“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” ~ W. Somerset Maugham – English dramatist & novelist (1874-1965)
Maugham’s thought holds a great relevance when it comes to picking up businesses for investment. The results of your investing efforts are decided not after you make or lose money in 5-10 years, but at the very moment you decide to own a specific business.
Pick up a business with good economics and with good margin of safety, and the probability of making money in the long run is high. Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high.
Warren Buffett says – “Time is the friend of the wonderful business, the enemy of the mediocre.”
While this principle may seem obvious, most of us learn it the hard way. In fact, most of us learn it several times over.
Anyways, this principle has been reiterated very well by Prof. Sanjay Bakshi in a presentation he made at a conference recently.
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His presentation broadly discusses a research study done by Credit Suisse and HOLT, which concluded how…
- Wonderful businesses are likely to remain wonderful (or at least good) for decades.
- Poor businesses tend to remain poor or they become slightly better but still remain below average.
While this has some great lessons for investors who are always in the hunt to find that “next” Asian Paints – and would rather do well to take a harder look at Asian Paints itself – I would like to add a warning here.
The research discussed in the presentation flies in the face of the concept of mean reversion that is one of the most powerful laws in financial physics and has worked well in the world of business and stock investing as well.
Mean reversion suggests that periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.
So if you go blindly by what you read in Prof. Bakshi’s presentation, and invest in business that have been great in the past, regardless of their valuations – assuming that they will remain great in the future as well – you may end up committing some big mistakes.
While a very few great businesses turn out to be outliers and remain great businesses for long, a majority of them move to mediocrity – either forced by competition, or led by their managers’ overconfidence, arrogance, flawed capital allocation decisions, and ultimately destroy return on capital.
This thought also stands true on the concept of survivorship bias.
The businesses discussed in the presentation may have been wonderful ten years back and are wonderful now, but there are have been far greater number of wonderful businesses of the previous decade that have bitten the dust.
The very characteristic of a large majority of Indian businesses – lack of innovation, short-termism, corporate mis-governance, and poor capital allocation of their promoters – has led to an extremely low number of Indian companies commanding any “sustainable” moat (over more than, say, 20 years) like their western counterparts.
So, most of the sustainable wealth creators in India have been arms of MNCs (Nestle, Colgate, HUL, Castrol), that have been able to hold their brand and business high.
This is the reason they have always commanded valuations that have been largely driven by “scarce quality premium”.
How long can such businesses command premium valuations in a highly competitive market like India, and how many Indian companies can sustain their little moats for long is a question that is anybody’s guess.
While we may love to hear stories of companies like Asian Paints, Nestle, HDFC, Hindustan Unilever, and Colgate, and how they have created tremendous value for their stakeholders in the past, we also need to understand what Horace said…
Many shall be restored that are now fallen, many shall fall that now are in honor.
Prof. Bakshi mentions that it’s important to go by the probability of success than the payoff from an investment, which is a very valid point.
But please also consider the margin of safety in a great business, for the absence of the same may kill all probabilities of its success as an investment.
Look at Infosys from 2000 to 2013 or Hindustan Unilever from 2003 to 2010, and you will understand where I’m coming from.
Howard Marks writes this in The Most Important Thing …
For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.
When people say flatly, “we only buy A” or “A is a superior asset class,” that sounds a lot like “we’d buy A at any price…and we’d buy it before B, C or D at any price.” That just has to be a mistake.
No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.
Hopefully, if I offered to sell you my car, you’d ask the price before saying yes or no. Deciding on an investment without carefully considering the fairness of its price is just as silly. But when people decide without disciplined consideration of valuation that they want to own something, that’s just what they’re doing.
Bottom line: there’s no such thing as a good or bad idea regardless of price!
I’ve heard a lot of people tell me that they are comfortable buying a company selling things like super-branded innerwear or expensive jewellery at 40-50x P/E just because the “per capita consumption of branded innerwear and expensive jewellery is extremely low in India and will catch up soon”.
In a country where over 60% of the population will continue to fight for its survival, and especially when we don’t see any end to inflation in necessities like food, clothing, and shelter, the “per capita” thinking can be dangerous.
So while I have no doubt that the probability of a great business to remain great or good is high (as Prof. Bakshi explains so beautifully in his presentation), it’s important to not be blinded by the past and pay any price to get on to it.