Idea Origination
Origination of the idea: Screening/Idea generation
All of our ideas originate from internal research.
We are always looking for new ideas and follow a multi-pronged and continual approach to find new investment ideas. These are as follows:
- A major screening process where focus is to take a set of companies across a certain market capitalization range and shortlist them based on key parameters being met
- Several mini processes are undertaken for market sub segments as well to look for ideas
- The work is augmented by extensive reading and engagement with industry contacts where certain companies are short listed and researched which are not part of the abovementioned effort
- Lastly, a daily detailed review of market movements and earnings reports feeds into the idea generation process as well
The end result is a continuous slow stream of ideas. However, given our stringent screening criteria only a few make the cut. The thought process is to own a business for 3-5 years and not have to reassess at the core thesis but keep tabs on the growth delivery. The basic investment thesis should have no questions.
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Idea Validation
Validation of idea: Fundamental factors
We typically validate ideas by building various analytical models internally. These are followed up by organizing conference calls or company visits to interact with management. Having spent an enormous amount of time doing this, we have built deep relationships with many companies /entrepreneurs with whom we constantly discuss industry/economic fundamentals and events.
We then conduct a projected forward analysis of future events affecting the company, such as earnings, revenue reports and cash flow. We contrast the outcome with consensus views and estimate potential market reactions to various plausible scenarios.
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Quantitative Validation
Some of the important parameters used in the research process are summarized below:
Quantitative parameters
There is a broad set of metrics used starting from the screening process all the way to the final earnings projection.
- Start with universe of stocks with market cap INR 800 Cr> cos.< 20,000 Cr.
- Short-list companies with above median score on chosen parameters. The important ones being:
- 5Y Revenue growth >10%
- RoCE>15%
- Debt to equity, Interest coverage
- Valuation metrics
- Capital intensity, asset turnover
- Long term trading pattern/volatility
- Forensic accounting screen (run the short-listed companies through the financial ratios listed below and eliminate companies with lower score).
- Bottoms up research and analysis (detailed analysis of last 5-10 years annual reports, management interviews and other published reports).
In the universe of stocks we look to identify companies for investment, the critical data point is earnings flow through which eventually drives returns. Thus, the emphasis on P/E, ROE matters eventually. Recall we look for strategic companies and deep value / turnarounds so multiple expansion is something we look for.
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Qualitative Assessment
The qualitative research is driven by V.E.C’s deep understanding of the Indian market that it has built since 1997 along with very strong relationships with companies and their managements. This network helps with feedback on governance as we look at newer companies where research availability is limited to none.
In smaller companies, the pedigree of the top management and their work ethics play a very important role and hence understanding management and their focus, their demeanour is very critical while evaluating investments in such companies. The success of any business enterprise depends upon its human capital, more so in a smaller company and hence our research lays a lot of emphasis on the same. A business franchise plus passionate/top pedigree people = very high returns.
There are several qualitative checks carried out as we research the shortlisted companies. The important ones are:
- 3rd party checks, management meetings (Corroborating management version with channel feedbacks and independent views on corporate governance).
- Interaction with dealers, customers, suppliers
- Employee well-being, longevity of careers. Tenure of key employees
- Track record of management.
- Board composition.
- Shareholding pattern.
- Do the promoters have a track record of remaining focused on their core operations?
- Does this company have strong track record of efficient capital allocation?
- Do owners of the Company have connection to political parties?
- What is the overall size of industry and its growth potential?
The final outcome of the process enables us to assess the standards of governance in the company.
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Investment Decision
The previous steps, which often are multiple iterations over a period of weeks, determine whether what appears to be a good fundamental or technical investment is actually a good investment opportunity in the stock on the longer time frame. Indeed, both factors need to be in place to have a truly successful investment.
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Portfolio Construction
Portfolio funnel
As explained in the document above, the first step is idea generation. It is a very bottom-up driven process. Companies that do not meet the defined criteria are excluded from the research shortlist.
Post the short list, the work moves towards evaluating the companies through multiple interactions with key stakeholders, visits to the sites, detailed earning models, competitive checks and a deeper focus on valuation, trading history as well as expected earning triggers over time.
The duration of the investment, whether the current environment is conducive or not to earnings growth are all taken into account to get to the final decision. Triggers if any, are evaluated along with expected return and risk/reward. We tend to look for businesses that can give us a CAGR of 20% return over medium to longer term and that eventual goal is always kept in mind.
Portfolio Construct
- The portfolio will be built on a bottom-up basis
- Number of holdings approx 15-20
- Sector limit 20%
- No market cap bias though below $100mn has to be a very unique opportunity
- Free float and trading volume taken into account while investing
Sizing of Position
We determine size of position using a range of differing inputs:
- Strength of conviction derived from fundamental and technical analysis
- Liquidity / float
- Estimated return
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Review & Exit
Exit Strategy
We exit the positions either when the price target has been achieved and we are unable to set a new target through reappraisal or when the trade is crowded out by a superior risk-return opportunity.
Portfolios are reviewed every month and post every quarter once earnings are reaffirmed. Given the long term focus, short term issues with the business do not lead to sell decisions though any derailment of the investment thesis could result in an exit.
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