Archive for the ‘Investing Philosophy’ Category.

 

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

 
 

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
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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 learnings
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

Blind extrapolation
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.

The changes
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.

 
 

Let me share the story a young guy who has just graduated. He recently got a nice job with a company and is able to save around 2 lacs per annum after all his expenses.

Now this guy is quite similar to all his peers, but different from his hot blooded brethren only on one small point. He believes in saving and investing, but does not want to chase stock market returns. In the last few years, he read a few books on investing by john bogle, and decided that he was going to invest in some decent mutual or index fund and then leave it at that.

You see, this young guy has a girlfriend and wants to spend time with her. In addition, he also wants to use his spare time pursuing hobbies like painting and travelling.

He sets up a simple plan:
– Save 2 lacs per year and invest it in a few index/ mutual funds
– Increase his savings by 5% every year to match inflation
– Invest each month via an SIP to put it on autopilot
– Avoid financial news on TV and use the spare time on other pursuits

Ten years later this guy who is now married, decides to have a look at his investment account. During this period, the overall market has delivered around 15% per annum for the last 10 years. He finds that his account is now around 67 Lacs. Not bad!

He goes back to his usual life and forgets about this whole stock market thing. The only time he checks is to extend the SIP in his account as most banks don’t provide a 10 year SIP option

Its twenty years now since he started and one day his wife asks him if they have decent savings which can be tapped for their daughter’s education, 10 years from now.

He goes back to his account and is pleasantly surprised to find that the account now has 3.7 Crs. He is confidently able to tell his wife that they truly afford a good quality education for their children.

At the age of 55, its time finally to fund their daughter’s education. Our guy, who is no longer as young, decides to look at his account and finds that the account has 16 crores!! This is far more than he ever imagined. Both he and his wife now start thinking of taking an early retirement. They figure that in 5 years’ time, the account would grow to around 29 Crs ** at the current rate if they can fund their daughter’s education from the liquid cash they have been holding on the side. This amount would be sufficient to retire and lead a comfortable life

Now I know some of you would raise objections like

– 15% consistent returns are good in theory, but the actual returns are more lumpy.
– Not everyone can save 2 lacs or do that without fail every year

Let me handle them both –

If you save consistently and do not withdraw the capital from the account, a smooth or lump 15% would still amount to the same in the end. It is only when people act smart and try to time in and out of market (and change the amount invested), that the eventual amount depends on the pattern of returns.

In addition, our overall stock market has delivered around 12-13% return in the last 20 years and if you add dividend and the effect of monthly cost averaging, a 15% CAGR is quite reasonable

On the second point, 2 lac saving per annum may not be possible for everyone, but I am sure a lot of two income professionals can muster this level of savings. In addition, I have assumed that the contribution rises only at 5% per annum. In most cases, earnings and hence savings can rise faster than that.

So my point is this – If the objective is to meet your personal financial goals, then discipline in saving and investing consistently is far more important than chasing the next hot sector or hot stock. Ocourse, higher returns will get you to your goals faster, but beyond a level of wealth, it more about flaunting than about its utility.

However, If the reason for chasing returns in the market is to get on TV or twitter to show the world how smart you are, then we are talking of a completely different objective. In such a case, the actual returns have nothing to do with the money or financial goals.

** If you wondering about the impact of inflation , a 6% inflation would still mean a nest egg of around 3.8 Crs in current money terms. In my books, even this is a good amount of money.