The entire approach of the O3 Core Value PMS is to mitigate the three major risks that lead to permanent loss of capital for the client, and these are:
• Business Risk – in order to reduce the incidence of this risk, they seek to invest in companies that have demonstrated market leadership traits, a track record of high return on capital, generation of positive free cash flows, and those which have demonstrated possession of competitive advantages needed to succeed in their respective businesses. Also, there is a constant effort to verify whether there are any threats to the sustenance of such competitive advantages.
• Management risk – In order to reduce the incidence of this risk, they seek to invest in companies where there has been consistency in capital allocation decisions, an absence of grievous moves against minority shareholders and a clearly articulated dividend policy.
• Price risk – In order to reduce the incidence of this risk, they evaluate the valuation of the stock carefully at the time of proposed purchase, and compare it to the history of valuation that the stock has enjoyed over the past 10 years, and also compare it to the expected growth rate in earnings over the next 2-3 years (based on consensus estimates available in databases such as Bloomberg). If the valuation is higher than the limits they have set for themselves, they refrain from buying the stock.
The key portfolio constraints as a part of the Risk Management Process are: –
(i) Stock concentration risk – Not more than 10% of the portfolio is invested in any single stock
(ii) Sector concentration risk – Not more than 30% of the portfolio is invested in any single sector
(iii) Liquidity risk – The 3-month average traded volume of the stock should be large enough to sell our intended holdings within 5 trading days.
Investment Philosophy: The security selection process flows from the Investment philosophy. Their stated philosophy is to buy strong businesses when they are quoting at reasonable valuations. Therefore, the research process and stock selection process is towards choosing strong businesses purchased when their stock valuations are reasonable. These should also be within measurable parameters (so that ambiguity is reduced).
They begin with filtering out companies that do not meet their criteria of what they mean by a strong business. A strong business should have the following characteristics:
• A Track record of at least 15 years, preferably longer
• A minimum scale of operations, defined as a revenue of Rs.500 crores or above in the last declared financial year.
• A score of 1 for every year (in the past 10 years) in which the company has recorded a Return on Capital Employed (RoCE) of 20% or higher. If the RoCE is less than 20% in a year, it will get a score of 0 for that year. Hence, the maximum that any company can score on this parameter would be 10 points.
• A score of 1 for every year (in the past 10 years) in which the company has recorded a positive Free Cash Flow (cash flows after working capital changes and fixed capital expenditure). If the company does not have positive free cash flow in a year, it will get a score of 0 for that year. Hence, the maximum that any company can score on this parameter too would be 10 points.
Cumulatively, on the two points above, any company can score a maximum of 20 points.
Their cut-off is 14.
The Investment Universe for the Core Value Strategy would be companies that qualify on all three parameters (a) a track record of 15 years or longer (b) recorded revenues of Rs.500 crores or higher and (c) a score of 14 out of 20 or higher on parameters (3) and (4).
Their commitment is that at any point of time, at least 75% of all investors’ funds would be invested in companies from this Universe.
A maximum of 25% is earmarked for companies that do not qualify to be in the Universe, primarily to accommodate (i) financial sector companies (ii) companies with revenues of less than Rs.500 crores and (iii) other companies who, because of the nature of the industries they compete in, cannot generate free cash flow or high RoCE consistently, but are strong competitors in their industries nevertheless.
After these initial filters, they see whether:
• the company has scope to grow its earnings sustainably over the next 3-5 years
• the company has had a track record of treating minority shareholders fairly
• the stock trades at a valuation that is within acceptable limits.
It is on point (c) above that they place special emphasis. A stock’s valuation is considered acceptable enough for purchase if:
its valuation is lower than its average valuation for the last 10 years, or
its valuation is lower than its estimated growth rate in earnings (based on Bloomberg’s consensus estimates)
In any case, they will not buy any stock if its valuation of today is greater than 1 standard deviation higher than its 10-year average valuation.
These processes are consistent with their basic investment philosophy of buying strong businesses at reasonable valuations.
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