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A catalogue of risk

September 26, 2015

9 Min read

Beta – This is the term used by academics to represent risk. In other words, for them volatility is equal to risk. This definition of risk makes sense, if one is a short term trader, but is completely useless for an investor.

I have never used beta or any such silly measures to evaluate risk and as an individual investor could not care less for an academic definition of risk.

In my view risk is multifaceted, fuzzy and grey and it cannot be boiled down to a single number. It is not even possible to minimize all forms of risk at the same time – for example you can minimize the risk of a quotational loss on your portfolio by increasing the cash component, but that increases the risk of missing out on the gains if the market moves upwards.

In a set of posts, i am going to list some of the risks which come to my mind. I will try to explain these risks and give some example too. In the end, I will share a framework which I use to think and make investment decisions. As always, if you are expecting a magic formulae at the end, you will be disappointed.

I am going to break down an investor’s risk in two sections – Risks faced by investor independent of the company/ stock and the business related risks of a specific investment. This post will cover the risks faced by all investors, irrespective of the type of investments.

Stage of life/ Age risk

This is a widely understood form of risk – As one grows older and approaches retirement, the capacity to bear risk reduces. As a 25 year old, one can afford to lose a large portion of one’s portfolio and can still recover from it as one has a long working life ahead. I personally managed to lose almost 25% of my portfolio in my 20s and although it hurt emotionally, it did not make much of a dent on my long term networth.

I personal think that all kinds of experimentation and trial and error should be done by an investor as early in their working life as possible. However once you cross late 30s or 40s, it is important to focus on risk reduction and avoid losing a large portion of your portfolio (small losses are however inevitable in equity investing)

The duration / cash flow needs

This is usually but not always related to the age of an investor. A younger investor can afford to take a very long term view of his or her investments and think in terms of multiple decades. An investor in his or her late 50s however has several cash flow needs on the horizon such as education for children and hence needs to design the portfolio accordingly. As a result, any capital which is needed in the next 5 years, should not be invested in equities. If you do so, you are exposing yourself to the risk that the market would drop at the time when this invested cash is needed, turning a temporary loss to a permanent one.

The interesting point is that this advantage is usually wasted by the younger investors. I have rarely seen investor in their 20s who are patient and long term oriented. At this stage in life, one usually feels invincible and smart. On top of that if you have graduated from some of the top colleges in the country, you close to 100% sure that you will beat the market in your sleep.

A majority of such over confident guys (and they are mostly guys) get their back side kicked and blame everyone else for their failure. A few however are sensible enough to realize their stupidity and work to fix it over time.

Emotional/ Attitude risk

This is a rarely discussed risk. Let me explain what I mean by this – One can call this temperament or maturity. There are some people who have temperamentally more suited to the stock market as they are calm, humble and eager to learn. In addition these people do not get swept by greed or fear. As a result such people are able to do fairly well over the long term.

On the other hand, you will often find people who are eager to invest in equities but are impatient and bring a level of arrogance to the stock market. They seem to believe that the stock market owes them high returns. As a result a lot of them assume that all they need to do is to buy some random stock touted by a talking head on TV and the money will start rolling in.

This attitude is however not specific to any age or gender, though I have seen it mostly in men. Women either stay away from financial decisions or if they are forced to manage it, are far more sensible as they realize their limitations.

Lack of knowledge + arrogance + greed/ fear is guaranteed recipe for disaster.

Knowledge risk

This is a risk a majority of investors in india face due to the huge amount of misinformation and misguidance by the financial services industry.

A lot of investors have been exposed to the traditional forms of investments such as fixed deposits or gold/ real estate. They are however approached by banks/ brokers and other financial agents from time to time on mutual funds, stocks or insurance and I have personally found that majority of this advice is toxic (see my post here on ULIPs).

The only way to manage this risk is to educate yourself on the basics and never to listen blindly to your friendly broker/ agent whose interest is in the commissions and often not your financial well being.

Inflation/ Cost of living risk

Quite self explanatory, but a very under-appreciated risk. A lot of people assume that if they invest in fixed income options, they have taken care of their investment needs. My own parents were guilty of this mistake in the past.

This risk unfortunately is a very slow and stealthy form of risk where one thinks that his money is growing, but in reality one is falling behind in terms of buying power. This risk comes to bite you at absolutely the wrong time – retirement. At that time, you realize that the nestegg is not sufficient to take care of a lot of your needs. In such cases, in absence of a social safety net, one either has to continue working or depends on others to make ends meet.

I see a lot of educated and young people in my own family ignore this risk to their peril.

Leverage risk

Leverage risk is commonly understood as the leverage taken by an investor in his portfolio. I prefer to expand this further and consider all forms of non –investing leverage too. For example, if you have a big home loan and other forms of leverage in the form of personal and car loans, then your flexibility as an investor is greatly reduced.

Lets say an individual earns around 10 lacs per year and has around 50 lacs as various forms of loans. This individual is paying around 50% of his earnings as debt repayment. If this individual has around 10-15 lacs as savings, can he or she really afford to invest in a highly volatile small cap fund ? If this was the financial profile of an individual in 2008, he or she would have panicked and sold all their stocks at the bottom.

I have personally looked at leverage in the above manner and worked to ensure that my total debt to networth never exceeds 30-40%. This ensures that my debt servicing is within control and any fluctuations in the stock market, will not force me to liquidate my positions to manage this debt.

Professional risk

I have never seen this risk discussed, but I think it influences your investing behavior a lot. If you have a full time profession (job or a business) which will put food on the table irrespective of how the stock market behaves, it is bound to impact your risk appetite.

A stable well paying job allows one to take a long term view and invest without worrying about the market volatility. On the other extreme if your monthly expenses depend directly on the stock markets – either from capital gains or through employment as a financial intermediary, then your risk appetite is greatly reduced.

A combination of risk

It may appear that several of the risks I have pointed out are overlapping in nature. I would agree with that and my post is not provide an exhaustive and non overlapping list of risks faced by an investor. The idea is to look at some risks which are faced by an investor, outside of the specific investment itself.

A lot of times, it is the combination of risks which become financially fatal for an individual. Lets say an individual does not save enough early in his or her career, and due to the inflation risk realizes later in life that his nest egg is not going to be sufficient. In absence of sufficient knowledge about various forms of investments, this investor under the influence of a unscrupulous broker may make wrong investment choices. Such an investor can get hurt very badly during a market downturn. I think I may have described the unfortunate situation for a lot of senior citizens.

I have tried to cover risks which are independent of the type of instrument chosen for investing. I think these risks play an important role in determining the nature of one’s investments and the kind of returns one can make. In the next post, I will discuss about the various forms business risks one needs to keep in mind when investing in equities.

I still stand by my post below on managing non – investing risks

http://valueinvestorindia.blogspot.com/2014/04/shortest-investment-book.html

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

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The madness for growth

By Rohit Chauhan

In Uncategorized

August 14, 2015

3 Min read

9 comments

Let me share some actual data, without sharing the name of the company initially

One year return = 69%

5 year return = 75% CAGR

I don’t know about others, but in my universe this kind of performance is something to kill for. At the same time, one has to be insane to expect this kind of growth forever. If one my positions were to deliver this kind of performance, I will consider myself lucky (not smart).

However I would not run around looking for such companies prospectively as they are like shooting stars – be glad you saw one (or hold one), but do not sit on your terrace forever waiting for one.

If an investor has an investing lifetime of 30+ years, even a 20% return will make him or her insansely rich. A 75% per annum return for 30 years ? look at the numbers below for comparison

1 lac becomes 2.37 Crs after compounding at 20% for 30 years

1 lac becomes 1,95,497 Crs after compounding at 75% for 30 years

However investors keep chasing these shooting stars

And what happens, when they are disappointed, even temporarily?

So what is the name of this mystery company? Its symphony limited

Below is the chart of the company for 5 years

The madness of growth

Is the name even important? This is not a one off case. Look for any company – good, bad or ugly. If the company shows a couple of quarter of growth, the stock price shoots up with no link to valuation, quality or sanity.

On the other hand if the music stops, even for 1-2 quarters, the response is brutal. The herd which rushed in blindly, now heads for the exit.

I don’t think this can be called investing – it’s a mad hunt for growth.

For the slowpokes like me, it is better to just sit and watch. The risk here is that the retail investor will again repeat the same lessons of the past – Buy high and sell low.

Added note: I have taken symphony limited as an example. I am not discussing the merit of this company as an investment. I may or may not hold this stock in my portfolio. The warning holds – if I discuss about gold, real estate or goat, I may or may not be buying or selling it. So please do your homework if you plan to buy anything discussed here, including the goat!

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The same rules apply

By Rohit Chauhan

In Uncategorized

July 20, 2015

1 Min read

5 comments

The best way to analyse any asset class is to look at the long term return for it

For example

Fixed income : inflation +/- 1%

Gold : Inflation + 1.5%

Real estate : Inflation + 3-4% (or more ?)

Equities : inflation + 6-7%

Now based on timing and in some cases, asset specific skills can help you beat these returns, but over the long run no matter how much you love the asset class, these returns do hold.

In 2011-2012, even my mother who only wishes the best for her son, was encouraging me to look at Gold and real estate. When people who truly love you start recommending an asset class , for your good, that’s a good sign of a bubble.

In this case, I bought a little gold for my mother and wife and they were quite happy about it. Now that was a decent investment – one cannot measure happiness 🙂

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A picture worth a thousand words ?

By Rohit Chauhan

In Uncategorized

May 30, 2015

1 Min read

7 comments

It is said that a picture is worth a thousand word. Hopefully ,some of the crudely drawn ones below, by yours truly are worth atleast a few words.

The Matrix

Time, Value and price

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Cheap and durable (price matters !)

By Rohit Chauhan

In Company analysis, Competitive advantage, Investment process

April 10, 2015

14 Min read

11 comments

Starting note: This is a long post and I am going to cover a lot of ground. I have tried to cover a vast topic in a few pages, which is usually the subject of entire books. As a result, I have tried to simplify and generalize in several cases to make a point.

In the previous post, I tried to make the point that it is not enough to say that a company has a moat and then rush to your broker to put in an order. One needs to answer a couple of questions

Does the company really have a sustainable competitive advantage or a durable moat? A high return on capital is a necessary but not a sufficient condition to demonstrate the presence of a moat
It is also important to judge the depth and durability of the moat. Deeper the moat and longer it survives, more valuable is the company

Do not focus too much on the math

I received a few emails asking me about the calculations on how I arrived at the PE ratios. As I said in my previous post, the math is not important for the point I am making – longer a company earns above its cost of capital, higher is its intrinsic value.

I would suggest that you use the standard DCF model and apply whatever assumptions you like for growth, ROE, free cash flow etc and just play around with the duration of the moat or the period for which the company can earn above the cost of capital. It should be quite obvious that longer the duration, higher is the value of the company.

For the really curious, I have uploaded my calculations here. Prepare to be underwhelmed!

Market implied duration

The other point i would like to make is by turning around the equation – If the company has a high PE ratio, the market is telling you that it expects the company to earn above its cost of capital for a long time.

For illustration, let’s take the example of Page industries (past numbers from money control, future numbers are my guess).

Future expected ROE = 50% (roughly 53% in 2014)

Future growth rate = 30% (40% growth in 2010-2014)

Terminal PE = 15

Current price = 14000 (approximately)

If I put in these numbers into DCF formulae, I get a Moat period of around 10 years.

So the market expects the company to grow its profit by 30% per annum for the next 10 years and maintain its current return on capital. This means that the company will earn a profit of 2000 crs by 2025.

So do I think that page industries will maintain its moat for 10 years or longer and grow at 30%?

I don’t know !

However if I did own the stock or planned to buy it, my next step would be to analyze the competitive strength of the company and see if the moat would survive 10 years and beyond, because if it didn’t I would be in trouble as a long term investor.

Precision not possible

In the previous example I used a fancy formulae and a long list of assumptions to suggest that the market considers page industries to have a competitive advantage period or moat (CAP for short) of 10 years.

Once you put a number to some of these fuzzy concepts, it appears that you have solved the problem and are ready to execute.

Nothing could be farther from the truth.

Anytime someone tries to give you a precise number on intrinsic value of a company, look for the assumptions behind it. As you may have read, the best tool for fiction is the spreadsheet.

The above calculation should be the starting and not the end point of your thinking. I typically do the above kind of analysis to look at what the market is assuming and put it into three broad buckets

2-5 years : Market assumes a short duration moat

5-8 years : Market assumes a medium duration moat

8+ years : Market assumes a long duration moat (bullet proof franchise)

Let’s look at some way to analyze the moat and bucket it in some cases

Measuring the moat

A substantial part of my post has been picked up from this note by Michael Mauboussin. The first version of this note was published in around 2002 and the revised one in 2013 (download from here)

If you are truly interested in learning how to discover and measure moats, I cannot stress this note enough (some important parts in the note have been highlighted by me) . Read it and then re-read it a couple of times. The only point missing from this note is the application of the concepts – Michael mauboussion does not provide any detailed examples of applying the concepts to a real life example.

Model 1: Porter’s five forces analysis

I am not going to write a detailed explanation of this model – you can find this here. I have used this model to analyze IT companies in the past – see here. A few more posts on the same topic can be found hereand here.

Let me try to explain my approach using an example from the past. Lakshmi machine works was an old position for me (I no longer hold it). As part of the analysis, I did the five forces review of the company/ industry which can be downloaded from here

A few key points about the analysis

The entry barriers were quite high in the textile machinery industry. Once a company like LMW has established itself and achieved a market share in excess of 50%, it was difficult for a new competitor to achieve scale. A textile mill with only LMW machines finds it easy to maintain and repair these machines (due to accumulated learning) or get this done from LMW which has a large service network. LMW, due to a large install base, is able to provide a high level of service (network effect) at a low cost (due to scale of operations). So we have a case of positive loop here– Largest company is able to provide a cost effective solution and high levels of service and still earn a good return on capital
The other factors such as Supplier power, substitute products etc are not critical to evaluate the industry
There is a certain level of buyer concentration, but the machinery segment has far higher concentration and hence the balance of power is still with LMW
Finally rivalry is muted as LMW has a level of customer lockin . A satisfied customer will prefer to continue with the same supplier (Who is also cost effective) as it allows it to achieve a higher uptime in operations and lower cost of maintenance (maintenance team needs to maintain only one brand of machines)

The above is also visible in the form of a very high return on capital for LMW – The company had a negative working capital for 10+ years and earned 100% + on invested capital at the time of this analysis

As I analyzed the company in 2008, I felt strongly that the company had a medium (5-8) or a long duration moat. It was not important to arrive at a precise number then, as the company was selling at close to cash on books and the business was available for free. Surely a business with a medium term moat was worth more than 0 !

Model 2: Sources of added value

The second mental model i frequently use is the sources of added value – production advantages, customer advantages and government (pages 34-41 of the note)

I have uploaded the analysis for CERA sanitary ware (current holding), I had done in 2011. Look at the rows 14-19 for the details.

A few points to note

The company enjoys scale advantages from demand, distribution, advertising etc. As the company gets bigger, these cost advantages would increase ensuring that the company will be able to price its product at the same level as its competitors and still earn a good profit
The company also enjoys customer side advantages from brand/ trademarks and availability
As you run through this checklist/ template, you will notice that a company could have either production or customer advantages due to various factors. However a company which has both has a powerful combination. If these two sources of value are working together and growing, then we may be able to say that the company has a medium or long duration moat
In case you are curious, I thought that CERA had a small to medium moat in 2011. This has expanded since then and the company most likely has a long duration moat now.

Model 3: High pricing power

Another key indicator of competitive advantage is the presence of pricing power. The following comment from warren buffett encapsulates it

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business.”

How do you evaluate this ? Look for clues in the annual report or management responses to questions in conference calls. Does the management talk of margins being impacted severely due to cost pressures ?

For example – Companies like Page industries or asian paints are generally able to pass through cost increases to customer without losing volumes. When the input costs drop they can either increase their margins or use this excess profit in advertising and promotions and thus strengthen their competitive position. Can steel or cement companies do the same ?

Other miscellaneous models

Is the competitive advantage structural (based on the business) or the management. An advantage based on the management is a weak moat and can change overnight if the same team is not in charge
Industry structure : A duopoly or an industry with limited competition is more likely to have companies with competitive advantage. Look at batteries, two wheelers or sanitaryware for example. One is likely to find companies with medium or long duration moats in such industry structures.
Govt regulation : This can be due to special ‘connections’. If you find a moat due to this factor, be very careful as this can disappear overnight

A brief synthesis

I have laid out various models of evaluating the competitive advantage of a company. Once you go through this exercise, you can arrive at a few broad conclusions

No moat: A majority of the companies do not have a moat. As you go through the above models and are hard pressed to find anything positive, it is an indicator that the company has no competitive advantage. Even if the company has been earning a high return on capital in the recent past, it could be a cyclical or temporary phenomenon. Look at several commodity companies which did well in the 2006-2008 time frame, only to go down after that.

Weak moats : If the moat depends on single a production side advantage such as access to key raw material or government regulation, it’s a weak moat (think mining or telecom companies). The company can lose the advantage at the stroke of a pen, law or whims and fancy of our politicians. In addition the pricing power of such companies is very low. I would categorize such a moat as a weak one and not give it a duration of more than 2-3 years.

Strong, but not quite : If the moat depends on customer advantages such as brands or distribution network, the moat is much stronger. A company with a new brand which is either no.1 or no.2 has a much stronger moat. I tend to give the moat a medium duration (5-8 years). The reason for being cautious at this stage is that the company clearly has a competitive advantage, but the strength has not been tested over multiple business cycle. In addition, in some case the business environment is subject to change and one cannot be too confident of the durability of the moat. The example of LMW or CERA in the past is a good one for this bucket

The bullet proof franchise :These are companies with multiple customer and production (scale related) advantages. These companies are able to command high margins, can raise prices and at the same time have a very competitive cost structures due to economies of scale. These companies have demonstrated high returns of capital over 10+ years and continue to do so. In such cases, one can assume that duration of the moat is 10+ years. These cases are actually quite easy to identify – asian paints, nestle, Unilevers, pidilite, HDFC twins and so on.

Moats are not static

A key point to keep in mind is that moats are not static, but changing constantly. In some cases the moat can disappear overnight if it depends on the government regulation (such as mine licenses), but usually the change is slow and imperceptible and hence easy to miss.

If you can identify the key drivers of a company’s moat, then you can track those driver to evaluate if the management is strengthening or weakening the moat. For example, the moat of an FMCG company is driven by its brands and distribution network. As a result, it is important to track if the management is investing in the brand and deepening/ widening the distribution network.

In the case of LMW, I think the moat has slowly shrunk due to the entry of Reiter ltd. Reiter was the technology partner and equity holder in LMW. The two companies have since parted ways and Reiter is now competing aggressively in the same space.

LMW has repeatedly indicated that they are now facing a higher level of competition in India and consequently there has been a slow drop in operating profit margins. In addition one can see an increase in the working capital usage too. I cannot precisely state that the moat duration has shrunk from 10.7 years to 6.3 years, but there is increasing evidence that the moat is under pressure. As a result, I exited the stock a few years back.

Putting it all together

Let’s assume that you have done a lot of work and figured out that company has moderate moat possibly 5-8 years. At this point, you can plug in the required variables into a DCF model and analyze the market implied duration of the moat (the way we did for Page industries)

If the market thinks that the company has no moat or a minimal moat, than you have a probable buy. If however the market implied moat is 10+ years, then the decision would be to avoid buying the stock, not matter how good the company

The above sounds simple in theory, but is far more difficult in practice – I never promised that I will be giving you a neat, fool proof formulae of making a lot of money by doing minimal work 🙂

The moat of a long term investor

If the all of the above sounds too fuzzy and cannot be laid out in a neat formulae, you should actually feel very happy about it. Think about it for a moment – if something is fuzzy and requires a combination of a wide experience, insight and some thinking, it is unlikely to be done successfully by a computer or fresh out of college analysts.

Can a research analyst go and present this fuzzy thinking to his head of research, who wants a precise target price for the next month ?

So any investor who has a long term horizon and is ready to invest the time and effort to do this type of analysis will find very little competition. It is a general rule of business that lower competition leads to higher returns – the same is true for investing too.

If you buys stocks, the way most people buy shoes, TV or fridges – after due research on features, durability (how long the consumer durable will last) and then compare with price, the result will be much better than average

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It is all about durability

By Rohit Chauhan

In Uncategorized

March 5, 2015

6 Min read

18 comments

The easiest way to justify a high PE stock is to say that it has a moat or in other words a sustainable competitive advantage. Once these magic words are uttered, no further analysis or thinking is needed. If there is a moat, it does not matter if the stock sells at a PE of 30 or 70. It is all the same.

On seeing this type of analysis I am reminded of the following the quote from warren buffett

“What the wise do in the beginning, fools do in the end.”

Moat =high PE, but high PE is not always = Moat

A company with a moat may be justified to have a high PE, but a high PE does not mean the mean presence of a moat.

Even if the company supposedly has a moat, it is important to judge the depth and durability of this moat. In addition , the company should also have the opportunity to re-invest future cash flows into the business at high rates of return to create further value.

Lets explore some of these aspects in further detail

More than knee deep

The depth of the moat is simply the excess returns a company can make over its cost of capital. If a company can earn 30% return on capital, we can clearly see that the moat is deep (18% excess return).

This aspect of the moat is the easiest to figure out – Just pick the financials of the company for the last 10 years and check the return on capital of the company. If the average returns are higher than the cost of capital , then we can safely assume that the company had a moat in the past (the future is a different issue).

I personally use 15% return on capital as a threshold. Any company which has earned 15% or higher over an entire business cycle (roughly 3-5 years) is a good candidate for the presence of a moat in the past. Its important not to consider a single year in the analysis as several cyclical companies show a sudden spurt in profitability, before sliding into mediocrity.

The durability factor

The presence of a moat in the past, is only the starting point of analysis.

The key questions to ask are

– Is the moat durable – will the moat survive in the future ?

– How long will the moat survive ?

– Will the moat deepen (Return on capital improve), remain same or reduce.

All these factor are very important in the valuation of a business. Let try to quantify them. I will be using the discounted flow analysis (without doing the math here) and will also be making some simplifying assumptions

EPS = 10 Rs
Return on capital (ROC) = 22%
Growth in profits = 15 %
Company is able to maintain this return on capital and growth for 10 years. After that the ROC drops to 12% and growth to 8% (leading to a terminal PE of around 12)

If you input the above numbers into a DCF model, the fair value comes to around 230 (PE = 23)

Lets play with these numbers now – Lets assume we underestimated the durability of the moat. The actual life of the moat turns out to be 20 years and not the 10 years when we first analysed the company. If that is the case, the fair value comes to around 430 (PE=43)

I just described the case of several companies such as HDFC bank, Asian paints, Nestle etc. In case of these companies, the markets assumed a certain excess return period, which turned to be too conservative. Anyone who bought the stock at a high looking PE, was actually buying the stock cheap.

The above point has been explained far better by prof. sanjay bakshi in this lecture.

Lets look at a few more happy cases. Lets assume that the company actually ends up earning an ROC of 50% with a growth of 20%. If you plug in these numbers, the fair value turns out to be around 440 (PE=44). I may have just described what has happened to page industries since 2008.

So what are the key points?

The market when valuing a company is making an implicit assumption on the future return on capital, growth and the period for which both these factors will last (after which they regress to the averages).

An investor makes an above average return only if these numbers turn out to be better than the assumptions built into the stock at the time of purchase.

What happens if the moat turns out to be weak or non existent ?

You have a dud !

Lets assume in our example, that the business tanks after you buy it. It is never able to earn more than 12% return on capital and grows at around 8%.

If the above unhappy situation happens, then the true fair value of the company is around 120 (PE=12). If this turns out to the case, then you will suffer from a 50% loss of capital as the market re-values the company.

Examples ? Look at the case of bharti airtel. The company was selling at around 470 or PE of 23 in 2007. The company had an ROC of 31% and growth in excess of 15%. The market was assuming an excess return period of 8-10 years at that point of time.

What has happened since then ? The stock price has dropped by around 25% from its peak over the last 8 years – a loss of 2% per annum, which is not exactly a great return.

The reasons are not difficult to see (as always, in hindsight). The telecom market after growing at a breakneck speed till 2007-08 started slowing down. In addition the competitive intensity of the industry increased with almost all other players losing money for most of the time. If these problems were not enough, Bharti went ahead and made an expensive acquisition (Zain) in Africa which suppressed the return on capital further.

In effect all the key drivers of value, turned south from 2007-08 onwards resulting in a loss for the long term investor.

We can derive some key points from the discussion till now

– A high return on capital in the past is a necessary, but not a sufficient condition to demonstrate the presence of a moat

– It is also important to judge the depth and longevity or durability of moat. If your estimate is correct and turns out to be higher than that of the market, then you will excess returns. If not, be prepared to lose money or at best make market level returns .

– As a corollary a buy and hold works only if you get the durability aspect correct. If the moat shrinks and disappears, a buy and hold strategy will not save you

So how does one figure out the durability of the moat. There is no magical formulae where you can punch in a set of numbers and out will pop the duration. It is a highly subjective exercise and the topic of the next post.

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Emotions and investing

By Rohit Chauhan

In behavioral finance, Uncategorized

January 6, 2015

10 Min read

17 comments

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

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

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

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

Fear

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

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

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

Greed

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

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

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

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

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

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

Love and security

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

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

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

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

Flaunting

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

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

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

Imagine this fictious dialogue

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

Versus

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

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

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

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

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

The driver

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

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

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

Take your pick

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

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

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

This brings me to a final anecdote –

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

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

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

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

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Scared ? Worried ?

By Rohit Chauhan

In Uncategorized, Views on news

December 16, 2014

2 Min read

3 comments

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

Worried about your stocks ?

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

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

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

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

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

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

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

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Active patience

By Rohit Chauhan

In General thoughts, Uncategorized

November 26, 2014

5 Min read

28 comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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How to reject a stock

By Rohit Chauhan

In Uncategorized

September 28, 2014

6 Min read

9 comments

How to reject a stock?

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

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

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

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

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

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

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

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

Building the framework

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The madness for growth

The same rules apply

A picture worth a thousand words ?

Cheap and durable (price matters !)

It is all about durability

Emotions and investing

Scared ? Worried ?

Active patience

How to reject a stock

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