Gokul Raj is a portfolio manager at the Munich based Bavaria Industries Group AG. Gokul has attained a 24.42% median return across his 13 SumZero ideas, many of which focused on undercovered emerging market names in countries including India, New Zealand, and Norway.
SumZero sat down with Gokul to discuss his investment background, recent ideas, and advice he has for investors following emerging markets.
SumZero: During your time as a SumZero member, you have topped the East/South Asia, GARP, Small-Cap, and Financials categories. Could you detail your background in value investing and your investment philosophy?
Gokul Raj, Bavaria Industries Group AG: As with most value investors, my journey wasn’t entirely planned. I was hooked to financial markets at a very young age serendipitously. I grew up in a small town in South India with a circle of family and friends that had nothing to do with markets, business, or investing. I am a self-taught investor and grew up learning the trade from the large-hearted investors who have shared their successes and mistakes with the wider public openly. I was also fortunate to get mentored by some of India’s finest investors during my early years.
While I have been investing in Indian markets (both personally & professionally) for over 10 years now, my investing experience globally is solely over the last 2 years. I headed the research team at a sell-side firm focused on Indian small & mid-caps that grew rapidly initially and then collapsed under the weight of new regulatory and compliance issues resulting from its growth. This, along with my admission into the London Business School made me shift my focus from India to Europe.
I play the entire gamut of value investing spectrum from deep value to quality compounders. While I do source varied kinds of interesting opportunities in India, my idea funnel in global markets is primarily focused on Spin-Offs and Compounders.
SumZero: Could you walk us through Bavaria Industries AG’s focus? What contrasts or comparisons do you see between investment strategy at family offices versus hedge funds that need to offer quarterly or monthly liquidity?
Raj: Bavaria Industries is a listed investment holding firm run by a Founder/CEO who controls the majority of its shares. He is a value investor with a solid long-term track record in both private and public equity investing. We primarily invest permanent capital (balance sheet cash), which allows us to take an extremely long-term and patient view of our investments. This gives us a tremendous advantage to capture the behavioral inefficiencies of Mr. Market. The other big positive of our investment structure is the ability to look at any opportunity in which the Risk to Reward is attractive. This flexibility allows us to look at ideas across different geographies, market capitalizations, and capital structure, whether the opportunities are in public markets or private equity deals.
SumZero: How does your being based in Munich differentiate you and your team as value investors?
Raj: We are a very small team of passionate investors. Being based in Munich allows us to stay away from the noise in the financial markets. The location has also helped the firm to build strong private deal sourcing abilities in the German-speaking regions of Continental Europe. We are now trying to replicate this deal flow in public markets by building mutually beneficial relationships with smart individual investors across the globe so that we can co-research and co-invest with them.
SumZero: Could you tell us a little bit more on this opportunity?
Raj: Due to my start as an individual investor, I am fully aware of the tremendous untapped potential among non-institutional investors who are managing a small capital pool and the internal limitations any fund has in sourcing niche ideas. We always encourage savvy investors to share private opportunities with us that they are currently investing in. We then research alongside them or independently evaluate the opportunity presented. If we end up investing in the idea, we generally pay our partner a small success finder fee and as the relationship develops, we move it into a profit-sharing agreement. If we don't like the idea, we end up explaining our issues with the opportunity in a transparent way. This helps us create a healthy Win-Win relationship with investors seeking to profit from our large capital base. We hope to grow and nurture this ecosystem as we go along.
SumZero: Most top-ranked SumZero members have a tight geographical or industry circle of competence. Your SumZero ideas have outperformed their benchmarks across a wide range of geographies and industries (e.g. India, Norway, New Zealand). Is there more in common between these stocks than meets the eye?
Raj: I think most of my ideas in would fall under the bracket ‘cyclical compounders’. While the term sounds like an oxymoron, it primarily refers to great businesses that operate in industries with structural long-term growth tailwinds but have huge short-term business cycles. For example, let’s take Ryan Air. The short-haul airline travel industry as we see it has always had structural growth opportunities. However, over the short term, the business and share price are hugely sensitive to the economic, interest rate, and commodity cycles. This set-up has enabled very attractive entry points into the stock several times in its history compared with other compounders whose business model and management quality are well known and tested.
As with many value investors, I evolved from focusing entirely on cheap stocks to appreciating quality and growth. While, I haven’t really been able to come to terms with paying high multiples for secular growth compounders, I am comfortable buying great businesses in cyclical industries experiencing a bad phase paired with the market over focusing on the short term and extrapolating the headwinds. In fact, the importance and utility of key characteristics that you would expect in compounders, like great management and capital allocation magnify in cyclical industries. This allows these companies to emerge stronger and bigger following each cycle. My watchlist consists of cyclical companies across geography and industries which I track closely and pull the trigger when I believe that the pricing is attractive.
SumZero: Could you walk us through your Summerset Group Holdings’ ORA business model? What adjustments did you apply to come to a < 1X P / B?
Raj: Not just Summerset, but all the listed retirement village operators in New Zealand operate on an ORA (Occupational Right Agreement) model. With the aging demographics of the country, there is a huge demand for retirement homes. The developer finds a good property and then builds up retirement homes and community areas suited to the elderly. The residents then buy a nontransferable right to occupy a retirement unit indefinitely without taking title to the underlying real estate. When the resident vacates the unit (usually on death), the operator repurchases the occupation right at a cost less a deferred management fee (DMF) that is roughly 5% a year (cap of 25%).
The average age of entry for these villages is 75+ and residents usually live for 3-4 years after moving to these villages. Summerset provides a continuum of care services for the elderly which provides a stable annuity like cash flow. So, the underlying business model is a hybridized property developer, time-share vacation seller, and health care operator. The operator is a real estate developer that finances development with customer deposits and gets to resell each development every five to seven years in perpetuity. This ORA model enables the operators to generate significant cash flows and profit from the real estate price appreciation without getting their capital locked.
The model creates a lot of distortion in the accounting statements. The occupation right is treated as an interest-free loan (occupancy advance on the balance sheet) rather than a sale. Consequently, no revenue is recognized (and no income tax is payable) when an occupation right is sold or even when resold after the first cycle. Instead, the company recognizes changes in fair value of its real estate produced by the development uplift in the first cycle and real estate price appreciation in the subsequent cycles. The DMF is recognized as non-cash revenue. The deferred management fee is amortized over the expected period of tenure. As a result, the income statement does not truly represent the underlying economics.
On the Balance Sheet, there are two big elements, investment property valuation on the asset side and the customer advances on the liability side. When we were buying the stock, the firm had 1.9 Billion of assets and the investment property was valued with a conservative cash flow discounting rate of 14.5%. The customer advance liability which is a float (costless liability in perpetuity) was 0.87 Billion $’s. Our argument was that even if we assume that just 60% of this float is not a true economic liability, then the stock was trading at 1X adjusted book. Now, we can say with hindsight that, we were buying the stock at 0.75X forward price/ book with the same 60% liability adjustment.
SumZero: Your Summerset idea mentioned that you spoke with the firm’s management team and industry professionals. Could you describe your primary / scuttlebutt research framework and how it plays into your research process?
Raj: I don’t have a fixed template on my scuttlebutt and generally let the idea decide what kind of research is required. My scuttlebutt is primarily to validate my thesis and look for potential thesis killers. If the thesis gets strengthened from the primary research, then that is just a bonus. I like speaking with competitors and stakeholders in the ecosystem and not just the management team. For example, in my recent Bank Norwegian idea, my discussion with some of the online loan sourcing websites gave me a strong understanding of the increased marketing inflation in the system because of competitive intensity and that was key for me to understand the scale advantages that Bank Norwegian had against many other newer players. I assess some of the finer qualitative metrics like organizational culture, management focus etc only over a period that I track the firm and not on first research.
SumZero: Your Wizz Air Holdings idea doubled in price over 9 months before you closed it. Are you still following the ULCC sector? Why has Wizz’s growth leveled off?
Raj: I don’t think that Wizz’s growth has leveled off. It still has a long runway for growth but the valuation re-rating in Wizz Air happened much sooner than I expected. While the company might still grow and compound value, we thought of taking the money out as the Risk-Reward wasn’t as attractive as before and we also found other opportunities in ULCC’s space where we could deploy capital. Yes, I continue to track most of the well run ULCC’s across both developed and emerging markets. It is interesting to note that several European and Asian airlines are struggling to stay afloat now with the rise in crude prices despite benign interest rates and demand environment. This shows how weak the industry is and when the economic cycle turns, there will be great growth opportunities for ULCC’s that have a strong balance sheet and focused execution. These ULCC’s always have a step increase in market share during a crisis. We might relook at Wizz air when the price is attractive.
SumZero: Many of your best performing SumZero ideas are on Indian equities. What advice do you have for fund managers interested in investing in India?
Raj: I don’t have any advice particularly regarding India, but the broader emerging market basket is a fertile hunting ground for cyclical compounders. These markets have an additional layer of cyclicality resulting from their dependence on foreign flows. As a buyer, you would always want to deal with a forced seller. The “Emerging Markets” are placed in a single cycle of foreign inflows even though their economies could not be more diverse. The broader flows into passive emerging market investment vehicles create huge distortions between prices and values of the underlying businesses. This gets magnified with herding effects and investors considering these positions as non-core. In effect, the opportunity to buy an asset with an intrinsic value of 100 at 50 and then sell it at 200 is much higher in those markets. If the underlying asset compounds in value, then you get the double engine of earnings growth and valuation re-rating. India is one of the main secular growth emerging markets that is cyclical from the flows perspective and that allows us to capitalize better on the underlying market inefficiencies.
SumZero: Where do you see the most value in the market today? And on the flip side, where do you see overvaluation?
Raj: The Emerging Markets index is down 20% from its highs in dollar terms and most markets haven’t delivered any returns even over a 10 year period in dollar terms when the US markets have been on a tear. So, you are seeing a lot of momentum flows exiting and some existential questions posed on EM only funds. We are seeing some interesting opportunities that are starting to emerge. I especially like some of the compounders in the ASEAN region. The watchlist I've curated over many years is starting to show early signs of attractive valuations. We have been accumulating a couple of them but still haven’t allocated anything meaningful. On the overvalued side, with the long bull market, there is enough investor complacency in a lot of the growth names and people are willing to look too far into the future without acknowledging the underlying risks. Some of the pockets in which I see clear overvaluation are the new age SAAS/ consumer tech businesses on the growth side and Holding discount/ Land ban/ SOTP stories on the value side.
SumZero: What role does SumZero play in your research process?
Raj: SumZero is an important idea sourcing tool for me as it is the most diverse investment platform. Also, since I follow most of the ideas and members regularly, it helps me to get a broader understanding of the kind of opportunities that are available in different parts of the globe. I have gained many investor friends from SumZero and also benefited immensely from the user comments on ideas.
SumZero: How has your investment approach evolved over time? Who or what are your biggest investment influences?
Raj: While my investment sourcing or research frameworks continually evolve as I keep looking at more varied businesses across geographies, the bigger learnings have been on position sizing and risk management. I have overtime understood the importance of knowing your inner-self well and that has helped me to slowly craft position sizing strategies and risk tools that are suited to my personal biases. One of my biggest influences on staying rational across market conditions is a popular Indian investor, Mr. Vijay Kedia with whom I have had the good fortune of discussing stocks and markets for a long time now.