Importance of selecting the right stock at the right price

While last year, in March 2020, the Covid situation appeared to be a bottomless pit, this year the magnitude and timeline of damage to the economy seem to be relatively more determinate. There has been no national lockdown and states implemented targeted lockdowns allowing manufacturing and construction activities in most cases. According to the Oxford Stringency Index, which measures the strictness of local responses to the virus, India's stringency was 96-100% in the summer of 2020. In comparison, at the end of May this year, India scored 82% in the Oxford Stringency Index, due to less severe lockdowns.

Markets around the world have traded in the range of 30-40 times a current year free cash flow over the past few years, which means current year cash flow is roughly between 2.5% and 3.0% of market value-added. If the impact of the pandemic on cash flows is for a specified period of time of a few months, the resulting impact on the value of the company will be limited. This is why the markets behaved very differently during the second wave of Covid.

The market's reaction to the first and second waves of Covid has only reinforced our belief that market timing is a folly. As active cases continue to decline and focus shifts to the economic recovery process, we strongly believe that regardless of the business cycle, for a winning portfolio, it is best to have a balanced approach backed by strong stock selection criteria.

We follow a simple philosophy of bottoming up stocks where you get huge returns over time by investing in large companies with attractive valuations. This philosophy consists of two components: business and evaluation.

For a company to be considered excellent, it must have three main features: excellent returns on additional capital, scalability, and good management in terms of implementation and governance. These attributes are included in the base value equation where value is a function of cash flow and growth. A superior return on additional capital is a prerequisite for generating sustainable free cash flow. Scalability is about growing a diverse group of businesses over time compared to their current size in relation to the industry. When you have such potential for cash flow and free growth, you need proper management that can be implemented through an approach to long-term value creation. Last but most importantly, the corporate governance DNA must be strong.

On valuations, it is necessary to look beyond commonly followed parameters, such as P/E or EV/Ebitda multiples, as these metrics can be very misleading and can lead to wrong decisions. Measuring the true value of a business requires a robust cash flow approach: Valuation is attractive when the current market price is discounted significantly from the intrinsic value, which is the present value of cash flows.

We have a unique and disciplined assessment framework based on the principles of free cash flow and return on invested capital, or what we call the Opco-Finco model. This framework analyzes the value of a company between two different components: one a function of the capital invested in the business and the other a function of the excess return on capital invested. This distinction reveals a lot about understanding the sources of value in a company.

We believe this is a more robust approach, as it helps normalize the balance sheet capital structure, which the traditional P/E multiples approach does not. This approach can also be applied to all sectors throughout the market value curve and lending itself well for relative comparison.

From a portfolio perspective, we believe that the best combination of the "right" stock and the " correct " price can be obtained using a cash flow analytical framework that helps capture the true economic value of the underlying business.

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