We had two major events in the last few weeks – The election of Donald Trump as the president of US and the Demonetization of the 500/1000 Re notes

Let’s look at the impact from these two events.

Let me start with the first event, which somehow was in the news for the last few weeks and I felt no need to respond or react. The event was a surprise for many and in a way similar to the Congress win in India in 2004. There was a sense that the market would crash if Donald trump is elected as president. I had no clue about what would happen if this event occurred, but to be frank I could not care less.

You will hear all kinds of reasons why some event will cause a cascade and impact a particular company in question. I personally think this is complete nonsense and one can link any number of remote factors together to make a case.

In investing, the key is to focus on the few critical factors which may impact your investment thesis and ignore the rest. I find it difficult to see why the election of a particular individual in a foreign company will have an impact on most of the companies in India at a micro level. Will consumers buy less soap or stop buying cars or going to movies just because Donald trump is elected in the US?

A final point on this count – Look at what has happened to the US market after the election. After an initial drop, the market is up. So much for predictions from all kind of pundits.

The more important event

The more relevant event for us has been the demonization of the high value currency. I personally think this a watershed event for the country. There are a lot of people looking at the interest rate and tax implications for the country, which I agree is quite good. However the bigger impact is from the signaling effect of this decision.

For starters, it creates a lot of positive emotion for the honest tax payer/ companies as they now feel that they are not idiots for paying their fair share.  This event is a positive boost for them.

The second impact of this decision is that it sends a message that the government is serious about reducing tax evasion and corruption. A combination of GST, JAM trinity and now demonetization could be effective in reducing tax evasion (but not necessarily eliminate it). This would apply to a lot of unorganized sector companies where there is substantial evasion of taxes. These events are creating a level playing field in terms of taxation and will benefit the organized companies in the long run.

Although the long term benefits are huge, the short term is going to be tough. This kind of event has first, second and higher order effects. On the surface real estate, gold, high value durables and other such purchases are likely to get impacted. However if you think further, this drop is likely to cause a ripple effect in other sectors such as lending, construction materials, auto components and so on.

Analyzing the impact on your portfolio

The key point in the analysis of any major event is to evaluate the long term impact to the business model and profitability of the company.

There will definitely be a short term impact of varying degrees to all the companies from a slowdown in the economy. The next 1-2 quarters are going to be ugly for a lot of companies and stock prices have started dropping in response to that. As we approach the end of the year, the selloff could increase as a lot of mutual funds and FIIs try to window dress their portfolio.

I have no such plans for my portfolio. I made an argument in a prior post that we need to be ready for short term volatility and 15% or more drops from time to time. If one cannot handle these swings, then equities are not an appropriate vehicle. I will not sell any stocks where I think the long term prospects continue to be good, even if the near term appears horrible.

An example

Let’s take the example of NBFCs to see how this event would impact some companies

A lot of NBFCs deal with customers who operate on cash due to lack of access to banking services. It is expected that these companies will be impacted as these customers are unable to make timely payments. We are most likely to see a large expansion of NPA in the next 1-2 quarters.

We should however keep in mind that an NPA is not the same as a loss. An NPA means that the borrower has not made a timely payment and as a result, the lender has to mark the loan as non performing, stop accruing the interest income and add provisions (set aside some part of the profits) to account for the higher risk of non-payment.

Even in the event of a loan going bad, the recovery varies from 30-70% based on the nature of the asset and the level of collateral. If the asset is a steel plant, it is quite obvious that it is large, illiquid and will require special skills to operate. In such cases, the recovery for the lender is on the lower side. In the case of other assets such as real estate, there is a large liquid market for the asset where it can be auctioned and hence the level of recovery is usually on the higher side.

Let’s look at a worst case scenario. Let’s say a company has around 1000 crs of assets on its books. Let’s make a very aggressive assumption that 10% of the assets will become NPAs with no hope that the borrower can become current on the loan. We can assume a 50% recovery rate on these NPA. So the eventual loss for the company would be to the tune of 50 crs.

So what does a loss of 50 Crs translate to? A company with 1000 Crs of asset will generally have an equity of around 150-180 crs and would be earning close to 30-40 crs pre-tax, pre-provision profits (profits before accounting for taxes and loan loss provisions). So in an extreme loss scenario, an average NBFC should be able to cover these losses in 1-1.5 years.

Keep in mind that the above loss scenario is quite high in nature. Most of our poorly managed PSU banks have much lower level of losses inspite of much more illiquid assets and lower recovery rates.

Losing your wallet

I had written a post on first principles thinking as applied to investing here. As noted in the post, the intrinsic value of a company is the discounted sum of all its future cash flows. If you think of a company in that fashion, then by how much will you reduce the future value of the NBFC?

To answer the above question, we need to consider a few points. Do we think that the long term prospects of the company have been harmed by the demonetization issue? Will the demand for credit reduce on a permanent basis due to this issue?

I think no matter how pessimistic you may be about the whole demonetization episode and the slow response of the government, it would be hard to argue that this issue will cause a permanent drop in demand for credit in the long run..

If that is the case, then this event is more like a finite loss event. I am not saying that this loss cannot be bigger than what I have discussed earlier, but it is not equivalent to a loss of earning power for the company. The competitive strengths for the company remain the same even after the event.

As an analogy, let’s say you are carrying 5000 Rs (in 100 Re notes :) ) and you lose your wallet. It is a loss of 5000 and your net worth went down by that amount. However you future earning power which depends on your skills and other factors did not change due to this event.

This analogy is not perfect and we are making several simplifying assumptions, but this is broadly what is happening to most of the companies. The same is not true if the fundamental business model depends on black money (casino or some real estate developers) or if the business cannot sustain a period of loss (as in the case of several small business operators).

The market reaction has been far more severe with some NBFCs losing almost 30% of their value in the last one month (almost 3-4 times our loss estimate).

Cash + courage = opportunity

We need to be prepared for a very ugly Q3. The demonetization event is likely to be quite disruptive to businesses in the short term, especially in the rural areas where banking services are poorly developed.

The stock market is already reflecting this impact. I am not thrilled about it but it is not shocking for me as such surprises happen from time to time. This is part of equity investing and one cannot make high returns unless one is emotionally prepared for such gyrations.

It will not feel good to keep losing money every day as the market corrects, but I plan to deploy some cash as bargains develop.

 
 

I recently did an interview with Vishal khandelwal at safalniveshak.

We covered several topics such as the process for finding investment ideas, position sizing, concentration versus diversification, facing market turmoil and many more.

You can find the interview here

You can read an earlier interview with vishal here.

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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.

 
 

I wrote this note to all of my subscribers. Hope you will find it useful too

A lot of new subscribers have joined us and so I am writing a short note to talk on several topics such as how to build your portfolio, our investment philosophy, ongoing crises etc.  For those of you, who have been with me for a long time, this may seem like an un-necessary repetition. However I think it is important for new subscribers to know what they are getting into with me and for the old subscribers to be reminded of it.

Let me state this again – My approach is to buy good quality companies at a reasonable price. There is nothing magical or new about this. Every other value investor professes to do this and I am no different. There is no secret sauce and I make it a point to share my thought process and analysis as much as feasible.

I am not looking for quick flips based on interest rate changes, slightly better monsoon, modi’s reaction to Pakistan or some astrology sign. There could be others who practice this type of investing and it may work for them. I have no interest in doing the same.

I have practiced a value based philosophy for the last 15+ years and it has served me well. I have no plans of changing a sound and logical approach for something else in the future. As long as I continue to do follow it rationally and with discipline, I think the long term results will be good even with occasional spells of under-performance.

Building your portfolio
One the first comments I get from a new subscriber after joining is this – I had a look at the model portfolio and I cannot buy more than 2-3 positions for now. I have a stock response for that – please be patient and give it some time. I have usually seen that most new subscribers are able match the model portfolio over a span of 2-3 years as some stocks drop below the buy level and new positions are added.

How true has this statement been?

If you look at the price action of our 17 odd positions for the last two years – you will find that at least 14 hit the buy point and even went lower for a few days or more. So in effect, it’s quite possible to be 80% matched to the model portfolio for those who joined the subscription in the middle of 2014. I do not have the statistics of how many have done that, but my point is that over a 1-2 year time frame, one will get enough opportunities to buy and build your portfolio. One needs to have the patience to do that and not get swayed by short term events.

Recurring crises
We started the model portfolio in Jan 2011. We have had several actual and imagined events such as Grexit (did not happen), Chinese hard landing (cannot say if that has occurred), Brexit (did happen), oil crash (occurred in 2014) and mismanagement of the Indian economy by the previous government.

These are the big events which come to mind. If you pick up a newspaper, there is a lot more to worry about from day to day. Now imagine if we had remained in cash or got frightened out of our positions due to some real or imaginary risk? Does it make sense to take actions based on unknown guesses about the future or concentrate on individual companies and make informed decisions?

Now someone could counter this logic by pointing the risk of 2008/09 collapse when mid and small caps crashed by 60%. What if one of these events had snowballed into a similar crisis?

Let me answer that concern via two arguments

– For starters, one cannot invest based on the low probability, high impact macro events. One can diversify against black swan risks at an individual company level, but not at the country level. To give an extreme and silly example – how will you protect yourself from the risk of an asteroid crashing into a major city in India and causing a major economic crisis? Can one really diversify against such an extreme risk?

– My second argument is that one needs to invest based on the higher probability risks (such as inflation) and insure against the low probability, but extreme ones. In other words, invest to beat inflation or secure your retirement and buy life/ health insurance to hedge the other extreme kind of risks. Finally there are some kind of risks, where one can only hope and pray that they don’t occur and we can do nothing about it.

Having the right temperament
If a 10-15% drop in the portfolio is going to scare you (as it may have in Feb of this year) and cause you to lose sleep, then equities are not for you. I can share my analysis and thought process, but cannot fix your temperament. You will have to bring a steady and calm mind of your own to the table.

If you think you cannot bear to see your portfolio drop by 15% or more from time to time, now is a good time to exit. I don’t think there is anything to be ashamed of in recognizing your risk tolerance and acting according to it. My own family was never into equities as they were never comfortable with the volatility of the stock market. I started investing for them a few years back after they felt confident that I will not blow up their savings (or maybe it was just their love for me …I don’t know)

Looking for trends
Some of you may have noticed that the model portfolio generally does not have a specific theme or view. One will often hear from investors that they have positioned their portfolio to benefit from better monsoon or revival in capex or some such factor.

The benefit of identifying a broad trend and then investing to it has a lot of upside. However I have generally not followed this form of top down, trend based investing as I have found it difficult to identify a truly long term trend and then find a reasonably priced idea to leverage this trend.

One needs to keep in mind that a good monsoon or lower inflation is not a long term trend, but only specific events which play out for a small period of time. A long term trend would be something like demand for housing/ housing loans which leads to a growth of 2-3X of the average GDP growth rate.

We have three positions which seem to play to this theme. However if you read the original thesis of these ideas, I was looking far more closely at the  company specific factors and only vaguely realized that there were some tailwinds for the sector. It is after holding these stocks for 2+ years that we can now make a story of a theme or trend for these ideas, but this was never the case when we started these positions.

Why am I discussing this point now? I think there is a lot of value in identifying such trends early and investing based on it, provided one does not overpay for it. As a result, I have now started looking at some of the current ideas from a trend point of view. We will however not know if the trend was real or a mirage, till a few years pass.