December 11, 2009

Test of patience

The last one year has been a value investor’s dream. Analyze and find an undervalued stock, buy decent quantities of it and voila!, in a few months time the market has recognized the undervaluation and corrected it. As a result most of the stocks in my portfolio have corrected substantially and I am looking at decent gains.

This has been the experience across the board and I don’t think it is proof of my or anyone else’s special genius or abilities. Now, before we start considering this as a normal state of affairs, let me point out an experience I have had for the last few years. This experience is not unique and has happened to me several times, but I am giving this example as it is recent and ongoing.

I read and analyzed Merck in Aug-Sept 2006 and found it to be substantially undervalued. The company had a growth problem, where due to the limited portfolio of products, its topline was more or less stagnant. However the company was able to improve its bottom line by 50% during the same period by cutting costs. In addition the company had almost 350 Crs in excess cash and was thus selling at 4-5 times its earnings.

So here was a company with great ROE, moderate growth and high cash balance selling for a song. I decided to start building a position and started buying the stock slowly. I eventually built my position for 2 years with the stock dropping during that period. The net result of the position was a loss of around 15% by the end of 2008 including dividends.

Was it a bad pick?
Now a valid argument could be that the stock was bad pick in the first place. In investing, it is important to remember that decision need to be made looking forwards and not backwards. My approach to investing is to compute intrinsic value with conservative assumptions and buy at a discount to this number. This approach may not work everytime, but works surprisingly well most of the time.

The company had a decent performance in the past, was reasonably well managed and had quite a bit of cash. During the period 2006-2008, the company was able to grow the topline by 30% and the bottom line by 10%. Not exactly a blowout performance, but pretty decent. In addition, there were a few things happening below the surface. The company started investing heavily in sales and marketing during this period due to which the topline started accelerating at the cost of the net margins.

The turnaround
The turnaround in the price finally came in Q2-Q3 2009 as the topline growth started flowing through to the net profit in terms of growth. At the same, the market was also in a mood to correct undervaluations and price most stocks closer to their fair value.

Whats the point?
The point is that undervaluation and fundamental performance alone are not sufficient triggers. A lot of times it is the market mood which decides when the undervaluation will correct and you will make your returns.

Now, one can say that if it all depends on the moods, then one should wait for the mood to turn and buy the stock before the turn happens. Well, on that please leave me a comment if you know some logical approach of figuring that out without getting into mumbo jumbo.

The point of the post is that an investor cannot control when the market will correct the undervaluation, but he or she can look for sound companies selling below intrinsic value, buy them and hold a portfolio of such companies with patience. Some of the holdings may take time, but over the course of time the portfolio as a whole will do reasonably well to be worth your while.


Manshu said...

It's great to analyze and look for undervalued companies. In the long run they will do well, if you have the patience and the cashflow to ride out the rough times. Practically speaking though, a lot of times, your patience runs or you come in the need for money, so I can understand a lot of investors not being able to use this philosophy often.

kumar said...

Hello Rohit,

I understand your premise on undervaluation and market mood. But, Merck is a bad example - MNCs in general are not really interested in Indian shareholders, their only interest is in enriching their parent company.


Anonymous said...

dear rohit
i have follwed ur blog n portfolio for last 2 yrs
my only regrets have been , i could have built up bigger positions on ur stock selection
now that i have learned my to calculte intrinsic value
i will be more confident on ur analysis
may be people like me have gained much more than urself using ur own portfolio
god bless people like u

KD said...

Dear Rohit,
Though not directly related to the argument about market perception of a stock, I just remembered an incident from Warren Buffett's life - that of his investments with Berkshire and Coca Cola and his decision not to invest in Tech sector. For both he was bashed up for long or he suffered for long, but finally he was proved to be right, and how!! Snowball is a great read for any investor..many lessons to be learned from the great great grandfather of value investing!!

Ravi said...

Hi Rohit,

It a classic case of Mr Market in a depressed mood and right now in a good mood. As I understand form the readings of great value investors we should not be basing our reference on the market price to determine if we are successful or we got the catlytic trigger we wanted. We should base it on the owner earnings (look through) that we got on that invetment. If you continue to get the earnings as per your initial expectation and the company continues to perform as per the expectation then, it is in our interest that market keeps the price subdued so that we can keep accummulating mmore and more of that business. I found this to be eye opening way of looking at things (not referencing our performance by calculating our portfolio market returns) when I read Robert Hagstorm (warren buffet way and warren buffet portfolio) and Klarman (Margin of Safety). This would help us not get swayed by the fear and greed that market goes through everytime. Yes, if we are playing for a short term, we should look fot catalyst that could cause the mispricing to correct but its only an assumption which no one can be sure off as the factor that we may consider as a catalyst could be taken with a pinch a salt by the market even when the catalyst happens (Mr Market is depressed, so he doesnt bother good catalyst when he is depressed).

Vikas Rana said...


As usual, a great post. This strengthens our belief in Value Investing.

I really like your coverage of different topics (Micro and Macro), it makes one a better investor.


rbery said...

Hi Rohit,

Now that your investment in Merck has appreciated are you considering selling or is the intrinsic value of the company much higher.


Investologic said...

Hi Rohit
Great post as usual. To make the maximum out out of undervalued companies, I use your approach combined with technical analysis. Undervalued companies eventually to spike up to their true values, sometimes really fast and sometimes really slow. I normally put these companies on watch list and then wait for them to hit an oversold or overbought territory to enter or exit. Once the stock reaches its intrinsic value, I tend to follow that more closely to completely square off a position !!!
Your inputs are always great !!

Unknown said...

Hi Rohit,
The question "was it a bad pick" is really relative. It may be a good pick wrt the risk free interest rate, or perhaps even the sensex/nifty. But was it a good pick wrt say, a Hero Honda, or a HDFC, which if bought in the same timeframe might have yielded better results?

Also, the question arises of the "circle of competence"....


Rohit Chauhan said...

Hi manushu
i think one should invest only that amount which one can hold for the long term ..otherwise you have to sell at the wrong time.
the problem of patience is a more diffcult one especially if you see others making quick money through speculative ideas


Rohit Chauhan said...

Hi kumar
i dont agree..all MNC's are not same. one cannot categorise MNC as all bad or all good. it is a case by case analysis ..merck has given decent dividends in the past and does not have a history of pulling a fast one on investors. that ofcourse is not a guarentee that they will not do it in the future.

and on the same lines novartis is also an MNC with much poorer corporate governance, but has given better returns


Rohit Chauhan said...

hi anon
it is good you have learnt how to calculate intrinsic value ..that would help you more in the long run than just following my picks


Rohit Chauhan said...

yes, snowball is quite a good book. shows ability of buffett to ignore the crowd and follow his convictions

Rohit Chauhan said...

a good way to put the same points. i agree 100% with it. the only downside is that one needs to have the conviction and patience to hold on to such an idea when the market is ignoring it


Rohit Chauhan said...

Hi vic
it remains to be seen how much the macro analysis would help the stock picks

i am still holding it as the company is still selling below intrinsic value


Rohit Chauhan said...

Hi arunsg
valid question was a better pick than the index, but was definitely as good as some other of my own picks. i have not compared with an hdfc or hero honda ..but the company has given me 20% p.a returns ..good but definitely not mind blowing returns.

the bigger question is this - is it possible to know the above before hand ? in retrospect it is easy to evaluate that, but when picking the stock one can only look at the fundamental performance and the underpricing. the problem is to avoid the hindsight bias.

sometimes the above is grey and if i dont have as much conviction, i dont build as big a position too.


Rohit Chauhan said...

i have not been able to figure out how to combine technical analysis with fundamental investing i have to be more patient.

if you have been able to figure that out, then i guess you can target higher returns


kumar said...

Sure, all MNCs are not the same, but their record of how they (most of them) have treated Indian shareholders in general is very poor.