Annual letter to subscribers: On risk, Bitcoin and thinking long term

The following note was published recently to my subscribers. Any reference to performance or individual companies has been removed to ensure compliance with SEBI regulations.

I hope you find the note useful

What drove the performance

We exited 5 positions and replaced them with four new positions during the year.

It’s a unique year that none of our portfolio positions dropped in value. It is however not surprising considering that various indices were up 40-50% during the year, with almost 100+ stocks increasing by 100% or more. If we just compare the numbers, our performance is nothing to get excited about.

If you just threw darts at the small cap index, you could have done quite well. If, however, you were ready to throw caution to the winds and were open to go down the quality curve, then the gains were even higher. I am not crying sour grapes here. Let me explain why -

At any point of time, I am looking at several companies and track them over time. If I find an idea interesting, I usually create a small starter position to understand the sector and company better.

A lot of such starter positions are up anywhere between 60 to 400% during the year. So, when I say that, if you were adventurous and ready to take on risk, the returns were higher, it is not an academic point. I have seen the same happen in my personal portfolio.

You may ask – why did I not do it in the model portfolio? To that point, let me state something which I have repeated in the past.

The model portfolio mimics our (Kedar and mine) personal portfolios (except for a few small positions) and that of my family and friends. I will never ever take excessive risk just to look good and gain some boasting points.

A year of misses

This was a very frustrating year too. A few new ideas passed through the initial filter and ended up on the tracking list.

Several of the companies on this list seem to be decent bets for the long run, subject to execution by the management. I prefer to start with a small position and increase the size as the management executes as per the plan. If, however the management slips or the business conditions change for the worse, we will exit the position.

In several of these trail positions, the stock price rose rapidly, in anticipation of the improvement. It’s quite possible that the market is able to foresee the improvement much before I can. In that case, we may end up starting the position late with a lower upside, but with much lesser risk.

We need to be patient in all such cases as you never know when opportunity would knock again.

Change in approach: fail fast and small

There has been a subtle change in my approach in the last 1-2 years which I think should be shared with all of you. I have become more open to trials (starting with small positions) and then killing these ideas quickly if they don’t work out.

It is one thing to maintain a buy list, but emotionally very different to actually commit money (even a small amount) to an idea. Once you do that, you are financially and intellectually (and even emotionally) vested into the position. In such cases, it is important to constantly stress test the idea and exit if the thesis does not pan out.

A failure on a small 1-2% position will not hurt our portfolio over the long run. If, however some of these positions work, we can scale into them and make them much larger.  This is the mental model used by venture capital firms and it makes sense to adopt a similar framework (even if the type of companies we target is different) for our portfolio.

What truly drives the long-term returns

I have shared the changes in the intrinsic value of the portfolio with the price changes in the past and would like to reiterate the following points again

a. Businesses and their intrinsic value tends to be less volatile than stock prices

b. Over the long term, stocks prices tend to follow intrinsic value. However, in the short term (1 year or less), these two numbers don’t have to move in lock step.  

c. If the underlying business is increasing in value, it makes sense to have patience as the returns will eventually follow. As an example, if we had gotten frustrated after the measly returns of the last two years and exited in 2016, then we would have missed the gains of 2017

2017 has been a year when the portfolio price has again caught up and run ahead of the value. As a result, we can expect lower performance for the next few years till we can get the fair value up via a combination of new ideas and increase in value of the current holdings.

In the long run, this back and forth will continue, and I don’t plan to play the game of timing to squeeze a few extra points of performance. We will focus on increasing the intrinsic value of the portfolio as much as possible and let the market give us gains as per its own schedule.

Measuring the risk

I had written about risk management in the last letter, which is reproduced below again

I am not trying to make the highest possible returns in the shortest period of time, but above average returns over time with the lowest possible risk, with risk management taking a higher precedence. Risk Adjusted returns are more important than absolute returns.

This focus on “Risk” has led us to cap our top positions at 5-7% at the time of purchase, keep sectoral bets capped at 20% and maintain a cash level of 12-15% over the lifetime of the model portfolio. A more aggressive stance in the form of more concentrated positions or lower cash would have raised our returns (5% per annum by my rough guess), but increased the risk too. I have no regrets of foregoing these returns. I will always prioritize risk over returns and if it means slightly lower returns, so be it.

If we continue to earn above average returns in the future, the magic of compounding with risk management will allow us to reach our destination. I want the journey to be pleasant and would like to sleep well at night. There is no point in dying rich if you have a terrifying time reaching that point.

I have discussed about risk in a subjective manner in the past, without using any ratios or measures. One quantitative measure is drawdown of the portfolio over various time periods.

On an annual basis, we can see that we have lost less than the market during downturns.

However, we do not have enough data points to make this evaluation statistically significant.

In order to have more data points, I have computed the monthly returns of the portfolio and compared it with the large cap index. For the data purists, a monthly period may not be the right duration or they may quibble about using a different index for reference. My response to that – it is better to be roughly right and directionally correct, instead of trying to get it right to the third decimal point.

For the duration of the model portfolio, the average monthly loss for the index has been around -3% (when the index has dropped during the month). In those periods, our portfolio dropped less than the index 63% of the times and our average drop during these ‘bear’ market months has been around -1.1%

The above statistic is quite noisy as I think monthly returns are usually meaningless, but over a long period this statistic can give an indication of the level of risk in the portfolio. In other words, we have had lower drawdowns. We cannot avoid bear markets, but if we lose lesser than the market, we should do quite well in the long run

I am more focused on reducing the risk, than doing better than the market. I have always felt and continue to feel, that the long-term momentum of the Indian economy and the stock market is such that we will do well over time as long as we can reduce the downside risk and avoid doing something stupid.

In case you are curious on how we have done during bull periods (when monthly returns are positive), the model portfolio has returned 5.3% versus the 4% by the index during the same period.

As you can see, that although we have done better than the market on average during the bull markets, our outperformance against the index has been higher during bear markets.

If you are really hoping to do well with me, hope for a bear market now.

Cash is not a macro call

We currently hold around 28% of the portfolio in cash which may appear to be some sort of a macro call. However, let me assure you, it is nothing of that sort. I have never bothered with economics forecasts around GDP, interest rates or any global or geopolitical situations.

My analysis is always bottoms up with a focus on company level factors.

The reason for the high levels of cash is that the price of several of our ideas have far exceeded my estimate of fair value due to which I feel that the long-term returns are likely to be lower compared to the risk of holding those positions. As a result, I have reduced the position size.

At the same time, the speed with which I can find and understand new ideas has been far slower than the rate at which the market has recognized and re-priced them. This is something I cannot fix unless I can buy some extra IQ points to speed up the pace.

The question I am constantly asking

As the markets have risen, I am constantly asking the following question for each position : Will I continue to hold this position if the stock price drops by 50%? If not, why am I holding it now?

The time for risk management is now, when there is euphoria all around and not when everyone is heading for the exits.

If anyone of you, cannot bear a 20-30% drop in your portfolio, it would make sense to do a mental exercise now – how much should I invest in equities so that even if the equity portfolio dropped by 30%, I will not lose sleep.  No one can answer this question, but yourself and the time to do it would be now.

Why do I constantly harp on risk? Is it because I foresee some market crash?

The emphatic answer for that is no! We are not in the business of forecasting which can be left to media personalities. For me and Kedar, Risk is personal and we want to look at it as an integral part of investing. Our monies and that of our families are invested in the same fashion as the model portfolio. We are not managers who will only benefit from the upside, but have no risk on the downside.

We will have quotational losses from time to time, but do not want to be in a situation where our greed or envy of some else’s performance leads to a permanent loss of capital for us, our families and you.

Bitcoin and popcorn

I have been asked by a few subscribers on what I think about Bitcoin. I have a rough idea of the technology that under pins cryptocurrencies – ‘Blockchain’ and think the technology has a lot of potential in reducing transactional costs, improve asset tracking, develop decentralized networks and several other use cases which we cannot imagine as of today.

That said, I do not have a view of Bitcoin as I do not understand it well. There are several other things I don’t understand well enough to be able to make money such as Short-term trading, technical analysis, Bio tech, Mongolian companies and so on. However, that does not disturb me as there is enough for me to do within the scope of what I do understand.

If we can invest conservatively and earn an above average return in Indian equities, the end result is likely to be very good. Why should we then get all worked up if something is doing well for others and they are becoming rich as a result?

There will always be someone doing better than us in all sorts of stuff. Someone could be running a restaurant or a tech startup which is doing very well. Does that mean we should follow them as a short cut to riches?

I continue to study the technology out of curiosity and watch the drama on the sidelines. I also have some popcorn (unbuttered to avoid cholesterol issues) on the side to enjoy the show.

The Indian bitcoins

When I look at companies which are priced at lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.

A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some “All knowing” entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.

The market on average and over time gets the valuations right, but not always.

As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.

How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past

In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.

How many companies in the above space currently sport a PE of 50 higher? around 22% or roughly 675. So, 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth

In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?

All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Of course, every individual thinks he or she is smarter, more handsome or <insert your criteria here> than the crowd (also called illusory superiority).

The odds are against everyone being right. So, it makes sense to be cautious and do your homework well enough.  Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.

A long-term partnership

I repeat this every time in the portfolio review and will do so again

– I do not have timing skills and cannot prevent short term quotation losses in the market
– My approach is to analyze and hold a company for the long term (2-3 years). As a result, my goal is to earn above average returns in the long run and try to avoid losses during the same period
– In spite of my best efforts, I will make stupid decisions and lose money from time to time. The pain felt will be equal or more as I invest my own money in exactly the same fashion

    Me and kedar look at our association with you as a long-term partnership. As a result, whenever someone joins us, we are very explicit in letting the person know that they cannot expect quick wins or a stock tip a week or something on those lines.

    

    We want your association with us to span years, if not decades. In our view, financial management is something which lasts a lifetime and hence, as your advisor, we want you all to focus on the long term. We try to instill this focus via multiple actions from our side such as       

      -   Avoiding a short-term focus on performance such as daily, weekly or monthly scorecards

-    Buy companies and hold them for the long term as long their prospects remain above average

-        Focus on risk and reducing the downside

A lot of subscribers have stayed with us for the long term and hopefully benefited from that. We will continue to maintain this approach irrespective of the latest trends in the market. If that costs us business, so be it. I would rather have some of you disappointed with the short-term result (and consequently leave), than lose money due to chasing the latest trends in the market and then leave (while cursing us).

If you are interested in our advisory services, please email us on enquiry@rccapitalmanagement.com

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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.

Proceed, but with caution

I recently published the following note to the subscribers of our investment advisory service. I have removed any reference to actual returns of the portfolio as I prefer new subscribers to join the advisory only if they agree with our investing philosophy, overall process and long term return goals and not fixate on how well we have done recently.

We have done significantly better than our long term goal of beating the index by 3-5% per annum, but that may appear measly to many investors who consider anything lower than 100% annual returns as sub-par.

To all such investors, our response has been that we are not the right portfolio advisors for you as we are fairly old school in terms of targeting above average returns, but with much lower risk. For us, the focus has been always been on risk, especially during times such as now when almost everyone appears oblivious to it and can only see clear blue skies.

The latest note was a party pooper and could have depressed some of the subscribers. I hope, if you manage to read through the whole thing, will reduce some of your optimism too.

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We have achieved our stated goal of outperformance relative to the indices. This has been achieved while holding around 10-20% cash at various points of time without any leverage or shorting any stocks.

The impact of holding cash is that it has depressed the annual returns by around 3-4%, but allowed us to manage risk and sleep well.

Should we celebrate?

It is easy to get ecstatic when the recent performance is good and depressed when the same is poor. Although I am not immune to these emotions, I do not let it over-ride my thinking. After a big gain in 2014, we had a weaker performance in 2015. I was not happy about this performance, but was not overly disturbed by it.

The following comment from the 2015 review, was true then as it is now

The swing in performance means that there is an element of luck in each year’s results and a swing in a particular year should not be over-analyzed. In plain words, I was not a genius in 2014 and did not become stupid after the calendar changed to 2015.

I have not become smart again in 2017.

We have tried to follow a consistent approach over time and avoided temporary fads in the market, even if it has meant underperformance in the short run. Over long periods of time, I strongly believe that the process of buying undervalued stocks and holding them for the long run will result in above average performance.

What drove the performance?

I have written earlier (see section – simple, but not easy framework) that portfolio performance is driven by two factors -

Factor 1:  Discount to Intrinsic value (referred to as IV in the rest of the note) of the portfolio
Factor 2: Average growth rate in the Intrinsic Value of the portfolio

The first factor is decided by the gap between purchase price and IV of the companies in the portfolio. This factor depends on the market mood, when investors are often too pessimistic about a company due to short term reasons. The second factor depends on the company performs in the long run.

The first factor can cause returns to spike from a single position or the entire portfolio depending on a change in the views of the market. Most investors fixate on this and get overly excited when this gap closes and they are able to earn a high return over a very short period of time. In contrast, the second factor is what allows one to compound wealth over the long term. These returns appear ordinary in the short run, but the power of compounding results in spectacular numbers over time.

In the first half of the year, we saw the first factor drive returns for the overall portfolio wherein the market re-appraised the value of several of our positions. The stock price for these companies rose by 50-100% during this period. If you look at the model portfolio table, you will notice that my estimate of the growth in IV is around 20-25% on average. So in effect, value kept building for these companies over the last 2-3 years and was suddenly recognized by the market over a short period of time.

Role of an Investment Advisor

I am not trying to make the highest possible returns in the shortest period of time, but above average returns over time with the lowest possible risk, with risk management taking a higher precedence. Risk Adjusted returns are more important than absolute numbers.

This focus on “Risk” has led us to cap our top positions at 5-7% at the time of purchase, keep sectoral bets capped at 20% and maintain a cash level of 12-15% over the lifetime of the model portfolio. A more aggressive stance in the form of more concentrated positions or lower cash would have raised our returns (5% CAGR by my rough guess), but increased the risk too.

I have no regrets of foregoing these returns. I will always prioritize risk over returns and if it means slightly lower returns, so be it.

If we continue to earn above average returns in the future, the magic of compounding with risk management will allow us to reach our destination. I want the journey to be pleasant and would like to sleep well at night. There is no point in dying rich if you have a terrifying time reaching that point.

I have written in the past that I am focused on companies which can increase their intrinsic value by 18-20% annually (Factor 2) and are selling at 20-30% discount to this fair value (Factor 1). I would of course love to buy a company which can grow at 40% and sells at 50% discount to fair value. However such bargains do not exist in the current market and we have to adjust to the reality we face for now.

I have explained the math behind the returns in the 2016 note here, and what this translates to in terms of the long term returns. You have to keep in mind that this is a broad framework for returns and not some mathematical formulae which will deliver this precise level of return all the time.

I can understand that a lot of investors find 20-25% returns below par and have a desire for much higher numbers. I have no problem with that. It’s just that my investing approach and numbers are not suitable for them. Both I and Kedar make it a point to emphasize this at the time of joining the subscription and we keep repeating (to the irritation for you) it so that our mutual expectations are in synch.

Lumpiness of returns

The annual CAGR number tends to hide the lumpiness of the returns at the annual and lower increments of time. If you think there is some kind of pattern to this lumpiness, let me know – I have been searching for it and have yet to find it.

The only consistent pattern we have followed is to buy companies below their intrinsic value and wait patiently for the market to realize the same. In some cases, the wait is short and in other cases it is longer. However, if I am correct in my evaluation, then the value is usually realized.

I have control over the process and the stocks we pick for the portfolio. The exact timing is, however, up to the market and unlike most of participants, I do not spend any effort in trying to get it right as long as the company is building value over time.

It is however not a given that I will always be right. If I am right 60-70% of the time, we will do fine. Any higher percentage would mean that I am being too cautious and sacrificing returns to appear consistent. So, if all my stock picks are working out, don’t be thrilled – it just means that I am being too cautious and leaving money on the table.

The topic of disruption

I wanted to touch briefly on this subject and how it relates to our portfolio and investment approach.

This topic is in the news and one keeps hearing of some new technology disrupting a stable industry which was earlier assumed to be immune to such threats. We have Amazon disrupting retail in the US, solar starting to disrupt energy markets, electric vehicles on the horizon with a high probability of disrupting the auto and oil markets. The list goes on and on. One often feels that a lot of this is hype and just headlines to grab your interest.

On the contrary, I personally feel that markets are being pretty sanguine about it. People may be talking about these risks, but they are not acting on it. Valuations seem to incorporate no disruption risk at all.

Why do I say so? Let’s go back to the basics. What is the value of a company?

It’s the sum of the discounted free cash flow, the company will generate, from now to its eventual demise. In most cases, when investors value a company, they estimate the cash for a certain period (8-10 years at best) and then add a terminal value to come up with a number. The key assumption behind the terminal value is that the company will survive forever (or for a very long period of time).

For example, a company like Maruti sells for 30 times earnings. This valuation implies that an investor expects the company survive beyond a decade for sure. At the same time, we have almost every other auto manufacturer such as GM, Ford, and Fiat etc. selling at 3-4-time cash flow. In these cases, the stock market expects the company to go out of business soon (within 4-5 years at best).

The reason for such a low valuation for the almost all the auto companies across the world (except India) is that the market foresees (correctly) a major threat of disruption. A disruption in a company’s business model is not a slow, long drawn process, but an abrupt one where the company goes from high profitability to heavy losses in a matter of few quarters. Look at the examples of Nokia, blackberry, Department stores in US and many more.

The common response to such arguments is that ‘This time it’s different’. For example in the case of electric vehicles, India does not have a charging infrastructure or Indians cannot afford such expensive vehicles etc etc. What a lot of investors miss is looking closely at the cost curves of these technologies. Batteries which are a major component of an EV cost are dropping in price at 14% per annum and that is with the current technology (without any radical break through).

In addition to this, an Electric vehicle lasts 4 times a regular vehicle, has minimal maintenance cost and an operating cost which is 20% that of a petrol vehicle. If you offer a better & cheaper product to a consumer, will they ignore it? Has it ever happened in the past? And what if the govt also decides to push for it due to environmental and foreign exchange benefits?

The point of all this discussion from an investor’s standpoint is that these kind of risks are being mispriced by the market. The market will continue to ignore these risks, until it becomes apparent and at that time the value destruction will be abrupt.

I am constantly reading up on these new trends and try to keep an eye on it. It is not possible for me to predict when these risks will materialize, but it is quite evident that they will come to pass eventually. In such cases, it is better to exit early rather than stand in front of an oncoming train and jump out of its path at the last minute. A last minute jump is often financially fatal if you mis-time it.

Managing risk

If there is a common thread in all topics in this note – it is risk or various forms of it. I have spoken about position sizing risk, duration risk (lack of patience leading to exiting a position at a loss in the short term) and business model risk (from disruption).

There are many more forms of risk, some of which we can hedge at either the position level (proper selection, pricing and sizing of the position) or at the portfolio level (appropriate levels of cash, reducing co-relation between position etc).

I usually discuss about the position risk in the individual notes. These half yearly notes are more focused on discussing some aspects of portfolio level risk.

So why this added focus on risk now?

I think managing risk is an essential part of investing and is even more critical during bull markets (such as now) when almost everyone is solely focused on returns.

You need to keep in mind that managing and reducing risk is not free in the short run, but pays well in the long run. One of the ways we are managing our risk is by capping the maximum allocation to a single position or a sector. Doing so not only reduces the risk (which is not visible), but reduces the return too.

In the same manner, we have been raising the cash levels as stock prices have increased way beyond their fair value in some cases. This decision is based on valuations and future prospects of each position and not on some near term forecast of the market (of which I have no idea and don’t care)

The net impact of all these actions is that it reduces our prospective returns. In the last 6+ years of the model portfolio, if we had kept the cash levels at 0 and a higher concentration in some of the positions, we could have easily done a much higher return.

It would also have given us a few sleepless night during this period due to the high volatility. I cannot speak for you, but I value my sleep and will not trade it for a few extra points of return.

There is no point of chasing higher returns if a drop in the market causes you to exit at the wrong time due to short term losses. In such a scenario a conservative investor who is satisfied with lower returns will come out ahead of a more aggressive one.

For the new subscribers (and prospects)

We have faced this question often when markets are hitting highs, especially from new subscribers – “There is nothing to buy”. To that, we have a standard response – This will occur from time to and time and there is nothing we can do other than ask you to be patient.

We have faced the current situation several times in the past (in 2012, 2014 and now) and it often felt that the opportunity to invest in good ideas was gone for good. However there is always some company specific opportunity or a general market drop (as in 2013 and Feb & Nov 2016) which allowed a recent subscriber to add to their portfolio. The only requirement at such times is to have a reserve of cash and courage.

So a simple formulae for all of us
In bull markets – have patience, avoid greed.
In bear markets – have courage and be greedy.

A repeat section

I repeat this every time in the portfolio review and will do so again
·       I do not have timing skills and cannot prevent short term quotation losses in the market
·       My approach is to analyze and hold a company for the long term (2-3 years). As a result, my goal is to earn above average returns in the long run and try to avoid losses during the same period
·       In spite of my best efforts, I will make stupid decisions and lose money from time to time. The pain felt will be equal or more as I invest my own money in exactly the same fashion

Finally a sales pitch – if you interested in joining our advisory, please email us on enquiry@rccapitalmanagement.com
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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.