Note: This interview was originally published in the December 2015 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.
Mr. Huzaifa Husain is the Head of Indian Equities at PineBridge Investments based in Mumbai. Since he joined the asset management company in 2004, Mr. Husain has been a key member of the team advising the PineBridge India Equity Fund (a Dublin domiciled India offshore fund). Prior to this, he was an Equity Analyst at Principal Mutual Fund and SBI Mutual Fund. Mr. Husain received a Post Graduate Diploma in Management (PGDM) from Indian Institute of Management (IIM) Bangalore and a B.Tech from the Institute of Technology (Banaras Hindu University).
In this interview for the Value Investing Almanack, Mr. Husain shared how he found his calling in value investing, and reveals key insights about his investment strategy and the underlying thought process.
Safal Niveshak (SN): Could you tell us a little about your background, how you got interested in investing so much to choose it as a career?
Huzaifa Husain (HH): In 1997, when I completed my management education at IIM Bangalore, SBI Mutual Fund offered me a role as an equities analyst. Thus began my career in equity investing.
My management education did not prepare me for equity investing. We were taught how to mathematically manipulate numbers, especially daily stock prices, most of which had no conceptual backing. I remember in my first year on the job, I tried every possible trick – charts, CAPM, etc. – in the textbook to figure out how to predict which stock will do well. I failed miserably. One day a friend of mine told me to read the letters of Warren Buffett. That is possibly the best advice I ever got in my life.
After that day, my investment philosophy has relied entirely on understanding the company, the people managing it and its prospects. Stock prices do not have any information other than what one can buy or sell the stock at.
SN: Do you believe in the concept of circle of competence? If yes, how have you built it over the years?
HH: Yes, of course. The success rate of doing an activity which is within the circle is much higher than that which is outside the circle. The circle is not a rigid one though and keeps expanding, albeit rather slowly.
My first task in the late nineties was to research equity stocks in the pharmaceutical sector. So, I bought a drug index book and catalogued nearly all major diseases and the drugs used to cure them. These drugs were then mapped onto the companies which produced them to understand company fundamentals. Then, when Indian pharmaceutical companies started targeting generic markets in US in early 2000, I studied the Hatch—Waxman Act, various generic court case judgments, etc. to understand the potential opportunity and risks. Thus, I gained expertise into the pharmaceutical sector.
Slowly I expanded it to another industry – telecoms – and studied the various technologies such as CDMA (Code-Division Multiple Access), GSM (Global System for Mobile Communications), etc. I also then brushed up my accounting knowledge as it plays an important part in understanding financials. In those days there was a heavy debate on ESOP (employee stock ownership plan) accounting in the US and so I read and understood the corresponding accounting standards (FAS 123). Slowly and steadily the circumference of the circle expanded to include more industries, different accounting policies and different ways to evaluate management.
The only way the circumference of the circle expands is by constantly accumulating experiences – either directly or by learning from others.
SN: What are some of the characteristics you look for in high-quality businesses?
HH: A high-quality business should require very little capital but generate a lot of capital and it should be able to maintain these favorable economics for a long time.
The reasons for a business to achieve these economics are numerous. Most important is the management’s focus on improving its competitive advantage compared to its peers. A pertinent question here would be why are such practices not copied by others? One big reason is the culture of an organization. A culture of success is not as common as one would assume.
There may still be cases where the best efforts of the management to succeed may still come to nothing. This can happen when competitors are irrational. This can also happen when the business itself is very complex. It is easy to estimate the costs and risks of making and selling shoes. It is probably not so easy to estimate the costs and risks of constructing a dam.
SN: How do you assess a management’s quality, especially given that disclosure levels are not high and standardized in India?
HH: Management quality is assessed on two dimensions – ability and integrity.
Ability encompasses the way the management deploys the cash it generates. It could invest back into the business to strengthen the competitive positioning of the business, it could buy another company in the same business, it could invest in a new business or it could buy a company in a different business. One should be able to assess the ability of the management by evaluating the management’s actions of deploying cash.
Integrity encompasses the way it treats shareholders. A management with high integrity will return excess cash back to shareholders. It generally would not overstate its financial numbers; most probably, it will understate them by reporting its numbers conservatively. In my experience, there is a high correlation between usage of conservative accounting policies and high integrity.
I think disclosure levels in India are generally quite high and I have not faced any problem in judging the past history of management decisions.
A simple discipline can be observed here – if the management is not willing to be transparent and honest, move on.
SN: Well, let’s talk about valuations. How do you think about them, and how do you differentiate between ‘paying up’ for quality versus ‘overpaying’?
HH: Good opportunities in investing are rare. A good opportunity is like searching for a needle in a haystack. One can of course wait for a day when there is a strong wind which will blow away the hay and make it very easy to find the needle. But then one has to be very patient as such days are few and far between. On the other hand, one typically will find opportunities to buy either a lousy business at cheap valuations or a good business at fair valuations. I would go for the latter.
How much should one pay for a good business? Of course I do not believe in over paying because I can always put my money in a fixed deposit without risk. So, one should carefully evaluate various scenarios in which the investment can make money. I can try and put in some numbers for the future, find out cash flows, discount them with the next best alternative rate you can get and finally add a buffer to the price. It is quite educational if one does this simple exercise which some call reverse discounted cash flow (DCF).
One important factor in doing this calculation is to make the right assumption of how much capital is required in the business. Generally, a good business which can generate high returns will not require a large amount of capital. Hence, such a business will have to pay the cash out, which means in applying a DCF model, the benefit of compounding will be absent and that would make a huge difference to the value.
SN: How do you determine when to exit from a position? Are there some specific rules for selling you have?
HH: One would exit for basically two reasons.
First, if the original hypothesis itself turns out to be incorrect. One example is when we bought a company which was a market leader in the domestic industry and was generating a lot of cash flows. The industry was growing very fast and so was the company. It was available at reasonable valuations. Then one day, the management decided to take the cash on the books plus take on debt and buy a company internationally which had poor economics. The management thought it could take such a company and make it competitive. Unfortunately, it paid a price which presupposed that it would succeed in doing so. Hence, there was no upside left, even if they succeeded. And the existing domestic business cash flows were now being used for this purpose instead of investing in the domestic business which needed enormous capital to grow. Since, this was a ‘game changing’ event, we decided to sell it.
Second, something better can be done with the sale proceeds. This is tricky. It requires two decisions – selling an expensive name and buying a cheap name. We do it rarely as we do not think there are so many good companies out there that one can keep churning without lowering the quality of the portfolio. If we do it, we ensure that the valuation differential between the stock being sold and the stock being bought is quite significant.
SN: Do you believe in investment checklists? If yes, what are the most important points in your checklist?
HH: I do have a checklist. Broadly there are three main items on my checklist – quality of business, quality of management, and price of the stock.
An important aspect of this checklist is that it is applied sequentially. The reason is because a good manager may struggle to generate good profits out of a bad business. Paying a low price for a lousy business may also not turn out great. Hence, only when a business is deemed to have strong economics and quality management, is the price evaluated for attractiveness.
SN: Apart from the qualitative factors, what are few of the numbers/ratios you look for while assessing the business quality?
HH: A reasonable idea of how much capital is required to run the business is critical. The nature of capital employed – fixed versus working – makes a huge difference to the way the business is run.
The returns generated on the capital employed irrespective of the leverage employed will demonstrate the quality of the business. Aggregating 10-20 years of financials gives one a good idea of how the money has been utilized. Cash flow efficiency (cash flow divided by profit) demonstrates the conservative nature of management in reporting their numbers.
SN: When you look back at your investment mistakes, were there any common elements of themes?
HH: Among the three things I look for in an investment – business, management and price – most mistakes happen in evaluating management. This happens especially if the management does not have a public history which can be evaluated.
The typical management behavior which hurts investors is their overconfidence. Business managers rarely will admit that they cannot deploy the cash which the business is generating. They will find some or other use for cash and eventually deploy it in a poor business.
Hence, it is best to use a higher threshold for management quality in case the business has historically retained most of the cash it generates.
Also public history of management is a very good guide. Don’t expect the management’s behavior will change because you bought the stock. It almost never will.
SN: What tricks do you use to save yourself from behavioural biases? What are the most common behavioural mistakes you make?
HH: Most mistakes in investment stem from lack of knowledge. When one is walking in the dark, other senses become heightened. Similarly, when one is operating in the field of investments and one does not know what one is doing, the basic human survival instincts (being with the crowd – herd mentality, avoiding danger – loss aversion, etc.) kick in. These instincts sometimes may mislead one in stock markets which is a massive melting pot of human emotions.
Many advocate changing behavioural responses. I think if you try to do that you are up against thousands of years of evolutionary survival strategies. Instead, focusing energies on accumulating knowledge is a more reasonable task.
SN: That’s a wonderful insight, so thanks! Any specific behavioural biases that have hurt you the most in your investment career?
HH: Nothing specific. Over time, a better understanding of how incentives drive human behavior has helped me decipher the happenings around me.
SN: How can an investor improve the quality of his/her decision making?
HH: If the investor’s knowledge of the company is among the top 0.001% of people who have some kind of understanding of the company he/she is investing the chances are that the decisions would be good. Hence, read everything you can lay your hands on relating to the company and its business. We actually do that when we buy a consumer durable or an automobile. I remember even though my father was no engineer, he used to ask people on two wheelers at a traffic signal what the mileage was before buying one. It is absolutely astonishing how much information one can glean if one puts in a slight amount of effort.
The next aspect is that the investor should realize markets are not always rational. I feel this is easier said than believed.
Investors while buying believe that the price is mispriced but once they have bought they forget that it can remain mispriced for a long time. Many would want the mispricing to be corrected as soon as they complete their purchase. Many would also pat themselves on the back if it does happen. But short term movements of a market are near random. Hence, be prepared for the worst. For example, the investor should be prepared for a huge drop in the stock price post his purchase. It may or may not happen but if it does, he should be mentally prepared to act rationally.
SN: How do you avoid the noise and the overload of information that is available these days?
HH: If you carefully analyze the information overload, most of it is very short term focused. Hence, if the time horizon of the investment is long, one needs to employ a filter which can eliminate short term noise. After all a company publishes only one annual report and declares four quarterly results every year. That is not much.
SN: How do you think about risk? How do you employ that in your investing?
HH: As an equity holder one would lose all one’s money if the company goes bankrupt. Hence, avoid companies which have large debt loads.
Avoid investing in a poor business. It is bad to lose money investing in a poor company. But it is worse to make money investing in them. The reason is, once you make money playing with fire, the chances are you will be attracted to it more often and sooner rather than later, it will burn. Hence, avoid investing in such companies irrespective of the valuations.
Remember no matter how well you think you can guess the future, it will not be as you predict. Hence, be prepared.
SN: What’s you two-minute advice to someone wanting to get into stock market investing? What are the pitfalls he/she must be aware of?
HH: Making money by equity investing is very difficult. Treat the stock market as a bazaar. Go with a list of things to buy. Make the list at home just as one would make a grocery list based on your nutritional needs. Don’t make decisions by watching the changes in the prices of stocks just as one would not decide to buy lemons because their prices are going up. Spend a lot of time deciding what to put on that list. One way to do it is to inculcate a phenomenal amount of curiosity in researching companies.
SN: Which unconventional books/resources do you recommend to a budding investor for learning value investing and multidisciplinary thinking?
HH: It is dangerous to read books especially on investing without reading about business history. It may cloud one’s view. Hence, I would recommend all budding investors read annual reports of companies for as far back as they can find. Read them across various companies over various time frames. They should be able to understand how companies have behaved over business cycles, how their valuations have changed, why did they succeed, why did they fail, etc.
Once a vast amount of business history is read and understood, all one needs to read are the letters of Buffett and Poor Charlie’s Almanack to build a framework.
Beyond that, remember what our vedas say on multidisciplinary thinking – आ नो भद्राः क्रतवो यन्तु विश्वतः (Let noble thoughts come to us from all sides).
SN: What a wonderful thought that was! Any non-investment book suggestions you have that can help someone in his overall thinking process?
HH: I find books written by Malcolm Gladwell quite interesting. Living Within Limits by Garrett Hardin has many interesting concepts on growth. The Corporation that Changed the World: How the East India Company Shaped the Modern Multinational by Nick Robins literally chronicles the birth of capitalism.
Reading judgments from the Supreme Court of India helps one understand how our Constitution works. An example would be the Kesavananda Bharati case which I believe should be a must read for every citizen of India.
Reading various government ministries’ annual reports, regulatory reports (RBI as an example), global central banker speeches, global anti-trust filings – all these help one understand how different aspects interact.
Finally, a study of human history is quite important. I would recommend Glimpses of World History by Jawaharlal Nehru.
SN: Which investor/investment thinker(s) so you hold in high esteem?
HH: Warren Buffett. Many have generated good returns in investing, but he has done it over larger and larger sums of money. He has never paid a dividend since 1967. That is what makes him a genius.
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?
HH: Personal life: Everything
Professional life: Nothing
SN: What other things do you do apart from investing?
HH: Spend time with my family.
SN: Thank you Huzaifa for sharing your insights with Safal Niveshak readers!
HH: The pleasure was mine, Vishal.
Note: We originally published this interview in the December 2015 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioural finance, click here to subscribe to VIA.