Value Investing, the Sanjay Bakshi Way 2.0 – Part 1

Image Source: Outlook India

After much delay owing to issues in getting mutually convenient dates, I have finally finished my interview of Prof. Sanjay Bakshi. 🙂

Here is the first part of the interview. As you will find below, it’s amazing the way Prof. Bakshi has explained critical concepts in investing in a highly comprehensive yet simplified manner.

Enjoy the wisdom!

Safal Niveshak: Let me start with a question I have been waiting to ask you for some time now. Through a comment on a link I shared on FB and through a few of your posts over the past few months, you have suggested that your investment philosophy has moved further towards high quality businesses, and great managements. Can you please elaborate on the same? What has been this transition all about? And why?

Prof. Bakshi: I started my career as a value investor in 1994. Over the last twenty years, I have practiced most styles of value investing including as Graham-and-Dodd style of investing in statistical bargains, risk arbitrage, activist investing, bankruptcy workouts, and Warren Buffett style of investing in moats. There have been times when I have owned 40 stocks and times when I have owned just 10.

I teach all these value investing styles in my course at MDI. I tell my students that they need to pick a style which suits their personality.

Some students have a statistical bend of mind and prefer to work with situations that can be evaluated more objectively than others. I tell them to focus on statistical bargains and risk arbitrage. I ask them to practice wide diversification.

Others like to delve deep into the fundamental economics of businesses and are comfortable with dealing with softer issues like quality of management. I ask them to focus on moats and diversify less. It all depends on what you enjoy doing over time and what has worked for you.

I have absolutely enjoyed practicing all these styles of value investing. Over the years, I also learnt a few additional things. One of them was about the idea of returns per unit of stress.

You can make a lot of money by being an activist investor, which I’ve done in the past. But it’s stressful. You can make a lot of money by shorting over-valued stocks of companies run by promotional and fraudulent managements. But it’s stressful. You can make a lot of money doing risk arbitrage where you have to monitor — perhaps 20 deals at any given point of time and be ready to react quickly when odds change. But it’s stressful.

I found that investing in moats is not stressful. It involves a slow and more meaningful understanding of how a business creates value over the very long term. And boy does it work!

I’d argue that if you pick 100 successful value investors who have compounded their capital over the long term (a decade or more) at a very healthy rate, then the vast majority of them would have accomplished that by first investing in high-quality businesses run by great managers at attractive prices, and then by just sitting on them for a long long time.

Moats are internal compounding machines. History shows that you get rich by just sitting on them because they do all the hard work for you. And I realized that over the years. Just as Mr. Buffett did when he too moved from classic Graham-and-Dodd to moats.

Let me give you an example. Many years ago, I co-authored a paper on Eicher Motors, which I think your readers would agree is a fantastic company. At the time, in 2008, the stock was selling at a ridiculously low price of Rs 200 per share even though the company had Rs 147 per shares in cash and no debt. That stock now sells at 5,500.

I presented that paper to two investors — both offshore funds. One of them bought it promptly and, over time, Eicher Motors became its best performing position. The other fund bought it too but sold out in less than a year when the stock went up a bit. So, you get two vastly different outcomes from the same stock. The fund that sold out did not have the patience. The other one did. And the fact that I had much more influence over the one which did not, or perhaps could not, exercise patience at the time, tells us something isn’t it?

I learnt a very important lesson from that one. Be patient with great businesses. Let them do the hard work for you. Just sit there.

So, a few years ago, I decided to increase my focus on moats. I enjoyed the process (and the proceeds) so much that last year I decided to exclusively focus on moats.

In this decision, apart from my own experience of investing in moats over the last 20 years, I was also influenced by two thoughts from two wise men. One of them was Pat Dorsey, the author of a wonderful book on moats. He wrote…

Moats can help you define what is called a “circle of competence.” Most investors do better if they limit their investing to an area they know well-financial-services firms, for example, or tech stocks-rather than trying to cast too broad a net. Instead of becoming an expert in a set of industries, why not become an expert in firms with competitive advantages, regardless of what business they are in? You’ll limit a vast and unworkable investment universe to a smaller one composed of high-quality firms that you can understand well.

And the other one was none other than Warren Buffett. I read something he had said a few years ago and it made a deep impression on me. He said…

The difference between successful people and very successful people is that very successful people say “no” to almost everything.

Twenty years is a long time to learn the importance of extreme specialization! If you work hard to specialize in a niche, and you keep doing it following a certain process, you’ll get good at it. It works in sports, it works in medicine and it works in law. It works in investing too.

And it isn’t that other styles of value investing won’t work. They will, if you focus on them.

I chose moats because I wanted to slow down, and not do too many stressful things. And the fact that investing in moats works beautifully if you only let them do the hard work for you, was a compelling argument too.

Safal Niveshak: While they are very critical, moats are also tough to define. I look back a dozen years and have to think that few would have thought a company like Asian Paints or Titan could have any meaningful competitive advantage. Yet with all its growth, there is no meaningful competition to Asian Paints today. My questions are –

• Can you give us an example of a sustainable competitive advantage in the current times?
• How does an investor know whether a moat is sustainable or fleeting?
• What are the early signs one needs to look for to identify eroding moats?

Prof. Bakshi: Actually, defining a moat is the easy part of the problem. The tough part of the problem is to get good answers to four questions:

1. How big and wide is the moat?;
2. How enduring is it?;
3. Can inept or corrupt management impair your ability to make a good return by owning this business for a long time?; and
4. How much money you will make by buying it now and holding on to it for a decade or more?

First the easy part. Many investors simply look for quantitative evidence of a moat relying on the wisdom of these words of Warren Buffett…

A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.

So far so good. But then the investors ignore businesses which may be earning a mediocre return right now but are on their way to earn superior, sustainable returns (“emerging moats”).

Investors also don’t bother asking the remaining three questions. Instead, they implicitly assume that the moat is an enduring one, management really doesn’t matter, and nor does valuation. Those are big mistakes in my view.

So your question as to whether a moat is sustainable or fleeting is a very intelligent one.

I tried to answer those questions in a series of lectures on Relaxo Footwear which was a case in my MDI course which got over in January.

Relaxo earns a pre-tax ROE of more than 35% a year so there is evidence of moat, but the remaining questions still need to be answered. Using Michael Porter’s framework on competitive advantage, we can think about the resilience of a moat from five perspectives –

1. Intensity of competition amongst existing players in the industry;
2. Threat of new entrants;
3. Threat of Substitute Products or Services;
4. Bargaining Power of Customers; and
5. Bargaining Power of Suppliers

I think its very important to have these five forces in mind when thinking about resilience of moats. In the Relaxo Lectures (I won’t go too much into the details) my friend Ravi Purohit and I showed that the structure of the industry meant that the intensity of competition amongst existing players was low.

We also showed that for a new entrant to enter the market and try to dislodge Relaxo from its current competitive position, the competitor would have to be willing to lose large amounts of money for long periods of time.

The threat from substitute products in footwear is quite low. I mean science is unlikely to deliver a new invention which would make it unnecessary for us to wear flip flops, sandals, and shoes, isn’t it?

Similarly we showed that the power of the company over its customers and suppliers was increasing and evidence supporting that was visible by studying the company’s improvement in gross margin and also because of the reduction in its working capital intensity over time.

The Relaxo Footwear lectures were offered as a template of course. In some businesses the threat from substitute products can be so high that it could turn a moat into a dinosaur in less than a decade.

See, for example what mobile telephony did to MTNL. Indeed the mobile phone has destroyed or is in the process of destroying or at least causing grave harm to entrenched players in many industries like manufacturers of cameras, scanners, flash lights, board games, and stand-alone mapping devices. Similarly the app store at Apple has ruined many a business model.

Disruptive innovations like the mobile phone and the Apple app store often produce new threats from substitute products and services which come from unexpected sources.

While investors are thinking too hard about other flashlight manufacturers or other camera manufacturers, they often don’t successfully anticipate threats from flashlights and cameras built into mobile phones.

Forget investors, even industry insiders don’t catch such threat early enough to be able to adapt. They are simply not conditioned to recognize it early.

People who focus on entry barriers (threat from new entrants) alone may forget that increased power of customers and/or suppliers could also significantly impair a company’s ability to deliver high returns on invested capital over time. Life for a towel supplier to Wal-Mart who contributes to most of its revenues is unlikely to be a happy one over time. Is that too hard to comprehend?

And that’s precisely why you need to have those five forces described by Porter on a checklist on moat investing. Otherwise, you may not remember them. I recall that famous quote from Robert Rubin – “Condoms aren’t completely safe. My friend was wearing one and he got hit by a bus.”

Risk in world of business too could come from sources you cannot imagine, so having a checklist to help you remember the multiple sources of risk to moats is a good idea for moat investors.

You need to ask yourself questions about how any or all of those Porter’s five forces could destroy or impair the moat you love so much right now. And you need to do it regularly. You need to be aware of those forces almost at a subconscious level to be able to evaluate the resilience of a moat.

So there has to be a moat checklist and those five forces form part of that checklist. And you have to keep going back to it and modify it over time as you gain experience.

As Mr. Buffett often says, a moat around a business castle is either constantly improving or eroding.

You ask: How do you get an early warning signal of an eroding moat?

Well, it goes back to those five forces of Porter. Is the intensity of competition amongst existing players increasing? If it is then how will you measure it? Wouldn’t it show up in reduced margins, increased battle over market share as reflected in slowing sales and/or increased spending on sales and marketing, increased working capital requirements as industry players offer better payment terms to customers and/or suppliers etc.?

A deterioration in the competitive positioning of a business will eventually be reflected in the numbers through:

1. Reduced returns on invested capital; and
2. Deterioration in the quality of its balance sheet.

But well before that happens, you should be able to pick up enough clues.

You’re really looking for clues and patterns like Sherlock Holmes did. I think every investor should read Peter Bevelin’s book on how to think like Sherlock Holmes and try to apply the learnings to investing.

Another trick to use is to evaluate the quality of decisions made by management. Are they doing things that will increase the size of the business’s moat in the long run or are they doing the reverse?

There are all sorts of business decisions which the management can take that will increase the size of moat of a business over time but will also reduce its near term earnings. And many managers hate those tradeoffs because their own compensation is based on the delivery of high near term earnings.

The presence of perverse incentives results in perverse outcomes. But if you want to change behavior, as Charlie Munger often says, change the incentives. Notice, for example, how changes in incentives implemented by a new owner are resulting in delivery of high operating cash flow at Thomas Cook which was a case in my course last year.

I think it’s also important for investors to recognize that in a few businesses:

1. Economic earnings exceed reported earnings and it’s the economic earnings that really count; and
2. Management focusses on growth in per-share intrinsic business value and not immediately reportable earnings.

Investors should seek such businesses for obvious reasons.

Safal Niveshak: In an Outlook article last year, you wrote about paying up for businesses with sustainable moats, like Nestle. My questions are:

• When is a company with sustainable moat attractive, and when it is not?
• How to your differentiate between “paying up” and “overpaying”…because people can rationalize any price with a behavioral explanation?
• If you find such a stock, when will you sell it?

Prof. Bakshi: That point about Nestle was perhaps one of the most mis-understood points in my writings and talks!

I wasn’t recommending Nestle at any price. I was demonstrating that long-term returns for investors who bought it in the past at prices which many value investors would consider to be expensive were exceptionally good. I wasn’t talking about the future. I was talking about what factually happened in the past.

The idea was to provide one data point (and there are many others as well) as strong disconfirming evidence against associating “expensive” with seemingly “high P/E” multiples.

I wanted investors to de-anchor themselves from earnings multiples based on recent earnings and reported earnings.

Most value investors understand that leaving the question of price aside, businesses with enduring moats are more attractive as investments than commodity-type businesses which have no low-cost advantages.

I think that point is easy to get. But not-so-easy point to get is that businesses with enduring moats are more attractive as investments than those which don’t have enduring moats even at relatively higher prices in relation to assets, recent earnings and cash flows.

In my view, a business with an enduring moat is attractive when:

1. It’s run by an able manager who possesses strong operating and capital allocation skills; and
2. It’s priced such that the expected return of acquiring and holding an interest in it for a decade or more is very attractive as compared to other alternatives available to you.

I think it’s important for investors to think in terms of expected returns instead of fuzzy concepts like intrinsic value even though they may be functionally equivalent.

There are, in my view, significant advantages of thinking in terms of “How much money am I going to make in this business over time?” over “What’s the discount to intrinsic business value?” The answer to the first question is what really matters isn’t it? Then why try to answer it indirectly?

And the beauty about investing in moats is that you think about expected returns after the business passes your business and management quality checks. That means that if you have no idea what the earnings of a business would look like a decade from now and whether or not those earnings will still be growing or not even after ten years, you should not invest in that business.

So the business quality checklist will eliminate a huge number of possible businesses to evaluate. This is what I believe Mr. Buffett meant when he talked about “circle of competence.”

Next, the management quality checklist would eliminate many more businesses from consideration. That would leave a handful of businesses which you would like and know pretty well and about which you’d have the ability to estimate a range of expected returns over a decade or more.

Now imagine you had done that exercise and come up with expected returns for about 20 stocks over the next decade. Which ones would be rational to include in your portfolio? And which ones should you not include in your portfolio regardless of how much you like the business and management?

Well, I propose that you use AAA bond yield as a benchmark. You may use long-term historical Nifty returns too if you prefer but I use AAA bond yield, which, at this time is about 10% pretax.

Imagine that there are a few stocks in your “investible universe” whose upper estimate of expected return is less than AAA bond yield. Would it be rational to own it? Of course not!

Why would you even want to invest in a business where you couldn’t even get a return above AAA bond return? This kind of thinking helps you in cutting down the list further by eliminating stocks which offer sub-par expected returns.

Once you’ve eliminated those stocks, then you could simply rank the remaining ones in descending order of expected returns and then allocate capital based on your conviction (as expressed in terms of expected return) keeping in mind the need to diversify into multiple names as well as other portfolio construction considerations dealing with limiting “aggregation of risk.”

Let’s say you decide to own just 10 names (and it could be 15 or 20 as well and I am not going to get into that debate). Then you’d know which ones to include in the portfolio and which ones to not include in the portfolio. You’d prefer the 10th one over the 11th one because it offers a higher expected return.

If you then stick to your policy of never having more than 10 names then you’d know which ones to kick out and which ones to keep in the portfolio. You’d be forced to take actions that maximize the expected return of the portfolio over a decade by making ideas you love compete with each other without ignoring other considerations relating to aggregation of risk and the need to diversify. And if you did it properly, you’d get quite unemotional about it over time.

So, in my view, thinking in terms of expected returns helps you to choose which stocks to buy and which ones to not buy. It helps you in position sizing. It helps you determine when to not buy and just hold a position. And it tells you when to sell and replace it with something better.

So, conceptually it’s a good idea, no? But there are “behavioral issues” in using a computer model while estimating expected returns. Richard Feynman was aware of the behavioral problem in using computer models when he said:

There is a computer disease that anybody who works with computers knows about. It’s a very serious disease and it interferes completely with the work. The trouble with computers is that you ‘play’ with them!

There are tricks to deal with the “behavioral issues” relating to this approach. One trick I use is to keep expected return calculation hidden while I am working on an opportunity.

I think its very dangerous to see that number before you’ve finished your work which involves careful thinking about various variables including business volume growth, realization growth, profitability, potential equity dilution, dividend policy, capital structure related issues and earnings multiple expansion/contraction.

Only after I have done my thinking about these points and have defined my ranges, the expected return numbers should be viewed. And once they are viewed they won’t be changed at that time.

The decision to invest or not invest would be based on that number. That number, of course, is subject to change later in light of new developments such as changes in fundamentals and/or stock prices or simply the passage of time.

There are other ways of dealing with “behavioral issues” in evaluating businesses with a lot of uncertainty but they usually don’t end up in moat portfolios so I won’t comment on them over here.

You ask about when will I sell a moat business. My answer is I’d sell it regardless of price if I determine that the moat not enduring any more, or if I determine that management is no longer both competent and honest. And you have to keep making those periodic evaluations to determine if you’re happy with the business and the management. Remember Keynes:

When facts change, I change my mind. What do you do Sir?

If the moat is still enduring and I still love the management, then I’d sell it only if I found something significantly better in terms of expected returns. That something significantly better could be another moat business which has also passed the management quality tests and, at its current asking price, offers a significantly better expected return. Or that something significantly better could be cash or bonds which in a bubble market may offer better returns.

Remember that an increase in price, other things remaining the same, implies lower future returns. So, while it feels good to see stock prices of existing positions go up, the expected future returns decline.

When it comes to moats, you have to be a reluctant seller. Logical reasoning has to snatch them away from you. At other times, you should let them do the hard work of compounding your capital for you.

Safal Niveshak: Do you believe in ‘Quantitative Value Investing’, or Magic Formula Investing? The reason I am asking this is because Graham, in a 1976 interview, said: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.” So, is the extra effort put into deep security analysis, when simple formulas generate equally satisfactory returns, justified?

Prof. Bakshi: I believe in value investing. Period. 🙂

There is nothing wrong in “quantitative value investing” or “magic formula investing.” If you follow a process which works, you’ll do fine.

I think the extra effort is worth it not just because there’s money in it but also because it’s enjoyable. So, even if Graham was right and there was more money in an algorithm-based investing model, I would still prefer what I do because I love it. I agree with MasterCard: “There are some things money can’t buy.”

Safal Niveshak: In your story you shared with an MDI alumnus in 2004, you talked about getting enamored with Buffett’s letters and Graham’s statistical bargain and starting an investment partnership upon your return from LSE. Then you mentioned that, within the next 3 years, you had shrunk it by 40%. My questions are –

• What were the mistakes/missteps that resulted in such capital erosion?
• What were the lessons you learned in the process? (Because this happened after you had gotten fairly familiar with Buffett’s and Graham’s teachings which is the same stage many of the new investors may find themselves now. So, your thoughts could be valuable lessons for investors starting out now)
• How did you tweak your investment process to avoid the repeat in future?

Prof. Bakshi: This is way back in mid 1990s when I had just started out. I was young and foolish (and now I am just older.)

I under-estimated the importance of management. I bought a large position in a business which I believed had moat characteristics. In the next bear phase its market value fell well below my cost. Then the management took the company private at a small premium to market but at a huge discount to value and also to my cost and I experienced a permanent loss of capital.

There were no SEBI delisting guidelines then to protect me. The intentions of the management were not good. I now avoid partnering with such people.

Investors should read this document. This is a public document published years before problems surfaced in this particular group. Had people read it and learnt about management intentions they would have kept away.

I now have a management quality checklist (which covers operating skills, capital allocation skills and integrity), which keeps getting tweaked over time. Some of it was published here.

As an equity investor, you have no say in management. You have no covenants to protect you. The only protection you have is avoidance. I recall Charlie Munger’s famous words about sensible lending:

The first chance you have, to avoid a loss from a foolish loan is by refusing to make it; there is no second chance.

I use the same logic when thinking about making long-term bets in moats. The first chance you have, to avoid a loss from investing in a great business run by a fool or a crook is by refusing to invest in it; there is no second chance.

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The second and final part of this interview will be published on Thursday, 20th March 2014.