The value of ‘overvalued’ stocks
I recently tweeted the following
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.
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.
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 🙂 )
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?
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?
Why not 5 years? Well now we are moving from the physical to the meta-physical 🙂 and debating the nature of reality.
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.
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.
Example: Cera sanitary ware, Amara raja batteries, Astral polytechnic etc
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.
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.
In such cases seemingly overvalued companies were truly overvalued.
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.
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.
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.
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.
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.
Platform Business
This is good note on what is a platform business
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.
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.
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.
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.
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 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.
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.
– 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?
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.
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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.
Active patience
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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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.
Shortest investment book
1. Save atleast 20% of what you earn
2. Buy a term life insurance policy such that the policy value = 30-50 times annual expenses (add health insurance to this if required)
3. Park 10-20% of savings annually in liquid deposits (Emergency fund or for down payment on a house)
4. Invest 60-80 % of savings via SIP in an index fund or a basket of diversified mutual funds like HDFC equity.
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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.
Facing despair
I was planning to continue on the previous post – ‘Failure to sell’ , but decided to write on a different topic as I have been receiving quite a few emails – full of despair and frustration.
A lot of young investors, who came of age in the early 2000s, entered the workforce when the economy was booming. If you passed out from a half decent college, you could get a decent job with a good starting salary.
As the economy was growing at 8%+, it was common for employees to be given 15% salary hikes (people quit in disgust if the raise was less than that) and the high performers got promoted every other year. In addition, flush with cash, some of the same people invested in the stock market or real estate and saw their net worth double in a few years.
You did not have to work too hard to do well
We are not entitled to be rich
I am going to ruffle a few feathers, but let me still say it – We had a dream run from 2003-2008 and now it is over. The days of 20% salary hikes and 30% stock returns are gone (at least for now) for the masses.
If you are really good at your job or in investing, you may get above average raises or returns, but that is not going to be the norm for everyone
If you entered the workforce in 80s or 90s, you may have seen tough times yourself (or maybe your family did). The reason why the current slowdown feels horrible is because our expectations are high now. Don’t get me wrong – I am equally angry with the government for running the economy to the ground.
Keep grinding
I faced a similar market from 2000-2003, when the market dropped by around 50% over a three year period. At the market bottom in April 2003, capital goods companies like BHEL, Blue star were selling at 5 times earnings. The current market darlings like Asian paints (15 times PE), Marico (around 5-7 times PE) and other consumption stocks were selling a very low PEs too.
At the risk of getting philosophical, I can think of the following things to do this time around
– Assess your risk tolerance: If you have trouble sleeping in the night after seeing your portfolio drop by 10-15% , you should reduce your level of equity holdings. My thumb rule – will I be able to sleep well if my portfolio dropped by 40%+ ?
– Clean out the trash: Now is a good time to clear up junk from the portfolio. A bear market and 40% loss on weaker ideas concentrates your mind. One should evaluate each position closely, sell the weaker ones and redeploy the cash in the better ideas.
– Have faith: There is no data or logical argument which can make you hold on to your stocks or add money to it. You need to trust that the markets will recover in time and so will your portfolio.
It is easy for people to say that they want to think independently and stand apart from the crowd. Now that that we have a blood on the streets and no end in sight, you will know whether you can truly do that.
At the risk of looking foolish, I plan to keep adding to my positions.
Edit : I have a day job to support my family. I will not starve even if my portfolio goes to 0. I would not do the same thing if I was living off my savings.
Searching the debris
There are two numbers I want to highlight
This is the drop in the CNX midcap and CNX small cap index since the start of the year. If these numbers look troubling, they don’t even represent the vertical drop in some stocks. I wrote about some such stocks in this post and now that seems to have become a daily affair with some stock just dropping like a stone.
No such luck these days!!
If the company you own comes out with slightly disappointing numbers or if there is whiff of a corporate governance issue, the punishment is brutal.
It would take real optimist to look for any good in this. I am in that camp.
If you are looking closely at the carnage, you may have noticed that companies with a weak business model or poor corporate governance are getting punished severely. At the risk of sounding insensitive, I would say that is the way markets should work. A properly functioning market should reward companies with sound business models and good managements and punish the wealth destroyers.
Digging through the rubble
A lot of investors, if there any left, are shell shocked with this sudden turn of events. The most common advice is to wait for the uncertainty to resolved. The reality is that the future is never certain – it is just that investors sometimes get optimistic and pay for the illusion of certainty.
The first point to keep in mind is to avoid anchoring to the pre-crash prices. A stock is not cheap just because the price has dropped by 90% – look at Deccan chronicle holdings. A large drop in the stock price is a good starting point, but not a sufficient condition for a bargain
The second point to keep in mind is to look closely at the fundamentals of the company. Is the company highly leveraged and with a weak business model? In addition, it is important to avoid companies with corporate governance issues.
The final point is regarding one’s own emotions and conviction. Once you have identified a good idea and believe that the market is being irrational in beating it down, it will require a lot of emotional fortitude to hold onto the stock. One is likely to get a daily dose of negativity via falling stock prices and bad news or reports about the company. It is unlikely that a company with a beaten down price is enjoying great growth and high expectations from the market. One needs to do his or her homework that the current downturn is a passing phase and the stock will give above average returns over the next 2-3 year time frame.
I am currently looking at some of the following companies. This is just a preliminary list and I may or may invest in any idea
- BHEL
- Infinite computer s ltd
- Manapuram finance
- FAG bearings
- Whirlpool India
- Eros international
- Tata motors
- Canfin homes – thanks to ayush mittal.
I am sure some of you would have rolled your eyes on reading this list. Well, I have never been the one to buy popular stocks anyway. I am usually fishing in areas where you will not find most investors.
A roller coaster ride since 2007 and negative returns since then in comparison to double digit returns in gold and real estate means that if you tell someone that you are investing equities, they think you need to be assigned to a mental institution. It is not easy to be any equity investor these days. However if you look past the gloom, then the current downturn is a decent time to pick good stocks.
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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.
Taking advantage of quarterly results
We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J
A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.
If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions
For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).
In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)
In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.
Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.
For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.
If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.
In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.
The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.
Read /listen to the conference call
The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.
All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting 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.
Trading on noise
Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.
In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)
If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.
I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.
If you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.
I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true
2013 market predictions
We are approaching the year end and soon the experts will start coming out with their predictions for next year. As there is a lot of competition to be the first one, I decided to get ahead in the line by kicking it off in November itself
So here goes
1. Barring any macro-economic shocks and if sensex earnings exceed 15%, the stock market should be up next year. If however we have a crisis in Europe or we get an oil shock then the index could even touch 10000 levels.
2. Gold could be up by 10%, if we get a major recession in US due to the fiscal cliff and it could surprise us on the upside if it coincides with the further instability in Greece and Spain. Over the long term, the macro-economic and supply-demand drivers point to a continued increase in gold prices.
3. Capital good stocks in India could surprise on the upside if the current momentum on the reforms continue. One needs to focus on high quality names in the sector
4. The consumption story continues to play out and high quality names should outperform the market in 2013, barring any sudden depreciation of the rupee. Demand from consumption centers, such as India and China largely seem to be on a firm footing
5. The real estate market will continue to face headwinds of high interest rates in the initial part of the year, but if RBI starts cutting rates in the second half, we could see higher activity in certain pockets of the market
6. Rohit Chauhan will become the smartest and richest investor in the Indian stock markets. President Obama and other world leaders will seek his counsel on how to fix the developed economies J
If facts change, do you change your mind?
I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.
Q4 sales growth, YOY – 60%
Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)
The explanation
It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.
Not a one off case
The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.
I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.
It is better to look foolish (in my own eyes), than miss out on a good idea
Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.