To do nothing

My grandfather once told me: Doing no business is a business decision.
Of course, later he admonished me for not investing more, or not selling out bits of my portfolio :)

Quite often, the intrinsic value of a company moves lesser than its market value.
Over the last few months, the Indian stock market has seen a ridiculous escalation in market prices of a lot of its listed companies.
In some cases, this was justified, and in other cases, I deem it pure speculation.

So, if a base case 25% RoE company moves from 8x PE to 30x PE over 2 years - what does one do?
A 5x-7x on a holding says nothing about how overpriced the company may be.
Furthermore, a strong moat evidenced by strong pricing power, strong staying power (balance sheet) and strong market position may justify a rich valuation.

Oddly enough, it may not justify a new investment in the same company based on the principle of margin of safety.

When companies are not priced compellingly well relative to its business strength - like the one foot fence that Buffett always talks about - it makes a lot of sense to do nothing and keep reading.

This is one such time period.

China

Michael Pettis talks about how China's course may evolve over the next few years.
- China's consumption (or rather, use) of hard commodities is still a large chunk of global demand.
- Oddly enough, the bubble has been deflating for a while now
- Chinese equity markets have been on the wane for some years now
- Commodity prices of, such as copper, iron have been falling for a while now
- My belief is that any company or economy that is reliant on Chinese consumption may have hard times coming up
- Any company that does not have pricing power in a globally dealt commodity may face hard times

And Tepper talks about how the bond bubble will begin to end, and more money will flow into equities.

Meanwhile, Indians believe that the bull market has not even started yet.

And Howard Marks says that we are now moving towards the zone of imprudence in the markets.

Dhanuka Agriluck and Tata Motors DVR

I made my first investment note on Dhanuka Agritech in 2010.

"Valuation of 7.5x PE; earnings yield of 13% on a trailing basis with mgmt guidelines for 40% topline CAGR"
"Capex is insignificant; their distribution reach and brand recall are significant barriers to entry"
"They seem to be more license-savvy, and understand their strengths and may be getting into hybrid seeds"
"Little potential of a loss and significant upside"
"The industry is very appealing, and consumption of agrochemicals should rise undoubtedly."

With that stupid analysis and a lot more literature and reading, I made my investment in 2011.

The question is: Was I smart or was I lucky?
I was definitely lucky.

But I was definitely wise when I chose not to sell at 130 a share in 2012, in favour of a cheaper company with better prospects. 
I said that I should just hold on to a company that is making significant returns on capital even in a bad year.

And currently, at 430 a share - I seem wise. But I'm not. I still think I got lucky with my relatively shoddy understanding.
Now: High returns on equity and capital, moat is improving with their focus on formulations and distribution in India only (Bangladesh ignored).
The problem is: what will the company do with the sizeable free cash flows? 
They cant buyback shares.

Another story is that of Tata Motors DVR, which I wrote about 2 years ago.
Here, I believe my analysis was much better. I was focused on the returns on capital at JLR, and the downside muted growth that JLR would do, and still I would do well.
The domestic business got clobbered both on PV and CV, and still, the company has done stupendously well.


All because of the gumption of the Tata and JLR heads who had the cojones to invest sizeable sums of money, and to release a game changing RR Evoque.

I think they got lucky with the Evoque.
I think I got lucky with the RR stable.
But I was smart to understand the irrationality of the mispricing.
Something similar happening in Korea with Hyundai that Tilson wrote about; and amazingly, Tata Motors DVR is cheaper than that, and according to me has a stronger moat and business.

Notes: 
China is a big profit center and the China bubble deflation will take a toll on JLR
Capex is super heavy, but most of it is towards expanding capacity and creating new models (unlike redevelopments at the German 3)
Accounting for depreciation is odd, because they capitalize 80%+ of spends relative to the Germans who capitalise 30% odd
Margins are higher than reported because China sales figures are inflated (I think, recorded gross of import duties)
The company is doing a lot to significantly improve the positioning and retain the premium value of Jaguar and Land Rover brands (and sub-brands)
The company is not chasing volumes at the cost of margins
The cyclicality of the sector can be a big headwind (as is usually) 


It's good to be lucky. 
As you can see: I am clearly biased.

By the way: Eicher Motors is valued at 27000 Cr and DVRs are valued at 120000 Cr
Which one is cheaper? 
 

Rain Industries

The beauty of a market place is that people compete to buy and sell.
The beauty of financial markets is that crazy people come to buy and sell securities and products of various kinds.

I was going through a screener 2 years ago and this company popped up; it was called Rain Commodities then. I said: Must be a weird, phony company.
It cant be valued at 1000 Cr and produce 300-800 Cr of CFFO.

A few months after that the front page of newspapers announces that this company is going to acquire a Belgian company for an EV of EUR 702 M.
Odd.

So, I look it up.

Interesting company.

1. Cement: 3.2 MTPA capacity, sells under the brand Priya Cement. Debt free.
2. Calcined Petroleum Coke: (What is that supposed to be!?) 2nd largest player in the world. Grew to this size after an LBO of an American company. Comparables: Oxbow Carbon, Goa Carbon
3. Coal Tar Distillation: (Huh!??) One of the largest players in the world. Comparables: Koppers Inc., Himadri Chemicals.

Problem:
1. Debt on books. High Yield debt issued by the US and European subsidiaries - USD 1.1 B odd.
2. Not enough word on the street about the company. So, could be a trashy company :|

And then, a nice man from Canada writes a beautiful report. A report that would make Mohnish Pabrai smile (he has always asked for good, detailed reports - it makes his job simpler).

Motilal Oswal comes out with a report.

And the company publishes very good annual reports. FY13 and FY12. They have a December ending.

The industry dynamics are not easy to understand, but from FY08 to FY13, PAT hasnt dropped below INR 300 Cr.
Today's market cap: ~INR 1300 Cr
The company has completed a few good buybacks in the last few years.
Investor Relations is friendly.
CEO is very low profile.
And hopefully, the company will issue shares to the public in the US within the next 2 years.

And there we have it:

An excellent earnings yield, high technical expertise based core businesses that require good relationships with customers and suppliers, a decent pricing power, access to capital in one of the largest pools of liquidity in the world AND with a massive margin of safety.

Disc: I hold equity shares in the company. Do your own research. I'm trying to fight these stupid positive biases I have developed.

The Long Game

The universe of things that have not come to pass
And
The work that goes into eventual greatness

These 2 profound models of thoughts go a long way into making us more humble about who we are and how we can be.

Dilip Sanghvi did not become worth USD 17 B worth overnight.
Avanti Feeds, Symphony Coolers and Just Dial have a limit to their short term voting machine based success.
Quality companies bought at rich valuations are good for investors only with hindsight - there are companies which were deemed quality and they then faltered. 

This post on Farnam street and the video in it makes me think of:
1. The effort it takes into becoming better and eventually, great.
Zuckerberg was lucky and brilliant.
Most of us are not.

2. The effort it takes towards creating an enduring corporation
Unless one has a brilliant product or service, it takes a lot of human power and ingenuity to create an organisation that succeeds. Read Dream Big - the story about 3G Capital.
Buffett started super early, was super smart and incredibly focused - and even then he made countless mistakes.

And here we are. Children of the internet age.
We believe that if we read a few books, and read letters written by great investors, we can find outstanding companies and compound capital for many years.
We believe that 1-2 years into the business, we will have garnered a lot of information to make our decisions sound.

Focusing on the long term, and staying away from stories of greatness and potential treasures - companies that go 10x in 2 years - go a long way towards ensuring long lived success.

Btw, I had said no to Avanti Feeds 2 years ago at 100 a share because the risk of the company going kaput was too great. Was I right or wrong?
It's at 1100 a share today, and worth more than 1000 Cr.

The fear of something big and bad

I have harboured concerns over China's growing bad debt problem/ credit bubble for over 2 years now. A recent quote cited by Prem Watsa is important:

Only 1 in 100 survived the 1929–1932 debacle if one was not bearish in 1925.

This was said by Ben Graham.

Prem Watsa has had a problem with global easy money and China's growing credit balloon. He is 100% hedged on his equity and recently, oddly, sold quality companies like Wells Fargo, J&J and US Bancorp from his portfolio to cover his massive short position on indices. He is also covering his company's ass against deflation.

And deflation seems to make sense when one thinks of the China's appetite for a lot of commodities diminishing very soon - there is a reasonable amount of consensus that for the last few years China had been importing some commodities just to avail of either stocking up or using it as collateral to finance more imports in a weird sort of ponzi scheme.

I recently read a very nice, short book called the One hour China book which explains a lot of what is happening there. The parts on manufacturing scale and the shadow banking system via trusts and wealth management products and loans made by state level organisations are very interesting.

Time will tell whether the China credit balloon will deflate over 10 years or more, or in a crazy implosion that will cause a severe recession in that country - and of course, the world as a result.

All that said, WB has often cited the uselessness of investing based on macro events.

But the ultra cautious - Klarman and Watsa are quite paranoid right now.
Things dont seem to make sense.

Addendum:
It's not often that Druckenmiller talks.
Talking about the Fed policy, basically saying that there is no systemic crisis but the ZIRP has to end now coz there is no need for it. And going by history, this policy will cause problems later.
Of course, he too says that despite compounding at 30% + for many many years, he was certain that the 1987 crash would lead to a depression.

Portfolio Management

When you're hunting for elephants, don't get distracted with rabbits.

This may be one of the most important topics for a fund manager.
I have read a lot in a short span of 2.5 years; after all, it's only when I stand on the shoulders of giants that I can see far.

I have noted that value investing is a tricky business, not because it's difficult - hell, it's easy to find a few bargains - but conviction, patience, gumption and controlling one's behaviour is mighty difficult.

Seth Klarman, Bruce Berkowitz, WB, Prem Watsa, RJ, JM Eveillard, Howard Marks, Leucadia and Markel guys, Mohnish Pabrai have been the main contributors towards who I am becoming.
And they dont talk much about diversification, rather, they talk about focus.
A focus on moats and the price you pay.

And then they say, dont invest in too many companies.
Because you definitely cant believe that you will make as much money on your 20th best idea as you will on your best or 2nd best idea.
I never understood a portfolio with more than 30 companies - Peter Lynch spoke often about his 1000+ companies, and I was baffled. How can this make sense?

Good, quality companies are hard to come by, and the essence of diversification lies in the ability to sell a company that is well-priced and buy another which is poorly priced.
May be it also keeps your brain more active.
And then, you run the risk of not putting enough money into a Berkshire Hathaway in the 1970s for example.

My concern is:
What if I find a company trading at 3x earnings/ cash flow/ whatever floats your boat - and I invest a princely 2% of my portfolio in it?
And what if I invest in another company at 8x, another 2%?
And what if the prospects of the cheaper company are better because of its odd moat?


The chief risk with over-sizing is highlighted by Mohnish Pabrai and his investment in Delta Financial. A 100 year storm tore down the business, and his investment went to zero.
But his concentrated quality portfolio still allowed him to keep compounding thence.


Finding a mispriced security is based on maths and knowledge and experience.
Structuring and controlling your portfolio can be based only on a checklist and what one is comfortable with - hence, art.

Pabrai, marketing, relationships and today

Longevity is more important that a short lived, sudden success.

Am currently watching Pabrai talking about Marketing and human relationships. One would think that someone in the stock market shouldn't care too much about the seemingly thoretical subject of marketing.
But, everything adds up.
For example, I can well imagine why Bajaj Auto will succeed where Hero will become mediocre.

Also talks a lot about cloning in businesses. It's fantastic to copy; somehow kids in India are more than happy to do so, but as grown-ups, they find it demeaning. 

In other news, there is a sudden bout of euphoria in the Indian markets because Narendra Modi will be India's next Prime Minister. Let's see what he does.
Meanwhile, I refuse to buy things based on prospects and at a price above my understanding.

There is a beautiful Seth Klarman quote.

“…conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.”

I think I am currently there right now. 

Price Actions

It's odd that one feels better with a paper gain than with a paper loss.
Particularly, when the underlying companies have similar performance, and potential prospects.

No wonder Buffett once said at an interview with the FCIC "... price action alone starts dominating people's minds."
Those words stuck with me, and now I see the gravity of the statement.

The potential of a value trap, the gnawing feeling of envy, and the doubt about an investment decision, all, after a period of time, are influenced by an asset price.

It is then that one has to sit back and question whether the mistake is in one's decision or in the markets'.

Mr. Market is there only to guide you, not to influence you.

I read this, and I spoke about this, but it is only in the face of exuberance that one questions one's judgements.

So many value investors

It's fun to see so many value investors out there who tend to focus on a company's moat and its growth potential. I find it odd that the word 'moat' has become so prevalent now, it seems that many companies have a moat.

People forget that a moat has to be wide, with crocodiles and Arnold Schwarzenegger in it (and Justin Bieber).

Anyway, I write today to emphasize the need for a margin of safety if one wants to be called a value investor. A margin of safety dictates that in the face of a downturn, the business is capable of withstanding the slowdown/ shock and then, able to realise its potential value.

In good times, investors forget about the margin of safety and conveniently account for that in terms of the growth of the company; said company shall grow, and in face of growing cash flows, my investment becomes safer.

It's easy to see the global potential for air coolers vis-a-vis air conditioners, but air cooler manufacturers may not be able to hold on to pricing pressures.
Consumer good manufacturers will compete with each other in a growing pie of the African and Asian and Latam continents, but only the best will be victorious.

Sanjay Bakshi recently wrote about the beauty of quality companies and how some of them have managed to deliver returns to shareholders even if shares were purchased at seemingly high valuations in the past. But very simply, people are focusing on the winners and not the losers. One could pick a potential good quality company today, and buy it at a good price, only to see it becoming Dexter Shoes, facing regulatory issues, or management issues.

Good quality companies are difficult to determine, and even when one finds such a company, what price allows for a margin of safety? Does a Bajaj Auto at 16-19x and 40-50% payout qualify as a good company with an adequate margin of safety? I think so - it's one of those rare beautiful companies. But does that make it a good investment today?

A rising tide lifts all boats. It is time for caution and hold on to that life vest.
Am afraid of Canada, China and Japan.

Mistakes

It's important to chronicle one's mistakes; it's humbling, humiliating and growth inducing.

People prefer talking about their winners, but it's the losers that one ought to worry about.

Luckily, position sizing helps with understanding the actual performance in a portfolio.

I bought Zylog Systems around the beginning of 2013. 

Of course, I have my original investment note citing a pure behavioural and Graham play.

There's a press release by the company saying nothing unusual is happening, and it is business as usual. This was when the share price was falling drastically, lower circuit after lower circuit.

" On the other hand the Promoters of the company have been buying and increasing their stake in the Company"

- Press Release.

I saw the balance sheet and said:

" Unless there is a fraud, I make money. " - this was at a share price of 73.

I did some background check on US visa applications, linkedin profiles, the canadian subsidiary (does it actually exist) and it did.

And then, there was some sort of a fraud; haven't been able to decipher what really happened. 

But, something wrong with receivables and the promoters used company money to buy shares in their own names.

So, there we go.

My hurry to invest and my disregard for potential fraudulent activity, caused me a few % points.

Lesson:

• Take it slow.
• Understand the downside
• Make sure you believe in the management
• Graham net-nets are quite a waste of time
• Spend more time on finding quality companies
• Understand the mistakes of others.

Mistakes of others:

• Dexter Shoes
• MTNL
• Cort Furniture
• Delta Financial
• US Air
• Berkshire Hathaway (original)
• General RE
• Renuka Sugar
• Bajaj Hindustan
• Suzlon

Lessons from Mistakes:

• Understand debt and debt covenants/ restrictions
• Understand industry changes
• Regulations have a tendency to kill companies
• Un-understandable liabilities are a pain to work with
• Can this business be seriously challenged?

I wrote this post after much deliberation, and based on the 2007 Berkshire letter where Buffett writes about his mistakes in "The good, the bad and the gruesome".