Tag Archives: family

Value Investor Interview: Samit Vartak

I recently interviewed Samit Vartak of SageOne Investment Advisors for my premium newsletter, Value Investing Almanack. Samit is one of the founding partners and Chief Investment Officer at SageOne, and is responsible for ensuring SageOne’s adherence to its core investment philosophy and discipline of risk management. As you would read in the interview below, Samit believes in risk management not by seeking extreme diversification or buying sub-par businesses at low multiples, but by building a reasonably diversified portfolio of high quality businesses having long term competitive advantages in attractive and high growth industries. Samit returned to India in 2006 after spending a decade in the US working initially in corporate strategy with Gap Inc. and PwC Consulting, and then with Deloitte and Ernst & Young advising companies on business valuation and M&A. This experience forms the backbone that helps him better understand businesses and their fair value. Samit is a CFA® charter holder, an MBA from Olin School of Business of the Washington University in St. Louis and holds a Bachelor of Engineering degree with Honors from Sardar Patel College of Engineering, Mumbai University. In his interview with Safal Niveshak, Samit shares his wide investment experience and how small investors can practice sensible investment decision making. Safal Niveshak (SN): Could you tell us a little about your background, how you got interested in value investing? Samit Vartak (SV): I come from a village named Mahim which is along the Konkan coast about 100 km north of Mumbai. My father is a farmer, who does that for living even now. As a kid I grew up on the farm and studied there until the 10th standard after which I came to Mumbai for higher education and completed my engineering. Financially, my father had to struggle immensely to educate me and my two younger brothers from his illusive farming income. Experiencing and living through my family’s struggle for money is the background that has influenced my investment style. After working with Mahindra and Mahindra for 3 years, I received scholarship from a prestigious US university to pursue an MBA for which I left for the US in 1997. Post MBA, I worked in the US until 2006 with the likes of PwC Consulting and Deloitte Financial Advisory Services. Half of my US experience was in Management Consulting, advising companies on improving operational efficiency, business processes and strategy. The other half was as a valuation professional advising PE/VC funds and corporates on valuations for their investments and M&A. This experience has helped me with the two most important aspects of investing – understanding businesses and understanding fair valuation for them. I caught the stock market bug in 1999 at the peak of the dot com bubble when making money had become very easy. This was the time when I followed exactly what is currently in my “what not to do” list as an investment process. I followed analyst recommendations, looked at simple valuation metrics such as PE ratio/PEG ratio, believed in forecasted numbers of analysts, and invested in companies where buy recommendations were the highest. No surprise that as the markets peaked, I started losing money and to recover my losses quicker I used derivatives/margin money and the result was that by 2001 my entire portfolio was wiped off. I cannot describe the agony that I went through in losing all I had earned and especially given my family’s financial struggle during my childhood. The guilt of wasting money which would have been so valuable for my family back home left such an indelible mark on me that I took a break from investing to introspect my mistakes and learn before investing again. That was the turning point and blessing in disguise in my investment journey. To further my learning, I decided to enroll for becoming a CFA (Chartered Financial Analyst) wherein I really learned the fundamentals and theory behind investing. I read about different investment styles, about experiences and methods used by successful investment gurus and tried to figure out what suits me and my temperament. My ultimate goal was to develop an investment style in which protecting capital was the primary goal and return on capital was a secondary goal. Currently I am the CIO and cofounder of SageOne Investment Advisors LLP, wherein we advise an offshore fund and few large domestic HNIs. We are three partners (Kuntal Shah and Manish Jain being the other two) who have been working together for the past 8+ years. SN: Pretty inspiring journey you have had, Samit. Thanks for sharing that. How have you evolved as an investor and what’s your broad investment philosophy? Has your investment policy changed much through the years? SV: Before talking about the evolution of my investment philosophy, let me start with our current investment philosophy we employ at SageOne. My personal portfolio replicates that of the clients’ and hence the philosophy is common. My path from engineering to business consulting to valuation professional to becoming a fund manager has been different and long compared to most and my philosophy has evolved accordingly. When you look at a business and if you get a feeling “I wish I owned this business”, that’s the kind of businesses we are looking for. We look for a business with long-term competitive advantage, in a stable industry, that has a huge and growing market for its products/services. If a business is inferior, then the price of the stock does not matter and it would not interest us. For improving the probability of finding such businesses, you need to focus on the right sectors. To put it other way, if you want to find the best marathon runner, first you need to know the right countries to focus on. Focusing on the right sectors is half the battle won in finding the right companies. I have written in detail regarding our philosophy and process on our website as well as in our quarterly newsletters found on the website. During my initial years, my sequencing was the other way around. Cheap valuation was the primary focus and then came the business. I would say, that has been the biggest change over the years and this has changed the downside risk profile associated with investing for me. SN: Apart from managing your own money, you are also managing others’. So, how is it being a money manager, especially during the extreme situations – euphoria or market crashes? How do you keep yourself sane when dealing with clients with undue expectations? SV: As an advisor or a money manager, choosing the right clients is extremely important. We are extremely choosy when it comes to accepting clients. You don’t want investors who would call you each time the market is down few percentage points. You want to make sure that the investor is sophisticated enough to understand the risks associated not only with equities but more importantly with the manager’s investment strategy. This is easier said than done, but continuous education of the clients regarding the risks and returns definitely has helped us. I came back to India in 2006 and it took me a while to get comfortable with investing in India and understanding the business environment here. Until then, I was just managing my own money to make sure I don’t use clients’ money for my education. I started advising external money only in April 2012. I think it’s very easy in this field to become insane with the kind of information overload with respect to global risks, industry risks, company risks, management risks and a never ending list. I moved to Pune in 2008 to stay away from market noise in Mumbai. Too much interaction with fellow investors can lead to diverting your focus from finding strong businesses to things like global macro, short term trends/changes in some industries, etc. SN: Choosing your clients well is a very important lesson for future money managers I believe. This is exactly what Rajeev Thakkar of PPFAS Mutual Fund told me when I interviewed him a few months back. Anyways, what has been the best and worst times in your experience as a money manager? How did you handle, say, a situation like 2008? SV: Given that I started advising external money only 4 years ago, the best times were 2011 to 2013 period when the expectations of most investors from India were so low that it reflected in the valuations of companies and one could pick really strong businesses at really attractive valuations. Last couple of years have been the really tough, since nothing really changed in India on the ground but the expectations from the new government went through the roof. In fact, the valuations rose when earnings were coming down in reality with global environment worsening. I have done a detailed analysis of the situation and the risks in my latest newsletter . As far as 2008 goes, it was period when I was managing my own money. One can’t escape the carnage if you are a long only investor in such periods, but what saved me relatively was the cash levels I maintained. I track valuation multiples and margins at sector levels over a long period of time. I try to keep cash levels based on risks associated with the current absolute valuation multiples as well as my assessment of sustainability of current margins. In 2008, the P/E multiples as well as profitability were at all-time highs and the Indian market faced dual risk of not only the P/E multiples contracting but also the net profit margins contracting to a more sustainable level. Assuming that the P/E multiples as well as margins would contract to the mean levels, P/E faced downside of 40% and net profit margins downside of 24% with combined downside risk of 55% which unfortunately for everyone more than played out. I have presented a detailed analysis on this in our July 2015 and October 2015 newsletters if anyone is interested in historical levels. SN: Good that you talked about the idea of sitting on cash when there is a dearth of opportunities, or when you find things heated up. For most investors, it is a painful decision i.e., not doing anything with cash and sitting tight on it especially for a longer period of time. What would you advise other investors, and especially money managers, on how to remain liquid when the situation demands and while defying the steady drumbeat of performance pressures? SV: It’s much easier for an individual investor to remain liquid as he is not answerable to investors. For a fund manager, it’s a very complicated situation with uncertainty of markets. If you are sitting on high levels of cash because you believe that the valuations are high and the markets are risky, the market can continue its uptrend for much longer and each such month can be extremely painful to watch. You may be eventually right, but answering questions of investors who are paying the opportunity cost can be frustrating and with that building pressure you may end up deploying that cash at higher levels. Opportunity cost is extremely difficult to handle even for the best of investors. See how even Stanley Druckenmiller flip flopped during the dotcom bubble. Even Warren Buffett was written off as past during that period since he stayed away from the best performing sector. I believe that you have to lose the small battles to win big in the long term and patience is the key. Investment is a test match. I invest my money the same way I advise our clients and if I personally find it risky to be fully invested, how can I take the risk with clients’ money? SN: Great thought! Anyways, what are some of the characteristics you look for in high-quality businesses? What are your key checklist points you consider while searching for such businesses? SV: As I have said before, the starting point for finding a high-quality business is to finding a high-quality sector. I am very numbers oriented and love tracking and analyzing various metrics at sectoral levels. You can’t judge a sector by looking at short term performance but evaluating how it did during couple of down cycles. As a process we have broken down the top 1,600 companies in terms of market cap into sectors. For each sector we evaluate parameters such as sustainable profitability (ROE/ROCE), volatility in margins, leverage, topline growth and cash generating history. Based on these, we had shortlisted top sectors and about 300 companies within those. Next step was to painstakingly look at each company to eliminate companies having history of bad corporate governance, loose/questionable accounting policy and inefficient capital allocation. Post this we came to our “fishing pond” of about 150 companies. Out of these strong businesses we look for companies that, based on our analysis, have potential to grow topline at more than 20% (ideally > 25%) with sustainable net margins over a 3-5 year period. Generally, 20-25% growth isn’t easy for companies when the nominal GDP is around 14%. The only way it’s possible is if the company can capture market share from unorganized players or public sector competitors or organized private competitors within the country or from competitors in other countries if export oriented. So we consciously look for such enablers of growth. SN: Nice process I must say. Well, if it’s possible, can you suggest a few sectors/industries you find appealing (based on their past performance and future prospects)? SV: Sectors such as building materials where the unorganised segment is huge (70%+ in some industries) and where brand is still valued by customers is appealing. Even batteries segment has a big unorganized segment and it’s a consumable, so demand isn’t cyclical and relatively less affected by capex cycles. I prefer sectors where demand isn’t dependent on favourable environment and product replacement can’t be postponed for too long. It’s very important to pick the right company in each. Once you study the sector, pick the one which you believe has the right targeted customer segment, has the right marketing strategy and the management is focused on that exciting opportunity versus having diluted attention on multiple businesses. SN: How do you think about valuations? How do you differentiate between ‘paying up’ for quality and ‘overpaying’? SV: Having worked as a valuation professional has helped me significantly in this area. Valuation is about your input assumptions or else it’s garbage in and garbage out. For coming up with reasonable inputs, you not only need to understand the company but also the industry, the competitive environment, business model, strategy of key competitors, etc. to be able to estimate the factors such as growth, profitability, re-investment rate and return on future investments. This may sound complicated, but if you have done thorough work on understanding the company and the industry/competitors you won’t find it difficult to judge whether the current valuation is a bargain or expensive. Rather than trying to come up with a specific number, I try to evaluate what’s a reasonable multiple for the company and if I feel that the probability of the current multiple contracting is very low, I get comfort. “Paying up” or “overpaying” are terms we have started using based on our perception of whether the P/E multiple is high or low. P/E multiples can be very deceiving. For e.g. let’s consider an example of a company from two analysts’ perspectives who are ascribing it a fair P/E multiple. A company generating ROE of 50% and both analyst expect earnings to grow at 25% for the next 2 years. So theoretically the company needs to deploy 50% of the profits for this growth (Growth = Reinvestment x ROE). The residual profits are paid out as dividends. Beyond two years, one analyst expects the growth to drop to 10% up to the 20th year. The second analyst expects the 25% growth to continue up to the 20th year. Let’s assume the terminal value of the company is the book value at the end of the 20th year. For the first analyst the fair one-year forward P/E multiple would come to about 12x, but for the second analyst it would be 32x (see workings below, or click here to download ). So the point I am trying to make here is that the duration of high growth has a huge impact on the eventual P/E multiple. If the company is trading at 20x, the first analyst would find it expensive but the second would find it a bargain. If your business analysis is in-depth, your chances of accurately evaluating the duration and hence the valuation would be much better. Please note that if a company’s ROCE is above its weighted average cost of capital (WACC) and if the company continues to grow above the WACC forever, the valuation and hence the P/E multiple would tend towards infinity. Conversely if the ROCE is below WACC and the company continues investing in new capex at ROCE lower than WACC, its valuation would tend towards zero. So theoretically no P/E multiple is low or high. If anyone is keen on learning more, you may find my lecture , given at Flame Investment Lab, useful. SN: That’s a brilliant way to look at valuations, Samit, and it solves a lot of questions in my head. Let me ask your thoughts about selling stocks. Are there some specific rules for selling you have? SV: For me the highest numbers of my exits have been driven by deterioration of the business environment. So either the business model has deteriorated because of regulatory changes such as what happened recently in cotton seeds, or the competitive intensity has changed and that makes it incrementally difficult to meet my 20% growth hurdle. Other reasons are management decisions regarding capital allocation or in financials the lending standards been relaxed. Valuation running beyond comfort is another common reason, but I am a little more flexible here versus brutal in the first two aspects. SN: Can you please share a real-life stock example when selling turned out to be a great decision for you, and one when it turned out to be a mistake? SV: J&K Bank worked out well when we exited it at the first signs of its lending standards deteriorating. La Opala exit didn’t work out well as we exited too early because of concern on valuations. The growth continued and with that the multiples kept increasing. We exited with a 5x return and the stock continued going up 5x further. SN: When you look back at your investment mistakes, were there any common elements of themes? SV: There have been many mistakes. The most common is in the event of any bad news (significant enough to trigger an exit) coming with regards to a portfolio company that you have held for some time and have developed connect with. The natural tendency is to find arguments against the bad news and try and shove it under the carpet. You try talking to the management and typically they are the worst people to talk to in such events because they will give you great comfort in their business as always. Holding something in your portfolio is as good as entering that stock at current market price. Many a times, I have held on to positions even if I would not be comfortable buying at current market price. You may justify it by giving false comfort of having bought at much lower price, but it’s a behavioural mistake that has to be rectified as a part of improving decision making. SN: Yeah, that’s true. Talking about behaviour, any specific biases that have hurt you several times as far as your investments are concerned? And what have you done to minimize the mistakes caused by such biases? SV: One very common mistake that has hurt me is that if you buy even a small quantity at low price, it’s much easier to add at higher level. But if you miss that first entry at extremely juicy price, it’s very difficult to buy later as you keep repenting that lost opportunity. Other mistake that is common is the cost of purchase. The entry point if low gives a lot of comfort to hold on even if you see business environment deteriorating for the company or if you find valuation uncomfortable. In reality we know that the exit point should be independent of the entry, but it’s very difficult to de-link. These are tough decisions and I consciously try to be aware of such biases to avoid them. I can’t say that I have mastered them 100%. SN: How can an investor improve the quality of his/her decision making? SV: As I just said, an investor needs to look afresh at his/her portfolio without the bias of having the stock already in the portfolio. This discipline would surely help in making better decisions. Other aspect which is extremely important and underappreciated in investing is temperament . For this, keeping your mind relaxed and away from “noise” is critical. I find exercise, meditation and frequent breaks away from investing very helpful. Each individual needs to find a way to relax and keep his/her mind fresh and peaceful. One can read and learn a ton about behavioural aspect, but if the mind is stressed, tired or confused, the chances of taking wrong decisions significantly rise. SN: How do you think about risk? How do you employ that in your investing? SV: I am not going to talk about the theoretical aspects of risk such as diversification, illiquidity, etc. which are a given for a money manager. I am sure your readers would have heard and read about them multiple times. I will stick to specific things that I follow. Once I am broadly excited about a business, my major analysis is on digging holes into my excitement. Once you like a stock, the natural tendency is to just jump in before the price runs up. When you take short cuts that’s exactly when risk crops in. As part of my analysis, I avoid talking to co-investors who already have vested interest and are also excited about the stock. Talk mainly to the company’s competitors because they generally will give you a different point of view on the industry and about why certain strategy is inferior. Talk to analysts who have negative view on the company. Find a strong devil’s advocate who will try and destroy your hypothesis. In that respect, having partners helps each of us as the other two play that role. Equity investments involves considerable risk. The key is to find ways to reduce it. There is no better way than to understand the dynamics of the business and run stressed scenarios of how it would survive in the toughest of economy. For me, mitigating risk is about building margin of safety and I try to use it in the outlook when I am valuing the business. E.g. If based on your study, you are confident that the business can grow at 25% for 7 years, assume only 4 years and see if you still find the price attractive. One other factor I would like to bring up is to be careful when blindly copying investment theories and strategies used by legendary investors in the United States. You have to remember that the US is one of the most successful and innovative countries in the world. When you companies with strong brands, IP and technology which is recognized all over the world things like “moats” and extremely long term investing works there. India is an emerging economy and many things such as regulations, government incentives, tax structure, FDI policies, IP policies, etc. keep evolving. Plus, we are relatively much weaker on brands, IP, technology and hence your investment strategy has to change accordingly. One has to be very vigilant about the above changes on your portfolio companies and be ready to exit with changing business dynamics. Following wrong investment strategy can be hugely risky. SN: That’s a nice insight. Well, what’s your two-minute advice to someone wanting to get into value investing? What are the pitfalls he/she must be aware of? SV: Most people want to be independent and for that they would have liked to own and run a great business, but for majority of them starting a business is too big a risk. Investing in stock market should be considered as a much lower risk option because you are able to partly own diverse set of already successful businesses. Look for businesses with the same passion as you would to start an exciting business you like. Set that priority and purpose right, and only then think about the price to pay for it. Learning about valuation is much easier once you do this. Don’t fall into the trap of scanning for value first and forgetting the real purpose of investing. SN: Which unconventional books/resources do you recommend to a budding investor for learning investing and multidisciplinary thinking? SV: Here are the three I would recommend – Understanding Michael Porter: The Essential Guide to Competition and Strategy by Joan Magretta The Little Book that Beats the Market by Joel Greenblatt The Five Rules for Successful Stock Investing : Morningstar’s Guide to Building Wealth and Winning in the Market by Joe Mansueto and Pat Dorsey SN: Which investor/investment thinker(s) do you hold in high esteem? SV: Being a numbers oriented guy, I like Joel Greenblatt’s way of scanning for great businesses. History and right parameters could be a great starting point to shortlist companies. There are different aspects to learn from many great investors. SN: Hypothetical question: Let’s say that you knew you were going to lose all your memory the next morning. Briefly, what would you write in a letter to yourself, so that you could begin relearning everything starting the next day? SV: Before investing, I will surely focus on writing about my family and people I love and are important in my life. I will write about the philosophy I follow in life. It’s too little a time to spend on writing about investing. In any case, I can always refer to my newsletters and our website to remind me of the philosophy I had followed. So some documented help is available on that front. SN: What other things do you do apart from investing? SV: I love sports and many of them, so watch and play whenever time permits. We came back to India in 2006 and one of the purpose was to make some difference to our home country. I involve myself during weekends in various activities such as cleaning garbage in our area, tree plantation in the forest that had been completely destroyed over the years, but my real passion is education. We all know the quality of education in our municipal schools. Students are not failed until grade 8th, but beyond that many find it extremely difficult to continue and the dropout level jumps. If quality help is provided at this stage, many can be helped not only from dropping out but also to complete graduation so that they can find meaningful employment. Even better, if they are provided good guidance to find their passion, many could become employers and big contributors towards development of our country. I am currently just helping monetarily in education of about twenty 8th to 10th grade students from a poor community, but I am working with an NGO in Pune which is doing phenomenal work in this area. My goal is to adopt an entire class of 8th graders and help them in the above aspect until graduation. SN: That’s very kind of you Samit! You definitely have inspired me and a lot of people reading this interview. Thank you so much for sharing your wonderful insights on investing. Thank you! SV: You’re welcome Vishal.

My Investment Approach

Being labeled as the “investment guy” to my family and friends, I often get hit with questions that go something like this: “What’s your investment philosophy, approach? How do you invest? What formula do you use? Or tell me what stock to buy so I can make money”. The frequency of questions and discussions grew overtime as my online persona developed due in part to my articles on Seeking Alpha and my blog . Those of you in the investment business know that you can’t really answer it with a one-liner. The purpose of this article is to provide a comprehensive answer to some of the questions I occasionally receive. Another purpose is that maybe it will spark other people to share and discuss their approach. Philosophy When it comes to the question of what kind of investor are you? I don’t like checking myself into a box but if I have to, I would have to check value investing. I don’t believe that markets are efficient, I believe companies have an intrinsic value, I look for a margin of safety, I have contrarian characteristics, volatility is not a measure of risk, and I buy things when they are on sale. I don’t speculate and I don’t short. I guess that on paper that would make me a value investor. But I’m not a purist. I also incorporate some growth investment characteristics and I also keep an eye on special situations. I don’t run an investment fund with strict investment boundaries, so my hands are not tied to a certain investment category. I’m free to go where the opportunities are. That’s why I don’t “categorize” my investment style. Back to the question “what kind of investor am I?” I’m never really satisfied with the answer the “I’m a value investor” and so my questioner. The phrase “value investing” itself can be more confusing than helpful. It’s like saying “I buy low and sell high”. So what’s a value investor? The short simplified answer is that it’s an investor that buys an undervalued stock. He’s looking to buy a dollar for fifty cent. Using that rationale then isn’t everybody a value investor? Obviously nobody buys a stock or an asset because they think it’s overvalued. Everybody thinks they are getting a bargain and it will be worth more. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. In other words, you can’t be a contrarian if everybody is a contrarian. In value investing, there are many schools of thoughts and it has expanded well beyond the Benjamin Graham school of strict value investing. I’m not a disciple of any value investing tribe. I believe value and quality goes hand-in-hand. I’m not overly fixated on paying low multiples. It is rare to get a truly great business at dirt-cheap prices. Unless you get really lucky, you are not going to find a quality business with a large economic moat trading at a price earnings ratio of six. At the base, when I buy a stock, I have a fractional ownership in the business. It might not be much, but a percentage of ownership in a company. This gives me an indirect stake in the assets and profits on the company. In today’s digital age where you can buy and sell stocks all day by just swiping your mobile, it’s easy to forget that shares represent ownership in a company that employs people, produces goods or services and, hopefully, generates revenue, profit and cash flow. I guess it’s psychological. I see the same effect when playing online poker versus playing at a table. Online, there’s a disconnect that happens in your mind that when you don’t see your chips, you forget that’s real money. Players are more “loose”, throwing money at bad hands and chasing streaks. That same behavioral disconnect happens when people see their portfolio filled with stickers bouncing around. I feel that the stock market is a mood gauge. It tells me what mood people are in any particular day. I can tell if they are panicking, depressed, or overly optimistically greedy. What you see bouncing around every day in your portfolio is price. It’s different from value. Value doesn’t bounce around. You need to develop your own opinion of value. Adding value requires one to see that the stock is mispriced. Share prices, you may have noticed, vary enormously over the course of a year. I keep seeing the same stat over and over again that the average stock moves around 80% from its peak to low during a 52-week period. I don’t know how accurate the stat is, but by looking at my portfolio there’s some truth to it. A business’s revenue, profit and cash flow rarely change anything as much as its share price. The reason for this is that the price of a company’s shares is only a reflection of what people are willing to pay for them at any given time. In other words, price doesn’t tell you anything about a company’s worth, but it tells you a lot about the popularity of the company with the crowd of investors. Sometimes, usually when prices are rising, they’re greedy. When prices fall, they become fearful and rush for the exits. All this emotion can push the share price a long way from the intrinsic value of the underlying business. I don’t worry about volatility. And by the way, volatility does not equal risk. I’m more concerned about permanent capital impairment. If something is going to be worth a lot more in the future I’m going to buy it regardless of the volatility. I also try to take advantage of volatility. When you have strong period of volatility like we saw at the beginning of 2016, it can cause investors to sell and sometimes to do so indiscriminately. There’s a Chinese proverb that goes something like “the greater the crisis, the greater the opportunity”. Or if you prefer an English quote, Winston Churchill said “Never let a good crisis go to waste”. Approach When looking at the investment merit of a company, I usually look for these four criteria: The company needs to be profitable and a strong generator of free cash flow with a good return on capitalI’m looking for honest talented managementReinvestment opportunities (capital discipline + allocation)Valuation: I want to buy the company at a bargain but I usually I have to settle for a fair price (a dollar for 70 cents if it’s an attractive company.) You will notice that the first three criteria are dependent on others and that means management plays a key factor. You can’t really have one without the other, over the long-run anyway. Good management will generate free cash flow and allocate capital in a disciplined manner. If point 1, 2, and 3 are solid, you probably wouldn’t find the company in the bargain bin unless you are lucky. I mentioned that I would settle for a fair price because usually you have to pay a premium for quality. Since I tend to hold my stocks for many years, I don’t really care if I buy Company X at $52 or $50. What I noticed is that the day Company X trades at $75, it’s not going to matter if you bought it at $51 or $50. The primary motivation for purchases is that values are good enough and that I have enough of a margin of safety for errors of judgment. The best business in the world is one that makes a good return on its capital and can reinvest profits at the same returns. That’s a compounding machine that generates great wealth over time. Time here is essential. You need patience and a cool head to ride the ups and downs. A trick is not to look at your portfolio every day. It deviates you from focusing on the long-term. It’s hard to do and you can train yourself. As to my analysis approach, I have more of a bottom-up style. I focus on the business, the fundamentals, the valuation, and look for a margin of safety. I read the filings, the presentations, conference call transcripts and related research. I talk to business people and people that are familiar with the industry. I also look at the competition to see how it’s doing. I don’t ignore the macro environment but I also don’t spend too much time on things I can’t control. Rather, I spend my time focusing on learning about the business than trying to predict the direction of interest rates or where we are in the business cycle. Besides, I already make enough mistakes. There already way too many PhDs getting burned trying. I’m very aware of the economic situation and I have my own views. However I don’t let my economic opinion make investment decisions. People often ask me what I think about this stock or that stock. Most of the times they bring up obscure companies that I have never heard of. Before they tell how Company X will revolutionize a certain industry, the first thing I do is I go right to the balance sheet. This will give me a snapshot of the health of the company to see if it will survive the next couple months. I want a clean balance sheet. Is the company financially sound? Can it pay its bills for a bit while I investigate further? Then I look at the cash flow statement and income statement last. The cash flow statement will tell me a lot about the operations of the company, its use of cash, and very importantly if it’s generating free cash flow. The income statement will tell me if the company is growing and its margins. This can be done pretty quickly once I have found something I like, I roll up my sleeves and I start digging deeper. I don’t try to time the market. If you are a market timer, you need to be right twice, once when you buy and once you sell. Some people might be successful at it, but I don’t have that skill. I don’t know anybody who is successful at it either. I also don’t always visit the companies and meet management. If it’s a big company that has analysts covering it, it would be a waste of time and they probably aren’t likely to meet me. Apple has 100 analysts, what is it that I know that they don’t? Tim Cook Is not going to pick up my call. In situations like researching small caps companies with no coverage, I take the time to talk to management. However I remain skeptical with what that management has to say. They will always tell you that things are ok. But it’s a good way to learn more about a company. I suggest that if you want to go further, sometimes talking to employees, or ex-employees, suppliers or the competition will tell you more about the company. A very important step that I take is that I try to put myself in the shoes of the seller. Why is this person selling their stocks? What’s the motive? What is it that they know that I don’t? How can this company blow up? How can I lose money? Sometimes when I find a company that I like you become too optimistic and you only want the info that validates your thoughts. The exercise forces you to think differently and to develop another perception as to the merit of the potential investment. It has prevented me from making mistakes. Valuation Arriving at the value of a company or an asset is more an art than a science. There’s no secret formula. Don’t waste your time on the secret sauce du jour. There’s not a single metric or formula that you can use that will make you money over and over again. Just buying low P/E or P/B stocks won’t make you rich. That would be too easy. Wouldn’t that be great? Adding value is a zero-sum game. You are buying a stock because you think it’s undervalued and the seller thinks it’s overvalued. You can’t both be right. Basically you need to be better than the person selling it. If you cannot value a business, then price has no meaning. You need to develop the ability to compare price to a certain value. That’s when it makes sense. You do not want to value a Ford at BMW prices. You want to buy a BMW at Kia prices. It is all about seeking a reasonable discount on its actual worth. When looking for investments, I focus more on the “art” side than the “science” side. The “science” side is the numbers and the valuation. If you run a screen for cheap stocks then you will have a lot of garbage to filter through. Over 90% of the companies caught in the screen are not investment worthy. And it’s brutally time consuming. Sure you can run sophisticated filters but you are competing in a crowded field. There are way too many people and computers already doing that. Everybody can run the numbers and screens. I don’t have an edge in that department. You won’t earn market-beating returns by simply picking the quantitatively cheapest companies. Cheap companies are cheap for a reason. I’ve seen stocks trading at 6x P/E drop to 3x P/E. That’s when the lessons really sink in. The ‘art’ part of investing is the difficult part. On the art side, I focus on the character of the business, its qualities and economic moat. Instead of going through 90% of the garbage from the screen, I’m looking at the 5% of companies that might be investment worthy. I try to figure out what enables some businesses to earn outsize profits for an extended time. How strong and enduring its competitive position is? What is the nature and source of their sustainable competitive advantages? These are some of the questions that I ask and they are not easy to answers. Another advice is to ask the question “why” a lot. Why is this company earning outsized profits? And keep going and going. It’s like peeling an onion. The “art” side is very subjective. There’s not a straightforward methodological approach to it. You use screens heavily, you need to screen the screen. The “art” side is refined with time and experience. I don’t think you can simply start with the art side. I think everybody starts with the screen approach and you realized how time consuming and inefficient this is. You go through each company on your list and you start noticing patterns on why these companies are terrible investments. You quickly become a better decision maker. Unfortunately, I do not have a clear-cut way of valuing businesses. Usually I arrive at a value conclusion with a range of values. I don’t really rely on DCF models even though they are thing of beauty. There are too many assumptions, projections, and you can play with the discount rate all you want. How do you seriously predict with any accuracy what the long-term cash flows are for a given company? Especially a company that is young or that might be using an innovative and new business model. There are so many disparate variables. The model is so hypersensitive that if one input is off one degree you will get out of whack values. There’s a joke in the industry that goes if the numbers blows-up my model, I will ignore them. Sometimes I take a stab at it but it’s not my preferred valuation method. Great businesses make a good investment, not great models. I don’t do any technical analysis. I dabble around with it but I never made a transaction based on it. The cup and handle pattern just doesn’t resonate with me. A friend of mine uses technical analysis pretty extensively and he gets really excited when he shows me these different chart patterns. I just don’t see it. My reaction to chart patterns is pretty much the same; “this looks like a chicken leg, so what?” His reaction is the same when I talk about the investment merits of a certain company and its valuation metric. It sounds like a foreign language to him. I’m not claiming that technical analysis is not working; it’s just simply not the right approach for me. It seems to be working for my friend. I guess the key is to incorporate it in your approach but it’s not on “my to-do list”. I don’t use a formal checklist although I probably should. There is already a lot of existing investment literature about the importance of using checklists in investing, most notably ” The Checklist Manifesto ” by Atul Gawande. Right now I rely on my common sense mental checklist like medical professionals operating on a patient should have clean hands. But medical professionals use checklists. I certainly think I could improve my performance if I use a practical checklist. Just relying on memory can be faulty. Reflecting back on some investment mistakes of the past, some of them could have been avoided with a checklist. However you need the right checklist. The issue is there’s not one perfect checklist. You can look at different templates but you need to build your own. You also need to adjust the checklist according to the company and industry you are analyzing. Also most investing errors are not from the lack of fundamental analysis, but originate from psychological missteps. So you need a checklist that keeps your behavior in check. A checklist is not a bullet proof method of eliminating mistakes. You still will make some. But it will minimize the chance of losses. At the end of the day, my role is to look for pricing inefficiencies. The greater the gap between price and value, the greater the margin of safety is. When calculating value, I don’t try to be too precise. I expect a range of outcomes. Finding ideas I’m free to invest in any asset class anywhere but I have a soft “no” list. I generally don’t do pharma, mining, and 95% of the tech stocks out there, etc…But I didn’t ban them from the investment universe. It’s just I don’t think the opportunities are worth the risk. Those sectors above usually lack an enduring competitive advantage and an economic moat. I also can’t buy them with a large enough margin of safety. I prefer companies that have hard assets and I invest in companies with a really strong brand and intangibles. I find it easier to calculate the downside. It really comes down to finding that competitive advantage. Great investments are identified by finding business models that would be impossible to ruin with competition. Sometimes there’s one or two abilities that make them better than their peers and that could be branding, distribution, product quality, low cost operator etc… I find a lot of ideas through reading. I can’t stress the importance of reading enough. I picked up most of my knowledge and ideas by reading. I believe that if you want to be successful in investing, it is important to be willing to learn and explore new concepts on your own. I read a lot of annual reports and I form an opinion about the companies. Usually what happens is that I end up with a list of companies on a watch list with the price I want to buy them at. It happens that the company could be on the watch list for years. So when the company hits my price target, I already know the company pretty well. If I find an undervalued stock that generates strong free cash flow (high free cash flow yield), usually something good will happen. The company might reinvest the cash to make it compound, make an acquisition, distribute a dividend, or buyback shares. Conclusion My approach to investment is a mix of value investing principles with my own twist to them. The truth is you need to develop your own approach. Warren Buffett is the most famous “value investor” but you can’t copy him. You simply can’t. You also can’t copy Carl Icahn or Michael Burry.You don’t have their resources or talent to influence management teams. You also don’t have access to the type of deals they do.Investors shouldn’t let somebody else’s opinion drive their decision. You need to have the capacity to think independently and develop your own perspective. As noted investor Sir John Templeton said: “It is impossible to produce a superior performance unless you do something different from the majority.” At the end of the day you need to know yourself and you need to develop your own investment style. Like I said there’s no secret formula to investing. It’s not supposed to be easy. That’s why only a few people are great at it. And they are great at it because they do their own thing. Like I already mentioned, there’s no secret formula. You need to take a position that others shun and avoid what is popular. That’s hard to do. Early on it will look wrong and it’s a brutal feeling to have. Focus on quality at a bargain and be patient. It’s the last part of the equation that’s the most difficult. You need nerves of steel to sit through some of the roller-coasters. . Emotions are the single most important factor for investing success. If you can’t control your temperament, everything else doesn’t matter. If you have the best strategy but you can’t hold on to it, you are doing more damage than good. If you have a solid opinion of value on your company, you will be facing the storm because you have something to focus on. I tried to jot down most as much as possible about my approach. Most importantly, I hope it helps answer some of your questions. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

General Mills (GIS)

On Friday, I sent out an e-mail to our e-mail subscribers, like we always do whenever we are about to have a transaction in our portfolio. I don’t usually address our portfolio transactions on the blog, but I thought I should clear something up. Some readers have been questioning why we recently sold out of certain stock positions, specifically General Mills (NYSE: GIS ) and Procter & Gamble (NYSE: PG ). These sales have been several months in the making honestly. Over the past two months, I have written a couple of posts about changes to our Portfolio Allocation and the ETFs that will make up the core of our future portfolio. Part of the focus of our portfolio has been to generate income from the dividend growth in our portfolio, but the other part of our focus is to grow our portfolios’ value by investing in undervalued business… that will prosper over the long term. Part of that concept means that we do need to take profits when the value of some of our assets become overvalued. A while back we sold out of our utility company investments, for instance. At that time (and currently), we felt that the valuations and growth prospects that the market was assuming did not justify our continued investment. Something similar has occurred over the past several months, in regards to consumer staples companies. While I consider General Mills a good company, it’s a mature business and its model is dependent on consumers continuing to pay a premium for the company’s name brand products and agricultural commodities remaining low. Therefore, I don’t believe it has the characteristics of a company we should own over the next 30 years. Profits over the past couple of years have been goosed by unusually low agricultural input costs, low transportation costs, and good consumer demand. Will these trends continue? I don’t know, but given the company’s current metrics, I am happy to book our profits. The other part of why we took our profits, is I am not particularly optimistic about the global economy. That outlook, which may or may not be justified, and our desire to shift our core holdings over to passive index investments… encouraged us that some of our capital was better in cash for the time being. While I never expect to time our portfolio’s transition from mostly individual stocks… to mostly passive index investments… perfectly, it makes sense to me to do some selling while those assets are at elevated levels. For the past few years, dividend growth investments have been very popular with investors…largely as a result of the current (artificially) low interest rate environment. Therefore, some consumer staples and utility companies are trading at price to earnings ratios approaching 30. That wouldn’t concern me at all if the underlying businesses were growing at a rapid pace, but instead, many are only growing (revenues and profits) at 2%-6% annually. At some point, the companies will likely need to grow faster, or the share prices will need to come down. The exception being if we are entering a sustained period of mild deflation, but that situation comes with its own problems. I have been called everything from a contrarian to a “nut” on this blog, but I have found most readers receptive to our ideas. I don’t know that I am really a contrarian and I don’t strive to invest the opposite of how most people invest. I just try to think independently, and follow the path that’s best for me and my family. So our portfolio is largely in cash and we’re happy to remain that way for the near term. I think we will have dramatically better investment opportunities within the next year. If I can leave you with a concept, without going on about all the virtues of cash, it’s that in the current economic environment Cash is Not Trash! In round numbers, our sale of General Mills freed up $11,500 in capital. We had owned the shares for about 2 years and enjoyed capital appreciation of 20.5%, as well as 2 years’ worth of dividend income. The cash has been added to our growing “war chest”. We will reinvest this capital in the global equity markets as soon as we see a great long-term opportunity, but we also invest a small portion of our portfolio in deep value investments. Time will tell what our next investment will be, but for now, I am happy to hold plenty of cash and wait for the proverbial “fat pitch”. Do you ever book profits, or are you strictly a “buy and hold” investor? Disclosure: I do not currently own shares in GIS or PG. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional.