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Arun Malhotra fund manager of CapGrow Capital is among the few fund managers who deploys every stroke in the book to generate better than market returns


Shishir Asthana

Every fund manager has his own technique of picking up stocks. Some are value investors in the style of Warren Buffett while some go for growth stocks. Others would look for turn-around stories and some are what one may call vulture investors, looking for companies that are all but dead.

All approaches of fund management lead to wealth creation, provided the fund manager continues with the same process and does not jump from one style to another from fear of underperformance. A good fund manager is one who does not stray from his investing style irrespective of the euphoria or chaos around him. But there are some who in cricketing parlance can be called all-rounders, who are good under any circumstance.

Arun Malhotra, founder and managing partner of CapGrow Capital, a Mumbai based PMS, uses all styles of investing and has been doing a good job of it. A hedge fund manager in his earlier avatar, Malhotra had been taught by the best in distressed investing, which he continues to use as a strategy to picking stocks along with investing in growth and deep value stocks.

Here is Arun Malhotra’s journey in the market and his investment style as told to Shishir Asthana.

What has been your journey till date and how did CapGrow start?

I graduated in mechanical engineering in the early 1990s and was always passionate about finance and equity markets. I used to skip college and attend AGMs that were held in Delhi. The key trigger was my Kotak Mahindra Bank IPO allotment--- my investment of Rs 4500 became Rs 160,000 within 45 days! That is when I understood the power of leverage in capital markets, the opportunity to create wealth.
I started with a stockbroking firm BLB Limited as an equity research analyst. Those were my early days in the stock market where the seeds of investing, the seeds of wealth creation, the insight into what to look for in a company were born. In 2001, I did my MBA from Simon Business School, the U.S and those were the best two years of my life in terms of learning with the greatest minds in finance. After MBA, I worked in the U.S for 2 years on the buy-side and came back to join US hedge fund Alden Global, promoted by Randal Smith, a pioneer in distressed investing. We were managing funds close to $300 million in Indian equities and convertible bonds. Post-2013, I was acting as a consultant to a European investment bank and managing my own money in listed equities. Based on the performance of the portfolio, I was approached by close friends and family to invest their money. This is when I decided to take a SEBI PMS license and CapGrow was born in Oct 2018 and in the last 12 months, despite markets being very turbulent, we have done reasonably well.

What was your investment strategy during your long tenure in hedge funds?

Our focus was on growth investing and deep value stocks. The 2008 crisis definitely taught us that Indian small and mid-cap stocks had lots of risks. The risk of corporate governance, the risk of fundamentals and the risk of liquidity, all played together. The crisis provided a lifetime opportunity as in some of the stocks where we were comfortable owning the equity, the bonds were giving us 40-50% dollar returns if held till maturity. The switch happened and in a couple of bonds we had blocking positions i.e. we were holding more than 26% and were involved in the restructuring of those bonds.

Till 2008 we were 90% in equity, out of that 50-55% in large caps and 40% mid-caps. Post-2008, we were 40-50% in bonds, 20-30% in special situations and 10-12% in pure equity. Convertible trades were the most profitable considering the risk-reward ratio.

Even in CapGrow we are running two strategies-one is Growth and the other is Special Situations Strategy. Special situations are a form of alternative investments that involve corporate actions or events and are not correlated to the market. Examples are mergers and demergers, spinoffs, tender offers, delistings, distress securities, capital restructurings, broken IPOs etc.

For example, we invested in a company where cash (including investments) was more than the market cap. The buyback happened at a much higher price and also the company declared a dividend yielding 25% return in 6 months.

There are only a few mutual funds and schemes that invest in such alternative strategies.

We do get hit in terms of timeline or situations where the thesis does not go as per our initial thought process. The Arvind demerger is a recent case where we lost money. Arvind had a lot of franchises and brands at their peak and now they are removing the brands that are not giving profits, leading to one- time costs and deteriorating financials.

We have 85% in growth strategy and ~15% is in Special Situation. This allocation the client has to decide. Lot of other PMSs hold non-special situation stocks in their special situations portfolios. We don’t deviate from our strategy. However, we provide clients with the flexibility to move between the two strategies.

What was the approach towards picking up a convertible bond and what was the approach towards buying equity during your hedge fund days?

We were in the business of exploiting the mispricing in both equity and bonds. I believe that you are betting on the guy, basically the Management. Hence, we should be comfortable with the management philosophy and corporate governance. Also, we should be comfortable with the fundamentals, the growth strategy, the balance sheet, the cash flow generation, the industry structure and the capital efficiency. For both straight and convertible bonds, we would look at the fundamentals, the credit metrics and how we are stacked in the capital structure and the liquidation value of the company in the worst-case scenario.

How would you look at ROE at different stages of the growth cycle? How would you pick stocks?

Our expertise lies in two investing themes- one is identifying high growth companies at an early stage and the other is distressed and special situations. We look at normalized earnings across economic cycles but are very sensitive to capital efficiency and the balance sheet strength. For example, in the past, I caught the sugar cycle right and made tons of money. In the down cycle, we ignore the ROE/ROCE and look at normalized earnings. But when we buy growth stocks, we are focused on the sustainable earnings with capital efficiency, the key growth drivers, the opportunity size and the management.

We don’t want growth at the cost of lower capital efficiency or a worsening balance sheet.

We would wait till the cycle recovers as the returns are enormous. Interestingly, the worst-performing stock gave a return of 3 times while the best stock gave a return of 40 times (Dwarikesh Sugar went from Rs.24 to Rs.800/-). Similarly, we recently invested in a telecom stock based on the same premise as the sector dynamics were reflecting a distress situation with high unsustainable debts and low equity valuations.

You are one of the few fund managers who would love investing in commodities?

We love distressed and deep value securities to generate alpha for us. The economic cycle offers tremendous opportunities to invest in companies with distressed valuations in commodities, while the company itself may be doing well. In commodities, we stay with the most efficient producer. We look at the one with the lowest cost of production.

As you mentioned, a major part of investing is dependent on the promoter and on corporate governance. How does a retail investor read the management?

There are a few indicators – the dividend-paying policy and capital allocation strategy, the insider buys and sells, the acquisitions and the price paid for them, the related party transactions and also the extent of management remuneration in relation to the profits. Just a glance through the annual report will provide all the answers.

Where does the concept of valuation stand while selecting stocks?

There exists a “scarcity premium” in the Indian equity markets. A few stocks have reached astronomical valuations because everyone is chasing the same set of comfort stocks, stocks that have good corporate governance and high growth characteristics. We do have high growth companies trading at the upper end of valuations in our portfolio but we are more comfortable with value buys and distressed valuations. We consider market Volatility as our best friend as it provides an opportunity to buy our favourite stocks at reasonable valuations.

What other aspects do you look at in investing? Do you run screeners for selecting a company?

We are a big believer in behavioural finance. We keep on collecting information, attending management meets, attending conference calls and analysing what the management is doing, their body language and their strategy. We as analysts are not mere reporters. We are interested in why things happen and what will be their impact. We also run 8-10 different screeners and we keep on doing that every 6-8 weeks depending on market volatility to identify new stocks that fit our investment criteria.
We don’t like unrelated diversification. Our experience also says people who chase growth through acquisition and unrelated diversifications ultimately destroy shareholder wealth. We need focused players, otherwise, most of the concerns are about organic and inorganic growth, confusing the analysts. We like simple businesses with simple economic models.

How much weight do you give to what the management is saying? Do you think they talk in an unbiased way?

The bias exists but the track record reveals a bigger story. The direction the company is going is more important to us. Our investment thesis remains intact as long as the company’s business remains on track to achieve our projections, barring a few delays due to unforeseen circumstances. But we closely watch their moves.

How do you invest? If you like a company do you go all in?

I would say we would take 50-60% of position on day 1 and then we build up our position in a staggered way.

In a falling market when do you know where the bottom is?

Our thesis is when the price comes down, we again revisit our assumptions and investment thesis and how has that changed in the current scenario. If nothing has changed, we would increase our allocation. There is no stop-loss strategy as such, but if the thesis has gone wrong for some reason, we would exit irrespective of the price. We also avoid scandal stocks and invest in clean management and clean balance sheets.

Auditors and internal processes are other factors that we closely look at. We actually rejected a company as the books were audited by a small audit firm in Delhi. We also look at ESOPs policy and how the senior management/ employees are treated. The contingent liabilities are also relevant. We also look at the payout policy of the company.

When do you decide to add in stocks that are doing well?

So a lot of times it is inverted triangle or a straight triangle. We normally buy 50-60% in the first tranche and as our thesis goes on improving we will keep on adding. We believe sizing up a position is the key. We normally try to keep around 25 stocks in our PMS portfolio. We don’t trade. We have an investment philosophy where we will sell the weakest stock in our portfolio and the prevailing price or the cost has no relevance for us. Wherever we feel fundamentals are weakening, we will exit it irrespective of the price going up or down. If a stock does very well, we adjust the size and reduce to normalize the weightage back to 10% levels. I think there is limited money available. Our single strength is asset allocation. Moving between cash and equity, moving between large cap to mid-caps at different points in the cycle is key to alpha generation. So if we have HDFC Bank and it exceeds a particular valuation and we feel divergence between the mid cap and large caps is huge and the probability of a mid-cap rally is high, we would trim our large cap positions and move some money to mid-caps.

Do you have worksheets and projections?

We do have projections, but I feel the historic track record is more important for us and how those numbers that we are projecting can come about in the future. The key thing is to get a handle on where the growth is coming from. How is the company making money? What is the economic model and how sustainable is it? We have our research process in place and each analyst should be able to explain his investment thesis for a stock on one single page to reflect clarity. We feel common sense is more important than financial knowledge.

When do you decide to sell? Is there a valuation number?

Selling is more difficult than buying. Selling could happen for a couple of reasons – one is if our investment thesis has gone wrong or there is a corporate governance issue, or some unrelated M&A at high valuations just for the sake of growth. Lastly, selling could be because of extreme valuations. There is no definition of extreme, but we can sense where the euphoria is, just as we can sense where the distress is. The two extreme points we can easily make out based on our experience in previous cycles. We probably won’t wait till the last 10-15 % of a rally, we would sell a little early and even while buying we won’t buy at the bottom because people who say that they bought at the bottom and sold at the top are either lucky or they are lying.

What have been your best stocks and ones that did not work? Could you share the story behind how you invested in it?

I would give you an example of a chemical company. It was available at Rs 1000 crore of market cap and gross block of Rs 600 crore and they were going to double their gross block in three years. That was one trigger. Secondly, the product which they were going to manufacture was an import substitute and we felt the management was conservative in their estimates. We built a big position there. Another stock is a retail-focused NBFC that was available at 5 P/E and 0.7 times P/B with one of the better balance sheets.
Yes, there are a few such companies. We are down in our investment in a rating company, we probably never thought that the rating agency could take such a big hit in view of the IL&FS crisis. That investment call is down 35%. I think there our understanding as to how the events will unfold has gone wrong.

Doesn’t it now qualify as a distressed stock for you? The business is good.

Yes, that’s why we haven’t sold it. We may still wait for one quarter or two to see what the direction is and how much time it will take for normalization of the business and the earnings.

What are your future plans?

I think the 1st year PMS performance has been established and the internal processes and systems are in place now. We have started marketing our PMS and are also in talks with wealth managers and distributors so as to ramp up the AUM to a reasonable size. I was a Manager to the fund have skin in the game, as I have my own capital tied in this PMS (approximately 10% of the fund is my own money). So this aligns my interest with the investors as there is no employee-owner conflict here.

Anything you would like to tell the retail investors who are coming to the market? Should they route their money individually or route it through mutual funds?

Key messages for retail investors:

Equity is the best asset class, whether it is PMS, Mutual funds or AIF.
Exit all WhatsApp groups that offer investment advice. Most of that is noise. And finally, choose your manager right and don’t look at their recent performance. Look at 3 & 5 year performances and the investment style and then invest. Also look at alternative form of assets like PMS, AIF and make sure the interest of the fund manager is aligned with the investors.

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If you don’t stay with your winner, you are not going to be able to pay for the losers.

- Jack Schwager