Gokul Raj P. (Bavaria Industries Group): Special situations, rights issues and tender offers

Gokul Raj P., Bavaria Industries Group

“So it’s effectively transfer of wealth from the people who are a little lazy and who are not doing their work to you who’s a little bit more active.”

[00:06:33]

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Tilman Versch [00:00:07] Hello Gokul. Welcome to our YouTube channel. Thank you very much for inviting us to Munich. I would like to ask you at the beginning for a short introduction about yourself.

Gokul Raj P. [00:00:19] Thanks Til for coming to our offices and asking me for an interview. So I come from India. I currently manage the public equities portfolio at Bavaria Industries Group. It’s a listed investment vehicle; we use the balance sheet cash to do both private and public equity investments, so I’m part of the public equity investments. So we do global public equity investments, both small, mid-, large caps irrespective of markets and size because we work with permanent capital. Usually these are long-term bets where we believe there’s an attractive risk/reward ratio.

About me personally, I come from India. I’ve been an investor in Indian markets for the last 10-12 years, mostly in small and mid-caps. I used to head a boutique research team focused on small and mid-caps in India and then I moved to London for my master’s and now I’m here in Munich with Bavaria Industries Group.

Tilman Versch [00:01:26] It’s nice to have you here in Munich.

Gokul Raj P. [00:01:28] Thank you.

Tilman Versch [00:01:30] How did you find your way into value investing? How did you get involved with the idea the concept?

Gokul Raj P. [00:01:36] So I think it was pretty accidental so as to say. I think it was in the early 2000s, it was the early stages of online brokerage penetration in India and the whole internet based stuff. My father had just opened an online brokerage account and he started investing and he’s a doctor, so he just started out investing in certain things. And as a young kid I think I got interested in what’s happening with stock markets, how do people make money and the usual curiosity that comes with that and then with the internet, it’s like you have all the material out there and once the first level of reading you do on something about value investing, then I got hooked. Then you do the usual, read everything about value investing and then learn about people. But the big difference would also be the fact that once I started with the boutique research firm, I started working with a lot of interesting clients with whom I was giving ideas and selling ideas.

So I had the opportunity to work with some of the smartest Indian investors focusing on small and mid-caps and because I’m giving them an idea and then they’re rejecting or selecting it, I get to learn their thought process. How do they think about the investment? How do they look at it? How do they position size it? How do they manage the risk? How do they exit the stock? So it was literally learning from very smart people and learning by investing in the markets and being in the markets so most of what I’ve learned is by being in the markets and doing in the markets rather than just reading from books and stuff like that. Of course you do that but that is always in parallel to investing as such because I think personally learning yourself or understanding yourself is as important as understanding the stock so for you to understand what is your bias, what is your comfort zone and so on and so forth. I think you can only learn that by investing in markets.

Tilman Versch [00:03:45] Can you please name some of the smart Indian investors?

Gokul Raj P. [00:03:48] Yes so, I’ll probably put two names out there from who I’ve learned a lot of things. So two of our clients so as to say, I won’t say clients but the people I’ve worked with, people I’ve learned a lot, was an Indian investor, Vijay Kedia, he’s a superstar in the Indian investing circles, in the small and mid-cap circles and the other one would be WestBridge Capital. It’s an institutionalized firm but probably the smartest investors in the small and mid-cap space. So I’ve had the good fortune to work and discuss ideas with both of them, give them some ideas, understand how they think about it and then speak with them across the different set of ideas and learn how to think about businesses, how to evaluate stocks and so on and so forth.

Tilman Versch [00:04:38] We will link the names in the show notes so others can get an idea of who those investors are.

Tilman Versch [00:04:50] What other value investors have influenced you besides the Indian ones?

Gokul Raj P. [00:04:55] Okay, globally it would be the usual names, Warren Buffett, Charlie Munger, Joel Greenblatt, Howard Marks, Seth Klarman and so on and so forth. So it’s usually the same set. Probably say, one of the biggest influencers has been Greenblatt primarily because I’d started my investing career doing a lot of special situations so Greenblatt had a disproportionate impact on me and also the fact that one of my professors at London Business School, Eddie Ramsden, worked with Greenblatt as well. So he’s been a big influence when I moved out of India and I started looking at global markets. So Joel Greenblatt would be one of the biggest influences.

Tilman Versch [00:05:46] What investors do you currently follow? What other investors are interesting for you?

Gokul Raj P. [00:05:54] I follow everyone!

Tilman Versch [00:05:58] By Reddit or something like that? How do you follow them?

Gokul Raj P. [00:06:03] I read every investor letter out and I look for ideas in Seeking Alpha, value investor clubs, SumZero. Of course there are a lot of people that you can follow on Twitter so I guess in the initial stages of looking for ideas, scouting, I look at ideas that come from everywhere.

Tilman Versch [00:06:22] Interesting.

Tilman Versch [00:06:25] You said your field of research is small and mid-caps and special situations. Can you somehow add more color to this please?

Gokul Raj P. [00:06:33] Yeah so probably I’ll say what I used to do in special situations, which is still something that I do, which is that broadly special situation, let’s say from an Indian context is usually rights issues, spin-offs and then tender offers. And then within tender offers you have buy-back based tender offers, M&A based tender offers, delisting based tender offers, right. So within these spots, I think spinoffs are a pretty well understood space where people know that when a conglomerate is demerging and spinning off its units, there’s usually value unlocking happening and all kinds of spinoff effects coming to picture. So that part is pretty well understood but I think the other interesting part is the rights issue. The reason rights issues are interesting is that rights issues are something where a company’s raising money from its existing set of investors by issuing fresh shares. So usually what happens it, let’s say you’re a company for simple terms, let’s say their stock is trading at $100 and then you’re doing a rights issue at $50, one is to one (1:1), which is that you’re asking everyone to put $50 more for one more share. So theoretically, what happens is every shareholder subscribes to the rights issue and then the share price settles at $75 so that there is no profit or loss.

But in reality the way how rights issues work is, if everyone gets an opportunity to subscribe to rights issues at a discount, there are a lot of people who don’t subscribe to it. It can be for any reason. For a retail investor, no one wants to fill out a right’s form and do it or an institution who doesn’t mind going and doing all this effort of someone who just doesn’t have the cash to do incremental allocation to this particular stock or risk management. So usually what happens is you always have a portion of the book that is not subscribed by the existing customer, shareholder base. So you as an existing shareholder sometimes get over allocation. So theoretically what happens is, let’s say you bought one share at 100, you have one rights issue that you can subscribe at 50 but let’s say instead of one, because of oversubscription you’re able to do two rights issue at 50 and then the stock settles at 75. Then your blended cost is not 75 at that point, your blended cost is like 66 or something like that so you’ve already made a 20% return.

So that’s the opportunity. That’s the inefficiency that comes from the rights issue process. And usually when you apply for, at least in India, when you apply for a rights issue, you can over apply, more than what is your percentage of allocation and then the company looks at how many people have applied and then allocates it. So usually you get an over allocation. And secondly, even though theoretically price should settle at 75, there are a lot of cases that markets are not that efficient and then the price trades at 76, 78, 80 or 60, 65, 70. So you always have inefficiencies that you can capture when you’re doing these rights issue based offers. And something similar happens in tender offers as well. Let’s say you’re having 100 shares and then technically the company is buying back 20%, not through the market route but through a tender offer route. So technically out of your 100 shares, only 20 shares could be bought back and usually buybacks are done at a premium, maybe a 30% premium or whatever it is. But in a lot of cases very few people take the effort to go and give back their shares for the buybacks. So in some cases when technically they should only buy back 20% of your shareholding, maybe they end up buying 50% of your shareholding at a premium.

So you make that alpha. So it’s effectively transfer of wealth from the people who are a little lazy and who are not doing their work to you who’s a little bit more active. So this inefficiency creates a lot of attractive money making opportunities and especially if you’re working in small caps or mid-caps where very little people follow it or there’s very little active shareholding, then this inefficiency is even higher and then you get very attractive investment opportunities in this space. And I think this global as well but every country will have its own tender offer regulations, rights issue regulations and so on and so forth so. So for example, I think in some markets in the US, these rights issues are tradable so if you’re not subscribing to the rights issue, you can sell your rights issue to someone else in the market. In India, that kind of stuff is not there so technically if you’re not subscribing to it, you’re going to effectively not apply for it.

Tilman Versch [00:11:46] How do you screen for these ideas or these special situations?

Gokul Raj P. [00:11:50] So for rights issues it’s usually the market announcement. So, for example in India you’d look at NSE or BSE which is the stock exchanges and then have a keyword for rights issues or something. I think for global markets you can do it through Cap IQ; some people do it through Google Alerts. So in a year, in every market there will be at least 5-6 rights issues, so it’s a very attractive space to work on.

Tilman Versch [00:12:20] Are there are certain risks in these special situations?

Gokul Raj P. [00:12:22] Yes. These are not arbitrage in the traditional word of arbitrage which is risk-free. There’s always risks in it but if you’re underwriting it better, then you can choose which are the rights issues that you need to participate on which are not. I’m not saying every rights issue is attractive, I’m just saying there are certain rights issues that are usually attractive compared to other things. What’s usually the problem is the inventory risk or in this case what I mean is, let’s say you’re buying something for the rights issue and then you’re not having profits on it and then you need to sell it and don’t get a good price. So usually when you do this rights issue on a good business, it makes more sense. So I would never want to do a rights issue on a business that I would hate or I think is disastrous but you have a lot of rights issues happening even in good businesses. So, the usual things that you look for is risk management in rights issues. So you’re looking for oversubscription. So what do you need? You need a very passive customer base. So, for example in India, if there is a stock where there is 40% retail shareholding, you can safely assume that only 10% of the shareholding base would apply for this rights issue or 50%. You can do your own sensitivity analysis and see at what point do I get how much oversubscription and that makes a big difference.

So let’s say if it’s a buy-back, and then you’re able to chart out different scenarios where if everyone subscribes, they buy back 20% of mine but if only 20% of the retained public subscribes maybe 80% of my shareholding is bought back from the market, then that decreases your risk a lot. Then you just need to sell your remaining portion in the market, right. So shareholding pattern analysis, who are the shareholders, what’s their incentives, how many people do you think would subscribe. All of this makes a difference and these are generally market price agnostic. So in the bull market or the bear market, rights issues should keep happening and their returns are not directly linked to how the market is doing at that point. So from a portfolio management point of view, these are good alternatives. So, the way I manage my portfolio would be, I’ll have a core portfolio which will continue to be the components of multiple stocks that can keep generating returns. And then I’ll always have stocks that are churning a little bit higher, this can be tactical opportunities of these kind of special sets. So the attractive part of these kind of opportunities is these are market agnostic, so they’re not directly correlated to the markets.

Tilman Versch [00:15:14] Is there anything else in the process you want to add about special situations?

Gokul Raj P. [00:15:18] The other big point is spinoffs as well. As retail investors, your nimbleness to enter and exit can give you tremendously attractive risk/reward opportunities in spinoffs. Again in spinoffs, I play the emerging markets spinoffs a little differently from developed markets spinoffs. Primary reason is, in developed markets, I think a lot of attractive opportunities emerge post the spinoff where a stock is being listed and there is a lot of forced selling, then the stock just keeps correcting initially and then you go and buy it as a liquidity provider or opposite side of the forced seller. So that’s the mispricing you’re capturing post the spinoff. In the emerging market, what I’ve seen the post spinoff forced selling is relatively lower because a lot of ownership still lies with some owner operator or retail shareholders where there is nothing like you need to immediately sell if certain market cap thresholds are broken or something like that.

So, the forced selling issues are much lower in the emerging markets. So what happens when you have the pre-spin-off stage and let’s say technically there’s $100 stock and then it’s getting split into 80 and 20, and your ability to buy it and then sell it on the day, whichever part you need to do becomes attractive. Because what happens is, if in your mind, if you are saying it should be an 80/20 there are a lot of times where market puts a 70/30 or 60/40 or 90/10. So for your ability to sell one, buy another or shuffle across these two stocks becomes a little bit easier. Or if it’s a three-way spinoff or four-way spinoff, there’s a lot of three-way spin-offs that happen in emerging markets, then you’re having three different stocks that are getting listed and everything is getting mispriced in the initial few days. Some of it is getting overpriced; some of it is getting under-priced. So for your ability to shift across these names helps you to create some value, other than the usual value unlocking theme and the usual every business at once it became separate then there’s separate focus and so there’s growth opportunities.

Other than those things, there’s this additional lever that you can get by shuffling across these names when a spinoff happens. So that would be on the spinoff part. On the tender offers or buy-back part I think the biggest thing is, other than the shareholder analysis, if you’re able to have a better understanding of the underlying businesses and in your view if you have a value to each of the opportunities, then your ability to size the positions becomes easier. So in a business which you don’t want to hold if the special situation is not happening, you can have a lower position but if it’s a business where you’re comfortable holding it irrespective of the special set, then you can of course do a 10% kind of position on those kinds of names.

So the risk management comes from the underlying business quality and the value that you ascribe to it, so this fundamental analysis with some amount of special set tactical selling. Because again, just being active makes a big difference in all these things. So for example when a spinoff happens, you always see that on the day, both the ex-date, when you can sell out or on the day the listing happened, there’s always the first few trades which are mispriced. The volumes are lower so technically a stock that’s spun out at $20 of a $100 stock that spun out to a $20 stock should ideally, the next day clear at $80 but we always see that it doesn’t happen that way. It sometimes trades at 90, 85, 80 or something of that sort. And if you’re nimble and you’re already on the screen on that day during those hours, maybe you get a chance to exit at 90 and that’s your Pure Alpha from the trading side. So that’s what’s attractive about these kind of special sets, it’s that you get to play the fundamental side and the special set or tactical side of the investment as well.

Tilman Versch [00:19:44] So you also need some trading skills to handle the situation?

Gokul Raj P. [00:19:48] Yes. You need to do that because when you’re analysing shareholding pattern or when you’re analysing what’s the kind of volumes that’s been there because going into a special set, you need to know how much shareholder churn has happened because if you see a lot of volume happening before the ex-date, you can be sure that a lot of these guys are special set guys who are coming in and that makes a difference. But if it’s a stock where you see that pre-spin-out, pre the ex-date on a tender offer, there’s very little volumes, then you can be reasonably sure that a lot of the shareholding is long-term orientated. So all this analysis of the volume, shareholding, these are not fundamental factors, these are not the usual analysis of a business and valuing the business; so that skillset along with the fundamental skillset is very valuable when you do special situations.

Tilman Versch [00:20:39] Do you have a rough time of how much you spend to do the special situation analysis?

Gokul Raj P. [00:20:46] So for me personally, it’s a matter of where the markets are. So for example let’s say in a bad market, the 2008 market, or in India the 2013 market, or the last year, last six months when markets were having issues, then I spend a lot of time on the core positions where I can really go and build a core compounder position at an attractive price. So then I don’t spend that much time on special situations. But in bull markets like say the last 15, 20 days, then I spend a lot of time scouting for special situations because the core portfolio. But usually we can say that on the fundamental side is what takes a lot of time; the technical side of research is maybe a few hours.

Tilman Versch [00:21:43] Can you name some examples of former special situations that were interesting to you?

Gokul Raj P. [00:21:50] I can name, but maybe from a live point of view. There’s a three-way spinoff in India happening in IIFL Holdings which is one of the portfolio companies of Fairfax India. So for global investors who look at Fairfax India, maybe they can have a look at it. So, there’s a company called India Infoline Holdings which is a financial services company that’s going through a three-way spinoff and that spinoff would probably happen in the next 50-60 days. All the clearances are there. So here you have a company that’s going to be split into three different companies. One is a fee-based business which is a brokerage business and the other is a wealth management business which is more like an asset management business and the third is a non-bank credit business, so all these three different businesses need a different kind of investor set and different kinds of valuation multiples.

So for example, you would probably do an earnings multiple on the brokerage business. On asset management maybe you’ll do a percentage of AUM kind of valuation. On the credit business it’s probably a price to book kind of thing. So what happens is, let’s say the last few months, the stock has been extremely volatile. That was a point at which you could have created a position where one of the businesses was free to you because of your valuation. So how this eventually turns out will be interesting to see. We’re in this position, as a disclaimer, we have a position at this point. How do we play it on the day of the spinoff, when the first three get listed? That’s dependent on where these three get priced. In my mind, I have a view of where they should be priced but you should have seen that the market has a different view and prices it differently. And then I would probably trade around those positions and then sell the ones which I think market is giving higher value on and then buy those things that I think market is giving a lower value.

But fundamentally, I think all the three business are pretty good so then it’s just a shuffling matter. And then I genuinely think this is a case where there’s value unlocking happening and also the fact that three different management teams are running businesses with clear rewards and ESOPs on their units creates a good culture for long-term growth as well. So that’s something that is happening right now.

Historically if you look, there have been a lot of these kinds of spinoffs that’s happened. In India or a lot of emerging markets, a lot of these spinoffs happen because there’s a family split. So there’s a family that is running and then there is a father who’s died and the brothers split the business then they spinoff these businesses. So that again, you can go and pick and choose which part of the business that you like. The most large scale spinoff that happened, which most people who follow India would know, was in 2003, 2004, 2005 phase, when India’s largest company, Reliance Industries split after their patriarch had a death and the two brothers split their businesses.

There are multiple companies that got created out of the parent, Reliance Industries. And by the time the bull market ended, which was 2007, you had both these people. One was the 6^th richest person in the world and one was in the top third richest people in the world or something. But four years back when it was a single company, all these guys put together were not even in the top 20 or something, so that kind of value creation happened. Similarly there was a big demerger process that happened in the Bajaj family where there’s a holding company which was an auto finance business and then there was a demerger that happened. The finance business got separated and the auto business got separated between the two brothers. The older brother got the auto business, and the younger brother got the finance business and that finance business stock would have multiplied 500 x since the spin.

So you have a lot of historical good opportunities that’s happened in these spinoffs and I think this will continue. It happens in every market, it’s not just an India specific phenomenon. The only difference is when you’re working on these spinoffs of special certain emerging markets, the way you play it should be different from the way you play a developed market spinoff or demerger or special set because the business culture is different. The shareholding patterns are different because in developed markets, the reasons a lot of this attractive stuff happens is you have a lot of passive ETFs holding in these shares and then you have sell downs and that creates opportunities.

Tilman Versch [00:26:49] Thank you very much for the great insights in this process and I’m very happy to have a second interview soon.

Gokul Raj P. [00:26:56] Thank you.

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Gokul Raj P.

Bavaria Industries Group

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