CategoryInvesting Philosophy

It must be quite apparent that I have mental block to trading. I had written a post on other blog on the same topic in 2004 which I posted again here. The post was written in jest. I do not look down on trading or consider value investing superior than any other form of investing. It is just that the mindset required for each of the approaches is very different.

Let me illustrate with an example

I typically invest in stocks which are undervalued due to some short term sector issue or due to investor apathy. The near term outlook is generally weak and there is no momentum behind the stock. As a result most of the time the stock drops after I start building a position. This happened almost 70-80% of times I have invested in a stock like concor, blue star, KOEL, asian paints, Gujarat gas etc in the past.

If I operated with a trader’s mindset, I would first not get into the stock and even if bought the stock a stop loss or similar such approach would cause me to exit the stock.

However a value investing mindset results in an opposite approach. I typically buy a stock which is selling at 40-50% discount to intrinsic value with a 2-3 year minimum time horizon. So if the market drops or the stock drops for non-fundamental reasons, I re-evaluate the stock to see if my thesis is intact and sometimes increase my holding.

I personally feel that it is difficult to have the two mindsets at the same time (atleast for me). It may not be impossible, but is fairly difficult and only a few investors would be great at both approaches (rakesh jhunjhunwala is one such investor whose name comes to mind).

I had a major mental block to trading in the past. I have started opening my mind to that approach to see if I can incorporate some aspect of trading into my value investing approach. I know for sure that I do not have the temperament of a trader and frankly would not be going down that path.

As deepak has put in the comment below, I think it is important for every investor to figure out his temperament as that has a major impact on every aspect of investing .

momentary lapse of reason said…
also some interesting statistic related to your trader/investor blog.for a trader to make a higher return than an investor over a long term( say 5 yrs) the trader should predict the market more than 70% of the time.. this is highly impossible unless your an oracle..and a piddly 20% pa is better than a 100% profit the first year and a 50% loss in the second. a 20% pa compounded for two years will give you a 44% return on initial investment. in the second case you’ll end up where you started. no gain.
7/11/2007 12:05:00 PM
Deepak Shenoy said…
Trading is a profession and usually involves going full time on it. Investing, on the other hand, tends to have inflows from other income sources. But yes, psychological traits make the trader or the investor. Trading is a mind-game rather than an “art” – it requires a different kind of mindset. Some people thrive in it – some people who run hedge funds have returned more than 100% every year for the last five years. Many others leave it for other stuff – even Wikipedia’s Jimbo Wales was a trader before WP.But intersting thoughts on this. Everyone has to make that call one day or the other.
7/13/2007 01:20:00 PM
Rohit Chauhan said…
yes it requires a very different mindset to be a trader. also i remember reading somewhere that there are very few successful long term traders than investors.i think trading is inherently more difficult and time consuming. very few individuals like rakesh jhunjhunwala are good at both due to the differing mindsets required

The gut feel test may sound totally illogical and irrational, but I have used it several times. I have posted my investment approach earlier here. As I wrote, I run various filters and do a 1-2 hour check on the basic financials of the company. That is followed by reading the Management discussion and analysis.

If the numbers do not look ok, I tend to give the idea a pass. There are no set rules for the numbers to look ok. Let me list a few cases

1. In case of aftek the acqusition of promoter held companies was a red flag for me. Clear case of conflict of interest
2. In case of Dr reddy’s and other pharma companies the valuation of the company seems to be high and I do not have the skills to evaluate the success or failure of ANDA filings
3. In case of JSW holding, more than 60-70% of the value is due to JSW steel. I do not have a specific insight into the steel business. As I could not evaluate whether JSW steel is fairly valued or undervalued, I decided to give JSW holdings a pass.
4. In 2004-2005, I felt bharat forge was fairly valued and could not project with confidence if the performance would continue. Hence gave the company a pass. Clearly a mistake, but a rational and acceptable one.
5. Indraprastha gas limited – Gas is available at a subsidy. Future margins may drop and hence the current price seems to be reflecting that. So no undervaluation although the stock appears to be so by past measures.

A lot of times, I have analysed the company and towards the end a few points keep nagging me. If I cannot evaluate those critical issues with confidence, I tend to give the stock a pass. The risk of this approach is that I tend to miss out on several good opportunities. I however do not agonize over it if the reason was related to my circle of competence, wherein I do not have the necessary knowledge to evaluate the company well.

In a few cases however, the level of undervaluation may be so great that I have a large margin of safety. In such as cases even if I have a few issues with the company, the downside risk is low and the risk reward equation seems to be fine. In such cases I may buy the stock and hold it till the undervaluation dissapears.

One of the most important aspects of becoming a better investor is to evaluate one’s performance. However I do not think an absolute performance is the right way to do it.

For ex: If one’s stock portfolio returned 2% during the period 2000- 2003, I would consider it to be a superior performance than a 30% increase from 2003-2006. The reason is that during the period 2000-2003 , the market lost more than 30%, whereas during the period 2003-2006 the market almost doubled.

I evaluate my own performance as follows

I use the following formulae to evaluate the performance on my stock portfolio. I am not referring to a single stock, but for the entire stock portfolio.

Return = End portfolio amount – starting portfolio amount – cash added (or removed)/ starting portfolio amount

The period for the above formulae can be a month, quarter or a year. I prefer to evaluate the performance annually.

I compare this performance with the following three benchmarks. You can look at these benchmarks as three rising levels of hurdles to be crossed.

Level 1 – No risk FD return – This is the return I get from investing in bank FD. The stock portfolio has to cross this level. Otherwise I am way better off investing in FD’s and going off to sleep.

Level 2 – Index fund return – This is the return one can get by investing in the index (NSE or BSE) via ETF’s or index funds. The stock portfolio has to outperform this level, other wise I am better off investing in an index fund.

Level 3 – Mutual fund return – I referred to it in my previous post. My stock portfolio return should exceed the return I get from my portfolio of mutual funds (post expenses). If not, then I am again better off handing my money to the fund managers and doing something better with my time.

A caveat – One should not make a decision based on a single year’s return. In a single year, the stock portfolio returns can be volatile and even be below level 1 benchmark . I prefer to look at rolling 3 year returns to reach some tentative conclusion. I would prefer to look at the results of atleast 5 years before reaching a conclusion that I have crossed each of the above benchmarks. For a 5 year period, one should look at the cumulative returns from the stock portfolio and compare it with the above 3 benchmarks. Only if one has done substantially better than the three benchmarks, can one conclude that he or she ‘may’ be a superior stock picker.

The above may sound harsh and pompish. But I think if one has to be better investor, honest appraisal of one’s performance is important. If I have five duds and my portfolio returns less than what I could get in an FD, then there is not much to be gained from a stock pick which doubled in 15 days. I may have bragging rights and may feel smart, but I am not being honest and objective about my performance.

I posted the reply from warren buffett on the above question. The key takeaway from his reply is that one should read a lot and invest your own money based on your ‘own’ ideas and analysis.

I will touch upon my approach to improve myself as an investor in this post.

I have been reading various investment related books, articles and annual reports for some time now. However my approach to it was disorganized and did not have any pattern to it. However in the last 2 years I have developed a plan to read with specific goals in mind.

I look at reading with two key objectives

1. Find new ideas (which are profitable)
2. Develop mental models to become a better investor (read this article from charlie munger on mental models)

I have broken the second objective into the following topics (related to investing)

Finance – topics such as Balance sheet, income statement, various ratios, analysis of these statements etc
Accounting – understand various accounting concepts and standards
Valuation
Competitive advantage and strategy
Probability and analysis of risk
Study of business models
Economics – mainly micro economics
Investing – value investing
Options, derivates and other financial instruments

I have better knowledge in some these areas relative to other topics. For example I have not read much on options and derivatives till date. Somehow I get put off by all the math in it (although I am engineer by background 🙂 ).

So at the beginning of the year I try to assess myself on these areas and try to identify the specific areas on which I would focus. For ex: I am currently focussing on topic 4 – competitive advantage. I identify books for this topic and add it to the list of books I would be reading over the course of the year. I run through all the topics in this manner and try to come up with a tentative book list for the year. This is not a list set in stone. If I find a better book for the topic I am interested in, I end up replacing it with that book.

In addition to the above book list, I have also listed the industry groups I would be focussing on this year. Currently my focus is on pharma. I have shortlisted around 5-6 industry groups for the year (see my industry analysis spreadsheet here). To improve my knowledge in a particular industry (related to topic 6), I read up on the annual reports of some of the top few companies in the industry. In addition, I try to read up on industry reports if I can get access to them for free.

This industry group analysis activity helps me in increasing my circle of competence and also helps me in coming up with new investment idea. Finally as all knowledge in investing is cumulative, I can easily use this knowledge again later to come up with good investment ideas.

Finally I run valuation screens and if I can get some undervalued candidates, I read up on them. This is more haphazard as I may get candidates in industries which I have no prior knowledge. However it is a good starting point in those cases. If the candidate is in an industry in which I have done some prior study, then the analysis is faster.

The last step is – as they say on shampoo labels – rinse and repeat. That is I keep repeating the above process. Ofcourse the books, the topics and the industry groups keep changing, but the approach is the same. This approach has been helpful as it keeps me focussed on areas which i need to improve and also to enhance my circle of competence

Ask any analyst, market commentator, investor or your friend on the future direction of the market and they will have a wide variety of views ranging from totally pessimistic to wildly optmisitic. Most will also have very plausible reasons to back up their viewpoints.

In reality, I doubt anyone can consistently time the market (and there is enough evidence to back it up). True some people can get it right sometimes, but I personally have never tried it as I know for sure that I will not get it right.

My approach to this question is ‘I don’t know’. I am not sure what will happen in the future. However that does not mean being blind to the present situation and doing nothing about. On the contrary I have some crude approaches to resolving this problem.

For individual stocks I typically maintain a valuation band (and not a price band). For example, if I think a business has very strong competitive advantage and will do very well, I tend to accord it higher valuations. As a specific case I can cite marico. Marico as a business was valued at a PE of around 10-12 in 2003, when I looked at it for the first time. I conservatively valued it at 20-22 at that time. Since then marico has done very well and may have improved its competitive position. As a result I have bumped up my valuation band to 25-27. The advantage I see in this approach is that I do not fixate on the price. Price is a function of the current earnings and the PE ratio, which in turn would depend on a variety of condition. By looking at a valuation band, I can assess the company’s competitive position and decide whether the current price looks overvalued or not.

Ofcourse the above approach is not perfect. A better approach would be to do a complete DCF analysis from scratch without any assumptions. However it is very time consuming and may not be feasible for me every time.

For the broader market, I have an even cruder method. I track the earnings growth, dividend yield and ROE of the market as a whole. I tend to treat a market PE of 20 as trigger to start investigating as to why the market should not be considered to be overvalued. A PE of 20 does not necessarily indicate an overvalued market. This number has to be seen in context of the other numbers I spoke of earlier. But at this point, I start analysing further and also look at reducing my holdings.

All of the above is hardly scientific and may appear as very crude. However I try not to be too smart in selling. I try to follow buffett’s advice (paraphrased) ‘Buy at such an attractive price, that selling becomes an easy decision’

In the end, my approach is to accept that I don’t know the future of the market and need to manage my emotions (greed at present!!). So a mechanical approach although sub-optimal works well for me.

As an aside, Mr market is current in complete euphoria with the kind of oversubscription for RPL and sun TV IPOs.

Great time for businesses to raise capital from the market !!

There are several business models which are seem to be inherently more risky and then there are some businesses which may not be risky to begin with, but changes in industry dynamics can make them risky for some time.

The indian pharma industry seems (atleast to me) to be one such industry. This industry is one of the few industries which is in the process to globalizing. A few years back companies like ranbaxy, Dr reddy’s lab etc got into the mode of releasing generics of blockbuster drugs which were going off patents. I remember distinctly that some of these companies were selling at fairly high PE. The analyst’s could see only a bright future and market was pricing accordingly. To be fair, there were murmurs of litigation risks etc, but somehow that was not visible in the price (with PE of 40 and more).

Later some of these companies had high profile clashes with pharma giants and lost some of the law suits. As a result the stock crashed when the expected payoffs did not materialise. I would look at this strategy of the pharma companies akin to bets in a casino, but where the odds in your favor. What I mean is that the expected payoff is positive in the companies favor, but often some of these bets could fail. So if the market values these companies as if all the bets are going to succeed, then there is a distinct over-valuation. But at the same time, every time a bet fails, if the market prices the company based on the latest failure, then there could be underpricing happening.

The problem (for me only) with the above business model is that I am not able to project the cash flow for such companies as I am not competent to evaluate the odds of success for such bets (investor who can could and should profit from it).

The business risk in the other globalizing star ‘IT services’ seems to be lower as these companies have used mainly labor arbitrage in the initial phases which is a lower risk strategy. However the market recognises that and has bid the stock prices up and so we have a lot of stock related investment risk.

I was have started analysing the textile industry recently. This industry seems to be globalising with the quotas gone. My initial thoughts on the business risk are

• execution risk for some companies. Not all managements have the capability to manage ‘hyper’ (50%+) growth. Look at arvind mills track record in mid to late 90’s. They invested heavily in denim using debt. The denim cycle turned south and this company was left saddled with huge debt
• Commodity nature of the product could result in pricing pressure on an ongoing basis
• Limited leverage with customers – Being a supplier to one of the major retailers will constantly expose these companies to pricing pressure and stiff competiton