In our blog Emerging Value : 28-Feb-19, we had made out the case for deep value emerging in the wider markets. We had also implied in the same blog that outperformance of our basket of risky ideas against the BSE SENSEX was becoming increasingly probable in the months ahead. It has been 10 months to date and the BSE SENSEX has continued it’s incessant climb upwards, while stock price performance in our basket of risky ideas has continued to lag. To be fair, the basket of risky ideas has nevertheless significantly outperformed the BSE Small Cap Index in the same period – although that is no consolation. The overall internal rate of return generated on risky portfolios advised by Aroha over the past 10 months has been about 9.72% versus that of the BSE SENSEX has been a whopping 19.50% .The Small Cap Index however has generated a paltry 0.73% internal rate of return over the same period. This clearly indicates that while we are convincingly outperforming the BSE Small Cap Index, we are continuing to significantly under-perform the BSE SENSEX.

Since inception our idea of investing in risky ideas has been to invest in small, relatively under-researched companies, generating high returns on capital and trading at a discount to our assumptions behind their intrinsic values. While assessing investible opportunities we have been prudent to place constraints on the valuations of these companies. This strategy has invariably led us down the path of investing in companies with relatively low price to earnings ratios. It has been our belief that investing at prudent valuations will eventually result in outperformance. The reality is that outperformance has eluded us not only over the last 10 months but also over the last 30 months or so. It has been a frustrating period where our belief in value investing is being put to a severe test.

As our portfolio lags the BSE SENSEX, there are pertinent questions to be asked. The first whether we as advisors are competent in what we are doing and second could we augment the value investing strategy today and improve outcomes for our clients. The answer to the first question lies in time. The longer we continue to underperform, the more likely we are incompetent – or at-least not as competent as a simple index fund. We are ready to wager that over a time frame of five years if underperformance persists – there remains no real reason for us to be stock pickers. We will undertake this introspection probably at the end of the second 5 year term of our Investment Adviser licence which comes to an end in October 2023.

The second question regarding how we could augment our value investing strategy has cornered our interest. Attending a few recent talks by prominent fund managers, we see the investment management industry being split wide open between value investing such as what we practice and quality investing as practised by a few. The argument behind value investing is more or less understood. i.e to buy companies with strong underlying fundamentals at a bargain. The argument for quality however seems more nuanced. Investors in quality companies say that high quality companies are ALWAYS a bargain buy. They say that the Price to Earnings multiples and similar other value metrics get amortized over a period of time and essentially become irrelevant. More importantly, according to them quality companies are able to generate a return on capital significantly above their cost of capital consistently. This combined with a consistent ability to grow their revenues, results in a compounded growth in earnings which ultimately makes the Price to Earnings ratio irrelevant over a period of time. They argue that not only will stock prices reflect the growth in earnings, but stock prices will move up in a smoother and steadier manner with less volatility. They say that these companies invert the risk-return conundrum, and their share prices rise higher with lower volatility than the rest of the market.

The proponents of quality however qualify their argument with the statement that quality companies are few and far between. They form less than 1% of the investible universe of companies in India. These companies have impeccable balance sheets, generate a return on capital employed consistently higher than their cost of capital, consistently grow their revenues and most importantly are monopolies or at worst duopolies in their markets. In market downturns, they hardly experience a blip and in-fact tend to gain market share from their competitors in tough times. The quality proponents further state that such monopolies are unique to India and the ongoing reforms being undertaken by the Government of India are only consolidating their positions of strength.

The primary tool for squeezing out risk in the value investing route is through purchase at prudent stock price valuations. Quality proponents also argue that squeezing out of risk is necessary, but the route taken to squeeze out risk comes from choosing companies with blemish-less balance sheets, generating returns in excess of their cost of capital and a long steady runway for incremental revenue growth. Crushing risk from these three directions reduces uncertainty and results in stock prices that rise at significantly lower volatilities than the market in general. Using stock price valuations as a tool to crush risk is anathema to quality proponents. Hence quality proponents are ready to buy quality companies at ANY price.

We do see some logic in the argument for quality. The main issue we have with investing in quality is how can we be sure that the quality is not ephemeral. Do we have the where-with-all to understand when a company no longer falls in the quality category ? Do we have the resources to access the market forces and the channels at play for these companies and take a nuanced view about temporary blips ? We admit that we have no such skills nor capabilities. There are likely to be fund managers who are much better than us in estimating and monitoring quality with a stringency that is not in our capability. The question is can we find such fund managers at a reasonable cost for our clients ? We are searching for such managers and believe that allocation of a portion of funds to such managers will help our clients generate better risk adjusted returns than having a pure value investing approach in their portfolios.