Value Investors Tribe

Author: Gautam Baid

The Joys of Compounding by Gautam Baid is a comprehensive stock market education guide for anyone who’s starting to learn about investments as well as for anyone who has been investing for a while. Gautam Baid skillfully articulates the lifelong learning required for investing as well as documents the essentials of investing in common stocks. In this part 4 of decoding the book we’ll summarize arguably, two most important concepts required to succeed in stock investments.

Understanding Intrinsic Value: Gautam Baid shares an interesting insight saying that calculating intrinsic value is rather an art form and use of mathematical modeling using spreadsheet or any other tool can only lead to a misleading results. Gautam Baid advices to use Warren Buffett’s description of calculating expected cash flows an asset is expected to generate over its useful life and then discount it back for the time value of money. Gautam Baid argues that Owner Earnings, which Buffett defined in 1986 letter to shareholders should be used to calculate intrinsic value (highly recommended to check it out).

Another interesting concept which Gautam Baid is that of Value Traps. Value traps are basically business which look cheap from statistical metrics but are actually expensive. He explains that Price/Earnings ratio (P/E), a commonly used metric for valuation, can be a common value trap. It is commonly understood that a high P/E ratio is an overvalued business leading to no returns in future. Gautam explains that even though markets are inefficient, they are not totally inefficient. A business trades at a cheaper valuation for some particular reason and a business trades at richer valuation i.e. high P/E because of its quality and possibly a moat around the business. Gautam lists four common parameters under which business might look cheap but is actually expensive when quality of business is analyzed. These four parameters are: Cyclicality of earnings, App risk (can also be called technology risk), Bad capital allocation and Governance issues.  

Margin of Safety: Gautam Baid explains that “Margin of Safety” are the three most important words in investing. Margin of safety is defined as a practice of buying stocks or any other investment asset significantly below the underlying value of the asset to account for error in judgment, market volatility or even tough luck. In stock market, prices of the business or stocks change daily and rarely does the value of business fluctuate at that rate. This implies that business get undervalued, fairly valued and overvalued quite frequently in the market. Buying a business by paying unreasonably high valuations rarely yield good returns. Gautam Baid explains how Nifty Fifty, which was highly popular in 1970s failed to provide high returns; some of the business have gone bankrupt which were popular in Nifty Fifty.

Gautam Baid also explained how Margin of Safety increases in a fundamentally strong business and how it reduces with a statistically inexpensive business with time. A fundamentally strong business, which has a durable and sustainable competitive advantage is able to generate high return on capitals and also has a long-run way for reinvestment. Most of these business for instance Costco, Coca-Cola, Amazon, Berkshire Hathaway and similar others generate high return on capitals for decades, beyond imagination of an investor. As a result, margin of safety increases with time for such businesses. On the other hand, statistically cheap business which can be categorized by low P/E ratio, low Price/Book Value ratio, low Price/Sales etc. do not have durable competitive advantage which leads to businesses failing to generate high return on capitals. Warren Buffett termed this as cigar butts and such businesses’ intrinsic value diminishes with time, reducing margin of safety. For cigar butt type businesses, in 1998 Berkshire Hathaway annual meeting, Charlie Munger famously said, “It’s not that much fun to buy a business where you really hope that this sucker liquidates before it goes broke!” To which Warren Buffett said, “We’ve been in a few of those too!”

This part 4 of summarizing important concepts from Joys of Compounding is to highlight some of the insights shared by Gautam Baid to be a successful investor. I highly recommend reading the book for some more interesting insights and to sharpen your skills.

Disclaimer: The content in this blog is purely for educational purposes. We do not claim any copyright of the book Joys of Compounding, all rights reserved by the publisher and the author of the book