‘In The Real World, Risk And Return Are Not Positively Correlated’

Indian stock markets have been rising like a well-kneaded dough on steroids, or is it like an inflated balloon? Everyone seems to be trading in stocks these days, and why not. After all, traditional savings instruments are offering abysmal interest rates and people are spending hours at home with various easy-to-use, zero-brokerage trading platforms. But before being swept away by this new romance--opening a demat account and buying cheap stocks--we need to slow down and go back to the basics. Thankfully, Saurabh Mukherjea, founder and chief investment officer at Marcellus Investment Managers, has come out with a new book Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation, which can help with that. As an aside, it climbed to the bestseller rank within hours of its release.

In this email interaction with Outlook Business, Mukherjea shares what are the mistakes Indian investors routinely make and a few helpful tips on how to pick the ‘diamonds’. He adds a word of caution about the unicorn mania too.

According to you, what is the philosophy that guides personal investment in India? What should it change to?

Most Indian families have a tendency to invest heavily in physical assets such as gold and real estate. In fact, the Reserve Bank of India says that 95% of household wealth is in such assets. Unfortunately, these physical assets are not able to create real wealth, that is, they are not able to compound faster than inflation. In our new book Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation, my colleagues, Rakshit Ranjan and Salil Desai, and I have shown that Indian families then exacerbate their wealth creation issues by lurching towards high risk financial investments such as credit risk funds. In the book, we lay out a middle path which can lead to consistent compounding for millions of Indian families. Our recipe–which arises from what we have implemented over several years for Marcellus’ Consistent Compounder Portfolio–is to look for clean companies which have strong competitive advantages alongside rational capital allocation. This method of investing is elaborated upon in our new book and we have seen that it has allowed our clients to compound their wealth historically at over 20% with volatility lower than a ten-year government bond.

What are some of the biggest challenges for an Indian retail investor?

There is a lot of excitement these days about investing in the Indian stock market. Forget the newbies, even the vast majority of seasoned investors don’t understand just how difficult it is to consistently make money in the Indian stockmarket. Here are some numbers which can help you come to terms with the challenge on hand.

Although, there are over 6,000 companies listed in India, just ten companies now account for 90% of the corporate profits generated in the Indian economy and just 16 companies account for 80% of the wealth generated by the Nifty50 over the past decade. On the other hand, not only have 50% of the index constituents from ten years ago faded into obscurity, a mere 15% of the stocks listed in the BSE500 a decade ago have delivered returns above the cost of capital (that is, 15%). As a result, generating consistent returns from the Indian stock market is much harder than investors–even professional investors–understand it to be. Our new book lays out a method which investors can use to swing the odds of making money firmly in their favour.

It has become incredibly easy to participate in stock markets, with platforms such as Robinhood. What is the good and what is the bad you see coming from this trend?

The RBI has said that the present skew of household assets in India (95% physical and only 5% financial) is neither desirable nor sustainable. So any medium, any method which encourages the financialisation of household assets should be encouraged. However, alongside bringing in a new generation of investors into the stockmarket, we as a country need to provide these investors with the right tools and with investment knowledge so that they can invest sensibly and compound their wealth steadily. Without such tools and such knowledge, the stock market can be a dangerous place for novice investors.

What are the essential tools for a first-time investor, other than buying your books? How familiar should she be with accounting as a language?

When you visit a new country, say Japan, it helps to know the language of that country (Japanese in this case). Whilst you can get by in Japan without knowing Japanese, you will get more out of your trip to Japan if you know the language. You will appreciate their sophisticated culture, their people and their food better if you know the local tongue. Similarly with investing–you can get by without knowing accounting but if you want to consistently compound your wealth without taking high risk, it is essential to understand how financial statements work. Our book will give you a checklist of things to look for when you are reading a company’s annual report. There are now many low-cost, high-quality online courses which will teach you the basics of accounting and show you how to read financial statements.

Why do you think capital-asset pricing model (CAPM) is still in favour that Indian investors refused to give up the belief that higher the risk, greater the reward?

Honestly, I don’t know too many people in India or abroad who use CAPM. CAPM is now used largely by academics and in business schools. It is little or no relevance in the real world because in the real world, risk and return are NOT positively correlated. In fact, as we demonstrate in Chapter 1 of Diamonds in the Dust, in India lower risk taking leads to higher returns.

While explaining profit risk, you seem to suggest that innovation is not adequately rewarded in India, where imitators spring up fast and by the dozen. In that context, what is your opinion about the euphoria around unicorns? Do you think they are too highly valued with low barrier to entry?

What works in the West in terms of barriers to entry often does not work in India and vice versa. We have provided in the book several case studies of Indian companies in which we have invested--such as Asian Paints – whose competitive advantages are centered on technology. And yet the same construct that has worked for Asian Paints in India is unlikely to be work for a Western paint company.

Similarly, Infoedge has built a dominant franchise in employment classifieds called Naukri.com. The moats around this business are so strong that over the past 20 years no Western entrant has been able to successfully compete with Naukri.com.

What worries us about a lot of the unicorns is that they are taking Western business models and applying them to India without understanding how barriers to entry in India differ from those in the Western world.

What in your opinion is good investment in R&D in the Indian context?

Several of companies profiled in Diamonds in the Dust have built their moats around consistent investment in R&D. Firms which invest 1.5% or more of revenues consistently in R&D and have well educated, technocratic promoters tend to be rare in India. We have a research process in Marcellus that allows our analysts to identify such franchises and then our fund managers build large positions in such franchises.

What is the one stock market trend Indian investors should keep away from and why?

I always worry when I see investors keenly following the news. That’s a good habit in schoolchildren because it allows them to build mental models about how the world functions. But being a keen follow of the daily news is a damaging habit for an investor because it predisposes him to make short term decisions and trade too much.

Metal, IT and realty stocks are doing well. What are the key things to watch out for in their financial statements and notes to accounts, and what are the key ratios to consider?

As we have explained in the chapters on forensic accounting in Diamonds in the Dust, regardless of which sector you are looking at there is a common set of ratios that will help an investor identify whether the promoter is doing naughty things with the accounts. For example, if over the course of six to seven years, you see that a company’s auditor’s compensation is growing faster than the firm’s revenues, that should make you worry about the company.

What do you say to critics who say that you have seen the stock market only when it is flush with money, and therefore to you no price seems too high to pay for a good company? When the markets begin to contract, what is your strategy to protect against the downside?

We began investing professionally at a time when there was no bull market. In our first year we saw DHFL, IL&FS and Yest Bank get into trouble. Then a year later we say the Jan-March 2020 COVID-19 meltdown. Through all of this we compounded our clients’ monies at around 20%. What helped us was the simple investment process we follow: look for clean companies which have strong competitive advantages alongside rational capital allocation. The same strategy that delivers upside is the strategy which protects us on the downside.