In Part 3 of the podcast interview with Sanjay Bakshi, value investor, behavioural finance expert at Adjunct Professor at MDI, talks about how he chooses his investments, whether technology is disrupting the concept of moat – or a company having competitive advantages over peers – and how investors should avoid value traps.
Listen to part 1 and part 2. The final part of the interview will be published tomorrow.
Q: What are some of the basic rules that you follow while investing in a company and how have they evolved over the course of your investment career?
A: They have evolved a lot and that applies to almost every investor. When I started practicing value investing about 25 years ago, I was purely a Graham investor. So, I was doing statistical bar games, I was doing risk arbitrage. The key source of margin of safety for me was from a low price in relation to perceived value; it could be a cash bargain, it could be high dividend paying stock, it could be a stock selling well below its net current asset. All the standard filters that Graham has spoken about in his books.
So you are not paying a lot of attention to the quality of the business or the quality of the management and you are very quant-oriented and of course, that kind of a strategy will work, provided you have lots of bets. You can’t have five names, you need to have 40 names or even more.
But over time, I became much more aware of the qualitative factors, management factors, softer factors, things that are hard to measure and it’s very difficult to put them in an Excel model for example. But they are very important, investing with the right kind of entrepreneur who has the right kind of skill-set and the right kind of ethics, for example, can create enormously beneficial outcomes.
So over a period of time, I ended up thinking about investing in three buckets. There is a business bucket, there is a management bucket and there is a valuation bucket.
In a Graham framework, the valuation bucket is of extreme importance in a sense that the management may be mediocre, the business may be very mediocre, but a low price could offset the disadvantages of having a mediocre business in your portfolio or a mediocre management running those businesses.
But the process that I follow now requires me to first love the business. If I don’t love the business, there is no point thinking about the management and there is no point thinking about the valuation. If I don’t like the people who run the business, I am not going to say a low price can compensate for all that.
So, yes, valuation is important and very critical but it comes after you have found a business that you love and after you have found people who run those businesses that you love.
Q: So, typically how much does it take for you to research a company?
A: It’s a good question and honestly, I spent six months in a stock and [and had the experience of] getting a lot of confidence and ending up with very bad outcomes. I have spent five minutes on a stock and with excellent outcomes and when I say five minutes it doesn’t mean that I just found a name and I bought that stock in the spur of the moment. Knowledge is cumulative. Sometimes you know that there is a great business out there and you haven’t bought it because it’s too expensive but you know that they are executing well and it’s a great business. But for whatever reason the stock price falls, it could be company-specific, it could be macro, it could be political, it could be anything, but it doesn’t take a lot of time for you to come to the conclusion that this is a great opportunity to be in. So, five minutes is all that it took in this one case and in another one I spent some six months and you do all the work and you collect all the data and you make a big investment memo and you have all this confidence but it kind of blows up in your face. So, yes these things happen.
I don’t want to say that there is a set time that one has to spend before determining. I do want to say one thing though, which is there is this concept, which the younger generation is much more familiar with. They call it FOMO, or fear of missing out. Now when you are doing research, one of the tendencies that you have to guard yourself against is FOMO, which is that the stock will run away, and you haven’t done the work yet, and other people are buying it and the stock is going up. So, one thing, which is very hard to do but it’s worthy of learning to do is to avoid FOMO.
Do the work, focus on the process – there is a process, there is a checklist for the business, there is a check list for the management, there is a checklist for valuation, finish the work. Before you finish the work, if it runs away, let it go. There will be other opportunities that will come but rushing in without finishing the work because you gave in to FOMO exactly during a bull market, for example, is likely to be very costly. I paid the price for that and I am not saying that I have become completely rational, but one of the things that I am working very hard on for myself is to get over this FOMO tendency.
Q: Do you recall any instances where you spent just about five minutes on a stock and that gave you some really good returns?
A: Yeah, I mean there is this company called P&G Hygiene and Health, and we know that they own the Whisper sanitary napkin franchise and it’s very easy to see that it has a great business. Now I want to mention I am not recommending this stock, I am using this just as an example and I don’t own it now. Just wanted to make the disclosure before we go further. So, here was the case when they had a couple of bad quarters and the stock fell like 40 percent and the business was excellent, was then excellent and is still excellent and it was a very simple decision.
There is a famous song by Richard Marx which goes along the following line that I would be right here waiting for you. So, you know you have done the work, you already know that this is a business and you like what they do and how they are executing. What you don’t like is the valuation and then it comes. It’s come not because there has been an impairment, it’s come because there is an overreaction to something, which is not very important. A couple of bad quarters doesn’t change the value at all, in my view, in the long run.
They own the Whisper sanitary napkin franchise. India is a country where you have 1.3 billion people, half of them are females and most of them don’t use sanitary pads. So there is a large market out there. This company in the branded space has more than the 50 percent of market share. So, it’s a very long runway kind of a business and they also owned Old Spice, and they own one more brand. So, it’s a three brand company and a few years ago, the stock fell to a price, which made me comfortable to own it. It was a five minute thing but there have been other situations where you spend a whole lot of time to gain conviction and then you give up because you just don’t understand it.
Q: Among other things you have also spoken about moats, wherein a company has a definite advantage over its rivals and is able to protect market share. How relevant are moats in today’s world? We have lot of this disruption happening because of technology, because of policy changes. What are your thoughts on that?
A: Firstly, the fact that I believe in the concept of moat doesn’t mean that I don’t believe in the other concepts of investing. As a teacher I teach different styles of value investing. I teach investing like Ben Graham, investing in debt restructuring for example. I don’t do debt restructuring, I don’t do bankruptcy workouts. I have done them in the past but I don’t do them anymore. But that doesn’t mean that you can’t make money there. It’s a great place to make money. I don’t do risk arbitrage anymore but I teach it.
But I agree with you that the nature of moats is changing. Standard moat businesses come from either brands, they come from intellectual property, they come from network economics and they come from the low cost advantage and I feel that out of these four, there is only one, which is unchanged and is unchangeable, which is the desire for customers to pay low prices. That means that if there is a business, which can earn a reasonably good return on capital while having the lowest cost advantage — that’s durable. If you can focus intensely on maintain your advantage, which means not getting too greedy about gross margins, not getting too greedy about your margins and trying to cut prices to the point where you are deterring competition. That sort of moat is going to stay around for a long time because I don’t think human nature is such that they would like to keep paying higher prices when the whole world starts laughing at them.
Which is what happened in many cases; there are these companies, which charge very high prices for their products because they can and in the past they could. But today consumers are far more conscious about the high prices they are paying compared to alternate products that come by at much cheaper prices but with similar value propositions. One example that is often used in this context is that of Dollar Shave Club and again it’s a good example to use because Gillette was spending an enormous amount of money in R&D and they have this extraordinary gross margins. You would expect that this will last forever, but today 13 or 14% of the market share has been taken away by this company.
They don’t spend a lot of money on advertising, they don’t spend a lot of money on R&D, they give a blade which is as good as any another blade and they turn it into a subscription model, which is very interesting because the subscription model is just an illustration of a point that it’s not just about technology innovation or about the other point that you made – regulatory changes that can cause moats to get eroded — it is also business model innovation. So you have to worry about all of those things.
Q: Very often, stocks that look like good bargains after having fallen sharply from their peaks, turn out to be value traps. Of course, the reason why they are also called value traps is because they are hard to spot. So, how does an investor distinguish between what’s a bargain and what’s a value trap?
A: That’s a good question and I deal with this all the time in my classroom. Knowing something that is cheap is one thing, knowing that it is cheap but cheap for the wrong reasons and those reasons that are not permanent is another thing. So, the way to understand this is there is value and there are value traps. In fact, Ben Graham writes about this in his book. Towards the end of Security Analysis, there is a chapter in which he talks about certain classes of businesses – he doesn’t use the word value trap but he is implying that – he talks about holding companies.
For example, we have seen holding companies, which own shares in other companies and nothing else, there is no business, there is no operating business, but they just hold shares of another company. They tend to sell at very steep discounts to the breakup values. Those shares could be sold in the market, sometime three to four times the current market value of the whole company and it’s very easy for a student of value investing to say, my god this is so cheap and therefore I should buy it. It’s cheap, we know that, that’s evident, but should you buy it? That depends on the presence or absence of a catalyst. How likely is it that that cheapness will go away? For that to happen they have to sell the shares and distribute the dividend, they have to have massive buybacks or have to liquidate the company. If none of those things are going to happen, then the probability of the value being realised is low, and that’s the important point for students to understand. That it might be cheap but if the cheapness is not going to go away for specific reasons — could be governance, could be structural — then it’s probably a value trap.
Then there are other kinds of value traps – I do a whole series of lectures on this, giving examples over there – but one of the classic value traps is the PE (price to earning) multiple value trap that you know in a cyclical business, which is experiencing a lot of shortage and an enormous jump in the profitability of that industry. The price has gone up 5-6-10 times and the earnings have gone up even faster, the stock looks cheap because you looking on a PE multiple based on the last 12 months or the forward 12 months something like that.
Graham warned about that also in his books. There is a chapter called ‘Trends’, in one of the best chapters that I have read in a book that Graham wrote — it is a small book called Interpretation of Financial Statements. In that chapter, he talks about a company, which is experiencing a positive trend line in earnings and it is cyclical and the question you have to ask is how likely is it that this trend will last and how much of a price you already paid it into that likelihood. It’s important to recognise that things that appear to be cheap are not always cheap and the vice versa is also true by the way.