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The Value Pledge

Fidelity India Mutual Fund's Nitin Bajaj says that in the long run, value investing is the best way forward

The interview appeared in the December, 2009 issue of Wealth Insight magazine.

Nitin Bajaj

Fund Manager, Fidelity India Special Situations Fund and Fidelity India Value Fund

Though India is famously touted as a growth story, Nitin Bajaj is convinced that in the long run, value investing is the best way forward. His value fund just got launched and he speaks at length on his investing philosophy.

Why launch a value fund now when the perfect time was 8 months ago?

Like Warren Buffet says, “If you feel you can time the market then I want to be your broker, not your partner.” I don’t think you can time things. Was it better to trade in March than today? Of course. But do you want to be in equity for the long term? If yes, then this is an alternate route.

What is your basic philosophy in running this value fund? 

I do not buy stocks I buy businesses. My goal is to buy good businesses at the right price. So, most of my work is centred on understanding the business. I view the stock market as a route to be able to buy into the business. 

Let’s say I am investing in Colgate. In that case, I am buying a toothpaste business in India. I need to understand how Colgate makes money. What it is that the company does that is sustainable. Why it is better than its competitors. And there is only one way to find out. And that is by research, research and more research. 

There won’t be any new finding. Only the price context will change. 

The price context will change and the reason the price context will change is because there are more sellers than buyers or vice-versa. When there are more sellers than buyers then obviously there will be some bad news. At that point, the understanding of the business will be vital. 

When I go to the market, there is someone selling me the stock because he thinks that things are going down. Otherwise he doesn’t sell. I think it is going up and that is why I am buying. The only way I can perform better is if I know more than him. I have to understand the business and the valuation better than he does. I have to create information asymmetry. I have to know more than the sellers. 

I do not invest in stocks that have catalysts or at least visible catalysts. Once a catalyst is visible, the stock is no longer cheap because it is visible to everyone. I do not mind buying stocks that are in bad circumstances, even a loss making one is acceptable if there is margin of safety.

You talk of information asymmetry. Do you just get information through fixed sources? How credible are the inputs?

I listen to everyone before I begin to filter it. When I worked in Paris covering tobacco companies, we once hired people to go and count cigarette butts in pubs and bars. This detailing is our advantage and that gives us the edge. That is information asymmetry. It is also built by talking to the supply chain and competitors. Generally, I find that when a supplier or a competitor says something good about a company, then it is much more credible than when the company says the same thing about itself. 

Why did you need to count cigarette butts? Are production statistics not reliable enough?

By the time the production statistics come they are too late.  You have to know before that. You have to have the leading indicator of the leading indicator. The reason we were counting cigarette butts was because there was a huge tax change in France and people were really worried that cigarette consumption was going to collapse and no one knew the answer, whether yes or no.

The only way we could know before the market did, was by seeing what was happening to the cigarettes butts in the bars and pubs over a period of 15 days after the tax changes.

What is the broad investment process you employ?

Since my starting point is to understand the business, 50-60 per cent of my time is spent doing just that. What I try to do is buy a good business when the market makes a mistake on it. I don’t want to buy a good business on fair price. The best example is Wal-Mart, the best retailer in the world. If you bought the stock in 2000, it was $50 a share. If you held on to it and sold it today, it would still be $50 a share despite the business becoming so much bigger in the meantime. What went wrong is that it was bought at the wrong price. The valuation entry price was wrong. That is very important. The price at which I enter has to reflect the margin of safety. I could be wrong on a business, so I want that margin of safety. I want the market to be my friend, not my enemy.

Secondly, I spend a lot of time on valuations. Valuation is an art, not a science. I look at everything - PE, PB, EV / replacement costs. Different kinds of businesses need different valuation tools. For a capital intensive business it will be replacement costs, for a franchise business or a brand business it will be PE or free cash flow. You can’t have a very hard and fast rule. I will be applying different rules to different kinds of franchises and will ensure that I have margin of safety.

The third thing I do is understand the expectations. I don’t want to buy good businesses which are on the front pages of newspapers for the right reasons, I want to buy good companies which are on the front page of the newspapers for the wrong reasons. My experience is that when expectations are high and everyone is talking nice, then it’s difficult to make money — the odds are high against you and the valuations are not in your favour. In 2003-04 everyone wanted to buy real estate, in 2005-06 everyone wanted to buy commodities. What may happen as a result is that I may miss a lot of opportunities because there is so much of momentum. These stocks are in the news so much that they keep going up while I stay away from them. But that is fine by me because in this business you are accountable for what you own, not what you miss. 

So you pick the opportunities on the way down.

Everybody wants to be on the boat going up and nobody wants to be on the boat going down. And that is what creates opportunity. 

For instance, let me tell you about tobacco companies in the U.S. and Europe in 2002-03. These traded on a 7-10 per cent dividend yield. The cigarettes business is a great business, though the product is not. It is an oligopoly. Since no country has more than two-three companies there is no competition. You cannot advertise, which means no new player can enter. And you have pricing power. But people were so intimidated by reading newspaper reports that volumes were falling that no one wanted to do the fundamental work of understanding the economics of the business. 

British American Tobacco (BAT) makes 50 per cent of the EBITDA margins with 3 per cent capex-to-sales and no incremental working capital requirement. You have 25 per cent free cash flow to sales; you get north of 100 per cent return on your tangible capital. 

The great thing about these companies was that they had learnt their lessons that diversification was bad. So all they did with their cash flow was either they would pay it as dividend or buy-back the stock, which was great. So the cash flow or the return on capital belonged to the shareholders.

We took big positions in all the cigarettes companies at that time and they are up between 3 and 4 times from there. And the markets have done nothing. The great thing was that the starting point was so good that the risk of losing money was very little. In investing, you win by not losing too often.

Investors just want to see returns generated. How difficult will it be to run an open-ended fund with this philosophy? 

All I say is, if you want to buy the next fashionable thing in the market, then this may not be your fund. There are plenty of ETFs around. But if you want to have money for your retirement or your children’s education, I think this is a good place to be. Historically, in any market, over any period of time, value does better than growth. Value outperforms in an emerging market, a developed market, in an inflationary or deflationary scenario, it outperforms in chaos and political stability. 

Second, you need to understand the investment process and how I think about businesses. You also need to understand the power of Fidelity’s research network. These will help me perform. I may try to buy some growth companies when they get mis-priced. I want to buy the fastest growing companies, but I want to buy them when they make a mistake or the market makes a mistake. I don’t want to buy a company at 30x the earnings, I want to buy it at 12x, if I like the underlying franchise. So, this fund is focussed on valuation anomalies. 

How much of the liquid universe of Indian stocks will qualify as your universe as of today?

Today, when I look around, I find more value in mid-caps. It’s difficult to find value in large-caps now. Maybe it’s because a lot of ETF money has come into India and foreigners buy what they know or what is visible. For now, I see many anomalies in the mid-cap sector in India.

How do you classify mid-cap?

The top 300-400 companies listed on the Bombay Stock Exchange. The fund has no bias though; if tomorrow, mid-caps become expensive and large caps become cheap I will go there. 

Can you give me an idea as to the complexion of the fund?

Being a risk-averse investor, my No. 1 rule is not to lose money. So I wouldn’t want to build a portfolio by solely taking mid-cap bets. The portfolio will have some large companies because you need liquidity in the fund. You can’t have everything in the mid-cap space and run a liquidity risk. 

If I was running an endowment fund, where I have privileged capital, or I was Warren Buffet where I am sure that the capital will not leave, then I may have considered going 100 per cent into mid-caps. But I have to respect the investor who puts in money and may need it anytime.

It’s about having a margin of safety since mid-caps can sometimes become liquidity traps. When you want to sell them there may be no buyers, so you need a higher margin of safety than with large-caps. You can’t sell mid-caps at close to peak, you have to leave something on the table. 

Let’s assume that you find yourself in a situation similar to what it was in January, 2008, prior to the crash. In such a situation where you are faced with an absolute dearth of value picks, would you stay fully in cash?

No. At Fidelity Mutual Fund, I will not be allowed to go up to 100 per cent in cash, or even 20 per cent in cash. Our institutional framework will not allow me to go more than 10 per cent in cash because we believe that investors have given us the money to invest. 

How would you justify being fully invested at that time?

If there is a bubble and the market goes to ridiculous multiples like 25x earnings, I would use cash purely as a tactical tool, not as a call on the market. 

Would it not go against the mandate of the fund?

I would communicate to my investors by explaining the situation and my stance in my monthly commentary. The option to redeem, or stay on, rests with them. That’s all I can do. But let us first get to the bridge and then think about how to get over.

Fair enough. But then such a situation cannot be ruled out.

When the market is on a momentum, then value fund managers appear foolish. That’s what value fund managers have to go through when the stock market is going through a bubble. But value investors must have the conviction to stay disciplined and stick by the process. And then, when the market does crash, you can have your pick of stocks. 

When the tech bubble burst in 2000, Anthony Bolton’s fund did not fall in absolute terms, but stayed flat. That is a great achievement. It requires tremendous courage from the fund manager, the management of the fund house and also investors to stand by their convictions.

You have to do your work and understand the business. Once that is done, you have to stick by your conviction and not worry too much about the momentum.

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