Raising portfolio quality

By Rohit Chauhan

In Investment process, Uncategorized

February 9, 2012

4 Min read

10 comments

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A bear market is a time for lots of activity for me. A 25%+ drop in 2011, with a near collapse towards the end of the year, threw up a lot of opportunities. During such times, the problem for me is that my portfolio soon starts resembling a zoo – it has a stock of each variety.

How do I end up in such a place?

I personally ignore short term forecasts and start buying a company (usually too soon) if the valuations are attractive and the long term prospects are good. The problem with this approach is that there is no grand strategy behind it. As a result I often end up with too many stocks in my portfolio

I have gone through such a phase several times in the past (in 2005, 2008 etc) and have had to prune my portfolio after that. This time around, I made a decision to limit myself to around 22-25 stocks and any further addition would require me to sell something – keeping the total number the same.

Now, one may argue that even 20-22 stocks are too many and one should have a more focused portfolio. Let me assure you that once I gain more experience and hopefully some wisdom, I will scale back the number to 15 or less. Till then this level of diversification is an insurance against my ignorance or stupidity.

So why limit yourself?

A different way of looking at this issue is to question the need to limit oneself to any fixed number of stocks. If you can find enough good and cheap stocks, why not load up on all of them?

I have followed this approach to a small extent in the past and have realized that this results in mental laziness. Once I buy a stock, the endowment effect kicks in and then I am reluctant to change my opinion on the stock even if the company is performing below average.

In all such cases, I have finally come to senses and have sold the stock usually at a small loss. The real loss however is the opportunity cost of deploying this capital in some other high quality idea.

What is the difficulty in exiting?

It would seem very easy to exit such stocks on a purely rational basis.  You look at the original thesis of the purchase (for example – the company will grow at X %) and compare it with what has happened since your purchase. If the company is performing below expectations and will continue to do so, then you sell the stock and move the capital to a better idea.

If only life was this easy ……

The emotional part

I find the emotional part of selling a stock, which has not done well to be a painful exercise. For starters, one has to admit that one has been wrong or unlucky (usually wrong) and in hindsight should not have bought the stock.

The next problem is to find another idea to replace the one being sold, which in turn will hopefully not be dud.

The worst of both worlds is to see the old stock soar in value after the sale (yes, I have had this one too – VST industries) while the new pick stagnates.

Selling to raise the quality

There are times when if you are fully invested, the only way to invest in a new idea is to sell an existing one. I have created an artificial constraint by limiting myself to 20-25 stocks. This constraint has now forced me to rank my stocks in an order and to look for the weakest ideas in the portfolio.  How do you do the ranking? Well that’s another post, and stock price is not the only criteria.

The weakest idea now gets compared to the new idea and if the new idea is much better, then it replaces the weaker one. You can call it the survival of the fittest – each stock has to earn its position and cannot just stay put in the portfolio. There are no holy cows!!

So which of my ideas are facing the axe? Some minor ones have already been axed. I have been reviewing the Q3 results and have a few more on the chopping block now (this one is a good candidate)

Selling the mediocre ideas to buy a more attractive stock is always painful for me, but over time I have found that my overall performance has benefitted by swallowing my pride and biting the bullet.

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

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A bet on china : MOIL

By Rohit Chauhan

In Company analysis, Uncategorized

January 28, 2012

4 Min read

3 comments

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This title must have made you wonder – now what leap of logic is this guy having here ?

Let me walk through the logic to prove to you that I have not lost my marbles (not yet !)

An IPO and frenzy

MOIL came out with an IPO in late 2010 and there was quite a bit of frenzy around it. I think the IPO got oversubscribed by 25 times which shows the level of investor enthusiasm. In my case, I have a personal rule – I never invest in an IPO ( I have written the reason here). As 80% of the IPOs are overpriced and quite a few are junk anyway, I would rather miss a few good chances than be stuck with a lot of duds.

I was asked about MOIL then by a lot of readers on the blog, and due to the above reason I did not look closely at the company.

So why now ? The simple reason is that the stock has dropped quite a bit since then and investor sentiment is a bit negative now. Any time a stock drops or almost everyone gets negative on something, you will find me fishing in that area.

Why the drop ?

MOIL is a mining company and derives almost 80-90% topline and profit from manganese ore. Manganese is a key input in steel making and hence the demand and price for manganese depends on the demand outlook for steel.

MOIL has very high operating leverage. The PBT/ sales ratio has fluctuated between 48% in 2007 to as high as 78% in 2009. The profitability in case of MOIL is highly correlated to manganese prices and due to low levels of operating costs (minimal raw material and manpower cost) in proportion to the sales, any rise in manganese price flows directly to the net profit.

In times of high demand and lower supplies of manganese, the international price for the same has gone up by 30-40% and driven up the profitability for the company. The company was coming off such a peak at the time of the IPO.

In a commodity business, high prices result in capacity addition which in turn drives down the price of the commodity. In case of manganese, South Africa and Australia are big producers  and have increased supply in the recent past. India imports manganese ore as the domestic supply is inadequate for the steel making and for making Ferro alloys (which are exported). As a result, the price of manganese in India is dependent on the international price.

The international prices for Manganese has dropped from their peak levels and so has the profit level for MOIL. Hence the drop in the stock price

So where does china come in ?

I hope you have followed my logic till now – manganese is used in steel making, South Africa and Australia are big producers, India imports manganese and hence manganese prices in india are dependent on international prices, which have dropped in the recent months

So what drives international prices for manganese ? China !

 China account for 50%+ of steel demand globally and is largest consumer of manganese. If china grows, demand and price for manganese goes up. If china slows down or has a hard landing (as some are suspecting), then steel and manganese demand will drop and so will the prices

Sooooo…the profitability in case of MOIL is tied closely to what happens in china

Should you buy MOIL?

If you have a view on what will happen in china in the next 1-2 years, then you may be able to make a decision. In my case, I cannot predict what will happen to the Chinese economy, Indian economy and Indian cricket team (maybe Indian cricket team !) and so I will stay away.

At the same time in the longer run as the company adds more mining capacity and acquires new mines (using the 2000 Crs cash on the book), it will become more valuable. At a certain price, the market may discount a further drop in manganese price and more . I will definitely start looking at the company more closely when everyone thinks it is the worst possible stock.

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

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The advantages of part time investing

By Rohit Chauhan

In Uncategorized

January 22, 2012

5 Min read

16 comments

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Does the professional investor, FII or the institutional investor have a big advantage over the small, part time investor?

Fact 1: The professional investor has access to in-depth research on a large number of companies. They also have access to the management and other industry professionals which allows them to cover an industry in depth and finally they do this on a full time basis. How can you beat that?

Fact 2: Very few mutual funds and institutional investors are able to beat the market over the long term (5+ years). In case of developed market such as the US where the performance numbers are more readily available (including those of hedge funds), only a handful can beat the market by a few  % points.

How does one explain these two contradictory facts?

There are several reasons for this contradiction and I will explore some to highlight how a small investor like you and me can still score over the big boys.

The over emphasis on industry knowledge

The number one advantage cited is that the professional has access to in-depth analysis of an industry and can thus make better decisions. I think this advantage is overrated.

As an individual investor, if one really wants to learn about an industry, a good starting point is to read the annual reports of the top 3-4 companies in the industry. In addition there is a wealth of information available on the internet which one can Google to explore an industry in depth.

In the pre-internet days, the professional investor had substantial advantage over the part time investor but now a lot of information is available at the click of a button.

The other point cited by those trying to sell you funds and other such products is they have access to the latest data on the industry. I don’t think this is a big advantage to a long term investor. If your time horizon is 3-4 years, then getting the monthly sales figures before everyone else is hardly of any advantage unless you want to trade on that information.

Professional behavior

The other advantage of the professional investors is assumed to be their experience and ability to act more rationally than the small investor. I have not seen any evidence which shows that the professionals are more rational than the rest of the market.

Several fund managers and FIIs have portfolio turnovers in excess of 100%, which means that these professionals have an average holding period of less than 1 year. In addition if you look at the FII behavior, they demonstrate the classic herd behavior – exit the market when everyone is doing so and re-enter when the market starts picking up or has already risen substantially.

The net effect of constant turnover and herd behavior is higher cost (transaction costs) and lower returns over the long term.

As an individual investor, I do not have the pressure to follow others or excessively churn my portfolio. I can afford to hold a stock for 5 years, if the long term outlook for the company is bright even if the short term price performance is expected to be terrible

The institutional pressures

The point which is never highlighted by brokers and professionals is the problem of institutional pressures. Professional managers live by the quarter – though they ask their customers (investors) to think long term.

Any fund manager who under performs the market for a few quarters is at the risk of losing his or her job as the fund management company faces the risk of losing the assets due to redemptions. In addition, even if the fund manager is rational and long term oriented, they cannot afford to take unpopular decisions such as buying capital goods or financial stocks now as any underperformance due to such stocks will result in a career suicide.

This institutional pressure more or less forces the fund manager to buy the popular stocks and mimic the index  with minor variations in the long run.

The small investor like you and me has none of these compulsions. In my case, other than the risk of looking foolish (sometimes publicly or worse in front of my wife) in the short term, I don’t face the risk of losing my job or ruining my career due to any unconventional decisions. This is a big advantage over the big boys

Is there any disadvantage?

The key assumption in my arguments till now is that the small investor is willing and able to devote a reasonable amount of time in researching companies and following up on them. There is no short cut for that.

Can you think of any time in college where you did not attend any classes or even study a new subject on your own and still managed to do very well in the final exam (without cheating of course )?

I personally think that if you are interested in investing and willing to devote 5-6 hours a week consistently on it for a long time, there is no disadvantage of information or insight versus the professional.   On the contrary as a small investor, one does not face the institutional pressure and thus has an advantage over the professional.

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One stock, three viewpoints

By Rohit Chauhan

In Company analysis, Uncategorized

January 8, 2012

7 Min read

15 comments

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Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company.  In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj marathe ( and a few more ).

We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias. 

The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.

Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions.  I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here . We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.

Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones 🙂

About

NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.

The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land

Financials

The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.

The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.

The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.

The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).

Positives

The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).

The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.

The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.

Risks

The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.

I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).

The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.

Management quality checklist

Management compensation: The management compensation is around 3% of net profits which seems reasonable.

Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.

Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.

Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.

Conflict of interest: None as yet

Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation

The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.

The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).

Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.

Conclusion

The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

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

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