Posts Tagged AmazingRead

Intense Learning…

Earlier this week, I had the privilege to be a part of an intense, immersive and absolutely enlightening investor conference in Goa. It was an invite-only and unfortunately, I am not at liberty to disclose either the names of participants in the conference, nor the name/theme. Participants were amazing. It was such an intensely collaborative conference that the time spent on the beach in 2.5 days of the conference was about 2.5 hours 🙂 But Goa, being the place it is, relaxes you completely in those 2.5 hours.

Anyway, enough about the background. I think I do have the liberty to compile a list of learning that I had from this conference. This is more like a list that I wrote down on paper, so there might have been a zillion other things that I missed. Papers get lost but Internet is forever (or something like that) and hence this attempt:

1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner  understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. (Book recommendation for this point: “Creating Shareholder Value”)

2) Crossing the Chasm. An excellent mental model to think about businesses, especially emerging businesses. There are two critical strategies for listed markets based on this mental model. a) Initially, follow a basket strategy in an emerging theme (bowling alley phase) and b) More critically (and this was the key learning), the leader usually gets a disproportionate share of the market and hence move capital from basket strategy to the leader once data/analysis points to who would be a leader.

3) Invest in Leaders: Try investing in large, proven and addressable markets (companies trying to create a market usually face a lot of headwinds and probably will not be successful). A further refinement would be to always invest in leaders in pull-based (demand) businesses.

4) What’s the DNA?: Understand the company’s DNA. Look for greatness DNA. The strengths and weaknesses of promoter/owner/leadership gets amplified in the company (and thereby earnings).

5) Write it down: Try and write down core investment thesis before investing in any stock (or selling a stock, for that matter). This would serve as a record to check against reality.

6) Sell a bit: Sell a bit of your most favorite/loved stock and check if the love holds (selling will trigger rationality in a much loved stock in your portfolio). Especially, sell a bit if numbers get disappointing to get rational.

7) Growth, growth, growth: The weightage for growth (usually, sales and then profits) in the Indian stock markets is 50%.

8) What’s your insight?: Decent opportunity size, difficult to dislodge and high predictability are critical factors for any business and in all markets (bull and bear). What requires more effort, insight and is more important to returns is the evaluation of a visible gap between performance and perception (especially, in bullish times like these).

9) Successful patterns: Some of the successful patterns in the Indian stock market have been Growth + Deep undervaluation, Operating leverage + reducing debt, maiden dividend, industries with a reform tailwind, demand businesses + oligopoly and small equity + illiquidity

10) Leverage Darwin: Buy shares (in tracking quantity) of all businesses that you like. Else, it’s usually ‘out of sight, out of mind’. And Darwin theory will force you to forget those stocks even though you seem to be hearing good news (since you don’t even own a share)

11) Read, Read, Read: I found that most good investors in that forum read, at a minimum, 500 annual reports a year (may not be 500 different companies; may be 5-7 annual reports of every company that one likes). And as Munger says, it adds up over a lifetime.

 12) Psychological Denial: One of the bigger mistakes that bright investors usually make is psychological denial. It’s not that they fail to recognize that the business is deteriorating. It is that they don’t act upon it. There would be plenty of time to recognize deterioration of a business and act upon it (sell). But psychological denial comes into play and these bright investors are left holding the bag.

13) Are you screwed yet?: If you are not screwed by the markets in 2 years (consecutively), then watch out. Screwing is just round the corner (not just a bull to bear, but due to transition from confidence to overconfidence, mistakes are bound to happen)

14) Don’t take the lollipop: Many a bright investor with wonderful track records for 5, 7, 10 years get lulled by the market and their analysis. Market, at some point in time, gives a wonderful, sweet (but dangerously poisonous) lollipop which these investors partook and then got rogered. Sometimes, they don’t recover financially and worse, are broken in confidence too. The key always is to be watchful.

15) My observation/contribution in the conference: Be absolutely obsessive about working capital (and detailed components). Working capital is a leading indicator of competitive advantage. If working capital (days) is increasing for all businesses in your portfolio, either you have a shitty portfolio or the economy is going in a tailspin.

P.S: As I mentioned earlier, these are the ones that I wrote down (the essence as such. Detailed discussions on these points obviously were a killer). Such was the intensity of the conference and discussions that there were a zillion other things which I couldn’t/didn’t note down. My biggest takeaway from this conference was the humility and down-to-earth behavior of these brilliant investors who have seen the ups and downs of the market for more than 10-15 years and also have made a lot of money still looking to learn, still looking to share and in general, being absolutely stellar. Lot to learn. And as Frost lingers on, ‘miles to go before I sleep, miles to go before I sleep’.

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Fantastic Read: Why We’re Short Netflix

Although not in the same league as David Einhorn, T2 Partners are reputed in their asset management and return generating skill. In this article, they lay out a case of why exactly they are short Netflix, and that too with a large position.

It’s an amazing read, not just for the financial analysis but also at various angles they looked at before they got convinced that they should short Netflix. (Netflix, by the way, appeared on the Forbes  where the CEO was the #1 Business Person of the year in 2010. This, in my opinion, is a great indicator for going short. Enron, anyone?)

The article: http://cache.dealbreaker.com/uploads/2010/12/Why_Were_Short_Netflix-T2_Partners-12-16-10.pdf

The entire article is a must read. Some tidbits from the article:

Our favorite shorts generally involve some or all of the following characteristics: outright frauds (our very favorite), industries in decline or facing major headwinds, lousy or faddish business models, bad balance sheets, and incompetent, excessively promotional and/or crooked management.  In general, we prefer to short businesses with these traits, even when their stockstrade at seemingly low valuation multiples, rather than shorting the stocks of good businesses with strong managements, even at high valuations.  Sometimes, however, the valuations becomeso extreme that we will short the latter, but generally only when we believe there is a catalystthat will impact the company and cause the stock to fall. Netflix falls into this latter category.

…because we think the valuation is extreme and that the rapid shift of its customers to streaming content (vs. mailing DVDs to customers) isn’t the beginning of an exciting, highly-profitable new world for Netflix, but rather the beginning of the end of its incredible run.  In particular, we think margins will be severely compressed and growth will slow over the next year.

Netflix’s core business model is buying DVDs and then renting them to its customers, who pay a fixed monthly fee for unlimited rentals delivered by mail plus unlimited streaming. This is a good business for two reasons: 1) Netflix has a better business model and better management than its bricks-and-mortar competitors such as Blockbuster and Movie Gallery,both of which filed for bankruptcy this year (the former continues to operate as it tries torestructure, while the latter has been liquidated); and 2) Netflix only has to pay once for the DVDs it rents over and over again to its customers thanks to what’s called the First Sale -3-Doctrine, which allows anyone who buys a DVD to sell, exchange, rent, or lend it to others, without paying the content owner

Netflix’s core DVD-based business model is rapidly shrinking as customers shift rapidly tostreaming content. Netflix has moved quickly to adapt, making its streaming service availableover the internet to customers’ computers as well as through various devices like iPads and iPhones, Tivos, game consoles….

…, our answer is that we believe that the same two factors that made Netflix a good business under its original business model don’t apply under its streaming model.

…In short, Netflix is moving from a business in which it was competing against smaller, dying, heavily-indebted companies with inferior business models to some of the largest, most powerful,aggressive and deep-pocketed companies in the world, which have big competitive advantagesover Netflix.

Unlike renting DVDs, in which Netflix is protected by the First Sale Doctrin, the laws around streaming contentrequire that Netflix must have an agreement with the content owner to stream it.  This is very badnews for Netflix because content owners are generally very savvy and are seeking to carefully control their content to maximize revenues.

Another risk factor we see for Netflix is that the company is much closer to saturating its marketthan is commonly believed.  The bulls argue that the company’s 16.9 million customers representfewer than 15% of the 115 million households in the U.S., but the company’s churn data presentsa different picture. We have analyzed the last decade of Netflix’s quarterly statements, in which the company discloses customer additions and cancellations, and calculated that Netflix has had approximately 30 million customer cancellations.  In other words, the company has had to add approximately47 million customers – more than 40% of U.S. households – to be left with today’s 16.9 millioncustomers (and many of these will cancel in the future; the churn rate last quarter was 3.8%). If history is any guide (we think it is), Netflix will need to somehow find another 47 millionsubscribers for the company to double its current subscriber count (a common medium-termobjective in many analysts’ view). We don’t think that many potential additions exist.

We don’t think there are any easy answers for Netflix.  It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.Under this scenario, Netflix will continue to be a profitable and growing company, but not nearlyprofitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.

Amazing analysis. As usual, we would know if T2 partners were visionaries (the reason attributed if Netflix goes down) or dumbs (reason attributed to analysts who suggested/shorted Amazon) only in hindsight. Neverthless, great learning in terms of how you look at a business and value it.

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