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Found this great article from Michael Mauboussin, Chief Investment Strategist of Legg Mason Capital Management (LMCM). It is a 12 page article on the common errors investors commit in using the DCF (Discounted cash flow) model.

Personally my approach to valuation (which is not original and mainly developed from reading) is to create a DCF model for three scenarios. I extend the current business condition and create an as-is scenario. So the assumption is that the current growth rates, margins, competitive situation etc will continue as is. The second scenario is an optimistic scenario where in I try to calculate the intrinsic value using the most optimisitic assumptions for growth rates, margins, competitive intensity etc. The third scenario is the pessimistic scenario with poor growth rates, high competitive intensity etc.

I try to associate probability against each scenario and try to calculate the expected value.

So expected value is = intrinsic value (as is) * probability for ‘as is’ + instrinsic value (optimistic scenario)* probability for optimisitic scenario + intrinsic value (pesimistic scenario) * probability for pessimistic scenario.

I also cross check the above expected value with ratio based valuations.

The above approach forces me to think harder on all my assumptions. Also when the annual results are declared for any company I have invested in, I go back to my excel spreadsheet and relook at the numbers, assumptions etc and calculate the new intrinsic value again. This gives me an idea on whether I should sell, buy more or hold.

I am not able to post my valuation / analysis spreadsheet on the blog. If any one is interested, please e-mail me on rohitc99@indiatimes.com

I was looking at one of my first few posts

Market now offering 10:1 odds

And

Investing based on odds …Does it work ?

And saw that back in 2004, the market odds were 10:1

So what are current odds?

With a PE ratio of around 19, the current odds are around 1.4:1 . These odds are based on the last 6 years data. Its very easy to calculate the odds. Just export the nifty PE data from the their website here. The odds are basically the number of days the nifty closed at a PE of more than 19 to the total number of days.

Now the above calculation is very simplistic and one can argue, backward looking. So if you believe the earnings will continue to grow rapidly, interest rates would remain at the current level and the ROE of the indian industry would remain at the current level (around 24%) or increase, then maybe the odds are better. But frankly the margin of safety does not exist. In may 2004, the odds were 10:1 and the expected returns much higher. That’s not necessarily the case now.

The above does not mean that there no investment opportunities out there. Its just that there is no low hanging fruit now. Back in 2003 or 2004, just putting money into the index was good enough. Any PE or valuation screen was throwing up a huge number of stocks. But now, I am not finding too many companies. I am currently looking at Micro inks and Asahi glass and would be posting my analysis soon.

update 21st : saw this update on moneycontrol – With the Sensex touching 11K today, analysts told Moneycontrol that the benchmark is fairly priced at current levels and apart from fundamentals, liquidity is trying to find value in Sensex stocks.

see this table in the article for the valuation of the top sensex stocks

what is magical about 11k ? read this speech by warren buffett at wharton (question 3) where he talks of valuation in terms of band. So it may be possible to say that 10-11k is fairly valued with a certain set of assumptions. But giving a precise number is trying to bring a level of mathematical certainty to something (valuation in this case) where it may not be possible to do so

Do read this speech by warren buffett. I learnt a lot from it

I got the following comment from abhijeet on my previous post. Instead of replying directly to the comment, I thought of putting my thoughts on options in a separate post.

I have been studying options and futures on and off for sometime (read a few books on it). However I am still not an expert or anywhere close to it to commit a meaningful amount of money to a position. However as a start, I have started looking at options as a defensive strategy. Let me explain

For various reasons I do not have a firm opinion on the valuation of IT firms. One can argue that the future is bright (see the latest issue of business today for no. of IT deals coming up for renewal this and next year), but at the same time there are several known factors which could upset the applecart. In the end there is little margin of safety in the true graham sense.

So if I hold IT stocks and have a fixed time horizon to sell the stocks, then buying put options is good strategy to limit the losses (and still have an upside). However this strategy is not a costless strategy. It may not be a strategy with a positive expected value. But buying puts acts like an insurance. In the end it would prevent something truly bad from happening to my portfolio, but it is not strategy to make money.

I still look at using options as a defensive strategy as I am not comfortable with an approach which could have an unlimited downside.

Covered call writing as mentioned in comment could be strategy to make money, but I have not tried it at all and not sure how much I could make (net of all the commissions, spreads on the options) unless I had a strong opinion on the stock on which I am writing the covered call. The other risk which I see in options is that not only one has to be correct on the stock, but one has to get the timing right (which I am very bad at – have been wrong more than 50 % of the time whenever I have tried timing)

In the final analysis, even if I am not planning to put any significant money in options, I see a definite value in learning about it.

A strange topic to write on and that too after a gap of almost 15 days. Not sure if anyone missed my posts, but I surely missed posting something on my blog.

I was away mainly due to my regular job demands. So during the last few weeks I did not have much opportunity to analyse any new companies or look at any new investment ideas. But I did have a chance to reflect on time as a key constraint.

Although time is a constraint for anything you do in life, I tend to think of time as a constraint or limitation on my much effort I can devote to investing and reading. Having a job, family and all other assorted interest puts a limit on what I can or cannot do in investing.

Thinking in reverse, I more or less know that I cannot do the following due to my time constraints

• options trading: It’s a specialised field, requires day to day supervision and lots of effort. Other than the fact that I am no way an expert in it, it is too risky for me as I just do not have the time or the stomach for it
• Deep value investing: This is the quantitative mode of value investing. I understand this form investing fairly well (atleast I think so), but this form of investing require more effort as one has to churn the portfolio more often. Also tempramentally, I am not comfortable with these ‘cigar-butt’ companies which are lousy companies, but may give a decent return. Also to practise this kind of investing, one has to diversify into a decent number of companies and then track them atleast quarterly
• Day trading: No time and no temprament for it at all. It looks like easy money these days. But long time back I made a promise to myself to invest into opportunities which I understand and avoid the ones I don’t. In the end I may miss some easy money, but avoid the pain too
• Gold/ Commodity trading: No time, special knowledge or temprament here

So by this reverse exclusion approach leaves me with searching for good companies with sustaniable competitive advantage which I can hold for long term. It may seem to be a very small area to work in, but it is not. For the size of my portfolio, if I can find 1-2 good companies a year, it is good enough.

Going forward (time permitting) I plan to expand my investment activity to special situation and deep value investing. But that is still some time off.

Also those of you who would have invested in reliance as an arbitrage situation, the bet would have paid off. Pre-split reliance was selling around 850 – 900 a share. Post spilt it is around 1140 a share. A 25 % return in 2 months.

Now I would like to boast that I made a killing and had some terrific insight …blah blah !!. That’s not true. I tried doing a sum of parts analysis before the split and read some articles on this arbitrage situation. Eventually I got stuck on two points

• How to value reliance infocomm. Conservative valuations (v/s bhart telecom) showed back of the envlope value of 275 per share (300 now). In the end I was not sure of how to value it
• If reliance infocomm could be valued at 275 per share, the value of the core business was at around a PE of 12 on current year earnings. Again I was not a 100 % sure if that was undervalued as the petrochemical business is on an upswing and the earnings were at a peak

In the end, as I was not very confident on my analysis, I did not make a big commitment. I am not regretting it though. I would rather do nothing if I am not sure than do something just because others are doing it (does not pay to have others think for you). However I am trying to reverse engineer the arbitrage and see how I could have analysed it better and ‘forseen’ this opportunity.

In anyone has an insight or did this in dec/jan before the split, please share with me. I would like to learn from you