## December 19, 2011

### Finding diamond in a coal mine

I have nothing against the airline industry, other than the fact that it is injurious to investor wealth.  There are other industries such as sugar which fall in the same group, where most of the players are not even able to meet their cost of capital over a business cycle.
I got several comments, where it was noted that there are some companies such as spice jet in the airline industry could turn out to be successful. A comparable example is bharti airtel which has done well in a fairly competitive industry with poor profitability (telecom)
I do not deny the fact that it is possible to find a profitable company which manages to buck the trend. There are often profitable companies in terrible industries and poor performers even in profitable ones (such as FMCG)
A probabilistic exercise
Let play a game of chance. Suppose I give you two dices and say that if you roll a 1,1 or  6,6 (both dices turn up one or six), I will pay you  5 for every one rupee you wager. Will you play this game?
If you understand the concept of expected value, you will decline it (read here about it and I will strongly recommend you to understand this concept thoroughly). You may get lucky once a while (roughly 5% of the times) but over a long period of time you will lose money by playing this game (you will lose 1 rupee 95% of the times and gain 5 rupees, 5 % of the times giving a net loss of .7 for the game)
So what does this game have anything to do with investing in an airline? Let me explain –
If you read through the previous post closely, you would have noticed that roughly around 16 or more airlines have failed till date and all the current ones are also losing money (some of these could fail too –at least for their shareholders). So even if spice jet or some other airline succeeds, you are talking of a 6-7% success rate in the industry.
Will you play a game where the probability of success is less than 10%? If yes what should be the payoff?
Well, venture capitalists who make such investments (low probability of success) typically expect a payoff of 20 or more for every rupee invested, to earn a respectable return on capital. Can you expect the same from spicejet or Jet airways?
But I am not putting all my money on airlines
You can make an argument that one is not really putting all his money in the airline industry and hence the above probabilities don’t apply. That is really not the case, as the said probabilities do apply to the specific idea, if not to the entire portfolio.
At the same time think of it – If you put a certain portion of your portfolio in industries with poor economics and high levels of failure, are you not setting yourself up for failure?  The ex-ante probability of success in all such cases is quite low. If you are really a smart investor, does it not make sense to invest in industries where the chance of success is high to begin with and then on top of that you can apply your considerable skills to improve the eventual outcome.
The counter argument
I can think of two counter arguments to my logic
The first one is that if one has some special skills or insight into the industry and thus an edge over the market, it makes sense to invest in that industry inspite of the problems. Even in such as case, I cannot think of a scenario where most of the investors would have a considerable edge in a wide range of industries (including the lousy ones).
The second counter argument is the graham style of investing – pick a lousy company so cheap, that when the industry turns a bit, this company goes from a bargain price to just about cheap. I have done this several times in the past and made some money from it. This is however a 1-2 year game of cycling through such stocks on a regular basis, and constantly looking for the next one. There is nothing wrong with it except, that it requires wide diversification and constant effort to look for new ideas.
Ignoring industries with poor economics or governance?
Does the above post mean that one should just ignore and never try to learn about an industry which is known for poor economics? I think that would be silly. It is not like one will get some kind of infection or loose money just by reading about such an industry. One should practice safe investing, but that does not mean one should not learn about these companies.
Let me give an example – I am quite allergic to real estate companies. The industry has extremely poor governance, unethical practices and is a cesspool of corruption. At the same time, it does not mean that one should never study or look at real estate companies.
I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean! The question I am now grappling with is how do you value a realesate company? That will most probably be the next post
Look for diamonds in a diamond mine
I think one should be intellectually honest with oneself. If you genuinely think that you have considerable insight into some industry and can do well inspite of the poor economics of the industry – then more power to you.
In my own case, inspite of understanding the poor economics of the sugar or metals industry, I have invested some money in the past and learned an expensive lesson.
I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine.

mkd said...

Excellent post Rohit. A must read for new as well as seasoned investors alike. Thanks for sharing.

Hemant said...

Rohit, I have recently started reading your blog and find it very informative. Thanks a ton for sharing all this knowledge.One problem I am facing is that I am not able to download any of the sheets that you have posted on google groups. I guess the google groups is no more active. How do I access those sheets that you have posted in your articles before?

Indrajeet Singh said...

you said something on real estate industry. what is your opinion on Anant Raj Ind- i feel it is one such gem. With liquidation value of its properties less debt will be more than current market price. should it not be screaming buy

Vic said...

Thanks Rohit for another excellent post. I love the way you ended your post "I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine"

:-)

Vic

Anonymous said...

Hi rohit

Kunal here nice to read ur views but my points are

1) Spicejet and indigo are very efficient company and to say they will loose money is painting every one with same brush

2) now airline models are very less capital intensive so even if they make 5-8% margin return on capital can be very good

3) If u see the situation of indian aviation market three players JET -26% share KFA -17% and AI -17% are in a position from where they have to survive (forget about additional capacity expansion ), and none of the outsiders will dare to launch airline after watching negative publicity that mallaya has . now spice and indigo gets free ride here. a market which is growing at 20% for next 8-10 years and only two or three are able to expand, so they will have 25-30% CAGR in rev.

4) when ever we buy equity we have limited liability only the money invested can be lost unlike mallaya we dont have to put our home on block . so here risk reward says even if spice makes loss for couple of years it will not loose too much as it is already discounted and if there might be a chance that with in next 12-18 months if u get couple of good quarters than u can have windfall profits . It can go to as high as 80-100 rs according to my assumptions.

By Kunal Shah

Rajesh.v said...

I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean!

------------------------------------
Mr.rohit, what are those companies?

Anonymous said...

Hi Rohit

How do you calculate excess cash in a business for analysis?

regards

hi rohit, i have read ur posts on MFs..one thing i need to ask abt ur mutual fund portfolio is diversification..i m commenting abt 5 funds u hav selected ( may possible tht u dnt have any positions in them right )
1. all ur funds are large caps nd multicaps..why?
2. dont u believe in core nd satellite approach which many magazines,papers are advocating these days
3. you are an aggressive investor nd ur MF portfolio doesnt reflect tht
4. u hav invested in growth style funds only..nt any value fund why? dont u think diversification in investment style is also necessary
5. i hav read abt MFs on many platforms, aggressive portfolio according to me would be - 1 large cap, 2 multi caps, 1 midcap, 1small cap/ midcap; among these funds min 2 must hav value investing approach..
do u see any flaw in dis strategy? please post ur reply..
because after reading ur posts i hav a feeling dat u cant go wrong on anything! i m quite eager to hear ur opinion on above points..sorry for posting my querry in this thread..

Rohit Chauhan said...

Hi mkd
thanks for the comment

rgds
rohit

Rohit Chauhan said...

Hi hemant
you are right ..the google groups are no longer active. i will post the spreadsheets on my blog again soon

rgds
rohit

Rohit Chauhan said...

Hi indrajeet
I have not looked at the company so cannot on the specific, however i have found that the liquidation value approach really does not work as it generally not practical to have liquidation of company. so the assets which you see generally do not come back to shareholder

you can use liquidation value as one data point ..but i will more concerned if the management is using the assets productively and will create value in the future

rgds
rohit

Rohit Chauhan said...

Hi vic
thanks ..i liked the statement too after i wrote it :)

rgds
rohit

Rohit Chauhan said...

Hi kunal
I agree with you comments in the short to the medium term : 1-2 yrs. With severe losses we may see rise in prices and profitability. it really cannot go down from current levels further otherwise everyone will get wiped out.

so in effect spicejet and others could make money in the next 1-2 years and in that wave the market could reprice these companies as if that is the new steady state, analyst will sing praises and you can exit with good returns.

however as i happens in a commodity business, this period of rising prices will be followed by new capacity , more competition and drop in profitability again and we will have a repeat. so unless one exits in the next 1-2 years, an investor will not make decent returns over a period of 4-5 years.

even if the planes are leased, it really does not change the economics much ..you are changing the upfront cash flow with a ongoing lease expense. financially the transactions may be different, but economically it is same as everyone in the industry can lease and hence the return on capital will tend to the same numbers

again - i am not saying you will not do well in the next 2-3 yrs ..you could get a double or even triple too. but airline stocks are not good for the average investor

rgds
rohit

Rohit Chauhan said...

Hi rajesh v
ashiana housing is one such company. its one of the better real estate companies

rgds
rohit

Rohit Chauhan said...

Hi anon
any cash on balance sheet more than 5% of sales is generally excess cash

rgds
rohit

Rohit Chauhan said...