CategoryRisk management

Basket Bet

By Rohit Chauhan
In Investment ideas, Risk management
June 22, 2020
4 Min read
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B

I wrote the following note to my subscribers on a recent position we have initiated. Specialty chemicals and Pharma is currently among the few sectors which have caught the fancy of the markets. I think these sectors do have the potential for above returns in the long term, though not every company will benefit equally from the tailwind.

The success or failure of each company will come down to the unique advantages/ competencies built by the management and their execution going forward. In addition to that, each company faces idiosyncratic (fancy word for unique) risks with FDA audits being one of them.

As a result, a single company bet can lead to losses even if rest of the sector does well

In order to mitigate this risk, I have taken a basket bet approach for the portfolio. This is also due to the fact, that one cannot estimate such risks ex-ante (before the fact). Diversification across the sector reduces, though does not eliminate the risk.

Pharma Sector bet

This is different from our usual transactions. This transaction is part of a sector bet. I am betting on the pharma sector for the following reasons

  • Several companies in the sector have been investing in R&D across a wide range of products such as Finished generics, API, Biosimilars and new dosage forms. As these investments have a long gestation period, the result is not fully visible in the P&L statement yet. We are now at the cusp of seeing the result of these investments, which have been made over the last 5+ years
  • Several companies have been investing on the front end (marketing) for the US and other markets. This allows the company to have a better control on the supply chain (with better margins) and work directly with customers. However, building the front end takes time and we are seeing early results of that.
  • The industry went through a growth phase till 2015, when it was hit by a mix of issues. The industry was hit by FDA audit failures which resulted in a loss of revenue for companies which failed the audit. At the same time, there was a consolidation of buyers (companies which buy pharmaceuticals for hospitals and pharmacies) which resulted in higher pricing pressure. This caused a drop in the growth and margins for the industry resulting in re-rating of the sector.
  • The industry has since then improved its processes and has a much better record of passing FDA audits. In addition to that, companies continue to invest in these processes to improve their compliance rate.
  • Several companies in the sector are now expanding beyond the US (and India) into other countries such as the EU, Japan and Africa. This should provide further growth opportunities for the sector.

We have an option to bet on a single company to play the above theme, but the risk of FDA audit and higher pricing pressures in some product segments continues to be high. I want to take advantage of this long-term tailwind and growth opportunity, but at the same time reduce the risk of failing an FDA audit.  Hence my plan is to go ahead with a sector bet where we will spread out our capital across a few attractive ideas.

I have not decided the number of companies or the size of the bet yet.

The ideas in this bucket – which I will call the pharma bet (PB) could be rotated in and out with a much higher frequency compared to other positions in our portfolio. I have been studying the sector for some time now and like a few other companies in this space. My plan is to add companies some of which could be long term plays whereas others could be more tactical in nature.

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Stress testing the portfolio

By Rohit Chauhan
In General thoughts, Investment process, Risk management
April 18, 2020
3 Min read
1 comment
S

< Company names and details of the same have been removed>

To all subscribers,

I have been asked about the impact of the ongoing epidemic (Covid19) on our portfolio companies. I have been doing this analysis and this note is to describe the process. This is a probabilistic exercise which depends on the following factors

  • How long will the lock down last?
  • Will the lock down be lifted in phases (both in terms of time and geography)
  • How will this event impact consumer behavior (short and long term)?

All the above factors are important, but unknowable for now. We have a range of guesses floating around with unknown probabilities. Instead of trying to guess what is going to happen, I have tried to analyze this situation in a different fashion. I have broken down the problem into three-time buckets with a specific set of questions for each bucket

Short term bucket (3months)

  • Does the company face bankruptcy risk (due to zero revenue)
  • What is the liquidity situation for the company? In other words, does the company have enough cash/ access to credit to tide over this period

Medium term bucket (3-9 months)

  • What is the break even revenue for the company at which it can it can sustain its manpower expenses and mandatory overheads (rent, power etc)

Long term bucket (> 9 months)

  • Is the long term demand for the company impacted by this event?
  • Will the consumer behavior change permanently such that the company’s business model will be impacted?

The above questions are crude approximations and I am not trying to come up with a numerical impact on fair values. I have seen some analyst reports where they have changed the target price by X%. Putting a number, does not change the fact that this is still a guess.

Some of the conference calls by company managements show that they are also grappling with the unknown and do not have visibility on the numbers. To assume that an outside investor can do better is silly.

I have evaluated these questions using the following data points

  • Liquidity risk/ Credit report from ratings agencies
  • Company annual reports/ financial statements to evaluate how long the company can survive with zero revenue and the level of topline needed for break even
  • Management commentary

The stocks in the model portfolio are arranged based on their risk profile. This sequence is again a rough approximation of the risk. What this means is that company 2 is not more risky than Company 1, but Company 2 has lower risk than Company 14 which is at the bottom of the portfolio.

Dynamic situation

The impact on each company will depend on how long the lockdown lasts, whether it is consumer facing and the fragility of its balance sheet. In our case, most of our portfolio companies (other than financials) have low to zero debt. There is only one position which has high debt levels and is exposed to the consumer. As a result, this company is the lowest in the model portfolio and has been on hold much before the current situation (old subscribers including me continue to hold it).

I will be addressing a few more topics in my next post with the above framework in mind.

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How do I execute ?

By Rohit Chauhan
In General thoughts, Risk management
March 29, 2020
3 Min read
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H

To all subscribers,

I have been emailed variations on this question – What, when and how much should I buy based on the model portfolio?

Before I share my thoughts, let me share a few pre-conditions

  • Please ensure that you have around 6-12 months of cash or equivalents (like FDs) to take care of your expenses. This would ensure that you can handle any loss or reduction in income.
  • Do not and I repeat, DO NOT invest any capital which you need in the next 2-3 years.
  • Do not use any form of debt to invest in the market. A lot of crazy stuff can happen, and we have seen the impact of debt in the form of margin calls in the recent past where individuals were forced out of their positions.
  • There will be volatility in the near term. Be prepared to see wild swings in portfolio.

Both me and kedar have arranged our personal affairs in the above manner. We maintain enough liquidity and avoid debt, so that we can remain rational inspite of extreme swings in the market. We have never used even a single rupee of debt to invest in the market. There is enough risk in equities and we don’t want to amplify it more.

Onto the question of how to execute

  • Please review your asset allocation (yourself or with your financial advisor) and invest an amount which matches with how much you are willing to allocate to equities. This allocation is based on individual situation and there is no fixed percentage. That said, one should exceed this allocation.
  • Once you know the amount you can allocate based on the previous points, one of the options is to invest it as per the model portfolio. If that is the case, the amount per position is based on the position size in the model portfolio (multiply position size % with the amount you want to invest)
  • I have shared the buy price which can be used as reference to make a buy decision. If the current price is below the buy price (which it is in most cases), then you can add that position to your portfolio.
  • I would suggest going for a staggered approach. Start with 25% of the final size and keep adding to it over the next few weeks/months (as long as it is below the buy price). You won’t get the absolute bottom for each position, but should get a decent average price
  • In terms of adding positions, go from the top to bottom. The bottom most positions have the highest risk, but also the highest upside (should they work out)
  • Be ready for wild swings in the price

It is natural to feel confused and concerned about losing money under the current circumstances. The best course of action in such a situation is to slow down your decision making. It is important first to survive and then thrive/ take advantage of the uncertainty.

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Economic sudden stop

By Rohit Chauhan
In General thoughts, Risk management
March 17, 2020
3 Min read
1 comment
E

I wrote this note over the weekend to my subscribers. This is a hypothesis based on how events have played out across countries. Things could get better, but the probability of that happening in the near term keeps reducing by the day. We are seeing the first order and maybe the second order impact of the Pandemic.

————————–

What is an economic sudden stop – It is when most economics activities for a location come to a sudden stop due to a financial or natural disaster. In most cases such sudden stops are local such as due to a flood or an earthquake.

On rare occasions we get economic sudden stops at country level due to economic reasons – think of Asian currency crises in 1997.

Global sudden stops are extremely rare and have happened only during the great depression in 1930s and 2008. Even during wars, we do not have such a situation.

The current crises has the potential of an economic sudden stop (and may have started). I have been thinking of this risk (which I have been referred to as a Tail risk). Over the weekend, I drew the following crude picture to illustrate my hypothesis (please excuse my drawing).

Key points

  • Due to the exponential nature of the spread of this infection, most countries have under-reacted in the beginning.
  • Once the numbers cross the threshold, a country has an Oh shit ! moment. US and Europe had it last week. I don’t think India has had it yet.
  • Once we cross this moment, we enter the panic phase quickly where all economic activity slows down dramatically as the country stops travel, and all kinds of social and business events which involve more than a handful of people (update : US has banned all events for > 50 people)
  • We will not see a gradual slowdown of economic activity. It will drop off the cliff.
  • As you can see from the picture, economic activity will resume (slowly) as the situation normalizes. As of today, we cannot predict when it will happen as it depends on both the domestic and International situation.
  • This is a major event and will permanently change the behavior of Individuals and Countries. Its too early to predict what will happen

Action plan

  • The focus should be on making through this event – both health-wise (both self and family) and financially
  • As I shared earlier, I will not try to rush into the market based on valuations alone. Depending on how things play out, the financials and even viability of a lot of business will change
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Battening down the hatches

By Rohit Chauhan
In Quick thoughts, Risk management
March 9, 2020
3 Min read
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I published the following note (with edits) to subscribers on 1st march before things started going downhill in a hurry. I have another note going out which will be posted here soon.

———————-

I have been watching the events around the Corona virus for the last few weeks and started seeing some impact on our portfolio, towards the end of January. I wrote a note – Why are we suffering, sharing the observation that our portfolio was behaving in a bi-polar fashion. The so-called quality stocks which have higher predictability of growth, were holding steady while the cyclical positions were being beaten down as if all these companies were headed to bankruptcy.

In hindsight, this behavior seemed to be a reaction to the risks which were developing in the global economy due to the Corona virus.

In the last few days, these risks have risen substantially. I am not an expert in these things, but the preliminary data seems to point to a high infection rate (also called R0 which is around 2.2 versus 1.3 for common flu, which means one person can infect two others). At the same time, the mortality from this infection is around 1.2-1.5%.

The above numbers are preliminary and likely to change. However, a few things have become obvious in the last 2 weeks

  • The transmission rate is quite high, which means that there is high risk of the infection spreading globally
  • We have already crossed or maybe are at the brink of crossing the point of containing the infection. Again, there is a lot of confusion around this point
  • In the worst-case scenario, even if the mortality rate is low, the absolute number of deaths will be high

Unfortunately, in India, we are quite used to such infections in our main cities due to poor levels of sanitation. We tend to take such events in a stride. However, this is not the case globally. Irrespective of the trajectory of this epidemic, there is a high level of fear across the globe. This is leading to a big slowdown across the globe as companies stop travel and governments quarantine portions of the population.

We are seeing the first order effects of the above event. Like the ILFS event in India, which had a domino effect on NBFC, real estate and the overall economy, the second and higher order effects will take time and will show up in surprising places. In my view, it is too early, and I would say impossible to predict how this situation will evolve (for better or worse).

I have reduced the position size for the three companies where I think the medium-term growth prospects were moderate and valuations continue to be on the higher side. I have raised the cash levels so that we have dry powder available to pick opportunities as they arise.

We have 30% cash in the portfolio now

If we are lucky, everything will return to normal and markets will resume their normal course. However, if the risks of a pandemic increase, we will see a lot of selling in the market. This selling will not be rational, and it will not be tied to the fundamentals of a company. In such panics, people sell whatever they can.

I have no plans of burying my head in the sand. If prices get attractive for some of the companies I have been tracking, we will add them to the model portfolio even if the prices continue to fall. I am willing to bear more pain in the portfolio as I think this will eventually pass.

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