Disclosure: No position in MCX.
I had earlier blogged about Ashiana Housing and this lecture on 21 December, 2013.
Varun Gupta, who is Wholetime Director at Ashiana Housing delivered this lecture to my students at MDI on 31 December, 2013.
Finally I got the time today to upload the edited lecture video on YouTube. I have spliced the lecture video into 25 segments. You can view the playlist here.
Before Varun delivered the lecture, students saw two videos. These were:
The lecture was organized with the help of my ex-student and colleague, Arpit Ranka. Thanks Arpit!
Note: I am long Ashiana Housing and hence you should assume I am positively biased in its favor.
I did another interview with Vishal Khandelwal of Safal Niveshak. You can get it from here.
My BFBV course @ MDI got over in January 2014. One of the highlights of the course was a live case on Relaxo Footwear, a company in which I am invested. The case was initiated at the beginning of the course.
On 15 September 2013, I posted a mail (The Relaxo Cinderella Project) to my students about the company. At the time, the stock price of the company was Rs 144 (on a 5:1 split adjusted basis).
Then, on 22 September 2013, my friend Ravi Purohit and I gave a joint lecture on the company (The Relaxo Lecture) in which we explained our investment thesis. At the time, the stock was quoting at Rs 150. Finally, I spoke about the company again in my class on 10 January 2014. By that time, Relaxo’s stock price had increased to Rs 224.
As I write this, it now stands at Rs 254. In this note, I am reproducing from my memory what I spoke on my 10 January class with some updated thoughts on the subject.
You can find the transcript here.
Alternate Link: https://db.tt/DSMrwoLm
Mohnish Pabrai delivered an excellent talk to my BFBV students on 26 December, 2013. You can watch the video from:
The two videos displayed during Mohnish’s talk can be viewed from:
Here is the BFBV end term exam administered in early December 2013. Students had been provied with extensive information on two companies beforehand which can be downloaded from here.
You’re welcome to post your answers here. I may not be able to give one-to-one feedback to everyone, however.
BFBV ENDTERM EXAM
SHRIRAM TRANSPORT FINANCE (60 marks)
Based on the information supplied to you earlier about this company, answer the following questions. Assume market interest rates to be 10% p.a.
SYMPHONY LIMITED (50 marks)
Based on the information supplied to you earlier about this company, answer the following questions. Assume market interest rates to be 10% p.a.
OTHER QUESTIONS (30 marks)
Disclosure: Long on all four companies mentioned above.
“The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.” – George Bernard Shaw
A few months ago, he was carried away to the prison by Delhi Police. In two days he will be Delhi’s Chief Minister.
I always find it instructive to pick up a good topical book which helps me understand what’s going on right now. And so, to understand the Kejriwal Phenomenon, I picked up David and Goliath: Underdogs, Misfits, and the Art of Battling Giants by Malcom Gladwell.
A few passages I highlighted in reveal that Kejriwal The Underdog, represents a pattern.
“He was an underdog and a misfit, and that gave him the freedom to try things no one else even dreamt of.”
“Much of what we consider valuable in our world arises out of these kinds of lopsided conflicts, because the act of facing overwhelming odds produces greatness and beauty… We consistently get these kinds of conflicts wrong. We misread them. We misinterpret them. Giants are not what we think they are. The same qualities that appear to give them strength are often the sources of great weakness.”
“Suppose you were to total up all the wars over the past two hundred years that occurred between very large and very small countries. Let’s say that one side has to be at least ten times larger in population and armed might than the other. How often do you think the bigger side wins? Most of us, I think, would put that number at close to 100 percent. A tenfold difference is a lot. But the actual answer may surprise you. When the political scientist Ivan Arreguín-Toft did the calculation a few years ago, what he came up with was 71.5 percent. Just under a third of the time, the weaker country wins.”
“T. E. Lawrence could triumph because he was the farthest thing from a proper British Army officer. He did not graduate with honors from the top English military academy. He was an archaeologist by trade who wrote dreamy prose. He wore sandals and full Bedouin dress when he went to see his military superiors. He spoke Arabic like a native, and handled a camel as if he had been riding one all his life. He didn’t care what people in the military establishment thought about his “untrained rabble” because he had little invested in the military establishment. And then there’s David. He must have known that duels with Philistines were supposed to proceed formally, with the crossing of swords. But he was a shepherd, which in ancient times was one of the lowliest of all professions. He had no stake in the finer points of military ritual. We spend a lot of time thinking about the ways that prestige and resources and belonging to elite institutions make us better off. We don’t spend enough time thinking about the ways in which those kinds of material advantages limit our options.”
“Why has there been so much misunderstanding around that day in the Valley of Elah On one level, the duel reveals the folly of our assumptions about power. The reason King Saul is skeptical of David’s chances is that David is small and Goliath is large. Saul thinks of power in terms of physical might. He doesn’t appreciate that power can come in other forms as well—in breaking rules, in substituting speed and surprise for strength. Saul is not alone in making this mistake. In the pages that follow, I’m going to argue that we continue to make that error today…”
“For some reason, this is a very difficult lesson for us to learn. We have, I think, a very rigid and limited definition of what an advantage is. We think of things as helpful that actually aren’t and think of other things as unhelpful that in reality leave us stronger and wiser. Part One of David and Goliath is an attempt to explore the consequences of that error. When we see the giant, why do we automatically assume the battle is his for the winning?”
“What the Israelites saw, from high on the ridge, was an intimidating giant. In reality, the very thing that gave the giant his size was also the source of his greatest weakness. There is an important lesson in that for battles with all kinds of giants. The powerful and the strong are not always what they seem.”
“Courage is not something that you already have that makes you brave when the tough times start. Courage is what you earn when you’ve been through the tough times and you discover they aren’t so tough after all.”
I had sent this to my BFBV students on 23 September when the stock was quoting at Rs 204 on a pre-split (5 for 1) basis.
Alternate Link: https://db.tt/MPJ8Qzdr
Unfortunately, the lecture could not take place as scheduled on 27 September. It is now scheduled to take place on 31 December.
Note: I am long Ashiana Housing and hence you should assume I am positively biased in its favor.
Edited transcript of talk delivered earlier today at OctoberQuest 2013, Mumbai.
I am experimenting with a new teaching style this year. Every year students work on projects in groups and it turns out no one cares about what happens in other groups. There is no collaboration.
This time, I am asking each group to work on each project. Each project is broken into “chunks.” The deliverables on each chunk will be collated and then the learnings from the project will (hopefully) emerge.
If you want to take a shot at it, here is the link:
There is one problem, however. There are so many experienced value investors who subscribe to this blog, that if they provide all the answers, it will defeat the purpose of teaching in this manner to my students at MDI. So, I will wait for a while before I approve any comment to enable the class to do some original work. Your patience will be appreciated. Thanks!
Transcript of my first lecture at BFBV course at MDI.
Huh? When did it start? Not for the last 16 years, no!
You can’t really stop what you haven’t started for last 16 years, can you?
Nevertheless, over those 16 years, Castrol India paid its shareholders dividends aggregating INR 28 billion and to top it all, as of the end of 2012, the company had Rs 6 billion in cash on its balance sheet.
Castrol is a cow that doesn’t need much grass but boy has it been milked!
In a recent interview with Charlie Rose, Larry Ellison talked about the long-term prospects of Apple without Steve Jobs.
I agree with Ellison and based on his writings (see below), I guess Warren Buffett would agree with him too.
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row.”
“If a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”
“As investors, we will be skeptical of businessmen trying to shepherd companies through brutally competitive industries. Instead, we will examine the entire investment landscape looking for businesses with solid moats. If some industries are more structurally attractive than others, we can choose to focus on only them because the odds of finding businesses with solid moats are higher. We can even afford to write off entire parts of the market if we don’t think they have attractive competitive characteristics.
A story on Financial Technologies (a stock which dropped 65% yesterday and then another 20% today) in today’s Livemint mentions “warehouse receipts.”
What’s the fear?
That there is no underlying commodity is the fear. NSEL says it will sell the commodity and meet its payment obligations, but what if there are no commodities?
Surely, there are warehouse receipts?
Yes, but these have been issued by a group company and there’s no clarity on the presence of commodities.
Die-hard Warren Buffett fans would remember the Salad Oil Scandal involving warehouse receipts too.
In an earlier post on floats and moats I had re-told that story, but let me do it here all over again.
The story starts in 1964. Warren Buffett is a young, dynamic investment manager and he is about to make his first big bet— a 5% stake in American Express. That’s 40% of his assets under management. Amex is embroiled in a scandal involving of things, salad oil.
Tino De Angelis, who is a convicted fraudster, is unable to get credit from a bank. So he comes up with a neat plan. Amex is a prosperous company with a stellar reputation. It also has a division that would specialize in “Field Warehousing”— a way for Amex to loan a business money based on inventory of goods and commodities.
Tino goes to Amex with many millions of pounds of very valuable salad oil and deposits it in one of Amex’s warehouses. Amex writes him a warehouse receipt, which he takes to a bank and uses it as a collateral to take out a loan.
There is a problem however. Tino’s “valuable salad oil” is actually seawater with no value. No one at Amex has bothered to check out Tino or opened the tank to see what’s inside. I guess there were issues with KYC even back in 1964.
Tino then takes the money from the bank and gambles it all away in— you guessed it— in commodity futures and options. He immediately files for bankruptcy. His bank goes to Amex with the warehouse receipt to recover his loan and oops do they have a problem when they open the tank containing sea water!
Amex discovers it has that it has a problem subsidiary. The extent of the problem? About $150 mil. That’s a very large sum of money in 1964. Amex’s Warehouse subsidiary files for bankruptcy but for Amex trust is everything. Its CEO says that Amex has a moral obligation to pay the bank even though its not legally obliged.
The market gets spooked. Amex’s stock drops from 60 to 35.
Ok, now let’s look at the magnitude of the problem— the way Warren Buffett sees it and the way the stock market sees it. First, from the market’s viewpoint.
As of the end of 1964, Amex’s consolidated balance sheet reveals that the company has no bank debt or bonds outstanding. Moreover the company has cash amounting to $263 Mil and a largely liquid securities portfolio having valued at $515 Mil. So, it appears that the loss of $150 mil on account of what now is being called as the “salad oil scandal” is not so huge that it can impair the company’s ability to survive and prosper. Until, of course, you look at $526 million dollars of travelers cheques outstanding and representing money taken by Amex in exchange of pieces of paper it has issued to millions of Americans which they can redeem for cash on demand.
What if there’s a run on Amex? The consequences could easily be devastating as the company would be forced to liquidate its assets to generate the cash to redeem half a billion dollars worth of travelers cheques.
Amex has not a missed a dividend in 94 years and now the stock market is pricing it for a potential insolvency.
We know that Warren Buffett disagreed with the market because over the next two years, he invests $13 million into Amex for a 5% stake and that is 40% of his partnership’s money. You don’t put 40% of you money into an idea unless you have deep conviction. So, what was Buffett thinking? Let’s speculate on that.
First, imagine that instead of $526 million of travelers cheques, Amex had bank debt of an equal amount outstanding. Would Buffett have invested? No. because the bankers would have immediately recalled their loans forcing Amex to get into a “fire sale mode” which could easily result in the decimation of its equity value. Clearly the bank debt of $526 million would be too risky but travelers cheques of the same amount instead, maybe not.
Second, how likely is that the millions of customers who hold the Amex travelers cheques will panic at the same time because of the “salad oil scandal” and will not only stop buying them, but will line up out Amex offices throughout the world to redeem them? Buffett goes investigating. He goes to shopping malls and observes customer behavior. He also asks an assistant to do the same in other parts of USA. Together they find that customers don’t care about the salad oil scandal and continue to buy and use travelers cheques.
The scandal’s tarnish is reflect in Wall Street’s valuation of Amex stock but has not spread to Main Street. He buys the stock.
He sells out by 1968 making a $20 million profit on his $13 million investment.
Unfortunately, no. Two key reasons.
If you bought the stock at its low price yesterday, using the “it-has-fallen-65%-so-how-much-more-can-it-fall?” “logic” you will be regretting your decision today.
There is no way a public market investor can intelligently estimate whether FT will be solvent or not a month from now. The needed information about the collateral behind those “warehouse receipts” simply isn’t there.
There are at least two more problems. First, when collaterals are sold off in a fire sale, typically they realise far less than their estimated value during normal times. The next few days for FT will not be normal.
Second, capitalism works on trust, and in an exchange business like that of FT, trust in the integrity of the system attracts buyers and sellers in the first place and their increased business volumes attracts more buyers and sellers and so a virtuous circle of “network effects” delivers the exchange owners with a moat. That trust now lies in tatters. So, even if FT remains solvent, its moat is now massively impaired, if not destroyed.
I have no position in FT or MCX or in any derivatives in either of these two stocks.
“The Deccan account is still not an NPA.”
Just an example of Psychological denial amongst bankers.
If an unpaid loan is not an NPA, what is it?
Reminds me of similar words once penned by Warren Buffett many years ago. He questioned the logic of companies not treating stock options as expense by asking three questions:
“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
Oh, I love those metaphors.
Once upon a time, I was reading an Aesop fable to my daughter.
The rabbit runs faster than the fox because the fox is only running for his dinner but the rabbit is running for his life.
I froze right there thinking
Hey Colgate is the rabbit and Unilever is the fox.
You see, Unilever had announced its intention to enter the toothpaste business. Market got spooked. Colgate stock fell.
An over-reaction obviously because
Colgate is the rabbit and Unilever is the fox
In a few weeks the market realised what Aesop had observed many centuries earlier. Colgate’s stock price recovered. Good trade. Thank you Aesop.
I have learnt that just as bacteria can’t grow exponentially for long, businesses too can’t grow exponentially for long regardless of what investment bankers say in their pitch books. I have discovered many hedgehogs who know just one thing, will over use it, and become supremely confident and a few foxes who use a multi-model framework, will use the appropriate ones to form their world views, and will never be absolutely sure of anything.
I have learnt the importance of cash in a portfolio from Buffett’s observation that if you want to shoot a rare, fast-moving elephant, you should always carry a loaded gun.
Aesop used the story of the swallow and other birds to teach me how evil spreads and why it’s terribly important to stop it early before it’s too late.
I have found opportunities when people throw out the baby with the bathwater or paint everything with the same brush.
Catching a falling knife is dangerous. And jumping out of a plane with a parachute which opens up 99% of the time ain’t worth it. If only the partners of LTCM had thought it that way, maybe they would have acted differently.
Victor Niederhoffer has observed that
In 1997, he bet heavily on Thai stocks using large amounts of leverage. Then the Asian financial crisis arrived and he blew up for the first time.
In the fall of 2001, he sold a large number of options, betting that the markets would be quiet, and they were, until two planes crashed into the World Trade Center. Niederhoffer blew up again.
Recently, he confessed
I made so many errors there it’s pathetic. I made one of my favorite errors: “The mouse with one hole is quickly cornered.” That is key. There are certain decisions you make in life that are irreversible, that lead you into a path you can’t get out of, and unless you have more than one escape clause, the adversary can gang up on you and destroy you.
Metaphors are useful. In fact you use them more often than you realise as George Lakoff and Mark Johnson write in their classic Metaphors We Live By. To see how, just imagine the conceptual metaphor ARGUMENT IS WAR and observe how it gets embedded in our everyday language.
Your claims are indefensible.”
“He attacked every weak point in my argument.”
“His criticisms are right on target.”
“I demolished his argument.”
“I’ve never won an argument with him.”
“You disagree? Okay, shoot!”
“If you use that strategy, he’ll wipe you out.”
“He shot down all of my arguments.
Metaphorical thinking is very powerful, says Roger von Oech, author of Innovative Whack Pack.
A wonderful harmony is created when we join together the seemingly unconnected.
A powerful way to join ideas together is to make a metaphor. You can do this simply by recognising similarities between unrelated phenomena. Indeed, this is how our thinking grows: we understand the unfamiliar by combining it to what we know. The first automobiles were called “horseless carriages.” Early locomotives were dubbed “iron horses.” Metaphors can also give us a fresh insight into a problem. For example, here are three metaphors for life. (1) Life is like a jigsaw puzzle but you don’t have the picture on the front of the box to use it as a guide. Sometimes, you’re not even sure if you have all the pieces. (2) Life is like a bagel. It’s delicious when it’s fresh and warm, but often it’s just hard. The hole in the middle is its great mystery, and yet it wouldn’t be a bagel without it. (3) Life is like a poker game. You deal or are dealt to. You bet, check, bluff, and raise. You learn from those you play with. Sometimes you win with a pair or lose with a full house. But whatever happens, it’s best to keep shuffling along.
What metaphors can you create?
You can extend the LIFE metaphor as George Lakoff and Mark Johnson do.
I’ve had a full life. Life is empty for him. There’s not much left for him in life. Her life is crammed with activities. Get the most out of life. His life contained a great deal of sorrow. Live life to the fullest.
I’ll take my chances. The odds are against me. I’ve got an ace up my sleeve. He’s holding all the aces. It’s a toss up. If you play your cards right, you can do it. He won big. He’s a real loser. Where is he when the chips are down? That’s my ace in the hole. He’s bluffing. The president is playing it close to his vest. Let’s up the ante. Maybe we need to sweeten the pot. I think we should stand pat. That’s the luck of the draw. Those are high stakes.
Sometimes metaphors clash so relying on the first one that comes to mind can be dangerous. For instance, when people think of first-mover advantage, they think of the early bird — you know the one who gets the worm?
Will that metaphor work every time. No!
To see why, think of
that second mouse— you know the one who got the cheese?
The big lesson here is that you must use metaphors but not overuse the ones that first come to your mind because that would make you look just like a man (or a woman) with a hammer.
Now, you wouldn’t want to be labeled that, would you?
Buffett tells us that the fundamental economics of a toll bridge are excellent. However, this post is not about a toll bridge. Rather, it’s about the “functional equivalents” of a toll bridge.
Now, apart from the reasons Buffett talked about, what are the other reasons that make a toll bridge a very good business model?
Now let’s think about what really happens on a toll bridge. If you stand at a vantage point high above the bridge, what do you see? Well, you see movement. You see traffic. And you see the toll barrier, i.e. the gateway. There has to be a gateway owned by someone and used by someone else to pass through. Vehicles passing through have to pay a toll. The toll keeper collects the money and opens the gate. Most of his effort came in making the toll bridge. Now, all he does is open the gate and collect the toll.
Now let’s see what we have. We have several key words or phrases to remember:
These terms constitute a “bridge” which will connect our physical toll bridge to the metaphorical one.
Do these terms remind you of something other than a physical toll bridge? Think about it for a while. What other business models require customers to pay the toll to use something that has no alternative in the mind of the users — something that involves movement of traffic and where the owner of the metaphorical toll bridge is the owner of a gateway?
In Orhan Pamuk’s best-loved novel “My Name is Red,” a chapter (“I am a Tree”) ends with this beautiful quote.
I thank Allah that I, the humble tree before you, have not been drawn with such intent. And not because I fear that if I’d been thus depicted all the dogs in Istanbul would assume I was a real tree and piss on me: I don’t want to be a tree, I want to be its meaning.
In the spirit of Orhan Pamuk’s metaphorical tree, our toll bridge is saying
I don’t want to be a toll bridge, I want to be its meaning.
Find other “toll bridges.” Here is a hint.
Post your thoughts. I will come back to finish this…
All right then. I have read your responses many of which were excellent!
It’s been such a long time. It feels good to be recognised at last. I am overwhelmed. You’ve figured out so many manifestations of me.
You spotted me in payment gateways like VISA and MASTERCARD. Billions of transactions go through me everyday.
You saw me in GOOGLE where advertisers pay me to make you discover them when you search for something that’s related to them. I am the gateway in the virtual world through which you end up going from where you are to where my customers want you to be.
In an earlier avatar, I used to be owned by newspaper and television tycoons. I was the gateway through which advertisers reached consumers but when GOOGLE arrived, I moved to greener pastures. As they say, the medium is the gateway.
You located me in the servers of the dominant stock (NSE) and commodity (MCX) exchanges, as well as transaction exchanges for second hand goods (EBAY). I am the gateway which allows billions of transactions to happen everyday and my owners take a cut every time a trade occurs.
You unearthed me in networks of gas pipelines (GAIL), electricity cables (POWERGRID). I am the gateway internet companies (BHARTI) use to make you pay for reading this. I am the network you use when you call your sweetheart or send him or her a gift (DHL).
Every year you notice millions of excited children rushing past me just to be close to a fictional character called Mickey Mouse.
Movie producers go through me to display their movies to you. Your iPhone has more than 50 apps bought from me — the iTunes store. Thousands of app writers pay me the toll to enable them to sell their apps to you. Hundreds of vendors use me — the amazon.com storefront — to sell their wares to you. They pay me a nice commission too, every time you buy.
If you are a company and you want to raise capital, you better go through me. I am the influential investment banker. I am the dominant credit rater. I can reduce your cost of capital. And I will collect my toll.
You found me in Religion too. I am the temple you give money to. Inside your mind, I am the
stairgateway to heaven.
You may think of me as evil, but look I am just a gateway who’s doing its job. You paid a bribe to a toll-keeper babu to move that environmental clearance file to that senior officer who has his own toll collector just outside her office. Yes, I know I am in trouble because of my friendship with a high-profile company. Arvind says I am its gateway for getting things done. Am I? I’ll leave that judgment to you.
So you see, I’ve been around. And I am awesome. But under what conditions do I become truly awesome? That happens if:
Now you know the criteria. But beware! There are many masqueraders out there pretending to be me. Why, only yesterday a brand was posing in front of you as me! Imposter!
Didn’t you know I don’t cost much to maintain? You don’t have to spend a fortune to take care of me. That’s not what happens with big brands. Their owners have to spend fortunes
investing in maintaining them — billions and billions of dollars every year. Brands are far more demanding than me. I don’t ask for much at all. My needs are few and far between. Just keep me in good shape by spending a little here and a little there and I will keep you happy year after year. When you think of me, think Vatican, not Coca-Cola.
There are some tiny toll bridges out there who aspire to be me one day. If you spot them early, and own them before they become big like me, you could become rich like me.
I can be yours, but first you’ll have to find me.
I have lost 100% of my money in Kingfisher and I am pissed.
Pissed with Kingfisher. Pissed with Wife. Pissed with Amex.
Pissed with Amex? What’s wrong with me? And how did I end up investing in Kingfisher?
Well, one evening, I took a friend to a very nice fusion food restaurant in south Delhi called Indian Accent.
I had booked a table for dinner using my Amex card concierge service but Amex screwed up. When we arrived, we were told there was no table booked for us.
My face, neck and ears suddenly felt impossibly hot. What must my friend be thinking? How could Amex do this to me? To ME?
In a fit, I yanked out my phone and called Amex. The girl on the other end of the line — we will call her Shilpa— couldn’t possibly have felt the heat of fury on my face but surely she would have been terrified of my shaking, trembling, and very loud voice.
CANCEL MY CARD NOW! I shouted.
While that poor girl was still trying to figure out how the fuck up happened, I borrowed a pair of scissors from the restaurant, cut up my card into two pieces and then told her how nice it felt to do it. Brilliant!
And then I remembered my points. A few hundred thousand of them. Shit!
I was about to lose my lovely Amex points. Deprival Super Reaction time! Do something! Why not transfer them to my Kingfisher air miles account? Great idea!
So I ordered Shilpa to immediately transfer them to my Kingfisher miles account. This happened about 18 months ago, when Kingfisher was not dead yet, had all its planes, and had very cheerful staff. Shilpa made the transfer with just a few keystrokes and that was that. For now.
Amex got in touch with me later, apologised about the fuck up, compensated me for the embarrassment, and reissued my card. But my Amex card points were now Kingfisher miles.
Things got worse for the airline and a time came when I was just too scared to be on a Kingfisher flight being flown by a very depressed pilot who hadn’t been paid his salary for several months and who felt that “today, I will teach him a lesson, now where’s that penthouse? “
Why take that risk?
But, why, you ask, didn’t I redeem my miles earlier? Well, my wife wouldn’t let me. The risk of cancelled flights was just too high, she reckoned. She switched me to super-efficient, low-cost Indigo and I never looked back.
And that, dear reader, is my sad story of how I ended up becoming an unpaid and unsecured creditor of a high-cost, highly-leveraged, loss-making, and soon-to-be-shut-down airline.
Who’s to blame for my losses? Amex. Kingfisher. Wife.
All of them. Anyone but me.
I asked this question from my students in the mid-term exam at MDI today.
Company A’s stock price is quoting at Rs 35 per share. Suddenly, a competitor of Company A makes an offer to buy out all the outstanding shares of the company at Rs 100 per share. The stock promptly zooms up to Rs 80, at which price you can buy a large quantity, if you wish.
You and your friend have evaluated this risk arbitrage opportunity. Here are your findings:
This is an experiment in teaching and learning from each other. Let’s see how it goes. If it goes well, I will repeat this experiment by introducing newer problems.
This current problem is a hypothetical one but serves as a really good basic template for working on risk arbitrage. In my view, risk arbitrage is an excellent building block for learning value investing because it requires a mindset of an unbiased, unemotional, and rational decision maker. Moreover, it does not require making long-term predictions about businesses, managements, or the economy.
This is an invitation to you to answer the questions listed above. I will accumulate the submitted answers over the next three days i.e. until 23 October 5:30pm. I won’t approve answers until the deadline has passed.
Once the deadline has passed, I will approve all the answers posted. Then, if needed, I will add more, complex questions. The process of questioning and answering will follow a method used by Socrates and which is called “Socratic Questioning”
Socratic questioning is disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion. The key to distinguishing Socratic questioning from questioning per se is that Socratic questioning is systematic, disciplined, and deep, and usually focuses on fundamental concepts, principles, theories, issues, or problems.
Hopefully, the process of Socratic questioning will produce some really good insights.
The person who submits the best answer and subsequent insights will be awarded a copy of “Thinking, Fast and Slow” by Daniel Kahneman. Just a small incentive for achieving a higher end. :-)
Many of you have given excellent answers. I will keep the answer brief because I want to spend time on the concept and also on taking the topic to the next template.
You should invest in this opportunity if you are looking for good bets which are not correlated to the market provided that it’s a small bet and it offers returns which are superior to a bond investment. As Ankur Jain (my ex-student and colleague) points out, we need to know the prevailing interest rates. The prospect of earnings Rs 10 on an investment of Rs 80 over a period of 90 days which translates into a flat return of 12.5% and an annualised return of about 51% looks very good because in the back of our mind we know that prevailing interest rates are much lower. But if India was going through hyper inflation and nominal interest rates were higher than 51% p.a., this would be a bad trade.
If CCI rejects the acquisition proposal then the offer stands cancelled and reason for owning the stock no longer exists. This sale will result in a loss but that is part of the (probabilistic) game we are playing. It would be foolish to anchor to cost (anchoring bias) or find new reasons to own the stock (commitment bias).
The correct psychological response to the loss scenario is to swallow your pride and to take the loss by “thinking like a trader.” You can console yourself by thinking “you win some, you lose some.” In other words, focus on process not outcome. Good processes in the probabilistic world of Fermat and Pascal sometimes result in bad outcomes. By keeping the eye on the process and being unemotional is the right psychological response.
If your friend refuses to make this bet, he is suffering from loss aversion. This is a very common bias and was discussed beautifully by Daniel Kahneman in his book “Thinking, Fast and Slow.” See this link titled “Samuelson’s Problem.” Risk arb teaches how to get out of loss aversion extremely well. If you don’t take losses which are going the occasional but inevitable outcomes of even good investment process, you won’t last very long in this game. That’s one huge reason why I consider doing risk arb as a great building block for other forms of value investing.
Kahneman also provides an elegant solution to the problem. Carefully read “Samuelson’s Problem” to find it. Many of you have referred to this “death bed problem” by using terms like “broad framing” and “loss aversion” in your answers. Those of you who have done this are bang on target.
I talked about the idea of socratic solitaire in an earlier blog post. I will use that idea again over here by asking some questions and answer them myself.
Question: Why a small bet? Why not bet the bank on such bets? After all they have large, positive expected payoffs!
Answer: Because there is a scenario where you may lose Rs 30 on a Rs 80 investment. That’s a loss of 37.5% of the capital invested in the operation. Moreover, the probability of this scenario is not tiny. It’s 20%. That’s why you will never make large bets in these situations? Look at this way: If you invest your entire bankroll on a series of such bets then a day will come when you will lose 37.5% of your capital. That would be bad financially. It will also be psychologically devastating. You don’t want those outcomes.
Question: Ok, then what about another bet, which has the same expected return but the loss scenario isn’t there at all?
Answer: In that case, you should willing to invest a higher amount than you would in the previous bet.
Question: What about fundamentals? Don’t I need to worry about that?
Answer: For the most part, no. In later templates, maybe but not in Template 1.Why? Because the offer is for all the shares, you are effectively buying, not the stock of Company A, but the bonds of offerer. Your analysis of this situation is the functional equivalent of doing credit risk analysis on the offerer. (This, by the way, is a very good example of a situation when a stock becomes a bond and where you should focus on underlying economic realities and not titles. As Shakespeare wrote: “What’s in a name? A rose by any other name will smell just as sweet.”)
If CCI declines to approve the deal, the offer will fail. When that happens, the instrument will cease to be an effective bond of the offerer and will start trading like a stock — like it did before the offer was made. In other words, it will crash. But since you’ve already decided to get out if that happens, fundamentals won’t matter much won’t they?
But, what if the stock keeps on tanking limit down every day and you can’t get out? This can happen because there are other arbitrageurs like you who are rushing for the exits. To all of you fundamentals don’t really matter here.
However, if the stock keeps on falling, a time may come when you will have to start thinking about fundamentals. :-) Tough luck! Just think about this for a moment. You bought a stock at 80 to make Rs 20 on it. Your return is CAPPED. Now the deal has collapsed because the CCI said no. The stock is selling at limit down every day and you can’t get out. It’s now at 20. What will you do? No matter how unemotional you are being asked to think about the situation, you will have the temptation to dig out that annual report, calculate the book value, economic earnings etc and consider holding on to this stock.
The idea of capped small absolute returns combines with the possibility of large losses can be remembered with the help of a powerful metaphor of “picking up pennies in front of a steamroller.” The money you make if things go right is small, and the money you lose if they go wrong is large. Keep that in mind when you plunge into risk arbitrage.
Btw, metaphors are very powerful way of thinking about the world around you and just like multiple mental models, you need a multiple metaphor framework.
Question: Ok, now I am really scared. Why do risk arb at all?
Answer: Two big reasons. One, it has a role in portfolio management. Recall low or no correlation to markets. That’s very attractive. When there’s a bull market on and you can’t find good stocks to buy, risk arb comes handy. It’s like a high interest lending operation. Money goes out for a short while, earns a good return (averaged out, if you do it right) and then it comes back, by which time stock markets may be lower and you may find a longer-term home for your money. So, one may think of money invested in risk arb as a cash equivalent but there are exceptions to this rule, as we will discover in a later template.
Two, you may want to do only risk arb and nothing else. Some people do that. It’s a lot of fun, and open offers are just one type of a risk arb operation. There are several more. Graham used to call them “special situations.” You can read up about a few I have done long time ago from here and the original “special situations” article by Ben Graham from here.
Question: Ok, I am back in the game! But tell me what can go wrong.
Answer: Like I said, you are effectively picking up pennies in front of a steamroller. Remember this: most surprises in risk arb are bad ones (asymmetric payoffs). There may be good surprises (we will discover them in future templates), but bad ones outnumber good ones. So, you have to keep on worrying about what can go wrong, where is the risk etc. While doing so, it’s a good idea to keep Robert Rubin’s observation about risk in mind: Condoms aren’t completely safe. My friend was wearing one and he got hit by a bus. :-)
That Rubin quote is very powerful advice on risk for risk arbs. Rubin, by the way, spent a good part of his earlier years in risk arb.
Question: Very funny! When should I sell out of this situation?
Answer: When you’re wrong, when something better comes along and you don’t have spare cash, or when you’ve made most of the money that you wre going to make in this trade. Here I have a rule of thumb. You bought it at 80. The max you can make is 100 so that’s 20 points. Now, let’s say 80% of those points are already in the bag. That is the stock price has risen to 96. From here onwards, out of a total 20 points, only 4 remain. For me, it’s a good idea to let someone else take the risk on those points. Keep Rubin’s advice in mind. If you hold on at 96 and some shit happens then you will lose the return and you may also lose your shirt. Why take the chance?
Question: Ok, makes sense. But who will buy from me?
Answer: Traders who want to buy today and tender in just a few days. Obviously if the stock has risen to Rs 96, this means that the offer is just about to close. The fellow who buys at 96 from you and sells it at 100 to the offerer makes 4 bucks on 96. That’s a 4.2% return. If he is going to make that return, say, in a week, then his annualised return comes to 217%. And you made a lower IRR in percentage terms, but look at it this way: who got most of the juice out of the trade? You! You let him have the rest of it because you figured that the remaining part of the return is just not worth the additional risk. There are two very important lessons here. One, don’t be fooled by a percentage.
And two, in risk arb there is no hold period. Either you are a buyer, or a seller. If the price has risen to 96 and you are not a buyer at this price, you should sell. That logic does not apply in buying long term equities where there is a price range for buying, holding, and selling. Now, I know many smart people who argue against this but that’s the way i feel about it. People who argue against this view are thinking like traders even for long term opportunities… But I diverge, so let’s get back to the topic.
Question: Ok, I understand that it’s rational to accept these types of bets because they are favourable bets, and they are small wagers so even if the loss scenario arises out of bad luck it won’t kill you. Why would someone reject such a bet then and still be rational?
Answer: Good question. The answer depends on how we define rationality. If we look purely at the investment merits, everyone who is looking for uncorrelated special situations should make this bet. But we have to think about incentives and perverse incentives. What if you are managing a fund in which if you get a bad outcome, it will look bad on you. Under such circumstances, in the interest of self-preservation, would it not be rational for the fund manager to reject such bets because they carry a not-insnificant loss scenario? So, on top of expected value framework, there is a “regret analysis” framework. Buffett ignores the “regret analysis” framework because over decades he has positioned himself in a manner which allows him this privilege. He does not care about short term performance, lumpy results. In his words, “we are willing to look foolish, so long as we are sure we have not acted foolishly.” Not many people have that privilege.
Ok, now we move to the next template where we increase the complexity a bit.
Company A’s stock price is quoting at Rs 35 per share. The promoters of the company, who hold 51% of the company’s shares sell out to a MNC at Rs 100 per share. The MNC makes a tender offer for an additional 26% at Rs 100. There is no regulatory risk like the CCI risk in template 1.
The stock has risen to Rs 60 per share. After the offer is over, you expect the stock price to fall back to the pre-offer level of Rs 35 which is also the price at which you will be able to liquidate your remaining shares. The offer will take 90 days to complete.
Try to answer these questions. This time, I will approve responses as they come in and give my own views in a while.
Then, we will go to the next template.
Again, we have excellent answers in comments. Without being too repetitive, here are my thoughts.
If everyone who is eligible to tender, tenders, then the operation involves:
Buying 100 shares @ Rs 60 resulting in cash outflow of Rs 6,000
Tendering all shares, getting 53 (=(26/49)*100) accepted at Rs 100. Cash inflow Rs 5,300
Selling the remaining 47 shares @ 35, resulting in a cash inflow of Rs 1,645
Ignoring time value of money and taxes (you can easily factor the former by using XIRR function in Excel), we find that for laying out Rs 6,000 we get back Rs 6,945. Accounting pre-tax profit of Rs 945 translates into a return of 15.75% over 90 days which annualises to 64% p.a. Not bad at all.
The actual return will be higher because not every one who is eligible to tender will tender. That’s discussed below in Answer 3.
Since you’re going to end up with some shares, you have to think about fundamentals. What if underlying value is far below Rs 35 — the level at which the stock was selling before the offer. What’s the sanctity of this Rs 35 number? It’s just a number — an anchor. We need anchors but not the wrong ones. The right anchor here is the underlying value and not the price at which the stock was selling before the offer.
Another danger here is to think along these lines: Well the acquirer who is buying is not a fool and if it’s paying Rs 100, then I can assume the stock won’t fall below Rs 35. This maybe true and maybe not. So, don’t fall for the bias from over-influence of authority, unless you have very good prior evidence to support the belief that the acquirer is not a fool. For example, Ravi Purohit has cited examples of two acquisitions done by a group, which has a solid track record in M&A.
People have generally stated correctly that the actual acceptance ratio will be higher because not everyone will tender. Here it’s important to think in terms of base rates. There is plenty of statistical evidence on tender offers from where these base rates can be calculated. While studying any given offer, it makes sense to first start from base rate and only then adjust that base rate probability by taking into account the peculiarities of the situation you’re evaluating.
Many people discard the base rate and start modelling their excel sheets by assuming a much higher proportion of non-tenderers (called “brain dead” investors in Risk arb parlance because these people won’t tender at 100 but will sell in the after-market at 35). Excel is a dangerous tool. It allows you to insert what you want to believe, as if it’s a fact. So, if you want to believe that a particular institutional investor who holds 10% stake, will never tender because he bought it at a higher price than the offer price of Rs 100 (loss aversion), then your model will project a higher acceptance ratio than would be the case if you had assumed that he would tender. And that would make the trade look profitable at a higher price and you’ll go and buy and later find that he tendered and acceptance ratio was not as good as you had projected and you ended up with either much less profit or even a loss.
So you have to exercise caution when making predictions about acceptance ratios. The outcome of the trade is likely to be highly sensitive to your predictions of acceptance ratios. It makes sense to do a scenario analysis and the trade may become uninteresting in the pessimistic scenario. Now that won’t happen in our example above because even if everyone tenders, the trade still makes sense, but it will happen in other situations.
One thing I have learnt here is that it’s just stupid to assume that a fellow won’t tender because “its rational to not tender.” Think about this for a moment. As value investors, we make a living by trading against irrational people. We think the world consists of a large number of irrational people and institutions. And yet, when it comes to risk arb, we tend to fool ourselves into believing that people will be rational when it comes to tendering shares. They wont always be. So, don’t implicitly apply the human rationality assumption.
The inversion trick is a very powerful idea because it de-biases us. We want to believe that LIC won’t tender or HDFC won’t tender and that will make the acceptance ratio so much better so we want to buy. Why not invert and figure out what the market price is telling us about the likely acceptance ratio, and then see if we agree or disagree with the market? Without going into the details, here’s the procedure.
We already know the offer price (Rs 100) and the current stock price (Rs 60). We know the time to closure (90 days). We have estimated the likely exit price for remaining shares (Rs 35). We also know that risk arbs will do a trade by insisting upon a return which is higher than the risk free return. So, let’s say the risk-free return is 10% p.a. and risk arbs required return is 14% p.a. We can plug in the 14% p.a. return to figure out the acceptance ratio which will deliver that return. Once we have that ratio, we can then approach the problem more objectively. Inversion, or backward thinking accomplishes just that: it makes us more objective. By thinking forward (i.e by estimating acceptance ratios by studying shareholding patterns, and base rates), we are prone to making mistakes. By thinking backward, we create a sanity check on thinking forward. So, we must use both types of thinking — forward and backward.
What should you do if the “implied acceptance ratio” by reverse engineering it from the data we have turns out to be way more than what you estimated by thinking forwards (using base rates, and then adjusting for them with the peculiarities of the situation being examined)? You should walk away from the trade. You have arrived at a conclusion that people who are setting the price in the market are over-optimistic.
Could there be alternate explanations? Yes! You may be competing with people who don’t have to pay taxes and/or have much lower transaction costs than yours or have access to low cost borrowed funds. For such arbs, certain trades will make sense while they won’t make sense for you.
Regardless of explanation (overoptimism or low cost advantage), your conclusion will be the same: Walk away.
I agree with the conclusions given by most of the commentators. Borrowing in Template # 1 does not make sense because of a loss scenario. Borrowing in Template # 2, MAY make sense. I liked L.J’s comment that “We must also keep in mind the temperament of the investor. If borrowing money makes you uncomfortable and you have trouble sleeping at night, it might be better to avoid it.”
Question: You have no clue whether an institutional investor will tender or not. How will you deal with that in your model?
Answer: I will toss a coin. In other words when I don’t know, I will simply be agnostic and assume a 50% chance of tender and in my model.
Question: How will you turn English words like “highly probable” “almost certain” “likely” “unlikely” etc into probability percentages?
Answer: I will use Sherman Kent’s framework and will do it routinely as a practise in applying Fermat/Pascal way of thinking to virtually everything in life.
Question: Should you use Template # 2, to create cheap shares in a stock you want to own?
Answer: Yes! L.J has mentioned this important point in his comment. So has Ashim. The idea is very simple. You love a stock at a price. There is an offer outstanding at a higher price. You can buy more shares, tender them in the offer and lock in a gain on shares accepted. The profit on shares accepted should be thought of as a reduction in the cost of the shares that are returned. Sometimes, this can result in a fantastic opportunities. This happened in the case of Eicher Motors a few years ago.
So, even if you are not a risk arb, but are a long-term investor, it makes sense to temporarily wear the hat of an arb…
Question: But my accounting cost won’t change, will it? If I buy 100 shares at 60 and tender them all in the offer at Rs 100 and 45 of them are accepted, then my accountant will record a gain of Rs 40 per share on 45 shares, and leave the cost of remaining shares unchanged. But if I think in terms of cash flow, then there is an initial cash outflow of Rs 6,000, then a cash inflow of Rs 4,500, then, ignoring taxes, I have a net cash outflow of Rs 1,500 and I am left with 55 shares, so my effective cost of creating those 55 shares is Rs 27. So, who is right — the accountant or the cash flow investor?
Answer: The cash flow investor. You should ignore accounting consequences, and compare effective cash cost of creating new shares (after considering taxes which for simplicity’s sake, I have ignored), with fundamental information like earnings and asset values. The prospect of creating the shares of a high quality company at a very low P/E or P/B is very attractive.
Ok, let’s add some complexity.
Company A’s stock price is quoting at Rs 35 per share. The promoters of the company, who hold 51% of the company’s shares sell out to a competitor at Rs 100 per share. The acquirer makes a tender offer for an additional 26% at Rs 100. It’s offer is subject to approval by CCI. In your estimate, the probability that the deal will get approved by the CCI is 80%. In the event of the deal not being approved by the CCI, the offer will be withdrawn. If the offer is withdrawn, the stock price will plummet to Rs 30 but the average price at which you should be able to sell all your shares will be Rs 35.
CCI will take 6 months to approve or reject the deal and then the deal will go back to SEBI for approval. Since the acquirer is involved in some litigation with SEBI on an unrelated matter, you think the offer could take a long time to be approved by SEBI, but you are confident it won’t take longer than 90 days after CCI decision. Thereafter another 30 days will be needed to complete the offer.
The bidder cannot, of its own accord, withdraw the bid and has deposited all the money required to fund the offer in an escrow account under the control of a highly reputed bank. Moreover the investment banker who has made the public offer is highly trustworthy.
Immediately after the announcement, the stock of Company A rises to Rs 65 per share. This stock also trades in the F&O segment of NSE and while options are quite illiquid, the futures contracts for each of the next three months trade at a premium to spot, reflecting cost of carry of about 12% p.a.
There is another potential bidder who has been giving media interviews about a counter offer. However, it has not come forward with a formal offer yet, and the last date by which it can do so will be 25 days from now.
In your judgment, in the absence of a competitive bid, the acceptance ratio is likely to be 67% of all tendered shares based on shareholding pattern as of now, before the offer, but since arbs are moving in, and there is a possibility of a competitive bid, things may change…
After the offer is over, you expect the stock price to plummet to Rs 35 — the price at which you will be able to liquidate your remaining shares.
In Template # 3, we experienced complexity like in messy real life. In such situations, different people, acting rationally, can come up with slightly different conclusions. Keep this in mind while you read my model answers to template # 3. Also focus more on the underlying principles on which I will rely rather than on the actual answers.
Let’s look at the base case of expectation of no competitive bid, no hedging, and transaction completing in 10 months (6 months for CCI + 3 months for SEBI + 1 month for offer formalities).
Let’s first figure out the acceptance ratio. The offer is for 26% our of a total of 49%, so the absolute minimum acceptance ratio is 53% (26/49). In the problem I have stated two things: (1) if there is no competitive bid, and no change in shareholding pattern, the acceptance ratio should be 67%; (2) since arbs are buying shares the acceptance ratio will change.
So the first major lesson here is to not estimate acceptance ratios based on old shareholding patterns. That’s because when arbs buy, they buy either to tender or to sell to other arbs, who will tender. So the shareholding pattern starts changing immediately after the offer is announced and the stock effectively starts moving from investors to arbs. This means that the actual acceptance ratio should be lower than 67%? So we need to model a lower acceptance ratio. A 67% acceptance ratio implied 39% of shares being tendered (26/39=.67) which means brain dead investors of 10% (49%-39%). Let’s model 6% brain dead investors instead of 10% because of arbs moving in. If we do that, then number of shares tendered will be 49%-6%=43% and acceptance ratio will become 60% (26%/43%).
So the first thing I have done is to recognise the unfavourable change in ownership structure in my model.
Now, let’s look at the base case.
Trade Today: Buy 100 shares for Rs 65. Cost: Rs 6,500
Sell in 10 months in offer: 60 shares at Rs 100. Total receipt: Rs 6,000
Sell in 10 month returned shares in market. 40 shares sold for Rs 35. Money received: Rs 1,400.
Total money received: Rs 7,400. Total money invested: Rs 6,000. Total return: Rs 900. Flat return in 10 months: 13.85%. Annualised return: 16.62%
Not bad, but not terribly exciting either. I can’t spike this return by borrowing because of a loss scenario (If deal falls all shares will have to be liquidated at 35).
Now, with this base case in mind, let me address the question with the observations that I very largely agree with Ravi Purohit’s replies. So let me just my perspective to his replies.
Identifying a deal and deciding the time to enter is are two different things. They need not co-incide. The key question to ask when you identify a deal is not should I buy but rather how can I make money in this deal?
It may make sense to buy the long position now but it does not make sense to short now. Why? To answer that consider what all can go wrong if you short a stock for hedging purposes. One, there are 10 months and you don’t have a futures contract for a 10 month duration, so you have to use shorter period contracts all roll them over. This exposes you to asset liability mismatch. In this particular case, if the arb interest is very high then the presence of shorts may make rolling over quite expensive.
Second, there is a possibility of a competitive bid. That possibility will become reality or disappear in 25 days. If you short now, you can get screwed if a large competitive bid happens. Why? That’s because the stock will shoot up and your short position will lose money. Moreover, you will find that you have over-hedged your position because with two offers on the table, the need to be short won’t be there. Two offers of 26% – one at 100 and one above 100 and total shares with public being only 49% makes shorting now a bad idea.
The general idea I want to invoke here is the idea of “preserving optionality” I wrote about this long ago, here and here. There is no point burning your bridges when the situation is volatile and dynamic such as in risk arb. The twists and turns in any risk arb is just another manifestation of the idea of volatility in option valuation. And options are worth more if volatility is high than when it’s not. So, keeping your options open till the last moment makes sense in risk arb. In the current situation, this means that considering shorting before the 25 day time limit for a competitive bid is over is a bad idea. And as Ravi has pointed out, the risk of deal failure due to CCI rejection won’t be known for 6 months so what’s the point of hedging now?
Why not break the trade into long buy at one time and short expected returned shares at a different time?
I have already address this above.
The worst case scenario is this: You buy now and you short now. Then there is a competitive bid and stock soars and you have loss on short position but which is offset by profit on long position. But since need to hedge has gone away because of two offers (so you think), you square up the futures at a loss but keep the long position intact. Then CCI rejects the deal and the stock collapses to 35.
As Ashim has mentioned, you have think in terms of decision trees and scenario analysis and expected value under various scenarios. As time moves forward some branches of your decision tree will disappear and new ones will appear. It’s a dynamic process — the very reason I like risk arb as a stepping stone for learning value investing generally.
You may decide to do nothing right now and wait for 25 days and then once the uncertainty about the competitive bid is over, work out the expected value at that time and then decide whether or not you want to take a position.
Alternatively, you may decide to take small long position now and then hope for competitive bid to materialise and then react to a bid materialising or not after 25 days. If it does materialise you may buy more shares, at a higher price and even if those news shares will cost you more and the return you will make on them will be lower than the return you make on the original quantity you bought, those lower returns will also come with lower risk of loss. So, you have to think of risk arb not in terms of just buy or not buy now but also in terms how much to buy and when always keeping in mind the dynamics of the situation. The same logic applies around the date of CCI approval. If the approval comes, the stock should move up. At that time you have evaluate if it makes sense to buy more or to liquidate the position. When you make that decision you will base it on your estimate of expected return as per information available at that time.
I have partially addressed this in the above paragraph. You have to think in terms of a probability chain. How many things have to go right for you to make money in this deal? The deal has to be approved by CCI, then by SEBI. If CCI approval probability is 80% and thereafter SEBI approval probability is 90% (you never know so you should not model certainty of approval), then the probability of both approvals coming through is 72%. And by the way these numbers are not static. They change. And you will know they are changing if you sit though the proceedings of CCI or reviewed SEBI approval process. So you have to change these probabilities based on new information and that could make the trade not worth doing or worth doing even more. What’s important here is to remember that its a very dynamic process and you have to keep on adjusting your estimate of returns based on events as they unfold. And while you do that keep in mind that decision trees expand by creation of new branches and also contract because of collapse of a few branches.
As mentioned by others, deal related volatility will revolve around: (1) competitive bid; (2) CCI approval; and (3) SEBI approval.
The award for the answers I liked the best goes to Ravi Purohit. Congratulations Ravi! And thanks a lot to the others for participating in this experiment.
You have a number of risk arb opportunities and they offer different expected returns. Some expected returns are below AAA bond yields. Others are well above.
This isn’t the first time a credit rater got screwed. And it won’t be the last.
Part of the reason, I feel, is that credit raters don’t rate companies. They rate paper.
Look. You are either a virgin. Or you’re not. There is no such thing as 73% virgin, is there?
The same logic applies to credit ratings. You are either creditworthy, or you’re not. Says who? Ben Graham.
If any obligation of an enterprise deserves to qualify as a creditworthy investment, then all its obligations must do so. Stated conversely, if a company’s junior bonds are not safe, its first-mortgage bonds are not a creditworthy either. For, if the second mortgage is unsafe, the company itself is weak, and generally speaking there can be no creditworthy obligations of a weak enterprise.
I have always found it irritating to see the whole panoply of gibberish like “AAA” “BBB” “CCC” “D+” “C-” blah blah blah…
Why can’t there be a single credit rating for a borrower instead of that?
You might think I am being naïve here much like the friend of a fishing tackle producer, who when he saw all those flashy green and purple lures asked him, “Do fish take these?”
“Charlie?” he said, “I don’t sell these lures to fish.”
I would rather be naïve and right, than be just wrong.
In his memorable song, “Everybody Knows“, Leonard Cohen sings:
Everybody knows that you love me baby
Everybody knows that you really do
Everybody knows that you’ve been faithful
Ah give or take a night or two
Everybody knows you’ve been discreet
But there were so many people you just had to meet
Without your clothes
And everybody knows
What happens when “mutual knowledge” between a select few (say, the senior members of the ruling political party of India and those of the main opposition party) becomes “common knowledge” for all?
All hell breaks loose!
Allow me to tell you how, with the help of a story.
There is a unique village in Haryana, in which many married couples live. Each woman in this village immediately knows when another woman’s husband has been unfaithful but not when her own has been (“mutual knowledge”). Moreover, very strict rules of the village require that if a woman can prove her husband has been unfaithful, she must kill him that very day.
Assume that the women never inform other women of their cheating husbands. As it turns out, twenty of the men have been cheating on their wives, but since no woman can prove her husband has been cheating on her, the village life proceeds merrily along.
One morning, a wise old man with a long, white beard comes to the village. His mystical powers and honesty are acknowledged by all and his word is taken as the gospel truth.
He asks all villagers to gather together in the village compound and then makes this announcement:
“At least one of the men in this village has been unfaithful to his wife.”
Once this fact, already known to everyone, becomes “common knowledge,” what happens next?
The wise old man’s announcement will be followed by nineteen peaceful days and then, on the twentieth day, by a massive slaughter, twenty women will kill their husbands.
Let’s start with the assumption that there is only one cheating husband in the village, Mr. A. Everyone except Mrs. A already knows about him. So when the wise old man makes his announcement, only Mrs B learns something new from it. She thinks:
If any other husband was the cheater, I would have known about it. I don’t know about it. So, the cheater must be my husband. I have to kill him now!
Now, let’s assume there are two cheating husbands, Mr. A and Mr. B. Every woman except Mrs. A and Mrs. B knows about both these cases of infidelity. Mrs. A knows only of Mr. B’s, and Mrs. B knows only of Mr. A’s.
One day 1, how would Mrs A think? Imagine you are Mrs A. What would you think immediately after the wise old man has spoken?
“Aha! So there is at least one cheater. But I already know Mr. B is a cheater. Mrs B will soon figure it out and kill him! I’ll wait.”
Now imagine you are Mrs B? How would you think, Mrs B?
“Aha! So there is at least one cheater. But I already know Mr. A is a cheater. Mrs A will soon figure it out and kill him! I’ll wait.”
And so Mrs A and Mrs B wait for each other to kill their husbands on day 1 but neither of them does. This puzzles both of them. Mrs A thinks:
“OMG! Mrs B did not kill her husband on day 1. Why? Oh! I know why! There must be two cheating husbands. I already know that Mr. A is a cheater. So, who’s the other one? OMG! If it had been anyone else other than my own husband, I would have known! This means my husband has been cheating on me! I have to kill him now!
As it happens, Mrs B is also thinking exactly as Mrs A. And so, on day two, both Mrs A and Mrs B will kill their husbands.
By a process of mathematical induction involving proof by contradiction, we can conclude that if twenty husbands have been cheating on their wives, then their intelligent wives would finally be able to prove this on the twentieth day, the day of the righteous bloodbath.
175 years ago, Hans Christian Andersen told the story of an emperor who had no clothes. In that story, you’ll remember
The naked emperor marched in the procession under the beautiful canopy, and all who saw him in the street and out of the windows exclaimed: “Indeed, the emperor’s new suit is incomparable! What a long train he has! How well it fits him!” Nobody wished to let others know he saw nothing…
But then suddenly, said a little child at last
“But he has nothing on at all.”
“Good heavens! listen to the voice of an innocent child,” said the father, and one whispered to the other what the child had said. “But he has nothing on at all,” cried at last the whole people.
In our present circumstances, there are some amongst the whole people who believe that
Sunlight is the best disinfectant.
God, I hope they are right…
This post was inspired by an excerpt from John Allen Paulos’ “Once Upon a Number”
The chronicles of Deccan Chronicle have been covered by the media extensively so I won’t go there. The stock price tells the story quite vividly. Take a look.
Since Jan 2008, the stock’s down 96% while the market is down 7%.
What’s an IPL team worth when its owner’s have no staying power? Between zero and whatever someone will pay for it, no? Cash flows really don’t matter. But then, they never mattered in IPL team valuations anyway.
In the end, it boils down to an Ultimatum.
Imagine that you are travelling on an airplane, sitting in an aisle seat next to an eccentric-looking woman in the middle seat (Vivian). Next to her, in the window seat, is a rather formal-looking businessman (Mark). About 30 minutes into the flight, Vivian interrupts you and Mark, and explains to you that she is quite wealthy, becomes bored easily on flights and likes to pass the time by playing games. She then pulls fifty $100 bills out of her wallet and makes the following proposition. “I will give the two of you this $5,000 provided that you can agree on how to split the money. In the splitting up the money, however, I will impose two rules. First, Mark must decide how the $5,000 is to be split between the two of you. Then, you (the reader) will decide whether to accept the split. If you do accept, then you and Mark will receive the portion of the $5,000 based on Mark’s allocation. If you do not accept the split, then you and Mark will each receive nothing.” Both you and Mark agree to play the game. Mark thinks for a moment and then says, “I propose that the $5,000 be split as follows: I get $4,900 and you get $100.” Now it is up to you: Will you agree to this split?
Before you jump to a conclusion, let me say that you will never meet Mark and Vivian again, and $100 is better than nothing. Take it or leave it?
The position of Deccan’s creditors is not much different from yours in the Ultimatum game. They have already rejected a “frivolous” bid for its IPL team and even though media reports say that the team has been sold, they also say that it’s franchise has been cancelled.
Whether BCCI will reverse its decision or not — at a buyer’s request who will pay BCCI the money it says it’s owed by Deccan — is difficult for me to say. But if the existing buyer develops cold feet, a new buyer may offer a much lower price for the IPL team.
For Deccan’s creditors, the choices are miserable: (1) accept anything that’s offered; or (2) get nothing. Those were your choices too in the Ultimatum game. And that is just so sad.
As for Deccan’s shareholders, they are standing at the end of a long queue consisting of the firm’s creditors ahead of them. They should pray they get at least something out of this mess. Ultimately.
Note: The Ultimatum example was quoted from Max Bazerman’s excellent book, Judgment in Managerial Decision Making
I got a mail from a student. Nikhil wrote:
Your approach to multidisciplinary thinking is highly pragmatic but it is an approach never taken in the entirety of our education. Throughout we are taught subjects individually and each of the problems that we are given is confined to the context of that particular subject only, even in our MBA the cases that we have usually try to deal with a business case within the context of a few concepts from a particular field such as marketing, finance or operations. Hence my problem is that I find it very difficult to be able to come out of the confines of one particular subject and think of a problem in a more holistic manner which would be useful in real life as well. The key issue is making a connect between the problem at hand and the list of mental models that you have stored away in the back of your head. Your functional equivalence approach is very useful but again how do you learn to apply it in situations? Can you guide me as to how I can start training myself to think in such a fashion, looking at a problem and coming up with a set of concepts to apply as in like the check-list you mentioned?
I promised Nikhil that I will write a teaching note. This is that note.
I am going to play a game based on ideas derived from Socrates and Charlie Munger. We will start with “Socratic Questioning” which is described as
disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion.
Socratic Questioning relates to “Socratic Method,” which is:
a form of inquiry and debate between individuals with opposing viewpoints based on asking and answering questions to stimulate critical thinking and to illuminate ideas.
Charlie Munger started using these two Socratic devices in a variation he called Socratic Solitaire, because, instead of a dialogue with someone else, his method involves solitary play.
Munger used to display Socratic Solitaire at shareholder meetings of Wesco Corporation. He would start by asking a series of questions. Then he would answer them himself. Back and forth. Question and Answer. He would do this for a while. And he would enthral the audience by displaying the breadth and the depth of his multidisciplinary mind.
I am going to play this game. Or at least, I am going to try. Watch me play.
What are the rules? Here are some tips from Charlie.
So, that’s what I’ll do. I will pick up the newspaper and identify a story. I will then ask a question relating to the story which I will try to answer by relating what I read to multiple mental models in my head. As I do that, I will experience related thoughts. I will not control those thoughts. More questions will arise. I will continue to relate my thoughts and questions to mental models from multiple disciplines. I will allow my mind to wander from one discipline to another finding more questions and looking for answers. In seeking answers, I will need some tools.
I will use five tools: (1) My brain; (2) My computer; (3) Wikipedia; (4) Google; (5) a couple of cards from Creative Whack Pack; and (5) My Kindle.
Each of these has its own benefits and disadvantages. My brain cannot store everything, but is good at recognising patterns. I have a ton of stuff I have collected on my computer over the years and I am likely to find something interesting that is related to whatever I am investigating but my computer can’t possibly have everything that’s worth knowing on the subject. So, I’ll get leads and I will investigate by going to Wikipedia, which is a great free resource for research but I have to be careful about its accuracy. Google is a great search engine but it also produces results which can cause unnecessary distractions. On the other hand, my Kindle has a a better organised body of knowledge – my library of 396 books. Kindle has a search function which allows me to search for terms across all my e-books which solves the “I-know-I-have-seen-something-like-this-before-but-I-don’t-remember-where” problem in paper books. Moreover, I expect to serendipitously find things related to my search terms – things I did not know existed in my library but have popped up while I was searching. At the same time, I must be careful not to get too distracted.
So I have my tools near me. Now I need a topic.
Let these pictures give us the topic.
Oh Shit! Who died? Why are these women crying?
What’s going on here? What are these people doing? What’s that building in the background?
These people are protesting against the construction of a nuclear power plant on India’s East coast in a place called Kundankulam in Tamil Nadu. The building in the background is Kundankulam Atomic Power Station and the women in the earlier photograph are crying because they are petrified at the idea of living near a nuclear power plant. You can read more about the ongoing protests from here.
But wikipedia only tells us about this one project. Our task however, begins from here. Let me now put one of the cards from Creative Whack Pack on the table.
Let’s get curious like Leonardo da Vinci and ask some questions.
Why are these people protesting? What are they scared of? How can we learn more about what’s happening in Kundankulam? Are there any precedents? What do they tell us? Is is only about nuclear power or are there other situations where similar protests happen?
Before I attempt to answer these questions, let me first put my second card from Creative Whack Pack on the table.
Now, I am going to use my associative brain, together with my research tools to study this topic.
Here are some thoughts that immediately occur to me – in no particular order. I record them in a mind-mapping software. While playing socratic solitaire I am essentially brainstorming with myself, so organizing thoughts is not as important as capturing them in the first place.
While you read about these thoughts, also notice how my associative memory (connection with a mental model) works. Here are some thoughts.
Interesting ten thoughts, no? And they began after I saw a couple of vivid photos. Now I want to allow serendipity to help me even more. I will do this by employing the remaining two research tools: my computer and my kindle.
Over the years, I have accumulated so many documents on my computer that the space they take up adds up to about 300 gigabytes!
Now I know serendipity works beautifully. So let me search for the term “NIMBY” on my computer. Who knows what I might find? Let’s see.
Searching, searching, displaying search results…
Whoa! What an astonishing gem I found. Granted, it may not be directly related to NIMBY, but its bloody interesting to me especially in context of what’s happening in Indian power sector. What did I find?
I found extracts from talks given by Warren Buffett and Charlie Munger. Let me reproduce them here. Their words:
Buffett: Politicians don’t like to face major brownouts. They can try and blame it on someone else – and they may well be accurate in blaming it on someone else. But the public is going to, at least partially, blame political leaders if this country runs out of electricity – because it hasn’t run out of the ability to build generators. We could create all the generators we need to have plenty of electricity – and we could create the transmission lines and all of that.
But you do need a flow of capital to the industry. And the law restricts that flow to quite a degree, I would say.
Munger: Well, the production of electricity, of course, is an enormous business – and it’s not going away. And the thought that there might be something additional that we might do in that field is not at all inconceivable. It’s a very fundamental business.
You’re certainly right in that we have an unholy mess in California in terms of electricity. It reflects, I’d say, a fundamental flaw in the education system of the country; that so many smart people of all kinds – utility executives, governors, legislators, journalistic leaders – seemingly had difficulty recognising that the most important thing with a power system is to have a surplus of capacity. Is that a very difficult concept?
Everybody understands that if you’re building a bridge, you don’t want abridge that will handle exactly the maximum likely load and no more. You want a bridge that will handle a lot more than the maximum likely load. And that margin of safety is just enormously important in bridge-building.
Well, a power system is a similar thing. Why do all of these intelligent people ignore the single most obvious and important factor – and just screw it up to a fair-thee-well?
Buffett: Charlie’s obviously right in that from a societal standpoint, you’ve got perhaps three goals in what you would like your electric utility business to be. One is that you would like it to be reasonably efficiently operated. Secondly, since it does tend to have in many situations monopoly characteristics, you would want something that produced a fair return, but not a great return, on capital – enough to attract new capital. And then third, you’d want this margin of safety – this ample supply.
When you’ve got a long lead time to creation of supply –which is the nature of putting on generation capacity – you need a system that rewards people for fulfilling that obligation to maintain extra capacity. A regulated system can do that. If you give people a return on capital employed so that if they keep a little too much capital employed they get paid for it, then they’ll stay ahead of the curve – they’ll always have 15-20% more generating capacity than needed.
One of the disadvantages of that regulation and the monopoly nature is that it doesn’t have the spur to efficiency. They try to build it in various ways, but it’s difficult to have a spur to great efficiency if somebody can get a return on any capital they spend. Therefore, utility regulators have always been worried about somebody just building any damn thing and getting whatever the state-allowed return is.
But I’d say that the problems that would arise from, say, a little bit of sloppy management are nothing compared to the problems that arise from inadequate generation.
So in California, in my view speaking as an outsider, utilities had the incentive at one time to maintain a little extra generating capacity because they were allowed to earn a decent return on it – a return sufficient to attract capital.
But they you had, I think, the forced sell-off of something like half of their generating capacity. And they sold it at multiples of book value to a bunch of people who became generators who are deregulated and don’t have an interest in having too much supply. They’ve got an interest in having too little supply. So they totally changed the equation – because the fellow with the deregulated asset for which he paid 3 times book now has to earn a return on that 3 times book what the fellow was formerly earning under the regulated environment at 1 times book.
So he’s not going to build extra generating capacity. All that does is bring down the price of electricity. He hopes things are tight. If you’ve got a utility plant that was put in place at X and then you go out and encourage entrepreneurs to buy it at 3X, you can’t expect electricity prices to fall. So you’ve created a situation, in my view, where the interests of the utility companies have diverged in a significant way from the interests of society. And that was a very, very basic mistake. It just doesn’t make any sense to me – but maybe I don’t understand it fully.
I really think that the old system made more societal sense: Let people earn a good return (not a great return, but a return that attracts capital) on investment that has built into it incentives to keep ahead of the game on capacity because you can’t fine-tune it that carefully. And you do have this long lead time.
Now, what you do with the scrambled eggs now – with all the political forces back and forth… I think that you better have a system that encourages building extra capacity because you don’t know how much rainfall there will be in the Pacific Northwest and therefore, how much hydro will be available. And you don’t know what natural gas prices will do and, therefore, whether it’s advantageous for a gas-fired turbine to be operating.
The old system really strikes me as somewhat better than this semi-deregulated environment that we have more or less stumbled into. Charlie, what do you think?
Munger: Of course, even the old system got in some troubles. Everybody had the NIMBY syndrome – “Not In My Back Yard.” Everybody wanted new power plants to be anyplace not near me. If everybody feels that way and if the political system means that the obstructionists are always going to rule – which is true in some places in terms of zoning and other matters – you’re in deep trouble. If you let the unreasonable, self-centered people make all of the decisions of that kind, you may well get so that you just run out of power. That was a mistake.
And we may make that mistake with the oil refineries. We haven’t had many new big oil refineries in the last period. So you may get to do this all over again.
Shareholder: You talked about your interest in investing in new electrical capacity. Would you expound a little bit in terms of what you think would be a rational business model and a fair social model for doing so?
Munger: Well, of course, the energy situation in California is a disgrace. It’s a disgrace to our educators who turned out people who could make such dumb decisions in spite of going to the best colleges and the best business and law schools. It’s a disgrace to both political parties who sat around. It’s a disgrace to the executives that participated in making the decisions. There‚s enough disgrace to go around. There was an easy idea to retain when you’re running hospitals in the middle of a desert where it’s 110 degrees outside. It was not a radical, hard-to-grasp idea that the one thing the civilization always wanted was a surplus of generating power. Is that really difficult to understand? Well, of course it isn’t difficult. But all these people had these other models: If we simply have free enterprise‚ meaning deregulation, as they called it‚ it will automatically cause a surplus. Well, of course, it didn’t automatically cause a surplus. To have a surplus of generating capacity, you’ve got to have a surplus of well-fueled plants capable of generating the electricity.
And of course, there’s the system of allowing NIMBYism (Not In My Back Yard)‚ everybody wants the school, but not near me. So no new school is created for 10 years in Los Angeles and the kids are in unspeakable conditions. Everybody wants a power plant, but not near me. And if you just allow that kind of paralysis in our governmental system‚ We richly deserved this miserable result. We earned it fair and square by extreme stupidity and indifference. And we’re doing the rest of the country an immense favor. We’re like the canary in the mine that dies, but saves the other miners. State after state is looking at California and saying, Boy, have those guys done us a favor. That is one kind of stupidity we don’t want to have.
So, obviously, we need excess generating capacity. And we’ve got to reduce the pollution as much as we can. But once we’ve got it down as low as it’s feasible to get it, we’ve got to have the capacity. We also need conservation. We also need utility rates which encourage the right habits. There are perverse incentives built into the rates. And there are all kinds of ways that could have been done better. It’s obvious what should be have been done: the right incentives in the rates, always a surplus of power. This does not take great brain power. But we just mushed around in the same crazy way we did with the public schools‚ and we allowed something very important to go to hell. It was really awful behavior‚ awful cognition.
And what’s really bad is that you can go to modern academia right now and nobody’s ashamed of these recent bad results. They think if you teach about Beowulf, you’ve done your duty. And the fact that the people leave you and can’t think their way out of a paper sack is not their fault. But that’s not true. We should be graduating people from our educational institutions that can think better and behave better. Sometimes you have to stand up and do things that are against your own interests, but in the interests of the larger civilization. And we have all failed to a fair-thee-well.
That said, we’re going to need a lot more power. And there’ll be all kinds of creative ways to handle the thing. There will be some opportunities in the future. It’s a great, big permanent business. And electrical power is not going to be obsolete. There aren’t many fundamental things in nature. And one of them is electrical power‚ electromagnetism. It’s not going away.
Wow! Cool isn’t it? And how did I find this? By storing it when I read it many years ago, then forgetting about it, then while working on this project letting my mind wander and searching for NIMBY on my computer and finding it all over again!
Never ever underestimate the power of serendipity.
So what should we learn from the above extracts from Buffett and Munger?
Indian power tariffs just have to go up. The state electricity boards are bankrupt. If India wants more electricity it has to produce the right incentives. And allowing a decent rate of return isn’t sufficient. You have to ensure that the return is actually realized. If state electricity boards can’t and won’t pay electricity bills of generators, then the promised return is not earned, so India can forget about attracting private capital. Those half finished power plants which depended on “cheap” south-east Asian coal that became expensive later on won’t be finished unless tariffs were increased. It doesn’t matter what power purchase agreements say. If coal price is not allowed as pass-through the regulator or government can’t say too bad! If they do that, the plants won’t get finished and India must live with electricity shortage. Incentives matter.
If you keep on giving free electricity to farmers, then you will eventually get shortages. People will have perverse incentives to divert power from agricultural usage to non-agri usage. It’s very hard to stop it. Gujarat has done it. Every state must follow what it did. But do the politicians have the will (balls?) I doubt it. So until the politicians can be “convinced” that to get surplus power, the generators must be more than adequately incentivised, India power sector will suffer and India will suffer along with it. Nuclear power is cheap, and much safer as compared to coal power especially when health costs are concerned. Kundankulam Project must be finished.
Cool, now that I have given my sermon, I can move on to the last tool I will use for this exercise.
There are many reasons why my wife is jealous of my Kindle but one huge reason why I love it so much is it has an awesome feature. As I type this blog, I find that I have 440 books on my Kindle. That’s an enormous library isn’t it? When all my books were on paper, I had this problem which inevitably made me say these words:
Shit man, I have read about NIMBY in some of my books but I don’t remember which ones!
And then I would spend hours browsing through books looking for that elusive sexy girl called NIMBY but I could never find her. I had a faint recollection of spending some very enjoyable time her but I could not find her anymore.
Enter Kindle. End of problem. Kindle allows you to search across all your books on the device for NIMBY or SUZIE or any woman or idea or concept you want to search. It’s like a google search engine on your books.
So I will do that now. I will search for NIMBY on my Kindle.
Switch Kindle on. Go to Search. Type NIMBY. Hit enter. Searching searching searching. A list of book appears. I go though them one by one.
Whoa! Look what I found! This from an excellent book called The Little Book that Builds Wealth.
Moody’s, the slot machine industry, and the for-profit education industry are all examples of single licenses or approvals giving companies sustainable competitive advantages. But this kind of moat isn’t always based on one large license; sometimes a collection of smaller, hard-to- get approvals can dig an equally wide moat.
My favorite example of this is what I call the NIMBY (“not in my backyard”) companies, such as waste haulers and aggregate producers. After all, who wants a landfill or stone quarry located in their neighbourhood? Almost no one, which means that existing landfills and stone quarries are extremely valuable. As such, getting new ones approved is close to impossible.
Trash and gravel may not sound exciting, but the moat created by scores of mini-approvals is very durable. After all, companies like trash haulers and aggregate firms rely on hundreds of municipal-level approvals that are unlikely to disappear overnight en masse.
What really makes these locally approved landfills and quarries so valuable for companies like Waste Management and Vulcan Materials is that waste and gravel are inherently local businesses. You can’t profitably dump trash hundreds of miles from where it is collected, and you can’t truck aggregates much farther than 40 or 50 miles from a quarry without pricing yourself out of the market. (Trash is heavy, and gravel is even heavier.) So, local approvals for landfills and quarries create scores of mini-moats in these industries.
Contrast waste and gravel with another industry that has strong NIMBY characteristics—refining. Although there hasn’t been a new refinery built in the United States for decades, and local approvals for expansions of existing refineries are pretty tough to come by, the economic situation of a refinery isn’t nearly as good as that of a landfill or quarry. The reason is simple: Refined gasoline has a much higher value-to-weight ratio, and it can also be moved very cheaply via pipelines.
So, if a refinery tried to raise prices in a particular area, gasoline from more distant refineries would flow into the locality to take advantage of the higher prices. As a result, while there are regional variations in gasoline pricing, refiners generally can barely eke out high-single-digit to low-teens returns on capital over a cycle, while aggregate producers and waste haulers enjoy much steadier returns on invested capital in the mid to upper teens over many years.
Absolutely incredible!!! Isn’t it?
We started this journey with a couple of photos of emotionally distressed people. As we dug deeper into the likely causes of their distress, we encountered several models from psychology, engineering, and economics. By allowing our minds to wander a bit like Leonardo da Vinci and by employing a technique invented by Socrates and polished by Munger, we discovered possible explanations to something that needed an explanation using a multidisciplinary toolbox. We also used serendipity and the associative nature of our minds to unravel various facets of a gal called NIMBY.
Her most interesting facet, to an investor, was hiding in a book on investing in moats. How one thing leads to another! Now NIMBY will take me for a holiday to a bunch of very exotic islands called MOATS. I will tell you that story on another day. Right now I am going to have some fun with her.
Hello there. My name is Umbridge. I am a slimy, green frog.
No, not the one who you heard croaking in a movie you watched last month. Nor the one you saw hopping about in your balcony this monsoon. (You shouldn’t have screamed at poor Groffy! He jumped over and broke a leg.)
I am the frog who boiled. And this is my story.
It started in a classroom. You see, the advantage of being a frog on a business school campus is that you can just hop over to any prof’s classroom and attend lectures unnoticed. You don’t have to croak your presence when the attendance is called out. No one asks any questions from you. And of course there is no fee to pay.
Look at this way. I am the most literate frog you know. With this introduction, let me croak my story to you.
There is this professor on campus. He teaches a big class in the auditorium. 140 human students meaning that I have to avoid being squashed under 280 very heavy feet. That’s quite a feat by the way. And then I have to hop over those huge stairs unnoticed to get a good vantage point from where I can see the prof and the vivid slides he puts on the screen.
One September morning it was drizzling on campus. My friends and cousins were merrily mud wrestling in our favourite puddle. I was shoving my cousin Kermit’s neck under water while she was splashing her feet wildly unable to breathe. Suddenly, I heard two students rushing past us.
We gotta run dude. I don’t want to miss this class.
Why? What’s the hurry man? It’s only a class.
He’s going to tell the boiling frog story today! My senior told me not to miss it.
Ok man, let’s run!
And off they went.
Boiling frogs???? They boil frogs???
How could anyone do that? My anger rose so quickly that I barely noticed just how far my eyes had protruded. My eyeballs almost fell out of their wet and sticky sockets. If my nostrils had flared any more they would surely have burst apart. And my breathing. Why was I panting?
Stop this atrocity Umbridge! I let go of cousin Kermit who by now that desperately choking and croaking under the mud in my puddle. I had to get to the auditorium and quickly.
How far is it? About 1,500 hops. I better be on my way. Hop Hop Hop.
Ten minutes later, I am stationed at my favourite spot in the auditorium. The lecture is already in progress. The prof is speaking.
…And so, imagine that everyday I consume 100 calories more than I expend. Will I look fatter the next day? Of course not. Not even the day after or the week after. Will I?
But if you saw me after an year, you’d notice that I have gained some weight. And if you saw me after 3 years, you’ll notice that I am obese. But if you saw me every day, you won’t notice that I gone from being fit to being obese in 3 years.
Small incremental changes tend to go unnoticed. This is a very powerful idea, which Charlie Munger called the boiling frog syndrome. If you put a frog in hot boiling water, he will instantly leap out of the pan and be never seen again. But, if you put a frog in a pan with room temperature water and slowly turn up the heat, he would’t be able to tell the tiny incremental changes. He will boil and die as this video shows. Brace yourself when you watch it.
By the time, the video reaches 1:36, my heart is pumping so loudly that I almost feel it burst my chest walls and hit the prof smash in his face. This is disgusting! I need to puke.
But, wait a sec! The video continues and now there is no real frog being boiled! A hoax!
Whew! I am sighing with relief and students are gasping. The prof, who now has a wide grin on his face, is saying
I can assure you that there is no truth whatever in this story, but the human equivalent of the boiling frog is there in all of us. Indeed, Charlie Munger once said that many businesses die just like the boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.
A metaphor! I smiled to myself. This is a cute prof. He is only talking metaphorically! There is no boiling frog. The video is a hoax too! Yay!!! I croaked out in relief.
The Prof is saying let me give you an example.
Take a look at these exhibits. They reflects a prosperous company. Why?
This is a profitable company having a market value of Rs 13,500 cr. Now take a look at these exhibits which display symptoms of a company in a precarious financial condition.
Unlike the earlier company, this company is highly leveraged with very low cash and bank balances. Now see it’s income statement.
Unlike the earlier company which was profitable, this company is into huge losses. It’s market cap at Rs 2,300 cr. is a small fraction of the market cap of the prosperous company you saw earlier.
Now let me tell you one thing: These two companies are the same at different times. This is what happened to MTNL over a span of about 6 years.
This is what Munger means when he likens businesses which die to a boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. Now you could see what happened to MTNL because I showed data pertaining to FY06 and then I showed you data pertaining to FY12. I exposed you to a high contrast effect, which always gets noticed. But investors who are looking at daily, weekly and quarterly information are likely to miss the tiny incremental changes or as Munger puts it, “miss a trend that’s destiny.”
So, the prof is asking, what’s the important lesson here? One student raises her hand.
Sir, this means that investors would be better off if they were exposed to lesser information and not more. Right?
Excellent answer! the prof says. Indeed there is a plenty of research done on this topic. In fact, way back in 1964, two researchers wrote a very interesting paper titled “Interference in Visual Recognition,” in which they described a fascinating experiment.
Take a look at the picture below. Do you see anything?
I see students shaking their heads. But I can see that it’s a fire hydrant. The one in the main building just outside the Director’s office. I have played hop skip and jump so many times on this hydrant. Why can’t they see it? Oh I get it? They aren’t frogs! Ha!
The Prof is saying.
This is a picture of an object which is out of focus. Human eyes can’t identify it in this state. Now imagine I divide this class into two groups. Both the groups will start by looking at the faded picture for 10 seconds. For one group, I will then bring the object into focus upto a point and then stop. I will do this in 20 tiny increments. For the other group too, I will bring this object into focus and stop at the same point at which I stopped for the first group, but the number of increments would be only 5. Now tell me which group will have more information?
A student replies, the first group! They will get to see a lot more data than the second group.
Right! But it turns out that the second group, which had less information, correctly guesses earlier what the object is. See this image.
He quotes from the paper
Pictures of common objects, coming slowly into focus, were viewed by adult observers. Recognition was delayed when subjects first viewed the pictures out of focus. The greater or more prolonged the initial blur, the slower the eventual recognition. Interference may be accounted for partly by the difficulty of rejecting incorrect hypotheses based on substandard cues.
It’s the same boiling frog syndrome again. When people see tiny incremental changes they take longer to recognise what’s going on. People who see just a few changes guess faster. Cool! So all those hourly bulletins issued by cousin Kermit titled “Likely Insect Whereabouts” are useless!
I should have known!
The Prof is now telling another story. This time it’s the story of Kodak.
A few months before kodak filed for bankruptcy, Lex of FT described situation briefly and beautifully:
The big story here is, of course, a simple tale with three parts: photography goes digital; Kodak doesn’t change with the times; the end.
Why did Kodak fail to change with the times. Part of the reason is the same boiling frog syndrome. To see how, let’s do a thought experiment.
Imagine that it’s 1998, just before digital cameras became popular. You are the CFO of Kodak and are enjoying the dominance of your company in the global photographic film market. The world is getting increasingly prosperous and film camera sales are booming because people want to preserve memories. More cameras means more demand for film. Life is good because Kokak is the dominant brand in the world.
One day an engineer walks in with what looks like a toy. He puts it on your table and makes an announcement:
This thing is going to kill us. This is a digital camera. The world will stop buying film cameras. We are going to die.
Now, since this is a thought experiment, let’s ignore the benefit of hindsight. We all know what happened to photographic film business but let’s ignore it for now. Put yourself in the shoes of Kodak’s CFO and give me four very plausible reasons which will convince you that the engineer is over-reacting to the threat from digitisation.
Student # 1: The Cost is too high. Digital cameras cost so much more than film ones. No one will buy them.
Student # 2: The quality sucks. The best digital cameras offer a maximum resolution of only 1.5 megapixel.
Student # 3: People will never watch photos on computers. They love printed albums.
Student # 4: People would never agree to store their memories on computers and take the risk of hard drive crashes and other disasters.
Great points! Now let’s see what happened to each of these objections. The cost went down, the quality got better and now you get 8 megapixel cameras inside mobile phones. New platforms like Facebook emerged on which you can do things with photos (sharing, commenting, tagging) which you couldn’t even have imagined as possible back in 1998. And as for security, online backup facilities, external hard drives, pen drives were invented.
So, you see every single objection to the possibility of digitisation killing the photographic film business turned out to be wrong. But notice that these changes did not happen in a day, or a quarter or a year. It took years. And the CFO and his colleagues, were just too close to all the noise (just like the people who were seeing too many images of the fire hydrant), that missed miss a trend that turned out to be Kodak’s destiny. It’s the same boiling frog effect again.
The boiling frog metaphor is a terribly powerful metaphor and can be applied in many situations. Take the case of the Indian government’s desperation to increase the price of diesel, which is being subsidised heavily because price hikes were not allowed earlier. And now, the government finds it very difficult to do anything about it.
Now imagine that the government had increased the price by just 20 paise a litre in a week. This would have gone unnoticed. In four weeks, the increase would have been 80 paise, and in a year, Rs 9.60, which is way more than Rs 5 increase implemented recently.
If the government had been psychologically astute, it could have used the boiling frog syndrome to implement a change in a manner which was much more likely to be accepted than the manner it actually chose. Partly as a consequence of this mis-step, it lost an ally. Not that she was worth keeping. Just saying.
We frogs surely have come a long way it seems! Humans are using us as examples of how to make people experience change! This was so cool, I am thinking but the Prof continues.
The idea of noise vs. signal has been further refined by the philosopher Nassim Taleb. He says
“Noise is what you are supposed to ignore; signal what you need to heed.”
“The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a confusion, that is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of changes are real improvements or degradations, the other half comes from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as people immersed in the news and markets price variations do, the split becomes 99.5% noise to .5% signal. That is two hundred times more noise than signal —which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker.”
The Prof also quotes Daniel Kahneman:
Investors should reduce the frequency with which they check how well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enough for individual investors. In addition to improving the emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes. The typical short-term reaction to bad news is increased loss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averse and to end up richer. You are also less prone to useless churning of your portfolio if you don’t know how every stock in it is doing every day (or every week or even every month). A commitment not to change ones position for several periods (the equivalent of locking in an investment) improves financial performance.”
So you see, you don’t have to suffer undesirable consequences of being boiled as a frog and you can use the metaphor to achieve desirable consequences of boiling other frogs.
But that’s not the end of the boiling frog story. There’s more. One big objection I have is that the boiling frog metaphor is used either to describe the absence of something undesirable being noticed by the one being boiled or used a tool to manipulate others. We have left out one very important application of the boiling frog syndrome. In fact, the negative connotation associated with the syndrome needs to change. You see, you can use the boiling frog syndrome to manipulate yourself. You can, and should become a boiling frog. Let me explain that with a couple of examples.
Take a look at this book.
This is a great book. 15 months years ago I was obese and unable to walk even one flight of stairs without losing my breath. Then I discovered this book and started using its techniques to start running. The book uses many techniques, of which one the major ones is boiling frog syndrome. You start with running just a few meters. The next day you a run a bit more then a bit more. In a few weeks, I was running 5 kilometres. In a few more, 10 km and before long i was running half marathons.
During this period, I also made changes in what I ate. My dieting and my running, both involved my treating myself like a boiling frog – small incremental changes. They went unnoticed at first, until people started noticing.
You see, all learning in that sense involves deliberate practice which occurs in tiny increments. Every day you add a bit to your knowledge and after many years of doing it right, you become an expert.
There’s another book I love on this subject.
I used this book, along with the book on marathon running to change my health and my shape. This book also teaches you how to become a boiling frog to achieve behaviour change that’s slow, goes unnoticed, and becomes permanent. The author quotes Lao Tzu
“A journey of a thousand miles must begin with the first step.”
“When you improve a little each day, eventually big things occur. When you improve conditioning a little each day; eventually you have a big improvement in conditioning. Not tomorrow, not the next day; but eventually a big gain is made. Don’t look for the big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens-and when it happens, it lasts.” -John Wooden, one of the most successful coaches in the history of college basketball
All changes, even positive ones, are scary. Attempts to reach goals through radical or revolutionary means often fail because they heighten fear. But the small steps of kaizen disarm the brain’s fear response, stimulating rational thought and creative play.
The class is now coming to an end and I, Umbridge the frog am feeling quite kicked about the whole thing! Can’t wait to hop back to my puddle and boast to cousin Kermit about just how far we frogs have come. We are now role models for humans to become better and better over time.
And that’s not too bad now is it?
Suzie blew me away. It happened in Goa. On Colva beach on a memorable windy evening in late October 2007. I will never forget Suzie. Or that evening.
I was there to visit an iron ore mining company. A boring company to visit indeed. You bore a hole into the ground, dig out the ore and you ship it to the buyers. Ore is bore. Even the name was boring.
Why couldn’t they ever send me to an exciting company? One that would change the world? Like that alternate energy company one I was reading about on my windy, turbulent flight to Goa? What’s it called? Never mind. Just get over this boring shit meeting.
The same questions again and again. But this is my job. I have to ask them.
Can you give me your latest estimate of proven reserves? I smiled on that one. Hard to supress it when you’re thinking that a mine is a hole in a ground with a liar on the top. Twain said that, isn’t it? Who cares? It’s a good quote to help me out of this boredom hole.
What will you earn next quarter? What’s your outlook for ore prices this month?
Month??? No one thought in terms of decades. Or even years. You can’t produce a baby in one month by getting nine women pregnant. Graham said that, isn’t it? No, that was Buffett. Graham would never say that without trying it out. Tee hee. That’s funny.
I was so bored. And I had to be here till tomorrow morning.
Hey! Wait a minute! Why not go to the beach?
Yes, I thought that’s a awesome idea. Beaches are good. Anything can happen on a beach. Tonight, I was prepared for an adventure. I needed one and fortune favours the prepared mind. Louis Pasteur said so.
I guess the problem is that I am just too cautious. Every time I’ve met a girl in the last two years, it has never worked out between us. I am too young to make any long-term commitments. Or, rather, I was. Until today. Tonight I feel different. Romance is in the Goa air. Or, maybe it was the double shots of Sea Breeze cocktail I drunk at the hotel bar before coming here. Who cares? Tonight, I throw caution to the wind.
And so I had a couple of drinks and I headed out towards the beach. And here’s how it happened.
Colva beach is so beautiful by the sunset. The wind is blowing softly and I just love it so much here. But I am lonely and tipshee and why I am I shlurring even while thinking?
Who’s that girl? Why is she standing alone in the water?
Look at that sunset! That’s what she’s gazing at and I gaze at her.
Her silhouette is so hypnotic, that I can’t even blink my eyelids. Why aren’t other people looking at her? Maybe they are just too engrossed in each other. Good. Or maybe she is that magical woman only I can see. She is there only for me. Or maybe I am just hallucinating.
Very gently, I tip-toe towards her, while the splashing, soapy waves wipe away the toe prints I leave behind. Softly, I enter the water and approach her.
Shit scared. My heart is probably racing at 200 beats a minute. OMG, she will hear, turn and scream! I pause three feet before her silhouette and see the contours of her outline against the sun behind her. She is as breathtaking to me as the sunset is to her.
I take a deep breath to slow my heart beat but the soft wind blowing towards me carries her mild but distinctively fruity fragrance inside my nostrils. She’s inside me now. I have inhaled her won’t let her go away so easily. But in ten seconds, I am breathless with my heart now pounding away at 240.
She turns her head a bit, still oblivious of my presence. I can see the shape of her face, her nose, her lips. She is the most beautiful woman he have even seen this close. She turns her head and smiles as if she knows. As if she is expecting me. She says
Are you here for me?
I knew you’d come. I’ve waited so long for you.
She smiles so beautifully. Everything about her is so awesome. And she moves her body like a cyclone. That’s a song, isn’t it?
She moves closer and it feels like a whirlwind. She touches me gently. On my neck. Feels my face. Caressed my arms. Ruffles my hair. As if she’s known me for a long time. And then she gently leans over and whispers in my ear.
My name is Suzie. No one else will see me. You can’t touch me but I can touch you. We will live here on the beach. And I’ll be yours so long as you will have me. Agreed?
At that moment, I felt so powerless. All I wanted was her. On any condition. I blurted a yes. She opened her arms, and came closer still. Then she hugged me tightly. Squeezed me for 30 seconds. It felt as if I was in a wind-tunnel.
We were married the next day. On the beach. She would be the wind beneath my wings and I was so happy that I was going to fly. Just like Jonathan Livingston Seagull.
I felt invincible. And I felt committed. I had made my vows. My commitment was for real.
And then my phone rang. It was my childhood buddy – a professor in finance. Kind of revered. He had just heard. He said
WTF? Are you crazy? Is this for real? Have you lost your senses?
How did you wind up with a girl like HER?
I knew my prof buddy meant well. But what did he know about love? He was practically married to his kindle and he couldn’t talk about anything but risk management.
So I told him. Life is short. It can come and go like a feather in the wind. Shania Twain said that. I told him that too. He said Shania who?
He tried hard to talk me out of it. I told him to forget it. It’s complicated. He hung up. I knew he’ll be back, though. Just like the terminator.
A week later, he called again. Said he is giving a talk in class which will be of particular interest to me. I must come. He has sent the tickets. I said I will go, just to make him happy.
And so I go to Gurgaon, to attend his class in mid November of 2007. He makes me sit in the front row. Now I won’t even able to sleep in the back bench!
The class is about his new fangled ideas – god knows where all he gets them from. Every year he comes up with a few.
He starts by talking about mental tricks like backward thinking and reductionism. He says there’s a bubble building up inside the global alternate energy sector but people inside the bubble don’t know they are inside it because they are inside it. I guess this means that HE is outside it and he will rescue those inside it. Hmmmm.
He reminds me and others that backward thinking is a trick we all learnt in school. It’s called proof by contradiction. So if we have to prove that proposition x is false, we first assume that it’s right. Then we show that if it’s right, it will result in an absurdity y. But that’s not allowed, so from this we deduce that proposition x must be false.
He then shows examples used by his guru Warren Buffett where he applied this technique. Apparently, Buffett proved, using this backward thinking technique that dot com companies were hugely overvalued in early 2000. He quotes Buffett:
“When we buy a stock, we always think in terms of buying the whole enterprise because it enables us to think as businessmen rather than stock speculators. So let’s just take a company that has marvelous prospects, that’s paying you nothing now where you buy it at a valuation of $500 billion. If you feel that 10% is the appropriate return and it pays you nothing this year, but starts to pay you next year, it has to be able to pay you $55 billion each year – in perpetuity. But if it’s not going to pay you anything until the third year, then it has to pay $60.5 billion each per year – again in perpetuity – to justify the present price… I question sometimes whether people who pay $500 billion implicitly for a business by paying some price for 100 shares of stock are really thinking of the mathematics that is implicit in what they’re doing. For example, let’s just assume that there’s only going to be a one-year delay before the business starts paying out to you and you want to get a 10% return. “If you paid $500 billion, then $55 billion in cash is the amount that it’s going to have to disgorge to you year after year after year. To do that, it has to make perhaps $80 billion, or close to it, pretax. Look around at the universe of businesses in this world and see how many are earning $80 billion pretax – or $70 billion or $60 or $50 or $40 or even $30 billion. You won’t find any…”
My prof buddy then gives another example of this technique used by another of his gurus – Ralph Wanger who proved that the disk drive industry was overvalued in early 1980s. He quotes Wanger:
“Remember back in the early ’80’s when the hard disk drive for computers was invented? It was an important, crucial invention, and investors were eager to be part of this technology. More than 70 disk drive companies were formed and their stocks were sold to the public. Each company had to get 20 percent of the market share to survive. For some reason they didn’t all do it . . .”
He then starts talking about using this technique to prove that the Global Wind Power industry is hugely overvalued. But this time he used another technique in addition. He calls it reductionism, an idea he says he picked up from another one of his gurus – Charlie Munger. He quotes Munger:
“At a very young age, I absorbed what I call the fundamental full attribution ethos of hard science. And that was enormously useful to me. Under this ethos, you’ve got to know all the big ideas in all the disciplines more fundamental than your own. You can never make any explanation that can be made in a more fundamental way in any other way than the most fundamental way.”
Munger, my prof buddy says, means that if you must prove or disprove something in social science, you should use the tools of not just backward thinking, but you should also use the tool of reductionism, whenever possible. In Munger’s worldview, its better for social scientists to respect the ethos of hard science and reduce problems in their domain to a hard science domain, where it would be virtually impossible to argue against the wise social scientist’s conclusions.
And then my prof buddy takes the aggregate market value of the wind power industry and uses the techniques of backward thinking and reductionism to show that there is not enough space on this planet to support the number of installations of wind power generators required to produce the quantity of power which would necessary to produce the earnings sufficient enough to support those gigantic valuations. He claims that he has reduced a social science problem to a hard science one.
He then puts up a video. But why is he looking at me when he plays it?
He says this extra-vivid video and other similar extra-vivid presentations made by agents of companies in the wind energy business together with soaring stock prices have mesmerised many a people who are living in a world of illusions. He quoted Galbraith.
This is a world inhabited not by people who have to be persuaded to believe but by people who want an excuse to believe.
He looks intently at me.
This business, my prof buddy says, is really a tax shelter business enjoying tailwinds for the moment. Eventually, it will face headwinds. When that happens, valuations will crash. But in the meantime, there’s a party on and no one wants to leave before the clock strikes twelve. The only trouble, he says, is that the clock has no hands…
Then, to illustrate his point, he puts up this slide.
Why is he doing this this to me?
No! No! No!
This can’t be true!!!
Oh God No!
Two days before my course started at MDI on Friday, I had a fall.
A rugged stone appeared from nowhere while I was running around a tomb. I fell. Hard. Bruised all over my arm and my knee. Skin off my palm. Bleeding, limbed back home, got fixed by a wife and a doc. It hurt like hell.
But now I just can’t get the Red Queen out of my head.
You see, I was trying to get somewhere. From my present state of moderate stamina to be able to run a half marathon by the end of this month. But for now I am back to where I started, which is basically nowhere. Just as the Red Queen said. I should have stuck to running on the boring treadmill (on which you really get nowhere) instead of running around the tomb of a king called Humayun who died 457 years ago.
Humayun, with his arms full of books, was descending a staircase from his library when suddenly Adhan (the call to prayer) was announced. It was his habit, wherever he heard the summons, to bow his knee in holy reverence. Kneeling, he caught his foot in his robe, tumbled down several steps and hit his temple on a rugged stone. He died three days later.
Those rugged stones are dangerous.
But hey I survived them! Just so I could tell you about the Red Queen. And her “effect.” And what it has to do with businesses and stocks.
The Red Queen is a fictional character in Lewis Carroll’s “Through the Looking Glass.” In a famous scene the Red Queen seizes Alice by the hand and drags her, faster and faster, on a frenzied run through the countryside, but no matter how fast they run, they always stay in the same place. Alice, who is understandably puzzled, says
“Well in our country you’d generally get to somewhere else – if you ran very fast for a long time as we’ve been doing.” “A slow sort of country!” says the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
In 1973, Leigh Van Valen, an American biologist possessing a multidisciplinary mind, morphed this story into what became the legendary “Red Queen Effect” – the idea that there is a constant “arms race” between co-evolving species.
In his excellent book “Deep Simplicity,” John Gribbin describes the Red Queen Effect in terms of an imaginary species of frog that feeds on an imaginary species of fly.
“There are lots of ways in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one possibility. If a frog has a particularly sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year.
Because of a mutation a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the flies have got more slippery bodies.”
In other words, you run, but your get nowhere. Just like me.
In his Pulitzer-prize winning book “The Emperor of All Maladies: A Biography of Cancer,” Siddhartha Mukherjee describes the evolutionary arms race between the drugs and cancer.
“In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfield’s cancer responded briskly at first. The fraction of leukemic cells in his bone marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response was short-lived. In the winter of 2003, Mayfield’s CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had become resistant to targeted therapy…”
“… Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles’ heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.”
While the Red Queen Effect predicts you will get nowhere, the effect marches on, jumping over one discipline’s jurisdictional boundary into others’. It jumped from fairy tale land to the disciplines of international diplomacy (“arms race”), evolutionary biology (“frogs and flies”), and the field of drug discovery. It also jumped over to the field of finance.
Take a look at this woman:
She is going nowhere by climbing up on a down escalator. Funny, isn’t it? We laugh at her predicament. But what about the predicament of investors who make no real progress with their money because choices they made failed to keep pace with a down escalator called “inflation?”
Warren Buffett has written about the effects of inflation on investors several times. Here is one except.
“Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.
High rates of inflation create a tax on capital that makes much corporate investment unwise—at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners—has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.“
They ask you to keep on pouring more and more capital into profitless growth. Buffett calls the worst business to be
“one that grows a lot, where you’re forced to grow just to stay in the game at all and where you’re re-investing the capital at a very low rate of return.”
He gives example of the airline industry.
“Investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.”
Graham used to talk about a fictional “Frozen Corporation” whose charter (“Memorandum of Association” in India) prohibited it from ever paying out anything to its owners or ever being liquidated or sold. And Graham’s question was
What is such an enterprise worth to public stockholders?
He was obviously talking about “value traps.” But Charlie Munger extended Graham’s metaphor by identifying functional equivalents of the Frozen Corporation in the real world.
“There is a class of business where the eventual “cash back” part of the equation tends to be an illusion. There are businesses like that – where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.”
The world is full of crappy businesses which are the functional equivalents of Graham’s Frozen Corporation. One of my favorite examples is Samtel Color, a company whose fortunes can be seen from the chart below:
This company, as far as I can make out, never made any real profit in a decade. In a capital intensive business like the Television manufacturing, the rate of obsolescence is very high. Black & White picture tubes got displaced by colour TVs and Cathode Ray Tubes got displaced by Flat Panel TVs. These plants don’t come cheap. A plant may have a useful physical life of 20 years but it becomes obsolete much earlier when customers shift preferences to the hottest new technology. For Samtel Color, this meant that its maintenance capex far exceeded accounting depreciation, resulting in no real earnings.
Such type of companies – and there are hundreds of them – face miserable choices. Either stop investing in new technology and die. Or pour more and more capital and still make no real profits. There is no real progress as they have to keep on running just to stay still. All of the dividends paid by Samtel Color over the last decade, for instance, weren’t really financed from economic earnings because there weren’t any. Rather, the money paid to stockholders came from lenders and – surprise! surprise! – from stockholders through issue of new shares for cash. That’s a ponzi scheme, isn’t it?
High capital intensity, insignificant, if any, economic earnings, and inevitably rising debt ultimately kills such companies. Regardless of how their stocks may perform in the short term, in the long-term they go nowhere (see Samtel’s stock price chart). Or they go to zero.
The Red Queen Effect haunts them.
Safal Niveshak (Successful Investor) was founded by Vishal Khandelwal, who is a friend on facebook. Out of curiosity, in June 2012, I ended up on this page of his site and liked his methodology enough to send a message to him, complimenting him on his efforts and his clear thinking.
Vishal wrote back and soon we were exchanging messages. One thing led to another and we met at The Aman, New Delhi on 29 July for breakfast, which lasted more than 2 hours, during which Vishal asked me few questions and recorded my answers.
Later, he painstakingly transcribed the interview into four parts, which he posted on his site. Here are the links:
In Part I of this series on floats, I wrote about how Berkshire Hathaway has been able to create less-than-free float from its insurance operations — a key reason for the company’s stupendous success. I also listed a few “general principles” on floats and showed how high-quality floats can become “unencumbered sources of value.”
In Part II, I expanded the discussion on Buffett’s attraction towards floats in a variety of business situations encountered by him in his long career, ranging from floats enjoyed by American Express and Blue Chip Stamps in his early years, to recent structured derivatives contracts created by him.
In this concluding part, I will shift focus away from Buffett (although I will use his thoughts on the subject) to other businesses that enjoy attractive floats.
Let’s start with HUL. Take a look at the company’s summarised balance sheet as on March 31, 2012.
Take a few moments to observe the above statement. I’ll wait for you.
Notice that HUL is debt free. Why? Let’s try to answer this question by reorganising the company’s balance sheet.
Each side of the HUL’s balance sheet — assets as well as liabilities — totals to Rs 11,407 cr. That’s not a co-incidence by the way. :-)
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be non-current investments (Rs 70 cr.), current investments (Rs 2,252 cr.), and cash and bank balances (Rs 1,996 cr.). These total to Rs 4,318 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 4,318 cr.
Operating Assets: Rs 7,089 cr. (balancing figure)
Total Assets: Rs 11,407 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 3,680 cr.
Debt: Rs Nil.
Float: Rs 7,727 cr. (balancing figure)
Total Liabilities: Rs 11,407 cr.
“Float?” Yes, float. Other People’s Money (OPM) which carries no interest. Hindustan Lever is debt-free because it has access to free money provided by other people. It does not need to borrow any money to finance its operations. That becomes rather obvious by re-looking at the following two figures:
Operating Assets: Rs 7,089 cr.
Float: Rs 7,727 cr.
Since this float, which is cost-less, is more than operating assets, can we infer that all of the company’s operations are financed with free money? Yes!
How could HUL achieve this feat? Let’s find out by quantifying the main contributor of the company’s float. Of the total float of Rs 7,727 cr., trade payables alone are worth Rs 4,844 cr, an amount which is more than sufficient to finance inventories and receivables aggregating to Rs 3,524 cr. Here’s the breakup:
Inventories: Rs 2,667 cr.
Receivables: Rs 857 cr.
Total: Rs 3,524 cr.
Trade payables: Rs 4,844 cr.
What does this mean? It means that HUL obtains trade credit from its vendors which is more than sufficient to finance its investment in receivables and inventory. That is, HUL operates on negative working capital, which is the key source of the company’s float.
How should we determine the importance of this float to HUL’s stockholders? By doing a thought experiment. Just like the importance of the person is realized when he/she is no longer there, let’s figure out the importance of HUL’s float by imagining that it’s not there. Let’s make the float of Rs 7,727 cr disappear. Poof! It’s gone!
But hang on a second. HUL still needs to have Rs 7,089 cr of operating assets, which need to be financed from somewhere and it’s source of free money — float — just evaporated. So, HUL needs to find alternate financing. There are only two sources: Debt and Equity. If HUL had to employ debt to replace float, then at current interest rates of 10% p.a. it would have to pay about Rs 700 cr. as interest, which if we consider, would have reduced its pretax profits from Rs 3,621 cr in FY12 to Rs 2,921. That’s a reduction of 19% in HUL’s pretax earnings.
Alternately, HUL could replace its float by issuing additional shares. Assuming it did so, at its current stock price of Rs 500, then in order to raise Rs 7,089 cr, HUL would need to issue 14 cr additional shares to its existing 216 cr shares. That’s an addition of 6% to its equity capital which would have resulted in no incremental earnings.
Either way we look at it, we can see that presence of float is quite important for HUL’s stockholders. Float prevents the company from the burden of interest-bearing debt. It also prevents the need to dilute equity.
Now’s lets look at another company — Nesco Limited — about which I had written a few years ago. Take a look at Nesco’s balance sheet as on 31 March 2012.
You’ll notice that just like HUL, Nesco too a debt-free company. Why? To answer that question, let’s reorganise Nesco’s balance sheet — just as we did in HUL’s case.
Each side of the Nesco’s balance sheet — assets as well as liabilities — totals to Rs 381 cr.
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be current investments (Rs 210 cr.) and cash and bank balances (Rs 4 cr.). These total to Rs 217 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 214 cr.
Operating Assets: Rs 167 cr. (balancing figure)
Total Assets: Rs 381 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 290 cr.
Debt: Rs Nil
Float: Rs 91 cr. (balancing figure)
Total Liabilities: Rs 381 cr.
Nesco’s operating assets of Rs 167 cr. are financed to the extent of Rs 91 cr. by OPM, which carries no interest. Was this float not available, Nesco would necessarily have to raise this money from debt and/or equity. Either alternative would have reduced earnings per share, as was the case in HUL discussed earlier.
So, how could Nesco obtain this float? Let’s find out by quantifying its main contributors. Of the total float of Rs 91 cr., advances & security deposits from customers alone are worth Rs 57 cr and trade payables are worth Rs 8 cr. These two items, which total to Rs 65 cr. are more than sufficient to finance inventories and receivables which total to Rs 13 cr. Here’s the breakup:
Inventories: Rs 5 cr.
Receivables: Rs 8 cr.
Total: Rs 13 cr.
Advances & security deposits from customers: Rs 57 cr.
Trade payables: Rs 8 cr.
Total: Rs 65 cr.
Nesco has three businesses each of which use float. Exhibition organizers who book Nesco’s exhibition center pay the company advance money to book space for various exhibitions. They also pay security deposits. Similarly, for occupying its commercial buildings, Nesco’s tenants pay security deposits to the company. Finally, for its manufacturing business, the company enjoys trade credit. Moreover, neither the exhibition business nor the commercial building business has any receivable or inventories, so the aggregate of trade credit and advances & security deposits exceed the aggregate investment in inventories and receivables.
Just like in the case of HUL, Nesco too, then, enjoys a negative working capital which is the key source of the company’s float. The only difference between the two situations is that while in HUL’s case, trade credit provided the float, while in Nesco’s case advances & deposits from customers primarily provide the float.
We’ll come back to a more detailed discussion about trade credit and customer advances & deposits. For the time being let’s recall how Warren Buffett thinks about float as an attractive source of financing. A key lesson from Buffett on this is:
If you get access to an enduring and free (or less-than-free) float — whether it comes from insurance underwriting, derivatives contracts, trading stamps, travelers’ cheques, stored value cards, deferred taxes or any other source — then assets financed with such a float will become “an unencumbered source of value” for your stockholders. This will happen because (1) the assets financed with such a float would still be valued on the basis of their expected future earning power; but (2) the true value of the liability represented by the float will be far lower than its carrying value, provided the float is both costless and long-enduring.
Those two factors — cost and duration — determine how attractive a float it. The lower the cost approaches zero, and the longer the duration approaches eternity, the more the float resembles a perpetual, zero coupon bond which, as I discussed in Part I, will be worth almost nothing as a liability which is really cool because assets financed from the float could be worth a lot, just as happened in the case of Berkshire Hathaway.
Conversely, the higher the cost approaches the cost of alternate financing, and the lower the duration of the float, the less attractive it becomes. Under such circumstances, liabilities which are source of float should be valued fully on the balance sheet of company having access to that float.
Costless and long-enduring floats, then, are a very attractive form of financing — more attractive than debt, and more attractive than additional equity. We saw this in our HUL “thought experiment” above. Buffett agrees with this line of thinking. When asked about the relative attractiveness of low-cost floats vs other forms of financing, he said:
“Our insurance companies have had a terrific experience on cost of float‚ and we’d like to develop it just as fast as we can. Right now we’ve have no interest in issuing a bond because we have more money around than we know what to do with, and it comes from low-cost float. But if a time came when things were very attractive and we’d utilized all the money from our float and retained earnings and we still saw opportunities, we might very well borrow moderate amounts of money in the market. It would cost us more than our float was costing us, but it would still provide us with incremental earnings. But we would try to gain more float under those circumstances, too.”
The correct way to think about floats, then, is to think of them, simply as a form of leverage. Leverage, however, is traditionally associated with interest-bearing debt. But a free float is also a form of leverage, isn’t it? After all, it’s OPM and that’s what leverage means. Just like low-cost debt can lever up the return on invested capital, a free, or low-cost float can lever up the return on operating assets and that’s what Buffett meant when he wrote:
Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” — that is, the degree to which its assets are funded by liabilities rather than by equity.”
“Funded by liabilities rather than equity.” He used the word “liabilities” and not “debt. That’s key. The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes.
Why, then, do businesses ever borrow money to fund their operations? Why don’t they just use free floats? The obvious answer to this question is that most businesses do not operate with a negative working capital. They simply don’t have free floats.
Recall that negative working capital arises when money tied up in inventories and receivables are more than offset by funds provided by customers by way of advances & deposits and also by trade credit. Let’s now return to the discussion of these two important contributors of free floats: Trade credit and advance payments & deposits from customers.
Trade credit is given to a firm by its vendors. Advance payments & deposits are given to a firm by its customers. Why, as was the case with HUL, would a firm enjoy substantial trade credit which more than finances its inventories and receivables? And why, as was the case with Nesco, would a firm get paid in advance by its customers and also receive substantial deposits from them, which, when taken together, more than offset its investment in inventories and receivables?
The answer to both these questions is “Market Power” — the power of a firm over its vendors (who give it large amounts of trade credit) and its customers (who give it large amounts of advance payments & deposits) in quantities large enough to ensure that the firm can operate with negative working capital, as we found in the case of Nesco. The super powerful ones can operate with negative net operating assets (where float exceeds investment in inventories, receivables, and fixed assets), as we found in the case of HUL.
Where does this “market power” come from? It primarily comes from two sources: (1) shortages; and (2) moats.
We have little interest in floats produced from shortages-derived market power. That’s because such floats are likely to be temporary, fair weather friends. To see how, think of a shipping company during a shipping boom when freight rates are sky high and every shipper is drowning in cash. The freight rates are high because of shortage. This shortage delivers market power to the ship owners, who can demand, and obtain, not only high freight rates, but also advance payments from their customers. These advance payments from customers, will temporarily reduce working capital requirements because receivables will turn into advance payments received.
Alas, such a happy environment is unlikely to last. The entry barriers in shipping are low, even though the gestation period is high. It’s only a matter of time when the supply of new ships will create a glut. Such a glut will have two consequences. One, freight rates will fall. And two, power will shift from shipping companies to their customers, who will now refuse to make advance payments and will insist on very lenient credit terms. For shipping companies, advance payments from customers will disappear, and will be replaced by receivables from customers. There will be dire consequences so far as working capital requirements are concerned: When its float disappears, a shipping company will typically find it hard to stay afloat unless it replaces the free source of finance with debt, or equity. This is happening now in global shipping industry.
This kind of power shift in a value chain is not limited to the shipping industry. You will find it in automobile industry, in textiles, in chemicals — in fact, you’ll find it in any commodity industry having low entry barriers.
In such situations, being impressed with temporary low-cost float during good times, could be a costly mistake. The lesson for long-term investors is clear: Beware of floats derived from shortages in commodity-type industries having low entry barriers. Recall, this lesson is consistent with Buffett’s belief that a float is attractive only if its cheap and enduring and a float produced from temporary shortages is anything but.
Let’s now talk about the second source of market power — one which is cheap and enduring, and one which should interest us a lot: Moats.
Buffett uses the metaphor of a “moat” to illustrate a business’s superiority “that make life difficult for its competitors.” A truly great business, says Buffett, must have an enduring moat around its economic castle that protects its excellent returns on invested capital. He writes:
“What we’re trying to find is a business that for one reason or another — because it’s the lost-cost producer in some area, because it has a natural franchise due to its service capabilities, because of its position in the consumer’s mind, because of a technological advantage or any kind of reason at all – has this moat around it. And you throw crocodiles and sharks and piranhas in the moat to make it harder and harder for people to swim across and attack the castle.”
Finally, we have reached the point which I wanted to make at the very beginning of this long series! Professors are rarely known for their brevity :-)
The point is this: Floats and Moats go together.
Think about it. What kinds of companies can operate with negative working capital (e.g. Nesco) or even negative net operating assets (e.g. HUL)? What power do such companies possess over their customers and suppliers, who happily (or even unhappily) finance their working capital (Nesco), or even the entire capital (HUL) employed by the business?
The answer, of course, is companies which possess enduring moats. While, HUL’s moat is derived from the company’s brands and distribution network, Nesco’s moat in its exhibition center business is derived from scarcity.
HUL’s moat is much more powerful than Nesco’s and that’s reflected in its negative net operating assets. All of HUL’s operating assets are financed by its float, while only part of Nesco’s assets are. Nevertheless, float in both cases levers up return on invested capital for both the companies.
To see how floats lever up returns on invested capital, consider that one of the consequences of a solid moat is that it enables a business possessing such a moat to earn excellent returns on its invested capital. Earning excellent returns on invested capital, in fact, is a pre-requisite for spotting a moat, according to Buffett. He writes:
“A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.”
Notice, he used the term “invested capital” which is the capital provided by investors — debt as well as equity — and does not include funds provided by floats. He did not use the term “total assets” although most great businesses possessing enduring moats will have good returns on assets and on invested capital.
How can a business earn excellent returns on invested capital? There are only two ways to do it: (1) maximise the numerator i.e. returns; and/or (2) minimise the denominator i.e. invested capital.
A moat (whether derived through pricing power or a sustainable low-cost advantage) can help the business achieve (1). A free, or a low-cost float (derived, of course, from an enduring moat) can help it achieve (2). How so? Let’s see how this happens in case of HUL and Nesco.
For FY12, HUL earned pre-tax profits of Rs 3,500 cr. On total assets of Rs 11,407 cr., this translates into a return on assets of 31%, which is fantastic. But, when we recognize that out of total assets of Rs 11,407 cr., float contributed Rs 7,727 cr., leaving only the balance 3,680 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 95%.
Similarly, for FY12, Nesco earned pre-tax profits of Rs 97 cr. On total assets of Rs 381 cr., this translates into a return on assets of 25%. But, when we recognize that out of total assets of Rs 381 cr., float contributed Rs 91 cr., leaving only the balance Rs 290 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 33%.
Think of it this way. A business may employ a large amount of assets, but such a business — because it has an enduring moat may enjoy significant market power over its vendors and customers. The business exercises its power over its vendors by insisting on, and getting away with, very lenient credit terms from them. In addition, power is also exercised over customers by insisting upon, and getting away with, receiving advance payments & deposits from them. The vendors and customers don’t have a choice. They have to adhere to the terms dictated by the business because for them, there is no other alternative. This market power, exercised in the manner described, results in the ability of the business to operate with negative working capital which reduces, or sometimes even eliminates, the need for stock and bond investors to invest anything in the firm’s operating assets. Invested capital (the denominator) is minimised, which results in a jump in return on that capital.
Let me give you another example — this time from USA.
Each side of the Amazon.com’s balance sheet — assets as well as liabilities — totals to $25 billion. The breakup of asset side is as under:
Financial Assets (Cash and cash equivalents and marketable securities): $10 billion
Operating Assets: $15 billion (balancing figure)
Total Assets: $25 billion.
Here’s the breakup of the liability side:
Equity: $8 billion
Debt: $ Nil
Float: $17 billion (balancing figure)
Total Liabilities: $25 Billion.
Amazon.com enjoys a float of $17 billion even though it employs only $15 billion of operating assets! No wonder it’s a debt-free company. But, how does it get so much float?
The main contributor towards Amazon.com’s float is accounts payable of $11 billion, which, when compared with inventories of $5 billion and accounts receivable of $3 billion result in a negative working capital of $3 billion. By keeping inventories low, by ensuring customers pay amazon.com quickly, and by taking longer to pay its vendors, Amazon.com has been able to build a huge float. In addition, the successful Amazon Prime service and sale of gift certificates enables the world’s largest online retailer to collect funds from customers in advance.
In 2011, amazon.com pre-tax earnings were $934 million, which when compared with total assets of $25 billion translate into a return of only 3.7%, but when compared with Equity of $8 billion, gets levered up to 12% ROE. Considering the prevailing low interest rates in USA, that’s not bad at all.
Amazon.com is a wonderful example of a situation where return on assets is mediocre, but return on equity is good, simply because the company has access to large amounts OPM on favourable terms. It’s the float which makes amazon.com profitable and it’s the float that keep the company debt-free. If you were to value amazon.com, you’ll have to think very hard about two questions: (1) How likely is it that amazon.com’s float is truly costless; and (2) How long will it last?
if you look carefully at the worlds’s debt-free companies (e.g. look at BHEL, BEL, EIL, Wipro, Infosys, Intuitive Surgical, and Apple) a pattern emerges. Many of these companies will, apart from being debt-free have the following additional characteristics:
In other words, where there are large enduring floats, you will find moats. This makes moat hunting an objective exercise, doesn’t it? Apart from looking for signs of moats indicated by high switching costs, low-cost advantages, intangible assets, and network effects as Pat Dorsey does in his wonderful book “The Little Book that Builds Wealth,” you may also spot an enduring moat by simply looking for the above pattern.
Finally, in your hunt for long-term high-quality businesses, as you witness the proximity between floats and moats, you will also discover that all floats are not the same. In particular, you will discover the following general principles:
Happy Moat Hunting!
Acknowledgements: I’d like to thank Priyank Sanghavi and Ankur Jain with whom I had extensive and very helpful interactions on the subject of floats and moats which helped me formulate my thoughts on the subject.
Note: This post is a continuation of a previous post titled “Flirting with Floats: Part I.”
While cheaper-than-free float provided by astute insurance underwriting is the kind of float Buffett loves the most, there are other floats he has “flirted” with during the course of his long career.
Perhaps it started with American Express.
Between 1964 and 1966, Warren Buffett bet 40% of his partnership’s capital on American Express’ (Amex) stock, which had been battered down by the company’s involvement in the then infamous Salad Oil Scandal. Buffett’s investment of $13 million gave his partnership a 5% stake in the company, implying a total market cap of about $260 million at that time.
I searched for and found out Amex’s annual report for 1964. I urge you to read it. Apart from the fact that both its main businesses (travelers’ checks and credit cards) were doing extremely well, you will notice three additional points by studying its balance sheet on page 27: (1) The presence of $263 million of cash; (2) absence of interest-bearing debt; and (3) Travelers’ checks outstanding totaling to $525 million (a liability).
Those $525 million travelers’ checks represent float. People pay for travelers’ checks upfront and cash them later. The lag between purchase and their subsequent cashing may last a few days or even a few years (and sometimes they never get cashed). In the meantime, Amex gets to use the float for its business – free funds which otherwise it would have had to pay for.
Even though the Salad Oil Scandal had decimated the company’s stock price, as it did not have any interest-bearing debt, and had substantial cash to pay for the losses arising out of the scandal, all that Buffett needed to examine was the probability of it’s float disappearing. That, of course, would have happened only if the millions of holders of Amex’s travelers’ checks lost the trust behind the “American Express” brand.
In Buffett’s biography, “Snowball,” the author, Alice Schroeder, writes:
“The company’s value was its brand name. American Express sold trust. Had the taint to its reputation so leaked into customers’ consciousness that they no longer trusted the name? Buffett started dropping in on Omaha restaurants and visiting places that took American Express cards and Travelers Cheques. He put Henry Brandt on the case. Brandt scouted Travelers Cheque users, bank tellers, bank officers, restaurants, hotels, and credit-card holders to gauge how American Express was doing versus its competitors, and whether use of American Express Travelers Cheques and cards had dropped off. Back came the usual foot-high stack of material. Buffett’s verdict after sorting through it was that customers were still happy to be associated with the name American Express. The tarnish on Wall Street had not spread to Main Street.”
Despite the scandal, Buffett had figured out that Amex’s float was not going away. Without mentioning the investment, he hinted to his partners what he had done, by writing:
“We might invest up to forty percent of our net worth in a single security under conditions coupling an extremely high probability that our facts and our reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”
I would speculate that if, instead of $525 million of cost-less float given to Amex by millions of its customers, American Express had $525 million of bank debt, Buffett would have stayed away from the stock. Bankers, he would have reasoned, could have easily recalled their loans from the scandal-ridden company resulting in a death spiral. But all of the customers holding travelers’ checks wouldn’t line up outside the company’s offices to cash them all. For them, the scandal was a non-event.
Buffett was right. Amex’s stock price trebled within the next two years as Wall Street slowly figured out what Buffett already had.
There is an important lesson about floats from the examples of Blue Chip Stamps and Amex: Float provided by millions of small customers can be quite enduring.
Amex’s float is similar to that enjoyed by banks on funds of customers they get to keep for free. Bankers are known to fight each other over floats represented by “non interest bearing current accounts” of large corporate customers. Free money, even for just a few days is worth fighting for, isn’t it? And then, of course, there is the case of very large sums of unclaimed deposits lying with India’s public sector banks. That’s float too.
What’s fascinating is how Amex’s float on travelers’s checks – something that attracted Buffett to the stock- became almost inconsequential over time, even though its dollar amount soared. As of the end of 1964, Amex had a total of about $525 million worth of Travelers’ checks outstanding, or 445% of its $118 million revenue for that year. That’s a big number. By the end of 2011, the company’s revenues had soared to $25 billion, while total travelers’ checks outstanding as of that year’s close were $5 billion, or just 20% of revenues. Paradoxically, the company’s credit and charge card businesses overtook the traveler’s checks business, which is now in terminal decline. Even so, Amex marched on and its the tag line for its travelers’ checks commercials (“Don’t leave home without them”) was altered to suit the commercials for its charge card. The new tag line became: “Don’t leave home without it.”
By 1968, Buffett sold out his 5% stake, which cost him $13 million for about $33 million. Many years later, he got back in the stock. By the end of 2004, Berkshire had bought a 10% stake costing it $1.4 billion. (That’s a good example of opportunity cost!).
The big problem for Buffett with Amex’s float was that he could only get a passive stake in it by buying his 5% stake. He could never control it.
All of that that changed when he, along with his friends bought Blue Chip Stamps.
In her excellent book, “Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger,” the author, Janet Lowe, relates the 1967 story:
“An early precursor to frequent flyer miles in the 1950s and 1960s, trading stamps, such as Green Stamps, Blue and Gold, and Blue Chip, were handed out as a customer incentive by merchants. Retailers deposited money at Blue Chip in return for their stamps, then the money was used to operate the stamp company and to purchase the merchandise handed out when stamps were redeemed. Shoppers were given a certain number of stamps for each dollar spent in a store, which they pasted into books, then redeemed for prizes such as toddler toys, toasters, mixing howls, watches, and other items. Because it took time to accumulate enough stamps to redeem merchandise-and because some customers tossed the stamps in the back of a drawer, forgot them, and never did redeem them-the float built up.”
Lowe explains how Buffett ended up buying into Blue Chip:
“Charlie and I talked a lot about investment ideas,” said Rick Guerin. “I’d react about Blue Chip Stamps in the newspaper, and I had an idea,” Charlie said, ‘I’ll take you to my friend who knows more about float than anyone.’” When Guerin was introduced to Warren Buffett, Rick realized, as he had when he first met Munger, that he was talking to someone exceptional. Rick was pleased when Buffett immediately saw the same potential value of Blue Chip’s float that he had seen. Just by investing the float alone, the company could amount to something. Buffett, Munger, and Guerin slowly began accumulating shares, with Buffett buying the stock both for his personal account and for the Buffett Partnership.”
I couldn’t help but notice one of the comments in this video:
“Thank you so much for posting this. My mother died about a year ago and in one of her cookie jars I found a stash of S&H green stamps. She never redeemed enough for so much as a plastic pitcher, but it was always fun saving them up. Ah, memories.”
The green stamp capitalist would respond with nostalgia: “Ah, Float.”
There’s a fascinating aspect to the Blue Chip story. The company, which was later merged into Berkshire, acquired See’s Candy for $25 million in 1972 at a time when See’s total capital employed was $8 million. Revenues for that year were $30 million and pre-tax earnings were less than $ 5million. By 2007, as Buffett proudly noted in his letter for that year’s performance, See’s revenues had grown to $383 million, and pre-tax earnings were $82 million and yet the capital employed to run that business was just $40 million.
This means, wrote Buffett, “we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.”
Buffett used Blue’s Chip’s float to acquire See’s and See’s float (as I shall explain later) to buy more businesses. He discovered that an enduring but free float, is a financial fountain that keeps pouring out cash.
But the really big (after insurance) attractive float that Buffett found, was given to him by the U.S. Treasury.
Berkshire owns marketable securities having market values far in excess of their acquisition prices. Taxes on gains realized on sale are payable only after the sale is made. If Buffett was to sell these securities, Berkshire would have to pay a very large tax bill. However, if he refuses to sell, and their market values continues to rise over time, then taxes not-due-but-which-would-have-been-due-if-he-had-sold-today would still need to be estimated and recorded as “deferred taxes” on Berkshire’s balance sheet. As of end 2011, these liability totaled to a staggering $ 38 billion.
For Berkshire, this $38 billion is also a form of float – functional equivalent to an interest-free loan from the U.S. Treasury. Buffett explained this power of delayed taxes by giving a wonderful example in his 1989 letter:
“Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.”
Is this “float” which appears as a liability on Berkshire’s balance sheet really worth its value as calculated by accountants? No, it isn’t. Just as was the case with insurance float, where fair value of the liability was much lower than its book value, Buffett explained:
“We would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after the end of the year? Obviously not – despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion.
On the other hand, is this liability for deferred taxes a meaningless accounting fiction because its payment can be triggered only by the sale of stocks that, in very large part, we have no intention of selling? Again, the answer is no.
In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election…”
To summarize, neither the insurance float, nor the float represented by deferred taxes on the liability side of Berkshire’s balance sheet are worth their book values. In his “Owner’s Manual” Buffett explains this again:
“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $100 billion.
Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”
As of the end of 2011, Berkshire’s balance sheet carries assets having an aggregate book value of $392 billion. About $100 billion of these assets have been financed by the best form of OPM which either costs Berkshire nothing (deferred taxes), or it pays Berkshire for having it (insurance float)!
For me, it’s very instructive to observe how Buffett has flirted with various kinds of floats throughout his career. The seductive appeal of free (or less-than-free) money is all too alluring. He explained the logic in his 1995 letter:
“Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” – that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly – to a degree that is not generally well-understood – because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms.“
Buffett hasn’t stopped looking for attractive floats. He once denounced derivatives as “financial weapons of mass destruction” but when he became aware that some of the esoteric derivative contracts could be a source of attractive float, he embraced them.
In his 2008 letter, Buffett disclosed that Berkshire was a party to 251 derivative contracts consisting of equity puts, credit default swaps, and others. Describing these contracts, Buffett noted:
“As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.”
Aha! We get to see the same combination we saw in Berkshire’s insurance float – an underwriting profit (implying less-than-free float), and freedom to invest that float in buying undervalued assets.
In his 2010 letter, Buffett again emphasized these points:
“The thought processes we employ in these derivatives transactions are identical to those we use in our insurance business. You should also understand that we get paid up-front when we enter into the contracts and therefore run no counterparty risk.”
“In aggregate, we received premiums of $3.4 billion for these contracts. When I originally told you in our 2007 Annual Report about them, I said that I expected the contracts would deliver us an “underwriting profit,” meaning that our losses would be less than the premiums we received. In addition, I said we would benefit from the use of float…”
“It appears almost certain that we will earn an underwriting profit as we originally anticipated. In addition, we have had the use of interest-free float that averaged about $2 billion over the life of the contracts. In short, we charged the right premium, and that protected us when business conditions turned terrible three years ago…”
“What is sure is that we will have the use of our remaining “float” of $4.2 billion for an average of about 10 more years. (Neither this float nor that arising from the high-yield contracts is included in the insurance float figure of $66 billion.) Since money is fungible, think of a portion of these funds as contributing to the purchase of BNSF.”
Money is fungible, says Buffett. As I described in Part I, if Buffett can figure out a way to borrow money for free or even less than that, and if he can get to keep that money for a long long time without putting up collateral, then the fair value of those liabilities on Berkshire’s balance sheet are far below their book values. Under those conditions, as Buffett himself put it in his 2007 letter, “our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
Attractive floats, then, are “unencumbered sources of value” for shareholders of companies which get to enjoy them.
Are there other business models which have access to cheap floats? Yes indeed, there are, and they go by the name of “moats.”
You see, Floats and Moats go together. That’s the subject matter of a subsequent post.
To be concluded…
There is a company which has the world’s strangest bond outstanding. Strange, because this bond has no maturity date. Stranger, because the bond issuer pays no interest on it. Strangest, because year after year, the issuer gets paid to have this bond on its balance sheet.
What better source of financing is there than one in which neither do you have to return the borrowed money, nor are you charged any interest to use it? In fact, you are paid to use it!
This is not a small bond issue in some obscure little country. As of end December 2011, this bond had a book value of about $71 billion and the issuer is an American company having a current market cap of $205 billion.
I am, of course, referring to the “float” enjoyed by the insurance businesses of Warren Buffett’s Berkshire Hathaway. “Float” in the insurance business, says Buffett, “arises because most policies require that premiums be prepaid and, more importantly, because it usually takes time for an insurer to hear about and resolve loss claims.”
This float, which has grown from $17 million in 1967 to an astounding $71 billion by the end of 2011, is a key reason behind Warren Buffett’s fame and fortune.
Float, as he explains is “money we hold but don’t own,” which, by the way, is how one would describe “other people’s money” or “OPM”, of which debt is the most common form.
The problem with plain-vanilla debt, however, is that its quite onerous for borrowers. When you borrow money conventionally you have to: (1) pay back the loan by some definite date; (2) pay the lender interest on the money borrowed over the course of the loan period; and (3) put up adequate collateral until full repayment of loan has been made. How very onerous!
Over the last 45 years, Berkshire’s insurance float enabled the company to effectively borrow huge amounts of cash, with no set repayment date, and with no tangible collateral put up. Even more astonishing is the fact that this money cost Berkshire less than nothing.
How did this happen?
For a typical insurer, the premiums it takes in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is the functional equivalent of interest on conventional debt. An insurance business is profitable over time if the cost of its float is less than the cost the company would otherwise incur to borrow funds. The business will have a negative value if the cost of its float turns out to be higher than market rates for money.
For Berkshire, the cost of its float, over the long term, has been less than zero. The net result of all this is that Berkshire has not only been able to borrow funds at a cost which is less than that of the U.S Treasury, it has been been paid to borrow that money.
It’s already well-known that the value of this large float with a negative cost has been huge for Berkshire’s owners. After all, access to tens of billions of dollars of less-than-free capital in the hands of one of the world’s greatest allocators-of-capital, has to be winning combination, isn’t it?
However, no matter how good an allocator-of-capital Warren Buffett is, that has little to do with the value of Berkshire’s insurance float to its owners. That’s because of a principle of finance (MM on Capital Structure) according to which the value of a firm’s assets have little to do with how they are financed. So, we mustn’t let Buffett’s brilliant track record in capital allocation influence us on how we should think about Berkshire’s insurance float. But we do need to understand just how does that float create value for Berkshire’s owners. That’s because, once we have understood how to evaluate Berkshire’s float, we will use that knowledge to understand other types of floats in a variety of business models.
Berkshire’s cost-less float can be best understood by comparing it with other forms of financing. When compared with plain-vanilla debt, it is obvious that borrowed funds which cost money, require posting of collateral, and which have to be repaid by a definite date are vastly inferior to Berkshire’s float which suffer from none of these disadvantages.
It’s when we compare Berkshire’s insurance float with equity, things gets really interesting. Buffett explained this point in his 1995 letter:
“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn’t belong to us. Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost.”
He explained it again in his 1997 letter:
“Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”
And again in his 2007 letter:
“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
And finally in his 2011 letter:
“So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”
The lessons in these four excerpts from Buffett’s letters are just about all we need to know to evaluate not just quality of Berkshire’s float, but that of just about any other float. Here, then, are a few general principles:
One way to see how the true value of an attractive float is far lower than its accounting value is to use the “inversion” trick often used by Charlie Munger by looking at the problem from the float provider’s viewpoint.
Imagine that you subscribe to a bond issued by a company at Rs 100. Imagine further that this bond carries no interest, and has no definite repayment date. For the moment, suspend your disbelief and ignore the question “Why the hell would I ever buy subscribe to such bond?” Just assume that you did.
How would you value this “perpetual, zero coupon bond?” What price would any rational person pay you for your bond? Almost nothing, isn’t it?
Now let’s invert the situation again and at look at this example from the viewpoint of the bond’s issuer. The bond appears as a liability on the issuer’s balance sheet at Rs 100. Now, if the corresponding asset on your balance sheet is almost worthless, should not the true value of this liability also be almost worthless from the issuer’s viewpoint? Of course it should!
Now let’s add a twist. Imagine that for some reason the company must pay back Rs 100 it owes you, but that it can find someone else to give money to it on identical terms so that even if you get paid, the company’s overall liability on account of the float remains unchanged. In effect, the company gets to use OPM to retire a liability represented by OPM. Even if some of the older providers of OPM have to be made whole, they are paid through refinancing on identical terms by newer providers of OPM. If this sounds like a ponzi scheme (without its derogatory connotation), then you’re right on spot!
That’s precisely what Buffett meant when he wrote the above-mentioned extract in his 2011 letter, which I am reproducing here with emphasis on key words:
“Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”
So long as one is certain that the size of a free float will not diminish over time because it resembles a “revolving fund,” one should value such a book liability at virtually nothing. And when that happens, then assets financed by such a float become “unencumbered.” This is what Buffett meant in his above-mentioned 2007 quote which I reproduce again with emphasis on key words:
“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
This insight – as to how do assets, when financed with cost-less floats become unencumbered, will be instrumental in our understanding the role of floats in evaluating the economics of businesses outside of the insurance industry.
That’s the subject matter of a subsequent post.
To be continued…
Many students of security analysis believe that valuing “surplus cash” on a company’s balance sheet is an easy task. Just add the nominal value of the surplus cash to the value of the operating business derived from some other method like DCF. Alternatively, take the market value of the firm and deduct the nominal value of surplus cash to arrive at market’s assessment of the fair value of firm’s operating business – called Enterprise Value (EV).
In other words, surplus cash can simply be added to the the fair value of the business estimated by the analyst to arrive at value of firm or it can be deducted from its market value to arrive at EV.
After all, a dollar is worth a dollar, no more, and no less. Isn’t it?
Using the idea of “dollar auction,” I have, over the last 11 years, routinely auctioned Rs 100-notes for as high as Rs 600 in my class. The red-faced winning bidder at the end of each such auction becomes the laughing stock for his/her classmates.
How can educated students value a currency note for more than its nominal value? The dollar auction game combines several psychological tendencies such as envy, deprival super reaction, low contrast effect, reciprocity, and social proof, resulting in a comical illustration of the prisoner’s dilemma again and again in my classroom. Under certain circumstances, as the dollar auction game shows, its rational for an individual to overpay for a Rs 100 note.
What about other situations where the nominal value of surplus cash residing on a company’s balance sheet differs from its fair value? While accountants and auditors would prefer to use nominal value (for them, its better to be precisely wrong than to be approximately right), we, as security analysts must consider the possibility that sometimes, or maybe even often, a dollar is not really worth a dollar.
So, what are the general principles to keep in mind while valuing surplus cash?
First, know what is surplus and what’s not. Money lying in bank accounts or mutual funds, but which are provided by customers (see advance from customers and/or deposits on the liabilities side of the balance sheet) are not surplus. This “other people’s money” is not surplus to the needs of the business. “Surplus” means that if you take it out, you don’t have to replace it. You can’t take out money taken from customers as advances without feeling the need to inject it back in the business. Although there are huge advantages of holding this type of “other people’s money” (that’s the subject matter of a future post), such advantages do not convert operating cash to surplus cash. For example, at this time, cash on the balance sheets of companies like EIL or BEL is not necessarily surplus because of large advances from customers as source of that cash.
Similarly, cash in some seasonal businesses may be surplus in lean seasons but required for conducting business for busy seasons. Such cash must not be treated as surplus even if the balance sheet date happens to lie in a lean season.
Second, other things remaining the same, a $100 bill in the hands of a value creator is worth more than $100 to his investors. Conversely, the same $100 is worth less than $100 in the hands of a value destroyer. Be wary of cash on the balance sheet of companies which have a demonstrated track record of value destructive allocation-of-capital decisions (primarily dividend policy, acquisitions, expansion, and diversifications).
Capital allocation skills matter.
Third, other things remaining the same, a $100 bill in the hands of scoundrel is worth less than $100 to his investors. Conversely, the same $ 100 is worth more than $100 in the hands of the honest manager. Be wary of cash on the balance sheets of companies run by crooks. Cash on Infosys’ balance sheet is worth more than cash on Aftek’s balance sheet.
Corporate governance matters.
Fourth, the further the cash is kept from the investor who has to put a value on it, the less valuable it becomes to him. This happens, for example, in the cash of holding companies which have subsidiaries which have subsidiaries which have the cash. In other words, the closer the cash resides near the pockets of the investors, the closer to it’s nominal value, should be its fair value to investors, other things remaining the same.
Distance from the owners matters.
Those, then are the general principles I think about when I think about surplus cash.
Investment returns are typically measured in the form of returns per unit of risk.
“Risk” however does not mean the same thing to different people.
To most financial academics, risk is a measure of volatility, a proxy of which is the famous beta. At the other extreme is Warren Buffett who thinks of risk as “probability of permanent loss of capital” and who claims that beta has nothing to do with risk.
While the debate on the meaning of risk between academics/finance practitioners who follow CAPM (a model that equates beta with risk) and value investors who follow Buffett is not going to end anytime soon, I propose that one should also think about measurement of investment returns based on “return per unit of stress.”
For proprietary investors (and maybe for all investors), stress should figure in one’s investment strategy, much more than it does, perhaps, even more than financial risk, because stress is a killer and high stress situations – whether they carry high or low investment risk – will always carry a high risk to one’s health. In fact, one can now measure how many years of one’s life is cut short by being exposed to a high stress life.
In my view, its no co-incidence, that day traders (who have very stressful lives) and who look like this…
… will possibly not live very long, while spiritual, long term investors like John Templeton (who lived till he was 95) have calm and serene faces and look like this:
If one was to think about stressful way of investing vs. a relatively stress-free way of investing, what would the differences look like? The following table offers some suggestions.
Low or No Stress
|Investing in Highly Leveraged Companies||Investing in Zero or Low Debt Companies|
|Borrowing to buy stocks||Never borrowing for buying straight equities|
|High Frequency Trading & Day Trading||Long Term Investing|
|Shorting||Long Only Investing|
|Business exposed to Negative Black Swans e.g. Banking and Commodity Trading||Businesses not exposed to black swans|
|Corporate Governance Issues||No Corporate Governance Issues|
|High P/E for Growth Stocks||Low P/E for Growth Stocks|
|Hostile Takeovers||Passive Investing|
|Dealing in F&O||Staying Away from F&O|
|Trading on Inside Information||Avoiding inside information|
|Event Driven Investing||Moats Driven Investing|
Once you start incorporating return per unit of stress in your investment thinking, the trade-offs become obvious. You would start settling for investment situations which offer a satisfactory return per unit of risk and stress over those which offer high returns per unit of financial risk but low returns per unit of stress. You will slow down and start appreciating the slow process of long-term, stress-free compounding as opposed to nerve-wracking, adrenalin laden high frequency operations in the stock market.
My advice to those who ignore the stress part of the equation but focus only on returns per unit of risk: You cannot take it away with you, so what’s the point of all that stress, just for the money?
The Children’s Investment Fund of UK is Coal India’s second largest shareholder and owns 1% of the company’s equity. The largest shareholder is The President of India who owns 90% of this $ 41 billion market cap behemoth.
The owner of 1% of this behemoth is now battling the owner of 90%. This “epic battle” has been covered by the media over the last few days.
And how is this “battle” taking place? By the firing of letter missiles by The Children’s Investment Fund to Coal India’s Board of Directors and the Secretary, Ministry of Coal and their subsequent release to the media.
Primarily, this fund accuses Coal India’s Board of Directors of “breach of fiduciary duty” for (1) not resisting government’s ”request” to roll back coal price hikes (it claims that Coal India sells coal at 70% below prevailing international coal prices); (2) refusing to defy the orders of India’s Prime Minister directing the company to urgently enter into fuel supply agreements with electricity generators in order to mitigate the power crisis faced by the nation; and (3) refusal to resist the Draft Mining Bill in India’s Parliament, which the fund claims is highly detrimental to the interests of Coal India.
The Children’s Investment Fund ends its letter by threatening Coal India’s individual Board members with legal action.
Does it have a case? It doesn’t.
Without going into the merits of the arguments made by the fund, I want to point out something it apparently missed. The Children’s Investment Fund bought into Coal India by making an application for allotment of shares under the company’s Offer for Sale made by The President of India in October 2010. It seems to me that the Fund forgot to read the small print in the offer’s prospectus.
Buried inside this 510 page document, however, is a section called “Risk Factors.” Of the seventy risk factors listed, just two are enough to demolish The Children’s Investment Fund’s case.
Risk Factor 17: “We sell our coal at prices lower than the prices otherwise in the Indian and international coal markets. Although pricing of coal in India was completely deregulated with effect from January 1, 2000, we have followed a strategy of focusing on improving cost efficiencies to avoid price increases, and generally consult with the GoI in determining the price of our coal.”
Risk Factor 55: “The interests of the GoI as our controlling shareholder may conflict with your interests as a shareholder. Under the MoU signed with the MoC and our Articles of Association, the President of India may issue directives with respect to the conduct of our business or our affairs for as long as we remain a government owned Company… In particular, the GoI has historically played a key role, and is expected to continue to play a key role, in regulating, reforming and restructuring the Indian coal mining industry. The GoI also exercises substantial control over the growth of the power industry in India which is dependent on the coal we produce and could require us to take actions designed to serve the public interest and not necessarily to maximize our profits.”
If Children’s Investment Fund was to carry out its threat of legal action, the learned judge would surely throw out the complaint upon reading these risk factors. Her judgment would be brief: Caveat Emptor – a Latin phrase for “let the buyer beware,” meaning that buyers must perform their due diligence before purchasing anything.
Then there is another issue I am highlighting here because The Children’s Investment Fund has kept quiet about it, which is not surprising. This issue revolves around two questions.
First, just how profitable is Coal India?
Coal India is a stunningly profitable company. Over the last seven years, it’s coal mining business has delivered pre-tax operating cash flows aggregating to approximately Rs 91,000 cr ($18 billion) or an average of Rs 13,000 cr ($2.5 billion) a year while employing average operating assets of just Rs 21,000 cr ($4 billion).
That translates into a stunning pretax return on capital employed of 62% a year on average, which makes Coal India not just the largest, but also the most profitable coal mining company in the world. When it comes to profitability, other global coal mining companies do not even come close.
Second, what causes Coal India to be so stunningly profitable? After all, this is the same company which is “run to serve the public interest and not necessarily to maximize its profits” according to its majority owner. And this very company also has a Board whose members are in “breach of their fiduciary responsibility” according to a minority owner.
How can such a company become the world’s largest and the most profitable one in its industry, one with zero debt, and one in possession of more than $10 billion of cash?
You see, the Lord (“President of India”) that Taketh is also the Lord that Giveth. Coal India is stunningly profitable because the “Lord” grants it coal exploration rights, mining rights, acquisition of land and surface rights, and many other rights at throwaway prices. If Coal India was required to pay market prices for these rights, it’s super profits would turn into horrendous losses in no time.
It cuts both ways. A minority shareholder mustn’t complain about the majority’s interference with free market forces, without willing to sacrifice the profits sourced from that very interference.
You can’t have your cake and eat it too.
I would like to thank Ravi Purohit for helping me in the research for the above post and also in formulating my thoughts on the subject.
Finally, I am told, Ram Kapoor kissed his own wife. Moreover, he seduced her and made passionate love to her. That too on TV.
This is HOT by Indian TV standards.
In its 166th episode of Bade Achhe Lagte Hain (“I Really Like You”) which aired on March 12, Ram did all of that. The viewers were surprised, thrilled, or shocked, depending on who they were sitting with while watching the episode. TRPs will now surely soar because now “expectations for more” have been created. A man has kissed a woman and she kissed him back. On TV.
Behind every kissable man, however, there is a woman, and maybe she is not his wife. In this case, the woman behind Ram’s kisses is Ekta Kapoor, Balaji Telefilms’ Joint MD who is actively involved in the production of the content produced by her company. Balaji is a content provider to Sony TV which airs Bade Achhe Lagte Hain.
Balaji’s stockholders should hope that High TRPs will eventually translate into higher income for the company which will result in the stock being re-rated. They need this break because the stock has been a huge under-performer for several years, as the two charts below show:
The company could certainly do with some real earnings as well. That’s because its content business has been losing money for several quarters after Rupert Murdock fell out with Ms. Kapoor one fine morning but oh that’s another story which will have to wait for another day.
At its current stock price of Rs 45 per share, the market cap is Rs 290 cr. The company has zero debt. It also has Rs 220 cr of cash. So one is paying only Rs 70 cr for the business – the risky business of making movies and TV content. But if you pack your TV serials with a lot of kisses and passionate love making, perhaps TRPs will go up even more and operating profits will soar and the stock will spurt upwards. It’s a risky bet but then Ms. Kapoor likes taking risk and clearly she believes that her strategy will be good for the stock. After all, she is putting her money where her mouth is by buying it consistently from the market.
Minority stockholders might have preferred a buyback at a good premium to current stock price to see a happy ending to their sad stock story. But they will have to wait for the longer version of another story which basically starts with a kiss…
Note: I have no position in this stock as of this writing.
I just loved reading this book.
I haven’t seen a better discussion of topics like these anywhere else recently:
Pantaloon Retail has a DVR (differential voting rights) outstanding which carries 1/10th of the voting rights enjoyed by the equity shares but also enjoys 5% more dividend rights than the common stock.
As of this writing, the stock sells at 163 and the DVR sells at 98. That’s a discount of 40%.
On 8 February, the company announced its intention to change the terms of the DVRs (called Class B shares). It is now proposed to increase the voting rights from 10% of those enjoyed by the common stock to 75% and to reduce the incremental dividend over the common stock from 5% to 2%. The explanatory statement states that “markets and investors have discounted Class B Share’s value beyond reasonable discount levels…” and “in order to help shareholders of Class B Shares, to achieve proper pricing for such shares and also to enhance the shareholder’s value, it is proposed to alter/modify the rights and interests of Class B Shares, with regard to voting rights and additional dividend entitlement, with a view to realize and unlock the true value of Class B Shares.”
See the actual text of the explanatory statement below:
Pantaloon Retail is traded in the F&O segment.
How should one think about this development?
Will the discount on the DVRs narrow because of this development? Why or why not?
How much money does the company stand to save by reducing the incremental dividend from 5% to 2%? What do you make of that?
I gave a talk titled” Understanding the Universe of the Unknown and the Unknowable” hosted by The CFA Society in New Delhi on 4 March. You can download the slides with notes from here.
The following is the transcript of a talk I gave to students of IIM Lucknow on March 17, 2011:
Today, I am going to tell you a story. Its a detective story with eight witnesses — each with a different point of view.
How many of you have seen the movie, “Vantage Point?”
In any case, let us watch the trailer.
Wikipedia describes the movie as “a 2008 American political action thriller which focuses on an assassination attempt on the President of the United States as seen from a different set of vantage points through the eyes of eight strangers…Displayed with eight differing viewpoints, an assassination attempt on the president occurs, relayed in a time span of 23 minutes. Each time the events unfold from the beginning, a new vantage point is shown revealing additional details, which ultimately completes the story of what actually took place during the incident and who was involved in the conspiracy.”
I got the idea about today’s talk from this movie. And so, I am going to introduce to you eight witnesses in this story. Each has a different point of view.
We are going to take one company — whose name shall soon be revealed — and then we are going to look at this company from the vantage point of each of these eight witnesses. The basic idea borrowed from the movie is that we get closer to the truth when we have multiple vantage points.
As we move from one vantage point to the next, you will get a piece of the puzzle. When you have seen all the eight vantage points, you will have all the pieces of the puzzle. You will get closer to the truth.
During this mystery—solving exercise, you will also recognize a few academic financial ideas and beliefs. You will see them crumble in the face of evidence.
In the end, you will see a more clearer picture of reality than would have been possible otherwise.
Our first witness is a business analyst. He is not trying to value the company. Rather, his job is to evaluate whether this is a great business or not. How would he do this?
First, he would look at the company’s balance sheet, an extract of which is reproduced below. Notice, you don’t know the name of the company yet, and you won’t for a while. Let’s keep the suspense on.
What do you see? Let me tell you what I see and while I see this stuff, some questions will arise, to which I would like to know the answers in due course. That’s part of the puzzle we are trying to solve, right?
I see a company which, as of end of March 2011, employed Rs 247 cr of assets. Out of these, Rs 139 cr was deployed in net fixed assets.
The first question that comes to my mind is whether the company is fixed capital intensive? Well, I don’t know the answer to that question until I get to compare the amount of fixed assets employed with annual revenues of the company. That’s what capital intensity (or fixed asset turnover) means — number of rupees of fixed assets required to produce a rupee of revenue. So, I don’t know yet if this business is fixed capital intensive or not. But I soon will. Lets move forward.
What else do I see? I see the company is sitting on investments worth Rs 190 cr. I have a whole lot of questions about that. What are these investments? Are they marketable securities? (Yes) Are they money parked in debt mutual funds? (Yes). Are they surplus to the needs of the business? (Yes).
What else that is important do I see on the face of the balance sheet? I see a negative working capital of 95 cr. Many questions arise. Why is working capital negative? Is this is a company which is running out of cash and is therefore, distressed?
Hmmm. I know the answer to that one and the answer is no.
How did I arrive at that conclusion? Think about this for a moment.
Let me tell you how I arrived at that conclusion. One piece of evidence is the presence of Rs 190 cr. of investments. As I look deeper in the investment schedule of the balance sheet, I find that almost all of this money is parked in money market mutual funds and therefore, is as good as cash. If this company was financially distressed, it won’t be sitting on so much of cash, would it?
The second piece of evidence that supports my hunch that this is not a financially troubled company, is to do with something that is missing on the balance sheet. Can you guess?
Take a look at the balance sheet again. What do you don’t see?
Debt! There is no debt!
If this company was financially troubled, you should have seen a lot of debt on the balance sheet. But there is no debt! The absence of debt proves that this company is not in distress.
You see, sometimes what you don’t see is terribly important. That’s a useful principle to keep in mind. Most people overweigh what they see and underweigh what they don’t see. But you’re not going be like most people, now, are you?
If the company has negative working capital, and is not in any distress because its debt-free and has substantial cash, then what could cause the working capital to become negative? Think about this for a moment…
Working capital can only be negative if current liabilities exceed current assets. So what part of current liabilities contributes towards negative working capital. Let’s take a look at the current liabilities schedule.
Notice that the company has sundry creditors of Rs 161 crores which, when compared with the total of inventories, receivables and cash on the current assets (see the balance sheet) would still result in a positive working capital. However, there is one item pertaining to Advances from Customers of Rs 92 cr in the above schedule which explains why working capital is negative.
What does this figure tell us about the quality of the business model of this company? Notice, we haven’t even looked at the income statement, or the cash flow statement yet. Those will come later. But without even looking at those statements, we can conclude that this company has a solid business model, enabling it to demand its customers to pay for its products in advance — thats what advance from customers means isn’t it? In an ordinary business, customers buy first, and pay later. In extraordinary businesses, customers pay first, and receive what they bought later. (In this case, the company’s customers are not end consumers but the distributors of its products who are willing to give it advances first and lift inventory later.)
So it appears that this company has an extraordinary business which is supported by our earlier two discoveries: the presence of substantial surplus cash held as investments, and the absence of debt.
Great businesses are much more likely to have the winning combination of: (1) being debt-free; (2) being cash rich; and (3) with a negative working capital. For example take a look at the balance sheet of two great businesses – Colgate and Hindustan Unilever- and you will find the same pieces of evidence.
So what have we discovered so far when we put ourselves in the shoes of a business analyst? We have discovered that this company is well financed and probably has a solid business model. Let’s move forward with our analysis.
By looking at the equity schedule we find that company has 1.54 cr shares of Rs 10 face value. Since there is no debt, we can take the total assets of Rs 247 cr and divide by 1.54 cr shares to arrive at the per-share book value of Rs 160.
Next, as business analysts, we want to determine the average capital employed in the company’s operations over the last few years. For that we need to look at figures given in the tables below for fixed assets as well as working capital.
Using the figures in the above table, we calculate average fixed assets employed in the business over the last six years. This comes to Rs 109 cr. Similarly, we calculate the average working capital employed over this period. This comes to a negative Rs 83 cr. Deducting Rs 83 cr from Rs 109 cr, we find that on average the company employed only Rs 26 of assets over the last six years.
Next, let’s take a look at the income statement which is given below:
The first thing that catches my attention is the total revenues of Rs 1,125 cr.
“My god!” I am thinking. This company employs, on average, only Rs 26 cr in assets but has revenues of more than Rs 1,000 cr! Wow! So, now we have the answer to the question I had asked in the beginning: Is this company capital intensive? The answer, of course, is no.
But wait a second. I also notice that of the revenues of 1,125 cr, Rs 653 cr — or 58% of revenues- goes to the government as excise duty! Wow! Thats big isn’t it? It makes me think: “Hey this company is in the business of making money for the government. And the government must depend on it.”
Can you guess what this business could be?
Let me fix my earlier error. I should compare net revenues after excise duty with capital employed to determine capital intensity. Net revenues of Rs 472 cr were produced by employing, on average, only Rs 26 cr of assets. So even after fixing my error, our conclusion that this business is not capital intensive is still valid. The capital turnover ratio of 18 times (472 cr/26 cr) implies very low capital intensity.
What other conclusion can we draw from this analysis? When capital turnover ratio is high, the company can afford to have a low margin, and still deliver an exceptional return on capital. That’s basic “du-pont analysis” you have read about elsewhere. That analysis, you will recall, involves splitting Return on Invested Capital (Profit/Capital) into two components: (1) Margin (Profit/Revenues); and (2) Turnover (Revenues/Capital).
In case of our company, we already know that Capital Turnover is 18. So, even if the company operates at a 5% margin, it can earn a 90% return on capital! Not bad at all.
The big lesson here is that not all low margin businesses are necessarily bad. So next time, you meet someone who tells you that his business has very low margins, ask him or her about its capital turnover ratio, before making any judgments about the quality of the business.
The next step for us is to see what’s the margin earned by our company. Take a look at the income statement again. From the Rs 98 cr of total profit before taxation and exceptional item, lets deduct other income of Rs 33 cr. which pertains to treasury assets. We are left with an operating profit of Rs 65 cr, which on net revenues of Rs 472 cr, translates into a profit margin of about 14%.
Wow! When we combine a 14% margin with a capital turnover of 18 times, we get a pretax return on capital employed of a staggering 250%! We can double check by directly comparing the pretax operating profit of Rs 65 cr with Rs 26 cr of average capital employed to get the same answer.
This is one hell-of-a-business isn’t it?
Two more questions come to mind: (1) Are the reported earnings real; and (2) if they are real, then what’s causing this company to be insanely profitable?
To answer the first question we need to look at the company’s cash flow statement, which is given below:
Recall that from the income statement, we found that the company earned an operating profit of Rs 65 cr in FY 2010. This figure was arrived at after accounting for depreciation. The cash flow statement above shows that cash generated from operations was Rs 81 cr and if we adjust this for the depreciation of Rs 18 cr, we arrive at Rs 63 cr. So, the cash flow statement is consistent with the earnings statement for FY 10. We can do the same analysis for the earlier years and we arrive at the same conclusion.
An extract from the cash flow statement for the last six years is given below:
Total cash flow from operations for these six years comes to Rs 567 cr and annual average cash flow comes to Rs 94 cr. However, since the FY 10’s number was less than the average, lets assume that number of Rs 81 cr to be our estimate of sustainable cash flow going forward. This Rs 81 cr of sustainable cash flow is an important number I want you to keep in mind.
When we compare sustainable cash flow of Rs 81 cr a year with average capital employed of Rs 26 cr, we find that the company earns a cash flow return on capital of 319%, which brings us to the second question I asked earlier: What makes this business insanely profitable?
It is now time to reveal the name of the company to you. Ladies and Gentlemen, the company we are examining is called VST Industries, the Hyderabad-based cigarette manufacturer which owns the “Charms” brand.
I think now you will begin to understand why is this company so profitable, isn’t it? Its because its in the business of selling nicotine to addicts who are brand loyal and price insensitive.
Just how insensitive have these addicts been? We can learn more about that by extracting some useful information from the annual reports of the company. Take a look at the following table:
Notice also that the number of cigarettes sold by the company in FY10 were less than the number sold in FY06. And yet, earnings have grown instead of shrinking as can be seen from the table below:
The reason for rise in revenues and profits despite lower business volume is pricing power. Price per cigarette stick has increased at an annual average rate of 13.9% a year. Every time the government increased excise duties on tobacco products, the company simply passes it on to its addicted customers.
That’s pricing power, which is one the most important attributes of a great business.
The next question that comes to mind is how sustainable are future cash flows of Rs 81 cr a year going to be?. To answer that question, we have to think about the likelihood of people giving up smoking. I think, we all agree, that’s not going to happen.
We als have to think about the possibility of a ban on tobacco consumption, imposed by the government. Now, take a look at just how dependent the government is on VST by looking at excise duties paid by the company over the years from the table below:
The table shows that over the last six years, VST has paid about Rs 3,000 cr as excise duty to government. Now, you tell me how likely is it that the government will kill this golden goose?
Combine this with the direct taxes paid by the company and we can easily conclude that the vice of tobacco has a very good friend in the form of India’s government and so its very unlikely to ban the product. This is a major assumption we are making, however – one that we will look at later on but for the moment lets assume that there is unlikely to be any significant threat to this company’s ability to continue to sell tobacco products to a large population of nicotine addicts.
Now lets shift focus from a business analyst’s vantage point to that of a prudent banker.
Imagine that you are an old-fashioned, prudent banker who believes in the banking dictum that one must lend money to only those borrowers who don’t need it.
How much money would you lend to VST against the security of its business (not counting the surplus cash on the balance sheet?)
What are the key factors that prudent bankers think about before deciding how much to lend to a borrower?
Three factors are critical: size, cyclicality, and interest cover. Other things remaining unchanged, its prudent to lend to large companies whose businesses are not cyclical. If a business is cyclical, then a prudent banker would not depend on peak earnings. Rather, he would compute average past earnings and then ask for a higher interest cover on those earnings than would have been the case if those earnings were not cyclical.
In the case of VST, we already know that the company is both large and not cyclical. Tobacco is one of the least cyclical businesses in the world, after all.
So how much you, the prudent banker, would lend to VST?
Let’s assume that you’d rely on the work done earlier by the business analyst. Let’s also assume that the prudent banker is happy to assume that VST is quite capable of delivering a sustainable cash flow of Rs 81 cr. a year. Let’s further assume that you, the prudent banker, would still insist upon a minimum interest cover of 3 times on the total debt of VST.
Divide 81 cr by 3 and we get Rs 27 cr. This is the maximum amount of interest that VST’s business can easily afford, says you the prudent banker. Given that current interest rates for high-quality borrower are 9% p.a. at present, this means that the maximum amount of debt that you the prudent banker will be pleased to give to VST comes to Rs 300 cr. (Rs 27 cr/9%). In other words, if you give a loan of Rs 300 cr to VST, then the interest on that loan at 9% a year would come to Rs 27 cr a year which would be one-third of its sustainable annual cash flow of Rs 81 cr. So there would be a huge margin of safety on your loan because before your loan is in jeopardy, the earnings of VST must collapse by 67% which is extremely unlikely given the stable nature of the business the company is into.
Paradoxically, the dangerous habit of smoking translates into safety for the prudent banker’s loan to the company.
We have now arrived at an important number of Rs 300 cr as the debt capacity of VST’s operating business. Notice this debt capacity has been arrived at without considering the surplus cash of Rs 190 cr in possession of the company. This Rs 300 cr, is the amount of loan that you, the prudent banker, would happily lend against the collateral of VST’s operating assets and their cash flow.
Now let’s put ourselves in the shoes of a smart value investor — someone like Ben Graham who wrote the book on Security Analysis. How would Ben think about this?
This is how he would think:
“Well, the business analyst has done some useful work and determined that VST is capable of delivering a cash flow of Rs 81 cr a year, and the prudent banker has determined the debt capacity of VST’s operating business to be Rs 300 cr. What if, instead of lending money to this business, I could buy the whole business, or parts of the business called shares, at less than debt capacity?”
After all it was Ben Graham, who wrote in his book “Intelligent Investor”:
“An equity share representing the entire business cannot be less safe and less valuable than bonds having a claim to only a part thereof.”
And, in his book, “Security Analysis” Ben wrote:
“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”
When it comes to VST, Ben is thinking:
The prudent banker will lend Rs 300 cr to VST. The business delivers Rs 81 cr of cash flow a year. Interest on that loan would be Rs 27 cr. So the prudent banker, by virtue of his loan, would have a claim on only ONE -THIRD of its cash flow. What if, I could buy into VST, a debt-free company, and acquire a claim on ALL of its cash flow for less than 300 cr? After all, if the prudent banker’s claim on only ONE-THIRD of its cash flow alone is worth Rs 300 cr, then my claim on ALL of its cash flow must be worth a lot more than Rs 300 cr.”
Ben would visualize that “hidden inside the stock of debt-free VST, is a bond component, which I can independently value and that value comes to Rs 300 cr. If I can buy the whole business for less than 300 cr, then something good should happen to me.”
And so, Ben would take the debt-capacity of VST’s operating business (Rs 300 cr) determined by the prudent banker. Then he would add the surplus cash of Rs 190 cr on the company’s balance sheet and arrive at Rs 490 cr. He would then divide this number by 1.54 cr shares outstanding which comes to Rs 318 per share.
Ben Graham, the smart value investor, would be pleased to buy VST’s stock at less than Rs 318 per share.
Did the stock fall below Ben Graham’s desired acquisition price? Take a look at the chart below:
In the bear market of 2008-09, VST’s stock price did fall to below the level of its debt-capacity per share, estimated by Ben to be Rs 318. At that price, the stock was a bargain.
Notice that the smart value investor Ben Graham never valued VST. All he did was to determine a price at which it was a bargain. He thought along the following lines: “I don’t know how much its worth. But I do know, it CAN’T be worth less than what a prudent banker would lend to it.”
There is an important lesson here. Smart value investors don’t always value stocks or businesses. Rather they seek a margin of safety. They know that the question ,”How is much its worth,” is tougher than the question, “Is this likely to be worth a lot more than my price?” Smart value investors keep away from making elaborate predictions. Instead, they focus on protection in the form of a margin of safety.
How would a bond fund manager think about VST? Well, we know one thing about him. He certainly won’t think out of the box like Ben Graham did.
If VST did have bonds worth Rs 300 cr outstanding, the bond fund manager would happily invest in those bonds. But if Ben Graham approached him and said: “Hey look at debt-free VST. If it had bonds of Rs 300 cr outstanding, you’d gladly buy them because they would be safe. This safety would come from a large size business, very stable cash flows, and an interest-cover of 3 times. But, you would have a claim on only one-third of its cash flows. You’d value that claim at Rs 300 cr. Why not buy the equity of this debt-free company instead for an effective price of less than the same Rs 300 cr, and get a claim on all of its cash flow?”
The bond fund manager would be aghast! He will politely tell Ben that he is not allowed to buy equities and that he is only a bond fund manager. Then Ben will tell him:“You know there is a hidden bond component inside the stock of VST, and that alone is worth Rs 300 cr, so how can the stock be worth less than that?”
Such an argument, which to me is very persuasive, won’t be so to our bond fund manager for he thinks in terms of silos. He goes by titles (like “bonds” and “stocks”) and not by economic substance.
You are Henry Kravis, who virtually invented the leverage buyout. How would you think about VST?
Imagine its March 2009. The world is apparently ending, and VST’s stock price has crashed to Rs 220 per share. With 1.54 cr shares outstanding, the market cap is Rs 338 cr.
You have done your homework. You know that the company’s business can generate a sustainable cash flow of Rs 81 cr a year. You also know that the company has Rs 190 cr of surplus cash. Relying on the work done by the business analyst and Ben Graham, you know that the minimum value of the stock is Rs 318 per share. That’s puts a minimum value of Rs 490 cr on the company.
It’s time to act. Very quickly, you incorporate a company. Let’s call it “Acquirer.” You, Henry Kravis, inject Rs 490 cr into that company, of which you borrow 90% or Rs 441 cr. The balance Rs 49 cr is your money.
What do you do with the Rs 490 cr in this new company? Well, you use it to make a tender offer to all the shareholders of VST at Rs 318 per share. Since the stock is quoting at 220, your offer price is 45% above the stock price.
Imagine that all shareholders of VST tender their shares to the “Acquirer.” What does the balance sheet of “Acquirer” look like after the acquisition? The cash on the asset side is replaced by a 100% ownership of VST’s shares. On the liability side, there is debt of Rs 441 cr, and equity of Rs 49 cr.
VST is now a 100% subsidiary of “Acquirer.” The entire operating business of VST plus its surplus cash would now belong to “Acquirer.” You would immediately make VST borrow Rs 300 cr from the prudent banker. The cash on VST’s balance sheet would now become Rs 490 cr.
You then merge VST into “Acquirer.” What would be the net result of this merger? The cash of Rs 490 cr, the operating business, and VST’s debt of Rs 300 cr will become part of the balance sheet of “Acquirer.”
The Acquirer’s balance sheet would now have cash of Rs 490 cr. and debt of Rs 441 cr + Rs 300 cr or a total debt of Rs 741 cr. You would immediately use all the cash to retire debt. As a result, the balance sheet of “Acquirer” would now consist of debt of Rs 251 cr (Rs 741 cr — Rs 490 cr). It would have no surplus cash, but would own 100% of VST’s operating business.
You, Henry Kravis, would then change the name of “Acquirer” to “VST Industries.”
What have you accomplished? Well, you have used the un-utilized debt-capacity of VST along with its surplus cash to acquire it, by putting up only Rs 49 cr of your own money! Granted that the balance sheet has Rs 251 cr of debt, but we already know that this level of debt can easily be serviced from the operating cash flow of Rs 81 cr a year. You can dedicate all surplus cash flow towards debt reduction and pay it all off in just six years, as the table below shows:
In six years you, Henry Kravis, would own 100% of VST, which would now be debt free. You would have bought the company from its stockholders by paying them 45% more than what the stock market was valuing the company for. And yet, your own investment for this acquisition was just Rs 49 cr!
In other words, in just six years, by putting up only Rs 49 cr, you would end up owning a 100% stake in a business capable of delivering Rs 81 cr of unleveraged cash flow a year. And you’ve have accomplished this by buying out the business at a 45% premium to its prevailing market price!
Not bad at all!
And, so much for market efficiency!
There is an important lesson here: Control value investors don’t worry about macro events that cause prices of great, stable, debt-free, cash rich businesses to drop to below the levels of their debt capacities. When such businesses become available at those bargain prices, they act fast. They do not allow the environment of uncertainty and fear prevailing at the time to shift their focus from what really matters — the fundamentals. They go by Warren Buffett’s advice, who famously wrote: “Fear is a foe of the faddist, but a friend of the fundamentalist.”
If you look at what Henry Kravis did to VST, from the vantage point of Modigliani & Miller (MM), you would say its impossible for one of MM’s famous theorem was on the “irrelevance of capital structure.”
According to MM’s proposition on capital structure, under certain assumptions, the value of a firm is independent of its capital structure. One of the assumptions is that the markets are efficient. If the markets were efficient, then there is no difference between price and value and there are no bargains. There can be no Ben Graham, and no Henry Kravis either.
MM’s proposition on capital structure means that in March 2009, when VST’s stock price was Rs 220 per share and its total market value was Rs 338 cr, then that value was “correct” because the “market is always right.”
The MM proposition on capital structure states, that if you make VST borrow Rs 300 cr the value of the firm will rise from Rs 338 cr to Rs 638 cr, comprised of debt of Rs 300 cr and equity of Rs 338 cr. The total cash with the company would now stand at Rs 490 cr. (Rs 190 cr + Rs 300 cr).
Then, MM proposition on Capital Structure states, that if you were to withdraw this cash of Rs 490 cr from VST, which is exactly what Henry Kravis did, then the value of the equity will simply drop from Rs 638 cr to Rs 148 cr.
Recall that the business generates Rs 81 cr of annual average cash flow and the first year’s interest at 9% on total debt of Rs 300 cr, would come to Rs 27 cr. MM on Capital Structure says that VST’s shares after the LBO, will be worth Rs 148 cr even though the business would have earned Rs 54 cr of cash flow after interest in that year!
Isn’t this baloney? Well, I certainly think it is.
People like Henry Kravis laugh at academics who concocted theories like MM on Capital Structure, a theory that all of you have read and I guess, so far assumed it to be correct. Well my advice to you is to dump MM and to pick up lessons from Ben Graham and Henry Kravis instead…
Imagine that you are a value-oriented manager who runs VST and its March 2009 and the company’s stock is languishing at Rs 220. You know that your company’s business is capable of delivering an annual average cash flow of Rs 81 cr. You also derive comfort from absence of debt and presence of Rs 190 cr as surplus cash on the balance sheet. And yet your company is being valued by the market at only Rs 338 cr.
What can you do about this? Well, you can do many things but lets just talk about three of them.
You make VST borrow Rs 300 cr. Add to this the existing surplus cash of Rs 190 cr, and you now have a total of Rs 490 cr. That’s Rs 318 per share. Then, you simply declare a special one-time dividend of Rs 318 per share! Remember, the stock price is Rs 220 per share!
What about MM on Dividend?
Recall from your earlier work in this MBA program that MM also had a famous proposition on dividends. According to this proposition, under certain conditions (the primary one being the assumption of market efficiency), the value of a firm is independent of its dividend policy. The proposition states – and all finance textbooks swear by this as if its the holy grail of finance – that if a company pays a dividend then on ex-dividend date its value will simply fall by the amount of the dividend paid. The theory further states that investors should be indifferent between dividends and capital gains because what they get by way of dividends, they will lose by way a decline in the market value of their shares. And if a firm does not pay a dividend, they will have equivalent capital gains on the stock.
Well, let’s apply this “theory” to VST. If VST’s stock price before the dividend announcement was Rs 220 per share, then after the payment of Rs 318 per share of dividend, its stock price should become negative Rs 98! Is that possible? Can stock prices be negative? Of course not. Ok, lets grant MM this. Let’s say since the price can’t be negative, but because MM on dividends is holy grail, we have to grant to MM that the stock price of VST post dividend of Rs 318 will go to zero!
How can this be? Let’s just do the math again.
Recall that what the company paid out as dividend consisted of its surplus cash (which, by definition it does not need to generate its annual average cash flow of Rs 81 cr) and Rs 300 cr borrowed. This Rs 300 cr borrowed can easily be serviced the operating business. We already know this from the work done by the business analyst earlier. We also know that the first year’s interest expense at 9% interest rate on Rs 300 cr of debt will be Rs 27 cr, leaving the company with cash flow for equity of Rs 54 cr. (Rs 81 cr gross cash flow less Rs 27 cr of interest). How can a business that earns Rs 54 cr of cash flow after meeting interest requirement be worthless?
This is an example of proof by contradiction, something you read about when you were in school. Well, its a trick, I advice you to use more often in much of everything you do.
We can never really prove anything. Nassim Taleb says if you want to prove the propositions that “all swans are white” then you can’t prove it by looking for white swans. If, for example, you see thousand swans and all of them are white, that does not prove the proposition that all swans are white. You can see a million — a billion swans — and if all of them are white that does not prove that all swans are white. But a single sighting of a black swan disproves the notion that all swans are white. So, you just have to learn this trick of disproving much-loved but wrong ideas in finance and other fields by looking for contradictions.
The example of VST’s special dividend is the functional equivalent of the black swan. It’s a contradiction that kills the MM Proposition on dividends, isn’t it?
You have Rs 190 cr of surplus cash plus you have debt capacity of Rs 300 cr which you utilize and now you have Rs 490 cr. You want to teach the stock market a lesson by valuing your company for only Rs 338 cr.
You are feeling angry at the market and you are feeling bold. You know your company’s stock is worth a lot more than its current price of Rs 220. You announce a buyback at Rs 500 per share!
WTF? Are you crazy?
Lets find out by doing the math. How many shares of the company can be retired at Rs 500 per share by using all of the cash of Rs 490 cr. Divide Rs 490 cr by Rs 500 per share and you get 0.98 cr shares, which out of the total existing 1.54 cr shares amount to 64% of the equity.
Let’s imagine that you go and implement this bold buyback plan and assume that its executed successfully. What will be the consequences?
The company would be left with only 0.56 cr shares. All the cash would be gone. There would be a debt of Rs 300 cr. But the company would still possess the operating business capable of delivering annual average operating cash flow of Rs 81 cr. Reduce first years interest of Rs 27 cr on the debt, and we are left with Rs 54 cr of cash flow for equity. Divide that by the remaining 0.56 cr shares outstanding, and you get cash flow of Rs 96 per share!
If MM is correct, then post buyback the value of the firm should simply fall by Rs 500 cr used for the buyback. The value of the firm before buyback was Rs 338 cr. Then it took Rs 300 cr of debt and the value rose to Rs 638 cr. Now, post buyback, according to MM, the value of the firm should fall to Rs 148 cr. But since there is debt of Rs 300 cr, according to MM, the stock price should become negative and since thats impossible, then it will surely go to zero.
Will the markets really value a stock capable of delivering a cash flow per share of Rs 96 at zero? So, perhaps, a buyback at 500 – at more than double the prevailing stock price, won’t have been as crazy as it looked, after all…
You have Rs 190 cr of surplus cash. You can borrow Rs 300 cr but you don’t do that. Instead of actually borrowing the money, you go and create bonus debentures worth Rs 300 cr and allot them proportionately to your stockholders!
Let me explain. We already know that the company can easily service Rs 300 cr of debt. But we dont need the company to actually borrow money. We can simply create a debt instrument out of thin air and distribute it to our stockholders. Let’s say the face value of every debenture we create is Rs 100. So there will be a total of 3 cr debentures. Let’s say the interest rate VST will pay on these debentures is 9% a year.
The company has 1.54 cr shares outstanding. These shareholders will receive 3 cr debentures. This means that for every one share, 1.948 debentures would be simply be given to the stockholders as bonus debentures.
If a stockholder owns 1,000 shares, their market value before the bonus debentures was Rs 2.2 lacs. Now this stockholder will receive a total of 1,948 debentures. How would the bond market value these debentures?
Since these debentures have a face value of Rs 100, a coupon of 9% a year which is the going rate of interest, and since the company would be very credit worthy even after these debentures were created, we can safely say that these debentures would be priced by the bond market at Rs 100 each. The aggregate market value of these debentures in the bond market will be Rs 300 cr.
The stockholder who owns 1,000 shares in VST worth Rs 2.2 lacs would receive 1,948 debentures, which would have an independent market value of Rs 1.95lacs, and he would still own all the shares!
The value-oriented manager did not change anything on the asset side of VST’s balance sheet. All he did was to create a prior claim and transfer it on a piece of paper called “debenture.” This debenture would be valued by the bond market independently. The bond market would correctly value 1,948 debentures at Rs 1.95 lacs and all of the 3 cr debentures at an aggregate value of Rs 300 cr.
If you were to believe MM on Capital Structure, however, the value of the investor’s 1,000 share would drop by Rs 1.95 lacs, from Rs 2.20 lacs to Rs 0.25 lacs and end up selling for Rs 25 per share.
The stock would drop to Rs 25, says MM, because there was no change on the asset side of the balance sheet! There was no new cash coming into VST or going out of VST.
MM on Capital Structure says that if the total value is to remain unchanged, and if we create debentures out of thin air, then the value of the equity shares must simply shrink by the exact amount of the value of the debentures. If MM is right, then the creation and distribution of 3 cr bonds worth Rs 100 each, should result in the drop in the value of the equity by exactly Rs 300 cr – that value would drop from Rs 338 cr to Rs 38 cr or Rs 25 per share.
And yet,this Rs 38 cr market cap company would be capable of earning cash flow for equity of Rs 54 cr. (see our computations in “Special Dividend” section above).
Do you really think that the market would value a firm capable of earning Rs 54 cr a year for Rs 38 cr?
How can the bond market value a claim on only ONE-THIRD of cash flow for Rs 300 cr, but the stock market value a claim on ALL of the cash flow for only Rs 338 cr, which still having surplus cash on balance sheet of Rs 190 cr?
Don’t you see the contradiction here?
Either the bond market is right, or the stock market is right. Both of them can’t be right! That would be impossible isn’t it?
Sherlock Holmes said: “When you have eliminated the impossible, whatever remains, however improbable, must be the truth”
Improbable as it may sound, ladies and gentleman, our method of analysis shows that its the bond market was right by valuing a small part of VST at Rs 300 cr and that stock market was wrong by valuing the whole of the company at Rs 338 cr, not evening counting Rs 190 cr of cash!
The important lesson from the three examples of special dividend, buyback, and bonus debentures is this: A value oriented manager can always do these things to force the stock market to correct its valuation mistake. Moreover, one does not need a Henry Kravis to take VST private using an LBO and enjoy all subsequent benefits for himself. The value oriented manager can achieve the same objective using bonus debentures, allowing the company’s stockholders to benefit from the creation of leverage on VST’s balance sheet.
Recall also that Ben Graham’s abstract idea of a “hidden bond component inside the stock of VST.” Well, the value oriented manager can literally use that idea to deliver to his company’s stockholders an actual bond instrument having an independent market value, thereby forcing the market to correct its valuation error.
We have come quite far in our investigations. But there is still one vantage point left — that of civilization.
None of the witnesses we have met so far have looked at the company from the civilization’s viewpoint by incorporating what Charlie Munger calls “virtue and vice” effects.
I said earlier, that you’ll get closer to the truth by having access to several vantage points. So let’s examine this last vantage point. Zoom out a bit and look at what’s really happening here. How does VST make money? What do you see?
I will tell you what I see. I see that VST makes money essentially by selling something that kills people. I know its legal to do it, otherwise VST would not be in the business of selling tobacco. But that does not change reality does it? Consider this: If tobacco was discovered today, and the world knew about its horrible effect on the health of smokers, would it be legal to sell it?
Of course not.
You see, things carry on, because they have carried on. The tobacco business is legal because its been around for so long and societies have this status-quo bias, this inertia which prevents them from change. Moreover, the tobacco lobbyists, who don’t want this change, are very powerful. Plus, of course, the government depends on the tax revenues.
What are the real costs of tobacco? I think we all agree that the real cost of tobacco is hardly in the cigarettes sticks. The real cost comes the form of disease and misery caused to smokers and their loved ones when they die from cancer. That real cost is borne not by the tobacco manufacturers, but by society.
Privatized benefits and socialized costs is what makes VST prosper.
How long will this last? I can’t say.
Will you buy the stock? I don’t know. It’s really up to you.
If you see this from the vantage point of a Ben Graham or a Henry Kravis, then maybe, at a price, you will. If you see it from another vantage point, perhaps, you won’t – at any price.
The choice really is up to you. Moreover, you can rationalize whatever you choose. Man, after all, is not a rational animal. Rather he is a rationalizing one.
I do know, however, that you get closer to the truth by having multiple vantage points.
Having just one vantage point in a detective story is not good enough.Having eight is rather cool.
Thank you for inviting me!
Note: An abridged version of this post will be published in the next issue of Outlook Profit.
Even if you put zero value on Ajay Piramal, as the stock market is doing right now, you’d have to agree that he’s beaten the hell out of that insanely crazy market.
Since 1988, when he took charge over what is now called Piramal Healthcare, and may soon be called by another name — Ajay Piramal has made his long-term investors not just rich. He’s made them fabulously rich.
Consider this: Over the last 23 years, investors in Ajay Piramal’s flagship company have compounded their money at an average annual rate of 28%. In contrast, Sensex compounded at only 17% a year. The difference between compounding money at 17% a year and at 28% a year becomes truly staggering over time. While Rs 100 became Rs 3,700 with Mr. Sensex in 23 years, they became Rs 29,230 with Mr. Piramal instead.
Ajay Piramal’s track record becomes even more impressive if one considers that the 28% a year return delivered by him was computed by using the currently undervalued stock price of Piramal Healthcare.
As I write this, the company has 20.9 crore shares outstanding selling at Rs 479. By the time you read this, however, the company would have bought back and extinguished 4.2 crore shares (20% of the total) at Rs 600 each.
An indication of the price at which the remaining 16.7 crore shares may be valued by the market after the buyback, one can look at the April 2011 futures price now quoting at Rs 450 per share. In effect, post buyback, the stock market is valuing Piramal Healthcare at about Rs 7,500 cr.
When Ajay Piramal bought Nicholas Laboratories from its foreign parent in 1988, the company’s market value was only Rs 6 cr. This launch pad into the drug space enabled him to ride on the wave of huge subsequent growth of the Indian pharma industry. After several brilliant acquisitions, mergers, spinoffs, and other corporate restructuring transactions orchestrated by him over the next 23 years, the company morphed into what became known as Piramal Healthcare.
Then, in May 2010, he stunned the business world by announcing that he has sold part of Piramal Healthcare’s business, constituting about half the company’s revenues, for a staggering $3.8 billion, or about Rs 17,140 crores, to Abbott Labs of USA. Two months later, he sold the company’s diagnostic business to Super Religare for Rs 600 crores.
These two deals, having an aggregate value of Rs 17,740 crores delivered an upfront cash of about Rs 10,200 crores to the company. The balance Rs 7,540 crores — almost all of it due from Abbott — would be received over the next 42 months. Having an insignificant credit risk, these future receipts, which are not conditional upon the achievement of any milestones, have an estimated present value of Rs 6,300 crores, assuming a discount rate of 10% a year.
The value of cash already received (Rs 10,200 crores) plus the present value of receivables (Rs 6,300 crores) comes to Rs 16,500 crores. From this, if we deduct taxes paid amounting to Rs 3,700 crores on the huge profits made on these disposals, Rs 2,500 crores utilized for the buyback, debt of Rs 793 crores, and two minor items relating to the payment of a non-compete fee and charity, we are left with net cash and cash equivalents of about Rs 8,700 crores as of now.
On a per share basis (post buyback), this comes to Rs 517.This is the number I want you to focus on because it exceeds the stock price of Rs 450 per share.
If Piramal Healthcare were to be liquidated today for just the cash and its equivalents, with no value received from the sale of its three operating businesses which Ajay Piramal decided not to sell, the stockholders would get about Rs 517 per share. The stock market, it its own “wisdom,” is valuing the whole company at Rs 450 per share.
In other words, if you were to believe the stock market, this company is worth more dead than alive.
For long-term investors, however, this is a great opportunity to partner with one of India’s great wealth creators on very favorable terms.
Given that the current market value of the company is less than cash assets alone, the stock market is putting no value at all on the three operating businesses which appear on its balance sheet. Then, of course, there is Ajay Piramal, who does not appear on the company’s balance sheet but, nevertheless, is its most important asset. He comes free too.
How often do you get a combination of: (1) a company with a large market capitalization; (2) cash in excess of its market value; (3) other assets having substantial future value; and (4) a brilliant and ethical owner-manager who has a demonstrated track record of enormous wealth creation for his long-term partners? Not very often, in fact, its very rare.
Ajay Piramal is a rare occurrence and his story is worth telling you about. But the real story of the man is not just about how remarkably he sold the formulations business to Abbott. Nor is it only about the numerous smart acquisitions he has done although that has grabbed most of the media’s attention over the years.
Ajay Piramal’s story is also about a man who has a contrarian bend of mind, who ceaselessly explores multiple ways of creating value, and who has a very long-term orientation about wealth creation.
Take a look at the following table, taken from a presentation available from the company’s website.
The stunning growth depicted in the table is the result of both organic and inorganic growth. That’s another very rare combination. Being successful in M&A transactions is rare enough (about 70% of acquisitions fail to create value). Being successful in M&A and in operating several businesses in multiple countries is very rare indeed.
One test of long-term managerial performance I use, and which is favored by Warren Buffett, is an “earnings-retention test.” The test measures how every rupee earned, and not paid out as dividends, by a company gets reflected in incremental market value over a five—year rolling period basis.
For companies that destroy value, every rupee of earnings retained is, over the long run, expected to translate into less than one rupee of incremental market value. For value creators, the equation is opposite. Every rupee retained should become much more than one rupee of incremental market value.
Going back to 1990, I applied this test to Ajay Piramal’s flagship company. Even if we ignore that the company’s stock is undervalued (which severely penalizes the results of this test), here is the report card: From 1990 to date: 5.8 times (that is, every Rupee 1 retained became Rs 5.80 in incremental market value); From 1995 to date: 5.5 times; From 2000 to date: 5.1 times; and From 2005 to date: 4.7 times.
Any way you look at it, Piramal Healthcare has been a consistent wealth creating machine, one which has been only partially recognized by the stock market. Had the market given full value to the cash, the three operating businesses, and Ajay Piramal at the company’s helm, the above results would look even more impressive.
Even with one hand tied behind his back, Ajay Piramal has been a champion jockey. Why, then, is the market treating him like an also-ran?
To find out the answer to that question, and many others, I met Ajay Piramal at his office in Mumbai last August. I met him again today (25 March).
Before meeting him, I studied every acquisition done by him since 1988 including Nicholas Laboratories in 1988, Roche Products in 1993, Boehringer Mannhiem in 1996, Hoechst Research Center in 1998, Rhone Poulenc in 2000, and ICI Pharma in 2002.
As I went through each of these deals, and as I studied his track record of managing the business over 23 years, a pattern emerged.
In deal after deal, it emerged that Ajay Piramal is a contrarian. Over and over again, he seems to watch what the crowd is doing, and then he goes and does the exact opposite.
Back in 1990s, when MNC pharma were participating in a kind of a “Quit India Movement,” Ajay Piramal bought them out one by one at distressed prices. Now, when MNC pharma is desperate to be a part of the “Indian pharma growth story,” he has sold out to Abbott.
His vision to expand the formulations business which focused on India, while other Indian pharma companies were focusing on exporting generics to the west, was another superb contrarian decision.
Ajay Piramal enjoys taking the road less travelled by. And it certainly has made all the difference.
Another pattern that emerges is that like any good value investor, he simply does not overpay for assets and he often finds value where there is a distressed seller.
When I asked Ajay Piramal about his acquisition strategy, he listed his three acquisition principles.
“One, there has to be a strategic fit and you have to be honest when you evaluate that. I have seen that there are many investment bankers and consultants who want the deal to happen and so they convince you that there is a strategic fit.”
“Two, M&A is a very heady thing to do for a CEO. At least for the first few weeks, everybody puts your photo in the newspapers and talk about you and so there is this tendency to over pay. And, as you know, 70% of M&A deals don’t create value. So whatever the value you have set out, you should not exceed that. We don’t believe that you can get value out of overpayment.”
“Three, never look for a perfect asset. If you are going to acquire a perfect asset then the whole world is going to bid for it and its a very easy calculation to understand value and then you have to keep outbidding the next bidder. So there has to be some chink.That asymmetry which you can recognize that is there today — an inefficiency perhaps, or something wrong which you can correct — that is where the value is created.”
“In every acquisition of ours there was something that other bidders found wrong and that’s why they didn’t do it.Take the classic case of Nicholas Laboratories in 1988. That company was a small multinational and for two or three years they was struggling and they wanted to exit. Another multinational had the offered to buy them out, they had gone through with it in terms of value. Everything was agreed because it was another UK company.”
“But the reason they did not do it, and this is what one of their directors later told me, is because they realized there was some contingent liability relating to some excise duty matter. And you know in many corporations nobody is willing to take the final decision. You need clearance from accounts, you need clearance from legal and so on.”
“If you asked a legal person if there is a risk? Yes there is a risk. But you have to evaluate the risk.Is it really going to materialize and if it does what could be the consequences. In multinationals nobody is willing to take the chance. Instead, they always say, we can’t do it. And that’s how we entered the pharma industry.”
“Or take a look at the Roche and Rhone Poulenc deals. In both these transactions, there was something which was wrong and thats why I tell people when they do M&A deals within our group that if you find everything right, then please understand you have to pay top dollar plus.”
“In the case of Rhone Poulenc, when we acquired it, we realized there was a manufacturing plant in Mumbai. A plant in Mumbai that does manufacturing is a cost. It is a value destroyer because the costs are high. And there are issues of union etc. To most people, that’s a negative. For us, that was a positive because we knew that we can deal with unions and that we can realize value from that asset by developing it.”
One metric commonly used in the pharma M&A deals is price-to-revenue. The highest Ajay Piramal ever paid was 3 times revenues for ipill, the popular oral contraceptive brand he bought from Cipla in March 2010). More typically, he paid less than one times revenue for most of his acquisitions.
When it came to the sale of formulations business to Abbott, however, he was able to obtain a stunningly rich price of 9 times revenues. In contrast, Ranbaxy sold out to Daiichi in June 2008 for 5 times revenues. Indeed, the sale of the formulations business to Abbott, is one of the most richly-priced pharma deals ever.
A big part of the reason why he got such a rich price, is to do with a “seamless web of deserved trust” Piramal has created with big pharma over the years.
When I mentioned this idea to him — an idea that was first articulated by Charlie Munger, Warren Buffett’s partner — he smiled at me. He knew what I was getting at. After all, Ajay Piramal is a Buffett and Munger fan and often goes to attend Berkshire Hathaway meetings in Omaha.
Charlie Munger attributes Berkshire Hathaway’s enormous success to this idea. “When you get a seamless web of deserved trust,” he once said, “you get enormous efficiencies. It’s what the Japanese did to beat our brains out in manufacturing: suppliers, employers, the purchasing company, management – all created a seamless web of deserved trust. It’s the same with good football teams. We are trying to live in a seamless web of deserved trust. It has worked for us, and it is the ideal way to live. How can Berkshire Hathaway work with only 15 people at headquarters? Nobody can operate this way. But we do.”
Now that we were warming up, Piramal wanted to tell me more about the creation of his own “seamless web of deserved trust” over 23 years.
“This web of trust extends to our dealings with everyone including those from whom we have bought businesses and those to whom we have sold. In almost every acquisition that we have done, there was somebody who was willing to pay higher — from Nicholas Laboratories, Roche, Rhone Poulenc, to ICI — there were higher bidders but we ended up acquiring these businesses. Why did this happen? The only reason why it happened every time is because of the trust we have.”
“Why did we get this valuation from Abbott? It is because of this trust. Seeing what other transactions in the environment before us (he is talking about Ranbaxy—Daiichi deal), they could have gotten another asset at much lower price. So why did they come to us? Because there was this level of trust and understanding.
“Having a “web of trust” is our philosophy. I am comfortable with it. We don’t have a single legal case. Why? Why did we not go into patent challenges? Because you can’t have a relationship where you keep fighting.”
Ajay Piramal wants you to know that by refraining from fighting big MNC pharma companies on their turf (as many Indian pharma companies have done), he was able to get a much better value for the formulations business from them on his turf. Can this advantage be replicated? I think so. How could it be otherwise?
Take for example the CRAMS business about which he is optimistic and has a long term vision. This is a small business at present but Piramal expects it to grow. Pfizer (the world’s largest drug company) is a customer of Piramal Healthcare in its customs manufacturing business.The act of letting someone else handle your intellectual property by big innovative pharma companies, requires a very high degree of trust in the manufacturing partner. By leveraging his web of trust, Piramal expects to become a “partner of choice” for big pharma companies.
Of course this requires a very long term vision, which is another element of the pattern that emerges by studying his track record.
He tells me “I don’t take much cognizance of the stock market which focuses on the short term. I will do what’s right for the business and the shareholders.Frankly, I don’t owe my job to an analyst. So, therefore, I can afford to take a long term view.”
For instance, he decided to go into drug discovery business very early. This business requires very long term thinking, ability to take risks, and to be prepared for failures, for the success rate is very low. Moreover, there is hardly any earnings visibility — something that most analysts abhor. But if you get lucky, then the sky is the limit.
If you step back a bit and see what is happening to the big pharma companies in USA and Europe, you will see that there is this big wave coming. Its a wave of shift of innovation from west to the east. Its a small wave right now. But Ajay Piramal can see it becoming a tidal wave in a few years.
Through Piramal Life (the unit was spun off from Piramal healthcare in 2007), Ajay Piramal has positioned himself just ahead of this approaching tidal wave. Shakespeare, who wrote “There is a tide in the affairs of men, which taken at the flood, leads on to fortune,” would have approved.
A big part of Ajay Piramal’s grand strategy is to retain Piramal Life. But why did he spin it off in the first place and what will he do with it now?
He tells me that Piramal Life was spun off from Piramal Healthcare in 2007 because it had a very different risk profile. By its very nature, the drug discovery business is a highly speculative business. Mixing it with the formulations business did not make sense, hence the spin off.
To many, Piramal Life’s spin off may have appeared as an attempt to correct a past mistake of going into the drug discovery business in the first place. After all, spin offs are often used to get rid of troublesome businesses created by overoptimistic and overconfident men. This, most definitely, was not the case here.
Both Ajay Piramal, as well as his highly qualified and accomplished spouse, Swati Piramal, who runs the company, are very optimistic about the long—term potential for the drug discovery business in India. In many ways, their contrarian traits can be seen from the way Piramal Life has been managed.
For example, if you run a drug discovery company, one way to de-risk the business is to out-license your molecules to a big, and more prosperous pharma company who will then put its financial, technical, and political strength behind its development and approval by regulators such as the FDA. Of course, they would do that in return for a big part of the upside. This is how drug discovery model has worked for decades.
Well, that’s not how contrarians Swati and Ajay would like to make it work for them. Piramal Life has 14 molecules under development, and has no intention, (at least, as of now) to out—license any of those molecules. The reason is simple: They don’t want to give away the upside. If they decide to out-license now, I won’t be surprised that they would be able to negotiate and obtain upfront, and subsequent payments several times the current market value of the company (current market cap at Rs 108 per share is Rs 274 crores). But that is not how they think. They think in terms of not years, but decades. They think in terms of not maximizing near term reported earnings, but maximizing eventual net worth.
Both of them share a dream of leading the first Indian company which goes from discovery of a molecule to the global launch of a drug. Can they do it?
Let me ask you the question another way. Given the resources — technical, human, financial, and their excellent relationships with big pharma — they now have, is there anyone else in India who can do it? And if they do it, can you imagine the financial consequences?
Sometimes in life, exposure to low—probability—high—positive—impact situations (positive black swans) can massively improve the financial results of that lifetime if you get lucky, for you only have to get lucky once in a big way to make it worth your while. And the best way to get lucky is to organize for good luck to come to you.
Louis Pasteur was right when he wrote: “Luck favors the prepared mind.” The minds of Swati and Ajay Piramal are prepared and they have positioned Piramal Life to have a chance for the “best shot at the goal” in the drug discovery business.
There are two more interesting aspects about Piramal Life worth noting here. One, the company has negligible revenues, is highly leveraged (at least when measured against debt service ratios), and has large accumulated losses. Typically, this implies a large bankruptcy risk.
However, the way I see it, the day Piramal Healthcare sold the formulations business to Abbott, the bankruptcy risk in Piramal Life disappeared because a very rich, committed, and long—term oriented parent now stood behind it.
Two, the large accumulated losses in Piramal Life alone would be quite useful to highly profitable and tax paying Piramal Healthcare. That’s because in a merger, they could be used as a tax shield. Back-of-the-envelope calculations show that these accumulated losses alone, are worth about Rs 60 per Piramal Life share, to Piramal Healthcare.
For these strategic and financial reasons, it makes imminent sense for Piramal Life to return to its very rich parent although there is no certainty by which this would happen.
Another part of Ajay Piramal’s grand strategy is to expand the three businesses that he did not sell. These are Custom Research and Manufacturing (CRAMS), Critical Care, and Over-the-counter (OTC) business. These businesses are small right now, but should grow in size as well as profitability over the next few years. Keep in mind that the growth-oriented Piramal is always on the lookout of cheap inorganic growth and it wouldn’t surprise me if he made a few very smart acquisitions in these businesses over the next few years.
The key thing, when you have cash, is to also have discipline. Famous fund manager Peter Lynch once wrote about the “bladder theory of corporate finance,” according to which the more the cash that builds up in the treasury, the more the pressure to piss it away. While this principle is largely followed by many companies and men who have suddenly come into cash, is it likely that Ajay Piramal is such a man?
I doubt it very much. His track record of demonstrated discipline in acquisitions speaks for itself. And recently, when Paras Pharma was being auctioned, while he had an interest in acquiring the company, he walked away because the asking price was too high. He agrees with Warren Buffett, who once said that the smarter side to take in a bidding war is often the losing side.
The key thing to remember here is that, given the current market value of the company, all of these businesses come free to the buyer of the stock at the current price. These include some of the most well recognized brands in the OTC business including ipill, Lacto Calamine, and Saridon.
Do you remember the jingle, “Sirf ek Saridon aur sardard se aaram. Na rahe pida na rahe dard. Bas ek, sirf ek, sirf ek Saridon?”). I’ve been humming it all day! (see this video: http://vimeo.com/20980858)
Well, if you own the stock at the current price, then among many other OTC products, ipill, Lacto Calamine, and Saridon come free (the brands, not the pills or the lotion).
Since the sale to Abbott, the media has been chasing Ajay Piramal about his plans for the cash. In response, he has consistently said three things.
One, he will reward shareholders. This is already done through the buyback. Two, he will expand the remaining three businesses he did not sell. And three, he will diversify into one or more new businesses.
This last statement has spooked the markets. Anytime a company announces a plan to diversify into a new business, the markets tend to dislike it. Usually the market is correct in this assessment because companies do tend to waste cash through diversification. However, my view is that you cannot paint everyone with the same brush.
Just as the market’s skepticism for Ajay Pirmal’s grand strategy of growth though acquisitions was wrong, its skepticism for his decision to diversify is also likely to be wrong. The market forgets that his original decision to move into the pharma business in 1988 was also a decision to diversify away from the textile business.
Nevertheless, the investment community is skeptical about what he will do with the money. Will he go into real estate? (He has denied this.) How about insurance? Or Retail?
My question about this is: Does it matter? Should one not focus on the man’s track record of wealth creation instead of worrying about whether he will go into real estate? And if he does go into real estate business, so what? Of all the people in India, he has one of the best experiences in the business. He was behind Peninsula Land, he was behind India REIT, he was behind India’s first retail mall (Crossroads) and he is behind Sunteck Realty.
Indeed, if Ajay Piramal were to announce that he will diversify into real estate, investors should rejoice for two reasons. One, the man has experience and track record of having done exceptionally well in that space. Two, the space is full of opportunities where he can create value by buying into distressed situations prevalent in the real estate space at present.
Then there is talk about his acquiring Hindustan Dorr—Oliver. So I asked him, not whether he would diversify into the real estate business in Piramal Healthcare, or whether he is going to buy Hindustan Dorr—Oliver. Instead, I asked him, what are the things he seeks when he wants to buy into a new business. He simply repeated his three acquisition principles mentioned earlier. How consistent! He did, however, mention, that he would expand overseas in both related, as well as unrelated ares.
One of the paradoxes about Ajay Piramal is that while he has a disdain for elaborate excel models of DCF valuation taught at business schools, it is the very same DCF (or rather the absence of the possibility of using it) which is a key reason for the street’s neglect for the stock.
When I asked him about how does he, when he buys into “less than perfect” assets, go about valuing them, and whether he uses formal DCF models or a more simple back-of-the-envelope calculations, this is what he told me:
“Management students may not like this. I am also a management student and both my kids are but let me tell you that management schools are doing a disservice by (overusing) DCF. There is nobody in the world who can predict what’s going to happen in 10 years. And I was a student, so I know how to “create value” — you change the terminal value and instead of 0.5% you will make it 2% growth and suddenly the value increases. So I don’t believe in this. I really do believe you have to get the back-of-the-envelope calculations right.”
“Who can predict what the market growth is going to be. If you tell me anybody who had predicted that the markets will grow like they have in India today. I don’t think so. If anybody could predict to me what is going to happen to the exchange rate which is another big variable? I don’t think so. Nobody can predict what happened to interest rates. So everything is variable and yet on that basis we make a fixed 10 year projection and do the DCF? I don’t believe in this and in my entire life I have never done it.”
So here is the paradox: Ajay Piramal has not made his money by relying on elaborate DCF modeling. On the other hand, sell-side analysts and many investment professionals make their living by DCF modeling. Pick virtually any research report on any stock and turn to the pages in the end and you will see what I mean. There will be projections about the future (many of which will turn out to be wrong), based on which there will projections of future cash flows, which would have been brought back to present value using more projections about cost of capital. This “false precision” is yet another form of “physics envy,” practiced by men (mostly) who forget that its better to be roughly right, than to be precisely wrong.
The trouble with doing DCF on Piramal Healthcare is this: How do you make the projections about a company, which is largely sitting on cash, and has plans to deploy that cash in some new businesses but at this time, even the owner—manager does not know which businesses the company will enter into? So, the analyst is thinking: “How can I even begin to apply DCF on Piramal Healthcare.”
“To a man with a hammer, everything looks like a nail.” The analyst, who only knows DCF, is like that man. He has just one tool — DCF — and he tries to use it on Piramal Healthcare and he fails, so he tries again by beseeching Ajay Piramal to tell him where will he put the company’s money, just so that he can make a model, but Ajay Piramal says: “I don’t know yet.”
After several failures, the analyst gives up.
My advice to the analyst is that he needs another tool, one which he will find if he reads the influential paper “Investing in the Unknown and the Unknowable (http://www.hks.harvard.edu/fs/rzeckhau/unknown_unknowable_PUP.pdf), by Harvard Professor and a, much admired by Charlie Munger, champion bridge player, Richard Zeckhauser.
In his paper, Prof Zeckhauser states, “Most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear… However, unknowable situations have been and will be associated with remarkably powerful investment returns… Indeed, I would speculate that the major fortunes in finance, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future.”
When it comes to valuing Piramal Healthcare, yes there is uncertainty. There is no visibility. But is this “uncertainty” the same as “risk?”
“Risk,” advices Warren Buffett, should be thought of as the probability of permanent loss of capital. While most uncertain situations are also risky (e.g. new startup ventures), this doesn’t mean that every uncertain situation is also risky.
I ask you to carefully think about this. Given what you now know about Ajay Piramal, given his past track record, and given the asking price for becoming his partner (free), how likely is it that if you do become his partner, and if you have a long—term view, you will suffer a permanent loss of capital?
While the street steers clear from Piramal Healthcare, India’s largest cash bargain, because “the outlook is uncertain and there is no clear visibility and that makes it too risky” does that have to mean that you should steer clear too?
That’s a question I will leave for you to answer. As for me, I have to tell you that I own shares in Piramal Healthcare, and I have to tell you that Ajay Piramal bought shares in the company in November 2010 at around Rs 460 per share, and that the company has just completed a buyback at Rs 600 per share. The stock is selling for 450. The cash per share is 517. Everything else is free.
The author is a Professor at MDI, Gurgaon where he teaches Behavioral Finance and Business Valuation. A condensed version of this post, will appear in the forthcoming issue of Outlook Profit.