Driven by process

After an impressive decade-long stint with Invesco AMC, where most of his funds appeared high up on the ranking tables, Vinay Paharia took over as the Chief Investment Officer at Union Asset Management last year. We caught up with him to understand his success mantra, what changes he is bringing about at Union AMC, and what his views are on the current state of the markets. Here are the edited excerpts.

Tell us about your journey in the field of equity investing? How has your thinking evolved over the years?
I grew up in a joint business family, where dining-table discussions often revolved around what impacts a business and what doesn't. The conversations also touched upon what's moving up or down in stocks and commodities.

I used to discuss stocks with my father and my grandfather. That's what piqued my interest in the world of investing but at that time I didn't know that you could make a career out of it. It was only when I was doing my summer internship during my post graduation in 2001 that the thought of making a career in the stock market crossed my mind.

I read a lot about this field, my first book being Peter Lynch's classic One Up On Wall Street. I read all the annual letters written by Warren Buffett. That formed the bedrock of my thinking process. Gradually, I joined the 'sell' side and after working for three years, I moved to the 'buy' side. That's where I wanted to be and that's where I could practise the craft of equity investing.

It's been close to one year since you joined Union Mutual Fund. What have been your key focus areas during this while and any changes that you are bringing about?
The biggest focus area has been setting up a unique and robust investment process and making sure the entire team is on the same page. We've followed it up with implementing it in our investment portfolios. In summary, this is what I've been focusing on.

Can you share more specifics about your process?
The first step of the process deals with stock selection. Our endeavour is to buy stocks which have growing intrinsic value and a margin of safety. Stock selection starts with the overall universe, which for us is all stocks having a market cap in excess of a defined threshold.

From this investment universe, we distil down stocks based on three filters - good business, good management and reasonable valuation. And then we arrive at a list of stocks which we call as the fund-house universe. This is usually around 130 to 150 stocks. Right now, as we speak, it is at about 138 stocks. All the funds necessarily have to buy stocks from the fund-house universe. They cannot buy stocks outside the fund-house universe.

Each stock in the fund-house universe is further segmented into either a growth company or a bargain company. Growth companies are characterised by intrinsic value growing at a rate higher than nominal GDP. So we segment a company as a growth company if it has an intrinsic value growth in excess of 11 per cent per annum over the next five years. And why would anyone buy a company which is having a growth in intrinsic value lower than the nominal GDP growth? You will only buy it if it is available at a deep discount to the current intrinsic value. We segment such companies as bargains.

The USP of our process is the use of fair-value approach to investing. In our view, fair value of any company is driven by four factors: earnings growth and its sustainability, return on equity and its sustainability, risk-free rate and riskiness of cash flows. An interplay of all these factors helps us judge the fair value of each company in our fund-house universe. The approach helps us to scientifically judge the risk-reward built in each opportunity.

The next step in the investment process is portfolio construction. Our philosophy simply states that we will construct portfolios which are true to their mandate. Portfolio construction is guided by portfolio-construction guidelines, which, in turn, depend on five factors. These factors are stock selection (growth stocks or bargain stocks), sector allocation (restriction or freedom on sector allocation), capitalisation (large-, mid- or small-cap allocation), asset allocation (equity, fixed income) and concentration (focused or diversified). Portfolio so constructed should then be true to mandate.

How often do you review your fund-house universe?
It is done on a real-time basis. That's where active management comes in. In addition, there is a hard quarterly review for each and every company.

How does your approach to evaluate a small-cap stock differ from that for a large-cap?
The most important factor of differentiation is the expected riskiness of cash flows. The smaller a company is, the higher the riskiness of its cash flows. Having said that, we are cognizant of the fact that small and mid caps have much higher growth potential than large caps and hence the portfolio needs to have a balanced approach towards risk and return. We generally concentrate our exposures in large caps, while extensively diversifying in small- and mid-cap space.

Do you have any ground rules on the number of stocks in your funds?
Currently, we don't have any concentrated or focused funds. All funds have more than 30 stocks. Overall, our operative principle is that we will be concentrated in large caps and diversified in small and mid caps, subject to the investment objective of the respective funds.

What are your top three red flags while doing due diligence on a company?
First and foremost is excessive leverage. We do not like leverage. We can take income-statement risk but we will never take balance-sheet risk.

Secondly, If the business is facing or is prone to some sort of disruption, it would be a red flag.

Finally, we would like to avoid value traps. A bargain company is one where intrinsic value is growing at a steady pace and market price catches up with intrinsic value. If market price is at a discount, over a period of time, it will move up to catch up with the intrinsic value. A value trap is one where the intrinsic value declines and meets the market price. The latter are the category of stocks we would avoid.

Mid and small caps can be minefields. You need to avoid a large number of red flags. There are many of them which we have internally documented. That is where I'm trying to bring in the discipline in terms of identification of red flags. If there are some red flags, we will wait and keep watching. We have an open mind on everything except managements which have short-changed minority shareholders. Management quality is a grey area. Our idea is to accept white or grey, but avoid as much black as possible.

How do you form a view about the management of a company?
Management quality has an objective as well as a subjective side to it. In case of objective assessment, the acid test of a good-quality management is capital-allocation track record. A good management is what a good management does. Putting up a business strategy is one thing and implementing it is another. So, execution of strategy is a very important tenet of judging the management. And then there are hygiene aspects like related-party transactions, promoter pledging, etc.

Beyond that, it's a grey area. There is no management which is completely white (saintly). But there are some which are completely black (poor managers short-changing minority investors). As a fund manager, my idea is to first avoid the black and then remove companies which are moving towards black. This is where the expertise comes in. I call it the common-sense filter and it is the most important final filter. So, if something doesn't appeal to common sense, say, the business is too good to be true or the management is too good to be true, it will go in the watch list. This is an aspect where I have a veto.

What's your view on the markets and are there any specific developments you are keenly watching these days?
The most commonly watched number nowadays is the potential index earnings growth. According to Bloomberg, the next two-year earnings growth rate is going to be 18 per cent. Last six-year earnings growth has been 9 per cent. So the popular perception is that earnings were not growing in the past and in the next two years we will have earnings surge which will propel the markets forward.

But this is a flawed concept. You should not base your investment decisions on index earnings. What is relevant is fair value. We do not have any tools to forecast the market in the near term but over a longer period of time, markets are completely driven by fair value.

Just to give you a glimpse, over the last six fiscal years, markets have given returns of close to 16 per cent CAGR, while the index fair value, based on our calculations, has increased by close to 14 per cent CAGR (note the earnings have grown at just 9 per cent CAGR in the same period). This is a very critical differentiator. For the future, we estimate the potential fair-value growth similar to past trends.

In our view, the fair value is likely to go up in early double digits and therefore we do not expect any magic in the market because of the so-called surge in earnings. Large caps are relatively attractive even though they are trading at a small premium to their fair value due to reasonable fair-value growth. On a selective basis, small caps have started becoming attractive, but on an aggregate basis, small and mid caps remain expensive compared to large caps.

So these are the broad two takeaways from our framework and we have incorporated these in all our funds.