Seeking Wisdom In India

I was extremely lucky to spend two months in India seeking wisdom from a lot of smart value investors. In this post, without revealing their identities, I will be summarizing what I learnt from them. If you like this post it’s because of them. If not it’s because of me.

1. Compounding Is Backloaded

Imagine that you invested $1 and compounded at 15% per annum. After 20 years your $1 will become $16.37. The mathematics behind this shouldn’t surprise you. But what surprised me was the fact that more than 50% of the returns was generated in the last five years. From the chart given below you can see that in the first five years the initial amount doubled. Whereas in the last five years the initial amount went up by eight times. The key takeaway is that compounding is backloaded. To generate extraordinary returns you need to let the compounding engine run for a very long time at a reasonable rate.

2. Live Long-Healthy-Life And Not-Lose-Capital

Since compounding is backloaded the only way to get benefited from it is to live a long and healthy life. But there are no formulas that can guarantee you a long life. All you can do in life is to do things that line up odds in your favor. Some of the activities like drinking, smoking, stress, overeating, envy, and lack of exercise will do a lot of harm. Better avoid them.

The key in investing is to stay in the game for a very long time without losing a lot of capital. There was a deep sea diver Natalia Molchanova who got overconfident in her skills and lost her life. This is very important in investing as a single big mistake could knock you out of the game. You have to get rich only once and the most difficult thing to do is to stay rich. Protecting your capital is the key and compounding works in reverse if you lose capital.

3. Big Money Is Made By Sitting On High Quality Business

Some investors were successful in identifying businesses which resulted in 100, 200, and 300 baggers. When asked how they did it, they replied, “I sat on high quality businesses for more than 25 years”. According to Peter Lynch, six out of ten winners in a portfolio can produce a satisfying result.

You don’t need to make money on every stock you pick. In my experience, six out of ten winners in a portfolio can produce a satisfying result. Why is this? Your losses are limited to the amount you invest in each stock (it can’t go lower than zero), while your gains have no absolute limit. Invest $1,000 in a clunker and in the worst case, maybe you lose $1,000. Invest $1,000 in a high achiever, and you could make $10,000, $15,000, $20,000, and beyond over several years. All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out. – One Up On Wall Street

Let us imagine that you’re going to pick ten stocks in your investing career. Applying Peter Lynch’s probability of 60% the odds of you picking ten winners is 0.6% ( 0.6¹⁰ * 100 ) which would be a rare six sigma event. The reasonable expectation is to have 2 – 3 winners, 3 – 4 mediocre performers, and 3 – 4 losers. So the only way to achieve superior performance is to let your winners run. From this simple exercise on probability we can clearly see why they held on to high quality businesses for a very long time. By doing that they are stacking the odds in their favor.

From the lens of probability one can clearly see how they achieved their results. But from the lens of psychology I awe at their results. How did they overcome the deep rooted psychological biases of loss aversion and disposition effect. How did they avoid selling-winners-and-holding-losers? The only explanation I have is that they are passionate in what they’re doing and they enjoy the process more than the proceeds.

4. Voracious Reading And Reflecting

My friend Ian Cassel recently wrote a tweet – “I’ve found great investor’s offices aren’t filled with computer screens.They are filled with books.”. And I found that all great investors offices were filled with shelves of books. All of them are voracious readers. They allocate a lot of time to think and reflect on what they read. What is the difference between reading and reflecting? This difference is beautifully explained by a neurosurgeon named Ebersold.

A lot of times something would come up in surgery that I had difficulty with, and then I’d go home that night thinking about what happened and what could I do, for example, to improve the way a suturing went. How can I take a bigger bite with my needle, or a smaller bite, or should the stitches be closer together? What if I modified it this way or that way? Then the next day back, I’d try that and see if it worked better. Or even if it wasn’t the next day, at least I’ve thought through this, and in so doing I’ve not only revisited things that I learned from lectures or from watching others performing surgery but also I’ve complemented that by adding something of my own to it that I missed during the teaching process. Reflection can involve several cognitive activities that lead to stronger learning: retrieving knowledge and earlier training from memory, connecting these to new experiences, and visualizing and mentally rehearsing what you might do differently next time. – Make It Stick

We all know that eCommerce is growing at a rapid pace in India. And majority of us can’t invest in them as they aren’t available in the public markets. Also their valuations are at stratospheric levels. One investor reflected on this and purchased companies in the logistics space that would get directly benefited from the eCommerce boom. By reflecting this investor applied second level thinking and bought the stock before it was obvious to the market.

5. Superior Search Strategy

A lot of retail investors, including myself, use cloning as their only strategy to identify companies to invest in. But to be a successful cloner one has to study them with a critical and cynical mind. But it’s damn hard to be in this mindset as these companies are already owned by authority figures. So the end result is copying and not cloning. Let me illustrate this with an example. Take a look at the table containing sales and profit-after-tax of a company whose name will be reveled later. In four years sales compounded at a low rate of 11% and profits didn’t grow at all.

What earnings multiple would you pay for this business? Since I haven’t given any information about the business model it’s hard to answer this question. But if I told you that investors were paying 70 times earnings for this business most likely you would cringe. Why did they pay such a high multiple? They paid because they saw the sales and profit numbers after they knew that an authority figure already owned it. This made their critical and cynical mind to shutoff.

All the great investors I met have a good understanding of around 100 to 200 businesses. And most of their investment ideas comes from this list. When they get an opportunity they already know what to buy and they just act on that opportunity. One question I had was – “How’s it possible to study and remember 100 businesses?”. The answer to that question is chunking. Like expert chess players they categorize 100 businesses into handful of industries and study them as groups. This way they need to study and remember 7 to 10 chunks instead of 100 separate businesses.

When top-level chess players look at a board, they see words, not letters. Instead of seeing twenty-five pieces, they may see just five or six groups of pieces. That’s why it’s easy for them to remember where all the pieces are. The analogy can be carried further. You’ll recall from our previous discussion of knowledge that the very best players know ten to a hundred times more than good club players. These chunks are the units of knowledge. Researchers estimate that good club players have a “vocabulary” of about 1,000 chunks, while the highest-ranked players have a vocabulary of 10,000 to 100,000. – Talent Is Overrated

6. On Valuation; Shooting-A-Fish-In-A-Barrel-Type

All the great investors I met didn’t use DCF for valuing their businesses. Some of them didn’t have excel installed in their computers. Their valuations are often back of the envelope and it’s akin to how Charlie Munger values a business – “Shooting a fish in a dry barrel with a shotgun”.

One investor focuses a lot on market capitalization and compares it with the potential market opportunity to value the business. He bought United Spirits in mid 90’s and his thought process on valuation went this way – “Half of Indian drinking population consumes Mcdowell’s. At that time the entire company was selling for $58 million which is ridiculously cheap and I loaded up.”. And I believe that he still holds United Spirits which is valued at $12.82 billion. This translates to a CAGR of 30%.

Another investor uses markets wisdom to his advantage. Remember what Ben Graham said – “In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.”. You construct a low-high price band for the last 10 to 15 years. If the current market price is selling at the lower end of the band you buy it. He only does this for high quality businesses with their durable competitive advantage still intact. If you wait patiently then market gives you an opportunity to buy great businesses like Nestle India at the right price.

7. Avoid Illusion Of Control

I spend around 2 to 3 weeks to learn about a company. And I make sure to read at least 10 years of annual reports. When I met these investors I expected them to read 10 to 15 years of annual reports. But I was surprised when some of them got what they wanted by reading 2 to 3 years of annual reports. When asked why they’re not reading 10 years of annual reports they replied – “Reading more doesn’t result in picking winners. In fact you’ll become overconfident and have illusion of control.”.

We read annual reports to (1) gather facts about the company, industry, and its competitors (2) identify key variables which decides the future of the company (3) weigh those variables and bet if the upside potential is much higher than the downside risk. If you can get all of these by reading two or three years of annual reports so be it. No one is going to award a trophy for reading 10 years of annual reports. Sometimes less-can-be-more. This experience reminded me of what Seth Klarman wrote about in-depth fundamental analysis is subject to diminishing marginal returns.

This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.

Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors’ quest for knowledge nevertheless.

Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor’s informational advantage.

David Dreman recounts lithe story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs….’ The stock fell from a high of 53 to 11. – Margin Of Safety

8. Few Books To Read

Some of the investors were generous enough to recommend and gift me books.

Closing Thoughts

The iron law of life is that everything, including good things, comes to an end. Purchases which buy experience makes people more happier than the materialistic ones. I spent money and time to seek the former. And I thank all those investors for providing wonderful experience which I will carry with me throughout my life.