Topic: Value Investing Pioneers Summit, Delhi. Session on “Not everything that counts can be counted” by Prof. Sanjay Bakshi

Contributed by: Ankur Kapur, CFA

The Delhi chapter of CFA Society-India had the privilege of hosting some of the most famous pioneers of Value investing in India during its inaugural Value Investing Summit on 21st Sep 2017. The bad weather at Mumbai and all the hassles at the airport that our prominent speakers had to endure couldn’t dampen the zeal even one bit and the event was a huge success.

Prof. Sanjay Bakshi started the much-awaited conference. He shared his thoughts on the topic – “Not everything that counts can be counted”. There are many situations in which applying a financial model may not help in any decision-making. For example, in 2012, Ajay Piramal sold the stake and had a huge pile of cash but no business plan. The company was trading at a value of less than cash, an attractive buy but no financial model could have indicated whether it is a good investment or not since the promoter did not have any business plan. However, given that in the past promoter was able to create immense value for the shareholders was the only basis to assume that promoter will be able to create value going forward as well.

In a presentation to CFA Society India members, Prof. Bakshi in 2012 talked about “understanding the universe of the unknown and the unknowable”. Prof. provided two pointers to assess risk 1) uncertainty is not risk 2) Exposure to uncertainty on favorable terms is desirable. If you are not certain of the risk of investment, it is a speculation at best. Equity markets are volatile and that provides the value investor opportunity to invest. However, these opportunities have to be availed at attractive or favorable terms. Investing in Piramal Enterprises in 2012 provided an opportunity to invest at favorable terms but typical discounting of cash flow approach would not have provided an answer. The way to achieve is to go beyond number and understand the underlying – culture of the company and strength of management.

Prof. Bakshi highlighted the relationship of investor and management through a picture from a hit Hindi movie, Sholay.

Dharmendra is the management and Amitabh is the investor. An investor has to ride along with the management; therefore, the strength and professional ethos of management have a significant role to play in order to make this relationship work and especially create value.

Albert Einstein “not everything that counts can be counted, and not everything that can be counted, counts”. Piramal Enterprises risk was not measurable but years after 2012 Piramal has created immense value for its shareholders.

Prof. Bakshi quoted Charlie Munger “It’s my view that economies could avoid a lot of trouble that comes from physics envy”. It is particularly for those investors who focus on precise numbers and make investment decisions. Munger provided a solution “I want economics to pick up the basic ethos of hard science..but not the craving for an attainable precision that comes from physics envy”. Financial analysis is an important aspect of investing but it is not the only thing to be looked at, there are other factors that are qualitative and often become more important aspects of investing.

A lot of investors and analysts use various definitions of measuring risk. One of the most popular ways of assessing risk is using CAPM i.e.

r_a= r_f+β_a (r_m+r_f)

Where r_f=risk free rate
β_a=beta of the compnay
r_m=expected market return

It is one of the most popular ways of assessing risk and provides a precise value, but often it is entirely wrong.

Buffet’s risk framework to assess risk:

1. The certainty with which the long-term economic characteristics of the business can be evaluated.
2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flow.
3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.
4. The purchase price of the business.
5. The level of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing power return is reduced from his gross return.

Buffet “IT IS BETTER TO BE APPROXIMATELY RIGHT THAN PRECISELY WRONG”

Even the smartest people commit the most stupid mistakes. For example, LTCM founded by Nobel laureates committed the most fundamental mistake of not understanding the risk that eventually led to the winding up of LTCM.

Six factors critical but hard to quantify:

#1 Owner earnings
Buffet “Owner earnings represent A) reported earnings plus B) depreciation, depletion, amortization, and certain other non-cash charges less C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in C)”

If C) is less than B) the company will be able to grow without investing in growth. However when C) is more than B), the company will need an additional amount of investment to achieve growth. Sustainable growth at a reasonable price may be achieved in the case where A) + B) > C).

Three reasons for the divergence between reported and owner earnings.

• Capex charged to revenue or vice verse.
• Depreciation and obsolesce.
• Changes in working capital.

#2 Unquantifiable people factor

Prof. mentioned about the most fundamental equation in finance.

A= P (1+R/100) ^n

The benefit of compounding is achieved only in the long-term. Focus on quarterly results and daily price movement does not add value. Business leaders must focus on the long-term and take strategic business decisions considering the long-term company goals.

#3 Ability to shut down system 2
A company focused on delighting customers, eliminating unnecessary costs and improving products and services, creates value.

#4 The value of reciprocity
If a company takes care of the stakeholders including suppliers, customers, and employees creates loyalty across the broad ecosystem of the company that is hard to calculate but has a great value.

#5 Reputational advantage
If the buyer has an advantage for the kind of value they bring to the table, the seller often prefers them and ready to sell at a price attractive to the buyer.

#6 Optionality
Operating within one’s circle of competence, avoiding auction type situation, avoiding leverage and a solid exclusive deal pipelines are ways to create value through optionality.

-AK