What’s on my mind – Dec 2011

By Rohit Chauhan

In Uncategorized

December 29, 2011

6 Min read

16 comments

W

I want to close the year by discussing a few things which are on my mind and do not warrant individual posts for each topic.

Buy or hold for a crash

The market has dropped by 22% in the case of large caps and more than 30% in case of mid caps or small caps. That’s painful to say the least and has driven a lot of investors (should we call them that?) out of the market.

The most common view (including of some smart fellow investors I personally know) is that we have a lot of pain to follow in the coming quarters and hence it would be smart to wait for the prices to correct further, before diving in.

I agree with everyone that power, infrastructure, real estate and as a result banking are in for rough times over the next few quarters. Where I diverge from almost everyone is that, prices in some cases reflect the pessimism and more. As a result, the valuations are quite attractive and as it not possible to predict stock prices (at least in my case), I would rather buy based on what I think I know (cheap valuations) than what I would like to guess (prices in the short to medium term)

This is a risky stand to take and I am standing completely away from the crowd. I can’t think of any analyst or newspaper (not that I care about them) that is encouraging the investors to get into the market. On the contrary, almost everyone is exercising caution.

My reason for deploying my capital on a consistent basis is that the short to medium term may be bad, but the economy should recover in the next 1-2 years and as a result some of the companies which are hated now, should do fine.

I may end looking like a complete moron or a hero in a year’s time.  I am hoping for my sake, that I am at best early and not wrong.

The story stocks

I come to the next point – my allergy with story stocks. If you have been around, you will remember that IT companies were the story stocks of early 2000, infra and real state in 2006-07 and consumption or consumer stocks since 2009.

I find it quite amusing when others expound the virtues of the current favorites. The typical argument is that the Indian middle class is growing, so it will buy more of X and hence the future of these companies is bright. I don’t disagree with this thesis at all.

What I find amusing is that this is hardly new. This has been the case for the last 15 years and it is only now that the market has taken a fancy to this concept and bid the valuations up. I have a mind block due to the fact that the market generally tends to overdo a good thing. In its enthusiasm for IT or infrastructure stocks, the valuations went way up and when the mood turned, the results were not pretty.

Just in case you are thinking that this is a case of sour grapes in my case ,I would like to add that I started my professional career with a consumption company (asian paints) and my initial investments were all such companies (pidilite, asian paints, GSK consumer, P&G etc) as they were much easier for me to understand .

One another point – If you think these companies and the stocks will continue to do well, then how can the rest of the industry (power, infrastructure, banking etc) continue to do badly as implied by the current valuations. If the current dichotomy were to continue for 5 or more years, we may have a very weird economic outcome in the country.

I personally like a lot these ‘consumption’ companies, but not the valuations.

What mutual funds to buy?

I recently received the following comment (slightly edited) on mutual funds.

One thing i need to ask about your mutual fund portfolio is diversification..i am commenting about 5 funds u have selected ( may be possible that u don’t have any positions in them now )
1. Are all your funds are large caps and multicaps..why?
2. Don’t u believe in core and satellite approach which many magazines, papers are advocating these days
3. you are an aggressive investor and your mutual portfolio doesn’t reflect that?
4. u have invested in growth style funds only..not in any value fund why? don’t u think diversification in investment style is also necessary

The above comment raises good questions and as it was not possible to do justice via a comment, I have decided to take it up in this post

First a disclosure – I do not hold any mutual funds now. It is true that I have held mutual funds in the past (for almost 8-9yrs) as I elaborated in this post. I also elaborated on why I followed this strategy inspite of investing in stocks (see here).

In addition to the reasons in the post, I have always had this question in my mind – Are my return due to luck or skill? One needs to look at performance over a long period of time to be sure that the results are mainly due to stock picking skills and not a fluke. After picking stocks for 10+ years and outperforming most of the mutual funds I held during this period, I am inclined to believe that it must be due to skill and hopefully not luck (though one can never be sure).

My mutual fund selection process has never been based on market cap, investment style or any core/ satellite approach. You can find my approach in selecting equity funds here.

Frankly, I find the entire market cap, value versus growth or any other approach of selecting mutual funds downright self serving on part of financial advisors, mutual fund companies and personal finance magazines. How will they make money if they give you a simple, though equally effective plan ?

I have never quite understood the market cap or sector approach to fund selection till date. It is like asking Sachin tendulkar to score a hundred while playing only 3 balls in each over. Why would you want to invest in a fund where you restrict the manager in his or her stock picks? I would rather go with a diversified fund where an intelligent manager can picks attractive stocks with no restrictions.

I would personally prefer to invest regularly in index funds or widely diversified equity funds with a long term track record . My suggestion may appear as odd and opposite of what almost everyone has to say. I would rather keep investing in mutual funds simple and focused on the basics and not get carried away with all the fancy marketing which is used to sell garbage to investors.

On the last point of being an aggressive investor? I actually consider myself quite risk averse (to the point of being chicken) and am constantly obsessing with the downside of my stock picks. The upside on the other hand usually takes care of itself.

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Finding diamond in a coal mine

By Rohit Chauhan

In Investment process, Uncategorized

December 18, 2011

5 Min read

16 comments

F

I have nothing against the airline industry, other than the fact that it is injurious to investor wealth.  There are other industries such as sugar which fall in the same group, where most of the players are not even able to meet their cost of capital over a business cycle.

I got several comments, where it was noted that there are some companies such as spice jet in the airline industry could turn out to be successful. A comparable example is bharti airtel which has done well in a fairly competitive industry with poor profitability (telecom)

I do not deny the fact that it is possible to find a profitable company which manages to buck the trend. There are often profitable companies in terrible industries and poor performers even in profitable ones (such as FMCG)

A probabilistic exercise

Let play a game of chance. Suppose I give you two dices and say that if you roll a 1,1 or  6,6 (both dices turn up one or six), I will pay you  5 for every one rupee you wager. Will you play this game?

If you understand the concept of expected value, you will decline it (read here about it and I will strongly recommend you to understand this concept thoroughly). You may get lucky once a while (roughly 5% of the times) but over a long period of time you will lose money by playing this game (you will lose 1 rupee 95% of the times and gain 5 rupees, 5 % of the times giving a net loss of .7 for the game)

So what does this game have anything to do with investing in an airline? Let me explain –

If you read through the previous post closely, you would have noticed that roughly around 16 or more airlines have failed till date and all the current ones are also losing money (some of these could fail too –at least for their shareholders). So even if spice jet or some other airline succeeds, you are talking of a 6-7% success rate in the industry.

Will you play a game where the probability of success is less than 10%? If yes what should be the payoff?

Well, venture capitalists who make such investments (low probability of success) typically expect a payoff of 20 or more for every rupee invested, to earn a respectable return on capital. Can you expect the same from spicejet or Jet airways?

But I am not putting all my money on airlines

You can make an argument that one is not really putting all his money in the airline industry and hence the above probabilities don’t apply. That is really not the case, as the said probabilities do apply to the specific idea, if not to the entire portfolio.

At the same time think of it – If you put a certain portion of your portfolio in industries with poor economics and high levels of failure, are you not setting yourself up for failure?  The ex-ante probability of success in all such cases is quite low. If you are really a smart investor, does it not make sense to invest in industries where the chance of success is high to begin with and then on top of that you can apply your considerable skills to improve the eventual outcome.

The counter argument

I can think of two counter arguments to my logic

The first one is that if one has some special skills or insight into the industry and thus an edge over the market, it makes sense to invest in that industry inspite of the problems. Even in such as case, I cannot think of a scenario where most of the investors would have a considerable edge in a wide range of industries (including the lousy ones).

The second counter argument is the graham style of investing – pick a lousy company so cheap, that when the industry turns a bit, this company goes from a bargain price to just about cheap. I have done this several times in the past and made some money from it. This is however a 1-2 year game of cycling through such stocks on a regular basis, and constantly looking for the next one. There is nothing wrong with it except, that it requires wide diversification and constant effort to look for new ideas.

Ignoring industries with poor economics or governance?

Does the above post mean that one should just ignore and never try to learn about an industry which is known for poor economics? I think that would be silly. It is not like one will get some kind of infection or loose money just by reading about such an industry. One should practice safe investing, but that does not mean one should not learn about these companies.

Let me give an example – I am quite allergic to real estate companies. The industry has extremely poor governance, unethical practices and is a cesspool of corruption. At the same time, it does not mean that one should never study or look at real estate companies.

I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean! The question I am now grappling with is how do you value a realesate company? That will most probably be the next post

Look for diamonds in a diamond mine

I think one should be intellectually honest with oneself. If you genuinely think that you have considerable insight into some industry and can do well inspite of the poor economics of the industry – then more power to you.

In my own case, inspite of understanding the poor economics of the sugar or metals industry, I have invested some money in the past and learned an expensive lesson.

I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine.

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Why I will never buy an airline stock ?

By Rohit Chauhan

In Industry analysis, Uncategorized

December 10, 2011

5 Min read

19 comments

W

The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air,  Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes.  In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze  behavior. It is generally a race to the bottom  as airlines compete on the basis of price. The majority of an airline’s costs are fixed  – cost of an airplane, fuel and salaries  do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is  the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government  to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees.  I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost  structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools)  healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia  prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of  the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly  (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by  jet or kingfisher the flight is good and the airhostesses are pretty J .  That is money well spent !

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Why do stocks go up?

By Rohit Chauhan

In Uncategorized

November 27, 2011

6 Min read

26 comments

W

This is an odd post to write when markets are dropping by the day. However I think that at times like these, it is important to remind ourselves of the basics so that one does not get overwhelmed by the negativity and fear around us.

So coming back to the question – Why do stocks go up? Well it depends on who you ask.

 If you ask a day trader, he or she is likely to say that it is due to volumes, the day’s news and finally due to sentiments. If you ask a technical analyst, the reason could range from the ordinary (volumes, patterns etc) to the esoteric (Elliot wave theory, Fibonacci sequence etc). If you ask the lay person, they would usually have no answer for it (as most consider the stock market to be nothing more than a casino).

As a long term investor, I prefer to ask the question in a different way. I am not concerned directly with the stock price, which merely reflects the business value over the long run. I am more concerned with what causes the business value to rise. If the intrinsic value of the business rises, the stock price is bound to follow sooner or later.

What is the difference?

If you agree with my argument that the key question to ask is what increases the intrinsic value, then the focus of analysis changes completely. One is no longer concerned with the market price (which will follow intrinsic value in time), but more concerned with the fundamentals of the business.

A focus on business value means that one is now concerned with the economics of the business, the competitive dynamics of the industry and finally the actions of the management.

The time horizon also changes from the short (price action) to the long term (business value). The reason for this change is also due to the fact that business value does not change much from day to day and usually takes anything from a few quarters to years to change.

What causes the business value to increase?

So let’s come back to the original question and restate it as – what causes the business value to increase?

Let me put a simple hypothesis – The value of a business usually increases if the management is able to invest, incremental capital at high rates of return.

Let me explain – Let’s say a company is earning around 15% on invested capital. If the management can re-invest the profits or borrowed money (incremental capital) at 20-25% on a sustained basis (say 5-8 yrs), intrinsic value is bound to increase and the stock price will follow in due course of time.

In the above example, if the management can re-invest at these high rates through new or existing businesses, then growth (which is what almost everyone is focused on) will follow automatically. Growth thus becomes a derivative of high rates of re-investment.

Examples of the value creators

Let try to understand the implication of the above hypothesis for various types of companies and see if it matches with reality.

Let’s look at the case of a few highly successful companies such as Hero Honda motors (10 yr CAGR = 34%) and HDFC (10 yr CAGR = 29.1%).

HDFC bank has maintained an average ROE in excess of 16% during the last 10 years and has grown its book value (which is a good proxy for intrinsic value) at the rate of 23% during the same period. The overall stock returns have followed this growth in book value, with a small delta coming through an increase in valuations (PE ratio).

The company has re-invested almost 75% of the profits (dividend payout is 25%) at high rates of return and thus increased the intrinsic value of the business

Hero Honda has an effective Return on capital of 100% or higher in its core business. It is very very difficult to re-invest all the profits back into the business at such high rates of return. The company has paid out a dividend of around 65% of its profits and re-invested the rest into the  business or held it as cash equivalents on its books.

Any business which can earn such stupendous rates of return on capital and re-invest even part of it at such high rates is likely to increase the intrinsic value of the business.

The value destroyers

The second group of companies are those which have a high return on capital, are not able to re-invest the profits at high returns but have chosen to retain this capital and invest it into low yielding deposits or mutual funds. These type of companies are actually destroying value as they are retaining the excess capital and ‘re-investing’ it at low rates.

The market clearly dislikes these type of companies and tends to give them a low valuation. An example which come to mind is a company  like Cheviot Company. These type of companies have above average rates of return in their core business, but choose to hold back majority of the profits on their balance sheet in low yielding deposits. These companies are value traps (in which yours truly has invested in the past)

The final group of companies are those which earn a low rate of return and tend to re- invest all the incremental capital at these low rates of return. This would include most of the commodity companies in sectors such as cement, steel, sugar  etc. These companies destroy value as they grow and hence never get decent valuations in the stock market. For example, pickup any sugar company and look at their  5 and 10 year returns. Investors have lost money over a 5 to 10 year period in these companies.

Does the hypothesis help in picking stocks?

The above proposition does not help one in picking the next multi-bagger. Although it is easy to see which company performed well in hindsight, returns come from being able to identify which company will do well in the future and then buy it at a reasonable price.

Inspite of this limitation, the above thought process helps one to avoid a certain set of companies. Not losing money is half the battle in the stock market.

If one has a 3-5 year time horizon, then it is important to avoid companies which are likely to destroy value by re-investing at low rates of return – in the core business or by just holding the cash.

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