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Mislead by the PE ratio

September 15, 2016

8 Min read

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

The advantage of writing a blog for 10+ years is that I don’t have to go anywhere to find examples of mistakes. I can always find one I have committed and written about it.

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

Reasoning from first principles

[youtube=https://www.youtube.com/watch?v=NV3sBlRgzTI&w=320&h=266]

In the above video, elon musk talks about reasoning from first principles. Why should one do that?

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

I wrote the following on it

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

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

You can find multiple definitions of cash flow, but the one which I like to use is the cash you can receive from the asset, without impairing its long term earning capacity. Lets apply this to a simpler example than a company – A house or a flat where it is easier to analyze the cash flows.

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

Maintenance expense usually involves repairing the house, cleaning it after the tenant vacates it and any other expense incurred to keep it in a rentable conditions. Other overheads can be society & broker charges to let out a house etc. So after paying out all these costs, the cash left behind would be the recurring free cash flow to an owner.

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

Discount – The definition of discounting can be found here. Usually this depends on the riskiness of an asset.

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

Over the long term these rentals usually follow the inflation rate. So over the life of a flat or a house, you will earn back around 60% of the cost in the form of rental. The value of land underlying a house or a flat has been known to appreciate at the nominal GDP rate (GDP growth + inflation rate).

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

Is this cheap or expensive? It depends on what you believe the price of land will be 30 years from now and if 12% is good enough for the risk and effort of managing a rental property.

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

This is however not always the case

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

On the other hand, lets assume that the government announces a large IT park close to the property and the rental go up by 5X. Irrespective of the actual increase in the property price, the cash flow based valuation definitely goes up as the rentals have increased drastically. This is what has occurred in several cities across the country in the last 10 years.

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

PE ratio in equities is even more misleading

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

In the example of Facor alloys, the PE appeared to be low based on the recent cash flow (as of 2010) which had been in excess of 30 Crs. As a result, if one assumed that these cash flows would persist, the company appeared cheap at 3-4 times cash flow.

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

In effect, the expected cash flow and duration turned out to be wrong. In such a scenario, the PE ratio was simply misleading.

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

Understand the business

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

So if a company is selling for 2 times earning and you are fairly confident that the current cash flow will persist for 5 years, then you have a bargain. On the other hand if you are looking at a commodity company whose cash flows depend on the price of a volatile commodity, then making any prediction is usually a waste of time. You may be able to look at some long price charts of the underlying commodity and get lucky from time to time, but good luck with trying to make it keystone of your investing strategy.

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

The sweet spot is usually when the valuations appear reasonable (in 15-25 range) and one can make a reasonable estimate of the cash flow based on an in-depth understanding of the company, its industry and the competitive situation.

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

Homework: Is coal india Ltd a value stock?

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

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

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A rational frenzy

By Rohit Chauhan

In Uncategorized

August 3, 2016

3 Min read

1 comment

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

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

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

We are now seeing growth in excess of 40% in this space. This is further aided by the fact that PSU banks and to a certain extent some private sector banks, are not capable or interested in serving these customers.

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

We are seeing this playout in the entire financial services space – Home loans, NBFC, Auto finance and even structured finance. This is likely to continue for the next 2-3 years.

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

We may not see the impact of these practices for the next 2-3 years, but if poor decisions are being made, the chickens will eventually come home to roost. We have seen that in the past in the sub-prime mortgage crisis in the US and the bad debt problems of the PSU banks now.

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

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

For now, we are not there yet and hence I am not taking any action.

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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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A statistical analysis of failures

By Rohit Chauhan

In Investing Philosophy, Investment process, Uncategorized

July 3, 2016

8 Min read

12 comments

I have often written about experiments and failures in the past (see here, hereand here). These posts have usually involved a failed experiment or idea and my conclusions or learnings from it. It has been a case of inductive reasoning (going from the specific case to general principles).

I recently initiated an exercise where I collated all the investments I have made since 2010/11 and analyzed the success rate of my picks. I have defined failure as a stock position which delivered less than 13% CAGR over the last 5-6 years.

Why 13% and not an actual loss? There are a few reasons behind it

– 13% is roughly the level of returns one can expect from an index and hence I have set that as the threshold
– It allows me to capture value traps as failures. These are stocks where the stock price has stagnated or trailed the index as I waited for valuations to revert to the long term averages.

The analysis was quite eye opening and although I had some vague idea of what to expect, the actual results were still surprising.

Surprisingly low hit rate

I have bought/ sold or held around 35 position in the last 6 years. Of these, I have lost money in 7 and consider 16 (or 45%) as failures (<13% category also includes the < 0% cases)

If you look at the above result, the conclusion could be that the overall portfolio has performed horribly. I am not going to share the actual results as that is not the purpose of the post and anyway I can claim anything in absence of independent verification. Let me just share that the portfolio has done substantially better than the common indices (substantial being 10% above the NSE 50 returns)

A common myth is that high returns need a 90%+ success rate (if not 100%).

The reason behind the myth

So why does almost everyone believe that one needs a perfect hit rate to achieve good returns? This myth is quite common as one can see from comments in the media, where people are surprised when some well-known investor has a losing position.

I think it speaks to the ignorance of the following points

– A losing position has a downside of 100% at the most, but a winning position can go up much more than that and cover for several such losses. Let’s say you have a portfolio of three stocks and two go to 0, but the third stock is a 5 bagger. Even in such an extreme example, the investor has increased his portfolio by 50% with equal weightage in all the three positions.
– Let’s take the previous example again and instead of equal weightage, let’s say the two failed position were only 10% of the portfolio, whereas the winning position was 90%. In such a happy scenario, the overall portfolio is up 4.5X.

In effect investors under-estimate the impact of upside from a winning position and the relative weightage of these winners. A portfolio is not like a true or false exam where every question gets the same marks. If you get something right, the weightage and extent of gain on that position matters a lot

So the next time, you read an article where some famous investor lost money on a position and chalk it to them being over-rated, keep in mind that the losing position could be a tiny starter position. A lot of investors sometimes start with a small position and then build it as their conviction grows.

The learnings

The main reason for this exercise was not to generate some statistics and leave it at that. I wanted to dig further and find some common patterns of failure. This is what I found

Blind extrapolation

The number no.1 failure for me has been when I assumed that the past performance of a company or sector would continue and hence the recent slowdown or poor performance is just a blip.

For example, I invested in a few capital good companies in 2010/11, assuming that the recent slowdown was just a blip. These companies appeared very cheap from historical standards and that motivated me to invest in some of them. I did not realize at the time, that the country was coming off a major capex boom and it usually takes 5+ years for the cycle to turn.

I have since then tried to dig deeper into industry dynamics and understand the duration of the business cycle of a company in more depth.

The forever cheap or value traps
These positions are a legacy of my graham style investing. These companies appeared very cheap by all quantitative measures. I would attribute the failure of these positions to the following reasons

–These companies were earning low returns on capital as the management had very poor capital allocation skills. To add insult to the injury, some of these companies refused to increase the dividend payout and just kept piling cash on the balance sheet. In all such cases, the market took a very dim view of the future of the company. Unlike the developed markets, India does not have an activist investor base and hence these companies end up going nowhere.
– I forgot to ask a very basic question: Why will the market re-value this company? What needs to change to cause this revaluation? In most of these cases, the company performance was not going to change substantially for a variety of reasons, and hence there was no reason for the market to change its opinion.

The turn which never happened

There have been a few positions where my expectation was the company will start growing again or will improve its return on invested capital (or both). In all such cases, the expected turn never happened and the company just kept plodding along with me incurring an opportunity loss during this time.

The problem with these kind of situations is that you don’t lose money due to which one is lulled into complacency. One fine day, after having waited for a few years, I realized belatedly that I was waiting for something which was unlikely to ever happen.

I have now changed my process to identify the key lead indicators for a company which need to change to confirm that the management is moving in the right direction. For example, is the management introducing new products, expanding distribution or trying something else to revive the topline? If the annual report and other communication continues to be vague on these points, it is best to exit and move on

Doing too much

There is another pattern I have noticed which is not obvious from the table. I have had a higher number of failures after a successful phase. I think this is most likely due to over confidence on my part which led to a higher number of new ideas in the portfolio with much lesser due diligence on each of them. The end result of this sloppy work was a much higher failure rate.

The changes

It is not sufficient to just analyze failure. One need to make changes to the process in order to prevent the same error from occurring again

Some changes in my process/ thinking has been

– It is difficult to invest in commodity/ cyclical stocks (atleast for me). I should tread cautiously and have a very strong reasoning behind such an investment (being cheap is not enough).
– Identify the reasons on why a company will be re-valued by the market. Also have a time frame attached to it (endless hope is not a strategy)
– Be your own critic. Confirm if the original thesis holds true? If not, exit. It is better to be proven wrong as quickly as possible.
– Growth is not all important, but absence of it can lead to a value trap.
– The most dangerous phase is right after a successful stretch. Resist the urge to extend your lucky streak by making investments into half-baked ideas. Take a break or vacation!

If there is one lesson from the above analysis you should take, it is that one does not need to have a very high hit rate to get decent returns. As long as one holds on to companies which are doing well and culls the poor performers rationally, the overall results will be quite good.

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It is never easy

By Rohit Chauhan

In Uncategorized

May 28, 2016

7 Min read

2 comments

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

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

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

In effect my effort has been to reduce the business risk of our portfolio. This however does not mean we do not face a price or a quotation risk. If the stock market drops by 20% (just an example, I don’t know what will happen), then our portfolio will get impacted too.

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

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

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

A repeat of history
The recent events and volatility we are seeing, is not new and has occurred from time to time. The reasons have been different, but the end result is the same – fear and rush to the exits.

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

My own portfolio is invested exactly the same as the model portfolio and hence it is not a theoretical loss for me. I have seen this happen several times, and still feel the same level of pain. Experience does not change the reaction to such losses.

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

I have been asked by some on how bad this can get? I don’t know and anyone who claims otherwise is lying. It could get worse and it will not be easy to hold on to our positions when everyone around us is panicking and selling.

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

Do not shorten your time horizon
Let’s say (and I hope that is the case), that you have invested your capital with a 2-3 year time horizon. As long as the market is rising, everyone is a long term investor. It is times like now that this belief is tested. There is no dial which increases or reduces the time horizon at an aggregate level. One needs to look at each holding and decide if you will be comfortable holding that position for the next couple of years.

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

We have held most of the companies in the model portfolio for atleast one or more years and have seen them go through their ups and down. I think most of these companies would be able to survive and manage the risks

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

The above is a very subjective point and varies from person to person. One way to think about it is to look at how much of your net worth is in equities and are you comfortable with it? Can you bear a 20%+ drop in your portfolio without losing your cool?

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

Do not fixate on the turn
Another common feature at a time like this is the tendency of investors to call the bottom of the market. This is a toxic way of managing the portfolio. It leads to a focus on the short term and disappointment if the turn does not happen.

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

There is no pill for courage
The final point I have to make is that there is no magic pill for courage. There is a reason why equities have high returns – Volatility and risk.

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

To summarize
– Think long term and focus on the portfolio with a 2-3 year time horizon. This means you should not be investing any money which is needed in less than 3-5 years.
– Ensure that the position size for each stock and the overall diversification lets you sleep soundly at night
– Focus on intrinsic value and performance of each company
– Do not try to time the market (now or any other time)
– Avoid listening to forecaster, pundits and other doom and gloom guys. It will weaken your resolve
– If you manage to hold your nerves and plan to invest, stagger it over time. I am planning to do the same.

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Chasing returns is not about the money

By Rohit Chauhan

In Uncategorized

May 12, 2016

5 Min read

9 comments

Let me share the story a young guy who has just graduated. He recently got a nice job with a company and is able to save around 2 lacs per annum after all his expenses.

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

You see, this young guy has a girlfriend and wants to spend time with her. In addition, he also wants to use his spare time pursuing hobbies like painting and travelling.

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

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

He goes back to his usual life and forgets about this whole stock market thing. The only time he checks is to extend the SIP in his account as most banks don’t provide a 10 year SIP option

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

He goes back to his account and is pleasantly surprised to find that the account now has 3.7 Crs. He is confidently able to tell his wife that they truly afford a good quality education for their children.

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

Now I know some of you would raise objections like

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

Let me handle them both –

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

In addition, our overall stock market has delivered around 12-13% return in the last 20 years and if you add dividend and the effect of monthly cost averaging, a 15% CAGR is quite reasonable

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

So my point is this – If the objective is to meet your personal financial goals, then discipline in saving and investing consistently is far more important than chasing the next hot sector or hot stock. Ocourse, higher returns will get you to your goals faster, but beyond a level of wealth, it more about flaunting than about its utility.

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

** If you wondering about the impact of inflation , a 6% inflation would still mean a nest egg of around 3.8 Crs in current money terms. In my books, even this is a good amount of money

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The search for a free lunch

By Rohit Chauhan

In Investment process, Uncategorized

April 15, 2016

1 Min read

2 comments

Ask any serious, long term investor on the type of company he or she would like to invest and you will almost always hear something along the following lines – A high quality company with sustainable competitive advantage (aka Moat) and long term growth prospects, available at a cheap or reasonable price

So what’s wrong with the above statement? It’s almost a truism and a guarantee of great results ….

This is a long post and I am trying out a new approach. Instead of posting the entire post with all the headache around the formatting, I have converted it into a pdf. please download this post from below

The search for a free lunch

——————————————————————————————————————————-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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Coca-cola, Marico and dogs

By Rohit Chauhan

In Uncategorized

February 4, 2016

6 Min read

9 comments

There is a class of companies which enjoy a very strong competitive position in their respective markets. These companies have strong brands with their customers, great return on capital and finally good management.

The market really loves these companies due to all the above mentioned factors. Consequently, these companies enjoy a fairly high valuation.

There is ofcourse one small problem – Some of these companies are not growing rapidly. They are probably growing in the range of 10-15%, which is slightly higher than the GDP, but definitely not at the 20%+ rates of the past (which got them in the present position).

Lets call this the coca-cola effect. Why coca-cola ? let me explain

Coca-cola is one the most admired and high quality company. It has a very strong brand which has thrived for 100+ years. In addition the company has a global distribution network which cannot be matched by any company in the foreseeable future (in beverages for sure).

The company grew rapidly in the late 80s and 90s and was valued at 40+ PE levels by early 2000

On top of this, the company was held by warren buffett. What could be a bigger endorsement?

There was one little problem – the company growth had already slowed, but the price was not reflecting this new reality. So what happened since then?

The company did quite well, but the stock went nowhere.

So lets define the coca-cola effect now
–           High quality company with great brands, strong competitive position and good management
–           Past history of high growth
–           High valuations
–           Slowing growth and lower probability of repeating the high growth of the past (key word – probability)
–           Price stagnates (low returns) as the earnings rise slowly , while the PE multiples contract in face of the new reality

Does this look familiar? I think so. I can think of a few companies in the indian market which will go through a similar phase. I will not give names as these are universally loved names and I will get hate mail and comments for suggesting that.

Let me however give a past example from the indian markets

Infosys ltd: see this chart below. The company has done well (profit grew by 15% CAGR during this period) but investors have made around 6% CAGR in last five years (excluding dividends)

Why does this happen?
I can think of two reasons

Hindsight bias – investors are looking at the past, whereas returns depend on the future growth ! As they say, you do not get to go to heaven twice for the same reason. So if the future growth slows down, the returns are likely to be sub-par.

Contrast effect / Frog in boiling water syndrome – The slow down or price change is not dramatic. Price does not drop drastically, but kind of bobs around for a while. So after 4-5 years of holding a company, an investor wakes up one day and realizes that they have made a paltry level of return.

How to manage this?
For starters, one should get over the warm and fuzzy feeling of holding such a stock (I am guilty of this too). It is easy to fall in this trap as the company has done well in the past, rewarded you handsomely and is still universally admired.

The second step to take is to look at the future growth prospects and try to arrive at an upper bound for it. If company sells at a high valuation and is unlikely to see a further multiple expansion, then this growth will define the future returns for the stock. If the expected returns do not match your minimum threshold, start exiting the stock slowly over time (few are able to do it in one shot due to the emotions involved).

The caveat around continued growth
Some of you would saying to yourself by now that my previous argument does not square entirely with reality. There are a few companies which do not fall in this bucket. Recall my earlier point about coca-cola : Past history of high growth and slowdown in the future.

The companies which do not stagnate are those which are able to maintain an above average growth in the future. Such companies may appear to be overvalued for sometime, but are able to keep growing and hence justify the valuation. As a matter of fact, some of these companies even appear to be undervalued in hindsight

So what happens when you confuse these kind of companies (with good growth prospects) with my earlier example (coca-cola). Let me call that the marico effect !

A close friend of mine used to work in Marico and based on my understanding of the business (and inputs from my friend), I purchased the stock in around 2002-2003 time frame at around 5 times earnings (no typo there).

Fast forward to 2006, and after a lot of analysis and mumbo jumbo, I sold the stock as it seemed overvalued at around 30 times earnings. I was right, for a period of 3 years and then spectacularly wrong. Have a look the price action below

If you are comfortable with the long term growth prospects of the company and believe that the company will do well over the next 5-10 years, it would be silly to sell the stock as the earning would slowly catch up to the valuations in time and once that happens, the stock returns would match the earnings growth

There are no short cuts here – you have to decide if you are holding a cocacola (high quality, low growth), a marico (high quality, high growth) or a dog (no quality, just fluff) and act accordingly.

There is one action, which you should take without hesitation if you are holding a dog – Sell before everyone else realizes that it is a dog. A lot of investors in 2015 bought dogs and have only recently realized – too late, they are holding dogs !
—————-
Stocks and dogs ! 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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A shift in retail

By Rohit Chauhan

In Uncategorized

January 2, 2016

4 Min read

6 comments

I recently tweeted the following

The current assumption is that the local corner retailer (kirana) which has survived the large retail chains will continue to do well inspite of the online threat. Let’s look at some of the arguments made to support this thesis

Convenience
It is undeniable that the local kirana store offers a lot of convenience and personalized service. My own mother continues to buy grocery from the local guy and he is able to provide personalized service and home delivery at the same price. What can really beat that?

My point – is this a real differentiator for all products? The current mobile carrying generation may really not care as much about it. Now it’s true that rice, oil and other staples will still be bought from the local kirana store, but what about the higher value items – both FMCG and otherwise ?

Will the consumer not use a blend of these two options? Buy the bulky staple from the local guy as it cheaper to do so, but buy the higher value (read higher margin) items online where the price could be lower and selection larger.

What happens to the profitability of the local store which uses the staples as a loss leader to drive sales for the other products?

Credit
That’s true for a large portion of the poor/ unbanked population. But is that also true for the middle class? What happens when newer forms of banking and credit options start proliferating? Does the local kirana store still have an edge?

Personalized relationship
This is a difference no online retailer can meet ..right? Welcome to the world of data analytics. Look at Netflix and Amazon who are now able to look at your purchases and make recommendations. With the improvement in data analytics, mobile and AI, this will only get better

Trend in other markets
There is a consistent trend in several markets towards the following

– Big box stores such as Costco/ Walmart etc which sell high volume staples at very competitive prices which no online retailer can beat (yet)
– Convenience stores such as 711 which are able to provide quick convenience at a much higher price/ margin. These stores usually cater to impulse buying (snacks, coffee etc) and also stock a small assortment of staples for emergency purchases (milk, eggs etc)
– Ongoing pressure on brick and mortar stores to match the pricing of their online counterparts

The retailer’s point of view
Till now we are talking of the landscape from the customer’s point of view. If you turn this around and look at it from the retailers’ point of view, the situation can appear quite bleak.

What happens to the profitability of the physical retailer if the high value/ high margin items continue to migrate online and all that remains are the bulk and low margin items which are more efficiently served by the high volume/ low margins chain stores such as D-mart ?

The retailer still has all the overheads for inventory, real estate and labor costs which are rising, whereas the margins keep shrinking. The end result is a drop in the return on capital. What does this do to the small time and marginal store?

I have tried to raise highlight some of the points one needs to think about when trying to answer this question. I don’t think that the small store/ kirana will disappear completely, but it is quite likely that they will keep shrinking and their share of the economic pie is surely to go down.

In addition this trend will not remain limited to the local grocery stores. One can extend the same logic to any other goods which has some level of standardization and does not require a high level of touch and feel.

The above speculation is based on the current level of technology. Now combine that with ongoing developments in Artificial intelligence/ Machine learning, advances in drone tech to reduce delivery costs and finally 3D manufacturing.

Does it still mean that retail as we know now, will remain the same? —————-
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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Not everything that counts, can be counted

By Rohit Chauhan

In Investment process, Portfolio management, Uncategorized

December 18, 2015

17 Min read

11 comments

In an earlierpost, I wrote about the two types of risks faced by an investor – risks faced by all investors irrespective of the nature of the investment and business risks associated with a particular investment.

In this post, I will try to describe a variety of business risks and how I use it via a checklists to further evaluate a business. The list I present below is by no means comprehensive (as I am not writing an academic paper) and just represent the ones I have faced in the past or can think of as I write this post.

Advance warning – this is a long post even if it is not comprehensive and there is no silver bullet or blue/red pill at the end to make investing easier.

Regulatory risk [earning excess returns from favorable regulations]
If a company is able to make above average profits due to a favorable regulation, then it is exposed to this risk. For example, think of a banking license or the right to supply natural gas to a specific geography such as Delhi in the case of indraprastha gas.

In these cases, the company has a pseudo monopoly due to a favorable regulatory position. If the terms of the regulation changes, the company could find that the economics of the business has worsened or worse, it no longer has a viable business at all.

There are a lot of examples of this kind of risk. For example, PNGRB – the gas regulator announced in april 2012 that they had the authority to fix gas prices and asked IGL to drop its price by 50%+. The company lost more than 50% of its value after the day of the announcement and since then has recovered most of it, after the supreme court overturned the decision. In spite of the favorable response, an investor in this stock has done worse than the index during the same time period.

The same story has played out for several companies in the mining space after the Supreme court order banning iron ore mining due to the illegal mining problem in some states. This kind of risk is critical in the case of telecom, power, finance and other heavily regulated industries.

The key point is this – If the business model of a company depends on specific regulations, then the company is always exposed to this kind of risk. . The company could be doing well for a long time and then suddenly the regulator or the government can change its mind and put the entire business at risk.

I have noticed that the market is usually sanguine about this risk and it is generally not priced in. However if the risk materializes, the reaction is swift and brutal. The only way to mitigate this risk is either to avoid such companies altogether or hope and pray that the regulator/ government does not change its mind on the key regulation.

Reputation risk [earning excess returns based on reputation/ brands ]
This is a key risk in those businesses which depend on the reputation of a brand or a company. If the company earns an above average profit due to a favorable image or brand position, then it is very important for the company to safeguard the brand.

In the event that there is some incident where the brand image is impacted, the management should react swiftly and prevent further damage to it.

Case in point – Maggi from nestle. Irrespective of the merits of the case, the response of the company to the whole lead content issue and subsequent recall was appalling. The issue surfaced in April and the company finally responded in June when the issue blew up in the media. This is a 1.2 Bn dollar brand and the management did not react to the situation till it finally got out of hand. Net result – The company lost close 20% of its market cap in the aftermath.

This risk is critical when the company you invest makes money based on the power of its brand and trust. The only way to mitigate this risk is to have a management which reacts promptly if it sees a risk to the reputation of the company or its brands.

Management risk [Poor quality management]
This is a risk commonly understood, accepted but least followed by a lot of investors. If you talk to someone who has been investing in the markets for a period of time, they will agree that it is important to invest only with a high quality management.

Lets first define what is high quality which I like to think of on two parameters

Capital allocation and distribution – does the management allocate capital at high rate of return in the business and distribute the excess to shareholders via dividends?

Ethical behavior towards all stakeholders – Does the management behave ethically or treat other stake holders (such as customers, employees, shareholders etc) in a manner they would like to be treated if the roles were reversed?

The first parameter is quite objective in a nature and can easily be verified by looking at the return on capital of the business over an entire business cycle. It is amazing to find that people end up investing with managements which have consistently destroyed wealth (several airlines come to mind). I understand that at a certain price, even a value destroying business can give good returns, but a majority of the investors end up buying such companies at the peak of a cycle when the profitability seems to be high (but is just a mirage)

The second factor is far more difficult to evaluate and needs careful study of the management’s actions over time. Again it is not easy to define the right behavior in several cases such as high compensation or bending regulations to gain an undue advantage in business.

Even if we leave aside some of the fuzzy stuff, it is quite easy in a lot of cases to just reject a company if several red flags pop up. In the end, my own experience has been that if you ignore this risk, it eventually catches up. A particular investment with unethical and incompetent management may not go south, but over time the law of averages work and the overall result will be poor.

The only way to mitigate this risk to avoid such companies and management. It will prevent a lot of anxiety, heartburn and sleepless nights

Customer concentration risk [All eggs in one or few baskets]
This risk arises when a company derives a large percentage of its revenue from a handful of customers. Although this is an easy to understand risk, it not necessarily as easy to evaluate.

For example, is it better for IT and other service companies to focus on their top customers who provide 80% of their revenue instead of spreading themselves thin? I don’t have an answer to this question.

There is one crucial factor to consider when thinking of this risk – Customer lock-in. If a customer is locked in with a company and cannot easily switch then it makes sense to devote enough resource to maintain this competitive advantage.

However if a customer can easily switch suppliers based on price, then customer concentration will kill a business. A company fighting price based competition and earning its revenue from a limited set of customers is never going to earn profits above its cost of capital and is likely to remain locked in a low return business.

This risk turns up in surprising places. China as a country is the largest consumer of most commodities such as steel. So when this ‘customer’ slowed, the price of the product collapsed and has hurt all suppliers in the product category. It does not matter if as a steel company you don’t supply to the Chinese market. Once the no.1 customer in the steel industry (accounting for 50%+ of global demand) slowed, everyone in the industry was going to get hurt.

There is no easy way to mitigate this risk and it requires a case to case decision. One needs to be aware of the level of concentration for the company and check if the management is focused on either reducing the concentration or has such as hold on the key customers, that it will not be exposed to price based competition.

Competitive risk
The easiest way to think about this risk is to count the number of companies in an industry and tabulate their market share. If you find just one company and that company has a 100% share, then you have found a monopoly with no competitive risk.

At the other extreme if you start listing the companies and end up with a long list of firms with each company having a tiny share of the market, then you are looking at an industry with high competition and poor returns.

I have generally used a simple thumb rule to evaluate this risk. If the top 3-5 companies account for 60%+ of an industry and most of them earn over 15% return on capital, then the competitive intensity within the industry is low. On the other hand, if I have to spend over a week finding all the companies in an industry and if the top 10 companies account for less than 50% share (assuming I can even get this number), then it is very likely I have stumbled into an industry with high levels of competition and poor profitability.

For example – most consumer brands have limited numbers of companies and high profitability. On the other hand, industries such as cement, textiles etc are the other end of the spectrum with a large number of companies and poor profitability.

As an investor, you can manage this risk by first diversifying across industries so that a sudden worsening of the economics in a particular industry will not sink the entire portfolio. The second way to manage this risk is to study each company and its competitive position in detail so that you are atleast aware of the risks and do not get blindsided by it. Finally, as an investor one is paid to understand and manage this risk.

Change or obsolescence risk
This risk is especially relevant in fast moving industries where the underlying technologies are going through a lot of change. Think of telecommunications – this is a fast paced industry which needs a lot of investment, but at the same time the underlying technology keeps changing rapidly (see my post herea long time back on the same topic).

We have seen the technology go from 2G to 3G to 4G to who knows what ( 5G is already being tested in labs and can do 1 gbps ). There is wifi, satellite or balloon internet and all sorts of communication tech coming up. Is it easy to predict what will be the shape of this industry in 2020? Doing a DCF analysis and putting a terminal multiple on the valuation of a telecom or similar company is sheer insanity.

The way to mitigate this risk is to have a very deep understanding of the particular industry, monitor the changes closely and not overpay for the stock. However if you do not have any specialized understanding of such an industry, it is best to stay away – discretion is often the better part of valor in investing

Commodity risk
This is the case where the price of a specific commodity drives the profitability of the business. This is obvious in the case of industries such as steel, metal, oil etc.

It was not so obvious in some other cases, till the commodity price dropped and hurt the industry badly. Take the example of jewelry/ gold loan companies.

These companies became the darling of the markets in the 2010-2012 period when the price of gold was going through the roof. A lot of these companies got a double boost from rising demand (due to rising gold prices) and from an increase in the value of their inventory.

Once the tide turned, some of these companies have struggled to remain profitable.

A similar story has played out in the agri space for seed companies (where the price of commodities have dropped) or mining firms.

One way to mitigate this risk is to evaluate a company over the entire business cycle and see if the company is merely the beneficiary of a lucky tailwind from rising commodity prices or will do well inspite of the commodity prices.

Capital structure risk
A company having a high debt equity ratio is generally a riskier company. What is ignored sometimes when evaluating this risk are the hidden liabilities which are the equivalent of debt, even though they do not appear as such on the balance sheet.

Take the example of tata steel and its pension liabilities or airplane lease and other fixed costs in case of airlines, which are a form of quasi debt.

The deadly combination is when some other form of business risk hits a highly indebted company. In such cases, the end result is often bankruptcy (atleast for the minority shareholders in india, promoters have no such risks)

How do you mitigate this risk? Learn to read the balance sheet carefully and understand all forms of fixed obligations which cannot be reduced even if the revenue goes down. Try to answer the question – How long will the company survive if its revenue dropped by 20%.

Valuation risk/ growth risk
This not a risk of the business risk. If you pay for the growth and it does not happen, then you are in trouble. An example which comes to mind is Hawkins cooker. A lot of investors continued to give high valuations to the company even when the growth slowed.

However once reality hit the market, the reaction was swift and sudden. As much as investors curse the management after such an event, I do not blame them for it. One can fault the management on not doing its best to deliver the highest possible growth, but then if growth is not visible, nothing stops an investor from exiting the stock for better opportunities.

There are several other companies (Which I will not name) which seem to be in a similar place – low growth, but high valuations. If we are lucky the drop in the multiple would be slow and gradual unless the growth picks up and justifies the valuations.

How do you mitigate this risk – simple, don’t follow the herd and think for yourself. If you don’t understand why a company sells for a high valuation, move on. Investing is not an exam paper where you have to answer all the questions to pass!

How to think about risks
Are you still reading? congrats !! you are true fan of this blog and also like to read boring stuff on investing J

It is easy to go on and on about risks and there are books on each type of risk. I cannot do justice to all of them in a single post. As an investor one has to evaluate all of these risk and more for each investment idea and identify which ones are the most critical.

Let me give an example – I used to hold Noida toll bridge company earlier in my portfolio . As I started thinking of the risks associated with the company, there were two key ones I was able to identify

– Reinvestment risk: The company had been generating a good level of free cash flow, but had no opportunity to re-invest it. A company which cannot re-invest its cash flows is equivalent to a long dated bond and will get valued as such. Hence in this case, once the company reached its steady state cash flow, the future returns were likely to follow the growth in cash flow which was expected to be in the range of 6-8%.
– Regulatory risk: The Noida toll bridge is a BOT project with an assured 20% return during the operation period (around 30 years). On top of that if the company did not make these returns in any year, the company could just carry forward the shortfall to the subsequent years. This meant that by 2011-12 the company had close 2000 Crs+ of shortfall on its books. The ground reality was that the Noida authority had refused to raise the tolls even by the level of inflation and every time they did, there were protests and dharnas. So the chance of realizing this shortfall was low.

The key point in the above idea was that the upside was limited and there was a regulatory risk which if it materialized, could completely destroy the investment thesis. So in a stroke of brilliance, after having held the stock for 2+ years and with a minimal gain, I decided to wise up and exited the company.

In July 2015, the management announced that company was re-writing the contract which would now end by 2031 and its likely the company will not be able to recover the prior shortfall. The stock dropped promptly as the market had assumed that company would be able to make up some part of this shortfall by an extension in the lease term or land development rights.

The above case is instructive of a variety of business risks. A lot of business risks are fuzzy and grey and one cannot put a precise number behind it. In addition, these risks do not materialize for a long time. However if one does materialize, the stock market is quite efficient in resetting the valuations promptly.

As an investor, you can ignore business risks at your own peril.

No mathematical precision
You would have noticed that I have not used any greek letters or volatility measures till now to measure the business risk. It should be quite obvious that these academic measures do not represent the risks for a company.

Think of the example of Noida toll bridge – did the past volatility of the company give any indication of the regulatory risk faced by the company?

The best one can do is to be aware and analyze these risks on an ongoing basis. If you are being compensated to bear this risk (in the form of expected returns), then you continue to hold the stock. If the returns are inadequate or if you think the downside from the risk will be too severe, then the best option is to sell and move on

My current approach to evaluating the risk is usually as follows

–       I have a checklist of all the above risks and use it to evaluate which of these risks are relevant for the company I am analyzing.
–       I try to dig deeper into the critical risks for the company and understand what are the key drivers and how it could hurt the company and its valuation
–       My job as an investor is to evaluate the upside from the bull case of the company versus the downside from all the risks facing the company. If the downside risk seems too high, I will just move on to the next idea.

One final point – if this sounds complicated and difficult to implement, let me assure you – it is and will always be. The upside is that with an increase in competition for investment returns, this may still be an area where a hardworking and diligent investor will continue to have an edge over others.

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The value of ‘overvalued’ stocks

By Rohit Chauhan

In General thoughts, Uncategorized

October 25, 2015

12 Min read

19 comments

I recently tweeted the following

This tweet was prompted by the debate – online, and sometime offline between the different approaches to value investing. These debates appear like religious arguments with each side claiming their god is the superior one.

I have never quite understood the point of these debates. There is obviously no single way of making money in the stock market. There are short term traders, buy and hold guys, debt specialists and all kinds of people in-between. Each approach has its strengths and weaknesses and no one can claim that a specific approach is inherently superior to the other, unless they are equally proficient in both.

I have come to realize that the most important factor to long term success is to understand which approach suits your temperament.

The value of learning
Some of you who have followed me on my blog, would have noticed that I try not be a dogmatic about any specific style. I have tried multiple approaches and continue to do so. I do have a dominant style which suits my temperament – buy decent quality companies and hold them for the long run, but I have tried deep value, arbitrage, options and all other types of investing.

Most of my experiments have been failures (see here and here) from a monetary perspective, but they have deepened my understanding on what works and does not work for me.

A valid question would be – why bother? Why not find an approach which works for you and then just stick with it (and maybe even publicly defend it as your faith 🙂 )

Let’s consider an analogy – let’s say you are a sculptor who likes to make figures using wood, stone and other materials. Let’s assume you are exceptionally good at making stone sculptures, but not so great on wood. You go to an exhibition and see some great wood figures and happen to meet the artist. The artist tells you about his techniques and the tools he uses. Assuming you want to get better on wood, will you start laughing at this artist and belittle his tools?

In a similar fashion if you are a deep value investor, what should be your reaction to the success of investors who buy and hold seemingly overvalued stocks?

Durable success

I know what the first objection is to this line of thinking – The success of these investors is just dumb luck. These guys are not really practicing value investing, but a form of momentum investing. It is just that the momentum has lasted for 5 years in some of these cases, and sooner or later this bubble would burst.

My counter point – sure that is possible, but what if this bubble has lasted for 10-15 years in some cases. Will you still just wave away these anomalies and label them as flukes?

I prefer to take a different approach. There is no religious debate to this in my mind – if something has worked for 3+ years in the stock market, then it is worthy of investigation. A lot of bubbles and temporary fads usually get washed out in 2-3 years and so 3 years is good cutoff point.

Why not 5 years? Well now we are moving from the physical to the meta-physical 🙂 and debating the nature of reality.

So what can one learn from this oddity where some companies manage to sell for seemingly high valuations for a very long time.

New business model or value capture
I think the first point to look for is whether there is a change occurring in the business model/ design, wherein due to changing customer needs and priorities, a new type of design is now more suited to meet them more profitably.

I would recommend reading the book – value migration, which goes over this concept in quite a bit of detail. The main point is that changing customer needs and priorities cause a change in the business design best suited to meet them. Companies which can identify and develop a business model to meet this new reality are able to accrue a lot of value for their shareholders.

For example, a rise in the income levels has caused the retail consumer to now value quality, brand image and convenience in addition to the price. As a result, companies which can meet this new set of needs have been able to create a lot of value.

It is easy to see this phenomenon around us – Bathroom fittings, automotive batteries, garments etc. Some of these products were commodities in the past, sold largely based on price. However increasing consumer purchasing power has meant that the priorities have shifted beyond price. Companies which have been able to adapt their business model to deliver on these new priorities of brand, quality and convenience in addition to price have delivered exceptional returns

Example: Cera sanitary ware, Amara raja batteries, Astral polytechnic etc

Opportunity size with durability

It is not sufficient to be able to meet the changing needs of the consumer, better than the competition. For starters, the opportunity size should be large so that the company can grow for a long time to come.

This is a major advantage of the Indian markets over almost all other foreign markets. Even niches in India have a market size running to millions of consumers and hence a company which can build a good business model can easily grow for years to come.

An additional point to keep in mind is the need for the company to develop a durable competitive advantage. Let’s take the case of the telecom industry in the early 2000s. The need for communication and mobile telephony was recognized by a few companies such as Airtel in the late 90s and these companies moved in quickly to satisfy the needs.

The market size was in the 100s of millions and most of the telecom companies were able to scale rapidly. However the edge or competitive advantage turned out to be transitory and as a result after a few years of high profitability, we soon had a lot of price based competition. As a result by 2007-08, most companies were losing money and did not create (actually destroyed) wealth.

In such cases seemingly overvalued companies were truly overvalued.

Kings of their domain

A productive area for finding multibaggers is in the microcap space, where the company operates in a niche and is growing rapidly as its business model is uniquely suited for that niche. In addition, the niche is large enough for the company to grow for a long time, yet not so big that it attracts large companies initially.

There are a few examples which come to my mind – Think of air coolers a few years back (symphony), CPVC pipes (Astral poly) or various niches in pharma and information technology.

A small company develops a unique set of skills for this specific segment and is able to dominate and grow within the segment for a long time. In addition as the niche is quite small, it does not attract much competition till it reaches a certain size.

However by the time the niche is big enough to catch the attention of larger companies in the overall space, it is too late as the specific company has established a dominant competitive position and cannot be dislodged.

A lot of these companies appear to be overpriced after they have started growing, but this ignores the possibility of above average growth and a dominant position for the company.

Capacity to suffer

This is a term used by Thomas Russo (see talk here) to describe companies which are capable and willing to make investments in the business for the long term, even though it penalizes the profits in the short term.

In most cases, due to market pressures, companies are not willing to hurt short term profitability to build the business for the long term and hence the few companies which are willing to do so, appear to be overvalued due to depressed profits.

Look at the example of Bajaj corp (an old holding which I have since exited). The company acquired no-marks brand in 2013 and started deducting the brand value on their P&L account. In reality the brand value is actually going up as the company continues to spend heavily on advertising (17% of sales) and hence the profits are understated.

The market did not like this short term penalty and punished the stock in 2013. The stock price has since recovered and we have a company which appears to overvalued due to the high investments in the business.

Platform Business
This is good note on what is a platform business

I do not have an example in the Indian markets, but will try to explain this using the example of a well know US company. Its 2004 and a well-known company called google decides to launch its IPO at a then PE of around 65. A cursory look shows the company to be grossly overvalued and as a result most of the value investors tend to give it a pass.

The company has since then delivered a return of around 26% p.a and I am sure this qualifies as a great return. So why did a company which appeared so overvalued turn out to be a 10 bagger.

My own understanding is that this result came about from multiple factors. To begin with, the company operates in a winner take all kind of a market where the no.1 company tends to dominate and capture almost all of its value. Once google had a 60%+ market share, the network effects kicked in and the company just kept getting more dominant in the search space.

Once this base was built, the company extended it to other platforms such as mobile where the next leg of growth has kicked in. These type of companies also have a very low marginal cost of production and hence any growth beyond a threshold, drops straight to the bottom line.

This however does not explain fully the reason behind its success – We have a management which in the words of Prof Bakshi in this note – are intelligent fanatics and also have the capacity to suffer (as referenced by Thomas Russo). As a result they have continuously invested in long term ideas (called as moonshots) even if it meant losses in the near term. You tube, android etc which are now bearing fruit were drains at one point of time.

Such companies have been referred as platform companies and usually appear highly overvalued in the early stages of growth. Another similar company seems to be Facebook.

A point of caution – For every successful platform company, there are atleast 10 pretenders which destroy value. So it is not easy to identify such companies ex-ante (atleast for me)

Rate of change matters
Let me introduce a new concept – business clock speed which I read here. This is the rate at which a business is changing. For example the rate of change in the social media business is high and conversely there are business such as paints or undergarments where the rate of change is low.

I think it is quite obvious that businesses with low rate of change can create a durable competitive advantage for the long term and hence a seemingly high price turns out to be cheap.

On the contrary very few high change businesses (google, Facebook being a few exceptions) turn out to justify their sky high valuations.It is difficult to establish a strong competitive position in an industry where the basis of competition keeps changing every few years – Just look at IBM which has had to re-invent itself almost every decade to stay in business and grow its value. For every IBM, there is DEC or Sun microsystems which did not make it.

It is quite rare

It is important to understand at this point that it is quite rare to find overvalued companies, which in hindsight turn out to be undervalued. A lot of overvalued companies, actually turn out to be just that and so it is important for a value minded investor to be cautious about such companies.

In addition it is not easy to identify such companies upfront (there are no simple screens for it) and one has to think deeply to develop the right insights to buy and hold such companies.

So why study ?
As I stated in the beginning of this note – If you want to be a successful investor, it is important to have as many mental models in your head. Investing in a cheap, low valuation companies is one such mental model. However this does not mean one should just wave away any company which is selling at a high price.

The advantage of understanding the drivers of success is that the next time when you are evaluating a company, it makes sense to check if this company fits into any of these models? One can ask some of these questions

–           Is the company overvalued simply because the management is investing in the business for the long term which has suppressed the near term profits?
–           Is the company developing a new business model which meets the changing requirements of the consumer much better than competition
–           Does the company have a durable advantage and a large opportunity space (the case for a lot of FMCG companies in India)
–           Does the company have network effects or is it a platform company run by an intelligent fanatic?
–           Has the company identified and developed a unique business model for a niche which it will dominate for a long time?

My post above does not cover all possible reasons why a seemingly overvalued company, will turn out to be cheap. There is no standard formulae or screen which will give you the answers. One has to study the company and the industry deeply to develop any useful insights (as fuzzy as they may be).

Inspite of the odds, if however if you do manage to get it right, it would be stupid to sell the company based on a PE ratio which appears higher than normal.
—————-
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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Mislead by the PE ratio

A rational frenzy

A statistical analysis of failures

It is never easy

Chasing returns is not about the money

The search for a free lunch

Coca-cola, Marico and dogs

A shift in retail

Not everything that counts, can be counted

The value of ‘overvalued’ stocks

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