How this D-Street wizard conquers greed and fear

Moneycontrol | October 25, 2016

Ramesh Damani sat down with Kuntal Shah, Partner of SageOne Investments, and asked him about his investment processes and how he controls emotions of greed and fear.

Ramesh Damani has returned with his signature Wizards of Dalal Street, this time focusing on young investors.
In the latest episode, he sat down with Kuntal Shah, Partner of SageOne Investments, and asked him about his investment processes and how he controls emotions of greed and fear.

Below is the verbatim transcript of Kuntal Shah’s interview to Ramesh Damani on CNBC-TV18.

Q: How did an engineer get interested in equity investing?
A: When I was in the last year of engineering, I had a colleague whose father was Director and then MD of ACC Cements and I used to learn the business from him and if you recall during that time the stock and the sector per se was one of the best performing sectors. In 1992, exactly 1991-1992 and I bought few shares and I understood the business that the business had de-regulated and the upside was there but the quantum of upside was even amazing to the management. I had a roller coaster ride in a sense that I didn’t book adequate profit in trying to plan the tax and I gave up almost all the gains and this experience gave me the exposure to the equity investment. I realised that if you could figure out these decisions are getting made, there is an intellectually satisfying career opportunity out there.

Q: So, you chucked up engineering?
A: I joined TVS Electronics for one day at a salary of Rs 6,000. By evening I could realise that I was not cut out for this job, I quit and I joined the stock market next day.

Q: What was your first exposure to the Dalal Street?
A: My first exposure to the Dalal Street was learning at the school of hard knocks on what is working at that point of time and the market was highly inefficient at that point of time. I got tutored by a friend’s father who had a Dalal Street broking licence. They gave an introduction to a London based family office where we initially started with all kind of event driven and catalyst driven strategies starting with close-ended Mutual fund arbitration.

Q: Give me an example of that?
A: During those times there were several close end funds launched like Unit 64, Mastergain, Mastershare, Morgan Stanley where those shares were listed on the stock exchange and were used to quoted a huge discount to their net asset value ( NAV ).

Q: But could be redeemed?
A: Could be redeemed once a year at a fair NAV level. So, we used to simulate the NAV during the year, pick up the units at discount and redeem to the mutual fund. We used to do several kind of arbitrages like open offer, buyback, merger and acquisitions (M&A) related, so we did open offer arbitrages of companies like NALCO, Wimco, Ondeo Nalco so on and so forth.

Q: What was stage II, I mean that strategy clearly didn’t last long?
A: That strategy was predominantly oriented to attain financial independence and had limited opportunity set available to it and you could only deploy x number of capital inside the strategy and as the trade got crowded we moved out and that is why the stage II of bottom-up stock picking of good compounding stories was born.

Q: The Americans call it the All-In strategy, isn’t that what you followed?
A: The initial phase once having attained the financial independence was wealth creation and for creating that we invested heavily in a concentrated manner in few selected ideas, which had asymmetric risk-reward return.

Q: Example?
A: The classic example which comes to my mind was a stock called Burroughs Wellcome a 51 percent affiliate of Glaxo PLC, which had a separate arm Glaxo which was also a listed company. Both were listed but Glaxo was highly liquid and had a 4x-5x valuation multiple compared to Burroughs Wellcome.

Q: Why?
A: The institutional imperative of liquidity I guess -- Glaxo was on the A group Burroughs Wellcome was not but Glaxo owned more of Burroughs Wellcome, had better superior attracts and the price that at which we got in was below the cash on the book of balance sheet of the Burroughs Wellcome.

Q: Buffett's net-net?
A: Net-net and that too it was size because Unit 64 was being wound down and they were the sellers and we picked up below the cash.

Q: You picked up how much of Burroughs Wellcome?
A: Our fund picked up 8 percent of the component.

Q: 8 percent of the Burroughs you picked up over there?
A: This was a classic mispriced trade with a catalyst of liquidity in a very short-term horizon.

Q: How did you work out? A: The labour court case which was preventing the merger domestically got wound up in one and a half years time. The mergers were announced and we landed up making something like 7.5x in one and a half year.

Q: There is a lesson in there that in finance school they teach you risk and return are directly proportionate, are they?
A: I think it is exactly opposite. Risk and return are not at all co-related in fact negatively co-related because fundamental rule of investing is don’t lose money. The rule number two is remember rule one. So, if you have to attain superior return, it is very incidental that you need to take lower risk.

Q: Give me an example of the quest for value investing? Why did that begin there?
A: As I said the wealth creation strategy of concentrated investment had a periods of lumpy but superior returns. However, it was a journey where alternative history could have been painful if your couple of investment idea were to head south. This was a strategy, which is not ideal for managing third party money. For third party money it is all about processes, processes, processes.

Q: What is the process that Kuntal Shah was at 3.0 in his life?
A: We -- at SageOne Investments Advisor with a help of my colleagues Samit and Manish -- have evolved a detailed framework of first filtering the ideas with a sole objective that the fishing pond in which we fish has the highest number of high quality fishes. This is attained by filtering the 550-600 ideas which typically constitute the investment universe of an average investor to 150 companies by simple filtration and then applying a bottom-up investors.

Q: What were those filtration techniques that you used?
A: The things which we look for the businesses are businesses which can grow their sales at far than higher than nominal gross domestic product (GDP) growth. Here we look at two factors how the companies can increase the unit volume, unit price realisation and product mix and on the margins side the product mix, economies of scale and the cost efficiencies. Then we look for the companies with high return on capital, return on equity, low leverage and free cash flow after accounting normalisation.

Q: Give me a few examples of your approach in this field?
A: I will give you an example that if I had to replicate a success story of my version 1 in version 3 -- was that we invested in time sharing company where accounting was such that 55-65 percent of what they collect, which had to be serviced over 25 years was accounting as revenue in number one while it was a front loading of income and back loading of expenses and this kind of investment would not have passed through the process that I am talking about.

Q: Give me an example of where the process actually helped you?
A: The process has helped us to minimise the volatility of the returns and helped us to have a very scientific way of constructing portfolio from a huge permutation and combination of outcomes, which are possible. To give you an example, if there is a oil well and if it runs dry then people say it is a bad investment. However, if it gushes out with oil then we say it is good investment but both are mathematically equivalent of the same. It is a hole with liars standing on the top of it.

Q: You have learnt a lot from your mistakes, I think sometimes mistakes is the best experience. Tell us some of the mistakes, what have they taught you?
A: The years of investing journey has taught me that sometimes the biggest enemy of investor is investor himself. While biblical era has taught us seven sins and with the compounding and the complexity of the current investment life the number of sins have multiplied, there are three sins I would like to particularly focus on and which are at the extremities of human emotions namely the fear of losing out on opportunity or losing capital, which results during the time of extreme pessimism in the market. The greed of missing out on the opportunity or compounding of capital, which typically happens at the bull end of the spectrum.

Q: We always swing between fear and greed.
A: The trick there I have evolved is to have a foot in the door strategy which by means I divest or acquire a part of the stock and I tend to average up. So that I don’t miss out and don’t have an anchoring or a confirmation bias. Second thing is at the time of extreme dislocation, many people are frozen to act. The correct answer to that is again the process because as Benjamin Graham has said all an investor need during the time of dislocation are cash and courage. The process will give you cash allocation to take some money off the table at a time of the bull market and re-invest at the time of following bust if you follow the process.

Q: You have often talked about the three phase of your life. You have been educated a lot, 25 years in the market who have been some of the most significant influences in your life?
A: Courtesy the technology and the internet sweeping in I have been able to read works of eminent people who have been in other locations which normally I wouldn’t have access to. I have been lucky enough to meet doyen's of investing in India some of them being Nemish Shah and Vallabh Bhanshali of Enam. Manish Chokhani, Durgesh Shah of Corporate Database, yourself and so many others whom I interact on a regular basis and learn from my colleagues and peers.

Q: You are happy with this business or you are missing engineering sometime?
A: I have forgotten I am an engineer. Good you reminded me today.