The other side of risk

Risk is often assumed to be “volatility” (measure of variation of price over a period of time), which is quite bizarre, ask any trader, for him / her it is bread and butter. 

Volatility in stock prices creates opportunity, your actions create risk.

So what is risk

One aspect of risk is loss of capital, so when we buy into something which has a high probability of faltering and going down we tend to take more risk ( think : buying IT stocks ’99, real estate and infra ’07 )

There is another aspect to risk which tends to get sidelined.

Picture this, there are ~5000 securities to choose from (India alone), As long term investors, we will typically hold ~20-25 ideas in the portfolio (beyond which diversification loses its significance).

We are betting on the fact that this small portfolio at any given point of time, comprising just 0.5% of the overall universe of stocks available will beat the market consistently over the long run (Only referring to long term, not the short term variations)

  While buying into an idea we are faced with two kinds of risks:

  1.     Loss of capital: Risk of downside from purchase price
  2.     Opportunity risk: Risk of under performance relative to better ideas

So let’s say, I bought Reliance Industries in the 1st week of January, 2009 at ~Rs.700, 1st week of January, 2015, price is ~Rs.930, so 6 year CAGR works out to be ~5%, my fixed deposit did better.

There is no loss of capital and I even got dividends, however it turned to be a poor investment decision, opportunity risk was very high (think: returns in Pharma, IT in the same periods)

Historical market returns have been ~16%, our portfolio has to beat this to justify the extra effort and risk.

We have to find ideas where the risk to capital and opportunity are low and consequently the probability of market beating returns higher.

 

Investing Framework

The information overload we face can be quite overwhelming, I find it really important to have a framework in place to filter and crystallize ideas, it enforces discipline.

Below, I have tried to consolidate my process to make an investing decision ( Seasoned and brilliant investors have helped me in this process through their selfless sharing of knowledge )

BUSINESS MODEL & INDUSTRY ANALYSIS:
  1. General intro about the company  ( Brief background, no. of production facilities, employees, etc )
  2. What is the business model? do you understand it? ( If you don’t understand it that well and if you still want to buy it, make sure the price you pay is really less compared to value )
  3. Is the business scalable? Can the products find a large number of customers? ( This is important, however again, if not scalable make sure you are buying with lots of operating leverage on the upside and current utilization is low )
  4. Where does majority of the business come from? ( Geography, clientèle ) ( It helps when client profile is well spread out and diversified in numbers as well as across geographies )
  5. Existing market share? expected 5 years out? ( Better if increasing, at least it must be stable, very difficult to make money of declining market share companies )
  6. Is the business capital intensive? ( Lesser the capital intensity the better it is, if you must buy a capital intensive company make sure, CFO, interest coverage is high and debt as low as possible and not to forget make sure you don’t pay a bomb to acquire it )
  7. Is the business heavily regulated? ( This is a good thing and a bad thing, good thing as it acts a entry barrier, bad thing because recurring interference is a pain, think airlines, alcohol, oil & gas etc)
  8. Name, Nature ( cyclical, secular ), size of industry? ( Own cyclicals when they are ugly and malnourished, not when they are fat and plump )
  9. Business ecosystem ( This is important, don’t be lazy, it’s going to throw useful insights into the business, preferable do this at the last just before the expected returns module )
FINANCIAL ANALYSIS:
  1. Growth in sales, profits, production capacity, realizations? ( Growth in all is very important, again if currently there is no growth make sure there is good build in operating leverage built in )
  2. Operating efficiency? ( check for margins, receivable, inventory, payable days, this is a good indicator to identify if the company has some edge over its competition  )
  3. Investing efficiency? ( check for ROE, fixed asset turnover , again its a good sign of competitive advantage )
  4. Capital structure? frequent debt & capital raising? ( raising too much debt is very risky and diluting equity too often is not a healthy sign, avoid both unless compelling reasons are there )
  5. Cash flow generation, free cash? ( very important, avoid companies that do not generate cash flows from its operations, free cash is a boon, market will always provide rich valuations for FCF + companies, also a sign of competitive advantage )
  6. Funding for growth? ( Substantial funding for growth should ideally happen through internal accruals, avoid companies which only rely on external sources )
  7. Red flags, concerns, contingent liabilities ( Read notes to account carefully )
  8. Other important observations from KPI ( Key performance indicators ) sheet
MANAGEMENT ANALYSIS:
  1. Key people in the management, promoter holding? ( Do some back ground check on key managerial personnel, promoter group ideally should have reasonable amount of their wealth tied to the company )
  2. Project execution & business expansion history? ( Timely execution of projects and expansion activities says a lot about the management, also check how management has tackled recession and problems in the past)
  3. Any deliberate adverse action against minority shareholders? Related party transactions? ( Watch out for amalgamation of subsidiaries, preferential share allotments to promoter group, too many related party transactions etc,)
  4. Compensation? ( 3-5 % is fine, don’t fuss too much about this unless there is something obviously alarming, think sun tv network )
  5. Ambitious? pursuing profitable growth? any diworseifications in the past? bad acquisitions? ( Beware of management getting carried away by growth, eventually many end up in a mess, think DLF, suzlon, ADAG companies, having said that also avoid companies with no ambition at all, think GM breweries,  )
  6. Management / promoters buying / selling shares? ( Naturally, you want them buying and not selling )
EXPECTED RETURNS:
  1. Brief note on why you want to buy / sell / hold ( If all / some of the above segments are in bad shape, there better be a really good reason for you to buy this company, for eg if a company is facing some temporary headwinds and has a strong probability of recovering think wockhardt, mcx, )
  2. What kind of upside is probable in future? Expectde returns? Approx time frame? ( if <100% in 3-4 years forget about it, look for something else, again there are always exceptions )
  3. Things which have to go right for you to make money on this idea ( fewer the better )
  4. Major risks?
  5. Under what circumstances would you sell? ( This is perhaps one of the most critical aspects of investing, risk is not only loss of capital but also loss of opportunity )

 

P.S : I am learning and evolving as an investor, constantly trying to improve, hence this framework is subject to changes. 

The Reading Dose – 1

Just a small compilation of some very good articles and posts I have read over the week :

1.  What happens when you lose sight of prudent risk management  – Disastrous story of a fund manager who lost close to a $100 million in a matter of weeks.

2.  Another brilliant post from Prof. Sanjay Bakshi – This time its an idea from the e-commerce sector, it’s a brilliant read.

3.  How to spot a 100 bagger – Raamdeo Agrawal on how to spot large trends and companies with huge potential,  make sure you read this over the weekend.

4.  Keeping things simple – Immensely insightful post from on of my favourite investing blogs, more often than not,one needs to weed out all the clutter and keep things simple and straightforward.

Adapt or Perish

Investing in capital markets is a RISKY business.

Not committing a decent portion of your wealth in equities is one of the largest sources of that RISK.

I stumbled upon a useful insight recently.

“A well-functioning stock market is the best medium available to adapt to the ever-changing dynamics of the world.”

Most of us work in industries which focus on providing very specific products or services, for e.g. real estate, IT services, pharmaceuticals, banking etc. Essentially we devote significant resources including time and money to hone a very specific skill set required for advancement and success in our professional lives.

The world is changing much faster than it used to and business cycles are shrinking, new technologies are re-shaping the very fabric of the business environment

It’s all too overwhelming, businesses which enjoyed huge monopolies are now faced with stiff competition, entrepreneurs are required to adapt too fast ( Think: textiles, real estate, stock broking, impact of e-commerce on brick & mortar retail )

Stock markets provide a very natural and an efficient hedge against this, with a decent mind and a rational perspective, you tend to invest in good businesses which are likely to perform well in future, in this pursuit you will pick up emerging companies of tomorrow and not yesterday.

It’s not surprising that the equity market is the best engine of wealth creation amongst all asset classes over a multi-decade period.

It’s also a pity that only ~2% of India’s population currently participates in the capital markets.

 

 

 

Sins of Investing

There are 2 emotions which have predominantly governed the stock markets, Fear and Greed.

There is one more and its called – ENVY.

Past couple of months have been a golden period for equities in India, everything is heading north and returns have really poured in.

Now imagine this –

In a scenario where everybody around you is minting money, everybody is a stock pandit and is painting the best picture possible for the future, brokerage houses have stock recommendations with a minimum 100% upside potential and people are buying fearlessly and flaunting their new stock picking abilities –

You find no opportunities to invest in! let’s say for some reason, your rational mind cannot justify the price you would be paying for the companies you like.

A situation like that, the feeling of being left out can really play with your mind in weird ways, you tend to get envious and jealous of people around and at this very crucial inflexion point you mess up.

Seasoned investors can naturally manage this a lot better, having previously burned their fingers, they focus on generating absolute returns on capital over the long term and do not bother with short-term temporary under performance.

There is nothing more counterproductive than envy. Someone in the world will always be better than you. Of all the sins, envy is easily the worst, because you can’t even have any fun with it. It’s a total net loss.” ~ Charlie Munger

Happy investing!

Idea generation

I have come to realise, there are 4 pillars to the investment process:

1. Idea generation

2. Analysis

3. Buying & allocation

4. Selling
Today’s post is about the first!

There are over 4000 listed companies in India alone, picking investments which can give you decent returns can by itself be a challenge, I have listed some ways you can pick quality companies from the available universe.

1. Quantitative screens : This can be a great starting tool to find interesting companies, you are very likely to tumble on great small / mid-cap ideas which are otherwise ignored and not followed widely by mainstream financial press the best screener for Indian markets is screener.in. you can also use the screener on the edelweiss website

2. Blogs : These are like gold mines, you will chance upon some of the best companies to invest in. The best part is that most of the initial research is already done for you, it’s an excellent starting point to dig deeper. I follow a multitude of blogs and really depend on them for generating new ideas.

3. Paid subscriptions : There are many paid online portals and blogs offering subscription based recommendations, this is money well spent. Some of the ones which are really good are blog.rcfunds.com, theequitydesk.com, equitymaster.com, katalystwealth.com etc. In addition to this there are also magazines one can subscribe to, I subscribe to capital mind, often it has decent ideas to offer.

4. News & exchange filings : Often mainstream news and exchange filings, can throw up interesting ideas. One can get a good idea of future plans of the company, buybacks, splits etc.

5. Industry sources : Sometimes you may have industry network which could lead you to discovering interesting ideas often these can give you very good insights to the business model of the company and its management

6. Observation : This is the most underrated source to generate ideas, there are so many products we use on a daily basis whose companies are listed, Peter Lynch, the legendary fund manager made some of his best investments this way

By no means is the above list an end, ideas can come from all kinds of sources, however this can serve as a decent starting point.

Happy Investing!

Alpha & Luck

Consider this, there are over 4000 (*) listed companies in India alone, if you are in a position to invest in international markets then you have to choose from over 15000 (*) probable companies across the many liquid and popular exchanges available.

If you invest based on fundamentals you would understand that as the number of securities in your portfolio increase, it gets harder to keep track of them and monitor them efficiently to generate positive alpha

A decent portfolio would on average have anywhere between 10-25 stocks above which the benefits of diversification would largely be exhausted

Further, a reasonable target from equity markets is to be able to compound capital at around 20 CAGR over the long term

Now, an aspiring investor needs to figure out which stocks does he have to hold at different times out of the available thousands in order to compound capital at desirable rates. No matter which kind of analysis you apply, you are going to have quite a handful to choose from.

This is why luck plays such an important part in determining your investing results

You can easily build a well analyzed and researched portfolio and a bulk of them could probably not do a thing for years or a black swan like event could hit a few of them and take you completely by surprise

The only way to protect yourself against all of these risks of capital loss and stagnation is to invest in high quality businesses with a reasonable dose of margin of safety, sit tight and allow luck to work in your favour.

Happy Investing!

(*) This is just an approximation.

 

Investing Resources & Books – 2

This is the 2nd part of the series, you can read the first part Here

Books:

1. The little book that ( still ) beats the market ~ Joel Greenblatt

If you are just starting out, this is should probably be one of the first books that you read, it’s like a foundation course on investing and business. The central theme of the book revolves around the fact that one should buy high quality companies at discounted valuations, as the author says frequently throughout the book ” Find out what the company is worth and pay a lot less for it ”

The Dhandho Investor ~ Mohnish Pabrai

This book is another gem, the main idea the author tries to convey is how to differentiate between risk and uncertainty. I remember one of its quotes very clearly ” Heads I win, Tails I don’t lose much “. It also talks about the power and magic of compounding.

3. The little book that builds wealth ~ Pat Dorsey

This book is all about the various forms of competitive advantages a firm can enjoy which enables it to achieve super-normal profitability for an extended period of time. It provides a good insight into how to identify a business with superior fundamentals

4. The 5 rules of successful stock investing ~ Pat Dorsey

This is slightly more detailed and elaborate and covers a more broader scope of topics, it takes the reader right from the fundamentals of investing to the valuation of companies, all in 1 book. It’s a great book for people to get their basics right and develop a sound investment process

5. One up on Wall Street ~ Peter Lynch

It’s one of my favorite books, I have read this one multiple times, it often reminds me to keep things simple. It emphasizes on investing in companies you know and can understand. There are no complex jargon here. Highly recommended for everybody, no matter what stage of your investing career you are in, this is one book you simply cannot miss

6. The black swan ~ Nasim Taleb

I must confess that I haven’t read the whole book, It proved too heavy and complex for my understanding, however there was one key insight I was able to pick up from the book which also happens to be its main theme ~ The role and impact of highly improbable and unlikely events on our lives. As far as investing is concerned, it has helped me remain skeptical and alert for any potential black swans lurking around

By no means is this list complete and as they say learning never ends, reading is to an investor what water is to life.
Keep reading
Cheers

Investing Resources & Books -1

As the title suggests this post discusses briefly the various books and resources which have helped me in my investing journey

Disclaimer: I am not paid to write this and it’s not promotional material

Blogs & websites :

1. Rohit Chauhan’s blog( blog.rcfunds.com)
What I really like about this blog is its originality and the logic in the ideas it tries to convey, material is very engaging and forces you to think. Posts are tagged into variety of categories and it’s a treasure for anyone who’s seriously wanting to learn.

Must Read: Rohit used to share his investing template, you can still check if it’s there on the blog it’s the best thing you can lay your hands on. It just shows how hard a person is willing to work to generate market beating returns, there is no complex financial modelling here, it’s simple enough for anybody to understand and follow.

2. Prof. Sanjay Bakshi ( fundooprofessor.wordpress.com ) 

If you don’t already know, he is the father of value investing in India, inspired by Warren buffet and Charlie Munger, some of his lectures which he graciously shares through his blog are for a lack of a better word mind-blowing.

Must Read: Relaxo lecture series is the most profound material I have read on investing yet. It should form as compulsory reading material at every Post graduate course in management.

3. Ayush Mittal & Family ( www.dalal-street.in & www.screener.in ) 

Screener.in is probably the most useful tool for any investor focused on Indian markets, I can’t even imagine the kind of effort which has gone into creating something like that. Yes and it’s available for free ( well at least for now 😉 )
Dalal-street.in is my go to destination when I am looking for new ideas. These guys have a great knack for identifying beautifully simple businesses which have indeed proven to be very successful.

Must Read: There is a small tab called “talks” on screener.in, it’s a hidden gem, they compile articles and interesting posts from around the web.

4. Safal Niveshak ( www.safalniveshak.com )

Having personally attended his investing workshop, I have greatly benefited from Vishal’s ideas and his investment process.
It is a treasure trove of information and insights into the world of Warren Buffet and many other value investors. What really appeals to me is that it can be followed and understood by everybody.

Must Read: There are interviews which he has conducted of many brilliant investors out there. It will require some patience in finding them, however one should read all of them, in addition to that you can subscribe to the value investing course, it is money well spent.

5. Basant Maheshwari ( www.theequitydesk.com ) 

Although I don’t subscribe to his paid service yet, the website is by itself a brilliant learning experience, it has one of the largest and the most communicative forum, lots of new ideas to pick up.

Must Read: Basant Maheshwari has written a book called “The Thoughtful Investor” , it’s a good read.

6. Base hit investing ( www.basehitinvesting.com )

Although this blog doesn’t discuss stocks of the Indian markets, it has one of the most insightful material on investing.

Must read : Read the articles tagged “Investment process “.

What I really like about all of them is that they don’t advocate short cuts, they have been in this business long enough to understand that it requires just as much effort, patience and perseverance as any other line of work.
Every time I read through these blogs I come out wiser and inch towards being a better investor.

Stock Idea – IPCA Laboratories

This one is a long post, I apologize in advance if you doze off while reading it, if you do manage to reach the end, feedback would be highly appreciated: p

About:

  1. Incorporated in 1949 and currently employees ~11,000 employees
  2. Integrated pharmaceutical company; currently having around 80 APIs and 350 formulations ( branded and generics )in its product portfolio
  3. Market leader in anti-malarial and Rheumatoid Arthritis with over 30% market share
  4. Formulations business is 76% of revenue and the remaining is API
  5. Share of exports is over 60%
  6. Has more than 12 manufacturing locations

Key Market Indicators:

Key Financials & Analysis:

kk

  1. Net worth ( Book Value ) measures the intrinsic and inherent value of stockholder’s equity, for IPCA labs, it has grown at an amazing 25% CAGR over the past 5 years, not only that, it has maintained an Return on equity (ROE) at an average of 24% over that period, this clearly states the superior fundamentals of the business and the efficient capital allocation skills of its management, maintaining a decent return on incremental capital employed by owners is one of the most challenging tasks for any company, IPCA labs seems to be doing a good job
  2. Company has delivered excellent growth over the past 5 years with Sales and PAT growing at 20.05% and 38.15% respectively
  3. Very less leverage which is a very good sign, when you look at that in conjunction with very little equity dilution, high growth and very good ROE, you realize the fantastic cash flow generating ability of the business and the superior capital allocation skills of the management
  4. The management is paying out only around 17% ( Avg 5 yrs ) of PAT as dividend and yet maintaining excellent ROE indicating that management is aggressively pursuing growth but not at the cost of profitability
  5. Fixed asset turns are impressive at an average of 1.97, the interesting thing is that over the past 5 years, this ratio has grown, indicating efficient use of assets by the company
  6. The business is consistently Free cash flow positive over the past 10 years
  7. Debtor receivable days have consistently come down and payable days have gone up indicating that the company is collecting cash faster and making payments later, further shows management efficiency
  8. Company is aggressively incurring capex aggressively to expand capacities, ~60% of PBT and ~10% of sales is incurred as capex

Reasons to buy:

  1. On fundamental grounds this is a company with superior fundamentals
  2. Company growing at +20% with little dilution or debt, this shows how large and deep the market potential is
  3. Management is decent and an efficient allocator of capital as evident from above analysis
  4. Aggressively investing in building capacities
  5. Recently one of its plants was inspected by US-FDA and it was shut down voluntarily by the company as a result of which the stock fell down by 13% ( this is where things get most interesting )
  6. The contribution of revenues from the US markets is ~10%, FY 2014 revenue was 3,296 cr ( Net ), let’s assume that 330 cr revenue from the USA is wiped off indefinitely
  7. PAT margin of 12% should mean an impact of ~40 cr on the bottom line
  8. So for FY 2015 let’s consider PAT to be 430 cr and assume there is no growth in any other segments either ( which by the way is unlikely as management has given guidance of 12% )
  9. So under these assumptions at 12% cost of capital, the current market price is assuming growth of ~12% for the next 10 years and 3% for the distant future
  10. The question is can the company do better? In our opinion it can and this is a very lucrative opportunity to buy this company
  11. The US-FDA issue is short term in nature as the management is committed to resolving it within 6-8 months time
  12. The company hopes to quickly regain lost market share as it would be difficult for competition to match its scale so quickly
  13. There is no penalty clauses with customers in case of discontinuation of supplies
  14. IPCA has been automating most of its production processes and management is confident that once it is complete, most of the issues raised by FDA will be resolved

Risks and Concerns:

  1. If the US-FDA issue isn’t resolved in time, it could further impact profitability and delay new launches
  2. Post resolving this issue the company could find it difficult to regain market share
  3. If there is a general slowdown in the industry
  4. Increased competition could impact margins

Conclusion:

  1. In our opinion this is an opportunity to buy a company with superior fundamentals at a discount
  2. It is a long term idea and would require patience for the returns to unfold, we think CAGR of 15-18% is comfortably possible over the next 3-5 years

Disclaimer : This is not a buy/sell recommendation, it is purely meant for discussion and knowledge purposes, please do your own homework

Sources: Company AR, presentation, Ace equity and third party research