The Jockey or the Horse? Wisdom from a Gentleman
(Oct 1, 2015)
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In this issue:
» Another airline bites the dust
» Should you be worried about the 'October Effect'?
» ...and more!
'Is this a business that can be run by any Tom, Dick, and Harry and still do well?' an elderly gentleman who resides in the same society as I do said to me one day while explaining his stock picking criteria. 'A positive answer to this question is an absolute must,' he added as we walked towards the main gate. 'If I have the slightest of doubt, I don't bother doing any further research. I simply move on to some other stock.'
This sounded like it was coming straight from the mouth of Peter Lynch, who once said that one should "Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it."
The gentleman surprised me:
No, I haven't read a lot of Peter Lynch and am not aware of any such quote from him. I have formed this opinion about businesses after having some painful experiences myself.
'Did it improve?' I asked him. The reply came in the negative, but something very important came along he opined. He happened to read an interview of one of his favourite CEOs who was concerned about a price war in his industry. The CEO was complaining how when industry competitors start acting foolish, the sensible guys also have to suffer. The CEO was worried about the rapid build up of capacity that was causing product prices to fall. And if the economic situation was to go downhill from there, his company could come under serious pressure.
About a few years back, my view about businesses and management was exactly the opposite. I used to think that a business is as good as the management team that runs it. These were the people with the Midas touch according to me. And therefore I used to invest in companies with the quality and the skill of the management as my topmost criterion.
After following this approach for a few years, I realised my track record was below average at best. While there were few winners, majority of the picks were either flat or had come down substantially in price. Still, I wasn't ready to junk my belief about management just yet. I thought my results were an aberration and the performance would eventually improve.
'The interview was sort of an epiphany for me,' the gentleman said.
It opened my eyes to a whole new set of thinking. I was beginning to realise that if the company is present in a weak industry, there isn't much even the smartest of managements can do. Take airlines for example. The industry is a nightmare for anyone looking to make sustainable profits. I am quite sure if Jack Welch is to be made the CEO of an airline company, Jack Welsh's reputation will take a beating and not that of the airline industry.
'But isn't investing also about valuations,' I tried to probe him.
I don't know why, but there are certain industries where as long as the management doesn't do anything very stupid, even a mediocre firm can earn good returns on capital and give good returns to shareholders. And there are industries where even the best run companies struggle to make consistent profits over the long term. Until a few years back, I wasn't paying attention to this rule. But now I only invest in companies where I am sure it is from an industry with favourable long-term economics. If I were to use an analogy, earlier I used to be more about the jockey than the horse. But now, it's mostly quality of the horse for me.
It certainly is. If a company in a bad industry is trading at attractive valuations with respect to the ones in a good industry, it makes all the sense in the world to buy the former. However, as an investor, I do not prefer benefiting from an improvement in valuations. I want to see the underlying business keep doing well and earn above average returns year after year.
'Well, it is hard to argue with logic of that kind,' I muttered under my breath as we exchanged goodbyes and parted ways.
Tell me one thing, leaving the question of valuations aside, wouldn't you want to invest in a firm that earns the highest returns on capital and then pays out the excess money as dividends?
What do you think? Are you more about the jockey or the horse? Let us know your comments or share your views in the Equitymaster Club.
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And if you still have doubts about the preeminence of owning a business in an industry with favorable economics, here's a live case study that's playing out these days. It was just a while back that the world watched the Tata Group and Singapore Airlines come together with much ambition and fan-fare to start a new airline called Vistara. Sheer management pedigree and business experience couldn't get much better than that could it?
In January this year, Vistara took its first flight. Unfortunately, its experience since then is likely to have left a bitter taste in the mouth of its owners. For all its planning, focus on service, gourmet meals, shining new planes etc, nothing was able to save it from the harsh reality of the airline industry. Since its start in January this year, Vistara has seen its planes fly almost 40% empty. As per reports in business dailies, the airline is now considering reconfiguring its aircrafts, and its plans.
While its financials are still not public, the airline industry in general is quite infamous for its rapid cash burn. So we wouldn't be surprised to hear that the airline has already lost a lot of money. Perhaps yet another lesson for investors in the importance of choosing to invest in industries with favourable long-term economics.
By the way, after the Monetary Policy decision this week, we wrote to you about how sharp rate cuts could turn India from a country of savers to a country of borrowers. Incidentally, Vivek Kaul has been able to explain the pro-borrower nature of the rate cuts and its crony capitalism bent...amazingly well... with a case study in today's Daily Reckoning.
Many in the stock market are calling it the 'October Effect'. The logic seems too simplistic to be true. Yet many not only believe it, but also fear it. So just what is this October Effect? As an Economic Times report observes, historically stock markets around the world seem to have their biggest crashes during the month of October. And as today's chart of the day shows, even the BSE Sensex seems to have seen some big falls during October. Today being the 1st of October, this begs the question: Should you be getting worried about your equity investments for the coming month?
The more nervous amongst investors out there are quick to point out to a host of negatives that could intensify the effect. FIIs may pull out more money as the US Federal Reserve has hinted about interest rates being hiked by year end. September quarter corporate earnings may be a dampener. China may throw up some more surprises.. and so on and so forth.
What do we think? We're of the opinion that this is nothing but a classic case of investor's being fooled by randomness. We as humans have for eons had a strong tendency to look for patterns. But our fervour for uncovering patterns often leads us to see these where none might actually exists. Some larger falls may have indeed taken place in the month of October, but this may be nothing more than a coincidence. It's hardly an occasion for much to be made out of.
Should investors be worrying about the 'October Effect'?
The Indian stock markets were trading strong today on the back of sustained buying activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading up by around 70 points. Gains were largely seen in pharma and power stocks.
"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."- Warren Buffett
|| Today's investing mantra
PS: Do you feel that there is too much doom and gloom in the news every day? People's negativity keeps increasing and they are prompt to criticise others' actions. Do you worry about what the world is coming to?
We wouldn't, if we were you. Seven years ago, Daan Utsav, India's very own festival of giving was born. It's a chance for citizens like you and me to perform small acts of kindness to make the world a little better for someone. Last year, dairy farmers in Gujarat donated 4,000 litres of milk to the poor, and rickshaw drivers each gave Rs 500 to sponsor a meal for the elderly! We love the idea of Daan Utsav, and the love the spirit of giving it carries with it.
Our partner organisation HelpYourNGO (supported by Equitymaster) believes that happiness comes from giving. This year, for Daan Utsav, they provide you with an opportunity to perform a small act that can bring a smile to someone's face. Did you know that Rs 700 will buy a cancer patient's rations for a month? AND Rs 1000 will buy textbooks for a bright but needy student. Each donation opportunity has been carefully screened by HelpYourNGO to provide the donor with an assurance that the donation will reach the beneficiary.
All of us have been gifted with opportunities to make wealth. Now here's a chance to repay society for all the good we have been given!
Editor's note: There will be no issue of The 5 Minute Wrapup on 2nd and 3rd October 2015.
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|This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).
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