Mutual Funds

‘We disregard the PE multiple’, says Prashant Khemka of White Oak Capital

Kumar Shankar Roy BL Research Bureau | Updated on January 30, 2021

Prashant Khemka, Founder of White Oak Capital

It can be highly distorted and, therefore, harmful to investing: Founder of White Oak Capital

For some, the market’s phoenix-like rise from Covid-battered nadir in March 2020 and the liquidity-fuelled nature of the bounce, sans strong earnings support, is reminiscent of a party that has gone too far into the night.

Prashant Khemka, Founder of White Oak Capital, is not from that camp.

The investing guru says it is impossible to time the market based on macro events or valuation calls.

Instead of trying to predict the market’s next move, White Oak’s India-dedicated funds with an AUM (assets under management) of $3.2 billion are focussed on finding under-valued opportunities, he claims. Excerpts from an exclusive interview:

The cornerstone of the retirement kitty of many Indians has been fixed income. You have never been a fan of investing in debt. Why?

Over the last 35 years, the returns from fixed deposits from reputed banks would have been quite low.

In comparison, if you had invested in the equity market, take the Sensex as a proxy, the investment would have compounded at the rate of 14-15 per cent.

So, ₹1 lakh would have become more than ₹1 crore in the market itself! With active fund management by managers like us, the alpha-creation would have been substantial.

Going forward, with the rates prevailing for debt, one would not even generate single-digit (percentage) returns after paying tax. I call fixed-income investing a guaranteed real loss over time.

But many are not comfortable about current equity valuations. What is your view on the valuation of equity markets in India and globally?

Even a few months ago, people were very scared about Covid, too. How many people do you or I know who jumped into the market in March, arguing it has become very attractive. In fact, many exited. Valuations cannot be looked at in vacuum. All valuations, in our view, are relative. US equity valuations would have a bearing on Indian valuations. So, there is a correlation between valuation multiples in India and elsewhere in the world.

The ultimate asset benchmark is US long bonds. Over the last 40 years, their returns have come down from double digits to around one per cent.

In the mid-nineties, the long bond rate was 6-7 per cent. If you invert the yield at 6 per cent, you will get 16 multiples roughly for bonds. At that time, the US equity market was also trading at similar multiple on a PE (price-to-earnings) basis.

Today, the bond yields are around 1 per cent, so multiples have gone to close to 100 times. So, if bond multiples have gone from 16 to 100 times, it is not a fair expectation from investors that the equity market multiples stay at 15-16 times.

Inflation expectations have come down dramatically, which have pulled down interest rates. And because of low interest rates, multiples of asset classes such as equity are higher.

Your investing framework does not look at P/E multiple. Why?

Yes, we have a deep-rooted disregard for the PE multiple. The reason is PE can be highly distorted, hence harmful to investing. We focus on a cash-flow based approach — discounted cash-flow (DCF) value and cash-flow multiples — as derived from our proprietary CLEIR (Capital Light Excess Investment Return) framework where every company we decompose into two entities FinCo and OpCo.

PE multiples fail to account for many things, and two primary ones I would like to mention.

Firstly, they fail to account for capital intensity of a business. Secondly, they fail to account for capital structure of a business.

You are long-time observer of how FPIs behave. In your view, what has driven record inflows into India in recent months? Are FPIs increasingly taking the index route?

If you see, India is one the few markets that have got strong global flows. To a considerable extent, this is also related to multi-regional portfolios. Asia funds are increasing allocation to India. Even dedicated India money has also started coming in over the last 2-3 months.

What has also helped is the changes in India weight in MSCI, FTSE global indices, and the large issuance like QIPs (wualified institutional placement) by banks, etc.

The vast majority of inflows are coming through actively managed funds. The index fund route is when someone wants to take India exposure very quickly, and then look for the right manager to change allocation from passive to active. Alternatively, index money comes from tactical asset allocators who want to be in for a very short period of time.

Given your global investing experience, which accounting practices raise an alarm?

One of the important metrics is free cash flow to earnings conversion. We look at how a company compares with others in the industry and search for a logical explanation if it’s different.

There are many times when companies get into the trap of ‘earnings smoothing’ (shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings). They believe investors like smooth earnings, and if they deliver that their valuation multiples would be higher.

Companies also indulge in working capital and profit margin trade-offs that are done to prop up reported earnings. For instance, a company may tell its clients to pay higher prices but give the time to pay six months later. The higher pricing adds directly to the bottom-line, but working capital increase does not hit reported earnings by that much.

What’s your advice to investors who are wary of losing returns in case the markets tumble from here?

Over the last many years, I have always been fully invested. In my view, it is impossible to time the market based on macro events or valuation calls. Rather than trying to predict whether valuation will go up or go down, we at White Oak focus on finding opportunities that are under-valued relative to the market and under-valued so much that regardless of where the market is headed, we can generate superior returns over the long-term.

One must understand that these are equity markets and they always tumble without giving notice. The fact that the market has rallied does not in itself increase the odds that it will tumble. One cannot say for sure that the probability of a 20 per cent fall is higher today compared with March 2020 when markets had bottomed out.

Published on January 30, 2021

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