If there was one man who could make everyone sit up and listen to him, it was Rakesh Jhunjhunwala. His high-pitched rhetoric transfixed all who listened to him, mainly because he passionately believed something that we would all like to believe as well: Our own great future. His conviction in the future of India was spell-binding, to say the least. Jhunjhunwala, 62, was an icon for millions of wannabe stock market millionaires. Everyone is aware that his riches were created through stocks he held for many, many years and the wait that proved to be worth it. What is less talked about is the serious risk that accompanied these investments when they were made. Even less known is the fact that it was his aggression in trading that had been his primary source of capital. The adulation for RJ is not just because of his long-running track record in investing but also because he had maintained his dignity for so long in stock markets, where high fliers have often turned out to be dubious or at least have tarnished their reputation at some point or the other.
Excerpts from an interview published in Outlook Profit issue dated February 6, 2009:
At a comparatively young age of 15, my fathers’ conversations with various people introduced me to the world of stocks and stock markets. I started reading the daily stock quotations in the newspapers and realised that stock values fluctuate and I found that fascinating.
I was a curious child and was constantly quizzing my dad as to why these values fluctuate. He asked me to relate fluctuations to the news items appearing in the newspapers, thus, beginning the unending process of my education as an investor.
I was told that profit and loss accounts and balance sheets play an important role in determining stock values, and thus I started reading every annual report that I could lay my hands on and scanned the newspapers for news on companies’ profits.
In the meanwhile, I completed my graduation and started my chartered accountancy. I soon realised that companies have the highest quantum of profits, or highest reserves and surplus, or that the highest net worth need not necessarily have the highest stock price. I read somewhere that “A balance sheet is like a bikini – what it reveals is alluring, what it hides is vital.” I learnt that this is right.
On completing my CA in 1984, I accepted the challenge of making a career by investing and trading in stocks. I started following stocks and markets very intensively, for stocks were now my livelihood, and I learnt that it’s not the sheer quantum of profits, but the quality of profits that matters as much. I was introduced to a simple mathematical equation. Earnings per share (EPS) x price earnings ratio (PER) = price. It was apparent that when both the variables determining price, that is, EPS and PER gain, the stock prices explode.
I believe that when we invest in a company, we invest in a business model. All profits arise due to certain prevalent factors which are dynamic in nature. In my analysis, rather than trying to project absolute profitability, I try to understand the reasons and circumstances that give rise to these profits. I learnt that EPS was very specific to each company, while the PER was dependent on various factors, both internal and external to the company. We could not look only at the sheer EPS of a company, but there was a need to look at the quality of EPS. The quality depended mainly on three factors: the accounting policies followed, cash profile of the profits, and, return on capital employed, that is efficient use of capital.
The internal conditions that determine PER include the reward records of the company, predictability of earnings, risk model, perceived growth opportunity, and the perceived integrity of the management.
I also learnt that markets disproportionately reward companies that are leaders, innovators and performers. We can predict future prices by predicting future EPS and PER, but in order to predict future profits, we need to understand real-life business.
While predicting a company’s profit, I assess the following:
The addressable external opportunity is available to the company. The scope of demand for the product or service of the company determines its addressable external opportunity. To illustrate, the profitability of Infosys fluctuates primarily with global demand for software services; Colgate India’s growth is dependent on the size and the growth of the toothpaste market in India.
The competitive ability of the company: This means delivering quality products/services at the lowest price to the widest customer base. I judge whether the company has a significant competitive ability to capture the opportunity in a profitable manner over a sustainable timeframe. This ability is a synthesis of various factors and can arise due to technology, marketing skills, locational advantages, network size, capital availability and size, skilled people, etc. Generally, this is not due to any single factor but is chemistry of various ingredients.
The effect of operating leverage on profits.
Scalability and integrity of the company: To illustrate, I remember reading about a Maruti car saying, “When I grow up, I shall be Mercedes.” Alas, many companies never grow up to become a Mercedes and remain Marutis despite optimistic assumptions of investors. This happens because the management is unable to scale up the business. This primarily happens because they may not have the vision, or risk appetite, or meritocracy, or the systems and processes needed to scale up the business.
I believe the prediction of EPS is mainly science and partly art. But prediction of PER is an art, with very little science. It is a chemistry that can be mastered only by experience. Like cooking and sex, it cannot be taught, but it has to be learnt. I learnt that understanding/predicting PEs is the most difficult of all and the most critical factor to successful investing.
When I evaluate an entry price, I always look for a margin of safety. I look at the gap between the entry price and the price in a scenario in which most of the positive assumptions don’t pan out as expected.
The ingredients of successful investing lie in locating gaps between current expectations and future likely performance which provide me favourable odds as an investor. Perhaps the single biggest error in the investment business is failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the stock price. When a company has strong fundamentals, investors tend to buy irrespective of expectations. Similarly, weak fundamentals cause investors to avoid a stock. These tendencies lead to an inability to properly calibrate the odds, producing suboptimal performance. The issue is not which stock will be the winner, but rather, which companies are available at valuations that promise superior returns. Understanding market expectations reflected in the odds (valuations) is as important as understanding fundamental business performance.
The great investor, Warren Buffett, has said, “Interest rate acts like gravity on all financial assets.” It is a fact that a declining interest rate is a great positive for stock valuations, and vice versa. In fact, one of the major reasons, Indian stocks went up in the earlier bull market was the continuous and secular decline in interest rates in the country.
One of my friends always says: ‘Trend is my friend’. The market always trends either upwards of downwards. As an investor, I learnt not to pre-empt trends, we must allow the trend to spend itself and only then react. Like all material things in life, even investing has a four-letter word attached to it – risk. I learnt that investing is risk taking, if anything. All risk taking associated with two human emotions, that is, fear and greed- greed of profits and fear of losses. The ability to strike the right balance between fear and greed is the most vital determinant of profitable risk taking.
Experience taught me that markets are prone to irrational exuberance, that is, bouts of extreme optimism as also manic depression, that is, bouts of extreme pessimism.
I think the price of Infosys in March 2000 at Rs.14,000 represented irrational exuberance, while the price of Rs.2,300 in September 2001, represented manic depression. It is such pendulum shifts from depression to exuberance or vice versa that create the opportunity to invest/disinvest wisely/profitably and to make money.
Over the years, I have learnt that not only is it critical and extremely difficult to identify such inflection points, it is more difficult to deal with such situations.
When markets are experiencing irrational exuberance (making money in the stock market is taken as a birthright), to be in cash and to be over-invested when the markets are gripped by fear and extreme pessimism, is as you all know easier said than done.
“In markets, it sometimes feels like being under-sexed in a harem and over-sexed in a desert.” I think good investors should be always feeling under-sexed when there is depression and over-sexed when there is irrational exuberance.
It’s a fact that one cannot be a successful investor without understanding the markets. Markets are the temples of capitalism. I have learnt that markets are ruthless and very intelligent. A market participant should always respect markets as being the ultimate arbitrators and deciders. I believe that the markets always decide rightly and correctly over a sufficient period of time. Sometimes, the ability of markets to filter and value truly astonishes me.
The other important thing for me is trading. If I don’t trade and don’t have profits where will I get the capital to invest? The only ways I can invest are to sell my old assets, have trading profits or borrow. So trading is important to generate capital. Trading also keeps you on tenterhooks – you are always alert and razor sharp. For trading, I look at technicals, which are essentially price movements. When price movements confirm my thought process, I buy aggressively. The sheer feeling that the markets have bottomed out or that fundamentals and valuations are favourable is not enough. The final confirmation has to come from price only. Having said that, I won’t build an investment portfolio on price confirmation only. However, if I have already bought the shares and the price gains, it gives me that much more confidence to hold or increase my stake. So I think to make a good investment, some kind of technical knowledge or a feel for the market is important.
Last but not the least, my experience as an investor has altered me as a human being. I, one of the most dogmatic men, have now learnt to say that ‘I can always be wrong’ at the end of every opinion that I express. I have also learnt that good investing calls for a careful examination of all points of view and alternative scenarios. Just as in a modern world, the ability to adapt and change and mitigate prejudice is crucial to success, so it is in the investing world. Discipline, just like in all walks of life, is very important in investing too. I have learnt that in investing decisions all factors are numerators but the denominator is only one which is price/value, for it is ultimately the price or value at which you buy/sell shares which determines not only your profit/gains but also the very important aspect of the risk that you take. At a value, I am a buyer of everything, including the most hated companies. It is important “what you are buying, but it is more important at what value/price you are buying.”
Finally, we invest in an uncertain and dynamic world. It is imperative to constantly review your investments, especially because changing circumstances could necessitate a change in the assessment of the future.
A review is also important because we don’t always make our entire investment at one go; instead, we may do it in phases as things pan out. I have always followed this principle for many of my investments. Consistent review also allows us to judge when it is appropriate to exit an investment.
Similarly, exiting a stock is an independent decision, not driven by profit or loss. I sell if I judge that I have better competitive opportunities. Since price equals EPS X P/E, I would also sell when the EPS or expectations about the EPS of a company are coupled with unreasonable P/E ratios. Since value and valuation are both transitory and have no definite benchmarks, I am not of the camp that says that you should sell just because the stock has historically expensive valuations. I evaluate the technical position in a stock when exiting as one can never predict the limits of extreme behaviour. Technical analysis helps me to sell beyond the fair value in the case when equities overshoot. While I don’t try to sell at the top, I do aspire to capture the overshooting beyond fair value.
I thought ‘beauty’ was a difficult adjective in the English language, until I started to assess value in order to invest. In conclusion, both beauty and value are the most difficult adjectives in the English language. My quest of finding beauty and value is a process of education that is just never ending as – I learn something new and educative with every passing moment.