AuthorRohit Chauhan

The Dilemma

By Rohit Chauhan

In Investing Philosophy, Uncategorized

March 3, 2012

4 Min read

24 comments

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I have several dilemmas in life – such as should I eat jalebis and other good stuff or go to the gym? Sleep late or go to office? But as these dilemmas are of no concern to others, I will leave them for my own thoughts

The investing related dilemma I have always faced and more so during a market crash is this – Should I invest in the high quality companies whose price has dropped a bit or the low quality cyclicals where the price has collapsed completely. I have tried both and will try to present how my thinking has changed and where it stands today.

Let’s look at two specific examples – one of a high quality and other an average company. The high quality company is one of my long term holdings – CRISIL and the other company is Denso India, which I have long exited.

The chart below is of crisil

I wrote about  this company earlier in 2009 and have held the stock since then. As you can see the company and the stock has not disappointed and have done far better than what I expected at that time.

I have had an eye on crisil for quite some time and finally took the plunge in 2009. It is easy see that the company has an enormous competitive advantage due to government mandated status of a certified credit rating agency and brand. In addition the company requires minimal capital to grow (mainly office space and some computers). The company is thus like a toll bridge which does not require any capital expense.

The second example is of denso India. I wrote about the company here. The company was a cash bargain (stock price below cash on hand).

This is the chart for denso India

I was able to buy at an average price of around 40 and exited at around 85-90 bucks. In hindsight, it turned out to be good operation. However as you can see from the chart, the stock has been sliding since then as the performance of the company went south in 2011.

Where’s the dilemma?

Some of you may be thinking – what is the dilemma here? You made money in both, so both options are great. Case closed.

I don’t think that one should reach that conclusion here. In the case of crisil, the company has been able to increase its intrinsic value at a good pace and the stock price has followed suit. I had to make a one time decision to buy the stock and since then have just sat on that decision.

The case of Denso india is more complicated. The company appeared to be a complete bargain in 2009 and in comparison to crisil was much cheaper. At the same time, the company did not have much of competitive advantage. The trick was to buy the company when it was dirt cheap and get off the bandwagon when it was merely cheap.

This is a more complicated operation than it appears on the surface. One had to time the buy pretty well. If you had bought too early, say in mid 2008, the eventual gains would have been around 30-40%. In addition the sell decision also had to be timed correctly. If you sold in 2011, the gains would have been paltry. I  was unusually lucky in this case.

Thus in the short term,  gains are much higher in Denso type stocks. However one has to make more decisions and then also find a new idea to re-invest the capital. In the case of companies such as Crisil, once you have made a buy decision, you can just wait and watch the magic of compounding take effect

So what is a good option?

If you have tendency to constantly ‘do’ something and want some action, then denso type stocks are a good option. If however, you can live with a few percentage point lower returns with the benefit of much lower effort and headache, then Crisil type of stocks should be your target.

In my case, I do have this tendency to constantly do something. As a result, I am always looking for the next new and shiny stock for my personal portfolio to get that extra return. At the same time I manage my family’s portfolio too. In that portfolio,  I have made the decision to buy high quality , fairly priced stocks and let them compound. The returns could be a bit less, but the risk is much lower and the heartburn almost non-existent.

Following is my partial list of high quality ‘wish list’ stocks

HDFC bank, Titan industries, ITC, Marico, Hero motorcorp, HDFC limited and nestle india.

Time  for some jalebis now . Gym can wait J

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My personal ten commandments

By Rohit Chauhan

In Uncategorized

February 18, 2012

1 Min read

23 comments

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I have a few thumb rules in investing which have helped me a lot of over time. These are not some universal  ten commandments but they have kept me out of trouble, especially the tenth one !

Thou shall not buy a stock on a broker or a TV channel’s advice

Thou shall not trade

Thou shall avoid predicting or investing based on short term forecasts or outlook

Thou shall not chase momentum stocks

Thou shall not invest in an IPO.

Thou shall not use leverage

Thou shall learn to live within means so as to have investible funds

Thou shall not buy gold, commodities or any kind of fancy and complicated instruments

Thou shall not chase returns – if it is too good to be true, it is a trap

Thou shall say ‘Yes Dear’ when asked by wife if she looks good in a dress  – most important rule to have  a happy married life J .

You can choose to ignore the first nine rules based on your personal style of investing, but if you ignore the tenth rule – do so at your own peril !!!

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Raising portfolio quality

By Rohit Chauhan

In Investment process, Uncategorized

February 9, 2012

4 Min read

10 comments

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A bear market is a time for lots of activity for me. A 25%+ drop in 2011, with a near collapse towards the end of the year, threw up a lot of opportunities. During such times, the problem for me is that my portfolio soon starts resembling a zoo – it has a stock of each variety.

How do I end up in such a place?

I personally ignore short term forecasts and start buying a company (usually too soon) if the valuations are attractive and the long term prospects are good. The problem with this approach is that there is no grand strategy behind it. As a result I often end up with too many stocks in my portfolio

I have gone through such a phase several times in the past (in 2005, 2008 etc) and have had to prune my portfolio after that. This time around, I made a decision to limit myself to around 22-25 stocks and any further addition would require me to sell something – keeping the total number the same.

Now, one may argue that even 20-22 stocks are too many and one should have a more focused portfolio. Let me assure you that once I gain more experience and hopefully some wisdom, I will scale back the number to 15 or less. Till then this level of diversification is an insurance against my ignorance or stupidity.

So why limit yourself?

A different way of looking at this issue is to question the need to limit oneself to any fixed number of stocks. If you can find enough good and cheap stocks, why not load up on all of them?

I have followed this approach to a small extent in the past and have realized that this results in mental laziness. Once I buy a stock, the endowment effect kicks in and then I am reluctant to change my opinion on the stock even if the company is performing below average.

In all such cases, I have finally come to senses and have sold the stock usually at a small loss. The real loss however is the opportunity cost of deploying this capital in some other high quality idea.

What is the difficulty in exiting?

It would seem very easy to exit such stocks on a purely rational basis.  You look at the original thesis of the purchase (for example – the company will grow at X %) and compare it with what has happened since your purchase. If the company is performing below expectations and will continue to do so, then you sell the stock and move the capital to a better idea.

If only life was this easy ……

The emotional part

I find the emotional part of selling a stock, which has not done well to be a painful exercise. For starters, one has to admit that one has been wrong or unlucky (usually wrong) and in hindsight should not have bought the stock.

The next problem is to find another idea to replace the one being sold, which in turn will hopefully not be dud.

The worst of both worlds is to see the old stock soar in value after the sale (yes, I have had this one too – VST industries) while the new pick stagnates.

Selling to raise the quality

There are times when if you are fully invested, the only way to invest in a new idea is to sell an existing one. I have created an artificial constraint by limiting myself to 20-25 stocks. This constraint has now forced me to rank my stocks in an order and to look for the weakest ideas in the portfolio.  How do you do the ranking? Well that’s another post, and stock price is not the only criteria.

The weakest idea now gets compared to the new idea and if the new idea is much better, then it replaces the weaker one. You can call it the survival of the fittest – each stock has to earn its position and cannot just stay put in the portfolio. There are no holy cows!!

So which of my ideas are facing the axe? Some minor ones have already been axed. I have been reviewing the Q3 results and have a few more on the chopping block now (this one is a good candidate)

Selling the mediocre ideas to buy a more attractive stock is always painful for me, but over time I have found that my overall performance has benefitted by swallowing my pride and biting the bullet.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer at the bottom of blog.

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A bet on china : MOIL

By Rohit Chauhan

In Company analysis, Uncategorized

January 28, 2012

4 Min read

3 comments

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This title must have made you wonder – now what leap of logic is this guy having here ?

Let me walk through the logic to prove to you that I have not lost my marbles (not yet !)

An IPO and frenzy

MOIL came out with an IPO in late 2010 and there was quite a bit of frenzy around it. I think the IPO got oversubscribed by 25 times which shows the level of investor enthusiasm. In my case, I have a personal rule – I never invest in an IPO ( I have written the reason here). As 80% of the IPOs are overpriced and quite a few are junk anyway, I would rather miss a few good chances than be stuck with a lot of duds.

I was asked about MOIL then by a lot of readers on the blog, and due to the above reason I did not look closely at the company.

So why now ? The simple reason is that the stock has dropped quite a bit since then and investor sentiment is a bit negative now. Any time a stock drops or almost everyone gets negative on something, you will find me fishing in that area.

Why the drop ?

MOIL is a mining company and derives almost 80-90% topline and profit from manganese ore. Manganese is a key input in steel making and hence the demand and price for manganese depends on the demand outlook for steel.

MOIL has very high operating leverage. The PBT/ sales ratio has fluctuated between 48% in 2007 to as high as 78% in 2009. The profitability in case of MOIL is highly correlated to manganese prices and due to low levels of operating costs (minimal raw material and manpower cost) in proportion to the sales, any rise in manganese price flows directly to the net profit.

In times of high demand and lower supplies of manganese, the international price for the same has gone up by 30-40% and driven up the profitability for the company. The company was coming off such a peak at the time of the IPO.

In a commodity business, high prices result in capacity addition which in turn drives down the price of the commodity. In case of manganese, South Africa and Australia are big producers  and have increased supply in the recent past. India imports manganese ore as the domestic supply is inadequate for the steel making and for making Ferro alloys (which are exported). As a result, the price of manganese in India is dependent on the international price.

The international prices for Manganese has dropped from their peak levels and so has the profit level for MOIL. Hence the drop in the stock price

So where does china come in ?

I hope you have followed my logic till now – manganese is used in steel making, South Africa and Australia are big producers, India imports manganese and hence manganese prices in india are dependent on international prices, which have dropped in the recent months

So what drives international prices for manganese ? China !

 China account for 50%+ of steel demand globally and is largest consumer of manganese. If china grows, demand and price for manganese goes up. If china slows down or has a hard landing (as some are suspecting), then steel and manganese demand will drop and so will the prices

Sooooo…the profitability in case of MOIL is tied closely to what happens in china

Should you buy MOIL?

If you have a view on what will happen in china in the next 1-2 years, then you may be able to make a decision. In my case, I cannot predict what will happen to the Chinese economy, Indian economy and Indian cricket team (maybe Indian cricket team !) and so I will stay away.

At the same time in the longer run as the company adds more mining capacity and acquires new mines (using the 2000 Crs cash on the book), it will become more valuable. At a certain price, the market may discount a further drop in manganese price and more . I will definitely start looking at the company more closely when everyone thinks it is the worst possible stock.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer at the bottom of blog.

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The advantages of part time investing

By Rohit Chauhan

In Uncategorized

January 22, 2012

5 Min read

16 comments

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Does the professional investor, FII or the institutional investor have a big advantage over the small, part time investor?

Fact 1: The professional investor has access to in-depth research on a large number of companies. They also have access to the management and other industry professionals which allows them to cover an industry in depth and finally they do this on a full time basis. How can you beat that?

Fact 2: Very few mutual funds and institutional investors are able to beat the market over the long term (5+ years). In case of developed market such as the US where the performance numbers are more readily available (including those of hedge funds), only a handful can beat the market by a few  % points.

How does one explain these two contradictory facts?

There are several reasons for this contradiction and I will explore some to highlight how a small investor like you and me can still score over the big boys.

The over emphasis on industry knowledge

The number one advantage cited is that the professional has access to in-depth analysis of an industry and can thus make better decisions. I think this advantage is overrated.

As an individual investor, if one really wants to learn about an industry, a good starting point is to read the annual reports of the top 3-4 companies in the industry. In addition there is a wealth of information available on the internet which one can Google to explore an industry in depth.

In the pre-internet days, the professional investor had substantial advantage over the part time investor but now a lot of information is available at the click of a button.

The other point cited by those trying to sell you funds and other such products is they have access to the latest data on the industry. I don’t think this is a big advantage to a long term investor. If your time horizon is 3-4 years, then getting the monthly sales figures before everyone else is hardly of any advantage unless you want to trade on that information.

Professional behavior

The other advantage of the professional investors is assumed to be their experience and ability to act more rationally than the small investor. I have not seen any evidence which shows that the professionals are more rational than the rest of the market.

Several fund managers and FIIs have portfolio turnovers in excess of 100%, which means that these professionals have an average holding period of less than 1 year. In addition if you look at the FII behavior, they demonstrate the classic herd behavior – exit the market when everyone is doing so and re-enter when the market starts picking up or has already risen substantially.

The net effect of constant turnover and herd behavior is higher cost (transaction costs) and lower returns over the long term.

As an individual investor, I do not have the pressure to follow others or excessively churn my portfolio. I can afford to hold a stock for 5 years, if the long term outlook for the company is bright even if the short term price performance is expected to be terrible

The institutional pressures

The point which is never highlighted by brokers and professionals is the problem of institutional pressures. Professional managers live by the quarter – though they ask their customers (investors) to think long term.

Any fund manager who under performs the market for a few quarters is at the risk of losing his or her job as the fund management company faces the risk of losing the assets due to redemptions. In addition, even if the fund manager is rational and long term oriented, they cannot afford to take unpopular decisions such as buying capital goods or financial stocks now as any underperformance due to such stocks will result in a career suicide.

This institutional pressure more or less forces the fund manager to buy the popular stocks and mimic the index  with minor variations in the long run.

The small investor like you and me has none of these compulsions. In my case, other than the risk of looking foolish (sometimes publicly or worse in front of my wife) in the short term, I don’t face the risk of losing my job or ruining my career due to any unconventional decisions. This is a big advantage over the big boys

Is there any disadvantage?

The key assumption in my arguments till now is that the small investor is willing and able to devote a reasonable amount of time in researching companies and following up on them. There is no short cut for that.

Can you think of any time in college where you did not attend any classes or even study a new subject on your own and still managed to do very well in the final exam (without cheating of course )?

I personally think that if you are interested in investing and willing to devote 5-6 hours a week consistently on it for a long time, there is no disadvantage of information or insight versus the professional.   On the contrary as a small investor, one does not face the institutional pressure and thus has an advantage over the professional.

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One stock, three viewpoints

By Rohit Chauhan

In Company analysis, Uncategorized

January 8, 2012

7 Min read

15 comments

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Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company.  In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj marathe ( and a few more ).

We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias. 

The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.

Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions.  I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here . We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.

Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones 🙂

About

NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.

The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land

Financials

The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.

The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.

The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.

The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).

Positives

The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).

The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.

The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.

Risks

The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.

I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).

The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.

Management quality checklist

Management compensation: The management compensation is around 3% of net profits which seems reasonable.

Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.

Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.

Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.

Conflict of interest: None as yet

Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation

The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.

The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).

Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.

Conclusion

The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer at the bottom of blog.

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Happy new year

By Rohit Chauhan

In Uncategorized

January 1, 2012

1 Min read

10 comments

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Wish you all a very happy new year



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What’s on my mind – Dec 2011

By Rohit Chauhan

In Uncategorized

December 29, 2011

6 Min read

16 comments

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I want to close the year by discussing a few things which are on my mind and do not warrant individual posts for each topic.

Buy or hold for a crash

The market has dropped by 22% in the case of large caps and more than 30% in case of mid caps or small caps. That’s painful to say the least and has driven a lot of investors (should we call them that?) out of the market.

The most common view (including of some smart fellow investors I personally know) is that we have a lot of pain to follow in the coming quarters and hence it would be smart to wait for the prices to correct further, before diving in.

I agree with everyone that power, infrastructure, real estate and as a result banking are in for rough times over the next few quarters. Where I diverge from almost everyone is that, prices in some cases reflect the pessimism and more. As a result, the valuations are quite attractive and as it not possible to predict stock prices (at least in my case), I would rather buy based on what I think I know (cheap valuations) than what I would like to guess (prices in the short to medium term)

This is a risky stand to take and I am standing completely away from the crowd. I can’t think of any analyst or newspaper (not that I care about them) that is encouraging the investors to get into the market. On the contrary, almost everyone is exercising caution.

My reason for deploying my capital on a consistent basis is that the short to medium term may be bad, but the economy should recover in the next 1-2 years and as a result some of the companies which are hated now, should do fine.

I may end looking like a complete moron or a hero in a year’s time.  I am hoping for my sake, that I am at best early and not wrong.

The story stocks

I come to the next point – my allergy with story stocks. If you have been around, you will remember that IT companies were the story stocks of early 2000, infra and real state in 2006-07 and consumption or consumer stocks since 2009.

I find it quite amusing when others expound the virtues of the current favorites. The typical argument is that the Indian middle class is growing, so it will buy more of X and hence the future of these companies is bright. I don’t disagree with this thesis at all.

What I find amusing is that this is hardly new. This has been the case for the last 15 years and it is only now that the market has taken a fancy to this concept and bid the valuations up. I have a mind block due to the fact that the market generally tends to overdo a good thing. In its enthusiasm for IT or infrastructure stocks, the valuations went way up and when the mood turned, the results were not pretty.

Just in case you are thinking that this is a case of sour grapes in my case ,I would like to add that I started my professional career with a consumption company (asian paints) and my initial investments were all such companies (pidilite, asian paints, GSK consumer, P&G etc) as they were much easier for me to understand .

One another point – If you think these companies and the stocks will continue to do well, then how can the rest of the industry (power, infrastructure, banking etc) continue to do badly as implied by the current valuations. If the current dichotomy were to continue for 5 or more years, we may have a very weird economic outcome in the country.

I personally like a lot these ‘consumption’ companies, but not the valuations.

What mutual funds to buy?

I recently received the following comment (slightly edited) on mutual funds.

One thing i need to ask about your mutual fund portfolio is diversification..i am commenting about 5 funds u have selected ( may be possible that u don’t have any positions in them now )
1. Are all your funds are large caps and multicaps..why?
2. Don’t u believe in core and satellite approach which many magazines, papers are advocating these days
3. you are an aggressive investor and your mutual portfolio doesn’t reflect that?
4. u have invested in growth style funds only..not in any value fund why? don’t u think diversification in investment style is also necessary

The above comment raises good questions and as it was not possible to do justice via a comment, I have decided to take it up in this post

First a disclosure – I do not hold any mutual funds now. It is true that I have held mutual funds in the past (for almost 8-9yrs) as I elaborated in this post. I also elaborated on why I followed this strategy inspite of investing in stocks (see here).

In addition to the reasons in the post, I have always had this question in my mind – Are my return due to luck or skill? One needs to look at performance over a long period of time to be sure that the results are mainly due to stock picking skills and not a fluke. After picking stocks for 10+ years and outperforming most of the mutual funds I held during this period, I am inclined to believe that it must be due to skill and hopefully not luck (though one can never be sure).

My mutual fund selection process has never been based on market cap, investment style or any core/ satellite approach. You can find my approach in selecting equity funds here.

Frankly, I find the entire market cap, value versus growth or any other approach of selecting mutual funds downright self serving on part of financial advisors, mutual fund companies and personal finance magazines. How will they make money if they give you a simple, though equally effective plan ?

I have never quite understood the market cap or sector approach to fund selection till date. It is like asking Sachin tendulkar to score a hundred while playing only 3 balls in each over. Why would you want to invest in a fund where you restrict the manager in his or her stock picks? I would rather go with a diversified fund where an intelligent manager can picks attractive stocks with no restrictions.

I would personally prefer to invest regularly in index funds or widely diversified equity funds with a long term track record . My suggestion may appear as odd and opposite of what almost everyone has to say. I would rather keep investing in mutual funds simple and focused on the basics and not get carried away with all the fancy marketing which is used to sell garbage to investors.

On the last point of being an aggressive investor? I actually consider myself quite risk averse (to the point of being chicken) and am constantly obsessing with the downside of my stock picks. The upside on the other hand usually takes care of itself.

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Finding diamond in a coal mine

By Rohit Chauhan

In Investment process, Uncategorized

December 18, 2011

5 Min read

16 comments

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I have nothing against the airline industry, other than the fact that it is injurious to investor wealth.  There are other industries such as sugar which fall in the same group, where most of the players are not even able to meet their cost of capital over a business cycle.

I got several comments, where it was noted that there are some companies such as spice jet in the airline industry could turn out to be successful. A comparable example is bharti airtel which has done well in a fairly competitive industry with poor profitability (telecom)

I do not deny the fact that it is possible to find a profitable company which manages to buck the trend. There are often profitable companies in terrible industries and poor performers even in profitable ones (such as FMCG)

A probabilistic exercise

Let play a game of chance. Suppose I give you two dices and say that if you roll a 1,1 or  6,6 (both dices turn up one or six), I will pay you  5 for every one rupee you wager. Will you play this game?

If you understand the concept of expected value, you will decline it (read here about it and I will strongly recommend you to understand this concept thoroughly). You may get lucky once a while (roughly 5% of the times) but over a long period of time you will lose money by playing this game (you will lose 1 rupee 95% of the times and gain 5 rupees, 5 % of the times giving a net loss of .7 for the game)

So what does this game have anything to do with investing in an airline? Let me explain –

If you read through the previous post closely, you would have noticed that roughly around 16 or more airlines have failed till date and all the current ones are also losing money (some of these could fail too –at least for their shareholders). So even if spice jet or some other airline succeeds, you are talking of a 6-7% success rate in the industry.

Will you play a game where the probability of success is less than 10%? If yes what should be the payoff?

Well, venture capitalists who make such investments (low probability of success) typically expect a payoff of 20 or more for every rupee invested, to earn a respectable return on capital. Can you expect the same from spicejet or Jet airways?

But I am not putting all my money on airlines

You can make an argument that one is not really putting all his money in the airline industry and hence the above probabilities don’t apply. That is really not the case, as the said probabilities do apply to the specific idea, if not to the entire portfolio.

At the same time think of it – If you put a certain portion of your portfolio in industries with poor economics and high levels of failure, are you not setting yourself up for failure?  The ex-ante probability of success in all such cases is quite low. If you are really a smart investor, does it not make sense to invest in industries where the chance of success is high to begin with and then on top of that you can apply your considerable skills to improve the eventual outcome.

The counter argument

I can think of two counter arguments to my logic

The first one is that if one has some special skills or insight into the industry and thus an edge over the market, it makes sense to invest in that industry inspite of the problems. Even in such as case, I cannot think of a scenario where most of the investors would have a considerable edge in a wide range of industries (including the lousy ones).

The second counter argument is the graham style of investing – pick a lousy company so cheap, that when the industry turns a bit, this company goes from a bargain price to just about cheap. I have done this several times in the past and made some money from it. This is however a 1-2 year game of cycling through such stocks on a regular basis, and constantly looking for the next one. There is nothing wrong with it except, that it requires wide diversification and constant effort to look for new ideas.

Ignoring industries with poor economics or governance?

Does the above post mean that one should just ignore and never try to learn about an industry which is known for poor economics? I think that would be silly. It is not like one will get some kind of infection or loose money just by reading about such an industry. One should practice safe investing, but that does not mean one should not learn about these companies.

Let me give an example – I am quite allergic to real estate companies. The industry has extremely poor governance, unethical practices and is a cesspool of corruption. At the same time, it does not mean that one should never study or look at real estate companies.

I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean! The question I am now grappling with is how do you value a realesate company? That will most probably be the next post

Look for diamonds in a diamond mine

I think one should be intellectually honest with oneself. If you genuinely think that you have considerable insight into some industry and can do well inspite of the poor economics of the industry – then more power to you.

In my own case, inspite of understanding the poor economics of the sugar or metals industry, I have invested some money in the past and learned an expensive lesson.

I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine.

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Why I will never buy an airline stock ?

By Rohit Chauhan

In Industry analysis, Uncategorized

December 10, 2011

5 Min read

19 comments

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The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air,  Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes.  In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze  behavior. It is generally a race to the bottom  as airlines compete on the basis of price. The majority of an airline’s costs are fixed  – cost of an airplane, fuel and salaries  do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is  the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government  to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees.  I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost  structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools)  healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia  prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of  the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly  (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by  jet or kingfisher the flight is good and the airhostesses are pretty J .  That is money well spent !

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