Lessons from Gautam Baid: Mastering Simplicity and Compounding

What makes a great investor stand out? For Gautam Baid, it's not just about crunching numbers or riding market trends – it's about embracing lifelong learning, focusing on simplicity, and letting wisdom compound over time. In our conversation with Gautam, he shares his journey from bold risk-taker to thoughtful investor, his philosophy on quality over quantity, and the life lessons that shaped his books The Joys of Compounding and The Making of a Value Investor. Dive in for timeless insights that transcend investing and touch every aspect of life.

Hi Gautam, let's start with what inspired you to write The Joys of Compounding. What key message do you hope readers take away from it?

My life epitomizes Isaac Newton's saying: "If I have seen further, it is by standing upon the shoulders of giants." The Joys Of Compounding is my heartfelt tribute to all my teachers who helped me achieve financial independence, become a better and wiser person, and embark on the path to a fulfilling and meaningful life. Writing about and sharing my life's biggest learnings was my way of giving back to the investing community from whom I have gotten to learn so much over the years. Our goodwill compounds when we share with others. We should act as a funnel, not a sponge.

As Munger so beautifully put it, "The best thing a human being can do is to help another human being know more." In life, the winners also lose occasionally, but those who help others win can never lose. So always help others rise. This is how goodwill compounds over time.

In the first chapter of the book, I state that: "Today, after having successfully achieved financial freedom through my passionate pursuit of lifelong learning, I can happily say that I am a better investor because I am a lifelong learner, and I am a better lifelong learner because I am an investor."

At the same time, the learnings aren't restricted to only about investing. This is because compounding does not apply only to money, social and intellectual capital also compound. Investing in yourself, in your relationships, and in your understanding of the world pays massive dividends over time. This in essence is the core message of the book, that the best investment you can make is an investment in yourself.

How has your investment philosophy evolved over the years?

Our personal experiences in the market over time eventually lead us to our individual investing styles. For many years, I primarily invested in micro-caps, small-caps and cyclicals. I used to take very high risks, and was fortunate that I achieved financial independence through that investing style before the bear market of January 2018 to March 2020 began in India. That entire bear market experience ingrained in my mind the significance of resilience and longevity – the key to compounding.

By the time the bear market ended, I had evolved from being a highly concentrated portfolio investor focused on statistically cheap securities, to one focused on quality and prudent diversification. The bear market brought about a profound shift in my thought process as an investor – henceforth, I focused on return of capital before return on capital. Capital preservation and a focus on quality would take precedence.

I learned one more big lesson for the rest of my investing career: however well you are prepared, and have calculated your odds, risk surfaces from places you can never imagine. Even if you are very careful in crossing the road by looking left and right, a drone might still kill you from above.

Things can go wrong in ways you never thought of, and your only defense against unknowns is prudent diversification – a portfolio of 20-25 stocks diversified across industries and risk factors. This practice insures against a catastrophic outcome for the portfolio as a whole, and also opens the door to optionality.

It is also important to note that nowadays, sector rotation in the markets occurs at such a fast speed that no investor or fund manager can afford to be disproportionately overweight on a single sector. A diversified portfolio helps maintain patience and avoid FOMO by letting one participate in a variety of tailwinds while tolerating the short-term headwinds in others.

My second book, The Making of a Value Investor covers the journey of my evolution as an investor during that bear market, and my reflections and learnings along the way.

In The Joys of Compounding, you have written and spoken at length about the importance of continuous learning. What are your favorite methods for acquiring and retaining new knowledge in investing?

Charlie Munger has aptly said, "The game of life is the game of everlasting learning." He also said that "Those who keep learning, will keep rising in life." These to me were profound words and I embraced them as a way of life.

The body is limited in ways that the mind is not. In fact, by the time most people are forty years old, their bodies begin to deteriorate. But there is no limit to the amount of growth and development that the mind can sustain. Reading keeps our mind alive and growing. That's why we should inculcate a healthy reading habit. Reading is also meditative and calming. Books are truly life-changing, once you've developed the habit of reading every day while watching your every thought. The neuronal connections that compound through the effort will make you an entirely new person after a few years.

Buffett and Munger estimate that they spend 80% of their day reading or thinking about what they have read. Therein lies the secret to becoming smarter. The way to achieve success in life is to learn constantly. Once, when asked about the key to his success, Buffett held up stacks of paper and said, "Read 500 pages like this every day. That's how knowledge works. It builds up, like compound interest."

Albert Einstein reputedly said, "Compound interest is the most powerful force in the universe." So what happens when you apply such an incredible power to knowledge building? You become a learning machine. One person who took Buffett's advice, Todd Combs, now works for the legendary investor. After hearing Buffett talk, Combs started keeping track of what he read and how many pages he was reading.

Eventually finding and reading productive material became second nature, a habit. As he began his investing career, he would read even more, hitting 600, 800, even 1,000 pages a day. Combs discovered that Buffett's formula worked, giving him more knowledge that helped him with what became his primary job – seeking the truth about potential investments. Even after achieving such enormous success, Buffett still reads for many hours every day. He often credits this good habit for much of his success in life. Reading allows him to learn the lessons of others.

What many people see as a three-hundred-page book is often the accumulation of hundreds and thousands of hours and decades of effort. Where else can you get the entire life's work of someone in the space of a few hours? The benefits of recognizing just a few extra learning opportunities compound over time and unlock promising possibilities in the future. The best way to learn something is to try it yourself, but the next best way to learn is from someone who has already done it. This is the importance of reading and vicarious learning.

Throughout the course of humanity, for a long time, we have been recording knowledge in books. That means there's not a lot that's new; it's just recycled historical knowledge. Odds are that no matter what you're working on, someone, somewhere, who is smarter than you have probably thought about your problem and put it into a book.

The more you read, the more you will build your mental repertoire. Incrementally, the knowledge you add to your stockpile will grow over time as it combines with everything new you put in there. This is compounding in action, and it works with knowledge in much the same way as it does with interest.

Eventually, when faced with new, challenging, or ambiguous situations, you will be able to draw on this dynamic inner repository, or what Munger refers to as a "latticework of mental models." (Mental models are an explanation of how things work, what variables matter in a given situation, and how they interact with one another. Mental models are how we make sense of the world.)

You will then respond as someone whose instincts and judgment have been honed by the experiences of others, rather than just your own. You will start to see that nothing is truly new, that incredible challenges can and have been overcome, and that there are fundamental truths about how the world works. So, learn from others. Figure out where you are going and find out who has been there before. Knowledge comes from experience, but it doesn't have to be your experience.

You recently tweeted, "So much noise to contend with as a fund manager in today's times. The behavioral edge is truly the most important one for investors in the social media dominated world." Can you explain the concept of "behavioral edge" and why you believe it's so crucial for success in today's markets?

Fifty years ago, the best investors were the ones with an informational edge. Today, the best investors are the ones with a behavioral edge. As the speed of information dissemination in the markets and competition for short-term outperformance among money managers increased over the years, time horizons and patience levels significantly decreased.

Today, an investor's edge is less about knowing more than others about a specific stock and more about the mind-set, discipline, and willingness to take a long-term view about the intrinsic value of a business. Patience with good businesses having growing earnings is key to long-term investing success, but it is not easy. Neuroscience has shown that the human brain processes value over different time periods inconsistently. We are short-term demanding and long-term inattentive. Our brain is hardwired for immediate rewards.

Since people first began investing, they have been searching for a magic formula for instant wealth. It is human nature to seek instant gratification, and the market is dominated by individuals who simply do not want to wait for much larger rewards several years down the line.

As a result, many investors end up engaging in "hyperbolic discounting," heavily discounting the distant but large cash flows of high-quality businesses by applying high equity risk premiums, and they end up with much lower estimates of intrinsic business value than otherwise would have been the case. Consequently, even though those businesses may be fairly valued in the short term, they end up becoming grossly undervalued on a long-term basis.

Professor Sanjay Bakshi illustrated this anomaly in his seminal October 2013 white paper on how quality businesses frequently end up getting mispriced by the market. (Any stock that has compounded at 15 percent to 20 percent for decades was, by definition, undervalued by the market for long periods of time.)

In The Joys of Compounding, you discuss the value of simplicity in investing. How do you identify businesses that are simple enough to understand and invest in?

Simplicity is the end result of long, hard work, not the starting point. The ability to reduce something to its essence is the true mark of understanding. Simplicity is a very powerful construct. Einstein recognized the power of simplicity, and it was the key to his breakthroughs in physics. He noted that the five ascending levels of intellect were, "Smart, Intelligent, Brilliant, Genius, Simple." For Einstein, simplicity was simply the highest level of intellect. In the field of investing, simplicity is the way to long-term success.

Unlike the figure skaters at the Olympics, we don't get extra points for higher degrees of difficulty in investing. Originality or complexity are neither necessary nor sufficient conditions for generating superior long-term returns. As investors, our job is simply to compound capital over time at the highest possible rate with the minimum amount of risk.

We achieve this objective by seeking out undervalued stocks of companies within our circle of competence. Investing is not about being original or creative; it is about looking for the greatest amount of value for the price paid with the least amount of risk. Putting in more time and effort does not guarantee better results in investing. Rather, doing less and making fewer but better choices is more beneficial.

Look for simple businesses that require fewer assumptions and fewer hypothetical scenarios to work out and that do not require discounting cash flows from way out into the future to justify the investment. In the chapter on simplicity in my book, I have also discussed the concept of minimalism.

Minimalism is basically an extension of simplicity – not only do you take things from complex to simple but also you try to get rid of anything that is unnecessary. Very few things really matter in life. Because few things matter, we must think carefully about what really matters to us and then commit our time primarily to those things. That way, we will remain focused on what matters rather than chasing the new thing, which will probably not really matter.

Applying this principle to the field of investing, it is important to identify and focus on the few key variables that really matter to an investment decision. This vastly simplifies the process and improves the probability of a successful outcome. It helps us separate the long-term signal from the short-term noise and to calmly think through any investing decision.

Yes, reading the annual reports, filings, press releases, and footnotes to the accounts is important, and occasionally we will be able to dig out some extra detail that might give us an analytical advantage, but, in my view, understanding the big picture (the two to three key variables that really matter) is equally, if not more important.

Some of us may be average at business valuation but still can achieve above-average results by being able to better put the available information in the appropriate context, by remembering the big picture, and by being able to pinpoint the few factors that really matter to an investment, because different metrics and facts are salient for different types of companies and investment situations.

In one of his past lectures at Columbia University, Joel Greenblatt taught his students the importance of always keeping the big picture in mind. He said, "Investing success has got nothing to do with the ability to do a spreadsheet. It has more to do with the big picture. Focus on the big picture. Think of the logic, not just the formula." In investing, and in many areas of life, less is more. Simplify, simplify.

What are some common pitfalls or "value traps" that investors should be wary of, and how can we avoid them?

Value traps are businesses that look optically cheap but actually are expensive in reality. This could happen for a variety of reasons:

• Cyclicality of earnings: A low P/E stock may look cheap because the business is enjoying cyclically peak earnings, but the normalized P/E may not really be low if adjusted for cyclicality.

• App risk: A taxi company may look cheap based on past earning power, but that may have existed only until Uber arrived.

• Bad capital allocation by the management: The market may correctly be punishing a business by assigning a low multiple to its earnings because the managers keep burning cash in bad projects and there is no prospect of such misallocation being stopped.

• Governance issues: A business run by a crook may appear to be quite cheap relative to the large amount of cash reported on its books, until that cash is completely siphoned off. Give zero valuation to the cash held in the books of a business being run for social purposes or owned by shady promoters. Gains in intrinsic value often are not reflected in realized returns for investors because insiders channel the gains to themselves. Remember, human nature does not change. Crooks don't suddenly sprout a sense of fiduciary duty. Always keep Thomas Phelps's words in mind: "Remember that a man who will steal for you, will steal from you." Avoid partnering with such forms of management even if it comes at the cost of missing an opportunity. The notional loss from not capitalizing on an opportunity can be made up any time, but the eventual realized loss from partnering with a crook is permanent and irrecoverable.

You've often talked about the importance of incorporating negative information into investment decisions. Can you elaborate on this?

To make good investing decisions, you need to actively look for reasons not to buy the stock in question. Invert, always invert. Simplifying helps us make better decisions by breaking down complex problems into component parts.

For example, I ask four inverted questions whenever I am looking at a stock. These questions break the mind-set of trying to find supportive bullish reasons and forces me to actively seek out disconfirming evidence.

1) How can I lose money? versus How can I make money? If you focus on preventing the downside, the upside takes care of itself.

2) What is this stock not worth? versus What is this stock going to be worth? If you can identify the floor price or a cheap price for a stock, it’s far easier to make profitable decisions.

3) What can go wrong? versus What growth drivers are there? Rather than focusing just on the growth catalysts, think probabilistically, in terms of a range of possible outcomes, and contemplate the possible risks, especially those that have never occurred.

4) What is the growth rate being implied by the market in the current valuation of the stock? versus What is my future growth rate assumption? A reverse discounted cash flow fleshes out the current assumptions of the market for the stock. We can then compare the market’s assumptions with our own and make a decision accordingly.

What are some "disqualifying features" you look for when evaluating potential investments?

Absurdly high valuations, bad corporate governance practices, gross capital misallocation, terminal value risk, wafer-thin margins, intense competition, high leverage, and negative operating cash flow.

What are the most important traits or habits that contribute to long-term investing success?

1) Learn to distinguish between investment and speculation. A speculator looks at a stock as a piece of paper. An investor looks at a stock as part ownership in a business.

2) Mr Market is always eager to hand you great opportunities from time to time on a platter. Stock prices fluctuate far more than the intrinsic value of the underlying business, sometimes wildly on either side – and therein lies the big opportunity. Widespread fear is your best friend as an investor, personal fear is your worst enemy.

3) Be an ardent student of crowd psychology, cognitive biases, market history and human behavior since objectivity, rationality and temperament are far more critical than raw intellect to succeed as an investor. Your personal behavior matters much more than advanced excel analytics and complex math. Always think quantitatively (numbers and probabilities) and not dramatically (vivid images and futuristic stories).

4) Develop a working knowledge of accounting as it is the language of business through which you understand how the balance sheet, income statement and cash flow statement tie together.

5) Always focus intensely on the underlying process rather than obsessing about the eventual outcome. Resist the illusion of control.

6) Always consider the outside view which takes base rates and statistics into account rather than only the inside view which makes predictions based on a narrow set of inputs.

7) The frequency of correctness does not matter; it is the magnitude of correctness that matters. Michael Mauboussin calls this "The Babe Ruth Effect".

8) Lastly, and most importantly, for any investment decision (and for all important decisions in life), always take the potential consequences into account instead of focusing only on raw probabilities.

Your second book, The Making of a Value Investor, focuses a lot on the Indian market, but the lessons in the book can be applied to all investors. For those who aren't already familiar with India or haven't invested there, what are the most important differences between India & other developed countries?

Free float in the Indian market is possibly the lowest among global markets. No other stock market has such high levels of promoter holding/insider ownership. There is a low supply of quality equities available in the market. As a result, in the Indian markets, quality with growth is generally available only at an expensive valuation.

There are different demand–supply dynamics at play, and that’s why valuations in the public markets of the US and other parts of the developed world are not comparable to India.

How do you balance diversification with the goal of investing in your highest-conviction ideas?

I size individual allocations in my fund portfolio according to my evaluation of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss coupled with above-average return potential. I initiate new positions with a minimum weighting of 3 to 5 percent and subsequently average upward if the management executes above my expectations.

Individual position sizing is important not only for its impact on overall portfolio performance but also for mental peace of mind. I sell down to my "sleeping point" if an individual position becomes a discomfortingly large percentage of my portfolio value. Always have bigger weights in businesses with high longevity, solid growth prospects, and disciplined capital allocators. As Mae West said, "Too much of a good thing can be wonderful."

What advice do you give young investors just starting their journey in value investing?

• Stick to your circle of competence, only invest in businesses you can understand well and in which you can reasonably assess that they will be earning significantly higher profits many years from now. Such businesses are usually less vulnerable to technological or "app" risk and operate in stable industries with low rates of change.

• Embrace inactivity and devote most of your time to reading, learning and improving your thinking. Low turnover leads to low frictional costs and these few extra percentage points saved every year lead to very large absolute savings over long periods of time because of compounding.

• Create an investment checklist. Every investor should read Atul Gawande's The Checklist Manifesto and The Investment Checklist by Michael Shearn.

• Maintain an investment journal which contains your original investment thesis at the time of making the purchase as well as the rationale for making the sale. This is the most objective way to remain true to yourself and more importantly to continuously keep learning from your mistakes.

• Focus on investing at reasonable valuations in low debt, cash flow generating businesses with high returns on equity and strong competitive advantage(s) which can grow for long periods of time with minimal or no equity dilution.

Buffett summarizes his investment philosophy as follows: 1. Find wonderful businesses; 2. With highly capable management; 3. Which trade at fair valuation levels. How would you define your investment philosophy?

At Stellar Wealth Partners India Fund, my investment philosophy is based on a core-satellite approach: shorter term tactical bets for 1-3 years based on variant perception which help generate alpha (~30% of the portfolio) and long-term bets on structural trends for more than 3 years which help provide long-term compounding with relatively low risk (~70% of the portfolio).

Variant perception comes from having a differentiated view on the short-to-medium term trajectory of a business. It refers to investment situations where you get ROCE (return on capital employed) expansion along with earnings growth; that in turn leads to valuation rerating, and you end up with multibaggers.

There are various triggers for various perception, including product mix change into a higher margin category, operating leverage, deleveraging, working capital improvement, industry cycle shift, regulatory change, improvement in asset turns, and corporate actions like spinoffs, management change, merger arbitrage, & divestiture of a loss-making or non-core business segment.

Long-term structural trends are found in industries with a favorable structure. They are organized as a monopoly, a duopoly, or an oligopoly and they are characterized by consistency & predictability of growth. Such businesses have a long runway for growth so you have visibility for many years ahead.

There are multiple structural growth plays available in the Indian market today, including contract manufacturing, energy transition, housing finance, building materials, branded discretionary consumption, financialization of savings, digital transformation, and data centers.

When did you develop an interest and knack for writing, and what role does writing (investing journal, writing out your thoughts, and so on) play in your overall process?

I spent ten dollars on a journal in late 2014, and I consider it to be one of the best value investments I ever made. Since that day, I have been keeping track of my investing decisions and subsequent developments in an investment journal. This has helped me a lot in learning about myself and improving as both an investor and an individual. I receive a lot of valuable feedback and use it to correct my biases. The process of structuring our thoughts into a journal entry helps bring clarity to our thinking.

A periodic review is an important part of the process. This is where you start getting better. Realizing where you make mistakes, why you make them, what are the common mistakes that you tend to make and why, will help you improve over time. Whenever the outcome of a past decision is known, revisit your decision journal. Odds are, you will discover some surprises. It won't be uncommon to find that, in many of the favorable outcomes, the original reasoning wasn’t always right.

Outcomes distort our thinking a lot. Unless we are intellectually honest, we will end up taking the wrong lessons from favorable outcomes. It is not intuitively natural to fact-check how the events unfolded, especially after a favorable result. We may be right a lot of the time, but it may well be for the wrong reasons. This self-realization can be very humbling. It is also how we learn and improve.

So, as you can see, writing is actually a thinking exercise and it is a medium for increased self-awareness and understanding.

What are some of your favorite investing books?

• Poor Charlie's Almanack – A life-changing book for investors and non-investors alike

• Seeking Wisdom by Peter Bevelin – The finest book I have ever read on multidisciplinary thinking

• All I Want To Know Is Where I’m Going To Die So I'll Never Go There by Peter Bevelin – The best book ever written on the theme of inversion

And I would print out the Buffett Partnership letters and the Berkshire Hathaway letters and owner’s manual separately.

Outside your passion for stock market and investing, are there any other interests / activities which are close to your heart?

I am very fond of reading on different subject matters from a wide variety of fields. To me it feels like an intellectual treasure hunt, you never know what hidden gems or new insights you will stumble upon when you begin a new book and start flipping through the pages. I enjoy watching Marvel, sci-fi, action thriller, comedy, and Bollywood movies as well as live performance shows of magic and illusion.

I also love traveling as I find it fascinating to personally experience the diverse beauty which exists in our world. Whenever I visit my home town in India, I enjoy spending time with my family, friends and relatives.

Anything else you'd like to share or add?

I would like to share some life principles whose importance I have come to appreciate more and more with the passage of time:

• The best investment you can make is an investment in yourself. The more you learn, the more you earn. An investment in knowledge pays the best interest.

• Live life as per the inner scorecard. Self-esteem beats social approval. Every time.

• Associate with and learn from people better than you and you cannot help but improve.

• Control over your personal time is much more valuable than high absolute levels of money.

• A long and healthy life is the key to compounding so eat less junk food and sugar, get sufficient sleep and engage in regular moderate exercise.

• Be kind, humble and empathetic to others and always help people unconditionally without expecting anything in return. Karma is like a big snowball.

• Always be thankful to God, your parents and those who helped you during your difficult times.

• Never underestimate the role of luck in every sphere of life.

Lastly, I would like to share my late maternal grandfather's eternal words of wisdom to me during my childhood which have had a lasting impact on my life – "There is no alternative to hard work."