Tribute to Charlie Munger

July 13, 2024 No Comments

“Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.”

-Charlie Munger, 1924 – ∞

Charlie Munger, partner of Warren Buffett, passed away recently at the age of 99. Warren credits Charlie for the mindset shift and phenomenal track record of Berkshire Hathaway. Charlie’s teachings have had an important impact on our thoughts and behaviour as well. While it is difficult to do justice to cover it all here, but as a token of tribute, we take a shot at sharing some of his worldly wisdoms around thinking, living and investing better:

Better Thinking

Lifelong multidisciplinary learning: “To a man with a hammer the world looks like a nail”.

Munger said that a single discipline often lacks tools to look at the world holistically. Having key mental models from multiple disciplines – compound interest from Mathematics, margin of safety from Engineering, natural selection from Biology, breakpoint, tipping moment and autocatalysis from Physics and Chemistry, behaviour from Psychology and many more – give better tools to analyse problems or opportunities. For eg. Economic theory predicts that demand falls as price increases. However psychology provides exception to this rule– often high prices of certain products indicate their exclusivity and in turn increase their demand.

Read read read: “In my whole life, I have known no wise people who didn’t read all the time – none, zero. Spend each day trying to be a little wiser than you were when you woke up. I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

The road to better thinking and learning is to read. Munger read in truck loads across diverse topics. Buffett said that Munger has the best 30 second brain, he can think about the answers before the question ends. Munger admits that he is able to do this because of hours of study and analysis that has gone into forming opinions on wide range of topics of general importance. Those who keep learning will keep rising.

Seek to invalidate: “Any year that we don’t destroy one of our best-loved ideas is probably a wasted year. Recognize reality even when you don’t like it – especially when you don’t like it.”

Seeking to invalidate long held incorrect beliefs is necessary to progress. The key is not to ignore disconfirming evidence but to embrace them. Munger gave example of Charles Darwin (father of the theory of natural selection), who trained himself to intensively consider any evidence that went against his hypothesis.

Human Biases: In his famous talk “Psychology of Human Misjudgement”, Munger shared 25 human tendencies/ biases that lead to judgement errors. An awareness about them can reduce errors. Here are a few popular misjudgements:
1. Incentive caused biases: it is difficult to do something that goes against incentives. For eg: AUM based fee or brokerage will lead to asset gathering or portfolio churn respectively.
2. Reciprocity bias: tendency to return favours and disfavours. For eg: releasing favourable equity research reports in exchange for investment banking deals (IPOs, M&A, block trades etc.).
3. Liking/ loving bias: tendency to ignore faults or grant favour to those liked or loved. For eg: getting investment opinions influenced by good looking/ presentable top management of a company.
4. Confirmation bias: tendency to look at facts selectively so as to support already held beliefs or conclusions. What a man wishes, that also will he believe. For eg: overlooking bad news around owned stocks.

Better Living

Invert, always invert – “If you want to achieve X, find how to avoid non-X. Invert, always invert. To live a good life, find how to live a bad life and don’t do it. All I want to know is where am I going to die so that I donot go there. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Track Record: “I think track records are very important. If you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world. Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.”

Work/ Career: “Three rules for a career: Don’t sell anything you wouldn’t buy yourself. Don’t work for anyone you don’t respect and admire. Work only with people you enjoy.”

Happiness: “Avoid envy, avoid self-pity, avoid resentment and have low expectations.”

Mistakes: “A meaningful life cannot be lived without making mistakes (corollary: pursuit of returns higher than risk-free rate will invite chances of mistakes). But try avoiding fatal ones by first learning from others’ mistakes.”

Better Investing

Below are few useful thoughts that Munger has shared on investing:

All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock. (inference: growth and quality are components of value)
A great business at fair price is superior to a fair business at great price. (Warren Buffett attributes the shift of his style and resultant success of Berkshire Hathaway to this one secret.)
There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash —and I don’t want to go back.
We have three baskets for investing: yes, no and too tough to understand.
The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, which can be very long, they don’t. It’s just that simple.
I want to think about things where I have an advantage over others. I don’t want to play a game where people have an advantage over me. I look for a game where I am wise, and others are stupid. And believe me, it works better. God bless our stupid competitors. They make us rich.
How could economics not be behavioural? If it isn’t behavioural, what the hell is it?
Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.
Understanding both the power of compound return and the difficulty of getting it is the heart and soul of understanding a lot of things.
It’s (investing) not supposed to be easy. Anybody who finds it easy is stupid.

Book suggestion: Those interested in reading more about him can start with Poor Charlie’s Almanac

Investment Process, Value Investing

Temporary Hardships

July 12, 2024 No Comments

Good businesses seldom trade at bargain prices. However some times, very rarely, they are struck by adversity that hurts earnings. In our experience the immediate price reaction to any sudden negative development for good business is mostly negative. If on a calm analysis we can conclude that the hardships are temporary and less impactful than the price has discounted, such bloopers can be a good opportunity to pick good businesses at good prices.

The obvious mistake that can be made is to misjudge permanent hardship as temporary, and structural headwinds as cyclical shifts. The only antidote against making this mistake is a sound understanding of the business and its industry.

MCX fell 84% in 2013 when NSEL fiasco came to light. Muthoot Finance fell 63% in 2013 after gold prices fell 20% and RBI imposed 60% LTV requirement. Inox Leisure fell 36% in 2018 when a PIL was filed to allow outside food. Canfin Homes fell 65% in 2018 after Canara Bank failed to sell its 30% stake at its desired price and IL&FS default further affected sentiments towards non-bank lenders. These were temporary hardships where we remained invested and/or added further and have been rewarded well.

Dish TV fell 80% due to Jio aggression and OTT popularity. DB Corp too fell 80% despite high cash generation and growing in circulation due to threat from internet. These are permanent hardships and we had to exit at par in former and loss in latter.

So long as demand continues to remain robust, business debt free or has access to capital, raw material or end product prices are cyclical, and remedial measures remain in control of management, the hardships are temporary.

However if there is challenge to long term sustainability of demand, or new technology brings in better and/or cheaper solutions hardships are permanent.

Curiously temporary hardships have higher visibility, permanent hardships are less noisy. Management and media miss the latter or hope it to be temporary. Nonetheless, ability to distinguish between the two can be profitable. Wherever prices misjudge the hardship to be permanent, it can be a good buying opportunity.

Macroeconomics, Quarterly Update, Value Investing

Letter to Investors – Jun 2022 – Extracts

July 8, 2022 No Comments

EXECUTIVE SUMMARY

Trailing twelve months’ earnings of underlying portfolio companies grew by 17%.
NAV fell by 8.2% YTD (Apr-Jun) with 62% funds invested. NSE Nifty 50 and Nifty 500 fell by 9.1% and 9.7% respectively.
Inflation is high globally and money supply is getting tighter, bringing in much missed sanity to asset prices.
Being prepared for this, we are investing our above-average cash reserves gradually. Valuations are still high in some pockets.
Stance: Neutral

Dear Fellow Investors,

It was the best of times, it was the worst of times

-Charles Dickens, The Tale of Two Cities

Rising global inflation and resulting tightening of liquidity has pulled global markets including Indian equities lower. While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention.

Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable rate of return. Inflation can adversely affect all the three elements of this value equation – (1) profits, (2) investments in working capital & fixed assets and (3) expected reasonable rate of return (aka cost of capital).

Profits – When revenues fail to increase as fast as costs during inflation, profitability suffers. There are two antidotes to this– (a) raise prices, and/or (b) control costs. There are many nuances to each of them.

Companies that sell unsubstitutable necessities such as staples, utilities etc. can raise prices without material effect on volumes. Inflation raises output prices for commodity producing companies (steel, copper, aluminium, oil etc.), but the benefits are temporary due to cyclicity – higher prices reduce demand and/or attract new supply that cool prices. For lenders, interest rates on loans are reset faster than cost of deposits and supports margins. Industries with low spare capacity can raise prices in near term without materially affecting volumes. On the other side, often regulatory caps on pricing can become a deterrent. If end consumers are seeing strain on their budgets, they will try to delay, substitute or downtrend. However, companies serving higher income consumers may be hit less.

On cost side, companies with high operating margins can maintain absolute profits without large increase in output prices during inflation. Illustration: if revenue is 100, operating cost is 30, then operating profit is 70 (and operating margin 70%). If costs rise by 10% to 33, just a 3% rise in sales price to 103 can protect absolute operating profits of 70. Whereas if the operating margins are 30%, a 7% rise in sales prices will be needed. Continuing on costs, companies with high operating leverage (high fixed costs) can see rise in margins with rise in volumes (rise in fixed costs is slower than rise in volumes and improves margins). Lastly, a lower cost player can breakeven when others in the industry bleed and can get stronger as competition dwindle.

Finally, if inflation leads to rise in interest rates or currency depreciation, companies with high debt or imports can see sharp rise in their interest and forex cost, that can further hurt profits.

Investments – Working capital and capital expenditure (capex) rise with inflation. Rising input prices increase investments in inventory, and rising output prices increase receivables. Some of this is negated by rise in payables. Dominant companies who can keep low inventories, receive dues faster from customers and delay payment to vendors can keep working capital low. Capex heavy businesses are worst hit during inflation. Maintenance or new capex rise in line with inflation. The rise has to be paid out of profits and this reduces free cash that can distributed to shareholders. Capex and working capital light businesses are best saved during inflation. Services are generally less investment intensive than goods. Companies where large capex is already done will also be less affected by inflation.

Discount Rate: Central banks usually raise interest rates to control inflation. This raises the hurdle rate that risky investments like equities should deliver. A higher discount rate reduces present value of future cashflows. There is no running away from this for any company, but loss making companies with back ended cashflows are hit more. Higher discount rates should make us wary of paying high multiples even for strong companies. Keeping other things constant, what was deemed fair at 30x earnings during low inflationary period can become expensive during high inflation.

For a given company, the net effect of inflation on all three variables – profits, investments and discount rate – need to be studied together to understand its investment merit. High points on profitability and/or investments may be nullified by low points due to high valuations. Moreover, short term effects need to be separated from longer term effects. Pricing tailwinds for many commodity producers may be cyclical. Stronger companies may sacrifice margins in near term to capture market share from weaker ones. In short, assessing impact of inflation on intrinsic value is little messy and we need to err on the side of caution. This means accepting that the sub set of companies whose intrinsic values may rise during inflation is very small.

By threatening to adversely impact cashflows and discount rates, inflation has arrested the unidirectional worldwide rise in asset prices. This is the bad part. However after two years, barring a few sector/ companies, valuations in many of our coverage stocks are coming back to reasonable levels. This is the good part. We are changing our stance from cautious to neutral.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Portfolio	YTD FY23	FY22	FY 21	FY 20*	Since Inception*	Outper-formance	Avg YTD Cash Bal.
CED Long Term Focused Value (PMS)	-8.2%	14.9%	48.5%	-9.5%	41.7%		38.0%
NSE Nifty 500 TRI (includes dividends)	-9.7%	22.3%	77.6%	-23.6%	49.8%	-8.1%	NIL
NSE Nifty 50 TRI (includes dividends)	-9.1%	20.3%	72.5%	-23.5%	44.3%	-2.6%	NIL
*From Jul 24, 2019; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

As shared in recent past letters in the backdrop of high valuations, our efforts have been to fall less. This quarter we have started to see small progress towards that. Versus Nifty500 we have fallen less by 1.7%. What gives us satisfaction is that for capital that was introduced in last twelve months (a period of high valuation), the weighted average marked to market loss is 0.5% versus Nifty 500’s loss of 7.9% in the same period.

Our minimum objective is to beat inflation on every incremental Rupee that we invest. At one stock price this is not possible and we wait. And at another it looks possible or even better and we act. We will continue to be guided by this principle.

A2. Underlying business performance

Past Twelve Months	Earnings per unit (EPU)²	FY 2023 EPU (expected)

Mar 2022	6.2¹	6.5-7.5³
Dec 2021 (Previous Quarter)	5.9
Mar 2021 (Previous Year)	5.3
Annual Change	17%
CAGR since inception (Jun 2019)	10%
¹Last four quarters ending Mar 2022. Results of Jun quarter are declared by Aug only. ² EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. ³Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above.

Trailing Earnings: Trailing twelve months Earnings Per Unit (EPU) of underlying companies, grew by 17% (including effects of cash equivalents that earn ~4-5%). This was in line with our start-of-the-year expectation. In Jun 2021 letter, amid very high uncertainty, we had pegged the FY22 expected EPU at Rs 5.8 per unit. Actual EPU has come at Rs 6.2.

1-Yr Forward Earnings: We introduce estimate for FY 23 earnings per unit at Rs 6.5-7.5 per unit. This wide margin is an acknowledgement of difficulty in predicting earnings during inflationary periods.

A3. Underlying portfolio parameters

Jun 2022	Trailing P/E	Forward P/E	Portfolio RoE	Portfolio Turnover¹
CED LTFV (PMS)	22.9x	20.2x	17.4%	1.4%
NSE 50	19.5x²	–	15.6%³	–
NSE 500	20.1x²	–	14.1%³	–
¹ ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. ² Source: NSE. ³Source: Ace Equity. ⁴Trailing Twelve Months.

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

There were no new mistakes to report this period. We continue to remind ourselves of our past mistakes:

From our two past mistakes- “Cera Sanitaryware” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy.

B2. MAJOR PORTFOLIO CHANGES

We added to our existing positions in four companies. Additionally, we trimmed our position in one company in some over-weight portfolios.

B4. FLOWS AND SENTIMENTS

Sentiments and flows continue to remain weak due to fear of monetary tightening and interest rate hikes required to cool down inflation that has crossed 8% in the US and the Euro Zone. Yields of 10 year US government bonds are up from 0.5% in Aug 2020 to 2.9% as of this letter. At 7.04%, India’s inflation has remained above RBI’s target of 6% forcing the RBI to announce out of schedule hike in policy rates of 0.4%.

Suddenly, the world that has been awash with liquidity is finding capital getting costly.

In the US, Tech heavy Nasdaq Composite index is down 32% from its recent highs. Morgan Stanley’s unprofitable Tech Index – an index of loss making tech companies – is down over 60% percent since the start of 2022. Covid darlings like Peleton, Zoom and Robinhood are down 80%-90% from their Covid highs.

IPO pipelines have dried up in the world including India. Private equity and venture capital funds including biggies like Sequoia Capital are advising their investee companies to change their focus from growth to profitability and cashflows. Many startups have been giving ESOPs to attract talent. With stock prices falling sharply, and ESOPs are no longer attractive, hiring cash costs will rise for startups at the time when capital is not easy to raise without downrounds. Startup layoffs are rising.

Total market capitalisation of all crypto currencies is down from peak of 3trn$ to under 1trn$. Bitcoin’s price is down from 60,000$ to 20,000$. Tokens like Terra and Luna have collapsed and Celsius has halted withdrawals (so much for de-centralised currencies).

In India, FPI (foreign portfolio investors) outflows have crossed 33bn$ in last 9 months since Oct 2021, highest ever. Infact, monthly FPI outflows of May 2022 were just 10% lower than Mar 2020 when markets fell over 30% (In May 2022, markets fell 4%). Thanks to continued retail inflows especially through domestic mutual funds the FPI selling has not caused as sharp a selldown as in the past.

In short, while retail enthusiasm remains intact, the general mood has turned from euphoria to caution. We like that.

C. OTHER THOUGHTS

Imagining a different world

If we dial back back a year, US 10 year G-sec were 1.3%, inflation had been below 2% in the rich world for over 11 years and capital was abundant. Tech businesses scaled massively and their stocks galloped at an unprecedented pace. New concepts such as SPAC, Crypto and Unicorns became popular buzz words. Capital was a moat. First mover startups with capital backing kept on growing despite losses. It was difficult to fathom a world of capital scarcity, rising inflation or disciplined valuations. Yet imagining a pause or reversal was an important part of an investor’s toolkit to control risk.

Cut to today, most of those unimaginable things have turned to reality. Inflation is above 8%, US 10 yr bonds are at 2.9%, and capital has become cautious. Tech stock, Crypto, SPAC and Unicorns are looking weak. If capital dries up it will be difficult to see loss making startups commanding multi-billion dollar valuations. Discipline capital spending and sensible valuations are making a comeback. And if this will continue for few quarters more it lead to an exact opposite situation to the one described in previous paragraph. Lower inflation, lower interest rates, growth, will look impossible. Yet imagining them to reverse in some point in future will be an important part of an investor’s toolkit to grab opportunities.

Most things in business including growth, margins, capital availability and valuation multiples turn out to be cyclical. Investment risks can be reduced if (a) we can understand where we are in the cycle and (b) we can position for gradual reversal of the cycle. This involves going slow when bottom up valuations donot makes sense and going fast when they do. We have traversed the first part by being cautious for last 18 months and keeping high levels of cash (often looking foolish). We need to be ready for the second part!

The right discount rate

As we discussed in the opening section, intrinsic value of any asset is the present value of its future free cashflows discounted at an appropriate discount rate. The appropriate discount rate should be the realistic return that one expects from investing in that asset. Such expectation is shaped by returns on risk free instruments of similar maturity. An equity share is a long dated asset, good ones are perpetual. Many great companies are in existence for over 100 years (For eg. Coca Cola, Unilever, P&G etc). In India, the longest dated risk free instrument is the 30 year government bonds. Their current yields are 7.5%. Given that equities are riskier and longer dated than this, we need to add some spread to this. Indian equity discount rates, thus, should be above 7.5% currently, but how much above is a matter of judgement.

Financial theory tries to use past volatility to arrive at this number and involves needless mathematical jugglery. We use a 10% discount rate for quality businesses and keep raising this for lesser ones. Mind you, present values are very sensitive to discount rates. A fall of 1% in discount rates, raises the present value of a 30 year cashflow stream growing at 5% annually by around 11%-13%. Without mathematical acrobatics, our practice is to use a high discount rate. If the business looks fairly valued leave alone cheap at that rate, we become interested.

***

As always, gratitude for your trust and patience. Kindly do share your thoughts, if any. Your feedback helps us improve our services to you!

Kind regards

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Suraj Fatehchandani, Sachin Shrivastava, Sanjana Sukhtankar and Anand Parashar

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Disclaimer: Compound Everyday Capital Management LLP is SEBI registered Portfolio Manager with registration number INP 000006633. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This transmission is confidential and may not be redistributed without the express written consent of Compound Everyday Capital Management LLP and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Reference to an index does not imply that the firm will achieve returns, volatility, or other results similar to the index.

Investment Process, Value Investing

QAAP/ GAAP

December 22, 2019 No Comments

Many investment styles – along the continuum of growth and value – go in and out of favour periodically. Success of one style sows the seeds of its own failure. When many investors adopt that style, the price rises way beyond most optimistic estimate of value.

One such style that has done well in recent years has been QAAP – Quality at any price or GAAP – Growth at any price. Rising flows and sombre economic outlook has led money to be hidden into few proven names that are perceived to have moats, growth, high returns on capital, charismatic management, and long run way.

Sure, there are a minority of companies that deserve paying up. We too have paid and remain ready to pay up for such exceptional businesses. But the base rate (past experience) of high earnings growth (30% or higher) for long period is very small.

Of 1326 listed Indian companies that existed and were profitable 20 years ago in the year 1999, two-third of the companies grew their earnings at less than 15% CAGR (cumulative annual growth rate) over next 20 years. And only 6% of companies grew their operating earnings at over 20% CAGR in the same period. Moreover, companies that grew over 20% CAGR in initial years saw their operating earnings growth falling to an average 10%. (Source: Capitaline)

Despite this high bar, and despite their earnings growth slowing down in recent 6 months, over 20% of NSE 500 companies today trade at P/E greater than 40x. Often markets get into growth narrative and recent tailwinds are misconstrued as moats. Stocks start trading at astronomic valuations assuming that high growth rates will continue. Long term earnings data gives clear evidence that such expectations exceed reality. Unbridled quest for QAAP/ GAAP may be a TRAP.

Note: This piece was part of one of our half yearly letters sent to our investors.

Investment Psychology, Value Investing

Behaviour As An Edge

December 21, 2019 No Comments

“What’s not going to change in next 10 years?”

-Jeff Bezos

Internet, securities regulations and entry of talented individuals have blunted the erstwhile investment edge offered by better information and better analyses. Rational behaviour – buying below intrinsic value and selling above it irrespective of short term noise – still remains a sustainable source of investment edge. That’s because institutional compulsions and human emotions & biases force participants to eschew this rationality and create mispricing. These two factors will not materially change in next 10 years.

Institutional Compulsion: Investment behaviour of fund managers at investment institutions is driven by minimising career risk. Their jobs, promotions and bonuses depend on increasing the assets under management (AUM) which in turn depends on matching or beating their benchmarks net of fees on quarterly basis. Often unconventional and/ or concentrated stock picks cannot offer this guarantee. Therefore most of them construct ‘index aware’ portfolios – euphemism for mimicking benchmark indices. Many companies that are out of index donot find buyers and remain mispriced. Rising interest in Index Funds/ETFs (passive funds that mimic benchmarks fully without any human discretion) will further aggravate this anomaly. Further, redemptions or regulations force fund managers to sell stocks irrespective of value. Recent SEBI reclassification drove lot of money out of mid and small caps to large caps irrespective of fundamental merit.

Human emotions & biases: While good for hunting, gathering and surviving, evolution has ill prepared us to do well in investing. Fear and greed were mental shortcuts that helped our hunter forefathers survive. They ran when there were rustlings in the bushes (fear). And, they overate/ stored whenever food was in excess (greed). These genes are passed on to us as their legacy. Price fall triggers the same fear. Risk aversion rises and future projections get grim. No price is too low. Conversely price rise engenders same greed. Risk taking rises and future projections get rosy. No price is too high. Behavioural Finance has demonstrated that we are not perfectly rational. We are susceptible to heuristics and cognitive biases.

Behaviour Edge: Knowing above, following offers a sustainable investment edge:

Operating only in businesses that one honestly understands and having a sense of their intrinsic values.
Remaining humbly aware of multiple possibilities including our own folly and therefore buying with a margin of safety.
Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
Raising money and/ or investing only when prices make sense (is harder than seems) and willingness to hold cash when opportunities are thin. Our ‘zero fee and profit share only’ structure supports this behaviour.
Looking for opportunities in spaces where price discovery is still inefficient.

Rational Money: A fund’s behaviour is derived from its investors’ behaviour. We may, thanks to above reasons, find bargain securities and buy. Prices however may continue to fall even after that despite fundamentals remaining intact. Interim NAV performance may look poor. If investors panic and withdraw on those times, the paper loss will be converted to actual loss and all our behavioural astuteness (1-5 above) will amount to nothing. A fund manager can be only as rational as the money she manages.

Note: This piece was part of one of our half yearly letters sent to our investors.

Investment Process, Value Investing

Owners’ Manual

August 24, 2016 No Comments

Our Owners’ Manual represents the collective will of all our partners. As trustees of our collective wealth, firm’s managing partners will always honour the manual in designing the firm’s investing and operating actions. We owe the inspiration to create this manual to Warren Buffett.

Here it goes:

Partners’ trust is our asset, their money our liability

- We put partners first in our incentives, conduct and communication. This is not a vague marketing catchphrase. Having known the compounding power of trust, it makes an immense business sense to do so. It would be foolish to do otherwise.
- We operate knowing that partners’ hard earned money is on the line. Our investment presupposes protection of capital. And our operations presuppose frugality.
- Noble intentions should be matched by concrete actions. The managing partners, therefore, have their major portion of networth invested in this firm. We eat our own cooking.

Our long term goal is to keep increasing “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.

- We donot treat stocks as screen tickers or lottery tickets. For us a stock represents part ownership in a live business that has an intrinsic value which may be different from its price.
- By owning a stock we get to own a share in economic earnings and net assets of underlying business. By economic earnings we mean normalised earning power.
- We will do well if, in long run, we can increase “our share in economic earnings and net assets of underlying businesses” as % of our investment cost.
- Essential to seeing this happen is that we buy good businesses at or below their intrinsic values and hold them till they remain good and inexpensive (points 3, 4 and 5 below).

First key to our work is conservative assessment of intrinsic values of underlying businesses

- Stated simply, intrinsic value of any business is the present value of its future cash flows.
- To make intrinsic values reliable, we try to limit our research to good businesses that have some competitive advantages, are simple to understand and are run by able and honest management.
- Moreover, our analysis presumes that most things in business– commodity prices, interest rates, and demand – will turn out to be cyclical. We give due credit to this reality while imagining future.

Second key is to buy at or below intrinsic value

- Key to reduce the risk of permanent loss of capital is not to overpay. Good businesses are rare and situations that make them available below intrinsic values are rarer still. Such situations broadly include:
  - Out of favour business (cyclical downturns, one time difficult but solvable problem)
  - General market downturns (recessions, depressions)
  - Contrary analysis (time arbitrage, different view)
  - Disinterest (small size, index exclusion)
- Owing to this dual rarity (rare business, rare prices), often we need to sit on cash (or cash equivalents) and wait. When owing to the four factors above (i to iv), opportunities do present themselves, we bet big by limiting our portfolio to 10-12 concentrated positions.

Third key is to hold businesses till they remain good and inexpensive

- Big money is mostly made, not by frequent buying and selling, but by holding.
- If the businesses that we buy (after step 3 and 4 above) remain good and inexpensive, holding them for long term renders focus and saves costs– two essentials for benefitting from the power of compounding.

Actions driven by rationality rather than emotions

- Owing to greed, envy or fear, short term prices sometimes get de-anchored from intrinsic values.
- Execution of points 3, 4 and 5 above will require us to remember this dichotomy, and keep our focus on intrinsic values.
- By not chasing hot stocks during bull runs, we like all value investors will see temporary but reversible periods of underperformance. Bear with us during those periods. We would be conserving cash to put to use when the bubble bursts. When bubble does burst, resist selling and if possible invest more. During those periods markets go on SALE and our hard work is rewarded.
- As a corollary, it would be unwise to gauge our performance from short term price movements. We, therefore, look at changes in fundamentals to review our performance.

Reporting philosophy

- We will follow the agreed reporting format irrespective of good or bad performance.
- The spirit of the reporting format is expectations managing partners will themselves have if our roles are reversed.
- Mention of mistakes will precede mention of accomplishments.

Investment Psychology, Value Investing

Human Diffuculties in Value Investing

August 24, 2016 No Comments

Charlie Munger, the partner of Warren Buffet and Vice Chairman of Berkshire Hathaway, noted “all sensible investing is value investing”. There are volumes of research on the fact that despite richest investors like Buffett and Munger attributing their success and riches to value investing, majority donot follow value philosophy.

Theoretically, value investing involves buying below and selling above intrinsic value. This sounds simple and sensible. However as Yogi Berra quipped “In theory there is no difference between theory and practice, in practice there is”. Value investing, like many disciplines, is easy in theory but difficult in practice.

It is difficult in practice because it is contrary to normal human nature and accepted social norms at each of its four broad steps:

Assessing Intrinsic Value : Assessment of intrinsic value involves future. The uncertain terrain of future needs large doses of skepticism, objectivity and humility over optimism, group-think and overconfidence.
Buying below intrinsic value: Bargains are found amidst fear and disinterest. Owing to biological adaptation over ages, brain is conditioned to prefer flight over rational thought when induced to fright. Similarly homo sapiens have preferred staying in the comfort of popularity over the risky pursuit of contrary solitude.
Waiting: Most money in investing is made by waiting, not frequent trading. In a world where activity is looked as synonymous to progress, the notion of buying and doing nothing for days stimulates guilt glands and consequently needless actions.
Selling above intrinsic value: Price rise intoxicates human mind. It forces it to keep on dancing long after the music has stopped. Greed, hubris and envy are all at play here. It requires an objective, non-greedy mind to stop dancing before the music is going to stop.

Overconfidence, fear, safety in crowd, needless activity, greed and envy are powerful tendencies that have served some utility in human evolution since hunter gatherer days. They are hard to resist and they operate automatically.

Value Investing calls for curbing these tendencies. This is hard to do. This makes value investing anathema to us homo sapiens. Fortunately, being aware and alert to the nature, cause and stimulant of these tendencies has proved to be a working antidote for successful value investors including Charlie Munger.