CategoryGeneral thoughts

I came across this article on the blog galatime. It’s titled ‘The effort effect’. The article resonated strongly with me. I think the power of mindset mentioned in the article is extremely crucial if one is to become a good investor.

The growth mindset (see diagram here) mentioned in this article is crucial to become a good if not a great investor. In comparison a fixed mindset (which a lot of us see around us) leads to poor performance in the long run. The key points of the growth mindset in terms of challenges, obstacles, effort, criticism and success of others are extremely relevant for an investor. As an investor one has to learn how to deal with new challenges and obstacles (the market and businesses around us are constantly changing). Effort is crucial in terms of a desire to constantly learn and improve oneself. Self criticism and an honest one is crucial too. One should be able to accept mistakes and learn from them and then move on. Finally I look at the other successful investors and try to learn from them.

The attitude referred to in the article is relevant to us not only as investors, but is important in other walks of life too.

In addition I found another link on the same blog on the mark of greatness. I found a similar article on greatness in fortune some time back (see link). The article in fortune mentions the following
Reinforcing that no-free-lunch finding is vast evidence that even the most accomplished people need around ten years of hard work before becoming world-class, a pattern so well established researchers call it the ten-year rule.

I have read in some other articles that 10 year or 10,000 hours of work is essential to achieve proficiency in a field. All the above research encourages me to keep working hard on becoming a better investor. Even if I don’t become a great or super investor, if I keep working at it, I will defintely be a better investor. My definition of a good investor is one who can beat the market by 5-10% points over a ten year period. I have done that for the last 6 years. I definitely plan to continue working on extending this performance.

update : 03/23

see here for an earlier post on the same topic

The RBI has just raised the CRR by another .5 %. This with inflation at 6.5%, although I feel this inflation is understated as the government’s basket of goods really not reflect an average middle class’s consumption profile. Rentals, education and health care alone are inflating in double digits.

I have never had any specific views on interest rates or inflation. I try not to base my investment plans on any predictions of inflation or interest rates. However that does not mean I don’t to react to it. In the past I have taken the following actions

In 2000-2001, I invested in fixed income debt funds. As the rates fell, the appreciation in these funds was substantial.

In 2003 when the interest rates were at an all time low, I moved my fixed income investments into floating rate funds and went long on by housing debt (see my thoughts on it here)

With rates hovering in 9-10 %, I have started looking at the option of moving out of floating rate funds into fixed income debt funds of average maturity (4-6 years duration). I have not made up my mind yet on it. I may wait for a couple of months more as I feel that the interest rates may rise a bit further. I am not sure about it and do not have specific views on it, but would wait and watch and react opportunistically to it.

As far as the stock market is concerned, I have been finding a few interesting opportunities such as indraprastha gas which I will explore further in a future post.

Additional comments – 15-Feb

Found this article on GEF (morgan stanley ‘s global economic forum)

http://www.morganstanley.com/views/gef/archive/2007/20070214-Wed.html#anchor4403

Following comments are worth noting

Excess liquidity conditions in late 2003 and 2004 resulted in banks searching for yield and charging negligible risk premiums for loan assets with inherently higher risks. Just about 12 months ago, banks were making little distinction between pricing credit risk for various types of loan assets. Almost all loans were being priced in a very narrow range of around 7.5-8%, which was very similar to the 10-year bond yields then. Indeed, banks’ lending behavior implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds.

If the past two months’ average credit growth of 30% and deposit growth of 22.5% are maintained, the banking sector SLR ratio will reach its maximum limit of 25% by March 2007.

I have been noticing in the past few weeks that interest rates have started hardening. I do not have the exact figures, but it seems that the rates for housing loans have started approaching double digits now.

I wrote a post on interest rates a year back (see here). Back in 2003-2004 the rates were at an all time low (as low as 7.5% fixed and 7.25 % variable). However everyone looking at the immediate past, were prediciting further drops (what else would explain almost everyone’s preference for variable rate loans?). I almost got into an argument with the loan officer in getting a fixed rate loan (the loan officer kept telling me that I was making a big mistake).

My logic in working out a rough pricing level for loans was detailed here. General extremes in valuations, whether stock or interest rates are easier to spot (although I cannot predict them). However I do not know if the rates are high now, will rise or fall in the future. What I feel strongly is that any rate lower than 8% is good and should be locked in via a fixed rate loan.

There are a few new conventional ideas now prevalent such as

– real estate is great investment at any price and will rise 20-30 % per annum due to the extreme shortage of real estate in india (for better idea of real estate bubbles, read about the 90’s real estate bubble in japan)
– Indian economy has entered a new era and stocks are worth more now. Every drop in the market as a result presents a new opportunity to buy

I don’t claim that I know any better on the above two new convential ideas in vogue currently. I am however unwilling to pay for the bright and shiny new future in these investment classes (stocks and real estate)

1991-1992: Harshad mehta boom
Story: Liberalisation

1994 – IPO boom

1999-2000: IT stock boom

2003 – ? : The india story .

‘India will grow at above average rates ( > 6 %) for the next few years and more. India has the requisite demographics, savings rate and the right condition for growth’

The underlying idea behind each boom was true and maybe sound. But typically the idea got carried too far. I am reminded of this quote from benjamin graham (paraphrased)

‘ It is not the bad idea which does you in, it is the good idea carried too far’

So you have a boom in the stock market, the commodities market, gold market, real estate market. Read somewhere that property in mumbai is more expensive than manhattan !!

Maybe it is ‘different’ this time …who knows ?

I am reminded of the following statement from warren buffett

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large dosesof effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

— warren buffett , letter to shareholders 2000

So maybe there are people who are smart to know when the market will turn. I don’t think I can do that. Better to hold back or if the froth in the market increases, start selling.

another indicator of the bull market – in any party or evening out with friends and family, i keep hearing of the fantastic real estate, IPO or stock tips which should not be missed. prefer to keep my mouth shut in such groups. Who wants to listen to a party pooper ! surprising bit is that no one talked about stocks in 2002-2003 .

Is it that software stocks are undervalued relative to the market? Will they outperform going forward? In our view, the risk-return matrix of investing in software stocks currently is equally poised.
On a relative basis, assuming a 15% CAGR growth in earnings of the BSE Sensex companies, the benchmark index is trading at a price to earnings multiple of around 14 times FY08 earnings. As compared to the same, the top five software majors, on an average, are trading at 19 times our estimated FY08 earnings. This is a 28% premium to the benchmark index. Considering the fact that earnings growth of the top three software companies i.e. Infosys, Wipro and TCS is likely to around 25% CAGR in the next three years (66% higher than Sensex earnings growth), we believe that the premium is justified

From: BSE IT: Has it tracked fundamentals

Question: Company A has a PE of 10, expected growth of 10 % for next 10 years and a ROE of 5 %. Company B has a PE of 15, expected growth of 8 % for the same period and an ROE of 20 %. Which company is cheap?

IT companies have a return on capital which is far in excess of 25%. However the key point in justifying the current valuations would be whether this level of growth and ROE hold? and that is where issues such as competivitive advantage of the indian IT service companies, their ability to contain costs, rupee – dollar rates etc comes in. So basically the answer to the question posed in the above article is not as obvious as the writer is suggesting (at least to me)

I typically avoid reading broker reports and their recommendations. The analysis is typically very shallow, incomplete
and hardly covers any of the key aspects in valuing the company. And worse is the tendency to compare apples and oranges, which in this case is to compare BSE sensex (which includes banks, commodity companies etc ) with an IT services company.

Answer to my question: Company A is a value destroyer and would need capital to grow at 10 % for next 10 years. So I would not pay more than 4-5 PE for the company.

Saw this recommendation on google. With google crossing 450$, I think analyst are tripping over each other in raising their price targets.

Gives me a feeling of deja-vu – remember year 2000, right after the internet bubble burst – when the conventional thought was that companies like e-bay, CISCO could not go down, because these companies had solid business models, were dominant in their industries and had a fantastic future ahead of them.

The recommendation also notes the following

Stahlman said he reached his estimate for $2,000 a share using a multiple of enterprise value, which adds market capitalization, preferred equity and debt and subtracts cash.
That’s based on the 6.2 multiple commanded by Redmond, Wash.-based Microsoft Corp., the world’s largest software maker and the company most often equated with Google as a competitor and model, he said.

Wow !! how can google be equated with microsoft ?? Don’t get me wrong …google is a great company and I love google product (I cant think of a day when I have not used the search engine). But google is not a monopoly by any stretch of imagination (which microsoft was for quite some time for OS and office products). Going forward the competition is only going to increase and I cannot think of goggle controlling the internet the way microsoft had a lock on the desktop.

The analyst predicts a sale of 100 billion some time in the future (does’nt say when) and the price of 2000 gives google a Mcap of 0.5 trillon dollars (500 billion !!!). Assuming google is doing extremely well even then, and has a Net profit margin of 20 % (current is 25 %), which I think is not very likely (but still lets assume for the sake of it). The PE at that time would still be around 25.

How many 100 billion dollar companies can grow at above average rates ?
How many 100 billion dollar companies have a net profit margin of 20 % or higher in a global market and can sustain it ?
How many 100 billion dollar companies have growths high enough to justify a PE of 25 ?

“Two things are infinite: the universe and human stupidity; and I’m not sure about the the universe.” – Albert Einstein

update : 01/20/2006

read views on google from bill miller. According to him the value of google could twice of the current price. At the same time following comments from him are worth noting

He said Google’s (Research) market-implied growth rate is about 28 percent. Consensus numbers for the company point to a 5-year growth rate of 33 percent to 35 percent, which then slows over the next 12 years to that of the overall economy, he said.
“The theoretical value of Google is still substantially higher than the market price. So the theoretically justified market cap under those assumptions is in the $240 billion range,” Miller said earlier this week.

Miller, who takes a long view on stocks and has low portfolio turnover, said there are still many unknowns about Google. Many companies start with great promise and then something goes awry and they disappear, he said.

Another topic at the bull session was whether Google’s users were “locked in” to its model, the way customers of Microsoft’s Windows operating system are, said John Miller, an economist at Carnegie Mellon University.
“Suppose you do have the best search engine. The big question is how sticky are the users,” he said.
In theory, customers could easily use a search engine other than Google, but Bill Miller said the fact that Google’s market share is stable suggests that a “psychological lock-in” driven by brand loyalty is keeping them coming back. (emphasis mine)

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

http://mckinseyquarterly.com/article_abstract.aspx?ar=1678&L2=5&L3=5

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn’t make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

I have always wondered why analysts give price targets, when it is extremely difficult to predict the price level of a security, which is dependent on a host of factors with a few of these factors related to the psychology of the market at a future date.

The typical research report ( at least the free ones which I typically read) usually starts off with a very brief background of the industry. It would then discuss the latest results with a brief analysis of the last 2-3 years. The next 2-3 years income statement and balance sheet is projected. The report would typically end with a price target with simplistic analysis which is typically based on the projected EPS and a PE no.

The more rigorous analyst would give his logic for the PE assumed(often  based on the past PE of the company ). Most don’t bother to do even that.

PE as a measure is fairly flawed measure as it does not consider the ROE of the firm, its competitive advantage, impact of industry dynamics etc. At the same time the number used in backward looking (based on past PE, earning etc).I would assume a more rigorous mode of valuation would be based on DCF, with various scenarios being considered and valuation range being arrived at (with degree of confidence for this range).

But then the analyst is giving the consumer (the investor) what he wants – A precise price target (which would be hopefully achieved in the future) , a certainty,  where none exists.

It’s not that all analyst reports are of a poor quality. Some do discuss the industry in depth and attempt to do a more thorough valuation exercise. But most are superficial and not worth reading. I have found the original source of the information – The annual reports, far more useful than the analyst reports and have never made a serious commitment of capital based on an analyst report.

Do we have any good source of analyst reports in India? If you are aware please email me.,