What they don’t teach you at business schools?
Firstly, treat people as people and not numbers and secondly, that’s not what I will discuss.
Although I attended a research-oriented school (Delhi School of Economics) for my master’s and not a business school but have worked in consulting firms and have a fair sense of what is taught in business schools.
In the year 2012, I started to explore the idea of advisory in India. After leaving corporate life, I reflected what I was taught in finance may not be right. A slight change in the cost of capital impacts my decision to buy or sell a stock, this can’t be right.
This questioning led me to understand the issues more deeply. In this article, I will share my learning (restricted to stock investing) that I feel is not taught in business schools or other finance (CFA) qualifications.
Efficient market: During the ’70s, Chicago’s GSB gave the Efficient Market Hypothesis concept to the world. I studied this in my CFA program and assumed it must be right. Well, if it is 100% right, why do people invest in stocks and why do we have investing legends such as Warren Buffet, Seth Klarman, Howard Marks etc. in the world. Something is amiss here. (investing in an index is also a unanimous view of active investors).
My view: Broadly the stock market is efficient. What does that mean? Acting on a news article or some information is quite silly. You must act only rarely when these inefficiencies emerge and when they do, you should not restrict yourself. However, the market rewards those who can think calmly and can place the decision on the next week/month. This will help take a long-term view of the situation or business.
Cost of capital: Extending the use of the Efficient Market Hypothesis, the Capital Asset Pricing Model was created to arrive at cost of equity. Again, quite a silly way to know something that can be ballpark and even that keeps on changing.
My view: Why can’t you use a cost of capital based on the quality of business and in turn quality of the business is linked to the stability of cash flows. Read here to know more.
Discounted Cash Flow (DCF): This is a very old method to arrive at a value. Business schools and a lot of other training companies teach this method. There are so many people whose livelihood is based on just teaching this method. However, this method requires massive assumptions and forecasting that leads to all sorts of issues.
My view: Teach DCF to understand what the market is expecting i.e., implied growth (reverse DCF). The implied growth rate can be used as a filter to understand any inefficiency. A bad quarter or CFO resignation or some allegation or SEBI inquiry can lead to opportunity. Often the stock price falls, implied growth also falls. If you feel the market is reacting to certain news, you can start building the position. However, this should not be based on what the newspaper is feeding you rather it should be an independent view.
You can value anything: Business schools teach methods on how to value all sorts of business. There are no distinction among great, good or gruesome businesses.
My view: The only businesses that are worth valuing are those that have a high Return on Investment (ROCE/ROIC). If a business is not generating a high return over 10 years plus, you can just avoid wasting time valuing those businesses.
Let’s see this in action:
If I apply 20% 10-year ROCE to top 100 companies, here is what you get:
Inflation in India is average at around 7% for the last 10 years. Let’s apply 7% average sales growth (5 years) to this list. We are left with 7 companies now.
Now we calculate the implied growth (reverse DCF on the list):
Finally, the work starts. We spend a lot of time to figure out whether market expectations are fair or not.
The decision to invest or not may be based on a few factors:
Free Cash Flow (FCF) Yield: This should be compared with the government yield. The stability and predictability of cash flows will supersede FCF yield.
Free Cash Flow (FCF) Growth: If the FCF growth is good, you can still proceed without getting too much concerned about FCF yield.
Price to Book (PB): March 2020 was the time to just look at this measure and invest. There was no need for further analysis of quality companies. All the quality companies were available at their 10-years low PB levels. This is the ratio recommended by Benjamin Graham but may not work all the time. Do not apply this to low-quality businesses.
Growth value: How much to pay for growth has been a challenging question for me to solve. Not all forms of growth can add value. The growth that increases ROCE adds value. So, we step back and break the growth value into cash return, organic return and inorganic return. This is done so that you don’t overpay. The net profit of the company can be distributed as a dividend (cash return) or invested back to run a business (organic growth) and/or buy other businesses (inorganic growth). As far as the cash return and organic return are more than 10%, a position can be built. If you are confident in the quality of investment decisions taken by the management then consider inorganic return as well.
Reading across discipline pays off more than working on Excel. Business schools and CFA Institute should spend time redesigning their curriculum to address multi-disciplinary approach to investing.
“Investing is simple but not easy” - Warren Buffet
To do well in investing, you need to be a student of history and human behaviour than just finance.
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