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Is this the costliest blunder moat investors commit?

May 21, 2015

In this issue:
» Look who has come to the rescue of PM Modi
» A round up on markets
» and more....

Our subscribers of ValuePro, a premium service that we have based on the principles of Warren Buffett, are by and large a satisfied bunch of people. If not for anything else for the fact that with both the portfolios that we have created, we have been able to beat the benchmark indices. However, we believe we could have made them happier. It's just that there have been a few slip ups in our choice of stocks.

None bigger than a stock that answers to the name of Maharashtra Seamless. Recommended in June 2010, this story certainly didn't pan out as expected. Mind you, we felt it had a lot of things going for it at the time of our recommendation. Its average return on equity was 23% over the 13 years prior to our recommendation with absolutely no debt on its books. What more, it also appeared to be using its cash flows quite judiciously. Thus, when it came to capital discipline, it had perhaps ticked all the right boxes.

Consequently, the reason the story failed to take off lay somewhere else perhaps. And what really helped us zero in on it was Warren Buffett's 1991 letter to shareholders.

You see, the hard taskmaster that Buffett is, there are only a few businesses on the face of this planet that make him go weak in the knees. And he likes to call them franchises. Now, what exactly are these franchises? Well, as per Buffett, these are those rare firms that can price their products or services aggressively. In other words, increase prices steadily year after year without worrying about market share whatsoever.

Buffett believes that this is only possible if the company's products or services are needed or desired, are thought to have no close substitutes and are not subject to any price regulation. Firms not meeting any of these criteria will have difficulty pricing its products aggressively. And therefore, they do not qualify to be franchises as per Buffett. In fact, he likes to call them just businesses.

As we came across this explanation by Buffett, it gave us a perspective that hit us like a ton of bricks! You see, so far, we had decided to term our mistake with respect to Maharashtra Seamless as an error of judgement. But Buffett's inputs on the topic literally made us see the light. What we had essentially done is we had assumed Maharashtra Seamless to be an economic franchise. However, in reality, it appears to be just a business in the sense that Buffett described it.

And why was this distinction important? Well, for the simple reason that if it indeed was a business the way Buffett calls it, then it also had to be valued that way. It can't be given a franchise like valuation which is the mistake that we committed.

Mind you, we are not terming the business as bad. However, we believe that given the nature of the industry that the company is in, it is a few notches below in terms of qualitative parameters than Buffett's idea of a franchise. And therefore, it has to be valued accordingly. Please note that investor can still end up making money on the stock provided he buys it a significant discount to its intrinsic value. However, this intrinsic value in turn has to be based on its earnings power as a business and not as a franchise.

Sadly, it is only after losing our subscribers 40% of their capital invested in the stock that this reality has dawned upon us. Nevertheless, there's a very important lesson that we have learnt here. And it is the fact that investing in franchise can be very lucrative. Buffett's track record is of course proof of the same.

However, one will have to work very hard to ascertain that the franchise is indeed a franchise and not just another business. For if there's even the slightest of doubt, you are better off valuing it like a business and then buying it at a margin of safety to its so called business value. Better still, you can simply ignore and move on to a stock whose business model you think can analyse with lot more confidence.

Do you think misreading the moat is the biggest mistake moat investors make? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day - Publisher's Note
Please note that as publisher, we respect the intellectual property rights of a third party and ensure that appropriate credit is given to the source of information/content. In this edition of The 5 Minute WrapUp however, there was this inadvertent error on our part in not mentioning the primary source, Ambit Capital and only referring the secondary source, Financial Express. We are thus removing the chart from the website in order to respect the intellectual property right of the original publisher.

The Sensex is up by 15% odd since the Modi government assumed power in last May. With stock markets being barometer of the economy in general, it is the tendency of people to link the government performance with market performance. In that sense many would say performance of the government has been good.

However, the Modi sarkar has drawn quite a bit of criticism as well in the last one year. Some say it's anti-farmer and pro-corporate. The opposition has labelled it suit boot wali sarkar. Some corporates have also been vocal in saying that the pace of reforms is snail paced and delivery is slow.

However, amidst all this criticism, one person has come to the defence of PM Modi and he is none other than our RBI governor, Dr Rajan. He was recently quoted saying that expectations from the government were quite unrealistic in the first place when PM Modi assumed power. And judging the performance of government so soon is premature. Yet, as per him the government has taken some concrete steps to resurrect the economy in such a short time frame.

We cannot agree with Dr Rajan more. For one, it may not be possible to meet expectations from all quarters at one go. Secondly, when expectation bar itself is so high even a slight delay results in disappointment.

Also, one must realize that resurrecting a 2 trillion dollar economy is not an easy job and PM Modi is not a student of Hogwarts School of Wizardry. Thus, he should be given more time to deliver. The real test of this government will be in 2019 when people shall compare delivery with promises. If execution happens then public expectations will be met we reckon.

The Indian stock markets were trading in the red at the time of writing. While the BSE Sensex was down by 27 points, NSE Nifty was down by 8 points. The Asian stock markets were trading mixed at the time of writing. European stock markets also opened mixed today.

 Today's investing mantra
"When you combine ignorance and leverage, you get some pretty interesting results". - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

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