Value Investing, the Chetan Parikh Way – Part 2

I recently had the privilege of meeting one of the highly regarded value investors in India, Mr. Chetan Parikh in his office in Mumbai.

Mr. Parikh is a director of Jeetay Investments Pvt. Ltd., a portfolio management firm. He is also associated with Capitalideasonline.com, a website dedicated to investor education.

Here is the first part of his interview.

In this second part, Mr. Parikh enlightens us on the mental models and checklist he uses to short-list companies for investment.

Over to Mr. Parikh.

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Safal Niveshak: Please explain the mental models you use to short-list companies for further research and to make your investment decisions. Please talk about some multidisciplinary models that have worked well for you in investing and life in general.

Mr. Parikh: It is paradoxical that to make sense of messy reality one has to deal with the highly abstract.

Any comprehension of any facet of the world, be it physical, natural or sociological needs insights (I hesitate to use the word theories) or more generically, mental models.

These mental models reduce the overwhelming complexity of reality to its crucial aspects which helps to make sense, like the equivalent of having specifications in engineering.

Use mental models to deal with complexity
Mental models are a powerful way of dealing with complexity.

It was Albert Einstein who stated…

The … goal of all theory is to make the …. basic elements as simple and as few as possible without having to surrender the adequate representation of ……..experience.

Furthermore, reality is multi-faceted (remember the blind men and the elephant) which also means understanding the interactions between these mental models as applied to the situation or problem being studied. This diagnosis should lead to more effective action.

There must be many ways on how one can use mental models, but I prefer to make my approximations of reality using simple diagrams drawn from systems theory as they better map the interactions and connections between the disparate mental models that find their place in those diagrams.

Whilst calculus teaches how to differentiate and integrate mathematically, I think that the mental models approximations help to differentiate and integrate conceptually.

Interactions can change depending on situation being studied. Take salt, for instance. Sodium and chlorine have a single type of interaction in all environments, but not hydrocarbons comprising of hydrogen and carbon.

For as the Sufi story goes: “You think that because you understand “one” that you can therefore understand “two” because one and one make two. But you forget that you must also understand “and”.”

It is when penciling in feedback loops that a lot of “why” and “what if” questions arise and the answers can come only through understanding, as distinct from information which is copiously available today and usually answers the “what” question and knowledge which answers the “how” question.

Of course, one needs the “whats”, “hows”, “whys”, and “what ifs” to answer the overarchingly practical “What the hell is going on here?” question.

An investor should be looking at possibilities in the future and the behavioral possibilities of any system or situation being studied depend on how structures and conditions change.

In many cases this makes prediction impossible and leaves a reasonably small subset of companies where the range of possibilities is not wide.

Alternatively, the price should have discounted the worst possibility. Given that understanding is not easy, given that information that does not fit our mental models is often discarded, we are often blundering “satisficers” according to Nobel Laureate Herb Simon.

“Bounded rationality” and behavioral biases often makes investors and managers view things in a manner that may not lead to desirable outcomes.

I have through my experience also learnt that there is a difference between my approximations of reality and reality itself. It has usually been based on…

1. Ignorance masked as “knowledge”;
2. Focusing too much on the short-term at the cost of trying to understand the long-term behavior and structure;
3. Extrapolating in a “non-linear” world;
4. Taking simplifications too far; and
5. Applying the wrong mental models.

In short, faulty understanding of reality itself. For as G. K. Chesterton, the famous author, wrote…

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is.

The only antidote I believe, to this is to remain a learner and to become what psychologist Don Michael calls “error-embracing”.

An experiment in investing
Here is a thought experiment on investing (adapted from a wonderful book, “Good Strategy Bad Strategy” by Richard Rumelt).

Imagine that you have found Aesop’s goose and it is not going to die, not going to mate, not going to eat or fall sick and will keep laying golden eggs every year worth Rs 1 crore.

There are no taxes and interest rates are to remain constant at 10 percent. You decide to encash your good fortune and sell the goose for Rs 10 crore to a gold miner.

Whilst the goose does have a competitive advantage (zero cost of production and a unique asset) in the gold mining business, the new owner will not become richer with the purchase. Unless a way is found to get the goose to lay more than Rs 1 crore worth of golden eggs every year.

Competitive advantage (or an economic moat) by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does.

Of course, if you were fearful and the buyer was greedy, you could have sold the goose for less than its economic worth and value would have been created on purchase, but let’s not assume irrationality.

Good investing comes from good business analysis more than good financial analysis.

Mental models that help to understand business strategies that lead to growing competitive advantage should be useful to investors.

Here are some from biology although there are many from other disciplines which I’m not listing.

a) Evolution as an algorithm: Innovation, formula that through trial and error creates new designs; Competition + variation + replication = natural selection + evolution; “Differentiate, select and amplify” resulting in novelty, knowledge and growth; Economic evolution dependent on physical and social (method of organization) technologies; In evolutionary systems, statsis will result in extinction; Economic equivalent of mutation and sexual recombination are business plans based on risk, relatedness and time horizon; Swarm intelligence.

b) Punctuated equilibrium: Removal of “keystone” species from ecosystems; Disruptive technologies, technology S-curves; Extrapolationism is not a good theory.

c) Co-evolution: Arms Race (Red Queen races) and thus the difficulty of maintaining sustainable competitive advantage; Organizational resources and business plans; Symbiosis and “switching costs”; Eras and stages of co-evolution; “All forms of life make one grand system” -Charles Darwin

d) Fitness: Designs are fit if they survive and replicate under the constraints of environment; Fisher’s fundamental theorem – average fitness of a population grows from generation to generation; The experience curve.

e) Adaptation: Evolution produces designs that reflect new selection pressures; Speciation; Usually resisted due to delusional optimism, psychological denial and loss aversion; Organizational structure – hierarchies, Skunk Works; Cultural norms and inertia.

f) Industry clockspeed: Fast clockspeed species have extremely short life-cycles; Sustainable advantage is a slow-clockspeed concept; Fast – clockspeed industries tend to generate hedging strategies.

g) Genes: Business genes or practices that perform the same role as genes in biology; Information stored in “organizational memory” and passed on between individuals and firms; Relationship between genes and organisms typically complex and indirect; Genetic engineering has begun the process of short cutting the process of species evolution, proactive chain (organizations, technologies, capabilities) will shortcut industry evolution; Business double helix and cycles between vertically integrated industries and horizontally disintegrated industries.

Let me elaborate. Differentiation is vital to evolution. As Robert Goizueta, the late CEO of Coca-Cola said: “In real estate it’s location, location, location. In business it’s differentiate, differentiate, differentiate.”

There is an absolutely amazing presentation by Mr. Rajiv Bajaj of Bajaj Auto which is one of the clearest expositions of good business strategy that I’ve come across.

I’m grateful to Mr. Darshan Engineer and Mr. Dhaval Shah of Siddhesh Capital Market Services Pvt. Ltd. for drawing my attention to this presentation and link.

There are some mental models from biology that one can apply to this presentation although there are many from other disciplines too.

Here are some of them from the presentation. I’ll like to thank my colleague, Mr. Anish Jobalia, for making the notes.

Scooter strategy (Speciation)
‘Speciation’ is the evolutionary process by which new biological species arise. ~ Wikipedia

• When we make a scooter, it has to come out of the same center from which comes the motorcycle. If we create a completely different platform, it won’t work
• One of the key difference between scooter and motorcycle is: In a motorcycle, one has to change gears, in a scooter one doesn’t have to
• Bajaj has to be paranoid about leadership in motorcycles. What if tomorrow someone made a motorcycle where you didn’t have to change gears
• If scooter technology is put in motorcycles, it can be done but price to pay is fuel economy
• Technology of ability to deliver high mileage as well as no gear technology would be meaningful to motorcycles
• Once we have that technology, it’s a piece of cake to make a scooter. This way we can make a scooter with a high mileage
• If we make a scooter, it will come from womb of a motorcycle. Then it will be de-risked completely

Three wheeler and RE 60 strategy (Speciation)

• Bajaj is the largest 3 wheeler maker globally
• As a leader, one has to attack oneself, strengthen oneself and guard oneself – Defense strategy
• People who use 3 wheeler deserve much more like a 4 wheeler : water cooling, fuel injection, steering wheel, seat belts etc
• Better 3-wheeler is a 4-wheeler
• Provide it at the same cost structure of a 3-wheeler
• It takes nothing to make a 3-wheeler (no high capital, no technology)
• Idea is to create a entry barrier to the high EBITDA business so that nobody would be able to copy the technology, certainly not China

ASEAN market strategy (Co-evolution)

• Entered Philippines and Indonesia 6 years back
• Approach was different in both markets: In Philippines went as Bajaj but along with Kawasaki because it already had the network while in Indonesia went by themselves
• Result was that in Philippines they are market leader (45% market share) while in Indonesia merely 2% market share
• Tie up with Kawasaki was to overcome the first mover disadvantage
• In Indonesia, people do not come into the showroom. Only way to reach them is through mass media
• To overcome this disadvantage, had to find a clever entry strategy i.e. Kawasaki

KTM Strategy (Co–evolution)

• We never pursued KTM for technology
• Started working with KTM in 2008 and by 2011, Bajaj had finished designing, manufacturing and shipping them back to Europe
• Chose to invest in KTM (47%) for guerilla marketing
• Bajaj is trapped in a value for money proposition. People would not buy the best of the motorcycles from Bajaj priced at a premium
• So invested in KTM

Hero as a competitor (Punctuated Equilibrium?)

• Biggest mistake Hero is making is that they are not defending their leadership
• Splendor has remained static for too long
• Hero thinks their brand is ‘Hero’
• Have to do something about the design, performance and price
• This is what happened to Chetak 15 years before. One day world moved past Chetak

Royal Enfield – Siddharth Lal (Fitness)

• Was clear from start that he would never participate in mainstream
• Strategy was to be a niche player and employ a guerilla strategy
• Never acts like a leader

Mr. Charlie Munger, the father of the “mental models” approach to thinking, once said: “Those who will not face improvements because they are changes, will face changes that are not improvements.” This is what evolution is about.

Safal Niveshak: How do you typically find ideas and what is your selection process before an idea gets added to your portfolio? What types of questions are on your investing check list?

Mr. Parikh: The first part of the question has been answered in my previous interview) and on Jeetay’s website.

We have different checklists depending on whether we are evaluating a potential purchase or whether we are reviewing an existing holding.

We would tend to emphasise business strategy more for a company with “moats” and catalysts and valuations more for the Grahamian sort of bets.

Broadly the sort of questions would test our understanding about…

• Business;
• Its strategy in relation to its competitive advantage and industry structure;
• Its operating efficiencies and operating leverage;
• Its capital structure;
• Financial analysis with a lot of emphasis on cash flows and balance sheet; the management – competence, integrity and compensation;
• Corporate governance and history of capital allocation.

Whilst evaluating the opportunities, we are looking for downsides.

Finally, if we think we have understood the business, we try to figure out the price we are willing to pay.