AuthorRohit Chauhan

Battening down the hatches

By Rohit Chauhan
In Quick thoughts, Risk management
March 9, 2020
3 Min read
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I published the following note (with edits) to subscribers on 1st march before things started going downhill in a hurry. I have another note going out which will be posted here soon.

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I have been watching the events around the Corona virus for the last few weeks and started seeing some impact on our portfolio, towards the end of January. I wrote a note – Why are we suffering, sharing the observation that our portfolio was behaving in a bi-polar fashion. The so-called quality stocks which have higher predictability of growth, were holding steady while the cyclical positions were being beaten down as if all these companies were headed to bankruptcy.

In hindsight, this behavior seemed to be a reaction to the risks which were developing in the global economy due to the Corona virus.

In the last few days, these risks have risen substantially. I am not an expert in these things, but the preliminary data seems to point to a high infection rate (also called R0 which is around 2.2 versus 1.3 for common flu, which means one person can infect two others). At the same time, the mortality from this infection is around 1.2-1.5%.

The above numbers are preliminary and likely to change. However, a few things have become obvious in the last 2 weeks

  • The transmission rate is quite high, which means that there is high risk of the infection spreading globally
  • We have already crossed or maybe are at the brink of crossing the point of containing the infection. Again, there is a lot of confusion around this point
  • In the worst-case scenario, even if the mortality rate is low, the absolute number of deaths will be high

Unfortunately, in India, we are quite used to such infections in our main cities due to poor levels of sanitation. We tend to take such events in a stride. However, this is not the case globally. Irrespective of the trajectory of this epidemic, there is a high level of fear across the globe. This is leading to a big slowdown across the globe as companies stop travel and governments quarantine portions of the population.

We are seeing the first order effects of the above event. Like the ILFS event in India, which had a domino effect on NBFC, real estate and the overall economy, the second and higher order effects will take time and will show up in surprising places. In my view, it is too early, and I would say impossible to predict how this situation will evolve (for better or worse).

I have reduced the position size for the three companies where I think the medium-term growth prospects were moderate and valuations continue to be on the higher side. I have raised the cash levels so that we have dry powder available to pick opportunities as they arise.

We have 30% cash in the portfolio now

If we are lucky, everything will return to normal and markets will resume their normal course. However, if the risks of a pandemic increase, we will see a lot of selling in the market. This selling will not be rational, and it will not be tied to the fundamentals of a company. In such panics, people sell whatever they can.

I have no plans of burying my head in the sand. If prices get attractive for some of the companies I have been tracking, we will add them to the model portfolio even if the prices continue to fall. I am willing to bear more pain in the portfolio as I think this will eventually pass.

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Avoiding failure

By Rohit Chauhan
In Investment process, Rejected investment ideas
January 17, 2020
5 Min read
3 comments
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The following is from my annual letter to subscribers. I will be posting the letter soon on the blog

There are a few irrefutable statistics of the India stock market. Over the last 10-year period around 50% of small caps (and roughly the same for midcap), lost money for their investors. Only 10% of the companies in this space accounted for most of the returns of the index.

In such a scenario, rejecting stocks is an equally important task in building a portfolio.

We have been focused on this aspect from the beginning of the model portfolio but have not discussed it in depth. The last two years has brought this factor into the spotlight and I want to share the process we use to filter ‘out’ stocks.

The first step in filtering out stocks is quite simple. I look at an idea and reject it if any of the following conditions are met

  1. Management has past record of illegal actions or are known for bad governance practices. This is a subjective criterion, but one can filter out the obvious cases
  2. Debt equity (other than financials) is greater than 1.5
  3. PE is greater than 60
  4. Company operates in an industry with poor economics (return on capital over a business cycle has been below 5%)
  5. IPOs

Some of you may look at this and point out that ‘so and so’ company has been a value creator in spite of meeting some of these conditions.

To this my response is this – An elimination process works on probabilities. If you pick 100 companies which have a very high PE or very high debt, 80% or more will lose money for their shareholders. There will always be some which buck the trend.

I am not trying to win an intellectual contest of picking a winner with odds stacked against it. If you play this game long enough, the probabilities eventually catch up with you.

If the idea survives this step, I move on to the next series of checks. These checks are detailed out in the spreadsheet I upload for every company. I have extracted the specific sections used to reject an idea and uploaded here for reference.

Please keep in mind these checks are not quantitative and there is no mathematical formulae which will throw up an answer. Think of these points as checklist/questions to dig deeper into the company

  1. Fragility – I added this section recently and use it to check whether the business would collapse if some of these risks materialize. For example – Does the company have a major concentration with a single customer or supplier. What will happen if this partner pulls out?
  2. Management checklist – I have had this section for a long time and have added to it over the years. There are sub-sections to check if the management actions have been ‘suspect’ in the past and point to unethical behavior
  3. Accounting – This has an exhaustive list of possible accounting games companies play. I have created this from multiple books on financial fraud and accounting malpractices. 2018/19 had a few repeats and some new ways of fudging accounts
  4. Risk analysis – I added this section a few years back and it is for a deeper analysis of risks and their probabilities.

As you can see from the file, this is a checklist to ensure that I don’t miss something obvious. At the same time, this will not prevent mistakes from happening. A management may be able to hide some of its behavior for a long time and it may come to light after we make an investment.

These points are not black and white and involve a judgement call on where to draw the line. In the past, I have been more tolerant of management behavior, but have realized that even if a particular idea works out, the long term average of such decisions will be disappointing ( I have called this riding a tiger in the past)

As you will note, this process works on evidence or past history of a company and its management. If that is missing, we are flying in the dark. This is another reason for me to avoid IPOs. In most IPOs, the business has been dressed up for sale and all the skeletons tumble out after the listing.

The aggregate performance of all the IPOs in the last 2 years bears this point. Pointing out a few successes, only proves that they are the exceptions and not the rule.

The downside of this process is that I may end up rejecting a company which turns out to be a success. I am comfortable with that problem as long as I can avoid failures. A portfolio of 20 companies out of a universe of 3000+ stocks means that will we miss a lot of winners.

The more important criteria is to avoid the losers.

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Are we on a different Planet?

By Rohit Chauhan
In General thoughts, Rejected investment ideas
December 3, 2019
5 Min read
9 comments
A

I was recently analyzing the asset management industry and started looking at HDFC asset management and other companies in the space. As I always do, I started comparing with other asset management companies around the globe. The valuation gap has blown my mind. I often wonder what Indian investors are smoking to be so optimistic.

The opportunity size is large and all kinds of nice things can happen, but this gap is not so big that valuations of Indian firms should be 5X of a similar firm.

Let me give you one such example – KKR & Co. This is a global private equity firm which has expanded into other aspects of Alternative asset management. The company has been investing in real estate, private credit, public markets and other hedge funds. The company has around 210 Billion in AUM and is valued at around 24 Bn or 11% of AUM

In contrast, HDFC AMC manages around 51.7 Bn and is valued at 11 Bn or 21% of AUM. So 2X the valuation on the face of it. Just hold that point for now.

The first reaction of most Indian investors would be to say that India has a long runway, HDFC is a strong brand, we will soon be a 100 Gazillion economy yada yada yada. The problem is that once the stock price rises, people come up with stories to justify it.

I am not denying that HDFC is a storied name and has good growth opportunities. However that does not mean you can justify any valuation. Let’s look at some facts

  • HDFC AUM has grown by around 21% CAGR over the last 5 years. KKR has grown its AUM at around 14% CAGR in the last 5 years. Just as HDFC has growth opportunities in India, KKR is growing globally and in multiple product categories such as Hedge funds, credit and other forms of alternative investments
  • I will argue that every dollar of AUM for KKR is much more valuable than that of HDFC. HDFC AUM is into Equity and credit mutual funds. HDFC AMC revenue was approximately 0.6% of AUM. Let’s bump it up to 1% to be generous.
  • In comparison, KKR invests in private equity, hedge funds and other alternative investments. If you have studied this sector, you would know that fees for such vehicles is higher than vanilla mutual funds. KKR earns a management fees of 1-2% and accrues a percentage of profits above a threshold, also called as carry. KKR earned around 1.8% of AUM as income in 2018 and for reasons I don’t have space to explain, it was much lower than what the company will earn in steady state. It will be safe to assume that KKR will earn around 2.5% of AUM as topline income as some of its newer funds mature
  • ROE is not important as asset management is an asset lite business and does not need capital for operations

From an AUM perspective, KKR may be growing slower than HDFC, but has better economics than the latter.

Wait, there’s more

Now let me share something which will make you think really hard

KKR invests its own capital (shareholder capital) in its private equity and other such funds. These funds have earned 15% CAGR (in dollar terms) over the last 20+ years. If you follow the global markets, you will know that is a great return. In other words, an investor in KKR is buying an AMC (like HDFC AMC), but also investing in the underlying Private equity and other funds.

KKR has around 18.22 dollars/ share (or 15 Bn) invested in such funds. This is the book value of the firm. If we exclude this number for a like to like comparison with HDFC AMC, the company is valued at 4.4% of AUM. This is for a firm growing its AUM by 13% where the topline is suppressed due to newer funds which are under-earning compared to the older funds.

In effect HDFC AMC is valued at 5X KKR for now. Also keep in mind, that there is pricing pressure on mutual funds globally (their fees are reducing) whereas alternative investments face no such pressure.

Think twice

Is the growth profile and runway for HDFC so much more than KKR? Does being India focused provide HDFC more stability than KKR? Btw, KKR is also invested in India via some of its PE and other strategies. HDFC can expand into alternative investments and grow that business, but that is nowhere on the horizon.

As I am not invested in HDFC AMC, the downside for me from being wrong is low. However investors in the company needs to think long and hard on what is so special about the company that it should be valued at such a premium.

Is it the whole brand name and quality narrative of 2019? (similar to the small and midcap narrative of 2017). What is so special about quality in India v/s all the other countries?

Are we on a different planet?

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Good company, bad stock

By Rohit Chauhan
In General thoughts, Investing Philosophy
November 4, 2019
6 Min read
5 comments
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I look at long term trends in the market and try to understand what I am missing. For example, amazon has always sold for an astronomical PE and I thought it was over-valued. However, the continued over-valuation, had me puzzled and I started reading up more on it.

I cannot get into the specifics here, but amazon is a case where the company is investing via its P&L (expensing the investments) due to which its current profits are suppressed. Think of it as a collection of businesses where one group is making above average profits and those profits are being re-invested in other loss-making new businesses. When you add the two together, the consolidated profit appears to be low. As a result, PE for the company appears to be optically high

I have used this learning to look closely at some of my ideas and tried to back out the investments which are being expensed in the P&L account. This ensures that I look past the optically high valuations and arrive at the steady state valuation, which may be lower.

Every company is not an Amazon

I wrote a post on this topic – The value of overvalued stocks, which is one of the most read posts on the blog. Since then quality and durability of growth has become near religion in the markets. Any one challenging or questioning this belief is seen as touch of step with the market. It is similar to the religion in mid & small caps in 2017 when I published this note – The Indian bitcoins

We have some companies in India, which continue to sell at high valuations and have done so for a long period of time. Are they similar to amazon?

For starters some of these companies are not growing at high rates. Some of them have grown at a low double digit CAGR in the last 10 years. In addition to that, these companies are not suppressing their cash flows to invest in new businesses like amazon. So, their PE is not optically high.

There is an element of truth behind this phenomenon. These companies enjoy a dominant position in their industry and have shown steady growth for a long period of time. The problem is that this growth is now being projected to last in excess of 20+ years. Can it last that long? Sure, it can – but a lot can change in that period too.

Nothing new under the sun

The interesting bit is that this is not a new phenomenon. If you looked at Infosys or WIPRO in 2000, you could have easily made a case for quality along with a large opportunity space for them. Both the companies did not disappoint – Infosys grew its revenue from around 900 crs to 87000 Crs over a 19-year period.

How did the stock do from its peak in March 2000 (PE of around 100) till date (before the recent drama)? It has given a return of 7% CAGR which is less than an FD return.

The company did its job and did not disappoint (26% topline growth for 19 years). It’s the investors who overpaid for it. There are more such examples from the recent past where the company has done well, but the returns were sub-par as investors overpaid for the stock.

Quality is a means, not an end

Quality is an input in the valuation and analysis of the company. It gives you the ability to project the cash flows of the company with higher certainty into the future. However, there is always a limit to this certainty.

If a company sells at 50 times earnings and is growing at 13% CAGR (1-2% above nominal GDP growth rate), it will require one to be sure of the cash flow for the next 23 years. That is a hell lot of certainty! and by the way in this scenario, the company has to perform better than this assumption for an investor to make higher than risk free returns (remember the Infosys example?)

Now some investors would like to argue that this is such a fantastic company, that the PE will keep rising. Welcome to the greater fool theory. You are in effect betting that the person buying from you expects the cash flow growth to extend beyond 23 years with certainty. Good luck with that

The end game

Some companies selling at high multiples are growing rapidly and if they can sustain this growth, will grow into this valuation. However, that is not the case with all the companies. Some companies have a very high market share in their industries and are unlikely to grow at super high growth rates.

A lot of these low growth, high valuation names face the risk of market moods. If the mood changes, valuations and stock price will drop. Unfortunately, the growth rates will not be high enough to bail out the investors over the long term.

These companies will continue to do well, and their sales and earnings will keep rising. Once the market fancy shift, investors will have to endure a long period of sub-par returns. This period can often stretch to years at a time.

In an age of instant gratification, how many investors have the patience to hold onto such ideas for years waiting for the earnings to catch up with the valuation? In case of fund managers, if they lag the markets for a year or two, they will lose investors and will be forced to move to something else.

Why no names?

I have not provided any quantitative analysis in the post. I could provide stats and numbers to make my point – but that will be useless. If you hold such a company, you will come up with reasons on why your specific case is unique or different (I have done the same in the past too).

I will resist naming these companies as I have no interest in getting trolled on social media. Calling them out is the equivalent of calling someone’s child ugly. It is better to keep such opinions private.

It is near impossible to accept something against the companies you hold. On top of that these are high quality, universally admired companies which have given good returns in the past. Most investors would never entertain the idea that these are good companies, but bad stocks

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Corporate tax cut – 3 Bucket analysis

By Rohit Chauhan
In General thoughts
September 24, 2019
2 Min read
1 comment
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I will keep politics aside as I dont like to muddy my thinking with that. The government announced a tax reduction recently from 33% to around 25%. The market has responded positively to this announcement. I will not get into the macro impact of this decision as it is too complicated for me due to the second and higher order effects.

I will use a functional equivalent to understand the impact on our portfolio positions. Think of this tax cut as similar to a permanent drop in the input cost. The impact of such a drop will not be the same across all companies. I would like to bucket it in three groups

Group 1: Companies with a strong competitive position and high growth prospects which allows them to deploy all their profits into future growth

Group 2: Companies with a strong competitive position which will enable it to retain the extra profits. However due to lower growth prospects, the company may return some of it to shareholders via dividends

Group 3: Companies with weak competitive position where most of the extra profits will be competed away.

The net impact

The drop in tax rate will create the most value for shareholders in group 1 companies. We are already seeing the evidence of that. Its quite possible that the market is under-appreciating the long-term benefits of compounding in such cases.

Group 2 companies will see an increase in fair value, but due to the absence of compounding of retained profits (as they are not able to re-invest their current profits fully), this increase is much lesser than that of Group 1.

Group 3 companies which account for almost 80%+ of all the companies would see an increase in fair value only if the demand for the industry improves as a result of price reduction and an improvement in GDP growth. It is difficult to estimate this increase as this will take time for this change to flow through the economy and there are other factors which would play an equally important role

I am not raising the valuation for our positions even though we hold a few in group 1 and group 2. I would like to see this effect flow through before I do that.

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Gloom and Doom

By Rohit Chauhan
In General thoughts, Views on news
August 24, 2019
5 Min read
2 comments
G

This was written to subscribers recently

It’s an understatement to say that things are getting scarier by the day in the stock market

We are seeing companies drop 20% or so in a matter of days (or sometimes in a day itself). I started reducing our positions in late 2017 as I became concerned with the valuations. However, I had no clue (and neither did anyone) that things would start falling apart in 2019. As a result, in hindsight we should have gone higher into cash. Please note the word hindsight which keeps coming up.

In the last two years we have exited the weaker positions where I was concerned about the business or management. We re-deployed some of that capital back into other positions, resulting in the same level of cash at the portfolio level. We will continue with this process in the future.

It reminds me of the famous bullet dodging scene in the movie ‘matrix’ – The hero -Neo manages to dodge multiple bullets from an agent, but one still gets him. In our case we have been able to dodge some, but got hit by a few inspite of our best efforts.

This dynamic now seems to be changing for the worse. There will be no dodging now.

Risks are rising

The drop we are seeing in the market seems to be pointing to something deeper. We are seeing a liquidity squeeze from multiple factors such as the NBFC crisis, high NPA in the system and possible global issues such as capital flight to the US dollar. There could be other issues too and your guess is as good as mine. In the end the reason does not matter.

The troubling part is that we are yet to see a major market meltdown in the US and other foreign market. I usually don’t talk much about macro issues but keep an eye on them. I will not go into various issues such negative bond yields across the board, inverting yield curves and other mumbo jumbo but say that the odds of a global recession are increasing. Combine this with trade issues and high debt levels, and we have a higher risk of a meltdown.

The above is not a given, but if it happens, we will feel the repercussions in India too.It could get worse if the system gets a macro shock.

I am not writing all of this to alarm you further. I don’t see an end of world scenario or anything of that sort. However, we need to understand the context of what is happening around us. It is easy to talk of a long-term view, but we may have to go through a lot of pain in the interim

Let’s look at the case of one of our holding. The company has dropped by 20% for no apparent reason. As we have done in the past lets invert the problem and look at reasons for the sale

< Company details and analysis has been deleted for this post >

A debt default or any other fraud will cause a steep drop in the stock price. However, it does not mean that a drop in the stock price is only due to management fraud or default.

A logical fallacy

I get emails from subscribers asking me for a reason after every such drop. If we continue to have market drops, we would see sudden drops in our stocks too. These drops could be due to various reasons – business, debt issues, margin calls, or fear induced selling.

One cannot find the reason for every case, nor can one generalize it to corporate governance or some other issue. We try our best to filter out unethical management before starting a position. However, it does not mean that we will avoid all of them. When we realize that we have made a mistake in terms of the business, management or under-estimated the risk, we will reduce the position or exit as we have done in the past.

I can assure you I am always alert to what is happening to our companies and their stock price. In most of the cases, I choose not to react by choice.

In the coming months, we could have more drops with some extreme ones too. Unless there is a fundamental issue with the business or management, I plan to bear these quotational losses. I have gone through such times in 2000 and 2008 and can tell you it is very painful to watch your portfolio get decimated. The only way forward is to have a sense of long-term optimism even when things around us are falling apart.

I have not invested the cash we hold till now. I want to wait patiently till we get some good bargains, which happens only when the news keeps getting worse. I hope you will have the courage and faith to invest at that time.

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End of the promoter put

By Rohit Chauhan
In Advisory letter, Investment process, Views on news
July 18, 2019
3 Min read
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E

Let’s look at the most basic of accounting equations (simplified)

Shareholder equity + Net Liabilities = Net assets

Net liabilities in this case are the on-balance sheet items such as debt, Account payables etc. In addition, there are also some off-balance sheet items such as contractual lease payment, accrued compensation etc. On the asset side, we have the obvious assets such as fixed assets, current assets and cash.

It’s an axiom or truth that the above equation needs to balance out. However, the Indian markets have long violated this axiom. There have been several instances where promoters created dubious or nonexistent assets via debt, defaulted on the debt and were still able to keep equity/ control in the firm.

This is slowly becoming a thing of the past.

The recent introduction of IBC and formation of the NCLT, means that once a company defaults on its debt, the debt holder can take the company to the bankruptcy court. Once that happens, the court can liquidate the firm (sell all the assets) and re-pay the debt holder. Whatever is left after paying all the debt and other claimants, is available to the equity owner.

In the past, the promoter could arm twist the debt holders and thus retain the value of equity. This is no longer possible now.

The 1934 edition of security analysis by Benjamin graham, long considered the bible of value investing, cover bankruptcy and net asset type of investing in detail. After the 1930s depression in the US, a lot of firms were available for less than net asset value (net value after deducting all liabilities). An enterprising investor could take control of such a company, liquidate all assets (often at a discount) and make more than the amount invested.

Although the concept holds true, that world no longer exists today. Most companies create value based on intangibles such as customer relationship/ brands etc. The tangible assets on the book are not worth much as standalone assets and even less in a fire sale. In most bankruptcy proceeding such assets sell for 20-30% of book value.

There have been exceptions to the above in case of some steel companies where assets have sold for 60%+. If you take most other companies in bankruptcy proceedings such as Jet airways, the assets on the book will fetch not more than 30-40% of their value.

If the above numbers are valid, then in most cases, the debt holder takes a haircut and is able to make 40-50 cents on the dollar if the business remains in operation (under a different management). If the business is liquidated, then the recovery is even less.

In all these cases, the equity holder gets nothing at all.

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Some early lessons

By Rohit Chauhan
In General thoughts
June 17, 2019
2 Min read
6 comments
S

In the early 90s, my dad invested with a middleman who promised 18% fixed returns. He also invested a small amount in the FD of a plantation company (companies in the business of growing teak and other wood). The returns were much higher than bank FDs and they were assured.

All was well for a few years till the middleman defaulted and we realized that the money had been lent out to a small time businessman who had gone bankrupt.

We had a tough time recovering the money from the businessman. The saving grace was that this businessman was an honest person and he re-paid as much as he could inspite of his stressed circumstances

The plantation company too stopped paying interest around the same time and when I visited their office, found that they still had a few employees hanging around. They offered me a nice cup of tea and nicely told me that the company had collapsed, and all the money was gone.

All of this happened before I got involved in equities and started investing money on my own.

I learnt a few things early on which have helped me all my life

  • The pain of losing hard earned money is very high. I saw my parents suffer emotionally as their trust had been violated. No amount of returns is worth this suffering
  • High returns and assured returns never go together. If someone claims so, they are fooling you and you will be out of your money in time
  • Do not trust anyone blindly. At a minimum, trust but verify
  • With fixed income, go for the safest option. The excess return is not worth the risk. If you want to take the risk – go for equities or some similar investment. At least you will not be lulled into a false sense of security
  • The world out there will prey on you if you are ignorant. You are responsible for your own money

Just in case if I am sounding too smart compared to my dad, let me assure you that I managed to lose even more money over the next few years than he ever did. The difference was that he was cheated whereas I lost because I thought I was too smart and no one could fool me!!

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Hypothesis and bets

By Rohit Chauhan
In Investment process
June 5, 2019
4 Min read
2 comments
H

I recently wrote this note to subscribers as part of a company analysis. I have removed names for obvious reason, but the point I am making remains valid.

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This is a good example of how most ideas work (if they are successful). It takes time and patience to stick around for a thesis to play out. The stock market is an efficient place and one should not assume that other investors are idiots. In most cases the market is right and is discounting the near-term results into the price. As a result, it may undervalue a company which has good long-term growth prospects but is facing temporary challenges.

The job of an investor is to evaluate if the challenges are temporary or permanent. If you think it is temporary, then it makes sense to start investing into the company via a small position. The reason for starting with a small position is to be open to the possibility that one is wrong about the hypothesis.

I have a reason why I always use the word hypothesis. It has a precise meaning. It does not mean a forecast or a guess. It means possibility or ‘what can happen’. The future is always indeterminate and as an investor one needs to consider the range of possibilities.

Think bets

This means that one starts with a small bet and raises the bet as more data comes in. This is the equivalent of starting with a small bet in poker and raising your hand as new cards open up (information comes in). If the data or cards do not fall your way – you fold your hand or sell out of the position.

If you have watched poker, you would have noticed that even the best players fold a lot of hands when they realize that the cards have not come their way, or they have made a mistake. Investing is similar. If you have made a mistake or data comes in such that the negative scenario appears more likely, then you reduce the size of the bet or fold your hand.

On the contrary, If the data starts pointing to the optimistic scenario (growth is returning back, ROCE is improving etc), then we start raising the size of the bet or in other words our position size.

This is what I am doing all the time – taking an initial position with a few hypotheses in mind and then raising or dropping the position size based on how the company performs or how the data comes in.

In some cases, the favorable scenario (which in my view has a higher probability) works out. In the case of company X, as growth returned we have raised the position. In some other cases, the growth and improvement in economics is yet to happen – we have kept the position size the same. In a few cases, if things worsen or if I am wrong, we drop or eliminate the position.

Right expectations

Why I have taken this detour in the quarterly update? I have sometimes received emails expressing surprise that I have turned pessimistic after sounding positive for a long time. In all these cases I am watching the company and industry and as the data changes or some events occur, I have changed my view of the company (sometimes late).

How else should one react? Should I just stick to my view so that I appear all confident and smart while I drive our portfolio and capital over the cliff? For our collective sakes, I hope that I can avoid my ego from getting in the way of making rational decisions. In the past, I would fret about it. Now, I just ignore and take the necessary decision irrespective of how I appear to others.

As a side note, there is another pattern you should observe. As the market discounts the next 1-2 years performance correctly, it means that the minimum time it will take for an idea to show results has to be more than that. In 2017, the market was discounting 2018 and early 2019 performance for Company X. As growth improved for FY19 and FY20, the market has taken note of it and started discounting the same.

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A future advise to my kids

By Rohit Chauhan
In General thoughts
May 24, 2019
6 Min read
7 comments
A

I recently tweeted the following

No one has a logical objection to saving and starting as early as possible in life. If you understand the power of compounding, you will not argue against this point.

The most common objection is against investing in index funds. A lot of people think its an admission of defeat if you go the route of index funds, especially when it so easy to do better than the market

Is it so easy to beat the index?

A lot of people look at the recent experience and conclude that beating the market will be easy going forward. In reaching this conclusion, they are ignoring some obvious points

  • Indian markets similar to global markets continue to get more transparent and hence more efficient. The more efficient a market, the harder it is to beat the index
  • At the height of the bull market in 2017, a lot of people thought anything less than a 40% CAGR was for losers. That expectation has a lot of arrogance built into it. If the overall market is going to deliver around 14-15% over a long period of time, then the only way an individual can achieve such high returns is by being a far superior investor. A few people may turnout to be exceptional. However, the ex-ante probability of that is usually low
  • Most investors ignore the aspect of luck. A lot of new investors started investing in the 2010-2013 period when small and mid cap valuations were at a decade low. We will get the same tailwind in the future.

We are already seeing the level of excess returns over the index compress in several markets such as the US due to rising competition. I think the same is happening in India. This is also called the red queen effect and we are seeing this in other competitive fields such as sports, business, marketing etc too.

Is it worth the effort?

Let’s assume that you work hard and do manage to beat the index. At this point, I would like to reference this post I wrote on the ROI of such an effort. Anyone who decides to become an active investor has to divert time from either full time work or from some other personal activities to make this extra return.

I have laid the math in the table below and you can play with the numbers in terms of your opportunity cost (salary, time with family or any other metric). There is no standard formulae to evaluate the ROI – this is something personal and only you can answer it. However, if you are in this only for the money, then a valid metric for comparison is your current hourly rate in terms of a full time job.

The question to answer is – When will the per hour wage from ‘active investing’ exceed the wage from doing a full time job?

A tough way to make easy money

As can be seen from the table above, the break even usually happens after 8-10 years of active investing. Even if you are great investor – compounding at 20%+ rate which very few investors or mutual funds achieve, the returns are back ended and come much later in life.

Now some folks will point to Rakesh Jhunjhunwala or warren Buffett or some such investor who have become famous and very rich through investing. This is the equivalent of someone pointing out one of the superstars in any field (cricket, Movies etc) and justifying their decision.

They are completely oblivious to the hidden evidence – for every Kohli, Aamir khan or any other hugely successful individual, there is large group of people who never made it big. The earnings per hour through active investing clearly show that making money via this route is not an easy way to get rich

Am I being a hypocrite?

One of the thoughts in your mind must be – This guy has been investing actively and is turning around and recommending others not do it. He is being a hypocrite as he wants to reduce his own competition.

I can assure you that the number of professional and individual investors getting attracted to market is very high and this post will make no difference to that. The rewards of success (or the allure) in this field is high enough to keep attracting new entrants.

As I have shared in the past, if I look back at the 20 years of my investing career, the economic (key word) ROI of the time spent on investing and writing this blog would be far less than a full time job. The only reason I have done this is because I have always loved the process and would do it even if I was not being paid for it (Which is true for this blog anyway).

Active investing is an irrational decision

If you agree with my argument that from an economic standpoint a career of investing actively in the market does not make sense, then saving early and investing via other instruments (mutual funds, ETF etc) is the way to go.

The above point does not mean that you don’t become financially literate. I think that is a must and should be made mandatory in schools. We should all have the minimum knowledge of personal finance to make sensible decisions. This would require only couple of hours a month. Once you have done that, you can use the rest of your time on other pursuits. That was the key point behind the above tweet

Unless you invest for a living (in financial services industry), I think investing directly in the market is not a rational decision. A lot of people do for the entertainment or bragging rights and in the end hurt themselves financially. People who are truly successful in it are those who love the process and don’t care only about the returns. If you are one of those folks, then welcome to my world and please ignore this post.

For others who are in it only for the money – find an area you truly love and get good at it. You will make a very good living at it and enjoy the process. The surplus income you make should then be invested in index funds. That’s what I am going to advise my kids.

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