Bharat Shah, Executive Director at ASK Group, spoke at the Morningstar Investment Conference on the fundamentals of investing. He started off by saying that exclusion is very much part of the game of investing: what you choose not to do has a deep bearing on investing success.
Below are excerpts from his presentation.
What investing is not….
Investing is not about trying to predict market levels. Though often many of us try to do so and the probability of success is no better than flipping a coin. Many predictions are made over a period of time, but the probability is half or even less than half in terms of successfully predicting the markets.
Investing is not trying to guess macro events; whether and when Yellen will choose to raise the interest rates, whether Trump will come to power, whether Rajan will stay or not. I am not saying these events are unimportant. But to confuse any of this with investing is an ultimate kind of insult to your portfolio.
It is not about predicting global macros, nor is it about predicting the local macros or market levels.
Investing is not about the kind of technical timing that often many of us have attempted.
Investing is not about trying to predict some grand theme or idea. All of us love to kind of leave our footprint when we try to say that this is the next new big wave or theme or idea.
What investing is……
- Investing is about the preservation of capital and its appreciation.
Preservation is vital because if you don't preserve capital, you don’t remain in the game. If you’re not able to put in the capital, then the task of growing from a depleted capital is an arduous and difficult task.
By preservation I don’t mean giving any kind of protection to the capital. It is not about guarding against the potential ups and downs. It is about guarding permanent loss of capital. That typically would happen if you dilute the quality.
Quality of business is a simple idea – the capability to generate a superior, sustainable long term, reasonably predictable return on capital employed, or ROCE. And not merely earnings growth, as people allude to.
Management quality is all about the ability to see the future, the ability to exhibit that future wealth by good execution, sound capital allocation and solid capital distribution and maintenance. These are the hallmarks of a great management.
A quality financial positioning is most likely an outcome of a good management and a good business. But that's not something that you can automatically assume, you need to verify that it does really exist.
If these three aspects of quality are all in place, then you can be confident that permanent loss of capital is something that you can guard against.
- Investing is about the distribution of capital.
This is fundamentally related to the long-term earnings growth. So, if somebody can assure me that business will grow at any X% per annum over 15-20 years and assuming that the starting point when you invest (valuation) is even - that is neither inflated nor against. Then it's almost mathematical that over a period of time, investment returns will be more or less the same as your long term earnings growth.
Therefore, ability to assess the earnings growth is very critical.
When we talk of the earnings growth, we are not talking about just profits. Look at cash flows. Again, you are not necessarily looking for dazzle or a huge shine in a short period, but a solid, sustainable, dependable, reliable kind of a compatible machine that should keep getting bigger and bigger over a period of time.
Earnings growth really is a function of two things. The size of opportunity and the quality of the management. The size of opportunity is not about how big something was or is, it's entirely about the potential to become much bigger. It's not about the size of the fish which is in market parlance, equivalent to the mid-cap, and the large cap and the small cap. That aspect is not as critical as the size pond or the size of the opportunity. The pond is simply large. Along with that if you get a big fish, it's almost nicer, but in a small pond having a big fish again is not a great combination.
Therefore, if we get a large size of opportunity and the great management, earnings growth will be an outcome. Earnings growth along with quality will result into an economic value creation. An economic value is nothing but an underlying economic rate of return that we earn in the business over the lifetime. If that economic value is bought at a discount or a margin of safety, then your investment returns can exceed the underlying (pool of returns).
- Investing is about having a Margin of Safety
The Margin of Safety is a function of two issues; one is a skill and second is (mental health).
The skill is in terms of the ability to value a business– you need a solid model to value a business. It is not confined to kind of a very simplistic number like PE. Unless and until you are able to do so, your ability to be an investor is impaired.
You also need an important element which is discipline the mental makeup, so that you buy quality at a reasonable price and stick to discipline while improving quality. If you overpay, the Margin of Safety will be lower and to that extent the investments you make can be lower than the underlying economics of that business.
Investment philosophy
1) Certainty of earnings growth - whether 14% or 17% or 18%, is far more important than just the brute high growth which is either short-term or difficult predict or in-determinant in itself.
2) More than the quantum of growth is quality of growth, which has a far deeper impact on the long-term earnings. All qualitative ideas are eventually reduced to the mathematics of investing when investing becomes a science of calculation. The mathematics of investing will show you that it is not necessary for you to earn great returns, simply because the underlying business will grow continuously at an extraordinary pace. What we need is a high quality of growth along with decent or better kind of earnings.
3) Buy only quality. Don’t buy mediocrity and justify it through the vision of cheapness or arithmetic.
