It is an old interview but it makes a good read…

Synopsis of the Interview with Mr. Sanjoy Bhattacharyya Chief Investment Officer of HDFC Mutual Fund.

“CIO: Thank you, Sanjoy, for giving us this opportunity to discuss the field of investments with you.  I would like to start by asking you what do you think is the best way to go about investing in the Indian context?

Sanjoy Bhattacharyya: I think that's a tough question. I don't think there is a straightforward answer.  Reflexively, it may appear that growth stock investing would work best in the Indian context.  The logic for that is related to the fact that the economy is growing at 5%+.  Unlike a lot of other countries in emerging markets, that are narrowly focused in terms of having strengths either in service businesses like Singapore or in smokestack manufacturing like Czechoslovakia, in India there is actually a diverse manufacturing economy.  In addition, the service sector has considerable strength in areas like software, hospitality, leisure, and entertainment (I think Bollywood probably rivals any other country in terms of size). 

Assuming India is going to witness meaningful economic growth across a wide range of industries over the next 10 to 20 years, the GARP ("Growth at a reasonable price") approach seems ideal.  Having said that, it's not absolutely clear that there are no equally worthwhile alternatives. This is because what happens in India is also affected by two other factors. 

First, we have a far larger number of listed companies for historical reasons. Therefore, for most individuals the investment universe is probably between 1200-1500 companies. Apart from the 250 largest companies, the other 1250 are completely neglected.  By virtue of that neglect great opportunities exist giving you tremendous room to make outsized gains. 

Second, till recently I think the Indian market was driven more by momentum rather than an assessment of business and economic fundamentals.  While that is changing, information dissemination and analysis is clearly less "efficient" in India than in developed Western markets like the USA. As a result, there is still considerable room for people who focus on extensive fundamental analysis to seek some kind of advantages in identifying value, which others may not have done.  A good illustration of this is Bharat Electronics. For years together till as recently as 2000-2001 it was absolutely undiscovered.  BEL is neither a small company nor an unknown company. On balance, I think it pays to be eclectic in the way in which you invest in India.

So while growth investing is probably the most frequent mode of investing, I would venture to say that all sorts of investors can succeed in India.  All they need to do is be analytically comprehensive, have clarity in terms of their investment horizon and recognize that no approach works all the time. The amazing thing is actually that in India, value investing as a long-term proposition is probably rewarded far more significantly than in most other markets. Market inefficiency does wonders for investment performance!

CIO: So, with that backdrop in mind, what have you chosen as your elements of investing, components of your investing, that make up your style of investing?  Which may be a collection of things that you learnt, read, understood over a period of time.

Sanjoy Bhattacharyya:  Actually when I started out, I was greatly influenced by the cigar butt approach.  In many ways, I still have a great attachment to that style given its simplicity and intuitive appeal. Further, it is easier to figure out and requires less use of judgment than other forms of investing. I have tried to adapt as I have gone along.  But even today the lure of a "cigar butt" remains  very strong.  So in that sense the most important influence in the way I have been shaped is Graham. I would say this --hackneyed as it may sound -- that if you really want to figure out what investing is about and you had to read just one book in your life, the book to read would be The Intelligent Investor by Benjamin Graham.

Having said that, sometimes in the late 80s I was fortunate enough to come upon a balance sheet of Berkshire Hathaway.   That was my introduction to Buffett and the simple point that he made was that if you have you choose between a good business and great management, clearly the choice is to buy a good business.  Because that's what drives earnings, that's what creates value and so on and so forth.  But the difficulty is - and where I come unstuck most often - is really figuring out that it is a good business. Not easy to get that right. You often make a lot of mistakes in figuring that out.  You think it's a good business.  But because you don't have the necessary understanding, the deep insights required to figure out what it takes to succeed in that particular business you end up getting it wrong.  I made the same mistakes, lost a lot of money and realized that not many people can successfully practice that form of investing.  It genuinely requires tremendous intellect and great judgement of managerial capability apart from being  very time consuming.

The other method with which I became acquainted is called GARP. Probably the second most common form of investing in India after momentum. In essence, you try and find growth and make sure that you are not paying too much for it. It is often confused with Buffett’s brand of investing or on occasion even with value investing because it's actually a corrupted version of both.  It has gained great popularity internationally as well.  The trick lies in judging what is a reasonable price in relation to how much growth there is.  These are both tough calls. It often works well in the short run because if you can spot something that you think is significantly at variance with what others are doing and is meaningfully undervalued, there is considerable opportunity to hop in & out. Even if you haven't got the degree of growth right -- how much growth and for how long, you can still make an honorable exit. In value investing the need to be patient is perhaps much greater.  GARP usually does not test your patience !!

Two other concepts shaped my investing.  One was the idea that while you need to have competent management, integrity in the people who run the company on your behalf is incredibly important.  Many people would say integrity is something that moves along a continuum. You can have people who are complete crooks as also managers or entrepreneurs who resemble saints. I have large numbers of the first kind, unfortunately just three or four examples of the latter (saints). I figured out early that if you know the left-hand side of that continuum is complete crooks and the right hand side is saints, I would never like to go to between the extreme left to the midpoint. I have a strong preference and am willing to pay to be much closer to the right extreme of the spectrum.

Thus, despite having made a large number of mistakes (in fact the number of mistakes that I have made in my life are so numerous that one could write an encyclopedia on this. I am sure that there are many more to follow) that is the one thing that has really saved me from great disasters.  The first principle of investing is that if you don't lose all that you have managed to put together then you live to fight another day.  That is one of the cardinal principles of investing - not just in India, but anywhere in the world.

Finally, I think I was greatly influenced by the fact that I had the good fortune of working at CRISIL. Being a credit rating analyst, my daily routine was to read balance sheets and meet people who ran large companies.  Speaking to them firsthand was a great education in terms of understanding what drives senior management thinking.  Equally important was the fact that I had an exceptionally knowledgeable and far-sighted boss - Mr. Pradip Shah.  He had a great role to play in influencing my analytical development - the tenets of business analysis, the need to be rigorous and comprehensive as a financial analyst, how to identify red herrings or warning signals from financial and business data.  He truly accelerated my development as an analyst. I should also acknowledge the contribution of my father, who I think was a wonderful investor. He started as a professor of accounting at IIMA but went on to teach organization structure and design.  He inculcated in me the habit of -

a) being rigorous and holistic in terms of an analytical framework,

b) being diligent and not giving up despite initial setbacks or failures.

In essence, his belief was that one has to keep on refining whatever thoughts or ideas or concepts you started out with.  One of the best ways to do that is just putting in the effort -- not believing that you have all the answers. This is something that I continue to believe in very strongly.  It really helped me because when you start from a low base, you know very little.   By reading a lot and speaking to people who have great depth in a particular area, it helps to streamline the process of how you think as an investor.

The other thing, which has worked in my favour, has been my association with some very savvy investors.  Not everyone has that good fortune.  Among them I think I should single out Raamdeo Agarwal, Chandrakant Sampat, Rakesh Jhunjhunwalla, Vivek Mundra and my father.  Each of these people really taught me something worthwhile.

CIO: So, Sanjoy, basically with the investment style that you just articulated, what do you think is a sensible investment objective that one should have in the context of the current interest rates at this point in time?  And also the objective if you could break it down between the risks and the returns?

Sanjoy Bhattacharyya: The answer to that for me is very simple.  My first principle is actually not to take on large risks.  One of the things I have learned and which I really believe in, contrary to most people I know is that risk is best defined as "not knowing what you are doing".  This is Buffett's definition of risk and far superior to what most of us are taught in business school. If you know what you are doing and you have put in a huge amount of work to be sure that you have got it right, then you can make very serious bets and I think that is what leads to long-term out-performance. It is absolutely vital to put in the necessary spadework before making a serious commitment.  While most people follow this precept in the rest of their lives, strangely they seem to think that it is unnecessary while investing.

In general my predilection is to maximize risk adjusted returns while confining risk to a minimal level.  Perhaps this has something to do with the fact that I was a credit rating analyst for seven years.  Downside protection was driven into my consciousness at a formative stage. .

CIO: You said that you have been quite risk averse; you tried to avoid taking any major risks.  What do you mean by that?  And how can one go about practicing it?

Sanjoy Bhattacharyya: Very often, I thought that I was taking low risks.  It turned out in hindsight that I was not - because I made some horrendous mistakes. I will give you a very funny example.  I bought a company, which was in the leather business, the owner of which was quoted in Time magazine, and Time magazine thought he was going to be one of the great success stories in leather exports from India.  A company called Cosmos Leather. I went out and bought a bucket load of this personally at Rs. 30 and had the extremely helpful experience of selling this at 60 paisa three years later.  One lives and learns.  The school of hard knocks (SOHK) is the best education one can have in this business.  It teaches you that very often you get even basic principles completely mixed up!

More seriously, however, one of the best ways to identify riskiness is to look at the long-term volatility of cash flows.  Of course, the assumption is that the financial statements are representative of business performance and disclosure standards are high. 

Second is to check out whether the business generates free cash flow.  Sometimes you can have high reported earnings and low to nonexistent free cash flow.  The existence of free cash flow ensures that the company is unlikely to be wiped out at the bottom of the cycle.  If you stick to this principle in a disciplined fashion, you will considerably lessen the amount of risk you take.

The third important element is the integrity of management. 

Fourth is the level of competitive intensity in the business.  After having paid a large amount of tuition fees in terms of flawed investments, the realization hit me that risk is typically much lower when you buy a monopoly.  It may sound obvious but most investors do not pay enough attention to this simple idea. When I started out at HDFC Mutual Fund, I was strongly advised against buying a company called Container Corporation.  The argument was that it was illiquid and would eventually crumble against the onslaught of a more efficient road transport system. At a fundamental level, what really appealed to me was the company's extremely conservative financial structure and monopolistic operating conditions.

So even if the growth slowed down and the operating environment got tough, Concor had the ability to be around for some time.  In addition, they had the support of the Indian Railways.  The assessment of Concor being a low risk business was right.  Funnily, the rest of the market did not think so because the stock traded at a PE multiple of 4 suggesting that the business was very risky.

The ability to be contrarian in this regard is worth a huge amount of money. Even better, it does not require the investor to understand quantum mechanics! 

The last thing about how to assess risk is to anticipate what can change in a business.  You have to try and figure out what this might be either by scanning historical precedent or divining the future. A number of investors thought that the companies focused on drug discovery in India in the early stages -- companies like Dr. Reddy’s and Ranbaxy - were low risk businesses.  But they aren't low risk businesses.  Not at all.  The whole process of drug discovery per se means that there are certain inherent risks.  It’s just that Ranbaxy as well as Dr. Reddy’s had good fortune when they started out.  Beginner's luck, in short.  The fact that they didn't run into problems does not mean that they are not risky businesses. 

CIO: So, out of all the things that you told us as components of your investing style, could you please dissect for us the necessary conditions that you would look at before you invest in a company and the additional conditions that that will just go about reinforcing your confidence in the company?  Which may not be present in all of your investments.

Sanjoy Bhattacharyya: Again, I don't get this right very often.  But if there are a few things that stand out in my mind as being vital, one is honest management.  I harp back to this again and again. It is basic to my way of thinking and you have to make the assumption (which is unfortunate!) that unless you have demonstrable proof on a long-term basis that people are honest, they are crooks.  This is cynical, but it helps a hell of a lot to save yourself from losses.

Second is that if you can't figure it out, it's not worth doing.  If others can figure it out, good for them.  Never rely on secondhand knowledge to determine where you should invest or for that matter, what businesses to buy into. For example, if most people tell you that the software businesses is going to grow to the sky, listen politely but figure out the rationale for yourself.

So you have to do your homework and understand most of the key elements of any business that you buy into provided you wish to make a meaningful investment.  If you are taking a flier and buy small quantities just for kicks, it's different.

Third, it helps a lot to buy cheap.”