In 2009, as markets around the world were breaking down, Sankaran Naren, one of India's top fund managers came across The Checklist Manifesto, a bestselling book by doctor-writer Atul Gawande.
The book deals with the simple yet powerful concept of the utility of creating check-lists -- it has achieved widespread practice in fields from medicine to aviation -- in order to reduce mistakes. Naren then went on to create a similar checklist that encapsulated the key points of his own investing framework.
In an interview with value investor Ramesh Damani for his CNBC-TV18 seriesWizards of Dalal Street, he outlined the three key criteria underpinning his market philosophy: pay close attention to fear, valuations and flows.
The checklist helps Naren, chief investment officer at ICICI Prudential AMC, reinforce his rules when emotion is ruling high in equities and helps him take a contrarian approach to investing.
For instance, earlier this year, metals firm Glencore lost about 90 percent of its value in London, following the commodity rout.
"It was led by smart people, had cash and was certainly not the worst in the world," he said. "That was the lemon moment. But for you to gather the guts to look at metals as a sector. But in the 15 days that followed that day [when Glencore hit a low], some metal stocks in India rallied 40-50 percent."
During times of bull market peaks, he keeps a market capitalization rule that comes in handy. "In early 2008, the mcap of some property stocks was more than the entire pharma industry and of some power stocks more than the FMCG pack," he pointed out.
Below is the verbatim transcript of S Naren’s interview with Ramesh Damani.
Q: Aviation, medicine, stock picking, disparate disciplines, but something ties them together, doesn't it?
A: If you at it in aviation it is completely prevented accidents. In medicine it has reduced the number of mistakes and that the same thing holds good for investment because in investing also if you reduce the number of mistakes you can make a lot of money.
Q: How did you come up with this checklist theory of yours?
A: Actually as part of our work we try to read books and there was a very nice book written by a person called Dr Atul Gawande called The Checklist Manifesto. It was a fascinating book because it was written by a doctor and there was a lot of reference to investing. That got me interested.
Q: Atul writes that, okay, you clean your hands for example, you have better outcomes in surgery or you use Quinine and you can cure Malaria for example. Markets are more nebulous, aren't they?
A: Markets are nebulous in the short run and there is clearly emotions which play a role but there is a history to market. You will see that there have been in crisis, there have been euphorias, there have been bubbles. So, what happens, if you look at the 11 years that I spent in mutual funds we have seen all kinds of market. You get a good grip if you use checklist on where you are in the cycle. For example you know when you are in euphoria, you know when you are in fear, you know that at points of time that you are in bubble.
Q: What is the checklist for putting money in equities?
A: In equities if you ask me, there are three things which matter; whether there is fear, how is the valuation and third is what is the flows. For example, whenever Foreign Institutional Investors (FIIs) sell, you have to put money in equities, because fear is rising. In fact they looked at the last 20 years and found that whenever FIIs have sold aggressively, like 1998, 2002, 2008, 2011 and recently in August-September 2015, those fire opportunities to invest. But if you did not have a checklist you would be wondering what would happen tomorrow, because every day you are worried what is happening in China, what is happening in emerging markets, but actually our checklist gives us the confidence to say it is time to put my money today.
Q: If checklist was all there was to your investment process, a database specialist would be a great stock picker but clearly that is not true.
A: That is why even if you make use of checklist, it does not ensure complete elimination of mistakes. It is not like in the airline industry where you can not have any accidents. You do make mistakes because markets behave differently, people in the markets behave differently, so it only reduces the number of mistakes. But once you reduce the number of mistakes, you are on a good wicket in the market over a long period of time.
Q: You met Atul Gawande. What did he explain to you about the checklist process?
A: He actually is a medical doctor and as a medical doctor he was telling us how beautifully using checklist reduce the number of mistakes in the operation theatre and he found there a lot of people like Mohnish Pabrai and others who use this checklist, what he wrote about medicine into investing and then he finally wrote the book.
Q: Give me an example in life where in your career a checklist has actually helped you.
A: Clearly if you ask me, you can see a bubble, for example if you look at a situation of fear, take metals for example in August-September in 2015, at that point of time, the key characteristic is fear. You have a company called Glencore Xstrata, which is listed in London, is down 90 percent and then you go and look at the company, it is led by smart people, has cash, it has not been the worst company in the world, so if you look at that day, you can clearly see that that is what I call almost like a lemon moment in metal. So for that day for you to gather the guts for you to look at metals as a sector and tell the external world that metals looks like a good pick was such a difficult thing and I couldn't believe when the 15 days which followed that day certain metal stocks in India gave 40 percent.
Q: Lots of periods in last 10 years, India is a very volatile market where you had fear and greed in equal measures. August 2013 the new Modi bull market, the Modi's election has the checklist helped you through all these situations?
A: Clearly we started learning about it only after the 2008 crash. So, till August 2013 as a house we were telling people to invest in our US bluechip fund because their checklist told us that till the current account deficit came down the US market would be more interesting to Indian investors because of the situation that dollar could keep appreciating against rupee. However, once the current account deficit came down in August-September 2013 we actually stopped marketing our US fund and we actually got the opportunity to look at investing into domestic closed ended funds and we launched some of them.
Q: How does Naren a Mechanical Engineer become interested in the stock market?
A: There is a long history to it. My mother passed away when I was 14 and I didn't have any brothers and sisters. My father used to have the habit of investing in public issues in 70s and 80s and that made him pretty interested and therefore he educated me right at the beginning which I am talking about in 80s in Chennai on the merits of equity investing.
Q: Let us move on to contrarianism which is the hallmark of your investing style. First let me ask you a question. Have you used WhatsApp?
A: Yes.
Q: Jan Koum was the guy who designed WhatsApp and he claims that he designed it because he wanted to call his father in the Ukraine and did not have the money to make the call and spawned a USD 20 billion empire as a result of that, that is his story. What is your story about contrarianism? How did you get into that?
A: In 1989, when I passed out of IIM, I started looking at the secondary market and I had an absolutely phenomenal investing experience between 1989 and 1994.
Q: Everyone is a genius in a bull market, we had a great bull market at that time.
A: So I was a genius growth investor who could make huge money, who could think of good ideas which were multi baggers. You know I always believed that by being an Mater of Business Administration (MBA) degree holder who knew how to look at an annual report, I had information arbitrage and I could make money off it. That I would make money so quickly in that boom was not something known to me, but when I made it, obviously you get drunk and then you make mistakes.
Q: What was that mistake?
A: The mistake was I thought that the foreign investors were very smart. There were a number of companies in 1994 like Natural Energy Processing Company Limited (NEPC), Southern Petrochemical Industries Corporation Ltd (SPIC), many of these companies they did Global Depository Receipt (GDR) issues.
Q: A dishonour list, if you will sometimes.
A: I do not want to mention that. I thought that I was buying some of these stocks at one-third the GDR price and I felt I am investing much better than their foreign investor who invested at three times the price, then after that I lost 90 percent and here I was in 1997, not knowing after the Asian financial crisis why I lost so much of money after being so smart? So that led us to a team of friends who had all made the same mistakes.
Q: The team of friends were a group of fellow investors in Chennai, right? That influenced you a lot. Just tell me a little bit about that.
A: Yes, actually that group you know were all people who needed, in those days I would call psychiatric help, because all of us had lost money in the 1994-1997 period. So we all needed support to know what mistake we made and looking for answers. So we got into this group. When we entered this group and then went about the process, we realized that you cannot be a momentum investor in the long run to make money. You need to know when to buy and you need to know when to sell and most of the time when you want to sell, the others should be interested in buying and you should be interested in not buying. So, that is how the whole concept of I would say contrarian thinking came and for which our first experience was in 1999-2000, the tech bubble when we saw stocks like Global Tele, DSQ software, Penton Media.
Q: They went to stratospheric heights, they were the most celebrated stocks.
A: And we had to avoid them and most people around us said, these people have more than 10 years of experience in equities and they are saying these companies are useless, we are making money. But contrarian investing that we have to look at the stock and come to a conclusion, we were negative on many of them. So contrarian investing helped us to stay solvent. First, we were considered irrational in 1999-2000, we did not get it and then we realized that we were solvent when the others became insolvent in 2001-2002.
Q: But it is painful to hold through that kind of a bubble rise. Being a contrarian investor Buffett was one at that time and every day the stocks rise and your stocks fall. So, how do you handle that intellectually?
A: It is very easy when you are managing your own money, but in 2007 I was running funds which many of them underperformed the benchmark in 2007. Out of the same streak of what I call contrarian investment and when you are handling other people's money and you are underperforming benchmark people came to me and said you are running value discovery but why are you not able to beat the benchmark and I said the contrarian investing style and whatever I had learnt in investing over 17 years told me that you have to be careful and I am going the infra names although I was running the infra fund then.
Q: But when you do contrarian investing, it is not just about being different from the crowd, you want to find triggers for a change, right? So, how do you assess the sector that you like?
A: Sometimes the triggers in 2007 frankly we never knew there was a global financial crisis coming in and towards the end of 2007 as the markets kept going up we didn't know what that trigger would be. But our 1999-2000 hat definitely told me that something will happen. When will it happen I don't know but 1999-2000 told me that it will happen and you won't know the reason.
Q: You look for anecdotal reasons that the public starts coming to the market, people talk nonsense, is that some of the checklist of a bear market?
A: Clearly off bull market. In that period I had analysts coming into my room and telling me the stock looks very cheap on 2014 earnings.
Q: In 2008, that triggers a bell.
A: That clearly triggered a bell and market caps in that period there were market caps which were astounding. If you look at some of the companies then like some of the real estate companies were higher than the entire pharma sector.
Q: A power company was bigger than the entire FMCG basket I remember.
A: Correct. So, those market caps don't lie. Earnings can go up cyclically, it can come down cyclically but market caps gave me the best reasons to stay rational but it was tough.
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Q: Let us talk about value investing, growth investing, value investing are they two different species?
A: Warren Buffett says it is joined at the hip. It is not like it is zero, one.
Q: Indian naturally favour value investing as a cultural ethos?
A: I have been surprised to know that Indians favour value investing in everything other than investing in stock markets. When it comes to sale of Amazon's or Flipkart's of the world they believe in value investing.
Q: We want a cheap shirt but not a cheap stock?
A: Yes, that is clear.
Q: How do you distinguish between a value stock and a value trap?
A: Intrinsically I think Indians are not value investors. They have to go through a cycle to become value investors. You don't start being a value investor on day one. I have a team of colleagues, many of them young and many of them will question me on many of my value investing stocks. I find that conversation with them has really helped to me avoid many value traps.
Q: Give me an example of a value trap that you avoided? How about the PSU banks which were the favoured sector in the market but you avoided them.
A: In 2008 due to what happened in the global financial crisis money went to public banks all over the world. That was a very interesting period where what you saw that in a sector where both private sector and public sector is there, the public sector gained in the year 2008 across the world.
So, people got into this perception that what as true in other sectors where private sector gains would not happen in banking. Whereas if you looked at the entire process, you knew that was a one time event out of GFC.
Q: Your checklist told you that problem is there in the credit cycle?
A: Yes. That is why from then on it was pretty easy to know that private banks would gain at the expense of public sector banks. Also 2008 proved that banking was a more unsafe sector from an equity investor point of view and you had to do your rigorous work than any other sector because of the persons whom I used to watch the Legg Mason Value Fund of Bill Miller, his fund got destroyed in 2008.
Q: He just got a whole bunch of wrong stocks.
A: Yes because he had 38 percent weightage in financials. That combination I realised that you have to be very careful in leverage sectors.
Q: That is after 20 years of outperforming the S&P continuously almost, the man went overweight and got a divorce.
A: Yes.
Q: You have a reputation in industry of not being afraid to trade your stocks.
A: Sometimes you do it but for example in 2012-13 for almost two years now I have been underweight some of the quality stocks and quality stocks have continued to do well. However what I find is with this whole world of passive investing which has come in the rest of the world there are opportunities which come due to induction of stocks into some index, dropping of stocks from index and those give me very good arbitrage opportunities.
Q: Other than your famous checklist, the famous contrarianism, what else do you look at? You have often said that current account deficit is something you pay a lot of importance to.
A: I do pay a importance to many factors. I believe that if you see capital being allocated well in a country or in a company, you tend to make money. So, you always look at how capital is allocated. If you feel capital is allocated well you tend to make money and that is true of a country also. If you see why India is one of the better equity opportunities is because there as a country we have allocated capital much better than some of the other countries which may have grown faster but have not allocated capital well.
Q: You are referring to China perhaps. Summarise for me what is S Naren's investing philosophy?
A: I would say that look for opportunities in fear, look for opportunities in greed and communicate. ICICI brand has given me the opportunity to communicate to the country and use this opportunity to make equities a good asset class for the entire country, educate people.
I have been in equity markets form 1989 but the average investor has not managed to make the money that the markets have given him.
Q: People fail to understand that index in 1980 was 100, it is closer to 30000 now, 300X move has been made and if your wealth hasn’t multiplied by that amount you have been doing disservice to your portfolios?
A: Absolutely. I think the entire savings market through the mutual fund industry is a beautiful opportunity for an investor and that is my main hope that we will try to increase assets that we can collect from investors and make money for them in the long run.
Q: I have a checklist of rapid fire round with you. You enjoyed your education the most where - IIT or IIM?
A: IIM.
Q: Would you prefer on a Sunday playing Bridge with your friends in Chennai or listen to Carnatic music?
A: Listen to Carnatic music and playing Bridge together.
Q: Are you an early riser or late sleeper?
A: Early riser.
Q: Tea or Coffee?
A: Coffee.
Q: Your favourite city in India?
A: Chennai. :-)
Q: If you had a choice of dinner with Atul Gawande or James Montier what would you pick?
A: Having met Atul Gawande this time it would me James Montier.
Q: Sensex 50000 by?
A: I can't predict and I don't believe that you can forecast so accurately.
Q: Your favourite ratio when you read a balance sheet?
A: Price to earnings (PE) ratio.
Q: An Indian investor that you admire the most?
A: Nimesh Shah.
Q: An Indian CEO that you have admired the most?
A: I think right now it is N Chandrasekaran.
Q: A stock pick that you are most proud of?
A: LMW in 1989.
Q: Your dumbest stock pick to date?
A: It has been textile companies and spending lot of time on many textile companies.
Q: Name the one thing that keeps you up at night?
A: I think the responsibility of managing our public money.
Q: One contrarian theme that you are focusing on right now?
A: Last few months it has been metals and oil and gas.
Damani: What you have said is that what is comfortable is really profitable but in the last 30 minutes you have not only given us comfort but also some profitable ideas how to invest your money.
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