How to spot a sunrise industry - Sunil Singhania, CIO Equities, Reliance Mutual Fund

Src : http://www.morningstar.in/posts/35302/how-to-spot-a-sunrise-industry.aspx

How to spot a sunrise industry

Morningstar | 29-12-15

Sunil Singhania, CIO Equities, Reliance Mutual Fund, shares his views during a panel discussion at the Morningstar Investment Conference held in Bengaluru.

Regarding sunrise sectors, what could investors expect?

India is a very large diversified economy driven by entrepreneurs. We grow despite the government rather than because of the government. Hopefully, this government will also support and we will grow much faster.

From an asset management perspective, it makes our life easier that India is behind the world by 15-20 years, though it's catching up in the sense that trends which used to take 20 years to come to India are now taking maybe 20 months or 20 days to appear. So, it's very easy to figure out that what would be the next sunrise sectors.

Around 15 years ago, I made my first trip abroad. The most of the time I spent in malls because we did not have any in India. Shopping was the biggest driver to go abroad. Now, when you go abroad, you don't even visit a mall because all the brands are present here. So, what happened there is ultimately going to come here.

So if you just simply start to analyze, you will find a few themes which might not be too big right now, but from a 1-year to 15-year horizon, they can really get big.

One is very clearly financial savings. Take Capital International, one of the largest asset managers in the U.S. In its initial 8 years, it reached a size of $2 billion assets under management. The next 30 years it grew 1000 times - $2 billion became $2 trillion.

We believe that the asset management business is just scraping the tip of the iceberg. We have a long, long way to go. And the next 10-15 years it could multiply manifold. So money moving to a very systematic wealth management financial savings kind of thing is a big theme. And whichever company you feel can benefit out of it are going to be the companies to bet on.

With both spouses working, I think QSRs - quick service restaurants, ready-to-eat food, are also segments that will grow.

Let me give you an example. My son was born in 1997 at Breach Candy Hospital in Mumbai. At that time my monthly salary was around Rs 15,000. The doctor wrote a prescription for a hepatitis B injection from SKF, which was SmithKline Pharma's earlier avatar.

The pharmacy quoted each injection at Rs 3,500 and I had to purchase three of them. I did not have the money that day, so made the purchase the next day. But I also ensured that I went and bought 100 shares of SKF. Within one month, the entire hospital bill of my son got paid by 100 shares of SKF.

So, sometimes these trends are visible in our own habits. So, if you are ordering something every day rather than cooking at home, it could be a big trend.

The other thing is brands. Tailored clothes or shirts are not common anymore. Everyone wants to sport a brand. Depending on your budget, you will buy Armani or Van Heusen or so on and so forth. Zara comes from a small country called Spain, whose population is equivalent to that of Mumbai. But Zara is a $70 billion brand globally and the biggest brand in India sells shirts worth $200 million.

Look at India - now 130 crore people, of which, let’s say 50% are men. I'm just taking an example so ladies please excuse me. But if 65 crore men, on an average, start to buy one extra shirt – that would mean 65 crore extra shirts. So, at an average price of Rs 1,000, it is Rs 65,000 crore extra spent on only shirts in a year. Again, we used to buy two shirts during Diwali and use them all through the year. Now, we shop regularly.

Brands are going to be a huge play.

Stocks are expensive but one must have a 10-15 years perspective.

Regarding sunrise industries, how does the health sector and health management industry look?

Health is a very good long-term sector in India.

Take the case of medicines. The total sales put together by all the companies is $12 billion, roughly Rs 75,000 – 80,000 crores. Pfizer's one drug, Lipitor, which was a cholesterol drug before it went off patent, had global sales of $14 billion. So, one cholesterol drug was bigger than the total of 130 crore people's medicine bill. So, there is a long, long way to go.

Second, affordability is improving. The propensity to take medicines is increasing. So is awareness. Lifestyle diseases are increasing.

As awareness and acceptability of life insurance and health insurance increases, the propensity to spend also does.

As a nation we are very under-served in terms of even basic medical facilities. So, it's going to be a great sector. As more hospitals get listed, as more specialty hospitals get listed - eye chain, cardiac chain, oncology chain, there will be various different specialized sort of opportunities also available.

The problem is that this sector is never cheap. It might appear a bit expensive, but if you look at it from a 5-10-15 years perspective, decent returns would be made.

What about sunset industries?

Doing business is becoming very difficult and very dynamic. For example, my son is now studying in the U.S. When he was applying to colleges, I would tell him to read the newspapers to increase his knowledge and awareness. And he said that the newspapers give stale news since he has already read it online the night before.

So, there will be lot sectors or industries where the way of doing business will change.

Someone was asking me about the advent of payment banks. There will definitely be some disruption. E-commerce, Flipkart is talking about doing $10 billion of gross merchandise value this financial year. While the traditional Hyper Cities and Shoppers Stop over the last 20 years have been able to reach only $1.5 billion. We continue to be positive on the brick and mortar play but the way of doing business is definitely going to change.

Every sector will have threats. Only companies which evolve and transform will be able to sustain. If not, the companies, irrespective of the sectors, will become sunset companies.

I Passed on Berkshire Hathaway at $97 Per Share - Rod Maciver

Src : http://microcapclub.com/2015/05/i-passed-on-berkshire-hathaway-at-97-per-share/

I Passed on Berkshire Hathaway at $97 Per Share

ROD MACIVER MAY 26, 2015

In 1982, working as a 26-year-old money manager, I passed on Berkshire Hathaway, which was trading at $97, because I thought it was too expensive. The price represented a 50 percent price to earnings and price to book premium to the broad market. Had I made a different decision – at the time I was sitting on a large cash position from a successful real estate investment – I would now be smoking $10 cigars and hanging out with swell chicks. I’ll wait, I thought, until it hits $60. I’m still waiting. On Friday BRK.A closed at $217,000.

Although I was familiar with Warren Buffett’s investment record – he was widely regarded as one of the best investors of his generation, and I carefully read the Berkshire Hathaway annual report each year – he had not attained the prominence he now has. I mentioned this to Ian, and he suggested I might write about what I learned from passing on Berkshire Hathaway, and the years I worked as an investment analyst on Wall Street.

By way of background, I did not finish high school. I left home at the age of fifteen and hitchhiked up into Canada’s subarctic and worked fighting forest fires and then as a forest tower lookout. The loneliness was too much for me, so at the age of eighteen I became a real estate salesman. In my early twenties I sold hotels and nursing homes, and then met with some success as a real estate investor. I became fascinated by the stock market, and a full time investor in my mid-twenties. Within a couple of years I was managing money, specializing in mismanaged, undervalued companies. They ran the gamut from companies whose stock had declined significantly, had new management, heavy insider buying, to the bonds of bankrupt or distressed companies, to companies with substantial real estate holdings, low insider ownership and minimal or no profitability. I was fairly successful at this in Toronto, acquired some major clients in New York City and in my late twenties moved to the US and started an investment research firm serving institutional money managers and corporate acquirers. I did that for five years, made some money and retired to the Adirondack woods.

Overall, I was successful but my performance was extremely volatile including two years in a row down over 40 percent. Most of my investments lost money or broke even; the few winners were up so much that overall my portfolio averaged a thirty percent return. Among my clients were some of the most successful corporate acquirers of the day – Sam Zell, Richard Rainwater, Leucadia, Jay Jordan, and some of the most successful money managers of the day, Chuck Royce, Leon Levy, Michael Price, Seth Klarman, Fidelity’s Alan Leifer, Ernie Kiehne of Legg Mason (Bill Miller was Ernie’s assistant at the time), George Soros — about 100 money mangers paid my firm $20,000 a year in soft dollars for my “contrarian research.” They followed my work because I studied, in an in-depth way, companies not otherwise followed by analysts.

Much of what I learned I learned from watching extremely successful investors make and lose money. And from losing my own money.

What did I learn?

Lesson 1: The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks salt water, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.

The approach that’s worked best in my experience is investing in high return on capital, low debt, growing companies that have the ability to reinvest earnings in the business and generate high returns on those reinvested earnings. The power of compound interest is so profound (mind-boggling really) that over time, returns in investments in those companies are enormous. The trick is finding companies that are compound interest machines. I remember Leon Levy, founder of Odyssey Partners, once telling me that John Paul Getty became the wealthiest man in the world by achieving a 17%percent compound rate of return, on average, over his career.

As in the case of Berkshire Hathaway, trying to invest in those companies based on an analysis of value is more likely to result in opportunities missed than it is make money. An approach that is much more likely to be successful – investing in high quality companies after a market decline of thirty percent, and retaining the liquidity to build positions in those companies after a fifty percent decline in the broad market averages. That takes extraordinary patience, which is a matter of personality.

Lesson 2: I’ve worked for two extremely successful investors who were experts in cyclical, commodity-dependent, capital intensive industries – real estate and mining – and learned that almost all of the real money made in those areas is made only by extremely patient investors who invest once every ten or twenty years, liquidate their holdings once a decade and spend long, long periods of time in cash.

One of those investors, Pat Sheridan, an owner of mines all over the world, once said to me that the classic business mistake was to be fully invested at the top of the market. The objective, he said, was to be liquid at the bottom because business cycles are primarily caused by the creation and destruction of debt. Those are functions of greed and fear, in other words of emotions. He built inventory (by buying mines) during times of low demand, and sold them during times of high demand, including one for $10 million in 2011. Managing cash is crucial to his strategy, he told me.

When oil or real estate prices increase, money flows in to take advantage of what appears to be above-average returns. Overcapacity results, prices decline, debt can’t be serviced and gets converted into equity or otherwise written off, capacity declines and within a few years commodity prices begin to recover. Then the whole cycle starts over again. The swings are unpredictable in terms of duration, but successful investors in those areas look for opportunities after a major (20 percent or more) capacity reduction in an industry, when the debt of the bottom thirty percent of companies in terms of quality of management and assets no longer exists and the debt of mediocre companies (the next ten or twenty percent of companies) trades at pennies on the dollar.

Three approaches, I’ve observed, work best over time: investing in the low cost producer with a durable cost advantage, investing in premium assets such as well-located real estate, and buying debt at pennies on the dollar after an industry wide collapse. All three strategies are most successful after a severe market decline when emotionally it is difficult to do.

The approach that almost always results in disaster – investing in cyclical stocks based on P/E ratios. Cyclical stocks are cheapest when, industry-wide, companies are losing money or have very low earnings, and most risky when they have low P/E and high price-to-book ratios.

Lesson 3: Most successful investors share some common personality characteristics.

They have superior analytical skills in at least one important area of investing. This results from an obsession with investing. They are students of the art. Ian, your commentary on this subject has helped me really focus on what I think I do better than most other investors. In your case Ian, I think that you have an important long term advantage in being willing to, and knowing how to, build relationships with management based on mutual trust and respect. In my case it is an ability to identify superior companies based on financial statement trends. I think. I hope. Only time will tell.

My skill evolved out of the realization that I could have avoided 90 percent of my disasters by spending a couple of hours with a company’s quarterly balance sheets and income statements. Instead, I would routinely fly thousands of miles, interview management, interview former executives and directors, especially those bearing grudges, visit company real estate and local appraisers, interview competitors, suppliers, and customers. I even, on occasion, would sit in a bar outside company factories and have a beer (or two) with workers coming off shifts. I studied accounting at night, read Ben Graham’s classic Security Analysis (twice) and spent twenty years running a business with customers, distributors, suppliers, employees and, as part of that, prepared financial statements once a month. I learned what fluctuations in twenty criteria including inventory, accounts payable and receivables and gross profit margin indicate about a company’s competitive position and prospects. That makes me uniquely qualified, I think, to analyze companies based on their financial statements. We’ll see.

Investing can be looked at as an emotional competition – your emotions and ability to control them versus the emotions of those you buy or sell securities from and to. A primary function of investment strategy is to counteract emotional impulses and thus survive (and take advantage of) adverse market developments. Investment performance is mostly determined by patience, risk management, a willingness to study, and what you do when things go differently than you anticipated. Those factors are personality driven.

In addition to having a clear concept of what their competitive advantage is over others, successful investors, I’ve learned, incorporate into their investment strategy clear concepts of acceptable risk, what constitutes an acceptable level of inactivity and length of holding period after funds are committed. And successful investors stick to their strategy. That strategy – for instance sitting on cash, sitting on losing positions, sitting on winning positions — must be based on self-knowledge. If the strategy is out of sync with the personality, it won’t work, no matter how well it has worked for others.

There are successful short and long term investors, but rarely are there successful investors who do both. A long-term investor must be a patient person. A short term trader who thrives on, perhaps needs, constant activity is likely to be an impatient person.

Regardless of short or long term investor/trader, risk management is crucial to survival and success. Once again, this is a personality issue. A successful investor’s strategy will anticipate adverse market developments – will assume that sooner or later they will be wrong and will lose money. Cash position versus invested capital is perhaps the single most important area of risk management, although acceptable debt levels (both in one’s own financial structure, and the companies in one’s portfolio) is also important. Does an investor have a cash management plan that fits with the other key elements of his or her investment strategy? Successful investors, in my experience, think their cash position through very, very carefully and they pursue a strategy that mitigates risk in what is otherwise a very risky field of endeavor – investing. Depending on the stage of the market cycle, very high or very low cash positions have a major impact on portfolio returns. And on investment survival.

Does and investor buy on strength or buy on weakness? Fluctuations in security prices are often determined by factors other than the underlying fundamentals of the companies involved. A stock can decline due to a major investor needing to raise cash, emotion, faulty analysis, and macro economic factors that do not affect the particular company in question. Is an investor a victim of those factors or a beneficiary? Does an investor know more about a particular company than the market? If yes, buying on weakness augments an investor’s returns. If not, returns are diminished by buying on weakness. Does an investor have the ability to admit when he or she is wrong and take action? Does an investor have the courage to buy during irrational price declines, when economic collapse is widely anticipated and discussed in the news media? Those factors impact long term returns, and they too are personality driven.

Ian, I find your belief that quality companies with market caps of under $30 million are more or less immune to general market declines because they have low institutional ownership very intriguing. Regardless, I strongly suspect that investing in quality companies that used to have market caps of over $100 million, and high institutional ownership, but now have market caps of under $30 million and no institutional ownership because the market is down 50%percent, is a lower risk variant on your strategy.

Whatever one’s position on that subject, an investment strategy needs to anticipate significant market declines, as well as declines in the securities in one’s portfolio, since declines have been a part of markets ever since markets were first created. Humans are emotional, therefore markets are emotional, debt results, markets collapse, and humans become more emotional. And master investors invest.

Or something like that.

Interview with Allan Mecham - Manual of Ideas

Src : http://manualofideas.com/members/pmr201004_allan_mecham_interview.pdf

MOI: Let’s switch gears and discuss the investment philosophy behind your  track record. Help us understand the kind of investor you are, perhaps by highlighting a couple of examples of companies you have invested in or decided to pass up. What are the key criteria you employ when making an investment decision?

Mecham: It’s really quite simple. I need to understand the business like an owner. The firm needs to have staying power; I want to be confident about the general nature of the business and industry landscape on a longer term basis. I’m big on track records, and generally stay away from unproven companies with short operating histories. I also believe a heavy dose of humility and intellectual honesty is important when looking at potential ideas.

There’s a strong undercurrent constantly percolating to buy something — it’s fun, exciting and feels like that’s what you’re getting paid for. This makes it easy to trick yourself into thinking you understand something well enough when  you don’t, especially if you are in the investment derby of producing quarterly and yearly returns! When looking at ideas, I have a Richard Feynman quote  tattooed in the back of my brain: “Don’t fool yourself, and remember you are the easiest person to fool.”

Ultimately, what tends to cover all the bases is the mentality of buying the business outright and retaining management. Critical to implementing this approach is, again, having a compatible investor base. “Whose bread I eat his song I sing”… An owner’s mentality forces you to think hard about the important variables and makes you think long term, as opposed to in quarterly increments. In fact, I think very little about quarterly earnings and more about the barriers to entry, competitive landscape/threats, the ongoing capital needs and overall economics, and most importantly, the durability of the business.

Over the years I’ve come to realize the importance of management, so we look hard at the people running the business as well. And, obviously, the price needs to make sense.

The criteria bar is set high; we really try to avoid mediocre situations where restlessness causes you to relax investment standards in one area or another. We also stress test the business under various economic scenarios and look to a  normalized earnings power. We passed up many seemingly attractive ideas over the years as we would ask, “What happens under 7-10% unemployment (when unemployment was in the 4-5% range) and 6-8% interest rates?” And we would ask, “Is the business overly reliant on loose credit extension and frivolous spending?” Many names didn’t hold up under these stress test scenarios, so we passed. We bought AutoZone [AZO] a few years back as it held up under various adverse macro scenarios, and in fact performed exceptionally well throughout the Great Recession. I constantly try and guard against investing in situations where the intrinsic value of the business is seriously impaired under adverse macro conditions. We prefer cockroach-like businesses — very hardy and almost impossible to kill!

MOI: You have said that “analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers.” Can you give us an example of how this tendency occasionally creates an attractive investment opportunity for the rest of us?

Mecham: Sure. In a generic form, I think there are many instances where a company hits a speed bump and reports ugly “numbers,” yet the long-term earnings power and  franchise value remain intact. Oftentimes a key cog of value is in a form that’s difficult to measure — brands, mindshare/loyal customers, exclusive distribution rights, locations, management, etc. Sometimes it’s the location of assets that can be hugely valuable. Waste Management [WM] and USG [USG] both have assets that are uniquely located and almost impossible to duplicate, which provides a low-cost advantage in certain geographies.Reputation is valuable in business, though hard to measure in numerical form. Reputation throughout the value chain can be a strong source of value and competitive advantage. I think Berkshire Hathaway’s reputation is very valuable in a variety of areas, most obviously in acquiring other companies.

The various cogs of value differ between companies, but many times the key variable(s) are difficult to capture in a spreadsheet model and/or are not given the weight they deserve.

MOI: You wrote recently that your “appetite is paltry for risky investments, almost regardless of potential reward. Theoretically this stance is illogical as ‘pot odds’ can dictate taking a ‘flyer’ — where the potential payoff compensates for the chance of loss — however these situations are difficult to handicap, and can entice one to skew probabilities and payoffs.” You put your finger on an interesting phenomenon: Many investors systematically overestimate the probability and magnitude of favorable outcomes. We recall the countless times we have read investment write-ups that peg the expected return at 50-100%, yet virtually no investor manages to achieve even 20+% performance over any meaningful period of time. What kinds of situations do you consider too risky or, more appropriately, too susceptible to the skewing of probabilities and payoffs?

Mecham: I’m not sure I can categorize the situations… Any time you are paying a price today that’s dependent on heroics tomorrow — fantastic growth far into the future, favorable macro environment, R&D breakthroughs, patent approval, synergies/restructurings, dramatic margin improvements, large payoff from capex, etc. — you run the risk of inviting pesky over-optimism (psychologists have shown overconfidence tends to infect most of us), which can result in skewed probabilities and payoffs. We want to see a return today and not base our thesis on optimistic projections about the future. Many earlystage companies with short track records fall into the “too risky” category for us. nvestments based on projections that are disconnected from any historical record make us leery. Investments dependent upon a continued frothy macro environment (housing, loose credit) are prone to over-optimism as well — how many housing-related/consumer credit companies were trading at 6x multiples growing 15%+ inviting IV estimates 5x the current quote?

Many times I think it can be a situation where you just don’t understand the business well enough and the bullish thesis is the nudge that sedates the lingering risks you don’t fully grasp. It’s important to keep the litany of subconscious biases in mind when investing. Charlie Munger talks about using a two-track analysis when looking at ideas. I think that’s an extremely valuable concept to implement when looking at investment opportunities. You have to understand the nature and facts governing the business/idea and, equally important, you need to understand the subconscious biases driving your decision making — you need to understand the business, but you also need to understand yourself!

MOI: How do you generate investment ideas?

Mecham: Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically. Companies and industries that are out of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare  for us to buy a company we haven’t researched and followed for a number of years — we like to stick to what we know.

That’s the beauty of the public markets: If you can be patient, there’s a good chance the volatility of the marketplace will give you the chance to own companies on your watch list. The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still.

MOI: You have stated that your “old fashioned style embraces humble skepticism and is wary of most modern risk management tools and ideas.” Give us a glimpse into how you construct and manage your portfolio — and how you protect it from the kind of upheaval the markets experienced in late 2008 and early 2009.

Mecham: There’s no substitute for diligence and critical thinking. It’s ingrained in my DNA to think about the downside before any potential upside. We try and stick with companies we understand, where we have a high degree of confidence in the staying power of the firm. We spend considerable effort thinking critically about competitive threats (Porter’s five forces, etc). We really stress long-term staying power and management teams with proven track records that are focused on building long-term value. Then we always “stress test” the thesis against difficult economic environments. As I said earlier, we try and guard against investing in businesses reliant on some type of macro tailwind.

If you have the above, combined with the freedom to take the long view, managing the portfolio is based more on intellectual honesty and common sense rather than any sophisticated “tools,” “models,” or “formulas.” If the financial crisis taught nothing else, it showed how elegant financial models that calculate risk to decimal point precision act like a sedative towards critical thinking and even common sense — “risk models” were like the bell that told the brain it was time for recess! I also think risk management by groups can have similar effects.  Being diligent, humble and thinking independently are key ingredients to solid risk management.

MOI: What is the single biggest mistake that keeps investors from reaching their goals?

Mecham: Patience, discipline and intellectual honesty are the main factors in my opinion. Most investors are their own worst enemies — buying and selling too often, ignoring the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity

The 400% Man

http://www.marketwatch.com/story/the-400-man-1328818316857

Published: Feb 13, 2012 12:03 p.m. ET

Last Updated: Feb 21, 2012 8:44 a.m. ET

How a college dropout at a tiny Utah fund beat Wall Street, and why most managers are scared to copy him.

By BRETT ARENDS COLUMNIST

On a fall day in 2010, half a dozen wealthy investors and portfolio managers converged on an office in midtown Manhattan. These were serious Wall Street moneymen; in aggregate, they handled more than a billion dollars. They had access to the most exclusive hedge funds and investment partnerships and often rubbed shoulders with the elite of New York, Greenwich and Palm Beach.

But on this day, they had turned out to meet an unknown college dropout from Utah -- and to find out how he was knocking them all into a cocked hat.

The unknown, Allan Mecham, had been posting mind-bogglingly high returns for a decade at a tiny private-investment fund called Arlington Value Management, and the Wall Streeters were considering jumping on board. For nearly two hours, they peppered him with questions. Where did he get his business background? I read a lot, he replied. Did he have an MBA? No. I dropped out of college. Did he have a clever computer model or algorithm? No, he replied. I don't use spreadsheets much. Could the group look at some of his investment analyses? I don't have any of those either, he said. It's all in my head. The investors were baffled. Well, could he at least tell them where he thought the stock market was headed? "I don't know," Mecham replied.

When the meeting broke up, "most people left the room mystified," says Brendan O'Brien, a New York City money manager who was there. "They were expecting to see this very sharp-dressed, fast-talking guy. They were saying, I don't get it, I don't understand why he wouldn't have a view on the market, because money managers get paid to have a view on the market." Mecham has faced this kind of befuddlement before -- which is one reason he meets only rarely with potential investors. It's tough to sell his product to an industry that's used to something very different. After all, according to their rules, he shouldn't even be in the business to begin with.

Over a 12-year stretch, through the end of 2011, Mecham, now a mere 34 years old, has earned an astounding cumulative return of more than 400 percent by investing in the stock of U.S. companies -- many of them larger ones like Philip Morris, AutoZone and PepsiCo. That investment performance leaves the stock market indexes and most mutual funds trailing far in the dust. Of the thousands of mutual funds in America, only a smattering of stock-oriented funds have done better, according to Lipper. Arlington, which is structured like a hedge fund, has put most firms in that category deep in the shade as well. It even managed to turn a profit during the crash of 2008, when Standard & Poor's 500-stock index fell nearly 40 percent. And Mecham has done this mostly while sitting in an armchair, in an office above a taco shop, in downtown Salt Lake City.

Mecham doesn't look, talk or act like a typical Wall Street manager. He's soft-spoken. He doesn't use jargon. He dresses like he works in a bookshop, with a patterned shirt and a plain tie. And the story of his success, arguably, says a lot about the flaws of the fund-management industry. By his own account, and those of other investors who have vetted his fund, Mecham has no secret sauce or amazing algorithm; what's extraordinary about this young man is how ordinary he is. But his investment approach relies on a handful of common-sense tactics -- focusing on just a few stocks, for example, and avoiding or ignoring short-term statistical analysis -- that big money-management firms either can't use or are reluctant to try. Skeptics and admirers alike agree that Mecham's approach involves a higher-than-usual potential for hefty losses. Russ Kinnel, director of fund research at Morningstar, says most fund customers would be unlikely to take that chance. "Pension funds, consultants, investors in general are quite benchmark-centric," Kinnel notes; they get uncomfortable when their money managers deviate.

But that notwithstanding, it would be a bit of a stretch to characterize Mecham as a rebel -- this is a man, after all, for whom one of the highlights of the past year was a trip to Omaha. (He took his girlfriend to Warren Buffett's annual investment conference.) As does virtually every other manager in the business, Mecham says he would like to raise more capital to invest -- his firm is small, with $80 million under management. But for now, the handful of pros who have jumped on his bandwagon are happy to have the fund remain undiscovered. It's clear that several think they're onto something special.

After the awkward New York meeting, O'Brien, who runs Gold Coast Wealth Management, was sufficiently intrigued to do more digging -- and after spending months talking with Mecham and checking his results, he got on board, investing more than $1 million with the Utah unknown. "To use a sports analogy," O'Brien says, finding Mecham was like "one of the rare few times when a star free agent becomes available in the beginning of his prime."

It's sensible these days for investors to approach the story of any stock market wunderkind with caution -- all the more so in the private-investment world, where money managers operate without the checks, balances and scrutiny that large mutual funds endure. Many such funds don't have to register with the Securities and Exchange Commission, especially if they're small and if big research companies like Morningstar don't track their performance. With the minimum stakes in such funds often very high -- at Arlington Value, the ante is typically at least $1 million -- investors have an even bigger incentive to do their own due diligence. (O'Brien, for instance, says he spoke to Arlington's auditors to confirm the investment figures, then did a background check on the auditors.) Factor in that the history of Wall Street is littered with the careers of investment hotshots who flamed out, and betting on a manager ultimately becomes a leap of faith.

Rule-Breaker's Rules

Money pros who know him say none of Allan Mecham's investing tactics are astonishingly difficult -- but for various reasons, most investors don't use them.

Ignore the economy. Where is the economy going next quarter? Where is the S&P headed? Mecham says he ignores those issues; instead, he looks for stable, defensive businesses that can thrive whenever bad times come.

Don't diversify. Most mutual funds own dozens or even hundreds of stocks (regulations usually require them to own at least 15). But to outperform with a big portfolio, a manager has to outsmart the market simultaneously on a raft of securities. Smaller funds and private-investment funds, which are not under the same requirements, can rely on just six or eight stocks.

Don't sweat the spreadsheets. Many Wall Street analysts build elaborate financial analyses to calculate a company's earnings growth and other patterns. But some say it's more productive to use that time trying to understand a company and its industry -- the management, the competition, the customers and so on.

Think decades, not quarters. Shareholders and managers tend to focus on companies' announcements of quarterly or annual earnings, and whether they beat or miss analysts' estimates. But some managers -- including one Warren Buffett -- say it's more useful to try to figure out where a company will be in a decade or more.

Don't just do something. Stand there! One of the toughest things for investors to do is to sit still and do nothing -- especially when nervous clients demand that they respond to short-term fluctuations in the market. But most of the time, say a few contrarians, inactivity is the right longer-term move. It's about "keeping emotions from corroding the decision process," says Mecham.

In Mecham's case, that faith resides in someone whose background is highly unusual for this industry. Mecham attended a community college and the University of Utah for two years -- but soon after starting an investment club, he says, he found his schoolwork boring by comparison. He would read books about investing and business. "I was 19," he recalls. "I was staying up till 3:30 a.m. devouring this stuff." Salt Lake City is a cohesive town where people know each other, and a classmate knew people at Wasatch Advisors, a local mutual fund company. Mecham landed a job there and eventually decided not to go back to school, choosing to stay on with the firm instead.

Mecham's Wasatch bosses say they remember him as a good, but not unusually good, employee who made one memorably successful stock pick, recommending that the firm buy a health-services company that did quite well. Still, it was only about a year before Mecham decided he could run money himself. He raised seed capital -- less than $200,000, he says -- from a handful of local investors led by Robert Raybould, a former real estate developer who is the father of Mecham's childhood friend Ben Raybould. And in 1999, Mecham launched his fund -- at the well-seasoned age of 22.

Since then, word of mouth has drawn more assets to Arlington, with Ben Raybould acting as Mecham's partner and the fund's main salesperson; regulatory filings show that the firm has about 120 investors, with more than 75 percent of them identified as "high-net-worth individuals." According to Raybould, of the $80 million in the fund, about half is investors' principal, and the rest, profit. But Mecham says his habits today are roughly the same as they were back when he had $200,000 to invest. He sits in that armchair by the window, carefully reading company filings and other records from atop a giant pile of material that he prints out each day. (Mecham prefers to read only on paper, not online -- old school.)

His investment approach will be familiar to anyone who has been even a casual follower of Buffett. Mecham looks for businesses with great long-term prospects, great management, strong cash flow and big defensive "moats," or barriers to entry for potential competitors. And he stresses the importance of sitting still and doing nothing. "Activity is the enemy of returns," says Mecham. "If I find two new ideas a year, that's phenomenal." Two ideas a year adds up to a pretty small portfolio -- Mecham typically owns between six and 12 stocks. (That's one thing that sets him apart from mutual fund managers; because of industry regulations on diversification, traditional funds typically have to have at least 15 holdings.)

The names of the stocks from which he has made his money over the years tell a lot of the story. They're not exactly glamorous or sexy businesses. (Mecham has never owned Apple. "Our portfolio is not one to get you excited," he jokes.) Some are well known, such as PepsiCo, fast-food giant Wendy's, health care firm Wyeth, consumer-products company 3M and Buffett's Berkshire Hathaway. Others are less so, like Watsco, a $2 billion company that's the U.S.'s largest distributor of air-conditioning equipment and supplies. Mecham says he loves the company's management and business model, but the choice was an industry pick as well -- in much of the country, he notes, when your air-conditioning system breaks down, getting it fixed "isn't a want, it's a need." Another little-known favorite, Heico, makes components for jet engines. Mecham's argument for the stock is brief, straightforward and Buffett-like: There are huge barriers to entry, he says, the replacement cycle is driven by regulation, and customers are not aggressive about demanding lower prices.

Indeed, Mecham can tell a good story like this about any stock he owns. But he writes these stories by himself, based on his own research -- unlike most fund managers, he generally doesn't meet company management. That's partly a function of his fund being small; he's not in a position to buy huge stakes that can make or break a company. But Mecham doesn't like meeting management even where it's possible. "Management is usually likable," he says. "They'll never tell you things are going to hell in a basket." Indeed, Arlington's worst patch came from getting too close to a company: local Internet retailer Overstock.com. Ben and Robert Raybould take the blame for persuading Mecham to invest in it and then persuading him to hang on when the stock cratered in 2005. Mecham called the decision "management by committee." The fund dropped by a third that year, while the market rose. Mecham argued with his backer, and in the aftermath, Raybould agreed to leave Mecham alone. (Overstock.com President Jonathan Johnson declined to comment about the stock price, but says he knows and likes Mecham.)

It was a very different story in 2008, Wall Street's annus horribilis, the year of Bear Stearns and Lehman Brothers. The financial meltdown was an event that blew up almost every smart money manager from Boston to Beijing. The S&P crashed 37 percent. Most actively managed stock funds did worse, and those that cut their losses often did so by fleeing stocks for cash. Arlington? It doubled down, loading up on stocks that would do well in a downturn.

An Elite Club

A 400% gain, which turns a $100,000 stake into a $500,000 jackpot, is a hall-of-fame feat for money managers. Below, some of the few who have pulled it off.

Warren Buffett

• Holding company: Berkshire Hathaway
• Market cap: $191 billion
• The 400% run: 80 Months. july 1989-February 1996
• The Oracle of Omaha has punched his 400 percent membership card more than once. This run, capped with a 57 percent gain in 1995 alone, got a boost from Buffett's famous investment in Coca-Cola, which he bought in 1988. Berkshire's recent returns haven't been as dramatic, but the company largely managed to avoid stumbles that have tripped up other well-known managers over the past decade.

Kenneth Smith (with others)

• Fund: Munder Growth Opportunities (MNNAX)
• Assets: $460 million
• The 400% run: 17 Months. october 1998-February 2000
• This fund, formerly known as Munder NetNet, epitomized the industry's embrace of the dot-com era. After it nearly tripled investors' money in 1999, its assets ballooned to more than $11 billion…and then the bubble burst. In the three years that followed, the fund lost 85 percent of its value. Over the past decade, though, Growth Opportunities, which has shuffled its management team, has beaten the market handily.

Bill Miller

• Fund: Legg Mason Capital Management Value Trust (LMVTX)
• Assets: $2.6 billion
• The 400% run: 85 months. April 1994-April 2001
• Miller, who quintupled investors' money in just seven years, attributes gains during this period to savvy tech calls: buying names like AOL and Dell early, then selling ahead of the tech crash. But he will be stepping down from the fund in April on a less triumphant note. After a series of big bets on banks went sour during the financial crisis, he has trailed the S&P 500 in five of the past six years.

Sam Stewart, Robert Gardiner, Daniel Chace

• Fund: Wasatch Micro Cap (WMICX)
• Assets: $275 million
• The 400% run: 90 months. november 1999-April 2007
• This fund managed a four-bagger in less than eight years by finding bargains among companies valued below $1 billion. The bad news: Small firms "struggled mightily" when financing dried up during the recession, according to Wasatch founder Sam Stewart. Micro Cap lost roughly half its value in 2008, but investors who stuck with it have beaten the S&P 500 by three percentage points a year, on average, over the past decade.

-- By Ian Salisbury

One was AutoZone, the chain that made more than $8 billion in revenue in 2011 selling car parts directly to consumers. Mecham had been building a stake since 2005, and he was convinced it was a "countercyclical stock" that would thrive even in a poor economy -- when consumers are hurting, he explains, they keep their old cars longer and fix them themselves. AutoZone stock gained more than 16 percent in 2008; since then, it has more than doubled. Mecham also zeroed in on Canadian insurance company Fairfax Financial Holdings. Wall Street had dumped the stock overboard in the panic, but Mecham had actually read the company's filings -- and he knew most of its assets were in Treasury bills and other ultrasafe positions. Arlington added to its already large position, and Fairfax rose 12 percent in the last two months of the year. The result: Arlington as a whole was up a remarkable 11 percent in 2008 and another 59 percent in 2009. No public equity mutual fund in America came close.

So why don't other mutual fund managers think and act like this? Bonnie Sewell, a wealth manager at American Capital Planning who oversees money for high-net-worth clients across the country, says concentrated portfolios can prove incredibly volatile. She says she wouldn't bet more than about 10 percent of a portfolio on an individual manager like Mecham, no matter how good, because of the inevitable risk -- or even likelihood -- that what goes up will come down. Regardless of their strategy, even managers with terrific track records can get cocky or complacent, or they can just make mistakes.

As investing sages like Buffett often point out, people on Wall Street are also subject to enormous career pressure to conform. If they took a big bet, like Mecham's on Fairfax, and it didn't work out, clients would bolt, and they typically would be fired or pushed out. But no one would get fired for missing an opportunity like that. The same goes for how managers react to short-term news in the market. Mecham says one of his big advantages over Wall Street managers is that he is free to ignore "noise" -- like the quarterly obsession over short-term earnings, which often drive stock prices sharply up and down as investors stampede in herd behavior. The first question he asks of any investment, he says, is where it will be in 10 years or more: "You have to have a high degree of confidence in the cash flows over the next decade." Mecham says that in contrast, the typical mutual fund manager is like someone who's hired to run a marathon -- only to have his clients announce that they're going to compare his time every 100 meters with that of an Olympic sprinter running a dash. "It's a myopic process," he says, with resignation.

Where does Arlington head next? Mecham says he won't compromise his strategy to play the Wall Street game. That leaves Ben Raybould battling to market a fund, and a manager, that many other money managers can't even understand. Mecham is bemused that so many people expect him to hold a broad basket of stocks and follow a benchmark, such as the S&P 500. "It's laughable to think that in this competitive world, you're going to find brilliant ideas every day," he says. "The world's just not set up that way."

Searching for multibaggers? Look for these traits: Raamdeo

http://www.moneycontrol.com/news/market-outlook/searching-for-multibaggers-look-fortraits-raamdeo_4544841.html

Dec 11, 2015, 07.57 PM | Source: CNBC-TV18 Searching for multibaggers? 

Look for these traits: Raamdeo Ahead of the launch of the 20th edition of Motilal Oswal's Wealth Creation Study, the brokerage's co-founder Raamdeo Agrawal says the 'Lollapalooza effect' is a powerful driver of outsized investment returns.

There are plenty of approaches which one can take trying to create wealth in the stock market. While some investors are the hands-off types, looking to invest in a well-diversified portfolio that will likely mirror the market's returns, others are more active, constantly evaluating the prospects of one stock versus the other.

For the latter, Raamdeo Agrawal, co-founder of Motilal Oswal, has an advice: look for the Lollapalooza effect.

The term, coined by Berkshire Hathaway vice chairman Charlie Munger, who describes it as a state in which several factors act at the same time in the same direction.  In the investing context, it means investing in a company that has several factors going for it.

Agrawal was exclusively speaking to CNBC-TV18 ahead of the launch of the 20th edition of Motilal Oswal's marquee Wealth Creation Study, authored by him.

The study's theme this year is 'Mid-to-Mega', or companies that can go from being ranked between 100 to 300, market capitalization-wise, to the top 100 in five or so years. "These could give returns of 10-12x," he said.

While the report shies away from naming names, it lays down a strong investing framework from which to draw, and underlines the importance of having the lollapalooza effect of MQGLP (mid-size, quality, growth, longevity and price).

Citing examples from the past, Agrawal said Eicher Motors was blessed with each of these factors back a few years back when its leadership in the cruiser bikes, a segment that exploded with the consumption boom, drove it from a market value of Rs 2,000 crore to about Rs 43,000 crore currently.

Below is the verbatim transcript of Raamdeo Agrawal's interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.

Latha: It would be always great if you can catch a midcap stock which is about to become a mega stock but give us your experience, what kind of times of earnings a person can make if he caught the right stock?

A: As far as the amount of money one can make, if you look at this current Wealth Creation Study which we are talking about, we have three categories of companies - the largest, the fastest and the most consistent. So if you look at the faster ones, among the fastest wealth creating companies is Ajanta Pharma. It has moved from almost like nowhere. In 2010 it was more like 900-800 rank company. So it was kind of a mini company and not a mid company and from Rs 200 crore marketcap, it is about Rs 12,000-13,000 crore marketcap now. So in five years it has done about 50 times of the money what one invested and you could buy and even sell today at about Rs 12,000-13,000 crore.

Eicher Motors, the larger one, has gone up from about Rs 2,000 crore to Rs 43,000 crore. So almost 25 times in the same five years period. So when you get the midcap or slightly smallercap company at the right point of time, the study has gone about how to figure out these companies when they are at that stage. So the amount of money you can make. One 5 percent allocation in your portfolio can change the entire profile of what you can make in that five-seven years in the market.

Sonia: It is a very interesting report you have and you have pointed out to us a couple of stocks that have moved successfully from midcaps to megacaps but what do you see as the way ahead in 2016 and 2017? After doing this research, have you identified any companies that are on their path to crossover from midcap to megacap?

A: We have avoided this time putting a specific recommendation on to the companies which are going to crossover. Yes, there are going to be at least 10-12 companies in this year which in next five years will move from midcap to megacap and they will create 40-50 times of the wealth.

One of the reasons the last year we did the study of 100x but that is very operational and probability of getting those kind of companies are very low. So we said let us go to the next best that is about 10-12x in next five years or seven years. So in that context if you look at the companies, I would avoid giving a name of a company which is going to move out there but the kind of companies even among the largercaps -- look at the companies like the biggest wealth creator has been Tata Consultancy Services (TCS), ITC, HDFC Bank. Even these companies have moved at a price of upwards of 20-25 percent CAGR.

So these four-five years have been the period of complete stagnation in terms of corporate profits in this stock market. So even in a very stagnant market, it is possible that a business or a company would move. Instead of focusing on which company, I think we have to do our own hard work but one must accept that -- now probably market is headed towards the situation where overall market may not move but individual stocks, individual businesses will get realigned. So my sense is there will be a lot of opportunities at a stock level, not so much at a market level. Definitely there will be 10-12 stocks, which will make a major move in next two-three years.

Latha: I was looking at your history of fastest wealth creators. This includes Dr Reddy's Laboratories, Cipla, it also includes the likes of Satyam and Unitech. So at what point do you get off the fast generators and preserve your wealth?

A: My 20 years experience is that typically the big ones -- they do last at the top but the fastest ones - they burn out the pace at which they go. So companies like even SSI in the feet of technology boom in 1999-2000, you saw Satyam, Wipro, Infosys but you also saw Pentasoft Technologies. Then in the realty boom in 2005-2007 you saw emergence of Unitech and all these kind of companies hovering the limelight.

So clearly when the companies don’t have -- it is a growth trap, earnings were growing but there was a complete lack of quality in underlying corporate management and the business itself. It was cyclical. So clearly one has to be very careful when one rides a very high growth company. That is what this study is all about.

When you look at these growth companies, either you are in the growth trap or you are in a quality trap. If you buy quality without growth then also you don’t make money but if you buy growth without quality then also you will not make money. So you have to buy growth, definitely with the quality and not without the quality. That is the message in the companies which have fallen.

Sonia: If you had to line up one-two-three in terms of the key parameters that one has to watch, where would you put growth, where would you put industry leading market share, where would you put management quality, how would you stack it up?

A: If you look at the qualities one is looking for, clearly one must look for traits of leadership even if the company is small. What happens is it looks that you can find industry leadership only in the large companies. It is not so. Even when the companies are mid in size -- for whatever maybe the business itself is new or it is in a niche when we looked at Eicher Motors -- four-five years back it was in cruiser bike, which was part of two-wheelers but it was very small, 4-5 percent shares but clearly, it was a leader in that particular segment and hence you can find that kind of leadership even when the company is Rs 1,500-2,000 crore kind of things. Today it has become Rs 40,000-50,000 kind of company so you can find.

When we looked at Bharti Airtel in 2003, it was about Rs 4,000-5,000 company. It was the leader of the wireless regulation, which was just knocking the door. So clearly, you have to look for leadership traits first and one of the things is that when you identify a midcap company, look at whether there is a leadership trait. Very recently, we saw the listing of Interglobe Aviation and it is a clear leader with 36-37 percent share of the market and almost 80-90 percent of the total profits of the industry. So clearly it is a big leader, though it has started off as almost as a large company maybe in the rank of about 105-110 but those ranks will move. If they are successful and the growth comes, the ranks can move from 100 to maybe 50-60. I would put the possible rank for this company to be more like around 50 in next two-three years. So clearly this kind of a rank change, position change can give a large perspective.

Latha: You borrow the phrase from Charlie Munger and you speak about the Lollapalooza effect, basically that refers to a whole host of factors coming together. Since you referred to Bharti, a huge new technology from landline to mobiles as well as the time when India was in the cusp of a very big growth rate from 5 percent for the last 10 years to 8 percent to the next six years. Tell us more, is that combination of factors needed to make a mid stock a mega stock?

A: Yes, the way we have gone up about writing the report and the way I look at personally, is that we call it MQGLP. M stands for mid-sized company, quality of business, quality of management, growth in the business and the longevity in growth and longevity in quality and then at a reasonable price. When all these five-six factors, size, quality of business, quality of management, growth and the long-term growth and long-term quality at the reasonable price, when all the six factors come together, it is some kind of a Lollapalooza effect. It is all forces coming together.

Can you buy a leader company growing very rapidly and growing for five-ten-fifteen years at a very reasonable price? So whenever you get this kind of opportunity, you must buy a lot. In the world of 3,000-4,000 listed companies, these things keep happening. Eicher is a Lollapalooza effect or emergence of Infosys in 1993 -- it is up 6,000 times in last 20 years. This is not a normal phenomenon. So when you want to make extraordinary money, you have to look for extraordinary confluence of events around that particular company and you can keep watching. It is not that one gets a notice of these kind of phenomenon but you can see over one-two years -- even if you have missed out two-three years of their story then in next 7-8 years, you can make a lot of money.

So we have seen companies like HDFC Bank. This is not an ordinary phenomenon that they get private sector bank license in 1995 and from after listing at Rs 40 that was about Rs 800-1,000 crore kind of marketcap today it is Rs 2,60,000 crore marketcap and still going at about 25 percent compounded. Till about 2000 you bought it, you still made it 100 times in next 15 years. So this confluence of event has to be worked in the corporate world.