AuthorRohit Chauhan

First of all – yipeeeee !!! No I didn’t win the lottery, but India won the Cricket World cup. Wow, what a match ! it was thrilling and exciting to say the least.

Now, coming back to more mundane things, I am often asked – where do I find my investment ideas ?. I would say that I find my ideas via two methods – Find and borrow (or steal).

Finding ideas
I have a fairly low tech way of finding ideas. I have a simple spreadsheet in which are listed companies by PE, market cap, profit etc. I use the following screener to generate a list based on the following criteria

Criteria : PE greater than 15, ROE less than 12%, and debt/Equity ratio less than 1.2
Correction : PE less than 15, ROE greater than 12%

Once I have the initial list, I eliminate some companies based on following the criteria
– Any company with losses for more than 2 years, sales degrowth or management issues etc.
– Micro-cap finance/ retail/ commodity companies as these companies are too risky and one has to analyze a long list, before one can find a good idea.

The above step has its shortcomings such as filtering out turnaround situations, but one has to have some cut off to get a manageable list

Stealing ideas
I am no Albert Einstein or a physicist trying to come up with the theory of relativity. There is no Nobel prize for finding an original idea. The market will reward an idea if it is good, irrespective of the source.

So where do I steal my ideas from?

For starters from other fellow value investors such as

Ninad Kunder
Ayush mittal
Amit arora
Neeraj marathe
TIP blog
Prof bakshi’s blog

I usually read their blogs on a regular basis and if there is an idea posted by them, I will start investigating it further. These are smart investors and I would be stupid to ignore the ideas posted by them. These ideas have already been analyzed, so I know that they are very likely to be attractive.

I will not buy these stocks blindly, but it’s a good starting point for further analysis

I have a preliminary list of companies, which I am looking at more closely now. These companies have passed the 5 min smell test (nothing obvious to reject these companies), but now require a more detailed analysis to make a decision.

I am listing two such ideas below. I do not hold any of the companies as of today and may not buy the stock if the company is not good enough for any specific reason

Geojit BNP Paribas
This is a financial services company – providing stock broking, portfolio management and other distribution services. The company has over 5 lac clients and now over 500 offices across the country.

I personally, use their brokerage service and have found to them to be on par with the other brokerage services. I am not pitching their service to you – I don’t have any financial relationship with them – just a customer as anyone else.

The company’s business is tied to the fortunes of the stock market and is very volatile. The company has grown its revenue from 80 odd crores to around 250 cr +. The net profit has grown from 18 Crs to around 50 Crs in 2010. This growth however has not been a smooth upward trend. As expected, 2009 which saw a severe bear market, saw a drop of 20% in revenue and 80%+ drop in net profits.

In spite of the volatility, the company has been doing well by expanding the client base and offices. The company is now selling at a very attractive valuation of less than 10 times earnings (with 30% of the market cap in the form of cash). In addition the company is also expanding in the gulf countries through various Joint ventures

Finally a key point – Rakesh jhunjhunwala is a director and a majority shareholder in the company. That in itself, does not mean that we should close our eyes and buy the stock. However, the company is definitely worth a closer look

Caution – If you look at the price history, you will realize that the company has dropped in price in the last 6 months. Now if that excites you, welcome to my world. A stock which has dropped in price in the recent past is good place for me to start investigating – does not mean I will buy the stock, but will definitely start analyzing it.

Deccan chronicles
This is a very interesting idea. It is a company which is way out of my comfort zone – It’s a publishing company which has also invested in an IPL franchise.

The reason I got interested is that the entire company is selling for 1600 Crs and a sum of parts value is around 4000 Crs (caution – this is just a back of the envelope calculation)

Let’s look at the various parts –

Deccan chronicle news papers
Supposedly, one of the leading papers in the south (based on the numbers provided by the company – 13.8 lakh readers in 2009 up from 4 lakh readers in 2005).

The newspaper business is generally a very profitable business and has great economies of scale – the marginal cost of adding a subscriber is fairly low and the contribution to the profit from each additional subscriber is fairly high.

This business made around 260 Crs in 2010 and can conservatively be valued for 3000 Crs.

IPL team – Deccan chargers
The other business, if you can call it that, is the IPL team – Deccan chargers. This business is barely profitable, but the latest auctions have netted around 350 Million dollars – which comes to around 1500 Crs and change.

Now, this valuation can be debated (depending on one’s point of view and whether India progresses in the world cup :)) – but let’s value this at 50% of the above auction price for the time being – 750 Crs

Beyond, the above two above business, there are some smaller business which I will ignore for the time being.

Total value
So the total asset value is around 4000 Crs and the debt of around 600 odd crores is offset by the cash on the books. Also, I will not worry about the debt as the newspaper business is pouring cash.

So the company is selling at less than 40% of asset value. In addition, the company has also announced a buyback of almost 270 Crs, which at current prices will reduce the share count by another 15%.

What am I still waiting for ?

So why I have not sold my dog, my car and my cow (ok, I don’t have a cow 🙂 ) and bought this stock. There are a few things which give me a pause.

– I have to make up mind about the management. Is the management like other publishing companies like sandesh – using the cash flow from a superb business (publishing) in all kinds of ventures or are they astute capital allocators? Market will value this company at the appropriate valuations only if the management allocates the cash flow from the core business into attractive areas

– What is a publishing company doing in the sports franchise business?

Anyway, if something is too good to be true, it usually is. I am still trying to look closely at the company to see what I am missing here

As always, please do your research before you buy the above stocks. I am not recommending these stocks and have no interest in doing so.

My portfolio is now a certified zoo. Although the bulk of my portfolio is in the top 10 holdings, I still hold several stocks which are not as attractive. I initiated a clean up few months back, but it is not as easy as i thought it would be.

How did I get here?
I have always had this problem to a certain extent – call it the teenager syndrome 🙂 – I fall in love with a different girl every month. The problem is that although I fall in love with new girls, sorry stocks, I have refused to let go of the old flames.

Some old flames are worth holding. Companies like asian paints, crisil and Gujarat gas are part of my core portfolio now. They may become overvalued from time to time, but they have phenomenal business models and great competitive advantages. These companies, if bought at the right price, are likely to give great returns over a period of 10 yrs.

The same is not true of several other stocks in my portfolio such as bharat electronics, Honda siel power products or novartis. These are companies with decent economics and fair management. It is just that they are not as attractive, both from a valuation and future performance perspective – call them mediocre stocks (though decent businesses).

I have been too slow in realizing that these stocks, at current prices, will not give great returns going forward.

So what should one do?
The most rational approach would be to sell the stock when it is selling at fair value or when a stock with superior risk reward characteristics is available.

I have usually been able to do that fairly well when the stock is very close to fair value or if I think the economics of the business are no longer attractive (or I have simply made a mistake in understanding it). I have been slow in making a decision on stocks which land in a grey zone. These are stocks selling at a moderate discount to fair value and have average prospects.

An example
Let me illustrate with an example – Bharat electronics. I purchased BEL in 2008-2009 time frame at an average cost of around 850 and have been able to get 100%+ returns in 3 years including dividends.

These returns though decent, are not earth shattering. They are in line with the returns I expected from the company when I invested in it. This company has a near monopoly in the Indian defence market and should keep doing reasonably well in the future.

I personally think that the stock is around 15-20% undervalued and is unlikely to give not more than 12-15% returns per annum over the next few years. These are decent returns, but unlikely to get your heart racing.

The key to such stocks is hold them till the undervaluation corrects itself and then be able to dispassionately analyze the stock and exit , if there are better opportunities available

If you know, why not sell it?
Good question – call it the endowment bias or inertia, but I have been slow to react. It has also been partly due to the issue of opportunity cost.

For most part of 2010 and 2011, I have not invested more than 50% of my net assets with the rest being in cash as I have not found attractive enough opportunities. In such a scenario, a moderately underpriced BEL seems to be a better choice than holding cash. The downside of such a thought process is that soon the portfolio becomes a zoo and one’s mental space (list of stocks being tracked) becomes too crowded.

So whats the plan?
Sell – though it’s not easy to sell and hold cash. In addition, one also faces the risk of regret if the stock which was sold recently, has a run-up after that. Who said investing was easy?

In the end, however to keep my sanity intact and manage a reasonable list of stocks, I plan to bite the bullet and sell these kind of stocks.

I was having such a happy time!. The economy was growing at 8%, midcaps and small cap companies were showing great increases in profits and the stock prices were following suit. The India growth story was coming true and due to my brilliance in recognizing it, my portfolio was up a billion percent from the 2009 lows. At the current rate, I could have retired soon. Damn this inflation !!

I am joking and being sarcastic.

Investing in inflationary times
If you follow the talking heads on TV and the self appointed gurus, then according to them you need an investing strategy for inflationary times, one for recessionary times, one for summer and may be one when it is cloudy in Timbuktu. I am in a real sarcastic mood 🙂

We have people recommending gold, silver, oil and all kinds of commodities. The time to buy commodities was 2009 when the world economy was in a ditch and not when everyone and his dog knows that commodities have gone up by 50% of more and are approaching peak levels

So what should one do? I cant speak for others, but I am not doing anything different from what I have always done – indentify good companies and buy them at a margin of safety – with emphasis on ‘margin of safety’

I often get asked – Company XYZ is a good company and growing rapidly. It sells at a high valuaton, but then the future is bright, so why not buy the stock?

Do you notice the assumption here?

‘The future is bright’
No one knows about the future. That is as close to a certainty one can have (not withstanding the claims by the gurus on TV). Did the market know that the world economy would fall off the cliff in 2008 or that inflation would spike in late 2010?

So how does one guard against the future – by insisting on a margin of safety when purchasing a stock. I will not buy a stock unless it is undervalued by a decent margin.

But, I did buy at a discount !
You may have valid point, that when you looked at a company, it appeared cheap based on the last few years of data. I have seen most of the people analyze the last five years of data and make a decision. Even I did that a few years ago.

The problem with looking at a short history is that one can miss some part of a business cycle completely and not realize how the company will do in that period.

An example
Lets look at an example to illustrate the point. I recently analysed construction material companies – visaka and Hyderabad industries.

Following are the net profit margins for visaka for the last few years
2005 – 6.9%
2006 – 6.5%
2007 – 5.5%
2008 – 1.8%
2009 – 6.3%
2010 – 9.5%
2011 H1 – 8.5%

There are a few things which stand out. The company’s margins have fluctuated a lot of in the last few years between a low of 1.8% to a high of 9.5%. The first point of analysis is to dig further and understand what was driving these margins.

If one analyses deeper, one can see that 2008 margins dropped due to a spike in raw material prices in 2008. So that gives a strong hint on how the company will perform in an inflationary environment.

2010 was a high in terms of margin and growth for the company. It is quite possible to assume that the company has reached a higher level of profitability. However if you dig deeper, you will find that there is no a particular reason in this industry for any particular company to have a much higher margin than others.

In addition, the other major companies like Hyderabad industries also had a cyclical high in profit margin in 2010. So the demand supply situation was favorable for the industry as a whole and the company was enjoying a nice tailwind

The 20/20 hindsight
It is easy to be brilliant in hindsight. You may be thinking – now this guy is telling us that he knew what was coming.

On the contrary, I had no clue whether the inflation would go up or not. My approach is to look at the last 10 years of performance and arrive at the margin range. In case of visaka, I assumed 5-7% for the company. At a normalized 7% margin, the company did not look very cheap.

So now what?
Things are never as good or as bad as they seem. The market may be over reacting to this whole inflation thing and this in reality is a good thing as several good companies may soon start approaching attractive valuations.

The key is to indentify such companies beforehand and then wait patiently for the market to offer an attractive price. It may soon be time to open up the wallet

I think being rational – making decisions inspite of your emotions telling you otherwise, based on facts and data is very critical to successful investing. I try very hard to be rational in making my investing decisions (though I am not successful a lot of times). So if rationality is an important goal for me, what do you think would be one of my most irrational activities?

I would say without hesitation – writing this blog. I have written over 400 posts on this blog and have been writing for close to 6 years now. 90% of the content on the blog is original – I don’t cut paste someone else’s content. If I cannot write something interesting, then why bother?

Now each post takes me around 1-2 hours to write. So If you do the math, it means almost 800-900 hrs of effort till date. This would amount to almost 3-4 months of lost income, as this blog makes next to nothing. So the point is why am I doing it?

I can list quite a few reasons now, but when I started in 2005 I had none. I tried thinking of some rational ones then, but as I could not think of anything I realized that the only reason was that I loved doing it. Some people like to watch TV, some like to paint and I like to invest and write (talk of a boring interest !!)

The start of investing
If I dial back time a bit further, the same situation existed at the time I started learning about investing. The first 3-4 years in the late 90s were a complete wash in terms of income. I made quite a few mistakes, but still managed to do fine in terms of the returns.

However if I look at the absolute amount of money I made in those days, it was peanuts. The only reason I kept doing it was that I enjoyed the process a lot. The income is now meaningful, but I love the process even more.

Being better at it everyday
I personally look at investing as an intellectual activity, where my measure of progress is not the returns alone, but also if I am becoming a better investor over time. It is always difficult to be very objective about it, but I feel I am a much better investor now than I was in 2005 – though I have no quantitative measure to prove it.

I will make a bold claim now. If some of you like me are not professional investors and are into investing because you love the craft, then it is a given that you will improve year on year, inch by inch and will do well in the long run. How will it be otherwise?

What about the money?
By the way, in case you are thinking that I am being hypocritical and don’t care about the money, that’s not true. I do care about money – have a family to feed :). Its just that investing and blogging in my case is more than just about money. If it was only about money, I would have never started it.

A surprising conclusion
I have come to a very surprising conclusion due to the above experience and based on what I have read about others. If you love doing something and really don’t care what others think or whether you will succeed or not, paradoxically you will get better over time and actually be more successful at it than you originally imagined.

What makes me think I am now more successful at investing? My wife now thinks that this odd thing her husband does on the side may amount to something 🙂

A typical research report provides you with a few years of historical data and a year or two of forecast, especially of sales and netprofit. The better reports may also include some kind of valuation based on PE and discounted cash flow to arrive at an estimate of fair value.

Most of these research reports, atleast the ones for which you don’t pay much will stop at this point. To be fair to the producers of these reports, you get what you pay for – in this case next to nothing.

The point is that these free reports provide only the basic quantitative information needed for a decision. One cannot make a purchase only on the basis of numbers without understanding the context of these numbers

What is the meaning of context ?
A company usually operates as part of an industry and is impacted by the various competitive forces of the industry. For example – if you operate in the FMCG industry, advertising and distribution is a major part of the expense. In a similar fashion, fuel, raw material and power are big expenses for a cement company and advertising is nice add-on, though not a competitive differentiator.

So if you are analyzing a consumer goods company, you have to focus on the advertising expenses. In addition you will also have to understand the width and depth of distribution, brands recall, performance of new products and similar such non-quantitative details.

In case of a cement company, one has to compare the cost of production of the company with other competitors and understand if the company has a sustainable cost edge over other companies.

It is important to understand that the financial numbers of the company have to be evaluated not only on the basis of time (past numbers) but also with reference to other companies in the business (national and international). It is a rare report, that goes into this level of detail.

Beyond the context
The exercise of calculating fair value of a stock is essentially trying to estimate the future of the company. It is silly to attempt mathematical precision in this task. One of the common criticisms of analysts is that their forecasts are generally wrong. I think it is stupid to expect any better from them. The world is far too complex for any person to be able to forecast anything in short term, forget the medium and long term.

I have a fairly elaborate template for analysing of a stock. An elaborate template does not make the analysis any better – it only ensures that I do not missing anything important. If you scan through the template, you will notice that I have a few sheets for DCF (discounted cash flow) analysis.

Now if I don’t consider DCF to be the end all of a stock analysis, why do I still do it? The main reason for doing a DCF analysis is to play around with various scenarios (in terms of sales and profit growths) and attempt to see how these scenarios have an impact on the fair value.

The standard approach for doing a DCF analysis is to look at the past numbers and to simply project them into the future, with minor variations in the numbers. The problem with this approach is that it is too simplistic.

A good starting point is to project the past numbers if you strongly feel that the past is a good indicator of the future. However it is important to look at possible scenarios in your valuation – try an optimistic scenario where everything works as planned and a pessimistic scenario when almost anything which can go wrong will do so. This approach will give you an upper and a lower bound to the fair value of the company.

How do you know what numbers to plug in for the two scenarios? This is where context of the current numbers and a qualitative understanding of the industry and the business comes into play. One has to have a sense of the business and the industry to put any meaningful numbers

The above approach takes away the need to make precise forecasts. You are now working with a range of values, which can re-worked as new data comes to light over time.

But this is all fuzzy !!
Absolutely right ! I personally feel that quantitative aspect of value investing is not more than 20% of the effort (and even that is an over estimation). The ‘numbers’ part of investing is the minimum. I will not invest in a company which has a high debt, is losing sales and has been making a loss for the last few years.

The first step I take is to look at the numbers to figure out if I need to dig deeper into the company or just move to the next idea. This step usually takes a few hours at the most and with practice and some automated options, it can be done even faster.

The real work starts after this first stage. There is no fixed formulae or approach for investing, but I will usually read through a couple of years of the annual report of the company, read about the competitors and understand the economics of the industry. Once I am done with a round of qualitative analysis, I fire up my DCF spreadsheet and plug in numbers to arrive at a range of the value. Over time I have realized that this step rarely throws any surprises.

If you do this exercise for a decent amount of time, you get a rough sense of the valuation as you are looking at the numbers. For ex: a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow.

An example
Let me give an example from my past experience to illustrate my point. I analysed a company called MRO-TEK in late 2007. You can read the analysis here. One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company.

I identified this negative fact, but there was no way to quantify this business risk. The last few years of data looked fine and stock appeared to be undervalued at the time. Fast forward to 2010 – The result for 2008 was a high water mark. The performance of the company has been sliding since then with the topline having dropped by 50% and the operating profit has turned negative. The company is simply operating in a fast changing hypercompetitive industry, where it is very difficult to make a profit.

I had a sense of this fact, but did not appreciate it fully (I am a slow learner 🙂 ). If I had not been lucky in getting a quick exit, I would have lost money on this. This idea was a case of sloppy analysis, where numbers would not have helped.

Is there a secret formulae?
There is no secret formulae for investing (if you are into quantitative investing, it’s a different story). At a certain level effective investing is very subjective in nature. It involves reading and digesting a lot of information and then combining it with your existing knowledge and experiences to come up with an estimate of fair value for the company

Unfortunately there is no shortcut in becoming a decent investor. One has to love the art of investing and be willing to learn and make small amounts of progress each day. Over time, the learning accumulates and you keep getting better at it.