I have been investing for the past 3-4 years in Indian stock markets. I have read and learned a lot about investing over these years. When I started, I read indiscriminately whatever I could get my hands on including investment philosophy of reputed investors like Charlie Munger, Warren Buffet, Benjamin Graham, Ray Dalio, Howard Marks, Jeremy Grantham, Seth Klarman, Sanjay Bakshi, Peter Lynch, Philip Fisher, Bill Gross, Prem Watsa and so on. Of course I have been influenced by some of these investors more than others. Most influential for me have been Warren Buffet, Charlie Munger and Sanjay Bakshi. Through this indiscriminate reading and through my own experiences, I have been able to put my investing philosophy within some kind of a framework. Through this article, I want to describe that framework as it stands currently.
What I have learned so far first and foremost is that, it is very difficult to make good money (by which I mean to beat the index) consistently in the stock market for any investor. Charlie Munger has said so himself –
Its not supposed to be easy. Anyone who thinks it is easy is stupid!!!
I feel that equity investing is like a game which is rigged against the average investor. It is akin to a casino, in which the odds by design favor the house and are against the players. In the casino, the game is rigged in such a way so as to give a slight advantage to the house such that over long period the house always wins. The trick is to invite the players with what appears to be a good deal (but is actually not) and then beat them.
In a similar way, the odds are stacked against the average investor in the stock market. There are multiple factors –both direct and indirect, which affect the price of any stock. These factors include the state of the general economy, the state of the particular industry and the competitive forces within the industry, technological changes and its affect on the company, company specific factors such as the quality of the products/ services, quality of management, and so on. As an investor, we are supposed to be at the top of each of these factors and how they affect our investments. For an average investor, this is indeed a difficult task.
To add to our difficulty, the stock market has come to be dominated by institutional investors such as money managers and ETFs. These are very smart people who have spent a considerable amount of time not only learning but practicing investing. The investing game is fiercely competitive and getting even worse. In all humility, we should remember that every time we make a new investment, we are competing against some very smart people. The tools which are available to these sophisticated investors are far better than those available to an average investor. It is like an amateur going to play in a game – let us take cricket – against the professionals. Imagine an amateur (like me) going to bat against the bowling of Shoaib Akhtar. What are the chances of me scoring a century? I can tell you for sure that the chances of me even scoring a single run are quite remote, leave alone a century. I simply do not stand a chance in that game.
This is a dramatic portrayal but puts across the point which I’m trying to make. Let me take this metaphor forward because it illustrates an important point. If I had to play cricket, how can I improve my chances of winning? Firstly, I will not play against the pros; choosing to play instead with other amateurs. Secondly, if I have to play against the pros I will never play by their rules. I should instead play a game which I’m more familiar with let us say underhand cricket. I might still lose but I have certainly improved my chances of winning. By and large, the chances of winning are better if we stick with option one, but if we have confidence in our ability and we play by our own rules and not by THEIR rules we can chose option 2 as well.
So, how is all this related to investing? There are close parallels to the options I have described above in cricket to investing.
Option 1 is quite straightforward. You may have guessed that these are situations where either institutional investors don’t participate or better yet, are actively retreating – not because of the inferior quality of the investments but because of some external reasons like their mandate etc. We can also refer to these situations as pockets of inefficiency in the market because that’s what they are. Below, I discuss couple of these pockets of inefficiencies which I have come across during my limited time in the market.
Option 1: Don’t compete with the pros – easy
- Demerger situations
- New venture by an established businessman
Much has been written about demergers and I don’t want to repeat it here. Essentially in a demerger a company is split among two or more companies. The shareholding pattern of each of the resultant companies mirrors the shareholding of the original company. In most cases of demerger, one of the companies being demerged (usually the bigger one) contains a mature business which is doing well and is loved by the institutional investors. The other company (generally the smaller one) contains a business which is growing and requires external support during its growth phase. The smaller company is a drag on the profitability of the bigger company and hence not liked by the investors. As a result of the demerger, all the shareholders are allotted shares in the smaller company proportional to their shareholding in the original company. After the smaller company is listed, most institutional investors exit because of various reasons – either the company is too small as per their mandate, or they originally invested because of the mature business and never wanted to be a part of this business. Whatever the reason, the end result is that there is a drag on the stock price of the smaller business for sometime after its listing because of the exit of the institutional investors. IF this is a good business, this creates a perfect window of opportunity for the retail investors.
If we chose wisely amongst multiple demerger opportunities that come along our way, this can be a very good opportunity to make some good money quickly. Below I have shown two demerger opportunities where I was involved – Orient Paper and Marico Kaya. Without going into details (which requires another article), I am presenting their share performance post the demerger.
Figure 1 – Orient Paper
Orient Paper was demerged in March 2013. It has given returns of 15%, 36%, and 39% CAGR over 1, 2, and 3 years respectively. CAGR till date is 71%.
Figure 2 – Marico Kaya
Marico Kaya was demerged in July 14. It gave an eye popping return of more than 600% in less than one year!! Its stock subsequently stopped trading due to some corporate restructuring.
New venture by an established businessman
The second case is similar to the demerger situation in some ways. In this case, an established businessman with a good track record sells his business. His plan is to start a new business (generally in a different sector) or focus his energies on an existing smaller business with the proceeds of the sales. This is an opportunity for average investors like us when the businessman uses the same listed entity to start the new business or continue the existing but small business. Again in this situation, the institutional investors generally exit after the sale of the mature business due to the same reasons as that of the demerger situation – company being too small, the mature business for which they invested has been sold off, mandate restrictions etc. Additionally, there is some fear in the market of promoters diverting the money for personal use. If the promoter is ethical and has a track record of ethical conduct and fair treatment of all stakeholders, it again creates that window of opportunity.
I have personal experience with one such business – Piramal Enterprises. This has been explained by Prof Bakshi here. I got attracted to Piramal Enterprises after reading this article. Please see below the performance of the Piramal stock post the sale of their pharmaceutical business to Abbott in May 2010.
Figure 3: Piramal Enterprises
Piramal stock was increased at a CAGR of -28%, -8%, 3%, 6%, 15%, and 16% over 1, 2, 3, 4, and 5 years respectively (without including the dividends for simplicity). CAGR till date is 22% and I believe the story remains intact with more to come in the future. Patience has been the key here.
These are just two areas with built in inefficiency which I have been able to identify during my limited time in the market. There might be more but I have not come across any which are as attractive as these two. For example, penny stocks are another area where generally the pros do not invest because of their mandate restrictions. Penny stocks are in general riskier because of a lack of disclosure and transparency issues. Plus, they are more volatile as they are prone to manipulation by speculators. But if we are able to identify an attractive company whose stock due to some reason is selling in single digits and we have the stomach to withstand the volatility, we should consider investing in it. But inherently the two situations which I have described above are more attractive than penny stocks. That is because not only are institutions not participating in those areas but they are actively selling their holdings creating a downward pressure on the prices and making them more attractive. The active selling is absent from the penny stocks because there are no institutions to begin with.
Finally, on the timing of selling and the returns. Patience is a virtue which is an ally in the stock markets just like in other areas of life. Once we have identified the investments correctly, we should give it time for the story to play out which takes its own time. Sometimes it might take longer but at other times we will get lucky and things will happen quickly. Of course, we can increase out chances of getting lucky when we remain disciplined and patient.
Option 2: If you have to compete with the pros, don’t play by their rules – difficult
The second option involves competing with the pros. No wonder this is more difficult option. However, we can increase our chances of winning if we stick to businesses we understand. I refer to these businesses as my circle of competence (CoC) – a term coined by Warren Buffet. A business comes within my CoC if I can answer the following questions in the affirmative – 1) Do I understand the business? 2) Can I say with reasonable amount of certainty that the business will still be around in 10 years? I try to invest in businesses only which come within the parameters of this CoC.
Do I understand the business? A good starting point to understand the business is to understand the Porters Five Forces for the business. I should have clarity around – 1) What products/ services does the company sell. 2) Who are its customers and what is their bargaining power. 3) How do they reach their customers – directly or indirectly (through intermediaries) 4) Who are their suppliers and what is their bargaining power. 5) Competitive Intensity within the industry.
Can I say with reasonable amount of certainty that the business will still be around in 10 years? For this we can look at the other couple of forces from Porter’s framework: 1) What is the threat of substitutes for their products/ services. 2) What is the threat of new entrants in this business.
If the answer to both of the above questions is yes, I will consider investing in them. However, even within this restricted CoC I will have hundreds if not thousands of businesses. As an average investor with little time on my hands, how to I decide where I will focus my time on? That is a question I have grappled with the most and still do. To narrow down the list, I chose to focus on an investment only if it has the potential to provide extraordinary returns (is it a fat pitch?). I’m sure you have heard the expression – “picking pennies in front of a bulldozer”. Well, I don’t want to be picking pennies anywhere leave alone in front of a bulldozer. What I have found during my very limited experience in the markets, that there are two situations where the rewards can be specially gratifying if the thesis turns out to be correct:
- A good quality business whose strength is underappreciated by the market
- A good quality business going through a temporary (and solvable) problem
What is a good quality business?
There are innumerable books which claim to teach us what is a good quality business. I certainly don’t mean to convey I understand what constitutes a good quality business but I have been trying for the past few years. In my very humble opinion, a good quality business is any business which is capable of creating REAL VALUE for ALL STAKEHOLDERS (including suppliers, customers, employees and shareholders) over EXTENDED periods of time. This is something I studied in business schools and is one of the few things which has stayed with me. While this is a very broad definition and one can be forgiven for thinking that it does not mean anything. In other words, we cannot gain any actionable investment insights from this definition of quality business. If so, I beg to disagree. Let me prove that by giving three examples of specific companies where this definition might have proved useful:
- Valeant Pharmaceuticals: I’m sure most people are aware of this one given the recent controversy surrounding this company. Their strategy was to buy other pharmaceutical companies and then astronomically raise the prices of some of their life saving drugs. A lot of sophisticated investors including Bill Ackman burned their fingers (or maybe more) in this fiasco. I failed to understand the value add that they are doing. The same drugs were available to the customers earlier as well. They were now being asked to pay much higher price for the same drugs just because it is now being sold by Valeant. Pardon my French but a strategy focused on fucking your customers cannot be sustainable!!!
- Herbalife: This is a story which is still ongoing and a decisive settlement of this argument is still some time away. Bill Ackman and Carl Icahn have sparred publicly over the merits of this investment. From my perspective, and if you understand the business strategy of Herbalife, it is based on manipulation of their own employees. This is a business where the line separating the employees and the customers is very blurred. It benefits a few employees at the top disproportionately at the expense of all the others. Again, a business which is not only not adding but actually destroying value for a lot of the employees/ customers cannot be sustained over the long term. My bet is that Herbalife will eventually collapse under the weight of its own malpractices.
- Vaibhav Global Limited (VGL): Last but not the least let me take one example closer home from Indian stock markets. The stock was recommended by Prof Sanjay Bakshi in a very persuasive blog post available here. If you do not know this business, I would suggest you read the note in its entirety. When I read the note, which is quite long and detailed by the way, one thing in particular caught my attention. The typical customer of VGL is – white, middle aged, female. And my guess is that middle-aged is a euphemism for old people. They sell deeply discounted jewelry to their customers in the US which is advertised and sold through their own TV channels. My conclusion right away after reading the note and watching this video was that VGL is not adding any REAL value to their customers. What they are doing in effect is systematically targeting one of the most vulnerable demographics through targeted advertisements. These advertisements use every tool available in the psychology shed to trick the customers into buying products which are supposedly deeply discounted and hence of questionably quality. One more thing is worth considering about the type of customers who will buy this deeply discounted jewelry. My two cents on this is that these will be people from economically weaker section of the society who have better use for their money but are instead tricked into buying the crap using a cocktail of psychology and glamor.
So, sometimes it can be helpful to think in broad terms about the business of the company. I have learnt a great deal on quality of business from reading the annual letters of Warren Buffet and from the blog of Prof Bakshi. However, my understanding on this topic is still evolving.
The thing about quality businesses is that, they generally command premium valuations and the challenge is to acquire them at a reasonable valuation. And that I think is the beauty of investing in listed companies. Because Mr. Market every once in a while provides that small window of opportunity when that great business is available at a reasonable valuation. I have described two situations of that window of opportunity above. First, when the quality is still not recognized by the market in general. Second, when the market assumes wrongly that the quality has been permanently impaired.
In both the situations, the rewards as I mentioned are extraordinary. And that is because, our hypothesis is different from the market view. Stock prices are NOT a reflection of the reality, but rather the markets perception of the reality. Accordingly, the stock prices already reflect that perception. We can make outsized returns only when we have more nuanced understanding of the reality than the market’s perception.
I’m sure there are many examples of both the situations but let me talk about one example of each case which I have personally experienced – Relaxo Footwear for case 1 and Shriram Transport for case 2. I got the idea for both these stocks from the posts of Prof Bakshi.
Relaxo Footwear: Relaxo is a quality business which sells high quality footwear at prices which are difficult to match by its competitors, of which there are few. Prof Bakshi explained the business and its strengths in detail in this post in September 2013. At the time the quality of the business was not widely recognized in the market and hence it was selling at a PE of ~15. Over the next two years, the market suddenly realized the strength of this business. Is PE increased from a very reasonable 15 in Sep 2013 to more than 50 in September 2015. Additionally, its earnings increased at a CAGR of more than 50% from FY2013 to FY2015 and accordingly the stock prices increased by a factor of 6 during this period. Market’s perception of the reality was clearly not correct in Sep 2013. If, like Prof Bakshi, we had a better understanding of the business than market’s perception, that insight could have made stellar returns for us.
Shriram Transport Finance Company (STFC): STFC is one of the largest NBFCs in India. Their primary business is to finance the purchase of second hand commercial vehicles for small entrepreneurs, for whom this is their first or the second vehicle. STFC has a virtual monopoly in this business. They are going through a rough patch due to the downturn in the economy which has a direct bearing on the business of their customers. Hence their customers have been unable to repay the money and they have experienced increase in NPAs. Market’s perception here is that their business strengths have been impaired which is evident from their relative valuations compared to their peers. My view here is that their underlying business strengths are still intact. While they have made a few mistakes, but they will learn from the mistakes and the business will be restored to its glory in the coming few years as the Indian economy recovers and capex cycle comes back. This is still an evolving story and only time will tell whether market’s perception or my understanding is closer to the reality.
Why invest in quality businesses (and management)?
So far we have looked at two situations where the probability of earning extraordinary returns is higher than others. Both these cases involve investing in companies with quality businesses. While I have so far not mentioned, but I invest in a business only when I’m convinced that the management is committed to the business, they are intelligent and hardworking people and who are above all else honest and ethical in their dealings (lets call them quality management for the lack of a better word). And I stick to quality businesses and management because it lets me sleep well at night.
Equity investing is like a minefield which is filled with risks of all kinds. Invest with quality businesses and management, helps in reducing or mitigating many of these risks. The risks in investing can in general be grouped into the following categories:
- Risk of an economic downturn/ recession,
- Business risks – which includes slowdown in demand for the goods/ services brought about by factors other than economic downturn, which could be
- industry wide: for example, with the emergence of internet, the newspaper business is facing a slowdown in demand
- specific to business – quality issues
- Financial risk – too much leverage
- Valuation risk
- Management risk – Incompetent/ unethical management
When we invest in quality (business and management), we implicitly or explicitly take care of most of the risks cited above except the first one. Because we understand the business and feel that the business will be around for 10 years at least, it mitigates some of the industry risk as the chances of rapid change and disruption in the industry are lower. By their very definition the chances of business risks in quality businesses are lesser than others. Additionally, quality businesses seldom require high amount of leverage and in rare cases where they do, quality management will always find ways of keeping the debt within reasonable limits. Finally, valuation risk has been an integral part of all the four investment situations we have discussed.
First we looked at two pockets of inefficiency in the markets which are created by active selling by the sophisticated investors. Usually, this selling is due to factors totally unrelated to the quality of stock or business, hence creating an opportunity for other investors. Second, we looked at two situations where our advantage is our superior understanding of certain business. In both these situations, our perception of reality is different from markets perception of reality. We are competing with the sophisticated investors and hence the risk in this case is that we are wrong.
I generally stick to these four situations. If I’m reasonably certain that I have identified one of these situations, I swing hard and would like to invest a substantial amount of money. And then I sit back and relax and wait to get lucky!!