You have a lot of cash burning in the pocket and are looking for an opportunity to invest. An old time favorite is now selling for cheap. All and sundry feel that the company is undervalued especially if a series of ifs and buts get resolved. You look at the annual report of the company and it appears cheap by historical standards. Feeling confident, you go ahead and put in a decent amount of money.

Smart decision? maybe, but then maybe not.

Looking forward
Although no one can predict the future, it is an unfortunate reality of the stock market that stocks are priced based on the expected future of the company. I am using the word ‘expected’ as no one knows for sure. If someone claims that they are a 100% confident, then either the person is a complete moron or trying to sell you something.

If you are in the business of stock recommendations and tips, appearing anything but 100% confident is professional suicide. So I would blame the investor more for the garbage sold in the market than the seller. Do you really think all this junk would sell if there was no demand? anyway I digress.

So if one cannot predict the future, how does one invest? There is no surefire approach, though one can improve the chances of success by picking a company in stable industry. If the industry is fairly stable and not undergoing too much change, it possible to guess (all investing is finally a guess ..sometimes a good one or sometimes bad) with reasonable accuracy on how the company will do in the next 3-5 years.

An example
Let’s consider two companies. I am comparing these companies not from a valuation or investing standpoint, but purely trying to contrast their business performance. Stock performance in the short term is a different issue.

Let’s take the example of Gujarat Ambuja and Bharti airtel.
Gujarat ambuja is in the business of manufacturing and selling cement. It has grown at an average CAGR of 13-15%, maintained a net margin of 15% and an ROE in excess of 25%. It is not possible to know the exact profit or sales (many try that though) for the next 2-3 years, but looking at the business and the economics one can make a fair guess that business could clock 5%+ growth and 15% ROE for the next few years. Anything can happen, but the probability of the business achieving these numbers is high.

Bharti telecom is a telecom service provider, which has done extremely well over the last few years. The company has grown the topline at 30%+ and profit at 45% per annum for the last 5 years. The company has maintained an ROE in excess of 25%. These kind of numbers would warrant a PE in excess of 20. However the market is currently assigning a PE of 11 which values it as a commodity business. So is the market wrong? Some would say so looking at the past performance.

However there are certain structural changes and realities in the telecom industry

1. The industry has been witnessing severe price competition for sometime now. All the other companies other than bharti do not have great fundamentals (please look at the complete financial statement for all these companies and not the P&L account alone to understand what I am saying)

2. The industry has faced a lot of change in the past and will do so in the future. Do you really think anyone can be sure how the industry will look like in the next 5 years? What will be the technological changes, new entrants, government regulations etc?

3. Bharti is now expanding internationally via the Zain acquisition. They are looking at additional acquisitions too. All this activity at the very least introduces more uncertainty into the equation.

The reason I have taken the example of bharti and ambuja cement is because I have analyzed both the companies in the past and gave a pass to both for different reasons. Ambuja cement was not cheap enough for me.

In case of bharti, if i was looking at the just the past data, it would be an incredible buy. However as I said earlier, investing and valuation requires looking ahead and in case of bharti my crystal ball is completely cloudy. It may be my own limitations, but that is precisely the point. If one does not have the confidence of being able to assess the long term economics of a company and its industry, then one should give the stock a pass. The last thing one should do is depend on someone else’s analysis to make a decision.

There is no penalty for missing on a stock idea – there are 5000 public companies and a decent portfolio requires 15-20 stocks at the most. I see no point in buying something where there are too many unknowns and I am not confident on how it will all work out.

I wrote a post in Nov 09 discussing some general topics such as dollar depreciation, auto sector etc. I also promised a monthly post, which I have not done for the last two months. Maybe my mind went blank for the last two months 🙂

Dollar depreciation
Predicting the demise of the dollar is an industry in itself. I wrote about it in November and think the long term direction for the dollar may be down. However there is a catch in this thinking – down against what?. Currency values are relative. The dollar could go down against the rupee, but appreciate against the Euro (as it is happening now due to the Greece debt crisis).

One has to be careful in making such open ended comments. However as this a personal blog, and no one will hold me accountable for it, I can write what I think :). Heck, others get paid for writing the same crap and are still not accountable for the stuff they write !.

So let’s see where the dollar goes in the next few years. My investing decision are rarely top down and I have not factored the dollar depreciation, central govt budget, the infrastructure boom in india or the mating habits of the kangaroo in my portfolio decisions. I will let the smarter folks do that ..for me the equation will remain the simple ..buy below fair value and sell when the price exceeds it. It has worked in the past and most likely to work in the future.

Stock ideas
A lot of work is going on here, but as of yet there is no output. The key is to keep analyzing companies, understand their economics and estimate the fair value. If the price is not right, then it makes sense to just wait for it to come to you. I don’t think cash has ever burnt a hole in my pocket and sometimes doing nothing is a good choice too.
As of now I am analyzing graphite india. I came close to pulling the trigger on Mangalam cement, but the price suddenly spiked , before I could start my buying.

Quarterly results
I have completed the quarterly result review of all my holdings and published a few here. In general, the results are as expected and as a result my estimate of intrinsic value has remained more or less the same for most of the companies.

In the case of BEL (bharat electronics), I have been surprised by the improvement in the performance. I had a major concern about BEL. The business had become extremely skewed by 2008, where in almost 80% of the profit was booked in the last quarter of the year. This is generally not good as it results in a sales push in the last quarter to meet the numbers and as expected, the accounts receivables started going up.

BEL has since then reduced the skew considerably and has improved its cash flow position. I have increased the fair value of the company by around 15-20%.

Waiting for a crash ?
I think this year will require more effort in generating decent returns. 2008-2009 was a test of guts. If one had the guts or the foresight (depending on how you look at it) to invest a bunch of cash in early 2009, one would have made a great return by now. However the common mistake a lot of investors do is to wait for history to repeat itself. I can bet there are quite a few investors waiting for the next crash to happen.

It may happen, who knows ? I am however not basing my decision on such hopes. Investing has to be done based on what we know now, not what may happen or wish will happen. The best preparation one can do for a crash is to be mentally prepared and have some spare cash lying around.

Working on mental blocks
It have started looking at the various mental blocks I have and am currently working on eliminating them. One mental block I have is an aversion to commodity companies (not banks as some readers think). I am currently reading and analyzing such companies – steel, cement, metals etc in more detail and working out the fair value of such companies.

At the current prices, I don’t find any of them attractive. I have developed a spreadsheet where I analyze and record the fair value of each of these companies and track it with the market price. When the price drops below a certain level, I will start building a position. So it’s a wait and watch mode for most of these companies as of now.

I do not have mental block against options and derivatives. I only have a different opinion of these instruments. These instruments in the hands of a new investor is like a blade in the hands of a monkey – most likely the monkey will hurt himself.

If you are wondering, I belong to the same monkey class and hence other than some small positions, I have yet to go whole hog on these instruments. My plan is to learn more of these instruments, start small and then increase my commitment over time. If this monkey is going to get cut, it’s likely to be a small razor blade and not a 2 feet sword 🙂