ValueWalk’s Raul Panganiban interviews Shree Viswanathan, founder and sole employee of SVN Capital. In this part, Shree discusses his one person investment team, the fee structure, his idea generation process, the quantitative standpoint of his investments, evaluating the company’s culture, and his thoughts on the long term risk free rate. Transcript continues.
Q3 2020 hedge fund letters, conferences and more
And in the future, as you grow, do you ever envision yourself having a big investment team beyond your beyond the one person?
I would hope not, I have bought [inaudible] Willow Oak, you know, it's a fantastic platform, the team around Willow Oak is exceptionally helpful and taking over all the operational responsibilities. But my objective is to keep this as a one man investment committee and be held accountable for all decisions, both good and bad. And, you know, create, it'll take this patient, long term, concentrated approach and create value.
Yeah, it's just very interesting, because your fee structure is performance based. So everything is solely relies on you as the only person.
Exactly. And not only the fee structure is performance based. It is also well aligned. You know, when I launched SVM Capital, just about two years ago, started off with a separately managed structure. Between that and the partnership, I have just about 94-95%, of my liquid network invested. So you know, I'm not only not only collecting free one leaf I perform, but also going through the same gyrations as my investors, since I'm on the same platform.
When you look for your ideas. Can you tell me about how you generate your ideas? And do you screen? And what metrics do you look at?
Sure. So I would say idea generation is both quantitative and qualitative. quantitatively, I've done a number of different screens, particularly on this, you know, days after something like today, definitely on my screens, I use Capital IQ, which allows me to look at securities on a global platform, but then qualitatively, that's where it's a lot more fun. I'm reading a lot. And talking to management teams, talking to other managers, asking management teams, who they respect and who they don't respect. So those types of those types of conversations and readings, lead me down a path which sort of, you know, expose me to newer, newer ideas to, you know, to go after, or new ideas, and in the process of learning about new businesses, business models, management teams, those are some of the exciting parts of what I do for a living.
And the quantitative, what do you look for there?
Yeah, it goes back to that quality of business aspect that I described in describing the four corners of the sandbox. What I'm looking for from a quantitative standpoint is you know, gross margin. Typically,you know, gross margin for most businesses remain stable over a long stretch of time. NET margin moves around for a variety of different reasons, but gross margin healthy gross margin is a is a good starting point. On the with respect to the balance sheet, you know, generally looking to see a balance sheet has any need for leverage, any need for outside financing, you know, real estate investment trusts and a few other levered operations need No outside financing for them to continue on. So whether there is any need for that, because those are not attractive enough for me. Um, how have the How have How has the company performed over a stretch of time? What has been the primary growth engine? Is it organic or inorganic, I generally don't like inorganic, even though I do own a portfolio company that is involved in acquisitions. We can cover that later if you want. With all that, and I'm looking to see if I'm looking to see if the company has generally performed at a healthy return, healthy return on invested capital, not looking for just return on invested capital. And looking specifically for two factors.
One, is incremental return on invested capital, no, what was the capital 10 years ago? What's the capital now? And what's the ones that are done back then in terms of cash, and what is their, you know, return now in terms of cash. So that sort of incremental return on capital is number one, and your ability to reinvest is absolutely important, it goes back to that point about compounding, using the power of compounding. It's great for a business to generate, you know, it's a 20% return on capital. But if they're going to be returning almost all of it back to me, in terms of dividend or buyback for that matter. It's a little less attractive. Now, I acknowledge the fact that not all businesses have the ability to reinvest all the time, I do have a few businesses that do return capital back in terms of dividends and buybacks. But ideally, this is what I would be looking for incremental return on capital and great reinvestment opportunities. Because at the end of the day, what what are we looking for, we're looking for great businesses, that can create value over the next, you know, if I have the patience to hold on to this good quality business over the next 10 years, the creating value part of it arrives as a product of this incremental return and reinvestment. So that's what I'm looking for. It involves a little bit more work while I'm finding ideas, and on top of it, I then go find the management owns a chunk of the business hour, they're getting compensated, and stuff like that. So the upfront work sort of whittles down the list to a very manageable.
And like what you said before, do you also try to find or look for companies with that 10 year or 10 plus year history to evolve?
Yeah, generally speaking. These are, you know, mature businesses that have been around and have the history to give me confidence that they can continue on with it next 10 plus years. Most of the businesses in the portfolio are in fact all the businesses in the portfolio have more than 10 year history.
And then you also mentioned the evaluating the management team and the culture and that kind of diligence. Can tell me more about that. And how do you evaluate the company's culture and what do you look for?
Yeah, so admittedly, no, this is a difficult, this is a difficult process. And I'm looking for, I'm looking to understand the quality of decision making at the time when those decisions were made. And fortunately, what happens is focusing on owner operated businesses, in our 10, they sort of helped me in this regard, to a large extent, you know, they still don't answer the culture part of it. They still don't specifically answer the cultural part of it. I'll get to that in a second. But owner operated businesses tend to be a lot more attractive. 10 of the 12 businesses in the portfolio are owner operated or family involved currently, so they generally tend to have less turnover at the C suite level.
C suite is where the decisions are being made. And I'd like for those decisions to be consistent over a period of time. And it allows me to sort of go back in time and understand what they have said in the past and be able to compare the results to what they have said in the past. That gives me additional confidence. Obviously a lot of reading in our annual reports, proxies, transcripts, conference participations, and then you know, management. I do try to meet with management teams, I specifically asked for these questions about, you know, who they respect and who they don't. And those all sort of helped me in forming some good idea about the quality of the management team. And then, you know, as Charlie Munger had said, you know, show me the incentives, and I'll show you the outcome. I try to I try and spend a lot of time on the proxy, you know, the annual report. And typically, I like for management teams to write some detailed letters, it's a, it's definitely a very American or Western European and American sort of a tradition, I don't see that quite as often in, say, Eastern European, or even in many Asian countries. But that sort of data gathering helps me for a decent opinion about the quality of the management team, then bring it back to that proxy par. No. I want the management teams to own a chunk, the compensation structure to be very well aligned. And incentive programme to be driven off of something to do with cash flow or something to do with return on capital. So just based off of revenue, I have come across good businesses this year, actually, and passed on them because it's an incentives are based on your revenue.
Do you also evaluate the company's board? And how much that goes into the investment decision?
Yeah, um, clearly, you know, having a having a capable board. And helping the primary objective of the management team CEOs helps the overall costs, and I'm looking for the board to get compensated. In terms of company shares, as opposed to purely in cash, I'd like for the board members to be good to be long term good holders of the stock as well. But beyond that, as I go down in size, you know, and that's something that I'd like to clarify, the portfolio doesn't have any size restrictions. You know, I have 100 and $50 billion market cap company in the portfolio, I also have a $500 million market cap company, the portfolio, so, but going to 100 and 50 billion market cap company and asking for board meetings, or board members, that doesn't generally work. But as I go down in size, I do get the opportunity to meet the board members sometimes. But it's just a matter of qualitative analysis. My primary thrust in that aspect is more on the management team. But I'd like for the board to be a good support mechanism for them with the management team.
And then as a global investor, we evaluate management of, with companies based in different countries, how much of the different cultures affects that evaluation or if it does?
Yeah, um, clearly, you know, that's a very important aspect of my qualitative analysis. As I said earlier, the country I don't necessarily start from a top down approach, saying, hey, this country is interesting. Let me pick a couple of securities from that country or a particular sector is interesting. Let me pick a couple of businesses from that sector. That's not approach. Every single business is sort of based on bottoms up fundamental analysis. So I just go the way these ideas Take me, if they take me to, say Mongolia or Nigeria, obviously that's a no go. But certain specific countries, what I'm looking for are no, no, from an accounting standpoint, I want them to be IFRS compliant. From a governance standpoint, it is just my understanding of the country's governance policies. You know, coming from India, which is a British Commonwealth. You know, it's one of those countries with a Judas prudence that sort of protects IP laws, which is somewhat comparable to the Western world. But there are many countries that where that is not the case. However, it's my understanding of how these IP laws or corporate governance, you know, survives in those countries. That's, that's important in how I evaluate. Interestingly enough equity capital markets, you know, Eastern Europe doesn't necessarily roll off of equal stones. But increasingly, I find Holland to be a little bit more attractive in that regard. And, and spending a little bit more time trying to understand the country, the governance, the local market, but that's, that's a market that has become a little bit more interesting outside of us, Western Europe, and even to a certain extent, Asia.
Oh, wow. Yeah, I would definitely like to talk about Poland a little bit more later on here. But just one more question on on your investment approach. Before we go into some ideas, the rates have been a pretty big topic this year. And, so I just want to know, what is the long term risk free rate that you use now? And what are your general thoughts on interest rates now, and and going forward as well?
So it's a very hot topic, as you said, amongst both value investors and you know, any other category that exists. But it is a fact that interest rate is the equivalent of gravitational pull in physics, as far as valuation or finance is concerned, right. Now, what are we what are we actually talking about? We are talking about valuing businesses. And what does that mean? It's essentially thinking about cash flow into time infinity, and discounting them back to current day, using an appropriate discount rate. And that discount rate is primarily driven by, you know, risk free rate, which typically is 10 year Treasury on a global scale that's used as the risk free rate. And then whatever the equity risk premium is, all that sort of leads you down to complicated mathematical computation. Or it can be simplistic mathematical computation. But it is a fact that interest rates do drive valuation.
In fact, even Warren Buffett has said that, if you tell me what rates are going to be, in 10 years out, I'll tell you, whether I'm interested in a specific security or not, that's how he thinks about it as rates, meaning discount rate is the denominator, whatever the cash flow is, is the new. So as the denominator kind of goes down, obviously, the resulting number is going to appear to levitate. That is something that we have observed in the overall market. But to answer your specific question as to how I think about taking that interest rate into account, I still use approximately 10% as the discount mechanism for for my cash. I'm obviously using that discount mechanism, relative to where the interest rates are today, it appears a little every little high. But then, you know, I don't want to get into the complicated math of computing what the weighted average cost of capital is, and just move it around by a few basis points here and there. It's a it's an easier approach in this regard, just to take a flat and percent rates do move around.
You know, there is a there are two individuals that I respect in this regard who think extensively as it relates to the US Treasury as it relates to interest rates. Number one is Jim grant of grants interest rate observer, writes enormous Lee enormously in this regard. And number two, there is a gentleman by the name of Van hoisington, out of Austin, Texas, and he manages a portfolio focused exclusively on US Treasuries, has done phenomenally well. And he also writes every quarter these days, and puts it out for free on his website. So those are two gentlemen that I follow, particularly Van hoisington Have the opinion that rates based on certain nerdish analysis of how he looks at the world arrives at the fact that the rates will continue to remain low, and inflation is likely to remain low. That's his view. I sort of respect both of them. I respect man hoisington quite a bit. So you can say that I'm somewhat biassed by hoisington viewpoint. That's a long winded way of saying I still come back to using 10%.
