Blog on Value Investing | Safal Niveshak

Being Average in the Age of Alpha

I was an average student in school. Though I was surrounded by high achievers, and never questioned the importance of being extraordinary, I somehow never expected myself to rise to their levels. The most common remark I found in my annual report cards read something like this – “An obedient boy who can do better than average with more hard work.”

I knew I could not work any harder and rise above being average.

Anyways, I never had the credentials to get into the best college after school, there were no scholarships on offer for me, and no one in my family, including myself, expected me to become a star in life.

Life continued this way even when I got into doing my MBA, again from an average college in Mumbai. My first job profile was average too, and it paid an average salary that, in my father’s eyes, was below average.

Living in a costly city like Mumbai also meant I never had better than average savings for the first few years of my life, even though I was saving as much as possible.

More than twenty-five years have passed since I started considering myself as an average person with average capabilities and average ambitions in life. Somehow, being like this in the world where people are seeking alpha, keeps me happy and satisfied with myself.

Buy and Hold: Simple, NOT Easy

This is the stock price chart of Asian Paints over the past 19 years (since May 2000). Point to point, the stock is up over 80x.

Our brain that works with perfection in hindsight would lead us to believe that buying and holding the stock during these 19 years would have been an easy choice for anyone who did it. After all, the only thing the investor would have done during these 19 years was, well, nothing.

I wish investing was that easy.

Of course, the idea of buying and holding high-quality businesses over a long period of time is simple. Everyone knows that, and even those who don’t practice it appreciate that this works with most high-quality businesses as history has proven time and again.

But then, it’s important to understand that the action of not doing anything over such a long period of time involves hundreds of decisions over months and years that lead to such inaction.

Latticework of Mental Models: The Rashomon Effect

The parable of six blind men and an elephant, goes like this —

When a group of blind men, who had never come across an elephant before, encounter the tusker for the first time, they try to conceptualize the animal by touching it. Each blind man feels a different part of the elephant’s body, but only one body part, such as the tail or the trunk. Then they discuss their understanding about the elephant.

The man who had touched the elephant’s side says, “It’s very much like a wall.”

The one who held the elephant’s tusk declares, “No! it’s like a smooth spear.”

“Not really. It’s like a python.” Claims the man who grabbed the trunk.

“You’re all mistaken.” shouts the man who got the elephant’s tail. “It’s like a thick rope.”

“I know we’re all blind but have you guys lost your mind also?” The fifth man who touched the animal’s ears says, “It’s like a big fan.”

“Come on, folks! What’s wrong with all of you?” Argues the sixth man who was leaning against the elephant’s knee, “It’s definitely like a tree.” [Read more…] about Latticework of Mental Models: The Rashomon Effect

Investing and the Art of Due Diligence

In the 2008 shareholder meeting of Berkshire Hathaway, a shareholder asked Warren Buffett and Charlie Munger –

“If you could not talk with management, could not read the annual report, and did not know the stock price of the company, but were only allowed to look at its financial statements, what metric would you look at to help you determine whether you should buy the company?”

They replied –

Buffett: Well, what we’re doing in investment – and what everybody does – is we’re laying out money now to get more money back later on.

Now, let’s leave the market aspect of the asset out of it. When you buy a farm, you really aren’t thinking about what the market on it is going to be tomorrow, next week, or next month. You’re thinking about how many bushels of beans or corn per acre you can get, and what the price is likely to be. You’re looking to the asset itself.

[Read more…] about Investing and the Art of Due Diligence

The Risks of Speculating During Rising Markets

It was sometime during late 1999 through early 2000, near the peak of the dot-com bubble, the legendary George Soros and his hedge-fund team were working on how to prepare for the inevitable sell-off in technology stocks.

The man in charge of Soros’ high profile technology funds was Stanley Druckenmiller – one of the best-performing hedge fund managers of all time, till date – and he was busy warning his team that the sell-off could be near and could be brutal.

As the markets soared further in March 2000, Druckenmiller was quoted as saying, “I don’t like this market. I think we should probably lighten up.” Soros himself would regularly warn his team that tech stocks were a bubble set to burst.

Despite this, when the sell-off finally did begin in mid-March 2000, Soros Fund Management wasn’t ready for it. His funds were still loaded with high-tech and biotech stocks. Just in five days, starting 15th March, Soros’s flagship Quantum Fund saw what had been a 2% year-to-date gain turn into an 11% loss. By the end of April, the Quantum Fund was down 22% since the start of the year, and the smaller Quota Fund was down 32%.

Post that, in April 2000, Soros said at a conference, “Maybe I don’t understand the market. Maybe the music has stopped, but people are still dancing.”

Wandering with a Beginner’s Mind

Among all the contemporary business leaders, very few come close to Jeff Bezos’ talent for communicating business strategies in a simplified manner. Like Warren Buffett, Bezos writes an open letter to Amazon’s shareholders every year. He’s been doing it for over two decades.

These letters have become an extraordinary source of insight into how Bezos (the world’s richest man) and his company (Amazon) think about customers, innovation, building products, and future.

Amazon started as an online bookselling platform and interestingly didn’t turn a profit for the first six years. Today it’s the second publicly traded company (after Apple) to ever hit a market capitalization of $1 trillion.

Like me, if you’re an admirer of Bezos, then you’re in the good company of people like Warren Buffett and Charlie Munger who are also big fans of the Amazon CEO. Buffett and Munger admit that they failed to see Bezos’ genius early on. Buffett called him the most remarkable business person of our age. Munger, in his nonchalant voice, said, “Jeff Bezos is a different species.”
[Read more…] about Wandering with a Beginner’s Mind

Investing’s False Positives

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It was sometime in early 2009 that, as I was running my screeners to find investment-worthy businesses, I came across a Delhi based packaging firm Uflex Ltd.

The company was involved in the flexible packaging business, was doing well in terms of growth, and expanding globally. What’s more, the stock was available at a single-digit P/E.

In all, it sounded like a great investment that was available cheap. Anyways, while I was busy preparing my rosy predictions for the business and the stock, I was warned by an analyst friend about some shady land dealings he had heard of about the company’s promoters. What is more, the promoters had pledged a large amount of their shareholding.

How to Be A Fortunate Investor

If you think I am going to talk about some mystical way to increase your luck in stock market, then you’ll be disappointed. Being fortunate in life and in investing is largely about increasing your odds of success. And how do you increase your odds?

“Study the principles of sound investing and work hard to implement those principles,” you might say. But is that sufficient? Studying, reading and working hard are all necessarily conditions for being successful in the stock market, however they are not sufficient. You need one more thing.

Let’s turn to world’s greatest investor to give us some clue. In his 1982 letter to investors, talking about two of his managers Phil Liesche and Ben Rosner, Warren Buffett wrote –

ROCE-Growth Matrix, and Few Potential Wealth Creators

One of the most important parameters to judge a business’s quality is its ability to generate a return on the money it employs on fixed and working capital. It is also one of the key metrics, which when measured over years, can help you assess a management’s quality.

Return on capital employed or ROCE also indicates a business’s ability to set prices that enables it to earn adequate margins, which when better than competitors also suggests the presence of moat.

Simply defined, ROCE shows how a company uses its capital efficiently by examining the profit it earns in relation to the capital it uses during a given year.

The formula commonly used to calculate ROCE is – Profit before Interest and Tax (PBIT) divided by Capital Employed (Equity and Debt).

Stock Analysis: The Most Important Things (Plus, A Case Study)

I recently came across a video* of Warren Buffett talking to a few B-School students on his trip to India in 2011.

The host asked him this question – What exactly goes through your mind when you’re actually making an investment?

Buffett’s reply to this question was brilliant for it contained the crux of everything he has said over the years about how to evaluate a certain business and it’s future economic potential (text in bold and brackets are mine) –

Well, if I drive by a McDonald’s stand or a Kentucky Fried Chicken stand I will automatically think to myself “What is this business worth?”
You know, how many customers can walk in the door (demand, scalability, growth potential)? What kind of gross margins (profitability, pricing power) can they have? How many people do they need (scalability)? How likely is it that another chicken stand opens across the street (competition, entry barriers, moat)?
I mean, all of those things. And that’s true of the chicken stand and it’s true of Google or you name the business. I mean, it’s all about evaluating the economic potential, the economic future of a given business. And most of them you don’t know the answer on (say no to most businesses, because you really don’t understand them).
But every now and then you run into one where you know the answer (simple businesses). But that’s all business is.
It’s what Aesop said a long time ago: “A bird in the hand is worth two in the bush.” (well, that’s the definition of discounted cash flow) You know, that was said in 600 BC and that’s now what’s called discounted cash flow and all that sort of thing. But he saw that and figured it out, you know, twenty-six hundred years ago. And all I’m trying to figure out is if I could take that dollar in my hand: When do I get the two dollars out of the bush (timing of future cash flows)? How sure am I of getting it out of the bush (certainty of future cash flows)? Is there some other bush where I can get three dollars out of it instead (opportunity costs, better alternatives)?
I mean, it’s very basic stuff (investing is simple, you see, but only if you keep it simple). And a lot of times you look at it and you say “I don’t know how many birds there will be in the bush.” (complex businesses, or those that undergo a lot of changes due to nature of industry, competition, etc.) So you go in to the next one until you find the answer (you just need a few good ideas in a lifetime).

Buffett, once more, makes it clear that rather than obsessing with the bewildering fusion of news and noise, you should concentrate on a few key elements in stock selection.

If I were to list down the most important questions on business/stock analysis based on what Buffett mentioned above and a simple checklist I maintain, they would be –

Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
Has the company grown its sales and EPS consistently over the past 5-10 years? (Consistency is more important than speed of growth)
How much are the company’s products in demand? Is there a long runway of growth for these products over the next 10 years? Could they be disrupted badly? (Past may have been good, but how good, sustainable the business could be in the future is of paramount importance; look at simple products/services that have low probability of getting disrupted)
Has the company been able to scale up its business in the past? Can it scale up well in the future? (Check if a business is too capital and/or labour intensive, for that may cause difficulties in scaling up without big side effects of doing so; historical track record of the management is a nice indicator of its future capabilities, but again if you expect the nature of the industry to not change much)
Will the company be around and profitably better in 10 years? (Suggests continuity in demand for and profitability of the company’s products/services)
How competitive is the industry in which the company operates? How has it done against its key competitors? Does the company have a sustainable competitive moat? (Pricing power, profit margins, lead over competitors, entry barriers for new players)
How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition over 8-10 years)
Does the company require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have; they may have or are likely to have stretched balance sheets that are detrimental to equity shareholders’ value creation)
Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)
Have the cash flows shown some stability in the past? (Good indicator of future certainty and timing of cash flows, which is a necessary aspect, not just to assess the continuity of a business but also to assess its valuations with some reasonable degree of success)
What are the opportunity costs of investing in this business? What would I compromise on if I invest in this business? (Check the next best alternative. Maybe that alternative is better than this business, so check for it)

Information, you see, generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent. These above questions should help you in this aspect i.e., getting you 80% understanding about the business you are analyzing without spending a lot of time on that.

Anyways, especially on the point about competitive analysis, I have done some number crunching for the three Indian 2-wheeler majors – Hero Motorcorp, Bajaj Auto and TVS Motor (based on numbers from Screener.in) – to give you some ideas on how you can do it for the company you are analyzing and its competitors (remember opportunity costs?).

The analysis, along with my observations, lie in this financial analysis excel document of Hero Motocorp in the sheet “Competitive Analysis.” Also, download the respective excels for Bajaj Auto and TVS Motor if you wish to extend your analysis using more numbers.

Keep It Simple, Please!
In stock investing, often we focus so much on trying too hard that either we never start working on the process of picking up great businesses (seeing the enormity of the task), or we start believing that our immense hard work and knowledge gives us great control over the future of stocks we own.

The reality is that, no matter how hard we try to analyze the intricacies of business, we may not be as important to the results as we’d like to think we are.

Like Seth Klarman wrote in Margin of Safety –

Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.
The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

And like Buffett explains to B-School students, please keep it simple!

* Watch 57:04 minutes onwards in this video for this particular discussion

Statutory Warning: Nothing I’ve written above must be construed as investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. My analysis may be biased, and wrong. I have been wrong many times in the past. I am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).