25 July 2014 – The Aleph Blog

Balancing Quality Against Valuation

Posted on 25 July 2014 by David Merkel

A letter from a reader:

Hi David,

I am XXX, from India. I started reading your blog since few months. Few of the things i learnt, and much more are really complex for me to understand, the learning is ON.

Somehow i decided that ” being good value investor and control the behaviour” is a gift of long practice and learning. So it takes time and for me the learning is still in lower phase. I am in middle of understanding Financial statements.

But before that i want to invest and enjoy the power of compounding. Till now i used Mutual Fund, Fixed Deposit (bank) for my wealth creation. As part of my milestone, i want to go ahead with shares for my Kids education and retirement.

I like to Buy Consumer staples like Nestle india, Gillete India, Glaxo Smith?india which are past compounders.?Given a India’s Economic growth and Population growth, I foresee these socks can do well. But it is already at very high PE (Nestle – 42, GSk consumer- 39, GSK pharma – 52, Gillette -141). I don’t foresee any panic selling on these stocks. What i will do? how i do buy Quality business with good valuation?

Kindly guide.

thanks for sharing such wonderful posts.

Dear Friend,

You have described the optimal situation: buy businesses that have well-protected boundaries, and buy them cheap. ?I wish I could do that. ?Everyone would like to do that.

But that is where judgment comes in. ?I would rather own cyclical businesses with competent and honest management ?teams, than own high growth businesses at very high multiples of earnings. ?I would also rather own slow growth businesses at modest multiples of earnings. ?Ask yourself: where am I getting a reliable stream of earnings and growth relative to what I am paying for the stock?

In general, with growth stocks, never pay more than 2 times the earnings growth rate ?for the P/E of the company.

Often you have to look at companies that are neglected, and I would like to recommend a book to you:?Investing in India. ?The author avoids highly valued companies in India, and aims to invest in companies that are fair to outside minority, passive shareholders.

Look at more stocks than just the highest quality stocks, and look at the valuation tradeoff between highest quality stocks, and lower quality stocks. ?Most value investors accept the lower quality stocks, if their ability to produce value relative to their price is better than that of higher quality stocks.

All that said, part of the question is how long will the high quality stocks have a significant advantage. ?In the US, on average, that advantage has not been long. ?Maybe things are different in India, but maybe not. ?Be careful. ?Remember, the cardinal virtue of value investing is having ?a margin of safety, not cheapness.

Sincerely,

David

Book Review: Panic, Prosperity, and Progress

Posted on 25 July 2014 by David Merkel

I love economic history books, and I believe that most investors should read economic history. ?History offers a broader paradigm for analyzing investment situations than mathematical models do.

Mark Twain is overquoted on this, but only because he deserves to be quoted:
?History doesn’t repeat itself, but it does rhyme.?

You can get a lot of insights into the present by reading this book. ?So many disasters occurred because people presumed that the future would be much like the past, and they ended up being the ones that took the large losses.

Further, this book will point out that how an asset is held will make a difference in its future performance. ?When there is not a lot of debt behind an asset, there may be good prospects. ?But when there is a lot of debt behind an asset, prospects are not so good because those that own the asset are relying on the asset to perform. ?Those who own an asset free and clear may get hurt if the price falls, but they won’t be ruined like the guy who has borrowed to own it.

This book takes on every major systemic crisis from the Tulip Bubble to the recent Housing/Banking crisis. ?This is my bread & butter, but I learned things in many of the chapters regarding things I thought I knew well. ?Truly, a great book.

What Could Have Made the Book Better

Financial crises don’t appear out of nowhere. ?Leaving aside war on your home soil, plague, famine, communism, etc., there is usually a boom that gives way to a bust. ?In some of his chapters, he could have spent more time describing the boom that led to the bust. ?This is important, because readers need to learn intuitively that the boom-bust cycle is normal. NORMAL!

Ignore the economists who think they can control the economy. ?They can’t do it, and this book helps to say that. ?Economists are always behind the curve. ?Politicians are even further behind the curve. ?Regulators are still further behind the curve, and usually do the wrong thing during crises as a result.

The author could have done more to suggest how individuals and policymakers should respond to financial crises. ?Better to have a book that advises us, than one that just reports.

Quibbles

On pages 421-422, he shows that he doesn’t get securitization, and blames the rating agencies, who were forced to rate novel debt for which they did not have a good model because the regulators outsourced credit risk measurement to them.

Summary

Most people would benefit from this book. ?It will teach you about financial crises and their aftermath. ?If you want to, you can buy it here:?Panic, Prosperity, and Progress: Five Centuries of History and the Markets (Wiley Trading) (Hardback) – Common.

Full disclosure: The PR flack?asked me if I would like a copy and I said ?yes.?

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.