Buy when there's blood in the streets, even if the blood is your own. Baron Rothschild

The importance of gum chewing in investing

How in the hell is gum chewing and investing related? According to Warren Buffett, a lot.

I look for businesses in which I think I can predict what they’re going to look like in ten to fifteen years time. Take Wrigley’s chewing gum. I don’t think the internet is going to change how people chew gum.” – Warren Buffett

In my earlier post Back from long hiatus and food for thought , I wrote about the importance of finding businesses which suffer from very little risk of change. The above quote by Warren Buffett inspired the earlier post and my way of thinking.

This leads me to another point. I mentioned in the same earlier post, Back from long hiatus and food for thought , of mistakes I made. Practically the largest and potentially most of the mistakes I made were not adhering to Buffets simple maxim of buying companies that make products or provide services that were guaranteed to change at the pace of snails in a marathon.  Investing in discretionary consumer products such as teenage fashion was a mistake as the internet has essentially changed the playing field. On top of that, fast fashion juggernauts such as Zara, H&M and Uniqlo are eating many fashion retailers lunch as we speak. Although the fashion retailers stock prices in my opinion are cheap, the competitive landscape is much more intense and they hardly have a any moats (sans weak brand intangibles) to fend threats off. I could go on and on about other mistakes made in dirt cheap precision tools companies with zero moats or really cheap engineering companies in cyclical decline with not much of a moat to speak off.

But it is more important to take those lessons, learn from them, move on, and keep in mind never to make them again. It is thus, a better use of time to identify and brainstorm on companies will make better and safer investments compared to the junk I bought in the recent past.

So lets start with some companies that will likely stand the test of time:

• Colgate (NYSE) There are not many large toothpaste competitors around. Crest is one of them and is owned by P&G. But Colgate continues to have the lions share of the global market and even has a stake in Darlie, a popular brand of toothpaste in Asia. Colgate is unlikely to grow at a fast pace but is likely to be unhampered by technological changes and is likely to be around for the next 50 years and beyond .

• Dulux (ASX), Nippon Paint (TYO) One of the more familiar paint brands in Asia are Dulux and Nippon Paint. The painting contractors may change but paint companies with the scale and familiar brand names are few and far between. As long as humans continues to reside and work in buildings and homes made of concrete and bricks, paint companies will continue to make money. Every couple of years, buildings require a new coat of paint so that forms a part of recurring income. There are innovations in paints such as odorless, reflective, dirt resistant, etc. However, the technological pace of the industry, especially for general building and home use is slow moving compared to businesses more focused on industrial coatings. Other familiar names of paint companies mainly in industrial coatings include Akzo Nobel (AMS), PPG (NYSE) and Sherwin-Williams (NYSE).

• KONE (HEL), Schindler (SWX) There may be a time when teleportation becomes a reality. But for now and likely a long time to come, we have to make do with elevators and escalators to move us up to vertical destinations in buildings. The businesses make strong recurring revenues from the servicing of the machinery. Again, there are few established players in the industry. The only technological changes which I can foresee are likely to be the changes in speeds of movement of the machinery, which I doubt are going to be earth shattering nor will they cost a fortune in R&D. The other companies include Otis which is part of United Technologies (NYSE) and ThyssenKrupp Lift, a part of ThyssenKrupp AG (FRA). The oligopoly is so strong that it attracted the attention of the EU which fined the cartel almost a billion Euros in 2007.

Just because it is a great business does not mean that it will make a great investment. Naturally, most people recognise the advantages of such businesses and so valuations for the above mentioned companies are high. The key is to purchase them when the entire market falls in a panic or if the company suffers from a temporary stumble .

There are many other businesses with huge moats and are generally shielded by the slow changes in technology which affects their services and products due to the nature of the industry. These factors ultimately gives them the pricing power for continued profitability.  I will list more of them in future posts. Please feel free to contribute your thoughts and additional names by leaving your comment!

Businesses reducing search costs

I recently chanced upon a Singapore mobile app, Carousell, which enables users to sell items merely by snapping a photo of the item via a mobile phone, entering the price and description and thats it. You then sit tight and wait for an offer to be made. Its functions are pretty primitive with no credit card payment backend system. Thus, buyers and sellers have to negotiate a final price, meetup location for the transaction or via mail and also payment methods (cash on meetups or bank transfers). Surprise surprise. Through Carousells short life span, more than a million items have been listed for sale and through personal experience, offers and transactions come in quick, as long as the price is reasonable. So there truly is a market out there.

It is a very primitive version of eBay or Gmarket embedded solely as a mobile app. You can only use the services as a mobile app, with no desktop based functions. I realised there are some very powerful economics attached to this little but very functional app and also it provided a good lesson on business and moats.

• Carousell essentially reduces search costs of both buyers and sellers much like recruitment firms such as Kelly Services, and also the online marketplaces like eBay and Alibaba
• Over time, as more users use the platform, critical mass begins to swell and creates a network effect where buyers and sellers connect with each other through this broker system.
• Switching costs increases for both buyers and sellers. They become familiar with the platform and may not want to risk using another platform which could have fewer number of potential buyers for their items or fewer sellers for the items they wish to purchase.
• At this point in time, economies of scale  form since it should not take much additional costs, if any, to add each new listings or users once the infrastructure is in place.
• Invariably, as more users hop on, people recognise the brand name (intangibles ) of the service and becomes more familiar with it. If anybody is seeking to purchase items B2B wise, Alibaba should be familiar to them. If you think about online bidding services, eBay probably would be the first name that pops up. That brand recall is valuable to any businesses.
• As such, competitors will find it increasingly hard to challenge the business as the passage of time progresses.

I believe what sparked Carousells success is also the fact that it makes use of what most of us have, a mobile phone. It is a pain free process to snap a photo to list the items for sale and users jump through very few hoops to create an account. Unlike the traditional ecommerce model where one has to painstakingly set up an account, configure payment systems, use a desktop or notebook computer to hawk their wares and touch up the images with Photoshop, Carousell has none of these. Thus, that hurdle which users have to jump across is very low.

It was a good mental exercise thinking about the advantages of Carousell as a business model since I managed to revisit why companies such as eBay which reduces search costs have such powerful engines and moats behind them .

Mohnish Pabrai and Guy Spier Talk Investing

I came across this short but interesting video of a conversation between Mohnish Prabai and Guy Spier. They spoke about a number of topics but I am going to touch on their point about uncovering hidden moats. The general idea is to take a proven concept or idea and supplanting that in another context such as another geographical location.

An example which was discussed was the for-profit education industry. It is an amazingly profitable industry in the US but due to regulatory issues, the industry has undergone plenty of pain in the last 1-2 years. Guy Spier argues that for-profit education overseas could represent a great opportunity and the industry dynamics may be much more favourable than the US. Thus, taking the basic premise that for-profit education is extremely profitable in the US and supplanting that idea in a different country throw up some very interesting opportunities.

Mohnish Prabai also noted that Indian listed subsidiaries of consumer companies such as Unilever, have done very well, far outpacing the growth of their parents stock prices. The reason for this is, besides India being an emerging market, it specifically has a growing proportion of people slowly switching to branded products such as soaps, away from non-branded ones.  That makes a lot of sense since developed countries would have similar grown through the same phase of gradually purchasing branded consumer products as their standards of living improved. Naturally, the stock prices of India listed consumer products did well.

I hope this quick post of my thoughts and summary of the video provides some interesting food for thought!

Back from long hiatus and food for thought

Its been some time since I last wrote. During the last 4 months, I embarked on a couple of new initiatives in life, made quite a few investing mistakes. lost a bundle and I am ready to move on. I shall write up on the mistakes and lessons learnt perhaps in the next couple of posts but for now, I would like to share a table of industries which I ranked based on 3 criteria:

• Industry history duration (20%)
• Risk of technological obsolescence in 20 years (40%)
• Level of competition (40%)

The rankings are subjective according to what I understand about each industry and criteria. I assign a number between 1 5 for each of the 3 criteria and then multiply the respective percentage weightage to each of them to get an expected value. The following results mirrors what I intuitively feel about each industry but going through this quantitative exercise gives me a better perspective of the distinct strength of an industry. I have only included the 35 top ranked industries below.

I felt the need to go through the exercise for a couple of reasons. It provides a mental picture of which industries are your best bets for long term compounding. First, not all industries are created equal. The nature of some industries such airlines require capex that eats up the bulk of the operating cash generated. Some industries spit out truckloads of cash due to consumer habits and require little more than marketing expenses. They include the alcoholic beverages and tobacco industries. And many of them have shown a great track record of doing so for decades. So that takes care of the odds of industry profitability going forward.

Secondly, for long term compounders, one of the major disasters that can befall on them are technological innovations that leaves them in the dust. So weeding out risks of technological threats to certain industries essentially puts your portfolio on autopilot without much of worries for some time to come. Remember how Polaroid and Kodak. once the most admired and profitable companies globally are now a silver of what they used to be due to the advent of digital photography? I cant see how the competitive landscape of confectionery products of companies such as Wrigleys chewing gum and Mars chocolates are going to undergo drastic changes from technological innovation that will change the way we consume them in the next 20 years and beyond for that matter.

Finally, the lesser the competition in the industry, the better. That means that the bulk of a growing pie goes to the existing players. Intuitively, some examples include the effective oligopoly of rating agencies, Moodys, S&P and Fitch. The fast food industry consisting of dominant players such as MacDonalds, Yum Brands (KFC, Pizza Hut, Taco Bell), Burger King and Wendys also come to mind.

I hope this is some good food for thought and there are certainly industries left out by the list that should rank high on the best or most profitable industries going forward. Thus, do share your thoughts on industries that you think should be on the list or individual companies by commenting below !

What happens when you dont buy quality

A friend pointed out an interesting lecture by Sanjay Bakshi at the Fundoo Professor called What Happens When You Dont Buy Quality And What Happens When You Do? The article made me think pretty hard about how I have been investing, how I feel about my positions (past and present) and the results that came along with it.

The crux of Bakshis argument is that it pays to buy a stock at a P/E of 20+ IF the company has a wide, unassailable moat that is not likely to come down under most circumstances during a long timeframe. With empirical data, he shows that returns have been shown to be extremely robust over extended periods of time for the high P/E stocks which most classical value investors would not think near of going. The magic of this seem to lie in CFROIs and compounding.

Thinking back on the successful investments I have made in the past, a higher rate of success seem to almost always be from companies that have a great moat and a reasonable P/E in times of turmoil either in the market or in the individual security. I have had much fewer successes with low P/B stocks in which I tried to await the market to bridge the gap between the lowly priced hard assets and what I perceived as correct higher marker value. Lower success rates were also experienced with low P/E stocks with no strong moats. And in the meantime while I await for the market to close the valuation gap, I do not get paid as much in terms of an increase in intrinsic worth of the company, compared to companies with a wide moat (moat companies earn more as each day passes and likely strengthens its existing moat). On the contrary, ones margin of safety may even be eroded as time passes on especially through cash burn and from encroaching competition which it lacks a moat to defend itself against.

Thus, Bakshis argument makes perfect sense and is probably much easier to adopt and is especially helpful psychologically when the going gets tough during uncertain market conditions. Of course, the underlying pre-requisite is to not over pay, in other words, at least pay a fair price, and to ensure the existence of the wide moat is real and sustainable .

Special situation: Bridgepoint Education tender offer

About a month ago, I started purchasing a couple of US-listed for-profit education stocks. The industry has been going through quite a bit of pain amid regulatory and litigation issues. Bridgepoint Education was among one of the stocks I bought. One fine day, I received a letter from my broker stating that Bridgepoint Education has launched a tender offer for about 18.8% of shares outstanding as a form of buyback.

I read through the tender offer document and realised, to my surprise that it was almost too good to be true. Therein lay an opportunity to make a pretty low risk annualised return of more than 100%. The only catch was that the quantum to be made was a little under USD 200.

seekingalpha.com/instablog/747089-alpha-hungry/2409512-bridgepoint-education-bpi-just-dropped-100-on-the-ground-heres-how-to-pick-it-up

Unfortunately, this offer has expired on 11 Dec 2013 but nevertheless, makes a good lesson learnt case study for future such opportunities. I managed to tender 44 shares instead of an intended 99 due to my own procrastination and lack of urgency but oh well, lifes like that some times. I am currently awaiting the final word on the verification by Bridgepoint Education.

Return On Capital

Most investors are familiar with return on capital (ROC) metrics. The straight forward sentiment is that the higher the Return on Capital, Equity, Asset, Invested Capital is, the higher the quality of the company is. A high return on capital naturally means that an investor should be willing to pay more of a premium to own the company. In this post, I shall refer ROC as a general term of the returns metrics.

However, there is a blind spot which some investors may not be acutely aware of. A high ROC tells an investor only how much a company can earn from its existing pool of capital. It does not guarantee that a company can earn that same high ROC given additional capital to expand. Granted, the likelihood of it being able to obtain at least a reasonable ROC on new capital is high. A high ROC on incremental capital naturally translate to higher profits and higher stock prices.

For a company with high ROC to work its magic, there must be areas where a company can deploy incremental capital. To illustrate with an example, consider that Coca-Cola earns almost 20% of ROIC which is pretty high when compared across almost any industries. If Coca-Cola is able to continue expanding through the building of new syrup plants, expanding distribution networks and increase marketing efforts like how it did decades ago, Coca-Cola would continue to grow at a pretty astonishing rate. This is further compounded by Coca-Colas strong economic moat, almost guaranteeing its pace of growing like a weed.

However, the reality is that it is hard for Coca-Cola to expand at a rate similar to how it did back in its heydays in the 1970s and 1980s, considering that right now, if you drive into a remote desert, you are even likely to find a store that sells Coke. There just arent that many other places where Coca-Cola hasnt latched its tentacles onto. So unless Coca-Cola finds a way to deploy new capital by setting up stores in Mars where Martians somehow acquire a taste for Coke and is able to pay for them in money acceptable to Atlanta, Coca-Colas growth is almost certain to slow down in the future. But of course, the next easiest way to deploy new capital would be to acquire companies and generate new brands like what Coca-Cola is doing with Dasani, Minute Maid, Vitamin Water, etc so while it is not impossible for Coca-Cola to grow, it is probably going to be much slower than their rocket fuelled past.

Thus, my points simply are:

• It is important to examine whether there are future growth areas where capital can be deployed or if the channels are all saturated
• Whether a company’s existing ROC can be deployed onto new capital at a similar rate or will the ROC on new capital be lower than the existing capital

My personal investing experience in Dolby, the company that licenses most of the sound technology in theatres, highlighted the ROC issue. It is a great company with a wide moat, high profit margins, pristine balance sheet, high ROCs and slow but growing profits and revenue. And it was pretty cheap to boot for such a high quality company. However, the stock hasn’t exactly flown off the charts and I highly suspect the reason is that there aren’t many areas where Dolby could deploy their capital where compounding could work its magic. Dolby already has a vast majority of market share in its technology in theatres globally and I imagine that it would be hard to sell incremental improvements in sound technology to existing customers. Thus, the missing ingredient of making Dolby a perfect investment would be additional areas of growth.