The Kolkata Chapter of the CFA society hosted Mr. Kenneth Andrade in Kolkata on 15th of June 2018 in a conversation about his investment style, investing journey and his experience over the last 25 years in this field.
Q. How has your career shaped up over the last 25 years and what are your learning’s from the last two decades of investing?
A. It takes two complete cycles for a fund manager to fully understand markets. It is then when one realizes that money is made in bear market but to do that one needs to survive over a cycle. A major part of my career over the years has involved assimilation and analysis of data points. The biggest lesson for any budding investor would be to observe bear markets as they give the best learning
Q. How were you able to identify many of the successful consumer franchisee companies at an early stage?
A. In 2007-08 when we bought many of these companies we were actually buying stable cash flow companies at historical low valuations. The main reason was the low valuations these companies were available at because they had not participated in the infrastructure and real estate boom of 2005-08. The best way to look at companies trading at low valuations is looking at which companies are able to earn money in down cycles. This helps in separating from the value traps which are usually the companies trading at relatively low valuations in an industry
Q. How do you view the deleveraging of corporate India and how should an investor views this transformation affecting the corporate climate in the country?
A. In the good time when consistently superior returns on capital are being achieved industries attract capital, which in turn brings competition and depresses the return. The gap between cost of capital and return narrows at this point of time and an investment, which looked attractive some time ago, now turns unviable. When companies go through this cycle we see very less investment coming into the sector at the bottom of the cycle. The returns are not too lucrative to encourage additional capex. The demand for most things in our country is linear and as new supply halts and the demand supply balance now turns in favor of demand is when you find that inflection point in an industry. We see a similar thing happening in the country right now in many sectors where new supply has halted because of unfavorable returns, which can be seen happening in the telecom industry
Q. Explain the working of the capital cycles with an example of any particular industry?
A. If we have a look at the power sector which was adding capacity relentlessly during 2010-2015 we can see how that depressed returns for the sector as a whole. A slew of capacity is now on stream earning returns below cost of capital, which has now led to a halt in incremental capacity additions in the sector. This has now led to supply demand equation being in the favor of supply at the moment. The demand grows at a linear rate and it will not be long when this equation shifts in the favor of demand. The companies generating free cash flows in today’s times in these sectors would be at advantage because they will be able to gain market share very fast
Q. How do you view capital efficiency and efficient capital allocation
A. The math of efficient capital allocation is well understood. It has to be above cost of capital to make any sense. However, often in industries trading at depressed valuations the returns on capital will be below the cost of capital. This is due to the nature of the capital cycle that the sector is undergoing. The advantage for an investor in these industries is that usually there is no fresh capital coming in the sector and thus finding companies which today are earning below average returns on cost of capital and would go on to achieve higher returns in the future due to the demand supply balance shifting in their favor becomes easier. This is what leads to an expansion in valuations.
Q. Why have you stayed away from investing in the financials sector?
A. The business model of the banks where they leverage the balance sheets 10-15 times makes them more vulnerable to shocks in the ecosystem. This coupled with the facts that valuations for most of the players are trading at historic highs makes me uncomfortable while selecting financials as a place to be putting money in. Also my inabilities to adjust to the hyper growth the sector has witnessed have led to the exclusion of financials in the portfolio.
Q. What are your views on democratization of capital and the reach of leverage to even the weakest section of the society?
A. I believe that there are many new opportunities opening up in the financials space as new sectors like asset management companies, exchanges and small finance banks come in the listed space. This should give a host of opportunities but I would be more comfortable buying them post the next down cycle. Also there is a belief that India will shift from a developing economy to a developed economy over the next decade and as that happens we will see people analyzing consumer trends more rather than annual government budgets
Q. Your thoughts on the whole agriculture & rural India theme and how do you view regulatory risks in this sector?
A. The sector is going through a phase where incremental capital additions have stopped due to regulatory interferences and sub par returns. Over this some companies have been deleveraging their balance sheets while growing well along the way. The profits look depressed but that should change over the cycle. Also one cannot take out the regulatory angle from this equation but the situation could look much different over the next two years.
Q. How do you view the SME space which has brought many smaller companies into the listed space?
A. I believe that post GST & demonetization contrary to popular belief that the smaller companies will become inefficient and wither away the exact opposite should happen. The smaller companies will come into the formal ecosystem and should flourish. This will be due to the ancillarisation of corporate India where the smaller companies will be able to take away market share from the larger players. Also if one is looking at valuations they should look at the peak and trough valuations of small cap companies versus large cap companies. If this data is analyzed we will see that smaller companies have yet not shown significant out performance over the larger companies
Q. How do you manage the poor liquidity in the SME space?
A. The problem of liquidity is prevalent in all spheres. Even larger companies face liquidity pressures when the companies are going through turbulent phases. Also before investing one should not focus too much attention on how would one get out.
Q. How do you construct a portfolio and what determines your largest allocation?
A. My largest position is usually in companies where I will not lose money. That is usually the strongest point of portfolio construction. Also, one cannot be correct on all of the positions and hence the focus should be on not losing capital in the companies where one can go wrong
Q. Do you focus on the macro economic environment before investing in companies?
A. In macroeconomics usually one can spend a lot of time trying to understand the forces and still not get any conclusion. Thus I believe that time is better spent in analyzing companies which will not be overly affected by a worsening macro climate
Q. While looking at value versus growth how do you avoid “value traps”?
A. One cannot always avoid value traps or any thus it is important to have a diversified portfolio so that even if one goes wrong in assessment of a situation it will not have a big impact on the overall portfolio
Q. What are the most important points one should look at before selling a stock?
A. Everyone should try and look at valuations from different angles and not just associate it from one or two ratios like Price to earnings. Many a times analyzing from the point of replacement cost, opportunity cost and other aspects when combined with individual valuation parameters would help in giving much better picture than a standalone examination via the Price to Earnings ratio
Q. What are your views on corporate governance and do you believe its cyclical?
A. Yes, it is true. The management will mostly be on shareholders side when everything is going wrong but its mostly when things are going great when managements turn towards poor capital allocation
Q. Going by the analogy of Mahabharata if we believe that markets are a “Chakravyuh” and the investors are “Abhimanyu” knowing very easily how to get in but not how to get out, how would you advise us in such a situation?
A. It usually works both ways and it is not always possible to get in and out at the correct time. Sometimes the investor will exit at the wrong time as well but that should be taken as a part of the game and move on.