General thoughts Archives - Page 4 of 11

Tail risks

March 13, 2020

6 Min read

I published this note to subscribers on 12^th 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.

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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.

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Are we on a different Planet?

By Rohit Chauhan

In General thoughts, Rejected investment ideas

December 3, 2019

5 Min read

9 comments

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?

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Good company, bad stock

By Rohit Chauhan

In General thoughts, Investing Philosophy

November 4, 2019

6 Min read

5 comments

I look at long term trends in the market and try to understand what I am missing. For example, amazon has always sold for an astronomical PE and I thought it was over-valued. However, the continued over-valuation, had me puzzled and I started reading up more on it.

I cannot get into the specifics here, but amazon is a case where the company is investing via its P&L (expensing the investments) due to which its current profits are suppressed. Think of it as a collection of businesses where one group is making above average profits and those profits are being re-invested in other loss-making new businesses. When you add the two together, the consolidated profit appears to be low. As a result, PE for the company appears to be optically high

I have used this learning to look closely at some of my ideas and tried to back out the investments which are being expensed in the P&L account. This ensures that I look past the optically high valuations and arrive at the steady state valuation, which may be lower.

Every company is not an Amazon

I wrote a post on this topic – The value of overvalued stocks, which is one of the most read posts on the blog. Since then quality and durability of growth has become near religion in the markets. Any one challenging or questioning this belief is seen as touch of step with the market. It is similar to the religion in mid & small caps in 2017 when I published this note – The Indian bitcoins

We have some companies in India, which continue to sell at high valuations and have done so for a long period of time. Are they similar to amazon?

For starters some of these companies are not growing at high rates. Some of them have grown at a low double digit CAGR in the last 10 years. In addition to that, these companies are not suppressing their cash flows to invest in new businesses like amazon. So, their PE is not optically high.

There is an element of truth behind this phenomenon. These companies enjoy a dominant position in their industry and have shown steady growth for a long period of time. The problem is that this growth is now being projected to last in excess of 20+ years. Can it last that long? Sure, it can – but a lot can change in that period too.

Nothing new under the sun

The interesting bit is that this is not a new phenomenon. If you looked at Infosys or WIPRO in 2000, you could have easily made a case for quality along with a large opportunity space for them. Both the companies did not disappoint – Infosys grew its revenue from around 900 crs to 87000 Crs over a 19-year period.

How did the stock do from its peak in March 2000 (PE of around 100) till date (before the recent drama)? It has given a return of 7% CAGR which is less than an FD return.

The company did its job and did not disappoint (26% topline growth for 19 years). It’s the investors who overpaid for it. There are more such examples from the recent past where the company has done well, but the returns were sub-par as investors overpaid for the stock.

Quality is a means, not an end

Quality is an input in the valuation and analysis of the company. It gives you the ability to project the cash flows of the company with higher certainty into the future. However, there is always a limit to this certainty.

If a company sells at 50 times earnings and is growing at 13% CAGR (1-2% above nominal GDP growth rate), it will require one to be sure of the cash flow for the next 23 years. That is a hell lot of certainty! and by the way in this scenario, the company has to perform better than this assumption for an investor to make higher than risk free returns (remember the Infosys example?)

Now some investors would like to argue that this is such a fantastic company, that the PE will keep rising. Welcome to the greater fool theory. You are in effect betting that the person buying from you expects the cash flow growth to extend beyond 23 years with certainty. Good luck with that

The end game

Some companies selling at high multiples are growing rapidly and if they can sustain this growth, will grow into this valuation. However, that is not the case with all the companies. Some companies have a very high market share in their industries and are unlikely to grow at super high growth rates.

A lot of these low growth, high valuation names face the risk of market moods. If the mood changes, valuations and stock price will drop. Unfortunately, the growth rates will not be high enough to bail out the investors over the long term.

These companies will continue to do well, and their sales and earnings will keep rising. Once the market fancy shift, investors will have to endure a long period of sub-par returns. This period can often stretch to years at a time.

In an age of instant gratification, how many investors have the patience to hold onto such ideas for years waiting for the earnings to catch up with the valuation? In case of fund managers, if they lag the markets for a year or two, they will lose investors and will be forced to move to something else.

Why no names?

I have not provided any quantitative analysis in the post. I could provide stats and numbers to make my point – but that will be useless. If you hold such a company, you will come up with reasons on why your specific case is unique or different (I have done the same in the past too).

I will resist naming these companies as I have no interest in getting trolled on social media. Calling them out is the equivalent of calling someone’s child ugly. It is better to keep such opinions private.

It is near impossible to accept something against the companies you hold. On top of that these are high quality, universally admired companies which have given good returns in the past. Most investors would never entertain the idea that these are good companies, but bad stocks

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Corporate tax cut – 3 Bucket analysis

By Rohit Chauhan

In General thoughts

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

By Rohit Chauhan

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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Some early lessons

By Rohit Chauhan

In General thoughts

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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A future advise to my kids

By Rohit Chauhan

In General thoughts

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

By Rohit Chauhan

In General thoughts

February 21, 2019

3 Min read

Add comment

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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The Indian bitcoins

By Rohit Chauhan

In General thoughts, Market analysis, Uncategorized

January 16, 2018

3 Min read

4 comments

The following note is from upcoming annual letter to subscribers. I will be publishing the rest of the letter on the blog soon

When I look at companies which are priced a lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.

A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some all knowing entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.

The market on average and over time gets the valuations right, but not always.

As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.

How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past

In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.

How many companies in the above space currently sport a PE of 50 higher ? around 22% or roughly 830. So 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth

In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?

All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Ofcourse every individual thinks he or she is smarter, more handsome or than the crowd (also called illusory superiority).

The odds are against everyone being right. So it makes sense to be cautious and do your homework well enough. Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Discounting hope

By Rohit Chauhan

In General thoughts, Investment process, Uncategorized

September 12, 2017

5 Min read

2 comments

It is widely understood that stock prices are forward looking – they discount the future expectations of cash flow of a company. In bear markets, these expectations are lowered as markets extrapolate recent trends (and assume a recession forever). On the flip side, the reverse happens during bull markets, when investors extrapolate the recent good results into the future and assume that there will be no hiccups along the way.

Finally, we have markets like now, where investors have gone ahead and extrapolated ‘hope’ and discounted that too.

The idea funnel

I maintain a 50+ list of stocks which I track on a regular basis and have created starter positions in a few companies which appear promising. The process i follow is to create a small position (usually 0.5% to 1% of my personal portfolio) and then track the company for a few quarters/ years.

In atleast 50% of the cases or more, I realize over time, that I am not too excited about the prospects of the company and exit the stock immediately. In a few cases, however the company and its stock may still hold promise. In such cases, I start raising the position size in the portfolios I manage.

The above approach allows me to run experiments with lots of ideas and controlled risk.

Discounting infinity and beyond

I am now noticing that some of the positions I hold on a trial basis have started running up based on hope.

Let me take one example to illustrate – Repro India.

Repro India is a printing business with operations in India and Africa. The company performs print jobs for publishers for all kinds of printed materials like books, reports etc. The company has had a chequered past with uneven performance.

The company was growing till 2012-14 with rising sales in India and Africa. The return on capital of this business was mediocre as the printing business involves high fixed assets, high and sticky receivables with average operating margins in the range of 15-18%.

The export business in Africa went into a nose dive in 2014 due to the drop in oil prices. The company was not able to collects its receivables as these African countries faced currency issues and hence incurred losses. Since then the company has been slowly recovering the receivables and nursing the business back to health. In addition the domestic business continues to be competitive and sub-optimal due to the lack of any competitive advantage

I would normally avoid such a company unless there are some prospects of improvement or change in the future. One such possibility exists for the company. This is the new BOD – books on demand business of the company.

The BOD business is similar to an aggregation model followed by companies such as uber or Airbnb. In the case of repro, the company has a tie up with Ingram (another US based aggregator) and other publishers in India to digitize their titles and carry them on its platform. These titles are then made available through ecommerce sellers such as Amazon or flipkart. When a user like you and me finds this title and purchases it, Repro prints the copy and delivers it you.

The business model is depicted in the picture below (From the company’s annual report).

The above business model ensures that there is no inventory or receivables for Repro or the publisher. The payment is received upfront and the product is delivered at a later date. This is a win-win business model for all the value chain participants as it eliminates the need for working capital. As a result, this business model is able to earn a high return on capital with the same or lower margins than regular publishing

Illustration from the company’s annual report

Repro is doing around 40-50 Crs of sales in the BOD segment and growing at around 70-80% per annum. The company has loaded around 1.4 Mn titles on its platform and plans to load another 10 Mn+ titles in the future. This business is at breakeven now. The BOD business has a lot of promise and it’s quite possible that the company will do well.

However, success in the business is not guaranteed. The company needs to scale its operations and could face competition from other print companies in the future (as the entry barriers are not too high).

The market of course does not care about the uncertainty. There are times, when markets refuse to discount good performance in the present and then there are time like now, when the market is ready to discount the ‘hope’ of good performance in the future. The stock sells at around 100 times the current earnings. As the legacy printing business continues to be mediocre with poor economics, it is likely that the high valuations are mainly due to the exciting prospects of the BOD business

I had created a small position a couple of months back and have been tracking the company. The stock price has risen by around ~~50%,~~ 60% since then even though the company is just above breakeven on a consolidated level.

I am optimistic about the prospects, but the execution needs to be tracked. I am not willing to pay for hope and so I am a passive observer for now.

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CategoryGeneral thoughts

Tail risks

Are we on a different Planet?

Good company, bad stock

Corporate tax cut – 3 Bucket analysis

Gloom and Doom

Some early lessons

A future advise to my kids

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The Indian bitcoins

Discounting hope

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