October 5, 2017

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.

September 13, 2017

Discounting hope

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

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

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

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

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

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

Let me take one example to illustrate – Repro India.

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

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

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

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

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

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


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

Illustration from the company’s annual report



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

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

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

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

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

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

August 5, 2017

Proceed, but with caution

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

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

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

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

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

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

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

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

I have not become smart again in 2017.

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

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

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


The first factor is decided by the gap between purchase price and IV of the companies in the portfolio. This factor depends on the market mood, when investors are often too pessimistic about a company due to short term reasons. The second factor depends on the company performs in the long run.
The first factor can cause returns to spike from a single position or the entire portfolio depending on a change in the views of the market. Most investors fixate on this and get overly excited when this gap closes and they are able to earn a high return over a very short period of time. In contrast, the second factor is what allows one to compound wealth over the long term. These returns appear ordinary in the short run, but the power of compounding results in spectacular numbers over time.

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

I am not trying to make the highest possible returns in the shortest period of time, but above average returns over time with the lowest possible risk, with risk management taking a higher precedence. Risk Adjusted returns are more important than absolute numbers.
This focus on “Risk” has led us to cap our top positions at 5-7% at the time of purchase, keep sectoral bets capped at 20% and maintain a cash level of 12-15% over the lifetime of the model portfolio. A more aggressive stance in the form of more concentrated positions or lower cash would have raised our returns (5% CAGR by my rough guess), but increased the risk too.

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

I have written in the past that I am focused on companies which can increase their intrinsic value by 18-20% annually (Factor 2) and are selling at 20-30% discount to this fair value (Factor 1). I would of course love to buy a company which can grow at 40% and sells at 50% discount to fair value. However such bargains do not exist in the current market and we have to adjust to the reality we face for now.
I have explained the math behind the returns in the 2016 note here, and what this translates to in terms of the long term returns. You have to keep in mind that this is a broad framework for returns and not some mathematical formulae which will deliver this precise level of return all the time.

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

The annual CAGR number tends to hide the lumpiness of the returns at the annual and lower increments of time. If you think there is some kind of pattern to this lumpiness, let me know – I have been searching for it and have yet to find it.
The only consistent pattern we have followed is to buy companies below their intrinsic value and wait patiently for the market to realize the same. In some cases, the wait is short and in other cases it is longer. However, if I am correct in my evaluation, then the value is usually realized.

I have control over the process and the stocks we pick for the portfolio. The exact timing is, however, up to the market and unlike most of participants, I do not spend any effort in trying to get it right as long as the company is building value over time.
It is however not a given that I will always be right. If I am right 60-70% of the time, we will do fine. Any higher percentage would mean that I am being too cautious and sacrificing returns to appear consistent. So, if all my stock picks are working out, don’t be thrilled – it just means that I am being too cautious and leaving money on the table.

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

This topic is in the news and one keeps hearing of some new technology disrupting a stable industry which was earlier assumed to be immune to such threats. We have Amazon disrupting retail in the US, solar starting to disrupt energy markets, electric vehicles on the horizon with a high probability of disrupting the auto and oil markets. The list goes on and on. One often feels that a lot of this is hype and just headlines to grab your interest.
On the contrary, I personally feel that markets are being pretty sanguine about it. People may be talking about these risks, but they are not acting on it. Valuations seem to incorporate no disruption risk at all.

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

For example, a company like Maruti sells for 30 times earnings. This valuation implies that an investor expects the company survive beyond a decade for sure. At the same time, we have almost every other auto manufacturer such as GM, Ford, and Fiat etc. selling at 3-4-time cash flow. In these cases, the stock market expects the company to go out of business soon (within 4-5 years at best).
The reason for such a low valuation for the almost all the auto companies across the world (except India) is that the market foresees (correctly) a major threat of disruption. A disruption in a company’s business model is not a slow, long drawn process, but an abrupt one where the company goes from high profitability to heavy losses in a matter of few quarters. Look at the examples of Nokia, blackberry, Department stores in US and many more.

The common response to such arguments is that ‘This time it’s different’. For example in the case of electric vehicles, India does not have a charging infrastructure or Indians cannot afford such expensive vehicles etc etc. What a lot of investors miss is looking closely at the cost curves of these technologies. Batteries which are a major component of an EV cost are dropping in price at 14% per annum and that is with the current technology (without any radical break through).
In addition to this, an Electric vehicle lasts 4 times a regular vehicle, has minimal maintenance cost and an operating cost which is 20% that of a petrol vehicle. If you offer a better & cheaper product to a consumer, will they ignore it? Has it ever happened in the past? And what if the govt also decides to push for it due to environmental and foreign exchange benefits?

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

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

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

There are many more forms of risk, some of which we can hedge at either the position level (proper selection, pricing and sizing of the position) or at the portfolio level (appropriate levels of cash, reducing co-relation between position etc).
I usually discuss about the position risk in the individual notes. These half yearly notes are more focused on discussing some aspects of portfolio level risk.

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

You need to keep in mind that managing and reducing risk is not free in the short run, but pays well in the long run. One of the ways we are managing our risk is by capping the maximum allocation to a single position or a sector. Doing so not only reduces the risk (which is not visible), but reduces the return too.
In the same manner, we have been raising the cash levels as stock prices have increased way beyond their fair value in some cases. This decision is based on valuations and future prospects of each position and not on some near term forecast of the market (of which I have no idea and don’t care)

The net impact of all these actions is that it reduces our prospective returns. In the last 6+ years of the model portfolio, if we had kept the cash levels at 0 and a higher concentration in some of the positions, we could have easily done a much higher return.
It would also have given us a few sleepless night during this period due to the high volatility. I cannot speak for you, but I value my sleep and will not trade it for a few extra points of return.

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

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

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

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

A repeat section

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

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

Finally a sales pitch – if you interested in joining our advisory, please email us on enquiry@rccapitalmanagement.com
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

July 13, 2017

The logic of patience

Investors hear a constant refrain – be patient, think long term, blah blah blah. Is it similar to the sermons we hear about eating well and exercising more?

Let me share some thoughts on why patience is a critical to earning above average returns. I will try to approach it based on logic and not because the gurus of investing have been preaching it
Let’s walk through a series of logical arguments

1.     The stock market is usually efficient and generally prices most companies correctly based on their near term prospects. So if a company is growing at 30% per annum, earning 25% return on capital and has great long term growth prospects, then the market will value it accordingly.

2.     One can do better than the market only if you have a view about the performance of a company, which differs materially on the upside. If the company performs as the market expects, there will be no impact to the stock price. Only if the company performs better than market expectations, will the stock price will adjust upwards in response to the positive surprise. This is something most investor miss. They are looking for high quality companies with good management. The trick is find those where the market has yet to recognize the quality or improvement in performance (and price it into the stock)

3.     If you combine point 1 and point 2, it follows that some of the ways to do better than the market is if
  • You are able to identify the turning point in a cyclical industry, before the market. As it not usually not possible to time this perfectly, the best option is to be a bit early when there are some green shoots visible and then increase the position as the recovery gathers strength
  • The profits of the company are suppressed due to some short term issues in the industry (weather, demonetization etc.) which will be resolved soon. In such cases, one has to create a position when the outlook is still horrible and hold on to it till the external factors change for the better
  • Some One-off event such as a demerger causes one of the constituents to be mispriced
  • The profit of the company is suppressed as management is investing in the business which is hurting the reported numbers. As the market is still fixated on the reported numbers, one can create a position at an attractive price. However one has to wait for the investment phase to complete and the true profitability surface
If you look at all the above cases, one needs to ignore the near term prospects which are being overly discounted by the market, and focus on the long term. As a result, in such cases you will not see a validation of your thesis as soon as you create a position.

In my experience, one needs to look out at least 2-3 years and make a purchase accordingly. One then has to wait patiently and keep checking if the company continues to deliver as per your expectations

The impact of competition
For those of us who started investing in the late 90s and even around mid-2000, the level of competition in the market was much lower. One could find companies earning 30% return on capital, growing at 15%+ CAGR and selling at 5 times earnings (Marico was one such company). All one had to do was to dig around a bit and put in the money.

The mutual fund industry was nascent at that time and there were very few individual investors. I still recall getting blank stares when I spoke about value investing.
This has changed completely in the last 10 years. We now have an army of smart investors (professional and part-time) who scour the market looking for opportunities. In such as climate, I can bet that you will not find any obvious mispricing which can filtered on a screen.

In such a case, one has to dig deeper and put in more time and effort in understanding the business and its management. Once you get a better understanding than most other investors , you have to buy the stock and wait till the market, hopefully comes around to your point of view.
It would be foolish to assume that the change of opinion will happen as soon as you are done with your purchase. Some of the near term factors which drive the pricing, need to change before the market accepts your view point.

When is patience a liability?
Patience is of course tied with your style of investing and time horizon. If you are a day trader or momentum investor, then time is not on your side. If you time horizon is days, weeks or month then thinking of a multi-year period makes no sense.

The trouble starts when one does not know what kind of an investor you are? A lot of people think they are long term value investors (as somehow that is fashionable these days), but act like day traders – selling and buying over weeks. If you do not get your time horizon and investment approach consistent with each other, then you are in trouble as your will quickly tire of holding the stock and sell just before the inflection

Getting an edge
I had earlier written above three kinds of edge in stock market investing. The information edge is now more or less gone with tools for quantitative analysis and wide dissemination of information by management (look at the number of conference calls hosted by companies!). One has to rely on analytical and behavioral edge to make above average returns.

I personally think that analytical edge too is over rated as it is not possible to consistently have a superior insight with all your positions. Assuming that you are smarter than the rest of the market at all times, is pure hubris. The only sustainable edge left for an investor is the behavioral one and being patient in an age of distraction and immediate gratification is at the core of this edge.
Being patient is therefore not a moral imperative or something you need to do for the good of humanity, but is a logical necessity to do well in the market in the long run as a value investor.
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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.