AA - Abhishek's Attic (place to store stuff to clear my head)!

Of course, it’s going to be difficult - The wisdom of Charlie Munger

Charlie Munger has been one of the guiding lights in my life. A hero for me. Not in investing but generally on how I should go about leading my life. I have gained immensely over the years from listening to his advice. he is one of the few great thinkers alive. Recently, he spoke at the Daily Journal Annual Meeting. Below are my notes from the talk. Things that resonated with me.

Q. Please share your thoughts on the recent WallStreetBets GameStop short squeeze. It seems to involve a lot of your standard causes of human misjudgment.
A. Well, it certainly does and that’s the kind of thing that can happen when you get a whole lot of people who are using liquid stock markets to gamble the way they would in betting on racehorses. That’s what we have going in the stock market. The frenzy is fed by people who are getting commissions and other revenues out of this new bunch of gamblers.
I think you should try and make your money in this world by selling other people things that are good for them. If you’re selling them gambling services where you rake profits off of the top, like many of these new brokers who specialize in luring the gamblers in, I think it’s a dirty way to make money and I think that we’re crazy to allow it.

Q. What do you think of all of the SPACs and the promoters pushing them?
A. I don’t participate at all and I think the world would be better off without them. I think this kind of crazy speculation in enterprises not even found or picked out yet, is a sign of an irritating bubble. It’s just that the investment banking profession will sell shit as long as shit can be sold.

You get crazy booms. Remember the .com boom? When every little building in Silicon Valley rented at a huge price and a few months later, about a third of them were vacant. There are these periods in capitalism and I’ve been around for a long time and my policy has always been to just ride them out and I think that’s what shareholders do.

Well, it’s most egregious in the momentum trading by novice investors lured in by new types of brokerage operation, like Robinhood. I think all of this activity is regrettable. I think civilization would do better without it. You’ll remember that when the first big bubble came, which was the South Sea bubble in England, back in the 1700s, it created such havoc, eventually, when it blew up, that England didn’t allow hardly any public trading in securities of any companies for decades thereafter. It just created the most unholy mess. So human greed and the aggression of the brokerage community creates these bubbles from time to time and I think wise people just stay out of them.

I think everybody is willing to hold stocks at higher price earnings multiples when interest rates are as low as they are now. So I don’t think it’s necessarily crazy that good companies sell at way higher multiples than they used to. On the other hand, as you say, I didn’t get rich by buying stocks at a high price earnings multiples in the midst of crazy speculative booms, and I’m not going to change. I am more willing to hold stocks at high multiples than I would be if interest rates were a lot lower, everybody is.

I think all good investing is value investing, and it’s just that some people look for values in strong companies and some look for values in weak companies, but every value investor tries to get more value than her pays for.

I don’t think I know exactly what the future of banking is, and I don’t think I know how the payment system will evolve. I do think that a properly run bank is a great contributor to civilization, and that the central banks of the world like controlling their own banking system and their own money supplies. So I don’t think Bitcoin is going to end up as the medium of exchange for the world. It’s too volatile to serve well as a medium of exchange. And it’s really an artificial substitute for gold. And since I never buy any gold, I never buy any Bitcoin. And I recommend that other people follow my practice.

I’m constantly making mistakes where I can, in retrospect, realize that I should have decided differently. And I think that that is inevitable because it’s difficult to be a good investor. I’m pretty easy on myself these days. I’m satisfied with the way things have worked out and I’m not gnashing my teeth that other people are doing better. I think that the methods that I’ve used, including the checklist, are the correct methods. And I’m grateful that I found them as early as I did and that the methods have worked as well as they have. And I recommend that other people follow my example.

It’s natural for people to think their own civilization and their own nation is better than everybody else, but everybody can’t be better than everybody else. You’re right, China’s economic record among the big nations is the best that ever existed in the history of the world. And that’s very interesting. A lot of people assume that since England led the industrial revolution and had free speech early, that free speech is required to have a booming economy, as prescribed by Adam Smith. But the Chinese have proved you don’t need free speech to have a wonderful economy. They just copied Adam Smith and left out the free speech, and it worked fine for them.

If you stop to think about it, business success long-term is a lot like biology and in biology, what happens is the individuals all die and eventually so do all the species and capitalism is almost as brutal as that. Think of what’s died in my lifetime. Just think of the things that were once prosperous that are now in failure or gone. Whoever dreamed when I was young that Kodak and General Motors would go bankrupt? It’s incredible what’s happened in terms of the destruction.

I think I’m not really equipped to comment on any subject until I can state the arguments against my conclusion better than the people on the other side. If you do that all the time, if you’re looking for disconfirming evidence and putting yourself on a grill, that’s a good way to help remove ignorance.

I think Warren and I are better at buying mature industries than we are at backing startups like Sequoia. The best venture capital operation, probably in the whole world, is Sequoia’s. They are very good at this early stage investing. I would hate to compete with Sequoia in their field. I think they’d run rings around me. So I think for some folks, early stage investing is best. For other folks, what I’ve done in my life is best.

A lot of the old moats are going away, and of course, people are creating new moats all the time. That’s the nature of capitalism. It’s like evolution in biology. New species are created and old species are dying. Of course it’s hard to negotiate in such a field. But there’s no rule that life has to be easy on the mental side. Of course, it’s going to be difficult.

Well, happy life is very simple. The first rule of a happy life is low expectations. That’s one you can easily arrange. And if you have unrealistic expectations, you’re going to be miserable all your life. And I was good at having low expectations, and that helped me. And also, if when you get reverses, if you just suck it in and cope, that helps if you don’t just fretfully stew yourself into a lot of misery. Always tell the truth and never lied to anybody about anything.

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Life as a full time investor

Once upon a time, I had a full-time job. I used to go to the office and do the “office work” and in the evenings and weekends, I used to hone my investing skills. After about 15 years of such existence and having reached a semblance of financial independence, I started toying with the idea of leaving my job and becoming a “full-time investor”, and FTI, in short.

In the investor circles, there is a perceived highbrow feeling that I get whenever I spoke to an FTI. In conversations, the FTIs would make me feel that unless you were part of the FTI crowd somehow you were not a serious investor. Which of course is really stupid. I know so many great investors who are happy and probably better off because they are part-time investors. Having a stable income from a job can be a very liberating thing. You can focus on identifying a handful of companies every year and then let those investments work the magic for you. Of course, if you yearn to be a day trader, having a job is not going to work.

As a full-time investor, the first thing that hits you is the amount of time you have at your disposal. And unless you are disciplined it can derail your efforts very quickly. Distractions in the form of Whatsapp, Twitter (ever notice how many so-called investors tweet so many tweets during the day?? I wonder what they actually do for work or is it all just an exercise in social media outreach) can take you down a rabbit hole and you realise that you have spent a few hours and accomplished nothing.

But having this additional time can be a boon. You get time to reflect on different businesses. You get a lot of time to learn different things. I focused a fair bit on reading much more diversely. You can slow down and learn things slowly, at your own pace. Macroeconomics, quantitative theory, technical analysis, geopolitics were topics I started picking up slowly.

My strategy is to break up my work into three distinct parts. I had two till some time back and added the third (will come to that shortly). Here are my parts of work:

  • Passive (reading, monitoring portfolio and watchlist stocks, learning new things, listening to podcasts)
  • Active (Writing, Coding, creating summaries of stuff which I have read or listened to, running screeners)
  • Thinking (the new addition)

I wasn’t keeping aside time for thinking. And the challenge was unless I actively keep aside time for thinking about making decisions like if I want to make a switch in my portfolio, I was leaving it aside for it to come and hit me while I was pursuing my active work like writing about my portfolio picks.

I started marking my days of the week based on themes of study. So, Monday and Tuesday are for Quant & technical analysis, Wednesday is earmarked for general reading including macro, geopolitics etc, Thursday and Friday are kept aside for looking at interesting businesses and business models. These theme-based days help in focusing attention and making progress in each area.

My biggest challenge was that I simply overworked and overstimulated myself. Previously, office work and investment study were different. With now both coinciding, I ended up doing investment work for 12-14 hours a day without a break, seven days a week.

For twenty years, my “hobby” or “passion project” was investing. Now that is the primary focus. So, after many years, the search is on for building a new hobby. Reading fiction, watching movies, sports have started taking up more time in the day which provides a mental break from investment work. Hopefully, once the pandemic is behind us for good, then I can resume playing again. Losing the battle of the bulge for the last twenty years, seriously considering taking up some sports or activity that will focus on the health and fitness aspect.

Looking back I feel lucky I started the advisory because it gives me some purpose and work to do. Otherwise, I would probably have just sat the whole day reading and writing!! Running the advisory, interacting with investors, reading and responding to their questions gives me an immense amount of pleasure and most of the time helps me in my learning process as well.

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@basumallick

Loved the blog post. I am in the same boat as you but have consciously kept my dermatology practice going albeit for a few hours a day. That helps in taking the mind away from the focus area of investing.

Mine are not as structured days as yours. The beauty of being a full time investor (or nearly a full time investor) is that your time is yours and you dont have to have any fixed hours or schedules to follow.

And there is so much to keep learning in the field of investing and test the learnings by doing practicals in the markets.

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Using Technofunda Strategy for Investing

Technofunda investing is a combination of technical analysis and fundamental analysis. Practitioners of technofunda investing usually approach it in one of the two ways - i) look for strong fundamental stocks and then look for good technical patterns or ii) look for chart patterns and then study the fundamentals of the stock.Nearly all fundamental investors are averse to using technical analysis and vice versa. Personally, I treat both forms of analysis as information streams. And the more the merrier. If I can use the fundamental information about a company’s business and combine that with what is happening in the demand-supply of the stock, then the results are superior to using either one approach exclusively.

So, why don’t more people do that? Firstly, the time frame is different. Fundamentalists usually are looking at a longer time horizon of a year or more whereas technicians typically look at holding for a few days or weeks. Very few technicians have a longer time horizon. Resolving this time horizon mismatch is something that has to be done first.

Secondly, there is a lack of knowledge and trust in the “other” discipline. Fundamentalists view charts as squiggly lines. And technicians view fundamentals as superfluous newsflow. It is at the core of their respective studies. The way I resolve it for myself is by telling myself that fundamentals cause the stock to perform over time and technicals cause the demand and supply conditions for the stock price movement. Both of these factors need to align for a long sustained rally in a stock.

I add a layer on top of technofunda which helps with holding performing stocks for longer periods. This approach is known as trend following. Trend following is usually associated with following the price. Although I use that to an extent, I tend to focus more on the fundamental trend following. This is a simple concept of continuing to hold stocks where the results are continuously good and are in an uptrend. Some of the biggest winners in the stock market come from these stocks. In fact, nearly all of the long term well-performing stocks fall in this category. I call them compounders. Because they tend to compound capital superbly well. If you make a basket of stocks filled with such stocks, the only active decision to make is when to sell. You do that when the fundamental or technical trend breaks down.

This has been one of the best ways I have found to get good returns while being invested in good quality companies.

This article first appeared in Economic Times - https://economictimes.indiatimes.com/markets/stocks/news/a-new-approach-to-investing-that-can-make-it-easier-to-spot-real-compounders/articleshow/81982817.cms

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The Perils of the 2020 Rally

We all will remember 2020 as the year of the Covid pandemic. When the first realisation hit our markets, lockdowns became a reality, markets fell off the cliff. The economies across the globe have remained weak. Every country has tried, based on its capability, to pump in liquidity and prop up their individual economies. In the last year, the US Fed has nearly doubled its balance sheet to more than $7.7 trillion through around $3.4 trillion in bond purchases. That extraordinary intervention, along with near-zero interest rates, has a single point agenda - to keep money flowing through the US banking system. As per data from IMF, countries have given stimulus between 2.5% to 10% of GDP.

This has resulted in an across the board asset price bubble. Nearly every asset class has been on the rise for the last year. Bitcoin, equity markets, oil, metals - you name it and they are up. The main reason is that there is a lot more money in the hands of people and it is flowing into various asset classes.

The second thing that has happened, at least in India, is a very large migration of mutual fund investors to direct equity. 10.8 million new demat accounts were opened by investors in India post-April 2020. Retail holding in NSE listed stocks is currently around 7%, which is an all-time high. Since July 2020, mutual funds have seen an outflow of 45,000 crs.

I believe that the market condition when a person starts his investing journey has a very large impact on the kind of investor he ends up becoming. For example, most people who started in the 2000-2007 period, ended up becoming growth-oriented buy-on-dips investors (I would put myself in this camp). People who started post-2008 to about 2013-14 were value investors. It is because those factors worked well in the period when they took their first steps.

What I fear is that the influx of a large number of new investors in the markets coinciding with a huge market rally despite weak economic conditions, sends the wrong message to this set of new investors. They may come away with the realisation that markets never go down and central banks can and will always support the market so there is nothing to worry about. And sometime in the future, this is likely to come back to haunt them.

This article first appeared on The perils of the 2020 rally - cnbctv18.com

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Don’t overanalyze PE multiple; understand business, growth levers

There is a raging debate these days on the price to earnings (PE) multiple. This debate is as old as the stock market and keeps cropping up typically when markets have been running at a high PE for a few years.

My thoughts on the PE debate is that it is a waste of time.

First, let’s put an objective and quantitative hat and attack this problem. What is high PE? Is 15 high? Is 25 high? Is 50 high? Or is 100 high? No one answers this question. We cannot have a debate where what one is debating on is a vague notion.

Second, let’s look at what PE is. In absolutely layman terms, PE is the multiple of earnings one pays to buy a stock. Every asset value can be broken up into two parts—i) intrinsic value, which is derived from its tentative future cashflows and ii) transaction value, which is derived from what value someone else will pay for it in a transaction. For example, a painting or a flower vase has no intrinsic value, but it has a transaction value based on what another person is willing to pay for it. As a brief aside here, this is what is happening in something like Bitcoin today. It has no intrinsic value. Its entire value is derived from the transaction value.

Where investing becomes challenging is, both the intrinsic value and transaction value cannot be reliably estimated for the future. A discounted cash flow method is one of the well-known and practised methods of calculating intrinsic value. This method also needs a large number of estimates and guesses. You need to forecast future cash flows, possible capex, discount rate, terminal growth rate etc. Any major deviations in any of these make the entire DCF exercise near about meaningless. What DCF as a practice is good for, if done well, is it helps in thinking through different scenarios and look at different levers that impact the cash flow of the business. You can get a rough idea of a range in which the intrinsic value could be.

The transaction value, on the other hand, is purely a function of demand and supply. So, if you think a Da Vinci painting (or Bitcoin or a piece of rock, whatever) will have higher demand tomorrow than supply, and more people will be willing to pay more than what they are willing to pay today, then the transaction value goes up. Sometimes the transaction value depends on the factors that influence intrinsic value as well. If there is a general consensus that a company is likely to do well in the future even though they may not have done well in the recent past, the stock price does not suffer, as the transaction value compensates for the fall in intrinsic value.

In PE as in real-life asset prices, both these components are present implicitly. Two stocks with the same earnings may have completely different PEs. That is because both their intrinsic value and transaction values could be different. We see this phenomenon play out in the private equity market. Companies with no current earnings get a high PE, because either there is an expectation of higher future earnings or there is an expectation that its stock will have higher demand than supply in the future.

One way to practically use the PE ratio, which I personally use, is to look at the relative PE. It is clear from history that some companies which have better governance, management, growth etc are always valued higher (that is, their transaction value is higher) relative to others. So, a way to quantify this is to look at a company’s PE to the index PE. If you do this exercise, what you do is you take away the exuberance of a bull market and the despondence of a bear market and normalise the PE ratio.

Another important point to understand is that PE is not a valuation metric that should be relied on solely for decision-making. One reason why it is so popular is that it is easily available and everybody can use it, even if they do not understand anything about the business.

My personal experience is that if, as an investor, you focus on understanding the business and its growth levers and leave the academic debates to others, you will probably do much better than if you focus on the PE debate and waste your time.

This article first appeared on Don’t overanalyse PE multiple; understand business, growth levers

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My highlights from the interview:

I remember a lot of value managers virtually going out of business in 2000. Julian Robertson threw in the towel and said he couldn’t take it anymore and stopped managing money in the early 2000s. Everything Julian was long, went up many fold and the tech stocks went down a lot.

Amazon at $3200 is not a bubble stock. Not whatsoever. It’s basically decent value. I don’t just mean Amazon, but a lot of the big FAAMG names.

Biggest Risk: Without a doubt: inflation strong enough that the Fed responds to it. This bubble has gone long enough and it’s extended enough that the minute they start tightening, the equity market should go down a lot. Particularly with so much of the cap weighted in growth stocks, which would be hit the worst.

Don’t confuse a genius with a bull market. [Retail investors could] lose enough money that they’re scarred.

I like a multi-disciplinary approach. My first boss taught me technical analysis. So, I use fundamental analysis and technical analysis. If there are 1000s of securities out there and my portfolio is only going to have 15-20, I’m never going to buy something that doesn’t have a great chart and fundamentals.

The other thing to me [that makes a good investor] is you have to know how and when to take a loss. I’ve been in business since 1976 as a money manager.

I’ve never used the stop loss. Not once. It’s the dumbest concept I’ve ever heard. [If a stock goes down 15%] I’m automatically out. But I’ve also never hung onto a security if the reason I bought it has changed. That’s when you need to sell.

Whether I have a loss or a gain, that stock doesn’t know whether you have a loss or a gain. You know, it is not important. Your ego is not what this is about. What this is about is you’re making money. So, if I have a thesis and it doesn’t bear out — which happens often with me, I’m often wrong — just get out and move on. Because I said earlier: if you’re using the most disciplined approach, you can find something else. There’s no reason to hang on to any security where you don’t have great conviction.

You just have to be disciplined and you’re constantly fighting on emotions. It doesn’t make any sense, but when a security goes up, every bone in your body wants to buy more of it. And when it goes down, you’re fighting and making yourself not sell it. It’s just the nature of the beast. And you cannot get crazy when it’s going up.

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Hello @basumallick
Great post and thanks for sharing your thoughts regularly.

One thing that make P/E irrelevant is, earnings are calculated for tax purpose.

If we can calculate P/E based on calculations of owners earnings (as P/OE) then it will make some sense.

These are my views!!!

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Summary of Annual Reports

Ever since I left my full time job and started investing full time, one of the most important thing I have looked forward to is to read annual reports, especially of lesser known companies. But I spent a lot of time in the last two years to hone my skills on technical analysis and quantitative analysis.

This year my team at Intelsense and I have decided to read as many annual reports as well and summarize the main qualitative parts into 2-3 page documents. It will help in two ways:

  1. Increase the coverage of stocks and understand the stories behind a large number of companies
  2. Have an archive that can be referred to later for a quick review of what happened.

The reason I have focused on the qualitative side is that it is fairly easy to just look up the financials on screener.

I will be posting the summaries on the respective company threads and also on my blog. In case, the company thread does not exist on VP, I will put it on this thread.

If there is any particular AR that anyone is looking to read a summary of, do let me know on dm and I will try to put it in priority in the queue.

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Basu da, Thanks for making this thread and educating everyone. I am interested in Deepak Nitrite, RACL Geartech and Polymedicure AR summary. Please do analyse this.

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Craftsman Automation AR Summary -
https://drive.google.com/file/d/1ArMB17QQ4lVg92wT1QJ_UkT0figfzCEe/view?usp=sharing

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NELCO AR Summary - https://drive.google.com/file/d/1cbK7wYw1QcMfKfVn46R7HSRGxBsLIxOX/view?usp=sharing

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Thanks. If you could add Alkyl amines in the queue.

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Summary of Vimta Labs AR 2021 - https://drive.google.com/file/d/1NNXkyrEtmaydu-HCWXZsebbq6RlcWN73/view?usp=sharing

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Thanks Abhishek da. These summaries are really wonderful.

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Going Down The Quality Curve

We are in a bull market. We have been in one since the cataclysmic fall of March 2020. In the technical sense, markets have been making higher highs. Nearly all technical indicators are bullish, which is usually the case in a bull market. There are a large number of sceptics waiting for a market correction. The market is obliging them once in a while with some pause, sideways consolidation and correction for a few days.

In the last one year, we have been seeing a very healthy sector rotation which has prevented any linear rise in any sector or a particular stock. The exception had been the Adani group stocks, which has also had their share of fall recently. 64% of stocks are still below Jan 2018 highs created by a booming mid & small cap bull rally.

Looking at the sectors which are rallying will give you a sense of the market. Commodity cyclicals like sugar, steel, cement have been at the forefront of the current rally. But other more “secular growth sectors” like IT, pharma, specialty chemicals have also participated in the rally in the last year. In such a market context, there are two completely divergent thought processes that run in the minds of investors. The first is the fear-of-missing-out. We want to be in the hot stock or the hot sector and ride the rally. We do not want to miss out on the rally that is happening where everyone else seems to be minting money. The opposite fear is that the market valuations are very high and makes us hesitate to deploy our capital fully. We are pulled at one time in two opposite directions and do not know what to do.

In a bull rally, the first casualty becomes the quality of the portfolio. Usually, the best quality companies rarely run spectacularly. They tend to be, what I call, “peaceful compounders”. It is the companies a few notches below in the quality curve that runs the hardest. And people with FOMO gravitate towards that. As any market veteran will tell you, you end up with a clutch of poor companies in your portfolio when the ensuing bear market comes.

So, the first and perhaps the most important thing to remember is to not dilute the portfolio quality. Does that mean you forego the rally and resign yourself to a more flaccid investment performance? Of course not. You can definitely participate in a sectoral rally but ensure that you are buying into the top one or two companies in that sector. And make sure you position size conservatively. Always, think of the downside first. Every bull market brings with it some narrative on why a particular cyclical industry has turned the corner and will henceforth be a secular growth story. Don’t fall for that. You should be able to understand both the bull and bear case before you invest.

The second part of investment hesitancy can be avoided by two simple rules. This bull phase may end tomorrow and it may go on for the next five years for all we know. It is important to have a well thought out “systematic” strategy before we invest in a market like this. The first rule of investing in a market like this is by investing slowly, in tranches over time. Take a few months to deploy your capital. Keep nibbling at the stocks you have shortlisted and accumulate them. The second is to have an exit strategy ready. You need to know when and how much you will sell and where you will put the cash. You also have to plan for when and how to get back into the market subsequently.

If all that seems very complex and difficult, just buy good quality businesses and try and ignore the short term market gyrations.

This post first appeared in bull market: How to survive when a bull market takes the U-turn - The Economic Times

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Excellent write up sir. Just if u can explain a bit from ur past experience of seeing several cycles, what happens to sector leader in sectors having tail winds and leading a bull run? Do everything comes crashing down. In 2000, only infosys and a few survived. In 2008, everyone went bust including the leader Unitech. How’s the base rate here?

Great points and especially relevant today. And the important aspects to also understand here are that ‘quality’ and ‘secular growth’ are not 2-3 years stories, but rather a qualitative framework encompassing management, industry, capital management, growth longetivity etc. Similarly a lot of stories currently playing in the ‘secular growth’ theme could be actually longer cycles - some very highly valued companies in the chemicals and healthcare come to mind.

Peter Lynch has a decent framework on this in his 2nd book. Known to own very many stocks and not be worried about churn and book profits frequently, he would move aggressively to high growth/lower market cap quality companies in bearish market periods and move into stalwarts/large caps during bullish periods like the current one where everything seems very rosy.

But the bottom line is our view is a long term timeframe, buying and holding onto quality as the core part of the portfolio is a great strategy. Whether it is the best is anyone’s guess, but considering past experiences, I am glad to have got the opportunity to exit some small/mid caps/cyclicals at the valuations that currently we are getting and putting the money into quality names or even international diversification.

Basically, ‘quality’ in my opinion takes years and decades to build - and does not change in 1 year. So the logic is to stick with places that you know have the quality, and if you have the vision and conviction, hope to identify just a few companies that might be quality companies in the future and hold them forever or buy them when the chips are down.

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Discounting DCF - Why DCF fails most of the time in valuing companies

This post was triggered by a valuation of Zomato. It came as a WhatsApp forward and I laughed out loud when I saw it. I have been a skeptic of DCF (discounted cash flow) and a lot of simultaneous thoughts ran through my mind.

The obvious problems of DCF are many. I will list a few of my pet peeves here:

1) Most of the present value is derived from the terminal value - Terminal value assumes that a firm will be in business forever. May not happen in real life. Secondly the growth assumptions of close to GDP growth rate is also fallacious. Who can determine what the GDP growth rate will be in 2040? India’s GDP before 1991 was an average of 4% and that of the last 30 years post-liberalisation at about 6%. Excluding the Covid period, it has varied from about 4% to 11%. So, what value should we take for terminal growth. Try changing it from 4% to 11% and see what a difference it makes to the valuation.

2) Arbitrary discount rate and cost of capital - The discount rate applied varies vastly over time and has a large effect on the DFC calculation. People use basic approximations like 10 or 30 year US treasury rates or some such risk-free rate. Again a few percent difference can make a huge difference in the final value, so much so that the entire valuation becomes redundant.

3) False precision bias - The entire process is full of assumptions. And it has to be because it deals with the future and as such cannot deal with any levels of certainty. But a DCF done in an excel gives a double digit precise value. People misunderstand accuracy for precision.

4) World is dynamic and things change - The world is changing all the time. I don’t think we need to remind ourselves of that in pandemic times. Like I keep saying no annual report had pandemic as a risk before 2019. So, making revenue, cash flow projections for the next 10 years is not only extremely difficult but, in my mind,foolhardy. People who were valuing Amazon had no clue that AWS would turn out and be as profitable as it has become. Similarly, glance back at DCF valuations done of Nokia in 2005-06 period. You will know what I am saying.

5) Gives a false sense of security - Because you think you have done a valuation, you believe you know what the business is worth. But that does not help you in real life. What do you do if the stock price falls below your calculated value? You buy more? Or sell? What if you buy more and it keeps falling? How long do you buy? What happens if the price goes up 2x-3x-5x from the calculated value? Do you sell because it’s overvalued? Do you hold on for more gains? So, you see valuation is just one small part of the whole.

6) It ignores market sentiments - Valuation depends on the sum of all future cash flows and also the “prevalent market sentiment”. The second part is actually equally important. The same company will be valued differently in a bear and bull market even if their underlying business performance is not impacted. Case in point is say Infosys in 2000 and 2001. Same company, doing the same thing, but market value is a fraction of the past.

Every asset value can be broken up into two parts—i) intrinsic value, which is derived from its tentative future cash flows and ii) transaction value, which is derived from what value someone else will pay for it in a transaction. For example, a painting or a flower vase has no intrinsic value because there is no cashflow, but it has a transaction value based on what another person is willing to pay for it. This transaction value keeps changing from time to time based on many other factors like liquidity, political and social situation etc.

Now having said so many negative things about DCF, it leaves us with two practical questions. Firstly, does it mean that we should completely ignore that process and secondly, if not DCF, then what?

Let’s try to answer them one by one.

The process of doing a valuation, especially one as rigorous as DCF, is very useful. It helps you walk through many aspects of the business and make your assumptions explicitly. Like what could be the revenue growth over time, what would be its components, at what margins etc. This helps in the understanding of the business in a much better manner.

And for the next question, I will let the great masters speak.

Munger: “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”

Buffett: “It’s true. If it doesn’t just scream out at you, it’s too close."

To summarize, you need to focus on understanding the business and its various levers well enough to figure out it is screaming at you to buy or sell. If you need excel for it, you don’t know the business well enough.

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This is vert well written. I am reading a book called Expectation Investing, where the author contends, reverse engineering the price, or inverting the price, to gauge the expectations of the market, may lead to better understanding. Finding it an interesting read.