Buy & Hold Style of Investing

Warren Buffett was once asked what his preferred holding period was when he bought stocks. His short answer? "Forever".

This one word represents the essence of Buy & Hold Investing. Investors who practice this strategy prefer to buy shares of blue chip companies at cheap valuations, which typically occurs when they pass through a difficult phase, and essentially hold the shares for as long as possible. During the long holding period, investors reap returns from multiple sources. More often than not, blue chip companies have high dividend yields, which may be reinvested in the stock. Secondly, as the company's earnings continue to grow, the stock price follows earnings. Thirdly, companies sometimes undertake stock buybacks, when they feel that the share price undervalues the company.

All of the above, deliver long term returns to patient investors. However, one must be aware that this is not the route to quick riches. Returns in buy and hold investing come from patiently holding stocks for many years and allowing the returns to compound.

However, the potential wealth that can be built through this style of investing is nothing to be sneezed at. For an example of this, the story of an American women known as Grace Groner is instructive.

Grace Groner worked as a secretary in Abbott Labs for over 30 years till he retirement, and earned a modest salary from this. She lived in a frugal way, and never engaged in any ostentation. When she died, she willed her estate to her alma mater. To everyone's surprise, including people she had known for many years, the estate amounted to over 7 million dollars. The source of her fortune? A decades old investment in shares of Abbott Labs, which had compounded over many years. Her original investment was just $ 180 (i.e. 3 shares of $ 60 each). Over 75 years between 1935 and 2010, her investment (including reinvestment of dividends, and many splits, bonus issues, etc by the company) had returned her more than 15% p.a.

As I said, the kind of wealth that Buy & Hold Investing can generate is nothing to be sneezed at.
The key is to identify blue chip companies which one strongly feels will survive for many years to come, and continue to generate earnings growth for many years. Warren Buffett purchased shares worth $ 10 million in The Washington Post company in 1973, through his investment company Berkshire Hathaway. Today that investment is worth over $ 1 billion, and generates annual dividends greater than the original purchase price of the position. If anyone knows of such examples in India, please write in to me @ my email address listed below.

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]

Mr. Market

In this blog post, I am posting an article sourced from about.com about the concept of Mr. Market, a revolutionary way to look at the ups and downs of the stock market and to maintain one's composure, in order to be able to make rational investment decisions.


Courtesy about.com

We are going to firmly establish the second of these valuable skills in this portion by explaining the concept of Ben Graham's "Mr. Market". This relatively simple metaphor will forever change the way you look at stock prices, and if employed correctly, increase your investment returns noticeably.

The concept of Mr. Market goes something like this: imagine you are partners in a private business with a man named Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his [the choice is yours]. The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because everything in his world at the time is cheery. His outlook for the company is wonderful, so he is only willing to sell you his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the while, the underlying value of the company may not have changed - just Mr. Market's mood.

The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have to take advantage of him [don't worry, he doesn't have feelings or mind being taken advantage of.] As long as you have a strong conviction of what the company is really worth, you will be able to look at Mr. Market's offers and reject or accept them... the choice is yours.

This is exactly how the intelligent investor should look at the stock market - each security that is traded is merely a part of a business. Each morning, when you open up the newspaper or turn on CNBC, you can find Mr. Market's prices. It is your choice whether or not to act on them and buy or sell. If you find a company that he is offering for less than it is worth, take advantage of him and load up on it. Surely enough, as long as the company is fundamentally sound, one day he will come back under the sway of a manic high and offer to buy the same company from you for a much higher price.

By thinking of stock prices in this way - as mere quotes from an emotionally unstable business partner - you are free from the emotional attachment most investors feel toward rising and falling stock prices. Before long, when you are looking to buy stock you will welcome falling prices. The only time you want to invite high stock prices is when you are eager to sell your securities for some reason. Thankfully, in most cases [except those caused by "Life" which we discussed earlier], you are free to wait out Mr. Market's emotional roller coaster until he offers a price that you consider equal to or higher than intrinsic value. This is perhaps your greatest advantage in your investments.

Broken Clock Syndrome

Whenever there is a stock market crash, there are sundry analysts/ investors/ economists/ bears, etc who proclaim that they had seen the crash coming, and that they had been predicting it since before the crisis.

Yes, there are some people who have a thought process that them to look at every stock market boom with a skeptical eye and judge whether it has been built on a shaky foundation. However, there is another group, the Perma-Bears, who are more often than not bearish on the economy and the markets. They emerge into the limelight when the market starts to move downward and then retreat into the background when the media moves on to the bulls when the market starts to move upward.

This is what is known as the Broken clock Syndrome. i.e. Even a broken clock is right twice a day. (A.M & P.M). Perma-bears are highly invested (I don't mean financially invested, but professionally), in down-markets, as these are the times when they get the highest amount of attention from the media and investors.

Investors who follow them might end up missing out on big returns. For instance, despite the market rebound in March 2009, Nouriel Roubini kept on predicting a double-dip recession, and many fearful investors decided to wait and watch. Before they realised the Sensex and Nifty had moved to much higher territory and they found themselves unable to enter due to higher valuations.

The conclusion: While it is difficult to precisely predict and time crashes and make investment decisions accordingly, it is still very useful to be follow the writings and talks of perma-bears. They serve as a valuable reality check. At the end of the day, it is upto the investor to follow his own instincts and make his own decisions. After all, if the perma-bears were really so effective, they would be billionaires, and not eternal optimists like Warren Buffett and Rakesh Jhunjhunwala.

Confirmation Bias

Confirmation bias is the cognitive bias due to which investors tend to seek out information that supports their preferences and ideas, while tending to subconsciously ignore information which negates their conclusions. Consequently, investors end up investing in situations which are not completely ideal.

For example, consider an investor who is looking to invest in the renewable energy space and thinks that Company 'X' might be a good stock to buy. He looks at the projected growth of the wind power industry, the forecasts for high oil prices which re-inforce his view that wind power is a high growth industry, and also looks at X's rapid growth and order book. He reaches the conclusion that X definitely an idea worth investing.

While he is still conducting his research, he has become emotionally invested in the idea due to the amount of time he has spent researching X. Now he encounters an article which suggests that while X very good prospects, its debt burden is a problem. The interest outgo as well is a strain on its financials, and is likely to impact earnings, which in turn will impact the stock price.

This is where confirmation bias kicks in. Due to his emotional commitment and the amount of previous research he has done, he is convinced that the possibility of the debt burden leading to financial difficulties is limited and hence he dismisses the issue.

The end result is a bad investment which comes back to bit our investor when the market sentiment shifts and the investment community starts to fret over X's debt burden. This is a recipe for a dramatic stock price collapse.

Peter Lynch's PEG ratio

Peter Lynch was the fund manager of the Fidelity Magellan fund, a large U.S. based equity fund which was the No. 1 ranked U.S. fund in its category for a number of years. During his stewardship of the fund, Lynch delivered an astonishing CAGR of 29% to his investors.

Peter Lynch is not, in the strict sense of the term, a value investor. He is probably best described as a GARP (Growth at a Reasonable Price) investor. We had discussed GARP earlier here. One of Peter Lynch's most famous tools is the PEG (Price-Earnings-Growth) ratio, which is a modification of the P/E ratio. The P/E ratio measures the company's price in relation to its earnings, and high P/E ratios are a clear no-go-area for v investors.

However, Peter Lynch believes that high P/E ratios are justified provided the company is growing its earnings at a pace fast enough to justify such high valuations. The PEG ratio is calculated by dividing the P/E ratio of the stock by its growth. A PEG ratio < 1 means that the P/E ratio, even if it is high by normal standards, is still not in over-valued territory. Hence, the stock might still be worth evaluating.

The risk here is that it is very difficult to exactly evaluate a company's potential growth. Even a company which is in a high-growth industry might be hit by unexpected hiccups, such as the departure of a respected manager, failures in R&D, etc.

Hence, my view is that while PEG is an attractive intellectual model, it is a highly subjective framework, in that it requires an investor to be able to evaluate the prospective growth of companies with a reasonable degree of certainty. As many investors found out to their dismay in 2008, even the best analysts are often unable to predict earnings accurately. Alternatively, investors/ analysts may predict earnings well, but the overall economic environment might deteriorate, and all such analyses might need to be invalidated.

With this in mind, value investors are advised to stick to investing in companies with a sufficient margin of safety, and to enter into PEG situations, only if they are very very confident of what they are entering into. 2 words come to mind: Buyer Beware!

Concentrated Portfolios

This is an article on value investors and concentrated portfolios I recently came across. It is available here.


Some of the brightest minds in investment agree on the notion of a concentrated portfolio.

In 1934, John Maynard Keynes wrote the following famous passage in a letter to a friend: 'As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for speacial confidence.'

Not only was Keynes one of history's foremost economists whose theories have had a major impact on the global economy, but he was also a confident and successful private investor. In fact, the fund he ran for himself, friends and family could be described as the first hedge fund , such were his strategies and techniques.

In short, this is the theory of the concentrated portfolio. Why have holdings in 50 stocks to lower risk and diversify when as an investor, you really only believe in a handful of those companies?

It is a theory to which Warren Buffett also subscribes. He believes that concentration will actually reduce risks. This is due to the extra care and attention we pay to an investment if we are to invest a relatively large part of our portfolio. Our comfort level needs to be higher and to do this, we need to conduct more research, due diligence and gain a greater understanding. If after all this we still invest, we were at least very well prepared.

It is a mystery to Buffett why an investor would choose a twentieth or thirtieth company for investment rather than adding more money to the number one holding. Despite the huge funds that have been under the control of Warren Buffett for many years, he still operates on this theory.

His real problem now is that there are fewer and fewer companies in which he can invest that are large enough to make an impact on his portfolio should results be favourable.

Most investors are aware that they do not have the skills or knowledge of a Keynes or Buffett and so, for obvious reasons, lack some of the confidence required to operate a concentrated portfolio.

Unsung Investor: John Neff

Courtesy about.com


Many ordinary folks never heard of John Neff. Yet, within the financial community, he remains one of the most respected, successful, and experienced investors of the 20th Century. Having run the Vanguard Windsor Fund from June of 1964 to December of 1995, he generated a CAGR, or Compound Annual Growth Rate, for his investors of 14.8%. That would have turned an initial $10,000 investment into around $587,000 as compared to only $250,000 for the S&P 500.

His Investment Approach
According to his own book, John Neff on Investing, and other accounts such as John Train’s great interview in The Money Masters of Our Time – John Neff – The Systematic Bargain Hunter, he is a classic value investor. Unlike many of his philosophical and intellectual contemporaries, however, Neff demanded that his stocks generate current income through large cash dividends. He felt that this provided a cushion against market volatility and gave the investor a sense of growth while waiting for Wall Street to recognize the true value of the company.

According to Train, John Neff sought companies with low price to earnings ratios and high dividend yields resulting in a portfolio with an average p/e of 1/3 below the market while averaging 2% more on yield. Train goes on to point out that in addition to looking for a sound balance sheet, satisfactory cash flow, an above-average return on equity, able management, the prospect of continued growth, an attractive product or service, and a strong market in which to operate, John Neff had created a financial metric he called the “terminal relationship” figure. This calculation allows the portfolio manager what he or she is getting for his money when buying a stock.

The calculation itself is easy: John Neff simply took the capital growth rate plus the dividend yield and divided it by the average price to earnings ratio of the entire portfolio. For example, if you had a portfolio you expected to grow earnings at 10% and it generated a 3% cash dividend yield, totaling 13%, and the price to earnings ratio of the whole group of stocks was 10, you would have a terminal relationship of 1.3. If, at the same time, the market had a growth rate of 12% plus a 1.5% dividend yield with a p/e of 17, it would have a terminal relationship of 0.79; far lower than your portfolio. This allows him to see that although the earnings of the market were expected to grow faster, the investor could expect higher returns because he was getting far more future profit for every $1 he spent on a stock. Neff even took this concept further, insisting that each new stock added to the portfolio be at least as attractive as the existing equities he already owned.

Sector and Industry Weightings
John Neff’s Vanguard Windsor Fund was very diversified, typically holding positions that were 1% of assets (although it is reported that he would go as high as 5% in an individual stock if it was extremely attractive.) But as pointed out by my earlier sources, Neff would weight the assets he managed heavily in favor of those areas of the market he thought offered the most value for the money. If, for example, he believed the property and casualty insurance industry was headed for a recovery after a cyclical downturn, he may only take a 1% position in an individual underwriter but he may acquire positions in twenty different enterprising, resulting in 1/5th of assets under management being exposed to that sector of the economy.

Dull and Out of Favor Stocks
Glancing over a portfolio managed by John Neff, you might be surprised to find a list of stocks that are very likely to be highly despised on Wall Street at the time. This disciplined value approach often meant moving into portions of the market for which investors had developed a fear, loathing, and even hatred. A fan of Buying on Bad News, he understood that Price is Paramount – that is, the return you earn is absolutely dictated by the price you paid.

Applying the John Neff Approach to Your Own Portfolio
In addition to the characteristics we already covered, here are some things you might want to look for in a stock if you are trying to invest like John Neff –

* Low Price to Earnings Ratio
* High Returns on Equity
* Management with Disciplined Capital Allocation that Returns Excess Funds to Shareholders
* Above Average Dividend Yield
* Terminal Figure at Least 2x that of the Overall Market
* Out of Favor Industries and Sectors that You Believe Will Turnaround
* Viable Product or Service with Promise

Growth at a Reasonable Price (GARP Investing)

As its name suggests, the GARP Strategy works on the belief that the best way to generate high investment returns is to identify companies growing at high rates (like growth investors), which are trading at cheap valuations (like value investors). This philosophy is derived from the investment philosophy and writings of Peter Lynch (the manager of the Fidelity Magellan fund from 1979 onwards, for 14 years). Peter Lynch delivered returns at a rate of 29% CAGR during his tenure at Fidelity Magellan. In India, Rakesh Jhunjhunwala is a well-known proponent of GARP investing. He is known to look for companies which are currently small or mid cap companies and with the potential to grow into large caps.

GARP investors seek to profit from investing in high growth companies, while trying to reduce downside risk. While this investment philosophy does not seek to completely minimise risk (as is the objective of value investors), it seeks to decrease the risk by insisting on a margin of safety. Such investors look at high earnings forecasts with a deeply skeptical eye, and try to identify companies with sustainable earnings growth.

GARP investors have longer investment horizons than growth investors. They The holding period can stretch over many years. GARP investors believe that earnings growth will eventually lead to stock price appreciation, and hence they generally try to hold investments for as long as possible to capitalise on the earnings growth. However, they might exit if their investment thesis becomes invalidated or if valuations become very high.

GARP investments can deliver extremely high returns. The sources of return are 2 fold. Firstly, as the market sentiment on the stock starts to reverse itself, the P/E multiple of the stock starts to get re-rated. Secondly, as the company's earnings continue to grow, the stock price continues to rise. Thus, GARP investments can outperform both growth and value.

Style	Pros	Disadvantages
Value	Invest only in stocks trading at a discount to Intrinsic Value	Value Stocks may actually Value Traps and take very long to recover
Growth	Invest in Stocks with high earnings growth	High Growth sometimes leads to expensive valuations. If growth doesn't keep up, it is a recipe for a big fall
GARP	Combination of Value & Growth. Invest in growth stocks only if they trade at cheap valuations. Usually small and mid-caps who have suffered hiccups in growth	Returns may take some time to be realised. GARP stocks might be under-valued for justifiable reasons. Downside risk is higher than in Value Investing.

Interview: Top Indian Value Investor Chetan Parikh Outlines His Fundamental Approach

I’m exceptionally proud and honored to present an interview with one of the top value investors of India, Mr. Chetan Parikh. This interview with Mr. Parikh represents one of the highlights of my career. Mr. Parikh is a man whom I admire and who has extensively contributed to the value investing community (via Capital Ideas Online and his numerous writings). I hope you enjoy the interview.

Mr. Chetan Parikh’s Background
Chetan Parikh is a Director of Jeetay Investments Private Limited, an asset management firm registered with SEBI. He holds an MBA in Finance from the Wharton School of Business and a BSc in Statistics & Economics from the University of Bombay. He has been investing in the Indian capital markets through proprietary investment companies and family trusts.

Chetan was rated amongst India’s best investors by Business India magazine. He is also the co-promoter of capitalideasonline.com, a well regarded investment website. His writings have been published in Business Standard, Business World, The Economic Times, and Business India. He is a visiting faculty member at Jamnalal Bajaj Institute of Management Studies (University of Bombay) for the MBA course.

Opening Questions
Q. There are many different approaches to investing. What led you to choose the value approach?
A. Value investing is a logical, safe and disciplined approach to investing. It requires a lot of patience which fits in with my temperament.

Q. Which investors do you admire? Besides these investors who else has influenced you?
A. Any value investor can learn a lot from the Masters. In India I’ve listened to and learnt from Prof. Rusi Jal Taraporevala and Mr. Chandrakant Sampat.

Q. What’s your opinion of the efficient markets hypothesis and practitioners of technical analysis?
A. I believe that the efficient market hypothesis in the various avatars (strong, semi-strong and weak) is not correct. Sometimes prices deviate far away from intrinsic values and it is possible to earn high risk adjusted returns. In fact, the lower the downside risk, the higher can be the upside reward. I do not know anything about technical analysis.

Q. Tell us about your approach to fundamental analysis-what is your focus? How do you search for your investment ideas? Where do most of these ideas come from? Describe your evaluation process (both quantitative & qualitative)? How long do you hold on to your positions?
A. My firm, Jeetay, principally invests in publicly traded Indian securities and seeks to maximize investors’ capital by buying securities trading at values materially lower than their true business value.

Jeetay aims to achieve high absolute rates of return while minimizing risk of capital loss. Jeetay combines the analytical vigor of determining the fair value of a security with a deep understanding of the Indian markets. Jeetay will invest in securities where it can ascertain the reasons for the market’s mispricing and the likelihood of the mispricing being corrected.

Jeetay follows the value investment philosophy, which means that the objective is to buy a security trading at a significant discount to its intrinsic value. Since the focus is on discovering undervalued stocks, the fund doesn’t base its investments on macro-economic factors like GDP growth.

Jeetay determines intrinsic value as the present value of the future cash flows of a company discounted at a rate that properly reflects the time value of the money and the risks associated with the cash flows. In other cases Jeetay invests in “Special Situations” which involve the following:

Repositioning assets to higher uses
Mergers and acquisitions / open offers
Restructuring troubled companies
Spin-offs
Buybacks
The fund invests in a company if the market price is quoting at a discount of at least 60% to the intrinsic value. It sells when the market value approaches intrinsic value or it finds a security trading at a steeper discount to intrinsic value.

Jeetay believes that while in the long term, a company is valued by its fundamentals, short term mispricing occurs due to investor psychology, liquidity and macroeconomic factors. This provides opportunities for the diligent and patient investor to make outstanding risk-adjusted returns.

The time horizon of Jeetay is 3-5 years. It believes that short-term market movements can be volatile and the market may recognize mispricing only in the medium to long term. Hence the emphasis is on understanding the corporate strategy and the resultant cash flows for a 3-5 year period. The probability of the markets recognizing the mispricing becomes high over the medium to long-term period.

The firm does not limit its investments to certain asset classes or sectors. The fund evaluates any sector or asset class where a conservative estimate of intrinsic value is determinable with a reasonably high probability and invests if the security is available at a reasonable margin of safety.

The firm does extensive research to arrive at estimates of expected cash flows, asset values and earnings. Jeetay culls information from public databases, quarterly and annual filings, annual reports, meetings with management, competitors, vendors, customers and other industry participants, industry experts, trade journals and bankers. Jeetay has extensive networks in India to get data and information for superior analysis. Jeetay believes that a disciplined private equity approach to investing that stresses on buying at a discount to intrinsic value will deliver consistent absolute above average investment returns and safeguard capital irrespective of the state of the markets.

Jeetay believes that the following steps are essential to its process:

1. Opportunity Identification. Jeetay identifies opportunities through a multitude of ways. Jeetay has numerous financial models and screens that are used to filter investment opportunities within the framework of the investment philosophy. Jeetay has many contacts and professional relationships. This gives it many opportunities consistent with the investment philosophy.

2. Analysis. Jeetay does intensive financial and qualitative analysis on companies once an opportunity is identified. The analysis is mainly to arrive at whether a disparity exists or not between the traded value of the security and its intrinsic value. Jeetay has substantial experience in determining the intrinsic value of a company across sectors. Multiple valuation metrics including discounted cash flow analysis, price to earnings, dividend discount model, price to sales, price to book, comparative analysis is used to arrive at the valuation of a company.

Other than financial analysis, Jeetay extensively meets every possible associate of the company to understand the opportunity better. These include vendors, customers, middle management, bankers, competitors, large stakeholders and senior management. This helps Jeetay arrive at a closer intrinsic value and also exit an investment if unfavourable events arise or the team’s original calculation of intrinsic value was wrong.

The analysis would focus on the 3B’s, – Understanding the business, analyzing the balance sheet and looking for bargains.

Take each in turn:

Business: What is the nature of the business and its competitive strengths and weaknesses? What is the competitive ecological niche that it occupies and how protected are its profits from predators there? What are the nature of the entry barriers or ‘moats’ - intangible assets, switching costs, network effects, cost advantages? How wide and deep are the moats? Does the business cover its cost of capital? A qualitative assessment of the business should be made to understand whether it is a superior or inferior business. Evidence of pricing power or the ability to lower cost of production and distribution should be searched for.
Balance Sheet: In order of importance is the balance sheet, the cash flow statement and the profit and loss account.
Bargains: One need not to be able to determine value exactly to know whether a stock is cheap or not. As Ben Graham wrote, “To use a homely smile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his weight.” A discount to value, a ‘margin of safety’ is paramount, without which an investor is relying on the whims of “Mr. Market” for his investment return.

Q. As a follow up question, how do you determine intrinsic value?
A. The textbook definition of Intrinsic Value is the present value of the future cash flows discounted at a rate that realistically reflects the time value of money, risk and volatility of the cash flows.

The problem is that it is difficult to:
1. determine the future free cash flows
2. determine the discount rate
3. determine the terminal value

There are very few companies, i.e. those that are franchises earning well over their cost of capital and growing whose intrinsic value can be calculated using the Dcf approach. Ben Graham’s method of bargain identification is useful in other cases.

You don’t have to calculate intrinsic value with precision (especially where it is not possible) to know whether a stock is cheap in seldom to its value or not.

Q. Do you invest in foreign companies? If so, do you evaluate foreign companies different than those based in India and how do you hedge currency exposure(s)?
A. I have not invested in foreign companies as of yet. Sitting in India, I would have to invest in the large cap stocks in foreign markets, and have not as yet found large caps in USA to be cheap in relation to my investing universe in India. Whilst markets may change, valuation principles are universal-they are the same whether it’s the USA or India.

Q. How many stocks do you typically hold in your portfolio?
A. In my family portfolio, given the time horizon and tax considerations, there is a heavy concentration on a few stocks that have franchise value and entry barriers. There are smaller positions, but the bulk of the portfolio is in a handful of stocks.


In the managed accounts, price in relation to value is of paramount importance and many of the businesses are clearly not franchises. The portfolio thus in the managed accounts tends to be more diversified with roughly around 18-25 positions. Cash is carried at all times in the managed portfolios, the level directly correlated with the valuation of the broad market.

Q. Do you invest in any fixed income? If so, tell us about the role of fixed income investments in your portfolio.
A. I do not normally invest in fixed income securities. Cash is usually a default position and varies directly with the level of the market. The cash is usually kept in the bank or in money market funds. I do not like to take a credit risk with money that I know will eventually be opportunistically deployed in the stock markets. The key is to be able to sit on your low-yielding cash without losing your patience.


Q. . How do you judge a company’s management?
A. There are three ways of looking at management:


1. their integrity
2. their competence – both operational and in capital allocation
3. their corporate governance

In the end you want to deal with people who do not make your stomach churn. Integrity and competence are both necessary in top management. Finally there is the factor of the passion to improve the game by never becoming complacent.

Sometimes a good price can cover a multitude of sins, including poor management. But if I had to hold a non-franchise investment for any length of time, management would certainly be an important factor. In many cases, it is the jockey, not the horse that one should bet on.

Q. What makes you sell an investment?
A. I sell when:

My original thesis was wrong
Price is reached
A better option comes along
Ben Graham’s criteria should be kept in mind. Switch for:

1. Increased security
2. Larger yield
3. Greater chance for profit
4. Better marketability

Q. How do you look at risk?
A. Risk is very subjective. Academic theory has one definition of risk namely standard deviation which is wrong. Actually, if one had to use statistical distributions to measure risk, then there are three dimensions, Variance, Skewness & Kurtosis.

I do not think however that risk can only be captured by statistical measures. To me, risk is simply the chance of permanent loss of capital and an investors’ job is to eliminate that risk. He may not be able to do so for individual securities, even with a margin of safety, but he has to do it in a portfolio context.

Q. What’s your take on leverage?
A. Leverage is one of the two things that can cause a permanent loss of capital to a value investor. Avoid it, unless you are willing to take a risk of a permanent loss to your capital. The other thing that can cause a permanent loss of capital is holding on to overvalued stocks, but I assume that a value investor would not do that.

I always carry cash for optionality, rather than borrow against my holdings should the opportunity arise.


Q. Do you invest in commodities, gold, real estate, etc? If so what has been your experience with these classes?
A. I have legacy investments in real estate. I view it as an inflation hedge and a different asset class in the portfolio.

Currently I have investments in gold as a hedge against a highly likely decline in the value of the dollar and a meltdown in financial assets. The economic problems in US are severe and the wrong treatment is being given. When fiscal and monetary insanity prevails, gold always reigns supreme. I’m not making a directional bet on gold prices – it is only a hedge against my financial investments.

Q. Tell us a little more about your involvement with special situations?
A. It depends on the definition of “special situations”. If special situations means a value stock with identifiable catalysts like change in management, operational and financing restructuring, buybacks, mergers and acquisitions etc, then we certainly do invest in special situations. We have investments in spin offs and in open offers as a result of takeovers.


Q. Have you ever taken the role as an activist investor, would you ever do so?
A. I’ve never wanted to take a confrontational attitude with management although sometimes I’m forced to. If I’m not happy with their policies, I sell - but my aim is to influence management through logic and rationality, not through financial blackmail.

There is a grey area however. I’ve been connected with the press through my columns in various newspapers and magazines and I’ve written about instances of corporate misgovernance there. But I’ve never threatened management.

I do not have the temperament to fight management or for that matter, anybody. I believe in exiting relationships where there is no mutual respect, rather than slugging it out for dominance.

Q. We understand that you are very focused on bottom up value investing-what has the financial crisis taught you?
A. I wrote this piece awhile ago and it would be related to the question above.

It may be interesting to use a cross-disciplinary approach to the problems and mistakes made by banks in the sub-prime market.

The power of rewards that leads to repeated actions and the flawed compensation structure that led to misaligned incentives could be one mental model. As Raghuram Rajan pointed out in Financial Times (Jan 9, 2008), the compensation practices in the financial sector are deeply flawed. The compensation is based on the so-called ‘alpha’ that a manager of financial asset generates. There are three sources of ‘alpha’:

1) Truly special abilities in identifying undervalued assets (eg. Warren Buffett)
2) Activism – using financial resources to create, or obtain control over, real assets and to use the control to change the payout obtained on the financial investment.
3) Financial engineering – financial innovation or creating securities that appeal to particular investors.

Many managers create ‘fake alpha’ i.e. they appear to create excess returns but are taking on ‘tail’ risks which produce a steady return most of the time as compensation for the very rare, very negative returns (‘black swans’). The AAA rated CDOs generated higher returns than similar AAA rated bonds. The ‘tail risk’, so evident in hindsight, of the CDO defaulting was not as small as perceived and so the excess return was compensation for that.

The credit rating agencies that rated these securities as AAA because of their ‘insured’ status were themselves wrongly incentivized (compensated by the issuers of the securities). Furthermore once their peers started issuing AAA ratings, ‘social proof’ came into play and the ratings war as to who assigned the highest ratings for junk became a classic Prisoners’ Dilemma..

This is proving to be a game of chicken between the regulators and the players (banks and monoline insurers). In a classic game of chicken, two cars drive towards each other. The first driver who turns loses. Of course, if neither car swerves then there is a crash. The best outcome for each player results when he goes straight whilst his opponent turns. Insane players have a massive edge in a game of chicken. At this point of time, the jury is out given the level of insanity in the system.


Q. How have you evolved as an investor?
A. I guess the process of evolution is never over. I started out knowing nothing but efficient markets and so the leap to value investing was a big one. I know I’ll never leap out of value investing, but the nuances may undergo changes, as also my ability to widen and deepen my circle of competence.

Q. What is the most interesting part of your job?
A. It is searching for investment ideas, working out the odds and reading from a wide variety of sources.

Q. Which books would you recommend?
A. Here are a few, but they are by no means exhaustive.

Everything by Jared Diamond
Everything by Garett Hardin
“The Road to Serfdom” - Friedrich Hayek
“The Prophet of Innovation”
“More than your know” - Michael Mauboussin
“The Robot’s Rebellion”
“The mind of the market” - Michael Shermer
Try to read all of Mr. Munger’s book recommendations and also the books in Mr. Peter Bevelin’s Bibliography in “Seeking Wisdom: From Darwin to Munger”. I do not think that I’ll be able to read all the books that have been recommended in my life time but I’m going to give it a shot.

Q. What is the biggest mistake keeping investors from reaching their goals? How have you guarded yourself against this folly?
A. Greed, fear, sloth and envy are the four emotions that are positively inimical to becoming a better investor.

Meditation, detachment from results, but attachment to efforts, yoga, discipline in living and thinking are some of the ways for self-improvement in investing.

One must also have an open mind to new ideas and try to become in the words of Mr. Munger “a learning machine.”

Q. What should investors understand before investing in India?
A. Indian markets are very volatile, so be very careful on entry prices. “Growth” is a seductive term and stories woven about growth even more seductive, but be very careful of paying too much for it. Homework matters. Liquidity can dry up, so be clear whether you can live with relatively illiquid positions.

Closing Questions
Q. If you could do anything besides allocating capital what would you do?
A. I would teach and write more often than I do.

Q. What message/advice would you give to readers of SimoleonSense?
A. Read a lot, be disciplined, be humble about your knowledge and stay within your circle of competence.

Q. What does the future hold for you, your funds, and website? Are you going to do this forever?
A. As long as I can, mentally and physically.

Miguel Barbosa: Mr. Parikh thank you for taking the time to interview with us.

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