Value investor india

August 26, 2012

6 Min read

Deep value investing or cigar butt investing, is buying stocks whose price is way below the various statistical measures of value of the company. Now, value can be measured by various means such as PE ratios, discounted cash flow analysis or asset values. In case of deep value investing, one is investing in stocks which are selling at a very low PE, below book value or in some cases even below cash held by the company.

This method of investing was introduced and popularized by the father of value investing – Benjamin graham in his classic security analysis (A must read for any serious investor). In this book, graham talks about companies selling below working capital, book value or in some extreme cases, even the cash held by the company.

This mode of analysis is a quantitative, statistics driven method where in one holds a large number of such ‘Cheap’ companies. A few positions work out, a few go down the drain and rest just stagnate doing nothing. In spite of such a mix, the overall portfolio does quite well and one is able to earn decent returns at low risk

The key element in this investment operation is wide diversification and constant search for new ideas to replace the duds in the portfolio.

Initial foray into high quality
My first exposure to sensible investing (reading economictimes and watching CNBC does not count in that), was when I read the book – The warren buffett way. I was completely mesmerized by this person and read all I could on him for the next few years.

After burning my finger a bit during the dotcom bust, my initial investments were in the warren buffett mold (high quality stocks with competitive advantages). My initial investments were in asian paints, pidilite, Maricoetc – the so called consumption stocks except that they were not called by this label then.

I have always wondered why these stocks are called consumption stocks? are capital goods and real estate ‘un-consumption’ companies whose products no one wants to consume J ? Anyway I digress

An experiment in deep value

Around 2006-2007, i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around 10-15% of my portfolio in names such as Denso, Cheviot company, Facor alloys and VST industries (see here), etc for a period of around 3-4 years.

I decided to terminate this approach in 2011 and have been exiting the positions since then. In the rest of the post I will cover my experience and learnings from this long run experiment.

The results

The results from this portion of the portfolio (which was tracked separately) was actually quite decent. I was able to beat the market by 5-6% points during this period. At the same time, this part of the portfolio lagged the high quality portion by 6-7% over the same time period. The difference may not appear to be big, but adds up over time to a considerable difference due to the power of compounding.

I have not completely forsaken this mode of investing and once in while could buy something which is very cheap and has a near term catalyst to unlock the value.

Why did I quit ?
I did not quit for the obvious reason of lower returns than the rest of the portfolio. The lower return played a part, but if I compare the effort invested in building and maintaining a deep value portfolio , it is much lower than trying to identify a high quality and reasonably priced company .

If one compares, the return on time invested (versus return on capital), the balance could tilt towards the deep value style of investing.
Let me list the reasons for moving away from this style of investing

Temperament – The no.1 reason is temperament. I have realized that I do not have the temperament to invest in this fashion. I do not like to buy poorly managed, weak companies which are extremely cheap and then wait for that one spike when I can sell it off and move on to the next idea. It makes my stomach churn everytime I read the annual report of such companies and see the horrible economics of the business and miserable performance of the management.
Life is too short such for such torture

Re-investment risk- The other problem in this mode of investing is the constant need for new ideas , to replace the duds in the portfolio. This exposes one to re-investment risk (replacing one bad stock with another bad idea), especially during bull markets.
Value traps – This part of the market (deep value) is filled with stocks which can be called as value traps. These are companies which appear cheap on statistical basis, and remain so forever. The reasons vary from a bad cyclical industry to poor corporate management. In all such cases, the loss is not so much as the actual loss of money, but the opportunity loss of missing better performing ideas.

Higher trading – The final problem in this mode of investing is the constant churn in the portfolio resulting in higher transaction costs and higher taxes, both of which reduce the overall returns.

The lessons
I know some of you, have never followed this mode of investing and have always invested in quality. The problem with investing in quality is the risk of over payment, especially if the quality is just an illusion (faked as in the case of several companies in the real estate sector in 2007-2008). Anyway, that is a topic for another post.

I am constantly experimenting , with a small amount , with new approaches and ideas. If there is a valid approach, which matches my overall value investing approach (momentum and technical trading is out), I will try it and see if it works for me. It is one thing to read about it and another to put some money into to it and immerse oneself in it.

As some has said – an expert is someone who has made the most mistakes and survived. Well, at the current rate of making mistakes, I hope to become an expert in the next 10-20 years J.

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Investing for dividends

By Rohit Chauhan

In Portfolio management, Uncategorized

August 12, 2012

5 Min read

4 comments

I recently got an email asking my views on investing for dividends, especially for retirement planning. I have never quite understood why there should be a difference between investing for dividends v/s for capital appreciation. My response (with light editing) follows the question below

Hi Rohit,

I have analyzed and concluded that a growth-based, active portfolio is not very suitable for retirement planning. One would have to shift towards a dividend-based, passive portfolio when one approaches retirement.

That way, one would not have to bother about the market gyrations and one can still receive an (almost) inflation-proof income flow. (Basically, I found that if the markets stay depressed for 5-7 years or more, one may have to sell a portion of the portfolio at unattractive price and that can start eroding the capital base very fast.)

I will be happy to know your views.

My response

Your question is very important.

I personally don’t subscribe to the view of investing for dividend v/s growth as I think they are two sides of the same coin. Let me explain

When selecting a company for the long term, we are looking for the following

a) Company earning high return on capital with good cash flows

b) Reasonable valuations

c) Good capital allocation policy by management

if you are able to achieve the above three criteria, you are assured of reasonable returns either through capital appreciation or dividend (and often both).

Let’s say the company is growing rapidly and able to invest the entire cash flow in the business. If the company makes 20%+ return on capital, then in such a case the company is growing at 20%+ rate if the re-investment rate is 100%. In such a case the value of the company will be increase by 3X time in 5-7 year. The market usually will not ignore the company and its stock price will increase too and you can always sell a small bit for income purpose.

The above case is usually in theory…high quality companies generally invest a large portion of their profits in the business and give a part out as dividend. If they can keep reinvesting the profit at a high rate of return, then they will hold the payout ratio constant (percentage of profit paid out). In such a case the dividend will grow at the rate of the profit growth, which is generally higher than the rate of inflation. An investor is thus getting an increasing dividend and should get a reasonable amount of capital appreciation too.

In case of some slow growing companies, if the company cannot re-invest a big portion of the profit into the business, then the amount paid out as dividend will start increasing at a rate faster than the profits. In such cases, one is making returns via dividends (assuming stock price remains constant). These companies are the equivalent of a high yield bond. This is what one may call investing for dividends, as one need not worry about the price of the stock (the dividend yield takes care of the income requirement)

In all the above cases, you are making a good return either through capital appreciation or dividend or in most cases, both. This again is not theory, as you will find this to be the case with a lot of high quality companies in India such as asian paints, nestle, Hero motors etc

What is required in the above cases is that the business is of high quality and management has good capital allocation skills (if it cannot use the profit, it returns it back to shareholder). If these conditions are not met, the stock price will start reflecting the poor performance and the dividends will weaken too.

If you accept what I am saying, you will understand why I don’t believe in dividend or growth investing. I would rather focus on the source of the returns (high quality business with good management and decent price) than the form of the returns (dividend v/s capital appreciation)

Regards

Rohit

I did not cover some points in the email, which I am covering below

Issue of volatility and retirement

How should one manage the market volatility near retirement, when there is a possibility of a large drop in the portfolio at the time of need.

The iron rule of investing in stock markets (if there are any to begin with) is that one should never put that portion of capital in the market which may be required in the near future (next 3-5 years). If you need the money for your kids education or marriage or some other purpose in the near future, put it in a fixed deposit ! period – there is no other sensible option. You should never be forced to sell at the wrong time (when the markets are weak)

Once you are closer to retirement, as any sensible financial advisor will tell you, you should start reducing the equity component to reduce the volatility in your portfolio. The exact calculation and approach is a bit detailed and beyond what I can cover in this post.

How am I planning for retirement? I don’t plan to retire 🙂

I am not joking. If you love what you do (in my case investing), why would you want to retire. If I retire, I will drive myself and my wife crazy.

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If facts change, do you change your mind?

By Rohit Chauhan

In behavioral finance, General thoughts, Uncategorized

July 19, 2012

3 Min read

12 comments

I have often ‘preached’ on this blog – when facts change, one should consider them rationally and change one’s mind if required. Well, as always, it is easier to preach than practice.

Let me tell you a recent story.

I spoke very briefly about a company in this post. The company was Ricoh (I) ltd. You can download my detailed analysis of the company here.

So after doing this detailed analysis in late 2010, I built a decent position at an average price of around 35-37 Rs/ share. The company continued to perform poorly (as I expected) as it had done an acquisition and was also investing heavily into sales and marketing.

The topline grew by 40%, but the net profit dropped from around 15 Crs to a loss of 5 Crs in 2012. The price continued to stagnate in the range of 37-40 rs during this period.

I have been consolidating my portfolio and weeding out the weaker ideas for the last 2 years. As a result, I exited Ricoh in the feb-march time frame. I think it was a rational thing to do based on the information I had as of March 2012.

The change

The company declared the Q4 2011 results in April and reported the following

Q4 sales growth, YOY – 60%
Net profit growth, YOY – 73% (12 Crs profit in Q4 versus 11 crs loss in Q3)

The price action can be seen below

As you can see, the market did not react immediately to the turnaround in the performance and there was a 1-2 month window for an intelligent investor to digest this information and purchase the stock.

So that proves my level of intelligence J

The explanation
It is easy to call the decision, stupid and move on. The true reason for my failure to capitalize on the change in performance (which I was expecting) is due to a behavioral bias.

The bias is called the commitment and consistency bias. In simple words, once one makes a decision, the tendency is to ‘commit’ to the decision and be consistent with it. This results in ignoring positive information as in the above case or holding on to a losing position (inspite of consistent negative news) and hoping that the price will rise in the future.

Not a one off case
The above incident was not a one off in my case. I have made the same mistake twice earlier – in the case of VST industries and Mayur uniquoters. I sold the stocks and then saw the fundamental performance improve, after the sale. Instead to getting back into the stocks (as I already knew about the companies), I just ignored them and lost out on pretty decent gains.

I have become alert to this bias now and am paying more attention to sudden turning points in the performance of the stocks I hold or have held in the past.

It is better to look foolish (in my own eyes), than miss out on a good idea

Added note – The above example does not mean Ricoh India is a good buy and should be purchased at the current price. It is quite possible that the performance may regress and so would the stock price. The example is only for illustrative purposes.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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A speculative bet

By Rohit Chauhan

In General thoughts, Uncategorized

July 5, 2012

4 Min read

7 comments

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative – Benjamin graham, father of modern security analysis and value investing.

Some background

I had written about globus spirits earlier – read here. The stock price has since dropped by around 10% versus the index, which has essentially been flat during this period.

So what happened during this period ? Well, the company declared the Q4 results and the market reacted negatively to the drop in operating margins from around 16.8% to around 13%. The company closed the year with a 40% growth in topline and a measly growth of 2.5% in net profits.

This drop in net margins was mainly due to an expansion in the capacity to 84Mn litres and additional new capacity of 40 Mn litres which should come online in the middle of next year. This additional capacity has caused an increase in manufacturing expenses (initial startup costs) and higher interest expenses (due to higher debt to add the capacity). These costs in combination have depressed the operating margins.

So what is my bet ?

I think that the drop in the operating margins is temporary due to the new capacity which is being added in the current and next year. As the new plant stabilizes, the extra costs should reduce and with the extra topline , we should see an improvement in the margins.

In addition, a decent portion of the additional capacity has been booked by USL for the franchise IMFL bottling (outsourced production) which should help in boosting the bottom line. The management is targeting a 15% operating margin for the next year.

The management has also indicated that they would be able to grow the topline by 20% or more in 2013 (which appears doable based on past results). If we put all of this together, the company should be able to increase the operating profits from around 73 crs to 100 Crs, with net profits in excess of 55 crs in 2013 (interest costs should also reduce due to a planned reduction in debt)

The company is current selling for around 5 times the current year’s depressed earnings of around 40 crs. The company is thus selling at historically low valuation too (past valuations have generally been in excess of 7-8 times earnings).

In addition, all the other companies in the sector sell for 10+ times earnings, inspite of having much lower ROE and higher debts.

So why is it speculative?

Have I built a good case that the company is really undervalued – from absolute, historical and comparative valuation perspective? I think I have done that. At the same time I am still calling it speculative …why is that ?

Please look at the definition in the beginning of the post – An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.

The key word in the above definition for our example is promise. I am not confident about the above analysis and think it is a 50-50 proposition. I am still concerned that the industry has extremely poor economics and it is generally quite difficult for a single company to buck the trend of an entire industry.

Speculation is subjective

The key point is that a stock can be both a speculation or an investment at the same time and that depends on the investor himself. If you know what you are doing, then it is an investment, otherwise it is a speculation.

The danger is not speculating, but in confusing a speculation as an investment and betting heavily on it.

I am personally not very sure if the above thesis will play out and hence have committed a very small amount of money to it. In effect, this position is just to scratch an itch and not meaningful. If it turns out well, I will brag about it on the blog, otherwise you will not hear a peep on it 🙂

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

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My experiences with deep value investing

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If facts change, do you change your mind?

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