Prabhakar Kudva, an engineer by education and an investor by choice, chronicles his serendipitous journey in to the world of value investing and shares some useful insights on portfolio construction.
Prabhakar is the co-founder and executive director at Samvitti Capital Pvt. Ltd. which manages the SEBI approved category III alternative investment funds. He has been involved with the equity markets for about ten years now. His focus has been investing in growth businesses that have the potential to scale up over the next several years. He blogs here.
Safal Niveshak (SN): Could you tell us a little about your background, how you got interested in investing, and how you’ve evolved over time as an investor?
Prabhakar Kudva (PK): If I have to sum up my life up till now in one word, that word like Prof Bakshi says, would be serendipity.
I was extremely fortunate to be born to a set of parents who imbibed very early into my thought process the value of good education and prudent behaviour. I am eternally grateful to them for encouraging me to read and buying me all the books I ever wanted to buy. I am originally from a place called Mulki, which is a small town in Mangalore district in Karnataka. My father was a banker and I spent most of my transformative years in Delhi. We used to visit our home town once every year during my summer vacations and that’s where my stock market journey began. My maternal uncle is an avid stock market participant and probably one of the early practitioners of technical analysis in India. I was 15-16 years old and when I visited him during vacations he used to make me sit through tens of charts as we analysed them together. I was intrigued at first and subsequently taken – like fish to water.
There was not a lot of internet those days and hence I couldn’t really catch up with the Buffetts, Mungers and Lynches of the world as early as I would have liked to. Unfortunately I was quite ok at academics and for the lack of a good “stock market degree” I ended up being a computer science engineer.
Engineers among the readers will know how much free time we have during our four years in college. I put it to good use. Internet had become more prevalent by then and I finally met Buffett, Munger, Lynch and Livermore on the web.
I graduated from being a chartist to a fundamental investor looking for “value”. I had all this knowledge about the markets and was hungry to apply it. No one was willing to hire an engineer as an equity analyst so I had to make do with a technology firm. I worked at this company for about 3 years and then serendipity struck again. My cousin is an entrepreneur and he co-founded a technology firm called Omnesys that builds order and risk management software for equity markets. Since he was aware of my keen interest in the markets, he offered a role where I could put both my engineering degree and my market knowledge to good use. I worked there for five very productive years, working with almost all the top rung brokers in India.
Not surprisingly, I used to moonlight as an investor all the while. While I was happy here, deep in my heart I always wanted to spend all my waking hours learning about businesses, valuing them and finding the next great wealth creator. That dream has now come true. I have very recently co-founded an asset management company called Samvitti Capital in my hometown Mulki, from where it all started. We now manage funds for a closed group of high net worth individuals via the SEBI regulated Alternative Investment Fund route.
SN: Wonderful! Can you now talk about the specifics of your training into value investing? Did any particular books or investors inspire you?
PK: I wouldn’t call myself a value investor in the general sense of the word. I have learnt over the years and rightly so that each of us should first understand ourselves before we understand what style might suit our temperament. Right from the beginning, I knew that you either have to multiply your money 10x or it’s not worth the pain. That was my temperament – there wasn’t much training required. This led me to the only place where that is possible – growth stocks. Therefore, I never pursued value in the Grahamian sense. For me value was in the growth and if there was no growth there was no value.
More than books I think what transformed my thinking was being associated with a forum called The Equity Desk. This was the only place at that time where I could discuss stocks with like-minded people. Articulating your thoughts for the world can do wonders to your thought process. The more I wrote, the more I received feedback and eventually that culminated into my thought process.
SN: True. But has it been a nice, safe ride? Or have there been difficult twists and turns in your journey as an investor?
PK: I may sound like a trader here but I think it applies equally well for all classes of investors – the most difficult part is to hold on to and buy more of your winners and sell the losers. This is what they’ll teach us in the kindergarten of the stock market, but psychologically it’s the most difficult thing to do.
Also the way I look at the winners and losers need not just be in terms of price, what I focus more on is winners/losers in terms of business performance including continuing ability to self-fund the business, high return on capital employed (ROCE), market share, mind share etc. If the price and business performance both convey that we have a winner at hand, I continue to buy. On the other hand, if either goes wrong, I start becoming more and more critical about why I own it.
SN: Now, talking about picking up high-quality businesses, what are some of the characteristics you look for?
PK: I look for a few key things:
1. Is the business cyclical or secular growth? I strike out the cyclicals.
2. Can the market cap be 10x the current value in less than ten years…and if yes, will the corresponding top line and bottom line at 10x valuation look achievable and/or reasonable?
3. Is the business generating free cash flow?
4. Is the return on total capital greater than at least 2 times the risk free rate?
5. Is there a scope for ROE expansion? Will it play out in the next couple of years? This is where the biggest winners come from.
If all of the above are in place, generally the management will be good too.
SN: That’s a good checklist to have. Anyways, you seem to run a concentrated portfolio. Was concentration your original investment style too, or have you evolved from a diversified investor to a concentrated one?
PK: There is a lot of debate on this topic. I don’t think as investors we should be deciding upfront whether we should be concentrated or diversified. The concentration or diversification decision should come from the stocks or businesses themselves. Let me explain.
Portfolio allocation is a function of:
1. Your knowledge and vision of the underlying business;
2. Your expected return from the stock vs. your opportunity cost;
3. The downside risk; and
4. Prevention of a ‘black swan’ scenario
If you find a business and its environment that you understand very well with a 10% downside risk, a 100% return possibility in an year – would it not make sense to put a lot of your money there – may be not all since Taleb told us about black swans.
If you find four or five of such businesses out of the twenty you’re evaluating, it makes no sense to buy a sixth one. You have to back your knowledge and hard work with meaningful amount of money.
However, if you have no special insights on any of the twenty businesses you are evaluating but they all just look “interesting”, it makes all the sense in the world to diversify.
So, it’s a big mistake to predefine your portfolio allocation and then go about researching or finding the few or many stocks to fit your portfolio. The portfolio allocation should be determined by the opportunities at hand and your comfort with them.
SN: What have been the biggest benefits and drawbacks you’ve ever faced while running a concentrated portfolio?
PK: The benefits and drawbacks are obvious. If you get it right, you win in one year as much as most people do in a few years and if you get it wrong, well you can’t afford to get it wrong in a concentrated portfolio – at least beyond a point. A concentrated portfolio forces you to get rid of your mistakes very quickly.
SN: That’s a great point! Portfolio concentration requires one to be a know-all kind of investor (you need to have an almost perfect information on a business) as one mistake can dent your returns big time. So, what is your research process like?
PK: No one can know-all. Not even the managements that run these businesses. So I don’t aspire to know all – however the importance of knowing all that you can, cannot be emphasized enough.
Generally, businesses have three phases – the discovery phase, the expansion phase and the saturation phase. If your portfolio is concentrated you’ll most likely want to own stocks in the expansion phase. In this phase they have already proven that they can be successful and they’re just replicating their success. In other words, the business model has hit the critical threshold where they have enough balance sheet strength to repeat their successful model onto the P&L and cash flow statements.
So that’s the key – don’t try to be a hero and concentrate with a unproven small cap and at the same time don’t concentrate with an L&T or HUL just for the sake of concentration – as it won’t yield anything meaningful for the risk taken. Concentrate (pun intended) on businesses in the sweet spot.
SN: Maintaining a concentrated portfolio also requires a very good understanding of the management. How do you assess a management’s quality?
PK: I take the following quote from Buffett quite seriously –
When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
I don’t assign a lot of value to a great management team. If the business performance over a reasonable period looks very good to me, I assume the management is good enough. If your focus is extremely good businesses, then the good management comes by default. If however you’re looking for average businesses, then management becomes important…but even in that case there is very little “analysis” one could do on the management either by meeting them or by deciphering their commentary. The best analysis of the management is the business’ track record.
SN: That’s fine. But how do you decide whether the managers have the capability to take the business to the next level from where they are currently, and whether they are honest? I mean, track records are good to look at but some of the world’s biggest disasters like Enron and Satyam also had great track records.
PK: I think the management should be what I call “passive aggressive”. They should be hungry for growth but at the same time be conservative to not bet the company during the good times. So essentially what we should look for is profitable growth that is self-funded.
If you look at Enron’s numbers, it was apparent that the growth was neither self-funded nor profitable on a cash basis. So I would stick to my assertion that management quality will be reflected in the numbers if one looks at the right things and compare the numbers within the same sector.
Satyam – I haven’t looked at their older numbers but again no amount of management interaction or analysis of other softer aspects would have told anybody that they are stealing money – especially when the stock was doing well. So Satyam is clearly a case of Black Swan to which by definition you can’t prepare for.
SN: Fair enough. Talking about valuations, how do you think about them? Do you have a preferred valuation framework to assess the attractiveness of an investment?
PK: In all these years of observing the markets what I have learnt is:
• Sustainable AND high ROCE businesses have high valuations and erratic OR low ROCE businesses have low valuations.
• Improvement in ROCE leads to valuation expansion and a fall in ROCE (in spite of growth in net profit) leads to valuation contraction.
With these rules at my disposal, I try to look for sustainable and high ROCE businesses trading at cheap or below average valuation.
I also look at businesses where there is scope for ROCE expansion – this leads to P/E re-ratings and gives us the multibaggers that we often dream about.
SN: Let me now ask you, after all the business and management analysis and valuations, how do you try to protect yourself against your biggest enemy – bad behaviour? In other words, how do you minimize the mistakes of behaviour in your investment decision making?
PK: This is one of my favourite topics. I might have devoured every book there is on behavioural biases. Having done that, what I have learnt from those very books is that no matter how much we try to be immune of these biases, they will still come and bite us one way or the other.
A possible solution and the only one there is I believe is to use checklists and carefully go through each bias and figure out if it applies to your current situation.
SN: Checklists surely save lives, in medical surgery and in investing. So, can you just name 3-5 top biases from your checklist that you try to keep a close eye on?
PK: The major ones would be the following:
1. Avoid anchoring to your entry price. Your entry price should not have any bearing on your decision to buy more or sell the stock.
2. Ownership bias. Just because one owns the stock we have a tendency to rationalize the bad events – in such cases I prefer to sell a small quantity. This gives me the clarity needed to act objectively.
3. Hyperbolic discounting. We all have a stronger preference to immediate payoffs when compared to payoffs that are a few years out. This is similar to postponing exercise because there is no near term payoff and we don’t value the long term payoff enough. This bias if tackled well, will allow us to forgo immediate consumption and invest it in equities for a longer term benefit.
Of course, there are many more such biases. One can maybe start with this book called Why Smart People Make Big Money Mistakes.
SN: Let me now turn to mistakes. Can you talk about your biggest investment mistake, what caused it, and the lessons you learned from it?
PK: Like I explained earlier about concentrated portfolios – I had these three businesses I understood well, there was limited downside risk in each and substantial upside potential. So it made sense to load up on these names – which I did. However I tried to get smarter and concentrated further within this concentrated portfolio. What I mean is instead of buying 33% each, I bought 60% of the first one and 20% of the other two. As luck would have it I paid a hefty price. The first one merely trebled in price while the other two went on to become five-six baggers.
The lesson learnt was you never know which one or two stocks that you pick will go the farthest. In most cases, it will be the one which you least expect. So even if you strike that, especially if you end up owning a concentrated portfolio, always, always, always maintain portfolio balance.
SN: That’s a really nice insight for people following a concentrated approach Thanks! Anyways, how do you determine when to exit from a position? Are there some specific rules for selling you have?
PK: Given that I like to own a focussed portfolio, the underlying businesses are generally strong, so the selling decision is mostly a function of finding a business/stock where the expected returns in the next couple of years is significantly higher.
The keyword is “significantly higher” – the competing opportunity should have to be compelling enough for it to enter the portfolio. This is because the business that you already own is relatively well known to you in terms of what impacts the business and what doesn’t.
This is terribly important during the bad times because you can easily differentiate between a temporary issue and a permanent one.
Of course, if something unexpectedly goes wrong with the business or its prospects you get out immediately.
SN: Hypothetical Question: Let’s say that you knew you were going to lose all your memory the next morning. Briefly, what would you write in a letter to yourself, so that you could begin relearning everything starting the next day?
PK: The most important thing in my life is my relationship with people who have made a difference to me, including my family and friends. So, of course, I would like to remember who the people I value and trust the most are.
I am assuming you’re asking from the stock market perspective, so I would like to remember the following:
1. Read everything written by Peter Lynch and Jesse Livermore.
2. Look to justify a 10x market cap from current levels.
3. Be mindful of the concept of opportunity cost.
4. Focus on businesses where ROCE/ROE can expand.
5. The best screen is the “new all-time high” list.
6. Keep holding and buying on to your winners and sell your losers. Here the win/loss need not just be price loss but more importantly loss in business parameters, as elaborated in an earlier answer.
7. If you think you have a potential winner at hand, which is a rare event in itself, bet meaningfully…or it’s not worth it.
SN: Wonderful reminders! As we near the close of this interview, what’s your two-minute advice to new investors or students interested in a career in investing?
PK: I am not sure if am qualified to give advice but the key lessons are:
1. Learn by practice – jump into the markets with a meaningful amount of money (too little and we won’t be impacted by biases).
2. There is way too much information out there – learn to differentiate between facts and judgement. Most of what you read will be judgements made using facts, by someone like you. The best way is to build your own judgements and not depend on others. If not, the least one can do is to validate if the judgements made by analysts, newspapers etc. are rational or not before acting on them.
3. Learn as much as you can about businesses. A lot of us have been guilty of reading way too much about how to become a better investor rather than spending time on learning businesses. I think it gives us some perverse pleasure to sit and hope that we’ll become great investors one day but the number one thing to do is to learn about businesses and how they make money. I would urge everyone including myself to, after a point, spend more time on studying the businesses than on how to study the businesses.
SN: Excellent advice! I especially love the one on the importance of studying businesses. Anyways, you seem to have learned a lot from reading Jesse Livermore. Can you enumerate a few big lessons from the legend that you’ve practiced personally?
PK: Yeah. Livermore’s biggest lessons for me are:
1. Stay humble and respect the market. Unless you are super confident of the underlying business, it pays to respect the price. This is not to say that markets are efficient but to say that unless you’re very well versed with the business you can never say if the price is efficient or not. So the options are to either respect the price or learn enough about the business to say that the market is wrong.
2. Keep your winners and cut your losers. I can’t reiterate it enough.
SN: What are your interests and hobbies? What keeps you occupied outside of work and investing?
PK: Unfortunately for a lot of people around me, I have no other interests or hobbies that are outside of investing. Everything I read or do can in some ways be tied back to investing.
SN: And which books – which are not very popular – would you recommend to a budding investor for learning investing and multidisciplinary thinking?
PK: Some non-popular but great books I would recommend are:
- Doyle Brunson’s Super System: A Course in Power Poker. There are immense parallels to investing in this book.
- John Brook’s Business Adventures
- Jesse Livermore’s How to Trade in Stocks
SN: Great, Prabhakar! Thanks a lot again for sharing your amazing insights with Safal Niveshak readers. I would especialy like to pull out your thoughts on maintaining balance in a concentrated portfolio, spending time on studying businesses, and acting on hardwork by way of meaningful allocation as the three big ideas from this interview, among many others. Thank you so much!
PK: It was my pleasure, Vishal. Thanks!