Source: Calvin & Hobbes
Calvin’s dad is right. The world is unfair. The business and the investing world are unfair too. If you think otherwise, bear with me for a couple of minutes, I will change your mind.
Even though I am a fan of Calvin, I think he is wrong here. Calvin says, “Why isn’t it ever unfair in my favour?” The world is always unfair in favour of someone or the other. It is we who fail to notice.
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Similarly, the world of investing is always unfair in favour of some businesses.
Don’t you think so?
- Y2K mania in the late 1990s
- RE/Infra/Construction boom in the mid-2000s
- FMCG/Steady compounders in the late 2010s
- Pharma at the stroke of Covid
- New age IPOs in 2021
- Defense/PSUs in 2022.
Don’t you think they all had an unfair advantage over other businesses in terms of the collective market appreciation for them in those times?
Likewise, different types of investors have an unfair advantage over others at different times in the market. Sometimes market favours value investing, sometimes growth investing, sometimes momentum investing, and so on and so forth.
But these are all about someone getting an unfair advantage over others for sometime.
Do you know there are some special types of unfair advantages that last for a very long time?
Let’s understand this.
Famous author and statistician, Nassim Nicholas Taleb, writes about Extremistan & Mediocristan in his book, The Black Swan. He describes the world of Extremistan & Mediocristan as follows:
“Assume you round up a thousand people randomly selected from the general and have them stand next to each other in a stadium…. Imagine the heaviest person you can think of and add him to that sample. Assuming he weighs three times the average, between four hundred and five hundred pounds, he will rarely represent more than a very small fraction of the weight of the entire population (in this case, about a half a percent.) … You can get even more aggressive. If you picked the heaviest biologically possible human on the planet (who yet can still be called a human), he would not represent more than, say, 0.6 percent of the total, a very negligible increase.”
“Consider by comparison the net worth of the thousand people you lined up in the stadium. Add to them the wealthiest person to be found on the planet—say Bill Gates, the founder of Microsoft. Assume his net worth to be close to $80 billion—with the total capital of the others around a few million. How much of the total wealth would he represent? 99.9 percent? … For someone’s weight to represent such a share, he would need to weigh fifty million pounds!”
Taleb further gives an example of Extremistan in book publishing. He says that if one randomly chooses a thousand authors, and adds up the total number of books they have sold. And then add one of the bestselling authors in the world, say J.K. Rowling, the author of the Harry Potter series. Her book sales would vastly exceed the total of the other thousand authors.
In today’s world, a more relatable analogy would be digital content. Take YouTube for example. We have a YouTube channel for Smart Sync Services. Our best content has about 5k views as on date. And I am sure there are would be a thousand finance content youtube channels like ours with a similar number of views for their best content. But when you look at someone like Rachna Ranade, her popular videos have views in millions.
That’s what Extremistan is all about.
From digital content let’s move to digital businesses listed on the Indian stock exchange.
Let’s understand what unfair advantages some of these digital/platform businesses have compared to their non-digital counterparts.
Balkrishna Industries (BKT) is an off-highway tire manufacturer based out of India and has a global market share in the mid-single digits. It has grown its sales, profits, and cash flows at a healthy double-digit rate in the last 10 years. And the market has also rewarded it handsomely. If you are short on time, read here to know more about BKT. To deep dive, check this out.
And now take a look at the image below:
To grow the sales, profits, and cash flows, it has to constantly work on increasing the volume of tires sold. And to do that, it has to constantly work on increasing capacity. It is evident in the investments in fixed assets every year as shown above. It is a business with linear growth. For getting more output, the business has to work equally on more inputs.
Let’s take a different business. CCL Products
CCL Products is in the production, trading, and distribution of instant coffee. The company has business operations mainly in India, Vietnam, and Switzerland. In the last few years, they have started transitioning from a B2B player to a B2C/FMCG player. If you wish to know more about CCL Products, you may check this.
Now check the image below.
The same thing. Linear business model. To grow more they have to produce more. To produce more they need to invest more in new capacities.
Both are decent businesses with a strong management track record and decent growth demonstration in the past. However, they belong to Taleb’s Mediocristan.
One new input is almost always similar to the average of all the inputs in the past.
But there are other businesses that are non-linear. They belong to Taleb’s Extremistan.
In those businesses, one new input can put them into a completely different orbit in terms of scale. Or they do not need to put in more inputs to create more outputs. These businesses are highly scaleable and benefit from network effects.
Think Amazon, Google, Facebook, Uber, Netflix, and the list goes on.
But for our example, let’s look at Indian Energy Exchange (IEX).
IEX is the first and largest energy exchange in India providing a nationwide, automated trading platform for the physical delivery of electricity. The exchange platform enables efficient price discovery and increases the accessibility and transparency of the power market in India while also enhancing the speed and efficiency of trade execution.
Btw, I am doing a deep dive on IEX on 31st January 2023 (Tuesday). You may register for the same here.
As against BKT & CCL, look at how little IEX has to spend on acquiring assets to grow.
That’s what an Extremistan type of business looks like. The one that benefits from non-linearity. And the one that has a lot of unfair advantages over the others.
That’s why they are valued differently.
|Businesses||Price to Earnings||Price to Book||Price to Sales|
And remember, these numbers are after a 55% fall in the share price of IEX in recent times.
Don’t get me wrong.
I am not proposing to avoid businesses like BKT & CCL and only focus on companies like IEX.
I only want to show how different these Extremistan businesses are hence how differently they will be valued by the market.
As an investor, do you still want to ignore them?
Ok. Let me make one last attempt to convince you.
My friend, Vikas Kasturi, a prolific value investor and thinker, is a much better authority on this subject. He writes this:
Now, if I was Calvin’s dad I would tell him:
The world is sometimes unfair in our favour. We fail to notice.
The business world is unfair in favour of some businesses. We fail to notice.
Those businesses belong to Extremistan. They are non-linear. You can’t ignore them.
For a curious investor, the investing world is also sometimes unfair in his favour. He just fails to notice.
Thank you for reading.
Happy Investing 😊
P.S.: I may have positions in some or all of the above-mentioned businesses. Hence, it is fair to assume that my thoughts are biased. Please do not take it as a recommendation to buy, hold or sell. If you like what you read above, you may like to know more about MissioN SMILE. You may download our MissioN SMILE app on your Android phone. (iOS App coming soon ). Lots of free & premium sessions on investing for you to explore and learn. 🙂