WF: Can you take us through what EPIC means and how does it help your fund management team in picking stocks?

Huzaifa: Before explaining our web-based proprietary tool, EPIC (Equity Platform for Investment Communication), I feel that discussing our approach to equity investing would be relevant to put things in perspective.

Point 1: We are driven by a "bottom-up stock picking" philosophy, which means we tend to focus predominantly on understanding individual companies, their business models and competitive advantages that would help generate good profits in future, which will finally get reflected in their valuations. In short, our focus is to do a lot of research on an individual company by being closer to it and then progressing on to another company. We pay much less attention to a "top down stock picking" approach which focuses on the economy and the industry.

Point 2: Given this focus, we tend to have a large team of analysts. In our organization every fund manager is also an analyst and has responsibility of tracking sectors / stocks. Though the fund manager is predominantly responsible for managing the fund, we believe that he should never move sight from the ball - so we need to ensure that he has the responsibility to track a few sectors / stocks. So, every member in the equity team is an analyst and only some of them have the added responsibility of being a fund manager. This again ties in with our core philosophy of bottom-up stock picking.

Now, in bottom up stock picking, what is important is how one evaluates a company. There are many ways to do it. Company / stock research or evaluation is a science as well as an art. It is a science because it basically looks into the financials of the company and what it has done till now. Company research is also an art because you have to understand what its right valuation is, do good projections and thereby understand whether the current price is the right price to get in to or get out of a company. Always remember that "price is what you pay, value is what you get".

In the process of conducting such an in-depth analysis of a company, one also looks at its past financial data like its Balance Sheets, Profit & Loss Statements, Cash Flow Statements etc. for a number of years. Now, just imagine the amount of time an analyst will have to spend if he has to sit and feed in all the financial data for some 250-300 companies into a spreadsheet before starting his actual work of analyzing those companies. Do not forget that analyzing these numbers would just be a part of his research process; he has to visit the company, find out the environment in which it operates etc.

Now, imagine a scenario where all the data for the past 10 years is made available to him in the required format and which is consistent across the firm. An analyst is no more required to sit and feed in the voluminous data into spreadsheets. This is made possible by our automated Equity Research Platform - EPIC. Under this platform, all the financial data is readily available for every company in the world that we track across the globe. Updating financial data into EPIC is outsourced at a global level to an international database firm whose core business is to collate such data and provide feed. Now that we have all the data, we can focus on the fundamental research of analyzing companies.

The next important thing in our research process is to project future numbers - for the next 3 years. Again, if the historical ten years data is present, it becomes easier to project the next 3 years. It also improves the productivity of the analyst as he no longer needs to sit and feed in the historical data. Future projections depend on his call, extensive research and his skill in understanding the outcomes.

In EPIC, all companies in the investment universe are grouped according to our growth expectations into 4 categories. This is done using the background of each company's growth history and our assessment of its current status and future prospects. We divide the universe into the following categories:

Exceptional Growth Companies - Companies with a new business plan, sound business model etc. Wealth Forum for example, is a new business model. High Stable Growth Companies - Companies in a growth phase having a robust earning stream which is growing such as Infosys High Cyclical Growth Companies such as cement companies Mature Companies such as power utilities, refining etc.

Once we have classified a company in one of these four categories, EPIC asks 3 questions relevant to that category which an analyst has to answer. The first question is about the expected growth in earnings. The second question is about its valuations followed by a third question about the consensus view or sell side view of the company.

Business.

Questions relating to business are slightly different for each category. For example, in the case of Wealth Forum, if we have to evaluate, the valuations will not be price earnings related but will be things like the likelihood of "success of the model" and, if successful, then its potential earnings. However, for Infosys (which is classified as a High Stable Growth Company), it would be price earnings related and similarly for mature companies, it would be price to book related.

This system has many advantages. It ensures that a steel company is analyzed in a particular fashion / format across the globe. This helps us compare notes and make better quality calls. It's a good way to remove individual biases and standardize output quality.

Valuations

The next important issue is valuations. In a cricket match, it is very easy to say that India is better than Zimbabwe; probably every one knows that. But when you start giving odds, it makes sense to place your bets on India - but after a particular level of odds, it might actually make sense to bet on Zimbabwe. In the same way, a focus on valuations helps you to decide "to go" or "not to go" - once you are convinced about the business.

Consensus view

And the third is to take a look around you, look at what others are thinking about the company / stock. If, for example, everybody is expecting an EPS of Rs 110 for a stock and you are expecting an EPS of Rs 80 and you say "it's a buy" on that basis, it probably won't fly because anyways, the market is already expecting Rs 110.

EPIC forces analysts and fund managers to go through a checklist and ensure that we don't miss out on something that is important. When a pilot sits in a plane and is ready to take off, he has a checklist in front of him, where he even checks things like whether the doors are closed or not. These minute details add up to ensure the complete safety of the flight

When an analyst goes and visits a company, he can get persuaded by the charm of the manager speaking to him. He can put out a "buy" recommendation without going through the rigor that is required. By using EPIC, analysts are committed to follow a rigorous fundamental research process and bring in more objectivity into their recommendations. The net result is qualitatively superior recommendations from our analysts and a lot more conviction in their ideas.

Even for future reference, EPIC also records the analysts' company visits. So at any point in time, the fund manager can simply pull out this record and see how many times his analyst has visited a particular company and what the company official has said. As fund managers, we have a habit of going with a diary and recording everything in it - and then the diary changes every year! Here, the process involves institutionalizing and recording all interactions the companies have had with the fund managers. This way I know that even if an analyst leaves the organization and a new analyst comes in, he has the entire history in front of him and therefore, would not need to start afresh.

Finally, we also disclose to our investors and distributors the ratings of each of our stocks tracked in EPIC. For example, out of a universe of, say, 270 Indian stocks, we are happy to share details of how many fit into each category (new business, growth oriented, cyclical and mature) as well as the ratings assigned to each of the stocks in the respective category (buy, hold, sell). Our distributors can actually review our portfolios against this internal analysis and satisfy themselves about how the application of the EPIC results in the portfolios we manage.

 

WF: Although you are a bottom-up stock picker and less inclined to look at the macro picture, there is some nervousness in the market about valuations after this sharp run up. Are you able to continue finding enough stocks that still give you good value - or if we look at it from the other perspective, are there any particular sectors that you think have run far ahead of, what you think is a fair value.

Huzaifa: That's a very good question. Actually in sectoral terms, I can very clearly identify value in an infrastructure related industry. These stocks have done very well in the past so I am not taking it away from them. But given the current level of infrastructural development which India is having, there has been a lull in the order flow. For example, electricity shortages are still there, award of road contracts have just started, nothing much has happened on the port sector. If I go sector by sector, I realize all of them are stuck at different places - some at a policy level, some at a land acquisition level, some for environmental clearances - and the government is not raising the right amount of noise required to get the whole thing sorted out.

Now if they succeed, and I am using the word "if they succeed", infrastructure companies will actually get a lot of orders and the execution of power projects will increase dramatically. This whole sector will suddenly see a huge amount of order inflows and thus, a lot of activity. While the valuation you are seeing today is on the higher side - and I am not denying it - they are on a higher side given the current business volumes. But this opportunity should increase in my view, and increase very significantly. The opportunity will suddenly expand and therefore, these companies will see a sharp rise in volumes and profits - which then won't make them appear as expensive as they appear now. So, this is one very clear area where we continue to see value.

Some of my concerns include the telecom sector. Although the sector has already seen a correction due to severe competition, the concern remains about how much more they can bleed due to the continued pricing war. There could be even more pain ahead in this sector.

Second, are the markets really tuned in for any interest rate hikes? It appears not. If interest rates go up, earnings of the banking sector can take a sharp dip due to higher provisioning on their bond portfolios. I am not sure whether the market is pricing in these kinds of earnings disappointments for banks.

Then, in the global commodities space, there is a concern that the global recovery may not be as good as the market expects. We can see it in the level of capacity utilization of various industries. If I look at the capacity utilization level of global steel, global aluminum and global refining, all these utilizations are far below what is considered to be normal. Today, prices are being sustained because utilization is low. If utilization increases, prices can correct unless demand picks up substantially. If for some reason, the commodity prices fall due to lack of demand or because demand has not recovered to that extent, commodity producers won't be able to increase utilization to make good the price fall. You could then be in for some negative surprises on earnings from this sector.

At this point in time, sectors that play the infrastructure theme and the domestic consumption theme are more attractive on a relative basis than global commodities, export oriented businesses and banks.