4 Rules of Value Investing

Warren Buffett is arguably the greatest equity investor of all time. An investment in Berkshire Hathaway in 1965 has yielded returns of 20% per year compounded. At this rate of return, money doubles approximately every 3.5 years. 1000 rupees invested in shares of Berkshire Hathaway in 1965 would amount to > Rs 35 lakhs by 2010 at 20% per annum. A savings account yielding 8% p.a. would have amounted to just ~ Rs 31000.

Despite such a phenomenal record, Mr. Buffett's investment techniques are not widely known and understood in India. While most serious participants in the Indian markets have heard of Mr. Buffett's name and track record, there is insufficient understanding of the methods that have helped him to deliver such results. Many people ascribe his phenomenal performance to his investment genius and maybe even luck.

Successful investing is a combination of art and science. While the 'art' aspect can gained only through years of experience, it is possible to discern some of the science of Mr. Buffett's investing techniques through his writings and speeches.

In a fantastic book titled 'The Warren Buffett Way', Robert Hagstrom has distilled the wisdom from Mr. Buffett's writings into 4 key attributes to be sought in any investment:

1. Competitive Advantage: As a long term oriented value investor, Mr. Buffett looks for companies having sustainable competitive advantages. Companies with such advantages generate high rates of return on capital, and hence are able to provide high returns to investors. Economics 101 tells us that any industry which is highly profitable attracts competitors who quickly bid down the levels of profitability in the industry. Only those players who have a sustainable competitive advantage can maintain their sales and profitability in the face of aggressive competition. Competitive advantage can come in multiple forms: 1. Cost Leadership. 2. Differentiation through presence in niches. 3. Intellectual Property leadership. 4. Economics of Scale, etc.
2. Circle of Competence: The main idea behind this point is that one must invest in companies and industries whose dynamics one understands. The importance of this cannot be understated. Investing in sectors and companies which we understand reduces the prospect of making some obvious errors in investment decision making. For example, some of us may work in the automobile industry. As industry insiders, we may understand the intricacies of various automobile components and which companies supply these parts. We may also be aware of which companies are industry leaders in specific segments of the market. This makes the process of investment decisions much smoother. Similarly, a pharma graduate might be better placed to identify key trends and companies in the pharma sector than a banker. Hence, Mr. Buffett advices customers to stick to their circle of competence.
   
   As an aside, during the height of the dotcom boom, Mr. Buffett eschewed investing in any technology companies because they were outside his circle of competence. Needless to say, this proved to be prescient when the dotcom boom subsequently turned into a catastrophic bust.
3. Management: In an F1 Race, the podium finish goes to the best combination of driver and car. This analogy is applicable in the field of investing. Mr. Buffett seeks rational managements, to whom the interests of shareholders are paramount. The key to identifying such companies is to look for those having significant management/ promoter ownership. This ensures that the interests of management are aligned with those of shareholders. Managements which frequently issue fresh shares and dilute equity usually destroy more value than they create.
   
   Further, managements are responsible for capital allocation decisions. Rational managements allocate capital where it can produce the best returns. Irrational managements may utilise capital for aggressive expansion or for value destroying mergers and acquisitions. Hence, it is very important to evaluate the management of a company before making an investment.
4. Margin of Safety: Among all the key tenets of value investing, this is often considered to be the most important. Value investing is all about investing in companies which are being quoted at a sufficiently cheap price in order to be able to provide sufficient downside protection. The essence of this is captured in the statement by another famous value investor, Mohnish Pabrai (whom we will be covering in a later post). Pabrai explains it as "Heads I win, Tails I don't lose much'. Therefore, a true value investment is only one which is purchased at a sufficient discount to the intrinsic value of the stock, so that even if the investment thesis does not pan out, the downside is limited, as a large part of the downside would have already been discounted by the market.
   
   While Mr. Buffett's investment performance might never again be matched by anyone, it is hoped that this article would demistify some of the fog surrounding investors' understanding of how these returns were achieved. As regular investors, we may not be able to match such a track record, but we may at least try to improve our investing process in order to better our returns.

- Vivek Iyer, Equity Research Analyst, HBJ Capital Services Pvt Ltd, [Vivek@hbjcapital.com]