This article is the first half of a two-part interview with Sanjay Bakshi, one of the great minds in value investing and behavioral finance in India. A finance professor, he also writes a popular blog called FundooProfessor, where he discusses investing and behavioral economics. In this part of the interview, Motley Fool analyst Rana Pritanjali asks Bakshi about when it's best to buy and sell, what makes a great value investment, and more. To read the second part, click here.
Rana Pritanjali: Do you think that missing out on early opportunities and selling stocks too soon are inevitable flaws of value investing? These flaws can look like sins in this seven-year bull market!
Sanjay Bakshi: Missing out on an early opportunity creates regret. Often that regret is unwarranted because for truly outstanding businesses, there will be multiple opportunities to buy the stock. By definition, a 100-bagger is a 10-bagger twice over. So even if someone bought it after it had become a 10x, it would still become another 10x.
One of the most counterintuitive ideas in value investing in high-quality businesses is the power of averaging up. Very few value investors appreciate this power. If you've picked the right kind of business, which will be worth several times current market valuation in a few years' time, then you must not hesitate in buying its shares simply because they are selling at an all-time high market valuation. Your focus should always be on potential future value a decade or so from now and how much money is there to be made between now and then.
There is a kind of pleasure that many value investors get from seeing the prices of their stocks fall from their cost because they can then buy more shares at an even lower price. To be sure, this practice -- called averaging down -- has its merits, provided one has picked the right business to invest into.
I don't have any particular issue about averaging down. What I do find surprising is that many value investors avoid investing in businesses simply because their stock prices are selling at an all-time high. Moreover -- and this is even more inexcusable in my view -- they refuse to buy more shares at prices higher than their cost, even though management has executed even better than what was originally estimated by the investors. In a sense, the investors fall for "anchoring bias" where they anchor to their cost price and keep hoping the stock price will fall below that price so they can buy more shares.
The reality is that in high-quality businesses, there will be multiple times to buy more shares, and one must never focus on the cost price of existing shares or the fact they happen to be selling at an all-time high price and much higher than one's own initial purchase price.
Equity investing has asymmetric payoffs. You can't lose more than 100% of your money, provided you have not borrowed money to fund the purchase. But you can makes tens of thousands of percentage points over your cost if you pick the right kind of businesses.
I love John Templeton's quote on the subject of when to invest: "The best time to invest is when you have money. This is because history suggests it is not timing which matters, but time."
Rana Pritanjali: What about selling too soon?
Sanjay Bakshi: I am as guilty about this one as anyone else. What's the remedy? I think the remedy is to read books like 100 to 1 in the Stock Market by Thomas Phelps, Common Stocks and Uncommon Profits by Philip Fisher, and Conservative Investors Sleep Well by Philip Fisher. Another remedy is to study the history of long-term wealth creation in equities. And to my mind, what that history tells us is that wealth creation comes from buying outstanding businesses at reasonable prices and then ignoring the market for a long long time. Just by sitting on your ass with outstanding, scalable businesses for a long time is a proven formula to create wealth. But for most people, sitting on their ass is just too painful. They want "action," and they fear losing their mark-to-market profits and want to jump from one stock to another like butterflies do with flowers.
My suggestion is that one's thirst for action can be met through other activities like bungee jumping, and one should switch off the TV and get rid of all apps on phones that provide real-time stock market data. Focus instead on fundamental performance of the portfolio and other businesses and their likely future value a decade or so from now.
Rana Pritanjali: Are you lenient on valuation for quality companies with huge market potential or huge optionality? In the U.S., Starbucks is a good example. Have you bought companies that might not fulfill the conservative wisdom of value investing? If so, what was your rationale?
Sanjay Bakshi: One of the most important pillars of value investing is the idea of margin of safety. But where does margin of safety come from? For a Graham-and-Dodd value investor, it comes from asset value, or from earning power over the purchase price, which is high in relation to a AAA bond yield. There is far less focus on the quality of the business or the management.
For a Charlie Munger/Philip Fisher type of value investor, the margin of safety comes from the ability of a business to deliver high returns on invested capital over time, and that comes from durable competitive advantage usually created by exceptional people. This type of investor does not hesitate in paying up for quality. But, by no means does this have to mean that he or she is overpaying. And the way to figure out whether this type of investor has overpaid or underpaid is not by focusing on P/E multiples based on historical earnings. The way to figure it out is by comparing the price paid by him or her with the earnings delivered by the business many years later. To be sure, paying high multiples of near-term earnings will make sense only if future earnings will be significantly higher than at present. So, the focus should be on long-term earning power and not current or past earnings.
In a sense, the classic Graham-and-Dodd investor believes in mean reversion. For him or her, bad things will happen to good businesses, and good things will happen to bad businesses. For a Charlie Munger/Philip Fisher kind of investor, the kinds of businesses he or she invests into have fundamental momentum -- that is, a probabilistic tendency to continue to deliver exceptional performance. In other words, these businesses do not conform to the principle of mean reversion -- at least not for a very long time -- long enough for them to become great investment candidates at the right price.
Now, momentum is a dirty word in value investing, but it need not be because I am taking about momentum in fundamental performance of businesses and not momentum in stock prices (although the former tends to create the latter). The Charlie Munger/Philip Fisher type of investor does not completely disagree with the idea of mean reversion that Graham-and-Dodd investors cling to. Rather, the Charlie Munger/Philip Fisher type of investor knows that there are some businesses that prove to be truly exceptional, where there is a persistence of high quality for long periods of time. And he or she chooses to focus on those and those alone. And when she finds them, she does not hesitate in paying up a bit for such outstanding businesses.
So, in a sense, among value investors, there is sort of a clash between two different ideologies in value investing -- mean reversion and momentum. And both ideologies are correct in my view. For most businesses, mean reversion applies, but for some exceptional ones, it applies after a long long time, and until then, momentum applies.
Rana Pritanjali: Do you think one should evaluate a business at the company level rather than at the sector level? For example, you might get a good company because of its unique characteristics, even in the airline sector. Do you agree? Or are you biased against any sector(s)?
Sanjay Bakshi: Both. A business does not exist in a vacuum. You have to compare how well or poorly it performs in comparison to its peers. My colleagues and I invested in a business that represents 1% of the industry's revenues but 5% of its profits. Isn't that an astonishing statistic? One way to search for exceptional businesses is to find those that deliver astonishing performance, and one cannot do that unless one looks at the business and the industry to which it belongs.
As for your question about the airline industry, my answer is yes. The correct way to think about such situations is to think like a Bayesian. So, there are prior odds, which reflect how tough the business is, and airlines is a tough business. We know that because we have all read Buffett, and we know the rate of failure in that industry is high. So we have this baseline information that warns us that there is this industry where most participants don't earn sufficient returns on invested capital. But that's just one part of the equation. The second part is to focus on specific factors relating to the airline business you are evaluating. Those factors reflect likelihood ratio; that is, the degree to which this particular airline is far better than the average airline. And then you combine prior odds with likelihood ratio to determine posterior odds, which reflects the probability that your chosen airline could be the next Ryanair.
So you must never ignore baseline information, but you should also focus on factors that might deliver far higher posterior odds than prior odds. I covered this in some detail in a talk I delivered.
The other thing you have to focus on is to think about the prejudices of Mr. Market because he has this tendency of painting everything with the same brush. So, occasionally you may find a Ryanair priced like the average airline company. And that's a good thing to find out.
I spoke about the prejudices of Mr. Market a few months ago. Get the transcript here.
Rana Pritanjali: People say that volatility is your friend and that permanent loss of capital is the real risk. But we're talking about human beings. If history has any significance, isn't volatility the real risk?
Sanjay Bakshi: Well, every value investor who has read Buffett, Klarman, and Howard Marks knows this. But the more interesting question for me is under what circumstances volatility equates risk. And of course, there are many situations where this happens. If you borrow money to buy stocks, or if you run an open-ended fund with daily or weekly redemption, or if your psychological mind-set does not permit you to think long-term, then, for you, volatility equals risk.
Rana Pritanjali: When I started investing, I had a strong preference for consumer goods companies, which have brand power, a loyal customer base, a light asset model, and high returns on capital. But with time, my preference has shifted toward companies that cater to businesses because they have an overall higher switching cost. People are a lot more finicky! But then companies such as Starbucks have still been able to maintain their dominant position. What differentiates Starbucks from other consumer brands? Do you have any such preference?
Sanjay Bakshi: There is a lot of fuzzy thinking about sources of competitive advantages. While it's great that authors like Pat Dorsey and others have written about these sources, one has to keep in mind that these things don't live in silos. They overlap.
Take brands. Don't they create high switching costs? Of course they do. Switching costs are not just financial; they are also psychological, and successful brands make customers switch them from system 2 type of reflective thinking to system 1 type of automatic, reflexive thinking. Why do most customers automatically pick Heinz ketchup instead of the cheaper, store brand ketchup from the supermarket shelf?
Brands also create scale, and scale produces cost advantages, which, if they are largely passed on to customers, not only allow the business to earn superior returns on capital but also deliver longevity because there is less incentive for potential competitors to enter the market.
Pricing power is like credit. You must have it in abundance, but you must use it sparingly. Very few businesses understand this trade-off between short-term profitability and longevity of superior returns on capital. I love businesses that understand this trade-off and always choose pain-today-gain-tomorrow type of decisions. What would you rather have? A Valeant, which buys life-saving drugs from innovators and then jacks up their prices like crazy, or an Amazon, run by a fellow [Jeff Bezos] who says: "We believe by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term."
Investors should study Amazon and Valeant. They should compare and contrast these two business models. Here are some Bezos quotes that reflect his savvy and long-term-focused thinking:
"A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it's durable in time -- with the potential to endure for decades. When you find one of these, don't just swipe right, get married."
"Percentage margins are not one of the things we are seeking to optimize. It's the absolute dollar-free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that's something that investors can spend. Investors can't spend percentage margins."
"Selling at low prices may undercut profits, but they create "a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com."
"When forced to choose between optimising the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows."
In Part 2 of this interview, Sanjay Bakshi talks about learning from mistakes, why macro events are hard to predict, the shorter lifespan of an average company in the S&P 500, and more! Click here to read Part 2.