Archive for the ‘Portfolio management’ Category.

 

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.

 
 

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,
I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response
Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following
a)    Company earning high return on capital with good cash flows
b)    Reasonable valuations
c)    Good capital allocation policy by management

if you are able to achieve  the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory…high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards
Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement
How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future  (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period – there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire 🙂

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

 
 

A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.

I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results

The reductions
As I wrote in some of the previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.

NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.

In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.

I created a position inspite of all the doubts. In hindsight I was too timid.

I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?

I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value

Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.

In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.

The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali 🙂

The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism

Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.

I will definitely read and respond to your email, but would ask you to be patient with me on that count.

A happy Diwali to all the readers