Archive for the ‘General thoughts’ Category.

 

A lot of people are celebrating these days and patting themselves on the back. We have a parade of investors touting their returns and claiming that 100% CAGR is for chumps. Multi-bagger could soon be a new name for kids 🙂

A bull market feels good and should be the best of times, right? How can one argue with that?

It feels great when your stocks are going up, making you richer by the day. You feel smart, on top of the world and in some moments can even see that retirement on the horizon when you stop working and live on the beach < insert additional fantasy as needed>

By my own estimates, I have lived through around 4 major and a couple more minor bull runs. It felt great during those periods as I  felt vindicated for sticking it out during the drops when everyone was rushing to the exits. It is only in hindsight, I have realized that bull market are dangerous in their own way and I was lucky to have survived the full cycle.

Let me explain

A confluence of factors

A typical bull market usually coincides with decent economic numbers when most companies are doing quite well. As a result, most participants become over optimistic and bid up the stocks of these companies. We thus have a confluence of factors – companies performing better than usual and being valued at higher multiples of peak earnings.

In addition to these factors, there are several psychological factors which come into play at this time. Let’s go over some of them

– Social proof: At such times, you see people around you getting rich and more reckless the person, higher the returns. It is not easy on the psyche to watch your friends get rich , whereas you sit around doing nothing.
– Scarcity: During bear markets, waiting helps. As the numbers are bad or getting worse, stock price for most companies stay stagnant at best. As a result, if you like to dig deep into a company, you have all the time in the world. No such luck during bull market. Any company with a half decent results gets bid up. As a result, you can either forgo an opportunity or buy the stock with lesser due diligence
– Confirmation bias: A bull market gives a positive signal and makes you feel that you are doing something right. As a result, there is a tendency to ignore risks and not look for disconfirming evidence
– Authority bias: If you switch on a channel, every other talking head and self-proclaimed guru on TV is painting the vision of a glorious future where all of us would be rich. This makes you feel as the only idiot who does not get it

In effect there are multiple psychological and other factors, which conspire to get your guard down and ignore the risks

A bad hangover

I can recall the emotional roller coaster in the previous cycle, with the only difference that these cycles used to run over a period of 3-5 years. The years 2001-2003 (which is ancient for most investors) was a grinding and slow bear market.

It was the exact opposite of what we see now. I can remember buying companies selling for 5 times earnings, growing at 15-20% per annum and still going down in price. If you think these were low quality stocks, then that was not the case. I am talking of companies like Marico and pidilite which are the darlings of the quality school of investing now.

A new investor like me just could not understand why the market was behaving in this fashion.

The market started turning in 2003 and from there it took off for the next 5 years. A lot of my personal holdings went up multiple times (no one used the term multi-baggers as often then) and it was great to feel vindicated/ smart.

The problem with feeling smart was that is that you also feel invincible. The net impact of all these emotions is that I made a few picks, which were marginal at best.  These sub-par picks came back to bite me during the next downturn when they performed far worse than the overall markets.

A fight against instincts

The natural instinct for any investor is do the opposite of what should rationally be done.  When the markets are dropping due to poor fundamentals and bad sentiments, the tendency of most investors is to withdraw into a shell and wait for the sky to clear up.

This is usually the wrong action. Unless you believe that the world is going to end (in which case, stocks should not be your worry), it makes sense to buy attractively priced companies as markets usually have a tendency to extrapolate the recent trends into the future.

The same tendency is also visible during bull markets which leads investors to buy at the wrong price. The right action at such times would be to sell or do nothing, if the company is not overpriced. I personally think that one should go one step beyond – use this period to clean up your portfolio. If you hold some companies, which you are not as confident about, sell them down and increase the cash holding. A bull market is a good time to  swallow the bitter pill when the overall portfolio is doing well.

It is not easy

I wrote this a year back after the market dropped by 15% and this still holds true, except the circumstances have changed to a bull market.  Instead of courage to manage the fear, one needs the same courage to manage greed and euphoria.

It requires an equal amount of effort (or even more) to watch everyone around you make easy money, while you stick to your principles and refuse to take part in the madness.

 
 

This is a term I like to use to represent the time, and mental energy devoted to each position in my portfolio. I would also add mental stress to the equation.

I have realized that in a lot of cases the percentage of mental capital allocated to each position does not match with the allocation of financial capital. On the contrary, some of my top position have needed the least amount of mental energy on an ongoing basis and caused the least amount of stress. This has been mainly due to the quality of the business and management.

On the other hand, some of the smaller positions in my portfolio have resulted in a much higher allocation of mental capital and that could be also the reason why I never raised the size of these positions.

Not a mathematical exercise

Unlike the amount of financial capital, one cannot calculate the percentage of mental capital allocated to a position. However there are several pointers one can use to see if a particular company is taking a dis-proportionate amount of your mental energy

– You are regularly surprised by the quarterly results
– The management makes your stomach churn and causes you to worry about the safety of your capital
– The industry is undergoing a substantial amount of change and you have no means of evaluating the economics of the business even for the short to medium term
– You keep coming up with new reasons to hold on to your position, even after your original thesis has been invalidated. The word ‘hope’ keeps coming up in your thinking
– You ‘worry’ about the position for any of the above or other reasons

The killer combination

If the financial and mental capital allocated to a position is too high, then we have a deadly combination. This is kind of an extreme situation can make you act irrationally and in the end be injurious to both your financial and mental health, if the position turns against you.

I have realized over time, unlike financial capital which can compound, mental capital is limited and does not increase much beyond a limit.  It is important to use it smartly both for your financial and mental health and finally for your quality of life.

A certain level of mental capital has to be invested when investing directly in stocks (instead of an index or mutual fund), but in some cases the level can go much beyond the amount of financial capital allocated to it. In such cases, I have usually found that selling down or completely exiting the position has freed up my mind to look for new ideas and devote more time to other stocks in the portfolio.

The tail (portfolio) should never wag the dog (your life).

 
 

We had two major events in the last few weeks – The election of Donald Trump as the president of US and the Demonetization of the 500/1000 Re notes

Let’s look at the impact from these two events.

Let me start with the first event, which somehow was in the news for the last few weeks and I felt no need to respond or react. The event was a surprise for many and in a way similar to the Congress win in India in 2004. There was a sense that the market would crash if Donald trump is elected as president. I had no clue about what would happen if this event occurred, but to be frank I could not care less.

You will hear all kinds of reasons why some event will cause a cascade and impact a particular company in question. I personally think this is complete nonsense and one can link any number of remote factors together to make a case.

In investing, the key is to focus on the few critical factors which may impact your investment thesis and ignore the rest. I find it difficult to see why the election of a particular individual in a foreign company will have an impact on most of the companies in India at a micro level. Will consumers buy less soap or stop buying cars or going to movies just because Donald trump is elected in the US?

A final point on this count – Look at what has happened to the US market after the election. After an initial drop, the market is up. So much for predictions from all kind of pundits.

The more important event

The more relevant event for us has been the demonization of the high value currency. I personally think this a watershed event for the country. There are a lot of people looking at the interest rate and tax implications for the country, which I agree is quite good. However the bigger impact is from the signaling effect of this decision.

For starters, it creates a lot of positive emotion for the honest tax payer/ companies as they now feel that they are not idiots for paying their fair share.  This event is a positive boost for them.

The second impact of this decision is that it sends a message that the government is serious about reducing tax evasion and corruption. A combination of GST, JAM trinity and now demonetization could be effective in reducing tax evasion (but not necessarily eliminate it). This would apply to a lot of unorganized sector companies where there is substantial evasion of taxes. These events are creating a level playing field in terms of taxation and will benefit the organized companies in the long run.

Although the long term benefits are huge, the short term is going to be tough. This kind of event has first, second and higher order effects. On the surface real estate, gold, high value durables and other such purchases are likely to get impacted. However if you think further, this drop is likely to cause a ripple effect in other sectors such as lending, construction materials, auto components and so on.

Analyzing the impact on your portfolio

The key point in the analysis of any major event is to evaluate the long term impact to the business model and profitability of the company.

There will definitely be a short term impact of varying degrees to all the companies from a slowdown in the economy. The next 1-2 quarters are going to be ugly for a lot of companies and stock prices have started dropping in response to that. As we approach the end of the year, the selloff could increase as a lot of mutual funds and FIIs try to window dress their portfolio.

I have no such plans for my portfolio. I made an argument in a prior post that we need to be ready for short term volatility and 15% or more drops from time to time. If one cannot handle these swings, then equities are not an appropriate vehicle. I will not sell any stocks where I think the long term prospects continue to be good, even if the near term appears horrible.

An example

Let’s take the example of NBFCs to see how this event would impact some companies

A lot of NBFCs deal with customers who operate on cash due to lack of access to banking services. It is expected that these companies will be impacted as these customers are unable to make timely payments. We are most likely to see a large expansion of NPA in the next 1-2 quarters.

We should however keep in mind that an NPA is not the same as a loss. An NPA means that the borrower has not made a timely payment and as a result, the lender has to mark the loan as non performing, stop accruing the interest income and add provisions (set aside some part of the profits) to account for the higher risk of non-payment.

Even in the event of a loan going bad, the recovery varies from 30-70% based on the nature of the asset and the level of collateral. If the asset is a steel plant, it is quite obvious that it is large, illiquid and will require special skills to operate. In such cases, the recovery for the lender is on the lower side. In the case of other assets such as real estate, there is a large liquid market for the asset where it can be auctioned and hence the level of recovery is usually on the higher side.

Let’s look at a worst case scenario. Let’s say a company has around 1000 crs of assets on its books. Let’s make a very aggressive assumption that 10% of the assets will become NPAs with no hope that the borrower can become current on the loan. We can assume a 50% recovery rate on these NPA. So the eventual loss for the company would be to the tune of 50 crs.

So what does a loss of 50 Crs translate to? A company with 1000 Crs of asset will generally have an equity of around 150-180 crs and would be earning close to 30-40 crs pre-tax, pre-provision profits (profits before accounting for taxes and loan loss provisions). So in an extreme loss scenario, an average NBFC should be able to cover these losses in 1-1.5 years.

Keep in mind that the above loss scenario is quite high in nature. Most of our poorly managed PSU banks have much lower level of losses inspite of much more illiquid assets and lower recovery rates.

Losing your wallet

I had written a post on first principles thinking as applied to investing here. As noted in the post, the intrinsic value of a company is the discounted sum of all its future cash flows. If you think of a company in that fashion, then by how much will you reduce the future value of the NBFC?

To answer the above question, we need to consider a few points. Do we think that the long term prospects of the company have been harmed by the demonetization issue? Will the demand for credit reduce on a permanent basis due to this issue?

I think no matter how pessimistic you may be about the whole demonetization episode and the slow response of the government, it would be hard to argue that this issue will cause a permanent drop in demand for credit in the long run..

If that is the case, then this event is more like a finite loss event. I am not saying that this loss cannot be bigger than what I have discussed earlier, but it is not equivalent to a loss of earning power for the company. The competitive strengths for the company remain the same even after the event.

As an analogy, let’s say you are carrying 5000 Rs (in 100 Re notes 🙂 ) and you lose your wallet. It is a loss of 5000 and your net worth went down by that amount. However you future earning power which depends on your skills and other factors did not change due to this event.

This analogy is not perfect and we are making several simplifying assumptions, but this is broadly what is happening to most of the companies. The same is not true if the fundamental business model depends on black money (casino or some real estate developers) or if the business cannot sustain a period of loss (as in the case of several small business operators).

The market reaction has been far more severe with some NBFCs losing almost 30% of their value in the last one month (almost 3-4 times our loss estimate).

Cash + courage = opportunity

We need to be prepared for a very ugly Q3. The demonetization event is likely to be quite disruptive to businesses in the short term, especially in the rural areas where banking services are poorly developed.

The stock market is already reflecting this impact. I am not thrilled about it but it is not shocking for me as such surprises happen from time to time. This is part of equity investing and one cannot make high returns unless one is emotionally prepared for such gyrations.

It will not feel good to keep losing money every day as the market corrects, but I plan to deploy some cash as bargains develop.