Saturday, March 16, 2019

Bodhi Tree Investing - The Quest for Permanence

Imagine yourself sitting under the Bodhi Tree at Bodh Gaya, the place where Gautama Buddha attained enlightenment after 49 days of rigorous meditation. After experiencing inner freedom, Gautama Buddha thanked the tree for giving him resilience and support during his struggle for enlightenment. This was in 3rd century BC.

Since then, Bodhi Tree has stood the test of time, although there are stories around people trying to cut and poison the tree. Also, there are stories that King Ashoka's daughter planted original shoot in Srilanka and this tree still flourishes with no signs of ageing. This is a symbol of history blending into oneness, where time loses its identity and transcends into permanence in contrast to this dynamic and disruptive world. 


Investing

There is of course a uniqueness to Bodhi Tree, the association with one of the greatest men that ever lived - Gautama Buddha. This is also one of the best example of Endurance.

It is important to understand what makes something survive and thrive for so long. And if we can draw out the parallels to companies for investing then it will be a true enlightenment as an investor - the path to permanence, resilience and endurance.

Last year, I came across interview of Anthony Deden - chairman of Edelweiss Holdings who focused on scarcity, permanence and independence as core pillars in his investment portfolio. The thoughts further inspired me to read through his letters to shareholders and they were eye-opener. I have tried to gather some learning and gathered my notes around the same in this blog.

Below is the video interview which I would highly recommend to watch.



Why this is important? Why should Capital preservation come first?

Capital represents our savings and lifetime work. To accumulate savings requires time, effort and sacrifice. We should have utmost respect for its irreplaceability. This triggers the quest to find place for the capital in partnering companies and owners that has permanence, endurance, independence and which is scarce.

Some of the qualities we should be looking at for investing in great businesses...

Customer-orientation and adaptive to change:

The primary focus of company should be on building great products and customer orientation and not profits. Walter Isaacson's biography on Steve Jobs clearly demonstrates this trait.
"My passion has been to build an enduring company where people were motivated to make great products. Everything else was secondary. Sure, it was great to make a profit, because that was what allowed you to make great products. But the products, not the profits, were the motivation […] it’s a subtle difference, but it ends up meaning everything: the people you hire, who gets promoted, what you discuss in meetings."

And this DNA of such companies is what make them scarce in the world where companies constantly chase profits. He understood that value is not merely in things one can measure. As such money should be byproduct of doing something extremely well - not the objective in first place.

He also understood what customer will need in future. That's evolutionary thinking and vision which is required.



This is beautifully explained by Walter in the same book through an anecdote.
"Some people say, “Give the customers what they want.” But that’s not my approach. Our job is to figure out what they are going to want before they do. I think Henry Ford once said, “If I’d asked customers what they wanted, they would have told me, ‘A faster horse!’” People don’t know what they want until you show it to them. That’s why I never rely on market research. Our task is to read things that are not yet on the page"
Understanding earnings power and thinking about what can go wrong:

In the letter published in July 2012, Tony Deden has referenced speech given by Sir Mark Webster Jenkinson on Earning Power of the business.
"To gauge the earning power of the business, it is essential to ascertain how the profits have been earned, where the profits have been earned and why the profits have been earned."
The emphasis is his and the statement is profound in that it forces us to decide on whether the business is desirable before we set out to see what it is worth. 



Notice that the how, where and why demand non-quantitative reflection. The task forces us to come to a judgment about all the things that can go wrong before we make assumptions about the future or attempt to assign a value to such holding. It forces us to make a judgment about the certainty of a stream of income and the permanence of its undertaking.

Avoiding risks and fragility, particularly from debt:

One of the factor around avoiding fragility to achieve endurance comes from conservative approach towards debt. Capital strength is one of the key ingredient of enduring businesses. This also gives independence of action and ability to bear pain in difficult times.
"Enduring businesses are customer-oriented and adaptive to change; have strong cohesion and sense of identity; display a powerful drive for progress; consider themselves stewards of a long standing enterprise—each generation being only a link in a long chain; are conservative in financing and frugal; they do not risk capital gratuitously; they associate debt with fragility and risk. Indeed, capital strength gives one options, flexibility and independence of action—not at the mercy of bankers and financiers. They believe that profitability is a mere symptom of health and not the cause; they have a low priority in maximizing shareholder wealth and they focus on capabilities, not mere competencies." 
                         - Speech to shareholders, London (October 2015)
The financial activity and world obsessed with using future earnings for short term benefit by taking debt has created illusion of profits which is not sustainable most of the times. And worse it takes away independence of the company during bad times, often even leading to insolvency.
"Distinguishing between the productive and unproductive has become difficult since financial activity, often for its own sake, dominates the business landscape and has deluded folks into believing that debt creation is wealth creation and that the ultimate end is money in itself. To make matters worse, much of what passes for prices on a day to day basis is the product of untold and often covert suppression, manipulation and distortion. Meaningless prices beget meaningless conclusions."
                                     - Letter to Shareholders (January 2011)
Long term thinking of owner-operators and extreme focus:

It is important to have mindset of owners for those who are running the businesses and same goes with investor. People do things better when they are owners and when they love their business more than they love the pursuit of money. 



By pursuing decision towards permanence, these owners can avoid large errors in judgment. Such companies eschew short-term results for the purpose of sowing seeds for another generation. Some other characteristics of these owners includes frugality in good or bad times, distaste for growth through acquisitions, aversion to debt, rates of reinvestment and ability to attract as well as retain talent.

They respect their minority shareholders, they have better and more meaningful relationships with their employees, suppliers and customers. They are focused on what they do. And they do it well.

Again, these are very rare characteristics and hence this makes such businesses scarce.

Similarly, as an investors when we think like owners, the aspects like survival and ability to endure become more important. The time preference automatically changes. We then are able to differentiate between value of the business and price of the business - the transition to permanence from what is momentary.

From an interview with Lane Wallace, “Original Sin on Wall Street,” The Atlantic, 19 Feb 2010:
"The price of the stock is a momentary, transitory thing that can be reversed in a moment, or washed away or greatly enhanced over the course of years and decades"
Conclusion:

In this chaotic, disruptive and world obsessed with short term results, an investor seeking capital protection having long term view about the investment process should think back and start quest for companies and owners with mindset as well as character of permanence, scarcity and independence..!! The quest is changing the focus from quantitative aspects to qualitative aspects. And when one gets that, it is a phase of enlightenment..!!

Just like Gautama Buddha achieved enlightenment under the Bodhi Tree...!!


Disclaimer: The article is for knowledge sharing purpose. This should not be considered as an investment advice in any manner. Please consult your financial adviser for any investing decisions.

We recently conducted TechnoFunda Webinar Series. Below is registration link for the recordings.

Register here: https://bit.ly/2TRNerp

References:
Edelweiss Journal: https://edelweissjournal.com/

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About the author: Vivek Mashrani, CFA
  • Vivek is CFA charterholder and MBA Capital Markets from NMIMS, Mumbai
  • Passionate about investing, books, travelling, swimming, yoga and meditation 

Follow on twitter @MashraniVivek

Friday, February 2, 2018

Bruce Lee Investing - Implementing value investing at its best

Like we discussed analogy of Bamboo in my previous article of Bamboo Investing, here is the analogy derived from different mental model in martial arts. This is from famous martial art legend - Bruce Lee.

Bruce Lee, Investing


Now, as we discussed in the article for "Quest of Investing in 100 baggers", the best strategy is to buy great businesses with competitive advantages below intrinsic value which offers margin of safety and hold them.

What if we want to practice this value investing concept to the extreme? So, here comes learning from Bruce Lee (below is the video advertisement of Skoda which we should look)


In this video, Bruce Lee is waiting for right opportunity to attack the opponent and when that opportunity comes, he hits a knockout punch. Can we apply this to investing? Why not?
"Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past."
Charlie Munger 
Now, here is the dialogue from movie MS DHONI - The Untold Story. The background is that Dhoni is very depressed and his coach gives him life lessons from cricket.


Again, the lessons from cricket are that when we see bouncer and swing balls, we defend or skip it without taking any risky shots. When we get full toss or loose balls then we take advantage of it and hit a six. So true for investing as well...!!

So the learning from above are:
- Keep evaluating the businesses and wait until you find a no-brainer
- Take action only when there is high margin of safety
- When we take action, allocate with full weight of capital

Mohnish Pabrai in his lecture at University of California talks about similar concept called: Few Bets. Big Bets. Infrequent Bets. Do watch his insightful video below. In his example he mentions that Warren Buffett and Charlie Munger invested in only 5 companies during 20 years!!


If we dissect the above strategy, there are very beautiful value investing concepts that emerge and tie-up for making one successful in investing.

High margin of safety and much more favourable odds

As a value investor, we know that investing is all about increasing odds in our favour. There is no way one can eliminate risk but by buying something way below intrinsic value we can ensure high margin of safety and odds of drastic loss decreases significantly.

Anurag Sharma explains this concept in "Book of Value" as below:
"Make no mistake: both gambling and investing are about making decisions now for outcomes in the unknown future. As such, they both require making assessments about the odds; understanding the underlying math is essential in either case. The difference is that where gamblers usually seek low odds with a high payoff , investors are inclined to seek out much more favorable odds for reasonably good returns (say, 9–1 odds for a 15 percent return with much upside potential). Marginally favorable odds (say, 51–49) would induce eager action from gamblers but none from investors."
So, when we wait for the right pitch to swing when the buying price is much below intrinsic value we essentially get extremely favorable odds for good returns essentially almost eliminating chances of loosing money (remember most important principle of Warren Buffett - Never loose money!!).

Also, it gives high margin of safety. It is beautifully explained in the newsletter "The Superinvestors of Graham and Doddsville" by giving example of truck going on a bridge.

"You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing."
Remember, here we are not timing the markets (which is impossible to do). We are simply waiting for the right opportunity (whenever it comes) to ensure sound investment with margin of safety and high allocation of capital in selected opportunities.

Again, as the quality of business is better there can be some compromise in terms of lower margin of safety since great businesses in itself provide margin of safety to an extent.

How to practice this principle?

There could be several ways to execute the above principle but there are few common things which are required:
  • Operate within the circle of competence and keep expanding it by learning new sectors, businesses and geographies
  • Always have cash which could be deployed at right time - Think cash as optionality
  • Understanding of no-brainer valuation of the company where there is high margin of safety and be ready to act
Remember that individual investors have very good advantage of doing this since mutual funds and other institutional investors have constant pressure to deploy funds and clear mandate agreed in advance.

This also implies that one need not rely on income from equity as their primary source of income. At least during the initial period of their investing.

Does such situations arise in efficient markets?

Although broadly markets are said to be efficient, there are swings in the overall market when market participants are in Euphoria and in Depression. It is very well proved in several books that prices fluctuate above and below intrinsic values and sometimes it happens to much more extreme levels.

Also, there are always pockets of sectors/companies in bear phase and bull phase within the broad market. 

There are several ways to spot such no-brainer situations. Professor Sanjay Bakshi had written detailed article to look at company from different viewpoints and then determine if company is worth buying - "Vantage Point". In this example he shows how VST Industries was no-brainer at one point of time.

Similarly, he explains how company like Piramal Enterprises was trading below cash when it sold it's business in his article - "The Grand Strategy of Ajay Piramal"

Some of the examples which I have seen recently:
  • Enterprise value of Cairn India and MOIL fell below net cash on books during the commodity downturn 
  • During the event of demonetization in 2016, several real estate companies were having valuations much below the inventory they were holding (Mohnish Pabrai actually explained this in detail and executed on opportunity - see video "Alpha Moguls")
  • There were several special situations like buyback and delisting where with minimal risk retail investors could have allocated capital for good returns (Example: Buybacks like HCL Tech, MPhasis, Infosys, TCS etc. gave 50%+ annualized returns without much risk last year)
Technical tools like supports and resistances, trend-lines, RSI oversold zones further helps in validating above situations and helps ride with other smart investors who act at such levels.

Obviously, one must access the promoter quality and corporate governance of the companies and decide margin of safety and in some case need to give a miss also. But as the concept says - we need not act on all the opportunities which come to us. Only few powerful decisions are sufficient.


Psychological factors

Is it easy to put this into practice? - The fight within

As I mentioned in the article "Quest for investing in 100 Baggers" Boredom Arbitrage

Investors crave activity and stock markets are built on it. The media feeds it all, making it seem as if important things happen every day. This results in churning of portfolio in very short time period.

The ecosystem doesn't want you to sit tight, they want to charge you fees, brokerage and sell you stuff. The greatest fortunes however come from gritting your teeth and holding on.


Seth Klarman in his book "Margin of Safety" aptly mentions:
"The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants."
This implies that it is very good if one has some other activity/hobby like reading books, music, sports, etc where one can find ways to avoid such boredom. 

Frustrating times 

There might be cases when one continuously examines several opportunities for long period of time but end up with no good position. That should be perfectly fine but very frustrating at times. One more quote from "Margin of Safety":
"Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden. The disciplined pursuit of bargains makes value investing very much a risk-averse approach."
Ability to Endure Pain

Although one buys way below intrinsic value with extreme margin of safety, there is no guarantee that price will not go further down. Market could be irrational for a long period of time and swings could be very extreme.

After investing with conviction and high margin of safety, one needs to have ability to endure pain when prices go further down and stays there for long period of time. There is very good lesson from movie Sultan which one can follow here.


Conclusion:

Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing and conviction as well as courage to swing it with full force (capital)...!! Just like Bruce Lee...!!


Disclaimer: All stocks quoted are just for example, these are not buy/sell recommendations.

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About the author: Vivek Mashrani, CFA
  • Vivek is CFA charterholder and MBA Capital Markets from NMIMS, Mumbai
  • Passionate about investing, books, travelling, swimming, yoga and meditation 

Follow on twitter @MashraniVivek 

Tuesday, December 19, 2017

Bamboo Investing - The rise of Phoenix in Stock Markets


The title of the post is Bamboo Investing. It's not about investing in bamboo trees, let me clarify that first. It's about mental models way of learning. Also, there is no real phoenix in the context!

Bamboo investing


Before we get to the point, here is a small puzzle. Below are the share price charts of few companies over certain time period. What is common between them?


Company-1: Specialty chemical company

Company-2: Auto manufacturing company


Company-3: Shrimp exporting company


So having started with puzzle, now there is another anecdote for you. This is about Chinese Bamboo. For those who haven't seen it, the picture is below.


Chinese bamboo tree is very typical. It can grow vertically almost 90 feet (that's almost as tall as a building!!).

This is how it GROWS:
One waters the bamboo tree for four straight years and nothing happens - absolutely NOTHING..!! The seed remains in the ground.

Then suddenly miracle happens in the 5th year. The Chinese bamboo tree finally emerges from the ground.

Within matter of six weeks it achieves height of 90 feet....just 1.5 months after waiting of 4 long years..!!

Learning from the story...
This is the common theme of the initial puzzle. A good stock may remain dormant and boring for many years, and then it would accelerate to surprise everyone. As such this can happen for the entire sector or most of the stocks in any country depending upon triggers.

One should watch for improvement in business fundamentals and Earnings power. If the prices don't move and business is improving, that's the best ground to hunt.

So the answer to the puzzle is that all of the above companies were boring and dormant but accelerated to become multi-baggers in very short period of time. The companies were Balaji Amines, Maruti and Avanti feeds but that's not important here.

What are the triggers?
Now, the above outcome is bit surprising since we say that markets are efficient. Then is there any anomaly?

Well, I have tried to think through and found that there are mainly two broad factors that drive it: Rapid earnings growth and PE re-rating (Had discussed this in detail in my article: Investing in 100 baggers)

1. Sector and country re-rating: This can happen when there are certain key changes in the sector and country which can expand the PE multiple rapidly despite no change in earnings growth (mostly in anticipation of future earnings growth)

Examples:
  • Entire Indian market got re-rated in 2014 after new government got majority in the elections
  • PSU oil companies got re-rated due to deregulation of fuel prices
  • Specialty chemicals and graphite electrode industry recently got re-rated due to shutdown of factories in China

2. Company is widening moat for long term: There might be instances when companies are spending in R&D, Brand building, building distribution network, trying to launch new product, trying to enter new markets, spending heavily to gain economies of scale or creating network effect etc. Basically, they are bleeding today to achieve sustainable long term growth.

This reflects poorly on income statement for short term but Earnings power of the company is constantly increasing which results in exponential long term growth.

Examples:
  • Amazon hiring staff to increase future sales by making systems and servers more efficient
  • Thyrocare taking hit on the margins to quickly gain market share from lower prices and harness economies of scale in future
  • Ola/Paytm keeping 0% fees for partners (drivers/merchants) to achieve network effect
  • Tata Sky giving set-top box free/subsidized to new customers to bargain better with content providers in future 

3. Efficient Capital Allocation: When companies demonstrate ability of efficient capital allocation creating shareholder value, then it can get re-rated and further execution accelerates this.

Examples:
  • Piramal enterprises sold part of Healthcare business to Abott in 2010 when it was trading at cash bargain, and now it has been rapidly re-rated due to efficient capital allocation (Read case study by Sanjay Bakshi: The grand strategy of Ajay Piramal)

4. Increased disclosure or market cap levels/low liquidity: There are several instances where disclosures for many small and midcap stocks are minimal. Also, some of these companies are too small to form part of mandate for large investors.

There may be very low liquidity for the stock. In these cases the stock gets re-rated very fast once it start falling under mandate of institutions or after improved disclosure levels.

Examples:
  • Companies like Poddar Developers and Mold-Tek Packaging did a QIP which resulted in higher disclosure and comfort from institutional shareholding 
  • Companies like Veto Switchgear coming out from SME exchange and getting listed on BSE and NSE, thus constraint of many funds that cannot buy on SME platform gets removed

5. Structural turnarounds: Many companies could be showing lower earnings or losses due to some structural bottlenecks. But when this gets resolved, there may be turnaround in the fortunes of the company.

This may be triggered due to single event like debt repayment, management change, regulatory change, change in strategy, consolidation of industry, structural fall in raw material prices etc.

Examples:
  • Indo Count industries changed its strategy and product lines after coming out of BIFR and it became 100x in ~2-3 years thereafter
  • Symphony changed it strategy from buying assets to becoming asset light and stock became multi-bagger

There may be several such factors which may result into multi-fold returns in very short period of time. But not every company which is dormant or boring will move like this.

One needs to ignore price movement and see if business is continuously improving. The lesson is one needs to stick to the original theme and if its intact or improving then just hold on.

Thomas Phelps in his book 100 to 1 in the stock market wrote that - Investors have been conditioned to measure stock-price performance based on quarterly or annual earnings but not on business performance. Ideally the focus should be on business performance.
Its important to focus on Earnings Power coupled with business strength.

How to identify such companies?
We can use TechnoFunda approach i.e. combination of Technical and Fundamental analysis. Some of the technical indicators like price-volume break-outs, momentum indicators, formation of trend lines are very powerful to identify such companies at inflection point.

Adding fundamental analysis on top of it can filter some of the false signals generated by technical and helps to identify and ride such companies with conviction and then again technical analysis can be used to determine Hold or Sell criteria.

Example:
Companies like BEPL, HEG etc. gave clear technical indications and this was coupled by fundamentals like ABS prices going up coupled with capex for BEPL and graphite electrodes prices going up for HEG along with shutdown of capacity in China.

See technical chart below for BEPL: There was price-volume break-out in Mar-2017 at ~25 and stock became almost 8x in less than 9 months. The capex approval came soon after break-out giving fundamental confirmation and conviction to hold. This was further accelerated by PE exit and promoter buying from the market.



For more on examples/approach you can see my presentation in article: Technical Analysis Overview

Thus, one must use TechnoFunda approach to identify such stocks and once these are identified correctly, just SIT tight until the story plays out and enjoy the Bamboo Investing way of wealth creation...!!

Disclaimer: All stocks quoted are just for example, these are not buy/sell recommendations.

Chart credits: Moneycontrol, ChartNexus

Also published in Transfin.
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About the author: Vivek Mashrani, CFA
  • Vivek is CFA charterholder and MBA Capital Markets from NMIMS, Mumbai
  • Passionate about investing, books, travelling, swimming, yoga and meditation 

Follow on twitter @MashraniVivek 

Monday, December 18, 2017

Top 15 book recommendations from Mohnish Pabrai

Mohnish Pabrai is a value investor and manages Pabrai Funds. He keeps on recommending great books on investing at various forums be it college guest lectures, corporate lectures, articles etc.


Below are top 15 books recommended by Mohnish Pabrai based on my reading experience of reading several books of his recommendation:

1. 100 Baggers: Stocks that Return 100-to-1 and How to Find Them by Christopher Mayer

2. A Short History of Financial Euphoria by John Kenneth

3. Poor Charlie's Almanack by Peter D. Kaufman

4. The Art Of Being Unreasonable by Eli Broad

5. A Random Walk Down Wall Street by Burton Malkiel

6. Where Are The Customers' Yachts? by Fred Schwed, Jr.

7. The Beak of the Finch: A Story of Evolution in Our Time by Jonathan Weiner

8. Am I Being Too Subtle? by Sam Zell

9. A Mathematician Plays the Stock Market by John Allen Paulos

10. A Gift to My Children: A Father's Lessons for Life and Investing by Jim Rogers

11. When Genius Failed: The Rise and Fall of LTCM by Roger Lowenstein

12. Zero to One: Notes on Startups, or How to Build the Future by Peter Thiel

13. Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

14. What Works on Wall Street by James O'Shaughnessey

Finally the last one authored by Mohnish Pabrai himself.....Dhandho

                                    



Sources: Private investor communications,  Google Talks/listMarketFolly,   Boston College talk

Disclaimers:
- This post is inspired by article from www.valuewalk.com
- The selection is based on my experience and not shortlisted by Mohnish Pabrai

Wednesday, November 29, 2017

Quest for investing in 100 Baggers

I recently read the book 100 baggers: Stocks that return 100-To-1 and How to find them by Christopher Mayer. I thought of writing a review and write summary of learning from the book for the benefit of fellow investors.

The three basic questions which every investor who wants to make 100 Bagger returns are: WHAT to buy? WHEN to buy? HOW to hold/sell?
                                           

Very simple steps to have 100 baggers in the portfolio:
  • Finding great business at reasonable valuation
  • Holding them for long period of time
According to Thomas Phelps's book 100 to 1 in the stock Market, to make money in stocks one must have - "The vision to see them, the courage to buy them and the patience to hold them."

Key areas to focus while identifying great businesses that can turn into 100 baggers based on patterns identified from past 100 baggers:
  • Business must be providing solution
  • Must have an enduring moat or competitive advantage
  • Excellent capital allocation strategy
  • Long runway
  • Earnings Power
  • Ability to re-invest capital at high return on capital
  • Company run by owners operator with skin in the game
What to look for: 
"Every human problem is an investment opportunity if you can anticipate the solution". 

Companies that have new methods, new materials and new products - basically things that improve life, that solve problems and allow us to do things better, faster and cheaper.

Study markets and invest in long term enterprises which have the potential to vastly outpace other companies and industries and stick with them as long as the theme is intact. So lesson is one needs to stick to the original theme and if it is intact just hold on.

Intuitive formula for 100 baggers:

Earnings Growth + PE Re-rating = Multi-Bagger

Key factors for Earnings Growth:
(a) Sales Growth
(b) Operating Leverage
(c) Margin Expansion
(d) Debt Reduction

The fastest multi-bagger returns come during the combination of all the above factors. 

(a) Sales Growth generally comes from gaining market share in the existing markets, expanding into new markets and creating new products

(b) Operating Leverage comes into play when businesses have high fixed cost which gets advantage of economies of scale, network effect and bargaining power to lower costs

(c) Margin Expansion happens from reduced cost, improved efficiency, pricing power and sticky products

(d) Debt reduction due to cash flow generation reduces finance cost and further improves earnings

Thus, single most important factor is GROWTH in all the dimensions - sales, margin and valuation.

Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity and correspondingly stronger returns on invested capital.

Identifying great businesses with enduring moat:
"A truly great business must have an enduring "moat" that protects excellent returns on invested capital" - Warren Buffett
In his The Little Book That Builds Wealth, Dorsey uses an analogy for why you should pay attention to moats: “It’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that last longer are typically able to command higher prices...The same concept applies in the stock market.”


Thumbnail

Some very common forms of Moats are:
  • Strong Brand
  • High switching costs
  • Network effects
  • Low cost advantage
  • Economies of Scale
  • Patents and IP
Moats, in essence, are a way for companies to fight mean reversion, which is like a strong current in markets that pulls everything toward average.

Michael Mauboussin has done some good work on Measuring the Moat. He suggested interesting mental model to find Moat in the sector value chain using industry map.

This details all the players that touch an industry. For airlines this would include aircraft lessors (such as Air Lease), manufacturers (Boeing), parts suppliers (B/E Aerospace) and more. What he aims to do is show where the profit in an industry winds up. These profit pools can guide you on where you might focus our energies. For example, aircraft lessors make good returns; travel agents and freight forwarders make even-better returns.

Some indicators of companies in value-chain having Moats:
  • Track record to earn a high return on invested capital
  • High gross and operating margins for long period of time
Gross margin is a good indication of the price people are willing to pay relative to the input costs required to provide the good. It’s a measure of value added for the customer.

Earnings Power and not Earnings:
One common trap is that earnings has many limitations. One has to also look for long terms earnings which can be produced by intangible growth-producing initiatives such as R&D, promo/advertising and employee education. These are expensed but benefits will be coming for long term.

Earnings power reflects the ability of the stock to earn above-average rates of return on capital at above-average growth rates. It’s essentially a longer-term assessment of competitive strengths. 

A company can report a fall in earnings, but its longer-term earnings power could be unaffected. In the same way, earnings may rise but the underlying earnings power may be weakening.

Capital allocation:

Saurabh Mukherjea talks about many Indian businesses which turned multi-baggers in his book "The Unusual Billionares". Efficient Capital Allocation is one of the most common and important characteristics of all great businesses that became multi-baggers.

Promoters/CEOs have five basic options to allocate capital:
  1. Invest in existing operations
  2. Acquire other businesses
  3. Pay dividends
  4. Pay down debt
  5. Buyback stock
There are three basic ways to raise money:
  1. Issue stock
  2. Issue debt
  3. Use the cash flow of the business
This forms the collective toolkit for capital allocation decision which if used wisely can generate excellent results for the company.
  • Capital allocation is the CEO's most important job
  • Value per share is what counts, not overall size or growth
  • Cash flow, not earnings, determines value

Long run-way:
We need to understand that value of a business is the sum of its future cash flows, discounted back to present. Hence, focusing on long run-way of business unaffected by disruption (or ones which can evolve) and having long term view is extremely important.

Return on Capital:
This is one of the most important parameter. If a company can continue to reinvest at high rates of return over long periods of time, the stock and earnings keep compounding which gives parabolic effect.
"If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result" - Charlie Munger

Company run by Owner-Operators:

Owner-Operators have skin in the game and an efficient capital allocation as owner can create miracles for the company. 

Also, it is easier to hold onto a stock through the rough patches knowing that we have a talented owner-operator with skin in the game at the helm.

Holding great business for long period of time requires investors to build resilient psychology.

Psychological factors

Boredom Arbitrage - having truly long term view of business:
Investors crave activity and stock markets are built on it. The media feeds it all, making it seem as if important things happen every day. This results in churning of portfolio in very short time period. 

The ecosystem doesn't want you to sit tight, they want to charge you fees, brokerage and sell you stuff. The greatest fortunes however come from gritting your teeth and holding on.

Most investors have been conditioned to measure stock price performance based on quarterly earnings but not on business performance. Investors can think in terms of years and invest in stock which are cheap today because others can't look beyond few quarters. 
Value investing
One can benefit from boredom arbitrage since people get bored holding the same stock for a long time - especially if it doesn't do much.   

Once we identify great businesses which can compound over long period of time, then only task left is SIT TIGHT. It takes longs than 3,5 or even 10 years to get 100-fold returns. And holding onto stocks beyond that period requires PATIENCE.

Roller coaster investing while holding:
As professor Sanjay Bakshi has put out very clearly in his article "Roller Coaster Investing" that holding great businesses for very long period of time involves tough times. One needs to develop ability to stomach the ups and downs and hold on.

For example, Netflix fell 25% in single day for four times since 2002 and there was a 4-month stretch when it dropped 80% but it became 60-bagger since 2002!! Apple had a peak-to-trough loss of 80% twice!!

As Philip Fisher puts in his book Common Stock and Uncommon Profits "If the job has been correctly done when a common stock is purchased, the time to sell it is—almost never.” 

This is the path of true wealth creation through stock market investing..!!

Also published in Transfin.

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About the author: Vivek Mashrani, CFA
  • Vivek is CFA charterholder and MBA Capital Markets from NMIMS, Mumbai
  • Passionate about investing, books, travelling, swimming, yoga and meditation 
Follow on twitter @MashraniVivek 

Friday, November 10, 2017

Overview of Technical Analysis

What is Technical Analysis?

Technical Analysis is the process of forecasting of future price movements based on systematic study of past price actions through pictorial representation.

Technical analysis effectively  indirect study of investor behavior and its effect on the subsequent price action based on information they hold.

Link to presentation: Technical Analysis Overview


Why does Technical Analysis work?

Although in ideal rational world, all the information must be publicly available and processed by market participants in rational manner to value underlying asset or company. But market is not always rational. 

Market undergoes mood swing between panic and exuberance due to underlying emotions of Fear and Greed. Hence, technical analysis works as effective tool to capture market trends created by human emotions. 

Warren Buffett gives analogy for this by quoting stock market as imaginary person - "Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed."


Foundation of Technical Analysis:

The basic foundation of Technical Analysis is similar to cause-effect principle in Physics. 



Similarly, any meaningful information in the market creates effect in terms of action by its market participant which thereby impacts price and volume of stocks. This can be further analyzed by Technical analysis for forecasting future price movements.

"Since all human actions obey laws, as fixed as those of geometry, psychology should be studied in geometrical form, and with mathematical objectivity..." - Spinoza

Dow Theory and premises of Technical analysis:


Although people know that Greed and Fear extremes embedded in the stock market, the history still repeats every time. Peter Bevelin in his book Seeking Wisdom - From Darwin to Munger writes "Fear is our most basic emotion. Fear has evolved to help us anticipate danger and avoid pain."

As science writer Rush Dozier in his book Fear Itself writes "Fear is fundamental because life is fundamental. If we die, everything else becomes irrelevant"


Pillars of Technical Analysis:

Any participant who wants to take advantage of information has to put money on the table to benefit from it. Any kind of information is thus reflected in the change in supply and demand. Key pillars that captures these changes are:

1. Trend
2. Price
3. Volume

Types of Charts used in Technical Analysis:

We would be learning below charts which captures price movements:
- Line charts
- Bar charts
- Candlestick charts


How can Technical Analysis complement with Fundamental Analysis?

Common dilemma in fundamental analysis:
- Selling too early; Not riding the trend
- Difficult to time entry and exit of cyclicals
- Valuations remaining expensive for prolonged period of time
- Information getting priced-in before news

Technical Analysis adds another dimension for buying and selling stocks through tools like trend lines, volume spurts, break-outs, resistance, supports, reversal patterns etc. When blended with Fundamental Analysis, this forms powerful combination. 


Technical Analysis for Long Term investing:

There is myth among people that Technical Analysis can only be used for intraday trading. This is not at all true. In reality, it can be used for medium and long term investing as well. 

I believe that both are highly complementary and should work together to tell you WHAT to buy or sell and WHEN to buy or sell.

Also published in Transfin.


Saturday, November 4, 2017

The most important books for stock market investing

One of the secrets behind successful investors is that they read a lot and imbibe the great learning of many value investors. We often call this "Vicarious Learning" i.e. learning from others.

These lessons from great investors become even more important when we can learn from their mistakes and then follow the process which they have refined after repeated mistakes. These are time-tested process on value investing which helps investors to make better decisions.

Charlie Munger once said, “You don’t have to pee on an electric fence to learn not to do it.” 




Here is the list of some of the most important books on investing which one should definitely read:

Common stocks and uncommon profits - Philip Fisher

This is an all time classic on investing. Gem of a book which explains in detail when to buy and when to sell. Fisher has described in detail the process for selecting great businesses with competitive advantages.

He has also given detailed checklist for stock selection. This is must read book for every serious investor..!!


The Intelligent Investor - Benjamin Graham

It is a widely acclaimed book by Benjamin Graham on value investing. Written by one of the greatest investment advisers of twentieth century, the book aims at preventing potential investors from substantial errors and also teaches them strategies to achieve long-term investment goals.

Over the years, investment market has been following teachings and strategies of Graham for growth and development. In the book, Graham has explained various principles and strategies for investing safely and successfully without taking bigger risks.

Penned by the famous mutual-fund manager, Peter Lynch, this book elaborates the many advantages that an average investor has over professionals and how they can help them reach financial triumph.

How To Use What You Already Know To Make Money in The Market explains how your knowledge alone can assist you beat the pros of investing. He has explained process to find great businesses surrounding us by keeping eyes and ears open!! His approach to investing is simple and powerful.

Five rules for successful stock investing - Pat Dorsey

This book is another investment classic which definitely reserves to be reading list of every value investor. Pat Dorsey has beautifully explained the process of finding moats - competitive advantages of great businesses that prevents competition to enter into its territory.

He has explained financial statements in very simple and powerful way. This is then followed by detailed discussion on how to find moats in different sector with powerful examples.



Poor Charlie's Almanack - Charlie Munger


This is gem of a book written by Charlie Munger - the Guru of Warren Buffett. This book is encyclopedia of life lessons of Charlie Munger and his investment journey.

The book is must read not only for improving investment decisions but also life decisions. It has a Ten Talks section that covers a wide range of his interests that ranges from how one attains worldly insight to how his Multiple Mental Models could be used for business.




Also published in Transfin.