Value Investing, the Sanjay Bakshi Way – Part 3

Here’s the third and penultimate part of my interview of Prof. Sanjay Bakshi. You can read the first two parts here – Part 1 | Part 2

Safal Niveshak: How can a small investor build up a “positive loop” that you talk about to increase his circle of competence, given the time, education or background constraints? How did you do this when you started out as a small investor yourself?

Prof. Bakshi: Buffett talks a lot about the idea of “circle of competence”. But what do we mean by the term?

I like to define it in a creative manner. Most of my students are engineers and have little or no accounting background. One way to think about circle of competence for them is to only specialise in engineering stocks. And students who are specialising in marketing may develop their circle of competence in FMCG stocks.

Creativity in defining your “circle of competence”
That’s the conventional way of thinking about circle of competence. There are other ways. For example, you may specialise in micro-caps. Some of my students are doing exactly that. They have no interest whatsoever in large cap stocks.

They are thinking – “I am managing a small amount of money, and I want an edge. I want to track companies which have never been tracked by any large, institutional broking house – where there’s no analyst coverage whatsoever.”

Well, I think that’s a very smart thing to do. You want to build a speciality or your own circle of competence in a manner that will give you an edge. That’s what you are trying to do.

The business of investing is a highly competitive business, so you must find an edge.

You may decide to specialise only in “special situations”. You may say – “I only want to work in event-driven strategies. I don’t want to take bets on India’s long-term growth story because almost everyone else is doing that. I know there are often mis-priced bets in the field of tender offers, share buybacks, large dividend payouts, spinoffs, going-private transactions, mergers and acquisitions, capital structure changes, asset sales etc.”

You may even decide to only work in bankruptcy workouts. Some of the highest risk adjusted returns have come in this field – for example, see what happened to Jindal Vijaynagar Steel and Wockhardt – and if some student of mine wanted to specialise in only this field and nothing else, I wouldn’t think of that as a bad idea at all.

You may develop your circle of competence in statistical bargains by using creative screens like debt-capacity bargains, cash bargains that are not likely to be value traps, dividend yield bargains, earnings yield bargains, net-nets, growth for free, debt-reduction, asset conversion etc.

You can have 15 different kinds of screens out there and you may never actually meet managements because that would bias you. You may rely on the edge you get from the numbers alone.

In effect, you’d operate like the owner of a successful casino having three key policies:

1. Every bet made by every gambler has odds titled in the casino’s favour;
2. You have lots of customers i.e., you practice wide diversification; and
3. You put a cap on the maximum bet that can be made by any customer on a single gamble.

These are three principles that work in running a successful casino and the same three principles that work in running a successful statistical bargains operation.

Or, you may think – “Well, I’m going to build my circle of competence by ignoring any company which has no moat – a term Buffett uses to describe a sustainable competitive advantage.” You may decide to only focus on moats.

Pat Dorsey in his wonderful book, “The Little Book that Builds Wealth” writes:

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.

Dorsey is obviously right. Any starting value investor should read this book in my view. He is giving you an elegant solution to the complex problem of developing an edge.

Investing is a very competitive business. You really need an edge. So you can pick any one of the above ways of creating one, or you may develop some other edge.

What I tell my students is that they should get exposure to a variety of value investing styles. You can create your own circle of competence by deciding to focus only on moats, or statistical bargains, or bankruptcy workouts, or special situations, or micro-caps etc.

I tell them, “Don’t limit yourself early on in your career. Try to get exposure to the Warren Buffett style of investing, the Ben Graham style of investing, the Marty Whitman style of investing. You should try them all and see what works best for you, because if you stick with something that suits your temperament, that’s likely to work for you.”

Safal Niveshak: How do you differentiate between risk and uncertainty and how do you deal with each of them. Also, how does one factor in the “uncertainty” part in margin of safety? Please help with 1-2 case studies from your personal experience in the past.

Prof. Bakshi: In March 2012, I gave a talk to the Indian Association of Investment Professionals, titled “Understanding the Universe of the Unknown and the Unknowable“.

Four Role Models
To answer your question as to how do I differentiate between risk and uncertainty, I’m going to pick up four role models: Warren Buffett, Richard Zeckhauser (Professor at Harvard University), Nassim Taleb, and Ben Graham.

Buffett on Risk
Let’s first talk about Buffett. What does he say about “risk”?

If you go through his letters, he talks about risk in a very different way as compared to the way finance academics talks about risk.

In academic finance, risk is the same as volatility. An asset that moves around a lot is riskier than an asset that doesn’t move around a lot and one of the measures of this movement is “beta”.

A stock with the beta of 3 is much more volatile – and therefore risky according to academic finance – than the stock with a beta of 0.5. There are elaborate asset pricing models based on this statistic in academic finance.

Moreover, cost of capital – the hurdle rate which determines whether to invest in a project or not – also has beta as a key component.

Buffett doesn’t agree with any of this. In his view, risk is something much simpler, although it cannot be reduced to a mathematical formula.

For him, risk is simply the probability of “permanent loss of capital” and that has nothing to do with the volatility of the asset’s earnings or price.

Assets could be very volatile but not necessarily risky. Conversely, assets could be very risky but not necessarily volatile.

One key component of risk for Buffett is inflation. He once wrote…

If you forego ten hamburgers to purchase an investment and then, over its holding period, receive dividends which buy you two hamburgers and receive, upon sale, proceeds that will buy you eight hamburgers, then you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.

Isn’t that fundamentally true? Isn’t this an accurate description of “permanent loss of capital”?

Yet people around the world think of treasury bonds are “risk free” even though the returns on such bonds are typically below the rate of inflation. You are virtually certain to suffer permanent loss of capital through them.

Equities, on the other hand, are thought to be risky simply because they are volatile even though they offer the best returns over time.

Taleb on Uncertainty
Let’s keep Buffett’s concept of risk in mind, and move on to Nassim Taleb’s idea of “black swans” – rare, high impact, and unpredictable events.

Black swans could be negative or positive.

Taleb advises you to avoid exposure to negative black swans and seek exposure to positive ones.

Zeckhauser’s Approach
Let’s keep this idea – of seeking exposure to positive black swans in mind, and move on to Richard Zeckhauser whose famous essay “Investing in the Unknown and Unknowable” is a must-read for all investors.

In this essay, Zeckhauser discusses a few critical things. Let me just list them out.

First, most investors can’t tell the difference between risk and uncertainty.

Risk, as you know from Buffett, is the probability of permanent loss of capital, while uncertainty is the sheer unpredictability of situations when the ranges of outcome are very wide.

Take the example of oil prices. Oil has seen US$ 140 a barrel and US$ 40 a barrel in less than a decade. The value of an oil exploration company when oil is at US$ 140 is vastly higher than when it is at US$ 40. This is what we call as wide ranges of outcome.

In such situations, it’s foolish to use “scenario analysis” and come up with estimates like base case US$ 90, probability 60%, optimistic case US$ 140, probability 10%, and pessimistic case US$ 40, probability 30% and come up with weighted average price of US$ 80 and then estimate the value of the stock.

That’s the functional equivalent of a man who drowns in a river that is, on an average, only 4 feet deep even though he’s 5 feet tall. He forgot that the range of depth is between 2 and 10 feet.

Let’s come back to what Zeckhauser says on this subject.

Most investors, according to Zeckhauser, whose training fits a world where states and probabilities are assumed to be known, have little idea how to deal with unknowable and treat as if risk is the same as uncertainty.

When they encounter uncertainty, they equate it with risk, and tend to steer clear. This often produces buying opportunities for thoughtful investors who shun risk but seek uncertainty on favourable terms.

Second, Zeckhauser states that historically, some types of unknowable situations – those that Taleb calls positive black swans – have been associated with very powerful investment returns and that there are systematic ways to think about such situations. And if these ways are followed, they can lead you to a path of extraordinary profitability.

One way to think of unknowable situations is to recognise the asymmetric payoffs they offer. The opportunity to multiply your money 10 or 100 times as often as you virtually lose all of it is a very attractive opportunity.

So if you have a chance to multiply your money 10 or a 100 times, and that chance is offset by the chance that you can lose all of it in that particular commitment, is a good bet, provided you practice diversification, isn’t it?

That’s the power of asymmetric payoffs.

So, Zeckhauser’s idea of profiting from unknowable situations is akin to Taleb’s idea of getting exposure to positive black swans.

Third, there are individuals who have complementary skills – they bring something to the table you can’t bring. They get deals you can’t get.

An example that comes to mind is the deal Warren Buffett got from Goldman Sachs when he bought the investment bank’s preferred stock on very favourable terms during the financial crisis of September 2008 – a US$ 5 billion investment in Goldman’s preferred stock and common stock warrants, with a 10% dividend yield on the preferred and an attractive conversion privilege on the warrants.

Essentially what Zeckhauser says is that there are people who can get amazing deals – that they have this ability to source these transactions. They have certain skills that allow them to attract such transactions to them – maybe they’ve got capital, contacts, or something in them which a typical investor does not have.

Zeckhauser advises that when the opportunity arises to make a “sidecar investment” alongside such people, you shouldn’t miss it.

For many Indians, sidecar investing can best by understood by remembering that famous scene in the movie “Sholay” in which one sees Veeru driving the mobike and Jai enjoying the free ride in a sidecar attached to the bike.

That’s essentially the idea here. The investor is riding along in a sidecar pulled by a powerful motorcycle driven by a man who has complimentary skills. The more the investor is distinctively positioned to have confidence in the driver’s integrity and his motorcycle’s capabilities, says Zeckhauser, the more attractive is the investment.

So how do you bring all this together? Let me summarise.

We talked about Buffett’s idea on risk. We talked about Taleb’s ideas on uncertainty and the need to avoid negative black swans and the need to get exposure to positive black swans. We talked about Zeckhauser’s advice on uncertain and unknowable situations and how to profit from them.

Sure, as value investors, we want exposure to positive black swans. But we are not like private equity investors or venture capitalists.

We are far more stingy and risk averse than those people. We want exposure to positive black swans on extremely favourable terms.

But what do we mean by “extremely favourable terms?” Well, that’s where Graham – our fourth role model comes in.

Graham’s “Margin of Safety”
Graham is all about “margin of safety”.

In his books, including “The Intelligent Investor,” he talked about margin of safety. In every operation he did, he was seeking out value much more than the price he paid. He was seeking out favourable odds of making money.

He didn’t know which of his bets will pay off. That is why he practiced wide diversification.

He was, in a sense, buying “free lottery tickets”. As a value investor, you won’t ever buy a lottery ticket but you don’t mind getting one for free.

The idea of collecting free lottery tickets is a very powerful idea in value investing.

Graham had situations where he could buy stocks of companies which were selling at multiples reflecting zero growth or no growth. Effectively the growth component of value was coming to him for free. That’s a “free lottery ticket”!

He thought of growth as an uncertain factor, and he was unwilling to pay for it. He was buying into uncertainty on extremely favourable terms.

So, we’re going to use Graham’s idea of creating free lottery tickets and combine it with Buffett’s thoughts on risk, Taleb’s idea of exposure to positive black swans, and Zeckhauser’s advice on sidecar investing with people who have complementary skills.

Case 1: Piramal Healthcare
This is an example that I gave in early 2011 in my blog.

Essentially, I wrote about Mr. Ajay Piramal – a man who build a business from Rs 6 crore to Rs 17,000+ crore in 22 years.

He did that by injecting very little amount of new capital. He did that by buying out distressed sellers who were very eager to exit the country in the pharmaceutical space. He also grew these businesses organically. And he had an excellent track record in increasing his topline (sales) by around more than 30% per annum, and also the bottomline (net profit) at that rate.

He also acquired about a dozen businesses, which did exceptionally well. Now, this is a very interesting point because if you look at the averaged-out experience in M&A, it sucks. Most acquisitions fail to create value and here is a man who has done a dozen of them, and they created value.

Then add to that a rare scenario, the fact that he is not just a shrewd buyer of cheap assets, he is also a great, high-quality-growth-oriented operating manager, as the numbers attest.

These two skills – great in operating skills and great in capital allocation skills (acquisitions) – they are rare as it is but rarer still in combination.

Now add the fact that Ajay Piramal was able to sell Piramal Healthcare’s formulations business to Abbott at a very rich price – in fact the most expensive large-size cross-border M&A deal in the pharma space ever. How did he do that?

Because he has complimentary skills. He built trust with MNC pharma, which was instrumental in his getting such a rich valuation.

Ajay Piramal did not sell all the businesses of the company. He only sold one – the largest one, and he retained four businesses about which he is very optimistic.

He kept CRAMS (Contract Research and Manufacturing Services), he kept OTC that has brands like Lacto Calamine, Saridon, iPill, and many others. He kept Critical Care, which is a business he created in anaesthetic gases. He also kept Piramal Life which is a very interesting business with positive black swan attributes and which was later merged into Piramal Health.

So, when I wrote that blog, the situation was that the stock market was valuing a drug pipeline consisting of 14 molecules and having a cost of between US$ 150 to 200 million (which if you were to think in terms of valuations in the US markets, could be worth several times that cost), three operating business with great long-term prospects, cash on the balance sheet, and Ajay Piramal – a great capital allocator with complementary skills, for less than cash alone.

Now, what’s the risk of suffering a permanent capital loss in a situation like that? Practically none, in my view.

So, in a sense, one could get exposure to positive black swans embedded in the drug pipeline business of Piramal Healthcare (Taleb) by making a sidecar investment alongside a man with great capital allocation and complementary skills (Zeckhauser) on extremely favourable terms (Graham) and have practically no risk of permanent loss of capital (Buffett).

Subsequently, Mr. Piramal used his complimentary skills to park some of the cash he raised from the sale to Abbott in a deal with Vodafone, locking in a guaranteed return of somewhere between 17% and 21% per annum while retaining the possibility of earning much more if Vodafone’s shares enjoyed premium valuation in its planned IPO.

Can you get a deal like that? Probably not. But people like Ajay Piramal can, and the stock market, sometimes offers you the chance to ride along a sidecar with such people on extremely favourable terms.

Safal Niveshak: Are there other good allocators of capital that you’ve identified in India?

Prof. Bakshi: There are so many of them. All the big companies that have done exceptionally well for shareholders, effectively they are excellent allocators of capital. Take a look at Nestle, for example.

But the question is not whether you can spot good allocators of capital. The question is whether you can become partners with them on favourable terms. That’s the key!

If you had bought Infosys in the year 2000 at a P/E multiple of more than 200 times, you would have 10 years of no returns.

Keep in mind this would have happened during a period when India experienced the biggest bull market in its history. So the best company with the best managers, best business model, most ethical and growth oriented management delivered zero return over a decade. And it isn’t that the earnings did not grow.

Every year’s earnings were higher than the previous year’s. And yet an investor for a decade didn’t make anything in that!

So much for long-term investing in high-quality businesses, without any regard to price being paid!

So it’s not about spotting a great business. It’s also about getting in on favourable terms.

Case 2: IL&FS Investment Managers
This is a current example. Please note that I am not making a recommendation here. I am merely citing how, at a price – which is not the current price, by the way, the stock of this company would be akin to acquiring a free lottery ticket.

This is a company which has got a very unique business model as an asset management company (AMC) managing about seven private equity funds in infrastructure and real estate. And, as you know, both of these spaces are completely bombed out and are riddled with huge uncertainties.

This company has no net debt, and it derives its earnings from these funds by way of two earning streams. One is the asset management fee, and the other is the “carry”, which is a profit share above a threshold, and is contingent on the performance of the funds under management. They have to deliver IRRs over and above a threshold to be able to earn that carry.

So, you have a highly predictable earnings stream and you have a highly unpredictable one as well – that’s what the uncertainty is about.

The business of AMC does not require much capital. And they have grown from nothing to US$ 3.2 billion of assets under management (AUM) in just about 8-9 years.

In most businesses you have to put up more, to earn more. This is one of those rare situations where earnings can grow disproportionately as compared to capital employed in the business.

Now, let’s add the idea of a “vicious circle” in which the company finds itself. Its ability to raise capital in more funds – that is its ability to grow its assets under management (AUM) – is dependent on the IRRs it delivers on existing funds.

If it delivers high IRRs, then two things happen:

1. The AMC gets a big carry and by the way the management team gets to keep 70% of that carry, so the incentives are extremely high to deliver those high IRRs.
2. The AMC can launch more funds to replace ones that are being liquidated.

But the ability to get those high IRRs is dependent on how well the infrastructure and real estate sectors do, and right now, as you know, they are doing terribly.

So the vicious circle arises out of the bad environment in infra and real estate making it difficult to get high IRRs on exits, making it difficult to both earn a significant carry and to launch new funds to replace old ones.

Will this vicious circle become a virtuous one where a recovery in infra and real estate sectors enables the AMC to get good IRRs on the investments made by the funds under its management, which in turn, deliver exceptional carry to the AMC and also make it much easier for it to grow its assets under management? I don’t know.

I do know, however, that one can think of it in terms of scenarios.

One scenario is that the infra and real estate space will recover, and that the AMC will be able to grow its AUM and will also earn a large carry. That’s the optimistic scenario.

Another scenario could be that AUM won’t grow from here and the AMC will earn a small carry.

Finally, we can visualise a pessimistic scenario that the company should be viewed as a liquidation play because they won’t get good IRRs and so will not earn any carry and that would destroy their ability to raise more funds and they would have to liquidate.

In this last, most pessimistic scenario, they would earn just the asset management fee till the funds are redeemed.

Now, what if, the market priced the stock at below the liquidation value envisaged under the most pessimistic scenario?

Would that not be akin to getting a free lottery ticket on the recovery of infra and real estate (Graham)?

Would that not be akin to getting exposure to positive black swans of growing AUM with hardly any incremental investment (Taleb)?

Would that not be akin to getting a chance to make a sidecar investment with private equity players having complimentary skills on favourable terms (Zeckhauser)?

And would that not be akin to an investment where the probability of permanent capital loss is negligible (Buffett)?

So, there is a price at which the stock of this company becomes terribly attractive. And you can work it out.

When it comes to understanding uncertainty in the above example, the mental model of “feedback loops” comes to mind. Vicious circles can turn into virtuous ones and if you can get in before they do, on very favourable terms, then good things should happen, if you keep on doing it repeatedly.