About the author:
Pulak Prasad is the founder of Nalanda Capital, a Singapore-based firm that invests in listed Indian equities and manages about $5 billion. He was with the global private equity firm Warburg Pincus for more than eight years where he was Managing Director and co-head of India. Before Warburg Pincus, Pulak spent 6 years at McKinsey in India, South Africa and the US. He joined McKinsey in 1992 from IIM Ahmedabad. Prior to the IIM, he was at Unilever in India as a production management trainee. He has an engineering degree from IIT Delhi.
Section 1: Avoid big risks
Before making money, learn not to lose money
Type I error: Make a bad investment erroneously thinking it is good — error of commission, false positive; error of committing self-harm
Type II error: Reject a good investment erroneously thinking that it is bad — error of omission, false negative; error of rejecting a potential benefit
The risk of these two errors is inversely related. Minimising the risk of a type I error typically increases the risk of a type II error and minimising the risk of a type II error increases the risk of type I error.
Imagine an overly optimistic investor who sees an upside in almost every investment and will make several type I errors by committing to bad investments but will not miss out on the few good investments. On the other hand, an overly cautious investor who keeps finding reasons to reject every investment is likely to make very few bad investments but will lose out on some good investments.
Should the investor (a) make a lot of investments so as not to lose out on some good opportunities and, as a result, live with some failed investments or (b) be highly selective to avoid making bad investments, thereby missing out on some good investments?
Warren Buffett’s two rules of investing:
Rule number 1: Never lose money
Rule number 2: Never forget rule number 1
Avoid big risks. Buffett is fixated on minimising the risk of type 1 errors. Don’t commit to an investment in which the probability of losing money is higher than the probability of making money. Think about risk first, not return. Risk is the probability of a capital loss — the higher the probability of loss, the higher the risk.
A great investor is a great rejector. There are very few good investments in the market.
The prevalence of type I and type II errors can lull us investors into thinking that we are better than we really are.
A dramatic performance improvement comes only when the rate of type I errors (errors of making bad investments) is reduced. Thus, whereas most investment books and college curricula focus on teaching how to make good investments, everyone would be better off learning how not to make bad investments. An investment career is probably among the very few that reward the sceptic more than the optimist. Buffett is the best investor in the world because he is the best rejector in the world.
Section 2: Buy high quality at a fair price
1. Avoid getting drowned by a deluge of data and information, Nalanda Capital initially selects a single business trait that brings with it many favourable business qualities: historical return on capital employed (ROCE)
The single business quality that correlates favourably with many other areas of business excellence is the historical return on capital employed (ROCE) — select only those businesses that have historically delivered high ROCE.
ROCE is the operating profit of the business as a percentage of total capital employed. ROCE for nonfinancial companies can be defined as EBIT Ă· (net working capital + net fixed assets).
- Operating profit is earnings before interest and taxes, or EBIT. This allows a better understanding of the businessâs operating performance, which profit after tax will distort as it adds financial measures like tax and interest.
- Total capital employed comprises two factors: net working capital and net fixed assets. In the net working capital number, they like to exclude excess cash (cash minus debt if cash happens to be much greater than debt) because extra cash is not an operating asset. High ROCE companies generate a lot of cash and incorporating them into the capital employed number will unnecessarily reduce ROCE. If you are uncomfortable with this, you can include a portion of cash in capital employed.
A consistently high-ROCE business is likely to:
- be run by an excellent management team.
- have a strong competitive advantage.
- allocate capital well.
- take business risk without taking financial risk, which increases the chance of business success.
There are two problems with the approach of choosing ROCE as the first filter.
- A consistently high ROCE in the past does not guarantee that ROCE will be high in the future.
- Making a preliminary list of only high-ROCE businesses is that it rejects companies (with low ROCE) that may become hugely successful in the future.
Selecting ROCE is a good starting point for analysis. It narrows down choices that allow them to do a lot more work to create a short list of attractive businesses after this initial filter.
The strategy of selecting only high-ROCE companies for their initial list invariably excludes some potential winners but it also excludes hundreds of low-quality businesses that they would never want to own. On average, the approach works well. There are no guarantees in investing.
2. Invest in only robust businesses that are resilient to internal and external shocks while continuing to evolve and grow.
Businesses must be robust to evolve.
Businesses must survive and prosper in a dynamic external environment, withstand internal strategic and organisational upheavals and evolve by taking calculated risks.
| Most robust | Least robust |
| Has delivered high historical ROCE over a long period | Has made operating losses for most or all of its history |
| Has a fragmented customer base | Is dependent on very few customers |
| Has no debt and has excess cash | Is highly leveraged |
| Has built high competitive barriers | Has been unable to keep competition away |
| Has a fragmented supplier base | Is dependent on a few suppliers |
| Has a stable management team | Management turnover is high |
| Industry is slow changing | Industry is evolving fast |
The author discovered that more levels of robustness lead to more evolvability. They choose to invest only in businesses that are robust at multiple levels as shown in the Exhibit above.
The greater the robustness, the greater the evolvability.
Robustness is a proxy for evolutionary and business success but doesnât guarantee it. Sometimes, robustness ceases to help businesses to adapt and grow. Just because a business is robust today does not mean it will continue to be so.
The only protection against the loss of robustness of a business is to be price sensitive. Nalanda does not invest unless the market offers us an attractive valuation, which happens rarely.
The author used the word ârobustâ to extend the margin-of-safety concept to many other facets of a company. He has sought a margin of safety on business quality by demanding high ROCE and a wide competitive moat, on the strength of the balance sheet by requiring it to be debt free, on the bargaining power of customers and suppliers by requiring them to be fragmented, and on the sustainability of economics by insisting that the industry be slow-changing.
3. Ignore proximate causes of stock price movements and focus on ultimate explanations of business success
The investing world must differentiate between proximate and ultimate causes. Proximate causes of share price changes can result from the macro economy, the markets, the industry, or the company itself. Since proximate causes are highly salient (e.g., the Fed announcing an interest rate cut or a company announcing a slowing of sales growth), investors may erroneously overweight them in their decision-making process.
Nalanda ignores all proximate causes when analyzing businesses — focusing exclusively on the business fundamentals, or the ultimate causes of the success or failure of businesses. They were aggressive investors during the financial crisis of 2008 and the early days of the COVID-19 pandemic because proximate worries compelled the markets to overlook the ultimate causes of the success of many high-quality businesses.
Over the long run, well-run businesses create a lot of value irrespective of the macroeconomic environment. Using proximate economic data to assess industry and company performance is very hard, if not impossible.
The author has not met a single finance professional who claims that markets can be predicted. So why do industry players spend so much time obsessing over future market levels? Why do fund managers devote enormous time and effort obsessing over what other fund managers think and do? Flawed incentives, false comfort, one-upmanship, etc. It doesnât really matter.
Thematic investing has three properties:
- Total addressable market (TAM): It shows the huge market potential. However, it does not tell us whether any profits will be made and even if a business can be profitable. Example: TAMs of apparel and footwear and food & beverage are huge but they are difficult to make money.
- Simplicity: Anyone can have some understanding of e-commerce, renewable energy, electric vehicles, fintech, self-driving cars, and artificial intelligence. The premise is seductive because it is straightforward.
- Actionable: They are listed in stock exchanges and we can invest. We can buy their products, use their services or follow social media on others’ reviews.
Fact is stranger than fiction.
How should Nalanda separate the proximate causes from the ultimate ones when there is euphoria or bearishness in a theme?
Unfortunately, he is not aware of a foolproof method for doing so. But here is what he does with Nalanda.
They define their unit of analysis clearly as the company. Not the economy, not the market, not a theme. They care about the fundamentals of the companyânothing else. They have never invested in a theme.
In his experience, developing a method and an instinct to separate proximate and ultimate causes of failure or success when they relate to a company event is invaluable for a long-term investor.
What allowed them to invest when the world seemed to be coming to an end?
They ignored all proximate causes of stock price decline and focused exclusively on the ultimate sources of success of a business.
It is common knowledge that lousy news attracts way more eyeballs than good news. We may blame the media for this bias, but psychologists have shown that people prefer reading bad news and remembering it better. The media simply exploit an existing prejudice. In times of crisis, this predisposition gets a steroid boost. Imagine reading the newspapers and watching TV in the weeks and months surrounding the Lehman collapseâheadline harassment would have taken its toll across the globe. This is where wonderful businesses were finally available at a price that we could not refuse.
4. Study and understand the history of a business and an industry instead of constantly obsessing over the future.
Nalanda develops a point of view on company financials, strategy, competitive position, and valuation by analyzing what has already happened without bothering about what will happen.
As long-term investors, they dissociated themselves from the âwhat will happen?â obsession and replaced it with âwhat has actually happened?â The former is a laundry list of conjectures and opinions, and the latter, to a large extent, consists of facts.
They donât forecast financials. They delve a lot into the historical numbers. As permanent owners, they are incredibly paranoid about the financial performance of the businesses. They don’t just analyse the company’s results in the context of its long-term history. As permanent owners, they want to invest in a business that performs well on a relative basis; one that performs better than the overall competition. Why waste time making useless forecasts when we can have so much to do with historical information available?
There is a simple reason why earnings are so hard to predict: multiplicative probability. Earningsâor profit after taxâis the last line item on a company profit-and-loss statement. We can calculate profit after tax after deducting from revenues the cash expenses, noncash expenses (like depreciation and amortization), financial charges, and taxes. Thus, the management needs to hit its target on all these line items to hope for an accurate earnings guidance. Many of these are not even under the management’s control.
Nalanda bases its assessment of a company on its riskiness, competitive moat, quality of financials, and management integrityânot on its ability to forecast earnings accurately. It is very hard to predict earnings consistently, so why measure anyone on it? They have never bothered to assess earnings guidance from companies.
The real question is not just about sustainable competitive advantage but about being consistently better than the competition. And what is the meaning of âbetterâ? It relates to measurable parameters like ROCE, market share, free cash flow, balance sheet strength, consistency of financials, and other such measures.
Have the company consistently been better than the competition?
They pay a multiple at or below the market for an exceptional business with high ROCE, a wide moat, and low business and financial risk. The general principle is that they assign a fair valuation based on historical, delivered financials.
When evaluating a business, risk comes first, quality second, and valuation last.
Relying on history is a time-tested way to keep the odds firmly in our favour. It will not guarantee a win every timeâno investment approach canâbut it will allow them to win often enough.
However, concentrating on the past does have two main downsides. We may wrongly assume that (1) a historically successful business will continue to be so, or (2) a failed or failing business will continue to be so.
5. Internalise the recurring patterns of success and failure in the business world
Where else have we seen this? Is this time different?
Nalanda Capital is an investor not in individual businesses but in proven and successful templates of businesses. They are big fans of Daniel Kahnemanâs âoutside viewââwhich is conceptually similar to convergence and compels them to seek similar patterns elsewhere before making an investment decision. However, applying the principle of convergence is tricky because we humans can see patterns where none exist. We can also miss out on one-off opportunities like Amazon that seem to defy the convergent notion that focus is the key to success.
Nalanda invests in convergent patterns. They seek patterns that repeat. As they say, âreplaying the tape of lifeâ often yields the same result. It operates on the principle that the business world is no different. There is a big difference between asserting âI love this businessâ and âI love this business construct.â We are fans of the latter, not the former. They donât care about a business; they are deeply attached to a business template.
6. Differentiate between the honest and dishonest signals of businesses
Zahaviâs handicap principle contends that a signal that is costly to produce is honest and can thus be relied upon by the receiver. The âcostâ may be in the form of additional resources required to produce the signal or an increased risk of mortality.
As investors, we, too, are bombarded with signals, many of which are dishonest. Examples include press releases, management meetings and interviews, investor conferences, and earnings guidance. All these signals attempt to favourably impress investors and are generally quite easy to produce. The author ignores all of them.
They rely exclusively on honest signals from businesses that, as in the natural world, are costly to produce (and more difficult to fake). These include past operating and financial performance and scuttlebutt signals from suppliers, customers, competitors, ex-employees, and industry experts.
They do meet management teams. They use these meetings to build relationships and to understand their corporate history and some of their past decisions. They never use management meetings to build an investment case or test key hypotheses because they know they will hear what they want us to hear, not what they want to know.
Section 3: Don’t be lazy — Be very lazy
1. Embrace the tenet that the long-term character of high-quality businesses remains unaffected by short-term fluctuations in the economy, the industry and even the business
High-quality businesses seem to undergo many changes when measured over days or weeks or months but are much more stable when the period of measurement is years or decades. Empirical data from the longevity of Fortune 500 businesses demonstrate the long-term resilience of exceptional businesses. About 40% to 45% of the Fortune 500 businesses of 1955 continued to be successful for the next sixty years.
Nalanda capitalized on the inevitable short-term fluctuations in high-quality businesses to invest at attractive valuations. However, since these opportunities arise infrequently, they rarely ever buy. They are lazy.
After investing, they ignore near-term fluctuations because the fundamental characteristics of stellar businesses remain stable over the long term. They never sell on valuationâthey are very lazy. They have sold only when there had been an egregiously bad capital allocation or irreparable damage to a business.
When we find high-quality businesses that do not fundamentally alter their character over the long term, we should exploit the inevitable short-term fluctuations in their businesses for buying and not selling.
Pulak Prasad’s investing principle which he called the Grant-Kurten principle of investing (GKPI)
GKPI means owning high-quality businesses that do not fundamentally alter their character over the long term.
The critical character traits of a high-quality business are stellar operating and financial track records, a stable industry, a high governance standard, a defensible moat, increasing market share, and low business and financial risk.
How can we use GKPI for buying? By exploiting short-term fluctuations.
In June 2022, excluding purchases during the previous two years, we owned twenty-eight businesses. In one of these businesses, we made more than one hundred times our money (Page); in two of them, we multiplied our money more than twenty-five times (Berger and Ratnamani); and in six of them, we made more than ten times our money (in Indian rupees). Unfortunately, all nine have suffered small but significant setbacks, some of which lasted many years (e.g., Ratnamani and Page). However, our adherence to GKPI ensured that we didnât panic, exercised patience, and stayed lazy.
Nalanda’s investing track records
Nalanda sells under the following three conditions:
- A decline in governance standards
- Egregiously wrong capital allocation
- Irreparable damage to the business
There is no point wasting time, energy, and brainpower on worrying about day-to-day upheavals in high-quality businesses. They can be highly resilient over the long term. So why sell?
All investing models have downsides. In my opinion, no investment strategy is foolproof. The application of GKPI will have Kodak-like downsides, but in their experience, it works well most of the time. And thatâs the best they can expect of any model.
2. Accept the pervasiveness of business stasis: Great businesses generally remain great, and bad businesses generally remain bad
Stasis is the default in the business world. Great businesses generally stay great and bad businesses generally remain bad. This is evident from the empirical data from the United States on the longevity of high-quality businesses.
Do not confuse stock price fluctuations with business punctuations. There are very few great businesses, and they are almost always unbuyable. Hence, they buy very rarely, and when they do, they buy a lot.
They avoid investing in bad businesses when their stock prices are on an upswing by focusing on the (bad) quality of the business and asking if Nalanda wants to own it forever. The probability that a not-so-great business becomes excellent over time is infinitesimal.
Their investment strategy is quite simple:
- Since the vast majority of businesses do not become great, their default strategy is not to buy. They are lazy buyers.
- They buy only if they can find a high-quality business that can stay in stasis over decades. If they believe they have such a business, they donât sell. They are very lazy sellers.
Research on industry and market concentration shows that:
- There are a few large and successful firms in most industries.
- These successful companies are becoming even more successful.
- Weak companies are getting weaker.
There is a tendency among investors to interpret stock price movement as the measure of business direction. The author observes that investors can commit two types of grave errors.
- They can treat an unfavourable stock price fluctuation as a negative business punctuation. This mindset compels the investor either to sell a good business or not to buy a good business when the price declines owing to a negative piece of news or event.
When we find high-quality businesses that do not fundamentally alter their character over the long term, we should exploit the inevitable short-term fluctuations in their businesses for buying and not selling. - They regard a positive stock price fluctuation as positive business punctuation. Doing so can lead to buying a lousy business (because it seems that things have permanently improved) or not selling one. Ask any long-term investor about their investment strategy, and almost all will proclaim that they buy and hold high-quality businesses.
We should avoid succumbing to the temptation of investing in a bad business on a stock market upswing; 3 simple rules:
- No sweets in the fridge.
The best way to avoid investing in bad businesses is to ignore them and their stock prices. - Business knowledge, not stock price data
Their soaring valuation is not an indicator that they are great businesses but that they have mastered the art of raising capital. - Do we want to own this forever?
The best protection against getting swayed by a false positiveâa stock price fluctuation that makes a lousy business look better than it isâis the question for every investment: Do we want to be permanent owners of this business? Are we absolutely sure that we are willing to live with it permanently? Are we willing never to sell it?
The starting hypothesis with every business is that we donât want to own it.
3. Be very patient and not to sell an outstanding business at almost any price.
The richest people in the world are the ones who refuse to sell; empirical evidence from a ninety-year-long study shows that great businesses create enormous wealth. Warren Buffett has shown that the strategy of holding forever works beautifully; those who stay invested can benefit from compounding.
Nalanda Capital has been successful not because they are better at buying but because they refuse to succumb to the temptation of selling.
What is needed to become a successful investor is not intellect, a commodity, but patience, which is not.
Reasons for not selling and letting the investments compound:
- Who are the richest? The ones who never sell.
- Empirical evidence shows that owning great businesses works (Oh, so well!)
In the Bessembinder study, there are two interesting insights. First, the quantum of wealth creation is almost eight times the dollar value of wealth destruction, although wealth destroyers outnumber wealth creators by almost 40%. Second, only a select few companies created most of the wealth, even among the wealth creators. - If there is an unbeatable formula, why not copy it?
Warren Buffett is highly successful and openly shares his secret of investing with his shareholders’ letters and shareholders’ meetings. He can easily learn and follow his approach. - How else do I pay for my mistakes?
Have a few great businesses to compound to pay for the investing mistakes. - The only way to benefit from compounding is to stay invested.
We cannot predict stock prices. We can make two predictions though. If we own a high-quality business, the share price will most probably (but not assuredly) react positively over the long run. Also, the share price will rarely make big moves and if we do not stay invested on those particular days, we can miss those substantial potential gains.
Not to sell when selling seems to be the most logical thing to do is correct. - Love the entrepreneurs
Pulak loves the entrepreneurs of the businesses he owns (endowment effect). - Not selling makes us better buyers
Nalanda is able to act decisively and disruptively because they are well prepared to buy as they are freed of the concerns of selling.
Objections and responses
- Why should I hold on to 60 PE?
Great business usually surprises on the upside. Valuation multiples generally do not stay benign for great businesses. And, why should we limit the calculation to only the next five years?
On average, over the long run, great businesses have a way of making us more prosperous than we ever thought possible. - My “incremental” return will be low from now on
Incremental over what period? One day, one month, one year, three years, twenty years? And why bother if it is a stellar business? - There is a better opportunity to deploy capital
Nalanda never indulges in “sell-high-to-buy-low” activity. They only sell if they have lost confidence in a business and when they do, they return the money to the investors.
The opportunity to own an outstanding business comes along very rarely and if we own this lottery, why should we kill the goose laying golden eggs? - Why should I do the whole day?
Investing is a unique profession in which inactivity can be hugely rewarding as evidenced by Nalanda. They will continue to be lazy, very lazy.
Conclusion: Reimagine investing by executing a simple and repeatable investment process
Business and investing are highly complex and our limited intelligence is incapable of fully comprehending them.
Nalanda has no interest in finding the “best investment” but in executing a sound investment process. Their 3-step investment process is simple and repeatable:
- Eliminate significant risks
- Invest only in stellar businesses at a fair price
- Own them forever
The process does not guarantee investment success every time but on average, it has worked out quite well for Nalanda. They always have and always will stick to the process irrespective of individual outcomes.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standardsâso when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines.
Warren Buffett, annual letter to shareholders, 1996
Our entire investment approach at Nalanda admits to, and hence compensates for, our profound ignorance:
- We avoid many categories of risks because of the wide range of possible outcomes in these situations.
- We invest only in exceptional businesses because most businesses fail, and we want to reduce uncertainty.
- We buy at an attractive valuation because, while we donât know what will go wrong, we assume that something will.
- We rarely buy, and sell even more rarely, because every activity may have unintended consequences we canât foresee.
As an older investor, I have only questions. I wish I had ready solutions for them, but I donât. So my only option is to internalize and implement a process that can simplify the worldâs complexity in a way that my intellect canât.
Pulak Prasad
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