How to pick stocks the Warren Buffett way

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Damani: Give me a stock where you were impressed by the process. The logic told you to buy it but the market was not in your favour and but it worked out ultimately for you. Give me an example of that?

Bhatkuly: One stock in which, which suddenly happen and for two years the market gave just the opposite that was United Breweries. At USD 40 million of marketcap or Rs 160,000 crore, it took me about eight month to buy 9.9% of the company, with the fund that I was running at that time.

Damani: With the 50% market share and a great brand name.

Bhatkuly: Yes, 50% share but if you look at bear (check) worldwide it's also unique. Look at the United States you will find that Anheuser-Busch dominates the US but it's not a meaningful percentage of the European market at all.

It tends to be a very local business. It's also a young person's drink. So demographic profile was incredibly powerful over here and here was the most dominant brand. It took a while for-and there was some balance sheet issues and it took them maybe a little longer than I thought for it to repair-but if you look at United Breweries, over the last few years, it has ended up becoming Asia's number one performing consumer.

Damani: There was a time when McDowell was available for Rs 200 crore-as you said the huge tailwinds behind it or demographic explosion-the IT explosion with people going out to have a drink. I mean you could cross the Ganges, so to speak, and people would die to buy this company and yet the stock market was valuing it at Rs 200 crore.

Bhatkuly: And in United Breweries it was even worst because 40% of McDowell's at that time was held by United Breweries. So you have got everything else along with it for Rs 160 crore-less than McDowell's.

Agrawal: When I bought Bharti at Rs 25, every single friend of mine-I am saying friends-they all dissuaded me from getting into this saying this is not my type of stock. They literally made me sell 80% of what I had bought. So by the time it was Rs 30-I'd bought Rs 125,000 from day one because I tend to buy heavily when I buy at the beginning because you get it cheap.

Damani: And the margin of safety is there.

Agrawal: Yes it is highest and conviction is highest. But in the next one-week I was out of my stock by 80%. Of course, the stock moved to Rs 30, so I made some profit and I said this 20% I am not selling because I just want to prove that I am right. And then at Rs 32-33, I couldn't resist myself, I again bought back and multiple times I bought it back.

Damani: You said you don't like over seven foot bars; you like one foot bars as Buffet used to say. Give me an example of that?

Bhatkuly: In investing, you are only as good as the assumptions that you make. If Raamdeo is looking at the earnings of Bharti, he is leading up with some assumptions and if you have lots of moving parts in any assumption that you make, the probability of error is always going to be very high. So predictability, I would say, is the cornerstone of valuation. If you are able to get the predictability right invariably your valuation judgments will also be right.

Look at the world around you right now. There is euphoria in commodities; steel is back to its all-time high. Pick a steel stock in India-you are working now with issues of what demand will be like; how much each company will sell; what the production capacity is going to be; what the capital structure is; what interest rates; what cost etc, that will come to bear-but even worse the end commodity is internationally traded, which is now a function of who is dollar bearish and therefore is using steel as a proxy? How much of China buying is going to lead to an appreciation or a depreciation of the price? You could be in a situation where the Chinese are generating surplus dollars instead of buying T-bills, they are just backing the truck up on owning commodities because they are net importers.

There is huge liquidity in the world and as a function of which everybody is making a punt and there is financial buying and there is a genuine demand. So what component of this is influencing the price, therefore, affecting my valuation of steel or Tisco (Tata Steel), apart from investing and all other paradigms that drive Tisco, which is hard enough anyway.

So you don't want to have too many assumptions and too many variables to get right because invariably the chances of getting them right will be very low.

Damani: "Only when the tide goes out, you discover who is been swimming naked." This is another great Buffet maxim. Tell me about that one?

Bhatkuly: This happens even in businesses apart from just the stock market. We have had a spate of scandals recently and there are many companies, which we found over time, which have cooked up earnings, which mislead all of us-cash disappeared, Satyam is a very good example of it. 

Damani: Enron?

Bhatkuly: Yes, but closer to home Satyam. All of us have visited the company, may be owned it at some point of time, have got sucked in by customers, referrals, GE, State Farm and many such marquee clients names that they have had and suddenly we found one fine day that the cash had disappeared; the employees were half of what they were and the business vanished.

Damani: Talking about crown jewels, the one that you always favored-"It's better to have a part interest in a Hope Diamond than to own all of a rhinestone."

Agarwal: This is about quality of businesses you own or companies you own. There are three types of companies: One is great company where you put little money and then it has a huge rate of return and year after the return is so much that you cant even consume it in the business and hence you pay out huge dividends. Other type of business is bulk of the so-called popular businesses is the ones where you get modestly high return but every year you keep redeploying that-like banks or Reliances of the world. For earnings growth they have to deploy the capital back. They make about 24-25% but you have to redeploy for next year's 25% growth.

Then the third is gruesome, which was most difficult for me to understand and one must get it right. Not only that the rate of return is low, at times it is negative, but the managers out there they would also like to grow it. So when they try to grow it they need huge amount of capital and they actually end up doing it and that's the problem of airline and textile and everything. So the gruesome businesses one must avoid.

Damani: I disagreed with you on airlines. You have to buy it at a sufficiently attractive price, which is true for any business.

Agarwal: The beauty of the stock market is that you cannot lose more than 100%. So in limited liability situation, if you buy anything at literally scarp price you are going to get lot of money. So these great businesses like Jet and all, which are clearly great franchises in their own business, howsoever bad might be the economics, if you buy at some fraction of the price-I mean like say Rs 10000 crore is the turnover, you buy it for Rs 1000 crore or Rs 1200 crore.

Damani: Which we did. But the economics also change-you start charging baggage fees, say for example, or you start charging for food and the economics of the industry change.

Bhatkuly: Yes, temporarily I would say that. These are great trading stocks. You buy them when they are ridiculously cheap-when the entire industry is going through an abysmal low. You sell them at slightly better when there is a little bit of semblance of pricing power and improved competitive environment and make no mistake that it will attract new entrants and that will be pretty easy to do because financing is so cheap and you will see a down cycle again.

These are cyclical businesses. Don't look at them as a long term investor. If there is a trading call-you are not talking about investing-you are talking about a quick punt. So it's a one-night stand.

Damani: Or you buy it when they are expensive in terms of PE and sell it when they are cheap in terms of PE?

Bhatkuly: When they are abysmally low in terms of what their aggregate build up or replacement cost is likely to be and sell them at a discount to replacement cost.

Damani: My favorite Buffet maxim, "A girl in a convertible is worth five in a phonebook". It's about everything we learn in investing that a bird in hand is worth two in the bush and dividends are better than future discoveries of oil.