Wish you a very Happy Diwali and happy investing for the coming year and many more.
On this happy occasion, I wanted to simplify the core principals of value investing (followed by great investment gurus of the world) for all of us. If you ask me to pen down investment philosophy followed by big investing gurus like Warren Buffet, Benjamin Graham, Phil Fisher, Peter Lynch, John Templeton in one simple line, I will say “Don’t invest in stocks, invest in businesses underlying them” or in other words “Buy a business not a stock” . This one insight if taken seriously could change your whole philosophy, temperament and approach of investing. It has changed mine drastically in the last 6 years.
If you imagine that you are in the market to buy best of breed businesses at bargain prices and not stocks, your whole approach and philosophy will transform. The key is that whether you buy or sell parts of a business (stocks) or whole of the business, you have to think like a business owner. Warren is very clear on this that there is no fundamental difference between buying a business and buying parts of it as stocks as he is an owner in both cases. And hence discipline and approach should remain the same in both cases.
What would you do if you want to buy few businesses (small fractions of businesses in this case) with your investible corpus? First of all, you will need to be a business analyst and business picker instead of a security analyst or stock picker.
Now what does a business analyst do before he decides to buy a business. He first determines his “circle of competence” as he would like to restrict his analysis to the sectors and industries he is comfortable and can understand the business . This restriction immediately eliminates the risk of getting into businesses you don’t understand and hence losing your invested capital. Warren never invested in internet/ dotcom companies as he thought they were outside his “circle of competence”
What does he (Business analyst) do next? He will initiate business analysis. He accumulates a shortlist of “best of breed” businesses for those sectors/industries from different sources (Applying some basic screening criteria, Bottoms up research, secondary research through internet, magazines, newspapers, fellow investors etc.). Once he gets a shortlist of 5-10 fantastic businesses, he goes through the annual reports, balance sheets, auditors notes etc. thoroughly to make himself comfortable with the business. He talks to the knowledgeable experts in relevant industries, industry veterans, competitors, clients etc. to get a qualitative knowledge about the businesses. By the time, he is done with the business analysis; he has got a good comprehension about the business models, products / services, stature/dominance of the businesses in their sectors, durable competitive advantages, favorable long term prospects, peer comparisons etc. Peter Lynch once said “Buy what you understand”
Once he is done with business analysis , he will do a thorough financial analysis (study P& L statements and balance sheets) to understand how the business has been doing in last 5-10 years and in recent times on some critical financial parameters like Revenue growth, Profit growth, Return on capital , profit margins , consistent earnings history, ability to generate strong cash flows, leverage/ debt etc. At the end of this , he will determine whether the chosen business has strong financials and strong balance sheet or not.
Once he has determined that, he does a management analysis. Quality company when combined with competent and honest managers leads to the right vehicle for long term wealth creation. He will do some primary and secondary research to know the top management team better; will look at the 5-10 years Return ratios (ROE/ROCE) to understand their track record on efficient capital allocation. He will also review the corporate governance track records of the company, accounting practices etc to understand the integrity and values of the management team which is very critical in today’s world where we have episodes like Bhushan steel, DLF and Satyam . He will also analyze the past and current annual reports to understand their vision, strategy and execution records. Warren once said “All we want is to be in business we understand, run by people whom we like and priced attractively”
Only when the business analyst has gone through and satisfied himself that a specific business in the short-listed is a high quality businesses with strong financials and quality management , he starts thinking about the true value and price of the business. This is the point he looks at the market for the first time to check the price to understand whether business is attractively priced or under-valued with respect to true or intrinsic value of the business( present value of all future earnings), giving him a “margin of safety”. Margin of safety is a core concept in value investing which was coined by Benjamin Franklin (considered as father of value investing and mentor to Warren) and is the difference between true/intrinsic value of the asset and price you are paying for it. Bigger is the margin of safety, better is the safety of the invested capital and better is the returns on the investment.. The analyst will look at current PE(Price to earnings ratio) and compare it with 5-10 years average historic PE, he will compare the current PE with industry PE , look at PEG ratio(PE/ growth) rand also compare PE ratio to ROE . This will give him an indication of whether the business is over-valued or under-valued. If the business is under-valued , he will go ahead and compute the valuation of the business and evaluate the quantum of under-valuation or price discount with respect to true value. If the price discount or margin of safety is substantial (25-30% or more), he will go ahead and buy the business. If the price is not attractive, he will wait for a market correction/ panic sell off, market recession(bear phase), specific industry recession or a temporary business calamity for getting attractive prices as the shortsighted and over-reactive market will hammer down the prices of fantastic businesses as well as other businesses with the same paint brush.
My business selection process/ methodology which I had discussed in my last blog on “ How to pick winning businesses/ stocks” is very aligned to this business owner / analyst oriented approach. Take a look at my methodology (below)
However, picking the right businesses at the right price is just half the battle. The other half of battle is portfolio management. How do you create and manage your portfolio of businesses? Should it very diversified or focused portfolio? Should you follow an active churning/ high turnover approach or inactive/ low turnover approach? When should you sell the stocks/ businesses?
Again the business owner/analyst perspective will help you in deciding this. If you imagine yourself as the business owner who is in the market to buy and own businesses. How many would he buy? Probably 10-15 businesses or less. Not more than that, as it’s not possible to track the performance and management actions of so many businesses. This will also force you to buy businesses where you have 100 percent conviction. Warren once said “with each investment, you should have the courage and conviction to place atleast 10 percent of your net worth in that”
Once you have a portfolio of best businesses, what would you do as business owner and analyst? Would you hop in and hop out like active fund managers or would you adopt a long term approach on holding these businesses? Of course, you would be patient and hold them for long term so that you can ride their growth cycle completely instead of hoping in and hoping out. This long term approach also helps in allowing the magic of compounding to work. Besides, your capital gains taxation and transaction costs also are minimized. The fund managers who follow active churning or turnover method have to incur heavy costs (transaction costs, taxes) as well as miss getting the complete effect of compounding. Typically, your portfolio turnover should not be more than 20-25% per year (which means that your average holding period should be 4-5 years). I have been following this focused portfolio with low turnover approach . It has helped me to beat the Sensex returns consistently in medium and long term.
When do you sell a specific business/stock (timing)? Again the same business owner and analyst mindset helps you to find the answer. Once, you pick the businesses, you as business owner/ analyst will stay with them for a long time (many years) so that you enjoy their long term growth potential fully. You won’t bother about the daily market noise or variations. You will not sell them, till a drastic change has happened in the business model or financials of specific business which has changed the long term economics of the business or till the market has shown irrational exuberance for the specific business and has made the business crazily over-valued. You won’t bother about short term market price variations or a correction till the fundamentals of the business has not changed significantly. As business owner, you will track the business metrics like business expansion plans, revenue visibility, revenue/ EPS growth trend over many quarters, Return on equity/ capital, operating cash flows, debt and cash on the balance sheet instead of market price variations. If the operating and business performance is stable, consistent and positive, the market price or valuation will take care of itself in long term(3 to 5 years horizon). Benjamin Franklin once said “market is a voting machine(un-predictable) in short term and weighing machine(reliable) in long term. Market will price your business correctly in long term and hence your patience and conviction will be rewarded.
Warren had said once” I buy businesses, not stocks, businesses I would be willing to own for ever”
With this quote, am closing this long blog. Hopefully it will change your investing mindset and temperament, just like it has changed mine.
Happy investing and Happy Diwali again