# Blast from the past- a prediction and a mistake

On 24th January 2014, I blogged about the broad NIFTY levels to keep in mind going forward in the post named-“The Fluttering of butterfly- the effect of currency volatility and equity valuations”.

For everyones benefit- let me quote a relevant paragraph here:

Let us assume that 6300 of 2008 is achieved! This implies 9450, adjusted for 7% inflation over 6 years. But even in that, circumstances the 9450 Rupees  of today is not equivalent to the 6300 Rupees of 2008. This is because in 2014 1 Rupee is 25% cheaper than 1 Rupee of 2008, since rupee has fallen recently very steeply. Thus the real amount NIFTY has to rise, to adjust this fall is ~12600.

The thesis is broadly right in ideation but quite way off in calculation. Before proceeding forward- can you spot the mistake here?

Fundamentally the root cause of currency volatility is the result of difference in inflation rates. To dig deeper, let us consider what is the effect of inflation on purchasing power of a currency.

It is a common knowledge that inflation is ultimately debasement of the currency. That is, the purchasing power of a unit of currency has eroded. In simple language- the amount of goods a single unit of currency(1 Re) could buy a unit of time back (1 year ) is more than the amount of goods it can buy today.

Now let us consider the case of two trading countries. When a country imports goods from another country, the importing country receives the goods and in exchange parts with its currency. If the importing country has higher inflation than the exporting country the currency of the exporting country will appreciate making its exports costlier for the importing country.To remain competitive the Central Banks will start printing money to remain competitive.  Conversely if the exporting country has higher inflation than the importing country, it can export away its excess liquidity (and hence currency) by investing more in its industry and increasing its exports. To aide in this “averaging” process- it has to export more and more of its currency and import more and more of the stable currency. As a result to aide the asset creation process the exporting country’s currency depreciates to aide other countries to build their factories. Which results in absorption of the capital(due to inflation), absorption of the cheap assets(due to currency depreciation caused by inflation).

In both the cases we see there is an effect of inflation “trading” (import and export) and currency adjustment to reflect capital cheapness/dearness in terms of asset cheapness/dearness.

In the above quoted paragraph I double counted the inflation. 9450 is the level we have to achieve in today’s rupee terms to scale the 2008 highs.

Our highest we have reached till now is 9100.

Error: 3.7%

# Distress Costs, Cash in the books and Value Investing

Cash on the books is always a great sight to see. Ample cash on the books though sometimes becomes an eyesore. Questions and concerns begin to rise regarding the use(or misuse) of the powder keg the management is sitting on. During a hammering, value investors cut from the Graham cloth swoop in screaming “bargain” and eyesight set clearly on that cash in the books.

But it is important for us to also understand that not all dollars are made equal, not all industries function similarly and not “all” inordinate amounts of cash is necessarily high. The traditional wisdom stands good still for the old economy companies. However it fails to explain the unusual circumstances for the knowledge companies.

## The factor of intangible assets

Intangible assets play an important role in the economic well being of modern day knowledge companies. For a pharma company, the knowledge of the drugs, molecules, well trained manpower, research pipeline et al. are the veritable intangible assets in its balance sheet. A few years ago, Infosys created a big hullaballoo by discussing the prospect of including its human resource capability in its balance sheet (as fixed cost).

Quite surprisingly, the grey area of finance and economics mix with subjectivity of human perspective mix quite well when evaluating these intangible assets. How will you value the presence of Ajay Piramal as the new manager of one of your investee companies? How will you weigh the enormous goodwill a brand like American Express or MasterCard commands?

The scenario is quite like the old philosophical adage- if a tree falls in the forest and noone is there to hear it, did it really fall? When there is no one to value or place a premium on an intangible asset of the company, is it really of any value(in accounting terms)?

But it is of value. It is of supreme value to the company itself. It is the very blood of economics for these knowledge based companies. The fact is market too realises this. In 2000s, about 30% of Pfizers valuation was based on its R&D expenditures.

However if the company is sold to an outsider, it will be difficult to put a dollar value to it. Hence in absence of such a “clear” signal, the company has to take the onus on itself to protect its intangible assets at all costs. Necessarily, all the expenditures needed to maintain it is also of paramount importance.

To take this point a bit further, any contingency which develops in this department also has to be satisfactorily met at all times. Thus quite a many company, desire to take debt in their books to bolster their cash levels and choose to pay off the interest cost out of their cash flow.

This added burden of tax also provides a tax shield, as long as return on capital of the business is more than the cost of debt.

## Distress Costs

But imagine if a company is in a net cash position and yet it is facing an intangible asset distress. For starters consider a near-complete wipeout of an IT company’s human resource by a man-made accident. For old economy companies a distress originating from debt is analogous to distress originating from intangible assets for knowledge based companies.

The possibility of such distress has to be matched with a distress cost for an owner-manager of a knowledge company. As a result, the distress cost arising from a distress(be it debt based or intangibles based) will be the financial impact of that default weighed appropriately by the probability of it occurring .

In light of such circumstances, a rational owner manager will seek to maintain enough liquidity at all times to comfortably sail through such distresses. This also explains why some companies have very high cash in their books without thinking about either distributing it, or investing it in other businesses. It is not up for distribution or investment because it IS already invested- it is invested in the core operations itself.

Thus the key takeaway from this discussion is:
1. Don’t judge the high cash in the books position by comparing it with other current assets. It is to often to fund the intangible assets/it distress of the company.
2. A cash bargain it is when, the holding cash in the books significantly outstrips the market capitalization and the distress cost of its intangible assets.

This in peripheral way also explains why a particular industry can horde significant amount of cash while the other industries don’t.
Consider the following table.

While all the industries save for the last, are knowledge based companies all of them have different average cash to net sales ratio. For a ratings business, the chances of meeting with a distress is pretty low(due to inherent economic advantages), whereas for the IT industry (a fragmented, highly competitive sector) the chances as well as the costs must be very high indeed.

However for an Indian railway wagons business, its intangible assets are pretty light. It has to have a huge and big pipeline of technology innovations to have something otherwise. As a result, an outsider can properly value its assets and thus the cash needed to tide over an intangible assets distress is pretty minimal.

# The paradox of holding companies

Holding companies in the world of investing stand for a mirage. Many a novice have sharpened their horns by ramming against them. Looking from a strict Benjamin Graham style of play(where market capitalisation is compared against tangible assets) has resulted in many a tears and heartburns. They are numerously termed value traps, the final frontier where valuation fails and even a quicksand of the novice investor.

It is not that, they have not made money for investors but more often than not, the discount they were hoping to be closed never materializes. An extremely cheap stock of holding company just corrects 25% upwards instead of the expected 250% and penalises the investor with a decent opportunity cost. As a result this is an interesting puzzle in the equity markets- why doesn’t markets correct the severe undervaluation?

Numerous reasons have also been forwarded- holding company discount, conglomerate discount and so on which are often the different names for the same phenomena. However blaming conglomerate discount for 40-50% discount either implies that it not merely a discount but a wholesale writeoff. In facing such beasts , it is important to remember the customary honourable solution. Gently take a step back, ever so silently without disturbing the sleeping beast.

However instead of a strategic and brave retreat, just shuffle and observe it from a different perspective.

## Look through Earnings

Throughout the 1980s Warren Buffett keeps etching, fleshing and time and again repeating the concept of look through earnings. In 1982 annual report he mentions( apparently, the then accounting rules don’t allow reporting of earnings where ownership is less than 20%)

“We prefer a concept of “Economic” earnings that includes all undistributed earnings regardless of ownership percentage. In our view the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used”

Finally in 1993 Warren goes to define it:
“Look through earnings consist of : (1) the operating earnings reported in the previous section, plus; (2) the retained operating earnings of major investees that, under GAAP accounting are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.”

In many ways, it reflects the difference between Berkshire Hathaway- a holding company and the other holding companies which never “come close to getting rightly valued.”

I believe Look Through Earnings is the correct lens to look through this problem. The entire ecosystem of Indian holding companies which I went through squarely looked costly to me rather than cheaply valued.

## Economic Fortunes are enmeshed

The paradox gets resolved if we think in these terms: Whenever an investor buys a business from the market, he links his fortune inextricably with the economic fortune of the business adjusted suitably by his own buying price. Post that step, any and all fluctuations, gyrations and information thrown by the market ceases to matter materially to the owner-investor as far as the economic fortune is concerned. This implies that for the holding company the ultimate benefit comes from the economic earnings of the investee firm, implying free cash flow.

If in this lens, we try to analyse a few holding companies, they look inextricably costly. While a vast majority of the holding companies have their precious capital parked in businesses with questionable economics, the free cash flow (or rather the free cash sink) these businesses appear to throw, adjusted for the stake the holding company owns is materially reducing its book value.

In light of such facts, it is not a surprise that holding companies trade at a material discount to the book value. Consider for example a holding company which in its quoted investments owns the steel, power and other energy companies from the same stable. In essence it is investing in sister concerns. Though creates unwieldy holding patterns but not a crime definitely. However what makes it an economic sin is that the biggest holding- the sister steel company is the fact that, if it would have in its utmost graciousness returned the entire free cash generated by its operations- it would have wiped the book value of the holding company.

## Capital Allocation

This problem can be described in only one way- capital allocation. Why allocate capital to a company which is a perennial cash guzzler rather than a cash thrower? But then the managers of these holding companies have precious little to do other than take a chunk of the stake away from the promoter’s names. Their decision making is zilch and capital allocation has nothing to do with it.

One holding company I came across, which also buys stocks of companies outside its parental stable is Bombay Burmah Trading Ltd. Not a pure holding company by itself, because it has its own operations of tea and coffee.However the proactive decisions (not necessarily the best) its management has taken has forced markets hand at valuing it at a premium to the book value. I consider the presence of an independent operation inside Bombay Burmah Trading Ltd to be an unintended advantage its owners , the Wadia group bestowed on it. Since a management which has some latitude in managing its operations will also be slightly more awake in picking and selecting the investee companies.

Before you go out and buy it, there are two factors worth knowing out here- one, it doesn’t imply that the aforementioned company doesn’t own its sister shares. At best its portfolio can be described a sister concern plus, implying sister concern stake and stake in other businesses(not necessarily the best ones), secondly the valuation of the same is too costly, perhaps only for my own taste.

There exists one holding company out there which breaks all these patterns and for breaking all of it, the market has rewarded it handsomely. That name is without doubt Berkshire Hathaway. But to be sure, that is not the only holding company out there which is charting a lone wolf story. There is Markel Inc and then there is Fairfax Holdings. All of them follow the best practice and praxis of capital allocation strictly.

# Optionality, Fragility and Liquidity

25 year old Sunil Darshan was hurting.
It was a crisp Tuesday morning outside. One of the first sunny mornings after 10 dreary winter days.
But Sunil couldn’t see all of that. His eyes were glued to the computer which was flashing his networth.
And this was the 16th day straight where it was falling.

But that was not why he was in pain. He over the course of a fortnight lost 60% of his networth. And he knew he couldn’t do much here. His hope prevented him from selling at a loss, his guts prevented him from holding onto the toxic garbage he put together.

Darshan is not alone here. The sins of Darshan have been repeated by the majority since time immemorial and yet few have figured it out.

6 years later, Darshan still remembers that morning.

“Much of the positions I was holding that day were based on one core theme- infrastructure play” says a much more chastened 31year old. Indeed an analysis of his investment highlights quite a many lacunaes in his thinking.

Out of 25 stocks he held, all of them were directly connected to one big theme in his mind- infrastructure. So though he believed he had multiple positions in his portfolio, he was betting on the continuance of “good fortune” of one particular industry.

However, lack of diversification was not really Darshan’s fault. It was not even half of his fault. His fault lay in not assessing the risks. Bob Pozen in his prescient advice about career mentioned something extremely interesting- ” you should begin by thinking carefully about why you are engaging in any activity and what you can expect to get out of it.”

Darshan never really questioned his actions or motives. Even worse he never assessed the probabilities, payoffs and the risks associated with any investing action of his.

When asked why he bought what he bought- “They were good companies, I thought they were making nice stuff” explains Darshan. However on buttonholing him regarding what he believed the measure of goodness was for these companies, Darshan couldn’t make a convincing argument.

“They were growing well, they were giving good returns”, adds Darshan hastily.

The problem with Darshan’s strategy is not what his measure of goodness is. But his lack of connection of that measure of goodness with the risks involved.
In short, he failed to assess his ideas in an objective way.

While much of this story is a hashed, rehashed topic exhorting people to be intelligent in their investing decisions and so on, but that is not the deeper idea here.

The deeper idea is the lack of the concept called fragility (popularised by Nassim Nicholas Taleb) in investors’ minds and portfolio. Fragility is a concept which tries to reason out which entities benefit from randomness and which don’t.

Perhaps robustness will give a better image.
Think about the ceramic vase sitting on your drawing room. Give it one jolt, and it will fall and break in thousand pieces. Think about the rubber ball. It can absorb huge amount of shocks and yet return back to its shape without discernible difference.

Anti-Fragility survives. Fragility doesn’t.
And one of the most important aspects of anti-fragility is diversity.

Darshan’s strategy of picking investments were based on only one criteria- past stock price performance. That itself is a recipe for fragility. He should have known that in any “market” the more the number of participant strategies running, the higher amount of diversity there is and the more “robust” that market is to external developments.

Here each stock represents a market in itself. And with Darshan’s strategy of picking up stocks based on past performance, he picked out such markets where the diversity was low. The only dominant strategy was “bigger fool” strategy. So when any new developments came in the form of less than optimal macroeconomic news, the shares tanked.

However successful investors don’t limit themselves to avoiding momentum stocks themselves. They go one step deeper and broader. They first bring the concept of fragility inside their head. Ed Seykota, the famous trend follower argued that winning without losing money is much like breathing in without breathing out.

Munger mentions in the same vein (without any possibility of any of them knowing each other) when asked about the drop in the value of Berkshire Munger said in a very direct way:

“Zero.  This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

Successful ones don’t jump around when they see declines, randomness, less than optimal outcomes. They have strengthened their minds with it.

And that’s one deep aspect of building anti fragility in their portfolios.

The second aspect of making investments fragility-proof is to make small bets (diversification) or make big bets in antifragile companies. The latter is the big idea here. A portfolio of anti fragile companies can also render the portfolio anti fragile.

Think how Buffett chooses his companies – companies existing for a long period, with high amount of predictability in its daily affairs, with high amount of return on capital, with very few or no change in its principal business in its entire history and in an industry which sees no significant change in its structure.

Phew!
Survivability (anti fragile survives). Check
Predictability(anti fragile to macroeconomic conditions). Check
Anti Fragile Industry. Check.

Often companies with high return on capital are symptomatic of anti fragility built in them. Moat is an essential marker of anti fragility. It absorbs shocks without hampering the business.

That’s a very good idea. Contrast it with how we handle our investment decisions. We seldom investigate companies keeping anti fragility in mind.

But Buffett & Munger surpasses even in their traditional ways of combating randomness. They incorporate OPTIONALITY in their portfolio.

But what is optionality!

Take a look at these ideas-

“Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun”

-1987 Annual Report

“…then act decisively when, and only when, the right circumstances appear.”

-Munger

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

-Charlie Munger

Buffett and Munger know the value of optionality. They understand that they need to carry a lot of cash not as a substitute for equity but as a means to buy equity.

They are carrying loaded guns all the time to pounce of deals when no one can else make such deals. And their “loaded guns” are $49bn. A very similar idea we have to use in our own portfolio. As the markets rise, every dollar kept in cash is going to hurt us. Every dollar. However going all in also prevents us from exploiting opportunities when they arise. A lot of people in the wake of GFC 2008, realised that things have got tremendously cheap, but didn’t have the money to buy it. Think about it for a moment. What can you do when you have cash in your hand in a sellers market? But optionality doesn’t only stretch to buying mispriced deals. It also stretches to situations where we don’t know the outcomes, the probabilities of outcomes and the exact payoffs from such outcomes. As the philosopher Taleb says- complex payoffs and extreme outcomes. Betting against an earthquake in California- complex payoffs. Insuring such an outcome, with payoff 5 times the actuarial amount- extreme outcome. Check. Check. Fly in Buffett and he pulls his trigger. He did this exact deal in 1997 California. (more information by Richard Zeckhauser) Complex Payoffs and Extreme Outcomes also require one to build a portfolio of such options. Bet small on each option, hoping law of large numbers to click in your favour. But lottery tickets seldom makes one rich. We also need a portfolio of provable investment channels- in my words portfolio of equity. It can be investments in yourself or in others. However they have to have a proven trackrecord. Think Buffett and his share purchase of Coca Cola. And then, to really take care of rainy days- you need a portfolio of bonds with you. It can be a job in government where there is ample job security or you can have a portfolio of fixed income assets supplementing your income. Or even, some cash to burn. And top all of it with plenty of cash. To move into any of the portfolios whenever you need it. Recently, I had this idea that we can extend this even to individual careers. As market rises all over the world, we are going to sacrifice process in favour of outcomes. We are going to increasingly sacrifice flexibility in terms of returns. And we are going to keep exhausting our cash piles only to be left with none when the horsemen of apocalypse come. # Banking on Trust-III This is the third and final post on the Banking on Trust series. While the previous post winded down to an extraordinary length I recognise it lacked the practical treatment. I hope to set it out right this time. For the first part see here and the second part take a peek here The last post, Banking on Trust-2 can be summarised in four words- “Management maketh, Management breaketh.” Due to the highly discretionary job of risk management and a fragile business model (need plenty of other people’s money to even work) a good management can be the invisible asset for a bank. And I argued, though admittedly without much proof, that Wells Fargo Corp’s management has been extraordinary in its handling of the business. Let us attack the issues one by one. #### Competitive Advantage 101 What separates a big 4 bank (Wells Fargo, JP Morgan Chase, Citigroup and Bank of America) from community banks? Short Answer: Scale Long Answer: Economies of Scale. Being larger in size Wells Fargo and Company (WFC) is able to keep its fixed costs per unit of loan disbursed far lower than its local competitors. With lower fixed costs, it is able to charge lesser interest on loans disbursed thus winning the first battle in a commodity business. Another question. What prevents the community banks from growing into a big 4 bank? Short Answerr & Long Answer: Search costs for customers The incumbent banks have been able to offer full services at a lower cost (due to scale) than community banks. As a result for a customer it is difficult to find a substitute of such a bank which offers all those services at lowest prices. And hence community banks stay ever small. The management of WFC understands these ideas very well. Yet they have taken their execution to a completely different level. By being one of the first banks to repeatedly innovate its financial offering (keeping in view changing regulations as well as customer needs) it has performed extremely well. Peruse this: #### A history of success of WFC 1967: WFC introduces a Mastercharge card as a new form of credit card. 1968: Under high inflation, FED restricts overseas spending. But outbound customers and expats need a solution to this new regulatory development. WFC recently opened London subsidiary WESTERN AMERICAN BANK swings into action- servicing the clients and turning in better than expected performance. Converts to a federal bank charter (Community Banks- 0, WFC-1) Mastercharge credit cards which turn out to be a success. Adopted in 37 States and used by 13million cardholders. These numbers generate substantial benefits for WFC. Accepted by virtually every major oil company. 1970: WFC organised as a bank holding company to broaden their services. New branches opened in Sydney, Hong Kong, Luxembourg, Mexico City, Managua etc. 1975: Its market share of the retail savings trade increased more than two points, a substantial increase in California’s competitive banking climate. With its increased deposits, Wells Fargo was able to reduce its borrowings from the Federal Reserve, and the 0.5% premium it paid for deposits was more than made up for by the savings in interest payments.[from wiki] 1978: Fed allowed banks and thrifts to offer savings intruments with interest rate linked to T bills (savings rate deregulation). Wells Fargo quickly deregulates its own savings rate. Launches two new plans in response to this. Automatically allows savings account interests to be moved into checking accounts. 1978-80: Wells Fargo’s investment services becomes a leader. More accounts garnered than any other money manager. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P500—brought many new clients aboard. In short,with a rise in offerrings WFC is constantly increasing the search costs for customer. But the management of WFC has one more ace up its sleeve. #### A mental model to analyse Mastercharge But wait a second here! Are we missing something? Yes surely we are! We missed an important development. In 1967, WFC launched a system of transaction where customers can take credit from their banks for purchasing items. It was named Mastercharge. Lets first explore, the success (if any) of Mastercharge as of 1969. 37 states out of 51 adopted it. 13mn customers use it. Almost every major oil company supports it. Can we make a reasonable guess on the future of Mastercharge? Its benefit to WFC? Surely we can. Mastercharge is nothing but the first credit card offering in the world. It is essentially making its customers dependent on itself! Thats the classic case of moat. Think about it! Marlboro, Coke, See’s Candies. All are businesses which will be sorely missed by its customers. Lets attack it from another perspective. Lets check if it can be lodged off from its perch (13mn cardholders, acceptance by major oil co.) by a new competitor. Have you heard of Replicator Dynamics? It is an interesting mental model. Its in essence a system which says- folks adopt those behaviours more readily which has the more payoff (the material aspects) AND is copied by more number of people. So we can see- people switching and adopting new behaviours. Something like people coming from different cultures quickly adopt the cultures of their new country. I will be talking about this mental model in another post (Stay tuned!) Lets apply it here. Assume that Mastercharge gets a new competitor called Surcharge. It is the new kid on the block. Zero people use this and no states have adopted it, yet. Now Alex wants to enroll in one of the two credit card companies- Mastercharge or Surcharge. What does Alex see? Alex sees around him 13mn customers already using Mastercharge. 13mn cardholders of Mastercharge! It effectively means wherever Alex looks, he sees every card holder as a Mastercharge holder. He is surely going to adopt that behaviour which is being followed by others [Replicator Dynamics]. But when 37 States and all the major oil companies have adopted Mastercharge, what does it imply? A large number of vendors are already using it. So for Alex, Mastercharge has clearly become significantly beneficial.Its the classic Network Effect at play. Each new vendor when joins the network makes the network more valuable to its individuals (Think Facebook in 2006 and 2014). So for Alex, not only does it make more sense for him to adopt Mastercharge than Surcharge, it also makes it more profitable to him (i.e. gives him disproportionately large material benefits than Surcharge). Thus we see, Mastercharge owning the market, like a boss! Mastercharge finally became -> this #### The ace up Wells Fargo’s sleeve #### The management perhaps thought, if I am indeed locking away the community banks in services why not go the entire way! Lets lock them out of physical proximity to customers as well! Take a look: Dotting the California: New Branches opened or pending in 1968 Its opening new branches so close to each other that it is effectively crowding out community branches. In the same year it merged with Bank of Pasadena (a 10mn$ deposit bank), Azusa Valley Savings Bank and First National Bank of Azusa (combined 11mn$deposits). It acquired Sonoma Mortgage Corp. In 1969, Wells Fargo has 19 offices in Southern California, the deposits exceeded 165mn$ and loans topped $230mn. Offices in South California In 1970, the conquest of Los Angeles and Orange counties(right) is shown. And also take a look at the San Jose metropolitan area expansion The Conquest of South-West America aka LA and California So we see an all out attack to disproportionately increase the search costs in every way possible. The qualitative aspects are done, let us train our guns on perspectives. Is the management really running a tight ship? Is it keeping its costs down? In contrast BofA had an overhead margin of 47% in 1998 inspite of 100 years+ of experience #### The management- does it go bonkers in good times? With the qualitative aspects out of the way, let us consider the quantitative aspects of management i.e. its ability to make conservative loans, predict their vulnerability and make the right amount of provisions so that, I repeat, so that the net operating profit after tax is smoothened. Take a look at this: The NOPAT barely nudged even in a downcycle What I did was simple. I took the Net Interest Income subtracted only the charged off loans so that I get the true picture of ‘damage’ in the current year and added back the loan provisions. Remember loan provisions exist to smoothen out bad loan losses. So ideally management should have anticipated the loan provisioning properly so that charged off loans are fully accounted for. But probability of loan going bad is a combination of expected and unexpected developments. Hence how good a management is, can be checked by how good its predictions are. In turn, how succesful it had been in making its NOPAT smooth. Since provisioning is tax free, I adjusted the tax accordingly. Taxes paid in real is the second row, and the last but second row are the taxes applicable on our adjustments, given the same tax rate. Take a look at NOPAT levels again. Remember in the period from 1970-72 US entered a recession. With each economic downturn banks are the first to suffer losses. And yet, Wells Fargo’s NOPAT has barely nudged. What do we conclude? We do conclude that Wells Fargo’s management has been extraordinary capable of cushioning the bank’s fortunes from macro economic shocks. WFC- 1 , Competitors – 0 So now it comes down to valuations. Lets take a look! #### Valuations- Valuing the Wells Fargo! It went public in 1972, and its average market cap for that year was around$1.5bn.
What growth expectations are we attaching to Wells Fargo?
Lets first try to establish a way to value this company.

We adopt the Economic Value Added (EVA) methodology to analyse this bank.

EVA = NOPAT – Shareholder Equity * Cost of Capital

Market Value of Enterprise = Shareholder Equity + Future Value of all EVAs

Using this framework, lets try to find out the EVA from 1967-1971. The cost of capital for a shareholder is merely the opportunity cost.The second best idea is investing in index, assuming a blank portfolio.Consider it to be the historical growth in index DJIA from 1940-1970. Thus the cost of capital equals 8%.

Hence plugging it in and assuming a 20% growth rate for the next 30 year, we arrive at its 1972 valuations of $1.5bn. 20% growth rate in EVA, discounted at 8% for the next 30 years. Is it too costly? Well it is if you see the time duration involved. Growing at the rate of 20% for the next thirty years is not a mean feat! However if you consider that this is a good business, with a responsible management at helm, with very interesting offerings like Mastercard and a deepening moat, then you might like to reconsider your position. But I will be fair. Had I been in 1972, I wouldnt have dared to buy it. But given the mental model working in my head now, I would have surely stalked this company very closely. #### Three Years ahead- August 1974 Let us consider three years ahead. Has the position worsened? Lets see. In 1974, Wells Fargo NOPAT was$66mn.
Equity stood at approx 450mn$. At a cost of capital at the same 8%, we have EVA of Wells Fargo in 1974 at$30mn.

If we assume the growth rate in EVA to be about 8% for the next 30 years, the future value of all EVAs come to $0.9bn. With the shareholder equity standing at$450mn, the market value of the enterprise comes to $1.35bn. In 1974 for about 4-5 months (from August-December) it traded at a marketcap of$860mn.

#### Fours more years ahead-  1978

Let us go four more years ahead. How well would we have fared in our assumptions?

Constantly increasing Earnings and Dividend per share

It clocked an average of 18% growth in the last 5 years. Topline growth has clocked an average of 17%.

And has the moat deepened?

Everincreasing return on shareholder equity! What else is it other than deepening moat. And this has come at the cost of dumb competition.

Remember Walmart? Walmart did the same with mom and pop shops.

But ladies and genetlemen, I will completely understand if you are hungry for some more.

Take a look at this:

Increasing return on assets for WFC. Almost a vertical line!

And take a look at its effect on leverage:

Falling leverage implies better asset utilisation and deepening moat.

It just shows one thing- Wells Fargo and Company will continue to make a heck lot of a money for its shareholders. In fact, from 1974, if you would have bought and held WFC it would have returned 29400% ; compounded yearly at the rate of 15% for the next 40 years.

1. John Hubers excellent posts on Wells Fargo which has served as an inspiration to conduct this study. here, here and here

2. Annual reports of Wells Fargo from 1968-71,1978,1988,1998

3. The featured image is taken from John Huber’s wonderful blog Base Hit investing

# Banking on Trust-II

In the last post Banking on Trust-1 we discussed Bruce Berkowitz ideas on bank as an earning machine, how it can be an earning machine (by turning into a franchise) and Wells Fargo’s success in the same. I ended the last post by promising we will be discussing Berkowitz’s idea of WFC’s management. But before I go forward I want to make a detour.  I am going to talk about banking business in general and then in the last few paras talk about Berkowitz’s observations. Financial sector is often the least understood sector. Investors and laymen alike find it increasingly difficult to make sense of banking as a business. When I first started this series, I wanted to build my circle of competency in this sector as well as keep a public record of my understanding for others to learn and correct. So without much ado, here it is.

In a business like banking it is important to understand the driving factors in its success.

To explore this idea let us try to understand the problems of its CEO. If we explore this idea, then lots of factors become clearer. Better yet, let us try to form a financial business from scratch. Each case will be taken up as a case study #.

Lets get started:

(Note: In all previous financial statements, the balance sheet preceded the income statement by 1 year)

##### Case Study #1: We have 1000$invested in a bond portfolio, which yields 22% annually and matures in 10 years. The loan portfolio is completely riskless. In this case, the balance sheet and the income sheet looks like this: A simple credit financing operation But note, that we would like to enhance the Return on Equity. The RoE of the operation is not very high. As a result, we would like to employ DuPont methodology for analysing RoE. It says: #### ROE = Profit Margin X Asset Turnover X Leverage So employing this we understand that, increasing profit margin will either require taking more risk on the loan book or procuring cheaper capital. Both of which is say for the sake of argument not possible. Since the portfolio churns once in 10 years, increasing the asset turnover is also not possible. So the only way is to take in more debt. ##### Case Study #2: Intaking a debt of$ 500 at the rate of 2% to the existing operation.

As a result the balance sheet and income statement will look like this:

The leverage is mere 1.5 and ROE has also jumped by a similar level. However in two aspects this scenario is divorced from reality.

Consider this, when a financing entity offers me loan at 2% which is risky asset, how can this credit financing operation find riskless assets at 22% yield?

So it will be prudent to recognise, understand and acknowledge that the bond portfolio cannot be riskless and definitely the interest spread cannot be this high.

Analogously, if risk and yield are correlated, then undertaking investments in riskless assets will lead to negative spread. That is cost of funds will exceed the yield from those funds. So let us still for the sake of argument  continue to believe that they are riskless, however reduce the spread from 20% (22%-2%) to 1%.

In other words, the yield on commercial loans we make here is 3%

##### Case Study #3: The yield on commercial loans is 3%

Ouch!

The ROE has fallen once more! And this reflects a more practical scenario. So is banking business doomed with rock bottom ROE?

No, not at all. Remember , we can pull the leverage couple of notches. Now its mere 1.5x leverage. Lets jack it up!

Lets make it 20:1, no 25:1 leverage.

##### Case Study#4: Effect of 25:1 leverage on ROE

Note, the increase on ROE. The ROE is now 19.60%.

By now quite a few ideas have started coming to your brain,  I am sure. But lets explore a bit more.

We need to consider the inherent riskiness of the loans as well. So lets do it.

Lets indeed treat the loans as risky assets. Which implies, there is a definitive probability of certain loans going bad. Now as we can foresee, if we leave the entity (financial entity) to run as it is, with no difference made to account for the riskiness of the loans, we can face these problems:

•  The Net Interest Income(NII) will be extremely volatile.
• In good times when cost of fund is cheap, the banks will how high profits and in bad times when the default rate rises the profits of banks plunge- making banks extremely coupled with the economy and more risky to own during the downtimes.
• Excess leverage of the banks make their balance sheets “fragile”- a small amount of default can wipe their equity portion and may even hamper their debt part.

These reasons and more, make it evident that “business as usual” is not wise. We will have to protect ourselves against bad loans while making some kind of provisioning to account for the riskiness of the portfolio.

If we think a bit more deeply, we can say for a bank the level of interest it can charge can be gleaned from this relationship:
$r_{l}=r_{b}+E(d)+k+c$
Here $r_{l}$ is the interest charged from the debtors, $r_{b}$ is the risk free rate, $E(d)$ is the expected annual default rate, $k$ is the risk premium and $c$ is the operating cost per unit of loan disbursed.

Thus, if $L$ is the loan disbursed on average, the cost of funding is $r_{d}$ and $\Delta BL$ is the bad loans charged off (i.e completely written off), then the NII for the bank in any given year will be:

$NII = \tilde{L}*((r_{b}+E(d)+k)-r_{d}) - \Delta \tilde{BL}$

Note: Here we are using $\tilde{L}$ and $\tilde{BL}$ to imply that these are not constants but are changing variables. Also we have not used the cost per unit loan in the above equation because we are considering Net Interest Income (i.e post overheads).

This is a situation which considers that there is no provisioning. As a result $NII$ will keep on changing as per the whims of $\Delta BL$. In bad times when the bad loans increase Net Interest Income will plunge perhaps even going into losses, and in good times when bad loans are below the $E(d)$ rates, Net Interest Income soars.

So remember we are the CEO of this investment operation. It is our duty to see that the health of the business is not adversely affected in any case. We have to thus protect ourselves from the bad loans coming to bite us. Especially in the bad times. Let us create a separate account, where part of the net interest income will be kept aside to cushion the fluctuations in $\tilde{BL}$ (bad loans).

Hence let us keep aside a fixed proportion, $\gamma$ annually of the value at risk.
What is the value at risk here?

Naturally it is expected rate of default $E(d)$ times the loan disbursed $L$.
Hence, provisioning equals $\gamma * E(d)\tilde{L}$.
So for each year, we will set up the amount by which provisioning exceeds $\Delta BL$.

As a result the Net Interest Income will look like this:

$NII = \tilde{L} \cdot ((r_{b}+E(d)+k)-r_{d})-\Delta \tilde{BL} - (\gamma \cdot E(d) \cdot \tilde{L} - \Delta \tilde{BL})$

On manipulating, we can find something interesting. We find:

$NII = \tilde{L} \cdot [r_{b} +k - r_{d}] + (1-\gamma)\cdot \tilde{L} \cdot E(d)$ $if LLP > 0$

Here LLP implies Loan Loss Provisions.

In case $LLP=0$ , the situation reverts back to the representation where there was no cushion.
So what do we see with all this?

We see, the cyclical fluctuations in $\Delta BL$ , bad loans i.e. is completely removed.
We also see, that it is a pseudo-expense.

Just like a manufacturing company can eschew depreciation completely and every few years it can show an extraordinary expense to replace the machinery, similarly without LLP the bank will show extraordinary losses every few years.
By using provisioning (which can be thought of as banking equivalent of depreciation), the CEO are able to smoothen out the profits and cycles

Thus let us account for the riskiness of the assets. Let us consider that expected value of defaults is 10%, and loan amount as per the previous case study was $26,000. Thus the value at risk is$2600. We set aside a proportion of this value at risk say about 1% as provisioning.

Furthermore let us assume there is no charge off this year.

##### Case Study #5: With 1% provisioning of VaR

Now we are getting closer to our ideas here:

What do we observe here?

1. Prudency demands we should be good at predicting the quality of our loan book, and honest in reflecting the same in our provisioning calculations.

2. In bull runs, there are additional pressure from market, from shareholders to constantly  beat the expectations. And it is that crucial time when CEO has to shut out the noise and allocate provisioning capital liberally. Because when economy contracts the bad loans will have to be offset from this.

3. CEO should build moats around their operation, so that customers dont switch easily at the drop of a hat and some amount of premium pricing can be charged for the services. .

4.  CEOs should be extremely low cost operators, so that the margins can be increased.

In this light it is important to note that the management of Wells Fargo have been prudent in recognizing risks,honest in acknowledging them and cautious in  accounting for them.

So what do we see, when Wells Fargo is hit badly by California Real Estate shock of 1990.

The management errs on the side of caution by high provisioning for the loan losses. So much so that, the earnings power of WFC is completely disguised.  Secondly, a manager who over reserves is one who will understand the price of risk. In other words, it is an indication of cautious, responsible and able managers.

Banking is a business where there is no place for gung ho managers. Being a business so fragile a tiny amount of neglect towards risk can wipe out the bank.

Berkowitz at one point drives home  harder the fact that Wells Fargo has captured the markets so heavily, mark my words, he says if Wells Fargo is to close down tomorrow then there would be significant shortfalls.

That, my friend is the mark of a company which has locked out any competition on its turf. In short it has got a moat around it!

What does it imply?

One thing. Management is the best as they come.

Wells Fargo is also the most efficient bank out there and has an ROE of 20% (as of 1990). Bruce Berkowitz at this point introduces PTPP Earnings, that is core earnings for a bank. It is called pre tax pre provisioning earnings. He points out that PTPP earnings of WFC stands at an astonishing \$33.

And their provisioning which is extremely conservative, and assumes a complete charge off is not so. In fact their non performing assets are earning  a modest amount of interest.

Buffett reflects Berkowitz idea toto. He echoes that management of a bank is the singlemost make or break factor. The next important factor is costs. Wells Fargo has an average cost of deposits at 0.36%.

Similarly its return on assets stand at 1.43%, return on equity at 13% and return on tangible equity stand at 18.3%. Compared to any cheap community banks Wells Fargo is far better in quality and far better in value.

This post has stretched far beyond usual ones. For now taking your leave. Adios.

In the next post of Banking on Trust series, I will be discussing the business aspects of Wells Fargo- its competitive advantages etc.

# The Trust Factor: The Piramal way of doing business

Ajay Piramal channels Warren Buffett. He follows him in his entirety. With all his warts and moles; idiosyncrasies and ingenuity.

A copycat? What’s wrong in it though?

But it will be an insult to Piramal to merely call him a blind follower. He is a true believer in the ethos of Buffett and Munger.
He just doesn’t limit their teachings in business, but mixes it liberally in his life and the way he conducts himself.

Take a moment to think about it. Why do we exactly adore Buffett?
We may adore Munger for his extreme wisdom, rapier wit and piercing observations.

But why Buffett?

Because he is a billionaire?
Because he is the most successful investor- a true rags to riches story?
Because he embodies self-sufficiency?

Perhaps. And perhaps not. There are umpteen other people with similar stories. We might not accept it but we adore him because he inspires trust.

He shows amazing consistency in his behavior, words and belief. He surrounds himself with people of similar impeccable integrity and prevents the use of legalese as a crutch for trust.

This is perhaps the least highlighted aspect of Buffett. He is extreme in identifying and cutting needless costs. And legal experts, consultants are nothing but that.

He rightly understands that human beings can and will game the system, and a legal document cannot protect him. What he employs is empathy, trust and marks human relationships as the bedrock of business.

He is known to acquire companies based on mere handshake. In contrast compare that with Daiichi -Ranbaxy deal. Plenty of investment consultants, plenty of legal documents and still plenty of hassles.

In economics there is a concept called signalling mechanism. Someones actions not only has a direct outcome to it, but also gives off an information.  That is every action also implies something.

Legal documents signal something as well. It implies- “I don’t trust you”. It implies- “I trust the legal guys, the investment consultants with skewed incentives far more than the person on the other end of the table.”. Humans are born with a superb skill set to game existing systems. Call it ingenuity, call it creativity. You just dont want to be on the receiving side of it.

And this signal subconsciously “inspires” unethical behaviour.  Traditional  ideas of buyers beware kicks in. The seller subconsciously understands  that trust is not expected of him. And he might as well game it.

Which brings us to two important mental models–  Expectation and Seamless web of deserved trust.

As natural beings, we are programmed to reciprocate.  And when we tell someone not only in words but also in action that we trust and thus we expect him to cooperate and trust us back- we don’t make him/her our adversary- we make that person our ally.

And what does lack of trust do?

Lack of trust led to World War I.
Lack of trust lead to arms races.
Lack of trust is costly.

Seamless web of deserved trust ought to be the bedrock of business. What does it mean? It means trust generated through one’s own action, and hence deserving. “Seamless web” means consistency. Consistency in every aspect of one’s conduct. So trust generated through consistency.

Its a tough way, especially when perverse incentives exist; but try distrust once and you will understand what I mean.

Which brings us to Ajay Piramal’s knack of doing business efficiently.

Specifically this line:

When they met, Pirmal, who had stitched more than 20 deals without using any bankers, expressed reservations.

20 deals without using any bankers! That’s a substantial confidence, huge amount of trust and an inordinate amount of cost saving.

Cost saving not only in banker fees, but in potential headache down the line. This action signals something.
It signals- “I trust you”

The article continues:

It also marked the beginning of a personal relationship that was rooted in financial services, but routinely sidetracked into business values, classical music, maths and spirituality, among other things.

Whoa!  How many business deals take place like this? I have seen hardball i-bankers conduct negotiations with their one hand sms-ing under the table .

Why?
To do course correction on ball busting !

Swati Piramal says her husband also has a unique ability to bring a personal touch to business relationships. For instance, on the eve of the deal with Shriram Capital, the Piramals hosted Thyagarajan and his family to a meal of South Indian delicacies prepared at home in Piramal House. Many of the deals he does are based on a personal equation, she says.”

Emphasis mine. Last quote taken from here

# Why I like JB Chemicals

JB Chemicals [JBCPL] is a ₹11.76bn Indian pharmaceutical company with well known brand names like Metrogyl, Rantac, Nicardia in its portfolio. In 2011, JBCPL sold the Russian OTC business to Cilag GmBH, a Johnson and Johnson company, for a sum of ₹960cr.

# Banking on Trust – I

This is the first part of a three part series on investing in banks. This is not a tip blog post, this is a discussion of different salient features which drive banking business. The method of analysis will be part inspiration and part plagiarism.  In 1992 Bruce Berkowitz gave an interview to Outstanding Investors Digest (OID) regarding Wells Fargo. These are some of the ideas presented by him and an exposition by me.

Wells Fargo is an American banking company with head quarter in South California. Its the second largest bank in US in terms of assets and the largest in terms of market capitalisation. It extensively takes home financing. In February 2014 it was ranked as the most valuable bank in the world for the second time in a row. Wells Fargo is owned by Berkshire Hathaway. At different points of time it was owned by some of the most stellar value investors of present era.Munger went to the extent of  calling Wells Fargo his investment filter. He implies that he constantly asks himself if he should put his money on a new investment when Wells Fargo is as a good and as cheap as it is.

But how do they think about a business as difficult as banking.

### “Its a simple case of a bank with tremendous earning power”

Bruce very early in his interview makes it clear what is the Big Rock in his thought process. He underlines that Wells Fargo is a bank with a tremendous earning power. Wait a second!  What does it even mean?

How do we identify the earning prowess of a bank?
Or rather what are the driving gears of a bank?

At the very core of its operations a bank is at the end of the day a commodity business. The commodity is not some agricultural produce but it is an economic produce- MONEY!

People go to banks to deposit their money and avail loan services. So when banks take deposits they incur expenses . Similarly when they disburse loans the interest income is their revenue.
No significant differentiator with respect to any other competitor. Of course a bank can raise the interest offered on deposits to attract more customers but it will be akin to making higher payments to your supplier. So higher interests offered to deposits imply lesser profits.
Compare this with a coal miner- another commodity business:

1. He has no pricing power- that is his price is dependent on the lowest price offered in the market.
2. The fruits of innovation is never going to create a unique production process for his own firm.

3. As a result, margins are going to be just enough for producers to survive.

So a bank can attract loan availing customers by lowering interest rate. However this is not going to make him any profits. It will be a value destructive growth.

However there are times when a bank can move away from a commodity business to a franchise model.

A related question here is- can we think about banking business in a different way?

### So many people are dependent…

A Bank can also be thought of as a platform!.  This is an incredible insight. Think of it, two persons walk in to a bank to avail loans. One of them is already a client in the bank having his own deposit. The other doesnt. Guess which one of them will walk out of the bank first with a loan in his hand?

Banks started loaning out to people they know to control their risks, but it has now spawned into a lock-in system. If you do business with this bank, your working capital loans of your business is given by this bank then you can’t shift away your deposit savings account to another competitor providing competitive rates!

And vice versa. If you do have a deposit account then selling the loan services to you is going to be easier from your as well as bank’s  perspective.  This is a way of thinking. In developed and matured economies the difference in convenience is not going to be huge, however my common sense says it should be present.

Now lets try to think a bit more through it- what if a bank has a branch at every corner of the road? The stupendous distribution system itself is going to lock away other competitors from even trying to enter this business. And that is one excellent reason why community banks thrive in US.  And that is the reason why local moneylenders thrive in India.

So a bank with the biggest number of branches is going to win. However, branches imply growth and the margins of this business is low (why? because at its core its a commodity business). Hence it is imperative that the efficiency of the bank is as high as possible.

Thus for a bank to reinvent itself as a franchise- it has to have an excellent cost structure, low cost of funds, excellent footprint and the efficiency gains which come from scalability.

In as many words, when OID asks Bruce Isnt that a contradiction in terms- a bank with a franchise?” He replies-” If I give you a billion bucks and let you pick your management team, how could you rationally hurt Wells?

Indeed how could you rationally hurt Wells Fargo when it has a 9000 branches spread all over US?

Footprint of Wells Fargo in US

Its scale leads it to earn a ROE of 20% and a NIM of 5.5% (at that time) and a 3.5% (today).

Additionally, Bruce points out that the banking structure at the upper reaches of the pyramid (that is where WF resides) is completely oligopolistic. WF forms the one of the banks in the quartet- Bank of America, Citigroup and JP Morgan Chase being the other three.

In the next post we will discuss on how Bruce talks about management quality, Warren Buffett’s views and some other accounting techniques and ideas

# The fluttering of a butterfly: The effect of currency volatility & equity valuations

I often talk how Indian markets even if they scale the 2008 highs are far cheaper than they were in 2009 or 2010. Here the idea is rooted in the simple idea that, a 100 bucks earned 6 years back is has a higher value than 100 bucks earned today. So NIFTY at 6300+ is cheaper today  (in relative terms atleast, if not in absolute terms) than  6300+ in 2008.

However,  there is an idea of “shifting grounds” here. Let us assume that 6300 of 2008 is achieved! This implies 9450, adjusted for 7% inflation over 6 years. But even in that, circumstances the 9450 Rupees  of today is not equivalent to the 6300 Rupees of 2008. This is because in 2014 1 Rupee is 25% cheaper than 1 Rupee of 2008, since rupee has fallen recently very steeply. Thus the real amount NIFTY has to rise, to adjust this fall is ~12600.

This makes our Indian markets cheap by atleast 53%. This is a silent fall! Had market fallen by 50% from the highs, we would have screamed “Bear!” but no one is looking things this way. Asset prices are still quoted in rupees which makes them cheaper not costlier. However good robust businesses are inflation proof. Or to be less categorical, good robust businesses are less affected by inflation. Thus their core business operations are working and growing well. And hence they are relatively cheaper!

A similar but opposite effect can be seen in the case of Nestle’ Inc and Swiss Franc. It can’t be said better than the residing guru of the value investing world