July – September 2007

October 29, 2007

Notwithstanding Indias prospects, the dangers of paying too high a price remain. Ben Graham pointed out the dangers of regarding stocks as attractive irrespective of their prices:

The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell…

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy “good” stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic. Countless people asked themselves, “Why work for a living when a fortune can be made in Wall Street without working?” The ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, with the not unimportant difference that there really was gold in the Klondike.

Our caution stems not from an inability to identify cheap stocks, but from the current market levels which are expensive by historical standards. India might be in a new-era of 8-10% GDP growth, but we would rather work our valuations on the assumption of a 5-6% growth rate. That is our way of building a margin of safety.

The danger of watching the stock market pendulum oscillate between fear and greed is that it can anchor the observer away from its natural resting point (intrinsic worth). To benchmark quarterly performance against the market is a nonsensical anchor  an invitation to be part of the crowd with all its impulsiveness, emotions and exaggerated sentiments. It takes discipline to resist the temptation of joining such a boisterous party. As Warren Buffett stated recently on the Chinese stock market. We never buy stocks when we see prices soaring. We buy stocks because we are confident of the companys growth. People should be cautious when they see prices rising.

To think of the stock market as a perpetual money machine is as much a fools errand as trying to find a perpetual motion machine. Illusion created the fable of the goose that laid the golden eggs. Greed killed it and fear followed the discovery that there were no golden eggs inside the dead goose. These three themes resonate perennially in the stock market  illusion, greed and fear.

Our test for holding stocks is very simple: are we straining our necks looking up at intrinsic value or precariously balancing ourselves on a tightrope looking down at it hoping that other clowns in the stock market circus will attempt an even more sensational balancing act at a higher level? (The main difference between a stock market and a circus is that the stock market does not have any safety net other than a bargain level purchase price).

To rely on Mr. Markets judgment in setting prices is to commit the folly of mistaking the wastrel for the wise. Our standards of value sometimes are at wide divergence with Mr. Markets pronouncement of prices. Its not that we dont desire to make money, its that we first desire not to lose it.

Our investments are primarily in three areas:

1. Companies with high earnings power priced for no growth when the facts are clearly otherwise
   
2. Special situations
   
3. Asset bargains.

Thanking you,

Warm Regards,

Chetan Parikh