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Interview

"If you cannot value a business, then price has no meaning"
In the second of a three-part interview, ASK group’s Bharat Shah elaborates on the investing lessons learnt over a 29-year-long career

Jitendra Kumar Gupta

How do you apply the art of exclusion in investing?

The art of exclusion is a very powerful idea in investing. You must filter out things such as bad management and bad business. Some of these filters are powerful enough to help you identify what to knock off your list. Businesses that do not have a material size of opportunity even after a considerable time period will continue to perform poorly.

Investing is both an 'art' and a 'science'. Art must precede science. What to reject comes from the 'art'. Then comes the character of the business and its valuation, which to my mind, is 'science'. If you start with 'science', not many options will be eliminated. For instance, if we apply the valuation filter, 90% of the companies, which are today trading at a single digit P/E, will land at your doorstep. On the contrary, if you start with the 'art' part of investing, 90% of these companies will be purged out and then you need to devote your time only to the remaining ones, maybe 4-5% of the entire universe. That is a far more efficient and time-saving exercise. It will make your decision-making skills sharper.

Tell us how has your investing evolved over the years?

Over my 29 year-long investing career, there are four to five elements that have altered. First, the 'art' part of investing, which is the difficult part, has been refined. The 'science' part is relatively easy to grasp and replicate. Once you are able to improve the 'art' part of investing, then you move ahead. At this stage, for a proportionate effort, you get disproportionate rewards.

In this business, you need not necessarily have Einstein’s grey cells. Broadly speaking, you need to understand the character of a business, which means what makes a business work, what makes it succeed and what will happen to it in the future. If you cannot understand diverse businesses; you cannot be an investor. The ability to value a business is more of a skill.

If you cannot value a business, then price has no meaning. Only if you are capable of comparing price to a certain value, will it make sense. Price is disobedient, volatile at times and depressed at times. The master is value. Thus, the second important aspect in investing is your ability to value. Without this skill, one cannot be an investor.

Then comes the 'art' — the first and most important aspect here is quality. You need to have the discipline to buy nothing but quality. In addition to this, you must purchase quality stocks with a meaningful safety margin. You do not want to buy gold at platinum’s price. Hopefully, you want to buy gold at silver's price. So it is all about seeking a reasonable discount on its actual worth. Here again, you need discipline.

The second aspect of the art of investing is wisdom. More than intelligence, the wisdom to stay on course plays a crucial role. Once you have understood the business, valued it, bought it at a sensible price with a sufficient safety margin, then do not flirt. Do not be temperamental, be patient, be prudent enough to realise that when you make a good choice it may not necessarily lead to instant gratification. The wisdom to foresee the larger purpose of what you have bought is vital. Thus, the ability to remain inactive as opposed to being hyperactive, which is what one usually tends to do, is an improvement I have brought about in myself.

So, the intellect to understand businesses, the skill to value it, the discipline to purchase at a meaningful price and the wisdom to stay on course are the critical aspects of investing. There is nothing more to it. While 'science' and 'art' should get almost equal weightage in the investing process, 'art' I would say, is 50.1 and 'science' is 49.9. But that minor difference can hugely impact the outcome.

I can’t emphasise enough on the power of filtering. The moment you allow your mind to be clouded and make that mistake of staring at the price to earnings multiple, dividend yield, etc, you will end up looking at 90% of unworthy names. The moment you learn to exclude, you will improve your effectiveness. I wish somebody had taught me this early on in my career. That would have helped me avoid many errors. This approach completely liberates you from the tyranny of so many idiotic, unwanted mechanical things that you do simply because you don’t know any better.

Another area where I have improved upon is valuing a business. Here, gathering inputs is an 'art' — how long will a business survive, what is the size of the opportunity; therefore, at what rate is it likely to grow, will the growth happen now or later, will it be relatively more consistent or volatile? However, converting all this information to a workable model to compute its value is a 'science'. Unfortunately, we do not have a clear-cut way of valuing businesses. This is one area where I have learnt a lot. Overall, I would say, my temperament as an investor is a fundamental change that has occurred over the years.

Most investors including Warren Buffett have evolved from pure Graham. Like Buffett says apart from Graham, he is more like Philip Fisher. His investing style now incorporates Munger’s multidisciplinary approach. Do you think this is the new order of value investing?

That was a huge evolution and a clear shift from Graham’s cigar-butt approach to investing. Graham's investing began just before the Great Depression and it continued for a few decades thereafter. His mind, attitude, methods and ideas were shaped by those events. Everything was so cheap, because after the debris of the Great Depression, only 11% of the market remained. The four years of carnage damaged 89% of the market. The cigar-butt approach was appropriate when the market was down in the dumps, which cannot be replicated in normal times. That is why the concept of quality emerged as a powerful idea in investing.

Quality was the idea of Phil Fisher and Buffett was a late adopter. He was too much of a Graham follower to begin with. It is only when he learnt of Phil Fisher's idea of quality that he became a complete investor. Also, Munger sharpened his ideas and intellect on how to appreciate quality and certainty.

Certainty is another very powerful concept. If Mount Everest is here, then I can see it, I can relate to it, I can decide what I should do with it. But if I have to predict that the mountain will emerge from the ocean, there is only a small tip that is visible, and only an estimate of the rate at which it is going to emerge, as is the case with say an e-commerce business, then that involves a high level of uncertainty. Munger pointed out how certainty is a powerful idea.

People often choose to predict. This is rooted in the human psychology. All of us want to say, I discovered this and I am Columbus. Even the most intelligent people are on the lookout for discoveries because of their ego; intelligence and sensible decision-making becomes a slave to that ego. This ego makes you do foolish things that your intellect will otherwise prevent you from doing. Investing is about making sensible bets by looking for certainty and then converting your margin of safety into a acceptable return.

Isn’t predicting an intrinsic part of finding multi-baggers?

Multi-baggers happen, you do not have to predict them. Do the right things and compounding will start to work. For instance, getting a 150% return in two years is not as attractive as getting a 5,000% return over a period of 25 years.

Preservation and appreciation are both critical to investing. To put it in perspective, the idea of preservation is 50.1% and the idea of appreciation is 49.9%. Preservation cannot be compromised under any circumstances. Preservation is not about guarding against the temporary ups and downs. It is about guarding against permanent loss of capital.

This is possible to achieve irrespective of the market. Preservation comes from the focus on quality — quality of management, the business and the balance sheet — which form the foundation of capital preservation. If you do not overpay, quality will still save you. On the contrary, even if you have got a bargain and you bought an inferior business, that bargain will probably not be able to save you.

Quality is the foundation of preservation, and earnings growth backed by quality of the growth is the foundation for appreciation. Quality will protect, growth will expand the value,and these two put together will give you safe and superior returns.

To read part one and part three, please click on the respective link

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