Blog

Throwing in the towel

By Rohit Chauhan
In General thoughts
May 16, 2020
3 Min read
Add comment
T

-2%

-28%

-48%

This is what you have lost in the last three years if you invested in nifty 50 (large cap), Nifty Midcap 100 and Nifty Small cap 100. Even these numbers understate the actual losses. Large caps appear to be a safe haven, but even that is driven by a handful of companies.

One can find comments on media, comparing equities with other asset classes such as fixed deposit, gold etc. and implying that equities are doomed to perform poorly in the future.

I think such people are too lazy to look at the data. Equities over a 3, 5 and 10 year periods outperform all other asset classes. What is not stated that equities DO NOT outperform in ALL 3,5 and 10 year periods. This difference may appear to be subtle, but the effect of it is not.

The probability of equity underperforming other asset classes is as follows

3 Year rolling buckets     :             25%

5 Year rolling buckets     :             18%

10 Year rolling buckets   :             10%

What the above stats mean is that for every 3-year rolling period, equities can underperform other asset classes such as fixed income, one out of three times. The recent 3- and 5-year period has been one of those times. This is another representation of risk, namely that a particular asset class will underperform from time to time.

If you are losing patience with equities as an asset class, there are two questions you need to answer for yourself

Do I believe equities as an asset class will deliver high returns in the future?

The way to look at this question is to look at the last 100+ year of data across countries. This data supports the view that equities do outperform all other asset classes over the long run. However, there are periods of underperformance which test the patience of almost all investors.

Do I believe the fund manager can deliver above returns?

The way to look at this question is to look at the performance of this individual/fund house over the long run (across market cycles). Different styles are in favor at different points of time. 2014-2017 saw small and midcaps do well. Large caps, especially quality has done well in the last two years. In order to eliminate the chance of luck, look at the performance of the manager over a 5 to 10-year period and check if the investment approach makes sense to you (and suits your temperament).

There is no magic pill which will convince you to invest in equities. Data can help you make a rational decision, but at different points of time in your investment journey, you will need some blind faith to keep going.

I have been through such periods in the past (in different aspects of life including investing) and often faith supported by data has worked for me.

Read onAdd comment

Regret minimization

By Rohit Chauhan
In General thoughts
May 7, 2020
6 Min read
1 comment
R

I shared a framework in the previous post on how I am analyzing  my current positions to evaluate the risk. Some of the companies in the portfolio have applied for a debt moratorium which if accepted, reduces risk for the company. At the same time other companies plan to raise debt to fund working capital due to the drop-in revenue.

We are likely to see similar actions by other companies across the spectrum (debt moratorium, debt or equity raise)

I have been running a similar filter on the new ideas too, which need to have the capacity to sustain operations for a year without running out of cash (either from operations, balance sheet or through borrowings)

Regret minimization

This is a lot of discussion in the media and investor community on the shape of the recovery – will it be a V, U, W or some other form. In my mind, this is an important but unknowable factor. It depends on the following factors which cannot be forecasted with any certainty.

  • How long will the lock down last?
  • Will the lock down be lifted in phases (both in terms of time and geography)?
  • How will this event impact consumer behavior (short and long term)?

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.

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.

I continue to look for companies which can survive the crisis and will add them to the portfolio in a staggered fashion. We will not be able to pick the absolute bottom or make the highest possible return, but at the same time will be able to avoid any extreme outcome.

Obsession with market bottom

There is a lot of chatter on social media and I have received some emails on this point too. The question usually is – Has the market bottomed or is it some way to go? The true question which people are asking is this – Is it safe now to buy stocks considering that the market has already passed its bottom?

Although there are some technical approaches which are used for finding market bottoms, I am in the camp that no one knows for sure and it is not even worth knowing. I personally think an obsession with market bottom is worse than a waste of time. It will impact your thinking and corrode your decision making.

If you agree with the analysis in my previous note, our focus should be on solvency and survivability of the companies we hold or plan to add. If a company can survive the next 1-2 years and its business model is not impacted, then it makes sense to start buying the stock if the valuation is attractive. This assumes that the company has good prospects in the long run.

We started adding to our positions recently and it is quite possible that the market and our portfolio could drop from the current levels. I am however not concerned with such losses. I am more focused on the short-term health and long-term prospects of the companies we hold.

Impact of one year

Let’s review the first principle of investing – The value of a company is the sum of discounted cash flow from now to the time when the company closes/goes out of business or is bought out.

If we analyze a company and conclude that it can survive the next 1-2 years of stress without an impact to the long-term business model, then it comes down to evaluating the impact of the epidemic to the fair value of the company.

Let’s assume that the company will not have any profits for 1-2 years. If you run a DCF with this assumption, the intrinsic value reduces by 8-12% depending on the assumptions around growth, return on capital etc. If that is the case, then most companies have corrected much more, and the market is assuming a worse outcome for them.

To be fair, a DCF is just one input and the market does not work on pure math and logic. The point I am trying to make here is that if we can buy or hold companies (based on our framework) which survive the next 1-2 years, without an impact to their long-term prospects, then the long-term returns would be good.

If you agree with the above approach, does it really matter if we are able to catch the bottom of the market or a particular stock? As I have said repeatedly in the past – If I get the analysis of a company wrong, a 10-20% difference in buy price will not make a difference. The key is to get the analysis right.

Changing my mind frequently

A lot of assumptions and expectations have changed in the last few months. What was considered impossible (locking down an entire country) has happened now. In such an environment, where facts keep changing, it is important to keep an open mind.

I am following the news as everyone else and do not have any special crystal ball to see the future. As a result, it is important to change your mind and not hold onto old assumptions. I did that in the early part of the year when I suddenly became bearish and raised the amount of cash in the portfolio.

We are adding to the portfolio (in a staggered fashion) but this is not based on some specific forecast. If the situation changes, I will change my stance again. Please be ready and prepared for any decisions I take.

Read on1 comment

Stress testing the portfolio

By Rohit Chauhan
In General thoughts, Investment process, Risk management
April 18, 2020
3 Min read
1 comment
S

< Company names and details of the same have been removed>

To all subscribers,

I have been asked about the impact of the ongoing epidemic (Covid19) on our portfolio companies. I have been doing this analysis and this note is to describe the process. This is a probabilistic exercise which depends on the following factors

  • How long will the lock down last?
  • Will the lock down be lifted in phases (both in terms of time and geography)
  • How will this event impact consumer behavior (short and long term)?

All the above factors are important, but unknowable for now. We have a range of guesses floating around with unknown probabilities. Instead of trying to guess what is going to happen, I have tried to analyze this situation in a different fashion. I have broken down the problem into three-time buckets with a specific set of questions for each bucket

Short term bucket (3months)

  • Does the company face bankruptcy risk (due to zero revenue)
  • What is the liquidity situation for the company? In other words, does the company have enough cash/ access to credit to tide over this period

Medium term bucket (3-9 months)

  • What is the break even revenue for the company at which it can it can sustain its manpower expenses and mandatory overheads (rent, power etc)

Long term bucket (> 9 months)

  • Is the long term demand for the company impacted by this event?
  • Will the consumer behavior change permanently such that the company’s business model will be impacted?

The above questions are crude approximations and I am not trying to come up with a numerical impact on fair values. I have seen some analyst reports where they have changed the target price by X%. Putting a number, does not change the fact that this is still a guess.

Some of the conference calls by company managements show that they are also grappling with the unknown and do not have visibility on the numbers. To assume that an outside investor can do better is silly.

I have evaluated these questions using the following data points

  • Liquidity risk/ Credit report from ratings agencies
  • Company annual reports/ financial statements to evaluate how long the company can survive with zero revenue and the level of topline needed for break even
  • Management commentary

The stocks in the model portfolio are arranged based on their risk profile. This sequence is again a rough approximation of the risk. What this means is that company 2 is not more risky than Company 1, but Company 2 has lower risk than Company 14 which is at the bottom of the portfolio.

Dynamic situation

The impact on each company will depend on how long the lockdown lasts, whether it is consumer facing and the fragility of its balance sheet. In our case, most of our portfolio companies (other than financials) have low to zero debt. There is only one position which has high debt levels and is exposed to the consumer. As a result, this company is the lowest in the model portfolio and has been on hold much before the current situation (old subscribers including me continue to hold it).

I will be addressing a few more topics in my next post with the above framework in mind.

Read on1 comment

How do I execute ?

By Rohit Chauhan
In General thoughts, Risk management
March 29, 2020
3 Min read
Add comment
H

To all subscribers,

I have been emailed variations on this question – What, when and how much should I buy based on the model portfolio?

Before I share my thoughts, let me share a few pre-conditions

  • Please ensure that you have around 6-12 months of cash or equivalents (like FDs) to take care of your expenses. This would ensure that you can handle any loss or reduction in income.
  • Do not and I repeat, DO NOT invest any capital which you need in the next 2-3 years.
  • Do not use any form of debt to invest in the market. A lot of crazy stuff can happen, and we have seen the impact of debt in the form of margin calls in the recent past where individuals were forced out of their positions.
  • There will be volatility in the near term. Be prepared to see wild swings in portfolio.

Both me and kedar have arranged our personal affairs in the above manner. We maintain enough liquidity and avoid debt, so that we can remain rational inspite of extreme swings in the market. We have never used even a single rupee of debt to invest in the market. There is enough risk in equities and we don’t want to amplify it more.

Onto the question of how to execute

  • Please review your asset allocation (yourself or with your financial advisor) and invest an amount which matches with how much you are willing to allocate to equities. This allocation is based on individual situation and there is no fixed percentage. That said, one should exceed this allocation.
  • Once you know the amount you can allocate based on the previous points, one of the options is to invest it as per the model portfolio. If that is the case, the amount per position is based on the position size in the model portfolio (multiply position size % with the amount you want to invest)
  • I have shared the buy price which can be used as reference to make a buy decision. If the current price is below the buy price (which it is in most cases), then you can add that position to your portfolio.
  • I would suggest going for a staggered approach. Start with 25% of the final size and keep adding to it over the next few weeks/months (as long as it is below the buy price). You won’t get the absolute bottom for each position, but should get a decent average price
  • In terms of adding positions, go from the top to bottom. The bottom most positions have the highest risk, but also the highest upside (should they work out)
  • Be ready for wild swings in the price

It is natural to feel confused and concerned about losing money under the current circumstances. The best course of action in such a situation is to slow down your decision making. It is important first to survive and then thrive/ take advantage of the uncertainty.

Read onAdd comment

Actions in the Fog of War

By Rohit Chauhan
In Advisory letter, Views on news
March 21, 2020
3 Min read
4 comments
A

From my recent note to subscribers,

To all subscribers,

I have been writing to all of you for the last few weeks as I became concerned about the Corona virus Epidemic by the mid to late Feb when our small caps positions started behaving differently.

As I thought through the situation, I could not see a scenario where this epidemic could be stopped without causing a huge disruption to economic activity. That was my reason for saying that Tail risks were not priced into the market.

That scenario is now playing out across the globe. We are seeing shutdown of entire regions now. This is what I meant by economic sudden stop.

If you notice, I arranged all my posts in a neat narrative as if all of this could be predicted with perfect foresight. The reality is that things are moving very fast and continue to be murky. We have yet to see the second and higher order effects of this crisis as it depends on how long the shutdown will continue.

For now, there are all kinds of opinions on how long this will last and when the economy will come back. I think the most important variable is how quickly the spread of this virus is contained across the globe. That is something, no one knows for sure (and everyone hopes is short).

We are making decisions in the fog of war. We will get some of them wrong, but the focus is to get a good percentage right. As you can see in the last few weeks, I have changed my thinking and cash levels in response to the data which was coming in (at a rapid rate). That is likely to continue and as a result, my thinking and decision will change as the situation changes.

The cash level is at 42% of the model portfolio, partly from selling down some of our positions and balance due to the drop in the portfolio. We had closed the year at around 23% cash level and have raised it by 40% in the last few weeks.

I want to share the following actions from a financial standpoint

  • Please ensure that you have at least 6-9 months of cash or FDs so that you can take care of your expenses if there is a loss of income. This will help you remain rational and avoid panic selling to meet expenses.
  • It is going to emotionally tough and gut wrenching to remain invested. Your mind and emotions will scream at you to get out. It will be a torture to put money into the market and lose 20-30% in a matter of days
  • I maintain a list of 200+ companies which I track from time to time. I have been working on this list for the last few weeks and updating them. The buy candidates will be from this list. I am in no hurry to rush in.
  • My focus is not to time the market or pick the bottom for specific companies. I am focused on ensuring that we pick companies which can make it through. If a company survives the next 6-12 months, the stock will do well.
  • I am not too concerned about valuations. At the current rate, valuations are dropping rapidly and if we pick robust companies, then returns will take care of themselves
  • It is a given that I will get the timing wrong. I will either buy too early or too late. I hope you have already realized that and are fine with it.
Read on4 comments

Economic sudden stop

By Rohit Chauhan
In General thoughts, Risk management
March 17, 2020
3 Min read
1 comment
E

I wrote this note over the weekend to my subscribers. This is a hypothesis based on how events have played out across countries. Things could get better, but the probability of that happening in the near term keeps reducing by the day. We are seeing the first order and maybe the second order impact of the Pandemic.

————————–

What is an economic sudden stop – It is when most economics activities for a location come to a sudden stop due to a financial or natural disaster. In most cases such sudden stops are local such as due to a flood or an earthquake.

On rare occasions we get economic sudden stops at country level due to economic reasons – think of Asian currency crises in 1997.

Global sudden stops are extremely rare and have happened only during the great depression in 1930s and 2008. Even during wars, we do not have such a situation.

The current crises has the potential of an economic sudden stop (and may have started). I have been thinking of this risk (which I have been referred to as a Tail risk). Over the weekend, I drew the following crude picture to illustrate my hypothesis (please excuse my drawing).

Key points

  • Due to the exponential nature of the spread of this infection, most countries have under-reacted in the beginning.
  • Once the numbers cross the threshold, a country has an Oh shit ! moment. US and Europe had it last week. I don’t think India has had it yet.
  • Once we cross this moment, we enter the panic phase quickly where all economic activity slows down dramatically as the country stops travel, and all kinds of social and business events which involve more than a handful of people (update : US has banned all events for > 50 people)
  • We will not see a gradual slowdown of economic activity. It will drop off the cliff.
  • As you can see from the picture, economic activity will resume (slowly) as the situation normalizes. As of today, we cannot predict when it will happen as it depends on both the domestic and International situation.
  • This is a major event and will permanently change the behavior of Individuals and Countries. Its too early to predict what will happen

Action plan

  • The focus should be on making through this event – both health-wise (both self and family) and financially
  • As I shared earlier, I will not try to rush into the market based on valuations alone. Depending on how things play out, the financials and even viability of a lot of business will change
Read on1 comment

Tail risks

By Rohit Chauhan
In General thoughts, Views on news
March 13, 2020
6 Min read
Add comment
T

I published this note to subscribers on 12th March, just the day before markets went haywire. I was feeling that Indian markets were not pricing in the Tail risks. That has changed since then. We are now seeing extreme volatility in the markets now.

————————

I wrote last week about the developing risks around the Corona virus epidemic. The main reason for raising cash was the concern I have around ‘Tail Risks’

What is a Tail Risk ? As per Wikipedia – Tail risk, sometimes called “fat tail risk,” is the financial risk of an asset or portfolio of assets moving more than 3 standard deviations from its current price, above the risk of a normal distribution. Prudent asset managers are typically cautious with tail risk involving losses which could damage or ruin portfolios, and not the beneficial tail risk of outsized gains.

The corona virus represents a tail risk in my mind. Even if we assume the health risk is low (I don’t know about that), the risk of an economic panic is quite high. I have been tracking the US markets and industries which are being hit due to this Epidemic. Industries in the travel and tourism space, have been hit hard. Travel and airline bookings have collapsed and places like Macau (casino in China) have reported an 87% drop in bookings.

The recent PMI (purchasing manager’s index) for China reported an all time low (lower than 2008). In effect economic activity is at a standstill in China (and now in Italy too). There are reports that it is re-starting, but it would take time as people are not going to forget about this event overnight and resume all the normal activities.

The bigger concern now is the spread of the virus in Europe and US (where it has been handled very poorly). US has been behind the curve and has yet to resume large scale testing. When that happens, the number of cases could increase, leading to slowdown in the economic activity. The US market is already starting to discount these concerns

Adding fuel to the fire

There could not have been a worse time for a large bank to Fail. Yes Bank which was on a life support, was finally taken over by the government (sort of). There is a moratorium on  withdrawals by depositors as RBI works through resolving the situation. SBI is likely to invest around 2500 Crs for a 49% stake with the rest coming from other investors.

I have serious concerns about this event. In response I wrote the following on twitter

The true franchise value of a bank is on the liability side – aka trust of the depositor. The depositor is your true customer from whom you make money – Interest spread (NIM) and other income from selling financial products. Lose the depositor and value of a bank = 0

If you want to ‘save’ a bank, ensure that the depositors have 100% faith on the bank. No doubts, ifs, buts and maybe. Look at how FDIC in the US resolves troubled banks. It comes from the experience of bank failures in the 1930s during depression

The long-term risk with the way Yes bank has been rescued, is the loss of Trust of ‘depositors’ with the banking system. Giving aspirin to a patient with cardiac arrest does not help. As Yoda once said – Do or Do not, there is no Try

I am very concerned the way this Bail out has been in done. In the US, such bailouts are done by the FDIC swiftly, without the customer realizing that ownership has changed until much later. Typically, FDIC agents land up at a troubled bank on a Friday, take over the bank and change the management over the weekend. When the bank opens on Monday, there is no change for the end customer. For them, there are no restrictions on withdrawals and life goes on as usual. A few days later they are informed that the bank name or owner has changed which has zero impact on them.

The above approach which was developed during the 1930s depression to avoids panic and helps in resolving a failed bank without causing a run on it.

In the case of Yes bank, the restriction on withdrawals mean that customers will continue to withdraw till they have their entire money out. Put yourself in a customers’ shoe – why would you risk your life savings/ cash with a small upside and the risk (even if imagined) of losing it all.

Is this an IL&FS repeat

The unfortunate answer is yes and this time around the general public has been impacted. When IL&FS collapsed, the impact was felt by corporates, NBFCs and mutual funds (debt funds). The general public was not impacted to the same extent.

This time around the impact is being felt by a much wider segment of the population. I believe that the government will not let the bank fail (as they have stated) and depositors will not lose money. However, the trauma of seeing your money blocked for a period of time will be high. A bank depositor never signs up for this.

The timing for this event is very unfortunate. IL&FS happened when the global economy was moving along fine. We have a major event occurring globally and now the problem with Yes bank is sure to add to the risk aversion.

Expect volatility

I exited/ reduced our position in financials and avoided any further investments in financials in 2019. We are seeing a repeat of sept 2018 now in the form of price reaction. The difference is that our exposure to the financial services space is much lower and hence the impact for us is muted.

As it occurred in 2018, the impact of these events will be felt in the coming months and in surprising places . Our portfolio will be impacted by these events and I don’t think there is any place to hide (other than cash).

If you are not fully invested and plan to add based on the model portfolio, I would recommend staggering your purchases. In terms of the cash in the portfolio, I plan to add new positions in the coming weeks/ months. I am not in a hurry to do so. We will take our time and not try to pick the bottom of this market. The key will be to invest in companies which can survive the tough environment and thrive when the tide turns.

Read onAdd comment

Battening down the hatches

By Rohit Chauhan
In Quick thoughts, Risk management
March 9, 2020
3 Min read
Add comment
B

I published the following note (with edits) to subscribers on 1st march before things started going downhill in a hurry. I have another note going out which will be posted here soon.

———————-

I have been watching the events around the Corona virus for the last few weeks and started seeing some impact on our portfolio, towards the end of January. I wrote a note – Why are we suffering, sharing the observation that our portfolio was behaving in a bi-polar fashion. The so-called quality stocks which have higher predictability of growth, were holding steady while the cyclical positions were being beaten down as if all these companies were headed to bankruptcy.

In hindsight, this behavior seemed to be a reaction to the risks which were developing in the global economy due to the Corona virus.

In the last few days, these risks have risen substantially. I am not an expert in these things, but the preliminary data seems to point to a high infection rate (also called R0 which is around 2.2 versus 1.3 for common flu, which means one person can infect two others). At the same time, the mortality from this infection is around 1.2-1.5%.

The above numbers are preliminary and likely to change. However, a few things have become obvious in the last 2 weeks

  • The transmission rate is quite high, which means that there is high risk of the infection spreading globally
  • We have already crossed or maybe are at the brink of crossing the point of containing the infection. Again, there is a lot of confusion around this point
  • In the worst-case scenario, even if the mortality rate is low, the absolute number of deaths will be high

Unfortunately, in India, we are quite used to such infections in our main cities due to poor levels of sanitation. We tend to take such events in a stride. However, this is not the case globally. Irrespective of the trajectory of this epidemic, there is a high level of fear across the globe. This is leading to a big slowdown across the globe as companies stop travel and governments quarantine portions of the population.

We are seeing the first order effects of the above event. Like the ILFS event in India, which had a domino effect on NBFC, real estate and the overall economy, the second and higher order effects will take time and will show up in surprising places. In my view, it is too early, and I would say impossible to predict how this situation will evolve (for better or worse).

I have reduced the position size for the three companies where I think the medium-term growth prospects were moderate and valuations continue to be on the higher side. I have raised the cash levels so that we have dry powder available to pick opportunities as they arise.

We have 30% cash in the portfolio now

If we are lucky, everything will return to normal and markets will resume their normal course. However, if the risks of a pandemic increase, we will see a lot of selling in the market. This selling will not be rational, and it will not be tied to the fundamentals of a company. In such panics, people sell whatever they can.

I have no plans of burying my head in the sand. If prices get attractive for some of the companies I have been tracking, we will add them to the model portfolio even if the prices continue to fall. I am willing to bear more pain in the portfolio as I think this will eventually pass.

Read onAdd comment

Avoiding failure

By Rohit Chauhan
In Investment process, Rejected investment ideas
January 17, 2020
5 Min read
3 comments
A

The following is from my annual letter to subscribers. I will be posting the letter soon on the blog

There are a few irrefutable statistics of the India stock market. Over the last 10-year period around 50% of small caps (and roughly the same for midcap), lost money for their investors. Only 10% of the companies in this space accounted for most of the returns of the index.

In such a scenario, rejecting stocks is an equally important task in building a portfolio.

We have been focused on this aspect from the beginning of the model portfolio but have not discussed it in depth. The last two years has brought this factor into the spotlight and I want to share the process we use to filter ‘out’ stocks.

The first step in filtering out stocks is quite simple. I look at an idea and reject it if any of the following conditions are met

  1. Management has past record of illegal actions or are known for bad governance practices. This is a subjective criterion, but one can filter out the obvious cases
  2. Debt equity (other than financials) is greater than 1.5
  3. PE is greater than 60
  4. Company operates in an industry with poor economics (return on capital over a business cycle has been below 5%)
  5. IPOs

Some of you may look at this and point out that ‘so and so’ company has been a value creator in spite of meeting some of these conditions.

To this my response is this – An elimination process works on probabilities. If you pick 100 companies which have a very high PE or very high debt, 80% or more will lose money for their shareholders. There will always be some which buck the trend.

I am not trying to win an intellectual contest of picking a winner with odds stacked against it. If you play this game long enough, the probabilities eventually catch up with you.

If the idea survives this step, I move on to the next series of checks. These checks are detailed out in the spreadsheet I upload for every company. I have extracted the specific sections used to reject an idea and uploaded here for reference.

Please keep in mind these checks are not quantitative and there is no mathematical formulae which will throw up an answer. Think of these points as checklist/questions to dig deeper into the company

  1. Fragility – I added this section recently and use it to check whether the business would collapse if some of these risks materialize. For example – Does the company have a major concentration with a single customer or supplier. What will happen if this partner pulls out?
  2. Management checklist – I have had this section for a long time and have added to it over the years. There are sub-sections to check if the management actions have been ‘suspect’ in the past and point to unethical behavior
  3. Accounting – This has an exhaustive list of possible accounting games companies play. I have created this from multiple books on financial fraud and accounting malpractices. 2018/19 had a few repeats and some new ways of fudging accounts
  4. Risk analysis – I added this section a few years back and it is for a deeper analysis of risks and their probabilities.

As you can see from the file, this is a checklist to ensure that I don’t miss something obvious. At the same time, this will not prevent mistakes from happening. A management may be able to hide some of its behavior for a long time and it may come to light after we make an investment.

These points are not black and white and involve a judgement call on where to draw the line. In the past, I have been more tolerant of management behavior, but have realized that even if a particular idea works out, the long term average of such decisions will be disappointing ( I have called this riding a tiger in the past)

As you will note, this process works on evidence or past history of a company and its management. If that is missing, we are flying in the dark. This is another reason for me to avoid IPOs. In most IPOs, the business has been dressed up for sale and all the skeletons tumble out after the listing.

The aggregate performance of all the IPOs in the last 2 years bears this point. Pointing out a few successes, only proves that they are the exceptions and not the rule.

The downside of this process is that I may end up rejecting a company which turns out to be a success. I am comfortable with that problem as long as I can avoid failures. A portfolio of 20 companies out of a universe of 3000+ stocks means that will we miss a lot of winners.

The more important criteria is to avoid the losers.

Read on3 comments

Are we on a different Planet?

By Rohit Chauhan
In General thoughts, Rejected investment ideas
December 3, 2019
5 Min read
9 comments
A

I was recently analyzing the asset management industry and started looking at HDFC asset management and other companies in the space. As I always do, I started comparing with other asset management companies around the globe. The valuation gap has blown my mind. I often wonder what Indian investors are smoking to be so optimistic.

The opportunity size is large and all kinds of nice things can happen, but this gap is not so big that valuations of Indian firms should be 5X of a similar firm.

Let me give you one such example – KKR & Co. This is a global private equity firm which has expanded into other aspects of Alternative asset management. The company has been investing in real estate, private credit, public markets and other hedge funds. The company has around 210 Billion in AUM and is valued at around 24 Bn or 11% of AUM

In contrast, HDFC AMC manages around 51.7 Bn and is valued at 11 Bn or 21% of AUM. So 2X the valuation on the face of it. Just hold that point for now.

The first reaction of most Indian investors would be to say that India has a long runway, HDFC is a strong brand, we will soon be a 100 Gazillion economy yada yada yada. The problem is that once the stock price rises, people come up with stories to justify it.

I am not denying that HDFC is a storied name and has good growth opportunities. However that does not mean you can justify any valuation. Let’s look at some facts

  • HDFC AUM has grown by around 21% CAGR over the last 5 years. KKR has grown its AUM at around 14% CAGR in the last 5 years. Just as HDFC has growth opportunities in India, KKR is growing globally and in multiple product categories such as Hedge funds, credit and other forms of alternative investments
  • I will argue that every dollar of AUM for KKR is much more valuable than that of HDFC. HDFC AUM is into Equity and credit mutual funds. HDFC AMC revenue was approximately 0.6% of AUM. Let’s bump it up to 1% to be generous.
  • In comparison, KKR invests in private equity, hedge funds and other alternative investments. If you have studied this sector, you would know that fees for such vehicles is higher than vanilla mutual funds. KKR earns a management fees of 1-2% and accrues a percentage of profits above a threshold, also called as carry. KKR earned around 1.8% of AUM as income in 2018 and for reasons I don’t have space to explain, it was much lower than what the company will earn in steady state. It will be safe to assume that KKR will earn around 2.5% of AUM as topline income as some of its newer funds mature
  • ROE is not important as asset management is an asset lite business and does not need capital for operations

From an AUM perspective, KKR may be growing slower than HDFC, but has better economics than the latter.

Wait, there’s more

Now let me share something which will make you think really hard

KKR invests its own capital (shareholder capital) in its private equity and other such funds. These funds have earned 15% CAGR (in dollar terms) over the last 20+ years. If you follow the global markets, you will know that is a great return. In other words, an investor in KKR is buying an AMC (like HDFC AMC), but also investing in the underlying Private equity and other funds.

KKR has around 18.22 dollars/ share (or 15 Bn) invested in such funds. This is the book value of the firm. If we exclude this number for a like to like comparison with HDFC AMC, the company is valued at 4.4% of AUM. This is for a firm growing its AUM by 13% where the topline is suppressed due to newer funds which are under-earning compared to the older funds.

In effect HDFC AMC is valued at 5X KKR for now. Also keep in mind, that there is pricing pressure on mutual funds globally (their fees are reducing) whereas alternative investments face no such pressure.

Think twice

Is the growth profile and runway for HDFC so much more than KKR? Does being India focused provide HDFC more stability than KKR? Btw, KKR is also invested in India via some of its PE and other strategies. HDFC can expand into alternative investments and grow that business, but that is nowhere on the horizon.

As I am not invested in HDFC AMC, the downside for me from being wrong is low. However investors in the company needs to think long and hard on what is so special about the company that it should be valued at such a premium.

Is it the whole brand name and quality narrative of 2019? (similar to the small and midcap narrative of 2017). What is so special about quality in India v/s all the other countries?

Are we on a different planet?

Read on9 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