Chetan Parikh enjoys high recall among value investors in India. Rightly so, as he has contributed the most towards creating awareness about value investing through capitalideasonline. His book, India’s Money Monarchs, co-authored with Utpal Sheth and Navin Agarwal, was the first to chronicle the thought process of prominent Indian investors. Over the years, Parikh has not only built an impressive investing track record, he continues to spread the good word by teaching security analysis at Mumbai’s Jamnalal Bajaj Institute of Management Studies.
Benjamin Graham laid the foundation for value investing, which Warren Buffett built on. But along the way, the architectural design underwent some significant changes. Buffett calls Graham’s The Intelligent Investor “by far the best book on investing ever written” and particularly commends chapters 8 and 20, which deal with the investor and market fluctuations and with the concept of buying securities with a “margin of safety”. While value investors are advised not to, it may be interesting to enter into the realm of speculation, and wonder what Buffett would change if he ever edited the The Intelligent Investor.
He may choose to rewrite parts of chapter 7 dealing with the purchase of “bargain issues” for enterprising investors and could well elaborate: “If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible… Unless you are a liquidator, this kind of approach to buying businesses is foolish. First, the original “bargain” price will probably not turn out to be such a steal after all… there is never just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return the business earns.”
He probably will not fully agree with certain parts of chapter 14 with its emphasis on the quantitative approach and diversification for the defensive investor. The Oracle of Omaha would add, “We are searching for operations we believe are certain to possess enormous competitive strength 10 or 20 years from now… When we own portions of outstanding businesses with outstanding management, our favourite holding period is forever… We believe a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristic before buying into it.”
Buffett will probably also emphasise Graham’s aversion to the use of higher mathematics in investing. Lord Keynes wrote in one of his essays about “several economists, who by 1871, were scribbling equations with x’s and y’s, big Deltas and little d’s.” That hallowed tradition has continued since for more than 140 years, combining spurious precision with erroneous conclusions — a direct result of rigorous logic following nonsensical assumptions.
That observation aside, if Buffett ever edited The Intelligent Investor, he would probably elaborate on Chapter 19, which deals with shareholders and managements. He may add his thoughts on the “unseen force” of the “institutional imperative”. He may perhaps not concur entirely with Chapter 19 on dividend policy, but would perhaps centre his discussion on dividend policy by stressing the nature of the business (“the great, the good and the gruesome”) and managerial rationality.
Buffett may well include a chapter on the importance of buying companies (even at fair prices) with pricing power, having low capital requirement for growth and having the ability to maintain and increase their competitive advantage. While he has elaborated in his letters on these characteristics, a qualitative and logical discussion on not just what “moats” are, but how they arise, how they can be identified (if within one’s circle of competence) before they are widely evident and what causes them to grow or diminish could conceivably rank along with chapters 8 and 20 as one of the most important in the book. A chapter will probably not suffice and so he may well add a part 2 to the book, titled “Strategic rationality and the investor.”
Here is a thought experiment on investing (adapted from Good Strategy Bad Strategy by Richard Rumelt). Imagine you have found Aesop’s goose and it is not going to die, mate, 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, but let’s not assume irrationality.
On many occasions, including at the recent Coca-Cola AGM, Buffett has talked about the importance of managerial attitude to increasing competitive advantage and not losing focus and becoming complacent. “You want a restlessness…a feeling that someone is always after you, but you’re going to stay ahead of them…That restlessness, that tomorrow is more exciting than today will have to permeate the organisation.” The Red Queen told Alice in Lewis Carroll’s Through the Looking Glass that “it takes all the running that you can do to stay in the same place”. Buffett, like the Red Queen, tells his managers to run at least twice as fast.
While the principles of value investing are eternal, analysis of competitive strategy is temporal. What sort of questions would Buffett address in elaborating on rational analysis of corporate strategy? Some come readily to the mind although there are many others. What causes products or services to be truly unique or at least perceived to be so? What can cause cost differentials to be sustained? How does an investor analyse economies of scale? How does an investor analyse the impact of changes in technology on entry barriers before they appear in the financial statements? What causes some industries to suffer relatively poor profitability in spite of barriers to entry? How important are entry barriers in rapidly growing markets at the early stages of their growth? Which sorts of industries are amenable to first-mover advantages and why does that happen?
For an outsider, an evaluation of corporate strategy is difficult even under the best of circumstances. Take the recent case of an Indian auto ancillary that is supplying largely to the commercial vehicle sector. Competition has knocked furiously and the company has been able to prevent commoditisation, it has been successful for a relatively small part of its turnover. More importantly, it subcontracted some of its activities and now finds a loss of bargaining power because its subcontractors have scaled up considerably. Its past margins and returns on capital employed are in danger of structural (and not cyclical) impairment. Going with historical valuations may lead to a value trap. The moat of scale had once been there, but the company allowed the drawbridge to be lowered and left its battlements thinly manned.
To cite another example, an Indian auto ancillary company that supplies to the commercial vehicle sector has a dominant distribution and service network, a “moat” that has been built over a long period of time. Any competitor wishing to enter its OEM business faces the chicken-and-egg dilemma: it cannot build volumes without having a vast network nor can it build a vast network without having sufficient volume. Some investors might also believe that the incumbent’s technology is its second “moat”. But if it is not unique, one may end up double counting. Therefore, counting two “moats” when there is only one is not prudent. Further, if any competitor is able to overcome the earlier-mentioned dilemma, which it may over a long period of time, the only moat the company enjoys may be in danger of being breached.
Given such pitfalls, the investor may get things precisely wrong, rather than approximately right, no matter how much he chooses to understand specific companies or the behaviour of stock markets. So, if neither Mr Market nor Mr Company will surrender their secrets, the first due to a whimsical nature and the second because doing so is illegal, how can an investor make money? Buffett stated in a 1984 talk at Columbia University: “I can only tell you that the secret has been out for 50 years, ever since Ben Graham and David Dodd wrote Security Analysis.”
The mists may have cleared, but the mountains still have to be climbed. Graham and Buffett have spilled their ideas to “flick them at the world”, and made investing a simple subject, though unfortunately, one in which very few can excel, because in the end, it is more art than science. Keynes wrote a wonderful passage on economics but the same holds true for investing: “Professor Planck, of Berlin, the famous originator of the Quantum Theory (in physics), once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. He did not mean that! But the amalgam of logic and intuition and the wide knowledge of facts, most of which are not precise, which is required for economic interpretation in its highest form is, quite truly, overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision.”