February 20, 2013

Facing the crash

The midcap index is down by around 7% since the start of the year and the small cap index is down by 9% during the same period.  That is quite a drop in a span of 45 days and it still does not represent the true carnage which has occurred in a few stocks which have dropped by 20% or more in the span of a few days.

The standard prescription
The standard prescription is to follow the fortunes of your companies like a hawk and to buy and sell the stock based on short term expectations. This approach helps you jump in and out of stocks and be ahead of the market at all times.

This prescription works well for highly cyclical stocks such as cement or steel where one needs to time the buy and sell decision to get above average results. The same approach is a disaster if applied to companies with above average economics (high return on capital with good growth prospects) at the hint of the slightest slowdown
I have personally paid the price for jumping in and out of stocks based on short expectations – such as with asian paints and marico (and more). I purchased these stocks in 2000 and sold them off in bits and pieces from 2006 and onwards.  The opportunity loss in all such cases has far exceeded the actual losses from all my failed stock picks

I won the battle (short term), but lost the war (long term).
How to handle such times
It is easy to preach rationality and follow it during times of rising markets. It is however a different ball game to be rational at a time such as now, when stocks can suddenly drop by 20% or more in a matter of a few days.

One way to prevent knee jerk reactions is to avoid checking your portfolio everyday.  One needs to turn off the financial channels and stop tracking the portfolio on a minute by minute basis. I really doubt the long term returns of one’s portfolio are dependent on any breaking news, which by the way is generally some useless piece of information
In addition to the above, one needs to have an appropriate level of diversification in the portfolio. I  general limit each position to around 5-7% in the portfolio to dampen the volatility. A higher level of concentration and the associated returns are thrilling when the market is rising. However during market swoons such as now, the momentum can suddenly turn and make a lot of individuals nervous. A focused portfolio is of no use, if you exit your positions at such times.

Finally, it is important to analyze the fundamentals of the company and try to look at it with a fresh mind after each quarterly result. It is important to avoid anchoring the thought process to the buy price and the original thesis and one should  look at the company based on the current price and its future prospects

What if I am wrong ?
One certainty about investing is that you will be wrong occasionally. The super investors are wrong less often than the less successful ones, but still make wrong bets.

In my case, if one of my picks crashes or the company comes out with a really bad set of numbers, the first thing I do is to avoid looking at the company for a few days – no I am not joking. The reason I avoid looking at the company is to prevent myself from reacting emotionally and taking a hasty decision. It is quite possible that I may lose 10-15% more on the position, but overtime I have realized that a calmer mind helps me in taking a more rational decision.
Once the panic dies down, I generally try to look at the results and key indicators of the business and try to see what I am missing (which the market sees). In several cases, I may conclude that the market is over-reacting and may decided either to do nothing or even add more to the position. Sometimes though, I have realized belatedly that I have messed up and  that the best course of action is to exit (and feeling like a fool at the same time).

A few months later, I will come back to the mistake again and analyse it further to avoid making the same mistake again (new ones will still happen!)
What next?
It is quite likely that things could get ugly before they get better. I personally have no way of knowing the future and my investment approach is not based on getting the short term right. I prefer to look at the 2-3 year prospects of the company and if the company is moving in the right direction, I would rather just buy and hold the stock (or buy more if the stock gets cheaper).


Krishna said...

Hi Rohit, Investing in stocks without a reasonable stop loss is a recipe for disaster. It is exactly the kind of argument that you articulated in this post that brought ruin to my portfolio after 2008 crash. I kept on holding to stocks for 'long term'. What is result at the end of 5 years? An irrecoverable loss of capital.

Please keep in mind that there are factors (which drive the stock price) which you are completely unaware. Chances are, by the time you become aware of them, permanent damage is already done.

I am all for long term investing, but you also need to implement safety mechanisms to protect yourself from capital erosion.

Anonymous said...

Hi Rohit,

Some time back you had posted abt Maharashtra seamless at that time I think it was ard 300levels. CMP 209.Pls share your views


Rohit Chauhan said...

Hi krishna
A stop loss is no safety again the risk of investing in stocks.

If one picks a wrong company or if the future turns out to be different from what one expected, a stop loss will not help you.

since 2008, there have been companies which have done well and so has the stock. at the same time sectors like RE and telecom were overvalued and some companies were outright frauds.buying them would result in a loss no matter the market level

if one had bought infosys in 2000, you would have broken even only by 2006. is that a faliure of having a long term view or buying overvalued stock ?

one cannot have a long term view and ignore valuations and quality of the business and expect the long term to help you out of these decision.

sorry, if i am coming across harsh, but i have made mistakes in picking the wrong stocks , which i openly discuss.holding them for the long term has not helped me.the only safety mechanism i know of is to learn constantly and get better at investing

Rohit Chauhan said...

Hi anurag
I looked at maharashtra seamless, but did not proceed as i did not like their plans of backward integration.since then the import of seamless pipes has hurt the industry badly and the economics of the business has worsened.


Ravi said...

Hi Rohit,

A great post as always. I think more is yet to come and we will have great stocks at discount prices which is what I hope. I know you were holding Balmer Lawrie for long and so do I. Do you continue to hold it? My understanding is that they have not used shareholder capital well in the past 3 years. The return on reinvested capital is pathetic as they are only investing in FDs and trying to revive tea business which is dead anyway. I know they have set their vision for 2015 and recent qtr their profitability went up 15% but would be glad to hear what you think about it? It was not overvalued 3 years back and it continues to be undervalued even now. Is this a classic value trap or is it just testing our patience?
P.S - Thinking of exiting this but I know it is hugely undervalued right now..so stuck in indecision

Pradeep said...

Hi Rohit,

On Asian Paints and Marico, when you bought AP - It appears it was trading between 10 and 15 times PE and Marico between 7 and 8 times. I may be off by some %age but I guess they might be trading at that range. In 2006, it appears that AP you might have sold at 27-30 PE and Marico between 25 and 30 PE. Since then both are up 4-6x aided by multiple expansion of around 30-40% and the rest by earnings increase. Now, looking back it might appear that selling was a mistake, especially from an opportunity cost perspective. However, holding onto a firm when it is trading at 25-30 PE seems to be a huge risk. It does not appear to me that you made a mistake. Do you think selling them at 2006 was a mistake from a process perspective? Would you hold on to AP or Marico now or would you sell it? (currently at 40 PE and 35 PE respectively)

Rohit Chauhan said...

hi ravi
you need to have a different set of expectations from balmer lawrie. this company will give you 15-18% returns on average. you will not make 20%+ returns here ...at the same time the downside risk is very low and there is roughly a 5% dividend yield too.

i dont think they have been bad capial allocators. on the contrary the management has improved the ROC on the core biz and are investing in the logistics busness wich hasa very high ROE. I agree the tea biz is better exited , but then being a PSU one cannot expect very aggresive action.

if you have modest expectations, then the company is fine. if you expect 25%+ returns then this is not the right stock


Rohit Chauhan said...

hi pradeep
you bring a very good point and i have given a lot of thought. it is easy to say that the decision was rational as we did not know that these companies would do well in the future.
the returns from 2007 onwards have been both due to earnings and growth and from PE expansion too as the market has fallen in love with FMCG stocks
that said, i think if a company has a sustainable competitive advantage and can grow above the rate of the economy, the a buy and hold could be a good strategy. you will have phasesof 2-3 yeas when the stock stagnates as the fair value catches up with the stock price.

case in point - crisil: it was a 4 bagger from 2008 to 2012 and has stagnated since then. company continues to do well and the price will follow in time. patience is the key in such cases

Anonymous said...

regarding balmer.Look at the dividend compounding rate!
32% compounded over 12 yr.(in case of balmer inv its 47% compounded over 9 yrs)
Even if the stock doesn't go anywhr,does it really matter??

There are two type of catalysts Natural(dividends),mang initiated(buyback,insider..)

and we all know milk is better than redbull..but it takes time...


Sachin Purohit said...

@Krishna..Talking about the 2008 crash, I had started buying Allahabad Bank at about Rs.90 just a few days before the crash started. As the markets crashed, it went all the way down to less than Rs.40. Honestly, that gave me a lot of worry. Had I applied stop loss on it, I might have sold of at a loss. But I saw the dividend yield of about 10% (Rs. 4 dividend over the price of Rs. 40) and a consistent performance that suggested that the dividends will only improve. I went ahead and bought even more aggressively. During the subsequent rise, I sold them off at Rs. 260. A stop loss strategy often is a "Continue Loss" strategy. There are times when it does work. Typically when you are not reasonably confident about the scrip you have purchased is a good candidate for stop loss.

Rohit Chauhan said...

Hi anon
true ..balmer lawrie is moderate risk and moderate return stock. one would be lucky to make anything beyond 15-18%, but downside is low too

sachin - agree with you. the reality is that if you make a mistake or are unlucky, then the stop loss does not help. it only crystalizes the loss. one needs do the homework and then have strenght of your conviction to hold


Ravi said...


It looks like no one noticed that I said return on reinvested capital. I know the current ROCE and ROE numbers of Balmer looks good. But if you see how much capital has been retained incrementally in the last two/three years and how much it has resulted in incremental growth in earnings its averages at about 12% compounding. Please note that if a company like Nestle just stops growing its operation and then starts investing all its profits from current operations in a fixed deposit year on year, the ROE and ROCE would still look good for a long time but decline gradually before ending up with an ROE of 8% (it would take a real long time for nestle to go there though as the ROE is too high). I knew that balmer was a slow grower and it is a great dividend paying stock. I was happy with the way they allocated their capital before towards high ROCE businesses lik logistics but in the last 3 years they have retained more cash which was not invested in profitable business like logistics ( a small portion was invested but margin pressues remained). They revived their tea busness and expanded container making capacity which is as such a low margin business with lot of competition. The management had recently woken up and started investing (coming up with a travel site for 25cr) Time will tell how that fares. As I mentioned before the recent qtr was okay but I look long term and I would give a C to the management as far as their capital allocation for last 3 years goes. I did not give a D because atleast they did not lose money in bad investments. With inflation being so high, they could have done a better job giving back the money to shareholders in stead of holding so much cash.

Rohit Chauhan said...

Hi ravi
for starters you cannot compare nestle with balmer.these are two different businesses with different economics and the valuations reflect the superior economics of nestle's business.

balmer lawrie has earned around 40% in incremental capital in the last 4-5 years. the problem has been that the company has accumulated the excess cash and not increased the dividend as much - still dividend has been growing by 16% per annum. the problem is that the company is making 40% on invested capital and generating far more cash than it can invest. it has a problem of plenty - not a bad problem to have. at the same time its a psu and it will always be conservative.

i think the management is doing a good job based on the hand they have been dealt. they are earning 40% in businesses which dont have the great economics such as FMCG

btw - have you looked at what the returns have been for the companies in the last 13 years ? balmer lawrie up 1400 % v/s 950% for nestle. you would not expect this considering that nestle has been galloping for the last 5 years

it all comes down to the valuations and how the company does versus that


Ravi said...

Hi Rohit,

I took Nestle example just to drive home the point that current ROE will reduce gradually to rate of return on reinvested capital. I neither say that Nestle is a great company nor that it is a great buy. Infact paying 40+times for a company that is growing at less than 12% (last qtr) is criminal. I was not trying to compare Balmer to Nestle as it would not be a fair comparison. I am not sure how you have calculated 40% return. It looks like you are looking at what they making in core business (ROIC). As far as I am concerned, the earnings generated by the company is shareholders'. A company should retain that capital only if they can generate meaningful return on the capital they retain. In Balmer's case as you rightly mentioned they have hoarded captial and actually invested less amounts in core businesses. When I say 12% compounding for last 3 years I am talking about return generated on complete shareholder retained capital. That is the reason the ROE has been falling consistently in the past 3 years. The contribution of Other Income to the net profit drives home my point. On consolidated basis, on Mar 10 they had a book of Rs.348.37 on which they were earning Rs73.72. By Mar12 they have retained Rs117.35 of earnings generated thereby increasing their book value to Rs.465.72. However this additional 117.35 has produced only an incremental earning of Rs17.19 in the past 2 years. If you calculate the rate of return it would be close to 12% compounding. This may be better than a bank giving FD of 10% (last 2 years as inflation and interest rates were higher) but as investor just getting 2% additional interest compared to a safe deposit is not that great. If they continue to do this the returns we should expect in the future will be far less. They can make it better by either paying out higher dividend and reducing their cash or by buying back stock. Being a PSU I am not sure if they would buy back.
Please note that this is purely to exchange thoughts and not to get into any arguments as to who is right. I have always seen that your view is fair and that is the reason I brought this topic for general thought exchange. I was purely looking at business of Balmer and not what the market has priced. In terms of market pricing my returns have given less than FD returns in last 3 years. I dont worry about that as Mr Market is wrong in keeping its price so depressed at this point (there has been pe compression).