Moats Versus Boats

“Most value investors take their inspiration from Ben Graham. The most famous of them all is Warren Buffett. He started off as what we call a boat type of investor and then went on to became a moat type of investor. But what does value investing really mean? When evaluating fixed-income securities, there is no disagreement over what value is; it is very easy to define. In equities, you have a notion of what short-horizon value is — what we categorise as relative value. The next big category is what is called deep value, and for the purpose of our discussion, we will call it boats. This is primarily the Graham-and-Dodd way of looking at things: in an extraordinarily cheap way. These guys made no distinction about the quality of the business.
They were just looking for cheap businesses,
which were very often very poor businesses. 

On the contrary, Buffett and Munger looked for high-quality businesses. Be it Graham or Buffett, for me, the most fascinating thing is: how do they view risk? The core idea they operate on is the concept of margin of safety. Like Charlie Munger, Buffett’s partner says: ‘You have got to have different checklists and different mental models for different companies. This is not an easy business.’ If one of the most successful investors in the world says this is not an easy business, then what are we to do? One thing we can do is listen to successful investors who have practised this craft in our part of the world.”

Those were the opening words of Vikram Kuriyan, clinical professor of finance, ISB at the annual investment conference titled ‘The Practice of Value Investing’ by ISB in Mumbai. Here is the first of the nine part series on the subject by three distinguished Indian investors — Jeetay Investments co-founder and director Chetan Parikh, Motilal Oswal co-founder Raamdeo Agrawal and Amansa Capital founder Akash Prakash.

Carl Jacobi, the great 19th century German mathematician, found that solutions for different problems could be found if the problems could be expressed in inverse by working backwards – that’s something Charlie Munger learnt. I recently came across a great article by British economist John Kay in the Financial Times. He spoke about the difference between Feynman Integrity and Stigler Conviction. For the physicist Richard Feynman, science involved a kind of leaning over backwards. For example, if you were conducting an experiment, you should record everything that might make it invalid, and not only those things that you think are right.

For George Stigler, the founder of the Modern School of Economics, the successful inventor is a one-sided man: he is utterly persuaded by the correctness of his ideas. He subordinates all other truths because he sees truth to be less important than the general acceptance of his truth. The distinction made by Isaiah Berlin about Tolstoy’s view of history is between foxes who know many small things and hedgehogs who know only one big thing. There are a lot of things that Feynman has written that are applicable to investing, including the bit about leaning over backwards. 

Having just finished reading an excellent biography of Roman stoic philosopher Lucius Annaeus Seneca, it was a treat for me to come across two recent letters by fund manager and author Chris Leithner on how the principles of stoic philosophy can be applied to value investing. One of the techniques of stoic philosophy is negative visualisation or, in simple language, picturing the worst-case scenario: the stoic way of inverted thinking. Negative thinking can paradoxically produce positive results by allowing for proactive risk management. Psychotherapist Albert Ellis called this the negative path to contentment.

Leithner states that Ellis “rediscovered one of the stoics’ key insights: sometimes the best way to navigate an uncertain future is to focus not on the bright side (“best-case scenario”) but rather the sombre side (“worst-case scenario”)… The ability to manage uncertainty by pondering negative thoughts is not just the key to a more balanced life: it’s a sine qua non of successful business, entrepreneurship and investment.” Investment consultant Charles Ellis wrote a book called Winning the Loser’s Game, where he said that investing is a game where the outcomes in the short term tend to be dominated by luck and high transaction costs. By avoiding mistakes, there is a better chance of coming out ahead. So, invert and ask: how could an investor lose money buying cigar butts and how could an investor lose money by buying into a wonderful business?

From a Grahamian perspective, the margin of safety comes from a study of the historical record of the company. The unstated assumption is that even if the company had a superior current earnings power, its growth rate should not be assumed to be greater than the historical growth rate of profitability. The Buffett/Munger worldview, I think, has a far greater appreciation of the value of superior earnings power combined with growth rates that could be significantly different from those achieved in the past. The emphasis here, I believe, was on future intrinsic value rather than on current conservatively calculated intrinsic value. Buffett/Munger relied primarily on the sustainability of the superior business model for value creation. That sustainability obviously depended on a long competitive advantage period. Graham focused primarily on the current price for value creation. Both models have their pitfalls and both have their advantages. 

What is it about spiderwebs that help them achieve their strength? The silk that spiders use to build their webs, trap their prey and dangle from the ceiling is one of the strongest materials in the natural world. But it is not simply the material’s exceptional strength that makes spiderwebs so resilient — it is the material’s unusual combination of strength and stretchiness: silk’s characteristic way of first softening and then strengthening when pulled. Damage also tends to be localised, affecting just a few threads, making it a very flaw-tolerant system. I think the Grahamian system can be thought to be like a spiderweb. There are so many screens that can be run using the Grahamian framework and many ideas that come out from that quantitative perspective. Some turn out to be gems and some, value traps. Ex ante, I have found it difficult to distinguish between the two.And Graham stressed on adequate diversification, again something that I have not found to be psychologically easy.

Sometimes, I have erred by having too many stocks in certain portfolios that I used to manage. Dragonflies have two eyes, just like humans, but very different from ours. Their eyes are enormous, with the surface covered with tiny lenses, aggregating in some species up to thirty thousand. Each adjacent lens covers a different physical space and thus gives a unique perspective. Its vision, thus, is a synthesis of these unique perspectives. Aggregating perspectives is the key to understanding ideas in the Buffett/Munger system, but it is not easy. It sounds simple but it is anything but.

One reason is that the quality and life cycle of the entry barriers are subject to enormous change — sometimes over short periods of time — emanating from circumstances and industries of which the investor may not have sufficient awareness or knowledge. Let me give you an example. The biggest threat to conventional carmakers using petrol/diesel engine technology is going to come from companies in the information technology space, companies like Foxconn, Tesla, Xiaomi and Apple, because electric vehicles are essentially computer tablets on wheels according to innovation expert Tony Seba. This disruption may happen in the next three to five years. The speed of change and the disruption possibilities have never been greater in many industries. Assessing how strong entry barriers are has become the biggest challenge for investors.

This is the first of a three-part series. You can read the second part here and the third part here