"We are no longer a broking business; we are a tech business who is doing broking"

The co-founder of India's biggest stockbroking company on what differentiates Zerodha and the source of his 'edge'

Everyone who has survived and then thrived in the stock market has a touchstone that they swear by. For Nithin Kamath, the co-founder of Zerodha, India’s biggest stockbroking company, it is hedge fund manager Larry Hite’s insight: "I have two basic rules about winning in trading as well as in life: (1) If you don’t bet, you can’t win. (2) If you lose all your chips, you can’t bet." Nithin may not have had beginner’s luck when he started trading but he has more than made up for it by sticking to Hite’s aphorism. As he shares in this Outlook Business interview with Editor N Mahalakshmi, it is risk management which makes or breaks a trader or any venture for that matter. To describe Zerodha as a successful broking firm would be an understatement as it is among the handful of start-ups which has profitably scaled without any external capital. As Nithin goes about further scaling Zerodha into newer territory, he finds himself on familiar ground as legendary trader Paul Tudor Jones. Having earned his chops predicting the 1987 Black Monday crash, Jones was asked if his firm would take it easy from thereon. He replied his risk management would now get even more stringent because, “there is more to lose”.

Take us through the initial phase of your career before founding Zerodha.
I started trading quite early, I was 17 or 18. I got introduced because there were some people in the neighbourhood who traded. My dad used to work in a bank and my mom used to be a Veena teacher. So, it wasn’t genetic. It was just being around people who traded, and I picked it up. It was the lure of quick money, which essentially is what gets a lot of people to the market.

How was the journey from thereon?
In the late 90s, when I had started, the world hadn't gone online. You would walk into a sub-broker’s office, sit there and essentially buy and sell stocks. In 2001, derivatives got introduced. One problem with actively trading stocks is that insiders have more information than you. It is very tough to make a buck in trading if you are constantly taking on someone who knows more than you.

I started trading derivatives when all this Y2K stuff was happening. I blew up money that I had saved, and I borrowed money and blew up that as well. I then joined a call centre towards the end of 2001 and worked there till 2005. It was mainly because I could trade during the daytime and kind of work at  night.

In 2005, I was working out in the gym and I accidentally met my first client. We started talking and he asked me what I do for a living and I showed him my trading account performance and he asked, ‘Can you also manage my money?’ He was the first customer. As soon as he cut a cheque, I quit my job and I started trading on his account on a profit-sharing deal. And then, through word of mouth, the customers started growing.

I became a sub-broker for Reliance Money when it had just launched in 2005-06. I had multiple customers and access to a terminal made it easy to place trades on their behalf. Around 2006-07, Nikhil, my younger brother joined. He is a sharper trader than I am.

In 2008, when the markets fell, we made some money, as we were short the index during that year. In 2009, we had enough trading capital of our own and I told Nikhil, ‘It doesn't make sense for two people to trade, why don't you continue trading fulltime and I will go give a shot at building a brokerage firm.’

The thought came about in 2009 because not only we had some money, but also as NSE in 2008 had launched a platform called NSE Now which was like a free trading platform that the exchange gave to their brokers to build a broking firm. Essentially, the biggest cost for you is technology and we saw that the tech was coming for free and we spotted an arbitrage opportunity there.

If the platform was coming for free, then maybe we could go and disrupt the existing way of doing business. That's how we ended up with this whole idea of Zerodha. When we started Zerodha in 2010, it was essentially meant for active traders, futures and options traders. Active traders, who were paying extremely high trading costs to brokers never used any of the services like research or availed of relationship managers or other overheads that traditional brokers had.

Did much of your founding team comprise avid traders?
When we started, it was me, Nikhil, Venu who heads our operations today,  Kannan for service-support, and Sameer who heads our risk management. Yeah, they were also trading in some form. Karthik who built Varsity, went to do his MBA and came back and joined us in 2013-14 but we were working together between 2006-09. When I say working together, he used to trade at our sub-broking firm, At the office, everyone used to sit together, trade and we used to do some client business.

Apart from creating Zerodha, which have been your best trades?
I think in hindsight, 2008 was probably one of the easiest years to make money because the direction was just south and all you had to do is just be with the trend. Like it’s trending in the last eight months. The last  seven-eight months have been an easy trade of sorts.

The problem with a market which goes up is, it goes up very slow. As a trader you get a lot more time to think. The more time you get to think, the higher the chance you drop off the trade. But when the market falls, what happens is that the potential energy is in your favour and it falls much faster. Even if you stick with smaller trends, smaller periods of time, you can make more money.

You said, 2008 seemed like a very easy trade. What learning have you carried from it over the years?
Trading is more about money management than the entry-exit strategy. How you bet matters more than entry and exit. For example, If the long-term trend is bullish, the long trade will probably be 2x the short trade because it makes no sense going against the trend. If you are going against the trend, the idea is to do with much less money, so your chance of losing reduces as well.

The problem with most people is that they end up having such severe drawdowns that the trades that work don’t really make enough money to cover the drawdown. I have learnt going bust twice that on any trade, you should not lose more than 1 or 2% of your capital. If you are placing big trades, of course you can get lucky and make money but it’s very likely that over long periods of time, you most likely won't come on top.

Every trader has to do what comes naturally to him and then kind of hone his skills around it. You can be trading based on your gut, you could be trading based on how bright the sun is today, it doesn't matter. What matters is knowing the trends, what kind of trend you are in and adjusting your bet sizes according to it and ensuring that your bet itself is a small portion of your overall portfolio.

Coming back to Zerodha, India Infoline launched 5paisa which really was disruptive in broking and then after a few years, it became the new normal. How do you plan to retain your edge?
A lot of people assume we brought in price disruption, but when we launched there was this Kolkata-based company called RK Global, doing trades at Rs.9. They had some clauses in terms of ‘pay this much money’, then you will be charged Rs.9/trade. Even when I was a Reliance Money sub-broker, they had a flat fee for trade but that too went – pay this much upfront to get a flat fee for trade.

When we started Zerodha, I kind of knew that one of the reasons why financial services firms are opaque in the way they work is because they have different deals for different customers. If you are an HNI you get some deal, if you are a low networth guy, you get another deal. Almost every financial services firm works like that.

The problem with a model like that is you are forcing yourself to be opaque. If you give different deals to different people, you can’t really come out and say this is my deal. So, the disruptive thing we did when we started Zerodha, was that every single customer gets the same deal.

We put this thing called a brokerage calculator. Now every broker has it, but at that time it was very disruptive saying, ‘here is where you get to see all the costs’ before you place a trade. People could offer low cost to compete with us, but they couldn’t copy that because they had different kinds of customers. The transparency wasn’t really there when we started the business.

Around 2013, is when Kailash joined. He is essentially the brain and heart of the tech at Zerodha and the product started. A lot of people ask me: what is so special about your product, I mean of course it’s minimalistic etc., but my usual go-to response to that question is why you think Google is special as compared to Bing, Yahoo etc. It’s the same search engine. It isn't just about a minimalistic look, it’s really about the engine that powers it.

It’s really the product which is keeping us ahead and at the end of the day, it is a product game. In the past, brokers or banks in India have all built their products over a vendor-based platform. So, the product has been standard. The way people have disrupted is using pricing or some new sales strategy or having more branches, more relationship managers and stuff like that.

Today, the product is a differentiator. As long as we can keep the product ahead of the competition, we maintain the lead. The day we don't, we lose. We are no longer a broking business; we are a tech business who is doing broking.

Do the investments done through Rainmatter also act as a nudge for retaining clients and growing the Zerodha brand?
Around 2015-16, one of the good things that Kailash did when we launched Kite, he built out this thing as the Kite Connect API ecosystem. Once Kite was built, we realized that the Indian market is shallow. We were already increasing awareness through Varsity which was doing well by itself. So, we felt the opportunity lies in building a niche user experience for the stock market. We had two options: attempt all those things ourselves or partner with start-ups.

Partnering seemed a better option. We shared the APIs, invited start-ups to build niche platforms to grow the market. Smallcase is the first start-up that came by. They create basket of stocks based on different ideas. It made ideas tradable but importantly each basket was not a single stock, it was a bunch of stocks, so customers were automatically diversifying. That addressed a big problem for retail brokers, which is, customers concentrating in one or two stocks.

For the start-ups, more than the money and the API, the most important thing was the credibility we brought. It took us two years to get to the first customer, Smallcase got there in two months as we showcased it to our customers as if it were our product.

Then, came Sensibull which is an options trading platform, followed by Streak which back-tests algo-trading programs. With Sensibull, the idea is to move people from trading naked options to trading strategies because your odds of winning goes up significantly. With Streak, the idea is to nudge people to back-test anything before they place the trade. Finally, Quicko helps traders and investors with tax filing.

Staying with Nudge, is it inspired by Richard Thaler's book? Has that product been already implemented?
Since we are all big fans of Thaler, we decided to call it Nudge. It also kind of implies to the customer, what we are trying to do, nudge him away. When this whole rush of new accounts was happening last year, the first Nudge we put out was around penny stocks, that is to alert people who don't know the risk of investing in penny stocks.

We had stuff around when Lakshmi Vilas Bank was going to zero or even when DHFL was plummeting. Everyday people come to buy that stock; I don't know for what reason. We kind of nudge them away from it, we tell them, "what are you smoking'.

The more important ones will happen in the next three to six months and will be around basic rules that need to be followed while trading and investing. For example, if you are going against the trend, the Nudge will be, "You are going against the trend, maybe you should buy less of this stock", or if Yes Bank has gone from Rs.400 to Rs.200, it is weak, not strong. So, if one is buying, they have to buy less or nudge them to diversify their portfolio.

Another reason why many people lose money is because they keep concentrating in two or three stocks. If someone keeps buying the same three banking stocks, the Nudge will be: you already have too many banking stocks, maybe you should diversify and buy something else. The issue is, people know these rules but they tend to forget.

I don't know if you have ever played poker. A lot of poker players know when they are making mistakes. There is something called Tilting. When you are in a tilt, you forget all the rules. And at that time when you are on a tilt, the best remedy is for one of your friends to say, ‘Why don't you take a break and come back?’ It’s almost like that. One of the Nudge we have is it will nudge the guy to take a break. For example, if you are having a drawdown, the Nudge says, ‘You know what, you lost this much money. Maybe you should go take a break.’ The idea is to lock him out of trading for a few hours or a few days so that he can reset and doesn’t override those rules.

We are probably one of the few brokers who have been able to do this because, each nudge reduces business. No Nudge will ever tell someone to trade more, it will always tell the customer to trade less. And because there is no revenue pressure or there is no investor to answer to, or there is no debt, we have the freedom to build something which is required for the business.

Does the Nudge flow from a set of principles or by mining specific portfolio behaviour of traders/investors?
We provide a setting to the user as it is almost impossible to figure out why, who is doing what. The other problem in fundamental analysis is that if a stock looked good at Rs.500, it is going to look brilliant at Rs.250. The Nudge here is not averaging more, the nudge here really becomes about diversification asking how much exposure should one stock have in your portfolio and, ideally, you shouldn't be breaking that rule. Just because the stock has fallen does not mean from 10% of your portfolio, it should go to 20%.

So, everyone gets opted into a certain setting and they get an option to change it. Say, someone has a Rs.100,000 portfolio, we will not allow him to have fewer than five stocks. It is not like we are stopping him from doing it. But what we are doing, every time he overrides, we capture and tag that option and remind that overriding this nudge, will cause this much profit or loss.

The other thing that we have recently done is allowing people to tag each trade. So, when you are placing a trade, it will quickly show you a tag. It is an easy way of journaling your trades. After say three months you look back and realize all your gut-based trades are losing money, but all your technical analysis trades are making money. Then you know what to do after three months.

Tell me more about poker and the kind of insights it has given you with respect to trading.
My tryst with poker started after I stopped trading. It is very tough to trade and run a business. Once you are in a trade, you are distracted in a way. I take trades to test the platforms etc. but no material trades at all. But, once you are used to trading, you get used to that adrenaline rush. For me, poker has been more of that.

The key to success in trading, in poker, in business and generally in life as well is around your risk management principles. Poker is a real way to test if you are sticking to it or not. I play if there are friends to play with, people I like to have a conversation and to see if I am still sticking to all my risk management rules. It is easy when playing poker to get carried away and forget those rules. It is just about testing yourself.

Are you sitting on enough capital to grow the business going forward or are you open to an IPO?
We haven't raised any external capital, we are profitable, and we really don't have a place to deploy the money we are generating as a business. As I said earlier, not having to worry about revenue growth is an edge, and when you do not care about revenue and growth, you can be very nimble as a business. Today's world is about fast meeting slow and not big meeting small. Problem is as soon you IPO, you are going to slow, you are answerable to people and their money. For us, it doesn't make sense to do it right now. 


"I stick with the Nifty as I feel governance is still a big issue in India"

Alternative Investment Fund True Beacon's CIO on why he does not invest in mid-caps and his investing approach

"There are old traders and there are bold traders, but there are very few old, bold traders,” goes a market saying attributed to legendary systems trader Ed Seykota. If Nikhil Kamath stays the course, he will end up amongst the few old bold traders. At 34, he is far from old but he has had a long innings in the market having started at the age of 17. Along the way, he also co-founded Zerodha with elder brother Nithin. The duo now wants to replicate the same success in wealth management through alternative investment fund True Beacon. With assets under management of Rs.4 billion, it has set its sights much higher with plans to raise a billion-dollar fund that would invest in Indian equities. In this Outlook Business interview with Editor N Mahalakshmi, Nikhil who doubles up as CIO at True Beacon talks about his investing journey and current market outlook.

As you reflect on your investing journey, how has your strategy evolved?
I started trading about 17 years ago, when I was 17 years old. In the very beginning, it was randomly buying something because it looked nice, based on a little bit of fundamental analysis or liking for a particular sector. It was then followed by technical analysis for four-five years where I would look at chart patterns, try to mix that with fundamentals and arrive at trades.

That was followed by quantitative for a few years, algorithmic that gave advantages with co-relation, mean regression strategy, and that was followed by watching sentiment, what promoters are doing, geopolitical issues and money flow across the globe.

Now, I think it is a combination of everything. Sometimes, it is a combination of two or three of these different methods, sometimes it is one in isolation, but I don't think I stick to one particular method anymore. I would call myself a cyclical investor who tries to take advantage of cycles in the market, sometimes these are short, sometimes these are long.

What is your stock screening process? How do you go about identifying stocks?
I stick to the Nifty as I don't like buying mid-cap companies, so my universe is small. I only have 50 companies to pick from. I choose sectors I like and then try to figure out companies that could do well. I stay with the Nifty as I feel governance is still a big issue in India. At least with the Nifty, you do not have to worry about that. 

What is the average holding period in your portfolio? How much profit comes through active trading and how much through buy & hold?
Active trading is the hedge component which is about 30%, passive is typically longer term. In India, if you actively trade derivatives, you are paying 42% tax. If passive, you are paying 10% if you hold for about 12 months. Typically, a vast majority of the portfolio is held for at least 12 months but if something cyclically changes about the sector, I will hold it for three-four years. 

Which sectors do you avoid? Is it to do with valuation or the characteristics of the sector?
I don't like the public sector because of regulation. You don't know how things will change tomorrow, so I avoid them. I also don't like stocks which are very closely linked to global commodities, say steel or cement. Commodity trends are set globally, and we specialize in India, so we stay away from it.

We also stay away from companies which are expensive. Whatever is the flavour of the season, we typically do not buy. Two years ago, NBFCs were very expensive including Bajaj Finance and Bajaj Finserv. So, we try not to enter those companies and pick modestly valued companies with reasonable book value and little debt.

After the Budget, there is optimism about power stocks and public sector banks. Does the recent price action change your opinion at all?
I think not just in India but across the world, we are getting to the point where renewables are becoming competitive from a price standpoint.  I think today solar power costs maybe 10-15% more than thermal power and wind may be 20-25% more. The problem is in transmission more than generation. We lose as much as 40-50 % of the power generated during transmission and I think a lot of money has been spent there to improve the infrastructure.

There is another issue. Private solar power and wind power plants have to sell through the public platform and at one particular rate. They can’t freely sell power to the private sector. That has to change to really incentivize people to come in and put money in renewable power.

When you invest in renewables, the biggest risk you face is technology itself evolving so rapidly that you end up destroying capital. Do you think these companies can create value over the long term?
I look at government power consumption data. I think it is a better metric of measuring how well the economy is doing than GDP because in GDP there are a lot of moving parts. But, when you look at actual power consumption, you tend to see what the industry is doing. I think there is plenty of scope here, because the size of the industry will probably grow 5x in 30- 40 years. Immaterial of the money that has come in and will continue to come in, a lot will change and it will open up many opportunities.

Are you now bullish on public sector banks?
Not bullish, but less bearish than many other companies because of their valuation. Even after the post-Budget run up, I think there is value out there. Then again, we are 1.3 billion people, about 40 million-50 million file income tax. Maybe 1.5-2 % pay reasonable amounts of income tax. This number has to go up unless we start de-growing and do terribly as a country. This tax paying population from 2-3% has to go up significantly and when that happens, I think more people will need access to the banking sector.

I personally hope that farming which is exempted from taxes right now will be under the tax net, especially for the wealthier farmers. When more and more farmers and rural communities come on the formal banking platform, the demand and use case for banking will be tremendous. So, public sector banks have an opportunity to grow over time.

What kind of bets have made you money? If you were to pick your top trades in the recent past, what would they be?
Reliance has made some money. Then, a couple of years ago when the whistle-blower news came, Infosys had dropped significantly. That’s when I went long Infosys and short TCS in the same proportion. These two companies have been co-related for a long time. Infosys traditionally was more expensive but at that point, TCS became a lot more expensive. Buying Infosys and shorting TCS when the co-relation diverged significantly was a good trade.

As for Reliance, we are in an economy where large is getting larger and proximity to power plays a huge part. I think Reliance ticks all those buckets. They are the largest, they are close to the government, and they probably will continue to do well as long as the incumbent government is in power. And, the whole opportunity of getting data to rural parts of the country is also excellent.

How were you positioned last March before the lockdown? Were you surprised by the pullback thereafter?
We got lucky as our hedges were linked to the economy slowing down, it had nothing do with Covid. The economy was slowing down much before the lockdown. On the contrary, the lockdown has helped more than it has taken away, because of pent up demand or whatever. We were hedged significantly pre-lockdown, in February and March we had about 70% hedges and when the correction happened, we did quite well.

The market fell 20-30%. we were only down between 7-10% so that really helped. On the flip side, when the market rallied, we underperformed a little bit. What we are trying to achieve is a risk profile when the market goes up 10%, we are typically up 6% or 6.5% but when the market goes down 10% then we are down 3.5-4%. We are always playing the arbitrage between a stronger company doing well versus a weaker company doing badly.

We are still not sure. We did not think that the market would recover in the manner that they had and we didn't exit our hedges. During February and March, we were about 70% hedged and as time progressed and the fundamentals became a little bit more reasonable, we started bringing down the amount of hedging from 70 to 60 to 50. We continue to be 50% hedged. While we did get alpha when the market corrected, we also lost alpha when the market went up. But, by virtue of being more hedged when the correction happened, net-net we are up.

Let’s talk about some of the worst trades you have done.
Buying stuff which is the flavour of the season has generally turned out badly for me. It happens in public equity, and it happens in private equity as well. If I were to give you an example of the private market, every SaaS company out there right now is the flavour of the season. They are getting ridiculous valuation. A company with million dollars in revenue is now valued at $100 million. People entering the SaaS industry right now probably will regret it 10 years down the line because they bought it at a high.

In terms of the equity market, pharma & IT had the attribute during the pandemic. But I like those sectors because they will not hit you badly in a correction. They are good places to hide. But not real estate which has seen a significant spurt of late. I don't think adding a significant corpus to real estate right now is very prudent and that is something I would avoid.

Why so?
I have always believed it has been overpriced in India, especially residential real estate. If an illiquid asset class yields annual rental return of 2.5%, which is half the inflation rate or the risk-free rate in the country, I don't see the sense. We buy real estate because we have been sold this idea, when we are growing up, that as a man you have to have a wife and a kid and a house to feel settled. Practically and mathematically, it makes a lot more sense to rent today than to buy considering you pay 2.5% of the price of the property and you don't have to put that money upfront.

Promoters of real estate companies have been making this argument for a long time that land is finite, and demand will continue to go up because of urbanisation. I contradict that by saying urbanisation in the manner that it happened in China might not necessarily be replicated in India.

When you look at the population, we always thought that it will grow, and India will have two billion people at some point. If you look at the replenishment rate, every couple has to give birth to 2.2 kids for the population to remain constant. In the latest census, in the first 17 states where they measured the birth rate, it had fallen to about 2.17. So, the whole narrative of rising population no longer holds good.

What variables are you watching now to confirm a change in sentiment?
From a one-year perspective may be not, but if you look from a three-month perspective, consumption has picked up. The number of promoters saying they are doing better than pre-pandemic has gone up progressively in the past two or three months. Whether it will sustain, none of them know.

I think by September we would probably know if this short-term spurt in consumption continues or we go back to the trend prevailing pre-pandemic where we were slowing down as an economy. I personally would bet on the pre-pandemic trend versus the chaos of the past three months.

That turning out to be the case, would your hedges increase from 50 to 70?
The current momentum has made it hard to hedge at 70%. We will be around 50, but there is a case for equities as countries have been printing money and devaluing their currency. If you take America for example, they were printing about $0.5 trillion/year between 1980 to 2000, from 2000 to 2019 they were printing about $1 trillion/year. In 2020 they printed about $4 trillion-5 trillion.

So, a lot of that money will flow into equity. That in turn, might again boost the market. If they print another $4 trillion-5 trillion next year, I will make a case for buying physical gold and storing it in a vault somewhere. I think gold will be a decent hedge against the dollar.