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.

 
 

I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (here and here).

Some good books/ resources on the topic are listed below

Poor charlie’s almanac

Thinking fast and slow

The psychology of influence

The art of thinking clearly

Seeing what others don’t : The remarkable ways we gain insight

Professor sanjay Bakshi’s website (here) and all his lectures (here). I would encourage everyone to read the lectures multiple times.

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy – This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted,  then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias

Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

It is however dangerous to get seduced by a story stock or company. Unfortunately you can find investors buying into stories all the time and overpaying for it. The stories change, but the basic theme is always the same. A new or exciting development comes to the attention of a few investors (IT stocks, real estate stocks or consumption stocks). These smart investors have the insight of investing early at attractive valuations. This ‘story’ is soon picked up by the media and now others follow blindly into the story at astronomical valuations. The ‘story’ feeds on itself and everyone looks good as long as the price is rising. At some point investors start realizing that the valuations are too optimistic and the selling begins. The ‘story’ is discredited and investors wonder how they got sucked into it

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Base rate neglect

If you ask someone an unpleasant question – are you more likely to die in an airplane crash or heart attack, what is the more likely answer? I can bet in the majority of the cases, it would be the airplane crash (heart attacks are a more common cause). An airplane crash is more vivid and comes on the front page of a newspaper, whereas heart attack deaths are almost never publicized.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

How does one take advantage of base rates? One needs to focus on areas where the odds favor you. It is far easier to do well with companies and industries where the underlying business has a high rate of return. In such cases, unless one pays too much, the investor is likely to do well over time.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

Over optimism and overconfidence

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

If you find yourself, attributing all the success to your intelligence and failure to bad luck and other factors, you may be crossing the line. As an investor, if your performance is not above average (after several years) and you still think that there is nothing wrong with your approach and think that it will all work itself out, then you need to dial down your confidence and optimism.

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

In my case, the actual results have given me the confidence to be more aggressive, though I still finding myself doubting all the time.

No silver bullets

We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

The first step in overcoming these biases is to recognize them and acknowledge that we are often influenced by them. The next step is often to build routines to reduce their impact or negate them completely. Some shortcuts I try to use

–          Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price

–          Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision

–          Try to look for at least three reasons which could cause the idea to fail

–          Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?

–          Avoid IPO, options and current fads

–          Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.

–          Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.

–          Don’t tell about your losses to your wife. She will think that you are smarter than you really are 🙂