Interview with Ian Cassel of MicroCapClub

I became a twitter follower of Ian last year and have enjoyed interacting with him on that platform, and through email over the last few months.

Ian runs MicroCapClub in the U.S — a forum meant for microcap value investors. Over the months, I have enjoyed reading up the materials posted on that site. But even more interesting has been receiving Ian’s wisdom through his wonderful tweets. Here are some of them:

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These are just some of Ian’s tweets that I loved. There are dozens of others. Follow him on twitter and learn from his wisdom and experience.

I am overwhelmingly in sync with Ian’s thoughts on investing, some of which are expressed in his tweets above.

A few weeks ago, Ian persuaded me to answer a few questions for an interview which you can read from here.

END

What is Staying Power?

A few days ago I asked a question on twitter: What is Pricing Power?

Yesterday, I asked another one: What is Staying Power?

I wanted to illustrate the power of focused thinking by “letting your mind wander.” What happens when you think about an idea and that idea only from multiple points of view?

Well, you get insights you wouldn’t get if you were distracted by other ideas.

Staying power is a very powerful idea. But where does it come from? The common answer I get from people is that it comes from a strong balance sheet. But that’s only part of the answer.

You have to keep asking where else does it come from. And one way to find out is by asking where does a strong balance sheet come from?

The insights gained through focused thinking on a question and that question alone produced some answers which I think will be useful for you. These are listed below. Remember that this is not an exhaustive list but is a pretty good first attempt to answer the question.

Business Model

From the vantage point of a business model, staying power comes from:

  1. A product or service that will not be obsoleted for a long time – usually these are things that serve basic human needs and aspirations.
  2. Multiple sources of revenue streams.
  3. Low customer concentration risk.
  4. Low supplier concentration risk especially when dealing with critical raw materials.
  5. A business which does not derive its key advantages from political clout.
  6. Slack in the form of un-utilised capacity especially in case of industries when most money is made during periods of shortages.
  7. High customer switching costs (financial or psychological e.g. in brands)
  8. Solid entry barriers which prevent a business from a competitive attack that can destroy it.

Corporate Culture

From the vantage point of corporate culture, staying power comes from:

  1. Willingness to cede market share when irrational competition drives down potential returns – and in the extreme case exiting a businesses.
  2. Refusal to invest in a business which deserves to die – i.e. not throwing good money after bad – and conserving it for productive uses.
  3. Unwillingness to bet the bank on a single idea – intelligent risk management as part of the DNA of the firm (including avoidance of gambling in the garb of risk management through derivatives).
  4. Willingness to make multiple small bets to grow the business so that no single bet or a group of bets, if they turn bad, can destroy the business.

Ownership Structure

From the vantage point of ownership structure, staying power comes from:

  1. Rich promoters who will, when needed, add financial strength to the business by infusing their own cash when no one else will (usually happens in family run businesses)
  2. Controlling stockholders who support investment for future prosperity instead of treating the business like a cash cow (although doing that makes sense in many circumstances)
  3. An ownership structure which, when combined with a great management team, creates stability for the firm e.g. through non voting shares (e.g. Google)

Balance Sheet

From the vantage point of balance sheet, staying power comes from:

  1. Low or no debt levels whether on or off balance sheet.
  2. A liquid balance sheet.
  3. Presence of non operating assets that can be sold for cash to save the business when needed.
  4. Absence of other encumbrances e.g. litigation that can drain resources or managerial focus.
  5. Low short-term debt, especially during cyclical downturns.

Profit and Loss Account

From the vantage point of P&L, staying power comes from:

  1. Size of revenues – generally speaking large businesses have better ability to withstand economic shocks than smaller ones.
  2. Multiple sources of earnings.
  3. Pricing power.
  4. Low cost advantage over competition so when industry conditions worsen the others suffer a lot more than you.
  5. Flexible cost structure – the ability to shrink the business without losing profit margins – low operating leverage.
  6. Low financial leverage as reflected by low interest cost in relation to earnings available to pay interest.
  7. Low economic depreciation – coming from a business that is not very capital intensive, and one that is not prone to become obsolete soon.
  8. Significant discretionary spending which can be curtailed during really bad economic and industry conditions – e.g. advertising.

Cash Flow Statement

From the vantage point of cash flow statement, staying power comes from:

  1. Low interest and principal repayments in relation to operating cash flow.
  2. Low maintenance capex and maintenance working capital needs.
  3. Ability to fund even growth and maintenance capex with internal resources.
  4. Low dividend payouts.

The Investor

From the vantage point of the investor, staying power comes from:

  1. Large number of years left to invest.
  2. Ability to handle volatility through financial strength – low or no debt and significant disposable income preventing the need to liquidate portfolio during inappropriate times.
  3. A frugal nature.
  4. Ability to handle volatility through psychological strength.
  5. A very long-term view about investing.
  6. Structural advantages – investing your own money or other people’s money who will not or cannot withdraw it for a long long time.
  7. Family support during tough times.

Creative thinking can be taught. It can be learnt. It requires deliberate practice. One of my favourite tools for creative thinking is Creative Whack Pack — a pack of cards that make my creative juices flow. Buy these cards. The author also sells them as an app for your smartphone. Buy the app. Here are a few cards I used for this particular exercise. Creative Whack Pack - Be Dissatisfied

Creative Whack Pack - Let Your Mind Wander

Creative Whack Pack - Change Viewpoints

Creative Whack Pack - See the Big Picture

Creative Whack Pack - Look Somewhere Else

This post is the outcome of the efforts of many twitter followers. Thank you.

END

ET Phones Home

Shailesh Menon of The Economic Times called me at home a few days ago and persuaded me to speak to him for a profile he was doing on finance academics in India who also practice value investing. 

http://ecoti.ms/08rvKa

 

Clarification: Quoting unnamed sources, the profile refers to a number of businesses I own. As of now, that’s not an accurate reflection of reality.

Implications of the Coming Capex in Coal

I wrote this mail to myself after reading several articles on the coming capex in coal and thought of sharing it with you.

Begin forwarded message:

From: Sanjay Bakshi <sanjay.bakshi>

Subject: Very balanced article on India’s dependence on Coal

Date: 27 May 2015 17:47:06 IST

To: Sanjay Bakshi <sanjay.bakshi>

http://www.theguardian.com/news/2015/may/27/why-india-is-captured-by-carbon?

Apart from huge investments in solar power, India is going to see huge expansion of coal mining capacity.

Abundant and cheap energy could make many businesses vulnerable to disruption (e.g. genset, inverter, and battery manufacturers). Overall, I am very cagey about investing in businesses that generate or store energy. But there will be other businesses which will benefit from this huge capex – businesses which facilitate the capex or benefit from that capex.

The idea is analogous to what Ralph Wanger calls “downstream effect.” Here is an extract from one of his interviews which I quoted in an article I wrote for ET in 1997.

“The airline example was a good case of a transforming technology. The jet engine was a terrific invention, and General Electric and Pratt & Whitney and Rolls Royce, I suppose, made reasonable money making jet engines. But for every dollar the jet engine manufacturer made, probably the airline made more. And the airline customers turned out to be the big beneficiary.

A good reason the western United States grew rapidly in the last 40 years was the jet plane. It made travel very practical… So the concept of transforming technology is that the big money is downstream…

…The railroads transformed the United States in very dramatic ways. The guys who made steam locomotives and railroad cars made some money, but you may not be able to name the major makers of locomotives, because they barely exist today…

…As you go downstream the dollars spread out. Now you probably can name the railroads that made a lot of money buying the steam locomotives and using them to build the railroad industry. The railroads made some good money. But the people who made even bigger money were the people along the right of way who could use the railroad to develop mines and factories and cities. So the guys who owned the silver mine here in Aspen saw the value of their mine at practically nothing before the railroad showed up, because they couldn’t ship the ore out on a practical basis without the railroad. But as soon as the railroad showed up the mines became economically profitable, the city grew, and the people who owned the land and built stores made a lot of money…

…Another example – one that is the most obvious and the most lasting trend is the whole idea of electronics, computers, communications, and information processing of all sorts. Here your transforming technology is really the semiconductor. It made computers practical, it made telephones much cheaper. All of the things you didn’t have in your house you can’t get along without today. Things like your cellular phone, your fax machine, your PC, your e-mail and your phone mail.

…Well until a few years ago I would guess the amount of money made by the American semiconductor industry was zero. There are many companies that made some money, but there were many companies that went out of business and made no money at all. Now everyone remembers how well Intel and Motorola have done, but they’ve forgotten about the Fairchilds and dozens of others who started barely and failed. Some of them took a lot of money down with them.

Intel was the exception. But when you think about the amount of money that Intel has made, I think you would easily find that Intel’s customers made more. The people
who are making real money on it are people like you. The reason you are in business is because of cable TV. That is a new technology and has enabled people to sell blue jeans and pantyhose to millions that they couldn’t have reached otherwise. And it needed electronics to make it possible. And we’ve made a whole lot of money owning cable TV stocks than we ever would have owning semiconductor stocks.”

One should think both upstream (businesses that benefit from supplying goods and services to facilitate the capex that is coming) and downstream (businesses that benefit from cheap energy – a cost benefit they will be able to retain because they have a moat).

Key questions:

  1. Which businesses will benefit from being facilitators of this capex?
  2. Which businesses will benefit from being beneficiaries of this capex?

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.

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