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August 13, 2021

2 Min read

The following was part of a note written to subscribers. Hope you find it useful

We bought the stock a year back and added to it in December. Since then, the stock price is up 70%+. In the interim, the price doubled and then gave up some of those gains. Our buy price and fair value did not change as much during this period, which shows that business performance does not swing as much as the price

Like several other companies, the stock went from a value/ growth to a momentum play in a matter of months

When we make an investment, it is with a 2-3 year ‘rolling’ horizon. We have a 2-3-year view, but if the company keeps performing, the horizon gets extended. After a few years, if you look at the holding, it seems to be a buy and hold position. However, the ‘hold’ part is always conditional on the performance of the company

In contrast a momentum investor buys a company, when it shows up high on their momentum list (highest returns in the look back period), with their own unique set of adjustments. The time horizon for such investors is much shorter. Momentum works for 6-9 months on average and requires such investors to exit and replace with new stocks which appear on their list

Same stock, different approach

Both the investors may be invested in the same stock but are playing a very different game with a different time horizon.

The price of the company, however, is impacted by the action of all the investors, irrespective of their motivation. A loss of momentum is further compounded by the exit of such investors/traders.

I am not making a moral argument in the above and there is nothing good or bad about it. It is stupid to accuse other investors of disturbing your game. We need to aware of what is happening but be clear about our motivations.

We have a longer time horizon with focus on the long-term performance of the company. If the execution falters, we will exit. Till then, we wait and watch

In the meantime, we will not do momentum or short-term trades with our positions. Doing so would be stupid on our part. If we want to play the momentum, then the approach is very different (regular, pre-decided exits). Mixing the two leads to the worst of the two worlds

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Investing in Long term Trends

In Advisory letter

August 7, 2021

3 Min read

I wrote the following as part of my half yearly letter to subscribers. Hope you find it useful (Names of specific companies have been edited out )

Some of our positions are a bet on Long term trends. Let me describe a few

Migration of manufacturing to India (CDMO, CRAMS, Higher exports etc.) – The underlying trend is migration of manufacturing, especially high value added to India. There are multiple drivers behind it such as the China + 1 approach by the importing countries, Comparative advantage of India in certain sectors and so on
Change in Real estate cycle – Real estate has been in a downtrend for the last decade. This is a cyclical industry with long duration cycles. Once the upcycle begins, it tends to last for 5-7 years
Re-start of the capex cycle/ Infra cycle – The Capex cycle peaked in 2008-09 and has been down since then. With rising demand and utilization, we should see capacity addition in the private sector.
Financialization of savings – Indians are increasingly investing in financial products and moving away from hard assets such as gold and real estate.
Formalization of the sector – We are seeing the formalization and consolidation of several sectors in the economy

There are some names which are repeated, and it is normal for an Industry to benefit from multiple trends at the same time. When this happens, it increases the tailwinds for the sector

There are a few factors to consider when investing in companies benefiting from long term trends

Betting on the right management: Companies riding a trend have a long runway ahead of themselves. If the trend holds and management is capable, the company can compound value for a long time. Identifying the trend is easy, betting on the right management is much more difficult
Optically expensive: Such companies appear expensive based on near term earnings. The reason is that the market is discounting a long period of above average compounding.

Case in point – HDFC bank and our own holding, Vinati organics. Vinati organics is up 50X since we first bought it in 2011. Our mistake was to look at the valuation in isolation and not in the context of the broader trend. As long as the trend holds and management is executing, one should hold the stock and be tolerant of higher valuations

Boredom is the enemy: Unlike cyclical stocks, timing the purchase is not critical. Most of these trends last for a long time. Betting on the right management and holding through periods where the business keeps moving forward, but the stock price remains stagnant is the key

It is easy to overdo this trend-based investing and get carried away. However, the most common problem I have seen is investors, including me, lose patience during periods of slower growth even when the primary trend is active.

This has been the case with Vinati Organics where the stock has compounded at 40% CAGR but in spurts. The picture below shows the periods of stagnation

As the above example shows, a great long-term result does not mean absence of short-term pain

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Simplicity is the key

July 28, 2021

3 Min read

2 comments

I wrote the following as part of my half yearly letter to subscribers. Hope you find it useful

When I started investing, I thought there is some magic formulae to grow your capital. After 10 years of search, I realized that the answer was staring me in the face.

The key to wealth creation was very simple – Save aggressively and invest patiently

I had always done the first, but was doing it wrong with the second part of the equation. Like most young, hot blooded guys, my focus was to make the highest possible return in the shortest time possible. After a decade of doing that, I realized that the stress and effort was not worth it.

In addition to the lost sleep, I was reluctant to invest most of my capital to my own stock selection. Most likely, it must have been the risk of my approach which made me cautious

Key decisions

Around the start the advisory I made a few key decisions based on my past experience

All of my Liquid networth in India (excluding my real estate and some smaller stuff like LIC) would go into stocks (my own picks)
I would invest my family’s capital in the same manner
I will not shoot for the moon and my focus would be on preservation of capital above everything else

These decisions led to the following actions

No investments in derivatives, margin trading, IPO or any high risk situation
No reaching for yield in debt. Keep most of my capital in stocks and the rest in FD
No short term trading

In other words, the sleep test. Can I sleep well in the night with my current portfolio ?

The decision to focus all my investments in one bucket – A diversified portfolio of stocks lead to a simpler portfolio, lower risk and a high allocation. There is no point making 40% CAGR if you allocate only 10% of your networth to it. A 20% CAGR with 80% allocation will lead to better results is a better option

I carried the same approach into the advisory as we have always believed in eating our cooking . Outside of a few experiments which if successful, make it to the recommended list, all my investments in India are the same as the Model portfolio. It has kept my life simple and the absolute returns are good enough for me

I am now thinking on how I can simplify my financial life further. A few thoughts

Identify a few stocks which have the benefit of a long term trend. Once you are invested, be patient, till the trend is valid
Eliminate all debt including contingent ones. An example of contingent debt is money for your kid’s education or for your own healthcare in the long run
Have a proper will in place so that your family doesn’t suffer if you get hit by a bus (hopefully never)
When in doubt, reduce risk. Investing is not a T20 match. You can always bat the next day

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How to make a Free lunch

In Portfolio management

March 13, 2021

5 Min read

There is a saying in financial markets – There is no free lunch. It means that the returns you make, are commensurate with the risks taken. For example – Higher return from smaller companies goes hand in hand with a higher risk of loss in this space. This was seen in spades during the 2018-2019 period when the index dropped by 40%+ and several companies by much more

A key point which is missed by most investors is that risk is clustered – It does not happen evenly over time. You will get a long period of high returns and then lose a lot of it in a short window. Most investors ignore this point towards the end of a long bull run and get hurt in the inevitable bust

The standard approach to managing this risk is via asset allocation and diversification. I wrote about it in detail under the section ‘Asset allocation and diversification’ in my annual letter to subscribers

Diversification been called the only free lunch in the market. It means that if you diversify across asset classes and rebalance regularly, you will make a higher ‘risk adjusted’ returns. What this implies is that you will not make the highest returns at every point of time but will make good returns over a long period of time.

Point returns v/s long term returns

This brings me to the problem of perverse incentives in the financial services industry. Any time an asset class is in a bull run, you will find a host of advisors and fund managers touting their fund as if it is permanent and will last forever.

An illustrative list

2003-2008: Real estate, Commodities, Infra

2014-2017: Small cap

2018-2019: Large cap, quality

2020: Gold

How do you manage this problem? It’s quite simple: Just diversify across asset classes. Define a target allocation and rebalance at a pre-determined frequency. I can assure you that you will do well in the long run and will also have the bragging right of being invested in the ‘hot’ asset class of the moment (just don’t talk about the rest of your portfolio)

Going beyond Asset classes

There is another approach to diversification which complements the above approach. It’s called factors-based diversification. Let me explain

You can find details on factors here. Quite simply, Individual factors are quantifiable variables which can be used to explain the returns of a stock/portfolio. Following are the key factors with a simplified explanation for each

Value: Cheapness or valuation. Cheaper stocks deliver higher returns

Momentum: Persistence of returns. Any stock/asset which has done well recently will continue to do well.

Volatility: Less volatile assets give higher risk adjusted returns

Size: Smaller companies give higher returns than larger companies (adjusted for risk)

Duration/Yield: Longer duration assets give higher returns than lower duration ones. For example, 10-year bonds give a higher return than 1-year bonds.

These factors have been researched and empirically proven to be robust across asset classes and time periods. The reason they work is that individual factors do not work all the time. This is the same point I made for all the asset classes: No asset gives high returns all the time, even if they give higher returns at various points of time.

We can expand our diversification approach to include factors. There are times when value stocks will outperform momentum stocks. At other times, quality stocks will outperform other factors.

No one can predict which asset class or factor will gain market fancy in the future. As I shared, the best way to manage the timing issue, is to diversify on both the parameters: asset class and factor type

How to diversify across factors

There are two obvious ways to diversify across factors. The simplest one is to split your funds 50:50 between Value and momentum funds/indices. As value and momentum factors are not correlated (when one works, the other doesn’t), you will do well irrespective of which factor is in favor

The other more complicated approach is to build a portfolio, which is a combination of the Value, Momentum, and quality stocks. This means that some of your positions will be deep value, some will be low volatility & high-quality positions and the rest would be momentum stocks. To keep it simple, you can just divide the allocation evenly among all the factors.

The downside of the second approach is that it requires far more effort and works only if you are an active investor who wants to get every possible edge in the market

Isn’t diversification for the clueless

A common push I get is that diversification is for the clueless (as Buffett says so). My glib answer is that most investors are not Warren Buffett. I have now been investing for 20+ years and no matter how hard I work, I will never be a super investor like one of the greats.

It is nice to quote these statements from the super investors, but the more important point is to evaluate your own performance and come to your own conclusions. I know for a fact (supported by evidence), that I have been far better served by being adequately diversified

In most cases, one would be far better served in being adequately diversified across asset classes and factors. It may not make you rich but will ensure that you have an adequate nest egg at the end of it.

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Investing is not an Engineering problem

December 29, 2020

3 Min read

I have an engineering background and a very quantitative/rationalistic lens of looking at the world (does not mean I am rational). What I mean is that when I am analyzing a company and valuing it, my assumption is that all investors will ‘objectively’ look at the numbers and value it in the same fashion.

This approach to investing has its merits and works most of time. However, it has limitations and overweighing it leads to problems.

The above is the performance of a company which by all objective standards has done reasonably well. It has grown topline at 14%, profits at 19% with an ROE of 17% over the last five years. However, the stock is down 70% during this period.

Now you may thinking that this company has some governance issues and there is something seriously wrong with its business model. Let me share the name of the company – Its Repco home finance. This is an old position and you can read the prior analysis here.

We closed the position in Dec 2016 when the company was selling at around 22 times earnings. The main reason for exiting the stock was that I was concerned about the quality of the book (NPA). How did the NPAs turn out?

I hate to say this, but I was right for the wrong reasons. The NPAs have risen in the last few years, but the rise has not been alarming, and it includes some of the worst periods for economy and the financial services Industry. Inspite of that the company closed FY20 with 4% GNPA (which is similar to most private sector banks).

The net NPA for the company is 2.8% which is not high and should improve going forward. So by all objective measures the company has done well but the stock is down 70%. It is selling at around 5 times earnings and 70% of book value.

We can all debate about what the future holds, but based on the past few years it is unlikely that it will be worse than the last few years. The above is but one example of how narrative often overwhelms the performance of a company.

A rationalist like me would say – Lets wait for some more time and the market will eventually recognize the true worth of the company. But the point is how long should one wait ? 3,5 or 10 years ? There is an opportunity cost of holding such a position

This kind of scenario has played out with a few of our other positions and has made me question the limits of fundamental analysis. This does not mean that fundamental analysis has no value and should be thrown out of the window. That would be equally foolish.

In order to account for such cases, I have become more sensitive to the narrative around a company and a sector. If the narrative does not change and the stock price does not reflect the fundamentals, then I am more likely to exit a position even if the numbers are fine. We can always re-enter the stock when the market starts changing its view.

Investing in the markets is not an engineering problem which can solved by logic alone. In the past I have failed to account for that to our detriment. The best way to manage this kind of trap is to have a time fuse for each idea. If market does not come around to your view inspite of no change in fundamentals, then one should just exit – No questions asked !

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The Momentum mindset

In Investment process

October 4, 2020

4 Min read

1 comment

From my recent note to subscribers

I have spent the last 9-12 months digging deeper into other approaches to investing. I have read up on the momentum style, technical analysis, trading, options and more. The reason was to understand how other investors think

It is easy to become dogmatic about your approach and think only you have access to the ultimate truth. I have been guilty of that. I have seen a few value investors (including friends) talk about these other approaches and that intrigued me to dive deeper.

It has given me a better appreciation of these other styles and understand (NOT predict) the price movement in stocks much better.

I have defined my approach as value investing – buying companies for less than their intrinsic value and then holding them for the long term (2-3 years). This approach involves deep analysis of the business and its prospects. However an under-appreciated aspect of value investing is the time horizon.

Value investing or in other words convergence of price to value of a company, usually happens in 2+ years. In the short term markets are quite efficient and tend to price the near term quite well. The gap (if there is any) usually closes over the long run.

The approach is sound and has worked for a long time. What has changed ofcourse is the definition of value. If you still follow the traditional approaches of PE, P/B ratios and so on, then you will not do well as markets and economies have evolved a lot in the last 15-20 years.

In comparison, other approaches such as Momentum (where you buy stocks which have done well recently in terms of price performance) have worked quite well in the recent past. This approach is practiced more widely in India and there are a lot of very successful practitioners. The difference however extends beyond just the approach. It also involves a shorter time horizon and a difference in temperament.

Although the upside is good, this approach comes with its own risk in the form of momentum crashes. Investors who practice this form of investing have a methodology (rules based or otherwise) to exit their positions when the momentum turns to reduce the downside.

This often means changing your view and portfolio positions overnight. It is important to recognize which approach fits your temperament and which positions make sense for it. The worst thing to do is to buy a momentum stock with a value investing framework.

The momentum mindset

Even though I am not picking stocks based on momentum (yet), I want to build that mindset into my decision making process. The trading or momentum mindset is more rational, even more so when it is rules based.

Investors who follow the non-discretionary approach in momentum or trading, exit their positions when their system gives the signal to do so. Their effort is to back test the system and validate it. However once that confidence is developed, it is followed with discipline.

On the contrary investors like me, tend to get wrapped up too much with our narratives (or stories). As result, even when external conditions change, we tend to stick to our outdated stories and refuse to exit the position.

I have been guilty of this and even when I do change my mind, tend to get emails accusing me of abandoning a stock as if we should remain married to it forever.

I have been re-thinking my approach and you could see a higher turnover or exits even where I was optimistic or positive earlier. Some of you will hate me for taking small losses when I am wrong. I will treat that as an occupation hazard.

It is far better to take a small loss initially than lose much more later.

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Negative free cash flow is (often) a good thing

In Business, Company analysis

September 16, 2020

4 Min read

1 comment

I tweeted the following half-jokingly

This is in response to comments from investors and analysts where they raise a red flag on a company with negative free cash flow, without further analysis.

What’s free cash flow

Let’s define free cash flow for a business

Free cash flow = Operating cash flow (including depreciation) – Maintenance capex

Maintenance capex is defined as capital required by a business to maintain its unit volume and competitive position. This capex would be in the form of working capital and fixed assets.

Let’s take a simplified example to illustrate it. Let’s say you own a house on your own piece of land (a rarity but go with me on this one). After a few years, you decide to get the house repainted as the old paint is peeling off and there are cracks in the wall. Let’s say you spend 5 lacs on the whole thing.

After the house is painted and repaired, you feel good about it. Keep in mind that the value of the house hasn’t gone up. If you were to list the house it would not sell for more (though it could have sold for less if the repairs had not been done).

Let’s fast forward a few years. You decide to extend your house and build a new room. The square footage of the house goes up by 15%. If you decide to sell the house now, you will be able to get a higher price for the house as the area of the house has increased.

The first scenario is that of maintenance capex – money spent to maintain value of the asset. The second is the case of growth capex – money spent to increase the value of the asset.

No published numbers

The same point holds true for a business/ company. The only difference is that a company will rarely break out the annual investment into maintenance and growth capex. This is something an investor has to figure out based on a study of the business.

Investors look at the cash flow statement with the following math

Operating cash flow + depreciation – working capital investment – fixed asset investment

If the above number is negative, they flag it as an issue. The problem here is that the investor is not distinguishing between growth and maintenance capex.

Any money spent on maintenance capex does not increase the value of the business. If all the investment in the above equation is maintenance capex and the resulting number is negative, then it is a red flag.

A lot of businesses, especially in the commodity space, have to keep investing just to stay in the same place from a competitive position. That’s the main reason why these businesses do not create value for their investors over a business cycle.

A company in growth phase and investing into growth capex, will also have negative free cash flow which could create value down the road.

How to evaluate growth capex

This requires a detailed understanding of the business and competence of the management.

There are businesses which requires very little maintenance capex (almost equal to depreciation) and re-invest all their free cash flow for growth and at high rates of return. Such businesses create a lot of wealth for their shareholders in the long run.

The key point to evaluate is whether the investment is being above the cost of capital (including debt). If yes, then you want the management to invest as much as it can (within reasonable limits) as these incremental investments will create value for us down the road.

The main job of the analyst is to figure out whether the management is truly investing above the cost of capital. That unfortunately cannot be accurately estimated to a decimal point, though there are indicators which can help you make an educated guess. You need to ask questions on the attractiveness of the industry, the opportunity size and capability of the management (based on past performance) and come up with a rough guess.

The next time you hear someone talk of negative free cash flow without an analysis of growth v/s maintenance capex – you can recall my tweet above. Such a person is implying that spending on education is a red flag as there no free cash flow being generated in the present.

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Survival is the ultimate prize

August 19, 2020

3 Min read

5 comments

It seems ages since I wrote the following comment three months back

How does one invest under such extreme uncertainty? One option is to assume that there will be a quick recovery and go all in. The other extreme is to wait till it is all clear and then deploy the capital. In the first approach one is making a bet on a specific scenario which may not occur, leading to sub-par results. In the second case, we may end up with sub-par returns too but only because prices will adjust once all the uncertainty goes away.

At that point of time the future was uncertain and anyone making a specific bet was ‘assuming’ a specific scenario. If we assume that 50% of the investors bet on rapid recovery and the other 50% bet on the whole thing dragging on, the first group turned out to be right.

You are now hearing from such investors who went all-in, in the month of March/April.

It could have easily gone the other way and in that scenario, the second group would be highlighting the merits of being cautious, whereas the first group would have been silent.

I personally avoid taking a specific view of how the future will unfold. The risk of doing so is high, if you get it wrong. If you are managing money for others (like me), then the risk is asymmetrical. If you get it right, you can tout your performance. If not, then your investors bear the brunt.

I will not tar all managers with the same brush. A lot of them, including us, are invested the same as their investors. In such cases, the behavior of the manager changes quite a bit. In such cases, your focus shifts to survival, than shooting the lights out. It does not mean that you will not make mistakes, but are very focused on managing the risk.

If the goal of investing for an individual is to achieve his/her financial goals, then the first priority is to ensure that you don’t incur a massive loss from which you cannot recover. The older you are, the higher the risk. I would recommend an individual investor to NOT look at the performance (especially near term) of professional investors. You should never do what this class of investors is doing, not because they are smarter (they are not), but because of the asymmetry of risk faced by them.

I took the following approach in the middle of the crisis

Under the circumstances, my approach is that of ‘regret minimization’. That’s a fancy way of saying that I will do something in middle, so that I can avoid FOMO (fear of missing out) if the first scenario occurs, but at the same time have enough dry powder available incase the economic recovery takes longer.

Instead of going all in, we have slowly added (and even sold) positions as shape of the crisis has become clear at the company level (and not at a macro level). It has allowed me to sleep well and live to fight for another day.

In investing, there is no finish line and gold medal at the end of it. The end goal is survival and meeting your financial goals.

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Basket Bet

In Investment ideas, Risk management

June 22, 2020

4 Min read