Value investor india

July 19, 2012

3 Min read

I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.

Let me tell you a recent story.

I spoke very briefly about a company in this post. The company was Ricoh (I) ltd. You can download my detailed analysis of the company here.

So after doing this detailed analysis in late 2010, I built a decent position at an average price of around 35-37 Rs/ share. The company continued to perform poorly (as I expected) as it had done an acquisition and was also investing heavily into sales and marketing.

The topline grew by 40%, but the net profit dropped from around 15 Crs to a loss of 5 Crs in 2012. The price continued to stagnate in the range of 37-40 rs during this period.

I have been consolidating my portfolio and weeding out the weaker ideas for the last 2 years. As a result, I exited Ricoh in the feb-march time frame. I think it was a rational thing to do based on the information I had as of March 2012.

The change

The company declared the Q4 2011 results in April and reported the following

Q4 sales growth, YOY – 60%
Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)

The price action can be seen below

As you can see, the market did not react immediately to the turnaround in the performance and there was a 1-2 month window for an intelligent investor to digest this information and purchase the stock.

So that proves my level of intelligence J

The explanation
It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.

The bias is called the commitment and consistency bias. In simple words, once one makes a decision, the tendency is to ‘commit’ to the decision and be consistent with it. This results in ignoring positive information as in the above case or holding on to a losing position (inspite of consistent negative news) and hoping that the price will rise in the future.

Not a one off case
The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.

I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.

It is better to look foolish (in my own eyes), than miss out on a good idea

Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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A speculative bet

By Rohit Chauhan

In General thoughts, Uncategorized

July 5, 2012

4 Min read

7 comments

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative – Benjamin graham, father of modern security analysis and value investing.

Some background

I had written about globus spirits earlier – read here. The stock price has since dropped by around 10% versus the index, which has essentially been flat during this period.

So what happened during this period ? Well, the company declared the Q4 results and the market reacted negatively to the drop in operating margins from around 16.8% to around 13%. The company closed the year with a 40% growth in topline and a measly growth of 2.5% in net profits.

This drop in net margins was mainly due to an expansion in the capacity to 84Mn litres and additional new capacity of 40 Mn litres which should come online in the middle of next year. This additional capacity has caused an increase in manufacturing expenses (initial startup costs) and higher interest expenses (due to higher debt to add the capacity). These costs in combination have depressed the operating margins.

So what is my bet ?

I think that the drop in the operating margins is temporary due to the new capacity which is being added in the current and next year. As the new plant stabilizes, the extra costs should reduce and with the extra topline , we should see an improvement in the margins.

In addition, a decent portion of the additional capacity has been booked by USL for the franchise IMFL bottling (outsourced production) which should help in boosting the bottom line. The management is targeting a 15% operating margin for the next year.

The management has also indicated that they would be able to grow the topline by 20% or more in 2013 (which appears doable based on past results). If we put all of this together, the company should be able to increase the operating profits from around 73 crs to 100 Crs, with net profits in excess of 55 crs in 2013 (interest costs should also reduce due to a planned reduction in debt)

The company is current selling for around 5 times the current year’s depressed earnings of around 40 crs. The company is thus selling at historically low valuation too (past valuations have generally been in excess of 7-8 times earnings).

In addition, all the other companies in the sector sell for 10+ times earnings, inspite of having much lower ROE and higher debts.

So why is it speculative?

Have I built a good case that the company is really undervalued – from absolute, historical and comparative valuation perspective? I think I have done that. At the same time I am still calling it speculative …why is that ?

Please look at the definition in the beginning of the post – An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.

The key word in the above definition for our example is promise. I am not confident about the above analysis and think it is a 50-50 proposition. I am still concerned that the industry has extremely poor economics and it is generally quite difficult for a single company to buck the trend of an entire industry.

Speculation is subjective

The key point is that a stock can be both a speculation or an investment at the same time and that depends on the investor himself. If you know what you are doing, then it is an investment, otherwise it is a speculation.

The danger is not speculating, but in confusing a speculation as an investment and betting heavily on it.

I am personally not very sure if the above thesis will play out and hence have committed a very small amount of money to it. In effect, this position is just to scratch an itch and not meaningful. If it turns out well, I will brag about it on the blog, otherwise you will not hear a peep on it 🙂

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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The return of the stock picker

By Rohit Chauhan

In General thoughts, Uncategorized

June 24, 2012

5 Min read

13 comments

The period from 2008 to 2012 has been a nightmare, right? How could it not be?

The market went from 20500 to around 17000 levels. That’s a loss of 18% in nominal terms, and if one considers an inflation of around 8%, then the loss is a mind numbing 42%. So if one had complete foresight and could see the future, then 100000 invested in a bank deposit would be worth 144000 versus around 82000 in the stock market.

So where is the debate in this?

The time of the stock picker

I know of several fellow investors who have actually done quite well during this period. They may have lost money on a few ideas here and there and suffered through temporary drops during the market swoons in 2008-2009. However over the course of these 4+ years, most of these investors have soundly beaten the market and delivered double digit annual returns

So how have these guys achieved this feat ? Do they have a special diet or drink something special 🙂 ? I don’t think so as far as I know

What has enabled these returns

I would say that there two reasons for the above result. All these investors who have done well, have a long term view of investing and don’t invest with one week or one month in mind. In most cases, they invest after a thorough analysis of the underlying business and only when the market undervalues the business.

A disregard for short term performance, usually results in a long term outperformance.

The second reason I would say is that all these investors are focused and work hard at finding good ideas and then purchasing the stocks, inspite of all the negative news around them.

It helps to be emotionally stable as far as the stock market is concerned. One need not be like Mr Spock from star-trek, but as long as you can avoid extreme greed or fear, you will do fine.

Hard work and focus

This is one of the most under-rated factors in being a successful investor. I am pretty sure most of us were told as young kids, that the way one can be successful in life is by working hard and being diligent about it.

This simple lesson which we apply to almost every other walk of life, is conveniently forgotten by a lot of people, once they enter the stock market. It almost as if, investors collectively expect a Santa Claus to give us returns just for putting up some money in the stock market.

I cannot think of any successful investor who has succeeded without a lot of effort and focus.

Enjoying the process

At the same time effort and focus is not enough to succeed in the long run, if you do not enjoy the process of investing. There are long periods of time when you will not make a meaningful return and all the effort would be seem to be in vain.

I personally went through this phase quite early in my life as an investor. The period 2000-2003 was one mind numbing and grinding bear market when the index went from 6000 levels to 3000 levels over a period of three years. It was no different from what we are experiencing now. Companies like L&T, concor, BHEL sold at 5 times earnings.

The only reason I was able to keep learning and keep going was due my passion for investing. A single digit return on a few lac of rupees is not even minimum wage …why else would any sane person keep working hard for less than minimum wage 🙂

Everyone can do it

The secret to being a successful investor is that there is no secret at all. Inspite of the nonsense propagated by media, that the common man should leave investing to professionals, I think anyone can become a good investor.

The most important factor to be a good investor is to really enjoy the process of investing. If one loves the process, he or she will find the means to continuously learn and improve as an investor. The returns usually come in time, if one is patient.

The return of the stock pickers

The period 2003-2008 was a big tidal wave. All one had to do was to point his or her boat in the right direction (real estate or infrastructure ?) and the wave carried you through.

The investors who have done well in the past few years are most likely the ones who enjoy the process (and ofcourse want to make money too) and are continuously learning and getting better at it. The last 4+ years have been a time of stock picking and hard work. If you looked for good ideas and operated with an independent mind, the results have been quite good.

Let me make prediction – I am close to 100% sure on this. Once the next bull run starts (it looks unlikely , but will happen in time), you will find a lot of new investors who will boast of their investing prowess and will think that making money in the stock market is easy and effortless.

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Moat or no Moat – Indian IT

By Rohit Chauhan

In Industry analysis, Uncategorized

June 15, 2012

5 Min read

25 comments

I recently posted the following comment on twitter

Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term

This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)

I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

Switching cost due to customer relationships
Economies of scale
Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

Let’s look at where we stand on these factors

a. Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.

b. Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further

c. Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)

d. Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.

Weak and strong moats

Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.

A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.

My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.

Some numbers

Let’s look at the ROIC numbers for some IT companies (Indian and global)

IBM – 15-20 % (based on invested capital including debt)

Infosys – 50% (based on invested capital, excluding cash)

NIIT tech – 25%+ (based on invested capital, excluding cash)

The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.

What explains this big difference?

Eliminating some factors

I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors

Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage

Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)

Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.

The future

I will take a guess now (which is as good as yours). I think the return on capital (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.

This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.

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If facts change, do you change your mind?

A speculative bet

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Moat or no Moat – Indian IT

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