AuthorRohit Chauhan

I received an email from Thirunarayanan with some interesting questions and have decided to publish my answers to his email.

1. You said that your goal is to beat the stock market by 5-8%. How did you arrive at this lower and higher end ? And why is that important ?

The market on an average has given 13-14% per annum over the long term, maybe even more. In case of most of the value investors – ones with public record- i have seen an outperformance of around 2-3%. The greatest of them all – warren buffett beat the market by around 13%. So i have taken a goal which is not as ambititous as buffett, but more ambititous than the average. Also as i do this part time, i dont think it would be easy for me to exceed 8% above market – which translates to around 20-23% per annum over the long run (5+ years).

The above goal is important, for the reason that the time and effort should justify the rewards. i can easily match the index or maybe beat it by 1-2% via index or mutual funds. So i should cross the high water mark of 1-2% to justify this effort, else i am better off investing in index and mutual funds – which i do now too. I have been lucky to have exceeded my goal till date.

2. You also mentioned that you wanted to beat the stock market on 3 year rolling cycle. How did you arrive at that number ? And what is the significance of this number ?

The reason of having a 3 yr rolling period is that a yearly or lesser number is too short to confirm if i am beating the market or not. Over 1 year or less, luck plays an important role and one cannot be sure if the performance is due to skill. However as the time period increases, the element of luck reduces and skill plays a bigger role in the returns. The reason for keeping it 3 years is that it long enough to eliminate substantial a component of luck, but not so long that i dont get feedback for a long time on whether i am truly beating the market or not.

There are ofcourse no hard and fast rules on the above parameters and i have set them to my own specific case.

3. I am assuming that you are publishing your whole portfolio and your thought process in your blog. What are the chances of someone coat-tailing? What are your chances of seeing some competition and see a rise in the share price because of your publication ? Either you will share forever or there may be a time when you will have to stop revealing a lot (because of competition or lack of time to blog)

I have no issues people coat tailing me, although i dont think that is a problem yet. i am not yet so famous or considered a super investor that people will blindly follow me. in addition, my picks usually have a bad short term outlook.

So it is unlikely someone will just buy what i discuss and see immediate benefit.My approach on the blog is to share my learnings and analysis, but i dont give tips. So an individual is left to make his decision, which is not easy if you are just following someone blindly. Also considering i am small investor and followed by others like me, it is very unlikely that any stock i discuss will have a price run up after i discuss about it. if that starts happening ..then i have arrived in life :).

On continuing to share my ideas i dont know how long this will continue. i dont see it stopping in the next couple of years ..however i do have plans to start private investment partnerships. When i do so, i will have look at the constraints such an arrangement will have. However that is still a few years away.

I have been receiving this question and its variants via comments and emails for the last few days.

Let me try to answer this question from my point of view. My response may not be typical of what is usually recommended and may not suit your specific case.

I am wary of a simplistic approach of selling stocks at an X % profit or at predefined index or price level. A decision to sell, like buying is more nuanced and requires more thought than that.

Two criterias for selling
In my case, the selling criteria is part and parcel of the analysis done before buying the stock. I typically will have an exit criteria in mind based on fundamentals and valuation at the time of buying the stock. If the business fundamentals deteriorate more than expected (see my post on India nippon), then I will sell the stock if I think that the drop is not temporary and the intrinsic value will stagnate or drop in the future.

The second case where i sell the stock is when the current price exceeds the intrinsic value by 10-15% and the future increases in the intrinsic value is less than the returns I can get via other opportunities. So if the stock is selling at intrinsic value and I can find another idea at a 40% or higher discount, then I will sell the stock and re-invest the proceeds in the new idea.

You will notice a lack of reference to any pre-determined index levels or fixed increase in stock price in my sell criteria. For starters, index levels do not have a direct bearing on individual stock. My pick can stagnate when the index is rising and vice versa. So selling a stock just because the index has gone up would be foolish

Mental accounting
I will also not sell stock just because it has gone up by X% to ‘book’ some profit and leave my profits behind. This would be a clear case of mental accounting (put cost and profit in different mental accounts) and an attempt to avoid regret. If one breaks the investment into different mental accounts, there is tendency to recover the cost and let the profit run. I see no reason to treat profits any different from the cost. The entire money is just one single account (available capital) and it is important to take decision on the entire holding as such.

Avoiding regret
A common reason for selling is also to avoid regret. If the market drops, I will regret losing the profit. However I would say that in the short term, it is impossible to avoid regret. If the market rises, then you will end up regretting selling the stock and losing on the upside.

If I cannot predict the markets and avoid regret, the best option is to have an approach based on intrinsic value and accept the fact that I could face regret in the short term irrespective of my decision. The same scenario occurred for anyone who waited for the election results to commence buying. In order to avoid the regret of buying at a higher price and then see the price drop after the elections, they ended up watching the price shoot up and are now regretting missing the rise.

Final bias – hindsight bias
The silliest reason by far is to evaluate a decision based on how the market moves in the short term. If the market rises after I decide to hold the stock, does it make me smart or stupid if the market drops? absolutely not !!

All investing decisions have to be taken based on current information and in absence of knowing which way the market will move, my decision can appear to be very smart or stupid in the short run. However if you follow a rational approach of buying and selling stocks based on some measure of value, then short term market movements should not trouble you too much (which ofcourse is easier said than done)

I mentioned in my previous post, that I plan to use the current market rally to clean up my portfolio of some clunkers. In this post, i will also analyse why I plan to exit these stocks and what I have learnt from them (something good should come out of it 🙂 )

VST industries
I wrote about VST industries in 2007 and built up a small position over the course of a year. My key assumptions were

– The company had grown its net profit at around 20% in the past and would continue to grow it by 6-7% in the future.
– The company will continue to maintain its return on capital at current levels and a reasonable dividend payout (then Rs 20/ share)
– The catalyst for unlocking value could be higher dividend, better growth rates in the topline or continued good performance of the topline and bottom line.

So what has happened since then ?
– The growth has decelerated considerably. Initially the topline slowed down and in the current year the bottom line has been stagnant due to higher tobacco prices
– The company has increased its dividend to around 30 Rs/share and is thus returning majority of its free cash flow to the shareholder. This is good sign as the management is returning capital as it cannot re-invest it in the business and is also not blowing it away on needless diversification
– The catalyst for unlocking value was higher dividend (which has happened) and a reasonable growth rate (which has not happened).

The key reason for the price stagnation has been a slowdown in the growth rates, due to which the market continues to give (rightly so) a low PE to the stock. My mistake in the above idea was a failure to recognise that cigarettes are a low growth category and a no.3 player in this industry is not going to perform too well. The company has been doing fine and will plod along.

Although, One can look at the stock with a 10% dividend yield, there are risks to the business model and future profitability (government taxation and attitude towards smoking).

One final point – Although I have eked out a small gain, I got thrashed (figuratively speaking 🙂 ) by my wife for investing in a tobbaco stock. According to her, I deserve to lose money on such a stock :).

India nippon electricals
I analysed this stock for the first time in 2007. This was a graham style deep discount idea.

My key assumptions were

– The net profit had grown by around 4% in the last few years. I expected the company to maintain the past growth rates.
– The company had a cash holding of 77 crs then, which has now increased to almost 100crs+. The company has a market cap which is less than the cash on books.

So what has happened since then?

– The core business of the company is on a downward slide now. The topline and bottom lines are both decreasing.
– The cash holding has increased since then, however the management is just sitting on the cash without any specific plans for the same.
– The market consider this company worth more dead than alive due to the fact that the core business is sliding and the management has not been able to turn it around and at the same time not returned the surplus cash to the shareholders

My key mistake in the above case was to ignore the management quality. I expected the business to have a very average performance due to the nature of the auto components business. However I ignored the management’s lack of interest in taking any value enhancing actions via dividends or buybacks. They have been sitting on the cash for quite some time and have not bothered to raise the dividend till date.

Holding the stocks at the current price is better than holding cash in my case. However I plan to exit once I can find an attractive idea. These stocks represent around 2% of my total portfolio and hence the impact on the overall portfolio is minimal. However keeping them around would be a waste of capital.

I may or may not declare the exact time of the sale too. If however I decide to provide an update, it would be via twitter as such an update is not suited for a post. If you are interested in it, then you can follow me on twitter.

As always, please read the disclaimer !

I typically do a detailed analysis of any company before committing a decent amount of money to the idea.

I have uploaded a detailed analysis of BEL (bharat electronics) and balmer lawrie in the past. I use this spreadsheet as a checklist and template for a detailed analysis. The spreadsheet is simple (though time consuming) and can be done by anyone. The spreadsheet ensures that I think through the idea in detail, but does not prevent me from making stupid decisions everytime.

It however takes a couple of days of complete this spreadsheet and in the end I post the summary of the analysis via a post on the idea. I have posted an analysis of LMW (lakshmi machine works) in the past and you can download the spreadsheet analysis from here. This spreadsheet was generated at the time i published the post on the company. Suggestion – do look at the sensitivity tab in the spreadsheet.

I have been toying with idea of how I can publish these spreadsheets on an ongoing basis. I have done them for free till date and am not interested in charging or making money off them. I actually find the idea of selling stock tips quite repelling.

At the same time I plan to leverage my work for other means such as charity. I am still working on that idea and will post in detail when I have done the necessary groundwork on it.

My plan is to connect with a well know charity and use my website and stock ideas to encourage contributions. If my blog and the stock ideas have been useful to readers, I hope they will contribute to a good cause in exchange. This will ofcourse be ‘voluntary’ and I have no plans of commercializing this blog, which is clearly a personal passion for me.

please feel free to leave a comment or email me on my plan.

The last one week has seen one of the biggest spikes in stock prices. Almost every kind of stock, has recorded a big jump in prices. Those of us who were lucky or had the foresight or both in buying stocks in the last 6 months, are now sitting on decent gains and must be feeling pretty smart and good about themselves.

I would hold my horses on that.

There is no harm in feeling good about it, but I would not let this feeling stop me from thinking rationally on what to do next.

Planning based on market forecasts !
One cannot be sure whether these price levels will sustain themselves or not. You will find every tom dick and harry trying to forecast or predict on what is going to happen. Well, if you are basing your strategy on these kind of predictions, then good luck with that.

I, for one have no clue and will not plan based on anyone’s predicitions or my ‘feel’ of what is going to happen. I did not have a clue in march, that the market would go up so soon and I don’t have a clue about the future market direction now.

During the period october 08 to March 09, I was a net buyer and commited a decent amount of money on a simple logic – The prices of the stocks I liked were attractive and way below intrinsic value and when they dropped below 50% of the intrinsic value, I bought.

Plan going forward
I have been analysing the annual results of all the companies I hold and re-evaluating the intrinsic value. If the price after the runup is still below instrinsic value and I expect the company to continue to do well and accordingly increase the intrinsic value at a decent rate, I will continue to hold. It would be stupid of me to sell a stock which still sells below instrinsic value, just because it has gone up by x%.

So what to sell ?
Now may also be a good time do some portfolio clean up. There are some holdings, especially in my graham style portfolio which are not doing too well in terms of business performance.

These companies have a stagnant or decreasing intrinsic value and hence holding them longer is of no benefit. I plan to take advantage of the recent runup to sell such holding and re-invest the cash elsewhere.

Finally, if the stock price has exceeded the instrinsic value and I don’t expect the increase in intrinsic value to be above a certain threshold, I will start liquidating the holding.

Let me explain: Suppose my estimate of intrinsic value is 100 and stock sells at 120. Now lets assume for simplicity sake that I think the company will increase the instrinsic value at 10% per year. So by the end of year two, the intrinsic value of the stock would be 121. Now for sake of an argument, lets say that the stock will contine to sell at a 20% premium to instrinsic value – 141.

On the other hand I can liquidate the stock at 120 and invest the capital in another company which is selling at say, 40% discount to intrinsic value. If this company also increases its intrinsic value by 10% per year and at the end of year two sells at intrinsic value, then the value of my holding would be 242.

The above is ofcourse a simplistic sceanrio and there are several other factors involved, but the thought process should be clear.

It is important to try to remain rational at all times as far as possible. Being overly giddy and happy now will hurt as much as being fearful did in the last six months.

Financials
The company declared fairly good results for 2009 with a topline and bottom line growth of around 30%. The ROE has been maintained at 30%+ levels and in addition the company continues to hold almost 10000 Crs of cash on its books.

The company continues to maintain one of the highest net margins (around 30%) in the industry. In the addition the various asset ratios such as fixed asset turns and working capital turns continue to be maintained at very high levels (in excess of 5)

Positives
The positives of the company are apparent. The company has very high margins, high returns on capital, has shown extremely high growth rates in the last 10 years and has one of the best managements in the country.

Risks
The positives of the company as far as the financial parameters are concerned are also the risks faced by the company. Contrary to the media reports, I don’t consider the recession to be a serious issue for the company in the long run.

The recession is bound end sooner or later. The company has substantial scale to ride out the recession. Inspite of the huge drops in the IT services market the company has been able to maintain its ROE and other financial ratios. At the same time, the company has now grown into a 4.5 billion dollar company and now competes with the likes of accenture and IBM.

Companies like accenture earn net margins in the range of 8-10% (with ROE in excess of 50%). These companies are fairly profitable companies in their own right, however not as obscenely profitable as the Indian vendors such as Infosys.

I personally feel, the tier I vendors have a good business model and will be able to do well in the long run. However their margins and profitability should eventually converge to the same levels as their foreign counterparts as they really don’t have any special competitive advantage over their foreign competitiors.

The above convergence could result in decent topline, but a lower bottom line growth.

Competitive analysis
I wrote about asian paints in an earlier post. I have worked in asian paints and have worked in infosys too. Both are good companies and have good managements. At the risk of comparing apples and oranges, I think asian paints has a higher competitive advantage over its competitors than a company like Infosys.

I have personally been involved in discussions within the company wherein we would struggle to differentiate ourselves with a competitor. I cannot say that for companies like asian paints (brand, distribution etc).

In spite of the above, infosys is a very good company with a decent business model. The biggest difference between a tier I company such as infosys and any other Tier II company is however the management (which I discuss below).

I personally feel, management quality is extemely important in the IT services business. This business has seen a lot of change and will continue to do so. A superior management will be able to drive the business better than the others.

Management analysis
Infosys is known for its management quality and corporate governance. Lets look at how it fares on the various points

– Management compensation : Management compensation seems to be fair. The CEO and top managers make less than 1% of the net profit. In addition the promoters/ managers have never awarded themselves any stock options till date.
– Capital allocation record : The capital allocation record is extremely good. Infosys is one of the few companies which explicitly state their ROE/ ROC objectives in the annual report (twice cost of capital on average capital employed). In addition, in view of the high cash holdings the company has raised its dividend to 30% of net profit from 2008 onwards. In summary the company has a fairly rational capital allocation process.
– Shareholder communication – The company has one of best disclosures and communication practise. I would advise you to read the annual report for this reason alone. The management has explained each P&L and Balance sheet transaction in detail and given the reasoning behind each. Most companies don’t bother with such disclosures at all.
– Accounting practise : Extremely conservative. Case in point – The company has adopted AS30 standard (mark to market accounting) a year in advance. This is the same standard which a number of other companies are resisting as they are likely to have huge MTM losses in the current fiscal due to rupee depreciation.
– related party transactions : Limited to transactions with subsidiaries.
– Performance track record : Very good. The company has always exceeded their guidance (although they under commit everytime). The company has performed quite well for the last 10+ years and have managed the growth fairly well.

Valuation
The company currently sells at a PE of around 14-15. I would not consider the company to be highly undervalued. Infosys of 2009 is not the same company as it was in 2000. In 2000, this was a very rapidly growing company, with commensurate risks. The company will have lower growth rate in the future , but at the same time it also has lower risks due to its scale and maturity of its business model.
I would roughly estimate the intrinsic value to be between 2000-2200 per share which can be revised based on how the company fares in the future. However it would be foolish to expect the company to fare as well as it has done in the past.

conclusion
Infosys is now a mature, well run company with above average growth. It has a shareholder friendly and competent management. The company should provide decent returns in the long run, but one should not expect very high returns.

Some Q&A
– Is it not smarter to invest in a smaller fast growing IT services company?
Yes, but the risk is also correspondingly higher. So it a different risk reward scenario in case of smaller IT services company

– Will cost pressures and other currency related issues not impact the company’s performance?
These issues impact all IT companies. However one can expect the management to respond smartly to these environmental changes by globalizing further. The management has successfully responded to the dot com bust, growth related issues and other challenges in the past. It is logical to expect that the management would continue to respond well to any current and new challenges.

Disclosure : I own the stock. Please also read disclaimer on my blog

I just couldn’t resist myself. I wrote in jan that the rebound would start on 22 april 2009 and then ‘predicted’ in feb that the bear market would end.

Wow! I got nailed it. I got two predictions right (ok, one is a little bit off, but give me a break). I am certified guru, soothsayer, the big kahuna and should be on CNBC !!. I should charge money for this 🙂

For those of you who reading this for the first time or are new to the blog – I am joking. I do not believe that anyone can predict the markets and it is a complete waste of time. If you guess enough times using all kinds of mumbo jumbo, you will get it right 50% of the times.

An investment strategy based on 50% success rate will get you nowhere.

A few more interesting points
I have noticed a few more interesting thought processes on other blogs and discussion boards.

– I like the company, but the next 3-6 months are likely to be bad and so I will wait till the performance turns
– I will wait till the election results are clear and then buy when the market crashes
– The export market is bad, US is doomed and I want to wait till everything recovers

So what is being said that one should buy when everything is bright and sunny (or at least everyone thinks so!). So the best time to buy was Late 2007 to Jan 2008. Everyone was optimistic about the world then. Now we all know how that turned out!

Maybe the above works if your investment horizon ranges from a few days to a few months.

However if you are investing for the long term, i personally think the smartest thing to do is to analyse companies in depth and buy them when there are selling at a good discount to instrinsic value.

In my previous post, I referred to a situation where I started buying maruti suzuki at 500 and when the price started going up, I hesitated and am still waiting to build a full position.

Although any price between 500-600 would have been good, I still ended up getting fixated with the price of 500 and lost a good opportunity. This bias is called as ‘anchoring’. An individual under the influence of this bias gets stuck or anchored to specific value (in this case a specific price) and does not take a rational decision.

So how should one avoid it ? My antidote to this problem is generally to focus on the intrinsic value and have a range of discounts (40-60%) from intrinsic value at which to do the buying. So if we say that maruti suzuki has an intrinsic value of around 1000-1100 , then any price between 450-600 is a good buying point. So, why didn’t I do it ? hmmm still thinking of a good excuse !.

Another mistake I have done in the past is to wait for the price to hit the 50% mark (50% below intrinsic value) and then start buying. The smarter thing to do, would be to buy in a price range.

A sell
I had anaylsed GSK consumer products a year back and had built a small position in it. However as the price never fell below 50% of my own estimate of intrinsic value, I never built more than a token position. The price crossed my estimates of intrinsic value recently and as a result I have closed my position at a decent gain.

The above idea is another example of anchoring where I got anchored to an exact 50% discount to intrinsic value. Finally, my own convicition about the stock has not been high and hence I could never convince myself to build a full position

Being featured
My blog was recently featured as one of the must read 15 blogs in india. A little publicity never hurts 🙂

In addition, my articles are now being published on some other sites, which you can see on the side bar under affiliations and a few more.

The affiliation with other sites is non financial. I have been aproached by various sites in the past to syndicate or publish my article and if I find the site to be decent, I have agreed to it.

However I have the following understanding with these and any future websites which may want to publish my posts
– I do not and will not write exclusively for anyone
– I will not promote any site on my blog. I will provide a link if required and the readers are free to navigate to the site and use it if they find it good.
– My articles should be published without editing and with due contribution to me
– Complete freedom on what I write.

So you may find articles from this blog being published at other sites too. However I do not have a business relationship with any of these sites. If that were to happen, I will be open and candid in letting everyone know.