[00:02:50] Gautam Baid: I still remember investing in a mutual fund called Reliance Power Sector Mutual Fund in late 2007, and a stock named Steel in January 2008 because both were in the hot and fancied sectors of power and steel at the time. These investments had sharply appreciated recently, and I simply engaged in blind extrapolation of the recent price trends without considering valuations or underlying business models. As a result, I paid the price like many other investors. Both investments crashed 60 to 70% within the first year, and I had effectively paid my tuition fees to the stock market despite this setback.

[00:03:31] Gautam Baid: However, my interest and enthusiasm for the stock market remained high throughout the first seven years of my professional investment banking career. From 2008 to 2013, I engaged in various forms of short-term trading and investing without conducting thorough research, and I wasn’t making any progress.

[00:03:49] Gautam Baid: It was during this period that I realized in order to become proficient in any field, two things are crucial: studying and practicing. If you want to become a good doctor, what do you do? You study and practice. If you want to become a good lawyer, what do you do? You study and practice. Similarly, if you want to become a good investor, what you need to do is study and practice.

[00:04:18] Gautam Baid: That’s when I decided to read up on all the investment classics, including “One Upon Wall Street,” all the referred shareholder letters, “Common Stocks and Uncommon Profits” by Fisher, and a host of other investment books. Gradually, I started improving myself as an investor. That’s when my true journey as a value investor really began. Because my knowledge base in investing was so small, it took off from that tiny base, and I was about to embark on the path of compounding knowledge in action.

[00:04:52] Gautam Baid: So that’s how I got started. As an investor, I worked as a portfolio manager of Global Equity Strategy at Summit Global Investments in Utah, USA, for four and a half years. While tracking global markets there, the Indian stock market stood out to me in terms of the number of high-growth opportunities it offered.

[00:05:14] Gautam Baid: About two years ago, I quit my job as a portfolio manager and started working on setting up my own India fund in the US. That’s a brief overview of my journey as an investor and my professional career. Now, you asked about how my investment philosophy has evolved and changed over the years. My personal investment opportunity set has significantly expanded with time and experience in the markets.

[00:05:42] Gautam Baid: Initially, like most investors, I started by investing in low price-to-earnings and low price-to-book stocks because I began by reading “The Intelligent Investor” by Benjamin Graham. Then, as I learned about Buffett, Munger, and Phil Fisher, I began investing in quality stocks at reasonable prices. But today, my investment approach covers multiple areas of the investment universe, including promoter and management change, merger arbitrage, spinoffs, cyclicals, and commodities.

[00:06:09] Gautam Baid: Instead of being restricted by my personal biased views to a very small opportunity set, as was the case during my early years, I’m now able to invest in a variety of industries and situations wherever I find missing value and a highly favorable risk-to-reward trade-off. You see, no single strategy works all the time and in every kind of market. That’s why it’s essential to build up one’s investing arsenal to be able to hunt for value from different areas.

[00:06:42] Gautam Baid: I have come to realize and appreciate just why this is so critically important. It’s because a bull market is always going on at some specific sectors of the stock market. For instance, during the 2009 to 2013 bear market in India, IT services, consumer discretionary, and pharmaceutical stocks created a lot of wealth for investors.

[00:07:04] Gautam Baid: Everyone should keep this important principle in mind that new trends, new sectoral trends always emerge during the end of a bear market. So if you keep your eyes and ears open and respect the collective wisdom of the market, the market itself will guide you in the right direction as to where the next leg of earnings upcycle is about to come.

[00:07:29] Gautam Baid: That is how you make those great returns for yourself and investors. During a bear market, pay very close attention to price trends in which sectors and stocks are breaking out to fresh 52-week highs. Because after every bear market, the sectoral leadership changes. So it’s very important to be very alert during those times.

 

[00:07:51] Robert Leonard: The first part of your book that I want to talk about is actually the title. It doesn’t get much more fundamental than that, and that’s the title. The reason I want to discuss it is because you emphasize how the best chance we have to improve our odds and success as investors is by focusing on compounding over time.So I was hoping you could elaborate on that concept for us. I think a lot of people get caught up in short-term performance and the news headlines of the day, and they forget to think about the long term. I truly appreciate how your book delves into what we should be focusing on instead.

[00:08:37] Robert Leonard: Take us through that.

[00:08:38] Gautam Baid: True. So all the great things in life, including investing returns, come from compound interest. Let me give you some numbers to illustrate this because the human mind is not intuitively wired to understand the exponential nature of compounding. If you start with $10,000 and compound at 20% for 25 years, your initial $10,000 will become $1 million.

[00:09:02] Gautam Baid: However, what would be your ending value at the end of year 20? So out of the $100, at the end of year 20, you would be at less than $40, which means that almost two-thirds of the $100x came in the final five years. The power of compounding is backloaded, and very few people are able to become wealthy through long-term investing because most of us lack patience.

[00:09:29] Gautam Baid: Most of us succumb to instant gratification. But investing is a long-term game, and the more time you give it, the lower the odds of disappointment. We have empirical data to prove this. If you look at the range of stock market returns as measured by the S&P 500 for any given year since 1950 (as of the end of 2022), the range of returns in the S&P 500 in any given year ranges from +47% to -37%.

[00:10:00] Gautam Baid: That’s the broad range you’re working with in a single year. However, if you extend your time horizon to five years or more (any rolling five-year period), the range of returns from the S&P 500 narrows to +28% to -6%. And if you further elongate your time horizon to 20 years, history teaches us that over any rolling 20-year period, the S&P 500 returns range from +17% to +6%.

[00:10:28] Gautam Baid: In other words, there has been no rolling 20-year period since 1950 in which you did not make at least a 6% average annual return from the S&P 500. This proves that if you extend your time horizon, you have the odds on your side. The probability of making positive returns is very, very high. That’s why everyone in the stock market should operate with a long-term perspective.

[00:10:55] Gautam Baid: The longer you extend your time horizon, the better your odds of success. So, this is why compounding is very powerful, and a long-term time horizon is an equally important component in the compounding equation. If you look at the compounding equation, the only variable that lies in the exponent is time.

[00:11:16] Gautam Baid: Therefore, you want to harness the exponential power of time in the compound interest equation.

[00:11:22] Robert Leonard: One of the other fascinating parts of your book is how you wrote that 50 years ago, the best investors were those who had an informational or analytical edge, whereas today it’s a behavioral edge. This resonates with me because I’ve spent a long time studying Warren Buffet. When I was just starting as an investor at a young age, around 14 or 15, I would read stories about how Buffet would go to the library and meticulously analyze annual reports. It made me believe that such practices were necessary for success as an investor.

[00:12:00] Robert Leonard: However, you argue that a behavioral edge is now more important. I find that incredibly interesting. The shift away from the traditional focus on analytical or informational advantages surprised me. Could you explain why you believe this is the case today and why things may have changed?

[00:12:19] Gautam Baid: Traditionally, there have been three sources of edge for the individual investor.

[00:12:24] Gautam Baid: Number one, the information edge, but with the advent of the internet, the information edge is now absent. It’s gone. Basically, the second source of edge traditionally for investors has been the analytical edge, but with more and more smart people entering the investing profession, even the analytical edge is far getting compressed.

[00:12:45] Gautam Baid: But the one edge, which is the most sustainable and durable in my view, is that of behavior and temperament. Fifty years ago, the best investors were the ones with the information edge, but today the best investors are the ones with the behavioral edge. As the speed of information dissemination and competition for short-term outperformance among money managers increased.

[00:13:09] Gautam Baid: Over the years, time horizons and patience levels significantly decreased. And today, an investor’s edge, it’s less about knowing more than others about a specific stock, it’s more about the mindset. Discipline and willingness to take a long-term view about the intrinsic value of a business. The market is filled with people who are just focusing on the short term on this quarter’s earnings per share.

[00:13:35] Gautam Baid: Printing right down to the last two decimal points, but that is not what investing is all about. Investing is about harnessing the power of compound interest over long periods of time by investing in good quality businesses or average quality businesses purchased at cheaper prices. Even that’ll work, but focus on the margin of safety at all times.

[00:13:59] Gautam Baid: Focus on quality, focus on the quality of the management, very, very important, and just have a long-term horizon. In investing, wisdom is much, much more important than raw intellect. Like I write in my book as well, because temperament is what differentiates the great investors from the average investors, like Buffet.

[00:14:20] Gautam Baid: Buffet has very rightly said that we don’t have to be smarter than the rest. We just have to be more disciplined than the rest. And that is where the wisdom lies. There’s so much wisdom in those words just by behaving sensibly. I think, you know, a very good title for a future book should be “The Sensible Investor,” because that’s what good investing is really all about.

[00:14:47] Gautam Baid: We just need to do sensible things and not do anything stupid. Charlie Munger also said the same thing, that people think I’m trying to do something brilliant, but all that I’m trying to do is not be stupid. It’s this desire to get rich quickly that leads most people to ruin in the market.

[00:15:09] Gautam Baid: So, if you’re willing to become rich slowly, this is the place for you.

[00:15:15] Robert Leonard: In your book, you also talk about this idea of an inversion technique. Take us through how this works and how an investor could apply this to their own strategy, and maybe provide an example of how you’ve done it.

[00:15:31] Gautam Baid: So, before I talk about the inversion technique, I would just like to quickly elaborate on the concept of the circle of competence.

[00:15:40] Gautam Baid: It simply means investing in businesses that you can understand. What is important is not the size of the circle of competence, that is the absolute number of businesses that you can understand. What’s important is that you’ve clearly defined its parameters, that is the kind of businesses you can understand.

[00:16:00] Gautam Baid: The inversion technique was espoused by Charlie Munger. He learned about it from the German mathematician Gustav Jacobi. And the inversion technique simply says, to arrive at a solution for any given problem, simply turn the problem backward or upside down. So if you want to arrive at your circle of competence, that is the businesses that you understand, try to draw a circle of incompetence, that is businesses that you cannot understand. Once you’ve drawn your circle of incompetence, that is businesses that you cannot understand, you’ll automatically get to your circle of competence, that is businesses which you can understand. And don’t make the mistake of venturing outside your circle of competence driven by the fear of missing out or FOMO during a bull market, because that’s a very common tendency.

[00:16:54] Gautam Baid: Instead, spend time learning about businesses outside your circle. Learn about those businesses, learn about those industries by reading about them. And then only gradually, you know, you’ll get to expand the edges of your circle of competence. And for any newcomer in the market who wants to understand, you know, how to define my circle of competence or expand the edges of my circle of competence, there is one simple way to do it.

[00:17:24] Gautam Baid: Read. That’s the only way you can expand your circle of competence. For instance, if you want to understand how to invest in community bank stocks, read a book called “Analyzing and Investing in Community Banks,” and then read the annual reports of some leading community banks in the industry. They’re relatively easy to understand and value, and over time as you get to learn more and more about how this industry functions, you can start investing in those businesses.

[00:17:56] Gautam Baid: An alternative way is to read up on the annual reports of companies in the industry in which you’re currently working. If you’re working in the medical devices industry, for example, start reading up on the annual reports of a few medical device companies. That’s also a good starting point. The reason why I emphasize reading so much is that in investing, the person that turns over the most rocks wins the game.

[00:18:25] Gautam Baid: In live business relationships or in investing, nothing will work unless you do, and there is no reason for any investor to settle for an inferior track record in marketplaces like us and India, which are filled with companies having outstanding fundamentals. So read and expand your circle of competence.

[00:18:45] Robert Leonard: You talk also in the book about the importance of having an investment checklist and how every investor should have one. I know everybody’s criteria is going to be a little bit different, but give us a sense of how an investor could go about building their own checklist and what it might include, or what you might recommend it should include.

[00:19:03] Gautam Baid: So let’s again use the inversion technique here. Inversion is a great way to narrow down your problem space. So instead of telling you the checklist items, the qualifying checklist items, I will talk about the disqualifying features in a checklist because that’ll greatly help you arrive at an investment decision faster.

[00:19:24] Gautam Baid: So in investing, there are only four things that can happen: a big profit, a big loss, a small profit, or a small loss. If you can avoid the big losses, you’ll do very, very well over time. And how do I go about avoiding the big losses for myself and my investors in my fund? It’s by avoiding certain things.

[00:19:49] Gautam Baid: These are the disqualifying features in my checklist, starting with number one: investing in cyclical or commodity businesses near the peak of their cycle, at their peak operating margins. That’s the first. Number two: investing in public sector enterprises because their majority owners’ primary motivation is not to do good for the minority shareholders, but to do societal good. Also, I avoid investing in number three: project-based businesses dealing with government tenders because in these kinds of businesses, receivables are very elongated and cash flow becomes a very big issue. So, you know, if you simply follow these disqualifying features in your checklist, then you’ll automatically know what to look for in a good business.

[00:20:35] Gautam Baid: And here, I would like to quickly add that how do we define a high-quality business? You know, if you just understand what defines a good quality or high-quality business, that itself will help bring a lot of clarity to your thinking as an investor, right? So, a high-quality business is one which earns higher returns on capital, which are well above its cost of capital.

[00:21:01] Gautam Baid: And the difference between the return on capital and cost of capital gives you the free cash flow yield. So, the business should have some competitive advantage or a moat which can protect this wide gap between its return on capital and the cost of capital for long periods of time. And number three, the business should have a sufficient number of reinvestment opportunities within its core business at high returns on capital.

[00:21:30] Gautam Baid: That is how that particular business becomes a high-quality compounding machine. So, these are the three fundamental attributes of a high-quality business, and through the inversion technique, I also explained to you what the disqualifying features are, which you can use in your checklist. So, combine these two aspects, and you’ll do very, very well.

[00:21:52] Robert Leonard: A component of your investing philosophy or strategy is that you emphasize the importance of focusing on simpler businesses. They generally require fewer assumptions and scenarios, and the cash flows aren’t always necessarily out in the distant future. So their value isn’t way out into the future either, making the business maybe a little bit more knowable or a little less uncertain.

[00:22:17] Robert Leonard: So when you do have a company that is more complex or where the cash flows are way out in the future, do you tend to just rule those companies out? Or how do you go about valuing companies like that when their total value is in the cash flows that are so far out?

[00:22:39] Gautam Baid: There’s a very good book by Adam Cecil written recently on investing in digital businesses for anyone wanting to understand how to value and invest in these digital companies, which have cash flows way out into the future.

[00:22:54] Gautam Baid: They can read that book. I’ll just talk personally about my investment philosophy. I’m a very conservative investor by nature, so I like to invest in companies where the earnings and cash flows are already on the table and available at very attractive prices. So I generally skip these digital companies that are currently unprofitable.

[00:23:16] Gautam Baid: In many cases, they’re unprofitable for a reason. So there are two kinds of digital companies: one, which is unprofitable by choice because they’re investing a lot of money in sales, general administrative expenses, and R&D, and many of those expenses are getting expensed in the income statement.

[00:23:35] Gautam Baid: So they are unprofitable by choice. But there is a very large set of digital companies that are unprofitable by design, by default. They can never become profitable. And there is a concept called unit economics, which basically means whether the lifetime value of a customer is positive or not.

[00:23:55] Gautam Baid: So as long as the lifetime total value (LTV) of a customer is positive, it makes sense to keep on investing to acquire more and more customers. And if the unit economics are positive, it further supports the investment. However, in the vast majority of cases for these digital companies, the unit economics itself does not make any sense. Therefore, they will never create any value for shareholders.

[00:24:23] Gautam Baid: So those kinds of companies should be avoided at all times.

[00:24:27] Robert Leonard: You make the delineation between a great company and a great stock, and how the market teaches us the lesson of how there’s a big difference between them. Dive into this a little bit more for us and help us understand why great companies are not always great stock picks, and they don’t always reward investors in the market for holding them.

[00:24:45] Gautam Baid: So, all the great investors in the world are ardent students of history, and history teaches us many lessons. So, let us look back in time to see what the future returns may look like for investors who are investing in today’s hot stocks and paying exuberant valuations for them. Let us go back to an era of very high investment exuberance, the Nifty 50, which reached its peak in 1972.

[00:25:14] Gautam Baid: For those in the audience who are not familiar with the concept of the Nifty 50, the Nifty 50 were a group of premier blue-chip growth stocks, including IBM, Polar, Kodak, and Coca-Cola. These stocks had very large market caps, proven track records, and had become institutional darlings in the early 1970s.

[00:25:35] Gautam Baid: At that particular point in time, no investor hesitated to pay 70, 80, or even a hundred times earnings for these stocks, the stocks of the most preeminent companies in the world. They had become one-decision, no-brainer stocks, with the simplistic-sounding philosophy of these fund managers that if you buy a great company, whatever be the price, you’ll end up making money. And it seemed so very intuitively appealing to the vast majority of the investing public that all of them fell for this theory.

[00:26:09] Gautam Baid: Subsequently, most of these growth stocks crashed 70 to 80% from the peaks by the end of 1972, and investors lost a lot of money.

[00:26:19] Gautam Baid: This is why Buffett said that for the investor, a too high purchase price for the stock of an excellent company can undo the subsequent decade of favorable business developments. So the price which you pay for a business matters a lot. If all that there was to investing was to invest in high-quality businesses, then all of us would know which the high-quality companies are.

[00:26:45] Gautam Baid: It would’ve made us all rich, but it’s not that simple. Eventually, all fast growers turn into stalwarts or slow growers, and this painful transition can lead to a long phase of valuation de-rating, which causes the stock to trade flat or sideways for long periods of time, and it can result in a lost decade for investors.

[00:27:08] Gautam Baid: I’ll give you an example here. From 2000 to 2013, the stock of Adobe gave zero return to investors. It was a great business in 2000, and it was a great business in 2013 as well, but for 13 years as an investor in Adobe, you made zero returns. So investing is all about finding pockets of mispricing where basically you’re getting more for the price that you’re paying with the lowest amount of risk. That is what good investing is all about. It’s not about paying excessive valuations for a business, however high quality it may be. So always pay attention to the margin of safety.

[00:27:51] Robert Leonard: With interest rates where they are and the economy and the stock market possibly pulling back a little bit, if investors are thinking, “Okay, maybe this is a good opportunity to pick up some shares of these high-quality great companies that I’ve had on my watchlist for a while,” they might still be unsure about the valuation.

[00:28:14] Robert Leonard: What should investors be looking for to indicate that a company’s valuation might be reasonable and it’s a good time to buy, or that the valuation might still be stretched?

[00:28:26] Gautam Baid: Well, it’s a very good question, and here I would like to make a very important statement. I believe the time for active investing has come to make a strong comeback. Over the last 15 years since 2008, index investing and passive investing have performed better. But in an era of high interest rates, the index may remain range-bound. However, it’s the time for bottom-up stock pickers to shine.

[00:28:53] Gautam Baid: So, here is where you’ll have to pay attention to valuations, cash flows, balance sheet management, quality, and all the good stuff. This is what we call the good old markets, like we used to have before 2008. It’s a normal market environment, and this is how markets have historically been. In this environment, you want to focus on companies that have earnings on the table and favorable valuations. Avoid paying very high price-to-earnings multiples in this high-interest rate environment, as interest rates act like a force of gravity for valuations in the stock market.

[00:29:31] Gautam Baid: So, if the risk-free interest rate is around 4% to 5%, it’s advisable not to pay more than a 25 P/E multiple for any business in the stock market, unless that business can provide longevity and visibility of growth for a very long period of time. The business needs to be rock solid and have a strong moat.

[00:29:55] Gautam Baid: In fact, in today’s times, who would’ve thought that the mode of Google in search could be threatened? But now we have got Chat GPT, which has led to this valuation de-rating of Google. So in today’s digital era, you know, it’s truly sacrosanct. Can you now form your initial hypothesis? This is about the strength of the mode, but given the technological advancements we are seeing in the world today, it’s very, very important to constantly monitor whether the mode is getting stronger or weaker.

[00:30:29] Gautam Baid: Because investing is all about terminal value. It’s all about the trajectory of the return on capital employed, the trajectory of the terminal value. Is the business becoming more valuable or safer over time? Are the cash flows becoming more robust over time, or are they getting threatened? And the market is very smart.

[00:30:51] Gautam Baid: If any business’s terminal value is getting threatened, the valuation de-rating will happen fast and furious, and you may end up investing in a value trap. So, avoid investing in value traps in the stock market. Very, very important.

[00:31:06] Robert Leonard: How can investors identify and then avoid value traps? I think this is a big problem, especially for value-focused investors.

[00:31:14] Robert Leonard: How do we identify and avoid them?

[00:31:17] Gautam Baid: In the stock markets, expensive is expensive for a reason, and cheap is cheap for a reason. Many times, switching from a high-pay stock to a low-pay stock proves to be a very big mistake. This is because, many times, there is this common investor tendency that we look at the sector leaders’ high valuation and try to find the poor cousin. We attempt to invest in a stock from the same sector at a relatively lower valuation. That is where maximum damage happens and permanent loss of capital occurs.

[00:31:53] Gautam Baid: So, what is the value trap? A value trap is a business that looks cheap based on non-trailing PE or price-to-multiples, but is actually very expensive in reality. What are the various signs of a value trap? Firstly, the cyclicality of earnings. A cyclical business may be operating at peak operating margins. You may be buying it at the peak of the industry cycle at a low price-to-earnings ratio. However, once you normalize the earnings and margins, the stock is actually very expensive. That’s one: cyclicality of earnings.

[00:32:28] Gautam Baid: Secondly, app risk. A stock of a taxi company may have looked very attractive in the past, but that was before Uber, right? Technological obsolescence or termination of terminal value can also lead to investing in value traps. In India, there are stocks of a few print newspaper companies listed at very cheap prices. But today, we don’t consume news by ordering physical newspapers. Most of us read news digitally. Therefore, where the terminal values are at risk, the P ratio may look cheap, but that’s actually a value trap. You have to focus on the denominator of the P ratio, the E, the earnings. If the earnings are in structural decline or are threatened to become zero over time, then those are value traps to be avoided.

[00:33:19] Gautam Baid: Number three: bad capital allocation. If management is constantly taking the cash flow from a business and investing it into value-destructive projects (which I’ve written about below, the cost of capital), the market is rightly giving that business a very low price-to-earnings multiple. So, don’t fall for that value trap.

[00:33:39] Gautam Baid: And finally, we have governance issues. The intrinsic value of a business with fraudulent management is zero. No price is cheap in such cases, so avoid those value traps as well. To sum up, cyclicality of earnings at risk, core technological risk threatening terminal value, bad capital allocation, and corporate governance issues are what lead to value traps in the market.

[00:34:04] Robert Leonard: How do you approach a situation when you find a high-quality company that passes all of your investment criteria, maybe checks all the boxes on your checklist, but the valuation isn’t quite where you want it to be or it does look a little bit stretched? How do you approach and handle situations like that?

[00:34:26] Gautam Baid: Investors with a bias against high P stocks tend to miss or end up missing some of the biggest stock market winners of all time. You mentioned this delicate balance between not wanting to overpay for a high-quality business. Here, I would like to share two white papers with your audience so that everyone understands what the justified P multiple is for a given stock or business.

[00:34:53] Gautam Baid: The first white paper is titled “What Does a Price-to-Earn Multiple Mean?” written by Michael Mosson. The second white paper is titled “The P Ratio, A User’s Manual” by Epoch Investment Partners. Once you read these two white papers, your thought process will become crystal clear regarding how the interplay between return on invested capital and growth in the business determines the justified or fair P multiple for a business.

[00:35:21] Gautam Baid: You may be surprised to know that for businesses that can promise longevity earnings growth of 12-15% over a decade or more, today’s justified P multiple for such a business is northward of 50 times or more. That’s why it’s very important to read these two white papers to understand the justified P multiple now.

[00:35:43] Gautam Baid: In India, the market in which I specialize, there are many large-cap consumer companies growing at 10-12% and trading at P multiples of 18-90. I’m not willing to pay such high P multiples for slow growth. However, if I can find these companies at the small-cap or mid-cap stage where they are growing much faster and have high longevity of growth, I’m more than happy to pay even as high as 40-50 times P multiple for the current year’s earnings because in such companies, once you’ve identified them at a small-cap or mid-cap stage and they have longevity of growth, the valuation multiple does not derate. In fact, the valuation multiple keeps expanding throughout the high-growth phase of a company as it transitions from a small cap to a large cap. Once it reaches the large-cap stage and growth matures, and starts slowing down, the valuation multiple starts normalizing down to a more steady-state P multiple.

[00:36:45] Gautam Baid: These are things that you get to learn only with the passage of time and experience in the markets. Don’t mechanically dismiss any company with a high P multiple. Look at which stage of the industry cycle and which stage of the company cycle the company is in. Is it in the growth stage, maturity stage, or decline stage? Then take your decision accordingly.

[00:37:11] Robert Leonard: In your book, you talk about looking for companies where the market’s expectations aren’t pricing in what you think will happen. And so, you’re talking about the justified PE. And because of this, you’re figuring out the implied growth that the market is pricing in. Is that the way you’re thinking about it?

[00:37:32] Gautam Baid: So, a reverse discounted cash flow (DCF) operation fleshes out the market’s expectations about growth and margins from the stock in question. One of the four questions I ask myself when evaluating a stock is: What is the market factoring in at this current valuation compared to my own future assumptions for this stock?

[00:37:53] Gautam Baid: You can simply carry out a reverse DCF operation and compare the market’s assumptions with your own to decide whether you want to invest in the company or not. In India, we have a tool called the Jury Finance, which allows you to conduct a reverse DCF operation easily and quickly. Once you have the market’s assumptions in front of you, you can compare them with your own and then make your investment decision.

[00:38:23] Robert Leonard: I’ve never used those implied growth rates in my own practice or my own investing, but it is something I’ve studied. Is that something that you always do in your investment process?

[00:38:34] Gautam Baid: I do. I do. So I think using DCF is a broad sanity check to evaluate valuations and whether they make sense or not. For businesses that are highly vulnerable to rapid shifts in technology, if I see that the market is factoring in more than 25 to 30% growth over the next 10 years or more, the base rate of success becomes very low. Good investors focus on base rates, which means referencing historical data and comparing the current situation to what has happened in similar situations in the past.

[00:39:10] Gautam Baid: History teaches us that in fast-moving industries characterized by rapid shifts in technology, you cannot expect a business to grow linearly for a long period of time because it can be threatened by rapid changes in the industry landscape. Therefore, I tend to be more conservative in those cases. I’m much more comfortable paying a higher multiple for a business that caters to basic human needs like shelter, food, and essential medicines. In those cases, I can have a longer time horizon and set of assumptions. However, for businesses that can be threatened by technology, I tend to become much more conservative in my estimates.

[00:39:52] Robert Leonard: Earlier, you touched on how you use negative information to guide your investment decisions. In your book, you talk about figuring out what a stock is not worth, which I’m hoping you can elaborate on. It’s an interesting way to value a company or think about valuing a company. I don’t hear a lot of people talking about what a stock is not worth.

[00:40:18] Gautam Baid: Again, the best investing decisions tend to be ones that seem obvious. Let me give you a live example from my India Fund. This is not investment advice, but rather an explanation of what a stock is not worth.

[00:40:33] Gautam Baid: There is a prominent industrial corporate group in India called the Arthi Group. They have various listed companies like Arthi Industries, Arthi Surfactants, Arthi Drugs, and Arthi Pharma Labs. AIE Drugs from that group is a low-margin, inferior generic drugs business. On the other hand, there is AIE Pharma Labs, which was spun off from AIE Industries.

[00:40:56] Gautam Baid: When a small-cap or microcap company is spun off from a large-cap parent with high institutional shareholding, those large-cap funds tend to start selling the shares of the small-cap stock in the open market, regardless of its valuation. This selling pressure can cause the stock to be available at very cheap prices.

[00:41:17] Gautam Baid: After the spinoff, due to this selling pressure from institutions, Arthi Pharma Labs had fallen to a trailing P multiple of 12 times. Now, if Arthi Drugs from the same corporate group, which is an inferior business, is trading at 23 times, how can the much more superior business of Arthi Pharma Labs be traded at half the valuation?

[00:41:40] Gautam Baid: It did not make any sense whatsoever. This is where, just by using common sense and understanding what a stock cannot be worth, you end up making great returns. In Stellar Wealth Partners India Fund, we bought a stake in Arthi Pharma Labs at a price of around 250 rupees. The stock has increased by more than 40% in just one month because now the market, once the forced selling from institutions was over, is quickly reevaluating the stock to at least the valuation multiple of Arthi Drugs, which is the inferior group company.

[00:42:18] Gautam Baid: A higher quality business from an industry cannot be worth half the valuation of a much inferior business from the same industry or the same corporate group. This is an example of what a stock could not be worth, and how we utilized this information to generate good returns for investors.

[00:42:38] Robert Leonard: We’ve talked about how compounding is the best, and it has such a big factor. It’s such a key to success in investing. But at the same time, people might come into a situation where they might have to sell a stock or they’re not sure if they should hold onto a stock because of valuation or how the company’s changing, etc.

[00:43:03] Robert Leonard: So, how often do you revisit your valuation analysis, especially when you have a really long-term horizon? How often are you recalculating the value?

[00:43:13] Gautam Baid: More than recalculating the value, I do look at the valuations on a one-year forward basis using my conservative estimates. And I do not sell a stock just based on high valuations.

[00:43:26] Gautam Baid: Because high-quality businesses are very rare to come by and they undergo long periods of time correction. But the advantage of a diversified portfolio is that when these high-quality businesses become overvalued in the short term and then undergo time correction and take rest, the rest of the portfolio starts firing, and that is what does the heavy lifting for you during such years.

[00:43:51] Gautam Baid: Now, while I mentioned I’m happy with staying put and holding onto highly valued high-quality companies, I’m not willing to hold on to a business that becomes absolutely valued. So what do I mean by “absolutely overvalued”? Personally, I’ve set this mental exit criteria that if a business crosses more than a hundred times earnings multiple, I’ll get out of the stock, no questions asked, even though it may go up even further from there during a period of market euphoria. That is the internal high hurdle I’ve kept for myself.

[00:44:28] Gautam Baid: And in India, it’s not uncommon to find the stocks of high-quality businesses trading at 40, 50, or 60 times earnings multiples because many foreign investors do not understand that the supply of quality equities in India is very limited. So these handful of quality businesses in India, which are roughly a hundred companies at max, enjoy what is known as a scarcity premium. That is why great investors don’t just try to apply rigid theories; they try to understand the ground realities of the individual stock markets in which they operate because, at the end of the day, the price of a stock is driven by only two factors: demand and supply.

[00:45:13] Gautam Baid: If the demand for high-quality equities is high and the supply of such high-quality equities is low in India, obviously the valuation multiples will be very elevated. But at the same time, you have to make sure that you don’t buy them at exorbitant valuations. Try to wait and acquire those companies at a reasonable price during a better market or a market crash like March 2020.

[00:45:40] Gautam Baid: However, it is very rare to find high-quality companies in India cheap per se, in absolute terms. So you have to make peace with that fact and then buy them at reasonable to fair prices, and then enjoy the compounding returns.

[00:45:56] Robert Leonard: It’s not really a super new topic, but a lot of people have been talking about India as kind of the next China, if you will, or growing as fast as China was, you know, a decade or two ago. And so, a lot of people are interested in the business and investment opportunities there. And I’d say that’s your specialty, investing in the Indian stock market. So, that said, I’m curious to get some insight from you, particularly for US investors who are looking to diversify their holdings away from just US stocks. How should they think about the Indian stock market and potentially investing there?

[00:46:39] Gautam Baid: It is my personal conviction and belief that the opportunities of the next 20 years in India will be far greater than those in the last 20 years, and the opportunities of the next 20 years will draw from that of the last 20 years.

[00:46:57] Gautam Baid: And where will these opportunities come from? They’ll come from two sources. Vary perception and long-term structural trends, vary perception – reference to having a differentiated view on the short to medium-term trajectory of a business – and vary perception, reference to situations where you get return on capital employed (ROCE) expansion coupled with earnings growth. You get valuation rerating, and you end up with multi-baggers. There are multiple triggers for perception number one.

[00:47:26] Gautam Baid: Product mix change into a higher-margin category. So, in these cases, what happens is the net profit grows at a faster rate than revenue growth because you’re introducing new higher-margin value-added products. Number two, operating leverage, which can come from having high and underutilized capacity just at the beginning of an industry upcycle.

[00:47:47] Gautam Baid: So that’s the second one. Number three, improvement in the working capital cycle if the company is able to negotiate better terms of trade with its customers and suppliers. Then the working capital cycle gets crunched down, and because working capital is a part of capital employed, your return on capital employed goes up, and you get valuation re-rating. Number four, deleveraging.

[00:48:12] Gautam Baid: As debt goes down, interest cost goes down, net profit goes up, market cap goes up. Also, because debt is a part of capital employed, your return on capital employed also goes up with a reduction in debt. Number five, positive regulatory change. So, in early 2020, the government of India started putting a heavy emphasis on ethanol blending.

[00:48:35] Gautam Baid: And since then, we have had many multibaggers coming from the sugar mill and distillery space in India. Number six, industry cycle shift. So, since the middle of 2020, the residential real estate cycle in India has turned around. After more than a decade, we have had many multibaggers coming from the building materials space in India.

[00:48:58] Gautam Baid: Number seven, improvement in asset turns. You can get this information from management on conference calls. You can ask them what is the expected turnover on the new fixed asset capacity? And there are two levers for ROC expansion. One is improvement in asset turns, and one is margin improvement. And between the two, I prefer the former because high margins tend to attract competition.

[00:49:24] Gautam Baid: Finally, we have corporate actions like spin-offs, promoter or management change, merger arbitrage, and divestiture of loss-making or non-core business segments. As you sell off a loss-making business segment, the net profit goes up, market cap goes up. And when you divest a non-core business segment, the markets reward the focused management with a higher valuation multiple.

[00:49:47] Gautam Baid: So, these are the various triggers for varying perception. Now, let’s talk about long-term structural trends. Long-term structural trends are found in industries with a very favorable structure. They’re organized like a monopoly or an oligopoly or ideally a duopoly at best because, you know, in a duopoly, companies generally do not engage in price wars. So, I really like to invest in industries with a duopoly structure. These kinds of industries have consistency and predictability of cash flows, and you have a long runway for growth ahead. So, you have visibility for many, many years ahead. Long-term structural trends are also characterized by value migration.

[00:50:29] Gautam Baid: So, in India for the last 20 years, we have had value migration from the unorganized to organized, public sector to private sector. So, find pockets of value migration where the value migration is taking place. And today, there are multiple structural growth plays available in the Indian stock market, including special ed chemicals with critical application, contract manufacturing, affordable housing, FinTech, financialization of savings, and branded discretionary consumption.

[00:50:57] Gautam Baid: The last two categories I mentioned, financialization of savings and branded discretionary consumption, are very, very important, and I’ll just quickly give you a brief of why I’m saying this. History teaches us that the fastest pace of wealth creation in any stock market takes place when that country transitions from a $3 trillion GDP to a $6 trillion GDP. And why does this happen? It’s because if you look at the history of the US, China, and Japan, when those countries’ GDP went from $3 trillion to $6 trillion, their stock markets did not just double, their stock markets tripled or even quadrupled.

[00:51:38] Gautam Baid: And why did it happen? It’s because as a nation transitions from a low-income per capita country to a middle-income per capita country, the basic spending on items like food does not go up much. But the spending on categories of branded discretionary consumption and financialization of savings, these two categories simply explode.

[00:52:00] Gautam Baid: Today, India is at a $3.3 trillion GDP. We are right in the sweet spot, and we are just on the cusp of the fastest pace of wealth creation in the Indian stock market. And already, in the last two years, the categories that outperformed the most were branded discretionary consumption and financialization of savings. These two themes outperformed the most. In fact, in India, from 35 million individual DMA or brokerage accounts three years ago, today we are standing at 120 million brokerage or dmat accounts. So, this financialization of savings trend is already exploding in full force, as seen in the last three years.

[00:52:42] Gautam Baid: So, for investing success in the Indian stock market, you want to position your portfolio to make the most of these two big themes.

[00:52:52] Robert Leonard: You’ve talked about how you don’t think passive investing in the sense of like an ETF or an index fund is going to be the way to go in the future. So do you think that might not be the best way to play this trend for the Indian stock market that you just talked about and all the, all the positives that are going forward for India right now 

[00:53:10] Gautam Baid: About the problem with an ETF or index is that it consists of good businesses and bad businesses. But you know, if you want to generate alpha and if you want to beat the index, by definition, you have to concentrate your portfolio into the best quality stocks and names which you can find. So, you know, like I mentioned to you, varying perception and long-term structural trends, these are the two key pillars of Stellar Wealth Partner India Funds’ investment philosophy.

[00:53:43] Gautam Baid: The long-term structural trends provide us with long-term compounding, giving us slightly equal or slightly better than the index returns. Whereas the shorter-term tactical opportunities found by variant perception help us to generate that alpha over time for investors. So, this is the reason why bottom-up stock picking and active investing are all set to make a big comeback.

[00:54:07] Gautam Baid: Because if the markets right now are expecting the interest rates to come down again, but what if the interest rates do not come down? In such a scenario, the index may become range-bound for a long period of time. We should remember that between the year 2000 and the year 2013, the NASDAQ Index gave zero returns for 13 long years.

[00:54:32] Gautam Baid: I’ll give you one more number from history. This was about the NASDAQ. Let’s look at the period from December 31st, 1964, to December 31st, 1981. During those 17 long years, the Dow Jones Industrial Average went from 874 to 875, a single point move over 17 years. So, we have had periods in history when the index gave no returns. In the case of the NASDAQ, it was 13 years, and in the case of the Dow, it was 17 years.

[00:55:04] Gautam Baid: So, it’s very, very important to be bottom-up. And why restrict ourselves to only a home country or have a home country bias? We live in a world which is very globalized, very digital, where information is readily available, and money frankly has no color. Every dollar spends the same, whether you make it from India, Europe, or the US.

[00:55:28] Gautam Baid: Ultimately, the beauty of capitalism is that money has a metaphysical attraction to places where it can grow. As investors start realizing the growth potential of the Indian stock market, they have no choice but to have some allocation. And it’s my personal conviction and belief that every investor in the world today should have some allocation to equities in their portfolios. It’s very, very important.

[00:55:55] Gautam Baid: And what is the reason why I say this? It took India 58 years to make its first trillion dollars of GDP, but it took India just seven years to reach its second trillion dollars of GDP, and the subsequent trillions of GDP will be achieved in faster succession. So, if we simply assume the market cap to GDP to approximate one, over time, one can just envisage and visualize the kind of wealth creation that lies in store for investors in the great Indian businesses — trillions of dollars over the next few decades. And who will capture the bulk of this upcoming wealth creation boom in the Indian stock markets?

[00:56:39] Gautam Baid: Over the next 20 years, the nation’s best-managed companies with a proven ability to scale up their operations will capture the bulk of this stock market expansion, which is about to take place. That is where you want to position your portfolio to generate wealth for yourself and your investors.

[00:56:59] Robert Leonard: Towards the beginning of the interview, you mentioned how there are always opportunities, even in bear markets. There’s always somewhere to find a new opportunity. And if we look at the US, it’s been one of the leading stock markets, and you talked about how in bear markets, new leaders often emerge. So, how should investors be thinking about where the new investment market leadership will come from? Is it going to be the US? Is it going to be a different market, generally? Where are you looking for the best opportunities for investors?

[00:57:37] Gautam Baid: This is not investment advice. Please do your due diligence. But one place where I would definitely look at is all the ancillary plays related to gold and silver. I think last year when the United States weaponized the dollar against Russia, it prompted many of the central banks and governments across the world to start stocking up on gold and silver, even though silver has industrial use. But there is a particular ratio of silver to gold below which silver tends to become very cheap. So, I think precious metals like gold and silver will do very well over the next five years. And if you can find ancillary plays related to gold and silver in the US stock markets, I think that is a good place to look at.

[00:58:29] Gautam Baid: At the end of the day, money chases growth in any stock market. If the growth in tech is slowing down and if no new sector is showing high earnings growth, money will automatically gravitate to such sectors after every bear market. So, I just mentioned gold and silver, but irrespective of any sector, a group of companies that are experiencing very high top-line growth, exemplifying sector leadership, that is where you want to position your portfolio in the stock market in which you operate. It’s all about earnings. We may have fads and trends like NFTs, SPACs, and all that speculation in 2020-2021, but ultimately, it was companies with solid earnings and strong cash flows that continue to perform well. Look at how Microsoft and Apple stocks have performed over the last two years. They’re still very rock solid. However, companies that were sensitive to economic conditions, like Google and Facebook, which derive most of their revenues from advertising, saw their valuations sharply decline. Additionally, Google faced headwinds with GT and Facebook had business issues. So, the market is very efficient. Over time, I have realized that the market is very smart. And if we simply respect the collective wisdom of the market and pay attention to it 24/7, we develop what I call a “feel” for the market. The market itself will guide you in the right direction. You just have to be humble and listen to it.

[01:00:05] Robert Leonard: Before we wrap up today, Gautam, where is the best place? Where do you want people to go to find your information online, find your book, etc.?

[01:00:16] Gautam Baid: Sure. So for people who want to learn more about the book, they can visit thejawsofcompounding.com. For people who want to learn more about my India Fund in the US, they can go to stellarwealthindia.com. And for people who want to invest in Stellar Wealth PMs, which is a portfolio management service for Indian citizens and NRIs, they can visit completecirclewealth.com.

[01:00:40] Robert Leonard: Great. I will be sure to put a link to all your resources and your awesome book in the show notes below. As everybody listens, knows all the resources, just swipe up on your podcast app. You can find them in the show notes below if you’re interested in checking them out more. Thanks again.

[01:01:02] Gautam Baid: This was a pleasure. 

[01:01:03] Robert Leonard: All right, guys, that’s all I had for this week’s episode of Millennial Investing, I’ll see you again next week. 

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