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Discounting hope

By Rohit Chauhan
In General thoughts, Investment process, Uncategorized
September 12, 2017
5 Min read
2 comments
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It is widely understood that stock prices are forward looking – they discount the future expectations of cash flow of a company. In bear markets, these expectations are lowered as markets extrapolate recent trends (and assume a recession forever). On the flip side, the reverse happens during bull markets, when investors extrapolate the recent good results into the future and assume that there will be no hiccups along the way.

Finally, we have markets like now, where investors have gone ahead and extrapolated ‘hope’ and discounted that too.
The idea funnel

I maintain a 50+ list of stocks which I track on a regular basis and have created starter positions in a few companies which appear promising. The process i follow is to create a small position (usually 0.5% to 1% of my personal portfolio) and then track the company for a few quarters/ years.

In atleast 50% of the cases or more, I realize over time, that I am not too excited about the prospects of the company and exit the stock immediately. In a few cases, however the company and its stock may still hold promise. In such cases, I start raising the position size in the portfolios I manage.
The above approach allows me to run experiments with lots of ideas and controlled risk.
Discounting infinity and beyond

I am now noticing that some of the positions I hold on a trial basis have started running up based on hope.

Let me take one example to illustrate – Repro India.
Repro India is a printing business with operations in India and Africa. The company performs print jobs for publishers for all kinds of printed materials like books, reports etc. The company has had a chequered past with uneven performance. 
The company was growing till 2012-14 with rising sales in India and Africa. The return on capital of this business was mediocre as the printing business involves high fixed assets, high and sticky receivables with average operating margins in the range of 15-18%.
The export business in Africa went into a nose dive in 2014 due to the drop in oil prices. The company was not able to collects its receivables as these African countries faced currency issues and hence incurred losses. Since then the company has been slowly recovering the receivables and nursing the business back to health. In addition the domestic business continues to be competitive and sub-optimal due to the lack of any competitive advantage
I would normally avoid such a company unless there are some prospects of improvement or change in the future. One such possibility exists for the company. This is the new BOD – books on demand business of the company.
The BOD business is similar to an aggregation model followed by companies such as uber or Airbnb. In the case of repro, the company has a tie up with Ingram (another US based aggregator) and other publishers in India to digitize their titles and carry them on its platform. These titles are then made available through ecommerce sellers such as Amazon or flipkart. When a user like you and me finds this title and purchases it, Repro prints the copy and delivers it you.
The business model is depicted in the picture below (From the company’s annual report).
The above business model ensures that there is no inventory or receivables for Repro or the publisher. The payment is received upfront and the product is delivered at a later date. This is a win-win business model for all the value chain participants as it eliminates the need for working capital. As a result, this business model is able to earn a high return on capital with the same or lower margins than regular publishing
Illustration from the company’s annual report

Repro is doing around 40-50 Crs of sales in the BOD segment and growing at around 70-80% per annum. The company has loaded around 1.4 Mn titles on its platform and plans to load another 10 Mn+ titles in the future. This business is at breakeven now. The BOD business has a lot of promise and it’s quite possible that the company will do well. 
However, success in the business is not guaranteed. The company needs to scale its operations and could face competition from other print companies in the future (as the entry barriers are not too high).
The market of course does not care about the uncertainty. There are times, when markets refuse to discount good performance in the present and then there are time like now, when the market is ready to discount the ‘hope’ of good performance in the future. The stock sells at around 100 times the current earnings. As the legacy printing business continues to be mediocre with poor economics, it is likely that the high valuations are mainly due to the exciting prospects of the BOD business
I had created a small position a couple of months back and have been tracking the company. The stock price has risen by around 50%, 60% since then even though the company is just above breakeven on a consolidated level.
I am optimistic about the prospects, but the execution needs to be tracked. I am not willing to pay for hope and so I am a passive observer for now.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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The logic of patience

By Rohit Chauhan
In Uncategorized
July 13, 2017
6 Min read
2 comments
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Investors hear a constant refrain – be patient, think long term, blah blah blah. Is it similar to the sermons we hear about eating well and exercising more?

Let me share some thoughts on why patience is a critical to earning above average returns. I will try to approach it based on logic and not because the gurus of investing have been preaching it

Let’s walk through a series of logical arguments

1.     The stock market is usually efficient and generally prices most companies correctly based on their near term prospects. So if a company is growing at 30% per annum, earning 25% return on capital and has great long term growth prospects, then the market will value it accordingly.

2.     One can do better than the market only if you have a view about the performance of a company, which differs materially on the upside. If the company performs as the market expects, there will be no impact to the stock price. Only if the company performs better than market expectations, will the stock price will adjust upwards in response to the positive surprise. This is something most investor miss. They are looking for high quality companies with good management. The trick is find those where the market has yet to recognize the quality or improvement in performance (and price it into the stock)

3.     If you combine point 1 and point 2, it follows that some of the ways to do better than the market is if

  • You are able to identify the turning point in a cyclical industry, before the market. As it not usually not possible to time this perfectly, the best option is to be a bit early when there are some green shoots visible and then increase the position as the recovery gathers strength
  • The profits of the company are suppressed due to some short term issues in the industry (weather, demonetization etc.) which will be resolved soon. In such cases, one has to create a position when the outlook is still horrible and hold on to it till the external factors change for the better
  • Some One-off event such as a demerger causes one of the constituents to be mispriced
  • The profit of the company is suppressed as management is investing in the business which is hurting the reported numbers. As the market is still fixated on the reported numbers, one can create a position at an attractive price. However one has to wait for the investment phase to complete and the true profitability surface

If you look at all the above cases, one needs to ignore the near term prospects which are being overly discounted by the market, and focus on the long term. As a result, in such cases you will not see a validation of your thesis as soon as you create a position.

In my experience, one needs to look out at least 2-3 years and make a purchase accordingly. One then has to wait patiently and keep checking if the company continues to deliver as per your expectations

The impact of competition

For those of us who started investing in the late 90s and even around mid-2000, the level of competition in the market was much lower. One could find companies earning 30% return on capital, growing at 15%+ CAGR and selling at 5 times earnings (Marico was one such company). All one had to do was to dig around a bit and put in the money.

The mutual fund industry was nascent at that time and there were very few individual investors. I still recall getting blank stares when I spoke about value investing.

This has changed completely in the last 10 years. We now have an army of smart investors (professional and part-time) who scour the market looking for opportunities. In such as climate, I can bet that you will not find any obvious mispricing which can filtered on a screen.

In such a case, one has to dig deeper and put in more time and effort in understanding the business and its management. Once you get a better understanding than most other investors , you have to buy the stock and wait till the market, hopefully comes around to your point of view.

It would be foolish to assume that the change of opinion will happen as soon as you are done with your purchase. Some of the near term factors which drive the pricing, need to change before the market accepts your view point.

When is patience a liability?

Patience is of course tied with your style of investing and time horizon. If you are a day trader or momentum investor, then time is not on your side. If you time horizon is days, weeks or month then thinking of a multi-year period makes no sense.

The trouble starts when one does not know what kind of an investor you are? A lot of people think they are long term value investors (as somehow that is fashionable these days), but act like day traders – selling and buying over weeks. If you do not get your time horizon and investment approach consistent with each other, then you are in trouble as your will quickly tire of holding the stock and sell just before the inflection

Getting an edge

I had earlier written above three kinds of edge in stock market investing. The information edge is now more or less gone with tools for quantitative analysis and wide dissemination of information by management (look at the number of conference calls hosted by companies!). One has to rely on analytical and behavioral edge to make above average returns.

I personally think that analytical edge too is over rated as it is not possible to consistently have a superior insight with all your positions. Assuming that you are smarter than the rest of the market at all times, is pure hubris. The only sustainable edge left for an investor is the behavioral one and being patient in an age of distraction and immediate gratification is at the core of this edge.

Being patient is therefore not a moral imperative or something you need to do for the good of humanity, but is a logical necessity to do well in the market in the long run as a value investor.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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How to lose money consistently

By Rohit Chauhan
In behavioral finance, Uncategorized
June 8, 2017
2 Min read
6 comments
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Guaranteed approach to losing money –  Look at the last 3-5 year returns and extrapolate mindlessly. Invest when past returns are highest and sell after the market corrects

Starting amount: Rs 100000

1.     Invest infrastructure mutual funds in 2008 (after the boom) based on hard selling by mutual funds
2.     Sell in 2009 with a 40% loss on average
3.     Recuperate from shock for 2 years
4.     Invest in gold mutual fund in 2011/12 after seeing 5 years of boom
5.     Lose 10% of principal in next 3-4 years
6.     Now, invest in mid and small cap funds, after 3 years of boom.

The investor has already managed to lose 50% of principal by now. The above tale may be an exaggeration, but you can check mutual funds with the above kind of performance, with most being launched towards the tail end of the boom. Someone is surely buying these funds at the top of a cycle !

It may not be the same investor in each case, but I can assure there are definitely a few who manage to achieve this ‘feat’ over a lifetime as they never get over their greed and refuse to learn from their losses (it is always someone else’s fault)

If you think, I am mocking such people – that is not the case. I did the same thing when I started out, but the only difference is I swallowed my pride, accepted my mistake and have tried to learn from it.

An oversized ego is always dangerous to the wallet

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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No pizza today

By Rohit Chauhan
In General thoughts, Uncategorized
May 20, 2017
4 Min read
5 comments
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I wrote the following note to my subscribers in response to two questions which are frequently asked by new prospects

a.     Please share your past performance
b.     How many stocks can I buy if I join your advisory today

The note below, seeks to answer the second question

Pizza versus investment advice
If you walk into a store or restaurant, you are handed the item or service as soon as you make the payment. Any delay or refusal to offer the said service is considered a breach of faith or fraud.

The above standard mode of exchange breaks down when we come to investment advice. The job of an investment advisor is to ensure that his or her clients make decisions which helps them in the long run (in achieving their financial goals). This can mean that the most sensible course of action often is do nothing and wait for the right opportunity to invest.

This is however not understood by the vast majority of investors who behave like a customer in a restaurant. A typical investor likes to be handed a menu card of stocks and would like to buy as many as possible even before the ink has dried on the cheque (metaphorically speaking). This expectation works if you order a pizza, but not when you are investing for the long run (5+ years).

The investment industry panders to this behavior and even encourages it. As much as one would like to blame the industry (and they have much to blame), the investor community is equally responsible for it. Stock markets are seen as a place to pat your ego (for recent high returns), indulge your gambling instinct or just entertain yourself.

In all my years, I have found very few who look at the stock market for what it really is – A place to invest your capital for the long term to earn returns above the rate of inflation and thus achieve your long term financial goals.

If you are in for the long haul, it makes sense to invest your hard earned money in the right company at the right price (price being very important). Often this happens, when everyone is running for the exit.

Walking the talk
It is easy to talk, but not easy to do the same thing unless your own money is on the line. My own funds, that of my partner kedar and our families is invested in the same fashion. Nothing focusses you on the risk, when your own money is on the line.

I get turned off when I read about fund managers and analysts who recommend a stock, but do not have skin in the game. It clearly means that they do not believe in what they say.

I made a conscious decision several years back that I will eat my own cooking and as a result, any loss in the portfolio is borne equally by me. In addition to this point, both me and kedar have made it a point to under-promise and hopefully deliver more. As result, inspite of a 100%+ rise in 2014, we decided to go low key as I knew that future results could be subdued for a period of time. I did not want to attract subscribers based on recent performance and disappoint them when I failed to meet their un-realistic expectations.

We continue to follow the same approach today. We will get excited when the market drops and go into hibernation when the market gets euphoric. The hibernation is limited only to activity and not to the effort of finding new ideas. We continue to build the pipeline, but the pizza will be served only when the time is right.

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