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.

Stock Diversification - what's the right way?

Stock Diversification – what’s the right way? (originally posted in June 2008)

“Through all its vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results. We must act on the assumption that they will continue to do so”. Benjamin Graham in “The Intelligent Investor” published in 1949. The Intelligent Investor was endorsed by Warrant Buffett as “by far the best book on investing ever written”

Benjamin Graham, who is credited with creating the foundation for modern fundamental analysis of stocks, created many well known and widely used theories for investors, including the concept of the ‘margin of safety’, which was aptly termed by Warren Buffett as the 3 most important words in investing.

Why is that? Because the first and foremost guiding rule of value investing is preservation of principal. In order to achieve this, the investor must find companies that are trading at a market price that is a discount to the intrinsic, or real, value. The difference between the market price and the intrinsic value of a stock is what is the margin of safety. Since stock prices tend to fluctuate based on emotions, interest rates, news, reports, and other forces outside the control of the general investor, hence higher the discount, higher is the margin of safety.

An essential element of the margin of safety concept is the principal of diversification. Graham recognized that no investor is perfect in his or her decision making, and unforeseeable market forces can cause unfavorable market turns for an investment even with a margin of safety. Proper diversification of a portfolio offers additional protection against these events.

In the ‘Intelligent Investor’, he wrote, “There is a close logical connection between the concept of a safety margin and the principle of diversification. Even with a margin in the investor’s favor, an individual security may work out badly. For, the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But the more the number of such commitments is multiplied, the more certain does it become than the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business”.

But how much diversification is appropriate? And is there complete unanimity on this amongst the modern day value investors?

Warren Buffett, who is certainly Graham’s most famous (and richest) disciple, clearly disagrees with his guru on this aspect.

“Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. The strategy we've adopted precludes our following standard diversification dogma.

Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful.” Warren Buffett in his 1993 letter to shareholders.

In another discussion, he said:

“If you are not a professional investor, if your goal is not to manage money in such a way as to get a significantly better return than the world, then I believe in extreme diversification. So I believe 98 or 99 percent, maybe more than 99 percent, of people who invest should extensively diversify and not trade….” “But once you’re in the business of evaluating businesses and you decide that you’re going to bring the effort and intensity and time involved to get that job done, then I think that diversification is a terrible mistake to any degree…. If you really know businesses, you probably shouldn’t own more than six of them. I mean, if you can identify six wonderful businesses, that is all the diversification you need, and you’re going to make a lot of money and I will guarantee you that going into a seventh one, rather than putting more money into your first one, has got to be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich on their best idea. So I would say that for anybody working with normal capital who really knows the businesses they’ve gone into, six is plenty, and I’d probably have half of it in what I liked best.”

- Warren Buffett at University of FloridaWe therefore have 2 views: one by the original Guru and the other led by a disciple who eventually came out of the Guru’s shadow and became a Guru in his own right.

In order to take this forward, we researched on the investment practices of some of the leading names in the US. These are all value practitioners and names that we respect for their investment ideologies.

Of the above list, 5 have investments of more than 50% in the top 5 stocks and 10 have more than 60% in the top 10 stocks.

Warren Buffett, who owns 39 stocks in Berkshire’s $66 billion equity portfolio, has 61% of his investment in his top 5 holdings, more than 83% in top 10 holdings. This is what Charlie Munger said: "Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way. It's been good for us."

Mohnish Pabrai likes to have 10 positions equal weighted. Currently he has 13 stocks, with 99.6% of the weighting in top 10.

Others like Bill Nygren of Tweedy Browne, David Dreman and George Soros have 28%, 36% and 29% respectively in their top 10 stocks.

Lets take this forward – diversification, even if done, may mean different things to different people. Many investors hold 50-100 stocks in their diversified portfolio. Some think that the Markowitz model, based on a seminal paper that won Harry Markowitz a Nobel Prize, is the right way to go. This model suggested that investors could reduce their risk by constructing a portfolio of assets with low cross-correlations. Diversification could also mean investing in different industries or different market caps or a combination of growth or value stocks.

Our methodology and its rationale

o We tend to typically start an investment with a size of anywhere from 3-5% of the total investible amount. Value investors very commonly invest early and sell early and hence this strategy, provides us with a foot in the door. We therefore get into a stock which after our due diligence looks interesting but where we may want to wait for the stock to fall further. If it doesn’t fall and instead rises, that’s fine – it’s a nice problem to have. We review our options at that time and may want to exit at a price which we think is an appropriate one.

If on the other hand it falls further, then presuming that in our view the fundamentals of the company have not changed, we may wait for the fall to be atleast 10% from our original price and then pick up another 3-5%.

o In most cases, we would stop averaging down after the stock reaches 10% of the total investible amount. Why?

o We feel that disclosure practices in the country, though along the lines of the developed countries still have some way to go.

o Furthermore, managements of mid-caps may tend to be less transparent in India in comparison to, say, the US (not to say that an Enron can be prevented in the developed world, but generally there is more transparency in those markets).

A cap on the total investment therefore helps us ensure that there is a discipline on the total amount that should be invested on one particular stock.

o Our current feeling is that this limit should apply only at the time of the purchase of the stock and not post purchase. Therefore, if after we have purchased the stock, its price rises and for this reason it becomes higher than 10% of the total portfolio, we do NOT sell some portion of the stock such that it reaches within the 10% cap. Presuming ofcourse that the stock has not reached its sale price as per our expectations.

o Industry caps, we feel, do have a value – we would not for example put all our monies in a Pharma or an IT sector, even though they may look very enticing. Given the overall cap of 10% on a single stock, we feel that having a cap of around 30% on one particular industry may make sense. There is however no logical basis for this cap.

o Overall, we do not expect our portfolio to have more than 30-40 stocks.

Clearly then, there is no one right or wrong way to invest and the investor has to follow what seems appropriate to them though it is agreed that too much diversification is inappropriate just as too much concentration is not right. Each to his own.

The Deadly Sins, the stock market and the art of survival

The Deadly Sins, the Stock Market and the Art of Survival (originally posted in June 2008)

Despite their many ideological differences, one of the things that various religious scriptures
converge on, are the deadly sins of human nature – Anger, Greed, Envy, Gluttony, Lust, Pride
and Sloth.

As part of our work routine, we go through research reports of several large institutions. And in
reading them, we would venture to add that when it comes to these institutional forecasters, overoptimism could be a deserved addition to the list. In proof of this, it was recently reported in
Bloomberg that only 5% of all advice on stocks ever got a ‘sell’ tag since the US’s Great Depression.

And taking up from where we left off last month in our article on Greed and Fear in the market, when it comes to the general investor, we should add despondency to the list of the deadly sins too. In proof of THIS fact, well, look around in the stock markets today.

Let us see how. At the time of writing this article, the (P/E)* multiple of the BSE Sensex is between 18 and 19. If we peel the onion a bit and look at the list of the BSE 500 list (which contains the top 500 important stocks), then we’d notice that there are 20 companies with P/E of over 100. Amongst these are BF utilities (1900), Reliance Power (750) and GMR Infrastructure (360). (No typos here!).

* P/E, for the uninitiated is the current price of the stock divided by past year’s profit. In that sense, the higher the P/E multiple, longer it should take to recover the price paid. Admittedly, the P/E ratio, despite being one of the most overused tool by analysts, is not something which can be taken merely at its face value. A stock which looks cheap at a P/E of 5 may turn out to be an expensive mistake. Similarly, a stock having a P/E of 100 may actually be cheap. That’s because the P/E of a stock is determined by the stock market on the basis of various factors, amongst these being Growth, Dividends, Level of debt in the company, industry and other macro outlook, quality of management etc. Hence for example, as long as the market feels that a company has a great future, (say, a doubling of profits year on year) they are willing to
pay a premium for it. Yet, due to its simplicity it is a good benchmark for the purpose of this article.

Being rationalizing rather rational, analysts provide all kinds of reasons for a stock to be a ‘buy’
even at seemingly ridiculous prices. Here is an excerpt from a large institution’s research report on GMR infrastructure (the same one with 360X P/E):

“We have valued GMR Infrastructure on a sum-of-the-parts basis using the DCF methodology for each of the projects. The projects in the power and road segments are valued on a single stage DCF method through the lifecycle of the respective project. Our price target is arrived at from the embedded value of each of the projects undertaken by GMR Infrastructure and as the company develops more projects our target price would be revised to include the value of the new projects.”

Ergo, they were asking us to put money on the stock since there are a number of operational projects that will be completed sometime in a distant FUTURE. Well, as value investors we like to invest on the present and only reasonably foreseeable future. Anything too far out in the future, is in our view, not quite certain. (Interestingly, at the time of that particular report, the price of GMR was 235 vs 110 now. The P/E of the company was not even mentioned in the report but we can guess that it would be closer to 700 at that time!)

Here is another excerpt, this time from an ‘India strategy report’ of another institution. Funnily
enough, their report is titled: ‘Stay defensive until macro concerns abate’. And included as one of
their ‘safe’ recommendations? Educomp Solutions. Here is what the report had to say:

‘A large and un-penetrated market and increasing importance of technology driven education delivery provides Educomp Solutions with enormous growth opportunities. We rate this stock a strong buy at 4039 with a target of 5313.’

Educomp, which was not so long ago selling at Rs 5,500 per share is now selling for RS 3,400 a share (note that the large institution had issued this as a ‘defensive’ buy at Rs 4,039). The company has a current market cap of 6000cr (roughly $1.5 Billion) vs their last full year profit of 71cr (roughly $17-18MM). That’s only around 84 times last year profit. That’s cheap. Compared to the PE of 150 when the stock was selling at Rs 5,500. Maybe there is logic to all this but we cannot fathom that.

‘Okay’, you say, ‘so you guys think that all those smart fellows employed by top notch institutions aren’t giving great recommendations, so what about you folks?’ Well, we are breaking our own little rule by talking about stocks, the variety of which we are comfortable with even in this environment.

Merck

Merck, for us is a defensive pick. Here is a company with a total market cap of Rs 550cr and a steady cashflow of around Rs 80cr. On a standalone basis, that works out to around 7 times cash profit. But it has around Rs 345cr of cash on its balance sheet. Hence the market is valuing a Company with a net market cap of Rs 205cr, with a yearly cash profit of 80cr at around 2.5 multiple. Now that’s a change from the companies with the 100+ P/Es!! Further, excluding the cash on its balance sheet, it has capital employed of Rs 95cr and hence a Return on Capital Employed of 85%. To top it, it has a dividend yield of around 6%. Can it go lower than the current price? Sure, if it does, we might want to pick up some more.

Wyeth

Wyeth, we feel, is an example of a dividend capture strategy. This cash rich company, currently priced at Rs 435 a share, is very likely to pay Rs 30 per share (same as last year) as dividend by August or before (it has paid its dividend by August for the last 9 years). That works out to close to 7% dividend yield. Tax free. Hence if one looks at the net cost to us (Rs 435-30 dividend), and then compare that to the chart above, one will see that a price of Rs 400 has not been breached since 2005.

One would say, that’s a reasonable probability that one would not lose money on this transaction and maybe make 7% or more in 3 months. That’s 28% annualized. We will take it.

BASF

This is an example of a ‘special situation’. This company, which is debt free and by itself not too
expensive, announced a few days back that the parent would like to acquire close to 22% additional equity in the company. This would take the parent stake from 53% to 75%. And they would do so at a price of Rs 274 vs the then market price of Rs 245. We estimated that after considering the percentage of public which will tender their shares for such an offer, we will make anywhere between 5%-10% in this transaction in a period of 2.5 months. That’s annualized yield of 24%-48%, relatively risk-free.

Many will sniff at the above examples because for them the stock market is a place for multibaggers, mistaken usually for only the high growth companies. But they forget that in buying such high growth companies, they may already be paying a high premium. In a market downturn therefore, they are the first ones to become despondent and reject the stock market as a casino where the house is the ONLY winner. As Buffett said, “The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do”. We have chosen the above examples to show that growth companies are not the only ones to profit from.

We do not venture to forecast which direction the market will take in the future but it is apparent that there are several headwinds to the world economy and hence it is important in our view to be focused on downside protection till clarity emerges (As John Maynard Keynes said, the markets can stay irrational longer than you can stay solvent). We have therefore allocated a part of our portfolio for tactical investments such as above.

However the ones listed above are not the only companies, and neither are these the only methodologies that we are adopting presently, but these are the simpler ones. Besides these, we are continuing to pick up cheap and fundamentally strong mid-caps, ones which have been discarded by the panic stricken market. Those that qualify are ones with a) consistently strong cashflows, b) little or no debt, c) products in demand, d) no foreseeable pressure on margins and e) a price that can yield us good returns in future. Alternatively, there could be beaten down stocks which are likely to benefit from the likely future events. More on these categories sometime later.

We end with what we have always been saying – the time to pick up stocks is when the prices are down because price is what determines the rate of return on the investment. In relevance to today’s times, we’d say that on a longer time scale this is the only way to beat inflation. If we just look around, there’s so much more choice in the stock market today than 6 months ago - it’s the off-season discount sale after all! And unlike hoarders of other commodities, there is nothing in the law preventing us from hoarding cheap stocks. Even though a sin in the scriptural sense, Greed can be good now! Mr. Market, in his manic worst refuses to acknowledge the value of even good companies and no amount of investor meetings by the managements of these good companies can convince the market participants otherwise. It’s a bit like that joke where the Doctor pronounces a patient dead. “But I am alive”, says the patient. “Shut up”, says the Doctor. “Do you know more than me?”

What James Bond and a Superinvestor have in common

What James Bond and a Superinvestor have in common (originally posted in May 2008)

There was an Archie comic that one had read many years ago in which he was stuck in a washroom and there was a raging fire outside the door. Archie kept thinking to himself, “What would James Bond do? What would James Bond do?” That’s when he got a brainwave - use a can of shaving foam to burst the doorknob open.

Putting oneself in the shoes of successful people to see how they would have managed a situation is very interesting. One such person that we look up to for our inspiration is Walter Schloss.

In a famous 1984 speech titled the "The Superinvestor of Graham-and-Doddsville," Buffett had proclaimed Schloss, 91, as one of the Superinvestors.

And why not – Schloss, who never went to college and in fact 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. An investor with $100,000 in the S&P 500 from January 1, 1956, to December 31, 2002, would have made $9.3 million. That same $100,000 invested in the Schloss partnership would have generated over $78 million.

A onetime employee of arguably THE creator of the concept of value-investing, Benjamin Graham, Schloss has a laid-back approach that today’s traders couldn't even begin to comprehend. He has never owned a computer and gets his prices from the morning newspaper.

A lot of his financial data comes from company reports delivered to him by mail, or from Value Line, the stock information service. How refreshing for today’s day and age where computer programs indicate when to buy or sell based on ‘market technicals’!

What are his investing methods? For one, he loves companies quoting 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.

Walter and his son Edwin are minimalists. Their office has one room (Schloss has that Depression-era thriftiness and even his wife once commented that he trails her around their home turning off lights to save money), they don’t speak to analysts or use the internet (even though surely this is an extreme in today’s times!). They do not attempt to get inside the business to know the details of the operation better than the management itself. They don’t claim or want that expertise, preferring to be generalists with a broader vision. What they do trust is their own judgment, based on discipline which has been perfected over time. And it always starts by reading the companies Balance Sheet right down to the footnotes.

Schloss once said, “I’m not very good at judging people. So I found that it was much better to look at the figures rather than people. I didn’t go to many meetings unless they were relatively nearby. I think if you were big, if you were a Fidelity, you wanted to go out and talk to management. They’d listen to you. I think it’s really easier to use numbers when you’re small."

He adds, “I would suggest that investors be very careful what they buy. I don't like debt, so buy a company that has not much debt. What I usually did was get companies that were having troubles, and the stock market doesn't like trouble. Then you have to have the courage and convictions and buy enough of the stock that would make a difference to you.”

We feel the above advices are invaluable while investing in the stock market. Here are some pointers:

Time in the market: Most investors want quick returns and long term investment for them means a couple of months or at most a quarter. With this approach, they tend to miss the woods for the trees. A short term downfall in profit of a company could actually be an opportunity to buy.

Book Value: Application of their strategy of investing in stocks available for under or at book value is very useful if used intelligently. For instance today in the banking sector, which we generally dislike because of the high leverage, there are a few options which are beginning to look interesting.

Use of debt by companies: Investors of a similar vintage as Schloss had an aversion to debt because of their experience of The Great Depression. But these are relevant concerns for any period. An individual going through a tough time financially can live on a small income as long as there are no fixed interest costs or debt repayment liabilities. But what if they had a mortgage payment to make every month? Then they are looking at bankruptcy or a debt spiral. Similarly, while choosing companies to invest in, especially when the world’s economic prospects are not exactly crystal clear, we feel it is better to look for ones with little or no debt. This is one reason of our attraction to the IT and foreign Pharma companies which have generally suffered due to concerns on the US economy and local pricing concerns respectively.

Ignore the Noise: There are too many people who profess to be experts in sectors or the stock markets. We have written about them earlier. Its one of the ironies that people who are closest to the sector or companies often make the biggest mistakes regarding them. Like Schloss, we also prefer to look at companies based on hard figures and not on the judgments of various experts.

In short, there are obvious great learnings in studying how someone like Walter Schloss bought and managed his investments. So next time we don’t have answers on how to react to a market situation, don’t be surprised if we mutter to ourselves, “What would Schloss do? What would Buffett do?”

Greed, Fear or both?

Greed, Fear or both?

Turn on a business channel (CNBC equivalent) on TV and, almost without fail, someone will be predicting that the market is getting ready to (a) soar, (b) crash or (c) remain in a trading range. And these 3 predictions could well happen in the same program when there are more than one ‘experts’ giving their opinions! Predictions are also available in abundance on interest rates, dollar, oil prices, gold prices, you name it. In our first article we mentioned how good these experts are at predicting.

Nevertheless, when the expert on TV mentions their ‘best pick’, everyone listens hard. Greed rules at this point in time. Further, in certain market conditions where everything you buy is going up, one might attribute this success to the wise expert when actually its not.
And that’s when the tide turns. For reasons out of the expert’s control, the markets turn sour and there are more sellers than buyers. More people, in effect, have fear. And they wish to sell FAST. Basic Economics says that when there are more sellers of anything than buyers, the price of that product will decline. Ditto for the price of a share.

Markets, they say, are ALWAYS ruled by fear and greed. And while we suspect that there may be an element of oversimplification in this statement, most of the time, they truly are. That’s probably because everyone is in it to make money (stating the obvious!) and there are 2 findings of Neuro-economics that shows how the human brain reacts to gain and loss:

First: Research shows that the neural activity of someone whose investments are making money is indistinguishable from someone who is high on cocaine. An unexpected gain fires up the brain (neurons go from firing 3 times a second to 40 times a second). That explains the Greed.

Second: As we have mentioned in one of our earlier articles, research has also shown that financial losses are processed in the same area of the brain which deals with mortal danger. This explains the fear.

You might be saying to yourself that greed and fear will never get in the way of your trading, but believe it or not they will be. All of us have some combination of these emotional forces.

Hindsight being a 20:20 vision, you could well look at a chart with periods of stock market lows and highs and say that well, what one should do is to ignore these conditions as long as the stock you hold is a good one. Easier said than done – because you already know how it turned out. But think of the next 20 years, say through to 2028 and you will realize that you have no idea how an investment in the market will turn out. That’s when uncertainty strikes the mind. That’s why they say that there is no risk in the past. The only risk you face is in the future.

What’s the lesson here?

Here are two quick tips to handle this: First; if you are likely to need money for something like a down payment on a house or for kids’ education etc., within the next 24 months, get that money out of the stock market. And if your goal truly is to achieve results in five years or 10 or 20, don’t measure and judge your success every day, every week, every month or every quarter.

The longer you have before you’ll need to use your money, the less you need to be concerned about what’s happening to it this very day. If you own a home and you don’t want to sell it, you will understand that daily or weekly or monthly changes in the market value don’t mean much to you. See if you can adopt the same attitude about your investments.

By extension, always avoid leverage or debt to buy stocks. Nor speculate. Essentially, never should there be a need to sell in distress.

Second: in his book written in 1951, Graham reiterates that an investor’s essential ally is the Price – as long as the price is low enough, one is far better off in avoiding reference to a market quotation for the stock on a regular basis. He further advises the motto; Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop. (Simple but far reaching advice for its time!)

Before we end, we cannot avoid the temptation to quote Warren Buffett who epitomizes the dispassionate investor. His 1986 Chairman’s letter states thus:

“When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into a stock market prediction: we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future.

What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics
will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Timing – Does it really matter? (Blog originally posted in April 2008)

o IMF says there are 25% of chances of a world recession
o US going through worse recession than 1929
o Soros says sub-prime losses could exceed $1 Trillion
o Indian inflation at 7%, Government worried
o World commodity markets on fire
o Oil past $105 a barrel, high oil prices to stay, says OPEC chief

Well, let us state the obvious – in the perennial financial yo-yo between greed and fear, the latter is clearly winning this round and investors are licking their wounds. With such headline news in the past couple of months and with the world stock markets being what they are ( with India and China “leading” from the front), the questions that we’d like to address are – how should investors react? Should they wait – for the recession to end or for the price of oil to come down or for rice or wheat or copper to be more affordable and so on? Is there a way to time the markets?

Answering this very question, over the years countless systems have been designed to make money in the stock market. They are inevitably constructed using historical data but as the likes of Long Term Capital Management (the company which employed Nobel prize winners and had MIT and Harvard professors on their rolls) discovered, models cannot predict everything. That’s probably because of two reasons. The first reason is, as Mark Twain said, history rhymes – it does not repeat. Secondly, what the models remove as outlier events (extremes which distort the general trends) often end up becoming realities (black swans).

Some experienced campaigners are humble enough to admit this shortcoming – Peter Lynch, the legendary head of Fidelity wrote in his book ‘Beating The Street’ about an annual gathering of the Barron’s roundtable, where a group of supposed experts debate about the various topics related to the stock market. He says that the year they were most optimistic about the future of the US economy and the stock market was 1987, which ended with the famous 1000 point drop. (In 4 trading sessions in Oct 1987, there was a 31% drop in the DJIA and the value of US Equities decreased by almost $1trillion – more than the current market cap of Indian equities). He adds, “Here is a group of influential professionals who manage billions of dollars that belong to other people, and from one Roundtable to the next we can’t agree on whether we are facing an imminent global depression or an economic swing.”

Before we move further, we’d just like to talk about a related topic – a part of the human psyche which has been built into our systems over the thousands of years of human existence – risk/ loss aversion.

This theory is based on certain experiments which were conducted and we will relate only to a part of the experiment here. A group of people were asked to choose between a sure gain of $100 or have someone flip a coin and give them $200 for heads and nothing for tails. Most people who were asked this question went for the sure $100. Let's see why. In a mathematical sense, a sure $100 and a fifty percent chance for $200 are equivalent. However, when a graph was built based on the responses, it was seen that an objective gain of say $100 may give 10 units of subjective satisfaction, but a gain of $200 won't give 20 units of satisfaction. Rather, one will feel only about 1.7 times as good. Hence, when the choice is between a sure gain and an uncertain, larger gain, the average person’s first choice would be to go for the sure gain.

On the reverse, Neuro-economics research shows that financial losses are processed in the same area of the brain which deals with mortal danger. People feel considerably more pain after incurring a financial loss than they do pleasure after achieving an equivalent gain.

Within the two aspects of loss aversion discussed above, perhaps lies the explanation as to why we want to be ‘sure’ about the timing before we enter the market.

Whenever there are biases, we are prone to take irrational decisions. So how should we react to all the negativity surrounding us today?

Lynch says, “Keeping the faith and stock-picking are normally not discussed in the same paragraph, but success in the latter depends on the former. You can be the world’s greatest expert on balance sheets or P/E ratios, but without faith, you’ll tend to believe the negative headlines”. He adds that whenever he is confronted with doubts and despair about the current Big Picture, he tries to concentrate on the Even Bigger Picture. The Even Bigger Picture tells us that over the last 70 years, stocks have provided their owners with higher gains than T Bills, bonds etc. And also that in the same 70 years, there have been 40 scary declines of 10 percent or more in the market. Of these 40 scary declines, 13 have been for 33 percent, which puts them in the category of terrifying declines.

He further adds that a decline in stocks is not a surprising event, it’s a recurring event. If you live in a cold climate, you expect freezing temperatures, so when your outdoor temperature to drop below zero, you don’t think of this as the beginning of the next Ice Age. You put on your Parka, throw salt on the walk, and remind yourself that by summertime it will warm outside.

Kenneth L. Fisher, in a book called “The only three questions that count”, wrote that the longer a bear market runs, the more likely it is that we will be waiting too long to get back in.

He says, “Further, if you get out successfully and time proves your success, your Stone-Age brain would like to keep you out until after that initial next bull market rocket ride. Staying out is more comfortable—it lets you feel right longer, particularly if you convince yourself the start of the rocket ride isn't real. Your brain wants to accumulate pride for having gotten out successfully. Switching back to bullish means you might be wrong and if you are people will ridicule you.”

“At market bottoms, bear markets do a V-bottom or sometimes a W-bottom. Think about the bottom like a V (or a W-if there is a double bottom). If you successfully get defensive sometime after the peak, does it matter which side of the V you get back in on? Not really.”

History has shown us that we are simply incapable of timing the market. Even the father of value investing, Ben Graham got it wrong – he was bearish when the Dow was only at 400 and had advised the young Warren Buffett to stay away from the market at that time. Furthermore, if one looks for the successful stock market investors, one will find that they had been long term stockholders in successful enterprises. Mr. Buffett is aware that great buys can show up even a raging bull market.

As regards the present negative headlines, well, the world has seen a fair share of them – sample the following: 1940: France falls to Hitler; Battle of Britain 1966: Vietnam War escalates-U.S. bombs Hanoi; highest price/debt ratio in a decade; 1969: Money tightens-markets fall; Prime rate at record high; 1973: Energy crisis-Arab oil embargo; Watergate scandal; 1974 Steepest market drop in four decades; Nixon resigns; Yen devalued; Franklin National Bank collapses; 2000: Dot-com Bubble begins to burst ; 2001: Recession, September 11th terrorist attacks; 2002: Corporate accounting scandals, Terrorism fears, Tensions with Iraq. Every time, it just SOUNDS like its different.

In 1979 when the Business Week ran a celebrated cover: “The Death of Equities”, it was a widely held view that the fact that shares were cheap was only proof of the fact that the market was not merely down but dead. Buffett strongly disagreed. In the same week, he penned an essay for Forbes saying, “The future is never clear; you pay a high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

So where does all this lead us? To the fact that it is not the timing but the Price that matters. Besides the kind of investment, it is the price which truly determines the rate of return on the investment. If a higher price has been paid for a fabulous company, then no matter what time you paid it, you are always at risk. Does it really matter if one buys a $1 bill for 50 cents and then the same $1 bill becomes 30 cents? We think not, because it only becomes more attractive, not less! Price, as Graham put it, is your greatest friend. We cannot live in the fear of cataclysmic events for ever. As per Lynch, the ‘penultimate preparedness’ is our way of making up for the fact that we didn’t see the last thing coming. Of course the great joke is that the next time is never like the last time.