CategoryUncategorized

Increasing circle of competence

By Rohit Chauhan
In Investment process, Uncategorized
January 19, 2006
3 Min read
2 comments
I

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.

Read on2 comments

Accouting standards and EDIFAR links

By Rohit Chauhan
In Uncategorized
January 14, 2006
1 Min read
Add comment
A

Added two links under ‘OTHER’ – one for the ICAI accounting standards and the other for EDIFAR, which the SEBI database for all the filings from listed companies.

Not exactly exciting stuff, but fairly important for an investor. I think as an investor it is crucial for me to understand the various accounting standards well and the EDIFAR database is good source of data on any company which I want to investigate. I typically read through analyst reports as a starting point (ignoring their recommendation) and then follow it up by looking at these filings for detailed information on the company.

Read onAdd comment

Can offshore outsourcers end reign of Big Six?

By Rohit Chauhan
In Industry analysis, Uncategorized
January 14, 2006
2 Min read
Add comment
C



Found this article on cnet.com on the trend in IT outsourcing industry in the near term

Almost $100 billion in outsourcing contracts will be up for grabs in the next two years, and big players including Accenture, Electronic Data Systems and IBM could feel their grip on the market weaken due to more competition from offshore companies.

My personal view point is that indian IT services companies like infosys, wipro etc will continue to gain market share and will show high growth for the next few years. Will the profit margin hold at the current levels. I think odds are against it. With the kind wage pressures already being felt and with dollar / foreign currency risks etc, I think the odds are that margin would come down over a period of time. More likely that the margins would drop by a few points every year till stabilise at 8-10 % (or maybe a bit higher). The key variable would how long will this take ? frankly I don’t have an idea. But I think it would be key variable for the current valuations to hold. If the slide is fast, then it would be difficult for the current valuations to hold up.

Read onAdd comment

Google to touch 2000 $ !!!

By Rohit Chauhan
In General thoughts, Uncategorized
January 12, 2006
4 Min read
6 comments
G


Saw this recommendation on google. With google crossing 450$, I think analyst are tripping over each other in raising their price targets.

Gives me a feeling of deja-vu – remember year 2000, right after the internet bubble burst – when the conventional thought was that companies like e-bay, CISCO could not go down, because these companies had solid business models, were dominant in their industries and had a fantastic future ahead of them.

The recommendation also notes the following

Stahlman said he reached his estimate for $2,000 a share using a multiple of enterprise value, which adds market capitalization, preferred equity and debt and subtracts cash.
That’s based on the 6.2 multiple commanded by Redmond, Wash.-based Microsoft Corp., the world’s largest software maker and the company most often equated with Google as a competitor and model, he said.

Wow !! how can google be equated with microsoft ?? Don’t get me wrong …google is a great company and I love google product (I cant think of a day when I have not used the search engine). But google is not a monopoly by any stretch of imagination (which microsoft was for quite some time for OS and office products). Going forward the competition is only going to increase and I cannot think of goggle controlling the internet the way microsoft had a lock on the desktop.

The analyst predicts a sale of 100 billion some time in the future (does’nt say when) and the price of 2000 gives google a Mcap of 0.5 trillon dollars (500 billion !!!). Assuming google is doing extremely well even then, and has a Net profit margin of 20 % (current is 25 %), which I think is not very likely (but still lets assume for the sake of it). The PE at that time would still be around 25.

How many 100 billion dollar companies can grow at above average rates ?
How many 100 billion dollar companies have a net profit margin of 20 % or higher in a global market and can sustain it ?
How many 100 billion dollar companies have growths high enough to justify a PE of 25 ?

“Two things are infinite: the universe and human stupidity; and I’m not sure about the the universe.” – Albert Einstein

update : 01/20/2006

read views on google from bill miller. According to him the value of google could twice of the current price. At the same time following comments from him are worth noting

He said Google’s (Research) market-implied growth rate is about 28 percent. Consensus numbers for the company point to a 5-year growth rate of 33 percent to 35 percent, which then slows over the next 12 years to that of the overall economy, he said.
“The theoretical value of Google is still substantially higher than the market price. So the theoretically justified market cap under those assumptions is in the $240 billion range,” Miller said earlier this week.

Miller, who takes a long view on stocks and has low portfolio turnover, said there are still many unknowns about Google. Many companies start with great promise and then something goes awry and they disappear, he said.

Another topic at the bull session was whether Google’s users were “locked in” to its model, the way customers of Microsoft’s Windows operating system are, said John Miller, an economist at Carnegie Mellon University.
“Suppose you do have the best search engine. The big question is how sticky are the users,” he said.
In theory, customers could easily use a search engine other than Google, but Bill Miller said the fact that Google’s market share is stable suggests that a “psychological lock-in” driven by brand loyalty is keeping them coming back. (emphasis mine)

Read on6 comments

Thoughts on valuation approach for Banks

By Rohit Chauhan
In Industry analysis, Uncategorized
January 11, 2006
4 Min read
1 comment
T



I have been reading shankar’s blog and left a few comments on his post about valuing a financial institution (like a bank or FI etc).

Shankar left me the following comment

Rohit, help me in arriving at a sustainable valuation model for banking sector. Debt recap / NCA will not work here. I can only think of P/E ratios but then this works on the whims and fancies of interest rates. Any guesses?

Its always easier to figure out what does not work v/s what does. That said, I have tried to come up with a valuation approach for banks and such lending institutions.

So here goes –

To start with let me try to list the reasons why valuing a bank is different from any other business

  • Role of cash: Cash for a bank is equivalent to raw material and is used for creating the Product – Loan / mortage etc. For other businesses, cash serves as a lubricant (for lack of better word) to run the business. Hence for most businesses, cash is held for liquidity purposes. For banks, cash or equivalents is held as a raw material itself.

  • Free cash flow: Free cash flow (after considering Capex) can be calculated easily for most businesses. Difficult to do for banks as their assets are not really the building / equipment etc. Assets are mainly the loans/mortages/ investment made out of cash. A business in absence of opportunities can return the cash to the shareholder. For a bank, the amount of free cash is not dependent on the opportunities itself. A bank has to maintain certain liquidity based on statutory requirements such as the risk profile of the assets.

  • Role of book value: for most businesses, book value is an indicator of money invested. But may not be a big indicator of the instrinsic value. For banks, book value (net of impaired assets) is much more important indicator of intrinsic value

  • Risk: Bank by their nature are risky businesses (I have read comments by buffett / munger to that effect). Any business which has a leverage of 10:1 (which banks do), can fall apart quickly due to mangerial mis-steps

My typical approach (which in my opionion is not sufficient) to value banks has been

  • P/B ratio – I try to look at the relative valuation through this ratio. A high quality bank (in terms of operational efficiency, NPA etc like HDFC bank) would sell at higher P/B ratio. It is important to figure out the correct book value (preferably book value net of impaired assets)

  • Long term return on equity – Higher the better, provided the bank is not making risky loans

  • % of Net interest income to total income – Would want fee based income to be a higher proportion of the total income. Fee based income is typically less volatile and has low risk.

  • Operational efficency – higher the better

  • Presence of competitive advantage through – Distribution network, brand and quality of management etc which will allow the bank to earn higher than average ROE without undue risk

So effectively I do not have a quantitative (discounted cash flow type) approach to value banks. However I have tried to use a relative valuation approach. At the same time, according to me banks are risky businesses. One can never be sure what is the risk in the loan portfolio / derivative portfolio of a bank (you just have to trust the management). As a result I try to look for a higher margin of safety. I typically try to buy only when the bank seems to selling between 1-2 times book value provided the bank is looking good on the other factors.

Please share your approach/thoughts on valuing a bank. It would help me/others in developing a better approach to valuing a bank or any other financial institution.

Read on1 comment

Stay away from the stockmarket ?

By Rohit Chauhan
In Market analysis, Uncategorized
January 5, 2006
3 Min read
Add comment
S

Found this post on mark cuban’s Blog

The Stock Market is for suckers….

I agree with mark’s basic premise which is that one should invest in the stock market only if one has an edge. However I do not agree completely with mark’s extreme view that the stockmarket is a place for suckers and there is always sucker on one side of a trade (although a lot of times there is one). The stockmarket is not a zero sum game and if one can avoid the extremes emotions of greed and fear, then one can get a resonable rate of return. Even on a trade, the buyer and the seller need not be a sucker. The seller may not be comfortable with the risk associated with the stock, may have achieved his targeted return or could be selling for some personal reason. The buyer on the other hand may have a similar view point, but could more comfortable with the risk on the stock, or could be hedging his position on some other stock.

I would say as an individual, I can have the following edge over the market

  • long term view : If I have long term view and can think beyond the immediate short term view point of the market, then I can find some good long term investment opportunities. For ex: FMCG in 2004 and early 2005 were good investment opportunities when the market was bearish about the short term outlook of this industry.

  • Investing in one’s circle of competence: As charlie munger’s says, it is not in human nature to be an expert in everthing. But if one works hard at it, then one can become an expert in a few areas. For me my circle of competence is limited to FMCG, industrial and a few other industries. So as long as I limit myself to these industries I should do fine. Ofcourse it means that the number opportunties are sometimes limited if these sectors are overvalued. But then as an individual one has the luxury of investing only when the opportunity is right.

  • As an individual investor, I have the luxury of being out of the market when I don’t find any values. A proffessional investor cannot do that

But at the same time, if one strays from his circle of competence and gets swept by greed or fear, then I think it is closer to gambling than investing (where the odds are against you )

Mark talks about technology investing in his post. Substitute ‘technology’ with any industry which is outside your circle of competence and I think the result would be the same. I think if one does not invest the required time to develop a deep understanding of atleast a few industries, then it is difficult to get a return higher than the market.

Read onAdd comment

Some thoughts on banks and their retail portfolio

By Rohit Chauhan
In Industry analysis, Uncategorized
January 1, 2006
2 Min read
1 comment
S

Found an interesting view on indian economy from the ‘Morgan stanley GEF’ website

Some interesting observation in the article

We believe that a large part of the recent growth in industrial production and to a lesser extent services sector growth has been driven by cyclical global factors. A sharp fall in real interest rates since 2000 has encouraged both the government and households to borrow aggressively.

And

Acceleration in consumption growth has largely been driven by a rise in borrowing rather than income growth. Strong domestic consumption has been one of the key factors pushing the combined growth of industry and services sectors, which has averaged 9.3% over the past four quarters.

Second, rapid growth in leverage is also resulting in more credit risk in the financial system. Our banks team sees a rising credit risk building in the system as Indian households have leveraged significantly above the fair level that is supported by the current trend in per capital income. The central bank also relayed similar concerns.

The above makes you think about the valuation of banks which are showing strong profits and very low NPA. For Ex: ICICI bank has brought down NPA from 4%+ to below 1%. What are the kind of risks these banks have on their balance sheet due to their aggressive retail loans ? Somehow retail loans are now seen as low risk, high return and high growth area for most of the banks. As a result there has been a substantial growth of the retail portfolio. Maybe the overall risks are low (atleast the market has priced the bank stocks accordingly). The problem with bank loans is that these problems can remain hidden for a long time. As buffett as ‘Its only when the tide goes out, that you realise who has been swimming naked’

Read on1 comment

Thoughts on business risk

By Rohit Chauhan
In Investing Philosophy, Uncategorized
December 24, 2005
3 Min read
2 comments
T

There are several business models which are seem to be inherently more risky and then there are some businesses which may not be risky to begin with, but changes in industry dynamics can make them risky for some time.

The indian pharma industry seems (atleast to me) to be one such industry. This industry is one of the few industries which is in the process to globalizing. A few years back companies like ranbaxy, Dr reddy’s lab etc got into the mode of releasing generics of blockbuster drugs which were going off patents. I remember distinctly that some of these companies were selling at fairly high PE. The analyst’s could see only a bright future and market was pricing accordingly. To be fair, there were murmurs of litigation risks etc, but somehow that was not visible in the price (with PE of 40 and more).

Later some of these companies had high profile clashes with pharma giants and lost some of the law suits. As a result the stock crashed when the expected payoffs did not materialise. I would look at this strategy of the pharma companies akin to bets in a casino, but where the odds in your favor. What I mean is that the expected payoff is positive in the companies favor, but often some of these bets could fail. So if the market values these companies as if all the bets are going to succeed, then there is a distinct over-valuation. But at the same time, every time a bet fails, if the market prices the company based on the latest failure, then there could be underpricing happening.

The problem (for me only) with the above business model is that I am not able to project the cash flow for such companies as I am not competent to evaluate the odds of success for such bets (investor who can could and should profit from it).

The business risk in the other globalizing star ‘IT services’ seems to be lower as these companies have used mainly labor arbitrage in the initial phases which is a lower risk strategy. However the market recognises that and has bid the stock prices up and so we have a lot of stock related investment risk.

I was have started analysing the textile industry recently. This industry seems to be globalising with the quotas gone. My initial thoughts on the business risk are

  • execution risk for some companies. Not all managements have the capability to manage ‘hyper’ (50%+) growth. Look at arvind mills track record in mid to late 90’s. They invested heavily in denim using debt. The denim cycle turned south and this company was left saddled with huge debt

  • Commodity nature of the product could result in pricing pressure on an ongoing basis

  • Limited leverage with customers – Being a supplier to one of the major retailers will constantly expose these companies to pricing pressure and stiff competiton

Read on2 comments

Warren Buffett on Benjamin Graham

By Rohit Chauhan
In Uncategorized, Warren buffett
December 19, 2005
2 Min read
4 comments
W

Found the following post on motley fool. I am waiting eagerly for the complete transcript of the Q&A though (emphasis mine)

I recently had the pleasure of taking a large group of students to Omaha for a Q&A with Buffett. When available, I’ll post the results of that Q&A if there is any interest here. In the meantime, I thought I’d mention my most memorable take-away from that meeting.A student noted that Buffett has been a much more successful investor than Graham, and yet Buffett attributes much of his success to Graham, why is that?For the first time, I heard Buffett address this issue head on. Buffett said that it’s true, Graham never got really rich from investing. Ben was much more interested in ideas than in making money. However, the lessons Ben taught are very profitable (in order):1. Stocks represent part ownership in the business. Before Ben, Warren charted prices and did lots of other silly stuff. Ben’s perspective was eye-opening.2. The concept of Mr. Market is vital. The market is very efficient, but not perfectly efficient–and that difference can make you very, very rich. At any point in time, the market price is usually, but not always, appropriate. An intelligent investor is one who can tell the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth.3. The margin of safety concept is also vital. Once an intelligent investor discerns the difference between the current market price for a stock and a resonable interpretation of what that part of the business is really worth, it becomes important to build in an appropriate margin of safety.These lessons are Graham’s most important contribution to Buffett and to you and me. Graham’s sensible perspective, combined with Phil Fisher’s (and T. Rowe Price’s) insights on wonderful companies, has made all the difference for Buffett. If we are paying attention, they can make all the difference for us too.

Read on4 comments

My investing philosophy

By Rohit Chauhan
In Investment process, Uncategorized
December 17, 2005
3 Min read
3 comments
M

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

Read on3 comments

Subscription

Enter your email address if you would like to be notified when a new post is posted:

I agree to be emailed to confirm my subscription to this list

Recent Posts

Select category to filter posts

Archives