Rohit Chauhan, Author at Value Investor India

A 2X in 3 years

February 1, 2014

4 Min read

I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.

I did not discuss about how to rank the various stocks in the portfolio. I will discuss the business aspect of the ranking in a future post. Let me share some thoughts on how to consider valuation when doing this exercise.

A 2X in 3 years
As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?

Note the use of the word – potential. One can never be sure if the stock would double.

How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.

If however the stock is selling below fair value, then we may get an additional bump from an increase in the PE ratio. However I would prefer to place a higher wieghtage on the earnings growth than the valuation – which depends more on the whims of the market.

Not a scientific exercise
One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.

All the above points are true and I could add more. However the point of the entire exercise is to look at the potential of each stock (atleast annually) and assess its attractiveness based on new information. It is easy to fall in love with a position (especially in my case) and hang on to an old thesis, whereas the world around the company has changed completely.

What do to with such cases
Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?

Lets bring in the concept of opportunity cost. Lets say you dont have a better idea. Then the alternative is to sell and invest it in a fixed income instrument. Is the opportunity cost around 9% then? .

I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned 15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio

Why is this your opportunity cost ? The reason is simple – you have been able to make this return in the past on average and if you sell the existing position and hold cash, something will surely come up in time to deliver this kind of return. You may not make this return the next month or next quarter, but can expect to make it over the next few years.

So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.
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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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Experimental investing reportcard 2013

By Rohit Chauhan

In Uncategorized

December 30, 2013

6 Min read

3 comments

I ran a few ‘experiments’ during the year, some of which I wrote about on the blog. As the year draws to a close, I am preparing the report card and as always it’s a mixed one – Lots of D and F and not a single A J

One point to keep in mind is that I run these experiments with miniscule amounts of money. The emotional pain is no less if the experiment fails, but the damage to the wallet is minimal (as my wife puts it, everyone needs their vices J).

Let’s look at some of these experiments, learnings and plans for next year.

Buying dirt cheap stocks
The main ‘idea’ behind these positions was that the stock was dirt cheap and hence once the pessimism cleared, the price would bounce back

Let’s look at two cases under this category

Business cycle related
The capital goods sector has been hit very hard in the last few years and the news worsened during the year. As I wrote in this post – ‘How I think about macro’, I personally thought the pessimism around this sector was overdone and one could look for some quality firms in the industry to take a position at rock bottom valuations.

My pick was BHEL as it was selling at a 10 year low in terms of valuation (you can download my calculations from here) and I personally thought that if the company could be profitable even under such trying circumstances, then it was worth a bet.

You can see the price action below

As you can make out, my timing was hardly perfect. I was early and averaged down as the price kept dropping. My average cost worked out to around 120 and my sale price was around 160, resulting in around 35% gain during the period

So what’s the grade ? It’s a B at best for the following reasons

Learnings
– I don’t have timing skills and this episode proved it again. I care about buying at the right price rather than at the right time. However in the above example, it is important to get the timing right too, otherwise one will have to wait for a long time. A number of fellow investors I know are experts at this – but I am not. As a result, this type of investing has rarely worked for me.
– Due to the lack of timing skills (and being aware of it), I have been hesitant to create a large position in such opportunities. The result of a small position is that a 33% return, does not move the needle on the portfolio. As a result, buying such kind of stocks, which I do not plan to hold for the long term are just a waste of time (for me)
– These kinds of timing opportunities in the end may just be good to keep me entertained, but will not add to my returns in the long run.

Management issue

I wrote about zylog here. I laid out the argument for this position in the post and the reason for the eventual exit.

What was the net result ? A 70% loss and an F grade.

It is easy to look at this episode with hindsight bias (management was suspect and hence one should not touch the stock). Around the same time last year, I was looking at some high profile cases of failure (read here) and wanted to test the following hypothesis – is it possible to figure out management fraud from publicly available documents such as annual reports (market grapevine does not count).

I looked at zylog and saw that the stock had dropped to around 20% of its peak price. As I could not find anything suspicious in the documents, I decided to create a tiny position in the company.

The above trade turned out to be a disaster as it soon became known that the management was indulging in insider trading.

Learnings

– The above action by a management would land it in jail in most countries. In India, they are just prohibited from trading in the market. Should we still wonder, why the small investor does not trust the stock market ?. I learnt a powerful lesson from this episode – if there is some smoke, there is usually a fire.

– As a small investor, I am a sitting duck and can be taken for a ride by a management if they wish to do so, without any consequences. The best bet for me is to have zero tolerance for management ethics. If something is fishy, don’t touch the stock, no matter how attractive the idea.

Value trade
I wrote about this short term opportunity here. As I noted in the post, this is a stock which had become cheap for short term reasons (quarterly earnings miss), though there was no long term issue or any management concerns.

The idea was to buy the stock dirt cheap and sell once the short term pessimism wears off. The price action of this trade is given below

So what was the net result – around 40% gain and I would give myself a B+.

This type of investing is more suited to my personal temperament. I am able to analyze that the market is being too pessimistic due to short term factors. If the business is doing fine and there are no management issues, I am able to take a mid size position and make reasonable returns over a one year time frame.

These kinds of opportunities are not risk free (infinite computers has its own issues) and there is always an element of luck in it. However, some of these opportunities can act as placeholders for cash, if I cannot find something better to do.

Not all trading
If you have started reading my blog recently, you may feel that I am into short term trading. That is miles from the actual reality. The above cases, are just experiments on the side, representing not more than 1% of my personal portfolio.

Why do it ? I will put it down to curiosity. I just like to explore different approaches and see how they work out. In the end, most of them turn out to be unsuitable to my temperament. I am not saying that these are not valid approaches (others may do it well), but just that they don’t suit my temperament,

The long term changes
The key change I have been focusing on my core portfolio, is moving towards higher focus or concentration. I have kept a fairly diversified portfolio in the past with majority of positions under 10% of the total portfolio. I have now started increasing the size of some positions where I have a higher level of confidence in them.

Chicken that I am, the move is likely to be very slow and measured.

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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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Patterns of failure

By Rohit Chauhan

In Investment process, Rejected investment ideas

December 14, 2013

5 Min read

12 comments

Failure is a better teacher than success. This holds true in the case of investing too. I have been looking closely at some of the recent cases such as Arshiya international, gitanjali gems, CEBBCO, Kingfisher airlines, Zylog limited and some older ones such as reliance communications, DLF, SSI, aftek and many more.

These are extreme examples of spectacular drops in stock price of 80% and more. These examples are the exact inverse of multi-baggers and a few of such positions can decimate one’s portfolio. I have mostly been able to avoid such cases in the past (except SSI and zylog, which was self inflicted) and think it is important to avoid such extreme failure to make above average returns

Why analyze such cases? On that count, I am following these comments from Charlie munger on learning from failure

You don’t have to pee on an electric fence to learn not to do it
Tell me where I’m going to die, that is, so I don’t go there

It is not always fraud
I have seen an oversimplification on the cause of failure in the above cases. A lot of investors think it has been caused by management stupidity or greed. The reason for this conclusion is due to some high profile failures such as satyam.

It is easy to say that the management was unethical (Which is true in several cases) and hence the business failed. I think that is intellectual laziness. There are several other companies where the management is a bit suspect, but the company and its stock has not collapsed (though did not perform as well)

Some key factors
On going through all these companies, I am able to see some common threads. These factors may be present in combination in some cases or one of the factors could be dominant in others. In most cases, however it was the combination which sank the ship

1. Low return on asset/ equity due to commodity or highly competitive business (think airlines or telecom)
2. Low free cash flow (after taking into account Working capital needs and obsolescence risk/ business model changes )
3. Growth obsession funded by debt, resulting in high debt equity ratios (2:1 or higher
4. Cyclical industry with 1,2 and 3
5. Growth obsession with expansion into foreign markets (most likely from pricey acquisitions) stemming from management’s grandiose views of building an empire (rather than focusing on value creation)
6. Management failure/ governance issue (with diversion of funds into sister firms in some cases)

The steps to destruction
Let’s look at some kind of chronology of events leading to the eventual collapse in the stock price

1. Company experiences temporary success due to a cyclical high or tailwinds (look at the long term base rate to identify this situation). In some cases, success is from sales perspective and ROE and cash flows are still weak.
2. Management feels bullish and starts adding capacity/ businesses. In a lot of cases this is funded by debt or FCCB type equity.
3. In some cases, management goes abroad and acquires assets at high prices stemming from delusions of empire building (aka ‘Indian name’ in foreign lands)
4. Business encounters a hiccup or a cyclical downturn. The cash flows dry up and management finds it increasingly difficult to service the debt.
5. Management fudges the numbers for some time and tries to keep things afloat (bullish statements, confidence in the business inspite of worsening fundamentals such as negative cash flow, worsening debt service ratios etc)
6. The pack of cards finally collapses when the company defaults on its debt (openly or in private). When the market gets a hint of this, the stock price collapses almost overnight and the outside investor is left holding the bag

What to avoid
If you like the principle of inversion and think high cash flows and low debt is the sign of a healthy company, then one should avoid a company with poor cash flow and high debt irrespective of the story or future prospects (which are always rosy).
It’s quite possible, that you may miss some of the real turnaround cases, but on the balance I think it one would do much better by avoiding such companies

Bull market stocks
A lot of companies with poor cash flows and high debt did quite well during the previous bull market and a majority of the investors choose to ignore the red flags. Why bother, when you are making money ?
It is during tough market conditions, that the chickens come home to roost, and a lot of investors (me included) get a lesson on risk.

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Its all about pschology

By Rohit Chauhan

In Uncategorized

November 25, 2013

7 Min read

2 comments

I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (hereand here).

Some good books/ resources on the topic are listed below

Poor charlie’s almanac
Thinking fast and slow
The psychology of influence
The art of thinking clearly
Seeing what others don’t : The remarkable ways we gain insight

Professor sanjay Bakshi’s website (here) and all his lectures (here). I would encourage everyone to read the lectures multiple times.

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy
This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted, then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

It is however dangerous to get seduced by a story stock or company. Unfortunately you can find investors buying into stories all the time and overpaying for it. The stories change, but the basic theme is always the same. A new or exciting development comes to the attention of a few investors (IT stocks, real estate stocks or consumption stocks). These smart investors have the insight of investing early at attractive valuations. This ‘story’ is soon picked up by the media and now others follow blindly into the story at astronomical valuations. The ‘story’ feeds on itself and everyone looks good as long as the price is rising. At some point investors start realizing that the valuations are too optimistic and the selling begins. The ‘story’ is discredited and investors wonder how they got sucked into it

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Base rate neglect

If you ask someone an unpleasant question – are you more likely to die in an airplane crash or heart attack, what is the more likely answer? I can bet in the majority of the cases, it would be the airplane crash (heart attacks are a more common cause). An airplane crash is more vivid and comes on the front page of a newspaper, whereas heart attack deaths are almost never publicized.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

How does one take advantage of base rates? One needs to focus on areas where the odds favor you. It is far easier to do well with companies and industries where the underlying business has a high rate of return. In such cases, unless one pays too much, the investor is likely to do well over time.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

Over optimism and overconfidence

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

If you find yourself, attributing all the success to your intelligence and failure to bad luck and other factors, you may be crossing the line. As an investor, if your performance is not above average (after several years) and you still think that there is nothing wrong with your approach and think that it will all work itself out, then you need to dial down your confidence and optimism.

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

In my case, the actual results have given me the confidence to be more aggressive, though I still finding myself doubting all the time.

No silver bullets
We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

The first step in overcoming these biases is to recognize them and acknowledge that we are often influenced by them. The next step is often to build routines to reduce their impact or negate them completely. Some shortcuts I try to use

– Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price
– Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision
– Try to look for at least three reasons which could cause the idea to fail
– Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?
– Avoid IPO, options and current fads
– Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.
– Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.
– Don’t tell about your losses to your wife. She will think that you are smarter than you really are J

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Becoming rational

By Rohit Chauhan

In Uncategorized

October 29, 2013

5 Min read

2 comments

I personally think that being rational is extremely important in becoming an above average investor. So how does one become more rational?

There is a book called – predictably irrational by dan ariely which talks of the irrational behavior in most of us. The more interesting part of the book however is the ‘predictable’ part. It means that most of us are consistently irrational. The good thing about this predictability is that if one can identify these patterns, then there is a possibility of reducing the irrationality (I don’t think it can be completely eliminated)

The first step in reducing the irrationality is to name and classify the various behaviors which impact us negatively as investors. I started exploring the various biases which affect us in the previous post and will continue with a few more in this post.

Authority bias

You may seen this bias in others (most people think they are themselves immune), when they purchased a stock based on a recommendation by some TV presenter or commentator. In other cases, the recommendation may be from a broker or some sales person in a bank.

I have personally avoided this bias in the above form by having a simple thumb rule – TV presenters are actors and should be watched for entertainment alone. As far as brokers and sales people are concerned, I refuse to listen to them.
The above comments may imply that I am immune to this bias – but I am not. I follow a few other bloggers and top investors. In the past, if one of them was invested in a stock, I would develop a much more positive view of the stock and even went ahead and invested in the same.

The biggest source of my bias has been from the top thinkers in the field of investing (Warren buffett, Ben graham etc). It is not that their teachings are not worthy of following, but I have followed them blindly without understanding the context.

Case in point – Warren buffett talks of the buy and hold philosophy. A lot of people miss out that they he does not imply buy and forget and certainly not buy and hold bad companies. The pre-requisite condition is that one should buy a good company at an attractive price and then hold it for a long time. I have bought duds and then held it for some time, thus compounding my mistake.

How does one avoid this bias – As in all other biases, it is not easy. I have found one approach which works for me a bit – Never accept blindly what others say (including your idols). I try to analyze the context of a statement or idea and try to think of a scenario where that idea is not true.

First conclusion bias
This is a very common bias and we know it by another name – First impressions. We tend to form opinions of other people in the first few seconds of meeting them and then any interaction tends to re-inforce the impression. This bias has a lot of implication in job interviews, but that is a separate topic.

In the case of investing, this is closely related to the commitment and consistency bias. As an investor, I have found that when I am looking at a company and its financials, I tend to form a fuzzy view of the company in the first few minutes – such as looks worth of investigation (may even buy) or maybe this company is junk. Once I reach this view (often subconsciously), my subsequent analysis and thought process is influenced by this first conclusion. In addition, if I make a token purchase the commitment and consistency bias kicks in. Once this happens, my decision is kind of locked (even if i think it is not)

How does one avoid it ? For starters, I look at a company and form a view (even if subconscious) and then just drop further analysis. I make a note of the company and then move on to something else – allowing for a cooling period. I will usually come back to it after a few days and then read up on it further – making notes as I go along.

The final decision to buy comes usually after a few weeks and even then the position is a small one. I am not sure if I have been able to reduce the bais, but it prevents me from buying a stock when I am in heat. The downside is that the stock price may run up before I can buy a full position, though in balance I would rather loose the upside occasionally than make a foolish decision.

The next post will the final one on this topic and I will explore a few more biases and discuss how it is important to build routines in your investment process to reduce their impact.

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Kill your beloved ideas

By Rohit Chauhan

In Uncategorized

October 22, 2013

5 Min read

10 comments

I have been reading a few behavioral finance books on the various biases which impact us as investors (and in other walks of life too). I have picked up this topic of study for a very specific reason.

I have been analyzing my investment process and am realizing that the weakest link continues to be the various biases which commonly impact us. If I look back at the last 15 years of my investing life, I can safely say that I was fluent in the basics in the first couple of years and could identify good ideas by the fifth year.

The above statement would imply that I was an expert by year 5 and poised to be a good investor. Unfortunately the reality was far from that – you can read my journey till 2008 here. Knowing what to do is different from doing it.

Let me list a few biases and how I was impacted by them. I will also try to explore what one can do to avoid them

Social proof

This is a bias where in one is influenced by other investors and the general mood of the crowd. I wrote about a mistake I committed a long time ago – purchase of SSI and IT mutual funds during the dot com boom.

Although I was new to investing (around 3-4 years), I understood the importance of valuation and of not overpaying for stocks. Inspite of being cautious for the majority of my portfolio, I still went ahead and committed 25% of it to IT related stocks. As I look back, I recall that the main reason was that a few of my friends were investing heavily in this sector (and getting rich). In addition to this, a nice and pretty broker also recommended a few hot mutual funds (such as ICICI technology fund) which were sure to make me rich in a few years.

How could I miss?

I managed to lose 80% of my capital in a short period of six months. This was unmistakable evidence that I had made a spectacularly wrong decision. Ever since then, I have followed a few simple rules to avoid getting influenced by the crowd
– Do not buy hot stocks. If the media is talking a lot about some hot sector or all my friends are getting into it, I will just avoid it. As a result I did not touch the real estate and infrastructure stocks during the 2007-2008 period and spared myself of a lot of agony
– Do not take stock tips from anyone, especially pretty girls J

Anchoring bias

This is a bias wherein one gets fixated on a variable in the decision making process and uses that to make all subsequent decision. This is a difficult bias to recognize and overcome.

I had been following Crompton greaves limited for some time and decided to buy the stock in 2011 after the company reported poor results in the first quarter. The stock dropped quite a bit after that and I started purchasing the stock as it ‘appeared’ cheaper compared to the past results.

In the case of stocks, investor returns are dependent on future performance, but the data to evaluate that comes from past performance. It is an art, more than science, to evaluate the past results and arrive at an appropriate conclusion. In the case of Crompton, I got anchored to the price and the past fundamentals and did not weigh the state of the industry and management issues more heavily.

How should one avoid this bias? Once you have purchased the stock, it is very difficult to avoid the anchor of the purchase price and past performance. The best approach I know of is to be aware of this bias and constantly question your reason for holding a stock.

Commitment and consistency bias

This is a tendency to be consistent with one’s behavior in the past. It is a good way to behave in life – if you have been a decent and honest person once, you want to continue and be committed to that behavior.

However this behavior can cause a lot of trouble for an investor. Once you have purchased a stock, there is a tendency to be committed to it and as a result one tends to underweight any negative information about the company.

Look at any stock boards – majority of the investors are talking about the positives of the company. If you are already invested in the company, does it make sense to find any additional information which just confirms your belief? How will that benefit your decision?

I have suffered from the same bias and I can’t think an easy way to avoid it. I have purchased value traps like Cheviot Company and held onto them even though the company continues to deliver mediocre performance and the stock price was stagnant.

The approach I take now is to rank all the companies in my portfolio in a descending order of attractiveness. This forces me evaluate more idea more objectively. Once I have my rank, I compare any new idea with the last idea in the list. If the new idea is better than the last one on the list, it gets replaced.

The title of this post comes from the concept of Darwinian selection – kill the weakest ideas to make way for the stronger one. This also reduces the impact of the commitment and consistent bias.

I plan to cover additional biases such as the authority bias, availability bias and more in the subsequent posts.

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Analysis: Supreme industries

By Rohit Chauhan

In Investment ideas, Uncategorized

September 18, 2013

7 Min read

17 comments

About

Supreme industries is a leader in the plastics processing industry and processed around 2.45 Lac metric tonnes in 2012. The company processes polymers and resins into various plastic products. The broad verticals for the company are as follows

Plastic piping including CPVC pipes
Consumer products such as molded furniture
Packaging products such as specialty and cross laminated films
Industrial products such as Industrial components and Material handling products
Construction business wherein the company has developed a corporate park on some excess land in Mumbai

The company has around 22 plants across the country which has helped it in reducing the transportation cost for the products (an important factor for operating margins).

Financials

The company achieved a topline of around 2900 Crs and is expected to close the current year at around 3500 Crs. In addition the company earned a profit of around 240 Crs (8% Net margins) and should be able to achieve a single digit growth during the year. The lower growth in net profits is due to lack of sale of commercial property in the current fiscal.

The company has been able to maintain an ROE in excess of 25% for the last 6 years. The debt equity levels have dropped from around 1.5 to around 0.6 during this. The company has also been able to improve the asset turns from around 2.5 in 2007 to 3.5 in 2012 as a result of an improvement in working capital turns (mainly driven by lower receivables as a percentage of sales).

The company has also improved its net margins from around 4% in 2007 to around 8% in 2012 driven by an improvement in overhead costs and depreciation as % of sales.

Positives

The company operates in a commoditized industry and as a result several products of the company earn low margins. The company is now focused on developing new products (called valued added products) such as CPVC pipes, cross laminated files and composite cylinders which have a higher operating margin (17%) than the other commoditized products such as molded furniture. The company plans to increase the contribution of these value added products to around 35% by FY15 and expects to improve the overall operating margins to around 15-16% levels

The company has a wide distribution and production network and well established brands in the plastics product space. The management has been able to use these assets effectively in entering higher margin products while exiting the commoditized segments at the same time.

The per capita consumption of plastics is around 7 kg versus almost 30-70 Kg in other countries. As a result, the industry is likely to see sustained growth for sometime as the per capita consumption increases with a rise in the income levels. In addition to the demand tailwind, companies like supreme are likely to benefit further as the industry continues to consolidate and the market share shifts to the organized players.

Risks

The company operates in a highly fragmented and commoditized industry. Although the company has been able to maintain the margins and a high return on capital by constantly introducing higher margin products, the moat or competitive advantage is not deep.

Brand name and a wide distribution network provide some level of competitive advantage, but the resulting moat is not wide and deep. As a result the company will have to constantly innovate to keep the return on capital high. The profitability could get hurt if there is a rapid commoditization of the various segments.

Competitive analysis

The plastics industry is a fragmented industry with a large unorganized sector, especially in commoditized products. The company has different competitors in each segment of operations.

In the case of PVC pipes the key players are finolex, chemplast sanmar, Jain irrigation, astral poly etc. In the packaging products there are around 6-7 large players and several un-organized ones. In consumer products nilkamal and Wimplast are the two key players. Finally in the industrial component segment there are a wide range of players ranging from Motherson sumi to Sintex industries.

Most major players earn an ROE of around 13-14%, with high leverage , except for astral poly which has an ROE of around 22% with low levels of debt (due its focus on a high margin and high growth product – CPVC pipes).

Overall the industry does not have high return on capital- due to the commoditized nature of the products. Supreme industries has been able to break away from the pack due to a portfolio approach to products (exit low margin products and move into high margin ones).

Management quality checklist

– Management compensation – compensation is around 5% of net profits. This is on the higher side, though not excessive

– Capital allocation record – The capital allocation record of the company has above quite good in the last 6-7 years. The management has been investing in high return projects and has also used some of the cash flow to reduce the level of debt. The ROE as a result has improved from the 20% levels to 30%+ levels in 2012

– Shareholder communication – adequate. Management provides decent amount of disclosure in the annual reports and also conducts quarterly conference calls to discuss about the performance.

– Accounting practice – appears conservative

– Conflict of interest – none appear to be of concern

– Performance track record – the management has been fairly transparent about its performance goals (growth and return on capital) and has been achieving them consistently in the last few years. In addition the management has been in this business for the last 40+ years and understand it very well.

Valuation

A discounted cash flow with conservative assumption of around 7-8% margins and 15% topline growth (10% volume growth + 5% inflation) gives a fair value in the range of around 530-570 per share. The growth assumption appears to be conservative as the company has delivered a 12% volume growth in the past. The risk is mainly around net margins which could come under pressure if there is faster commoditization in the industry.

The company has sold between a PE of around 8-9 and 18-20 in the past. The current PE of around 15 is at a midpoint and as a result the company does not appear to be overvalued.

Finally the company has shown a higher growth and Return on capital as compared to almost all other players in the industry (except astral poly) and hence has a higher PE (but not much) than others.

In summary the company does not appear overvalued and may be undervalued by around 30-35% from its fair value.

Conclusion

Supreme industries operates in a growth industry (due to increasing demand for plastic products) where the average profitability is quite poor. The company has been able to perform better than the other players by being focused on the newer and higher margin products. The management is as focused on ROC (return on capital) as on growth as compared to several other players who are pursuing growth at low returns.

Inspite of the above average returns and competent management, the company is unlikely to enjoy very high valuations like the FMCG industry as the overall profitability of the industry is low and the pricing power of branded products not very high. Supreme industries appears to be modestly undervalued and the returns are more likely to come from a consistent increase in profits than from revaluation by the market.

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When the tide goes out

By Rohit Chauhan

In Uncategorized

August 24, 2013

6 Min read

6 comments

‘Only when the tide goes out do you discover who’s been swimming naked ‘– Warren Buffett.

It’s now clear to the entire world, that we as a country have been swimming naked. If you look at the last 50 years of our history, the 2003-2008 period looks more like an aberration or accident. We benefited from a wave of liquidity and enthusiasm for the BRIC countries (including India) and as a result were able to grow in excess of 8%, inspite of not having the institutional structure (such as a responsive bureaucracy) to support it.

Now the tide (liquidity and enthusiasm) has gone out and the visible symptom of years of mis-management is the crash of the rupee. I am extremely pessimistic about the macro picture and the ability of our political system to fix it.

….and yet my finger is itching to press the buy button !!!

No, I am not blind to the risks and as depressed about the country as any other Indian. Let me explain my reasoning behind this apparently contradictory stance.

What are the options?

Let’s define the problem – The main outcome of the currency crash and other macro problems on the common investor is a further rise in inflation. We are likely to see double digit inflation for some more time. This is likely to destroy the real value of our capital if we do not find means of protecting or growing it.

So if you have some capital (equity, real estate, cash or FD) with you, what are the options for it ?

If you decide to hold cash or some form of an FD (which seems to be the safest bet), you have to keep in mind that the real return (after deducting the 10%+ inflation) is likely to be negative. For reference – do a search on East Asian crisis of the 90s and other such events in the past. You will realize that any form of fixed income investment did far worse than other alternatives.

The second option is real estate. I have been pessimistic about real estate for a long time and with low gross yields of 2-3%, think it is overvalued. However if one has the skill to find some undervalued property and can hold on to an illiquid investment for some time, then this could be a possible option. At the same time, if you are thinking of using a loan to finance it – forget about it. If the currency rate continues to depreciate, we may see a further rise in interest rates (which has already started) and the loan which you are planning (or already have), may become even more expensive.

The next option is gold. This seems to be a good option as it is likely to hold value in real terms as the currency continues to depreciate. I think there is some truth in it – though I don’t think I understand how to value gold and hence I am not likely to go for it. In addition, gold at best is a defensive option (will protect principal, but unlikely to grow it in real terms over the long term)

I know that readers of this blog already know where I am going with this logic – equities. But before I get there, let me digress a bit.

I think the number one asset to invest at any point of time is you. If you invest (money and time) in developing your skills and become really good at whatever you do, then macro factors are unlikely to impact your earnings in the long run. If you are a talented, the market will pay you for what you are worth (and more of it in a depreciated currency).

The last option, which seems to be the most risky is equities. The reason it appears to be risky is due to the vividness of the risk. If you own a stock and inflation rises, the impact is visible immediately. On the other hand, options such as cash or real estate seem to be safe as we do not get a quote on it daily. However that is just a false sense of safety as the real value is eroding silently. A fixed deposit or debt instrument in the last five years has lost value due to inflation and so has real estate (if it has not appreciated by more than 12% per annum).

The case for equities

One can easily point out that equities are no better as the index has dropped in the last five years and hence the loss is even higher in real terms. That is true if you have been invested in the index for the last few years. At the same time, there are several companies such cera sanitaryware or crisil which have done quite well during the same period.

The key point is this – if you are an investor who can evaluate stocks (as quite a few readers of this blog are), then a carefully selected portfolio of above average companies (defined by high return on capital and good management) has done quite well in the last five years in spite of the extreme macro environment.

Let’s look at the same point mathematically – If you are able to buy a company, which is earning around 20% return on capital (and can do so for the next 3-4 years), one is likely to double his money in this period (unless the economy implodes completely) if the valuation remains the same. Finding such a company is not easy, but if the market keeps dropping, one is likely to find good companies at attractive prices

There are some caveats to the above suggestion –

– You have some amount of skill in finding good companies. Investing blindly worked only from 2003-2008.

– You have the patience and courage to hold onto stocks when the market is collapsing and everyone around you is heading for the exits

– You don’t need the money in the next five years. If you are retired or need money in the near term, please don’t think of putting it in the stock market.

My plans

I keep a wish list of stocks – these are companies which I would like to buy, but the price was never attractive in the past. One such company was crisil, which I bought in 2008 and have held on to it since then. There are a few other companies such as ITC , Marico (and more) in the list which I am watching. If the market keeps dropping, my wish may come true.

In summary, if you want to protect your capital from the impact of inflation, you need to find investments which have the capability to generate a 20%+ return on capital and are priced reasonably. If you look at the history of various asset classes across countries and time periods, equities come closest to it.

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Facing despair

By Rohit Chauhan

In General thoughts

July 31, 2013

4 Min read

5 comments

I was planning to continue on the previous post – ‘Failure to sell’ , but decided to write on a different topic as I have been receiving quite a few emails – full of despair and frustration.

A lot of young investors, who came of age in the early 2000s, entered the workforce when the economy was booming. If you passed out from a half decent college, you could get a decent job with a good starting salary.

As the economy was growing at 8%+, it was common for employees to be given 15% salary hikes (people quit in disgust if the raise was less than that) and the high performers got promoted every other year. In addition, flush with cash, some of the same people invested in the stock market or real estate and saw their net worth double in a few years.

You did not have to work too hard to do well

We are not entitled to be rich

I am going to ruffle a few feathers, but let me still say it – We had a dream run from 2003-2008 and now it is over. The days of 20% salary hikes and 30% stock returns are gone (at least for now) for the masses.

If you are really good at your job or in investing, you may get above average raises or returns, but that is not going to be the norm for everyone

If you entered the workforce in 80s or 90s, you may have seen tough times yourself (or maybe your family did). The reason why the current slowdown feels horrible is because our expectations are high now. Don’t get me wrong – I am equally angry with the government for running the economy to the ground.

Keep grinding

I faced a similar market from 2000-2003, when the market dropped by around 50% over a three year period. At the market bottom in April 2003, capital goods companies like BHEL, Blue star were selling at 5 times earnings. The current market darlings like Asian paints (15 times PE), Marico (around 5-7 times PE) and other consumption stocks were selling a very low PEs too.

At the risk of getting philosophical, I can think of the following things to do this time around

– Assess your risk tolerance: If you have trouble sleeping in the night after seeing your portfolio drop by 10-15% , you should reduce your level of equity holdings. My thumb rule – will I be able to sleep well if my portfolio dropped by 40%+ ?

– Clean out the trash: Now is a good time to clear up junk from the portfolio. A bear market and 40% loss on weaker ideas concentrates your mind. One should evaluate each position closely, sell the weaker ones and redeploy the cash in the better ideas.

– Have faith: There is no data or logical argument which can make you hold on to your stocks or add money to it. You need to trust that the markets will recover in time and so will your portfolio.

It is easy for people to say that they want to think independently and stand apart from the crowd. Now that that we have a blood on the streets and no end in sight, you will know whether you can truly do that.

At the risk of looking foolish, I plan to keep adding to my positions.

Edit : I have a day job to support my family. I will not starve even if my portfolio goes to 0. I would not do the same thing if I was living off my savings.

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Failure to sell

By Rohit Chauhan

In Uncategorized

July 21, 2013

4 Min read

12 comments

Bear markets are a good time to reflect !

In a bull market, any pick – good or bad, goes up and everyone feels like a genius. However at times like now, where any kind of mistake is brutally punished, it is easier to uncover flaws in one’s investing process.

So, I have been thinking about my investing process and have realized that one part of my process is exceedingly weak – The selling process

Why should one worry about the process ? If you are interested in understanding it in more detail – read this noteon ‘process versus outcome’. In a nut shell, if you get the investing process right, the outcome (investment returns) will take care of itself. It is the equivalent of getting your batting technique right, if you want to be a good batsmen and get high scores consistently.

Over applying buy and hold

As most of you are aware, I am heavily influenced by warren buffett and his investment philosophy. My introduction to investing was through his ‘shareholder letters’ and as a result, I have taken his teachings to the heart.

One of the key tenets of buffett’s philosophy is buy and hold, where one looks for companies with sustainable competitive advantage and buys them at a reasonable price. Once you make the purchase, buffett advises the investor to hold for long periods of time (provided the business maintains its competitive position)

The above is a very sensible approach and would work for majority of the investors. At the same time, the key point in the ‘Buy and hold’ philosophy is to buy a high quality company where the intrinsic value is growing and let time do its magic (via compounding).

The unsaid bit is that it is often dangerous to apply this approach to other type of companies such as cyclical or deep value plays. I have done that in the past, leading to poor results

A differentiated approach
It has become slowly dawned on me (I am slow learner J), that one needs a more nuanced approach to sell, depending on the nature of the investment. In the rest of this post and the next, I will try to categorize the various types and look at the sell approach one needs to adopt for each of them – This is ofcourse a work in progress and by no means any kind of rule set for me.

Cyclicals – As the name suggest, this group includes companies which are heavily impacted by the state of the economy. This group would include metals, cement, auto and capital goods type of companies. The defining feature of these companies is the high profit levels at the top of the economic cycle and the steep drop in the same(leading to losses sometimes) when the economy goes into the reverse.

Such companies look cheap when the economy is doing well and expensive when things are bad, such as now. If you were to buy and hold such companies over the course of the entire economic cycle (from bottom to top to bottom), the overall returns would be very average. The key in such type of investments is to be able to buy when the company is at or near the bottom of the cycle (difficult to identify usually) and sell as the business recovers – without waiting for the cycle to top.

There is a perfect example for this type of an investment – Ashok Leyland.

I wrote about the company herein 2008 and kept buying it as the stock crashed during the lehman crisis. My average cost basis was around 11 / share (post split). I was out of the stock by mid 2010. You can see the price action below

The timing was perfect and as much I would like to think that it was my brilliance, it is usually due to plain dumb luck.

The commercial vehicle business turned in 2010 and has been going downhill since then. The stock price has followed suit

If I had held the stock from 2008-2013, I would have made around 12% per annum , which is not bad but nothing to crow about too.

So the key point with cyclicals is this – Buy and hold does not work (usually) and timing is critical for above average returns

To be continued ……………

—————
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

A 2X in 3 years

Experimental investing reportcard 2013

Patterns of failure

Its all about pschology

Becoming rational

Kill your beloved ideas

Analysis: Supreme industries

When the tide goes out

Facing despair

Failure to sell

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