CategoryGeneral thoughts

I published the following note to all subscribers. Please read the disclaimer at the end of the note

The following holdings positively impacted the portfolio performance

• Apar Industries
• Bector Foods
• CERA sanitaryware
• Polycab limited

Conversely, these holdings had a negative impact:

• Aarti industries
• Quess Corp
• Puravankara

Style drift and new approaches

In my 2022 year end note,  I spoke about some changes in my approach and using stop loss to manage the risk.

These changes are by design and have not been done lightly. I have always resisted chasing performance based on the latest fad of the day. However, my failures with a few positions such as PEL, Edelweiss and Shemaroo made me question the process and look for my blind spots.

When these positions declined, I dug deep into the financials and thought a lot on it, but could not find a clear way to answer the question – do we sell or hold? The numbers looked good and so we held. It turned out that the market had already anticipated the collapse in the earnings.

That has led me to a 3+ year journey of understanding technical analysis, momentum, factors in investing and so on. As I have studied these other areas, I have adapted my value approach to fit the changing market structure.

10-15 years back, markets were slow in responding to earnings miss and business cycles. These things have changed considerably now. Markets react much faster now – mainly due to higher competition and automated algorithms. In effect the time horizon of markets is shifting.

I have now blended momentum and Technicals to my value style. The core focus on value and long-term value creation remains, however, momentum sometimes acts as a booster and Technicals are more like a trip wire to alert us

Purity of style

I have practiced value investing for 20+ years now. I used to wear it as a badge of honor and made it a part of my identity as an investor. Even my blog is titled valueinvestorindia.com

It is time to go beyond that.

I am not talking about switching from a long term buy and hold to swing trading. However, being religious about my approach is not the way forward. I have belatedly realized that other approaches to investing have their own strengths & weakness and adapting some of these strengths to our style strengthens it.

For example: Risk management is a strong point of successful traders and blind spot for buy & hold value investors like me, who believe in holding a stock forever irrespective of losses.

In a similar manner, momentum/quant investors have simplicity of approach in their favor. Their approach can be boiled down to a few bullet points and easily automated. Value investors like me have layers and layers of complexity. I have used this mindset to strip away the non-essentials.

For example: Over the short-term valuation and management quality are important but not critical. Overweighing this information, which does not add to returns, means we have missed out on good ideas with a 1–2-year time horizon

Stop loss and zone of action

I spoke about having stop loss for each position in my last update. I review the stop loss regularly but will not share it with anyone. The reason for it is simple – I want to retain the flexibility to change my mind.

There is nothing special about the stop loss. It is based on a blend of fundamentals and technical factors including max loss or downside. In case of long-term holding, the stop loss is wider than a trade as that is a position we wish to hold longer.

As long as the price is above the stop loss and I am comfortable with the long-term fundamentals of the company, I will not react.

We cannot react every time the stock drops or rises a few % points. On the other hand, we don’t want to ignore a 20%+ drop, which we have done in the past. A few % change matters for a swing trader but is noise for us. However, a 20%+ drop means that there is something occurring at the company or sector level and a lot of investors including traders are exiting the stock.

At such points, we need to react and make a decision. Are we ok with holding the stock for an extended period and bearing a much larger loss or should we exit and live to fight another day. On this count my thinking has changed. I would rather take a hit to my ego and come back to the position another time.

Evolution

I rarely talk about the macro conditions. It’s not that macro is not important, but there is already enough noise and drama around it

For example – The fed or RBI decision on interest rates is the same for all financial service companies. What’s the point of talking about it? A good financial institution will figure out a way to work around it. HDFC bank has performed well over 30 years even as PSU banks have faltered. Surely it is not because of the interest rates.

I want to focus on what matters for a company and how it can do well in the long run. In the same manner, I want to do the same for us when writing to all of you.

My investment approach and framework will have a lot more impact on our relative returns than the macro. If the world has a major event, such as COVID, all investors including us will be impacted. Our approach will however decide the level of impact.

I spoke extensively about the evolution of my investment approach in this podcast. You can review it if you are interested.

A long-term partnership

We repeat this every time in the portfolio review and will do so again (more for the benefit of the new subscribers)

• We do not have timing skills and cannot prevent short-term quotation losses in the market.
• Our approach is to analyze and hold a company for the long term (2-3 years). As a result, our goal is to earn above average returns in the long run and try to avoid losses during the same period.
• Despite our best efforts, we will make stupid decisions and lose money from time to time. We feel the same pain as we invest our own money in the same stocks.

We will treat all of you in the same manner as we would want to be treated if our roles were reversed. This means that we will be transparent and honest about our actions even when we have made a mistake.

Disclaimer – Stocks mentioned in the above note are for information / illustration purposes only. This is not a Buy / Sell recommendation.

Let me share two personal stories, one recent and another from 25 years ago.

I have a relative who recently passed away at the age of 50 due to a heart attack. He had a very stressful job and was facing financial pressures as well. After losing his job, he found himself short of money, and it seems (though I don’t know for sure) that he thought an easy way out of his financial troubles would be to trade in the stock market.

He lost his savings and sunk deeper into debt. I am certain that all these stressors took a toll on him.

The second story is even closer. This is the story of my own father, who passed away around the same age as this relative. I have shared this story here. He lost money with a plantation company, and when I visited their office, I was told that the money was gone. I can never forget this episode in my life.

Have a Heart

I recently posted a tweet when a bank in the US collapsed

If one invests in a ‘teak’ company or in the stock market, the person may have some idea that they are taking a risk. However, when a depositor puts money in the bank, they are NOT putting that money in with an upside

I received a few replies back, saying that such people do not deserve to get their money back if they did not analyze the bank’s financials before putting their money in. I have analyzed banks for 25 years and am sure that I know more about banks than these folks. Barring a handful of analysts or insiders, no one, including the top management, can tell you with certainty that the bank will not fail.

You have to be a heartless !@@### (insert your choice of word here) to make this statement.

I have been very numbers-driven throughout my investing life. However, there are areas in life where I draw a line. The safety of a person’s life savings is one of them. You can never understand the despair of a person who has lost his life’s savings

Implicit trust

There are vehicles such as bank FD, government debt, Debt mutual funds etc which have an unwritten safety/guarantee implicit in them. If you make every depositor or investor read the 100 page prospectus or study 10 years of financial statements, the system will come to a grinding halt

Our world works on implicit trust and not everything can be driven by contracts or due-diligence. Do you check the safety certificate of a plane or its maintenance manual before boarding a flight. We implicitly trust the system to make flying safe for us

If a plane goes down, we don’t blame the passenger for it

Even if you don’t consider the humane aspect, you will realize that if you do not the guarantee deposits, the whole system will collapse

Don’t believe me? read about the banking failures of last 100 years and you will understand why regulators and government rush in to protect depositors. Hint: they did not in the 1930s and that led to the collapse of the US economy

Are more regulations the answer

There are a lot of regulations from SEBI, and these keep growing by the day. My partner, Kedar, carries all the burden, and it is tough to keep up. However, considering the number of bad actors and terrible advice on social media, I personally think that’s a small price to pay (for people like us)

Bad faith investment advice and get-rich-quick schemes are not harmless gimmicks. They cost lives and destroy families.

I was in college when my dad passed away unexpectedly.

It was a shattering experience and only those who are unfortunate to experience it early in life can relate to it. Your notions of stability, risk and how you see the future changes completely

As I came to terms with his death, I was forced to deal with my family’s finances. This was the start of my investing journey. Till that time, I was never bothered about money, much less about stocks and bonds

We were financially insecure and that feeling drove me to learn about money & financial independence which led me to stocks, Warren Buffett and so on

I cover my initial years of investing in this video

A lot of time has passed since then and I have done well beyond my expectations. However, I don’t think my world view has changed. Such events influence your thinking on risk & money for a lifetime

I often chuckle when I read about some formulae on risk and all kinds of mathematical approaches. These formulae are without context and designed for some hypothetical person with no emotions and life experiences.

We all go through different life experience and our notions of risk, money and future are different. My own life experiences means that I will always remain a financial chicken all my life

I wrote this note to our subscribers today. Hope you find it useful

At the height of the epidemic, I shared my thought process on the next steps

How does one invest under such extreme uncertainty? One option is to assume that there will be a quick recovery and go all in. The other extreme is to wait till it is all clear and then deploy the capital. In the first approach one is making a bet on a specific scenario which may not occur, leading to sub-par results. In the second case, we may end up with sub-par returns too but only because prices will adjust once all the uncertainty goes away.

We paid a price for being conservative. We lagged the indices in 2020 at a time when others rode the surge in small caps and achieved stellar returns

I wrote the following at the end of 2020

At that point of time the future was uncertain and anyone making a specific bet was ‘assuming’ a specific scenario. If we assume that 50% of the investors bet on rapid recovery and the other 50% bet on the whole thing dragging on, the first group turned out to be right.

You are now hearing from investors who went all-in, in the month of March/April. It could have easily gone the other way and in that scenario, the second group would be highlighting the merits of being cautious, whereas the first group would be silent.

I personally avoid taking a specific view of how the future will unfold. The risk of doing so is high, if you get it wrong. If you are managing money for others (like me), then the risk is asymmetrical. If you get it right, you can tout your performance. If not, then your investors bear the brunt

I continue to stand by my conservative approach, though I should have reacted faster when all central banks pumped in a huge amount of liquidity into the system. By the time, I could appreciate the dynamics, it was too late

I have been following this drama closely and by mid of 2021, felt it was getting crazy. Valuations of profitless growth companies in the US went through the roof, Crypto was all rage and then we had the NFTs.

Some of these innovations could change the future, but why would I pay for a promise? If you are a buy & hold buyer (as many claim), then you should be paying a price which doesn’t discount the future. On the contrary at height of the mania, buyers were paying for the most optimistic future

The last one year has reminded me of the 2000-2001 dotcom mania. I had just started investing and resisted the mania for a long time, but finally succumbed to it in early 2000 when the bubble peaked. I promptly lost 80%+ of my meagre investments in the next few months

The advantage of experience is that if you can avoid repeating the same mistake. I have stayed away from all this madness and just watched it with amusement. You can see all the updates on my twitter feed @rohitchauhan

When the tide goes out

I created a presentation last year but did not upload it then for some reason. Interest rates have been on a 40 year downward trend and were close to 0% (and even negative). The investing world has gotten so used to this zero cost capital, that even a slight increase would be devastating to most assets

Although I could not forecast inflation and other macro issues, it was clear than any normalization or even reduction in the liquidity was going to be a problem for the market

We know what has happened since then – Inflation has surged due to war, supply shortage of commodities and all kind of supply chain issue

The net result is that interest rates are rising and have some distance to go. All central banks, including RBI have to raise interest rates and reduce liquidity to control inflation

Flip the script

So what’s my point in all this ? We all know what is happening.

If a cut in rates and increase in liquidity, resulted in a V shaped recovery, then the reverse should cause an extended downturn?

I think a lot of the correction has happened. However that does not mean markets cannot shoot on the downside. Long term investors often ignore the implications of liquidity

The net result is that the tailwinds of the last 2-3 years are now headwinds. If this turns out to be true, then there is no central bank to bail out investors this time around in the near term

Hunker down

My thinking is colored by my experience after the dotcom bust. As liquidity was pulled back, it took the markets years to normalize and start growing again. The current events are not the end of the world. At the same time, we should not expect that market will turn suddenly and resume their upwards trend

We are holding 20% cash as I write this note. My plan is keep looking for new opportunities (as always) and start with small positions. As these companies execute, we will scale into the position over time

Even as we invest and reshuffle our portfolio, we should expect losses in the near term. No amount of conservatism can save us from that. I have harping about diversification and asset allocation for last 2 years as I felt that a lot of the recent rise has been due to liquidity conditions around the globe

We can expect volatility and a tough slog for some time. The key is to manage the risk and focus on building a diversified portfolio

Let me share two graphs, which appear quite similar

Are they from the same data but drawn differently? Both graphs show periods of growth followed by consolidation or pullback

Let me zoom out and show the source of this data

The first graph is that of our model portfolio and second is of Vinati organics. One is a portfolio of stocks and another is a portfolio of products. Our portfolio has delivered 24% CAGR in the last 10 years and Vinati organics delivered 40% CAGR over the same period.

There is a deeper lesson in the above charts

Progress is never linear. It happens in fits and starts with periods of stagnation and backtracking.

Short-term thinking and extrapolation

It is easy to enter the portfolio (or a stock) at point A and just extrapolate that trend or at point B and do the same. The problem with this mindset is that the individuals expect progress to be linear and steady (purple line) whereas reality is the brown line of our portfolio

This is a problem no one can solve for us. I have seen this all my life, especially with investing. A lot of investors want immediate gratification and jump in at point A, only to be disappointed.

The right mindset is to zoom out and look at the long term trajectory. Does the mindset and approach of the advisor make sense and will it work over the long run. Is yes, then you must give it time to play out

What drives this behavior ?

I think the problem is our own expectations and lack of patience. We want immediate and consistent results. That’s the point of tweet below

The world is not kind to give something for free. If you want zero volatility – go for a fixed deposit. If you want high returns, the price you pay is the volatility of the returns.

Somehow everyone gets this in other facets of life – everything of value has a price. Patience and persistence is the key to success – in stock markets and a lot of other endeavors

In March 2020, during the depth of the Covid crisis, I did a bankruptcy risk analysis of all my positions. I wanted to evaluate, how long these companies would survive, under various lockdown scenarios such as a drop in topline by 50% or zero revenue for an extended period

Although the severity of the crisis turned out to be much lower, there was a non zero probability that the pandemic could get worse and cause a longer shutdown

I used the recent financial results and credit rating report for the analysis. The review was broken down into break even analysis (how long the company could survive on zero revenue) and long term demand/business impact

Getting a grip on the risk

This analysis allowed me to evaluate the risk of individual positions, their correlations and not to panic at the bottom. At the same time, it also prevented me from being sanguine about the risks.

The benefit of this exercise was that i able to avoid selling at the bottom and started adding to the model portfolio in steady /regular fashion from Mid April 2020 as the worst case scenario did not play out. This analysis continued to help me in subsequent waves of the pandemic as I had already done the work of evaluating the worst case scenario

Although this was a stressful exercise done in the middle of all the uncertainty, it allowed me behave more rationally and in a measured fashion. For me, there was never a eureka/light bulb moment when I decided to go all in. As I shared in my earlier post, my top priority was return of capital than return ON capital

Following is a sample of the analysis and are my raw notes. This is no longer in the portfolio (as shared in the prior post – a mistake) and also not a recommendation to buy or sell

April 2020 : Thomas cook (I) ltd [Company is in the travel space – epicentre of the crisis]

Liquidity risk: CRISIL AA-/Negative as of 3/27

Crisil report: Liquidity Strong

Liquidity remains strong, with cash and cash equivalents of Rs 1,724 crore as on December 31, 2019, against repayment obligation of Rs 73 crore over the 12 months till December 31, 2020. Liquidity is driven by the nature of operations with significant advances from customers. Financial flexibility is enhanced by the ability to contract short- and long-term debt at competitive rates. On a standalone level, TCIL has no long-term debt, and working capital limit has been sparsely utilised. Its subsidiaries are expected to service debt through internal accrual and need-based support from TCIL.

CRISIL believes TCIL’s profitability and cash flow metrics could be materially impacted by continued travel restrictions due to prolonged Covid-19 situation.

Cash burn rate: Company has a cash outflow of around 250-300 Crs/ quarter from salaries, overhead and other expenses. Company has used up around 150 crs of surplus cash. Float is likely to drop. With full stoppage of travel company is likely to lose 200 Crs in Q1 and around 200-250 crs in assuming travel starts picking up end of year slowly. Company has cash and equivalent of 1700 crs, free cash of 200 crs (50 crs after buyback) and only 75 Crs of re-payment till end of the year

Assuming 50% drop in topline, company could lose atleast 500-600 Crs this year. Can take on debt of 400-500 crs including loans/ funding from parent to sustain the year. Some recovery could happen in 2021 and 2022 could see return to normalcy

Break even analysis

Company has a GPM of around 25%. Company needs 1200-1400 Crs of cash flow for Break even basis. Based on this, the company will achieve cash flow break even with 25% drop in topline. Due to the severe stoppage of travel and tourism, even this is not likely. Q1 could see almost 70% drop and Q2 could at best be 40% of capacity. Normalcy will only return from Q3 onwards.

In view of this, the company will need close to 800-900 crs of cash flow and will need to take on 500 -700 crs of debt at a minimum to support the operations.

Long term demand/ Business model impact

Short term fragility is from complete stoppage of travel/forex, MICE events etc. Long term risks/ fragility comes from OTL and move to online travel, which for now is lower risk and with tightening of capital, could reduce.

The following was part of a note written to subscribers. Hope you find it useful

We bought the stock a year back and added to it in December. Since then, the stock price is up 70%+. In the interim, the price doubled and then gave up some of those gains. Our buy price and fair value did not change as much during this period, which shows that business performance does not swing as much as the price

Like several other companies, the stock went from a value/ growth to a momentum play in a matter of months

When we make an investment, it is with a 2-3 year ‘rolling’ horizon. We have a 2-3-year view, but if the company keeps performing, the horizon gets extended. After a few years, if you look at the holding, it seems to be a buy and hold position. However, the ‘hold’ part is always conditional on the performance of the company

In contrast a momentum investor buys a company, when it shows up high on their momentum list (highest returns in the look back period), with their own unique set of adjustments. The time horizon for such investors is much shorter. Momentum works for 6-9 months on average and requires such investors to exit and replace with new stocks which appear on their list

Same stock, different approach

Both the investors may be invested in the same stock but are playing a very different game with a different time horizon.

The price of the company, however, is impacted by the action of all the investors, irrespective of their motivation. A loss of momentum is further compounded by the exit of such investors/traders.

I am not making a moral argument in the above and there is nothing good or bad about it. It is stupid to accuse other investors of disturbing your game. We need to aware of what is happening but be clear about our motivations.

We have a longer time horizon with focus on the long-term performance of the company. If the execution falters, we will exit. Till then, we wait and watch

In the meantime, we will not do momentum or short-term trades with our positions. Doing so would be stupid on our part. If we want to play the momentum, then the approach is very different (regular, pre-decided exits). Mixing the two leads to the worst of the two worlds