Latest stories

Gloom and Doom

By Rohit Chauhan
In General thoughts, Views on news
August 24, 2019
5 Min read
2 comments
G

This was written to subscribers recently

It’s an understatement to say that things are getting scarier by the day in the stock market

We are seeing companies drop 20% or so in a matter of days (or sometimes in a day itself). I started reducing our positions in late 2017 as I became concerned with the valuations. However, I had no clue (and neither did anyone) that things would start falling apart in 2019. As a result, in hindsight we should have gone higher into cash. Please note the word hindsight which keeps coming up.

In the last two years we have exited the weaker positions where I was concerned about the business or management. We re-deployed some of that capital back into other positions, resulting in the same level of cash at the portfolio level. We will continue with this process in the future.

It reminds me of the famous bullet dodging scene in the movie ‘matrix’ – The hero -Neo manages to dodge multiple bullets from an agent, but one still gets him. In our case we have been able to dodge some, but got hit by a few inspite of our best efforts.

This dynamic now seems to be changing for the worse. There will be no dodging now.

Risks are rising

The drop we are seeing in the market seems to be pointing to something deeper. We are seeing a liquidity squeeze from multiple factors such as the NBFC crisis, high NPA in the system and possible global issues such as capital flight to the US dollar. There could be other issues too and your guess is as good as mine. In the end the reason does not matter.

The troubling part is that we are yet to see a major market meltdown in the US and other foreign market. I usually don’t talk much about macro issues but keep an eye on them. I will not go into various issues such negative bond yields across the board, inverting yield curves and other mumbo jumbo but say that the odds of a global recession are increasing. Combine this with trade issues and high debt levels, and we have a higher risk of a meltdown.

The above is not a given, but if it happens, we will feel the repercussions in India too.It could get worse if the system gets a macro shock.

I am not writing all of this to alarm you further. I don’t see an end of world scenario or anything of that sort. However, we need to understand the context of what is happening around us. It is easy to talk of a long-term view, but we may have to go through a lot of pain in the interim

Let’s look at the case of one of our holding. The company has dropped by 20% for no apparent reason. As we have done in the past lets invert the problem and look at reasons for the sale

< Company details and analysis has been deleted for this post >

A debt default or any other fraud will cause a steep drop in the stock price. However, it does not mean that a drop in the stock price is only due to management fraud or default.

A logical fallacy

I get emails from subscribers asking me for a reason after every such drop. If we continue to have market drops, we would see sudden drops in our stocks too. These drops could be due to various reasons – business, debt issues, margin calls, or fear induced selling.

One cannot find the reason for every case, nor can one generalize it to corporate governance or some other issue. We try our best to filter out unethical management before starting a position. However, it does not mean that we will avoid all of them. When we realize that we have made a mistake in terms of the business, management or under-estimated the risk, we will reduce the position or exit as we have done in the past.

I can assure you I am always alert to what is happening to our companies and their stock price. In most of the cases, I choose not to react by choice.

In the coming months, we could have more drops with some extreme ones too. Unless there is a fundamental issue with the business or management, I plan to bear these quotational losses. I have gone through such times in 2000 and 2008 and can tell you it is very painful to watch your portfolio get decimated. The only way forward is to have a sense of long-term optimism even when things around us are falling apart.

I have not invested the cash we hold till now. I want to wait patiently till we get some good bargains, which happens only when the news keeps getting worse. I hope you will have the courage and faith to invest at that time.

Read on2 comments

End of the promoter put

By Rohit Chauhan
In Advisory letter, Investment process, Views on news
July 18, 2019
3 Min read
Add comment
E

Let’s look at the most basic of accounting equations (simplified)

Shareholder equity + Net Liabilities = Net assets

Net liabilities in this case are the on-balance sheet items such as debt, Account payables etc. In addition, there are also some off-balance sheet items such as contractual lease payment, accrued compensation etc. On the asset side, we have the obvious assets such as fixed assets, current assets and cash.

It’s an axiom or truth that the above equation needs to balance out. However, the Indian markets have long violated this axiom. There have been several instances where promoters created dubious or nonexistent assets via debt, defaulted on the debt and were still able to keep equity/ control in the firm.

This is slowly becoming a thing of the past.

The recent introduction of IBC and formation of the NCLT, means that once a company defaults on its debt, the debt holder can take the company to the bankruptcy court. Once that happens, the court can liquidate the firm (sell all the assets) and re-pay the debt holder. Whatever is left after paying all the debt and other claimants, is available to the equity owner.

In the past, the promoter could arm twist the debt holders and thus retain the value of equity. This is no longer possible now.

The 1934 edition of security analysis by Benjamin graham, long considered the bible of value investing, cover bankruptcy and net asset type of investing in detail. After the 1930s depression in the US, a lot of firms were available for less than net asset value (net value after deducting all liabilities). An enterprising investor could take control of such a company, liquidate all assets (often at a discount) and make more than the amount invested.

Although the concept holds true, that world no longer exists today. Most companies create value based on intangibles such as customer relationship/ brands etc. The tangible assets on the book are not worth much as standalone assets and even less in a fire sale. In most bankruptcy proceeding such assets sell for 20-30% of book value.

There have been exceptions to the above in case of some steel companies where assets have sold for 60%+. If you take most other companies in bankruptcy proceedings such as Jet airways, the assets on the book will fetch not more than 30-40% of their value.

If the above numbers are valid, then in most cases, the debt holder takes a haircut and is able to make 40-50 cents on the dollar if the business remains in operation (under a different management). If the business is liquidated, then the recovery is even less.

In all these cases, the equity holder gets nothing at all.

Read onAdd comment

Some early lessons

By Rohit Chauhan
In General thoughts
June 17, 2019
2 Min read
6 comments
S

In the early 90s, my dad invested with a middleman who promised 18% fixed returns. He also invested a small amount in the FD of a plantation company (companies in the business of growing teak and other wood). The returns were much higher than bank FDs and they were assured.

All was well for a few years till the middleman defaulted and we realized that the money had been lent out to a small time businessman who had gone bankrupt.

We had a tough time recovering the money from the businessman. The saving grace was that this businessman was an honest person and he re-paid as much as he could inspite of his stressed circumstances

The plantation company too stopped paying interest around the same time and when I visited their office, found that they still had a few employees hanging around. They offered me a nice cup of tea and nicely told me that the company had collapsed, and all the money was gone.

All of this happened before I got involved in equities and started investing money on my own.

I learnt a few things early on which have helped me all my life

  • The pain of losing hard earned money is very high. I saw my parents suffer emotionally as their trust had been violated. No amount of returns is worth this suffering
  • High returns and assured returns never go together. If someone claims so, they are fooling you and you will be out of your money in time
  • Do not trust anyone blindly. At a minimum, trust but verify
  • With fixed income, go for the safest option. The excess return is not worth the risk. If you want to take the risk – go for equities or some similar investment. At least you will not be lulled into a false sense of security
  • The world out there will prey on you if you are ignorant. You are responsible for your own money

Just in case if I am sounding too smart compared to my dad, let me assure you that I managed to lose even more money over the next few years than he ever did. The difference was that he was cheated whereas I lost because I thought I was too smart and no one could fool me!!

Read on6 comments

Hypothesis and bets

By Rohit Chauhan
In Investment process
June 5, 2019
4 Min read
2 comments
H

I recently wrote this note to subscribers as part of a company analysis. I have removed names for obvious reason, but the point I am making remains valid.

—————

This is a good example of how most ideas work (if they are successful). It takes time and patience to stick around for a thesis to play out. The stock market is an efficient place and one should not assume that other investors are idiots. In most cases the market is right and is discounting the near-term results into the price. As a result, it may undervalue a company which has good long-term growth prospects but is facing temporary challenges.

The job of an investor is to evaluate if the challenges are temporary or permanent. If you think it is temporary, then it makes sense to start investing into the company via a small position. The reason for starting with a small position is to be open to the possibility that one is wrong about the hypothesis.

I have a reason why I always use the word hypothesis. It has a precise meaning. It does not mean a forecast or a guess. It means possibility or ‘what can happen’. The future is always indeterminate and as an investor one needs to consider the range of possibilities.

Think bets

This means that one starts with a small bet and raises the bet as more data comes in. This is the equivalent of starting with a small bet in poker and raising your hand as new cards open up (information comes in). If the data or cards do not fall your way – you fold your hand or sell out of the position.

If you have watched poker, you would have noticed that even the best players fold a lot of hands when they realize that the cards have not come their way, or they have made a mistake. Investing is similar. If you have made a mistake or data comes in such that the negative scenario appears more likely, then you reduce the size of the bet or fold your hand.

On the contrary, If the data starts pointing to the optimistic scenario (growth is returning back, ROCE is improving etc), then we start raising the size of the bet or in other words our position size.

This is what I am doing all the time – taking an initial position with a few hypotheses in mind and then raising or dropping the position size based on how the company performs or how the data comes in.

In some cases, the favorable scenario (which in my view has a higher probability) works out. In the case of company X, as growth returned we have raised the position. In some other cases, the growth and improvement in economics is yet to happen – we have kept the position size the same. In a few cases, if things worsen or if I am wrong, we drop or eliminate the position.

Right expectations

Why I have taken this detour in the quarterly update? I have sometimes received emails expressing surprise that I have turned pessimistic after sounding positive for a long time. In all these cases I am watching the company and industry and as the data changes or some events occur, I have changed my view of the company (sometimes late).

How else should one react? Should I just stick to my view so that I appear all confident and smart while I drive our portfolio and capital over the cliff? For our collective sakes, I hope that I can avoid my ego from getting in the way of making rational decisions. In the past, I would fret about it. Now, I just ignore and take the necessary decision irrespective of how I appear to others.

As a side note, there is another pattern you should observe. As the market discounts the next 1-2 years performance correctly, it means that the minimum time it will take for an idea to show results has to be more than that. In 2017, the market was discounting 2018 and early 2019 performance for Company X. As growth improved for FY19 and FY20, the market has taken note of it and started discounting the same.

Read on2 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