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.
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.
- 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.