May 29th, 2020

One area where perspective plays a very important role is in the valuation of businesses. We refer to this casually as the syndrome of “being in the boat” versus “being out of the boat”.

The implication of this is that in the case of certain businesses when one is “in the boat “ as it were, meaning one has been invested in the business for a period of time, one believes that there is a fairly good understanding about the business, its growth prospects, its earnings drivers, the competency of its management team and its culture. While valuations optically might seem elevated, there is a strong tendency to defend the valuation as the investor has a point of view and is sometimes quite anchored to it.

However, if one is “out of the boat” which is that one is not invested (but is perhaps looking to invest), the same business with the same understanding about its prospects and its earnings drivers, might look “expensive” and that “expensiveness” might also be articulated quite convincingly to defend that particular position.

As investors, it is extremely important for us to understand the forces at play and the fact that each investor’s perceptions of risk, return, opportunity cost and investing time frames are different. There are myriad factors at play. The tougher question (and one that must be asked) also is this : had we not invested in the business when we did but had to invest NOW, how would we be thinking about the business in light of valuations, other things being equal? It is a matter of discipline to try to understand the behavioural aspects and the opposing points of view at play in order to arrive at the most optimal decision.

One of the highlights of Bay Capital’s own investment process and approach is in the devil’s advocate system. The devil’s advocate system is where each new investment idea is looked at from a different point of view and this makes for all the relevant data points to be fully assimilated and understood. The “10th man” (a principle that emerged in Israel as a result of the Yom Kippur War and later popularized in the Brad Pitt film, World War Z) views the same investment through the prism of risk and attempts to challenge conventional wisdom not least in the context of valuations so that the team arrives at the most optimal decision.

The devils advocate system will start to gain greater importance for us in the days to come. The diversity of our team (a subject about which we hope to write and share our thoughts in the weeks to come) plays a very important role in this system. What might have seemed absurd at the beginning of the year is reality now. As investors, the question “What will a pandemic and its after-effects do to your business and how do you think you will navigate through it” was not among the set of questions that any investor would have asked of their investee businesses! However, now businesses will need to be more mindful of the different risks that are out there and calibrate their thinking accordingly.

As for us, the next time one of the team asks a “What if”, we would hope that we are able to look past the absurdity of it, take a step back and appreciate the point of view!

Posted by Siddharth Mehta, Founder & CIO