Shuchi Nahar's Weekend Blog!

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Art of Investing by - Sajal Kapoor

June 20, 2020

Art of investing by - Sajal Kapoor

SHUCHI.P.NAHAR

Background

Sajal Kapoor is into operational risk and regulatory compliance industry and within that
industry he has been working across domains from banking to healthcare to investment forms.

Over the last 20- 25 years and that has been highly rewarding and productive because,
a. That gave him the opportunity to look at the world from a risk and compliance point of
view.
b. Experience that he got from the industry ,experience working through banks and
healthcare firms, consultancies and investment firms gave him a sort of a different
perspective and somewhere in the background starting around mid 90s this hunger and
drive to know more about this animal called mr. market and that started emerging.
c. It has been a very long and rewarding journey it has had its own sort of ups and downs
like any investor goes through and but those ups and downs are like the tuition fee that
you pay and you get to get yourself up and running and so after some initial hiccups and
there was an IPO boom going on in mid nineties some money was lost of experience and
he is always hunting for that unknown , unseen undiscovered and potentially
undervalued business somewhere and that's being his journey.

Sajal kapoor has also tried and restrict himself to the pockets where he has got some sort of
inherent advantage. So he restricts himself to 3-4 sectors only and that kills the 80% of the
universe. He will not even consider looking at that and by so its his professional and investing
passion combined together that gave him a lot of unseen perspectives.

Investing Framework- Seven Core Pillars

All seven pillars are important. Emphasizing one over the other will not justify the essence of
the investing framework.
One important lesson for all we need is to keep learning , keep evolving and and this is not done
instantly , any imagination or sort of a rigid framework will keep evolving and as you go along.
Investing as we know is all about continuous learning so the moment you stop learning you'll
start crashing.

1. Circle of Competence
2. Management
3. Industry structure
4. Business economics

5. Psychology
6. Narrative and Numbers
7. Cycle and valuations

1. Circle of Competence

Over a period of time after losing money in certain sectors and gaining disproportionately and
some of the other sectors coupled with his sort of professional career and background he
understood that it's very important to stick to your circle of competence.

As Warren Buffet says it doesn't matter how big your circle of competence is as long as you
know the boundaries and that's fine and the whole benefit of staying inside the circle of
competence is that you don't have to be better than and everyone everywhere right and so you
just aim to win in the league in which you play.

And the league in which sajal kapoor play is all about sustainable long-term compounding
businesses the pharmaceuticals be chemicals he has played some autos as well these are the
four key pockets.

He has played over the years and and as I call them that circle of components is tend amount
to circle of luck so the more you shrink your circle and the greater your luck quotient goes up
the other thing is that it's easy to learn from your mistakes.

So if you are playing within a restricted sort of COC and mistakes will tend to happen mistakes
as sajal kapoor says he has made mistakes in pharmaceuticals , made mistakes in FMCG and he
has made mistakes even in my very small tiny circle.

But you will find it easier to to learn from those mistakes because you know the boundaries of
yours and of your circle of competence and there was a tweet that he did last year from Joel and
that said that “choosing individual stocks without any idea of what you are looking for is like
running through a dynamite factory with a burning match. you may live but you are still an
idiot” because you don't know what you don't know and that's that's the reason and defining a
circle of competence is important.

Basic General guidance to new entrants

Quest : If someone who wants to invest in equity, how do one realize or identify stocks around
the
the
circle of competence say for example , If someone is into the business of chemicals so how do
someone identify the circle of competence with less background in investing ?
Ans: So if you are in the chemical industry you have an inherent advantage you understand the
supply chain dynamics you can talk to your suppliers you talk to your business partners so you
know the end-to-end chain and the trade channel and so on .
That is giving you some edge but investing is slightly different so you have the domain
knowledge but then what is suggested is such a person should start attending AGM and start
attending con calls.

Start reading the the controls of not only the companies that you want to invest into but as
many as possible within that sector and try and connect your thoughts in terms of where the
puck will likely be not where it is today you don't make money from historic earnings market
rewards the the future potential or the Delta relative to the valuation.

So you need to understand where the puck will likely be and for that you need to unfortunately
do some hard work and go through the Con calls go through the annual reports, AGM and if
you're not confident there is no shame in investing through mutual funds to begin with and
have your own logbook of your learning and then take notes through these channels.

The importance of reading as many con calls as you can and the reading over the years annual
report is of great importance but this whole journey may take some time right it's not going to
happen tomorrow and in then meanwhile not to miss out the compounding opportunity you
can start investing through a good mutual fund.

2. Management

Second important pillar in my framework is management and and and you cannot get this
pillar wrong because anything multiplied by a zero as raamdeo agrawal says quite often is zero
and many people have said so so the the management is the allocator of the capital is and it's
the agent and the managing our business and you can't get that wrong.

So having a skin in the game : is important so management should have some material
ownership of the business and typically sajal kapoor says he go for nothing less than 30% in the
Indian context but he may prefer less globally , so if it's a well diversified large business like a
Lanza or the GSK or a Unilever he don't care because they're professional managed managers.
He won't care about the promoter stay because the promoter is usually a sleeping entity in
those businesses but talking more from an Indian context he thinks 30% is the sort of the
threshold the minimum threshold that he has used and usually comfortable.

Walking the talk by this he means management could talk the talk in an endless manner but
if they are not actually implementing and not following it up with some concrete action or
ground then that that doesn't make sense.

How to validate? Sajal kapoor suggest going through the con calls or past annual reports and
where they show an example further down and you need to go back go back five ten years look
up the annual reports and if the con concalls , just randomly picks up and try and connect the
dots that you know what the management was telling say in 2010 or 2015 and how much of that
has actually transformed into an implementation and action in terms of taking the business
forward .
So that's another critical point and also how do they react to stock movements if the stock price
is correcting how do they react , if the stock price is rising how do they how do they behave and
some see that on the annual report they say their market capitalization has gone up by some
percent or in the next five years they want to be at a certain market cap as the management.

So be wary of them , management cannot control that. It's not within their sort of powers they
cannot control the external environment they don't control the cycle, they can just control
their balance sheet.

So if management is quoting some sort of growth its an important sort of red indicator if the
management is talking about a more interested in a stock price and also listen to their
interviews and see how they interact with the with the stakeholders how they answer queries on
the con calls and what's been there a capital allocation track record you get it from the ROCE
and that type of thing any known integrity issues of fraud just do googling talk to people and
you will get some sense there and lastly what about their strategy, is the strategy been
consistent or not?

Let's take example of Biocon , Kiran Majumdar she is active on all social platforms and people
find it inappropriate but her goal is to develop blockbuster molecule , ones that could benefit
masses so it's all about affordable innovation and look at the scale of that the business has done
right from 50 crore to 318 million in revenues to it's 55 billion rupees and plus in 20 years so a
huge scale up has happened and the chatter and the noise was very negative all throughout but
that's where you need to sort of differentiate between the noise versus the voice.

3. Industry structure

Next sort of pillar the third pillar which is the industry structure and the devil is always in
in the detail so if you read a good book from pat dorsey there is one also a little book that builds
wealth and I remember there was a quote along the lines that moats are always absolute and
not relative .

On this company in an instruction effective industry could well be better having a wider mode
relative to the best company in a brutally competitive industry like a commodity so that quote
from little book that builds wealth it's a great book I would encourage but superficially when
you look at the industry structure you may think that it's all about the Porter's five forces.

our suppliers, the threat of substitutes and so on but it's much more deeper and wider than
that because there are geopolitical pressures , there are regulatory aspects especially in the
industries where sajal kapoor invest , like in the chemicals and pharma.

Pharma sector directly is an umbrella industry in itself because you can look at the generics
and that will be a completely different from api's and then you've got biologics, biosimilars ,
innovators these small big innovators, virtual biotechs and each of these is a sort of a mini
industry in its own.

Because the the five forces and the industry dynamics are very different and so there is no such
thing as a pharmaceutical industry , that's the myth there are ten different sort of industries
within that umbrella and you got to have a very clear understanding of the the dynamics play
out because the dynamics are very different across generics and the innovator even the custom
 y y g
synthesis the the content development and CDM or crams as we sometimes each of these sort of
components are very different in terms of the industry structure and when the industry
structure turns from negative to positive you make money.

Chemical industry structure was in 2012 because China started withdrawing and the whole
structure and something similar happened with the cement industry 20- 25 years ago cement
industry today is very stable it wasn't like that in the mid 90s . If you want to trade a stock you
have to analyze this stock you know the technicals the head and shoulders and whatnot the cup
and fill them all your cycle but if you want to invest you have to analyze the industry structure

and the underlying business and then so that's a very fundamental third pillar in my in my
framework.

4. Business Economics

Fourth pillar that is all about these sort of business economics and all as Charlie Munger says
that almost all good businesses they engage in pain today and gain tomorrow so you need to
invest in capabilities and capacities up front and the cash will come at at a later point in time
and and this cycle is different for every business.

So the example of a pharmaceutical business if you are setting up a cream-filled facility it's a
four to five year gestation period assuming that you are targeting the regulated market the
unregulated markets maybe two to three years but no less than that so the capital allocation will
not be known tomorrow so if you're putting up a greenfield facility and you want to make
complex api's or injectables or the highly regulated markets of Japan and and yes it's a five year
game approximately and at the end of that when the cash is starts and coming out you would
figure out whether the management was right in calling that out.

Understanding the economics of the industry they saw what was happening in the world and
implementing upfront in their own companies. Example to go for the backward integration and
this is all the size of the opportunity and the other important dynamics in this business
economist is the entry barriers because of the opportunity is huge but there are no entry
barriers as so for solar industry for the economics of the business will get killed no one would
make money you need to worry about the the entry barriers and of course the capital efficiency
which is and of course how clean is the balance sheet, because the quality of the business is easy
to quantify you look at the balance sheet in a down-cycle at the bottom of this we look at the
cash flows.

5. Psychology

The psychology of the market as well as your own psychology, what kind of investor you are,
what are your goals, what are your aims, what are your objectives and you need to align the two
so the first thing is to try and understand yourself .

Then decodes that investing lies at the intersection of economics and psychology and the place
where the net present value means freedom and greed and fear and everyone is doing this DCF
analysis and all the rest of it but these are all about under evaluation over valuation and and the
psychology of the market participants from immense fear to extreme euphoria they will keep
repeating and if you understand the psychology.
If you understand the business if you understand the domain in which you are playing inside a
circle of competence you can have a reasonable estimate not an accurate estimate reasonable ,
estimate of the the likely value of that and if the market is giving you in a good opportunity to
buy and you move because if you see that this is a significant discount because of the market
and excelling or whatever and if there is an extreme euphoria

6. Narrative and Numbers

a. Narrative must be seen in numbers ( over the period )

b. CFO has to compound overtime
c. Market value= NPV of future cash streams

Narrative and Numbers and this is something that has evolved in recent years and that the
narrative has to match the numbers The numbers have to match the narrative one without the
other is not game.

Mostly in pharmaceutical business ratios like CFO/EBITDA not less than 0.6 or we can track
enterprise value or operating cash flows , ROE or ROCE , WACC, CFO or FCF , EV TO CASH
SALES.

Don't invest or liquidate .

Look at the enterprise value you look at the operating profits you look at the cash flows and you
look at for a better ratio so typically in anything less than 0.6 for CFO to EBITDA is a red flag.
Some companies so jubilant Life Sciences for example did this propose at 250 or something
recently but if you look at the CFO to a better ratio for jubilant Life Sciences is one of the best in
the industry it's 0.8 you almost have to match the narrative and try to just extent.

The other example is the Tyche Industry. They haven't done anything else far as the cash flow is
concerned the stock may be busing along. It was buzzing around yesterday as well and it's an
industry company . But the highlight that look if you look at their operating cash it has done
nothing from point to point it has done nothing it has it's up and down but it should be a
gradient of 30-40 degrees right something like this.
One Another is positive solara pharma again early listing only two three years of cash but they
started scaling up quite well and that's what is likely to see in the businesses that over time the
cash should be be growing because see if you are getting good operating cash flow and if the
management is prudent they can find some growth capex and opportunities to utilize that cash
it could be an M&A it could be an organic initiative . so focus has to be on the balance sheet
focus has to be on the operating cash flows.

7. Cycle and Valuations

Refrain from valuing business on P/E or P/B when the past few years have been miserable or
wonderful.
Instead one should focus on EV/Free Cash Flow or EV/OCF.

Final pillar is all about this cycle and evaluations and so there are multiple cycles that come into
play. There's always that GDP or the economic cycle is a concrete cycle and the most important
cycle is the business cycle because .

The business cycle is about to turn , where the market cycle is or the economic cycle is so the
economy may suffer but pharmaceutical chemical companies may do relatively better even as
opposed to some of the more and heavy industrial sectors that are more heavy and they need
the real economy.

You know the capex play for example and so the business cycle you need to understand the
business cycle that where is it in the business cycle if the capacity has been extended or
expanded for some niche launches and the business is about to turn into a positive cycle and
regardless of where the market of the economic cycle is the gains will flow if the market cycle is
conducive and is helping that are a couple of extra percentage point view gains but 80% of the
gains will come from the business cycle you get the business cycle wrong and and you cannot
make money regardless of where the economic cycle is regardless.Business cycle is very
important and again you get it from Con Calls , annual reports and the AGM's.

The business cycle which used to be a 6-7 year old cycle you don't know actually the
a business cycle will last for three years or one years or five years. How do you deal with that
predictive model and whether you can actually predict the business cycle anymore?

So you cannot time the cycles if they are getting shorter and shorter so that's a very valid great
point in fact the way the cycles are getting shorter but you still cannot predict it this is a good
thing in the sense that generation takes a lot of based out of companies start and getting more
frugal people are realizing that a lot of the cost can be taken off the P&L because things can be
done remotely and so on so the new world will look very different.

The cycles are getting shorter and they are very credible and because they are unpredictable you
should try and predict what you can do which is again balance sheet and cash flow and sheet in
cash flow but that's ROA , ROC metrics.
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SHUCHI NAHAR

NISM Certified Research Analyst Equity

Research Analyst CFA(l1) , Student of
Law and Finance, Aspiring CS

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So the business that has the potential to keep the weighted average cost of capital down has the
potential to incrementally improve the ROA & ROC through fresh and capex or internal
improvements and has the capability to compound the cash flow.

That will create wealth. It will create a lot of wealth if you are prepared to hold such a business
for a longer and duration and don't worry about the day to day price generation because in 10-
20-30% of all coming understand the business have a conviction to understand the industry
structure and follow some sort of framework.

If you are too much obsessed with the numbers and the ratios you will unlikely make a serious
success. As Peter Lynch was one of the early guys that sajal kapoor started following, read his
books and he has got an immense respect and credibility.

But sajal kapoor has a framework more on the investing side and to build that knowledge you
would have to start from somewhere so again he says keep reading, keep reading , about the
business keep reading about other businesses in the same sector and pick just one sector.

Keep repeating the same thing for every sector you pick and follow the same rigorous process
every time.

Thanks to Face2Face hosted by Vivek Bajaj Co-Founder of stockedge & Elearnmarkets.com.

It was great and insightful session from Sajal Kapoor , must watch session . Looking forwaard
to learn from you sir.

SHUCHI.P.NAHAR

Unknown June 20, 2020 at 10:26 PM

Very aell consolidated...
Madam, sajal sir had given another presentation/ session on CDMO/CRAMs...
Do write a blog on it also.. Thanks

Unknown June 20, 2020 at 10:26 PM

Well*

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