The Investing Journal

Notes on long term thoughtful investing

Blind-spots in investing

“Success is a lousy teacher. It seduces smart people into thinking they cannot lose” – Bill Gates

“It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so” – Mark Twain

I was in the process of glancing through some of my past investing mistakes and trying to understand what went wrong into these. Fortunately, given the amount of importance we as value-seeking guys put on buying businesses at good enough margin of safety, there haven’t been any big permanent value destroyers – as yet. And remember, we are still in the middle of a kind of rare bull market. Losing money in such an environment takes a lot of effort in itself 🙂

But then this mindset of seeking value quite often leads us to so-called ‘value traps’. Meaning that something might be optically cheap but it is not if someone digs deep enough into it. So, what happens to appear as sizeable ‘discount’ to intrinsic value turns out to be not so. What follows is cheap getting cheaper.

It would be fine if it was something out of the blue coming and eroding its inherent intrinsic value – you can’t help it. But more often it happens to be something which I’m either already aware of or something which is there in the public domain much before I invested into it but I just did not take good enough efforts to understand it.

While the latter problem could be tackled by ensuring one spends enough of time and take requisite efforts, it’s the first one which is a bit scary. It’s like a thief doing his job right in front of your eyes and you are busy preparing ‘chai-nashta’ for this guest of yours in order to make his stay more pleasant & memorable. Sure it would be memorable. We can call this process ‘feeding your biases’.

Why does it happen? Where does all our experience and interpretation abilities sometimes go when we need them the most?

As I think about it, I see two forces acting within me while I’m trying to arrive at a go or no-go decision. Most of the times in such situations my experience instead of helping me is actually pushing me in the exact opposite direction. Something like ‘pattern recognition’ process going all wrong.

Generally, such situations aren’t all black or white. There are a few characteristics which appeal to our investing framework (maybe its the good price tag at which it’s available or maybe its the admirable set of guys who are running it or it may be a once prosperous business available at a fair price) and then there may be some negatives which we know might do the damage but we think that its probability of turning out is just remote. And then one fine day we get the dreadful news delivered to us in the golden envelope.

It happens when those seemingly ‘good’ characteristics override an unbiased assessment which one should be doing. We all have our preferences. Someone might like to own a good 30%+ RoE business and someone else might strive for a 30%+ growing business and then some might like to own something trading at a 30%+ discount to its intrinsic value – all of these are our cravings. And problem arises when these go out of their proportion and starts impacting our decision-making process.

What to do about it?

Let’s try to ‘invert’ this question in order get some more answers. So, now the question is how do you expose yourself to blindspots while investing?

  • Maybe you should try to finish your research as fast as possible so that you might overlook stuff
  • Don’t pause much to stop and think what you are reading as you research
  • Do not seek out multiple sources of information which are there in the public domain
  • Don’t ever talk to a person having a view opposite to your own view.
  • Don’t use checklists. And don’t ask many questions and hence don’t seek answers
  • Ignore the base rates underlying the success of any business in a given industry
  • Don’t think about changing business landscape and emerging competition
  • Allocate a huge portion of your capital to such situations in order to maximise the impact
  • Execute driven by the flow of ‘animal spirits’ within you. Trust your gut feeling.

You might get the idea clear now.

So, it looks like these blind spots are not as ambiguous as we might think. They are fairly clear standing right in front of you but you don’t see it because you have chosen to be blind to it.

Hmm. Looks like its the time to think deeper about some of our current ideas 🙂

But human mind has this inherent resistance to change its perspective once it has created one which it happens to like.

Reminds me of this quote from Munger:

What I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort. And here again, it doesn’t just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck’s crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like.

 

Evaluating Lending Businesses & the Positive Feedback Loop

Lending businesses are fascinating. In any other business, the scale at which it operates depends upon the capital its owners has invested in the first place. Although it can borrow can get some extra scale, its ability to do so is very much limited to say 1-3x of equity capital. And higher its debt gets, lower goes its ability to attract further funds.

And then you see the financials of a bank or a non-banking financial company (NBFC). For these, every rupee of capital enables them to do business (i.e. lending) worth Rs 8-10. They get to borrow funds at nominal cost in form of deposits (savings account / FD) from lay investors who are hardly even aware about the risks involved.

How many account holders even care to see the leverage at which a particular bank is operating? A look at SBI’s leverage can make any sane individual sweat but that doesn’t explain why is it the largest bank in the country. Especially when it comes to mobilizing deposits.

So, their ability to mobilize funds from unsuspecting public at rates less than that of of inflation is an advantage. And so is their ability to lend in a country like India where bond markets, unlike equity markets, are very much restricted in their operations.

Add to these the fact that each of these require an approval from the regulator before starting up their operations and voila – you get a sector wherein number of players and hence the competition in the market is relatively limited (versus say that in cement or steel which has virtually zero barriers to entry)

All of this in a country which has one of the lowest penetration of debt in the world and whose appetite for credit is growing at a healthy rate over the years. What else can one ask for! But off late, things doesn’t look as rosy as it should be for these companies. So, what’s the catch?

The basic economics

Leverage is toxic in nature.

If a bank writes loans worth Rs 100 in a given year, it just requires loans worth Rs 10 to go bad for it to be declared ‘bankrupt’. This is because its networth is tiny versus those loans.

Its business is essentially that of borrowing Rs 90 at attractive rates, and along with it own capital of Rs 10, lend Rs 100 at lucrative rates. From the differential spread, pay for its operating expenses and take home the balance left over as profits.

It’s far different from an arbitrage. That is because if its borrowers find it difficult to service back a portion of that Rs 100, it has to swallow all of those losses on its own. There is no ‘pass-through’ of the same to its lenders or deposit holders.

Good Bank vs Bad Bank

So, what is required to be successful in this business? As prospective owners, this is a question which one needs to frequently answer while evaluating any business. In case of these lending companies, these are:

(i) Ability to timely recover almost all of the money which is being lent along with the interest amount: 

Remember the leverage involved here is huge and there is no pass through. If you couldn’t recover even say 3% of your loan book, you loose 30% of your networth. Hardly worth those narrow spreads!

Look like a ‘too big to meet’ kind of a hurdle, right? True. But then there those rare lenders which have been able to do this consistently over last 2-3 decades. Studying their lending focus areas can help us uncover some of the key success factors here.

  • Lend more to individuals to the extent of their earning power. Recovery rates here are surprisingly good. No one wants their CIBIL score to deteriorate due to a missed car or home loan EMI. This is provided you have been judiciously lent i.e. within their earnings ability.
  • In case of corporate loans there are two things to take care of – lending to good quality corporates and keeping your maturities short. While the former is self explanatory but in case of the latter generally it is observed that, lower the loan tenure, higher is the ability to recover your amount. Hence, lending for working capital requirements and other short maturities triumphs longer tenure loans. This does way the risks involved with lending to under construction projects which ultimately may or may not fly.
  • Have a sticky relationship so although tenure may be shorter, it is almost seamlessly renewed thereby doing away with screening for newer borrowers just to replenish existing bucket. Thereby keeping operating costs under control.
  • Doing secured lending (‘good quality corporates’). And this in no way is restricted to tangible assets (though having this with low loan to value ratio is good) but also the size of cash operating cash flows which the borrower generates. Security in form of ‘earnings’ could add a lot of comfort. Some lenders charge rates of unsecured loans (18%+) whose earnings, in their assessment, are very much secured!
  • Lending at competitive rates with industry leading shorter processing times.

(ii) Having the lowest operating cost structure (interest as well as non-interest costs): Remember, banks are spread earners. So, one way to maximize this spread is to lower your costs i.e. interest cost and operating expenses.

Interest costs could be lowered by having higher portion of borrowed funds coming from lower interest sources. So, higher the contribution from current account (close to 0%) and savings accounts (~3.5%), the better it is. And these are more sticky in nature. People do not frequently move their saving account balances from one place to another even if it is marginally higher.

Another area to improve your cost structure is to have a ‘cross-selling’ strategy in place i.e. your branches are able to sell more and more types of products to the same set of customers. That is like selling your savings account holder your credit card service, insurance products, mutual fund products, brokerage products, home loans, personal loans, etc.

If it is a single segment focused NBFC which cannot do cross-selling functions than achieving an ability to deliver your services in quickest possible time with lowest possible cost should compensate. Or your average yields (interest income) and asset quality need to good enough in order to make the model viable. But remember, higher yields and better asset quality rarely goes hand in hand. More on this later.

Positive Feedback Loop

This is where it get even more interesting. Recall that, in any lending business, there is this function of 3 key elements. Interest Income (-) Interest Cost = Profit Spread.

This profit spread needs to be high enough to provide for (i) employee salaries (ii) provide for bad debts and (iii) ultimate profits to owners.

In this equation, it is the point (ii) that is, magnitude of bad debts, which is like the joker in the pack. It has the highest impact on ultimate networth of the bank and, unfortunately, it is also the one which is highly uncertain. Especially if the bank in question is doing more project finance of longer tenure.

But for those few lenders which can keep their operating costs (interest & non-interest costs) low while maintaining impeccable lending discipline are able to earn good enough spreads even while dealing in low yielding, low risk segments. And these are precisely those segments where your asset quality is the best.

And what is more important is their competition is here even more limited. All those lenders who find their interest and other costs higher will find it difficult to break into the lending segments in which an efficient bank operates.

So, for a newer entrant with a relative cost dis-advantage (i.e. lack of lower interest savings account), it has to invariably break into higher risk, higher yielding segment. And it is those risks which are more uncertain here than what a top tier (in terms of cost efficiency) lender takes up. For us as owners it means that we need to quite weary about the sustainability of its networth figure. More so if its borrower base is concentrated enough.

So by keeping your costs low (interest as well as non-interest), a lender can operate in low risk segments thereby considerably lowering the uncertainty involved with respect to asset quality and ultimately shareholder’s networth.

The good thing here is that cost advantages here are structural and not easy for newer entrants to replicate even if they have zero issues on asset quality in the initial loan book building period.

Though PSU banks, despite having a higher composition of low cost funds (savings account balances), lost out to private banks over the last 2-3 decades. But the reason here was their inability to maintain their asset quality. This makes it difficult to maintain their market share during stressful times.

Had the government not infused funds into these from time to time, most of them would have been dead by now!

Its a rare combination to have a competitive cost structure with an impressive asset quality maintained consistently at all times. And this is where our focus should be as prospective owners.

This means that out of those dozens of listed lending companies out there, our hunting ground is restricted to just 3 or 5 companies. This isn’t necessarily a bad situation.

Also, it is our job to remain vigilant that these good quality lender and not drifting away from their earlier established lending practices. That could be done by looking for aggressive lending practices like higher loan to value ratio, project finance, longer duration loans and the likes.

It is finally our funds – in form of that tiny networth – which is at stake.

The positive feedback loop operates well on its own unless it is being interfered. Which in this case would be a significant deterioration in lending metrics.

 

 

 

 

 

 

 

 

Attitude towards investing > your investing approach

One thing that never stops surprising an experienced investor has to do with divergent perspectives which people operate within the markets. And this is despite the fact that all of these participants have one common objective – to earn adequate returns while minimizing the risks, overtime.

There are believers of ‘technicals’ who earn money through reading stock price movements and then there is this broad group of ‘fundamental’ investors who differ amongst themselves with respect to the horizon one employs. All of these fellows wholeheartedly believe what they do is best way of earning money within their defined circumstances.

A mutual fund manager who earns a fixed fee over assets under his management tries to attract as many investors as possible. And given that most of these lay-investors go by near term performance for choosing between the wide array of funds, fund managers take upon themselves to ‘maximize’ their short term performance. Key thing to note is that such fund managers make money off their investors and not necessarily for their investors. Making sustainable above average returns, while controlling for risks, deploying a myopic focus on near term results is just improbable. This has what experience and in-depth studies conducted over a long periods have shown.

Differing attitudes towards long term investing

It would be unfair to say that investing approaches differs only with respect to their horizons. In fact, within the long term bucket, there are further multiple classifications depending upon willingness and patience levels of the practitioner. Not every long term investor would feel good about owning something (or atleast evaluating) with a 5-7 years kind of horizon.

Add to this the fact that each investor has his own sweet spot where some may be comfortable with just 7 securities in the portfolio while others may feel safer with 20-25 names. Preferences of such type has a significant impact on ones security selection process. Hence, expecting a ‘consensus buy’ within the like-minded group of people is little too much. But one needs to be cognizant about where does the differences lie. You don’t want to end up owning companies run by crooks just because it is trading at inexpensive terms. Here, chances are one may under estimate risks since they aren’t as clear as the returns which the excel sheet is showing.

Another place where investors with similar horizons and portfolio concentration could differ is with respect to one’s preference for good ‘quality’ companies over others. Quality would mean companies which makes 20%+ return of networth, has high free cash generation, enjoys some sort of a competitive advantage and are governed ethically.

Here, quality seekers would be more wiling to pay up a fair price for such businesses versus an average business which is trading at a substantial discount to its fair value. And it sometimes seems as if they are content with the moderate internal growth compounding which these established companies usually do. But such an approach helps them to keep chances of permanent loss of capital to its minimum.

Which of these approaches is the best?

Answering this question with the approach one practices regularly would be like deluding oneself!

More than any specific approach, what would help an investor is to keep an open attitude towards investing. This is to say that investing is an art which only improves with complete dedication, over time. If you see something work really well that you initially believed would not, it might help to stop and introspect. Was it luck? or was it a low probability event kicking up? or just a temporary outcome of an irrational market? But if someone with a very long track record of doing things you thought is not possible, it might help to learn something from him or her. Proponents of efficient market hypothesis still consider Berkshire’s track record as an ‘outlier’ thereby allowing themselves to ignore the methods with which it has earns those exceptional returns

Personally, I had a notion early-on that investing into equities is inherently speculative. But after coming across Buffett’s biography accidentally, it showed me its not. And given the generosity of Mr Buffett with respect to sharing his learning through his talks and letters, in a short span in time one moves from being a dis-believer to become a disciple of life long learning.

Studying the duo Buffett & Munger would tell one the intellectual openness they have applied all through their career. Munger thought that he could be a more successful investor than a lawyer and he switched despite coming from a background which would suggest otherwise. And in their initial years, both of them started as ‘bargain hunters’ i.e. looking to buying companies trading at below its book value and then selling it off over a couple of years. It was only after a decade long practice when the bargain pool dried up and they were almost like shutting down shops (Buffett had actually shut down his partnership firm) they realized that investing into companies with competitive advantages could be even better than bargain investing. Imagine how it is to believe in something totally opposite to what you have done every day till the age of 40!

And if these are too old an example, here is another one which suggests that they haven’t impaired their openness even today. Berkshire is a major investor in US airlines and Apple despite the duo saying on record almost for a half a century that airlines are the worst assets to own and most of the technology companies are not investible for someone with 5-10 year kind of horizon given the inherent intensity of change in tech. They were even successful to convince Bill Gates into this line of thought 2-3 decades back!

Its not to say that these are not well thought of investments or that Berkshire is ‘barrel scratching’. Each of these decisions have seen some deeper thoughts go into the same. Of course, they could be wrong in their thesis but the key to learn from this is to never stop, as Mr Munger would say, ‘killing your own best ideas’.

Ideas or approaches are not something to be treasured – they ought to be challenged from time to time. And if they still pass those harsh tests of time, only then are they worth committing to yourself!

Long term consequences of short-termism

Jeff Bezos had sometime back said that there are two kinds of managements, those that create wealth for their shareholders and those who don’t.

Hardly revealing right? After all, why would someone put in hours of labor and humongous amount of resources only to risk it going all the way down to zero?

But each one of us have come across companies or people who does the very same thing – work every day (usually in some wrong direction) to put themselves into trouble.

Think about those inflexible trade unions in an already dying industry. They would fight for a wage hike irrespective of the fact that doing so which reduce company’s life from a couple of years to a couple of months.

Or the management operating within that industry. They would commit further capital in form of machinery upgradation to get an edge over their sick counterparts. Probably because some of their peers are already doing so. They may seem to oblivious to the fact that they are into some kind of an ‘endgame’

From the lenses of Psychology

As a long term investor, there is hardly anything worse that can happen than the management whom you have entrusted your capital gives itself away to short-termism. Prioritizing near term (and hence usually insignificant) achievements over those hard long term oriented resource allocation decisions.

Publicly traded companies more often fall for this trap. Ask any company executive ‘what would you do differently if your company was not publicly traded?’ More often than not you will come across some interestingly revealing answers.

Studying the psychology of human mis-judgement can reveal some useful answers.

(i) Incentives: Every decision is right or wrong based on the time horizon one is looking at. In cricket, for example, aggressive shots from batsman is an absolute must in a T20 game but could be a bane in test cricket. Similarly, if the top executives are paid for scoring high in form of near term earnings, long term investments would be deferred to the extent possible. This would give your rational competitor an important lead. As the saying goes ‘penny wise and pound foolish‘. If managers are paid only for hitting sixes, rest assured you would be losing the gruelling test match.

(ii) Social Proof: A listed company of desent size will generally be chased by several analysts and fund managers. And given that most of these participants like celebrating ‘the quarterly results fest’ as religiously as they can, what invariably follows is a mental pressure of ‘beating the expectations’ every quarter. This is what social proof is – we judge whether a particular behavior is right or not based on other peoples reaction to it. Add to this the fact that your peer group is also into playing this type of quarterly beauty contest and you would know what you have to do.

(iii) Deprival  Syndrome: Sometimes you are so accustomed to a particular way of doing business that its very difficult to leave it for something even better. Sam Walton in his biography mentions that ‘variety’ store owners were so attached to earning 45-60% kind of margins that they couldn’t even think of getting into discount retailing with 30% kind of margins. Despite it being a much superior business model and had a clear preference of buyers towards it. Its very difficult to see your revenues or margins go down. Even if that’s the only way ahead for building a sustainable business.

(iv) Cognitive Dissonance: Business landscape is all full of potholes. And then there are these occasional sharp turns. If one such turn means that you need to part away with your competitive advantage in order to survive, more often you will find that turn would not be taken up. They would continue to drive thinking it as the regular highway! The result – a fatal crash. At the time of iPhone’s launch in 2007, almost all of the top executives at Nokia thought iPhone would not be able to dent Nokia’s market share. We all know what followed.

What’s our way out?

As business owners with long time horizon in our minds, we need to find not only those businesses which are strong & trading at attractive prices but also need to know something about the guys who are running it. Having like-minded guys up at the realm is what one needs.

There are couple of things we can do.

(i) Know how they are incentivised: As Munger says ‘tell me how someone is incentivised and I will tell you how would he behave’. Are those ESOPs have a tenure, on average, of 1-2 years or are long term in nature (>5 years)? How much is the stake of current management into the company? Are they investing a sizable portion of their compensation back into company?

(ii) Past decision-making track record: Have they delayed an important capital expenditure to the extent they could or are they preemptively allocating resources? Have they pro-actively took a toll on their earnings in order to create a stronger business?

(iii) Quarterly results: How do they feel about their quarterly hits & misses? Personally, I would respect someone who can keep himself calm over short term gyrations.

Conclusion

Running a public company is not easy. There are hundreds of people with different attitudes towards wealth creation tracking you every time. This leads to multiple interpretations of the very same facts. It is in the backdrop of this high decibel noise in which managers need to prove their conviction. What we need as long term investors is to partner with those types which have their attitudes and, more importantly, incentives aligned with us.

In a world which is increasingly getting obsessed with short-termism, as falling average holding periods would convey (down from 3-5 years couple of decades back to <12 months now), ability to think about longer time periods is an advantage in itself.

Strong but questionable form of competitive advantage

Charlie Munger in one of his speeches described a test he has performed at a number of US schools –

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes.

And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. 

And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes. (luxury goods)

And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent?

He further says –

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent.

You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sale

The Principal – Agent Problem

The concept which Munger wants us to grasp through this small extract is that of agency problem. This is where mental models of ‘conflict of interest’ & ‘incentives’ collide to give rise to this particular behavior. Its not only highly profitable for its exploiters – it is pretty much legal and goes unnoticed most of the times.

In order for this thing to work, three things are required:

(i)  Presence of an ‘agent‘ or someone who acts on behalf of the payer. Essentially acting like a middle men between seller and the buyer.

(ii) Complexity, such that payer or the buyer is unable to understand things on his own. And hence has to invariably rely on such agents

(iii) Absence of stringent regulations. This means that agents are free to deviate and seek to further their own self-interests over that of their clients.

These three combined creates an opportunity for profit seeking capitalists to go for not-so honorable means to generate excess returns by overcharging their customers and sharing part of those proceeds with the agents.

Personally if you ask me, such businesses are painted with those darker shades of grey. It is certainly not commendable kind of work which they do. And those excess commissions which are paid to the agents makes the entire transaction highly inefficient.

Some Examples

Pharmaceutical Companies: Doctor is the last person we would like to argue about anything. Whatever he or she says, to us it is like writing on the wall. And we know that it is upon them where most of the marketing efforts of the pharma companies goes. By paying them commissions based on prescriptions they make, branded pharma companies have successfully earned excess returns for decades. More in so in case of ‘branded generics’ (which is certainly a paradoxical term in the first place)

Financial Services: Here again ignorance of a lay person is exploited by sellers of financial products like brokers, insurance agents and mutual fund distributors. To their unsuspecting clients, they are ‘advisers’. And to the fund houses or institutions whose products they sell, they are called as ‘distributors’. Their principal business is earning commissions. You can imagine where would those money-minded guys like their clients to put their money.

Just like these, there are hundreds of other businesses which have made excess returns over decades by excessively relying on incentives and over charging the end user.

Notes for the investor

(a) Such overcharging can go unnoticed for decades. Many a times clients are indifferent since the magnitude of such overcharging could be meaningless for them in the overall context (think low ticket, but highly important items like medicines).

However, regulators could spring up a surprise anytime. And in a country with as low purchasing power as ours, it is not as difficult for the government / regulators to justify some of its acts.

(b) Also, with improvements in technology, alternative channels are opening up which not only does away with those agents but also removes information disparity between buyers and sellers. For example, its very easy today to figure out generic versions of branded drugs today with just a click of the button. There are websites available which compares financial product offerings across several players in the industry. Till sometime back, it was almost unthinkable!

(c) Another thing to remember is that these excess profits have a disproportionate impact on a company’s bottom-line if a company has mix of regulated products as well unregulated ones forming its sales.

For example, assume a pharma company which has about 10 products forming bulk of its revenues. Now, assume that in 8 out of those 10, it makes a meager 10% margin at operating level. Whereas, for other 2 newly launches products, it makes about 50% margins. The result – it makes around 18% margins.

Now, if for some reason, say due to regulatory push, it is forced to bring down those 50% margins to 10%, the overall profit margins come down from 18% to 10% – almost like halving it! And given that markets uses profitability as a metric to value these companies, market cap would follow a similar journey.

Such examples are far from fantasy. Numbers of many branded pharma companies would convey this story when DPCO came into force couple of years back.

Also, many US exporting generic pharma companies which saw handsome rise in their margins due to back-to-back ‘block buster’ drug launches over last 5 years have also started to see pressures on their margins. Number and magnitude of potential block buster drugs have been declining since some time. (Remember the coveted ‘patent cliff’?)

Having too few products generating super-normal profits can put an investor in a tight spot when margins for those fortunate products starts to normalize.

 

Summing it up

To sum up, investors which are lured into these companies need to be cognizant about the following:

(i) Such businesses work till the time they are ‘under the radar’. Best thing to hope for them is that they never too much attention (especially of the negative type)

(ii) Sometimes, if 2 out of 10 products of a company is sold via such means, you could be sure these 2 products would account for a significant chunk of profits. And the impact of these two going would be huge. This point is more relevant for pharma companies selling ‘branded generics’.

(iii) Assessing sustainability of these is challenging. Hence, never fail to look at alternative scenarios where you put together probability of profit erosion and magnitude of erosion. In the world of technology in which are living, many of those information dis-symmetries between buyers and sellers are slowing going away.

Finally, it may not be the most honorable way to earn money as an owner. In words of Mr Munger, it is akin to spending your life ‘selling something you would never buy’.

It is sort of an inefficiency with capitalism (and our ignorance) has allowed to foster over really long time period of time.

 

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