I personally think that being rational is extremely important in becoming an above average investor. So how does one become more rational?

There is a book called – predictably irrational by dan ariely which talks of the irrational behavior in most of us. The more interesting part of the book however is the ‘predictable’ part. It means that most of us are consistently irrational. The good thing about this predictability is that if one can identify these patterns, then there is a possibility of reducing the irrationality (I don’t think it can be completely eliminated)

The first step in reducing the irrationality is to name and classify the various behaviors which impact us negatively as investors. I started exploring the various biases which affect us in the previous post and will continue with a few more in this post.

Authority bias

You may seen this bias in others (most people think they are themselves immune), when they  purchased a stock based on a recommendation by some TV presenter or commentator. In other cases, the recommendation may be from a broker or some sales person in a bank.

I have personally avoided this bias in the above form by having a simple thumb rule – TV presenters are actors and should be watched for entertainment alone. As far as brokers and sales people are concerned, I refuse to listen to them.

The above comments may imply that I am immune to this bias – but I am not. I follow a few other bloggers and top investors. In the past, if one of them was invested in a stock, I would develop a much more positive view of the stock and even went ahead and invested in the same.

The biggest source of my bias has been from the top thinkers in the field of investing (Warren buffett, Ben graham etc). It is not that their teachings are not worthy of following, but I have followed them blindly without understanding the context.

Case in point – Warren buffett talks of the buy and hold philosophy. A lot of people miss out that they he does not imply buy and forget and certainly not buy and hold bad companies. The pre-requisite condition is that one should buy a good company at an attractive price and then hold it for a long time. I have bought duds and then held it for some time, thus compounding my mistake.

How does one avoid this bias – As in all other biases, it is not easy. I have found one approach which works for me a bit – Never accept blindly what others say (including your idols). I  try to analyse the context of a statement or idea and try to think of a scenario where that idea is not true.

First conclusion bias

This is a very common bias and we know it by another name – First impressions. We tend to form opinions of other people in the first few seconds of meeting them and then any interaction tends to re-inforce the impression. This bias has a lot of implication in job interviews, but that is a separate topic.

In the case of investing, this is closely related to the commitment and consistency bias. As an investor, I have found that when I am looking at a company and its financials, I tend to form a fuzzy view of the company in the first few minutes – such as looks worth of investigation (may even buy) or maybe this company is junk. Once I reach this view (often subsconsicously), my subsequent analysis and thought process is influenced by this first conclusion. In addition, if I make a token purchase the commitment and consistency bias kicks in. Once this happens, my decision is kind of locked (even if i think it is not)

How does one avoid it ? For starters, I look at a company and form a view (even if subconscious) and then just drop further analysis. I make a note of the company and then move on to something else – allowing for a cooling period. I will usually come back to it after a few days and then read up on it further – making notes as I go along.

The final decision to buy comes usually after a few weeks and even then the position is a small one. I am not sure if I have been able to reduce the bais, but it prevents me from buying a stock when I am in heat. The downside is that the stock price may run up before I can buy a full position, though in balance I would rather loose the upside occasionally than make a foolish decision.

The next post will the final one on this topic and I will explore a few more biases and discuss how it is important to build routines in your investment process to reduce their impact.

 
 

I have been reading a few behavioral finance books on the various biases which impact us as investors (and in other walks of life too). I have picked up this topic of study for a very specific reason.

I have been analyzing my investment process and am realizing that the weakest link continues to be the various biases which commonly impact us. If I look back at the last 15 years of my investing life, I can safely say that I was fluent in the basics in the first couple of years and could identify good ideas by the fifth year.

The above statement would imply that I was an expert by year 5 and poised to be a good investor. Unfortunately the reality was far from that – you can read my journey till 2008 here. Knowing what to do is different from doing it.

Let me list a few biases and how I was impacted by them. I will also try to explore what one can do to avoid them

Social proof

This is a bias where in one is influenced by other investors and the general mood of the crowd. I wrote about a mistake I committed a long time ago – purchase of SSI and IT mutual funds during the dot com boom.

Although I was new to investing (around 3-4 years), I understood the importance of valuation and of not overpaying for stocks. Inspite of being cautious for the majority of my portfolio, I still went ahead and committed 25% of it to IT related stocks. As I look back, I recall that the main reason was that a few of my friends were investing heavily in this sector (and getting rich). In addition to this, a nice and pretty broker also recommended a few hot mutual funds (such as ICICI technology fund) which were sure to make me rich in a few years.

How could I miss?

I managed to lose 80% of my capital in a short period of six months. This was unmistakable evidence that I had made a spectacularly wrong decision. Ever since then, I have followed a few simple rules to avoid getting influenced by the crowd

Do not buy hot stocks. If the media is talking a lot about some hot sector or all my friends are getting into it, I will just avoid it. As a result I did not touch the real estate and infrastructure stocks during the 2007-2008 period and spared myself of a lot of agony

– Do not take stock tips from anyone, especially pretty girls 🙂

Anchoring bias

This is a bias wherein one gets fixated on a variable in the decision making process and uses that to make all subsequent decision. This is a difficult bias to recognize and overcome.

I had been following Crompton greaves limited for some time and decided to buy the stock in 2011 after the company reported poor results in the first quarter. The stock dropped quite a bit after that and I started purchasing the stock as it ‘appeared’ cheaper compared to the past results.

In the case of stocks, investor returns are dependent on future performance, but the data to evaluate that comes from past performance. It is an art, more than science, to evaluate the past results and arrive at an appropriate conclusion. In the case of Crompton, I got anchored to the price and the past fundamentals and did not weigh the state of the industry and management issues more heavily.

How should one avoid this bias? Once you have purchased the stock, it is very difficult to avoid the anchor of the purchase price and past performance. The best approach I know of is to be aware of this bias and constantly question your reason for holding a stock.

Commitment and consistency bias

This is a tendency to be consistent with one’s behavior in the past. It is a good way to behave in life – if you have been a decent and honest person once, you want to continue and be committed to that behavior.

However this behavior can cause a lot of trouble for an investor.  Once you have purchased a stock, there is a tendency to be committed to it and as a result one tends to underweight any negative information about the company.

Look at any stock boards – majority of the investors are talking about the positives of the company. If you are already invested in the company, does it make sense to find any additional information which just confirms your belief? How will that benefit your decision?

I have suffered from the same bias and I can’t think an easy way to avoid it. I have purchased value traps like Cheviot Company and held onto them even though the company continues to deliver mediocre performance and the stock price was stagnant.

The approach I take now is to rank all the companies in my portfolio in a descending order of attractiveness. This forces me evaluate more idea more objectively. Once I have my rank, I compare any new idea with the last idea in the list. If the new idea is better than the last one on the list, it gets replaced.

The title of this post comes from the concept of Darwinian selection – kill the weakest ideas to make way for the stronger one. This also reduces the impact of the commitment and consistent bias.

I plan to cover additional biases such as the authority bias, availability bias and more in the subsequent posts.

 
 

About

Supreme industries is a leader in the plastics processing industry and processed around 2.45 Lac metric tonnes in 2012. The company processes polymers and resins into various plastic products. The broad verticals for the company are as follows

– Plastic piping including CPVC pipes
– Consumer products such as molded furniture
– Packaging products such as specialty and cross laminated films
– Industrial products such as Industrial components and Material handling products
– Construction business wherein the company has developed a corporate park on some excess land in Mumbai

The company has around 22 plants across the country which has helped it in reducing the transportation cost for the products (an important factor for operating margins).

Financials

The company achieved a topline of around 2900 Crs and is expected to close the current year at around 3500 Crs. In addition the company earned a profit of around 240 Crs (8% Net margins) and should be able to achieve a single digit growth during the year. The lower growth in net profits is due to lack of sale of commercial property in the current fiscal.

The company has been able to maintain an ROE in excess of 25% for the last 6 years. The debt equity levels have dropped from around 1.5 to around 0.6 during this. The company has also been able to improve the asset turns from around 2.5 in 2007 to 3.5 in 2012 as a result of an improvement in working capital turns (mainly driven by lower receivables as a percentage of sales).

The company has also improved its net margins from around 4% in 2007 to around 8% in 2012 driven by an improvement in overhead costs and depreciation as % of sales.

Positives

The company operates in a commoditized industry and as a result several products of the company earn low margins. The company is now focused on developing new products (called valued added products) such as CPVC pipes, cross laminated files and composite cylinders which have a higher operating margin (17%) than the other commoditized products such as molded furniture. The company plans to increase the contribution of these value added products to around 35% by FY15 and expects to improve the overall operating margins to around 15-16% levels

The company has a wide distribution and production network and well established brands in the plastics product space. The management has been able to use these assets effectively in entering higher margin products while exiting the commoditized segments at the same time.

The per capita consumption of plastics is around 7 kg versus almost 30-70 Kg in other countries. As a result, the industry is likely to see sustained growth for sometime as the per capita consumption increases with a rise in the income levels. In addition to the demand tailwind, companies like supreme are likely to benefit further as the industry continues to consolidate and the market share shifts to the organized players.

Risks

The company operates in a highly fragmented and commoditized industry. Although the company has been able to maintain the margins and a high return on capital by constantly introducing higher margin products, the moat or competitive advantage is not deep.

Brand name and a wide distribution network provide some level of competitive advantage, but the resulting moat is not wide and deep. As a result the company will have to constantly innovate to keep the return on capital high. The profitability could get hurt if there is a rapid commoditization of the various segments.

Competitive analysis

The plastics industry is a fragmented industry with a large unorganized sector, especially in commoditized products. The company has different competitors in each segment of operations.

In the case of PVC pipes the key players are finolex, chemplast sanmar, Jain irrigation, astral poly etc. In the packaging products there are around 6-7 large players and several un-organized ones. In consumer products nilkamal and Wimplast are the two key players. Finally in the industrial component segment there are a wide range of players ranging from Motherson sumi to Sintex industries.

Most major players earn an ROE of around 13-14%, with high leverage , except for astral poly which has an ROE of around 22% with low levels of debt (due its focus on a high margin and high growth product – CPVC pipes).

Overall the industry does not have high return on capital- due to the commoditized nature of the products. Supreme industries has been able to break away from the pack due to a portfolio approach to products (exit low margin products and move into high margin ones).

Management quality checklist

–          Management compensation – compensation is around 5% of net profits. This is on the higher side, though not excessive

–          Capital allocation record – The capital allocation record of the company has above quite good in the last 6-7 years. The management has been investing in high return projects and has also used some of the cash flow to reduce the level of debt. The ROE as a result has improved from the 20% levels to 30%+ levels in 2012

–          Shareholder communication – adequate. Management provides decent amount of disclosure in the annual reports and also conducts quarterly conference calls to discuss about the performance.

–          Accounting practice – appears conservative

–          Conflict of interest – none appear to be of concern

–          Performance track record – the management has been fairly transparent about its performance goals (growth and return on capital) and has been achieving them consistently in the last few years. In addition the management has been in this business for the last 40+ years and understand it very well.

Valuation

A discounted cash flow with conservative assumption of around 7-8% margins and 15% topline growth (10% volume growth + 5% inflation) gives a fair value in the range of around 530-570 per share. The growth assumption appears to be conservative as the company has delivered a 12% volume growth in the past. The risk is mainly around net margins which could come under pressure if there is faster commoditization in the industry.

The company has sold between a PE of around 8-9 and 18-20 in the past. The current PE of around 15 is at a midpoint and as a result the company does not appear to be overvalued.

Finally the company has shown a higher growth and Return on capital as compared to almost all other players in the industry (except astral poly) and hence has a higher PE (but not much) than others.

In summary the company does not appear overvalued and may be undervalued by around 30-35% from its fair value.

Conclusion

Supreme industries operates in a growth industry (due to increasing demand for plastic products) where the average profitability is quite poor. The company has been able to perform better than the other players by being focused on the newer and higher margin products. The management is as focused on ROC (return on capital) as on growth as compared to several other players who are pursuing growth at low returns.

Inspite of the above average returns and competent management, the company is unlikely to enjoy very high valuations like the FMCG industry as the overall profitability of the industry is low and the pricing power of branded products not very high. Supreme industries appears to be modestly undervalued and the returns are more likely to come from a consistent increase in profits than from revaluation by the market.

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 on the blog.