Notes on long term thoughtful investing

Category: General Thoughts (Page 1 of 2)

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.

 

When the tide goes out

Good performance of my investee companies over last couple of months had for once made me feel like investing equivalent of ‘Bahubali’. It was only after my colleague revealed that his ‘1-share’ portfolio of 90 companies – brought for the purpose of attending AGMs – has done equally handsomely!

So much for hours of struggle with those puzzling questions!

But by no means I & my colleague alone. In fact, last few months of eye pooping performance have certainly boosted the confidence of many investors including hundreds of ‘first timers’. And this is most unfortunate experience a beginner can have.

Small bets going good early-on means that appetite for taking larger bets only increases.

And the result? ‘Tuition fee’ when things revert back to mean would be enormous for the poor fellow. At worse, it could result in loss of self-confidence and a perpetual aversion to equity investing.

Though losing money is never a good proposition but losing it early-on and learning lessons out of it is way better than other way around.

Where’s the party tonight?

During times as speculative as they are today, a new specie springs to life. They find things so well suited to their ‘capabilities’ that people cannot have less of them. They seem to be always in demand – called, tracked, followed by several of other, less enlightened fellows. You can call them ‘tipsters’.

They might not be as good as people believe them to be. And many times even they fail to understand what & why they are doing something. But still they don’t shy away from ‘guiding’ others.

Valuation is not something they burden themselves with. They look at more ‘concrete’ things like stock price and charts. Their mantra – “Go where the money is”.  This short classic from 1990’s accurately portrays their role in the character of ‘Prasad the stock picker’.

Another more aggressive species of the same genus are speculators. They are shrewd (or atleast think so). They certainly know what they are doing.

For them, it’s like playing the game of ‘musical chair’. It’s all good till the time music continues. All they are looking to do is grab a chair just when the music ends so that they remain in the game – at least for the next round.

But do they know this – in the game of musical chair, probability of losing increases successively as one graduate from one round to another. As such, qualifying players face poorer odds as they keep on adding wins. If win to loss ratio is 9-1 in round 1 with 10 people playing the game, it becomes 1:1 in the tenth round. Moving from near certain event to a random event.

From the lenses of an owned-minded investor

For a rational investor, it looks like the ‘alice-in-the-wonderland’ kind of situation. Things are getting expensive and then some more. And then again a bit more expensive. Eventually, he is done selling and has nothing left to offer to quench market’s hunger. All he has is cash and a hope that ‘this too shall pass’

While holding cash is the best thing to do during the times of irrational optimism, it does test one’s patience and, if the situation prolongs, one’s belief system. It is said that during the latter phases of dot boom during late 90s many value investors had either shut shops or converted in favour of the trend to their peril.

Only the ones with strong mind continued while seeing their assets under management dwindling down for quite a few years until their conviction was proved right.

‘Survival of the fittest’ as Darwin said.

 

Only the paranoid survive

During those patience testing times what should the owner-minded investor do? Become a bit more ‘accommodative’ with his expectations from the business thereby paying up a bit more to Mr Market? Or stay committed to his course & not loosen-up his expectations keeping up his guard?

These are challenging questions with no real answers. Only thing I could say to pacify this fellow investor is to stay vigilant, assess his expectations from the business over the longer periods regularly in order to bring them closer to the probable scenario.

 

Hindsight is always 20/20

All of us know some of those lucky fellows who for some reason or the another had an opportunity to sell out before 2008-09 crash. People sometimes envy them.

It could be to meet their personal needs (buying a home, repaying some debt) but they certainly had the last laugh.

Now, if someone today (when the market is general is more expensive than that of 2007-08) says that he is going big on cash, natural reaction is to laugh at them (mostly, silently in your mind).

How incoherent can our thoughts be!

First we make our choices; thereafter they make (or break) us

Dot com boom lasted for about 5 years. And those 5 years would be one of the toughest for money managers with an owner-like attitude towards investing.

For a moment, assume that you are given a chance to choose the future you. Do you then wish to become a tipster or a speculator and thereby make some handsome gains during the intervening period with little surety of you getting to keep those gains?

Or you wish to maintain your owner-like way of investing and bear the intermediate consequences (seeing other guys getting rich faster) with decent probability of having the last laugh?

Or try to do both and risk losing away a hard-to-maintain clear thinking mind in favour of making some speculative gains?

To each one of us, there would be different answers to these question. All we need to do is to ensure whatever we choose; we do so wisely knowing the consequences which would follow. After all, tides rise only to recede.

Investing is not just about deep moats

Buffett has taught us a lot about the importance of having a business with a strong competitive advantage around it. He called them businesses with a ‘moat’.

Due to Berkshire’s increasing size ($400Bn+ market cap currently) things have become complicated, overtime. Anyone who has read his annual letters written over last 3-5 decades will see some subtle changes in his investment style. A look at Berkshire’s investment portfolio over the decades would drive home the point.

As I flip through the pages I see:

(i) Increasing number of securities in the Berkshire portfolio. So he was more concentrated earlier than now

(ii)  Find investments in ‘non moat’ companies like Kaiser Aluminium (1977-1980), Handy & Harman (1979-1986, precious metals), F W Woolworth (1979-1980, retail), Cleveland-Cliffs Iron Company (1980-1981)

(iii) Investments in wholly owned businesses increased over the years vis-a-vis Berkshire’s equity investment portfolio.

While his preference shifted overtime, his core principles are still the same. In fact, his principles are as same as they were when he was a bargain-hunter. Though his methods have evolved over the decades.

What the above points reflect is his growing inability to invest over a wider spectrum of companies due to Berkshire’s size. A billion dollar investment would not move the needle for a $400Bn company.

This means he cannot trade in and out as easily versus what he could do in 70s and 80s. Hence, Berkshire, over the decades, has become less opportunistic and today looks more like a conglomerate rather than an investment company as it was started out.

And being less opportunistic is the least kind of restriction an investor would like to have. Especially, when your job is basically that of buying from a pessimist and selling it to an optimistic fellow couple of years down the line.

If I had to summarize Buffett’s investing lifespan, it would be something like this-

Started as a bargain hunter – over 1-2 decades saw this pool drying up – matured into someone who invests in a much broader universe – continued for another couple of decades – started out buying outright businesses & holding them forever in order to mitigate shrinking pool of potential marketable instruments – Berkshire becoming more like a conglomerate with earnings from wholly owned businesses surpassing those from his investment portfolio.

It is the last part of the chain which reflects his preference of buying moat businesses which he could hold-on forever.

As his disciples, today countless of other smaller investors think of following the oracle’s footsteps – buying only the ‘moat’ businesses and hoping to hold it for very long periods of time.

This is an unnecessary restriction to take up. As an investor managing lot lower funds, taking advantage of volatility should be a corner stone of one’s investing strategy!

I myself was guilty of ascribing too much value to moat companies. Undoubtedly, they are must-haves but that (a) shouldn’t mean that you restrict yourself investing only in wide moat companies (b) pay irrationally high price of the same (c) not sell when market is paying an absurd premium for it (you can buy it back later, once the euphoria settles)

What price to pay?

How can you bid for something if you don’t know what is its worth?

How can figure out something’s worth if you don’t understand what it is upto?

Hence, starting point for every investor is answering out some key questions about the business. If you can answer those, it means you understand it. If you are struggling to answer them, no worries just move on to the next. We need just a couple of these at a time in our portfolio and there are more than 4000 listed companies in India. So, you get the point.

Once you know you can ascertain the key drivers of the business, its key risks and understand sustainability of the business, then comes the time to value it.

When it comes to valuation, figuring out longevity is the key. Why longevity? ‘terminal value’ is the significant contributor to any going concern’s valuation. Go wrong here and you are sooner or later in trouble.

Also, stronger the business, more sustainable would be its margins & return on capital and vice-versa.

One needs to do some classification work here. I personally put them into three buckets –

(i) Wide moat businesses with 10-15+ years of competitive advantage period. That is to say they could maintain their margins for 15 years or so kind of long periods while growing their sales at a good rate (10-15% depending upon the industry)

(ii) Strong businesses with 5 to 7 or 10 years kind of competitive advantage period

(iii)  Typical businesses which have no advantage as such but business would continue to earn around cost of capital sort of return on equity. Key thing here is sustainability of existing revenues & margin. So, margins may not be high, but at least they should be maintainable over a cycle. Only then it could be reliably valued.

Things become interesting when –

(i) You get to buy a ‘wide moat’ business at the price of a ‘strong’ business

(ii) ‘Strong’ business at the price of a ‘typical’ business

(iii) ‘Typical’ businesses trading at scrap-like valuations

It becomes somewhat irrational when –

(i) ‘Typical’ businesses are selling at valuations of a ‘strong’ business

(ii) ‘Strong’ businesses at ‘wide-moat’ valuations

(iii) ‘Wide-moat’ at some god-like valuations. So market is saying that it could sustain and grow for next quarter or sometimes, even half a century. It becomes a point for us to say ‘bid adieu’

So, if 2011-2013 were the interesting times in the market, now we are in the midst of some irrational frenzy. But this too shall pass.

But the key thing to remember is not to restrict your investing universe or your thinking at any point in time. Principles need not change over one’s life but methods applied should reflect the circumstances under which the decision is made. And those circumstances are different between us and Mr Buffett.

So while he can more or less invest only in wide-moat businesses due to Berkshire’s size, we have two more ponds to look at. And remember, size of the pond dramatically increases as we move a step down in each of the above case.

Let us try to do what he did in 70s and not what he is forced to do today.

 

 

Sell Decision: Some mistakes to avoid

So markets are at a high and in many ways it can benefit us. Apart from swelling our prides, it can add value in terms of having a portfolio clean up by giving away the over-priced stuff. And bull markets are not known to last forever. So it might be the right thing to dwell upon this subject for a while.

Pitfalls to avoid

Obviously, the above line of thinking i.e. selling the ‘over-valued’ means that one knows a lot better than others. Market prices reflects future cash flows anticipated from the business. And higher those stock prices go, higher are the in-built expectations from the company.

At one level though, especially during times when market is enthusiastic about the company in question, those growth anticipations goes through the roof – as its sky rocketing stock price would suggest.  So selling it might make sense. Right?

Most of the times, especially when you are sitting on some hefty gains, one might think like doing so. After all, if the stock is priced to perfection then how can one go wrong by not selling it to its eager buyers?  Well, sometimes you could go wrong.

Don’t think so? Then check what Rosenfield, one of the investing greats, had said in an interview with Jason Zweig about his sale of Intel Shares in 1980 which is published in the book Concentrated Investing

“On its sale, the Intel investment had generated a profit of 4,583 percent. Rosenfield told Zweig, “I wish we’d kept it. That was the biggest mistake we ever made. Selling must have cost us $50 million, maybe more.” Zweig didn’t have the heart to tell the then 96-year-old Rosenfield that the shares he sold would have been worth several billion dollars in 2000.”

Consider this an extreme example (!), but the moot point is there are some pitfalls to be avoided before making a sell decision.

 

Not all businesses are the same

Future cash flows are easier to predict, in a certain range, for some businesses than others. And market expectations can swing quite wildly for the latter than the former.

Hence, while arriving at a decision – whether it is buy or sell decision – one needs to think deeper. After all, this is what investing is all about – trying to bring down your frequency of error and its magnitude.

In case of a sell  decision, there could be a significant difference between the rate at which one thinks a business can compound its earnings and what that business end up actually achieving over the years.

Following are those ‘hard to tell’ business-types about which one needs to be doubly sure before arriving at a ‘sell’ decision.

(i) Asset-light businesses: By definition these are non-capital intensive businesses. For a moment stop and think how did the Indian IT companies grew at 20-30% CAGR over last 2-3 decades and simultaneously remain debt-free at all times? I believe it was a combination of global outsourcing demand + domestic pool of engineers + low capital intensity. After all, office space along with those desks and chairs, could be rented out right?

Also, some of the businesses which operate on float i.e. negative working capital are actually paid to grow instead of paying up to grow.

Whenever such asset light businesses see strong structural uptick in demand, they can step up their size with relative ease and cater to it. And it can also do so vice-versa.

Think how opposite is the case with capital intensive businesses like cement & steel. It takes them 4-5 years to add capacity. And by the time it comes up, demand cycle might have already turned upside down leaving them with surplus capacity and excessive debt.

Hence, instead of jumping to sell at some modest pick-up in demand, sit back and at least give it a shot of how things could look like 5-7 years down the line under different demand situations.

(ii) Non-linear businesses: If you ask me what could be even better than an asset light compounder – a neatly built non-linear business should be it. Non-linear businesses means those which need little incremental capital or expense outlay to grow its revenues. Google, Intel, Microsoft and our home grown Naukri.com are some of those types. Think about the regret which the seller who sold these years or decades back would have today!

But then there is lot of survivor-ship bias involved here. For every one Google there are dozens of those companies which ended up being bankrupt while trying to be one.

Hence, when you have yourselves owning one of those non-linear types which is showing positive signs of life and which markets have also noticed, don’t just run to the door as yet. Think scenarios. And if so seems fit, sell.

(iii) Surplus resources: Capital intensive businesses but with surplus resources, which are currently undervalued by the market, for one reason or the other, could temporarily achieve the status of an ‘asset-light’ type. The tenure of this would depend upon how much surplus are those resources vis-a-vis the demand environment.

Think about those NBFCs and banks which are currently operating at well below the permissible regulatory threshold of leverage. Also, some of these are currently operating at levels below their respective peers. Those are surplus resources which could be deployed if industry so demands.

Another example could be a manufacturing company operating at sub-optimal levels and which could cater to much higher demand levels by a combination of increasing utilization levels & brown field expansion.

(iv) Superior cash generating businesses:  Businesses with strong internal cash generation and close to zero debt can go ahead to invest and meet demand as the situation may warrant.

Ideally, a growing industry with long enough run away and strong cash generation capacity along with low debt levels could create lot of value overtime. So even if you wish to sell it given the enthusiasm around the company, plan to repurchase it as and when the tide goes down – as it generally will.

 

By no means is the above list conclusive. Instead, its an attempt to make us think deeper before we think of running towards the door. Irrespective of your past gains or losses, it is important to think and act like business owners at all times – be it while buying, holding or selling it.

Let’s not allow speculators – who are propping up the stock prices – to increase our error rates. We alone are enough!

Personally, have found this to also be the hardest part of equation i.e. arriving at a range where one is confident enough to give up his stake. And finally there may not be any right or wrong decisions but something you are comfortable executing it. After all, there is a limit to which one can expand his temperament.

If holding something outrageously priced keeps you awake at night, it could worthwhile trading it off for a sound sleep!

 

 

 

Markets are at a High

“The stock market is a giant distraction to the business of investing” – John Bogle

Stock market is a place with an ongoing tussle being the proverbial ‘bulls’ and the ‘bears’. Or as a philosopher might put it, between greed and fear. May be a neurologist might call it a fight between the two chemicals which our brain secretes – testosterone and cortisol.

Whichever way one thinks about it, markets reflect the underlying psyche of its constituents. And these are people with their own fantasies and fears.

Sometime either of these bull & bear periods could be prolonged enough to engulf even the toughest of the minds.

When it so does, the results are pretty silly. An adult with all this accumulated wisdom and with access to all unbiased facts ends up acting foolish. He does what his mind is ‘hardwired’ to do right since the days in savanna – following the crowd. “After all”, he thinks, “how can all of these intelligent fellows be wrong?”

And they are – if all are justifying their actions based on that of others. How is much is worth all your wisdom if you wish not to use it?

To me, it is crystal clear that we are living in one such irrational period of time. Broader market multiples are way far from where they generally are. In fact, they are literally going through the roof!

Image Source: Multi-Act newsletter (March 2017)

Current valuations are atleast 50% higher than their long term averages based on price to earnings ratio. And the results of such divergences have seldom been a ‘happy ending’.

So for current valuations to revert back to their long term average, there has to be at least one third of price correction or earnings should rise by 50% in the near term. Safe to say, chances of former is higher than the latter.

What should one do?

Armed with this knowledge, how should one respond? Is there a way to protect ourselves from someone else’s folly or even better, can we take advantage of Mr. Market’s folly?

This is how I happen to think about the subject:

  1. Predicting a fall is a futile exercise:

    Facts show that valuations are stretched and at some point, it has to revert back to its mean. But they don’t tell when. And they never do. There are hundreds of important variables interacting to determine our future. And to predict the it, one first have to predict those hundreds of variables, accurately.

    Any one wishes to give it a try?

  2. Ignoring valuations is dumb:

    People say that Indians are very price conscious. One generally does research, read reviews and ask friends before buying a 10K smartphone. They hardly do the same thing when investing 10L.

    Valuation is like gravity. Ignoring it is like intentionally hurting yourself. Higher the sums, more would be the damage.

  3. Be comfortable living with volatility:

    Just as gracefully one accepts ‘multi-baggers’, one need to take in those horrifying 50% falls. As Charlie Munger says, if you cannot stomach 50% declines in your investment you will get the mediocre returns you deserve.

    Well, I would add to it two things here (a) do not invest sums you would be needed within the next 5 years (b) if you indeed cannot stomach that kind of volatility, choose someone to work with who has a demonstrated track record of doing do.

I continue to do things I generally do. That is trying to turn around stones in search for bargains. Needless to say, this search has become painstakingly more difficult since, during such times, what we get is more dirt beneath those stones rather than what one would expect.

Which is fine. I don’t expect Kohli to turn centuries in every match then why should I expect too much from myself every now and then? I plan to continue with the routine and occasionally doing away with the overvalued securities and waiting on the crease for the ball that I can play well. Its test cricket which people are mistakenly considering as T20s. Difference between how one plays in each of these is huge!

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