May 29, 2016

It is never easy

The following note was sent out to our advisory clients in February. This was in response to the jitters, some of them were experiencing after a 15% drop in the market. I think this is valid in all kinds of markets including the optimistic one we have now.
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I am not feeling any better knowing that the model portfolio is down less than the overall indices. I increased the cash holding a bit in the last few months and avoided the momentum stocks in the later part of 2015. Inspite of these defensive measures, the portfolio is getting hit and it is not pleasant to see losses every day.

At the end of 2014, after a 100%+ rise, I had written the following

It is easy to feel smug and complacent after a 100%+ rise in the portfolio. However it is precisely at this stage that the risks are the highest. The various companies in our portfolio are performing quite well in terms of business performance (topline and profit growth). In addition, we exited a few companies where I felt that the performance depended more on the macro than the company specific condition such as the management or the target market

In effect my effort has been to reduce the business risk of our portfolio. This however does not mean we do not face a price or a quotation risk. If the stock market drops by 20% (just an example, I don’t know what will happen), then our portfolio will get impacted too.
If your time horizon is less than 3 years and you cannot bear a 15%+ drop in the portfolio, then you need to take action when the times are good (such as now) and not after the market drops due to some macro factor.

In my case, I consider my equity investments with 3-5 year perspective (or more) and will continue to hold the positions through any future volatility.

I did not know when a drop in the markets will happen, but was sure that it would occur as that is the nature of markets – greed and fear. We had a period of greed in 2014 and 2015, which has now turned to fear.

A repeat of history
The recent events and volatility we are seeing, is not new and has occurred from time to time. The reasons have been different, but the end result is the same – fear and rush to the exits.
At times like these, no one is looking at the company and its fundamentals. The selling is often driven by panic and a desire to reduce the pain.

My own portfolio is invested exactly the same as the model portfolio and hence it is not a theoretical loss for me. I have seen this happen several times, and still feel the same level of pain. Experience does not change the reaction to such losses.
The only difference is that I try to ignore the pain and focus on the individual companies, their business and the intrinsic value. That helps me in maintaining some level of rationality.

I have been asked by some on how bad this can get? I don’t know and anyone who claims otherwise is lying. It could get worse and it will not be easy to hold on to our positions when everyone around us is panicking and selling.
How to handle the volatility
Let me share how I am looking at the current situation (as I have done in the past)

Do not shorten your time horizon
Let’s say (and I hope that is the case), that you have invested your capital with a 2-3 year time horizon. As long as the market is rising, everyone is a long term investor. It is times like now that this belief is tested. There is no dial which increases or reduces the time horizon at an aggregate level. One needs to look at each holding and decide if you will be comfortable holding that position for the next couple of years.
I have been doing that for all the positions in the model portfolio and have exited some, where my level of confidence was not high . As the market crashes and causes some level of business risks, it is important to have a decent understanding of the companies in the portfolio.

We have held most of the companies in the model portfolio for atleast one or more years and have seen them go through their ups and down. I think most of these companies would be able to survive and manage the risks
Position size and diversification
I have often been asked about position size and the level of diversification one should have in the portfolio. I have a much simpler approach – size it to a point where you can sleep well. If the size of a position or the level of diversification causes you lose sleep, then it is too high.


The above is a very subjective point and varies from person to person. One way to think about it is to look at how much of your net worth is in equities and are you comfortable with it? Can you bear a 20%+ drop in your portfolio without losing your cool?
Look at the intrinsic value
I have always emphasized the important of intrinsic value and its growth for a company. One should always focus on that number. As a long as that number is stable or increasing, then one should stop worrying about the stock price.


Do not fixate on the turn
Another common feature at a time like this is the tendency of investors to call the bottom of the market. This is a toxic way of managing the portfolio. It leads to a focus on the short term and disappointment if the turn does not happen.
My approach during such times in the past has been to add to my positions slowly over time as they became cheaper (subject to size limits) and not expect to make a killing in the short term.

There is no pill for courage
The final point I have to make is that there is no magic pill for courage. There is a reason why equities have high returns – Volatility and risk.
My effort is to reduce the level of risk (of permanent loss of capital) in the portfolio. I have not tried to reduce volatility actively. Courage and ability to ignore the volatility comes down to temperament and that cannot be supplied by anyone.

To summarize
– Think long term and focus on the portfolio with a 2-3 year time horizon. This means you should not be investing any money which is needed in less than 3-5 years.
– Ensure that the position size for each stock and the overall diversification lets you sleep soundly at night
– Focus on intrinsic value and performance of each company
– Do not try to time the market (now or any other time)
– Avoid listening to forecaster, pundits and other doom and gloom guys. It will weaken your resolve
– If you manage to hold your nerves and plan to invest, stagger it over time. I am planning to do the same.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

May 12, 2016

Chasing returns is not about the money


Let me share the story a young guy who has just graduated. He recently got a nice job with a company and is able to save around 2 lacs per annum after all his expenses.
Now this guy is quite similar to all his peers, but different from his hot blooded brethren only on one small point. He believes in saving and investing, but does not want to chase stock market returns. In the last few years, he read a few books on investing by john bogle, and decided that he was going to invest in some decent mutual or index fund and then leave it at that.

You see, this young guy has a girlfriend and wants to spend time with her. In addition, he also wants to use his spare time pursuing hobbies like painting and travelling.
He sets up a simple plan:
-           Save 2 lacs per year and invest it in a few index/ mutual funds
-           Increase his savings by 5% every year to match inflation
-           Invest each month via an SIP to put it on autopilot
-           Avoid financial news on TV and use the spare time on other pursuits

Ten years later this guy who is now married, decides to have a look at his investment account. During this period, the overall market has delivered around 15% per annum for the last 10 years. He finds that his account is now around 67 Lacs. Not bad!

He goes back to his usual life and forgets about this whole stock market thing. The only time he checks is to extend the SIP in his account as most banks don’t provide a 10 year SIP option
Its twenty years now since he started and one day his wife asks him if they have decent savings which can be tapped for their daughter’s education, 10 years from now.

He goes back to his account and is pleasantly surprised to find that the account now has 3.7 Crs. He is confidently able to tell his wife that they truly afford a good quality education for their children.
At the age of 55, its time finally to fund their daughter’s education. Our guy, who is no longer as young, decides to look at his account and finds that the account has 16 crores!! This is far more than he ever imagined. Both he and his wife now start thinking of taking an early retirement. They figure that in 5 years’ time, the account would grow to around 29 Crs ** at the current rate if they can fund their daughter’s education from the liquid cash they have been holding on the side. This amount would be sufficient to retire and lead a comfortable life

Now I know some of you would raise objections like
-           15% consistent returns are good in theory, but the actual returns are more lumpy.
-           Not everyone can save 2 lacs or do that without fail every year

Let me handle them both -
If you save consistently and do not withdraw the capital from the account, a smooth or lump 15% would still amount to the same in the end. It is only when people act smart and try to time in and out of market (and change the amount invested), that the eventual amount depends on the pattern of returns.

In addition, our overall stock market has delivered around 12-13% return in the last 20 years and if you add dividend and the effect of monthly cost averaging, a 15% CAGR is quite reasonable
On the second point, 2 lac saving per annum may not be possible for everyone, but I am sure a lot of two income professionals can muster this level of savings. In addition, I have assumed that the contribution rises only at 5% per annum. In most cases, earnings and hence savings can rise faster than that.

So my point is this – If the objective is to meet your personal financial goals, then discipline in saving and investing consistently is far more important than chasing the next hot sector or hot stock. Ocourse, higher returns will get you to your goals faster, but beyond a level of wealth, it more about flaunting than about its utility.
However, If the reason for chasing returns in the market is to get on TV or twitter to show the world how smart you are, then we are talking of a completely different objective. In such a case, the actual returns have nothing to do with the money or financial goals.

** If you wondering about the impact of inflation , a 6% inflation would still mean a nest egg of around 3.8 Crs in current money terms. In my books, even this is a good amount of money
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

April 15, 2016

The search for a free lunch

Ask any serious, long term investor on the type of company he or she would like to invest and you will almost always hear something along the following lines – A high quality company with sustainable competitive advantage (aka Moat) and long term growth prospects, available at a cheap or reasonable price

So what’s wrong with the above statement? It’s almost a truism and a guarantee of great results ....

This is a long post and I am trying out a new approach. Instead of posting the entire post with all the headache around the formatting, I have converted it into a pdf. please download this post from below

The search for a free lunch

-------------------------------------------------------------------------------------------------------------------------------Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.


 

February 4, 2016

Coca-cola, Marico and dogs

There is a class of companies which enjoy a very strong competitive position in their respective markets. These companies have strong brands with their customers, great return on capital and finally good management.

The market really loves these companies due to all the above mentioned factors. Consequently, these companies enjoy a fairly high valuation.

There is ofcourse one small problem – Some of these companies are not growing rapidly. They are probably growing in the range of 10-15%, which is slightly higher than the GDP, but definitely not at the 20%+ rates of the past (which got them in the present position).

Lets call this the coca-cola effect. Why coca-cola ? let me explain

Coca-cola is one the most admired and high quality company. It has a very strong brand which has thrived for 100+ years. In addition the company has a global distribution network which cannot be matched by any company in the foreseeable future (in beverages for sure).

The company grew rapidly in the late 80s and 90s and was valued at 40+ PE levels by early 2000

On top of this, the company was held by warren buffett. What could be a bigger endorsement?

There was one little problem – the company growth had already slowed, but the price was not reflecting this new reality. So what happened since then?


The company did quite well, but the stock went nowhere.

So lets define the coca-cola effect now
-           High quality company with great brands, strong competitive position and good management
-           Past history of high growth
-           High valuations
-           Slowing growth and lower probability of repeating the high growth of the past (key word – probability)
-           Price stagnates (low returns) as the earnings rise slowly , while the PE multiples contract in face of the new reality

Does this look familiar? I think so. I can think of a few companies in the indian market which will go through a similar phase. I will not give names as these are universally loved names and I will get hate mail and comments for suggesting that.

Let me however give a past example from the indian markets

Infosys ltd: see this chart below. The company has done well (profit grew by 15% CAGR during this period)  but investors have made around 6% CAGR in last five years (excluding dividends)


Why does this happen?
I can think of two reasons

Hindsight bias – investors are looking at the past, whereas returns depend on the future growth ! As they say, you do not get to go to heaven twice for the same reason. So if the future growth slows down, the returns are likely to be sub-par.

Contrast effect / Frog in boiling water syndrome – The slow down or price change is not dramatic. Price does not drop drastically, but kind of bobs around for a while. So after 4-5 years of holding a company, an investor wakes up one day and realizes that they have made a paltry level of return.

How to manage this?
For starters, one should get over the warm and fuzzy feeling of holding such a stock (I am guilty of this too). It is easy to fall in this trap as the company has done well in the past, rewarded you handsomely and is still universally admired.

The second step to take is to look at the future growth prospects and try to arrive at an upper bound for it. If company sells at a high valuation and is unlikely to see a further multiple expansion, then this growth will define the future returns for the stock. If the expected returns do not match your minimum threshold, start exiting the stock slowly over time (few are able to do it in one shot due to the emotions involved).

The caveat around continued growth
Some of you would saying to yourself by now that my previous argument does not square entirely with reality. There are a few companies which do not fall in this bucket. Recall my earlier point about coca-cola : Past history of high growth and slowdown in the future.

The companies which do not stagnate are those which are able to maintain an above average growth in the future. Such companies may appear to be overvalued for sometime, but are able to keep growing and hence justify the valuation. As a matter of fact, some of these companies even appear to be undervalued in hindsight

So what happens when you confuse these kind of companies (with good growth prospects) with my earlier example (coca-cola). Let me call that the marico effect !

A close friend of mine used to work in Marico and based on my understanding of the business (and inputs from my friend), I purchased the stock in around 2002-2003 time frame at around 5 times earnings (no typo there).

Fast forward to 2006, and after a lot of analysis and mumbo jumbo, I sold the stock as it seemed overvalued at around 30 times earnings. I was right, for a period of 3 years and then spectacularly wrong. Have a look the price action below


If you are comfortable with the long term growth prospects of the company and believe that the company will do well over the next 5-10 years, it would be silly to sell the stock as the earning would slowly catch up to the valuations in time and once that happens, the stock returns would match the earnings growth

There are no short cuts here – you have to decide if you are holding a cocacola (high quality, low growth), a marico (high quality, high growth) or a dog (no quality, just fluff) and act accordingly.

There is one action, which you should take without hesitation if you are holding a dog – Sell before everyone else realizes that it is a dog. A lot of investors in 2015 bought dogs and have only recently realized – too late, they are holding dogs !
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Stocks and dogs ! discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.