Prof. Bakshi is one of most revered names in the investment industry. He doesn’t speak about investment returns nor does he engage with business media. On the contrary, a student of stock market attending his lecture often is enlightened with learnings from Warren Buffet, Charlie Munger, Ben Graham, Philip Fisher and other great investors around the World. It’s the uncanny ability to apply those learnings and making them super easy for audience to understand those learnings that leaves a lasting impression.

The lecture was titled – The Evolution of a Value Investor that took place on Sunday, February 23, 2020. Prof. Bakshi spoke about his 25 years and constant evolving value investment framework. The focus was on 2 names that redefined his investment ideology whose ideas most of us are following in some way or other.

1. Ben Graham
2. Philip Fisher

Prof. Bakshi started his session by speaking about Ben Graham where he highlighted his learnings from Special Situations and Bargain Securities. 

In the 3^rd edition of Securities Analysis, Ben Graham has written an essay about Special Situations which entails as betting on happening or non-happening of a corporate event such as merger/demerger, bonus, rights issue, etc.

Features of Investment in Special Situations

• Great Returns 

There is a possibility of getting a 40 to 50% return in less than 1 year by investing in such news based activities.

• Uncorrelated Returns

In a normal investment framework, one is worried about market risk. Whereas in Special Situations framework, event risk is far more important than market risk.

• No need for predicting future fundamental performance

• Lots of fun

It’s definitely a lot of fun when there is a chance of making a quick buck in a limited time frame. Kind of gives a dopamine effect to the brain.

Since these situations seem like a low hanging fruit on a tree for most investors. It’s very easy to copy and replicate an almost similar performance. Hence, over the years a lot of things happened.

• Competition Caught Up

The arrival of arbitrage funds in the mutual fund category was a game changer in the industry. These funds were created for exactly the same purpose. With more money pouring in, prices shot up quickly and the returns on these special situations came down.

Another reason was that there were no entry barriers to invest in such kind of events. Not as if one needed an intellect or patience of Warren Buffet. These were just low hanging fruits which everyone could see how to make money from.

• Patsy in the Game

Patsy is made in reference to a dumb guy who doesn’t know what’s happening. As Warren Buffet says, in the game of bridge – if you can’t figure out who is the patsy in the game then it’s probably you. 

Special Situations are all about information asymmetry, where one person has a little more information about the company than the other. Since, this little edge can give huge rewards but being on the wrong end, might also make you a patsy in the game.

• High IRRs, Low Wealth Creation

To create sustainable wealth, money should remain invested in the business for long periods of time. Investing in such situations may result in high internal rate of returns (IRRs) but since cash remains idle for most part of the year, it results in low wealth creation for investors.

• Trying to predict the behavior of other investors

In the subject of Behavioral Finance, we learn that it’s impossible to predict the behavior of masses or crowds.  Most investors have lost a lot of money doing the same. However, the paradox of investing in special situations is that constantly we are trying to predict the behavior of other people.

Rumors spread around quickly which affects our conviction. Other than investors, sometimes even regulators or governments play some spoil sport. This drives down our profits. It’s a struggle to accurately predict the behavior of others accurately, all the time.

• Errors of Omission

There are a lot of moving parts in the deal. Such as some court cases going on a particular project, some corporate governance issue which has not come to light as yet but can come into news anytime, etc. These sort of issues are very hard to focus on from a 6 month to 1-year perspective and hence it removes our focus on compounding our capital for long periods of time.

What Ideas should be discarded from Special Situations

1. Short Term Thinking
2. Dependence of Returns on the Behavior of Other People.

Ideas to be implemented

1. The Idea of Upside Potential v/s Downside Risk

In certain special situations, there is a tremendous upside potential with limited downside risk. This happens when a company demerges or spins off a non-profitable unit or sells it to someone which unlocks hidden value of the company.

• Taking Advantage of Market Over-reaction to Adverse Events

Demonetization is an adverse event where markets over-reacted to a lot of things. When money comes back into banks as deposits, it makes a bank healthy which is good for the economy in the long term. But in the short term, markets tanked giving pockets of opportunities.

• Importance of Reinvestment Risk

In special situations, cash is lying idle to wait for the next big idea to jump in. There is little chance for that reinvestment to work in exactly the same way or even better. There can be times where money is lost which brings down the overall return on investment for the year.

Prof. Bakshi then went on to speak about Bargain Securities, something that Ben Graham is famous for and which even Warren Buffet used to practice in his early days.

Features of Bargain Securities of Ben Graham 

• Low Price as your friend

Earning power yield which is the opposite of price to earnings multiple should be more than prevailing bond rate. Using this multiple, Graham would figure out whether the price is low or expensive.

• Low price in relation to average past earnings power

There can be situations where current earnings are low but the average past earnings are higher. The reason for low current earnings could be some short term bad situations. In such a scenario, usually price is down due to disappearance of earnings. Bet here is that the earnings will one day go up.

• High Dividend Yield

• Low Price in Relation to Asset Value

• Low Priced Common Stock

• High Cost Producers & Leverage

A way to think about this is a stretch rubber band that comes back to normal shape once it’s released. When commodity prices go up, Graham advocates investing in high cost producing companies. 

For example, when steel prices go up buy a high cost producer of steel. When the cycle turns, there is a disproportionate impact on profits. Because revenue numbers go up, while input costs remain same. So there are good operating profits generated which help in paying out interest costs on debt. This pushes the Net profits upwards and so does Earnings per Share (EPS) hence the rubber band was stretched with low EPS which is now coming back to normal.

• Relatively Unpopular Large Companies

Problems in Bargain Investing

• Value Traps

Investors should always keep in mind the golden rule – stocks are sometimes cheap for very good reasons. Such as bad management quality, shady promoter activity, bad balance sheet quality, etc.

• Errors of Omission

Since, the focus is too much on bargains, an investor tends to miss out on compounders. Sometimes they just don’t pay up for quality businesses looking for bargains. Charlie Munger changed this behavior of Warren Buffet in the late 1980s after which Berkshire bought a good stake in Coca Cola.

• Selling a good business too early

As there is no effort to work on quality of the business. An investor tends to exit the stock once the bargain is over. This is a lot more painful when the stock continues to climb upwards even though there is no perceivable bargain in the framework.

• Need for constant monitoring

80 to 100 stocks are difficult to monitor. Especially with so many moving parts. The constant buying and selling often disrupts the long term wealth creation aspect.

Common Factor in Graham’s Stock Philosophy 

Mean Reversion (Apna Time Aayega)

Bad periods will be followed by good periods.

Other Aspects of Graham’s Philosophy

• Relatively Small Holding Periods

• High Degree of Diversification

Looking for statistical good bargains. Hence, the portfolio is diversified upto 80 to 100 stocks in such situations.

• Earnings Power Growth as a Speculative factor

• Protection v/s. Prediction

Pain won’t last forever. Hence, protection from volatility is countered by wide diversification.

After an extensive discussion on Graham’s philosophy, Prof. Bakshi spoke about the second most influence in his life as a value investor – Philip Fisher. As he had spent a lot of time focusing on Graham’s philosophy, he went through a few things about Fisher very quickly. Fisher is completely opposite to Graham. He loves good companies that keep on compounding at decent rates for long periods of time. The idea of concentrated portfolio emerges from Fisher’s philosophy which our readers will discover further.

Key Features of Fisher’s Investment Philosophy

• Growth

Contrary to bargain companies whose prices are low for a specific period of time, Fisher speaks about investing growth companies that will compound its earnings over long periods of time.

• Innovation

Companies that innovate in various production processes that are usually hidden from its competitors are companies that possess strong growth over long periods.

• Low Dividends

Companies that use money in good IRR projects rather than distributing them as dividends.

• High Profitability

• Self-Funding Growth

EPS of the company that keeps on growing.

• Entry Barriers

• Management Quality

• Paying up for Quality 

Price in relation to future expected earning power of the company. Graham pays for price in relation to current earnings of the company. Another opposite feature.

• Low Diversification

Less than 10 stocks which is completely opposite to 80 to 100 stocks of Graham.

• Very Long Holding Periods

Common Factor in Fisher’s Investment Philosophy

Fundamental Momentum (Abhi toh party shuru hui hai!)

Things are good, they are going to get better.

Benefits of following Fisher’s Philosophy

1. Slowing down by making fewer decisions
2. Appreciation of qualitative factors
3. Freeing up time

Downside of following Fisher’s Philosophy

1. Overconfidence was costly.
2. You could go wrong as management quality may change after purchase of stock or you can go wrong about the future earnings power
3. No return for 10 years
4. Business maybe very good when purchased but then story changes.

Ideas from Fisher to accepted in the portfolio

1. Fundamental Momentum
2. Paying up for quality with a caveat

Discarding ideas from Fisher

1. Very long holding periods: As business cycles are getting shorter due to tech disruptions
2. Extremely concentrated portfolios

Adding more ingredients by Prof. Bakshi on his portfolio

• Different perspective on diversification

Having a focused portfolio of 15 stocks at max. in the portfolio.

• Anti-fragility (Desirable)

Pain of others is a blessing for you. Because they did some dumb things which you didn’t.

• Earnings power v/s Reported Earnings and Owner Earnings v/s Reported Earnings

Graham v/s. Fisher

Both ideologies are right but the tools are different. People get into trouble when they mix up both these ideologies. Example, Graphite story was of Mean Reversion and people confused it for Fundamental Momentum.

Synthesis between Graham and Fisher

• Mean Reversion: In the long term, it’s a very powerful force.

• AAA Bond Yield as a key mental construct

Suppose if the AAA bond purchased for Rs. 100 yields 10% interest, then an investor makes Rs. 10 (pre-tax) each year. This should be seen as an indicator of business’s earnings growth that should happen more than AAA Bond Yield so that the investor is better off purchasing equities of a business.

• Earning Power Growth as a speculative component

The approach here is for an earnings power growth of a stock is when the market thinks it will shrink and all it has to do is not shrink. And then when it grows, it makes a lot of money for investors. Return on investment will come from growth.

Benefits of treating Earnings Power Growth

1. No longer required to make elaborate projections about quantum and timing of growth.
2. As multiple re-ratings are not in our control.
3. If a large part of an excellent return has come from P/E multiple expansion as opposed to earnings power growth, then at some point stock will get vulnerable.
4. Because you are reasonably diversified, hopefully you won’t get it wrong in every security in the portfolio.
5. Protection v/s Prediction
6. Focus on Portfolio’s Earnings Power Growth and not individual stocks.
7. Buy high growth, high P/E stocks with moderation of risk.

The closer you are at the portfolio level to a AA Bond Yield Earnings, the more protected your portfolio will be from value impairment.

Discarding Ideas

1. Low price can compensate for poor quality
2. Too much diversification

End of Presentation

Then came the Question and Answer session where Prof. Bakshi was very open about his views on NBFCs and PSUs. He sees pockets of opportunities there. To a peculiar question of a largest private bank, Prof. Bakshi candidly mentioned that there are several ways of making money but very few ways blowing it up. An investor should study of how businesses blow up as there are hidden markers everywhere before such an event unfolds.

We thoroughly enjoy such knowledge sessions from veteran investors. Investment industry pays its deepest respect to investors such as Prof. Bakshi who come out and pour gold to others by sharing their knowledge, wisdom and practical application without having any second thoughts. It’s our constant endeavor to spread such pearls of wisdom with our readers, this Thursday Trivia is dedicated to Prof. Bakshi.

– Jinay Savla