By Hari Ramachandra

Sanjay Bakshi has been an adjunct professor at Management Development Institute (MDI), Gurgaon — one of India’s top business schools —  where he teaches a popular course on Behavioral Finance and Business Valuation. MDI students have elected Sanjay as the best professor for several years.He received his M.Sc. (Economics) from London School of Economics and Political Science. He is also a fellow member of the Institute of Chartered Accountants of India.
sanjay_bakshiProfessor Bakshi has trained many students who are successful fund managers and investment professionals. He has a strong following among value investors and students in India and across the world. He regularly invites successful value investors like Mohnish Pabrai as guest speakers to his class at MDI. You can find some of the talks on his YouTube channel.  He also writes a popular blog called Fundoo Professor.
In this interview Prof Bakshi answers questions on Moats, technology and disruption of business models, investment environment in India and more. We thank him for generously sharing his time and wisdom with us.

Moats and Disruption

Q: Regarding Disruption You have suggested that even industry insiders don’t catch such threat early enough to be able to adapt.

“While investors are thinking too hard about other flashlight manufacturers or other camera manufacturers, they often don’t successfully anticipate threats from flashlights and cameras built into mobile phones. Forget investors, even industry insiders don’t catch such threat early enough to be able to adapt. They are simply not conditioned to recognize it early.” source

Porter’s five forces provides a good framework to think about threats from disruptive technologies or business models.However without deep understanding of the industry it’s really hard to apply Porter’s five forces effectively. Can you please share your advice with individual investors (our audience) to help them develop better understanding of an Industry and the threats facing companies in those industries.

A: The first thing to recognize here is that you can’t “develop a better understanding” for all industries. That’s because of two reasons: (1) the limitations of the human mind — there’s a limit to how much you can learn and different people have different circles of competence; and (2) some industries, by their very nature, are just too hard to understand because they encounter just too much change and uncertainty and no matter how smart you are, you will inevitably get something important wrong. As Graham used to say, the value of analysis diminishes as the role of chance increases. So, in these situations, analysis doesn’t really help. Luck helps of course, but luck is temporary…

You mentioned Porter’s five forces framework (see below) and of course that’s quite useful for investors. But I think that when you combine it with another framework provided by Warren Buffett, it works even better.

Here’s the Porter framework.


Rivalry Among Existing Competitors

How would you go about measuring the rivalry amongst existing competitors? Well, first you have to identify the competitors. I say that because sometimes it’s hard to do that. It’s hard to know the size of the market, the number of market participants etc. Take the footwear industry, or the cooler industry. What do we know about them? We know they are highly fragmented. We also know that the unorganized segment is far bigger than the organized segment. And we know that organized players are taking market share from the unorganised ones. But do we know the size of the market? No, we don’t. Do we know the number of participants? No, we don’t. And so in such cases you have to go by management estimates and crosscheck data from multiple sources if possible.

And then you have to look for quantitative clues that will help you determine whether the rivalry is stable, increasing or reducing over time. Some of those quantitative clues would be changes in market share, operating profit margins, working capital intensity, marketing spent, capex done or planned by competitors, M&A activity in the industry, and antitrust measures, if any, taken by regulators.

And these numbers interact. Take, for example, a downward trend in operating profit margins of the industry. If you observe such a trend over a few quarters, then you have to ask if whether or not its caused by an increase in competitive intensity thanks to price cuts by one or more players and if that turns out to be the then you have ask if it’s likely to be short-lived or not.

Similarly, if an existing competitor starts spending much more on advertising and sales commissions than before, you have to ask the same questions.

If there’s lots of M&A happening in the industry it could mean a reduction in the competitive intensity in the industry. If, on the other hand, you find out that Competition Commission has accused players in an industry of operating a cartel, then you should expect competitive intensity to increase in the future.

Bargaining Power of Buyers and Suppliers

The bargaining power of buyers and suppliers (which includes human resources hired by the business) can be quantitatively measured by watching working capital turns and the trends in that ratio. If, for example, the ratio of average receivables as percentage of annual revenues increases from 20% to 50%, that’s a clue towards a shift of power from the business being examined to its customers. Once you find a clue like this, you can go deeper and find evidence that either validates or invalidates your hypothesis that power is shifting to the customer. And then you can also ask questions about the permanence of this shift…

The other effect of such power shifts is its impact on owner earnings. Buffett defined owner earnings as:

(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).” 

The bolded part of the above definition is absolutely critical but is often ignored by analysts. If bargaining power is permanently shifting from a business to its customers and/or suppliers,then the amount of working capital needed by the business just to stay its ground in terms of unit volume and competitive position will increase. That increase is (c) in the above equation and should be treated as a charge against earnings. Of course, when you do that in practice, then in many cases, you find that (c) exceeds (a) + (b) which means that there are are not real earnings to speak of. And if there are no real earnings there is no real value although the asset in question may enjoy fabulously high value for a while. As Buffett once said:“Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.”

The combination of the Porter framework with Buffett’s owner earnings framework has given me some very useful insights.

Threat of New Entrants and Threat of Substitute Products or Services

There is quite a bit of literature on this subject so I will stick to just one point and that’s about the threat represented by new types of business models.

I think investors should read book like Business Model Generation and Business Model Navigator learn about disruption caused through what is called as business model innovation.

An insightful article (Tesla’s Real Innovation Isn’t the Electric Car: It’s the company’s business practices—and they should make a lot of industries very, very nervous) by Daniel Gross on Tesla which was published by Slate is also worth reading and learning from.

And here’s one by by Sam Knight titled How Uber Conquered London which I loved reading in The Guardian.

Q: The theme of Davos 2016 was “The 4th Industrial revolution” which they describe as the coming together of multiple disruptive technological forces like Artificial Intelligence, internet, mobile and cloud which when applied together has huge potential to disrupt many industries and change the way we like , work and do business. I have following questions in this context:

  1. As Davos 2016 has described “The 4th Industrial revolution”, it seems like a confluence of multiple forces, does it qualify as a lollapalooza effect ? If so how should an individual investor approach investing in such an environment ( in the next decade )
  2. Even amidst massive disruption of the newspaper industry, Warren Buffett is comfortable owning and investing in newspapers ? Can you help us understand his thought process ? Do you see any lessons we can learn here.

As for your questions related to 4th Industrial Revolution and if it is a lollapalooza effect, the answer to me is yes. Investors should be very conscious of the risk of disruption. The pace of change will keep accelerating and entrenched businesses models will be disrupted as I discussed above. The books I cited above are useful but there are other books on this subject that have helped shape my thinking. Here are links to three of them.

  1. Singularity is Near: When Humans Transcend Biology
  2. Exponential Organizations: Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it)
  3. Abundance: The Future Is Better Than You Think

Your second question is very interesting. Why did Buffett buy newspapers? Aren’t paper newspapers a dying industry?

“Among other reasons, two stand out. One, he bought controlling interests so he can make the capital allocation decisions. So, even though the businesses may die in a few years, he won’t be investing new money in them. Instead, he would be wringing cash out of these businesses. And second, he paid very low multiple of earnings to buy them. So, it makes sense for him to do this. But in my view, investors who buy minority equity positions in publicly traded businesses which are prone to disruption cannot take the same position that Warren Buffett did. They should be very worried about the threat of disruption and how managements deal with it. And most managements do not think about this problem the way Buffett and Munger think about it. In fact, many years ago, in a dialogue with shareholders of BRK, here is what they said on the subject, which I think is very instructive.”

Munger: “I think its in the nature of things for some businesses to die. Its also in the nature of things that in some cases, you shouldn’t fight it. There’s no logical answer in some cases except to wring the money out and go elsewhere.”

Buffett: “And that’s very tough for managements to do. In fact, they almost never face up to that. It’s very rare. And its logical that it would be rare. In a private business, its understandable why they would face up to it- whereas in a public company managers may be far better off ignoring that reality than accepting it.”

“I think investors should read the above and also research Buffett’s decision to shut down the textile operations of BRK (which he wrote about in his letter in the 1985 annual report of BRK) and Munger’s discussion of his decision to get out of Savings and Loans industry and using the sale proceeds to buy the stock of the very disruptors of that industry.”

Business Fundamentals & Value Investing

Q: In one of your interviews you mentioned “Investors ignore businesses which may be earning a mediocre return right now but are on their way to earn superior, sustainable returns (“emerging moats”)” Many times business undergoing transformation are selling for discount but there is also a risk of value traps. What would you advise investors looking at such an opportunity?

A: “Emerging moats and value traps are different concepts. I think it’s useful to imagine business quality on a spectrum where, on one end, you have pure commodity businesses where no industry participant enjoys a low cost advantage and on the other end you have global franchise businesses with significant pricing power. An emerging moat business lies somewhere on the spectrum between these two extremes but more importantly, it is moving towards the better end of that spectrum. And that movement can be observed though a variety of developments as Warren Buffett wrote in his letter:”

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.

Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were running those long before we came along; our only function since has been to stay out of the way. If you see these heroes – and our four heroines as well – at the annual meeting, thank them for the job they do for you.

I love the idea of emerging moats because of their valuation. Because they are emerging (and they might well submerge which is always a risk), markets look at such businesses with skepticism which is reflected in relatively low market valuation in relation to prospective owner earnings a few years from now. Sometimes, the degree of that skepticism is unwarranted and therein lies an opportunity.

Value traps, on the other hand, are businesses which “look” cheap but are not really cheap. This could happen for a variety of reasons such as cyclicality of earnings, technological obsolescence, serious mistakes in capital allocation by the management, or other governance issues.

A low P/E stock may look superficially cheap because the business is enjoying cyclical peak earnings and the P/E is not really low if one adjusts for cyclicality. A taxi company may look cheap based on past earning power which existed before Uber arrived. The market may correctly be punishing a business by assigning a low multiple to its aggregate earnings because the managers keep burning cash in bad projects and there is no prospect of such misallocation being stopped. Or a business run by a crooked manager may look cheap to the naive value investor but the market knows better.

Q: In one of the previous interviews at Safal Niveshak you have listed the quality of management as one of the two factors which makes a business with an enduring moat attractive, On the other hand Warren Buffet prefers to own a business that can be run by a ham sandwich, i.e. he puts more emphasis on the business model rather than the quality of management. Can you please help us reconcile these two seemingly differing opinions about the importance of management?

A: Well I did that in a document titled “Why you shouldn’t invest in a business which even a fool can run.” So, I would request you to read that doc. Clearly, business quality comes first and management quality comes next. But that does not have to mean that either is unimportant. Both are critical in my view. You can have a great manager in a mediocre industry which creates a wonderful cost advantage that’s hard to replicate. Or you have a reasonably good management in a fantastic business which has solid entry barriers. In either case, foolish management can destroy the business.

Q: Can you please share an example where the management has widened the moat of a business. As you have mentioned earlier by the time it is reflected in ROIC numbers, it might be too late. How can we identify signs of moat widening efforts by a management

A: I think the best example of that which comes to my mind is that of amazon.com. Everything about Jeff Bezos and his philosophy on long-term thinking and innovation and customer orientation is worth learning from.

Q: How can an individual investor with no access to management evaluate a management, what are some of the signs you look for apart from reported items like salaries, conflict of interest , interested party transactions etc

A: Every investor has access to management. There are occasions where my colleagues attend AGM’s of companies we are researching after buying 1 share.

Evaluating management is an art. You should watch what they do and not what they say. And when you do that, you should have some empathy for the entrepreneur who is running the company. He is not a robot programmed to maximise shareholder value all of the time. He is prone to making mistakes. He will have some attributes that you dislike. Is that a reason to reject investing with him? I don’t think so. Time after time I have read about objections from investors who are obsessed with what Munger calls as Kantian Fairness Tendency. The world is not a fair place. There will almost always be some unfairness if you invest in a business run by an intelligent fanatic. You have to maintain a balance. I try to do that by keep Ben Franklin’s essay on Prudential Algebra in mind.


Q: One of my all time favorite among your quotes is “Return per unit of Stress” . It has helped me gain a different perspective not just about investing but also in other aspects of life. For example I use it now when I am evaluating job opportunities ( my post referring your quote here). Can you please share with our audience – how you came to this realization in your investing life. Do you apply this outside the context of investing, if so could you share an example?

A: Thanks. I am happy you found that inspirational. We talk a lot about “risk-adjusted returns” but rarely about “stress-adjusted returns.” And, as you know, in my view, both matter. It’s a very well documented fact that stress is a killer. And it just so happens that there are some types of behaviour in world of business and investing that are far more stressful than others. Take shorting stocks for example. Or using a lot of leverage or investing in businesses run by people who made my stomach churn. I found those experience very stressful. So, gradually, over time, I moved away from those activities.

I guess this realization is also a function of growing older. When you are young, you don’t worry so much about stress. Indeed, I believe that stress in moderate is actually good for you — but extreme stress causes much harm. When I was much younger in 2000 — I got involved in a hostile takeover battle. It was a thrilling (and profitable) experience. I wouldn’t do something like that today. The whole idea of being an activist like Bill Ackman — I find that not at all interesting to me anymore.

Do I use this realisation outside the world of investing? Yes, I do. So when I am driving to work, there are two routes to take. One is a shorter one but requires lots of twists and turns and traffic lights. The other one is longer but is a lot less stressful. And despite the fact that second route takes longer, and probably costs a bit more in terms of fuel consumption, I prefer it over the first one.


Q: In the past year there has been a significant excitement in the value investing community about India. Celebrity investors like Prem Watsa and Mohnish Pabrai have shown interest and committed capital. However there is a popular opinion among investors that most of the companies listed in the Indian stock exchange are not trustworthy and only a small percentage of companies are worth investing in. In this context I have the following questions

  1. What in your opinion has changed in india that is attracting foreign capital and is it sustainable
  2. What is the best way to participate in the Indian growth for an average investor (passive) outside India ( assuming he or she is not an Indian citizen )

A: Well, to be honest I like to see that there is this prejudice against Indian entrepreneurs because that prejudice creates bargain prices. The reality is that some of the entrepreneurs I have studied are comparable to the highest entrepreneurs I have studied outside India.

I like to think that what’s changed over the years is that thanks to role models like Narayan Murthy of Infosys, and others, many Indian entrepreneurs recognize that wealth creation is not a zero sum game and that if they behave ethically, the businesses they run so well will enjoy a much higher P/E multiple than would be the case if they didn’t. And a high multiple stock not just creates high valuation for the business, it also provides it with a wonderful tool to grow in-organically too.

Earnings are created by businesses but earnings multiples are created by markets. And, other things remaining unchanged, a business that’s run in the interests of all stakeholders is worth more than one which is run in the interests of just the controlling stockholders. As Warren Buffett once correctly stated:

“Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.”

As to your other question about what’s the best way for a foreign investor to participate in India’s growth, my advise is to find someone trustworthy and competent, who represents your interests and not those of issuers of securities and invest through him/her. Local domain knowledge is essential. It’s hard to understand India from a distance. One has to be here, but then that’s a very biased view so I will stop there.





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