Blog

Value trading

By Rohit Chauhan
In Uncategorized
September 27, 2012
7 Min read
14 comments
V

I am going to discuss a new term –value trading in this post. It is a very interesting concept and it was first mentioned by my good friend – arpit ranka.  I cannot claim any originality on this concept, but once it was mentioned  by arpit, I started thinking about it and found a lot of validity and relevance to my style of investing.
What is value trading? (my definition)
Value trading is best described as buying a stock with the expectation of selling the same (hopefully with a gain) in a short period of time based on the realization of a single or multiple triggers. This trigger can be fundamental in nature such as normalization of sales/ profit margins (from a temporary low), business event such as launch of a new product or new capacity or change in the business environment for the better such as moving from extreme  to moderate pessimism .
In addition to the fundamental issues, the trigger could be technical in nature such as short term overselling of a stock due to unexpectedly poor results or some temporary event such as elections which do not really impact the fundamentals of the business
In all these cases, one is expecting that the trigger will occur in the short term and the stock price will get a quick bounce (10%+) and one would be able to exit with a nice little profit
How does it differ from value investing
The above definition may sound a lot like value investing and I have been guilty of mixing the two for all these years. However as I think back, I have come to realize that they are not strictly the same and confusing the two can actually be harmful (as I will explain later in the post)
If one invests  with a long term horizon in mind, then it is critical to have a good idea of the intrinsic value of the company. In addition this intrinsic value should increase over time, if one is to make above average returns in the long run.

So in effect, one is playing a short term trigger in the case of value trading versus betting on the business in the case of value investing.
Examples of value trading
Lets look at some example I have posted in the past and look at which bucket these ideas fall into

  1. Patels airtemp
 I would call this ideas as a value trading idea as this company is in a highly cyclical industry. At the time of buying the stock, I was expecting that the downturn in the capital goods industry would not be deep and the fundamentals of the company and  its stock price would soon bounce back.
The trigger has yet to happen and as result the stock has slid further since the time I wrote about it.
  1. Ashok Leyland
I started looking closely at this company in mid 2008 and by the end of the year the bottom had fallen out of the commercial vehicle market (the company stopped production for a month in dec 2008 to reduce the inventory). I purchased the stock in early 2009 at highly depressed prices.
The trigger – normalization of commercial vehicle sales happened quite quickly towards the end of 2009 and the stock turned out to be a four bagger.
In both cases, I expected a normalization of  the fundamental performance and a bounce back in the stock price. In one case it happened faster than expected resulting in a large gain and in the other case the downturn has been deeper than expected and hence the stock price continues to languish
  1. Amara raja battery
The company is a no.2 player in the battery industry and operates in a close duopoly. The key insight in this idea is that the company is expanding its competitive advantage (brand and distribution) and also benefiting from  migration of demand from the un-organized to organized sector
I would tag this as a value investing idea as i don’t expect a specific trigger other than the fact that the company is improving its competitive position and hence should see an improvement in profitability and growth.

The first two examples I have discussed should bring out the following key point – In a value trading idea, the intrinsic value may not expanding or could be declining too. However the stock is undervalued and a set of triggers could close the gap with the intrinsic value. You can call this mode of investing as deep value investing or graham style investing too.
The last example of amara raja is more of a buffett style, high quality stock where although  one is expecting the gap with the intrinsic value to close, the bigger gains come from an increase in the value of the company itself.
The differentiating factors
The two modes of investing differ on several factors. The first factor is time – Time works against you in the case of value trading. If the trigger happens quickly,  the price rises quickly to the fair value and one can exit with a nice little profit. On the other hand if trigger gets delayed, then the overall returns may remain the same, but the annualized return is much lower.
In case of value investing, time works in your favor. As the company continues to grow its intrinsic value, the stock price should hopefully follow it (some times in spurts) and thus the idea becomes a buy and hold kind of idea.
The second factor where these two approaches differ is the nature of the business. The value trading approach works better in commodity  and cyclical industries. If one can catch the bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then the gains are very high when the cycle swings back to a normalized level. At the same time, one needs to also ensure that the stock is sold once the cycle has turned .
Value investing approach works where the economics of the business is good and the company has a competitive advantage. In such cases, if one buys the stock at reasonable valuations, then returns are good over a long period of time
Do not mix the drinks !
I would say that value investing or long term investing should occupy a larger portion of the portfolio. If however you have the time and energy to look for  value trading kind of ideas and can play them well,  the portfolio can get an extra boost from time to time
The danger is really from mixing the two approaches as I have done in the past. I have bought  trading kind of ideas and held on to it for a long time (assuming it was a long term investment). In such the cases the absolute returns came through, though the annualized returns were mediocre due to a delay in the key triggers.
The correct approach would be to keep in mind the nature of the idea (trading v/s investing), identify the triggers and the time it would take for the same to play out. If the triggers change or get delayed , then one should exit a value trading kind of idea. In contrast in a value investing idea, time is working in your favor and temporary hiccups are sometimes a good time to add to the position. In all such cases, one should just sit tight with the position.

Read on14 comments

A simpler way to invest

By Rohit Chauhan
In Uncategorized
September 13, 2012
4 Min read
17 comments
A

Let’s do a thought experiment – Let’s say you are going on a multi-year cruise or journey around the world and need to invest your or your retired parent’s money. Let’s also assume that you want to ensure that the money is secure, but at the same time earns a decent rate of return (Which beats inflation).

Investments of this type should have the following characteristics
a.    The portfolio of such investments should be reasonably secure – low probability of long term loss of capital, though temporary fluctuations are fine
b.    Above average rate of return – The investments should beat the inflation and possibly earn a few percentage points above it, so that your family can withdraw a small portion of the capital without a reduction in principal
c.    Low maintenance – should not require your family or you to run around, doing tons of paperwork or other tasks to manage it
Let’s invert the question and look at what will not be good options
a.    Fixed deposit – Safe and low maintenance, but the rate of return barely beat inflation. As a result, if you use up the interest , the capital base will get eroded by inflation
b.    Real estate – May be secure and give above average returns, but requires constant work (maintenance, repair, payment of taxes etc). In addition, you cannot really invest small amounts of money into it.
c.    Gold – If you have been following me for sometime, you know my distaste for it. It is not an income producing asset and I cannot think of any family selling gold for meeting expenses – Remember the old Hindi films, where the family sells gold when it is in dire circumstances? We are too conditioned by those images.
I know you would have realized where I am going – equities!, but then not all types of equities. The above criteria eliminate some types of companies from the consideration set.
a.    New companies with a short operating history – Sure, the company is going to be the next titan or  ITC  (fill in the name), but if the companies goes down the drain while you are away then your family is in trouble
b.    Speculative companies – Loss making or penny stocks which have performed poorly in the past but have a very bright future.
c.    Companies with poor management – I don’t want to hand over my money to a crooked management who could cheat me in my absence (remember we are away for a long period of time)
If you think through all these options, you will realize that you are left with a small list of companies which meet the following criteria
a.    Durable competitive advantage – The company has done well in the past and you are assured that it will do well for a long period of time in your absence
b.    Good management – You can trust the management to be good caretakers of your money in your absence
c.    Reasonable prospects – The Company may not have phenomenal growth prospects, but should deliver above average growth.
If you put all these points together, I hope you can see a picture forming. We are talking of companies such as
Asian paints
HDFC ltd
HDFC bank
Crisil
ITC
Titan etc
A portfolio of such companies would be fairly safe as one is talking of good companies with above average economics and decent management. These companies may not be the next multi-bagger, but it is easy to see that they will give one a 15% or higher annualized return for a long period of time.  Even if you consume 3-4 % of the return (via dividend or sale), your capital will still compound at 10-11%, which will take care of the corrosive effects of inflation.
If the above makes sense, then why am I not following it? Let me tell you why – The desire for higher returns! I think I can make higher returns than what I can get from these companies.
Please note the word – ‘Think’ and not would. Anyone who decides to invest on their own in all kinds of midcaps, small caps and other equity options is implicitly assuming that he or she can do better than these proven ‘blue chips’.
I am not saying that some people cannot do better, but I don’t think the lay investor who chases the current fad and hot tips, will do better than a basket of such companies. It is often smarter to make a sure 15% than chase the dream of 100% returns.
Read on17 comments

My experiences with deep value investing

By Rohit Chauhan
In Investment process, Uncategorized, Warren buffett
August 26, 2012
6 Min read
13 comments
M

Deep value investing or cigar butt investing, is buying stocks whose price is way below the various statistical measures of value of the company. Now, value can be measured by various means such as PE ratios, discounted cash flow analysis or asset values. In case of deep value investing, one is investing in stocks which are selling at a very low PE, below book value or in some cases even below cash held by the company.

This method of investing was introduced and popularized by the father of value investing – Benjamin graham in his classic security analysis (A must read for any serious investor). In this book, graham talks about companies selling below working capital, book value or in some extreme cases, even the cash held by the company.

This mode of analysis is a quantitative, statistics driven method where in one holds a large number of such ‘Cheap’ companies. A few positions work out, a few go down the drain and rest just stagnate doing nothing. In spite of such a mix, the overall portfolio does quite well and one is able to earn decent returns at low risk

The key element in this investment operation is wide diversification and constant search for new ideas to replace the duds in the portfolio.

Initial foray into high quality
My first exposure to sensible investing (reading economictimes and watching CNBC does not count in that), was when I read the book – The warren buffett way. I was completely mesmerized by this person and read all I could on him for the next few years.

After burning my finger a bit during the dotcom bust, my initial investments were in the warren buffett mold (high quality stocks with competitive advantages). My initial investments were in asian paints, pidilite, Maricoetc – the so called consumption stocks except that they were not called by this label then.

I have always wondered why these stocks are called consumption stocks? are capital goods and real estate ‘un-consumption’ companies whose products no one wants to consume J ? Anyway I digress

An experiment in deep value
Around 2006-2007, i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around 10-15% of my portfolio in  names such as Denso, Cheviot company, Facor alloys and VST industries (see here), etc for a period of around 3-4 years.

I decided to terminate this approach in 2011 and have been exiting the positions since then. In the rest of the post I will cover my experience and learnings from this long run experiment.

The results

The results from this portion of the portfolio (which was tracked separately) was actually quite decent. I was able to beat the market by 5-6% points during this period. At the same time, this part of the portfolio lagged the high quality portion by 6-7% over the same time period. The difference may not appear to be big, but  adds up over time to a considerable difference due to the power of compounding.

I have not completely forsaken this mode of investing and once in while could buy something which is very cheap and has a near term catalyst to unlock the value.

Why did I quit ?
I did not quit for the obvious reason of lower returns than the rest of the portfolio. The lower return played a part, but if I compare the effort invested in building and maintaining a deep value portfolio ,  it is much lower than trying to identify a high quality and reasonably priced company .

If one compares, the return on time invested (versus return on capital), the balance could tilt towards the deep value style of investing.
Let me list the reasons for moving away from this style of investing

Temperament – The no.1 reason is temperament. I have realized that I do not have the temperament to invest in this fashion. I do not like to buy poorly  managed, weak companies which are extremely cheap and then wait for that one spike when I can sell it off and move on to the next idea. It makes my stomach churn everytime I read the annual report of such companies and see the horrible economics of the business and miserable performance of the management.
Life is too short such for such torture

Re-investment risk- The other problem in this mode of investing is the constant need for new ideas , to replace the duds in the portfolio. This exposes one to re-investment risk (replacing one bad stock with another bad idea), especially during bull markets.
Value traps – This part of the market (deep value) is filled with stocks which can be called as value traps. These are companies which appear cheap on statistical basis, and remain so forever. The reasons vary from a bad cyclical industry to poor corporate management. In all such cases, the loss is not so much as the actual loss of money, but  the opportunity loss of missing better performing ideas.

Higher trading – The final problem in this mode of investing is the constant churn in the portfolio resulting in higher transaction costs and higher taxes, both of which reduce the overall returns.

The lessons
I know some of you, have never followed this mode of investing and have always invested in quality. The problem with investing in quality is the risk of over payment, especially if the quality is just an illusion (faked as in the case of several companies in the real estate sector in 2007-2008). Anyway, that is a topic for another post.

I am constantly experimenting , with a small amount , with new approaches and ideas. If there is a valid approach, which matches my overall value investing approach (momentum and technical trading is out), I will try it and see if it works for me. It is one thing to read about it and another to put some money into to it and immerse oneself in it.

As some has said – an expert is someone who has made the most mistakes and survived. Well, at the current rate of making mistakes, I hope to become an expert in the next 10-20 years J.

Read on13 comments

Investing for dividends

By Rohit Chauhan
In Portfolio management, Uncategorized
August 12, 2012
5 Min read
4 comments
I

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.
Read on4 comments

If facts change, do you change your mind?

By Rohit Chauhan
In behavioral finance, General thoughts, Uncategorized
July 19, 2012
3 Min read
12 comments
I

I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.

Let me tell you a recent story.
I spoke very briefly about a company in this post. The company was Ricoh (I) ltd. You can download my detailed analysis of the company here.
So after doing this detailed analysis in late 2010, I built a decent position at an average price of around 35-37 Rs/ share.  The company continued to perform poorly (as I expected) as it had done an acquisition and was also investing heavily into sales and marketing.
The topline grew by 40%, but the net profit dropped from around 15 Crs to a loss of 5 Crs in 2012. The price continued to stagnate in the range of 37-40 rs during this period.

I have been consolidating my portfolio and weeding out the weaker ideas for the last 2 years. As a result, I exited Ricoh in the feb-march time frame. I think it was a rational thing to do based on the information I had as of March 2012.
The change
The company declared the Q4 2011 results in April and reported the following

Q4 sales growth, YOY – 60%
Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)

The price action can be seen below

As you can see, the market did not react immediately to the turnaround in the performance and there was a 1-2 month window for an intelligent investor to digest this information and purchase the stock.
So that proves my level of intelligence J

The explanation
It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.

The bias is called the commitment and consistency bias. In simple words, once one makes a decision, the tendency is to ‘commit’ to the decision and be consistent with it. This results in ignoring positive information as in the above case or holding on to a losing position (inspite of consistent negative news) and hoping that the price will rise in the future.

Not a one off case
The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.

I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.

It is better to look foolish (in my own eyes), than miss out on a good idea

Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

Read on12 comments

A speculative bet

By Rohit Chauhan
In General thoughts, Uncategorized
July 5, 2012
4 Min read
7 comments
A
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative – Benjamin graham, father of modern security analysis and value investing.
Some background
I had written about globus spirits earlier – read here. The stock price has since dropped by around 10% versus the index,  which has  essentially been flat during this period.

So what happened during this period ? Well, the company declared the Q4 results and the market reacted negatively to the drop in operating margins from around 16.8% to around 13%. The company closed the year with a 40% growth in topline and a measly growth of 2.5% in net profits.
This drop in net margins was mainly due to an expansion in the capacity to 84Mn litres and additional new capacity of 40 Mn litres which should come online in the middle of next year. This additional capacity has caused an increase in manufacturing expenses (initial startup costs) and higher interest expenses (due to higher debt to add the capacity). These costs in combination have depressed the operating margins.
So what is my bet ?
I think that the drop in the operating margins is temporary due to the new capacity which is being added in the current and next year. As the new plant stabilizes, the extra costs should reduce and with the extra topline , we should see an  improvement in the margins.
In addition, a decent portion of the additional capacity has been booked by USL for the franchise IMFL bottling (outsourced production)  which should help in boosting the bottom line. The management is targeting a 15% operating margin for the next year.
The management has also indicated that they would be able to grow the topline by 20% or more in 2013 (which appears doable based on past results). If we put all of this together, the company should be able to increase the operating profits from around 73 crs to 100 Crs, with net profits in excess of 55 crs in 2013 (interest costs should also reduce due to a planned reduction in debt)
The company is current selling for around 5 times the current year’s depressed earnings of around 40 crs. The company is thus selling at historically low valuation too (past valuations have generally been in excess of 7-8 times earnings).
In addition, all the other companies in the sector sell for 10+ times earnings, inspite of having much lower ROE and higher debts.
So why is it speculative?
Have I built a good case that the company is really undervalued – from absolute, historical and comparative valuation perspective?  I think I have done that.  At the same time I am still calling it speculative …why is that ?
Please look at the definition in the beginning of the post – An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
The key word in the above definition for our example is promise.  I am not confident about the above analysis and think it is a 50-50 proposition. I am still concerned that the industry has extremely poor economics and it is generally quite difficult for a single company to buck the trend of an entire industry.
Speculation is subjective
The key point is that  a stock can be both a  speculation or an investment at the same time and that depends on the investor himself. If you know what you are doing, then it is an investment, otherwise it is a speculation.
The danger is not speculating, but in confusing a speculation as an investment and betting heavily on it.
I am personally not very sure if the above thesis will play out and hence have committed a very small amount of money to it. In effect, this position is just to scratch an itch and not meaningful. If it turns out well, I will brag about it on the blog, otherwise you will not hear a peep on it 🙂

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

Read on7 comments

The return of the stock picker

By Rohit Chauhan
In General thoughts, Uncategorized
June 24, 2012
5 Min read
13 comments
T
The period from 2008 to 2012 has been a nightmare, right? How could it not be?
The market went from 20500 to around 17000 levels. That’s a loss of 18% in nominal terms, and if one considers an inflation of around 8%, then the loss is a mind numbing 42%. So if one had complete foresight and could see the future, then 100000 invested in a bank deposit would be worth 144000 versus around 82000 in the stock market.
So where is the debate in this?
The time of the stock picker
I know of several fellow investors who have actually done quite well during this period. They may have lost money on a few ideas here and there and suffered through temporary drops during the market swoons in 2008-2009. However over the course of these 4+ years, most of these investors have soundly beaten the market and delivered double digit annual returns
So how have these guys achieved this feat ? Do they have a special diet or drink something special 🙂 ? I don’t think so as far as I know
What has enabled these returns
I would say that there two reasons for the above result. All these investors who have done well, have a long term view of investing and don’t invest with one week or one month in mind. In most cases, they invest after a thorough analysis of the underlying business and only when the market undervalues the business.
A disregard for short term performance, usually results in a long term outperformance.
The second reason I would say is that all these investors are focused and work hard at finding good ideas and then purchasing the stocks, inspite of all the negative news around them.
It helps to be emotionally stable as far as the stock market is concerned. One need not be like Mr Spock from star-trek, but as long as you can avoid extreme greed or fear, you will do fine.
Hard work and focus
This is one of the most under-rated factors in being a successful investor. I am pretty sure most of us were told as young kids, that the way one can be successful in life is by working hard and being diligent about it.
This simple lesson which we apply to almost every other walk of life, is conveniently forgotten by a lot of people, once they enter the stock market. It almost as if, investors collectively expect a Santa Claus to give us returns just for putting up some money in the stock market.
I cannot think of any successful investor who has succeeded without a lot of effort and focus.
Enjoying the process
At the same time effort and focus is not enough to succeed in the long run, if you do not enjoy the process of investing. There are long periods of time when you will not make a meaningful return and all the effort would be seem to be in vain.
I personally went through this phase quite early in my life as an investor. The period 2000-2003 was one mind numbing and grinding bear market when the index went from 6000 levels to 3000 levels over a period of three years. It was no different from what we are experiencing now. Companies like L&T, concor, BHEL sold at 5 times earnings.
The only reason I was able to keep learning and keep going was due my passion for investing. A single digit return on a few lac of rupees is not even minimum wage …why else would any sane person keep working hard for less than minimum wage 🙂
Everyone can do it
The secret to being a successful investor is that there is no secret at all. Inspite of the nonsense propagated by media, that the common man should leave investing to professionals, I think anyone can become a good investor.
The most important factor to be a good investor is to really enjoy the process of investing. If one loves the process, he or she will find the means to continuously learn and improve as an investor.  The returns usually come in time, if one is patient.
The return of the stock pickers
The period 2003-2008 was a big tidal wave. All one had to do was to point his or her boat in the right direction (real estate or infrastructure ?) and the wave carried you through.
The  investors who have done well in the past few years are most likely the ones who enjoy the process (and ofcourse want to make money too) and are continuously learning and getting better at it. The last 4+ years have been a time of stock picking and hard work. If you looked for good ideas and operated with an independent mind, the results have been quite good.
Let me make prediction – I am close to 100% sure on this. Once the next bull run starts (it looks unlikely , but will happen in time), you will find a lot of new investors who will boast of their investing prowess and will think that making money in the stock market is easy and effortless.
Read on13 comments

Moat or no Moat – Indian IT

By Rohit Chauhan
In Industry analysis, Uncategorized
June 15, 2012
5 Min read
25 comments
M
I recently posted the following comment on twitter
Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term
This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)
I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,
The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows
  • Switching cost due to customer relationships
  • Economies of scale
  • Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
  • Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.
Let’s look at where we stand on these factors
a.    Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.
b.    Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further
c.    Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)
d.    Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.
Weak and strong moats
Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.
A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.
My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.
Some numbers
Let’s look at the ROIC numbers for some IT companies (Indian and global)
IBM – 15-20 % (based on invested capital including debt)
Infosys – 50% (based on invested capital, excluding cash)
NIIT tech – 25%+ (based on invested capital, excluding cash)
The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.
What explains this big difference?
Eliminating some factors
I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors
Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage
Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)
Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.
The future
I will take a guess now (which is as good as yours). I think the return on capital  (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.
This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.
Read on25 comments

Evaluating the impact of rupee depreciation

By Rohit Chauhan
In General thoughts, Uncategorized
May 30, 2012
4 Min read
6 comments
E
The 22% drop in the rupee against the dollar is worrying to say the least. There are several ramifications for the Indian economy, if the slide continues.  Anything which impacts the economy, is bound to impact the stock market as a whole.
One can find a dizzying array of macro-economic analysis on the impact of the rupee depreciation and as many forecasts of the future levels of the exchange rate.
I personally consider macro-economic analysis too complex due to the huge number of variables involved in it and hence any analysis from my end is as good as yours. Instead I have been trying to evaluate how the rupee depreciation will impact my portfolio on an individual stocks basis.
I think there are three factors through which the fundamental performance  can get impacted
Factor 1: Level of Raw material / capital good import
What is the level of raw material / capital goods imported by the company?. If the company imports a substantial amount of raw material/ capital goods then it is likely to get impacted severely, if it cannot pass on the costs to the end user without impacting the volumes
Factor 2: Level of export
What is the level of export sales in the revenue of the company. A high level of export will benefit the company, if the company can maintain or improve its margins as a result of the rupee depreciation.
Factor 3: Level of foreign debt
What percentage of debt is ECB (external commercial borrowings) or FCCB? There are two key points to note here – What is the maturity schedule (payment timing) and the level of debt in comparison to equity / market cap?
The above three factors cannot be looked in isolation and have to be combined to come up with a final impact on your company.
For example – A company may have a high level of export and imports, with the exports exceeding the imports (due to value addition on the raw material). In such a case, the company will have a net benefit.
 A company using domestic inputs and exporting most of its output will gain the most from the depreciation (IT and pharma). Conversely a company using imported inputs and selling most of it domestically will be hurt badly (Oil companies).  Finally a company with high level of imported inputs, selling domestically and also carrying a high level of foreign currency debt is toast (to put it politely)
If level of export >= import + debt payment (ok)
If export < import + debt payment (trouble)
Let me give you two examples of the analysis I am currently doing on my portfolio stocks
Balmer lawrie
The company has zero debt and actually has excess cash of around 200 Crs. So we do not have forex related debt risk with the company
The company imported around 4% of its inputs and earned roughly the same amount in exports.  So at first glance, the company has close to zero risk from higher raw material costs due to currency depreciation. However the grease and lubes division uses various base oils which are petroleum based and will be impacted by the price of crude oil. As the division does not have much of a pricing power, the net margins of this division are likely to be impacted.
The other divisions such as logisitics and tours & travel are unlikely to be impacted directly due to the currency depreciation.  However the overall business will definitely be impacted by the overall slowdown in the economy.
Lakshmi machine works
The company has close to 700 Crs+ excess cash on the books and hence the risk of forex debt does not exist.
The company exported around 250 Crs of machinery and components in 2011 and imported roughly the same amount in terms of raw materials and spare parts. As a result , the company is unlikely to get directly impacted by the rupee depreciation. On the contrary, the company could benefit to a certain extent as the competitive pressure from imported machinery will reduce.
Finally I think that the textile industry level issues will have a bigger impact on the company performance than the currency depreciation.
Not a quantitative analysis
The above analysis is not a precise numerical analysis and I would be suspect of any such analysis, as there are too many variables which impact the performance of a company. The best one can do in the current circumstances is to figure out if your portfolio company falls in the high risk or low risk bucket (due to the currency depreciation).

If the risks are too high (even if not quantifiable), then one should consider reducing the position size even if it results in a loss

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog

Read on6 comments

The problem with historical returns

By Rohit Chauhan
In Uncategorized
May 20, 2012
6 Min read
21 comments
T
What is the most commonly heard refrain about the stock market these days?
My guess is that a lot of people now believe that the stock market is a nasty, volatile place where a serious investor cannot make any money. It is a place for gamblers, traders and at best for the short term investor. It is not the place where you invest your retirement money.
One cannot blame the common man for this view. The recent history of the stock market has only re-enforced the above viewpoint. The problem however is that recent history is a poor guide to the stock market or as a matter of fact for any asset returns.
Some historical numbers
Let’s look at some numbers.
The sensex went up roughly from 1300 levels in 1991 to 4000 in 2000. This gives us an average annual return in the 10-12% range. The sensex then rose from around 4000 to 20000 in the next ten years, returning around 17.5% per annum.
These returns are very impressive and also completely meaningless. These numbers hide more than they reveal. These numbers hide the fact the stock market returns are lumpy and do not come in smooth even intervals. None one made an even 17.5% per annum return during the period from Dec 2000 to Dec 2010.
Let’s break down this period as follows
Dec 2000 – Dec 2003: Index went from 3973 to 5838 (13 % per annum)
Dec 2003- Dec 2007: 5838 to 20286 (36% per annum!!)
Dec 2007 – Dec 2010: 20286 to 20509 (around 0.4% per annum)
As you can see, the returns have been lumpy and were concentrated in the 2003-2007 period.
How does the common investor behave?
Imagine an investor in 2007, who has always invested in fixed deposits, gold or real estate. He has been watching the stock market for the last 4 years and has seen the stock market rise by 300%. He is watching his friends and relatives get rich. At the same time, every time he or she visits the bank, the nice personal banker tries to push the hot mutual funds of the day by showing the fantastic returns of these funds for the last 3 years.
If you were looking at the data in 2007, it looked fantastic no matter how you sliced and diced it. The 1, 3, 5 and 10 or 20 year returns looked good.
So let’s say you got taken by the historical returns and went and bought a whole bunch of mutual funds and stocks. What happened after that?
Dec 2007 – Dec 2011: 20286 to 15454 (- 5% per annum for next 4 years)
Ouch!!!
What is the general perception now?
I have been reading quite a bit of the analysis that the stock market is a bad place to invest. Even if you are a long term investor and were invested for the last 3, 5 or 10 years, other asset classes such as fixed deposits would have beaten the stock market at a much lower risk.
I find this argument shallow and intellectually lazy.
The problem with this argument is that the person making this argument is doing data mining. He is slicing the data in such a way that it just proves his point and does not really highlight the main point about the markets
So what are the main points?
I would say there are several points worth remembering
  1. The stock market is a volatile place and returns come un-evenly. As you saw from the data above,  past returns have not been smooth fixed deposit type returns, but lumped in short periods of time.
  2. Valuations matter! If you buy at high valuations (dec 2007) and sell at the time of low valuations (say Dec 2009), you will lose money. Period!
  3. The stock market is a risky place. There will be long periods of time where you will not make money or even loose money. At a point when everyone is pessimistic or has given up, the stock market has a tendency to turn and surprise everyone. The same holds true at market peaks too.
Other asset classes
Let’s look briefly at some other asset classes.
Gold (all prices in dollars per troy ounce)
1971- 1981: 40 – 460 (25% per annum)
1981 – 1991: 460 – 362 (-2 % per annum)
1991 – 2001: 362 – 271 (-3 % per annum)
2001 – 2011: 271 – 1571 (19% per annum)
As you can see from the above numbers, gold seems to have followed a similar trajectory. There have been periods of high returns, followed by long periods of dismal returns (40 year returns have been around 9.5% per annum)
I don’t even consider gold as an investment as it does not generate any cash flow and is merely an insurance against armageddon or end of the world scenario. But I think I am in the absolute minority, considering the fact that Indians are the largest buyers of gold and absolutely love this metal. So in the end, one cannot really put a price on love!!
I don’t have the numbers for real estate, but anecdotally real estate has displayed a similar pattern. The returns were poor from 1993 to around 2003. The major gains came from 2003 to around 2008 and now the real estate market has slowed down considerably.
You will definitely find examples, where someone purchased a piece of land outside the city and was able to get 10X his or her investment. However a single multi-bagger is not representative of an entire asset class.  That’s like saying that as Hawkins cooker went up by around 1600% in the last 5 year, the entire stock market should also have done well.
The curse of past returns
I am not optimistic that the general, un-informed investor is going to change any time soon. The majority of investors are hard working, middle class people with busy lives. Investing and  the stock market is the last thing on their mind. The time when the market does catch their attention, is when it has gone up considerably. As a result, most of the retail investors end up entering the market at precisely the wrong time.
Past returns are a good starting point to evaluate the long terms returns of an asset class. However these returns are not written in stone. The best approach to evaluate the likely (not guaranteed) returns one will make, is to calculate the expected returns at any point of time and make buy or sell decisions accordingly. The topic of expected returns is however a much more complex topic, and possibly one for a future post.
Read on21 comments

Subscription

Enter your email address if you would like to be notified when a new post is posted:

I agree to be emailed to confirm my subscription to this list

Recent Posts

Select category to filter posts

Archives