“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” ~ W. Somerset Maugham – English dramatist & novelist (1874-1965)
Maugham’s thought holds a great relevance when it comes to picking up businesses for investment. The results of your investing efforts are decided not after you make or lose money in 5-10 years, but at the very moment you decide to own a specific business.
Pick up a business with good economics and with good margin of safety, and the probability of making money in the long run is high. Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high.
Warren Buffett says – “Time is the friend of the wonderful business, the enemy of the mediocre.”
While this principle may seem obvious, most of us learn it the hard way. In fact, most of us learn it several times over.
Anyways, this principle has been reiterated very well by Prof. Sanjay Bakshi in a presentation he made at a conference recently.
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His presentation broadly discusses a research study done by Credit Suisse and HOLT, which concluded how…
- Wonderful businesses are likely to remain wonderful (or at least good) for decades.
- Poor businesses tend to remain poor or they become slightly better but still remain below average.
While this has some great lessons for investors who are always in the hunt to find that “next” Asian Paints – and would rather do well to take a harder look at Asian Paints itself – I would like to add a warning here.
The research discussed in the presentation flies in the face of the concept of mean reversion that is one of the most powerful laws in financial physics and has worked well in the world of business and stock investing as well.
Mean reversion suggests that periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.
So if you go blindly by what you read in Prof. Bakshi’s presentation, and invest in business that have been great in the past, regardless of their valuations – assuming that they will remain great in the future as well – you may end up committing some big mistakes.
While a very few great businesses turn out to be outliers and remain great businesses for long, a majority of them move to mediocrity – either forced by competition, or led by their managers’ overconfidence, arrogance, flawed capital allocation decisions, and ultimately destroy return on capital.
This thought also stands true on the concept of survivorship bias.
The businesses discussed in the presentation may have been wonderful ten years back and are wonderful now, but there are have been far greater number of wonderful businesses of the previous decade that have bitten the dust.
The very characteristic of a large majority of Indian businesses – lack of innovation, short-termism, corporate mis-governance, and poor capital allocation of their promoters – has led to an extremely low number of Indian companies commanding any “sustainable” moat (over more than, say, 20 years) like their western counterparts.
So, most of the sustainable wealth creators in India have been arms of MNCs (Nestle, Colgate, HUL, Castrol), that have been able to hold their brand and business high.
This is the reason they have always commanded valuations that have been largely driven by “scarce quality premium”.
How long can such businesses command premium valuations in a highly competitive market like India, and how many Indian companies can sustain their little moats for long is a question that is anybody’s guess.
While we may love to hear stories of companies like Asian Paints, Nestle, HDFC, Hindustan Unilever, and Colgate, and how they have created tremendous value for their stakeholders in the past, we also need to understand what Horace said…
Many shall be restored that are now fallen, many shall fall that now are in honor.
Prof. Bakshi mentions that it’s important to go by the probability of success than the payoff from an investment, which is a very valid point.
But please also consider the margin of safety in a great business, for the absence of the same may kill all probabilities of its success as an investment.
Look at Infosys from 2000 to 2013 or Hindustan Unilever from 2003 to 2010, and you will understand where I’m coming from.
Howard Marks writes this in The Most Important Thing…
For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.
When people say flatly, “we only buy A” or “A is a superior asset class,” that sounds a lot like “we’d buy A at any price…and we’d buy it before B, C or D at any price.” That just has to be a mistake.
No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.
Hopefully, if I offered to sell you my car, you’d ask the price before saying yes or no. Deciding on an investment without carefully considering the fairness of its price is just as silly. But when people decide without disciplined consideration of valuation that they want to own something, that’s just what they’re doing.
Bottom line: there’s no such thing as a good or bad idea regardless of price!
I’ve heard a lot of people tell me that they are comfortable buying a company selling things like super-branded innerwear or expensive jewellery at 40-50x P/E just because the “per capita consumption of branded innerwear and expensive jewellery is extremely low in India and will catch up soon”.
In a country where over 60% of the population will continue to fight for its survival, and especially when we don’t see any end to inflation in necessities like food, clothing, and shelter, the “per capita” thinking can be dangerous.
So while I have no doubt that the probability of a great business to remain great or good is high (as Prof. Bakshi explains so beautifully in his presentation), it’s important to not be blinded by the past and pay any price to get on to it.
Dear Vishal
Good Morning to you
You have come out with a very good article,I am not contradicting what Prof.Bakshi said,but we can’t say that there can’t be a earnings contradiction for these companies,in the current scenario where the inflation is too high,and the consumption story is declining.
I think you remember,when we were discussing the Jubilant Food works story,at Vadodara railway station when you were en-route to delhi six months back.We were discussing how people are spending less in QSR,due to higher inflation and static and depressing job markets and were of the opinion that at that rate their was no margin of safety,though the business was in a good growth phase and an increasing middle class disposable income.
But the current sales tactics of Jubilant has proved me right,where they are coming out with various discount schemes to prop up the sales,we should remember that by this schemes,the company might be able to increase the top line,but for that is it sacrificing the bottom line for the same.Then as an owner of the business it is unacceptable to me.
Let me add an example from My circle,some six month back one of my friend who had some amount for investment,bought a flat for around 75,00,000 lacs in a posh region of vadodara,he just checked his purchase with me,when i said that he had paid around thirty percent higher for the flat,his answer was quite baffling to me.He said no problem yaar i will rent till then and then after some period will sell it for a profit of 2500000 lacs.
Now this was something like “Finding a bigger fool then you,to sell your expensive ware”.Six months down the line,flat prices in that area has crashed by 5 to 10 % already with much more price reduction to follow.Even his rental yield at higher end will not come more than 3.2 %(Worse than savings account interest rate) on the net investment on the flat.
Now if we construct all the above things with the price of stock.Everything was good,the flat in a posh area,good construction,but the only thing that spoiled the investment was the price paid.
we should remember that for any product,the price paid is the paramount thing.
I do not deny that ITC,Asian paints,Colgate, are not good business,but what is the price that is paid to acquire that business is of paramount importance.Let us construct this post of Vishal,with also one of Prof.Bakshi’s page that is owner operated business.By buying business at any rate we are putting ourselves in the category of OO3.Classic example right now is Apollo Tyres buying Cooper tire….Ego is playing a greater role in this acquisition,then good investment synergies,A black swan event will be enough for Apollo tires also to go down in the sea with cooper.
But against my this validation,there may be some opposition voices,which may say that do you believe that this great stocks may come to a mouth watering prices,well i would like to say it may or may not.but need not go back to history too much,we could see that in 2008 itself ,this so called consumption stocks were ruling at such prices,where you could have easily accumulated it.
As i have said equity market is 90 % waiting and 10% playing game,which is why Warren Buffet compared it with his favorite game baseball,I would like to mention his quote here which is true to the core,
“THE STOCK MARKET IS A NO-CALLED-STRIKE GAME. YOU DON’T HAVE TO SWING AT EVERYTHING – YOU CAN WAIT FOR YOUR PITCH. THE PROBLEM WHEN YOU’RE A MONEY MANAGER IS THAT YOUR FANS KEEP YELLING, ‘SWING, YOU BUM!’”
So wait for your pitch,sooner or later you are going to get it.
Thanks vishal for such a wonderful analogy.Carry on
Thanks and Regards
Happy and Safe Investing
Reni George
Thanks a lot Reni for your invaluable comment and sharing the examples. It’s fine to pay up for a good quality business, but it’s scary when people take this too far! They end up buying what’s glamorous, and end up in the ditch.
So the thought of “buying quality” comes with a lot of disclaimers. Regards.
Hi Vishal,
I had a question. I have not read Credit Suisse research, but I would like to think that it treats survivorship equally for poor and good businesses. I dont think we are considering for poor businesses those which survived or failed and for good businesses only the ones which survived. I think if we start out with a good business which fails after 10 yrs, then it can be put in the bucket of poor businesses.
Thanks.
Gourav, you can read the study here. Regards.
Thanks for sharing the link, Vishal.
Hi Vishal, as you may have guessed, I am not a diehard believer in the “India consumption story”. On the other hand, I believe Indian culture has figured out a way to be sustainable over centuries, through simple living, and being engaged with the moment. So I would not bet on the “per capita” story. I think India has too many people sharing limited physical resources, so the majority of us may have to settle for simpler and more basic consumption lifestyles than say, the Americans. Otherwise, we will have civil war. Also, the role of government will remain strong in India, and private sector players will have to operate under strict regulation to ensure resources are shared fairly and as per rules.
I do agree with Prof.Bakshi that great businesses will create huge value for investors, businesses that fulfil basic human needs and have a great reputation and scale. However, identifying these needs exceptional clarity of thinking. Also, one needs to follow these on a regular basis and look for signs that the business could be going from great to good to even average. And know if one is getting into these businesses when they are far too mature, and the best growth is behind them. And if one is getting into them at the right price, since price for these businesses is so dependent on them maintaining their high ROE over the foreseeable future. Estimating all these needs exceptional vision and clarity of thinking, strong sense of rationality, wonderful practical business sense and great control over emotions. How many of us have these?
One needs to know oneself, before selecting one’s approach. The cigarette butt approach is relatively less risky, for those with above average skills who are willing to give time to study the companies. Even here, one could end up in many value traps. Identifying great businesses that will go on for 20 years, and investing in them at a right price is a far more difficult skill. Maybe one has it, but one better know oneself well before embarking on these.
Also, I do not believe in mean reversion. There will be outliers all the time, the normal distribution. I think it is possible for positive congregation of forces to result in formation of an exceptional group, that provides great value on a sustainable basis for a long period of time. History is replete with such instances. However, one needs to be very wise (have a latticework of workable mental models, that is based on pragmatic experience), in order to be able to identify these exceptional formations, and get into them early enough at the right price.
Regards,
Rajaram
Thanks for writing in, Rajaram!
Yes, the need for a constant study of businesses you own is important – to look for signs of the shift in underlying economics.
One does not need to predict the future…just look for the obvious signs that emanate from the business. And this can happen with some clarity only when one buys a business he/she understands. Regards.
Let me add a practical exercise related to this topic….
We have two companies…
Company A
NetBlock+ Working Cap — 1000Cr
NetProfit — 100Cr
Market Capitalization —- 1000Cr
Company B
NetBlock+ Working Cap— 3500 Cr
NetProfit — 800 Cr
Market Capitalization— 20000
Lets assume both these company will grow at 20% and both are debt free companies.
As you can see Company A trading at 10 PE and Company B trading at 25 PE.
Lets assume all other aspects of these companies are identical.
I want to own one of this business for next 10 years which one should I own and why ?
Thanks for the exercise, Dhanesh! Based on your calculations, here are what my numbers show.
If all other things remain constant, both the companies will generate similar returns by the end of 10 years – 416%.
However, if you look carefully to the ROC numbers, they are rising for Company A (weaker and lesser valued company to start with) and falling for Company B (stronger and higher valued company to start with).
So, if investors were to consider these performances, the P/E for Company A will rise and that for Company B will fall.
However, even if we assume that investors wake up just in the 10th year, and give a 15x multiple for Company A (from 10x for the previous 9 years), and 20x of Company B (from 25x for the previous 9 years), the returns change drastically.
Just because of this last year’s changes in P/E multiples, the return for Company A would stand at 674% and those for B would stand at 313%.
In fact, even if the P/E multiple for A rises just by 1x, to 11x, and that of B falls by 1x, to 24x, even then A will be a winner in 10 years.
So, a weaker company to start with (A) turns out to be a winner in the long run.
The question to ask of “great” companies today is – how many such companies are able to sustain that kind of growth and returns over the long run? I think they are very few.
Regards,
Vishal
I Should have mention that “Return on Capital” will remain where they are now for 10 years.
Now which one I should own ?
Dhanesh, in that case, Company B will outperform if things (ROC and P/E) remain constant for 10 years.
However, again, if you were to make changes in just the 10th year – like ROC for Company A rises to 15% (from 10%) and the P/E gets re-rated to 15x (from 10x), while ROC for Company B falls to 20% (from 23%) while its P/E gets re-rated downward to 20x (from 25x), Company A will end up having a better result.
Now one may argue that I am making “random” assumptions to show the Company B has a chance of outperforming over 10 years. But please bear in mind that I am just making the change in the 10th year while businesses change every year, and I am just showing how just a year’s changes can reverse the performances.
The point I am trying to make here is that when you pay low prices, then you don’t need very good things to happen for you to have a good return. When you pay those low prices, then even if some bad news comes out about the company, it’s already discounted, the market ignores it. Whereas if any good news comes out, you have a jump, you have a positive, skewed result. So you end up with P/E multiple going from 2 to 3 which is not expensive by any means, but you can see what impact it has on the overall returns.
By the way, these last words in bold letters are from Prof. Sanjay’s Bakshi’s interview with Capital Ideas Online, which he gave some years back. 🙂
As Prof. Bakshi quoted Buffett in that interview – “You pay a very high price in the stock market for a cheery consensus”.
BTW, here is the excel that shows my calculations.
It’s very difficult to speculate on What PE market would pay for particular company on Year 10. I don’t have any opinion on that.
Let me explain the point I am trying to make with this exercise….
This is a typical scenario; I as a value investor have been facing on my every investment.
Whether to buy Company A (Average business with very attractive price) Vs Company B (Good Business with expensive price).
Let’s take Graham’s advice and try to Value Company like a business owner who wants to own it as a private business.
As I already put out Company A and B both has a market to grow at 20% provided their respective business owners make approximate capital investment.
Company A:-
I am buying company A for 1000 Crores
NetBlock+ Working Cap — 1000Cr
NetProfit — 100Cr
It makes ROCE – 10%
I as a owner ready to fund whatever company needs to grow at 20% (as any owner would do , except few people).
Here is the snapshot of next 10 years
As you can see company has grown at 20% but it needed additional capital because previous years profit is not enough to support growth of 20%.
As a owner I have spent 1000Cr to buy a business and then I spent another 2079Cr to support growth.
Total I have spent 3079Cr to make 515Cr profit on 10th Year, that makes my return (515/3079)*100=13.96%.
Company B:-
Similar snapshot for Company B
As you can see company generates more than enough profit to support 20% growth and it pays small profit back to owner each year.
Company B has gave 2079Cr back to owner in last 10 Years, it makes total ownership cost for a owner = 20000-2079 =17921.
Owners return on Year 10 = (4127/17921)*100 = 23%
As a private owner Company B has been more profitable to me, even though I paid a higher price (PE of 25) relative to its Year 1 earnings.
As Buffet said – “Time is the friend of the wonderful business, the enemy of the mediocre.”
As Charlie said – “If a company can deploy capital 18% for long period , large profit can be made even after paying expensive looking price.”
This is exactly Berkshire is doing…
1. Buying business which is generating higher ROCE and can maintain ROCE for longer period.
2. Shutting down business which generates lower ROCE.
Many value investors including me have tough time paying anything above 15 PE for any company regardless of quality.
Hi Vishal,
Am a freq reader of your site, but my 1st comment here.
I have 2 points to make:
– it is hard to raise RoCE (first hand experience from my own small business) unless you do something to improve either margins or reduce capital need. Assuming RoCE to increase with profit growth may not be the prudent thing – chances are high that RoCE might stay same or worsen (with more competition as company grows)
– yes, its possible to keep increasing profits at 20%, but like Dhanesh pointed out, it needs new capital addition which in turn brings down RoCE.
Like Dhanesh, I would prefer B which has more efficient return on capital.
Should we not focus on how capital efficient the company is and what will it take to give us the necessary profit growth? Would like to know your thought process in this regard.
Hi Prem,
Since you like Company B , I will sell it for 180000 Cr . Would you like to buy it ?
As you can see , Now the company profit is 4127 Crores.
Dhanesh
Hi Dhanesh,
If we’re paying 180,000cr – turns out into a 43.6 p/e (starting price).
The company we’re looking at has a return on capital of ~23. Over next 10 years, extrapolating your table, profit grows to 25,560cr. The company would have paid out a small dividend each year (or retained).
Now, even if the p/e at 10th year were to contract to half (22) – the company is now valued at 22×25,560=562320cr. On our original investment of 180,000 cr, its a 12% return. So inspite of overpaying at 43 p/e and selling at a contracted pe of 22, we still made 12%.
Now, would I buy this company?
All other things aside, my answer is no.
– our investment will work out *just okay* only if last year p/e stays above 18.
– if p/e drops below 15, the returns would drop below what you’d get for a govt bond now. Not worth the risk.
But as return on capital increases and is a sustainable one due to a competitive advantage – the answer moves in favor of a “yes” (leaving aside things like whether you understand the sector, etc).
If return on capital jumps to 30%, if p/e drops to 22, we’d have made 15% without counting dividends. Better the ‘sustainable’ return on capital, better the investment even if you overpay. Of course, that doesn’t mean its okay to overpay like Vishal pointed out. Chances are high that the return on capital may not sustain – why Vishal stresses on margin of safety.
Please feel free to point out mistakes / incorrect assumptions.
Prem,
My conclusion would be same as yours. Margin of Safety is very thin if purchase is made at 180000 Cr.
Dhanesh
Hi Vishal, good post. Interestingly, there is another presentation posted by Prof. Bakshi where he has provided illustrations on why value investing in India is not likely to work well. In that presentation, he has compared investing in companies like Bosch, STFC, etc at prices that may “seem expensive” to investing in companies that are cheap using Graham’s techniques and it so turns out that the former worked out better ! He states that that happens because investors will always be wrong about computing the Intrinsic Value or the Margin of Safety for those kind of stocks. That somehow contradicts the point you’re making above, specially the quotes you’re using from Howard Marks. Investing in high quality companies at the “right price” is an extremely rare skill. Given this rarity factor, wouldnt value investors be better off relying on the mean reversion principle & investing in a basket of undervalued stocks so as to be able to generate alpha ? Eg, when Bosch fell to 8,000 levels, you were actually writing posts on BHEL being on your watchlist. Isnt BHEL a much poorer business to be in(going by the history of wealth creation) than BOSCH? So why is it that BOSCH did not figure on your watchlist but BHEL did? My view is quality can be bought only when markets are hammered out of shape, eg. Oct 08 to Mar 09 periods. And those kind of levels appear only once in a decade…
Cheers,
Thanks for your comment, Sam!
I completely agree to Prof. Bakshi’s thoughts on investing in great businesses at prices that may “seem expensive” as against investing in businesses with poor economics at cheap prices.
All I warned in today’s post that investors must not go overboard in buying any great business at any price.
Of course, it is difficult to estimate IV with any accuracy, but then some things are “obviously expensive”, like some businesses are “obviously great”. These are the situations an investor must avoid, or must be very careful of.
Please look at my response to Dhanesh above, and you will understand where I am coming from.
As for your point about Bosch vs BHEL and why I wrote on the latter in one StockTalk, please understand that my reports have been based on requests from readers and not out of my own choosing at most times.
Also, as far as BHEL is concerned, I believe it is a business like Company A in the above example – low (but not bad) returns as compared to Company B (maybe a Bosch), but then a slight change in future returns on capital and valuations may alter the field.
I have nothing against Bosch or quality businesses selling at “expensive looking” prices, but it’s just I have warned investors to not go overboard and buy anything at any price.
Like, a friend (who is also a reader) bought Shriram Transport today morning after reading Prof. Bakshi’s presentation, and then called me to confirm whether the business is really good. 🙂
That’s the fear I had while reading Prof. Bakshi’s presentation – that a lot of his readers may act blindly and do incredulous things!
Regards,
Vishal
BTW, BHEL was a much bigger long-term wealth creator than Bosch till the fall started in late 2010. 🙂
May be this is an example where we need to consider both of the recent presentations by Prof Bakshi (one related to promoter quality and the other you referred).
Hi Vishal,
In Prof. Bakshi’s article he advocates momentum instead of mean reversion for great businesses. You have mentioned mean reversion as the main. Can you elaborate more on mean reversion concept? Is it something that MOST of the great companies will go through or the chances are remote?
Prof. Bakshi also mentions that Buffett looks at momentum while investing in great business. That makes sense when I look at the great businesses that Buffett has purchases (Coke, See Candy etc). Does mean reversion apply to these companies as well at some point in time?
Buying great companies at any price does not make sense to me. Prof. Bakshi has changed the quote – “Many shall be restored that are now fallen, many shall fall that now are in honor.” to “SOME shall be restored that are now fallen, SOME shall fall that now are in honor.” Changing “Many” to “Some” gives a lot of confidence to buy great companies at high P/E – considering that the momentum will continue. Is that the case?
To be frank, I am confused about momentum vs mean reversion . It would be great if you can cover these in detail in the value investing course. Thanks
Hi Shamil,
I agree to Prof. Bakshi’s thoughts on “momentum” in a great business (that remains great for long, and is an outlier) and poor business (that remains poor for long). What I mean by “mean reversion” is for a large majority of businesses that seem great now and turn mediocre over a period of time.
This is especially in case of Indian companies, that lack the “sustainable moats” that so many US companies like Sees and Coke seem to have. Look at history, and you would find a very tiny number of “Indian” companies that have sustained their business leadership and great economics beyond 15-20 years. I have mentioned a few reasons in the post why they are not able to sustain the same for long.
For most of them, they fall to “average quality” over a period of time.
So I will take the Credit Suisse study – that is largely for US companies – with a pinch of salt.
Don’t get confused – buy businesses that have great underlying economics and pay up for them. Only, don’t overpay from them. Your study of the business and where it may be going would tell you whether you are paying up or overpaying.
Hope this helps.
Anyways, I’ll cover more on this in Mastermind, when we discuss the relevant lesson(s).
Regards,
Vishal
Thanks Vishal. It makes sense after thinking about businesses in Indian context. As Buffett says, he was fortunate to be born in US where there are a large number of quality businesses.
I re-read your article and see the key point you are making.
“While a very few great businesses turn out to be outliers and remain great businesses for long, a majority of them move to mediocrity – either forced by competition, or led by their managers’ overconfidence, arrogance, flawed capital allocation decisions, and ultimately destroy return on capital.”
Yes, that’s my core point, Shamil! 🙂
Hi Vishal, thanks for your quick revert. Some very interesting points coming up here. Firstly, Prof Bakshi’s second post is contesting this very aspect that you’ve mentioned: “some things are “obviously expensive””. He seems to be saying that even if you end up overpaying, if the business is great, you will end up making money. I believe thats a fallacy unless an investor is trained in identifying such businesses. There are very few investors who are so gifted that they have a niche in identifying businesses that have very solid “sustainable” moats that can continue for very long periods of time.
I also do appreciate the cautionary note you’ve brought out vide your post.
What I want to bring out here is that the GARP kind of investing is an extremely niche area and very very few investors can make money using GARP stocks. Value investing on the other hand will entail buying companies that are undergoing difficult business times, but value investing also works (refer link on Buffett vs Schloss vs Munger: Schloss was a classic old school value investor vs Buffett who’s GARP & he too did generate some serious Alpha). Your response to Dhanesh above is also alluding to that point. Here’s another good resource on why Value Investing will likely work.
One thing to note is that for value investing to work, having a diversified portfolio is an absolute must. GARP investors typically have concentrated portfolios.
I always thought that you were a big fan of BHEL. Didnt know you covered it merely because your readers wanted you to. (you even covered it here)
And the BHEL vs Bosch chart makes great viewing 🙂 But BHEL did fall hard….and worse could be staring at an abyss.
Best,
Sam
Sam, I just replied to Dhanesh again with my calculations…and that maybe answers your question.
I believe Prof. Bakshi is talking about “paying up” and not “overpaying” as he has talked about buying P/Es of 25x and P/BV of 2.5x which are not that expensive for quality businesses. In fact, as he mentioned in his interview with CIO that I have linked in my last reply to Dhanesh, he has talked about the dangers of overpaying.
I agree to your following point – “One thing to note is that for value investing to work, having a diversified portfolio is an absolute must. GARP investors typically have concentrated portfolios.”
I am not a “fan” of BHEL, but just like the stock owing to its present valuations versus the business’s decent economics. But if you were to put a gun to my head and ask me to select my top 10 picks for lifetime, BHEL would not be there. 🙂
Anyways, thanks for sharing the Tweedy and Gurufocus links! Regards.
Hey Vishal,
Yes, your calculations do help clarify. This is a very interesting topic because effectively growth and value are joined at the hip.
Prof. Bakshi has been kind enough to post his views too. Thanks Prof 🙂
The challenge to pick up stocks that have solid moats in the Indian markets would be that such stocks do not correct very easily and do not correct very heavily. So investors need to be very patient and have to be willing to sit on cash for very long time periods. Which is a fair ask I believe.
Privilege of sharing the links is all mine. I’ve benefitted from your blog posts, I’ll be glad if anything I’ve shared helps you.
Cheers,
Sam
Hi People,
Seems like I have stirred the hornet’s nest. A couple of quick clarifications:
1. Most value investors refuse to look at stocks having P/E multiples of 25 or P/B of 2.5 (in case of financial stocks). I wanted to show that obsession with mental anchors like P/E multiples is wrong and very costly (in terms of huge opportunity costs which should not be under-weighed.)
2. Mean reversion is a very powerful model but one should be careful in its application. Stock returns revert to mean (they can’t go too far for too long from average corporate performance) while stock prices of an index do not (as in the long run they go up because of earnings retention and consequent rise in book values and also because the people who create the indices like to drop the really bad, fraudulent companies from their cherished indices).
3. Every great business is not destined for oblivion. There is a huge concentration of aggregate owner earnings over decades from just a handful of industries (think pareto principle). The airlines tend to go bust, the companies which sell chocolate tend to make money. The steel guys make money in some years and tend to blow it away in other years. There are very very good reasons for dominant companies in some industries to become enormous cash cows over “centuries” (yes that the word Mr. Buffett used in his letter). It is THOSE companies that tend to get under-priced by markets over the long term. We know this because, averaged out, they beat the market and also deliver returns better than AAA bonds. However, a tendency is not the same as certainty. There is no business out there, no matter how great it is, that can’t be ruined as an investment by a high enough price. It’s just that a 25 P/E multiple, for such a business operating in a country like India, not as high as it seems. To paraphrase Buffett: “(SOME) Stocks are high, they look high, but they are not as high as they look.”
Vishal, thanks for clarifying things here.
Dear Prof. Bakshi,
Thanks for clarifying things here and putting them into perspective! Thanks also for sharing your thought process through that beautiful presentation.
Regards,
Vishal
Prof Bakshi, In last century many lakhs hours of humane efforts are burnt trying to predict stock market, share price and companies for investment purpose. If same amount of time and efforts should have been put in more relevant activities result has been truely phenomenal, but in case of investment it is just mixed. Till 1991 our share market is extremely undervalued with market cap / GDP ratio below 20%, so investors have made good money during those days and market undervaluation has evaporated by 2006 with market cap/GDP ratio of around 1. Actually market cap/ GDP ratio of more than 60 % is not justified for socialist and govt heavy country like india so we have range bound market for last 6-7 years with few pockets like FMCG/Pharma out-performance. In next 3-4 years also it is highly unlikely that FMCG company is likely to outperform and likely to be flat to negative return. I also think that FMCG companies has created more wealth in indian market than even US market may be because it is extremely difficult to create new durable companies/assets in indian scenarios so few who succeed tend to outperform. Only with new theory and thesis one likely to create enormous wealth and those kind of low hanging fruits in Indian stock market no longer exists.
Dear Prof. Bakshi,
First of all, please accept my sincere thanks for putting up the transcripts, notes, presentations and case studies prepared for BFBV class. It has been of tremendous help to many people like me in moving up the learning curve. I would like to take this opportunity to share my thought process and observations on the idea of “paying up” for values. I am struggling to still get full hang of this idea and look for your guidance on the same.
First of all, I have observed, that many a times, some people take “paying up” too far and take that as an excuse to justify any valuation saying that one has to pay up for a great business. They quote, Warren Buffet’s example of paying up for See’s candy/Coca Col/ Gillette. However, from whatever preliminary research that I have done, Buffet did not pay 40-50 times earning in any of these great businesses. He paid 12-13 times for See’s candy, 17 times for coca cola (which he considered as one of the greatest business in the world). So my first doubt is “how much is too much?”. Again, I am not alluding that one should get anchored at some P/E multiple of P/B multiple. However, beyond certain valuation, risk-reward tend not to be in favour of investor. odds of winning starts to be against the investor (though, it does not preclude the chances of winning altogether!). And I understand it correctly, the whole idea in Buffet-Munger philosophy is to invest in “mispriced bets” where odds of winning are predominantly in investor’s favour.
Secondly, my understanding is that irrespective of “investing approach” followed by any of the great value investors, the common thread that binds them is margin of safety. Now, if we decide to pay for quality, how do we ensure that there is enough MoS in the price that we are paying for? In order to determine margin of safety, one has to calculate IV of the business with foresight (and not with hindsight). In many cases where people are willing to pay 30-40 times earnings, MoS can only exist if one assumes that business continues to grow @ 20+% rate for next 15-20 years at constant and/or increasing margins with same asset deployment efficiency. Now what are the odds of this scenario playing out considering that business environment can be very dynamic and many of the factors not present today can crop up in next 5-10 years and change the game completely. Sometimes, people apply these kind of assumptions even to businesses where they clearly see that competitive intensity is rising consistently. So, I am struggling, that even after I conclude that the business is “great” business and have reasonable certainty of cash flows and ROE, what is the reasonable “Ceiling” on growth rate one should assume to arrive at IV and hence MoS?
The last question is about making capital allocation decision. I very well understand, that some of the great businesses like Asian Paints, Nestle, ITC etc have been trading at premium valuations all the while and have still been great wealth creators for investors. However, while, one is looking at “opportunity set” available, where numbers of “good” businesses ( growing at good rate, having some pricing power, operating in duopoly/oligopoly, have reasonably good moat of brand and distribution reach) are available at very reasonable price where MoS is high even after making very conservative assumptions, how should one take “capital allocation decision” on paying up high value for “great businesses”?. In other words, on the continuum of low quality/cheap business – extremely high quality/high valuation; there exist a set of businesses which are decent quality and available at very attractive price. How should one decide capital allocation approach along the continuum of businesses?
Your observations/inputs will be of great help.
Thanks & Regards,
Dhwanil Desai
Dear friends,
I don’t’ know whether this is the right thread to post my query, however since the discussion focusses on the appropriate valuation , I am proceeding with my question:
We are aware that Banks and other Financial Companies are valued using P/ABV parameter and not PE basis.But how does that explain the valuation of HDFC Bank and Gruh Finance. HDFC Bank for example has consistently traded at P/ ABV of 4+. Few are of the opinion that Growth stocks even though in Financial Sector are to be valued on the basis of PE. But then, isn’t it a risky proposition although management quality is also to be considered.
Please share your thoughts.
The discussion and the presentation was very stimulating and it really echoed Buffetism well, but one question that remains unanswered is at what price stocks for companies like Nestle, ITC etc. should be purchased as they are rarely available at their IV.
Manoj, Prof. Bakshi has made a case for investing in such stocks (like ITC) at 25x P/E, and these have been available at such levels at several times in the past. The key point is to act when the iron is hot…while knowing what you are getting into.
One observation I had with regards to paying up for quality after read prof Bakshi’s article
That an investor’s call on it being ‘quality’ for a long period of time has to be precise or else he will pay a heavy price. So it may be very important that an investor truly understands why the business is great, and therefore what he is paying up (and not overpaying) for is indeed sustainable high quality.
Yes Akshay, to know what you are getting into is of great importance.
Vishal,
Thanks a lot for articulating your thoughts as well. I totally agree with your ending notes that great business need to be picked at discounted price rather than at great price. Investor should never forget the margin of safety principle while buying business. There are going to be few misses and there will be times when investors are going to make decent above average returns. Above all, one needs to treat the pleasure and pain equally. Delaying Instant gratification is a quiet a task in itself. Its about building a controlled mind and it definitely takes a lot of hard work to develop it.
Thanks to Sanjay Bakshi for the fantastic article and thanks to you to have summed it up.
Regards,
Naveen
Thanks for your feedback, Naveen!
Hi Vishal,
Sanjay Bakshi has put the valuation argument to rest with his data point for a great business. The trick is to find a great business and hang on to it till it remains great.
As you said a great business may not remain great say after 5-10 years because of many reasons. Hence an investor need to constantly watch for any decline in the operating parameters and take a call with an open mind.
Finally ” Investing involves some predictions and future forecasting as well. Those who are too fixated with present valuations will have to be satisfied with mediocre returns only.”
Regards,
Raj
Agree with your observations and thoughts, Raj.
Hi Vishal,
I am unable to open the presentation from Bakshi sir. Would it be possible for you to re-post the same?
Regards,
Shantanu
PS: Would be great to finally meet you in Pune on 27th Oct.
Hi Shantanu, not sure why you faced the issue, as I can download it at my end.
Anyways, you can download it directly from Prof. Bakshi’s website.
Even I look forward to meet you on the 27th. Regards.
Even I am struggling since a long time to really understand Prof Sanjay Bakshi series of presentations on buying quality business and they are really eye opener for me. Some of the key takeaways for me are
1) Look beyond reported numbers be it ROE or cash flows or PE or any other number. Just because PE is 2-3x does not mean stock is cheap and PE of 20-25 does not mean its expensive….
2) Scale of opportunity: When a stock is trading at a PE of 20-25x and the scale of opportunity is very large, which will enable company to employ large amount of capital at high ROIC, then such stock is cheap.
3) Last and most important, when one is buying such stocks at FAIR PRICE then holding has to be in terms of DECADES and not in terms of years. Which also mean, one should be confident of quality of such business and opportunity available to them…This is most tough. Unless and until one is confident that business can survive and grow in high double digits for next decade, one should think before investing at FAIR PRICE, because in such cases margin of safety comes from future growth and not in the statistical cheapness of stocks….
To be very frank, it quite tough for me to invest at fair price. What I am doing is allocating a small portion of my portfolio to such stocks and trying objectively to look at size of opportunity available compared to their market cap.
I think its very important to read Prof. Sanjay post on “Return per unit of stress” to truly understand, prof growing emphasis on quality stocks. Read post here.
In one of his replies in the same blog, he made it more clear his reasoning for shifting away from cigar butts and cyclicals. Here is what he said – “I haven’t completely withdrawn from cigar butts, or cyclicals or event driven investing Taha. Its just that I have started focusing a bit more on being able to sleep a bit better than before (moving out of F&O and shorting was very useful there), not bite nails too much (reducing exposure of delistings where one doesn’t know if the book is built or not even until the last moment). I have also reduced activity greatly (my broker friends don’t like this which is understandable). I guess as one grows older, things like stress reduction come automatically…”
Thanks Vishal for sharing Prof Bakshi’s perspective on investing – it is a brilliant piece written to draw attention – and makes the point using certain examples which prove that point. However, as is apparent from the comments of other readers – it also muddies the (already muddy waters) by debunking of the classic value approach of looking at good value stocks through a combination PE ratios, current cash flow, book values (and with lots of patience).
You write very well Vishal – and most of us (regular readers of your blog) keep coming back to your blog because of the consistency with which you say things. I suggest you keep reinforcing your own theme and investment philosophy – and not confuse the lay readers by alluding to other approaches however earth-shattering they may be.
Some of the important parameters to evaluate the ‘fair price’ of a ‘high value’ stock as per the above article of Prof Sanjay Bakshi are PE charts and P/BV charts. I request Mr Vishal to please guide me how to find those charts from the Internet . I will be extremely thankful for the help .
The article by Proff Sanjay Bakshi is based on a research paper as stated by him . The inferences are based on solid statistics and supported by logic . With my experience of about 33 years in security analysis with a very reasonable benefit derived therefrom i can say that Mr Sanjay was able to present the Warren Buffet’s methodology of investment in a nutshell . I congratulate Mr Sanjay for presenting a complicated and comprehensive investment technique in a most simple way .
i recommend investors to go through the article word by word , digest the points and then question its veracity .I have had a similar approach at least from past 15 years though i could not realize what i am doing in an analytical and methodical way like Mr Sanjay. That is why he is a Professor and i am not!