The Indian bitcoins

The following note is from upcoming annual letter to subscribers. I will be publishing the rest of the letter on the blog soon

When I look at companies which are priced a 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 830. 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. Ofcourse 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.

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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.

Discounting hope

It is widely understood that stock prices are forward looking – they discount the future expectations of cash flow of a company. In bear markets, these expectations are lowered as markets extrapolate recent trends (and assume a recession forever). On the flip side, the reverse happens during bull markets, when investors extrapolate the recent good results into the future and assume that there will be no hiccups along the way.

Finally, we have markets like now, where investors have gone ahead and extrapolated ‘hope’ and discounted that too.

The idea funnel

I maintain a 50+ list of stocks which I track on a regular basis and have created starter positions in a few companies which appear promising. The process i follow is to create a small position (usually 0.5% to 1% of my personal portfolio) and then track the company for a few quarters/ years.

In atleast 50% of the cases or more, I realize over time, that I am not too excited about the prospects of the company and exit the stock immediately. In a few cases, however the company and its stock may still hold promise. In such cases, I start raising the position size in the portfolios I manage.

The above approach allows me to run experiments with lots of ideas and controlled risk.

Discounting infinity and beyond

I am now noticing that some of the positions I hold on a trial basis have started running up based on hope.

Let me take one example to illustrate – Repro India.

Repro India is a printing business with operations in India and Africa. The company performs print jobs for publishers for all kinds of printed materials like books, reports etc. The company has had a chequered past with uneven performance. 

The company was growing till 2012-14 with rising sales in India and Africa. The return on capital of this business was mediocre as the printing business involves high fixed assets, high and sticky receivables with average operating margins in the range of 15-18%.

The export business in Africa went into a nose dive in 2014 due to the drop in oil prices. The company was not able to collects its receivables as these African countries faced currency issues and hence incurred losses. Since then the company has been slowly recovering the receivables and nursing the business back to health. In addition the domestic business continues to be competitive and sub-optimal due to the lack of any competitive advantage

I would normally avoid such a company unless there are some prospects of improvement or change in the future. One such possibility exists for the company. This is the new BOD – books on demand business of the company.

The BOD business is similar to an aggregation model followed by companies such as uber or Airbnb. In the case of repro, the company has a tie up with Ingram (another US based aggregator) and other publishers in India to digitize their titles and carry them on its platform. These titles are then made available through ecommerce sellers such as Amazon or flipkart. When a user like you and me finds this title and purchases it, Repro prints the copy and delivers it you.

The business model is depicted in the picture below (From the company’s annual report).

The above business model ensures that there is no inventory or receivables for Repro or the publisher. The payment is received upfront and the product is delivered at a later date. This is a win-win business model for all the value chain participants as it eliminates the need for working capital. As a result, this business model is able to earn a high return on capital with the same or lower margins than regular publishing

Illustration from the company’s annual report

Repro is doing around 40-50 Crs of sales in the BOD segment and growing at around 70-80% per annum. The company has loaded around 1.4 Mn titles on its platform and plans to load another 10 Mn+ titles in the future. This business is at breakeven now. The BOD business has a lot of promise and it’s quite possible that the company will do well. 

However, success in the business is not guaranteed. The company needs to scale its operations and could face competition from other print companies in the future (as the entry barriers are not too high).

The market of course does not care about the uncertainty. There are times, when markets refuse to discount good performance in the present and then there are time like now, when the market is ready to discount the ‘hope’ of good performance in the future. The stock sells at around 100 times the current earnings. As the legacy printing business continues to be mediocre with poor economics, it is likely that the high valuations are mainly due to the exciting prospects of the BOD business

I had created a small position a couple of months back and have been tracking the company. The stock price has risen by around 50%, 60% since then even though the company is just above breakeven on a consolidated level.

I am optimistic about the prospects, but the execution needs to be tracked. I am not willing to pay for hope and so I am a passive observer for now.

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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.

No pizza today

I wrote the following note to my subscribers in response to two questions which are frequently asked by new prospects

a.     Please share your past performance
b.     How many stocks can I buy if I join your advisory today

The note below, seeks to answer the second question

Pizza versus investment advice
If you walk into a store or restaurant, you are handed the item or service as soon as you make the payment. Any delay or refusal to offer the said service is considered a breach of faith or fraud.

The above standard mode of exchange breaks down when we come to investment advice. The job of an investment advisor is to ensure that his or her clients make decisions which helps them in the long run (in achieving their financial goals). This can mean that the most sensible course of action often is do nothing and wait for the right opportunity to invest.

This is however not understood by the vast majority of investors who behave like a customer in a restaurant. A typical investor likes to be handed a menu card of stocks and would like to buy as many as possible even before the ink has dried on the cheque (metaphorically speaking). This expectation works if you order a pizza, but not when you are investing for the long run (5+ years).

The investment industry panders to this behavior and even encourages it. As much as one would like to blame the industry (and they have much to blame), the investor community is equally responsible for it. Stock markets are seen as a place to pat your ego (for recent high returns), indulge your gambling instinct or just entertain yourself.

In all my years, I have found very few who look at the stock market for what it really is – A place to invest your capital for the long term to earn returns above the rate of inflation and thus achieve your long term financial goals.

If you are in for the long haul, it makes sense to invest your hard earned money in the right company at the right price (price being very important). Often this happens, when everyone is running for the exit.

Walking the talk
It is easy to talk, but not easy to do the same thing unless your own money is on the line. My own funds, that of my partner kedar and our families is invested in the same fashion. Nothing focusses you on the risk, when your own money is on the line.

I get turned off when I read about fund managers and analysts who recommend a stock, but do not have skin in the game. It clearly means that they do not believe in what they say.

I made a conscious decision several years back that I will eat my own cooking and as a result, any loss in the portfolio is borne equally by me. In addition to this point, both me and kedar have made it a point to under-promise and hopefully deliver more. As result, inspite of a 100%+ rise in 2014, we decided to go low key as I knew that future results could be subdued for a period of time. I did not want to attract subscribers based on recent performance and disappoint them when I failed to meet their un-realistic expectations.

We continue to follow the same approach today. We will get excited when the market drops and go into hibernation when the market gets euphoric. The hibernation is limited only to activity and not to the effort of finding new ideas. We continue to build the pipeline, but the pizza will be served only when the time is right.

Mental capital

This is a term I like to use to represent the time, and mental energy devoted to each position in my portfolio. I would also add mental stress to the equation.

I have realized that in a lot of cases the percentage of mental capital allocated to each position does not match with the allocation of financial capital. On the contrary, some of my top position have needed the least amount of mental energy on an ongoing basis and caused the least amount of stress. This has been mainly due to the quality of the business and management.

On the other hand, some of the smaller positions in my portfolio have resulted in a much higher allocation of mental capital and that could be also the reason why I never raised the size of these positions.

Not a mathematical exercise

Unlike the amount of financial capital, one cannot calculate the percentage of mental capital allocated to a position. However there are several pointers one can use to see if a particular company is taking a dis-proportionate amount of your mental energy
-           You are regularly surprised by the quarterly results
-           The management makes your stomach churn and causes you to worry about the safety of your capital
-           The industry is undergoing a substantial amount of change and you have no means of evaluating the economics of the business even for the short to medium term
-           You keep coming up with new reasons to hold on to your position, even after your original thesis has been invalidated. The word ‘hope’ keeps coming up in your thinking
-           You ‘worry’ about the position for any of the above or other reasons

The killer combination

If the financial and mental capital allocated to a position is too high, then we have a deadly combination. This is kind of an extreme situation can make you act irrationally and in the end be injurious to both your financial and mental health, if the position turns against you.

I have realized over time, unlike financial capital which can compound, mental capital is limited and does not increase much beyond a limit.  It is important to use it smartly both for your financial and mental health and finally for your quality of life.

A certain level of mental capital has to be invested when investing directly in stocks (instead of an index or mutual fund), but in some cases the level can go much beyond the amount of financial capital allocated to it. In such cases, I have usually found that selling down or completely exiting the position has freed up my mind to look for new ideas and devote more time to other stocks in the portfolio.

The tail (portfolio) should never wag the dog (your life).

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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.

On outperformance

Some excerpts from my annual review to subscribers. Hope you will find it useful

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

a.     Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.
b.     Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models
c.     Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is slowly reducing with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. However in the end, it also depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In such a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

How does patience help?
Take a look at the 5 years history one of our oldest positions – Cera sanitaryware.

 

The company has performed quite well in terms of profits in the last 5 years and grew its net profit by 30% in FY 15 and 23% in FY16. Compare this with the stock price – The stock dropped from a peak of around 2500 in early 2015 to a low of 1500 in the span of one year, even though sales and profit continued to grow at a healthy pace.

These swings are usually due to short term momentum traders who want to move from company to company to catch the incremental 10%. I am glad that we have such investors in the stock market as it gives us an opportunity to buy from time to time when the price drops below our estimate of fair value.

We will continue to get such kind of opportunities in the future. The key is to be patient and act when an opportunity is presented.

Skin in the game
It is not easy to remain focused on the long term. In my case, I do not feel any pressure to negate this advantage and let me share why.

The reason for holding onto this approach is that this is something which has worked for me over 20 years and for others over a much longer period. If one can identify good quality companies at a reasonable price, then the returns over the long term will track the performance of the business (more on it later in the note). The value approach works over time, even if it does not work all the time

In addition to the above, my own net worth and that of my close friends and family is invested in the same fashion. I will not take the risk of blowing up to show short term results. Nothing focuses your mind, when your own net worth and that of friends and family is invested in the same fashion.

Let’s try to understand the math behind my expectations of the long term returns. This is a repeat for some of you, but is worth reading again.

The math behind the returns

At the time of starting the model portfolio, I stated 3-5% outperformance as a goal and this translated to around 18-21% returns over time. How did I come up with this number and more importantly does it still hold true?

Let’s look at the math and the logic behind it. The outperformance goal ties very closely with my portfolio approach and construction. We typically have around 15-18 stocks in the portfolio, bought at 60-70% discount to intrinsic value on average. Most of the companies we hold have an ROE of around 20-25% and are growing around 18-20% annually. These numbers may vary, but on average they will cluster around the above figures over time.

Let’s explore a specific example based on these numbers. Let’s say a company valued at 100, growing at around 20% is purchased for 70. Let’s assume I am right in my analysis and the stock converges to fair value in year 3. If this happy situation comes to pass, the stock will deliver around 34% per annum return.

Now in year 3, we could sell the stock and buy a new one again and make similar returns. This may occur from time to time in individual cases, but is not feasible at the portfolio level unless the market is in the dumps and stocks are selling at cheap prices. It is unlikely that our positions would be in a bull market and selling at full price, when other stocks are available at a discount.

In such a case,  if the quality of the company is high and we continue to hold on to it, it will deliver a return of around 20% per annum in the future (assuming the stock continues to sell at fair value going forward). If you add 2 % dividend to this 20% annual increase in fair value, the stock could deliver around 22% for the foreseeable future.

The portfolio view
The math, explained for a single stock, works at the portfolio level quite well. As per my rough estimates, the model portfolio has grown at around 22% per annum in intrinsic value. It was selling at around 27% of intrinsic value when we started and is at a 20% discount now. You have to keep in mind that there are just estimates on my part and I cannot provide any mathematical proof for it. However I have found that these two variables have worked quite well in understanding the performance of the portfolio over the long run – discount to intrinsic value and growth of the value itself.

As the intrinsic value has grown over years and the gap closed, we have enjoyed a tailwind and hence the returns have been a bit higher than that of the intrinsic value. The returns are often lumpy as can be seen from the performance.

Where will these returns take us?

If you talk to some investors, they would scoff at 20% returns. Let look at this table for a moment

I am sure a lot of you have seen the above table. It shows how much 1 lac will become if you allow it to compound at a certain rate of return for 10, 20 and 30 years.

There is something different in the table, from what you would have normally seen. The rate of return numbers seem to be random – 7%, 13% etc., but they are not. Let’s look at what they signify

7 % - This is normally the rate of return one would get from a fixed deposit in the bank
13% - This is the average rate of return from real estate over long periods of time. I would get eye rolls when I quoted this number in the past. The recent and ongoing experience is changing that now.
16% - this is roughly the kind of return you can get from the stock market index over long periods of time
20% - This the level of returns we ‘hope’ to achieve in the long run (3+ years or more)

There are a few key implications of the above table

-        A small edge over average returns adds up to a lot over time
-        The key to creating wealth in the long run is not just super high returns, but to sustain above average returns over a long period of time. It is of no help if you compound at 30% for 20 years and then lose 80% of your capital in the 21^st year. The key is to manage the risk too.

If we achieve our stated goal over the long term, the end result will be quite good. There are two risks to this happy end – avoid blowing up (which I am focused on) and early retirement (mine), which you have to hope does not happen either involuntarily (I get hit by a bus) or voluntarily (I head off to the beach).

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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.

My interview on safalniveshak

I recently did an interview with Vishal khandelwal at safalniveshak.

We covered several topics such as the process for finding investment ideas, position sizing, concentration versus diversification, facing market turmoil and many more.

You can find the interview here

You can read an earlier interview with vishal here.

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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.