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September 24, 2019

2 Min read

1 comment

I will keep politics aside as I dont like to muddy my thinking with that. The government announced a tax reduction recently from 33% to around 25%. The market has responded positively to this announcement. I will not get into the macro impact of this decision as it is too complicated for me due to the second and higher order effects.

I will use a functional equivalent to understand the impact on our portfolio positions. Think of this tax cut as similar to a permanent drop in the input cost. The impact of such a drop will not be the same across all companies. I would like to bucket it in three groups

Group 1: Companies with a strong competitive position and high growth prospects which allows them to deploy all their profits into future growth

Group 2: Companies with a strong competitive position which will enable it to retain the extra profits. However due to lower growth prospects, the company may return some of it to shareholders via dividends

Group 3: Companies with weak competitive position where most of the extra profits will be competed away.

The net impact

The drop in tax rate will create the most value for shareholders in group 1 companies. We are already seeing the evidence of that. Its quite possible that the market is under-appreciating the long-term benefits of compounding in such cases.

Group 2 companies will see an increase in fair value, but due to the absence of compounding of retained profits (as they are not able to re-invest their current profits fully), this increase is much lesser than that of Group 1.

Group 3 companies which account for almost 80%+ of all the companies would see an increase in fair value only if the demand for the industry improves as a result of price reduction and an improvement in GDP growth. It is difficult to estimate this increase as this will take time for this change to flow through the economy and there are other factors which would play an equally important role

I am not raising the valuation for our positions even though we hold a few in group 1 and group 2. I would like to see this effect flow through before I do that.

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Gloom and Doom

In General thoughts, Views on news

August 24, 2019

5 Min read

2 comments

This was written to subscribers recently

It’s an understatement to say that things are getting scarier by the day in the stock market

We are seeing companies drop 20% or so in a matter of days (or sometimes in a day itself). I started reducing our positions in late 2017 as I became concerned with the valuations. However, I had no clue (and neither did anyone) that things would start falling apart in 2019. As a result, in hindsight we should have gone higher into cash. Please note the word hindsight which keeps coming up.

In the last two years we have exited the weaker positions where I was concerned about the business or management. We re-deployed some of that capital back into other positions, resulting in the same level of cash at the portfolio level. We will continue with this process in the future.

It reminds me of the famous bullet dodging scene in the movie ‘matrix’ – The hero -Neo manages to dodge multiple bullets from an agent, but one still gets him. In our case we have been able to dodge some, but got hit by a few inspite of our best efforts.

This dynamic now seems to be changing for the worse. There will be no dodging now.

Risks are rising

The drop we are seeing in the market seems to be pointing to something deeper. We are seeing a liquidity squeeze from multiple factors such as the NBFC crisis, high NPA in the system and possible global issues such as capital flight to the US dollar. There could be other issues too and your guess is as good as mine. In the end the reason does not matter.

The troubling part is that we are yet to see a major market meltdown in the US and other foreign market. I usually don’t talk much about macro issues but keep an eye on them. I will not go into various issues such negative bond yields across the board, inverting yield curves and other mumbo jumbo but say that the odds of a global recession are increasing. Combine this with trade issues and high debt levels, and we have a higher risk of a meltdown.

The above is not a given, but if it happens, we will feel the repercussions in India too.It could get worse if the system gets a macro shock.

I am not writing all of this to alarm you further. I don’t see an end of world scenario or anything of that sort. However, we need to understand the context of what is happening around us. It is easy to talk of a long-term view, but we may have to go through a lot of pain in the interim

Let’s look at the case of one of our holding. The company has dropped by 20% for no apparent reason. As we have done in the past lets invert the problem and look at reasons for the sale

< Company details and analysis has been deleted for this post >

A debt default or any other fraud will cause a steep drop in the stock price. However, it does not mean that a drop in the stock price is only due to management fraud or default.

A logical fallacy

I get emails from subscribers asking me for a reason after every such drop. If we continue to have market drops, we would see sudden drops in our stocks too. These drops could be due to various reasons – business, debt issues, margin calls, or fear induced selling.

One cannot find the reason for every case, nor can one generalize it to corporate governance or some other issue. We try our best to filter out unethical management before starting a position. However, it does not mean that we will avoid all of them. When we realize that we have made a mistake in terms of the business, management or under-estimated the risk, we will reduce the position or exit as we have done in the past.

I can assure you I am always alert to what is happening to our companies and their stock price. In most of the cases, I choose not to react by choice.

In the coming months, we could have more drops with some extreme ones too. Unless there is a fundamental issue with the business or management, I plan to bear these quotational losses. I have gone through such times in 2000 and 2008 and can tell you it is very painful to watch your portfolio get decimated. The only way forward is to have a sense of long-term optimism even when things around us are falling apart.

I have not invested the cash we hold till now. I want to wait patiently till we get some good bargains, which happens only when the news keeps getting worse. I hope you will have the courage and faith to invest at that time.

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End of the promoter put

In Advisory letter, Investment process, Views on news

July 18, 2019

3 Min read

Let’s look at the most basic of accounting equations (simplified)

Shareholder equity + Net Liabilities = Net assets

Net liabilities in this case are the on-balance sheet items such as debt, Account payables etc. In addition, there are also some off-balance sheet items such as contractual lease payment, accrued compensation etc. On the asset side, we have the obvious assets such as fixed assets, current assets and cash.

It’s an axiom or truth that the above equation needs to balance out. However, the Indian markets have long violated this axiom. There have been several instances where promoters created dubious or nonexistent assets via debt, defaulted on the debt and were still able to keep equity/ control in the firm.

This is slowly becoming a thing of the past.

The recent introduction of IBC and formation of the NCLT, means that once a company defaults on its debt, the debt holder can take the company to the bankruptcy court. Once that happens, the court can liquidate the firm (sell all the assets) and re-pay the debt holder. Whatever is left after paying all the debt and other claimants, is available to the equity owner.

In the past, the promoter could arm twist the debt holders and thus retain the value of equity. This is no longer possible now.

The 1934 edition of security analysis by Benjamin graham, long considered the bible of value investing, cover bankruptcy and net asset type of investing in detail. After the 1930s depression in the US, a lot of firms were available for less than net asset value (net value after deducting all liabilities). An enterprising investor could take control of such a company, liquidate all assets (often at a discount) and make more than the amount invested.

Although the concept holds true, that world no longer exists today. Most companies create value based on intangibles such as customer relationship/ brands etc. The tangible assets on the book are not worth much as standalone assets and even less in a fire sale. In most bankruptcy proceeding such assets sell for 20-30% of book value.

There have been exceptions to the above in case of some steel companies where assets have sold for 60%+. If you take most other companies in bankruptcy proceedings such as Jet airways, the assets on the book will fetch not more than 30-40% of their value.

If the above numbers are valid, then in most cases, the debt holder takes a haircut and is able to make 40-50 cents on the dollar if the business remains in operation (under a different management). If the business is liquidated, then the recovery is even less.

In all these cases, the equity holder gets nothing at all.

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Some early lessons

June 17, 2019

2 Min read

6 comments

In the early 90s, my dad invested with a middleman who promised 18% fixed returns. He also invested a small amount in the FD of a plantation company (companies in the business of growing teak and other wood). The returns were much higher than bank FDs and they were assured.

All was well for a few years till the middleman defaulted and we realized that the money had been lent out to a small time businessman who had gone bankrupt.

We had a tough time recovering the money from the businessman. The saving grace was that this businessman was an honest person and he re-paid as much as he could inspite of his stressed circumstances

The plantation company too stopped paying interest around the same time and when I visited their office, found that they still had a few employees hanging around. They offered me a nice cup of tea and nicely told me that the company had collapsed, and all the money was gone.

All of this happened before I got involved in equities and started investing money on my own.

I learnt a few things early on which have helped me all my life

The pain of losing hard earned money is very high. I saw my parents suffer emotionally as their trust had been violated. No amount of returns is worth this suffering
High returns and assured returns never go together. If someone claims so, they are fooling you and you will be out of your money in time
Do not trust anyone blindly. At a minimum, trust but verify
With fixed income, go for the safest option. The excess return is not worth the risk. If you want to take the risk – go for equities or some similar investment. At least you will not be lulled into a false sense of security
The world out there will prey on you if you are ignorant. You are responsible for your own money

Just in case if I am sounding too smart compared to my dad, let me assure you that I managed to lose even more money over the next few years than he ever did. The difference was that he was cheated whereas I lost because I thought I was too smart and no one could fool me!!

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Hypothesis and bets

In Investment process

June 5, 2019

4 Min read

2 comments

I recently wrote this note to subscribers as part of a company analysis. I have removed names for obvious reason, but the point I am making remains valid.

—————

This is a good example of how most ideas work (if they are successful). It takes time and patience to stick around for a thesis to play out. The stock market is an efficient place and one should not assume that other investors are idiots. In most cases the market is right and is discounting the near-term results into the price. As a result, it may undervalue a company which has good long-term growth prospects but is facing temporary challenges.

The job of an investor is to evaluate if the challenges are temporary or permanent. If you think it is temporary, then it makes sense to start investing into the company via a small position. The reason for starting with a small position is to be open to the possibility that one is wrong about the hypothesis.

I have a reason why I always use the word hypothesis. It has a precise meaning. It does not mean a forecast or a guess. It means possibility or ‘what can happen’. The future is always indeterminate and as an investor one needs to consider the range of possibilities.

Think bets

This means that one starts with a small bet and raises the bet as more data comes in. This is the equivalent of starting with a small bet in poker and raising your hand as new cards open up (information comes in). If the data or cards do not fall your way – you fold your hand or sell out of the position.

If you have watched poker, you would have noticed that even the best players fold a lot of hands when they realize that the cards have not come their way, or they have made a mistake. Investing is similar. If you have made a mistake or data comes in such that the negative scenario appears more likely, then you reduce the size of the bet or fold your hand.

On the contrary, If the data starts pointing to the optimistic scenario (growth is returning back, ROCE is improving etc), then we start raising the size of the bet or in other words our position size.

This is what I am doing all the time – taking an initial position with a few hypotheses in mind and then raising or dropping the position size based on how the company performs or how the data comes in.

In some cases, the favorable scenario (which in my view has a higher probability) works out. In the case of company X, as growth returned we have raised the position. In some other cases, the growth and improvement in economics is yet to happen – we have kept the position size the same. In a few cases, if things worsen or if I am wrong, we drop or eliminate the position.

Right expectations

Why I have taken this detour in the quarterly update? I have sometimes received emails expressing surprise that I have turned pessimistic after sounding positive for a long time. In all these cases I am watching the company and industry and as the data changes or some events occur, I have changed my view of the company (sometimes late).

How else should one react? Should I just stick to my view so that I appear all confident and smart while I drive our portfolio and capital over the cliff? For our collective sakes, I hope that I can avoid my ego from getting in the way of making rational decisions. In the past, I would fret about it. Now, I just ignore and take the necessary decision irrespective of how I appear to others.

As a side note, there is another pattern you should observe. As the market discounts the next 1-2 years performance correctly, it means that the minimum time it will take for an idea to show results has to be more than that. In 2017, the market was discounting 2018 and early 2019 performance for Company X. As growth improved for FY19 and FY20, the market has taken note of it and started discounting the same.

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A future advise to my kids

May 24, 2019

6 Min read

7 comments

I recently tweeted the following

No one has a logical objection to saving and starting as early as possible in life. If you understand the power of compounding, you will not argue against this point.

The most common objection is against investing in index funds. A lot of people think its an admission of defeat if you go the route of index funds, especially when it so easy to do better than the market

Is it so easy to beat the index?

A lot of people look at the recent experience and conclude that beating the market will be easy going forward. In reaching this conclusion, they are ignoring some obvious points

Indian markets similar to global markets continue to get more transparent and hence more efficient. The more efficient a market, the harder it is to beat the index
At the height of the bull market in 2017, a lot of people thought anything less than a 40% CAGR was for losers. That expectation has a lot of arrogance built into it. If the overall market is going to deliver around 14-15% over a long period of time, then the only way an individual can achieve such high returns is by being a far superior investor. A few people may turnout to be exceptional. However, the ex-ante probability of that is usually low
Most investors ignore the aspect of luck. A lot of new investors started investing in the 2010-2013 period when small and mid cap valuations were at a decade low. We will get the same tailwind in the future.

We are already seeing the level of excess returns over the index compress in several markets such as the US due to rising competition. I think the same is happening in India. This is also called the red queen effect and we are seeing this in other competitive fields such as sports, business, marketing etc too.

Is it worth the effort?

Let’s assume that you work hard and do manage to beat the index. At this point, I would like to reference this post I wrote on the ROI of such an effort. Anyone who decides to become an active investor has to divert time from either full time work or from some other personal activities to make this extra return.

I have laid the math in the table below and you can play with the numbers in terms of your opportunity cost (salary, time with family or any other metric). There is no standard formulae to evaluate the ROI – this is something personal and only you can answer it. However, if you are in this only for the money, then a valid metric for comparison is your current hourly rate in terms of a full time job.

The question to answer is – When will the per hour wage from ‘active investing’ exceed the wage from doing a full time job?

A tough way to make easy money

As can be seen from the table above, the break even usually happens after 8-10 years of active investing. Even if you are great investor – compounding at 20%+ rate which very few investors or mutual funds achieve, the returns are back ended and come much later in life.

Now some folks will point to Rakesh Jhunjhunwala or warren Buffett or some such investor who have become famous and very rich through investing. This is the equivalent of someone pointing out one of the superstars in any field (cricket, Movies etc) and justifying their decision.

They are completely oblivious to the hidden evidence – for every Kohli, Aamir khan or any other hugely successful individual, there is large group of people who never made it big. The earnings per hour through active investing clearly show that making money via this route is not an easy way to get rich

Am I being a hypocrite?

One of the thoughts in your mind must be – This guy has been investing actively and is turning around and recommending others not do it. He is being a hypocrite as he wants to reduce his own competition.

I can assure you that the number of professional and individual investors getting attracted to market is very high and this post will make no difference to that. The rewards of success (or the allure) in this field is high enough to keep attracting new entrants.

As I have shared in the past, if I look back at the 20 years of my investing career, the economic (key word) ROI of the time spent on investing and writing this blog would be far less than a full time job. The only reason I have done this is because I have always loved the process and would do it even if I was not being paid for it (Which is true for this blog anyway).

Active investing is an irrational decision

If you agree with my argument that from an economic standpoint a career of investing actively in the market does not make sense, then saving early and investing via other instruments (mutual funds, ETF etc) is the way to go.

The above point does not mean that you don’t become financially literate. I think that is a must and should be made mandatory in schools. We should all have the minimum knowledge of personal finance to make sensible decisions. This would require only couple of hours a month. Once you have done that, you can use the rest of your time on other pursuits. That was the key point behind the above tweet

Unless you invest for a living (in financial services industry), I think investing directly in the market is not a rational decision. A lot of people do for the entertainment or bragging rights and in the end hurt themselves financially. People who are truly successful in it are those who love the process and don’t care only about the returns. If you are one of those folks, then welcome to my world and please ignore this post.

For others who are in it only for the money – find an area you truly love and get good at it. You will make a very good living at it and enjoy the process. The surplus income you make should then be invested in index funds. That’s what I am going to advise my kids.

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Weekend Thoughts

February 21, 2019

3 Min read

I am have been mulling a few things over the last few weeks. Thought of sharing it with all of you. I may probably do this again in the future on other topics

Cut and run

In the last few months, we have seen stocks nose dive when the market learnt that, management was doing something unethical or working against the shareholders. The examples are quite well known and need not repeated.

The reaction is swift and brutal. I have learnt this painful lesson personally in the past, on a few investments. In the first case – SSI tech, which occurred in early 2001, I kept holding the stock waiting for some miracle to happen. In the end, I lost around 90% of my investment in 2 years. The same occurred with Zylog in 2012-13, but as this was a tiny speculative position, the loss was very small.

We have been lucky to have avoided such a situation till date. However, it does not mean I am exempt from it. Inspite of my best efforts, I may end up trusting a management who could turn out to be a fraud.

To be clear, I don’t think we have any such position where I think the management is cheating us.

I want to make it clear that if such a situation were to occur and it becomes apparent that the management is either fudging the accounts or cheating the minority shareholders, i will not hesitate to exit even if it means a financial loss and me looking like a dumb fool.

I have learnt that exiting such a position and salvaging whatever you can is always the best option. Case in point: I sold zylog for a 30% loss at around 30-35/ share. It now sells for 0.8 (yes that’s not a typo)

Pick and choose

I am aware that some of you use the model portfolio as a starting point and pick and choose some positions out of it. I have no problems with it personally and you are free to make your decisions.

That said, I am would not do that if I were in your place. The reason has nothing to do with my ego or that I am some awesome investor whose every word is gospel.

The true reason is actually the opposite. Even the best of investors do not get more than 70% of their picks right (in our case its around 60-65%). This means that around 1 in 3 picks are wrong and will lose money.

When you pick and choose from the model portfolio, you are making an implicit bet that you have the skills to know which one of my three picks, will fail. I cannot judge that for anyone – that is for you to answer for yourself.

My own process acknowledges the above failure rate and hence most of the new positions start small and at a lower priority in the model portfolio. As the company/ management performs, I raise the position size (often after a long time). If on the other hand, I make a mistake, I simply take the loss and move on.

The key point in this process is that my focus is on the portfolio, which should do well and not on individual positions alone. Doing a pick & choose means, that you are ignoring the portfolio approach (or handling it yourself)

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Building an edge

In Advisory letter

January 19, 2019

5 Min read

In an earlier note, I wrote about the three factors which contribute to outperformance (doing better than an index). I expanded on the third factor in the most recent update.

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.

Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models

Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is eroding with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. Ultimately it, depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

An enormous advantage
We started the advisory in 2011. At the outset, we made a few decisions which has made our life simpler and saved us a lot of pain.

We will not tout the wins on social media, which are often due to luck and can easily get hit by a random event causing a loss for anyone trying to follow them. If it works well, the person taking the tip attributes it to their genius. If it fails, we are responsible. Considering that the best of investors don’t get it right more than 60-70% of the time, what is the upside other than an occasional ego trip?
We will focus on the investment process as that is the only repeatable aspect of investing over which we have some control. We cannot control the outcome.
We will focus on the long term as short-term results are prone to random events, but the noise cancels out over time
We will not indulge in making fun of other investors when we are doing well. It is stupid behavior and extremely petty. There are times when every investor goes through a bad patch – so what goes around comes around

Some of the behavior we see in the media, although loud, petty and promotional is not irrational. It allows the advisor/ fund manager to get visibility and increase their AUM. In the end, managing a fund is a business and one cannot live on high ideals alone.

The problem with this behavior is the type of investors you attract. If you talk about short term performance and multi-baggers, then you will attract people looking for quick gains and easy profits. The downside of having such investors, is that they get quickly disappointed when the inevitable downturn hits the market.

Looking for quick gains, such investors join at the top and manage to get quick losses.

For the fund manager, there is no downside. If the market keeps going up, they get to make their fees. If the market drops and they lose a few investors, which is part of the normal business cycle. They just need to wait for the next bull market for a new crop of performance chasers.

Both me and Kedar don’t want to play this game. We are not running this advisory for the good of mankind, but do not like this behavior. In addition, we are in a financial position, where we do not depend on the fees we earn to put food on the table.

Why am I sharing this now after so many years?

The reason for sharing is that a person cannot be rational and make decisions for the long term if that results in career risk. Try telling your family that you took a 5-year view which cost you your job. It is never going to happen.

We have taken this element of risk out of the equation for us. As I mentioned earlier – we do not depend on the advisory to put food on our table. In addition, our own money is invested in the same way as the model portfolio. Put the two together and you will realize that we are willing and able to think long term with a focus on risk reduction.

I think this is a very important edge for us compared to most fund managers. We can safely ignore short term fads (such as the bull market in small and mid-caps last year) and panics and rationally manage the portfolio. This allows us to take bets which are unpopular and hold on to them.

In an age of huge computing power and easily available information, one is unlikely to get a durable analytical or information edge over other investors. However, the third edge – behavioral which is durable and cannot be competed away, is available to us due to the reasons I have shared.

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The Journey matters

In Uncategorized

January 2, 2019

4 Min read