Friday, March 30, 2018

The Prejudices of Mr. Market: Prof.Sanjay Bakshi

Gyan on Treadmill dated 25-Mar-2018

This is an excerpt from the talk given by Prof.Sanjay Bakshi as a part of Google Talks. Summary of other presentations by Sanjay Bakshi can be read HERE.

In this presentation, Prof. Bakshi talks about various prejudices of Mr.Market. He starts off by identifying four stakeholders. These are Customer (what is the pain of the customer is company alleviating), competitor (why a competitor won't enter the market, could be due to a moat - competitive advantages or could be due to statutory / patent entry barrier), Entrepreneur (has he got it in him to stick to it) and Mr.Market.

The current talk focus on Mr.Market.

Most of the time Mr.Market is very emotional given to extreme elation or despair. He can be very euphoric or very depressed. When interacting with Mr.Market, you have to understand that Mr.Market is there is serve you, not to guide you. 

The prejudices of Mr.Market stems from Representative Heuristic. We make judgements about similar past experiences to determine the probability of future events. One example is of Insurance companies catogarize the potential customers. 

Stereotyping is the social grouping that we do in our minds. This helps decision making, but can lead to wrong decisions. In the world of investing, hostile stereotyping by Mr.Market can have great consequences for a value investor. For example, Mr.Market says that Airline Industry is a bad industry. Mr.Market is depressed about ALL the players in the Industry. However, there could be very good SPECIFIC value investing opportunities in this industry. Similarly, currently in India, Mr.Market is downgrading pharma industry. A discerning value investor can identify great opportunities when Mr.Market allows his temporary prejudices to significantly undervalue great businesses..

The five prejudices are explained below.

Prejudice 1: Marshmellows
Tendency of investor to catogarize stocks as cheap or expensive based on their reported PE multiples. This approach is wrong because the reported earnings could understate the true earnings, especially in a 'moted business'. This is because the money charged for Moat Expansion is charged to P&L as an expense, whereas it should be charged to Balance Sheet as expenditure with potential future opportunities.

Prejudice 2: Hidden Champions
Great companies that lies hidden from the market. The companies will have dominant market share in their market, some of them 70-80%. Why do these companies lie below the radar? This is because large number of products offered by hidden champions go unnoticed by consumers. These are mainly B2B companies and supply products or services that are not discernible in the final product or service. In India, many of the auto ancilliary companies could fall into this category. How many of us have heard of companies like Subros, Minda or Talbros? Another examples is profitable niches hiding in Industries with commodity characteristics.

Prejudice 3: Learning Machines
These are companies that make mistakes and learn from those mistakes. Mr.Market can easily misprice such opportunities.

Prejudice 4: Serial Acquirers
Most acquisitions do not add value. So markets look at these with scepticism and tend to undervalue these companies. However, as with Learning Machines, there are exceptions to the rule and that makes an exceptional value investing opportunity. The characteristics of good serial acquirers are one, extreme financial discipline, that is, willingness to walk away from a deal if it doesn't make economic sense. Two, providing a permanent home to a promising business, three, preserving the successful culture of the acquired company and four, providing growth capital for inorganic bolton acquisitions.

Prejudice 5: Freaks and Misfits
Markets tend to expect rational behavior from entrepreneurs. And if an entrepreneur do not meet the standards of Mr.Market, he will tend to undervalue the business. Some of the exceptional entrepreneurs are 'slightly crazy'. They will be passionate, fanatics, slightly crazy, many not meet the societal mores, some time even indulging in actions bordering on illegal. A value investor who can identify such an entrepreneur in the early stages of his growth and attach himself to his coattails (become a passive partner) can make huge wealth over long-term, since in the long-term, the performance of the company catches up with the market. Only challenge is that as an investor, YOU should be ready to overlook some of the questionable characteristics and actions of this exceptionally talented entrepreneur.

There are two lessons from this talk. One, Mr.Market corrects his prejudices as more information come in. He is a learning machine. Two, Mr.Market is far less prejudiced than some of us. We need to learn a lot from Mr.Market

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