Going beyond technicalities in investing

Sep 17, 2018
Understanding human nature is key to evolving as an investor. Gautam Baid shares some interesting insights on how to get an investing edge.

If you want to be an investor, Gautam Baid has a rudimentary checklist of sorts which you can employ.

  • You don’t need to be a brilliant mathematician. Addition, subtraction, multiplication and division is all the math skill you need.
  • Neither do you need to sport a very high IQ.
  • Having a long-term mindset is a huge structural advantage.
  • You need to put in considerable effort – often thousands of hours, while being acutely aware that the hard work will not yield instant results.

If you scored well on the above, you have got off to a good start. But before you get all cocky, here’s the clincher (there’s always one, isn’t it?). The above statements are like icebergs; much of its force lies beneath the surface. What he does not blatantly spell out is that a passionate investor must go beyond technicalities.

A portfolio manager at Utah-based Summit Global Investments, Baid’s intellectual curiosity, his propensity to latch on to the acumen of other successful investors, and his desire to compound knowledge, improves his rationality quotient which, in turn, imparts an informational edge over other investors.

Let’s look at some of the advice he imparts.

Look for “untapped” pricing power.

Investors hunt for undervalued or mispriced stocks in a bid to unlock significant value. He also advocates being on the lookout for undervalued or mispriced products or services which have untapped pricing power.

Think about it. Most businesses consistently raise their prices. How about looking for a business that has not raised its prices in a long time, causing its product/service to become underpriced and undervalued to customers? Now the business has a pent-up pricing power that can be released in the form of future real price increases for a certain period of time. Real pricing power indicates an inefficiently priced product or service. This undervaluation is a source of great potential value as the business begins to price its product or service more efficiently, i.e. raise prices in real terms.

Take GEICO, the direct seller of automobile insurance to Americans. The company has the lowest operating costs in its industry primarily because it sells directly to its large customers base instead of hiring insurance agents. This cost advantage is a strong moat. The more customers that buy from a low-cost producer, the more its cost advantage moat widens over time, creating a “flywheel” that accelerates as the business grows.

Closer home, he believes that Hester Biosciences is also a low-cost producer with significant untapped pricing power. Hester is one of India’s leading animal healthcare companies and second largest poultry vaccine manufacturer with a market share of around 35%. The company has four verticals (Poultry Vaccines, Large Animal Vaccines, Poultry Health Products, Large Animal Health Products) and a state-of-the-art manufacturing facility for its products, which are distributed through Hester’s pan-India distribution network and exported.

Baid believes that Hester is expected to sharply ramp up operations at its Nepal plant which will be primarily dedicated to developing PPR vaccines for exports. Global agencies Food and Agriculture Organization (FAO) and the World Organization for Animal health (OIE) have earmarked $7.2 billion for the eradication of peste des petits ruminants (PPR) disease, globally by 2030. In addition to PPR vaccine, Hester has also developed Brucella cattle vaccine. Looking at the size of the opportunity, even gaining marginal market share could provide very strong revenue traction. Moreover, Hester enjoys a significant low-cost advantage among its global peers for these vaccines.

But being a realist, Baid expects to derive returns in an irregular and lumpy manner over the next many years (as the stock price is expected to keep factoring in the tender win announcements till 2030).

Warren Buffett expressed his comfort with such delivery in his 1996 letter to shareholders: “Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.” This also summarizes Anthony Bolton’s approach to investment (as explained in  Investing Against the Tide). He always aimed for the highest average returns from his portfolio over the longer term, even if it involved a more volatile performance record over individual years.

It is no different for Baid who believes that it is the cumulative total returns over the long term which ultimately matter.

Dig deeper when it comes to competitive advantage.

Baid is a strong believer in economic moats, which are competitive advantages. While there are other investors who think similarly, there are two derivatives worth mentioning with regards to the Competitive Advantage Period, or CAP.

High-quality businesses typically demonstrate sustainable competitive advantages which are manifested in pricing power, network effects, high switching costs, patents, favourable access to a strategic raw material resource or proprietary technology, and government regulation which prevents easy entry. Baid emphasizes that one of the most highly underappreciated sources of a sustainable and difficult to replicate competitive advantage is “culture”, best epitomized by companies like Berkshire Hathaway, Amazon, Costco, Piramal Enterprises and HDFC Bank, to name a few.

Culture is critical as it drives the “why” of an organization. Not only does it steer the company towards honesty and integrity, which lowers the risk of business, but motivates its employees to create a business that can change, disrupt and redefine the current environment. Though the impact of culture is lost on a vast majority of investors, it does leave a footprint on the top line and bottom line.

All the above can confer a strong competitive advantage which in turn enables a high Return on Invested Capital (ROIC) for long periods of time (also known as the Competitive Advantage Period, or CAP). Growing firms with high ROIC and longer CAPs are more valuable in terms of net present value.

In the light of CAP, understanding the drivers of a P/E ratio is far more important than the absolute value of the ratio itself since it has to be looked at in the context of prevailing interest rates at the time. While determining the fair P/E ratio for a stock, most investors focus on predictability and consistency of cash flows, top line and earnings growth, capital intensity and working capital requirements of the business but end up neglecting the duration of CAP. This “longevity” is what leads to great wealth creation over time through compounding.

The market gives very high current valuation multiples to businesses with established moats and assured longevity of earnings growth over the next 10 years. Longevity of growth is given greater weight than the absolute rate of growth. That is why stocks with 12%-15% assured earnings growth for the next 10+ years get current P/E multiples of 40x-50x.

Try to identify “emerging moats” so that you benefit from high earnings growth during the initial stages and the subsequent valuation multiple expansion as well. Even if you miss the initial phase, a lot of wealth can also be created over the intermediate stage.

Think in terms of Opportunity Cost.

Instead of blindly adhering to absolute valuations, Baid passionately believes that analysing in terms of opportunity cost is a very powerful mental model in investing.

Think about it. The endowment effect is a strong behavioural trait whereby an investor ascribes more value to the stock because he owns it. Investors in love with their existing holdings fail to conduct a rigorous opportunity cost analysis on an ongoing basis. But if they were concerned about every single dollar (or rupee) invested, they would. Every single dollar spends the same and investors should strive to achieve the biggest bang for their buck.

Baid suggests that one use a very high hurdle rate or absolute return expectation when assessing any potential investment opportunity. He tends to gravitate towards securities that can potentially deliver at least 26% CAGR over the next three years with a very high degree of certainty or predictability.

Baid also cautions investors to be aware of the anchoring bias. Despite a poor medium-term appreciation potential, investors will cling to their stock simply because it was bought at a much lower price. One effective way to counter this is to mentally liquidate your portfolio at the start of every trading day and ask yourself a simple question – “Given all the current and updated information I now have about this business, would I buy it at the current price?”

To wrap it up….

Baid suggests that investors develop a working knowledge of accounting as it is the language of business through which they can understand how the balance sheet, income statement and cash flow statement tie together.

Having said that, he cautions that they never forget that rationality and temperament are far more critical than raw intellect. At least as far as investing goes. Your personal behaviour, crowd psychology and cognitive biases are all crucial. Understanding human nature is key to evolving as an investor.

Disclaimer: The views and opinions expressed by Gautam Baid are solely his own and do not reflect the views of Summit Global Investments. Any recommendations, examples, or other mentions of specific investments or investment opportunities of any kind are strictly provided for informational and educational purposes and do NOT constitute an offering or solicitation, nor should any material herein be construed as investment advice.

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