Arohan’s investing life

Warren Buffett is the super investor of our time and probably the best known investing celebrity. Even a small investment in Buffett’s holding company, Berkshire Hathaway, when Buffett took the helm, would have made any investor a millionaire many times over. In 1965, when Buffett took control of the company, a single Berkshire Hathaway share was changing hands at around $16. Today it trades at $128,000 (and has traded as high as $151,000 in recent past). This is a return of almost 800,000%. A $1000 investment in Berkshire shares in 1965 would be worth $8 million today. This investment has compounded at the rate of 22.7% annually for over 40 years

Alas, Mr Buffett is close to retiring. He has already picked his successor is in the middle of what can be termed as a very keenly watched succession planning exercise where he is slowly disposing off his holdings and therefore relinquishing control of the holding company. He is adamant however, that any successor to his position will continue the invesment philosophy that he espouses. Berkshire Hathaway could still be a good long term hold but a new investor may very well ask the question: are there any other investment similar to Berkshire Hathaway that I can buy now and hold for long term and expect great returns?

Before we attempt to answer this question, we should review what makes Mr Buffett such a successful investor. What makes up his investment strategy? The genius of Buffett does not lie in devising elaborate and highly sophisticated strategies that the hedge funds are so enamored with. He does not seek to take advantage of every sliver of in-efficiency that the market throws up (although that can be a great wealth creation tool in itself: to wit, George Soros). His genius lies in the common sense approach he takes to his investments, the simplicity of it, and immense patience. Most can understand his approach to investing, very few have the patience to sit still and do nothing, which is what is needed to let your investments mature and bear fruit. My take on his approach boils down to 3 simple principles:

1. Pay less than the actual worth
2. Use judicious leverage
3. Wait

Let’s look at these 3 principles in brief detail:

Pay less than the actual worth: This comes to us naturally when we shop. Buying a stock is no different. The problem is that there is no MSRP on the stock price. So how do you judge the worth of the stock or the company you are considering acquiring? We all know the price. Market sets the price. But what is the value or worth of the stock?

To figure this out, one has to almost always look at the assets that the company has. These assets can be in the form of book value, or patents or brands that can be monetized. In rare situations, you may be able to find a company that has more cash (minus debt) on the books than its entire market capitalization (yes, they still exist), in which case it is easy to see that the company’s liquidation value is higher than the stock price. However, in most situations like this you will find that the company has assets that are just not valued correctly (maybe real estate carried at cost where market value may be significantly higher in orderly liquidation) , or may be a de-facto monopoly in an industry that produces ‘basic’ products, or may be brands that can be monetized but the market has not ascribed any value to it. In some variants of these situations, one will find, that the company is priced at such variance to its book not because of its ‘hidden’ assets but more due to visible signs of distress in its business. Is it just incompetent management, that once replaced will go a long way towards restoring the business health? Maybe a temporary slip-up?

Use judicious leverage: To me, this can occur in two distinct manners. First is when you can borrow money with as little risk as possible and use it for investment alongside your own money. Investors can already borrow money on margin for investments, and that is what most hedge funds do, however, that money is not risk-free. For that to be risk-free, your investment will have to be risk free. (Come to think of it, if you can borrow money at low enough interest and invest with a 10×1 leverage in treasuries, you will generate returns that will give any hedge fund a run for its money). What Buffett does is to invest the float generated by its insurance companies (which is excess capital over what is reasonably needed to meet claims). While not completely risk-free, it is pretty close (as long as the insurance business is run profitably). If you own a profitable business, this is akin to taking the free cash flow and using it for investment purposes

The second way that Buffett uses leverage is a bit subtle. He prefers to buy businesses that are scalable with very little additional capital investments. If you are able to buy a company that is profitable today but only uses part of its capacity now, imagine how profitable the company would be if you grow it and start using 100% of the capacity. This is leveraging your existing assets to generate growth. Of course, the company has to be in an industry where such growth is possible (or should have some advantage that it can use to gain market share in a stagnant industry)

Wait: The toughest of it all. If you buy a business at a price lower than its worth, and/or, you buy a business that has a potential to grow without much additional expenditure (growing profit margins), than what you need to do is to give time for the market to realize the true worth of the business and the business to realize its full profit potential. Waiting is an integral part of this investment process. One cannot expect overnight riches this way. The whole investment theses is built around giving the investment time to mature. If one gets bored waiting, find a hobby (like bridge!) or get a day job to pass time or better still, actively participate in the businesses you bought helping them along the path that you envision (tough to do if you only bought a few hundred shares)

A side note: Financial media falls over backwards extolling the virtues of buy and hold method of investment. It is important to realize that a blind buy-and-hold is not a guarantee of investment success. A lot of ground work needs to be done in selecting your investments before the buy-and-hold principle can do its magic

Additional side note: Taxes are a drag on compounding. Dividends are taxed twice. Long term investors should almost always prefer investing in businesses that compound capital internally (meaning, reinvests in growing its business or portfolio) over a business that prefers to pay out dividends, unless in a tax advantaged account.

In Part 2 of this article, we will examine a few investors (and their investment vehicles) against the principles outlined above and see how close they come to matching Warren Buffett. You may be surprised to find that using same/similar principles, one can arrive at a very different investing style and still be very successful. Stay tuned …

A quick note regarding several investments that were recommended (and the author took a personal stake at the time of recommendation).

WSCI: WSI Industries was recommended as a growing metal working company with excellent prospects. I took a position in the company in the $4-$5 range several months ago. In the last one month, I have liquidated my entire position in the company in the $9-$10 range for close to a double. Very satisfying return for a few months work. The stock today is trading close to $14. If I had held for another month, I could be looking at a triple instead of a double. But I have no regrets. The company is approaching 40 PE and is getting quite frothy at these levels even if you take into account their projected growth for the next few years.

CFC:I am still holding Countrywide. If you recall, the play here was to buy Countrywide as a cheaper way of getting into Bank of America. The risk is that the Bank of America acquisition of Countrywide may not close. I am still comfortable in my position and will continue to hold

WM: I am still holding Washington Mutual and am currently underwater. However I am willing to wait out the current crisis of confidence as I think the company is taking the right steps to ensure that it survives
C: I have since my last writing on Citigroup increased my position in the company. The company is very quiet on what they are doing to improve their capital structure. However, they recently entered in an agreement to liquidate a part of their debt portfolio (to private equity) for about 10% discount. I think the company will correct course and come out stronger than many expect and in 3-5 years time should reward a patient investor handsomely

Additional notes: I have also increased my stake in BAM (Brookfield Asset Management), MKL (Markel), ACAS (American Capital Strategies), LUK (Leucadia), SLT (Sterlite Industries) and added positions in BRKB (Berkshire Hathaway B shares) and EPI (Wisdomtree India ETF)

Please note that if you choose to act on any of the recommendations/ideas outlined above, make sure that you conduct your own due diligence and understand the risks you are taking. I am not a financial advisor

Two interesting articles/stories caught my eye today

The first one talks about the mind boggling 2007 total compensation (earnings + stock) to Blackstone Group’s co-founder Stephen Schwarzman. According to this AP story, his compensation in 2007 was $350.7 million and along with stock grants valued at $4.77 B during Blackstone’s IPO, his total takeaway was $5.13 Billion in 2007 alone

With earnings like this, it is no surprise that many hedge fund managers are now counted among the Forbes Global Richest list.

This brings us to the second article that examines what would have happened if Warren Buffett had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment compound. To quote from the FT article,

At “2 and 20″, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.

It is basically saying that if Buffett had followed the Hedge Fund model of compensation, his accumulated wealth would have been just 10% of what it is today

The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager. For Mr Buffett, and indeed many entrepreneurs, net worth is primarily determined by the equity stake in the business that they own. Equity ownership lets the business income continue to compound in the business. As the business grows, the net worth of the owner grows correspondingly (the story would have had a different ending if Buffett had kept diluting his stake in Berkshire Hathaway by continually bringing in new investors like a hedge fund does)

Also to note (and a point unaddressed by the FT article) is the effect of taxation. While a hedge fund manager pays taxes each year (capital gains or income, a matter of controversy for sure but not relevant to this analysis), Mr Buffett will only pay taxes if he sells his equity (again, the fact that his charitable actions have helped him avoid taxes altogether is besides the point)

If you are a superlative investor (like Mr Buffett or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term

Maybe that is why Warren Buffett long ago discarded the investment partnership model. Or maybe another reason why Blackstone, Fortress et al. are now choosing to go public bestowing large equity stakes on their founders

Two years ago I expended considerable time and effort to find a way to invest in Indian companies on local Indian exchanges. Yes, we can buy ADS/ADRs on American exchanges and for some companies that do not trade in US, one may be able to buy GDRs on some European exchanges (depending on whether your broker is capable of executing these international trades). I called up Indian brokers with no luck. Called up the international trading desk with my US broker and they told me that they can transact on most exchanges in the world but not in India. Buying GDRs on European exchanges was always an expensive proposition

There were very few options to invest in Indian companies. Few Open ended mutual funds did exist (Eaton Vance (ETGIX) and the excellent Matthews India (MINDX) that came later). There were also a few close-ended funds (India Fund (IFN) and Morgan Stanley India Investment Fund (IIF)) but the expense ratios were always on the high side

My issues with all these options were that they were invariably overloaded with IT and Software names. While this industry has been the driver behind India’s past growth, I believed that the future growth in India will likely come from more basic industries such as materials, steel, cement, banking, communications, etc. Industries that are core to what can be the largest national infrastructure buildout (along with China) in the next decade or so

It has been a long time coming. Two new ETFs were launched recently that track indexes (separate and proprietary) based upon local Indian stocks on NSE and BSE exchanges. The expense ratios are also more reasonable now. The following is a brief introduction to these two ETFs. (If you are interested in these, please be sure to hope on to the respective sites and peruse the prospectii. A few links are provided for your dd pleasure)

1. Wisdom Tree India Earnings Fund (EPI) based on Wisdom Tree India Earnings Index

The fund tracks a proprietary index composed of profitable Indian companies weighted by Earnings. The index currently holds about 150 companies and therefore is well diversified. The expense ratio is a reasonable 0.88% and the top holdings and sector weightings are more to my liking

The fund started trading on NYSE ARCA in late February. Today’s quote is 23.94 and the NAV is around 23.4. It therefore trades at a slight premium to NAV

More Information about the fund is at the Wisdomtree site

More information about the index is here

2. Powershares India Portfolio (PIN) based on Indus India Index

This fund tracks a proprietary index based on the 50 largest companies in India and is market capitalization weighted. The expense ratio is 0.78% (besting the Wisdomtree ETF by 10 basis points) and its top 10 holdings are pretty similar to EPI (although the weightings are different)

The fund started trading today. The offer price was 25

More information on the Powershare fund can be had here

My take: I personally prefer the Wisdometree ETF despite its slightly higher expense ratio. First of all, its average PE ratio is about 17 compared to about 20 for PIN and about 27 for the Indian stocks as a whole. Secondly, EPI is more diversified across multi-caps and gives an exposure to the small and medium cap companies in India, which is where a lot of growth will occur. PIN has minimal small cap exposure and is not likely to have one based on how it index is constructed

A word of caution: These ETFs are very recent and it is generally wise to wait for sometime before buying into them. If you buy too early, you may end up paying a good premium to the NAV

Another word of caution: Investing in foreign markets is more risky than investing domestically (but than it is the same thing they tell you in India if you want to invest in American stocks …). Also you will be exposed to the currency fluctuations (which if you ask me is probably a good thing since I do expect the Indian Rupee to continue to strengthen against USD for the foreseeable future). There may be less transparency in the company financials in emerging markets (you know, as opposed to , let’s say, in US, assuming you ignore the current events here in the States). Etc, Etc.

Typically I avoid funds, instead choosing to buy individual stocks. However, I will make an exception here as these ETFs still remain the best way to buy into the Indian markets

This of course is not a new revelation. However, many readers and investors do not grasp the amount of risk that may be present in smaller companies. A big part of this risk may be just volatility due to illiquid nature of stock, but there are some other more basic risks that an investor needs to be cognizant of when investing in this asset class

To illustrate the points that I am making in this article, I will take an example of two stocks that the readers of this blog are already familiar with. Both these stocks have been discussed here in the past

Syntax-Brillian (BRLC)

This is a major egg on the blog author’s face. However, the case study on this company is worth reviewing to learn where we went wrong.

The rationale for investing in this company was many fold. Syntax-Brillian makes excellent quality HD LCD tvs (brand name Olevia) and sells it at a value price while maintaining great margins due to its optimized supply chain. The market for LCD TVs is growing and the future of the sector looks bright due to a potential for substantial increase in demand in the US due to forced HD conversion in 2009 as well as increased demand in China due to the upcoming olympics. Both markets where Syntax-Brillian is a significant player. The stock was trading at 10-11 PE when it was purchased and had just finished the year with triple digit revenue increases (YOY) and was on the verge of announcing two large big box retailers in US. So what could go wrong???

Well, plenty did go wrong. I would not dwell on BRLC’s history of missing projections to the street (after all if the stock is undervalued and still showing extremely high growth in business, why worry if the analysts estimates are missed. The stock price has to catch up to the potential, right!). No, the problem with the company was (is) really basic. It is in the execution and financial controls

Anyone who has owned a small, fast growing business, or for that matter worked in such business understands that growth requires working capital. If a company plans to grow (as an example) by 50% next year and sports 3-5% net profit margins, not enough cash is generated today to finance the growth for tomorrow. The shortfall needs to be made up by external financing (working capital)

Syntax-Brillian was constantly in need for financing to support its growth. The situation was made worse by the significant amount of business it did in China, where apparently the payment terms of 120 days is common place. This means that the product sold in China did not actually result in cash inflow until 120 days later. Meanwhile the company still has to pay its employees, its vendors (who are typically on a shorter payment term), etc.

And as the sales grew, the cash flow gap became wider and wider and recently it became so acute that one of the institution (Silverpoint)  funding Syntax-Brillian started the process to rein the company in by tightening the controls and increasing the cost of financing. The company, now it appear, has to review its finances on a weekly basis with its lenders and a lot of business planning discretion now no longer rests with the company executives

Ah, the pitfalls of debt financing!

It is not as if Syntax-Brillian did not try equity financing. Over the last 2 years, the equity holders were diluted numerous times to a total of greater than 50% dilution. A part of the stock price decline IS due to the dilutive effect of incremental equity sales.

In short, the company and the stock has been killed by extreme growth (I say killed, but the company is still solvent, although the future looks difficult)!

Generally a growing company picks a growth rate that is sustainable and can be funded either organically or even externally if the company is able to manage its fundamental ratios. But a steady and manageable growth rate did  not appear to be what the company was after as it raced to gain market share as the olympics and the forced HD conversion in US draw closer

There are only two outcomes that can be positive for a company in this situation. Slow the growth down and steady the ship, or, become a thorn in an incumbents boots so much that one of them choses to acquire the company. Sadly, enough shareholder value has already been destroyed before any of these possibilities can come to fruition

Growth at a reasonable price (GARP) is not enough. What we need is Sustainable Growth at a Reasonable Price (S-GARP)

I have exited this name with substantial losses

WSI Industries (WSCI)

This is a company in the metal service industry that we have discussed a few times in the past on this blog. As was reported earlier, the company had announced a significant increase in future business due to new customer acquisition. Subsequent to that, the company reported its quarterly earnings that bettered the estimates and more importantly, showed that the new customer has already started to become accretive to its earnings. The stock responded appropriately, jumping as high as $11s and finally settling down in the $8 range. This stock was purchased in $4-$5 range so there is a good capital appreciation already on my books. I am holding on to the investment for the time being

The important lesson from this is, when investing in micro/small cap companies, one needs to keep a close eye on the investments. The best rewards come to those who hold long term but it is also necessary to monitor the company’s business performance for signs of weakness and act accordingly

PS: Sorry for the brief unintended hiatus from posting! Sometimes life interrupts without warning!