What we don't know

During the recently concluded Emerging Markets Finance Conference, organised by Finance Research Group,  Michael Barr presented on the topic 'Finacial Regulation: The Long View'. As a precursor to his talk on the Dodd-Frank Act, Michael presented how financial crises are caused because of things 'we don't know'. It's not as simplistic as it sounds and luckily for us, Michael broke it down.

As an amateur investor who's grappling with so many unknowns, I thought Michael's first slide was very relevant to the investing process. After all, most financial misadventures, at the level of the entire economy or in individual investing, are caused due to human misbehaviour. We can save ourselves a lot of trouble by being intellectually honest and putting unknowns under different types before making any investment decision. Here's the list:

1. What we once knew but have now forgotten - Well, shame on you! As George Santayana famously said, "Those who cannot remember the past are condemned to repeat it." Enough said.
   
   
2. What is knowable but is kept hidden - There's some leeway to get around this. Attend conference calls and ask tough questions. Reach out to investor relations and seek meetings with management (some investors think that they might get biased after such meetings and that concern is warranted). Also one could do some scuttlebutt on their own and speak with customers, suppliers, dealers, etc. in the value chain to know things. Beyond this, if you're still unsure, you should give the idea. When in doubt, tune in later.
   
3. What we know, but don’t know what it means - These fall out of your circle of competence and are best avoided. For example, I know there's an NPA problem in Indian banking presently. So what? Can I take a contrarian call on some banks that are financially healthy? No, because I don't know how to evaluate NPAs, let alone the health of financial firms.
   
   There's scope for improvement here. Try to get to the bottom of things. Increase your circle of competence. If something seems difficult to understand, inverting might be helpful.
   
4. What we don’t know that we don’t know - The Black Swan. Even with the biggest firms (with supposedly high levels of transparency), agency problems will remain and in certain cases, shareholders will be poorer for it. For example, the Satyam scandal. If auditors were duped, there's little chance you'd have been diligent enough to see through the accounting gimmickry. Or the recent Welspun issue. Consider these as black swan events and move on. But learn from these events, so as not to repeat mistakes from type 1. This way you will be cognisant that none of your positions should be large enough (no matter how great your conviction is) to cause you permanent damage.
   
5. What we should do about things we know - Undoubtedly the most hilarious. On one hand, not acting on what we know leads to errors of omission. But on the other, acting inappropriately might lead to errors of commission.
   
   I am firmly in the camp that believes it's best to pass opportunities where one cannot ascertain potential upside/downside AND where the risk reward ratio is not favourable. With this framework, it's probably better to have errors of omission than errors of commission. Errors of commission can be avoided to some extent by putting every investment thesis through a checklist to see which ideas survive and how much you should bet on them. If type 4 types unknowables don't spoil the party, at least some of your investment thesis will stand the test of time. Only a few of these are required to make the biggest positive impact on your portfolio in the long run.

So what can you do?

• Type 1: Eliminate them. History is a great teacher and it's highly likely that the situation at hand resembles something that's happened in the past. Not to you maybe, but maybe to some other great soul. Buffett says - "It's good to learn from your own mistakes. It's better to learn from others' mistakes."
  
  Read financial history, about investing legends and their investment process. You're likely to come across many companies from mature economies such as US and these learnings may be directly applicable to India currently or in the future.
  
• Type 2 & 3: These can be minimised through constant learning and an increasing circle of competence.
• If you are unable to increase your competence because of lack of will/time, pass such opportunities for a future date when you're more inclined to think about them in greater detail.
• If you can't eliminate the 'hidden' aspect of the unknown, be cognisant that it might come to bite you in the ass as a type 4 unknowable. Even if the risk/reward ratio is highly favourable, you're better off not assigning high weight to such a position in your portfolio.

• Type 4: What you cannot avoid, you must live with. Take these in your stride. Don't give very high weights to any position no matter how high your conviction.
  
• Type 5: Stick to the checklist and create feedback loops to your investing process. Be the devil's advocate and ask - what you think you know is really all that is required to know? If the answer is not a resounding yes, there's scope for improvement.

It is my attempt to think about the moving parts of any business and put different components under these different silos. Hopefully, this will make me cognisant of strengths and weaknesses of my knowledge and lead to more sound decisions.

Investment Checklist III - From the customer's perspective

This chapter in Shearn's book goes to the heart of the scuttlebutt approach that is so popular. Not all investors use this approach. But viewing the business through the customer's perspective can be very useful. It can expose some biases that we're falling prey to. Often we like to hear good news about the business under consideration. This positive feedback loop can actually be hugely detrimental to a sound investment thesis. The scuttlebutt approach finds answers from stakeholders who actually drive the demand for a business i.e. the customers.

This post also begins to focus on concepts for competitive advantage that were missing in the previous post. Okay onto Shearn's checklist then -

1. Who are the core customers of the company? - Sometimes a major share of the revenues can come from a small percentage of customers. Understanding why these customers will stick around at times of distress can be the differentiating factor for a company's success.
2. Is the customer base concentrated or diversified? - Without product differentiation, a company is better off with a diversified customer base.
   
   Unfortunately unlike US companies, Indian companies are not obligated to mention the names of customers that contribute the most to their revenues. But with a little search should generally reveal names.
3. Is it difficult to convince customers to buy the company's products? - A company having an aggressive sales strategies without other merits will not have a sustainable advantage.
   
   
4. What is the customer retention rate? - Brand loyalty can be the make/break thing for a company. It pays to hear from the horse's mouth why it will/will not drink the water.
   
   Companies which have subscription services might be susceptible to disruption. Tracking customer retention is crucial here. Even if there are newer customers, without returning customers a business cannot grow e.g. Why should Mahindra Holidays/Wonderla/Speciality Restaurants continue to increase profits if they don't have returning customers?
   
   It is informative to speak to sales people and see whether they receive commissions for customer retention. e.g. the insurance business is completely based on this.
   
   If a company is selective about its customers, it's usually a good thing. This shows that the company wants to work with long-term clients who'll provide sustainable business.
5. Is the company customer friendly? - A customer friendly business, especially where customer-company interaction is very frequent is likely to do better.
6. What pain does the company alleviate for the customer? - This is important to determine for service oriented companies.
7. To what extent are customers dependent on the company's product/service? - Discretionary customer spending is likely to drop in times of financial hardship. Products which are more "need to have" are unlikely to face pressure.
8. If the company disappeared tomorrow, what would its customers do? - This reinforces the need-to-have v/s nice-to-have thinking. e.g. most fixed income managers would be completely lost without ratings companies.

Investment Checklist II - Understanding the Business - the basics

Once a company catches your attention, the first thing to do is to study the business. How does the company make money? What products/services does the company sell? If you can't describe the core business in a couple of words, it definitely deserves a place in the 'too tough' bucket. With modest effort, if you can't understand the business, you should not proceed any further.

Even if you're able to describe the business, you may have no competence in evaluating the business. For example, I might have some inkling about the oil and gas industry (because I worked in it for three years), but I am no master. So before I write my investment thesis, I must pin answer some questions -

1. Do I want to spend time studying this business? - Two things may deter you to proceed with the company at hand. You might not be interested in the business or you might discover that the learning curve is too steep. In the former case, you should definitely give up the chase. A company which bores you initially is unlikely to keep become the bedrock of investment success. (Second level thinking would also apply here - some of the best investment bets come from companies ignored by Mr. Market in the short term for being too boring!) In the latter case, you can be a good judge of the opportunity cost of your time and make a rational choice. The time taken to develop an understanding of the underlying business can be immaterial to investment success. But the depth of knowledge is not. I now try to aim for an inch wide, a mile deep sort of understanding of the companies that I'm invested in.
   
2. How would you evaluate the business if you were the CEO? - If you've always worried about your investment as a minority shareholder, you're probably not a long term investor. Wealth creation in the long term comes from alignment of interests between management and shareholders. Think like Buffett and try to evaluate a business like you'll hold it forever. This allows you to think like the CEO of the company. Not only will you pay attention to understand the business in great detail, you will also be able to evaluate management decisions in line with the company's vision.
   
3. Can I describe business operations in my own words? - You've probably done the short version of this already. But this delves into more specifics. Write down your answers to these questions and other things you think are relevant to your company. Doing this will expose grey areas in your understanding.
• What does the business manufacture/deliver?
• What are the raw materials used? How are these procured?
• Who are the customers? How is delivery done?
  
4. How does the company make money? - When I was reading Shearn's work, I thought he was being repetitive here. But the example provided by him does good justice. At the onset of the financial crisis, few financial gurus would have understood the complexity of credit default swaps. It was definitely right to say then that AIG is in the insurance business. That answered our previous question. Easy enough, but was that sufficient? NO.
   
   When the business model becomes so arcane that it's difficult to predict the effect of esoteric events on product groups, it's probably best to not bet. Personally, and given the lack of experience in my investment career, I try to stick to businesses which sell a single product/service.
   
   
5. How has the business evolved over time? - Has the company evolved into developing competitive advantage over a prolonged period of time or was it just at the right place at the right time? For cyclical industries, a bull run can see many companies rise to historic highs. With the incoming tide, everything rises. Only by delving into the past we can separate the wheat from the chaff. Good place to start is the company's website. Then onto annual reports, forums and any other media articles.
   
6. In what foreign markets does the company operate and what are the underlying risks? - Many companies have revenue streams outside their home country. In the Indian context too, a number of domestic players are entering newer geographies to diversify their customer base. This growth-oriented strategy comes with its own share of risks and opportunities.
• Similar to the overall study of the company's history, it is important to study the history of a company in foreign countries. Each operation is an economic unit unto itself and can be expected to have unique customer preferences. 
• Unless the product/service being sold needs no differentiation in foreign markets, a company will have to spend significant resources on R&D and marketing to appeal to its new customers.
• Do foreign operations have their own management teams? - Strategies in developed/mature markets are unlikely to work in developing/nascent markets.
• Is revenue growth translating into profit growth? - Be cautious if the company does not break-up its profits between geographies. The company may be masking bad performance in some countries with better performance across others. Only with a proper break-up between revenues and profits amongst the geographies can we get a good sense of multiple streams of income. Generally when a company enters a new market, it has larger costs than in mature markets. This goes beyond fixed costs to set-up plant and equipment. To gain market share, a new entrant has to fight incumbents and can be expected to have larger advertising and marketing costs.
• What are the risks to the foreign currency earnings? - Earnings are most likely denominated in currency of the foreign country where subsidiary is located. These earnings are subject to country, political and currency risks. One must be cognizant of these before extrapolating past successes onto newer geographies.
• Country risks - Protectionism and tax inefficiency are some examples. Good places to get a flavour of macroeconomic conditions are World Bank's Doing Business Report and BMI's Country Risk Reports.
• Currency risks - Currency fluctuations will have an impact on the revenue reported in the home country. Most companies use forwards to hedge their revenues. This means setting an exchange rate in the future based on current rates. This gives greater clarity in terms of expected future income. Some companies export and import from the same countries. This serves as a natural hedge to their operations. Hedging policy can be found in annual reports and management disclosures to investors.

This post helps us evaluate businesses from the management's perspective. Nothing has been said so far about the competitive landscape in which the business operates. The focus has only been on what the business does and not on how it competes with other businesses. In the next post, we will view businesses from the customer's perspective. That will do more justice to questions on industry and competition.

Investment Checklist I.I - Filtering your ideas

Once you have a hunting ground for ideas, the next task is to filter them and put them in different buckets. Charlie Munger does this quite simply. He has only three buckets - in, out, too tough. But how to filter?

Circle of Competence

Working inside your circle of competence is crucial. It's not so much that you can never make money outside your circle of competence, but mistakes made here will take a toll on your portfolio and consequently your mental well-being. Also with investments failures outside your circle of competence, you are unlikely to learn anything from a post-mortem. 

Try to widen your circle of competence. Don't be despondent if you're unable to do so. You will find opportunities if you're patient enough. For example, till recently Buffett did not invest in technology stocks. He was ridiculed prior the tech bubble, but in hindsight his obstinacy saved him. 

Once you have identified that an idea is within your circle of competence, you may proceed to detailed questions based on past performance.

Criteria is a filter

Shaern points to a number of questions which can be used to filter investment ideas. More than anything else, I like to boil it down to some very basic things. Motivated from an interview with the Big Bull, I like to look for five things during my initial search - 

• Opportunity - This is a measure of how long the runway is for the industry and consequently the business. 
• Scalability - Is the business scalable? Can additional plants/manufacturing units be put up with increased return on incremental capital?
• Management integrity -  Probably the most important facet to avoid sour grapes in the Indian context. Does the management have a clear vision? Does it communicate this is a transparent way to stakeholders? Are minority shareholders given an equal opportunity to reap benefits from the underlying business?
• Competitive ability - This covers aspects related to Porter's five forces and moats.
• Valuation - "Price is what you pay; value is what you get" - always remember this. Without a reasonable estimate of value, you're only gambling.

Valuation is a criteria

There are numerous ways to arrive at valuations - DCF, relative or residual. Each has its own pros and cons. What one may use is highly dependent on the situation at hand. [post forthcoming]

For instance, Shearn quotes the example of Brad Leonard who uses enterprise value (EV) to EBITDA as a qualifying valuation criteria. In his words - 

"When you are paying one or two times EV to EBITDA, not much needs to go right. If the business survives, you win. As long as the business does not end, you don’t need to make a lot of great assumptions in your analysis. If instead I were paying a 5 percent earnings yield (earnings divided by market capitalization) on depressed earnings, it would not really be that cheap."

Valuation lies in the eye of the beholder. Subject to inherent assumptions, two people can come up with varied notions of intrinsic value. They may be both right (or wrong) at the start, but in the long run, the one to gain profitably from investing is likely the one who's honest and conservative in his assumptions and bets with good margin of safety.

Using a tracking sheet

A tracking sheet is a wonderful way to monitor businesses. More often than not, you'll encounter businesses which look strong fundamentally but do not offer any margin of safety. A tracking list gives you a number of advantages in making rational decisions:

• The sheet keeps our favourite businesses on the radar. An alert system can be incorporated to notify us about stocks that offer good price-value propositions in the future.
• Putting a business on the tracking sheet helps wear off the novelty of a new idea. We are conditioned to act impulsively and the sheet instills the discipline to think holistically before a buy decision.
• Ignoring other businesses in the sheet is the opportunity cost of making a new stock purchase. One is likely to make the best choices amongst a list of relatively good stocks. Over time, this is likely to deliver handsomely to the overall portfolio.

I've touched base with the most rudimentary ideas here - in further posts, I'll delve deeper into each of the matters listed here.

Investment Checklist I: Hunting for ideas

This is the first in a series of posts inspired by Michael Shearn's work The Investment Checklist. I'll be following a chapter-wise format as provided in the book. I will also follow up points made in the book with my own commentary of my understanding so far. For any examples provided in the book, I will use Indian examples for my own benefit (and hopefully for yours too).

This post deals with generation of investment ideas. Quite frankly, I am boggled with the multitude of options illustrated in investing literature on how to make money. The answer perhaps lies in developing your own strengths, learning about your biases and making informed and rational decisions with a long term perspective. Investment ideas can be qualitative or quantitative or both. Let's start with hunting grounds for investment ideas.

At the outset, Shearn warns his readers quite prophetically -

"You need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime."

Are we indulging in intellectual masturbation here? What is the point of this all, if you're not going to get rich. No, no. I didn't say it. If you're a Munger fan and practice second-level thinking, you've probably already figured it out - most of your money will be made in just a handful of investments. So pull no punches when opportunity presents itself. But how many punches - if you're listening to Buffett, no more than 20!

Some places to seek new ideas:

1. Times of crisis undoubtedly present exceptional opportunities. Take for example the Asian crisis of 1997-98, the tech bubble of 2000 or the mortgage crisis of 2008. Most of the these opportunities arise out of forced selling. This happens when institutions must make good on large-scale client redemptions. Even though fund managers may have some inclining that the stocks they're dumping are intrinsically undervalued, they have no choice but to meet their mandates.
   
2. Other examples of forced selling include selling after a stock is dropped out of an index. This usually happens because stocks are ousted as index constituents based on some mathematical computation (such as market cap). Spin-offs may also present If such stocks are fundamentally sound, they may present good opportunities.
   
   Comment: In the Indian context, I am unaware of any academic study which checks the stock performance of stocks which dropped out of indices. But the exercise may be worthwhile. With regard to spin-offs too, I am not very well informed. In recent times, Syngene IPO and the run up in both its stock and that of its parent Biocon may be a worthwhile consideration [post forthcoming].
   
   

   

   Syngene and Biocon (after listing of Syngene)

3. Broad market sell-offs: look for sectors which are in greatest distress. In other words why is capital scarce in such sectors and why are investors fleeing? Invert and ask yourself, when the
   cycle reverses - which companies will stand to gain the most.
   
   Inversely, which sectors seem to have an abundance of capital? Which sectors have highly leveraged balance sheets and appear to be heading into bubble territory? These may the ones to avoid.
   
   Comment: As an illustration I compared the BSE Metal Index with the Sensex. Metals unde-performed the broader market for three years from 2012 to 2015, but staged an impressive comeback in 2016 during which time Sensex has been almost flat [post forthcoming].
   
   

   

   Sensex v/s Metals (2013-15)



Sensex v/s Metals (2016)

4. Stock-specific sell-off: When bad news hits a particular business, investors dump the stock quickly. This can be good hunting ground if you can make the distinction between permanent and temporary distress. Take for example, Buffett's investment into American Express after the Salad Oil Scandal.
   
   Comment: In the Indian context, think of the Maggi fiasco. Or more recently, the Welspun cotton-issue or promoters at VRL saying they will get into airlines. Are these investment bets for the future? I don't know. But if you do your homework and find the distress temporary and inconsequential to long term profitability for the companies, these may present good buying opportunities. [posts forthcoming]
   
5. Stock screens: Tools like screener.in are indispensable to retail investors. They help us quickly sort through a multitude of companies using financial indicators which are most important to us. But perhaps, screens are too simplistic. When the devil lies in the detail, some caution is warranted. A principal concern can be in the nature of accounting itself. One needs to look at real earnings [post forthcoming]. Also, if you're looking at earning multiples, a temporary loss can throw a company out of the screen. Most importantly, without the necessary tools build into a screen, it's difficult to investigate the qualitative aspects on an investment thesis such as management integrity.
   
   Comment: For example, Lycos Internet is always thrown up on my screen whenever I use return metrics for screening. But it's trading at PE of 0.88 currently! Surely something must be wrong here? Could this be a case of creative accounting? [post forthcoming].
   
6. Low lifes: It maybe worthwhile to investigate companies which are hitting 52 week lows. Some companies may be deservedly in the list, but some may be going through temporary distress. If you can connect the dots with point 4 related to stock specific sell-off, you may find good bargains.
   
   Comment: For example, look at Speciality Restaurants. The company has been hitting lows since its IPO. But they have no debt on their books and whenever I've been to Mainland China, I've always been pleasantly surprised with the quality of their service. A turnaround could augur well for shareholders. [post forthcoming]
   
7. Coat-tailing: Following investments of renowned investors and betting with them is called coat-tailing. It can be incredibly useful to hunt for investment bets. A word of caution is warranted here. Without an investment thesis, betting your money is akin to gambling. So while coat-tailing may be a good idea to discover companies, without independent research you cannot build conviction.
   
   Comment: Investments above a certain percentage of shareholding of the company or monetary value must be disclosed as Bulk/Block deals to the exchanges. These can be the mostly timely indicators of interest by seasoned investors. Annual reports also carry names of top ten shareholders besides promoters and management.
   
   
8.  Buying shares to track a business: Sometimes you need motivation to get things going. This involves buying small quantities of some companies which look interesting but where you've not completely formed your investment thesis. These holdings generally don't affect your overall portfolio (consequently, you can't expect to gain enormously if these do well too). Paul Sonkin of Hummingbird Value Fund calls this the grab bag. This idea maybe seem to be at odds with Warren Buffett's 20-punch rule, but examples like American Express come very infrequently. In most cases, conviction builds over time. The idea is to keep these holdings in your mind space and research in greater detail (even if valuations aren't very rosy). In the long run, when the iron is hot, you'll know where to strike.
   
   Comment: I've been guilty of indulging in some investments with this point of view. Consumer discretionary businesses like Wonderla Holidays and Mahindra Holidays present some examples.
   
9. Looking inside: Sometimes you already own the best ideas and don't need to go looking around. When valuations are favourable and your original investment thesis is still at play, you can buy more stocks of business you already own. Think in terms of opportunity costs.
   
10. Researching IPOs: Shaern points to something important - while researching IPOs, you don't have any prices to disrupt your valuation process. Without availability bias, you're likely to form an independent opinion of the company. Soon after listing, you can validate your valuation against the market quoted price. IPOs are inherently cyclical in nature (just look at the money raised in 2016 compared to previous years). In a bull market, valuations can be exaggerated. Having an independent opinion can save you from losses. Moreover, many IPOs are likely to be those of new-economy firms. Tracking changing industry trends in the market can serve in the long haul.

This list is obviously not exhaustive. To an amateur whose just starting off though, this list can be handy. To cut it short, ideas can be discovered anywhere. If you're a Peter Lynch follower you'd keep an eye for brands in the supermarket too.

Please note: I'm not a SEBI registered investment advisor and my discussion of stocks is not a recommendation to buy/sell/hold or transact in any way on the stock exchange. Please do your due diligence and make informed decisions. 

Are you ticking the boxes?

Numerous investors [here and here] have highlighted the use of investment checklists in screening potential investments. Mohnish Pabrai likens the investment process to surgeries and flying airplanes and is inspired by Atual Gawande's book Checklist Manifesto. Bottom line - seemingly complex tasks can be broken down to simple ground rules. Breaking decisions over smaller bites consumes lesser mind space and avoids biases.

Smart investors make their own checklists and I was educated on this quite early on. Still, you only appreciate the process till the rubber meets the road. For example, I discovered Michael Shearn's book The Investment Checklist even before I started building my portfolio. When I read the book initially, I was able to go only so far. Most of what was written seemed obvious and mundane. There were some aha! moments, but without practice, I felt like I was indulging in intellectual stagnation.

In my own journey so far, only six months old mind you, I've already bought some stocks. Although I've tried to stick to the basics (such as reading annual reports in detail, performing independent valuations and buying with a margin of safety), I now feel the need for well-grounded rules. Most of purchases have come without any record of investment thesis. I know I will regret this later and let biases ruin my rational decision making if I don't indulge in making a checklist now.

I already feel animal spirits taking over me. The markets are on a downward trend following the Trump election and the demonetisation wave. The 'buy low, sell high' mentality drives me to jump into the market impulsively and buy more. However, without a sound understanding of my present holdings and almost no understanding of other businesses in the market, I feel intellectually incapable to act. Therefore, I am wary to make any more purchases till I build strong investment thesis for my present holdings. Making a checklist will not only screen my present holdings for possible errors, but serve as a template for future purchases. I think this exercise is well deserved and will serve me well in the long run!

For starters, I've decided to back to 'The Investment Checklist'. The next couple of posts will look at Michael's checklist in greater detail.

Getting started: How to think about potential investments?

Everything that needs to be said has already been said. But since no one was listening, everything must be said again.

- Andre Gide 

The best ideas are already out there. So there's no need to reinvent the wheel. Save yourself the trouble of thinking you're truly special to come up with innovative solutions every time. Some of the world's most successful value investors are cloners, and there is no shame in it.

With reference to thinking about potential investments and tracking them on an ongoing basis, the following are useful:

1. The four-quadrant approach is an effective way to think about your potential investments. It avoids the clutter and neatly organizes companies into four buckets as per business and valuation. Going ahead it makes sense to have rules about how much you will be willing to bet into these buckets.

2. Vishal (founder to Safal Niveshak) has done a great favour by teaching amateur investors how to keep track of their investments using Google Finance and Excel. It's a very handy tool and serves as a ready reckoner of potential investments. 

Most often good businesses are not available at cheap valuations. If you're not completed convinced about growth, you may not invest in such companies. It's important to keep them on your radar though so that when the iron is hot (good business; good valuation), you can strike them! This is where the excel sheet is most useful.

Cheers, and happy investing!