AuthorRohit Chauhan

I recently responded to an email Q&A from PJ Pahygiannis. We covered some of the following questions and more

– Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas from?
– How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?
– What are some of your favorite companies, brands, or even CEOs? What do you think are some of the most well run companies? How do you judge the quality of the management?
– What kind of bargains are you finding in this market? Do you have any favorite sectors or avoid certain areas, and why?
– How do you feel about the market today? Do you see it as overvalued? What concerns you the most?

My response has been published on gurufocus.com. You can read the entire Q&A here. I hope you find the Q&A useful
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

We had two major events in the last few weeks – The election of Donald Trump as the president of US and the Demonetization of the 500/1000 Re notes

Let me start with the first event, which somehow was in the news for the last few weeks and I felt no need to respond or react. The event was a surprise for many and in a way similar to the Congress win in India in 2004. There was a sense that the market would crash if Donald trump is elected as president. I had no clue about what would happen if this event occurred, but to be frank I could not care less.

In investing, the key is to focus on the few critical factors which may impact your investment thesis and ignore the rest. I find it difficult to see why the election of a particular individual in a foreign company will have an impact on most of the companies in India at a micro level. Will consumers buy less soap or stop buying cars or going to movies just because Donald trump is elected in the US?

The more important event
The more relevant event for us has been the demonization of the high value currency. I personally think this a watershed event for the country. There are a lot of people looking at the interest rate and tax implications for the country, which I agree is quite good. However the bigger impact is from the signaling effect of this decision.

The second impact of this decision is that it sends a message that the government is serious about reducing tax evasion and corruption. A combination of GST, JAM trinity and now demonetization could be effective in reducing tax evasion (but not necessarily eliminate it). This would apply to a lot of unorganized sector companies where there is substantial evasion of taxes. These events are creating a level playing field in terms of taxation and will benefit the organized companies in the long run.

Analyzing the impact on your portfolio
The key point in the analysis of any major event is to evaluate the long term impact to the business model and profitability of the company.

I have no such plans for my portfolio. I made an argument in a prior post that we need to be ready for short term volatility and 15% or more drops from time to time. If one cannot handle these swings, then equities are not an appropriate vehicle. I will not sell any stocks where I think the long term prospects continue to be good, even if the near term appears horrible.

Let’s take the example of NBFCs to see how this event would impact some companies

We should however keep in mind that an NPA is not the same as a loss. An NPA means that the borrower has not made a timely payment and as a result, the lender has to mark the loan as non performing, stop accruing the interest income and add provisions (set aside some part of the profits) to account for the higher risk of non-payment.

Let’s look at a worst case scenario. Let’s say a company has around 1000 crs of assets on its books. Let’s make a very aggressive assumption that 10% of the assets will become NPAs with no hope that the borrower can become current on the loan. We can assume a 50% recovery rate on these NPA. So the eventual loss for the company would be to the tune of 50 crs.

Keep in mind that the above loss scenario is quite high in nature. Most of our poorly managed PSU banks have much lower level of losses inspite of much more illiquid assets and lower recovery rates.

I had written a post on first principles thinking as applied to investing here. As noted in the post, the intrinsic value of a company is the discounted sum of all its future cash flows. If you think of a company in that fashion, then by how much will you reduce the future value of the NBFC?

I think no matter how pessimistic you may be about the whole demonetization episode and the slow response of the government, it would be hard to argue that this issue will cause a permanent drop in demand for credit in the long run..

As an analogy, let’s say you are carrying 5000 Rs (in 100 Re notes J ) and you lose your wallet. It is a loss of 5000 and your net worth went down by that amount. However you future earning power which depends on your skills and other factors did not change due to this event.

The market reaction has been far more severe with some NBFCs losing almost 30% of their value in the last one month (almost 3-4 times our loss estimate).

We need to be prepared for a very ugly Q3. The demonetization event is likely to be quite disruptive to businesses in the short term, especially in the rural areas where banking services are poorly developed.

It will not feel good to keep losing money every day as the market corrects, but I plan to deploy some cash as bargains develop.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I wrote this note to all of my subscribers. Hope you will find it useful too

Let me state this again – My approach is to buy good quality companies at a reasonable price. There is nothing magical or new about this. Every other value investor professes to do this and I am no different. There is no secret sauceand I make it a point to share my thought process and analysis as much as feasible.

I have practiced a value based philosophy for the last 15+ years and it has served me well. I have no plans of changing a sound and logical approach for something else in the future. As long as I continue to do follow it rationally and with discipline, I think the long term results will be good even with occasional spells of under-performance.

One the first comments I get from a new subscriber after joining is this – I had a look at the model portfolio and I cannot buy more than 2-3 positions for now. I have a stock response for that – please be patient and give it some time. I have usually seen that most new subscribers are able match the model portfolio over a span of 2-3 years as some stocks drop below the buy level and new positions are added.

If you look at the price action of our 17 odd positions for the last two years – you will find that at least 14 hit the buy point and even went lower for a few days or more. So in effect, it’s quite possible to be 80% matched to the model portfolio for those who joined the subscription in the middle of 2014. I do not have the statistics of how many have done that, but my point is that over a 1-2 year time frame, one will get enough opportunities to buy and build your portfolio. One needs to have the patience to do that and not get swayed by short term events.

We started the model portfolio in Jan 2011. We have had several actual and imagined events such as Grexit (did not happen), Chinese hard landing (cannot say if that has occurred), Brexit (did happen), oil crash (occurred in 2014) and mismanagement of the Indian economy by the previous government.

Now someone could counter this logic by pointing the risk of 2008/09 collapse when mid and small caps crashed by 60%. What if one of these events had snowballed into a similar crisis?

–           For starters, one cannot invest based on the low probability, high impact macro events. One can diversify against black swan risks at an individual company level, but not at the country level. To give an extreme and silly example – how will you protect yourself from the risk of an asteroid crashing into a major city in India and causing a major economic crisis? Can one really diversify against such an extreme risk?
–           My second argument is that one needs to invest based on the higher probability risks (such as inflation) and insure against the low probability, but extreme ones. In other words, invest to beat inflation or secure your retirement and buy life/ health insurance to hedge the other extreme kind of risks. Finally there are some kind of risks, where one can only hope and pray that they don’t occur and we can do nothing about it.

If a 10-15% drop in the portfolio is going to scare you (as it may have in Feb of this year) and cause you to lose sleep, then equities are not for you. I can share my analysis and thought process, but cannot fix your temperament. You will have to bring a steady and calm mind of your own to the table.

Looking for trends
Some of you may have noticed that the model portfolio generally does not have a specific theme or view. One will often hear from investors that they have positioned their portfolio to benefit from better monsoon or revival in capex or some such factor.

One needs to keep in mind that a good monsoon or lower inflation is not a long term trend, but only specific events which play out for a small period of time. A long term trend would be something like demand for housing/ housing loans which leads to a growth of 2-3X of the average GDP growth rate.

Why am I discussing this point now? I think there is a lot of value in identifying such trends early and investing based on it, provided one does not overpay for it. As a result, I have now started looking at some of the current ideas from a trend point of view. We will however not know if the trend was real or a mirage, till a few years pass.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

A commonly used thumb rule in investing is that a company selling below a PE of 10 is likely to be cheap and one above 30 is likely to be expensive. I have been guilty of using this rule, often subconsciously and have paid a heavy price for it.

To see the example of a PE driven investment gone wrong, read the analysis of Facor alloys here. In a year’s time, I realized that I had made a mistake and exited this position with a 12% loss – you can read my analysis here.  If I had held on to the position, I would have lost close to 85% of my investment, even as the stock continued to sell at a very low valuation (current PE being 3)

Reasoning from first principles leads one to understand the fundamentals factors driving the issue in question. So how do we apply this concept to investing?

Quite simply, the one absolute and immutable fact of investing is that the value of an asset is the sum of the discounted free cash flow, it will generate over its life time. The above statement does not mean that an asset cannot sell above or below this value from time to time, but anyone holding an asset over its life time, cannot make more than the cash flows its generates over this period.

Lets break the above point down into its key components
–           Free cash flow
–           Lifetime
–           Discounted

Free cash flow – Can be estimated as follows : Gross rent – taxes – maintenance expense – other overheads

Lifetime –  This is the period an asset can be expected to generate a cash flow. In case of a flat or house one can take as it as 30 years, before one has to permanently replace it with a new construction. In an extreme condition you can stretch it to 50 years, however try letting out a very old house and you may realize that the rentals are much below the market rates.

So how would you value the house or flat now?
The gross rental yields these days are usually around 2-3%. At these yields , one is in effect paying 50 times pre-tax free cash flow. This of course assumes 100% occupancy and no taxes.

If you put all these cash flows together and discount it at around 10%, the final DCF value comes to about 1.5X purchase price. In other words, the asset is generating an IRR of 12%.

The problem with PE ratios
As you can see from the above example, the PE ratio is dependent on several variables which we had to estimate upfront. In the case of some assets such as a rental property, it may be possible to estimate it with a certain level of confidence.

Let say, for the sake of example, that the house turns out to be on an old burial ground where there are ghosts and so one want to rent or buy that land J . What happens then? Well the entire investment goes to zero.

So the initial PE turns out to be cheap or expensive depending on the subsequent cash flows and terminal value of the asset

In the case of companies, the problem we face is that the cash flows are quite difficult to estimate, there is no fixed duration and the terminal value in the real long run for any business is usually 0.

The above assumption turned out to be wrong. The cash flows were at a peak due to a cyclical high in demand from the steel industry. In addition to a crash in the demand, the management diverted the cash flows to another sister firm which demonstrated poor corporate governance.

As a counter example, consider the case of CRISIL(a past holding) which has always appeared expensive based on the usual measures of valuation. However the company has delivered above average returns as it has generated the expected cash flows without much variability in a fairly predictable fashion. The competitive position continues to improve and the company is likely to keep growing with a high return on invested capital for the foreseeable future.

The only way to evaluate if a company is over or underpriced is to be able to predict its cash flow. The higher the valuation, the longer the prediction period.

On the flip side, if you are looking at a company selling for 100 times earnings, one needs to have a high degree of confidence on the expected cash flow for 20+ years and beyond. Anyone claiming such clairvoyance is worth of worship !!

In summary, the best way to approach an investment candidate is to filter out the extreme cases and then dig into the business as much as possible. This should help one make a reasonable estimate of the cash flows and its duration. Once you have a reasonable fix on these key inputs, doing a valuation and comparing it with the market price is the easy part.

It is selling for 10 times earnings net of cash for sure. Personally I think the PE ratio here is meaningless. One is making a bet that Coal will continue to be a dominant fuel for us for the next 10-20 years in face of dropping cost of solar and other energy sources such as Natural gas. In addition there is also the headwind of climate change regulations and drop in prices globally. In short I don’t know enough to predict the cash flow and hence the idea is a pass for me. If you plan to buy or hold it, you need to answer the above questions with a high degree of confidence.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

The following note was recently sent out to the subscribers. I hope you will find it useful.

A few of you may have noticed the frenzy around the NBFC and especially the MFI (micro finance institutions) space. The buying frenzy is not entirely irrational.

The Indian household debt at around 9-10% of GDP is among the lowest in the world and there is a huge pent up demand in the retail / MSME segment. The introduction of adhaar, regulatory changes and several new technology tools is now allowing the NBFC segment to reach new customers at a much lower cost and achieve rapid growth.

So we have a confluence of factors coming into play here – A new regulatory and technology platform which allows companies to reach out to a large set of under-served customers at a time when the dominant players in the ecosystem, namely banks, are not in a position to take advantage of these opportunities.

Tread with caution
There is however a dark side to this whole opportunity – A growth of 30%+ may lead to poor lending practices and weak credit underwriting in several cases. This may be truer in the case of newer institutions which lack the experience and management bandwidth to manage this growth (and later collect the bad debts).

The time to be cautious is now and not when poor lending practices lead to a blow up in the future. In other words – tread with caution and be sure what you are buying.

What are we doing ?
We are already around 20% of our model portfolio in financials via four companies. These companies operate in different segments of the financial ecosystem and I believe that the management of each of these companies is competent and has seen multiple cycles in their respective businesses. At the same time, if the frenzy continues and our concentration in this business segment continues to grow, I will start reducing the position size.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

The following note was sent out to our advisoryclients in February. This was in response to the jitters, some of them were experiencing after a 15% drop in the market. I think this is valid in all kinds of markets including the optimistic one we have now.
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I am not feeling any better knowing that the model portfolio is down less than the overall indices. I increased the cash holding a bit in the last few months and avoided the momentum stocks in the later part of 2015. Inspite of these defensive measures, the portfolio is getting hit and it is not pleasant to see losses every day.

At the end of 2014, after a 100%+ rise, I had written the following

It is easy to feel smug and complacent after a 100%+ rise in the portfolio. However it is precisely at this stage that the risks are the highest. The various companies in our portfolio are performing quite well in terms of business performance (topline and profit growth). In addition, we exited a few companies where I felt that the performance depended more on the macro than the company specific condition such as the management or the target market

If your time horizon is less than 3 years and you cannot bear a 15%+ drop in the portfolio, then you need to take action when the times are good (such as now) and not after the market drops due to some macro factor.

In my case, I consider my equity investments with 3-5 year perspective (or more) and will continue to hold the positions through any future volatility.

I did not know when a drop in the markets will happen, but was sure that it would occur as that is the nature of markets – greed and fear. We had a period of greed in 2014 and 2015, which has now turned to fear.

At times like these, no one is looking at the company and its fundamentals. The selling is often driven by panic and a desire to reduce the pain.

The only difference is that I try to ignore the pain and focus on the individual companies, their business and the intrinsic value. That helps me in maintaining some level of rationality.

How to handle the volatility
Let me share how I am looking at the current situation (as I have done in the past)

I have been doing that for all the positions in the model portfolio and have exited some, where my level of confidence was not high . As the market crashes and causes some level of business risks, it is important to have a decent understanding of the companies in the portfolio.

Position size and diversification
I have often been asked about position size and the level of diversification one should have in the portfolio. I have a much simpler approach – size it to a point where you can sleep well. If the size of a position or the level of diversification causes you lose sleep, then it is too high.

Look at the intrinsic value
I have always emphasized the important of intrinsic value and its growth for a company. One should always focus on that number. As a long as that number is stable or increasing, then one should stop worrying about the stock price.

My approach during such times in the past has been to add to my positions slowly over time as they became cheaper (subject to size limits) and not expect to make a killing in the short term.

My effort is to reduce the level of risk (of permanent loss of capital) in the portfolio. I have not tried to reduce volatility actively. Courage and ability to ignore the volatility comes down to temperament and that cannot be supplied by anyone.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

Now this guy is quite similar to all his peers, but different from his hot blooded brethren only on one small point. He believes in saving and investing, but does not want to chase stock market returns. In the last few years, he read a few books on investing by john bogle, and decided that he was going to invest in some decent mutual or index fund and then leave it at that.

He sets up a simple plan:
–           Save 2 lacs per year and invest it in a few index/ mutual funds
–           Increase his savings by 5% every year to match inflation
–           Invest each month via an SIP to put it on autopilot
–           Avoid financial news on TV and use the spare time on other pursuits

Ten years later this guy who is now married, decides to have a look at his investment account. During this period, the overall market has delivered around 15% per annum for the last 10 years. He finds that his account is now around 67 Lacs. Not bad!

Its twenty years now since he started and one day his wife asks him if they have decent savings which can be tapped for their daughter’s education, 10 years from now.

At the age of 55, its time finally to fund their daughter’s education. Our guy, who is no longer as young, decides to look at his account and finds that the account has 16 crores!! This is far more than he ever imagined. Both he and his wife now start thinking of taking an early retirement. They figure that in 5 years’ time, the account would grow to around 29 Crs ** at the current rate if they can fund their daughter’s education from the liquid cash they have been holding on the side. This amount would be sufficient to retire and lead a comfortable life

–           15% consistent returns are good in theory, but the actual returns are more lumpy.
–           Not everyone can save 2 lacs or do that without fail every year

If you save consistently and do not withdraw the capital from the account, a smooth or lump 15% would still amount to the same in the end. It is only when people act smart and try to time in and out of market (and change the amount invested), that the eventual amount depends on the pattern of returns.

On the second point, 2 lac saving per annum may not be possible for everyone, but I am sure a lot of two income professionals can muster this level of savings. In addition, I have assumed that the contribution rises only at 5% per annum. In most cases, earnings and hence savings can rise faster than that.

However, If the reason for chasing returns in the market is to get on TV or twitter to show the world how smart you are, then we are talking of a completely different objective. In such a case, the actual returns have nothing to do with the money or financial goals.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.