October 18, 2016

Temperament cannot be bought or taught

I wrote this note to all of my subscribers. Hope you will find it useful too

A lot of new subscribers have joined us and so I am writing a short note to talk on several topics such as how to build your portfolio, our investment philosophy, ongoing crises etc. For those of you, who have been with me for a long time, this may seem like an un-necessary repetition. However I think it is important for new subscribers to know what they are getting into with me and for the old subscribers to be reminded of it.
Let me state this again – My approach is to buy good quality companies at a reasonable price. There is nothing magical or new about this. Every other value investor professes to do this and I am no different. There is no secret sauce and I make it a point to share my thought process and analysis as much as feasible.

I am not looking for quick flips based on interest rate changes, slightly better monsoon, modi’s reaction to Pakistan or some astrology sign. There could be others who practice this type of investing and it may work for them. I have no interest in doing the same.
I have practiced a value based philosophy for the last 15+ years and it has served me well. I have no plans of changing a sound and logical approach for something else in the future. As long as I continue to do follow it rationally and with discipline, I think the long term results will be good even with occasional spells of under-performance.

Building your portfolio
One the first comments I get from a new subscriber after joining is this – I had a look at the model portfolio and I cannot buy more than 2-3 positions for now. I have a stock response for that – please be patient and give it some time. I have usually seen that most new subscribers are able match the model portfolio over a span of 2-3 years as some stocks drop below the buy level and new positions are added.

How true has this statement been?
If you look at the price action of our 17 odd positions for the last two years – you will find that at least 14 hit the buy point and even went lower for a few days or more. So in effect, it’s quite possible to be 80% matched to the model portfolio for those who joined the subscription in the middle of 2014. I do not have the statistics of how many have done that, but my point is that over a 1-2 year time frame, one will get enough opportunities to buy and build your portfolio. One needs to have the patience to do that and not get swayed by short term events.

Recurring crises
We started the model portfolio in Jan 2011. We have had several actual and imagined events such as Grexit (did not happen), Chinese hard landing (cannot say if that has occurred), Brexit (did happen), oil crash (occurred in 2014) and mismanagement of the Indian economy by the previous government.

These are the big events which come to mind. If you pick up a newspaper, there is a lot more to worry about from day to day. Now imagine if we had remained in cash or got frightened out of our positions due to some real or imaginary risk and compare that to what we have achieved in those years. Does it make sense to take actions based on unknown guesses about the future or concentrate on individual companies and make informed decisions?
Now someone could counter this logic by pointing the risk of 2008/09 collapse when mid and small caps crashed by 60%. What if one of these events had snowballed into a similar crisis?

Let me answer that concern via two arguments
-           For starters, one cannot invest based on the low probability, high impact macro events. One can diversify against black swan risks at an individual company level, but not at the country level. To give an extreme and silly example – how will you protect yourself from the risk of an asteroid crashing into a major city in India and causing a major economic crisis? Can one really diversify against such an extreme risk?
-           My second argument is that one needs to invest based on the higher probability risks (such as inflation) and insure against the low probability, but extreme ones. In other words, invest to beat inflation or secure your retirement and buy life/ health insurance to hedge the other extreme kind of risks. Finally there are some kind of risks, where one can only hope and pray that they don’t occur and we can do nothing about it.

Having the right temperament
If a 10-15% drop in the portfolio is going to scare you (as it may have in Feb of this year) and cause you to lose sleep, then equities are not for you. I can share my analysis and thought process, but cannot fix your temperament. You will have to bring a steady and calm mind of your own to the table.

If you think you cannot bear to see your portfolio drop by 15% or more from time to time, now is a good time to exit. I don’t think there is anything to be ashamed of in recognizing your risk tolerance and acting according to it. My own family was never into equities as they were never comfortable with the volatility of the stock market. I started investing for them a few years back after they felt confident that I will not blow up their savings (or maybe it was just their love for me …I don’t know)
Looking for trends
Some of you may have noticed that the model portfolio generally does not have a specific theme or view. One will often hear from investors that they have positioned their portfolio to benefit from better monsoon or revival in capex or some such factor.

The benefit of identifying a broad trend and then investing to it has a lot of upside. However I have generally not followed this form of top down, trend based investing as I have found it difficult to identify a truly long term trend and then find a reasonably priced idea to leverage this trend.
One needs to keep in mind that a good monsoon or lower inflation is not a long term trend, but only specific events which play out for a small period of time. A long term trend would be something like demand for housing/ housing loans which leads to a growth of 2-3X of the average GDP growth rate.

We have three positions which seem to play to this theme. However if you read the original thesis of these ideas, I was looking far more closely at the  company specific factors and only vaguely realized that there were some tailwinds for the sector. It is after holding these stocks for 2+ years that we can now make a story of a theme or trend for these ideas, but this was never the case when we started these positions.
Why am I discussing this point now? I think there is a lot of value in identifying such trends early and investing based on it, provided one does not overpay for it. As a result, I have now started looking at some of the current ideas from a trend point of view. We will however not know if the trend was real or a mirage, till a few years pass.
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 16, 2016

Mislead by the PE ratio

A commonly used thumb rule in investing is that a company selling below a PE of 10 is likely to be cheap and one above 30 is likely to be expensive. I have been guilty of using this rule, often subconsciously and have paid a heavy price for it.

The advantage of writing a blog for 10+ years is that I don’t have to go anywhere to find examples of mistakes. I can always find one I have committed and written about it.
To see the example of a PE driven investment gone wrong, read the analysis of Facor alloys here. In a year’s time, I realized that I had made a mistake and exited this position with a 12% loss – you can read my analysis here.  If I had held on to the position, I would have lost close to 85% of my investment, even as the stock continued to sell at a very low valuation (current PE being 3)

Reasoning from first principles

In the above video, elon musk talks about reasoning from first principles. Why should one do that?
Reasoning from first principles leads one to understand the fundamentals factors driving the issue in question. So how do we apply this concept to investing?

I wrote the following on it

Quite simply, the one absolute and immutable fact of investing is that the value of an asset is the sum of the discounted free cash flow, it will generate over its life time. The above statement does not mean that an asset cannot sell above or below this value from time to time, but anyone holding an asset over its life time, cannot make more than the cash flows its generates over this period.

Lets break the above point down into its key components
-           Free cash flow
-           Lifetime
-           Discounted

You can find multiple definitions of cash flow, but the one which I like to use is the cash you can receive from the asset, without impairing its long term earning capacity. Lets apply this to a simpler example than a company – A house or a flat where it is easier to analyze the cash flows.
Free cash flow – Can be estimated as follows : Gross rent – taxes – maintenance expense – other overheads

Maintenance expense usually involves repairing the house, cleaning it after the tenant vacates it and any other expense incurred to keep it in a rentable conditions. Other overheads can be society & broker charges to let out a house etc. So after paying out all these costs, the cash left behind would be the recurring free cash flow to an owner.
Lifetime -  This is the period an asset can be expected to generate a cash flow. In case of a flat or house one can take as it as 30 years, before one has to permanently replace it with a new construction. In an extreme condition you can stretch it to 50 years, however try letting out a very old house and you may realize that the rentals are much below the market rates.

Discount - The definition of discounting can be found here. Usually this depends on the riskiness of an asset.
So how would you value the house or flat now?
The gross rental yields these days are usually around 2-3%. At these yields , one is in effect paying 50 times pre-tax free cash flow. This of course assumes 100% occupancy and no taxes.

Over the long term these rentals usually follow the inflation rate. So over the life of a flat or a house, you will earn back around 60% of the cost in the form of rental. The value of land underlying a house or a flat has been known to appreciate at the nominal GDP rate (GDP growth + inflation rate).
If you put all these cash flows together and discount it at around 10%, the final DCF value comes to about 1.5X purchase price. In other words, the asset is generating an IRR of 12%.

Is this cheap or expensive? It depends on what you believe the price of land will be 30 years from now and if 12% is good enough for the risk and effort of managing a rental property.
The problem with PE ratios
As you can see from the above example, the PE ratio is dependent on several variables which we had to estimate upfront. In the case of some assets such as a rental property, it may be possible to estimate it with a certain level of confidence.

This is however not always the case
Let say, for the sake of example, that the house turns out to be on an old burial ground where there are ghosts and so one want to rent or buy that land J . What happens then? Well the entire investment goes to zero.

On the other hand, lets assume that the government announces a large IT park close to the property and the rental go up by 5X. Irrespective of the actual increase in the property price, the cash flow based valuation definitely goes up as the rentals have increased drastically. This is what has occurred in several cities across the country in the last 10 years.
So the initial PE turns out to be cheap or expensive depending on the subsequent cash flows and terminal value of the asset

PE ratio in equities is even more misleading
In the case of companies, the problem we face is that the cash flows are quite difficult to estimate, there is no fixed duration and the terminal value in the real long run for any business is usually 0.

In the example of Facor alloys, the PE appeared to be low based on the recent cash flow (as of 2010) which had been in excess of 30 Crs. As a result, if one assumed that these cash flows would persist, the company appeared cheap at  3-4 times cash flow.
The above assumption turned out to be wrong. The cash flows were at a peak due to a cyclical high in demand from the steel industry. In addition to a crash in the demand, the management diverted the cash flows to another sister firm which demonstrated poor corporate governance.

In effect, the expected cash flow and duration turned out to be wrong. In such a scenario, the PE ratio was simply misleading.
As a counter example, consider the case of CRISIL (a past holding) which has always appeared expensive based on the usual measures of valuation. However the company has delivered above average returns as it has generated the expected cash flows without much variability in a fairly predictable fashion. The competitive position continues to improve and the company is likely to keep growing with a high return on invested capital for the foreseeable future.

Understand the business
The only way to evaluate if a company is over or underpriced is to be able to predict its cash flow. The higher the valuation, the longer the prediction period.

So if a company is selling for 2 times earning and you are fairly confident that the current cash flow will persist for 5 years, then you have a bargain. On the other hand if you are looking at a commodity company whose cash flows depend on the price of a volatile commodity, then making any prediction is usually a waste of time. You may be able to look at some long price charts of the underlying commodity and get lucky from time to time, but good luck with trying to make it keystone of your investing strategy.
On the flip side, if you are looking at a company selling for 100 times earnings, one needs to have a high degree of confidence on the expected cash flow for 20+ years and beyond. Anyone claiming such clairvoyance is worth of worship !!

The sweet spot is usually when the valuations appear reasonable (in 15-25 range) and one can make a reasonable estimate of the cash flow based on an in-depth understanding of the company, its industry and the competitive situation.
In summary, the best way to approach an investment candidate is to filter out the extreme cases and then dig into the business as much as possible. This should help one make a reasonable estimate of the cash flows and its duration. Once you have a reasonable fix on these key inputs, doing a valuation and comparing it with the market price is the easy part.

Homework: Is coal india Ltd a value stock?
It is selling for 10 times earnings net of cash for sure. Personally I think the PE ratio here is meaningless. One is making a bet that Coal will continue to be a dominant fuel for us for the next 10-20 years in face of dropping cost of solar and other energy sources such as Natural gas. In addition there is also the headwind of climate change regulations and drop in prices globally. In short I don’t know enough to predict the cash flow and hence the idea is a pass for me. If you plan to buy or hold it, you need to answer the above questions with a high degree of confidence.

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.

August 3, 2016

A rational frenzy

The following note was recently sent out to the subscribers. I hope you will find it useful.

A few of you may have noticed the frenzy around the NBFC and especially the MFI (micro finance institutions) space. The buying frenzy is not entirely irrational.

The Indian household debt at around 9-10% of GDP is among the lowest in the world and there is a huge pent up demand in the retail / MSME segment. The introduction of adhaar, regulatory changes and several new technology tools is now allowing the NBFC segment to reach new customers at a much lower cost and achieve rapid growth.

We are now seeing growth in excess of 40% in this space. This is further aided by the fact that PSU banks and to a certain extent some private sector banks, are not capable or interested in serving these customers.
So we have a confluence of factors coming into play here – A new regulatory and technology platform which allows companies to reach out to a large set of under-served customers at a time when the dominant players in the ecosystem, namely banks, are not in a position to take advantage of these opportunities.

We are seeing this playout in the entire financial services space – Home loans, NBFC, Auto finance and even structured finance. This is likely to continue for the next 2-3 years.
Tread with caution
There is however a dark side to this whole opportunity – A growth of 30%+ may lead to poor lending practices and weak credit underwriting in several cases. This may be truer in the case of newer institutions which lack the experience and management bandwidth to manage this growth (and later collect the bad debts).

We may not see the impact of these practices for the next 2-3 years, but if poor decisions are being made, the chickens will eventually come home to roost. We have seen that in the past in the sub-prime mortgage crisis in the US and the bad debt problems of the PSU banks now.
The time to be cautious is now and not when poor lending practices lead to a blow up in the future. In other words – tread with caution and be sure what you are buying.

What are we doing ?
We are already around 20% of our model portfolio in financials via four companies. These companies operate in different segments of the financial ecosystem and I believe that the management of each of these companies is competent and has seen multiple cycles in their respective businesses. At the same time, if the frenzy continues and our concentration in this business segment continues to grow, I will start reducing the position size.

For now, we are not there yet and hence I am not taking any action.
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.

July 4, 2016

A statistical analysis of failures

I have often written about experiments and failures in the past (see here, here and here). These posts have usually involved a failed experiment or idea and my conclusions or learnings from it. It has been a case of inductive reasoning (going from the specific case to general principles).

I recently initiated an exercise where I collated all the investments I have made since 2010/11 and analyzed the success rate of my picks. I have defined failure as a stock position which delivered less than 13% CAGR over the last 5-6 years.
Why 13% and not an actual loss? There are a few reasons behind it

-   13% is roughly the level of returns one can expect from an index and hence I have set that as the threshold
-   It allows me to capture value traps as failures. These are stocks where the stock price has stagnated or trailed the index as I waited for valuations to revert to the long term averages.

The analysis was quite eye opening and although I had some vague idea of what to expect, the actual results were still surprising.
Surprisingly low hit rate

I have bought/ sold or held around 35 position in the last 6 years. Of these, I have lost money in 7 and consider 16 (or 45%) as failures (<13% category also includes the < 0% cases)

If you look at the above result, the conclusion could be that the overall portfolio has performed horribly. I am not going to share the actual results as that is not the purpose of the post and anyway I can claim anything in absence of independent verification. Let me just share that the portfolio has done substantially better than the common indices (substantial being 10% above the NSE 50 returns)
A common myth is that high returns need a 90%+ success rate (if not 100%).

The reason behind the myth
So why does almost everyone believe that one needs a perfect hit rate to achieve good returns? This myth is quite common as one can see from comments in the media, where people are surprised when some well-known investor has a losing position.

I think it speaks to the ignorance of the following points
-   A losing position has a downside of 100% at the most, but a winning position can go up much more than that and cover for several such losses. Let’s say you have a portfolio of three stocks and two go to 0, but the third stock is a 5 bagger. Even in such an extreme example, the investor has increased his portfolio by 50% with equal weightage in all the three positions.
-  Let’s take the previous example again and instead of equal weightage, let’s say the two failed position were only 10% of the portfolio, whereas the winning position was 90%. In such a happy scenario, the overall portfolio is up 4.5X.

In effect investors under-estimate the impact of upside from a winning position and the relative weightage of these winners. A portfolio is not like a true or false exam where every question gets the same marks. If you get something right, the weightage and extent of gain on that position matters a lot
So the next time, you read an article where some famous investor lost money on a position and chalk it to them being over-rated, keep in mind that the losing position could be a tiny starter position. A lot of investors sometimes start with a small position and then build it as their conviction grows.

The learnings
The main reason for this exercise was not to generate some statistics and leave it at that. I wanted to dig further and find some common patterns of failure. This is what I found

Blind extrapolation
The number no.1 failure for me has been when I assumed that the past performance of a company or sector would continue and hence the recent slowdown or poor performance is just a blip.
For example, I invested in a few capital good companies in 2010/11, assuming that the recent slowdown was just a blip. These companies appeared very cheap from historical standards and that motivated me to invest in some of them. I did not realize at the time, that the country was coming off a major capex boom and it usually takes 5+ years for the cycle to turn.

I have since then tried to dig deeper into industry dynamics and understand the duration of the business cycle of a company in more depth.
The forever cheap or value traps
These positions are a legacy of my graham style investing. These companies appeared very cheap by all quantitative measures. I would attribute the failure of these positions to the following reasons

- These companies were earning low returns on capital as the management had very poor capital allocation skills. To add insult to the injury, some of these companies refused to increase the dividend payout and just kept piling cash on the balance sheet. In all such cases, the market took a very dim view of the future of the company. Unlike the developed markets, India does not have an activist investor base and hence these companies end up going nowhere.
-  I forgot to ask a very basic question: Why will the market re-value this company? What needs to change to cause this revaluation? In most of these cases, the company performance was not going to change substantially for a variety of reasons, and hence there was no reason for the market to change its opinion.

The turn which never happened
There have been a few positions where my expectation was the company will start growing again or will improve its return on invested capital (or both). In all such cases, the expected turn never happened and the company just kept plodding along with me incurring an opportunity loss during this time.

The problem with these kind of situations is that you don’t lose money due to which one is lulled into complacency. One fine day, after having waited for a few years, I realized belatedly that I was waiting for something which was unlikely to ever happen.
I have now changed my process to identify the key lead indicators for a company which need to change to confirm that the management is moving in the right direction. For example, is the management introducing new products, expanding distribution or trying something else to revive the topline? If the annual report and other communication continues to be vague on these points, it is best to exit and move on

Doing too much
There is another pattern I have noticed which is not obvious from the table. I have had a higher number of failures after a successful phase. I think this is most likely due to over confidence on my part which led to a higher number of new ideas in the portfolio with much lesser due diligence on each of them. The end result of this sloppy work was a much higher failure rate.

The changes
It is not sufficient to just analyze failure. One need to make changes to the process in order to prevent the same error from occurring again

Some changes in my process/ thinking has been
It is difficult to invest in commodity/ cyclical stocks (atleast for me). I should tread cautiously and have a very strong reasoning behind such an investment (being cheap is not enough).
Identify the reasons on why a company will be re-valued by the market. Also have a time frame attached to it (endless hope is not a strategy)
Be your own critic. Confirm if the original thesis holds true? If not, exit. It is better to be proven wrong as quickly as possible.
Growth is not all important, but absence of it can lead to a value trap.
The most dangerous phase is right after a successful stretch. Resist the urge to extend your lucky streak by making investments into half-baked ideas. Take a break or vacation!

If there is one lesson from the above analysis you should take, it is that one does not need to have a very high hit rate to get decent returns. As long as one holds on to companies which are doing well and culls the poor performers rationally, the overall results will be quite good.

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.