Some excerpts from my annual review to subscribers. Hope you will find it useful

Sources of outperformance

Superior performance versus the indices can usually be broken down into three buckets

– Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.
– Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models
– Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is slowly reducing with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. However in the end, it also depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In such a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

How does patience help?
Take a look at the 5 years history one of our oldest positions – Cera sanitaryware.

The company has performed quite well in terms of profits in the last 5 years and grew its net profit by 30% in FY 15 and 23% in FY16. Compare this with the stock price – The stock dropped from a peak of around 2500 in early 2015 to a low of 1500 in the span of one year, even though sales and profit continued to grow at a healthy pace.

These swings are usually due to short term momentum traders who want to move from company to company to catch the incremental 10%. I am glad that we have such investors in the stock market as it gives us an opportunity to buy from time to time when the price drops below our estimate of fair value.

We will continue to get such kind of opportunities in the future. The key is to be patient and act when an opportunity is presented.

Skin in the game
It is not easy to remain focused on the long term. In my case, I do not feel any pressure to negate this advantage and let me share why.

The reason for holding onto this approach is that this is something which has worked for me over 20 years and for others over a much longer period. If one can identify good quality companies at a reasonable price, then the returns over the long term will track the performance of the business (more on it later in the note). The value approach works over time, even if it does not work all the time

In addition to the above, my own net worth and that of my close friends and family is invested in the same fashion. I will not take the risk of blowing up to show short term results. Nothing focuses your mind, when your own net worth and that of friends and family is invested in the same fashion.

Let’s try to understand the math behind my expectations of the long term returns. This is a repeat for some of you, but is worth reading again.

The math behind the returns
At the time of starting the model portfolio, I stated 3-5% outperformance as a goal and this translated to around 18-21% returns over time. How did I come up with this number and more importantly does it still hold true?

Let’s look at the math and the logic behind it. The outperformance goal ties very closely with my portfolio approach and construction. We typically have around 15-18 stocks in the portfolio, bought at 60-70% discount to intrinsic value on average. Most of the companies we hold have an ROE of around 20-25% and are growing around 18-20% annually. These numbers may vary, but on average they will cluster around the above figures over time.

Let’s explore a specific example based on these numbers. Let’s say a company valued at 100, growing at around 20% is purchased for 70. Let’s assume I am right in my analysis and the stock converges to fair value in year 3. If this happy situation comes to pass, the stock will deliver around 34% per annum return.

Now in year 3, we could sell the stock and buy a new one again and make similar returns. This may occur from time to time in individual cases, but is not feasible at the portfolio level unless the market is in the dumps and stocks are selling at cheap prices. It is unlikely that our positions would be in a bull market and selling at full price, when other stocks are available at a discount.

In such a case,  if the quality of the company is high and we continue to hold on to it, it will deliver a return of around 20% per annum in the future (assuming the stock continues to sell at fair value going forward). If you add 2 % dividend to this 20% annual increase in fair value, the stock could deliver around 22% for the foreseeable future.

The portfolio view
The math, explained for a single stock, works at the portfolio level quite well. As per my rough estimates, the model portfolio has grown at around 22% per annum in intrinsic value. It was selling at around 27% of intrinsic value when we started and is at a 20% discount now. You have to keep in mind that there are just estimates on my part and I cannot provide any mathematical proof for it. However I have found that these two variables have worked quite well in understanding the performance of the portfolio over the long run – discount to intrinsic value and growth of the value itself.

As the intrinsic value has grown over years and the gap closed, we have enjoyed a tailwind and hence the returns have been a bit higher than that of the intrinsic value. The returns are often lumpy as can be seen from the performance.

Where will these returns take us?
If you talk to some investors, they would scoff at 20% returns. Let look at this table for a moment

I am sure a lot of you have seen the above table. It shows how much 1 lac will become if you allow it to compound at a certain rate of return for 10, 20 and 30 years.

There is something different in the table, from what you would have normally seen. The rate of return numbers seem to be random – 7%, 13% etc., but they are not. Let’s look at what they signify

7 % – This is normally the rate of return one would get from a fixed deposit in the bank
13% – This is the average rate of return from real estate over long periods of time. I would get eye rolls when I quoted this number in the past. The recent and ongoing experience is changing that now.
16% – this is roughly the kind of return you can get from the stock market index over long periods of time
20% – This the level of returns we ‘hope’ to achieve in the long run.

There are a few key implications of the above table

– A small edge over average returns adds up to a lot over time
– The key to creating wealth in the long run is not just super high returns, but to sustain above average returns over a long period of time. It is of no help if you compound at 30% for 20 years and then lose 80% of your capital in the 21st The key is to manage the risk too.

If we achieve our stated goal over the long term, the end result will be quite good. There are two risks to this happy end – avoid blowing up (which I am focused on) and early retirement (mine), which you have to hope does not happen either involuntarily (I get hit by a bus) or voluntarily (I head off to the beach).


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 You can read the entire Q&A here. I hope you find the Q&A useful


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.