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.
Published by fundooprofessor
I am Distinguished Adjunct Professor at Flame University, Pune. Previosuly, I was Adjunct Professor at MDI, Gurgaon, where I taught MBA students two popular courses titled “Behavioral Finance & Business Valuation"(BFBV) and Forensic Accounting and Corporate Governance (FACG) for many years.
I am also Managing Partner at ValueQuest Capital LLP— an investment advisory boutique which helps its clients invest their capital in good quality businesses.
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Fundoo Professor 
A minor clarification – when you say using 20x, i am presuming you are using an exit multiple for terminal value. In your experience does that work better in Indian context than the typical DCF way of calculating TV.
The role of limiting to a 20x conservatively estimated owner earnings multiple 10 years from now is that of a safety valve. There are other safety valves too which I described in the final Relaxo lecture. Two biggest safety valves, of course, are insistence on buying a moated business run by a great manager.
By limiting myself to valuing the business at a MAXIMUM of 20x estimated owner earnings 10 years from now I achieve two key objectives: (1) I side-step the issue of fair value (no one really knows that) and shift the focus to expected return; and (2) I am no longer constrained from investing in businesses which appear expensive because they sell at high P/E multiples (including those selling at more than 20x owner earnings at present). Therefore, I will gladly buy a business selling at 25x owner earnings at present, because it offers a lucrative return despite multiple contraction over the next 10 years.
In the end, whether I invest or not, and how much of my portfolio will be invested in a given business will largely depend on the expected return between now and 10 years.
Keep in mind that to have an exit multiple of 20x owner earnings 10 years from now, you have to be virtually certain that the business will be a growing one even after 10 years.
What kinds of errors I might be making while using this method?
One is the error of omission (Error # 1) that is I will not buy a great business which would have offered an excellent return had I used an exit multiple of more than 20x. Since, I capped that multiple to 20x, the expected return became mediocre and I rejected the idea at that price.
And two, even if I limit myself to valuing a business, no matter how great it might be, to 20x estimated owner earnings 10 years from now, I might be making an error of commission (Error # 2). That is, I might be over-paying for the business.
Given the presence of other safety values in the system, my expected loss from Error # 2 is small, if any. But I might be wrong on this. Therefore, I am open to revising my views on this based on experience I gain over the next few years. Till date, however, the loss from this error has been zero.
The opportunity cost of not investing a great business (Error # 1) because I limited myself to exit multiples of 20x estimated owner earnings ten years from now is acceptable. You can’t catch every fish worth catching out there.
Though not a big fan using multiples for TV, I agree with the logic and admire the simplicity of its usage. Many thanks for walking me through it. (PS: Havent read your Relaxo note – will do so soon).
Thanks a lot sir for posting your views on a very imp. topic….I arrived at something similar conclusion on selling part after studying short sellers and posted those views in my post “What Long term investors can learn from short sellers”
Thanks again…
Dear Prof. Bakshi,
Thanks a lot for sharing your thoughts on this subject. It was wonderful to note your views.
While I fully agree with your views, I had two questions which continue to perplex me:
1. Taking the illustrative example of Relaxo, lets say one has bought the stock after doing the analysis and is holding on to the stock. Let say, theoretically, the share price was to become Rs. 5,000. Should one still ignore the share price and focus only on the business fundamentals (which continue to remain intact) or would there be a theoretical price at which holding on would become absurd. As followers of Warren Buffett, we know severe limitations of efficient market theory and know Mr. Market does give great opportunities from time to time and that’s how we can exploit that. Doesn’t this happen both ways…where Mr. Market is manic depressive. If we look at benefiting from the depressive part and purchase at times of great pessimism, wouldn’t it make sense to benefit from his manic part also and sell at times of great exuberance (which we feel is not justified)?
2. Considering the achoring and commitment bias and other related concepts, if we were to look at our investments from a snapshot perspective, i.e. the way things are as on date instead of considering our purchase price, holding period etc (thus more from Balance Sheet perspective instead of P&L perspective), assuming the transaction / friction costs as zero, on any day we are indirectly taking a decision to buy or sell stocks (i.e. even the stocks we are holding are more like the purchases made on that day. We also have the option of selling and holding to cash as on date). I recollect seeing a similar perspective you had shared in one of your writings which is quite powerful. This becomes very relevant when we are not managing billions of dollars and can move in and out rather easily without impacting the share price to a great extent. With this view, lets share Relaxo’s share price is Rs. 5,000 and we hold on to it, it means we have purchased at that price on that day (else we could sell it and hold on to cash). Assuming the benefit of our small size, if we are not comfortable purchasing at that price, then rationally speaking why should we be comfortable holding at that price?
I understand there is no right or wrong answer but the above questions seem quite relevant and I have not been able to answer them. As always, your thoughts on the above would be wonderful and insightful. Look forward to the same.
Thanks and regards,
Aditya Bob Mahendru
There is no business so good that it can’t be ruined as an investment at some price. That’s basic common sense. My point in the email exchange was that when it comes to scalable moated businesses, then the normal rules that work with other types of businesses don’t apply.
Selling out of a great business just because its market value has gone up is almost always a bad idea.
But “almost always” does not mean “never”. Between “almost always” and “never” there is a gap and you should think deeply about that gap. While thinking about it, keep in mind that:(1) a dominant, scalable, moated business run by a great manager will much more likely present you with pleasant surprises than unpleasant ones; and (2) There comes a price at which even a great business, if bought at a fancy price, will deliver you a mediocre (or even a negative) return even after counting those pleasant surprises.
So, you really have to calibrate your thinking keeping those two points in mind…
Your second point refers to an inherent contradiction in my email exchange with Vishal. You’ve identified an important paradox. If I am right (and I believe I am), then you should be happy to hold a stock but not buy it at today’s price. To a rationalist, this looks absurd. Isn’t a hold decision the functional equivalent of sell and buy decision ignoring transaction costs and taxes?
As I said in my email thread:
Some readers may be very uncomfortable by reading what I wrote above. Their discomfort will arise from questions like: (1) How can rules to hold on to a stock differ from rules to buy it in the first place?; and (2) If you won’t buy the stock now, then why would you hold it? Isn’t that illogical and an example of endowment effect?
I offer you the following passage from Mr. Munger’s famous talk on Academic Economics, as my defence.
“When I was young, everybody was excited by Godel who came up with proof that you couldn’t have a mathematical system without a lot of irritating incompleteness in it. Well, since then my betters tell me that they’ve come up with more irremovable defects in mathematics and have decided that you’re never going to get mathematics without some paradox in it. No matter how hard you work, you’re going to have to live with some paradox if you’re a mathematician.
Well, if the mathematicians can’t get the paradox out of their system when they’re creating it themselves, the poor economists are never going to get rid of paradoxes, nor are any of the rest of us. It doesn’t matter. Life is interesting with some paradox. When I run into a paradox I think either I’m a total horse’s ass to have gotten to this point, or I’m fruitfully near the edge of my discipline. It adds excitement to life to wonder which it is.”
Thanks a lot Prof. for your great reply. It does provide a lot of valuable insights that are really helpful.
The excerpt of Mr. Munger’s talk was very interesting in the context. In fact I was going through Mr. Buffett’s letters and found a paradox there as well on this subject matter. Of course, his situation is very different due to his size and importance of maintaining his reputation of “Buyer of Choice” who would not sell the businesses. Nevertheless, his views are full of wisdom and I am sharing some excerpts below:
“Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results—not by their daily, or even yearly, price quotations—whether our investments are successful.
Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings.
However, our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses—a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price.
A determination to have and to hold, which Charlie and I share, obviously involves a mixture of personal and financial considerations. To some, our stand may seem highly eccentric. (Charlie and I have long followed David Ogilvy’s advice “Develop your eccentricities while you are young. That way, when you get old, people won’t think you’re going ga-ga”)
Our attitude, however, fits our personalities and the way we want to live our lives. Churchill once said, “You shape your houses and then they shape you.” We know the manner in which we wish to be shaped. For that reason, we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting and unpleasant ones.”
On this subject matter, I also found an interesting observation by Mr. Munger. When Mr. Mohnish Pabrai had met him, he asked Mr. Munger a similar question and this is what he said
“I asked Charlie if he would still promote buy and hold forever notion (see page 65 of his book) if he were running a small pool of capital. He said that he’d do it like he did when he ran his partnership – buy at a discount; sell at full price and then go back. With their present situation he said that it makes no sense to do that.”
Awesome. Thanks for that excerpt.
Thank you Prof for sharing your amazing insights in a simple comprehendible manner.
I have also been struggling with the appropriate hurdle rate for expected future returns, when i think about look out earnings and exit multiple. In the Relaxo lecture and elsewhere, you seem to quantify it as 2x prevailing AAA yield.
1) Is it correct to think of hurdle rate as a personal choice and thus distinct from one individual to another, as many believe, or should there be a logical anchor to the expectations? Most investors i know seem to have a hurdle rate in the region of 20-25% for equity investments. Those having too high a hurdle run the risk of passing up investing in great businesses since they set the bar too high. Those setting it too low may end up paying a fancy entry price.
2) Should the hurdle rate change from time to time? Here i quote from your Relaxo Final lecture where you seem to allude to this point.
“The above framework is just a template which needs to be updated periodically based on fundamental performance numbers or other developments relating to the company, the industry, or the economy which warrants such an update. For example, if the company performance deteriorates for whatever reason and I come to the conclusion that such a deterioration is not an aberration, then I must change my expected return estimate accordingly. Similarly, if interest rates drop to 6%, then a stock which offers a 12% expected return would start looking quite attractive. And so on. In other words, the template is dynamic and not static. It reflects your thinking about the long-term fundamental performance of the business and its relative attractiveness at its prevailing market price as compared to passive instruments (AAA bonds) and other opportunities available to you”
If hurdle rates were to change frequently in line with interest rate changes or otherwise, would it not add to the difficulty in the decision to hold?
3) Following from the above thought, is there any merit in considering the cost of opportunity for other market participants (question relevant for today’s environment of free money) in coming to one’s conclusion on hurdle rate?
Regards
Abhinav Mansinghka
In a world where interest rates are 10% if you can find long-term opportunities that will give you 18% you should be more than satisfied. That’s how I look at it. If someone else finds a 25% opportunity and I don’t invest in it, it doesn’t bother me. Being envious is a bad idea in investing and in life. That’s a big lesson for every student of Charlie Munger.
Your hurdle rate should naturally be anchored to passive, relatively effortless fixed income returns. In a world where AAA bond yields jump to 16%, then an expected return of 18% in equities will be a bit silly, no? Therefore, you have to have an adjustable aspirational level and then go around looking for opportunities that will meet your aspirations. If you can’t find them, then you must lower your expectations. If you want happiness in investing and in life, having an adjustable aspirational level is important. Look up “satisficing” in wikipedia…
Reblogged this on Financial Markets.
Dear Mr Bakshi
You have been like a Dronacharya for me. I am an unknown Eklavya who has learnt from you so much. I completely agree with your last comment that with interest rates at 10%, a return of 18% whould make one feel happy. But as Taleib says, we all suffer from a social treadmill effect and are more unhappy with someone getting 25% returns rather than my own returns of 20%. Some things never change. Ever since I learnt the concepts of Moats through your writings, the wisdom of Munger, Areily and Benjamin Franklin and something most wonderful called sidecar investing, I have generated a respectable CAGR of 21% on my investments.
Please continue the good work and spread your pearls of wisdom. Why don’t you start a Mutual Fund?
On the subject of Buying vs. Holding, I like what Guy Spier said in one of his talks. He said when he buys a business he knows it is definitely worth more than $X (below which he will buy) and definitely less than $Y (above which he will Sell) Between X and Y, he will keep holding to minimize transaction costs. I like the simplicity of his approach, he doesn’t try to estimate the exact fair value of a business(which is most probably impossible). It is also similar to your approach in the sense that Deciding to buy a stock vs. Deciding to Hold a stock will yield different results.
Somewhere in the comments section you elude to the paradox. I wonder if its really a paradox or a behavioral bug.
Would you invest incremental money in the same proportion as your current portfolio?
i.e. say you started off at 100 units of personal wealth, and had a certain allocation across stocks. Why should 110 units (i.e. an increment of 10 – say you won a lottery) cause you to have a different allocation than before? i.e. in this case you not buying relaxo? If you did have the same allocation as before then there is no difference between buy/hold.
These could be a valid reason why a 110 unit portfolio can be different than a 100 unit one. i.e. tax, market impact of moving in and out of positions. But, I dont think this is the point you were trying to make anyways. So we will ignore it for now.
The paradox I referred to arises from this question: Is there a logical “hold” period for a stock? If yes, then it must mean that you’d not buy more, nor will you sell what you have, and that’s why you’d hold.
For some people, there is no such thing as a “hold” period for a stock. You are either a buyer or a seller. For people holding this belief, there is no paradox. For them, all portfolios at all times will be either identical or very closely resemble each other. But then this must also mean that the moment they find something even slightly better than something else they had bought earlier, then they should replace the investment deemed to be inferior with an investment deemed to be superior. Logically that means that if the worst position in their portfolio — let’s call it A — offers a return of 15% p.a. and they found something that offers a return of 15.01% — let’s call it B — then they should sell A to buy B. And if that’s the case, then they will spend most of their investing lives comparing, constrasting, and replacing. The number of investment decisions they’d make would also increase dramatically. So, life for people who believe there is no hold period, is going to be quite difficult…
I am fine with the paradox being called as a behavioral bug, but it’s a bug that delivers good results and there is an explanation for it (keep eyes wide open before marriage but only partly open thereafter), and so it doesn’t really bug me anymore. 🙂
Dear sir
First of all many many thanks for running such a blog so that the investor can learn those who can’t directly learn in your class. I am very big fan of yours after reading few articles that are really helpful like Moat and float , vantage points and Relaxo lectures . You are now my become role model or teaching guru . I come to know about you while listening the one lecture on youtube by Rajeev Thakkar of PPFAS . Happy because i learning a lot but sad why so late , can be benefited a lot if come to know earlier.
I want to just know in case For Example In Relaxo lecture you have projected the market cap of 6700 Crore in 2023 and suppose because of sharp market appreciation relaxo achieve that target i.e 6700 Cr in 2 years say in 2015 end. Then what will be your decision in a condition that
1) projection still remain same based on current company performance and fundamentals.
2) Total market is at all time high and looking very expensive as well.
3) You are not able to find right now any other stock at fair price .