AuthorRohit Chauhan

I was planning to publish the post below today, but then these attacks happened in mumbai. I am extremely angry and frustated, partly due to the fact that I have lived a considerable part of my life in mumbai and still have a lot of friends in the city. I wish I could write more. My only hope is that if you belong to mumbai, you and your family members are safe.

To buy or hold ?
Almost all markets, worldwide are dropping almost on a daily basis. Just as it was a no brainer last year to buy some stock and watch it go up, the reverse is happening now. I have received comments and emails asking if the right strategy in such circumstances is to wait for the bottom ?

Most of you, who have made any purchases in the last few months, would have seen the prices drop further. A common reaction is to regret the purchase and to think that holding out would be much better. I used to be prone to this ‘hindsight’ bias too. It is very common to see ‘hindsight bias’ in both bear and bull markets. After the event, you will feel or others will tell you that it would have been good to hold out (in a bear market) or to have bought (in the bull market).

Hindsight bias
This is faulty thinking. Although Hindsight is 20/20 , you cannot invest based on hindsight. Does anyone know how the market will do in the next few days or months or a year ?
If you do then you should buying options and betting on the direction ( I have done that a few times in the past). However when investing for the long term, based on underlying business value, timing cannot be perfect. As I have said in the past, if the stock looks undervalued by a large margin, create a 20-25% position. You can later add to this position as the price changes.

I typically create a 20-25% position and then start buying more if the price drops. If the price increases, then I will just hold and do nothing. The problem with this strategy is that it works well in bear markets, but fails in bull markets. During bull markets, such opportunities are quickly discovered and the price adjusts accordingly. This strategy could save you money in bear markets, but cost you in a bull market.

I am currently looking at CRISIL closely. I have written about it in the past and will publish some analysis in a subsequent post.

This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

– The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
– There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
– There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?

In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?

If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
And
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing – security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.

You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her 🙂

If you were to ask someone about his favorite stock, the odds are that the idea would be a company with high growth prospects. This extreme bias in favor of growth is quite pervasive. You will it in analyst reports, on TV and on discussion boards too.

The flip side is that if you mention a company with low or poor growth prospects, the other person is completely surprised. It is like you have belched in a social gathering!!

The problem is that almost everyone favors growth without really thinking about it. It is almost a herd like behavior where we have been conditioned to prefer companies with high growth prospects.

Is growth always good?
Growth in a company is usually a good thing, though not always. It is not written in stone that if you buy a high growth company, you will make good returns. There is more to investing than just growth. The value of a company depends on the following factors

– Does the company earn more than the cost of capital? More the better
– How long will the company earn more than the cost of capital? This is known as the competitive advantage period. Longer the better
– If the company earns more than the cost of capital, growth is good and adds value.

Mental checklist
So anytime you look at a company with high growth prospects, think of the following points

– Is the company earning more than the cost of capital and how sustainable is it? remember that companies earning high returns with high growth rates attract a lot of competition. Competition in turn drives down growth and return on capital
– How sustainable is the growth of the company?
– Does the valuation discount the growth already? I have seen a lot of people miss this point completely and overpay for growth most of the times.

The above factors are quite subjective and not really quantifiable. As a result high growth investing is not easy, requires more experience and judgment and there is a bigger chance of getting it wrong

Missing other opportunities
The flip side of focusing on growth alone results in missing opportunities where the growth of company is low or non-existent. Low growth industries are characterized by a lower competition, moderate competition and fewer companies with some enjoying a dominant position in the industry.

It is far easier to find a mispriced company in such situations as there are fewer investors following these companies.

I recently got a comment which raised the following points

– You seem to have done badly when the market went down and well when the market went up. I don’t see any special skill in that.
– The picks you have shared have not convinced me that these picks will do better than what I can achieve via indexing
– A lot of people seem to agree with your analysis. However if the stocks you have analysed do badly then the market is right and not you or the entire group, which agrees with you.

I have responded to the comment, but wanted to discuss these points via a post.

Special skills or not ?
The first and most important point for the readers of this blog is this – This blog is about ‘learning and applying value investing principles’. This blog is not about my performance or how good or bad an investor I am. Value investing is a commonly used approach to investing and my attempt has been to learn and share my learnings with everyone. My own performance (good or bad) do not change the principles.

My personal focus always has been to take publicly available data, analyse it and present the conclusions. It is not a sermon I am preaching from mount olympus. I am providing my viewpoint and analysis and opening it up for discussion – for and against it. If you are expecting stock tips or some kind of portfolio management, then you will be dissapointed.

I have never disclosed my performance on this blog and will not be doing it via this blog. My personal objective is to beat the index by 3-5% on a rolling 3 year basis. I have done that by a decent margin with low risk. I try to lose less than the index during bear markets and match the index during the uptrend. Till date, I have been able to achieve that.

You may have a different risk reward objective and may find this level of outperformance poor. Well, to each his own. Remember the following fact – A 3-5% outperformance is an annual return of 16-18% which is not easy to achieve. Over long term, this kind of annual return can add up to a decent amount. However over the last 3-4 years (till 2007), a lot of investors came to expect a return of 40% as a minimum.

How will the picks do?
How do you react when the price drops, but the company continues to perform well ? Do you think that you are doing badly?

If yes, then your approach is different from mine. My yardstick for performance is business performance. If the company does well, it is only a matter of time when the stock price will catch up with the underlying value. Sometimes it takes a few months and sometimes a few years.

A valid counterpoint can be – how are you sure that the price will converge to value ? It is based on my personal experience and based on what I have read about the experience of other value investors.

The other way of analysing performance is to compare the returns of your portfolio with the index on a long term basis ( I use rolling 3 years as 1 year is too short and more than 3 years is a bit too long). If you cannot beat the index, then you should look at passive indexing and not pick stocks. I have always maintained a mutual fund and index portfolio as benchmark to see how I am doing. Till date the results are good.

Finally, I am not trying to convince anyone with my analysis. I am presenting my analysis and opinions. It is upto to the reader to agree or dis-agree with the analysis.

Group think
I have never derieved satisfaction with how many people agree with me or not. The success of my picks will depend on the quality of my analysis and not how many people agree or disagree with me. I personally prefer counterpoints to my thesis as it helps me in improving the quality of the analysis.

I evaluate the success based on a single criteria : Is the business performing as expected or better ? If the business is performing well, I will hold the stock even if the price has not followed the business performance in tandem as price eventually follows value. I don’t judge my ideas based on short term swings in price. However if my assumptions or analysis are wrong, I have exited the position irrespective of the price in the past

I received this excellent question from prabhakar via email and have taken the liberty of posting the reply on the blog.

Hi rohit,
I have a query that’s bothering me a lot for quite some time now. Let me clarify at the outset that i believe in value investing(Buy something good way below its intrinsic value),no doubts about it.
Now i am stuck between two schools of thought here.
1) The Warren Buffett way — Buy a “great company” that is stable, when there is temporary trouble and it is selling below its intrinsic worth. Your returns will be decent(no multibaggers here) and compounded long term it work out well for you.
2) The Rakesh Jhunjhunwala way -Buy companies that are selling below intrinsic worth but that have a huge potential to scale big. You possibly get a multibagger here or you dont get anywhere.Example would be Titan & Pantaloon retail that he bought when they were relatively unknown.
Now the question is should we sacrifice multibagger potential for something that is stable?Or should we have both types of stocks in our portfolio.Whats your opinion?Which of the two philosophies is better?

Let me know your views if you find time.

I have thought along the lines of this question for quite some time and can reply from my personal perspective. Let me caution you – The answer to this question is very personal and depends on your own skills and beliefs.

I believe both the styles are equally good and can provide good returns. I would actually extend the question to RJ or WB or Benjamin graham (BG) style or a combination of each.

Key points of each approach
There are some key elements to each of these approaches. Benjamin graham’s (BG) approach is a very quantitative approach to value investing. The selection of an undervalued company is done based on various quantitative criteria such as low PE ratio, Market cap less than net current asset etc. There is a low to almost non-existent focus on the nature and quality of business. This approach is easy to follow, low risk and requires ample diversification.

WB’s approach takes elements of Graham’s approach such as margin of safety etc. However this approach relies less on the quantitative elements of the company and more on the qualitative elements of the business such as sustainable competitive advantage. The undervaluation is due to temporary factors such as losing a customer or some scandal, which has caused the earnings to drop in the short term. However the long-term prospects are still intact and hence the company is a good bet. WB’s approach focuses on the certainty of the long-term prospects of the company.

RJ’s approach builds further on WB’s approach. Here you are looking at companies, which are not undervalued by the traditional measures such as PE, DCF etc. The value lies in the business model and what the company will develop into.

Some Indian examples
A typical graham style company would be Denso or Cheviot Company. Here the company is selling for less than cash on the books or close to it. These companies are cheap by the traditional valuation measures.

A WB type investment could be GSK consumer or Concor or maybe Asian paints. These companies have a long operating history. They have a predictable business model and some competitive advantage. It is easy to look at the long term history of the business and project it to arrive at some measure of value. This investment approach is more difficult than the Graham style investing as it depends on the qualitative aspects of the business too. However it is possible to follow this style as it has quantitative elements to it and does not require a very deep understanding of business models.

An RJ type investment could be pantaloon or titan. This approach to investing requires a very deep understanding of business models and an appreciation of the qualitative aspects of business such as management quality, addressable opportunity etc. The current numbers of the company will not help you make a decision. If you get it right, the rewards are huge.

In addition RJ is moving deeper into this style by investing in smaller and smaller companies at an early stage (VC style) where the risk-rewards are higher.

So which is it ?
For me it is the BG or WB style. My skills have not matured enough for the RJ style of investing. I have looked at titan in the past and could not see the value. The reason I could not see value was due to my own shortcomings.

You may notice that my core portfolio is based on the WB style of investing, where as the other portfolio is based on the BG style of investing. I don’t have an RJ style investment at all and it is possible that I may never reach that level to make that type of an investment.

A common mistake
Don’t get me wrong on these examples. Yes bank, ICSA, Pyramid saimira and Dish TV are some examples, which fall under the RJ style of investing. The current numbers do not show an obvious undervaluation. The value lies in the future prospects of the business. Some of these companies have a new business model and if you can figure it out correctly, then you will make it big on these stocks.

I have however stayed away from these stocks as they are outside my competency.

I have seen a lot of new investors look at RJ’s philosophy and apply it to their picks. There is nothing wrong with it if you have it figured out and have the results and confidence to follow it. However I personally would not recommend following this approach till you have the knowledge, skill and temperament to follow it.

RJ’s approach is not for the faint hearted who is not ready to do his homework. RJ’s approach is easy to understand, but quite diffcult to execute and that where his genius lies.

I wrote in the previous post that I have changed my portfolio design and split it into two categories. The first group is the core portfolio which contains the long term ideas where the intrinsic value is increasing and I feel strongly about the long term prospects.

The second group called the graham portfolio, named after the dean of value investing – benjamin graham, will contain the statistically cheap stocks. These stocks are cheap by various measures such as PE ratio, Mcap less than net current assets etc.

I received the following question from manish and thought of replying to via a post

Also I will be curious to know your strategies for these two portfolios. Will you be looking for a certain percentage of gain (say 50%) for Graham Style stocks and exit. I believe you will keep holding Core Portfolio forever (until business is intact).

The graham portfolio would be at best 20-25% of my total portfolio. The percentage is not fixed and will depend on the number of attractive ideas I can find.

I will not looking at a percentage gain to exit these stocks. For me the sell decision would be based on two factors – If the stock is selling at or 90% of intrinsic value I will sell the stock. In addition if the fundamentals deteriorate considerably or if the valuation gap does not close in 2-3 years, I may decide to bail out.

The holding period for the core portfolio could be longer as the intrinsic value of the companies is also growing. So unless the stock is grossly overpriced, I may continue holding a stock for some time.

Lesser analysis
In terms of analysis, I spend a considerable amount of time on the stocks in my core portfolio. However for the graham ideas, I am looking at cheap, obviously undervalued stocks and hence the extent of analysis would be less. I would be balancing the risk by diversifying more in the graham portfolio. The graham portfolio is an opportunistic reaction to the market crash.

An idea: HTMT Global
HTMT global is an IT/BPO company. Hinduja TMT (now called Hinduja ventures) demerged their IT/BPO business in 2006 and merged that into HTMT Global from Oct 2006.

Financials
HTMT global had a revenue of around 673 Crs in 2008 and a net profit of around 87.4 Crs. The company had a net profit margin on a consolidated basis of around 13% and an ROE of around 26% on invested capital. The total capital is around 823 Crs and a net cash of around 430 crs on the balance sheet (held in the subsidiary)

HTMT global on standalone basis (excluding subsidiaries) earned 367 Crs and a net profit of around 58.8 Crs. The company had a net margin of around 16% on a standalone basis. The lower margins on a consolidated basis is due to the Subsidiary ‘Affina’, which was turned around during the year.

Growth numbers are not representative as the demerger happened in the middle of 2007, however the company has been growing in excess of 30%.

Positives
The company is doing quite well and has been expanding the scope of its operation in terms of headcount, new clients etc. Athough the numbers are not comparable, the company has shown almost 50% growth per annum for the last 7 years (although from a small base – see pg 6 of annual report). The company has a cash of almost 470 crs (Q1 09) which has been earmarked for accquisitions and should add value to the company
The financials are quite good, with good free cash flow and a good dividend payout of almost 100%.

Finally the valuation is amazing. The company is being priced for less than cash on the books which means that the company worth more dead than alive

Negatives
Hindujas control this company and are not know for corporate governance. In addition the credit crunch and recession could hurt the company’s growth. However in the long term this should increase the offshoring.

Conclusion
Unless you believe that the company is worth less than cash, you cannot justify the valuations. One likely reason for the crash in price is the sell-offs by FII’s.

I am still looking for more negatives on the company, but cannot find any. One has to keep in mind that the stock price is assuming worse than bankruptcy. Personally, I am looking at this stock for my Graham portfolio.

Over the past few months I have modified my portfolio structure a bit. I have now divided my portfolio into two portions. The core portfolio, consists of companies where the intrinsic value is increasing and i have a higher level of confidence about the company. The other portion is more of a graham style portfolio. This consists of companies which are extremely cheap based on the various measures such as market cap less than cash on book, ultra low PE or market cap less than net current assets.

The core portfolio is a larger portion of my total portfolio and has companies, for which I have done a deeper and detailed analysis. The ‘graham’ portfolio on the other hand consists of the ‘cheap’ ideas. These companies may not score high on corporate governance or may not be a great businesses, but they are insanely cheap.

The idea behind this ‘cheap’ stock portfolio is to take advantage of the large number of opportunities, which are coming up in the market now. Ofcourse the number of stocks I plan to hold in the ‘graham’ styled portfolio could be between 15-20 or even higher versus 10-12 in the core portfolio.

So why this disclosure?
I will post on such cheap companies as time permits. I am planning to add them under the category of ‘graham’ type stocks – cheap stocks, but not necessarily great companies.

This type of value investing is also called cigar butt investing and it was developed in 1920s by the dean of value investing – Benjamin graham. This type of investing is low risk, involves quite a bit of diversification and works best during bear markets.

So please don’t be surprised if I post on ‘not so great, but cheap’ companies. One can get decent returns from such a portfolio, provided you have adequate diversification.

Is the stock undervalued?
I am getting several comments and emails asking whether so and so stock looks cheap. The odds of a stock being cheap these days are very high. If you pick 10 stocks randomly, I bet 5 will be cheap. However the question most of us should be asking is not whether the stock is cheap, but whether one understands the company well enough and will have the emotional fortitude to withstand another 20% drop in the stock price.