Benjamin Graham There Are No Iron-Clad Laws

During my course at Flame University “Art of Investing with Neeraj Marathe”, Mr.Durgesh Shah Sir has suggested me to read a book which is “Big Mistakes”. So that I am hereby starting to write my learning from the book.

We make many mistakes in life and learn from those mistakes. We keep focus on does not repeat the same mistakes again and again.

My Guru always quotes that “If we focus on avoiding mistakes then we won half of the battle.” We always cannot keep on making mistakes and learning from it but also we can learn from others mistakes which we can avoid during our journey.

Learning from others mistakes and experience is the easiest way to learn and grow.

I am hereby starting my learning from mistakes made by well know investors. Upcoming series will be going to include learning from the book “Big Mistakes”. I am grateful to Michael Batnick – author of the book.

The first article of the series, I start with Mr. Benjamin Graham who is a father of a value investing. He has given a new direction to the investing field.

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Mr. Graham is a guru of Mr. Buffett and we cannot imagine investing field without Mr. Graham. Few biggest gift from Ben Graham to the investing field are Margin of safety, the difference between price & value, calculation of value to the business, etc.

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Many a time, we think that stocks fall ~40-50% from the high price, we should start trying to catch “falling knives” (Such terminology is widely used by so-called professionals). But we should focus on the value of the particular business rather focus on the high price and current price. During recent fall to the stock market, many of the people started picking stocks just because they fall much from the high price.

Indian companies examples

One of the media & Entertainment Company which is falling by ~51% from its high price but the company is making losses, negative CFO, management is taking a higher salary and also giving a loan to the subsidiary companies.

One of the companies which are into the DTH services and that company fall by ~79% from its high price. The company is making very little profit, very little FCF, huge debt, negative ROE% and where value can be still very less.

Such a fall in price does not make it attractive to buy which has very little or no value.

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The market always works in a pendulum and people generally forget the nature of the pendulum. The pendulum always moves towards both extreme directions.

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Whenever pendulum moves towards the bullish extreme, many of us forget that such situations will not stay forever. Many of us forget about the risk which involves during the bull phase. And start taking higher risk for generating higher returns; which invites a further huge amount of risk. At bullish sentiment, people generally buy assets at the highest valuations multiple and that invites the risk to the particular asset class. This scenario has a very high chance of getting damage to our wealth compared to generating a higher return.

Reverse to such scenario, whenever the pendulum moves towards extreme bearish phase, then generally people start recognizing the risk and start avoiding to invest in the particular asset class; which take out the risk from that particular asset class. Such a scenario is the appropriate time for capturing the opportunities because in such scenario we have very less chance to lose.

When people warmly accept any securities then the price will go far from the value and when people avoid or hate any securities then the security will fall in its value.

Mr. Graham has a strategy to purchase undervalued securities and shorted overvalued securities which have made him successful. Mr. Graham has started with $450000 and which he turns to be $2500000 in just three years.

During the last month of the year 1929, Dow Jones has started going down and Mr. Graham has started to cover his short positions and shifted to preferred stocks by considering prices are low. But the calculation of Mr. Graham went wrong and he lost 20% while Dow Jones down by 17%. After this Mr. Graham has considered that market has made the bottom and he used to leverage money to boost profit but again his calculation went wrong and he lost 50%. During the year 1929 to the year 1932, Mr. Graham has lost 70% of his money.

My learning

We should not take leverage to boost up our profits from the market, we cannot measure the madness of the market. I have implemented this learning from the mid time of my investment career and I have parked my money where I am convinced to park. I have never taken a leverage position rather I have to keep liquidity with my portfolio (I was holding ~73% liquidity in my portfolio during January – 2018 and currently having ~65% liquidity position). I have always focused on capital protection over the missing out of opportunity.

 An example of one the biggest wealth creator company of the Indian stock market—

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Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

WARREN BUFFETT’S LETTER – 1996

Warren Buffett’s Letter – 1996

Acquisitions

Kansas Bankers Surety (KBS)

The company is an operating into the business of insurance which has a presence in 22 states, decent underwriting record with Don Towle as a manager. They made a deal to acquire a company at $75 million.

FlightSafety International

The company is the world’s leader in the training of pilots. The company operates in 41 locations, outfitted with 175 simulators of planes ranging from the very small, such as Cessna 210s, to Boeing 747s. About half of the company’s revenues are derived from the training of corporate pilots, with most of the balance coming from airlines and the military. They made an acquisition at $1.5 billion.

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We need to prepare a list of the errors which can be dangerous for the health of our investment and work to avoid those errors. If we work on the avoiding mistakes then we can win 50% of the battle.

List of mistakes which I have experienced during my investment journey –

  • Never ignore the true value of the company—Every business has some value and that we should not have to ignore. If we commit such a mistake then the market will defiantly punish us. Be careful with the true worth of the company and only buy it when it falls below its true worth. And if business not available below its true worth then ready to missed that opportunity. Loss of opportunity is better than the loss of capital.
  • Don’t buy HOT —-If we buy the hot business such as recent trend, new IPOs, business on which everyone is bullish etc., then we must have to exit it at the proper time. So if we aren’t able to exit at the proper time then it’s better to let it go such opportunities. If we buy HOT then that HOT will BURN our portfolio.
  • Buying a high leverage business — We need to avoid a business which has a huge borrowings, such borrowings can kill the business and also kill our investment journey.
  • Using the wrong valuation method — Every business will not get valued with a similar valuation matrix. We need to identify the nature of the business and then value a particular business. Such as we should not use the valuation matrix of growing non-cyclical business for cyclical business, should not use the valuation matrix of assets light business for assets heavy business and vice-versa. If we made such a mistake then whether we might miss a decent investment opportunity or we might lose our capital.
  • A mistake of buying a story, not a fundamental — I have never ever made such a mistake because I am a hard-core lover of numbers. But I have seen many of the people who always focus on the story and also which is very trending to the market. I believe that without the support of numbers, no story can survive for long. In the year 2014-15, Logistics stocks due to GST gets a trending story but due to lack of good numbers, the story gets failed. People generally avoid numbers due to lack of understanding of it. I firmly believe that “Stories are for kids, not for investors.”
  • Investing without a process and philosophy — I can overcome this mistake at the initial period of my investment journey and that is only because of my guru – Neeraj Marathe Sir (who always believe on having a process and philosophy for making an investment). I have seen many people who spent lots of time into the market but they do not have any process or philosophy. They change their philosophy as they meet various people. If we do not have our own process and philosophy for making an investment then we will not able to create a successful investment journey. I also learn from my guru that we must have our philosophy in a written format so that we can refer it over a period of time and stop ourselves from occurring a mistake.
  • Not using a checklist — We should have a checklist for a business, industry, financial, management etc. so that we can focus on the points to study and also not forget any point to study. I am using a checklist for the last 3 years and I can say that having a checklist helps me a lot. My checklist keeps on improving as my experience grows.
  • Making an investment decision with disturb mind — We should avoid making an investment decision while our mind is disturbed. Disturbance in mind will end up with the faulty investment decision and which can be harmful to our wealth.
  • Cloning a well-known investors/fund managers — Again I can overcome this mistake at the initial period of my investment journey and again credit goes to my guru. If we have our process and philosophy then we will not try to clone others. I have seen many people who have spent 10-15-20 years to the stock market then also not having any process and philosophy & they clone others. Many of the people have cloning as their investment philosophy because they love to use shortcuts. I always remember the quote of my guru –

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When Company does not have an opportunity to reinvest earnings at a higher rate than the company should distribute those earnings to the shareholders so that they can use it somewhere for getting a higher return. If the company does not have a good opportunity to reinvest earnings and then also company does not distribute earnings as a dividend then we need to be careful with a company (Question on the capital allocation decision of a management or earnings can be manipulated or business always needs a huge capital to sustain only).

Examples – No/Low growth high dividend payout

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Examples – No/Low growth low dividend payout

AIE

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We need to check the above-mentioned factors in the company where we have made an investment and where we want to make an investment. Most important is to gain a market share. The company cannot able to gain market share, though the company has a competitive advantage then that competitive advantage not useful for us. We should not focus on the leadership position of the company rather need to focus on the companies which focus on the manufacturing, distribution, packaging and product innovation. Market leadership can be changed if the company does not focus on the mentioned points.

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According to Mr.Buffett, paying a higher price does not risk for the good companies compared to paying higher prices for the bad companies.

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Let me take an example of one the biggest wealth creator company of the Indian stock market—

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If someone has bought this company during the March-2000, at the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all-time high price for calculating returns). Though revenue has grown at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by a good management team. During March-2000, the company was traded at 64x P/E at the low price of Rs.275 and this multiple is common nowadays.

When management of a good business diverts their focus into the business which is not performing well then such decision of the management affect the performance of the business.

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Example – We have seen examples such as liquor manufacturer enter into the airlines business, airport contraction business has diversified into the power business.

Mr.Buffett has also mentioned the Circle of Competence concept –

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Control on our temptation, control on our emotion towards our investment is essential to survive and create wealth from our investment.

Warren Buffett’s Letters 1957 – 2012

WARREN BUFFETT’S LETTER – 1990-91

WB Letter 1990

Mr. Buffett mentioned that we need to thoroughly analyze earnings and accounting numbers; we should not focus on the big auditor names.

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Low prices and low cost of operations for their Jewelry and furniture business creates huge volume growth. Such a low cost of operation is difficult to adopt by competitors.

While we are analyses an insurance company then we check combined ratio for the measuring profitability of the insurance company but with it, we need to check –

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Mr. Buffett mentioned that the majority of the companies follows what their peers are doing though they seem foolish.

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Example of PSUs & Private Bank

i) PSU Bank

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ii) Private Bank

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We should not focus on the buying an only a cheap companies without knowing the quality of assets on which they seem cheap. We can see that PSUs banks have majorly traded at discount compare too few private banks which have a quality of books. PSUs banks seem cheap on the basis of Price to Book Value but the quality of books is questionable, which we have already experienced.

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Mr. Buffett has mentioned some of the qualities of management which we also can check when we make any investment.

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As an investor, we need to always focus on the Margin of Safety which is mentioned by the Ben Graham. The margin of Safety provides us a safeguard against any errors occurs by us.

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WB Letter 1991

In long run, our investment returns will occur through the stock prices but stock prices are derivatives of the future earnings of the business. If a business is not performing well, earnings not grown in future then stock prices also not given us return in long run. So that we need to keep a focus on the business performance, earnings growth driver of business rather keep a focus on the stock price performance.

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When we talk about the strong franchise of business then we should focus on the criterion into the business which mentioned by Mr. Buffett. All businesses do not fall under the mentioned criterion but those businesses fall under mentioned criterion those can earn a higher return on capital for the longer period of time through price it’s product/services aggressively. If business having a strong franchise then we does not require a strong management to run the business.

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Liquor is a desired of people and customers does not have any close substitute (legal) of it but in India, the price of liquor is regulated so that we cannot say that liquor business has a strong economic franchise. Watching movies at the multiplex is a desired of people, no close substitute is available for it and also a price of the ticket is not regulated.

Whereas those businesses which do not have strong franchises then those businesses can only earn decent from a low-cost production of products/services or a shortage of products/services. And shortage does not stay for a longer period of time. Shortage of particular product with huge industry size invite more players into the industry which reduces the profitability. Continuously remaining low-cost producer, business needs to be run by the strong management or else business will not sustain as a low-cost producer for the long period of time.

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We generally provide difference valuations to the businesses where we can foresee constant earning with the lower capital requirement and where we cannot foresee earning with cyclical business nature. Mr. Buffett has explained this concept by mentioning Media business and steel business. He mentioned that we believe that media business having a constant revenue and steel business having a cyclical business nature but when media business has started to getting deteriorate then we revise our way to value media business.

See’s Candy

Berkshire Hathway had bought See’s Candy through Bluechip stamp in the year 1972. A company owned $7 million of tangible net worth with $10 million of excess cash. A seller had asked $30 million (cash adjusted) for the 100% ownership of See’s candy. Buffett and Charlie were ready to pay only $25 million for See’s. Buffett and Charlie have been experienced a pricing power to the business and they felt lucky that seller agreed to sell See’s at $25 million to Berkshire. See’s sales grown from $29 million to $196 million and pre-tax profit has grown from $4.2 million in the year 1972 to $42.4 million in the year 1990.

H.H.Brown

Berkshire has made an investment in the H.H.Brown company, which is a shoe manufacturing business. H.H.Brown is a leading manufacturer of work shoes and boots in North America. Mr. Buffett knows that shoe business is tough to perform due to higher inventories and receivables but he has experienced that H.H.Brown has done well in the leadership of Frank and Mr. Heffernan.

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If we got a good business which is run by a good manager in the bad industry then we should check such business as an investment candidate.

Berkshire Hathway earns from holding policyholders fund which Mr. Buffett called as “Float”.

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Berkshire Hathway has beat government bond in 20 years from 25 years till the year 1991 and cost of the fund remains satisfactory which help Berkshire Hathway to grow well. Insurance business of the company sustain well, increases float. Lower cost of float and Berkshire has compound it in a good manner which is a major strength of the company for being an out-performer.

Mr. Buffett has mentioned that they don’t like to trade business to business. He considers that He & Charlie are not as much smart to earn well by buying and selling businesses for a longer period of time. He likes to buy a business which has a long-term economic characteristic, run by quality people and available at a sensible price.

Mistake Du Jour

In this section, Mr. Buffett has written about the mistakes which he has incurred. He believes that people cannot able to see mistakes incurred by Berkshire, that does not reduce the cost associated with mistakes. Berkshire has missed few opportunities such as esoteric invention (such as Xerox), high-technology (Apple), or even brilliant merchandising (Wal-Mart) but they do not consider it as their mistake. Such type of the businesses does not fall under their competence area to understand so they have missed it. Few mistakes which they have occurred from their competence area.

In the year 1988, they decided to purchase 30 million shares of Federal National Mortgage Association (Fannie Mae). They owned stocks since earlier years and also understand the business. But when they have bought 7 million shares and the stock price has started moving upside and they have stopped buying it. They do not want to repeat mistakes which they occurred while buying shares of Coca-Cola, they have to keep on buying shares of Coca-Cola though the price has moving upward. But here, they sold 7 million shares which they hold due to a small position. Such a mistake has cost to Berkshire is about $1.40 billion.

Warren Buffett’s Letters 1957 – 2012