Thursday, March 20, 2014

Safal Niveshak: Value Investing, the Sanjay Bakshi Way 2.0 – Part 2

For Part 1, which was a great overview on MOAT investing, go HERE. A big thanks to Vishal Khandelwal for doing these brilliant interviews.


As a disciple of Ben Graham, when working on any business and not necessarily moats, I developed my own ways of thinking about valuation.

Graham used to talk about protection vs prediction. He used to say that investors should seek protection in the form of margin of safety either through conservatively calculated intrinsic value (usually based on asset value) over market price or superior rate of sustainable earnings on price paid for a business vs a passive rate of return on that money.

That approach works well in many businesses as even though their future fundamental performance is largely unpredictable because one is, in effect, underwriting insurance.

Graham’s methods helped investors deal with the unpredictability problem in security analysis. For example, when you bought the stock of a company selling below net cash and the operating business was not losing money, then you were effectively getting the business for free. Even if the business may have been mediocre, it was free. And the typical Graham-and-Dodd investor absolutely loves freebies.

That kind of approach enabled you to justify a purchase because value was more than price even though one did not know by how much. Poor management quality was dealt with through insistence on an even lower price in relation to value.

For Graham, there were no good or bad businesses, only good or bad investments. And that approach can work if you practice wide diversification and buy out-of-favor businesses which are perhaps not doing very well right now but eventually might.

So there was an inherent belief in the idea of mean reversion i.e., poorly performing businesses would improve their performance over time.

In case of predictable businesses with stable cash flows, I used to talk about “debt-capacity bargains” and still teach that concept to my students. That’s because I think the idea of “debt capacity” is a very powerful mental construct in valuation.

The basic idea here was that the value of a debt-free business has to be more than its debt capacity. I discussed it in detail in one of my more popular lectures titled “Vantage Point” so I won’t get into the details here.

Similarly, buying into businesses where pre-tax earnings yield was in excess of twice of AAA bond yield, and the business had a strong balance sheet was one of the key methods of Graham for identifying a bargain security.

If you had a reasonable degree of confidence that average past earning power will return soon and the business had staying power (that’s why the insistence on a strong balance sheet), then sooner or later the market will recognize that the stock had been beaten down too much and there would be a more than satisfactory appreciation in its market value.

And even if you go wrong on a few of these positions, because you had so many, things would work out well eventually.

But as you move towards enduring moats, you move towards predictability and higher quality. In such situations, the need for protection in the form of high asset value or high average past earnings in relation to the asking price goes away.

Of course, that does not mean that you don’t need a margin of safety any more. Far from it. It’s just that the source of that margin of safety now resides in the quality of the business you’re buying into, its long-term competitive advantages, its ability to grow its earnings while delivering high returns on incremental capital without need for issuance or new shares or significant debt.

It also comes from the superior ability of the management to create a moat and to do all things necessary which will widen it over time.

Finally, the safety margin comes from buying the business at a valuation that would, in time, prove to be a bargain, even though today it may appear to be expensive to many investors.

It’s obvious that the art of making even reasonable estimates of future earning power of businesses a decade or more from now cannot possibly be extended to most businesses.

But I think — and I’ve learnt this over the years by studying investors like Charlie Munger and Warren Buffett — you can do that for a handful of businesses. And as Mr. Munger and Mr. Buffett like to say you don’t need very many.

Then, if that’s true, and I think it is true, you can reach out reduce the problem to just a handful of variables that will help you come with a range of potential future earnings and market values and from that you can derive a range of long-term expected returns. And I tried to explain that in my final Relaxo Lecture.

So, to summarize, 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.

I also strongly feel that when it comes to moats, it makes sense to think in terms of expected returns and not fuzzy intrinsic value.

What will not work is to apply the same methodology to every business.

For example, in my view there is a way to invest conservatively in businesses which are likely to experience a great deal of uncertainty. But you simply can’t use that approach when dealing with enduring moats. And vice versa.

You need to have multiple models to deal with different situations to avoid the “to-a-man-with-a-hammer-everything-looks-like-a-nail” trap.