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Value Research
w w w. v a l u e r e s e a r c h o n l i n e . c o m

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
 Contents
VALUE INVESTING
3
Foreword
Dhirendra Kumar
CEO - Value Research

5
CEO’s Letter
Nimesh Shah
6 Value Investing Basics
Guide to value investing
MD & CEO - ICICI Prudential AMC All you need to get started

9 Buffett’s Commandments
Investing lessons from the world’s richest
z
z
Approach to investing
Intrinsic Value
and best money manager
z Understand competitive advantages
z Markets and investing
z Businesses to invest
z Businesses to avoid
z Views on select businesses
z Evaluate company managements
z 9LHZRQLQÁDWLRQ
z Advice to investors

22 Guru Screens
Five seasoned value investors and their step-by-step approach to value investing

Benjamin Graham Walter Schloss Joel Greenblatt John Neff Peter Lynch
The master’s Buy value, diver- The creator of The money Invest in only
time tested sify adequately, the Magic master of what you know
principles be patient Formula our time

Value Investing 1
Expert Speak

34 Francisco García Paramés

Co-manager, Bestinver Asset Management

46 Companies with Moat

Companies with Economic Moat
:KHQLQYHVWLQJLQDVWRFNWKHÀUVWTXHVWLRQ
you need to ask is: does it have an economic
moat? And the second: how long will it last?

z Network effect
Smart ways to enhance a product’s value

z High switching cost

Creating entry barriers for competitors

38 Charles T. “Chuck” Akre

Founder, Chairman, and CIO of z Low cost advantage
Akre Capital Management 5HODWLYHORZFRVWKDVLWVPDQ\EHQHÀWV

z Intangible assets
%HQHÀWIURPKLGGHQYDOXHZKHQLQYHVWLQJ

z (IÀFLHQF\RIVFDOH
Gain from price advantage when investing

z Expanding the moat

Beware of companies with narrow moats

60 Word of Mouth
Wise men and their views on value
investing and more

42 Sankaran Naren
CIO, ICICI Prudential Mutual Fund

2 Value Investing

In pursuit of Value
V
alue Investing is not about following
fashions, it’s about following value.
That’s something that Warren Buffett
learned from his guru, the original
conceptualiser of Value Investing, Benjamin
Graham. My company’s name drives its origins
from the concept of value investing, and for
over two decades we have sharply focused on
fundamentally-driven value investing
principles.
There are a variety of ways of defining
Value Investing, but basically it boils down to a
simple concept, that of buying quality stocks
that appear to be undervalued when evaluated
by a measure of intrinsic value. Now, there
may be many, many ways of
defining quality and intrinsic
value but regardless of what one
picks, a few additional things
becomes clear the moment one
becomes a follower of Value
Investing. These are, in no
particular order: investments
must be made with a time
horizon of years, the current
direction and momentum of
Dhirendra Kumar stock prices is irrelevant and
CEO - Value Research therefore, technical analysis is
rubbish and the fashion of the
day (meaning, the majority) is
more often wrong than right.
At the heart of Value Investing lies a very
simple concept which every housewife
shopping for vegetables understands, but
which far too many investors do not—you must
buy things cheap. When it comes to
investments, that means buying a stock for
less than it is inherently worth. And that
means that its current price should be less
than its inherent worth, not some future price
and future date.
Interestingly, Buffett over the years has fine-
tuned value investing principles with a few
cautionary notes thrown in. He says that
buying things cheap is not something that
FOREWORD
takes a lifetime to figure out. It’s not as if
someone has to do a 5-year course and read big
books and understand complex mathematical
formulae and then finally you learn enough to
understand the theory of Value Investing.
None of that. You just have to appreciate the
idea of buying things cheap—of paying less
than they are worth to you.
To understand this, it just takes five minutes
of thinking, perhaps not even that. Either you
get it or you don’t. Either you are the sort of a
person who buys things cheap or you are the
sort who buys things expensive in the hope of
selling them even costlier later on. It goes
without saying that the actual practice of
Value Investing requires some study and a
great deal of discipline. However, once you
have made the decision to buy stocks only on
the basis of their fundamentals and not on
momentum or on future hopes, you have made
a beginning.
In this special issue on Value Investing, we
have analysed and put together Warren
Buffett’s wisdom on value investing, which will
go a long way in understanding and practising
Value Investing. Then there is a section on five
gurus of value investing who are not
theoreticians, but actual practitioners of value
investing. We have detailed their methods and
processes to identify value stocks. There are
also interviews with three expert fund
managers who have been espousing the
virtues of value investing with the funds that
they manage.
Teaming up with Charlie Munger, Warren
Buffett has often talked about the importance
of an economic moat for companies that he
would consider investing in. Just as a moat
around a medieval castle kept the castle safe
from intruders, an economic moat around a
company keeps the company safe from
competitors and other profit-draining forces.
This special issue ends with the section on
economic moats; based on which Warren
Buffett has made his biggest purchase ever.
Value Investing 3
 Ways to
Invest Wisely

Invest in mutual funds with Essential reference for Invest wisely. Ask questions. Track your investments.
confidence thoughtful stock investors Come to your trusted expert

valueresearchonline.com

H
aving closely tracked the Indian stock
market from close quarters since a
couple of decades, I ought to tell you
something upfront: Nothing works better than
buying into companies at prices that are low
enough and waiting for them to deliver
returns. The concept of value investing
elucidated so comprehensively by the stalwarts
from Benjamin Graham to Warren Buffett to
David Dreman, and many more is a subject
that is close to my heart. These gurus have
proffered us timeless advice and tools, which if
adhered to could produce sound and unusual
results in any portfolio.
Value investing as a concept and method
will remain with us forever. The challenge for
anybody is to identify those areas where one
can see value. The challenge for those
attempting to seek long-term gains in the
market is in identifying the “right” price at
which to purchase equity. For the most part,
this is one area not terrifically accurate when
it comes to producing results as depicted in an
investment portfolio.
The market today offers us innumerable
opportunities to study value investing through
multiple sources such as the internet, blogs
and visual platforms. Yet, despite this plethora
of media and the abundance of information
and ideas available to study and dissect this
concept in detail, there’s always need for
more—especially concerning the tools utilised
by the masters of value investing.
In this context this book on value investing
CEO’S LETTER
The challenge for those
attempting to seek long-
term gains in the market is in
identifying the right price at
which to purchase equity
becomes one of the most significant books
you’ll read on buying assets at bargain prices.
In it you’ll find a rich trove of the top masters
of value investing and their diverse methods
of investing—with one common goal, that of
seeking and investing only in attractively-
valued assets.
It’s a book that not only explains the
traditional mechanics of value investing, but
goes beyond in illustrating how the investing
maestros gainfully employ these ideas in
practice in real life. It’s one that encompasses
almost the entire universe of the value-
investing theory, history and practice—one
that could prove to be an invaluable aid in your
value-investing journey.
NIMESH SHAH
MD & CEO
ICICI Prudential AMC
Value Investing 5
VALUE INVESTING BASICS

Guide to value
investing
There are myriad techniques used by investors to identify undervalued stocks,
value investing is a long-term strategy to purchase stocks where the market price is
below an assessment of the stock’s intrinsic value

6 Value Investing
F
or students, practitioners and
followers of value investing, Warren
Buffett is the man to look up to. A Buffett speaks
follower of Benjamin Graham, the
father of value investing, Buffett has become “Most analysts feel they must choose
more famous than his teacher by developing on between two approaches customarily
what Graham taught him. thought to be in opposition: “value”
Over decades, Buffett’s partnership with
and “growth.” Indeed, many investment
Charlie Munger and his brush with Phil
Fisher gravitated him towards looking for
professionals see any mixing of the two
quality stocks rather than just those that were terms as a form of intellectual cross-
quantitatively cheap. The results of his dressing. We view this as fuzzy thinking.
investment process are here for all to see. In our opinion, the two approaches are
For those of you who would like a reminder, joined at the hip: Growth is always a
value investing is a long-term strategy which
component in the calculation of value,
focuses upon thorough analysis to identify
and then purchase stocks where the market
always a component in the calculation
price is below an assessment of the stock’s of value, constituting a variable whose
intrinsic value. The main idea is to buy a importance can range from negligible
stock for less than it is truly worth, according to enormous and whose impact can
to the firm’s financial statements, in the be negative as well as positive. In
expectation that over time this intrinsic value
addition, we think that the very term
will be recognised by the market and you will
be proved right.
“value investing” is redundant. What is
The disparity between intrinsic value and “investing” if it is not the act of seeking
market value exists due to human behaviour; YDOXHDWOHDVWVXIÀFLHQWWRMXVWLI\WKH
as Benjamin Graham notes: “Most of the time amount paid?”
common stocks are subject to irrational and
— Warren Buffett, 1992 Annual Letter to Shareholders
excessive price fluctuations in both directions
as the consequence of the ingrained tendency

Value Investing 7
VALUE INVESTING BASICS
of most people to speculate or gamble.”
This disparity between a fundamental value
based assessment of the true value of a firm
and what the market believes it is worth is a
well known flaw of markets and can endure
over long periods of time, sometimes years! It
is for this reason why value is touted as a long-
term strategy. Indeed, in the words of Warren
Buffett; “I never attempt to make money on the
stock market. I buy on the assumption that
they could close the market the next day and
not reopen it for five years.”
The attraction of value investing lies not
only in the capital gains that can be obtained
from buying low and selling high, and in the
benefit of securing a stream of corporate
earnings at a low price, but in the margin of
safety provided by the disparity between what
was paid for the share and what you believe it
is actually worth.
The vast wealth accumulated by celebrated
proponents of value investing like Walter
Schloss, Joel Greenblatt, John Neff and Peter
Lynch among many others, is evidence of the
efficacy of this approach. While there is
clearly a bias inherent in the use of such
individuals as examples—after all, investors
find fame only if they are successful—other,
more extensive studies have also found that in
the long run a value investment strategy has
RISK MANAGEMENT
z Margin of Safety
z 6RPH'LYHUVLÀFDWLRQ
z Patience—Default
Strategy
REVIEW
z Key Issues
z Personal Biases
8 Value Investing
The best quality of Buffett is
that he has been teaching
his methods to all who are
willing to listen
outperformed both growth stocks and the
market as a whole.
In your investing career, you may come
across many fellows—day traders, technical
analysts, quants and efficient market
theorists who will dismiss Value Investing
methods. Yet, none can claim the same
success that Warren Buffett commands the
world over.
The best quality of Buffett is that he has
been teaching his methods to all who are
willing to listen. His shareholder letters,
interviews and lectures are a treasure trove
for those wanting to drink from the fountain
of knowledge. His methods are easy. What is
more difficult, however, is the discipline to
follow them through.
This special edition is a collection of
insights, views and most importantly, proven
models that follow value investing tenets and
have worked over time. We hope this issue will
occupy pride of place on your bookshelf.
SEARCH
z Cheap
z Ugly
z Obscure
z Otherwise Ignored
VALUATIONS
z Assets
z Earnings Power
z Franchise
 BUFFETT’S COMMANDMENTS

Approach to investing
Buffett’s approach to investing is grounded in values – he does not speculate, nor
does he view buying stocks as short term trades

B
uffett elaborates his stock picking
process in four simple steps and says;
“We make quick decisions because we Buffett speaks
have filters before we get to the point of
making a decision.”
1. Can we understand the business? What will I call investing the greatest business in the world,”
it look like in 10-20 years? Take Intel vs because you never have to swing.” You stand at the
Chewing gum or Toilet paper. We invest plate, the pitcher throws you General Motors at 47!
within our circle of competence.
U.S. Steel at 39! And nobody calls a strike on you.
2. Does the business have a durable
competitive advantage? This is why I won’t
There’s no penalty except opportunity lost. All day
buy into a hula-hoop or a Rubik’s cube \RXZDLWIRUWKHSLWFK\RXOLNHWKHQZKHQWKHÀHOGHUV
company. I will buy soft drinks and chewing are asleep, you step up and hit it.
gum. This is why I bought Gillette and Coke. — Forbes 1974
3. Does it have management I can trust?

“I want a simple business, easy to understand, great

It’s far better to buy a
wonderful company at a fair
price than the other way round
4. Does the price make sense?
Ask yourself when was the last time you us
looked at a stock and thought where it will be
ten years later? or if you will be comfortable
holding this stock for say at least five years if
by any chance you cannot sell it earlier?” Very
few people actually look so far ahead, because
it requires a level of understanding that many
do not acquire. Buffett advocates reading
voraciously to overcome this shortfall. Also
talking to as many people possible associated
with the industry gives a crash course on what
matters. This approach if followed diligently
for every stock one invests in can greatly
improve the returns on the investment.
economics now, honest and able management, and
then I can see about in a general way where they will
be ten years from now. If I can’t see where they will be
ten years from now, I don’t want to buy it. Basically,
I don’t want to buy any stock where if they close the
1<6(WRPRUURZIRUÀYH\HDUV,ZRQ·WEHKDSS\RZQLQJ
it. People buy a stock and they look at the price next
morning and they decide to see if they are doing well
or not doing well. It is crazy. They are buying a piece
of the business. That is what Graham—the most
fundamental part of what he taught me. You are not
buying a stock, you are buying part ownership in a
business. You will do well if the business does well, if
you didn’t pay a totally silly price. That is what it is all
about.”
— Lecture at the University of Florida Business School, 1998

Value Investing 9
BUFFETT’S COMMANDMENTS

Intrinsic Value
Intrinsic value gives a measure of how far the price is on either side, and though
Buffett has never fully elaborated on how he arrives at intrinsic value; he has
explained how to look at it

Buffett speaks
“Let’s say you decide you want to buy a farm and you
make calculations that you can make $70/acre as
the owner. How much will you pay [per acre for that
farm]? Do you assume agriculture will get better so
you can increase yields? Do you assume prices will
go up? You might decide you wanted a 7% return, so
you’d pay $1,000/acre. If it’s for sale at $800, you
buy, but if it’s at $1,200, you don’t.”
— Annual Meeting notes 2007

“In 1974 you could have bought the Washington Post

when the whole company was valued at $80 million.
Now at that time the company was debt free, it owned
the Washington Post newspaper, it owned Newsweek,
it owned the CBS stations in Washington D.C. and
Jacksonville, Florida, the ABC station in Miami, the
CBS station in Hartford/New Haven, a half interest
in 800,000 acres of timberland in Canada, plus
a 200,000-ton-a-year mill up there, a third of the
International Herald Tribune, and probably some other
things I forgot. If you asked any one of thousands of
investment analysts or media specialists about how
much those properties were worth, they would have
said, if they added them up, they would have come up
with $400, $500, $600 million.

10 Value Investing
 Now, if you come back, and the value you
assign the company is $400 million, and the
company is selling for $400 million in the market,
you still have a story but it doesn’t do you any
JRRGÀQDQFLDOO\%XWLI\RXFRPHEDFNDQGVD\
it’s $400 million and it’s selling for $80 million-
that screams at you. Either you are saying that
the people that are running it are so incompetent
that they’re going to blow the $400 million, or
you’re saying that they’re crooked. Or, you’ve got
a screaming buy when you can buy dollar bills
for 20 cents. And, of course, that $400 million,
within eight or 10 years, with essentially the same
assets, [is now worth] $3 or $4 billion.”
But now you say “I don’t know how to evaluate
the Washington Post.” It isn’t that hard to
evaluate the Washington Post. You can look and
see what newspapers and television stations sell
IRU,I\RXUÀ[LVDQGLW·VVHOOLQJIRUVR
what? You can’t [invest safely with such a small
margin of safety]. If your range is $300 to $500
and it’s selling for $80 you don’t need to be more
accurate than that.
I was a chartist. I loved all that stuff. I had
charts coming out my ears. Then, all of a sudden
a fellow explains to me that you don’t need all
that, just buy something for less than it’s worth.”
— Lecture to MBA students 1991

YOU HAVE TO GET TO THE INTRINSIC VALUE!

The simplest explanation of the intrinsic value
is offered by Buffett himself. It is the
“discounted value of the cash that can be
taken out of a business during its remaining
life.” That definition by itself opens up
Pandora’s box. Estimating how much cash the
business can generate during its remaining
lifetime can be baffling alone. If you manage to
do that – despite its problems (discussed in
depth below), then there is the grey area of
using discounting – what rate to use?
Problem: The first decision that
you will need to make is of
opportunity cost. Picking stocks An investor needs
brings in the concept of
opportunity cost. Every
to do very few
investment decision you make things right as
will be at the cost of one you
didn’t. This is not lost on
long as he or she
Buffett. “The first question we avoids mistakes
ask ourselves is, would we
rather own this business than
more Coca-Cola, than more Gillette .... We will
want companies where the certainty gets close
to that, or we would figure we’d be better off
buying more Coke. If every management,
before they bought a business, said is this
better than buying in our own stock or even
buying Coca-Cola stock, there’d be a lot less
deals done. We try to measure against what we
regard as close to perfection as we can get”.
Using DCF analysis to arrive at the intrinsic
value is not without its problems. Forecasting
future cash flows is one of the biggest
criticisms of using DCF analysis. At what
rates will the company grow in the future is
difficult to assess. A historical high growth
rate is no guarantee of the same trend to
continue in the future. Yet, analysts still pencil
in growth numbers into stock value
assessments 5 years from now. It is their way
of telling you that they do know how the
business will pan out in the future.
Here is an easy explanation; “Let’s say you
decide you want to buy a farm
and you make calculations that
you can make $70/acre as the
owner. How much will you pay
[per acre for that farm]? Do you
assume agriculture will get
better so you can increase
yields? Do you assume prices
will go up? You might decide
you wanted a 7 per cent return,
so you’d pay $1,000/acre. If it’s
for sale at $800, you buy, but if it’s at $1,200,
you don’t.”
Here’s another way to look at intrinsic
value. “If you were thinking about paying
$900,000 or $1.3 million for a McDonald’s stand,
you’d think about things like whether people
will keep eating hamburgers and whether
McDonald’s could change the franchise
agreement. You have to know what you’re
doing and whether you’re within your circle of
competence”.

Value Investing 11
BUFFETT’S COMMANDMENTS
Understand competitive
advantages
It is not enough for companies to be market leaders; they need to have some
advantages that put it far ahead of competition
B
uffett searches for this particular
quality in all his investments. It is not
enough for companies to be market
leaders. They need to have some advantages
Buffett speaks
“Think of Disney. Disney is selling Home Videos
for $16.95 or $18.95 or whatever. All over the
world—people, and we will speak particularly
about mothers in this case, have something in
their mind about Disney. Everyone in this room,
when you say Disney, has something in their mind
about Disney. When I say Universal Pictures, if
I say 20th Century Fox, you don’t have anything
special in your mind. Now if I say Disney, you
have something special in your mind. That is true
around the world.
Now picture yourself with a couple of young
kids, whom you want to put away for a couple of
hours every day and get some peace of mind. You
know if you get one video, they will watch it twenty
times. So you go to the video store or wherever
to buy the video. Are you going to sit there and
premier 10 different videos and watch them each
for an hour and a half to decide which one your
kid should watch? No. Let’s say there is one there
for $16.95 and the Disney one for $17.95—you
know if you take the Disney video that you are
going to be OK. So you buy it. So you can get a
12 Value Investing
that put it far ahead of competition – whether
in terms of economics of scale or brands or
lowest cost producer or high switching costs
and of course high entry barriers.
little bit more money if you are Disney and you
will sell a lot more videos. It makes it a wonderful
business. It makes it very tough for the other guy.
How would you try to create a brand—
Dreamworks is trying—that competes with Disney
around the world and replaces the concept
that people have in their minds about Disney
with something that says, Universal Pictures?
So a mother is going to walk in and pick out a
Universal Pictures video in preference to a Disney.
It is not going to happen.
Coca-Cola is associated with people being
happy around the world. Now you give me—I don’t
care how much money—and tell me that I am
going to do that with RC Cola around the world
DQGKDYHÀYHELOOLRQSHRSOHKDYHDIDYRUDEOH
image in their mind about RC Cola. You can’t get
it done. You can fool around; you can do what
you want to do. You can have price discounts on
weekends. But you are not going to touch it. That
is what you want to have in a business. That is
the moat.”
— Lecture at the Univ. of Florida Business School, 1998
 BUFFETT’S COMMANDMENTS

Markets and
investing
The market is one beast we can never fully comprehend, shut out all the noise and
go after only where you see value

Buffett speaks
“You’re dealing with a lot of silly people in the you paid or the fact that you own it. Any feeling I
marketplace; it’s like a great big casino and have about the market is not reciprocated. I mean
everyone else is boozing. If you can stick with it is the ultimate cold shoulder we are talking
Pepsi, you should be OK.” First the crowd is about here. Practically anybody in this room is
boozy on optimism and buying every new issue in probably more likely to be a net buyer of stocks
sight. The next moment it is boozy on pessimism, over the next ten years than they are a net seller,
buying gold bars and predicting another Great so every one of you should prefer lower prices. If
Depression.” you are a net eater of hamburger over the next ten
— Forbes 1974 years, you want hamburger to go down unless you
are a cattle producer.
“I have no idea where the market is going to go. The NYSE is one big supermarket of
I prefer it going down. But my preferences have companies. And you are going to be buying
nothing to do with it. The market knows nothing stocks, what you want to have happen? You want
DERXWP\IHHOLQJV7KDWLVRQHRIWKHÀUVWWKLQJV to have those stocks go down, way down; you will
you have to learn about a stock. make better buys then. Later on
You buy 100 shares of General twenty or thirty years from now
Motors (GM). Now all of a sudden I don’t care if the when you are in a period when you
you have this feeling about GM. It stock price goes are dis-saving, or when your heirs
goes down, you may be mad at it. dis-save for you, then you may
You may say, “Well, if it just goes
from $10 to $2 but I care about higher prices. There is
up for what I paid for it, my life will do care if the value Chapter 8 in Graham’s Intelligent
be wonderful again.” Or if it goes goes the other way Investor about the attitude toward
up, you may say how smart you VWRFNPDUNHWÁXFWXDWLRQVWKDW
were and how you and GM have and Chapter 20 on the Margin of
this love affair. You have got all these feelings. Safety are the two most important essays ever
The stock doesn’t know you own it. written on investing as far as I am concerned.
The stock just sits there; it doesn’t care what — Lecture at the Univ. of Florida Business School, 1998

Value Investing 13
BUFFETT’S COMMANDMENTS
Businesses to invest
There are good businesses and there are the bad ones that only keep on guzzling
cash; begin with understanding what the company does
B
uffett first looks at the business that the
prospective investment candidate
operates in. He has gone on record
several times stating that he likes businesses
that he can understand.
His 2007 Annual Letter tells its all where he
states that a truly great business must have an
enduring ‘moat’ that protects excellent returns
on invested capital. “The dynamics of
capitalism guarantee that competitors will
repeatedly assault any business ‘castle’ that is
earning high returns. Therefore a formidable
barrier such as a company’s being the low-cost
producer (GEICO, Costco) or possessing a
powerful world-wide brand (Coca-Cola, Gillette,
Investors need only to know to
value a business, and how to
think about market prices
American Express) is essential for sustained
success.”
In the November 1999 edition of Fortune
magazine Buffett had written that he did not
invest in innovation more because of the
relatively limited longevity and defensibility
of competitive advantage, and the difficulty of
identifying the few winners in advance and
being able to buy them at reasonable prices.
Yes, this can characterise the explanation as
Buffett not understanding technology. But it
would likely be more accurate to say that what
Buffett doesn’t understand is not, in fact,
technology, but the prices other investors are
willing to pay for technology.
14 Value Investing
Buffett speaks
“You really want something where, if they don’t have
it in stock, you want to go across the street to get it.
Nobody cares what kind of steel goes into a car. Have
you ever gone into a car dealership to buy a Cadillac
and said “I’d like a Cadillac with steel that came from
the South Works of US Steel.” It just doesn’t work
that way.”
“First question “how long does the management
have to think before they decide to raise prices?”
You’re looking at marvelous business when you look
in the mirror and say “mirror, mirror on the wall, how
much should I charge for Coke this fall?” [And the
mirror replies, “More.”] That’s a great business. When
you say, like we used to in the textile business, when
you get down on your knees, call in all the priests,
rabbis, and everyone else, [and say] “just another
half cent a yard.” Then you get up and they say “We
won’t pay it.” It’s just night and day. I mean, if you
walk into a drugstore, and you say “I’d like a Hershey
bar” and the man says “I don’t have any Hershey bars,
but I’ve got this unmarked chocolate bar, and it’s a
nickel cheaper than a Hershey bar” you just go across
the street and buy a Hershey bar. The ability to raise
prices – the ability to differentiate yourself in a real
way, and a real way means you can charge a different
price –makes a great business.”
— Lecture to MBA students, 1991
 BUFFETT’S COMMANDMENTS

Businesses to avoid
Search for large businesses with understandable, enduring and mouth-watering
economics that are run by able and shareholder-oriented managements, else..

Buffett speaks
“Our criterion of “enduring” (moats) causes us to Think airlines. Here a durable competitive
rule out companies in industries prone to rapid advantage has proven elusive ever since the days
and continuous change. of the Wright Brothers. Indeed, if a farsighted
Though capitalism’s “creative destruction” capitalist had been present at Kitty Hawk, he
LVKLJKO\EHQHÀFLDOIRUVRFLHW\LWSUHFOXGHV would have done his successors a huge favor by
investment certainty. A moat that must be shooting Orville down.
continuously rebuilt will eventually be no moat The airline industry’s demand for capital
at all. Additionally, this criterion eliminates the HYHUVLQFHWKDWÀUVWÁLJKWKDVEHHQLQVDWLDEOH
business whose success depends on having a Investors have poured money into a bottomless
great manager. pit, attracted by growth when
If a business requires a
Unless you can watch they should have been repelled
superstar to produce great by this very factor.
results, the business itself your stock holding And I, to my shame,
cannot be deemed great. A decline by 50% with- participated in this foolishness
medical partnership led by out becoming pan- when I had Berkshire buy U.S.
your area’s premier brain Air preferred stock in 1989.
surgeon may enjoy outsized ic-stricken, you should As the ink was drying on our
and growing earnings, but that not be in the market check, the company went into
tells little about its future. The a tailspin, and before long our
partnership’s moat will go preferred dividend was no longer
when the surgeon goes. You can count, though, being paid.
on the moat of the Mayo Clinic to endure, even But we then got very lucky. In one of the
though you can’t name its CEO.” , recurrent, but always misguided, bursts of
— Annual Letter 2007 optimism for airlines, we were actually able to sell
our shares in 1998 for a hefty gain. In the decade
“The worst sort of business is one that grows following our sale, the company went bankrupt.
UDSLGO\UHTXLUHVVLJQLÀFDQWFDSLWDOWRHQJHQGHU Twice.”
the growth, and then earns little or no money. — Annual Letter 2007

Value Investing 15
BUFFETT’S COMMANDMENTS

Views on select
businesses
A lot can be picked up by going through Buffett’s views on various companies and
industries, we look at investments he talks of and those he would pass on

Buffett speaks
“Ratings agencies are still good. It’s a business with
few companies in it, it doesn’t require capital, and
has the fundamentals of a good business.”
— Annual Meeting notes 2005

“The total market value when I bought PetroChina

was around $35 billion, so I paid only three times
last year’s earnings. The company does not have
unusually large amounts of leverage and this is
unusual. It has a stated policy of paying out 45%
of its earnings in cash, so that’s a 15% cash yield
[based on last year’s earnings]. I simply read the
annual report. I had no contact with management nor
did I attend any management presentations. I just
VDWLQP\RIÀFHDQGLQYHVWHGPLOOLRQZKLFKLV
worth $1.2 billion today.”
— Annual Meeting notes 2005

“I sold my entire GEICO position in 1952 for

$15,259, primarily to switch into Western Insurance
6HFXULWLHV7KLVDFWRILQÀGHOLW\FDQSDUWLDOO\EH
excused by the fact that Western was selling for
slightly more than one times its current earnings, a
p/e ratio that for some reason caught my eye. But
LQWKHQH[W\HDUVWKH*(,&2VWRFN,VROGJUHZ
in value to about $1.3 million, which taught me a

16 Value Investing
lesson about the inadvisability of selling a stake
LQDQLGHQWLÀDEO\ZRQGHUIXOFRPSDQ\µ
— Annual Letter 1995
“Charlie is on the board of Costco. Costco and
:DO0DUWKDYHÀJXUHGRXWKRZWRGRWKLV>EH
XOWUDORZFRVW@DQGWKH\·UHZLQQLQJ,W·VDOZD\VD
JRRGLGHDWRJRZLWKWKHORZFRVWSURGXFHURYHU
WLPH%HLQJWKHORZFRVWSURGXFHURIVRPHWKLQJ
that people need is a good business.”
— Annual Meeting notes 2004
“There are many things you don’t know by looking
DWDÀQDQFLDOFRPSDQ\·VÀQDQFLDOV:H·YHVHHQ
HQRXJKWREHZDU\:HFDQ·WEHVXUHWKDW
we like what’s going on. With some types of
companies, you can spot problems early, but you
VSRWWURXEOHVLQÀQDQFLDOLQVWLWXWLRQVODWHµ
— Annual Meeting notes 2001
“The Buffett grocery stores started in 1869 and
ODVWHGIRU\HDUV7KHUHZHUHWZRFRPSHWLWRUV
2QHZHQWRXWRIEXVLQHVVLQDQGWKHRWKHU
LQ:HKDGWKHZKROHWRZQWRRXUVHOYHVDQG
still didn’t make any money. How many retailers
have really sunk, and come back? Not many. I
can’t think of any. Don’t bet against the best.”
— Student Visit 2005

,03257$1&(2)%22.9$/8(
Related to the misconception that value investment had come after IBM had already
investing is buying stocks cheap is the belief rallied up in the markets at the time!
that book value is of primary importance There could have been a time in the past
when investing like Warren Buffett. A number where looking at book values could have
of old-school investors look at the book value worked, but markets now are primarily driven
to assess the attractiveness of a stock. by earnings and the sustainability of those
Buffett has been categorical in displacing earnings. Book values have taken a back seat.
the myth that book value is an important He uses book value not to value his firm but
consideration in investing. “Book value is to give investors a rough idea of where
virtually not a consideration in investment Berkshire’s intrinsic value could stand.
decision-making at Berkshire. Their pursuit of “Inadequate though they (book value figures)
high return businesses usually are in telling the story, we give
leads to companies with you Berkshire’s book-value
minimal book values” he says. Book value is virtu- figures because they today
Elsewhere he again has
categorically stated the use of
ally not a consider- serve as a rough, albeit
significantly understated,
book value in looking at a ation in investment tracking measure for
potential investment. “We
generally do not look at book
decision-making at Berkshire’s intrinsic value. In
other words, the percentage
value when evaluating a stock”. Berkshire change in book value in any
This is another approach given year is likely to be
where Buffett has digressed reasonably close to that year’s
from his teacher. Graham was big into book change in intrinsic value”. For investors
values. In 2011, Buffett announced that he had therefore growth in book value could
bought $10 billion worth of stock in IBM (the In India, the favourite way to look at
IT MNC). This surprised many value investors. publicly traded banks is on their respective
Buffet bought IBM for the moat that it book value. At a suitable multiple of book
possessed and the growth opportunities that value, banks become attractive or otherwise.
lay ahead of it. What is relevant to to note is What Buffett looks at (even when looking at
that he paid 10 times book value to buy IBM – banks) is not book value but the earnings
and he made it Berkshire’s second largest power – to see how much the bank earns in
holding at the time of purchase next only to relation to the assets it has. And how easy
his famed Coca-Cola investment. And this those earnings are to figure out.

Value Investing 17
BUFFETT’S COMMANDMENTS
Evaluate company
managements
Management plays an important filter, because investors do not run the
businesses, but the original owners continue to run the show
Buffett speaks
“Well, what do you look for in a girl? Seriously, you
look for the logical things - passion, an interest in
running the business, honesty. Such as, do they love
the business, or do they love the money? This is the
ÀUVWÀOWHU0UV%UDQ1HEUDVND)XUQLWXUH0DUWXQWLO
she died at the age of 103 - that’s passion.”
— Tuck School of Business Trip to Omaha, 2005
“We got a book from an investment bank from
someone who bought a business a few years ago
[and now wanted to sell it]. The business was a piece
of meat to them. What are the odds that they didn’t
doctor the books?”
— Annual Meeting notes, 2003
“Passion is the number one thing that I look for in
a manager. IQ is not really that important. I’d say
intelligence, energy, integrity. If you don’t have the
ODVWRQHWKHÀUVWWZRZLOONLOO\RX$OO\RXKDYHLVD
crook who works hard.”
“The primary test of managerial economic
performance is the achievement of a high earnings
rate on equity capital employed (without undue
leverage, accounting gimmickry) and not the
achievement of consistent gains in EPS.”
— Annual Letter 1979
18 Value Investing
,$0,19(67,1*,1$672&.
127,1$%86,1(66
Buffett is not just a successful stock pick-
er but rather a more successful business
buyer. And his success has more to do with
the wonderful businesses that he owns
rather than their stock price movement.
Says Charlie Munger; “”We’ve really made
the money out of high quality businesses...
Over the long term, it’s hard for a stock to
earn a much better return than the business
which underlies it earns. If the business
earns 6 per cent on capital over 40 years
and you hold it for that 40 years, you’re not
going to make much different than a 6 per
cent return - even if you originally buy it at
a huge discount. Conversely, if a business
earns 18 per cent on capital over 20 or 30
years, even if you pay an expensive looking
price, you’ll end up with one hell of a result.”
-- A Lesson on Elementary, Worldly Wisdom
As It Relates To Investment Management &
Business, Charlie Munger.

View on inflation
It is not enough for companies to be market leaders; they need to have some
advantages that put it far ahead of competition
Buffett speaks
“And then came along a 1924 book--slim and
initially unheralded, but destined to move
markets as never before—written by a man
named Edgar Lawrence Smith. The book, called
Common Stocks as Long Term Investments,
chronicled a study Smith had done of security
price movements in the 56 years ended in 1922.
Smith had started off his study with a hypothesis:
6WRFNVZRXOGGREHWWHULQWLPHVRILQÁDWLRQDQG
ERQGVZRXOGGREHWWHULQWLPHVRIGHÁDWLRQ
It was a perfectly reasonable hypothesis. But
FRQVLGHUWKHÀUVWZRUGVLQWKHERRN´7KHVH
studies are the record of a failure—the failure of
facts to sustain a preconceived theory.”
— Forbes 2001
´$QLURQ\RILQÁDWLRQLQGXFHGÀQDQFLDO
UHTXLUHPHQWVLVWKDWWKHKLJKO\SURÀWDEOH
companies—generally the best credits—require
relatively little debt capital.
%XWWKHODJJDUGVLQSURÀWDELOLW\QHYHUFDQ
get enough. Lenders understand this problem
much better than they did a decade ago—and are
correspondingly less willing to let capital hungry,
ORZSURÀWDELOLW\HQWHUSULVHVOHYHUDJHWKHPVHOYHV
to the sky.”
— Fortune, 1977
BUFFETT’S COMMANDMENTS
´,QÁDWLRQDFWVDVDJLJDQWLFFRUSRUDWHWDSHZRUP
That tapeworm preemptively consumes its
requisite daily diet of investment dollars
regardless of the health of the host organism.
:KDWHYHUWKHOHYHORIUHSRUWHGSURÀWVHYHQ
if nil), more dollars for receivables, inventory
DQGÀ[HGDVVHWVDUHFRQWLQXRXVO\UHTXLUHGE\
the business in order to merely match the unit
volume of the previous year. The less prosperous
the enterprise, the greater the proportion of
available sustenance claimed by the tapeworm.
—Annual Report 1981
´7KDWFRPELQDWLRQWKHLQÁDWLRQUDWHSOXVWKH
percentage of capital that must be paid by the
owner to transfer into his own pocket the annual
HDUQLQJVDFKLHYHGE\WKHEXVLQHVVLHRUGLQDU\
LQFRPHWD[RQGLYLGHQGVDQGFDSLWDOJDLQVWD[
on retained earnings)—can be thought of as
DQ´LQYHVWRU·VPLVHU\LQGH[µ:KHQWKLVLQGH[
H[FHHGVWKHUDWHRIUHWXUQHDUQHGRQHTXLW\E\WKH
business, the investor’s purchasing power, that
is real capital shrinks even though he consumes
nothing at all actually. We have no corporate
VROXWLRQWRWKLVNLQGRIDSUREOHPKLJKLQÁDWLRQ
rates will not help us earn higher rates of return
on equity.”
— Annual Report 1979
Value Investing 19
BUFFETT’S COMMANDMENTS

Advice to investors
Advice on anything is greatly sought in his Annual Meetings, and he has helped
hundreds of thousands of investors become better in life and investing simply by
learning from him

Buffett speaks
“I have always worked at a job that I loved. I loved it
just as much when I thought it was a big deal to make
$1,000. I urge you to work in jobs that you love. I
think you are out of your mind if you keep taking jobs
that you don’t like because you think it will look good
on your resume.”
— Lecture, University of Florida Business School, 1998

“I never borrowed money. Even when I had $10,000.

Basically, what difference did it make. I was having
fun as I went along it didn’t matter whether I had
$10,000 or $100,000 or $1,000,000 unless I had a
medical emergency come along.”
— Lecture, University of Florida Business School, 1998

“I think you should read everything you can. In my

case, by the age of 10, I’d read every book in the
Omaha public library about investing, some twice.
<RXQHHGWRÀOO\RXUPLQGZLWKYDULRXVFRPSHWLQJ
thoughts and decide which make sense. Then you
have to jump in the water – take a small amount of
money and do it yourself. Investing on paper is like
reading a romance novel vs. doing something else.
<RX·OOVRRQÀQGRXWZKHWKHU\RXOLNHLW7KHHDUOLHU\RX
start the better.”
— Annual Meeting notes 2007

20 Value Investing
“This (non-insurance) group of companies sells
products ranging from lollipops to jet airplanes.
6RPHRIWKHEXVLQHVVHVHQMR\WHUULÀFHFRQRPLFV
measured by earnings on un-leveraged net
tangible assets that run from 25 per cent after-
tax to more than 100 per cent. Others produce
good returns in the area of 12-20 per cent.
A few, however, have very poor returns, a
result of some serious mistakes I made in my job
of capital allocation. These errors came about
because I misjudged either the competitive
strength of the business being purchased or
the future economics of the industry in which it
operated.
I try to look out ten or twenty years when making
an acquisition, but sometimes my eyesight has
been poor. Charlie’s has been better; he voted
no more than “present” on several of my errant
purchases.”
— Annual Letter 2011
“The one thing I will tell you is the worst
investment you can have is cash. Everybody is
talking about cash being king and all that sort of
thing. Cash is going to become worth less over
time. But good businesses are going to become
worth more over time.”
— Buffett & Gates at Columbia Business School, 2009

NO DIVIDENDS? IS EVERYTHING OKAY?

Dividends are considered a very important
part of investing. Many investors are very
serious about dividends. They invest only in
companies that have a good dividend history
and avoid others that are not generous enough.
But a high dividend payout ratio may not
always be the best take for investors.
A healthy dividend payout is often taken
lapped up by the markets. The stock gets a
thumbs-up and all parties - the company and
its shareholders are happy about the outcome.
But dividend largesse may not
always be in favour of
investors. Companies could Buy into a com-
deploy that cash into existing
growth opportunities to remain
pany because you
competitive and in the game. want to own it, not
According to Buffett, a
company can utilise its cash in
because you want
four ways. First, re-invest the the stock to go up
proceeds back into the business.
Second, go in for an acquisition.
Third, re-purchase shares and finally, pay out
dividends.
Paying dividends may not always be the best
option. Here’s how paying no dividend could
impact fortunes of companies like Coke. “If
Coke had paid no dividends, and simply
repurchased shares and developed the bottling
system, the shareholders probably would have
been even better off. They’ve been
sensationally well as it is, but they probably
would have been even better off than they have
been with the dividend policy they have. And
that’s true for Gillette and Disney” (Berkshire
Annual Meeting, 1997).
This is a concept that Munger, Buffett’s
partner laments. “That (utilising cash for other
than dividend) is not the standard thing that’s
taught in the corporate finance departments of
our major universities. Why do we have this
simple idea and they have another one? I’ve tried
to understand why they think the way they do,
and I have great difficulties with it. I’ve just
concluded that they’re wrong”.
Buffett’s preference for
no-dividends does not mean
that he disapproves dividends
that he gets from his
investments. His largest four
investments - Coca-Cola, Wells
Fargo, IBM and American
Express together bring in $1.1
billion by way of dividends!
Berkshire Hathaway is
famous for not paying any dividends. Many
years ago, Buffett would explain this decision.
“It (Berkshire) won’t pay any dividends either.
That is a promise I can keep. All you get with
Berkshire, you stick it in your safe deposit box
and then every year you go down and fondle it.
You take it out and then you put it back. There
is enormous psychic reward in that. Don’t
underestimate it.
- Lecture at the Univ of Florida Business
School, 1998

Value Investing 21
GURU SCREENS

Benjamin Graham

The father of value

investing was the first
stock analyst to
institutionalise
fundamental research.
His focus on value
stocks—companies with
assets that far
overweighed their stock
price analysing their
balance sheet, income
statement and financial
ratios were what got
Graham excited or not

The master’s
time tested principles
22 Value Investing
G
raham was an investor and
investing mentor who is
generally considered to be the *UDKDP·VÀOWHU
father of security analysis
and value investing. His ideas and
methods on investing are well
documented in his books Security
1 The simple criteria that he used in his studies included one
that involved using an Earnings Yield (inverse of PE ratio)
and the ratio of stockholders equity
Analysis (1934) and The Intelligent

2
Investor (1949), which are two of the
(DUQLQJV<LHOGWKHÀUVWFULWHULD*UDKDPSXWIRUZDUGZDV
most famous investing books. Graham’s
main investing principle revolved
to be at least twice that of what AAA rated corporate bonds
around margin of safety. yielded. According to him, for an investor to venture into stocks,
Margin of safety is the principle of that should be the minimum rate of return
buying a security at a significant

3 The other criterion was based on the assumption that a

discount to its intrinsic value, which is
thought to not only provide high-return
company should own at least twice of what it owes. In other
opportunities but also to minimise the
downside risk of an investment. In
words, the ratio of shareholder equity to total assets should be
simple terms, Graham’s goal was to a minimum of 50 per cent
buy assets worth $1 for 50 cents. He did
this very, very well.
According to him, investors should
analyse a company’s financials and
4 This mechanical stock selection called for holding a portfo-
lio of 30 such stocks for a period of three years or till a 50
SHUFHQWJDLQ³ZKLFKHYHURFFXUUHGÀUVW

Analyse a company’s
ÀQDQFLDOVDQGFRPHXS
ZLWKDQLQWULQVLFYDOXHDQG
EX\RQO\ZKHQWKHVWRFN
LVWUDGLQJDWDGLVFRXQWWR
5 How much could an investor applying this technique expect
WRJDLQ"8VLQJERWKWKHVHÀHOGVDQGRQWKHEDVLVRIH[WHQ-
sive back-testing dating back 50 years, Graham suggested that
an investor following this strategy could have netted twice as
much as the Dow and could going forward, expect annualised
gains of at least 15 per cent.

WKLVLQWULQVLFYDOXH

come up with an intrinsic value and

6 Additionally all stocks had to have a maximum PE of 10.
Graham was against buying stocks above that premium.

then buy these stocks only when the

stock traded at a discount to this
intrinsic value. His favourite margin of
safety stocks were companies that were Timeless principles
trading at 2/3rds of their net current
assets. The Great Depression of the late Graham based his studies on Earnings Yield (inverse
1920’s and 30’s brought many of such
of PE ratio) and the ratio of stockholders equity.
stocks up but these type of stocks have
mostly vanished since. Another concept, margin of safety played a big role.
Safety also showed up in Graham’s Margin of safety means that the investor should
approach in other ways, such as his
DQDO\VHDFRPSDQ\·VÀQDQFLDOVDQGFRPHXSZLWKDQ
reluctance to invest in stocks of
companies that he found too risky. LQWULQVLFYDOXH7KHQEX\RQO\ZKHQ
Graham’s basic ideas are timeless and the stock traded at a discount to this
essential for long-term success. He
intrinsic value. Graham called this
turned margin of safety into a science
at a time when almost all investors Margin of safety.
viewed stocks as speculative, which can
be seen in the filters he used.

Value Investing 23
GURU SCREENS

Walter Schloss

A super investor,
anointed thus by none
other than the world’s
greatest investor
himself, Warren Buffett.
Schloss’ life is a fine
example of how deep
value can survive
amidst all the noise of
the smart money, the
fast money, the quants
and the chartists

Buy value, diversify

adequately, be patient
24 Value Investing
S
chloss was a direct student of
Benjamin Graham, and is one
of the ‘Super Investors’ 6FKORVV·ÀOWHU
mentioned by Warren Buffett in
his famous essay The Super Investors
of Graham-And-Doddsville.
According to Schloss, the lows of the
1 Below book and little debt are just starting points. Schloss
would be interested only in companies that engaged in man-
ufacturing of some sort. He was not comfortable with service
stock price over the last couple of years industries and would even ignore successful franchises such
give a good idea of where the stock can
as McDonald’s restaurants. He was interested in companies in
land in case of a weakness. Conversely,
the highs of the past can indicate the
basic industries
level of fall the stock has seen. And it
is always better if the management
owns a lot of stocks; not to forget that
the management’s reputation is a deal
2 Buying assets at a discount is a better deal than buying
future earnings which may or may not turn out as expected.
That was Walter’s motto. While earnings could change rapidly,
breaker. Holding period should range asset values change more slowly. This focus on assets led him
between four to five years as depressed
to buy stocks at or below their book value
stocks can take time to turn around.
Methodical, value based investor;
Schloss famously summed up his
investment philosophy in one sentence:
‘We buy cheap stocks’. He followed a
3 New listings would never excite Walter. No, he liked his
companies with a track record of 20 or even 30 years. That
kind of being around just gives a better picture, more visibility,
more understanding and more comfort
Holding period should
UDQJHEHWZHHQIRXUWRÀYH
years as depressed stocks
4 The lesser the debt, the more the margin of safety. Whether
it was the effect of the Great Depression which he lived
through or prudent investing philosophy, Walter avoided com-
can take time to turn panies with debt like a plague
around
Graham style value approach to
5 He looked at the balance sheet and the income statement
but never met managements
investing throughout his entire career
and rarely talked to management,
choosing to invest only on the numbers.
Specifically, he liked to look at the
assets (book value) more than the
income statement. He liked to buy
stocks at low price to book ratios, and Timeless principles
when he did look at earnings, he liked
low prices to normalised earnings. Schloss’s starting point was to look below book and
He liked stocks with long (15-20 year)
little debt. He would be interested only in companies
histories and track records and would
study how earnings and asset values that engaged in manufacturing of some sort. He was
fluctuated over various cycles. not comfortable with service industries and would
Schloss never liked losing money
even ignore such successful franchises as McDonald’s
and owned his stocks for an average of
4 years and often owned 60 stocks or restaurants. He would be interested in
more at a time and sometimes as many companies in basic industries.
as 100, because he claimed not to be a
good judge of business trends or
management capability. So he needed to
take a diversified approach so he could
sleep well.

Value Investing 25
GURU SCREENS

Joel Greenblatt

A professor at the
Columbia University, he
is also the founder of
hedge fund Gotham
Capital which he set up
in 1985. Greenblatt is
well known for his two
books: You Can Be a
Stock Market Genius:
Uncover the Secret
Hiding Places of Stock
Market Profits and The
Little Book That Beats
the Market

The creator of the

Magic Formula
26 Value Investing
J
oel Greenblatt, set up hedge
fund Gotham Capital in 1985.
The reason you should learn *UHHQEODWW·ÀOWHU
about Greenblatt’s techniques is 7KH0DJLF)RUPXODÀOWHULVDPRGLÀFDWLRQRI*UDKDP·V6LPSOHVW
because his Gotham Capital returned
Way to select bargain stocks. Greenblatt combines companies
40 per cent annually for 20 years!
Buying good, profitable companies at
with high earnings yield with high return on capital to come
cheap prices is not exactly a up with a list of high quality companies trading cheaply. He
revolutionary idea; this is what Warren made some of his own adjustments to how to come up with his
Buffett has successfully done for VFUHHQ:HHOLPLQDWHGEDQNVÀQDQFLDOLQVWLWXWLRQVDQGXWLOL-
decades. But Greenblatt has created a WLHVWRWU\WKH*UHHQEODWWÀOHUDQGFDOFXODWHG(DUQLQJV<LHOGE\
systematic way to do it, and most of the GLYLGLQJ(ELWE\(QWHUSULVHYDOXH
heavily lifting of number crunching is

1
done by his Magic Formula. The magic
formula is a stock screener, which (DUQLQJV\LHOGFRPSDUHVWKHSURÀWJHQHUDWHGZLWKWKH
ranks stocks by two factors: PDUNHW·VYDOXDWLRQRIWKHFRPSDQ\(%,7HQWHUSULVHYDOXH
Profitability, based on Greenblatt’s
chosen metric, Return on Capital and
Earnings yield, the inverse of the PE
ratio, defined here by him as EBIT/
2 7KHVHZHUHWKHQUDQNHG7KHKLJKHVW(<ZDVUDQNHG
and so on

3
Enterprise Value.
Greenblatt called these inputs ‘Good’ 1H[WFDPHWKH52&(ZKLFKZDVGHULYHGE\GLYLGLQJ(ELWZLWK
WKHVXPRIQHWÀ[HGDVVHWVDQGZRUNLQJFDSLWDO
The Magic Formula
is simply a combined 4 5HWXUQRQFDSLWDO (ELWQHWÀ[HGDVVHWVZRUNLQJFDS-
LWDO7KHVHZHUHUDQNHG7KHKLJKHVW52&(ZDVUDQNHG
ranking of Return on and so on
Invested Capital and
Enterprise Value/EBIT 5 The two ranks were combined with the lowest ranks
FRPLQJÀUVW

6 The top 30 stocks were selected. After due research into

and ‘Cheap’ factors. looked for
companies that were both good and
each of them, these stocks should be held for a period of
cheap. This formula had, and continues
to have, extraordinary out performance
WKUHHWRÀYH\HDUV
and Greenblatt still feels that a focused
approach to investing will yield higher
returns, but a formula approach, that is
buying a more diversified basket of Timeless principles
quantitatively undervalued stocks is an
approach he now prefers due to it’s Greenblatt stresses discipline and his research shows
simplicity and diversification, yet still
that while beating the market is hard, it doesn’t
above average return potential
Although his philosophy is Graham, have to be complicated. The hard part comes not in
his strategy was much more focused. GHYHORSLQJDFRPSOH[VWUDWHJ\EXWLQVWHDGLQÀQGLQJ
The Magic Formula is simply a
a proven approach and sticking with it through good
combined ranking of Return on
Invested Capital and Enterprise Value/ times and bad.
EBIT (a variation of the more well
known PE ratio). For casual investors,
Greenblatt recommends buying a
portfolio of 20-30 Magic Formula
stocks, holding for one year, and then
re-running the process annually.

Value Investing 27
GURU SCREENS

John Neff

A ‘professional’s
professional’ is how
John Neff is often
referred as because
other fund managers
give Neff their money to
invest in the markets. A
contrarian investor to
the core, he specialises
in buying quality
companies that are out
of favour

The money master

of our time
28 Value Investing
J
ohn Neff was born in the midst
of the Great Depression, and
lived with the lesson his father 1HII·VÀOWHU
taught for life; pay close
attention to the price you pay. Neff was
a contrarain guru who found that
stocks with lower PE ratios and lower
1 Low PE stocks: According to Neff, low PE stocks (in their sin-
gle digits) always existed because “the market’s boundless
capacity for poor judgment ensures a steady supply of out-of-
expectations, tended to outperform, favour candidates”
because any hint of improvement

2
exceeded the low expectations investors
had for them. His belief stemmed from
Earnings growth: Companies with a respectable earnings
the fact that stocks with high PEs often growth but not too excessive. EPS growth rate was thus
flopped, because even strong results taken between 7 per cent and 25 per cent
couldn’t match investors’ expectations.

3 Sales growth: Sales growth determines whether the cash

By focusing on beaten-down, unloved
stocks, Neff was able to find value in
register would keep on ringing. Sales growth rate was also
places that most investors overlooked.
With this approach, over his 31-year
taken between 7 per cent and 25 per cent
tenure (1964 to 1995), the Windsor Fund
averaged a 13.7 per cent annual return,
beating the market by an average of 3.1
percentage points per year. Neff did
4 )UHHFDVKÁRZ&RPSDQLHVVKRXOGKDYHHQRXJKFDVKDYDLO-
able at their disposal to buy back stock or pay dividends or
LQYHVWSURÀWDEO\ZKHUHWKHPDQDJHPHQWVHHVÀW&RQVHTXHQWO\
this by focusing first and foremost on FRPSDQLHVZLWKSRVLWLYHIUHHFDVKÁRZLQWKHSUHFHGLQJWZR
years are taken into consideration

Buy stocks that look bad

to less-careful investors
and hang on until their
real value is recognised.
I’ve never bought a stock,
unless, I felt it was on sale
5 Operating margins: Companies with operating margins
better than their respective industry medians, again for the
preceding two years, are considered
6 Total return ratio: Here, only stocks with total return ratio
that is twice the market’s return ratio are considered

value, and a key part of how he found

value involved the PE ratio. In John
Neff on Investing, he has written that,
“Personally, I prefer a different label: Timeless principles
‘low price-earnings investor.’ It
describes succinctly and accurately the I call myself a ‘low price-earnings investor’. I search
investment style that guided Windsor
for stocks that are cheap in relation to their total
while I was in charge.”
However, the PE wasn’t always a UHWXUQZKLFKLVGHÀQHGDVWKHUDWLRRIWKHVXPRI
lower-is-better ratio for him. If their earnings growth plus their dividend yield to the
investors knew that a firm was bad,
PE ratio). Absent stunning growth rates, low PE
they’d rightly avoid its stock, giving it a
low PE ratio but little in the way of stocks can capture the wonders of PE
future growth prospects. While his style expansion with less risk than skittish
may not have been flashy or eye-
growth stocks.
catching, the returns he generated for
clients were dazzling–so dazzling that
Neff ’s track record may be the greatest
ever for a mutual fund manager.

Value Investing 29
GURU SCREENS

Peter Lynch

A return of 28 times in
13 years. That defines
Peter Lynch’s
achievement as the
portfolio manager of
the Fidelity Magellan
Fund between 1977
and 1990. In India, he
is known for his two
very popular books on
investing: One Up on
Wall Street and
Beating the Street

Invest in only what

you know
32 Value Investing
P
eter Lynch firmly believed that
individual investors had
advantages over professionals 7KH/\QFKÀOWHU
when it came to research,
because unlike the latter, individuals
had more freedom to act independently
and explore the market without being
1 Slow Growers: These are large and mature companies not
expected to grow faster than the economy but at the same
time are regular dividend payers. These are not the type of
tied down by committees and superiors. stocks that Lynch liked.
According to him this flexibility to

2
act gives small investors an edge as
they have a better ability and potential
Stalwarts: These are large companies that are still
of discovering profitable investments. compounding their earnings by at least 13-12 per cent.
He encourages the adoption of the 7KHVHÀUPVSURYLGHGRZQZDUGSURWHFWLRQLQEDGPDUNHWV
bottom-up approach to discover good

3 Fast-Growers: These are smaller, more aggressive

investment opportunities. He suggests
digging up possible investment options
companies with annual earnings growth of 20 per cent to
one-by-one, then getting familiar with
the company and lastly conducting the
25 per cent a year. This category was Lynch’s favourite and he
fundamental analysis to verify growth bet the biggest gains could be made of these types of stocks
and profitability potential. but they also carry along considerable risk.
‘Local knowledge’ is what Lynch

4 Cyclicals: These we know; steel, cement, aluminium, etc in

preached and claimed as the key
which there is no end to ups and downs
Never invest in any idea
you can’t illustrate with
a crayon, and remember,
5 No growers: Or Turnarounds, are stocks that promise to
turnaround in a year or two but those that still take time.

you can’t see the future

through a rear-view mirror 6 Asset opportunities: Companies that are essentially what
we call asset plays – with assets that outweigh their
market capitalisation.
element to successful investment. His
well-known investment principle of
‘Invest in what you know’ is still
deemed as being one of the most
essential lessons for any serious
investor. What he adopted was a ‘story’
approach to investment. He believed
the more one knew about the company, Timeless principles
its business, its products, and its
competitors, the more chances there Invest in what you know. An individual investor
were of finding a good ‘story’ which
is more capable of making money from stocks than
had high possibilities of coming true.
Additionally, he also considered a fund manager, because they are able to spot good
small or emerging companies as good investments in their day-to-day lives before Wall
investments as they have higher
Street. Since most people tend to become expert in
growth prospects than more mature
companies. However, Lynch stressed FHUWDLQÀHOGVDSSO\LQJWKLVEDVLF
strongly that having a good company is principle helps individual investors
not enough, you have to research the
ÀQGJRRGXQGHUYDOXHGVWRFNV
fundamentals, and look at the
valuation. He presented six types of
possible ‘stories’ for companies that are
part of the filter he used to invest.

Value Investing 33
EXPERT SPEAK

Stick to quality
The belief of leading a simple life is extended to investments by Francisco
García Paramés, Co-manager, Bestinver Asset Management, also popularly
known as the Warren Buffett of Europe. In this interview, he shares his Value
Investing secrets and why sticking to quality businesses pays off

34 Value Investing
How did you get into investing? charge more than its competitors. So by
I was very lucky. I started working for Acciona, definition, you have a good competitive
a large industrial conglomerate, in 1991. A few advantage if you can charge higher prices and
months into the job I was assigned as an as a result of which you will end up with
analyst to Acciona’s small investment higher returns than the competition.
management business, Bestinver. A year later
when the fund manager, who was a value- There are a lot of companies with good brands
oriented guy left, I took over the management like BMW. You will find that the value of the
of the fund. brand does not get reflected in the balance
Around that time I chanced upon Peter sheet. How do you factor brands into your
Lynch’s One Up On Wall Street. I also started valuation?
reading everything about Warren Buffett, Brands are extremely important to some
Benjamin Graham and other value investors. companies. BMW, for instance, would be worth
All these things allowed me to develop a clear a lot less without the brand. But we don’t
framework very early in my career. You could calculate the value of the brand per se. We
say that value is now ingrained in my DNA. value the brand because of its ability to allow
the company to earn higher returns and
What is your approach to stock picking? generate higher amount of free cash flow. In
We approach stocks the same way as an the case of BMW, the brand allows it to earn 25
entrepreneur would. If an entrepreneur sees a per cent return on capital employed. That is an
company that is undervalued, he buys the extremely good return because all the other
whole company. We buy shares. We look mainstream companies are earning
for good businesses with strong only 10 per cent (RoCE).
competitive advantages that
are trading at a discount to WE How to identify value traps?
our estimate of their fair
value. We also follow
HAVE MOVED After being in the business
for 20 years, I have learnt
what other value TO HIGH-QUALITY that value traps are
investors are BUSINESSES WITH HIGH companies with low
doing—what they are
buying and what they
RETURN ON CAPITAL quality businesses. We
used to buy average
are recommending. We EMPLOYED, AND VERY businesses at five times
are very open to that. HIGH BALANCE SHEET free cash flow (FCF);

How do you identify

STRENGTH TO AVOID
companies with strong VALUE TRAPS
competitive advantages?
A strong competitive
advantage is one that we
understand will still be there after 10
years. For instance, we look at the economies
of scale, and whether new competitors will
develop that scale. We talk to clients—whether
they are willing to leave the company. We talk
to a lot of people—the company, competitors,
suppliers and customers—to understand how
strong the competitive advantage is.
How do you differentiate between a company
that has a strong competitive advantage and
one that has only a strong brand?
Well, take the case of Sony. Sony is a good
brand and everyone knows Sony. But it cannot
charge 20 per cent more than its competitors.
On the other hand, take BMW. It can still
now we only buy high-
quality businesses at
10-12 times FCF. A
company with a return on
capital of 12 per cent, which
enjoys a good position in the
market but is unable to raise prices
because of competition, could be an example
of a value trap.
How do you avoid companies that may not
grow in revenues or profits?
We have had our share of value traps over the
years. But lately, we have moved to high-
quality businesses with high return on capital
employed, and high balance sheet strength. We
have moved away from average companies that
are only undervalued. In the case of high-
quality businesses, even if they don’t grow,
they tend not to be value traps. That is because
they generate so much free cash flow that the
value of the stock grows over time.

Value Investing 35
EXPERT SPEAK
How do you arrive at fair value in case of
value stocks?
If the business is good and it has a competitive
advantage that is sustainable, which means
that free cash flow should be stable over the
next 10 years, then we apply a 15 times
multiple to the free cash flow. It is that simple.
Why 15 times? Is it the maximum that you are
willing to pay?
Fifteen times is the average that stocks in the
US have traded at for over the past 200 years
and it translates to about 6.5 per cent free cash
flow yield which seems reasonable to us. We
like to pay 11-12 times FCF; 15 times is the
maximum, the target price. It is very
uncommon for us to buy stocks trading above
12 to 13 times FCF. But this also depends on the
alternatives available in the market. If
the overall market is overvalued,
we may pay 14 times. We try to
buy as low as we can but you
have to see what the market
is quoting at.
Do you apply the 15
multiple to all
companies?
Not all, but most of
them. In some cases we
make an exception for
very high quality
businesses, in which case we
apply 17 times multiples. But
for the not-so-good businesses we
apply 13 to 14 times FCF. As a general
rule, we apply 15 times, and that’s it.
What do you do when you find a company that
you like, trading at say 20 times or more?
You never say never in life, but I can say that
in 20 years we have generally not done it. And,
in case I do find a company that I like at more
than 20 times FCF, I will go for a holiday!
For how long do you wait for a stock in your
portfolio to perform?
Oh, forever! We have been shareholders of
some companies for more than 20 years and we
will continue to hold those shares provided the
business is growing every year in value and
the market doesn’t recognise it. For instance,
there is a Spanish company that we have been
holding for the last 20 years, which has gone
up from 15 to 400. We have made 25 times our
36 Value Investing
money but we still continue to hold our shares
in it because we think it is worth 600 or more.
So, when do you sell?
We sell only when we find something better.
When a stock goes up 20 per cent, it becomes 20
per cent less interesting for us and we may be
interested in buying something else. But
sometimes a stock doesn’t move and we find
alternatively something more interesting. So
we sell something we like for something we
like more. But it’s also relative. When a stock
approaches 15 times FCF, we are more willing
to sell, but it all depends on the alternatives. If
the alternative is cash we will sell more slowly.
Are there businesses that you avoid?
Well, we stay away from businesses that we
don’t understand or businesses that we
think change too often. This is the
Warren Buffett approach where
we avoid things that we
cannot forecast for the next
10 years.
What is your experience
in managing investor’s
expectation?
It is difficult. That is
why we allocate a lot of
time to properly talk and
inform our clients. We
consider our clients and
potential clients as
co-investors. Thus, we need to
make sure that they share our values
and targets before they take the decision to
invest with us. The decision, very importantly,
always rests with the client—we don’t push
them to come. This requires an exercise of
communication, education and honesty which
we have implemented in several ways to
guarantee alignment of interest in both
directions. If we do our communication job
correctly the expectations of our clients
should be exactly the same as ours.
How do you reconcile your investors’ ability to
redeem their investments anytime with the
fact that your portfolio positions are built to
be held forever?
The first point is that we openly recommend
our clients to invest in Bestinver, and in
general terms when they invest in equity, only
the money they will not require for, at least 5-7
years. This reduces very much the amount of
money someone is able to allocate, we thus
avoid short-term investors or nervous money.
And, we recommend repeating this process
annually, renewing their investment
commitment only with the portion of money
that has this patience at each moment. If the
investors are rigorous they will cash out
gradually, just keeping the portion of their
money with the recommended 5-7 year horizon.
Of course this is not a written commitment; it
is only a moral commitment to be used as a
guide. And majority of our co-investors follow
our recommendations.
We also release the appraisal value of our
portfolio versus the market price every month;
it is a very important signal to decide if one
should be invested or not. The wider the gap
between appraisal and market price, the more
they should invest, and vice-versa. We must
remember that Mr. Buffett stayed out of the
market playing bridge for two years because he
couldn’t find any interesting investment.
The game is not only a matter of being
invested for good, but a rational selection
process. The only reason to be invested in an
asset (our funds) is a rational selection of
alternatives (risk-reward). We consider that
our money could not be invested better than in
our funds, because the businesses and
companies in which we are invested are the
best risk-reward alternative that we know. But,
anyone may know other assets which bring a
better risk-reward. In that case, they should
look at those investments.
And finally we dedicate a lot of effort to
education. We have an annual investors’
meeting in which more than 3,000 investors
gather. We write papers to share our views and
values with clients. We participate in investor
summits, which are limited in number, but are
very focused and of high-quality. And we have
an Investor Department that permanently
keeps in touch with investors to inform them
about investments of the portfolio, views,
news, risks, etc.
You are known to be an avid follower of the
Austrian School of Economics. What can an
investor learn from the Austrian school?
You can learn a lot of things. For instance, if a
company is making a lot of money you will
have other companies coming in with more
capital and returns will go down. On the other
hand, when everybody is losing money then
capital goes out and returns will start
improving.
You can learn that if you manipulate
interest rates you can run into problems. If
you lower interest rates too much, that could
lead to an incentive to invest too much. Take
another instance. Growth in an economy
should be based on savings and productivity
growth. If you look at China, you will see a
savings rate of 30 per cent with productivity
growth of 6-7 per cent every year. We are
absolutely confident that China’s growth is
sustainable and that’s due to the Austrian
economics approach. It helps to have a
framework that can help in stock selection.
So, what books on economics do you
recommend?
I used to read the works of Spanish professor
Jesús Huerta de Soto. He is one of the world’s
leading Austrian economists. He has written
an extremely good book on economic cycles
and money and banking that for me was very
useful in avoiding banks in Spain and the rest
of the world.
Are you invested in any Indian company?
Not really. But we invest in companies in
Europe that have operations in India, like
BMW and Schindler, among others. We invest
in Europe because we think Europe is much
less efficient than the US. And it is closer to
home. We find very good companies at very
good prices of around eight times earnings. So
we have not gone far to China or India. Plus,
we think travelling too far from your home
country to invest makes the investment
process weak. We try to avoid that as much as
we can.
You invested in Arcelor only a few days before
Lakshmi Mittal made a bid for the company.
What attracted you to Arcelor?
We invested in Arcelor in the Spanish fund. We
used to own Aceralia, a Spanish company that
was bought by Arcelor, and then Arcelor was
bought by Mittal. It was a commodity business
and we bought it when the commodity was still
low and was not recognised by the market. We
did that five years ago. We bought some of
them and we just played the cycle over there.
And how much money did you make out of the
whole Arcelor-Mittal acquisition?
It was 50 per cent but that was pure luck.
Value Investing 37
EXPERT SPEAK

Never sell the gems

Running a concentrated value portfolio comes naturally to Charles T. “Chuck”
Akre, founder, chairman, and CIO of Akre Capital Management, who explains key
tenets of his investment approach; the three-legged stool. In this interview he
shares his wisdom about compounding machines and investment philosophy

38 Value Investing
Can you tell us how you got into investing? suppose the company does not pay any
I kept moving in the direction of things that dividend? The answer is that at the end of the
interested me and ended up getting involved in year you either look into your lockbox or you
the stock market after I finished school. Then I ask your accountant and he tells you that the
became a stockbroker and did that for 21 years. shareholders’ capital went up by X amount.
I morphed over into the research end of the Therefore, the way you tell whether an
business and started putting those research investment is successful is by growth in the
ideas into an investment management firm at real economic value per unit of ownership. We
the brokerage in Washington in 1985-86. And, I often use the visual construct of a three-legged
started my own firm in 1989. stool to help us think about that. Leg one has
to do with the business model—identifying
How has your thought process evolved? these high-return businesses. Leg two is what
The evolution of thought process started way we call the people model—identifying
back when I was a broker. I was puzzled by the managers who view the public shareholders as
question of what makes a good investment and partners. Leg three has to do with the
what makes a good investor. I started analysing re-investment model—the skill of the manager
the rate of returns of all kinds of asset classes. and the nature of the business; whether there
I looked at the rate of return for common is an opportunity to re-invest all the excess
stocks for the preceding 60 years of capital generated in ways that will
recorded history. It stood at 10 help it to continue earning high
per cent. I said to myself: rates of return. When we find
what’s important about 10 LEG companies that have all the
per cent? What I ONE IS three, we call them our
concluded was that it IDENTIFYING HIGH- compounding machines.
was at that rate because Then, we don’t want to
it was related to the RETURN BUSINESSES; pay too much for them.
real rate of return LEG TWO IS IDENTIFYING
earned by all of these SHAREHOLDER-FRIENDLY How do you go about
businesses on their looking for companies
owners’ capital—what MANAGEMENT; AND LEG with moats?
we call RoE today. THREE IS REINVESTING That is a critical
This caused me to EXCESS CAPITAL question. I grew up in the
posit this notion that my Washington area. A man
return on an asset will by the name of Eugene
approximate the RoE over a Meyer bought the Washington
period of years, given constant Post in 1934 off the steps of the
valuations and the absence of any courthouse in a bankruptcy sale. For the
distribution of profits. Do a back of the next 65-70 years, Washington Post was a great
envelope calculation; take a $10 stock with a $5 business with a great franchise and a moat
book and $1 worth of earnings. The RoE is 20 that got better.
per cent. Distributing none of the earnings However, about 10 years back or so,
and keeping the valuations constant you get 10 circulation at the Washington Post and all the
times earnings and two times book. Grow the other major dailies of this country started
earnings by 20 per cent and we find the declining, but at a very modest rate of 1-2 per
earnings become $1.20, the RoE is still 20 per cent per year. Washington Post could overcome
cent, and the price at 10 times earnings goes to the impact of that with its pricing—its moat.
$12. Therefore, the return on the asset We could see a little erosion around the
approximates the RoE. edges of the franchise in circulation but that
The second piece is: how do you measure was not worrisome. Then some years ago, the
when an investment is successful? If I throw business model just fell off the cliff for
that question at you, you would say, ‘If the Washington Post and for every other major
price goes up!’ Well okay, now suppose it is a newspaper because the internet had struck at
private company and you do not have the their principal revenue driver—advertising.
opportunity for price discovery, then how do The Internet made it faster, cheaper, and more
you tell? Well, if they pay me a dividend! But focussed for advertisers than print advertising.

Value Investing 39
EXPERT SPEAK
Therefore, here is an economic moat that
prospered for nearly 70 years and then just
disappeared overnight. It is a very interesting
lesson and we see it in a lot of places.
I was reading a piece earlier where the
author was reading a speech given by Charlie
Munger to a bunch of students. It was about
Coca Cola and Munger never even once in his
description talked about balance sheet or
income statement or cash flow or anything like
that. He talked about market shares, brand
name, and all of those issues. So whenever we
are looking for businesses, we try to
understand the nature of the moat and the
economic conditions that cause the business to
earn above-average rates of return.
Do you have a benchmark for the minimum
return on capital you expect?
Years ago, I used to keep the
threshold limit at 20 per cent in
terms of RoE. Today I would
say it is generally in the
mid-teens. However, what
we are really looking at is
free cash flow return on
owners’ capital and then
try to make adjustments
for if they are buying
back the stock above
book, etc. What we are
trying to understand is:
what is the nature of the
economic opportunity and is it
getting better or worse?
Nevertheless, you have invested in
companies with even lower RoEs.
Yes, I will explain with an example. We have
owned a company called Markel Corp for 20
years now. It is a speciality property casualty
insurer. For the majority of that time, say 15
years, it grew book value per share at around
20 per cent. However, in the last five years it
has been growing at about half that rate.
We continue to hold it for a couple of
reasons. One, we are probably in our sixth or
seventh year of weak pricing environment in
the property casualty business. My experience
is that it will turn one of these days. And when
it does, it will have a powerful effect on the
economics of a company like Markel.
Two, the people who run Markel think about
the business as owners and have a history of
treating public shareholders in a fair and
40 Value Investing
equal way. Many years ago, for instance, they
eliminated their options programme and
instead offered employees a programme to buy
the shares at a discount. They found it made
more economic sense for the public
shareholders.
Three, the reinvestment part of the
business. In the last couple of years, Markel
has embarked on a model that is similar to
Berkshire, in that they are quite active in
buying 80 per cent or even 100 per cent of
businesses that have nothing to do with
insurance. They are building an economic
engine inside the corporation away from their
insurance business, like Berkshire has done.
So we think the opportunity exists for them to
compound the book value at a rate that is in
the upper teens or higher and we expect to see
it in the next couple of years. That’s why
we haven’t sold it—great people,
great history with great
opportunities, but going
through a bit tough period.
What is your rationale
behind investing in loss-
making companies?
One of my largest and
most successful
investments has been in
a company called
American Tower (owner
and operator of wireless and
broadcast towers). It is hard
on a GAAP accounting basis to
understand what is really going on
because on a GAAP basis it does not really
show up. In fact, they are growing their free
cash flow per share in the upper-teens, if not
in the low-twenties, and they have been like
that for years. So we take a look at that and we
can see how the company is adding value by
adding more towers, by adding more tenants
per tower, and by charging more rent per
tenant. They have the shelter of depreciation,
which makes it look like they are not making
any money. You cannot look at the traditional
measures there to understand it. But we can
see the growth in the free cash flow per share.
Looking at stuff that way has allowed us to
make an investment which formed one of our
major purchases in October of 2002 at 80 cents
a share. In the first ten years the stock price
was up more than 60 times and has been up
ever since.
You don’t seem to sell your holdings anytime is very appropriate in today’s economy where
soon. Why don’t you have sell targets? we have very high levels of unemployment,
Our strategy is to compound our capital at an reduced access to credit, and higher food and
above-average rate and at below-average risk. energy prices. The consumer does not have as
The way we hope to do that is by identifying much cash to spend and so businesses
what we call our compounding machines. We designed to help stretch the dollar are
know that periodically the market will both particularly well positioned.
overvalue and undervalue the businesses we
own. Let us talk about the case of them being You have seen many decades in the market
overvalued. If the business model is intact and and have witnessed a number of booms and
if the people’s behaviour is the kind of thing busts. When do you see the next boom?
that we respect and if the re-investment I have no idea. But what I do believe is that
opportunities and the historical record because we have no clear path to solving the
continue to be terrific, then we rarely sell financial crisis in the United States and
something simply because it has become Western Europe, the US stock market and
expensive. quite likely those of Western Europe can
The reason is that the really good ones are continue to be very volatile as they respond to
hard to find. Remember that we run good news and bad news which will pop up on
concentrated portfolios; we do not a regular basis. From my perspective,
want to own lots of things. We this is actually good news—that
want to own exceptional kind of volatility will
things, and the really good OUR increasingly give us
ones are hard to find. That STRATEGY IS opportunities periodically.
is the reason that we TO COMPOUND OUR Two, I do not expect a
often hold things for the boom in our economy
very long period. CAPITAL AT ABOVE- anytime soon. But I
Will I be better off if AVERAGE RATE AND also recall that in the
I sold them at the top BELOW-AVERAGE middle of January 1991
and bought them at the the US stock markets
bottom? Of course! Am RISK BY IDENTIFYING exploded. It was the day
I able to tell when that is COMPOUNDING the US troops went into
going to be? No. My life MACHINES Kuwait to free the
experience is that if the Kuwaitis from Saddam
stock is at $40 and I think it Hussain. The stock market
is worth $25 and I sell it at $40 went straight up all the way to
because I want to buy it back at the first quarter of 2000 with the
$25, my experience is that it trades down exception of the big hiccups in 1998 of
to $25.05 and then goes to $300 and I don’t ever the Russian sovereign debt default and the
get my position back. Therefore, we are always failure of Long Term Capital Management
trying to make sure that we own the (LTCM).
compounders. Now, our economy was in real bad shape
from 1991 through 1994—we had the Resolution
How did you navigate the 2008 financial crisis? Trust Company (RTC), a government agency,
Largely we stayed with our investments and absorbing financial institutions and spewing
they went down a lot. It was quite a frightening out the assets at distressed prices. There were
time for me and my clients and we have tried no tower cranes in the skyline of Washington
to make some adjustments as a result. We now DC for a period of three to four years and all
try to better incorporate our world view into economic activity had come to a halt. Yet, the
our individual security selection. stock market went up all through that time. I
Therefore, we now have investments in think it was because it could see that there
Dollar Tree, which is a chain of discount were solutions that were going to work.
stores that sells every item for $1.00 or less and Therefore, the markets can go up even when
Ross Stores, which is another discount store. economic activity has not picked up. But my
Those are two businesses designed to allow expectation is a fair amount of volatility for
consumers to stretch the dollar. We think that some time.

Value Investing 41
EXPERT SPEAK

Suffering is part of
value investing
A combination of underinvestment and valuations give you the best value
investment says Sankaran Naren, CIO, ICICI Prudential Mutual Fund in this
interview detailing his view on the timeless investment strategy

42 Value Investing
Is there any difference in the way value
investing is followed in India compared to US?
Value investing as a strategy is not unique and
it can be managed in different styles. In the
US, they have the Benjamin Graham style, the
Warren Buffett style and the David Dreman
style; so I would say that there are different
styles within value investing. But what exactly
is value investing? Value investing is buying
cheap and waiting for returns to come over a
longer period of time. It is just that—you have
bought cheap and you can make a lot of money
on that call.
It all started with Benjamin Graham who
conceptualised value investing. He created an
allegory known as ‘Mr Market’. ‘Mr Market’
becomes happy at some point of time and
brings up the prices. There are times when
‘Mr Market’ is very sad and brings
down the prices; over a period of
time, ‘Mr Market’ goes
through good and bad INVESTORS
emotional cycles. After
Graham, Warren Buffett
HAVE TO
took value investing in REMEMBER THAT IN
a different way; he EQUITY MARKETS, ONE
focused much more on
quality of business
CAN HAVE AN ‘ABSOLUTE
than Graham. What VALUE OPPORTUNITY’ AS
both of them did was WELL AS A ‘RELATIVE
modified and adapted
into different strategies
VALUE’ PERIOD
by money managers across
the world. Unfortunately for
us, the intellectual capital of
everything comes from the West.
We watch the trends in the West and
learn from them. Consequently, we get
numerous opportunities to learn from their
mistakes and implement accordingly.
Value investing as a model will always exist;
you have to identify the areas where you can
see value. When the investor doesn’t see
‘absolute value’, he has to move to ‘relative
value’, and in my opinion, even relative value
at a point of time works well. If we go back to
India’s biggest bull period in 2007, it was
difficult to find absolute value at that time. In
that year, although pharmaceutical, technology
and consumer stocks were relatively highly
valued, investors who had invested in these
three sectors had a very positive experience.
Investors have to remember that in the
equity markets, one can have an ‘absolute
value opportunity’ as well as a ‘relative value’
period. But investors can make money in both
the situations; the only point is that returns
will be far higher if they buy when there is
absolute value, while in relative value, returns
might be lower.
Whenever there is a global event due to
which stocks take a beating, investors get a big
opportunity to make absolute value. To give an
example, in the last decade, there were two
major events. One was the 9/11 World Trade
Centre event in the US; that event resulted in
stocks going down across the world. Now if
investors had bought stocks at that point of
time, they could have made good money. The
second big event was the crises after the
Lehman failure. The point is to make big
absolute value, you need a big global event
because lots of markets have coupled; when
you have big global events, all the
markets become cheaper which
provide investors the biggest
opportunity for absolute
value.
Can you elaborate on
the 3Ms on which you
have built your
investment strategy?
During the pre-2007
phase, we used to
identify companies by
looking at their balance
sheets and their financial
ratios. We used to meet those
companies and based on our
conviction, we would invest or not
invest in those companies. But after the
2008 crises, we realised that we were looking at
‘our world of companies’, which also formed
part of the global world. Many global events
are now known to many of us, which forced us
to start looking into the future.
With the internet age and books, I came
across the writings of Howard Marks, Michael
Mauboussin and James Montier. They had
written books and articles during the period
2007-09 and subsequently. In case of Howard
Marks, his articles helped me get an
intellectual footing, which, in turn, helped me
to take the right calls. After reading their
works, I realised that I could implement their
learnings in my job of managing other
people’s money. In a country like India, we
always believe in some theories and in some
people. The advantage here was that none of
Value Investing 43
EXPERT SPEAK
these three people were India-centric, so there
was no question of biases. It resulted in
reading only their theories and not their views
about India. I think that when you apply those
theories in India, we get certain benefits.
From Howard Marks, I learnt to recognise
that in every market condition, there are some
cycles. For example, one could clearly see the IT
cycle during 1998-2000 and the infrastructure
cycle during 2004-07. To go outside asset classes,
you could see there was a pro-real estate cycle
and pro-gold cycle post 2008. Howard Marks’
theory helps you to understand that there are
cycles of certain sectors and one should always
be aware of those cycles. If you take Michael
Mauboussin, he taught me that if I have a
certain view on markets, then I should also
know what will make me change my view. To
give an example, in 2011-12 when India’s
current account deficit (CAD) was
high, we thought that
international investing was
the most attractive
investment opportunity.
Thanks to him, when the
CAD started coming
down, I knew I had to
change my view on those
investments and start
looking at Indian
markets, which had
turned attractive.
James Montier wrote a
book on value investing; he
was one of the few people who
had written about the tenets of
investing. I would say that it was one of the
best articles I have read. This article should be
read every six months so one doesn’t forget the
lesson. It teaches us to look from the ‘top down-
bottom up’ approach. For example, we were
underweight on the banking sector based up
our top-down approach, but subsequently, our
‘top down- bottom up’ approach suggested that
we should invest in banks. Similarly, we asked
people to invest in public sector undertakings
(PSUs) because from a classic ‘top down- bottom
up’ approach, we found value in those stocks.
Value investing requires a great deal of
research, discipline, and patience. What do
you suggest an investor just starting out could
do to practice these habits?
I think practicing value investing is not very
easy. It’s not simple to just start off as a value
44 Value Investing
investor because as human beings and with
our history of trying to protect ourselves from
risk, we find comfort in the herd. But value
investing is exactly the opposite—you have to
stand at the other side of the market. In my
personal case, the experience during the 1994-
96 period made me a value investor. But later
when I started practicing value investing and I
managed to stay afloat during the bubble of
1998-2000, value investing became a way of life
for me. So as I said, in my life, it was the
period of 1994-96 where I made mistakes and
during 1998-2000, I managed to maintain my
wisdom. In 1994-96, I never realised that in
equity you have to become increasingly
cautious when valuations expand. At that time,
many stocks fell between 70-90 per cent.
Similarly, value investing for a common man
should involve one bubble where he
loses money and another bubble
where he shows his resolve for
value investing principles.
But with an investment
team such as that of ICICI
Mutual Fund, with team
members continuously
sharing their past
experiences, investors
can move to value
investing without
making a mistake. For a
layman, making some
mistakes is inevitable in
order to understand the virtue
of value investing. Whether they
will straight away become value
investors is a little difficult to predict.
How do you practice patience with value
investing when managing an open-ended fund?
Our experience suggests that in any 10-year
timeframe, there will be one year when you
can get badly hurt and at that time you must
be willing to take that pain. As we have seen in
the past, no bubble lasts long and it has to
burst. During the bubble period, one may have
to suffer. My reading suggests that I survived
2007 when almost everything had turned
expensive. One has to endure as we don’t have
any control over the performance of the
market. As is known, the market can boil
whenever it wants and that is the period when
as a value investor, your patience is tested.
Though I was convinced about my value
investing principles, as a fund manager of an
open ended fund, it’s an extremely tough task
to live through that ‘bubble phase’. I say this
because ICICI Prudential Value Discovery
which I managed at that time, used to witness
continuous redemptions. On the other hand, I
used to also manage ICICI Prudential
Infrastructure which was part of the bubble,
and was seeing steady flows. It wasn’t a
comfortable experience for me. I think the
major flaw of a good thing about genuine value
investing is that the strategy will always fail
when there is a bubble. During the tech boom
of 1998-2000, Buffett was widely criticised for
not investing in IT companies. He went
through his own ‘agnipariksha’ during that
phase and came out victorious because he
stood to the principle of value investing.
Suffering is part of value investing.
How easy were these habits to
form as a value investor?
Basically one should have an WHEN
introspective mind to try THE CAD
and see what decisions
went wrong. If
STARTED COMING
introspection is built DOWN, I KNEW I HAD
into an investor’s TO CHANGE MY VIEW
framework of life, I
think he will eventually
AND START LOOKING AT
end up as a value INDIAN MARKETS,
investor. It was just WHICH HAD TURNED
looking back at the
mistakes made over the
ATTRACTIVE
period of time that forces you
to think about the errors and
rectify it; this path normally leads to
value investing. I believe that value
investing is a framework where one has to pass
through turbulent times during the bubble and
deliver superior returns over the longer
duration. But I believe that many people don’t
believe in introspection; if they did, they would
become value investors. I have learned from
reading books that it is much easier to have a
few people around you who believe in you. For
me, value investing was inculcated by having
another set of people who also lost money in the
1994-96 phase and we decided to introspect to see
what went wrong.
With the abundance of stocks out there, could
you share the process you use to narrow it
down in search of a value investment?
One of the most important lessons Buffett has
taught is that while practicing value investing,
one has to ‘concentrate’. As fund managers, we
manage billions of dollars, and stocks above a
certain size form part of our investment
horizon. In the first part, we look at the stocks
which have performed badly. We also figure out
why institutional investors are underinvested
and why external analysts have degraded that
particular stock - this is the starting point for
us. Similarly, we also look at stocks which have
done well and why institutional investors are
overweight, and why analysts have put ‘BUY’
for that particular stock.
In both the scenarios, we try to make a case
to move out of a set of stocks, which have done
well, to stocks which have done badly. In the
next part, we try to find out why people are
negative on that stock, meet the management of
the company and do our own internal research.
But that is not enough; when we are
using value investing, we figure
out whether that stock can
improve from the current
situation. Currently the
fund is managed by a
colleague; he meets the
companies and sector
analysts among all the
brokerages. He also
reads all the annual
reports, participates in
conference calls, he looks
at where the stock is
placed in a cycle (this is
what we learnt from Howard
Marks); with all these aspects,
he decides whether the stock should
be bought or not. So it’s a combination of
cycles, sector, industry and company valuations
that are considered before including the stock
in the portfolio. A combination of
underinvestment and valuations give you the
best value investment.
You are known to be a contrarian; do you think
this works best for value investors?
Yes, I think being contrarian works best for a
value investor. This is particularly true for a
fund manager who is a value investor because
he has to manage a pool of public money
continuously. What I have found is that it is
very easy for a value fund manager to be
contrarian. If you are not contrarian, it
becomes difficult to manage public money. We
often use ‘relative value investing’, which
works very well with a contrarian strategy.
Value Investing 45
COMPANIES WITH MOAT

Companies with
Economic Moat
When investing in a stock, the first question you need to ask is: does it have an
economic moat? And the second: how long will it last?

46 Value Investing
T
he naive investor thinks that investing is an easy task. All
he has to do is identify companies that have posted great
returns in the past. And if their valuations are also
reasonable, he can go ahead and invest in those
companies. Alas, after losing money and a considerable
amount of time, he discovers that this rather simplistic approach to
investing doesn’t work. Why?

The primary reason lies in the inherent perpetuate their rule. The modern corporation
nature of capitalism. Capital flows to the point too tries to develop competitive advantages that
of maximum return. When a firm produces will allow it to earn high profits for a
outsized profits, its success attracts prolonged period.
competition. Other entrepreneurs enter the A firm’s economic moat arises from one or
field with their own, often lower-priced more of the following factors: High switching
offerings, and take away the first mover’s costs, Cost Advantage, Intangible assets,
market share. Competition forces the leader to Network Effect and Efficiency Scale. Choose a
cut prices and this whittles down his margins. company based on these moats, but do keep a
Thus, over time the returns of most firms tend close watch to ensure that the stock’s script
to regress to the mean. unfolds along expected lines. One reason is that
A few exceptional firms, however, manage to over time a lot of moats get breached. And
buck this Darwinist trend. Despite second, despite its competitive advantage,
competition, they produce above-average other things could go wrong, say, the
returns for years, sometimes management could slip up on
decades. Such firms are said execution.
to possess ‘economic moats’. In business Buffett Take Suzlon’s example. It
While it can’t be said with
certainty who coined the
looks for economic was one of the early movers
and its name was
term, legendary investor castles protected by synonymous with wind
Warren Buffett has done his
bit to popularise it. When
unbreachable moats energy. But then the
company made expensive
asked what type of firms he and loooks for a big acquisitions from which the
liked to invest in, he said:
“Look for durability of the
moat with piranhas payoff (in terms of
technological acquisition)
franchise. The most and crocodiles didn’t arise as expected. Its
important thing to me is debt level rose. It got a
figuring out how big a moat number of orders from the
there is around the business. What I love, of US and in Europe for setting up wind energy
course, is a big castle and a big moat with farms, but the blades that it supplied developed
piranhas and crocodiles.” cracks. A good story suddenly went awry,
The moat analogy is drawn from medieval resulting in it facing losses. Thus, even when
times when kings lived within formidable you invest in a company with a visible
castles surrounded by deep and wide moats economic advantage, you can’t afford to let
that kept invaders at bay and enabled them to your guard down.

Value Investing 47
COMPANIES WITH MOAT

Network effect
The network effect differs markedly from achieving economies of scale which is
supply-side driven and is limited by production capacity

48 Value Investing
T
his source of moat is built by firms
when other firms design products that
compliment an existing product, thereby
enhancing that product’s value. For example,
the fact that there are literally millions of
people using eBay is the thing that both makes
eBay’s service incredibly valuable and makes
it all but impossible for another company to
duplicate its service. It also makes it difficult
for rivals to enter the market.
By definition, network effect is an economic
condition created by a company that produces
a particular product or service in which its
perceived value increases the more it is
adopted by other users. And, as long as the
perceived value exceeds the price paid for the
product or service, more people will want to
own or use it.
Such entry barriers could arise from
regulations, say, via licences or patents.
Patents also create strong economic moats.
Once a drug has received all the regulatory
approvals, the regulator grants the
pharmaceutical company the exclusive right to
manufacture and sell that drug molecule for 20
years. Since no other company can
manufacture the same molecule, the patent
holder has limited or no competition and
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WRHQWHUWKHPDUNHWPDNLQJ
LWQHDULPSRVVLEOHIRUWKHQWR
GXSOLFDWHWKHLURIIHULQJ
enjoys high profits. Patents account for the
consistently high profits of pharma majors
such as Pfizer.
Firms also create high entry barriers for
rivals by using the network effect to their
advantage. The network creates a virtuous
cycle: as more members join the network, the
latter becomes more valuable; and as it
becomes more valuable, more members get
attracted to it. Facebook owes its success to the
network effect. The network effect is also
created through superior distribution and
quality after-sales network.
Many Indian players are able to sustain
their lead by virtue of the powerful
countrywide distribution networks they have
built over the years. New entrants can’t
develop them overnight as doing so requires
Indian
CASE
Entry barriers, as we said, could get created
by regulations, such as the need to obtain a
licence to run a particular business. Players in
the Indian telecom and aviation sector have
EHQHÀWHGIURPWKLVW\SHRIHQWU\EDUULHU2QO\D
limited number of licences are issued in each
telecom circle, which limits competition, while
in aviation foreign airlines are not allowed into
the country.
Take for instance ITC, it enjoys a competitive
advantage that is government mandated
because foreign tobacco brands such as
Rothmans or Benson & Hedges can’t come into
India and start manufacturing cigarettes as the
Indian government will not permit them.
So between bidis at the lower end and
imported cigarettes at the top end, ITC has
the entire market to itself. Its brands are so
powerful that whenever the government hikes
excise duty rates during the budget time, it
is able to pass this on to customers without
losing market share. The company has further
cemented its leadership position by building up
a powerful distribution network.
both time and money. Exide, the leader in
batteries, has a distribution reach that is twice
as large as that of the number two player,
Amara Raja.
Likewise, in the automobile sector, Maruti,
Hero MotoCorp and Mahindra and Mahindra
all owe their dominance partly to their
product suite but also largely to a strong
network of sales and service centres that
extends even to semi urban areas across
the country.
Value Investing 49
COMPANIES WITH MOAT

High switching cost

High switching costs in a market segment also acts as an entry barrier for
competitors who may be considering entry into that market segment

50 Value Investing
O
ne way to create an economic moat is by
creating high switching cost for
customers, there by forcing them to stay

Indian
than think of shifting to another product or
service. Of course, one may still shift if the
benefits of shifting far exceed the costs
associated with switching.
In such companies, the cost of switching
goes beyond pure costs and may entail time as
well, which may hold one to stick to the CASE
product or service over competition. For
instance, if one were to switch from one
technology to another, there would be delays in In India, both DTH service providers and banks
terms of need for training to manage the new EHQHÀWIURPKDYLQJKLJKVZLWFKLQJFRVWV:KHQ
technology.
you take a dish from a DTH service provider,
Successful businesses can manage to retain
a high percentage of their customers by you pay a cost for the set-top box and the dish
employing strategies that incur high costs for
their customers who intend to switch over to
their competitors. Such ‘high switching costs’
dissuades their customers from crossing over
to their competitors.
High switching costs created by an
enterprise in a particular market segment may
also act as an entry barrier for competitors
who may be considering entry into that market
segment. Moreover, switching costs can be of
different types such as capital investment in
Mission critical products, and
those that require a lot of
training for users, usually carry
high switching cost
equipment, cancellation fees, learning and
training costs and installation costs or
uncertainty. Mission critical products, and
those that require a lot of training for users,
usually carry high switching cost.
Take for instance SLR cameras; there are
those who swear by Nikon and then there are
those who will not pick anything other than a
Canon. To ensure that a photographer sticks to
its stable; both camera manufacturers have
designed the lenses that will only fit with
respective camera bodies. Even if one camera
maker introduces a better feature, the user will
find the cost of shifting to be immense.
In the case of professional photographers,
one may need to be trained to use competing
products, for which they may have to contend
with lost time and money resulting from their
DURXQG5V,I\RXZLVKWRVZLWFKWKHQ
you would have to pay this amount again to the
QHZVHUYLFHSURYLGHU7KLVDFWVDVDGHWHUUHQW
WRVZLWFKLQJ
Switching from one bank to another has
become such a painful exercise today that
few customers would undertake it unless they
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would have given his bank account for dividend
payment from mutual funds and for income-
WD[UHIXQG+HZRXOGKDYHLVVXHGSRVWGDWHG
cheques for repayment of loans and given ECS
PDQGDWHVIRU6,3V7KXVWKHUHDUHMXVWWRRPDQ\
WKLQJVOLQNHGWRWKHEDQNDFFRXQW7RRSHQD
new bank account, he would have to get KYC
done again, go through a lot of documentation
processes, and then re-issue all the
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FRVWLQWHUPVRIWKHSDLQLQYROYHGLVKLJK
The ushering in of mobile number portability,
by allowing subscribers to take their numbers
with them to a new player, works in the
opposite direction by lowering switching cost
IRUFXVWRPHUVLQWHOHFRP
learning phase or switching phase from one
camera to the other. The switch from one
platform to the other is not only expensive, it
also takes time to unlearn and learn afresh
ways to get used to the camera with the new
operating system and features.
Value Investing 51
COMPANIES WITH MOAT

Low cost advantage

Companies that can figure out ways to provide a good or service at a relatively low
cost have an advantage because they can undercut their rivals on price

52 Value Investing
C
ompanies that can figure out ways to
provide a good or service at a relatively
low cost have an advantage because they
can undercut their rivals on price. Dell
Computer is a textbook example of a low-cost
producer because its large size allows it to
negotiate favourable component costs, and its
direct-sales distribution system allows it to sell
PCs more efficiently than rivals who use
resellers.
It is for this reason that a company that
offers a product with similar attributes as that
of its rivals, but at a lower cost, enjoys a
powerful economic advantage. However, for it
to be meaningful, the low-cost advantage must
be sustainable and not temporary. The success
of low cost companies is prevalent in
commoditised businesses, wherein buyers or
consumers are indifferent to brands and make
their choices based more on features and
pricing. In the case of computers and airlines,
low cost can be a powerful source of economic
advantage.
Low cost advantage may
be through proximity to
raw materials or to the
marketplace, proprietary
technology or other factors
Firms become cost leaders either because of
the processes they employ or due to economies
of scale. In the case of Dell, it manages to keep
its costs low through its process-based
advantage. In the US, Dell begins
manufacturing a computer only after it is
ordered over the Internet or phone, thereby
saving on inventory costs. Insurers like GEICO
keep their costs low by selling insurance over
the phone instead of following the
conventional agent route, which turns out to
be more expensive.
Firms also manage to keep costs low by
using economies of scale, that is by spreading
their fixed costs over an increasing number of
units of products sold. In the case of Microsoft,
for instance, once the cost of developing a
piece of software has been incurred, the
marginal cost of producing another unit is
nearly zero. Yet another example is that of
Walmart, which runs its business model on
scale. The sheer size and volume of orders that
Indian
CASE
In India the best example of a low-cost product
is the Nano. Many car companies had in the
past tried to build a care that cost about a lakh,
but it was Ratan Tata’s single-minded focus
that helped deliver this product.
The success of low-cost airlines over
shadows the failures of some players, but the
reason for the success of a low-cost carrier like
Indigo is their ability to manage its costs better
than the rest. On the services front, several
Indian software companies have gained from
the low-cost advantage with services that
they provide globally, making them the most
preferred technology solutions providers and at
WKHVDPHWLPHGLIÀFXOWIRURWKHUFRPSHWLWRUVWR
break their stronghold.
The example of low cost advantage typically
comes in manufacturing facilities; for instance,
Tata Steel is one of the lowest cost steel
makers in the world, which makes the company
competitive. This steel maker has managed
to keep costs low by having access to its own
mines, which ensures that the company does
not have to depend on other sources.
Walmart can place, allows it to pare its
suppliers’ margins to the bone. The case of
Walmart is unique and is something that very
few other players in the retialing business have
manager to crack.
Having once gained the low-cost advantage,
market leaders can develop a stranglehold on
the market by using their profits to lower costs
further, spend more on advertising, offer
greater commissions to distributors, and so on.
For rivals, it becomes progressively more
difficult to break the leader’s stranglehold.
Value Investing 53
COMPANIES WITH MOAT

Intangible assets
To become successful at buying and holding stocks for long-term capital
appreciation, you need to identify the hidden value of such intangible assets

54 Value Investing
A
s we move from manufacturing to
service based economies, an increasing
large proportion of the firms that we
value derive their value from intangible assets
ranging from technological patents to human
capital. A casual observation of goods and
services around us will throw up brand names
that provide these goods and services. Brands
are more than trademarks that identify
products and services. Branding encompasses
everything related to vision, mission, business
strategy, strategic marketing, and
communication programs.
In a sense branding is a serious, long-term
investment that must deliver Return On
Investments (ROI) like any other business
activity. Therefore, the brand itself and the
portfolio of brands must be perceived as assets.
Using the right metrics to measure brand
value, equity and activities are crucial. No
wonder, a more lasting source of economic
moat is differentiation based on branding or
intangible assets.
If a firm consistently produces products or
services that are perceived to have better
Long-term buy-and-hold
investors should familiarise
themselves with Buffett’s
concepts of economic goodwill
and competitive advantage
quality, then over time it becomes a trusted
brand that customers prefer over rivals.
Besides quality products and services,
advertising too plays a major part in brand
building. Through consistent advertising, a
firm can firmly implant in customers’ minds
that its products or services have certain
desirable attributes.
Globally the best example of a brand that
has thrived not for decades but for more than a
century owing to the power of branding is
Coca Cola, which according to Warren Buffett
is only flavoured sugar water after all. Several
iconic brands have become iconic because of
the business they are in as well. American
Express, McDonald’s, Wrigleys and Apple
among others.
An extension of the brand are intangible
assets, which are identifiable non-monetary
Indian
CASE
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powerful brand that enjoys customers’ trust,
even when there are 20 odd private insurers,
the company still maintains over 70 per cent
market share. In fact insurance in India is
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%DQNDQG+')&WKHKRXVLQJÀQDQFHFRPSDQ\
have built powerful brands that customers
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used the power of branding to create top-of-
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6WUDQJHO\1HVWOHORVWPRQH\SURPRWLQJ
0DJJLHQRRGOHVZKHQLWZDVÀUVWODXQFKHGLQ
India, as it was a new product for the Indian
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it has not only created a category, it rules the
category with huge recall.
assets that cannot be seen, touched or
physically measured. Some of these are trade
secrets, copyrights, patents, trademarks. So, if
a company acquires assets at the prices above
the book value, it may carry goodwill on its
balance sheet. Goodwill reflects the difference
between the price the company paid and the
book value of the assets
From the investor’s point of view, a firm
may be said to possess a powerful brand if
customers are willing to pay a premium for it
compared to a commodity version of that
product. Closer home, Titan’s jewellery foray
has been a success because in a segment
dominated by Mom and Pop stores, it is
regarded as a trusted brand. Since it belongs to
the Tata group, customers feel that the
company will not cheat on the quality of gold
or diamond that it uses in its jewellery.
Value Investing 55
COMPANIES WITH MOAT

Efficiency of scale
These companies have a durable advantages over their competitors because they
have price advantages, and therefore attract more customers

56 Value Investing
E
fficiencies of scale is such a
manufacturing-related term that many
think it to be only applicable in the case
of manufacturing companies. This is a great
moat, which arises when a business is so large
that it can make a product or deliver a service
cheaper than the competition. Most investors
confuse efficiencies of scale to what it is not.
For instance, high market share is not the
same as high return, likewise technology is
rarely moat-worthy just the way process can be
made irrelevant or imitated.
Charlie Munger, the influential partner to
Warren Buffett’s success, talked about the
economies of scale in widening a moat. In fact
he goes further to detail this into the supply-
side and demand-side economies of scale. For
instance, according to Munger, Walmart has
massive supply-side economies of scale
through its investments in distribution and
technology systems, giving the company a
wide moat to generate a high degree of
operational effectiveness which adds it its
profitability, which is why Walmart has cost
advantage as a moat.
In case of demand-side economies of scale,
its not just low cost, but also the demand for
the low cost that over rides everything else. To
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VRPHWKLQJWKDWFDQKDPSHU
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put his point across, Buffett mentions the
example of Wrigley, where over the years the
company has not only built a brand recall, it
has also managed to take away any price
advantage that competitors may have with
its sheer scale that is demand-oriented.
Buffett explains that by simply being so well-
known, Wrigley has advantages of scale,
something that he refers to as an
informational advantage.
Given the two sides of the coin; it is evident
that some demand-side economies are not
strong enough to stay with a dominant
supplier. For instance, credit card markets
did not tip enough to prevent multiple
providers or a single low cost airline did not
tip and is instead a trend followed by even full
Indian
CASE
In India the best case for economies of scale
are cars from Maruti Suzuki, which with its
wide reach has the necessary demand-side
economies and with its manufacturing setup
the supply-side economies. These two factors
makes the company function with a large scale
LQDQHIÀFLHQWPDQQHU7KHIDFWWKDWGHVSLWH
several other auto manufacturers setting shop
in the country, Maruti beats them hands down
in the number of cars and models it has to
offer as well as the reach that it has across the
country.
$QRWKHUFRPSDQ\WKDWPDQDJHVWREHQHÀW
IURPHIÀFLHQWVFDOHLV$VLDQ3DLQWVZKLFKLVWKH
largest paint manufacturer in the country, that
it is well distributed in India and has presence
DEURDGPDNHVLWEHQHÀWIURPWKHHIÀFLHQW
scale. To some extent ITC, especially the
WREDFFRGLYLVLRQEHQHÀWVIURPHIÀFLHQWVFDOH
service airlines.
However, some companies have both demand
and supply-side economies of scale, such as
Amazon. For example, the more people who
provide comments on Amazon the more
valuable it becomes to other users due to
demand-side economies. Amazon also has huge
advantages on warehouses and the supply
chain on the supply-side.
A word of caution; economies of scale gives
big companies access to a larger market by
allowing them to operate with a greater
geographic reach. However, size does have its
limits, because after a point, an increase in
size actually causes an increase in production
costs, which is nothing but diseconomies of
scale, which reverses the benefits.
Value Investing 57
COMPANIES WITH MOAT

Expanding the moat

The history of business is littered with the wrecks of companies with false moats
such as Palm Pilots, Kodak and Blackberry to name a few

58 Value Investing
W
arren Buffett, who coined the phrase
economic moats, likes to make the
distinction between wide and deep
moats. Today, wide moats are better than deep
moats, or in other words, it’s preferable for a
company to hold a range of competitive
advantages rather than one advantage in
particular. If a company has competitive
advantages across a number of its product
lines, it’s more likely to withstand competitive
threats for a long time.
Should a company with moat hit a roadblock
in one area of its business, other areas can
easily pick up the slack—hence, explaining the
reason why a bank will sensibly branch into
credit cards, commercial borrowing, financial
planning services, asset management,
insurance and so on. The wider the moat, the
more likely excess returns on capital can be
Beware of companies
that promote their great
management, great execution
and big market share, which
do not bring a sustainable
advantage on their own
sustained over the long term.
Having identified a company with a wide
and deep moat, you then need to pay attention
to few more points before you decide to invest
in it: Are the return numbers strong? If a
company has an economic moat, that moat
must translate into strong financials. If it
doesn’t, then the moat is not very relevant
from an investor’s point of view. Pay a
premium valuation for these companies only if
they have high return on capital employed and
a high level of free cash flow.
Is the valuation right? Just the way most good
things in life are usually expensive, often
companies that have economic moats trade at
high valuations. While you should be ready to
pay a high valuation for these stocks, at the
same time, you should also be wary of
overpaying. There is a way to deal with the
issue of high valuation: you could wait for
markets to enter a bear phase, when even
bluechips become available at generous
valuations or you could run a discounted cash
Indian
CASE
Sustaining the moat is important and crucial to
investments. So, if your holding period is going
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about whether the stock’s moat will last for the
QH[WÀYH\HDUV7DNHIRULQVWDQFHWKHHUVWZKLOH
Hero Honda, which was the market leader
before the two partners went their separate
ways. The single entity had an almost 50 per
cent market share, however, post the split Hero
0RWR&RUSKDVIDFHGGLIÀFXOW\PDLQWDLQLQJ
its market share and faces concerns over the
future of technology for its next-generation
bikes to drive sales.
flow (DCF) analysis that will tell you whether
the current market price is attractive vis-à-vis
the stock’s intrinsic valuation.
Pat Dorsey, author of The Little Book that
Builds Wealth says that management has more
influence on a commoditised business and one
should ask whether management understands
what drives the moat.
Investors should take another leaf out of
Buffett’s book by playing the game of the
‘Snowball’. If you invest in an industry with
good economics you are far more likely to end
up a winner as the odds are more stacked in
your favour. Remember when you do the
analysis, you will have to project earnings for a
longer period, at least 10 years, which means
your holding period will also have to be long to
justify paying high valuations.
The terminal value that you attach to these
stocks will also be higher because of their
ability to sustain a high level of earnings for
long. The discount rate that you apply will
also be lower due to the lower risk these
stocks carry.
Value Investing 59
WORD OF MOUTH
It is remarkable Buy stocks of growing
how much long- businesses, managed
term advantage people by people of vision, who
like us have gotten by XQGHUVWDQGVLJQLÂFDQWVRFLDO
trying to be consistently and economic trends and who
are preparing for the future
not stupid, instead
through intelligent R&D
of trying to be very
— Thomas Rowe Price Jr.
intelligent
— Charlie Munger

When you go through

VRPHWKLQJOLNHWKHÂQDQFLDO
crisis, it makes a
psychological imprint on
you. It becomes hard to
interpret information in a
way that is positive. I’m
emotionally very neutral
about economic things.
That’s why I can look at
them objectively
— Bill Ackman

In life
and business,
there are two cardinal It is not
VLQVWKHÂUVWLVWRDFW whether you
precipitously without are right or wrong
thought, and the that is important, but
second is to not act at how much money you
make when you are
all. In this business:
right and how much
It you want a friend, you lose when you
get a dog are wrong
— Carl Icahn — George Soros

60 Value Investing