You just moved from a much smaller organisation. Is it not restraining moving to a larger, process-oriented set-up?
Processes are needed in a group that manages a trillion dollars in assets. And this is a positive in the long-run. Investors need to have the confidence that their money will be taken care of in the way it should be regardless of individual changes, to a certain extent. They need to know that their money is not being put into someone's hands but an organisation is managing it.
Give us an example.
We have a model for equity evaluation called EPIC - Equity Platform for Investment Communication. This is a web-based, real time equity platform. Once I enter the system, I can pick up any country and any stock being covered and see what AIG analysts have to say about it.
The moment I select a company to cover, the system automatically downloads 10 years of its historical data. Third party research gets incorporated into the system so I get to know other views about the stock. After the analyst researches the company, he inputs his observations and findings. He has to answer queries that are fixed according to category for every company and there is a slot for additional comments. So I can look at this and see the analysts reasoning on why he is giving a “sell” or “buy” on a stock and his target price. This eliminates the emotional bias.
So a new person coming in cannot reinvent the model. He cannot say “I refuse to look at the company the way you are looking at it. Actually, this is what the company is all about.” I am comfortable with this process because it lowers human error.
Is your team big enough to conduct in-house research?
Size of the team is no indication of the quality of research. We cover 200 companies in-house. Including me, there are two fund managers, two analysts and one dealer.
Do you invest in your own funds?
Yes. AIG as a group does so.
Sub-prime loans are given to people with suspect or sub-optimal credit quality. House prices were going up substantially. So even if someone could not service his loan, the lender would foreclose. The problem started when property prices began to fall and interest rates began to rise. These were all variable loans with reset clauses. The sub-prime loans were at a teaser rate for two years. Since most were done in 2005, it is time for a reset.
With interest rates going up and property prices falling, the rates of default are expected to go up.
Isn't it a challenge setting up a new business at a time when the markets are volatile?
Equity, as an asset class, offers a higher compounded rate of return compared to any other asset class. If I look back 15 years, I would have got the highest compounded return in equity than any other investment. Take rolling 15-year periods anywhere and you will find it true.
The second way is to look at equity as a market. The estimated real GDP growth rate in India is 8.5 per cent. Other economies may be larger but ours is growing faster. As an equity investor, I would rather invest in a growing economy. So in addition to equity offering better returns than any other asset class, we are talking of a growth story in India. Markets will be markets. One cannot expect it on a linear basis to always be worth more tomorrow than today.
What returns can an investor expect?
The Indian market over the last four years, from 2003 to 2007, has been a one-way street with just two or three bumps. So expectations are extremely high. But if you look at realistic expectations of return, 15 per cent compounded for 20 years is very high. If I started last year, I would have made nearly 50 per cent. I might not revert to 15 per cent but get a significantly higher experience of return than average because of when I started from. But if I start today, my expectation should be realistic at 15 per cent. You can get lucky or unlucky when you start but if you stay long enough, you will revert to the mean.
So entry does not matter at all?
It does. Some have not done well because they entered the market when it was significantly expensive. And I am not talking about price but the PE of the market. In 1992 when the market was 4200, it was trading at a PE of 40 times. If you entered at that time, till about a month ago at 15,000, you would have made an approximate 8 per cent return. That is what an RBI bond would have earned. So even from a worst possible scenario you still would do better in equity. But had you entered the market in 1993 instead of 1992, your returns would be totally different.
International credit markets are under stress - there is a lack of confidence. Since markets move in tandem, India is hit.
The second is the political issue where a certain section of the ruling coalition does not agree with the nuclear pact with the US. The worst scenario is that the Left withdraws support and the government goes into elections. This will result in a delay in government actions. But Indian corporates have survived all sorts of governments. The reform process has been set in motion in such a way that it is not possible to simply reverse it.
You think it is wise to enter the market now?
We invest in companies, not in the government. If our companies continue to make profit and have a sound business, we have nothing to fear. When companies make money, they earn a net profit. This translates into an Earnings Per Share. The price we pay is a multiple of this EPS. It will contract today because the market thinks times are bad, which is a good time to enter. At some point of time earnings will go up, the PE too will go up. Even if does not, the stock price will go up. So if we believe that our buys are of significant long-term value, the turmoil in the market turns out to be an opportunity.
Look back. We had all sorts of industrial problems, sub-par economic growth at 4.5 per cent which we used to call the Hindu rate of growth. But the equity markets still delivered a compounded return of 18 per cent. So despite a bleak economic environment, we made decent returns in equity. Now that the environment has changed, why can't we expect 15 per cent compounded? We believe that earnings and growth rates will remain strong in the coming years.
Would you have a problem investing in, say, a tobacco company since it has ethical issues?
AIG, as a group, believes in corporate social responsibility which is doing business the right way. Smoking is legal and it is up to an individual to make a choice.
Infosys is one of your biggest holdings. Don't you think the best days are over?
Look at scalability. Infosys has done exceedingly well and five years from now will be three times its current size. The question is will they be able to sustain their margins? Even if they don't, they will make a lot more money three years from now than they are making today. Pressures exist, it will not be as exciting as it was before but it will be premature to write it off today.
The model for the software sector continues to be strong. A software programmer in the US will cost $1,20,000 per annum. Someone doing the same job in India will cost $30,000 with the inflated costs that he is now asking. Is this going to dramatically change? Not likely.
The appreciating rupee has not changed the picture to a point where there is no opportunity. Competition is stiff. In India, you have an Infosys, Wipro, Satyam, TCS and so many others doing the same thing. They will compete with each other but the business proposition won't change.
No favourites. We follow good management and companies available at a price which is reasonable compared to expected growth. So this can be in any sector, even one which no one likes. We would avoid sectors which are running ahead of fundamentals and where valuations don't reflect an opportunity. Sectors which intrinsically are lower yielding like commodities.
Why no real estate stocks in your portfolio?
It's difficult to paint all real estate companies in one colour. However, my belief is that the valuations that most of the real estate companies are selling at, are based on expected sales of flats in the next few years. A few things can go wrong.
Firstly, you need money to build a property. The money needed for such development is huge. From where will they get it? The banking industry won't lend solely to them. Till date, real estate developers took an advance from 20 per cent of the people and 20 per cent of the value from all the people who are going to buy it. They put in some of their own cash. This worked because the costs of construction and land acquisition were lower. They would then build the property and sell the flats.
Now, they are talking about townships. So this incremental model which worked for so long will not hold because the model has changed. The challenge is to raise such money. If property prices fall then you have no leverage. Today, if I want to buy a nice apartment, there are none. But when all the projects come up, I will have a choice. If supply goes up, price has to fall - simple market dynamics. So people are buying at today's demand and supply and pricing the company depending on projection of prices three years from now. Their judgment could go horribly wrong.
Why no aviation stocks in your portfolio?
Look at the dynamics of the sector. There are high fixed costs - a few aircraft, fuel, costs of personnel and airport landing charges. Then there are other costs of issuing tickets, security checks and embarking and disembarking. The only way to continue making money is ensure huge volumes. That is not a given. If things go right, it will go very well. If they have every seat booked on every flight for the next three years, they will make serious amounts of money. If it was only Indian Airlines and Jet Airways, we would buy both of them. The industry has expanded too rapidly, too soon. Till it consolidates, we won't be comfortable with aviation stocks.
Why is banking your most heavily invested sector?
Because the benchmark, BSE 100, is 21 per cent in banks. But Indian banks are cheap - specially public sector banks. If we have 8 per cent GDP growth over the next 15 years, then the best proxy for growth is banks.
Do you believe in holding cash as a defensive position?
Not in this equity fund. We would do so in a dynamic asset allocation fund. Currently we are fully invested in 42 stocks.
This interview appeared in September 2007 Issue of Wealth Insight.
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