Thoughts on business risk

There are several business models which are seem to be inherently more risky and then there are some businesses which may not be risky to begin with, but changes in industry dynamics can make them risky for some time.

The indian pharma industry seems (atleast to me) to be one such industry. This industry is one of the few industries which is in the process to globalizing. A few years back companies like ranbaxy, Dr reddy’s lab etc got into the mode of releasing generics of blockbuster drugs which were going off patents. I remember distinctly that some of these companies were selling at fairly high PE. The analyst’s could see only a bright future and market was pricing accordingly. To be fair, there were murmurs of litigation risks etc, but somehow that was not visible in the price (with PE of 40 and more).

Later some of these companies had high profile clashes with pharma giants and lost some of the law suits. As a result the stock crashed when the expected payoffs did not materialise. I would look at this strategy of the pharma companies akin to bets in a casino, but where the odds in your favor. What I mean is that the expected payoff is positive in the companies favor, but often some of these bets could fail. So if the market values these companies as if all the bets are going to succeed, then there is a distinct over-valuation. But at the same time, every time a bet fails, if the market prices the company based on the latest failure, then there could be underpricing happening.

The problem (for me only) with the above business model is that I am not able to project the cash flow for such companies as I am not competent to evaluate the odds of success for such bets (investor who can could and should profit from it).

The business risk in the other globalizing star ‘IT services’ seems to be lower as these companies have used mainly labor arbitrage in the initial phases which is a lower risk strategy. However the market recognises that and has bid the stock prices up and so we have a lot of stock related investment risk.

I was have started analysing the textile industry recently. This industry seems to be globalising with the quotas gone. My initial thoughts on the business risk are

• execution risk for some companies. Not all managements have the capability to manage ‘hyper’ (50%+) growth. Look at arvind mills track record in mid to late 90’s. They invested heavily in denim using debt. The denim cycle turned south and this company was left saddled with huge debt


• Commodity nature of the product could result in pricing pressure on an ongoing basis


• Limited leverage with customers – Being a supplier to one of the major retailers will constantly expose these companies to pricing pressure and stiff competiton

Thoughts on business risk

There are several business models which are seem to be inherently more risky and then there are some businesses which may not be risky to begin with, but changes in industry dynamics can make them risky for some time.

The indian pharma industry seems (atleast to me) to be one such industry. This industry is one of the few industries which is in the process to globalizing. A few years back companies like ranbaxy, Dr reddy’s lab etc got into the mode of releasing generics of blockbuster drugs which were going off patents. I remember distinctly that some of these companies were selling at fairly high PE. The analyst’s could see only a bright future and market was pricing accordingly. To be fair, there were murmurs of litigation risks etc, but somehow that was not visible in the price (with PE of 40 and more).

Later some of these companies had high profile clashes with pharma giants and lost some of the law suits. As a result the stock crashed when the expected payoffs did not materialise. I would look at this strategy of the pharma companies akin to bets in a casino, but where the odds in your favor. What I mean is that the expected payoff is positive in the companies favor, but often some of these bets could fail. So if the market values these companies as if all the bets are going to succeed, then there is a distinct over-valuation. But at the same time, every time a bet fails, if the market prices the company based on the latest failure, then there could be underpricing happening.

The problem (for me only) with the above business model is that I am not able to project the cash flow for such companies as I am not competent to evaluate the odds of success for such bets (investor who can could and should profit from it).

The business risk in the other globalizing star ‘IT services’ seems to be lower as these companies have used mainly labor arbitrage in the initial phases which is a lower risk strategy. However the market recognises that and has bid the stock prices up and so we have a lot of stock related investment risk.

I was have started analysing the textile industry recently. This industry seems to be globalising with the quotas gone. My initial thoughts on the business risk are

• execution risk for some companies. Not all managements have the capability to manage ‘hyper’ (50%+) growth. Look at arvind mills track record in mid to late 90’s. They invested heavily in denim using debt. The denim cycle turned south and this company was left saddled with huge debt


• Commodity nature of the product could result in pricing pressure on an ongoing basis


• Limited leverage with customers – Being a supplier to one of the major retailers will constantly expose these companies to pricing pressure and stiff competiton

Warren Buffett on Benjamin Graham

Found the following post on motley fool. I am waiting eagerly for the complete transcript of the Q&A though (emphasis mine)

I recently had the pleasure of taking a large group of students to Omaha for a Q&A with Buffett. When available, I'll post the results of that Q&A if there is any interest here. In the meantime, I thought I'd mention my most memorable take-away from that meeting.A student noted that Buffett has been a much more successful investor than Graham, and yet Buffett attributes much of his success to Graham, why is that?For the first time, I heard Buffett address this issue head on. Buffett said that it's true, Graham never got really rich from investing. Ben was much more interested in ideas than in making money. However, the lessons Ben taught are very profitable (in order):1. Stocks represent part ownership in the business. Before Ben, Warren charted prices and did lots of other silly stuff. Ben's perspective was eye-opening.2. The concept of Mr. Market is vital. The market is very efficient, but not perfectly efficient--and that difference can make you very, very rich. At any point in time, the market price is usually, but not always, appropriate. An intelligent investor is one who can tell the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth.3. The margin of safety concept is also vital. Once an intelligent investor discerns the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth, it becomes important to build in an appropriate margin of safety.These lessons are Graham's most important contribution to Buffett and to you and me. Graham's sensible perspective, combined with Phil Fisher's (and T. Rowe Price's) insights on wonderful companies, has made all the difference for Buffett. If we are paying attention, they can make all the difference for us too.

Warren Buffett on Benjamin Graham

Found the following post on motley fool. I am waiting eagerly for the complete transcript of the Q&A though (emphasis mine)

I recently had the pleasure of taking a large group of students to Omaha for a Q&A with Buffett. When available, I'll post the results of that Q&A if there is any interest here. In the meantime, I thought I'd mention my most memorable take-away from that meeting.A student noted that Buffett has been a much more successful investor than Graham, and yet Buffett attributes much of his success to Graham, why is that?For the first time, I heard Buffett address this issue head on. Buffett said that it's true, Graham never got really rich from investing. Ben was much more interested in ideas than in making money. However, the lessons Ben taught are very profitable (in order):1. Stocks represent part ownership in the business. Before Ben, Warren charted prices and did lots of other silly stuff. Ben's perspective was eye-opening.2. The concept of Mr. Market is vital. The market is very efficient, but not perfectly efficient--and that difference can make you very, very rich. At any point in time, the market price is usually, but not always, appropriate. An intelligent investor is one who can tell the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth.3. The margin of safety concept is also vital. Once an intelligent investor discerns the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth, it becomes important to build in an appropriate margin of safety.These lessons are Graham's most important contribution to Buffett and to you and me. Graham's sensible perspective, combined with Phil Fisher's (and T. Rowe Price's) insights on wonderful companies, has made all the difference for Buffett. If we are paying attention, they can make all the difference for us too.

My investing philosophy

I think it is extremely important to have well defined investing philosophy to guide one’s decisions and to also to keep your head when there is too much fear or greed in the market.

With the Indian market touching new highs everyday, resisting the urge to get on the bandwagon is fairly important. I have had a loosely defined approach with which I have become comfortable both in terms of the risk and the return and most importantly I am able to sleep soundly in the night.

So here goes my personal investing philosophy (in no specific order)

1. Invest in companies with sustainable competitive advantage in my own circle of competence with a time horizon of 3-5 years.


2. Invest in companies where the risk reward ratio is atleast 3:1 in my favor and I have a ‘variant perception’ from the market.


3. Avoid investing based on any macro-economic point of view or short term opinion (mine or someone else) of the market


4. Try to beat the market by 5% over a period of 10 years and lowest possible risk (the key word being try)


5. Avoid loosing money

Thoughts behind each point

1. I feel comfortable investing in a company whose business is simple to understand and preferably will increase its intrinsic value over a period of time. This enable me to practise a buy and hold philosophy


2. I prefer 3:1 odds in my favour and a 40-50% discount from conservatively calculated intrinsic value as it enable me to get an average return of 18% per annum


3. I have avoided investing based on macro-economic point of view or any short term outlook as I am not good at it and consider most of it as noise to be avoided


4. A return of 5% over the market give translate roughly into 17-18% per annum. Not exactly a return which would get me into investing hall of fame, but over a long period of time it is good for me as it comes with low risk


5. Point 5 has meant that I have passed a lot of opportunities which looked good, but were not obvious slam dunks. As a result I have been guilty of omission than commision (though I have had my share of duds)

So how has above philosophy worked for me. I would say pretty well, because I think I have been able to achieve more than my targeted returns with very low risk and most importantly, have been able to sleep well.

Please feel free to share your investing philosophy

My investing philosophy

I think it is extremely important to have well defined investing philosophy to guide one’s decisions and to also to keep your head when there is too much fear or greed in the market.

With the Indian market touching new highs everyday, resisting the urge to get on the bandwagon is fairly important. I have had a loosely defined approach with which I have become comfortable both in terms of the risk and the return and most importantly I am able to sleep soundly in the night.

So here goes my personal investing philosophy (in no specific order)

1. Invest in companies with sustainable competitive advantage in my own circle of competence with a time horizon of 3-5 years.


2. Invest in companies where the risk reward ratio is atleast 3:1 in my favor and I have a ‘variant perception’ from the market.


3. Avoid investing based on any macro-economic point of view or short term opinion (mine or someone else) of the market


4. Try to beat the market by 5% over a period of 10 years and lowest possible risk (the key word being try)


5. Avoid loosing money

Thoughts behind each point

1. I feel comfortable investing in a company whose business is simple to understand and preferably will increase its intrinsic value over a period of time. This enable me to practise a buy and hold philosophy


2. I prefer 3:1 odds in my favour and a 40-50% discount from conservatively calculated intrinsic value as it enable me to get an average return of 18% per annum


3. I have avoided investing based on macro-economic point of view or any short term outlook as I am not good at it and consider most of it as noise to be avoided


4. A return of 5% over the market give translate roughly into 17-18% per annum. Not exactly a return which would get me into investing hall of fame, but over a long period of time it is good for me as it comes with low risk


5. Point 5 has meant that I have passed a lot of opportunities which looked good, but were not obvious slam dunks. As a result I have been guilty of omission than commision (though I have had my share of duds)

So how has above philosophy worked for me. I would say pretty well, because I think I have been able to achieve more than my targeted returns with very low risk and most importantly, have been able to sleep well.

Please feel free to share your investing philosophy

One way of looking at market valuation ?

I have followed a thought process (and here) in terms of looking at market valuation in terms of PE bands. So if the market is below a PE of 12 or below, it likely to be undervalued (odds are favorable for an investor – to the tune of 7:1 or better). At the same time if the PE is more than 20, the market is moving towards overvaluation (unless there is a recession in the economy and earnings are really depressed) and the odds are against an investor (1:3 or worse). However, I found it difficult to form a firm opinion between the above PE levels. The market is typically between these two levels 60-70 % of times and as result I am inactive and not buying an ETF or Index funds. However if the market drops below a PE of 12 or below, I usually start buying actively and if the market goes above a PE of 20, I start a slow liquidation.

I don’t use the above approach to individual stocks, where it is possible for me to have a better idea on whether the stock is over or undervalued (provided the stock is in my circle of competence).

I was pleasently surprised to find the following reply from Warren buffett in his Q&A at Wharton.

I would suggest downloading the Q&A (pdf) and going through the complete transcript for other nuggets of wisdom from buffett.



Q: You made an argument for 7% returns over the next decade in Fortune. Given that (1) profit margins are at least 30% above historical averages, (2) the ratio of prices/GDP is at least 25% above historical averages, and (3) interest rates are ~25% below historical averages, assuming mean reversion, wouldn’t one conclude that while economic earnings growth plus dividends may be 7%, that we are at an unsustainable valuation plateau?


A: We are near the high-end of the valuation band, but not really at an extreme. I have commented on the market 4 or 5 times in Forbes interviews previously (1969, 1974, 1981, and 1977 in Fortune). Most of you can say if something is overvalued or undervalued, you can spot the occasional extreme cases.
There is a big band of valuation and the idea is to calibrate extremes. When I look at a business, I look for people with passion. I can recognize a 98 or a 6, not a 63 (emphasis mine). This rule is good enough in life and investment. You refer to my 2001 article, but returns have not exceeded 7%, so I guess that this is not that precise of a band.

One way of looking at market valuation ?

I have followed a thought process (and here) in terms of looking at market valuation in terms of PE bands. So if the market is below a PE of 12 or below, it likely to be undervalued (odds are favorable for an investor – to the tune of 7:1 or better). At the same time if the PE is more than 20, the market is moving towards overvaluation (unless there is a recession in the economy and earnings are really depressed) and the odds are against an investor (1:3 or worse). However, I found it difficult to form a firm opinion between the above PE levels. The market is typically between these two levels 60-70 % of times and as result I am inactive and not buying an ETF or Index funds. However if the market drops below a PE of 12 or below, I usually start buying actively and if the market goes above a PE of 20, I start a slow liquidation.

I don’t use the above approach to individual stocks, where it is possible for me to have a better idea on whether the stock is over or undervalued (provided the stock is in my circle of competence).

I was pleasently surprised to find the following reply from Warren buffett in his Q&A at Wharton.

I would suggest downloading the Q&A (pdf) and going through the complete transcript for other nuggets of wisdom from buffett.



Q: You made an argument for 7% returns over the next decade in Fortune. Given that (1) profit margins are at least 30% above historical averages, (2) the ratio of prices/GDP is at least 25% above historical averages, and (3) interest rates are ~25% below historical averages, assuming mean reversion, wouldn’t one conclude that while economic earnings growth plus dividends may be 7%, that we are at an unsustainable valuation plateau?


A: We are near the high-end of the valuation band, but not really at an extreme. I have commented on the market 4 or 5 times in Forbes interviews previously (1969, 1974, 1981, and 1977 in Fortune). Most of you can say if something is overvalued or undervalued, you can spot the occasional extreme cases.
There is a big band of valuation and the idea is to calibrate extremes. When I look at a business, I look for people with passion. I can recognize a 98 or a 6, not a 63 (emphasis mine). This rule is good enough in life and investment. You refer to my 2001 article, but returns have not exceeded 7%, so I guess that this is not that precise of a band.

My hurdle rate for active investing

I use a hurdle rate which I need to cross if I need to justify the time and effort I spend on investing actively, rather than using a mechanical approach of rupee cost averaging (using an ETF or an index fund)

A rupee cost averaging approach of investing Rs 1000/- per month, every month for the last 10 years would have lead to an average return of around 15% per annum (As an added factor, I added a filter of stopping the plan when the market P/E exceeded 25. I added this filter to ensure that I would avoid putting money in the market when the market seemed overpriced by a decent margin).

This strategy would work even better with a mutual fund with a good long term record of beating the market by a resonable margin (resonable being +3% above market return over a period of 5 years or more).

So in effect if the portfolio of stocks picked by me, does not exceed this hurdle rate of 15% per annum (for a rolling cycle of 5 years and not for every year), then it would not justify the time and the effort.

Luckily till date I have exceeded this rate. But the results are not conclusive, because it could be due to dumb luck. I would consider the results to be conclusive only if I can achieve this kind of outperformance for a period of 10 years or more.

My hurdle rate for active investing

I use a hurdle rate which I need to cross if I need to justify the time and effort I spend on investing actively, rather than using a mechanical approach of rupee cost averaging (using an ETF or an index fund)

A rupee cost averaging approach of investing Rs 1000/- per month, every month for the last 10 years would have lead to an average return of around 15% per annum (As an added factor, I added a filter of stopping the plan when the market P/E exceeded 25. I added this filter to ensure that I would avoid putting money in the market when the market seemed overpriced by a decent margin).

This strategy would work even better with a mutual fund with a good long term record of beating the market by a resonable margin (resonable being +3% above market return over a period of 5 years or more).

So in effect if the portfolio of stocks picked by me, does not exceed this hurdle rate of 15% per annum (for a rolling cycle of 5 years and not for every year), then it would not justify the time and the effort.

Luckily till date I have exceeded this rate. But the results are not conclusive, because it could be due to dumb luck. I would consider the results to be conclusive only if I can achieve this kind of outperformance for a period of 10 years or more.

The World According to "Poor Charlie"

Found this great interview with charlie munger. Some interesting excerpts from the interview

How much of your success is from investing and how much from managing businesses?
Understanding how to be a good investor makes you a better business manager and vice versa.
Warren's way of managing businesses does not take a lot of time. I would bet that something like half of our business operations have never had the foot of Warren Buffet in them. It's not a very burdensome type of business management.
The business management record of Warren is pretty damn good, and I think it's frequently underestimated. He is a better business executive for spending no time engaged in micromanagement.

Your book takes a very multi-disciplinary approach. Why?
It's very useful to have a good grasp of all the big ideas in hard and soft science. A, it gives perspective. B, it gives a way for you to organize and file away experience in your head, so to speak.

How important is temperament in investing?
A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.

How should most individual investors invest?
Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund. I think that works better than relying on your stock broker. The people who are telling you to do something else are all being paid by commissions or fees. The result is that while index fund investing is becoming more and more popular, by and large it's not the individual investors that are doing it. It's the institutions.

What about people who want to pick stocks?
You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge.

What do you think of the efficient market theory, which holds that at any one time all knowledge by everyone about a stock is reflected in the price?
I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don't think it's totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It's efficient enough, so it's hard to have a great investment record. But it's by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

What would a good investor's portfolio look like? Would it look like the average mutual fund with 2% positions?
Not if they were doing it Munger style. The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?

Should people be investing more abroad, particularly in emerging markets?
Different foreign cultures have very different friendliness to the passive shareholder from abroad. Some would be as reliable as the United States to invest in, and others would be way less reliable. Because it's hard to quantify which ones are reliable and why, most people don't think about it at all. That's crazy. It's a very important subject. Assuming China grows like crazy, how much of the proceeds of that growth are going to flow through to the passive foreign owners of Chinese stock? That is a very intelligent question that practically nobody asks.

Ibbotson finds 10% average returns back to 1926, and Jeremy Siegel has found roughly the same back to 1802.
Jeremy Siegel's numbers are total balderdash. When you go back that long ago, you've got a different bunch of companies. You've got a bunch of railroads. It's a different world. I think it's like extrapolating human development by looking at the evolution of life from the worm on up. He's a nut case. There wasn't enough common stock investment for the ordinary person in 1880 to put in your eye.

The World According to "Poor Charlie"

Found this great interview with charlie munger. Some interesting excerpts from the interview

How much of your success is from investing and how much from managing businesses?
Understanding how to be a good investor makes you a better business manager and vice versa.
Warren's way of managing businesses does not take a lot of time. I would bet that something like half of our business operations have never had the foot of Warren Buffet in them. It's not a very burdensome type of business management.
The business management record of Warren is pretty damn good, and I think it's frequently underestimated. He is a better business executive for spending no time engaged in micromanagement.

Your book takes a very multi-disciplinary approach. Why?
It's very useful to have a good grasp of all the big ideas in hard and soft science. A, it gives perspective. B, it gives a way for you to organize and file away experience in your head, so to speak.

How important is temperament in investing?
A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.

How should most individual investors invest?
Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund. I think that works better than relying on your stock broker. The people who are telling you to do something else are all being paid by commissions or fees. The result is that while index fund investing is becoming more and more popular, by and large it's not the individual investors that are doing it. It's the institutions.

What about people who want to pick stocks?
You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge.

What do you think of the efficient market theory, which holds that at any one time all knowledge by everyone about a stock is reflected in the price?
I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don't think it's totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It's efficient enough, so it's hard to have a great investment record. But it's by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

What would a good investor's portfolio look like? Would it look like the average mutual fund with 2% positions?
Not if they were doing it Munger style. The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?

Should people be investing more abroad, particularly in emerging markets?
Different foreign cultures have very different friendliness to the passive shareholder from abroad. Some would be as reliable as the United States to invest in, and others would be way less reliable. Because it's hard to quantify which ones are reliable and why, most people don't think about it at all. That's crazy. It's a very important subject. Assuming China grows like crazy, how much of the proceeds of that growth are going to flow through to the passive foreign owners of Chinese stock? That is a very intelligent question that practically nobody asks.

Ibbotson finds 10% average returns back to 1926, and Jeremy Siegel has found roughly the same back to 1802.
Jeremy Siegel's numbers are total balderdash. When you go back that long ago, you've got a different bunch of companies. You've got a bunch of railroads. It's a different world. I think it's like extrapolating human development by looking at the evolution of life from the worm on up. He's a nut case. There wasn't enough common stock investment for the ordinary person in 1880 to put in your eye.