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An investment career is probably among the very few that rewards the skeptic more than the optimist.
An investment career is probably among the very few that rewards the skeptic more than the optimist.
Debt diminishes strategic flexibility and hence long-term value creation.
Debt diminishes strategic flexibility and hence long-term value creation.
For a day trader or even an investor whose holding period ranges from three to five years, a reasonable amount of leverage may not matter. But for a permanent owner like Nalanda, any constraint that prevents a business from taking calculated strategic bets is undesirable.
For a day trader or even an investor whose holding period ranges from three to five years, a reasonable amount of leverage may not matter. But for a permanent owner like Nalanda, any constraint that prevents a business from taking calculated strategic bets is undesirable.
A strong balance sheet is not the one that maximizes debt to minimize the cost of capital but the one that minimizes debt to maximize the safety of capital.
A strong balance sheet is not the one that maximizes debt to minimize the cost of capital but the one that minimizes debt to maximize the safety of capital.
Some of our portfolio companies do occasionally make acquisitions. Our counsel to them is to be deeply skeptical of the potential value creation in all cases.
Some of our portfolio companies do occasionally make acquisitions. Our counsel to them is to be deeply skeptical of the potential value creation in all cases.
An economic franchise arises from a product or service that (1) is needed or desired; (2) is thought by its customers to have no close substitute; and (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover,
We should expect the following from a quality management team. That they deliver products and services to their customers that are superior to those of their competitors, allocate capital prudently, attract and retain quality employees, manage their cost structure (which is commensurate with their size and revenue), maintain a quality balance sheet, and continuously innovate by taking calculated risks. All this should—and does—correlate with high ROCE.
We assume that a company with high ROCE is, on average, deploying its capital well. It may make some poor decisions, but overall, we believe its capital allocation and strategic decisions are quite sound.
Consistently High-ROCE Business Allows Companies to Take Business Risk Without Taking Financial Risk, Which Increases the Chance of Business Success
All companies, if they want to grow and succeed, need to keep taking calculated risks.
Those that don’t take risks either atrophy or remain small and irrelevant; those that venture to take bigger risks than warranted implode. It is in the Goldilocks zone of calculated risk-taking that most companies thrive. High ROCE allows a company to keep taking calculated business risks. This is how.
Does this proximate cause have anything to do with the cause of ultimate business success?
Fund managers have a Pavlovian reaction to macro or market data. Will
The explanation that comes to mind was offered by the great John Maynard Keynes when he opined that the stock market players were playing a complex guessing game.11 He asked us to imagine a game in which competitors pick the six prettiest faces from one hundred photographs. The winner is not the one who picks the prettiest faces but whose choices match the average of all the competitors.
We ignore all market forecasts. Well, maybe not entirely. I do look at them on days when I want to have a good laugh.
Like almost every proximate theme before and since, the automotive tech theme has three properties. It hypes up total addressable market (TAM), is simple to understand, and is actionable.
In my experience, there is only one problem with chasing a proximate theme based on TAM. It’s useless. It makes astrology-based forecasts look respectable. TAM is pointless because it does not tell us whether any profits will be made, and even if a business can be profitable, TAM is silent on who will make that moolah.
The second reason for the seductiveness of a proximate theme is its simplicity.
I don’t know where the theme of automotive start-ups will end up in 2025 or 2030. What I do know, based on the history of capital markets and new-age technologies like railways and the internet, is that this theme will face its comeuppance someday.
In an essay on the theory of evolution, the late Harvard paleontologist Stephen Jay Gould wrote, “The present becomes relevant, and the past, therefore, becomes scientific, only if we can sum the small effects of present processes to produce observed results.”4 He could have been writing about the way we invest.
We interpret the present only in the context of history. • We see the same set of historical facts as everyone else. • We have no interest in forecasting the future.
We study the history of a business to understand its financials, assess its strategies, gauge its competitive position, and finally assign value to it. So let’s take them one by one.
Why fritter away time making useless forecasts with so much to do with the historical information we already have?
“Strategy” is a loaded word. For our purpose, let me just define it as “whatever companies do to achieve their goals under conditions of uncertainty.” Purists will quibble on the definition of “tactics” versus “strategy.” Let them. As folks investing real money, we can move on to more practical problems.
Investors, analysts, and academics have
beaten the term “sustainable competitive advantage” to death. Still, as in evolutionary theory, the real question is not just about sustainable competitive advantage but about being consistently better than the competition. And what is the meaning of “better”? For us, it relates to measurable parameters like ROCE, market share, free cash flow, balance sheet strength, consistency of financials, and other such measures.
Throughout grade 7, he showed us directly and indirectly that history can teach us less about who they were and much more about who we are.
The Australian mammals are all marsupials who give birth to undeveloped young ones and raise them in an external pouch; most of the world has placental mammals (like us) who give birth to fully developed infants.
Convergence in nature symbolizes a profound fact: There is a pattern to success and failure.
Convergence in business symbolizes a profound fact: There is a pattern to success and failure.
As Kahneman himself states succinctly, “ ‘Pallid’ statistical information is routinely discarded when it is incompatible with one’s personal impression of a case. In the competition with the inside view, the outside view does not stand a chance.”
one of the immensely underappreciated values of any strategy—including an investment strategy—is what it advises us not to do.
Instead, this chapter intends to make the simple claim that one of the most important questions an investor can ask is, “Where else has this worked?”
As I have made clear in previous chapters, we have no interest in investing in low-quality or mediocre businesses at any price. Our portfolio companies are truly stellar based on verifiable empirical data on historical financials, industry market share, balance sheet quality, and customer satisfaction. Moreover, the markets are generally quite efficient—businesses like these are rarely available at a throwaway price. Since we have chosen to invest exclusively in world-class businesses, we have two options:
Invest at a high valuation hoping that the price will rise further, or 2. Stay inactive for long periods until we get the price we want.
Why should we risk investing at high valuations when we know that the result will be poor on average? Some of you may detect a paradox here. Unlike LSV Asset Management, which relies on sophisticated quantitative analysis, we do in-depth qualitative research on industries and businesses. As a result, we know a lot about our portfolio companies and their industries. Given that we have an informed view of them, should we not be willing to pay up when the opportunity arises? No. Why? Because I have more respect for the convergence theme with respect to valuation and potential returns than my
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Everything should be made as simple as possible, but not simpler.”
Convergence is the dominant pattern in the natural world. 2. On rare occasions, it isn’t.
We can replace just one word to derive the same two critical lessons for us investors:
Convergence is the dominant pattern in the business world. 2. On rare...
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And herein lies Zahavi’s lesson for us investors: Lend credence only to those signals from companies that are costly to produce.
“dishonest” signal does not imply that the sender is dishonest, although they might be; it simply means that the signal may not communicate what it is supposed to. Just as in the natural world, an honest person in a business setting can send a dishonest signal without necessarily having a bad intention.
Have you ever read management interviews that claim they aren’t innovative, don’t have the best business leaders, aren’t “leveraging” technology, aren’t customer focused, don’t treat their employees well, don’t listen to shareholders, make bad capital allocations, and ignore the value of making “sustainable” investments? I haven’t. But the fact remains that most of the businesses I have encountered in my life as a consultant and as an investor have been deeply flawed in more ways than one. They either don’t know it or won’t admit to it.
We do meet management teams. We use these meetings to build relationships and to understand their corporate history and some of their past decisions. We never use management meetings to build an investment case or test key hypotheses because we know we will hear what they want us to hear, not what we want to know.
We should trust only costly signals emitted by companies because they are the only ones we can rely on. But what signals are costly to produce and hence reliable? Broadly, there are two.
