I recently responded to an email Q&A from PJ Pahygiannis. We covered some of the following questions and more
– Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas from?
– How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?
– What are some of your favorite companies, brands, or even CEOs? What do you think are some of the most well run companies? How do you judge the quality of the management?
– What kind of bargains are you finding in this market? Do you have any favorite sectors or avoid certain areas, and why?
– How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
My response has been published on gurufocus.com. You can read the entire Q&A here. I hope you find the Q&A useful
A commonly used thumb rule in investing is that a company selling below a PE of 10 is likely to be cheap and one above 30 is likely to be expensive. I have been guilty of using this rule, often subconsciously and have paid a heavy price for it.
The advantage of writing a blog for 10+ years is that I don’t have to go anywhere to find examples of mistakes. I can always find one I have committed and written about it.
To see the example of a PE driven investment gone wrong, read the analysis of Facor alloys here. In a year’s time, I realized that I had made a mistake and exited this position with a 12% loss – you can read my analysis here. If I had held on to the position, I would have lost close to 85% of my investment, even as the stock continued to sell at a very low valuation (current PE being 3)
Reasoning from first principles
In the above video, elon musk talks about reasoning from first principles. Why should one do that?
Reasoning from first principles leads one to understand the fundamentals factors driving the issue in question. So how do we apply this concept to investing?
I wrote the following on it
Quite simply, the one absolute and immutable fact of investing is that the value of an asset is the sum of the discounted free cash flow, it will generate over its life time. The above statement does not mean that an asset cannot sell above or below this value from time to time, but anyone holding an asset over its life time, cannot make more than the cash flows its generates over this period.
Lets break the above point down into its key components
– Free cash flow
You can find multiple definitions of cash flow, but the one which I like to use is the cash you can receive from the asset, without impairing its long term earning capacity. Lets apply this to a simpler example than a company – A house or a flat where it is easier to analyze the cash flows.
Free cash flow – Can be estimated as follows : Gross rent – taxes – maintenance expense – other overheads
Maintenance expense usually involves repairing the house, cleaning it after the tenant vacates it and any other expense incurred to keep it in a rentable conditions. Other overheads can be society & broker charges to let out a house etc. So after paying out all these costs, the cash left behind would be the recurring free cash flow to an owner.
Lifetime – This is the period an asset can be expected to generate a cash flow. In case of a flat or house one can take as it as 30 years, before one has to permanently replace it with a new construction. In an extreme condition you can stretch it to 50 years, however try letting out a very old house and you may realize that the rentals are much below the market rates.
Discount – The definition of discounting can be found here. Usually this depends on the riskiness of an asset.
So how would you value the house or flat now?
The gross rental yields these days are usually around 2-3%. At these yields , one is in effect paying 50 times pre-tax free cash flow. This of course assumes 100% occupancy and no taxes.
Over the long term these rentals usually follow the inflation rate. So over the life of a flat or a house, you will earn back around 60% of the cost in the form of rental. The value of land underlying a house or a flat has been known to appreciate at the nominal GDP rate (GDP growth + inflation rate).
If you put all these cash flows together and discount it at around 10%, the final DCF value comes to about 1.5X purchase price. In other words, the asset is generating an IRR of 12%.
Is this cheap or expensive? It depends on what you believe the price of land will be 30 years from now and if 12% is good enough for the risk and effort of managing a rental property.
The problem with PE ratios
As you can see from the above example, the PE ratio is dependent on several variables which we had to estimate upfront. In the case of some assets such as a rental property, it may be possible to estimate it with a certain level of confidence.
This is however not always the case
Let say, for the sake of example, that the house turns out to be on an old burial ground where there are ghosts and so one want to rent or buy that land 🙂 . What happens then? Well the entire investment goes to zero.
On the other hand, lets assume that the government announces a large IT park close to the property and the rental go up by 5X. Irrespective of the actual increase in the property price, the cash flow based valuation definitely goes up as the rentals have increased drastically. This is what has occurred in several cities across the country in the last 10 years.
So the initial PE turns out to be cheap or expensive depending on the subsequent cash flows and terminal value of the asset
PE ratio in equities is even more misleading
In the case of companies, the problem we face is that the cash flows are quite difficult to estimate, there is no fixed duration and the terminal value in the real long run for any business is usually 0.
In the example of Facor alloys, the PE appeared to be low based on the recent cash flow (as of 2010) which had been in excess of 30 Crs. As a result, if one assumed that these cash flows would persist, the company appeared cheap at 3-4 times cash flow.
The above assumption turned out to be wrong. The cash flows were at a peak due to a cyclical high in demand from the steel industry. In addition to a crash in the demand, the management diverted the cash flows to another sister firm which demonstrated poor corporate governance.
In effect, the expected cash flow and duration turned out to be wrong. In such a scenario, the PE ratio was simply misleading.
As a counter example, consider the case of CRISIL (a past holding) which has always appeared expensive based on the usual measures of valuation. However the company has delivered above average returns as it has generated the expected cash flows without much variability in a fairly predictable fashion. The competitive position continues to improve and the company is likely to keep growing with a high return on invested capital for the foreseeable future.
Understand the business
The only way to evaluate if a company is over or underpriced is to be able to predict its cash flow. The higher the valuation, the longer the prediction period.
So if a company is selling for 2 times earning and you are fairly confident that the current cash flow will persist for 5 years, then you have a bargain. On the other hand if you are looking at a commodity company whose cash flows depend on the price of a volatile commodity, then making any prediction is usually a waste of time. You may be able to look at some long price charts of the underlying commodity and get lucky from time to time, but good luck with trying to make it keystone of your investing strategy.
On the flip side, if you are looking at a company selling for 100 times earnings, one needs to have a high degree of confidence on the expected cash flow for 20+ years and beyond. Anyone claiming such clairvoyance is worth of worship !!
The sweet spot is usually when the valuations appear reasonable (in 15-25 range) and one can make a reasonable estimate of the cash flow based on an in-depth understanding of the company, its industry and the competitive situation.
In summary, the best way to approach an investment candidate is to filter out the extreme cases and then dig into the business as much as possible. This should help one make a reasonable estimate of the cash flows and its duration. Once you have a reasonable fix on these key inputs, doing a valuation and comparing it with the market price is the easy part.
Homework: Is coal india Ltd a value stock?
It is selling for 10 times earnings net of cash for sure. Personally I think the PE ratio here is meaningless. One is making a bet that Coal will continue to be a dominant fuel for us for the next 10-20 years in face of dropping cost of solar and other energy sources such as Natural gas. In addition there is also the headwind of climate change regulations and drop in prices globally. In short I don’t know enough to predict the cash flow and hence the idea is a pass
I have often written about experiments and failures in the past (see here, here and here). These posts have usually involved a failed experiment or idea and my conclusions or learnings from it. It has been a case of inductive reasoning (going from the specific case to general principles).
I recently initiated an exercise where I collated all the investments I have made since 2010/11 and analyzed the success rate of my picks. I have defined failure as a stock position which delivered less than 13% CAGR over the last 5-6 years.
Why 13% and not an actual loss? There are a few reasons behind it
– 13% is roughly the level of returns one can expect from an index and hence I have set that as the threshold
– It allows me to capture value traps as failures. These are stocks where the stock price has stagnated or trailed the index as I waited for valuations to revert to the long term averages.
The analysis was quite eye opening and although I had some vague idea of what to expect, the actual results were still surprising.
Surprisingly low hit rate
I have bought/ sold or held around 35 position in the last 6 years. Of these, I have lost money in 7 and consider 16 (or 45%) as failures (<13% category also includes the < 0% cases)
If you look at the above result, the conclusion could be that the overall portfolio has performed horribly. I am not going to share the actual results as that is not the purpose of the post and anyway I can claim anything in absence of independent verification. Let me just share that the portfolio has done substantially better than the common indices (substantial being 10% above the NSE 50 returns)
A common myth is that high returns need a 90%+ success rate (if not 100%).
The reason behind the myth
So why does almost everyone believe that one needs a perfect hit rate to achieve good returns? This myth is quite common as one can see from comments in the media, where people are surprised when some well-known investor has a losing position.
I think it speaks to the ignorance of the following points
– A losing position has a downside of 100% at the most, but a winning position can go up much more than that and cover for several such losses. Let’s say you have a portfolio of three stocks and two go to 0, but the third stock is a 5 bagger. Even in such an extreme example, the investor has increased his portfolio by 50% with equal weightage in all the three positions.
– Let’s take the previous example again and instead of equal weightage, let’s say the two failed position were only 10% of the portfolio, whereas the winning position was 90%. In such a happy scenario, the overall portfolio is up 4.5X.
In effect investors under-estimate the impact of upside from a winning position and the relative weightage of these winners. A portfolio is not like a true or false exam where every question gets the same marks. If you get something right, the weightage and extent of gain on that position matters a lot
So the next time, you read an article where some famous investor lost money on a position and chalk it to them being over-rated, keep in mind that the losing position could be a tiny starter position. A lot of investors sometimes start with a small position and then build it as their conviction grows.
The main reason for this exercise was not to generate some statistics and leave it at that. I wanted to dig further and find some common patterns of failure. This is what I found
The number no.1 failure for me has been when I assumed that the past performance of a company or sector would continue and hence the recent slowdown or poor performance is just a blip.
For example, I invested in a few capital good companies in 2010/11, assuming that the recent slowdown was just a blip. These companies appeared very cheap from historical standards and that motivated me to invest in some of them. I did not realize at the time, that the country was coming off a major capex boom and it usually takes 5+ years for the cycle to turn.
I have since then tried to dig deeper into industry dynamics and understand the duration of the business cycle of a company in more depth.
The forever cheap or value traps These positions are a legacy of my graham style investing. These companies appeared very cheap by all quantitative measures. I would attribute the failure of these positions to the following reasons
– These companies were earning low returns on capital as the management had very poor capital allocation skills. To add insult to the injury, some of these companies refused to increase the dividend payout and just kept piling cash on the balance sheet. In all such cases, the market took a very dim view of the future of the company. Unlike the developed markets, India does not have an activist investor base and hence these companies end up going nowhere.
– I forgot to ask a very basic question: Why will the market re-value this company? What needs to change to cause this revaluation? In most of these cases, the company performance was not going to change substantially for a variety of reasons, and hence there was no reason for the market to change its opinion.
The turn which never happened
There have been a few positions where my expectation was the company will start growing again or will improve its return on invested capital (or both). In all such cases, the expected turn never happened and the company just kept plodding along with me incurring an opportunity loss during this time.
The problem with these kind of situations is that you don’t lose money due to which one is lulled into complacency. One fine day, after having waited for a few years, I realized belatedly that I was waiting for something which was unlikely to ever happen.
I have now changed my process to identify the key lead indicators for a company which need to change to confirm that the management is moving in the right direction. For example, is the management introducing new products, expanding distribution or trying something else to revive the topline? If the annual report and other communication continues to be vague on these points, it is best to exit and move on
Doing too much
There is another pattern I have noticed which is not obvious from the table. I have had a higher number of failures after a successful phase. I think this is most likely due to over confidence on my part which led to a higher number of new ideas in the portfolio with much lesser due diligence on each of them. The end result of this sloppy work was a much higher failure rate.
It is not sufficient to just analyze failure. One need to make changes to the process in order to prevent the same error from occurring again
Some changes in my process/ thinking has been
– It is difficult to invest in commodity/ cyclical stocks (atleast for me). I should tread cautiously and have a very strong reasoning behind such an investment (being cheap is not enough).
– Identify the reasons on why a company will be re-valued by the market. Also have a time frame attached to it (endless hope is not a strategy)
– Be your own critic. Confirm if the original thesis holds true? If not, exit. It is better to be proven wrong as quickly as possible.
– Growth is not all important, but absence of it can lead to a value trap.
– The most dangerous phase is right after a successful stretch. Resist the urge to extend your lucky streak by making investments into half-baked ideas. Take a break or vacation!
If there is one lesson from the above analysis you should take, it is that one does not need to have a very high hit rate to get decent returns. As long as one holds on to companies which are doing well and culls the poor performers rationally, the overall results will be quite good.