How would you know if you are overpaying or paying up for a quality business?

A learning enthusiast and a student of investing asked this question in a direct message. I am putting my thoughts together here so that a wider audience would benefit.

You are not alone

I face the same dilemma. I manage and overcome this dilemma by following a process. Am I overpaying or paying up for a quality business? This is great question. It’s not only a great question but also important because there are no definite answers and exact methods to find out. There are no precise formulas. Nor are there step-by-step gimmicks to apply so one can arrive at a crystal-clear solution. However, you can follow a process that suits your temperament and improve the odds in your favor. What process? I will come to that in a moment.

There is very thin line and distinction between overpaying and paying up for a quality business. Often that line is blurred and that’s what leads to confusion if one is doing the right thing.

The beauty about investing is you don’t have to swing at things you are not sure of. If you are going to search for opportunities just to own quality businesses, sooner or later you will end up overpaying. Instead, if you just wait and wait, there will be a time when you will “know” you are paying up and not overpaying. The key here is to wait, not search. When an obese person walks in, you know he is overweight. You don’t have to know he weighs 110 kgs. If you are a basket ball coach, you are looking for tall guys. You don’t have to know they measure 6.2

Whenever there is a dilemma if one is overpaying or paying up, it is safe to assume that one is biased towards some action for sake of it and hence overpaying. Doing nothing for long spells pushes you to take some action, and that precisely is the time one should do nothing.

?Faulty thinking

Are we overpaying or paying up; why should we limit this dilemma only for quality businesses? The valuation we are willing to pay, should be one of our primary concerns, regardless the nature of the business – great, good or gruesome. One of the biggest myths is that a company trading at a 60 times earnings multiple is overvalued and expensive and a company trading at 10 times earnings multiple is undervalued and cheap. This kind of thinking is faulty. Valuations seen in isolation don’t mean much. They must be seen in totality.

?Nor will a traditional DCF with a short forecast period tell you if a business is overvalued or undervalued. Short forecast periods will not capture the sustainable competitive advantages and the long growth run-ways that typically last for ten, fifteen or twenty years for great businesses. So, a traditional DCF that looks at say the next five years will result in overvaluation. Therein lies the opportunity for the long-term investor, if one can simply extend the investment horizon and think in multiple decades.

?To a man with hammer, everything looks like a nail. What you need is a bag full of tools. You need to consider a business from various vantage points. Qualitative aspects matter more than quantitative factors. That’s why investing is more of a creative art, and less of a hard science. Investors those who try to quantify every damn detail end up buying statistically cheap duds. Great investors price value. Average investors value price. It’s far important to be approximately right than to be precisely wrong.

Machines are for answers, humans are for asking questions

The most important points to consider are: Is it a simple business to understand and evaluate? How sustainable are the competitive advantages of the business? How attractive is the economics of the business? Is it capital and working capital intensive? Is it an asset-light business? How sensitive is the company’s gross margins to fluctuations in raw material prices? Can the company increase the price of its end products, adjusted for inflation without hurting its unit-volume growth? Does the company have a bloated cost structure? Is the business operations heavily funded by debt? Are there frequent equity dilutions at the cost of existing shareholders?

How long can the business sustain high rate of growth? Is the growth run-way really long? How big is the size of the market in which the company operates? Is the return on invested capital in excess of twenty percent? Does the company have a dominant market share and mind share? Are there enough opportunities to reinvest the excess cash the company generates? What have they done with excess cash in the past? Are there new players getting into the market threatening the incumbent players? Is the management honest and competent? Are they good and rational at allocating capital? Do they treat the minority shareholders fairly? Has the company created at least a rupee more in excess value compared to every rupee it has retained in the last decade? Then, finally comes what price are you willing to pay.

What process?

Warren Buffett said “There is no secret to how we go about investing. We haven't succeeded because we have some great, complicated systems or some magic formulas we apply or anything of that sort. What we have is just simplicity itself.”

?A robust investing process is asking a series of good questions without the need to finding the right answers. Because if you don’t ask, the answers, even if you find them have no-where to go. They don’t fit-in in your brain. Knowledge is seeing the dots. Wisdom is connecting the dots. As Warren Buffett said “investing brilliance is the ability to simplify a mass of information into a simple yes or no decision.”

?So how does one go about doing the above. Let me share, what I do, in brief. Investing is a process of elimination; not adding layers and layers of complexity. I constantly run the above questions, you may call them filters, through my mind, each of the company I come across. Over the years, through the process of elimination, I have about 100-150 odd companies that have passed those filters. This is my investible universe of excellent companies and great businesses I would like to own someday at a fair price. (Apart from what I already own).

Next, I have the history of these companies for the last 10-20 years. I pull out their annual reports, quarterly filings, con-call transcripts, presentations, articles in newspapers and business publications. Like a doctor, you build a case history for each of these companies. You study them in-depth. Take each of the companies at some point in history and value them as if you don’t know how the future unfolded. I am not interested potential winners or prospective multi-baggers without a solid history. Past is a good guide to future.

?Let us say you take about two weeks to deep dive into each of the companies. By the end of an year you would know something valuable about 24 companies from your list. Do this for five years and you would know something valuable about all the companies in your investible universe. Knowledge is cumulative. The key in the above process is to prepare. You are not hunting for multi-baggers. You are not in search of opportunities. You are preparing, so you can recognize when you see one.

At the beginning of this post, I had mentioned that you will “know” if you are overpaying or paying up for a quality business. What did I mean by “know.” Take each of the companies from your list and practise valuing the business on the back of an envelope. The idea of elimination to arrive at a list of great companies is simple. By definition, great businesses are stable, consistent and predictable. So you can value them with a reasonable degree of confidence. For instance, take a company from your list and see how it was valued in 2015 assuming you knew nothing about the future that unfolded in 2016 till date. Take each of the company and repeat the exercise. Evaluate and value the company at different times. Do this enough, and you will get better and better at figuring out if you are overpaying or paying up. You got to think like a chess grandmaster. Look for patterns, construct and deconstruct various moves on the chess board. The process is simple; but not easy.

Investing is a discipline

Investing has very little to do with your IQ and brilliance. Investing is a discipline. What do I mean by discipline? Discipline is all about painstaking preparation - laborious, dull, boring and not-so-glamorous. It’s what you do behind the scenes. There is no one to cheer you up. You do the same things every day. Knowing the desired outcome may or may not happen. That’s why most won’t do it. But you do it anyways. And that’s the only edge you have. That’s the key. Your investment discipline will define who you are as an investor. Investing is hard to teach. It can only be learnt. It is a single player game; not a team sport.

By the way, you don’t need ten ideas in a year to get rich. You need one, just one, every two or three years. And over a lifetime four or five will be more than enough to make you super rich. Till then focus on the process and prepare. There are no secret formulas.

Charlie Munger once said “One person told me, I have a list of 300 potentially attractive stocks and I constantly track them, waiting for just one of them to get cheap enough to buy." Charlie then added “Well, that's a reasonable thing to do. But how many people have that kind of discipline? Not one in hundred.”

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