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PJ Pahygiannis
PJ Pahygiannis
Articles (149) 

19 Questions With Gautam Baid, Portfolio Manager, Global Equities

'Having a long-term mindset is a huge structural advantage'

March 27, 2017 | About:

1. What is the best investment advice you have ever been given?

It was undoubtedly the one shared by Benjamin Franklin – "An investment in knowledge pays the best interest." In today’s age of ever increasing automation, one needs to be a learning machine to remain forever relevant in the workforce as well as in one’s business. As so beautifully articulated by Charlie Munger (Trades, Portfolio), “Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

2. What level of math is needed in order to understand the entirety of finance and investing?

I would like to quote one of my favorite investors Peter Lynch on this who has said: “Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.” Addition, subtraction, multiplication and division is all the math skill you need. Investors should ignore formulas with Greek letters in them. Strive to keep the entire analysis process as simple as possible. If you need to open an Excel to evaluate a potential investment opportunity, watch out!

3. Is "value investing" (Warren Buffett (Trades, Portfolio) and Benjamin Graham approach) a good investment strategy for long-term goals like investing for retirement?

Buffett has provided the best answer to this question in his 2011 annual letter:

"Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire (NYSE:BRK.A)(BRKB) we take a more demanding approach, defining investing as the transfer to others of purchasing power nowwith the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

Regular monthly investments in high quality businesses at fair prices for long periods of time is possibly the most effective way to build up a sizable retirement corpus and strong purchasing power during one’s retirement years. Because you are buying more stocks when they go down and less when they go up, this technique helps you to make rational buying with the potential for better risk-adjusted returns over time. In finance parlance, this is called “dollar cost averaging,” and it works – as long as you’re not buying into bubble-level valuations like in 2000.

For people with full-time jobs, building wealth has a very simple formula: “Spend less than you earn, and invest in a group of high quality businesses (or a broad index fund) over long periods of time.”

4. What should I know before I start value investing?

You should clearly define your time horizon at the very onset. Value investing works best when practiced over very long periods of time to reap the full benefits of compounding, the eighth wonder of the world. Having a long-term mindset is a huge structural advantage to have as an individual investor amidst an environment where fund managers are constantly being evaluated on their monthly or quarterly performance which in turn leads to mispricing in many securities when they dump the short-term underperformers or chase the recent sharp outperformers.

Learn to distinguish between investment and speculation. A speculator looks at a stock as a piece of paper. An investor looks at a stock as part ownership of a business.

Develop knowledge of accounting as it is the language of business through which you understand how the balance sheet, income statement and cash flow statement tie together.

Understand the perils of leverage and why not to use it. To better imbibe this learning, read “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein.

Avoid “the risk of ruin” by placing all your eggs in one basket and betting the entire house on one single investment. Diversify well by industry so that the individual stocks are not highly correlated to each other.

Assess your existing skill sets in an honest manner to establish an initial circle of competence which you can gradually expand over time as you get to learn about newer businesses and industries.

Know yourself since investing is a highly personal activity and is most effective when you are able to firmly stick to a disciplined strategy across market cycles, both bull and bear.

Be extremely humble and be mentally prepared for failures from time to time. Peter Lynch had once said: “In this business, if you’re good, you’re right six times out of 10. You’re never going to be right nine times out of 10.” The frequency of correctness does not matter; it is the magnitude of correctness that matters. Michael Mauboussin calls this “The Babe Ruth Effect.”

If you aren't passionate about value investing and putting in the thousands of hours it takes to become a good investor, then this isn't the field of work for you, and that’s perfectly acceptable. If you're in this activity simply for the money, then you'll burn out very quickly. You don't have to have a very high IQ to become a good value investor. What you need is a good temperament and high levels of intellectual curiosity, patience and the willingness to work hard over a long period of time to compound knowledge and improve your rationality quotient so that you can decisively act when the obvious no-brainer opportunities keep present themselves from time to time.

5. How should one invest in a bear market?

The fundamental tenets of investing do not change in a bear market, they remain firm and consistent forever, across market cycles (that is why they are called investing “principles”). Just focus on investing at reasonable valuations in low debt cash flow generating businesses with high returns on equity and strong competitive advantages which can grow for long periods of time with minimal or no equity dilution.

6. What are examples of sustainable competitive advantages?

Strong brands with “share of mind” which confer pricing power, network effects, high switching costs, patents, favorable access to a strategic raw material resource or proprietary technology and government regulation which prevents easy entry – these can confer a strong competitive advantage which in turn enables high returns on invested capital for long periods of time (also known as the competitive advantage period or CAP). Growing firms with longer CAPs are more valuable in terms of net present value. One of the most highly underappreciated sources of a sustainable and difficult to replicate competitive advantage is “culture,” best epitomized by Berkshire Hathaway. To illustrate the critical importance of culture just consider this: Between 1957 to 1969, Buffett did not mention the word “culture” even once in his annual letters. From 1970 to 2016, he has mentioned the word 30 times! Some of my favorite books on competitive advantage are "The Little Book That Builds Wealth" by Pat Dorsey, "Understanding Michael Porter" by Joan Magretta and "Different" by Youngme Moon.

7. What are the absolute best, most crucial tips/ideas to succeed in long-term investing?

Stick to your circle of competence, only invest in businesses you can understand well and which you can visualize earning materially higher profits many years from now. Such businesses are usually less vulnerable to technological or “app” risk and will be present in stable industries with low rates of change.

Embrace inactivity and devote most of your time to reading, learning and improving your thinking. Low turnover leads to low frictional costs and these few extra percentage points saved every year lead to very large absolute savings over long periods of time because of compounding.

Create an investment checklist. All value investors should read Atul Gawande’s "The Checklist Manifesto" and "The Investment Checklist" by Michael Shearn.

Maintain an investment journal which contains your original investment thesis at the time of making the purchase as well as the rationale for making the sale. This is the most objective way to remain true to yourself and more importantly to continuously keep learning from your mistakes. The significant positive intrinsic value of one’s own mistakes (and even more importantly, the vicarious learning from others’ mistakes) is highly underrated in the investing community.

Read Benjamin Graham. Read Warren Buffett. Read Munger. Read George Goodman. Read Burton Malkiel. Read Thomas Phelps. Read Pat Dorsey. Read Joel Greenblatt (Trades, Portfolio). Read William O’Neil. Read Stephen Penman. Read Michael Shearn. Read William Thorndike. Read Robert Hagstrom. Read Peter Senge. Read Daniel Kahnemann. Read Jason Zweig. Read James Montier. Read Richard Thaler. Read Nate Silver. Read Philip Tetlock. Read Peter Bevelin. Read Michael Mauboussin. Read Nassim Nicholas Taleb. Read Robert Shiller. Read Charles Wheelan. Read Yuval Noah Harari. Read Peter Bernstein. Read Charles Mackay. Read John Galbraith.

Read, re-read and reflect on your learnings from the above teachers. Read the classics more than once and you will notice that with the passage of time, because of your accumulated personal and vicarious experience – you are able to obtain additional and newer insights. Be a learning machine.

8. What are the essentials of due diligence when investing?

Pay extra emphasis on management quality, balance sheet quality and quality of “reported” earnings (focus on free cash flows). You should partner only with ethical and prudent promoters in businesses that have very low debt (finance companies are the exception to this rule) along with favorable working capital cycle and solid free cash flows.

The company should be operating in a growing market, with a solid competitive advantage & the ability to grow using internal accruals without resorting to debt or diluting equity, is owner-operated who is minority shareholder friendly and is prudent at capital allocation.

9. What kind of stocks would you rather avoid holding because they are more risky than others?

Buffett defined “gruesome” businesses in his 2007 annual letter. Avoid any business that

  • Consumes more cash than it generates, therefore requiring constantly raising capital.
  • Has egoistic managers who boast of invincibility about their existing high market share.
  • Earns low rates of return which is lower than its cost of capital.
  • Operates in an industry with no entry barriers, leading to lower margins.
  • Operates in an unstable industry and is vulnerable to rapid technological changes.
  • Requires to constantly invest just to remain competitive (the “red queen effect”).
  • Doesn’t have an ability to increase prices because of commodity nature of its product.
  • Engages in zero-sum games with its stakeholders.

10. What are some investment lessons you learned in 2016?

Not to venture outside one’s circle of competence. One should not chase “hot” stocks swayed by exciting “stories,” “narratives” or “futuristic concept” since most of these kinds of businesses usually have unproven track records and/or lack of profitability and cash flows.

11. What discount rate do you use in your valuation?

Thinking in terms of “Opportunity Costs” is a very powerful mental model in investing. Many investors fall in love with their existing holdings (endowment effect) and do not conduct a rigorous opportunity cost analysis. Every single dollar spends the same and one should strive to achieve the biggest bang for their buck from every single dollar invested. Use a very high hurdle rate (discount rate/absolute return expectation) when assessing any potential investment opportunity. Personally, I do not invest in any security unless it can potentially deliver at least 26% CAGR over the next three years with “a very high degree of certainty/predictability.” (As per the rule of 72, you double your capital every three years by compounding at 26%, 10 times in 10 years and 100 times in 20 years!). I have difficulties assessing any business’ prospects beyond three years, so I initially think in terms of three-year periods

12. Which is more useful, earnings yield or (price-earnings) P/E ratio? Why?

Both are useful in their own way. I usually compare the market earnings yield (inverse of the P/E ratio) and compare it to existing interest rates to get a general sense of the relative attractiveness of stocks versus bonds.

Understanding the drivers of a P/E ratio is “far more” important that the absolute value of the ratio itself since it has to be looked at in the context of prevailing interest rates at the time. While determining the fair P/E ratio for a stock, most investors focus on predictability and consistency of cash flows, topline and earnings growth, capital intensity and working capital requirements of the business but end up neglecting “the duration of competitive advantage period.” This “longevity” is what leads to great wealth creation over time.

13. With just public information, how can you be confident that your valuation is correct while the market is wrong?

The average NYSE stock fluctuates by 80% annually (i.e., the 52-week high is 80% above the 52-week low for the average NYSE stock). This phenomenon is probably much more pronounced in many countries than it is in the U.S., meaning that the number of mispriced opportunities is far greater in highly volatile markets, particularly EMs. And all this happens despite the barrage of public information out there. Why do such anomalies arise so frequently? It is because the investing public is very emotional and our brains have evolved very slowly from the times of our hunter-gatherer ancestors. I do not need to get my valuation exactly right to the last decimal; all that I need to ensure is that I am buying at a large discount to what I believe the business will be worth five to 10 years from now, while initially making sure that it has robust growth prospects for the immediate next three years.

14. What are the key attributes of a great investor?

Michael Mauboussin authored a brilliant paper on this very topic in August 2016 titled “Thirty Years: Reflections on the 10 Attributes of Great Investors.” Let me outline them below along with my favorite book(s) on each topic for the benefit of all the readers.

  • Be numerate (and understand accounting) – "How to Read a Financial Report" by John Tracy, "Accounting for Value" by Stephen Penman, "Financial Shenanigans" by Howard Schilit, "Quality of Earnings" by Thornton L. O'Glove, "The End of Accounting" by Baruch Lev.
  • Understand value (the present value of free cash flow) "Creating Shareholder Value" by Alfred Rappaport, "Valuation: Measuring and Managing the Value of Companies" by Tim Koller, David Wessels and Marc Goedhart for McKinsey & Co.
  • Properly assess strategy (or how a business makes money) "Business Model Generation" by Alexander Osterwalder and Yves Pigneur.
  • Compare effectively (expectations versus fundamentals) "Expectations Investing" by Alfred Rappaport and Michael Mauboussin.
  • Think probabilistically (there are few sure things) "The Drunkard's Walk" by Leonard Mlodinow, "Innumeracy" by John Allen Paulos.
  • Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected) "Stalking the Black Swan" by Kenneth Posner, "A Few Lessons From Sherlock Holmes" by Peter Bevelin.
  • Beware of behavioral biases (minimizing constraints to good thinking) – "Thinking Fast and Slow" by Daniel Kahnemann, "The Art of Thinking Clearly" by Rolf Dobelli, "Your Money and Your Brain" by Jason Zweig, "Why Smart People Make Big Money Mistakes" by Gary Belsky and Thomas Gilovich.
  • Know the difference between information and influence – "The Crowd" by Gustave Le Bon, "The Art of Contrary Thinking" by Humphrey Neill, "Influence" by Robert Cialdini (the chapter on “Social Proof”), "Madness of Crowds" by Charles Mackay, "A Short History of Financial Euphoria" by John Galbraith.
  • Position sizing (maximizing the payoff from edge) "The Warren Buffett Portfolio" by Robert Hagstrom, "Fortune’s Formula" by William Poundstone.
  • Read (and keep an open mind).

I would add two more vital qualities to the above list – extreme levels of patience coupled with the ability to act decisively when the no-brainer opportunities present themselves.

15. What are the best books on investing?

Investing is multidisciplinary in nature as showcased in Robert Hagstrom’s book “Investing: The Last Liberal Art.” Some great books to develop knowledge and wisdom are "The Intelligent Investor" by Benjamin Graham, "The Essays of Buffett" by Laurence Cunningham, "Common Stocks and Uncommon Profits" by Phil Fisher, "Where Are The Customers’ Yachts?" by Fred Schwed, "A Random Walk Down Wall Street" by Burton Malkiel, "One Up on Wall Street" by Peter Lynch, "The Most Important Thing" by Howard Marks (Trades, Portfolio), "Reminiscences of a Stock Operator" by Edwin Lefevre, "Against The Gods" by Peter Bernstein, "More Than You Know" by Michael Mauboussin, "Influence" by Robert Cialdini, "Seeking Wisdom" by Peter Bevelin, "Your Money and Your Brain" by Jason Zweig, "Thinking Fast And Slow" by Daniel Kahnemann and "The Fifth Discipline" by Peter Senge. One also should be an avid student of financial history and crowd psychology and read the classics by Charles Mackay, Gustave Le Bon, John Galbraith and Edward Chancellor.

16. What skills are needed to succeed in distressed debt/special situations investing?

You need to be a very voracious reader to be able to uncover these special situation opportunities from time to time. Equally important, you need to possess a contrarian mindset.

17. What are the best books about special situations investing?

The most seminal book in this field in my view is “You Can Be A Stock Market Genius” by Joel Greenblatt (Trades, Portfolio). Don’t go by the ludicrous title; you can strike gold by reading this masterpiece!

18. What are the best web sites to follow for value investing-oriented investment ideas?

Morningstar, Value Line, Microcap Club and The Manual Of Ideas are some very good resources.

19. For an individual relatively unsophisticted nonprofessional investor, what are the most undervalued asset classes today, and what are the best funds or mechanisms to invest in them with a buy-and-hold mentality?

Since this advice is for nonprofessional investors, I would simply recommend them to regularly invest in low-cost index funds for the long term and avoid seeking high returns in an area they would not fully understand. The reason being that the most undervalued asset classes tend to be the ones that are neglected, out of favor, disliked, are undergoing temporary problems or are at near the bottom of the cycle in a cyclical industry – these situations require a higher level of expertise and dedicated time and effort.

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