Intelligent investing

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).

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

1. The portfolio of such investments should be reasonably secure – low probability of long term loss of capital, though temporary fluctuations are fine
2. 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
3. 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

1. 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
2. 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.
3. 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.

1. 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
2. Speculative companies – Loss making or penny stocks which have performed poorly in the past but have a very bright future.
3. 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

1. 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
2. Good management – You can trust the management to be good caretakers of your money in your absence
3. 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.

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 ? 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