You can read the first part of this Interview is available here.
How do you typically find ideas and what is your selection process before an idea gets added to your portfolio?
I somewhere read Warren Buffett as saying, “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.”
And then, he has said many times that he is a better investor because he is a businessman and he is a better businessman because he is an investor.
So, my experience as an entrepreneur has been very fundamental to being better at investing. And this has especially happened over the past three years. Of course, I was investing in the stock market earlier as well, but I did not have a well laid-out process then.
Most of my investing prior to 2011 happened on the back of recommendations from my analyst friends, whom I really trusted (and there were just a couple of them), because I was not legally allowed to buy stocks I was analyzing. Of course, even when I bought stocks based on my friends’s recommendations, I used some my own understanding as well. But as I realize now, that was just to confirm the original hypothesis.
Coming to the present times, my understanding of how I must run my own business helps me a lot on deciding which businesses to buy, and which ones to avoid with a 10-foot pole.
So the first thing I look at is the quality of business. And here are a few things that help me decide whether a business is good or not.
One of the first things I look for in a business is how complex it is to understand – the “too hard” stuff as Warren Buffett calls it.
If there are a lot of regulations involved (energy, power etc.), or if the business has an unproven past (green energy, ecommerce, pharma R&D), I simply avoid it. Then, there are some businesses – like those from the real estate and infrastructure sectors, and business groups that have a history of being unethical – I don’t trust, so I avoid these as well.
Then, there is a third category of businesses that I avoid – ones that harm the ecosystem in which they operate. Like cigarette, alcohol, and stock broking companies. Banking is one more sector I avoid as I do not understand how they account for the money they borrow and lend.
Then, I assess whether a business has the ability to sell its products/services to the world rather than a single region or a single market. In other words, I ask whether it has a large and unlimited market opportunity in front of it. This is because if the opportunity is not large, it’s difficult for me to assess the sustainability of the business and its earnings growth 10-15 years down the line.
This thinking has helped me avoid businesses like retailing store that has been doing well for years – then another bigger and better retail store moves nearby, and it’s kaput for the first store.
Anyways, the next question I ask is whether the business is a commodity or enjoys some brand power in its industry. I try to seek out companies that are either market leaders or are operating in industries with low competition, either due to an exclusive licence or brand name or similar intangible that makes the product or service unique.
The reason I look for this aspect in a business is because I am searching for companies that earn high gross profit and net profit margins and also high return on equity – better than the industry average – and can sustain these over the long run. ‘Sustainability’ is the keyword here.
A high gross margin is an indicator of pricing power, which is the result of a moat the business has. Investing in moats has worked well for me in the past, and I am in no mood to shift from this sphere.
Another important factor that I consider is how the company has grown its earnings over the past 8-10 years. Research states that a typical business cycle lasts for seven years, so this is the minimum time for which I study a company’s earnings growth. Here, I am looking at earnings that have risen consistently in the past, and without much volatility.
So, if I am given a choice between –
– A business that has seen sharp surges and cliffs in its earnings growth in the past, and has earned, say and average Rs 100 per shares in EPS over the past 10 years; and
– A business that has seen a gradual rise in its earnings in the past, and has earned, say an average Rs 70 per shares in EPS over the past 10 years
…I will choose the latter. So you see, it’s again sustainability that I am looking for.
What is more, I also try to assess whether the business has the capability to grow earnings at a minimum 15%+ per annum over the next 10 years or not. Again, here, my idea is not to try and count the leaves on a tree in the next season – quarterly or annual EPS estimates – but to assess what the next season is going to be i.e., where the business is headed.
Rising earnings serve as a good catalyst for stock prices in the long run, and thus I try to seek companies with strong, consistent, and expanding earnings.
The third question I ask is how conservatively or aggressively the business is financed. I am a debt-averse person myself, and hate the thought of borrowing money to buy anything.
The only times I have borrowed money in the past were to buy my house and car, and I cleared both the loans as fast as I could.
So, I look for companies that suit my personality in terms of their debt profile. What this means is that I try to seek out companies with conservative financing, which equates to a simple, safe balance sheet.
Such companies tend to have strong cash flows, with little need for long-term debt. I look for low debt to equity ratios, plus companies that have history of consistently generating positive free cash flows.
The fourth thing that I look at in a company I am researching is whether it sticks with what it knows. Thus, again, I am looking at a business that suits my personality. I find it difficult to think or work on things that I don’t understand – my circle of incompetence – and that is what I expect from a business as well.
So, I look at the company’s past pattern of acquisitions and new directions. They should fit within the primary range of operations for the firm. I am cautious of companies that have been aggressive in acquisitions in the past.
This is also given my direct experience in the stock market, where I have seen most acquisitions been made not for the benefit of the acquirer’s business but to satisfy the ego of the CEO/promoter.
Then, I look at how good the company has been in terms of investing its retained earnings – profit that is left over after paying dividends. Here, I look at the return on equity (ROE) profile of the business in combination of its debt, which must be low.
Now, as far as ROE is concerned, an absolute number may fool investors, as it has fooled me in the past. Earlier, I thought a higher ROE was always a great thing, till I came to realize that companies can artificially raise their ROE using debt.
So, one formula I use now to dissect the ROE is the DuPont model, which captures management’s effectiveness at three key factors that determine the quality of a business – (1) Generating profits (net profit margin), (2) Managing assets (asset turnover), and (3) Finding an optimal amount of leverage (financial leverage).
I see Du Pont model as one of the best formulas ever created to measure the quality of a company’s business and also the quality of its management, and I suggest all investors use it before getting happy about companies with high and/or rising ROEs.
Then, I also consider how capital intensive the business is. I have learned from reading Warren Buffett that companies that consistently need capital to grow their sales and profits are like bank savings account – you can earn more interest only by depositing more money – and thus bad for an investor’s long term portfolio.
So, I seek companies that don’t need high capital investments consistently. Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. Here, more than just an absolute assessment, I do a comparison against competitors.
To just sum up what I mentioned above, here are the few key questions I ask every time I look at a business that can potentially become a part of my portfolio –
– Is this business inside my circle of competence?
– Is the business simple to understand and run? Complex businesses often face complexities difficult for its managers to get over.
– Has the company grown its sales and EPS consistently over the past 8-10 years? Consistency is more important than speed of growth.
– Will the company be around and profitably better in 10 years? This suggests continuity in demand for the company’s products/services.
– How well has the company done in retaining its earnings?
– Does the company have a sustainable competitive moat? Pricing power, gross margins, lead over competitors, entry barriers for new players.
– How good is the management given the hand it has been dealt? Capital allocation, return on equity, corporate governance, performance against competition.
– Does the company require consistent capex and working capital expenditure to grow its business? Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have.
– Does the company generate more cash than it consumes? Cash generators have a higher probability of surviving and prospering during bad economic situations.
You see, in tying up my investing with how I want to live my life, I want to study and invest in a business that leaves me with a lot of free time, which I can spend with my family and in reading books, instead of worrying about where the business is headed.
And that’s why the simplicity of the underlying business and cleanliness of its management are the foremost priorities for me.
I don’t want to invest in anything that could potentially give me stress, which could also affect my personal life.
Finally, I have learned over the years through reading investing greats and more from my own experience, that sensible investing is always about using folly and discipline – the discipline to identify excellent businesses, and waiting for the folly of the market to drive down the value of these businesses to attractive levels.
As an investor, you will have little trouble understanding this philosophy. However, its successful implementation depends upon your dedication to learn and follow the principles, and apply them to pick stocks successfully, which I am trying to do.
After you have assessed a business’s quality, how do you go about valuing them? What is your thought process on this intriguing subject of valuations?
After a company meets my business quality checklist points as I enumerated in the above answer, I consider its valuations to check how cheap or expensive it is trading at compared to its long term earnings power.
I use a mix of valuation models like DCF or discounted cash flow, reverse DCF, Bruce Greenwald’s EPV or earnings power value, Stephen Penman’s Residual Income Model, and the Graham formula.
Now, as I have realized from the numerous mistakes I have made in the past in valuing stocks – it’s a fuzzy concept, you see – valuations is not about identifying the “target price” for the stock. It’s not about estimating or predicting where the stock would or should trade in the future.
Instead, I now use valuations to understand the perceptions of other investors embedded in the market price, so those perceptions can be challenged.
As Stephen Penman writes in his wonderful book, Accounting for Value – “The investor is negotiating with Mr. Market and, in those negotiations, the onus is not on the investor to come up with a forecast or a valuation, but rather to understand the forecast that explains Mr. Market’s valuation, in order to accept it or reject his asking price.”
In simpler words, what Penman suggests is that instead of estimating an intrinsic value for a business, we must focus on assessing whether the stock’s existing market valuation (which is based on what others are willing to pay for it now) is right or wrong.
We must focus on identifying the amount of speculation in a stock’s current price, which causes the stock to be priced more than what the book value and future earnings would justify.
So, rather than trusting the market to deliver returns in the long run, I try to assess whether the market’s long run expectation for the business I am studying is a reasonable one or not.
In all, my view is that investors must not take a valuation model too literally. Instead, they must see a valuation model as a tool to challenge the stock price.
Rather than plugging a growth rate into a model, apply the model to understand the future growth that the market expects.
After all, valuation is not a game against nature, but a game against other investors, and one proceeds by first understanding how other investors think.
As an investor, you are not required to establish a valuation, but only to accept or reject the valuation of others. That makes the job much easier, isn’t it?
But again, the underlying idea is to use a variety of valuations models instead of laying your complete faith on only one.
You see, even if a carpenter finds the hammer to be his favourite tool, he never comes on the job with just a hammer (at least not intentionally). He brings his toolbox with a variety of tools in it. Right?
It’s the same with investing. You have a few valuation tools at your disposal, and they all have advantages and drawbacks. However, by using them in conjunction with one another and being aware of their strengths and weaknesses, you may make a more accurate valuation of any given company.
Here, it’s important to remember that investing is about trying to predict what will happen in the future. Our ability to do this is very limited. The future of most businesses is highly uncertain, because they operate without a durable competitive advantage and are therefore bounced about and pummeled by the waves of relentless competition and creative destruction.
On the other hand, there are a select few businesses where you can make meaningful predictions about where they will be in ten years. You are able to see that the conditions that led to their success over the past ten or twenty years – or, in rare cases, fifty years – are likely to remain in place for the next ten or twenty years.
So the most important elements in valuing a business are to have a very clear view of why a company is a good business and a very clear view of where the business will be in a few years.
The problem with cranking out valuation methods is that they create the impression of false precision – like using DCF will make us believe that that we can actually look into the future and plainly see a company’s free cash flows for the next decade or more.
So before you get down to valuations, spend time and energy on what really matters and what is doable. Remember that there are things that are important and knowable and there are things that are important and unknowable.
A company’s stream of cash flows over the next ten or twenty years is very important but for most businesses falls into the column of unknowable.
If you don’t get the part right about whether it’s a good business and where it will be in a few years, the investment most likely won’t work out as planned – whatever its valuation tells you.
All in all, while analysing businesses, the less non-mathematical you are, the simpler, sensible, and useful will be your analysis and results. Great analysis is generally “back-of-the-envelope”.
Also, your calculated intrinsic value will be proven wrong in the future, so don’t invest your hard-earned savings just because you fall in love with it.
Don’t look for perfection. It is overrated. Focus on decisions, not outcomes. Look for disconfirming evidence. And then, please act on your conviction.
To be continued…