Investing in Quality Businesses & the Art of Lifelong Learning w/ Gautam Baid (TIP566)

Companies with negative working capital operating on other people's money can be identified by looking for the line item 'Advances from Customers' in annual reports, indicating that customers pay upfront before product or service delivery, which signals something very special is taking place in that business.

“And how can you identify such companies as a research analyst or a fund manager? Look for an item titled 'Advances from Customers.' When you're reading through the annual report, look for this particular item: any companies receiving advances upfront from the customer before delivering the product or service. It indicates that the business is operating on negative working capital, and there is something very special taking place in that particular business.”

Quality stocks are like tennis balls that bounce back and make new highs after falling, whereas junk stocks are like eggs that splatter and never recover, making how much you recover after a bear market far more important than paper profits made during bull markets.

“Ensure that you have tennis balls, which are high-quality businesses, rather than eggs, which are bad-quality junk stocks that splatter after they fall onto the floor... Both quality and junk stocks fall, but quality eventually recovers and goes on to make new highs, whereas junk stocks lie low for many years and never recover.”

The stock market is untreatable because it is a complex adaptive system with trillions of moving parts, and applying the Buffett-Munger test of whether something is both knowable and important shows that where the stock market is headed, the economic trajectory, and future interest rates are important but unknowable, making macro forecasting a waste of time for investors.

“It is because the stock market will always be untreatable because it is a complex adaptive system. It's trillions of moving parts in it, and the way Buffett and Munger tackle a decision, you know, when they are tackling a challenge or a problem and making a decision, they ask themselves a simple question: Is it knowable? And is it important? So where the stock market is headed, which way the economy headed, what is the trajectory of future interest rates? All of these are important but unknowable.”

A high-quality business has three fundamental attributes: return on capital employed far above the cost of capital, a strong competitive advantage or moat to sustain higher returns on capital for a long period, and sufficient reinvestment opportunities within itself at higher returns on capital to become a compounding machine.

“Number one, the business has to be earning. The return on capital employed should be far above the cost of capital... Number two, the business has to have a strong competitive advantage or what Buffet calls a 'moat'... And number three, and most importantly, the business has to have sufficient reinvestment opportunities within itself at higher returns on capital. This is how the business becomes a compounding machine.”

Developing a conducive learning environment requires being away from distractions of business noise, television, social media, and digital media; embracing digital minimalism to develop a long attention span and focusing on books, essays, and long-form articles rather than tweets and short posts enables deep understanding.

“You know, first we shape our environment, then our environment shapes us, right? So it's very important to be away from all the distractions of, you know, the business, television noise, the social media noise, and all the digital media noise... embrace what is known as digital minimalism. So basically, you try to develop a long attention span... Focus on developing a long attention span and focus more on reading books, essays, and long-form articles rather than tweets and, you know, short posts, because you want to develop a deep understanding of any subject.”

Historically, the probability of making money from stocks trading at more than 100 times price-to-earnings multiple on a one-year forward basis has been very, very low, so investors should place significant emphasis on base rates and use reverse discounted cash flow analysis to inform exit decisions when valuations lack margin of safety.

“Historically, the probability of making money from stocks trading at more than a hundred times price-to-earnings multiple on a one-year forward basis has been very, very low. As an investor, I always strive to tilt the odds in my favor as much as possible. That's what investing is all about—a probabilistic bet on what the future holds, right? So, I place a significant emphasis on base rates.”

If entering into a high-growth business at the introduction stage or early growth stage with a long runway for growth ahead (18+ years), even paying a very high price-to-earnings multiple still results in substantial profits because high growth bails out valuation contractions, but entering at the decline phase leads to sharp P/E de-rating and permanent loss of capital.

“If you're able to enter into a high-growth business at the introduction stage or between the introduction stage and the growth stage, and you have a long runway for growth ahead for the next 18 years, even if you pay a very high P multiple (a lot of price-turning multiple), you still end up making a lot of money in such stocks because in such businesses, the high growth tends to bail you out, even if the valuation contracts a bit along the way. But if you're entering into such highly valued stocks just when they're about to enter into a decline phase, that is when the sharpest pace of P/E de-rating happens.”

When economies transition from low per capita income countries to middle-income countries, basic spending on food doesn't increase much, but spending on branded discretionary consumption and financialization of savings explodes — these two categories have driven stock market outperformance in US, Japan, and China as their GDPs doubled.

“when any nation transitions from a low per capita income country to a middle-income country, the basic spending on items like food does not go up much, but the spending on branded discretionary consumption and financialization of savings, these two categories simply explode... you want to position your portfolio for long-term success by having a high allocation of these two particular themes: branded discretionary consumption and financialization of savings.”

Many people achieve success in investing, but sustaining success and building on it over an entire lifetime requires a sense of gratitude, a constant learning mindset, and a sense of humility.

“In my book, I've read that jobs are compounding. I've written that many people achieve success, but to sustain the same and build on it over an entire lifetime requires a sense of gratitude, a constant learning mindset, and a sense of humility. It's very, very important.”

No company or business is 100% great or 100% bad; investors must never think in terms of black or white but rather in shades of gray, think probabilistically rather than deterministically, and always seek mispriced gambles where one gets more value for the price being paid with the lowest amount of risk.

“No company or business is a hundred percent great, and no company or business is a hundred percent bad. Never think in terms of black or white in the investing field. Always think in shades of gray. Don't think deterministically; think probabilistically... You want to get more value for the price being paid, the lowest amount of risk. And at the end of the day, unknown unknowns keep happening in any industry or business.”

By prudently diversifying across risk factors and sectors, if one can survive in the market game for the long term, the force of capitalism is so strong that one cannot help but become rich over time because of the power of compounding.

“So how do you tackle that? You prudently diversify across risk factors and sectors. That is the approach you have to take. If you can just survive in this game for the long term, the force of capitalism is so strong that you can't help but become rich over time because of the power of compounding.”

The stock market is designed to exploit investors' biggest weaknesses of greed and fear, which is why most people cannot sustain in investing for long enough; success requires a calm and mature temperament, a sense of equanimity toward market fluctuations, and thinking like a businessman rather than a stock analyst.

“But the stock market is designed in such a way as to exploit our biggest weaknesses of greed and fear. That's why most of us cannot sustain in this business for long enough. You have to have a calm and mature temperament and have a sense of equanimity towards market fluctuations. Focus on the business and think like a businessman, not as a stock analyst.”

You have to reinvent yourself by unlearning, relearning, and learning about new industries to outperform the rest; the investment profession is a highly competitive intellectual sport where you have to be a learning machine all the time.

“It's not about blending again; you have to unlearn, relearn, and reinvent yourself. You need to start learning about many new industries in order to outperform the rest. The investment profession is a highly competitive intellectual sport, and you have to be a learning machine all the time.”

Super-normal profits are earned by companies that are leaders in their industry with little or no competition, and the best form of competitive advantage is to have no competitor in the customer's mind through brand recall so strong that it is very difficult to recall the next closest competitor.

“What matters for successful investing is not how fast a particular industry is going to grow. What matters is if you can identify pockets within the value chain of that industry that have supply-side dominance... And why is that? It's because competition acts as friction for value creation, and the best form of competitive advantage is to have no competitor in the customer's mind.”

As the world tries to shift away from China and build a reliable second supplier source, India is becoming a preferred partner through specialty chemicals with critical applications, driven by the 'China Plus One' strategy.

“Specialty chemicals with critical applications led by China Plus One. As the world tries to shift away from China and build a reliable second supplier source, India is becoming a very preferred partner for many foreign companies.”

What matters for successful investing is not how fast a particular industry is going to grow, but rather identifying pockets within the value chain of that industry that have supply-side dominance, where companies have dominant market share and face little or no competition.

“What matters for successful investing is not how fast a particular industry is going to grow. What matters is if you can identify pockets within the value chain of that industry that have supply-side dominance. You want to look for companies that have dominant market share and face little or no competition.”

Investors should always remain humble; the moment success gets to one's head and one starts thinking of oneself as a master of the universe, one lets down one's guard and forgets the basic tenets of investing taught by Benjamin Graham.

“And you know, the best investors know this ever after a recent big win. That is when basically we let down our guard and we forget the basics of investing, the basic tenets of investing, which Benjamin Graham has taught us in The Intelligent Investor. So those three fundamentals should never be forgotten, and we should always be humble, grounded, and take a long-term approach.”

Constantly seeking dopamine rushes through checking email, social media likes and retweets, or external validation leads to short-term thinking and fear of missing out, which should be avoided in favor of reinforcing fundamental investing principles through repeated reading and study.

“If you're constantly trying to get those dopamine rushes by checking your email or checking social media for likes and retweets, or trying to look for social external validation, that is when you basically fall prey to short-term thinking and form fear of missing out.”

The investment process used when managing a fund needs to be replicable, repeatable, and scalable to build a scalable investment architecture that ensures successful investment firm building while taking care of clients' interests.

“The investment process that you select when you're managing a fund needs to be replicable, repeatable, and scalable. Because you want to basically build a scalable investment process, a scalable investment architecture, because that is the way you build a successful investment firm, while taking care of your clients' interests at the same time.”

History teaches that for any sustained long-term bull market, you need a revival of the capital expenditure cycle; in India right now both the credit growth engine and CapEx cycle revival are firing up simultaneously.

“history teaches us, Clay, that for any sustained long-term bull market, you need a revival of the CapEx cycle. So here you have the twin engines of credit growth firing up the GDP and the CapEx cycle revival firing up the stock market. So, both these factors are aligning in India right now.”

The investment industry has become more of a marketing industry focused solely on garnering assets under management (AUM) and earning hefty management fees, with zero downside risk for fund managers regardless of performance, leading to sub-standard investor results where only the hedge fund manager becomes rich while clients remain poor.

“The investment industry has become more of a marketing industry with the sole objective of garnering AUM (assets under management) and earning hefty management fees. And since there is no skill in the game in most cases by the fund manager, there is zero downside risk. So basically, you're just getting paid through management fees irrespective of performance... As a result, only the hedge fund manager becomes rich, but not the clients who are supposed to become rich.”

As a fund manager, there are three fundamental differences compared to managing a personal brokerage account: heavy emphasis on quality investments, heavy emphasis on prudent diversification, and careful selection of high-quality service providers to ensure disruption-free operations.

“As a fund manager, there are three fundamental differences compared to managing your personal brokerage account. Money. As a fund manager, you put a heavy emphasis on quality. You put a heavy emphasis on prudent diversification, right? And you also make sure that the service providers which you select for your fund are of very high quality.”

The banking system credit is one of the biggest drivers of GDP growth in any country; between 2011 and 2020, Indian banking was plagued by non-performing assets and asset quality issues that constrained lending and slowed growth, but recent banking reforms have cleaned up balance sheets, and corporate India has improved its balance sheet and reduced debt, positioning both for fresh credit growth and CapEx revival.

“One of the biggest drivers of GDP growth in any country is the banking system credit. Credit is the driver for growth in any country, right between 2011 and 2020, the Indian banking system was plagued by a plethora of bad asset quality issues... But because of a series of banking reforms in India over the last many years, the banking system's balance sheet has been cleaned up, and now they're very enthusiastic about lending again. At the same time, corporate India has greatly improved its balance sheet and reduced debt over the last decade, and they're primed for a fresh round of CapEx.”

The incentive structure of macro forecasters is broken — major media outlets perform forecasts to drive clicks, and forecasters have no personal incentive to be accurate since they don't lose money if wrong, unlike investors who have skin in the game.

“understanding the incentive structure of the people, you know, performing market forecasts. Maybe it's some major media news outlet trying to drive clicks.”

Pricing power comes when the brand becomes synonymous with the product category itself, as exemplified by Jockey for underwear in India, Royal Enfield for leisure biking, Symphony for air coolers, or Xerox for photocopying in its heyday.

“And where does pricing power come from? It happens when the brand becomes synonymous with the product category itself. Look at Jockey for underwear in India, Royal Enfield for leisure biking, or Symphony for air coolers, or Xerox for photocopying in its heyday. The brand has to become synonymous with the product category. That's when you get pricing power.”

Businesses earning below their cost of capital destroy shareholder value over time because intrinsic value reduces with each passing day, forcing them to rely on external capital markets for financing and becoming vulnerable to capital access disruptions.

“Because the moment you invest in a lower quality business that is earning below its cost of capital, even though that business may be growing fast, it ends up destroying shareholder value because the intrinsic value reduces with each passing day. Any business that earns less than its cost of capital is actually destroying shareholder value over time.”

Warren Buffett used a highly principled approach during his Buffett Partnership days characterized by sincerity, integrity, authenticity, and honesty, charging zero management fees, a 6% cumulative compounding hurdle rate with high watermark provision, and 25% incentive performance fee on returns over 6%, which Gautam replicated but improved by lowering performance fee to 20% to maximize net investor returns.

“Buffett used to charge zero management fees, a 6% cumulative compounding hurdle rate with a high watermark provision. A high watermark is simply the previous all-time closing high on an annual closing basis that the fund NAV has reached. And finally, he used to charge 25% of incentive performance fee on returns over 6%. AB gone one Step further an improved upon the Buffet partners FP structure by lowering the performance incentive fee from 25% to 20% in order to maximize the net realized returns for my investors.”

Charlie Munger has reoriented his mind to experience dopamine kicks through learning new things rather than through external validation, and all investors should embrace this attitude and develop a love for learning and reading.

“Charlie Munger, very smartly, has reoriented his mind to experience dopamine kicks, pleasure chemicals released in his brain, by learning new things. I believe all of us should embrace that kind of attitude and develop a love for learning and reading.”

Berkshire Hathaway had to evolve decade after decade as different competitive forces emerged; Buffett wouldn't have bought Apple or Coca-Cola in his early partnership days but had to learn new things with Munger's help, demonstrating the necessity of continuous learning even for the greatest investors.

“Berkshire Hathaway had to evolve decade after decade. When Buffett first started his partnership, he probably would have been upset if he had bought a company like Apple or Coca-Cola. He had to learn new things along the way and have Munger help him out.”

Companies with staying power tend to have higher longevity and longer duration of cash flows, resulting in higher intrinsic value over time.

“Companies with staying power tend to have higher longevity and longer duration of cash flows, resulting in higher intrinsic value over time.”