It is easier to eliminate bad stocks rather than selecting good stocks to invest, according to veteran investor Samir Arora.
Arora, founder of Helios Capital Management, believes that stocks do not have a well-defined parameter of being good. Hence, it is advised that investors use the process of elimination while building their investment portfolio.
"Over the years, we've realised that it is easier to say what is bad and not buy it. So, say in a market with hundred stocks, broadly we figured out in India and in the US that about 30% to 35% of the stocks do very very well each year. We find that half have to beat and half have to be beaten for the market to be as defined. One third really beat by a massive margin, which means you start with your universe and reject as many stocks as you want. Because rejecting stocks is easier than saying what is good," Arora told BOOM.
"What we say is take your hundred stock, whatever be your market, remove stocks because they have very, very clearly bad valuations or clearly bad sectors, which means could be very much government policy driven, very global; remove clearly leveraged companies, remove clearly bad management history companies, which everybody knows are broadly bad," he added.
Arora also cautioned investors against investing heavily in government-backed companies citing their poor record of return on investment with government-backed infrastructure projects particularly prone to draining money. Citing Zee's poor performance in the market, Arora believes that the root of their troubles lies in the investment in Essel Infra.
"The summary has been that the maximum money has been lost in sectors where there was a connection with the government. If you look at all the bankrupt guys, all of them have lost because of becoming bullish on infra. Their first project may have been successful, but then they goofed up because they tried to buy it one more time.
"It is the system. So, for example, if a road is ready, but it is stuck, because some guy has appealed to the government or in a court. The system, where you needed help from a court or help from some lender or help from some state government, basically did not turn up for all these guys. And at some conceptual level If you look at Zee, the reason why their stock is down because of Essel infra," Arora said.
- There is no way to define a good stock
- Do not decide in advance how long you'll hold on to a particular stock
- Stagger your investments when buying stocks in new companies
- Hedge Your Bets On Consumer, Financials, Technology and Retail Sectors
- Follow trends in the US even while investing in India
Edited excerpts follow
Govindraj Ethiraj: Samir, what is your investment or investing philosophy?
Samir Arora: So, first of all, we are talking about equity markets per se only because I am an equity investor and not a debt plus equity investor. So, in equity investing, the big picture philosophy generally has been that you find good because the opportunity in the marketplace is to buy a few shares or even a small weighted in shares and then write the benefits of the growth of that company. But there are many ways you can invest. You could invest in bad companies and hope that they will become good, there are many people who - not in India so much but in the world - will do activist investing or they will buy very cheap stocks and hope that they will turn around.
Or you buy what we do, which is normally called growth investing. Which means that when we buy shares, we are riding off the efforts of the company, our job is only to choose between those companies, rather than say that then we will add some more value. Which for example, some PE funds may do, who after buying a share will advise the company tell them how to change boards and auditors and all that. We are basically saying find the best companies, buy them and then let them do all the hard work.
GE: Having said that, what's your next layer of filters? How would you identify the companies? Are you usually driven by sectors and industries and how do those change when times change?
SA: So, what happened is that over the years, I realized that it is very, very difficult to find what we call good companies. Because a good company, let us say, is defined as being in a good sector, good management, good history, good corporate governance, good accounting and then good valuations. And the problem in markets is that there is no definition of good. So, for example, by the time you say that, say the management of HDFC Bank is good, it will take you 10 years of that company doing well for you to feel 'yes, this company is got good management'. And even then, you don't know whether it is good management or good one guy or whatever.
So, over the years, we've realized that it is easier to say what is bad and not buy it. So, say in a market with hundred stocks, broadly we figured out in India and in the US that about 30% to 35% of the stocks do very very well each year. How to come to that number is we are all comparing ourselves with the market average or the market or benchmark or is a index and the index return is broadly an average of those say 100 stocks.
So broadly plus minus a little bit around half the stocks will beat the market and half will be beaten by the market. Sometimes this number will be less because say a large company goes up, say Reliance in India or Amazon in US, then it tells me the index performance so that even fewer stocks have to go up for that market to be up whatever it is. So we find that half have to beat and half have to be beaten for the market to be as defined. One third really beat by a massive margin, which means you start with your universe and reject as many stocks as you want. Because rejecting stocks is easier than saying what is good.
For example, we know that if an employee steals money, he's bad. But if he doesn't steal money, is he good? No definition. If a person harasses people on the job or he harasses women, he's bad. You can't say I'm a good employee because I don't harass women. So what we say is take your hundred stock, whatever be your market, remove stocks because they have very, very clearly bad valuations or clearly bad sectors, which means could be very much government policy driven, very global; remove clearly leveraged companies, remove clearly bad management history companies, which everybody knows are broadly bad. And once in a while, they may turn out to be better also. But at your level, and then you remove everything, you'll be left with about half the market.
This is without doing anything other than reading. And then if you will be left with 10 private sector banks, say five pharma companies, then you select within them. This is from a purely retail point of view. But instead of going in and saying, 'I know this company is very good', because you don't know. And by the time you know, it may still do well for some more years. But most of the juice has been taken out because by the time you became comfortable that it is very good. Many years would have passed.
GE: So what's the time horizon that that you usually look at before your own funds or in general?
SA: So the idea is that we find that although people say that stocks do well when held for the very long term, the reality is that when you buy 10 stocks, only three will be worth holding for the very long term. You can't go in saying that I will buy these 10 stocks straight away for the long term. Because as I said, by the time you get confidence that these are the stocks for the long term, actually, their story is over.
So my favorite example for that is that Warren Buffett bought Coke. And you know, he drinks coke every day at his AGM and all that. But actually, Pepsi has outperformed Coke since the day he bought it. And there are many examples like that, that you feel you got the best stock when actually you haven't. So what we are saying is you buy stocks initially with a one to three year horizon. And if that company is doing well, obviously, you will keep it.
But let's look at Rakesh Jhunjhunwala. So we know that Rakesh Jhunjhunwala has basically made all his money in four or five stocks. Titan, some Lupin, some CRISIL, but let's say two, three more. But it's not that he's bought five stocks, he would have bought maybe 80 stocks in his life. And then some x, y and z didn't work. The TV18 didn't work. What worked he kept. So that is what we mean rather than saying that I bought only five stock because I believe in them so much.
I have one more favorite story on this. When Steve Jobs died, 80% of his net worth was in Walt Disney and 20% only in Apple shares because he had got Walt Disney shares for selling Pixar to Disney. Why didn't he know that in 10 years that Apple is going to be the biggest company in the world? Why didn't he know it? Why didn't Bill Gates know that when he hired Satya Nadella, he will do such good things and Microsoft will suddenly become what it is now? He sold all his shares. Bill Gates is not even having, I think 5-10 billion of shares in Microsoft out of 100 billion or 140 billion mark net worth because he sold it all off. So point being, even an insider doesn't know that what will happen in ten years.
First, if you broadly accept that a large number of stocks do well, a large number being called into as one third. Try and eliminate as many as you can by going the reverse way, by just saying blatantly we know this history of this fellow or we know that the sector is very bad, or it's very government policy driven, or it is very global, so I won't be able handle it. We'll be left with half only. From that half, you have to go to one third is much easier, then we'll go one to anything in one third.
GE: You talked about the one two and three years. So I'm assuming that also means that there is nothing particularly when you're a fund or even for that matter if you're an individual investor, there is nothing like a long term because long term is something...
SA: The long term will be there because when you bought it, it continued to do well, so you kept it for long. Like I have owned HDFC Bank for more than 24 years. My story has come in a book called "Bang for the Buck" written by Tamal Bandopadhyay. But when I bought it in the 1996 IPO, I didn't know that this is going to be turning out to be like this. But then every year it did well, why would I sell it? Similarly, look at the other way around. So we bought Bajaj Finance in January 2011. Why would anybody think that this is the company which is going to go up 70 times. But you bought it saying, okay, it's worth 2%-3% of your portfolio. Because the management is good, Bajaj family is good. You know, this new guy who's joined them at that time is good, Rajiv Jain. If Rajiv Jain knew that this stock will become a 35 billion market cap company he would not have joined their company saying I want 20% stake or something like that.
So the point is not that you don't stay for the long term. I am saying it is highly unlikely that you will directly be able to buy a stock for the long term. So don't put that standard on yourself because then you will wait for too much confirmation before you will buy. And that would mean that you will miss two things. The fact that a large number of people do well, and those guys also don't know that they want to do well, except that they are good sectors, good history, they are trying to make a serious job of it and, and so you will buy too late basically. Therefore, if you keep waiting for that highest conviction, to say that I will hold it forever.
And secondly, we have seen that companies who can't hold for 20 years. Look at the other holdings of Mr. Buffett because the advantage of analyzing him is not to say that we are like him, but because his data is available. For 25 years you can see what he held and not held in the top names. So he owned Wells Fargo in some 90s and in this year it is down 55%. So, whatever he may or may got blown up in one year and maybe in between also. So the point is you will never know beyond a point.
So long term is very much there. But long term maybe you will buy 10 stocks, three will become long term. Rest will still make you good money, because a lot of shares go up for five, six years, and then they either plateau out or even blow. We made nearly 50 times on Pantaloon and now pantaloon is bankrupt. But when we were buying Pantaloon, we were not speculating. At that time, it was a fair new retail in 2001. I think we bought Alliance days, and then we bought it in the new Helios days. And then after some years, I think we sold it off. So we may have made 30 in the end because it went up 50 and then fell. So you can't say in 2001 that in 2021, they will be doing badly. So you never know.
GE: If you were to now look at a basket of 10 stocks today, what would be your, how would you select those 10 today?
SA: So first thing is how to mentally think of stocks in terms of whether to buy or not buy. So we think there are two ways you can mentally. One is high confidence in reasonable return. That means the confidence is high, but the return will be low. And the second is reasonable confidence in high return. We are too old too experienced to say high confidence in high return, there is no such category. So let's say high confidence in reasonable return would mean, that the company is doing well but everybody knows about it. It is a big part of the market. But it is reasonably valued based on historical numbers and its growth, the management generally has been good and will keep you out of trouble. And if the market is doing well, they will do well, if the market is doing badly, maybe they'll outperform.
So today's context, these stocks will be these private sector banks. It could be a few multinationals. It could be these consumer names. It could be the tech names like TCS or HDFC Bank, those kinds of obvious names. But the obvious names also you're choosing out of 50 names because there'll be other names that you can easily ignore. Commodity companies, highly leveraged companies, infrastructure companies, state owned companies broadly they will not work. So, there's still value in choosing 10 out of say 30 or 50 large companies.
And there the rejection can be on sectors that are clearly in stress. Or where the government policies play a big part. Then you are doing the other group where you say reasonable confidence in high return. Which means you found everything ok. We have seven factors, good industry, good management -- but we don't know good so we will say not bad. That means you didn't find anything bad in them. So industry, management, accounting, medium term triggers, valuations. And now we put a new one where we look at whether your sector can be disrupted or not.
Now, with this, I am not trying to find the good company because even today, we don't know what is good management, if you meet a new management. See, we can say TCS is good management, but that poor guys have been working hard for 20 years. So now we can say good management. But if I were to meet a new company which is benefiting from China plus one strategy, or CRAM strategy. All these guys are the future. Some of them will be future winners, but today, how can I call them good? All I can say, 'yeah, he looks educated, he's got some training, the theme is good, he's not bad. There is no history of bad. Generally, whatever they have done for four or five years is good, and the theme is powerful. So, I will buy 2% in the first month, I will buy five 6% of my portfolio.
Then I buy in the second group what we call reasonable confidence in high return. There should be no factor on which it is bad. It may not be good. First of all, it should not be bad on any factor. Then you say it is not bad that mostly for many people anyway means it is good. And then you buy a smaller stake. And you rely on serendipity of the market that a large number of stocks do well which is one third. So in that mix, you will find some stocks, which will fall off after some time, they will break even, some will drop and some will do very well.
Another thing for first starting with a smaller position is that when good news comes out, you are willing to add because you say it is my stock. Suppose I've been looking at a stock, which I say is very good. But I need to wait one more year when I will be really convinced. By that time, in that year it goes up 40%, I will never buy. I'll say I thought of it when it was 200. I knew it was good. But if I bought a little bit at 200 it goes to 300 in my stock. I also done well in it easier to average. Because when the day you start analyzing, for whatever reason that price will become your price.
So therefore, we say, just eliminate the bad. That is a massive improvement over the market. After that you try and choose how you can reduce it a bit further. If you, after this first exercise, find that there are still too many names left. We find that basically 50% is left. And some stock you're not saying I will never buy. You're saying I will not buy for now. So for example, for five, six years, there was massive fight in the telecom industry, between Bharti and the new guys, the old guys. So what was the need to buy Bharti? We didn't buy it for six years. We said we will look at it when it ends. Today we say that for fertilizer industry, for road building, government doesn't have money, why are you telling me that you got an order? There's nobody in the country who will give you money on time when you do make the road.
We are saying for the moment you remove all these you will anyway be left with a more reasonable thing and then if you make a mistake, that mistake will be less costly. It will not be somebody will go bankrupt. You may underperform because something goes wrong again.
GE: At a time like this, the market is very, very bullish. Some may argue that the market and the economy are a little out of sync. But that also happens very often. So how do you then pick stocks? Do you revert to sort of looking at what the economy and the macro economic signals are? Or do you stick to the stocks?
SA: No, basically, you have to stick a little bit to the economy, those stocks are dependent on the economy. For example, why we are not buying any infra stock, which we used to own, including the biggest obvious ones, is because we know that the government has no money. So how can they pay anybody? In India, the corporate sector today does not have the confidence to do CapEX. So why are you recommending all these heavy engineering tech companies? Nobody has money, so you have to look at the economy.
So the way we have reconciled it right now is to say, when the economy is experiencing a K curve, we have some groups of sectors going up, and some are going down, and some are sort of hanging around. But mostly, the disparity between groups is going up. Because whatever was happening pre-COVID has got accentuated with COVID. So if there was previously X percent people going online every year, now for the next four years, number has gone online now. And then similarly, on the other side, if you are slowly getting disrupted because of having say Netflix, now that has got accelerated. don't feel that randomly stocks are going up. It looks like the market is up, because we are looking at it from March.
You look at it from December, because December was pre-COVID. And now COVID is about to end. So in that the market is down some 3%-5%. And many stocks are down 20% - 30%, which have either a shorter-term problem, like say some of these strong banks, or they seriously have a threat of disruption. And the stocks that are up are actually stocks which are not necessarily greatly benefiting, but have been greatly protected, like the tech sector, pharma. Reliance, many of these consumer companies, they're up. Some are up a lot, basically the pure beneficiaries, and the ones which have not been badly hit are flat-ish. And the stocks which have a shorter-term problem and a longer-term problem are down 30% - 40%. Everything has not gone up.
GE: Let me ask you about the mistakes that you've made, or the one or two mistakes that you've made, and that you've really learned from and, and which obviously, you'd like to share.
SA: We have made so many mistakes that we tell our new investors that we have made mistakes on account of the previous investors, because we made those mistakes three years, two years, five years, 10 years ago, and from every mistake you're learning. But if I were to summarize them, the summary has been that the maximum money has been lost in sectors where there was a connection with the government. Basically, maximum money has been lost in infrastructure projects. And we bought many of them in our life, because in the 2004-05 era, and even previously, you would buy companies on the basis that India is behind the world on infra; that if you privatized Delhi airport you would make a lot of money; that if you get a lot of road orders, you are in business, and every one of them we have lost.
And actually, if you look at all the bankrupt guys, all of them have lost because of becoming bullish on infra. Their first project may have been successful, but then they goofed up because they tried to buy it one more time, whether it is GMR GVK, or JPA. In some conceptual sense, everything was related to government being a client, I would say. And we have had a big share in that. Other than that, you don't broadly blow up those shares, you lose some or you underperform.
So now we are not buying any in infra because there is neither the confidence in the corporate sector because you don't need a successful winner for others to copy. So for example, then in 2004-05, this Jindal steel and power. They had some 1000-megawatt power, which was free pricing or whatever. They were a small company in that sense, but they were a lot of money. Some billions of dollars of power investment went in and they blew up.
Similarly, it happened with Telecom. Initially, Bharti and all made money and some 20 guys lined up. So right now first guy also we don't have in this world so that would be an easy one to explain. Otherwise individually we made many. Our Amitabh Bachchan Corporation went to zero. But to lose 50%, yeah we have done that at least 10 times in our life.
GE: It's interesting that you're saying that the external factor, which is government policy, in this case is more to blame...
SA: Not policy. It is the system. So, for example, if a road is ready, but it is stuck, because some guy has appealed to the government or in a court. What if the other power guy was very aggressive in bidding for his power. So, it need not be that the central government is doing it. I mean the system. Let's call it the system where you need help from a court or help from some lender or help from some state government. Basically, not turned up for all these guys. And at some conceptual level If you look at Zee, the reason why their stock is down because of Essel infra.
Everything effectively is at some level of infra. Now you call it whoever's fault, it's not a policy fault. It could be that you didn't get land and nobody's willing to get you that last piece of land. It has happened in many companies. It's not external. That is what we were supposed to have analyzed. That this ain't it so easy. It is as much analysts want.
GE: When you look ahead now, you mentioned the example of HDFC Bank and many of your peers have quoted HDFC Bank maybe also because you all started investing around the same time. So could one find a stock like that today?
SA: No you will find but you will not know then? I have found many. But later on you turn around and think 'what a great goldmine we bought. Every year, it will go up 20% or so we'll be happy. But then the same 20% becomes over 10-20 years becomes a massive multibagger. So I'm sure we have. But we say, we will dare not say today straightaway. Because of the number of companies that end up doing badly after having started well, that if it is continuing to do well, we are there. But let us not say publicly, too much about any one company because what happens is you become a prisoner of that associate, not necessarily that SEBI will come.
But if I tell everybody "this is the new XYZ and tomorrow something goes wrong, I don't want to have any psychological listing that I can't sell it because I was so public. But broadly, the themes that make money in the long run are basically the three-four themes. Which is financials, consumer and technology, pharmaceutical retail, type. If you look, it's very easy. Look at the Forbes billionaires list. And see where those billionaires are coming from. They will come from these sectors. They will not come from commodity sector, cement sector, steel sector. There isn't one billionaire out of 400 who went into and bought steel or something. Basically, they'll be from finance, consumer tech pharma and somebody might be doing a little bit different. So, these are the sectors where long term wealth has been created.
GE: To pick up on the two examples you gave HDFC Bank and Bajaj Finance. These companies internally are different and you pointed it out yourself. When you look back, is there any trend in the success stories or for that matter, the failures in terms of who they were or where they came from?
SA: So I think a large insider owner or promoter is not such a bad idea. I don't think it is true that it should be professionally run because we have seen professionally run companies basically being totally taken advantage of by the management. I will privately and separately tell you and prove to you how some of these largest companies basically, are the private fiefdom of these guys. One of them has recently retired, and all these guys by just looking at the fact that the employees own 15% to 20% of a company. You know that the government is there, and there is nobody else.
It's actually not a bad mix to have initially the promoter because the son is starting and then maybe he has a CEO or even if he's on his own. Take Kotak Bank. Basically the promoter is been running it. And now we're not happy that RBI is saying change the CEO. He is 55-60 years old, why should he retire? I don't think there is been a distinct that family driven businesses are bad. Reliance - such a great return for investors some 18% per annum for 30 years. I don't think has been a big negative.
GE: If I heard you, right, you're saying that is that you're leaning towards more promoter-run companies?
SA: I'm saying that there has not been any negative necessarily, because you're promoter-driven. In fact, every new company mostly is promoter-driven, because the promoter has started it and come to you. There are very, very few companies which could be called publicly held from day one. Unless it is a subsidiary of some existing state-owned company. How will you start from scratch with a completely management-driven company? It will not be. It will mostly be somebody owning a large stake and then over time diluting to the market.
GE: I've asked you about the analytical approach among other things, and you've been an active fund manager sitting right here in Mumbai. You also require something else. You need, maybe a calm mind, an ability to disconnect. What would you say is your biggest asset or strength?
SA: First of all, you have to be able to handle losses. Like in 2008, you should be able to still sleep peacefully, and get up easily. But the other thing to which I attribute my performance to be a bit different from the guys here is because I read a lot. Maybe others also read. But I feel that has been massively helpful, too. And one more thing that has helped is to think in terms of what is happening in the US. It does not matter whether the same thing happens here or not. But if it happens there, in India the stocks go up.
So for example, ESG. We may not care about ESG here, but if you see for the last three years, Indian oil companies, Indian coal companies India aluminum companies, none of them are working. For example, I believe that in US, the auto industry is going to get disrupted because these driverless cars are coming, they have already started. And they are hugely, hugely beneficial for the public. Because, A, the car gets used full time otherwise private owners owning for 3%- 5%. Parking, so much space across the cities and all will be saved.
So in US, it will get disrupted. It doesn't matter whether India get disrupted because we have potholes and we don't have anything. But if it doesn't do well there, because then if it really becomes like that, then the buyer will be a bulk buyer. It'll be another business. It will not be tyre selling to retail. So it'll become even more difficult. And you can see it in their market caps. Tesla's market cap. It'll get also disrupted on electric, nothing has to happen in India. But the stock has gone. If it works there, even if it takes 15 years later to come here. So these connections, sometimes they work sometimes they don't. But I think that they have helped me to position which sectors I like and not like by seeing what is happening in the rest of world.
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