Preston Pysh  1:14  

All right, Stig, take it away. 

Stig Brodersen  1:16  

Let’s just jump right into the first question. As a student at London School of Economics, you read an article about Warren Buffett. It was completely contrary to what you have been taught about efficient markets. Today, it might seem serendipitous that you found value investing. But where would you have been both in your investing career and personal life if you had applied fully what you were taught at London School of Economics?

Sanjay Bakshi  1:40  

You’re right about the LSE story. When I was at the LSE, I was studying the standard academic finance courses. I was being taught about the efficient market hypothesis. I was learning the capital asset pricing model and the modern portfolio theory.

It essentially revolved around a few key ideas. One of them was that humans are rational. It doesn’t make any sense trying to do any sort of analysis, whether it is fundamental analysis or technical analysis or what have you. There’s no point trying to find any sort of market inefficiency because there isn’t any. You should just go out and buy the market portfolio. 

I was studying all these ideas which are very fascinating at the time. I accidentally came across an article about this obscure guy. Nobody knew about Warren Buffett except in the value investing circles. Today, almost everybody in the finance circles knows about Warren Buffett. 

I discovered Buffett by reading an article. That article said a few things which were very interesting and were sort of contrary to what I was being taught. Basically, it said that here’s a guy with a wonderful track record. 

I was being taught about all these concepts where professors were not really rich guys. I was very intrigued because he was a rich guy who made all his money in the stock markets. He was saying something so different from what I was being taught at the LSE. 

I was very intrigued by that. Their article also said that he has a wonderful track record, and he operates out of Omaha, which is in the Midwest. It is far removed from Wall Street. Mr. Buffett tries to keep very far away from Wall Street. 

And thirdly, he is very articulate about how he thinks about the world of business and investing. He writes wonderful letters. And those letters, by the way, are available for free to anybody who writes to Berkshire Hathaway. 

I did write to a company and I got those letters. Of course, I had to pay the postage money to get those letters in London. And by the way, I think that was the best investment I ever made. It was a monumental discovery. 

For me, it changed my life. I discovered this accidentally. It’s sort of hard to visualize a world coming back to the question that you were asking me about what my personal life would have been, or my professional life would have been if I had never discovered Buffett or value investing. 

It is very hard to visualize an alternate scenario where I would never have discovered Buffett. But I do know that if that hadn’t happened, then I wouldn’t be a full time investor. I think part of the fun of being a value investor is the sheer thrill of finding and exploiting an inefficiency in stock markets. 

But when you start believing that there is no inefficiency, which is what the academic finance papers tell you, then there is no fun left either in my view. Come to think of it,  people who believe that markets are efficient and have behaved in accordance with that belief, haven’t done so badly. 

They’ve gone out and made very long term investments in index funds. Index funds tend to beat the most active managers, but there is no fun in just buying the index. Part of the reason why people practice value investing is that they believe that they can spot and exploit inefficiencies on high returns at the market with lower risk.

I think a very big part of that reason is the sheer thrill and fun of finding bargains before others, and then having the pleasure of the market eventually agreeing with you.

Preston Pysh  4:49  

Sanjay, I’m curious. What investment truth do you hold today that very few people agree with you on?

Sanjay Bakshi  4:57  

Value investing is hard. If you think about it, it has come free to other professions like law or medicine, or even trying to be a good sports person. A big part of the reason for that is the feedback is sort of delayed. That makes it very hard to separate skill from luck. 

If you’re practicing to be a good shooter, for example, then every shot that you take has immediate feedback. You learn from your mistakes quickly. In value investing, the results of investment operations take a long time. Often, it could take up to several years. It’s a probabilistic game. 

You may have played very well and yet may end up with mediocre outcomes because you encountered some bad luck. Does that make you a bad investor? Of course not. The best investors in the world who have created billions of dollars of wealth by exploiting market inefficiencies also tend to underperform the market. It could sometimes take for prolonged periods of time. We all know this. 

At the same time, some lucky gamblers who indulge in reckless gambling operations sometimes hit the jackpot. They tend to get labeled as geniuses based on outcomes and not process. 

This is the world which is clearly inhabited by people who tend to focus on outcomes, instead of the underlying processes. We all know that process is far more important than outcome. For me, that’s the important truth that very few people agree with me on. 

I say that in the sense of “Watch what they do and not what they say.” I mean, almost everybody agrees with the idea that process is more important than outcome, but far few people behave in accordance with that belief.

Stig Brodersen  6:21  

Today, we see multiple disruptive technologies like artificial intelligence, internet, mobile, and cloud, just to mention a few. We see so much disruption in the way we live our lives, the way we work, and the way we conduct business. How do you factor the disruption into your investment strategy?

Sanjay Bakshi  6:40  

Clearly, the disruption risk is very real. The pace of change is only accelerating over time. Many value investors underestimate the impact of disruption on investment returns. As I’m speaking to you as a professor, I come across a lot of young value investors. My job is to guide them as to how to think about concepts like disruption. 

Now, one reason why potential future disruption, if it is properly discounted by the market almost always results in P multiple. That’s a big reason why people tend to underestimate the impact of destruction. Naive value investors tend to get very attracted by low P multiples. 

The earnings are high. You’re comparing those high earnings and past earnings with the current valuation. The market has already figured out that this business is prone to disruption and brought down the value of that company. 

And because the current earnings are high, or the past earnings were high, the current drop in stock price almost always creates a low P multiple. It is a big mistake that a lot of investors make. They don’t think hard enough about how earnings will evaporate because of disruption. 

I think the second mistake that people make is that they underestimate the time over which the earnings of an existing business could be decimated by disruption. They forget that the pace of change is accelerating. This error is costly because it results in overvaluation and the models used by investors.

The way I deal with the risk of disruption coming to your question is basically to avoid it. I mean, try to avoid situations where those invested in businesses are prone to disruption. And clearly, there are some industries where disruption risk is higher than other industries. 

Avoiding trouble is the key here. Charlie Munger has a wonderful quote. It goes along the following lines. He said that, “All I want to know is where I’m going to die, so I never go there.” I think that’s pretty fundamental, isn’t it?

Stig Brodersen  8:25  

I love that quote. 

Preston Pysh  8:26  

I don’t know how anyone can’t love Charlie Munger. One of the things that Charlie and Warren are really well known for is this idea of investing with companies that have moats. And for people that don’t understand what we mean when we say moats, it’s simply a metaphor for describing a company that has a strong competitive advantage in business. 

I’ve read some of the ideas that you’ve written out there about moats and competitive advantage. It’s interesting because you’re looking for a company that might not have the strongest moat today. But the moat is trending in a direction where it will be the strongest moat in the future. Could you talk to our audience a little bit about this idea?

Sanjay Bakshi  9:05  

When you think about moats or the idea of a competitive advantage, it has to show up in numbers. If not now, then eventually. What are those usual suspects? When we think about the numbers, the people who are very quant oriented try to think about ways in which you could measure and quantify it. Then what are the usual suspects? 

You mentioned, one of them which is the high return on invested capital. Growth is a very important component. You don’t want to look at a business that is going to be able to continue to invest incremental capital at high rates of return. 

If a business could do that without recourse to outside capital markets – no dilution, no need for borrowing money, there’s preferably large positive free cash flow which is sufficient to fund all growth, then there is no need to depend on outside capital markets or as what Buffett calls it, “the kindness of strangers.” 

All of those are very good quantitative markers of quality of moats. It has more characteristics. The way the world has moved in the last several years, people have moved away from deep value investing in cigar butts into high quality businesses. 

These markers that I mentioned are easily measurable. These are like low hanging fruit. You could easily pull them out from any good database. Everybody loves a high return on capital businesses with low leverage and high growth prospects. There’s no need for access to outside capital markets. 

The problem is that when you’re operating in a competitive environment, these assets tend to get priced too high. There isn’t any edge left over there. The future returns of owning those businesses are not going to be as exciting as perhaps would be in a situation where you were to identify a business which is going to turn into a high return on capital business. Isn’t one right now? 

You’ll see a path which will lead that business to become a high return on capital business before your competitors. Clearly, there is a potential edge for investors over there.

What are the primary reasons for a low return business to become a high return? There are many reasons, but I’ll just cite 4 or 5 of them. I think they are good patterns to look for when you want to move from a business. It may be what some people believe to potentially have a moat and will ultimately be seen by the wider audience. It will get reflected in higher valuation. 

One of them is fixing past capital misallocation mistakes. This usually happens in conglomerates where businesses have made some really bad decisions in the past. The people who made those bad decisions are no longer involved in running those companies. 

And then, a new guy comes in. He is not brain blocked by past dumb decisions. He has the right financial incentives to fix the mistakes made by others. He’s pretty good to do those things. He could end up restructuring the whole piece that will ultimately result in removing low return capital businesses, selling them off for cash, and then using that money to fund the growth of high return capital businesses. 

All of that will ultimately be reflected in the quantitative markers for more than I mentioned earlier. You will see a higher return on capital. If there is an inefficient operation being fixed, that would be a good template to work on. 

The second pattern that I see here is businesses with the upfront burden on the P&L, or of intelligent initiatives that build more and bring on the earnings. And when the earnings come down artificially, that has brought down those earnings who are very intelligent because they build a bond with the customer, loyalty, and brand recognition. 

The idea is that you don’t want your customers to even think about the competitor. You don’t want them to do competitor shopping. You want them to just see your product and buy it without even thinking too much about it. That’s something that happens to customers of Costco, for example, or to somebody who’s buying a book on Kindle who doesn’t even think about looking at other alternate ebooks. 

All of those things, to get to the point where the customer doesn’t even think about the competition takes a lot of upfront burden on the P&L. That brings down the earnings. The quantitative impact of bringing down those reported earnings is that the earnings on invested capital ratios are starting to look very mediocre or very poor. The way the whole thing works is that upfront pain followed by back-ended benefits will show up in the numbers ultimately.

That’s a very broad category of situations where businesses are investing for the future. They are building phenomenal loyalty, which will give them lifetime value customers while getting lifetime value. It’s not showing up in the numbers right now. 

I think the third big category where this happens is geographical expansion. It is a business which is already moated and has a wonderful high return on capital cash. It is generating characteristics, and is now able to gradually scale up. It goes to different markets geographically. 

When you do that, when you open new branches, when you open new retail outlets, all of that, again, is being funded from the cash flow of the existing operations elsewhere. All of that costs money and it hurts your return ratios. When you set up a new retail operation in a different state in a country, the footfalls are not sufficient in the initial period to make that operation very profitable. That sort of pulls down the return ratios. 

Intelligent *inaudible* and steady geographical expansion, which increases the size of the market is a good pattern to look for. The last one, which I want to highlight is inorganic growth. There are some really good outstanding capital allocators out there. They are able to acquire assets at valuation that are quite compelling. 

The reason why they are able to do that is because they’re basically buying inefficiently managed assets. They have a system of turning them into far more efficient assets, to even increase the scale of their operations. 

When you buy a business which has a lower margin profile than your existing operations, but you have a way to increase the margins of that business over a period of maybe 2 to 3 years, the moment you buy it, it brings down the average return on capital. It brings on the average margin of the business. A lot of people don’t like that. 

Market participants who are fixated on reported earnings and reported returns on capital don’t like that kind of setup. I think those are the 3 or 4 broad patterns. I think they give an indicator of a mode sort of emerging and becoming bigger and better over time.

Stig Brodersen  15:00  

That’s really inspiring. We as value investors, or just the investing community in general, we talk a lot about risk-adjusted returns. Then you talk about stress-adjusted returns, which I absolutely love. It’s a very profound concept. How do you think through the process of achieving the best possible stress-adjusted returns, while being the best version of yourself?

Sanjay Bakshi  15:22  

The idea came to me about 7 years ago. I was looking at my own life as an investor over the years. I’ve made a lot of stupid mistakes over time. I was really looking at situations where not only was I going to have financial losses, but I would have a lot of stress. 

There are all kinds of things that people do in financial markets that are very stressful. I’ve done many of those things. I’ve sort of learned this the hard way. I started thinking about the idea that instead of thinking only about returns per unit of risk, which is the standard metric, why not also think about returns per unit of stress? After all, you only live once, right? 

You want to have a good and stress-free life. You want to be able to sleep well at night. What are the kind of situations where you get sleepless nights? I thought about those and came up with a whole bunch of situations where you can’t sleep well at night. It’s a high stress situation. 

And then I came across the opposite, such as situations where there is no stress or very low stress. Clearly, if you are investing in a business which has governance issues, where the guy who’s running it is a crook, and has no interest in the interest of the minority shareholders. Then obviously, even if you buy it at a valuation that is compelling and cheap, you’re going to have sleepless nights. 

 If you have a big position in that kind of a situation, you will not be able to sleep well at night. You will keep thinking about, “What is he going to do to me tomorrow? What is he going to do to me the day after tomorrow?” I’ve done that in the past. I found that very stressful. 

In contrast, if you invest with somebody who’s a true fiduciary, or has the fiduciary gene, and you think he’s not going to wrong you. He may make mistakes. That’s okay. But he’s not going to do anything that will harm you in a manner which will benefit him personally. 

I think you can sleep a little better at night if you had those kinds of businesses in your portfolio. Similarly, if you think about leverage at your own portfolio level or at the level of your investing companies, when you invest in highly levered businesses, it causes stress because they are inherently fragile structures. Whenever there is an economic slowdown, or there is some kind of global macro fear, these companies and businesses tend to get hurt the most. 

Similarly, if you borrow money to buy stocks at that portfolio level, you are prone to getting wiped out. What’s the point? Why take on all that stress? Shorting is another situation. People talk about shorting. Nobody talks about the stress of shorting. 

Everybody talks about the logic of shorting. It’s true that there are some manipulative companies, overvalued companies, and fraudulent companies out there. Think about what shorting does to people’s lives. In short a stock, theoretically speaking, you may be wiped out. You have an infinite loss potential out there. That’s not the case when you go long. 

Clearly, shorting is something I’ve done. I’m just talking to you from my own experience. I’ve shorted stocks. I got badly hurt. And when that happens to you, it doesn’t just ruin your health, it ruins your relationships. You get very irritable. You start fighting with your family for no apparent reason. The reason is because you are so stressed out because of the things that you have done, which you shouldn’t have done in the first place. 

There are all sorts of things. I wrote in a blog piece about this. The basic idea is instead of focusing on only returns and risk of loss, think about your health, your peace of mind, your need to be able to sleep at night, and about the quality of your relationship with your friends and your family. They are important, right? 

Now as to your other point that you ask about, how to become the best version of yourself, this is something that I wanted to share with you. This is a lesson I picked up from one of my friends in *inaudible*. He basically wrote something which was very profound. 

He said, “Compare yourself with an earlier version of yourself.” That version may have been from 5 years ago or a year ago. It doesn’t matter. But you’re only comparing yourself with yourself a few years ago, or a few months ago, or a few quarters ago. That is very fundamental. It’s very important to understand what that kind of thinking does to you.

Thinking that the other guy is so rich, I’m not rich, I’m miserable because of that, and etc. None of that matters. You’re only comparing yourself with yourself. It also forces you to learn from your past mistakes so that you never repeat them. It sort of turns you into a learning machine. 

I think it is very important to never get into a comparison with other people. But always try to think about the mistakes you’ve made last year, or the year before, or in the last 5 years. How can I make sure that I never make those mistakes again? And then you try to become better at your game over time.

Preston Pysh  19:43  

Sanjay, one of the most important things for our audience is reading. We’re kind of curious what you would describe as the best investing book that you’ve ever read. Most importantly, what was it that you took away? What were the most important ideas that you took away from that reading?

Sanjay Bakshi  19:59  

It isn’t a book actually. It’s something that is available for free. It’s such an irony that the best so-called book out there, in my view are the letters of Warren Buffett. This is how I discovered the idea of value investing. I always think that they are the best source of education for anybody who wants to learn anything about the world of business, of investing, or of human behavior in a corporate setup. 

There is no better place than to read those letters thoughtfully. I do have some suggestions about how to read those letters. A lot of people read them in chronological order, which is fine. But I think it’s more interesting if you were to convert those letters in a PDF document and learn about a specific idea by searching for a specific phrase. Let’s say, “buybacks. ” 

Buffett’s thinking on buybacks has changed over the years. There are profound lessons to be learned about this. In his earlier letters for example, he used to talk a lot about the importance of buybacks, how value can be created by buying back shares at a low valuation, and how that is a great capital allocation. 

Over the years, he has gradually mellowed down. I realized that it’s a zero-sum game. It’s important to give the right signals to the market and let the partners who want to exit from the stock have full information.

It’s very fascinating to learn about the idea of buybacks by just researching the term “buybacks” in the letters. The letters will not maybe add up to about 1,000 pitches. What I’m trying to convey here is the idea that if you want to learn about buybacks, go and download all the PDFs, convert them into a single PDF, search for the term “buyback,” pull out all the sections where Buffett talks about buybacks, put them in a different document, print the document, deep dive into it, and make notes. 

You will learn more about buybacks, or for that matter, anything on dividends, and on executive compensation. There are 50 other things that you could research, and learn about what Buffett or Munger, or anybody for that matter. The letters of Charlie Munger, I think, are equally important. 

I think what is important is not to know the names of the books, but learn how to read those books. You should know how to learn from those books, and how to apply them in your daily practice of value investing, which is more important.

Stig Brodersen  22:08  

We will definitely add a link to Warren Buffett’s letters. We’ll also make sure to add a link to Sanjay Bakshi’s Twitter handle if you want to contact him directly, as well as his blog post about stress-adjusted returns.

Preston Pysh  22:20  

Stig, I just want to highlight also that we have one more resource for people out there who want to learn more about Sanjay and his thoughts on value investing. We had our good friend, Hari Ramachandra from our Mastermind group. He conducted a YouTube discussion and Skype interview with Sanjay about a year or so ago. 

He asked some really great questions. We also want to have a link to that in the show notes for people who want reference to Hari’s interview with Sanjay. 

With all of that, Sanjay, thank you. Seriously, thank you so much for making time out of your day to connect with us and our audience. We’re just truly humbled and honored to have you on the show.

Sanjay Bakshi  23:00  

Thank you so much. It was a pleasure speaking to you today.

Stig Brodersen  23:03  

All right, guys. So at this point in time of the show, we’ll play a question from the audience. This question comes from John.

Audience 1  23:10  

Hey, Preston and Stig, this is John. I was wondering about your thoughts on the brokerage industry at large, specifically discount brokers. I know you have a page on your website that kind of goes in depth about them. I was just wondering if you could speak to your favorites, what broker you use, and just maybe give us a little more insight into the brokerage industry. Thanks, 

Stig Brodersen  23:30  

Great question, John. It’s a really relevant question. It might surprise a lot of our listeners. In our more than 200 episodes of The Investor’s Podcast, we haven’t been talking too much about brokers. 

It might seem a bit weird since we talk about stocks all the time, so why not talk about the broker. What’s the platform you need to actually buy the stocks? That process is actually very simple. The choice in many ways is also very simple. 

A stock is the same regardless, whether you bought it, or *inaudible* brokers or e-trade. You should really just buy the cheapest. This also implies that the general rule is you should use an online discount broker, and typically not go through your bank. Especially if you’re doing more than a few trades per year, it really makes sense to switch to an online discount broker. 

But again, I really recommend that you find the cheapest for you. And when you do, please make sure you also check out which brokers have various bonuses. It might be commission-free trades when you sign up for an account. 

When I say the cheapest for you, it really depends on how you trade. You have brokers who have very low commissions for stocks, and then you have other brokers who are really good, if you’re familiar with buy options. 

Also keep in mind that some of the more expensive brokers, especially banks, might even charge you for having an account on top of the commission that they’re charging you. 

You were asking which broker we use. I reside in Denmark. For that reason, I have a Danish broker but it’s the same principle. Another thing that’s applicable to a lot of our listeners is do not only look at commissions, but also look at the conversion fee that you might be using if you’re juggling different currencies. 

We’ll make sure to add a link to the page you refer to, John. We’ll include our favorite American brokers. We’ll also include our thoughts and recommendations about that. We’ll also add a link to a video that Preston did about the American broker he uses and why. We also have a quick discussion there about the best international broker. 

We typically prefer First Trade because it’s the cheapest. But when it comes to international brokers, it’s very difficult because of all the regulations. It’s a bit tricky to have a one-size-fits-all due to regulation. 

Preston Pysh  25:43  

John, I really don’t have too much more to add to what Stig had already said. I think he really kind of hit the high points there. 

The only caveat that I have is the YouTube video that I made from a couple years back about which brokers I use, the methodology, and how I think through what Stig described there. This is before Robin Hood was a broker. I think that it’s really important for people to specifically here in the United States to look into Robin Hood. 

I say that because to conduct a trade on the Robin Hood platform, it is completely free. To even do options trading is completely free on Robin Hood. I’m not 100% sure, but I believe there’s no annual fees or anything like that. 

I would tell you to look into that, in addition to some of the tools and resources that we have out there. The video that Stig was talking about is still a good resource because it helps a person understand the difference between a discount broker and a traditional broker that you’d go through. 

John, thank you so much for leaving such a great question. As a token of our appreciation for leaving your question. We’re going to give you access to one of our free courses on the TIP Academy page on our website. The course that we’re going to give you is our Intrinsic Value course. 

Our Intrinsic Value course teaches people how to determine the value of an individual stock. It also teaches you how to think about the market cycle of when you’re buying your stock. It also teaches you some stuff about options trading. 

We’re really excited to give you this course. If anybody else out there wants to check out the course, you can go to tipintrinsicvalue.com, or you can just go to our website and click on Academy. There is a link at the top of the page. It courses right there. 

If anyone else wants to leave a question on the show, go to asktheinvestors.com. And if your question gets played on the show, you’ll get a free course.

Stig Brodersen  27:29  

Alright guys, that was all the Preston and I had for this week’s episode of The Investor’s Podcast. We’ll see each other again next week. 

Outro 27:36  

Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. 

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