I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.

I did not discuss about how to rank the various stocks in the portfolio. I will discuss the business aspect of the ranking in a future post. Let me share some thoughts on how to consider valuation when doing this exercise.

A 2X in 3 years

As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?

Note the use of the word  – potential. One can never be sure if the stock would double.

How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.

If however the stock is selling below fair value, then we may get an additional bump from an increase in the PE ratio. However I would prefer to place a higher wieghtage on the earnings growth than the valuation – which depends more on the whims of the market.

Not a scientific exercise

One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.

All the above points are true and I could add more. However the point of the entire exercise is to look at the potential of each stock (atleast annually) and assess its attractiveness based on new information. It is easy to fall in love with a position (especially in my case) and hang on to an old thesis, whereas the world around the company has changed completely.

What do to with such cases

Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?

Lets bring in the concept of opportunity cost. Lets say you dont have a better idea. Then the alternative is to sell and invest it in a fixed income instrument. Is the opportunity cost around 9% then? .

I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned  15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio

Why is this your opportunity cost ? The reason is simple – you have been able to make this return in the past on average and if you sell the existing position and hold cash, something will surely come up in time to deliver this kind of return. You may not make this return the next month or next quarter, but can expect to make it over the next few years.

So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.

 
 

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.

 
 

Failure is a better teacher than success. This holds true in the case of investing too. I have been looking closely at some of the recent cases such as Arshiya international, gitanjali gems, CEBBCO, Kingfisher airlines, Zylog limited and some older ones such as reliance communications, DLF, SSI, aftek and many more.

These are extreme examples of spectacular drops in stock price of 80% and more. These examples are the exact inverse of multi-baggers and a few of such positions can decimate one’s portfolio. I have mostly been able to avoid such cases in the past (except SSI and zylog, which was self inflicted) and think it is important to avoid such extreme failure to make above average returns

Why analyze such cases? On that count, I am following these comments from Charlie munger on learning from failure

You don’t have to pee on an electric fence to learn not to do it
Tell me where I’m going to die, that is, so I don’t go there

It is not always fraud
I have seen an oversimplification on the cause of failure in the above cases. A lot of investors think it has been caused by management stupidity or greed. The reason for this conclusion is due to some high profile failures such as satyam.

It is easy to say that the management was unethical (Which is true in several cases) and hence the business failed. I think that is intellectual laziness. There are several other companies where the management is a bit suspect, but the company and its stock has not collapsed (though did not perform as well)

Some key factors

On going through all these companies, I am able to see some common threads. These factors may be present in combination in some cases or one of the factors could be dominant in others. In most cases, however it was the combination which sank the ship

1. Low return on asset/ equity due to commodity or highly competitive business (think airlines or telecom)
2. Low free cash flow (after taking into account Working capital needs and obsolescence risk/ business model changes )
3. Growth obsession funded by debt, resulting in high debt equity ratios (2:1 or higher)
4. Cyclical industry with 1,2 and 3
5. Growth obsession with expansion into foreign markets (most likely from pricey acquisitions) stemming from management’s grandiose views of building an empire (rather than focusing on value creation)
6. Management failure/ governance issue (with diversion of funds into sister firms in some cases)

The steps to destruction

Let’s look at some kind of chronology of events leading to the eventual collapse in the stock price

1. Company experiences temporary success due to a cyclical high or tailwinds (look at the long term base rate to identify this situation). In some cases, success is from sales perspective and ROE and cash flows are still weak.
2. Management feels bullish and starts adding capacity/ businesses. In a lot of cases this is funded by debt or FCCB type equity.
3. In some cases, management goes abroad and acquires assets at high prices stemming from delusions of empire building (aka ‘Indian name’ in foreign lands)
4. Business encounters a hiccup or a cyclical downturn. The cash flows dry up and management finds it increasingly difficult to service the debt.
5. Management fudges the numbers for some time and tries to keep things afloat (bullish statements, confidence in the business inspite of worsening fundamentals such as negative cash flow, worsening debt service ratios etc)
6. The pack of cards finally collapses when the company defaults on its debt (openly or in private). When the market gets a hint of this, the stock price collapses almost overnight and the outside investor is left holding the bag

What to avoid
If you like the principle of inversion and think high cash flows and low debt is the sign of a healthy company, then one should avoid a company with poor cash flow and high debt irrespective of the story or future prospects (which are always rosy).

It’s quite possible, that you may miss some of the real turnaround cases, but on the balance I think it one would do much better by avoiding such companies

Bull market stocks
A lot of companies with poor cash flows and high debt did quite well during the previous  bull market and a majority of the investors choose to ignore the red flags. Why bother, when you are making money ?

It is during tough market conditions, that the chickens come home to roost, and a lot of investors (me included) get a lesson on risk.