Tuesday, April 28, 2015

The Value Canvas: Conviction grading

Eric Ries has written a wonderful book on Lean thinking for start-ups. The book describes a method to analyse your start up on a single page – albeit a large A3 or an A2 or a whiteboard page. I put that together with the framework Donald Francis came up with and now use something called a value canvas with consists of:
  • Conviction canvas
  • Pricing canvas

The Conviction Canvas

Sunday, April 26, 2015

Macro factors: Corporate profits to GDP

"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn't going to happen."
Warren Buffett

While doing some research for a completely orthogonal topic to this one, I found a Buffett saying similar to the one above. That got me thinking about why Buffett says the magical 6% number. Putting that 6% number together with his quote on total market cap to GDP being under 1x we can conclude that he believes the maximum price to earnings for all companies should be 1/6% or 16.67. The average P/E over the last 16 years of the NIFTY in India is 18.48 which is consistent with this notion as well.

Let’s look at the history of this macro factor: corporate profits to GDP in India:

Saturday, April 25, 2015

Controlling the value chain

“You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.”

Warren E. Buffett

Ability of a company to control the value chain is a testament to the management of the company and is exhibited by high profit margins and high returns on capital.  There are 3 components to a firm’s economics:

  • Customer side
  • Supplier Side
  • Productivity

Thursday, April 23, 2015

Cloning the Dolly Khanna portfolio blindly: 40%+ in fy2014 with 14% Index outperformance!

Several value investing students in the US follow the 13F filing of their favorite managers. A 13F is a public disclosure of an institutional manager's holdings to the SEC. Now, the bad news is that unfortunately I do not know of a 13F equivalent in India. The good news is that moneycontrol has a shareholding screener where you can search for a shareholder name and the site will search the company filings for that name. You can also scour online blogs to figure out who holds what. Then you can look at the shareholding history on the BSE (Bombay stock exchange) website and calculate the shares they held.

After the article on "Dolly Khanna's ridiculous 89% return" many a reader asked me "This is all very good, but what's in it for me?" so I thought I should run an analysis to see if I bought/sold all that I could find about Dolly Khanna stocks 50 days after the end of the quarter what return would that portfolio get? The reason I picked 50 days after the end of the quarter is because by then all companies have reported their shareholding patterns. You could buy some earlier and some later but that analysis would take too long. In any case I think this one is more punitive on the return as well.

Wednesday, April 22, 2015

Valuation of the ability to command prices: The brand

“Your premium brand had better be delivering something special, or it's not going to get the business.”
Warren Buffett

Willingness to pay for a brand is something that has to be measured in the marketplace. If you are looking at something like Tide from P&G and see a generic washing powder you could see the reaction of people who may or may not pay up for the brand. Another way to check this is to compare the margins of the company in question with competition and with generic manufacturers of the same thing. Ajanta pharma is a generic branded formulations manufacturer whose margins are more than the non-branded generic manufacturers.

Tuesday, April 21, 2015

Valuation of very high quality companies: Low rate of change economics

“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like.”
- Warren Buffett

Low rate of change is a confusion concept and it took me a while to understand this. The “low” part of this statement is very relative and is highly interlinked with your circle of competence. In general businesses like Coke are the lowest rate of change. The product of coke has been constant for over half a century and people are willing to pay up for it. In terms of rapid change you can see semiconductor companies. Now Intel could be a business that people find a great moat in but the rate of change is very high.

Monday, April 20, 2015

Valuation of very high quality companies

As per popular demand I will get back to the getting conviction: Fundamental factors - points to watch out for later. Lets cover another very interesting topic for now.

The aforementioned concepts are the basics of valuation but as you might have noticed there are few subjective questions that remain unanswered:

  • How do you find the right discount rate?
  • How do you find the right growth rate?
In addition you will never find a hindustan lever or a dabur or a Britannia trading in single digit P/E multiples - despite the mood swings of Mr. Market. Does that mean the intelligent investor never buys into these wonderful companies?

Saturday, April 18, 2015

Getting conviction: Fundamental Factors #4: Cash flows

Cash flow is the best indicator of the health of a company. It also typically has tell tale signs of what is really going on. I, of course, cannot cover this entire topic in an article but definitely can give you some pointers on where to look and a flavour of the cash flow analysis methodology:

8.        Cash flow quantity – If the cash flow from operation is on an average lower than net income it should be a huge warning sign that earnings are overstated. In some cases even when cash flow from operations is good some expense items may have been capitalized by classifying them as cash flow from investing. Now the best way to judge this is to see the delta revenue, Net income and cash flow from operations that that investing has created. Studying the cash flow from investing is also a good practice to understand the expensing and capitalization practices.

Friday, April 17, 2015

Getting conviction: Fundamental Factors #3

This post is a continuation of the following posts:
Lets continue on the list of things to watch out for:
6.        Options dilution - Many companies give stock options to management in order to motivate them to perform better. Companies with too many stock options typically are not great to invest in – in my experience. A small amount of stock options can be a good tool although I must say no options is better than some options. 

Thursday, April 16, 2015

Getting conviction: Fundamental Factors #2

In the previous post we learned the board metrics to judge the fundamentals and a couple of things to watch out for. Unfortunately there are several other things to watch out for.

Continuing the list (of things to watch out) for:
3.        Expensing or capitalizing grey area items – for example some companies may capitalize and show as cash flow from operations their research and development costs. What needs to be determined is that whether the item capitalized actually has long term value. You also need to study how previously capitalized grey area items are depreciated.

Tuesday, April 14, 2015

Getting conviction: Fundamental Factors

Fundamental factors are typically the numbers in the game for the intelligent investor. In this section one typically looks at:

  • ROE and ROIC over the years and their volatility
  • Dividend percentage of earnings
  • Net profit after tax margin
  • EBITDA margin
  • PAT Growth
  • Working capital usage as a % of sales (Debtors, creditors and inventory)

Sunday, April 12, 2015

Envy in the driver’s seat

“It’s not greed that drives the world, but envy.”
Warren Buffett

Envy is an emotion triggered in a person when she or he thinks that another has something better. Envy can cause a series of wrong decisions and make investors do things that are completely irrational. During the pre Y2K dot com boom several investors made lots of money on technology stocks. Companies with very large negative margins were valued at billions of dollars. It was said that a man with an idea could be funded with millions. At this point Buffett clearly said that he did not understand technology and thus wanted to stay away from it. It was probably Buffett’s control on his envy that enabled him to stay away from this potentially disastrous trade. During the ensuing dot com bust he got several opportunities to buy lots of cheap high quality moat businesses.

Saturday, April 11, 2015

Is too much math bad for investing?

“If you need to use a computer or a calculator to make the calculation, you shouldn't buy it.”
Warren Buffett

We've already talked about the LTCM debacle and they were very good with their math. There are entire funds running based on mathematics today such as Renaissance technologies and other statistical arbitrage shops. These products are good and probably very few statistical arbitrage (statarb) shops are able to do this consistently. Even statarb shops have to sit it out when they are unable to find any opportunities. Then why does Buffett say don’t do the math?

Friday, April 10, 2015

The IGValue Feedly Channel

If you like feed readers you should definitely try feedly. It was a wonderful interface and formats content to make it easy to browse. Check out the IGValue feedly page at:


I would be obliged if you could tell me whether you like the content in the Feedly format and if you could compare the content to the flipboard format mentioned in the IGValue Flipboard Magazine article.

Thursday, April 9, 2015

Social proof is not an investment thesis

“the prices on the market are the ultimate form of social proof”
Charlie Munger

The most common form of this bias is where an investor feels “I have bought 2 stocks and both have gone up by 20%. I told my friends and everyone says I am a good stock picker”. This as you all probably already know is not true. Many a time people look to other people to see what they are doing. Yes this is also called cloning – but blind cloning is also dangerous. You should definitely look at what other successful investors are doing but should understand the investment thesis before taking the plunge. All decisions of any legendary investor are not correct – even Berkshire makes mistakes and Warren Buffett is the first one to report all on each annual report.

Wednesday, April 8, 2015

Reciprocation maybe good manners but bad for investments

“You’re like a one-legged man in an ass-kicking contest.”
Charlie Munger

Reciprocation is a powerful psychological tool. Recently a box showed up to my house address to my sister’s from Dabur. It had several products of Dabur – and in standard packet sizes. The whole thing in a store would probably cost 500 rupees. It forced us to try the products and after six months I found myself asking for several of those products in a grocery store which I never knew about before. It got me thinking why was I asking for those products? The answer lies in reciprocity. Dabur had given us some products for free and now my mind somewhere in the subconscious had registered that I need to reciprocate. The products in question were not bad but not really better in quality than the competition. But they got my attention.

The question is how does this impact investing? Its impact on the investor can be small gifts from a broker make you want to give him some business. Now you may not realize it (and in some cases the broker also may not realize it) but you may end up buying something you shouldn’t have. Several banks and wealth managers send their customers gifts on festivals. In order to avoid this bias you have to return these or not do business with the ones who do because it can cause reciprocation bias.

Tuesday, April 7, 2015

Why does very high IQ not give you an edge in investing?

“You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”
- Warren Buffet

In the hedge fund world you find fund manager after fund manager pitching the smartness of their investment team to the investors. Some will only hire out of the Ivy leagues. Some will have an interview process that could match that of the most competitive companies in the world like Google or Facebook or General Electric. The results, however, don’t seem to correlate with IQ. Take the example of Long Term Capital management (LTCM). It was led by John Meriwether and had Myron Scholes and Robert Merton on the board who shared a Nobel prize! 

Monday, April 6, 2015

How to get started with Value investing - Step 2: Common sense check

On popular demand this section is a continuation of the articles in on getting stared with portfolio management:

“Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

- Charlie Munger

In order to avoid the “fake precision in math” problem I usually do a common sense check. Here is where you want to think about the investment thesis that you can do in your mind. Typically to simplify things I use only the following data points for this:

Saturday, April 4, 2015

Pavlovian association bias: We are no smarter than the dogs

Pavlov was a Russian physiologist who conducted an experiment where he sounded a bell at the time a dog ate food. Over time just the sound of the bell caused the dog to salivate. This type of conditioning is called the Pavlovian association bias and can be lethal in investing. This is the bias running in the background that sometimes drives customers to buy the higher value item linking expensive=better quality. The automotive industry has this syndrome played out in wonderful detail. BMW has created a brand for itself where car buyers believe that its quality is better. Several studies have shown that car makers like Honda and Toyota have similar or sometimes even better quality, provide the same features but still consumers continue to buy BMW and it remains one of the most profitable car companies around. Cars like the Rolls Royce or the Bentley have often been proven of poorer quality than several cheaper cars but they continue to sell because of the Pavlovian association bias.

Thursday, April 2, 2015

How can consistency & commitment be bad for the investor?

Consistency and commitment are supposed to be virtues in society. When you take a stance after researching it thoroughly it becomes very difficult for you to see the other side of the picture. This is also stated as resistance to change in management folklore. When the added pressure of public disclosure of the stance is present very few people have the capability to change the stance.

Incentive cause bias: the most common pot hole

The incentive cause bias is rationalization by the professional that what is good for the professional is good for the client (and maybe the world) as well. This is rampant in the financial services industry. The article on avoiding IPOs is a prime example of this kind of bias in the financial world. Trusting your broker or for that matter any financial institution blindly can cost you a lot of money. A financial institution serves its own interest by making money on financial transactions. At the same time you believe that the financial institution is acting in your interest. The interest of the financial institution and yours can only go hand in hand if the institution through systems and processes ensures that it is a win-win situation for both parties. This is very rarely the case. 

Wednesday, April 1, 2015

Common anchors and how to get rid of them

Anchoring is defined as the common human tendency to rely too heavily on the first piece of information provided to make subsequent decisions. Dangerous market anchors in the world of portfolio management are (but not limited to):
  • Index P/E – relatively valuing companies to the index P/E is very dangerous
  • Price relative to the all time high – if a stock was trading at 50% over its fair valuation and is now trading at 25% over its fair valuation, it does not imply that one should buy it just because it’s down by 15%
  • Trading close to the all time or 5 year or one year low – Just because something is at an all time low or close to it does not mean it’s cheap. There could be something really bad going on with the company
  • Buying on days when the stock is down and selling when it’s up – again these are path dependent results and do not add to your returns. If it did many people would chase this arbitrage, some might even write computer programs to do this, and it would no longer be true. If you don’t believe me you can back test this to realize that the return generated from doing this is pretty much the cost of trading.