What Causes Permanent Loss of Capital - Flame PDF

What causes Permanent Loss of Capital?
HIGH VALUATIONS or ABSENCE OF SUSTAINABLE PROFITS

Presentation given at Flame Alumni Meet, July 2, 2016
ContrarianValueEdge.Wordpress.Com
Acknowledgement
Entire presentation is inspired from reading interviews/articles of Mr. Bharat Shah and
Prof Sanjay Bakshi. Needless to mention any error in this presentation is due to my
misunderstanding
The concept of Good Business and Bad Business is inspired from the post by
Abhinav/Niren on Manufactured Luck blog here .
Bharat Shah Says Quality growth sustained over time will enhance value. Therefore,
even if one has misjudged the value and overpaid, rise in value over time will give a
chance to catch up and will let avoidance of permanent loss of capital. A pure cigar butt
may not enjoy such luxury.
Question: How many companies have destroyed value over long term [> 5-8 Y]
despite enhancing value over time [> 15% CAGR driven by PAT and ROE > 15%, self
funded growth]
Growth of intrinsic
value will bail you
out in case of
misjudgment of
value
Stable or declining
intrinsic value. If you
Misjudged value
Permanent
destruction of capital
Few notes about this study

Used Ace equity and tried to find cases where wealth destruction has happened over
various period despite quality growth [PAT CAGR > 15% and ROE avg > 15%]
Basic assumption is one buys and hold stocks for the period under consideration.[20002016, 2003-16, 2007-16, 2009-16 and 2011-16]
The entire study is based on historical numbers whereas in investment one need to
assess future. One can reject this study as HINDSIGHT and SURVIVALSHIP BIAS. But I
think one can learn from history on what has worked and what has not worked in the
past.
Findings of Study: More Wealth Destroyed by Companies Which Failed to Sustained Profits than by High
Valuations
Market Cap > 100crs
All Market Cap
During 1993-98 period low ROE companies dominate list of wealth

destruction
The ROCE of a staggering 46% of these companies has declined to less than 15% during the
period under study [1993-1998]
Source: Motilal Oswal Wealth Creation Study 1993-98

If one had bought Nifty Fifty at the peak of Dec 1972 and held for next 25 years,
returns closely match S&P 500.
Bad News!!! Finding Companies with Sustainable ROE > 15% is NOT Easy
In 2004 about 26% of companies ROE > 15% [568 out of 2,200]. By end of 2014 this
number declined to 4%. Putting another way in 2004 there were only 4%
companies with sustainable RoE > 15% [86]
On Survivorship bias
Take any idea in value investing and youll find the same survivorship bias. But extreme
success in investing has come to those who have found patterns that have worked
really well.
Mr. Taleb has roughly said that there wont be enough data in Mr. Buffetts lifetime to
know if he had any skill or whether he was just lucky.
On Importance of Patterns in finding

Good Business
Take Charlie Munger. He talks about learning by studying great failures and great
successes and identifying common elements. He wants you to recognize patterns. If
theres a pattern associated with success, he implicitly assumes causality. If theres a
pattern thats associated with failure, he does that again. He said avoid the patterns that
cause failure (all I want to know is where I am going to die, so I never go there). He says
look for patterns which produced extreme successes and if you find them, back up the
truck on them.
Maybe, just maybe theres a pattern which helps us understand whats a good business
and what's a bad business ex ante and not ex post.
Trying to Study Past Success and Failure Patterns
Four sources of Permanent Loss of capital

Management risk
Business Risk
Very difficult to measure and quantify..

I am trying to study these risks through
Past Success Patterns and
Failure patterns still work in progress
Balance Sheet Risk

Valuation risk
Sources of Permanent Loss of Capital

Business Risk As Graham put it. Real investment risk is measured [] by the
danger of a loss of quality and earnings power through economic changes or
deterioration in management.
Balance Sheet Risk As Graham noted: The purpose of balance sheet analysis
is to detect the presence of financial weakness that may detract from the
investment merit of an issue.
Valuation Risk Valuation risk is perhaps the most obvious. Buying an asset that
is expensive means that you are reliant upon all the good news being delivered
(and then some). There is no margin of safety in such stocks.
Of the above three risks, Valuation Risk is highly overrated compared to other
three risks
Source: Value Investing: Tools and Techniques for Intelligent Investment, James Montier
Good Business vs Bad Business

Which is a Good business [Non-financial]
Over long term Sales, PAT and EPS CAGR > 15%
Self sustainable growth indicated by ROCE and ROE > 15%
Which is not a Good Business
Mere high ROE does not make any business Good Business [Even if ROE > 50%]
e.g.. HLL, Castrol etc.
At minimum, Sales and PAT CAGR should be equal to or higher than nominal GDP
growth rate.
Note: 15% is not that important.. What's important is that this number should be equal to or more than nominal
GDP growth of the country over long term.then only I think its possible to beat inflation and earn some real
rate of return.
Without minimum growth in intrinsic value, stocks will fall into

Class II securities as defined by Benjamin Graham
Source: Security Analysis, Benjamin Graham
If a company provides only assurance of long term durability without any

assurance on minimum growth in intrinsic value over long term [> 5-8
yrs.], then I would classify such companies under Class II rather than
under Class III.
Growth in intrinsic value can absorb many adverse development on
business side.
Why I am insisting so much on GROWTH rather than just

long term durability?
It is a myth to believe that one can earn investment returns even if the
underlying business has inferior economic value creation; or, that a
business creates outstanding economic value but somehow does not get
reflected in investment returns. Neither can happen. Certainly, not over a
long enough period of time. An investor can generate investment returns,
even superior to the underlying economic returns if he can buy such a
business at a Margin of Safety (or, Price-Value Gap) to its intrinsic worth.
Bharat Shah Says When growth goes away, Equities reduced to a Bond.
It will be treated like a bond for a while. If the picture deteriorates further,
then it will be treated worse than a bond
Price is perhaps the single most important criterion in sound investment decision
making. Every security or asset is a "buy" at one price, a hold at a higher price, and a "sell" at
some still higher price.
From above quote its clear that Seth Klarman does not think at a particular price, any business is bad for
investment
How do we reconcile this entire presentation with above quote
Timing and controlling your losses is key in Bad Business
Source: Manufactured Luck blog [Comments are mine]

1) Entry/Exit timing is key As intrinsic value is either growing
modestly or flat or declining
2) Your losers control your return
Highly unlikely that you can make
5-10x returns
1) Correct assessment of Business/

Management and Balance sheet risk
is the key
2) Your winners control your return
Appendix
Out of 350 companies which destroyed wealth during 2000-16 < 1% are cases where PAT CAGR > 15% and
ROE avg > 15%
Source: Ace Equity, all the data last updated in Jan/Feb 2016
There were around 1,600 active companies as on March 2000. Out of these 550 [34%] companies had destroyed wealth
during 2000-2016 and the common characteristic among them is either PAT CAGR < 15% or ROE avg < 15%. Out of
these only 4 companies whose PAT CAGR and ROE average was > 15% still destroyed wealth.
Alok Industries increased its PAT at 18% CAGR but due to repeated dilution its EPS declined from INR 7 in 2000 to INR 2
by 2015. It was trading at 7x PE compared to > 400x for Wipro. Still Alok destroyed more wealth compared to Wipro
Why Infosys which was trading at more than 200 PE [TTM basis] not present in the above list. Of course paying high
valuations for Infosys resulted in mere 9% CAGR in price despite massive increase in earnings..
No way I am suggesting that we should ignore valuation for good businesses. What I am suggesting is we should give
more importance to sustainable PAT and ROE. Valuation can increase/decrease returns, cannot cause or prevent
permanent destruction of capital over long term
[> 5-8 years].
Out of 200 companies which destroyed wealth during 2003-16

< 1% are cases where PAT CAGR > 15% and ROE avg > 15%
Source: Ace Equity, all the data last updated in Jan/Feb 2016
There were around 2,000 active companies as on March 2003. Out of these 200 companies destroyed wealth
during March 2003- June 2016. common characteristics of these companies again either PAT CAGR < 15% or
ROE avg < 15%.
Both Jupiter Bioscience and Alok Industries are cases of repeated dilution.
Out of 1,800 companies which destroyed wealth during 2007-16 < 1% are cases where PAT CAGR > 15%
and ROE avg > 15%
There were around 2,800 active companies as on Dec 2007. Out of these 1,800 companies destroyed wealth
during Dec 2007-June 2016. Common characteristics of these companies again either PAT CAGR < 15% or ROE
avg < 15%. Only 16 companies out of 1800 were those whose PAT and RoE > 15%
Out of 800 companies which destroyed wealth during 2009-16 <

2% are cases where PAT CAGR > 15% and ROE avg > 15%
There were around 2,500 active companies as on March 2009. Out of these 800 companies destroyed wealth
during March 2009- June 2016. common characteristics of these companies again either PAT CAGR < 15% or ROE
avg < 15%.
Out of the above, Coral, Temptation foods and Parekh Aluminex appears to be case of mismanagement. Other six
companies market cap is less than 15crs on average as on March 2009
Last four [Zicom, Jupiter, Lycos and Neo] are cases of repeated equity dilution
Out of 1,470 companies which destroyed wealth during 2011-16 only 2% are cases
where PAT CAGR > 15% and ROE avg > 15%

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What causes Permanent Loss of Capital?

HIGH VALUATIONS or ABSENCE OF SUSTAINABLE PROFITS

Few notes about this study

During 1993-98 period low ROE companies dominate list of wealth

Source: Motilal Oswal Wealth Creation Study 1993-98

On Importance of Patterns in finding

Trying to Study Past Success and Failure Patterns

Four sources of Permanent Loss of capital

Very difficult to measure and quantify..

Balance Sheet Risk

Sources of Permanent Loss of Capital

Good Business vs Bad Business

Without minimum growth in intrinsic value, stocks will fall into

Source: Security Analysis, Benjamin Graham

If a company provides only assurance of long term durability without any

Why I am insisting so much on GROWTH rather than just

Timing and controlling your losses is key in Bad Business

Source: Manufactured Luck blog [Comments are mine]

1) Correct assessment of Business/

Out of 200 companies which destroyed wealth during 2003-16

Out of 800 companies which destroyed wealth during 2009-16 <

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