Hi, Welcome to the 10th Special Edition
Brief Overview of What We will cover in this Issue
Detailed Key Takeaways from the book I am reading Currently
Key Learnings from 3 Different Shareholder Letters
Investing Framework inspired by Rakesh Jhunjhunwala
Market Bottom, Reading, Proxy & Contrarian Investing
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You Can Be a Stock Market Genius (Part-1)
Consitentancy and Compounding
At first blush, the word “phenomenal” and an increased annual yield of 2 or 3 percent seem somewhat incongruous. Though it is true that after twenty years of compounding even 2 percent extra per year creates a 50 percent larger nest egg,
Diversification isn’t a solution to market risk
It turns out that diversification addresses only a portion (and not the major portion) of the overall risk of investing in the stock market. Even if you took the precaution of owning 9,000 stocks, you would still be at risk for the up and down movement of the entire market. This risk, known as market risk, would not have been eliminated by your“ perfect” diversification.
Statistics say that owning just two stocks eliminates 46 percent of the non-market risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four-stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks. Without quibbling over the accuracy of these particular statistics, two things should be remembered: 1. After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and 2. Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
Secret Hack of High Returns of Joel Greenblatt
If you spend your energies looking for and analyzing situations not closely followed by other informed investors, your chance of finding bargains greatly increases. The trick is locating those opportunities.
It’s like the old story about the plumber who comes to your house, bangs on the pipes once, and says,“ That’ll be a hundred dollars.” “A hundred dollars!” you say.“ All you did was bang on the pipes once!” “Oh no,” the plumber responds.“ Banging on the pipes is only five dollars. Knowing where to bang— that’s ninety-five dollars.” (Most Important Thing)
In the stock market, knowing where to “bang” is the secret to your fortune.
Some Basics about Special Situations
The first is pretty simple. You have no choice. If you are truly looking at situations that others are ignoring, there will rarely be much media or Wall Street coverage. While there is usually plenty of industry or company information available, some of it quite helpful, almost none will focus on the special attributes that make your investment opportunity attractive. This should be fine with you; “the more the merrier” is not your credo.
The other reason to do your own work is closely related. As much as possible, you don’t want to be well paid merely for taking big risks. Anyone can manage that. You want to be well paid because you did your homework.
The idea is to place your “bets” in situations where the rewards promise to greatly outweigh the risks.
Naturally, everyone would like to invest in situations where the odds are stacked in their favor. But most people can’t because they don’t know these special opportunities exist.
The payoff to all your legwork and analysis is the opportunity to invest in situations that offer unfair economic returns. Your extraordinary profits will not be a result of taking on big risks; they will be the justly deserved pay for doing your homework.
The odds of anyone calling you on the phone with good investment advice are about the same as winning Lotto without buying a ticket. (Say No to Tips)
It’s much safer to be wrong in a crowd than to risk being the only one to misread a situation that everyone else pegged correctly.
You can’t always choose your battles or your playing field. When it comes to the stock market, though, you can.
The most successful horseplayers (I guess they lose the least) are the ones who don’t bet on every race but wager on only those occasions when they have a clear conviction. It makes sense that if you limit your investments to those situations where you are knowledgeable and confident and only those situations, your success rate will be very high.
On Concentration Portfolio
The strategy of putting all your eggs in one basket and watching that basket is less risky than you might think.
However, if your goal is to do significantly better than average, then picking your spots, swinging at one of twenty pitches, sticking to net serves, or any other metaphor that brings the point home for you is the way to go. The fact that this highly selective process may leave you with only a handful of positions that fit your strict criteria shouldn’t be a problem. The penalty you pay for having a focused portfolio— a slight increase in potential annual volatility-should be far outweighed by your increased long-term returns.
Past price movements (Volatility)
In fact, not only doesn’t a stock’s past price volatility serve as a good indicator of future profitability, it doesn’t tell you something much more important— how much you can lose. Let’s repeat that It doesn’t tell you how much you can lose. Isn’t risk of a loss what most people care about when they think of risk? Comparing the risk of loss in investment to the potential gain is what investing is all about.
Look down, not up
So one way to create an attractive risk/ reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself. In other words, look down, not up, when making your initial investment decision.
→ If you don’t lose money, most of the remaining alternatives are good ones.
→ There are plenty of ways to achieve substantial wealth through investing in the stock market. Likewise, there are plenty of people who try. There are, however, only a select few who succeed.
→ According to Lynch. He believes that with a reasonable amount of company research and investigation— the type well within reach of the average investor— everyday insights and experiences can be turned into a profitable stock portfolio.
THE SECRET HIDING PLACES OF STOCK MARKET PROFITS
Stock-market profits can be hiding anywhere, and their hiding places are always changing.
The list of corporate events that can result in big profits for you runs the gamut— spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, and distributions. And it’s not just the events themselves that can provide profits; each such event can produce a whole host of new securities with their own extraordinary investment potential.
The great thing is, there’s always something happening.
Dozens of corporate events each week, too many for any one person to follow. But that’s the point: you can’t follow all of them, and you don’t have to. Even finding one good opportunity a month is far more than you should need or want.
There are no flaws in the investment methods of Warren Buffett or Peter Lynch. The problem is that you’re not likely to be the next Buffett or Lynch. Investing in great businesses at good prices makes sense. Figuring out which are the great ones is the tough part. Monopoly newspapers and network broadcasters were once considered near-perfect businesses; then new forms of competition and the last recession brought those businesses a little bit closer to earth. The world is a complicated and competitive place. It is only getting more so. The challenges you face in choosing the few stellar businesses that will stand out in the future will be even harder than the ones faced by Buffett when he was building his fortune. Are you up to the task? Do you have to be?
→ Finding the next Walmart, McDonald’s, or Gap is also a tough one. There are many more failures than successes. Using your own experiences and intuition to choose good investments is excellent advice.
→ Graham figured that if you owned twenty or thirty of these statistical bargains, you didn’t need to do extensive research. You don’t. Reading and studying Graham’s work is how I first became fascinated with the stock market.
→ It’s just that if you are willing to do some of your own work, pick your spots, and look in places where others are not looking, you can do significantly better than Graham’s more passive method.
Although most people take comfort in crowds, this is not where successful investors generally look for good investment ideas.
Keep this concept in mind as you read through the next several chapters. It’s great to look for investments in places others are not, but it’s not enough. You also have to look in the right places. If you preselect investment areas that put you ahead of the game even before you start, the most important work is already done. You’ll still have plenty of decisions to make, but if you’re picking and choosing your spots from an already outstanding menu, your choices are less likely to result in indigestion.
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Q: Is it possible that just by picking your spots within the spinoff area, you could achieve results rivaling those of investment greats like Buffett?
A: Nah, you say. Something’s wrong here. First of all, who’s to say that spinoffs will continue to perform as well in the future as they have in the past? Second, when everyone finds out that spinoffs produce these extraordinary returns, won’t the prices of spinoff shares be bid up to the point where the extra returns disappear? And finally— about these results even greater than 20 percent— why should you have an edge in figuring out which spinoffs have the greatest chance for outsize success?
Of course, spinoffs will continue to outperform the market averages—and yes, even after more people find out about their sensational record. As for why you’ll have a great shot at picking the really big winners—that’s an easy one—you’ll be able to because Book will show you how. To understand the how’s and the why’s, let’s start with the basics. Why do companies pursue spinoff transactions in the first place? Usually, the reasoning behind a spinoff is fairly straightforward:
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Why do companies pursue spinoff transactions in the first place? Usually, the reasoning behind a spinoff is fairly straightforward:
→ Unrelated businesses may be separated via a spinoff transaction so that the separate businesses can be better appreciated by the market.
→ Sometimes, the motivation for a spinoff comes from a desire to separate out a “bad” business so that an unfettered “good” business can show through to investors.
This situation (as well as the previous case of two unrelated businesses) may also prove a boon to management. The“ bad” business may be an undue drain on management time and focus. As separate companies, a focused management group for each entity has a better chance of being effective.
→ Sometimes a spinoff is a way to get value to shareholders for a business that can’t be easily sold.
Occasionally, a business is such a dog that its parent company can’t find a buyer at a reasonable price. If the spinoff is merely in an unpopular business that still earns some money, the parent may load the new spinoff with debt. In this way, debt is shifted from the parent to the new spinoff company (creating more value for the parent). On the other hand, a really awful business may actually receive additional capital from the parent— just so the spinoff can survive on its own and the parent can be rid of it.
→ Tax considerations can also influence a decision to pursue a spinoff instead of an outright sale.
→ The initial excess supply has a predictable effect on the spinoff stock’s price: it is usually depressed. Supposedly shrewd institutional investors also join in the selling. Most of the time spinoff companies are much smaller than the parent company. A spinoff may only be 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spinoff’s business, often the size of these companies is too small for an institutional portfolio, which only contains companies with much larger market capitalizations.
Why Spinoff Gives high Returns
One last thought on why the spinoff process seems to yield such successful results for shareholders of the spinoff company and the parent: in most cases, if you examine the motivation behind a decision to pursue a spinoff, it boils down to a desire on the part of management and a company’s board of directors to increase shareholder value.
You don’t need special formulas or mathematical models to help you choose the really big winners. Logic, common sense, and a little experience are all that are required. That may sound trite but it is nevertheless true. Most professional investors don’t even think about individual spinoff situations. Either they have too many companies to follow, or they can only invest in companies of a certain type or size, or they just can’t go to the trouble of analyzing extraordinary corporate events.
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Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spinoff than to palm off some of the parent company’s debt onto the spinoff’s balance sheet?
When you’re “digging” with an exciting goal in sight, the nature of the task changes completely. The same thinking applies here. it all boils down to a simple two-step process. First, identify where you think the treasure (or in our case the profit opportunity) lies. Second, after you’ve identified the spot (preferably marked by a big red X), then, and only then, start digging.
Spinoffs Required Patience, it isn’t an easy lottery
If you have an impatient nature and are partial to fast action, waiting around for spinoffs to play out fully may not be for you. Horse racing never succeeded in Las Vegas because most gamblers couldn’t wait the two minutes it took to lose their money.
The financial markets have also been known to accommodate those who prefer instant gratification.
On the other hand, having the time to think and do research at your own pace and convenience without worrying about the latest in communication technologies has obvious advantages for the average nonprofessional investor.
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The First thing to check in the spinoff
As my first move with any of these filings is to check out what the insiders— key management and/ or controlling shareholders— are up to, it was nice to see part of the answer right on the first page following the introduction. Under the heading“ Reasons for theDistribution,” the Board of Directors of Briggs revealed the primary reason for the spinoff.
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1st Case Study Strattec
As primarily a manufacturer of locks and keys for new automobiles and trucks, Strattec, according to logic and the Form 10, fell under the category of the original-equipment manufacturer (OEM) for the automobile industry.
The next logical step was to find out at what price most other companies in the same industry traded relative to their earnings. Very simply, if all the OEM suppliers to the auto industry traded at a price equal to 10 times their annual earnings (i.e., at a price/ earnings ratio or P/ E of 10), then a fair price for Strattec might end up being $ 11.80 per share ($ 1.18 multiplied by 10).
While all of this analysis was fine and dandy, unless Strattec started trading at $ 6 or $ 7 a share due to intense selling pressure, I wasn’t going to get rich from anything discussed so far. Further, I didn’t know much about Strattec’s industry, but I did know one thing. Supplying parts to auto manufacturers is generally considered to be a crappy business.
The interesting part came when I was reading the few pages listed under the heading of “Business of the Company.” This was not hard to find. It turned out that Strattec was by far the largest supplier of locks to General Motors, and that this business represented about 50 percent of Strattec’s sales. Strattec also provided almost all of Chrysler’s locks, and this business totaled over 16 percent of Strattec’s total revenues. From this, I guessed that Strattec must be pretty good at making car
Certainly, if I did decide to buy stock in Strattec, Warren Buffett was not going to be my competition. (Actually, as a general rule, Buffett won’t even consider individual investments of less than $ 100 million; here the entire company was going to be valued at less than $ 100 million.)
In short, it was easy to buy shares in Strattec at a very attractive price. This was confirmed as Strattec traded to $18 per share before the end of 1995—a 50 percent-plus gain in less than eight months. Not too bad—and fortunately, far from an unusual spinoff opportunity
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2nd Case Study: Home Shopping Network
According to the article, Home Shopping had plans to spin off its broadcast properties “to improve the quality of earnings.” What this meant, I would find out later. It certainly looked like both the parent company, Home Shopping Network, and the spinoff, Silver King Communications, was worth some more study.
Management believes that the financial and investment communities do not fully understand how to value HSN [Home Shopping Network], in part because HSN is both a retail-oriented company and a broadcast company. Broadcast companies are typically valued based on cash flow while retail companies are typically valued on an earnings-per-share basis.
Figuring out the proper earnings multiple (P/ E ratio) for the combined businesses was very difficult. According to the filing, the retail business should be valued based on a multiple of earnings, the broadcaster on a multiple of cash flow.
Of course, you wouldn’t know that HomeShopping’s broadcast division was such a big cash generator merely from looking at earnings. The broadcast properties contributed only $ 4 million to operating earnings, but as we’ve already seen, they added over $ 26 million to Home Shopping’s operating cash flow.
I didn’t buy Silver King anticipating this particular series of events. However, buying an ignored property at a low price allowed a lot of room for good things to happen and for value to be ultimately recognized.
The combined value of Home Shopping Network stock and the spun-off Silver King shares created a one-day gain of 12 percent for HSN shareholders. No matter what the academics may say about the efficiency of the stock market, clearly, there are still plenty of inefficiently priced opportunities available— to investors who know where to look, that
Excerpts and Learning from Articles/Blogs
AIKYA 2022 Letter (Art and Science of Downside Protection)
When times are good, and share prices are rising, most companies appear to be of high quality. Both managers and investors tend to overlook the sources of downside risk and instead get seduced by ever rosier expectations of the future. It is only when bad times arrive that the true resilience and quality of a company is tested. Many risks seen as low probability before, become real, while sources of future upside disappear. As the passage quoted above illustrates, the human brain is not designed to correctly weigh probabilities and assess future downside risks.
portfolio of well-managed high-quality businesses is likely to compound capital irrespective of what happens to the economy, as strong businesses tend to get stronger with every downturn.
Farnam Street Letter to Shareholder
What determines your returns are two things:
1. The results of the business.
2. The excitement of people about that business’s future prospects.
More accurately, it’s the change in those variables over your measurement period that will dictate your return experience.
1 Main Capital Letter
In his 2020 paper, Behavioral Finance and the Sources of Alpha, Russell Fuller outlines three primary areas where investors can gain an edge in investing: informational, analytical, and behavioral. The first two sources of edge relate to forming better forward expectations than the market. The third involves capitalizing on the behavioral inefficacies of other market participants
Informational edge involves getting better data faster than others. It continues to get competed away with each passing year.
Analytical edge can be thought of as interpreting readily available information better than others. It involves evaluating multiple quantitative and qualitative factors, such as industry dynamics, business trends, and management actions, all of which influence the performance of a company and the value of its equity.
Behavioral edge comes from being unconstrained, staying rational and investing with a true long-term orientation. There are many institutions that are forced to abide by inflexible mandates, such as only investing in high growth or low multiple stocks or selling a stock if a company stops paying a dividend or falls below a certain price
To elaborate, I don’t believe that it is rational to sell stocks based on the worry of every imminent economic slowdown, especially without having a strong view on the duration or magnitude of such a slowdown.
None of the rational people I know look to sell their house and plan to buy it back in 2-3 years just because they think a recession is coming. My father-in-law, who is a dentist, has never talked about selling his practice for a few years and buying it back when the economy is on a more stable footing. However, this is exactly what many stock market investors try to do each time there are headlines of a looming slowdown
While I am always thinking about, evaluating, and re-underwriting each of our investments in real-time and on a continued basis, there are times when the near-term outlook is uncertain simply because of economic factors rather than business-specific ones. During these times, I strive to hold companies that are best positioned for the medium and long term, rather than worry about the next few quarters of reported earnings.
The problem with selling each time we worry of a pending slowdown is that sometimes one won’t come and by the time it becomes obvious, the prices of stocks, goods, and services will have increased meaningfully. In that case, the purchasing power of cash is permanently impaired.
Mind Over Math
What about these stories from the investing world? Sound awesome, don’t they? We believe in people who tell us that it’s possible to do in a month what the ‘Alpha Investor’ has done annually over the last seven decades. We get carried away thinking we will get what they got.
It’s a trap. While a bit of luck and a large amount of the unknown can create super-outcomes, there is no known method to madness. No shortcuts to ultra-results.
Numbers don’t mean anything in isolation. Investors fixated on the most recent performance of a fund, for instance over the last one or two years, are mistaking themselves with randomness. It takes at least a month to even start a start-up in India, let alone get the first sizeable sales number under the belt.
Equity investors on the other hand focus on what’s happening today rather than focussing on what I call the ‘Investment Biomarkers’.
There is ample evidence that manager performance is cyclical. Investors end up chasing the top funds because it’s our nature to believe that what has happened recently and is happening today will continue forever. It doesn’t.
Small Video Clips
Proxy Investing: How S Naren picked Metal over Auto and Consumer durable which delivers decent returns for him (10:54 To 12:33)
The insurance sector isn't penetrated, Actually, it's over penetrated (Sridhar Shivaram, Enam) (09:36 to 12:22)
4 Kinds of risk in Investing (Amit Jeswani) (17:02 to 19:08)
Market Bottomed out on worst news :) (25:31 To 26:48)
A good investment framework inspired by Rakesh Jhunjhunwala (with an example of Praj) (9:48 to 15:05)
Long term Benefits of reading (19:14 to 20:58)
Don't sell just because one quarter went wrong or something temporary incident happened (26:52 to 29:14)
Should you trust the company's number 100%? (41:33 to 43:34)