What's On Your Mind, Mr. Buffett ? 2017

Learning from the master

An avowed drinker from the Buffett fountain of wisdom on what he has imbibed 

This story goes back to 1996, when I was living at our plant site in Orissa. I am sure most of you have never been to a cement plant and many would never have lived in an industrial town. Being a colony set up around the factory, these places are quiet after sundown. Home to work is about 6 minutes, so, commute does not eat up your time. As a result, once you get home, you have a lot of time – to play your favorite sport, to catch the news, to read and to think.

I was reading a lot of books on leadership, strategy and general management at the time. One day, I do not quite remember how, I stumbled upon the book, “The Warren Buffett Way”. It was a pretty thin book and once I started reading it, I couldn’t put it down. Not that the book was great but the topic and the personality covered made it immensely readable. That was the first book that I ever read on investing. Given my chartered accountancy training, the subject just hooked me. During my articleship days at Price Waterhouse (as it was called then), I had seen many of my colleagues discuss stock ideas but at the time I never got sucked into the conversation. But once I read this book, I just had to learn more.

Once I had got initiated, I just had to go to the source, so I went straight to the Berkshire Hathaway website and downloaded all the letters Mr Buffett had written to his shareholders. Though he had been writing to his shareholders since 1957, the website only had letters starting since 1977. I read each of those letters taking furious notes along the way. Then it was one book after another, some on Mr Buffett, some on investing. I had effectively enrolled in the Investing 101 program, in some ways, like Eklavya. It was long distance learning, with no direct contact with the guru.

Around April 1997, I had come to Delhi to attend my first child’s sports day at a play school in Nizamuddin. There, I bumped into an old friend from the Price Waterhouse days. During our conversation, I learnt that after he completed his chartered accountancy program, he had got into investing. And not just any kind of investing, he had got into value investing – the very subject I had been reading about over the past year. That was the start of my investing journey, after spending a bit over a year just reading.

To be a great investor, you need to be wired in a certain way along several dimensions. Just being good with numbers alone will not take you very far. Understanding human psychology alone will not take you very far. Having a great memory alone will not take you very far. Great people skills, while critical to do well in life, will, by itself, not lead you to great financial success. Appreciation of the innards of several businesses, by itself, is not a guarantor of investing success. Enjoying reading and being able to speed-read will, by itself, not lead to financial freedom. Having humility, though a critical trait, is not going to make you rich. Finding your passion early in life will not make you abnormally rich. Having unwavering passion for the same subject for five decades will lead to excellence in whatever field you choose, but may not be financially as rewarding as investing could be. 

Getting exposed to other geniuses like Mr Benjamin Graham and Mr Charlie Munger, the two biggest influences in the life of Mr Buffett as an investor, was circumstance. Not to mention, a great mind.

The genius of Mr Buffett is that he is wired to be an expert along most of these dimensions. This is not to say that he has not worked very hard for his success, but the point is that he had the key ingredients when he came into this world. Many other investors have tried hard to replicate that success. Why is there only one Warren Buffett? It is because, as Mr Munger says, you need to have several influencing factors going in the same direction to get a lollapalooza effect. 

So, let’s get started on what I learnt from Mr Buffett. I have learnt along so many dimensions that if you are reading this article to get investing insights, you will be disappointed. Let me start with thinking about how to think. And then talk about a few other things that I learnt from the inimitable Mr Buffett.

Permutations, combinations and probability theory
Human minds have evolved to react to threat perceptions. And the response mechanism is usually hard wired, based on several millennia of real life experiences. See lion – run kind of responses. These shortcut responses have a purpose in life. It is to take decisions fast without wasting the computing capacity of the mind. However, the system, like any other system, also has drawbacks. It tends to oversimplify and forces you to take a decision, which ends up being suboptimal. In the investing world, this manifests as greed and fear. When the front pages are filled with negative news, the automatic response is flight to safety – keep money in a bank fixed deposit. Never mind that the bank itself might go bust.

What works better is to find out what are the key possible outcomes, what might happen if each of those scenarios play out and what is the probability of each of those scenarios playing out. So, if the economy is in trouble, it need not mean that everything is in trouble. There will always be things that will be needed in any kind of economy. And it is precisely at the time of a crisis that it makes sense to buy them.

Now it takes a lot of mental courage to get yourself to write the cheque at times like that, but if you have run through the decision tree with the probability of each branch of that tree, you are much better equipped to pull the trigger. The same principle applies to almost anything you do in life, even running a business.

The human mind has other limitations too. It tends to remember the big issues that need to be dealt with. However, in life, not much is achieved without rigor. As they say, God lies in the details. So, while the mind is not equipped to remember a long list of to-dos; that is precisely what is required to do a thorough job. Whether it is investing or performing a medical procedure or flying an airplane or, for that matter, running a business. For doing a thorough job at anything that is mildly complex, there is no substitute for checklists. Of course, if you are Rajinikanth, my apologies for suggesting the use of checklists.

To be able to handicap odds of any event on any decision tree, it is critical to understand human psychology - why people do what they do, what are the forces that affect their decisions, what kind of compromises might be made in making the decision, etc. These are all aspects which are important in assigning a probability to major outcomes on a decision tree. So, if you are studying a company for a possible investment and you want to figure out how the company might do in future, you would be well served if you are able to analyse the psychology of the key players in the industry, key players in the customer industry, the ministry that influences that industry, etc. The bad news is if you are a number-crunching kind of investor, you could be completely misled by the spreadsheet which has no qualitative input built into it. The good news is if you keep abreast of going on in the country and the industry, over time, you will have a reasonable understanding of what might happen in certain situations. And you can use that experience to attach odds to various possible outcomes.

Backups, breakpoints and critical mass
Anyone who has ever worked on a Windows machine knows what a powerful concept backup is! In life, Murphy’s Law is everywhere, not just inside your computer. And therefore, when a company prepares a business plan, it needs to have backups. Life is unpredictable and without a plan B and a plan C and sometimes a plan D, E and F, results achieved will be very different from plan A. But how does this apply to investing? When we sit down to project earnings growth, we need to think where that growth is going to come from. And while making our own assessment of earnings growth, we need to be aware of how many backup plans there are to create that growth. The fewer the backup plans, the more fragile the growth assumption.

Likewise breakpoints are a great model. A rubber band will take only so much stretching before it reaches breakpoint. Likewise any balance sheet and income statement will take only so much leverage and no more. A diligent investor must be able to assess what that breakpoint is and what could happen beyond that.

I am sure all of you would have heard of the term critical mass. Usually, it is used when describing a raging bull charging towards you! However, it has other applications as well. It takes a lot of effort to get a business off the ground – just like the infancy years of a new born. The mother struggles for years before she can start sleeping according to a routine again. Then come the kiddish  years, when a lot of supervision is still needed but less than an infant. Gradually over time, the child becomes an adolescent and starts helping with house chores and other stuff. And when s/he finally becomes an adult, s/he contributes to the earnings of the family, sometimes dramatically increasing the household income. Business works the same way. There is a point in any good business where incremental effort shows up disproportionately in the profit figure. Investors call this the hockey stick growth phase in the life of the business. Investors who can figure out where that point is can land themselves in the land of the 100-baggers. People who invested decent sums of money in companies like Infosys, Hero or Bharti at the inflexion point never needed to buy another stock, if they chose not to.

Bean counters are not the most respected souls on the planet. That said, understanding what accountants understand is critical to being a good investor. Mr Buffett himself endorsed this by saying that accounting is the language of business. 

To understand what results a business is producing, it is imperative that you have a good understanding of accounting. I am a chartered accountant by training, so I understand the nuts and bolts of numbers fairly well. But after I started investing, I was able to connect business to numbers in a completely different way. It is the difference between knowledge and wisdom. When you have knowledge you know about it, but only once you have experienced something do you get wisdom. Only by reading Mr Buffett’s writings did I learn what to look for in the numbers and how to interpret some key numbers. I also learnt to appreciate that accounting is only a crude approximation and not a science. So, one should understand that numbers are not cast in stone and that from time to time, these approximations will go wrong.

Circle of competence
This is a big one. Sounds simple enough – know what you know. But when you start applying this principle in life, you learn what you thought you knew, but never really did know. And it’s all relative. You might know something but unless you know it better than the others in the game, you have no comparative advantage. It is possible to know very little and make a lot of money but you must know exactly what you know. As an example, many years ago, we were looking to buy some land. We looked at various options of similar land and decided to buy the one that was near an important site. 

All other things being equal, land near that site should have been equal or more expensive than other comparable land. On the contrary, it was cheaper. This is classic market inefficiency. We knew what we were doing, we understood the risks and we bought. Over the six years we have held the land, the price has multiplied 15 times.

Margin of safety
When projections do go wrong, either due to error in estimation or worse, due to error in business judgment, you need chapter 20 of The Intelligent Investor – Margin of Safety. In many ways, if you learn this lesson really well, you probably do not need much else of what I have written in this article. The concept is that if you buy anything cheap enough, relative to its intrinsic value, it becomes almost impossible to lose money. And interestingly, once you make sure that you will not lose money, it is almost guaranteed that you will make super-normal returns. How? Think of an iPad, which retails at say $500. Now let us say that is its intrinsic value to a buyer. If you are trading in iPads and buy it close to or higher than $500, you will almost never make money.

In fact, there is a high probability that due to the price you paid and obsolescence risks, you will likely lose money. On the contrary, the lower the price you buy it at, the higher the probability that you will find a buyer at a higher price (not lose money) and the more money you will likely make (higher upside). In value investing, return is inversely proportional to risk. The lower the risk, the higher the return! The principle is that simple and it applies equally to buying equity or anything else for that matter. It is just good old wisdom that you have seen your mother practice when she took you along while going shopping. Let me now talk a bit about what I have learnt from Mr Buffett as a human being.

Dealing with people
Mr Buffett is a great judge of people. He has seldom erred in choosing his business partners. Once he chooses the right people to partner with, he never loses an opportunity to praise them publicly. Of course, it is all genuine praise, but I have seen many who fear that praise may go to the executive’s head. And so, they refrain unless they absolutely have no choice.

On the flip side, as and when he is in disagreement with something or someone, he makes sure he never criticizes the person in public, if at all. The principle he follows is be specific in praise and general in criticism.  These are simple principles, which we have all heard of while growing up, but as we grow older, we stop practicing these things, despite the fact that they are hugely important for building great relationships.

The more successful you get, the more enemies you get. People get jealous and try to pull you down. That is part of human psychology. It is not only in the Mahabharata and in textbooks. It happens in real life. And one way to minimize the conflicts that arise from comparisons and jealousies is to be humble. Mr Buffett still lives in the same house that he bought way back in 1958.

The other big thing that neutralises jealousy is philanthropy. When you publicly give away a big part of your fortune to the underprivileged, people in general will respect you. That’s not to say that one should give away wealth for this reason. Giving, by itself, is a very enriching experience. The feeling of being able to change the quality of lives of people is a massive reward in itself. 

I could go on but I guess you get a picture of the complexity of what it takes to be a great investor. To say that Mr Buffett is simply a good value investor is to oversimplify, greatly, a nuanced human being. Charlie Munger once said, the concept of value investing is simple, but that does not mean practicing it is simple. I hope I have been able to explain in some detail why it is not so. And why there is only one Mr Buffett.

The writer is the executive chairman at Revathi Equipment