe it will work only here. 

Mahalakshmi: But, Singhania, Mukherjea made this interesting point that you don’t get high-quality companies such as Pidilite at low or reasonable P/E. Do you agree and, if you do, how would do respond to such a situation?

Singhania: No, you will not get it at 10x. But, if you work towards it, you will get it at a reasonable P/E, which might be 25x or 30x or 40x, depending on the growth rate. Again, I am saying that if a company is growing at 25%, and if the view is that for the next 10 years it’s going to grow at 25%, we will not shy away from buying it at 40x-50x. The problem is with buying a company growing at 10-12% for 70x or 80x. We are not able to understand such a trade. 

Technology companies are growing faster. Take the growth of last 10 years of all the four large technology companies and map them against the MNCs, and you will see that the former is growing faster. The tech companies trade at one-fourth the valuation of MNCs, though the tech companies give much higher cash conversion and do significantly higher distribution of cash by giving out dividends and through share buybacks. But, rules are different for different sectors. 

Mahalakshmi: With respect to the predictability of future earnings, history tells us that most companies have not been able to navigate a change in technology or paradigm well. Of course, we can always say that technology is not a disruptive change but is an enabler and that companies with free cash flows will be able to leverage it to further their business. But, even two years ago, we would never have imagined that Ola would grow to be Mahindra & Mahindra’s or Bajaj Auto’s competitor. Today, competition is coming from the periphery and attacking any and every business in unknown ways. Given this, how can we justify paying a premium for predictability? Also, do we not run the grave risk of overestimating the predictability of these companies?

Mukherjea: The job of an investor today is far harder than it was a decade ago for two reasons, first is that technology is creating new competition and the second is that smart management teams are using that same technology to ramp up more. With the first, the downside risk is greater, like the lovely example you sighted of Ola taking on two-wheeler manufacturers. With the second, it’s even harder because you think you know Pidilite, you think you know Dr Lal Pathlabs, you think you know Bajaj Finance, till they do the next ramp up. That’s why the investor has to work doubly hard for the modest fees that he collects. Successful investing has increasingly become about making superior judgments about qualitative factors. I wish it wasn’t, I wish it was easier, but I don’t get to choose. These qualitative factors include management quality, which takes into account corporate governance, the ability of the management to use technology and drive longer-term compounding. I don’t have the time to give the entire framework, but I’ll give a couple of simple things that we do. 

We look at the extent to which the boardroom of a company includes people who have grown within the organisation, and the extent to which it has lateral hires. We prefer companies in which people were recruited early in their career and they grow into their boardroom positions because it suggests that these people know the company well, they know the industry well and the company has a great ability to groom talent. Secondly, we look for decentralisation of authority. If you have a Hitler running the company, a lalaji who barks out orders every morning or evening, we tend to stay away. We speak to the zonal management to find out how clearly their targets are set for them, and how much support they get from marketing and in terms of technology. We like decentralised companies. 

Checking these seven to eight softer factors has become critical to our process, as much as reading the annual report and doing forensic accounting.

Mahalakshmi: Going by that logic, Singhania, it’s a lot easier to take these calls on multinational companies because the processes are well laid out. Therefore, the downside is limited. It would be far more difficult to take calls on smaller companies, especially if you are planning to invest in the mid-cap space. How do you manage that and how do you protect your downside?

Singhania: We don’t only look at mid- and small-cap companies. We also invest in large cap. Also, a lot of these companies started small. Pidilite, may be in 2000, would have been one-hundredth of its current market cap. Therefore, it would have been a micro-cap or even a small cap in current parlance. So, you have to start looking at them early and that is the only way you can play the compounding game. The other thing is that it is a myth that only larger companies have good management, and that mid-size companies have bad management. I don’t know why people believe that. The moment you bring up mid-cap companies, people say that management is an issue. But, most of the scams have happened in large companies. Small companies are so small, what scam will they do? 

Obviously, when a company is large, the foundation is strong, balance sheet is large and strong, and therefore near-term volatility impacts smaller peers. But, ultimately, when you decide on investing in either, the process should be the same. The other thing is that any company that is only value does not give you returns. So we only look at companies whose profit growth can be 2x in the next five years. Unless there is growth in profit, you will not make consistent returns. When you are investing in a company, you must pick one in which profit is growing, therefore your value keeps on growing, and thus margin of safety keeps getting better and better. 

We are not looking at companies that have 90% ROE, but are okay with companies with 25-30% ROE and are growing at 15%, available at 15x or 17x. ROE would be that there is more money to be made there because a lot of these companies will grow into a size that a lot of investors cannot afford to miss that opportunity. The last bit is that, if it was just a buy-and-hold strategy for 30-50 years, I don’t think I or Mukherjea or hundreds and thousands of portfolio managers would have been needed. A portfolio created in 1960 would have survived in 1970, would have survived in 1980, would have survived in 1990 and would keep growing for the next 50 years. If Mukherjea has these 10 companies, then he doesn’t need to work. He can take a holiday because these companies will keep on compounding for the next 10 years. 

Mahalakshmi: Mukherjea, how do you respond to that? What if investors say that you have already shared what the secret sauce is, told us which are these 10 to 15 companies that we need to stay invested in for the next 10 years?

Mukherjea: There are 40 books on Warren Buffet and the Berkshire Hathaway annual report pretty much says what the company owns. In spite of that, it is not easy to do what he does. It’s simple, but not easy, and that’s how investing should be. We publish our books so that people understand how simple it is, but this doesn’t mean investing is easy. Also, because of what we do, busy people like you do not have to worry about this and can say, here is our money, you manage it for us while we run magazines and publications.