The "WHY" Mental Model

I was thinking  of  writing on this topic after after I saw this lecture on TED by Simon Sinek and then read his book. 

The trigger came after reading this paragraph in Kiran's superb blog 

1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner  understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. .

So here goes my rant :) 

The Traditional way of evaluating a business has this flow:-

• What's of the business/Evaluation of outcomes- To quote Simon Sinek all business know what they are doing. They know are selling cars, homes, pipes, IT services etc etc. These "what's" are evaluated using metrics like Revenue, Profits, Growth Rates etc
• How's of the business/ Levers of business - We then try to evaluate the levers of business like the domains in which business competes, which products sell where, what are their weaknesses, Moats etc etc. These " how's" are evaluated using metrics like Return on capital, Return on Assets, cash flow etc.
• By this time our investment decisions is almost made and we typically look for confirming evidence. Very rarely will we go to the next step of 
• Why's of the business/ Purpose of business- This is the domain where things become grey and fuzzy. This is where we need to think of words like Trust, Loyalty, Vision etc. There are no metrics to evaluate these. Think of a stock in your portfolio and ask can you measure the trust or loyalty generated by it. Its a tricky one to answer. And therefore most of the times this is ignored.

To summarize, we start with what are the outcomes of business, then try to identify how they are achieved and then pretty much stop.

The new way of thinking prescribed by Simon Sinek is to invert this process:

• Start with the "WHY"- Try to identify the purpose of existence of a company. Great enduring businesses know this crystal clear and all their actions are defined basis that. Few examples
• Apple- The founders gene was to rebel and almost all their products reflect that
• Coke- All along the single message they have tried to convey is Coke stands for happiness. Look at any campaign, product , communication and its always has this philosophy
• Google- Do no evil. Again every single google product tries to do this. Every communication to their hiring page reflects this

From a business perspective this defines the way it creates space in its customers mind.                   We ( can say for most of us) trust Google, We ( can't say for most in India) love every apple               product.

Their "WHY's" have resonated with their customers to create an unflinching loyalty.     

I realized while reading few Buffet letter that how rarely does he comment on metrics related               to How and What of business. Most of the times he comments on "Why" and things associated           with it like Trust, Loyalty, Belief etc

• The "How" is next- This is where we start to look at how business is trying to achieve the why. Spends on moats, technology, asset turns, RoE etc etc
• The "What" is last- This is where we evaluate if the How's are working. 

For me this has been a great mental model to use. Now I try to find the "WHY" of business using

• Mission/Vision Statements
• AR Commentary on these statements, if any
• Promoter interviews
• Scuttlebutt to see how these are translated at ground level for companies

Earlier I would ignore these portions. Now, I read them and try to see if its just  jargon or does the business actually try to follow it. If its jargon then for me that becomes almost like a no-go criterion.  

In some cases these statements will be so obfuscated that you just can't figure out the WHY. To me that is also a no-go.

As of now with my limited experience I see the clarity of "WHY" beautifully displayed in few businesses which i own.

Look forward to more suggestions on finding the "WHY" :)

cheers,

Saurabh

PS- The stocks mentioned above are held by me. This is not a recommendation to buy or sell any stock.

Guest Post: Its only Words

This is a Guest Post from a renowned investor known in our world as VIJI. I have been lucky to learn quite a bit from him, and going forward would try to post nuggets from him.
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Experience teaches many lessons provided one has open mind to learn.  As an investor, I have learned many lessons over the years. One of the more important lessons is to be leery of repetition.

If I hear a word, phrase, or a concept repeated often to explain a myriad of phenomena, I immediately question the worth of the commentary, as well as the validity of the commentator's underlying thesis.Repetition of the familiar is often a mental short cut. It allows the commentator to explain a cause and effect relationship, even though he/she might be unsure of the relationship (or he/she might simply be attempting to fill space).

Below are a few commonly invoked buzz words or phrases investors would be better off ignoring.They simply fail to impart any insight yet their use is ubiquitous.

Fear: This word is most often used upon the bursting of an asset-price bubble. Investors are fearful, so that's why we are in a recession. Unfortunately, fear is wrongly used as a synonym for uncertainty.An investor is more often uncertain, not fearful. And he is usually uncertain, and rightfully so, after the bursting of an asset-price bubble because he is unsure of governments response to the bursting. And he is uncertain how other market participants will react to the government's response. Therefore, it is uncertainty keeping him out of the market, not fear.

Greed. The word “greed” is often associated with fear. It was greed that led to an asset-price bubble.But asset-price bubbles form not because of greed, but because of investors acting on outside incentives.Investors acting on incentives, even if the incentives are misguided, doesn't mean the investors are greedy.Greed is also incorrectly used to denote ambition. The two are not the same. Ambition means working to get what you want.Greed is an attempt to get something for nothing. Most investors and analysts are ambitious, not greedy.

Probabilities and Statistics. An analyst who says “there is a 40% chance of the economy falling into recession” is proffering nonsense. Economies and investments are not a gamble like the roll of a fair die, where you know there is a 20% chance of hitting any number.Economies and investments deal mostly in uncertainty, not risk. Uncertainty cannot be quantified, because it  deals with un-quantifiable human action.Risk - like the chance of a house burning down within a five-kilometer square radius - is quantifiable because it is not influenced by deliberate human action.Ignore prognostications like “ABC company has a 70% chance of hitting Rs XYZ  within the next three months.” There is simply no way of knowing, unless the source of the prediction is revealed, such as “according to current options prices.”

Market Efficiency. This should only refer to ease and cost of exchange between individuals. Instead, market efficiency is used to reflect fully and realistically all that is known about a company.If markets are truly efficient, as some academics believe, then there would be no RJ or for that matter even Warren Buffet.It is impossible to know the amount of information embedded in a stock price.

Markets Acting. Any reference to a market doing anything is wrong from the start. Markets cannot act; they can't do anything. A market isn't a place; it's a process of exchange.When a reporter says something like “the market sold off today,” he is talking about the activity of many individual investors and then ascribing that to “a market.” To refer to the market doing anything on its own is to talk of the market as if it were an acting entity, which it isn't. Markets reflect the actions of individuals; the markets themselves do nothing. The distinction is worth remembering, because there is rarely only one reason for why the market ended the day up or down. All individual investors don't act on the same information.

I am not mentioning  these mental short cuts to point fingers.

I have been guilty of invoking them myself on occasion.The key is to become aware of the habit, and not be fooled.

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cheers,
saurabh
PS- I took the shortcut to writing a post, please don't do that while taking investing decisions.

Weekend Learning

Last weekend I had a chance to meet some fantastic investors (Gaurav , Ayush , Neeraj, Ashish, Puneet, Suhail) and also got a mail from a friend of friend who attended Valuex (An investor conference in Mumbai held last Saturday). Basis these interactions i have tried to capture the learning i had and highlighted one's which I personally find of key importance

Investment Philosophy:

1. In India Statistical Bargains remain cheap for a very long time, due to limited catalysts. These catalysts such as form of investor activism, minority stockholders doing some corporate action etc are usually inactive. Statistical Bargains originated in US, where there are means to induce these catalysts. Also, lack of growth in US companies has led to investments moving to these ideas.
2. India, we all agree is a growing economy, and hence the best bets are the ones which have a growth component attached. Buy stocks at reasonable valuation( Margin of Safety) which show signs of growth and then ride the growth. Also, in such stocks be mentally prepared for horizon of 3-5 years and also ups and downs in between. If one is able to ride the growth they can be the big winners.
3. Their are 3 segments to broadly classify businesses B2C , B2B & B2G (Business to Government)  and clearly B2G is most frowned upon
4. People are scared of investing in illiquid stocks because they are scared of working hard --> Stocks are usually illiquid because they have not yet been discovered. Infosys used to trade less than 1,000 shares / day in 1994.
5. In an Indian context Price is what you pay, Value is what the promoter allows you to make. Cash, real estate, assets should be taken with a grain of salt as most likely a promoter will not allow you to realize its value.

Investment Methodology:

1. Promoter integrity is the top thing too look. Indian promoters find ways to take out money and hence it is key to be associated with right kind of people. Meeting distributors, creditors, end-users is one way to see how involved the management is in the business. Attending AGM's is another way to get a feeler on the company and also to understand the outlook and future plans of promoters.
2. RoE is the holy grail. If RoE is less than cost of capital creating sustainable wealth is almost impossible. 
3. Also evaluate company on asset turnover and margins. These are the 2 levers which company has to increase RoE
4. Double Counting creates bubbles: During periods of boom margins are the highest to which we apply high valuation multiples. Margins are mean reverting, thereby in your analysis it is important to adjust for this factor
5. Don't mix your investment themes. Example, Special Situations with bargains or with long term ideas.
6. Even if stock is up 100% from your purchase,but if you find growth story intact and valuations cheap keep adding.  Its all about buying well, rather than selling well.
7. Have an exclusion list. If any company falls in that sector/ concept don't waste time. For example, most of us agreed that B2G is an example of ideas to avoid.
8. Dumbest thing to do is forecast. Be comfortable with the idea that you don't know the future. It is very difficult to comes to term with this.
9. In bear markets don't use relative valuations but use your judgement on absolute valuations. In bull-markets use relative valuations to make selling decisions.

Psychological Biases and other thoughts

1. Use Anchoring bias as a tool to take decisions. If you find a stock good, buy it then you will be anchored to that price rather than waiting for price to come down.
2. Assuming that all stocks which you have will be a 10 bagger is living in fool's paradise, but if your process is right you will get once in a while a large bagger. 
3. Make sure your investment process does not change in good or bad periods. Good performance makes one complacent while bad performance makes one defensive
4. Differentiate between Hold-to-Maturity and Revert to Mean Ideas in your portfolio:

   Hold-To-Maturity: Great businesses which are compounding machines that have been bought at reasonable valuations. These are long-term investment ideas. 

   
   

   Revert to Mean: OK businesses at beaten down valuations because of poor performance where performance can bounce back in the foreseeable future. 

5. Markets are not efficient but they reflect current investor psychology. 
6. How do you determine in an investment decision whether you suffer from overconfidence or are just an independent thinker. Every business has certain milestones, when those milestones are not being hit by the business you must reconsider your investment 
7. Use simple scenario analysis to avoid investment pitfalls. For e.g. to Justify 2000 valuations for IT they would have to go at 75%-100% in the foreseeable future. If they did this for over 10 years, they would have become 40% of India's GDP. Even if they did manage to do this the Rs would have to go down to Rs 25 whereby margins for these companies were not sustainable. 
8. Read, read and read more. Few books recommended
1. Finding the next Starbucks
2. The Warren Buffet Way
3. Commentary of international value funds

And finally, we did discuss some stock ideas like Suprajit, GRP,Atul Auto, Magma Fincorp, Ashiana Housing, Ashok leyland, Clariant, BASF etc.

Hopefully we all will benefit from these thoughts, and incorporate the same while evaluating an idea.

cheers,

saurabh

PS- Don't consider all of us bores. We did discuss things beyond stocks and investing :)

Piramal Healthcare, Ajay Piramal & Value Investing

Piramal Healthcare stock idea is a very well known one in value investing universe and it has been told eloquently here (PHL ).

The idea of putting this post came after reading another of Mr. Piramal's interviews. This post is not to prove that whether PHL is a good investment or not, but to showcase why Ajay Piramal classifies as a classic value fund manager. His past records clearly indicate that he is one of of the best known capital allocator in Indian context.
But, what I find equally fascinating is how he tackles various behavioural biases and shows traits necessary for one to be successful investor. Given below are excerpts from few of his interviews which showcase these traits.

Interview 1: Outlook Business

Overconfidence and Ego : On the groups strategy he says, "Also, when you adopt an acquisition-led strategy like we did, you have to keep your ego aside. I think many people overpay because when you make acquisitions, you hog the limelight. Across the world, most acquisitions don’t succeed because the CEO’s ego comes in the way — I have to do this and become numero uno. You have to be objective. If I lose an acquisition, I don’t lose sleep. If I gain one, I don’t go over the moon. Then, acquisitions don’t succeed if you don’t have a deep understanding of the industries, how this acquisition fits into your plan, and how can it create value for you."

Interview 2: Hindu Business line

Incentive Bias: Ajay Piramal, stays clear of advisors/ investment bankers as he believes they are motivated by their own incentives and not clients. To quote him 
"According to me in an acquisition, you have to understand, as your advisor, what is the vested interest of an investment banker …an investment banker, by and large how is the investment banker incentivised? Irrespective of whether he is selling to you or he is acting on your behalf , the way he is remunerated is if he does the deal. It doesn't matter. It is in his interest and his progress in his organisation also is – either his bonus or his promotion is dependent on how many deals he does. So he doesn't bother whether it's in your interest or not, he wants to get the deal done, so therefore he cannot offer you honest advice…I believe that you have to take your own decision.”

Interview 3: Business Standard 

Contrarian Ideas: On being asked why Piramal Group has been buying trophy realty assets in Mumbai when the property markets are still very sluggish. 
He replies saying, "Our strategy has always been contrarian. Because the market is sluggish, there is opportunity and we are getting much lower valuations. Take the Mafatlal Mills case. That asset was quoting at twice the price of what we finally paid for. In Mumbai, we believe the demand will never come down. But the market has stayed sluggish because in the last 1-2 years, approvals have not come in for good reason. Under earlier regime, anybody could get an approval and many defied logic. We decided to stay out at that time. Since it is becoming more transparent we are willing to enter and explore projects a lot more proactively."

Interview 4 : Deccan Herald :

Integrity & Circle of Competence: After the Abott deal he talks about the people approaching him with various ideas and how he was not lured by them "Because people knew we had money, we had so many people approaching us for projects in the infrastructure sector," he said. "These people had no experience and no knowledge and no track record of having built a business in any area. And yet they were coming to us saying we have licenses and approvals. That just didn’t sound right or smell right.They’d name politicians from the centre and the state who had it all tied up for them. It didn’t sound right. Obviously there were things going on in the system.

Each day, they paraded through his office: The investment banker who decided to build a 500-megawatt power plant, the coal trader assured of a government coal allocation, small-time miners with pretty presentations promising land, licenses and financing.

Interview 5: Moneycontrol

Long Term Approach & Humility : One of the interviewers asks Mr. Piramal that athough company has derived value of Rs.850/ share,  shareholder's are getting much less value. To which his reply is

"So Mr Singhvi I understand your concern as a shareholder that you are only getting Rs 500 a share. But I would ask you to be patient, the deal is not even closed yet, we have not even got the money yet and we have assumed that this is the value that we have created and in fact you are saying that we have destroyed value after having received it. Probably you are being too harsh and you are not giving enough time. So please understand—what the board would like to do and what the management wants to do with this business. We can create value through the existing businesses that continue to remain with the company.
We have demonstrated that in the past and we will continue to demonstrate in that. Our belief is that we as a management can create greater value for the shareholder if the money remains with us than it is in the hand of the shareholder and with us as promoters having the largest share a of holding, we would be very conscious that we have to create value, that’s one thing. I have also said that we will definitely consider a special dividend.
The third thing I am saying is that if in the next two years, if we feel that we cannot create greater value than what shareholders can do then we will return the money. But you have to look at it as a long term play. We have always looked at business not in one or two months play but as a long term play. That’s what I would ask our shareholders to do as well."

To me investing your money in PHL is akin to investing your money with a value investor who knows what he is doing and clearly establishes a hurdle rate for himself.

Regards,

PS- Invested in PHL

Portfolio Management- Process of Reviewing

Update::

I have Exited Garware Wall Ropes. It appears cheap but if one looks at its RoE & RoCE numbers business it is not a great business. My fair value estimates were in range of Rs. 60-70, and giving a 50% discount to that my buying range would have been around Rs.35 which i think is also near to its 3 year lows. My buying price was 57, so took exit and plan to invest in other ideas.

Original Post given below::
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 In my last post i shared that i try to construct my portfolio around 3-4 themes. This time around I am writing on my methods of reviewing my portfolio. 

We all know that as soon as a stock enters ones portfolio one is immediately impacted by endowment bias (Details).Under the effect of this bias the simple task of reviewing portfolio and weeding out not so great ideas becomes a huge challenge.

To over come this I am trying to use decision tree method outlined below

Step 1:: Is this business good, bad or average and is this a business i understand? I don't look at numbers here but try to use some basic ideas like is it a no1 or no2 player in a segment, does it have pricing power, is it dominant player in niche segment, is the management honest etc to understand the business. For example I hold First leasing which is definitely an average business as it is a NBFC focusing on leasing business and doesn't have any of the above characteristics. Similary, I am not very confident in understanding chemical/pharma companies and hence i avoid them.

Step 2:: I then verify my above hypothesis by checking some basic numbers like past RoE, Cash Flows, Low Debt/Equity, growth rates, dividend payouts etc. 

Step 3:: If my hypothesis is correct and it confirms that it is a bad business or it is a biz that I don't understand then i try to exit that stock. Nothing is worse than holding a stock with bad business in the hope that price will rise. ( Unless you have some insider info)

Step 4:: In case though if its a good or average business then I move to the valuation bit.

• Step 4.1:: For average business I try to calculate the intrinsic value of the company using conservative estimates. Although, there is no fixed methodology for this but for pointers one can refer to this (Intrinsic value calculation) brilliant work by Vishal. Since the business is average i would keep the margin of safety(MOS) as high as 50%. Also, average business don't get re-rated very easily so one should think on what are the catalysts for getting this stock re-rated ( debt-reduction/PE investment/Stake sale) and what is the time frame for this event etc. 
• Step 4.1.1:: In case i hold a stock which doesn't meet my MOS criteria then i will try to exit the stock
• Step 4.2.2:: In case i hold a stock which meets the criteria then i try to evaluate it with stocks which are good business. In case the price of these great business are not right i hold on to these average businesses idea.

• Step 4.2 :: For good business I again try to calculate the intrinsic value of the company. For these business i keep a margin of safety around 25%. 
• Step 4.2.1 :: In case i hold stocks meeting my MOS criteria I keep adding the stock till my allocation limit, usually by selling the average/bad business ideas.
• Step 4.2.2:: In case the MOS is not available then i hold the stock and wait for the idea to be rightly priced.

I try to follow a similar process for a new idea. As said in my previous post i try to maintain 3-4 themes in my portfolio and try to do a similar check as above within these themes.

As of now I am evaluating if the below 3 stocks and hope to reach a conclusion soon.

1) First Leasing

2) Garware Wall Ropes
3) Ashoka Buildcon


Regards,
Saurabh