Tweaks to our investing framework

The headline first.

“There is no change to the basics of our investing approach.”

Our investing approach consists of

• Investing only with Promoters / Managers who have the best interests of shareholders at heart and who are competent in the business that they run.
• Investing in businesses where the underlying characteristics are good. These are, limited competition and pricing power which ultimately is shown by high return on capital employed.
• Limited use of leverage in the non banking / financial businesses we own.
• A good potential for growing the business is usually a positive provided it can be done in a capital efficient manner.
• Buying at attractive valuations.

Investors who do not care for the nuances may ignore this post completely.

For investors who wish to look under there hood, there are some tweaks we have made to our investing approach.

1. Change in the way we look at Dividends

The tax laws have changed over time. A sole proprietor and a partnership firm pay tax at let us say 30% and that is the end of the matter. A company however, apart from this tax of say 30% has to pay an additional tax each time it distributes its earnings. We have a dividend distribution tax of say around 20%.

A consequence of this tax policy is that the effective tax rate for a dividend paying company is higher than that of a company which retains the earnings to re-invest. Consequently we are explicitly bumping up the tax rate for dividend paying companies when we calculate the valuations of the companies that we own.

Our preferred order of capital allocation by our investee companies is as follows:

• Re-invest in own or allied line of businesses
• Invest in a new line of business (discussed in point number 3 below)
• Undertake share buybacks (discussed in point number 2 below)
• Pay dividends (not preferred really now, this is contrary to our older approach and at variance with what our founder once wrote)

Some of the companies that we own, do not pay dividends (Alphabet Inc, Facebook Inc, Amazon Inc) and we are happy with that. We would be happier if some of our other investee companies eliminated dividends (say HDFC Bank) given that they have to periodically issue additional shares. It would be more efficient to retain the earnings and issue fewer shares.

2. Change in the way we look at Share Buybacks

The gospel for share buybacks has been that they are good if the shares are significantly undervalued and should not be done otherwise.

Many share buybacks have been criticised for mopping up the additional share dilution on account of ESOPs.

While there is merit in the argument of not issuing ESOPS at lower prices and buying back at higher prices, the fixation on the valuation is misplaced in our opinion.

A share buyback where all shareholders participate proportionately is economically no different as compared to a dividend. It is just more efficient.

We would prefer companies undertaking share buybacks.

3. Change in the way we look at Conglomerates

Conglomerates have been universally treated by analysts as a bad word. There is even a terminology for the valuation fall this results in called the “Conglomerate Discount”. The legendary investor Peter Lynch has also coined a word “Di-Worsefication” for this tendency to get into unrelated businesses.

There are plenty of vivid examples of wealth destruction. Say a liquor group getting into airlines.

There are however equally vivid examples on the other side. Berkshire Hathaway, Alphabet, Tata Group and Bajaj Auto (prior to the finance division spin off) are examples. Wipro would have remained Western India Vegetable Products Ltd. if the promoter had taken the advice against diversification too seriously.

One consequence of analysts hating conglomerates is that some conglomerates may end up being under-researched as the company may not neatly fall into one sector / analysts coverage area.

We view conglomerates as neither inherently good nor inherently bad. A conglomerate can be wealth creating or it can be wealth destroying. We will evaluate each company on its own merits.

4. Recognition of the concept of capacity to suffer

There are brilliant articles / talks by Thomas “Tom” Russo on the capacity to suffer. A brief idea can be had by accessing the following link https://bit.ly/2LiCFJi

Many a decisions by the managements of the companies in our investee companies may be wealth accretive in the long run and may depress current reported earnings. We will try and not penalise such decisions and look through the current reported earnings to try and understand true long term cash flows / value.

5. Side-bets in the Startup space

Increasingly the world is changing at a fast pace. A lot of the nimble companies begin as start ups and stay unlisted till the time a lot of value capture has happened and only then go on to list on the stock exchanges.

We have no competence to invest in the start up space. Some of our investee companies are investing small amounts (relative to the overall company balance sheet) in startups in areas where they have expertise and this is resulting in a positive impact on our investment returns.

We are happy where our investee companies are taking such efforts to sacrifice small near term earnings to get a large upside potential from some of these startups.