Humble Investing
Creating an Enduring Framework & Process for Portfolio Management
CONTENTS
CORE FRAMEWORK
ENTRY PROCESS
Idea Generation
Investment Selection
PORTFOLIO CONSTRUCTION
Position Sizing
Core & Explore Construct
EXIT PROCESS
ALPHA GENERATION
PRACTICAL EXAMPLES
My Successful Investments
My Mistakes
MANAGING OPM
How do I think while managing other people’s money?
What should an investor, investing in my fund, expect?
CORE FRAMEWORK
“Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.” ~Warren Buffett, Berkshire Hathaway Letter, 19921
Not merely listening to Warren Buffett has helped me, but as I have made many investing mistakes based on free cash flow and earnings yields, I have internalized that the above quote truly captures the essence of value investing. Value Investing is simply buying something for less than it’s worth. I follow this timeless principle of value investing while managing money.
However, learning vicariously and experientially, I’ve observed that speculation ruins the so-called “dumb money” while dogma ruins the perceived “smart”. I do not believe in just “Value Factor” investing where one buys stocks trading at very low multiples. Without context, it matters little to me - whether a stock is selling at earnings multiple of 7, 17 or 170. A business is worth the sum of its future free cash flow discounted back at an appropriate long term interest rate. That’s how a buyer of a private business would value a business. One won’t think about the multiple first and the cashflow one can get out of the business, second. Rather, one would do the reverse and arrive at a multiple one wants to pay for a business. I try to think and invest similarly.
Still, for me to consider investing in a business, it should not only have an attractive free cash flow yield with reasonable margin of safety but also have certain qualitative characteristics: a strong balance sheet, a simple yet sustainable business model with low terminal value risk and a rational capital allocation framework in place from an honest and adaptable management, the only real link between business value and total shareholder returns. For the long term, I primarily stick to a diversified core portfolio of such companies. Tactically, I explore and take small positions in special situations that arise from infrequent market dislocations, leading to a long tail of holdings in my portfolio.
*I've explained my Core & Explore Construct below.
ENTRY PROCESS
Idea Generation
Over the course of several years, I’ve gotten ideas from 13F Filings and Factsheets of some of the greatest investors and from widely available platforms such as Value Investors Club, screener.in and Twitter. I also like Peter Lynch’s framework for idea generation - ideas can come from anyone from anywhere. Reading one earnings’ call transcript can lead to another company.
Through these sources, I’ve built a long and structured coverage universe of hundreds of companies. Periodically, I keep reviewing this list. As a practice, I have built Prof. Bruce Greenwald’s Asset Value and Earning Power Value models2 for several of these companies. I have an evolving understanding of how to value specific companies in many different sectors, and my models can adapt. Ideally, I want to buy quality companies where the spread between my estimate of the intrinsic value of the business and the market price is the highest. In my quest to achieve this, I sort my watchlist of quality businesses based on this value and price dispersion.
However, without being too dogmatic, I try to find attractive opportunities. I would consider even a seemingly bad quality business for a small allocation in my portfolio, if the risk/reward is in my favor. I assess that based on various factors: margin trend, balance sheet profile, ROIC (return on invested capital) trajectory, fundamental changes in the industry structure, cyclical uptick in earnings, unreasonably low market expectations built into the stock price, etc., as value investing does not mean buying only good businesses; it means buying businesses well.
In markets, the pendulum can erratically swing from one extreme to the other on any industry. Therefore, I often find individual ideas by thinking about operating performance and valuations of the businesses across sectors that have been performing well and badly at any given time. This way, we found really attractive opportunities in the Financial Sector, the Information Technology Sector, and hospitals in the Healthcare Sector in India.
*I managed the Taurus Tax Shield Fund from May 02, 2022 through August 04, 2023
Investment Selection
I like the idea of buying growth at a reasonable price (GARP) stocks. However, this well-intentioned idea has transcended the boundaries of investing to enter the realm of speculation because Buffett has taught us to buy a great business at a wonderful price while he himself does so, rarely. Perhaps, he knows that most investors neither have the fortitude nor the gumption to buy good securities really cheap.
Over the years, I’ve watched many “investors” including famed hedge fund managers and venture capitalists slap insanely high growth rates and margin assumptions on businesses to justify astronomical valuations for unprofitable businesses in highly dynamic industries, as if nothing can ever fall short of expectations. If you curiously question the assumptions of these “investors”, they would tell you such assumptions are “reasonable”. I simply avoid such mental gymnastics. Rather, I’m always looking for really attractive opportunities, yet I always keep mediocre companies as the secondary option for my portfolio over the higher quality ones.
As value and growth are joined at the hip, I want both. I find it hard to hold a business long term if it is not growing. A profitably growing business not pricing in its potential is my prescription to avoid most of the value-traps. Understanding the past and the present operating performance of the company, I also try to avoid investments that require high growth rate assumptions to work out. Embedding margin of safety at every step in my investment selection process, I look for the following qualitative characteristics in an investment:
Simplicity: I firmly believe that focusing on a select few things in business is effective. A business should be simple for me to understand. If a company has lots of adjacent businesses, it will probably be too complex to understand, and I am more likely to miss where the negative shock may come from. A consumer packaged goods company focused on chocolates and candies and a luxury watch manufacturer are great examples of simple business models whereas a semiconductor company is an example of a complex business model whose odds of future success are best handicapped by a specialist in the space.
Competitive Advantages: A business must be focused on making lives easier/pleasurable for its customers, and it should have some sort of a mouse trap with its customers: 1) regulatory capture like that of a stock exchange or a rating agency, 2) mindshare like that of the cigarettes and an energy drink maker, 3) sticky/contractual customer base like that of a mission-critical API/Chemical company, 4) distribution advantages like those of an adhesive and a baby milk powder maker, 5) geographical and cost advantage of a high quality zinc producer, 6) preferable and/or aspirational product/brand like that of a luxury jewelry maker 7) network effects of a social media company, etc. All such businesses usually have one or a combination of several such advantages.
Sustainability: A business model must have a profitable growth flywheel that has sustained its momentum for an unusually long period of time in the past and is likely to do so in future, aided by some sort of moat i.e., competitive advantage and/or total addressable market for its product/service. The longer the company can defend its moat, the longer the sustainability of its cash flows and reinvestment runway, reducing its terminal value risk. A simple business with a sustainable business model doesn’t require one to make bold predictions.
Good Corporate Governance:
“We seek to identify and own highly intelligent companies – companies that are focused on driving shareholder value higher, through great operations and intelligent long term strategic thinking combined with smart capital allocation.” ~Turtle Creek, 2020 Letter to Unitholders3
Judging people, especially avoiding charlatans, is a critical part of my investing process. Good Corporate Governance is not only limited to the integrity of the management - visible from the past actions related to how it treats its minority shareholders but also extends to the 1) capital allocation talent - visible in the business’s long term ROIC ranges, 2) ability to adapt/evolve - visible from some of the pivotal/key business decisions, and 3) hunger to grow - visible from long term Sales and Earnings CAGR (compounded annual growth rate).
a good ROIC: ROIC tells us how much a business earns on its existing investments. If ROIC-WACC > 0, a business is probably creating shareholder value. In India, the WACC (weighted average cost of capital) for most companies is ~12%. So, I’m inclined toward investing in companies that can consistently generate and sustain a >12% ROIC for a very long period. Typically, my core portfolio is made up of businesses that generate >15% ROIC.
a good Sales and Earnings CAGR: The Nifty50 Index has grown its EPS from4 Rs.73.73 in January 2003 to Rs.831.09 in January 2023 - a CAGR of 12.88%5. So, I’m more interested in companies that have been able to grow earnings at least in line with this historical EPS CAGR.
long term: Long term is not some timeframe. It is a way of thinking. Ideally, I want to own all the businesses I buy, forever, but it is an objective, not a prescription. So, realistically, when I’m researching a company, I look at its past 3 year, 5 year, 10 year sales and earnings growth and think about the same for the next 3-4 years. But I always think about the longevity of its competitive advantages for a much longer timeframe, as that lowers the terminal value risk, leading to higher intrinsic value even for businesses that have relatively matured.
*I have also reluctantly learned to admire the management teams that can tell their story well, while reinvesting in the business to build a powerful franchise for the long term. A good storytelling, backed by execution can help management teams control the narrative. And that may lead to increased market capitalizations for these companies, reducing their cost of capital to "keep building".
Low Leverage:
“Ants have adapted to be Resilient to extreme events, even though most days it costs them from a productivity optimization perspective.” ~Brinton Johns and Brad Slingerlend, Complexity Investing6
Lots of good analyses on capital structure focuses on minimizing WACC that is usually possible through debt. Using leverage could prove to be prudent 80% of the time, but it can wreck the income statement and the balance sheet during the rest 20% of the time so much that it may become impossible for businesses to bounce back. Businesses get destroyed when they add greedy fragility to their existence. Typically, I avoid companies with complex capital structures and those that use high debt to reduce their WACC, primarily to garner higher multiples for their stocks as it masks the low ROIC of a business. Personally, I value resilience more than I value optimization, just as ants do. However, whenever a company with sustainable business and good corporate governance increases the use of cheap debt, I look for a potential capital structure arbitrage opportunity.
*As on July 31, 2023, 20 out of 27 positions (~62% of the AUM) in the Taurus Tax Shield Fund have no debt.
Reasonable Valuation: What I buy is very important, but what price I pay is equally or more important to me. “Reasonable” and “Attractive” are the key operating words in describing my investment selection process. For me, a reasonable valuation is not the one that fairly values a business, but a cheap valuation that substantially undervalues the sum of the future free cash flow of a business. It is a valuation from which I can expect to generate an acceptable return on my investment.
an acceptable return: The Nifty50 Index has gone from 1,086 points in January 2003 to 18,064 points in January 2023 - a CAGR of ~15%.7 However, the index’s earnings yield has also trended lower as its P/E went from 14.74 to 21.74 during the same period. Without the multiple expansion, the index would have a CAGR of 12.88%. Hence, I consider an IRR (internal rate of return) of ~13% an acceptable one, supported by India’s GDP growth8 and inflation rate.9
*USD has appreciated from Rs.47 to Rs.82 during the same period - a CAGR of 2.82%.
Sometimes, a business is trading at a reasonable valuation in plain sight, but more frequently, I must think about the sustainability and longevity of the competitive advantages and the free cash flow trajectory of a business. If the market underestimates a business’s potential, the probability of positive surprises grows significantly.
While I tend to be prepared for the left-tail risks that could negatively impact a specific business, I also acknowledge the concept of Mean Reversion.10 Valuing a business, I rarely assume that a business’s valuation multiples and operating performance deviate dramatically from their long term averages in my favor. Still, I try to decipher the range of possible outcomes for each individual business in my portfolio, being cognizant of the fact that the best and worst outcomes in history exceeded the best and worst outcomes at that time.
Based on these ideas, I try to figure out what market expectations are embedded into the stock price. Keeping a decent margin of safety, depending on the terminal value risk in the business I am valuing, I arrive at a price I want to pay. Typically, the weighted average of the valuation multiples of the companies in my portfolio would be visibly reasonable.
*Weighted Average Multiples of the Taurus Tax Shield Fund
PORTFOLIO CONSTRUCTION
I believe that investing is much more art than science. Knowing oneself, one must paint one’s own canvas - a portfolio uniquely suited to one’s own personality and subjective understanding of businesses. Therefore, I’ve found that no position construction formula is prescriptive for me.
When a business comes into my radar, the first thing I think about is whether the product/service has a good value proposition and whether the business meets my quality parameters. Then I think about the valuation, and what I need to assume to get a decent return on my investment from the current price. The higher the quality and the expected return (based on my conservative expectations), the larger the position.
Position Sizing
“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so”. ~Mark Twain11
After selecting an investment, I try to assign probabilities for a range of outcomes on an investment through Bayesian Analysis.12 These probabilities are imperfect and subjectively dependent on my qualitative judgment of a business.
Ideally, I want to allocate the highest amount to the investments where the probability of my judgment being correct is the highest, as good investment ideas are scarce.13 However, I want to stay rational in my actions and do not want my profits/losses to cloud my judgment. I have allocated much higher weights to positions in my personal portfolio in the past. But today, a ~8% allocation to a business in my portfolio (at cost) works as an alarm for me to be less aggressive. I’m always constructively “worried” about my positioning, and such a position size cap prioritizes resilience and longevity over optimization of the portfolio returns.
*Most mutual fund mandates prohibit a fund manager to allocate more than 10% of the fund's assets into an individual position.
Averaging Down
“Losers average losers.” ~Paul Tudor Jones14
I believe that averaging sensibly,15 over time, is what separates a good investor from a mediocre one. With the benefit of hindsight, averaging down when one’s proven right feels great, but it could prove catastrophic in many situations. So, I predominantly average down aggressively in profitably growing companies that surpass the quality criteria I described in my ‘Investment Selection’ process.
As I try to inculcate margin of safety at every step in portfolio management, a stock going down a lot from my purchase price on a full position size, under normal market conditions, may mean I have been proven wrong, as timing the entry points matter. Even before entering a stock, I almost always have a clear plan of action in mind for my investments. I have a good idea about what I would do during a rise/a drawdown in the market value of that investment. I’m also prepared for a languishing price for a prolonged period.
Time reveals a lot about the accuracy of one’s decisions in markets. Unconventionally, once I make a purchase at a price that offers an acceptable IRR, I go into the rest and digest mode on that idea. I let it simmer for days and even months. I also try to understand the near term temporary risks to the stock price, so I can craft a sharper plan of action to scale up my position at a lower price.
As I build conviction, I average down on a good business because now my expected IRR has gone up. But customarily, I avoid averaging down on an investment in a business: 1) if I’ve reached a maximum manageable position size, 2) that is highly levered, 3) that is cyclical 4) whose competitive position has been threatened.
Averaging Up
Over a period of time, I’ve observed that good investments make one average up, not down. There are only two scenarios in which I will average up on an investment: 1) if the intrinsic value of the business has gone up at least in tandem with the price action, 2) if the intrinsic value of the business is higher than I initially thought was the case.
Core & Explore Construct16
“Don't tell me what you think, tell me what you have in your portfolio.” ~Nassim Nicholas Taleb, Skin in the Game17
Most investors want to buy high quality businesses, but there are ample opportunities in the lower tier businesses primarily because most investors wouldn’t touch such stocks. Usually, ~70% of my portfolio is the core that is diversified among 10 stocks that fit my business quality framework described above; these stocks have a secular growth trajectory with potential to compound earnings over a very long period. But the remaining ~30% is the explore part of my portfolio, comprising stocks that may deviate meaningfully from my quality framework. I believe such a portfolio is more concentrated than most of the intelligently constructed portfolios, yet more reflexive than the highly concentrated portfolios that rely on bolder predictions.
Nonetheless, I believe that no stock in my portfolio compromises on first principles of value investing – paying for something less than it’s worth. The explore part will have various types of stocks such as 1) Asset Plays – businesses that are trading below the replacement cost of the assets 2) Turnarounds – businesses that had management issues, but now material change is happening there or businesses that have a certain vertical with large TAM (Total Addressable Market) and/or businesses that have improving ROIC, 3) Cyclicals – businesses that are at their cyclical troughs in my opinion, and seldom 4) Unprofitable hyper-growth businesses with strong value proposition, reinvesting for their future.
Many times, I do not sweat on an exit strategy in a good quality business, but I have clear exit multiples (based on my understanding of their long term Ranges) in my mind for a lower quality business in my portfolio. Rarely, but if such a business improves qualitatively, I would stay with it longer unless my exit process commands me to sell.
*Monthly Factsheets: As of July 31, 2023, ~68% of the Taurus Tax Shield Fund's AUM is allocated to the top 10 holdings.
EXIT PROCESS
Most value investors including me have a bias toward understanding the downside from an investment well, but upside rips in stocks can take us by surprise, and these up-moves are as hard to manage as the downside. So, I try to hold stocks much longer, making it critical for me to predominantly invest in profitably growing quality businesses.
Rarely falling prey to the Disposition Effect,18 I would continue to hold a stock as long as the business is doing well and the valuation is merited, even sometimes at a premium. Yet, I try to understand the market psychology and narrative on the stock, based on commentary from market participants. I try to decipher when the stock has significantly deviated away from its fundamentals on the upside and has entered the positive momentum territory where each new piece of information about the stock is taken positively. In such a case, I would sell slowly and gradually on every rise, even when I “feel” that irrationality on the upside can prevail for much longer.
I would also sell a stock if: 1) a new issue surfaces about management’s integrity and corporate governance, 2) the operating performance of the business falls short of my conservative assumptions 3) the competitive position of the business has seriously been threatened, 4) my expected IRR from the stock drops below an acceptable IRR, 5) I believe that my thesis and understanding on the business and/or valuation were incorrect, 6) a better investment opportunity comes along.
ALPHA GENERATION
My objective is to perform better than major indices and my benchmarks. If I do not do so in the long term, I believe that there is no reason for my existence as an active money manager. Still, I do not claim to generate alpha, while simultaneously believing that I would perform decently well over the long term.
I believe there are 3 types of edges in the market:
Informational Edge:
"With enough insider information and a million dollars, you can go broke in a year." ~Warren Buffett
With the widespread information on companies today, it is very hard to get any informational edge. Company-related critical information must lawfully reach the broader markets at once. Managements and outsiders who have this information are known to have some “Black Edge”19 that, if used unlawfully for personal gains, may lead them into precarious situations. Nevertheless, most markets participants are complacent. I do not have any material informational edge, but reading and thinking take a lot of time and effort. Those who are inclined to do so have some edge over other market participants.
Analytical Edge:
"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." ~Warren Buffett, Berkshire Hathaway Letter, 200520
I take solace in the fact - if the great Sir Isaac Newton did not have an analytical edge in markets, I and most other investors do not stand a chance.
While I do not have any analytical edge compared with the growing number of Quants and Mathematical Ninja traders who can crunch large datasets and analyze the information much faster with precision, keeping an eye on a select few important business related micro variables that impact the stock, I may analyze an information that others deem useless, and make sense of it. Contrarily, I may choose to ignore a piece of information completely while others are sweating on the same.
Additionally, I do not believe that being more analytical in markets increases one’s probability of success. To succeed in investing, one needs to develop sound judgment and stomach volatility. One needs to comprehend relevant qualitative and quantitative facts, synthesize them to reach a reasonable conclusion, and behave well over time.
Behavioral Edge:
“One does not have to be smart to make a fortune. All he has to know and do is what it takes. Of times, that is so simple as to be beneath the notice of anyone but obvious Adams.” ~Thomas Phelps, 100 to 1
Investing is a humbling endeavor. It is the only profession, I can think of, where a non-professional may beat well-experienced professionals by a wide margin, merely by behaving well i.e. buying fear and selling greed.
Informational and Analytical edges are rendered completely useless if one isn’t self-aware and can’t control one’s emotions. One must learn and train oneself to behave well. What one shouldn’t do while investing in capital markets is as important as what one should do. Hence, I want to invert the question from “how will I invest well?” to “how will I invest terribly?”.21
There are many ways to fail at investing well. Barring speculators, I believe there are two terrible types of investors: 1) those who can't change their minds, 2) those who change their minds too often. I have observed that the absolute best investors persevere with the ideas they've internalized over long periods of time, and they have a sense when these ideas have been structurally challenged. Conviction can neither be borrowed nor be built on shaky foundations and belief systems.
While investing, I try to keep an open mind, yet never giving up on first principles of value conservation and value creation.22 Neither I try to be contrarian nor I try to be with consensus. I try to be rational and decisive. I try to think independently and correctly. I consistently work on my temperament to prepare for inevitable market drawdowns. My natural inclination is to be almost always wary of consensus. I try to have some variant perception23 on a specific business. I try to find disconfirming evidence against the existing and potential investments I like and do the reverse on those that I don’t.
No matter how much the upside is, I refuse to buy great businesses if they’re trading at prices that do not offer margin of safety. Markets oscillate between greed and fear. When they don’t aggressively do so, they entice people into doing something dumb. I buy fear, and I refuse to buy fancy, fad and greed. In my attempt to avoid stupidity, I am willing to remain relatively inactive for long periods of time. I refuse to invest in assets I do not understand well. The cost of this perceived behavioral edge is that I may underperform at times. Yet, I’m willing to pay this cost for the prize of doing decently well over the longer term.
"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." ~Paul Samuelson24
Most market participants are trying to get rich quick whereas I want to compound slowly, because I do not believe one can get rich quick. One can only get poor quickly. Most market participants are chasing high and quick returns. Going for a high IRR doesn’t take guts; going for a reasonable one does. Humility in position sizing and portfolio construction combined with realistic return expectations with good grasp on base rates are critical to success in investing.
I do not chase alpha. Alpha is a by-product of sound investing process, right behavior and mental fortitude. I believe that I have developed a sound process that has the capacity to suffer. I know that I try to behave well. I realize that I’m not as good as Buffett or Munger at analyzing a business and taking an extremely concentrated position. If diversification is the protection against ignorance, I need some of that protection. I think for myself and my fund’s unitholders. I know that losing money on a large concentrated position may dampen my self-confidence, a valuable asset as an investor, and make it harder for me to bounce back. That sort of self-awareness, combined with patience and decisive action, is my edge.
PRACTICAL EXAMPLES
*I believe that a great investment writeup is one where you have several lines about a business model and its moat, and few about valuation. But a great investment is the one that can be explained only in those few.
I’m extremely fortunate to have both passion and aptitude for investing. Through a lot of introspection on each investment I have made so far in my investing voyage, I have either learned something about myself or investing. Every stock purchase/hold/sell decision I’ve taken has been good, bad or mediocre.
Some of my decisions have had more impact on my learning curve than others, some of my decisions have completely uprooted certain thought processes, and some of my decisions have reinforced my beliefs in fundamental tenets of investing. But I don’t believe I have ever taken a decision that hasn’t had any impact on me consciously or subconsciously. Here, I share a few examples of investments that have been pivotal in my evolution as an investor.
My Successful Investments
If you buy something that's generating a 12 percent cash return and you buy it with 3.5 percent money, it creates a lot of free cash flow. ~Dr. John Carl Malone, Mavericks Lecture, 201225
In early 2015, I had just finished reading The Outsiders by William N. Thorndike, Jr., and I came across a NYT article26 about John Malone backed Charter Communications trying to acquire a much larger cable company, Time Warner Cable.27 My understanding of Malone was limited to the aforementioned book, and it was hard not to admire him. I think I understood his old playbook - buy great cash flowing assets with lots of cheap debt, ruthlessly cut costs, leading to realized synergies (that Malone believed most companies only talk about but never achieve), partly retire shares from the increased FCF that the company generates and partly pay debt bringing leverage down over several years and increasing overall FCF and FCF/Share from share repurchases. It wasn’t easy, but Malone had similarly built TCI, once the largest cable company in the US.
When I learned that Charter would go from being the 12th largest internet broadband player in the US to the 2nd largest after Comcast, I was intrigued. The news also mentioned that Malone’s company, Liberty Broadband that already owned a 25% stake in Charter, backed the deal, and would purchase a huge chunk of the merged new company (NewCo) at $176.95/Share28. Simply adding up the FCF of Charter and Time Warner, one could figure that it is possible that the company will generate $25/Share of FCF within 2 years.
That year, while talking with David Faber on CNBC, Malone mentioned that the former COO of Cablevision, Tom Rutledge, who will head the NewCo, is the best cable operator in the country. Cablevision had also done well under Rutledge, so Malone’s statement was backed by facts. Then Tom Rutledge in one of the similar interviews argued that the likelihood of the DOJ objecting to the deal wouldn’t be logical, as the NewCo would still be relatively smaller than Comcast.29
Later, Malone publicly commented that if the deal gets blocked, Liberty could reasonably argue for breaking up Comcast30, an improbable event at the time, for various reasons. In February 2016, the shares fell during a market drawdown and concerns regarding the Department of Justice (DOJ).
"A small extra gain is generally not worth the substantial risk the deal will break up." ~Edward Oakley Thorp, A Man for All Markets31
In my mind, the probability of the deal getting through was very high because the NewCo would still be smaller than Comcast, and the DOJ wouldn’t be unfair to Charter. I was trying to look for disconfirming evidence against my aforementioned hypothesis, and there were a few concerns in my mind as well. But in May 2016, the FCC (Federal Communications Commission) approved the merger.
From $180/Share in February 2016, the shares rose to $225/Share, yet, the market cap of the combined company after share issuance would be no more than $60Bn at this share price (considering no positive impact on the operations from the merger) whereas the standalone Time Warner and the standalone Charter was valued at $50Bn and $20Bn, respectively, when they were separate entities. I began buying shares at $240/Share, and wrote my investment thesis here.
Over time, the companies merged, and Charter became a behemoth. John Malone along with Tom Rutledge implemented his playbook really well - they issued debt to acquire Time Warner, cut costs, retired approximately 50% of the float, and brought down leverage over the next few years. In 2021, Charter’s FCF was ~$45/Share and the stock price crossed $815/Share. I had sold the stock at ~$650/Share.
What I learned: 1) Sometimes, capital markets are incredibly inefficient at pricing stocks, even large cap stocks, especially when there’s some uncertainty regarding a situation, and we can benefit if we are patient and prepared. 2) A capital allocator at the helm of any business is an extremely important variable in how a business performs. 3) Leverage is usually bad, but it could prove to be an exceptional tool in the hands of a seasoned capital allocator with a sustainable business model. 4) Focus on the long term opportunity, as equities really represent minority interest in a business.
“I don’t mind not having caught Amazon early. The guy (Jeff Bezos) is kind of a miracle worker, it’s very peculiar. But I feel like a horse’s ass for not identifying Google earlier. We screwed up.” ~Charlie Munger, Berkshire Annual Meeting, 201932
I had already researched Alphabet, and the moat of the business was hidden from no one. I felt that I may not get an opportunity to buy the business at an attractive valuation, and I had missed buying the stock during its epic bull run. However, in 2019, the company reported a quarter, and the stock fell ~10% within a day. A 10% overall drop is common in any stock at any given point in time, but a 10% drop in a business with a $700Bn market cap got my attention. Alphabet was already very large. I read and listened to the earnings call, and I figured it was an overreaction, as nothing had operationally changed in the business. The “tepid” 17% revenue growth - the lowest in 5 years - was a result of high market expectations, as the company had grown revenue 28% the previous year.
In my mind, at that scale, Alphabet was still a high growth company, as not many companies could grow revenue in the high teens, and that too at such a massive scale. After the drawdown, the stock had begun trading at 22x FCF, a nearly 5% FCF yield. I considered it attractive for a business growing revenue and earnings that fast and generating ~17% ROIC , despite significant billions of dollars of investments in the moonshots that the company called “Other Bets” in its financial statements. The digital transformation was still going on, the search engine and YouTube adoption were still growing fast, and the internet penetration in countries such as India is still increasing at a great pace. I figured that if the business could easily grow revenue and earnings ~15% (Alphabet had been doing much better in the past) for the next 3 years, my IRR could be at least in line with the business growth. In April 2019, I began buying shares at $60/Share (adjusted for 20:1 Split in 2022).
The stock had already risen from $60 to $70 by December 2019. In March 2020, Covid concerns brought the markets down, whereas the technology companies benefited. Working from home, people frantically used the internet and Alphabet’s various services: Google Search, Gmail, YouTube, etc. In one of the quarters in 2021, the company reported ad revenue growth of ~70%. The valuation floor and investor expectations had now been set higher. At its peak in 2022, the stock traded at $150/Share. I continue to hold the stock.
What I learned: 1) Whether you like a stock that the market thinks is terrible or you like a stock that the market also likes, variant perception on any given investment is somewhat important. In Alphabet’s case, the consensus was that the company is good, but it may not be as deeply moat-ed as the consensus earlier believed, whereas I thought that the company is still great, and its competitive advantages are still very much intact. One can have a variant view on a business, on its management, and/or on its valuation, but one must strive to have one. 2) Neglecting to look at a company that has already become large is a fallacy. Alphabet is one of the most followed companies in the world; almost every research and investing shop covers the stock, yet even such companies can be inefficiently priced. 3) Understanding the SOTP (Sum-of-the-Parts) value of a company could help one parse through the Total, as it was the case with the “Other Bets” investments Alphabet was making.
“I think of the highest quality companies as being in a class of their own: the 99th percentile is not 10% better than the 90th percentile but 10x better.” ~Josh Tarasoff, Founder, Greenlea Lane Capital33
In 2017, Natarajan Chandrasekaran34 was appointed as the chairman of the Tata Group. In one of the interviews, he talked about bringing efficiency to Tata Group of companies. He had begun making major changes. At that time, I had read the financial statements of most of the companies in the group, but I did not buy any.
In July 2020, I revisited those companies and Tata Power stood out - a Tata Group name with high debt, but nearly no bankruptcy risk backed by liquidity and cash flow at the Group level - trading at 0.8x its book value with ROE going as high as 13% during a cyclical uptick.
The whole power sector in India had gone through a long decadal consolidation and almost no market participant except a few seasoned value investors talked about it in the News or in person. Tata Power was attractive, but it did not pass my quality filters, so I began looking for more power stocks with Tata Power as a good secondary option. Most of the companies did not meet all my quality filters.
But as I screened for high ROIC companies in the sector, IEX with its ROIC ranging between 50% and 100% from 2012 through 2019 stood out. With >95% market share in power trading in India, IEX is a monopolistic platform that facilitates trading of power units, renewable energy certificates and energy saving certificates. It is a mission critical platform for many distribution and electricity generation companies that require physical delivery of electricity. It was evident that the business has significant competitive advantages including network effects and regulatory capture.
I believed that the markets broadly understood these advantages well, as even when most companies were trading at low teen earnings multiples, the shares of IEX were selling at 32x. I believed that IEX, with no debt, consistent >50% ROIC, >15% long term earnings CAGR, and its monopolistic market position, could organically benefit from the cyclical uptick in the power sector. Moreover, I could hold a quality business such as IEX for a long time, as the business’s ROIC and growth would probably create immense shareholder value. I believed that the shares had a strong downside protection that one rarely finds in stocks selling at seemingly high multiples.
I bought shares between November 2020 and February 2021 for an average cost basis of Rs.68.50/Share (adjusted for 2:1 bonus shares issued in 2021). At a ~3% earnings yield, >15% earnings growth and a possible bump to earnings within the next 2 years, I believed that the stock could double over the next 4 years, a CAGR of ~19%.
When IEX reported earnings in March 2021, the earnings grew a mere 7%, but the management commentary regarding future expectations from the business operations excited the markets, and the stock began rising. For the September 2021 Quarter, the company reported QoQ revenue growth of >21%, and the stock crossed Rs.300 mark. During this time, the earnings multiple of IEX went from a reasonable 32x to an unsustainable ~90x, and I gradually exited my position at an average price of Rs.228/Share. IEX at its peak traded at Rs.323/Share.
What I learned: 1) An earnings multiple by itself doesn’t hold much signal. Digging a little into qualitative characteristics of a business one intends to buy can be extremely valuable, as it provides one the gumption to buy and hold stocks that other market participants may deem expensive for various reasons. 2) Good businesses such as IEX are rare. If one can find and purchase such businesses over time, one can generate superior risk-adjusted returns, and one doesn’t need to necessarily sell these businesses, as one can average them up/down as long as the business is doing well and the valuations remain reasonable. 3) Do not sell a great business on the first sign of a good run-up in the stock price; stay with it. Look for market inefficiencies and the deviations from value to stock price not only while buying the stock but also while selling.
“Everything I’ve done has been on that basis and for the most part at Oaktree we don’t buy high quality assets, we buy low quality assets for the most part but we try to buy them so cheap that we’ll make money.” ~Howard Marks, Youth Financial Summit, 202235
As I mentioned under IEX above, Tata Power was trading below book value and the replacement costs of its assets. Before I began buying the stock in August 2020, it had already rallied ~114% in the previous 3 months. But I was focused on improvement in the business’s fundamentals. My ultimate average cost basis for the stock was Rs.62.08/Share, ~0.80x book value at the time. A business that doesn’t generate an ROIC above its cost of capital should deservingly trade below its book value, but Tata Power was able to meet its cost of capital, if not exceed it.
The company had 3 major businesses: Power Generation, Distribution and Renewables that would be de-merged into an InvIT (Infrastructure Investment Trust). There were some other core assets that the company would sell to de-lever.
Now, the value was going to be unlocked, and there was another business segment of Electric Vehicle Charging that had good growth potential. It was not beyond the realm of possibilities that the market could re-rate the whole business because of the InvIT and the EV Charging business.
Because Tata Power was a levered power company with ROIC sometimes going as low as 9% on overall business, I did not intend to hold it forever. However, the stock was attractive at a market capitalization of approximately Rs.15,000 Crores. The company had 9,000 Megawatts power generation capacity that could alone be worth at least Rs.36,000 Crores. Then it had many other assets including >3,500 circuit kilometers in urban areas such as Delhi and Mumbai; it was worth another Rs.10,000 Crores. Backed by the Tata Group, the company had nearly no risk of bankruptcy even if it incurred losses. The risk/reward was skewed in an investor’s favor.
In the very next quarter, Tata Power reported that it had reduced its debt from Rs.48,000 Crores to Rs.36,000 Crores through a few divestments, and the stock began rising. From a low base in 2020, the company reported a slew of good operating results, and I gradually exited the stock at an average price of Rs.185/Share by October 2021. I had imagined the stock price rising substantially from my cost basis, but I did not anticipate the speed at which it would rise. At its peak so far, the stock has traded at over Rs.280/Share in April 2022.
What I learned: 1) Optically bad-looking companies could be good investments, and as investors, we must be open minded to explore opportunities. 2) If I can handicap the probability of a business going bankrupt, based on its management pedigree, balance sheet, and profitability, buying it below the replacement value of its assets could prove to be lucrative. 3) I must always have a long term view on an investment working out, but I must not overstay my welcome in a cyclical/levered/commoditized business.
*Rs.1,000 Crores = $122Mn
“I like cigarettes, Miss Taggart. I like to think of fire held in a man's hand. Fire, a dangerous force, tamed at his fingertips. I often wonder about the hours when a man sits alone, watching the smoke of a cigarette, thinking. I wonder what great things have come from those hours. When a man thinks, there is a spot of fire alive in his mind - and it is only proper that he should have the burning point of a cigarette as his one expression.” ~Courteous Old Man, Atlas Shrugged36
Most people agree that smoking is illogical as it destroys both - a smoker’s health and wealth, but “the human mind does not run on logic any more than a horse runs on petrol. In real life, most things aren't logical — they are psycho-logical”37, writes Rory Sutherland in his book, Alchemy.
I believe the above quotes by Ayn Rand and Rory Sutherland are the key insights into the human psyche and why people smoke and may keep smoking for a very long time.
My thesis for ITC, a cigarette monopoly (~77% market share) in India, was very simple. ITC has had 4 types of enduring competitive advantages in its cigarette business:
Lindy Effect:38 Tobacco, as a product, is Lindy. Despite strict regulations against the product, it has flourished for centuries, and it will probably flourish for centuries because humans have been intoxicating themselves since the dawn of humanity. ITC, established in 1910, as Imperial Tobacco Company, has itself been in business for more than 110 years. From a terminal value standpoint, one would be hard pressed to find such a durable business.
Tobacco License:39 Government bodies - FSSAI (Food Safety and Standards Authority of India) and CBN (Central Bureau of Narcotics) - do not hand out tobacco/cigarette licenses easily. Rather, these bodies discourage tobacco chewing, smoking and sales of cigarettes, and the companies seeking tobacco manufacturing/distribution licenses must follow resource-draining cumbersome regulations and restrictive guidelines to get one. The government levies heavy taxes on cigarettes and tobacco products. Since 2016, it has also made it compulsory for the tobacco companies to put disturbing pictorial warnings that cover 85% of the packaging40 of tobacco and cigarette packs to dissuade potential future smokers.
COTPA, 2003:41 Cigarettes and Other Tobacco Products Act prohibits all companies to explicitly advertise their tobacco products, publicly. If a new company acquires a cigarette manufacturing/distribution license, it cannot effectively reach smokers en masse. Experienced in tobacco business, ITC has a regulatory capture (built over decades) that is extremely hard to breach.
Time & Mindshare: If one of the above moats of ITC are penetrated by any new company that manages to acquire a tobacco/cigarette manufacturing/distribution licenses, it would be incredibly hard for this company to convince loyal ITC’s Cigarette (brands such as Gold Flake, Classic, etc.) smokers to switch because of its superior brand loyalty built over decades. Time and heritage are few of the biggest assets that ITC possess.
But ITC has always had these competitive advantages. What made the stock languish for such a long time and what changed that the stock began its up-move?
In 2013, ITC reported an EPS (earnings per share) of ~Rs.6, and the stock traded at Rs.240/Share, a ~40x earnings multiple on a company that grew earnings at ~11%, leaving little margin of safety for potential investors expecting a reasonable rate of return on their investment in the stock.
From 2013 through 2019, the company had grown earnings at a meager CAGR of ~6%. Unsurprisingly, the market expectations had lowered over time, and ITC traded at the same Rs.240/Share 6 years later in November 2019, when I made it a small position in my portfolio. However, in 2019, ITC’s EPS was Rs.10/Share, and the earnings multiple had de-rated to a more reasonable ~24x, and ITC grew earnings by ~14% sales by ~11%, the highest growth of the preceding 5 years.
In my view, the reason for the languishing stock price was perhaps apparent in the ROIC falling from 35% in 2013 to somewhat stabilizing at a 23% (still very healthy) in 2017, due to incremental investments in its FMCG (Fast Moving Consumer Goods) business and especially, in its low ROIC hotel business.
During the Covid’s first wave in March 2020, there was a huge sell-off in broad markets, and the indices fell more than 35%. The hospitality businesses were explicitly and adversely affected because of the nationwide lockdown. During this panic sell-off, ITC’s stock price also fell sharply, and traded at Rs.138/Share.
In the quarterly earnings call after March 2020, ITC’s management explained that it will just finish up the existing hotel projects and won’t plough capital into hotels. This was a positive development, but the market’s reaction toward the stock was subdued. I managed to bring my average cost basis down to Rs.202/Share, a ~16x earnings multiple on a TTM (trailing twelve month) EPS of Rs.12.40. Moreover, ITC had no debt and held Rs.20/Share in cash, receivables and investments. Excluding this Rs.20/Share, my average cost basis on ITC’s operating business was <15x earnings. At an attractive ~6% earnings yield and nearly ~5% dividend yield backed by its FCF, ITC had little room for multiple compression, if any, and the business could grow earnings at least at a ~6% rate for a very long time. From my average cost basis, I was underwriting at least a ~12% CAGR on my investment. Any positive surprise over my long holding period could push the stock substantially higher.
Further, ITC’s non-tobacco businesses had been growing, and especially its FMCG business was growing revenue in the high teens. FMCG’s EBITDA margin had also gradually increased from 2.5% in 2017 to 7.1% in 202042. The management set an objective of building a Rs.100,000 Crore revenue FMCG business by 2030, and it communicated that it remains on track to achieve its target.
While many market participants argued that ITC’s FMCG business needed to do well for the stock to rise, I wasn’t personally counting on the FMCG business to do very well. The shares were so absurdly low priced that neither I had to fantasize about the possibility of stock's re-rating nor I had to sweat on the segment’s margin expansion. I focused on the facts. The FMCG business was a call-option for me, yet I imagined that the segment’s FCF over time could be as large as its Cigarette business’. If that were to happen, my investment would outperform even my most bullish expectations.
“The first rule of a happy life is low expectations. That's one you can easily arrange. And if you have unrealistic expectations, you're going to be miserable all your life." ~Charlie Munger, Poor Charlie’s Almanack
Until March 2022, ITC was trading at Rs.240/Share, close to where I bought my first stack of shares in November 2019, more than 2 years ago. On a TTM basis, ITC reported a ~22% Sales growth and the EPS bounced back to pre-covid levels of Rs.12.40. The results strengthened my conviction in the business. ITC’s businesses including Hotels and Papers businesses also got a tailwind from the reopening after the nationwide Covid-induced lockdowns, and the business operations gathered momentum. The expectations have reset again, and the stock is trading close to it’s all time high of Rs.480/Share, a ~31x earnings multiple on TTM EPS of Rs.15.40/Share. I reckon that the majority of the re-rating in the stock has taken place because of the growth in its tobacco business whereas other market participants I have interacted with believe that it is because of other businesses bouncing back. I think I continue to have a variant perception of the stock. I continue to hold.
What I learned: 1) Opportunities to buy good businesses at really cheap prices are rare in stock markets. I must continue to learn about other wonderful businesses to be prepared to pounce on such opportunities. 2) If I can verify facts on a business, my Contrarian thinking will most probably be rewarded. I must continue to be an independent thinker and continue to think for myself. 3) The beauty of holding a good business operation is that I don’t have to worry about selling it. I must continue to evaluate it periodically and on any material developments, but I must not sell it only to “manage risk”. I can hold a good business as long as it keeps executing and/or the market price deviates significantly from the value on the upside. Therefore, I must strive to find the highest quality businesses for my core portfolio, and patiently wait for them to be available at attractive prices. 4) Entry points matter in buying even the best businesses.
*I don’t look for long shots and multi-baggers, but I’m always looking for potentially the most certain money that can be possible in equities. The risk-adjusted returns matter to me. If a stock, for which I had to assume high growth rates for the business, advances by x% and the one for which I had to assume no growth advances by the same degree, it compels me to think deeper and introspect whether my mental models were flawed at the time of making the purchase. Good outcome on an investment may not tell me whether my thought process was correct, but right reasoning usually helps.
My Mistakes
My mistakes include both the errors of omission and the errors of commission. The following are a few examples of those:
"Earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies. Now, if you think that the return on equity of Japanese business is going to increase dramatically...and you're correct, you're going to make a lot of money in Japanese stocks...if a company's earning 5% on book value, I don't want to buy it at book value if I think it's going to keep earning 5% on book value. So a low price-book ratio means nothing to us. It does not intrigue us." ~Warren Buffett, Berkshire Annual Meeting, 199843
From a high of >$115/Barrel in September 2013, Oil prices had fallen to $45/Barrel in January 2015. As a novice, I had just entered the stock market after reading The Intelligent Investor by Benjamin Graham, the father of Value Investing, in October 2014. Without much nuance, I had superficially learned the concept of buying stocks below their book values.
CHK was the second stock I bought in my career. The company had ~$9Bn of debt, but it also had assets worth >$25Bn as per the company’s presentation, and (I realized later that the assets would only be worth that much only if the oil and natural gas prices stayed elevated) the stock was trading below its book value. I bought CHK at $14.50/Share. Soon after my purchase, the stock went up to $19/Share, but I kept holding. Neither I understood the unit economics of the business, nor I understood how risky its business model was, as it was solely dependent on oil prices and natural gas prices staying high. Sometimes, the stock price oscillated more than the crude oil price, making it an incredibly difficult holding, especially for a novice like me at the time.
In May 2015, I came across an article on Carl Icahn, the (in)famous activist investor raising his stake44 in CHK as the stock price fell precipitously. That influenced me and gave me some hope to hold on, as I had read just a little bit about Carl Icahn’s activism. However, by January 2016, Crude Oil traded below $30/Barrel, and CHK fell to $1.55/Share. Rather than holding on, I sold my shares for an 89% loss. Little did I understand how the stock market can behave in the short term. Within a few weeks after I sold my shares, the stock price went up to $7.50/Share, ~5x from my selling price on the news that Carl Icahn raised his stake in the company. In CHK, I went wrong on nearly everything - my buy, my hold and my sell. In June 2020, CHK filed for Chapter 11 of the US Bankruptcy Code.
What I learned: 1) Book Value without relation to the Earning Power Value of a business is not useful. Today, if a business is trading below its book value, it is highly likely that the business has bad unit economics. 2) Understand the business’s unit economics. Understand the variables that drive the stock price. CHK’s stock was an indirect speculative bet on oil prices and natural gas prices staying as high as $85/Barrel and ~$3/Million Btu, respectively. It only became apparent to me when the equity began evaporating with every percentage point drop in oil prices. 3) Never get influenced by anyone else’s purchase. As an investor, I must think for myself. 4) Never underestimate a company’s debt, especially in a commoditized business. Given the company’s fragile business model, cyclical nature of the business and mediocre management, CHK’s current ratio of 1.30 was risky. 5) Avoid selling a stock just to reduce the pain of seeing the losses in your account.
“Interoceptive pathways keep our brain constantly updated on the state of our body. The signals we considered, reporting on heart rate, blood pressure, body temperature, muscle tension and so on, served mostly homeostatic needs. Yet the notion of a gut feeling implies much more than this: it implies that gut feelings guide us in even the most complex mental tasks, like figuring out the stock market.” ~John Coates, The Hour Between Dog and Wolf45
After investing in Charter alongside John Malone, I believed that he would be successfully able to implement his cable strategy in Latin America and the Caribbean with the acquisition of Cable & Wireless for $8.2Bn including its debt of $2.7Bn through Liberty Global.46 LILA was a spin-off from Liberty Global.
Observing Charter successfully implement Malone's playbook, I had made LILA a large position in my portfolio at an average cost of $22/Share (or a ~$6Bn in market cap) during late 2016. As I attended one of the company’s earnings calls, the company’s CEO, Mike Fries at the time called the stock price “really, really cheap”, but repurchased only a minuscule number of shares. With a few divestments, Fries also tried to reassure the investors that the potential synergies from the merger remain on track, and the combined company will generate huge FCF going forward, as the industry in the region is quite fragmented. The shares still fell.
As the quarters went by, LILA still had little to show for in terms of profits and synergies. I was getting convinced that the company may have overpaid for the C&W’s assets. If that were the case, the company could be in deep trouble because of its huge debt pile, as the cash flows were not adequate. As the shares recovered, I sold them at par in 2017, nearly after a year of holding.
As of today, the shares trade at ~$8 with $1.80Bn in market cap, down ~80% since the spin-off. In 2021, LILA acquired another business, Telefonica’s Costa Rica operations. In the most bullish scenario, I can imagine that the company may generate $300Mn of FCF, but it is really hard to go buy the stock because of several capital allocation mistakes in the past.
What I learned: 1) Any management’s success in one geographical location (such as North America) doesn’t necessarily translate into success in another region (such as Latin America). 2) In investing, it is extremely important that we learn as much from our correct decisions as we learn from the incorrect ones. Be humble with your position sizing. LILA had debt and an unproven track record in Latin America. At one point, LILA was ~25% of my personal portfolio. I could’ve lost two-thirds of that, had I not been proactive in making the decision to cut the position at par. 3) Acquisitions are challenging, and they can wreck the financial statements of the businesses, sometimes forever. 4) Leverage on the balance sheet can be troublesome, even for the most seasoned capital allocators, if they pay too high a price for an acquisition and/or things go awry on the operational front. 5) Gut feelings are essential for rational choice. Using them to make a decision is not something to be ashamed of. Owning LILA for a year or so, I never quite “felt” right going through its earnings calls. I believe it was my gut telling me the whole time that I’m missing something. Fortunately and eventually, I listened to my gut and saved myself from incurring losses here.
“I would invest in pantyhose rather than communications satellites and motel chains rather than fiber optics.” ~Peter Lynch47
While working on my Apple MacBook and fiddling with my iPhone, I committed all the above mistakes. I had forgotten Peter Lynch’s famous words “Invest in what you know, and know what you own”. I bought Chesapeake Energy over Apple, and I deserved the losses I incurred, for using my galaxy brain.
After Steve Jobs died in October 2011, markets were skeptical of Apple’s innovation engine. Not believing in Apple's ecosystem and new service offerings, most market participants had begun believing that the company was merely a hardware provider that will end like Blackberry.
The result of this perception: one of the most loved brands in modern history, Apple, had a languishing stock price from 2012 through 2016. At a market capitalization of $594Bn, the company was trading at a P/E of ~12.8 and a P/FCF of ~9.7 while it had $146Bn in net cash on the balance sheet and a ~20% ROIC. By all accounts, the business surpassed all of my quality filters, and it was cheap.
The 13F Filings from Berkshire Hathaway showed that even Warren Buffett’s highly respected conglomerate had bought a small stake in Apple. I learned that either Todd Combs or Ted Weschler had bought the initial stake. However, later, Buffett revealed that he himself made Apple the largest position in Berkshire’s equity portfolio, buying a 5.40% stake in the company between 2016 and 2018. On the back of successful product launches, growth in the services business and share repurchases, Apple’s shares are up ~6x since Berkshire began buying. Berkshire last added to its stake in Apple in the first quarter of 2023. Apple grew its FCF by 19.89% year-over-year in 2022 to ~$111.44Bn48. Currently, the company has a market capitalization of $2.92Tn, and every perceived problem of the past seems trivial today.
What I learned: 1) Always validate/reject your priors through data and facts. This sounds elementary, but I still fall prey to my own biases. Investing is a serious business that demands sincerity. Despite being a Buffett admirer and glancing through all the financial statements of Apple, I did not buy the stock because I had a preconceived notion that the company was too big for me to make a good return on my investment. 2) Never deviate from the first principles of investing. Stock prices follow earnings and fundamentals of a business. 3) Be curious and genuinely interested in an idea. Never be dismissive of any business until you have worked on understanding it. I did not delve deeper into understanding the business’s ecosystem and its implications on future earnings prospects of the company. 4) While I was relatively new to the world of investing in 2016, not buying Apple was an error of omission because the business was within my circle of competence. I compounded my error further by not buying it later. Gradually, I’m realizing that repeated errors of omission are usually errors of commission.
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong." ~George Soros, The Alchemy of Finance
In 2019, I stumbled upon this idea while going through the factsheet of PPFAS Long Term Equity Fund (now PPFAS Flexi Cap Fund)49. There were also headlines about the Key Managerial Personnel changes at Persistent Systems, including the CEO50 and the Head of Technology Services.
The new management stressed on the importance of letting go of unprofitable and low margin businesses from certain clients and focus on stickier subscription businesses. At that time, the business was lumpy, but Persistent still had a 10 year Sales CAGR of ~18%, a 10 year Average ROIC of ~16%, and it was converting nearly 80% of its net income into FCF. Market participants had concerns regarding the fragility of the business due to client concentration. The top customer contributed 20% of the total revenue and the top 10 customers contributed >50% of the revenue. The new management had begun addressing these issues. Hence, the stock, being an ignored small cap, was trading at Rs.560/Share, ~10x its earnings or 0.80 times Enterprise Value/Sales, as it had ~Rs.1,000 Crores (~30% of the market capitalization) in Net Cash and Cash Equivalents. Excluding cash, one was getting the standalone business for ~7x earnings.
The stock looked attractive, but I also had the same concerns as the other market participants. I did not buy, but I added the company to my watchlist, and I kept listening to the company’s earnings calls. In April 2020, I bought the stock at Rs.511/Share during the Covid-19 induced drawdown in the markets. I took a small ~1% position, but in the next two quarters, Persistent reported 19% Sales growth while operating profit kept growing above 20%. As the stock reached Rs.1,700/Share, I reduced some, and I completely got out of my position at an average selling price of Rs.2,800/Share. The business has kept delivering since then, and today, the stock trades at Rs.4,800/Share, a P/E of ~40x.
Allocating such a small position to a company like Persistent has been one of my biggest mistakes in my investing journey, as one doesn’t identify such ideas often. Neither I had the courage to back my conviction to make it a larger position nor I had the gumption to hold the stock as it became a 10 bagger. Despite being right on the business, the management and the overall trajectory of the turnaround, I made a minuscule amount on an investment that could've been life-changing and career-defining for me.
What I learned: 1) Be decisive. Build conviction through a deep understanding of businesses, and have the courage to back your conviction. Pounce hard when the opportunity comes. 2) Position Sizing matters. Multi-baggers in one’s portfolio do not matter as much as the right position sizing does. 3) There’s a time to go slow on an investment, and there’s a time to pounce. Do not pounce when you can go slow, and do not go slow when the window of opportunity is open for a short period of time. 4) Price Anchoring bias is the enemy of a rational investor. The price one pays has no bearing on where the stock could/would/should go. If you purchased a business with enough margin of safety, don’t be afraid to average it up while the business continues to perform and the stock is attractive.
MANAGING OPM
How do I think while managing other people’s money?
“Our job is to create wealthy investors, not run after them.” ~Parag Parikh, Founder, PPFAS51
In the field of Finance, most of the people who say “What is good for the client is good for us” are merely virtue signaling. I differentiate the business of gathering AUM from the business of investing. There are phenomenal business people who run asset management companies, rarely generating returns superior to their benchmarks and peers, regardless of the asset classes they’re managing. I admire their entrepreneurial prowess and sales acumen for gathering large AUM. However, there is little to learn from them about investing well and portfolio management.
I think of investing as a profession that is focused on great outcomes for the clients. As doctors are health professionals, portfolio managers are wealth professionals who must prioritize improving their clients’ financial lives over selling more fee-generating products. I think of myself as a fiduciary for my fund’s unitholders, and I do everything in my power to serve their interests over everything else.
What should an investor, investing in my fund, expect?
I believe it is extremely important to do decently well over a long time in investing rather than try to hit it out of the ballpark. I’m not the right portfolio manager for you, if you want to outperform every month, quarter or even a year. I’m not the right manager for you, if you have an investing horizon less than 3 years. I’m not the right manager for you, if you fear underperformance during spectacular bull markets.
However, over a very long term, one can expect to do reasonably well in a fund I manage. During the roaring bull markets, one can expect our cash levels to build up. This is not a “cash call” I take; cash is my default position. Rising cash level means that I do not find enough attractive opportunities to invest incremental amounts in individual stocks. Similarly, during drawdowns, one can expect our cash levels to go down over time, and sometimes swiftly during sharper drawdowns. I think this is good news for the investors who want to compound their capital over a longer period.
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Disclaimer: This post is for informational purposes only. I may or may not hold securities discussed above. This is NOT a recommendation to buy or sell securities discussed. Please do your own research before investing.
Rs. Symbol used throughout this post is the Indian Rupee (INR). $ Symbol used throughout this post is the US Dollar (USD).
Quoted by Howard Marks, The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor, Chapter 14, Knowing What You Don’t Know
When do you average down?, John Hempton, Bronte Capital
I borrowed the phrase Core & Explore from Anthony Robbins
Nassim Nicholas Taleb, Skin in the Game: Hidden Symmetries in Daily Life, Introduction
Edward Oakley Thorp, A Man for All Markets, Chapter 17, Period of Adjustment
Courteous Old Man, an owner of a small newsstand quoted by Ayn Rand, Atlas Shrugged, Chapter 3 - The Top and The Bottom
Rory Sutherland, Alchemy, Introduction: Cracking the (Human) Code
Nassim Nicholas Taleb, Antifragile: Things that Gain from Disorder, Glossary
John Coates, The Hour Between Dog and Wolf, Page 1, Chapter 4, Gut Feelings
Warren Buffett also said, "if you can't hold the stock for 10 years don't even think about it for 10 min.." your approach looks more inspired from Indian fund managers obsessed with PE ratios than Buffett. The frequent portfolio churn can be avoided.
This constant urge to find new idea to invest can be dangerous. Humans are biased thinking if you are not constantly churning, you are not working. Instead find handful of excellent businesses and holding them for longer term may be more rewarding.