When You Buy a Bank…

Proposition 1: When you buy into a bank with your own money, you buy into a highly leveraged situation. That’s because banks employ huge amount of leverage. This leverage will magnify your returns – both positive as well as negative.

Proposition 2: When you buy the shares of a debt-free business with your own money, there is no use of leverage at your or the portfolio company level. But you can do a thought experiment and imagine that you brought into this debt free business with borrowed money and then calculate the expected return on your money.

If you don’t make that adjustment, you are comparing apples with oranges which doesn’t make sense to me. For me, to be able to buy into a bank I love, the expected return on its stock should be materially higher than the expected return of owning a debt-free business that also I love. But, if such an adjustment ensures that I will almost never buy a bank then so be it.

It’s important to recognize that (1) leverage affects returns no matter where it resides (at the portfolio level or at the portfolio company level); (2) leverage adds to investment risk; and (3) investors should seek significantly higher returns to compensate for additional risk that leverage adds to the portfolio. 

Reply to a Mail from a Friend on Valuation

Begin forwarded message:

From: Sanjay Bakshi <sanjay>

Subject: Re: question

Date: 11 April 2015 10:11:48 GMT-4

To: XXXX

I don’t think in terms of entry multiples. I do think about exit multiples though and never value a business at more than 20 times owner earnings ten years from now. And I only limit to high ROE, low leverage businesses (most of my portfolio businesses are debt-free) which can grow earnings where return on incremental capital is high.

Under those conditions, no matter what the entry multiple, I can estimate a return over ten years. If entry multiple is high, I factor in a multiple contraction, and if low, then an expansion. Obviously the best returns come in the latter situation but by focusing on expected returns, I have sometimes bought high P/E businesses too because even if there was a multiple contraction, there is good money to be made in a decade…

In some businesses, I don’t go beyond 5 years – as my visibility is a lot less in them.

Also when I said 20x multiple ten years from now as maximum I will value the firm at, I mean it. Many of them are valued at 15x and some as low as 10x…

It’s pretty rudimentary, but has worked for me over the last several years…

On 10-Apr-2015, at 19:33, xxxx wrote:

stupid question may be : how will you correlate a compounder roe, eps growth to a pe multiple or any multiple. have u come across any mathematical formula. i think i saw some people writing about it but cant remember.

no rush or urgency.

Lecture on Value Investing @ IIM Ranchi

Recently, the students of IIM Ranchi invited me to deliver a talk on value investing. You can view the video recording from here.

A “noise reduced” version can be seen from here.

The presentation slides can be downloaded from here.

Why The Rules For Buying Vs. Holding A Stock Are Not The Same

A few weeks ago, Vishal Khandelwal of Safal Niveshak and I had an email exchange on this subject. Vishal published that conversation in his excellent Value Investing Almanack (subscription required).

That email conversation is now public. You can read it from here.

Why You Shouldn’t Invest in a Business That Even a Fool Can Run

A post in a Facebook group called Charlie Munger Fan Club prompted me to write this note on that group. I thought of reproducing it here (with minor changes).

“You should invest in a business that even a fool can run, because someday a fool will.” Warren Buffett’s famous quote, is often misunderstood. When he spoke those words, I don’t think he meant them strictly. Some investors I know, however, disagree with me. They cite other quotes which reinforces the viewpoint.

Here is the first one, from his 2007 letter:

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low- cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But 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.”

Here is the second one from his 1991 letter:

“An economic franchise arises from a product or service that:(1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

And here is the third one from his 1980 letter:

“We have written in past reports about the disappointmentsthat usually result from purchase and operation of “turnaround” businesses. Literally hundreds of turnaround possibilities indozens of industries have been described to us over the yearsand, either as participants or as observers, we have trackedperformance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

All of the above thoughts expressed by Mr. Buffett make many of his followers believe that superior management is irrelevant for investment evaluation purposes. And it’s easy to come to that conclusion if you go by what Mr. Buffett has said in the above quotes.

But if you go deeper, you find something else. I did, and here’s what I found.

In his 1990 letter, Mr. Buffett articulated his rationale for investing in Wells Fargo. He wrote:

“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussingthe “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”

His words “leverage magnifies the effects of managerial strengths and weaknesses” imply that whenever leverage is high, management factor is important.

Take HDFC Bank. Would you like to remain invested in HDFC Bank if it was run by a fool who doesn’t know anything about risk management and would love to learn on the job?

Which other highly leveraged industry has attracted Mr. Buffett’s interest? Well, the answer of course is the insurance industry.

Insurance uses float (other peoples’ money) which is another form of leverage. The role of management becomes terribly important in this business. That’s because its easy for a fool to under-price insurance contracts, the consequences of which will not show up in the P&L for many years.

This even more true in the Super Cat insurance business. That’s because there is little baseline information to be relied on to adequately price insurance contracts.

The same logic applies to derivatives, where leverage magnifies the effects of smart, as well as, dumb behaviour.

Imagine if one day someone like Kenneth Lay replaced Ajit jain to run Berkshire Hathaway’s Reinsurance business and its derivatives book!

Which other business models require you to focus a lot on managerial skills? Well, one that comes to mind would be a good business which operates on wafer-thin margins but still delivers an acceptable return on equity because of high capital turns and/or presence of float.

Take, for example, the case of Mclane, a Berkshire Hathaway subsidiary which is a distributor of groceries, confections and non-food items to thousands of retail outlets, the largest of them being Wal-Mart.

In his 2003 letter, Mr. Buffett wrote: “McLane has sales of about $23 billion, but operates on paper-thin margins — about 1% pre-tax.” In 2014, McLane earned $435 million on revenues of $47 billion.

In his 2009 letter Mr. Buffett acknowledged the importance of the management factor in Mclane. He wrote:

“Grady Rosier led McLane to record pre-tax earnings of $344 million, which even so amounted to only slightly more than one cent per dollar on its huge sales of $31.2 billion. McLane employs a vast array of physical assets – practically all of which it owns – including 3,242 trailers, 2,309 tractors and 55 distribution centers with 15.2 million square feet of space. McLane’s prime asset, however, is Grady.“

Running a business like McLane profitably is not easy. The wafer thin margin of just about 1% means that a small slippage in costs can quickly turn the business from being profitable to become a loss making one. And when you combine very high capital turns with operating losses, you sprint towards bankruptcy. So you have to be very very efficient to run a business like McLane. A fool cannot run a business like that successfully.

Based on what I wrote above and other stuff I have read on this subject, I do not think Mr. Buffett meant it literally when he said “You should invest in a business that even a fool can run, because someday a fool will.”

If you read between the lines you find that there have been several occasions — and I just cited three)— where without a highly competent manager in place, Mr. Buffett would never have invested in the business.

We should look at the whole picture and carefully observe what Mr. Buffett does, not just what he says. And, to my mind, he has never invested in a business where he felt the incumbent management was foolish. Nor, in my view, would he like any of his businesses to be eventually run by a fool.

The Mohnish Pabrai Lecture @ MDI

Mohnish Pabrai delivered a wonderful talk in my class at MDI in December 2014 which you can see from here.

My favorite part of the video is when Mohnish talks about how he used what he had learnt while practicing value investing lessons to create and run his Dakshana Foundation. Over time, Dakshana has produced a stupendous track record. According to the Foundation’s Annual Report for 2013

Since inception in 2007, the IITs have accepted 631 Dakshana Scholars (out of a total universe of 1288 Dakshana Scholars) – a success rate of 49%. Not too shabby – considering that the IITs accept under 2% of applicants. In 2014, out of 259 Dakshana Scholars who took the IIT entrance test, 167 made it – a success rate of 64.4%. 

Wow!

Mohnish invited a few Dakshana Scholars to attend his talk. Their presence and interaction with Mohnish made the experience all the more memorable and enriching.

The Sunil Agrawal Lecture Video and Slides

On 28 Jan, 2015, Sunil Agrawal, Chairman and MD of Vaibhav Global Limited delivered an inspirational talk to my students at MDI about his journey as an entrepreneur. Displaying extraordinary candor, he talked about the story of his ups and downs and what he has learnt over the last 35 years.

You can watch the video playlist from here and his presentation slides from here.

Before Sunil delivered his lecture, I had written a teaching note for my students which you can get from here.

 

 

62-Bagger and Counting: An E-commerce Business That Actually Makes MONEY But Almost Didn’t

Here is a teaching note I prepared for my students before tomorrow’s guest lecture by Sunil Agrawal, CEO of Vaibhav Global Limited in my class at MDI.

Disclosure: I own shares in VGL. This note is not a recommendation to buy VGL’s shares. Rather, it’s a document I have written to help you understand what I liked about VGL. To be sure, there are many things to not like about VGL. There isn’t enough time to list them all. In any case, you should assume that I am biased and I could be wrong. I have been wrong many times in the past.

The Ajit Isaac Lecture Video

The Ajit Isaac Lecture Video is ready. You can view it from here.

It would be best to read my teaching note on Ajit and his presentation slides before you see the video.

Enjoy. And Learn.

The Ajit Isaac Lecture Presentation

Ajit Isaac, CEO of Quess Corp (formerly known as IKYA Human Capital), a subsidiary of Thomas Cook India Limited (which is a subsidiary of Fairfax Financial Holdings Limited) delivered a fantastic lecture in my class today.

Ajit Isaac in my class

Ajit Isaac in my class

Ajit spoke from his heart to my students about his journey as an entrepreneur and how he grew his business from a one-room operation in 2007 to having 90,000 employees in 2014. He also covered topics such as how he thinks about businesses, the role of extreme focus, how he has build Quess organically and inorganically (his track record in M&A is fabulous), how important is integrity, how he thinks about profitable growth without taking unnecessary risks, and his aversion to debt and how the cultures at Fairfax and Quess compliment each other.

He also took great efforts to explain the fundamental economics behind each business vertical in Quess. My introductory slide before Ajit started addressing my class was this one:

Introductory Slide # 1

Introductory Slide # 1

That one word is “FOCUS”

Introductory Slide # 2

Introductory Slide # 2

I cited a wonderful book, titled “The Little Book of Talent,” and the first advice of its author, Daniel Coyle is that you should stare at who you want to become.

Introductory Slide # 3

Introductory Slide # 3

“If you were to visit a dozen talent hotbeds tomorrow, you would be struck by how much time the learners spend observing top performers. When I say “observing,” I’m not talking about passively watching. I’m talking about staring—the kind of raw, unblinking, intensely absorbed gazes you see in hungry cats or newborn babies. We each live with a “windshield” of people in front of us; one of the keys to igniting your motivation is to fill your windshield with vivid images of your future self, and to stare at them every day. Studies show that even a brief connection with a role model can vastly increase unconscious motivation.”

“The key to effective engraving is to create an intense connection: to watch and listen so closely that you can imagine the feeling of performing the skill. For physical skills, project yourself inside the performer’s body. Become aware of the movement, the rhythm; try to feel the interior shape of the moves. For mental skills, simulate the skill by re-creating the expert’s decision patterns. Chess players achieve this by replaying classic games, move by move; public speakers do it by regiving great speeches complete with original inflections; musicians cover their favorite songs; some writers I know achieve this effect by retyping passages verbatim from great works. (It sounds kind of Zen, but it works.)”

Ajit is a great role model for a future generation of entrepreneurs and value investors. He is worth staring at.

Introductory Slide # 4

Introductory Slide # 4

You can get a copy of Ajit’s excellent presentation from here. I will post the video soon after I get it from MDI. An earlier teaching note I had prepared on this lecture can be downloaded from here.

Disclosure: I own shares in Thomas Cook India Limited, which is the holding company of Quess Corp. This is not a recommendation to buy TCIL’s shares.

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