Notes on long term thoughtful investing

Month: November 2016

Position Sizing

As an investor, amongst some of the advantages we enjoy is that of ‘diversification’. Unlike a businessman whose entire fortune is tied to one particular field of operation, we can spread it across multiple such businesses. Though that doesn’t mean our financial result from owning that particular business will turn out to be different from that of the business owner but we are better able to manage risks associated with any particular set of variables at the portfolio level.

But just like many other simple ideas whenever we take something to the extremes, we end up turning a boon into a bane. While taking away risks associated with owning a single business, the proponents of (excessive) diversification end up taking (ignorantly) the risk associated with too much diversification.

Speaking with excessive diversification, Phil Fisher said –

Too few people, however, give sufficient thought to the evils of other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them.

So, in otherwords to do away with the horrors of ‘putting all eggs in one basket’ we have ignorantly created entirely new set of complexities. It is not unheard of and in fact some of the top funds in the country hold as much as 40-80 stocks in their portfolio. They seem to be inspired by Noah’s rule – two of each and end up with a zoo 🙂 But to be fair some of these funds do suffer from something like ‘diseconomies of scale’ – they are too big a fish for the pond they are in. But it is not unheard of people – without having any size constraints – end up owning more than 25-30 stocks.

Which is the right number?

This is not the right question to ask in my view -partly because there are no precise answer for this. As investors we are trying to do away with risks while maximising our returns like improving upon our returns per unit of risk.

As Buffett said, in investing risk lies not knowing what you are doing. So for a professional investor if there is a particular industry or business which he cannot make out head or tail of it, his ideal weight there should be not more than zero. Again, it is not necessary to understand all the intricate details of a potential investment but certainly he should be able to understand it to the extent of action he is taking.

So, you certainly do not need to know what all goes into making ready to cook noodles but what you should know is factors which could influence its demand, the probability of adversities hitting the business from time to time, competition and how do they stack up against the company so on and so forth.

So if we cannot understand all the adversities which business in question generally faces or arrive at a reasonable range of probabilities of those adversities affecting the company then probably we may not be competent enough to own it. Which is fine. There are thousands of companies listed in India and we just need to move on to the one next in queue 🙂

So coming back to the question, if there is no specific number to hook ourselves too, then what is it which should guide us in our portfolio construction?

Fisher has answered this question beautifully with an analogy of his –

How much diversification is really necessary and how much is dangerous? It is somewhat like infantrymen stacking rifles.

A rifleman cannot get as firm a stack by balancing two rifles as he can by using five or six properly placed. However, he can get just as secure a stack with five as he could with fifty.

In this matter of diversification, however, there is one big difference between stacking rifles and common stocks.

With rifles, the number needed for a firm stack does not usually depend on the kind of rifle used. With stocks, the nature of the stock itself has a tremendous amount to do with the amount of diversification actually needed.

So adequate diversification depends up nature of the business in question. Given that expected returns are otherwise equal, a company which has its business spread across three different segments such that none of the segment contributes significantly versus the other, the amount of weight one can have in his portfolio for such business would be higher than the one which derives returns from just one segment assuming both of these businesses are otherwise equally strong.

For example, if otherwise expected returns are more or less the same, one can have more weight in HUL which has its business spread across multiple SKUs versus Bajaj Corp which is sort of a one product company earning all of his revenues from sales of light hair oil brand ‘Almond drops’.

So ‘strategic business unit’ (SBU) is what one should look at. While owning businesses we are indirectly owning their earning machines i.e. the SBU. If an investor assigns equal weight to Bajaj Corp and HUL, we should be aware that his exposure of a particular SBU is higher in case of former than the latter company. There is nothing wrong in his if one is compensated well enough to do so. But why take additional risk for free?

Second thing which Fisher says is management bandwidth. Generally, we see that in small companies, decision making is centered around one particular individual. Though nothing wrong in this since sometimes it is due to visionaries like these that the company has attained a particular level in the business but if the shoes are too big to fit and if there is no one else standing in the queue to take realms of the company then there is some additional risk here. Though it would be wrong of think of it as fatal. Replacement only takes time and patience from us as owners.

Also, family managed businesses may sometimes end up having lower bandwidth from a non-family driven or a professionally managed business. But again sometimes the commitment level of the management which some of these family owned businesses is difficult to match by someone who draws monthly salary. And there is also lesser chance of CEO leaving the company and joining a competitor 🙂 . But then these companies are good till the time family members stick together. Many of the synergies across products which they today enjoy would disappear tomorrow if the family were to split.

One last thing which one should look at is the exposure to the portfolio from owning businesses operating in similar SBUs. So if out of the love for recently announced ‘demonetisation’, if one ends up owning 20 stocks – 15 of which are banks, needless to say he is taking excessive risk and his portfolio is as good as undiversified. Hope he is also accompanying his investee companies in the evening calls which RBI has with banks these days!

One of the investor I follow and respect had 40% of his portfolio parked in Berkshire Hathaway stock (a company owned and managed by Buffett and his partner Charlie Munger) few years back. Given that Berkshire owns hundreds of SBUs – most of which are franchise in itself – and the depth of the management along with succession planning which they had been worked upon for more than a decade now, it does not seem so surprising to me now. Though I think this guy does have guts made up of steel – and hopefully so that of his clients 🙂

Thanks for reading. Hope you enjoyed as much as I did while writing it. If you have some additional points / insights, do write in the section below. It would be interesting to expand upon this concept further.


Niraj Bardia

Disclaimer: Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions.

Some notes on ‘Measuring the Moat’

Recently, was fortunate enough to come across a report by Michael Mauboussion & his team titled ‘Measuring the Moat’. Moats, as such is an interesting concept and its application in evaluating businesses was popularised by Buffett.

This is what he said more than two decades back –

What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something that differentiates the company from its nearest competitors – either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing – even though you can’t see it.

This report builds further on that concept and explains its readers some of the factors which makes an investment attractive and unattractive.

Why is it important for us as investors? For a long term investor, his results will not be far different from that of the firm & the industry in which it operates. Hence, it is imperative to understand the underlying businesses well before committing larger sums for years. Also, the most important thing – it is fun & challenging enough to delve deeper for understanding these 🙂

Would recommended everyone to spend sometime thinking about what Mr. Maubossion is saying in order to improve our own lenses of evaluating things. I personally found the discussion which begin post porter’s five forces section revealing. Also, interesting was the discussion on why sometimes established incumbents loose to smaller entrants in the industry with a slightly different but efficient business models.

Some of the points which I found useful & revealing out of this report along with my interpretations of the same are:

  • Asset specificity (at industry level):

Can the assets be put to use to some other purpose or are the fortunes tied to a very narrow business area? Take for example pipe manufacturing industry. Given the thin operating margin generally, high production scale is the key to lower costs and remain competitive. Also, equally important is to keep those capacities running. As a result, we generally see higher segmental concentration either in line pipes or sewage pipelines or oil & gas related pipes. Add to this, there is geographical concentration involved since pipes are generally bulky to transport over longer distances. These explains why companies witnesses wide swings in profitability regularly over the years.

As a rule in the world of business & investing, higher business (product & geography) concentration & general slowdown in the industry would only lead to  intense competition amongst the participants in business which produces undifferentiated products. Hence, having cost advantages is crucial in ‘commodity’ like or average businesses.

One of the successful players in this tough industry is Ratnamani which have managed to navigate through these vicissitudes reasonably well over the years. But this is more of an exception rather than a norm.

  • Production Scale:

This concept applies to both manufacturing & software products industry. Though there is a subtle difference. While production costs fall only upto a point called ‘minimum efficient scale of production’ in case of manufacturing firms, that for software products keeps on falling with each incremental user. They key is IP protection and product differentiation as only then will the excess returns stay. Customer captivity is also vital in case of software products. Important example here could be Microsoft, Android.

Another key takeaway is to look at dominating companies within fast growing industry closely. It is possible that with increase in market size, other players might achieve similar production scale advantages leading to evaporation of excess returns. Maruti of 1990’s is an example.

  • Fleeting moats:

Moats give pretty strong foundation to the success an economic castle. But what if a newer entrant manages to destroy those foundations? Apple, Google destroyed branding, distribution & ecosystem advantage which Nokia enjoyed – just like Kodak. Currently, Pantanjali is attacking the establishments of Indian FMCG players. Difference between the former was technology advantage which newer entrants had. In the case of latter, how much damage Patanjali does would depend upon how deep does patanjali brand resonates with the customers, distribution reach it manages to expand and switching incentive it could provide by pricing its goods lower.

Technology companies generally have higher rate of changes and hence weaker moats, if any.. more so if areas of operations are limited / concentrated.

  • Barriers to Exit:

Low investments need and non-specific assets leads to lower exit barriers and vice-versa. Telecom space in India, incidentally, suffers on both counts.

  • Demand Variability:

When demand for products is highly variable, it induces excess capacity creation at peak which means when cycles moves through difficult times, there is intense rivalry amongst firms. Whenever demand is variable generally there is a lack of co-ordination amongst the participants which means pricing pressures do not easily abate during down cycle.

Cartel is difficult to sustain since given the fluctuating demand, there is an incentive strong enough to cheat.

  • Stagnant Industries:

No growth or very low industries are like zero sum games. In order to make more economic profits, one needs to snatch market share away from other players which intensifies rivalry unlike in industries where economic profits are continuously rising for all the players. Hence, rivalry could be stronger here.

  • Rate of change in cost:

To what extent can a new comer enter the industry and also have the advantage of lowering his costs over incumbent players such that new comer happens to have a lower cost of production. Happens with businesses dependent upon technology led upgradations (like textile, cement, telecom etc). Legacy systems becomes unproductive over relatively shorter time frame in some of these industries.

  • Economies of Scope:

Lowering per unit cost of production by pursuing multiple activities in related field of operation such that activities become path dependent overtime. Some chemical companies happen to develop their business models around this concept.

In my view, this is a good enough moat especially if a player is able to gain significant market share in one or more of these products. This reduces an opportunity for competitors to replicate similar model since market size itself would not warrant such replication.

  • Network Effects:

There are two types of networks (i) Radical or hub & spoke and (ii) Interactive. Interactive (naukri) is stronger than Radical (V-Mart, Walmart). Latter may have scale advantages.

Another interesting discussion is on innovation & disruption. It nicely explains why it is more probable than not that incumbents would ignore / ridicule a ‘disruptor’ which only allow them time & resources to improve upon their processes to later take on incumbents.

It talks about mini-steel mills in 1970s which started with using scrap steel as raw material for finished steel. Initially their quality was not as good as that of integrated steel mills and hence their products found limited adoption, mostly into rebar segment, but their prices were competitive. Integrated steel mills did not mind to get out of those segments since any which ways much of that was low margin business for them. But this allowed mini-steel mills to prosper and overtime improve upon quality of their output and capture even more market share.

This in some ways also helps us understand why facebook paid staggering $19Bn for whatsapp. By doing this, they not only got their feet into an evolving ecosystem with an established product but also avoided the threat of future competition from it which could have meant losing billions in form of prolonged competition directly and indirectly.

There are lot of interesting stuff to learn from this beautiful work and above list is able to just provide a fraction of those learnings. It is highly recommended to spend some time going through it.


Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions.

Philip Fisher on ‘When to buy’

Recently, I was reading one of the best works of Philip Fisher – his book ‘Common Stocks and Uncommon Profits’ written more than half a century ago. His thought process happens to be simple but highly effective – a best known combination for success in the business of investing. Although as contradictory it may sound, just like Benjamin Graham, he had adopted throughout his career an owner-like attitude while evaluating stocks. And just like Buffett, his favourite holding period was near about forever! In fact, he continued to hold his investment in Motorola for about 21 years right till the day he died. It is rare to find people having this kind of temperament in investing – despite this being precisely the field where one cannot ask for anything less than this type of commitment at least while evaluating businesses.

In one of the chapters of the book discussing when to buy stocks, his owner like thinking shines beautifully. Reflecting upon his long experience in the markets he observes-

As word first gets out about a spectacular new product in the laboratory of a well-run company, eager buyers bid up the prices of that company’s shares. When the word comes of successful pilot-plant operation, the shares go still higher. Few think of the old analogy that operating a pilot plant is like driving an automobile over a winding country road at ten miles per hour. Running a commercial plant is like driving on that same road at 100 miles per hour.

Then when month after month difficulties crop up in getting the commercial plant started, these unexpected expenses causes per-share earnings to dip noticeably. Word spreads that the plant is in trouble. Nobody can guarantee when, if ever, the problems will be solved. The former eager buyers of the stock become discouraged sellers. Down goes the price of the stock. The longer the shake-down lasts the more the market quotations sag.  At last comes the good news that the plant is finally running smoothly. A two-day rally occurs in the price of the stock. However, in the following quarter when special sales expenses have caused a still further sag in the net income, the stock falls to the lowest price in years. Word passes all through the financial community that the management has blundered.

Buffet has said long back that in investing risk lies in not knowing what one is doing. Although, this was a hypothetical example put up by Fisher, such cases are not entirely unheard of in the markets. Quarterly number focused members of the street are known to experience such vicissitudes & mood swings. An investor having owner-like attitude would have better navigated such turbulences which is the part and parcel of our profession. Having known that these near term setbacks are actually indicators of things actually panning out, he would have only added to his position at such bargain prices. It couldn’t have been a better time for him.

What is interesting is that this attitude of the street i.e. focusing on near term results has not much changed since last 60 years when Fisher wrote this. Nor do I think it would change over the next 60 years 🙂

Further, he continues –

At this point the stock might well prove a sensational buy. Once the extra sales effort has produced enough volume to make the first production scale plant pay, normal sales effort is frequently enough to continue the upward movement of the sales curve for many years. Since the same techniques are used, the placing in operation of a second, third, fourth, and fifth plant can nearly always be done without the delays and special expenses that occurred during the prolonged shake-down period of the first plant. By the time plant Number Five is running at (optimum) capacity, the company has grown so big and prosperous that the whole cycle can be repeated on another brand new product without the same drain on earnings percentage-wise or the same downward effect on the company’s shares. The investor has acquired at the right time an investment which can grow for him for many years.

Though he talks about timing in the end, what really created an impact on me was his ability to think through clearly about his stocks for years together. Usually, one might have sold his position, at a descent profit when commercial plant came into operations and market corrected itself and now starts pricing thing efficiently. But Fisher did not think so. He could see that, although stock is now fairly valued with respect to its current earnings, this business could actually go upon expanding its sales as well as its margins which could create a bigger impact on profits. He could see capacity going 5x after years of initial commissioning.

Obviously, lot of things have to go right for the company for this to happen but he was willing to wait and see it coming thereby selling in finally at an even higher profit. It was his owner-like approach, understanding of the business and long term thinking which would have earned him this.

He came in hunting for a bargain like a ‘value guy’ and left out earning profits which ‘growth investors’ would envy – if at all such stereotype distinction exists.

Idea is thinking about stocks not as mere pieces of paper but as businesses in their own right, as Graham would say.

 

Mental Model: Creatures of Habit

Think how repeatedly every time we go to same grocery store to buy our day to day merchandise. Or how frequently we take the same route to our office everyday though there being a couple of routes of reaching it. We go to the same garage every time our car needs some work to be done. We almost religiously eat the same brand of noodles, brush our teeth from same brand of toothpaste and shave from the same brand of shaving gel & razor month after month. It is startling to see this type of consistency in our day to day life in an era where in ‘disruption’ is the most used (and abused 🙂 ) term!

One of the reason behind all of this is that we humans are loss averse which means our mind wishes to avoid the need for frequent decision making and rather stick with the status quo if it satisfies our basic needs. Given the complexity which the decision making process involves, we satisfice ourselves.

Edgar Rice Burroughs in his book ‘The Beasts of Tarzan’ writes –

We are, all of us, creatures of habit, and when the seeming necessity for schooling ourselves in new ways ceases to exist, we fall naturally and easily into the manner and customs which long usage has implanted ineradicably within us.

So, unless our needs change, our decision remains more or less the same which overtime becomes our habits. As such, ‘creatures of habit’ is an important mental model. Think about the wealth it would have created – and is still creating – for those that have been on the receiving end of this right from our regular grocery store to multi-billion dollar global conglomerates.

Businesses Enjoying this

Let’s see how some of the successful businesses globally are utilising this tendency to their advantage.

Mc Donald’s

It is the world’s largest restaurant chain operating in about 119 countries selling burgers & fries which is certainly not difficult to make or imitated by others. Then what explains this type of success enjoyed by it over the years? Rory Sutherland, Vice-Chairman of international advertising firm Ogilvy & Mather in his interview says –

Why do we go to McDonald’s? Is it the best food in town? Probably not. The search cost of finding the best place to eat in town, given that we’ve only got one shot at having a meal in a strange town, would be pretty high. But also when you go into McDonald’s you know you’re not going to be ripped off, you’re almost certainly not going to be ill. By contrast I’ve become ill after eating at Michelin-Starred restaurants quite frequently. Once you understand the perfectly sensible evolutionary instinct to satisfice, then the preference for brands is not irrational at all: I will pay a premium as a form of insurance for the reduced likelihood that this product is appalling.

So as much as the quality & taste of the delicious food it serves, its huge network of restaurants spread across almost every important city on the planet and the mindshare it has built over decades enables it to compete and succeed by doing something as simple as making and selling good quality burgers.

Starbucks

It is worth prodding the reasons behind the success of a café serving expensive coffee – whose prices were multiple times that of competing brews when it started its operations. Dan Ariely beautifully explained this in his book ‘Predictably Irrational’ –

You are sleepy and in desperate need of a liquid energy boost as you embark on an errand one afternoon. You glance through the windows at Starbucks and walk in. The prices of the coffee are a shock—you’ve been blissfully drinking the brew at Dunkin’ Donuts for years. But since you have walked in and are now curious about what coffee at this price might taste like, you surprise yourself: you buy a small coffee, enjoy its taste and its effect on you, and walk out.

The following week you walk by Starbucks again. Should you go in? The ideal decision-making process should take into account the quality of the coffee (Starbucks versus Dunkin’ Donuts); the prices at the two places; and, of course, the cost (or value) of walking a few more blocks to get to Dunkin’ Donuts. This is a complex computation—so instead, you resort to the simple approach: “I went to Starbucks before, and I enjoyed myself and the coffee, so this must be a good decision for me.” So you walk in and get another small cup of coffee. In doing so, you just became the second person in line, standing behind yourself.

A few days later, you again walk by Starbucks and this time, you vividly remember your past decisions and act on them again—voilà! You become the third person in line, standing behind yourself. As the weeks pass, you enter again and again and every time, you feel more strongly that you are acting on the basis of your preferences. Buying coffee at Starbucks has become a habit with you.

Its rich ambience, huge network of café covering every nook and corner of the US and brand recall adequately supported by distinguished menu makes it a business which its competitors envy.

Gillette

It happens to be one of the world’s most valuable brands with its products – razors & blade – enjoying 70% market globally. Will you buy a product offered by its competing local brand which happens to be 10-15% cheaper? Never. You don’t wish to run the risk of hurting yourselves while shaving. Besides, you might think, the life of a branded product may end being longer than that of a local unbranded one thereby more or less compensating for the price difference.

Great product, almost omnipresent like availability of its products and strong brand recall is something which Gillette enjoys to its advantage.

There are several examples of businesses enjoying one or the other competitive advantage due to the tendency of its customers to maintain status quo and to satisfice rather than acting as rational beings 24×7.

 

Common Themes

Did you notice the common thread running across the above examples? For this principle to work, there must continuity which must be maintained i.e. habits should not be interrupted or broken else they may change. And what ensures that kind of continuity which works in their favour?

Well, first thing is availability i.e. product or service should be available whenever required. Starbucks would have been in a weaker shape had it not been in every corner of US and so would be Mc Donald’s. They need to be present where ever their customers need them. That is another reason why we find Mc Donald’s more frequently nearby interstate highways. We plan our journey stops depending upon where its stores are located so as to avoid eating potentially unhygienic food. Similarly, Gillette’s blades need to be present at a stone’s throw away distance where ever its customers reside.

Second, they need to continuously invest in advertising & marketing to maintain and expand the mindshare which they enjoy. It is an intangible asset which they are building but which gets no mention on their annual balance sheets – given that it cannot be precisely measured. There are a few things cannot be precisely measured but that does not deny their existence..this is an another topic altogether which can be saved for some other day.

Amount spent on it is charged against current profits but it would be reasonable to expect the benefits to flow for quite a long period.

Limitations

Every mental model has its limits. Recognising those limits are sometimes more important they knowing the advantages they may enjoy.

Let’s go back to our garage example. If the mechanic which frequently repairs your car happen to be replaced by a new recently trained one who made a small mistake while working on your car such that it is in a far worse condition now then you had left it in, you might think twice about bringing it back to the same place next time. In the words of Mr. Burroughs, there is a seeming necessity now to retrain yourselves.

When needs change, it is only reasonable to expect change in people’s behaviour which was otherwise set.

So, if tomorrow another competitor selling razors & blades happens to establish trust similar to what Gillette enjoys while selling them at a fraction of what Gillette charges, it would put their business at risk. They key is to assess how deeper has the challenger managed to build that trust and can Gillette also lower the amount which it charges by lowering its cost to its competitor’s levels? In essence, it becomes a race: whether Gillette would be faster to build those cost competencies – and disrupt its own business –  or whether the challenger would go on building a combination of cheaper economics and strong mindshare. By the way, as we speak, this race is actually being unfolding sparked by a small start-up called ‘Dollar Shave Club’ now acquired & resourced by Unilever.

This was just another attempt in order to assess and better understand how far does this simple concept of habit goes – and how powerful it is. It is never just one thing which ensures investing success in a world as complex as the one in which we live. It is rather a latticework of such models. Hope you enjoyed reading this and it added to your understanding of how world works just as much as it did to me while writing this. Cheers.