I recently tweeted the following
This tweet was prompted by the debate – online, and sometime offline between the different approaches to value investing. These debates appear like religious arguments with each side claiming their god is the superior one.
I have never quite understood the point of these debates. There is obviously no single way of making money in the stock market. There are short term traders, buy and hold guys, debt specialists and all kinds of people in-between. Each approach has its strengths and weaknesses and no one can claim that a specific approach is inherently superior to the other, unless they are equally proficient in both.
I have come to realize that the most important factor to long term success is to understand which approach suits your temperament.
The value of learning
Some of you who have followed me on my blog, would have noticed that I try not be a dogmatic about any specific style. I have tried multiple approaches and continue to do so. I do have a dominant style which suits my temperament – buy decent quality companies and hold them for the long run, but I have tried deep value, arbitrage, options and all other types of investing.
Most of my experiments have been failures (see here and here) from a monetary perspective, but they have deepened my understanding on what works and does not work for me.
A valid question would be – why bother? Why not find an approach which works for you and then just stick with it (and maybe even publicly defend it as your faith )
Let’s consider an analogy – let’s say you are a sculptor who likes to make figures using wood, stone and other materials. Let’s assume you are exceptionally good at making stone sculptures, but not so great on wood. You go to an exhibition and see some great wood figures and happen to meet the artist. The artist tells you about his techniques and the tools he uses. Assuming you want to get better on wood, will you start laughing at this artist and belittle his tools?
In a similar fashion if you are a deep value investor, what should be your reaction to the success of investors who buy and hold seemingly overvalued stocks?
I know what the first objection is to this line of thinking – The success of these investors is just dumb luck. These guys are not really practicing value investing, but a form of momentum investing. It is just that the momentum has lasted for 5 years in some of these cases, and sooner or later this bubble would burst.
My counter point – sure that is possible, but what if this bubble has lasted for 10-15 years in some cases. Will you still just wave away these anomalies and label them as flukes?
I prefer to take a different approach. There is no religious debate to this in my mind – if something has worked for 3+ years in the stock market, then it is worthy of investigation. A lot of bubbles and temporary fads usually get washed out in 2-3 years and so 3 years is good cutoff point.
Why not 5 years? Well now we are moving from the physical to the meta-physical J and debating the nature of reality.
So what can one learn from this oddity where some companies manage to sell for seemingly high valuations for a very long time.
New business model or value capture
I think the first point to look for is whether there is a change occurring in the business model/ design, wherein due to changing customer needs and priorities, a new type of design is now more suited to meet them more profitably.
I would recommend reading the book – value migration, which goes over this concept in quite a bit of detail. The main point is that changing customer needs and priorities cause a change in the business design best suited to meet them. Companies which can identify and develop a business model to meet this new reality are able to accrue a lot of value for their shareholders.
For example, a rise in the income levels has caused the retail consumer to now value quality, brand image and convenience in addition to the price. As a result, companies which can meet this new set of needs have been able to create a lot of value.
It is easy to see this phenomenon around us – Bathroom fittings, automotive batteries, garments etc. Some of these products were commodities in the past, sold largely based on price. However increasing consumer purchasing power has meant that the priorities have shifted beyond price. Companies which have been able to adapt their business model to deliver on these new priorities of brand, quality and convenience in addition to price have delivered exceptional returns
Example: Cera sanitary ware, Amara raja batteries, Astral polytechnic etc
Opportunity size with durability
It is not sufficient to be able to meet the changing needs of the consumer, better than the competition. For starters, the opportunity size should be large so that the company can grow for a long time to come.
This is a major advantage of the Indian markets over almost all other foreign markets. Even niches in India have a market size running to millions of consumers and hence a company which can build a good business model can easily grow for years to come.
An additional point to keep in mind is the need for the company to develop a durable competitive advantage. Let’s take the case of the telecom industry in the early 2000s. The need for communication and mobile telephony was recognized by a few companies such as Airtel in the late 90s and these companies moved in quickly to satisfy the needs.
The market size was in the 100s of millions and most of the telecom companies were able to scale rapidly. However the edge or competitive advantage turned out to be transitory and as a result after a few years of high profitability, we soon had a lot of price based competition. As a result by 2007-08, most companies were losing money and did not create (actually destroyed) wealth.
In such cases seemingly overvalued companies were truly overvalued.
Kings of their domain
A productive area for finding multibaggers is in the microcap space, where the company operates in a niche and is growing rapidly as its business model is uniquely suited for that niche. In addition, the niche is large enough for the company to grow for a long time, yet not so big that it attracts large companies initially.
There are a few examples which come to my mind – Think of air coolers a few years back (symphony), CPVC pipes (Astral poly) or various niches in pharma and information technology.
A small company develops a unique set of skills for this specific segment and is able to dominate and grow within the segment for a long time. In addition as the niche is quite small, it does not attract much competition till it reaches a certain size.
However by the time the niche is big enough to catch the attention of larger companies in the overall space, it is too late as the specific company has established a dominant competitive position and cannot be dislodged.
A lot of these companies appear to be overpriced after they have started growing, but this ignores the possibility of above average growth and a dominant position for the company.
Capacity to suffer
This is a term used by Thomas Russo (see talk here) to describe companies which are capable and willing to make investments in the business for the long term, even though it penalizes the profits in the short term.
In most cases, due to market pressures, companies are not willing to hurt short term profitability to build the business for the long term and hence the few companies which are willing to do so, appear to be overvalued due to depressed profits.
Look at the example of Bajaj corp (an old holding which I have since exited). The company acquired no-marks brand in 2013 and started deducting the brand value on their P&L account. In reality the brand value is actually going up as the company continues to spend heavily on advertising (17% of sales) and hence the profits are understated.
The market did not like this short term penalty and punished the stock in 2013. The stock price has since recovered and we have a company which appears to overvalued due to the high investments in the business.
This is good note on what is a platform business
I do not have an example in the Indian markets, but will try to explain this using the example of a well know US company. Its 2004 and a well-known company called google decides to launch its IPO at a then PE of around 65. A cursory look shows the company to be grossly overvalued and as a result most of the value investors tend to give it a pass.
The company has since then delivered a return of around 26% p.a and I am sure this qualifies as a great return. So why did a company which appeared so overvalued turn out to be a 10 bagger.
My own understanding is that this result came about from multiple factors. To begin with, the company operates in a winner take all kind of a market where the no.1 company tends to dominate and capture almost all of its value. Once google had a 60%+ market share, the network effects kicked in and the company just kept getting more dominant in the search space.
Once this base was built, the company extended it to other platforms such as mobile where the next leg of growth has kicked in. These type of companies also have a very low marginal cost of production and hence any growth beyond a threshold, drops straight to the bottom line.
This however does not explain fully the reason behind its success – We have a management which in the words of Prof Bakshi in this note – are intelligent fanatics and also have the capacity to suffer (as referenced by Thomas Russo). As a result they have continuously invested in long term ideas (called as moonshots) even if it meant losses in the near term. You tube, android etc which are now bearing fruit were drains at one point of time.
Such companies have been referred as platform companies and usually appear highly overvalued in the early stages of growth. Another similar company seems to be Facebook.
A point of caution – For every successful platform company, there are atleast 10 pretenders which destroy value. So it is not easy to identify such companies ex-ante (atleast for me)
Rate of change matters
Let me introduce a new concept – business clock speed which I read here. This is the rate at which a business is changing. For example the rate of change in the social media business is high and conversely there are business such as paints or undergarments where the rate of change is low.
I think it is quite obvious that businesses with low rate of change can create a durable competitive advantage for the long term and hence a seemingly high price turns out to be cheap.
On the contrary very few high change businesses (google, Facebook being a few exceptions) turn out to justify their sky high valuations.It is difficult to establish a strong competitive position in an industry where the basis of competition keeps changing every few years – Just look at IBM which has had to re-invent itself almost every decade to stay in business and grow its value. For every IBM, there is DEC or Sun microsystems which did not make it.
It is quite rare
It is important to understand at this point that it is quite rare to find overvalued companies, which in hindsight turn out to be undervalued. A lot of overvalued companies, actually turn out to be just that and so it is important for a value minded investor to be cautious about such companies.
In addition it is not easy to identify such companies upfront (there are no simple screens for it) and one has to think deeply to develop the right insights to buy and hold such companies.
So why do this study
As I stated in the beginning of this note – If you want to be a successful investor, it is important to have as many mental models in your head. Investing in a cheap, low valuation companies is one such mental model. However this does not mean one should just wave away any company which is selling at a high price.
The advantage of understanding the drivers of success is that the next time when you are evaluating a company, it makes sense to check if this company fits into any of these models? One can ask some of these questions
– Is the company overvalued simply because the management is investing in the business for the long term which has suppressed the near term profits?
– Is the company developing a new business model which meets the changing requirements of the consumer much better than competition
– Does the company have a durable advantage and a large opportunity space (the case for a lot of FMCG companies in India)
– Does the company have network effects or is it a platform company run by an intelligent fanatic?
– Has the company identified and developed a unique business model for a niche which it will dominate for a long time?
My post above does not cover all possible reasons why a seemingly overvalued company, will turn out to be cheap. There is no standard formulae or screen which will give you the answers. One has to study the company and the industry deeply to develop any useful insights (as fuzzy as they may be).
Inspite of the odds, if however if you do manage to get it right, it would be stupid to sell the company based on a PE ratio which appears higher than normal.