Seven Patterns of Inefficiency in Pricing of Quality Businesses

Here are some of broad patterns of inefficiency that I have encountered over the last few years of practicing value investing in better quality businesses:

  1. The market’s inability to appreciate the probable future value of higher quality businesses with very long runways (something I covered here);
  2. A niche business which is doing something remarkable but it belongs to an unremarkable, largely unprofitable, commodity-type industry and the market is failing to make the distinction;
  3. Mispriced B2B businesses which are enormously profitable but remain below the radar because, unlike B2C businesses, their output doesn’t show up in the final product or service;
  4. The market’s inability to spot an emerging moat that is growing slowly over time (the “boiling frog syndrome”);
  5. The market’s inability to forgive an entrepreneur “learning machine” who has learnt very important lessons from his or her past mistakes and is unlikely to repeat them;
  6. The market’s propensity to misunderstand the integrity of an entrepreneur;  and
  7. Because of its intense dislike of conglomerates, the market’s inability to treat as exceptions, the great capital allocators who create well-managed, and highly profitable diversified conglomerates over time.

There are several other patterns that play out in classic Graham-and-Dodd style cigar butts but the above list pertains only to patterns that I could identify with in better quality businesses misunderstood by markets.

I am not citing examples because I don’t want to talk my book. Nevertheless, some of you may find this framework useful in two ways: (1) It may help you relate what you already own to one or more of these patterns; and/or (2) It may help you find new opportunities which conform to one or more of these patterns.

Note: Among other things, this post was inspired by a wonderful excerpt I recently saw from “Margin of Safety” by Seth Klarman in which he writes:

Necessary Arrogance
“At the root of value investing is the belief, first espoused by Benjamin Graham, that the market is a voting machine and not a weighing machine. Thus an investor must have more confidence in his or her own opinion than in the combined weight of all other opinions. This borders on arrogance, the necessary arrogance that is required to make investment decisions. This arrogance must be tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard working. Their sale of shares to you at a seeming bargain price may be the result of ignorance, emotion or various institutional constraints, or it may be that the apparent bargain is in fact flawed, that it is actually fairly priced or even overvalued and that sellers know more than you do. This is a serious risk, but one that can be mitigated first by extensive fundamental analysis and second by knowing not only that something is bargain-priced but, as best you can, also why it is so. You never know for certain why sellers are getting out but you may be able to reasonably surmise a rationale.” [Emphasis mine]

I Just Lost a Friend

By the time you read this, you may have seen many obituaries of my friend Parag Parikh — who recently died in a tragic road accident in Omaha.

Parag, some of those obits say, was a contrarian value investor and money manager who took the high road in serving his clients, first at his firm’s PMS and then at his mutual fund. I want to focus instead on Parag, the remarkable human being who transformed many lives.

“Parag” in hindi means nectar which is appropriate because I know of many people who drank the nectar of Parag’s generosity and kindness. Let me tell you about just three of them.

Back in 1998, I was struggling to become a successful value investor. Having returned from England in 1994, and being bitten by the value investing bug, I had started my investment boutique with a very small corpus contributed by friends and family members. It would take many years before I achieved any real success, but in the meantime to make ends meet, I used to write columns in The Economic Times and a few other publications.

One day I had the opportunity to meet Parag who, it turned out, had read a few of my articles. He was running a PMS scheme at the time — something I thought I might want to do one day and so I was excited to get an opportunity to meet him.

Without my telling him anything, Parag saw my “situation,” understood it, and invited me to write for his firm. I accepted his offer and wrote thirteen columns for him on topics such as a (hypothetical) leveraged buyout of Bajaj Auto, the rigged market in PSU stocks, special situations investing and why value investors should stay away from IPOs. Those articles got me a lot of recognition in the investment community which was very helpful to me at the time. So, even in my early days as a value investor, Parag had propelled me forward.

He never stopped.

Over the years, we had stayed in touch and Parag had kept himself abreast of my progress as a value investor and also as a teacher.

Then, in 2011, he reached out to me with an idea. He was going to hold a symposium comprising of value investors. Titled “OctoberQuest,” the event would seek to be an “intellectual hotspot for exchange of thoughts and sharing of experiences among like-minded peers.”

Parag wanted me to address my peers in the value investing community many of whom were much older than me! When I read his mail, the nervous and introverted part of me took over. Speaking in front of students who know little is nothing as compared to addressing peers who know much more. That thought made me supply Parag with one excuse after another to somehow escape from all this.

It didn’t work.

After reading a series of email exchanges, Parag called me and said: “Sanjay, you can do it.” He talked me into it and on 28 September, just a few days before the conference I wrote to him: “Your persistence got me! If it’s ok with you, I will move my timetable a bit and come to attend your wonderful conference.”

Parag replied:

“Dear Sanjay, thank you so much. Your presence means a lot to me and also to the value investing community. We will schedule your speech first thing in the morning after the keynote address by Mr.Chandrakant Sampat.”

Shit! I was going to speak immediately after the legendary Chandrakant Sampat! Images of tomatoes and eggs being thrown at me immediately came to mind. It was too late though to back out now as a commitment to a friend had been made. So, I gathered all the courage I had and went on the stage and spoke something unremarkable to my peers. Afterwards, Parag came up and announced that from now on I will be the keynote speaker at his conference.

Parag was doing it again. He was propelling me forward.

Of the next three OctoberQuest keynote talks I delivered, two went viral on the net. (The third one remains unpublished.) I still get mails from people from around the world about them and have made many friends and earned a lot of respect because of those talks — something that wouldn’t have happened but for Parag.

Arpit Ranka is one of my brightest students. He dropped out of college to study from me and ended up topping my class. When the course finished, he came to me for career advise. I told him to go get a college degree. Thankfully, Arpit didn’t listen. Instead, he went to Parag, who immediately hired him. Over the course of next few months, Parag mentored Arpit and invited him to collaborate with him on his second book. That book, on behavioural finance, contains Parag’s accumulated wisdom of more than three decades.

Arpit recalls the experience:

“Sometimes a gesture remains with you for your entire life. One such gesture on his part, which greatly exaggerated my contribution was him sharing 25% of the royalty of his book with me. I consider myself blessed to have worked under somebody like Parag bhai, who not only inspired you immensely but then went out of his way to recognise your contribution, which was effectively fruit of his trust more than anything else!”

Years later, Arpit went on to become a very successful value investor and I was delighted to learn recently that one of the world’s largest University endowments reached out to him to explore a working relationship with him. Unfortunately, Parag didn’t get to know this. Had he known, he too would have been so proud of Arpit.

Like Arpit, Megha More is also a bright ex-student. She went to work for Goldman Sachs and after a while when she found herself drowning in that ocean she sought my help. She had an interest in behavioral finance so I sent her to Parag who immediately hired her. She recalls:

“I would sit with him in his office for about 30 mins to an hour daily and just rake in all the wisdom that he so freely and happily imparted.”

Megha’s story is inspirational because it shows how one thing can lead to another. She recalls how Parag encouraged her to stay fit:

“When I informed him that I have joined a gym, he was elated. He knew I had almost an hour long commute to work. He immediately said, “I will allow you to leave one hour early daily if you promise you won’t skip the gym.””

Megha went to Chicago to be with her husband and ended up running the Chicago marathon. A few years ago, she returned to India and started a fitness company which was recently funded by a venture firm at a multi-million dollar valuation. She recalls:

“I had tears in my eyes when I informed him about my personal decision to move to US, but he spoke to me like my father would and said “This is the first of many sacrifices that you’ll make in your marriage. Don’t start this beautiful journey with a regret. You were meant to be here with us for this limited time only.”

There is no other way I can justify losing Parag than by quoting his own words to Megha: He was meant to be here with us for this limited time only.

Note: And edited version of this post will be published in the forthcoming issue of Outlook Business.

Update: Outlook Business Link.

Breaking News on Breaking News

Vishal Khandelwal of Safal Niveshak pens his thoughts on news. Some of my own thoughts on news, reading, connecting the dots, and impersonating Sherlock Holmes are also included. 

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.

 

 

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