There are more than 5000 companies listed on NSE and BSE, out of which only about 1600 are of any size. We have used comprehensive filtering to shortlist about 150 companies that met our stringent requirements. We not only went through quantitative parameters over past several years but also manually eliminated companies with suspect management. This forms our fishing pond to build portfolios. We like “fishing in a pond where the fish is of high-returning variety”.
High Returning Businesses
We look for businesses with long-term competitive advantage, in attractive industries from the point of view of long term value creation. Return on capital (ROCE) is a very good indicator of the quality of the management team and the competitive advantage of a business. Typically we look for sustainable ROCE and ROE of at least 20% but preferably above 30% that has been achieved without too much leverage (debt). The business should have long-term growth potential of above 20% per year and it should not require too much additional dilution (other than for financial companies) of equity to achieve such growth.
Competent/Genuine Management
The most important factor in India is to stay away from managements that are here to steal from investors; and believe us we know of many. Here we maintain “zero” tolerance policy and we prefer letting go of a good opportunity even if we have some doubts about the management’s integrity. Once the management passes the above hurdle, we look for their competence in running the business and allocating capital. We want to associate with managements who use capital wisely and return any excess capital to the shareholders (in form of dividends) if there is lack of highly profitable opportunities available to invest in.
Risk-Reward Tradeoff
Our primary focus is on superior businesses and would not buy a weak business irrespective of its price. For a weak business which has no competitive advantage and which cannot sustain its returns (ROE/ROCE) above its cost of capital, no valuation multiple is low enough. We believe that the most important factor that drives value of any business is the “duration” over which the company can sustain its competitive advantage and hence superior returns. It is our overriding belief that, especially in the opportunistic markets in which we work, “if we avoid the losers, the winners will take care of themselves.” We would rather not invest than make a bad investment for the sake of it.