3 Strategies for Competitive Advantage

In an earlier post, we had discussed Warren Buffett's 4 rules of value investing. these rules are: Competitive Advantage, Reputed Management, Businesses within Circle of Competence, Price.

In this post, we delve deeper into the topic of competitive advantage. Michael Porter, a professor at Harvard Business School, has devised 3 strategies to attain competitive advantage.

Courtesy valuebasedmanagement.net

Approach 1 to Competitive advantage: Cost leadership.
• = a firm sets out to become the low cost producer in its industry.
• Note: a cost leader must achieve parity or at least proximity in the bases of differentiation, even though it relies on cost leadership for it’s CA.
• Note: if more than one company aim for cost leadership, usually this is disastrous.
• Often achieved by economies of scale

Competitive advantage model 2: Differentiation.
• = a firm seeks to be unique in it’s industry along some dimensions that are widely valued by buyers.
• Note: a differentiator cannot ignore it’s cost position. In all areas that do not affect it’s differentiation it should try to decrease cost; in the differentiation area the costs should at least be lower than the price premium it receives from the buyers.
• Area’s of differentiation can be: product, distribution, sales, marketing, service, image, etc.

Competitive advantage 3: Focus.
• = a firm sets out to be best in a segment or group of segments.
• 2 variants: cost focus and differentiation focus.

Unknown Companies Produce Best Stock Returns

INSEAD professors - Lily Hua Fang & Joel Peress, have recently published research which concludes that investors can out-perform the market by investing in stocks with very little media coverage, and few or no analysts following the companies.

The Professors researched all of the listed stocks on the NYSE between 1993 & 2002, and analysed coverage in 4 publications featuring information about each of these companies. The publications were: the New York Times, USA Today, Wall Street Journal, and Washington Post.

The Professors found that companies with no media coverage during the period of the study, performed (risk adjusted) on an average 3% p.a. better than stocks with better media coverage. In the small cap segment, this out-performance was even more prominent, with "no-media" small cap stocks outperforming by 8-12% (after factoring in the added risks of investing in small and mid cap stocks).

Full Article

What is the source of this out performance?

Value investors would be quite familiar with this concept. By definition, value investors are in the business of seeking out stocks which are being ignored by the rest of the market for various reasons, and to try and hold these stocks patiently until the market re-evaluates the stock . Small, unknown companies are the best candidates for such investments.

The lower the media coverage, the greater the potential for the company to be undervalued in comparison to its fundamentals. For instance, company 'A' might be sitting on a land-bank which, if monetised, may lead to high upside for the stock. However, due to the obscurity of the company, the outside world might not yet discovered this story. If a smart media outlet or analyst picks up the information and highlights it to the rest of the world, then increasing numbers of investors will 'discover' the story and may decide to buy pushing up the stock price.

The best gains will go to those investors who managed to enter the investment before its discovery by the wider world. Hence, it is very important for value investors to constantly be on the lookout for unknown, unsung companies which are below the radar of the media, and the analyst community.

"Value Investing And Behavioral Finance" By Parag Parikh (Author)

It is one of the good book on value investing, we would suggest our reader to read this.....Value Investing And Behavioral Finance Book Description....

When others are greedy be fearful and when others are fearful be greedy? ill-timed bouts of greed and fear among investors make stock markets volatile. Rational and successful investing is all about restraining and channelizing these emotions and understanding behavioral finance, not market sentiments, crowd behavior or company performances?

At a time when market upheavals are eroding investors' confidence, dooming life's earnings and corporate fortunes, and whipping up mass hysteria? Value Investing and Behavioral Finance comes as an antidote to investor anxiety and a guide to sane and safe investment decisions. Using investing trends in Indian capital markets over the last three decades, it shows how collective behavioral biases affect investment decisions, returns and market vagaries. As a corrective, it spells out long-term value and contrarian investing strategies based on the principles of behavioral finance.

Further, it advises on how to spot investment opportunities and pitfalls in commodity stocks, growth stocks, PSUs , IPOs , sectors and index stocks. It also alerts the reader to a "bubble" or crisis situation, and ways to identify and insure against it.

Value Investing and Behavioral Finance , a timely offering from a seasoned investment strategist, is a must read for stock brokers, bankers, lay investors, portfolio managers, fund managers, and students of finance.

Parag Parikh, an alumnus of Harvard Business School , is the founder-chairman of Parag Parikh Financial Advisory Services Ltd .( PPFAS) with over 25 years of experience in the financial sector. Thoroughly conversant with the dynamics of the Indian stock market, and a vocal proponent of behavioral finance and value investing in India , Parag has an abiding passion for making financial market a better and safer place for investors through emotionally restrained, rational, value-based and long-term approach to investing.

- Source (Web)

Characteristic of Value Stocks....

{Click the above image to enlarge}

What Does Value Investing Mean?

The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

The big problem for value investing is estimating intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value.

Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.

-Source (Web)

What Does Intrinsic Value Mean?

#1. The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.

#2. For call options, this is the difference between the underlying stock's price and the strike price. For put options, it is the difference between the strike price and the underlying stock's price. In the case of both puts and calls, if the respective difference value is negative, the instrinsic value is given as zero.

For example, value investors that follow fundamental analysis look at both qualitative (business model, governance, target market factors etc.) and quantitative (ratios, financial statement analysis, etc.) aspects of a business to see if the business is currently out of favor with the market and is really worth much more than its current valuation.

Intrinsic value in options is the in-the-money portion of the option's premium. For example, If a call options strike price is $15 and the underlying stock's market price is at $25, then the intrinsic value of the call option is $10. An option is usually never worth less than what an option holder can receive if the option is exercised.

Growth At A Reasonable Price - GARP

An equity investment strategy that seeks to combine tenets of both growth investing and value investing to find individual stocks. GARP investors look for companies that are showing consistent earnings growth above broad market levels (a tenet of growth investing ) while excluding companies that have very high valuations (value investing). The overarching goal is to avoid the extremes of either growth or value investing; this typically leads GARP investors to growth-oriented stocks with relatively low price/earnings (P/E) multiples in normal market conditions.

GARP investing was popularized by legendary Fidelity manager Peter Lynch. While the style may not have rigid boundaries for including or excluding stocks, a fundamental metric that serves as a solid benchmark is the price/earnings growth (PEG) ratio. The PEG shows the ratio between a company's P/E ratio (valuation) and its expected earnings growth rate over the next several years. A GARP investor would seek out stocks that have a PEG of 1 or less, which shows that P/E ratios are in line with expected earnings growth. This helps to uncover stocks that are trading at reasonable prices.

In a bear market or other downturn in stocks, one could expect the returns of GARP investors to be higher than those of pure growth investors, but subpar to strict value investors who generally purchase shares at P/Es under broad market multiples.

-Source (Web)

Morningstar's Market Valuation Guage

In an earlier post, I had discussed the contrarian approach to equity research as used by Morningstar.com. There I had mentioned that their approach is to provide their estimate of a stock's intrinsic value, rather than provide target prices. This approach seems to be a pretty useful tool for value investors.

Based on its intrinsic value methodology, Morningstar also provides a market valuation guage, where the site tracks the level of the stock market (currently not available in India), based on the the estimate of the Stock market's intrinsic value.

The chart is available here:




Based on the above estimate, the US market is marginally overvalued as compared to Morningstar's estimate of Fair Value.

Nouriel Roubini & the Stock Market

The original idea for this post came from Ekonomiturk

Of late, Nouriel Roubini has been called a perma-bear by many people, and hence he has got knocked down few notches from the pedestal of Market Oracle where he had been placed in the wake of the Great Recession of 2008-09.

However, a new chart (shown below) seems to suggest that Nouriel Roubini does have the ability to predict market movements even when the general trend of the market is upwards. It is just that these predictions are quite unintentional. Mr. Roubini seems to be providing cues on when to buy and sell stocks in the market.

The good folks at Ekonomiturk have put out a chart which compares the popularity of the search keyword 'Nouriel Roubini' on Google (through Google trends) and the gyrations of the S&P 500. It seems that their movements are negatively correlated. i.e. when the market starts to take a breather and corrects after a few days of rising, the public starts to seek out Nouriel Roubini, to see whether the most recent crash is likely to lead to a double-dip recession and a harrowing market crash.

As soon as the correction ends, and the upward trend resumes, Mr. Roubini's popularity on Google crashes with the force of waves crashing into Marine Drive during the monsoons.

Here's the graph.




As a value investor, I try to avoid making my investment decisions based on such indicators, but it is a fun way to understand investor behaviour. I would file this post under my 'Behavioural Investing' bookshelf.

India's Buffett Ratio

A few days back, I had discussed the Buffett Ratio, i.e. the ratio of the stock market capitalisation to the GDP of the country. This post is available here. In that post, I had provided data-points for the U.S. markets, where the Buffett Ratio currently reads at ~ 85%.

I recently came across a data-point of this ratio for India, courtesy equitymaster.com



The value of the Buffett Ratio for India is hovering around 100% as I write this post. As a value investor, I would be a bit concerned, when the value of the stock market's capitalisation crosses the annual income generated by the country's economy. Think of the Buffett Ratio as the P/E of the underlying economy. So, based on the above graph, I would say, the market is valuing India at a P/E > 1.

Now, I know there are a lot of reasons why India's markets are trading at such valuations. The pundits would explain this using buzzwords like GDP Growth, demographic dividend, English speaking population. However, as a value investor, it seems to be a time to be cautious, and to be in selecting stocks.

Magic Formula: An offshoot of Value Investing

Steve Forbes at Forbes.com has been conducting a number of fascinating interviews recently, with various famed value investors. In a recent interview, I came across a description of the "Magic Formula" investing strategy developed by Joel Greenblatt in his book "The Little Book that Beats the Market".

The magic formula reduces the value investing process to just 2 variables: Earnings Yield (Inverse of P/E) & Return on Capital.

A guy named Shankar had set up a website for Indian magic formula stocks called www.magicformulaindia.com. This website used to replicate the Magic Formula methodology and spit out a list of stocks which met the criteria laid out by Joel Greenblatt. Sadly, this website is not up and running anymore, as Shankar has moved on to other (presumably better) stuff.

A description of the Magic Formula way of Investing, straight from the horse's mouth follows (from the Forbes.com interview):

Greenblatt: This is what I wrote the book about five years ago. It follows the principles I've used in investing since I started my firm in 1985, and I've been teaching at Columbia for the past 14 years and these are the principles I've used to teach. About seven or eight years ago, we set out to test it. The two things I look at are earnings yield, which is how cheap is the company. A simple earnings yield would be the inverse of the P/E ratio or earnings to price. So, in other words, if something earned $2 and it cost you $10 a share, you'd have a 20% earnings yield.

We use a more sophisticated metric than just earnings, than just price. But the concept is the same. We use EBIT--earnings before interest and taxes--and we compare that to enterprise value, which is the market value of a company's stock plus the long-term debt that a company has. That adjusts for companies that have different ratios of leverage, different tax rates, all those things.

But the concept is still the same. We want to get more earnings for the price we're paying. That was sort of the principles that Benjamin Graham taught, meaning that cheap is good. If you buy cheap, you leave yourself a large margin of safety. Warren Buffett had a twist on that and said, "Gee, it's nice to buy cheap things but I also like to buy good businesses." So if I could buy good businesses at a cheap price, it's better than just cheap.

We have another metric that we look at in the magic formula which tries to determine those companies that are in better businesses. So we look at a business' return on capital. I described in my book the example that I gave to my son which is he had a friend that used to buy a pack of gum before he went to school with five sticks of gum in it. And he paid 25 cents for the pack of gum and at school he'd sell each stick of gum for 25 cents. So he would collect $1.25 and the pack would cost him a quarter and he would make a dollar for every pack he sold in school.

So we supposed that his friend grew up and opened a chain of gum stores. And let's say to set up a store with inventory in the whole store, displays and everything else it costs $400,000 to open a gum store. And each year one of those gum stores earn $200,000 a year. So the cost of setting up the gum store is $400,000 and each year it spits out $200,000 a year in profit. So that's a business that earns a 50% return on capital.

Then I said, "Let's suppose we have another business and I called that 'Just Broccoli' and it was also a store but only sold broccoli." But it still cost $400,000 to open a store. Each year, that store only earned $10,000. So that's a 2.5% return on capital. So we simply say that a business that earns the higher return on capital [is better].

So what the magic formula does is ranks companies first according to cheapness based on their earnings yield; the higher the earnings yield, the cheaper it is. So you rank all companies, thousands of companies based on how cheap they are based on their earnings yield. Then in a totally separate way you rank all companies again, but this time you're just ranking them based on their return on capital; the higher the better. So you do two rankings--one just based on cheapness and one based on return on capital. Then what the magic formula does is combine those rankings. So, in other words, if you were the cheapest company on this list, you'd get a 1 for cheapness and if you were the 200th highest return on capital, your combined score would be 201. If you were the 60th cheapest out of 2,000 companies and you were the 60th best return on capital, you'd get a combined score of 120. So you want to get close to 2, which is the best you could do. So the 120 score would come out better than the company that was the cheapest in the universe, which was 201.

The Buffett Ratio

Within the value investing community, there is a consensus that it is impossible to time market and entry with any degree of success. The best investors can try to do is to develop some tools to gain an overall sense of the level of valuation of the market, and try to base their investment decisions on them.

In an earlier post, I had written about the Market P/E ratio and how it can help investors to get an overview about where the market stands as compared to its historical valuations. In this article, I would like to discuss the Market Cap/ GDP ratio, popularly known as the Buffett Ratio.


This is how it is calculated:


When market valuations reach very high levels, the ratio crosses 100%, implying that the market's valuation is greater than the value of all goods and services produced by the economy in the year just gone by. Given that the stock market is but an aggregation of the underlying businesses which make up the economy, it is a sign of high optimism when the market's valuation crosses the country's GDP.

One of the fundamental rules of value investing is to invest only when the asset being acquired is available at a discount to its intrinsic values. The Buffett Ratio gives an idea of how expensive or inexpensive the market as a whole is.

Traditionally, value investors have focused on the valuations of individual stocks, and not given too much attention to the state of the economy as a whole. But, in the wake of the Great Recession just past us, there is renewed interest among them to incorporate some techniques which give an indication of where in the business cycle the economy is, and whether the stock market is keeping up with this or whether it has overshot fundamentals.

The following graphs are available here and are updated regularly, so the information shown here is up-to-date.

Latest Graph of US GDP & Market Capitalisation



Latest US GDP/ Market Cap Ratio

Interview with Mohnish Pabrai on Forbes.com

Mohnish Pabrai, whom we had briefly discussed in an earlier post on the 4 principles of value investing, has an interview on the Forbes.com website. The transcript follows:

The video and transcript is available here


Transcript:

Introduction

Hello, I'm Steve Forbes. It's a pleasure to introduce my featured guest, Mohnish Pabrai. Mohnish is managing partner at Pabrai Investment Funds, a value investing shop in Irvine, California.

Before getting into money management, Mohnish studied engineering and founded an IT consulting firm. But surprisingly, Mohnish says tech is one sector he won't invest in.

Mohnish has closely studied Warren Buffett's investment strategy and incorporates a number of the oracle's ideals in his own investing. He's also author of The Dhando Investor: The Low-Risk Value Method To High Returns.

Mohnish's advice to retail investors: use index funds, because finding a manager who can beat the index consistently is incredibly rare. He also advises investors to look at investing as a leisure activity. In fact, Mohnish encourages a regular afternoon nap.

In a moment, my conversation with Mohnish Pabrai.

Lessons From Buffett

Steve Forbes: Mohnish, thank you very much for joining us today.

Mohnish Pabrai: You're most welcome.

Forbes: You are one of the noted value investors, one of those who is an admirer of Warren Buffett. What did you take from Warren Buffett? And what do you do differently from Warren Buffett? You're not a clone.

Pabrai: Well, you know, we will never have another Warren. I think Warren is a very unique person. And also, I think that his investing prowess is so strong that many of his other attributes and, I would say, his other qualities get ignored. I believe the best things about Warren have nothing to do with investing. But they have everything to do with leading a great life. So many of the things, I think, most of the great things I've taken from Warren have more to do with life than investing.

Forbes: Such as?

Pabrai: Well, such as, you know, how to raise a family, interaction with friends, the importance of keeping your ego in check. You know, humility. Just a whole bunch of different attributes. The importance of candor, the importance of integrity. Just all these, the soft skills that are very important in life.

Forbes: They do interconnect. Now, in terms of how you approach an investment, you, I think, probably pay more attention to intangibles than perhaps Warren Buffett or Ben Graham might have done.

Pabrai: Well, Warren pays attention to intangibles, but Ben Graham was very much a tangible guy. And yeah, so we're looking at the qualitative as well as the quantitative. And yeah, so I would say that one way to look at that is to consider what Charlie Munger would call his latticework of mental models. So when you look at a business, look at it in a broader context of how it fits into the world. And sometimes, if you can see it in a light that the world is not seeing it in, that can give you an edge.

Forbes: Munger also said, "You have three choices: yes, no, or too difficult." You subscribe to that too.

Pabrai: That's right. And 98% is too difficult.

Find Deep Moats

Forbes: So that gets to knowing your areas of competency. You share Warren Buffett's antipathy to technology. Not that you dislike it, but you just don't feel you're going to bring value added there.

Pabrai: Yeah, you know, my degrees are in computer engineering. I spent a lot of time in the tech industry. And I like to say that I don't invest in tech because I spent time in it. And I saw firsthand that the durability of technology moats is many times an oxymoron.

Forbes: Now, quickly define moats, in terms of a business that keeps the competition away.

Pabrai: Well, you know, if you talk to Michael Porter, he would give you five books on what is meant by, you know, strategy and competitive advantage and durable competitive advantage. And if you talk to Warren and Charlie, they would just say it's a moat. And they'd break it down to one word. But basically, it's the ability of a business to have some type of an enduring competitive advantage that allows it to earn a better-than-average rate of return over an extended period of time. And so some businesses have narrow moats. Some have broad moats. Some have moats that are deep but get filled up pretty quickly. So what you want is a business that has a deep moat with lots of piranha in it and that's getting deeper by the day. That's a great business.

Invest Leisurely

Forbes: So summing up in terms of what do you think do you bring to value investing that others perhaps don't, that give you a unique edge?

Pabrai: I think the biggest edge would be attitude. So you know, Charlie Munger likes to say that you don't make money when you buy stocks. And you don't make money when you sell stocks. You make money by waiting. And so the biggest, the single biggest advantage a value investor has is not IQ. It's patience and waiting. Waiting for the right pitch and waiting for many years for the right pitch.

Forbes: So what's that saying of Pascal that you like about just sitting in a room?

Pabrai: Yeah. "All man's miseries stem from his inability to fit in a room alone and do nothing." And all I'd like to do to adapt Pascal is, "All investment managers' miseries stem from the inability to sit alone in a room and do nothing."

Forbes: So you don't feel the need to pick 10 stocks a quarter or one stock a quarter, just what turns up?

Pabrai: You know, actually, I think that the way the investment business is set up, it's actually set up the wrong way. The correct way to set it up is to have gentlemen of leisure, who go about their leisurely tasks, and when the world is severely fearful is when they put their leisurely task aside and go to work. That would be the ideal way to set up the investment business.

Forbes: Does this tie into your ideas and other value investors' ideas of low risk, high uncertainty?

Pabrai: That's right. I mean, I think the low risk, high uncertainty is really something I borrowed from entrepreneurs, and you know, the Patels in India or the Richard Bransons of the world. Basically, if you study entrepreneurs, there is a misnomer. People think that entrepreneurs take risk. And they get rewarded because they take risk. In reality, entrepreneurs do everything they can to minimize risk. They are not interested in taking risk. They want free lunches and they go after free lunches. And so if you study any number of entrepreneurs, from Ray Kroc to, you know, Herb Schultz at Starbucks and to even Buffett and Munger and so on, what you'll find is that they have repeatedly made bets which are low-risk bets, which have high-return possibilities. So they're not going high risk, high return. They're going low risk, high return.

And even with Bill Gates, for example, the total amount of capital that ever went into Microsoft was less than $50,000, between the time it started and today. That's the total amount of capital that went into the company. So Microsoft you cannot say was a high-risk venture because there was no capital deployed. But it had high uncertainty. Bill Gates could have gone bankrupt. Or Bill Gates could have ended up the wealthiest person on the Forbes 400. And he ended up at the extreme end of the bell curve and that's fine. But he did not take risk to get there. He was comfortable with uncertainty. So entrepreneurs are great at dealing with uncertainty and also very good at minimizing risk. That's the classic great entrepreneur.

Low Risk, Low Capital

Forbes: This is your almost third career. And this idea you have on uncertainty and risk. You started a company. It worked. You sold it. You started another company. It did not work. What did you learn from that that gave you insights on investing that, those that had not been in the trenches, don't bring?

Pabrai: Well, the first company took no capital and generated an enormous amount of capital for me. Then I got fat, dumb and happy and my second company, I put in a lot of capital.

Forbes: You thought you knew what you were doing.

Pabrai: And I violated the low risk, high uncertainty principle. I got my head handed to me. And I got that seared heavily in my psyche. And now the third business, if you call Pabrai Funds a business, I call it a gentleman of leisure activity, but Pabrai Funds is, again, low risk, high uncertainty in the sense that there is no downside. It never took capital. So it's a great business.

Forbes: So as a gentleman of leisure, is that why you take a nap each day at 4 p.m.?

Pabrai: There's nothing better. Do you have a nap room?

Forbes: I wish.

Pabrai: You know, when I went to Warren's Berkshire headquarters last year, my friend Guy asked Warren, he said, "Warren, Mohnish has a nap room in his office. Do you have a nap room?" And Warren's answer was, "Yes." Okay, so I was surprised. So I said, "Warren, you're telling me in Kiewit Plaza, there's a nap room for you." He says, "Yes." He says, "Not every day, but every once in a while, I need to go to sleep in the afternoon."

Forbes: Well, there's something to that. My father called it having a conference.

Pabrai: That's right. No, it does wonders. I have a hard time getting past the day without the nap, so the nap is a must.

Forbes: So having those two experiences, no capital, then as you say, fat and happy and then you got your head handed to you, when you look at an equity, when you look at a possibility, what are those experiences, give what insight do you get from those experiences.

Pabrai: Well, the insight is the same, in the sense that I think that, you know, Warren says that I'm a better investor because I'm a businessman. And I'm a better businessman because I'm an investor. So the thing is that my experiences as a businessman have very direct, long-term positive impacts on me as an investor, because when I'm looking at an investment, I now look at it like the way I looked at my first business, which is, the first thing I'm looking at is, how can I lose money on this? And can I absolutely minimize my downside? The up sides will take care of themselves. It's the downsides that one needs to worry about, which is why even the checklist becomes important. But so the important thing that value investors focus on is downside protection. And that's exactly what entrepreneurs focus on is what is my downside? So that is the, I would say, the crossover between entrepreneurship in investing and value investing especially is protect your downside.

Pabrai's Fees

Forbes: Now you're a hedge fund manager, but you're unusual. First, your fee structure. Explain that.

Pabrai: Well, you know, my fee structure, one of my attributes about a great investor is be a copycat. Do not be an innovator.

Forbes: What's it, pioneers take the arrows?

Pabrai: Yeah. When I started Pabrai Funds, I actually didn't know anything about the investing business. And the only, if you can call it a hedge fund that I was familiar with, was the Buffett partnerships. And when I looked at the Buffett partnerships, I found that Warren Buffett charged no management fees. He took 25% of the profits, after a 6% hurdle. And all of that made all the sense in the world to me, because I felt it aligned my interests completely with my investors. So I said, "Why mess with perfection? Let's just mirror it." And that's what I did. And what I didn't realize at the time, it took me a few years to realize it, is that that mirroring created an enormous moat for Pabrai Funds. Because the investors who joined me will never leave, because it's the first question they ask any other money manager they go to work for or they want to put money with is, "What is your fee structure?"

When they hear the fee structure, they say, "I'm just going to stay where I am." And so first of all, it creates a moat where the existing investors do not want to leave. And the new ones who join the church are happy to join.

Forbes: You're also unusual in another way. You don't seem to go out of your way to woo institutional investors.

Pabrai: Yeah, I mean, I think I'm looking for people who want to invest their family assets for a long period of time. I really don't want investors who are looking at putting things into style buckets or going to look at allocations every quarter or might need to redeem in a year and those sorts of things. So their frameworks are very different. So in general --

Forbes: So someone who comes with you is a minimum of, what, two years, three years, what, before you allow them an exit?

Pabrai: Our exits are annual. So people can get out once a year. But what we suggest to them is to not invest if they don't have at least a five-year horizon. But we don't impose any, because people can have hardships. They can have all kinds of things happen.

Forbes: Now, low cost, one of the things that apparently institutional investors are flummoxed by is, it's you.

Pabrai: Our total expenses for running the funds, which the investors get charged for, is between 10 and 15 basis points a year. That's what they pay for, for all the accounting, audit, tax, administration and everything. They don't pay for my salary or my staff's salary. We take that out of the performance fees. And they only pay the performance fees after 6%. So what a deal.

Forbes: Now you're not big on schmoozing investors.

Pabrai: You know, I think the thing is that every business ought to figure out who their ideal customer is.

And at Pabrai Funds, what I've found is that investors who do their own homework, find me and do the research on me on their own, without any middlemen involved, and then invest in Pabrai Funds like Amazon, which is wire the money and send the forms, tend to be the best investors. In fact, the investor base we have is mostly entrepreneurs who created their wealth themselves. And they're very smart. And they're in a wide range of industries. In fact, my analyst pool is my investor base. So I have investors in all kinds of industries. And when I'm looking at investment ideas in particular industries, I can call them. And I get the best analysts at the best price with no conflict of interest. So it works out great.

Forbes: Free. That sounds really good. They pay you.

Pabrai: Yeah, exactly. It's great.

Forbes: You're not even registered with the SEC?

Pabrai: I think the hedge funds so far have not had to. I don't know if the rules will change. If the rules change, of course, we'll follow the rules. But you know, we have audits by Pricewaterhouse. We have to report 13fs to the SEC. So I think there's plenty of disclosure and transparency.

Forbes: You also don't engage in things like short selling.

Pabrai: You know, why would you want to take a bet, Steve, where your maximum upside is a double and your maximum downside is bankruptcy? It never made any sense to me, so why go there?

Forbes: You focus on a handful of individual investors, maybe institutional investors, but people who know you, are with you.

Pabrai: Right.

Forbes: You're not part of a formula, not spit out of a computer.

Pabrai: That's right.

Use Index Funds

Forbes: What's an individual investor to do? You have some unique advice for individual investors.

Pabrai: Well, the best thing for an individual investor to do is to invest in index funds. But even before we go there, you know, Charlie Munger was asked at one of the Berkshire annual meetings by a young man, "How can I get rich?" And Munger's response was very simple. He said, "If you consistently spend less than you earn and invest it in index funds, dollar cost average," because you're putting in money every paycheck, he said, "that in, what, 20, 30, or 40 years, you can't help but be rich. It's just bound to happen."

And so any individual investor, if they just put away five, 10, 15% of their income every month, and they just bought into the low-cost index funds, and just two or three of them, to split it amongst them. You're done. There's nothing else to be done. Now if you go to active managers, the stats are pretty clear. Eighty to 90% of active managers underperform the indices. But even the 10 or 20% who do, only one in 200 managers outperforms the index consistently by more than 3% a year. So the chances that an individual investor will find someone who beat the index by more than 3% a year is less than 1%, it's half a percent. So it's not worth playing that game.

Forbes: And in terms of index funds, S&P 500 or --

Pabrai: I'd say Vanguard is a great way to go. I think you could do S&P 500 index. You could do the Russell 2000. And if you wanted to, you could do an emerging market index. But you know, I think if you just blend those three, one-third each, you're done. And if you're in your 20s and you start doing this, you don't need to even go into bonds and other things. You can just do this for a long time and you'll be fine.

Don't Go In The Roach Motel

Forbes: On TV, when these folks make recommendations, you compare it to if you buy something that you heard somebody recommend on TV as going into the roach motel. Can you please explain?

Pabrai: Well, you know, you remember those ads that ran where the roaches check in.

Forbes: Yup.

Pabrai: But they never check out. So the thing is, you watch some talking head on TV. And he tells you, "Go buy whatever company, Citigroup."

When its price gets cut in half, he's nowhere to be found. And now you're like that roach in the roach motel and you don't know what to do. You don't know whether you should hang on or sell or stay. So the only reason --

Forbes: Or if it goes up, do I get out? Do I wait?

Pabrai: Yeah, yeah. If it goes up 10% or 50% or 100%, what are you supposed to do? Do you want to go for long-term gain, short-term gains? Basically, you have no road map. So the only way one should buy stocks is if you understand the underlying business. You stay within the circle of competence. You buy businesses you understand.

And if you understand the business, you understand what they're worth. And that's the only reason you are to buy a stock.

The Chinese Books

Forbes: And looking around the world, you made mention I think in the past, if you want an index fund with the emerging markets, okay. But you have us take a skeptical eye to investing in other countries around the world. You don't preclude it, but you see some risks.

Pabrai: Well, you know, Steve, there's plenty of great opportunities in many countries. But I would say it's probably a no-brainer to avoid Russia, Zimbabwe. And even if you look at a place like China, which I think will create incredible amount of wealth for humanity in this century, the average Chinese company has three sets of books.

You know, one for the government and one for the owner's wife and one for the owner's mistress. And so the problem you have is you don't know which set of books you're looking at. And so I think in Chinese companies or even in Indian companies, there you have to add another layer, which is you have to handicap the ethos of management. And that can get very hard, especially when someone like me is sitting in Irvine with naps in the afternoon, trying to figure that out.

Forbes: You also say you don't think you get much talking to CEOs, because they're in the business of sales.

Pabrai: Yeah, you know, the average CEO, first of all, the average public CEO is a person you'd be happy to have your daughter marry, any five of them. But they got to those positions because they have charisma and they are great salespeople. Now you cannot lead, you cannot be a leader, without being an optimist. So CEOs are not deceitful. I think they are high integrity people. But if you sit down with a high charisma CEO of an oil company, and he knows everything about oil and you know nothing about oil, by the time you finish that meeting, you just want to run out and buy all the stock of his company that you can. And it's just not the right way to go about it. So you're better off not taking the meeting, but looking at what he's done over the last 10 or 15 or 20 years. So not being mesmerized by charisma will probably help you.

Forbes: And what areas are you looking at right now? You remember back in 1968, '69, we did a story on Buffett when he was fairly unknown. And he was getting out of the market, height of the bull market of the '60s. Five years later, after the crash of '73, '74, we went out to see him again, to see what he was saying after the market had gone down 50, 60%. And he politically incorrectly said that he felt like a sex maniac in a harem because of all the bargains around.

Pabrai: Right.

Forbes: You've probably had the same feeling a year ago. What do you see? How does the harem look now?

Pabrai: That's right. In 1969, Warren told you that I feel like a sex-starved man on a deserted island. And in '74, that deserted island had become a harem. Well, nowadays, we're twiddling our thumbs. It's good that I enjoy playing racquetball and bridge and so on. So there's a lot of bridge. There's a lot of racquetball. And you know, I have an eye out on the markets, but there's just not a whole lot of value presently. But value can show up tomorrow, for example. So we're not in a hurry. Happy to have a leisurely lifestyle and wait for the game to come to us.

Make Checklists

Forbes: So in the first quarter of 2010, did you add any positions?

Pabrai: Yeah, actually, we did. We did find. In fact, there's one I'm buying right now. But I found two businesses, but they're anomalies. They were just, you know, businesses that had distressed in them because of specific factors. And I think we'll do very well on both of them. They'll go nameless here. But no, I think, for example, in the fourth quarter of 2008 or the first quarter of 2009, you could have just thrown darts and done well. And that is definitely not the case today.

Forbes: And finally, telling you about mistakes, one of the things I guess an investor has to realize, they cannot control the universe. Delta Financial. You had done the homework, you fell and then events took it away from you.

Pabrai: Well, Delta Financial was a full loss for the firm, for the fund. We lost 100% of our investment. It was a company that went bankrupt. And we've learned a lot of lessons from Delta. And one of the lessons was that Delta was, in many ways, a very highly levered company and they were very dependent on a functioning securitization market. And when that market shut down, they were pretty much out of business. And they were caught flat-footed. And so there's a number of lessons I've obviously learned from Delta.

It's easier to learn the lessons when you don't take the hits in your own portfolio. But when you take the hits in your own portfolio, those lessons stay with you for a long time.

Forbes: So that gets to, you're a great fan of The Checklist Manifesto. And you now have checklists. You said one of the key things is mistakes, in terms of a checklist, so you don't let your emotions get in the way of analyzing. What are some of the mistakes on your checklist now that you go through systematically, even if your gut says, "This is great. I want to do it."

Pabrai: Yeah, so the checklist I have currently has about 80 items on it. And even though 80 sounds like a lot, it doesn't take a long time.

It takes about 30 minutes to go through the checklist. What I do is when I'm starting a business, I go through my normal process of analyzing the business. When I'm fully done and I'm ready to pull the trigger, that's when I take the business to the checklist. And I run it against the 80 items. And what happens the first time when I run it, there might be seven or eight questions that I don't know the answer to, which is great, which what that means is, "Listen dummy. Go find out the answer to these eight questions first." So which means I have more work to do. So I go off again to find those answers. When I have those answers, I come back and run the checklist again. And any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you're looking in front of you with all your facilities at the range of things that could possibly cause a problem.

And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. And at that point, kind of, you have a go, no-go point, where you can say, "I'm comfortable with these risk factors here. I'm comfortable with probabilities. And I'll go ahead with it." Or you can say, "I'm just going to take a pass."

And one of the things that came out of running the checklist was I used to run a 10x10 portfolio, which is when I'd make a bet, it was typically 10% of assets. And after I incorporated the checklist and I started to see all the red flags, I changed my allocation. So the typical allocation now at Pabrai Funds is 5%. And we'll go as low as 2%, if we are doing a basket bet.

And once in a blue moon, we'll go up to 10%. In fact, I haven't done a 10% investment in a long time. And so, the portfolio has become more names than it used to have. But since we started running the checklists, which is about 18 months ago, so far it's a zero error rate. And in the last 18 months, it's probably been the most prolific period of making investments for Pabrai Funds. We made a huge number of investments, more than any other period, any other 18-month period in our history. So with more activity so far, and it's a very short period, we have a much lower error rate. I know in the future we will make errors. But I know those errors, the rate of errors will be much lower. And this is key. The thing is that Warren says, "Rule number one: don't lose money. Rule number two: don't forget rule number one." Okay, so the key to investing is downside protection. The upsides will take care of themselves. But you have to make sure that your losers are few and far between. And the checklist is very central to that.

Forbes: Can you give a couple of the things that are on your 80, checklist?

Pabrai: Oh yeah, sure. The checklist was created, looking at my mistakes and other investors' mistakes. So for example, there's questions like, you know, "Can this business be decimated by low-cost competition from China or other low-cost countries?" That's a checklist question. Another question is, "Is this a win-win business for the entire ecosystem?" So for example, if there's some company doing, you know, high interest credit cards and they make a lot of money, that's not exactly, you know, helping society. So you might pass on that. Also, a liquor company or tobacco company, those can be great businesses, but in my book, I would just pass on those. Or a gambling business and so on.

So the checklist will kind of focus you more towards playing center court rather than going to the edge of the court. And there's a whole set of questions on leverage. For example, you know, how much leverage? What are the covenants? Is it recourse or non-recourse? There's a whole bunch of questions on management, on management comp, on the interests of management. You know, just a whole, on their historical track records and so on. So there's questions on unions, on collective bargaining. So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money. And he lost it to low-cost Chinese competition. So that led to the question. And I looked at CORT Furniture, which was a Charlie Munger investment.

And that was an investment made at the peak of the dot com boom, where they were doing a lot of office furniture rentals. And the question was, "Are you looking at normalized earnings or are you looking at boom earnings?" And so that question came from there. So the checklist questions, I think, are very robust, because they're based on real world arrows people have taken in the back.

Forbes: Terrific. Mohnish, thank you.

Pabrai: Well thank you, Steve.

Value Investors & The Market's P/E Ratio

The P/E Ratio is a tool used by value oriented investors to identify prospective stocks for investment. Value investors usually prefer stocks with low (preferably single digit P/E ratios). The P/E ratio is also used as a tool to analyse the overall level of the market and to decide whether to commit to fresh investments or to bide time and wait for better valuations.

There are many versions of the P/E Ratio in vogue in the investment community. There is the P/E ratio which uses earnings for the most recently ended financial year. Another version uses earnings numbers from the 4 most recent quarters, and is known as the TTM P/E (Trailing Twelve Months). A further variation in the calculation of the P/E Ratio is the Forward P/E, which uses the consensus earnings estimates of analysts. The current price of the stock or index is divided by this forecast earnings level to arrive at the Forward P/E.

The P/E Ratio is a very useful barometer to decide whether to take fresh positions or whether to wait and watch for better valuations. To a value investor, the purchase price and the consequent margin of safety are very important, and hence it is critical to not make purchases when individual stocks or markets are over-valued.

Huge spikes in the market's P/E ratio have often preceded major market crashes. This is evident from the chart shown below. From the Great Depression to the Dotcom Crash to the Great Recession, there has always been a significant spike in the P/E Ratio before the onset of a major stock market crash. The current TTM P/E of the S&P 500 is 21.86. The TTM P/E Ratio of the NSE Nifty is 23.21. Clearly, this is above the long-term average of the S&P 500 as well as the NSE Nifty. Analysts are justifying the elevated P/E ratios by explaining that the TTM earnings underlying the current P/E ratios are depressed by the low corporate earnings in Q3 & Q4 FY 2009, and markets are trending up in the hope that corporate earnings are about to perk up significantly.



(Image Source: www.multpl.com)

In January 2008, analysts were using the same logic to justify the then high P/E ratio (Nifty P/E > 28) of the market by projecting that forward earnings would continue to grow at heady rates.

For value investors, these high values are cause for caution. Sure, there are many segments of the market, as well as individual stocks, which have still not recovered from their losses during the recession, and are quoting at single-digit P/Es. This calls for a lot of introspection before making investments. What is the reason for the low P/E? Does the company meet the rules of value investing - Competitive Advantage, Management, Margin of Safety, and does it lie within the investor's Circle of Competence? These are important questions to consider

5 Must-Read Books for Value Investors....

The internet provides many lists of the books recommended for investors. This article will list books which are specially recommended for upcoming value investors.

"The Intelligent Investor" (1949) by Benjamin Graham
Authored by the Benjamin Graham, widely recognised as the father of Value Investing, this book laid the foundations for the investing practices of generations of highly successful investors. His most famous student, Warren Buffett, sings this book's praises at every opportunity, and has often said that his investing philosophy is 85% Benjamin Graham. Written in a highly engaging style, this book presents an investment philosophy that differs remarkably from the one seen and heard on business channels everyday. The concept of Mr. Market, an abstraction for the irrationalities of the market is perhaps one of its most enduring creations. Warren Buffett's testimonial for the book: "By far the best book on investing ever written."

"Security Analysis"
From Wikipedia: "Security Analysis, authored by professors Benjamin Graham and David Dodd of Columbia Business School, laid the intellectual foundation for what would later be called value investing. The work was first published in 1934, following unprecedented losses on Wall Street. In summing up lessons learned, Graham and Dodd chided Wall Street for its myopic focus on a company's reported earnings per share, and were particularly harsh on the favored "earnings trends." They encouraged investors to take an entirely different approach by gauging the rough value of the operating business that lay behind the security. Graham and Dodd enumerated multiple actual examples of the market's tendency to irrationally under-value certain out-of-favor securities. They saw this tendency as an opportunity for the savvy."

This book is often credited with creating the profession of equity research analysis, by developing a rigorous framework for analysing securities and providing guidelines for valuing undervalued securities. It transformed the much reviled profession of the stock forecaster, into the analytical profession of equity analysis, which is an integral part of the financial markets today.

"The Essays Of Warren Buffett: Lessons For Corporate America" (2001) by Warren Buffett and Lawrence Cunningham
While Warren Buffett has not himself authored any book explaining his investment style, he has been writing annual reports ever since he took over the reins of his firm - Berkshire Hathaway. In these letters he explains the rationale for his investment decisions and also gives useful insights into his views on corporate strategy, governance and various other issues related to business. These letters are freely available to the general public, and contain all of Mr. Buffett's letters written since 1977. Lawrence Cunningham has done a fantastic job of organising all these writings into a single book, and has categorised the diverse writings of Mr. Buffett into various chapters organised by subject matter.

"Rule #1", by Phil Town
This book is ideal for novice investors interested in understanding the philosophy of value investing. Some reviewers have criticised this book for making sweeping generalisations, and for trying to make investing sound like a discipline that is very easy to master. The book's contribution, however, lies in the fact that it serves as a useful stepping stone before one begins to delve deeper and deeper into the concepts and ideas underlying value investing. As a personal note, this book, which I came across while casually browsing in a bookstore, was my introduction to the field.

"Value Investing and Behavioral Finance", by Parag Parikh
Parag Parikh is a noted Indian value investor, who runs a highly successful investment advisory service. This book explains Value investing in an Indian context with numerous real-world examples. The field of Behavioral finance is intimately linked with value investing, as various behavioural biases often tend to impact investment decision making. This book serves as a very useful introduction to this emerging discipline within finance, which has been getting much higher levels of attention from investors in the wake of the recent financial crisis.

Another famous book known as "Margin of Safety", by Seth Klarman, a famous value investor, is often included in the list of most recommended books on value investing. The book is currently out of print. Such is this book's reputation, that a used copy of this book once sold for $ 700, and it routinely quotes for $ 2000 on eBay and Amazon.

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

Reversion to the Mean.....

"Many shall be restored that are now fallen; and many shall fall that are now in honour"
(Horace: Roman Poet. Published in 18 B.C.)

On 3-Sep, 1929, the Dow Jones Industrial Average touched a high of 381.17. It touched a Great Depression time low of 41.22 on 8-Jul, 1932. The Dow returned to its pre-Depression value again only in 1954. The BSE Sensex was quoting at 20873 points in January 2008. In March 2009, the Sensex touched its crisis-time low of around 8100 points. The Sensex has recovered most of its losses and, it is now heading towards 18000.

An old Persian saying goes, "This too shall pass". How many investors had the experience and the equanimity to step back when valutations got over-heated in January, 2008. How many of us had the courage to re-enter in March, 2009? An awareness of Mean Reversion might have at least sown a seed of doubt and prompted us to act. We may not have been able to time our moves exactly, but we might not have been blind-sided by the sudden upheavals in the market.

Over the 80 years between the Great Depression of the 1930s and the late 2000s recession, developments in economic research have helped us to reduce the intensity and duration of major economic upheavals. However, the economics profession still hasn't been able to resolve the fundamental problem - how to prevent bubbles in the first place. In fact, economists even disagree about the desirability of preventing bubbles from inflating. One school of thought suggests that limiting bubbles stifles innovation. Exhibit 'A' in their argument? Would the huge investments in communication bandwidth and infrastructure have taken place if not for the dotcom boom?

It seems clear that for the foreseeable future, investors will have to keep a cautious watch to ensure that we donot get caught up in bubbles. An understanding of 'Mean Reversion' will keep investors aware and alert at all times for potential storms coming our way.

As a statistical concept, Mean Reversion (also known as Regression to the Mean) is defined as follows: "A variable that is extreme on its first measurement will tend to be closer to the centre of the distribution on a later measurement". This has been observed in a remarkable array of physical and biological phenomena. Mean reversion is also observed in financial markets, which are nothing but collections of biological actors (Automated trading algorithms would perhaps qualify as Physical actors? But we will leave that discussion for another day.)

An adaptation of this concept to the field of investing might read as follows: Any investment that delivers exceptional returns during one period of observation is highly likely to deliver lower than average returns during the next period of observation, and vice versa. This phenomenon has been observed in different markets and at various levels of granularity. For instance, Emerging Markets as a category delivered exceptional returns during the 2003-2007 boom. However, they under-performed to a greater extent than developed markets during the financial crisis. Small and mid cap stocks out-performed before the crisis and vice versa. Fixed Income securities under-performed during the boom (which is to be expected in rising interest rate environments). However, during the rapid interest rate cuts initiated by central banks around the world to stem the crisis, fixed income funds outperformed. This applies to individual stocks as well. For instance, many stocks which were listed during the last stages of the boom and delivered huge post-listing gains, went through catastrophic drops over the past few years, and have still not recovered.

Wise investors with enough experience of the markets are aware of this phenomenon, and tailor their investment decisions accordingly. On 17 October, 2008, in the aftermath of the crash of Lehman Brothers and with the world economy looking as if it was at the edge of collapse, Warren Buffett wrote an editorial in the New York Times, in which he made a bullish buy call on the US stock markets. He wrote that he was personally buying stocks of blue-chip U.S. companies and advised other investors to do the same. On the day, he issued his call, the S&P 500 closed 940. The latest quote on the S&P 500 is currently quoting at 1187, just 150 points below its peak in January, 2008.

Booms and Crises cannot be predicted with any regularity. But the next time investors hear the phrase "Its different this time" to justify the latest boom, they would be well advised to remember 2 words - "Mean Reversion".

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

Are there any value picks in this market? Yes, I believe there are a few options like – Jocil.

The company is a subsidiary of Andhra Sugars (55.02% stake) and is listed only on NSE. The company specializes in manufacturing of Stearic Acid Flakes, Fatty Acids, Toilet Soap, Soap Noodles and Refined Glycerine. The company has been doing contract manufacturing of toilet soaps for leading FMCG brands such as – HUL ( Liril, Lifeboy etc), ITC (Vivel, Superia etc), Marico ( Manjal, Jasmine etc), Johnson & Johnson (Savlon) etc.

Very strong financials:

• Jocil has been growing at a CAGR of 51% for last 3 years and a CAGR of 25% for last 5 years, yet it is available at a P/BV ratio of just 1.25, TTM PE of just 6.
• It is a debt free company. Has excess cash of 25 Cr on Balance Sheet (as of 31st March 2009)
• Has limited investment in inventory and debtors. Hence the business is not working capital intensive.
• Has a track record of excellent dividend payout ratio. (Payout ratio has been around 35% for last two years)

So at CMP of 265, we are getting an FMCG related company at a M Cap of about 115 Cr having atleast 25 Cr as cash on Balance Sheet, turnover of approx 300 Cr, Operating profit of approx 35 Cr and a Net Profit of 21 Cr. Isn’t it a value pick?

Other trigger could be – If the company maintains the div payout ratio of even 30%, it means a 150% dividend this year.

Company’s website: http://www.jocil.in