Shine on, Blue Star

Blue Star India has been in the business of cooling for many decades now. Historically they have largely been a B2B company, but recently they have also ventured into selling cooling solutions directly to retail consumers.  This company has been delivering excellent return on investment over the last decade. Blue Star is the biggest player in the commercial cooling business in terms of market share, and it has a very good brand reputation for commercial cooling solutions.  Blue Star is in 3 lines of businesses –
1) Electro Mechanical Projects and Packaged Air Conditioning Systems – which covers the design, manufacture, installation and maintenance of central air conditioning plants as well as contracting services in electrification, plumbing and fire fighting. This is primarily a B2B business.
2) Cooling Products – Room air conditioners for both residential and commercial applications, commercial refrigeration products and cold chain equipment. This represents the fastest growing business segment, and in the coming years might scale up to be much larger than the Electro Mechanical Projects and packaged air conditioning division, which currently earns over 60% of revenues
3) Professional Electronics and Industrial Systems – special industrial projects undertaken for steel and power plants, testing equipment from manufacturing companies, and a small medical equipment business
More details can be found in the company’s annual report.
In FY11, the company's current assets have gotten a bit out of hand, with increased inventories and receivables. Almost all of this working capital increase has been funded by new debt. While there has definitely been a case of management slipping up in letting the working capital requirements grow so much so quickly, the resultant dip in the company’s operating performance has caused the stock price to be punished quite severely.  This punishment has meant that the company is quoting at a market cap of a little over Rs 2,100 cr currently (The company has averaged an EBITDA of Rs 275 cr over the last 4 years). This represents a great investing opportunity since the punishment has been far in excess of the crime.
By all accounts, the FY11 income statement and balance sheet have been the worst of the last five years. But the current market cap is definitely understating the worth of the company by a fair margin. Here is why:
1)      Return on Investment: The company has consistently delivered a return on investment above 20% in each of the last 5 years – that is right, even in the just past bad year FY11. The average RoI over the last 5 years (including FY11) is a staggering 37%.
2)      Cash flows: The company has been throwing off strong cash from operations, well in excess of any reinvestment needs of the business. Only FY11 was a bad year from a cash flow perspective. The Cash Conversion Cycle (receivable days + inventory days – payable days) has been negative in 4 of the last 5 years – testimony to Blue Star’s strong leverage with its customers and suppliers.
3)      Debt: After using only a miniscule amount of leverage for a long time, in FY11, debt levels mushroomed to fund the increased receivables and inventories. However, even at current levels, debt is less than two times annual EBITDA and debt service (interest payments, finance charges) is less than a one-fourth of the corresponding period’s EBITDA level. The debt is easily serviced and in fact the company can comfortably take on some more debt. In such circumstances, management is, reassuringly for us, working on reducing the working capital requirements, and correspondingly retiring some of the debt
4)      Growth industry: Blue Star is involved in cooling offices, industries, airports, power plants, hotels, restaurants, retail spaces (showrooms) and so on and so forth - an unending list of commercial entities. They are the largest player in this business and have the best brand in the business. In addition to HVAC (commercial cooling solutions), they are now offering complete electrical, plumbing and firefighting (MEP) services. The brand, the large installed base, scale of operations and full bouquet of MEP services are all sharks and alligators in a very formidable moat around the business that will make it very, very difficult for a competitor to complete effectively against. Blue Star has now also ventured into the consumer (B2C) cooling business and has started selling retail – you may have noticed their advertisements on television – this business has been growing at a vociferous pace and bodes well for future growth. Blue Star is in some ways a bet on and a proxy for the scaling up of Indian businesses and an increase in per capita incomes over the long term
5)      Promoters: While Blue Star is an excellent company in a growth industry, it also has the benefit of having superlative management in the mix. Both the exceptional return on investment and strong operating cash flows are a by-product of management’s simple thinking and focus on getting the few important things right. This is evident in reading the company’s annual reports, which are not only very informative and educational, but also reflect the lucidity of their thought processes. This is a welcome change from most annual reports we peruse, where empty platitudes and insipid inanities adorn page after page. What is even more heartening to note is that management frankly acknowledges that they were caught sleeping at the watch in FY11, and have undertaken measures to rein in the runaway working capital. We should start seeing the positive effects of these measures over FY12 and FY13

This golden combination of great business, attractive long term prospects for the industry and a superior management at the helm is a very rare. Combine the very reasonable valuation the stock is quoting at currently, and you are looking at a singularly rare amalgamation of ingredients to create a blockbuster investment. The stock has lost almost 50% in the last few days, owing to the bad results announced over the last quarter. But if you believe that the company will revert to its historical efficiency in fund management and operations, then the earnings and RoI should see a big jump in the coming few quarters, and consequently the stock price should rise again. From the Q1FY12 (July 29, 2011) Investor Report, 'the company will be tempering  revenue growth through this year as it works on reducing the capital employed in the business'. Consequently the income statement might have to get worse before it gets better. If the stock falls further in response, it will represent a bigger discount in this ongoing sale.

Truth and falsehood, belief and disbelief

Truth and faleshood may be valid logical constructs, but they are not viable constructs from the perspective of human understanding and knowledge. What we in our day to day life take for truth and falsehood are actually in reality belief and disbelief. I ventured down this line of thinking after watching the movie, 'The Invention of Lying' (http://www.imdb.com/title/tt1058017/). The premise of the movie is that there is a world where the concept of lying does not exist, and everyone speaks the truth. In this world, the protaganist suddenly finds that he is the only one able to lie, with quite profitable results, as you can imagine. But is such a world without lying even possible? What is a lie? It is stating something that you know is not true. So lying is defined in terms of truth. But then, what is the truth? Is it stating something you know to be, or exist, indisputably? Or is it stating something that you believe to be, or exist, indisputably? There is a difference between knowing the truth and believing something to be true. We can only believe something to be true, and can never know something to be true. In the movie, the characters take everything anyone says to be true, since apparently the concept of lying is unknown, I wonder how they dealt with ambiguous or uncertain situations? A person may state what he believes to be true, but his belief may be mistaken. Take a character from such a world whose watch is running slow, but he does not know this - if someone asks him for the time, he will state the time based on what his watch shows, and what he believes to be the true time. But a comparison with another watch will show that he was lying, albeit unknowingly. This brings out the difference between knowing and believing. He believes the time is 9:15 AM, but the true time is 9:20 AM. If he states his belief, he is liar, isn't he? And knowing that people can lie, even mistakenly, it logically follows that other people will be skeptical of what people claim to be the truth, and will want to double check the facts. Thus a real world with people and uncertainty, and without lying, is logically not possible.

Ten thousand years ago, ancient man used to believe in the truth of Gods and exotic beings that lived in the heavens among the stars, and influenced things we observed on our earth. Over the last one thousand years, owing to Copernicus, Galileo, Newton and a whole host of others, we 'discovered' classical mechanics, and started believing in forces such as gravity and electromagnetism that influenced things we observed on our earth and the observable universe. In the last century or so, thanks to quantum mechanics, we now believe that the forces may actually be strings or particles or waves or a combination of them, and we cannot know anything for sure, and can only give a probability estimate for any event we observe in the universe. So you can see that as we think our understanding of the universe has improved over the millenia, it is in fact one set of beliefs replacing another, with the only requirement that the new set of beliefs is able to explain a few things that the old set of beliefs could not successfully explain. Note that we are only dealing in beliefs that try to explain observations - however we do not know what the truth is, or in fact, if the concept of the truth even makes sense in this context. And if this was not enough, the latest set of beliefs (quantum electrodynamics) that we take for truth now seem to suggest that we will always have to deal in beliefs, and that there is no one truth.

So when we say something is true, we are merely stating our belief. This belief may be modified in time, as new facts emerge. This belief is a good enough substitute for the truth for most of us, as we go about our mundane lives. We do not need to distinguish between our beliefs and what might be an unknowable, and therefore useless, truth. Given this background, we now come back to our starting premise - that truth and falsehoods are not valid constructs in reality, and belief and disbelief are what we are left with. So, is the world protrayed in the movie even possible? I think not - since in reality, we do not have truth and untruth - the movie should have been called 'The Invention of Disbelief', since all the charatecters in the movie are credulous and believe whatever anyone else says, until our protaganist comes along.

Bajaj Holding

Bajaj, like Tata, is an old and trusted name in India. The Bajajs have been around for decades. But in their newest avatar post the demerger of their flagship Bajaj Auto in 2007, they own and manage two exciting (value investor wise) businesses - Bajaj Auto Limited and Bajaj Finserv.

Bajaj Auto Limited is a two and three wheeler manufacturer - it is India's second largest two wheeler manufacturer and the world's largest 3-wheeler manufacturer. Bajaj Auto the business has done excellently well in the last 3 years - with very high and increasing returns on capital invested (it has averaged an RoE of 52% over the last 4 years). The consolidated revenue has grown from Rs 9,254 cr in FY08 to Rs 17,955 cr in FY11, PAT has grown from Rs 748 cr to Rs 3,454 cr in the same period and the market cap has consequently sky rocketed from ~Rs 8,300 cr in FY08 to ~Rs 42,000 in FY11. Under Rajiv Bajaj, the MD, the company has very successfully implemeted a strategy of focusing on higher end products and created a strong brand. The stock is moderately expensive at 12 times ttm PE, the company has negligible debt, negative working capital and negative cash conversion cycle and an exceptional Return on Investment.

Bajaj Finserv is a financial services company and manages - Bajaj Allianz Life Insurance Corporation (BALIC), Bajaj Allianz General Insurance Corporation (BAGIC), Bajaj Finance (NBFC that is into two wheeler and consumer durable loans etc) and Bajaj Financial Solutions (wealth management and advisory business in startup phase). The main profit driver so far for Bajaj Finserv has been BALIC, followed by BAGIC and Bajaj Finance. The good thing about Bajaj Finserv management (Sanjiv Bajaj, Rajiv Bajaj's brother, is the MD) is that they are prudent and conservative - for instance, they do not chase business at the cost of profitability. So in some years, depending on interest rates and other macro economic variables and regulatory requirements, they may lose market share since they do not pursue new business as aggressively as LIC or ICICI does. But this policy of prudence while writing new business premium will also ensure that they do not have too many bad years from a profitability perspective. This fact is reflected in their combined ratios (best in the industry) and their annual results - BALIC and BAGIC are the most profitable private sector insurance companies in their respective domains. Bajaj Finserv is currently quoting at between 5 and 6 times ttm PE.

While I think both Bajaj Auto and Bajaj Finserv are great businesses, from an investment perspective I find Bajaj Auto to be slightly expensive. Bajaj Finserv is currently quoting at a reasonable valuation.

But there is a great investment opportunity in the form of a holding company, Bajaj Holdings and Investment Ltd (BHIL). BHIL holds 31% stake in Bajaj Auto and 38% stake in Bajaj Finserv. The company's market cap is a little over 3 times the FY11 consolidated net profit (the underlying companies themselves are currently trading at much higher multiples of their respective consolidated earnings - Bajaj Auto at 15 times and Bajaj Finserv at 6 times). BHIL currently is quoting a market cap of a little over Rs 8,300 cr. Consider below, the share of profits of the associate companies (that BHIL has a significant stake in) that should accrue to BHIL owing to its shareholding.

(All amounts in Rs cr)

In FY10, BHIL's share of its associates profits totalled Rs 773 cr and its investment activities (interest, dividends, capital gains on sales of investments) earned it an additional Rs 771 cr, totaling Rs 1,544 cr. In FY11, its share of associate companies' profits was Rs 1,662 cr (helped by an almost doubling of profits from both Bajaj Auto and Bajaj Finserv), while the investing activities earned another Rs 1,000 cr for a total Rs 2,662 cr. Of course you need to subtract the expenses of the holding company BHIL from these cash flows, but those are minimal. And what multiple do you currently have to pay to get access to the upsides from these cashflows generated by good solid businesses with efficient and honest management and having great long term potential? - slightly over Rs 8,000 cr - a little over 3 times.

Both the large associate companies (Bajaj Auto and Bajaj Finserv) are great businesses in terms of the industry they are in as well as in having good management, and should continue to increase their profitability. Below is the position of BHIL's investments as of 31 March 2011, at cost and at current market value.

(All amounts in Rs cr)

You can see that the balance sheet carries the investments at cost (which is an 80% discount to current market value). Even considering this highly truncated value (80% discount to market values), the value of investments of BHIL is close to half its current market cap.

One final issue on the holding company discount. Mr Market tends to always value holding companies at a discount from the value of their underlying (investee) companies, due to the additional management layer in between. But I do not see a reason for a discount (or at least such a huge discount of 80%) in this case. One, the promoters have a track record and a reputation of integrity and fairness. Two, and more importantly, they have demonstarted this by paying out all the dividends BHIL has earned from its investee companies out to the final shareholders of BHIL and then some more. So effectively, there is no leakage of dividends at the holding company level.

Dividend received by BHIL from investments

FY09 - Rs 145 cr

FY10 - Rs 141 cr

FY11 - Rs 225 cr

Dividends paid out by BHIL to its shareholders

FY09 - Rs 101 cr

FY10 - Rs 318 cr

FY11 - Rs 390 cr

So the company is not hoarding dividends received from underlying companies, but is distributing them out to shareholders and adding to the pie from their investment returns.

The underlying companies - Bajaj Auto and Bajaj Finserv - themselves have all the ingredients of being blockbuster stocks - they are in high growth sectors, have excellent return on equity, and have good cash flows. Through BHIL, one gets access to the upsides of the cash flows of these two excellent companies - at slightly over 3 times multiple of annual earnings. In all, definitely a huge bargain.

The Piramal Arbitrage

There is a unique opportunity to make a profit out of an arbitrage situation with regard to two Ajay Piramal controlled companies.

Background - In 2007-08, Ajay Piramal spun off the New Chemical Entity, the entity doing research on new chemical and biological molecules that could evolve into blockbuster drugs in the future, out of what was then the pharma company Nicholas Piramal, and into Piramal Life Sciences Limited (PLSL). Nicholas Piramal was subsequently renamed Piramal Healthcare Limted (PHL). In mid 2010, Ajay Piramal pulled off a coup of sorts by selling the domestic formulations business and the Diagnostics business of PHL (which together accounted for almost 60% of PHL's then revenues) for fairly high valuations, and netted PHL about Rs 17,740 cr from this slump sale. Out of this amount, about Rs 10,200 cr was paid up front in 2010, and the balance of about Rs 7,540 cr is to be paid over the next 4 years. This future payment, which is not contingent on any conditions being fulfilled, has a net present value of approximately Rs 6,500 cr (keep this number in mind), discounting at a rate of 10% per annum.

The opportunity - The NCE unit, which is currently part of PLSL is now to be demerged back into PHL, for PHL stock. The proposed price is to issue 1 PHL share for every 4 PLSL shares currently held by the existing PLSL shareholders, for giving up the future potential of the NCE business to PHL. As of Friday, 22nd July's closing prices, PHL stock closed at Rs 400 a share, while PLSL closed at Rs 94.85 a share, both on the BSE. The demerger proposal is to be put to vote in a shareholder meet on 9th August 2011. Upon shareholder approval, the share exchange will be done on a Record Date to be decided by the boards of PHL and PLSL. So here is the arbitrage opportunity - going long on 4 PLSL shares, and short 1 PHL share (or multiples thereof) - if things work out as planned, there is a guaranteed profit of a little more than 5% (less transaction costs) to be made in less than a month. Of course, in life, nothing is guaranteed or risk free. The risks here are that the deal does not receive shareholder approval on 9th August for some reason, or the Bombay High Court disallows it or delays it for some reason - I estimate the probability of either event happening to be small.

But here is how I would play this trade - While a conservative investor would be well advised to go along with the above arbitrage opportunity and net a (almost) risk free 5% with cash deployed for less than a month (which annualizes to 60%), without caring about the underlying details of the businesses, a more intrepid investor might want to look under the hood and take a slightly different approach. Stock market price quotes are opportunities to buy small portions of great business at sometimes really favourbale valuations, that would never be possible if you were negotiating with the owners for an outright purchase of the whole business. Of course, this is assuming that the managers of the business are honest and treat all shareholders (including minority shareholders) alike. With this assumption, I do not see any difference between buying only a small portion of a business as compared to buying out a whole business. In Ajay Piramal's case, based on past track record, I would venture to state that this is a reasonable assumption to make. Based on closing prices of July 22nd 2011, the market is valuing PHL at just shy of Rs 6,700 cr. So if one were to buy PHL for Rs 6,700 cr today, one will, over the next 4 years, be eligible to receive an aggregate sum of Rs 7,540 cr (with an NPV of Rs 6,500 cr) as balance payouts from the slump sale done in 2010. So the payouts alone should recoup the intial investment. But in the balance, after recouping the investment, you are still left with the operating businesses of PHL, which had a revenue of Rs 559 cr and a profit after tax of Rs 71 cr in Q4FY11 (March 2011). Note that these businesses have immense potential to grow revenues and profitability in the future and you are getting these businesses for virtually no price. On top of this, PHL also had an investment income of Rs 130 cr in Q4FY11, which is just sweet gravy on the top.

So to sum up, at the current quoted price (Rs 400 on the BSE), PHL is an absolute bargain. PLSL represents an opporuntity to buy into PHL at a further 5% discount. Keep an eye out for these two stocks - a further divergence in their valuations (lower PLSL prices and higher PHL prices) will magnify the bargain in this opportunity, at least until the demerger happens.

Ideal characteristics of a stock

While searching for ideal stocks to invest in, there are two aspects one needs to consider:
a) Finding excellent businesses b) Finding great stocks among these businesses

a) Finding excellent businesses - An excellent business is one which has certain economic 'forces' that aid its profitability. There are some characteristics that such businesses display, that allows one to identify them. These characteristics are:
        i) High Return on Invested Capital: This is the single most important metric in determining if a business is a good one, or an excellent one. Return on capital invested is the retained earnings in a given period on the total capital that was available to the business at the start of that period. Return on investment can be measured as
   
                RoI = Net margin x Total Asset Turnover

A consistently high net margin indicates a business that has superior pricing power and lower competitive intensity. This ability to raise prices by reasonable amounts in response to market forces (or pricing power) is more often displayed by B2C companies, than B2B companies. B2C companies tend to create brands, their customers are many and diverse, and the customers are sticky. This gives the company leverage over its customers, and the consequent pricing power. In the case of B2B companies, the customers tend to be fewer in number, and a few customers can contribute a significant portion of revenues. In such cases, naturally, the leverage and pricing power is relatively less. Therefore B2C companies in general make for better businesses on a long term basis, from the perspective of an owner of the business. B2B businesses that replicate some of the characteristics of a B2C business can be attractive due to an economic moat - like being in a monopolistic position or having a sustainable lower cost of production than competing businesses.
      
        Increasing consumption => Increased earnings for the B2C companies => Increased earnings for the B2B companies => Higher raw material prices
       
The above flow diagram indicates the flow of value creation through the value chain. B2C businesses can create value in the long term on a sustainable basis only if consumers are consuming more and increasing spending. B2B businesses in turn can create value only from their customers, the B2C and other B2B businesses. And the value of raw materials only comes from their demand and consumption by various businesses. We see that at each step in the value chain, the flow of value created is in the opposite direction to the flow of price. B2C businesses derive value from consumers, B2B businesses derive value from B2C and other B2B businesses, and raw materials derive their value from all the business that use them. For raw material prices to be high, businesses that use them should do well. For B2B companies to do well, B2C companies need to do well. And for B2C companies to do well, consumers should do well. Hence we see that generally speaking, B2C companies are closer to the consumers, and the source of value, than B2B companies.

        Consumers    <many to few>    B2C    <few to few>    B2B    <few to few>    Raw materials

Coming to the other half of the Return on Investment equation, Total Asset Turnover indicates the efficiency of usage of capital invested in the business. This is the ratio of total sales in a given period to the average total assets in that period. The total assets include the net current assets (current assets such as inventories, cash, receivables minus the current liabilities), the Fixed Block (Capital Investments) made by the company and also any investments.
Businesses having the golden combination of high net margins and high total asset turnover, lead to a high return on investment. Such businesses, even in the absence of outstanding managerial skill at the helm, can yield satisfactory returns.

Let me give an example to help illustrate this. Assume you have won a lottery for one million rupees. You have always had a love for coffee and you want to use the one million rupees as your investment in a coffee related business. Say you have the following options: Option A - You could sell coffee beans; Option B - You could set up a factory that manufactures coffee making machines; Option C - You could set up a coffee shop where you make and sell coffee; Option D - You could hire a barista to make and sell a variety of excellent coffees

Option A, selling coffee beans, your margins are very low (you are selling a commodity) and all your returns have to come from asset turnover -  a high asset turnover and you are doing okay, but a low asset turnover, combined with the low margin nature of the business, will make it a very difficult proposition for you. Increasing asset turnover is very difficult - you do not have anything differentiating your coffee beans from other competitors’ and owing to their large coffee plantations, your competitors have a much lower cost of production of coffee beans than you. So you are squeezed on both the margin front and the asset turnover front. Low net margin, low asset turnover. Bad business.
Option B, becoming a coffee machine manufacturer, means you have to make capital investment in setting up the coffee machine manufacturing plant. Once the plant is up and running, the success of your business will depend on the quality of your coffee machines. If you make good quality machines and provide good service, you may be able to charge a premium for your coffee machines. But you will have to keep investing in maintenance and upgradation of the coffee machine plant, as well as in improving your sales and marketing and after sales service. So although your margins may be high if you make good machines and have created a good brand, your total asset turnover will be impacted by repeated investments you will have to make in the business. High net margin, low asset turnover. Moderate business.
Option C, where you set up a coffee shop - your margins are still low (since anyone out there can make coffee), but with good service you are able to increase your sales, and thus your asset turnover. Low net margin, high asset turnover. Moderate business.
Option D, where you also set up a coffee shop, but with premium coffees, great service, and great sales and marketing. Over time, owing to your differentiated product, you are able to build a brand and a following of faithful coffee drinkers, who are addicted to your coffee, and cannot go a day without it. Now you can raise the price of your product, and your demand does not drop off. Your big circle of customers only encourages more and more people to try your product out, and in turn your circle of customers gets even bigger. High net margins, high asset turnover. Excellent business.
Note that the above example is obviously contrived – you can encounter excellent businesses even if one of the two – net margins or total asset turnover is low– low margins can be more than compensated for by high asset turnover and vice versa. This example is only manufactured to aid illustration of the points I am trying to make.
        ii) Strong cash flows: Businesses that have strong operating cash flows will need lower infusions of external capital for funding future growth. Examining cash flows is an important way to distinguish between really good businesses, and businesses that are only 'paper tigers' - that exhibit strong revenue and net profit growth on their accounting statements, but which are not sustainable - either because they are funding growth through disproportionately higher receivables or through plain accounting gimmickery and window dressing. Ideal businesses will have Low Receivables and High Payables - most of the revenue is realized as actual cash flowing in to their coffers, while the cash outflows for costs and expenses can be delayed. Such companies have a very low or negative net working capital and cash conversion cycle (the cash conversion cycle is = receivable days + inventory days - payable days).

Of course, the debt should be as low as possible, ideally none. Even if it is there, it should be easily serviceable. By this, I mean that the debt service (finance charges, interest payments) should be less than one third or one fourth of the EBITDA of the company for a given period.
While the above are some quantitative metrics that can be measured for any business under evaluation, there are some intangible, qualitative aspects that need consideration as well. One must consider the nature of the industry that the business is in – an excellent business in an industry that does not have a bright future (think Kodak, one of the best photographic film camera companies, being decimated by digital photography or Barnes and Noble, one of the world’s best physical book retailers being killed by digital bookreaders and online retailers or Microsoft, owner of the dominant Windows operating system and Microsoft Office productivity software being threatened by cloud computing) makes for an unsound investment. I think this is the single reason Warren Buffet does not invest in technology companies – however good a business in this industry may be, the nature of the industry itself is so fast changing and unpredictable that it is almost impossible to determine how the technology landscape will look even a decade from now.

The other qualitative aspect to consider is the nature of the management. While it is true that if all the economic forces we encountered till now favor a business, then management has to work very hard indeed to deliver disappointing results, finding an excellent business with superlative management will mean, to paraphrase Wodehouse, ‘all is for the best in the best of all possible worlds’. This is especially true in the Indian context – where it is relatively easier for dishonest promoters to ride roughshod over minority shareholders’ interests.

b) Finding a great stock - Once one had identified a clutch of excellent businesses, the next stop is to pick great stocks from among these businesses. And this is largely a function of the price these businesses are available at. Borrowing from Benjamin Graham, one should view the purchase of stocks or other securities of businesses as not much different than buying a chunk of said business. Based on the historical data, especially the margins, asset turnover, cash flows, and the industry it operates in, one can determine the potential future cash earnings of the business. This steam of future earnings (very conservatively estimated) is used to determine the intrinsic value of the company. One then employs a margin of safety to discount this intrinsic value. The margin of safety is your insurance against even your conservative estimates being wrong.  If the current quoted market value of the business is less than this margin of safety discounted intrinsic value of the business, then the business represents an attractive investment opportunity.

The hardest part of undertaking the above exercise is estimating that intrinsic value from the historic earnings and financials results, in conjunction with one’s understanding of the future economics of the industry.
Some industries have the above favourable economic forces automatically aiding them owing to their very nature. Hence it is common to encounter good business from these industries -
• Cigarette/Liquor companies - B2C with inelastic demand, high margins and high asset turnovers, and higher payables than receivables
• FMCG companies - B2C companies with strong brands, slightly less pricing power compared to tobacco/liquor companies but much higher asset turnover more than compensating for lower margins
• Media Distribution companies - Newspapers, television stations - B2B companies with respect to revenues (since most revenue is from advertising), B2C companies with respect to content. The internet and mobile devices might change the dynamics of this industry, especially for newspapers and the print media
• Insurance companies and banks – The business model allows them to generate float (insurance premia and deposits taken on in advance against promise of future payments). Performance completely dependent on investment results of float collected and efficiency of float collecting operations. While banks have the risk of ‘run on bank’ due to fractional reserve banking (a complicated way of saying that all banks under today's banking system employ a high degree of leverage), insurance companies do not have this risk.

Two worlds

There seem to be two schools of thought even within the world of value investing. One is the Cigar Butt school, whose ideology was propounded, practised and popularized by Benjamin Graham, and whose modus operandi of investing was to look for very, very cheap stocks (cash bargains, net current asset bargains etc) that automatically implied a reasonable margin of safety by their cheapness, and to invest small amounts in a few such securities. The key is to spread the risk around by investing in a fair number of such securities, and rely on this diversification to compensate for any lack of knowledge or clarity about management, business underpinnings and other such details about the company. You had to rely on the margin of safety and diversification to protect your capital across the entire portfolio, and seek your return on capital on the few securities that should work out if you have a large enough set of securities in your portfolio.
    This approach was followed by Benjamin Graham and Warren Buffet in his early day (before he was influenced by Charlie Munger). Sanjay Bakshi has apparently evolved in the reverse direction from Warren Buffet, and now follows the many diversified Cigar butt portfolio method of investing (could this be because of bad experiences he may have had in the Indian stock market?).
    There is however a problem with this approach. You are spreading your capital across many securities, so the ability of each investment to impact your total portfolio value is limited. Thus, you do not get the full benefit for being right on some ideas. However on the other hand, you are also protected on the downside, in case some of your ideas do not work out. This appears to be a more conservative way of investing (or maybe it is a lazy way of investing, since you do not want to put in the effort to understand all the required details about the company to determine its intrinsic value and the risk factors that may prevent the market cap of the company from rising above this intrinsic value).
    The second school is the Great Business at fair value school. Here, you know enough facts about the business to be very, very sure that the intrinsic value will go higher in the future, so you can afford to concentrate your portfolio, and invest more capital in a few such opportunities. Here, being right brings tremendous rewards, and your portolio value can grow quite fast. It comes with the risk that a few bad eggs in the portfolio and can do a lot of damage to the value of the whole basket. So it all comes down to how sure you are of your facts, and how certain you can be about the intrinsic value going up. Warren Buffet seemed to be quite sure, and so he took more chances and it paid off hugely for him. In the context of the Indian stock markets, is it ever possible to be so sure, without having a direct line to the company management? Is this the reason why Sanjay Bakshi started off in the Great Business at fair value school, and ended up moving more towards the Cigar Butt school?