What I Learned About Investing from Darwin

by Pulak Prasad

Nalanda’s investment philosophy can be summarized in ten words: We want to be permanent owners of high-quality businesses.

As a result, we are highly vigilant and do not even start assessing the business fundamentals until we have convinced ourselves that the promoters have impeccable integrity.

We always hire a forensic diligence expert to assess if the owner or senior managers have a dubious past.

Managements that have underperformed for long periods are able to convince investors to bet on their businesses with nothing but fancy promises and McKinsey reports.

Elephants Can’t Dance? Inside IBM’s Historic Turnaround.

Only three businesses out of about thirty in our portfolio have some debt. But even this debt is quite small—the maximum debt/equity ratio among these three is 0.3.

Asian Paints is India’s largest paints business and probably one of the country’s best-run businesses. As an aside, it is sadly not in our portfolio. I had a chance to buy it during the global financial crisis of 2008, but I refused to pay 15 percent more for the privilege of owning this marvelous compounder. I was a fool. Anyway, let’s return to a more pleasant topic.

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.

If a business is a serial acquirer, we stay away.

If any of them start becoming serial acquirers, we will promptly press the exit button.

Between 1843 and 1850, 442 railway companies made a public offering of shares.

The common thread that binds eighteenth-century railways and twentieth-century dot-coms is the potential for enormous value destruction wrought by a fast-changing industry.

Reliance Power and Jaiprakash Power Ventures, whose market values were $29 billion and $23 billion, respectively, in early 2008. Each was valued at less than $700 million at the end of 2021, a collapse of more than 97 percent.

We at Nalanda love stable, predictable, boring industries. Give us electric fans over electric vehicles, boilers over biotech, sanitaryware over semiconductors, and enzymes over e-commerce. We like industries in which the winners and losers have been largely sorted out and the rules of the game are apparent to everyone.

First, government-owned businesses. Unlike the Western world, India has a large number of publicly traded government-owned companies.

The second category of owners we avoid religiously is the listed subsidiaries of global giants.

Lyudmila’s experiment had essentially converted a population of wild foxes who avoided humans into dog-like creatures that could be kept as pets in any of our homes.

At Nalanda, here is what we begin with while short-listing businesses: historical return on capital employed (ROCE).

I claimed that Costco at an operating margin of 3 percent is a better business than Tiffany at 19 percent.

As a business owner, I am much more concerned with the superior operating performance of a business. While taking on leverage (which will improve ROE but not ROCE) and “planning” for taxes may benefit a firm in the short to medium term, in my experience, success over the long term comes only by running great operations. Which brings us back to ROCE.

The median historical ROCE of our portfolio of thirty businesses—most of which are more than thirty-five to forty years old—is about 42 percent.

Once we have short-listed a company based on its sustained high ROCE, we start analyzing its competitive advantages.

If I were to try to build multi-megabyte spreadsheets to test various scenarios of a particular capital decision, I would fail miserably. Twice. Once in making the spreadsheet and again in reaching an erroneous conclusion.

A company delivering high ROCE with modest revenue growth will generate excess cash. This is not an opinion—just a mathematical fact.

Havells is India’s largest consumer electrical equipment business and sells fans, lights and lighting fixtures, circuit breakers, wire, water heaters, and kitchen appliances like blenders and

Our preliminary short list of about 150 companies consists only of those that have delivered ROCE of more than 20 percent over the past five to ten years or more.

One of the best-run companies in our portfolio is Page Industries, which we were very fortunate to buy a few days after the collapse of Lehman in late 2008.

Still, in 2010 we invested in India’s leading plastic pipes business (used in homes and agriculture), Supreme Industries, whose debt/EBITDA ratio was 0.6. Not high, but not zero either.

Within a few years of our investing, the company’s inventory and receivables started climbing steeply, a leading indicator of potential sales issues.

What is “fair”? Rather than describe it, let me state the actual number. The median trailing twelve-month (TTM) entry PE ratio for the Nalanda portfolio is 14.9. The median TTM PE for the period from 2005 to 2020 for India’s primary index, Sensex, is 19.7 and for the Midcap Index is 23.8. Thus, we are buying what we think are exceptional businesses at a 25 to 30 percent discount on the index.

I challenge you to find me an expert who asserted in May 2020 that the market would be up by 25 to 30 percent by the end of December. I could not find one. Trust me, I tried.

Here is my question for you: What do you think Nikola’s market value was at the end of December 2020, three months after the Hindenburg exposé? Remember that the company had no battery or fuel cell technology, had no prototype, its founder had exited ignominiously, GM had terminated the partnership, and the government had begun investigating fraud. My answer would be close to zero. Nope. It was $6 billion!

According to an article in the Financial Times in January 2021, these companies had amassed a market value of $60 billion, but most had not generated a single dollar of revenue. And why didn’t they have any revenue? Because, like Nikola, they didn’t even have a product! The popular saying “fact is stranger than fiction” is tailor made for the valuation of new-age automotive start-ups.

As a matter of comparison, after recording its first revenue in 2008, Tesla took nine years to cross $10 billion. And remember that Tesla had the lion’s share of the market in those years.

We invested in Vaibhav in late 2007. After underwhelming performance for a few years, the company grew its revenue and operating profit at an annualized rate of about 30 percent from the year ended March 2011 to 2014.

On October 7, 2008, three weeks after Lehman’s collapse, we bought 8 percent of the company for INR 455 per share. This was a 23 percent premium to the prevailing stock price of INR 370 per share. We took a notional loss the very next day after our purchase. In fact, the stock price did not cross our buy price for six months, until April 2009. At the end of July 2022, Page was at INR 48,873, a multiple of 107 times our buy price. During this period, the Sensex went up 5.5 times.

Our trailing twelve-month (TTM) PE multiple for buying Page? 18 times.

We interpret the present in the context of history. Evolutionary biology does not make predictions as physics and chemistry do. Nor do we. Instead, our investment approach attempts to explain the present by interpreting what occurred in the past.

Although Darwin attained fame as a zoologist and botanist, he boarded the Beagle as an enthusiastic geologist.

I guarantee that the similarities in figure 5.1 will floor you.

We have owned Berger since 2008.

For example, why has revenue growth declined to 10 percent over the past year compared to its longer-term average of 15 to 16 percent?

We avoid the automotive component space because, in general, its clients, the automotive companies, do not allow them to make money.

We studied history, built hypotheses, did not bother predicting, and have been happy owners in the business since 2013.

Do you see anything in the formula about how much debt the company is carrying? Do you think a company with a considerable debt load should have the same cost of equity as a company with no debt?

Occasionally, we stretch a bit by paying a trailing multiple in the high teens or low 20s for a truly unique business, but these occasions are few and far between. The median trailing PE multiple for our portfolio when we bought the companies is 14.9.

Thus, in the case of Nokia, while most historical signals would have led one to conclude that the company had been truly outstanding, the very nature of the technology industry, in which rapid change is the norm, should have made any investor pause.

We don’t invest in individual businesses. It may seem like we do, but we don’t.

We invested in Info Edge in late 2013. It runs India’s leading job site, Naukri.com, and is led by Sanjeev Bikhchandani and Hitesh Oberoi, two of the most well-regarded entrepreneurs in India.

We need to see the evidence that our investment thesis has worked elsewhere.