Over optimizing the portfolio

I have often been asked by subscribers - what fixed income option would I recommend for the cash they hold?

My response is that I usually hold my cash in short term FDs or at the most in short term debt funds with high rating and from a well-known fund house.

The main criteria I use in selecting a fund are
-           Fund should have a high AUM (> 1000 Crs) for liquidity purpose
-           Should be from one of the well know fund house, preferably backed by a bank
-           Should have a low expense ratio (as far as possible)
-           Should have a 3-5 year operating history or more

You may have noticed that I have made no reference to returns. This is by design as I am looking at high safety of capital and liquidity in this case. The entire point of holding cash or equivalents is that it should be secure and can be accessed at times of market stress without any loss.

Some of you may be unhappy that these options provide ‘only’ 4-5% returns which are quite meager.

Do the math

Let’s do some math. I usually hold somewhere between 10-20% cash in my portfolio. In a crazy bull market such as now, it may go upto 30% level, but on average it hovers around the 15% mark. Let’s assume I get very creative and aggressive with the cash holding and can earn around 10% returns on it. Keep in mind, that the level of risk rises exponentially in case of fixed income instruments. A vehicle giving 10% when the risk free rate is 6%, is not 60% more risky, but carries several orders of magnitude higher risk.

Let’s say, that I still decide to move forward and invest all the cash in such a vehicle. So in effect I have made 4% extra on the 15% cash holding which translates to an extra 0.6% return on the overall portfolio. This additional 0.6% would translate to roughly 7% additional return over a 10 year period.

Is it really worth the risk? Does one really need the extra 0.5- 1% return when rest of the funds are already invested in equities?

There is no free lunch

One of the reasons for holding cash and equivalents is to lower the risk of the portfolio, especially when it is high in the equity market. If you are attempting to get higher returns via fixed income instruments, then you are just changing the label of the investment, but not the level of risk in the portfolio as a whole.

A fixed income label does not change the nature of risk. It is the characteristics of the instrument and its past behavior which defines the same. The worst aspect of investing is to take on higher risks unknowingly and then get shocked when it comes back to bite you.

Please always keep in mind – there are no free lunches in the market. There are absolutely no ‘assured’ high return fixed income options (the term itself would be an oxymoron). If someone tries to sell you one, please run away from the person as fast as you can.

It is not a race

I will never tell anyone of you what to do as you need to make your own decisions. However, let me share what I have been doing for the last 10+ years – I have my funds in safe and relatively secure FDs earning pathetically low rates of returns. This allows me to sleep soundly and have one less thing to worry about. If the equity portion of my portfolio does well, then I don’t need the extra 0.5%. If it does badly, the 0.5% will not save me.

In the end, investing is not a 100 meter dash where the winner gets a gold medal and the fourth place goes home dejected. As a long as I can make a decent return (being 18 %+) over the long run, I would rather exchange a few extra points for much lower risk. The journey would be far more pleasant and I will still reach my financial destination (maybe a year later).

Ps: This does not refer to any investment options such as real estate from a diversification point of view. This is mainly about the desire to optimize the cash portion of the portfolio.

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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.

A statistical analysis of failures

I have often written about experiments and failures in the past (see here, here and here). These posts have usually involved a failed experiment or idea and my conclusions or learnings from it. It has been a case of inductive reasoning (going from the specific case to general principles).

I recently initiated an exercise where I collated all the investments I have made since 2010/11 and analyzed the success rate of my picks. I have defined failure as a stock position which delivered less than 13% CAGR over the last 5-6 years.

Why 13% and not an actual loss? There are a few reasons behind it

-   13% is roughly the level of returns one can expect from an index and hence I have set that as the threshold
-   It allows me to capture value traps as failures. These are stocks where the stock price has stagnated or trailed the index as I waited for valuations to revert to the long term averages.

The analysis was quite eye opening and although I had some vague idea of what to expect, the actual results were still surprising.

Surprisingly low hit rate

I have bought/ sold or held around 35 position in the last 6 years. Of these, I have lost money in 7 and consider 16 (or 45%) as failures (<13% category also includes the < 0% cases)

If you look at the above result, the conclusion could be that the overall portfolio has performed horribly. I am not going to share the actual results as that is not the purpose of the post and anyway I can claim anything in absence of independent verification. Let me just share that the portfolio has done substantially better than the common indices (substantial being 10% above the NSE 50 returns)

A common myth is that high returns need a 90%+ success rate (if not 100%).

The reason behind the myth

So why does almost everyone believe that one needs a perfect hit rate to achieve good returns? This myth is quite common as one can see from comments in the media, where people are surprised when some well-known investor has a losing position.

I think it speaks to the ignorance of the following points

-   A losing position has a downside of 100% at the most, but a winning position can go up much more than that and cover for several such losses. Let’s say you have a portfolio of three stocks and two go to 0, but the third stock is a 5 bagger. Even in such an extreme example, the investor has increased his portfolio by 50% with equal weightage in all the three positions.
-  Let’s take the previous example again and instead of equal weightage, let’s say the two failed position were only 10% of the portfolio, whereas the winning position was 90%. In such a happy scenario, the overall portfolio is up 4.5X.

In effect investors under-estimate the impact of upside from a winning position and the relative weightage of these winners. A portfolio is not like a true or false exam where every question gets the same marks. If you get something right, the weightage and extent of gain on that position matters a lot

So the next time, you read an article where some famous investor lost money on a position and chalk it to them being over-rated, keep in mind that the losing position could be a tiny starter position. A lot of investors sometimes start with a small position and then build it as their conviction grows.

The learnings

The main reason for this exercise was not to generate some statistics and leave it at that. I wanted to dig further and find some common patterns of failure. This is what I found

Blind extrapolation

The number no.1 failure for me has been when I assumed that the past performance of a company or sector would continue and hence the recent slowdown or poor performance is just a blip.

For example, I invested in a few capital good companies in 2010/11, assuming that the recent slowdown was just a blip. These companies appeared very cheap from historical standards and that motivated me to invest in some of them. I did not realize at the time, that the country was coming off a major capex boom and it usually takes 5+ years for the cycle to turn.

I have since then tried to dig deeper into industry dynamics and understand the duration of the business cycle of a company in more depth.

The forever cheap or value traps
These positions are a legacy of my graham style investing. These companies appeared very cheap by all quantitative measures. I would attribute the failure of these positions to the following reasons

- These companies were earning low returns on capital as the management had very poor capital allocation skills. To add insult to the injury, some of these companies refused to increase the dividend payout and just kept piling cash on the balance sheet. In all such cases, the market took a very dim view of the future of the company. Unlike the developed markets, India does not have an activist investor base and hence these companies end up going nowhere.
-  I forgot to ask a very basic question: Why will the market re-value this company? What needs to change to cause this revaluation? In most of these cases, the company performance was not going to change substantially for a variety of reasons, and hence there was no reason for the market to change its opinion.

The turn which never happened

There have been a few positions where my expectation was the company will start growing again or will improve its return on invested capital (or both). In all such cases, the expected turn never happened and the company just kept plodding along with me incurring an opportunity loss during this time.

The problem with these kind of situations is that you don’t lose money due to which one is lulled into complacency. One fine day, after having waited for a few years, I realized belatedly that I was waiting for something which was unlikely to ever happen.

I have now changed my process to identify the key lead indicators for a company which need to change to confirm that the management is moving in the right direction. For example, is the management introducing new products, expanding distribution or trying something else to revive the topline? If the annual report and other communication continues to be vague on these points, it is best to exit and move on

Doing too much

There is another pattern I have noticed which is not obvious from the table. I have had a higher number of failures after a successful phase. I think this is most likely due to over confidence on my part which led to a higher number of new ideas in the portfolio with much lesser due diligence on each of them. The end result of this sloppy work was a much higher failure rate.

The changes

It is not sufficient to just analyze failure. One need to make changes to the process in order to prevent the same error from occurring again

Some changes in my process/ thinking has been

-  It is difficult to invest in commodity/ cyclical stocks (atleast for me). I should tread cautiously and have a very strong reasoning behind such an investment (being cheap is not enough).
-  Identify the reasons on why a company will be re-valued by the market. Also have a time frame attached to it (endless hope is not a strategy)
-  Be your own critic. Confirm if the original thesis holds true? If not, exit. It is better to be proven wrong as quickly as possible.
-  Growth is not all important, but absence of it can lead to a value trap.
-  The most dangerous phase is right after a successful stretch. Resist the urge to extend your lucky streak by making investments into half-baked ideas. Take a break or vacation!

If there is one lesson from the above analysis you should take, it is that one does not need to have a very high hit rate to get decent returns. As long as one holds on to companies which are doing well and culls the poor performers rationally, the overall results will be quite good.

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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.

Taking advantage of quarterly results

We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J
A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.
If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).
In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)
In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.
For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.
If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.
The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call
The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.
All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

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.

Trading on noise

Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?

In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise

If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real  cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise

I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive

If you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?

I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

-          A price target with a 15-20% upside within the year

-          A success rate of 55% or less in terms of success rate (preferably over a year)

-          Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?

The Dilemma

I have several dilemmas in life – such as should I eat jalebis and other good stuff or go to the gym? Sleep late or go to office? But as these dilemmas are of no concern to others, I will leave them for my own thoughts

The investing related dilemma I have always faced and more so during a market crash is this – Should I invest in the high quality companies whose price has dropped a bit or the low quality cyclicals where the price has collapsed completely. I have tried both and will try to present how my thinking has changed and where it stands today.

Let’s look at two specific examples – one of a high quality and other an average company. The high quality company is one of my long term holdings – CRISIL and the other company is Denso India, which I have long exited.

The chart below is of crisil

I wrote about  this company earlier in 2009 and have held the stock since then. As you can see the company and the stock has not disappointed and have done far better than what I expected at that time.

I have had an eye on crisil for quite some time and finally took the plunge in 2009. It is easy see that the company has an enormous competitive advantage due to government mandated status of a certified credit rating agency and brand. In addition the company requires minimal capital to grow (mainly office space and some computers). The company is thus like a toll bridge which does not require any capital expense.

The second example is of denso India. I wrote about the company here. The company was a cash bargain (stock price below cash on hand).

This is the chart for denso India

I was able to buy at an average price of around 40 and exited at around 85-90 bucks. In hindsight, it turned out to be good operation. However as you can see from the chart, the stock has been sliding since then as the performance of the company went south in 2011.

Where’s the dilemma?

Some of you may be thinking – what is the dilemma here? You made money in both, so both options are great. Case closed.

I don’t think that one should reach that conclusion here. In the case of crisil, the company has been able to increase its intrinsic value at a good pace and the stock price has followed suit. I had to make a one time decision to buy the stock and since then have just sat on that decision.

The case of Denso india is more complicated. The company appeared to be a complete bargain in 2009 and in comparison to crisil was much cheaper. At the same time, the company did not have much of competitive advantage. The trick was to buy the company when it was dirt cheap and get off the bandwagon when it was merely cheap.

This is a more complicated operation than it appears on the surface. One had to time the buy pretty well. If you had bought too early, say in mid 2008, the eventual gains would have been around 30-40%. In addition the sell decision also had to be timed correctly. If you sold in 2011, the gains would have been paltry. I  was unusually lucky in this case.

Thus in the short term,  gains are much higher in Denso type stocks. However one has to make more decisions and then also find a new idea to re-invest the capital. In the case of companies such as Crisil, once you have made a buy decision, you can just wait and watch the magic of compounding take effect

So what is a good option?

If you have tendency to constantly ‘do’ something and want some action, then denso type stocks are a good option. If however, you can live with a few percentage point lower returns with the benefit of much lower effort and headache, then Crisil type of stocks should be your target.

In my case, I do have this tendency to constantly do something. As a result, I am always looking for the next new and shiny stock for my personal portfolio to get that extra return. At the same time I manage my family’s portfolio too. In that portfolio,  I have made the decision to buy high quality , fairly priced stocks and let them compound. The returns could be a bit less, but the risk is much lower and the heartburn almost non-existent.

Following is my partial list of high quality ‘wish list’ stocks

HDFC bank, Titan industries, ITC, Marico, Hero motorcorp, HDFC limited and nestle india.

Time  for some jalebis now . Gym can wait J

Buy and hold investing

The idea of buy and hold was popularized in the US by warren buffett, the guru of value investing (and if you have realized, my intellectual guru too).

The idea behind buy and hold has been that one should buy the stocks of the really good companies and hold them for the long term (sometimes over decades) without concerning ourselves with the short term swings in the stock market.

A myth on buy and hold
A few commentators project buy and hold investing as a form of investing requiring no thinking and analysis. All one needs to do is to go ahead and buy an Infosys or a levers or titan at any valuations and just hold onto it. One does not even need to check on the performance of the company, even briefly, on an annual basis.

These commentators point out to investors who made an investment in a levers or Infosys years ago , just sat on their positions and are now comfortably rich. This is survivorship bias. For every levers or Infosys, there is a company which went bust or went nowhere.

Buy and hold is not brainless investing!!

It requires work, even if there is no activity (read – trading). It may sound easy, but it is not. By the way, why should earning a decent amount of money, while sitting on one’s a**, be easy for everyone?

Why are there no such recommendations?
You may wonder, why one cannot find such recommendations from brokers or analysts. Why don’t they indentify such companies and recommend it to investors?

Let me take a personal example. As far back as 2000, inspite of being a novice, I had a decent amount of conviction that asian paints was a good company (as I had worked with them). I invested a decent sum at that point of time in the stock.

Now lets assume you are my client. Let’s say in 2000, I recommend this stock and you pay me a commission.

You come back next year and we have this conversation

You : So Rohit, what should I do with asian paints?
Me : Nothing. The company’s doing well. Just hold on to it. By the way, you will be getting a bill for my recommendation next month
You (thinking) : What ??!! this dude did nothing for me this year and is charging me. I am not coming back

So I assume you get the point why brokers and tipsters cannot make a living by giving out such buy and hold ideas which can make you rich.

Please note that the advisor is still doing work. He or she has to keep analyzing the company and track how it is doing. The only difference is that as long as the company keeps doing well, there is no need to trade the stock.

The unfortunate reality is that most investors believe some activity is needed to make money and on top of that if an advisor is to be paid, he or she should be ‘doing’ something.

Is it relevant now?
I feel like a dinosaur these days, especially when talking to my friends. The holding time spans range from a few months to a year. If I point out to long term stock ideas, the same friends are quick to point out the fantastic returns they have been able to make in the last 6 months on midcaps and microcaps.

Why wait for the long term when one can get instant gratification :)

The problem with a short term approach, disconnected from an underlying philosophy, is that it works till the going is good. If the market turns south, then the same investors would lose their shirt and all their undergarments and would start singing the buy and hold tune.

An investing philosophy should be based on fundamentals and not on the current fads of the market.

How to practice buy and hold?
I personally do not believe in going and buying a stock blindly and then holding on to it forever (hoping it will do well). I think one should be able to identify on the basis of a reasonable amount of analysis and experience a list of good, long term ideas.

What should be the characteristics of such companies?

A decent operating history – The company should have been in the business over 10 years with an above average record of performance.

Sustainable competitive advantage – The company should have a strong competitive position in the industry so it can sustain its above average performance in the long run

Decent to attractive industry with minimal change – It is important to avoid industries with a lot of change (ex: telecom) or currently in a decline (example – jute). In addition, commodity type industries are also not a great place to find such ideas, though one cannot rule it out.

The hit by truck test – If the unfortunate happens, can you leave the stock untouched in your account as an asset for your family?

The key is to identify a list of such attractive ideas and invest a small amount of money in it (if the valuation are not too high). Once you do that, you need to start following the company and the industry on a regular basis. In time, over a few years, you will become more and more comfortable with the long term prospects of the company.

The idea is not keep adding money as you become more confident of the long term prospects of the company (long term being more than 5 years). One needs to be patient and should let the opportunity come to you. When the market drops due to some short term concern, it is time to add a meaningful amount of money to some of these ideas.

The above approach is not easy. It requires effort and patience. However if you can build a portfolio of 4-5 such companies, you are set for life.

I have been able to identify a few such companies over the last few years. The notable ones are asian paints, Crisil and maybe a Gujarat gas. These names are not set in stone, but are fairly good ones for me.

I am planning to look at new ideas such as titan, HDFC bank, ITC etc and start following them closely. The next time a market crash happens, I plan to load up on these stocks, as I did on Crisil in 2008.

My personal investment journey - II

In the previous post, I described my investment journey till 2003. By mid of 2003, I had spent close to 6-7 years on reading and studying about the topic. I had read dozens of books on warren buffett and other value investors. In addition I had been analying companies for the past 5 years. So I understood the basics of investing, valuation and other aspects of investing.

What was missing was the experience and the softer aspects of investing. I had allowed myself to be swayed by the surrounding euphoria (partly though) in 2000. In addition by 2002-2003 when there were values all around (companies like L&T, blue star etc were available at a bargain), I was still not confident enough to go the whole hog.

If you have gone through this phase or are going through it, you will understand. If you have not seen a lot of success (mine was relative, I had done well compared to the market) and even if you feel that your are doing the right thing, it is not easy to jump in again completely. So during this phase, I increased my holdings, but I was very cautious (maybe overcautious) about it.

The market had gone nowhere for the last 10 years and so unlike today, no one was interested in stocks.

So what were the key learnings for me till 2003 ?

1. Do not over pay for a stock. I learnt this from SSI. Yes, sky is the limit for these hot companies. However for every Infosys or PRIL or L&T, there are 10 pretenders. In addition this kind of early stage investing requires a different mindset. I do not have that kind of mindset.

2. focus on companies with sustainable competitive advantage which have a profitable growing business and are available at a reasonable price. I have made the best returns from this group. Ignore the long shots ..companies which will be the next HDFC, next infosys, next L&T etc. Buy HDFC if it is available at a reasonable price otherwise find something else.
Valuation and price matters. Promise is all great, but if a company does not meet the promise then the stock price gets killed. I learnt it from SSI and a lot of other investors are learning that lesson now via other companies.

3. Be honest and brutual about your mistakes. Do blame others like analysts, media, friends etc. If you have made a mistake, accept it and move on. In short – don’t whine !!


2003 – 2006 (Beating the market and making some money)

By the end of 2003, the market was up 73% and I beat the market by a few points. As I had beaten the market during the bear phase too, I had gained in absolute terms by the end of the year.

The portfolio mix was roughly the same, with a new addition by end of the year of kothari products which was a small position (I started experimenting with a few graham type stocks)

By 2004 year end, my portfolio was doing fairly well. I had done better than the market with good gains in asian paints, concor, blue star etc. In addition I created a new position in BayerABS and Balmer lawrie by the end of the year.

I did no major additions or sale during 2005. Most of the stocks did well and the valuation gaps closed for several of my earlier picks as the market started recognizing these companies. I was able to do better than the market and was now fairly confident of my approach, which was now working well.

2006 was also a year with almost no activity in terms of buying or selling. To certain extent, I was still riding my earlier picks and to a certain extent I was finding it diffcult to find ideas which were as attractive as my exisiting one. I had done most of my picks during the bear market of 2001-2003 when good companies were available at throwaway prices. I was still searching for similar opportunities in 2006. That ofcourse was a foolish thing to do then. I was not going to get those kind of opportunities in a bull market.

By end of 2006, most of the companies I held, seemed to be fully valued. I liquidated almost 60-70% of my portfolio and ended the year with small holdings in asian paints, reliance (which I got through my RPL holdings), Bayer ABS and balmer lawrie. In addition I started building a small position in Merck and KOEL.

As an aside, in 2004, I discovered blogging and created my blog. This was my first post.

2007 (rethinking the approach)

I began 2007, with a fairly liquidated portfolio and few holdings.The really good companies seemed to be fairly valued and so I was not interested in them. As this time I started exploring graham kind of opportunities.

Till 2007, my approach was always to buy good companies and hold them for a long time. However I was always split between the idea of buying and holding even after the company was selling at or above my estimate of intrinsic value.

In 2007, I read a book by Mohnish pabrai (Dhando investor) and also a few other books and comments by warren buffett. I kind of realised that if one is interested in making higher returns then you have to look at buying undervalued companies and selling at intrsinsic value. The portfolio churn is more and you have work harder at finding new ideas, but the returns are higher. So I had a slight change in approach in 2007.

I built a position in KOEL (kirloskar oil) and sold when it hit intrinsic value. I created new positions in cheviot, India nippon, novartis, VST, manugraph, HPCL, grindwell norton etc. In addition I bought and sold IGL (after I felt I was wrong in my analysis), and did the same with MRO tek when it reached intrinsic value.

2007 was a crazy year. Anyone could have made money. I did well too (maybe too well). However I did not go whole hog as I was not comfortable with the valuation for most companies. I had not forgotten my earlier lessons. Frankly I don’t care how well others are doing or what they are recommending. Maybe some people can trade profitably by looking at the tides, but that’s not for me. Real estate companies, Capital goods companies looked like IT companies of 2000 and so I stayed away from them.

2008 (Doing more of the same)
Jan started with a major high in terms of the market and low activity from my end. I have been analysing companies since then and looking for new ideas constantly.

2008 has seen the market tumble from the all time highs. As I was not comfortable with the valuations by the end of 2007, I did not add much to my holdings. I try not time the market, but time the price (this is a quote by warren buffett). What that means is that my buy and sell decisions are based on the discount at which good companies are selling to their intrinsic value. If there is a big discount I will buy irrespective of the market level. Ofcourse, most of the times this approach takes you out of the market at highs and makes you more active when the market is tanking.

My activity levels in terms of buying or selling are higher this year. My portfolio was in a semi-coma state for a long period as there was not much to do. However with a slight change in approach and better values, there is more activity now.

Future ?

I don’t know how things will work out. What I know for sure is that I plan to keep reading and learning. I plan to add arbitrage to my portfolio and make it a higher percentage. However overall, I plan to develop my approach further and deepen my understanding of various areas such as accounting, options pricing, and economics etc . The focus is to learn topics which would improve me as an investor.

If you have been with me for these two posts, you can see why I have a strong preference for value investing. This approach has worked for me and allows me get a good night sleep. It fits my temprament of slow and delibrate thinking. I do not like fast paced action and thrills (in my portfolio, movies are a different matter).

Even among valueinvestors, there are varying styles and each one selects a different set of companies for his or her portfolio. I think it is driven a lot by one’s experiences. In my case, I have stayed away from high growth, hot sexy companies due to my bad experience with SSI and other IT companies. On the other hand the boring, dull but solidly profitable companies have given me great returns. Hence my preference for those kind of companies.

My Personal investment journey - I

There is a certain level of curiosity in knowing what the other guy is making or getting in terms of investment returns. A lot of people and friends I know like to flaunt the returns they are getting from the market (The stock I bought last month doubled !!). Maybe it is an ego thing or maybe just a topic of discussion.

I personally prefer to discuss about specific ideas, both in person and on my blog. I find that more interesting and educational for me and others. As a result of this quirk, I have never discussed about the overall returns I have made from the stock market on my blog. I am not selling anything to anyone and just like to share my ideas with like minded people. I am happy if people read what I have to say and can learn something (maybe) with me.

I have been asked about my investing experience and the kind of returns I have made. I have made 32% returns (annualized and unleveraged) over the past 8-9 years following a value approach. These may not be the fantastic returns some of you expect or may have achieved. However they are far more than what I have targeted for myself. Investing is side thing for me and is not my profession. I primarily invest for myself and my family and prefer a buy and hold (not buy and forget) approach. My personal portfolio is low on risk and volatility as I prefer a good night’s sleep.

It may be possible to get higher returns through alternative approaches. However I have found that value investing suits my temprament and the returns I have made are more than satisfactory for me.

A word of caution : I tend to hold a number of stocks which I discuss on this blog. However the purchase price for the stock and portfolio weightage of the stock makes a lot of difference to the overall returns. So please do not buy the stocks I discuss without your own analysis.

In terms of personal disclosure, this maybe as far I would like to go. I am not intending to disclose my overall portfolio and returns on an ongoing basis. Investing rationally is diffcult enough. I do not want to do it publicly and make it more diffcult for me.

However more important than the returns is my investment journey till date. I will be discussing the details in this and the next post. It is likely to be a long post, and maybe boring (no excitement in the way I invest). However what I have gone through may echo what you have or are going through.

1997-1999 (The start)
I had completed my MBA and was working in sales and marketing. I was responsible for handling the finances of my entire family and for me capital preservation was more important. I knew the basics of finance, however that was not sufficient to invest intelligently. An MBA education teaches you about corporate finance, but does not teach you to be an investor.

So during this phase I started learning the basics such as what is an FD, what is a mutual fund etc. Internet was not common then and so my learning was based on economic times and a few books I could get. There were no live quotes then, so one had to look at the papers to get the daily quotes.

During this period I came across the book – The warren buffett way and was competely struck by it. I was completely bowled over by warren buffett. I started reading any books I could get on him. I think I must have read around 20-25 books on him till date. These books led me to other investors like Benjamin graham, Phil fisher etc. By the end of 1999 I had read quite a few books on these masters.

This was more of a reading/ learning phase. The two stocks I bought during this phase were Reliance petroleum and Arvind mills. I read an article in business world on RPL and hence bought that stock. Arvind mills had given a presentation in my college some time back and I liked what I had heard and so went and bought a small amount of the stock.

Well, RPL did well and Arvind mills tanked as the denim industry went into a downturn.
Prior to these two stocks, I bought the following stocks also
IFCI – because the dividend yield was high
Karur vyasa – It was cheap on P/B basis
Larsen toubro – It was a well known company then though not a hot stock.

So by the end of 1999 (before the IT boom), I had a hodgepodge of stocks in my portfolio with most of them doing badly. The good thing was that I was learning and constantly re-evaluating the stocks I had. I soon realised that I had goofed up in some of my picks like IFCI and arvind mills and sold them at a good loss. The rest I held on.

2000 ( The greed phase)
By start of 2000, I felt I had learnt a lot and was ready for the dive ( don’t laugh). So starting from Jan 2000, I started looking at stocks. However all the reading for the last 2-3 years had made me wary of the IT stocks due to the high valuations. I luckily avoided picking any specific stocks during the early part of the year.

However it is not easy to avoid greed, especially if you are new to the market. Thinking that mutual funds are safe, I setup an SIP for some IT and general funds. Well, by the end of the year the IT funds and other funds had tanked and I got an expensive lesson.

Toward the end of the year, I started analsying a few companies and picked up SSI and asian paints. My analysis for asian paints was correct and I have benfitted from it. However in case of SSI I ignored the high valuations. I built a DCF model and pretty much made assumptions to justify the price. I paid for it by losing 90% of my investment on it.

So by end of 2000, after 4 years of learning, all I had to show was a drop of 15% in personal investments and ofcourse a lot of learning in terms of what not to do.

The reason, I think I never gave up was because I was already in love with investing and reading and so was not very dissapointed by the losses. By the way, I had still done better than the market averages. Why is that important? I will come to it by the end of my investment journey

2001-2003 (rebuilding the portfolio)
By 2000, I had got an expensive lesson for being greedy and for ignoring valuations. However I never letup on my learning. I was actually enjoying the process and knew by then that I was fairly passionate about it (money or not). Access to information through the internet made the learning process easier too.

By mid 2001, I started re-analysing my portfolio and identifying my mistakes. Overall, I think I did not have too many. I sold off SSI and exited the IT funds. The rest of the portfolio remained the same. I started analysing stocks and picked up the following companies during the 2001-2003 phase

- Blue star
- Concor
- ICICI bank (had bought the IPO, just increased the holding)
- Marico
- Pidilite
- Gujarat gas

In addition I moved into a few good mutual funds and exited the poorly performing funds. By Mid 2003, my portfolio had done much better than the market, but was below cost in absolute terms as the market had been dropping for the last 2 years.

It is easy to look back and regret that mid 2003 was an all time low (index was around 2900) and one should have invested heavily into the market. But if like me, you were new to the market and had faced only a bear market, it was a very diffcult thing to do. It was difficult to see a bull market over the horizon.

In hindsight (which is always perfect), my portfolio was well positioned for bull run. It however did not feel that way at that time.

By the way, I was not done doing stupid things. I was sick of L&T’s performance (due to the cement division), their management and the stock price. So I sold it after 4 years at a 10% gain. What happened after that ? see here

To be continued …..

Trading v/s Value investing mindset

It must be quite apparent that I have mental block to trading. I had written a post on other blog on the same topic in 2004 which I posted again here. The post was written in jest. I do not look down on trading or consider value investing superior than any other form of investing. It is just that the mindset required for each of the approaches is very different.

Let me illustrate with an example

I typically invest in stocks which are undervalued due to some short term sector issue or due to investor apathy. The near term outlook is generally weak and there is no momentum behind the stock. As a result most of the time the stock drops after I start building a position. This happened almost 70-80% of times I have invested in a stock like concor, blue star, KOEL, asian paints, Gujarat gas etc in the past.

If I operated with a trader’s mindset, I would first not get into the stock and even if bought the stock a stop loss or similar such approach would cause me to exit the stock.

However a value investing mindset results in an opposite approach. I typically buy a stock which is selling at 40-50% discount to intrinsic value with a 2-3 year minimum time horizon. So if the market drops or the stock drops for non-fundamental reasons, I re-evaluate the stock to see if my thesis is intact and sometimes increase my holding.

I personally feel that it is difficult to have the two mindsets at the same time (atleast for me). It may not be impossible, but is fairly difficult and only a few investors would be great at both approaches (rakesh jhunjhunwala is one such investor whose name comes to mind).

I had a major mental block to trading in the past. I have started opening my mind to that approach to see if I can incorporate some aspect of trading into my value investing approach. I know for sure that I do not have the temperament of a trader and frankly would not be going down that path.

As deepak has put in the comment below, I think it is important for every investor to figure out his temperament as that has a major impact on every aspect of investing .


momentary lapse of reason said...
also some interesting statistic related to your trader/investor blog.for a trader to make a higher return than an investor over a long term( say 5 yrs) the trader should predict the market more than 70% of the time.. this is highly impossible unless your an oracle..and a piddly 20% pa is better than a 100% profit the first year and a 50% loss in the second. a 20% pa compounded for two years will give you a 44% return on initial investment. in the second case you'll end up where you started. no gain.
7/11/2007 12:05:00 PM
Deepak Shenoy said...
Trading is a profession and usually involves going full time on it. Investing, on the other hand, tends to have inflows from other income sources. But yes, psychological traits make the trader or the investor. Trading is a mind-game rather than an "art" - it requires a different kind of mindset. Some people thrive in it - some people who run hedge funds have returned more than 100% every year for the last five years. Many others leave it for other stuff - even Wikipedia's Jimbo Wales was a trader before WP.But intersting thoughts on this. Everyone has to make that call one day or the other.
7/13/2007 01:20:00 PM
Rohit Chauhan said...
yes it requires a very different mindset to be a trader. also i remember reading somewhere that there are very few successful long term traders than investors.i think trading is inherently more difficult and time consuming. very few individuals like rakesh jhunjhunwala are good at both due to the differing mindsets required

The Gut feel test of investing

The gut feel test may sound totally illogical and irrational, but I have used it several times. I have posted my investment approach earlier here. As I wrote, I run various filters and do a 1-2 hour check on the basic financials of the company. That is followed by reading the Management discussion and analysis.

If the numbers do not look ok, I tend to give the idea a pass. There are no set rules for the numbers to look ok. Let me list a few cases

1. In case of aftek the acqusition of promoter held companies was a red flag for me. Clear case of conflict of interest
2. In case of Dr reddy’s and other pharma companies the valuation of the company seems to be high and I do not have the skills to evaluate the success or failure of ANDA filings
3. In case of JSW holding, more than 60-70% of the value is due to JSW steel. I do not have a specific insight into the steel business. As I could not evaluate whether JSW steel is fairly valued or undervalued, I decided to give JSW holdings a pass.
4. In 2004-2005, I felt bharat forge was fairly valued and could not project with confidence if the performance would continue. Hence gave the company a pass. Clearly a mistake, but a rational and acceptable one.
5. Indraprastha gas limited – Gas is available at a subsidy. Future margins may drop and hence the current price seems to be reflecting that. So no undervaluation although the stock appears to be so by past measures.

A lot of times, I have analysed the company and towards the end a few points keep nagging me. If I cannot evaluate those critical issues with confidence, I tend to give the stock a pass. The risk of this approach is that I tend to miss out on several good opportunities. I however do not agonize over it if the reason was related to my circle of competence, wherein I do not have the necessary knowledge to evaluate the company well.

In a few cases however, the level of undervaluation may be so great that I have a large margin of safety. In such as cases even if I have a few issues with the company, the downside risk is low and the risk reward equation seems to be fine. In such cases I may buy the stock and hold it till the undervaluation dissapears.

How to be a better investor – evaluating performance

One of the most important aspects of becoming a better investor is to evaluate one’s performance. However I do not think an absolute performance is the right way to do it.

For ex: If one’s stock portfolio returned 2% during the period 2000- 2003, I would consider it to be a superior performance than a 30% increase from 2003-2006. The reason is that during the period 2000-2003 , the market lost more than 30%, whereas during the period 2003-2006 the market almost doubled.

I evaluate my own performance as follows

I use the following formulae to evaluate the performance on my stock portfolio. I am not referring to a single stock, but for the entire stock portfolio.

Return = End portfolio amount – starting portfolio amount – cash added (or removed)/ starting portfolio amount

The period for the above formulae can be a month, quarter or a year. I prefer to evaluate the performance annually.

I compare this performance with the following three benchmarks. You can look at these benchmarks as three rising levels of hurdles to be crossed.

Level 1 – No risk FD return – This is the return I get from investing in bank FD. The stock portfolio has to cross this level. Otherwise I am way better off investing in FD’s and going off to sleep.

Level 2 – Index fund return – This is the return one can get by investing in the index (NSE or BSE) via ETF’s or index funds. The stock portfolio has to outperform this level, other wise I am better off investing in an index fund.

Level 3 – Mutual fund return – I referred to it in my previous post. My stock portfolio return should exceed the return I get from my portfolio of mutual funds (post expenses). If not, then I am again better off handing my money to the fund managers and doing something better with my time.

A caveat – One should not make a decision based on a single year’s return. In a single year, the stock portfolio returns can be volatile and even be below level 1 benchmark . I prefer to look at rolling 3 year returns to reach some tentative conclusion. I would prefer to look at the results of atleast 5 years before reaching a conclusion that I have crossed each of the above benchmarks. For a 5 year period, one should look at the cumulative returns from the stock portfolio and compare it with the above 3 benchmarks. Only if one has done substantially better than the three benchmarks, can one conclude that he or she ‘may’ be a superior stock picker.

The above may sound harsh and pompish. But I think if one has to be better investor, honest appraisal of one’s performance is important. If I have five duds and my portfolio returns less than what I could get in an FD, then there is not much to be gained from a stock pick which doubled in 15 days. I may have bragging rights and may feel smart, but I am not being honest and objective about my performance.

How to be a better investor – My approach

I posted the reply from warren buffett on the above question. The key takeaway from his reply is that one should read a lot and invest your own money based on your ‘own’ ideas and analysis.

I will touch upon my approach to improve myself as an investor in this post.

I have been reading various investment related books, articles and annual reports for some time now. However my approach to it was disorganized and did not have any pattern to it. However in the last 2 years I have developed a plan to read with specific goals in mind.

I look at reading with two key objectives

1. Find new ideas (which are profitable)
2. Develop mental models to become a better investor (read this article from charlie munger on mental models)

I have broken the second objective into the following topics (related to investing)

Finance – topics such as Balance sheet, income statement, various ratios, analysis of these statements etc
Accounting – understand various accounting concepts and standards
Valuation
Competitive advantage and strategy
Probability and analysis of risk
Study of business models
Economics – mainly micro economics
Investing – value investing
Options, derivates and other financial instruments


I have better knowledge in some these areas relative to other topics. For example I have not read much on options and derivatives till date. Somehow I get put off by all the math in it (although I am engineer by background :) ).

So at the beginning of the year I try to assess myself on these areas and try to identify the specific areas on which I would focus. For ex: I am currently focussing on topic 4 – competitive advantage. I identify books for this topic and add it to the list of books I would be reading over the course of the year. I run through all the topics in this manner and try to come up with a tentative book list for the year. This is not a list set in stone. If I find a better book for the topic I am interested in, I end up replacing it with that book.

In addition to the above book list, I have also listed the industry groups I would be focussing on this year. Currently my focus is on pharma. I have shortlisted around 5-6 industry groups for the year (see my industry analysis spreadsheet here). To improve my knowledge in a particular industry (related to topic 6), I read up on the annual reports of some of the top few companies in the industry. In addition, I try to read up on industry reports if I can get access to them for free.

This industry group analysis activity helps me in increasing my circle of competence and also helps me in coming up with new investment idea. Finally as all knowledge in investing is cumulative, I can easily use this knowledge again later to come up with good investment ideas.

Finally I run valuation screens and if I can get some undervalued candidates, I read up on them. This is more haphazard as I may get candidates in industries which I have no prior knowledge. However it is a good starting point in those cases. If the candidate is in an industry in which I have done some prior study, then the analysis is faster.

The last step is – as they say on shampoo labels – rinse and repeat. That is I keep repeating the above process. Ofcourse the books, the topics and the industry groups keep changing, but the approach is the same. This approach has been helpful as it keeps me focussed on areas which i need to improve and also to enhance my circle of competence

How to be a better investor – from Warren buffett and Charlie munger

Berkshire had their annual meeting on May 5th and 6th. During the Q&A session the following question was asked on how to become a better investor. I have read something similar from warren buffett earlier and could not resist posting the answer to the question again. The reply goes to the heart of becoming a better investor and I try to follow it in an effort to improve myself as an investor. Time will tell if I have been successful at it or not.

What is best way to a become better investor? Get an MBA, is it genetic, read more “Poor Charlie's Almanac”?

WB: Read everything you can. In my own case, by the time I was 10, I read every book in the Omaha Public Library that had to do with investing, and many I read twice. You just have to fill up your mind with competing thoughts and then sort them out as to what makes sense over time. And once you've done that, you ought to jump in the water. The difference between investing on paper and in real money is like the difference in just reading a romance novel and…doing something else. The earlier you start the better in terms of reading. I read a book at 19 that formed my framework ever since. What I'm doing today at 76 is running things in the same thought pattern that I got from a book at 19. Read, and then on small scale do some of it yourself.

CM: Sandy Gottesman, runs a large and successful investment operation. Notice his employment practices. When someone comes in to interview with Sandy, no matter his hage, Sandy asks, “what do you own and why do you own it?” And if you haven't been interested enough in the subject to know, you better go somewhere else.

WB: If you buy a farm, you'd say “I'm buying this because I expect it to produce 120 bushels per acre, etc…from your calculations, not based on what you saw on television that day or what a neighbor said. It should be the same thing with stock. Take a yellow pad, and say I'm going to buy GM for $18 billion, and here's why. And if you cant write a good essay on the subject, you have no business buying one share.

Further thoughts on pricing strength of a business

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )


But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?


According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

‘I don’t know’

Ask any analyst, market commentator, investor or your friend on the future direction of the market and they will have a wide variety of views ranging from totally pessimistic to wildly optmisitic. Most will also have very plausible reasons to back up their viewpoints.

In reality, I doubt anyone can consistently time the market (and there is enough evidence to back it up). True some people can get it right sometimes, but I personally have never tried it as I know for sure that I will not get it right.

My approach to this question is ‘I don’t know’. I am not sure what will happen in the future. However that does not mean being blind to the present situation and doing nothing about. On the contrary I have some crude approaches to resolving this problem.

For individual stocks I typically maintain a valuation band (and not a price band). For example, if I think a business has very strong competitive advantage and will do very well, I tend to accord it higher valuations. As a specific case I can cite marico. Marico as a business was valued at a PE of around 10-12 in 2003, when I looked at it for the first time. I conservatively valued it at 20-22 at that time. Since then marico has done very well and may have improved its competitive position. As a result I have bumped up my valuation band to 25-27. The advantage I see in this approach is that I do not fixate on the price. Price is a function of the current earnings and the PE ratio, which in turn would depend on a variety of condition. By looking at a valuation band, I can assess the company’s competitive position and decide whether the current price looks overvalued or not.

Ofcourse the above approach is not perfect. A better approach would be to do a complete DCF analysis from scratch without any assumptions. However it is very time consuming and may not be feasible for me every time.

For the broader market, I have an even cruder method. I track the earnings growth, dividend yield and ROE of the market as a whole. I tend to treat a market PE of 20 as trigger to start investigating as to why the market should not be considered to be overvalued. A PE of 20 does not necessarily indicate an overvalued market. This number has to be seen in context of the other numbers I spoke of earlier. But at this point, I start analysing further and also look at reducing my holdings.

All of the above is hardly scientific and may appear as very crude. However I try not to be too smart in selling. I try to follow buffett’s advice (paraphrased) ‘Buy at such an attractive price, that selling becomes an easy decision’

In the end, my approach is to accept that I don’t know the future of the market and need to manage my emotions (greed at present!!). So a mechanical approach although sub-optimal works well for me.

As an aside, Mr market is current in complete euphoria with the kind of oversubscription for RPL and sun TV IPOs.

Great time for businesses to raise capital from the market !!