Value Investing, the Sanjay Bakshi Way – Part 4

Here’s the final part of my interview of Prof. Sanjay Bakshi. You can read the first three parts here – Part 1 | Part 2 | Part 3

Safal Niveshak: Can you draw down a series of steps and checklists – the process – you use to identify stocks to buy using the value investing route?

Prof. Bakshi: You need different checklists for different styles of investing.

If you are analysing a bankruptcy situation, the checklist you will use will obviously be different from the one when you are buying into a business on the basis of the skills of one person, like Ajay Piramal.

Buying into Piramal Healthcare was essentially a bet on the man’s ability to allocate capital. So to evaluate how likely he will do that in the future, your checklist must first examine how well he allocated capital in the past and also how did he treat his minority investors in the past.

Once you’ve done the past evaluation and formed a positive view, the next question that you have to answer on your checklist is: How likely is it that Ajay Piramal will get opportunities to allocate capital well in the future within his circle of competence?

You also have to think about how the existing businesses the company owns may do in the future and as you know one of the businesses – drug discovery – is one that possesses the possibility of delivering one or more positive black swans.

So your checklist has to incorporate how to deal with the uncertainty.

Obviously, the due diligence required in such an investment operation is very different than one required in evaluating the economics of a tender offer.

When there’s an open offer at Rs 100 and the stock is selling at Rs 95, you can make Rs 5 in a two month period, then the process revolves around whether they (the company) are going to honour it or not, whether the offer will get delayed or not, and what are the risks involved in the transaction.

In such situations, you really don’t have to worry about the quality of the management, the earnings, P/E multiples etc. Those things become completely irrelevant.

So you have to think about the process very carefully, and every style, every single opportunity will have its own checklist.

Safal Niveshak: But what could be a checklist for a small investor who is focusing on a simple Buffett kind of a strategy – buying good companies with durable moats?

Prof. Bakshi: The single most important thing here is that if you buy great companies, then you can go wrong only when you overpay for them.

If it’s going to remain a great company, you are unlikely to have a permanent loss of capital. Even in Infosys, people who got in it in 2000 have not lost money. They have made a little money, but much less than what they would have made if they had been smarter.

It’s hard to lose money in a great company, run by ethical managers, except when you have grossly overpaid for it. Even if you have moderately overpaid for it, it is not going to kill you in the long run.

People get killed by buying mediocre or shady companies at high prices. They don’t get killed by buying good companies at good prices.

The checklist for a small investor who focuses on buying good companies with durable moats would revolve around three factors – business, people, price.

For evaluating business, I highly recommend reading Pat Dorsey’s book – “The Little Book that Builds Wealth”.

It’s such a simple, common-sensical book that investors can learn from. It will help them in spotting moats. It will also help them in keeping away from thousands of companies that have no moats. So, for “business” factor checklist, read that book.

For “people factor”, you need a checklist for evaluating managements. Perhaps, we can work on this together for the benefit of your readers.

It would be a simple checklist covering skills (operating as well as capital allocation) and ethical conduct.

There are lot of red flags one should look for:

• You don’t want to see management paying itself exorbitant salaries and perks.
• You don’t want to see promoters merging their private companies into the company whose stock you are evaluating.
• You don’t want them to appoint their relatives who don’t have adequate qualifications.
• You don’t want them to have a lot of related-party transactions with their own privately held companies.
• You don’t want to be involved with companies where the promoters trade in and out of the stock.
• You don’t want to be get involved with promotional managements.

Essentially, you want to keep away from shady promoters.

For “price factor,” a simple rule can be used. You don’t have to make it complicated. A rule like never paying a more than a P/E multiple of 13 (where “E” is expected minimum future earnings) can be used. Since the stock has already passed the tests on “business factors” and “people factors,” having a simple rule on the “price factor” makes a lot of sense.

Safal Niveshak: At low valuations, the mediocre companies are anyways value traps, right?

Prof. Bakshi: Absolutely! So the checklist that I would have for a small investor would also have a question – Is this the right time to buy stocks?

The simple rule that I can give is that the Indian stocks have hovered from 11x P/E multiple on the lower end for the NSE-Nifty to a 27x on the higher side.

Data Source: Ace Equity
So obviously if you are buying stocks when the P/E multiples are 23, 24 or beyond, you should be a bit careful. You shouldn’t put a lot of money in stocks.

But if the stock that you like a lot is available to you in an environment where the aggregate multiples are 12-14, or even right now, which is about 15, then it’s a good environment to buy into long term stocks.

So think a little bit about timing. You don’t want to buy great companies at fabulous prices during bull runs. You want to buy them in bear markets, and then you have to exercise patience.

Safal Niveshak: Yes, I have a kind of a checklist that I use with my stock analysis. It’s like a logic chart that helps you go through a checklist of what you want to see in a company and what you want to avoid, including a behaviour checklist. I’ll share it with you.

Prof. Bakshi: Yes, I’ve seen it. It’s very good. It would also be great if you had a checklist on corporate governance, including things like what auditors are saying about the company, how frequently auditors are being changed, what is happening in the insider activity, are they trading in and out of the shares very frequently, or are they not doing that and they are building a stake in the company and are there for the long term.

Safal Niveshak: Thanks for the idea! My next question – If you were to go back to the start of your career as an investor, would you like to change something – add or delete?

Prof. Bakshi: I’ll add patience.

One of the things about investing is that when you are young, you are much more impatient than when you get older. Maybe it’s to do with age, maybe it’s to do with experience, or maybe it’s to do with learning the hard way.

So I would add patience. I used to be much more active earlier. I used to be hyper-active – jumping in and out!

I realized that it was a mistake. So that is one thing I would definitely add – the value of patience.

Recall the point I made earlier about the role of long term compounding at a given rate which will give you much better results than the same rate of compounding achieved by jumping in and out of the market.

The second thing I would add is this – I would think very carefully about the idea of value traps.

Again, this is something I’ve learned the hard way and I am still learning it, by the way – that you end up buying into things that you think are cheap, but they will remain cheap for very good reasons.

Graham used to say that in the short-run the market is a voting machine but in the long run it’s a weighing machine.

Well, some people take that metaphor too far (I certainly did) and forget that it’s not a law of physics for every cheap stock to eventually rise to its intrinsic value.

Value investors should recognise that out of a universe of 6,000 stocks, a significant number would be “value stocks” but a very significant proportion of “value stocks” are “value traps” and it’s important to avoid those and focus on the rest.

The third thing I wish I had added earlier is this – Paying up for quality.

These three things even Buffett learned over time. He was much less patient than he is now – he bought Berkshire Hathaway which he later confessed to be a value trap and he extricated himself from a bad situation by taking out the cash flow from the shitty textile business and putting it into cash generating businesses.

He also learned, over time, to pay up for quality.

I think when people think in terms of cost, they don’t think a lot about “opportunity cost.” For most people out-of-pocket costs loom much larger than opportunity costs, and since foregone opportunities are not out-of-pocket costs, people under-weigh them.

Not paying up for quality carries huge opportunity costs. These costs won’t show up in your P&L because a P&L does not reflect what you could have done but did not do.

The errors of omission are sometimes far more than the errors of commission. In the long run, opportunity costs really matter in the long run.

You must not say – “Well, my P&L will never show the opportunity losses, therefore they don’t matter.”

Safal Niveshak: You talked about holding on to a stock if you had bought it on favourable terms. The question is – How long should one wait for the value to be realised?

Prof. Bakshi: Graham had a very simple rule of dealing with value traps.

He basically said, “I’m doing statistical bargains. I don’t know which of these companies are going to perform, but I will limit the underperformers.”

So he kept a very simple rule. He would sell a stock if it went up by 50%, or 3 years, whichever happened first.

That was a very simple rule which largely kept him out of value traps.

But, this kind of a rule applies only to Graham & Dodd statistical bargains.

On the other extreme is the Philip Fisher Rule.

In his book, he writes, “If the job has been correctly done, then the time to sell a stock is almost never.”

Warren Buffett grabbed this rule and he dropped the Graham rule. Of course he did that after he changed his investing style as well.

Think of the following combination:

• A high return on capital with the ability to reinvest that capital at a high rate of return
• Those returns are sustainable because there is a moat – either in the form of a low cost advantage or in the form of a pricing power
• You can continue to grow without requiring new outside capital (so there is not dilution of equity)
• Balance sheet is extremely conservative (no debt and plenty of surplus cash )
• Management that is both skilful – both in operations and in capital allocation – and honest
• The entry price at which you had bought this share is not at the frothy end of the bubble market, and the multiple you had paid for this company is not excessive in relation to its own history.

If you get this combination, you’ll do very well over the long term, which is more than a decade. I have yet to encounter an exception to this rule.

Maybe there could be 4-5 years when the stock doesn’t do anything. But I don’t know an exception to this rule when you have all these attributes and you didn’t do well in the truly long run, which in my view is about a decade.

So that’s the point here. Think in terms of decades. Don’t think in terms of 3-4 years.

Indian stocks, from September 2007 till July 2012 have done nothing. So does that mean that Indian stocks are dead? Does that mean this is death of equities? I don’t think so!

I think we are poised for a very long bull run which will start, I don’t know when, but I think it’s going to start. And I think money will be made by the patient investor. But there will be periods of underperformance.

You are really looking for businesses that are going to keep on doing well even during adverse economic conditions, and stick with them.

So when it comes to the idea of selling, I wouldn’t want to sell them just because they didn’t do anything for the next 2, 3, or 4 years. I won’t apply the Graham rule to such stocks.

It’s very rare to find such situations. Think about Nestle. The guy who found it 20 years ago or 10 years ago, doesn’t need to do anything else in his life. For him, to switch out of that stock simply because it’s moved up a lot, or not gone anywhere for 3 years – either of those two decisions – would have been foolish.

Thus doing anything in that stock would have been a mistake, other than just buying and sitting on it. Some stocks are of that nature and true wealth is created by being in those stocks and remaining there – not by jumping in and out.

Safal Niveshak: When you came back to India in 1994 after finishing your course at LSE, you believed in India growth story and that you can apply Buffett principles here. What are your views on India growth story now?

Prof. Bakshi: I still believe in the India growth story. I believe that India will create more wealth in the next 20 years than it has in the last 30 years and the pace of change is only going to accelerate. Even though things don’t look good right now, things didn’t look good in 1991 also.

Safal Niveshak: Maybe that’s also because of the “recency effect”. We are seeing and hearing bad news all around us!

Prof. Bakshi: Absolutely! I have no hesitation in saying that the entrepreneurial spirit of India is alive and kicking.

A new wave of entrepreneurs will come, and replace the older ones. And the next wave of optimism is going to be bigger than the previous one.

And this is going to keep on happening. This is cyclical, but living standards will continue to grow and people are going to get richer and they are going to continue to spend and consume. Companies are going to benefit from this process for a long-long time. There is no stopping India as far as I can think.

As far as applying Buffett principles over here is concerned, I think those principles – whether they came from Buffett or Philip Fisher or Ben Graham or Munger – they make a lot of sense.

These are universal principles. But you have to adapt them to local conditions. You cannot blindly copy-paste!

I’ll give you an example. Graham used to invest in “net-nets”. This was at a time when the working capital of a company was a very important component of value. Today you live in a world where the best companies have negative working capital.

So the importance of working capital in the valuation of a company has actually gone down. This is point number one.

Two, in early situations, when companies sold below working capital, they could be liquidated for working capital at least, plus some money for fixed assets, and you could actually get liquidation value which was more than the market cap. Therefore there were good reasons to buy into those situations.

The probability of liquidation was higher then, than it is right now. American companies had diffused ownership. Indian’s companies are mostly controlled by a family of promoters who own stakes large enough to prevent any liquidation.

So a prosperous company selling below liquidation value is not going to be liquidated. And a troubled company doesn’t have much of a liquidation value for stockholders.

Think Kingfisher here. And most troubled companies have no working capital left anyway.

So, relying on working capital as a source of margin of safety is a very dangerous idea in the current environment where companies will not get liquidated.

The idea of buying into net-nets worked in the US for a while, but if you blindly copy-paste it here – a completely different market because ownership is concentrated – then it’s not going to work.

Safal Niveshak: Can you describe some of your most notable investment mistakes and what did you learn from them?

Prof. Bakshi: I will talk about three classes of mistakes.

First one is over-confidence, which results in over-sizing.

Buffett influenced me a lot in the early years of my career, a lot more than other people. I had only one role model then, while now I have many more.

He basically talked about focused investing. He talked about “betting the bank” or “backing up the truck” so to speak – putting a lot of money behind the ideas in which you have the maximum conviction.

In early years, I made this mistake. Even up to recently I made this mistake of buying into situations where I had a lot of confidence (which in hindsight turned out to be overconfidence), which resulted in over-sizing of the bet, and which was a bad idea that had bad consequences.

You have to think very carefully about position-sizing. No matter how good you feel about an idea, there has to be a cap. And that cap should not be 40-50%.

No matter how confident you are, you shouldn’t have more than maybe 10% in a stock. You should have at least 10 names in a portfolio – maybe more, but 10 is the minimum that you need to have.

I know there are people who will disagree with me completely, but I am giving you my thought process. I am giving you an insurance policy against over-confidence.

The second mistake that I made is again to do with something I mentioned earlier – “opportunity loss” which occurred not only by mistakes of omission but also by selling too early.

The sell decision is a very difficult decision, much more difficult than the buy decision.

A stock you own goes up 100% and you start thinking, “Oh my God, it’s already gone up so much! How much more can it go?” You get fearful of losing gains already made and you sell it and then it goes up by another 300%!

Safal Niveshak: Indeed! Anyways, can you talk about 5 reasons why you would sell a stock?

Prof. Bakshi: Single most important reason to sell a stock is that you made a mistake. It doesn’t matter what it cost you.

In fact, you should be blind to cost when determining whether you made a mistake or not. If the reason why you bought a stock no longer exists, sell it.

Most people find this very hard to do. They get emotionally attached to their earlier stock picks – even when they are obviously wrong. Or they start thinking, “It’s below my cost, and I can’t sell it because if I do, I’ll have a loss.”

That kind of thinking is foolish. The loss happened the day the wrong stock was bought, not on the day it was sold. On the sale date, economic loss became accounting loss, that’s all.

So, not selling something simply because it is below cost is a foolish way of thinking. You see, going wrong in a buy decision is ok. No matter how careful you are, you’re going to make mistakes. But holding on to something rotten – simply because its below cost or in the hope that someday it will go up – that kind of a mistake is inexcusable.

Making mistakes is ok, perpetuating them is not.

The second reason to sell is when it’s gone to fair value. So there is no margin of safety left.

The value was 100, you bought it at 30, it’s gone to 90-95, nobody is sure what the value is but the price is absolutely sure, and there is very little margin of safety. So you sell it.

Notice, I said “it’s gone to fair value” and not that “its price has increased to fair value”.

For a stock to no longer be a bargain, it’s not necessary for price to rise to value. It can happen the other way as well – Value can fall to a point where there is no margin of safety left.

And value falls for all sorts of reasons – there could be an unexpected impairment arising out of a bad capital allocation decision, a natural calamity which destroys earning power, an adverse and unexpected change in regulatory environment, etc.

So, you have to keep in mind that it’s not necessary for price to rise to meet value. Value can come down to say hello to price as well.

Reason number three to sell – selling an 80-cent dollar to buy a 30-cent dollar. Of course you will do this only when you don’t have any investible cash left.

Reason number four to sell – A stock has risen so much that it has become just too big a part of the portfolio that it is giving you sleepless nights.

Sell it down to the sleeping point. It’s not just about making money, you see. It’s also about living a stress-free life.

What’s the point of becoming so rich that you’re not unable to even sleep?

Reason number five to sell – Pare exposure to equities in a bubble market.

This is a top-down decision. Everyone loves their stocks in a bubble market because they are getting rich and they don’t want to leave the party. But the party will end eventually as all bubbles burst.

Doesn’t it make sense to pare exposure to equities despite the temptation to stay invested? I think there is. And if you have to sell, then you will have to deal will reducing exposure to your much-loved ideas. Hard to do, but necessary!

One way to deal with it is to think along the following lines – “I’ve to let you go right now, or at least a part of what I own of you, but I know you will come back to me, and then maybe we will live happily ever after. But for now, it’s bye-bye!”

In other words, follow Gordon Gekko’s modified advice – “Don’t get [too] emotional.”

Anyways, coming to the third mistake I’ve made in investing: Not paying up for quality.

Again, the results of such a mistake will never show up in the P&L. They will show up in the opportunity P&L.

So in my mind map, I have this opportunity P&L. It’s fascinating to think about this for a minute. It relates to the idea of circle of competence.

Buffett talked about circle of competence – things you can do well – this is your opportunity set. It’s okay for things that are outside your circle of competence for you to ignore them. It doesn’t matter if somebody else is doing very well in venture cap, private equity, or something that you have no clue about. So those are the things that are outside your circle of competence and you don’t have to worry about them at all.

But things that you could have done, which are within your circle of competence, but you did not do, they end up on your opportunity P&L.

The fact that I did not buy the 100-bagger like Google will never enter into even my opportunity P&L. This is because I could never have done it. I don’t understand that thing.

But the fact that I missed out on an opportunity that became a multi-bagger that was within my circle of competence because I understood it and because it was a very-high quality situation, and I didn’t buy it because I thought it will drop another 5% and then I’ll buy it – that’s a very costly mistake that appears on the opportunity P&L.

You need to fix not just mistakes of commission, but also mistakes of omission. You just have to learn to change your behaviour in order to reduce the losses that figure on your opportunity P&L.

Safal Niveshak: Are there any risks inherent to value investing except falling into value traps?

Prof. Bakshi: First, if you use the wrong kind of money for value investing, then you will fail. And the wrong kind of money is what I call as “impatient capital.”

Borrowed money is impatient capital. Interest keeps on compounding and markets don’t always co-operate, so you mustn’t borrow money to practice value investing, most of the time. There are exceptions but they are very few.

Another form of impatient capital is money taken from clients for value investing but money which can be withdrawn by the clients at a very short notice. That kind of money is not suited to value investing. Value investing needs patient capital.

Second, if you don’t have the right temperament, you will fail.

It doesn’t matter that you understand the idea of value, and you know there is the margin of safety. If you don’t have the right temperament – for example, if you get influenced by people in a party who are investing in the latest hot real estate fund and you feel that you have missed out on the action – all your friends are making money and you look like a fool and your temperament doesn’t want you to look like a fool – then value investing is not for you.

If you’re a party person, or you love being popular, or you love a lot of action, then don’t try value investing. It’s not for you. Do something else.

Typical value investors are loners. They hate crowds. They are independent thinkers who don’t get influenced by what the crowd is doing. They love doing unconventional and unpopular things. They are also extremely patient.

Safal Niveshak: How do you deal with a situation when you fall into a value trap? Please help with 1-2 case studies from your personal experience.

Prof. Bakshi: The first thing to do is to recognize it. Many people find this hard to do. They go into denial.

If something you bought has gone down 50%, something is wrong either with the market, or maybe something is wrong with you. And it’s not a good idea to assume that the market is wrong. It’s often wrong, no doubt, but not always.

Look at the fate of folks who bought into DLF, Unitech, Lanco, Rcom, and Suzlon in Jan 2008 and who are still holding those stocks. Here are the stock price returns from 1 Jan 2008 till date:

• Lanco: -85%
• DLF: -80%
• Unitech: -95%
• Suzlon: -95%
• RCom: -93%

People, who held on to these names since 1 Jan 2008 – at some point, they went into denial. They kept on inventing new reasons to own these stocks even though the original ones were no longer valid.

People need a way to de-bias themselves and one good way to do that is to mentally liquidate the portfolio and turn it into cash and then, for each security, ask yourself, “Knowing what I know now, would I buy this stock?”

Often the honest answer would be a most certain “no”. Then the next question you have to face is – “Then why do I own it now?”

You have to deliberately expose yourself to cognitive dissonance and then you have to learn to promptly resolve it.

I used the above names as examples even though none of them were value stocks. But the same rules apply to value stocks, which turn out to be value traps. You have to recognise it which will expose you to cognitive dissonance, and then you have to rationally resolve the dissonance. And there is only now way to resolve it rationally – swallow your pride and sell it.

I’m reminded of something that someone sent to me recently titled – “Ten Rules for Being Human”.

Of these, as investors, there are four that really stand out.

Rule Two – You will be presented with lessons.
You are enrolled in a full-time informal school called “life”. Each day in this school you will have the opportunity to learn lessons. You may like the lessons or hate them, but you have designed them as part of your curriculum.

Rule Three – There are no mistakes, only lessons.
Growth is a process of experimentation, a series of trials, errors and occasional victories. The failed experiments are as much as a part of the process as the experiments that work.

Rule Four – A lesson is repeated until learned.
Lessons will be repeated to you in various forms until you have learned them. When you have learned them, you can go on to the next lesson.

Rule Five – Learning does not end.
There is no part of life that does not contain lessons. If you are alive, there are lessons to be learned.

• Read “Ten Rules for Being Human” by Dr. Chérie Carter-Scott

Safal Niveshak: Certainly! As they say that the romance of life is not in “knowledge”, but in “knowing”. So you have to keep learning.

Prof. Bakshi: That’s true Vishal.

Safal Niveshak: Finally, what’s your recommendation for books that an investor must read?

Prof. Bakshi: Everybody will talk about the classics. But the single most important source that I talk about is the letters of Warren Buffett.

One of the things about valuation is that people don’t put a lot of value on things that come to you for free. And because these letters are free on a website, people say, “Oh, they’re there for anybody and they are free, so they aren’t worth much.”

That’s completely the wrong way of thinking about it!

Those letters are the most valuable source for learning about finance and investing in the whole world. And unfortunately people don’t treat them as such simply because they are free.

The other thing is that you have to read these letters by downloading them, taking a printout, and spending 2-3 days on one letter. You cannot skim through them. You have to read each one of them in a slow manner to actually absorb and make notes of what is important and connect various these across letters. You have to really do that!

Then, of course, there are all these classic books like:

• The Intelligent Investor by Ben Graham
• Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay
• The Short History of Financial Euphoria by John Kenneth Galbraith
• Security Analysis by Graham & Dodd
• Margin of Safety by Seth Klarman
• The Black Swan by Nassim Taleb
• Influence by Robert Cialdini

So those are the classics. But I want to talk about four recent books that I liked a lot.

One of them is “Thinking fast and Slow” by Daniel Kahneman, the Nobel laureate who’s created the field of behavioural economics.

Another really good book that I read last year was “One Small Step Can Change Your Life: The Kaizen Way”. It’s about making small incremental changes in your life, like what Charlie Munger talks about the “slow contrast effect” or the “boiling frog syndrome”.

Slow changes will get unnoticed, but if you have to change a habit, do it gradually, very slowly. And it works. It worked for me.

There are two other recent books I liked. One of them I mentioned earlier: “The Little Book that Builds Wealth” by Pat Dorsey.

Then there’s a book that came last year, and it’s exceptionally good for those who have accounting knowledge. It’s called “Accounting for Value” by Stephen Penman.

He’s a professor at University of Columbia, and one who has related modern DCF with value investing styles of Graham & Dodd and Warren Buffett. He teaches you how to think about valuation, without thinking about beta, or capital asset pricing model. It’s a very good book.

Safal Niveshak: Do you plan to write a book?

Prof. Bakshi: Eventually I will. But for now, I prefer to blog and talk.

• Read Prof. Bakshi’s Blog

Safal Niveshak: Thank you so much Prof. Bakshi for taking out time from your busy schedule to answer so many questions on value investing that readers of Safal Niveshak have put forward to you. It has been a great session of knowledge sharing from you.

I thank you on behalf of the entire Safal Niveshak tribe. Hope to meet you soon. Thank you!

Prof. Bakshi: The pleasure was all mine, Vishal. All the best!

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This concludes my interview of Prof. Bakshi, which I believe has been an enlightening experience for you (like it has been for me).

Let me know your biggest learning from this interview and how it has changed your thinking about investing.

Wishing you a very happy Independence Day! Remember what Mahatma Gandhi once said – “Freedom is not worth having if it does not include the freedom to make mistakes.”

So, as an investor, don’t fear making mistakes. But more importantly, learn from your mistakes. Better still, learn from others’ mistakes…vicariously.

I’m sure Prof. Bakshi will then be proud of you!