A happy new year to all the readers and thank you for reading and visiting my blog
Wishes for the new year
W
Annual portfolio review – 2010
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It’s the time of the year when everyone looks at the year gone by and makes resolutions for the new year. My resolution for the new year? run a 5K marathon 🙂. Anyway, I digress. This blog is not about my attempts to get fit.
I did an annual portfolio review in 2009 here. I think the returns in 2009 were out of the ordinary as the stock markets were recovering from a huge shock. I did not expect the 2010 returns to be any close to it. That prediction turned out to be true.
How I evaluate performance
The most typical approach to evaluate performance is to look at the annual return and if it has met your expectations (which vary from individual to individual), then one can declare victory and move on. As you might suspect I don’t stop at that.
Annual returns are important, but not the sole indicator of performance. A year’s return is driven more by luck than skill. A few lucky picks can give a big boost to your portfolio and a few bad ones can ruin the year. One has to distinguish skill from luck. I look at the portfolio performance for the last 2-3 years and compare it with my objective – which is to beat the index by 5-8% per annum.
Now, there is no audit of my performance, so I can claim whatever I want – no one can verify it. So instead of trying to quote a number, let me state that I have achieved my goals by a wide margin in 2010 and for a 3 year period too
Is 5-8% outperformance not for the wimps?
Now some of you who would have dabbled in small, micro or no cap stocks may be thinking – what a sissy 🙂 . I can do far far better than this dude
My response – that’s absolutely true. My personal goal is not to achieve the highest possible return. My goal is to achieve decent returns at moderate to low risk. My own portfolio has around 15-20 stocks, with no stock more than 5% of the portfolio. I have structured my portfolio to achieve a decent level of outperformance, but ensure that a single bad idea will not ruin my networth.
Think of it this way – A 5-8% outperformance will give me a 19-22% annual return. That means 5-7 times my original capital in 10 years. If I achieve this I will be very pleased with my performance.
Additional parameters of evaluation
I have another parameter which I use to evaluate the attractiveness of my portfolio – let’s call it the ‘discount to fair value for the portfolio’. Let me explain
Let’s say I have two stocks in the portfolio (1 share each)
Stock A – fair value is 100, current price is – 60
Stock B – fair value is 100, current price is – 70
So for total portfolio (A+B) – fair value is 200, sum invested is 130.
The ‘discount to fair value of the portfolio’ is 35% (200-130/200). I generally focus on this number quite closely. This is a very useful number to make buy/ sell decisions and structure the portfolio (more on it in another post)
I am listing the actual discount below for a few years (end of year)
2008- 60%
2009 – 26%
2010 – 36%
The numbers are quite instructive. In 2008, as the market crashed I added stocks to my portfolio and saw this number rise. In 2009 as the stock prices rose, this number reduced (as the portfolio gained in value).
So in 2010, how did this number increase?
Quite simply, I reduced my fully valued positions and kept adding to the undervalued position. Although this is not a magic number, I have seen that if I have done my homework well then a large discount has typically led to a good performance over time.
My overall objective is to keep this number between 30-40% or more.
Specific performance
Let’s get from the abstract to the concrete (hopefully I have not lost you !)
The big winners for me were – Gujarat gas, Merck (finally !), LMW, grindwell Norton (which had not done well last year), Honda siel (surprise), Cheviot (some movement !) , Ashok Leyland etc. I have constantly been selling some of these stocks.
I have added some new positions, some of which are listed here.
I sold off these position or reduced these stocks substantially – NIIT tech, Patni, Infosys, Sulzer, ESAB india, Concor, Denso, VST and Ingersoll rand.
Ofcourse not everything was a winner – VST for one was a very average pick.
The new areas in 2010
I have started exploring several new areas – more from a learning standpoint. I have been experimenting on options and arbitrage.
Options have been a mixed bag and I plan to pursue it more as an insurance than to make money off it. I plan to focus more on arbitrage in the future as it is an interesting field and works well my investment approach.
Plans for 2011
I have no grand strategy for 2011. No hot sectors, must have stocks for next year. The strategy is going to be the same – keep looking for good and cheap stocks the old fashioned way – read and analyse.
Arbitrage – Kesar enterprise
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Now, before I start crowing, let me come clean on a few points. The Kesar enterprise arbitrage idea was brought to me by ninad (see his blog here). I was smart enough to get on the ride.
This deal was announced in March and it took around 9 months for the deal to complete. I have also listed some thoughts and analysis (which include substantial inputs from ninad) over the course of the deal at various points of time
Basic idea
Kesar enterprise is a sugar company with a division which was expanding into the warehousing and other port related infrastructure such as storage. The company announced in Dec 2009 that they would be demerging the infrastructure business. You can find the announcement here.
I am posting my personal notes on the deal below
De-merger evaluation – March 19th
Kesar enterprises has announced the de-merger of its Sugar biz from the Infrastructure warehousing biz.
The numbers for each biz is as follows (in crs)
Warehouse/ transport divison
Revenue: 16 Crs (2010 expected)
PAT: 7-8 crs
Return on assets – 30%+
Valuation – around 60-70 crs minimum
Sugar divison
Revenue – 285 crs gross including excise
PAT – 2-3 crs.
Over 10 years the company has made very small profits. So difficult to value based on profits.
Inverting the problem – Mcap of the company is 82 crs. So is the sugar biz atleast 20-30 crs?
Alternative valuations
Book value – 40-50 crs (after all debt). So liquidation value is higher
Comparative valuation – based on price / sales, most of companies in this sector are priced around 1-2 times. Due to poor profitability, we can price this company at 50% of sales – 100 crs?
On capacity basis, a comparable company like dhampur sugar (UP based company), sells for 0.011 Crs/ TCD. Kesar enterprise sugar business can then be valued at 80 crs.
So total conservative value is around 140-200 crs.
Action plan – create initial position at 120 levels
Negative case – March 30th
Sugar prices tumbling and market has caused the stock prices to drop by 30% in feb and march. Kesar has seen stock price drop by 10-15%.
2011 will see surplus sugar and hence the futures have started going down. Stock prices could drop
further – if that is the case, delay increasing the position, close to the ex-date as possible
Debt getting split – more to infra company: need to track this
Midcap discount – look at midcap futures to hedge?
How to hedge against drop in sugar industry – can use puts on Balrampur chini and Bajaj Hindustan
Stock goes ex-date – May 19th
The ex-date was 14-May. The sugar business has dropped to around 50 rs which gives a mcap of 30 crs. The sugar biz is in down cycle and hence the prices for all companies have crashed
Key mistake and learning – did not hedge on the down turn in sugar as I was thinking on 30-march.
Action plan – wait for upturn in sugar to exit the sugar biz. A sale at 60 and higher should work out in the deal. May have to sustain further drops before recovery.
Kesar enterprise stock recovers – Sept first week
Price now at 70 levels. Sell the stock!!
Kesar infrastructure yet to be listed – Dec first week
Was able to sell the sugar piece @65-70 prices. Deal which was expected to take 4-5 months at max has taken twice that amount – around 9 months already. No updates yet.
Stock finally listed – Dec 22nd
Kesar infrastructure finally listed at 99. A gain of 30% in nine months. May hold on to the stock
Key learnings
· Such arbitrage deals take longer than expected. Patience is the key here
· One cannot ignore short term implications on the stock price and treat it as a long term idea. If possible, options can be used to hedge the position only if the timelines are certain
· Build the arbitrage position over a period of time and not immediately after the announcement as the price drifts downwards once the buying/ selling pressure subsides
Short analysis – WIM plast ltd
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I typically look at 1-2 companies every week in some detail, to figure out whether they are attractive enough for further analysis. As I have said in the past – rejection is easy for me. It takes me 10-15 min or sometimes lesser than that to reject a company.
Investing into a company is like marrying or atleast a medium term relationship for me (unlike a one night stand) and as a result all the stars have to align themselves for me to commit my money to an idea.
WIM plast is one of those companies which has passed the initial filter phase and I am doing a little more detailed work on it.
About
WIM plast is in the business of plastic moulded furniture (brand – cello) and into extruded cello bubble guard sheets which have multiple applications such as false ceiling, signage etc.
The company has been in this business for the last 20+ years and is part of the cello group.
Financials
The company has had an erratic performance in the past. Most of the analysis you will find on the web and in broker reports talks about the great performance since 2007. These reports breathlessly report the doubling of the sales in the last 3 years and a 60% per annum growth in profits during the same time. This is a perfectly idiotic way of analyzing a company
One has to look at a much longer time period to analyze the performance of the company. I typically look at the last 10 years of performance (nothing sacred about that). A long term performance shows how the company has done during past slowdowns and gives a much better idea of the sustainability of the current performance.
The 10 year performance of WIM plast shows a very different view. The topline -sales dropped from 80 odd crores in 2000 to around 56 Crs by 2006. The profit also dropped during this period from 11 crs to around 2 Crs in the same period. I have not been able to find why the topline dropped over the span of 6 years. Most likely it looks like a combination of increasing competition in moulded furniture and slowing demand.
The company has since then been able to increase sales to almost 140 Crs in 2010 and had a net profit of around 16 Crs. During the current year, the company is likely to clock a topline of around 150-160 Crs and net profits of around 14-15 Crs (profits likely to stagnate due to rise in raw material cost which depend on petroleum prices)
The company came up with a new product – Cello bubble guard in 2004-2005 and completed the plant by 2006. The product seems to have started selling well from 2008 onwards. Again the company does not disclose the product splits, so I am guessing that this is the reason for the growth during the 2006-2010 period.
The positives
The company managed its balance sheet well during the down years. The company has been able to keep debt low (below 0.5 times equity) and is now debt free. In addition, the company has an above average ROE of 20%+, has been able to keep inventory and debtor levels low and improve the net margin during the 2006-2010 time period
The company has had a very good dividend policy and has kept the payout high even during the down years. The company has now started increasing the payout (dividend yield is around 2.5%) as its performance has improved.
The company is also investing around 100 Crs in its baddi plant for cello bubble guard to expand capacity and thus increase the turnover (see here)
Finally the company sells at a low valuation of around 6-7 times earnings
The questions
As I said earlier – I am still in the dating phase :). I have not made up my mind. There are still a lot questions in my mind
– Why did the performance drop from 2000-2006?
– How is cello bubble guard doing? What is the competitive situation for the product, its margins and what are the substitutes for this product?
If you or anyone has looked at this company or used its products or know someone who uses the products (cello bubble guard), please leave me a comment or email me on rohitc99@indiatimes.com
Conclusion
I need to do further research on the company. The key to the success of this idea is the future performance of the cello bubble guard product. If this product does well and can get a good margin, then the net profit will increase and the stock price will improve too.
disclosure – no postion in the stock as of today
There is always a risk
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The last six months have been a ball. If you were smart or lucky (or both) to have picked the right midcap or small cap stock, you could have seen a 100-200% return by now or may be even more.
In the initial stages, it is quite likely that the diligent and focused investors picked these stocks after doing a decent amount of analysis and research about the underlying business and the company. It is also quite likely that these investors were not expecting the stock to double or triple in such a short period of time.
What the smart investors do in the beginning, the herd does in the end.
I have been amazed to see the euphoria and enthusiasm about the mid caps, small caps and even no caps (companies with no profit or business). In the last few months, I have seen articles in economic times and other such papers encouraging investors to get into such stocks – right after these stocks had gone up 100% or more.
The near term versus long term
I would recommend that you do a small exercise. Go to finance.google.com or any such website and look at the price action for several midcap and small caps. You will find a hockey stick graph.. a flat line for couple of years and then a huge swing in the last few months.
It’s quite possible that the fortune of several such companies has suddenly turned and they deserve a higher valuation. However I find it hard to believe that all of a sudden, all these mid caps and small cap companies deserve an en-masse re-rating
There is always a risk
I have no idea if these stocks will rise in the coming months or continue to drop in price. One point is however clear – A lot of these companies have a higher level of business risk than the large cap companies.
A lot of these companies are no.3 or 4 in the industry. They do not have a competitive position that is as strong as the no.1 or no.2 player. As a result, if the demand slows or if there is cost inflation, the profits of these companies would be the first to get a hit. If such a scenario happens, then the stock price correction could be swift and brutal.
Unfortunately a lot of investors have forgotten this point in the last few months and only see the returns while ignoring the risks
What to do about these risks?
The first point in investing in mid and small caps is that one should have the appetite for high volatility and risk which comes with these types of stocks. If you are going to get scared with a 20% or higher drop in the stock price, then these stocks are not appropriate for you.
The second point to keep in mind is that some ideas in this segment are bound to fail. The governance and competitive position of these companies is quite poor. As a result some of these companies will hit a bump, from which they may never recover or take a very long time to recover. In such cases, one has to bite the bullet , sell and move on
Finally, if you have done your homework and know the company will do well in the long run, then just ignore the market noise and either sit pat or if you have the guts, then buy more when the price drops due to some short term sentiments.
Personally, if I was starting out new, I would avoid mid-caps and small caps altogether. I would focus on the big companies, learn about them and invest in those companies in the beginning.
Sure, I will make lower returns and will not be able to boast that I had a multi-bagger, but then in the end at least I will have a bag left when others lose their bag, shirt and all other parts of their clothing.
Short update on the paid service
I have been surprised by the phenomenal response to the paid service. I ended up getting a response far in excess of what I had planned and could handle. As a result, I have taken off the subscription forms till I am able to meet the demand I already have.
Added reminder – if you have subscribed to the mailing service, please remember to check your mail box and use the link to confirm the subscription. If you have already confirmed the subscription, I have sent an email about the service details. Please remember to check the email for details.
Continued analysis – Hyderabad industries
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Statutory warning – Long post detailing further analysis of the company. Can knock you off to sleep – please be seated while reading 🙂
I described my process of analyzing two companies from the sector – construction material, in an earlier post. At the end the analysis, the only conclusion I reached was that the companies were still attractive enough to continue my analysis and invest more time in them.
I had a look at visaka industries and for non quantitative reasons have decided not to go further with it. The main reason is management. I am not comfortable with the open ended risk of the investment in the power plants at a cost of 5000 crs. I do not have clarity on it and hence in view of a risk which I cannot evaluate, I decided not to pursue the analysis any further.
We can debate back and forth on this, but my personal approach is to look at it as a binary decision. If I am not comfortable with the risk, I tend to quickly move on. There is no point in doing some fancy calculations here. I may have missed quite a few opportunities in the past, but this approach has also helped me avoiding risks which I don’t understand. I would rather commit the error of omission than the error of commission.
Hyderabad industries
I have initiated a deeper analysis of Hyderabad industries now. The performance of the company has been good, but unspectacular in the last few years. Ofcourse one cannot expect spectacular performance in a commodity and mature industry such as building construction material.
The company re-structured in 2004 and has since then been doing fine. The company has been able to maintain a net margin in the range of 6-9%, ROE in excess of 15% , a top line growth of around 10% and a bottom line growth in excess of 15%. It is important not to take 2009 as a representative year in making these calculation, as margins were far above average in that year and these margins are already trending down in the current year.
Rough cut valuations
Once I am comfortable with the fundamentals of the company, my next step is generally to do a very rough cut, fundamentals based and price based valuation (see page – other valuations in my valuation template).
The reason for a two fold check is to quickly see if the fair value of the stock is below the current price and then to compare the current valuations (current PE) with the valuations in the past (around last 10 years). The past history of the valuations allows me to look at how the market has valued this company in the last 10 years. In addition, when you compare these valuations with the fundamental performance, you tend to get a lot of insights into how the market looked at this company in the past (more on it in the next few paragraphs)
The normal earnings of the company can be taken as around 40-50 Crs over a business cycle. So one can very roughly value the company at around 400-550 crs.
The last ten years of valuation shows the company’s PE has ranged between a low of 4 and a high of 10-12 (ignoring the extreme low valuations of 2008-2009 when everything crashed). These valuation levels have to be compared with the earnings of the company which have been very volatile.
It is obvious that the company saw rapid price increase in 2004-2006 when its fundamentals improved and saw a PE of around 10 times peak earnings. After 2006, the margins started dropping due to higher capacity and so did the stock. The stock price did not recover till late 2009 when the fundamentals started improving again.
The current valuations and price may appear as bargain based on the recent history, but looking back a few years, it does not look like a no-brainer.
A 20% price drop from here could make it a very compelling buy.
Question – what if the price runs up and I miss the opportunity?
Response – Well that’s the risk of being patient. I would prefer the price to come to me, rather than chase it. If not this company, then there are 5000 other companies to look at !
Checklist analysis
At this stage, even if I am not completely bowled over by the price, I will perform a checklist analysis on the company. I have listed various checks on the accounting, business model, management factors in my valuation template, which I run though to find any specific red flags.
Some of the key highlights of the checklist review
– Company has around 35 Crs of contingent liabilities (taxes etc). This translates to around 6 months of annual profits. Nuisance, but not too much to worry about
– The company has a foreign exchange risk due to import of asbestos which accounts for around 50% of total raw material costs.
– No specific accounting red flags
Competitor/ industry analysis
The next step for me usually is to analyse the industry and competition and see where the company stands viz-a-viz other companies. This industry is partly fragmented, but the top 4 players account for almost 65% of the market share.
The top four players are
Hyderabad industries
Visaka industries
Ramco industries
Everest industries
On checking the fundamental performance of all these companies, it seems that their average ROE is in the range of 13-20% range. The debt varies from 0.4 (for visaka) to .75 for ramco industries. Sales for the top 4 companies have grown by an excess of 20% and bottom line by around 10-15% range. These are not exact numbers, but they paint a decent picture of the industry.
Some key takeaways are
– The ROE for the industry over a business cycle is around 13-15%
– The topline for the industry is growing (as expected), however competition has ensured that profits have not grown as fast
– The net margins for the industry are in the range of 6-7%.
– No specific company has a breakaway performance from the rest of group, yet Hyderabad industries and Visaka seem to have slightly better performance and low debt levels
– Small amount of industry consolidation seem to be happening as the top players are growing faster than the market.
In summary, the industry leader – Hyderabad industry is only slightly better than the other competitors and seem to selling at cheaper levels.
Multiple model analysis
I have borrowed this approach from Charlie munger, who has stated that one should apply various mental models from multiple disciplines to improve decision making. For example – economic models of demand and supply, psychological models etc.
A few key takeaways for Hyderabad industries
– The demand and supply elasticity for the industry is high. In plain English that means that any drop in demand will cause commensurate drop in price which is bad for profitability
– Competitive advantage in the industry is weak and limited to brands, distribution network and to sourcing from the production side.
– Management seems to be rational and has disposed off weak businesses in the past.
Inverting the problem
What will cause one to lose money on this idea? I always ask myself this question to find disconfirming evidence. I can think of two points
– Demand supply situation worsens with new capacity. This would cause price to drop and a lowering of profitability. 2009 profitability was much higher than average and reversion to mean will not be good for the stock
– Industry is cyclical and hence net profit and stock price may trend downwards in the subsequent months (capacity addition or surplus capacity is available)
Final conclusion
I could go on and on in terms of further analysis, but in interest of keeping the post to a reasonable size, let me summarize my thinking till now
The sector seems to have above average profitability over a business cycle. In the recent past, the margins and hence profitability were above average and hence the stocks in this sector appear very cheap.
It is important to value stocks in this sector based on normalized profits and make a decision based on that value. The past few years of data shows an average margin of around 6-7% for most companies – except for extreme demand collapse or shortage conditions. In view of this, Hyderabad industries seems to have fair value in the range of 500-550 Crs for the company. At current price, it is at a discount of around 40% to fair value.
I do not have a position in this stock and will continue to analyse further and may or may not take a position. The above analysis was for illustrative purpose only and if needed, to put you to sleep 🙂 …sweet dreams !
Construction material companies – Visaka and Hyderabad industries
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I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!
So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.
About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards
These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.
The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.
A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.
The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban – more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.
Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.
At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.
In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.
Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).
The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.
Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.
Performance of the top two players
Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.
The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.
The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.
Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.
Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.
The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.
Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.
The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.
My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).
It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.
In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.
If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.
Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.
Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.
I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.
I have several questions in my mind which I need to resolve –
– Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
– Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?
The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.
Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.
Buy and hold investing
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The idea of buy and hold was popularized in the US by warren buffett, the guru of value investing (and if you have realized, my intellectual guru too).
The idea behind buy and hold has been that one should buy the stocks of the really good companies and hold them for the long term (sometimes over decades) without concerning ourselves with the short term swings in the stock market.
A myth on buy and hold
A few commentators project buy and hold investing as a form of investing requiring no thinking and analysis. All one needs to do is to go ahead and buy an Infosys or a levers or titan at any valuations and just hold onto it. One does not even need to check on the performance of the company, even briefly, on an annual basis.
These commentators point out to investors who made an investment in a levers or Infosys years ago , just sat on their positions and are now comfortably rich. This is survivorship bias. For every levers or Infosys, there is a company which went bust or went nowhere.
Buy and hold is not brainless investing!!
It requires work, even if there is no activity (read – trading). It may sound easy, but it is not. By the way, why should earning a decent amount of money, while sitting on one’s a**, be easy for everyone?
Why are there no such recommendations?
You may wonder, why one cannot find such recommendations from brokers or analysts. Why don’t they indentify such companies and recommend it to investors?
Let me take a personal example. As far back as 2000, inspite of being a novice, I had a decent amount of conviction that asian paints was a good company (as I had worked with them). I invested a decent sum at that point of time in the stock.
Now lets assume you are my client. Let’s say in 2000, I recommend this stock and you pay me a commission.
You come back next year and we have this conversation
You : So Rohit, what should I do with asian paints?
Me : Nothing. The company’s doing well. Just hold on to it. By the way, you will be getting a bill for my recommendation next month
You (thinking) : What ??!! this dude did nothing for me this year and is charging me. I am not coming back
So I assume you get the point why brokers and tipsters cannot make a living by giving out such buy and hold ideas which can make you rich.
Please note that the advisor is still doing work. He or she has to keep analyzing the company and track how it is doing. The only difference is that as long as the company keeps doing well, there is no need to trade the stock.
The unfortunate reality is that most investors believe some activity is needed to make money and on top of that if an advisor is to be paid, he or she should be ‘doing’ something.
Is it relevant now?
I feel like a dinosaur these days, especially when talking to my friends. The holding time spans range from a few months to a year. If I point out to long term stock ideas, the same friends are quick to point out the fantastic returns they have been able to make in the last 6 months on midcaps and microcaps.
Why wait for the long term when one can get instant gratification 🙂
The problem with a short term approach, disconnected from an underlying philosophy, is that it works till the going is good. If the market turns south, then the same investors would lose their shirt and all their undergarments and would start singing the buy and hold tune.
An investing philosophy should be based on fundamentals and not on the current fads of the market.
How to practice buy and hold?
I personally do not believe in going and buying a stock blindly and then holding on to it forever (hoping it will do well). I think one should be able to identify on the basis of a reasonable amount of analysis and experience a list of good, long term ideas.
What should be the characteristics of such companies?
A decent operating history – The company should have been in the business over 10 years with an above average record of performance.
Sustainable competitive advantage – The company should have a strong competitive position in the industry so it can sustain its above average performance in the long run
Decent to attractive industry with minimal change – It is important to avoid industries with a lot of change (ex: telecom) or currently in a decline (example – jute). In addition, commodity type industries are also not a great place to find such ideas, though one cannot rule it out.
The hit by truck test – If the unfortunate happens, can you leave the stock untouched in your account as an asset for your family?
The key is to identify a list of such attractive ideas and invest a small amount of money in it (if the valuation are not too high). Once you do that, you need to start following the company and the industry on a regular basis. In time, over a few years, you will become more and more comfortable with the long term prospects of the company.
The idea is not keep adding money as you become more confident of the long term prospects of the company (long term being more than 5 years). One needs to be patient and should let the opportunity come to you. When the market drops due to some short term concern, it is time to add a meaningful amount of money to some of these ideas.
The above approach is not easy. It requires effort and patience. However if you can build a portfolio of 4-5 such companies, you are set for life.
I have been able to identify a few such companies over the last few years. The notable ones are asian paints, Crisil and maybe a Gujarat gas. These names are not set in stone, but are fairly good ones for me.
I am planning to look at new ideas such as titan, HDFC bank, ITC etc and start following them closely. The next time a market crash happens, I plan to load up on these stocks, as I did on Crisil in 2008.
Some portfolio changes
S
A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.
I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results
The reductions
As I wrote in some of the previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.
NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.
In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.
I created a position inspite of all the doubts. In hindsight I was too timid.
I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?
I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value
Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.
In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.
The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali 🙂
The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).
I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.
I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism
Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.
I will definitely read and respond to your email, but would ask you to be patient with me on that count.
A happy Diwali to all the readers
On the previous post and some additional thoughts
O
I recently made a discovery – The higher the market goes, the more I get a lot of intellectual thoughts. This is exactly reverse of a lot other people who seem to be finding a lot of good ideas to invest in the market. Well I guess I may have to work a bit harder to find something good …sheesh why isn’t it easy to make money in the market 🙂 ?
All IT stocks overvalued?
I was not precise enough in my previous post. I think some of the large cap IT stocks are fairly valued, if not overvalued and hence there is no margin of safety. That is they are priced for perfection.
The same may not be true for several midcaps, though I think one cannot make a general statement. As I have written in the past, general statement such as ‘market is overvalued or undervalued’ are meaningless and the same holds true for IT stocks too. So let me be more precise – companies like Infosys, Wipro and TCS seem fairly valued.
In case of Mid –cap IT companies like NIIT tech, patni or hexaware it is not as clear, atleast to me.
I typically value stocks using 3 different approaches at the same time. The first approach is the discounted cash flow – try to estimate the future cash flow (or earnings) and then discount them to arrive at a net present value. The second approach is to look at past valuations of the company and compare with the current valuation. The third approach is to look at the relative valuation of the company with others in the same sector.
I try to evaluate a stock on all the three approaches and see if they are pointing in the same direction. A stock may appear undervalued in terms of the DCF value and with reference to other companies in the sector, but appear fairly valued compared with its past valuations.
Now such a situation, which is currently present in case of Mid-cap IT and some cement companies, definitely throws up a key question for me – Why should the market value the mid-cap IT companies at a higher level in the future than it has done in the past ?
A typical case where the market values a company at a higher levels than in the past is when the growth or return on capital of the company has increased and the market now thinks that the company has a much better future and prices it accordingly.
In case of mid-cap IT companies and various other mid-caps, I am grappling with the same question – what is it that I know which the market has not considered, that would cause it to value it more in the future. In some cases it is easy to figure that out, but I am not able to figure it out in case of IT companies.
Hence my statement – Some IT-midcaps may be undervalued depending on your point of view. My point of view is that i can’t think of any unrecognized factors which may cause the market to re-price these companies upwards.
On the contrary I can only think of negative factors, several of which are not yet priced into these stocks. You may have a better insight on factors which may cause the market to value these companies higher and so both us are correct from our respective points of view.
The problem with stock tips
Moving on the next general thought – stock tips. Regular readers to this blog know that I am totally against stock tips. Other than the reason that I think that most of the stock tips are given by the unethical to the unsuspecting, I also believe that such tips do not help in the long run.
It is easy to take stock tips and follow them in a bull market. Even a dart throwing monkey can come up with some profitable ideas (unfortunately I am not as smart as this monkey during bull runs :)) and it would not difficult to follow them. How many of us will have the courage to hold on to such stock tips when the market drops or add to such positions? I cannot speak for others, but I definitely cannot blindly follow others when the market is in a free fall.
The only way one can follow stock tips or such a person is to understand that person’s underlying approach and then have some amount of blind faith on the skills of such a person. So the next time you decide to follow someone else stock picks, remember that you are putting some amount of blind faith in that person, which will be tested when the market drops (which it will sooner or later).
How to get decent return these days?
One of the readers asked me a question on the previous post – how do I make decent return these days when a lot of stocks appear overvalued and fixed income options don’t give much returns?
I don’t have an easy answer – if I had one, don’t you think I would be using it?
The first option is to keep analyzing stocks everyday (as I am doing) and hope that you may hit a few good ideas in due course of time. If you can find a few such ideas, you will have to have the courage to buy such stocks, knowing fully well that such stocks could drop if the market were to drop suddenly.
The other option is to do nothing and sit tight. This option is not easy too as you will have to watch your friends make easy money while you sit like a dumb dodo, doing nothing.
Either of the options are not easy – in one you face the risk of losing money (atleast in the short term) if the market drops and in the other you are foregoing easy money. You have to choose your poison.