Valuations are crucial to investing, not PE multiples: Prashant Khemka

All kinds of private banks are likely to see higher credit costs over the next year or two or maybe even three because the economy has gone through a very difficult time but it is not something that is going to surprise the market, says the founder of White Oak Capital Management.

You have invested in companies like Asian Paints, Nestle which are big beneficiaries of market share gain. Where do you think the market share gain is going to be an ongoing process? If you bought into telecom companies 20 years ago you would have benefited because as the telecom business moved from public sector to private sector. It is currently happening in the banking sector. How can one capitalise on the market share shift theorem?
I would say that at all times, there are companies in any sector which are either gaining or losing share. There are many companies who structurally are able to gain share over prolonged periods of time because of certain core advantages. You may call these competitive advantages. These advantages could be related to a number of attributes. It could be as simple as execution capability -- the execution DNA -- of the organisation.

In industries or sectors like private banks, there is a brand and there is a network of branches but that brand and networks in most successful cases has been on the back of superior execution over multiple decades.

IT services is an example of this. There is hardly any edge from brand or intellectual property in India but execution can be a big differentiator. There were many companies back in early 90s and late 80s which were similar in size or not too different from each other like Infosys or Wipro, TCS or HCL Tech. Fast forward 30 years and many of those companies no longer exist. Companies which did not execute well have ceased to exist whereas the successful companies have created tremendous wealth for investors.

Our portfolio, generally speaking consists of either industry leaders or dominant players and typically regardless of their position in the industry, these are market share gainers on back of strong execution DNA of the organisation which allows them to grow faster than the economy and the corporate sector and the industry. While maintaining growth in itself is not useful unless it is accompanied by superior returns on incremental capital, these are companies which while growing faster than industry have superior returns as well as good corporate governance.

You also have a very large exposure to consumer staples. Some would argue that Asian Paints, Nestle are expensive stocks. These are great businesses and good franchises but if you are buying them at these valuations, the scope of making money may be limited. Are you not cognisant of valuations which some of these companies have to offer?
Valuation is very critical to investing. It is very integral to every investment decision that we make. So I am glad you raised this question. By the way, the key managers have fairly well diversified portfolios. They have investments in staples, retail, banking and also in healthcare, IT services. They are able to find very exciting opportunities across the spectrum.

We have a highly valuation sensitive approach. Though we may not look at the standard metric that most people use, we never look at PE multiples for an example. The team may evaluate companies, decide to buy some, own them for years and eventually sell out without ever mentioning the PE multiple. What we focus on is value as well as price to cash flow multiple based on our proprietary CLEIR framework or Capital Light Excess Investment Return framework where every company we decompose into two entities FinCo and OpCo where FinCo is just the invested or dumped capital.

Market price is a function of EPS into PE. If you have to break it down for our viewers, where do you think there is scope for EPS to go higher and where do you think there is scope for PE, which is a function of liquidity and perception, to go up?
I liked the way you framed it. I completely agree but I just want to caveat one thing that the fundamental law of valuation is value is equal to present value of future cash flows or you can write cash flow divided by R minus T. You can translate that into a thumb rule which is PE multiple and there is a linkage between PE multiple and those cash flow multiples. You can then translate that. Over a long period of time it would be earnings growth multiplied by change in PE multiple plus the dividend yield. That would be the change in market value for any individual company price and returns.

So if you ignore for a minute the dividend yield and focus on EPS growth and PE multiples, you will have to go stock by stock, company by company in every sector and you will be able to find companies that can substantially outgrow the marketplace from an earnings growth perspective.

Even if there is multiple compression in such companies, the combination of the two over time can deliver strong returns. And there are companies where multiples might neither grow nor decline and yet the earnings growth would be fairly robust and can deliver strong performance. Yet again, there would be companies where there is potential for some multiple expansion on top of strong earnings growth. I cannot talk specific examples, but let us take private banks which currently have been quite beaten up post the COVID situation. It is possible if things were to normalise in a couple of years or sooner in 12-15 months, while in the interval these companies would have credit costs that would be at higher levels than what they have historically been. But once they are past the squeeze, the stronger franchises and regular good quality asset books of these banks have the potential to gain market share and not only deliver higher earnings or cash flow growth but also benefit from multiple expansion.

What is your view on financials because if you are bullish on India you have to be bullish on financials. Where do you stand? Do you think a large part of the structural gains are behind us?
Certainly. First of all, there are sectoral problems that would affect various players to varying degrees. 25 years ago a lot of them got licences. Some of them have gone bankrupt or had to be bailed out and yet others have created lakhs of crores of franchise value despite being in the same sector. Going forward over the next 25 years, I will be very surprised if that is not repeated, that some of the current players struggle whereas others continue to thrive or new ones who thrive and create tremendous shareholder wealth.

We may talk at an overall sector level, but I would want to re-emphasise the importance of individual names. All kinds of private banks are likely to see higher credit costs over the next year or two or maybe even three because we have gone through a very difficult time in the economy but is it something that is going to surprise the market? Is it something that investors are not baking in the current prices? I do not think so. That is the reason why private banks collectively are down about 33% year to date despite the market being down in single digits now. The challenges are there but the better run banks would face fewer challenges, would have lower credit costs and might surprise the market positively on the degree of credit costs that they face.