The return of the stock picker

By Rohit Chauhan

In General thoughts, Uncategorized

June 24, 2012

5 Min read

13 comments

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The period from 2008 to 2012 has been a nightmare, right? How could it not be?

The market went from 20500 to around 17000 levels. That’s a loss of 18% in nominal terms, and if one considers an inflation of around 8%, then the loss is a mind numbing 42%. So if one had complete foresight and could see the future, then 100000 invested in a bank deposit would be worth 144000 versus around 82000 in the stock market.

So where is the debate in this?

The time of the stock picker

I know of several fellow investors who have actually done quite well during this period. They may have lost money on a few ideas here and there and suffered through temporary drops during the market swoons in 2008-2009. However over the course of these 4+ years, most of these investors have soundly beaten the market and delivered double digit annual returns

So how have these guys achieved this feat ? Do they have a special diet or drink something special 🙂 ? I don’t think so as far as I know

What has enabled these returns

I would say that there two reasons for the above result. All these investors who have done well, have a long term view of investing and don’t invest with one week or one month in mind. In most cases, they invest after a thorough analysis of the underlying business and only when the market undervalues the business.

A disregard for short term performance, usually results in a long term outperformance.

The second reason I would say is that all these investors are focused and work hard at finding good ideas and then purchasing the stocks, inspite of all the negative news around them.

It helps to be emotionally stable as far as the stock market is concerned. One need not be like Mr Spock from star-trek, but as long as you can avoid extreme greed or fear, you will do fine.

Hard work and focus

This is one of the most under-rated factors in being a successful investor. I am pretty sure most of us were told as young kids, that the way one can be successful in life is by working hard and being diligent about it.

This simple lesson which we apply to almost every other walk of life, is conveniently forgotten by a lot of people, once they enter the stock market. It almost as if, investors collectively expect a Santa Claus to give us returns just for putting up some money in the stock market.

I cannot think of any successful investor who has succeeded without a lot of effort and focus.

Enjoying the process

At the same time effort and focus is not enough to succeed in the long run, if you do not enjoy the process of investing. There are long periods of time when you will not make a meaningful return and all the effort would be seem to be in vain.

I personally went through this phase quite early in my life as an investor. The period 2000-2003 was one mind numbing and grinding bear market when the index went from 6000 levels to 3000 levels over a period of three years. It was no different from what we are experiencing now. Companies like L&T, concor, BHEL sold at 5 times earnings.

The only reason I was able to keep learning and keep going was due my passion for investing. A single digit return on a few lac of rupees is not even minimum wage …why else would any sane person keep working hard for less than minimum wage 🙂

Everyone can do it

The secret to being a successful investor is that there is no secret at all. Inspite of the nonsense propagated by media, that the common man should leave investing to professionals, I think anyone can become a good investor.

The most important factor to be a good investor is to really enjoy the process of investing. If one loves the process, he or she will find the means to continuously learn and improve as an investor.  The returns usually come in time, if one is patient.

The return of the stock pickers

The period 2003-2008 was a big tidal wave. All one had to do was to point his or her boat in the right direction (real estate or infrastructure ?) and the wave carried you through.

The  investors who have done well in the past few years are most likely the ones who enjoy the process (and ofcourse want to make money too) and are continuously learning and getting better at it. The last 4+ years have been a time of stock picking and hard work. If you looked for good ideas and operated with an independent mind, the results have been quite good.

Let me make prediction – I am close to 100% sure on this. Once the next bull run starts (it looks unlikely , but will happen in time), you will find a lot of new investors who will boast of their investing prowess and will think that making money in the stock market is easy and effortless.

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Moat or no Moat – Indian IT

By Rohit Chauhan

In Industry analysis, Uncategorized

June 15, 2012

5 Min read

25 comments

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I recently posted the following comment on twitter

Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term

This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)

I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

• Switching cost due to customer relationships
• Economies of scale
• Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
• Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

Let’s look at where we stand on these factors

a.    Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.

b.    Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further

c.    Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)

d.    Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.

Weak and strong moats

Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.

A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.

My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.

Some numbers

Let’s look at the ROIC numbers for some IT companies (Indian and global)

IBM – 15-20 % (based on invested capital including debt)

Infosys – 50% (based on invested capital, excluding cash)

NIIT tech – 25%+ (based on invested capital, excluding cash)

The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.

What explains this big difference?

Eliminating some factors

I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors

Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage

Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)

Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.

The future

I will take a guess now (which is as good as yours). I think the return on capital  (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.

This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.

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Evaluating the impact of rupee depreciation

By Rohit Chauhan

In General thoughts, Uncategorized

May 30, 2012

4 Min read

6 comments

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The 22% drop in the rupee against the dollar is worrying to say the least. There are several ramifications for the Indian economy, if the slide continues.  Anything which impacts the economy, is bound to impact the stock market as a whole.

One can find a dizzying array of macro-economic analysis on the impact of the rupee depreciation and as many forecasts of the future levels of the exchange rate.

I personally consider macro-economic analysis too complex due to the huge number of variables involved in it and hence any analysis from my end is as good as yours. Instead I have been trying to evaluate how the rupee depreciation will impact my portfolio on an individual stocks basis.

I think there are three factors through which the fundamental performance  can get impacted

Factor 1: Level of Raw material / capital good import

What is the level of raw material / capital goods imported by the company?. If the company imports a substantial amount of raw material/ capital goods then it is likely to get impacted severely, if it cannot pass on the costs to the end user without impacting the volumes

Factor 2: Level of export

What is the level of export sales in the revenue of the company. A high level of export will benefit the company, if the company can maintain or improve its margins as a result of the rupee depreciation.

Factor 3: Level of foreign debt

What percentage of debt is ECB (external commercial borrowings) or FCCB? There are two key points to note here – What is the maturity schedule (payment timing) and the level of debt in comparison to equity / market cap?

The above three factors cannot be looked in isolation and have to be combined to come up with a final impact on your company.

For example – A company may have a high level of export and imports, with the exports exceeding the imports (due to value addition on the raw material). In such a case, the company will have a net benefit.

 A company using domestic inputs and exporting most of its output will gain the most from the depreciation (IT and pharma). Conversely a company using imported inputs and selling most of it domestically will be hurt badly (Oil companies).  Finally a company with high level of imported inputs, selling domestically and also carrying a high level of foreign currency debt is toast (to put it politely)

If level of export >= import + debt payment (ok)

If export < import + debt payment (trouble)

Let me give you two examples of the analysis I am currently doing on my portfolio stocks

Balmer lawrie

The company has zero debt and actually has excess cash of around 200 Crs. So we do not have forex related debt risk with the company

The company imported around 4% of its inputs and earned roughly the same amount in exports.  So at first glance, the company has close to zero risk from higher raw material costs due to currency depreciation. However the grease and lubes division uses various base oils which are petroleum based and will be impacted by the price of crude oil. As the division does not have much of a pricing power, the net margins of this division are likely to be impacted.

The other divisions such as logisitics and tours & travel are unlikely to be impacted directly due to the currency depreciation.  However the overall business will definitely be impacted by the overall slowdown in the economy.

Lakshmi machine works

The company has close to 700 Crs+ excess cash on the books and hence the risk of forex debt does not exist.

The company exported around 250 Crs of machinery and components in 2011 and imported roughly the same amount in terms of raw materials and spare parts. As a result , the company is unlikely to get directly impacted by the rupee depreciation. On the contrary, the company could benefit to a certain extent as the competitive pressure from imported machinery will reduce.

Finally I think that the textile industry level issues will have a bigger impact on the company performance than the currency depreciation.

Not a quantitative analysis

The above analysis is not a precise numerical analysis and I would be suspect of any such analysis, as there are too many variables which impact the performance of a company. The best one can do in the current circumstances is to figure out if your portfolio company falls in the high risk or low risk bucket (due to the currency depreciation).

If the risks are too high (even if not quantifiable), then one should consider reducing the position size even if it results in a loss

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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The problem with historical returns

By Rohit Chauhan

In Uncategorized

May 20, 2012

6 Min read

21 comments

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What is the most commonly heard refrain about the stock market these days?

My guess is that a lot of people now believe that the stock market is a nasty, volatile place where a serious investor cannot make any money. It is a place for gamblers, traders and at best for the short term investor. It is not the place where you invest your retirement money.

One cannot blame the common man for this view. The recent history of the stock market has only re-enforced the above viewpoint. The problem however is that recent history is a poor guide to the stock market or as a matter of fact for any asset returns.

Some historical numbers

Let’s look at some numbers.

The sensex went up roughly from 1300 levels in 1991 to 4000 in 2000. This gives us an average annual return in the 10-12% range. The sensex then rose from around 4000 to 20000 in the next ten years, returning around 17.5% per annum.

These returns are very impressive and also completely meaningless. These numbers hide more than they reveal. These numbers hide the fact the stock market returns are lumpy and do not come in smooth even intervals. None one made an even 17.5% per annum return during the period from Dec 2000 to Dec 2010.

Let’s break down this period as follows

Dec 2000 – Dec 2003: Index went from 3973 to 5838 (13 % per annum)

Dec 2003- Dec 2007: 5838 to 20286 (36% per annum!!)

Dec 2007 – Dec 2010: 20286 to 20509 (around 0.4% per annum)

As you can see, the returns have been lumpy and were concentrated in the 2003-2007 period.

How does the common investor behave?

Imagine an investor in 2007, who has always invested in fixed deposits, gold or real estate. He has been watching the stock market for the last 4 years and has seen the stock market rise by 300%. He is watching his friends and relatives get rich. At the same time, every time he or she visits the bank, the nice personal banker tries to push the hot mutual funds of the day by showing the fantastic returns of these funds for the last 3 years.

If you were looking at the data in 2007, it looked fantastic no matter how you sliced and diced it. The 1, 3, 5 and 10 or 20 year returns looked good.

So let’s say you got taken by the historical returns and went and bought a whole bunch of mutual funds and stocks. What happened after that?

Dec 2007 – Dec 2011: 20286 to 15454 (- 5% per annum for next 4 years)

Ouch!!!

What is the general perception now?

I have been reading quite a bit of the analysis that the stock market is a bad place to invest. Even if you are a long term investor and were invested for the last 3, 5 or 10 years, other asset classes such as fixed deposits would have beaten the stock market at a much lower risk.

I find this argument shallow and intellectually lazy.

The problem with this argument is that the person making this argument is doing data mining. He is slicing the data in such a way that it just proves his point and does not really highlight the main point about the markets

So what are the main points?

I would say there are several points worth remembering

1. The stock market is a volatile place and returns come un-evenly. As you saw from the data above,  past returns have not been smooth fixed deposit type returns, but lumped in short periods of time.
2. Valuations matter! If you buy at high valuations (dec 2007) and sell at the time of low valuations (say Dec 2009), you will lose money. Period!
3. The stock market is a risky place. There will be long periods of time where you will not make money or even loose money. At a point when everyone is pessimistic or has given up, the stock market has a tendency to turn and surprise everyone. The same holds true at market peaks too.

Other asset classes

Let’s look briefly at some other asset classes.

Gold (all prices in dollars per troy ounce)

1971- 1981: 40 – 460 (25% per annum)

1981 – 1991: 460 – 362 (-2 % per annum)

1991 – 2001: 362 – 271 (-3 % per annum)

2001 – 2011: 271 – 1571 (19% per annum)

As you can see from the above numbers, gold seems to have followed a similar trajectory. There have been periods of high returns, followed by long periods of dismal returns (40 year returns have been around 9.5% per annum)

I don’t even consider gold as an investment as it does not generate any cash flow and is merely an insurance against armageddon or end of the world scenario. But I think I am in the absolute minority, considering the fact that Indians are the largest buyers of gold and absolutely love this metal. So in the end, one cannot really put a price on love!!

I don’t have the numbers for real estate, but anecdotally real estate has displayed a similar pattern. The returns were poor from 1993 to around 2003. The major gains came from 2003 to around 2008 and now the real estate market has slowed down considerably.

You will definitely find examples, where someone purchased a piece of land outside the city and was able to get 10X his or her investment. However a single multi-bagger is not representative of an entire asset class.  That’s like saying that as Hawkins cooker went up by around 1600% in the last 5 year, the entire stock market should also have done well.

The curse of past returns

I am not optimistic that the general, un-informed investor is going to change any time soon. The majority of investors are hard working, middle class people with busy lives. Investing and  the stock market is the last thing on their mind. The time when the market does catch their attention, is when it has gone up considerably. As a result, most of the retail investors end up entering the market at precisely the wrong time.

Past returns are a good starting point to evaluate the long terms returns of an asset class. However these returns are not written in stone. The best approach to evaluate the likely (not guaranteed) returns one will make, is to calculate the expected returns at any point of time and make buy or sell decisions accordingly. The topic of expected returns is however a much more complex topic, and possibly one for a future post.

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