“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.

• The black swan – unpredictability, futility of forecasting etc
• The black swan – unpredictability, futility of forecasting etc
• The black swan – unpredictability, futility of forecasting etc
• Where does the index stand
• Where does the index stand

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)

• On the previous post and some additional thoughts
• On the previous post and some additional thoughts
• On the previous post and some additional thoughts
• One way of looking at market valuation ?
• One way of looking at market valuation ?

-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

1. BHEL
2. Infinite computer s ltd
3. Manapuram finance
4. FAG bearings
5. Whirlpool India
6. Eros international
7. Tata motors
8. 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.

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.

• India’s Enron – Satyam
• India’s Enron – Satyam
• India’s Enron – Satyam
• Corporate governance – Satyam and other Indian companies
• Corporate governance – Satyam and other Indian companies

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.

• Analysis: Globus spirits
• Blue star india – A quick look
• Blue star india – A quick look
• Blue star india – A quick look
• Analysis – Patni computers

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).

• Wish I sold off my entire portfolio in Jan !!
• Wish I sold off my entire portfolio in Jan !!
• Wish I sold off my entire portfolio in Jan !!
• Should I sell?
• Should I sell?

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.

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.

• Berkshire hathaway annual meeting and quarterly results
• Berkshire hathaway annual meeting and quarterly results
• Berkshire hathaway annual meeting and quarterly results
• Is a strong brand a profitable franchise ? – comments / thoughts/ cases
• Is a strong brand a profitable franchise ? – comments / thoughts/ cases