In essence, what is value investing all about? While there is no denying that a number of different methods have delivered great results, what really distinguishes successful value investors are three basic requirements. First is the need to exercise emotional discipline. Second is the need for a robust and consistent framework for arriving at investment decisions. Finally, the ability to develop rational and detailed insights about how a business prospers and fails while thinking independently is vital. Much has been written about the second and third aspects, yet somehow the first idea has received scant attention. What follows is a brief attempt to explore how an investor can systematically inculcate emotional discipline.
The vast majority of individuals are driven by fear, greed and a deep-rooted gambling instinct. We often believe what suits us and disregard what the facts dictate. Typically, this habit is driven either by over-confidence or self-denial. Unwittingly, the Internet often fuels this danger of over-confidence by creating an ‘illusion of knowledge’. Many investors naively believe that their investment skills increase dramatically simply by having greater access to information!
Another serious shortcoming is related to a lack of conviction in our own efforts and analysis as compared to the ‘wisdom of experts’. It is wonderful to listen to Warren Buffett on CNBC. But acting impulsively on what he has said because of the fear of being out of step can be lethal. Constantly looking at short-term results fosters strong emotional responses quite akin to those one experiences at the casino. This is what leads to over-trading and acute stress.
Creating a framework to instill emotional discipline requires accepting a number of basic premises.
Premise 1: It is impossible to predict with any certainty how the market will behave in the short term.
Premise 2: Be fearful when others are greedy and greedy when others are fearful.
Premise 3: Avoid owning companies that lack pricing power, leaving the business vulnerable to the scourge of inflationary pressures.
Premise 4: The ability to come up with high-quality investment ideas has no relationship to the current level of the market.
Premise 5: Volatility, not to be confused with risk, provides the long-term investor great opportunity.
How do these beliefs affect behaviour in the current context of persistent volatility and shaky fundamentals? Europe remains in intensive care despite the brave posturing of Chancellor Merkel and President Sarkozy. President Obama finds that he is unable to forge a political consensus essential to pursue rational social and economic policy objectives. Nearer home, effective political governance has been torpedoed by a slew of corruption scandals and internecine wrangling within both the BJP and Congress. Inflation remaining stubbornly high has fatally impeded growth across the board. Given this background, the schizophrenic behaviour of the domestic equity market is driven by the whims of international investors.
Keeping in mind the need to find the delicate balance between identifying top-drawer businesses, preserving a margin of safety and emotional discipline, a number of investment ideas merit detailed consideration. The appeal of Bharat Electronics (Rs. 1,535) is not just that it is an impeccably managed quasi-monopoly, but also the fortress-like balance sheet, swelling order book and metronomic free cash flow available at a multiple of just over 12 times current earnings. Concerns about increasing competition going forward are more than compensated by the exceptional down-side protection and growing civilian market related to defense electronics applications.
FDC (Rs. 91) despite being incredibly low profile and a niche player in opthalmics, anti-infectives and oral rehydration therapy is a veritable cash machine. It has an impressive net profit margin of 20 percent by virtue of its remarkably resilient brand franchise and commendable operating efficiency relative to best in class. With five-year average return on equity (ROE) north of 25 percent, competent and focussed management and a private equity (PE) of 11, the single digit revenue growth is entirely acceptable.
Despite exceptionally strong growth in profits, a dominant position in the fertilizers and chemicals business and ROE in excess of 30 percent, GSFC (Rs. 443) trades at a PE of 4. The whimsical behaviour of the major shareholder, partly reflected in a lackadaisical dividend pay-out, is the primary reason for the valuation anomaly. While this is clearly not a stock for the faint-hearted, a patient investor may well be handsomely rewarded given the improved outlook for the fertilizer industry.
Gujarat State Petronet (Rs. 102) offers the unusual combination of an unregulated utility with significant growth round the corner. Apart from highly predictable earnings, given the defensive nature of its business, sensible management has ensured rational capital spending and consequently, impressive capital efficiency. The result is a chance to own a business that earns a ROE of 30 percent at a PE of 10, with growth thrown in for free!
IL&FS Investment Managers (Rs. 28) is remarkable not because the average ROE for the past five years is 50 percent+ and the stock trades at a PE of 9! The stock is a compelling investment since it represents the only opportunity to buy an established asset manager with an enviable franchise among international private equity investors based on consistent performance and a credible management team. The lure of benefiting from the ‘carry’ built into the fee structure, the charm of the non-linearity in the business economics and the strong likelihood of sustained revenue growth in excess of 20 percent all pale in comparison to the historic dividend yield of 5 percent!
Best wishes for the festive season as you soak in Spinoza’s timeless wisdom: “It is necessary to know the power and infirmity of our nature, before we can determine what reason can do in restraining the emotions, and what is beyond her power.”
Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.