CategoryGeneral thoughts

In March 2020, during the depth of the Covid crisis, I did a bankruptcy risk analysis of all my positions. I wanted to evaluate, how long these companies would survive, under various lockdown scenarios such as a drop in topline by 50% or zero revenue for an extended period

Although the severity of the crisis turned out to be much lower, there was a non zero probability that the pandemic could get worse and cause a longer shutdown

I used the recent financial results and credit rating report for the analysis. The review was broken down into break even analysis (how long the company could survive on zero revenue) and long term demand/business impact

Getting a grip on the risk

This analysis allowed me to evaluate the risk of individual positions, their correlations and not to panic at the bottom. At the same time, it also prevented me from being sanguine about the risks.

The benefit of this exercise was that i able to avoid selling at the bottom and started adding to the model portfolio in steady /regular fashion from Mid April 2020 as the worst case scenario did not play out. This analysis continued to help me in subsequent waves of the pandemic as I had already done the work of evaluating the worst case scenario

Although this was a stressful exercise done in the middle of all the uncertainty, it allowed me behave more rationally and in a measured fashion. For me, there was never a eureka/light bulb moment when I decided to go all in. As I shared in my earlier post, my top priority was return of capital than return ON capital

Following is a sample of the analysis and are my raw notes. This is no longer in the portfolio (as shared in the prior post – a mistake) and also not a recommendation to buy or sell

April 2020 : Thomas cook (I) ltd [Company is in the travel space – epicentre of the crisis]

Liquidity risk: CRISIL AA-/Negative as of 3/27

Crisil report: Liquidity Strong

Liquidity remains strong, with cash and cash equivalents of Rs 1,724 crore as on December 31, 2019, against repayment obligation of Rs 73 crore over the 12 months till December 31, 2020. Liquidity is driven by the nature of operations with significant advances from customers. Financial flexibility is enhanced by the ability to contract short- and long-term debt at competitive rates. On a standalone level, TCIL has no long-term debt, and working capital limit has been sparsely utilised. Its subsidiaries are expected to service debt through internal accrual and need-based support from TCIL.

CRISIL believes TCIL’s profitability and cash flow metrics could be materially impacted by continued travel restrictions due to prolonged Covid-19 situation.

Cash burn rate: Company has a cash outflow of around 250-300 Crs/ quarter from salaries, overhead and other expenses. Company has used up around 150 crs of surplus cash. Float is likely to drop. With full stoppage of travel company is likely to lose 200 Crs in Q1 and around 200-250 crs in assuming travel starts picking up end of year slowly. Company has cash and equivalent of 1700 crs, free cash of 200 crs (50 crs after buyback) and only 75 Crs of re-payment till end of the year

Assuming 50% drop in topline, company could lose atleast 500-600 Crs this year. Can take on debt of 400-500 crs including loans/ funding from parent to sustain the year. Some recovery could happen in 2021 and 2022 could see return to normalcy

Break even analysis

Company has a GPM of around 25%. Company needs 1200-1400 Crs of cash flow for Break even basis. Based on this, the company will achieve cash flow break even with 25% drop in topline. Due to the severe stoppage of travel and tourism, even this is not likely. Q1 could see almost 70% drop and Q2 could at best be 40% of capacity. Normalcy will only return from Q3 onwards.

In view of this, the company will need close to 800-900 crs of cash flow and will need to take on 500 -700 crs of debt at a minimum to support the operations.

Long term demand/ Business model impact

Short term fragility is from complete stoppage of travel/forex, MICE events etc. Long term risks/ fragility comes from OTL and move to online travel, which for now is lower risk and with tightening of capital, could reduce.

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

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

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 !

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.

-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.

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.