Good Business Vs Bad Business for Investors? No its Just NOT dependent on HIGH ROE.


  • In no way I would like to take any claim for the below finding. The below finding stuck me while re-reading all the interviews of Mr. Bharat Shah.
  • The concept of Good Business and Bad Business is inspired from the post by Abhinav/Niren on Manufactured Luck blog here .
  • The concept of Change in Intrinsic Value is inspired from Prof Sanjay Bakshi blog post “The Final Relaxo Lecture” in which he advices us to focus on expected return rather than on intrinsic value.

In my earlier post on “What causes Wealth Destruction over Long term? Lack of Growth and ROE below 15% or High Valuations?” I indicated that

For majority of the non-financial companies [with very few exceptions] common cause of wealth destruction is when Sales/PAT CAGR or ROCE or ROE average is lower than 15%. If all the four conditions are satisfied it’s highly unlikely [though there are few exceptions especially in metals & others] that wealth will be destroyed over a long period of time [5-8 yrs]. Am nowhere suggesting that if one has a Long Term view then one can buy at any price. What I am suggesting is IF ONE’S AIM IS NOT TO LOOSE MONEY, one should invest ONLY AND ONLY if one feels that company can sustain Sales/PAT/ROCE and ROE above 15% over long term basis

In the current post I am presenting more evidence that its the lack of sustainable growth over 15% over long term which causes destruction of wealth and NOT High Valuations. High Valuations will only result in low single returns for extended period of time. I have tried to classify all business on the basis of CHANGE IN INTRINSIC VALUE rather than abstract terms like High Quality, Low Quality, Cigar Butts, Deep value, High PE, Low PE, High Dividend yield etc.

You can download my study note from here or alternatively from here

Below are the finding based on my above study:

If Long term Growth < ROE, then change in Intrinsic value is NOT equal to ROE. In this case Change in Intrinsic Value is equal to average of PAT and Book Value CAGR

Change in Intrinsic Value

For companies like Hindustan Unilever and Castrol where PAT Growth is less than ROE, Growth in Intrinsic Value depends on PAT CAGR and not High ROE [even if its more than 50%]

High ROE

To avoid Permanent Loss of Capital or Risk of Earning less than 15% Price CAGR, avoid investing in Bad Businesses. A Bad Business is any Business where Long Term Change in Intrinsic Value is less than 15% CAGR

Good Bad business

I am classifying business as good or bad purely from investors perspective. For the society as a whole a business classified here as bad might be a good business and vice-versa

Unless Intrinsic Value grows at > 15% CAGR, Buying companies with Single Digit PE will NOT result in Price CAGR more than 15%

Single digit PE

What causes PERMANENT LOSS OF CAPITAL? High Valuations or Lack of Sustainable Growth > 15% CAGR. Look for which companies are NOT PRESENT in this list and think Why?


Wealth D 2007

Companies which destroyed wealth between Dec 2007 and Jan 2016 [All companies with Market cap > 5K crs as on DEc 2007

Wealth D 2003

Companies which destroyed wealth between March 2003 and Jan 2016 [All companies with market cap of > 100crs as on March 2003

Note: See disclaimer at the end of the study note

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What causes Wealth Destruction over Long term? Lack of Growth and ROE below 15% or High Valuations?

Note: This is still a work-in-progress and am no way suggesting below finding are conclusive. Any how presenting my findings, with a view to receive some feedback.

Acknowledgement: In no way I would like to take any claim for the below finding. The below finding stuck me while re-reading all the interviews of Mr. Bharat Shah, who along with Prof. Sanjay Bakshi has influenced my thinking and investment philosophy to a great extent. But if there are any errors in below finding of-course its only my fault.

Mr. Bharat Shah says “Equity is all about growth. When the growth goes way, equity becomes a bond and bond is clearly not equity. Idea of growth is to get a compounding power, to get a value much higher than the net worth or what suggest and essentially since the equity markets thrive on growth, the idea is to hunt for virtuous market cycles where largely you will see growth sustaining”

[You can read the related post on Mr. Bharat Shah here ]

Below are my finding after studying data for 2000-16, Mar 2007 to Jan-2016 and for Dec-2007 to Jan-2016:

  1. For majority of the non-financial companies [with very few exceptions] common cause of wealth destruction is when Sales/PAT CAGR or ROCE or ROE average is lower than 15%. If all the four conditions are satisfied it’s highly unlikely [though there are few exceptions especially in metals & others] that wealth will be destroyed. Am nowhere suggesting that if one has a Long Term view then one can buy at any price. What I am suggesting is IF ONE’S AIM IS NOT TO LOOSE MONEY, one should invest ONLY AND ONLY if one feels that company can sustain Sales/PAT/ROCE and ROE above 15% over long term basis. To put it in another way, it’s highly unlikely that over Long Term one can make any real material wealth if above four conditions are not satisfied, even if one buys business very cheap. [ofcourse one can make money if one is good at Short Term trading. I am definitely very bad in Short Term trading]. In absence of profit growth above 15% even high dividend payout ratio may not help much. As Bharat Shah says “Without growth, equities are worst than bonds”
  2. Why all the above four conditions need to be satisfied simultaneously is that one cannot expect PAT to grow at 15% CAGR if sales are not expanding, it can happen for 2-3 years but not permanently. Higher ROCE is required, else it means company is maintaining higher ROE only by increasing leverage even when profit margins are declining. [Of course I am making it simple. There will be lot of other factors but my guess is that it will mostly get capture in these numbers]
  3. High valuation will result in destruction of wealth over 8-9 years only if subsequently there is collapse in profit growth /ROE. Else worse case one may single digit return but no destruction of wealth. Destruction of wealth will happen only if one pays ATROCIOUS VALUATION at the beginning…

What will cause business to sustain above four critical parameters above 15%? I have attempted to explore that in the above post on Mr. Bharat Shah and in the post on Sustainable Moat: Five force analysis is NOT Enough , Ralph Wanger- Identify LT trends, Buy Small Cap & Aim only Multi-Baggers.

This post is aimed at quantifying numerically what destroys value. I have tried to capture qualitative factors which causes wealth destruction in my earlier post on WHAT LONG TERM INVESTORS CAN AND SHOULD LERAN FROM SHORT SELLERS and in COMMON MISTAKES BY INVESTORS

Let me know if you disagree. 

Find below data for

You can go through few examples here [Still work in progress]


Posted in Investing | 5 Comments

How can we have a 100 bagger in US Home Builders which went through once in a life time housing crash?

Disclaimer:  This is not a recommendation to Buy/Sell/Hold.

While reading 100 Baggers: Stocks That Return 100-to-1 and How To Find Them I came across a US home builder by name NVR inc. I was surprised to note that it has returned 232x [including dividends] since 1992 despite the fact that home building is a cyclical industry and USA had went through once in a century housing crash during 2006-2009. Moreover, as per popular belief there are no entry barriers or moats in sector. Most of the home builders concentrate more on building land banks. So, I decided to do a detailed study of the reasons with the sole motive to learn lessons for investment in Indian real estate companies.

This study is based on publicly available information and my very limited analysis [Negative understanding of US companies and markets] It’s possible that there are some errors. This sort of study suffers from lots of hindsight bias. I believe in the principle that we should study both extreme success and failures and learn lessons from both. Of course the aim is not to find another 100 bagger in Indian Real Estate Industry but to find companies which to some extent follow NVR business model which makes them resilient to face extreme period of demand slowdown.

You can download my NVR case study of 100 bagger from here.

You can also go through extract of excellent discussion on Value Investor Club 

UK Home Builders

Another company which because of its sensible business model outperformed all its peers is UK  based Berkeley Group. Berkeley Group is perhaps the only listed UK home builder which had not reported losses even during 2007-09 housing crash.


Source: Expecting value

According to this article Berkeley group followed few rules which differ it from other UK Home Builders.

  • Leverage profile of the group – very little, particularly compared to other house builders – and the lack of cyclicality you would expect to find in this sort of company. The group has never made a net loss.
  • The assets side of Berkeley’s balance sheet actually shrunk from 2003 – 2007,by over 10%. Most of the other house builders got around twice as big over this period, leveraging up to buy as much as possible… but most of the other house builders were then too busy dealing with land impairments and credit availability to double the size of their inventory holdings from ’09 – ’14, buying when the market was genuinely cheap.
  • This is great counter-cyclicality. They’re not lazy with the money, either – in 2005, 2007 and 2008 they made substantial returns of owners’ capital [buy-back], which cumulatively totalled more than the whole share price in 2005. They were also planning to give money back in 2009 to finish their return-of-capital scheme, but politely nudged shareholders into letting them keep the money to reinvest in land holdings. [Bold mine to put emphasis]

Request investors you have followed NVR & Berkeley group closely to highlight any more reasons which I failed to notice.

Indian Real Estate

[Click on the image to enlarge]

Indian Real

Source: Ace Equity

From the above table it will be quite clear that profitability was never a problem for Indian Real Estate Industry. What’s missing is 1) Focus on Return on Assets  by proper allocation to current land needs instead of building huge land banks and 2) Maintaining strong balance sheet to enable to face inevitable slowdown. 3) Most important to find promoters who are willing to share profits with minority shareholders.

In Indian Real Estate market  there is NO Company which is following business model like NVR. If any company come close to 40-50% of the business model being followed by NVR it is 1) Ashiana Housing 2) Godrej Properties

I AM REFERRING ONLY TO THE BUSINESS MODEL of BOTH COMPANIES.  AT CURRENT PRICE I WILL NOT BUY EITHER ASHIANA HOUSING OR GODREJ PROPERTIES. [Please do not ask at what price I will buy these companies 🙂 ]. I have still few unanswered questions, as far as Godrej properties is concerned.

Ashiana Housing:

Ashiana Housing has already provided more than 100x returns in last 12-15 years. This itself make it worthwhile to study to understand why Ashiana Housing is able to creat such tremendous wealth when most of the other real estate companies has destroyed or not created any value since their listing. This in itself do not mean that it’s a buy at current price. What I am suggesting is just study the company business model.

You may find my notes helpful in your study. You can download my notes from here which has extracts from annual report and transcripts..

Prof. Sanjay Bakshi has written extensively about Ashiana Housing here and here [don’t forget to read comments section]

Godrej Properties: Though I like Godrej Properties business model, am still struggling with few questions mainly its focus on high-end housing.

You can download my notes from here 

High ROE is a common factor among NVR, Berkeley Group and Ashiana housing

I have rarely come across any report on Indian Real estate company which gives any importance to company’s ROCE and ROE. It looks as if ROCE & ROE do not matter for real estate companies. Most of the reports focus only on the NAV from the existing and upcoming projects completely ignoring the historical and prospective ROCE & ROE. I think this is completely WRONG. I strongly believe that its NOT a co-incidence that NVR, Berkeley group and Ashiana Housing which outperformed all their peers in their respective markets have high ROE. Lets see what Warren Buffet has said about this in his letters.

“Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. For years the traditional wisdom— long on tradition, short on wisdom— held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“ In Goods We Trust”). It doesn’t work that way.

Asset-heavy businesses generally earn low rates of return— rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation.

Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. Unfortunately, a few have very poor returns, a result of some serious mistakes I have made in my job of capital allocation.”

But the opposite is not true. All the real estate businesses which generate high ROE may not be equally valuable. Recall from the above, Buffet is referring to return on “Unleveraged net tangible assets” So if the high ROE is from financial leverage, then its not of much help. I have also analysed few other US listed Home Builders, where if one had focused only on high growth and RoE, would have made a wrong decision. One should realize that home building is a highly cyclical sector and companies which take both operating risk [in the form of huge land bank] and financial risk [in the form of huge leverage] will suffer deeply in case of any demand slowdown and fall in land prices.

Disclaimer:  This is not a recommendation to Buy/Sell/Hold.

Registration Status with SEBI:

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

Details of Financial Interest in the Subject Company:

I  may or may not hold any of the companies discussed above in the portfolio which I managed for my family and close friends. Please consult your financial advisors before taking any buy/sell/hold decision. I may change my opinion post publication of this note and may not be able to update because of time constraints. At current price there is NO margin of safety for the stocks discussed in this post and I will not buy any of them. 

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Some Common Mistakes by Investors

Over the last one year I attended 3-4 fantastic value investing conferences. Many of the investors had spoken their heart out and many were not comfortable sharing their presentation publicly. Hence I have omitted the company and speaker names. But this compilation of mistakes of these investors could be helpful to both amateur and experienced investors.

Whenever I meet an experienced investor, I am more interested in their mistakes and not their success stories. I believe everyone investment philosophy should be as per their personality, so it’s not possible to follow someone else philosophy. But we can learn a lot from other’s mistakes.  According to Dhirendra Kumar of fund tracker Value Research, Prashant Jain of HDFC mutual fund did not manage funds differently from other fund managers. “He just kept it simple and committed lesser mistakes,”. Read this fantastic article by Shane Parrish on Avoiding Stupidity is Easier than Seeking Brilliance to understand importance of studying mistakes.

Here is the list of mistakes shared by investors:


  • Overlooking obvious good companies because of some small wrong acts of management eg. High remuneration, preferential issues at lower price etc. Refusing to invest in micro and small cap with fantastic business model and growth because of some IGNORABLE wrong acts of management is one of the most common mistake.
  • Investing with fraudulent management
  • Don’t be too close to management


  • Despite sitting on 65% cash during 2007-08 crisis I did not have buy list. Important to have your buy list which you want to buy during correction.
  • Chasing mediocre opportunities.
  • Buying low quality cheap companies.
  • Value traps
  • Fraudulent companies.
  • Buying statistically cheap companies.
  • Buying not enough due to price anchoring bias.
  • Historically making money from leveraged company insignificant.
  • Take valuation risk and not insolvency risk.
  • Have a clear idea about where you will and will not invest. Exclusion is a more powerful idea than inclusion. Not possible to do research on all the listed companies.


  • Selling very early [This is the top mistakes of all investors]
  • Difficult to time market: Successfully exited during 2007 euphoria but entered quite early.
  • Buying and selling in one shot instead of in a staggered way.
  • Falling in love with stock and failed to notice fundamental deterioration.

Special situation

  • Despite all catalyst, in-depth research process, special situation did not play out.
  • Black Swan in special situations more common
  • Allocation most important in special situations, max 4-5%


  • Endowment bias – not listening to contrary opinion on stocks which I own.
  • Commitment bias – publicly spoken about stock – made it an ego issue – could not exit the stock before crash.
  • Maintain investment diary clearly writing reasons to buy/sell. WRITE REASONS for rejecting stocks too. When we write we think deeply and clearly. Use checklist to overcome various biases.
  • 30% of results are not correct even if audited by big 4. That’s why it’s very important to link P&L & Balance sheet to company’s business model, terms of trade and competition. One should read notes to account carefully.
  • Focus on action not on words.
  • Success breeds ARROGANCE.
  • Beware of quality traps – High valuation but low growth.
  • Ignored valuation during tech bubble and invested in stocks quoting at PE multiple of > 100x.
  • Scuttlebutt suffers from huge sampling bias. Be careful while drawing conclusion based on your interactions with ex-employees, customers, suppliers etc.

My top mistakes

  • Authority Bias: Failing to do full due diligence because stock is bought by some famous investors [Which Mohnish Pabrai calls it as cloning]. Though I have never practiced blind cloning, I have realized that when you pick up stock because some famous investors have invested in it, we tend to suffer from some authority bias. But this do not undermine the advantage of cloning. One should just be aware of its side effects. I have found some investors who refuse to invest in ideas which come through other investors and some who blindly invest in successful investor ideas. Both are bad. One needs to remember that investors are like parasites who just need to hitch on to good things. Whether you discover this good thing or it comes through someone else, really does not matter. Just be sure that its a good thing based on your due diligence and conviction. There is no place for ego in investment success.
  • Investing against my own personality -I cannot invest without indepth research but followed a widely diversified portfolio. I eloborated more on this here [Return per unit of time invested]
  • Changing investment thesis just because of increase in price – Eg. Halonix – I invested in a classic deep value out of favor stock and when price increase by 4x and it was trading at fair value, decided to “Let the winners run”. I failed to appreciate that “Let the winners run” is appropriate only for growth stocks which enjoy strong moats for next 5-7 years and not very stock. Exiting at fair value is very important in case of Graham stocks.
  • Focus on deep value rather than growth: Despite repeated reminders by many of my value investor friends I failed to appreciate the importance of growth. India is a growth market and growth stories will get re-rated faster compared to deep value. Whether one looks for growth over 2 years, 5 years or 10 years is upto each investor. But growth is a very important consideration. Now I look for minimum 20-25% profit growth over next 5 -7 years.

I would like to end this post with a contradictory thought that trying to avoid every mistake may lead to increase in errors of omission. Below is an extract from superb presentation “Moats versus Boats” by Chetan Parikh.


Request: I request all investors to share their top three past mistakes. It will benefit everyone. If you are not comfortable sharing on public platform, feel free to e-mail me at or

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My presentation at Flame Alumni meet

Disclaimer:  This is not a recommendation to Buy/Sell/Hold.

Recently I was lucky to get an invitation to make a presentation at Flame Alumni meet. Unfortunately I goofed up a bit. I was told to make presentation on my Mindmap process but I misunderstood as my Investment process. May be it was the result of over excitement over my first public presentation.

Few years back, Flame University had started a new initiative called Flame Investment Lab . I got to know about the program last year. Last year I was hesitant to attend the program because of the fees, but this year decided to attend the program. I am glad that I attended the event. The best part of this program is that you get to connect with lot of value investors who do not have any online presence. Getting a chance to interact with who’s who of Indian stock market is an experience in itself.

I will rank my presentation in the bottom quartile compared to rest of the presentations. Nevertheless I am sharing my presentation hoping that it will help at least to new investors in building up their investment process. You can download the presentation from here or from here

You can download my checklist [Mindmap] from here [on which I was supposed to make presentation] or from here

You may also want to go through Tasty Bites mindmap to understand the checklist better.

You can use Xmind free software to create mindmaps

Details of Financial Interest in the Subject Company:

My close relatives  have holding in the company. Please consult your financial advisors before taking any buy/sell/hold decision. I may change my opinion post publication of this note and may not be able to update because of time constraints

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Zen Technologies – Huge potential, but are margins sustainable?

Disclaimer:  This is not a recommendation to Buy/Sell/Hold.

Zen technologies is a micro-cap company and is engaged in manufacturing weapon and non-weapon simulators, primarily for use by armed forces, para military, police forces etc. You can read the inspiring 20 year journey of company’s managing director Ashok Atluri here.

What attracted me towards Zen Technologies is that it’s trying to solve a genuine problem of Indian Army. There is severe shortage of shooting ranges and ammunition for training for Indian Army. Even if there is no shortage, it’s not practical or advisable to use live weapon during regular training for cost reasons.

Western world is advanced in its adoption of simulators. This is what US Navy has to say “We intend to take the numbers dramatically higher in the simulator, not because it’s cheaper, but because the training is that much better”

In my review of last 10 years annual report, I have not come across any instances of misallocation of capital or any act which is against minority interest. Ofcourse there are a couple of failures like its venture into gaming industry, civil simulation market for CV/Cars etc. Management had been quite over optimist in its projections. For instance in 2005 management guided for 40% CAGR for next three years but absolute increase was less than 30% during 2005-08.

During 2001-2010 company posted average EBITA margin of more than 45% even after spending substantial amount on research & development. On average company had spent more than 15% on R&D during last ten years.  It’s a working capital heavy business, but due to outsourcing model investment in fixed asset is quite less.

Company claims to have more than 30 products, but according to my reading of annual report company could commercialized only 5-6 products till date. Other products are developed in anticipation of requirements. The total value of orders pending as on 31 March 2015 is around Rs 118.94 Cr including AMCs worth Rs 79.04 Cr. AMC’s will be executed over 5 yrs staring FY18

You can read this latest presentation to get more info

I like the business and management but unable to determine whether margins will be sustainable over next 5 years. There are lots of international and local players in the market like Alpha Design, Saab, Thales, Cubic Defence, Megitt, CAE. Even if due to Make in India policy Zen gets preference, it might be asked to match the prices quoted by international players.

You can download the compilation of annual report and peer comparison from here

Disclaimer:  This is not a recommendation to Buy/Sell/Hold.

Registration Status with SEBI:

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

Details of Financial Interest in the Subject Company:

Myself/ my close relatives  do not have any holding in the company. Please consult your financial advisors before taking any buy/sell/hold decision. I may change my opinion post publication of this note and may not be able to update because of time constraints.

Posted in Investing, Stock Ideas | Tagged | 1 Comment

Tasty Bites: An Indirect play on India’s QSR industry

This is not my original idea. I liked it when Om & Kiran explained me the business model of Tasty Bites.

Disclaimer:  This is not a recommendation to Buy/Sell/Hold. I am not a SEBI registered analyst. See at the end for full disclaimer. It’s safe to assume that I have vested interest in the stock.

Tasty Bites [TB] is an indirect play on the rapidly rising QSR industry in
India, which is growing at high double digits.  As a policy Tasty Bites focuses only on vegetarian food, as it believes there is worldwide movement towards vegetarian food. It supplies frozen foods and sauces to India’s leading QSR players like Domino’s, Mc Donald’s etc.  Tasty Bites is  a market leading player of ready-to-eat foods in USA for Indian foods.

I started analyzing this stock during mid August 2014. By the time I attended AGM and got convinced of the story, price had already increased tremendously  When I analyzed it, I thought it’s a long-term story [> 5 yrs] and price will remain flat for next few years as it will take time for the company to build scale. Nevertheless I decided to recommend my close relatives to buy their target quantity at then prevailing price. I had earlier tried my skills in timing the entry with another stock and failed miserably, ultimately ended up recommending the same at higher price.

On 15th April 2015 , Kagome, a leading food company of Japan, bought majority stake in Preferred Brands International (PBI), the ultimate holding company of Tasty Bite Eatables. Founders have not diluted their stake, Kagome bought the stake held by PE players in PBI.  Kagome acquired PBI at ~ 700crs equity valuation compared to Tasty Bites current valuation 260crs [@ INR 1,000 per share]. One can argue that as PBI sources majority of its products from TB and do not have its own manufacturing facility, even TB should trade at similar valuations. I disagree with that. In my opinion TB should first demonstrate its performance by improving ROE and sales growth before it can command such valuations. Moreover, PBI business model is asset light with all the capital cost being incurred by TB.  Nevertheless, for TB its tie up with Indian QSR companies can be game changing event, if its able to scale it up over next 3-5 years.

Kagome in its filing with exchange, has given guidance of doubling the revenues and profits of PBI over next two years compared to FY 15 forecast. As majority of purchases of PBI are from Tasty Bites, it implies that even Tasty Bites sales and profits should increase at high double digits.

Given below are the links to presentation & Mind map which I shared with few of my friends with whom I work closely [prepared long back and not updated since then]


Industry & Peers

Extracts of last 15 years annual report

Disclaimer: This is not a recommendation to Buy/Sell/Hold.

Registration Status with SEBI:

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

Details of Financial Interest in the Subject Company:

Currently, my close relatives own stocks of Tasty Bites based on my recommendation. But their purchase price is substantially lower than current market price. Current price may or may not offer any margin of safety to fresh buyers. Please consult your financial advisors before taking any buy/sell/hold decision. I may change my opinion post publication of this note and may not be able to update because of time constraints.

Posted in Stock Ideas | Tagged , | 7 Comments

What Long Term Investors Can and SHOULD LEARN From Short Sellers

Note: Unless otherwise stated, entire text in this blog post is from two books 1) Art of Value Investing 2) Art of Short Selling . David Einhorn quotes are from his book Fooling Some of The People All the Time. My comments are in italics. 

Let me make it clear at the outset that I had never done short selling nor do I plan to do in future. But I found principles of short selling technique to be equally helpful to long-term investors. For short sellers the maximum upside is 100% whereas downside is UNLIMITED. These asymmetrical returns force short sellers to be much more diligent and conservative compared to long only investors. I was surprised to note that most successful short sellers NEVER SHORT ANY STOCK MERELY ON OVER-VALUATION. I am not talking here about short sellers who short a stock in the morning and cover their position by the end of the day.  I am talking about short sellers, who after deep analysis create a position and hold on to it until their conviction pays off. 

Charlie Munger once said, ‘All I ever want to know is where I’m going to die, so I never go there’. My sole attempt at studying short selling technique is to find what successful short sellers look for in a good short and to avoid such stocks. 

Study of short selling technique helps in solving the puzzle “When to sell” & What to avoid

The point is that the toughest call for investors-even in a bull market-is when to sell. The best managers either sell stocks soon with a small loss, realizing a mistake, or sell stocks later, noting a change in prospect after gains, when prices begin to drop. Short-selling skills teach us the discipline of anxiety, of when to be scared. The analytical wisdom shows us when the numbers start to turn bad in a sacred-cow holding or which stocks not to buy at all. Individuals can employ the analytical techniques of short selling to avoid owning stocks that will explode otherwise well-conceived portfolios and to escape the new-issue frenzy of rabid retail brokers. Knowledge of professional methods of short selling saves money in the long run.

When to sell

Focus on deteriorating fundamentals rather than on VALUATIONS ALONE

Jim Chanos discussed about his firm stock selection methodology for shorting stocks during his testimony to US SEC in 2003.

Kynikos Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on securities issued by companies that appear to have (1) materially overstated earnings; (2) an unsustainable or operationally flawed business plan; and/or (3) engaged in outright fraud.

One can notice absence of any reference to valuation in the above statement. In my view, its intentional. Business fundamentals, quality of earnings and management honesty is given more importance over valuation. 

We’re not playing for a multiple reduction, or a reversion to the mean for the industry. My biggest mistakes have generally been because I stayed with shorts just because they were expensive. The multiple game is a dangerous one— valuations can be crazy and stay crazy. We typically want to see something already or soon to be going very wrong. Our best shorts in the past 10 years, in fact, have been more in low-multiple companies, where we believed the earnings were illusionary.A lot of our best shorts have looked cheap all the way down. Just because something is cheap doesn’t make it a good value. A lot of times the company can get into distress due to a declining business. That defines a value trapJim Chanos, Kynikos Associates [See Jim Chanos presentation on value trap for more examples]

We look at the same things everyone else does but with the idea that these are moving targets. Balance sheets should give you some sense of intrinsic value on the downside. On the upside, we have to worry about the unlimited potential. We look at things like market sizes and the law of large numbers, as to whether companies can grow their way out of a bad accounting situation or a leveraged situation. On the short side, the financials are often misleading. What might appear to be value sometimes is not. A book value that is comprised of goodwill and soft assets sometimes might not provide downside support if a company is troubled. Valuation itself is probably the last thing we factor into our decision. Some of our very best shorts have been cheap or value stocks. We look more at the business to see if there is something structurally wrong or about to go wrong, and enter the valuation last – Jim Chanos interview with Columbia Business School

For the most part, we avoided the damage in the short portfolio by refusing to sell short anything just because its valuation appeared silly. We reasoned that twice a silly valuation is not twice as silly. It is still just silly. Kind of like twice infinity is still infinity. Instead, we concentrated on selling short companies with high valuations combined with misunderstood fundamentals and deteriorating prospects. As always, frauds were preferred. – David Einhorn

A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. If the stock is sold short simply because of valuation, the market immediately shows how high the earnings multiple can go. Buy index puts, instead; a valuation short is no different than a market bet. If the stock is shorted because of perceived temporary problems and because of excessive valuation, good management can fix the problems fast. 

When Gurus short

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Which companies or sector or situations to avoid

Debt-financed asset bubbles

The first and most lucrative category of short ideas are the booms that go bust. Booms are defined as anything fueled by debt/credit in which the asset’s cash flows do not cover the cost of the debt. We’ve had our most success with debt-financed asset bubbles—as opposed to just plain asset bubbles— where there are ticking time bombs in terms of debt needing to be repaid, and where there are people ahead of the shareholders in the bankruptcy or workout process. The debt-financed distinction is important. It kept us from shorting the Internet in the 1990s— that was a valuation bubble more than anything else. —James Chanos, Kynikos Associates

Technological obsolescence – the old/incumbent product is usually replaced faster than the consensus believes it will be

The next category involves technological obsolescence. Economists talk quite rightly about the benefits of “creative destruction,” where new technologies and innovations advance mankind and grow GDPs. But such changes also render whole industries obsolete. Disruptive technologies have two sides and always have. You saw it in the 1980s as personal computers wiped out the word-processor and minicomputer markets. What’s playing out now is the transformation from an analog to a digital world. While that’s created great fortunes like Google’s , it’s also wiping out whole businesses. Traditional music retailing was one of the first to start going. Then came video rental. Value investors will invest into these types of markets at their peril. Cash flows evaporate faster than you ever dreamed. —James Chanos, Kynikos Associates

In fact, I’ve given some lectures on the concept of value traps. Probably our best ideas over the past ten or 12 years have been ideas that looked cheap and which actually ensnared a lot of value investors. The investors didn’t realize that these businesses were deteriorating faster than their ability to generate cash. Eastman Kodak was a great example of that. A few famous value investors were buying it all the way down because they assumed that the decline in the business would be a slow glide that would allow the company to harvest cash flows for the benefit of shareholders. The fact of the matter is that, for most declining businesses, management tends to redeploy cash flow into things outside of their core competencies in a desperate attempt to save their jobs. In the case of Kodak, they took some of their patent proceeds and cash flow and invested in a printer business, which is another declining business model. They ended up being decimated by their own invention of digital photography. When analyzing Kodak as a short candidate, valuation was almost the last aspect that we considered because, as I said, some of the best short ideas can look cheap from a valuation standpoint – Jim Chanos interview with Columbia Business School

Companies with weak moats and excessive leverage

We’re looking for companies with weakening moats, often coupled with a resulting deployment of capital into areas in which they have no competitive advantage. Even better is when they’re deploying not just excess capital, but leveraging the balance sheet to do so. —James Crichton, Scout Capital

We also look for long-term structural declines— kind of the opposite of what we look for on the long side. Wall Street tends not to fundamentally mark stocks down until bad news actually shows up in the numbers. We’ll ignore the supposed value today and focus on whether we think the “E” in a P/ E is going to be materially less in three to five years. —Ricky Sandler, Eminence Capital

Avoid blind cloning

I guarantee that in every great blow-up there has been at least one big-name investor involved all the way down. Don’t stop your work on the downside because you can’t imagine so-and-so owner making a mistake. It happens all the time. —James Chanos, Kynikos Associates.

 Emerging moats or traps

The next level of financial complexity is a concept or theme stock from companies that sell a product or service to fill a newly perceived need. By taking a cynical look at business plans, the investor can determine which of the numerous innovators might succeed and can then take advantage of brokerage hysteria and enthusiastic price inflation to sell the stock. The odds are with the short sellers: New-business statistics show failure rates far in excess of success. From the short point of view, the most important decision on a concept stock is: Does this work-is the prospective return worth the risk for the stockholder? The second question is: How soon will the new company run out of money? – Art of Short Selling.

Dead Companies Walking have few interesting examples of companies which might appear to be emerging moat at the time of investment but whose business plan itself was fundamentally flawed.

Chemtrak [Stock symbol: CMTR] only product was an over -the-counter blood test for cholesterol levels. Chemtrak’s management was much more cerebral in their approach. They had scientifically analyzed the health-care market and come up with a product they were convinced would fill an important need. The problem was, their analysis was just plain wrong. Even though heart disease is a major problem in this country, American consumers were simply not going to buy what Chemtrak was selling. Lots and lots of very smart people make this mistake. They fixate on some given set of data or analysis instead of the most important data set of all: how people in the real world behave. You can know everything there is to know about your industry— market trends, leading indicators, the latest technology—but if you don’t know your own customers, you might as well be trying to sell gumbo to gray-haired flower children.
PlanetRx (stock symbol: PLRX) launched a website which allows customers to order prescription drug online. The biggest flaw in the business model was customers had to wait 2-3 days before they receive their medicine. The majority of people who used prescription medications were senior citizens. Company failed to appreciate that customers can simply drive down to the local drugstore and get their pills in fifteen minutes.

Consumer fads

Investors—typically retail investors— use recent experience to extrapolate ad infinitum into the future what is clearly a one-time growth ramp of a product. People are consistently way too optimistic and underestimate just how competitive the U.S. economy is in these types of things : Cabbage Patch Kids in the 1980s, NordicTrack in the early 1990s, George Foreman grills in the early 2000s. —James Chanos, Kynikos Associates

Accounting irregularities where the economic reality is significantly divorced from the accounting presentation of the business

We also look for accounting irregularities, which can run the gamut from simple overstatement of earnings , often a gray area, to outright fraud. We’re trying to find cases where the economic reality is significantly divorced from the accounting presentation of the business. It’s not GE managing earnings— everybody does that. We want to see something way beyond that, where management is going out of its way to mislead. It could be the hiding losses in offshore subsidiaries like Enron. It could be abusing mark-to-market accounting as Baldwin-United and many others did. It could be Boston Chicken, a big winner for us in the 1990s, lending money to franchisees to cover losses and not reserving for the receivables. The biggest abuse in accounting today, often legally, is in acquisition accounting. —James Chanos, Kynikos Associates

We primarily look for material disconnects between our view of economic earnings and the earnings that are reported and people are using to value the stock. It could be accounting related, so we pay careful attention to things like rising accounts receivable relative to total sales, cash from operations that is not keeping pace with net income, and decreasing returns on capital —James Crichton, Scout Capital

I have developed something called the C score, which is basically a six-variable method for searching out ideal short candidates that are potentially manipulating earnings. The variables are a growing difference between net income and cash flow from operations, increasing days sales outstanding, growing days sales inventory , growing other current assets to revenues, declining depreciation relative to gross property, plant and equipment and, finally, total asset growth greater than 10 percent. There’s a high probability that companies that score high on those six measures are actually manipulating earnings. By also requiring some measure of high valuation, say a price/ sales ratio greater than 2 ×, we can imagine stock prices for the remaining companies going south quite fast. —James Montier, Société Générale

The accounting-based analysis is not difficult to do, but it takes time, patience, and a suspension of belief. A Wall Street pundit recently commented that this level of fine-toothed work is too costly for brokerage analysts or institutional managers to perform because of the time and skill required. The lack of attention by other professional investors to these financial details provides the inefficiency in information dissemination that is so central to the short seller’s art.

Reading notes to account much more important now

Managements have gotten so good at playing Wall Street that I’ve actually become more skeptical of the metrics they want you to focus on. For example, when people would question the earnings at Tyco, former management would say “There can’t be anything wrong with earnings, just look at our cash flow.” It turns out that just about every cash-flow lever possible was being gamed at Tyco. Capital spending never seemed to grow, until you looked at the footnotes on future contingencies and saw they were calling everything operating leases that never showed up in the capital spending Always read all of the documents. “Footnotes and disclosures buried deep in corporate 10-Q and 1-K reports.”

Focus on Quality of earnings

The quality of earnings is a major issue with short sellers. Companies repeatedly try to include nonoperating earnings in “earnings” to create the appearance of growth and financial well-being. This subterfuge requires the analyst to read the footnotes and the management discussion of earnings in the 10Q. Sometimes in extreme cases (Crazy Eddie in Chapter 10), the verbiage is dramatically different in the quarterly report and press releases than in the 10Q.7

Look for accounting gimmicks: Clues that the financial statements do not reflect the true state of corporate health.

The next level of complexity combines costs and revenues-the company manages earnings by delaying expenses and accelerating revenues. The asset side of the balance sheet rises as prepaid expenses build, and net income stays consistent, always upward by a comfortable growth rate. Companies that have perfect growth rates should always be carefully studied for gimmickry on the balance sheet-in particular, burgeoning prepaid expenses and deferred costs.

I did a guest post on “Financial Shenanigans” written by Dr. Howard Schilit here. This is an excellent and must read book to asses the quality of earnings and balance sheet. 

Mere accounting irregularity is not enough, focus on the fundamentals of the business

I evaluated shorting America Online and determined that even if the accounting were wrong, it was a lousy short because the true economics of the business were incredibly compelling. The stock was inexpensive considering the company’s economic profits. I calculated the net present value of a subscriber by comparing the up-front cash customer acquisition costs to the subscription payments over the expected life of the customer relationship. America Online was adding so many new customers that it would not take long to justify its seemingly lofty stock price. Add in the possibility of new revenue streams, including advertising, and I saw it was a really bad short idea. Perhaps this is what “value investor” Bill Miller saw that convinced him to step out of the box and take a large long position. I did not have the guts to buy America Online, but contented myself by not shorting it and arguing with those who did –  David Einhorn

Joe Feshbach said “The mistake is always shorting the company that’s not that bad.” “The biggest mistakes we’ve made are where we’ve seen a company that is overstating earnings but where the internal engine of the business is still strong.”

We have historically been drawn to financial services, where companies can really boost earnings by generating bad loans for a while. We’ve also been in consumer products, certain parts of the natural resource situations (which effectively become accounting plays) and generally companies that grow rapidly by acquisition. Where we see the juxtaposition of a bad business combined with bad numbers, that’s really in our wheel house – Jim Chanos interview with Columbia Business School

Be wary of companies who misread or alienate their customers or do not confuse your own taste with consumers

In 2012 , JCPenney’s (stock symbol: JCP) management team famously “fired its customers” by eliminating coupons and stocking more expensive brand-name merchandise. Essentially, Johnson wanted JC Penney and its shoppers to be something that they’re not. He wanted them to be more like the scene at Apple Stores, or even Target, when in reality, there was probably more overlap with Macy’s, or even Walmart. The overall impression is that Johnson would probably never shop in JC Penney, and that he certainly didn’t understand or have much respect for the store’s shoppers. If that’s the case, no wonder Johnson’s stint as CEO was such a disaster Read more here

Johnson’s doomed upscale strategy shows the dangers of confusing your own tastes with the tastes of your customers – Dead Companies Walking

Prof Sanajy Bakshi commented something similar in response to a question on Thomas Cook

“It important to form views based on actual data rather then perceptions formed from one’s own opinions. I haven’t used a travel agent for a holiday for more than a decade. I don’t wear Relaxo flip flops. I don’t wear Killer Jeans either. Nor do I use Bajaj almond oil or any hair oil for that matter. I don’t use products made by Page Industries either. But the business volume growth experienced by companies who manufacture these products tell a different story. We should create our opinions based on actual, verifiable facts and not personal impressions because personal impressions are very often not representative of underlying reality.”

Be wary of getting ‘Too Close’ to management

The Feshbachs do not find company visits or Wall Street analysts productive ways to gather information. Talks with management are not fruitful.

One of the biggest things I see quite often is getting too close to management. We never meet with management. For all of the bad asymmetries of being on the short side, one of the good asymmetries is that we don’t rely on the company. We can get information from the company if we want to, as we can go through the sellside. Those that are long the stock and are close to the company almost never hear the negative side in any detail. The biggest mistake people make is to be co-opted by management. The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive…Jim Chanos interview with Columbia Business School

McBear keeps a low profile relative to his peers because he gathers important information by visiting companies. He feels Wall Street analysts are a poor conduit for company insights because they screen out relevant facts. A good listener asking thoughtful questions can learn critical facts about business trends.

People in management positions, even very senior management positions, are often completely wrong about the fortunes of their own companies. More important, in making these misjudgements, they almost always err on the side of excessive optimism – Dead Companies Walking

Bernie Madoff was a respected, even revered figure in the Jewish community— and many of his victims came from that world [Jewish] because of it. This is an age-old problem in both business and investing. Call it the country club effect. Even the sharpest, most astute professionals tend to perform less due diligence when they’re dealing with someone with whom they have an affinity. Whether these ties are based on ethnic, class, or family background is immaterial. The affinity fallacy happens across all groups – Dead Companies Walking

My focus is majorly on small & mid-caps companies where disclosure standards are still very pathetic for most of the companies. I do interact with management. But I try to do more than half of my research before approaching the management. 

Companies with HIGH presence of institutional shareholders will fall much more steeply when earnings disappoint or if the company is facing any problem


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Concluding remarks

Successful short sellers look for the following before they decide to short any stock:

  • Business : Secular problems or fundamental change in the nature of business 
  • People: Dishonest and incompetent management.
  • Balance Sheet: Higher leverage is preferred.
  • Profit & Loss account: Quality & Sustainability of earnings. Simple overstatement of earnings is NOT ENOUGH. Short sellers are looking for cases where  economic reality is significantly divorced from the accounting presentation of the business
  • Price: Valuation is given least preference by most short sellers.


Additional points

On Cable companies

Because they believe management when they say that gross cash flow is going way up and required capital is going way down over time. The reality is the cable executives are not blessed with any great crystal ball themselves, and we believe they always underestimate the competition. Satellite came out of the blue. Now the Bells are going to compete with them. On top of that you’ve got wireless broadband coming on. I’m convinced television programming is going to go over the Internet, an open system that’s the most efficient distribution network ever created. This I see very clearly happening – people setting programming for Internet standards. The Bells wiring fiber optics to get into the video business is going to be over an Internet standard. Everybody will be selling broadband access as a commodity. In such a world, a cable or satellite company packaging channels with some choice but not much and charging you 40% off the top is insane. At the end of the day, the cable company is the middleman. In a digital world, middlemen margins get crushed, because the marginal cost of transmitting a bit of information is zero. If you are a middleman with a closed architecture, you’re in a world of trouble. Content producers are going to find a way to reach the consumer more directly and split those 40% cable EBITDA margins with the consumer. They’ll go to Microsoft or Scientific-Atlanta and ask for an interface that’s easy to use that allows the consumer to buy programming and pay for it directly. You won’t need to pay Time Warner or Cablevision 40 cents on the dollar for that pleasure. We’ve been saying for a few years that you want to be long proprietary content and short distribution. – James Chanos, Kynikos Associates

Links to some good articles:

Lessons in short selling: Why Jim Chanos targeted Enron

Jim Chanos presentation on value traps

Lessons from a short seller

Dead companies walking


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Bharat Shah: Buy Quality & Only Quality at Fair Price and Hold for LT

Deep Value vs High Quality Debate:

Let me clarify at the outset I have no intention to either directly or indirectly criticize anyone following DEEP VALUE investing philosophy or for that matter any philosophy. Till early 2014, I  have followed deep value philosophy. As I highlighted in my post on RETURN PER UNIT OF TIME INVESTED I realized Deep Value investing philosophy do not match with my personality.

Unfortunately over last few months, I have seen tendency by a few investors trying to go overboard in proving the other CAMP (if that’s the right word) as WRONG.   Let me quote what Prof Sanjay Bakshi  said in one of his interview to Vishal Khandelwal

“Some students have a statistical bend of mind and prefer to work with situations that can be evaluated more objectively than others. I tell them to focus on statistical bargains and risk arbitrage. I ask them to practice wide diversification  Others like to delve deep into the fundamental economics of businesses and are comfortable with dealing with softer issues like quality of management. I ask them to focus on moats and diversify less. It all depends on what you enjoy doing over time and what has worked for you.
“I tell my students that they need to pick a style which suits their personality”
“If you are going to invest like Ben Graham, then your sources of margin of safety are different than if you invest like Warren Buffett. You just have to be aware of those sources and also of their limitations”
Note: Entire post on Bharat Shah is basically a compilation from his various interviews. Bharat Shah had never used the term 4Ps in his interviews. I found it convenient to combine his various thoughts under my favorite concept of 4Ps. Normal text represents exact reproduction from original interviews with minimum editing to make sure continuity of thoughts. My comments are in italics.

Bharat Shah

Why do I keep studying about investment philosophy of great investors?

In every branch of knowledge there are always people who can teach you and who have something valuable to share which stays forever in our minds. It is up to each individual, whether he has the desire, intensity and humility to learn or absorb from the masters.

Quote from Few Lessons from Sherlock Holmes

History often repeats itself.  There is nothing new under the sun. It has all been done before. (Holmes; A Study in Scarlet) Mr. Mac , the most practical thing that you ever did in your life would be to shut yourself up for three months and read twelve hours a day at the annals of crime. Everything comes in circles … The old wheel turns, and the same spoke comes up. It’s all been done before, and will be again.” 

Just reading about these investors will NOT HELP. You need to get your head in control

But just by knowing or reading about them will not equip you fully. Craft can be taught or learned (and that too, only for the basic building blocks) but wisdom and character need to be built by self. One has to understand and build one’s own methods. The giants [Warren Buffet & Philip Fisher] you mention have thrown light on our path, but we have to walk the path ourselves and deal with challenges. Giants who stood before us shows us the path of equity investing but the journey have to carve out by ourselves.

Getting head in control

And if one can’t bring to bear all of the above traits while investing, then one is better off finding out whom he can entrust that responsibility. Investing is not necessarily a DIY scheme.

Focus on trends

Note: Few months back I got opportunity to interact with Mr. Bharat Shah. He told me that he has changed his opinion about trends. This is what he had to say “Investing cannot be held hostage to finding some mega trends which is fundamentally going to alter and produce some multi-baggars.   Trends are more likely to be known after they occur. Our ability to predict trends is very low. Being into the trend very early may test your patience for too long. Its also possible that one might bet on trends too late. This is not a consistent way of investing. So its better to focus on bottom up research based on individual metrics of each business focusing on size of opportunity, quality of management and quality of business which is reflected in ROE and buying at some discount to fair value. Edit date: 19 July 2015

Picking up or spotting an opportunity will be based on some significant change or trends that you think are happening or likely to occur. Based on that, you want to analyse what may qualify within that trend because, more often than not, if you have understood an apocalypse-like trend at a fairly early stage, you have a higher chance of catching a multi-bagger. But having done that, you still want to subject it to the discipline of meeting minimum underlying ROI, ROE and other economic characteristics.

I have covered the importance and identification of long term trends earlier here. I would like to quote one para from that post

Mr. Wanger seeks growth potential, and he does so first by determining broad areas for potential future growth. Thus, his approach starts with a top-down outlook: He first identifies general “themes”—strong social, economic, or technological trends that will last longer than one business cycle (at least five years or more). The advantage of focusing on long-term trends, he says, is that most other investors are focused more on shorter-term predictions of two years or less, and it is difficult to outguess the competition, particularly since most investors are privy to the same information.

Look for 4Ps at Fair Price


Size of Opportunity is the mother idea. It is less about how big a business was or is. It is virtually all about how big it can get from where it is. It dwells almost entirely in future rather than in the past or present. It is more about the size of a pond rather than the size of a fish. Pond has to be large so that there is headroom for a capable fish to grow. But wallowing in very shallow waters is not a very attractive idea. It is important to buy a large size of opportunity so that the business becomes a compounding machine aided by high quality earnings and greater predictability of that earnings growth.



Management Quality is far more tangible than is believed to be. In the buoyant phase of markets, this truth is conveniently ignored but at one’s investment peril. This can hardly be over-emphasized. Capital allocation and capital distribution skills are the hallmarks of a good management. Integrity, vision and execution are the defining attributes of a quality management. It is only when a large size of opportunity meets with quality management, that the outcome is gratifying.

Management needs to be judged by Objective [ROE] + Subjective [Interviews] ways

Capital allocation and capital distribution are objective methods to judge the record of the management. On the other hand, the subjective aspects of assessing management would involve interactions with them to understand their thinking, their philosophy, the way they survey the landscape (within and without their own business), their vision, and their knowledge of opportunities and threats in the environment they operate in. However, these are only additives (and not a substitute) to the objective aspect of the business – return on equity (ROE), which is the  “holy  grail  of the management.” A long-term ROE will tell you most things that need to be told about the management; that is the measure one would trust more than anything else. Meanwhile, you can always embellish your perspective by having a dialogue with the management to understand their value system, integrity, and thinking. Rarely is it seen that a high quality business is managed by a weak management. Also, low-quality businesses typically have the effect of repelling good management and conversely, bad businesses typically seem to beget bad managements. This is also why, it is important to focus on high quality business because along with a good business, there is a high probability of getting a good management as well.

Prof Sanjay Bakshi quote on this

“The first chance you have, to avoid a loss from investing in a great business run by a fool or a crook is by refusing to invest in it; there is no second chance.”

The operating words in my opinion are FOOL OR A CROOK. Here I would also like to quote Mr. Basant Maheswari quote from his excellent book “The Thoughtful Investor” which has changed the way I invest and analyse small & mid-cap companies

While it is important to be cautious on management pedigree it is also essential not to be unduly suspicious unless an investor has serious reasons to doubt the integrity of his senior business partner. In the absence of any indication to the contrary an investor while evaluating the management should generally follow the theory that a person is innocent till proven guilty because most of the debate on management quality happen around the small caps whose potential for gains remain multifold and hence the costs of existing an investment due to faulty judgement is very high.”

I used the above rule in Kitex Garments, where despite few corporate governance concerns, my conclusion is that MANAGEMENT IS NOT FOOL OR CROOK.

Mft not crook


Quality of business & Earning [Product]


The union of the above two results in the Earnings Growth. This is key because the absence of growth or its materiality reduces equities to bonds.

The growth doesn’t necessarily have to be dazzling. What’s more important for the growth is to be long-term, relatively predictable and consistent. Such growth creates compounding machines. While growth is essential, it is not enough by itself. It needs to be Quality Growth for it to create value. Quality comes from the ability of the underlying business to create rising economic value. That can happen only when business generates not only superior but also Durable, Predictable and Consistent ROCE. Quality of business is at a heart of good stock picking for outstanding long-term value creation. Again, it is only when a reasonable growth cohabits with high quality of growth, that great economic value is created.

An investor in (such) a business can create investment returns only if the underlying business can create economic value. Ultimately, investing is nothing if not business like. Size is a necessary but not sufficient condition for value creation. It’s the ability to ward off competitive challenges and to thrive over time, enjoys some moat which gives it pricing power or resilience to external threats. It is a myth to believe that one can earn investment returns even if the underlying business has inferior economic value creation; or, that a business creates outstanding economic value but somehow does not get reflected in investment returns. Neither can happen. Certainly, not over a long enough period of time. An investor can generate investment returns, even superior to the underlying economic returns if he can buy such a business at a Margin of Safety (or, Price-Value Gap) to its intrinsic worth. In essence, the science and art of investing lies in the above, rather, simple ideas. However, investing is simple but not easy

Understanding Porter Anlalysis” & Pat Dorsey Little book That Builds Wealth is a must read if one wants to understand business quality in greater depth.  [Click on the link to view the mindmap]


Predictable earnings growth is not necessarily the same thing as consistency of earnings growth. In a given period, it is possible that earnings growth may, incidentally be consistent, but the character of the business may be such that it may not be amenable to predictable earnings growth. The businesses with a fundamental character, amenable TO BOTH CONSISTENT AND PREDICTABLE GROWTH have a greater chance of value creation. But when a business enjoys very sustainable long-term, consistent franchise with decently predictable earnings, then in the eyes of the market for every rupee of earnings growth the ascribed value is more than proportionate.

 Market pays premium to predictable growth

We studied last 10 years, 15 years of many of these businesses [Asian Paints, HDFC, Sun Pharma etc] and we have seen that they do not have to grow at a dramatic pace in order to give meaningful returns. Most of these businesses have grown their earnings at about 18-20-22% but the market returns have been anywhere around 25% or better than that. Even if going forward, the valuations do not get re-rated, you still can hope to get that 18-20% underlying compounding which is still pretty good to my mind.


By holding a pebble for a long time, it can’t turn into a diamond. You need to buy only quality and you need to buy that at a margin of safety. You then need to hold that investment over a long period of time with discipline and to have wisdom not to prematurely part with the journey at every challenge or at every twist. If one does this; rewards are plentiful and outstanding. Investors who want to benefit from long-term wealth and value creation need both the capabilities: to understand the businesses and to have the ability to value them, but to also have the discipline to buy quality at a margin of safety and having wisdom to stay the course.

Read this excellent blog post by Ian Cassel, to understand the importance of having conviction to hold and staying invested for long term, rather than trying to time the market. Even T Rowe Price study says that “even during a period when a stock is compounding between 6-8x [over 10 years], its price could drop significantly along the way [>25%]”

A purely “Grahamian” value is less of an attraction to me than value backed by above average earnings growth.

I believe there are  times when you may  come across a  business which may not fulfill all the quality criteria. In other words, some of the operating characteristics of the business may not be as enduring or as powerful as some alternate business opportunity that may be before you. However, there could be other factors that can still make them very attractive – one of the most important being the element of earnings growth.  High growth rate coupled with acceptable productivity of capital can many a times be a more potent and powerful driver of stock prices than, let’s say, high productivity of capital but with low underlying levels of earnings growth. A purely “Grahamian” value is less of an attraction to me than value backed by above average earnings growth.

To get good compounding in the long-term, you need reasonable, not exceptionally high growth. 

It is a myth to assume that only very high earnings growth produces value. The certainty of earnings affects value creation more than just the assumption of very high growth, which may or may not materialise. Equally, I would say the quality of earnings is superior in terms of creating value rather than just the quantum of earnings growth. I would any day prefer a business making 45%-50% return on capital employed even if it is growing earnings at 15%-20% rather than the other way around. With a mediocre business having a 15% return on capital employed, pretending to grow at 30-35-40% is unsustainable. So, we need to be clear about what are the right filters which will create value. While people say there are various ways to reach Mecca, but in investing there are relatively very limited ways of doing the same. Tweaking things based on the situation does work sometimes–in very bullish markets it can give different rewards.

Absence of growth or its materiality reduces equities to bonds.

Equity is all about growth. When the growth goes way, equity becomes a bond and bond is clearly not equity. Idea of growth is to get a compounding power, to get a value much higher than the net worth or what suggest and essentially since the equity markets thrive on growth, the idea is to hunt for virtuous market cycles where largely you will see growth sustaining.

Two major contradictions may emerge. One business may be profitable. May be growing, may have excellent ROCE and yet valuation may look modest or may diminish. That may sound like a contradiction but could happen because markets may realize that the future size of opportunity is unlikely to be much larger and to that extent it comes an investment in bonds rather than an equity investment or it becomes a business with a limited life rather than the going concern, an assumption which we usually apply to an equity investment.

When the eventual size of the opportunity is not very large, to begin with, or it is more or less fully exploited, then it has a very cathartic influence on the extent of value creation or its continuation. Such businesses become cigar butts (RATHER THAN FULL CIGARS). They produce an interesting conundrum. Good profitability, decent capital efficiency, even reasonable (current growth) rate and yet increasingly crimped value creation. Similarly, Value creation dies when future growth stops.

During 2012-13, many of my friends whom I got to know through tried explaining me that market pays for growth, but I continued my focus on deep value ideas. Am sure , all of them must be SHOCKED when they got to know I bought Symphony at > 20x PE multiple.  

When to sell

Three things could act as ‘sell’ triggers. One, when the company’s prospects are impaired on a long-term basis. Two, current stock valuations fully discount the company’s fundamentals and lastly, better opportunities are available elsewhere

Prof Sanjay Bakshi on when to sell moat business

“If the moat is still enduring and I still love the management, then I’d sell it only if I found something significantly better in terms of expected returns. That something significantly better could be another moat business which has also passed the management quality tests and, at its current asking price, offers a significantly better expected return. Or that something significantly better could be cash or bonds which in a bubble market may offer better returns “

“When it comes to moats, you have to be a reluctant seller”

I would be more reluctant to sell merely on fair valuation grounds and would like to wait for better opportunities unless valuation gets obscene compared to size of the opportunity.



Quality should be the first filter and not cheapness

While considering an investment, the basic trick is not to look at valuation as the first filter; quality should invariably be the first filter. Only after ascertaining the quality, focus should shift on optimizing the valuation. If we turn our attention to value or cheapness first then chances are that we will acquire a motley crowd of every mediocre businesses; and as they compete with each other for self-destruction.

Prof Sanjay Bakshi quote on this

“And the beauty about investing in moats is that you think about expected returns after the business passes your business and management quality checks. That means that if you have no idea what the earnings of a business would look like a decade from now and whether or not those earnings will still be growing or not even after ten years, you should not invest in that business”

PE multiple NOT CORRECT measure for HIGH QUALITY business 

There is an overbearing tendency to judge valuation from the prism of a rather simplistic and inadequate yardstick such as price earning multiple. Growth of profits over long time and even more importantly, quality of growth, have far more impact on the valuations than what a short term number such as price earning multiple can ever capture.

Valuation is not merely simple straight equation that low PE is equal to higher return and high PE will lead to lower returns, or low PE is cheapness and high PE is expensiveness. It is a more involved subject that. It is about judging the quantum, durability and secularity of (earnings) growth, quality of earnings and the consistency in the pattern of these earnings and one’s ability to understand how far these can sustain in the future. All these aspects have a deep bearing on what the value is. VALUATION IS OVER THE LIFE OF THE BUSINESS RATHER THAN JUST THE IMMEDIACY. So, it is not about discounting price with the immediacy of earnings, it is more about the ability to understand the factors that will cause those life-long factors is the ART PART. And one has assigned a number to each element, and then converting these data points into the actual value computation number is the science part, which is more mathematical. Ability to understand what is quality of the business, the size of opportunity, how much is the compounding power of that business to grow its earnings and the ability to understand that valuation is not merely PURE MATHEMATICAL NUMBER LIKE PE but a more evolved and sophisticated idea – all this is ART.

Look for fair price rather than MOUTH-WATERING VALUATIONS

Looking at mouth-watering cheapness in investing is a flawed idea. Unless the markets are so depressed that you get stocks very cheap or some specific stocks, due to specific reasons, are available much cheaper than what they deserve, you do not get extremely cheap valuations. You have to hunt for a reasonable valuation. In the long-term, things that add value have clearly worked.

My all time favorite to take a call about entry price is the expected return method highlighted by Prof. Sanjay Bakshi’s in his Final Relaxo Lecture.

Mediocre business – A STRICT NO NO

Trying to make a compromise on quality in order to buy an arithmetical cheapness is very bad. That is clearly a no-no as an option. So you want to be only in a quality space and within that you want to find opportunities which pass the test of valuation and sustainability.  I would definitely prefer a richer business at a reasonable valuation rather than an inferior business at seemingly very cheap valuation. It is important to buy only quality at of good  margin of safety as one can get, rather than buying inferiority but justifying that with arithmetical “cheapness”, which more often than not is a “honey trap”.

 Market timing

I am building my investment portfolio for 5 to 10 years and not for three to six months. Here is the video link [start at 21:35] where Bharat Shah talks about the study he has done where over a period of 2001-13, timing was of not much use if one is buying quality business and holding it for alteast five years…

Time allocation is as important as capital allocation

Casting the net wider has no merit, in the practice of investment. Exclusion, its method and its fineness are virtues in the field investment. Only a few need to come through, which can then be studied well.

For an investor focussed on QUALITY like me right filters might be secular trends plus 4Ps plus fair price. For investor focussed on Graham type of business filters might be different. But having filters are important because NO ONE HAS UNLIMITED TIME TO ANALYSE EVERY IDEA. I have covered the importance of knowing what to ignore in RETURN PER UNIT OF TIME INVESTED.

Ambit data crunching shows that out of the 5,000 [most active] companies listed in India, 4,000 failed to keep up with inflation over the past 20 years. So, 80 percent of the market does not even beat inflation. This suggests that 80 percent of the Indian market is a value trap. It is the other 20 percent that people earn their living from.

The essence is to have a business-like approach to investment. Or, in other words, the typical style should be that of a ‘private-equity’ investor in terms of ownership of FEW businesses and the TIME-FRAME of investments. 

Let me quote Peter Thiel from Zero to one here [on reason for focusing on > 10x returns over 10 years which is typical life of a PE fund]

The error lies in expecting that venture returns will be normally distributed: that is, bad companies will fail, mediocre ones will stay flat, and good ones will return 2x or even 4x. Assuming this bland pattern, investors assemble a diversified portfolio and hope that winners counterbalance losers. But this “spray and pray” approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single -minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place. The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined. This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. VCs must find the handful of companies that will successfully go from 0 to 1 and then back them with every resource. Of course, no one can know with certainty ex ante which companies will succeed, so even the best VC firms have a “portfolio.However, every single company in a good venture portfolio must have the potential to succeed at vast scale.”

I strongly recommend everyone to read various blog posts about venture capital investing on

To me, reading and investing are two sides of the same coin.

For me even both even blogging and reading are same. Though initially I started blogging to network with more like minded investors, over period I realized it gives amazing clarity of thoughts. Its the next best thing to TEACHING, I guess. 

Whether one should be worried about risk of Crash in China’s economic growth? 

Concerns are an alter ego of the markets. They will forever dissuade you from participating in a sensible way. Worrying about issues over which you neither have control nor predictability, or which have a coherent relationship to a simple business like investing does not make sense. We make it grandiose and over-complicated by adding dimensions that are spurious.


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Ralph Wanger Part II: Have your own investment Philosophy, Value vs growth investors

You can read part I of this post hereNote: Unless otherwise stated, the words in italics are extracts from the book “A Zebra in Lion Country” 


“An investment philosophy is important not in the abstract but because it will keep you on the right track.”

You need to have a strategy, a way of looking at the world of stocks. A Haphazard collection of stories won’t help. Successful investors don’t operate that way. They have a philosophy that dictates what kind of stocks they want to own and they stick to their catechism.  When you think of the best-known names in the business – John Templeton, Warren Buffet, Peter Lynch and John Neff – you can immediately attach an investment style to each. Develop a set of convictions you adhere to, you can turn your back on thousands of stocks and concentrate on a manageable universe. A set of guidelines – and I urge you to put them down on paper – gives you confidence when time are rough. It helps you make the toughest decisions: when to sell. But it has to be YOUR STRATEGY [emphasis added], what’s right for you. Every singer must sing her own song.

Michael Sherne in his book “Investment Checklist” stress the same point.

When filtering through the many investment opportunities the stock market is offering at any given time, it is important for you to establish criteria of the types of businesses and management teams you are searching for. These criteria serve as a filter, so you don’t have to review thousands of investment opportunities and therefore can reject investment ideas quickly. If you have ever purchased a home, when you first started looking, you were probably overwhelmed by the number of houses that were available. At some point, you probably began to establish criteria for the types of houses and areas you were interested in, and this helped you narrow the list of houses that were potential candidates for purchase. The investment criteria you develop will work in the same way. Your criteria can be as simple as looking for a simplified business with a large market opportunity, managed by a great management team, and trading at a low price. You can also set criteria of what you do not want to invest in. For example, you may want to avoid businesses that have a high dependency on commodity resources, such as exploration and production (E&P) businesses, because oil prices are difficult to forecast. By articulating and following strict criteria, you can put the odds of making a successful investment in your favor.

I have already written in detail about the importance of having one’s own investment philosophy in my earlier post Return Per Unit of Time Invested.


People do seem to be born with a predilection for one style or the other. It’s a matter of personality. If you are pursuing a style that doesn’t fit your temperament, you won’t be happy. Show me an unhappy investor and I will show you an unsuccessful investor.The value investor is hitting for singles. He will be delighted if he doubles his money in a couple of years; few value ideas pay off better than that. If his analysis is correct and the company is worth more than the market recognises, however the downside is limited. The growth investor is going for home runs. He dreams of making 5-10 times his investment. And his downside is considerable, since high-multiple stocks can become average-multiple stocks at the drop of a penny in expected earnings. You never know for sure if a company’s going to do what you hope it will.

Growth itself is one component of value. A growing stream of earnings is certainly worth more than a static stream of earnings. You could even say that growth generates value. It can disappear as growth slows, but so can any other part of value equation. A low PE can disappear, if earning shrink. So can a low price to book ratio.

There is no reason to be a pure this or pure that. I look for – Growth at reasonable price. I want good growing companies, but I don’t want to overpay.

Whatever your style but focus only on multi-baggers.

Sometime back I had an interesting discussion with Manish Dhawan of Mystic Wealth on Moat vs Value investing. This is a never-ending debate and both sides have well articulated points. A mid-way could be focusing on multi-baggers. Whether one is investing in moat or broken businesses or nets-nets, the focus should be to earn 3-5x our initial investment and in terms of CAGR atleast 25% return. We can reduce the available investment universe to a much more manageable level by focusing on 3-5x returns.

Ofcourse, if one is investing in cigar-butt type of investment, purely on numbers, then one can buy even with 50-100% return expectations. But in that case one needs to do wide diversification [> 50 companies and no position more than 2% each]

Moat companies are resilient to bubbles and macro uncertainty

Having said that, my personal Investment Philosophy is to allocate most of my capital to companies having moats and 15-20% to situations which offers possibility of 3-5x returns in 3-5 years. Slowly, I have started focusing more on emerging moats rather than established moats. If a company has some sort of moat [whether established or emerging] then there is higher probability that it can grow at higher growth rate for long time. Another reason for my preference towards moat companies is that they are resilient to bubbles and macro uncertainty. Prof Sanjay Bakshi explained this point very well in one of his interview.

Investors should be cognizant about bubbles in various asset classes (real estate, commodities, equities, gold etc) and position themselves to not be hurt when the bubbles burst. That, by the way, is one reason why I like moats. Companies that buy commodities and sell brands, for example aren’t likely to be hurt by a commodity price bubble occurring or bursting. If the business has pricing power, then if commodity input prices rise, the business has the ability to pass it on to customers without fear of volume decline or loss of market share. If the bubble bursts, and commodity prices crash, then the business can either pass all of the benefit to customers to drive volume growth or retain some of it for itself. That’s the thing about moats. They are resilient. They can withstand shocks way better than other businesses which don’t have moats.


To avoid: Start-ups, Tiny techs, the near venture capital situations, marginal and unfinanced companies and turnaround situations.

In the words of Basant Maheshwari

A micro cap which hasn’t proved its business model is another type of company to ignore. One way of doing so is to filter out companies that have not reached critical mass [ He suggests a revenue threshold of INR 100crs for Indian companies]. The idea behind putting this filter of critical mass is because most small sized companies die a natural death without becoming large sized corporations and hence one should wait to see business reach some degree of scale before jumping in to buy.

In case of highly leveraged companies its important to manage position size [Whitney George of Royce & Associates] 

You can’t take a long-term view without confidence that the company’s financial condition will allow it to meet out-of-left-field macro or micro challenges. There’s an old saying that the balance sheet doesn’t matter until it’s all that matters, so we want to be ahead of that. That’s particularly important in smaller companies, which are generally built on more fragile foundations than big, diversified ones. We measure leverage fairly broadly by looking at the ratio of assets to stockholders’ equity. This allows us to see risk items that might not otherwise show up if we were primarily focused on long-term debt, like higher-than-usual levels of receivables , or bulging inventories, or increasing short- term bank lines of credit that may have a way of turning into more permanent debt. Our general rule of thumb, for non-financials, is to look for a 2: 1 ratio of assets to stockholders’ equity, which we consider a reasonable margin of safety.


No matter how selective you are, things still go wrong…. You should own atleast a dozen stocks if they are small cap, so a couple of winners can offset a couple of duds.

Whitney George of Royce & Associates echoes the same idea

Small-cap stocks by definition are more fragile, more likely to have one dominant product or one key executive or one big customer. Strange things happen , so you have to diversify no matter how much you may love individual names. When something strange happens in one of Johnson & Johnson’s or GE’s businesses, it’s a rounding error to the overall company. In a small-cap it can blow it up, so you don’t want to be overly exposed in any one name.

Even Philip Fisher suggests allocation between 5-10% to each small & mid cap stock, depending upon the risk involved. You can download detailed discussion by Philip Fisher from here.  This is one of  one of the simple yet most powerful discussion on diversification on small & mid-caps that I have come across till date.

Across market cap & Style

I have already covered this point in detail in an earlier post. You can read it here. [Under title “Diversification across Market Cap”]

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