I was planning to publish the post below today, but then these attacks happened in mumbai. I am extremely angry and frustated, partly due to the fact that I have lived a considerable part of my life in mumbai and still have a lot of friends in the city. I wish I could write more. My only hope is that if you belong to mumbai, you and your family members are safe.

To buy or hold ?
Almost all markets, worldwide are dropping almost on a daily basis. Just as it was a no brainer last year to buy some stock and watch it go up, the reverse is happening now. I have received comments and emails asking if the right strategy in such circumstances is to wait for the bottom ?

Most of you, who have made any purchases in the last few months, would have seen the prices drop further. A common reaction is to regret the purchase and to think that holding out would be much better. I used to be prone to this ‘hindsight’ bias too. It is very common to see ‘hindsight bias’ in both bear and bull markets. After the event, you will feel or others will tell you that it would have been good to hold out (in a bear market) or to have bought (in the bull market).

Hindsight bias
This is faulty thinking. Although Hindsight is 20/20 , you cannot invest based on hindsight. Does anyone know how the market will do in the next few days or months or a year ?
If you do then you should buying options and betting on the direction ( I have done that a few times in the past). However when investing for the long term, based on underlying business value, timing cannot be perfect. As I have said in the past, if the stock looks undervalued by a large margin, create a 20-25% position. You can later add to this position as the price changes.

I typically create a 20-25% position and then start buying more if the price drops. If the price increases, then I will just hold and do nothing. The problem with this strategy is that it works well in bear markets, but fails in bull markets. During bull markets, such opportunities are quickly discovered and the price adjusts accordingly. This strategy could save you money in bear markets, but cost you in a bull market.

I am currently looking at CRISIL closely. I have written about it in the past and will publish some analysis in a subsequent post.

This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

– The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
– There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
– There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?

In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?

If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
And
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing – security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.

You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her 🙂