Notes on long term thoughtful investing

Month: March 2017

Bruce Greenwald on Intel & some thoughts on Tech

Technology happens to be one of the toughest spaces to invest. Why? For the simple fact that this sector see one of the fastest rate of change. Take mobile devices for example. In a short span of just over a decade world evolved from landline to handheld mobile phones then to feature phones and currently, smart phones. And this is communication sector to be precise – not even core tech driven like PC or processor chipset or anything like that!

It is rare for a conservative investor to find worthwhile opportunities in this space. Probability of finding one would be like in low single digits or something I believe. But then there are few exceptions and market happens to be very charitable sometimes in handling these to us 🙂

Following is the brief excerpt I found interesting while reading the book Value Investing: From Graham to Buffett & Beyond by Bruce Greenwald which though somewhat dated by accurately portrays what advantage Intel used to enjoy over its competitors –

“Consider the competition between Intel and Advanced Micro Devices (AMD) to produce the next generation of microprocessors for desk-top computers. Because Intel has established access to customers through long-standing relationships with computer manufacturers, supplemented by the “Intel Inside” campaign, it can expect that a successful next-generation chip will capture roughly 90 percent of the processor chip market.

Even if AMD beats Intel to the market, its successful chip will, at least initially, grab a much smaller share. If Intel responds quickly and effectively, it will relegate the AMD chip to a minor-say 10 percent-market share. Thus, AMD’s spending on R&D, ignoring for the moment any difficulties it may have in financing that spending, will be paid for by future sales that are small compared to those of Intel.

Assuming that R&D spending rises proportionately with sales, Intel will be able to spend much more than will AMD on next-generation technology. In fact, Intel only spends five times as much; the difference is still potent. Provided the company doesn’t get distracted or otherwise fail to perform, Intel’s economies of scale help transform a temporary into a durable-if not eternal-competitive advantage.”

As Buffett & Munger often say, survival of the fattest!  

Despite being operating in one of the toughest spaces in the world few companies grow on to become dominant enough to improve their survival rates. And these are subtle changes in the landscape of business which one needs to lookout for.

But what comes along with it is above average levels of uncertainty and the probability of being wrong. And this is something which one needs to remember.


What explains a ‘multi-bagger’?

Couple of days back, I & my philosopher friend were having an interesting discussion and that was not about life 🙂 We were arguing whether small caps & mid-caps stocks regularly trade at their closer to their intrinsic values or not. In the midst of all this there came this question to us – if markets were to be efficient in their jobs, what explains some of these smaller market cap companies going multi-fold in their market values within a short span without their core business seeing much of a change? And this gave us some interesting insights.

For understanding this, let us take the case of a company which saw their market values going up by a couple of times in a very short period (i.e. < 12 months).  And compare this with its intrinsic values.

Case Study: Ratnamani Metals & Tubes Ltd

It happens to be an efficiently managed pipe making company, as it past numbers would suggest. Its longer term RoEs have been ~25-30% over a capex cycle.

If we were to make some simplifying assumptions and were to value it on price to book multiples, it would look something like this –

Fair Price to Book Value Multiple Calculation

Now, clearly these are quite conservative assumptions to have. To put things in perspective, over last 10 years, company has managed to grow its sales over 23% CAGR while what have factored is inflationary rate of growth of 5%. It certainly could do better, but let’s keep that aside for a moment. Our RoE assumption also happens to be on a lower side than what company earns over a cycle.

So, with these conservative assumptions one can pay up to as much as 1.9x the book value of the company and still make 12% CoC and any upside if sales were to grow faster than 5% & RoE better than 18%

This is how it has traded in the market if were to look it at Price to book multiples alongside its RoE.

Price chart considering price to book multiples and RoEs

Surprising isn’t it? Company like this was trading at closer to its book value between 2010-2013 – at nearly 50% discount to its fair value of ~1.9x.  Then on one fine day in 2014 market said ‘Oops, my bad’ and took it way past this.

Currently, it trades at closer to 3x book which leaves very little margin of safety for us.

During these five years, company was debt-free, growing it sales at ~10% CAGR & book value at 20% CAGR but still markets did not notice or took 5yrs to make good its wrong.

Well, then how was the scenario for a 2010 investor? Did he made anything of significance till 2014? Answer is a resounding yes! A 2010 buy & hold investor made 16% CAGR till 2014 and a year later, if he still continued to hold it, stock went up 3.5x taking his total CAGR to ~45%! And all this while company continued to do the exact same thing – making hollow metallic tubes & selling it at a descent margin.

This was not just one case, starting from 2014 there have been hundreds of stocks, mostly in the small & mid-caps space, which has doubled or more in a very short span without their business seeing much of a change.

In fact, BSE small cap & mid cap indices have roughly doubled between 2014 & 2015 which is certainly a rare occurrence.

But let’s not get carried away, there is a yet important thing to understand here. If a stock was trading ~2.5x does it still makes sense for our purposes as value investors? I think it sounds less attractive despite all our conservative assumptions about the company which it is certainly going to exceed in the foreseeable future.

Why? Simply because as shown above, it could be a mistake – though not a terrible one – to buy these smaller market cap stocks paying full price or rather a fair price for it. Market generally has a tendency to price them lower than their fair values for reasons which are difficult to understand. But if you look back to our price to book chart, you would see that market value for Ratnamani went up to 4x book back in 2008 and when it started to correct, it did not stop at 2x, it went on sinking lower and took 6 years to correct this ‘mistake’.

This is what Graham said about the topic in his beautiful work The Intelligent Investor. It worth spending some time thinking on this. He refers what we call small & mid caps as ‘secondary’ companies:

“In the great bull market of 1920s relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather storms and that it had a better chance for really spectacular expansion that one that was already of major dimensions. The depression years 1931-32, however, had a particularly devastating impact on the companies below the first rank either in size or in inherent stability. As a result of that experience investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former. It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

When investors rejected the stocks of secondary companies, even though these sold at relatively low prices, they were expressing a belief or fear that such companies faced a dismal future. In fact, at least subconsciously, they calculated that any price was too high for them because they were heading for extinction – just as in 1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limitless. Both of these views were exaggerations and were productive of serious investment errors.”

Notice how the above psyche squarely correlates with what we are seeing today in the market! He further writes –

“This brief review indicates that the stock market’s attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation. As it happens, the World War II period and the postwar boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly. Thus by 1946 the market’s pattern had completely reversed itself from that before the war. Whereas the leading stocks in the Dow Jones Industrial Average had advanced only 40% from the end of 1938 to the 1946 high, Standard & Poor’s index of low-priced stocks had shot up no less than 280% in the same period. Speculators and many self-styled investors—with the proverbial short memories of people in the stock market—were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the opposite extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusiasm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968—the emphasis now being placed on new offerings of the shares of small companies of less than secondary character, and on nearly all companies in certain favored fields such as “electronics,” “computers,” “franchise” concerns, and others.

As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite under valuation.”

One can correlate what Graham says with the price chart above. 2007 & 2008 saw price multiples for the company zooming to 4x only to trade at 1x a year later! And do so for almost next 5 years. Paying up fair price for it meant that investor had to face prolong periods of lack lustre returns and even after considering the re-rating which happened again in 2014, his CAGR would be lot less as against the case if he waited for an attractive discount to fair value to enter in the stock.

The concluding para by Graham on the topic is worth absorbing –

“If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways.

First, the dividend return is relatively high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five-to seven-year period these advantages can bulk quite large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.”

This is the privilege of being a value investor 🙂

To sum-up, it is always good to enter into a small or mid-cap company which is trading at a substantial discount to its fair value. Because then earnings yield are good and assuming average rate of growth for the business, we can have a reasonable return expected out of it – all this while keeping enough margin of safety in hand which could translate into excess returns when first dosage of enthusiasm strikes the market. This could be, though not meant to be, a recipe for a potential multi-bagger.

But while buying something around fair value one needs to be aware that when the periods of dopamine inspired years end, prolong period of depressingly low multiples would follow. It could be a recipe of potential and unintended disaster.

As the saying goes ‘be greedy when others are fearful and be fearful when others are greedy’.



P.S. 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.

Analysing Buffett’s own ‘Punch card’

Over the years, Buffett & his partner Charlie Munger has agreed that around 8 or 10 decisions of theirs over the last 50 years could largely be credited for Berkshire’s success which is one of the largest companies in the world today.

Buffett has been a believer of ‘punch card investing’ and this is what he said to a group of students back in 1991:

“I always tell the students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision they used up one of those punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five, or three, or seven and you can get rich off five, or three, or seven. But what you can’t get rich doing is trying to get one every day.” 

So good investments opportunities are rare to come across in one’s investing life. And in order to make most of it one needs to be able to spot on the same and commit substantial amount to it as well. You don’t want to diversify away your best investment ideas, right?

Buffett’s own ‘Punch card’

Since Berkshire was a public company, it is relatively easier for people to track how he went about allocating capital by buying businesses & stocks over time. In the book ‘The Warren Buffett Way’, Robert Hagstrom talks about some of Buffett’s very successful investments in one of the chapters.

Going through these, one can spot repeat themes in Buffett’s act. We can classify them into three major categories:

(a) Franchise businesses going through a period of exceptional stress: (Washington Post, GEICO)

Buffett’s thinking was clear that these two companies are franchises and not businesses (that is to say that these companies enjoy competitive advantages or moat which are rare to find in the business world).

Just to put how severe street’s accusations were on these two companies, GEICO was trading down from its 1972 high of $61 to $2 in 1976! Markets thought that company would go bankrupt while Buffett saw that its franchise in the minds of its customers is still intact. All it needed was capital & someone at the top who could start putting things in order. So he was buying shares while Jack Byrne was taking realms of the company. He bought 1.3 million shares at an average price of $3.18. Rest, as we know, is history. Market value of the company had risen from $300 million in 1980 to $4.6 billion in 1992!

The case with Washington Post was less severe but no less interesting. In 1973, company was trading at a market cap of $80 million while Buffett thought that it is at as much as worth $300-400 million. Company was going through its own share of operational problems but he knew that it could be fixed. So while in 1973, company’s pre-tax margins were 10.8%, 15 years later it was not only above its historical average of 15% but had reached a new high of 31.8%. All this meant that a dollar invested in the company in 1973 was worth $89 by 1993.

To be sure, I certainly don’t think that even Buffett would have thought how enormously successful things would turn out to be with these two companies. Though it was for sure that there is significant value in these two cases, final upside was driven by excellent execution over the years by managements of these companies. And that is always the case whether it is be a franchise company or a company with average prospects. Had management’s execution not being this great, we would not have been talking about them at all 🙂

Another thing worth noting is how squarely these two fell in his circle of competence. In fact, Berkshire was already holding full ownership in newspaper & insurance businesses before he made those stock investments.


 (b) Strong Franchises seeing renewed management focus after a bad patch of years: (American Express, Coca Cola, IBM)

Joseph Schumpeter once remarked that successful businesses stand on a ground that is ‘crumbling beneath their feet’. For most part, I believe this reflects the inherent complacency which some of these ‘giants’ develop after having achieved unthinkable success. That partly reflects what happened with this group. But luckily for them, their underlying business was still strong and they, at the time of Buffett’s purchase, were still dominant.

These three companies were generating significant amounts of free cash flows but they were not doing much with it – some were in fact mis-allocating it. In all three cases there came a time when complacent managers where replaced with more sobering & rational ones. What invariably followed was selling off of non-core businesses, renewed focus on core business and returning back the excess cash to the owners.

All this meant that company’s per share earnings had quite a headroom to grow for years ahead along with a chance to partner with a rational management which is supported by a franchise like underlying business and all this available at a reasonable price. As Buffett says, too much of a good thing could be wonderful!


(c) Partnering with able managers to unlock value of an inefficiently managed Franchise: (Capital Cities acquiring American Broadcasting Companies, 3G capital acquiring Heinz)

Buffett once famously said that ‘when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.’

But these two cases were different. Here was a chance to partner with excellent managers which are to go about taking charge of lousily managed business but the one with strong underlying economics.

Here was an opportunity to make ‘whole’ something that was otherwise missing from the equation i.e. able & owner-like managers.

Capital cities operating margins, at the time, were around 28% while that of ABC was a 11% and Tom Murphy, manager of Capital Cities, had a plan. Buffett knew Murphy for almost a decade now by the time this deal came up and he knew cable companies enjoys excellent economics. And so he came about investing into the deal by way of share issue.

Similarly, in case of Heinz, he saw Murphy like passion in the management team of 3G capital supplemented by their track record back in Brazil. And he signed the deal.

In both the cases, newly installed efficiency focused management was able to drive significant productivity gains adding more dollars in profit for every unit of sales.


 We can clearly see Buffett’s preference for buying franchise businesses at a reasonable price (and this explains why he says that his favourite holding period is ‘forever’ – such businesses enjoy longevity which is otherwise rare to come across).

Also visible is the fact that he did all this without over stepping his circle of competence (well, one can argue about the case with IBM but that is a topic for some other day 🙂 )

Want to learn how to go about identifying companies which would fill up our own punch cards? Who else can we learn better from if not from the masters themselves!


Niraj Bardia