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A few key themes

February 21, 2013

Greg Speicher in his ebook 115 Investment Ideas talks about a particular theme (among many) which is especially pertinent and timeless :- AVOID STUPID MISTAKES.  In investing this is a pure gold because an investor how much ever good or nuanced is always prone to making mistakes. Its easy to overlook or even underestimate the importance of a particular element. With such mistakes one is set back quite substantially in his personal wealth. I have observed and caught myself making mistakes in the past. Though its a shallow consolation to see the number of  mistakes reducing with time (Note to Self: it will be interesting to make a study of the mistakes/per 100 analysis I commit and perhaps try to put it on a Poisson distribution ) yet it is still serious enough problem for me to ignore it.

A mistake doesnt only set you back in money but also in time and thats a serious cost. And to reduce it, I have a list of lessons I have built for me which I periodically go through. These lessons are reproduced here:

  1. Evaluate Management, Business and then Valuation , in that order and importance. Bulk of the effort will go in evaluating management credentials, the second part in understanding the industry challenges and problems and developments. And if the field is clear, move in the valuation side of things. Management has to be evaluated on three dimensions:- their integrity,their cash allocation skills and their operational skills. Management is hired by you to handle the last two but when you hire you will look at the first quality right at the start. My biggest mistake had been Kothari Products.I bought it in Feb 2011 at a price of 374/- with an aim of about 750-800. It was a standard gutkha, pan masala brand, the iconic Pan Parag is from their stables, had good amount of cash, in fact cash holding was more than their market cap. Its volatile and low ROE business like Construction and Share Trading was camouflaged and the company deserved a good price for its business. Except it didn’t. The stock was a value trap purely because management were rentiers. I finally sold it at 407 in 2012 September. The stock barely paying me a return of AAA bond.
  2. Growth will not be value accretive if there is no competitive advantage , this is an extremely pertinent idea as this market stupidly chases growth in its any form, any price and at any potential. Consider company in an industry which has no competitive advantage. None, nada, nothing. Its a  highly fragmented industry and competitors are bleeding just like this company. One year by the usual bearings of providence, the company gets bumper profits and decides to grow in itself. Which implies capex. This decision is wrong on many levels. Firstly, this industry has atrocious ROCE in itself and your company is no better than most. So investing in a low ROCE business is stupidity which stands to reason that the money wont be value accretive, i.e a 1Re investment will add a maximum of 1Re value and can even add less than it, which will mean that its value destructive. In another level, if you build capex in a business where there is no competitive advantage then it stands to reason that the great profits which you earned in one year is the average experience, i.e everybody made money that year. Which in turn implies that everyone is going to invest in growth just to stay afloat just to earn more money, which implies that the price of the final product will plummet. Growth is simply not value accretive! Consider just one small change here. The protagonist company has wonderful competitive advantages. In a business environment replete with competitors selling products utterly indistinguishable from each other, your company builds products which are sheer art in itself. Then, you as a CEO can invest as much money as you want to and still earn value accretive growth for your shareholders. Hence, what is the key lesson coming from here. If the industry is in a commodity business, then its value is its on going “no-growth” valuation. Hence a commodity business is buy-able only if its quoted valuation drops significantly from its on going asset value. e.g to think construction business, or iron ore business or even electronics business as other than commodity business as foolery. However APPLE is in Electronic Devices business but it is not in the business of selling electronic devices, its in the business of selling experiences and thats a great thing. My mistakes in this hall of fame: Polyplex, Precision Wires
  3. PE is not a measure of value , this theme is repeated elsewhere as well, however its worth allocating time and effort to it. PE calculation bungles up at two distinct levels- to believe that market cap is the valuation of the company and EPS is the true cash flow to the shareholder/company. And as we know two wrongs dont maketh one right. Consider for instance CRISIL, a business which is quoting at an enormous PE of 25 or so. But if you are a strategic buyer you will not only get huge cash in its books but also a very high quality cash flow stream, a moat almost impossible to dislodge to say just the least. And even from a valuation perspective using EV/FCFF is a winning idea than using EV/EBITDA or PE. My mistakes in this hall of fame: Selling STRIDES ARCOLAB too early, DECCAN CHRONICLE (you can put this as an example of any mistake on this list and still be right, it was a wrong decision on so many levels for me)
  4. Once you have found a good investment, the right time to sell is almost never, Imagine your bank comes to you and says that we held a lottery last month to select the lucky few customers who will get extraordinary high rate of interest. For ever! You are one of the three customers chosen and starting today, your money is being compounded at the new rate of interest. Will you rush to your bank and withdraw your money today? Or tomorrow? Or a year later? Or rush to your friends to borrow money from them so that you can store ever increasing amount of money in this wunder bank! Now what is a good investment? An investment is a good investment which can grow sustainably very high amount of money for a very long time. Which means the key concepts are: high rate of return, long time and highly scalable business. My mistake in this hall of fame: Selling Strides Arcolab too early.
  5. Overconfidence Bias: Amateurs have a wonderful ally with them- their sense of confidence, their sense of can-do spirit, naivety. But such an ally also have to be reined back. Overconfidence is a highly infectious disease and have killed many a brilliant mind. Fight it. My mistake in this hall of fame- too many to even recall 

These were mine, and now it time to reveal yours. What mistakes did you make?

Bettering circle of competence

January 10, 2013

Financial Businesses are my blind spots. I can’t visualize them. I can’t understand the difference between one financial business and another. However I am a little better with brick and mortar companies. To further add to the woes, the sector almost always is so mired in regulations that understanding the source of sustainable competitive advantage is a worthy edge in itself. On top of that, worthy literature on investment in financial stocks is few and far in between.

Thus for me, it had been a tough situation to understand the challenges, threats and opportunities in financial businesses. However recently I came across a few ideas to really have an insight into this sector of the economy. And I would suggest anyone wishing to improve his circle of competence to take up the following:

  • In US, the major financial companies which are public are- Goldman Sachs, Morgan Stanley,Wells Fargo etc. Dig up the 10-K and 8-K reports for one of their business cycles-here credit cycle and do thorough reading of them.
  • Give yourself a rest and try to write on the potential drivers of this business and how one should go about valuing it.Make sure you write it.
  • Google up Aswath Damodaran’s work on valuing financial stocks. That is the feedback on your understanding.
  • Take a rest, and write some more on your understanding. Reread Aswath Damodaran’s work again.
  • Google up famous investors logic on investment in companies in this business. Bruce Berkowitz’s interview to Outstanding Investors Digest in 1992 is a classic, so is Buffet’s article to OID titled “A security I like”. Read them multiple times.
  • Take a rest. Write again.
  • Now read the regulations of India: In this case- Economic Survey, RBI website and budget and white papers will be helpful. Google is your guide here.
  • Now read the annual reports of the big leaders in this space.

This is a long drawn out process. It will take time for the ideas to get cooked. For me as I understand, it will take about 2 years which is a good reasonable time to “have a grip” on the dynamics of this business and another 2 years of understanding and analysing it. Of course one may get a headjump if someone is there to hasten up the second installment of 2 years, but it will take atleast 2.

 

Benchmarking: The only way

December 16, 2012

To control something,you have to measure it

Control Engineering 101, will teach you this thumbrule over and over again. If you have to ‘control’ something, you have to measure it first. However, we need to understand that ‘controlling’ doesnt mean to restrain something or the usual literary way we understand this verb. In this proverb you can safely replace the word improve wherever you find the word control.

Philip Tetlock has an interesting observation to make. During the closing years of the 80’s decade, the liberals as well as conservatives had something or the other to predict about the action of Soviets and thus guide the posture apropos of United States.But as is wont no one could really predict the fall of USSR. However what followed was startling because each one of the expert pundits added a rider to defend their core of the belief system. Each of them found out something which they believed  played an important role in the subsequent events, and about which they added an appropriate rider. Tetlock calls it “outcome irrelevant learning”.

If we look around ourselves we will find the a huge chunk of decisions which we are called upon to make has considerable amount of vagueness,arbitrariness or plain incompleteness about the facts surrounding it. Pursuits of successful speculation, political decision making, strategic decision making(to lead the company into a high risk, high reward pathway or a low risk, mediocre reward path), hiring people etc, to speak just a few of. Additionally to add to the milieu, we often claim to have intuition or knowledge to aid us in the same. Or in other words a skill which sets us apart. Stock pickers talk about hunch,political experts talk about  irrelevant superfluous things like the college they went to(to incite halo effect) or quote the instances where they have got right(survivorship bias) to improve respectability,leaders claim again hunch etc. But each time if we genuinely make a note of success vs failures we will come to a jarring conclusion- people are extremely confident about themselves and their skills, they know a lot less than they believe they know and worse the guy on top probably knows fewer things than the intern who joined last month in making decisions which matter.

Decision making is a relatively newly acquired skill when we talk from an evolutionary point of view and hence, we have very fat tails of outperformance among the morasses of mediocrity.Very few people have really been able to do better than a chimp or random chances in the long run.

However consequent to the Red Queen Effect in life we need just a bit of edge to be successful. We need to make slightly better decisions than others,slightly better investments than the others and hire slightly better people than others.However since the vast majority wallow in the dark labyrinth of human misjudgements, we just need slight improvement. Which implies the marginal value of improvement at this stage is extremely high. The possible rewards are seemingly vast. Warren Buffett is an extremely pertinent example of the same, Nate Silver similarly. What they have done is, they have spent quite a lot of time thinking about how to navigate in the best way through huge forests of data and observation.

Though it will be an easy exhortation to ask an average person on the street to make effort to improve his decision making, it will not be an easy project at all. However the project is very simple(not easy). Daniel Kahnemann’s advice is to invest in a very cheap notebook. It automatically implies that people should actively be 1) aware of themselves 2) really motivated to improve their decision making 3) take the effort to spare 5 minutes making a decision, writing the inputs in that cheap notebook,ruminating over the different aspects and formulating  an action course to resolve the situation.

It is difficult exercise from a psychological perspective. We are given to believe that we canWe can make split second decisions, we should have faith in ourselves etc etc. The deep overconfidence is ingrained in us to such a degree that it is difficult to challenge it. A second and even more important idea is, people are very very reluctant thinkers. Thoreau once said-

People would rather die than think. Most do

And this is true for all of us.

So whats the easy low hanging fruit to begin with. Keep records. Measure your decision making, measure your cognitive hunches. Because to control something you have to measure it first.

And this brings us to the idea of benchmarking. I have so very often seen this that it is not even funny. The best performing portfolios belong to those who benchmark, keep record of everything involved in the decision making. Coversely, if you want to lose money, make decisions on the basis of hunch, never keep records of the same, never keep records of the variables that you took help of while making the decision etc. In other words lack of benchmarking. Buffett has the best performing portfolio over the long run because he constantly subjected his decisions to measures of logic and business sense(my own observation). He has encouraged very few biases (look at his comment on the worst investment he has ever made).

To round it off, Tetlock said in one of his talks:

The Nate Silver episode illustrates in a small way what I hope will happen over and over again over the next several decades, which is, there are ways of benchmarking the accuracy of pundits. If pundits feel that their accuracy is benchmarked they will be more careful about what they say, they’ll be more thoughtful about what they say, and it will elevate the quality of public debate.

It would behoove for us to believe someone is benchmarking us.

PE is not a proxy for cheapness

December 15, 2012

 Every time you see the word EBITDA in a presentation, you should replace it with BULLSHIT EARNINGS, because that’s what they are!

Human understanding of complexity work on abstraction. He seeks examples, stories to comprehend reality better.But in this attempt a silent trade off is done.

When we try to parse data, comprehend ideas and make a decision we are called upon to deliberate on different perspectives and even weigh in the different facts to make a “well-informed decision”. However, human beings through millions of years of evolution have almost always learned to vote or veto. To make a clear distinction almost always bordering on the boolean system- true or false, yes or no etc, makes things simple and easy to decide. “He is good, he is bad. She is beautiful, she is ugly”. Boolean Information, boolean decision making.

But then, as man decided that he must settle down, he congregated together, invented religion and to propagate slightly more abstract ideas discovered the form of storytelling. The invention of stories was perhaps the turnpike of human civilization. Ideas could be propagated in an easier way, man learned to fine-tune his “weighing machine of facts and perspectives” and to make matters simpler philosophers started attaching morals to the stories to not only help man to understand reality but also make decisions for him. However storytellers soon realized that stories had to be simple. It can’t really talk about existential dilemmas because early human mind can’t handle dilemmas better. Dilemmas mean conflicting perspectives, hazy visualization and lack of plausible abstraction.

So in effect, stories by definition of being abstraction just reveal part of the reality to us. And in exchange of comprehension we choose to forego “fidelity”, complete insight and sometimes even make mistakes in understanding the problem at hand.

Price to Earnings ratio, just like others metrics and ratios tell a story. But like all stories its also guilty of abstraction. The reason for not  not using PE as a single point metric of the cheapness of a business stems from multiple ideas

  1. Turnaround/Cyclical: Cyclicity in business is one of the most often cited reason and doesn’t require more information. However turnaround because they are so rare in the world of business is a better candidate to be cited here. Many turnaround candidates quote low PE levels, reasons attributable sometimes to general market pessimism, pessimism towards the business or the sector or plain underestimation of the management or a combination of all three. However a low PE level and a possible turnaround in near future isnt the be-all and the end-all of investment in such cases. One in essence really needs to look into the interactions between the balance sheet and profit and loss statements. I.e in simpler words look at the real cash flow coming to the owners. PE deals with only one perspective, the GAAP bottomline. But it is not the true bottomline. The bottomline can be either more than this or less than this. A conservative investor needs to look into the free cash flow coming in because turnarounds can take a lot longer than anticipated and in such cases neither equity nor debt funding remains viable options. The only safety net on such occasions is the cash in the books and the cash from operations. Each reinforcing the other.Moral of the story: PE is not the true metric of cash flow here, and thus not the true proxy of valuation.
  2. Growth with a strong product pipeline:A high PE likewise is not a proxy for the dearness of the business. Nothing is more clearer in businesses than pharmaceuticals. Pharmaceuticals run on medicine launches, which are protected by patents from FDA often for a short duration of about 7 to 12 years. PE in those cases can drastically make a cheap company look costly. Of course, discounting properly the hype surrounding product launches.
  3. Ego vs Sanity: Often market in its wisdom falls in love with businesses which reek of ego and vanity. Airline business is one of them, Hotelling business is another-especially in the luxury segments. The high PEs awarded to those businesses during those periods are not a measure of their viability. And just on the other side, there are cash spewing extremely boring businesses. Lubrizol was one of them when Buffett scooped it up. FMCG companies do undergo such periods of pessimism.Sometimes morbid businesses like cemeteries etc traditionally reside in that blind spot of the market.Awarded a very low PE incommensurate with the fundamentals,the PE figure screams-“I am bankrupt, I am dead!” but then thats just a story.

I am sure there are many we can find ourselves if we wish to. Possible candidates are- business sales where PE can look ridiculously low because PAT is inflated by Exceptional Items, behaviour unbecoming of management and then an acquisition fuelled growth and the PE which can come from that.

PE is one of the most used and abused metric out there. EV/EBITDA is another. They all tell stories. Rationalizing them is a road to poorhouse. And even worse is believing the reasons given for its use without subjecting them to critical analysis. What can be the best practice for investors is to not look at them at the first glance, or even the second. Taking up the annual report is perhaps the best first course of action for us.

The Case of Weak, Non Linear Forces

December 7, 2012

What does the recently concluded 68th round of NSSO survey on household expenditure signal about the future of biscuit companies? How does the Srinath Reddy Panel Recommendations on Universal HealthCare affect Britannia’s long term business prospects?
What has ‘jugni’ grown in remote villages of Haryana got to do with growing urban prosperity?

In business like in real life, its not always the absolute performance that matters, but the relative one. To win in life, one need to be just marginally better than the rest of the peers and thats an unchangeable fact at the core of every competition. One may strive for kaizen but at the end,  even the perfect has to better himself to win if everyone else is also perfect. Business schools teach Porters five forces and the culmination of bandwagon effect, network effects and plain expert bias convinces everyone that these are the forces one must focus on. But since everyone is focussing on them, the marginal utility of leveraging that knowledge diminishes.

Instead what one must focus on, are the invisible forces. There are two invisible forces in business, weak ones and the non-linear ones.If a force is weak, it takes time for effects to show and we humans rarely have ability to understand and comprehend such slow changes.We never spot ourselves growing tall, or getting fat. We wake up one day and notice that the clothes dont fit anymore.In business world it is even more serious, one wakes up one day and sees his profit has dropped and then finds ways to explain it with the facts he knows without making the effort of seeing new perspectives.

Thats why it is invisible. It is invisible not because we can’t spot it even if we wanted to but its invisible because we dont give it a serious look. It is popularly called in esoteric circles as boiling frog syndrome.

A second type of invisible force is what the baseball fans call- curveball. A curveball is difficult to play because human mind is an able extrapolating machine. But it always extrapolates linearly. Very similar in business world is the presence of non-linear forces. No one finds rural household expenditure growth exceeding urban expenditure growth a worthy phenomenon to discuss. FMCG companies just one day find that rural demand is unrelenting whereas urban demand has lost its way and thus they keep shipping the same old products in an ever increasing numbers to the villages.

Noone sees it as a secular change and no one realises that for the first time exclusive product lines keeping exclusive rural needs in mind has become economically viable. Or take the fact that India today suffers from malnutrition as well as lifestyle diseases in equal measures. Government’s focus on making UHC affordable will lead to a better life for middle class elders,for whom till date 70% of their medical expenses were out of pocket(OOP). OOP expenses tend to be costly for the individual leading to a cascading effect of lower quality healthcare and at times even postponement of HC.

Srinath Reddy Panel’s recommendations makes it a priority in the coming years for government to focus on making HC affordable, cutting down OOP expenses and the works. Couple it with the paradigm change in pension structure(from fixed benefits to fixed contribution), one sees a veritable market open up for age-related nutrition products,lifestyle related nutrition etc.

Or take the fact that the growing middle class urban ‘tastes’ have undergone a more Continental shift- leading to economic viability of crops which were earlier not possible. Zucchini has entered the dining rooms and taken the Indian palates.Attached with the fact that government seldom tries to ‘protect’ horticulture farmers( which is a good thing), the vegetable growers of Haryana have become the Zucchini growers of Haryana because it fetches a remunerative price. Riding on the retail modernization trend, improving urban connectivity the farmer are able to send their zucchinis fresh and ‘pricey’. And by the way they pronounce it as ‘jugni’.

Right this moment there are millions of incremental changes, weak forces and non-linear effects playing out on one’s investments future prospects. Some positive, some negative. Investors need to analyze these possible forces and threats more accurately. He needs to put on the proverbial lenses to understand what can really kill his company.It is not easy,especially when we seek out confirming evidence. It wont be even complete or thorough or all-encompassing.But then, we need to be just a hair width better than everyone else and this is where the alpha is gonna come from.

After all, the last buggy whip maker didnt really know what hit him!

Something for free

December 6, 2012

Financial media down somewhere between birth and maturity decided there are two paradigms of investing- value and growth. One where you bought a dollar worth of stuff with 50cents and the other where you paid not today’s earnings but tomorrows growth. So somewhere when value investing got squashed people decided to shift to growth and glamour. The transition is not quite clear to me but this is something I speculated it to be. Somewhere also down there, growth investing got replaced by the notion of senseless ideas like investing in IPOs or buying in stocks which has shown great growth in the past few 3 quarters but sank money in the preceding 30.

However, it will be more fruitful to think from a different paradigm. This follows directly from the idea of “Quality of Margin of Safety”. A business/company can have many aspects. If you think like a diamond curator, facets,a business has many facets. It can be its valuation, management, underlying business fundamentals, growth, return on invested capital, inventory turns etc. Furthermore, you need multiple lens, through which you will analyse it. It can be a catalyst pending, mental models and even “stress tests”(what if the growth halves tomorrow?)

These are not exhaustive items but just indicative. When one analyses one aspect much of the hidden facets remain unexplored. Thus preventing one to make a proper judgement on the requisite time period one should hold onto it, the threats one can meet along the way etc.

So while doing valuation exercise, one should ask: “What am I getting for free?” The answer will give one the desirability of the investment. One might choose to put the managerial skills and integrity far higher than growth. If so then its his/her choice and should thus stick to it. The question thus remains, not only what he gets for free, but also what is the quality of goods he is getting for free.

Didnt people say-“never look a gift’s horse in the mouth”

I guess they were just plain wrong!

The Quality of Margin of Safety

December 3, 2012

Value Investors in the traditional mold of Graham and Dodd swear by margin of safety. When you buy a rupee note for 60 paise, the forty paise is your margin of safety. The difference between the truth and the reality, the estimate and the known.

The closer the estimate is to the inherent truth, one has the luxury of making an investment with as low margin of safety as he warrants. So if one intends to sell another person a rupee for 90 paise, that 10 paise is his margin of safety and irrespective of a lower margin a rational investor will buy it. He will buy it, till its 99paise for an immediate gain of 1 paise.

However, when the estimate is just that-an estimate and the “truth”, the real intrinsic value lies in a hazy range the need for margin of safety becomes apparent. For a company whose estimated value lies between 300-650 range, and if the price of the security is 280,500 or even 700- the opportunity for profit in such a scenario become a matter of speculation and not that of certainty. However if the price of the same security quotes for a modest sum of 100, the margin of safety will take care of any possible error in the estimate and yet allow the investor to gain. This is the supreme logic in value investing and if one remembers this everything else is mere detail.

But the quantity of margin of safety is not the only marker  in real life operations. In real life time is a variable which changes many things. When one offers a rupee for 60 paise, there is no way of the investment becoming more risky (i.e less margin of safety) without an increase in the quoted price of that rupee. I.e when the same rupee is quoted for 80 paise, there is a loss of 20 paise in margin of safety but there is also a 20 paise gain in the value of the investment. However in cases of business, time is a variable which can change things.Even if one doesnt make a single penny, he/she might stand to lose his margin of safety.
And here in comes the need for not only quantity but also quality of margin of safety.

Consider,

Problem 1: A business whose market value(the money you have to put on table to buy the entire business off) is 500crores. It has cash in its books worth 800 crores; net fixed assets worth 300 crores.

Expected Action of an intelligent investor: He will buy the business, liquidate the company, sell assets, pocket the cash.

Problem 2: A business whose market value is 500crores. It has cash in its books worth 800crores, net fixed assets worth 300crores and government regulation prevents one from liquidating a business.

Expected Action of an intelligent investor: He will buy the company and try to sell it off to a sophisticated investor who knows how to value to business better than Mr. Market.

Or buy a stake in the company and wait for Mr. Market to correct its mistake.

Sidenote: For those who believe that government preventing the liquidation of a business is improbable, it is indeed true for India where the byzantine corporate laws and labour laws make exiting a business prohibitively costly. One might sell the assets but can’t fire his employees.

Problem 3: A business whose market value is 500crores. It has cash in its books worth 800crores, net fixed assets worth 300crores; government prevents exiting a business and the company is losing 100crores per year.

Expected Action of an intelligent investor: None. He/She needs to wait to make Mr. Market correct its folly but waiting will lower his margin of safety and thus lower his prospective returns.

This points to one thing- not only the margin of safety but the quality of it is extremely important. Each investor should ask oneself -for 50 paise am I being offerred a rupee note, or a rupee worth of bond, or a rupee worth of a matured business, or a rupee worth of a sustainable growth business, so on and so forth.

Each successive option better than the previous one. But this is not the only metric. A rupee worth of business quoting at 80 cents with good management is far better than a rupee worth of business quoting at 30cents,saddled with bad management.

So its more important to ask , what do I get for free than merely asking- is there anything for free?

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