Understanding and applying value investing principles

Self torture

2013-06-17T02:41:00.004+05:30

I wrote about two companies in January – Deccan chronicles and Zylog systems (read here).

In case of deccan chronicles, the stock had dropped more than 90% from its peak and a debt default and other allegations were already in the newspapers.

In case of zylog, my impression from reading the annual reports was summarized as follows

poor operating performance resulting in cash flow problems (in addition to commoditization of the core business)
Cash flow problems resulting in higher debt which was taken to fund the growth
higher debt resulting in promoter pledges to get the funds
Point a. causing the stock to drop, resulting in margin calls and forced sale of the pledged stock.
The forced sale, causing further steep drop in the stock price

As part of the disclosure, I indicated in the post that I had a very small speculative position in the stock and in the comments section provided the following rationale for it

zulfiqar

i am testing a hypothesis that the management will fix cash flow problems and the business is worth more than the current mcap.however it is a speculative position with a large probability of loss. it is also a very tiny, insignificant position

hi anil
i would not call such postions a mistake. i do such things actively - on very tiny amounts

these position have a large learning value which is worth more than the money lost. one could get the same by just watching it, but when you put real money, the experience is very very different. it helps one in avoiding such mistakes in the larger serious position.

A new update

On June 14^th, SEBI barred the promoters (read here) from buying or selling any securities in the stock market

The key points in the news article seem to be the following

Sebi had, suo moto, carried out an examination in the scrip of Zylog Systems in view of surveillance alerts regarding variation in price. Sebi during examination of the scrip prima-facie observed that the company provided misleading information to the stock exchanges wherein it stated that its promoters have been buying and increasing their stake while actually the promoters were net sellers and their shareholding declined due to invocation of pledge by financiers. Similar misleading clarification was also given by the promoter of Zylog Systems, Sudarshan, to the media.

Sebi order said that Zylog Systems disclosed incorrect and false information in the quarterly shareholding pattern for the four quarters in the year 2012 to the stock exchanges by overstating the holding of the promoters and understating the quantum of shares pledged by the promoters.

Sebi also observed various instances of non-adherences to accounting standards and listing agreement in the annual report by Zylog Systems.

In addition to the above, the latest results show that the promoters have pledged close to 95% of their holding in the company (up from 75% in the previous quarter)

What next
As I indicated in the earlier post, I created a small tracking position to follow the company and confirm my thesis that the debt/ cash flow problems are temporary and should get solved.

I am not sure if the thesis will turn out to be correct or not, but the SEBI order changes the whole picture. I am fine with poorly performing businesses and will hold the stock for the long term if the management is competent and working on fixing the issues. However, if there are coporate governance issues, then all bets are off.

Although the position was small, a loss always pinches. In this case, I walked into it with open eyes – a case of self torture :)

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

How I think about macro

2013-05-22T14:53:00.003+05:30

Charlie munger (warren buffett’s partner at Berkshire Hathaway) was recently asked about his views on macro and he said something to the following effect (in my own words)

“If thing are bad now, they will get better in time. If they are fine now, something will go wrong in due course. We don’t make money by predicting the timing.
At Berkshire, we're trying to swim well against the tide or with it, we just keep swimming."

If you have not heard or read about Charlie munger, I would suggest that you read up anything you can find about him. He is one the smartest and wisest person you will ever come across.

Ignoring macro ?
It was fashionable among value investors to completely ignore the macro till the crisis of 2008 – they spoke about it as a badge of honor.

The pendulum has swung the other way since then. I see a lot of investors being cautious about macro, to avoid a repeat of 2008.

I think macroeconomic thinking can be broken down into two elements

- Understanding industry dynamics and trying to evaluate the long term economics of the company
- Understanding macroeconomic variables such as inflation, interest rates etc and trying to forecast or guess so as to make investment decisions.

The first element is crucial in understanding the company and its profitability in context of its industry. One needs to be aware of the competitive situation in the industry to be able to figure out the long term outlook for the company.

The second element which is generally reported on by media and guessed by an army of pundits, soothsayers, forecasters and talking heads is a waste of time. Very few, if any can forecast any of these variables with any level of accuracy and no one gets it right in the long run (remember oil was supposed to go to 200$ / barrel in 2008 ?)

The comment by Charlie munger should be seen in context of the second aspect of macroeconomic thinking – there are variables such as interest rates, exchange rate etc which can impact your performance, but as they cannot be predicted , it is far better to concentrate your energy on understanding the company and its industry and learn to live with the other aspects of macroeconomics (interest rates, inflation, exchange rates etc)

The capital goods industry

Lets look at an example. The capital goods industry is going through one of the worst cylical downturns in the last 10 years. The last time the industy went through such as patch was in the 2001-2003 time frame (I remember those times !).

I don’t think anyone can predict with precision when the cycle will turn (although a lot of people claim to be able to do so), but one can be sure that the cycle will turn eventually.

If you can understand the economics of this industry and can find some high quality firms at reasonable prices, I am sure the returns over the next 2-3 years will be good. Let me give a tip – Look at a company like BHEL or blue star or thermax and ask these questions

Are these companies likely to go out of business soon ? (current valuations seem to say so)

Is it likely that these companies will do well once the cycle turns ? (though we don’t know the exact timing ?)

Are these well managed companies with competitive advantages ? ( I believe they are)

The typical talking head on TV or broker needs to be right in the next 3 months. As an individual investor, I don’t have to play by the same rules. If I can find a company which will do well in the next 2- 3 years, I can ignore the near term outlook.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Snatching defeat from the jaws of victory

2013-04-29T03:09:00.004+05:30

I wrote about hinduja global solutions (Now HGS) in jan 2009 (see here). The company was selling for below cash and thus the operating business was available for free.

As we know, the stock markets recovered by May 2009 and HGS was up 200% in a short span of 4 months.

In case you are wondering, this post is not about how I smartly exited in July and make 200% of capital.

The company performed extremely well in 2010. Net profits were up by 100%, Net margins hit 14% and this was inspite of the company carrying a large amount of cash on the balance sheet. I was feeling pretty smart about it.

The slow slide

The price action from the peak in 2009 shows only part of the story. The company has increased its sales from around 900 Crs in 2010 to around 1550 Cr in 2012 at a CAGR of 30%+. The net profit however dropped from 130 Crs to around 106 Crs in 2012 and may drop further to around 80 Crs in the current year.

I kept buying the stock during this period, anchored to the earlier levels of profitability.
The company has thus been able to grow through a combination of organic initiatives and acquisitions, but saw a drop in profitability due to lower margins and lower capital turns. In effect, the growth came through, but the economics of the industry has deteroriated during the same period. The company has gone from above average profitability (20%+ROE) to below average levels in the current year (single digit ROE)

The lessons
There are two key takeaways from the above loss.

The first lesson is that if the initial expectations on the economics of an industry do not play out, one should accept the reality as soon as possible and act on it. The second lesson for me is that I should give a higher weightage to the qualitative aspects of the business and not focus too much on the valuation. In case of HGS, the large amount of cash on the balance sheet (and corresponding low valuation) distracted me from the deteriorating economics of the business – A value trap.

The blind spot problem
I have looked at the various companies in the past and have wondered why others keep buying/ recommending it when it is obvious that the company does not have above average profitability and cannot be a good long term investment.

The thing with blind spot is that the same issues are not visible to yourself, where one may keep rationalizing your own decision for a long time.

It is not easy to accept a mistake, especially a slow one , resulting in the boiling frog problem. Hopefully this lesson will stay with me for a long time and prevent me from making the same mistake again (new ones will however happen)

Searching the debris

2013-04-08T08:09:00.001+05:30

There are two numbers I want to highlight

-13% and -15%

This is the drop in the CNX midcap and CNX small cap index since the start of the year. If these numbers look troubling, they don’t even represent the vertical drop in some stocks. I wrote about some such stocks in this post and now that seems to have become a daily affair with some stock just dropping like a stone.

I have to be honest about one thing – I have never seen such bungee jumping in the Indian markets. In the good old days, the market took its own sweet time to react to any fundamental or corporate governance issue and as a result an investor had a lot of time to get off the train wreck.

No such luck these days!!
If the company you own comes out with slightly disappointing numbers or if there is whiff of a corporate governance issue, the punishment is brutal.

The good news

It would take real optimist to look for any good in this. I am in that camp.

If you are looking closely at the carnage, you may have noticed that companies with a weak business model or poor corporate governance are getting punished severely. At the risk of sounding insensitive, I would say that is the way markets should work. A properly functioning market should reward companies with sound business models and good managements and punish the wealth destroyers.

In case you think I am being insensitive to the plight of a lot of small shareholders, let me tell you that I have suffered for my poor decisions in the past and some of my current holdings have got impacted too. The market is not a good place to discover yourself.

Digging through the rubble
A lot of investors, if there any left, are shell shocked with this sudden turn of events. The most common advice is to wait for the uncertainty to resolved. The reality is that the future is never certain – it is just that investors sometimes get optimistic and pay for the illusion of certainty.

One can choose to either wait for the fog of uncertainty to clear up or better yet have the courage to start digging through the debris to see if there are some gems lying around.

The first point to keep in mind is to avoid anchoring to the pre-crash prices. A stock is not cheap just because the price has dropped by 90% - look at Deccan chronicle holdings. A large drop in the stock price is a good starting point, but not a sufficient condition for a bargain

The second point to keep in mind is to look closely at the fundamentals of the company. Is the company highly leveraged and with a weak business model? In addition, it is important to avoid companies with corporate governance issues.

The final point is regarding one’s own emotions and conviction. Once you have identified a good idea and believe that the market is being irrational in beating it down, it will require a lot of emotional fortitude to hold onto the stock. One is likely to get a daily dose of negativity via falling stock prices and bad news or reports about the company. It is unlikely that a company with a beaten down price is enjoying great growth and high expectations from the market. One needs to do his or her homework that the current downturn is a passing phase and the stock will give above average returns over the next 2-3 year time frame.
I am currently looking at some of the following companies. This is just a preliminary list and I may or may invest in any idea

BHEL
Infinite computer s ltd
Manapuram finance
FAG bearings
Whirlpool India
Eros international
Tata motors
Canfin homes – thanks to ayush mittal.

I am sure some of you would have rolled your eyes on reading this list. Well, I have never been the one to buy popular stocks anyway. I am usually fishing in areas where you will not find most investors.

A roller coaster ride since 2007 and negative returns since then in comparison to double digit returns in gold and real estate means that if you tell someone that you are investing equities, they think you need to be assigned to a mental institution. It is not easy to be any equity investor these days. However if you look past the gloom, then the current downturn is a decent time to pick good stocks.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Value trade: Infinite computer ltd

2013-03-11T03:26:00.001+05:30

In an earlier post, I discussed about a new mental construct – value trade. This is basically an investment operation where one buys a super cheap stock in the hope that it will become merely cheap (as my good friend neeraj puts it).

The idea is to buy a stock which is selling at dirt cheap price due to various short term reasons such as selling pressure, unexpected bad results or sheer neglect. The hope is that the market will get over this extreme pessimism (temporary) soon and will price it at slightly more reasonable levels (though still cheap).

In such cases, I am out as soon as the stock recovers (as I have done with some ideas in the past – Globus spirits).

About

Infinite computers is a 1400 Cr IT services company. The main business segments of the company are application management services, infrastructure management services, Product engineering services and a new division – Mobility solutions.

The application management services involve the usual ADM and other support services. This is the bread and butter of the Indian IT industry. This segment contributed to around 68% of the revenue for the company and is characterized by repeat revenue, moderate levels of margins and high levels of competition

The infrastructure management services contributed around 16% of the revenue and is similar to the application management services in terms of profitability and competitive pressures. These two segments are being commoditized across the industry and the days of fantastic profits are gone.

The product engineering services involves some kind of IP based revenue sharing model. I could not find any revenue data for this segment, but based on the other segments would assume around 14-15% of the total revenue.

The mobility solutions segment is a new segment referred to as Infinite convergence solutions. This is a messaging platform (details here) acquired from Motorola and supports around 100 Mn+ global subscribers.

Financials

The company has grown from around 350 Crs in 2007 to around 1400 Crs for the year 2013 which translates to around 25% CAGR growth. The net profit for the company has grown from around 3 Crs to around 120-130 Crs for the current year. The net margins have improved from around 9% to around 11% levels, mainly due to a small reduction in the manpower cost (as % of sales)

The company has been able to deliver an ROE of 20%+ in the last five years. In addition the company been able to maintain receivables at around 25-30% of revenue which seems reasonable for a company of its size.

The company is a debt free company and has around 130 Crs cash on the books (30 % of market cap). The management has been investing capital into the business, has a 30% dividend payout ratio and the rest has been accumulated as cash on the books. In addition, the company also did a small buyback in the last one year.

Positives

The company has a very strong balance sheet and good returns ratio. The management has invested capital sensibly in the past and has a reasonable dividend policy in place. In addition, the top management is a buyer of the stock at the current levels (though one should not read too much into it)

The company has a high level of repeat business, which provides a high level of confidence to the sustainability of the revenues.

Risks

The company has been able to grow the topline and profits since 2007 and now has considerable cash on the books. At the same time, the company was not very profitable from 2005 to 2008 (average 2-4% margins) and had a very low topline growth of around 5% per annum during this period.

The company operates in a highly competitive, global and fragmented industry – IT services. The industry is facing commoditization and is very likely to have lower profitability in the future. The company is focused on the telecom industry which has its own competitive pressures with the additional risk of a very high proportion of revenue from the top 5 clients. This exposes the company to a high level of topline and profit risk, if there is any loss of business from the top few customers.

Finally, the company is also expanding into the product space which is a high risk, high return kind of a business. The company has invested in excess of 80 Crs on various product related businesses and these intangible assets may incur a write down if these ventures were to prove unsuccessful.

Catalyst

In case of a long term idea, a buy and hold strategy works quite well as the company is growing its intrinsic value. In case of mid cap IT companies, the economics of the industry over the long term is not very clear (atleast to me). As a result, the returns have to come over the next 9-12 months and this is usually driven by a catalyst.

In case of infinite computer solutions, the 2013 profits have been a bit suppressed by the forex losses and once this headwind dies down , we should see a better growth in the net profits. A consistent dividend payout of 30% - growing with the profits should serve as another catalyst.

What can go wrong? A loss of any of the top 5 customers would hit the topline and profits. A sudden slowdown in north america would impact the company as this region accounts for almost 80% of the revenue. If any of this happens, the stock is likely to drop in the short term

Finally, if the management does an overpriced acquisition or has to write down the intangible assets, the market is not going to like that.

Conclusion

The company sells at a PE of around 4 and an EV/EBDITA of 1.7 (after excluding cash). At these levels, the market believes that the company will soon be out of business. The company does face multiple risks (which company doesn’t), but none of the risks appear to be fatal. In addition, as far as I can tell, the management seems to be doing a good job of managing the business and a fair job of allocating capital.

If one believes that the company is not going out of business, then one does not need any fancy calculations to realize that the stock is cheap.

Why a value trade?

I am not comfortable with the economics of the IT services industry. This industry is commoditizing and the wage arbitrage game is slowly coming to an end. The super high returns on capital are likely to trend down – as has already occurred for several mid cap companies in this space.

At the same time, I cannot resist an undervalued stock which can deliver above average returns in the medium term (9-12 months).

Note: This idea was emailed to me by chaitanyya and it is not an original idea. I have a small starter position and will add or reduce based on the price and performance of the company. Please do your own due diligence.

Disclaimer : Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Facing the crash

2013-02-20T23:41:00.002+05:30

The midcap index is down by around 7% since the start of the year and the small cap index is down by 9% during the same period. That is quite a drop in a span of 45 days and it still does not represent the true carnage which has occurred in a few stocks which have dropped by 20% or more in the span of a few days.

The standard prescription

The standard prescription is to follow the fortunes of your companies like a hawk and to buy and sell the stock based on short term expectations. This approach helps you jump in and out of stocks and be ahead of the market at all times.

This prescription works well for highly cyclical stocks such as cement or steel where one needs to time the buy and sell decision to get above average results. The same approach is a disaster if applied to companies with above average economics (high return on capital with good growth prospects) at the hint of the slightest slowdown

I have personally paid the price for jumping in and out of stocks based on short expectations – such as with asian paints and marico (and more). I purchased these stocks in 2000 and sold them off in bits and pieces from 2006 and onwards. The opportunity loss in all such cases has far exceeded the actual losses from all my failed stock picks

I won the battle (short term), but lost the war (long term).

How to handle such times
It is easy to preach rationality and follow it during times of rising markets. It is however a different ball game to be rational at a time such as now, when stocks can suddenly drop by 20% or more in a matter of a few days.

One way to prevent knee jerk reactions is to avoid checking your portfolio everyday. One needs to turn off the financial channels and stop tracking the portfolio on a minute by minute basis. I really doubt the long term returns of one’s portfolio are dependent on any breaking news, which by the way is generally some useless piece of information

In addition to the above, one needs to have an appropriate level of diversification in the portfolio. I general limit each position to around 5-7% in the portfolio to dampen the volatility. A higher level of concentration and the associated returns are thrilling when the market is rising. However during market swoons such as now, the momentum can suddenly turn and make a lot of individuals nervous. A focused portfolio is of no use, if you exit your positions at such times.

Finally, it is important to analyze the fundamentals of the company and try to look at it with a fresh mind after each quarterly result. It is important to avoid anchoring the thought process to the buy price and the original thesis and one should look at the company based on the current price and its future prospects

What if I am wrong ?

One certainty about investing is that you will be wrong occasionally. The super investors are wrong less often than the less successful ones, but still make wrong bets.

In my case, if one of my picks crashes or the company comes out with a really bad set of numbers, the first thing I do is to avoid looking at the company for a few days – no I am not joking. The reason I avoid looking at the company is to prevent myself from reacting emotionally and taking a hasty decision. It is quite possible that I may lose 10-15% more on the position, but overtime I have realized that a calmer mind helps me in taking a more rational decision.

Once the panic dies down, I generally try to look at the results and key indicators of the business and try to see what I am missing (which the market sees). In several cases, I may conclude that the market is over-reacting and may decided either to do nothing or even add more to the position. Sometimes though, I have realized belatedly that I have messed up and that the best course of action is to exit (and feeling like a fool at the same time).

A few months later, I will come back to the mistake again and analyse it further to avoid making the same mistake again (new ones will still happen!)

What next?
It is quite likely that things could get ugly before they get better. I personally have no way of knowing the future and my investment approach is not based on getting the short term right. I prefer to look at the 2-3 year prospects of the company and if the company is moving in the right direction, I would rather just buy and hold the stock (or buy more if the stock gets cheaper).

Taking advantage of quarterly results

2013-02-07T07:01:00.000+05:30

We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J
A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.
If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).
In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)
In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.
For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.
If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.
The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call
The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.
All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

Falling off the cliff

2013-01-13T03:36:00.002+05:30

You may have heard about the fiscal cliff drama in the US. We have some companies which have already gone through their own version of the cliff

Look at some of the price action below

As you can see in these two cases, the price has dropped by 75% or more in the last 6-12 months. I normally ignore fluctuations in stock price, as most of it is noise. However a drop of 75% or higher is a signal that something fundamental is happening.

Why analyze failure

The question is why bother to analyze such cases? I subscribe to the philosophy that if one wants to be a good investor, then one should study and learn from exceptional success and failure. One should not only analyze companies which have done well in the past (such as Hawkins or titan), but also look at the companies which have destroyed a large amount of shareholder wealth.

The best reason for analyzing failure is illustrated by the phrase – invert, always invert, by Carl Jacobi who said that one of best ways to solve some problems is by inverting them.

As Charlie munger has said, if you want to succeed, learn to avoid failure. If one can identify why the above companies dropped off a cliff, one can use that learning to avoid such cases in the future.

Is it all fraud?
It is easy to ascribe the drop to some kind of fraud (as it happened in the case of satyam) and avoid any further analysis. I think that is intellectual laziness and will not help us learn anything.
I would like to put the above examples in two buckets

Attractive core business, with management diversifying into poor businesses with heavy leverage
Mediocre core business with poor cash flow resulting in high debt

Poor diversification and failure of corporate governance
You can read the story of Deccan chronicle here. In a nutshell, the company had a very profitable core business – newspapers and diversified into loss making ventures such as Deccan charges, retail ventures etc.

Over time these cash guzzling businesses consumed the entire cash flow of the core business and more , resulting in high levels of debt on the company. The management on its part, hid the problems and the extent of the debt from the shareholders. When the same was disclosed, the stock price collapsed.

It was not easy to see this problem coming (atleast to me) as the annual report as late as 2011 did not display any kind of serious problem. We had a failure of corporate governance and lack of appropriate disclosures (fraud or not, I am not sure).

Weak core business

The case of zylog systems is different. If you read the past annual reports, you will be able to see that the company has not been generating adequate free cash flows and has funded the high levels of growth via debt. The ‘cliff’ seems to have happened due to the following events

poor operating performance resulting in cash flow problems (in addition to commoditization of the core business)
Cash flow problems resulting in higher debt which was taken to fund the growth
higher debt resulting in promoter pledges to get the funds
Point a. causing the stock to drop, resulting in margin calls and forced sale of the pledged stock.
The forced sale, causing further steep drop in the stock price

Difference between the cases
Although the end result is the same (as of today), the underlying cause is different. In addition, it is easier to identify companies with a weak core business (and high debt and promoter pledge).

In comparison, companies like Deccan chronicle had a healthy amount of cash on the balance sheet until it suddenly became known that there were a lot of hidden issues (and debt). Such companies are more difficult to identify and one is likely to only get some faint signals that there is something out of place.

Learnings

So what can one learn from the above cases ? Let me share mine

Follow the cash flow, ahead of the profits. If the company is showing a high level of growth, which is increasingly funded by debt, one should get cautious. It is a time bomb, which can blow up if things don’t play out as planned.
Poor Capital allocation – if the management is investing in all kinds of ventures with a history of poor profitability, then one should avoid such companies . These kinds of decisions eventually catch-up with the company.

Disclosure : Have invested a tiny amount zylog from a tracking perspective. Please make your own decisions and read the disclaimer

Model portfolio performance 2012

2013-01-07T00:08:00.000+05:30

Let me warn you at the outset. This post is going to be a sale pitch about my paid subscription service. I am going to discuss about the performance and tell you why it is the best thing to have happened to mankind J.

If you do not like these kind of posts, please don’t read any further. I promise you that you will not hear on this topic for the next six months.

< Start of sales pitch>
I announced a subscription service in nov 2010 and formally launched it in Jan 2011. The service is not a portfolio management service or advisory service. I have posted my personal portfolio and detailed analysis of each stock idea and leave it to the reader to make their own decisions

The performance has been as follows

Portfolio return from 29.01.11 to 31.12.2012: +40.01%
NSE Nifty 50 return from 29.01.011 to 31.12.2012: +7.1%
CNX midcap from 27.01.011 to 31.12.2012: -7.9%

Portfolio performance relative to index: +33% (NSE50)

We achieved a -7.8% in 2011 and a +51.9% return in 2012, giving us return of +40.01% since the start of the service. We have achieved our stated goal of 3-5% outperformance relative to the indices. The model portfolio has now outperformed the indices by around 16.3% on an annualized basis.

How is the service different?
Everyone claims what they have to sell is different. Let me point out my reasons for it (you can be the judge of whether that is true or not)

Long term approach – Almost everyone in the financial industry claims to have a long term view and then turns around and makes buy/sell decisions each week. In our case, we have held most of our positions for last 2 years (sold off the poor ideas) and may continue to do so. I have always invested this way in my personal portfolio and see no reason to change something which has worked for me.

Eat my own cooking – I am not doing anything special for this subscription service. I have published my own portfolio and a detailed analysis of all the ideas in the portfolio. My personal incentive is to earn highest possible return at lowest risk for my own portfolio and any stupid idea hurts me as much as any subscriber (you can atleast blame me, I have no one to blame).

If you are interested in getting more details about the service, please join the mailing list below.

link - http://forms.aweber.com/form/50/1660147450.htm
<End of sales pitch>

And we will be back to our regular programming soon J

A happy new year

2013-01-02T01:02:00.000+05:30

Wish you all a very happy new year

Trading on noise

2012-12-27T22:53:00.003+05:30

Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?

In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise

If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise

I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive

If you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?

I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

- A price target with a 15-20% upside within the year

- A success rate of 55% or less in terms of success rate (preferably over a year)

- Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?

Vote on an article topic

2012-12-17T05:06:00.003+05:30

update: 23-12
A lot of readers have responded to the survey. My personal thanks to all of you, who have responded.

The topic which got the maximum vote is - How to search for and analyse investment ideas ?

The balance questions were ordered in the following manner with the second and third place a close tie
How to read and analyse an annual report - second place
Discounted cash flow analysis - third place
My goofups and learnings of 2012 - fourth place
Portfolio management for professionals - fifth place

I will be putting together a post over next month, for the topic which got the highest ranking I will take up the next two topics too in due course of time.

The topic which was my favorite - about my magnetic personality :) got 15% votes. atleast 15% of you like my magnetic personality !!! :)

-----------------------------------------------------------------------------------------------------------------
I get emails from a lot of readers to write about various topics. The topics requested are important for most investors and I think a majority of the readers of the blog would benefit from them.

I have put a poll on the list of topics which have been requested in the past (except point 6) and would write on the topic which gets the most votes. If you want a different topic to be written about and is not on the list, please leave a comment and i will take it up in a future poll.

I am sure you can guess, which topic will get my vote :)

Triveni turbines limited - Waiting for growth

2012-12-11T03:29:00.004+05:30

About
Triveni turbine is a Bangalore based company in the business of manufacturing and servicing steam turbines upto 30 Mw. In addition the company has a JV with GE (general electric) for turbines in the range of 30-100 Mw.

The company has around 2500 turbine installations globally and is a market leader in India in the sub 30 Mw range with a market share of around 55%.

Steam turbines have multiple applications such as co-generation, captive power plants, and Industrial drives and in ships. The company supplies industry specific turbines to multiple industry segments such as sugar, cement, steel, chemicals, municipal solid waste and textiles.

Financials

The company was spun off from triveni engineering in 2011, which also has a sugar, water management and gears business. The turbines business has grown from around 280 crs in 2006 to around 670 Crs in the current year at a CAGR of around 13%. PBT has risen from around 37 Crs to 140 crs in the current year at a CAGR of 20%+.

The company has been able to maintain an operating margin of roughly 25% during this period and a return on capital in excess of 100%. The company is able to earn such a high return on capital due to negative working capital and high operating margins.

Positives

The company earns a very high return on capital which points to the presence of a sustainable competitive advantage. It enjoys a very high market share in India and is now expanding into export markets too

The company also has the following four growth engines working for it

-      Industrial demand for power via captive power plants. Additional demand from co-gen opportunities
-      Service demand from the install base and for turbines of other manufacturers.
-      Demand from the JV with GE in India and abroad for the 30-100 Mw range
-      Export demand for sub 30 Mw product range

In addition to the above growth opportunities, the company is currently running at around 40-50% of capacity and can expand sales with minimal capex.

Risks

The key risk for the company is a delay in the revival of the capex cycle. The investment cycle has slowed down in India and in the export markets. As a result the company has struggled to grow the topline and profits in the last 2 years. If the capex does not revive, the company could face stagnant profits for some more time.

Competitive analysis

The key competitor for the company in India is Siemens. However companies like Siemens and BHEL have a very wide range of products and are not as focused on a single product in a narrow range (below 30 Mw). Most companies in this sector enjoy a decent return on capital and hence triveni turbine should continue to earn a high return in the foreseeable future.

Management quality checklist

-          Management compensation : reasonable at around 1-2% of profit
-          Capital allocation record : In the short operating period as an independent company, management has used the free cash to pay down the debt and the company should be debt free by the end of the year
-          Shareholder communication – fairly good. The company shares adequate details via the annual report and quarterly investor updates and conference calls.
-          Accounting practice – appear conservative
-          Conflict of interest – none

Valuation

The company is currently selling at around 20 times earnings. On the face of it, this does not appear to be cheap. At the same time one has to look beyond the raw numbers. The topline and profits for the company have stagnated in the last 2 years with a complete collapse of investment demand.

During this period, several capital goods companies have made losses and have seen their working capitals blow up. During one of the worst downturns in the sector, the company has remained solidly profitable and continues to operate with a negative working capital.

In addition the company expanding its export business has a thriving and growing turbine services business and should see additional revenue from the JV with GE. We may not see a PE expansion as the company is already operating very efficiently, however as the topline and profits start expanding, we should get a return commensurate with the growth.

Conclusion

The company operates in a niche and has a sustainable competitive advantage due to its customer relationships and service network. In addition the company has formed a JV for the 30-100 Mw range which should enable it to expand the target market for its products.

The company’s performance has stagnated in the last 2years due to the macro economic conditions. However the long term prospects remain intact and the company and its stock should do well in the long run.

Disclosure: No position in the stock as of writing this post

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.

2013 market predictions

2012-11-23T01:39:00.000+05:30

We are approaching the year end and soon the experts will start coming out with their predictions for next year. As there is a lot of competition to be the first one, I decided to get ahead in the line by kicking it off in November itself

So here goes
1.    Barring any macro-economic shocks and if sensex earnings exceed 15%, the stock market should be up next year. If however we have a crisis in Europe or we get an oil shock then the index could even touch 10000 levels.

2.    Gold could be up by 10%, if we get a major recession in US due to the fiscal cliff and it could surprise us on the upside if it coincides with the further instability in Greece and Spain. Over the long term, the macro-economic and supply-demand drivers point to a continued increase in gold prices.

3.    Capital good stocks in India could surprise on the upside if the current momentum on the reforms continue. One needs to focus on high quality names in the sector

4.    The consumption story continues to play out and high quality names should outperform the market in 2013, barring any sudden depreciation of the rupee. Demand from consumption centers, such as India and China largely seem to be on a firm footing

5.    The real estate market will continue to face headwinds of high interest rates in the initial part of the year, but if RBI starts cutting rates in the second half, we could see higher activity in certain pockets of the market

6.    Rohit Chauhan will become the smartest and richest investor in the Indian stock markets. President Obama and other world leaders will seek his counsel on how to fix the developed economies J

Did I get you? Do you realize how absurd these predictions are?

There is a consistent pattern in all these predictions. They are not predicting anything and are simply stating that a market will go up if all conditions are right, otherwise it will go down (if the conditions go bad). This is similar to what you would hear from an astrologer if you were to ask him about your future.

One more point – I did not make up all these predictions. I just googled some sites and cut and paste what I found for 2012 (yes for the current year !!).

If you really feel the urge to get some predictions for 2013 on the cheap, please email me and send me 10 Rs. I know a guy on the street with a parrot, who for 10 bucks , will ask his bird to pick a card and will use the card to tell you the future. The parrot is a better fortune teller (50% accuracy), is crisp and short (no beating round the bush) and much cheaper.

For the patient investor: ILFS investment managers

2012-11-11T01:20:00.003+05:30

About
IL&FS investment managers is a private equity/ fund management company promoted by ILFS (50.5% ownership). The company is in the business of raising funds from investors (institutional – both in India and abroad) in the form of individual fund offerings.

These funds have their individual mandates such private equity investments, infrastructure or real estate type investments. The company is responsible for investing the funds, managing the risks of individual investments and then finally working out exits from these investments. The company has been fairly successfull in managing the funds, generating 20%+ returns on most of the funds in the past for the fund investors.

The main source of revenue for the company is the fixed 2% management fee on these funds and an override on the returns over a threshold (a percentage of the gains made, above a threshold)

Financials

The company has delivered a 35% growth per annum over the last 8 years. The company earned around 225 Crs in 2012.

The company has grown the net profits at around 40% over the same period and made around 74 Crs in 2012. The main cost for the company is compensation for the employees and overhead expenses incurred on launching and operating the funds. The company has been able to maintain net margins in excess of 30% in the last 10 years.

Finally, the company has been able to maintain a high ROE of 30%+ and if one excludes the excess cash on the balance sheet, the ROE would be in excess of 50%.

Positives

The business requires minimal incremental capital to grow. The main assets of the company are the brand, its relationships with clients and the skills/knowledge of its employees.

The company needs very little capital to grow (some extra office space and maybe a few computers) and hence the entire profit is truly free cash flow. The company has consistently maintained a high dividend payout ratio in the past (over 50%) and used the excess capital to acquire a new fund (saffron) in 2010.

The company has a long operating history in raising and investing funds in various opportunities in India with good results (returns in excess of 20%). As a result the company has a good reputation with current and potential investors which should help the company raise additional funds from the clients in the future.

Risks

The company operates in a very competitive environment with minimal entry barriers. The company now faces stiff competition from a large number of Indian and international competitors such as hedge funds and other private equity funds. This has resulted in higher competition for raising India specific funds and investing the same in attractive opportunities (businesses) in India. This could result in lower returns for the fund investors and hence lower income for the company in the future.

The slowdown in the investment cycle, recent actions by the government such as the GAAR fiasco and other global macro-economic factors have made it difficult for the company to raise new funds. In addition the exit timelines for the fund investments have increased due to weak stock markets, resulting in lower returns for the fund investors. All this has impacted the revenue of the company which depends on the volume of funds managed (AUM) and the carry (excess returns over a threshold). It is unlikely that the investment cycle will turn around quickly, due to which the company may face a longer period of low revenue growth or even de-growth over the next few quarters.

Management quality checklist

Management compensation: fairly high at 25% of revenue. However this kind of compensation is typical of the industry.
Capital allocation record: extremely good. The company has maintained a very high dividend payout ratio and has indicated that they will dividend out almost the entire profits to the shareholders.
Shareholder communication: Quite good. The company provides adequate details of the business in its annual reports and conducts quarterly conference calls to keep the shareholders updated on progress.
Accounting practice: conservative
Conflict of interest: none

Valuation

The company is currently selling at a PE of around 7 which is on the lower side of the past PE range of the company (6-23). A company earning an ROE of around 30% and with a 15%+ growth prospects can easily support a PE of 15 or more. The company thus appears undervalued by most objective measures.

Conclusion

The company has performed extremely well in the past and has rewarded the shareholders well. The period from 2003-2008 was a bull market for private equity and stock markets resulting in high returns for the company’s funds. This resulted in good profits and high growth for the company.

The markets have slowed down considerably since the 2008 financial crisis and the Indian government has made it worse in the last few years. As a result, the company has struggled to raise new funds which is needed to drive the topline and profits for the company. It is likely that the company will take a few more quarters before it can raise and deploy new funds and a result the topline and profits could stagnate for some time.

The long term prospects of the company are good, though it will take time for the company to start growing again. This would test the patience of most investors.

Disclosure: No position in the stock as of writing this post

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

Investing to be rich

2012-10-17T05:57:00.004+05:30

If one wants to be rich, one should learn how to invest on your own…right ? that way you can compound your capital and retire rich ! Isnt that obvious ?

If I am asking this question, you can guess I don’t believe it to be the case.
I get asked this question in different shapes and forms and a typical email goes like this

Rohit – I am currently X years old and want to become financially independent in the next 10 years so that I can purse XYZ (insert a dream here). Can you suggest how to become a better investor so that I can have enough money in a decade to pursue my dream ?

What does it take to be an active investor ?

It takes a few hours a week for a year or so to become financially literate, which involves having a reasonable understanding of various investment options such as fixed deposits, mutual funds, stocks, and insurance etc. Once you reach this level of understanding, you can with a moderate amount of effort, identify a mix of assets which will help you earn around 12-14% return per annum (depending on the mix of debt and equity)

In effect, you can spend a few hours a month and earn 12-14% on your assets over the long term. We can call this a baseline level of effort.

Now lets assume that you are not satisfied with the above returns and would not settle for anything less than 20%+ levels (around 10 times in the 10 years). If you wish to achieve these level of returns, then you need to invest atleast 15+ hours a week on learning various aspects of investing and in finding new opportunities on a regular basis.

What is the return on time in case of active investing?
So what do I mean by the term – Return on time ? Let me illustrate with an example.

Let’s look at a typical case of a young professional who has a full time job. Let’s assume the following

Annual salary in year 1 = 10 lacs
Annual savings in year 1 = 5 lacs (I know this is too high, but we are considering an optimistic scenario)

Salary increases each year by 10% and so does the savings. This individual has two options for his/ her savings. They can be financially literate and spend minimal time (a few hours a month) and earn around 12-14% per annum or spend 15 hrs or more on investing and earn a much higher return.

Lets also assume the individual works around 40 hrs each week in his / her job (would be higher in reality)

So whats does the return on time (money earned per hour spent) look like for the person in terms of active investing ?

Lets look at the table below

I have plotted the savings, the extra returns earned by putting in extra hours each week (15 hrs per week) and the per hour return

A few things standout,

In the initial years when one has a small level of savings and is just starting out, the per hour ‘salary’ from investing is way below the per hour salary from a job. The higher your education or skill, the larger the gap.

This is the best case scenario. The above picture worsens if one gets hit by a bear (a certainity in a 10 year period). The last column shows that this ratio becomes favorable only after 8-9 years

Implications of the analysis

The above analysis though silly, lead us to a fairly important conclusion. If the only reason you want to become an active investor is to make more money, then it is not a very smart way to do it.

For starters, all the time spent in the initial years will appear to be a complete waste of time. Most of the people soon realize that the extra returns are really not worth the time.

In addition, if you start late in a bull cycle (as most individuals do), the quick and easy returns are soon lost in the subsequent bear market. In most cases, such individuals throw in the towel and move on to other pursuits in life.

Finally, the additional hours spent on investing means that one does not have time for any other pursuits like having girlfriends or other hobbies at the prime time of their life (early to late 20s).

My personal story

The above table and discussion is not theoretical. I have personally lived it for the last 15 years. I started investing in the late 90s (around 1997). I think I was financially literate by around 1998 and around that time came across the book – The warren buffett way. I read about this person who had become the second richest person by investing in stocks and was completely mesmerized by it.

I read the biography of warren buffett (Making of an American capitalist) and his letter to sharehlolders and anything else I could find about him. It was in late 1999 , early 2000 that I finally turned to active investing.

As you can see, my timing was perfect. I made some money for around 3-4 months of 2000 and then lost all the gains by the end of year - some on paper and some of it was a permanent loss as I had put money in IT/ Internet oriented mutual funds (don’t ask what I was thinking).

The years from 2000-2003 was one long bear market, where the market slowly went down from 4000 levels to around 3000 in a period of three years. If I put the numbers in the earlier table, my ‘salary’ from investing was negative, whereas I was making a good income from my full time job.

Any rational person after three year of losing money, would have given up investing and move onto something else in life. I did not even think of it as I was extremely passionate about it and inspite of mediocre absolute returns, I was still beating the market by a large margin.

The market turned in mid 2003 and as it took off for the next 5 years, so did my portfolio.

Better way to well

As you can see from my personal experience and from the analysis, that investing is definitely not a quick or easy way to becoming rich.

Let me suggest an alternative – If you are really passionate about something or good at your full time job, focus on it and get better at it. You will have fun doing it and over a decade you will make a decent amount of money out of it. Invest the money saved, sensibly by becoming financially literate and you will realize that not only is your life more pleasant , but that you also have enough tucked away for a rainy day.

I know this is not the conventional wisdom and we have a cottage industry of people encouraging others to invest on their own. I would rather follow my interest/ passions and become good at it (the money usually follows then), than do something just for the sake of a little extra money.

In case you wondering about the life I had outside work and investing early on …I am not going to disclose than on my blog and get in trouble with my wife J

Value trading

2012-09-27T18:55:00.001+05:30

I am going to discuss a new term –value trading in this post. It is a very interesting concept and it was first mentioned by my good friend – arpit ranka. I cannot claim any originality on this concept, but once it was mentioned by arpit, I started thinking about it and found a lot of validity and relevance to my style of investing.

What is value trading? (my definition)

Value trading is best described as buying a stock with the expectation of selling the same (hopefully with a gain) in a short period of time based on the realization of a single or multiple triggers. This trigger can be fundamental in nature such as normalization of sales/ profit margins (from a temporary low), business event such as launch of a new product or new capacity or change in the business environment for the better such as moving from extreme to moderate pessimism .

In addition to the fundamental issues, the trigger could be technical in nature such as short term overselling of a stock due to unexpectedly poor results or some temporary event such as elections which do not really impact the fundamentals of the business

In all these cases, one is expecting that the trigger will occur in the short term and the stock price will get a quick bounce (10%+) and one would be able to exit with a nice little profit

How does it differ from value investing

The above definition may sound a lot like value investing and I have been guilty of mixing the two for all these years. However as I think back, I have come to realize that they are not strictly the same and confusing the two can actually be harmful (as I will explain later in the post)

If one invests with a long term horizon in mind, then it is critical to have a good idea of the intrinsic value of the company. In addition this intrinsic value should increase over time, if one is to make above average returns in the long run.

So in effect, one is playing a short term trigger in the case of value trading versus betting on the business in the case of value investing.

Examples of value trading

Lets look at some example I have posted in the past and look at which bucket these ideas fall into

Patels airtemp

I would call this ideas as a value trading idea as this company is in a highly cyclical industry. At the time of buying the stock, I was expecting that the downturn in the capital goods industry would not be deep and the fundamentals of the company and its stock price would soon bounce back.

The trigger has yet to happen and as result the stock has slid further since the time I wrote about it.

Ashok Leyland

I started looking closely at this company in mid 2008 and by the end of the year the bottom had fallen out of the commercial vehicle market (the company stopped production for a month in dec 2008 to reduce the inventory). I purchased the stock in early 2009 at highly depressed prices.

The trigger – normalization of commercial vehicle sales happened quite quickly towards the end of 2009 and the stock turned out to be a four bagger.

In both cases, I expected a normalization of the fundamental performance and a bounce back in the stock price. In one case it happened faster than expected resulting in a large gain and in the other case the downturn has been deeper than expected and hence the stock price continues to languish

Amara raja battery

The company is a no.2 player in the battery industry and operates in a close duopoly. The key insight in this idea is that the company is expanding its competitive advantage (brand and distribution) and also benefiting from migration of demand from the un-organized to organized sector

I would tag this as a value investing idea as i don’t expect a specific trigger other than the fact that the company is improving its competitive position and hence should see an improvement in profitability and growth.

The first two examples I have discussed should bring out the following key point – In a value trading idea, the intrinsic value may not expanding or could be declining too. However the stock is undervalued and a set of triggers could close the gap with the intrinsic value. You can call this mode of investing as deep value investing or graham style investing too.

The last example of amara raja is more of a buffett style, high quality stock where although one is expecting the gap with the intrinsic value to close, the bigger gains come from an increase in the value of the company itself.

The differentiating factors

The two modes of investing differ on several factors. The first factor is time – Time works against you in the case of value trading. If the trigger happens quickly, the price rises quickly to the fair value and one can exit with a nice little profit. On the other hand if trigger gets delayed, then the overall returns may remain the same, but the annualized return is much lower.

In case of value investing, time works in your favor. As the company continues to grow its intrinsic value, the stock price should hopefully follow it (some times in spurts) and thus the idea becomes a buy and hold kind of idea.

The second factor where these two approaches differ is the nature of the business. The value trading approach works better in commodity and cyclical industries. If one can catch the bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then the gains are very high when the cycle swings back to a normalized level. At the same time, one needs to also ensure that the stock is sold once the cycle has turned .

Value investing approach works where the economics of the business is good and the company has a competitive advantage. In such cases, if one buys the stock at reasonable valuations, then returns are good over a long period of time

Do not mix the drinks !

I would say that value investing or long term investing should occupy a larger portion of the portfolio. If however you have the time and energy to look for value trading kind of ideas and can play them well, the portfolio can get an extra boost from time to time

The danger is really from mixing the two approaches as I have done in the past. I have bought trading kind of ideas and held on to it for a long time (assuming it was a long term investment). In such the cases the absolute returns came through, though the annualized returns were mediocre due to a delay in the key triggers.

The correct approach would be to keep in mind the nature of the idea (trading v/s investing), identify the triggers and the time it would take for the same to play out. If the triggers change or get delayed , then one should exit a value trading kind of idea. In contrast in a value investing idea, time is working in your favor and temporary hiccups are sometimes a good time to add to the position. In all such cases, one should just sit tight with the position.

A simpler way to invest

2012-09-14T04:12:00.002+05:30

Let’s do a thought experiment – Let’s say you are going on a multi-year cruise or journey around the world and need to invest your or your retired parent’s money. Let’s also assume that you want to ensure that the money is secure, but at the same time earns a decent rate of return (Which beats inflation).

Investments of this type should have the following characteristics

a. The portfolio of such investments should be reasonably secure - low probability of long term loss of capital, though temporary fluctuations are fine

b. Above average rate of return – The investments should beat the inflation and possibly earn a few percentage points above it, so that your family can withdraw a small portion of the capital without a reduction in principal

c. Low maintenance – should not require your family or you to run around, doing tons of paperwork or other tasks to manage it

Let’s invert the question and look at what will not be good options

a. Fixed deposit – Safe and low maintenance, but the rate of return barely beat inflation. As a result, if you use up the interest , the capital base will get eroded by inflation

b. Real estate – May be secure and give above average returns, but requires constant work (maintenance, repair, payment of taxes etc). In addition, you cannot really invest small amounts of money into it.

c. Gold – If you have been following me for sometime, you know my distaste for it. It is not an income producing asset and I cannot think of any family selling gold for meeting expenses – Remember the old Hindi films, where the family sells gold when it is in dire circumstances? We are too conditioned by those images.

I know you would have realized where I am going – equities!, but then not all types of equities. The above criteria eliminate some types of companies from the consideration set.

a. New companies with a short operating history – Sure, the company is going to be the next titan or ITC (fill in the name), but if the companies goes down the drain while you are away then your family is in trouble

b. Speculative companies – Loss making or penny stocks which have performed poorly in the past but have a very bright future.

c. Companies with poor management – I don’t want to hand over my money to a crooked management who could cheat me in my absence (remember we are away for a long period of time)

If you think through all these options, you will realize that you are left with a small list of companies which meet the following criteria

a. Durable competitive advantage – The company has done well in the past and you are assured that it will do well for a long period of time in your absence

b. Good management – You can trust the management to be good caretakers of your money in your absence

c. Reasonable prospects – The Company may not have phenomenal growth prospects, but should deliver above average growth.

If you put all these points together, I hope you can see a picture forming. We are talking of companies such as

Asian paints
HDFC ltd
HDFC bank
Crisil
ITC
Titan etc

A portfolio of such companies would be fairly safe as one is talking of good companies with above average economics and decent management. These companies may not be the next multi-bagger, but it is easy to see that they will give one a 15% or higher annualized return for a long period of time. Even if you consume 3-4 % of the return (via dividend or sale), your capital will still compound at 10-11%, which will take care of the corrosive effects of inflation.

If the above makes sense, then why am I not following it? Let me tell you why - The desire for higher returns! I think I can make higher returns than what I can get from these companies.

Please note the word – ‘Think’ and not would. Anyone who decides to invest on their own in all kinds of midcaps, small caps and other equity options is implicitly assuming that he or she can do better than these proven ‘blue chips’.

I am not saying that some people cannot do better, but I don’t think the lay investor who chases the current fad and hot tips, will do better than a basket of such companies. It is often smarter to make a sure 15% than chase the dream of 100% returns.

My experiences with deep value investing

2012-08-26T06:15:00.001+05:30

Deep value investing or cigar butt investing, is buying stocks whose price is way below the various statistical measures of value of the company. Now, value can be measured by various means such as PE ratios, discounted cash flow analysis or asset values. In case of deep value investing, one is investing in stocks which are selling at a very low PE, below book value or in some cases even below cash held by the company.

This method of investing was introduced and popularized by the father of value investing – Benjamin graham in his classic security analysis (A must read for any serious investor). In this book, graham talks about companies selling below working capital, book value or in some extreme cases, even the cash held by the company.

This mode of analysis is a quantitative, statistics driven method where in one holds a large number of such ‘Cheap’ companies. A few positions work out, a few go down the drain and rest just stagnate doing nothing. In spite of such a mix, the overall portfolio does quite well and one is able to earn decent returns at low risk

The key element in this investment operation is wide diversification and constant search for new ideas to replace the duds in the portfolio.

Initial foray into high quality
My first exposure to sensible investing (reading economictimes and watching CNBC does not count in that), was when I read the book – The warren buffett way. I was completely mesmerized by this person and read all I could on him for the next few years.

After burning my finger a bit during the dotcom bust, my initial investments were in the warren buffett mold (high quality stocks with competitive advantages). My initial investments were in asian paints, pidilite, Marico etc - the so called consumption stocks except that they were not called by this label then.

I have always wondered why these stocks are called consumption stocks? are capital goods and real estate ‘un-consumption’ companies whose products no one wants to consume J ? Anyway I digress

An experiment in deep value

Around 2006-2007, i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around 10-15% of my portfolio in names such as Denso, Cheviot company, Facor alloys and VST industries (see here), etc for a period of around 3-4 years.

I decided to terminate this approach in 2011 and have been exiting the positions since then. In the rest of the post I will cover my experience and learnings from this long run experiment.

The results

The results from this portion of the portfolio (which was tracked separately) was actually quite decent. I was able to beat the market by 5-6% points during this period. At the same time, this part of the portfolio lagged the high quality portion by 6-7% over the same time period. The difference may not appear to be big, but adds up over time to a considerable difference due to the power of compounding.

I have not completely forsaken this mode of investing and once in while could buy something which is very cheap and has a near term catalyst to unlock the value.

Why did I quit ?
I did not quit for the obvious reason of lower returns than the rest of the portfolio. The lower return played a part, but if I compare the effort invested in building and maintaining a deep value portfolio , it is much lower than trying to identify a high quality and reasonably priced company .

If one compares, the return on time invested (versus return on capital), the balance could tilt towards the deep value style of investing.
Let me list the reasons for moving away from this style of investing

Temperament – The no.1 reason is temperament. I have realized that I do not have the temperament to invest in this fashion. I do not like to buy poorly managed, weak companies which are extremely cheap and then wait for that one spike when I can sell it off and move on to the next idea. It makes my stomach churn everytime I read the annual report of such companies and see the horrible economics of the business and miserable performance of the management.
Life is too short such for such torture

Re-investment risk- The other problem in this mode of investing is the constant need for new ideas , to replace the duds in the portfolio. This exposes one to re-investment risk (replacing one bad stock with another bad idea), especially during bull markets.
Value traps – This part of the market (deep value) is filled with stocks which can be called as value traps. These are companies which appear cheap on statistical basis, and remain so forever. The reasons vary from a bad cyclical industry to poor corporate management. In all such cases, the loss is not so much as the actual loss of money, but the opportunity loss of missing better performing ideas.

Higher trading – The final problem in this mode of investing is the constant churn in the portfolio resulting in higher transaction costs and higher taxes, both of which reduce the overall returns.

The lessons
I know some of you, have never followed this mode of investing and have always invested in quality. The problem with investing in quality is the risk of over payment, especially if the quality is just an illusion (faked as in the case of several companies in the real estate sector in 2007-2008). Anyway, that is a topic for another post.

I am constantly experimenting , with a small amount , with new approaches and ideas. If there is a valid approach, which matches my overall value investing approach (momentum and technical trading is out), I will try it and see if it works for me. It is one thing to read about it and another to put some money into to it and immerse oneself in it.

As some has said – an expert is someone who has made the most mistakes and survived. Well, at the current rate of making mistakes, I hope to become an expert in the next 10-20 years J.

Investing for dividends

2012-08-12T20:25:00.004+05:30

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,

I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response

Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following

a) Company earning high return on capital with good cash flows

b) Reasonable valuations

c) Good capital allocation policy by management

if you are able to achieve the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory...high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards

Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement

How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period - there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire :)

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

If facts change, do you change your mind?

2012-07-20T04:42:00.000+05:30

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.

A speculative bet

2012-07-05T06:59:00.001+05:30

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.

The return of the stock picker

2012-06-25T04:35:00.000+05:30

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.

Moat or no Moat – Indian IT

2012-06-15T06:04:00.001+05:30

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.

Evaluating the impact of rupee depreciation

2012-05-31T04:44:00.001+05:30

The 22% drop in the rupee against the dollar is worrying to say the least. There are several ramifications for the Indian economy, if the slide continues. Anything which impacts the economy, is bound to impact the stock market as a whole.

One can find a dizzying array of macro-economic analysis on the impact of the rupee depreciation and as many forecasts of the future levels of the exchange rate.

I personally consider macro-economic analysis too complex due to the huge number of variables involved in it and hence any analysis from my end is as good as yours. Instead I have been trying to evaluate how the rupee depreciation will impact my portfolio on an individual stocks basis.

I think there are three factors through which the fundamental performance can get impacted

Factor 1: Level of Raw material / capital good import

What is the level of raw material / capital goods imported by the company?. If the company imports a substantial amount of raw material/ capital goods then it is likely to get impacted severely, if it cannot pass on the costs to the end user without impacting the volumes

Factor 2: Level of export

What is the level of export sales in the revenue of the company. A high level of export will benefit the company, if the company can maintain or improve its margins as a result of the rupee depreciation.

Factor 3: Level of foreign debt

What percentage of debt is ECB (external commercial borrowings) or FCCB? There are two key points to note here – What is the maturity schedule (payment timing) and the level of debt in comparison to equity / market cap?

The above three factors cannot be looked in isolation and have to be combined to come up with a final impact on your company.

For example – A company may have a high level of export and imports, with the exports exceeding the imports (due to value addition on the raw material). In such a case, the company will have a net benefit.

A company using domestic inputs and exporting most of its output will gain the most from the depreciation (IT and pharma). Conversely a company using imported inputs and selling most of it domestically will be hurt badly (Oil companies). Finally a company with high level of imported inputs, selling domestically and also carrying a high level of foreign currency debt is toast (to put it politely)

If level of export >= import + debt payment (ok)

If export < import + debt payment (trouble)

Let me give you two examples of the analysis I am currently doing on my portfolio stocks

Balmer lawrie

The company has zero debt and actually has excess cash of around 200 Crs. So we do not have forex related debt risk with the company

The company imported around 4% of its inputs and earned roughly the same amount in exports. So at first glance, the company has close to zero risk from higher raw material costs due to currency depreciation. However the grease and lubes division uses various base oils which are petroleum based and will be impacted by the price of crude oil. As the division does not have much of a pricing power, the net margins of this division are likely to be impacted.

The other divisions such as logisitics and tours & travel are unlikely to be impacted directly due to the currency depreciation. However the overall business will definitely be impacted by the overall slowdown in the economy.

Lakshmi machine works

The company has close to 700 Crs+ excess cash on the books and hence the risk of forex debt does not exist.

The company exported around 250 Crs of machinery and components in 2011 and imported roughly the same amount in terms of raw materials and spare parts. As a result , the company is unlikely to get directly impacted by the rupee depreciation. On the contrary, the company could benefit to a certain extent as the competitive pressure from imported machinery will reduce.

Finally I think that the textile industry level issues will have a bigger impact on the company performance than the currency depreciation.

Not a quantitative analysis

The above analysis is not a precise numerical analysis and I would be suspect of any such analysis, as there are too many variables which impact the performance of a company. The best one can do in the current circumstances is to figure out if your portfolio company falls in the high risk or low risk bucket (due to the currency depreciation).

If the risks are too high (even if not quantifiable), then one should consider reducing the position size even if it results in a loss

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