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Déjà vu again

By Rohit Chauhan
In General thoughts, Market analysis
February 27, 2022
4 Min read
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The following was posted to all the subscribers. Hope you find it useful

Market drops have become a once in two year events

2016 – demonetization (note here)

2018 – ILFS crisis (note here)

2020 – Covid Crisis (note here)

2022 – Drop in US markets and now Russia Ukraine war

There is no regularity to these events and does not mean we will get these drops in even years. Such drops have occurred in the past and will occur in the future too.

You have to study the market history to know that there is always something to worry about and scare the markets

Bottoms instead of top down

I have never planned the portfolio based on some specific forecast or event. In the last 11 years of our advisory, we have seen all kinds of micro and macro events occur. At that time, the event appeared to be a big deal and then eventually everyone adapted to the new situation

What I have changed in the recent past (as I noted in the annual letter) is my response to company level events. If a company is not doing well or the management is lacking in execution, we would rather exit than hope things will work out

Doing so ensures that we clear the portfolio of its deadwood and have positions with higher level of conviction. That’s the reason we have 25% cash level in the portfolio, not because my crystal ball forecasted a downturn in 2022

What does the crystal ball say now?

My crystal ball is as murky as it always has been. The same is true for others, even if they claim otherwise

However, a few long term trends which impact investors the most, seem to standout. Inflation and by proxy interest rates appear to have bottomed and could rise in the future. This will exert a downward pressure on valuations.

Commodity prices and supply chains will continue to get disrupted due to this conflict and other geopolitical events

All of this means a lot more volatility in businesses and stock prices

How to invest with higher volatility

In my mind higher volatility means that managements of companies will have to be flexible and adapt faster to change. For us as investors, this means that the operating environment for our companies could change suddenly leading to a break in our thesis

When that happens, we may have to sell and move on. Holding onto an outdated thesis and hoping it works out is a recipe for disaster

We have been doing that for the last 6 months and will continue to do so. I am not counting on luck to bail me out.

The second change is portfolio diversification across companies and sectors. I have tried to spread out our investments across companies and sectors to ensure that a hit in one does not derail the portfolio. The same holds true for your overall portfolio outside of equities. I would recommend being diversified across asset classes with allocation adjusted to your personal situation

A plan of action

A lot of you have asked if you should add to positions which have dropped below the buy price. The simple answer is Yes. The only time when this happens is when there is chaos and crisis in the world. Such prices come only during times of trouble

It does not mean that if you start adding today, you will not see lower prices. No one can predict how low the markets can go and when they will turn around.

This is the price of investing in equities and no matter what system you follow, there will always be losses from time to time. you can use a stop loss but then on the flip side if the market suddenly turns, you will lose the upside.

The best option is to invest in a steady and measured way keeping in mind that your purchases could show a loss in the short to medium term. Invest only if you don’t need that money for the next 3-5 years and the amount is such that these losses will not cause you to lose sleep

We continue to look for new ideas and with the recent drop, a few are becoming attractive by the day.

As always, our money is invested the same as the model portfolio and we continue to eat our own cooking

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Playing games

By Rohit Chauhan
In General thoughts, Investment process
February 18, 2022
3 Min read
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I got introduced to poker in 2020 and have taken to this game. You can read the rules of the game here. The rules are quite simple. The richness comes from the lack of perfect information

As the community cards open on the board, one bets not only on one’s own cards but also based on the strength of the opponent’s hand. As the opponent’s hand is hidden from us, we are forced to make probabilistic decisions

As the card are dealt, one makes these decisions based on betting and other actions (called as tells) of the opponent. The beauty of the game is that one can see the result of the decisions quite quickly – in a matter of 5-10 min as the hand is played out. This allows for rapid learning

As you play the game, the parallels with investing/trading become clear. Investing has far more variables and is not the same as poker. That said, both involve decision making under uncertainty

I wanted to share some learnings from the game, as related to investing

  • Losing even when odds are in your favor: Decision making under uncertainty involves making probabilistic decision. Even when the odds are in your favor, the result can go against you. The probability of win could be 60% which is considered high in poker, yet 40% of the time the result will be against you (no surprise there). This happens often and inspite of all the rational thinking such events do upset me. Most other players in poker or investing are not even thinking of probabilities

The key is to focus on the process and not the outcome (easier said than done)

  • Keeping losses low: Odds will often not be in your favor and you will be tempted to make a bet. At such times, folding your hand against all your instincts is the right decision. Making such decisions is never easy as one is losing money – by folding in poker or selling a position in the portfolio. However, such decisions are the key to doing well in the long run.

What ‘feels’ good in the short term is not good for long term results and vice versa. That’s why investing is simple but not easy

  • Know yourself: Some players are aggressive risk taker. They will bluff often and make big bets when odds are slightly in their favor. Other players like me are more conservative. I am constantly calculating the odds and making bets accordingly. I am also focused on not going bust in a game (losing my entire stack). I invest in stocks in the same manner. The only difference in my poker game is that I will occasionally bet high when the odds are really good.

Successful players play to their natural bent of mind, but at the same time should try to do what is not comfortable for them. Combing the right amount of offense and defense is an art and a lifelong process in poker and investing

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The difficulty in selling

By Rohit Chauhan
In behavioral finance, Investment process
November 10, 2021
4 Min read
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I wrote this note to our subscribers recently. Names of companies are not investment advise and we may or may not hold them in the model portfolio

Hope you find this note useful

————————————————————–

I have identified myself as a buy and hold investor for a long time. I started investing in late 90s and was looking for a guru/north star at that time. This was the start of the internet era and unlike today, there were no online resources on investing

I came across Warren Buffett through a book –  The Warren Buffett way and was hooked by his persona and investment philosophy. As it usually happens, once you admire someone, you tend to follow almost everything they say or do

Buy and Hold (or hope?)

One of the core tenets of Buffett’s philosophy has been buy and hold. I have embraced this philosophy whole heartedly in the last 20 years. Even though there was a degree of blind faith in following this approach, I have been amply rewarded for it

Over the course of time, as I have thought about it, I have realized some nuances to it. This has made me question if buy and hold (as I practice) makes sense in ALL cases

The precondition to the buy and hold philosophy is that you buy a great business with great management and hold for the long term to benefit from compounding. If either condition is not met, one should not buy the business in the first place

I have often made the mistake of defaulting to buy and hold inspite of the management or business being below average instead of selling and moving on

Why is selling tough?

The reason is not difficult to see – selling is tough and there is always regret in hindsight. No matter what logic you use, there is always something to regret about

For example

  • Follow a valuations-based sell approach and you get the case of Vinati organics where one should have done nothing
  • Don’t follow the valuations/stage of the cycle approach and you get Piramal enterprises or Edelweiss where you overstay you position and lose all your gains and some
  • Make a mistake in evaluating a business and don’t exit promptly and you get Shemaroo ent with an 70% loss
  • If you like the business and management, but keep holding on, waiting for the business to turn, you end with an opportunity loss as with Thomas cook (I) ltd
  • Sell early and you may end up with a Balaji amines and miss out on a multi bagger

I cannot think of an example where I did not have any regret. When one faces this situation, the natural tendency is to do NOTHING and hope it will all work out. I am trying to avoid that now

Make mistakes and fix them

We sold IEX and reduced our position in Laurus labs recently. If these stocks keep rising, I will regret selling early. I will make decisions against my natural instincts, expecting to wrong a few times.  If I am wrong, such as in the case of IEX or Laurus labs, we can always turn around and buy the stock again.

If I am accused of flip flopping, I consider that as a compliment. My loyalty is to the portfolio and you (the subscribers) and not to the stock or the company we hold

Ps: In the list of companies above, I have shared the worst of my decisions in the last 10 years. There are more and it’s a long list. You can accuse me of making dumb decisions from time to time, but no one can say that we try to hide them. All my decisions and thinking can be accessed here and my public blog

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Checking for survival during Covid

By Rohit Chauhan
In General thoughts
September 12, 2021
4 Min read
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In March 2020, during the depth of the Covid crisis, I did a bankruptcy risk analysis of all my positions. I wanted to evaluate, how long these companies would survive, under various lockdown scenarios such as a drop in topline by 50% or zero revenue for an extended period

Although the severity of the crisis turned out to be much lower, there was a non zero probability that the pandemic could get worse and cause a longer shutdown

I used the recent financial results and credit rating report for the analysis. The review was broken down into break even analysis (how long the company could survive on zero revenue) and long term demand/business impact

Getting a grip on the risk

This analysis allowed me to evaluate the risk of individual positions, their correlations and not to panic at the bottom. At the same time, it also prevented me from being sanguine about the risks.

The benefit of this exercise was that i able to avoid selling at the bottom and started adding to the model portfolio in steady /regular fashion from Mid April 2020 as the worst case scenario did not play out. This analysis continued to help me in subsequent waves of the pandemic as I had already done the work of evaluating the worst case scenario

Although this was a stressful exercise done in the middle of all the uncertainty, it allowed me behave more rationally and in a measured fashion. For me, there was never a eureka/light bulb moment when I decided to go all in. As I shared in my earlier post, my top priority was return of capital than return ON capital

Following is a sample of the analysis and are my raw notes. This is no longer in the portfolio (as shared in the prior post – a mistake) and also not a recommendation to buy or sell

April 2020 : Thomas cook (I) ltd [Company is in the travel space – epicentre of the crisis]

Liquidity risk: CRISIL AA-/Negative as of 3/27

Crisil report: Liquidity Strong

Liquidity remains strong, with cash and cash equivalents of Rs 1,724 crore as on December 31, 2019, against repayment obligation of Rs 73 crore over the 12 months till December 31, 2020. Liquidity is driven by the nature of operations with significant advances from customers. Financial flexibility is enhanced by the ability to contract short- and long-term debt at competitive rates. On a standalone level, TCIL has no long-term debt, and working capital limit has been sparsely utilised. Its subsidiaries are expected to service debt through internal accrual and need-based support from TCIL.

CRISIL believes TCIL’s profitability and cash flow metrics could be materially impacted by continued travel restrictions due to prolonged Covid-19 situation.

Cash burn rate: Company has a cash outflow of around 250-300 Crs/ quarter from salaries, overhead and other expenses. Company has used up around 150 crs of surplus cash. Float is likely to drop. With full stoppage of travel company is likely to lose 200 Crs in Q1 and around 200-250 crs in assuming travel starts picking up end of year slowly. Company has cash and equivalent of 1700 crs, free cash of 200 crs (50 crs after buyback) and only 75 Crs of re-payment till end of the year

Assuming 50% drop in topline, company could lose atleast 500-600 Crs this year. Can take on debt of 400-500 crs including loans/ funding from parent to sustain the year. Some recovery could happen in 2021 and 2022 could see return to normalcy

Break even analysis

Company has a GPM of around 25%. Company needs 1200-1400 Crs of cash flow for Break even basis. Based on this, the company will achieve cash flow break even with 25% drop in topline. Due to the severe stoppage of travel and tourism, even this is not likely. Q1 could see almost 70% drop and Q2 could at best be 40% of capacity. Normalcy will only return from Q3 onwards.

In view of this, the company will need close to 800-900 crs of cash flow and will need to take on 500 -700 crs of debt at a minimum to support the operations.

Long term demand/ Business model impact

Short term fragility is from complete stoppage of travel/forex, MICE events etc. Long term risks/ fragility comes from OTL and move to online travel, which for now is lower risk and with tightening of capital, could reduce.

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