The Investing Journal

Notes on long term thoughtful investing

Page 2 of 7

Capital Cycle Investing: Figuring out the Fade Rate

Reading about how other successful investors have, over the years, threaded their path ends up uncovering some fresh insights. And even if many a times these insights are not as ‘ground breaking’ as others, these offer interesting perspectives to look at existing realities. They helps us by way of broadening our worldly understanding of the events around us.

For example, Graham’s way of looking at market fluctuations have added a new dimension to our understanding about market movements. No longer are we avoiding volatility. Rather, we are seeking to reduce the chances of permanent loss of capital. And volatility, in many ways, is a core driver of our overall returns.

Similarly, Buffett’s calling to sometimes pay up for certain kind of businesses has helped us to embrace entities with hard to replicate advantages. His concept of ‘circle of competence’ has ensured that losses due to one’s ignorance are minimized. And Munger’s system of multi-disciplinary thinking promises us of reaching places which otherwise was unthinkable.

Left upon us, harvesting such deep in-sights would have easily taken a lifetime of trial and errors. As Newton once said we are truly ‘standing on the shoulders of giants’.


Capital Cycle way of investing

Recently, I was reading ‘Capital Returns’ – an impressive collection of essays written by Marathon Asset Management over 2004-2014. In one of its chapters, they discusses their core investing framework. It goes like this:

Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one. From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons.

This chart conveys the above para beautifully –

Capital Cycle approach to investing

Capital Cycle approach to investing

Notice that they do not get themselves tied with the conventional way of ‘growth vs value’ investing way of thinking. At times, they become growth investor without paying up for growth and at other times they turn into value seekers. At both the times their expectations are higher than that of the market which presumably is on the pessimistic side.


Expectations Investing Vs Capital Cycle Investing

One can draw parallels between this and ‘expectations investing’ which Michael Mauboussin has effort-fully explained us over the years. Essentially, he says that successful investing is about figuring out those situations where market’s expectations are pessimistic than what a rational mind would expect. And also avoiding those where expectations are going through the roof!

But at one place this theory diverges from mainstream investing. While expectations investing could be applied to every kind of company, capital cycle approach deals with more or less those areas where rules of capital cycle applies. That is to say that franchise companies where in excess returns do not converge to average rate of return over very long periods are more or less left out of the investing universe. Guys at Marathon refer to them as situations where in ‘capital cycle breaks or cease to operate’

In a way, this theory excludes those fertile hunting grounds based on which Buffett has built $450Bn worth Berkshire over more than half a century!

Another point at which this theory departures is that on number of stocks to be held within a portfolio. Marathon says that they are looking to bet on an industry which looks well placed to benefit from a cyclical upturn. Hence, while individual companies matter, but what they are more concerned is with their portfolio’s exposure to a particular sector.

Invariably, this means that although their ideas may be concentrated on few events unfolding at the industry level, their portfolios are diversified. Nothing wrong in this. Only problem is that the effort required to be spent on managing a portfolio goes up as the number of stocks in it goes up. Those nagging company specific issues does consume our limited ‘mind share’

What compounds the problem further is that there are limited number of sectors in an economy and each of these are not investible at all points in time. That means one needs to look at multiples countries and multiple sectors there in. This widens the landscape sufficiently. However, it also means that now one is dealing more often in unfamiliar terrain. And getting one well acquainted to each of these is not easy. Also, dealing with multiple currencies has its own set of challenges.

Ability (and conviction) to concentrate on a limited number of stocks is advantageous in multiple ways.

Despite all of the above differences, capital cycle approach is worth understanding and Marathon’s collection of essays are worth reading. Given the challenges they face, the efforts they undertake while investing in broader geographical markets and their experiences there in are worth meditating.


Management Evaluation: Why is it important & how to go about it

Investing, in simple terms, is about figuring out two things:

  • The depth of competitive advantage enjoyed by the company, if there’s any.
  • Based on (i) above, trying to come up with a conservative estimate of its value in light of the business landscape 5-10 years from now

Or this was what I used to think before I came across this quote by Buffett –

 “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”


Why is it more often ignored?

 The shorter investing horizon which most of the investors (read as speculators) employ make them oblivious to capital allocation and management’s temperament. Actions of  the same company managed by same set of guys receives different interpretations from different investors depending upon from where do they belong.

Different horizons make interpretations go haywire. Take Valeant for example. They were acquiring brands and improving its margins. Near term, quantitative assessment would put them as ‘turnaround specialist’ or even as ‘bargain investors’ glorifying what they were doing. But a closer look would reveal that they were rapidly taking on debt and hiking up drug prices. Also, their frequency of going out for an acquisition was a bit scary.

If you had a 2-3 year horizon, you would have liked the immediate gratification which shareholders were blessed with by such aggressive moves of the management. Whereas, if you employed an owner like mind-set (thinking as if you buying 100% of the business possibly to own for next decade or so) those drug price hikes and ever increasing leverage would have seemed scary.


Why is it necessary?

For someone planning to hold a concentrated portfolio with longer time horizon and employ an owner-like mindset to investing as I plan to, ignoring management assessment just because it isn’t as black and white as we expect doesn’t make any sense.

Even for someone who uses a shorter horizon to invest (< 3 years), ignoring management quality may not serve him well over his investing lifetime. Valeant is not just one singular example. Investing mistakes are filled with such kind of thrash.

Following are some points why I feel its indispensable:

  • Capital Allocation: Need I say more? Buffett has said it so clearly. What management does today with our moneys will decide how much would we earn as owners tomorrow.
  • Effort Allocation: In non-asset intensive businesses, more than capital allocation, business strategy or effort allocation is something one needs to watch out. Take for example IT services. The areas where the respective managers focus today would mean how these companies look like 5 year hence.
  • Management creates moat: While moats or competitive advantage rests on what kind of industry company is into, management has an important role to play depending upon the industry. Jockey and Rupa are the brands belonging to same industry but the return they generate on capital is widely different
  • Management widens the moat: Having a moat is not sufficient. Eventually, there is a possibility that competition might be able to narrow the differences. What is more than important than having a moat is to understand that whether the management’s action deepening it further or actually doing the reverse i.e. filling it with mud?
  • Sharing the rewards: Is the management (especially promoter-manager) privately taking up all the gains or are happily sharing them with their non-controlling co-owners. Lot of MNCs would fail this test.

The above points are by no way exhaustive but should communicate why is it important to not roll your eyes when it comes to qualitatively assessing the management.

But how should one go about it?


Analyzing Management

Let’s look at Buffett’s decision-making matrix.

Buffett’s decision-making matrix

Buffett has taught us to focus on what is ‘knowable and important’. That is to say focus on what matters and what we can possibly know about. No point worrying about unimportant or unknowable things.

When it comes to management’s evaluation, it sits in two quadrants.

It is important and hence would appear in the top boxes. It’s partly knowable and partly unknowable.

To the extent we have its past track record, we can study it and make a probabilistic assessment of its future track record (similar to pattern recognition). Its past track record is knowable & important while its future, depending upon the course of actions which management takes, is unknowable beyond a certain degree of probability.

If for some reason (takeover, succession, merger, etc) decision making were to change then it makes sense to study the history of this new decision maker. If that’s not yet available, it would be difficult and we could be early in terms of making an assessment based on limited history.


Factors to consider

Most of the things to consider would depend upon the context of industry it is into and its economic prospects. But some general things would be:

  • Capital allocation: Invariably this is the first thing to consider. Where have been they investing over last 5-10 years? Is it diluting the existing core business or strengthening it? How does the incremental return on capital looks like?
  • Leverage: Are they too fond of visiting their bankers frequently or they prefer to sleep well?
  • Payout: Are they expanding the kingdom at cost of its citizenries?
  • Equity raise: Do they frequently find themselves short of funds or they highly value their stake in the company?
  • Private profiteering: Like making themselves and their relatives unduly rich at the cost of their non-controlling co-owners? Are they operating the ‘two-handled pump’ (deliberately reporting poor numbers to bid the stock down to aggressively buy shares and then do the opposite to sell it to the gullible public)
  • Temperament: What do their comments in annual report, concalls tells you about their thought process – do they have the temperament to create long term wealth by delaying gratification or is it the reverse?
  • Relative comparison: How have they being doing versus their close competitors – gaining business or giving its own business and making competition gradually dominant?
  • Accounting: Do they like inflating their book earnings because they find it doing so in reality a bit difficult?

These are just some pointers. The aim is to avoid partnering with guys who, as Buffett says, cause your stomach to churn!

I certainly do not expect black & white answer post this type of qualitative assessment. But would surely try to avoid those deeper shades of grey whenever I come across it. Nothing stops the management to not repeat an adverse act unless there is an expressed, clear intent to not to do so again. But again, there are limits to which we can trust someone who has betrayed us once, right?

The more we align our thinking to that of a business-owner, the better served we would be in our endeavour to create wealth out of the market over our investing lifetime.

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.

Is it a brand or just another name?

Things are never as black and white as one would expect in life. With experience, each one of us realizes that its mostly about ‘different shades of grey’ with some occasional patches of blacks & white here and there. Then, why should it be any other way when it comes to investing?

Whenever a business in question is enjoying dominance in its ecosystem (i.e. enjoying a strong competitive advantage), it is never due to just one factor. In fact, more often than not it is due to cumulation of multiple factors stacked one after the another. Hence, it makes our job as business evaluators difficult.

If you know that business is a dominating one, why bother cutting things down to the bone? Well, if you cannot explain something in simple terms, you probably don’t understand it as clearly as you think you understand – as yet. More specifically sometimes, out of the contributing factors leading to the dominance, some are just far more important than the rest. And it is those important ones which we need to track as owners.

Given that as value investors we more often take the contrarian route in stock selection (and are also handsomely compensated for doing so) the critical job then is to ensure that our conviction is rightly placed. Or at least realize early-on that we are wrong.

Its all about the brand, silly

Given that most of these dominant companies have reputation attached to their name, more frequently it looks like as if it is the brand which is driving things up. In most of the cases, it cannot be farther from truth.

Let’s take up a recent example. Couple of days back it was reported that an Spice Jet aircraft had an explosion in one of  its engines. There were no causalities as the aircraft was empty. In fact, the nearby fully loaded Indigo wasn’t as lucky and some of its passengers had suffered some minor injuries due to it (another case for airline rivalry! Michael Porter always knew this)

But do you think this incident would alter the your flight booking behavior henceforth? Mostly likely, it wouldn’t. We know that probability of things going wrong with an aircraft is one in a million and that’s about it. In fact, driving related casualties is far higher in India than mid-air casualties.

And now let’s take up not so recent example. Remember about ‘worms in cadbury’ episode  or ‘lead in maggi’ ? The probability of having each of these in your next serving is even lower than that of one in a million. But it had an effect on buying behavior in general – at least temporarily.

Also, its impact could have been far higher had it not been for the damage control measures which each of these companies took. Its closer to two years since maggi was reintroduced in the market clearing all the accusations levied on it. However, it is yet to achieve its erstwhile market share – though it has seen a robust recovery.

Airline and other two episodes highlights to us two things: (i) role of brands in the respective businesses and (ii) its resilience.

Something unfortunate happened with an airline carrier and with a noodle maker. But response to each of these events was vastly different. Why should so be the case?

The answer – in some businesses the role which a brand plays is far higher than others. Higher its importance, higher is the impact when ever it takes upon a hit.

Irrespective of however importance we may assign to the ‘name’ of a particular company or its product, the fact is not all names graduate to become a reputed brand – even in case of a dominant company. More often than not its just a name (or not a very strong brand) which we mistakenly ascribe far more weightage than we should.

Fertile hunting grounds

Fortunately, in order to asses whether brand is ‘the most important thing’ or not, one does not need to wait for an ‘episode’. There are other ways out there to figure it out!

For brands to prosper, they require suitable ‘breeding’ grounds. That is to say ‘names’ graduate to become strong ‘brands’ only under certain recognizable conditions. Investing in many ways is about pattern recognition.

So which are those situations?

When we purchase something, we undergo either of the two kinds of decision making processes: automatic decision making and appraisal based decisions. One may spend his days (and some sleepless nights) trying to figure out which car to buy. While we pickup our toothpaste from a frequently visited store’s shelf without even caring to turn around and look at its MRP.

So while brand plays some role while buying a car and a toothpaste, it is the latter where its relevance is just too high. Car buying process is more model specific and somewhat manufacturer agnostic – economy and maintenance cost matters more than manufacturer’s badge. Whereas today morning when I ran out of my supplies of colgate, I spent a minute thinking whether I should just skip brushing my teeth today (I didn’t skip finally! somewhat reluctantly tried another ‘indigenous’ brand)

Also, much more stronger and globally successful car manufacturers with a brand stronger than that of Maruti has entered post 2011. However, company’s market share has not been dented materially.  It is somewhat hilarious to see global giants like Toyota, GM and Ford finding it difficult to compete with India-Japan JV player. But this is how it is. And it offers us lot of important lessons on auto businesses in general.

Let’s go back to our car & toothpaste example. Most of the answers we are looking for are embedded here.

We know that brand has lot more to do with automatic decision making situations than the appraisal based ones. So, what drives automatic decision making? They are

(i) Continuity of use:   Higher the frequency of buying decision, closer it gets to our ‘reptilian’ brain or unconscious mind

(ii) Low ticket size: Lower value items are not where we spent sleepless nights thinking which product to buy. Loss-aversion behavior is low in low ticket value items.

(iii) Habit vs Novelty: We are creatures of habit. So, we do seek consistency. Situations which reinforce this need of ours generally gets an upper hand in decision making. Whereas novelty hurts habit forming process. This is one reason why parachute oil is sold in its trade marked blue bottles since decades. And so are the amul girl and parle-g boy not growing up.

(iv) Widely available: Products should be readily available. Stock-outs or travelling a couple of kilometers to buy my preferred brand of toothpaste only incentives me to try something else. And may be, convert

The above are just a few which can serve as good starting points. There is nothing known as ‘all inclusive’ atleast when it comes to investing.

Hopefully, you got a glimpse of what differentiates a stronger brand from others. Like the introductory para said, its never black or white. While there are degrees to which brands plays a role in different businesses, there are only a few places where its role is sin-qua-non. And it is those grey areas which sometimes can give us some sleepless nights. Probably this is why it said that investing is simple but not easy!

Next time if someone walks up to you and pitches a steel company because it is having a strong brand, change the topic immediately. You now know its not brand, its just a name. And name don’t drive return on capital employed over longer periods.

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.



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