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.
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.
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.
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.
Buy QUALITY at MARGIN OF SAFETY and SIT TIGHT
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 Valuepickr.com 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”.
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 25iq.com
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.