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.
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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.

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.

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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 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.