A reader of Steven Covey’s books would be very familiar with the Law of the Farm.
In agriculture, we can easily see and agree that natural laws and principles govern the work and determine the harvest. Things must be done in season according to natural cycles. The farmer must prepare the ground, put in the seed, cultivate, weed, and water if he expects to reap a harvest.
In the long run, the Law of the Farm governs in all arenas of life. And there is no way to fake the harvest. It is a universal and timeless truth.
While he rightfully says that the Law of the Farm, or LOTF, is applicable to all arenas of life, it does lends itself wonderfully to investing.
ANKIT KANODIA of Smart Sync Services explains this in detail.
If you look up agricultural cycle in Wikipedia, it is described as “the annual cycle of activities related to the growth and harvest of a crop. The main steps for agricultural practices include preparation of soil, sowing, adding manure and fertilizers, irrigation, harvesting, and storage.”
If I had to explain stock investing using the LOTF, I would draw an analogy with the above. After all, investing is also a long-term cycle of activities.
- Research on an investment idea and initial due-diligence (preparation of the soil)
- Buy the stock (sowing the seeds)
- Maintain due-diligence of businesses, management and valuation (adding manure and fertilizers, irrigating the land)
- Sell the stock and keep the cash ready for re-investment opportunities (harvesting and storage).
You cannot sow something today and reap tomorrow. It takes a while before a seed turns into a fully grown tree and starts bearing fruit. You water the ground daily, but may see no result for a long time. But eventually, your effort pays up.
But as long-term investors, we are good at the first two steps. We tend to fail at the 3rd and 4th. That is because we conflate buy-and-hold with buy-and-forget.
Yes, we must be patient. But we must never take our eye off the ball. You can hold on to your stocks for years on end with the hope that they will generate a good return on the initial investment. But you cannot take that for granted.
I have learnt that not all seeds in the stock market can be watered until the time of harvest. Some stocks need to be moved out of the portfolio even harvest.
The reasons could be internal:
- A mistake at the soil preparation stage (failure to recognise the red flags during the initial due-diligence)
- A mistake at the sowing stage (buying the stock at high valuation)
The reasons could be external:
- Maintenance due diligence reveals that facts related to business, management, or valuation have changed for the worse.
- A sudden change in the weather condition has led to a situation where growing that particular crop is difficult (example- COVID-19 scenario for some companies or industries)
Moreover, even the seeds that grow into high-yielding crops need to be harvested at some time. This is something we tend to ignore and get complacent with our portfolio.
The steps are clear to the farmer, and the feedback on failure is extremely stark. If a crop is destroyed due to adverse climate conditions, or pests and diseases, the result is visible.
However, in investing we take movements in the price of the stock as the only feedback to validate our hypothesis. And there have been many cases of stocks lying undervalued for a long period of time despite good fundamentals.
Conversely, there are cases of fundamentally weak companies where the stock price continues to move upward for a long time. The LOTF catches up eventually. So, the good company gets rewarded by the market and the bad get punished at some point in the future. But this may take a lot of time to happen.
A smart investor should be able to differentiate between the two and not get enamoured by only the movement in the stock price.
Let me explain with an example - Mayur Uniquoters.
The company
It is the largest manufacturer of artificial leather/ PVC vinyl, using the 'Release Paper Transfer Coating Technology' in India. Over two decades, production rose from 0.25 million to 3.05 million linear meters per month, through their six state of the art Italian coating lines.
They are suppliers to the automobile industry, footwear industry, furnishing industry, and leather goods and garments industry. Their list of customers include marquee names like Chrysler, Ford, Honda, Tata, Mahindra, Maruti Suzuki, Relaxo and Bata.
What impressed us in 2019
Their robust business model was backed by impressive numbers:
1. Being debt free for a long time, internal accruals were enough to fund the capex requirements.
2. Operating Cash Flows (OCF) as a percentage of sales had been increasing over the years.
3. Sales growth was really good at a CAGR of around 19% for the last 10 years. However, the growth rate had slowed down over the last three years.
4. Working capital as a percentage of sales had increased substantially over time, from 10% in 2009 to 30% in FY19.
5. Operating Margin had continuously improved over the past decade. The FY19 margin of 26% was impressive considering the fact that majority of the market was unorganized.
6. Return on equity (RoE) was very healthy at about 20% with no leverage on the books.
When we made the purchase
The company had done phenomenally well between 2010 and 2015, and it was evident in its stock price. So when it tumbled from Rs 533 in 2018 to Rs 360 in March 2019, it got our attention.
The company in March 2019 quoted at around 17 times P/E (TTM – Trailing 12 months). Given the strong business fundamentals and debt free balance sheet, the valuation appeared reasonable. Margin profile had always been improving with more scale and increase of export contribution in sales.
Sales had not grown much in the last three years, but witnessed decent growth in the first nine months of FY2019. Hence we believed it to be a good time to buy.
Why we changed our minds
When we bought, we did so with the idea of holding it for a long period of time as we liked the business and the management. But due-diligence revealed considerable sectoral headwinds which would not allow the company to meaningfully grow its sales for some time.
Moreover, the management was so focused on maintaining its margin and image of premium quality that it paid no attention to strategize how to grow sales in the current environment.
As we were impressed with the management and the quality of its products, it took some time to realise the problem of slow growth. But, ultimately we changed our mind and sold the shares at a loss.
Application of the LOTF:
- Select the right seeds to sow. But remember that you cannot buy everything you like.
- Do thorough due diligence. Always compare your investment with other investible ideas.
- Wait for the right time to sow the seeds.
- Post sowing, be alert, and don’t forget the maintenance, continue with due diligence. You do not have to hold everything you buy.
- Some stocks will have a longer shelf life in your portfolio. And many will not.
- Your job as a farmer/investor is to observe on a constant basis and act accordingly.
- Have the courage to take the right decisions. Be prepared to change your mind when facts change or when you realize that you made the mistake in the first place.
Let me end with a quote from well-known American micro-cap investor, Ian Cassel.
Your initial due diligence might get you into a position but your maintenance due diligence is what will make you the big money and save you from big losses. Don’t rely on yesterday’s analysis. Companies are always evolving in good and bad ways. Know what you own at all times.
