Gold Ahoy!

I have to admit. It’s not my forte. And that’s why I decided to put some research into it. With the gold prices going sky high and some well known investors like Jim Rogers and David Einhorn recommending that some part of the portfolio be dedicated towards gold, it certainly deserved serious attention from an investor.

A bit of background

Gold has been valued from the early Bronze Age. The first known gold objects, dating possibly as far back as 5000 BC were Egyptian ornaments, ritual vessels, and personal jewellery. Gold’s high melting point and resistance to corrosion made it indestructible and very useful indeed.

Goldsmiths in the 17th century issued certificates representing gold on deposit, which were among the earliest forms of gold backed paper notes. When the Bank of England was created in 1694, it mainly financed government debt by issuing these notes.

Safe Haven

“Europe collapsed and North America collapsed!”, said the Indian finance minister, Pranab Mukherjee as he announced India’s purchase of 200 tonnes of gold from the IMF. This purchase was the single largest central bank purchase in 30 years over as short a period as a fortnight.

This must have been a BIG decision by the country’s think tank considering that this constitutes over a 50% addition in its gold reserves. After the purchase India now has close to 560 tonnes of gold (about 6% of the reserves in value), that’s the ninth largest gold holdings amongst central banks. China on the other hand has grown its gold reserves by 75% vs. last year (as of now China has around 1000 tonnes of gold, constituting around 2% of its reserves). Compared to some of the other nations like Germany (69%), Italy (66%), France (70%) – this is still a miniscule percentage.

And therein lies the logic of the gold purchase by India and China – diversification of risk to assets other than USD. At a governmental level, it pays more to safeguard the country's assets than to look for returns.

Gold and Dollar are considered the world’s primary safe haven investments. If the confidence in Dollar collapses, gold then takes over as the world’s sole safe haven investment. In that sense, gold has historically provided a low and even negative correlation with most other asset classes and has been used as a portfolio diversifier whenever there has been a perceived high level of risk.

As the following chart shows, gold rose from USD 100 per ounce in the period ‘75-’78 to a high of USD 750 per ounce around the early ‘80s. This was a period marked by high credit (average annual credit grew by 11%) and at times higher inflation (average inflation rate of 12% in 1974 and again in 1979-1980). Investors flocked to buy gold as confidence level in the world economies fell.



Just immediately after this, gold’s price fell massively (in 2000 it was back to around USD 250 per ounce) as monetary order was restored and the economy and stocks soared.

Moving back to the present times, with the US Congress spending billions of dollars in stimulus funds to jump-start the economy funded almost entirely with debt, the dollar has become weak since currency investors tend to shy away from high-debt countries - just like in equities where (all other things being equal) we would not prefer to invest in a company that is highly levered.

In the case of a country, a high level of debt also causes higher inflation, another reason for investors to stay away from USD and hence moving into the only other known safe haven – gold.

Resultantly, the yellow metal now rules over USD 1100 per ounce. This means a return of over 50% over last year.

Crystal Ball gazing

So with gold now at the USD 1,100 per ounce levels, bets are being placed on what could be the next probable price target. Wild guesswork is at work, as is usual. And some say that even US$ 1,500 by the end of 2010 does not look like a very tall order.

It was reported that Barrick Gold, the world's largest producer of gold is moving to completely close its hedging operations as it does not believe that gold prices could fall a great deal from here. The company feels that global output has been falling by roughly 1 m ounces a year (approx 33 tonnes) since the start of the decade and hence, there is a strong case to be made that we are already at 'peak' gold.

And with central banks around the world also turning into net buyers of gold in recent times, supply crunch is likely to worsen a great deal more, taking gold prices even higher.

Barrick is not the only one betting on higher gold prices in the future. Marc Faber, one of the world's pre-eminent investors has also jumped on to the bandwagon. "We will not see less than the US$ 1,000 level again", he is believed to have said at a conference today in London. "Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold", he is reported to have said.

Even the best can’t be right all the time

The average investor is blindly following these noteworthy men.

But as the earlier chart depicting the gold price showed, gold as an investment suffers from the same malaise as any other investment. Buy at a high and the probability increases that you will lose.

Notwithstanding what Barrick believes, the Fortune magazine has reported that gold miners invested more than $40 billion into new projects since 2001, and they "are now bearing fruit." Bullion dealer Kitco "predicts that these new mining projects will add 450 tons annually -- or 5% -- "to the gold supply through 2014, enough to move prices lower." The demand also brings out sellers of scrap gold, which adds even more to the supply.

All this while world demand for gold (as in the demand from the ordinary consumers) has dropped 20% in the past year. In fact according to the World Gold Council, India's gold demand dropped 38% in the second quarter, with jewellery purchases down 31% from a year earlier. For India! This is where everyone loves gold!

By the above logic, if the supply is going to move up and the consumer demand is down, the only reason that the gold will continue to rise in the future is if the investors continue to buy more gold.

Don’t know if it is the right comparison, but this sounds like a giant Ponzi scheme. As long as there is fresh demand from investors, the prices will rise. And we know these don’t last forever. Remember oil DID NOT reach USD 200 per barrel from the USD 130 levels or so, despite a lot of the so called experts preaching that it might.

What can turn the tide?

Very clearly the return of the US economy back on track.

As mentioned earlier, all things considered, gold is essentially a bet on the collapse of the current monetary arrangement based on paper currencies. And although the US dollar might look like it is overvalued and prone to collapse, what if the US economy does not collapse and actually recovers and the Fed starts raising interest rates?

Mr. Buffett is already betting on it.

“It’s an all-in wager on the economic future of the US. I love these bets... America’s best years lie ahead, no question about it” so said the sage of Omaha, Warren Buffett as he announced the acquisition of Burlington, a US railroad company at a total price of USD 44bn, his company's highest investment thus far. Ever.

As for gold, he had the following to say:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

(Fittingly one commentator used the above to say this about printed money: “It comes in abundance from trees with little to no efforts, we print as many as we want and assign whatever value to it, but we make certain it contains official looking faces and logos so that we can pay people with it to stand around guarding it!)

So there. After all the research, I have to admit that I still don’t know how to value gold like I would value a company. Which means that if I can’t invest in (Indian) equity, which at this point in time seems the case, then gold doesn’t look the right choice of investment either. Back to square one.

Umm, and Indian equities?

Well just because the US economy is looking to come out of the doldrums and Mr Buffett is betting big time on it, I am afraid it does NOT mean that the Indian equities will follow suit. This could well mean a flight of capital from emerging markets like India and back to US (I referred to this in my last blog entry too), with obvious effects on the market levels.

Meanwhile, the best strategy in my view is to keep smiling that golden smile and hold on to the cash. The time to invest will come.

Whither the markets?

Whither the markets?
November 1st 2009

In the Indian family context, until the first child is born, the question that a couple is most often badgered with is - when is the good news coming? Atleast that was the case over a decade back (thats when we had our babies, so obviously after that thankfully we stopped getting those questions).

And in the context of the stock markets, though the 'good news' had been discounted for a long time (remember the 'green shoots'?), yet when it actually came, there was much excitement around it. I am referring to the latest numbers reported for the US economy showed that the US GDP had grown by 3.5% YoY during the quarter ended September 2009 (3Q09). See the graph below.



For real?

Many though, are still doubtful whether this is sustainable. This is given that a large part of this growth in US GDP has been brought about by the government's stimulus program that has helped raise consumer spending, and housing and automobile demand.

For instance the cash for clunkers program. This is the program wherein the US government was offering a cash subsidy to consumers to exchange their old cars for new ones and was done with a view to bail out auto companies, which stood on the brink of bankruptcy. This has pushed up the automobile output during the September quarter by a massive 158% YoY, which in GDP terms, according to the US Bureau of Economic Analysis, added around 1.6% to the US GDP growth figure reported. Thus without it, GDP growth would have been only 1.9% (3.5% minus 1.6%) during the third quarter.

Sauce-Bearnaise Syndrome

I heard of this term only recently. Basically if you end up eating something that violently disagrees with your system and you end up vomiting, you'll likely find yourself suffering from Sauce-Bearnaise Syndrome. Otherwise known as taste aversion, it causes us to associate the taste of the food we've puked up with the illness that caused it to such an extent we're unable to face eating it again.

If from my notes you get the distinct feeling that I am being too pessimistic in my views of the stock market, then you know the equivalent of the Sause-Bearnaise syndrome is working on my mind where investing is concerned. I still haven’t quite forgotten the paper losses of just a few months back.

People who came out of the Great Depression in the US are known to have been highly risk averse when it came to investing. Including the great Ben Graham, the eventual teacher to some of the greatest minds on the investing landscape, including Warren Buffett and Walter J Schloss. So I am in August company where this feeling is concerned.

The sky is falling!

I read somewhere that losing in the stock market is an everyday reality: Stock prices go up and down daily. Inflation corrodes the purchasing power value of investments-day after day. The challenge-and the opportunity-is to lose less.

General George Patton said it this way: "Let the other poor, dumb son-of-a-bitch give up his life for his country." They are all talking about the same thing: Don't be heroic. It doesn't pay.

I am not the only one with the feeling that notwithstanding the streaming economic good news, all is not well in the stock markets.

Renowned economist Nouriel Roubini said on Oct 31st that we can possibly have a market crash all over the world. The reason? He is of the opinion that everybody is currently busy shorting the dollar, borrowing and investing in assets all over the world. That has helped push the dollar to a 14-month low.

People are essentially borrowing at zero percent interest rates in the US and investing in other countries, which is even more beneficial for them because we currently have a falling dollar. But according to him, the dollar will eventually rebound. And when that happens, everyone will have to close their short positions and dump their assets, and this is how we can have a market crash all over the world all over again!

A journalist on the FT, who I respect for his views also said that the next ‘correction’ in the stock markets will be caused by the foreign exchange markets, predominantly the US Dollar.

There is no doubting that the greenback has taken a beating. The rupee has gained ~5 per cent since this time last year, the euro has gained ~18 per cent, gold has risen in value by 17 per cent against the dollar since the start of the year etc.

The oil-exporting world is worried, since oil is priced in dollars. As is the Indian infotech industry since the bulk of its earnings are in dollars. The Chinese are practically paranoid, for they are the world's biggest lenders to the US. You would be too, if you had invested $2.27 trillion mostly in US government bonds. The governor of the People's Bank of China, wrote in a recent essay that the world needs a new global currency to replace the dollar.

Some of the dollar's recent losses are, of course, a manifestation of the perceived return to normalcy in the financial world, and a reversal of global capital's "flight to safety" in the dollar last year at the height of the financial crisis. As appetite for riskier investments returns, capital is moving out of the dollar comfort zone in search of better returns.

But more deep-seated concerns about the structural weaknesses in the US economy -- principally, a toxic mountain of debt and the absence of a strategy to overcome it -- are giving rise to a chorus of concerns that the dollar is at risk of collapsing and being dislodged from the pedestal of its global reserve currency status.

As if till now you weren't convinced of my negative views on the markets, I am going to quote another interesting article - this time something that I saw on the Wall Street Journal. This one said that the markets in the emerging economies could be headed for a downturn irrespective of how the developed countries fare in the future.

Basically as per this theory, if the US and Europe continue to grow sluggishly, countries relying on exports such as China and Brazil will be hit hard. So if the world economy slows further, commodity prices will plunge. On the other hand, if the US economy for instance starts growing at a strong pace, interest rates will head upwards and the dollar will appreciate thereby taking the sheen off emerging markets.

Damned if I do, damned if I don’t!



Despite the interesting insights that these theories provide, why should we concerned on this? Because foreign money flows into the Indian markets are the ones that move our markets. As seen from the chart above, there emerges a very close connection between how FIIs (foreign institutional investors) have behaved in the past and how the Sensex has danced to their tunes. And as compared to the FIIs, inflows from Indian mutual funds have been relatively steady and small.

When Warren Buffett was asked in 2006 whether there was a bubble in commodities, Buffett observed that, like most trends, it was driven by fundamentals at the beginning and then speculation takes over. 'As the old saying goes, what the wise man does in the beginning, fools do in the end.'

This was in the May 2006 period when the stock market was booming, just ahead of its correction. Every second fund manager was aware of the market's potential fragility and Buffet's analogy resonated with many investment people. 'It's like being Cinderella at the ball,' he said. 'You know that at midnight everything's going to turn back into pumpkins and mice. But you look around and say “one more dance" and so does everyone else. The party does get to be more fun-and besides, there are no clocks on the wall. And then suddenly the clock strikes twelve, and everything turns back to pumpkins and mice.'

For us, this means that till the time the FIIs decide to stick around, well and good, but when its time for the clock to strike midnight - for whatsoever different reasons - could be the dollar, could be their reporting periods or their percieved attraction to another market - they will go home.

And?

Well, while everyone has to have an their own independent line of thinking on investments. From my standpoint: Wait.

Mohnish Pabrai, said in an interview recently that one of Warren Buffett’s key trait that he has followed is that “you make few bets, you make big bets, infrequent bets and you only make bets when the odds are heavily in your favor.”

I so whole heartedly agree. I was having difficulty finding real values in the Indian stock markets. And notwithstanding the recent ‘correction’ in the Indian stock markets (probably caused by the exit of some fickle fund money), I am not waiting with bated breath on the big crash which may or may not happen. I would invest when the odds are heavily in my favour.

It is in times like these when interesting opportunities usually start to appear. I hope I can write soon about those.

Because that would be the real good news.

Armageddon Off The Table?

Armageddon Off the Table?

It was reported recently that 2 new luxury flats in Hong Kong had been put on the market for a record per square foot price of HK$75,000 (US$9,640) as the buoyant economy and stock markets on the Chinese mainland had lifted demand for exclusive properties even beyond pre-crisis levels. Sun Hung Kai Properties, the world’s biggest developer by market value, now aims to sell the three-storey apartments – on the 91st to 93rd floors of twin 270m towers – for HK$300m each, HK$50m more than previously priced.

Singapore Property Price Index had risen so much so fast that in fact the government had to recently take steps to cool down the housing market.

The Standard & Poor’s 500 Index has had the biggest rally since the 1930s as it has climbed over 50 percent in six months; the Shanghai Stock Exchange Composite Index nearly doubled from November to July before pulling back last month and the Indian stock exchange has almost doubled from its lowest point this year.



On the other hand, Nuriel Roubini, the NY University professor also known as “Dr Doom” who in 2006 foretold the worst financial unraveling since the Great Depression wrote in the FT that, “There is a big risk of a double-dip recession,” He had earlier written in March that the advance was a “dead-cat bounce,”.

Interviewed recently by CNBC Roubini said "It's going to be death by a thousand cuts. The financial system is severely damaged, and it's not just the banks. The gap between supply and demand is so huge we could stop producing new homes for a year to get rid of all the inventory," he said.

So are we there yet or not – remember that during the decade-long Great Depression there were many stock rallies, including a 67% gain in the Dow in 1933. So is this what it is – a dead cat bounce, as Professor Roubini calls it?

Don’t know, but please see below the movement in BSE Sensex since Jan 2007 and its PE multiple:



What seems clear is that the Indian market is now back to where it was in August/ September of 2007. And just like those times, it is very difficult to find value in the prices – at 20+ x on PE, I am not sure if things are cheap anymore. There are other factors such as dividend yield and Price to Book which are giving the same message.

Fact is that we have heard a lot about the “green shoots”, but the way the markets have moved up, it seems everyone is already discounting that the green shoots will soon become large forests. To me, it seems that though some of the imbalances underlying the credit crisis are ebbing, others are persisting and new ones are being created by policymakers’ attempts to stimulate economies and markets. Everything is not yet hunky dory and to my mind atleast 2 issues remain:

1. US fiscal issues and related issues
2. Bubbles in emerging markets

On the US fiscal issues, I came across a nice statistic recently – one year after the collapse of Lehman Brothers set off a series of federal interventions, the government is the nation’s biggest lender, insurer, automaker and guarantor against risk for investors large and small.

Hence, the US government is financing 9 out of 10 new mortgages; if you buy a car from General Motors, you are buying from a company that is 60 percent owned by the government; if you take out a car loan or run up your credit card, the chances are good that the government is financing both your debt and that of your bank. And if you buy life insurance from the American International Group, you will be buying from a company that is almost 80 percent federally owned.

For much of the period since the Second World War, the dominant force in global demand has been consumption in the developed nations, with US consumers being the largest single block. The mirror of this was in Asian countries, which had low consumption but managed to expand their exports and built large FX reserves in the process.

However, the recent crisis had a dramatic effect in reducing these imbalances rapidly. The US trade deficit shrank from around –5% percent of GDP in early 2008, to –2.4% in early 2009. The household savings ratio fell close to zero during the boom as a result of easy credit, but rose steeply as the crisis intensified, reaching almost 4.5% in the early months of 2009, taking it halfway back to the level of around 9% that prevailed for three decades before Mr. Greenspan’s expansionary Fed policies. Will this remain at the same levels or will the consumption go back to earlier levels soon?

Can the Asian countries, faced with export declines of between a quarter to 50%, regain growth without relying on the (earlier) booming consumer markets like the US and boost domestic demand on their own? Can the developed economies of today manage to keep their banking systems stable and can its consumers reduce debt relative to income gradually rather than suddenly?

In 2007, the US accounted for about 30% of world con¬sumption while China accounted for 5.3%. It is being projected in some quarters that China will overtake the USA as the largest consumer market by 2020. By then, China is expected to account for 21% of global consumption, and the USA for 20%. The assumption is that this will result from a combination of China’s income growth, currency appreciation, demographics, in addition to the deleveraging effect among US consumers.

This view is widespread. Recently, Sir John Major, former Prime Minister of UK was asked as to which countries he thought will likely lead us out of this recession. His answer: China. Perhaps followed by other parts of South East Asia as well.

Are we relying too much on China – whose transparency in facts and figures are much in suspect? Are we at the cusp of a historic shift in consumption pattern from the developed to the developing nations? Is the market recovery too soon too fast? Are there bubbles forming – property/ stock prices etc, fueled by easy money availability?

I don’t know the answers to this and the many questions that are being asked. What I do know is that with price and value in reasonable balance, the future course of the markets will largely be determined by future economic developments that defy prediction. There are very few names that are compelling buys at this point in time.

On balance, I do think that while Armageddon may be off the table, better buying opportunities may lie ahead. Unfortunately I am sure there are many others like me (not to mention institutional funds) waiting to invest their monies at the hint of a fall. So either the fall has to be huge and dramatic, or else we just need to go back to being tactical in investments again and not look for the easy kills anymore. Time will provide the answer to that one. Meanwhile, my money is lying safe in my bank account. I hope.

Active or Passive Voice?

Active or Passive Voice?



We had once recommended a stock called Merck Limited on our blog. It seemed to be a value investor stock by all counts.

The cash flow of the company is reproduced below:



Looking at the last 5 year results, the company has made a good (and stable) profit and the average cash flow from operations works out to around Rs 93cr. – the last years cash flow fell because of higher inventories and receivables – a sign that the company probably tried to push its products at the end of the year. Nevertheless, a company with high cashflows.

Its dividend has been rising over the years – from Rs 2 per share in 1988 to Rs 20 per share in the 2007. However, in 2008 they did drop the dividend to Rs 17.5 per share to conserve cash, keeping the tough economic conditions in mind. Even at this reduced dividend, the dividend yield works out to around 4.5% on the CMP of Rs 398. Certainly, a situation where we are being paid to wait for the stock price to appreciate.

The company’s current market cap is around Rs 670cr, of which are Rs 330cr (as at the Dec’08 closing) was held as cash/ bank/ investments (not adding another 36-40cr in cash that they made till June’09). Hence, the market is valuing the company with an average cash flow of say 80-90cr a year at Rs 340cr (market cap of Rs 670cr less cash held of Rs 330cr). Say around 4-5 X of cash. That should be considered cheap.

Surely in the near term the prospects look tough given that around 50% or more of the company’s products are covered under the Drugs Price Control Order (DPCO), which means that to that extent they do not have the freedom to price their products (mostly vitamins). With input costs having gone up, this has meant reduced margins – which is showing in their recent performances. But thinking the contrarian way, Merck, being an MNC would like to introduce more products to get out of the DPCO’s grasp. And the company has been on the ‘prowl’ (as reported in a newspaper article in 2003) for an acquisition in the Indian market and has been conserving cash (almost 50% of their market cap) for that purpose.

But 2 years into my personal investment, lets relook at these assumptions: Merck (the parent company) has a 100% subsidiary through which it is reportedly introducing new products (this way they don’t have to share their profits with the minority shareholders). And why has the company not been able to find any acquisition target in India despite being on the ‘prowl’ for the last 6 years?

The market usually tires of waiting for a catalyst and that is true for Merck as well. But despite this, the price chart below shows that even during the period 2008- early 2009 when the markets went for a long holiday, the stock has actually done well to hold its own and didn’t fall by much. It has therefore served its purpose as a defensive stock when it was recommended in June 2008 (its market price then was around Rs 330 and hence has provided a 20%+ return).



But whereto from here?

Either we give up – admitting that it is unlikely to reach its expected value – which to me is atleast around double of its current market cap. Or else we wait.

But besides this, is there another choice? Should we just act as a Buy and Hold investor or try to be THE catalyst? That is the subject matter of this article.

Ronald D. Orol has covered this in a book called Extreme Value Hedging, wherein he has written on value investing v/s shareholders activism to catalyse value and about the pros and cons of the 2 styles.

He writes that Mohnish Pabrai, managing partner at Pabrai Investment Funds of Irvine, California, is a true value investor. Unlike activist investors, at no point will Pabrai engage or even seek to talk to the executives at the companies he allocates funds.

Executives at one company called him one day to see if he had any advice or ideas. Pabrai, an 18 percent investor in the corporation, says the call was a big mistake. "I have never made a phone call to any management of any of the companies I am an investor in," Pabrai says. "The way I see it, if they need my help, there is a problem."

In fact Pabrai questions whether activists, in their drive to raise the value of corporate shares, are actually improving the long-term businesses interests of their target companies.

Opportunity Partners' Phillip Goldstein (now runs a hedge fund called Bulldog Investors) takes issue with the idea that activists aren't contributing to the long-term viability of corporations. On the other hand, sometimes value investors infuriate activists with their passive approach. Goldstein says he once approached a value investor who held a substantial position in a company to see if that manager would support a possible proxy fight he was considering. Goldstein was contemplating a proxy contest to oust directors and pressure executives there to sell the business. The support of this particular value investor would go a long way toward putting sufficient pressure on the company's management. But without them, Goldstein says, he didn't believe he had enough leverage to sway the executives.

"I said to them that I believed the company was on a course for declining value and that it needed something to change its direction," Goldstein says. The value investment fund managers responded in a way Goldstein didn't expect. No decision would be made one way or another on a proxy contest until it happened. The manager was unable to tell Goldstein whether he would support his possible endeavor. "Do they even know why they own the stock?" Goldstein asked. "They want to stay aloof, but what they are doing is harming their investors."

Which approach is better? Goldstein says it's unfair to compare the profitability of the two approaches. It depends on a case-by-case, fund-by-fund analysis. Either can be successful or a failure in different instances, and when one strategy is successful, it often may be because it took advantage of the other strategy.

There are some definitive differences and similarities. While value investors, for the most part, quietly sit and wait for their investment to appreciate, activists must be successful at wooing other investors to support their efforts.

But unlike traditional value investors, activists will use their knowledge of the company's legal structure, their ability to file lawsuits, engage and negotiate with management, and launch proxy fights to provoke change and improve value. Insurgents argue that value investors must be careful not to fall in the value trap, that is, invest in a company they expect to appreciate in value within five years and find out five years later that because of management or external factors that company still remains intractably undervalued. (I am close to 2 years in my investment in Merck India.)

Zeke Ashton, founder of $50 million Dallas-based value fund Centaur Capital Partners, says a key difference between activists and value investors is temperament. "To be a successful activist investor, in many cases, takes a confrontational personality;' Ashton says. "It requires someone that will fight with management to accomplish certain goals."

Goldstein agrees that temperament is important to the approach. A successful activist can't get aggravated or lose sleep when faced with lawsuits or screaming CEOs. He adds that an activist must enjoy being the catalyst. "How much abuse can you take before you say this is not right?" Goldstein asks. "You can't be a shrinking violet and run for cover anytime somebody sues you; otherwise, you're going to get bullied."

Many traditional value managers will become reluctant activists if they become sufficiently aggravated about a particular situation. Even value investor extraordinaire Warren Buffett, arguably the most successful stock picker, has on occasion taken an activist tack. In a 2001 confer¬ence call, Buffett expressed his displeasure with real estate company Aegis Realty Inc.'s decision to buy P.O'B. Montgomery & Company, a Dallas-based shopping center developer, for $203 million. He also was involved in several quarrels with management of Berkshire Hathaway before he bought enough shares to take over the company in 1962.

Value investor Christopher H. Browne, managing director of Tweedy, Browne Company LLC, another firm that we think are amongst the true value investors, also grudgingly engages in reluctant activist efforts in some situations, when provoked.

On the other hand, Walter Schloss, (called a ‘superinvestor' by Warren Buffett) and a value investor about whom we had written in May’08, is truly of the old order. He likes to buy and wait, his usual holding period being 4 years. “Something will happen”, he likes to say.

In comparing value investors to activists, it is unclear whether the approach favored by Schloss, Pabrai, or Goldstein makes the most sense.

To me, the best investors are those that can adeptly engage in both value and activist strategies based on changing circumstances. Goldstein was once asked whether as a hedge fund manager he was more interested in the activism or in making money. His response: “I am out there to make money. The activism is the means to the end. “

I have to agree with that.

At my own end, I am clear that companies like Merck do not deserve to be listed on the stock market unless they can efficiently allocate capital. They need to either acquire a company at the right price (which I am sure would have been available a few months back when EVERYTHING was cheap) or distribute the cash as dividend. Or acquire the public shareholding by doing a buy-back. But surely something needs to be done.

While it can’t be me (I have a day job), I am hoping that just as in the cartoon someone will come out of the woods and insist (with a growl, I might add) that the management stops thinking that the company is their own backyard. The investors need their living room space too.

Till that happens, I am willing to wait – its not as if there are a lot of other investing opportunities right now in the Indian market and hence the opportunity cost is not high. All said and done, Merck continues to be a defensive bet even in the present market. And being a rationalizing person, I would think that I am still only at half of Schloss’s normal holding period. Maybe something WILL happen.

The Rare Contrarians

The Rare Contrarians

It isn’t as bad as the cartoon sounds. Contrarian investing is not something that I discovered as a strategy when all else failed. It is in fact a basic tenet of value investing.

The question however is when and how to use it.

It is one of known precepts of sound investment that the best companies for investment are those which show large predictability and stability in earning power. However, these have to be picked up at the right price. Buffett is the super specialist in this and we can look at some of the companies that he has invested in over the years to reaffirm that: Coca Cola, Gillette, Walt Disney Company, Hershey Foods, McDonald’s Corp., Nestle etc. Surely these are great companies, but rest assured that he would have waited till he thought the price was right. The price, as I have written earlier, changes everything.

But as usual there are other ways of making money in the market than by investing only in companies with predictable earning power of the nature shown by such consumer companies as above.

The important part is whether one can keep their cool and think the contrarian way.

Sir John Templeton was ofcourse famous for scouring for bargains when the rest of the investors were running for cover. One of his famous quotable quotes was “If you want to have a better performance than the crowd, you must do things differently from the crowd.’

Oh, that’s easy! Not really..

Because this may happen when the entire market has spasms (more vivid at this point in time) or it may happen when a company is hit due to business cycles. In both situations most of the market participants are frozen into inaction (or worse since they may be selling). Not Buffett who proclaimed to Forbes after the 1974 crash that he felt like an oversexed guy in a whorehouse.

A private business might easily earn twice or maybe even a higher multiple in a boom year as against in poorer times, but its owner would never think of correspondingly marking up or down the value of his capital investment. This is one of the most important lines of cleavage between the stock market and the canons of ordinary business. Contrarian investment is all about having an asymmetrical perspective; to be able to look beyond the prevailing current views and look at the longer term.

Graham has noted in his classic book, Securities Analysis (1951) that the market level of common stocks has been governed more by their current earnings than by their long term average. This fact accounts in good part for their wide fluctuations in prices.

Funny, how these things haven’t changed over time.

There is another aspect that can co-exist with the above and this is something that I would like to bring out additionally in this article. Graham noted in the same book that that low priced common stocks appear to possess an inherent arithmetical advantage arising from the fact they can advance so much more than they can decline.

It is a common place of the securities market than an issue will arise more readily from 10 to 40 than from 100 to 400. This fact is due in part to the preferences of the speculative public, which generally is much more partial to issues in the 10-40 range than to those selling above 100.

This however may mean different things to different people. If not applied properly this may mean investing in penny stocks which are trading at those levels for all the right reasons – example a smart promoter may have sub-divided the stock into smaller face value or else the company may be selling out of date products (like buggy lights in the age of super fast cars) and hence does not have good prospects. Or else a company may be going into extinction for legal or other reasons etc.

It is important, therefore, to understand what the true meaning of ‘low price’ is.

In my view, the price should be low in relation to the company’s assets; its sales and its past and prospective profits under favourable business conditions. It also should have sold repeatedly in former years at many times the current low price.

Ergo, the current conditions bad conditions should be non-permanent.

Please see comparison the financial performance of 2 companies: Eveready Industries and Nippo Batteries. They are in the same industry, viz., manufacture and sale of dry cells. While the former is the leader in the field, the latter had better managed financials and was a ‘safer’ company to invest in.



While Eveready has had ~3X the sales of Nippo Batteries, it has been dogged by overall poor financials driven by high interest charges and depreciation charges. As compared to this, Nippo has been a zero debt company with, in fact, excess cash lying on their balance sheet. In 2007 when prices of their main raw material began to go up, Nippo managed to bring its PBDIT back at earlier levels by better cost management and because it did not have any interest liability. Eveready’s capital structure with high debt levels (they were also investing in building a Greenfield plant) did not allow it to do that. Resultantly, in 2007 and 2008, they lost money.

So far so good. But as I said earlier, its the price which is the main thing. So let us compare the financial performance of the companies to their price movements.






As is clear, when the markets crashed, Eveready was punished even more by the markets, with their price falling from a high of 130 levels in 2005/ 2006 to a low of 13 or so in 2008.

On the other hand, Nippo fell only from 400 to around 300 in the same period. The markets clearly did the right thing by not punishing a steady performer like Nippo. But is there a case that there was an over-reaction on Eveready?

Well, the company did make losses in 2007 and 2008. Question is, was it a permanent situation?

It wasn’t very difficult to see that the price of Zinc, a critical raw material for the industry would come down eventually, especially with the world’s economic aspects not appearing too bright. Secondly, it was trading at a fraction of its book value, but it was holding its sales pretty well by entering into low priced products. Thirdly, it’s management was trying very hard to bring down the debt levels by selling excess land. And fourthly, its product was not getting out of fashion anytime soon. In a place like India where shortage of electricity is perennial, there are places where flashlights are a way of life – and that means battery usage. Newer electronic equipments mean more remotes, and by implication more batteries. And they have a massive distribution set up, a hallmark of a good retail company. It was just a question of waiting for the margins to start looking healthier.

What caused its recent price performance? Their recent quarter was a very good one, aided by low raw material price, good sales and a break by the government on industry’s excise duty charge. In just one quarter, 2 years of wait came to an end.

The market is usually preoccupied with looking at the better performers. There is truly very little patience for the non-performer. Therein lies the major opportunity.

We had written about Eveready Industries in our Blog in October 2008, when the price was around Rs 20. It ofcourse further fell to a low of Rs 13, but recently it touched a high of mid 60s, which is when we exited the stock fully, having achieved our price objective. Don’t get me wrong – I had started buying when the price was much higher than Rs 13. However, I continued to buy as the price kept dropping with the result that by the time the stock reached its nadir, this was THE worse dog in the portfolio (now you see the logic of showing a cartoon with a dog talking). But by the time it reached its recent high price, it more than made up for the lost time.

A classic example of both contrarian investment as well as the power of investment in a true low priced stock. With results like these, why listen to your dog and end up changing your investment style?

No disrespect to dogs ofcourse. I love them too.

Are We There YET?

“Are We There YET?” (Originally published in November 2008)


In that lovable movie ‘Shrek 2’, Shrek and his wife, Princess Fiona, just back from their honeymoon, are requested to join her Royal parents at the ‘The Kingdom of Far-Far Away’. Reluctant at first, Shrek finally embarks upon the journey alongwith Fiona and their happy-go-lucky partner, The Donkey. They travel night and day through rain, hail and snow. But true to its name, ‘The Kingdom of Far-Far Away’ was REALLY that – far, far away! But, the Donkey is bored with the travel. He keeps asking Shrek: “Are we there yet?” to the point where Shrek is at his wit’s end. So much so that towards the end of the trip Shrek starts asking the same question – Are We There Yet?

Falling profits, plummeting demand, job cuts, and bankruptcies –pretty much all that one gets to read as headlines these days – is making everyone search for clues as to whether the world has reached its economic nadir, the point from where the recovery will start. Are we there yet? There are no clear answers.

Widespread problems and no quick fix visible

What IS clear is that the ongoing crisis has exposed how complicated the world’s financial system has become. No nation or individual has possibly been left untouched. Admittedly, the current turmoil is larger, more complicated, more interconnected and more global than most had anticipated. Even countries, which till just a couple of months back looked like they were sitting pretty on the back of high commodity prices are battling a bubble-bursting experience of their own. At a personal level, youngsters who are starting their careers are just as impacted, as those who have worked for decades.

Meanwhile, the economic indicators continue to disappoint. Consumer spending is down – especially in the US (where it all started and which continues to be the bellwether for world economics), where such spending represents two-thirds of the US’s economic activity. Malls are sporting sale signs, some seven feet tall. And yet sales are dropping. Worse, it is reported that the slowdown has hit luxury chains AS WELL AS stores that sell mass goods, suggesting that consumers at all income levels are snapping their wallets shut.

In consequence of this, there could be another lurking problem. As World Bank chief, Robert Zoellick has mentioned in a post, the current crisis, largely stemming from banking sector problems, will lead to round two: collapsing international trade and the resulting hit on small export-oriented economies. A leading indicator of which is the Baltic Dry Index. (Every working day, the Baltic Dry Index surveys shipping brokers around the world and asks how much it would cost to book various cargoes of raw materials on various routes.) The index has recently fallen to an all-time low (closing at 842 on Friday, November 7) from a high of 15,000 about a year ago. Once trade slows down, some countries' economic growth will be reduced substantially: some East Europeans, some countries in East Asia, and Latin America. This could well lead to more problems with the financial institutions. Scary thought # 1.

According to available data, this is proving to be one of the worst times for funds. In 5 of the last 10 years, fewer than 15 percent of hedge funds had lost money. Even in the worst year, 2002, 31 percent finished down, according to estimates from HedgeFund.net, a unit of Channel Capital Group. This year, some 70 percent of hedge funds had lost money from Jan. 1 through the end of September.

Losers include well-known traders like Kenneth C. Griffin, who runs the Citadel Investment Group; Lee S. Ainslie, head of Maverick Capital; and David Einhorn, the head of Greenlight Capital, who pointed out the troubles at Lehman Brothers before many others.
Pessimism is feeding on itself as managers exchange increasingly gloomy emails about the coming meltdown.
"Be careful buying ANYTHING today," Kyle Bass, managing partner of Hayman Advisors, warned in an Oct. 17 letter to investors. "There will be a time to buy stocks, and that time is a few years into the future when the strong have separated themselves from the week ... a time when unemployment has hit 10% and U.S. GDP has dropped 4-5% (maybe more)."

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be "vicious and protracted." "The financial market collapse and bailout makes us sick," he wrote. "There is likely more carnage to come."
Howard Marks, chairman of Oaktree, a giant LA-based fixed-income hedge fund firm, said some "great" investors he knows were "genuinely depressed" when the credit crisis reached a peak in October.
There is no question that hedge funds are downsizing at present. And a few of the troubled ones have temporarily refused to give investors their money back by freezing their funds. That is NOT the whole story though. The average hedge fund uses leverage, to the tune of about 1.4 times. This is down significantly from a year ago, but it might mean that hedge funds may need to liquidate investments of at least $500-550 billion in order to meet current redemption requests by current year-end. Scary thought # 2.

Collateral Crisis and Governmental Role

Clearly, there’s been no lack of commentary on what’s happened over the last 15 months or so. If we were to summarize it simply: the world enjoyed a strong growth phase in mid 2000s led by global expansion. This encouraged investors (including financial institutions) and consumers to get comfortable with greater leverage – which actually makes some sense in low-volatility environment. For example, it helps boost returns for investors and increases affordability for consumers.

The problem came when there were excesses, which certainly was the case in 2007. As per John Galbraith in his brilliant book called ”A short history of financial euphoria”, “All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment. There can be few fields of human endeavor in which history counts for so little as in the world of finance”.

These excesses have now resulted in a substantial unwinding process and a collateral based crisis. Specifically, a collateral-based crisis is marked by a devastating positive feedback loop: an asset price drops, leading to a margin call, leading to asset sales, leading to a further drop, leading to another margin call, and so on. Governments can possibly solve liquidity-based crises with injections of liquidity. Collateral crises are much more damaging and prolonged and require substantial natural de-leveraging.

The usual approach towards managing a financial crisis is via the monetary policy – spend more and reduce interest rates. Unfortunately, in a number of countries (like India), there is less maneuverability since they have been attempting to cut their high budgetary deficits for a few years now. Still, some economies like China that have budget surpluses have introduced a fiscal stimulus package worth almost USD 600 bn.
However, in using monetary policy there is a dilemma. If the central banks lower interest rates to mitigate liquidity pressures, there is a possibility that the currency might depreciate further. This may likely lead to a run on a few currencies with further implications on the financial sector. Scary thought # 3.
Some of the emerging economies and in particular the East European economies do not have adequate forex reserves. Hence, economies like Hungary, Romania and Denmark have actually had to RAISE interest rates to prevent currency depreciation. Iceland had lowered interest rates on 15 October 2008 from 15.00% to 12.00% but reversed its decision on 28 October 2008 to raise its rates from 12.00% to 18.00%!
Furthermore, the governments can only attempt to push further liquidity through banks and financial institutions. But globally it has been reported that financial institutions had about $5 trillion of tier-one capital on the eve of the credit crisis. Those in the United States and European Union had about $3.3 trillion of tier-one capital supporting a loan book of some $43 trillion. As per a report, if we apply mark-to-market rules, global financial sector losses are estimated to amount to 85% of tier-one capital. Hence, we can expect these institutions to be just a wee-bit reluctant to lend for a while despite the friendly nudges from the Government.

Lastly, as Governments move to kick-start their economies by spending more, they would need to increase their issuances of Treasury Bills, causing a flood of paper with attendant risks and less than adequate returns on such paper.

Philosophy
Clearly a lot can go wrong. But for a moment lets remove all the intricacies and try to understand this situation with a bit of Philosophy. (We tend to agree with the Hungarian central bank governor András Simor who In a WSJ interview, said recently: In today's world you need a psychologist and not an economist to understand markets.)

With a sense of Déjà vu (we wrote some of the following lines in our very first write-up), we’d like to mention that there’s no gainsaying that humans learn everything through imitation. They are either influenced by someone’s company or they put someone as their ideal and follow them, making progress or taking inspiration from them. It has been found that infants begin mimicking facial expressions within one hour after birth, and we go on imitating words, faces, body language, styles of dress, so¬cial fads, and fashions until we die. In fact in a number of experiments it has been shown that people in a conversation do not merely mimic the dominant conversationalist, but mimic simultaneously, including accent, speech rate, vocal intensity, pauses, and quick¬ness to respond. If the dominant person talks loudly, everybody else also tends to bellow.

Doing exactly what everybody else is doing, no matter how dumb it may look to outsiders, is ingrained in all beings. We have this subconscious feeling that if we aren't doing what everybody else is doing, then its not a good thing. Chickens who have eaten their fill begin to eat again when they are placed with a hungry chicken who is pecking voraciously at a pile of grain. Ants work harder when paired with other worker ants.

And humans? Despite our vaunted individualism, we are the most imitative animals on earth. We mimic the shot of our favorite cricket player or the expression of our favorite actor. We even laugh more when there is a laugh track. This is described as the “Social Proof”.

Another interesting aspect is what has been described as the “negativity bias”. As per this, it is our biological nature to accentuate the negative, to notice the one dumb thing that goes wrong rather than five or ten things that go right. We differentiate between negative and positive events in just a tenth of a second, and the negative ones grab our attention.

For Instance, when researchers show test subjects a paper with a grid of smiley faces on it and one angry face, the test subjects instantly zero in on the angry face. Reverse the pattern, and it takes them much longer to pick out the solitary smile. An angry face would tend to grab our attention more urgently than many smiley faces because it represents a potential threat.

Negativity bias also helps explain why we suffer exaggerated fear of economic loss but experience relatively little emotion about profit. We remember Black Monday from 1987 and even Black Thursday from 1929. But, where is White Wednesday or Bright Friday? Banished from memory.

Perhaps the above 2 principles can somewhat explain the economic cycles. After all, there are times when there is extreme exuberance in the economy and in such times, more investment, capacity addition and large M&As are almost a norm. A business head not doing so is almost made to feel like they are from another planet. Such new investment stimulates demand, producing economic growth, which in turn reinforces confidence, which then results in even more investment. Eventually, confidence gives way to overconfidence and overcapacity. And as the boom wears on, firms tend to take on more and more unnecessary costs. Executives get jets for their personal use; armies of personnel are built within silos. As a result somewhere below the glowing surface of the economy, efficiency suffers.

And sure enough, there are other times when people are evermore hesitant to invest (this is more vivid now!). This too is contagious. And when enough firms choose to wait, the economy falls into a depression creating serious hardships for much of society. Eventually, things become so bad that even a string of good news is quickly discounted. Like in Shrek 2, the honeymoon gets over and so begins the traverse through the difficult conditions in search of the kingdom of far-far away. Where presumably everything will be OK once again. But this too changes and the whole cycle repeats all over again.

So, Are we there YET??

There are many who have recently ventured to answer the question “Are we there yet?” Most have been downright despondent but here we mention one of Peter Drucker's ideas wherein he suggested that accepting what everybody knows without any examination would often result in faulty decisions. This is the backbone of the Contrarian theory of investment as well.

So instead, we quote from a fund manager’s letter who is more positive – a rarity these days. Mentioning that Mr. Buffett rarely takes the initiative to comment on the markets, this writer mentions of the instances when he has made the exception: “In the 1999 article, within 4 months of the market’s top, he (Buffett) suggested that real returns from the market going forward were likely to be about 4%, and if he was wrong, he thought his number was likely too high. In the past decade, we’ve (US markets) been very close to a zero real return.

“In October 2008, he wrote that “the market will move higher, perhaps substantially so, well before either economic sentiment or economy turns up”. Exhibit 6 plots Buffett’s market calls on the rolling 10 year returns. He has proven to be reliably prescient.”



In our own little view, we believe that the crisis may not be over yet by any means and worse may still be ahead. However, depending upon everyone’s individual ability to put aside some money for the future, one should look at picking up some of the great investments, which are strewn all around us. In times where large-cap companies have shrunk to become mid-caps and maybe even low-caps, you might be surprised how much of a good stock only a little bit can buy. Shelve that party you’ve been planning. Buy a good stock instead!

What if the markets go down more, much more? Well remember Mr. Buffett’s distinction between Price and Value. Price is what you give, Value is what you get. If something worth $1 is available for 50¢, should you defer the purchase in the fear that the next day it MIGHT go down to 25¢? Well, is there any rule that says that if a company is going for free (eg. A debt free company where market cap = or < cash on the books) it cannot go for a higher discount? No such rule that we are aware of, though it would be reasonable to presume that at some point in time such a company (in a simplistic scenario) will become a takeover candidate. Or atleast the price will rise such that it ceases to be a free lunch.

Further, do remember that India continues to be largely a domestic story and the only question is whether the growth will be closer to 5 or 6 or 7%. And yet, hidden somewhere in the macro country level PE ratios, are companies that are going for free, with dividend likely to be continued and maybe increased. Or with likely growth figures likely to be far higher than the much quoted GDP growth figures. Investments made now will, as one of our American friends has commented, make many millionaires and billionaires of the future.

Brevity of memory is not a problem only for the speculative times, it works with equal force during the bad times also. Our suggestion: stop worrying about whether we have reached the bottom, let it run its course like it always does. Keep moving through the sand and the snow towards the oh-so-far-far-away promised land. Meanwhile why look at the stock quotes on a daily or hourly basis? As Shrek suggests to Donkey, find something to keep busy. Well, maybe watch a few cartoon movies with the family.

The 'Bookies' and The 'Booker' Awards

The ‘Bookies’ and The ‘Booker’ Awards (originally published in October 2008)

As usual our title does not reflect accurately, the contents of the article: this article is neither about gambling nor about books and certainly not about awards given to writers. It is about one of the oldest valuation methodologies, one that is not used commonly in these days of complex and catchy jargons but one which we believe when used in the current state of the markets, can be used as one of the investment themes in a portfolio. We are referring to the Book Value method of valuation (at-last some small connection to the title, after all!).

The American humorist, Will Rogers had it right when he said, "Only buy stocks that go up. If they aren't going to go up, don't buy them." For some (most?) investors this means “buy anything High" and “sell anything Low”. We, on the other hand, believe in buying “Value” stocks.
But what is “Value”? A Google search produces a variety of criteria that help to identify Value Stocks; the standard ones being low Price to Book Value*, low P/E ratio, high dividend yield etc. None of these themes, including low price to book value, may work in isolation (more on this later). Notwithstanding this, the idea behind looking at stocks with low book value is that it could provide a floor for a company's share price.

* In the simplest form, the book value of a company is its net worth. But actually it’s a bit more than this: Ben Graham , the father of value investing, took the view in his 1934 book, Security Analysis, that only Tangible assets (like Machinery, cash, receivables etc) should be taken to compute net worth and not intangible assets (eg. Brand value or goodwill). As per him, the intangibles could, in some situations, even be superior assets. However he preferred not to put a value to them while analyzing a company.

On the other hand, Graham’s best known disciple, Warren Buffett loves companies with valuable, and sometimes irreplaceable, goodwill. To Warren Buffett, it is this intangible good will that continually produces profits without the need to spend money on maintenance, upgrading or replacement. After all, what would you consider the important element of profits for Coca Cola: its name and recipe (intangibles), or the various factories (tangibles) that produce the drink? However, for reasons of ease and for the sake of conservatism, we have taken the Ben Graham definition for our purpose.

But how useful or relevant is the concept of Book Value?

There are strong views on both sides.

In one of our earlier blogs, we have written about Walter Schloss, who was amongst those who studied and worked under Ben Graham (in a famous 1984 speech titled the "The Superinvestor of Graham-and-Doddsville," Buffett proclaimed Schloss as one of the Superinvestors). Schloss, who never went to college and started out as a Wall Street runner in the 1930s, has lived through 17 recessions and innumerable stock market ups and downs. Started in late 1955, Walter J. Schloss Associates during its 47-year performance history generated in excess of 15% gross annualized returns for its partners, 50% more than the S&P 500. His investing method? He loves companies quoting well below book value. In his view, assets are more stable than earnings. The market ofcourse thinks differently and focuses on short term prospects. And this throws up opportunities. In Schloss’s long experience, a company whose shares can be bought at a significant discount to their book value has a great chance of either becoming profitable again, or being taken over by other companies. Both scenarios hold great prospect with regard to the stock price. Ofcourse this approach tends to take time and his usual holding period is 4 years. And Schloss has the patience to hold on. “Something will happen”, he likes to say.

Adding to this view, there was also a study conducted by 2 eminent American economists, Eugene Fama and Kenneth R. French, on the performance of low price to book value stocks. The study covered the period from 1963-1990 and included nearly all the stocks on the NYSE, AMEX and NASDAQ. The study found that the lowest book/price stocks outperformed the highest book/price stocks 21.4% to 8% AND had lower price risk as compared to the ‘growth’ stocks.

On the flip side, some researchers believe that stocks quoting below book value are risky because they are down-and-out and in danger of getting worse: in other words a “value trap”. There are still others who rightfully point out that book value is not a representative value since it may differ significantly from both market value and the replacement cost.

Amongst those who have spoken against the book value concept is Warren Buffett. As is well known, Buffett had acquired a textile business in the 1960s, which due to various reasons he eventually closed down in the 1980s and sold its assets by way of an auction. Referring to this transaction, Buffett wrote the following in his 1985 letter to the shareholders of Berkshire Hathway:

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.”

So are we recommending a methodology that has been nixed by the Investment world’s superman? Well quite certainly like most others, this is not a methodology that can be implemented blindly or in complete isolation. In fact, in the bearish conditions that exist today, more than one theme can usually be used to describe a good stock. The Book value method, when used in combination with other factors, can be a useful defensive investment tool. And one that we have adopted amongst several others that we use to invest.

While looking at a stock quoting under book value, one thing that we do is to look for reasons as to why the market is offering the stock at a considerable discount and then consider whether those reasons are valid. This normally prunes down the list to just a handful.

We quote from some of the examples from the Indian market that we have invested in recently:
Eveready Industries: This company is India’s largest dry cell manufacturer having a dominant market share and products available at over 3MM retail outlets. It had fallen into bad times because the price of zinc, one of its main raw materials, rose around 4X between 2005 and 2007.

They tried to pass on some of the cost to the customers, but that led to a fall in volume especially in the lowest rung of their target segment which was price sensitive. Recently however, zinc (still one of the key raw materials for the company) like other commodities has been under pricing pressure and has fallen over 60% from its peak. The company has also undertaken measures to reduce debt and as of last quarter it had become profitable again. It is available at less than 50% of its book value.

Banking sector: The financial sector (despite the issues of high leverage, low return on assets and other ills) is one that becomes attractive when it starts trading at a discount to book value. The fact, that in these times when some of their international brethren are gasping for breath, they are not exactly everyone’s top picks only makes our job simpler. Additionally, India’s reserve requirements are one of the highest among major world economies, requiring banks to maintain 25% as SLR. If one believes, as we do, that given a scenario of lower oil and a good monsoon, the inflation is set to drop within the next few months, then so would the interest rates. This will make a direct impact on the value of the securities held by banks.

Despite the above argument, we need to look for financial institutions which are punished only because they happen to be, well, financial institutions. One company which is a pure play on interest rates where we have invested is PNB Gilts; a subsidiary of Punjab National Bank dealing only in Government Securities. This company is also available at around 50% of book value. Besides the interest rate related impact, an additional item which makes this interesting, is that PNB is looking to divest a part of its 74% stake in the company and has said clearly that they will not entertain a sale at below book. Failing a sale, they plan to merge this with the parent bank. Given the multiple likely catalysts, we feel that this is a good enough bet. In this we follow a quote made famous by Mohnish Pabrai: “Heads I win, tails I don’t lose much.”

Someone else we like to read and follow is Bruce Greenwald, Professor at the Columbia University and author of a book called Value Investing: From Graham to Buffett and Beyond. In an interview he mentioned some important considerations for value investing:

One, it is just inescapable that whenever someone sells a stock, somebody else is buying it; and whenever someone buys a stock, somebody else is selling it. And one of them is wrong. (In other words, we need to be certain about the ‘why’ of investing. And it can’t be that someone else is also buying). Two, have patience and discipline. Finally, Diversify.

Well, we do follow the above advices and believe that while we may not get the booker awards for our articles but our investments are likely to be a rewarding experience. We are willing to place our bets on that.

Sense and Nonsense in the Markets

Sense and Nonsense in the Markets (originally posted in August 2008)

It has been said that man is a rational animal. All my life I have been searching for evidence which could support this: Bertrand Russell

Rational behavior is one of the most accepted assumptions in social science. Much of financial theory is based on the no­tion that everyone acts rationally – attempting to maximize their gain and minimize their pain when making investment decisions. Modem port­folio theory, for example, assumes that investors seek to earn the highest return at any given level of risk. The arbitrage pricing theory says that two identical securities cannot sell at different prices for very long, be­cause rationally minded traders will buy the cheap and sell the dear until both are priced identically. And the efficient market theory (EMT) preaches the futility of using new information to generate excess return, because the universe of rational investors will act in such a way that the information is instantaneously reflected in asset prices. Hence, with so many millions of investors studying the market, the theory goes, no stock can ever sell for more or less than its true intrinsic worth.

But how far is that a fair assumption? How efficient are the markets?

Looking at the chart below, it is difficult to opine that the markets were efficient between late last year and now. One can pick up almost any company’s stock performance during this period to prove this but lest that appear as a recommendation, we have chosen a company that we referred to in one of our earlier letters, viz., BASF (we have sold the stock since – with higher than the initially expected results). Can we say that BASF’s intrinsic worth increased 140% from August 2007 to Jan 2008 and then fell over 50% by July 2008? Judging from the stock price, it sure did.

How rational are human decisions?

A pair of powerful spectacles has sometimes sufficed to cure a person in love: Friedrich Nietzsche

If a computer is asked to choose between two alternatives, it would use logic and mathematics to calculate potential gains or losses before making its choice. But humans, with their limited cognitive abilities, cannot take a decision based solely on strict mathematical calculation or logic. There would likely be an element of ‘biases’ in that decision.

This aspect of human decision making and its impact on stock markets has been studied by scholars since the early part of the century. In his 1938 book The General Theory of Employment, Interest, and Money, John Maynard Keynes coined the term animal spirits to describe ‘the spontaneous urge to action’ frequently exhibited in manias and market crashes.

In more recent times, this behavioral aspect of finance has been even more widely embraced to explain the baffling volatility of financial markets. In their 1985 paper “Does the Stock Market Overreact?,” Richard Thaler and Werner DeBondt suggested that the tendency of stocks to fall in and out of favor is the result of the human tendency to think more about recent events and to lose sight of the long run. How often does it happen that the analysts and the investing public give up on a company because of recent bad performance? So very often that this provides every practiced investor an opportunity to buy into a good company at prices they like.

Another human tendency is to pay more if they feel that they might lose out to someone else. Richard Thaler described this in a book called The Win­ner's Curse. This explains why purchasers tend to bid more aggressively in an auction as the number of competing bidders increase and why gamblers go for long shots at the end of a losing day. It also explains why at times you will notice a stock rising immediately upon market opening (or just before closing). People want to grab it before ‘it goes too high’ or ‘it is discovered by others’ etc.

There can also be simple Demand and Supply related reasons for market irrationality: Foreign institutional investors were the major sellers on the Indian bourses in the last 7 months, accounting for outflows equivalent to $15Bn. Some of the bigger US and European financial institutions form a bulk of the pull out. Given that the original reason for the pull out (which really started in January 2008) was the Sub-Prime issue in the US, how possible is it that they pulled out the funds in order to bolster the financials of their parent institution?

There are many other kinds of biases and there can be other reasons for the irrationality but that that is a topic deep enough to be taken up much more elaborately, perhaps at a later stage. Suffice it is to say that there are times when irrationality does exist in the market.

Role of Information and Experts in biases

Be careful about reading health books. You may die of a misprint: Mark Twain

Information is an important reason for many of the human biases since it is neither universally available (the common investor cannot visit companies regularly, speak with trade associations, suppliers, distributors, or sit in on conference calls with management), nor is it interpreted identically. Hence most of us depend, in varying degrees, upon newspapers and other published material including reported comments from the senior functionaries and experts. Unfortunately if one was to pick up more than one newspaper describing a single event, it is entirely possible that one would come across different sets of analysis on the same event.

The ‘experts’ themselves often think nothing of changing their tune along with the latest song. Pick up an oil expert’s comments of around 30-40 days ago and compare them to the latest ones and you will get the drift. Example, on June 25th, CNN reported the OPEC president as saying that the oil prices would rise to $150-170 a barrel during the northern hemisphere summer. The same gentleman caused a flutter when on July 28th, merely a month after the earlier utterance, he said that crude prices were abnormally high and that the longer term prices will be around $78 a barrel. (Note that the last price quoted is quite precise, not even in a range.)

Do we ever learn from the past?

I am always ready to learn although I do not always like being taught: Winston Churchill

If one reads some about the Tulipomania of 1637 when the Dutch speculators saw tulip bulbs as their magic road to wealth (this was a time when, it is said, a bulb of no previously apparent worth might well have been exchanged for a new carriage, two grey horses and a complete harness), it would be clear and humans have and will remain driven by the twin devils of greed and fear.

Hence, in the tangible, sensible world of say, clothing, electronics, oil or cars, when prices increase we tend to buy less. But the stock market? That has to be one of the only institutions where most participants feel more secure while buying a stock that is MORE expensive than one that is cheap. As ridiculous as it may seem while reading this, for most people, a rising stock price indicates an improvement in the com­pany's intrinsic value, and a declining price represents the opposite! Therefore, at higher prices it is almost a rule that the quantity of stock demanded also rises. Don’t the newspapers also encourage this by highlighting stocks that show ‘technical strength’ (meaning that a stock is on its way up) and those pushing through a ‘higher moving average’?

As an example, we had written about a stock in our last write-up called EID-Parry. To recall, we had mentioned that considering the market value of their listed subsidiary company and the anticipated receipt (in cash) of the proceeds of a non-core business, the base business was coming for free. This stock had 20 times higher volume (sale/ purchase) at a price of Rs 254 (average price on Aug 7th) than at a price of 172 (Jul 21st). The marked portions in the chart below show how volumes in this stock jumped as prices went up. Obviously many investors were more comfortable buying at a higher price 250+ than when it was languishing at 170 or thereabouts. Meanwhile many others would have profited by selling at the higher price, earning a profit of 60% from the low just about a fortnight ago.

Conclusion

Despite all the biases that exist, can we conclude that there is NO efficiency in the market? No, we do not wish to say that. Usually, the stock market as a collective institution is fairly efficient. Whenever market prices diverge from fundamentals, smart investors buy that stock and keep buying till the anomaly vanishes. A similar thing would happen in reverse (if an asset was artificially expensive). Isn’t that how the cheaper stocks that one buys eventually reach their potential and we are able to profit from it? There are, however, short windows of time in which such opportunities do become available. These could happen because of a variety of reasons, for example when fear rules the street in a bear market. Or at an industry level it could happen due to a short term event like the recent interest rate hike (bad for rate sensitive industries like auto or the banks). And at a company level it could happen because of a bad quarter or bad press. Etc. But eventually, the price does reflect value. Meanwhile the intelligent investors have profited.

It is fair to say that larger the number of smart (professional or otherwise) investors, the faster the prices would return to fundamental levels. In that sense, a country like the US is bound to have more efficiency (most of the time) than, say, India. Opportunity for us. Also, the larger capitalized stocks are normally considered better in terms of efficiency, than the smaller capitalized companies, simply because they tend to get more attention from analysts (too much attention can also trigger a herd mentality but that’s another topic). Again, this could provide an opportunity to the alert to pick up something in the latter category.

We would prefer to end by saying that humility is normally the best policy. Unless you can spot a clear inefficiency - and come up with a plausible explanation of why others have not pounced on it already - it is probably wise to assume that the markets are efficient. Some people, some of the time, will be able to outsmart the markets. But not most people most of the time.

The free fall And The Free For All

The Free Fall And The Free For All (originally posted in July 2008)

It was recently reported that 2 gentlemen, Guy Spier and Mohnish Pabrai, both of whom run their own US based investment funds, spent $650,100 (the amount goes for charity) just to have the privilege of having lunch with Warren Buffett in the month of June. With Buffett!! The man who, putting it in polite terms, is not exactly known to be a spendthrift (when his daughter was born, he refused to buy a separate cot for her and a drawer in the bedroom served as a sleeping place for the baby).And if just by chance anyone thinks that this is a lot of money to spend just to be able to spend a couple of hours with the world’s best known investor, then it is worth knowing that two days after that meal, the auction closed on eBay for next year's lunch with Buffett. The winner, a Chinese money manager named Zhao Danyang, bid $2.1 million.

Peter Lynch, the erstwhile head of Fidelity Investments mentioned in his book that investors would buy one share of Berkshire, just to be able to get the pearls of wisdom contained in its annual report written by Warren Buffett (this was before these reports were put up on the internet by Berkshire). He adds that at $11,000 a share, that had to be the most expensive subscription for any magazine in history.

So while some investors idolize Warren Buffett and his ideologies, unfortunately the majority are swayed by the emotions of the stock market. We examine one such sector in India where the investors forgot to ask ‘how much?’ while buying the stocks.

India ‘Realty’ sector - too much fiction

The ingredients were all there – India’s large population (with 50% under the age of 25) all requiring a place to stay, the lacking infrastructure – ports, airports, roads combined with the one of world’s fastest growing economies. Enough data was provided by analysts in support of the fact that this could be a $0.5Trillion business opportunity from 2007-12. On the other hand, the real estate buyers were in a fix. Property they wished to buy was only available at high prices. Supply was limited. And demand for property increased due to higher incomes and the ability to borrow more from banks. The desire of many private banks and many government-owned banks to gain market share and build their retail, home loan portfolio saw this dramatic run-up in the borrowing capacity of buyers. The story was complete. A rush of IPOs, and the investors swooping in on existing developers in the market. The result is shown in a self-explanatory table below, that shows how these companies fared recently in the market.

* Public Issue/ Large private placement in 2007

For those who are more graphical oriented, here is a gem that we picked up from an external source. It shows the market cap of the largest real estate company (DLF Limited) in January and the market cap of the ENTIRE real estate companies as of July beginning:

If we were to analyze this, it seems that the problem was not with the companies alone (some of them are world class) or with the market opportunity, which despite all the doom-sayings, are still strong for a country like India. The problem, on one end was economic – when there is pent up demand of a commodity (in this case real estate), large capacity additions will come (both by way of new developers raising their hands to be counted and that of availability of land) such that the supply will force the price to drop. But isn’t that Economics 101? The real problem was that investors forgot this rule and thought that the pent up demand will remain forever.

Please see below: looking at just one company, Unitech, it seemed no price was too much to own the stock. The company was showing outstanding quarterly results with growth in sales and PAT exceeding 100%. Similar situation prompted the large shareholder-owners of some of the listed real estate developers to go in for some audacious land purchases, in process taking large debts. With sales now not as brisk as in the years 2006 and 2007 and cash flows are not as per expectations and committed to large projects, they now need to pay for the new land and the initial cost of development to get the land into some sort of ‘build-able’ shape. With the central bank clamping down on liquidity to manage inflation, loans have become dearer and it is reported that some developers are taking funds from private financiers at rates ranging from 24%-50%. In the last 2 quarters, Unitech has showed negative quarterly growth on both Sales and PAT.

Templeton (who died recently) had once cited a very interesting statistic. At its peak of real estate bubble in Japan in 1980s - the market value of the land underneath the Imperial Palace of Japan in Tokyo was more than the market value of the land in the whole of California! High prices were then justified in the same manner they were justified in India - shortage of space, rise in living standards, easy credit etc.

When it comes to investing, nothing is more important than the ability to think clearheadedly for oneself — and Buffett is unsurpassed on this front. In the late 1990s, he was widely criticized for his refusal to invest in booming tech and Internet stocks, a decision that was richly vindicated when the bubble burst. We may shake our heads at the housing bubble in USA. But we built one right here in our own back yard. Buffett has made a fine art of keeping that kind of distracting noise at bay.

India’s stock markets have lost around 40% since the start of the year. Much of it was contributed by fall in sectors where the euphoria was so high, for instance the realty sector. The unfortunate aspect (or fortunate for the alert investor) is that when such an event happens, the other stocks are also affected by the negative sentiments, though not necessarily to the same extent. Buffett is known for his penchant for creating ‘free lottery tickets’ and with market conditions being what they are, there are a number of free lottery tickets available. We just take 2 examples to illustrate our point.

Ramco Industries

This is a company which manufactures asbestos sheet used for construction activity and is part of a larger group with interests in cement, textiles and IT. Being linked to the construction industry, it has shown very good growth rates in volumes, but has been hurt on the RM cost, primarily cement. What is not realized is that the company has a natural hedge because it holds 20% of Madras Cements, a group company. Hence, if the company is suffering from high prices of cement, then its own group company is benefiting from those very high prices. Furthermore, the market in its wisdom is valuing the entire company at Rs 350cr ($80MM) whereas the market value of just its holding in Madras Cements is Rs 600cr ($150MM). And it has a perfectly sound business with annual cashflow from operations of atleast $10-12MM. Free lottery ticket.

EID Parry

Again, part of a large group, this company is primarily into manufacture of sugar, a cyclical sector which has seen better days. The interesting aspect of this stock is that the current market cap of this company is Rs 1500cr ($375MM) but the market value of its holding in a group company, Coromandal Fertilizers is Rs 1100cr ($275MM). On top of it, this company has recently sold a business (unrelated to its sugar interests) to Roca of Spain for a value of approximately $180MM, an amount which it is about to receive. And the base sugar business is coming for free. Which is supposed to be an upcycle soon.

The cornerstone of Buffett’s investment philosophy is not to count on making a good sale. It is rather to have the purchase price so attractive that even a mediocre sale gives good results. What better than to ‘buy’ something for free?

Achieving emotional detachment that investing requires is tough. As we have written earlier, Buffett, epitomizes the disengaged style of investing, avoiding any unnecessary distractions that might impair his judgment. Which is why, he once wrote that he has so much zest for his work that he and Charlie Munger, ‘tap-dance to work’.

At this point in time, the stock market, petrified with fears of sub-prime loans, high oil, inflation, Iran tensions, elections and recessions is awash with such opportunities. The ‘experts’, who we have written about in one of our earlier articles, are busy animatedly discussing whether the market will fall further, or has fallen enough. But such are the interesting times that we live in, that investors who didn’t think twice about investing in companies at 90-100 times earnings (or with no earnings even) are unwilling to look at good companies which are available virtually for free.

The Sensex now trades at a forward PE multiple of less than 15X, which is similar to the US. The BSE 200 and 500 are trading around 13.5-14X and the mid-caps are available for even lower. Everyone expects that India’s GDP growth will slow down to around 7%. Morgan Stanley in one of its reports has suggested that India’s corporate earnings growth will SLOW DOWN to around 18% in the next fiscal year. We are not sure how a fair multiple to a market should be computed, but a 7% GDP growth and an 18% corporate earnings growth, when the world isn’t exactly a bed of roses, doesn’t sound all that bad.

So here is the irony. While some smart investors can spend in millions just to be able to have a lunch with Warren Buffett, based on Buffett’s very principles, there are free lunches available in the stock market and yet there are few willing to take a bite.