Interview with John Huber – Part 2

John Huber Basehit Investing Interview


You can read Part 1 of this interview here.


Dev: As a long-term investor, how should one control oneself to not to panic? Also, when should one panic (say, panic to buy more when markets falls a lot)?

John: This just comes from maintaining a discipline about your investment philosophy.
I think it’s helpful to keep in mind that stocks aren’t trading vehicles, but pieces of real businesses. And if you’re buying a business that produces x amount of cash flow, the lower the price, the better.
As Buffett says, whether it’s stocks or socks, we like buying merchandise when it’s marked down.


Dev: I am a conservative investor who focuses a lot more on Return of Capital than on just return on capital. Though every individual’s risk and investing profile is different, do you think that focusing on mistake-reduction is what investors should focus on? Or lets say that just like in the game of Tennis, its best to first work towards reducing unforced errors. Does it help in winning the game of investing too?
John: Absolutely. I think the vast majority of investment mistakes come from “stretching” too far for upside potential at the expense of downside risk.
The tennis analogy is a good one—amateur tennis players win matches not by making the most forehand winners, but by making the fewest mistakes. Just hit the ball over the net. In investing, it’s very difficult to make up for losses. So keeping a relentless focus on preventing losses has always been at the core of my investment approach.
To use one more sports analogy—focus on base hits, not home runs.


Dev: As an investor, hardest thing about investing is to find a balance between 1) riding out periods temporarily unfavorable to your views and 2) realizing your views are wrong and moving on. How should an investor maintain that balance?
John: This varies case by case, but certainly you have to be honest with yourself. If you’ve made a mistake (which all investors do, and will continue to do), you should be honest in your assessment, sell the stock, and move on.
Of course, the market is volatile so sometimes general market conditions take all stocks lower, and this volatility might have nothing to do with the intrinsic value of stocks in your portfolio.
So company specific situations should be differentiated from general market volatility.


Dev: In his book Thinking, Fast and Slow, Daniel Kahneman talks about two approaches to thinking. System-1 (which is fast, instinctive and emotional) and System-2 (which is slow, effortful and calculating). How can an investor make use of these two systems to invest? At the face of it, System-2 seems like a better choice. But are there any market situations, where thinking in System-1 mode can work wonders for long-term investors?
John: I’m not very familiar with Kahneman’s work, although I’m familiar with his ideas you referenced.
I think generally speaking, my style of investing falls very much in category #2. Thinking logically, rationally, and patiently has always been beneficial to me.


Dev: Do you think lack of preparedness is what causes most investors to miss out on wealth creation opportunities in stock markets? (Both mental as well as financial preparedness)
John: I think that has a lot to do with it. But I think the biggest reason investors probably fall short of what they hope to achieve is lack of discipline (selling during downturns, and buying when outlooks are more optimistic). Generally, investors need to do the opposite to do well over time.
For people with full-time jobs and excess earnings, building wealth is a very simple formula.

Spend less than you earn, and invest in a basket of good businesses (or a broad index fund) over long periods of time.

In America especially, earnings of S&P 500 companies will be much higher 10 and 20 years from now, dividends will be two or three times the levels they are now collectively, and stocks will be much higher.
Dollar cost averaging works – as long as you’re not buying into bubble-level valuations (like 2000). Try to buy stocks when they are down, save more than you earn, and you can’t help but become wealthy over a working lifetime.


Dev: How do you manage your own money? Funds? Direct Stocks? How do you go about it?
John: I invest in stocks. Saber’s strategy is to buy well-managed businesses with stable competitive positions, predictable cash flow, and high returns on capital. I try to invest in these high quality compounders when they are priced well below my estimate of their fair value (or the value a private owner would pay for the entire business).
Because of my standard of looking for both high quality and discounted price, I tend to only invest in a small group of stocks at any given time.
I feel that owning a few things that I understand very well is much less risky than owning a lot of things that I don’t know so well.


Dev: What is your advise for those who are just starting their investing journey?
John: Read about value investing – specially Warren Buffett. I think the simple logic of value investing makes intuitive sense, and it works over long periods of time.
I think investors who don’t have time to manage their own money should invest in index funds, or possibly with an investment manager who uses a straightforward value investing approach, but the best way to learn is through practice.
Those who want to learn to manage their own investments should get in the habit of reading a lot. Study Warren Buffett’s letters, and begin reading company annual reports. Knowledge is cumulative, and it’s possible to do well in investing with the right approach combined with the right temperament.


Dev: For most common investors, it’s suggested that they should Dollar-Cost Average through mutual funds. Not trade much in individual stocks. Buy some shares directly here and there. Tell me what is wrong about this that these people fail to understand?
John: I believe this is good advice generally, but I would say that instead of mutual funds, I would prefer most investors using simple, low-cost index funds (ETFs). These are similar to funds in that they are diversified with hundreds of stocks, but different in that they are passively managed (they are designed to match the performance of an index, such as the S&P 500 in the US).
The costs of these index funds are much lower than the cost of actively managed funds. Of course, a good investment manager can outperform the index over time, but these managers are rare and it’s often easier to focus on just putting money into one or two diversified passively managed index funds.
Dollar cost averaging simply means putting more money to work over time, and I think this is a good approach for working people because they are steadily getting more money each month from their paycheck. Some months will be making purchases at higher prices, but some months will be at lower prices.
This mechanical method is helpful because—if one sticks to it—can help you be disciplined when bear markets (and fear of stocks) come around again. That is the time to buy as much as possible.


Dev: As someone who spends his day in midst of financial data and news, how do you filter out what is good and what is not to get to your daily reading list? How to become a good consumer of financial content?
John: I generally stick to my routine. I get up each day at 5am, read the Wall Street Journal (and sometimes a few other papers), and then (after spending an hour helping my family/kids get ready for the day) I begin working on whatever research project I have going on at the current time.
I don’t pay much attention at all to mainstream media (CNBC, Bloomberg, etc…). I spend most of my time reading primary materials (company reports, industry reports, trade magazines, etc…). I also make phone calls to people to learn more about businesses, but most of my time is spent reading. So I pretty much stay away from mainstream business media.


Dev: What is your daily reading list?
John: Wall Street Journal, Economist are daily reads (Economist comes each week, but I read a few articles each day).
I also read NY Times, Financial Timesand a few other papers, but not necessarily daily.
But most of my time is spent reading about companies through books, annual reports, industry research, etc… this varies from day to day, but each day involves a lot of reading.


Dev: 5 quotes that should be framed and put on every investor’s desk?

John:
  • There are two rules of investing: #1: Don’t lose money. #2: Don’t forget rule #1. – Warren Buffett
  • I will tell you how to become rich: Be fearful when others are greedy, and be greedy when others are fearful. – Warren Buffett
  • An investment in knowledge pays the best interest. – Ben Franklin
  • Just practice diligently and you will do very well. – Johann Sebastian Bach
  • And the one thing that all those winner bettors in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. – Charlie Munger
  • It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. – Charlie Munger (an extension from the previous quote).

Dev: 5 books that everyone looking to become better investor must read. Atleast one each from domains of building processes, psychology and financial analysis.

John:

Dev: Lastly, I know this might sound funny, but how to find a company like Google, Apple, Tesla, Berkshire, etc. early on. And more importantly, how to have the conviction to stay with them?
John: This one is tough. We should all be so fortunate to find one of these in a lifetime, but most of us won’t. The good news is, you don’t need to find the next Google or Microsoft to become a very good investor over time.
I’m not sure there is a specific way to describe how one could locate such an investment.
It’s part preparation, paying attention, working very hard, and learning about a variety of companies.
But to find an investment of the kind you mentioned, it’s also part luck – being in the right place at the right time.
If you find such a great business, it takes discipline and foresight to stick with it through periods of seemingly overvaluation and short-term underperformance.
It’s hard to specifically set out to find such an investment. I think focusing on working a specific investment process is a better approach. Look for base hits, and maybe one day you’ll come across a home run idea.

Ben Graham made 20% per year buying bargains, and then happened across GEICO, which made him very wealthy. He had many base hits, and one home run. But the home run wasn’t necessary to produce.


Dev: That’s all from my side John. I thank you for answering my questions. It was wonderful to have you share your insights.

John: Thanks Dev.




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Interview with John Huber – Part 1

John Huber Basehit Investing
John Huber is portfolio manager at Saber Capital Management and author of the popular investing blog Base Hit Investing. In his own words, his investment style (which is amazingly methodical) is influenced by Warren Buffett, Ben Graham, Walter Schloss and Joel Greenblatt.
 
I have become a big fan of his writing and thought process, ever since I came across his blog and strongly recommend it to anyone interested in following a structured approach towards investing and improving as a rational thinker.
 
I thank John for agreeing to get interviewed for Stable Investor.
 
So lets get straight to the interview now…



Dev: Hi John. Tell me something about your investment journey. How did you get to where you are?

John: I’ve always loved investing. My father was an engineer by trade, but was very active in the stock market (investing his savings) and by extension, I became interested in stocks.
 
But I came to the world of investment management unconventionally. I began my career in real estate, and I established a few small partnerships with family members and friends to begin buying undervalued income producing property. We bought residential properties as well as small multi-family properties.
About ten years ago, I began studying the work of Warren Buffett. Like many value investors, the simple logic of value investing really resonated with me right from the start.
 
I began studying Buffett’s letters, and reading various Buffett biographies. I set a goal early on to establish a partnership that was similar to the partnership Buffett set up in his early days.
 
After a number of years, I was fortunate to build up enough capital to support my living expenses while also seeding my investment firm. Saber Capital Management was established in 2013 as a way for outside investors to invest alongside me. Saber runs separate managed accounts, so clients get the transparency and liquidity of their own brokerage account. Our goal is to compound capital over the long run by making concentrated investments in well-managed, high quality businesses at attractive prices.
 
Dev: I know you focus a lot on having a process-oriented approach towards investing. How should one go about creating and refining one’s investment process?
John: It’s a great question. I think developing an investment philosophy is very important.
 
There are many different investment approaches out there — even within the value investing category. I think it’s important to first identify an investment program that will work (value investing — or buying stocks for less than what they are worth) works over time.
 
But I also think it’s important to understand your own personality, your own skill sets, and your own circle of competence.
Look at Benjamin Graham and Charlie Munger as an example. An approach that worked for Ben Graham was a completely different approach that ended up working for Charlie Munger, yet both were fantastically successful. But they both had different skill sets and preferences.
Graham loved numbers, he loved the mathematical aspect of investing. He thought of a portfolio like an underwriter would think of the insurance business—buying stocks for less than their net asset values worked collectively as a group over time, but any one individual situation was difficult to predict (just like insuring 1000 automobile policies with a given set of underwriting criteria would lead to very predictable results—although on a case by case basis it would be very difficult to predict which driver would end up making claims). So Graham’s preference for these investment tenets led him to manage a diversified portfolio of value stocks.
On the other hand, Charlie Munger became fascinated by great businesses. He wanted to own companies that could compound at high rates of return over long periods of time. He loved thinking about the intangible qualities of great businesses.

He once asked an associate to write up an investment thesis on Allergan, and when the associate came back with a list of Graham-esque metrics, Munger told him to forget the numbers and research why the company had such an advantage over its competition.

He was interested in brands, pricing power, predictability of earnings, high returns on capital — things that produced growth and compounding value over time.
Both Graham and Munger were enormously successful in their partnerships—both producing around 20% annually over the period they managed money, but both did so in very different ways.

Neither were right or wrong in their approach, but both managed money according to their personalities.
I think if you first identify what works in investing, and then you tailor it to what you like and what you understand, you’ll do well over time.
Along with value principles, discipline, and patience, perhaps Polonius has some good words of advice when it comes to setting up an investment process when he told his son Laertes in Hamlet: “To thine own self be true”.
 
 
Dev: How to generate new investment ideas and more importantly, how to filter those Ideas?
John: I used to do a lot of screens and other mechanical methods to generate ideas, but I find the best way to look for good investments is just to read as much as possible, build watchlists of good companies that you feel you can understand, and then patiently wait for opportunities to buy stocks on that watchlist. Inevitably, if you have a list of 50 or so businesses, there are almost always opportunities on at least a few of them to make an attractive purchase of an undervalued stock.
So most of my time is spent reading about companies and trying to always increase my understanding of the companies I follow, while also slowly expanding my circle of competence.
 
I read a lot of company annual reports, but I have also found a lot of value reading books about businesses, or books about general industries. I also read numerous newspapers, and the Economist.
Often, investment ideas come from situations that occur within companies on my watchlist that I already know well. Other times I read about a special situation or corporate event in the news that might offer an interesting investment idea.
 
So while my method isn’t scientific, my routine is quite replicable, and it basically involves a lot of reading and thinking. I would say that it is an approach that helps me always be tuned in to a variety of interesting situations where opportunities often pop up. But most importantly, it’s an approach that helps me continually learn, and I enjoy that aspect of investing.
Dev: Do you believe in importance of having an investment checklist?
John: I do think having a checklist can be a very valuable exercise. I’ve discussed checklist items before, but I’ve also adapted this point of view in recent years as well.
 
While I consider various checklist items when evaluating a business, I have found that because each investment situation is so different, that unlike flying an airplane that requires the same multi-point checklist before each flight, each investment is like a snowflake—it is unique and not exactly like any other investment.
 
So while I’m 100% sure that studying case studies is a valuable exercise (especially investment failures of great investors — something Mohnish Pabrai discusses which is a great idea), I’m not sure that a single checklist will be suitable for each investment idea. 

Studying why Dexter Shoe was a bad investment is a very valuable exercise. But the lessons learned from that case study might not transfer directly to another investment situation with its own unique set of variables.
So I don’t have a practice of running a bullet point mechanical checklist, although I think that might work for other investors and it’s certainly not a bad idea.
 
Instead, I choose to try and locate investments with very few variables that are required for the investment to be a success. I try to identify those variables, and then evaluate them over time as the investment plays out.
I think studying case studies probably helps you build a mental database of checklist items, so maybe indirectly we all have checklists as investors, but I choose to focus on each individual investment as its own situation with its own set of variables, and I try to reduce risk as much as possible by locating ideas with very things that can go wrong. The lower the hurdle, the better I like it.
 
Note – John has agreed to share a checklist which he prepared few years back. Below is the snapshot of the checklist. Though he doesn’t strictly follow the checklist approach anymore (as discussed above too), it can still be a great starting point for those who are setting out to build their own checklists. You can read about it in detail here.

Dev: It’s very easy to say that investors should only invest when value on offer is blindingly more than the price that needs to be paid. But how does one implement that in reality? Being greedy when others are not, is actually quite difficult to do.
John: As I said before, each individual investment is different, so there isn’t necessarily an exact approach that can be implemented with each stock being evaluated.
 
But I think the first thing is to stick to businesses that you can understand. This is widely discussed, and highly touted, but I think it still might actually be under-appreciated. 
 
Reducing unforced errors in investing goes a long way to producing great results over time. And reducing mistakes comes from sticking to what you know, and picking your spots.
 
I think patience is a real virtue in investing, and over the course of time, there will be a number of opportunities to buy good businesses at prices that are clearly well below their intrinsic value. The key is to have a list of companies you know very well, and then just wait for one of them to fall significantly below your range of estimated values. Easier said than done, but being patient is very key.
 
It is also a necessity in investing to have a calm demeanor and a contrarian attitude in general — the market is often correct, so being a contrarian for contrarian’s sake alone isn’t rational, but you must be able to be detached from the crowd so that in times of general market panic, you are willing to buy stocks even when the near term outlook is bleak. This is also easier said than done, but it helps if you have a long-term view of stocks, and stick to owning good businesses that you understand well.
One other thing to point out—I’ve read the average NYSE stock fluctuates by 80% annually (meaning the 52 week high is 80% above the 52 week low for the average NYSE stock). This holds true across every index, and every country (probably much more pronounced in many countries than it is in the US).

Note – Check out a similar analysis on Indian markets here.

So stock prices are very volatile. There is no way that the average company’s intrinsic value fluctuates this much on an annual basis.

So this of course means that stock prices fluctuate much more dramatically than true values do, giving investors an opportunity.
And since these statistics refer to annual levels, it means that there are a lot of opportunities each year in the stock market to buy undervalued merchandise.
 
Dev: Joel Greenblatt (of Magic Formula fame) once said, “My largest positions are not the ones I think I’m going to make the most money from. My largest positions are the ones I don’t think I’m going to lose money in.” What are your thoughts on this?
John: I completely agree with this. In fact, my largest position right now is Berkshire Hathaway, which became my largest position in February (I wrote a post recently outlining my thoughts on Berkshire).

The stock doesn’t have tremendous upside as its capital base is so large now, but it has—in my opinion—virtually no chance of any permanent downside.
 
These are my very favorite investment ideas because they allow you to put a lot of capital to work with no risk, and I’ve found that often the market “corrects” itself sooner, meaning that sometimes 2 or 3 year return potentials occur in a year or less, simply because of general market volatility.
 
1) Don’t lose money.
 
2) Don’t forget rule number 1.
 
Trying to stick to companies you understand and sticking to businesses that are growing value over time helps reduce risk.

I think keeping a relentless focus on capital preservation is the best way to produce great results over time.
 
Dev: Another of Greenblatt’s idea has been to focus on the Key Variables of an Investment. He mentioned once that he might be average when it comes to the valuation exercise. But was above average at putting the information in context, remembering the big picture, and being able to pinpoint what factors really matter to an investment. How does an investor focus on what really matters?
John: I agree with Joel on this point as well. I think many investors get lost in the weeds — they become too focused on their models, their excel spreadsheets, or trying to predict what margins will be in 2019, etc.

I think gaining an understanding of the big picture is usually the most important objective when looking at a stock.
 
The big picture often means identifying the most important drivers of value in a business.
These value drivers could be things like cost advantages (Wells Fargo gathers deposits cheaper than just about every other bank), network effects (the more people that use Visa’s network, the more valuable it becomes), supply chain management (Amazon), economies of scale (Walmart’s leverage over suppliers), sometimes brands are very valuable assets (Nike, or even Apple for example), and sometimes it could be the management team that is just executing a business model well or is very adept at allocating capital (Berkshire Hathaway is an obvious example, but there are many companies that owe large portions of their success to the management team).
 
Many of these things can’t be measured by simply looking at the financial statements, so it helps to identify these things and keep them in mind when analyzing businesses, because often these big picture items continue to be the reasons for the company’s success going forward.
To be continued…

Interview With Mid-Cap Mogul Kenneth Andrade

Kenneth Andrade Interview Midcap
Image Source: Livemint

 

I recently had the privilege of talking to Kenneth Andrade, who is widely acknowledged as one of the best fund managers in the mid-cap space in India.

Most people already know this legend and many refer to him as the ‘Mid-Cap Mogul’. Hence, an introduction is not necessary in Kenneth’s case. But for those who don’t know, he was the fund manager of IDFC Premier Equity Fund – one of the most popular and best performing mid-cap funds ever.

Ability to think out-of-the-box to identify the big theme, build investment hypothesis around it and most importantly, convert it into winning investments. This was and is his expertise. Now he has moved on from IDFC MF and turned into a private investor.

In this interview, he answers my questions about investor psychology, investing in stocks for the long term and mutual fund investing.

So here it is…

Common Investor Psychology

Dev: One of the biggest problems of common investors is their inability to sit. So how does an investor stay put even if (say) markets have moved from 10,000 to 20,000 in just a couple of years and he/she wants to book profits?

Kenneth: Investors do stay put in investments; except in equities. This probably is associated with the volatility of the asset class and the lack of a fixed return or physical asset.

Also no one likes negative returns and the equity asset class can’t promise that every year.

The western world has found a way around this with their pension plans. India still needs to get there. As a discretionary investor they will always give into greed at the top of the markets and fear at the bottom of the cycle. Hence the only way out is to package products, which eliminate or smoothen out volatility. Manufacturers in India have been experimenting with hybrids. They tend to cushion the volatility of the markets. Maybe that’s one way to keep the investor interested. It may not be the most efficient way of equity investing but the yields across market cycles would still be higher than mere fixed income products.

 

Dev: It is said that in investing, it’s very important to avoid making big mistakes. Even someone like Charlie Munger believes, that not making big mistakes is a huge determinant of whether one will have financial success in life or not.

How does a common investor identify his limitations, create a simple mental framework and more importantly, implement this framework to avoid making big mistakes?

Kenneth: The way I would address this is to invest in what you know. I am very apprehensive in putting money to work either in a company or an investment, which I don’t understand. I guess the same would apply to any investor.

One way of avoiding mistakes is to understand what you do, that way you can identify and correct it when and if it does go wrong. If you don’t know the investment, you would never know if things are going wrong in the first place.

 

Dev: What according to you is the biggest reason most investors don’t succeed in stock markets?

Kenneth: I guess most serious investors do succeed in markets. The longer you stay invested, the better are the results. Investing needs to be passive and rather than focus on prices investors should concentrate on the underlying. This is a learning process. And being persistent is the key to long-term success. A lot of investors give up in the short term.

 

Dev: How important it is for investors to have reasonable expectations? Many investors start believing that markets will continue to perform well, just because they have done so in the past. How does one correct this perception?

Kenneth: In the beginning of 2013, 10-year index returns converged with liquid fund returns. There is no set rule that equity or any asset class will deliver an above average return in perpetuity. Sure if you play with statistics, we can prove otherwise.

In the long term, any manager or fund with a return over 5%-7% (post tax) over the risk free return is a job well done. If that is the benchmark, then it is fairly important to anchor investor expectation around this number. Of course at times this could be significantly higher if a couple of asset classes do extremely well.

 

Dev: Volatility is one of the most recognizable and hated aspects of equity markets. And because of volatility, most investors do the exact opposite of what needs to be done. They buy (on fear of missing out) when markets are high and sell (out of fear), when its low. This seems to be driven primarily by the perception of volatility and risk being same things.

But that is not correct as per my understanding. So how does one start believing and also, convince others about the fact that volatility is an aspect of risk and it is not 100% same as risk.

Kenneth: I guess the latter part of the question can only be experienced with time in the market. In one of my presentations lately I made a point that you need to use volatility to your advantage. Markets overshoot in both directions, and if you take advantage of this it could be extremely profitable. But one needs discipline to take advantage of these extremities.

Mutual Funds

Dev: The best time to invest was yesterday. Next best is today. Though its easier said than done for most people (who invest for long term goals), how does one go about convincing people to stick with to long term mindset when it comes to investing?

Kenneth: It’s the discipline that’s very important for that. And more than convincing, it’s the investor experience in the product category that matters. If any consumer has had a good experience of a product or a service, chances are he will stick to that regime. So it’s important that a habit is cultivated.

A lot of investors like to see markets trend up so that their money is multiplied everyday. Logically if I had a steady income – I rather want to invest in a market that is sideways to down for even maybe 5-7 years. (Read I Pray for Bear Markets) That keeps my average holding of my investments low. Then if markets doubles or trends upwards, which they normally do once in 5 years, it’s a very profitable trade.

If you do the math investing in a market, which is trending upwards is very inefficient. You have a very high weighted average cost of holding and a relatively lower return than the former.

 

Dev: It is said that apart from returns, one should also consider many other factors while selecting a mutual fund for investing. Which factors according to you should form the key criterias for fund selection?

Kenneth: Investing in any portfolio should be a long-term commitment. Likewise the long term is also associated with durability. So if one needs to buy a MF scheme for the long term, the portfolio also needs to be in sync. There are a lot of funds out there, which promise long-term returns with the top stock undergoing tumultuous changes. Portfolio churn is never good for the long-term investor. If this were so with the underlying fund, at most the best return would be index linked. One needs to watch for this.

Stocks

Dev: Inspite of MFs being the best option for common investors*, people do get attracted by the glamor of investing directly in stocks. As per my understanding, this is human nature and people will continue to do so.

But when they do it, it also makes sense to invest only in companies, which dominate their industries with no-to-moderate debts and positive cash flows (atleast for non-professional investors, these criterias should be good starting filters).

How can an investor go about finding such companies? Another problem with finding such stocks are the perennially high valuations, which they are assigned. How does one go about investing in such companies?

* neither has the time nor expertise to analyse individual stocks.

Kenneth: MFs reduce volatility and at the same time offer participation in the growth of the capital markets. Their models are largely disciplined with managers allocating money across a number of companies. Individuals can replicate this off course by buying stocks directly. The error that most investors commit is the discipline of diversification. If this were managed well the outcomes would not be very different from diversified mutual funds.

The second part of your question resonates around investment styles. And no one style fits all. But by sticking to what you understand best will give you more upsides than downs. Don’t diversify your style.

As an investor I have always shied way from levered companies (excessive debt). And I consistently look for stocks and business that are out of favour. That way you know you are getting in at the ground floor.

An example of an ideal investment case would be a loss making company with a shrinking balance sheet in an industry that is under stress. So go one step backward on what creates capital efficiency – higher profits and capital employed (RoE = Net Profit/ Shareholder Capital). The former is the function of the environment; the latter is the function of the management. Look out for the latter, this should not be bloating. Chances are these stocks will come extremely cheap because of the cycle they are in.

As investors we all consistently focused on return. On the contrary we should be risk managers. A bull market gives you the return because all stocks participate; a manager has a very little role in that. It is the downside that counts.

You have to have a framework that works in a market offering you negative returns and measure your successes by buying companies that survive an economic slide.

 

Dev: In one of your interviews, you said that it is very important to go for companies, which are in a space that is scalable and significant. But as Graham said in Intelligent Investor, “obvious prospects for physical growth in a business, do not translate into obvious profits for investors.”

How does one think on those lines, so as to avoid the pitfalls of investing in the wrong company in the right space? Is it that the predictability of understanding the environment that a company operates in, and the ability of the company’s management to actually execute in that environment is the most critical aspect of decision making?

If yes, how does one be sure about the management here?

Kenneth: A company profit is limited by the size of its industry. Hence my fetish for scale sets in. Off course once this scale is established, the execution has to be profitable market share growth.

In my framework any company that loses market share raises a red flag, the cost of building back market share gains is ridiculously expensive. It is an easy parameter for most investors to track. (This framework may not strictly apply to commoditized business, but it works in most cases).

Getting back to the scale question, I love excesses. I always am on the look out for the next stock market bubble and the reasons that would cause it, but I would rather preempt them. Else like every one else I end up being the follower. If this is the context, I would necessary need to find scalability in the business and in the mid term markets extrapolate these numbers creating these excesses.

 

Dev: Most people say that India will continue to grow for years to come. As investors we need to be optimistic about future prospects. But as I read in one of your interviews, you said that it is very important not to go into an expanding economy with the wrong portfolio.

Most people are looking at the same set of sectors, which have done, well in recent past. But to outperform over the long term, one needs to know what can drive the next bull market. Though its tough for common investors to do it, what would you advise a person who is willing to put in place a mental-framework to think on those lines?

Kenneth: That’s an easy one. Demand creates profitability, which creates market caps which in-turn creates the need for fresh capacity. So in this framework, companies, which were growing 15%-20% per annum, set up capacities to grow between 30%-50% using near term historical numbers to justify the capital investment. This creates excessive capacities. Which is why the same sectors get very capital intensive and never return to historic levels of capital efficiency and then valuations.

If the above is true, we would need to let go of the past and look at industries where supply constraints or competitive intensity is low. Chances are they hold on to their profits and efficient capital allocation. One way of tracking this is leverage. Banks usually are arbitragers of high capital efficient business and low interest rates. They usually fund excessive creation of capacity based again of near term historical numbers, which they extrapolate into the future. So look for what these institutions fund, it may be the beginning of the next economic bubble; and excessive lending may end up being the end of one.

 

Dev: I know that you like buying companies, which are efficient with their use of capital. How can one analyse companies to find efficient use of capital. And more importantly, how does one create a list of such (prospective) companies in the first place?

Kenneth: Go one step behind. In one of the question above I alluded to two components of the capital efficiency ratio – the numerator and the denominator (ROE = PAT/ Shareholder Capital; ROCE = PBIT/ Capital Employed). The numerator is profitability, which largely is the function of the economy; I don’t believe I can predict a complex subject of growth.

The denominator however is the function of the management and efficient capital allocation. A lower denominator is all I look for and you don’t need a model to predict that. This is already in public domain. Just look for the latter. If you buy a portfolio of 20 companies that meet this criterion, the probability of going wrong is well zero!

 

Others

Dev: Few books which you would ask everyone to read, to get their thoughts about investing and money ‘corrected’ and streamlined.

And what will you suggest for someone who is interested in doing deeper analysis of the actual businesses behind the stocks?

Kenneth: I have always identified with the Peter Lynch style of investing, which is what makes his two books my all time favourites. i.e. 1) One Up on Wall Street and 2) Beating the Street

And nothing beats company annual reports if you want to deep dive into an analysis of a company.

 

Dev: How do you avoid noise and information overload, which are so prevalent these days? How does an investor focus just on what is important?

I feel that noise is generally made up of opinions people have. And I may be wrong, but most people don’t know what they are talking about when discussing about future. How does one stop oneself from becoming influenced by such noises?

Kenneth: As an investor I am always looking at a right price to buy a good business at. So noise is welcome if it gets me to that objective. Else, file all the information you get in some remote corner of your grey cells. Chances are you will need this sometime in your investing journey.

 

Dev: That’s all from my side Kenneth Sir. I thank you for taking time out of your busy schedule to answer my questions. It was wonderful to have you share your insights.

Kenneth: Thanks Dev.

Interview with Morgan Housel – Part 3

Interview Morgan Housel Part 3

You can read previous two parts of this interview here (1) and here (2).

Dev: For most common investors, it’s suggested that they should Dollar-Cost Average* through mutual funds. Not trade much in individual stocks. Buy some shares directly here and there. Tell me what is wrong about this that these people fail to understand? *Rupee-Cost Average (in Indian context)

Morgan: I think it’s a great approach, and it’s how I manage my own money. There is, and always will be, a tendency for people to try to squeeze a little more return out of their money by buying this, selling that, hedging this, shorting that … the bias is toward activity because it gives you the impression that effort is synonymous with results. But it rarely is in investing. Investing is one of the few professions where “don’t do anything; just find a hobby and go away” is some of the best advice.

Dev: How do you manage your own money? Funds? Direct Stocks? How do you go about it?

Morgan: I dollar-cost-average from every paycheck into Vanguard index funds, and buy individual stocks occasionally when I think an idea is really attractive. I own about 10 individual stocks. Too many people argue over whether you should be passive or active; I don’t see it as a contradiction to be both. I also have a lot of my assets in cash.

Dev: As someone who spends his day in midst of financial data and news, how do you filter out what is good and what is not to get to your daily reading list? How to become a good consumer of financial content?

Morgan: There’s no substitute for creating a list of trusted sources. If you go into your reading blindly, you’ll step on landmines of terrible content left and right.

Dev: What is your daily reading list?

Morgan: Easiest way is to see the list of those I follow on Twitter.

Dev: So given the importance of reading and researching for someone like you, how does Morgan Housel spend a typical day at office? What about weekends?

Morgan: I do most of my reading in the morning, and most of my writing in the evening. A lot of writers do the opposite, but it’s what works for me. I can’t write or focus until I’ve consumed an inhumane amount of coffee. So from about 6am to noon, I’m usually just reading, browsing Twitter, skimming books, trying to think of something to write. I have meetings and other obligations throughout the day, and most of my writing is done between about 3pm and 7’m. I read books in the evenings and on weekends.

Dev: 5 quotes that should be framed and put on every investor’s desk?

Morgan:

“Timing the market is a fool’s game, whereas time in the market is your greatest natural advantage.” — Nick Murray

“In expert tennis, 80 percent of the points are won, while in amateur tennis, 80 percent are lost. The same is true for wrestling, chess and investing: Beginners should focus on avoiding mistakes, experts on making great moves.” — Erik Falkenstein

“Risk is what’s left over when you think you’ve thought of everything.” — Carl Richards

“If you look carefully, almost all Old Money secrets can be traced to a single source: a longer-term outlook.” — Bill Bonner

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” — Charlie Munger

Dev: 5 books that everyone looking to become better investor must read. Atleast one each from domains of building mental models, psychology and financial analysis.

Morgan:

Risk Savvy by Gerd Gigerenzer. It’s about how humans are bad at interpreting statistics and how that causes us to make bad decisions.

The Great Depression, A Diary by Benjamin Roth. Roth was a lawyer during the Great Depression, and kept a detailed diary about what life was like in America was like during the chaotic 1930s. His son published it in 2010, and it is the single best economics book I think I’ve ever read.

The Better Angels of Our Nature: Why Violence Has Declined by Steven Pinker. Violence — war, murder, rape, torture, execution, robbery, lynching, racism, you name it — has declined substantially almost everywhere in the world over the last several hundred years. We are, on average, living in the most peaceful and safe period the world has ever seen, but few want to admit that.

The Half-Life of Facts: Why Everything We Know Has an Expiration Date by Samuel Arbesman. Textbooks used to teach that a human cell had 48 chromosomes. More than one-third of all animals once classified as extinct are later rediscovered. Depending on the field, huge numbers of studies once considered “groundbreaking” can’t be reproduced in subsequent trials.

This Will Make You Smarter by John Brockman. It’s a long collection of short (one-page) essays by some of the smartest people in the world who were asked the question, “What Scientific Concept Would Improve Everybody’s Cognitive Toolkit?” You won’t put it down.

Dev: What is your advise for those who are just starting their investing journey?

Morgan:

  • Read as much as you can.
  • Be twice as humble as you currently are.
  • Realize that time is your most powerful weapon, and one that older investors can only dream about.

Dev: Final question. I love to read what you write in various columns at Fool and WSJ. But when do I get to read a book authored by Morgan Housel?

Morgan: Stay tuned. Might be a busy year for me. 🙂

Dev: That’s all from my side. Thanks a lot for sharing your wisdom with us Morgan

Morgan: Thanks Dev.

Interview with Morgan Housel – Part 2

Morgan Housel Interview Part 2

You can read Part 1 of this interview here.

Dev: As an investor, hardest thing about investing is to find a balance between 1) Riding out periods temporarily unfavorable to your views and 2) Realizing your views are wrong and moving on. How should an investor maintain that balance?

Morgan: There’s no simple answer. It’s a really complicated problem, and usually you only know the answer in hindsight.

The best solution is a combination of humility, and being totally open to opposing viewpoints. It’s natural to fight back against people who disagree with you, because you take their opinions as an attack on your intelligence. It’s a really dangerous mindset.

The best investors in the world pay close attention to opposing viewpoints, trying to find out how they’re wrong, rather than looking for information that confirms they’re right.

Charles Darwin spent most of his life trying to prove that evolution was wrong, obsessing over evidence that disconfirmed his own views. That made him an incredibly effective scientist. It seems counterintuitive, but it’s such a smart way to think.

Dev: It’s very easy to say that investors should only invest when value on offer is blindingly more than the price that needs to be paid. But how does one implement that in reality? Being greedy when others are not, is actually quite difficult to do.

Morgan: It’s way easier said than done. The mindset you need to have in investing (and this goes for most things in life) is “If things get really awful, will I be able to handle it and do OK?”

When you can answer yes, the odds fall in your favor because you’ll be able to endure a huge range of outcomes, both positive and negative.

It’s classic margin of safety, which many investors understand but few actually implement. Most people need their forecasts to be accurate in order to do OK, which is a really dangerous spot to be in.

Dev: In his book Thinking, Fast and Slow, Daniel Kahneman mentions about two approaches to thinking.

System-1 (which is fast, instinctive and emotional) and System-2 (which is slow, effortful and calculating). How can an investor make use of these two systems to invest?

At the face of it, System-2 seems like a better choice. But are there any market situations, where thinking in System-1 mode can work wonders for long term investors?

Morgan: I don’t think so. Investments are inherently long-term things and are distorted by emotion.

Anytime you’re forced to make a snap judgement about what to do with your money the odds of future regret are extremely high.

I’d actually recommend waiting at least a week before making any investment decision.

Dev: We as humans are not only very poor at predicting the future, but we’re not even good at remembering the past in certain situations. How does one correct atleast the 2nd part (Remembering the Past) and also, how not to fool oneself when one remembers the past?

Morgan: One thing I love doing is reading old news. I live in Washington DC and can visit the Library of Congress, which has every edition of the Wall Street Journal, NYT, and Washington Post going back to the mid-1800s.

I absolutely love reading old versions, seeing how people thought and what people predicted with the benefit of hindsight. There’s so much to learn.

Another thing I find helpful is keeping an investment journal, writing down your thoughts and how you feel about the market and different investments so you can recall them objectively later.

The only way to fight how tendency to rewrite the past in our minds is to actually write today down to revisit it tomorrow.

Dev: How do you think one should view markets through the long lens of history rather than the short-term news filter? Any mental tools you use to achieve it?

Morgan: Most people have a distant financial goal, like retirement or funding your kids’ education. A helpful lens when reading financial news is to ask, “Does this story have any impact on my ability to retire in X years?”

99% of the time the answer is “no” and you can happily move on.

Dev: Do you think lack of preparedness is what causes most investors to miss out on wealth creation opportunities in stock markets? (Both mental as well as financial preparedness)

Morgan: It’s a lack of understanding of what an opportunity looks like. There’s a fundamental irony in investing that all past bear markets look like opportunities, but all future bear markets look like risks.

So even if people prepare for bear markets, not realizing how beneficial they are for long-term investors is part of the tragedy.

Dev: In another of your interviews, you said: What’s really interesting about finance is that the more you learn the more you realize how little you know.

Can you elaborate on that? How can common investors, who are almost always short of time, realize the importance your quote?

Morgan: I think this is true for a lot of things in life. The deeper you dig, the more you realize how much randomness, chance, and luck plays a part in determining the specific path of individual outcomes.

What was the most important economic event of the last 20 years? Probably 9/11, and it’s so easy to see how it could have either been foiled, or way worse than it actually was. Same with WW2, the Cold War, fall of Soviet Union, etc.

There’s a long history of things that never happened and alternative outcomes that people discount more than they should.

Continued in Part 3.

Interview with Morgan Housel – Part 1

Morgan Housel Interview Part 1

Morgan Housel is widely considered as one of the most insightful investment writers in the world today. He is a columnist at the Motley Fool and Wall Street Journal.

I have been a long-time admirer of Morgan’s ideas and can safely say that his writings should be in the must-read category for everybody, who is interested in improving his/her investment process.

I thank Morgan for agreeing to get interviewed for Stable Investor. Apart from his ideas about how to become a better and sensible investor, he also shares how he transitioned from Investment Banking to Private Equity to finally, Investment Writing!

So lets get straight to the interview now…

Dev: You are a celebrated writer. Tell me something about your journey. How did you get to where you are? Did you always wanted to write about investing?

Morgan: I knew I wanted to get into finance when I was a teenager. The idea of earning money for what looked like doing nothing (passive interest) just seemed cool to me.

When I was 17, I put $1,000 into a bank CD (similar to Indian FDs). I must have known how interest worked, but I remember a week later the balance was $1,000.03, and I thought it was the coolest thing I had ever seen.

And investing in – actually owning – shares of great businesses really caught my attention.

Throughout college I planned on being an investment banker.

That was plan A, B, and C.

But I got an investment banking internship in my junior year, and instantly hated it. The culture turned me off 100%, on the first day.

I like thinking things through, researching, learning … but the culture of investment banking was like a fraternity where people were just trying to prove that they were tougher and could work longer hours than the next guy without actually getting stuff done.

So I quit.

I got a job in private equity, which I really enjoyed. But this was summer of 2007, and credit markets blew up – not a good place to be when you need to borrow lots of money to buy companies.

I had a friend who wrote for the Motley Fool, and he said I should check it out. I never in a million years thought I’d be a writer. I really didn’t like writing. But I gave it a shot, and that was 8.5 years ago.

I’m still here, and I love it. Couldn’t imagine doing anything else.

 

Dev: What do you like more? Investing? Or writing about investing?

Morgan: I view them as one and the same. Writing helps me organize my thoughts and think through how I feel about investing and trying to identify what people do right and wrong in investing.

There’s no doubt that I’m a better investor because I’ve spent almost a decade writing down everything I see, how I feel, what I observe other people doing, etc.

Even if you’re not a professional writer, I think everyone should keep an investing journal. It’s a great way to turn half-thoughts into fully formed theories you can live by.

 

Dev: In an interview of yours, you said: To get ahead in investing you have to do something other people can’t do or won’t do. So according to you, what are those things?

Morgan: Doing something that other people can’t do means being smarter than everyone else.

But that’s nearly impossible these days, because there are so many brilliant investors. And a lot of the market is now driven by computer machines that humans will never outsmart. So to get ahead you have to be willing to do something other investors aren’t willing to do.

To me, that means having a longer time horizon.

Almost anyone can do that, but very few are willing to do it.

If you can think about the next five years while everyone else is thinking about the next five months or five days, you have an edge over the competition that will serve you well over time.

 

Dev: Market is a volatile animal and it will remain so. So as a long term investor, how should one control oneself to not to panic? Also, when should one panic (say, panic to buy more when markets falls a lot)?

Morgan: It’s two things. One is knowing enough market history to realize how common volatility is.

If you’re new to investing, a 10% decline seems really strange. You’ll say, “Wait, I just invested $10,000, and now I only have $9,000. This doesn’t seem right. Someone’s scamming me. I’m out.”

But if you know market history, you’ll see that a 10% decline has occurred, on average, about once every 11 months over the last 100 years – a period when the market increased in value by 18,000-fold (in US markets).

Once you know that, you might view volatility as something that’s normal and common, like a big snow storm, rather than something indicating a serious problem.

Second, you have to have an asset allocation that fits your personality. Some people have a low risk tolerance, regardless of age.

If you’re not comfortable having a ton of money in the market, don’t’ feel ashamed to have a lot of your assets in cash and bonds. The low returns from bonds and cash are nothing compared to the devastation you can do to your wealth by selling stocks after a big bear market because you couldn’t stand the pain.

Everyone needs a plan that works for their personality and disposition. For reasons I don’t understand, we rarely talk about that, and pretend that all investors of the same age and income have the same risk tolerance.

Continued in Part 2 and Part 3.

I want to interview You.


Yes. You read it right.
I am interested in interviewing YOU and knowing how you manage money.
I believe that everyone we meet, knows something we don’t. So here is my chance to learn something from you.
And if you agree, I can share the interview with readers of Stable Investor too.
I am sure that there are many readers, who have managed their finances brilliantly till now. But since they are not as free as me to write everything on a blog, their knowledge and skills remain largely unknown to most people.
I want to solve this problem.
I am willing to learn from you about your financial journey. I want to ask you questions about how you manage your income, your existing assets, how you plan for your future goals, etc.
Now frankly speaking, I am a little apprehensive about this. As many people prefer not talking about money and how they handle it.
But I will still take my chances here and ask you all.
So here it is…
If you are willing to share how you manage your money, then I am ready to interview you. It can be via email or telephone.
After the interview, I would also want to publish broad details as a post on Stable Investor.
If you want to stay anonymous, that is fine with me too. Your name will not appear anywhere.
So if you are interested, then just click the link below. You will be taken to a small form, where you need to give your preferred mode of interview and few other details.
____________________________

____________________________

Once I have the details, I will send you individual mails to take it further.
So looking forward to a ‘Yes’ from you.
Regards,
Dev

PS – I have still not finalized the questions. Once I get suitable number of positive responses, I will do so.

Interview – Safal Niveshak’s Vishal Khandelwal – Part 4 (Final Part)

This is the fourth and final part of this interview. You can read the first three parts at the following links:

Part 1  |  Part 2  |  Part 3
Question 10.

From your blog I know that you do not prefer Index Funds even though they are highly recommended as decent options for average long term investors. Do you think that an average investor is better off picking an actively managed fund over index funds, despite the risks associated with fund manager and his team’s ability?
A. To clarify my stand on index funds, these are what I personallydon’t prefer because I trust a few active managers more than the index. However, that’s not to take away from the simplicity of investing in index funds, which people not wanting to choose active managers or direct stocks, must do.
In investing, the most important thing is to know what you don’t know. So if you don’t know how to pick stocks directly and how to pick the right active funds directly, it’s better to start with a passive, low-cost index fund.
Since there’s not much differentiation between different index funds, pick the one with the lowest cost and from a decent fund house.

Question 11.

As an allocator of capital for your personal and family wealth, what percentages do you generally have in equity / non-equity baskets (ignoring real estate investments)? The percentage allocations might be dynamic depending on market conditions, but what is the thought process behind the decision making when allocating capital to various asset classes?
A. Well, my allocation is not so much dependent on the market conditions as it is dependent on when I need the money.
Any money I need in the next 1-3 years, plus my emergency fund that is around 6-8 months of my household expenses, I don’t invest much of that in stocks.
However, of all the money I need beyond three years, I invest 80-90% of the same in equities, either directly in stocks or through equity funds.
Largely, I try to keep 80/20 allocation between equity and bonds, with the latter also including some gold.

Question 12.

If you were to go back to the start of your career as an investor, would you like to change something – add or delete?
A. Nothing to delete, but I will like to add a greater amount of patience. I have always been a long term investor, but I have lost a lot of wealth-creation opportunities by owning some great businesses for just 2-3 years which should’ve been owned for 15-20 years. So I have lost a lot of potential gains.
Another mistake I made, which I would like to correct if I were given a chance to go back in the past, is that I used to get anchored to stock prices. So I’ve sold a lot of stocks that earned me 100-200% returns just because they earned me 100-200% return, and because I was anchored to my buying price.
Your original cost price, as I realize now, does not matter when you are making a decision to hold or sell a stock, or buy more of the same. Then, once you have bought a great business – and there aren’t much of such businesses – it’s important to sit tight on it for years until the business itself does not change for the worse.
So yes, if I could, I just want to add more patience to my past investing decisions. How I wish that was possible. 🙂

Question 13.

What would you say to those who are just starting to learn about the markets and investing their own money?
First, read Safal Niveshak. 🙂
Jokes apart, here are my ten quick suggestions to a new, young investor –
1.      Start…don’t wait
2.      Read everything
3.      Know that you don’t know…a lot
4.      Keep it simple and minimalistic
5.      Turn off the noise
6.      Have patience
7.      Focus on process, and outcome will take care of itself
8.      Accept that you will make (a lot of) mistakes
9.      Find your role models
10.    Know what to avoid (like leverage, trading, and speculation)
Finally, while these ten suggestions/rules can help a new investor take better care of his/her money and financial life, I would also suggest him/her to not get too focused on these things that he/she loses out spending time on the real joys of life.
As a wise man, or maybe a woman, once said, “No matter how hard you hug your money, it never hugs back.”

Question 14.

For a young person who avoids investing in stock markets (due to risks & volatility), what examples will you share to convince him to start investing?
I don’t believe in convincing people, but inspiring them.
So, to such a person, I will try to inspire him/her by sharing my own experiences and the numerous stories of others who have created wealth for themselves using the power of compounding over long periods of time.
I will also gift him a few books like…
These books have inspired me a lot when it comes to taking proper care of my money, and I am sure these will inspire the person I gift them to, if he/she were read them diligently.

Question 15.

What’s your final, two-minute advice for an investor?
A. Nothing, as I’ve already advised a lot. 🙂
Just love your family more than the money. Be a good son/daughter, spouse, and parent.
Your best investment in life would not be any stock or bond or real estate or gold, but the time you spend with your child. Life can pull you in a thousand directions, and you might ignore it especially when your child is little. But remember – Children don’t stay little for long. So, slow down…take some time…give some time…invest some time.
And finally, please take care of your health. If you want to benefit from compounding, you need to be alive and in good health beyond 50 years of age.
If you have great health and a loving family, there’s no bigger wealth you can ask for in life.

The End

______________________________________________________________________________

Brief Bio

Vishal Khandelwal has 11+ years experience as a stock market analyst and investor, and 3+ years as an investing coach. He is the founder of Safal Niveshak, a website dedicated to helping small investors become smart, independent, and successful in their stock market investing. Over the years, Vishal has trained 1,500+ individual investors in the art of investing sensibly in the stock market, through his Workshops and online investing courses.