Author Rohit Chauhan

In General thoughts, Market analysis

February 27, 2022

4 Min read

The following was posted to all the subscribers. Hope you find it useful

Market drops have become a once in two year events

2016 – demonetization (note here)

2018 – ILFS crisis (note here)

2020 – Covid Crisis (note here)

2022 – Drop in US markets and now Russia Ukraine war

There is no regularity to these events and does not mean we will get these drops in even years. Such drops have occurred in the past and will occur in the future too.

You have to study the market history to know that there is always something to worry about and scare the markets

Bottoms instead of top down

I have never planned the portfolio based on some specific forecast or event. In the last 11 years of our advisory, we have seen all kinds of micro and macro events occur. At that time, the event appeared to be a big deal and then eventually everyone adapted to the new situation

What I have changed in the recent past (as I noted in the annual letter) is my response to company level events. If a company is not doing well or the management is lacking in execution, we would rather exit than hope things will work out

Doing so ensures that we clear the portfolio of its deadwood and have positions with higher level of conviction. That’s the reason we have 25% cash level in the portfolio, not because my crystal ball forecasted a downturn in 2022

What does the crystal ball say now?

My crystal ball is as murky as it always has been. The same is true for others, even if they claim otherwise

However, a few long term trends which impact investors the most, seem to standout. Inflation and by proxy interest rates appear to have bottomed and could rise in the future. This will exert a downward pressure on valuations.

Commodity prices and supply chains will continue to get disrupted due to this conflict and other geopolitical events

All of this means a lot more volatility in businesses and stock prices

How to invest with higher volatility

In my mind higher volatility means that managements of companies will have to be flexible and adapt faster to change. For us as investors, this means that the operating environment for our companies could change suddenly leading to a break in our thesis

When that happens, we may have to sell and move on. Holding onto an outdated thesis and hoping it works out is a recipe for disaster

We have been doing that for the last 6 months and will continue to do so. I am not counting on luck to bail me out.

The second change is portfolio diversification across companies and sectors. I have tried to spread out our investments across companies and sectors to ensure that a hit in one does not derail the portfolio. The same holds true for your overall portfolio outside of equities. I would recommend being diversified across asset classes with allocation adjusted to your personal situation

A plan of action

A lot of you have asked if you should add to positions which have dropped below the buy price. The simple answer is Yes. The only time when this happens is when there is chaos and crisis in the world. Such prices come only during times of trouble

It does not mean that if you start adding today, you will not see lower prices. No one can predict how low the markets can go and when they will turn around.

This is the price of investing in equities and no matter what system you follow, there will always be losses from time to time. you can use a stop loss but then on the flip side if the market suddenly turns, you will lose the upside.

The best option is to invest in a steady and measured way keeping in mind that your purchases could show a loss in the short to medium term. Invest only if you don’t need that money for the next 3-5 years and the amount is such that these losses will not cause you to lose sleep

We continue to look for new ideas and with the recent drop, a few are becoming attractive by the day.

As always, our money is invested the same as the model portfolio and we continue to eat our own cooking

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Playing games

In General thoughts, Investment process

February 18, 2022

3 Min read

I got introduced to poker in 2020 and have taken to this game. You can read the rules of the game here. The rules are quite simple. The richness comes from the lack of perfect information

As the community cards open on the board, one bets not only on one’s own cards but also based on the strength of the opponent’s hand. As the opponent’s hand is hidden from us, we are forced to make probabilistic decisions

As the card are dealt, one makes these decisions based on betting and other actions (called as tells) of the opponent. The beauty of the game is that one can see the result of the decisions quite quickly – in a matter of 5-10 min as the hand is played out. This allows for rapid learning

As you play the game, the parallels with investing/trading become clear. Investing has far more variables and is not the same as poker. That said, both involve decision making under uncertainty

I wanted to share some learnings from the game, as related to investing

Losing even when odds are in your favor: Decision making under uncertainty involves making probabilistic decision. Even when the odds are in your favor, the result can go against you. The probability of win could be 60% which is considered high in poker, yet 40% of the time the result will be against you (no surprise there). This happens often and inspite of all the rational thinking such events do upset me. Most other players in poker or investing are not even thinking of probabilities

The key is to focus on the process and not the outcome (easier said than done)

Keeping losses low: Odds will often not be in your favor and you will be tempted to make a bet. At such times, folding your hand against all your instincts is the right decision. Making such decisions is never easy as one is losing money – by folding in poker or selling a position in the portfolio. However, such decisions are the key to doing well in the long run.

What ‘feels’ good in the short term is not good for long term results and vice versa. That’s why investing is simple but not easy

Know yourself: Some players are aggressive risk taker. They will bluff often and make big bets when odds are slightly in their favor. Other players like me are more conservative. I am constantly calculating the odds and making bets accordingly. I am also focused on not going bust in a game (losing my entire stack). I invest in stocks in the same manner. The only difference in my poker game is that I will occasionally bet high when the odds are really good.

Successful players play to their natural bent of mind, but at the same time should try to do what is not comfortable for them. Combing the right amount of offense and defense is an art and a lifelong process in poker and investing

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Checking for survival during Covid

September 12, 2021

4 Min read

In March 2020, during the depth of the Covid crisis, I did a bankruptcy risk analysis of all my positions. I wanted to evaluate, how long these companies would survive, under various lockdown scenarios such as a drop in topline by 50% or zero revenue for an extended period

Although the severity of the crisis turned out to be much lower, there was a non zero probability that the pandemic could get worse and cause a longer shutdown

I used the recent financial results and credit rating report for the analysis. The review was broken down into break even analysis (how long the company could survive on zero revenue) and long term demand/business impact

Getting a grip on the risk

This analysis allowed me to evaluate the risk of individual positions, their correlations and not to panic at the bottom. At the same time, it also prevented me from being sanguine about the risks.

The benefit of this exercise was that i able to avoid selling at the bottom and started adding to the model portfolio in steady /regular fashion from Mid April 2020 as the worst case scenario did not play out. This analysis continued to help me in subsequent waves of the pandemic as I had already done the work of evaluating the worst case scenario

Although this was a stressful exercise done in the middle of all the uncertainty, it allowed me behave more rationally and in a measured fashion. For me, there was never a eureka/light bulb moment when I decided to go all in. As I shared in my earlier post, my top priority was return of capital than return ON capital

Following is a sample of the analysis and are my raw notes. This is no longer in the portfolio (as shared in the prior post – a mistake) and also not a recommendation to buy or sell

April 2020 : Thomas cook (I) ltd [Company is in the travel space – epicentre of the crisis]

Liquidity risk: CRISIL AA-/Negative as of 3/27

Crisil report: Liquidity Strong

Liquidity remains strong, with cash and cash equivalents of Rs 1,724 crore as on December 31, 2019, against repayment obligation of Rs 73 crore over the 12 months till December 31, 2020. Liquidity is driven by the nature of operations with significant advances from customers. Financial flexibility is enhanced by the ability to contract short- and long-term debt at competitive rates. On a standalone level, TCIL has no long-term debt, and working capital limit has been sparsely utilised. Its subsidiaries are expected to service debt through internal accrual and need-based support from TCIL.

CRISIL believes TCIL’s profitability and cash flow metrics could be materially impacted by continued travel restrictions due to prolonged Covid-19 situation.

Cash burn rate: Company has a cash outflow of around 250-300 Crs/ quarter from salaries, overhead and other expenses. Company has used up around 150 crs of surplus cash. Float is likely to drop. With full stoppage of travel company is likely to lose 200 Crs in Q1 and around 200-250 crs in assuming travel starts picking up end of year slowly. Company has cash and equivalent of 1700 crs, free cash of 200 crs (50 crs after buyback) and only 75 Crs of re-payment till end of the year

Assuming 50% drop in topline, company could lose atleast 500-600 Crs this year. Can take on debt of 400-500 crs including loans/ funding from parent to sustain the year. Some recovery could happen in 2021 and 2022 could see return to normalcy

Break even analysis

Company has a GPM of around 25%. Company needs 1200-1400 Crs of cash flow for Break even basis. Based on this, the company will achieve cash flow break even with 25% drop in topline. Due to the severe stoppage of travel and tourism, even this is not likely. Q1 could see almost 70% drop and Q2 could at best be 40% of capacity. Normalcy will only return from Q3 onwards.

In view of this, the company will need close to 800-900 crs of cash flow and will need to take on 500 -700 crs of debt at a minimum to support the operations.

Long term demand/ Business model impact

Short term fragility is from complete stoppage of travel/forex, MICE events etc. Long term risks/ fragility comes from OTL and move to online travel, which for now is lower risk and with tightening of capital, could reduce.

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Looks can be deceptive

In Investment process

September 4, 2021

3 Min read

Following is from a note published to subscribers. Hope you find it useful

It may appear that our outperformance is from how well we do in an upcycle. That is not entirely true. let me share some stats

Losing less than the indices

I have no preference for any particular market cap but tend to avoid the smallest companies from a risk and liquidity standpoint. Outside of that, any company is fair game for our portfolio

If you look at the table above, one period of outperformance stands out. In 2018 and 2019, when the market went south, we lost much lesser than the market

We were outperforming when it did not appear that way. Losing less than the market in bear markets is also an achievement, even though it may not appear to be. Some of the subscribers who joined us during this period, threw in the towel before the market turned as they did not agree with that notion.

The period of 2018-2020 was not an easy one. I made some of the worst mistakes of my investing career – Shemaroo, Edelwiess Financial services and Thomas cook (sat on it for too long). These losses are seared into my memory. When you lose your own money and that of your family, it is not easy to forget

In spite of these mistakes, we lost much lesser than the indices. The key was to keep our heads down, keep working and wait for the tide to turn. It was also important to have some extra cash in place

Regular theme

The last few years are NOT an aberration. This has occurred regularly, and it will occur again. You can take the following as a given

We will lose money from time to time, at individual stock and portfolio level, even though I am focused on not losing money, which includes my own
There will be long stretches of underperformance with sudden spurts of outperformance
Returns will be lumpy and unpredictable
If you do not have the patience to stick around, you may exit at the wrong time

Let me share another metric to underscore my point

The model portfolio is up around 50% from 15^th Jan 2018 to 30 Jun 2021. What is special about these two dates? The small cap index peaked on first and then went into downturn. It regained this peak again this year.

We are up 50% from peak to peak

The key is to evaluate performance is to do it over a cycle and not from the bottom to the top of a cycle (when everyone looks like a genius) or from top of a cycle to the bottom, when any outperformance is hidden

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Momentum and Time frames

August 13, 2021

2 Min read

The following was part of a note written to subscribers. Hope you find it useful

We bought the stock a year back and added to it in December. Since then, the stock price is up 70%+. In the interim, the price doubled and then gave up some of those gains. Our buy price and fair value did not change as much during this period, which shows that business performance does not swing as much as the price

Like several other companies, the stock went from a value/ growth to a momentum play in a matter of months

When we make an investment, it is with a 2-3 year ‘rolling’ horizon. We have a 2-3-year view, but if the company keeps performing, the horizon gets extended. After a few years, if you look at the holding, it seems to be a buy and hold position. However, the ‘hold’ part is always conditional on the performance of the company

In contrast a momentum investor buys a company, when it shows up high on their momentum list (highest returns in the look back period), with their own unique set of adjustments. The time horizon for such investors is much shorter. Momentum works for 6-9 months on average and requires such investors to exit and replace with new stocks which appear on their list

Same stock, different approach

Both the investors may be invested in the same stock but are playing a very different game with a different time horizon.

The price of the company, however, is impacted by the action of all the investors, irrespective of their motivation. A loss of momentum is further compounded by the exit of such investors/traders.

I am not making a moral argument in the above and there is nothing good or bad about it. It is stupid to accuse other investors of disturbing your game. We need to aware of what is happening but be clear about our motivations.

We have a longer time horizon with focus on the long-term performance of the company. If the execution falters, we will exit. Till then, we wait and watch

In the meantime, we will not do momentum or short-term trades with our positions. Doing so would be stupid on our part. If we want to play the momentum, then the approach is very different (regular, pre-decided exits). Mixing the two leads to the worst of the two worlds

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Investing in Long term Trends

In Advisory letter

August 7, 2021

3 Min read

I wrote the following as part of my half yearly letter to subscribers. Hope you find it useful (Names of specific companies have been edited out )

Some of our positions are a bet on Long term trends. Let me describe a few

Migration of manufacturing to India (CDMO, CRAMS, Higher exports etc.) – The underlying trend is migration of manufacturing, especially high value added to India. There are multiple drivers behind it such as the China + 1 approach by the importing countries, Comparative advantage of India in certain sectors and so on
Change in Real estate cycle – Real estate has been in a downtrend for the last decade. This is a cyclical industry with long duration cycles. Once the upcycle begins, it tends to last for 5-7 years
Re-start of the capex cycle/ Infra cycle – The Capex cycle peaked in 2008-09 and has been down since then. With rising demand and utilization, we should see capacity addition in the private sector.
Financialization of savings – Indians are increasingly investing in financial products and moving away from hard assets such as gold and real estate.
Formalization of the sector – We are seeing the formalization and consolidation of several sectors in the economy

There are some names which are repeated, and it is normal for an Industry to benefit from multiple trends at the same time. When this happens, it increases the tailwinds for the sector

There are a few factors to consider when investing in companies benefiting from long term trends

Betting on the right management: Companies riding a trend have a long runway ahead of themselves. If the trend holds and management is capable, the company can compound value for a long time. Identifying the trend is easy, betting on the right management is much more difficult
Optically expensive: Such companies appear expensive based on near term earnings. The reason is that the market is discounting a long period of above average compounding.

Case in point – HDFC bank and our own holding, Vinati organics. Vinati organics is up 50X since we first bought it in 2011. Our mistake was to look at the valuation in isolation and not in the context of the broader trend. As long as the trend holds and management is executing, one should hold the stock and be tolerant of higher valuations

Boredom is the enemy: Unlike cyclical stocks, timing the purchase is not critical. Most of these trends last for a long time. Betting on the right management and holding through periods where the business keeps moving forward, but the stock price remains stagnant is the key

It is easy to overdo this trend-based investing and get carried away. However, the most common problem I have seen is investors, including me, lose patience during periods of slower growth even when the primary trend is active.

This has been the case with Vinati Organics where the stock has compounded at 40% CAGR but in spurts. The picture below shows the periods of stagnation

As the above example shows, a great long-term result does not mean absence of short-term pain

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Simplicity is the key

July 28, 2021

3 Min read

2 comments

I wrote the following as part of my half yearly letter to subscribers. Hope you find it useful

When I started investing, I thought there is some magic formulae to grow your capital. After 10 years of search, I realized that the answer was staring me in the face.

The key to wealth creation was very simple – Save aggressively and invest patiently

I had always done the first, but was doing it wrong with the second part of the equation. Like most young, hot blooded guys, my focus was to make the highest possible return in the shortest time possible. After a decade of doing that, I realized that the stress and effort was not worth it.

In addition to the lost sleep, I was reluctant to invest most of my capital to my own stock selection. Most likely, it must have been the risk of my approach which made me cautious

Key decisions

Around the start the advisory I made a few key decisions based on my past experience

All of my Liquid networth in India (excluding my real estate and some smaller stuff like LIC) would go into stocks (my own picks)
I would invest my family’s capital in the same manner
I will not shoot for the moon and my focus would be on preservation of capital above everything else

These decisions led to the following actions

No investments in derivatives, margin trading, IPO or any high risk situation
No reaching for yield in debt. Keep most of my capital in stocks and the rest in FD
No short term trading

In other words, the sleep test. Can I sleep well in the night with my current portfolio ?

The decision to focus all my investments in one bucket – A diversified portfolio of stocks lead to a simpler portfolio, lower risk and a high allocation. There is no point making 40% CAGR if you allocate only 10% of your networth to it. A 20% CAGR with 80% allocation will lead to better results is a better option

I carried the same approach into the advisory as we have always believed in eating our cooking . Outside of a few experiments which if successful, make it to the recommended list, all my investments in India are the same as the Model portfolio. It has kept my life simple and the absolute returns are good enough for me

I am now thinking on how I can simplify my financial life further. A few thoughts

Identify a few stocks which have the benefit of a long term trend. Once you are invested, be patient, till the trend is valid
Eliminate all debt including contingent ones. An example of contingent debt is money for your kid’s education or for your own healthcare in the long run
Have a proper will in place so that your family doesn’t suffer if you get hit by a bus (hopefully never)
When in doubt, reduce risk. Investing is not a T20 match. You can always bat the next day

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How to make a Free lunch

In Portfolio management

March 13, 2021

5 Min read

There is a saying in financial markets – There is no free lunch. It means that the returns you make, are commensurate with the risks taken. For example – Higher return from smaller companies goes hand in hand with a higher risk of loss in this space. This was seen in spades during the 2018-2019 period when the index dropped by 40%+ and several companies by much more

A key point which is missed by most investors is that risk is clustered – It does not happen evenly over time. You will get a long period of high returns and then lose a lot of it in a short window. Most investors ignore this point towards the end of a long bull run and get hurt in the inevitable bust

The standard approach to managing this risk is via asset allocation and diversification. I wrote about it in detail under the section ‘Asset allocation and diversification’ in my annual letter to subscribers

Diversification been called the only free lunch in the market. It means that if you diversify across asset classes and rebalance regularly, you will make a higher ‘risk adjusted’ returns. What this implies is that you will not make the highest returns at every point of time but will make good returns over a long period of time.

Point returns v/s long term returns

This brings me to the problem of perverse incentives in the financial services industry. Any time an asset class is in a bull run, you will find a host of advisors and fund managers touting their fund as if it is permanent and will last forever.

An illustrative list

2003-2008: Real estate, Commodities, Infra

2014-2017: Small cap

2018-2019: Large cap, quality

2020: Gold

How do you manage this problem? It’s quite simple: Just diversify across asset classes. Define a target allocation and rebalance at a pre-determined frequency. I can assure you that you will do well in the long run and will also have the bragging right of being invested in the ‘hot’ asset class of the moment (just don’t talk about the rest of your portfolio)

Going beyond Asset classes

There is another approach to diversification which complements the above approach. It’s called factors-based diversification. Let me explain

You can find details on factors here. Quite simply, Individual factors are quantifiable variables which can be used to explain the returns of a stock/portfolio. Following are the key factors with a simplified explanation for each

Value: Cheapness or valuation. Cheaper stocks deliver higher returns

Momentum: Persistence of returns. Any stock/asset which has done well recently will continue to do well.

Volatility: Less volatile assets give higher risk adjusted returns

Size: Smaller companies give higher returns than larger companies (adjusted for risk)

Duration/Yield: Longer duration assets give higher returns than lower duration ones. For example, 10-year bonds give a higher return than 1-year bonds.

These factors have been researched and empirically proven to be robust across asset classes and time periods. The reason they work is that individual factors do not work all the time. This is the same point I made for all the asset classes: No asset gives high returns all the time, even if they give higher returns at various points of time.

We can expand our diversification approach to include factors. There are times when value stocks will outperform momentum stocks. At other times, quality stocks will outperform other factors.

No one can predict which asset class or factor will gain market fancy in the future. As I shared, the best way to manage the timing issue, is to diversify on both the parameters: asset class and factor type

How to diversify across factors

There are two obvious ways to diversify across factors. The simplest one is to split your funds 50:50 between Value and momentum funds/indices. As value and momentum factors are not correlated (when one works, the other doesn’t), you will do well irrespective of which factor is in favor

The other more complicated approach is to build a portfolio, which is a combination of the Value, Momentum, and quality stocks. This means that some of your positions will be deep value, some will be low volatility & high-quality positions and the rest would be momentum stocks. To keep it simple, you can just divide the allocation evenly among all the factors.

The downside of the second approach is that it requires far more effort and works only if you are an active investor who wants to get every possible edge in the market

Isn’t diversification for the clueless

A common push I get is that diversification is for the clueless (as Buffett says so). My glib answer is that most investors are not Warren Buffett. I have now been investing for 20+ years and no matter how hard I work, I will never be a super investor like one of the greats.

It is nice to quote these statements from the super investors, but the more important point is to evaluate your own performance and come to your own conclusions. I know for a fact (supported by evidence), that I have been far better served by being adequately diversified

In most cases, one would be far better served in being adequately diversified across asset classes and factors. It may not make you rich but will ensure that you have an adequate nest egg at the end of it.

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Investing is not an Engineering problem

December 29, 2020

3 Min read

I have an engineering background and a very quantitative/rationalistic lens of looking at the world (does not mean I am rational). What I mean is that when I am analyzing a company and valuing it, my assumption is that all investors will ‘objectively’ look at the numbers and value it in the same fashion.

This approach to investing has its merits and works most of time. However, it has limitations and overweighing it leads to problems.

The above is the performance of a company which by all objective standards has done reasonably well. It has grown topline at 14%, profits at 19% with an ROE of 17% over the last five years. However, the stock is down 70% during this period.

Now you may thinking that this company has some governance issues and there is something seriously wrong with its business model. Let me share the name of the company – Its Repco home finance. This is an old position and you can read the prior analysis here.

We closed the position in Dec 2016 when the company was selling at around 22 times earnings. The main reason for exiting the stock was that I was concerned about the quality of the book (NPA). How did the NPAs turn out?

I hate to say this, but I was right for the wrong reasons. The NPAs have risen in the last few years, but the rise has not been alarming, and it includes some of the worst periods for economy and the financial services Industry. Inspite of that the company closed FY20 with 4% GNPA (which is similar to most private sector banks).

The net NPA for the company is 2.8% which is not high and should improve going forward. So by all objective measures the company has done well but the stock is down 70%. It is selling at around 5 times earnings and 70% of book value.

We can all debate about what the future holds, but based on the past few years it is unlikely that it will be worse than the last few years. The above is but one example of how narrative often overwhelms the performance of a company.

A rationalist like me would say – Lets wait for some more time and the market will eventually recognize the true worth of the company. But the point is how long should one wait ? 3,5 or 10 years ? There is an opportunity cost of holding such a position

This kind of scenario has played out with a few of our other positions and has made me question the limits of fundamental analysis. This does not mean that fundamental analysis has no value and should be thrown out of the window. That would be equally foolish.

In order to account for such cases, I have become more sensitive to the narrative around a company and a sector. If the narrative does not change and the stock price does not reflect the fundamentals, then I am more likely to exit a position even if the numbers are fine. We can always re-enter the stock when the market starts changing its view.

Investing in the markets is not an engineering problem which can solved by logic alone. In the past I have failed to account for that to our detriment. The best way to manage this kind of trap is to have a time fuse for each idea. If market does not come around to your view inspite of no change in fundamentals, then one should just exit – No questions asked !

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The Momentum mindset