Category: Mental Models

The agony of rising prices

Even if you are barely active in stock markets , whatsapp messages like below of technology stocks hitting all time high and making 5X or 10X in a year would be coming to you. This is in a year when we are in middle of a global pandemic

Value investors are simply downplaying the fact by calling it as 2000 internet bubble phenomenon and are not participating .

However I reckon that we are trying to fit square pegs (traditional linear models) in round holes (solving Non linear problems)

Evolution has taught us to think in terms of linearity

If you’re still having trouble grasping this, it’s not your fault. Decades of research in cognitive psychology show that the human mind struggles to understand nonlinear relationships. Our brain wants to make simple straight lines. In many situations, that kind of thinking serves us well: If you can store 50 books on a shelf, you can store 100 books if you add another shelf, and 150 books if you add yet another. Similarly, if the price of coffee is $2, you can buy five coffees with $10, 10 coffees with $20, and 15 coffees with $30.

Source – HBR

Drawing … Read the rest

MOIL – Debt Capacity Bargain ?

The rest of post is inspired by and adapted from this wonderful post on debt capacity bargains by Prof Sanjay Bakshi.

MOIL, a Mini Ratna, is India‘s largest  producer of manganese ore accounting for ~50% of the country’s total output. At present, MOIL operates 10 mines, six located in the Nagpur and Bhandara districts of Maharashtra and four in the Balaghat district of Madhya Pradesh. All these mines are about a century old. Except three, rest of the mines are worked through underground method.

MOIL is a debt free company, here is a snap shot from 2014-15 annual report

MOIL-1

How much money would you lend to MOIL against the security of its business ?

 

Other things remaining unchanged, it’s prudent to lend to large companies whose businesses are not cyclical. If a business is cyclical, then a prudent banker would not depend on peak earnings. Rather, he would compute average past earnings and then ask for a higher interest cover on those earnings than would have been the case if those earnings were not cyclical. ~ Sanjay Bakshi

 

Earnings of MOIL are not stable and dependent of future of steel industry and we know that the steel … Read the rest

Learn to evaluate management

Evaluating management is one of trickiest part while building an investment case. Especially, when it comes to small caps and mid cap companies run by first or second generation promoters, were much information about them in not available publicly.

Also many of retail investors don’t have privilege to meet management, time to attend AGMs and question management over quarterly conference calls (if they do). So how does one evaluate management ?

Well I don’t have a panacea but in this post we will try an establish a process which can give us reasonable ammunition to understand and evaluate management. As an investor you start with a hypothesis that management is honest, able, trustworthy and intelligent and then as you run a series of checks, you may find that one or more components you wished for are missing therefore at the end of checks you can take a call whether you want to partner with such management or not.

While there are numerous parameters which you can use to evaluate management quantitatively we believe below are good for a start

  1. Depth
  2. Integrity
  3. Disclosure Norms
  4. Compensation
  5. Skin in the Game
  6. Regulatory compliance issues
  7. Walking the talk

 

Depth – While evaluating depth … Read the rest

Why Paying up can cost you – Analysis using payback box

Motilal Oswal wealth studies are great source of learnings for any investor, They adopt a unique approach of taking up a theoretical concept every year and then explain it through numbers.

In year 2000, they introduced a concept called payback period, this is what the study said

Focus on payback period

As the legendary Warren Buffett says, “Investing is laying out money now to get more money back in the future in real terms, after taking inflation into account”

Generally, it is observed that market price is often based on the assumption that earnings will grow at their current rate for another five or more years and then remains constant

P/E is a very useful tool of valuation but does not reflect growth assumption upfront

PEG is another useful tool but assumes stable growth rate for a long time. It also relies too much on current growth rates. But the reality is that new economy companies record high growth rates in the initial stages, but are unable to sustain for a long period. This leads to mis-pricing

Keeping the above shortcomings and market wisdom in mind, we decided to examine the concept of “pay-back ratio” or “purchase price recovery in

… Read the rest

Understanding business Models

Over last few weeks, I have started reading an excellent book on business models – Business Model Generations – A handbook for Visionaries, Game Changers and Challengers – This book is must read for all buddying investors

The book is logically structured right from providing canvas for depicting business models of the company then moving on to patterns, design and strategy

BM-1

I will do few posts on the book as there is enormous ground to be covered, In this post focus would be on what authors call as building business model canvas using key nine building blocks

A business model describes the rationale of how an organization creates, delivers and captures value

There are nine building blocks of a business model – While at first I found this to be another fuzzy MBA thing which has lot of academic value but no practical value 🙂

However once I started practising it and drew the canvas of a business which I thought I knew, I realised that there were quite a few areas of business were I had little or no knowledge, This was truly an humbling experience

Let’s first understand what are the key nine building blocks (Note most is … Read the rest

Why sitting on your ass works in Investing

In my last month’s newsletter, I briefly touched upon deliberating on idea of selling and not holding stocks at over stretched valuation

Charlie Munger says ,

Investing is where you find a few great companies and then sit on your ass

Fisher famously stated that

the time to sell a stock is almost never if the right kind of company is purchased after extensive research and analysis

Another theory could be that I am operating under disposition effect i.e. instead of looking at the overall portfolio performance, I am looking to gain from every stock. This narrow framing leads to selling winners and holding onto losers, I partially mitigated this by always looking for performance at portfolio level rather than at individual level

Also, it’s painful to sell winners too early. If they really skyrocket

See how some of our exited positions have sky rocketed in this bull run

Sitting-1

My investing philosophy is also evolving, I liked what Buffet wrote in 1967 letter

sitting-2

My logic was that for a small portfolio, this is the best way to gain size, i.e. buy things at attractive prices and then resell them when price catches up and keep doing this till portfolio attains … Read the rest

What is maintenance Capex ?

Let me share the story of Jenny and her lemonade stand

If you are unable to read post click this link

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Other good articles on the subject

1 and 2

Images – Google image search… Read the rest

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Understanding Pricing Power

What is pricing power ?

A simple question from Prof Sanjay Bakshi on Twitter got a gamut of responses from his legion of followers, Don’t miss the entire discussion here

I have tried to penned down my understanding in form of few questions hope they help you next time when you are evaluating a business

When you think of Pricing Power

What’s obvious ?

When a company has following attributes

  1. Easily pass on increases in costs to customers without having volume declines
  2. Strong brands and customer loyalty allowing company to charge premium price over competitors
    1. Pricing power is when you can sell $120 phones(manufacturing cost) to people at $650 just because you are Apple
    2. Making/marketing a product that is so loved by customers that they find ‘value’ even at increased prices
  3. The ability to increase the prices of your product without losing market share to competition
  4. Ability to price ahead of inflation
  5. When elasticity of demand of your product is not price sensitive

What’s not so obvious ?

  1. Pricing power isn’t just about increasing prices of your OUTPUT .It’s also about lowering prices of your INPUTS
  2. Pricing power is not just about RAISING prices. It includes power to CUT prices,

… Read the rest

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Learn how to Dissect RoE

There is almost a unanimous agreement in investment community that RoE is an important indicator of health of a company, High sustainable ROE implies sustainable competitive advantages and hence investment attractiveness of the company

Sustainable is a key word here so always execute ROE analysis for at least 5 years if not 10 years to arrive at a conclusion

DuPont comes in handy to break down ROE, I will not go into details of DuPont , you can read this article to get yourselves accustomed to DuPont

You can use Tankrich Valuation Tool to do DuPont analysis in 5 mins, post analysis how do you dissect RoE ?

This will be largely dependent on how familiar you are with operations of the company and industry, We will take a case today and see if we can put together a generic framework for dissecting RoE

Friends this is going to be a long post so take out your pen, paper, food and time and lets dig in. The company that we will use as case is Ajanta Pharma

The RoE for last 5 years has been ..

roe-1

Fantastic improving from 16% to 41%

The frame-work that we are going to use … Read the rest

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Use earnings framework to find great business

One quote is copy pasted on my desktop as a sticky note and I read it every time I look at new investment opportunity

What to look for in a great business?

A high return on capital (not contributed by a very low margin operation where margins could fall) which is sustainable – pricing power, low cost advantage etc. Ability to deploy incremental capital at high rates of returns i.e. growth prospects. Ability to self-fund growth – Prof Sanjay Bakshi

A useful way to start would be to create a framework that can help us identify great businesses. Let’s try to build a framework by analysing earnings of company as in long run it is earnings which drive stock prices

But how do we analyse earnings of the company? I use a triangular approach

Determine the authenticity of Earnings – To ensure an accountant is not cooking the books and accrual earnings reported by company are authentic

Composition of Earnings – A simple DuPont break down of ROE to determine sources of a company’s return on equity. This would help us understand what contributes to high or low return on capital

Source of growth of Earnings – Understanding what factors … Read the rest