Coimbatore Talk

What Do Conservative Value Investors Look For In

Risk Seeking Entrepreneurs?

Ladies and Gentlemen,

Happy Republic Day to all of you!

I am pleased and honoured to be invited to address you today on this wonderful day
which also happens to be the 1st Foundation Day of Firebird Institute of Research and
Management. I am grateful to Dr. Sundararaman, Prof. Ganesan and Mr. Vyas for extending
this invitation to me.

The topic I have chosen is an interesting one: What Do Conservative Value Investors
Look For In Risk Seeking Entrepreneurs?

Why did I chose this topic?

Well, I was informed that many of the participants here are entrepreneurs and Dr.
Sundararaman, who is also an entrepreneur, asked me to talk to you about what conservative
investors like me look for in people like you.

To be sure, there are huge differences between me and you which might make one
wonder if we belong to the same planet. I will talk about the differences shortly. But,
regardless of those differences, I want to tell you that while I was preparing for this talk, I was
reminded of the famous scene in the move Jerry Maguire in which Jerry, (played by Tom
Cruise) says to Dorothy (played by Rene Zellweger):

You Complete Me.

Clearly, we complete each other. You give us opportunities to participate in your dreams
with our capital, and our capital might enable you to make those dreams come true.

I have been a value investor now for more than 22 years and as the years have gone by, I
have become increasingly appreciative of the importance of partnering with the right kind of
entrepreneurs.

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The famous economist John Maynard Keynes, who was also a very successful investor,
ultimately came to the same conclusion when he wrote:

As time goes on, I get more and more convinced that the right method in investment is to put fairly
large sums into enterprises which one thinks one knows something about and in the management of
which one thoroughly believes.

In the end, for people like me, investing, is pretty much like something that was depicted
beautifully in a famous scene in the movie Sholay.

Harvard Universitys Professor Richard Zeckhauser described it like this:

The investor rides along in a sidecar pulled by a powerful motorcycle. The more the investor is
distinctively positioned to have confidence in the drivers integrity and his motorcycles capabilities, the
more attractive the investment.

We have, amongst us, respected entrepreneur Mr. P.V. Chandran, who is promoter and
CEO of Ambika Cotton. For me, he is the driver of that motor cycle and I am the guy sitting
next to him, in the sidecar.

Its been quite an enjoyable ride. Thank you Mr. Chandran.

A disclaimer: I and my firms clients are investors in Ambika Cotton.

However, this is not a stock recommendation.

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Now, let me talk a bit about the qualitative factors people like me look for in people like
you and make some recommendation to you from the vantage point of a value investor.

Attitude Towards Risk Taking

Entrepreneurs are, by definition, risk takers. Value investors, by definition, are risk averse.

Part of the reason is that we have different world views is that we have different role
models. You have role models like Dilip Sanghvi, Narayana Murthy, Azim Premji, and Kiran
Mazumdar-Shaw who took risks, and successfully built admirable businesses.

Value investors, on the other hand, have role models like Warren Buffett, Charlie Munger
and Benjamin Graham who built admirable track records in value investing and taught us
about margin of safety and the two rules of investing.

Rule # 1: Dont lose money.

Rule # 2: Dont forget Rule # 1

As a professor at Management Development Institute, I teach my students, many of who

will become value investors, about the dangers of over-confidence e.g. by showing them what
generally happens to businesses which use excessive leverage or become serial acquirers or
diversified conglomerates. Generally speaking, the outcomes in these situations are quite bad.

But, at the same time, I teach my students, in the hope that they will become
entrepreneurs, the benefits of over-confidence.

If people were not over-confident, no one will start a new business. I mean if
entrepreneurs were like value investors and looked carefully at odds of success before starting
a new venture, they would never start one. Clearly, civilization is better off having over-
optimistic entrepreneurs.

The behavioral economist and Nobel laureate Danny Kahneman agrees. In his book,
Thinking Fast and Slow, he writes:

Optimistic individuals play a disproportionate role in shaping our lives. Their decisions make a
difference; they are the inventors, the entrepreneurs, the political and military leadersnot average
people. They got to where they are by seeking challenges and taking risks.

[Entrepreneurs often] make decisions based on delusional optimism rather than on a rational weighting
of gains, losses, and probabilities. They overestimate benefits and underestimate costs. They spin
scenarios of success while overlooking the potential for mistakes and miscalculations. As a result, they
pursue initiatives that are unlikely to come in on budget or on time or to deliver the expected returns
or even to be completed.

As value investor, I can tell you this: we want you to be a bit over-optimistic and over-confident,
but we do not want you to be delusional. I agree with Kahneman when he writes that

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the blessings of optimism are offered only to individuals who are only mildly biased and who are able to
accentuate the positive without losing track of reality.

We value investors very much appreciate the wise advice once given by Charlie Munger
that one should

Never underestimate an man who overestimates himself

but we do not want you to give in to psychological denial which is a very common
cause for people going broke. Thats because they simply refuse to accept the possibility that
their business ventures could fail and so they keep throwing good money after bad and they
keep doing till the point when theres no money left anymore.

The other advice I have for you is that once you have taken enormous risks and those risks
have paid off and made you rich and successful, you should change gears and become a bit
more like conservative value investors because crazy risk taking usually tends to ultimately end
up in a blowup.

And so, once you have become successful, avoid the two most common causes of blowups:
excessive financial leverage and excessive position sizing.

As this picture shows, in a leveraged capital structure, you are at the end of the queue and
when times are bad, theres nothing left to eat.

No doubt, financial leverage can get you higher returns on equity. But it also increases the
probability of your going back to zero, should disaster strike. And disaster strikes are common
in the world of business and when that happens only those with staying power and capacity to
suffer tend to survive. And so, if you are in this for the long haul build something thats
disaster-resistant and one way to do that is to avoid excessive financial leverage.

The other point I made was about position sizing something that we value investors
fret about a lot.

Do not bet so much on one project that the consequences of its failure could take you back to
zero. Focus not just on probabilities, but also on consequences. And when consequences are bad

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and unacceptable, no matter how low the probabilities, dont do those things.

Focus vs Distraction

Value investors love focused entrepreneurs who resemble this tiger with an intense focus.

Here, I want to say a couple of things about diversification.

First, the averaged out experience of diversified businesses in the stock markets is not
good. Focused businesses which tend to specialize in a niche tend to enjoy much higher
valuations than diversified ones. This means that most diversified conglomerates tend to sell at
valuation which are far less than their break up values.

Second, investors can achieve the benefits of diversification within their own portfolios by
buying stocks of focused companies in different industries. So why would they want to buy
shares in a diversified conglomerate unless it was so efficiently run that it provided some
advantages that investors could not replicate themselves or if they could buy a lot of it at a
discount and then break it up?

So, my advice is that focus on building a niche for yourself which allows you to not only
earn high returns on capital because of the efficiencies derived from intensified focus, you will
also get significant reputational advantages in your industry as being a reliable, trustworthy
supplier of very high quality products or services to your customers which will hugely reduce
their incentives to shop around for a different vendor.

In my firm, we love to invest in focussed, niche businesses and have done quite well
because of that preference. However, there is also a lot of value in a certain kind of
distraction which can lead to accidental discoveries. We call that serendipity or accidental
discovery.

My friend and fellow value investor Anant Jain, who introduced me to Dr. Sundararaman
likes to cite a story about him and his companys successful product called Quick Dry which
was the result of accidental discovery through tinkering.

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We value investors love this kind of tinkerers. We know much of discoveries in science
took place thanks to accidental discoveries like Quick Dry as once explained by Arlene
Goldbard, a Blogger:

Penicillin was just some mold inhibiting the growth of another lab culture; lasers at first had no
application but were thought to be useful as a form of radar; the Internet was conceived as a military
network; and despite massive National Cancer Institute-funded cancer research, the most potent
treatmentchemotherapywas discovered as a side-effect of mustard gas in warfare (people who were
exposed to it had very low white blood cell counts). Look at todays biggest medical moneymakers:
Viagra was devised to treat heart disease and high blood pressure.

Now, let me go back to the earlier point I made about position sizing. The Quick Dry
project was a small project for Shiva Texyarn. It was an experiment which succeeded. But the
consequences of failure were not going to destroy the company.

We value investors love to find such combinations entrepreneurs who have an intense
focus on their business, but also at the same time are open to experimentation in their own
fields. These experiments are small, but have large payoffs on success with low costs of failure.
Its a wonderful combination.

A disclaimer: I or my firms clients are not investors in Shiva Texyarn and

this is not a stock recommendation. I used this example just to illustrate my
point about innovation with proper risk management as a very attractive
combination.

So my advice here is to remain focussed, but at the same time, be willing to experiment, to
tinker around and come up with unique ideas within your industry. Some of these ideas could
change the world, and make you (and us value investors) a lot of money. But at the same time,
do not ignore the importance of risk management. Dont bet your house on one idea not
when you are already rich and successful.

Capital Discipline

Capital does not come free. It has a cost. Markets reward businesses which are efficient
capital allocators and punish the inefficient ones. They do this, primarily by assigning a higher
multiple to the earnings of the efficient allocators.

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Look at it this way. The businesses create the earnings and markets assign the multiple.
And by and large businesses which earn high returns on capital, enjoy high multiples.

The authors of a wonderful book called The Value Imperative quote the mission
statement of a company:

The objective of our company is to increase the intrinsic value of our equity shares. We are not in
business to grow bigger for the sake of size, nor to become more diversified, not to make the most or
the best of anything, nor to provide jobs, have the most modern plants, the happiest customers, lead in
new product development, or achieve any other status which has no relation to the economic use of
capital. Any or all of these may be, from time to time, a means to our objective, but means and ends
must never be confused. We are in the business solely to improve the inherent value of the equity
shareholders' equity in the company.

This is important stuff. If you want a high p/e multiple on your stock, then you cannot
ignore capital discipline. You may have a smaller company with lots of capital discipline with a
market value several times that of a larger one with poor capital discipline. At the end of the
day, you to ask what would you rather own: a Rs 1,000 cr. revenue company valued at Rs 500
cr., or a Rs 400 cr. revenue company valued at Rs 2,000 cr.?

So, I urge you to learn the best ideas about capital discipline by studying the best capital
allocators out there which usually happen to be those companies which enjoy the highest
p/e multiples over a prolonged period of time.

This is a vast subject and we dont have time to get too much into the details but I urge
you to not ignore it.

Marshmallows

Heres an experiment with wonderful lessons for life. Danny Kahneman says on Walter
Mischels books cover: Your view of human nature will change profoundly as you read this
brilliant book.

Now, lets watch two video clips about this experiment.

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Link

Link

Do grownups behave like children? It turns out that they do. And one way to describe this
is with the help of this equation.

This, of course, is the compound interest formula and all of you know it very well. You
know that you compound capital at 13% year vs. 15% a year, over the long term the terminal
values that come out will be vastly different. Delayed gratification works.

However, in my view, many entrepreneurs do not sometimes understand the power of

delayed gratification inside a business. This happens because they do not fully appreciate the
inherent tradeoffs in that equation between those two variables which are circled in red.

Think of it this way. R is the returns you can generate and n is the period over which you
can generate those returns.

We investors want you you to generate a high R but we do not want you to compromise
on the n which is the period over which you can deliver those returns. n refers to longevity of
the business. We want to invest in business that last a long long time and which can also earn
a handsome returns on capital. In fact, we would much rather own a business which has a
lower but still good R but a very high n. Thats because if we do the math, well end up with

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way more money in the end that way.

And there are all kinds of tradeoffs between R and n. For example, extraordinarily high
profitability as represented by R is likely to attract competition which could reduce n. Why
not earn a reasonable return and reduce the incentives of potential competitors to attack your
castle? Why not make customers happier by lowering prices which will make it unnecessary
for them to look somewhere else? So, by earning a reasonable R, you not only deter
competition, you also get customer loyalty. And that increases n.

Over the years I have seen businesses implode or lose a lot of reputation and market value
because they got too greedy. They wanted more R and didnt realise they were lowering n.

One is reminded of the case of Valeant, a pharma company that jacked up the prices of
its drugs some of the prices were raised by 23 times causing huge backlash from society
and regulators. The current market value of Valeant is now less than 5% of its value in July
2015. Were those extra profits worth it?

One is reminded of a textile company that recently lost a very large customer and half its
market cap because the customer found it was mixing cotton and claiming something else.
Were those extra short-term returns worth it?

One is reminded of the predatory lending and recovery practices of certain micro finance
companies in Andhra Pradesh resulting in suicides by illiterate and gullible borrowers who
found themselves in debt traps. Those finance companies maximised their R but
compromised on their n. Ultimately the government stepped in and brought in regulatory
changes which led to 80% decline in the market caps of those companies. Were those
predatory practices worth it?

One is reminded of those textile companies in Tirupur who listened to their bankers and
got involved in derivative contracts they didnt understand but got tempted by some extra
returns without thinking about the increased risk involving the longevity of their businesses.
Many of those companies blew up. Was it worth it?

No, it wasnt. It never is.

So my advice to you is not to cut corners, and build something that will last. That will be
good for you, good for people like me, and good for civilization.

Thank you.

Sanjay Bakshi
Coimbatore
January 26, 2017