Archive for the ‘Portfolio management’ Category.

 

Some excerpts from my annual review to subscribers. Hope you will find it useful

Sources of outperformance

Superior performance versus the indices can usually be broken down into three buckets

– Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.
– Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models
– Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is slowly reducing with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. However in the end, it also depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In such a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

How does patience help?
Take a look at the 5 years history one of our oldest positions – Cera sanitaryware.

The company has performed quite well in terms of profits in the last 5 years and grew its net profit by 30% in FY 15 and 23% in FY16. Compare this with the stock price – The stock dropped from a peak of around 2500 in early 2015 to a low of 1500 in the span of one year, even though sales and profit continued to grow at a healthy pace.

These swings are usually due to short term momentum traders who want to move from company to company to catch the incremental 10%. I am glad that we have such investors in the stock market as it gives us an opportunity to buy from time to time when the price drops below our estimate of fair value.

We will continue to get such kind of opportunities in the future. The key is to be patient and act when an opportunity is presented.

Skin in the game
It is not easy to remain focused on the long term. In my case, I do not feel any pressure to negate this advantage and let me share why.

The reason for holding onto this approach is that this is something which has worked for me over 20 years and for others over a much longer period. If one can identify good quality companies at a reasonable price, then the returns over the long term will track the performance of the business (more on it later in the note). The value approach works over time, even if it does not work all the time

In addition to the above, my own net worth and that of my close friends and family is invested in the same fashion. I will not take the risk of blowing up to show short term results. Nothing focuses your mind, when your own net worth and that of friends and family is invested in the same fashion.

Let’s try to understand the math behind my expectations of the long term returns. This is a repeat for some of you, but is worth reading again.

The math behind the returns
At the time of starting the model portfolio, I stated 3-5% outperformance as a goal and this translated to around 18-21% returns over time. How did I come up with this number and more importantly does it still hold true?

Let’s look at the math and the logic behind it. The outperformance goal ties very closely with my portfolio approach and construction. We typically have around 15-18 stocks in the portfolio, bought at 60-70% discount to intrinsic value on average. Most of the companies we hold have an ROE of around 20-25% and are growing around 18-20% annually. These numbers may vary, but on average they will cluster around the above figures over time.

Let’s explore a specific example based on these numbers. Let’s say a company valued at 100, growing at around 20% is purchased for 70. Let’s assume I am right in my analysis and the stock converges to fair value in year 3. If this happy situation comes to pass, the stock will deliver around 34% per annum return.

Now in year 3, we could sell the stock and buy a new one again and make similar returns. This may occur from time to time in individual cases, but is not feasible at the portfolio level unless the market is in the dumps and stocks are selling at cheap prices. It is unlikely that our positions would be in a bull market and selling at full price, when other stocks are available at a discount.

In such a case,  if the quality of the company is high and we continue to hold on to it, it will deliver a return of around 20% per annum in the future (assuming the stock continues to sell at fair value going forward). If you add 2 % dividend to this 20% annual increase in fair value, the stock could deliver around 22% for the foreseeable future.

The portfolio view
The math, explained for a single stock, works at the portfolio level quite well. As per my rough estimates, the model portfolio has grown at around 22% per annum in intrinsic value. It was selling at around 27% of intrinsic value when we started and is at a 20% discount now. You have to keep in mind that there are just estimates on my part and I cannot provide any mathematical proof for it. However I have found that these two variables have worked quite well in understanding the performance of the portfolio over the long run – discount to intrinsic value and growth of the value itself.

As the intrinsic value has grown over years and the gap closed, we have enjoyed a tailwind and hence the returns have been a bit higher than that of the intrinsic value. The returns are often lumpy as can be seen from the performance.

Where will these returns take us?
If you talk to some investors, they would scoff at 20% returns. Let look at this table for a moment

I am sure a lot of you have seen the above table. It shows how much 1 lac will become if you allow it to compound at a certain rate of return for 10, 20 and 30 years.

There is something different in the table, from what you would have normally seen. The rate of return numbers seem to be random – 7%, 13% etc., but they are not. Let’s look at what they signify

7 % – This is normally the rate of return one would get from a fixed deposit in the bank
13% – This is the average rate of return from real estate over long periods of time. I would get eye rolls when I quoted this number in the past. The recent and ongoing experience is changing that now.
16% – this is roughly the kind of return you can get from the stock market index over long periods of time
20% – This the level of returns we ‘hope’ to achieve in the long run.

There are a few key implications of the above table

– A small edge over average returns adds up to a lot over time
– The key to creating wealth in the long run is not just super high returns, but to sustain above average returns over a long period of time. It is of no help if you compound at 30% for 20 years and then lose 80% of your capital in the 21st The key is to manage the risk too.

If we achieve our stated goal over the long term, the end result will be quite good. There are two risks to this happy end – avoid blowing up (which I am focused on) and early retirement (mine), which you have to hope does not happen either involuntarily (I get hit by a bus) or voluntarily (I head off to the beach).

 
 

I ran a few ‘experiments’ during the year, some of which I wrote about on the blog. As the year draws to a close, I am preparing the report card and as always it’s a mixed one – Lots of D and F and not a single A 🙂

One point to keep in mind is that I run these experiments with miniscule amounts of money. The emotional pain is no less if the experiment fails, but the damage to the wallet is minimal (as my wife puts it, everyone needs their vices :)).

Let’s look at some of these experiments, learnings and plans for next year.

Buying dirt cheap stocks

The main ‘idea’ behind these positions was that the stock was dirt cheap and hence once the pessimism cleared, the price would bounce back

Let’s look at two cases under this category

Business cycle related

The capital goods sector has been hit very hard in the last few years and the news worsened during the year. As I wrote in this post – ‘How I think about macro’, I personally thought the pessimism around this sector was overdone and one could look for some quality firms in the industry to take a position at rock bottom valuations.

My pick was BHEL as it was selling at a 10 year low in terms of valuation (you can download my calculations from here) and I personally thought that if the company could be profitable even under such trying circumstances, then it was worth a bet.

You can see the price action below

Capture

As you can make out, my timing was hardly perfect. I was early and averaged down as the price kept dropping. My average cost worked out to around 120 and my sale price was around 160, resulting in around 35% gain during the period

So what’s the grade ? It’s a B at best for the following reasons

Learnings

–          I don’t have timing skills and this episode proved it again. I care about buying at the right price rather than at the right time. However in the above example, it is important to get the timing right too, otherwise one will have to wait for a long time. A number of fellow investors I know are experts at this – but I am not. As a result, this type of investing has rarely worked for me.

–          Due to the lack of timing skills (and being aware of it), I have been hesitant to create a large position in such opportunities. The result of a small position is that a 33% return, does not move the needle on the portfolio. As a result, buying such kind of stocks, which I do not plan to hold for the long term are just a waste of time (for me)

–          These kinds of timing opportunities in the end may just be good to keep me entertained, but will not add to my returns in the long run.

Management issue

I wrote about zylog here. I  laid out the argument for this position in the post and the reason for the eventual exit.

What was the net result ? A 70% loss and an F grade.

It is easy to look at this episode with hindsight bias (management was suspect and hence one should not touch the stock).  Around the same time last year, I was looking at some high profile cases of failure (read here) and wanted to test the following hypothesis – is it possible to figure out management fraud from publicly available documents such as annual reports (market grapevine does not count).

I looked at zylog and saw that the stock had dropped to around 20% of its peak price. As I could not find anything suspicious in the documents, I decided to create a tiny position in the company.

The above trade turned out to be a disaster as it soon became known that the management was indulging in insider trading.

Learnings

–          The above action by a management would land it in jail in most countries. In India, they are just prohibited from trading in the market. Should we still wonder, why the small investor does not trust the stock market ?. I learnt a powerful lesson from this episode  – if there is some smoke, there is usually a fire.

–          As a small investor, I am a sitting duck and can be taken for a ride by a management if they wish to do so, without any consequences. The best bet for me is to have zero tolerance for management ethics. If something is fishy, don’t touch the stock, no matter how attractive the idea.

Value trade

I wrote about this short term opportunity here. As I noted in the post, this is a stock which had become cheap for  short term reasons (quarterly earnings miss), though there was no long term issue or any management concerns.

The idea was to buy the stock dirt cheap and sell once the short term pessimism wears off. The price action of this trade is given below

Capture2

So what was the net result – around 40% gain and I would give myself a B+.

This type of investing is more suited to my personal temperament. I am able to analyze that the market is being too pessimistic due to short term factors. If the business is doing fine and there are no management issues, I am able to take a mid size position and make reasonable returns over a one year time frame.

These kinds of opportunities are not risk free (infinite computers has its own issues) and there is always an element of luck in it. However, some of these opportunities can act as placeholders for cash, if I cannot find something better to do.

Not all trading

If you have started reading my blog recently, you may feel that I am into short term trading. That is miles from the actual reality. The above cases, are just experiments on the side, representing not more than 1% of my personal portfolio.

Why do it ? I will put it down to curiosity. I just like to explore different approaches and see how they work out. In the end, most of them turn out to be unsuitable to my temperament. I am not saying that these are not valid approaches (others may do it well), but just that they don’t suit my temperament,

The long term changes

The key change I have been focusing on my core portfolio, is moving towards higher focus or concentration. I have kept a fairly diversified portfolio in the past with majority of positions under 10% of the total portfolio. I have now started increasing the size of some positions where I have a higher level of confidence in them.

Chicken that I am, the move is likely to be very slow and measured.

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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.

 
 

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.