Value investor india

Value trading

September 27, 2012

7 Min read

I am going to discuss a new term –value trading in this post. It is a very interesting concept and it was first mentioned by my good friend – arpit ranka. I cannot claim any originality on this concept, but once it was mentioned by arpit, I started thinking about it and found a lot of validity and relevance to my style of investing.

What is value trading? (my definition)

Value trading is best described as buying a stock with the expectation of selling the same (hopefully with a gain) in a short period of time based on the realization of a single or multiple triggers. This trigger can be fundamental in nature such as normalization of sales/ profit margins (from a temporary low), business event such as launch of a new product or new capacity or change in the business environment for the better such as moving from extreme to moderate pessimism .

In addition to the fundamental issues, the trigger could be technical in nature such as short term overselling of a stock due to unexpectedly poor results or some temporary event such as elections which do not really impact the fundamentals of the business

In all these cases, one is expecting that the trigger will occur in the short term and the stock price will get a quick bounce (10%+) and one would be able to exit with a nice little profit

How does it differ from value investing

The above definition may sound a lot like value investing and I have been guilty of mixing the two for all these years. However as I think back, I have come to realize that they are not strictly the same and confusing the two can actually be harmful (as I will explain later in the post)

If one invests with a long term horizon in mind, then it is critical to have a good idea of the intrinsic value of the company. In addition this intrinsic value should increase over time, if one is to make above average returns in the long run.

So in effect, one is playing a short term trigger in the case of value trading versus betting on the business in the case of value investing.

Examples of value trading

Lets look at some example I have posted in the past and look at which bucket these ideas fall into

Patels airtemp

I would call this ideas as a value trading idea as this company is in a highly cyclical industry. At the time of buying the stock, I was expecting that the downturn in the capital goods industry would not be deep and the fundamentals of the company and its stock price would soon bounce back.

The trigger has yet to happen and as result the stock has slid further since the time I wrote about it.

Ashok Leyland

I started looking closely at this company in mid 2008 and by the end of the year the bottom had fallen out of the commercial vehicle market (the company stopped production for a month in dec 2008 to reduce the inventory). I purchased the stock in early 2009 at highly depressed prices.

The trigger – normalization of commercial vehicle sales happened quite quickly towards the end of 2009 and the stock turned out to be a four bagger.

In both cases, I expected a normalization of the fundamental performance and a bounce back in the stock price. In one case it happened faster than expected resulting in a large gain and in the other case the downturn has been deeper than expected and hence the stock price continues to languish

Amara raja battery

The company is a no.2 player in the battery industry and operates in a close duopoly. The key insight in this idea is that the company is expanding its competitive advantage (brand and distribution) and also benefiting from migration of demand from the un-organized to organized sector

I would tag this as a value investing idea as i don’t expect a specific trigger other than the fact that the company is improving its competitive position and hence should see an improvement in profitability and growth.

The first two examples I have discussed should bring out the following key point – In a value trading idea, the intrinsic value may not expanding or could be declining too. However the stock is undervalued and a set of triggers could close the gap with the intrinsic value. You can call this mode of investing as deep value investing or graham style investing too.

The last example of amara raja is more of a buffett style, high quality stock where although one is expecting the gap with the intrinsic value to close, the bigger gains come from an increase in the value of the company itself.

The differentiating factors

The two modes of investing differ on several factors. The first factor is time – Time works against you in the case of value trading. If the trigger happens quickly, the price rises quickly to the fair value and one can exit with a nice little profit. On the other hand if trigger gets delayed, then the overall returns may remain the same, but the annualized return is much lower.

In case of value investing, time works in your favor. As the company continues to grow its intrinsic value, the stock price should hopefully follow it (some times in spurts) and thus the idea becomes a buy and hold kind of idea.

The second factor where these two approaches differ is the nature of the business. The value trading approach works better in commodity and cyclical industries. If one can catch the bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then the gains are very high when the cycle swings back to a normalized level. At the same time, one needs to also ensure that the stock is sold once the cycle has turned .

Value investing approach works where the economics of the business is good and the company has a competitive advantage. In such cases, if one buys the stock at reasonable valuations, then returns are good over a long period of time

Do not mix the drinks !

I would say that value investing or long term investing should occupy a larger portion of the portfolio. If however you have the time and energy to look for value trading kind of ideas and can play them well, the portfolio can get an extra boost from time to time

The danger is really from mixing the two approaches as I have done in the past. I have bought trading kind of ideas and held on to it for a long time (assuming it was a long term investment). In such the cases the absolute returns came through, though the annualized returns were mediocre due to a delay in the key triggers.

The correct approach would be to keep in mind the nature of the idea (trading v/s investing), identify the triggers and the time it would take for the same to play out. If the triggers change or get delayed , then one should exit a value trading kind of idea. In contrast in a value investing idea, time is working in your favor and temporary hiccups are sometimes a good time to add to the position. In all such cases, one should just sit tight with the position.

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A simpler way to invest

By Rohit Chauhan

In Uncategorized

September 13, 2012

4 Min read

17 comments

Let’s do a thought experiment – Let’s say you are going on a multi-year cruise or journey around the world and need to invest your or your retired parent’s money. Let’s also assume that you want to ensure that the money is secure, but at the same time earns a decent rate of return (Which beats inflation).

Investments of this type should have the following characteristics

a. The portfolio of such investments should be reasonably secure – low probability of long term loss of capital, though temporary fluctuations are fine

b. Above average rate of return – The investments should beat the inflation and possibly earn a few percentage points above it, so that your family can withdraw a small portion of the capital without a reduction in principal

c. Low maintenance – should not require your family or you to run around, doing tons of paperwork or other tasks to manage it

Let’s invert the question and look at what will not be good options

a. Fixed deposit – Safe and low maintenance, but the rate of return barely beat inflation. As a result, if you use up the interest , the capital base will get eroded by inflation

b. Real estate – May be secure and give above average returns, but requires constant work (maintenance, repair, payment of taxes etc). In addition, you cannot really invest small amounts of money into it.

c. Gold – If you have been following me for sometime, you know my distaste for it. It is not an income producing asset and I cannot think of any family selling gold for meeting expenses – Remember the old Hindi films, where the family sells gold when it is in dire circumstances? We are too conditioned by those images.

I know you would have realized where I am going – equities!, but then not all types of equities. The above criteria eliminate some types of companies from the consideration set.

a. New companies with a short operating history – Sure, the company is going to be the next titan or ITC (fill in the name), but if the companies goes down the drain while you are away then your family is in trouble

b. Speculative companies – Loss making or penny stocks which have performed poorly in the past but have a very bright future.

c. Companies with poor management – I don’t want to hand over my money to a crooked management who could cheat me in my absence (remember we are away for a long period of time)

If you think through all these options, you will realize that you are left with a small list of companies which meet the following criteria

a. Durable competitive advantage – The company has done well in the past and you are assured that it will do well for a long period of time in your absence

b. Good management – You can trust the management to be good caretakers of your money in your absence

c. Reasonable prospects – The Company may not have phenomenal growth prospects, but should deliver above average growth.

If you put all these points together, I hope you can see a picture forming. We are talking of companies such as

Asian paints
HDFC ltd
HDFC bank
Crisil
ITC
Titan etc

A portfolio of such companies would be fairly safe as one is talking of good companies with above average economics and decent management. These companies may not be the next multi-bagger, but it is easy to see that they will give one a 15% or higher annualized return for a long period of time. Even if you consume 3-4 % of the return (via dividend or sale), your capital will still compound at 10-11%, which will take care of the corrosive effects of inflation.

If the above makes sense, then why am I not following it? Let me tell you why – The desire for higher returns! I think I can make higher returns than what I can get from these companies.

Please note the word – ‘Think’ and not would. Anyone who decides to invest on their own in all kinds of midcaps, small caps and other equity options is implicitly assuming that he or she can do better than these proven ‘blue chips’.

I am not saying that some people cannot do better, but I don’t think the lay investor who chases the current fad and hot tips, will do better than a basket of such companies. It is often smarter to make a sure 15% than chase the dream of 100% returns.

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My experiences with deep value investing

By Rohit Chauhan

In Investment process, Uncategorized, Warren buffett

August 26, 2012

6 Min read

13 comments

Deep value investing or cigar butt investing, is buying stocks whose price is way below the various statistical measures of value of the company. Now, value can be measured by various means such as PE ratios, discounted cash flow analysis or asset values. In case of deep value investing, one is investing in stocks which are selling at a very low PE, below book value or in some cases even below cash held by the company.

This method of investing was introduced and popularized by the father of value investing – Benjamin graham in his classic security analysis (A must read for any serious investor). In this book, graham talks about companies selling below working capital, book value or in some extreme cases, even the cash held by the company.

This mode of analysis is a quantitative, statistics driven method where in one holds a large number of such ‘Cheap’ companies. A few positions work out, a few go down the drain and rest just stagnate doing nothing. In spite of such a mix, the overall portfolio does quite well and one is able to earn decent returns at low risk

The key element in this investment operation is wide diversification and constant search for new ideas to replace the duds in the portfolio.

Initial foray into high quality
My first exposure to sensible investing (reading economictimes and watching CNBC does not count in that), was when I read the book – The warren buffett way. I was completely mesmerized by this person and read all I could on him for the next few years.

After burning my finger a bit during the dotcom bust, my initial investments were in the warren buffett mold (high quality stocks with competitive advantages). My initial investments were in asian paints, pidilite, Maricoetc – the so called consumption stocks except that they were not called by this label then.

I have always wondered why these stocks are called consumption stocks? are capital goods and real estate ‘un-consumption’ companies whose products no one wants to consume J ? Anyway I digress

An experiment in deep value

Around 2006-2007, i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around 10-15% of my portfolio in names such as Denso, Cheviot company, Facor alloys and VST industries (see here), etc for a period of around 3-4 years.

I decided to terminate this approach in 2011 and have been exiting the positions since then. In the rest of the post I will cover my experience and learnings from this long run experiment.

The results

The results from this portion of the portfolio (which was tracked separately) was actually quite decent. I was able to beat the market by 5-6% points during this period. At the same time, this part of the portfolio lagged the high quality portion by 6-7% over the same time period. The difference may not appear to be big, but adds up over time to a considerable difference due to the power of compounding.

I have not completely forsaken this mode of investing and once in while could buy something which is very cheap and has a near term catalyst to unlock the value.

Why did I quit ?
I did not quit for the obvious reason of lower returns than the rest of the portfolio. The lower return played a part, but if I compare the effort invested in building and maintaining a deep value portfolio , it is much lower than trying to identify a high quality and reasonably priced company .

If one compares, the return on time invested (versus return on capital), the balance could tilt towards the deep value style of investing.
Let me list the reasons for moving away from this style of investing

Temperament – The no.1 reason is temperament. I have realized that I do not have the temperament to invest in this fashion. I do not like to buy poorly managed, weak companies which are extremely cheap and then wait for that one spike when I can sell it off and move on to the next idea. It makes my stomach churn everytime I read the annual report of such companies and see the horrible economics of the business and miserable performance of the management.
Life is too short such for such torture

Re-investment risk- The other problem in this mode of investing is the constant need for new ideas , to replace the duds in the portfolio. This exposes one to re-investment risk (replacing one bad stock with another bad idea), especially during bull markets.
Value traps – This part of the market (deep value) is filled with stocks which can be called as value traps. These are companies which appear cheap on statistical basis, and remain so forever. The reasons vary from a bad cyclical industry to poor corporate management. In all such cases, the loss is not so much as the actual loss of money, but the opportunity loss of missing better performing ideas.

Higher trading – The final problem in this mode of investing is the constant churn in the portfolio resulting in higher transaction costs and higher taxes, both of which reduce the overall returns.

The lessons
I know some of you, have never followed this mode of investing and have always invested in quality. The problem with investing in quality is the risk of over payment, especially if the quality is just an illusion (faked as in the case of several companies in the real estate sector in 2007-2008). Anyway, that is a topic for another post.

I am constantly experimenting , with a small amount , with new approaches and ideas. If there is a valid approach, which matches my overall value investing approach (momentum and technical trading is out), I will try it and see if it works for me. It is one thing to read about it and another to put some money into to it and immerse oneself in it.

As some has said – an expert is someone who has made the most mistakes and survived. Well, at the current rate of making mistakes, I hope to become an expert in the next 10-20 years J.

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Investing for dividends

By Rohit Chauhan

In Portfolio management, Uncategorized

August 12, 2012

5 Min read

4 comments

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,

I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response

Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following

a) Company earning high return on capital with good cash flows

b) Reasonable valuations

c) Good capital allocation policy by management

if you are able to achieve the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory…high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards

Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement

How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period – there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire 🙂

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

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