The Aamir Khan style of Investing

I’ve said in the past you should think of investment as though you have a punch card with 20 holes in it. You have to think really hard about each one, and in fact 20 (in a lifetime) is way more than you need to do extremely well as an investor – Warrent Buffett


There is very little in common between Amir Khan (Bollywood actor) and Warren Buffett. One is an actor, the other, an investor. The former says he doesn’t care about money while the latter used to dream of being rich even when he was still a youngster. Etc.

And yet, there IS something similar between them: the desire to excel.

And, something else that is even more relevant to this article – the fact that they both choose the ‘project’ that they want to be associated with, very very carefully.



Warrent Buffett, is the master of inactivity. If anyone ever had any doubts about that, they should read some of his quotes:

"Wall Street makes its money on activity…You make your money on inactivity"

"Charlie and I decided long ago that in an investment lifetime it's 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" - Warren Buffett

NO ONE ever rushes Warren Buffett into an investment. He invests when he is ready for it.

He probably learnt this from his teacher, Ben Graham who had this to say:

"While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster" - Benjamin Graham

Bitten by the Great Depression, Ben Graham could similarly never be pushed into investing. Many, including Buffett, would recommend companies to Ben Graham. But he would reject most – till he found the one company that met all his criteria for investment.



Amir Khan, on the other hand, is known to take on one acting project a year. And when THAT one movie comes out, people wait for that movie with great eagerness and more often than not, is a blockbuster hit.

This is not a blog on movies or I would have talked about how each of Aamir’s movies in the recent past has delivered a meaningful message to the masses. Suffice to say that he chooses the story, the director and the producer of his movies very very carefully – and then makes a success out of it.


And there is a financial logic to this as well.

As per a study called “The Cost of Active Investing,” by Kenneth R. French, a finance professor at Dartmouth (known for his collaboration with Eugene F. Fama, a finance professor at the University of Chicago, in creating the Fama-French model that is widely used to calculate risk-adjusted performance), investors (in US) collectively spend around $100 billion as (brokerage and other) fees.

Thats a heck of a lot of money to line someone else's pocket.

You can bet Warren Buffett didn't contribute much to the fees figure - since he likes to buy and then hold his investments.

You might argue that as an individual, one doesn’t end up spending all that much on fees.

That may well be true in your case, but then don't forget that the government also taxes only the short term gains (if at all one has a profit)- so the more buying and selling one does, the higher the tax one pays.

Making investments at the drop of a hat (Ben Graham would have called these speculations) could also mean that not enough research has been gone into it, and hence the likelihood of losses is higher.


So on one hand, one has a situation where as an ‘active’ investor, one pays more fees, more taxes (if there is a profit) and/ or suffer losses (if it is a bad decision).

Alternatively, one can wait for the right opportunity, research it well thereby ensuring that the odds are in one's favour. And then invest a good sum behind it.

I wonder which strategy makes more sense?

Umm... no need to ask Aamir or Mr Buffett.


Over the last few weeks, I have not bought anything in the stock market (save for one opportunity that I did invest in, but that was not discovered by me and hence not fair to talk about it). Most stocks that I have looked at seem to be fairly (or over) priced.

And besides that, I haven’t even had too much time to do research – with my professional life keeping me busy and some bug in my research software making it difficult to do full justice to the research.

But as I have rationalized above, I have not felt obliged to invest into something that I would regret later. Better to commit an error of omission (missing out on a buying opportunity) than commission (error of judgment in the buying) as Mr Buffett says.

Quite the contrary, I have SOLD some of my holdings such that all stocks which had reached their potential have been converted to cash.

And so I will wait for the right opportunity to invest, till I feel that the odds are overwhelmingly in my favour of making good money.


With Amir Khan and Warren Buffett thinking along the same lines, I am in august company.

The Mutual Fund conundrum

About 20 years ago, I asked for advice from a close friend and guide, about what and where to invest successfully. Till then ofcourse I had no knowledge about picking stocks and like most beginners I had entered the market at its highest point, expecting to make a fast buck. Needless to say most of my investments were languishing at the time.

I recall vividly that my learned friend calmly looked at the list of my investments (which were quite a few in number, though small in value) and commented that with the number of stocks that I had, I could well be a mutual fund. I wondered at the time what he meant.

I figured that much later. This article will delve into a very important aspect of investing: How much diversification to target when investing in stocks. There are many views on this but the one that I have to come believe as the best, is what I will describe in this article. I also have to admit that I took long to appreciate the concept and so I understand fully how difficult it is to EXECUTE, mainly due to our mental blocks – even though it may be easy to read and understand. (But before giving up on it, please read and understand it!).

$$$$$$$$$$$
The concept starts with the understanding of a simple home truth. You don’t get rich on percentages. You get rich by the actual cash. If Warren Buffett is rich, it is not only because he has had a compounded return 25% (or so) on his investments. It is because he has $45bn of net worth to prove it.

In yet other words, if one invested in a good stock and got a return of 100%, then that may not necessarily mean that one got rich. Richer, yes. But not necessarily rich. To become rich, one has to put a larger AMOUNT of money behind that idea.

Conservatism, though, can come in the way of implementing this simple idea. One is not sure of one’s own abilities to pick the right stock. And if that is the case, then for sure diversification is the right answer (though if one is not sure, then investing is a bad idea to start with).

But if one does discover a gem – which happens every once in a while – then adequate fire power needs to be put behind that idea. And the surer you become of the idea, the larger the amount that needs to be put behind it.

The Great Gambler
Although I still slightly hate that comparison, I hesitatingly do admit that gambling and investing CAN be similar in some respects. Warren Buffett and fellow billionaire Bill Gates are obsessive bridge players, and one of Warren's boyhood business ventures was selling horse-race tip sheets. Also, Pimco's Bill Gross, widely acknowledged as the world's greatest bond mutual fund manager, started his career as a professional blackjack card counter in Las Vegas -- an experience he believes contributed greatly to his success.

If one sees a gambler spreading their chips over virtually the entire table, then this should tell you that they have no idea what they are up to. Although such a gambler would have a high frequency of winning, they would also have a low payoff because their losses (with the other chips that didn’t win) will offset their winnings. Very similar to an investor who talks about how one of their stocks shot through the roof, only to confess later that unfortunately they had invested very little in that stock. (sound familiar?)

The similarity between winning in both investing and gambling, can then be described in terms of understanding what probability one has of winning. And then putting an appropriate amount on that winning position so that the overall profit is substantial.

The Kelly formula



One way to figure this is the Kelly formula, created by John Kelly, an American scientist. The formula simply states that an investor should calculate edge divided by odds to determine how much to invest in a security.

The formula (edge/odds), in expanded form, is: (P*W-L)/P. In this formula, P is the payoff, W is the probability of winning, and L is the probability of losing.

Here, the P (payoff) in the formula is how much money you'll make or lose for every dollar you invest. In investing terms, if you think a stock can triple, then you're getting $2 in profit for every $1 you invest, so the payoff is $2*.

If with experience and your informational advantage you know that the probability of that happening is say 60%, the amount one should put behind this idea is as follows:

($2*60%-$1*40%)/ $2 = ($1.2-$0.4)/ $2 = 0.40 or 40% of your investible surplus.

This then becomes the maximum amount that can be invested.

Warren Buffett, without ever describing his technique as the Kelly formula, had invested upto 40% of his net worth into a single idea – American Express Bank, which later prospered.

Charlie Munger, describes this thought as follows:

“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

* Note that the assumption in the formula is that if you lose, the loss is 100%, which is actually never the case – hence there are limitations to the formula’s usage. Hence, we could imagine a more likely scenario in the stock market as below:

Probability of having a gain of 50% on your investment = 60%
Probability of having a loss of 30% on your investment = 40%

The way to recompute the odds in this case would be to bring down the ratio of gains to loss to a simpler form. Hence a 50 (gain):30 (loss) should be restated as odds of 1.66:1. The Kelly formula can now be used as follows:

(1.66*60%-1*40%)/ 1.66 = (0.996-0.40)/ 1.66 = 35.9%

My own technique
For many reasons – one of which being that I am not Warren Buffett, I have always found it easier on the mind to invest upto a maximum of 10% of my investible surplus as I become surer of the investment idea. This means that I can often start with a smaller amount, especially if I think that there is an opportunity to achieve a better price compared to the existing price. If the price falls, I stock upto 10% of my investible surplus on that idea.

(Note though, that I don’t let the concept become a fetish. For instance if the price of the stock goes up, I don’t sell some of the stock just to ensure that the stock remains at no more than 10% of the investible surplus. On the other hand, there are times where I have broken the 10% rule and invested higher than 10%, especially if the price has fallen. This lets me average the price down, when I am sure that the investment idea is still valid.)

Number of stock holdings and conclusion
If one does invest bigger amounts on a single, sure idea, then by definition, one should NOT have too many stocks on one’s portfolio. If all stocks are invested upto 10%, then a maximum of 10 stocks would form the portfolio. It could be extended to, say, upto 20 stocks as some stocks could just be toe-holds.

Compare that now to the number of stock positions that the average mutual fund has. Is there ANY mutual fund that has 10% in even one stock? Not many. No wonder then, that a large number of mutual funds lag in performance even when compared to the stock market returns over a longer period of time.

The final word then is - don’t try to be a mutual fund! They are not worth being the benchmark.

Good stock ideas are rare – they should be. But when you do get them, put enough resources behind them and reap the benefit.

As a parting shot, a joke on Mutual Funds:

A customer asks a fund manager: “The markets are down 10% and the fund is down 12%. I thought you said that the fund is market neutral?” The fund manager replies:

“Sir, the fund is market neutral. We still make our 2% no matter what the market is!”

Happy investing..

FACTS and FAQs

Men will be men and the investors will be investors. These past couple of weeks they (investors) haven’t been able to decide whether the world is coming to an end or getting better. And so the market’s daily roller coaster continues.

But let’s step back and look at things a bit logically. It was always naïve to believe that a financial crisis so deep was going to go away so quickly. It was only that the way the markets were so positive in the past one year, it would have been easy to believe that the problems of 2008-09 were now something for our kids to learn in their history classes.

I don’t believe it is that way. And it is not about Hungary or the PIIGS or Japan. There is a large and growing list of member countries in the “Stretched Economies of The World Club”.

I also think that bailouts (or promises of bailout) for any country in trouble MAY well mean that we end up stretching the problem – basically because the ones providing the bailout are not in the pink of financial health themselves (as I read an apt comment somewhere, “…distressed eurozone borrowers are to be saved by more borrowing by … er … the distressed eurozone borrowers.”).

But I must say that I do see it from their point of view also – after all it can’t be an easy decision to allow a country to go bankrupt and let the banks take a huge charge off. See the following that I picked up from a report which shows the extent of foreign bank ownership in European debt. Any mess up on one – and who knows what it may lead to:



Source: “Avoiding the Sovereign Avalanche”, Citigroup Global Markets, May 2010

So while the world leaders can talk of the ‘growth agenda’, I suspect that ‘de-leveraging’, by which process the countries (and individuals) start to show some fiscal prudence and cut down on their debt levels, will impact the world’s growth in the next few years. And fortunately or unfortunately, as the above picture shows, the world is so inter-woven today that this will impact all countries and all humans.

So how do we react to the uncertain times as investors?

Well, since this is the season of half year close and every CEO and CFO face their investors armed with a list of possible Q&As and FAQs, I decided to make one myself.

Except, that to get the answers to the questions, I picked up verbatim, from my usual haunts: Ben Graham’s ‘Security Analysis’, Warren Buffett’s annual letters and a few other books. Here goes..

As a value investor do you care about the macro-economic conditions?

We do not believe that short run price movements – the day to day or month to month variations – are a valid or profitable concern of the security analyst. But the broader fluctuations of the market, which tied in with the accepted concept of business cycles, should not be left out of reckoning. (Ben Graham)

OK. So which way do you think the market is headed?

We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.

“Forecasts”, said Sam Goldwyn, “are dangerous, particularly those about the future.”

Even now, ..... I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

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. (Warren Buffett)

But surely it is difficult to remain aloof when there is chaos all around! How should one react to market ups and downs?

Our brains have undergone millions of years of evolution, yet they are poorly evolved to deal with the vagaries of the stock market. When the lion roars, our brains tell us to start running. We don’t process; we just run. When stock prices drop dramatically, the fear that sets in is similar to hearing the lion roar. Our first instinct is to sell the turkey, purge the memory of ever having owned it, and run away. (Mohnish Pabrai)

Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices). It's only when the tide goes out that you learn who's been swimming naked. (Warren Buffett)

But surely, you would care if there are no buyers in the market?

I buy on the assumption that they could close the market the next day and not reopen it for five years. (Warren Buffett)

Do you believe that a stock is good or bad?

Almost any security may be a sound purchase at some real or prospective price, and an indicated sale at another price. (Ben Graham)

How relevant is the past to what happens in the future? Some people say that this cycle will last 2 years, some say 5-10 years. We are confused.

Gentlemen, listen to me slowly. Flashbacks are a thing of the past. (Sam Goldwyn) History does not repeat itself, it rhymes. (Mark Twain)

OK, so if the past is not necessarily a reflection of the future, how do we guard against the hazards of the future?

The hazards of the unknown future may be met by the security analyst in several ways. He may place his prime emphasis upon the presence of a large margin of safety for the security, which should be able to absorb whatever adverse developments are reasonably likely to occur. In such cases he will be prepared to see unsatisfactory earnings for the issue during depression periods, but he will expect that 1) the company’s financial strength will carry it unharmed through such a setback and 2) its average earnings will be enough to justify full the stock purchase he is recommending. (Ben Graham)

Any special technique of analysis if the situation does become dire?

The technique of valuing or appraising common stocks becomes more dependable in the frequent cases .... when shares can be purchased at a figure which is well below a) earning-power value, b) book value, and c) average market quotation in the past, the combination of elements holds good promise for the investor. (Ben Graham)

Is a good company still good when the market falls?

Managers .... should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: "Four, because calling a tail a leg does not make it a leg."

Is it important to do what we think is right? Or should we be listening to the big investment professionals?

You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumour after all.” (Warren Buffett)

So you think there is scope for the small investor in a market that is dominated by big players?

Many commentators .... are fond of saying that the small investor has no chance in a market now dominated by the erratic behaviour of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. (Warren Buffett)

If I invest in the way that you recommend, how long will it take for the value to appear?

No matter how great the talent or effort, some things just take time: you can’t produce a baby in one month by getting nine women pregnant. (Warren Buffett)

I am impressed, you seem to have a good answer to all my questions! And it seems you are looking forward to the market to move downwards. Are you holding cash?

Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun. (Warren Buffett)

Hey, I just figured that whatever you have said is all copied from other people’s sayings! There is nothing extra-ordinary in whatever you have told us today.

Ben Graham taught me.. that in investing it is not necessary to do extraordinary things to get extraordinary results. You only have to do a very few things right in your life so long as you don’t do too many things wrong.

So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.") (Warren Buffett)

Love you forever!

I love a song by Nat King Cole which goes like this:

When I fall in love,
It will be forever..
Or I’ll never fall in love.
In a restless world like this is,
Love is ended before its begun.
And too many moonlight kisses,
Seem to cool, in the warmth of the sun.
When I give my heart, it will be completely.
Or I’ll never give my heart...
And the moment, I can feel that, you feel that way too,
Is when I fall in love,
With you..

Keynes was one of the greatest economists of the twentieth century. The worst of his critics would also have to admit that he had a certain turn of phrase and wit and has many wonderful quotes to his credit. One of such a memorable quote is:

When the facts change, I change my mind. What do you do, sir?

The movers in the stock markets certainly take the idea of moonlight kisses and changing one’s mind (so what if the facts change or not) to the very core of their heart. No wonder the markets go thru such gyrations daily. When the emphasis is on short term gratification, not many want to think about long term love for their stocks. Sample some of the following headlines from the international newspapers (I tend to save some of the news items every once in a while just to keep a string of how market perceptions change very quickly):

• U.S. Stocks Plunge Most in Year as ’Panic Selling’ Grips Market – Bloomberg, May 6 th
• US markets open sharply higher on enthusiasm on European debt – NYT, May 10th
• Strong Rally on Wall Street Pushes Major Indexes Up 4% - NYT May 11th.
• Renewed Worry Over Europe Pushes Stocks Down, Dollar Up; S.&P. 500 Falls Nearly 2% - NYT, May 15th
• 2010's coming stock market crash: 1987 all over again – Fortune, May 17th
• Stocks Dropping Near Bottom of May 6 Crash Signal Worse to Come – Bloomberg May 21 st
• “We have just entered Act II of crisis” – Soros* – Bloomberg, June 10th
• Stocks, Commodities Rise as Yen Weakens on U.S. Sentiment Data – Bloomberg, June 14 th

* Soros’s son said the following of his father, "My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bulls**t, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it's his early warning sign."

The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return – Warren Buffett

Mr. Buffett thinks very differently than most others (duh.. that’s probably why he is amongst the richest humans as well!). He would rather invest for the long haul – as he says, his favourite holding period is ‘forever’. For this of course, he looks for companies which have, amongst other qualities demonstrated earning and pricing power. Amongst the better known examples of such companies in his portfolio are Coca Cola and Gillette.

I and a friend had identified, what we thought at the time (around 2½ years ago), looked like a typical ‘Buffett company’ in India, called Indraprastha Gas Limited (IGL).

Today, this is another company that I have retained in my portfolio despite having gained over 120% of my initial buying price. Only recently, I decided to reignite my love affair with the company. And I bought more stock at this higher price.

If one sees the cash flow performance of the company below, the reason would be apparent.



The company has shown a 5 year compounded annual growth rate (CAGR) in cash flow from operations (CFO) of 17% and importantly, has been consistent in showing such a growth. To me this shows that the company’s capital expenditure (also growing and financed so far entirely from internal resources) has been productive.

A bit of background on the company will further confirm why this is a good business.

IGL is currently the sole supplier and marketer of Compressed Natural Gas (CNG) to the automotive sector in the National Capital Territory (NCT) of Delhi. It took over the Delhi gas distribution business from GAIL, one of its promoters (the other 2 promoters being Bharat Petroleum Corporation Ltd and the Delhi Government).

Also, as a perspective, CNG has a c. 50% pricing advantage over petrol, is cleaner and it’s demand is helped by the fact that as per a court/ Government of Delhi direction, ALL public transport buses, taxis, light commercial vehicles and auto rickshaws plying in Delhi can only run on CNG – the step was introduced to arrest the rising pollution levels. And clearly the step has helped to arrest the rising pollution levels. So if you feel for the environment, that’s another (though convoluted) reason to invest in a company like this! Better than investing in a cigarette company!

Consequently, the number of vehicles on CNG in Delhi have grown from 90k in 2004 to 300k in 2009. And climbing with the commonwealth games around the corner.

The company’s EBITA margin has always been maintained at well over 30% and the company has been able to protect its margins by raising CNG prices whenever its input prices have been increased. It has done so in every year since 2005 and has done the same over the last few days too. Any step by the government to free the petroleum prices (right now there is an element of subsidy) will only result in making CNG even more competitive.

Besides CNG for the automotive sector, IGL also supplies Piped Natural Gas to the domestic and commercial sectors in Delhi and surrounding areas.

So, here is a monopoly business with considerable moats, as Buffett calls it, since even though competition has been allowed, putting up a competing and independent infrastructure like underground pipes and CNG stations will never be easy. Further, the existing demand is sticky (customer don’t change their CNG car engine to petrol very often) and likely to grow with the economy (and also because of the pricing advantage of CNG). AND the company has pricing power.

And to cap it, the company has so far had a history of growing dividend every year.

One of the only issues that I have had with the company so far is that it was not spending enough on capital expenditure to increase its CNG stations or on the PNG network (one of the very few cases where I like capital expenditure). All this seems to have changed recently, and the company has decided to invest large sums of money (double of what it has cumulatively invested in its corporate existence) on expansion.

At the current price, it is available at 17x trailing PE and 12x trailing free cash flow. So while it has risen by 12% since I decided to write about this company a week ago, it still looks on its way to doubling again in 3-4 years along with its cash flow. That is unless the market decides to rerate the company by giving it a higher multiple, which is entirely possible. In which the returns are likely quicker.

Now, of course the facts may change – there could be a forced cap on CNG prices (in which case I’d say the margins would become more reasonable) or they could diversify into something totally unrelated (with such quasi government companies, how can one tell?).

But till the facts do change, it does seem worth more than just a few moonlight kisses, what do you say?

Show Me The Money!

Show me the Money




I love money. And early on when I was learning the ropes in value investing, I was taught to extend that love to companies who in turn generate a lot of money. Not necessarily by way of profits but in cash flow terms.

That’s when having a high CFO (Cash Flow from Operations) means more than a reference to a drunken Chief Financial Officer.

Over the last few couple of weeks, a few (82 to be precise) companies had shown up in my filter. 3 of these companies are the subject matter of this article.

One is Tata Communications (it showed up on my filter because it has had a negative 54% return on price in the last 12 months).

As mentioned earlier, in order to value a company, I look at its cash flows quite carefully. I have reproduced a simplified version of this company’s cash flow below:



Of the lot of numbers that are appearing in the table, I would like to bring the reader’s attention to the ones which are highlighted in yellow. Firstly, the company has shown a rising CFO – which is good news.

But as you would notice, the same is the trend on the capital expenditure, which has tripled from around Rs 1063cr (~USD 220m) in 2006 to Rs 3222cr (~650m) in 2009. At the same time, their profitability has come DOWN.

This in turn means that while the company can call this capital expenditure (capex) anything it wants, we should consider this capex as a necessary drain on the company’s financial resources and hence should take a substantial portion out of its cash flow from operations to arrive at the Free CFO.

As also apparent, having such negative cash flows have caused the company’s borrowings to go up, and consequently the interest cost.

Obviously, the hallmark of a competitive industry where one has to continue to invest to stay at the same level vis-à-vis the rest of the players.

Unfortunately, the stock market is littered with companies with similar problems and I find it is best to ignore them.

The other company that came up on my screen is a company called Smarlink Network Systems. This is a small market cap company (Rs 137cr), priced at around Rs 45 currently. There is no debt on books, and it has a low PE (~7X) and PB of (<1).

This company demerged from a company called D-link for which it now does the marketing of networking and communications equipment.

Due to the demerger, the past few years CFO is not relevant but if this year is any indication, then a free CFO of around 24-25cr should be reasonable (that works out to <6X of the market cap).

What’s more, there were liquid assets (Mutual Funds etc) on books, though since there has been a scheme of arrangement, I can’t be certain that these will continue to be on the books of the company. However since I can see some ‘other income’ in its quarterly results it is reasonable to assume that there are some other liquid assets. And to top it, there's been some insider buying in Feb and March.

All good signs in my view.

Yet another small cap company that came up on my horizon is Manugraph India. It has a market cap of Rs 155cr and a PB of 0.63. Below is how it’s price has moved in the last 3 years. From around Rs 200 in the ga-ga days of 2006/ 2007, (even till mid 2008, the price was Rs 100), the price is now at around Rs 51. I love researching such companies!!



Looking at this company’s cash flow (below), one can see why the company has been treated shabbily by the market. Its 2009 CFO was around half of its peak in 2006, as the economic slowdown hit its printing machinery business.



But what if the cash flows were to come back to earlier levels? How reasonable an assumption is that? Even if these come back to the AVERAGE levels of the last 6 years (Rs 56cr less say Rs 10cr as maintenance capex on a conservative basis), that would work out to < 5X the EV.

In order to find something more about the company, I requested a friend to call them at their India office but the company refused to provide any information about their operational prospects.

But I have learnt to live around shortcomings of this nature (heuristic thinking!). Please see the tenor of their announcements at the stock exchange since 2009:

Jan 6th, 09

Manugraph India Ltd. has informed the Exchange that the prevailing worldwide recessionary and sluggish market conditions have adversely impacted the orders of the Company. Some customers have either cancelled or postponed or requested for keeping in abeyance, the confirmed orders, which in turn has resulted in piling up of the inventory beyond reasonably high level, and thereby increasing the cost carrying inventory. This situation constrained the management to implement cost cutting measures meticulously, one of such being operation of plants for five days a week instead of six days at both the units at Kolhapur. The management is, however, hopeful that the situation will improve in the near future. The management will take periodic review of the situation and keep the exchange apprised of the important development.

June 3rd, 09

Manugraph India Ltd. had informed the Exchange that operations of plants of the company at Kolhapur have been reduced from 6 days a week to 5 days due to sluggish market conditions. The Company has now informed the Exchange that the Company does not foresee any improvement in business conditions. Also exports have slowed down significantly. Considering this local and global scenario, the company has been constrained to suspend the production at Unit No.II at Kolhapur and also has reduced its operations at Unit No.I substantially in consonance with the orders in hand and to reduce the piling of inventory. Until such time the situation does not improve, the Company will take cost cutting measures which are necessary to improve its working and reduce the financial burden.

Jan 12th, 10

Manugraph India Ltd. has informed the Exchange that: "With the improving economic scenario and order book position, both the manufacturing units at Kolhapur are currently operating at normal capacities".

Clearly, one can sense the change in underlying tone in the most recent announcement. I also like the fact that the company is making an effort to keep its shareholders abreast of the latest developments, good or bad and has taken sensible steps in cutting costs when necessary.

Hence even though I don’t have precise information, looking at the cash flows in relation to the market cap, the low current market price, which is around 10% off its lowest in the past 3 years (even when the economy was down), combined with the improving economic fundamentals, I am reasonably confident that there is limited downside but a good probability of a good return.

For me, both of the latter 2 companies are buys – examples of when the market is not recognizing a company’s cash flow generation capacity.

I have backed myself and these companies and have invested in them. Time now to wait. To see the money.

Why do stocks go up?

Why do stocks go up? Benjamin Graham, the father of value investing was asked that question. And his answer was: I don’t know.

Many others are less frank. Some say it has to do with earnings, others say it has to do with the market fancy or hype. For most others, it is akin to asking a question like, is there life anywhere else in space – some will say an emphatic “yes”, others will say “no” and many others will shrug their shoulders and say, “who knows?”

On Jan 31st of this year, I looked at a stock called ‘Standard Industries’, which looked cheap. It was then priced at Rs 24 with a market cap of Rs 154cr. Its main line of business used to be chemicals and textiles at one point in time (it is a 104 year old company). However it lost its way on the main business. But here is the twist: fortunately it had 93 acres of land in navi mumbai. They asked a Singapore company to develop 30 acres and recieved around 230 cr. for the same last year.

Why it looked cheap was as follows: While the company was valued at Rs 154cr., it had Rs 139cr. of hard cash sitting on its balance sheet. And it had 63 acres of land left from the original 93 acres.

So if one was to extrapolate the value of the 63 acres of land on the basis of what they had received for the 30 acres, it meant that it had land worth at least Rs 460 cr. With the hard cash of Rs 139 cr., the company should have been valued at almost Rs 600 cr. Against this, the current market cap was of Rs 154cr. More or less at a quarter of its value.

Being on a day job and working out of Singapore, I requested a friend, a professional and a past master in this field, to find out why the market was treating the company so shabbily. He found out through a colleague that there was indeed no reason for the market to not recognize the value. But there was a problem. The volume was very low and so buying a meaningful quantity was difficult.

Meanwhile, within a month and a half of this dialogue, here is what happened to the stock price:



And ofcourse the volumes went up too.

Hence, to ask the earlier question in a more pointed way, what has changed between February of this year and now, when the price is pushing Rs 52 a share (117% increase)?

Well nothing as far as the company is concerned. There are no announcements from the company, no news announcement far as I can tell. Note that it has still not reached anywhere close to its true value, but once the market decided that it is undervalued, it was being bought like it had just been launched.

And the answer is??

Well I am in the category of the ‘shrug-your-shoulders-and-say-who-knows?’ But I can quote something else from Ben Graham, which has remained with me ever since I read it:

If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

Day-to-day price changes can be inexplicable. And that's a really good reason for not watching one’s portfolio too closely. Concentrating on the company's intrinsic value and acting on it is far healthier than worrying about why stocks go up.

Shinier Teeth or brighter clothes?

Looking at my personal portfolio, one of the stocks that has returned me ~ 100% on the original investment (made around 2.5 years back) is Colgate Palmolive India.

Browsing through my research notes of the time (Q4 2007) when I had done the research on the company, I had written the following:

Result: Financially a strong company, debt free, cash rich and generative, knows how to keep shareholders happy either by giving higher dividends or as happening now, by returning capital (deemed dividend). Has deep franchise value in the market and consequent high ROE (50%+).

Now, just as a perspective, this was a time when the stock market was reaching dangerous levels and the markets were about to crash at the start of 2008. The chart below shows the price movement of the company as it charted through choppy waters of the economic meltdown and beyond.



As is evident, the stock has returned around 64% or so in the last one year, which is really around the same as that of Sensex so I wouldn’t call it an extra-ordinary performance in a relative sense. The real extra-ordinary performance was in the fact that it provided the rest of its increase in value (40%) during the time the markets were discarded like old fashioned trousers by the investors. So in that sense, it served its purpose for me as a great hedge against the uncertainties. Perhaps like Gold would have.

On the other hand, I looked at the performance of another wonderful company of our times: Hindustan Unilever Limited (HUL) (which I don’t own).

This company, like Colgate, also has super ROE of over 50% - last year the ROE was over 100%. And it is MUCH bigger in size than Colgate. It is also a company’s whose financial management is the matter of folklore amongst finance professionals (I did a project on its working capital management when I worked for Modi Xerox and then again looked at its insurance management – they had a unique system of self insurance – when I was at PepsiCo India. In both instances we implemented the learnings from my projects and saved a lot of money for the respective companies).

This is a company that generates to the order of around Rs 2000-2500 cr of free cashflow every year, has around Rs 2000 cr in liquid or near liquid assets, has a negative working capital and has some of the best brands and minds in business.

When Professor Greenwald (Columbia University) had come visiting India in January of 2008, he had singled out this company as the one to invest in, given the times that we were headed into (I remember it was only a few days after his warning at the conference that the world stocks went into a tailspin).

And HUL’s subsequent price performance (shown below) right through the crisis has proved Professor Greenwald’s words entirely true:



However, unlike Colgate, the price performance of HUL has languished in the past year. In the last one year, it has returned 2.5%. Comparatively, the Sensex returned over 65%.

So unlike Colgate, which has continued to perform in good times and bad, HUL has served the investor well only during the bad times.

The difference in the 2 companies lies inter-alia in the growth rates – and we know the market is obsessed with growth. Colgate has done supremely well on this front– growing its topline by around 15% and more (quarter over previous year quarter). And its PAT has grown by even a higher percentage.

HUL on the other hand, has had an anaemic growth in topline and its PAT has in fact shrunk. This is the result of its ongoing ‘Detergent wars’ with P&G (which I might add that it has been on the losing end of) and earlier due to a severe cost inflation.

This ofcourse may be a simplistic explanation and there could be many other factors – like management quality etc, which I do not have enough knowledge about.

The comparative story of these 2 stocks provides me with many important lessons, 3 of which are:

Firstly, this debunks the theory that a ‘good company’ (which HUL surely is, looking at its brand value and financial solidity) equates to a good investment. In fact compared to both HUL and Colgate, there are many stocks that have returned over 200% in the last one year alone. Even now, HUL is valued at over Rs 48,000 cr (USD 10bn) in the market, which to me, still looks rich. But then so is Colgate looking at its present price, though the latter has growth in its favour.

Secondly, what may be a good investment during a certain period may NOT be a good investment during another period. HUL was a ‘safe’ stock during the crisis due to its financial solidity. At that time, most investors were more worried about the return OF investment than return ON investment (incidentally something which we should always remember).

And surely in that respect, HUL had all the hallmarks of safety. An FMCG company in a huge market, great brand names, no debt and steady cash flows. Growth was not important. But when the economies became steadier, every investor headed for the greener pastures. Suddenly the same company LOST in market value despite having more cash on its books and having had a more profitable year than earlier.

Lastly it reminds me that the price of purchase is all important. I wouldn’t buy Colgate at today’s prices because the growth is factored in it. But there must have been a time when HUL was much more expensive than it is today. Its price in 2006 was higher than now by 33%. So in a sense, the stockholder who purchased the stock at that time has really paid the price (pun intended) of buying the stock expensive.

Neither did they have the benefit of the bull market of 2007, nor the recovery of 2009/ 2010. They only had the pleasure of knowing that they did not lose as much as others did over 2008.

As a parting shot, I would say that what may seem uninteresting today may not remain so forever. Managements and companies change every now and then, and so should opinions. If HUL were to come back on a sustainable growth trail with a brilliant marketing strategy that blows P&G away, then who knows – it may yet again become the stock market’s darling.

That’s the beauty of the stock market. It has time for everyone – the shining teeth as well as the brighter clothes.

Here we go again

Yippee!!

It is not yet like the ‘old times’ but I sure hope it is a start. Late last week’s global sell-off was almost as good as anything we have seen since the worst fears of the crisis began to abate last spring. The fear is back and for some, the rebound is just a memory.

We all know why it happened (though I have to admit that for me, the reason is not that important – if we were to believe in Taleb, there could have been ANY reason for the markets to fall. After all there was so much belief in the ‘green shoots’).

But still a quick run through on the reasons being quoted:

Firstly, there is this lack of confidence in the European governments' ability to repay their debts. So fears over Greece added to a troubled auction of Portugal's debt. Which then were added to the concerns that actually Spain's bigger economy could be in even deeper trouble than Greece or Portugal's. And ofcourse there are the issues with Ireland and Italy.

(Altogether, there is an acronym for this combination of countries – PIIGS. Not a very adorable term if you happen to be from any one of those countries). See chart below which depicts 10 years government bond spreads for each of these countries (specially note Greece’s trend line – not yet a Greek tragedy but maybe a Greek drama).



And to these concerns over sovereign debt came the news of rising unemployment in the US. For all one knows, there could be a glitch in the data compilation – if it can happen to reports on melting glaciers, why can’t it happen to jobless claims data?

Notwithstanding how the data came about, there were 6 per cent more new jobless claims last month than in December. This was certainly not in the script that the ‘markets’ were waiting to read.

“If you're not confused, you're not paying attention”

Ofcourse we know what effect it had on financial markets. On the equity front, the Emerging market equity funds lost $1.6 billion in weekly withdrawals, the biggest outflows in 24 weeks. Even Gold and crude were no exceptions. See the chart below.



“Expert: Someone who brings confusion to simplicity”

The interesting thing however, is the change in tone of the commentators and the role played by the media in hyping such events. I am not sure whether in such times all commentators change their messages from positive to negative or the media only reports the negative side. I suspect it could be a combination of both.

So amongst others we have reports of JPMorgan Chase saying that it was turning “less bullish” on developing-nation equities in the first half of 2010 and the term ‘double dip’ beginning to mean a bit more than dipping your favourite tea bag a second time. Naseem Taleb has also reportedly said that if there is one trade that every human should have, it should be shorting US Treasuries.

“One man’s meat is another man’s poison”

On the other hand, there are others like Kraft Foods, the maker of Oreo cookies, who have just issued bonds for its takeover of Cadbury Plc. Pepsico did the same for its acquisition of 2 of its bottlers. In fact companies in the U.S have spent the highest portion of bond-sale proceeds in more than a decade for acquisitions and expansions. This was ofcourse led by Warren Buffett’s “all- in wager” on a US recovery (purchase of Burlington rail by Buffett) and taking advantage of the lowest borrowing costs since 2004.

So everyone obviously doesn’t think alike. And these mixed signals are exactly what creates the confusion. And by the way, this also tells us why someone buys stocks when exactly at the same time someone else is selling (buy has to equal sell at all times – if everyone was a seller at a particular time, who would buy?). And so it is in times like these that value investors start to find bargains.

A couple of mispriced stocks came on my radar over the last little while. Two of them are Aditya Birla Chemicals (earlier called Bihar Caustics) and Visaka Industries.

Aditya Birla Chemicals (ABCIL) – CMP 77/- ; PB of 0.6; market cap of Rs 170cr

The company’s main products are caustic soda and chlorine. The industry has been plagued by over-capacity (more than 80% new capacity has been added in the industry both within and outside India) and countries like US and China have reportedly resorted to dumping in the Indian markets. In consequence, companies like ABCIL and Gujarat Alkalies have been forced to cut prices. This has led to a recent fall in their realizations and hence profits.

However, the interesting thing is that over the last 6 years, ABCIL has had a free cashflow (pre capex) of Rs 50-60cr a year. Also, their known capital expenditures seem to be over and they have repaid quite a bit of debt. Hence, at this point in time, the market is valuing the company at ~ 3.5-4X its yearly free cash generation.

This company therefore could become a rerating candidate – that could happen in case there are ‘surprisingly’ good results over the next couple of quarters (that in turn could happen if the prices of caustic soda trend upwards). Or they may decide to do something with their extra cash (as mentioned their capital expenditure now should be limited). For example, they may decide that the market is not rating their company fairly and may do a buy back. Either way, this is a cheap company (which could well become cheaper, but that should not matter).

Visaka Industries – CMP 123/-; PB of 0.87; market cap of Rs 200cr (USD 45m).

This company manufactures asbestos cement products. The business has been showing a growth YOY and QOQ. It has paid a minimum Rs 3 as dividends since 2005 (around 2.5% yield at current prices) and over the last 6 years, the company has had a free cash flow of around Rs 25-30cr. This company is what we would call a ‘GARP’ (growth at reasonable price). Demand for the company’s products are likely to go up, as these are attractive to the rural market, being affordable as well as weather and fire proof. These are therefore natural upgrades from thatched and tiled roofing that exists in many parts of the rural housing.

“I have nothing to offer. Except my own confusion.”

As an aside, I was re-reading Malcolm Gladwell’s “Outliers’ recently. The concept behind the book is that when we hear the success stories of some of the biggest names like Bill Gates or The Beatles, we conjure up visions of brilliance and the extraordinary talent they have/ had. However, by diving deeper into the lives of a few of these successful people, the writer illustrates that there was much more to the success than just talent. It was about being born at the right time.

In a similar way I believe that by being born in an era where the balance of global economic power is shifting eastward, we too have a historic opportunity available to us. To be able to get good returns in the right priced opportunities available in places like India or China.

And the more the prices fall, the better the probability that we can realize the historic opportunity quicker. So let the confusion reign – its better for investors like us. There is no confusion in my mind on that.