Rohit Chauhan, Author at Value Investor India

Emotions and investing

January 6, 2015

10 Min read

We are all supposed to be perfectly rational, supercomputers that can do a discounted cash flow analysis on every investment idea we come across. If this is not enough, we are also supposed to be able to compare all investment options at the same time, before making a decision.

This is what most ivory tower professors would have us believe (except one ). Ofcourse this does a lot of disservice to a budding investor, who feels stupid when he or she lets emotions creep into the decision process.

I have invested for around 15 years now and in the countless investors I have followed, I have yet to come across anyone who comes close to this mythical investor. For the ordinary investor like me, I find it far more useful to acknowledge my irrationality and learn to work with it. Although there are no universal rules to managing emotions when investing, let me share my experiences as some would definitely be instructive.

Let’s start with a list of some commonly felt emotions and their impact –

Fear

Think back to August – Oct 2013. Rupee dropped close to 71 to a dollar. Current account deficit was around 5% and at the risk of expanding further. The Indian government led by congress was in a state of paralysis. The net effect – The stock market dropped close to 10%. The same story had occurred in 2003, 2008-09 and 2011.

Inspite of the economy and market coming back after a few years in the past, a majority of the commentators and investors decided to stay away from the market. This is even more surprising considering the fact that Mid caps and small caps were selling at 5-6 year lows and some highly profitable and growing companies were available at decent valuations.

My thinking: It is not that I am immune to fear and pessimism. I felt equal depressed about the state of affairs and angry with the government. However, during such times I go by my sense of history (past record of the stock market) and valuations. If the company is doing well and available at decent valuations, I will buy the stock without worrying about when I will be proven right. How does it matter if the stock doubles in one year or the end of year three?

Greed

I don’t have to go far on this one. Look around now – after almost five years, the small investor is now coming back. We have mutual funds advertising the last one year results and people are now getting excited about equity after a 55% rise from the bottom.

This is a very predictable pattern. Gold increased by 19% CAGR from 2001-2011 and everyone was bullish about gold.

Indians, with a perennial love for gold, found one more reason to buy it and anything associated with gold such as jewelry companies got swept up in the same euphoria.

Gold is down 25% now and so are gold related companies. As far as I know, I am not seeing analysts recommending gold or gold related companies now

So the emotion of greed is obvious – once we see others make money, it is easy to be envious and follow the crowd. The result is predictable too – The last people to join the herd also lose the most money.

My thinking: I have a standard thumb rule. Do not buy something which almost everyone is recommending. If I do buy into something which is the current flavor of the market, I try to move slowly into it so that I don’t lose much if the tide turns. In addition to that, I won’t buy something I don’t understand. For example – I was never able to understand what the true free cash flow for most gold companies is (except titan industries), considering all their profits are generally eaten up by inventory. As a result, I just stayed away from them.

Love and security

Now this is not an emotion, one associates with money and investing. I did not consider it relevant for a long time, but as I think about gold and real estate, I can see the role of these two key emotions

I first realized the importance of love and security as an investment criteria when my mother tried to convince me to buy gold to secure the future of the family. I tried to explain that equities give a better return, but soon realized that there was no way I could convince her. Of course, she decided to take matters in her own hands – she went and bought some gold for the family and said that that was her way of providing security to the family 🙂

The effect of emotional attachment is very high with gold – When it goes up, people justify its purchase based on the price rise. If it goes down, the justification changes to it being undervalued or being a hedge against catastrophe or any other reason you can think of.

If you still don’t agree with me – go to your spouse or any other member of you family and suggest the following: Please hand me your gold, I will sell it and invest it in a higher return instrument. In X number of years from now, you can buy more gold than what you have now. I have tried it and I am scared to use the two words ‘gold and sell’ again in the same sentence 🙂

Flaunting

If you think, love and security alone explains the fascination for gold – think again. I always found it irrational to buy gold or even real estate (beyond your housing need) if all that you are looking for is high returns.

This thinking changed when my family and in-laws felt that I had finally arrived in life when I bought my own flat with a big loan and essentially signed my life to the housing finance company (read EMI!). I never got any praise for buying an asian paints or any other long term compounder , whereas the flat was a concrete evidence (no pun intended) that I was doing something right in life

There is a tangible quality to both gold and real estate. You can see it, feel it and even flaunt it . In the past one could look and touch the stock certificates, but now with demat accounts what are you going to show others?

Imagine this fictious dialogue

Mom to her friend: My son has finally arrived in life! he bought a 1000 sqft flat in XYZ location. We are going to grah pravesh (house warming). Why don’t you join us?

Versus

Mom to friend: My son bought 1000 shares of asian paints. Let me show you his demat account! you know this company has a sustainable ……… will this dialogue ever happen!!

It’s the same with gold. Your wife or mother can wear the gold and in a lot of cases this serves to signal that the family or husband/ son is wealthy. So gold and real estate actually help in feeling secure or in displaying wealth. It is incidental that they earn some return too.

These emotions sometimes creep into stocks too. At the height of a bubble, investors want to invest in the hottest companies so that they can show their friends and colleagues how smart they are.

My thinking: In my own case, I have usually not felt the need to flaunt (or so I believe). At the same time, I try hard to avoid envy, which causes one to do stupid things such as chase the latest investment fad or buy stuff to show off.

There are only a two exceptions to the above rule in my case – The first one is that the emotional value of your own home is high, so it don’t look at it as a financial decision, but something which makes my family feel secure. The second one is that when my wife wants to buy jewelry I look at it as an expense to keep her happy

The driver

Volatility in prices is not an emotion in itself, but a driver of a lot of emotions we have been talking about. When stock prices crash, we can see that investors are overcome by fear, despair and in some cases complete disgust to the point of avoiding equities forever.

On the contrary if prices rise rapidly the reverse happens – we see greed and euphoria. These feelings are common to all investments, but as the volatility is high in stocks compared to other options, these emotions are amplified in the stock market.

I personally think that one of the reasons investors make higher returns in stocks compared to other options on average, is due to the higher volatility which tends to put off a lot of people. Investing in stocks is tough emotionally, no matter how long one does it. You go through periods of sickening drops and exhilarating spikes and it never gets easier, emotionally.

Take your pick

So it comes down to what one is looking for in their investments. If you want to flaunt your wealth or to feel warm and fuzzy, then go for real estate and gold. The returns could be good, if you have specialized skills in these asset classes, but then that is a different ball game.

If you want complete peace of mind – invest in Fixed deposits and sleep well. There is no harm in that!

If you are ready for a few sleepless nights, stomach churning drops in your networth (even if temporary) or sudden euphoric rise, and have nerves of steel to handle all of these emotions, then you will be rewarded with higher returns over the long term. That is equity investing

This brings me to a final anecdote –

I was discussing about expected returns of various types of assets such as real estate and stocks with a friend. I mentioned that one should expect anywhere between 15-18% from the stock market in the long run. To this, my friend replied that he ‘wanted’ nothing less than 20% per annum.

I asked my friend on why he ‘wanted’ these returns? Ofcourse he had no reason for it. It was just something he thought should be the case!

My reply was that like my kids, if you are wishing for something as they wish during Christmas from santaclaus, you should not hold yourself back. Why stop at 20%, why not ask for 100% – maybe your wish will come true!

We are still good friends, but don’t talk about investments any longer :). This is the final emotion a lot of uninformed investors suffer from – Hope

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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.

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Scared ? Worried ?

By Rohit Chauhan

In Uncategorized, Views on news

December 16, 2014

2 Min read

3 comments

Oil down 50%+, Ruble crashing. Rupee on its way down and maybe the stock market too !

Worried about your stocks ?

Take a deep breath and ask these questions (I ask some of them and a lot of times the answers I get make me see my mistake)

Are you retiring next year ? If yes, why the hell is that money in the stock market!

Do you understand the business and have confidence in the long term performance of the company ? If not, why did you invest in the first place?

Do you lose sleep from the volatility and quotational loss of your portfolio ? If yes, why are you not in just fixed deposits?

Do you have good health, another source of income and don’t need the money in the next few years ? If yes, then stop watching the financial news and go back to some more productive activities?

As I said in the previous post, I have a consulting service to provide a list of very productive activities to people who watch too much Financial news ! Call me for a free consultation 🙂

If you think this is new – read this, this and this. This is almost an annual or a once in two year affair. For the some of you who were wishing for bad times, be careful what you wish for! you may finally get it, so better be ready for it.

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Active patience

By Rohit Chauhan

In General thoughts, Uncategorized

November 26, 2014

5 Min read

28 comments

I think the next 2-3 years are not going to be easy, just because we are in a bull market. A few of you who decided to invest when India was supposedly going down the drain, must be feeling good about it. It is fine to feel good about it, but one should not get carried away by it.

More noise
In a bear market, as we had in the last 3-4 years, almost no one spoke about the stock market except as a place to avoid. Unless you turned on one of the financial news channels, it was easy to avoid any talk about it.

The advantage of this comparative silence was that you could think investing without too much distraction. The situation has changed quite a bit in the last few months. We now have friends, colleagues and relatives, all getting excited about the market. If like me, your acquaintances know that you invest in the stock market, I am sure you must get badgered with tips for the top ten hot stocks which will double in 21 days – small caps especially.

In my case you can imagine the disappointment – recommending people to invest in 2013 when no one wanted to, and being cautious now when everyone and his dog thinks we are at the start of a multi-year bull run.

Feeling envy
It is easy to feel envy when you see others do better during such times. The media adds fuel to the fire by publishing the list of stocks which have gone by 50 or 100 times in the last 4-5 years. Ofcourse, they were silent when these stocks were starting the journey.

In addition, you now have friends and other investors boasting how they doubled their money in the last six months, by buying the hottest idea.

One can abandon his or her approach and start chasing such stocks which have worked well for others in the past. From personal experience, I can tell you that this never works out (atleast for me).

Unnecessary churn
As the market touches new high, I think some people get itchy to sell stocks which have given high returns and recycle them into new positions, which ‘appear’ to be cheap.

I am looking for new ideas too, but will not do it for the sake of ‘doing something’, unless I think it will add to the overall returns. If this means doing nothing for long periods of time – so be it.

Let me explain further – I currently have around 19-20 positions in my portfolio. I am constantly looking for new ideas. As I am close to fully invested, I will have to sell an existing idea, incur the brokerage and taxes (if any) and then buy the new position. The implication of this decision is that I expect this new idea which has been analyzed for a few weeks, will do better than an existing company which I have analyzed and followed for more than a year.

There are people who are smart enough to do this consistently – I am not one of them. I do not want to take these decisions lightly. If the time horizon is 2-3 years and more in my case, it is really important that I take a little more time to think through this decision.

Being patient is never easy
I have found bull markets to be far more difficult to handle than other times. For starters, it involves doing nothing for long stretches of time, when stocks are going up and you are missing out on easy money ( that the easy money is lost in the end is a different matter).

Let me ask a few rhetorical questions (which I keep asking myself too) – is it really important to have all the hottest stocks in your portfolio? Is it really necessary or even possible to have the highest possible returns at all times, if a lower rate of return at much lesser risk will meet your goals ? Is this investing or just showing off?

The main challenge we will face in the coming months and years is to keep our heads amidst the euphoria. It is very easy to get carried away and starting buying marginal companies showing profit and stock price momentum – I have done that a bit in the past and it has always come back to bite me.

Let me suggest a few activities to keep you busy while waiting for the right opportunity
–          Watch TV soaps, especially the family dramas. They have a lot of twist and turns too (or so I have heard)
–          Take up body building or weights. You will have chiseled body if the bull market turns out to be a 10 year one J
–          Go for long walks and walk a little more every day. If this a long bull market, you may be walking the whole day
–          If you are single, go to parties and have fun. If you have been investing in the past and not partying, shame on you anyway – what a waste of youth!

For those of you who like me, cannot do any of the above – keep faith and hope. This too will pass. The skies will turn dark again, and they will be gloom and doom. You will get your chance then J

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How to reject a stock

By Rohit Chauhan

In Uncategorized

September 28, 2014

6 Min read

9 comments

How to reject a stock?

Is this a crazy idea? Why should you have a checklist to reject stocks?

You will generally find ten tips to select the next ten bagger, but not many write on how to reject stocks.

Let me first try to convince you why this a sound idea –

The problem of abundance
A typical well diversified portfolio tends to have 15-20 stocks (anything more does not reduce risk any further). Let’s assume that the holding period is 2-3 years per stock. So in effect one needs to find and replace 5-7 stocks per year in the portfolio.

Even if one assumes a much higher level of diversification, I cannot see a scenario where one is replacing more than 10-12 stocks per year (as an investor and not as a trader).

We have around 5000+ companies listed in the stock market and a selection of 10-12 stocks means that you will reject 4990 stocks (if you were able to have a look at all the companies each year). That is around a 99%+ rejection rate. Even if you were to play around with the number of stocks you can analyze each year and the number you end up selecting, I cannot envisage a scenario where you will reject less than 95% of the stocks you review.

If you are rejecting stocks most of the time, does it not make sense to have a checklist to make the process more efficient and robust?

Finally a corollary to my point –The main problem is that we are not limited by choice, but by time and effort.

Building the framework

To design a rejection checklist, it’s important to understand what we are looking for and identify factors which negate that.

At the risk of oversimplication, I would say a long term investor is looking at high rates of return for a long period of time. Putting it quantitavely, I would say that I am looking at a CAGR of 26% per annum for 3-5 years or longer if possible.

So what are some of the characteristics of a company which can deliver these kinds of returns?

–          The company operates in an industry with above average growth rate which means that the industry is growing atleast at 15%+ rates (higher than the GDP).
–          The company is able to earn a high rate of return on capital (atleast 15% or higher) for a long period of time (sustainable competitive advantage)
–          Company is led by a competent and ethical management
–          The company is selling at reasonable valuations

Easier to reject stocks
You must have noted that I have omitted a lot of factors which go into selecting a winning stock and that’s precisely my point. Selecting a profitable stock is a complicated Endeavour and one can write books on it and still not cover all the points needed to identify a profitable idea.

On the contrary if one inverts the idea and looks for an approach on how to lose money on stocks, the list becomes surprisingly small. This is also called the Carl Jacobi maxim on inversion

So let’s look at how we can select stocks to lose money
–          The company operates in an industry which is in a terminal decline (fixed line telephony) or is highly cyclical, commodity in nature and with very poor return on capital (metals, sugar, airlines etc)
–          The industry is subject to a lot of change (regulatory, competitive or technological) which causes several companies to fail or loose money due to sudden change in the competitive scenario (telecom, mining etc)
–          The company is managed by an unethical and incompetent management (do you need examples here?? – just look around )
–          The stock is purchased at high valuations in a cyclical industry right at the peak of the business cycle. To add insult to injury, the company is managed by an unethical and incompetent management. This combination of factors is guaranteed to loose atleast 50-60% of your capital if not more

That’s it! I think the above four factors will help you weed out 80% of the stocks in less than an hour

Is it comprehensive and works 100% of the time?
Of course, this list is not comprehensive. I can come up with a lot of additional points, but I can say that these broad criteria can be used to eliminate a lot of companies at the first glance.

Some of you may point out that you are aware of a company XYZ with above characteristics, which gave a 50% upside or has even been a multi-bagger.

My counter point is – Do you really want to search for a needle in a haystack when there are often gems lying around? If your idea of fun is to find that nugget of gold in a pile of manure, then welcome to my world. I have engaged in it often and the results are not great compared to the effort put in. In addition if you are not a full time investor, then it makes all the more sense to focus your limited time on good opportunities.

The benefit of my mistakes
The list I have shared is not something I have just dreamed up while sipping coffee. I did a small exercise of listing of my failures for the last 15+ years and found a few common threads among all of them. If I boil it down, it comes down to the four points listed above.

Now, I know some investors who are able to make good returns by investing in cyclical or commodity stocks. Some others are able to do well, even if the management is not great. However I am quite sure that a majority of investors cannot achieve superior results if they decide to ignore one or all of the four points listed above.

Let me make another bold claim – if you want to lose 90% of your money, buy a highly cyclical and commodity type company at high valuations at the peak of the business cycle and run by an incompetent and crooked management. You will be guaranteed this result. How do I know – I tried it a few times and have never failed to loose my shirt (and other garments!)
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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.

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The costs of investing

By Rohit Chauhan

In Uncategorized

August 27, 2014

7 Min read

12 comments

Cost is an important, though poorly understood aspect of investing. It is important for the simple reason that costs reduce the overall return one makes from an investment option. It is also poorly managed as people focus too much on explicit costs (cost of brokerage or fees) and ignore the hidden ones (such as opportunity costs).

As an investor, you have the following few options

a.    Fixed deposit : cost 0, likely return : 8-9% (pre-tax)
b.    Index fund ETF: cost 0.6% to 1%. Likely return : 14-15% (pre-tax)
c.    Mutual funds (HDFC equity fund): cost 2%. Likely return : 20-21% (pre-tax)
d.    PMS: usually 2% of asset and % of gains. Likely returns: Who knows?

The options

Fixed deposit and index funds are zero or low cost options with the FDs having no volatility, but much lower returns. IF you want to build wealth, an FD is not going to get you there. Index funds are a decent alternative, where the risk of active portfolio management is removed. You don’t have to worry if your portfolio manager is an idiot who will underperform or worse lose money over the long term.

The third option is a well managed, diversified mutual fund with a long operating history. We can quibble about which mutual fund to choose, but I prefer one which has been conservatively managed for a long time. HDFC equity has been around since 1995 (almost 20 yrs) and has delivered good performance over the years. I am not recommending HDFC equity fund, but using it as an example of a well managed fund which has returned above average returns over the long term.

The last option is private vehicles such as PMS (portfolio management schemes). These involve high costs, and in some cases deliver good returns. However they have a mixed record and are generally not a good option for most investors due to a high minimum investment.

The math

Let’s take a hypothetical case

Let’s say you have 9 lacs to invest. It is Jan 2011 and you are looking for some avenues. You decide to invest equally in the three choices I have discussed above (lets ignore PMS for the time being)

At the end of 3.5 years, you will have following sums with you
Fixed deposit (pre-tax): 4.05 Lacs (pre-tax) and 3.84 Post tax
Index fund (pre-tax and post tax): 4.18 Lacs (net 1% as cost)
Mutual fund (pre-tax and post tax): 4.62 lacs (net 2% management fee )

The last 3.5 years have not been really that great for the stock markets (around 10% CAGR). Inspite of that, the index fund was able to do better than the FD on a post tax basis. The same held true for a well managed mutual fund too.

The explicit costs
In order to make the higher returns, an investor had to contend with all the volatility and noise in the market. In addition to the emotional toll, there was an explicit cost of around 3% for the index fund and around 6% for the mutual fund.

Most investors tend to ignore these costs unless it is pointed out to them. If someone told them upfront that a 3 lac investment in a mutual fund would cost them 18000 over three years, they would balk at it and run towards FDs , real estate or gold.

Inspite of these costs, if an investor could stomach the volatility, he or she came out ahead during one of the lousy periods in the stock market.

Implicit costs

If you think explicit costs are bad, I would say the hidden costs are even worse.

So what is the hidden cost for an FD? It’s the opportunity cost to create wealth. In the above example an FD would cost 20% more than a mutual fund over a 3-3.5 year period (difference between the amounts after 3.5 years between the two options).

This difference only increases over time and would be even wider once the market performs close its long term average (15-17%) and interest rates drop.

I am sure I will get a counter point – how about real estate or gold. Let’s look at each of them –

If you bought 3 lacs of gold in Jan 2011, you would have around 3.78 Lacs of gold now (at pre-tax). I don’t want to discuss taxes as paying taxes on gold is different issue altogether. So gold did barely as well as an FD. Keep in mind that gold over a 20 year or longer period has delivered 9-10% per annum despite the recent runup (excluding transaction and holding costs)

Let’s move onto the next darling – real estate. So what returns can one get here? Well all of us have stories about how person xyz made 10X the capital in 5 years. Well, that is the equivalent of saying some investors made 20X their capital in page industries.

The returns on a specific investment – a stock or a property is not same as the return of an entire investment class. If you want to look at the average returns, look at this table by NHB. The returns vary from -15% for a Kochi to 249% returns for Chennai over a 7 year period. So we are talking of -2% to 15% per annum for different locations. This does not even include taxes, brokerage, and maintenance fee (For property).

Now the final argument would be – I was able to find a property and invest in it for a 10X gain in the last 5 years !

Congrats – but then you are missing the final point. The final point is the cost of time and effort – if you are a full time or even a part time investor in RE, you are using knowledge/ skill/ time to dig out such deals and investment in them. As you do this, you are not using your time do XYZ (spend time working, with your kids, play – whatever you can think of)

Compare all costs
IF you truly want to compare multiple investment options, compare all the costs – implicit and explicit

The explicit costs are fees and taxes. These are generally obvious and laid out to an investor (though still ignored). The implicit costs are usually hidden and often bigger – they are the opportunity costs of money (not investing in equity) and of time (spending time on investing versus other pursuits)

It is foolish to look at some costs and declare a particular option as better. Maybe I value peace of mind and time with family more than returns – in that case an FD is better. My own dad valued these attributes more than returns and spent his spare time with his kids and on his own hobbies (without ever depriving us of anything in life)

On the other hand, there are people like me who love the process of investing and enjoy the higher returns. In my case, the vehicle is stocks and some other cases, it is real estate. There is an implicit cost (time and energy) involved in earning the higher returns, which we don’t mind incurring, but it is a cost all the same (my wife can vouch for it !)

In addition to these costs and corresponding returns, I would say there are emotional and bragging benefits to various options which will be the subject of the next post.

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An update on selan exploration

By Rohit Chauhan

In Uncategorized

July 24, 2014

3 Min read

4 comments

I had written a note about Selan exploration here. I will not repeat the analysis as the main thesis laid out earlier, still holds true.

An update

The company is cheap from multiple perspectives – enterprise value per barrel of oil reserves, EV/EBDITA etc. However due to lack of timely clearances for drilling new wells, the production and profits have stagnated for the last few years. As a result, the stock price stagnated for a few years, before the recent run from the 200 levels to around 620 now.

The company has recently started receiving approvals and has been able to re-start the drilling program. As per the latest annual report, the company has been able to drill around 10 wells and is in the process of completing the same (connect the drilled well to pipelines or other modes of transport)

In addition to the above disclosure, there is another very key variable which is showing an upward trend – development of hydrocarbon properties. This is the cost incurred by an oil and gas company to prospect for locations for new wells and then drill the well and complete it. The company has spent close to 80 Crs in the last four years in prospecting for new drilling locations.

The more interesting bit is that the company has ramped up the actual drilling and completion expenses in the current fiscal which has jumped up from 6 crs to around 55 Crs. This is a very critical variable to track as oil and Gas Companies need to drill new wells to grow production (and hence profits and cash flows).

We cannot be sure how many of these wells will be successful and when exactly they will come online. At the same time, the typical lead time from start of drilling to production of oil and gas varies between 6-9 months. So we are in effect talking of about 3-6 months of time for the oil production to ramp up.

In addition to the above, the new government seems to be focused on improving the speed of clearances and get projects moving on the ground. Considering that approvals came to standstill in the last few years, any progress on this front will help the company tremendously.

This is not a core position
This is not a big position as i think it is risky for the reasons already detailed in my earlier post. Let me repeat the key ones

– The company has inadequate level of disclosures for an Oil and gas exploration company

– The management provides the minimum level of commentary on the performance and outlook for the company. There are no interviews, quarterly conference calls etc. In effect short of speaking to the management directly, there are no publicly available sources of information. One is driving through a foggy windshield and being forced to make inferences based on published data

In view of the above, I have around 2% of my portfolio allocated to this idea and may add more if I think the price is getting attractive.

Please do not consider this to be a stock recommendation and do you own homework. Please read the disclaimer if you still have some doubts

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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.

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How to miss a 10 bagger

By Rohit Chauhan

In Uncategorized

May 31, 2014

7 Min read

31 comments

What is worse than losing 100% on a stock ? It’s missing a 10 bagger !

What’s worse than missing a 10 bagger ? It missing a 10 bagger which you identified and decided to take no action inspite of knowing about the company. Now you must be thinking – that’s quite dumb ! In a way it is, but as always the story is more nuanced than just being dumb.

So what’s the name of this mystery company ?

Let me give some more hints J ..I wrote about it in July 2010 when it was selling for around 80 Crs market cap. It now sells at around 1400 crores. That’s a 20 bagger excluding dividends during a period where the market has gone nowhere.

I won’t tease you any more ….the company name is Mayur uniquoters! See the post here.

Now I can assign this to bad luck and move on. However I have never operated this way – I want to dissect each failure – failure of losing money or failure missing out on a 10+ bagger.

How did I miss it?

I wrote about this company in July 2010 when it was a micro cap and started a small position in the company. I was comfortable with the financial performance of the company, but was concerned with a corporate governance issue – issue of warrants to the promoter at below market price, when the company did not really need the extra capital.

As the stock price rose, I lost interest in the company and sold my small position as I was not comfortable with the corporate governance issue. In hindsight, I do not fault myself for this decision – it was the right thing to do based on the facts known to me at that point

The downside of labeling

So where did I really go wrong? As I look back, I can attribute the failure to a label I attached to the company. I was not comfortable with the management and attached the label of ‘poor corporate governance’ to the company.

After I sold my position in 2010, I continued to track the company and could clearly see the good performance. Inspite of the facts, I refused to change the label and remain locked to an existing view although the management did not show any new governance issues.

First conclusion or confirmation bias

The other name for this locking is called the first conclusion bias (read here). Once I had reached a conclusion I refused to change it, inspite of evidence to the contrary. It is only after the evidence became too obvious to ignore that I have revisited my conclusion and realized the flaw in my thinking

The illusion of high valuation

If mayor uniquoters was an isolated example, it would have been comforting to ‘label’ it as an aberration and move on. However there are a few more examples (atleast ones which are obvious to me).

Let me give another example and the back story behind missing the multi-bagger

Hawkins cooker: This stock was pointed out to me in 2010 when the company was selling at a PE of around 15. The company was and is easy to understand, has great economics and a wonderful management. So if such a company was presented to me on a platter , why did I ignore it ? The single word for that is valuations – The Company was selling at a PE of 15+ which in my mind was expensive.

I started off my investing life with high quality companies such as asian paints and Pidilite selling at reasonable valuations (15-18 times earnings) and slowly graduated to graham style low PE stocks (the reverse of most people). Over time, I got locked into a mental model where I started equating a low PE with an attractively priced stock and a high PE with an expensive stock.

The above thought process holds true in isolation, but it is important to consider the PE ratio in context of business quality. A business with weak economics is a bad stock even if it has a low PE and an exceptional business with a moderately high PE can still be a great stock. I have been aware of this fact, but still had to relearn this important concept all over again

How to change your mind ?

It would be safe to assume that if you are presented ‘data’ which contradicts your assumptions, you will change your prior conclusions ? Atleast not in my case !

Let me point to two extreme example –

Ajanta pharma has been a multi-bagger since it was pointed out to me by a very smart investor – Hitesh. I still have the email in which he shared the idea with me in 2011. At that time, I was not comfortable with pharma companies and thought that I could not judge Ajanta’s future prospects accurately.

That’s a reasonable argument and can be a plausible reason, but for the fact that this idea was posted on the website – valuepickr by Hitesh and donald. This website is run by Donald Francis and it has a lot of good investors who write regularly on it. The good thing about this forum is that Donald, Hitesh and ayush have encouraged a long term investing mindset with a focus on the process of investing. I am not praising the website due to any vested interest (I don’t have any), but think that one should read through the analysis on some of the picks made by the team

I personally follow this site and occasionally post on it too. Ajanta pharma and Mayur uniquoters are two such ideas which were posted on this site and analyzed in a lot detail. I have been following these companies over the last few years and inspite of over whelming evidence did not take the plunge

So much for changing my mind based on evidence !

How to change ?

The first step in fixing a blind spot is recognizing one. Now that I have recognized multiple biases in my case, I have started focusing on the following points in my investment process

–          Do not equate a high PE with expensive. Analyze the business in detail and determine if the company can still double in 3 years at current or slightly lower valuations
–          Focus on quality before valuations
–          Constantly question my own conclusions. I have started doing this after each quarterly result – does the company match the original thesis (positive or negative)? Do I have access to some new non-quantitative information which should prompt me to revise my original thesis ?

I have already made changes in my stock picks in the recent past and the initial results are good. In summary I think there is a lot of value in analyzing the success of other people – not to be envious of them, but to reverse engineer it and improve your own process.

Ps: if you guys have some stock tips, do send it my way. I will have a more open mind on it now J
—————-
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.

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Shortest investment book

By Rohit Chauhan

In General thoughts, Uncategorized

April 19, 2014

1 Min read

20 comments

1.    Save atleast 20% of what you earn

2.    Buy a term life insurance policy such that the policy value = 30-50 times annual expenses (add health insurance to this if required)

3.    Park 10-20% of savings annually in liquid deposits (Emergency fund or for down payment on a house)

4.    Invest 60-80 % of savings via SIP in an index fund or a basket of diversified mutual funds like HDFC equity.

The above is enough for 90% of the people to retire comfortably at the end of a 40 year working life. Anything beyond this just commentary !

So there you go – no need to listen to any broker , read this blog or any investing book J.

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Patient Wealth creation

By Rohit Chauhan

In Competitive advantage, Investment process, Uncategorized

April 5, 2014

7 Min read

8 comments

This is a commonly used, but rarely defined word. I am going to argue in this post that the sole purpose of investing is wealth creation.

What is wealth creation ?

Let’s take a numerical example. Let’s say you have 100 Rs. You can invest it in an FD at around 9-10%. At the end of 5 years, you will have around 161 Rs. We can call this the baseline level of return .

However putting money in a Bank FD is not a riskless transaction. If the inflation during this period turns out to be 11%, then you would have lost 5% of your buying power. On the other if we take the average inflation of the last 20 odd years, then the buying power would have risen by 15% over the same period.

Have you created wealth in the above case ? I would say yes, as you have been able to increase your buying power over the investing period, but not by much (15% at best on average).

Let’s say one were to invest in the stock market (via index funds) for a 5 year period. On average, the market has returned around 15-17% per annum over the last 20+ years. If you back out an inflation assumption of 7%, then the buying power would rise by 61% for the period. Now we are talking of some serious wealth creation !

However the above example has a catch – I spoke about an average return of 15-17%. The reality is that the stock market returns are lumpy and you can have a period of 2003-08 of 30%+ returns and then a period of 2% returns for the next 6 years (2008-2013). So in this case, one is talking of wealth creation with an added level of risk.

The above examples are quite obvious , but ignored by many. We need to concentrate on post tax, post inflation returns to evaluate the wealth creation potential of an investment option. If you have a higher buying power after taxes and inflation, then you have created wealth.

The aspect of time
I arbitrarily considered a time period of 5 years in my example. What is the correct period? 1 month, 1 year or 20 years?

I would argue that the time period for wealth creation should be driven by your personal goals. Are you saving (and creating wealth) for the purpose of buying a house or retirement? If that is the case, then the period should be upwards of 10 years.

Let’s put the above two point together – One needs to make a level of post tax, post inflation returns over the investment horizon (10 years +) such that you can meet your personal goals. Why else would you put your money at risk?

Now there a lot of people who invest for the thrill of it (for 100% return in days !!) or to boast of their investing prowess to their friends and impress the other sex , mostly women – who from my personal experience, don’t care about such silly things J ).

It is fine to put your money in the stock market to feel macho about yourself – but let’s not call that investing. Bungee jumping off a cliff is also done for thrills, but no one calls its investing !

Following the logic

If you agree that the purpose of investing is wealth creation over a long period of time, it is important not only to earn high returns, but to also do it consistently over a period of time. There is no point earning 30%+ returns for four years and then losing 50% in the 5^th(Which will translate into an 8% annual return)

Why is consistency important ? If you can earn 15% consistently for 20 years, you will have 16 times your starting capital and 40 times if the rate rises to 20% per annum. This is simply the magic of compounding.

Now If you shift your focus from high returns (to feel good or boast about it) to consistent returns (to create maximum wealth), the investing approach changes.

Implication of consistent returns

If you are looking for above average, but consistent returns for the long run what should one look for ? If you are looking at earning a 15-20% return over a 10-20 year period , I would suggest looking for companies which are earning this kind of return on capital now and have the capability to do so for a long period of time.

If you can find a company which has a sustainable competitive advantage (sustainable being the key) or a deep and wide moat, then it is likely to maintain its current high return on capital. If you buy such a company at a reasonable price (around the median PE value for the company), the results are likely to be good over time.

Let’s look at an example here – This is a current holding for me and not a stock tip. The name is Crisil.

You can read the analysis here.
Following is a table of price, and annual return/ CAGR for the last 10 years

As you can see, even if you purchased the company on 31^stDecember each year (blindly without worry about valuation), you would have done well. This result boils down to the following reason

– The company has a wide and deep moat in the ratings industry due to government mandated entry barriers (none can just start a ratings agency), Buyer power (Companies have to pay to get their debt rated and the cost is usually a small percentage of the debt) and lack of substitutes (even banks insist on company ratings now based on RBI directive).
– The deep and wide moat has enabled the company to maintain a high return on capital of 50%+ for the last 10 years. The company has been able to re-invest a small portion of its profits to fund its growth and has returned the excess capital to shareholders via dividends and buybacks.

A strong competitive position and good management with rational capital allocation approach has resulted in a very good result for the shareholders.

The catch
There always a catch in investing – nothing is as easy as it looks. For starters, this approach requires a huge dose of patience.

How many active investors (me included) would like to select a stock once in a few years and then do absolutely nothing for a long period of time ? In every other profession, progress is measured by level of activity – except investing, where sometimes doing nothing is much better.

The other catch is that this approach is very boring. You find a few companies like crisil and then spend maybe 1 hr each quarter and a few hours every year end reviewing the progress. If the company is still performing as it always has, you have no further work left. If you are a professional investor, what are you going to do with the rest of your time ??

The last catch is that this approach has a level of survivorship bias. If you select a wrong company or if the competitive advantage is lost during the holding period, then the returns are likely to be poor or even negative.

Returns over entertainment
Although this ‘rip van winkle’ approach makes a lot of sense, I am unlikely to follow it fully. I enjoy the process of investing, looking for new ideas and doing all kinds of experiments. At the same time, a major portion of my portfolio is slowly moving towards such long term ‘wealth creation’ ideas.

In the final analysis, investing should be about wealth creation and achieving your financial goals.

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A contingent stock

By Rohit Chauhan

In Investment ideas, Uncategorized

March 8, 2014

7 Min read

5 comments

A few disclosures – This is a borrowed idea. I will not use the word steal, as I got it from a friend J

This idea was published by Ayush on his blog (see here) and then he mentioned it to me via an email. I was intrigued by the extremely low valuation (which is not obvious) and some medium to long term triggers.

I started looking at the company in the month of December, and before I could create a full position, the stock price ran up. Inspite of the run up, the company is an interesting, though speculative opportunity.

Another disclaimer – I hold a small position in my personal portfolio, but as it is a speculative idea, I have not added it to my family or the model portfolio.

The company

The name of the Company is Selan exploration and it is an E&P (exploration and production) company. The company has five oilfields – Bakrol, Indrora, Lohar, Ognaj and Karjisan

As part of the NELP policy, the company has the rights to explore and develop these oil fields. The company was among the first private sector players to get the rights to do so and if successful in finding oil and gas reserves, they have to pay a certain level of royalty to the government. In addition, the entire production of the company is taken up by the government or PSU under the production sharing contracts

The E&P business

The basics of exploration and production are actually quite simple to understand – The government grants the license to explore and exploit a specific area which may be rich in hydrocarbons, under a specific contract. The company winning the contract then undertakes exploration of the area using various advanced technologies such as 3D seismic surveys and exploratory drilling to identify the size of the reserves and the best location to drill wells to exploit these reserves.

Once the reserves are delineated (identified), the company applies for the various clearances (such as environmental) which once approved, allows the company to drill production wells. Although the technology is quite advanced and allows a company to identify deposits accurately, it is not a precise science and hence a certain percentage of the wells may turn out to be dry wells (not enough oil in that particular location). These dry wells have to be abandoned and the cost has to be written off (similar to a product which fails in the market).

The productive wells, once online produce oil and gas which is transported via pipelines or other means to oil refineries.

The problems

Let’s start with the problems which have caused the stock price to stagnate over the last few years. That will also give us an idea of the medium and long term triggers for the company.

The company was granted the exploration rights in the 90s and has been able to increase the production from 62000 BOE in 2004 (barrel of oil equivalent) to roughly 2.82 Lac BOE in 2009. I described the process of license, survey, clearances and approvals to get to the final production stage of drilling the production wells and pumping out the oil.

As you see from the process, we have government involvement at each step and anything where the government is involved means lack of clarity and uncertain timelines.

As has happened for multiple sectors in the economy, the clearances for drilling production wells came to a halt in the last four years. Due to the nature of oil exploration and production, the current wells start getting exhausted in time and if you are not drilling new wells, the overall production starts dropping.

In case of Selan exploration, production dropped from 2.8Lac BOE in 2009 to 1.64 Lac BOE in 2013. The revenue dropped from 99 Crs to around 97 Crs in 2013 and the net profit was roughly the same (at around 45Crs)

A mumbo jumbo of terms

Before I get into what is the opportunity here, let’s talk about a few terms for the Oil and gas industry. For starters, barring Selan and Cairn (I), I don’t think the PSUs in this sector are worth considering as investments. These companies are run as piggybanks by the government to subsidize fuel in the country. It is debatable on how good that is for me as a citizen, but I am clear that it is a disaster for a shareholder.

If you want to understand how the industry works (without the chaos of government interventions), you may want to look at US and Canada based companies such as Chesapeake, Devon energy or Exxon Mobil. If you are looking at a pure play E&P Company, there are several small companies such as Novus energy or Jones energy.

Why bring up these non Indian companies? Any US or Canada based company has to declare several key parameters which help an investor to analyze an exploration company. Some of those parameters are

2P reserves (proved and probable reserves)

Operating netback per BOE : revenue minus cost

NPV10: DCF valuation of the reserves (revenue based)

EV/BOED: Enterprise value/ Barrel of oil equivalent in reserves (valuation measure)

Cost curves, EUR, Exploration cost and well IRR (for each field)

Current oil flow rate (BOED) to understand the current revenue levels

You can find the definitions easily by doing a Google search for these terms.

So which of this data is provided by Selan exploration? None!

Are they doing anything illegal? No, because I don’t think there are clear disclosure norms on the above for Oil and gas companies in India (none that I could find). In comparison, Cairn (I) has more disclosures and communication.

The thesis
In absence of this disclosure, why even bother and move on to something else? That is a valid point and hence I have called it a speculative bet as I am making it with minimal information.

What do we know here?

For starters, it seems that the company has 79.2 Million (7.9 Crore) BOE of reserves in two fields alone (Bakrol and Lohar). The company sells at around 1.2 dollar/ BOE (EV/2P) versus 5.5 for cairn (I). Comparable companies in the US/Canada sell at around 8-12 dollar/BOE. Of course the foreign companies are not comparable, due to a very different regulatory environment.

In addition to this valuation gap, we are not even considering the potential reserves in the other fields (which seem to be bigger than the ones in production). So we are talking of a situation where the market is valuing the company based on the current production rate (Which is suppressed due to lack of approvals) and is not giving any credit for its reserves.

The company is able to generate a pre-tax profit of around 70 dollars / BOE versus 10-25 Dollars for the US/ Canada companies. The huge difference is due to the fact that Selan produces mostly oil compared to oil and gas in case of other companies.

So the company is very cheap based on known reserves and is also quite profitable. In addition the company has spent close to 65 Crs in the last three years on exploration expense (remember the surveys to find the oil and gas reserves?). Once it starts getting the approvals, it can start drilling the wells and start pumping out money …sorry oil.

So why is this still speculative or contingent? It is contingent on the company receiving approvals – Which is seems to be getting recently based on the update in the latest quarterly report. These approvals are based on the whims and fancy of our government and one can never be sure what will the scenario be next year.

Why is it speculative – because there is so little disclosure and we are using the reserve numbers from a past annual report? We do not have any clear updates in the latest reports and so it is like driving with a foggy windshield window.

I have taken a small bet on the company to track the company and may buy or sell in the future based on new developments. As always, please do your homework and make your own decisions.

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

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AuthorRohit Chauhan

Emotions and investing

Scared ? Worried ?

Active patience

How to reject a stock

The costs of investing

An update on selan exploration

How to miss a 10 bagger

Shortest investment book

Patient Wealth creation

A contingent stock

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