Negative space, in art, is the space around and between the subject of an image. Negative space may be most evident when the space around a subject, not the subject itself, forms an interesting or artistically relevant shape, and such space occasionally is used to artistic effect as the ‘real’ subject of an image. In graphic design for printed or displayed materials, where effective communication is the objective, the use of negative space may be crucial. The best storytellers can artfully shape the narrative like designers make use of negative space. The Buffett/Munger way of investing is a bit like looking for negative spaces. What lies beyond the numbers is more interesting than the numbers themselves. And in this process, when one is dealing in shadows, one can go wrong. I think, in India, return has not only been about current or emerging moats, but to a large extent also on the addressable growth and market opportunities that have been present in industries. Competitive advantage comes in a variety of ways — cost advantages, network effects, intangibles like brands, regulatory advantages, switching costs and even things like the culture of a company. But having a competitive advantage is not enough. It must be an increasing competitive advantage.
For huge return, a large market opportunity is also necessary. And I will show you why through this example. Imagine that you have found Aesop’s goose and it is not going to die, not going to mate, not going to eat or fall sick and will keep laying golden eggs worth ₹1 crore every year. There are no taxes and interest rates are to remain constant at 10%. You decide to encash your good fortune and sell the goose for ₹10 crore to a gold miner. While the goose does have a competitive advantage (zero cost of production and a unique asset) in the gold mining business, the new owner will not become richer with the purchase, unless a way is found to get the goose to lay more than ₹1 crore worth of golden eggs every year. Competitive advantage (or an economic moat) by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does. Of course, if you were fearful and the buyer was greedy, you could have sold the goose for less than its economic worth and value would have been created on purchase.
These, I believe, are important factors that can bring about large shifts in value migration. They require the use of mental models that fall outside the normal use of spreadsheet growth rates. The growth here cannot be easily predicted. I have never felt comfortable going much beyond what I can easily predict with a high degree of conviction, but I want to underscore the importance of these factors in giving huge return to some investors. The technology and pharma sectors are ones that readily come to mind, but there have been examples of large wealth creation over short periods in other industries. While a large part of the Grahamian thinking is about eschewing speculative endeavours, which means making assumptions of growth that may be different from what has been achieved historically, moat investing is different in as much as it usually has what Graham, I dare say, would have called a large speculative component.
The question that a Buffett/Munger investor would ask would be about the likely changes in business design and the business model, what could be the share not of the market, but of the market value a few years down the line, who could be the most important competitor to the company a few years down the road, which business designs could have superior economics and how will value thus migrate away from the company. It means thinking strategically rather than just quantitatively. And since it focuses on changes that may or may not happen in the future, it is inherently speculative. If wrong, value destruction for the shareholder can happen in both the paradigms. This is interesting, because one actually has to change how one perceives a company. You start out focusing on price and the company starts developing strong moats and addressing much larger market opportunities. If you don’t catch on to the change, you sell too early and leave a lot of money on the table. So a Grahamian caterpillar turns into a Buffett/Munger butterfly. I’m not going to name them, but two of the three stocks that have been 100-baggers for me over relatively short periods of time have been in this category. The Buffett/Munger framework has given me 25-year 100-baggers.
Spot that change
My friend and noted investor Dileep Madgavkar, whose ideas I respect, introduced me to the idea of delta in investing. This means to not only look at the fundamentals, but also at the changes, the deltas, in the fundamentals. Not just the changes in margins or changes in return on capital employed, but even changes in intangibles such as the size of the moat. Markets re-rate and de-rate on deltas and it is important to understand what causes them. I think it is important to be on the sharp upside of the sigmoid curve. It’s about getting in early in a large market opportunity. In my case, I must hasten to add, in most stocks where I have ridden the sigmoid curve up, it has been largely through luck. Awareness of ignorance, I believe, is a great strength. Only when you know something about a subject, can you be aware of what you don’t know.
As Warren Buffett has often stated, investors must know when they are operating well within their circle of competence and when they are approaching the perimeter. What needs to be thought about should be important and to some extent predictable within a reasonable narrow band of high probabilities. What needs to be avoided is the circle of illusory competence that deals with a whole bunch of things that are not knowable, by which I mean predictable within a narrow band of high probabilities. It is easy to migrate from the good circle to the other one because of all the cognitive biases that we are prone to and the tendency to confuse luck and skill. But I believe the trick is to not try to become an expert in too many things, but to be patient for the right price when you know what you truly know.