My Email Exchange with Prof. Sanjay Bakshi on Valuations

In the March 2015 issue of my premium newsletter Value Investing Almanack, I wrote on the topic of Valuations as the cover story.

My idea was to bring forth varied thoughts on valuing stocks and especially from the angle of drawing the line between paying up and overpaying for high-quality businesses.

I showed the draft of my note to Prof. Sanjay Bakshi, and he was kind enough as always to share his thoughts on how investors must look at valuations, especially when they are looking at expensive-looking, high P/E stocks in their portfolios.

What follows below is our email exchange on the subject. I am sharing it here so that a wider audience benefits from Prof. Bakshi’s thoughts on the important subject of valuations.

In the meanwhile, if you wish to read the complete March 2015 issue of Value Investing Almanack, and my detailed take on valuations and a lot of other ideas, please click here to subscribe.

Before I share Prof. Bakshi’s thoughts on valuations, here is what he has to say on the Value Investing Almanack newsletter…

This is probably the first investment publication in India which needs special software to open and read. There is a cost involved too and not just financial. But then, as Mr. Buffett likes to say “price is what you pay, value is what you get.”

As a paid subscriber to Safal Niveshak’s Value investing Almanack, I fully expect to derive value far in excess of price paid. I recommend you to subscribe too.

~ Prof. Sanjay Bakshi

My Email Exchange with Prof. Sanjay Bakshi
Vishal (VK): How do you look at valuations? And how do you determine at what valuation should you buy or hold a particular stock?

Prof. Sanjay Bakshi (SB): The decision to buy is not the same as the decision to hold on to something that’s really worked for you for exactly the reasons you envisaged before you bought it in the first place.

Let me explain how that works.

In my final Relaxo lecture, I had articulated my thoughts about determining expected return of an investment operation involving the buying and holding the business for a decade. In order to make that estimate, I built in several sources of “redundancies” to act as sources of margin of safety.

First, I applied the method to a business model which is suited to that method (easy to understand, moated businesses, with a dominant market position and strong long-term growth prospects derived from both business volume growth as well as realisation growth). It would be foolish to apply this method to every business model.

Second, while making assumptions about owner earnings a decade later, I used assumptions which were conservative as compared to the actual performance of the business in the past.

Finally, while determining the exit multiple 10 years later, I used an exit multiple of well below 20x — a cap I use for all expected return models as an exercise in discipline, even though I know that many businesses would be worth a lot more than 20x earnings a decade from now, given their profitability and growth potential even beyond 10 years.

The idea behind the above is to create multiple sources of margin of safety. The first point delivers a margin of safety by keeping you away from bad businesses. Investors should recognise that margin of safety, apart from a low price, can also come from a high quality business.

The other two points help you think about reasonable valuation a decade from now.

To be sure, no one knows what the value of the business will be a decade from now. But, by exercising caution using the method I described above and in my lecture, one can come up with some notion of “expected return”.

Now, all that one has to do is to figure out it makes sense to buy the stock or not by calculating the expected return and comparing it to other opportunities available to you at that time.

VK: And how does one make a hold decision?

SB: Let me tell you my thoughts on the other decision I mentioned earlier — the decision to hold on to a business which works well for you for reasons you have articulated in the original investment thesis. The big lesson here is to not focus on the stock price but to focus on performance of the underlying business. As Mr. Buffett says, focus on the playing field, not the scoreboard. Too many investors look at the score board instead of the playing field. That is, they tend to focus on the current stock price, the current P/E multiple or the percentage gain in the stock price in relation to the gains in some index or some other stocks. And, if they own the stock, they start thinking along the following lines:

1. OMG it’s gone up so much so quickly, so I better sell. (Anchoring to cost)
2. It’s selling at xyz P/E multiple which is so high compared to the past P/E multiple history of the stock, or the P/E multiple of the stock market, or the P/E multiple of other similar businesses, so I better sell. (Anchoring to historic or near term P/E Multiple)
3. If I plug in the assumptions that I used in my original expected return model, then at the current stock price, the model will predict a very low future expected return, and so I should sell. (Anchoring to ultra-conservative assumptions used before buying despite seeing far better performance).

That kind of thinking works well with other types of value investing, in particular, with classic Graham-and-Dodd style of value investing. But I don’t think it applies to moat investing.

What’s the big lesson in common stock investing? The big lesson is to buy great businesses at reasonable valuations and then to sit on them for a long-long time. If you take a sample of 100 very successful investors who have compounded their capital at a high rate for a long-long time, you will find that an overwhelming majority of them simply did not sell the great businesses they had bought by giving in to any of the three temptations I listed above.

In particular, they did not overdo the excel modelling to keep calculating the future expected returns based on current stock price. Nor did they worry about selling a stock simply because it was not quoting at a P/E multiple which made the stock look expensive. Rather they followed Philip Fisher’s advice who wrote this in his classic book on investing titled “Common Stocks and Uncommon Profits.”

At this point the critical reader has probably discerned a basic investment principle which by and large seems only to be understood by a small minority of successful investors. This is that once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all. However, recommendations and comments continue to pour out of the financial community giving other types of reasons for selling outstanding common stocks. What about the validity of such reasons? Most frequently given of such reasons is the conviction that a general stock market decline of some proportion is somewhere in the offing. In the preceding chapter I tried to show that postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly. This is because the investor is ignoring a powerful influence about which he has positive knowledge through fear of a less powerful force about which, in the present state of human knowledge, he and everyone else is largely guessing. If the argument is valid that the purchase of attractive common stocks should not be unduly influenced by fear of ordinary bear markets, the argument against selling outstanding stocks because of these fears is even more impressive. All the arguments mentioned in the previous chapter equally apply here.

This brings us to another line of reasoning so often used to cause well-intentioned but unsophisticated investors to miss huge future profits. This is the argument that an outstanding stock has become overpriced and therefore should be sold. What is more logical than this? If a stock is overpriced, why not sell it rather than keep it?

Before reaching hasty conclusions, let us look a little bit below the surface. Just what is overpriced? What are we trying to accomplish? Any really good stock will sell and should sell at a higher ratio to current earnings than a stock with a stable rather than an expanding earning power. After all, this probability of participating in continued growth is obviously worth something. When we say that the stock is overpriced, we may mean that it is selling at an even higher ratio in relation to this expected earning power than we believe it should be. Possibly we may mean that it is selling at an even higher ratio than are other comparable stocks with similar prospects of materially increasing their future earnings.

All of this is trying to measure something with a greater degree of preciseness than is possible. The investor cannot pinpoint just how much per share a particular company will earn two years from now. He can at best judge this within such general and non-mathematical limits as “about the same,” “up moderately,” “up a lot,” or “up tremendously.” As a matter of fact, the company’s top management cannot come a great deal closer than this. Either they or the investor should come pretty close in judging whether a sizable increase in average earnings is likely to occur a few years from now. But just how much increase, or the exact year in which it will occur, usually involves guessing on enough variables to make precise predictions impossible.

Under these circumstances, how can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate? Suppose that instead of selling at twenty-five times earnings, as usually happens, the stock is now at thirty-five times earnings. Perhaps there are new products in the immediate future, the real economic importance of which the financial community has not yet grasped. Perhaps there are not any such products. If the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 per cent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later.

If the job has been correctly done when a common stock is purchased, the time to sell it is-almost never.

So, if you want to emulate Fisher, you should use the rudimentary model I described in my lecture to help you decide if you want to buy the stock or not, that model should not be the one to use to help you determine if you should hold or sell. This is key.

VK: Okay, so as Charlie Munger says, one should not be the ‘man with the hammer’…

SB: People use the same models for everything. I see it all the time when I see people using pre-designed templates to analyse every business. You see it in most sell-side research reports. It reminds me of Charlie Munger’s favourite quote that to man with a hammer everything looks like a nail.

What model one should use to make the hold or sell decision? After much reflection, my thoughts on this subject have evolved over the years.

The first thing to ask is whether the business is delivering what you envisaged. Here it’s important to not measure this performance every quarter. This is another mistake many analysts make. They look at performance every quarter. Why do they do it? Well, the key reason is that the information is there. That’s an illustration of availability bias. But you don’t have to use the information that is there because that information may be noise.

Imagine, for example, that companies were required to provide, not just quarterly performance numbers but also monthly ones. Indeed, let’s take it to the extreme and imagine that you had available daily performance numbers? How important would those numbers be? I would argue they would be close to useless. More data does not result in more insights. Often, it results in bad judgments.

You really have to train yourself to observe if, by and large, the business is delivering performance in line with your long-term projections. Some slippages must be tolerated. Some mis-allocation of capital decisions must be tolerated too. The approach is similar to Ben Franklin’s advice that you should “keep your eyes wide open before marriage, half shut afterwards.”

Equally important is to determine that the performance is coming from variables you had envisaged and not some other factor. What you’re trying to determine, roughly speaking, is whether directionally, the business is delivering the long-term numbers you imagined, which if it continues to do will easily enable it to command the valuation a decade or so from now that your rudimentary model came up with

If the answer to that is overwhelmingly yes— as happened with Relaxo — then the model you use to help you decide to hold or sell must allow the very strong possibility that in great businesses you tend to get good surprises and they tend to do better than you envisaged. (BTW, in the case of Symphony that has been stunningly true).

In the case of Relaxo (and I am using it just as an illustrative example) this has turned out to be the case. So, to help you determine if you should hold or sell a business that’s really working for you, you should use what I call as blue sky scenario. While I don’t have time to explain this in detail, basically it means that you should not use the same assumptions you used when you bought the stock. This is especially true when the business you bought into is doing far better than you had anticipated.

If you bought the right type of business, then there is likely to be tendency for it to deliver better than what you envisaged. If you see that tendency play out after you have invested, don’t ruin it by staying with the original model. Your model has to be adaptive. If the performance is far better (or worse) than you envisaged, you have to change the model unless the improvement (or deterioration is likely to be temporary).

As Keynes used to say, when facts change, I change my mind. You have to have the same mindset when it comes to investing in both directions. That is, if the business is delivering far poorer performance than what you had envisaged earlier, and that performance is likely to continue because the moat is impaired, then your original model needs to be re-worked and it may well turn out to be the case that you should sell the stock. You have to have the ability to be detached from the outcomes, based on dispassionate analysis of real, meaningful data (not noise).

One last point: If something is working for you, and you don’t have cash and if something else turns up and you like it a lot, then you should sell what’s working for you only when what you want to buy will give you a significantly higher expected return. Otherwise, just hold on to your great businesses and let them compound your capital for you.

To summarise, you should follow the advice of John Maynard Keynes, Ben Franklin, and Philip Fisher. Keynes said –

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave causes, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.

Franklin advised that you should…

…keep your eyes wide open before marriage, half shut afterwards.

And Fisher wrote –

If the job has been correctly done when a common stock is purchased, the time to sell it is-almost never.

Some readers may be very uncomfortable by reading what I wrote above. Their discomfort will arise from questions like:

1. How can rules to hold on to a stock differ from rules to buy it in the first place?
2. If you won’t buy the stock now, then why would you hold it? Isn’t that illogical and an example of endowment effect?

Those would be very valid questions. And maybe I will address them one day. For now all I will say is that the overwhelming evidence out there tells us that true wealth over the long term from owning equities is created by listening to the advice of Keynes, Franklin, and Fisher.

VK: Thank you Prof. Bakshi for sharing your thoughts!

SB: My pleasure, Vishal!

---

P.S. Click here to subscribe are read the complete March 2015 issue of Value Investing Almanack.