Intelligent investing

Charlie munger (warren buffett’s partner at Berkshire Hathaway) was recently asked about his views on macro and he said something to the following effect (in my own words)

“If thing are bad now, they will get better in time. If they are fine now, something will go wrong in due course. We don’t make money by predicting the timing. At Berkshire, we’re trying to swim well against the tide or with it, we just keep swimming.”

If you have not heard or read about Charlie munger, I would suggest that you read up anything you can find about him. He is one the smartest and wisest person you will ever come across.

Ignoring macro ?

It was fashionable among value investors to completely ignore the macro till the crisis of 2008 – they spoke about it as a badge of honor.

The pendulum has swung the other way since then. I see a lot of investors being cautious about macro, to avoid a repeat of 2008.

I think macroeconomic thinking can be broken down into two elements

- Understanding  industry dynamics and trying to evaluate the long term economics of the company

- Understanding macroeconomic variables such as inflation, interest rates etc and trying to forecast or guess so as to make investment decisions.

The first element is crucial in understanding the company and its profitability in context of its industry. One needs to be aware of the competitive situation in the industry to be able to figure out the long term outlook for the company.

The second element which is generally reported on by media and guessed by an army of pundits, soothsayers, forecasters and talking heads is a waste of time. Very few, if any can forecast any of these variables with any level of accuracy and no one gets it right in the long run (remember oil was supposed to go to 200$ / barrel in 2008 ?)

The comment by Charlie munger should be seen in context of the second aspect of macroeconomic thinking – there are variables such as interest rates, exchange rate etc which can impact your performance, but as they cannot be predicted , it is far better to concentrate your energy on understanding the company and its industry and learn to live with the other aspects of macroeconomics  (interest rates, inflation, exchange rates etc)

The capital goods industry

Lets look at an example. The capital goods industry is going through one of the worst cylical downturns in the last 10 years. The last time the industy went through such as patch was in the 2001-2003 time frame (I remember those times !).

I don’t think anyone can predict with precision when the cycle will turn  (although a lot of people claim to be able to do so), but one can be sure that the cycle will turn eventually.

If you can understand the economics of this industry and can find some high quality firms at reasonable prices, I am sure the returns over the next 2-3 years will be good. Let me give a tip – Look at a company like BHEL or blue star or thermax and ask these questions

- Are these companies likely to go out of business soon ? (current valuations seem to say so)
- Is it likely that these companies will do well once the cycle turns ? (though we don’t know the exact timing ?)
- Are these well managed companies with competitive advantages ? ( I believe they are)

The typical talking head on TV or broker needs to be right in the next 3 months. As an individual investor, I don’t have to play by the same rules. If I can find a company which will do well in the next 2- 3 years, I can ignore the near term outlook.

There are two numbers I want to highlight

-13% and -15%

This is the drop in the CNX midcap and CNX small cap index since the start of the year. If these numbers look troubling, they don’t even represent the vertical drop in some stocks. I wrote about some such stocks in this post and now that seems to have become a daily affair with some stock just dropping like a stone.

I have to be honest about one thing – I have never seen such bungee jumping in the Indian markets. In the good old days, the market took its own sweet time to react to any fundamental or corporate governance issue and as a result an investor had a lot of time to get off the train wreck.

No such luck these days!!

If the company you own comes out with slightly disappointing numbers or if there is whiff of a corporate governance issue, the punishment is brutal.

The good news

It would take real optimist to look for any good in this. I am in that camp.

If  you are looking closely at the carnage, you may have noticed that companies with a weak business model or poor corporate governance are getting punished severely. At the risk of sounding insensitive, I would say that is the way markets should work. A properly functioning market should reward companies with sound business models and good managements and punish the wealth destroyers.

In case you think I am being insensitive to the plight of a lot of small shareholders, let me tell you that I have suffered for my poor decisions in the past and some of my current holdings have got impacted too. The market is not a good place to discover yourself.

Digging through the rubble

A lot of investors, if there any left, are shell shocked with this sudden turn of events.  The most common advice is to wait for the uncertainty to resolved. The reality is that the future is never certain – it is just that investors sometimes get optimistic and pay for the illusion of certainty.

One can choose to either wait for the fog of uncertainty to clear up or better yet have the courage to start digging through the debris to see if there are some gems lying around.

The first point to keep in mind is to avoid anchoring to the pre-crash prices. A stock is not cheap just because the price has dropped by 90% – look at Deccan chronicle holdings. A large drop in the stock price is a good starting point, but not a sufficient condition for a bargain

The second point to keep in mind is to look closely at the fundamentals of the company. Is the company highly leveraged and with a weak business model? In addition, it is important to avoid companies with corporate governance issues.

The final point is regarding one’s own emotions and conviction. Once you have identified a good idea and believe that the market is being irrational in beating it down, it will require a lot of emotional fortitude to hold onto the stock. One is likely to get a daily dose of negativity via falling stock prices and bad news or reports about the company. It is unlikely that a company with a beaten down price is enjoying great growth and high expectations from the market. One needs to do his or her homework that the current downturn is a passing phase and the stock will give above average returns over the next 2-3 year time frame.

I am currently looking at some of the following companies. This is just a preliminary list and I may or may invest in any idea

1. BHEL
2. Infinite computer s ltd
3. Manapuram finance
4. FAG bearings
5. Whirlpool India
6. Eros international
7. Tata motors
8. Canfin homes – thanks to ayush mittal.

I am sure some of you would have rolled your eyes on reading this list. Well, I have never been the one to buy popular stocks anyway. I am usually fishing in areas where you will not find most investors.

A roller coaster ride since 2007 and negative returns since then in comparison to double digit returns in gold and real estate means that if you tell someone that you are investing equities, they think you need to be assigned to a mental institution. It is not easy to be any equity investor these days. However if you look past the gloom, then the current downturn is a decent time to pick good stocks.

Disclaimer : 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.

We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J

A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.

If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).

In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)

In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.

For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.

If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.

The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call

The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.

All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

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.