Learning from Berkshire’s Acquisition Criteria

Looking at the 100-plus businesses that Buffett has accumulated, a casual observer may feel that it is a collection of random businesses. But look closely and you will find a pattern. Who else, but Buffett has articulated the common thread amongst all his businesses when he published the Berkshire’s Acquisition Criteria.

A fact that we need to keep in mind is that these criteria are not for his general stock purchases but for acquiring controlling stake or whole companies, but they give a glimpse of how Buffett things about buying companies.

There are six criteria which are simple and straightforward.

1. Large purchases (at least $50 million of before-tax earnings)

Buffett looks at opportunities to deploy large amounts of cash. It makes very little sense to buy companies which would make up a fraction of a percentage or a couple of percentages in his overall portfolio. The same principle applies to investors as well – to look for companies where we can invest between 5-10% of our portfolio with conviction.

2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations)

Buffett looks for companies with regular and consistent cash flows and earnings. This significantly reduces his universe of investible stocks as some sectors are by their nature not amenable to such characteristics. Cyclicals like cement, metals, sugar, oil have never been part of Buffett’s core holdings -though he has had shorter term (five years) positions in stocks like PetroChina.

"Both our operating and investment experience cause us to conclude that turnarounds seldom turn," Buffett wrote in 1979, "and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."

Investors should focus on finding good businesses with reasonably consistent cashflow and ability to generate profits for a prolonged period (many years or decades) and then try to buy them at a discount to intrinsic value.

Having a portfolio of good businesses, without being leveraged and not needing to pull out of the market when there is a downturn, can produce good results over a long period of time.

3. Businesses earning good returns on equity while employing little or no debt

Stocks of highly leveraged companies should come with a statutory warning like in cigarette packs, “Investing in highly debt-ridden companies is injurious to wealth”! The foremost reason for problems in companies over a long period of time, which results in permanent loss of capital for investors, is high debt. If an investor can simply avoid them, half the battle is won.

Return on equity (ROE) is one of the most important ratios to look at for a company. A business needs to be able to generate ROE above its cost of capital and above an investors opportunity cost to be considered for investment.  Over a long period, a business which generates high ROE will tend to be value accretive.

4. Management in place (we can't supply it)

An honest and competent management that treats minority shareholders as equal partners in the business is crucial for the long-term success of an investment. Since, minority shareholders usually are not able to control or influence management decisions and policies, special emphasis is required to understand that the management would not try to enrich itself at their expense or try to get into ‘diworsifications’ for self-aggrandizement.

5. Simple businesses (if there's lots of technology, we won't understand it)

Here again the focus is on businesses which can be understood by the investor – the circle of competence. Understanding means that the investor understands the industry dynamics, the competitive positioning of the company within the industry, how the company makes money, the demand and supply economics etc. It also means some idea about how the long-term future would look like for the business. This is precisely why Buffett tends to avoid those industries and companies which are prone to rapid disruption and change and sticks to the old-world businesses.

An investor can start with studying businesses that they are familiar with and learn more about it and its competitors. Over a period, the circle of competence can be expanded to include new industries and companies by continuous learning.

6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)

Price is the most ready-made data that is always available for listed stocks. Every day Mr. Market gives a quote that an investor can either take or let pass. This criterion, if strictly interpreted, is not for investors, but can be expanded to incorporate the most critical concept of “margin-of-safety”. An investor should only look to buy a business if the quoted price is below the intrinsic worth of the stock. It also protects an investor from mistakes and market downturns.

Since last year the Q&A session at the Berkshire Annual Meeting has been webcast live giving an opportunity for investors across the world an opportunity to watch the Buffett-Munger duo in action, answering questions across various topics. Every year, there is some nuggets of wisdom that can be learnt from these sessions and this year was no different.

Munger and Buffett have spent their entire lives by sticking to their investment principles not chasing fads. “A lot of people are trying to be brilliant, and we are just trying to stay rational”, said Munger. Buying and holding great businesses over very long periods of time has been extremely rewarding. As Buffett aptly put, "We did not buy American Express or Wells Fargo or United Airlines or Coca-Cola with the idea that they would never have problems or they would never have competition. But we did buy them because we thought they had very, very strong brands”. Brands of course allow Buffett to invest in companies where he can predict consumer behavior in the long term.

Over the years, Buffett has been sector-agnostic and bought wherever and whenever he has seen value.

"Charlie and I really do not discuss sectors much, we're really opportunistic. We're looking at all kinds of businesses all the time. We're hoping, we get a call, and we know in the first five minutes whether a deal has a reasonable chance of happening… We don't really say we'll go after companies in this field or that field”, Buffett said.

Markets are at time irrational and provides good companies at cheap valuations. That is the time when margin of safety in stocks are high and investors need to take advantage of. As Buffett mentioned, "It is the nature of market systems to occasionally go haywire in one direction or another."

The world is seeing a plethora of new technologies resulting in completely new businesses. In the coming years, some existing businesses will die and others will take their places. Buffett mentioned that artificial intelligence would result in significantly less employment in certain areas, but that’s good for society, though it may not be good for a given business. As an example of such widespread disruption and its impact on businesses, Buffett said, “Autonomous vehicles, widespread, would hurt us if they spread to trucks, and they would hurt our auto insurance business. They may be a long way off. That will depend on experience in the first early months of the introduction. If they make the world safer, it will be a very good thing but it won't be a good thing for auto insurers."

If we follow the basic rules laid down by Buffett, keep learning continuously and apply common sense to investing the long-term outcome is likely to be positive.

PI Industries - another look

I have been invested in PI Industries for many years now. The aspects which appealed to me first, continue to appeal to me even now. The company has, over the years, managed to strengthen its moat and scale greater heights. The way the company has scaled its CSM & CRAMS business along with strengthening domestic distribution has been exemplary. 

Recently, during the Valuepickr conference in Goa, I was thinking about if PI's business moat and whether it was widening or shrinking. So, I decided to see how they were placed and see if I can poke some holes in their story.



BEAR CASE

• Move from contract research to manufacturing will mean additional capex, reduced asset turns and lesser ROE
• Risks - i) GM seeds, ii) herbicide resistance in plants, iii) client concentration, iv) gene-edited seeds
• Contract research market is slowing due to:
• New molecules are more difficult to get
• 1st year sales have reduced drastically
• High cost of new development of new molecules
• Bio-tech is replacing agrochemical usage
• Bayer, PI's largest client, is forecasting poor agrochemical growth due to high inventory, farmer stress in Brazil and Europe, reduction in corn acreage in US
• Excel Crop has applied for manufacturing registration of (Bispyribac Sodium) Nominee Gold
• 33% of the products in PI’s portfolio is in-licensed and faces a risk of import restrictions
• Tax rates to go up substantially from 10% to 22-23%
• With Bayer's acquisition of Monsanto (if it gets completed), there may be some changes in the relationship with PI

BULL CASE

• $6bn is going off-patent in next 6 years
• Moving to Pharma CRAMS, a much larger market. Inducted a team from AstraZeneca over last 2 years. They have also inducted a Pharma veteran - Mr Balaganesh, ex-MD and Head of Research of AstraZeneca's anti bacterial research facility - on their board as Additional Independent Director. Several other senior level recruitments to drive Pharma CSM.
• Domestic market to grow substantially. 
• Imports made more stringent, hence more products to be made in India versus imported
• Recent tie-up with Kumiai Chemicals for producing Nominee Gold in India and also partner on other new molecules
• JV with Mitsui for providing registration services - pre-launch feasibility analysis, market research and feasibility analysis. Mitsui is a global major in performance materials, petro & basic chemicals and functional polymeric chemicals
• JV with BASF to produce 
• Pendimethalin - Global sales US$325m - directly competing with Rallis in India
• Saflufenacil - Global Sales US$180m
• Dimethenamid - Global sales US$145m
• Order book of $1 bn (June 2017) for 8-9 molecules
• Improving margins due to better product mix and operating leverage
• Jambusar facility capacity utilization is 65-60%, leaving a lot of room for operating leverage to kick in
• Global AgChem spending has been on a downswing and a recovery is supposed to pickup from 2018

From Bayer's presentation - Jun 2016

CONCLUSION:

PI seems to be consciously changing themselves with JVs & partnerships to launch newer service offerings and product launches in India. Having done very well during the time AgroChem producers have struggled globally, they are poised for better times in FY19. The near term (1 year) may still remain a struggle due to the industry headwinds and revenue growth may not be very strong. The business seems to be on a very strong wicket specially given that agriculture as a sector is likely to be very strong with increased global population and need for more efficient & abundant farm production.

Highlights from Book - Common Stocks and Common Sense - Edgar Wachenheim

Common Stocks and Common Sense by Edgar Wachenheim is a case-study based book on investing. In structure it is similar to Beating the Street by Peter Lynch. Edgar used to run Greenhaven Associates with an excellent long term track record. In the book, he goes through some of his picks, the rationale of why he bought them, his process of stock selection and the emotions that goes with investing. It is a good book dealing with real-life examples of a good value investor. 

Below are the key points I noted from the book.



The strategy is to try to purchase deeply undervalued securities of strong and growing companies that hopefully will appreciate sharply as the result of positive developments that already have not been largely discounted into the prices of the securities.

I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.

When an investor is barraged with particularly bad or good news, he can reread the memos, notes, and models he wrote before the occurrence of the news. He then can ask himself three questions: What really has changed? How have the changes affected the value of the investments under consideration? Am I sure that my appraisal of the changes is rational and is not being overly influenced by the immediacy and the severity of the news?

When we purchase a stock, we are interested in what the company will be worth two or three years

I knew that my projections of IBM’s earnings and values were nothing more than best guesses based on incomplete information. However, having the projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

I greatly admire Warren Buffett. He is one of the great investors of all time. But I strongly disagree that the shares of most wonderful businesses can be held forever because most wonderful businesses become less wonderful over time—and many eventually run into difficulties.

My job would be a lot easier and much more relaxing if I could fill a portfolio with outstanding companies that I never would sell. But our ambitions lead us to seek shares that are temporarily deeply undervalued and then sell the shares when they become fully valued. This is an approach to investing that is less relaxing and that requires considerable effort and time, but that has worked for us.

I almost always start my analysis of a company by studying its balance sheet. It is said that a shareholder makes money off the income statement, but survives off the balance sheet, and I agree.

When studying a balance sheet, I look for signs of financial and accounting strengths. Debt-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and “hidden” assets and liabilities all are among common considerations, with their relative importance depending on the situation. If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.

If a company’s balance sheet passes muster, I then try to get a handle on management. The competence, motivation, and character of management often are critical to the success or failure of a company. To form an opinion on management, I normally pay careful attention to the management’s general reputation, read what the management has said in the past, assess whether the management’s stated strategies and goals make sense, and analyze whether the management has been successful carrying out its strategies and meeting its goals.

However, I am humble about my abilities to accurately assess managements. Experience shows that investors can be unduly impressed by executives who are charismatic or who purposely say what investors want to hear—who play to their audience. Also, investors frequently will undeservedly credit management for a company’s favorable results and vice versa. Favorable or unfavorable results often are fortuitous or unfortuitous.

After trying to get a handle on a company’s balance sheet and management, we usually start studying the company’s business fundamentals. We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.

Our models normally include earnings projections for the next two or three years. Our valuation is based on a multiple of projected earnings and cash flows.

In the stock market, it is best to be flexible and not be tied to conventions or rules.

My own policy is that no single stock should equal more than 12 percent of the total value of a portfolio and that no single industry should equal more than 25 percent of the total value. When measuring the percentages, I use the cost of the stock rather than its market price. That way, I am not forced to reduce the size of a position that appreciates faster than the portfolio as a whole.

Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking ones neck out—all efforts that human beings too often prefer to avoid.

In the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments. It comes with the territory. So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks. However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities. One should not invest with the precept that the next 100-year storm is around the corner.

I revise models frequently because my initial models rarely are close to being accurate. Usually, they are no better than directional. But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good. I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time. Thus, one would do just as well by flipping a coin.

In the end, the psychological rewards of being right can be as important as—or more important than the monetary rewards. And they are interrelated. When you feel good, you are more likely to do well.

But I believe that investors sometimes need to be open to new ideas that challenge previous convictions. In the investment business, as in life, one becomes disadvantaged if one develops tunnel vision.

Often, when I am in a quandary about whether to sell one of our holdings, I sell half or some other fraction that makes sense under the circumstances.

Occasionally, a black swan adverse event does derail one or more of our investments. When this happens, we must be ready to unemotionally rethink the economics of continuing to hold the investments—and, if necessary, sell.

When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course. We do not seek new theories that will justify our original decision. We do not let errors fester and consume our attention. We sell and move on.

Our central strategy is to purchase deeply undervalued securities of strong and growing companies that likely will appreciate sharply as the result of positive developments.

To successfully assess probabilities and make good investment decisions, an investor should hold considerable amounts of information about the companies and industries he is investing in. Having superior information (both quantity and quality) can give an investor a competitive edge. To obtain information, we spend a large percentage of our time researching the fundamentals of companies.

Pay more attention to what managements do than to what they say. Remember, managements, like most other people, tend to act in their self-interest.


Favor managements who are highly incentivized to achieve higher prices for their shares.

Learning from Security Analysis - Part 1

I have started re-reading Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburner for sometime, but since the last time I read this was about 14 years back, decided that I have changed too much not to re-read this once more. Hoping to learn a lot more the second time around.

From the preface to the 6th edition by Seth Klarman

Value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over - or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.

It is not enough just to number crunch. A business participates in a complex adaptive system, which is continuously in a flux. We need to be able to understand businesses and their operating environments; political, economic and social environments are also important to be understood.

While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided. 

Before buying, it is important to ask the question, why is this cheap?

When bargains are scarce, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of compelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. -- This is a difficult thing to do emotionally, especially in a rising market.

Like Klarman says, this is a very very difficult thing to practice. In a rising market, most value investors get out too early, which in itself is not a bad thing, but tests ones patience and fortitude immensely, to see ones friends keep making money when one is out of the market, sitting on cash.

Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future. 

Keep sharpening your saw or as Peter Lynch has said, keep turning over as many rocks as possible. I think it is important to study business in a pattern to get the most benefit. I like to look at a particular industry and multiple stocks within it.

Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. **First, sell targets, once set, should be regularly adjusted to reflect all currently available information.** Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators. 

For stocks which are compounding machines, we need to keep updating the intrinsic value, so that we do not get out of them too early. On the other hand, a sense of what a stock is worth is a must at all times for all stocks in one's portfolio.

Aarti Industries - Good Chemistry

Business Overview
• Aarti Industries (AIL) has 3 divisions –
    o Specialty chemicals - Polymer & additives, Agrochemicals & intermediates, Dyes, Pigments, Paints & Printing Inks, Pharma Intermediates, Fuel Additives, Rubber chemicals, Resins, Fertilizer & Nutrients
    o Pharmaceuticals – APIs, Intermediates for Innovators & Generic Companies
    o Home & Personal Care - Non-ionic Surfactants, Concentrates for shampoo, hand wash & dishwash
• One of the leading supplier to global manufacturers of Dyes, Pigments, Agrochemicals, Pharmaceuticals & rubber chemicals.
• Manufacturing units (16):
    o Specialty chemicals - 10
    o APIs - 4
    o home & personal care chemicals – 2

Specialty Chemicals
• Largest nitro-chlorobenzene producer of India with a capacity of 60,000 TPA
• Amongst the largest producers of Benzene based basic and intermediate chemicals in India
• Lowest cost producer of Benzene in the world
• Exports account for 51% of specialty chemicals division with 90% of exports USD denominated
• Offers 100+ products to MNCs globally; has "strategic supplier" status with many
• Globally ranks at 1st – 4th position for 75% of its portfolio
• Works on a cost+ model. Increase in cost of benzene will increase working capital requirement funded by short term debt. Decrease may lead to inventory losses and revenue reduction
• Benzene accounts for ~60% of the company’s revenues, while aniline and sulphuric acid compounds contribute ~12% to revenues.
• With start of the Dahej facility of 30,000 TPA capacity in Q1FY18, AIL will also enter toluene chemistry.
• Exports contribute ~50% to revenue with incremental capex planned to enhance standing in the export market.
• Co supplies products to more than 500 domestic customers and over 150 international customers from 50 countries with a major presence in USA, Europe, China, Japan and India. The customer list comprises marquee brands like BASF, Bayer, Clariant, Dow, DuPont, Flint Ink, Hunstman, Makhteshim Agan, Micro Inks, Solvay, Sudarshan, Sun Chemicals, Syngenta, Teijin, Ticona, Toray, UPL Limited

Pharma
• Pharma business has broken even in FY12 and can aid in growth
• Company has two USFDA facilities one for API and another for Intermediates.
• Comprises of about 15% of total revenues
• 48 commercial APIs with 33 EDMF, 28 USDMF and 16 CEP. 12 new APIs under development

Home & Personal Care Chemicals
• Low margin business
• Expected to grow on the back of larger consumption of hygiene and personal care products. Increasing consumption is driving the demand for range of cosmetic chemicals, health care products and hygiene products using performance chemicals, polymers and oleo chemicals.
• Comprises of about 5% of total revenues

Industry Overview
• Indian specialty chemicals industry is around $25 bn (FY13-14 FICCI report)
• India contributes about 3% of global specialty chemicals industry, which leaves a very large opportunity size.
• Global chemical companies are de-risking the supply chain for their raw-material by diversifying from China to India
• The most impactful regulation from an Indian perspective has been the European Union’s REACH (Registration, Evaluation, Authorization and Restriction of Chemicals), which went into effect in June 2007. This legislation addresses the production and use of chemicals and their potential impact on human health and environment. The substantial impact of REACH will come into play following the implementation of Phase 3 from June 2018 that will regulate any chemical supplied to EU at quantities of 1 tonne per annum or more. Aarti has been REACH-complaint since 2011.

Competitive Landscape
• Chlorination (ranked among the top three globally)
• Nitration (ranked among top four globally)
• Ammonolysis (ranked among the top two globally) Hydrogenation (ranked among the
top two globally), and
• Halex Chemistry (only player in India).

Risks & Concerns

• Co operates in an environmentally sensitive sector and is open to regulatory risk. Government can put in place stringent environmental guidelines which may make their products uncompetitive internationally.
• Fire and accident hazards during operations causing major disruptions cannot be ruled out.
• Issues with US FDA / cGMP on pharma APIs
• Co has exposure to foreign currency fluctuations
• Debt is high
• Though co works on a cost plus basis model in its speciality chemical segment, any significant increase in benzene prices will increase the working capital requirement for the business funded by short term debt, leading to increase in interest outgo and decline in profitability.

Management
• Management compensation aggregates to 10.25cr and is especially high amongst the Gogri family members.
• Management has maintained a dividend payout of over 25% for the last 10 years
• Management is paying out full tax

Financials
• Net debt / Equity is 1.9 at the consolidated level, which is on the higher side. Interest coverage ratio is 4.89 which is healthy.
• Co has maintained strong operating cash flow / net profit ratio, which means they have been able to generate cash successfully over a long period of time.

Piotroski's F-score Analysis

Co fairs well in the Piotroski’s F-score with a score of 6 (out of 9). The 3 points where it did not get a score were very near misses.

Dupont Analysis

• Majority of the ROE is being derived from the financial leverage. The co is slowly improving its margin profile and can maintain its ROE at the current level, even if they reduce debt. At the same level of leverage, ROE can be improved by better margins.
• With a large part of the capex already done, specially for the toluene plant, asset turnover is likely to improve, thus improving ROE further.
• The co is consistently improving its ROE over the last 5 years

Key Assumptions & Key Monitorables
• Growth led by capacity addition will continue
• Debt-Equity levels will not rise further
• Margins will be on an upward trend based on better product mix
• No issues with US FDA or any other regulatory compliance
• Toluene and ethylation plants get onstream with good capacity utilization

Valuation

Stock Update: Century Ply

Q3 FY17 investor presentation and concall summary -

• Hoshiarpur plant for MDF is to start in Mar 2017
• Sainik sold 11,819 CBM (cubic meter) vs 12,037 cbm last year. This is despite impact of demonetization
• Ply sales have been strong in January 2017 as well
• There are around 3,300 plywood units in the country and out of 3,300 units, 2,500 are totally exempted, the turnover is less than Rs1.5 crore, 700 units are under the partial exemption their turnover is Rs1.5-5 crore and only 100 units are there which are in the full duty paying
• MDF: Co 600 CBM/ day capacity MDF plant is expected to come on stream by April, 2017. It entails an investment of 380 cr with 207 cr spent till Q3FY17. 
• The company would also use the MDF produce to make value added products like doors, pre-laminated boards. While it would also produce high density fibreboard (HDF) for manufacturing wooden flooring
• Market share: The company looked to maintain market share in difficult times post demonetisation. Hence, it gave dealers some discounts which led to a margin contraction. However, going forward, the management has indicated that they would reduce these discounts over the time
• Demonetisation impact: The management believes that demonetisation impact is over as the company witnessed ~5% growth in January, 2017. Though the unorganised sector is still witnessing problems, the company believes that it has a great opportunity to capture market share from unorganised players post demonetisation
• Pre-lam particle board plant: Currently, the company has a capacity of producing 1000 boards/day at its pre-lam unit and it would augment its capacity to 3000 boards/day by commissioning one more unit in next 3-4 months
• Commercial veneer: The realisations of commercial veneer increased sharply during the quarter as company sold premium veneer. It expects to maintain such realizations, going forward
• Pricing changes: The company has not taken any price hikes post demonetisation. It would benefit from softening raw material prices and so would look to maintain prices, going forward before the final rate of GST is known. Further, the unorganised players have already take price hikes of ~5% post demonetisation and could also take further price hikes. This would lead to contraction in price differential between organised and un-organised products which would help the company gain market share from unorganised players
• Winding up furniture business: The company has decided to completely wind up its furniture business which it started in 2012. Over the years, the division has accumulated losses of ~25 crore
• Laminates capacity expansion: The company is planning to rampup its laminates capacity by 50% to 7.2 mn sheets
• GST rate: The management expects a GST rate of either 18% against the current incidence of ~27-29%. Post GST implementation, a level playing field would be established and organised players are set to benefit

Near term triggers
• GST implementation is likely to migrate unorganised to organised sector
• Pre-lam is expected to give good growth
• MDF, new facility, is expected to give good growth - FY18 revenue is expected to be around 400cr; At full utilization it can generate 600 cr

Learnings from Buffett's 2017 Annual Letter

This year Buffett dealt with a few important points. I found his lengthy discourse on the superiority of index funds intriguing - but not really applicable for the Indian markets as here, maybe unlike in the US, there is significant outperformance by good funds over the index.

On being in the market

The years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost  certainly do well.

Having a portfolio of good businesses, without being leveraged and not needing to pull out of the market when there is a downturn, can produce good results over a long period of time.

On share repurchases

It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.

Here, I think, the Indian tax laws on dividend distribution has skewed the investor giveback so that companies are looking at share repurchases as an alternate mode of returning cash to shareholders. But, in general, the principle outlined by Buffett holds true.

On insurance operations

A sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.

This is important bit of wisdom to be kept in mind, since we are seeing listed companies in this space now in India. Insurance is a long gestation business which has the potential to create significant wealth for shareholders.

My takeaways from Howard Marks' presentation

My notes from Howard Marks' presentation on 2-Mar-17:

• Definition of "great" companies is dubious. Very difficult to identify great companies over a very long period
 
• Investing is not a matter of buying good things, but buying things well (buying assets which are out of favour)
 
• Forecasting is not possible as the future is not knowable. Try to know the knowable. Focus on specific sectors, industries, companies
 
• The main decision to make at any point in time - whether to play defensive or offensive. You cannot play both at the same time.

• Low purchase price is more important than anything else (including quality of company)
 
• Have to think differently (variant perception) and better - need to have some knowledge different from everyone else
 
• Most investors behave pro-cyclically
 
• You need to have a philosophy and process that you can stick to even in most trying of times
 
• Most corrosive of emotions is to sit up and watch others make money
 
• Plan to survive the "worst day" in the market without having to sell. The challenge is we don't know what the "worst day" will look like, but can get an idea from the past.

• Hubris, ego, over-confidence are enemies of an investor
 
• Your approach needs to be consistent with your personality
 
• Turn cycles to your advantage
 
• Look at E/P and compare with interest rates to get a sense of overall market valuations

Overall, it was a great presentation with some very good Q&A. Thanks to Prof Bakshi for inviting me and hosting such a fabulous and memorable event.

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 6

Finding bargains
• Investment is the discipline of relative selection
• Our goal isn't to find good assets, but good buys. Thus, it's not what you buy; it's what you pay for it.   
• The necessary condition for the existence of bargains is that perception has to be considerably worse than reality.

Ultimately, we are all looking to make money from stocks. So, even though HUL is a great business, it is unlikely to make to really wealthy. A good business is not always a good stock and vice versa.

Patient Opportunism
• Sometimes we maximize contribution by being discerning and relatively inactive. Patient opportunism - waiting for bargains - is often your best strategy.

Patience and being emotionally able to sit tight on a position or with cash is critical, although one of the toughest things to do. This is where the right investing temperament is required. As Jesse Livermore said famously and is also oft repeated by Charlie Munger, "Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting."

Having a sense of where we stand
• Most people strive to adjust their portfolios based in what they think lies ahead. At the same time, however, most people would admit forward visibility just isn't that great. That's why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.

Move beyond "hope trades" to discerning what is going on in the markets today and calibrate your actions based on that.

Investing defensively
• If we avoid the losers, the winners will take care of themselves.
• Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don't knowand can't control are hallmarks of the best investors I know.
• Worry about the possibility of loss. Worry that there's something you don't know. Worry that you can make high quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing goes wrong, surely the winners will take care of themselves.

Avoiding Pitfalls
• The success of your investment actions shouldn't be highly dependent on normal outcomes prevailing; instead , you must allow for outliers.
• Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery.

Shit happens. Be prepared, atleast mentally to deal with it. Don't put all your eggs in one basket no matter how good and insulated the basket is!!

Reasonable Expectations
 • Investment expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk that is perceived.

Don't try to overreach. Having an unreal and unjustified return expectation is the beginning to investment mistakes. Don't pick a return (like 25% or 30% or 40%) out of thin air and hope to make that every year. It will necessarily make you do things which will eventually lead you to losses.

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This concludes the learning and musings from Howard marks' The Most Important Thing Illuminated.

You can read the previous posts in order:
Part 1
Part 2
Part 3
Part 4
Part 5
Part 6

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 5

Being attentive to cycles
• Just about everything is cyclical. Cycles always prevail eventually. Nothing goes in one direction forever.
Awareness of the pendulum
• There are a few things of which we can be sure, and this is one: extreme market behaviour will reverse. Those who believe that the pendulum will move in one direction forever - or reside at an extreme forever - will eventually lose huge sums. Those who understand the pendulum's behaviour can benefit enormously.

This is one of my core beliefs. In sports, we call this by "law of averages" or "rub of the green". Mean reversion works, but in some cases, you may need to have a suitable long term time frame to judge its impact.

Combating negative influences
• Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
• From time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price. We must constantly be on the lookout for things that can't work in real life. In short, the process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses.

Again, something very very core to my belief system. Temperament is what differentiates the good investor from the bad. And the ability to say "No" to things or stories that don't make sense regardless of who is saying it.

Contrarianism
• You must do things not just because they are the opposite of what the crowd is doing, but because you know why the crowd is wrong.
• Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortable idiosyncratic portfolios, which frequently appear imprudent in the eyes of conventional wisdom.
• Only a skeptic can separate the things that sound good and are from the things that sound good and aren't. The best investors I know exemplify this trait. Skepticism and pessimism aren't synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

Taking a view that is different from the majority is a psychologically difficult thing to do. But the best results are obtained by people who are able to stand apart from the crowd.

Guru Speak - Charlie Munger speaks at the Daily Journal annual meeting

Always instructive to hear Charlie Munger.

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 4

Howard Marks has written extensively on risk and its management.

The riskiest things: the most dangerous investment conditions generally stem from psychology that's too positive. For this reason, fundamentals don't have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.

The greatest risk doesn't come from high quality or high volatility. It comes from paying prices that are too high. This isn't a theoretical risk; it's very real.

Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe.

Risk is inherent in the price you pay for stocks. The higher price you pay, the higher risk there is. Irrespective of the quality of the business.

The possibility of a variety of outcomes means we mustn't think of the future in terms of a single result but rather as a range of possibilities.

No one knows the future, so deterministic projections make little sense. It is better to think in terms of a range of outcomes that covers the most likely future scenarios.

Invariably things can get worse than people expect. Maybe "worst case" means "the worst we've seen in the past". But that doesn't mean things can't be worse in the future.

Careful risk controllers know they don't know the future. They know it can include some negative outcomes, not how bad they might be, or exactly what their probabilities are.

Case in point, 2008, was much worse that what most investors had expected.
 

I'm very happy with the phrase "perversity of risk". When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counter-intuitive.

My core investment assumption is that the market is a complex adaptive system and is auto-correcting in nature. we cannot determine outcomes from a linear thought process.

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors' results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

If you minimize your losers, the winners will take of itself!

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 3

There are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that belief strongly enough to be able to hang in and buy as price decline suggests you are wrong. Oh yes, there's a third:you have to be right.

This will only come from experience of being right about your view.

For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are a few assets so bad that they can't be a good investment when bought cheap enough.

There's no such thing as a good or bad idea regardless of price!

This is a critical point that people miss in their quest for "quality" stocks!! **Quality is not irrespective of price.**

Investing is a popularity content, and most dangerous thing is to buy something at the peak of popularity. At that point, all favourable facts and opinions are already factored into its price, and no new buyers are left to emerge.

There is no easy way of identifying when the peak of popularity is reached. But one should have a general sense of when prices have gone up way beyond their worth. And then the trick is to have the emotional fortitude of getting out of the position.

The safest and potentially mist profitable thing to do is to buy something when no one likes it. Given time, it's popularity, and thus it's price, can only go one way: up.

This requires a certain mindset of contrarianism and ability to sit through extended period of non-performance of stock price. This may specially be difficult when other stocks are running up consistently.

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 2

Since other investors may be smart, well-informed and highly computerized, you must find and edge they don't have. You must think of something they haven't thought of, see things they missed bring insight they don't possess. You have to react differently and behave differently.

Out of the main four edges that an investor can have, namely i) information, ii) analytical, iii) knowledge and iv) time, here Marks is talking about the analytical or insights edge. With the same set of information, can you have better or different insights which will result in a differentiated result for your portfolio.

To achieve superior investment results, you have to nonconsensus views regarding value, and they have to be accurate.

For your performance to diverge from the the norm, your expectations - and thus your portfolio - have to diverge from the norm, and you have to be more right than the consensus. Different and better: that's a pretty good description of second-level thinking.

I think this is the simplest yet most overlooked part. You cannot get superior results by doing what everyone around you is doing. Some investors I know of surround themselves only with people who have very similar viewpoints about life and markets. To me, they are living in an echo chamber. To really have a nonconsensus view, you have to actively look for disconfirming evidence. That is, an idea which is exactly opposite to the one you hold.

As Charlie Munger has said, " It's bad to have an opinion that you are proud of if you can't state the arguments for the other side better than your opponents."

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 1

Over the years, I have come to the conclusion that the most critical aspect in investing is to be able to build the right temperament. To me this is the secret sauce that separates the men from the boys and enable some to consistently outperform others, and their benchmarks.

Temperament is something that needs to be learnt through experience. We can augment it by taking a leaf out of the book of the masters. Over the last 15 years, I have tried to read as much as possible about experiences of great investors and fund managers, to try to understand how to improve my temperament.

Let me start a series of posts on this topic over the next few days, with the writings of a great investor who I have followed for the last decade. Not only is he a great investor but he is a fantastic communicator and has that rare gift of making complex subjects appear simple. He also is extremely generous in sharing his knowledge and experience with the general public. He is Howard Marks.
You can read his book "The Most Important Thing Illuminated"


His memos are available at https://www.oaktreecapital.com/insights/howard-marks-memos

Here are some excerpts from his book and some commentary where it is necessary:

To me, risk is the most interesting, challenging and essential aspect of investing.

The real test of investing is not getting returns but ensuring the downside is always protected. As Buffett has said famously, "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1."

You must be aware of what's taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this - more than anything else - is what dooms most investors to being victimized repeatedly by cycles of boom and bust.

History, of markets and in general, is essential to know. You need to understand the causality of consequences of events. Those who do not know history are condemned to repeat it. Which basically means you need to have some mechanism of capturing your past mistakes for posterity and are able to ensure that they are not repeated again.

ACTIONABLE - A checklist of past mistakes and the reason those occurred is a good starting point.