Archive for the ‘Warren buffett’ Category.

 

I received this excellent question from prabhakar via email and have taken the liberty of posting the reply on the blog.

Hi rohit,
I have a query that’s bothering me a lot for quite some time now. Let me clarify at the outset that i believe in value investing(Buy something good way below its intrinsic value),no doubts about it.
Now i am stuck between two schools of thought here.
1) The Warren Buffett way — Buy a “great company” that is stable, when there is temporary trouble and it is selling below its intrinsic worth. Your returns will be decent(no multibaggers here) and compounded long term it work out well for you.
2) The Rakesh Jhunjhunwala way -Buy companies that are selling below intrinsic worth but that have a huge potential to scale big. You possibly get a multibagger here or you dont get anywhere.Example would be Titan & Pantaloon retail that he bought when they were relatively unknown.
Now the question is should we sacrifice multibagger potential for something that is stable?Or should we have both types of stocks in our portfolio.Whats your opinion?Which of the two philosophies is better?

Let me know your views if you find time.

I have thought along the lines of this question for quite some time and can reply from my personal perspective. Let me caution you – The answer to this question is very personal and depends on your own skills and beliefs.

I believe both the styles are equally good and can provide good returns. I would actually extend the question to RJ or WB or Benjamin graham (BG) style or a combination of each.

Key points of each approach
There are some key elements to each of these approaches. Benjamin graham’s (BG) approach is a very quantitative approach to value investing. The selection of an undervalued company is done based on various quantitative criteria such as low PE ratio, Market cap less than net current asset etc. There is a low to almost non-existent focus on the nature and quality of business. This approach is easy to follow, low risk and requires ample diversification.

WB’s approach takes elements of Graham’s approach such as margin of safety etc. However this approach relies less on the quantitative elements of the company and more on the qualitative elements of the business such as sustainable competitive advantage. The undervaluation is due to temporary factors such as losing a customer or some scandal, which has caused the earnings to drop in the short term. However the long-term prospects are still intact and hence the company is a good bet. WB’s approach focuses on the certainty of the long-term prospects of the company.

RJ’s approach builds further on WB’s approach. Here you are looking at companies, which are not undervalued by the traditional measures such as PE, DCF etc. The value lies in the business model and what the company will develop into.

Some Indian examples
A typical graham style company would be Denso or Cheviot Company. Here the company is selling for less than cash on the books or close to it. These companies are cheap by the traditional valuation measures.

A WB type investment could be GSK consumer or Concor or maybe Asian paints. These companies have a long operating history. They have a predictable business model and some competitive advantage. It is easy to look at the long term history of the business and project it to arrive at some measure of value. This investment approach is more difficult than the Graham style investing as it depends on the qualitative aspects of the business too. However it is possible to follow this style as it has quantitative elements to it and does not require a very deep understanding of business models.

An RJ type investment could be pantaloon or titan. This approach to investing requires a very deep understanding of business models and an appreciation of the qualitative aspects of business such as management quality, addressable opportunity etc. The current numbers of the company will not help you make a decision. If you get it right, the rewards are huge.

In addition RJ is moving deeper into this style by investing in smaller and smaller companies at an early stage (VC style) where the risk-rewards are higher.

So which is it ?
For me it is the BG or WB style. My skills have not matured enough for the RJ style of investing. I have looked at titan in the past and could not see the value. The reason I could not see value was due to my own shortcomings.

You may notice that my core portfolio is based on the WB style of investing, where as the other portfolio is based on the BG style of investing. I don’t have an RJ style investment at all and it is possible that I may never reach that level to make that type of an investment.

A common mistake
Don’t get me wrong on these examples. Yes bank, ICSA, Pyramid saimira and Dish TV are some examples, which fall under the RJ style of investing. The current numbers do not show an obvious undervaluation. The value lies in the future prospects of the business. Some of these companies have a new business model and if you can figure it out correctly, then you will make it big on these stocks.

I have however stayed away from these stocks as they are outside my competency.

I have seen a lot of new investors look at RJ’s philosophy and apply it to their picks. There is nothing wrong with it if you have it figured out and have the results and confidence to follow it. However I personally would not recommend following this approach till you have the knowledge, skill and temperament to follow it.

RJ’s approach is not for the faint hearted who is not ready to do his homework. RJ’s approach is easy to understand, but quite diffcult to execute and that where his genius lies.

 
 

The above is a statement by warren buffett. It is a very apt comment. Value investing does not require a major leap of faith. Most of us can find companies selling below intrinsic value. That is the simple part. The difficult part is ignoring your emotions and buying such a stock.

Value investing is even more difficult when the market is in a momentum phase, as it was during 2003-2007, when most of us could have made money by buying the hottest stock. Investors piled into real estate, infrastructure and other hot stocks and made good money as a result. Unfortunately very few have been able to hold on to the gains. Some may have suffered losses if they entered these stocks late in the game.

In addition a lot of these investors are now blaming the markets, the weather, the government and everyone else except themselves for the losses. I have personally learnt a key lesson over time – blame yourself for the losses and you will learn from the mistakes and not repeat them in the future.

Value investing is dumb
I frequently got mail or comments then, which went this way – My friend and my milkman have made a lot of money in the last 2 years. You keep talking of value investing, intrinsic value etc etc. All that is fine …but where are the results ? I think value investing is dumb !

My response typically was – Value investing is not a fad or a technique. It is buying something for less than it is worth. However this approach has to be combined with the temprament of not getting swept up in the euphoria of the markets. As much as one has to buy undervalued stocks, one has to avoid overvalued or fully valued stocks too.

So the reason value investing is diffcult is because one looks like a complete dumb a** buying stocks which have been dropping for some time, which do not have sexy prospects and which no one wants.

Price tracks value ..eventually
In the end price tracks value. Let me repeat – Price always tracks intrinsic value. This is the fundamental law of markets. The stock price may get disconnected from intrinsic value for some time, however it eventually converges to the intrinsic value of the company. So the key to making money is to buy below intrinsic value (preferably where the intrinsic value is also increasing) and sell when the stock sells above the intrinsic value. That’s all there is to value investing ..simple to understand but not easy to execute.

As an aside, I saw the following discussion on TED ( a discussion board on stocks) and liked what vivek had to say. I would recommend reading his response towards the end of the thread. I could not have said it better. Vivek’s response kind of demonstrates why value investing is not easy

 A Balmer Lawrie is still available at these valuations, but can you go beyond ” Balmer Lawrie makes a 52-week low or What return the stock has given in the last 3 years”…..the answer will be a flat “No”…..

 The thing is one needs to train his eyes….thats all’ 

 
 

Berkshire hathaway (warren buffett’s company) is having their annual meeting over this weekend. This meeting is called the woodstock of capitalists. I have been reading and following buffett for the last 10 years and tend to read his every interview, speech and the Q&A session of the annual meetings.

You can find a great compilation of everything buffett here

His letter to shareholder are a must read and I would recommend reading them multiple times.

Berkshire declared their quarterly results and reported a 65% drop in profits. Although as an indian investor, we cannot invest in this company, I would recommend reading the letter to shareholders and analysing the company to learn how a great company works and what it means to be shareholder oriented (the company is a gold standard).

I cannot explain the company in detail here. However if you have been following the company and have an idea about it, below is my analysis of the cause of the drop in profits.

Buffett has called derivatives as financial weapons of mass destruction and has cautioned against them. I am pretty sure that media, seeing a drop in profits due to derivatives, would crow about how the world’s greatest investor has himself got burnt by the same. However one has to understand that though buffett has warned against using derivatives if the company cannot understand the risks behind it, he himself understands them better than most and clearly knows what he is doing.

The quarter’s loss have been due to mark to market loss on the put options and CDS written by buffett. The put option buffett has written is similar to supercat insurance written by the company. The company gets a premium and insures a low probability event. if the event occurs then the company has to pay the insured amount. now over the years buffett has indicated the they could lose money on specific policies, but over a long term , they work with the odds on their side and would make a profit.

In case of the put, although we do not have the specific details, i would assume a similar approach. In addition buffett has indicated that he looks at the exposure also (total max loss) and no matter what the odds would never risk a huge amount. The puts are deep puts and the odds of the markets being lower 20 years later is low (we dont know what is the strike price of the puts, but they are based on the index and not on a company).

Berkshire accounts for MTM losses or profits which are accounting or book keeping losses/ profits if the options are closed today (unlikely to happen). So the company gets to keep the premium, invest it and get a good return from it for the next 20 years. This is on a low probability event that the market would be way lower 20 years later, in which case the company may well exercise the put and buy the index at the ultra-low valuations.

You would think that if the above is such a good deal, then why are other companies not doing it?

It is explained in the current year’s letter to shareholder and I can think of the following reasons

– The accounting as we can see in this quarter is very volatile. There are almost no companies which would risk a billion dollar hit to their results via such derivatives. The CEO would lose his job for such results
– There is counter party risk too. The buyer of the put option should believe that the company writing the put will be around 20 years later to pay up. Very few companies can do that

ofcourse media is going to make a show about this drop as they dont understand the company or how the options in this case are different from the one’s written by banks and other financial institutions.