Thursday, 28 December 2017

2017: Year in Review

2017 was an interesting year, both for the markets and for the world. India saw a major tax reform in the rollout of GST. Along with last year’s demonetization, it resulted in a definite slowdown in business performance, where companies took time to adjust themselves to the new way of doing business. Globally, tensions rode high with North Korea and US presidents taking potshots at one another.

Bitcoin became the rage this year. At the time of writing this, it has already risen more than 15 times. A lot of my friends have asked me about how to invest in them in the last one month, which gives me an impression (and I could be very wrong) that we are staring at a classical bubble. Most of the signs of a bubble are visible in the way the cryptocurrencies are trading today. The fall may not come immediately, but the story is unlikely to end well for those who are coming to the party late.
In India, Sensex has gone up about 25% over the year.

2017 was fairly challenging in identifying good companies which were available at reasonable valuations. Across global markets, valuations have been fairly high throughout the year.

As an investor, I focus on generating absolute returns with a usual time-frame of 2-3 years for an investment to work out. I try to identify businesses with good management and reasonable growth that can compound well over time. Along with that I also focus my energies on identifying turnaround sectors and companies – those where things are getting from worst to bad or from bad to good.

The focus for 2018 remains the same. I continue to look for good, well-managed, undervalued mid and small cap stocks which have a promise of above-average returns.

I am a firm believer in wealth creation through equities over the long term and I think we in India are in the midst of a multi-year bull market. Some of the reasons why I think we are in a major bull market are:


i) Global liquidity: Globally, some $9 trillion of global government debt still trades at negative rates. Investors are desperate to find avenues where they can get a positive return.

ii) Domestic participation: Participation in equity through mutual fund SIPs has gone up consistently. Just a look at the numbers shows that SIPs in the full year FY16-17 was Rs 43,921 crores and in 8-months of Apr-Nov Fy17-18 is already Rs 40,780 crores! Monthly SIPs are closing in on Rs 6,000 crores per month.

iii)TINA (There Is No Alternative): With low interest rates, real estate market in dumps after demonetization and gold prices also stagnant, common Indians are flocking to the equity markets through the SIP route.

iv) Growth: India is already more than a $2 trillion economy and GDP is growing at 6-8%. This means in the next 8-10 years India will double its economy size. Just think about the implications of it. We will be adding as much to the economy in the next 8-10 years, as we currently have! The per capita income will correspondingly double as well, bringing millions (if not billions) of people out of poverty into the consuming class.

It is not as if everything is rosy. Indian demography is both its advantage and its weak point. If as a country we are unable to provide jobs or livelihoods to the millions of young people, then we are most likely going to see increased social tensions. They may come up in different forms and may not be directly attributable to economic challenges, but the root cause will most likely point to that.

Short-term government policy, taxation rules can be risky and create uncertainties for businesses and the markets as we have seen with both the demonetization and GST exercises. Global macro factors can also result in changes in market dynamics in the short-to-medium term.

Overall, the future for Indian equities looks to be bright over the long term. Like every year, 2018 will bring with it its own set of challenges. There is no way to predict how the year will pan out. The only thing for sure is that it will be volatile.


May we live in interesting times.

Here is wishing all a very happy and prosperous New Year.

Tuesday, 12 December 2017

Friday, 8 December 2017

Weekly Reading: Some interesting stuff

A Q&A with arguably India's best banker today - Uday Kotak

Why professionals will beat amateurs in the future

Lou Simpson, former chief investment officer for Geico discusses his portfolio strategy

A logical future is for blockchain based currency issued by central banks in lieu of paper currency

Focus in the answer to superior results. And a Not-To-Do-List!

A sneak peak into the famous and controversial Paul Singer and his hedge fund Elliot Management. The article also covers how they took on Samsung and how at times their practices can border on the boundaries of ethics.

Tuesday, 21 November 2017

Weekend Reading: Some Interesting Stuff

How the future of labour is not doomed by automation and thoughtful policies can make a better tomorrow for jobs

How Kaspersky antivirus software was used by Russian spies

Relying on averages is misleading for non-homogenous data sets

Why money to PSU banks should not be given with a rider

In Japan, you can pay an actor to impersonate your relative, spouse, coworker, or any kind of acquaintance.

How the insolvency and bankruptcy process is a once in a lifetime event

Wednesday, 15 November 2017

A Few Lessons From Sherlock Holmes - Peter Bevelin

Since I read Peter Bevelin's Seeking Wisdom, I have wanted to read his other books. So, I managed to get through his "A Few Lessons From Sherlock Holmes" recently. To be honest, I was a bit disappointed. The book seemed, to me, to be a collection of quotes from Sherlock Holmes books collated thematically. Though Seeking Wisdom was also on similar lines, that is, someone who had read all of Munger's writings and speeches would actually find it very repetitive, it had a structure to it. Also, Seeking Wisdom can be read without knowing anything about Munger, which is not really the case in this instance.

I had highlighted some quotes from the book. I am putting them here. Hope this is beneficial for those who have not read the book to get an idea of what it is about.

What distinguishes Holmes from most mortals is that he knows where to look and what questions to ask. He pays attention to the important things and he knows where to find them.

To know what to do and not do, we first need some genuine understanding on how reality is - how things and people are and what works and not

Considering many ideas over a wide range of disciplines give us perspective and help us consider the big picture or many aspects of an issue

But only what is useful - it can be dangerous to know too much

He said that he would acquire no knowledge which did not bear upon his object. Therefore all the knowledge which he possessed was such as would be useful to him.

It is useful to know something about human nature and what motivates people

Ask: What is in their interest to do?

But knowledge doesn’t automatically make us wise - the most learned are not the wisest

What is the problem? What do we ultimately want to achieve or avoid? That is the problem which we have to solve.

“The greatest sign of an ill-regulated mind is to believe things because you wish them to be so.” (Louis Pasteur)

Never jump to conclusions and try to collect facts as open-minded as possible

“Men see a little, presume a good deal, and so jump to the conclusion.”

It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.

Don’t be too quick Let us know a little more before we act.

And don’t blindly collect endless amounts of facts

One forms provisional theories and waits for time or fuller knowledge to explore them.

Data! Data! Data!...I can’t make bricks without clay.

Make sure “facts” are facts - Is it really so? Is this really true? Did this really happen?

We must look for consistency. Where there is a want of it we must suspect deception.

Don’t miss the forest for the trees - It is not the amount of information that counts but the relevant one.

Separate the relevant and important facts from the unimportant or accidental

The first thing was to look at the facts and separate what was certain from what was conjecture.

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital. Otherwise your energy and attention must be dissipated instead of being concentrated.

There may be many theories that fit the facts

Sometimes it helps to shift perspective

Never trust to general impressions, my boy, but concentrate yourself upon details.

What have we overlooked?

Sometimes we overlook that which is most obvious

In searching for the obscure, do not overlook the obvious.

Use the simplest means first

Sometimes things are not as simple as they seem. But sometimes they are not as complex as they seem, either

But don’t try to over-simplify complex matters - especially when we deal with systems with complicated interactions

What normally happens in similar situations? Why should this be any different?

Analogies - What does this case resemble? What is the same between this situation and others?

Negative evidence and events that don’t happen, matter when something implies they should be present or happen

What doesn’t matter? What can’t happen? What can’t it be? What can’t be done?

Test Our Theory- if it disagrees with the facts it is wrong

Facts don’t lie but we may have interpreted or stated them wrong and therefore drawn the wrong conclusion

Patience - Take time to think things over

And avoid distractions and concentrate on the problem

Put yourself in the other person’s shoes

Get a different view - talk it over with someone else

Don’t make the world fit your tools and use the right tool for the job

Watch out for overconfidence

Update our beliefs in light of new information

Criticize ourselves - Have we tried to find evidence against what we believe? Why might we be wrong? What have we overlooked? What (new) information or evidence is needed to make us change our mind?

When we get better understanding or the facts or evidence don’t agree with the theory we must change the theory and change course

Learn from your mistakes - and learn the general lessons

To learn we must face the mistakes and try to find out why we made them. Then comes our gain.

Know our limitations

Don’t think about how to get things done, instead ask whether they’re worth doing in the first place

Avoid danger - we shouldn’t expect to survive when we enter tough seas

We shouldn’t disregard even a small probability

The future is hard to predict

Friday, 20 October 2017

Weekly Reading: Some interesting stuff

How the term "Demographic dividend" is being misused and what it really means

One of those "list articles" on what the author has learnt from Stan Druckenmiller. Some of the points are really important.

Google, Twitter and Facebook workers who helped make technology so addictive are disconnecting themselves from the internet.

Intelligence is not the same as critical thinking and the difference matters

A good primer on Indian Steel industry

Saturday, 30 September 2017

Weekly Reading: Some interesting stuff


The situation of Graphite producers in China

Cities are wooing Amazon for their 2nd HQ

China is looking to upset the current petrodollar system by introducing a gold-backed “petroyuan” oil futures contract. And since China is the largest importer of oil globally, this shift away from the petrodollar could be bad news for the US but it could be great news for gold owners

To listen and understand; to question and disagree; to treat no proposition as sacred and no objection as impious; to be willing to entertain unpopular ideas and cultivate the habits of an open mind.

Is this the beginning of the end for booze companies?



Wednesday, 27 September 2017

Tata Global Beverages



NOTES FROM AR 2017
Tata Global Beverages (TGB) is a natural beverages company with brand presence in over 40countries. As the second largest tea company in the world, with a growing interest in coffee and water, TGB is home to a stable of innovative global and regional brands, including: Tata Tea, Tetley, Himalayan natural mineral water, Tata Gluco+, Good Earth tea, and Eight O’clock coffee.

• 2nd Largest player in branded tea in the world
• 20,000+ SKUs produced across tea, coffee and water
• 40+ Countries with significant brand presence

BRANDS
• Tata Tea - Premium, Elaichi Chai, Chakra Gold, Gold, Teaveda, Kanan devan, Gemini, Agni
• Tetley - Presence in UK, France, US, Canada, India, Australia, Middle East, Poland
• Good Earth, Jemca, Vitax, Teapigs, Joekels
• Coffee - Eight O'Clock, MAP, Grand Coffee, Tata Coffee Grand
• Water - Tata Water Plus, Tata Gluco Plus, Himalayan
• Company has entered the new Asian markets of Singapore, Malaysia and China, which are large tea consuming markets. The company has entered a tie-up in the e-commerce channel in China to focus on the business-to-consumer (B2C) category.
• Co has undertaken a multi-year extension of its partnership with Kuerig in US, for the manufacturing, sales, licensing and distribution of the EOC coffee and Tetley tea brands in K-Cup pods for use in Keurig brewers
• Tata Coffee Limited, a subsidiary which operates in the non-branded business, announced the setting up of a state-of-the-art Freeze Dried Instant Coffee plant in Vietnam with an installed capacity of 5000 MT per annum.
• Tata Starbucks our 50% JV had opened 91 stores; performed very well in the current year with double digit growth

Continued focus on health and wellness
• Expanded portfolio of green teas and fruit & herbal teas, in line with this trend. Tetley Super Green Tea (fortified with vitamins). Tata Tea Teaveda and Tetley Balance two product ranges inspired by Ayurveda and containing herbal ingredients - were launched in India and Canada
• Eight O’Clock coffee in the USA launched a new line called Infusions

Premiumisation
• Tetley Indulgence launched in the UK is a range of black teas in indulgent flavour twists such as cookies & cream, chocolate mint, gingerbread, and spiced apple.
• TGB collaborated with Starbucks to create a signature innovation, India Spice Majesty Blend especially for the Starbucks Teavana™ portfolio in India
• Himalayan natural mineral water - launched a sparkling variant in select channels and also piloted ‘Orchard Pure’ flavoured water
• Tetley now outperforms the herbal tea category's growth- Tetley +19% vs Category +6% (as per Nielsen study)
• Promoter shareholding is 34.4%
• Institutional shareholding is 33.64%
• In the process of divesting the Instant tea business in China. The decision to divest was taken mainly due to the marginal nature of the business and under-performances as compared to plans.



Q1FY18 Analyst Presentation
5th consecutive quarter of operating profit growth despite higher spends behind brands and competitive intensity in developed markets
• Improvement in tea volumes whilst softer volumes in coffee
○ Improvement in India despite impact of GST transition in India
• Good improvement in Profit before exceptional and tax despite higher advertisement
○ Effective management of commodity costs
○ Good cost management
• Commodity costs
○ Softness in India tea prices
○ International tea prices hardening further impacted due to Brexit
○ Coffee Costs – showing a hardening trend
• Volatile currency markets
○ Brexit leading to GBP depreciation
• Increased focus on under performing businesses
○ Exit from China Business
○ Exit from the Russian business

India Business: - India business grew by ~4%-5% which was impacted by GST transition
• Gluco-D have witnessed steady acceptance from the consumers
• 50% tea consumed and sold in India is branded tea.
• Tata Tea Elaichi growing at robust pace
• Tata Coffee Grand gain shares with new variants
• Launched Fruski on a pilot basis - a tea based RTD.
• Starbucks currently operates in 95 stores which will be start generating EBITDA profit in next ~1-2 years

UK business:- Strong performance in UK driven by growth in market share across major categories despite sustained decline in overall tea market and continued competitive intensity. Green tea continue to grow well. Teapig the super premium brand posted good growth

Bangladesh has witnessed robust growth in Q1 FY18 with record profits in Q1 FY18.

USA - Promotional phasing and higher commodity costs impacted performance of EOC business in US during the quarter. Tetley green tea reflects modest growth despite decline in category.

Russia was a loss making unit which have been restructured, going ahead performance from international business will improve.

Non branded - Topline declined due to reduction in sales volumes of instant coffee and plantation products (impacted due to lower crop and lower export realization due to stronger INR).
Tata Coffee infused in aggregate an amount of US$6 million (mn) on greenfield freeze dried instant coffee facility in Vietnam

Canada witnessed an improvement in the topline. The company continued its value and volume leadership in the country. It also launched Tetley RTD in three flavours - Lemon Ginger, Peach mango and Pomegranate Berry
In order to drive its performance, the company has come up with strategic priorities, which include base business rejuvenation, investment for growth and driving operational efficiency.
The company intends to invest in incubatory businesses - Starbucks and Nourischo to drive future growth. Under Nourishco, the company has launched variants of Tata Gluco Plus, Himalayan flavoured & sparkling water. Nourischo has witnessed traction in the operating profit.

What is Changing?
1. Continuous debt reduction
2. Focus on higher margin products to increase margins
3. Getting out of loss making or non-performing geographies like Russia signals management intent on turnaround
4. As per media reports, Tata Global Beverages may sell its stake in various Tata group’s listed companies to its parent, Tata Sons, in the coming months. TGBL currently owns 725 crore worth of stake in other Tata group firms, viz. Tata Chemical and Tata Investment Corporation. TGBL has a 4.39% stake in Tata Chemicals and 0.29% stake in Tata Investment Corporation. The company may utilise the funds towards a) brand building activities or b) payoff of the debt or c) dividend payout, or a combination of these

RISKS
* Business is dependent on bulk tea & coffee prices
* Exchange rate fluctuations
* Gradual move of taste from tea to coffee and other drinks

FINANCIAL


Friday, 15 September 2017

Weekly Reading - Some interesting stuff

Ray Dalio's principles, before his book launch

Characteristics of successful investors (a bit generalized)

A glimpse of how man & machine work 'hand-in-hand' at Amazon

A lot more Lithium mining is needed in the near future

Having a kaleidoscope of mental models helps in navigating the investment world when most are edges are disappearing

The tough stance of RBI and the changing regulatory environment is forcing Essar to look at paring its debt

Friday, 8 September 2017

Weekly Reading: Some interesting stuff

What provides the edge - deep research or insights derived from thinking over multiple subjective arguments?

Deliberate practice does not add much value in a probabilistic field of work such as investing

Chinese flying trains - An alternate future of transportation?

Ashish Chugh's take on investing in Indian markets

Fear of missing out has taken over from value discipline, a development that is a sure sign of a bull market. Also, includes a discussion on bitcoin and ETFs.

An interesting business model - MoviePass users receive a debit card that they can use to see up to one conventional 2D movie a day.

Saturday, 2 September 2017

Weekly Reading: Some interesting stuff

Media needs a champion who can take on the government without fear

Setting priorities of life - from a person who survived a near-death experience

Harvey’s floods shut down almost all of Texas state’s plants, 61 percent of U.S. ethylene capacity has been closed, resulting in a sharp spike in prices

On Sept. 1, Google shared a list of the most-searched “how-to” questions around the world. It’s a moving portrait of all the beauty, bewilderment, and struggle of human existence. 
https://qz.com/1068114/googles-most-searched-how-to-questions-capture-all-the-magic-and-struggle-of-being-human

The economics of free
https://www.economist.com/news/finance-and-economics/21727073-economists-struggle-work-out-how-much-free-economy-comes-cost

Friday, 18 August 2017

Himadri Chemicals - A play on Li-Ion Battery

Himadri is a Kolkata based company mainly focusing on coal tar pitch and carbon black.
Product chain
Main Products

Coal tar pitch:
- used in the manufacture of aluminum, which is used in automobiles, airplanes, televisions, radio components, rockets, beverage cans, wires, cables, smartphones, furniture, foil wraps.
- finds downstream use in the manufacture of graphite electrodes in electric arc furnaces.
- specialized coal tar pitch, which is used in long war head missiles.
- manufactures coal tar-based thermoplastic polymeric coating, which is used as an anti-corrosive material in underground and offshore pipelines.
- Coal tar distillation capacity is 4 lakh MTPA.
- 70% market share
- Debottlenecking of capacity at 20cr planned to increase capacity

Carbon black:
- used for reinforcement of elastomeric materials. Carbon black is a critical raw material in tyre and other rubber industries, inks, plastics and paints.
- manufactures a range of specialty carbon black with specific applications in plastics, fibre, inks and food grade materials.
- Carbon black capacity - 1.2 lakh MTPA
- 17% market share

SNF:
- manufactures SNF (Sulphonated Naphthalene Formaldehyde), which enhances the performance of concrete for commercial and core infrastructure constructions.
- manufactures PCE (poly carboxylate ether) which is a performance chemical used in next-generation super-plasticisers to manufacture high-strength, high performance concrete.
- Dumping from China poses a threat
- SNF capacity - 68,000 MTPA - Largest capacity in India

Advanced Carbon (Anode for Li-Ion batteries):
- manufactures advanced carbon used in the manufacture of lithium-ion batteries that power smartphones, electric vehicles and digital cameras as well as airplane brakes that make flying safer.
- The consumption pattern of anode materials are slowly shifting from natural to synthetic graphite. Himadri offers anode materials in both synthetic and natural varieties.
- Co is the only company in the world to have in-house access to raw material making its products superior in quality.
- Moved from batch processing to continuous processing.
- Current capacity is 5 MT/month. New capacity of 50 MT/month coming onstream from 15 Sep 2017.
- Expected CAGR of 40%; no need to have firm contracts as demand is huge
- Realizations are 6 lakhs - 7 lakhs / MT for the finished product.

Plants:
Himadri has seven manufacturing units across India – four in West Bengal and one each in Andhra Pradesh, Gujarat, Chhattisgarh – and is now setting up its eighth unit in Odisha. The Company exports products to more than 10 countries.

The Company had been incurring losses during the last three years, even though at the operational level, they reported profitability. Primarily, the losses that the Company incurred were due to a depreciation of the INR and inventory losses on account of fall in the price of crude oil. The inventory pileup continued during the first two quarters of 2016.
The co took measures to reinforce operational efficiencies; appointed a consultant with global expertise to help us incorporate best-in-class practices.

The business model is unique and fully integrated to manufacture speciality chemicals. Use coal tar as the raw material and distil it to produce naphthalene, oils of various grades and coal tar pitch. The naphthalene produced is used in-house to manufacture SNF and refined naphthalene of the highest purity. Heavy creosote oil is sold to customers for specialised applications while other oils are used for making carbon black. We also produce
clean and green power. The power generated is used to power the entire complex while the balance is sold to the State Grid.

Inelastic Demand:
Aluminum smelters cannot moderate consumption during a downturn without having to shut down one (or some) of their manufacturing units. The cost of shutting down and starting afresh is too high. This means that coal tar pitch manufacturers are assured of regular offtake in even the most challenging
of markets. The strong offtake across the last two years, when aluminum and graphite industries were going through their worst phase, stands testimony.
Reason for decline in the Company’s earnings in the last 3 years:
- INR depreciation
- inventory losses due to fall in crude

What has changed:
- reduced its exposure to foreign currency loans
- debt reduction
- net debt of the company reduced by 225 Crores during 2015- 16, including the repayment of long-term debt of 122 Crores, even as the financials appeared stressed.
- LT debt reduced from 414 cr in 31-Mar-17 to 310 cr on 30-Jun-17, reduction of 104 cr.
Non-promoter holding:
- Bain Capital
- Vallabh Bhansali

RISKS
- The profitability of the company is susceptible to volatility in raw-material prices (forming 85% of total cost of sales) as the prices of raw-material are volatile in nature due to linkage with crude oil prices and global demand and supply.
- The company is also exposed to foreign exchange fluctuation risks due to high dependency on imported raw-material, foreign currency term loan and no fixed hedging policy.
- HSCL’s operations are working capital intensive due to requirement of high level of inventory on the back of lead time involved in import of few raw-materials (imported pitch and carbon black feedstock) and high credit period offered to its customers.

Financial Ratios from Screener

Disclosure: Not currently invested.

Friday, 28 July 2017

ValuePickr Goa Meet - Disruptions in Technology

This year my main presentation at the ValuePickr Goa meet was on disruptions from technology. Being from the tech industry, this is a topic which is very close to my heart. I enjoy following new tech and new tech businesses. Wearing my investor hat, it is also wonderful to evaluate businesses which may be benefiting from tech upheavals.

What tech disruptions basically implies is, it impacts the terminal value of an investment. If you think of the value of a business, it is the sum total of all cashflows from now till eternity. Now if a business is severely disrupted, the terminal value of perpetuity goes down to zero (0). In a DCF, the terminal value is what derives the majority of the current value - sometimes 80-90% of it. So, if the TV goes down to zero, we need to question the overall valuation we are willing to pay for such businesses.

On the other hand, I also argue that in most circumstances, disruptions are relatively slow (from an investment perspective) and investors do get a chance to react. For example, Kodak did not get wiped out overnight, it took years for that to happen. So, it's important to be aware of change but not get swayed by it. Its important to understand the scale and impact of change before reacting.


Friday, 21 July 2017

Stock Update: Supreme Industries

BEAR CASE
  • RERA to impact housing demand adversely. Negative impact on pipes segment.
  • Competition is strengthening in pipes with Astral, Ashirvad & Finolex. Supreme has lost market share from 35% in 2009 to 26% in 2017.
  • Competition is moving across the value chain and product range. e.g. Astral is moving into agri pipes and Finolex is moving into plumbing pipes.
  • No major breakthrough product from the company in the recent past that can boost sales majorly. Composite cylinders still in initial stages.


BULL CASE
  • Overall price cap on crude and buildup of new Polymer plant capacities in USA, China and Middle East will keep a lid on high Polymer prices.
  • Govt focus on 1) Affordable housing, 2) Formalization of economy through adoption of GST, 3) Doubling of farmer's income by 2022, 4) Swacch Bharat Abhiyan, 5) 100 smart cities
  • The distributors strength has gone up to 2973 by the end of March 2017 compared to 2699 by March 2016.
  • Market leader in plastic piping systems with 7230 SKUs
  • New Kharagpur plant for PVC,CPVC & HDPE pipes to commence from Nov'17. New Roto moulding plant at Kharagpur to commence from Aug'17
  • The co has launched Overhead Water Tanks in various capacities from 500 liters to 5000 liters. Also launched Septic tanks in collaboration with a South African company
  • Co manufactured solvent cement – SILBOND was approved by NSF-14 in both the varieties i.e., PVC and CPVC. The PVC variety also was certified by BIS and hence the products are going in the market with necessary ISI and NSF marking. The Company has further introduced BLUE SEALANT suitable for metal threaded joints. As a result Company now got all the products available in the segment of adhesives, solvents & lubricants required for various Piping Systems.
  • Informal sector comprises of 40% of plastic furniture segment and with GST that share is expected to reduce over time
  • Co has started exporting to USA and has found good acceptance for some of its products
  • Co is making car interior parts for Honda and Maruti Suzuki and is continuously acquiring new business from existing customers
  • Co has started a new product range using foam for children's education, toys, sports, health sector and interior decoration
  • Composite cylinder order for 2.5 lakhs pcs from Bangladesh. BIS certification received and HPCL is expected to start trial runs.
  • Capex planned at 300-350 cr in FY17-18

Monday, 10 July 2017

Learning from Berkshire’s Acquisition Criteria

Looking at the 100-plus businesses that Buffett has accumulated, a casual observer may feel that it is a collection of random businesses. But look closely and you will find a pattern. Who else, but Buffett has articulated the common thread amongst all his businesses when he published the Berkshire’s Acquisition Criteria.

A fact that we need to keep in mind is that these criteria are not for his general stock purchases but for acquiring controlling stake or whole companies, but they give a glimpse of how Buffett things about buying companies.

There are six criteria which are simple and straightforward.

1. Large purchases (at least $50 million of before-tax earnings)

Buffett looks at opportunities to deploy large amounts of cash. It makes very little sense to buy companies which would make up a fraction of a percentage or a couple of percentages in his overall portfolio. The same principle applies to investors as well – to look for companies where we can invest between 5-10% of our portfolio with conviction.

2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations)

Buffett looks for companies with regular and consistent cash flows and earnings. This significantly reduces his universe of investible stocks as some sectors are by their nature not amenable to such characteristics. Cyclicals like cement, metals, sugar, oil have never been part of Buffett’s core holdings -though he has had shorter term (five years) positions in stocks like PetroChina.

"Both our operating and investment experience cause us to conclude that turnarounds seldom turn," Buffett wrote in 1979, "and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price."

Investors should focus on finding good businesses with reasonably consistent cashflow and ability to generate profits for a prolonged period (many years or decades) and then try to buy them at a discount to intrinsic value.

Having a portfolio of good businesses, without being leveraged and not needing to pull out of the market when there is a downturn, can produce good results over a long period of time.

3. Businesses earning good returns on equity while employing little or no debt

Stocks of highly leveraged companies should come with a statutory warning like in cigarette packs, “Investing in highly debt-ridden companies is injurious to wealth”! The foremost reason for problems in companies over a long period of time, which results in permanent loss of capital for investors, is high debt. If an investor can simply avoid them, half the battle is won.

Return on equity (ROE) is one of the most important ratios to look at for a company. A business needs to be able to generate ROE above its cost of capital and above an investors opportunity cost to be considered for investment.  Over a long period, a business which generates high ROE will tend to be value accretive.

4. Management in place (we can't supply it)
An honest and competent management that treats minority shareholders as equal partners in the business is crucial for the long-term success of an investment. Since, minority shareholders usually are not able to control or influence management decisions and policies, special emphasis is required to understand that the management would not try to enrich itself at their expense or try to get into ‘diworsifications’ for self-aggrandizement.

5. Simple businesses (if there's lots of technology, we won't understand it)
Here again the focus is on businesses which can be understood by the investor – the circle of competence. Understanding means that the investor understands the industry dynamics, the competitive positioning of the company within the industry, how the company makes money, the demand and supply economics etc. It also means some idea about how the long-term future would look like for the business. This is precisely why Buffett tends to avoid those industries and companies which are prone to rapid disruption and change and sticks to the old-world businesses.
An investor can start with studying businesses that they are familiar with and learn more about it and its competitors. Over a period, the circle of competence can be expanded to include new industries and companies by continuous learning.

6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)
Price is the most ready-made data that is always available for listed stocks. Every day Mr. Market gives a quote that an investor can either take or let pass. This criterion, if strictly interpreted, is not for investors, but can be expanded to incorporate the most critical concept of “margin-of-safety”. An investor should only look to buy a business if the quoted price is below the intrinsic worth of the stock. It also protects an investor from mistakes and market downturns.

Since last year the Q&A session at the Berkshire Annual Meeting has been webcast live giving an opportunity for investors across the world an opportunity to watch the Buffett-Munger duo in action, answering questions across various topics. Every year, there is some nuggets of wisdom that can be learnt from these sessions and this year was no different.

Munger and Buffett have spent their entire lives by sticking to their investment principles not chasing fads. “A lot of people are trying to be brilliant, and we are just trying to stay rational”, said Munger. Buying and holding great businesses over very long periods of time has been extremely rewarding. As Buffett aptly put, "We did not buy American Express or Wells Fargo or United Airlines or Coca-Cola with the idea that they would never have problems or they would never have competition. But we did buy them because we thought they had very, very strong brands”. Brands of course allow Buffett to invest in companies where he can predict consumer behavior in the long term.

Over the years, Buffett has been sector-agnostic and bought wherever and whenever he has seen value.
"Charlie and I really do not discuss sectors much, we're really opportunistic. We're looking at all kinds of businesses all the time. We're hoping, we get a call, and we know in the first five minutes whether a deal has a reasonable chance of happening… We don't really say we'll go after companies in this field or that field”, Buffett said.

Markets are at time irrational and provides good companies at cheap valuations. That is the time when margin of safety in stocks are high and investors need to take advantage of. As Buffett mentioned, "It is the nature of market systems to occasionally go haywire in one direction or another."

The world is seeing a plethora of new technologies resulting in completely new businesses. In the coming years, some existing businesses will die and others will take their places. Buffett mentioned that artificial intelligence would result in significantly less employment in certain areas, but that’s good for society, though it may not be good for a given business. As an example of such widespread disruption and its impact on businesses, Buffett said, “Autonomous vehicles, widespread, would hurt us if they spread to trucks, and they would hurt our auto insurance business. They may be a long way off. That will depend on experience in the first early months of the introduction. If they make the world safer, it will be a very good thing but it won't be a good thing for auto insurers."

If we follow the basic rules laid down by Buffett, keep learning continuously and apply common sense to investing the long-term outcome is likely to be positive.

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