January 16, 2018

The Indian bitcoins

The following note is from upcoming annual letter to subscribers. I will be publishing the rest of the letter on the blog soon

When I look at companies which are priced a lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.

A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some all knowing entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.

The market on average and over time gets the valuations right, but not always.

As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.

How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past

In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.

How many companies in the above space currently sport a PE of 50 higher ? around 22% or roughly 830. So 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth

In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?

All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Ofcourse every individual thinks he or she is smarter, more handsome or <insert your criteria here> than the crowd (also called illusory superiority).

The odds are against everyone being right. So it makes sense to be cautious and do your homework well enough.  Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.

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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.

January 2, 2018

Ignoring the oncoming train

I shared the following note with subscribers on how the current trends in solar/wind power and battery technology are likely to cause disruption in the energy markets. The impact of this disruption is already being felt in the capital goods sector, which is an early proxy of the long term trends in an industry. Any management planning to invest with a 20 year horizon will carefully analyze the long trends before committing capital for this duration..

I have kept out the name of the company we hold, for obvious reasons, but the conclusions are valid for any company in the energy sector value chain. In addition, I think these technologies are likely to have a huge impact in the transportation, oil & gas, coal, power storage and other industries too

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I highlighted the following risk in 2016 for our holding.

Solar energy – I wrote extensively about it in the previous year’s update and the solar energy market continues to develop as expected. It is critical to track this sector as solar is a substitute for other forms of energy (such as coal or Oil) and hence its adoption will have some impact on the demand for the products of the company.

The company continues to focus on process co-gen, waste to energy (including biomass based power generation) and the IPP sector. As I wrote in the previous update, the first two sectors continue to do well as they serve as a complementary power generation system. The IPP segment however is under threat as solar can easily displace this at a lower cost and the company’s performance seems to bear this out.

I have been tracking the renewable and battery/ storage space for the last few years. Let me share some data points before discussing the implications

The graph below shows the price trends for the next 5 years. Please keep in mind that the drops in the recent years have been much higher than predicted and there is no reason why the current rate of 15% annual price drop will not continue

This is a comparative cost across countries


As you can see, India has the lowest costs due to lower soft costs (aka labor costs).

The recent solar auctions in India and several parts of the world are now hitting the 1.3-1.5 Re/KWH levels already and this is expected to drop further. In comparison, the cheapest fossil fuel generated power – Coal, is priced at around 3 Rs/KWH and rising due to transport and other costs

At this point, a lot of naysayers, point out the lack of storage and intermittency of solar and wind power. Let’s look at another data point – Cost of lithium ion storage. This has now hit 200 dollars/ Kwh and continues to drop by around 15% per annum. At the current rate, the cost ofs batteries will drop below 100$/ KWH in 3 years. Why is 100$/KWH important?

This is the point at which solar + Large scale storage start becoming cost competitive with base load or Coal based power. Again, keep in mind that these trends will not stop in 2020, but will keep continuing beyond that due to economies of scale and new research (in other forms of batteries such flow batteries, Lithium air etc)

Is this all hypothetical?
We may assume that all this is theory and the energy markets are yet to be disrupted. That is not true and we already have a few early signs of disruption

a. Gas based Peaker plants (which take care of sudden spike in demand for electricity) are not being built as it is cheaper to use battery storage to take care of such spikes


b. Companies like GE and Siemens have seen a large drop in demand for gas turbines and announced  re-structuring of their power business.


c. What natural gas did to coal, will be repeated again

In 2012-14, we had a new technology called fracking reach scale in the US. This technology had been in development for almost a decade and hit an inflection point in 2014. The resulting glut in natural gas led to a sharp drop in the price as can be seen in the chart below.


The result of this drop was that, natural gas suddenly became cheaper (and cleaner) than coal and caused a switch in fuel for power generation. This can be seen in the picture below. This in turn led to a drop in the demand and price of coal, leading to large scale bankruptcies in the coal sector in the US

Keep in mind that fracking only works if you already have deposits of gas/ oil in place, but were uneconomical earlier. There is no such limitation for solar or wind energy.

Please ignore the S curve
Lets go back to the first principles in economics – People respond to incentives. Companies, individuals and governments are not going to switch to solar or wind energy because they have suddenly realized that these are green technologies, but the because these technologies are now becoming cheaper than the alternatives (fossil fuel).

We still have a lot of naysayers including some of the think tanks, who keep suggesting that these disruptions are atleast 15-20 years away. If you look at the numbers, for some reason their predictions assume that the price drop in these technologies will change from the current 15%+ to around 3-5% due to which the uptake of these technologies will proceed in a linear fashion.

You can believe these predictions if you are ready to ignore the S-curve model of adoption, which states that these kind of non-linear technologies follow an exponential adoption rate till they hit saturation. 


Look at the example of cell phones, internet, Computers and so on which show the adoption rates are only speeding up, not slowing down !



We cannot predict precisely when the inflection will occur. However, it is not difficult to see the disruption ahead. At the current valuations, the market is not discounting the threat of disruption for companies in the capital goods sector, oil & Gas, automotive, power and coal sector.

We can wait till the threat becomes obvious and then exit our positions. I am however not inclined to wait till the last minute before jumping off the track, even though I can dimly see the train coming towards us.    

October 5, 2017

Over optimizing the portfolio

I have often been asked by subscribers - what fixed income option would I recommend for the cash they hold?

My response is that I usually hold my cash in short term FDs or at the most in short term debt funds with high rating and from a well-known fund house.
The main criteria I use in selecting a fund are
-           Fund should have a high AUM (> 1000 Crs) for liquidity purpose
-           Should be from one of the well know fund house, preferably backed by a bank
-           Should have a low expense ratio (as far as possible)
-           Should have a 3-5 year operating history or more

You may have noticed that I have made no reference to returns. This is by design as I am looking at high safety of capital and liquidity in this case. The entire point of holding cash or equivalents is that it should be secure and can be accessed at times of market stress without any loss.
Some of you may be unhappy that these options provide ‘only’ 4-5% returns which are quite meager.
Do the math
Let’s do some math. I usually hold somewhere between 10-20% cash in my portfolio. In a crazy bull market such as now, it may go upto 30% level, but on average it hovers around the 15% mark. Let’s assume I get very creative and aggressive with the cash holding and can earn around 10% returns on it. Keep in mind, that the level of risk rises exponentially in case of fixed income instruments. A vehicle giving 10% when the risk free rate is 6%, is not 60% more risky, but carries several orders of magnitude higher risk.
Let’s say, that I still decide to move forward and invest all the cash in such a vehicle. So in effect I have made 4% extra on the 15% cash holding which translates to an extra 0.6% return on the overall portfolio. This additional 0.6% would translate to roughly 7% additional return over a 10 year period.
Is it really worth the risk? Does one really need the extra 0.5- 1% return when rest of the funds are already invested in equities?
There is no free lunch
One of the reasons for holding cash and equivalents is to lower the risk of the portfolio, especially when it is high in the equity market. If you are attempting to get higher returns via fixed income instruments, then you are just changing the label of the investment, but not the level of risk in the portfolio as a whole.
A fixed income label does not change the nature of risk. It is the characteristics of the instrument and its past behavior which defines the same. The worst aspect of investing is to take on higher risks unknowingly and then get shocked when it comes back to bite you.
Please always keep in mind – there are no free lunches in the market. There are absolutely no ‘assured’ high return fixed income options (the term itself would be an oxymoron). If someone tries to sell you one, please run away from the person as fast as you can.
It is not a race
I will never tell anyone of you what to do as you need to make your own decisions. However, let me share what I have been doing for the last 10+ years – I have my funds in safe and relatively secure FDs earning pathetically low rates of returns. This allows me to sleep soundly and have one less thing to worry about. If the equity portion of my portfolio does well, then I don’t need the extra 0.5%. If it does badly, the 0.5% will not save me.
In the end, investing is not a 100 meter dash where the winner gets a gold medal and the fourth place goes home dejected. As a long as I can make a decent return (being 18 %+) over the long run, I would rather exchange a few extra points for much lower risk. The journey would be far more pleasant and I will still reach my financial destination (maybe a year later).

Ps: This does not refer to any investment options such as real estate from a diversification point of view. This is mainly about the desire to optimize the cash portion of the portfolio.
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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.

September 13, 2017

Discounting hope

It is widely understood that stock prices are forward looking – they discount the future expectations of cash flow of a company. In bear markets, these expectations are lowered as markets extrapolate recent trends (and assume a recession forever). On the flip side, the reverse happens during bull markets, when investors extrapolate the recent good results into the future and assume that there will be no hiccups along the way.

Finally, we have markets like now, where investors have gone ahead and extrapolated ‘hope’ and discounted that too.

The idea funnel
I maintain a 50+ list of stocks which I track on a regular basis and have created starter positions in a few companies which appear promising. The process i follow is to create a small position (usually 0.5% to 1% of my personal portfolio) and then track the company for a few quarters/ years.

In atleast 50% of the cases or more, I realize over time, that I am not too excited about the prospects of the company and exit the stock immediately. In a few cases, however the company and its stock may still hold promise. In such cases, I start raising the position size in the portfolios I manage.

The above approach allows me to run experiments with lots of ideas and controlled risk.

Discounting infinity and beyond
I am now noticing that some of the positions I hold on a trial basis have started running up based on hope.

Let me take one example to illustrate – Repro India.

Repro India is a printing business with operations in India and Africa. The company performs print jobs for publishers for all kinds of printed materials like books, reports etc. The company has had a chequered past with uneven performance. 

The company was growing till 2012-14 with rising sales in India and Africa. The return on capital of this business was mediocre as the printing business involves high fixed assets, high and sticky receivables with average operating margins in the range of 15-18%.

The export business in Africa went into a nose dive in 2014 due to the drop in oil prices. The company was not able to collects its receivables as these African countries faced currency issues and hence incurred losses. Since then the company has been slowly recovering the receivables and nursing the business back to health. In addition the domestic business continues to be competitive and sub-optimal due to the lack of any competitive advantage

I would normally avoid such a company unless there are some prospects of improvement or change in the future. One such possibility exists for the company. This is the new BOD – books on demand business of the company.

The BOD business is similar to an aggregation model followed by companies such as uber or Airbnb. In the case of repro, the company has a tie up with Ingram (another US based aggregator) and other publishers in India to digitize their titles and carry them on its platform. These titles are then made available through ecommerce sellers such as Amazon or flipkart. When a user like you and me finds this title and purchases it, Repro prints the copy and delivers it you.

The business model is depicted in the picture below (From the company’s annual report).


The above business model ensures that there is no inventory or receivables for Repro or the publisher. The payment is received upfront and the product is delivered at a later date. This is a win-win business model for all the value chain participants as it eliminates the need for working capital. As a result, this business model is able to earn a high return on capital with the same or lower margins than regular publishing

Illustration from the company’s annual report



Repro is doing around 40-50 Crs of sales in the BOD segment and growing at around 70-80% per annum. The company has loaded around 1.4 Mn titles on its platform and plans to load another 10 Mn+ titles in the future. This business is at breakeven now. The BOD business has a lot of promise and it’s quite possible that the company will do well. 

However, success in the business is not guaranteed. The company needs to scale its operations and could face competition from other print companies in the future (as the entry barriers are not too high).

The market of course does not care about the uncertainty. There are times, when markets refuse to discount good performance in the present and then there are time like now, when the market is ready to discount the ‘hope’ of good performance in the future. The stock sells at around 100 times the current earnings. As the legacy printing business continues to be mediocre with poor economics, it is likely that the high valuations are mainly due to the exciting prospects of the BOD business

I had created a small position a couple of months back and have been tracking the company. The stock price has risen by around 50%, 60% since then even though the company is just above breakeven on a consolidated level.

I am optimistic about the prospects, but the execution needs to be tracked. I am not willing to pay for hope and so I am a passive observer for now.

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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.