My name is Aziz Dodhiya and I am chief investment officer for the Valueoperations funds. Our common sense approach to stock market is very simple, we do not bet on daily up’s and down, instead we buy outstanding business with bright prospect at the right price and at all the other time we protect your money by keeping them in the safety net of ‘cash’.

Welcome to the part two of the common sense investing series. There are only three well taught lessons that you have to remember while investing in the stock market.

  1. Understand why market swings around, the way it does.
  2. Know how to identify great business, and
  3. Learn the logical way to value those businesses.

If you follow these three steps of understand, identify and value consistently over the time then you cannot help to do well. Whether you are buying stock or any other asset class, you will do far better than all the others who do not follow this approach of investing.

Knowing which business is great and which is bad is relatively very easy job. Understanding business is very straightforward if you know what to look at, I will share that in this article but the hard part is being patient and waiting for the perfect opportunity and keeping your head where everyone is losing theirs. Temperament is very important ingredient in investing but unfortunately that is the domain of your parents.

Let me show you now that how you already know how to identify great business and the mediocre one. Imagine you own a business that requires you to invest rupees one crore (10 million) initially and in the first year you earn rupees ten lakh (1 million) in profits. In the second year than you earn 20 lakhs (2 million) and then thirty lakhs (3 million) a year after and then 70 lakhs (7 million) and then one crore (10 millions) and then one crore thirty lakhs (13 million) and so on. Now think about it how desirable this business will be. Now suppose you own different business that requires the same initial investment and also generates same profits but there is one important difference. This new business requires you to reinvest half of your profits back into the business each year to keep it successful against its competitors.

Now, which business would you prefer to own? Half of the profits of the second business will never be distributed to you or in other words you will not receive it. I would describe it as, more capital required to generate the same level of earnings from the second business. Therefore it is less profitable.

Let’s compare other two businesses. The first business had initial capital contributed by you of rupees one crore (10 million) plus also a debt of rupees thirty lakhs (3 million) borrowed from the bank. The second business operates exactly in the same industry and had invested one crore (10 million) initially but has no borrowings. Both the businesses earn same level of profits in its first year of rupees ten lakhs (1 million). Which would you prefer to own?

When it comes to debt, less is more. Finally, what should you think of the business whose management bought more indebted company for fifty lakhs (5 million). The answer to that question is partly in this article that I will try to share with you.

These examples are not hypothetical either. The names are removed and the numbers are changed but they are taken from the real listed companies from the stock market. Here is the interesting bit, when I present the right information to you taken from the annual report and present you in the logical way a light is suddenly shined on simple facts that will help you make right decision about which is the more desirable business.

Now suppose we go all the way back in 2004 and two of us decide to start a business. We reach into our pockets and write a cheque for rupees four thousand two hundred and forty crore (42.4 billion) of our own money to kick start the business. This money will reflect as our capital or net worth in the Balance sheet of the business. Now we both head to the bank and borrow another four thousand seven hundred crore (47 billion) rupees. Now that is the total debt this company had now which also you can see in the balance sheet. So our business starts in 2004 with our equity of 42.4 billion and 47 billion of rupees in debt. We had total of 89.4 billion rupees invested and our loan to value percent is 111%. Most people think it is pretty safe. In other way to look at this, we can say that we don’t own anything but we owe everything what we have in the business to the bank. We will talk about this later in the series.

Now after running this business for one year the manager we hired to run this business report us profits of rupees five hundred and eighty five crore (5.85 billion). Is that good? 5.85 billion Profits where you contributed 42.4 billion in the business that reflects around 14% return. You can’t get that return in the bank, so good job done.

Let’s now fast forward to 15 years today and look back over a decade and half. Over that period of time the profits had joy ride. They had gone as high as rupees nine thousand three hundred crore (93 billion) to rupees two thousand two hundred and seventy five crore (22.75 billion). But this year, we will assume as 2015, the business will report profits of rupees five thousand three hundred and eight crore (53.08 billion). This represents almost 9 times more profits from the year 2004!

You might be thinking that this is really good business and we had really done well by starting this business as our profits had grown 9 folds in one and half decade. But here is the important part of understanding great businesses. To achieve this auspicious 9 folds earnings this financial year, so far we both had tipped in another 577.16 billion or rupees fifty seven thousand seven hundred and sixteen crore rupees of our own money and on top of it we borrowed additional 616.67 billion rupees or sixty one thousand six hundred and sixty seven crore.

For the same one and half decade we collected rupees 41.57 billion or four thousand one hundred and fifty seven crore rupees as dividends. So all of our remaining profits were reinvested in the business to grow. But hang on a second, in 2015 the business had reported a return of mere 8% only. There were many banks which were ready to offer a better returns if we would have invested our money with them. The inflation in the country averages out around 8% – 10% so technically we lost 2% of our purchasing power of our capital.

What if I tell you that 5 years back the business was fetching a return of 24% on your contributed equity and later to become big and grow its business it has brought down the returns below double digit and also chewed of lot of your own money to keep functioning on the name of growth. You would have been better off selling this business at that time.

The picture what I had painted about this business to you, what do you think? Is it a good one? Will you be happy to own this business outright if you got a chance to do it? Or will you try to come out of this business? The answer to the first question is ‘NO’, it is not good business to own today, it would be a good idea to sell it five years ago when business was flourishing. I will be not happy to buy this business outright today and yes will try to come out of it.

You did not need me to tell those answers, isn’t it? You already knew that. What this business is doing is sucking all of your profits and giving you low returns, returns lower than the bank interest rate where your initial capital is risk free.

Now this is not just any hypothetical example. It is a real business with real numbers, it is listed in the stock market for a very long time and the company is India’s one of the iconic telecom company Bharti Airtel.

You know what, it is hard to believe that in the stock market yet this business is trading above its book value. What this mean is someone is willing to pay more than what you had invested in this business so far. Why? One of the logical answer I can think of is because you don’t own but owe this business to the bankers. The bankers had put more money than you and are valuing this business on its assets but not on how efficiently you are allocating to make money.

I did not wanted to talk about returns here but in the last 16 years the absolute return this business had given is 350% which is around 8% compounded per year. In the last five years the returns are negative. The asking price in the stock market for this business is today trading below what the shareholders and the bankers had chipped in so far.

This whole article is to explain as Warren Buffett says, if you are not willing to buy the business as whole, you should not buy few stocks of it.

A disclaimer to add, we use to own this business for a while during the time frame we had discussed above but had sold it 5 years ago.

To share your views please feel free to leave comment and I will get back to it. Meanwhile see you next week talking about common sense in investing with part three.