Archive for the ‘Uncategorized’ Category.

 

Let me share some actual data, without sharing the name of the company initially

One year return = 69%
5 year return = 75% CAGR

I don’t know about others, but in my universe this kind of performance is something to kill for. At the same time, one has to be insane to expect this kind of growth forever. If one my positions were to deliver this kind of performance, I will consider myself lucky (not smart). However I would not run around looking for such companies prospectively as they are like shooting stars – be glad you saw one (or hold one), but do not sit on your terrace forever waiting for one.

If an investor has an investing lifetime of 30+ years, even a 20% return will make him or her insansely rich. A 75% per annum return for 30 years ? look at the numbers below for comparison

1 lac becomes 2.37 Crs after compounding at 20% for 30 years
1 lac becomes 1,95,497 Crs after compounding at 75% for 30 years

However investors keep chasing these shooting stars

capture 1

And what happens, when they are disappointed, even temporarily?

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So what is the name of this mystery company? Its symphony limited

Below is the chart of the company for 5 years

Capture

The madness of growth

Is the name even important? This is not a one off case. Look for any company – good, bad or ugly. If the company shows a couple of quarter of growth, the stock price shoots up with no link to valuation, quality or sanity.

On the other hand if the music stops, even for 1-2 quarters, the response is brutal. The herd which rushed in blindly, now heads for the exit.

I don’t think this can be called investing – it’s a mad hunt for growth.

For the slowpokes like me, it is better to just sit and watch. The risk here is that the retail investor will again repeat the same lessons of the past – Buy high and sell low.

Added note: I have taken symphony limited as an example. I am not discussing the merit of this company as an investment. I may or may not hold this stock in my portfolio. The warning holds – if I discuss about gold, real estate or goat, I may or may not be buying or selling it. So please do your homework if you plan to buy anything discussed here, including the goat!

 
 

The easiest way to justify a high PE stock is to say that it has a moat or in other words a sustainable competitive advantage. Once these magic words are uttered, no further analysis or thinking is needed. If there is a moat, it does not matter if the stock sells at a PE of 30 or 70. It is all the same.

On seeing this type of analysis I am reminded of the following the quote from warren buffett

“What the wise do in the beginning, fools do in the end.”

Moat =high PE, but high PE is not always = Moat

A company with a moat may be justified to have a high PE, but a high PE does not mean the mean presence of a moat.

Even if the company supposedly has a moat, it is important to judge the depth and durability of this moat. In addition , the company should also have the opportunity to re-invest future cash flows into the business at high rates of return to create further value.

Lets explore some of these aspects in further detail

More than knee deep

The depth of the moat is simply the excess returns a company can make over its cost of capital. If a company can earn 30% return on capital, we can clearly see that the moat is deep (18% excess return).

This aspect of the moat is the easiest to figure out – Just pick the financials of the company for the last 10 years and check the return on capital of the company. If the average returns are higher than the cost of capital , then we can safely assume that the company had a moat in the past (the future is a different issue).

I personally use 15% return on capital as a threshold. Any company which has earned 15% or higher over an entire business cycle (roughly 3-5 years) is a good candidate for the presence of a moat in the past. Its important not to consider a single year in the analysis as several cyclical companies show a sudden spurt in profitability, before sliding into mediocrity.

The durability factor

The presence of a moat in the past, is only the starting point of analysis.

The key questions to ask are

– Is the moat durable – will the moat survive in the future ?
– How long will the moat survive ?
– Will the moat deepen (Return on capital improve), remain same or reduce.

All these factor are very important in the valuation of a business. Let try to quantify them. I will be using the discounted flow analysis (without doing the math here) and will also be making some simplifying assumptions

1. EPS = 10 Rs
2. Return on capital (ROC) = 22%
3. Growth in profits = 15 %
4. Company is able to maintain this return on capital and growth for 10 years. After that the ROC drops to 12% and growth to 8% (leading to a terminal PE of around 12)

If you input the above numbers into a DCF model, the fair value comes to around 230 (PE = 23)

Lets play with these numbers now – Lets assume we underestimated the durability of the moat. The actual life of the moat turns out to be 20 years and not the 10 years when we first analysed the company. If that is the case, the fair value comes to around 430 (PE=43)

Capture

I just described the case of several companies such as HDFC bank, Asian paints, Nestle etc. In case of these companies, the markets assumed a certain excess return period, which turned to be too conservative. Anyone who bought the stock at a high looking PE, was actually buying the stock cheap.

The above point has been explained far better by prof. sanjay bakshi in this lecture.

Lets look at a few more happy cases. Lets assume that the company actually ends up earning an ROC of 50% with a growth of 20%. If you plug in these numbers, the fair value turns out to be around 440 (PE=44). I may have just described what has happened to page industries since 2008.

Capture3

So what are the key points?

The market when valuing a company is making an implicit assumption on the future return on capital, growth and the period for which both these factors will last (after which they regress to the averages).

An investor makes an above average return only if these numbers turn out to be better than the assumptions built into the stock at the time of purchase.

What happens if the moat turns out to be weak or non existent ?

You have a dud !

Lets assume in our example, that the business tanks after you buy it. It is never able to earn more than 12% return on capital and grows at around 8%.

If the above unhappy situation happens, then the true fair value of the company is around 120 (PE=12). If this turns out to the case, then you will suffer from a 50% loss of capital as the market re-values the company.

Examples ? Look at the case of bharti airtel. The company was selling at around 470 or PE of 23 in 2007. The company had an ROC of 31% and growth in excess of 15%. The market was assuming an excess return period of 8-10 years at that point of time.

What has happened since then ? The stock price has dropped by around 25% from its peak over the last 8 years – a loss of 2% per annum, which is not exactly a great return.

The reasons are not difficult to see (as always, in hindsight). The telecom market after growing at a breakneck speed till 2007-08 started slowing down. In addition the competitive intensity of the industry increased with almost all other players losing money for most of the time. If these problems were not enough, Bharti went ahead and made an expensive acquisition (Zain) in Africa which suppressed the return on capital further.

Capture2

In effect all the key drivers of value, turned south from 2007-08 onwards resulting in a loss for the long term investor.

We can derieve some key points from the discussion till now

– A high return on capital in the past is a necessary, but not a sufficient condition to demonstrate the presence of a moat
– It is also important to judge the depth and longevity or durability of moat. If your estimate is correct and turns out to be higher than that of the market, then you will excess returns. If not, be prepared to lose money or at best make market level returns .
– As a corollary a buy and hold works only if you get the durability aspect correct. If the moat shrinks and disappears, a buy and hold strategy will not save you

So how does one figure out the durability of the moat. There is no magical formulae where you can punch in a set of numbers and out will pop the duration. It is a highly subjective exercise and the topic of the next post.

 
 

We are all supposed to be perfectly rational, supercomputers that can do a discounted cash flow analysis on every investment idea we come across. If this is not enough, we are also supposed to be able to compare all investment options at the same time, before making a decision.

This is what most ivory tower professors would have us believe (except one ). Ofcourse this does a lot of disservice to a budding investor, who feels stupid when he or she lets emotions creep into the decision process.

I have invested for around 15 years now and in the countless investors I have followed, I have yet to come across anyone who comes close to this mythical investor. For the ordinary investor like me, I find it far more useful to acknowledge my irrationality and learn to work with it. Although there are no universal rules to managing emotions when investing, let me share my experiences as some would definitely be instructive.

Let’s start with a list of some commonly felt emotions and their impact –

Fear

Think back to August – Oct 2013. Rupee dropped close to 71 to a dollar. Current account deficit was around 5% and at the risk of expanding further. The Indian government led by congress was in a state of paralysis. The net effect – The stock market dropped close to 10%. The same story had occurred in 2003, 2008-09 and 2011.

Inspite of the economy and market coming back after a few years in the past, a majority of the commentators and investors decided to stay away from the market. This is even more surprising considering the fact that Mid caps and small caps were selling at 5-6 year lows and some highly profitable and growing companies were available at decent valuations.

My thinking: It is not that I am immune to fear and pessimism. I felt equal depressed about the state of affairs and angry with the government. However, during such times I go by my sense of history (past record of the stock market) and valuations. If the company is doing well and available at decent valuations, I will buy the stock without worrying about when I will be proven right. How does it matter if the stock doubles in one year or the end of year three?

Greed

I don’t have to go far on this one. Look around now – after almost five years, the small investor is now coming back. We have mutual funds advertising the last one year results and people are now getting excited about equity after a 55% rise from the bottom.

This is a very predictable pattern. Gold increased by 19% CAGR from 2001-2011 and everyone was bullish about gold.

spdr

Indians, with a perennial love for gold, found one more reason to buy it and anything associated with gold such as jewelry companies got swept up in the same euphoria.

Gold is down 25% now and so are gold related companies. As far as I know, I am not seeing analysts recommending gold or gold related companies now.

thanga

So the emotion of greed is obvious – once we see others make money, it is easy to be envious and follow the crowd. The result is predictable too – The last people to join the herd also lose the most money.

My thinking: I have a standard thumb rule. Do not buy something which almost everyone is recommending. If I do buy into something which is the current flavor of the market, I try to move slowly into it so that I don’t lose much if the tide turns. In addition to that, I won’t buy something I don’t understand. For example – I was never able to understand what the true free cash flow for most gold companies is (except titan industries), considering all their profits are generally eaten up by inventory. As a result, I just stayed away from them.

Love and security

Now this is not an emotion, one associates with money and investing. I did not consider it relevant for a long time, but as I think about gold and real estate, I can see the role of these two key emotions

I first realized the importance of love and security as an investment criteria when my mother tried to convince me to buy gold to secure the future of the family. I tried to explain that equities give a better return, but soon realized that there was no way I could convince her. Of course, she decided to take matters in her own hands – she went and bought some gold for the family and said that that was her way of providing security to the family 🙂

The effect of emotional attachment is very high with gold – When it goes up, people justify its purchase based on the price rise. If it goes down, the justification changes to it being undervalued or being a hedge against catastrophe or any other reason you can think of.

If you still don’t agree with me – go to your spouse or any other member of you family and suggest the following: Please hand me your gold, I will sell it and invest it in a higher return instrument. In X number of years from now, you can buy more gold than what you have now. I have tried it and I am scared to use the two words ‘gold and sell’ again in the same sentence 🙂

Flaunting

If you think, love and security alone explains the fascination for gold – think again. I always found it irrational to buy gold or even real estate (beyond your housing need) if all that you are looking for is high returns.

This thinking changed when my family and in-laws felt that I had finally arrived in life when I bought my own flat with a big loan and essentially signed my life to the housing finance company (read EMI!). I never got any praise for buying an asian paints or any other long term compounder , whereas the flat was a concrete evidence (no pun intended) that I was doing something right in life

There is a tangible quality to both gold and real estate. You can see it, feel it and even flaunt it . In the past one could look and touch the stock certificates, but now with demat accounts what are you going to show others?

Imagine this fictious dialogue

Mom to her friend: My son has finally arrived in life! he bought a 1000 sqft flat in XYZ location. We are going to grah pravesh (house warming). Why don’t you join us? <so that she can show the house and feel proud>

Versus

Mom to friend: My son bought 1000 shares of asian paints. Let me show you his demat account! you know this company has a sustainable ……… will this dialogue ever happen!!

It’s the same with gold. Your wife or mother can wear the gold and in a lot of cases this serves to signal that the family or husband/ son is wealthy. So gold and real estate actually help in feeling secure or in displaying wealth. It is incidental that they earn some return too.

These emotions sometimes creep into stocks too. At the height of a bubble, investors want to invest in the hottest companies so that they can show their friends and colleagues how smart they are.

My thinking: In my own case, I have usually not felt the need to flaunt (or so I believe). At the same time, I try hard to avoid envy, which causes one to do stupid things such as chase the latest investment fad or buy stuff to show off.

There are only a two exceptions to the above rule in my case – The first one is that the emotional value of your own home is high, so it don’t look at it as a financial decision, but something which makes my family feel secure. The second one is that when my wife wants to buy jewelry I look at it as an expense to keep her happy

The driver

Volatility in prices is not an emotion in itself, but a driver of a lot of emotions we have been talking about. When stock prices crash, we can see that investors are overcome by fear, despair and in some cases complete disgust to the point of avoiding equities forever.

On the contrary if prices rise rapidly the reverse happens – we see greed and euphoria. These feelings are common to all investments, but as the volatility is high in stocks compared to other options, these emotions are amplified in the stock market.

I personally think that one of the reasons investors make higher returns in stocks compared to other options on average, is due to the higher volatility which tends to put off a lot of people. Investing in stocks is tough emotionally, no matter how long one does it. You go through periods of sickening drops and exhilarating spikes and it never gets easier, emotionally.

Take your pick

So it comes down to what one is looking for in their investments. If you want to flaunt your wealth or to feel warm and fuzzy, then go for real estate and gold. The returns could be good, if you have specialized skills in these asset classes, but then that is a different ball game.

If you want complete peace of mind – invest in Fixed deposits and sleep well. There is no harm in that!

If you are ready for a few sleepless nights, stomach churning drops in your networth (even if temporary) or sudden euphoric rise, and have nerves of steel to handle all of these emotions, then you will be rewarded with higher returns over the long term. That is equity investing

This brings me to a final anecdote –

I was discussing about expected returns of various types of assets such as real estate and stocks with a friend. I mentioned that one should expect anywhere between 15-18% from the stock market in the long run. To this, my friend replied that he ‘wanted’ nothing less than 20% per annum.

I asked my friend on why he ‘wanted’ these returns? Ofcourse he had no reason for it. It was just something he thought should be the case!

My reply was that like my kids, if you are wishing for something as they wish during Christmas from santaclaus, you should not hold yourself back. Why stop at 20%, why not ask for 100% – maybe your wish will come true!

We are still good friends, but don’t talk about investments any longer :). This is the final emotion a lot of uninformed investor suffer from – wishful thinking