QAAP/ GAAP

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.

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Behaviour As An Edge

“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:

  1. Operating only in businesses that one honestly understands and having a sense of their intrinsic values.
  2. Remaining humbly aware of multiple possibilities including our own folly and therefore buying with a margin of safety.
  3. Understanding that (a) intrinsic values are less volatile than price, and (b) emotions revert to mean.
  4. 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.
  5. 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.

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Assessing Demonetisation’s Impact on Indian Equity Markets

“The more things change, the more they remain same”

Jean-Baptiste Alphonse Karr

In a surprise move India demonetised 86% of its currency notes (by value) recently. Given the current size and complexity of Indian economy, there are limited useful precedents to reference its possible impact on markets and investment landscape.

Criticisms of the current demonetisation hover around the fact that demonetisation per se is an inefficient tool to curb black money. It would, however, be unwise to assume that demonetisation will be a standalone episode. There may be further actions to take India on a path of a tax paying and cashless economy.

However, the kind and extent of future measures to curb black money remains uncertain. Hazarding a guess on long term impact on markets therefore remains an arduous task. Given this uncertainty, a probabilistic decision tree approach (possible scenarios and their probabilities) may be right way to think about possible impacts on markets.

Let’s start by an extreme first hypothesis: a 100% tax paying economy. And try to imagine the impact such India will have on its markets. Of course anything less than 100% will dilute the impact commensurately.  We may then proceed to contemplate the probability of this hypothesis coming true.

Aggregate demand is the most critical driver of long term market performance. And money, black or white, is a prerequisite of demand. What we call black too creates its own consumption and investment demand and supports many sectors, their employees and their supply chain.

Take for example real estate. A house needs over 50 agencies – cement, iron, steel, paints, plastic, sanitaryware, ceramics, furnishing, electrical fittings,  etc. All these agencies have their own vendors (for materials and machinery). Further, all these participants in turn have their own employees. In addition, rising real estate prices creates wealth effect and promotes consumption spending. Real estate, thus, has a huge economic multiplier effect.

Few more industries, in addition to real estate, that have prospered from demand generated by black money include  gold, offshore investments, luxury goods, leisure, entertainment, travel, and apparel to name a few. A large informal sector thrives simultaneously with formal economy largely due to tax evasion. These all are industries in themselves that have their own ecosystem of employees and suppliers. It will not be wrong to say that curb on black money should affect all these ecosystems materially. A curb on corruption in China, for instance, significantly affected sales of luxury watches. But before we conclude destruction of wealth in these sectors we need to see mitigating factors.

With curb on black money, large portion of wealth will flow from above sectors to the financial system in from of bank deposits and to government in form of taxes.

Money moving from dead investments like gold and real estate (land) to formal banking channel for further lending may seem like a positive impact of demonetisation. Before cheering, however, we need to subtract two negative consequences: one, the forgone consumption demand generated by wealth effect of rising prices and two, the demand loss from the ecosystem displaced (jewellery, real estate brokers, farmers’ wealth etc). Moreover banking system has its own lending inefficiencies as seen from past bad loans (NPAs).

This leaves us with the windfall going to the government. The way government spends that money, therefore, will have important counter balancing effects on economy and markets.

Let’s present our second extreme hypothesis: government will use the money in the best way. That means government will spend the money on projects that can have multiplier effects: infrastructure (roads, railways, airports, seaports, power etc.), housing for all, tourism, and direct benefit transfers under aadhar.

Displacement from real estate due to curb on black money can easily be counter balanced by public spending on infrastructure and housing. Additionally, infrastructure investing can save time and costs for all businesses.

Tourism is another sector that offers huge potential of job growth and catalysing local economies, not to mention accretion of useful foreign exchange. Countries endowed poorly with natural resources have used tourism to great mitigating advantage.

Aadhar linked subsidies can direct resources directly in hands of left out sections of economy in a leak-proof and efficient manner and sustain their demand.

If the above steps lead to kick starting a multiplier effect and tax buoyancy, government may go ahead and reduce tax rates to further put cash in the hands of people giving further boost to aggregate demand If this second hypothesis turns out to be true, the mitigant effects will be powerful enough to create an overall positive long term impact for economy and markets.

Government – the chief actor

We can see that in a white economy, government becomes the chief actor and its actions will decide long term impact on markets. Unless the government acts right, a move to a white society will not alter behaviour and fail to make much impact on markets. Let’s explore possibilities.

Take for instance real estate transactions where there is a marked difference between market values and guideline values. Unless this system migrates to one used in developed world, how will current practices change?

Take next the tax and judicial administration. Most tax evasion happen by way of understatement of sales and/or overstatement of expenses. In a fiercely competitive business environment, tax evasion led profit margins soon force all players to resort to the same. The administrative and legal machinery somewhere lets them get by. We thus move into the territory of reforming tax administration and judicial system– two of the most challenging reforms.

Infrastructure – one of the best options for public spending – has issues too. Government will need private partnership to do that. Past successes of PPP (Public private partnership) have been limited owing to issues in land and environmental clearances, lack of appropriate risk allocations, mistrust between parties and populist considerations. Focus on low cost bidding has also led to problems of quality and financial viability. While none of these are non-solvable issues, need is of the right mindset and efficient execution.

Thus for citizens to pay full taxes, major reforms are needed in public administration, judicial machinery and real estate regulations to name a few. Realism will dictate us to assign only small probabilities to these issues getting addressed soon. That leaves lot before India moves to a 100% white economy.

Thinking about another extreme side of the argument: if government fails to make best use of the windfall, a white economy will be slightly negative for markets.

High probability is of both hypotheses coming only partly true: a partially white economy and partially efficient government machinery. Such scenario would best be neutral for markets in long term. There will be costs to some sectors in the long term but those would be partly mitigated by government actions. Life would remains as usual!

Disclaimer: This article’s scope is limited to discussing demonetisation’s impact on markets. In no way does it underestimates the positive social, geo political (terrorism and counterfeit notes) and political impacts of this move. Democracy discourages bold decisions with short term pains and long term gains, for the next government may take the credit! The dare, we believe, needs a thumbs up.

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Owners’ Manual

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.
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Human Diffuculties in Value Investing

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

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