How to Make Life-Changing Returns in Commodities, Cyclicals, & Spinoffs | Gautam Baid (TIP544)

Introduction

Clay Finck introduces the podcast and explains that he will be covering Gautam Baid’s book, The Joys of Compounding. He also mentions that most chapters in the book are standalone.

Recap of Previous Episodes

Clay Finck recaps the previous episodes where he covered personal development, philanthropy, good karma, achieving financial independence, assessing management teams and more.

Chapters 15-21 Overview

Clay Finck provides an overview of the topics covered in chapters 15-21 which include journaling as a tool for self-reflection, understanding incentives, avoiding value traps, investing in commodity sectors and spinoffs.

Chapter 15: Journaling as a Powerful Tool for Self-Reflecting

Gautam Baid discusses how our memories are mostly fiction because our brain is continually optimizing and conserving energy. Clay Finck explains how journaling can help us record why we made certain decisions and analyze what we got wrong.

• Reconstruction of memories happens every time we access it.

• Journaling allows us to make quality decisions by recording why we made certain decisions.

• Having a notebook that tracks all important decisions helps identify flaws in thinking.

• A journal helps avoid hindsight bias by allowing continuous learning from mistakes.

Conclusion

Clay Finck concludes the episode by discussing planning fallacy which leads to overly optimistic forecasts.

Investigating Bad Outcomes Before They Happen

This section discusses the importance of investigating potential bad outcomes before making an investment.

Prospective Hindsight Technique

• The prospective hindsight technique involves visualizing a year after purchasing a stock and imagining that you have lost money on your investment.

• Value investors always consider potential downside risks when evaluating an investment.

• When making an investment, ask what can go wrong, what are the risks, how likely are they, how big are they, and can you bear them if they come true.

Journaling as a Thinking Tool

• Journaling is a useful tool for retaining what we've read and deepening our understanding.

• Writing aids self-reflection and improves memory.

• An added benefit of journaling is that it deepens commitment to making good things happen in our lives.

Never Underestimate the Power of Incentives

This section discusses the power of incentives in shaping behavior and decision-making.

Understanding Incentives

• When someone is selling something, consider their incentives for doing so.

• People follow incentives like ants follow sugar.

• The iron rule of life is that you get what you reward for.

Unintended Consequences of Incentive Systems

• Ignoring second or third-order effects of incentive systems often leads to unintended consequences.

• An example is monetary rewards offered to help exterminate unwanted animals such as rats and snakes. Authorities failed to foresee that people would start breeding these animals.

Understanding the Power of Incentives

This section discusses how incentives can be a powerful tool in driving behavior and decision-making, but also highlights the potential downsides of misaligned incentives.

The Power of Incentives

• Even those who understand the power of incentives may underestimate their impact.

• Stock options incentivize management teams to maximize short-term earnings, potentially at the expense of long-term sacrifices.

• CEOs with significant personal investments in their company are more likely to be deeply incentivized to give it their all and focus on long-term success.

• Buffett believes that tying compensation to key value drivers is important for aligning interests between management and shareholders.

The Downsides of Misaligned Incentives

• Incentive-caused bias is pervasive across professions, leading individuals to act immorally or make suboptimal decisions due to perverse incentives.

• Incentive-caused bias operates automatically at a subconscious level, leading individuals to believe that what is good for them is also good for clients or customers.

Creating Win-Win Relationships through Incentives

This section explores how understanding incentives can help create win-win relationships in various contexts.

Examples of Misaligned Incentives

• Outsider CEOs may avoid long-term value creation due to pressure from quarterly Wall Street estimates.

• Lawyers may encourage unnecessary litigation, doctors may prescribe expensive drugs instead of generics, contractors may game cost-plus arrangements, and auditors may overlook accounting irregularities due to misaligned incentives.

The Power of Incentives in Creating Win-Win Relationships

• Incentives can encourage desirable behavior and disincentivize undesirable behavior.

• Understanding incentives can help investors make better decisions, such as considering insider ownership in a company.

• Creating a compensation structure that rewards desired behavior can align the interests of employees and employers.

Gautam Baid's "The Joys of Compounding" Book Summary

In this section, Gautam Baid discusses the importance of being wary of firms that advertise their hot funds and create new sector funds to try and sell more. He also emphasizes the importance of achieving financial independence to overcome incentive-caused bias.

Be Wary of Firms That Advertise Hot Funds

• Firms selling funds will likely do whatever they legally can to understate fees.

• Be wary of firms that advertise their hot funds or create new sector funds to try and sell you more.

• Don't invest in a fund just because it has performed well in the past.

• Look for firms that do a good job of educating their clients.

Achieving Financial Independence Overcomes Incentive-Caused Bias

• The best way to overcome incentive-caused bias is to achieve financial independence.

• Financial independence empowers you to see things as they really are.

• Only free people can be honest, only honest people can be free.

Chapter 17: Being Directionally Right with Our Investments

In this section, Clay Finck discusses Chapter 17 from Gautam Baid's book "The Joys of Compounding," which covers the importance of being directionally right with our investments.

Keep Investment Thesis Straightforward

• When purchasing a company, make sure it's obvious and your investment thesis is straightforward.

• Buffett wants to buy a business trading below his assessment of intrinsic value.

• Don't obsess over short-term earnings; focus on finding a big gap between current price and long-term earning power using conservative estimates for margin of safety.

Investing Requires Nuanced Judgment

• Investing is part art and part science, and nuanced judgment is required.

• A spreadsheet can only do so much; it's not useful in modeling things like trust, integrity, goodwill, reputation, or execution capabilities.

• Everyone will have their own approach that they are comfortable with.

The Key to Investing Success

In this section, Clay Finck discusses Gautam Baid's view on the key to investing success.

Behavior Matters More Than Fees or Analytical Abilities

• The key to investing success is not how much you know but how you behave.

• Your behavior will matter far more than your fees, asset allocation, or analytical abilities.

• Recognize your own limitations and skillset.

Calculating Intrinsic Value

• Buffett cautions investors from using precise numbers when calculating the value of a business.

• Focus on the range of potential outcomes and the probabilities assigned to those outcomes.

• Investing is less a field of finance and more a field of human behavior.

Intelligent Investing Is All About Understanding the Intrinsic Value

This section discusses intrinsic value and how it is determined. It also highlights the importance of understanding maintenance CapEx and duration of competitive advantage period.

Intrinsic Value

• Determining intrinsic value is an art form that cannot be achieved by following rigid rules or plugging data into a spreadsheet.

• Intrinsic value is a moving target that changes as fundamental data comes out and investors update their expectations based on knowledge and past experience.

• The intrinsic value of an asset or business is the sum of cash flows expected to be received over its remaining useful life, discounted for time, value, money, and uncertainty of receiving those cash flows.

• Use owner's earnings rather than gap EPS figures when determining earnings figures. Gap earnings can understate earnings figures used to calculate Buffett's owner's earnings amount.

Competitive Advantage Period

• Durability of the moat is the key factor in determining whether a business is worth more than what the market thinks.

• The longer the competitive advantage period, the more likely a business is worth more than what the market thinks.

• Focus should be shifted from entry PE multiples to duration of competitive advantage period.

Maintenance CapEx

• Businesses with high maintenance CapEx should have lower valuation multiples because they require more investment to maintain their current level of operations.

Valuing a Business

In this section, Gautam Baid discusses how to value a business and the importance of understanding capital expenditures within the business. He also talks about how stable operations and cash flows can make it easier to predict future outcomes.

Understanding Capital Expenditures

• Gautam Baid emphasizes that understanding capital expenditures is crucial when valuing a business.

• Stable operations and cash flows make it easier to predict future outcomes.

• Buffett and Munger do not use weighted average cost of capital (WACC), but instead look at opportunity cost perspective.

• Bruce Greenwald instructs students in his classroom to use a 10% discount rate in their calculations.

Intrinsic Value of a Business

This section focuses on calculating intrinsic value for businesses. Gautam Baid explains why he uses a 10% discount rate when calculating intrinsic value, and why it's important to have a range on the company's intrinsic value.

Calculating Intrinsic Value

• Companies with an uncertain future should have higher discount rates than more stable companies.

• Gautam Baid personally almost always uses a 10% discount rate when calculating intrinsic value.

• It's important to put a range on the company's intrinsic value and only purchase businesses trading at the lower end of estimates for margin of safety.

Value Traps

This section covers what are called "value traps" - businesses that look cheap but are actually expensive. Gautam Baid lists four common sources of value traps.

Common Sources of Value Traps

• The first common source of value traps is cyclicality of earnings.

• Many high dividend yield stocks in expensive markets eventually turn out to be value traps and destroy wealth.

• Expensive is expensive for a reason, and cheap is cheap for a reason in the stock market.

• Prices usually move first, and the reported fundamentals follow.

Conclusion

Gautam Baid concludes by cautioning against investing in melting ice cubes and avoiding businesses with wide ranges of potential outcomes.

Final Thoughts

• Avoid investing in melting ice cubes - what appears to be cheap can continue becoming cheaper if industry headwinds intensify.

• Gautam Baid lists four common sources of value traps.

Four Key Risks to Consider When Investing

In this section, Clay Finck discusses four key risks that investors should consider when investing.

Governance Issues

• Unethical managers have a way of siphoning cash from the business, so be wary of businesses run for social purposes or owned by shady promoters.

• Remember that a man who can steal from you will steal from you.

Financial Risk

• Be cautious of companies with high debt levels and those that don't give a high return to investors, as they may even produce negative returns which is destroying value for shareholders.

Market Risk

• The market can be unpredictable and volatile, so it's important to consider market risk when investing.

Margin of Safety

• A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

• Always be conscious of starting valuations when placing bets because eventually valuations that are simply too high will drift back down to more reasonable levels often at the expense of poor intermediate-term performance.

• Our goal as value investors should be to compound at a moderate but steady rate of return over a long period of time. This is vastly superior to generating sharp outperformance for a year or two because these outlier high returns just aren't sustainable and they aren't really reliable.

Investing Without Margin Of Safety: The Nifty 50 Bubble

In this section, Clay Finck talks about the Nifty 50 bubble and how investing without margin of safety can lead to poor performance.

The Nifty 50 Bubble

• The Nifty 50 were a group of premier growth stocks such as Xerox, IBM, Polaroid, and Coca-Cola that became institutional darlings in the early 1970s.

• Many analysts claimed that the only direction they would go is up. Since they had made so many people rich, few if any investors could fault a money manager for buying them.

• However, all of these stocks had proven growth records, continual increases in dividends and high market caps. These last characteristics enabled institutions to load up on these stocks while significantly influencing the price of their shares.

• The Nifty 50 were often called one decision stocks buy and never sell because their prospects were so bright.

Investing Without Margin Of Safety

• One of the classic examples of investing without a margin of safety was those who believed that the Nifty 50 could never go down in the early 1970s.

• Had you bought during the height fees in 1970, Lawrence Hamtil reflected on the Nifty 50 bubble stating that investors should always be conscious of starting valuations when placing their bets. With few exceptions, eventually valuations that are simply too high will drift back down to more reasonable levels often at the expense of poor intermediate-term performance.

• This appears to be true no matter how revolutionary the business appears to be or how much potential you believe it has.

Growth Stocks

• It's easy to buy into the hype of a gross stock but it's incredibly difficult to sit on it for five years or more if the stock is going nowhere while the rest of the market is going up and gross stocks are correcting.

• All fast-growing companies eventually have that growth slow which can lead to a painful transition for investors and potentially even result in something like a lost decade for that stock or that type of industry or sector.

• Remember that a company can do exceptionally well with their growth, but the stock can still go nowhere if you're buying at a really high price.

Investing Success Over Long Periods of Time is Extraordinarily Difficult

Clay Finck and Gautam Baid discuss the difficulty of investing successfully over long periods of time. Only 5% of Indian enlisted companies above a certain size threshold were able to grow their earnings by more than 20% annually, while 55% had earnings decline over the previous decade. A bull market can trick investors into thinking that investing is easy, but one year of big losses can undo many years of good decisions.

The Importance of Not Losing Money

• One single year of a big loss can undo many years of good decisions in the past.

• Buffett's number one rule for investing is to not lose money, and his second rule is not to forget rule number one.

• Many traditional value investors opt for finding value in stocks that are statistically cheap, otherwise referred to as deep value.

• Owning quality businesses is the best form of long-term investing.

Paying Attention to Price When Buying a Business

Clay Finck discusses how paying attention to price when buying a business is crucial. Buffett won't buy unless he's certain there's a large margin of safety in his purchase to make sure he doesn't lose any money. While some investors focus on finding value in stocks that are statistically cheap, others offer growth at a reasonable price and pay up for quality. The investment styles may be different, but the objective is actually the same: both are trying to buy something for less than it's worth.

Paying Up for Quality Businesses

• It's worth paying up a bit for high-quality businesses that compound their capital at high rates of return and have a long runway for growth ahead.

• High-quality businesses can help increase your margin of safety given that you have a long enough time horizon with your purchase.

• When investing in short-term opportunities such as a commodity, a cyclical, or a special situation type play, pay really close attention to the price.

• When investing in long-term opportunities, pay really close attention to the quality of the business and the quality of the management team.

Buffett's Transition from Graham's Cigar Butt Approach

Gautam Baid discusses how Buffett transitioned from Graham's cigar butt approach to Phil Fisher's approach of finding high-quality businesses. The Graham and Dodd investor believed in the concept of mean reversion, while Phil Fisher recognized that there were actually some cases where mean reversion really didn't apply. Benjamin Graham's profits from GEICO exceeded his profits from all of his other investments combined.

Mean Reversion vs. High-Quality Businesses

• It's much better to pay a fair price for a wonderful business than a wonderful price for a fair business.

• A study done by Credit Suisse in 2013 provided strong evidence of the outperformance of high-quality businesses over time.

Great Businesses Tend to Remain Great and Poor Businesses Tend to Remain Poor

This section discusses a study that shows how great businesses tend to remain great while poor businesses tend to remain poor. The study also reveals that markets systematically underpriced quality over long periods of time.

Key Points:

• Only 6% of companies in the study went from the lowest quartile to the highest quartile of performance.

• Despite being recognized as successful businesses, the fourth quartile of businesses continued to deliver outstanding investment results over the long term.

• Markets systematically underpriced quality over long periods of time.

Investing In Commodity and Cyclical Stocks Is All About The Capital Cycle

This section explains how investing in commodities requires an understanding of the capital cycle. It also provides insights on how to capitalize on opportunities in cyclical industries.

Key Points:

• To understand commodity investing, you need to understand the capital cycle which is similar to the concept of mean reversion.

• Look for industries that are in major down cycles and starved for capital. Find individual companies selling at a huge discount with manageable debt levels capable of surviving another couple of years in this downturn.

• High levels of capital investment are a direct sign of a capital cycle that is about to harm investors. These types of industries are all about supply and demand. Supply can be forecasted accurately but forecasting demand based on recent trends can trip up investors.

• Profiting from cyclicals is all about seizing the opportunities when you see them. Be prepared and ready to act. Properly allocate your time playing offense as well as defense.

The Importance of Intellectual Curiosity in Investing

This section emphasizes the importance of intellectual curiosity and continuous learning in investing. It also provides insights on how to capitalize on opportunities in the stock market.

Key Points:

• The importance of satiable intellectual curiosity along with a deep passion for continuous learning cannot be overstated in the investing profession.

• Opportunities in the stock market can spring to life on short notice. Take advantage of them by being prepared and ready to act. Properly allocate your time playing offense as well as defense.

• Work hard today to let good luck find you tomorrow.

Gautam Baid's Investment Strategies

In this section, Clay Finck discusses Gautam Baid's investment strategies. He talks about how Gautam ventured into the graphite electrodes industry in India and made a game-changing investment that positioned him to make a killing during the next cyclical upturn.

Graphite India

• Gautam purchased Graphite India in August 2017, which was the highest quality company with the strongest balance sheet in the sector.

• The stock declined for the first two weeks he owned it while a lower quality company he had analyzed had shot up by 50%.

• Rather than feeling bad for himself, he fully embraced learning everything he could to make sure he was making the right decision.

• He realized critical insights such as high-cost producers tend to go up far more in the upcycles than low-cost producers.

HEG

• After extensive research, Gautam moved his money into what he previously saw as a lower quality opportunity in the graphite electrode space to a company called HEG in late 2017.

• He ended up making 270% on his investment in less than five months and later re-entered that position to achieve another 64% gain through August of 2018.

Commodity Stocks

• Commodity stocks are not long-term investments. They generate alpha in portfolios over short time periods, and timing is really critical.

• For a successful investing career, what matters is the long-term compounded annual growth rate and overall portfolio value with least possible risk.

Spinoffs

In this section, Clay Finck discusses Gautam Baid's thoughts on spinoffs. He talks about how Munger explained that investors would do well focusing on three things: watching what other great investors are doing using the 13F filings, analyzing cannibals, and carefully studying spinoffs.

High Base Rates of Success

• Spinoffs have high base rates of success.

• A study done by a consulting firm, The Edge and accounting firm Deloitte, found that the worldwide asset class of spinoffs generated more than 10 times the average gains of the MSCI World Index during the first 12 months that the spinoff company was independent from the parent company.

Investing in Spinoffs

In this section, Clay Finck discusses the opportunities that arise when a small-sized company is demerged from a large-sized parent and listed. He explains how spinoffs occur and why they are interesting to look at.

Profitable Opportunities in Spinoffs

• A profitable opportunity often arises when a promising but small size company, demerged from a large size parent is listed and has residual institutional holding.

• During its initial weeks and months of trading, you often observe selling by institutions that cannot hold the new stock in their portfolios because of certain rigid institutional mandates.

• As a buyer, it's best to be on the opposite side of such trades where the other party is being forced to liquidate holdings at any price, regardless of the underlying value.

• The time to buy is when those investors are in a hurry to dump shares at any price.

Reasons for Spinoffs

• Spinoffs occur because the sum of the parts is more than the whole. So, a larger business may want to spin off unprofitable businesses or recognize that there’s more value to be discovered by spinning off a company that deserves a higher multiple than the parent company.

• Klarman has written about how spinoff companies often don’t publicize the attractiveness of their business and undervaluation because they prefer to initially fly under the radar. This is because management receives stock options based on initial trading prices until options are actually granted to them.

• Greenblatt highlights five different reasons why spinoffs may occur: conglomerates tend to trade at what is known as a conglomerate discount; separating bad businesses from good ones; realizing value for subsidiaries that can’t be easily sold; recognizing value by avoiding selling businesses and then incurring tax bills; resolving regulatory hurdles where they need to split up the company in order to be acquired by another business.

• Gautam recommends studying the relevant SEC filings to check whether spinoff management will have a substantial options package.

Investing in Spinoffs

• Joel Greenblatt is widely known for investing in spinoffs as he wrote about them in his book, You Can Be a Stock Market Genius.

• Greenblatt tends to look for spinoffs that institutions aren’t interested in. They have high levels of insider ownership, and he looks for spinoffs where value is unlocked in either the parent company or the spinoff.

• Gautam understands the power of incentives and recommends looking up the spinoff's form 10-12B filing for those companies in the US and search for the term executive compensation to see how many shares of new management.

Spinoffs and Insider Buying

This section discusses spinoffs and insider buying as a way to improve near-term and long-term earnings.

Spinoffs with Insider Buying

• Insiders have a ton of reasons to sell a company, but there’s really only one reason they want to buy: they believe the price of the shares will go up.

• A cluster buy is when three or more managers make open market purchases in a short period of time.

• Old school value investor Jay John studied the first-year performance of spinoffs in the US from 2001 through 2011, which had insider buying within a week of being spun off.

Performance of Spinoffs

• 11 out of the 12 spinoffs in Jay John's study beat the S&P 500 by a large margin.

• Live Nation Entertainment increased by 87% in the first year, and Genworth Financial increased by 46%.

• Spinoffs receive little attention from Wall Street are usually misunderstood and thus mispriced by investors.

Key Takeaway

• Apart from strongly incentivized management, the initial forced selling and spinoffs often lead to some attractive opportunities.