Interview Chetan Parikh

1 Dear Readers, I’m exceptionally proud and honored to present an interview with one of the top value investors of India, Mr. Chetan Parikh. This interview with Mr.Parikh represents one of the highlights of my career. Mr. Parikh is a man whom I admire and who has extensively contributed to the value investing community (via Capital Ideas Online and his numerous writings). I hope you enjoy the interview. Before we begin, I would also like to thank Mr. Prashant Patel, a loyal reader of SimoleonSense, for facilitating this interview. Thank you very much, I wish both gentleman the best of health. -Cordially, Miguel Barbosa Founder of SimoleonSense.com “Enriching Ideas for Intelligent Investors” Mr. Chetan Parikh’s Background Chetan Parikh is a Director of Jeetay Investments Private Limited, an asset management firm registered with SEBI. He holds an MBA in Finance from the Wharton School of Business and a BSc in Statistics & Economics from University of Bombay. He has been investing in the Indian capital markets through proprietary investment companies and family trusts. Chetan was rated amongst India's best investors by Business India magazine. He is also the co-promoter of capitalideasonline.com, a well regarded investment website. His writings have been published in Business Standard, Business World, The Economic Times, and Business India. He is a visiting faculty member at Jamnalal Bajaj Institute of Management Studies (University of Bombay) for the MBA course. Copyright SimoleonSense & Miguel Barbosa 2009 Opening Questions Q. There are many different approaches to investing. What led you to choose the value approach? A. Value investing is a logical, safe and disciplined approach to investing. It requires a lot of patience which fits in with my temperament. Q. Which investors do you admire? Besides these investors who else has influenced you? A. Any value investor can learn a lot from the Masters. In India I’ve listened to and learnt from Prof. Rusi Jal Taraporevala and Mr. Chandrakant Sampat.

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Q. What’s your opinion of the efficient markets hypothesis and practitioners of technical analysis? A. I believe that the efficient market hypothesis in the various avatars (strong, semistrong and weak) is not correct. Sometimes prices deviate far away from intrinsic values and it is possible to earn high risk adjusted returns. In fact, the lower the downside risk, the higher can be the upside reward. I do not know anything about technical analysis. Q. Tells us about your approach to fundamental analysis-what is your focus? How do you search for your investment ideas? Where do most of these ideas come from? Describe your evaluation process (both quantitative & qualitative)? How long do you hold on to your positions? A. My firm, Jeetay, principally invests in publicly traded Indian securities and seeks to maximize investors’ capital by buying securities trading at values materially lower than their true business value. Jeetay aims to achieve high absolute rates of return while minimizing risk of capital loss. Jeetay combines the analytical vigour of determining the fair value of a security with a deep understanding of the Indian markets. Jeetay will invest in securities where it can ascertain the reasons for the market’s mispricing and the likelihood of the mispricing being corrected. Jeetay follows the value investment philosophy, which means that the objective is to buy a security trading at a significant discount to its intrinsic value. Since the focus is on discovering undervalued stocks, the fund doesn’t base its investments on macroeconomic factors like GDP growth. Jeetay determines intrinsic value as the present value of the future cash flows of a company discounted at a rate that properly reflects the time value of the money and the risks associated with the cash flows. In other cases Jeetay invests in “Special Situations” which involve the following: • • • • •

Repositioning assets to higher uses Mergers and acquisitions / open offers Restructuring troubled companies Spin-offs Buybacks

The fund invests in a company if the market price is quoting at a discount of at least 60% to the intrinsic value. It sells when the market value approaches intrinsic value or it finds a security trading at a steeper discount to intrinsic value. Jeetay believes that while in the long term, a company is valued by its fundamentals, short term mispricing occurs due to investor psychology, liquidity and macroeconomic

3 factors. This provides opportunities for the diligent and patient investor to make outstanding risk-adjusted returns. The time horizon of Jeetay is 3-5 years. It believes that short-term market movements can be volatile and the market may recognize mispricing only in the medium to long term. Hence the emphasis is on understanding the corporate strategy and the resultant cash flows for a 3-5 year period. The probability of the markets recognizing the mispricing becomes high over the medium to long-term period. The firm does not limit its investments to certain asset classes or sectors. The fund evaluates any sector or asset class where a conservative estimate of intrinsic value is determinable with a reasonably high probability and invests if the security is available at a reasonable margin of safety. The firm does extensive research to arrive at estimates of expected cash flows, asset values and earnings. Jeetay culls information from public databases, quarterly and annual filings, annual reports, meetings with management, competitors, vendors, customers and other industry participants, industry experts, trade journals and bankers. Jeetay has extensive networks in India to get data and information for superior analysis. Jeetay believes that a disciplined private equity approach to investing that stresses on buying at a discount to intrinsic value will deliver consistent absolute above average investment returns and safeguard capital irrespective of the state of the markets. Jeetay believes that the following steps are essential to its process: 1.

Opportunity Identification. Jeetay identifies opportunities through a multitude of ways. Jeetay has numerous financial models and screens that are used to filter investment opportunities within the framework of the investment philosophy. Jeetay has many contacts and professional relationships. This gives it many opportunities consistent with the investment philosophy.

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Analysis. Jeetay does intensive financial and qualitative analysis on companies once an opportunity is identified. The analysis is mainly to arrive at whether a disparity exists or not between the traded value of the security and its intrinsic value. Jeetay has substantial experience in determining the intrinsic value of a company across sectors. Multiple valuation metrics including discounted cash flow analysis, price to earnings, dividend discount model, price to sales, price to book, comparative analysis is used to arrive at the valuation of a company. Other than financial analysis, Jeetay extensively meets every possible associate of the company to understand the opportunity better. These include vendors, customers, middle management, bankers, competitors, large stakeholders and senior management. This helps Jeetay arrive at a closer intrinsic value and also exit an investment if unfavourable events arise or the team’s original calculation of intrinsic value was wrong.

4 The analysis would focus on the 3B’s, – Understanding the business, analyzing the balance sheet and looking for bargains. Take each in turn 1. Business: What is the nature of the business and its competitive strengths and weaknesses? What is the competitive ecological niche that it occupies and how protected are its profits from predators there? What are the nature of the entry barriers or ‘moats’ - , intangible assets, switching costs, network effects, cost advantages? How wide and deep are the moats? Does the business cover its cost of capital? A qualitative assessment of the business should be made to understand whether it is a superior or inferior business. Evidence of pricing power or the ability to lower cost of production and distribution should be searched for. 2. Balance Sheet: In order of importance is the balance sheet, the cash flow statement and the profit and loss account. 3. Bargains: One need not to be able to determine value exactly to know whether a stock is cheap or not. As Ben Graham wrote “To use a homely smile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his weight.” A discount to value, a ‘margin of safety’ is paramount, without which an investor is relying on the whims of “Mr. Market” for his investment return. Q.. As a follow up question, how do you determine intrinsic value? A. The textbook definition of Intrinsic Value is the present value of the future cash flows discounted at a rate that realistically reflects the time value of money, risk and volatility of the cash flows. The problem is that it is difficult to 1. determine the future free cash flows 2. determine the discount rate 3. determine the terminal value There are very few companies, i.e. those that are franchises earning well over their cost of capital and growing whose intrinsic value can be calculated using the Dcf approach. Ben Graham’s methods of bargain identification is useful in other cases. You don’t have to calculate intrinsic value with precision (especially where it is not possible) to know whether a stock is cheap in seldom to its value or not. Q. Do you invest in foreign companies? If so, do you evaluate foreign companies different than those based in India and how do you hedge currency exposure(s)?

5 A. Have not invested in foreign companies as of yet. Sitting in India, I would have to invest in the large cap stocks in foreign markets, and have not as yet found large caps in USA to be cheap in relation to my investing universe in India. Whilst markets may change, valuation principles are universal-they are the same whether it’s the USA or India. Q. How many stocks do you typically hold in your portfolio? A. In my family portfolio, given the time horizon and tax considerations, there is a heavy concentration on a few stocks that have franchise value and entry barriers. There are smaller positions, but the bulk of the portfolio is in a handful of stocks. In the managed accounts, price in relation to value is of paramount importance and many of the businesses are clearly not franchises. The portfolio thus in the managed accounts tends to be more diversified with roughly around 18-25 positions. Cash is carried at all times in the managed portfolios, the level directly correlated with the valuation of the broad market.

Q. Do you invest in any fixed income? If so, tell us about the role of fixed income investments in your portfolio. A. I do not normally invest in fixed income securities. Cash is usually a default position and varies directly with the level of the market. The cash is usually kept in the bank or in money market funds. I do not like to take a credit risk with money that I know will eventually be opportunistically deployed in the stock markets. The key is to be able to sit on your low-yielding cash without losing your patience. Q. . How do you judge a company’s management? A. There are three ways of looking at management 1. their integrity 2. their competence – both operational and in capital allocation 3. their corporate governance In the end you want to deal with people who do not make your stomach churn. Integrity and competence are both necessary in top management. Finally there is the factor of the passion to improve the game by never becoming complacent. Sometimes a good price can cover a multitude of sins, including poor management. But if I had to hold a non-franchise investment for any length of time, management would certainly be an important factor. In many cases, it is the jockey, not the horse that one should bet on. Q. What makes you sell an investment? A. I sell when

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1. My original thesis was wrong 2. Price is reached 3. A better option comes along Ben Graham’s criterion should be kept in mind. Switch for 1. Increased security 2. Larger yield 3. Greater chance for profit 4. Better marketability Q. How do you look at risk? A. Risk is very subjective. Academic theory has one definition of risk namely standard deviation which is wrong. Actually, if one had to use statistical distributions to measure risk, then there are three dimensions, Variance, Skewness & Kurtosis. I do not think however that risk can only be captured by statistical measures. To me, risk is simply the chance of permanent loss of capital and an investors’ job is to eliminate that risk. He may not be able to do so for individual securities, even with a margin of safety, but he has to do it in a portfolio context. Q. What’s your take on leverage? A. Leverage is one of the two things that can cause a permanent loss of capital to a value investor. Avoid it, unless you are willing to take a risk of a permanent loss to your capital. The other thing that can cause a permanent loss of capital is holding on to overvalued stocks, but I assume that a value investor would not do that. I always carry cash for optionality, rather than borrow against my holdings should the opportunity arise. Q. Do you invest in commodities, gold, real estate, etc? If so what has been your experience with these classes? A. I have legacy investments in real estate. I view it as an inflation hedge and a different asset class in the portfolio. Currently I have investments in gold as a hedge against a highly likely decline in the value of the dollar and a meltdown in financial assets. The economic problems in US are severe and the wrong treatment is being given. When fiscal and monetary insanity prevails, gold always reigns supreme. I’m not making a directional bet on gold prices – it is only a hedge against my financial investments. Q. Tell us a little more about your involvement with special situations?

7 A. It depends on the definition of “special situations”. If special situations means a value stock with identifiable catalysts like change in management, operational and financing restructuring, buybacks, mergers and acquisitions etc, then we certainly do invest in special situations. We have investments in spin offs and in open offers as a result of takeovers. Q. Have you ever taken the role as an activist investor, would you ever do so? A. I’ve never wanted to take a confrontational attitude with management although sometimes I’m forced to. If I’m not happy with their policies, I sell - but my aim is to influence management through logic and rationality, not through financial blackmail. There is a grey area however. I’ve been connected with the press through my columns in various newspapers and magazines and I’ve written about instances of corporate misgovernance there. But I’ve never threatened management. I do not have the temperament to fight management or for that matter, anybody. I believe in exiting relationships where there is no mutual respect, rather than slugging it out for dominance. Q. We understand that you are very focused on bottom up value investing-what has the financial crisis taught you? A. I wrote this piece awhile ago and it would be related to the question above. It may be interesting to use a cross-disciplinary approach to the problems and mistakes made by banks in the sub-prime market. The power of rewards that leads to repeated actions and the flawed compensation structure that led to misaligned incentives could be one mental model. As Raghuram Rajan pointed out in Financial Times (Jan 9, 2008), the compensation practices in the financial sector are deeply flawed. The compensation is based on the so-called ‘alpha’ that a manager of financial asset generates. There are three sources of ‘alpha’: 1) Truly special abilities in identifying undervalued assets (eg. Warren Buffett) 2) Activism – using financial resources to create, or obtain control over, real assets and to use the control to change the payout obtained on the financial investment. 3) Financial engineering – financial innovation or creating securities that appeal to particular investors. Many managers create ‘fake alpha’ i.e. they appear to create excess returns but are taking on ‘tail’ risks which produce a steady return most of the time as compensation for the very rare, very negative returns (‘black swans’). The AAA rated CDOs generated higher returns than similar AAA rated bonds. The ‘tail risk’, so evident in hindsight, of the CDO

8 defaulting was not as small as perceived and so the excess return was compensation for that. The credit rating agencies that rated these securities as AAA because of their ‘insured’ status were themselves wrongly incentivized (compensated by the issuers of the securities). Furthermore once their peers started issuing AAA ratings, ‘social proof’ came into play and the ratings war as to who assigned the highest ratings for junk became a classic Prisoners’ Dilemma. The managers themselves seem to have been suffering from 1) self-serving bias (i.e. an overly positive view of their own abilities and an overly over-optimistic view of the future) 2) self-deception and denial for they seem to have indulged in collective wishful thinking 3) bias from consistency tendency (they must have looked for evidence that confirmed their optimistic beliefs and kept on being consistent to their original ideas even when problems surfaced) leading to 4) status quo bias or the do-nothing syndrome 5) impatience in valuing the present more highly than the future again caused by incentives that made them so myopic 6) bias from envy from managers who were making large returns with apparently no extra risk which led to 7) distortion by contrast comparison because the steady escalation of commitments must have seemed incrementally small caused by 8) anchoring to what seemed like small relative numbers 9) social proof which led to imitating the behavior of their peers 10) bias from over-influence by authority in that the CEOs of the banks that have suffered the most seem to have been run by people who did not have a ‘trading’ or ‘market’ background and they were swayed by the ‘experts’ they were overseeing which led them to 11) sensemaking in that they were too quick to draw conclusions and may have become 12) reason-respecting in that they complied with requests from their subordinates merely because they had been given some reason leading to 13) a do-something syndrome all caused by 14) mental confusion from stress. Competition for business must have led to the ‘winner’s curse’ i.e. overestimating the value of the securities and overestimating predictive ability. Collectively they did not foresee that their actions had adverse systemic consequences and the implications to their balance sheets if things went wrong (falling housing market, soft economy, bankrupt insurers). They failed to consider the increasing instability due to their actions caused a phase change as a tipping-point was reached and that a system is only as strong as its weakest link. In factoring the odds, the managers seemed to have underestimated risk exposure where the frequency and magnitude of consequences was unknown because of the novelty of the securities. They seem to have underestimated the number of possible outcomes for the unwanted events currently being witnessed. They certainly do not seem to have correctly calculated expected values or else they would not be in the hole they are currently in. They in fact did not consider the consequences of being wrong. They probably worked in an ‘illusion of control’ over what were probabilistic events and thus did not factor in a ‘margin of safety’. In the limited history of the securities, the managers overestimated the evidence from the small sample of data.

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From an anthropological viewpoint that was commented on by Gillian Tett in Financial Times, one should look at the political structures of the survivors. CEOs of the relatively unscathed banks ‘tended to be meddlers – very hands on’. They had a direct career experience in trading and managing market risk. Thus the mind-set was different from being a lawyer or a salesman. Furthermore, the losers had more hierarchical structures in which the different ‘business lines have existed like warring tribes, answerable only to the chief. Moreover the most profitable tribe has inevitably wielded the most power – and thus was untouchable and inscrutable to everyone else.’ This is proving to be a game of chicken between the regulators and the players (banks and monoline insurers). In a classic game of chicken, two cars drive towards each other. The first driver who turns loses. Of course, if neither car swerves then there is a crash. The best outcome for each player results when he goes straight whilst his opponent turns. Insane players have a massive edge in a game of chicken. At this point of time, the jury is out given the level of insanity in the system. Q. . How have you evolved as an investor? A. I guess the process of evolution is never over. I started out knowing nothing but efficient markets and so the leap to value investing was a big one. I know I’ll never leap out of value investing, but the nuances may undergo changes, as also my ability to widen and deepen my circle of competence. Q. What is the most interesting part of your job? A. It is searching for investment ideas, working out the odds and reading from a wide variety of sources.

Q. Which books would you recommend? Here are a few, but they are by no means exhaustive. 1. 2. 3. 4. 5. 6. 7.

Everything by Jared Diamond Everything by Garett Hardin “The Road to Serfdom” - Friedrich Hayek “The Prophet of Innovation” “More than your know” - Michael Mauboussin “The Robot's Rebellion” “The mind of the market” - Michael Shermer

Try to read all of Mr. Munger’s book recommendations and also the books in Mr. Peter Bevelin’s Bibliography in “Seeking Wisdom: From Darwin to Munger”. I do not think that I’ll be able to read all the books that have been recommended in my life time but I’m going to give it a shot.

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Q. What is the biggest mistake keeping investors from reaching their goals? How have you guarded yourself against this folly? A. Greed, fear, sloth and envy are the four emotions that are positively inimical to becoming a better investor. Meditation, detachment from results, but attachment to efforts, yoga, discipline in living and thinking are some of the ways for self-improvement in investing. One must also have an open mind to new ideas and try to become in the words of Mr. Munger “a learning machine.” Q. What should investors understand before investing in India? A. Indian markets are very volatile, so be very careful on entry prices. “Growth” is a seductive term and stories woven about growth even more seductive, but be very careful of paying too much for it. Homework matters. Liquidity can dry up, so be clear whether you can live with relatively illiquid positions. Closing Questions Q. If you could do anything besides allocating capital what would you do? A. I would teach and write more often than I do. Q. What message/advice would you give to readers of SimoleonSense? A. Read a lot, be disciplined, be humble about your knowledge and stay within your circle of competence. Q. What does the future hold for you, your funds, and website? Are you going to do this forever? A. As long as I can, mentally and physically.

Miguel Barbosa: Mr. Parikh thank you for taking the time to interview with us. For more information on Chetan Parikh visit the following:

Home Page: Capital Ideas Online Latest Articles: 1. 2. 3. 4.

Debt deluge Animal spirits and expectations Endless Desires Alleviating Investment Risk

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Economics Of Population

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