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?