AuthorRohit Chauhan

I am getting frustrated these days.

I had filtered 2-3 stocks and was fairly comfortable with the business and the valuations. So after doing my slow and steady analysis (I have do my detailed analysis!!), I was ready to pull the trigger. On checking the stock price I realized that the stock had jumped 15-20% and had literally run away from me.

Multiple cases
Now, if this happened once or twice I would be fine. However there seem to be too many value investors out there now :). For some reason, a lot of undervaluation is getting corrected across a wide variety of stocks. There have been phases in the market such as in 2007-2008, when real estate or some other sector was hot and people like me could find nice and cheap stocks in the mid-cap, IT or pharma space. No such luxuries now !

Some examples
Well, I am not going to let the analysis go waste. So let me list the stocks I came close to buying and then missed. These stocks are in my list and I could buy some in the future if the price is right and the fundamentals still good, but for now its wait and watch

Hawkins cooker – This is one of the first runaway stocks for me. The company is in a duopoly kind of a market for branded cookers. It is also into cookware products. It is fundamentally a strong company, with high ROE, decent growth and a strong balance sheet. The Company has decent competitive advantage via brands, extensive distribution network in its niche and has improved its performance too in the last few years.

I was asked about this stock by prabhakar kudva and found it to be a sound stock. The stock was selling at around 20-30% discount to its fair value then (my estimates) and as result I did not create a postion. The stock has since then gone up by 50%. I do not regret ‘not’ buying this stock as much as it was not cheap enough for me. Ofcourse the counter point can be that my estimates were too conservative.

Mangalam cement – I analysed the company here and placed an order at around 130 levels. I don’t recall the exact price, but my order did not get filled due to a 2-3 re difference. It now gets interesting! I got anchored to this price of 130 and wanted to buy the stock at a discount of 40% to my estimate of fair value.
The market had other plans and the stock suddenly jumped by 8-9% and it now trades in the 160-170 range which is not a price at which I would create a position in this stock

Amrutanjan – The company is a 100 yr FMCG company in the business of headache balms, cold rubs etc. The company has a strong balance sheet, with almost 70 crs of cash and investmentd. The company has an ROE on invested capital of around – 30%+ and competitive advantage from the brands and distribution network .

The company recently sold off some excess property and has been using the cash to do a buyback and also gave a special dividend. Overall the company has good fundamentals, strong competitive advantage and the management is allocating capital well. Finally the company was available at a PE of 8 (excluding cash) a month back. This was decent stock to buy, but I missed the boat on this one too.

So whats the point ?
Is it a case of sour grapes or a case of wanting cry in public for missing such nice opportunities to make money 🙂 ?

I do my weeping in private :). The point is this – This risk is not missing these stocks. I am likely to miss such ideas during bull markets as the window of undervaluation closes quickly. The bigger risk is a change in my thought process.

I find myself getting impatient now, once I find a half attractive idea. In past when there was no risk of such stocks running away from me, I would analyse the company in detail and take weeks on end before making a decision. Now due to the above risk, I have done superficial analysis in some cases and later found that I missed some risks in the company. I have been lucky till date that I have not shot myself in the foot due to my impatience, but will have to be more careful in the future.

It is better to commit an error of omission than an error of commission (miss on a good stock than buy a lousy one).

A disclosure first – This idea was originally brought to me by ninad during our discussions and I have been analyzing it with ninad and arpit since then. Its amazing how soon one forgets the source of an idea, especially a successful one 🙂

Since my last post on sulzer, the price has corrected to around 1200 levels and is steady at this level. This is roughly around 85-90% of my estimate of fair value. I am now planning to exit this stock over the next few weeks.

The delisting process would take a few months and I plan to keep a track of the stock. If the price drops or some new information comes up to indicate a higher price for delisting, I may initiate a new position.

The returns ofcourse would be 8-10% at best, as the major gains are generally made at the time of the announcement. However an 8-10% gain over a period of 2-3 months is not a bad deal and actually fairly good from an arbitrage point of view. So stay tuned!

On options trade
I have received several responses via comments and emails. The key point of the post is a focus on risk. The most critical aspect when dealing with options to understand and manage risk. I am looking at two ways of doing so

Position size – I have created a small position as I am still a novice in options. If I lose money, it will sting me but not kill me. On the other hand a gain would pay for my coffee for a month – I have expensive tastes !

Focus on downside – My focus has been on much I can lose. One of the reason to post was to hear from other readers on the likely risks in this approach. If you feel that risks which I have not considered in the post, please leave me a comment or drop me an email at rohitc99@indiatimes.com.

Some of you, on reading the title must be wondering – Rohit is again on his options trip ! this dude is going to get kicked big time, one of these days 🙂

Well, in the spirit of learning and experimenting lets look at an options strategy, that I think marries the value investing approach with options quite well.

What are covered calls?
You can read about call options here. Selling covered calls mean selling a call option in the market while holding the underlying stock. Selling a call option without holding the underlying stock is naked selling (no its not selling without wearing your clothes :), but you could lose them if the naked selling bet goes wrong).

How does it work with value investing ?
The logic is as follows – Suppose you hold a stock which is a mid to long term holding. Lets say you bought the stock for 60 Rs and think the fair value is 100. Now let’s assume that the stock is selling for 95 and you plan to start exiting at 100-105 as you really do not want to hold above fair value. In such as case, one can sell a call on the stock for a strike price above the current quote, say around 110-115.

If the stock continues to climb, the call will get exercised and you will get the 110 exercise price + the premium amount. If the stock drops back and if you had planned to hold on to the stock for the long term as long as the price was below fair value and the fundamentals are good, then you pocket the premium and continue holding the stock.

An example
Lets take the example of a favorite of mine – Infosys technologies. My own estimates of fair value for the stock are around 2700-3000. The stock is currently selling for around 2700 which is close to fair value.

The first option for me is to sell the stock once the price crosses 2700 and be done with it. The other option is to start selling covered calls with a strike price of 3000 or higher. If the stock keeps rising and the call gets exercised, then I will end up exiting at 3000 + premium as planned. On the contrary if the stock drops from here, I can pocket the premium for free. The flip slide is that I will lose money on the stock as it drops.

The risks
If someone ever tells you that there is no risk in an investing strategy, ask him what he is smoking or drinking.

There are several risks in the above plan and it works only for a very specific situation. I would sell a covered call on a stock which I think is selling close to fair value and I would not mind holding it if it dropped below this price – the second part of the statement being the key. As a corollary, the reason I would not mind holding if the price dropped is because I think the company will continue to do well and will increase its intrinsic value at a good rate.

A valid question would be – why not sell and move on? . One reason for trying this approach is plain experimentation – with limited amounts of the stock. The second reason is that I would continue to hold on to the stock for the long term as the company is still doing fine and selling covered calls increases my returns. At the same time if the stock gets too overvalued, I would exit it by selling via the covered call.

If you do not want to hold the stock for the long term and would regret holding it if the price drops, then one should just sell the stock and move on. In summary this is a strategy of trying to be a bit too clever and squeezing out a few percentage points of returns.

As an aside which options should one sell in this case ? – I would prefer to sell the ones with the longest duration (May 2010 exercise) as I would also benefit from the time decay and the premium is also worth the effort.

You have a lot of cash burning in the pocket and are looking for an opportunity to invest. An old time favorite is now selling for cheap. All and sundry feel that the company is undervalued especially if a series of ifs and buts get resolved. You look at the annual report of the company and it appears cheap by historical standards. Feeling confident, you go ahead and put in a decent amount of money.

Smart decision? maybe, but then maybe not.

Looking forward
Although no one can predict the future, it is an unfortunate reality of the stock market that stocks are priced based on the expected future of the company. I am using the word ‘expected’ as no one knows for sure. If someone claims that they are a 100% confident, then either the person is a complete moron or trying to sell you something.

If you are in the business of stock recommendations and tips, appearing anything but 100% confident is professional suicide. So I would blame the investor more for the garbage sold in the market than the seller. Do you really think all this junk would sell if there was no demand? anyway I digress.

So if one cannot predict the future, how does one invest? There is no surefire approach, though one can improve the chances of success by picking a company in stable industry. If the industry is fairly stable and not undergoing too much change, it possible to guess (all investing is finally a guess ..sometimes a good one or sometimes bad) with reasonable accuracy on how the company will do in the next 3-5 years.

An example
Let’s consider two companies. I am comparing these companies not from a valuation or investing standpoint, but purely trying to contrast their business performance. Stock performance in the short term is a different issue.

Let’s take the example of Gujarat Ambuja and Bharti airtel.
Gujarat ambuja is in the business of manufacturing and selling cement. It has grown at an average CAGR of 13-15%, maintained a net margin of 15% and an ROE in excess of 25%. It is not possible to know the exact profit or sales (many try that though) for the next 2-3 years, but looking at the business and the economics one can make a fair guess that business could clock 5%+ growth and 15% ROE for the next few years. Anything can happen, but the probability of the business achieving these numbers is high.

Bharti telecom is a telecom service provider, which has done extremely well over the last few years. The company has grown the topline at 30%+ and profit at 45% per annum for the last 5 years. The company has maintained an ROE in excess of 25%. These kind of numbers would warrant a PE in excess of 20. However the market is currently assigning a PE of 11 which values it as a commodity business. So is the market wrong? Some would say so looking at the past performance.

However there are certain structural changes and realities in the telecom industry

1. The industry has been witnessing severe price competition for sometime now. All the other companies other than bharti do not have great fundamentals (please look at the complete financial statement for all these companies and not the P&L account alone to understand what I am saying)

2. The industry has faced a lot of change in the past and will do so in the future. Do you really think anyone can be sure how the industry will look like in the next 5 years? What will be the technological changes, new entrants, government regulations etc?

3. Bharti is now expanding internationally via the Zain acquisition. They are looking at additional acquisitions too. All this activity at the very least introduces more uncertainty into the equation.

The reason I have taken the example of bharti and ambuja cement is because I have analyzed both the companies in the past and gave a pass to both for different reasons. Ambuja cement was not cheap enough for me.

In case of bharti, if i was looking at the just the past data, it would be an incredible buy. However as I said earlier, investing and valuation requires looking ahead and in case of bharti my crystal ball is completely cloudy. It may be my own limitations, but that is precisely the point. If one does not have the confidence of being able to assess the long term economics of a company and its industry, then one should give the stock a pass. The last thing one should do is depend on someone else’s analysis to make a decision.

There is no penalty for missing on a stock idea – there are 5000 public companies and a decent portfolio requires 15-20 stocks at the most. I see no point in buying something where there are too many unknowns and I am not confident on how it will all work out.

I wrote a post in Nov 09 discussing some general topics such as dollar depreciation, auto sector etc. I also promised a monthly post, which I have not done for the last two months. Maybe my mind went blank for the last two months 🙂

Dollar depreciation
Predicting the demise of the dollar is an industry in itself. I wrote about it in November and think the long term direction for the dollar may be down. However there is a catch in this thinking – down against what?. Currency values are relative. The dollar could go down against the rupee, but appreciate against the Euro (as it is happening now due to the Greece debt crisis).

One has to be careful in making such open ended comments. However as this a personal blog, and no one will hold me accountable for it, I can write what I think :). Heck, others get paid for writing the same crap and are still not accountable for the stuff they write !.

So let’s see where the dollar goes in the next few years. My investing decision are rarely top down and I have not factored the dollar depreciation, central govt budget, the infrastructure boom in india or the mating habits of the kangaroo in my portfolio decisions. I will let the smarter folks do that ..for me the equation will remain the simple ..buy below fair value and sell when the price exceeds it. It has worked in the past and most likely to work in the future.

Stock ideas
A lot of work is going on here, but as of yet there is no output. The key is to keep analyzing companies, understand their economics and estimate the fair value. If the price is not right, then it makes sense to just wait for it to come to you. I don’t think cash has ever burnt a hole in my pocket and sometimes doing nothing is a good choice too.
As of now I am analyzing graphite india. I came close to pulling the trigger on Mangalam cement, but the price suddenly spiked , before I could start my buying.

Quarterly results
I have completed the quarterly result review of all my holdings and published a few here. In general, the results are as expected and as a result my estimate of intrinsic value has remained more or less the same for most of the companies.

In the case of BEL (bharat electronics), I have been surprised by the improvement in the performance. I had a major concern about BEL. The business had become extremely skewed by 2008, where in almost 80% of the profit was booked in the last quarter of the year. This is generally not good as it results in a sales push in the last quarter to meet the numbers and as expected, the accounts receivables started going up.

BEL has since then reduced the skew considerably and has improved its cash flow position. I have increased the fair value of the company by around 15-20%.

Waiting for a crash ?
I think this year will require more effort in generating decent returns. 2008-2009 was a test of guts. If one had the guts or the foresight (depending on how you look at it) to invest a bunch of cash in early 2009, one would have made a great return by now. However the common mistake a lot of investors do is to wait for history to repeat itself. I can bet there are quite a few investors waiting for the next crash to happen.

It may happen, who knows ? I am however not basing my decision on such hopes. Investing has to be done based on what we know now, not what may happen or wish will happen. The best preparation one can do for a crash is to be mentally prepared and have some spare cash lying around.

Working on mental blocks
It have started looking at the various mental blocks I have and am currently working on eliminating them. One mental block I have is an aversion to commodity companies (not banks as some readers think). I am currently reading and analyzing such companies – steel, cement, metals etc in more detail and working out the fair value of such companies.

At the current prices, I don’t find any of them attractive. I have developed a spreadsheet where I analyze and record the fair value of each of these companies and track it with the market price. When the price drops below a certain level, I will start building a position. So it’s a wait and watch mode for most of these companies as of now.

I do not have mental block against options and derivatives. I only have a different opinion of these instruments. These instruments in the hands of a new investor is like a blade in the hands of a monkey – most likely the monkey will hurt himself.

If you are wondering, I belong to the same monkey class and hence other than some small positions, I have yet to go whole hog on these instruments. My plan is to learn more of these instruments, start small and then increase my commitment over time. If this monkey is going to get cut, it’s likely to be a small razor blade and not a 2 feet sword 🙂