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.

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
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.

1 comment:

Anonymous said...

Rohit, This comment is not linked to this post. It is about demonetisation and its impact on real estate companies. I am not sure whether any real transaction in India is done completely transparent way. When we buy the flats from the builder we might be paying in white . Can the builder acquire lands without much liquid cash? Asthana Housing is one company that I respect a lot. Does their annal reports provide any clue on this.