Wish you all a happy new year

Wish you all a very happy and prosperous new year. Thank you all for visiting and reading this blog.

Lure of the long shot

Let me tell you a short story : There was once a smart young guy who like all of us was a charming, intelligent and hard working fellow (please replace guy with gal – for the ladies reading this blog). Now this guy, like others knew that the stock market is the place to invest your money if you want to get a good return. So he would occasionally dabble in the stock market and would make a few bucks here and there, nothing serious though.

One day our friend was relaxing at home, watching CNBC, where a smart confident looking analyst recommended the stock of a hot upcoming company (lets call the company longshot). The analyst was extremely bullish and was going ga-ga over the prospects of the company. This was a hot company in a hot sector (hot – hot !!). The company had increased its profits by 5 times in the last 3 years and was growing rapidly. The promoters were confident that sky was the limit and they would be the next infosys of their industry.

Our friend on hearing this tip was intrigued. He decided to call his friends and his broker to find out more (research !). His broker was ofcourse estactic about the company and his friend (who was a budding investor himself ) was also very positive. So having received two solid recommendations, our friend decided to invest 100000 (20% of his networth) in the company.

Fast forward 2 months : The company’s stock rose 4 times during this period. Our friend was completely delerious. He felt like a winner now. Ever since he bought this stock, he was following it closely. He would read every article on the company, every interview by the CEO. He was even participating on various stock forums where are almost everyone was more than 100% sure that the company would do very well. There were a few morons, who kept pointing to the high valuations, but then what would they know !.

The company had been reporting rising profits for the last 10 quarters and the next quarter was expected to be great. Our friend was giddy with excitement. He dreamt of the stock going up still further (everyone believed that !).

Fast forward 6 months : No one saw it coming. The company report good profits, slightly below expectations, but still good profits. The market reacted strangely to this news. The stock dropped 20% !!. Our friend was surprised. However he was re-assured by his friends and fellow investors on the stock forum that this was just a temporary reaction and the management and other analysts believed the same thing.

A few morons again pointed out that the valuation was too high, but they were abused and kicked out of the stock forum (sheesh !! what spoilsports ..our friend thought).

Fast forward 3 months : The company reported profits below forecast. They still reported a good growth, but below forecast. They however reduced the outlook for the next year as recessionary conditions had reduced the order inflow. Once this news came out the stock tanked by 50%.

Our friend was still up by 60%. However he was surprised by the sudden drop in the stock. How could the stock drop so rapidly ? He felt regret that he had not sold when the stock was at its peak. Now the stock had dropped almost 60% from that level. There was no point selling now …so he held on

Present day : The bad news kept flowing in. The stock dropped another 50% and was now below his cost. Our friend was angry with the analysts and the management who misled him. He was feeling cheated. He still visits the stock forum and is now looking for the next PRIL or L&T or infosys (or whatever you can think of)

End of story

I am currently reading a book ‘your money and your brain – the science of neuroeconomics’. It is a great book on the behavioural aspects of investing. I have not written much on emotions and behavioural aspects of investing on my blog. However I think these aspects of investing are equally if not more important than the analytical aspects.

The above story is something which a few of us have gone through or seen others go through. Some will learn the right lessons from it, whereas others will keep their head in the sand and blame others for their losses.

There are several behavioural baises in the above story which I will discuss in the rest of the post.

tendency to consider gain, but ignore the probability of gain
social proof bias
hindsight bais
commitment and consistency tendency bias
predicition bias
pattern seeking bias

Let me go through each of the above now

tendency to consider gain, but ignore the probability of gain : The book mentioned above discusses this bias in detail. I have know about this bais, but when I read about it in the book, it was like a light bulb going on. Humans have a tendency to over wiegh the gain, but tend to underwiegh the probability of gain. This tendency explains why people buy lotteries. The odds of winning the lottery are very low, but the likely gain is very high. An odd of 1 in 10 million cannot be ‘felt’. However a gain of 10 million is vivid. You can imagine all the stuff you can buy with it.

This bias explains why people go for long shots in investing even if the valuation (or odds) is high. The gain appears tangible, but the low probability does not register. This is also the reason why people are looking for the next infosys or the next L&T or PRIL etc. What most people forget is that the odds of finding one is low (would you have predicted that infosys would do as well in 1993 ? the promoters could not !). This bias explains why our friend is still looking for the next longshot.

social proof bias : If others are recommending the stock, then I must be correct. As the above book and countless other books on the same topic have stated – Humans are social creatures and like to stay with the crowd. You don’t want to stand away from the crowd and be proven wrong. Easier to buy a hot stock and be proven wrong, than buy a beaten up stock that no one likes.This bias explains why our friend felt comfortable with the company when others were recommending it.

Hindsight bais : This is the tendency to believe that you always knew the outcome after it has occurred. The book explains this bias very well. You will find a lot of pundits saying that the stock was bound to drop (or rise) after it has done so. What they don’t tell you is that they did not have this insight before the event happened. One of the key reasons for writing an investment thesis and publishing on this blog is to avoid this bais. I am no different than others and could easily fool myself that I always knew what was bound to happen.

Commitment and consistency bias : Once you make a commitment (especially public), you have tendency to be consistent with it. No one likes a person who changes his mind and is not ‘faithful’. Our friend bought the stock, committed to it and hence could not bring himself to selling it when the fundamentals turned bad. I personally try to avoid this bias by publicly not committing to buying or selling a stock on the blog. I prefer to publish the analysis and leave it to the readers to take their decision

Predicition bias – The book explains this bias in a lot of detail. Humans have a bias to predict events. If you toss coins in front them, there is an automatic tendency to predict the next toss even if they know it is random. There is a deep biological basis behind it (too lengthy for me to go into). All of us suffer from it and it seems to be a sub-conscious tendency. This bias explains why people are continously tryind predict price movements in the stock market even though they are random. This bias also explains the attraction for technical analysis.

Pattern seeking bais – This bais also has a biological basis and closely linked to the previous bais. All humans try to find patterns, even in random data. It is an inbuilt tendency and an automatic one. The book (your money and your brain) goes into detail and explains it fairly well. This bias explains why people on seeing 4 quarter of rising earnings or 3 weeks of rising prices seem to find a pattern in it and predict that the next quarter or price will be higher than the previous one. Our friend with others was suffering from the same bias and assumed blindly that the earnings and the stock price will continue to rise.

There are several other such biases which I will cover in future posts. I personally think all of us suffer from these biases (less or more) and the difference between a successful and average investor is that the successful ones are able to reduce or compensate for these baises.

These biases are not weakness. These tendencies come from the human evolution and served us well in the past and continue to do so. If some one yelled fire and everyone started running away from it, would it be smart to be a contrarian to run towards it ? The worst that can happen if you follow the crowd (social proof) is that everyone will look foolish if there was no fire. But if everyone is correct and you go against the crowd, you may pay with your life.

These biases however work against us in the financial markets. They cannot be compensated easily. I have been reading on them (see this article by charlie munger on it) for the last few years and know several times that I am operating under their influence, but can still not avoid acting otherwise. The bigger problem is when you don’t even know that you are operating under their influence and they are hurting you.

Now if believe you are above all these influences and it is others who suffer from them, then you are suffering from another bias – where almost all individuals think that they are better than the average. The book gives example of several experiments which were done to demonstarte this bias. Most investors, drivers etc feel that their skills are superior than the average (even if the evidence is to the contrary).

I personally operate with the assumption that I am influenced by all these biases and instead of ignoring them, I should be focussing my effort on reducing their impact.

A Graham style deep value stock portfolio

Benjamin graham is considered as the dean of value investing. Warren buffet was graham’s student and considers him as his mentor. Buffett’s followed graham’s approach to value investing in the early part of his career. However later, he expanded on graham’s approach and started focussing on the quality of the business too.

Graham’s approach is basically picking stocks which are statistically cheap. What that means is that the stock is cheap based on various quantitative measures such as mcap being less than Net current assets, or the stock is selling for less than cash on books. The disadvantage of this approach is that you may end up buying some complete dogs which are cheap for a reason. The underlying business would be going downhill and so the value is just an illusion.

Graham understood this and he circumvented it by diversifying. So the key point in building a portfolio of cheap graham style stocks is to diversify the holding. It makes sense to hold 15-20 stocks at a time and to keep selling the stocks when they reach 80-90% of intrinsic value and to replace them with other cheap issues.

With the current drop, I can see more of such opportunities coming up. The last time I saw such an opportunity was in 2002-2003 time frame.

The initial filter criteria I am using is as follows

Mcap less than 500 crs
Debt / equity ratio less than 0.5
No loss in the preceeding 5-6 years
PE less than 7
ROE atleast 8-10%

I have been developing a list of such ideas and have loaded a list of possible ideas in google groups (stock screen graham). I have holdings in HTMT global, LMW and Denso india. I am still analysing the other stocks in the list and have yet to make up my mind on them.

The key point, and I repeat, is to hold a large portfolio of these stocks via diversification. Some will turn out to be clunkers, but on an aggregate the portfolio should do well.

Now you may have a valid counterpoint – why buy this stuff when there are good companies getting cheap by the day. That is true ..but if like me you also take a long time to analyse each company, then the above mechanical approach is a quick way to assemble a decent portfolio. If you have the cash and the nerve (I could use a stronger word here :) ) to invest when everyone is pessimistic, then the mechanical graham style of investing can be used to quickly assemble a decent portfolio while the opportunity lasts.

Please keep in mind that this list is just raw analysis and not a final list of stocks from which I plan to build my graham style portfolio. I will keep adding and dropping stocks and will upload the revised list when I do so.

Real estate – current reality and some thoughts

I had written about real estate and its valuation a year back. I would suggest reading the earlier post before proceeding on this one.

The usual approach to valuing real estate is to look at the rental yields.

Rental yield = net rental after all expenses / capital value.

Investors expect yields to be in the range of 4-6%. This equates the capital value to around 16-25 times the rentals being received on a property.

Ancedotal evidence
I have a few friends who have trying to rent out their apartments in bangalore. They are finding it diffcult to get a rent of 11000 per month on a 2 bedroom, 1200 sqft apartment. Supposedly the apartment is worth between 40-45 lacs (atleast, depending on who you ask).

So based on the valuation thumb rule, either they should get a gross rental (excluding expenses) of around 16000-20000 at a minimum or the property value should be around 25-30 lacs.

Now I can consider my 2 bedroom dinghy, a tajmahal and value it at 50 lacs, but the value has to be backed by rentals. I personally think the litmus test of property values is the rentals one can receive on it. Property values are like stock prices. They have an element of underlying value (cash flows in stocks and rentals in case of property), but at the same time there is a speculative element too. The speculative element appears as a part of the quoted price – stock price or property value.

When investors are optimistic, stock prices are bid up and when they are pessimistic they bid them down. Simple isnt it ? well almost everyone forgot this basic idea for real estate. Property prices rose 2-10 times across the country depending on the location and type of property

Is the valuation approach correct ?
Now you can say that this valuation approach is incorrect. Consider this – if I have to invest in an illiquid asset, will it not expect 14-15% returns over the long term ? So if I am getting 2-2.5% via rentals, then my property should appreciate by 12-13% p.a over the long term to get decent returns.

Well, globally over a range of markets, real estate is known to return 2-3% returns over inflation ( so around 7-8 % in case on india) over the long run.

You may argue, as several of my friends have – this time it is different. India is doing well, incomes are rising, there is limited land and huge demand etc etc. Well, to that I can say, please read the history of the real estate boom and bust in japan in late 90s, in california and florida in 80s and check what is happening in the US, dubai and other markets. Similar faulty logic was given to justify the inflated prices, till the bubble burst and prices returned to reality.

Hope and belief does not count
Investing in any asset, stock or real estate cannot be based on borrowed wisdom. If you want to make money, use common sense and read about it before taking a plunge.

Unfortunately a lot investors in the US and maybe in india got greedy and speculated in stocks, real estate and other assets in the last 2-3 years.

Real estate like any other asset is known to get overpriced from time to time. I strongly felt that the huge surge in global liquidity from 2003 drove the interest rates down in india and pushed the stock and real estate prices up.

All talk ?
You may be thinking – everyone is smart after the fact. If you were so smart, what did you do about it ?
For starters, I was not smart about it. I avoided being greedy and tried to use common sense. I personally like to run my finanical affairs with a margin of safety. For example, when buying an apartment, my primary considerations were the following

- can I afford the EMI – I tried to keep the EMI at 40% of my current gross income (not future income)
- would I be able to keep the house if the worst case scenario happened, such losing my job or loss of income.
- What would my debt equity ratio after buying the property (see this post for more details of my logic)

2003-2004 was a great time to take housing loan. Banks and HFC were giving variable rate loans at around 7.5% and fixed term loans at 7.75%. I had no idea whether the real estate prices would boom or go down. However what was obvious then, was that banks were underpricing debt. Let me explain my logic for the same

A loan by a bank is basically a product which has a cost and a profit margin for the bank.

So interest charged = bank’s profit margin + cost

Cost = interest paid by the bank + loan losses due to bad loans (typically around 1-1.2 %) + overheads (typically around 0.5%)

The interest rates paid by the bank is dependent on the inflation.

So for a 7.75% charge, the bank was assuming a cost of fund of 6% (7.75 – 1.2-0.5 %). This was too low. This is the cost at which the Indian government is barely able to borrow, much less the banks.

The subsequent events have borne out the above logic. The loan losses were underestimated by the banks and the cost of funds was underestimated too. As a result, bank have now repriced their loans and are not likely to underprice them as low as 2003-2004 time frame.

During the 2003-2004 time frame, I strongly felt that the loan rates were too low. In response to that, I refinanced my loans and increased the duration from 15 to 20 years (see an earlier post on the same). The key was to focus on what I know (loan rates were low) and avoid speculating on what I could not know (real estate prices would rise or fall)

Have I gloated enough?
The above thought process turned out to be too conservative. Others who took higher risks in 2003-2004, were rewarded handsomely. So, my decision was not some unqualified success. However I am still very happy with decision as my conservative approach has helped me in avoiding losses in the past.

Being rational and avoiding greed is like virginity. Either you have it or you don’t.

Collateral damage
Not everyone who is suffering in the US or india was greedy or speculated in real estate. Some of the buyers in the US were first time buyers who bought property as their first home at speculative prices. These people are now facing ruin due to drop in home prices. One feels sorry for them.

What does the future hold ?
I don’t know :) ..what one can do is to look at history and try to learn from it. History does not always repeat, but it is good starting point. In most of the real estate bubbles, the market takes upto a decade to recover the earlier peaks.

One should also remember that real estate typically gives a few percentage points over inflation. If you speculate in an illiquid asset, by buying it on debt, you are asking for trouble.

A simple idea

I have written about the overall market a few times in the past (see here). The problem with market analysis is that it is fuzzy and not actionable. For example, if someone were to say that the market is undervalued, what does that mean and what should one do about it?

Most of the times, market analysis is just noise. Good to hear and entertain yourself, but not really actionable. That said, there are a few times when the overvall market levels can be analysed and some buy or sell decisions can be taken.

I have generally invested in the overall market via an ETF (exchange traded funds). An ETF can be bought or sold like a stock and esentially represents an underlying index (see here for more details).

I bought heavily (by my standards) in 2003-2004 and held the ETFs for 2-3 years. I started moving out by 2006 and was completely out by mid 2007. As I have written in the past, I have followed a very simplistic approach on investing in ETF’s : Buy when the PE is below 12 and start selling once it crosses 17-18.

There are several valid drawbacks of using this approach, such as
- PE data is based on historical data. However the market is not stationary (which means that the index of year 2000 is not same as index of 2008), and hence the data is not comparable across time horizons
- PE data is backward looking, whereas the returns will depend on what happens going forward.
- There is no hard and fast rule that the market is undervalued below a PE of 12 and overvalued above 18. If the economy is going into a recession then a PE of 12 is not low as the earnings are about to fall off.

In spite of all the above drawbacks, I have found that buying below a PE of 11-12 and selling above 17-18 works well over a 2-3 year time frame. The returns are not fantastic, maybe a 40-50% returns over a 2-3 year time frame. However as it involves a minimal effort, I think it is worth it. The above approach may not give big returns, but it definitely gives better returns than a fixed deposit.

I have also uploaded an analysis of the market data – PE, P/B etc for the last 9 years (see file history data.xls in google groups). The data is downloaded from the nse website. As you can see from the data, the market has been below the current PE (11.9) only 2% of the days. I personally think that the odds are decent at the current market levels.

Overseas investing

I was recently chatting with sandesh and he asked me a question – Why don’t you invest in US based companies? Is it due to the fact that you consider them outside your circle of competence or some other reason ?

My response was – As an indian resident, I cannot invest out of india and that is the main reason for not looking at US companies.

So much for due diligence ! It seems one can invest abroad through ICICI direct and this facility has been available for some time. I do not know if there are some restrictions on the type of stocks one can buy and so would appreciate if some one can leave a comment on it.

I have been following a few companies in the US, mainly out of curiosity and as a learning experience. The one company I would like to own is Berkshire hathaway. This company is run by warren buffett and as most of the readers of this blog would know, I am a Buffett fan.

Warren buffett has been the chairman and CEO of this company since 1967 or 68 (don’t have the exact date). The company stock price and intrsinic value has grown by 20%+ since he took over the management of the company (you do the math of what 1000$ invested then would be worth now after almost 40 years of compounding at 20%+ per annum).

The core business of the company is insurance. In addition Buffett has invested capital by accquiring a collection of good companies or by investing in stocks. The company is a major shareholder in companies such as Cocacola, Amex, washington post etc and a 100% owner of companies such as See’s candies, DQ, GIECO etc.

It is diffcult to analyse the company in a short post and I will do a detailed post later if I can confirm that an Indian investor can invest in this company. However irrespective of the outcome, I would recommend everyone to read Buffett’s letter to shareholders (download here) and analyse the company. I have read these letters multiple times and I can tell you from personal experience that these letters are the best education in economics, finance and investing.

I have analysed the company to understand the economics of an insurance business and also to see the disclosure a shareholder friendly management (Buffett is known for his shareholder orientation and ‘really’ considers them as partners).

I am uploading the valuation of the company (BRK valuation.xls) in google groups (see here). The company is undervalued from my perspective. I would encourage you to download the annual report and read through it. It is a big report and takes effort to understand it, but it is worth it.

Caution: The company is undervalued, but the stock is not cheap. The ‘A’ stock is worth around 100000 usd (50 lacs per share) and the ‘B’ stock (which is 1/30 of A stock) is worth around 3200 usd (1.6-1.7 lacs per share). The reason for this high price is that buffett has not split the stock for the last 40 years (read the owners manual in the Annual report for the reason).