Moats Versus Boats - Part 9

Let me stay a while on the asymmetry of risk and reward. India is a country where the regulatory assumptions and environment changes very dramatically. This can fundamentally change the valuation or earnings power of the business. If you go back five years ago, we were buying private sector banks. It was very clear that there was going to be a fundamental shift in market share from public sector to private sector banks. You had an economy where nominal GDP was growing at 13-14%. You had the banking system growing at 16-17%. There was no rocket science, it was clearly going to happen and the market eventually valued in the assumption.

And sometimes it is a simple normalisation trade. We bought a company called Cholamandalam Investment a very long time ago. We bought it at a RoE of 0.8% and the RoE is now is about 10. We just  looked at 20 years of NBFC industry data and Chola was massively under earning for a variety of reasons. But it seemed clear that they would go back to normal levels of profitability and margins which other NBFCs had and the market would then price it in. So this is another example where our assumption of company's earnings power and business was very different from the market from a 5-year perspective. That was a situation where we were right and we made a disproportionate return.

That said, in my opinion selling is a far more difficult decision than buying. So, when do you decide to get off the gravy train? What level of overvaluation is too high? It is a tough decision. I would say that our plan is to stay invested as long as we possibly can. The other guide is normalisation of margins. When you evaluate your holdings, ask yourself: is it cheap or expensive and on what margin profile? The big thing all of us get trapped in is paying high P/E multiples for bad margins or higher than normal margins. What you want is to buy into a business at lower than normal margins and paying a cheap P/E multiple for those margins.

You need to look at long term margin sustainability and base your valuation on that sustainable margin, not on the current margin, which could be way too high or way too low. The last point is that when you get a good investment you must go all in. All the mistakes that we have made is where we have been too conservative. If you are getting a good stock, good business, good management and good valuation and an IRR of 25-30%, don't waste time waiting for the last 5-10% trying to time the market. Go the whole hog and get as much stock as you possibly can.

This is the last of a three-part series. You can read the first part here and the second part here