This is Part 2 of the note by Balaji Sridharan, an equity investor, who shares his approach and thought process on investing.
In Part 1 he suggests that every equity investor asks two questions:
- Am I an above average investor objectively?
- Is investing worth my time?
He then goes to explain how possibly can an individual investor seek those answers.
Subsequently, he questions whether one is ready to be an equity investor by taking up three 3 hurdles that one has to face.
You can read the Part 1 here.
Part 2 continues.
Once you are past all these hurdles, the question “how does one think about companies” arises?
There is enough literature out there from Ben Graham, Seth Klarman to Phil Fisher taking from deep value to high quality, growth companies. We will not rehash about any of these. Instead we will talk about a few of the filters that I use to pick stocks.
At the top of the list is whether the business is predictable.
What this essentially means is that can you envision what the company will look like five years from now?
If the business is not predictable, then it is good to give it a pass. Tons of businesses do not pass this criterion. It is very tough to envision how a Google, Facebook, Microsoft, Apple or Amazon will look ten years from now. It has to be noted that these companies together represent over $1.5 trillion in market cap. They have created huge shareholder value over decades.
But how many of us would have guessed ten years ago the fate of Blackberry and Nokia? How do we know whether we are picking up a Blackberry or Apple? Going by that logic, since you are not sure that these businesses are going to survive or not, it warrants that these must trade at a lower multiple than a predictable industry. However, given the scalability of the technology businesses, the market tends to value them at a premium. It is entirely possible to hold them in a very diversified portfolio knowing that all of them would not go kaput but it is of limited use in the concentrated portfolio. It spikes the risk up too much.
Second, is the business run by competent, honest management?
This is very subjective and tough to evaluate especially in the Indian context. I have found something or another that I have disliked about all the Indian stocks that I have seen without exception. In the Indian context, I am looking at governance at large to serve in the interests of the minority shareholders. As long as the management has treated minority shareholders okay, I have gone along with them. This includes no accounting shenanigans, enriching promoters at the cost of the minority shareholders, low debt (except for financial stocks).
If you listen to the management, you will learn a lot. I will give you a great example. I was looking at Valeant Pharma since 2014 mainly because Sequoia was involved in it. Then, Bill Ackman entered when the Allergan deal was on the table. Without using hindsight bias, if one were to read to the shareholder letters and the annual reports from Valeant, they said all the right things about shareholder value creation.
The thing that bothered me was every year they made an acquisition and I could never figure out how their base business was doing and acquisitions were always a big piece of their business every year.In contrast, with Berkshire, it is rarely more than 10% of the market cap of the company.
Back to Valeant. I started listening to Mike Pearson’s interview. He said something in one of the interviews in early 2015 that raised all the red flags for me. He mentioned that he was able to integrate the business within six months of buying it so that he can focus on the next one.
Being a business leader in life, I knew it was next to impossible to completely integrate complete multi billion $ businesses in six months. It was a huge red flag. I parked it aside wondering whether I was letting go of a good opportunity.
A ray of hope came when Charlie (Munger) commented in the Wesco annual meeting later that year that he was not too fond of them (take this with a pinch of salt – read about authority bias) and then of course Valeant fell apart in late 2015.
Listening to what management says is key. If they paint too rosy a situation, be careful about it as well. A simple sentence made me pause and re-think an idea I had spent almost hundred hours researching. It is critical to actively think about the ideas.
Third, what is the source of high returns for this business and why is it sustainable?
In other words, what drives the high return on equity or the source of competitive advantage? Again, there is enough literature out there that talks about competitive advantage from Porter to India’s own Sanjay Bakshi. When you understand the competitive advantage, see whether it is sustainable and for how long.
Competitive advantages change over periods of time. Coca-Cola was a great company thirty years ago and is a good company now. The moat has narrowed. Think about how the moats change over time. When you understand the company well, you will be able to see the future. Write down your vision and see how it unfolds. A moderate scenario must be able to net you good returns from the market.
Predictability helps you see the sustainability of the competitive advantage. Ask what can go wrong in your scenario. Here’s a simple heuristic. Try to kill the company and if it keeps surviving no matter how much capital you throw at it, that’s a good company with a good competitive advantage.
Lastly, make sure that you pay a reasonable price to get good returns in a moderate scenario.
If the stock ticks all four check boxes, it might make sense to put it in the portfolio. This means that a single idea will take hundred of hours of intensive study to get into the portfolio. There will also be several others that will lie by the wayside because they failed to hit some check box or the other.
Like I said, it is simple but not easy.
I hope the above ideas help the new equity investor to pick stocks that are investment worthy.
Between you and me: Do you think you are now cut out to be an equity investor and pick stocks for your portfolio? Or are you better off outsourcing that job?
The comments section awaits your responses.