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Note: - All the businesses that are mentioned here are for educational purposes only. We may or may not have vested interest in the businesses. We are not SEBI registered analysts.
Earlier, we used to run screeners to find stocks available at low valuations and further try to understand if the business is fundamentally sound before investing.
Over the years, we faced two issues:
First, Reinvestment Risk, a lot of such opportunities didn’t allow long term holding as the price value gap converged and we had to sell and again look for new ideas.
Second, we may anchor our thesis on business quality and may end up paying more (type 1 error), or we may anchor our thesis on low valuations and may end up buying low-quality businesses (type 2 error). In the tradeoff between type 1 error and type 2 error, we would much rather minimize type 2 error and absolutely try to avoid buying low-quality businesses.
To quote Charlie Munger here, “A great business at a fair price is superior to a fair business at a great price.”
Over a period of time, we worked on developing a framework looking at major wealth creators historically in the Indian equity market. We have sought to distill common characteristics of such businesses and make a framework to identify future wealth creators.
We call this proprietary framework the ‘Ranking of Business Models’ framework. This framework helps us first select a good business model and then allocate higher to great businesses.
Selection of a stock is based on,
Essential qualities/Characteristics of Business Models (in order of preference):
Management - consists of checking Integrity, Energy and Intelligence of the management team.
Longevity – ensuring demand for products will exist over a long period of time.
Structural Headwinds - There should not be any long term headwinds which can drastically reduce the growth prospects of the sector. Example - 4G for Radio industry.
Scalability – Huge size of opportunity and ability to capture it due to competitive advantage.
Favorable Industry Structure – Analysis through application of Porter’s Five forces of competitive position and determining whether the industry structure is favourable. (Leadership preferred).
Business Economics - Ability of the business to consistently generate ROE above the hurdle rate of 15% for a long period of time.
Note: Selection is actually an elimination test and all of the above criterias need to be satisfied in the mentioned order to proceed further.
Allocation is based on, other Desirable Competitive Advantages:
Non GDP dependent growth - Where the growth is not related to GDP. Essential products/services are best however if discretionary demand than prefer non-perishables.
Antifragile – in case of a downturn, the company not just survives but becomes stronger. Example - HDFC Bank
High Switching Cost/Pricing Power - Customers find it hard to switch to using other products/brands.
Annuity Revenues - Annuity Revenues unless low base of penetration and huge opportunity for industry growth.
Capacity to Reinvest- (a) Own Business/Adjacencies - The company launches their differentiated products rather than copying them from their competitor's portfolio. Organic Growth and building from scratch. Example: B Natural fruit juice by ITC (b) Sidecar Investing - The ability of a company to acquire other companies in the same or different industry. Inorganic Growth. Example - Teamlease doing bolt on acquisitions to enter new segments or geographies.
Ability to Capture Dominant Market Share - Example Infoedge, Naukri.com dominates the recruitment sector & accounts for almost the entire profit pool of the recruitment industry.
Long Term Tailwinds – E.g. value migration in the banking sector from PSBs to private banks. Another example would be the increase in use of internet serving as a tailwind to digital content providers.
Optionalities – Small experiments which can give asymmetric returns while making sure that the company doesn’t get drastically impacted even if few of such experiments fail.
Reasonable Valuation - Focus not on entry multiples but returns which come through long term earnings growth adjusted for PE compression/expansion.
Allocation is a grading test, you may not satisfy all criteria, but the more grades you get, the higher the allocation.
Building the Investment Universe:
There are basically three sources “in order of preference” through which we build our investment universe:
Cloning - We follow investment gurus that match our investment thought process; we find their investment picks and apply our own framework of “Ranking of Business Models” for selection. Some of the gurus we follow who invest in the Indian market are Bharat Shah, Ramesh Damani, Prof. Sanjay Bakshi and Utpal Sheth. We also follow overseas investors like Pat Dorsey, Tom Russo and Nick Train to learn about the investments they have made and then we search for similar companies in India.
Base Rate Investing - Involves finding companies/sectors globally which have created massive wealth and look for similar opportunities here in India. For example - QSR, Staffing, Food Delivery, FMCG & Financial Services.
Other Cases - Companies not falling in the above 2 categories but still exhibiting characteristics of Moats in terms of financials. E.g. Paint industry globally is not a very profitable segment like it’s in India as seen in Asian Paints.
Once the Universe is built, and then it’s not that you blindly clone the universe (Authority Bias), as per our Circle of Competence, we then follow the ‘Ranking of Business Models’ framework to select and allocate to great businesses.
Developing a Circle of Competence
We believe that we need to develop an art of saying “no”. Seneca in his memoir “On the shortness of life” says that “How many have laid waste to your life when you weren’t aware of what you were losing, how much was wasted on pointless grief, foolish joy, greedy desire, and social - how little of your own was left to you. You will realize you are dying before your time.”
Saying ‘no’ to almost everything will allow you to ‘say yes’ to the things that matter.
We follow the process in which:
We read a lot
Think deeply
Apply it in our practice
Analyze the results
Improvise/Adapt as per the mistakes
Update our Mental Models
Keep refining our Circle of Competence and
Rinse & Repeat the same.
To filter noise from signal we do,
For the companies we track - Read articles on our investment universe by setting up Google Alerts, BSE Alerts, Social Media Alerts (Twitter and other platforms) - Focus on fundamental things with long term impact, business strategy, industry dynamics, government regulations, etc. We look at information like volume growth, new product launches, size of the market opportunity and change in management.
For thought process and other industry insights - Follow industry stalwarts on Twitter and other social media platforms, where they share curated content - Read various blogs from where we source the best information to update our thought process e.g. Farnam Street - Read various curated publications like Ken, ET Prime - Listen to quality podcasts like, Knowledge Project by Shane Parrish, Investor Field Guide by Patrick O’Shaughnessy and Capital Allocators by Ted Seides.
To avoid various biases & save time - Rather than watching prices regularly, we have setup price-based filters in Google sheets, on the achievement of which some renewed thought process is required to buy/hold/sell - Prefer going through notes/ recordings then actually attending investor meets - Prefer attending Con-calls (Research Bytes) or questioning the IR offline compared to management meetings
Concentrated Vs. Diversified Portfolio
Regarding this matter, we would like to quote Buffett. “I have two views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification.”
We initially used to have around 25-30 stocks in our portfolio as we were learning and experimenting with different investing styles as well and refining our Circle of Competence.
Currently the thought process is that every new business seeking entry in the portfolio will only be added if it provides some sort of diversification to the portfolio in terms of,
Different segments within the same industry (within the overall exposure limit to the industry) a. E.g. Retail focused Bajaj Finance vs. SME focused DCB Bank b. E.g. Oberoi Realty targets Mumbai market and Sobha targets the Bangalore market
Different business/industry drivers (what drives QSR- Quick Service Restaurants is different from what drives staffing companies)
Different Mental Models (InfoEdge has Network Effects, Brand, Scale Advantages, SideCar Investing, etc)
This strategy automatically ensures that only a few names come in the portfolio.
For overall portfolio construction, we would highly recommend one to read through Prof. Bakshi’s insightful PPT on this topic. We really found the analogy insightful, of comparing a portfolio to a plane and ensuring multiple engines so that the plane doesn’t crash. Also we liked the fact that a lot of times, certain industries are correlated – for e.g. NBFCs and Banks or Financial Sector and Real Estate and one should club them together to calculate overall exposure to that segment.
That being said and done, there is no one way to reach Mt. Everest or make money. There are multiple examples of good investors who have made a lot of money by being quite diversified as well.
Rate of disruption
Lot of businesses can get disrupted over a period of time,
So we prefer to focus on the “Rate of Disruption” than the disruption itself. We focus on companies where the rate of change is not so swift.
Let’s look at 3 types of businesses:
Businesses with high rates of change – You have to avoid such business as you won’t get time to exit. For instance let’s go back in time and look at the cellphone industry, where new phones are launched every month - Motorola's flip phones (e.g. Moto Razr) were widely celebrated inventions in the 2000s. But, due to the rapidly changing nature of the industry, Motorola couldn't sustain itself.
Businesses with moderate rate of change – You will get reasonable time to see how disruption is playing out E.g. Cinemas are facing tough competition from Netflix, as it started making original content which gained traction among audiences. The added convenience of watching video on demand any time anywhere is a big plus for Netflix vs. Cinema Halls. No wonder, in the US, tickets sold per person have declined to their lowest point since the early 1970s.
Businesses with lower rates of change – You will get a good amount of time to decide. Leading FMCG brands like Kraft Heinz which have legacies dating more than a 100 years are increasingly under pressure from retailers pushing their own private label, both offline like Costco and online like Amazon.
However, please remember sometimes such value migration trends are not permanent as the industry can reinvest itself against competition like how Swiss watches positioned themselves as luxury timepieces against the onslaught of digital watches which were more accurate. However, now they are again getting threatened with the rise of wearable & smart watches.
Antifragile Businesses
While studying business failures we found it insightful to look at cases where dominant brands lost most of their market share quickly to competition. For e.g. Everyuth dominated the Face wash market, but due to the lower entry barriers of the industry and lack of stickiness of customers with their product, their market share was eroded with the entry of new players.
Such fragility prompted us to work hard on understanding whether such weak links exist in our portfolio.
Prof. Bakshi has covered in his seminal presentation given at IIC on this topic in quite detail. He lucidly explains various forms of fragility and how to deal with it.
As investors we tend to test the longevity of business in our ‘Ranking of Business Models’ framework using the above tests of fragility in the presentation.
One mental model which can really help the investors in this regard is the Lindy Effect, which implies that the longer a company has been around, the higher is the probability that it will stay around for even longer.
This topic is explained in the book “Antifragile: Things that Gain from Disorder” by Nassim Nicholas Taleb.
Fragile - There are some businesses which get killed or get badly injured when the businesses are in downturn for example DHFL, Hubtown etc.
Resilient - There are some businesses which survive the downturn for example Sobha, Oberoi Realty, Ashiana Housing, etc.
Antifragile - There are some businesses which get stronger with the downturn for example Godrej Properties, Bajaj Finance etc. In fragile industries, partner with antifragile players to benefit from each crisis.
In a nutshell, we always think of fragility in terms of “what few factors can potentially mar this business”. Now in such cases sometimes probability of such events happening may be remote but one needs to think in terms of outcome not in terms of probability. The portfolio should be able to survive the tail event.
For further reading:
Prof Bakshi PPT on thinking in terms of outcomes and not probabilities
The Book Antifragile: Things That Gain from Disorder by Nassim Taleb
Article by Contrarian Edge – Part 1 and Part 2
Reasonable Valuations
First of all, we tend to look at valuations as the last step of our ‘Ranking of Business Models’ process, because a person who looks at it at the initial stage may filter optically expensive stocks as the business might be investing for the long run (capacity to suffer framework).
Investor Returns = Price CAGR due to change in PE Multiple + Expected earnings growth
Price CAGR:
As per Rule of 72, in next 10 years
If PE doubles, it is +7% CAGR
If PE halves it is -7% CAGR
Earnings growth - Expected earnings growth CAGR over next 10 years
So, if you expect DMart’s PE multiple to come down by 50% over the next 10 years while maintaining the earnings growth rate of 25%.
Investor Return = -7%+ 25% = 18%
“Investment decision is your Investment Return > Hurdle Rate, then you can invest”
In a nutshell, we are open to investing in DMART as well even if entry multiples look obscene provided we have confidence in earnings growth CAGR.
Link to better understand the simple technique of valuation used above as adopted by Marcellus Investment Managers:
Thoughts on Selling/ Rules for Selling
Our typical holding time horizon is in decades and for truly great businesses we give an extremely long rope in terms of valuations till the time below issues don’t arise.
Change in thesis
Change in management leading to change in management style
Impairment of Moats
Disruption in the business
Poor Capital Allocation
Corporate governance issues
Management involved in unethical practices
More detailed points can be found in our 4C’s of investing presentation along with a video.
Hold Vs Buy
What investors need to understand, that holding a stock is not a binary buy or sell decision. If we are holding a stock in portfolio, it doesn’t mean we are implying that one should be buying the stock. Once a stock has been bought, there is a considerable hold period before selling the stock.
To get more insights into this topic one can read the articles
Charlie Munger on the Paradox in Hold vs. Buy Decisions by Prof Bakshi,
The Art of Holding and The Conviction to Hold by Ian Cassel.
Rebalancing of Portfolio
Consider rebalancing the portfolio, if some other opportunity looks better on your ranking of business models framework. Our constant endeavour is to improve the quality of businesses in our portfolio.
The End
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Very insightful article on the concept of Ranking/allocation and tools to shortlist and rank them.