CategoryInvestment process

My decision to sell L&T in 2003 (after holding for 4 years) has been my worst investment decision till date. Although my cost basis was 190 odd (pre-divesture) and I sold at 230 odd (again pre-divesture) and did not lose money on it, I consider it to be one of my worst decisions because of the following reasons

1. The stock has since then become a 10 bagger (sells at around 2250 without considering the value of cemex)
2. I sold off because I became exasparated with the management. Between 2001 and 2003, they would constantly pay lip service to divesting the cement division and would then drag their feet on it. What I failed to realise at that time was that the Kumarmangalam birla group would be able to force the management to divest the business eventually.
3. Did not appreciate the importance of the business cycle. The E&C sector was in doldrums at that time and as a result L&T (E&C) division profits were depressed. The E&C sector turned around big time after 2003 and every E&C company has benefited since then
4. Did not do the sum of parts analysis – basically that the sum of value of the various L&T divisions was more than the complete entity.

In the end, my regret is not that I missed a 10 bagger. What clearly pricks me is that my analysis was sloppy and I did not evaluate all the factors clearly. I was looking at the company with a rear mirror view (the Margins and the ROE were poor then and I expected it to continue).

However, I have tried to learn something from this disaster. So here goes

• understand the sector dynamics when investing in a stock.
• Appreciate the importance of business cycle. Although predicting it is not critical, but a basic understanding is a must.
• Focus on sum of parts versus looking at a company as a whole, especially if the company has various different businesses.
• Have patience
• Try to avoid a rear mirror view.

Have you had such an experience?

As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.

I work in the tech industry and have always been fascinated by technology and the role it is playing in improving our lives (definitely mine – cannot think of life without broadband, internet, e-mail, google etc).

Back in 2000, during the tech bubble, like others I got swept by the internet and technology mania and went ahead in invested in technology stocks. The basic logic of my analysis was correct, but I got the valuation wrong (overpaid for the optimism). After promptly losing money and later reading munger and buffett’s thoughts on technology, I have changed my approach to technology.

I am by no means a techno-phobe. I spend time reading tech blogs, looking and trying to understand changes happening in technology and how it seems to be impacting various businesses such as newspapers, media, advertising etc. But it is diffcult to realistically forecast a technology business out for several years. It is more so for technology businesses as valuations of most of these companies is high and to make any money, one has to be able to forecast the cash flows for 5 years or more.

Over time based on what I read and based on my experience, I now prefer companies which are predictable than which will have the highest growth. My own experience has been that markets tend to pay more for growth than predictability ( FMCG v/s IT services stock ?)

At the same time the decision to invest in tech stocks also boils down to one’s investing philosophy. I have tend to have a focussed portfolio with a few names and want to hold for 3-5 years with low maintenance (quarter or annual followup). As a result it is difficult for me to hold technology stocks as it requires too much effort to follow them.

As an aside I work in IT services. So my professional career is tied to the Tech industry. The last thing I want to do is put all my eggs in the same basket. That is not the typical way of looking at diversification. But for me the income stream through my career and my stock portfolio need to diversified sufficiently. Who wants to be lose a job and also see the stock portfolio crash at the same time, because the industry hit a roadblock !!

I keeping reading this debate on whether long term buy and hold is a smart strategy or is it a fad followed by buffett followers.

It would seem to me that such a discussion clearly shows that the person debating it really does not get the core idea of the approach. Long term buy and hold is not long term buy and forget. There is no such business which one can buy and forget. When there is such intense competition, one has to follow or track the company in which one is invested.

My typical approach to understand the industry and then the company in detail. If I am comfortable with the company and the industry and if the valuation is compelling, I tend to slot the company into one of the three buckets

Type 3 companies are value stocks (graham style) where the intrinsic value of the business is flat or at best increasing very slowly. I hold such companies till they come within 90% of my estimate of intrinsic value and then I sell them. I do not see a benefit of holding such companies too long if the company is selling close to the intrinsic value which is turn is flat or worse, shrinking

The other end of the spectrum are my type 1 kind of companies. These are dominant companies with strong competitive advantages and their intrinsic value is increasing at decent pace. Such companies are more of the buy and hold ‘longer’ type of companies for me. I typically read the quaterly updates for these companies and try to check if their competitive strenghts are intact and they would continue to increase their moats as time passes. I have found that selling such companies when they touch their intrinsic value (atleast my conservative estimates) has not been a good idea. Most of these companies do well over time and their intrinsic value keeps increasing. So even if the company is moderately overvalued, then I would tend to hold on. Ofcourse if the company is wildly overvalued, then I would sell the stock.

The type 2 companies are between 1 and 3. This is grey area where majority of my picks lie. Most of these companies have decent comptetive advantages and their intrinsic value increases erratically. So these kind of companies require more attention and at the end of each year, I go over my thesis and try to re-think whether I should hold onto the stock or sell it , especially if it is selling close to the intrinsic value.

All of the above is a decent amount of work. Which is why I don’t hold more than 10-12 stocks in my portfolio. But finally I think there is no buy and forget kind of stock. Ofcourse I don’t follow the stock on daily or weekly basis. My follow up is more quaterly or annual.

Found this Q&A buffett had with University of Kansas Business School Students. As usual the Q&A was a learning experience for me. In particular I found the following reply interesting

Q: What sources of investment ideas are available today?
WEB: First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonable predict. An example is chewing gum versus software. You also have to recognize what you can and can not know. Put everything you can’t understand or that is difficult to predict in one pile. That is the too hard pile. Once you know the other pile, then its important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis (emphasis mine). We’re getting ready to make a $5 billion investment and this was the process I used.
I used to handicap horse racing. The odds had to add to 100%. Sometimes there would be what in horse racing is referred to as an “overlay”. We’re looking for overlays in the stock market. It’s like a treasure hunt.
You can increase your sources of investment ideas by widening your circle of competence. I’ve widened my circle over the years. I only needed to understand insurance in 1951. There were enough opportunities in that sector alone.

The above answer had me thinking. I have been making an effort in trying to learn about various industries and deepen and wide my circle of competence. The process I am following is

– pick up an industry and identify the major players in the industry
– If available, read a sector analysis report from any major brokerage firm: These reports give me good starting point and allow me to develop an initial understanding of the industry
– Use the initial understanding to build my ‘industry analysis’ worksheet
– Come up with additional questions (in terms of the competitive dynamics of the industry)
– Read the AR for the major companies (initially for the current year and then for the previous)
– Update the ‘industry analysis’
– Do valuation analysis for some of the companies which may be cheap

At the end of the above process I may find some companies worth investing. A lot of times I draw a blank. But I guess it is fine because as long as I keep doing this and improving my circle of competence, opportunities will come up.

I think it is extremely important to have well defined investing philosophy to guide one’s decisions and to also to keep your head when there is too much fear or greed in the market.

With the Indian market touching new highs everyday, resisting the urge to get on the bandwagon is fairly important. I have had a loosely defined approach with which I have become comfortable both in terms of the risk and the return and most importantly I am able to sleep soundly in the night.

So here goes my personal investing philosophy (in no specific order)

1. Invest in companies with sustainable competitive advantage in my own circle of competence with a time horizon of 3-5 years.
2. Invest in companies where the risk reward ratio is atleast 3:1 in my favor and I have a ‘variant perception’ from the market.
3. Avoid investing based on any macro-economic point of view or short term opinion (mine or someone else) of the market
4. Try to beat the market by 5% over a period of 10 years and lowest possible risk (the key word being try)
5. Avoid loosing money

Thoughts behind each point

1. I feel comfortable investing in a company whose business is simple to understand and preferably will increase its intrinsic value over a period of time. This enable me to practise a buy and hold philosophy
2. I prefer 3:1 odds in my favour and a 40-50% discount from conservatively calculated intrinsic value as it enable me to get an average return of 18% per annum
3. I have avoided investing based on macro-economic point of view or any short term outlook as I am not good at it and consider most of it as noise to be avoided
4. A return of 5% over the market give translate roughly into 17-18% per annum. Not exactly a return which would get me into investing hall of fame, but over a long period of time it is good for me as it comes with low risk
5. Point 5 has meant that I have passed a lot of opportunities which looked good, but were not obvious slam dunks. As a result I have been guilty of omission than commision (though I have had my share of duds)

So how has above philosophy worked for me. I would say pretty well, because I think I have been able to achieve more than my targeted returns with very low risk and most importantly, have been able to sleep well.

Please feel free to share your investing philosophy

I use a hurdle rate which I need to cross if I need to justify the time and effort I spend on investing actively, rather than using a mechanical approach of rupee cost averaging (using an ETF or an index fund)

A rupee cost averaging approach of investing Rs 1000/- per month, every month for the last 10 years would have lead to an average return of around 15% per annum (As an added factor, I added a filter of stopping the plan when the market P/E exceeded 25. I added this filter to ensure that I would avoid putting money in the market when the market seemed overpriced by a decent margin).

This strategy would work even better with a mutual fund with a good long term record of beating the market by a resonable margin (resonable being +3% above market return over a period of 5 years or more).

So in effect if the portfolio of stocks picked by me, does not exceed this hurdle rate of 15% per annum (for a rolling cycle of 5 years and not for every year), then it would not justify the time and the effort.

Luckily till date I have exceeded this rate. But the results are not conclusive, because it could be due to dumb luck. I would consider the results to be conclusive only if I can achieve this kind of outperformance for a period of 10 years or more.

I saw this concept in the book ‘A mathematician plays the stock market’ which I am reading currently and liked the explaination and its relevance to me as an investor.

Expected value is essentially the sum of product of gain/losses from an investment and the associated probabilities. The expected value is the most likely result from an investment.

Let me explain

Let us consider a stock S. I have reasons to believe that the stock would decrease in value by 10%, with a 80% probability. At the same time, there is a long shot product if successful could result in bumper profits and could increase the stock price by 100%. However the chances are just 20% for this event.

So in the above scenario the expected value from the stock is = (-10%)*.8+(+100%)*.2 = 12%
However value most likely result to be expected from such as stock (atleast 80% of the time) is a return of –10%.

A large group of positive ‘expected value’ investment with negative ‘value to be expected’ should be profitable over a period of time. This is same as the principle of arbitrage or value investing from ben graham. The above concept is also critical if one is dealing with options. For example, sellers of put options have a negative expected value (sometimes very high), but a small positive ‘value to be expected’.

So next time if some analyst talks of a positive ‘value to be expected’, you may want to check the assumptions and figure out the ‘expected value’ of the recommendation