1987

I believe that Classics are called Classics because they are. I read WB's 1987 letter to BRK's shareholders today.

• Mr. Market can act crazy, so it's important to wait for the right opportunities
• The best businesses are those which don't have to change themselves too much over a multi-year time frame
• It's better to be prepared with a loaded gun while hunting rare elephants - liquidity more important than opportunity cost
• He wasted his time (while at the partnership) by hunting for mediocre or bad businesses at cheap prices. His preference has become excellent businesses managed by good managers
• They are not macroeconomic analysts, or technical analysts or security analysts - they are business analysts. If they don't understand it, they won't go ahead
• There is no need to churn a portfolio based on a target price being reached. As long as a well bought business (marketable securities) is run well by good managers and is making a satisfactory return on equity, is churning out good quality earnings and is not overvalued - there is no need to sell out. Example: In 1987, GEICO, Cap Cities and the Washington Post Co. had a cost price of USD 560 Mn and a Market Value of USD 2 Bn. The Earnings were approx USD 100 Mn which is a 5% yield on market value of holdings; but I believe that his philosophy was that as long as things dont get wildly overpriced, the holding wont be sold

Market Inefficiences

One of the beauties of the markets is that they are based on the whims of human behaviour.
This is quite brilliant.

Tata Motors DVR 'A' shares
1/10th the voting rights, equal claims under liquidation and entitlements and 5% more dividend.
i.e. I need 10 DVR shares to cast a vote equivalent to a normal share's vote.
5% dividend: On a face value of INR 2/-, a DVR shareholder is entitled to 5%*INR 2 = INR 0.10 more of dividend against a normal share's dividend.

A company which has good corporate governance need not need shareholder activism especially if the some strong insurance funds and the promoter holding is excessive. Ergo, A Kingfisher Airlines may need shareholder activism whereas an Infosys would not. This of course is debatable but even in case of a dispute, the odds of shareholder activism in Infosys would be limited to something like "Please disburse cash" or "Please change your auditor".

If more A Shares are issued, the entire shareholder base is diluted and hence A shares are more or less the same as the normal shares (except for the voting rights).

If I were to say all the above, which flows correctly in terms of logic, one would assume both classes of shares to be trading at a similar price.
Fact: A Shares have traded at a 30%-50% odd discount to normal shares for a long time now.
However, and this is what most analysts fail to recognize, the shares are not convertible, and hence that does not necessitate convergence of values. But, the above information does necessite convergence.
In addition, the convergence can be in any direction.
All the posts I have read or people I have spoken to say that there is no logic for the huge discount, but they always talk in relative terms.

I say: Forget the discount. Focus on the price that is being demanded. Forget the normal shares' price. Focus on the DVR shares because they offer a roughly similar entitlement.
DVR A shares trade at INR 140 on a total base of 320 Cr odd shares which gives the company an equity value of INR 44,800 Cr or INR 448 Bn. Factor in some conversion and issues and we may come to INR 47,000 Cr.

PAT for the year was INR 13000 Cr largely because of a tax break. However, the tax break was real although not sustainable. Let's negate for taxes and PAT may reach INR 9000 Cr.
In addition, FY12 was not what one would call a good year; it was a 'decent' year. Just read about the Eurozone crisis, and the India slowdown and the US recovering and the China mystery :P
Alternatively, when one looks at fund flows to equity shareholders from JLR, it is a hefty INR 8500 Cr after R&D expenses and capacity investments of about GBP 1.5 Bn or INR 12000 Cr.
Muy Bien?

The India business' fund flows are not very clear but my estimate is that it was negligible because of the poor performance of the passenger vehicles segment and investments in capacity.

Based on broad ranges, the price of DVR shares seem to be attributing a value of 4x-6x P/E or a 5x-7x P/Cash Flow based on FY12 earnings.

The markets are brilliant because very few people can wait to see this market inefficiency be erased.
Retail investors are not patient.
PE investors will move away in 5/7 years.
MFs are subject to retail investor moods and always hold a diversified portfolio.
Luckily, I have a 10 year + horizon.

The potence of Tata Motors and of JLR is formidable - that evaluation will remain proprietary.

Valuation

Multiples approach, peer comparison, forms of discounted cash flows... these are the usual ways of looking at valuations of companies.
Valuations of companies matter differently based on the time horizon and objectives of investments

How about:

What is the earnings yield based on the current price at which I can buy the company?

What am I really buying with an equity share? (look at minority, preference, debt)

What is the company doing with its cash earnings? -> Is it going into repaying creditors? funding working capital? funding expansion through fixed assets? rewarding employees?

How certain am I that this company will make this much money (profits) in the future? Is there potential for losses?

How certain am I that this company can make a lot more money in the future?

How can the company utilise the cash it generates in growing the business at a similar rate as in the past?

Through all of the above, how can the value of the company erode relative to the current market value? And how can the value of the company substantially increase from hereon?

How sustainable are the company's operations in relation to the field of business in which it operates? i.e. does it have to keep changing itself at a fast pace/ slow pace/ or not really...

Gum

There is so much to learn from WB. "Will the internet change the way I chew gum?" "Will the internet change the way I buy gum?" "Ok, you buy the internet, I buy the gum."
There is no substitute for surety. Established business will perform well over the long term if they stay away from risks. So, if quarterly results worry you because copper prices went up and the cost of goods went up, that usually means that an established company is going to do something to tackle such issues in the future. Hence, earnings in the future will be taken care of.
And this is where consumption companies can be excellent; once a customer is addicted to a brand he/ she does not want to change and will willingly pay marginally higher for the perceived better quality.
Sadly, how does one have any inkling of how sales can grow over a 10 year period in a sector that is fraught with competition? And this is where art comes in...

Fallacies

I decided to write today because I felt myself succumbing to temptation. Just because a security rather undervalued and the corporate governance is top-notch, does not mean that 1- the future of the sector is bright or 2- one should chase the stock on its upward descent.

1. Even though I might make money on this particular investment (I will call it SP), the angle to it is that of a short-termish gain. That of a 1-2 year horizon. I want to make it a rule, that I will get into a company only if I see some visibility to the sector 10 years into the future. There are large potential risks to sectors which see drastic changes in the medium term future. In 2007, could Dell have foreseen the disruptive changes to the PC/ laptop market because of tablets? It was in the USD 20-28 range and now has been struggling in the mid 10s.
Of course, changes are wonderful. A retailer will have to change its mode of operations because of e-commerce but the essence of the industry lies in getting the right product in good condition to the customer while keeping the customer experience great. So, a Crossword or Landmark will evaporate but a STAR Bazaar may not. It is also difficult to replace cola drinks or coffee or tea or pesticides or financial services or automobiles. And here I lead on from my previous post; in order to cope with change, how must an organisation change its core product/ service offering? A Kotak Bank will not need to change as much as a Tata Motors would have to in terms of resources that are required to conduct that change.

2. This is primarily related to psychology. "I don't want to miss out on this opportunity. Ok, I was timid at first, but let me buy in at a 15% premium because it wont make that big a difference."
Sadly, buying above your comfort zone gives rise to an erosion in one's margin of safety. At times, it is prudent to sit back and let others fight it out over getting shares of a company; The stock may soar higher or the dust may settle along with the price. There are many opportunities in the market. Always keep your eye on your downside.

Basic Rules

This post is an endeavour at lining out some basic rules to investing:

1. Understand competitive capabilities:

A company might have a superior product, be in a wonderful sector or have excellent management whose interests are aligned with that of the company. 

Finding a superior product or service is not easy. A wonderful sector need not help a mediocre company. Only excellent management can influence the performance of a company over the long haul in a sector that allows them to do good and eventually come up with a superior service.

Not every company can create Ikea, Coke, McDonalds; however, some companies can create a 'pull factor' in a commoditized sector. For Example: GEICO. It is auto insurance, but it does it really well and prices it really well. In addition, the float is supposedly managed really well. Voila. A wonderful business.

Therefore, competitive advantages need not be derived from something outstanding. It can well be derived from doing something well and continuously doing it well while striving to better oneself. This can be attained only when management realises that it needs to delegate work and create a new rung of leaders; this is because empowered people do awesome work. So an Infosys does not do something that nobody else does, nor is it irreplaceable. But, it has created wonderful bonds with its customers through its pursuit of transparency and quality of work. I am reasonably confident that it will make a successful transition into becoming an outstanding global organisation.

This need not be the sole way because a See's Candies depends on one core function: Keeping its customers happy and providing quality produce. Quality without Compromise. 

Companies need to focus on the differentiating factor while keeping their eyes on keeping their employees and customers happy. Happy and motivated employees will take care of other stakeholders and customers will take care of business dynamics.

2. Price:

There are possibly millions of people who can read financial statements. And yet, there are very few long term awesome investors. Odd? One needs to understand a fund manager's motivations. Sadly, a fund manager tends to focus on making the next year's buck and beating the market. At times, staying with the market suffices. Reminiscences of a Stock Market Operator will always remain a classic because it showcases speculative behaviour and how, during euphoric and depressive times markets make specualtors of investors. Hence, investors tend to dwindle in numbers. 

Investors tend to forget a basic rule of 'Don't lose money'. With their eyes focused on a future that has not yet happened and constantly apprehensive of that which is going on around them, investors start behaving strangely. One would pay USD 500 for the iPad 3 but how can one pay USD 620 for a share of Apple? Sure, it is making money right now and ex-cash it gives about 6-8% on market value in earnings. But can that 8% be sustained? I don't think so. Eventually, what does the Company have? iPod, iPad, iMac, iPhone. What next? Nobody knows but everybody wants to believe that the stock is on its way to USD 1000. 

My point is that, sure, Apple is a fantastic company and if it has indeed created USD 100 Bn of a cash stockpile - that is truly awesome. But even awesomeness has a price. It is important to understand what that price is. 

Oddly, that price is a function of investor behaviour, time horizons, temperament, risk appetite and belief in the future path. All of these are vague terminologies. This creates mis-pricing. A BRK is on its way up and an AAPL is on its way down.

Benjamin Graham spoke of Intrinsic Value. An iPad3 is valued at USD 500 but it may have an intrinsic value of USD 5,000 for a person who loves entertainment and simplicity on the move. It may have an intrinsic value of USD 50 for a person who bought it just to show-off, but the act of showing-off creates pleasure for the consumer much in excess of USD 500; and hence the purchase is warranted. However, a Company's intrinsic value can be judged more easily within a shorter range because a Company's value is arrived at through economics. Link - This is Buffett from 1979.

Never pay a price for a company that is in excess of what you believe is beyond the sustainable profitability of the company or a reasonable estimate of a company's replacement value.

3. Price and Competitive Advantage:

At this point, your screen might have a semi-liquid substance on its surface. I apologise for my drool. This is the sweet spot. At times, awesome companies or awesome companies in the making are beaten down by fools. This happens in times of domestic/ global economic/ socio-political carnage or it happens at times of rumours or myopic visions by people looking at such companies. At these times, it is extremely difficult to stand pat and lap up shares which are being beaten down or are unavailable because of scarce liquidity. How would an investor answer this question - "How can you be buying shares of X Company when nobody else is interested and when it is at such a low valuation, which in turn means that everybody else thinks that this company is a dud?" 

The answer would be "Umm... kindly repeat your question as a statement"

4. Smile:

Smile to work. Traders cannot smile to work because the stress of bearing market volatility is too much at times. One needs to be patient, introspective and contrarian. Nothing is worth losing sleep over, unless it is someone you care about. Money comes and goes. A happy person works well. It's as simple as that.

5. Leverage Kills:

The lure of leverage is damning. "Let me boost my returns by taking a 10% load on my equity - that is barely anything." True. But the next 10% will also be 'barely anything'. It is a trap that people fall into in pursuit of bettering returns. The real risk is in losing money, and not in volatility. Leverage increases volatility of personal earnings and chances of poor health (Ask your heart). Stay away from leverage unless playing with your kid on the see-saw.

6. Belief Systems:
This is, again, a combination of points 1 and 2. If so many people can read statements, why can't they be good fund managers/ investors? Some of the reasons are: psyche, circumstances, temperament, etc. I have outlined this earlier. However, as a successful investor one needs to understand the lollapalooza effect as cited by Charlie Munger. A set of circumstances that provide a fillip to a company. These circumstances can be caused due to mismanagement by competitors, awesome management by the company's heads, change in regulations, change in business dynamics (internet, globalization, etcetera), change in demographics, a domestic or global wealth effect, etc.
In short, one needs to pay very good attention to where this company has the ability to go while keeping its moat intact. A case in point is Rakesh J's investment in Titan. Let's assume that he didn't have insider information; in that case, he understood the real potential of Titan's products. He also made a bet on how India's consumption is going to change. Women buyers, youth fashion for sunglasses, a desire for good quality watches in India, a B2B business for precision instruments... I have not read about Titan but here, I am making a guess about the business prospects of a company. Of course, it had to start with an undervaluation relative to the Company's intrinsic value (or so I assume).
My point here is that one needs to understand the potential for a business. How much and how can an automotive parts company grow? Relative to that, what would the dynamics and potential be for a financial supermarket in a strongly developing economy?

WB's notes

WB has accumulated and created a great amount of wealth for himself and for his investors, respectively. Oddly, he hasn't done much except for being patient, strong-willed and resourceful. He has changed his method of functioning as the years have passed him by. He has been one of the longest serving chairmen of a company ever. I wonder if that is correct English. Doesn't matter really.

Luckily for us, he has learnt so much over the years, a lot of which he has been willing to share with his patient viewers, listeners and readers.

1. Goodwill is an intangible asset, but it is far from worthless. In fact, it can be grown over a period of time and still remain intangible yet amazingly resourceful to the company.

2. Understand motivations of each party, because everyone tends to fend for him/herself. This simple observation can give answers to why fund managers - hedge, mutual, private equity - behave the way they do and why they can almost never be true value investors. Therein lies the key, most investors tend to want to get out at various points of time; simultaneously, there are always buyers. Amazing ! Which means that one of them is wrong; but often, the seller got out with a profit and the buyer goes on to make a profit... so who is wrong?
One answer is that the eventual seller makes a loss, or along the way one speculator/ investor or caped crusader will lose money. But the real answer lies in the power of compounding. The one who gives up on it, loses. The original seller, sold and went somewhere else. Did he make money there? For how long? How much? To whom do the profits belong? Where does the fund manager's interests lie?

The simple observations are of course that brokers tend to give it buy calls, brokers don't believe in investments for more than 6 months or 1 year... because that is where their business lies - the churn. Investment bankers are in it for the fee, the reputation and the following, which helps them garner the next 1.5%.

3. Fear and Greed. Don't be afraid just because the share price is falling. Ask yourself why it is falling and ask yourself if you have made a mistake. With a sufficient time horizon, volatility is just a blip.

4. The real risk is not in the volatility. It is in the risk of losing money. Absolutely. If you sold out because prices fell and you got scared, you are a moron. You didn't deserve to be there. The real risk lies in bad analysis, bad pricing, and fraud.

5. You are correct because your analysis is correct and not because the market says you are correct. The correctness of a decision cannot be judged from its outcome.

6. He bought into KO when it was one of the largest companies in the US and when it was widely followed by most analysts. Yet, he is the one who had the guts to buy in and stay put for the last, what, 24 years. And he has made in excess of 16% compounded if I am not mistaken. How? Everybody knew the company, everybody had supposedly valued the company and everybody had access to the same type of information.
What WB saw was, here is a product that cannot be replaced. Here is a product that is so cheap and still so profitable per bottle. Here is a product that has no boundaries to its marketability. What if it sells 10% per capita that of the US, in China or in the rest of Asia, to 10% of that population? Can anybody compete with it? He basically, created a rough business model showing the sustainability and evolutionary capability of the business. It is quite simple really.

7. Stay away from bad management, bad governance and thumb-suckers. This is the most difficult to evaluate, but with enough work, one will get it.

8. A simple yes or no decision. Investment decisions have two alternatives. Yes and No. By becoming a person who is hell bent on getting out at a certain time in the future, one becomes greedy and narrow-minded. With that, decisions become complicated.

9. Short term gains cannot be ruled out when it comes to investing. But understand that the beginning has to be on the premise of undervaluation relative to intrinsic value. With that in place, one saves his/ her ass if things go bad. Furthermore, in case of over-valuation in the short term, its perfectly alright to sell out.
Do look up his PetroChina investment.
There are exceptions to the undervaluation rule. And that is in case of extraordinary competitive advantages which justify overpaying.

10. One should never 'invest' with the hope that some moron will pay 15x or 50x of book earnings in the future. What the market decides to offer is the market's prerogative. The value of a company should be ascertained within a range based on competitive advantages, business potential and a reasonable prediction of cash flow potential. RoC and RoE are figures more important than profit margins.

11. Debt is dangerous. Leverage is dangerous. Derivatives are dangerous. In short, liabilities are dangerous. Sadly, the lure of money and excitement causes sensible people to do irrational things.

12. Reputation, family and a good night's sleep are possibly more important than most things money could buy.

13. Sloth is under-rated. It is more important to be patient and lazy while ascertaining an investment decision than it is to be active. It surprises me that investors are always invested. MFs are. PE funds ache to be deployed within 3 years of closing; weird because regardless of the quantum involved, their objective is only to be deployed. Therefore, during high valuations, they can't opt out and say 'we will invest when the euphoria has died down'. And while exiting, they don't have the luxury to wait for the market to appropriately value their investments. If a fund manager decides to sit on 50% cash and does not make a single investment in a year, the investors will be gnawing at him based on the activity that the rest of the investment world is busy with - but why should a manager overpay for an asset or pay for a sub-standard asset or better yet, overpay for a substandard asset? The answer is based on what the competition is doing. Odd world we live in.
Thinking is a painful game and saying no one investment after another is even more painful when one sees prices becoming richer and good companies becoming more expensive. But it is the thinkers who win in the end, because euphoria will always find a way into the markets and so will gloom.

I have written a lot. Tired.

Sentiments

All outstanding shares of a company are owned by some entity or the other. All of them. Hence, most of these entities want the quoted share price to go higher. What about a person who founded the company 20 years ago? If he is cash-wealthy, I assume that he doesn't care too much about the share price.

Oddly, there are always naysayers who believe that the price will go down or that it will advance much less than that of other companies.
Oddly, at times there are investors who don't care much about the quoted share price as long as what is offered is substantially below the company's intrinsic value.

And such is the market. It is made of creatures, all of whom have different beliefs, desires and demands. Somehow, these three tend to interact with each other. Analysts, traders, bankers... all of them tend to have opinions. Most of them tend to believe that a well-managed company with a good product will do good in the long run. However, the most that investors tend to hold on to is for 5 or 7 years. Greed and fear start playing with them and they ache to sell out before they believe that prices will drop.

People are weird. They focus on the short term and they let feelings interfere with unemotional decisions. It's important to shut out the noise and jive to one's own rhythm.

Market Behaviour

So the stock mentioned below is an illiquid trade. Anyway, for its IPO the Company was valued at 100x. Post-listing, as was the case with most companies in 2007, the stock zoomed to 150x in a matter of weeks. For that year, the Company made about 4.5% on its IPO market cap and 13% on its networth.
Four years hence, the Company is valued at 35-40x. The absolute profit for the year is about half that of the listing year, which I believe is an aberration due to circumstances and accounting entries.
Does the valuation make sense? Are people really able to understand the true potential of this company? And why do people, and therefore markets, behave the way they do? Can the Company go back to 12%+ on its networth? What is the size of the networth? What is my downside from here onwards!?

Pricing

I see share prices in terms of 'value of the entire equity portion of the company'. I started buying when the company was worth 120. I continued buying in the same doses while the price was flat and when it started rising.
Unfortunately, the price is now near 156 (30% up) and I am done with only a quarter of my purchases.
Fortunately, the company is still significantly undervalued.
Unfortunately, I started buying at a much lower price - I ache for those prices again!!
Oddly, I expect another global equity downturn soon - nothing has changed wrt Europe, US's systemic crisis and China's hidden dirtballs.
Therefore, do I wait for that downturn? Or do I keep buying like a moron?
Plan: I buy until 25-30% of my capacity and then reduce the frequency of my purchases until 50%. At 50% I reassess the notion of sitting on my rear.

Butts and Abstinence

One of the most important things in investing is to protect one's downside - the reason is that a single bad year can ruin compounding prospects.

1. If the market values a company at USD 100 Mn and your analysis pegs the value north of USD 150 Mn... is it a good buy?
2. If the market values a company at USD 100 Mn and your analysis pegs the value at USD ~80 Mn... is it a good buy?

Question 1:
What if the company is Kodak in 2003?
What if the company is Apple in 2002?

Question 2:
What if the company is Archer Daniels Midland in 2007?
What if the company is IBM in 2011?

My point here is that there is no absolute rule just based on valuations. It's hard enough coming to a range of values for a company. It's rather difficult peering into the future. Oddly, investing is primarily about the future because that is when your potential value will be realised.

The philosophy used by WB towards the beginning of his career was the classic Graham and Dodd Cigar Butt investing with an both eyes on Margin of Safety. He would invest in a company like Kodak and wait for the market to come up to his confident valuation numbers. Luckily, he was rather smart and therefore hit quite a few homeruns - somewhere along the way he bought into disasters such as Berkshire Hathaway, Dexter Shoes, US Air and of course, Solomon Brothers.

A few key things make investments disasters even though one may have entered with a margin of safety:
1. Management
2. Industry dynamics
3. Business Environment
4. Currency
5. Corporate Governance

By far, the most important are management and corporate governance, and more important that this is corporate governance. One should see what went wrong with BRK's Solomon investment - it is plausible that BRK may never again enter that sector unless if in the form of a superior security, e.g. preferreds in Goldman Sachs.
Once, a margin of safety has been established, it is essential to understand how the company is going to realise its full potential. What if it is as culturally and managerially broken as Kodak or Yahoo! ? Odds are that the company's management will indulge in thumb-sucking while money is being burned away in sustaining an unsustainable business operation.
The problem with the cigar butt investing approach is that the one last puff may take a long time to be realised unless one can influence the board or the management.

How did WB manage to invest in IBM at a supposed 3x book value? It is quite contrary to the margin of safety approach... or is it? WB bought into Coca Cola when it was near its then all time high (in 1988-89) - what led him to do this?
Sustainable competitive advantage or Moat.
How difficult is it for another company(ies) to enter my investee company's business domain?
How easy is it for my investee company to build on its business and pricing power?
Can IBM be seriously challenged in its domain expertise and reliability? Is its consumer loyalty questionable?
Can Parle increase prices of its Bisleri bottled water without driving consumers away? Does it have a brand that is blindly relied on?
The question for smaller companies is: Is the management sincere about keeping progress and innovation uninterrupted? Is the management careful and caring with respect to its investors and employees? Is it in a sector where it really knows what it's doing? How good is the competition that surrounds it?

As an investor, the difficulty with these questions (or may be the ease!) is that answers can be substantiated only over a period of time; often, gut instinct needs to be strong and no numbers can support you in answering these questions.

Going back to Margin of Safety. It is essential because a good company at a bad price is worse than a good company at an OK price. May be it is better to buy into IBM at a 20% overvaluation than it is to buy into Netflix at a 60% overvaluation. The trouble is that there are many non-quantifiable attributes to a company which cannot be incorporated into a numerical value.

Lethargy bordering on sloth is more important than people think it is.