Project Interview with Prof Sanjay

Interview with Prof. Sanjay Bakshi

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Chetan Parikh interviewed Prof. Sanjay Bakshi, CEO of Tactica Capital Management on 22nd

March 2007 in Gurgaon.

CIO: Thank you for giving us the time to talk to you.

Prof. Sanjay Bakshi: It’s a pleasure to meet you here in my office. We are meeting after more

than four years and I remember very fondly what happened on the previous occasion! Indeed

I still get fan mails from people about the talk I delivered at your invitation at the Oxford

Bookstore in 2002. I don’t talk to the media. I talk to my students in the classroom at MDI (six

months in a year) and I frequently talk to some value-oriented friends. You are the only one

whom I have met from the media in the last four years!

CIO: Many thanks.

Prof. Sanjay Bakshi: So it’s a pleasure to have you here and I just want to open up the

presentation, which I had given to the invitees at Oxford Bookstore in 2002. This presentation

was titled, “Value Investing – a Conservative Way to Invest.” I had started by describing what

is value investing and why the focus of conservative investor is first one not losing money

than on making it (downside risk more important than upside potential) and then I gone on to

the better part of the presentation, which essentially dealt with three value investing themes.

These were: (1) Cash bargains; (2) Debt-capacity bargains; (3) Debt pay-down.

I only focused on these three themes in that presentation and gave a number of examples.

Some were past examples whereas some others were current examples at the time of that

talk. With the benefit of hindsight, I can now tell you that things have worked out pretty well

for me professionally using those three themes.

But knowledge is incremental, especially in the profession of security analysis, and

experience is a good teacher � so I have evolved over the years and there have been many

changes in the way I think about investing. In my early years I was very influenced by Mr.

Buffett. But over the last few years, I have become more influenced by Mr. Graham.

Hopefully, today we will interpret Graham�s bible for this profession, the Security Analysis

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and of course the Intelligent Investor.

Ten Deep Value Themes

So today, I am going to continue with where I left off in 2002 and focus on ten deep value

themes. Some of these are old themes and I just want to revisit them. And then I want to talk

about other themes on which I have accumulated some wisdom over the years. Specifically, I

am going to talk about:

The changes in my thought process over the years

The classic Ben Graham themes

Capital structure related themes

FM strategies � I won�t reveal what �FM� stands for right now – a bit of mystery I want to

introduce to hopefully keep your readers awake!

Dividend policy related themes

Event-driven themes

Availability bias related themes � after my last interaction with you I became hugely

interested in psychology and spent a lot of my time learning it. Indeed, I now teach a paper

on behavioral finance which focuses on the �foolish man models� from psychology rather

than �the rational man models� from economics which I had been mis(taught). Over the

years, I have developed some themes which arise purely out of biases most people and

certainly Mr. Market suffer from. And some of these are hugely important in my view. One of

them, of course, is the availability bias. And I have a whole set of strategies coming out of

that bias.

Mean reversion strategies

Value-plus-momentum strategies, and

Over-optimism related strategies. The last one is essentially to do with shorting overvalued

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stocks as a hedge against a major decline the the prices of deep-value shares.

1) The Classic Ben Graham themes:

Let’s just go to classic Ben Graham strategy. Of which six of them are:

i. Cash bargains

ii. Debt capacity bargains

iii. Earning yield bargains

iv. Large, unpopular companies

v. Low-priced common stock, and

vi. Special situations

The subject is vast. Graham’s book (Security Analysis) is very useful. And if one really applies

in a creative way the essence of what Graham taught in that book, to what is happening

around us now, one can, in my view, build an entire life�s career around just a few of the

things he taught. Personally, for me it’s been very interesting to see how the same logic

works even seventy years after the book was first published. And Graham put it down his

ideas so eloquently and they are all there and people just don’t use those ideas in the way I

think they should be used.

i. Cash bargains

I talked about cash bargains in 2002. We know that, if the market value of a company is less

than the net cash (cash and marketable securities net of current liabilities and debt) in its

possession, then you�re getting the fixed assets and assets other than cash, essentially for

free. But Graham gave a warning �Be careful about cash being dissipated away if there is a

loss-making business out there.� So you may have a company whose stock sells at a price

making it a �cash bargain� and the business is losing money. In such cases, the market is

right in valuing the stock at below cash, because the investors will not see the cash. And

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that’s what I too had said in 2002, but then I had some additional thoughts on that subject,

over the years.

Take holding companies, for example Nalwa Sons or Jindal South West Holdings or

Consolidated Finvest, all of which are so-called-cash bargains. My simple question here is

where is the catalyst? Is it a family dispute? Is it the presence of Mr. Soros, for example in the

case of Jindal Southwest Holdings? Your know Jindal South West at Rs 225 at present is really

interesting because the company holds shares in JSW Steel on which futures and options can

now be traded. So one could technically go long in the holding company and short the

underlying and have a very interesting trade out there. But you can only make money on the

trade if you narrow the spread. Alternatively, one could just buy the holding company as a

very cheap way of getting an interest in JSW Steel. Well whether Mr. Soros will be able to

narrow the spread or whether people who are in that particular situation will be able to do it

and whether it make sense for us to buy into that situation or not, that’s debatable.

But in the absence of a catalyst, I don’t feel very excited about holding companies as I used

to at one point of time. I now feel that it takes a huge amount of patience for such situations

to work out in the absence of a catalyst. Moreover, the basic structure of holding companies,

as Graham had mentioned in his book, is a very defective corporate structure. It may be a

wonderful structure from the controlling stockholders� point of view – from the market’s

point of view it’s a very defective structure. The more layers you put in between the eventual

property and the ultimate owners, the more reluctant would the market be to give full value

to that property.

This is pretty much the case with close-ended mutual funds and conglomerates, which are

the other two forms of bad corporate structures. Holding companies are a bad corporate

structure from minority shareholders� viewpoint. Indeed, in my view, holding companies are

even more inferior to close-ended mutual funds because at least the latter have a limited life.

As per the Indian regulations, all closed-ended funds are to be liquidated by the date

mentioned in the initial offer document, which ensures that the discount to NAV will

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eventually vanish otherwise it would violate the no-arbitrage principle in financial markets

(None of the funds are ultimately liquidated � all of them are converted into open-ended

funds thus demonstrating the classic agency conflict involved here but that�s another story).

Unlike closed-ended mutual funds, however, holding companies have an unlimited life

because they are companies and not funds. This makes holding company akin to perpetual

close-ended funds run by managements who really have no interest in unlocking value for

their shareholders. Its no surprise that discounts in holding companies are much more than in

close-ended mutual funds like Morgan Stanley Growth Fund.

Operating companies with cash

Another thing I want to say about cash bargains is that operating companies with cash are far

better than �boxes of cash� i.e. holding companies with no operating business. So, in

contrast to pure holding companies, which are nothing but �boxes of cash�, if you have an

operating business which generates surplus cash, and in addition you have a substantial cash

on the balance sheet, and if the company is under-leveraged, and if the stock price is not

presently implying a cash bargain in the pure Grahamian sense, but is low enough, so that

one can actually estimate as to how soon will this company become a cash bargain � well

that�s a very attractive combination in my view. It’s far better in terms of relative

attractiveness than just a box of cash because the box of cash is really something they can

take away. They can replace it with some loan and the loan terms could be very onerous. So,

all sorts of things can happen which could prevent a minority investor to be able to realize

that value of surplus cash.

In contrast, when you get a cash-generating operating business, a zero-debt company, lots of

cash on the balance sheet, and a market price of the stock which is not very far from the net

cash on the balance sheet, you have an attractive, low risk, high reward situation. By high

reward, I do not mean a multi-bagger, but rather a return which is at least twice of the AAA

bond yield, which incidentally, is what a Grahamite tries to look for.

So, I have sorted of moved away from pure holding companies without catalysts to

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companies which are debt-free, selling at low price/earnings multiples – so low that if you

remove the net cash from the market value, the operating business turns out to be selling for

a very low multiple of the underlying corporate earning power. Indeed, you can actually

predict, under reasonable assumptions, as to how many quarters or years will it take for this

company to go below cash if the stock price remained unchanged. And, in my view, that�s a

very useful way of thinking. I think these companies will not sell below cash for a prolonged

period. Unlike boxes of cash, many of which deserve to sell below cash, cash-generative

operating businesses don’t deserve to sell below cash.

So companies like Neyveli Lignite or GAIL or some other companies which can easily be found

would probably fit this criteria One could predict perhaps how many quarters, how many

months, how many years will it take, if the market value were to remain unchanged, for this

company to sell at below cash because you can estimate how much cash is being made and

you can estimate how much dividend is being paid out. Cash is coming in and there are no

other uses of cash. So it�s all there in the cash flow statement and in the earnings

statement and one can make a reasonable judgment as to how many years will it take to �

so if something is just two or three years down the road to end up being below cash, I want to

be an owner of that particular stock. I think it’s a very conservative way of investing,

particularly if you combine it with dividend yield which is fairly satisfactory to begin with. So,

that was my other observation about cash bargains.

Why do markets hate the most easily valued asset on the balance sheet?

CIO: Why do markets hate the most easily valued asset on the balance sheet? Cash is after

all easiest to value. It’s there, but the markets just hate it. Why does that happen?

Prof. Sanjay Bakshi: Well, I think one reason why that happens is that Mr. Market loves EPS.

And cash doesn�t contributes much to that EPS. It produces low treasury income and it

doesn’t show up much in the EPS.

Another reason is that Mr. Market fears that the cash can easily be transported away by the

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insiders. Now, you can’t transport the plant and machinery, but you can easily siphon off

cash, so to speak. So, it’s not that tough to remove cash and markets are very skeptical and

that skepticism gets reflected in low price/earnings ratios of businesses which has surplus

cash. And that skepticism may often be overdone, by and large the market is not totally

wrong on this. While many Indian companies have been good allocators of capital, the

dividend policy of many many others are pathetic. They should dramatically increase their

payout policies. You see much better values and the cash on the balance sheet would get

much better value in the market. So one of the things which we will come to later when I’m

talking about dividend policies is that what investors can do is to make a point with the

management to increase the dividend payout when the money inside the firm is not being

valued properly by the markets. It is more valuable in the pockets of the investors than in the

pockets of the company.

ii. Debt capacity bargains

On debt capacity bargains, there�s been no change in my views over the last few years.

Graham was right when he wrote that an equity share representing the entire business

cannot be less safe and less valuable than a bond having a claim to only a part thereof. And I

have used that theme over and over again to identify, and, indeed arithmetically prove the

cheapness of some stocks. Mr. Munger taught us that if we have a problem to solve, then if

we reduce the problem to a discipline, which is more fundamental to our own discipline, then

we have a very good basis of solving that problem. Graham�s approach to debt capacity

bargains reduced the equity valuation problem to basic math, a fundamental discipline. So,

when you come down to that level of accuracy, it’s impossible indeed to argue that the debt-

capacity bargain stock you are looking at isn�t cheap.

The private equity boom in this context is important because debt-capacity bargains are

natural candidates for going-private transactions. In my view, the private equity boom is here

to stay. Some people think it’s a bubble and assume that private equity players will stay for a

while and then will go away. However, my view is that as an alternate to the stock market,

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companies that are not being valued properly are likely to be taken out of the market by

smart private equity players. And that’s generally a good thing. Because if markets are not

giving good and appropriate value to listed stocks and somebody else is willing to pay a

premium over the market value to the controlling and minority stockholders, then he has the

right to enjoy the difference between his estimate of value and what he paid to take the

company private, to the exclusion of the others. And I think that part of the return in private

equity is a very substantial part, plus there is the incentive effect to correct misallocation of

capital from such companies the system. And, of course, the private owners have the

valuable option to decide when to bring the company back to the public markets, which not

co-incidentally, will be when markets are salivating for more stocks in that particular industry,

so that much of extra return is also there. So I think that the private-equity wave is going to

become a much bigger wave. I don’t think that’s a fad. It’s here to stay.

The debt capacity bargains idea, which made me lots of money, led me to think about capital

structure as such. You know how important capital structure is and of course there is plenty

much to learn in Graham’s books on that subject.

CIO: Could you comment on some such companies?

Capital Structure Strategies:-

Prof. Sanjay Bakshi: Yeah. If you look at Abbott India, if you look at the surplus cash in the

company�s possession and if you net it out from the market value of the company, you end

up with a business value which is fairly low, given the quality of the business, given the

returns that the business earns on the capital. So it’s a cheap stock out there. And if it is a

cheap stock, then insiders have strong incentives to take the company private. They are not

doing it (apart from two small buybacks). There are different reasons for that. But these

companies really don’t deserve to be in the market. They should be taken out from the

market. Persistently, they sell at below what they are really worth. And I think a lot of that

has to do with the amount of cash in the balance sheet, and management�s reluctance to

give it back to the company�s owners.

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In many of such situations, insiders are not really worried about increasing their stake in the

company or increasing the stake of the minority investors by virtue of a buyback or a

leveraged recapitalization which. They are not doing any of those things, but I think they

should. They should really think about it. And I don’t know whether it will happen or not but it

should happen.

CIO: So would you look at Abbott India as a good investment at this level given that it is

cheap but that there may not be any catalyst?

Prof. Sanjay Bakshi: It�s a cheap stock. But if I were to look at it, I would look at it with the

point of view of being a catalyst in the process of getting the company taken private. So, if

they are holding a percentage, why not go and make an open offer for the rest of the

company and become a private owner with the management, which is generally a very good

management. And of course you know the other thing about what would happen if you were

to make such an offer. If somebody were to come out and say well this company is out there

and it’s undervalued and the management is not doing anything about it and if I make a

public offer to buy out and take this company private, how will the other side respond what

Mr Munger calls �effects of effects�)? I think they’ll probably respond by delisting the

company – you have to spur them to do it. They won’t do it on their own but if you nudge

them a bit they will in all likelihood do it. If you have the capital and if you have the

conviction then the odds of losing money are very low.

What happens to a company that has too much equity and what happens when the company

has too much debt?

Modern corporate finance proclaims that capital structures don’t matter. And I think that�s

nonsense. I think it’s better to ignore what Modigliani and Miller has said and instead listen to

what Graham had said on he subject and and what KKR has done. What did Graham say? The

essence of what Graham said, although he never used the phrase �optimal capital

structure� is that there is such a thing as an optimal capital structure. And he used his own

system of credit analysis which is very unique. For example, he never believed in credit

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ratings because credit raters rate instruments whereas he rated companies. He had a single

rating for a company. In Graham�s framework, if a company was credit worthy and all of its

debt instruments were also credit worthy, otherwise he would not touch it. And he said that if

a company is debt free, then the optimal amount of debt it should have on its balance sheet

is the amount, which would classify as a high-grade investment from the bond-holders�

viewpoint using Graham�s framework of credit analysis.

So in the sense that’s what he meant when he said there is a thing as an optimal capital

structure and there are all sorts of businesses which are not amenable to debt financing, so

they shouldn’t have any debt in them, for example, new startups, or companies having

businesses with very volatile cash flows, but if there is a large company with very low debt-

levels having very stable cash flows then it can have a cheaper source of capital than equity

on its balance sheet. How much debt to put? Well, he had a very simple formula and I think

that works. You don’t have to be exactly right, you can be just roughly right.

And KKR took it to the extreme by putting a huge amount of debt on target companies to

finance their acquisition at large premiums to pre-acquistion market prices. KKR did it and

the private equity boom is showing that it can be done and companies are being taken

private and they are putting debt on the balance sheet. And the main thing that works here is

the change in the incentives. The interesting thing that demolishes the MM argument is that

MM forgot or they didn’t think about the possibility of a jump in EBITDA itself.

KKR showed that by putting large amounts of debt on the balance sheet of an under-leveraed

company you can change the management�s incentives in a manner so that it has much

less desire to spend money on those fancy carpets or the air planes, then certainly the

margins went up and the EBITDA went up and if EBITDA goes up, the enterprise value goes

up. If there is no change in EBITDA, you have more debt, equity will shrink, if you have more

equity, debt will shrink � that�s what MM thought would happen � they forgot that people

respond to incentivres. The total value of the firm is independent of capital structure if you

ignore, among other things, the incentive effects of debt on a mismanaged, under-leveraged

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company. But, if EBITDA itself changes, the value goes up and that value will go to the equity

because the claimants to the debt are fixed. Incidentally, there is a wonderful Harvard case

on Sealed Air, which I think every investor should read.

So, all of this, led me to think about what happens when a company has too much equity and

what happens when the company has too much debt. So that sort of morphed into different

things evolving from the idea of capital structure. So if the company has too much equity and

the Abbott kind of situation or the stock is a debt-capacity bargain, there is too much cash,

they need to distribute the cash. And there have been some minor transactions where we

have made some money like Hindustan Lever shareholders got bonus debentures and

Thermax shareholders got bonus preference shares. So those were transactions, which were

effectively distribution of cash by changing eh capital structure. They were delivering

shareholders instruments, which were debt instruments that they could sell in the market

priced as debt instruments, but they were changing the capital structure. They were moving

towards what was optimal and it was done at a time when the companies were undervalued

so there was a major upside returns for investors who understand how these things work. I

think this model is replicable by other similar companies in India � there are lots of such

companies.

On the flip side you have companies with restrictive capital structures. There is too much

debt and too little equity. There is money to be made there too because the fact that you are

observing the company now which has too much debt means that you were not participating

in the original calamity which caused all the debt to come up in the first place. So the market

is putting a very low value on the enterprise, because it’s highly leveraged and it sells at a

ridiculously low PE multiple. But, if the present value of debt was reduced as opposed to the

book value of debt,, either voluntarily or otherwise under CDR (Corporate Debt

Restructuring), which has been a major trigger for such transactions to happen, you are on to

something. So we look very closely at corporate debt restructuring as the theme arising out

of the debt reduction theme, arising out of the capital structure theme.

Interview with Prof. Sanjay Bakshi

Equity is just a balancing figure and if you can value the corporate entity without thinking of

the capital structure and net off what you think that debt is worth under changed

circumstances, there may be instanes where you have a hugely under- valued equity.. Of

course, we have to project as to how that value will rise as debt is reduced and how likely is it

that debt will get reduced and whether their source of debt reduction would be voluntary or

involuntary. It could be probably voluntary in CDR cases under a strict timetable. They have

to adhere to the timetable. The interest of the minority investors in such transactions get

perfectly aligned with the interest of the lenders to the firm because under the CDR package,

the lenders will get the company�s management to stop all that stupid diversification and

they have people to ensure that it happens and they stop the dividend, and instead focus on

debt service and debt reduction, which is exactly what a value investor wants. Paradoxically,

the skipping of the dividend produces a very low market price. So you have a system now

where you can effectively project as to when will this company be substantially less

leveraged which means an automatic expansion of the equity valuation and when will the