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.

Not everything that counts, can be counted

In an earlierpost, I wrote about the two types of risks faced by an investor – risks faced by all investors irrespective of the nature of the investment and business risks associated with a particular investment.

In this post, I will try to describe a variety of business risks and how I use it via a checklists to further evaluate a business. The list I present below is by no means comprehensive (as I am not writing an academic paper) and just represent the ones I have faced in the past or can think of as I write this post.

Advance warning – this is a long post even if it is not comprehensive and there is no silver bullet or blue/red pill at the end to make investing easier.

Regulatory risk [earning excess returns from favorable regulations]
If a company is able to make above average profits due to a favorable regulation, then it is exposed to this risk. For example, think of a banking license or the right to supply natural gas to a specific geography such as Delhi in the case of indraprastha gas.

In these cases, the company has a pseudo monopoly due to a favorable regulatory position. If the terms of the regulation changes, the company could find that the economics of the business has worsened or worse, it no longer has a viable business at all.

There are a lot of examples of this kind of risk. For example, PNGRB – the gas regulator announced in april 2012 that they had the authority to fix gas prices and asked IGL to drop its price by 50%+. The company lost more than 50% of its value after the day of the announcement and since then has recovered most of it, after the supreme court overturned the decision. In spite of the favorable response, an investor in this stock has done worse than the index during the same time period.

The same story has played out for several companies in the mining space after the Supreme court order banning iron ore mining due to the illegal mining problem in some states. This kind of risk is critical in the case of telecom, power, finance and other heavily regulated industries.

The key point is this – If the business model of a company depends on specific regulations, then the company is always exposed to this kind of risk. . The company could be doing well for a long time and then suddenly the regulator or the government can change its mind and put the entire business at risk.

I have noticed that the market is usually sanguine about this risk and it is generally not priced in. However if the risk materializes, the reaction is swift and brutal. The only way to mitigate this risk is either to avoid such companies altogether or hope and pray that the regulator/ government does not change its mind on the key regulation.

Reputation risk [earning excess returns based on reputation/ brands ]
This is a key risk in those businesses which depend on the reputation of a brand or a company. If the company earns an above average profit due to a favorable image or brand position, then it is very important for the company to safeguard the brand.

In the event that there is some incident where the brand image is impacted, the management should react swiftly and prevent further damage to it.

Case in point – Maggi from nestle.  Irrespective of the merits of the case, the response of the company to the whole lead content issue and subsequent recall was appalling. The issue surfaced in April and the company finally responded in June when the issue blew up in the media. This is a 1.2 Bn dollar brand and the management did not react to the situation till it finally got out of hand.  Net result – The company lost close 20% of its market cap in the aftermath.

This risk is critical when the company you invest makes money based on the power of its brand and trust. The only way to mitigate this risk is to have a management which reacts promptly if it sees a risk to the reputation of the company or its brands.

Management risk [Poor quality management]
This is a risk commonly understood, accepted but least followed by a lot of investors. If you talk to someone who has been investing in the markets for a period of time, they will agree that it is important to invest only with a high quality management.

Lets first define what is high quality which I like to think of on two parameters

Capital allocation and distribution – does the management allocate capital at high rate of return in the business and distribute the excess to shareholders via dividends?

Ethical behavior towards all stakeholders – Does the management behave ethically or treat other stake holders (such as customers, employees, shareholders etc) in a manner they would like to be treated if the roles were reversed?

The first parameter is quite objective in a nature and can easily be verified by looking at the return on capital of the business over an entire business cycle. It is amazing to find that people end up investing with managements which have consistently destroyed wealth (several airlines come to mind). I understand that at a certain price, even a value destroying business can give good returns, but a majority of the investors end up buying such companies at the peak of a cycle when the profitability seems to be high (but is just a mirage)

The second factor is far more difficult to evaluate and needs careful study of the management’s actions over time. Again it is not easy to define the right behavior in several cases such as high compensation or bending regulations to gain an undue advantage in business.

Even if we leave aside some of the fuzzy stuff, it is quite easy in a lot of cases to just reject a company if several red flags pop up. In the end, my own experience has been that if you ignore this risk, it eventually catches up. A particular investment with unethical and incompetent management may not go south, but over time the law of averages work and the overall result will be poor.

The only way to mitigate this risk to avoid such companies and management. It will prevent a lot of anxiety, heartburn and sleepless nights

Customer concentration risk [All eggs in one or few baskets]
This risk arises when a company derives a large percentage of its revenue from a handful of customers. Although this is an easy to understand risk, it not necessarily as easy to evaluate.

For example, is it better for IT and other service companies to focus on their top customers who provide 80% of their revenue instead of spreading themselves thin? I don’t have an answer to this question.

There is one crucial factor to consider when thinking of this risk – Customer lock-in. If a customer is locked in with a company and cannot easily switch then it makes sense to devote enough resource to maintain this competitive advantage.

However if a customer can easily switch suppliers based on price, then customer concentration will kill a business. A company fighting price based competition and earning its revenue from a limited set of customers is never going to earn profits above its cost of capital and is likely to remain locked in a low return business.

This risk turns up in surprising places. China as a country is the largest consumer of most commodities such as steel. So when this ‘customer’ slowed, the price of the product collapsed and has hurt all suppliers in the product category. It does not matter if as a steel company you don’t supply to the Chinese market. Once the no.1 customer in the steel industry (accounting for 50%+ of global demand) slowed, everyone in the industry was going to get hurt.

There is no easy way to mitigate this risk and it requires a case to case decision. One needs to be aware of the level of concentration for the company and check if the management is focused on either reducing the concentration or has such as hold on the key customers, that it will not be exposed to price based competition.

Competitive risk
The easiest way to think about this risk is to count the number of companies in an industry and tabulate their market share. If you find just one company and that company has a 100% share, then you have found a monopoly with no competitive risk.

At the other extreme if you start listing the companies and end up with a long list of firms with each company having a tiny share of the market, then you are looking at an industry with high competition and poor returns.

I have generally used a simple thumb rule to evaluate this risk. If the top 3-5 companies account for 60%+ of an industry and most of them earn over 15% return on capital, then the competitive intensity within the industry is low. On the other hand, if I have to spend over a week finding all the companies in an industry and if the top 10 companies account for less than 50% share (assuming I can even get this number), then it is very likely I have stumbled into an industry with high levels of competition and poor profitability.

For example – most consumer brands have limited numbers of companies and high profitability. On the other hand, industries such as cement, textiles etc are the other end of the spectrum with a large number of companies and poor profitability.

As an investor, you can manage this risk by first diversifying across industries so that a sudden worsening of the economics in a particular industry will not sink the entire portfolio. The second way to manage this risk is to study each company and its competitive position in detail so that you are atleast aware of the risks and do not get blindsided by it. Finally, as an investor one is paid to understand and manage this risk.

Change or obsolescence risk
This risk is especially relevant in fast moving industries where the underlying technologies are going through a lot of change.  Think of telecommunications – this is a fast paced industry which needs a lot of investment, but at the same time the underlying technology keeps changing rapidly (see my post here a long time back on the same topic).

We have seen the technology go from 2G to 3G to 4G to who knows what ( 5G is already being tested in labs and can do 1 gbps ). There is wifi, satellite or balloon internet and all sorts of communication tech coming up. Is it easy to predict what will be the shape of this industry in 2020? Doing a DCF analysis and putting a terminal multiple on the valuation of a telecom or similar company is sheer insanity.

The way to mitigate this risk is to have a very deep understanding of the particular industry, monitor the changes closely and not overpay for the stock. However if you do not have any specialized understanding of such an industry, it is best to stay away – discretion is often the better part of valor in investing

Commodity risk
This is the case where the price of a specific commodity drives the profitability of the business. This is obvious in the case of industries such as steel, metal, oil etc.

It was not so obvious in some other cases, till the commodity price dropped and hurt the industry badly. Take the example of jewelry/ gold loan companies.

These companies became the darling of the markets in the 2010-2012 period when the price of gold was going through the roof. A lot of these companies got a double boost from rising demand (due to rising gold prices) and from an increase in the value of their inventory.

Once the tide turned, some of these companies have struggled to remain profitable.

A similar story has played out in the agri space for seed companies (where the price of commodities have dropped) or mining firms.

One way to mitigate this risk is to evaluate a company over the entire business cycle and see if the company is merely the beneficiary of a lucky tailwind from rising commodity prices or will do well inspite of the commodity prices.

Capital structure risk
A company having a high debt equity ratio is generally a riskier company. What is ignored sometimes when evaluating this risk are the hidden liabilities which are the equivalent of debt, even though they do not appear as such on the balance sheet.

Take the example of tata steel and its pension liabilities or airplane lease and other fixed costs in case of airlines, which are a form of quasi debt.

The deadly combination is when some other form of business risk hits a highly indebted company. In such cases, the end result is often bankruptcy (atleast for the minority shareholders in india, promoters have no such risks)

How do you mitigate this risk? Learn to read the balance sheet carefully and understand all forms of fixed obligations which cannot be reduced even if the revenue goes down. Try to answer the question – How long will the company survive if its revenue dropped by 20%.

Valuation risk/ growth risk
This not a risk of the business risk. If you pay for the growth and it does not happen, then you are in trouble. An example which comes to mind is Hawkins cooker. A lot of investors continued to give high valuations to the company even when the growth slowed.

However once reality hit the market, the reaction was swift and sudden. As much as investors curse the management after such an event, I do not blame them for it. One can fault the management on not doing its best to deliver the highest possible growth, but then if growth is not visible, nothing stops an investor from exiting the stock for better opportunities.

There are several other companies (Which I will not name) which seem to be in a similar place – low growth, but high valuations. If we are lucky the drop in the multiple would be slow and gradual unless the growth picks up and justifies the valuations.

How do you mitigate this risk – simple, don’t follow the herd and think for yourself. If you don’t understand why a company sells for a high valuation, move on. Investing is not an exam paper where you have to answer all the questions to pass!

How to think about risks
Are you still reading? congrats !! you are true fan of this blog and also like to read boring stuff on investing J

It is easy to go on and on about risks and there are books on each type of risk. I cannot do justice to all of them in a single post. As an investor one has to evaluate all of these risk and more for each investment idea and identify which ones are the most critical.

Let me give an example – I used to hold Noida toll bridge company earlier in my portfolio . As I started thinking of the risks associated with the company, there were two key ones I was able to identify

- Reinvestment risk: The company had been generating a good level of free cash flow, but had no opportunity to re-invest it. A company which cannot re-invest its cash flows is equivalent to a long dated bond and will get valued as such. Hence in this case, once the company reached its steady state cash flow, the future returns were likely to follow the growth in cash flow which was expected to be in the range of 6-8%.
-  Regulatory risk:  The Noida toll bridge is a BOT project with an assured 20% return during the operation period (around 30 years). On top of that if the company did not make these returns in any year, the company could just carry forward the shortfall to the subsequent years. This meant that by 2011-12 the company had close 2000 Crs+ of shortfall on its books. The ground reality was that the Noida authority had refused to raise the tolls even by the level of inflation and every time they did, there were protests and dharnas. So the chance of realizing this shortfall was low.

The key point in the above idea was that the upside was limited and there was a regulatory risk which if it materialized, could completely destroy the investment thesis. So in a stroke of brilliance, after having held the stock for 2+ years and with a minimal gain, I decided to wise up and exited the company.

In July 2015, the management announced that company was re-writing the contract which would now end by 2031 and its likely the company will not be able to recover the prior shortfall. The stock dropped promptly as the market had assumed that company would be able to make up some part of this shortfall by an extension in the lease term or land development rights.

 

The above case is instructive of a variety of business risks. A lot of business risks are fuzzy and grey and one cannot put a precise number behind it. In addition, these risks do not materialize for a long time. However if one does materialize, the stock market is quite efficient in resetting the valuations promptly.

As an investor, you can ignore business risks at your own peril.

No mathematical precision
You would have noticed that I have not used any greek letters or volatility measures till now to measure the business risk. It should be quite obvious that these academic measures do not represent the risks for a company.

Think of the example of Noida toll bridge – did the past volatility of the company give any indication of the regulatory risk faced by the company?

The best one can do is to be aware and analyze these risks on an ongoing basis. If you are being compensated to bear this risk (in the form of expected returns), then you continue to hold the stock. If the returns are inadequate or if you think the downside from the risk will be too severe, then the best option is to sell and move on

My current approach to evaluating the risk is usually as follows

-       I have a checklist of all the above risks and use it to evaluate which of these risks are relevant for the company I am analyzing.
-       I try to dig deeper into the critical risks for the company and understand what are the key drivers and how it could hurt the company and its valuation
-       My job as an investor is to evaluate the upside from the bull case of the company versus the downside from all the risks facing the company. If the downside risk seems too high, I will just move on to the next idea.

One final point – if this sounds complicated and difficult to implement, let me assure you – it is and will always be. The upside is that with an increase in competition for investment returns, this may still be an area where a hardworking and diligent investor will continue to have an edge over others.

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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.

Investing for dividends

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,

I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response

Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following

a)    Company earning high return on capital with good cash flows

b)    Reasonable valuations

c)    Good capital allocation policy by management

if you are able to achieve  the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory...high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards

Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement

How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future  (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period - there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire :)

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

Annual portfolio review – 2010

It’s the time of the year when everyone looks at the year gone by and makes resolutions for the new year. My resolution for the new year? run a 5K marathon :). Anyway, I digress. This blog is not about my attempts to get fit.

I did an annual portfolio review in 2009 here. I think the returns in 2009 were out of the ordinary as the stock markets were recovering from a huge shock. I did not expect the 2010 returns to be any close to it. That prediction turned out to be true.

How I evaluate performance

The most typical approach to evaluate performance is to look at the annual return and if it has met your expectations (which vary from individual to individual), then one can declare victory and move on. As you might suspect I don’t stop at that.

Annual returns are important, but not the sole indicator of performance. A year’s return is driven more by luck than skill. A few lucky picks can give a big boost to your portfolio and a few bad ones can ruin the year. One has to distinguish skill from luck. I look at the portfolio performance for the last 2-3 years and compare it with my objective – which is to beat the index by 5-8% per annum.

Now, there is no audit of my performance, so I can claim whatever I want – no one can verify it. So instead of trying to quote a number, let me state that I have achieved my goals by a wide margin in 2010 and for a 3 year period too

Is 5-8% outperformance not for the wimps?

Now some of you who would have dabbled in small, micro or no cap stocks may be thinking – what a sissy :) . I can do far far better than this dude

My response – that’s absolutely true. My personal goal is not to achieve the highest possible return. My goal is to achieve decent returns at moderate to low risk. My own portfolio has around 15-20 stocks, with no stock more than 5% of the portfolio. I have structured my portfolio to achieve a decent level of outperformance, but ensure that a single bad idea will not ruin my networth.

Think of it this way – A 5-8% outperformance will give me a 19-22% annual return. That means 5-7 times my original capital in 10 years. If I achieve this I will be very pleased with my performance.

Additional parameters of evaluation

I have another parameter which I use to evaluate the attractiveness of my portfolio – let’s call it the ‘discount to fair value for the portfolio’. Let me explain

Let’s say I have two stocks in the portfolio (1 share each)

Stock A – fair value is 100, current price is – 60

Stock B – fair value is 100, current price is – 70

So for total portfolio (A+B) – fair value is 200, sum invested is 130.

The ‘discount to fair value of the portfolio’ is 35% (200-130/200). I generally focus on this number quite closely. This is a very useful number to make buy/ sell decisions and structure the portfolio (more on it in another post)

I am listing the actual discount below for a few years (end of year)

2008- 60%

2009 – 26%

2010 – 36%

The numbers are quite instructive. In 2008, as the market crashed I added stocks to my portfolio and saw this number rise. In 2009 as the stock prices rose, this number reduced (as the portfolio gained in value).

So in 2010, how did this number increase?

Quite simply, I reduced my fully valued positions and kept adding to the undervalued position. Although this is not a magic number, I have seen that if I have done my homework well then a large discount has typically led to a good performance over time.

My overall objective is to keep this number between 30-40% or more.

Specific performance

Let’s get from the abstract to the concrete (hopefully I have not lost you !)

The big winners for me were – Gujarat gas, Merck (finally !), LMW, grindwell Norton (which had not done well last year), Honda siel (surprise), Cheviot (some movement !) , Ashok Leyland etc. I have constantly been selling some of these stocks.

I have added some new positions, some of which are listed here.

I sold off these position or reduced these stocks substantially – NIIT tech, Patni, Infosys, Sulzer, ESAB india, Concor, Denso, VST and Ingersoll rand.

Ofcourse not everything was a winner – VST for one was a very average pick.

The new areas in 2010

I have started exploring several new areas – more from a learning standpoint. I have been experimenting on options and arbitrage.

Options have been a mixed bag and I plan to pursue it more as an insurance than to make money off it. I plan to focus more on arbitrage in the future as it is an interesting field and works well my investment approach.

Plans for 2011

I have no grand strategy for 2011. No hot sectors, must have stocks for next year. The strategy is going to be the same – keep looking for good and cheap stocks the old fashioned way – read and analyse.

Some portfolio changes

A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.

I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results

The reductions
As I wrote in some of the previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.

NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.

In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.

I created a position inspite of all the doubts. In hindsight I was too timid.

I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?

I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value

Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.

In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.

The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali :)

The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism

Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.

I will definitely read and respond to your email, but would ask you to be patient with me on that count.

A happy Diwali to all the readers

Stocks Tips are not portfolio management

The standard service provided by most brokers, analysts and blogs is stock tips. The analyst typically analyses a company (often superficially) and after declaring it cheap, gives a price target. The brave ones may attach a time frame to the target too. There are several points missing in the above model for a typical investor

- How much of the stock should the investor buy?
- Should the investor buy a full position at the current price or build it over a period of time?
- What is the level of risk of the stock and how does it correlate with the stocks in the portfolio?
- Most importantly, when and under what conditions should the investor buy or sell the stock?
The analyst or the broker involved gets paid for recommending the stock and their responsibility stops at that point. None of the above points are considered when providing the service. In addition, there is sometimes no follow up and review of the stock on an ongoing basis which would help the investor decide whether he or she should buy, hold or sell the stock.

The above missing points in the standard model of the industry are provided at a high price via portfolio management services. I am not aware of the exact pricing, but have been told that it is generally around 2% of the portfolio and some percentage of the gains achieved by the portfolio manager.

This model is ofcourse stacked against the typical investor. The portfolio manager makes money irrespective of whether the investor makes a profit or not.

A decent portfolio management service should have the following features

Stock idea: The service should provide the stock idea with an estimate of fair value and a clear explanation of the risk involved in the stock. I don’t believe that a stock can have only an upside without a downside risk.

Position sizing: The service should provide a recommendation on the position size (amount of stock) and also provide regular inputs if the position has to be built over time.

Correlation risk: There is no diversification if one buy 3 cement and 2 telecom stocks in a portfolio. A lot of times the risk is not as obvious, but should be analyzed when recommending a stock and deciding on the position size

Regular update and sell recommendation: This is sorely missing from the current model. You will rarely find a sell recommendation from an analyst.

I am not aware if the above comprehensive service is available at a decent price. Most of the brokers provide stock tips or similar such recommendations with an eye on generating commissions through buy or sell action of the investor. As a result it is impossible for brokers and analyst to have their incentives aligned with yours.

An example
I discussed my portfolio in this post. I provided a listing of all the stocks in the portfolio with their 2009 gains and also an analysis of the idea in some cases. Does this list give an idea of the portfolio performance ? hardly. Some the ideas in the portfolio were analysed in 2006, some in 2007 and some in 2008. I don’t build a full position at the time of the analysis unless I think that the stock is extremely cheap and there is no point in waiting. The positions were built over the course of time as the stocks got cheaper or the fundamentals improved.

It is important to understand one point – A decision to buy need not be made at the time of analyzing the stock. One should analyse the stock and make a note of it (in my case I have a tracking spreadsheet). If the price drops below a certain threshold, one can start buying or increasing the position. If the price rises, well then move on to something else. It pays to do your homework in advance.

I typically analyse a stock and provide the readers with all the required information to make a decision. However there is still quite a bit of ongoing effort required to track the fundamentals and the price and make buy, hold or sell decisions. These decisions have to be made in context of one’s personal situation.

In my own case, I exited most of my positions in 2006-2007 time frame. I started buying a little bit in mid 2008. My main buying came during Oct 2008 – Jan 2008. As a result I did not hit the precise bottom of the market, which anyway has never been my goal. If the market keeps going up, I will keep exiting my overvalued positions slowly over this year. If however, the market crashes, and I can find undervalued ideas, I will start buying again.

I may have a long term view on stocks, but I am constantly evaluating my ideas on the four factors discussed about and making changes to the portfolio. A long term approach is not a brain dead approach.

The relevant returns
The relevant returns for any portfolio should be for the two year period 2008-2009. Most of the long term investors lost money in 2008 and made it back in 2009. If one has to evaluate the success or failure then one should look at the combined returns for these two years. In my case, I am more than pleased with my returns as I cleared my target by a wide margins (target being to beat the market by 5-8% per annum). I don’t expect to have a repeat performance in 2010.

Conclusion
Building a low risk portfolio and maintaining it, involves quite a bit of effort. If one is not ready to put the effort behind it, then a sensible option is to invest in mutual funds (inspite of all their drawbacks) or in index funds. Stock picks and tips will help you trade and have the thrill of jumping in and out of the market, but if you want to build your networth over a period of time, don’t expect these services to help you on that.