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http://www.igvalue.com/2015/04/the-value-canvas-conviction-grading.html

Eric Ries has written a wonderful book on Lean thinking for start-ups. The book describes a method to analyse your start up on a single page – albeit a large A3 or an A2 or a whiteboard page. I put that together with the framework Donald Francis came up with and now use something called a value canvas with consists of:

Conviction canvas

Pricing canvas

#business valuation #value investing #warren buffett

macro, GDP, P/E, corporate profits to GDP, GDP slicing, economic pie, value investing, macro betting, politics

#value investing #macroeconomics

valuation, value investing concepts, intelligent investor, lean canvas, lean thinking, value canvas, conviction canvas,management, management quality, business quality

#value investing #warren buffett #business valuation

Rules of the game

Here are a few simple rules that I use to kind of keep on track. A few of them were borrowed from Guy Spier's book, The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment. Would love to hear your feedback on these and if you agree with them.

Never sell for 2 years after you have bought: This does multiple good things for you. Firstly if you know this you will always think a lot before you become a partner in the business. Secondly it eliminates all biases and gives you enough time to do in depth research before you sell out your interest in the business. This by no way means that you should stop thinking about the business or reading or doing research during the two years. On the contrary it means that you do highly diligent research during those two years in order to affirm or dispute your thesis.

Check prices at most once a week: Checking your portfolio company prices multiple times makes it more likely for you to do something in the heat of the moment – which is precisely what you are trying to avoid. As Buffet one said “You don’t get rich just to look at the ticker tape”

Avoid talking about current positions:When you have bought an interest in a business talking about it does various things. For one it commits you to a position and you may not be able to retract from that position. Secondly it puts emotional pressures on you of being wrong and take rash decisions.

Discuss ideas with few rational and clam sounding boards: You want to discuss your ideas with a sounding board. The most important function of this is to actually present your case in a simple manner to someone who you think is competent of critiquing your ideas. You don’t have to necessarily agree with them but just a healthy discussion is good to clear up your thoughts.

Write a note before taking a position: The note history or what I call the verdict log gives you a clear understanding of why you took certain actions in the past. It also is very useful in learning from your experiences and mistakes.

Learning from Mistakes: You always want to write up a piece for yourself to learn from your mistakes. When you do make a mistake creating a checklist item is also very useful.

Give yourself liquidity from the portfolio only once a year: This is very important because intra year positions can move around and getting out at the wrong time can seriously hamper your returns.

Buy only after complete analysis: Buying into something that looks like the greatest opportunity ever is the fastest way to fall into a value trap. Complete the analysis before you buy along with the conviction matrix and valuation sheet.

Stay within your circle of competence:Your circle of competence is defined by business you understand – as Mohnish Pabrai puts it “You should be able to think like the CEO of that business”. Which implies that you understand the suppliers, employees, customers, value creation mechanism, moat strength, growth avenues, etc. In order for a business to be in your circle of competence you should have studied at least a few companies if not all in the space to understand relative strengths. If there are significant private players that is important as well.

Avoid use of anchors: Anchors are pseudo valuation metrics that do not make business sense. Examples include buy when the stock is down 20% from the highest price in the past – who is to say that the highest price was rational or today’s price is rational or whether there were material changes in the middle. Relative cheapness on P/E or P/B is another anchor which is very tempting. There are only 2 determinants of the buy decision – value and price. If the price is significantly lesser (I think Berkshire says at least 25%) than the value you buy – else you don’t.

Don’t look at the stock price before doing the analysis – This is again very hard to follow especially because most websites will pop the price in your face in big bold 20 point font. TO illustrate this point I would like to make the present the following Buffet quote: “I don’t want to know the price of the company’s stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance, it may influence my analysis.”

#value investing concepts #concepts

How to get started with Value investing

Many times I am asked: This is all very good but how can it benefit me? And I was planning to cover this in a short few articles but I was chatting with a friend of mine who said

“All this motherhood stuff is great but I will only read your stuff if it can benefit me!”

And this is coming from a guy who has lots of experience in various business fields in various countries for decades. He has probably read more business books than I have seen in libraries and bookstores. This probably means what he is saying might actually have a tiny bit of weight to say the least. You can thank him (or not if you don’t like this section) for this factor being covered over several articles.

First up the question you need to ask yourself is whether you want to execute the strategy yourself or find a manager. The thing is that value investing can be a part time or full time job. Depending on your diligence and discipline the results can vary. If you can spend a few hours every day religiously to the task there is nothing like doing this yourself. Several people who have gotten good at it do this as a profession now. Besides I find it fun and some even tell me that it’s akin to a gambling addiction.

Gambling is defined on Wikipedia as:

“Gambling is the wagering of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods. Gambling thus requires three elements be present: consideration, chance and prize. The outcome of the wager is often immediate, such as a single roll of dice or a spin of a roulette wheel, but longer time frames are also common ...”

All three elements of gambling are present in value investing – consideration, chance and prize. The thing is that the long term element takes a bit of the element of gambling out of the value investing theory. My rule of not selling out until minimum one year (but try for at least two years) drives this point home. But other than the term of the investment it is very hard to argue that value investing or for that matter any kind of investing as a hobby or a profession is not very different from a gambling addiction. Self proclaimed arbitrageurs will tell you that they are not gamblers as they probability of success is a 100%. The set of situations with a probability of 100% is small and is mutually exclusive from the set of situations found in the investment world. Yes one can get very close to the 100% situation but never have I come across a 100% probability arbitrage trade.

If you are not interested in doing this yourself – don’t think you read this book for nothing. Knowing these principles will enable you to select a good manager. One could make a checklist that outlines the principles in this book but like most things about value investing these principles are not hard and fast. The attributes of a good investment manager are no different from those of a good manager of anything. The main attributes are honesty, diligence, ability to identify mistakes & correction and sticking to the plan.

In the few next articles I will outline a simple few steps that will cover the steps to becoming a good value investor. This by no means is the only way to becoming a good value investor. It is just a rationalization of what I have seen others do and what I have experienced myself. If you have a better course I would love to hear about it (and amend my article alongside).

#value investing concepts #concepts

Long short & the myth of market neutrality

“The market can stay irrational far longer than you can stay solvent”

- John Maynard Keynes

Long short strategies when right can produce wonderful returns as well but the risk associated with these is far higher than you think. On paper these strategies look wonderful. Imagine if you can make the market return without the downside because your longs and shorts offset each other. Many funds claim to be market neutral but in reality they have massive amounts of implicitly leverage. When you short a stock the most you can make is 100% but the most you can lose is infinite.

Shorting also creates bad karma as Guy Spier very aptly puts it in his book. Thinking about negative elements attracts you to negative actions. Think about a company that is trading at 3x its intrinsic value. Now imagine that if it grows at 20% the value will catch up with your shorted price very rapidly. In 6 years it is like to be at that value. How do you know that in this 6 year period the stock will fall? Many would make the argument that a short position is a positive carry trade – which means you get paid interest on the money you receive when you short a stock but that carry by no means pays for the risk of the short position.

Other might make the argument that you can short using equity swaps or futures or forwards or options. While these are all instruments you can use to short, they can be highly dangerous if they move the wrong way. Implicit leverage from shorting can cause massive permanent capital losses.

Most short funds (with famous investors like Bill Ackman) are able to make the short trade work with producing lots of high quality research on the topic and spreading it. That takes the shape of activism that small and even medium scale funds cannot do – let alone retail investors. Another side effect of this type of activism is that it is very difficult to back track if you’re wrong after you have made many statements publicly one way or another.

Empirically I don’t know of any long short equity funds that have beaten the market for a 20 year period.

#value investing concepts #concepts

Why focus on equities?

You can generate much larger and outsized returns with minimal riskusing arbitrage strategies. There are several arbitrage opportunities available to investors in warrants, Rights, Options, Futures & forwards to name a few. These are typically wonderful opportunities especially if the capital you are running is small. The annualized returns from these can be much larger than buy and hold on good companies. So then why should you even look at at equities?

The downside is that they suck up lots of your time and many a times require some special infrastructure like database subscriptions and technological infrastructure like servers and software. For example statistical arbitrage may generate massive returns at a very low risk – and several money managers use it but the initial investment required in the servers, hardware and software would be in the millions of dollars.

Another downside is that opportunities show up in various places and are not always available. You need to be constantly on the lookout in several nooks and corners. Overall this is a wonderful area of value investing but needs you to do this at scale with large teams.

Even bonds are typically fixed term and to generate large outsized returns you either need to use lots of leverage or repeatedly find opportunities that provide returns much larger than the risk taken. Bonds can also be very illiquid and might need large amounts of capital to trade.

Publicly listed equities (on Dalal Street, wall street, or any other exchanges) provide several advantages over the rest. The capital required for an equities portfolio can be very small and very big. The liquidity of the securities is large and you can generate good returns without the use of leverage. It is the only strategy in which once you have found a continuous compounding company at a good price it can generate wonderful returns for you for decades. This is the reason why Berkshire has been able to hold on to wonderful businesses for years.

#value investing concepts #dalal street #concepts

Volatility: Friend or foe of the value investor?

Volatility is the variation in stock prices. Mathematically it is the square root of the variance. The more a stock moves up and down the higher the volatility. Investors typically fear volatility and are much happier in lower volatility environments as it is perceived is lower risk. But image if you know that you have the opportunity to buy something at various prices every 365 days at prices that differ by over 50%? Wouldn't this be very exciting for you if you knew the value of the underlying security?

Efficient market theorists will tell you that the higher the volatility the higher the risk of the business. This is because they believe that volatility implies that the value of the business is actually moving up and down on a daily basis – and because of the fluctuations it could go down as well as up which is risk.

Value investors believe that the higher the volatility the more the opportunity to buy businesses at a discount to fair value. If a stock is likely to move 20% up and down from today’s price the probability of buying it 20% lower than today’s price is higher than something that only is likely to move 5% up or down.

The index given its diversification should typically have much lower volatility than individual stocks as per the efficient market theorists. In order to make sense of the volatility I would like to present a graph of the difference between the minimum and maximum value in the 365 day period preceding each date as a percentage maximum value divided by minimum value minus one. (The example index in this case is the CNX NIFTY on Dalal Street in India)

I think it would not take much for me you convince you that the value of all the companies in the index should move by on an average 54% each 365 day period. This volatility is what you need to take advantage of by buying when the price is right. I am not suggesting you start trading the index as a value investment strategy but the underlying stocks in most cases are even more volatile than this.

You will experience deep fear every time you buy something that falls by 30% but you need to understand the underlying business and not fear the quote Mr. Market is giving you.

#volatility #value investing concepts #dalal street #concepts

Has the advent of the internet moved the cheese of value investors?

Several of my blog readers have asked me whether the advent of the internet and digital age made markets a lot more efficient. It is true that it is much easier to get access to information today than it was before the digital age. For example till a couple of decades ago you had to order annual reports in physical form but today you can go to a website and get the information. Several value investing blogs, forums and social media have information about publicly listed businesses. The exchanges on Dalal Street and elsewhere provide tons of information on actions, financials, key dates, conference calls and more. The key management personnel are on facebook, twitter, LinkedIn and various other social and professional networks. You might even have them as 2nd or 3rd degree connections in the worst case. This could enable to get their bio-data and contact your friends to get impressions.

The truth is that there is an information overload and the amount of available information on a business CANNOT be processed by the portfolio manager. The key is not the quantity of information or even the quality of information but the ability of the value investor to discern the important parts and most importantly follow the rules and psychology of value investing.

The institutional performance derby continues as it did in the past. In fact some would say that the manic depressive moods of Mr. Market have been exacerbated to an extent because of the information overload. A general feeling of doomsday is coming or everything is rosy is far more likely to spread in an internet world because of the speed of information travel.

Trading volumes are an indication of the manic depressive moods of Mr. Market.

Data from World bank

http://data.worldbank.org/indicator/CM.MKT.TRNR/countries/1W-US-IN?display=graph

As you can see the global volume numbers are well over 100% which means that the entire market changes hands at least once a year. If you change 100% of your portfolio once a year you are bound to be fickle. No wonder many a value investor has said that one of the biggest advantages you can have is a long term mindset.

Delivery percentage of total shares traded is another great indicator. This means how many shares after changing hands actually ended up from the hands of a seller in the hands of a buyer. They may have changed hands many times during the day. So a delivery % of 50% indicates that the shares on an average changed hands 2 times during the day. A delivery percentage of 30% indicates 3 times and of 20% indicates 5 times per day!

Delivery % of NSE stocks

If shares change hands 2 to 5 times during a day I am sure you understand why I (and many value investors) believe that the market is not efficient. There is no way that the value of a company changes enough for the average participant to change his mind 3 times a day. I accept that some of this may be due to statistical arbitrage funds buying on exchange and selling on the other but both exchanges have a very low delivery percentage.

Needless to say that the internet age has made trading easier that it used to be in the pre internet days. The transaction costs are lower than ever. This reduces friction and the efficient market theorists say make markets more efficient. But this also gives rise to emotions of investors being expressed rapidly in the markets. People can trade on the move on mobile apps – so some are even trading while driving home. Bad behaviour of fellow commuters might even drive some trading!

#Sensex #portfolio manager #portfolio management #NSE #NIFTY #macro #index return #dalal street

Judging the quality of management

Management is a big issue in value investing in India. From the US perspective Buffet is of the view that you don't need a great management to run a good business and a business with poor economics cannot be turned in a business with good economics with good management. In India the control environment is not as great and thus investors are in the dark about how to judge management. My attempt here is to provide a framework checklist that can give you some cues into how to judge management.

Director Remuneration - Typically the whole direct set should not exceed lower of 1% of revenues or 10% of PBT. Higher numbers indicate that the management is more interested in getting compensated than driving up the value of the company.

I find that too low director remuneration can also be an issue unless the promoter is already a very rich person and is taking little salary.

History - if there is a history of delisting of securities one should tread carefully. A very wise investor once told me that the maximum amount of wealth is created when a management team after trying unscrupulous looking stunts comes back with a listed company and have tasted the salt of the market cap game.

Professional history - Professional history of each of the individuals also matters

Changes in auditors, CFO or legal council - can signal issues within the company.

Quality of audit firm - is highly important but given the history of Satyam computers case a brand name is not a perfect protection for investors.

Interest / other income from investments - If the investments or cash balances are not earning any income or are not clearly stated then it is a warning sign

High % of pledged shares - can mean the promoters have taken loans against the stock of the company. This per say is not a bad thing but can mean several linked things like over leveraging, betting more than they have, etc.

Cash flow from operations vs net income - if this is happening you need to be worried about overstated financials

Increasing working capital - If the working captial consumption is going out of control (Rising inventories, debtors )

Creditor balance - Too high a creditor balance can signal a callous attitude towards suppliers who are stakeholders in the sucess of the company like investors, lenders, customers and employees.

Low average employee compensation - This is a bad management scenario - and signals low quality of employees in the organization

Too much cash hoarding on balance sheet is a warning sign too - one needs to be careful of such situations.

Royalty payments to promoters is a warning sign as well

Investments in unrelated businesses are also highly bothersome

Focus on unlisted entity - while having a languishing listed entity is also a dangerous situation

If you decide to meet management BEWARE - they are excellent sales people and typically investors get mesmerized with management

There is a wonderful article by Ashish Kila (Perfect Research) on the role of management in long term investing that I highly recommend.

#value investing concepts #strategy #management #integrity #honesty #concepts

Circle of competence

Your circle of competence is the companies for which you can think like the owner, CEO or board. What does think like the CEO mean? It means you understand the:

· Products & services –

o what the product or service s

o How is the product or service beneficial to the customer?

· Customers

o Why they buy

o what are their alternatives

o how does this product or service benefit the customer

o what is the customer willing to pay for this

o How does this company create value for its customers?

o How loyal are the customers?

o Can the customers be made more loyal over time? Is the company taking rapid actions to make the customer more loyal?

· Suppliers & supplier economics

o How much control do suppliers have over the business?

o Can the business grow large enough to be able to control the suppliers?

o Does the business have supplier alternatives?

o How can the costs be controlled?

· Pricing

o How will an increase in price impact sales?

o Can cost increases be passed on to the customers?

o Can unreasonable price increases be done over time?

· Competition

o Is the competition smarter than this company?

o How can the company beat the competition?

o What are the advantages and disadvantages of the company over the competition? How will these evolve over time?

· Change management

o How rapidly is the customer, product, service, delivery

o Can this product or service become obsolete?

o Can the entire industry become obsolete?

o Is the company a change leader, follower or will it succumb to change?

· Industry

o What is the market size?

o What are the related products that can be forward or backward integrated?

o Is this company the industry leader or does it have the capability to be the industry leader?

· People

o How well are they compensated?

o Does the best talent work for this company? If not who does the best talent work for and why?

o How will the people costs evolve?

o Will the company be able to scale management like its people?

· Scalability

o How can the business be scaled going forward?

o How rapidly can the assets be made to sweat?

As you can probably guess – no one is born with a circle of competence. As you go along your value investing journey your circle of competence will rapidly expand. Over time your sense of an industry or business will improve rapidly if you continue to look incisively at companies.

Before you finalize on an investment I would strongly recommend you study a few of the competitors with the same level of detail. That will give you a sense of the overall business model. You should especially study the top few companies in the industry and a few of the large laggards. That way you can understand what drives success and failure.

Increasing your circle of competence is very important as it keeps opening new avenues to you. If you find something that you don’t understand going at it with all gusto is good but only to a point. Sometimes some businesses are best left alone. If the complexity is something you don’t understand it does not necessarily mean you are not smart. It may mean that you don’t have the pieces of the puzzle together yet or it does not suit your style of thinking. All businesses need not suit everyone. Examples of industries that some investors have been known to leave alone due to complexity in the past are technology companies and pharmaceutical companies.

#value investing concepts #strategy #concepts

Dolly Khanna's ridiculous 89% return in FY2015 so far

Yes - the Rajiv / Dolly Khanna portfolio is up 89% this year. I have tried to break this down in as many positions as I could find. All the December 2014 shareholding patterns are not out yet so some changes might happen to this portfolio as well. Wherever numbers for Dec 2014 were not available I used Sep 2014 numbers. I arbitrarily assumed around 10% (10 Cr to be exact) of cash at 31 Mar 2014. Learning:

17 open positions - concentration level is a bit lower than most value investing portfolios

High concentration in the top 4 - Over 50%

Only 2 loss making positions - Selan Exploration (due to wild swing on the oil prices) & Nucleus software

Returns so far from the reconstructed portfolio via public filings seems to be better than RJ as well - but yes this is a much smaller portfolio and to be fair RJ at this scale might have been generating similar returns

25% portfolio turnover so far in FY2015 is fairly low

Several multi-baggers in a single year

Return from 1 Apr 2014 89% 83% 87% 35% Total 196 191 195 141 104 Cash (assuming zero on 31 Mar 2014) 10 10 15 2 10 Portfolio Value 186 181 179 139 94 Stock 23-Jan-15 31-Dec-14 30-Sep-14 30-Jun-14 31-Mar-14 Cera Sanitaryware 27 23 21 17 13 Hawkins Cooker 25 21 18 21 18 RS Software 24 26 33 14 7 Huhtamaki PPL 17 15 17 13 9 Avanti Feeds 14 15 15 7 - Nilkamal 11 11 9 7 3 Liberty Shoes 9 8 9 7 5 Wim Plast 9 9 9 6 4 Aditya Birla Chemicals 9 9 11 8 6 Selan Exploration Technology 7 8 15 18 15 Nucleus Software 7 6 8 8 8 IFB Industries 6 6 - - - Manjushree Technopack 6 6 6 4 2 Asian Granito 6 6 - - - IFB Agro Industries 4 5 3 - - Premier Explosives 3 3 2 2 - Mold-Tek Packaging 3 3 2 1 - Heritage Foods - - - 7 5 Relaxo Footwears - - - - -

I don't understand the rationale behind the Asian Granito or the IFB recent acquisitions. Still working on figuring that out. My opinions on the rest were covered in a previous article on the Dolly Khanna Q2 FY2015 Portfolio.

#dolly khanna #concentrated portfolio #cloning

Pricing Equity Securities

Pricing is a topic of much debate and causes much heartburn. I am going to attempt to demystify the pricing aspect of securities and put into perspective the pricing of Indian security markets.

For the readers new to finance, I would suggest you read the following articles before reading this one: IRR, Dividend Yield, ROIC, Retained earnings

The Basics

100 rupees in the bank today are worth 100 rupees to you today as you can go to an ATM withdraw it and spend it right away. What are 100 rupees expected 1 year from now?

This depends on 2 factors:

Probability of receiving the 100 rupees

Interest rate

The lower the probability of receiving the 100 rupees the higher the interest rate. The interest rate at 100% probability is called the risk free rate. There is nothing that is actually risk free but government bond yield over the same period is called the risk free rate.

The probability of earnings in a company is far from risk free. Your interest rate (or discount rate as it is called in the equities world) is the return you expect from the security. For a company that is highly likely to produce earnings (for example a utility provider whose demand is completely inelastic) the discount rate assumption is typically AAA rated corporate bond yield net of tax. For simplicity in this discussion we will assume this yield to be 9.8%, which means a post tax return of 6.86%. Typically stocks with low single digit growth and high probability of consistency should trade at around 1/6.86% = 14.5 times earnings. Reason for 1/bond yield is because this is priced like a perpetuity.

The earnings multiple

The earnings multiple or P/E is typically a good measure of value. Assuming that the growth from the 5th year till the 10th year will be 8% and a 20% expected return on equity the implication of a P/E multiple is shown below. So if a stock is trading at a

AAA Coporate bond yiled 9.80% Net of tax yield 6.86% 5 to 10 year growth rate 8.00% Expected Return from equity 20.00% Dividend Yield 0.00% P/E 5 year Growth Required for a fair price 10 6% 12 11% 15 17% 16 18% 17 19% 18 21% 20 24% 22 26%

Another parallel analysis that I saw on Prof Bakshi's blog comments was to assume 15x multiple after 5 years and calculate the IRR assuming today's purchase price, dividends and the exit. Both styles of analysis give fairly similar results. For companies already trading below 15x earnings assuming an exit at 15x is a bit

Impact of Quality of company - the moat

The moat does 2 things:

Below a certian moat grade one should stay away. An example of this might be sponge iron manufacturers or oil miners or any miners where the protfitability purely depends on the commodity cycle. Those are dangerous as prices can move both ways and you are essentially buying commodity futures with higher than commodity futures risk. There can however be cigarette butt investment opportunities in the space.

The better the moat the lower the risk of earnings consistency and earnings growth. Higher probability of growth means that the growth This drives valuations of some companies to absurd levels where the investors are willing to take lower rates of rate. In reality taking a 6% discount rate and 22% growth rate you can even justify a 30x multiple. Such multiples are valid only in very rare cases.

P/E 6% 10% 15% 10 -2% 1% 6% 12 1% 5% 10% 15 6% 10% 15% 16 7% 11% 16% 17 9% 13% 18% 18 10% 14% 19% 20 12% 17% 22% 22 14% 19% 24% 25 17% 22% 27% 30 22% 26% 32% 35 26% 30% 36% 40 29% 34% 40% 45 32% 37% 43% 50 35% 40% 46%

Price/Book Ratio valuation

The role of price to book ratio is typically for relative valuation between companies but not in absolutes. Also book value is rarely marked up for asset appreciation so P/B for an older company will always be higher than a newer one. For special cases such as banks book value is fairly accurate and thus this becomes relevant for banks and financial companies.

Overall this is a valuation metric that I don,t know how to use.

Other considerations

Maximum growth of a company without altering capital structure is ROIC % x Retained earnings % - Assuming growth rates north of this is not practical

There is lots of literature out there that says that traditional measures of valuation cannot value super quality high moat companies. I don't understand that mindset. It is similar to the Phil Fisher mindset of growth investing and has produced wonderful results for several people but all stocks eventually get to levels that can be explained using simple methods of bond valuation.

Wild valuations can happen when tulip mania type activities occur. I think the power grid price soon after the IPO reached 160/share when the EPS was something like 3.25/share. Even at a discount rate of 6% a physical utility like power grid is unlikely to grow 30% a year for 5 years so that valuation was definitely too high.

Price is the biggest driver of risk

Nothing is more important than the price you buy at. To illustrate this:

Entry Price Exit Price 5 Year Return 80 200 20% 90 200 17% 100 200 15% 110 200 13% 120 200 11% 130 200 9% 140 200 7% 150 200 6% 160 200 5%

If the price doubles the return falls by 4x!

Overall pricing equity securities is a very vague & ambiguous science when it comes to deciding what growth and what expected return is required. Overall the goal is to buy things at a rational price where the valuations are not exuberant.

#valuation #risk #pricing

The Rakesh Jhunjhunwala Portfolio estimate

I have made an earnest attempt to find out all the positions of fabled investor Rakesh Jhunjhunwala (RJ). Unfortunately I don't know of a good shareholding screener that will give you the history. The best one out there is from moneycontrol.com but it is not able to give you the exact data - maybe because it runs with the exact investor name and does not group across investor vehicles. All the data for this article has been taken from the BSE and NSE websites.

These are purely estimates and I have no clue about several other stocks that RJ might own. I have arbitrarily assumed 10% cash on 1 Apt 2015. He of course owns the right stuff given that he has outperformed the index by a large number.

Learning from the portfolio:

For a portfolio that is worth 0.1% of the market the number of positions is relatively few - at around 30

High concentration in top few positions - Top 2 positions account for 50% or so and 66% in top 4

Net trading is very low - less than 20% of original portfolio value over 3 quarters. Maybe there is more trading in and out but this is the net change in position.

There are 5 names that are listed only on the BSE

Numbers are in INR Crores.

Return from 1 Apr 2014 50% 42% 41% 31% Total 8,731 8,271 8,219 7,606 5,816 Cash (assuming zero on 31 Mar 2014) 236 236 431 529 500 Portfolio Value 8,496 8,035 7,788 7,077 5,316 Stock 23-Jan-15 31-Dec-14 30-Sep-14 30-Jun-14 31-Mar-14 Titan 3,220 3,012 3,213 2,767 2,110 Lupin 1,066 1,022 998 737 690 CRISIL 840 760 806 717 492 Rallis 461 426 443 442 340 Karur Vysya 211 201 186 196 158 Delta Corp 149 141 138 144 154 Aurobindo Pharma 354 339 289 222 153 Geometric 167 156 177 178 142 VIP Industries 115 111 106 103 131 DHFL 238 194 167 185 112 NCC 487 551 116 239 106 Agrotech Foods 136 120 115 118 92 Praj Industries - - - - 79 Escorts 85 86 102 91 77 TV18 Broadcast 104 90 82 82 64 Firstsource solutions 74 87 101 103 63 Kesoram Industries 92 92 81 81 54 Anant Raj 35 35 41 57 43 Geojit BNP Paribas Finacial Services 81 76 82 73 40 Pipavav Defense and Offshore 126 127 99 145 35 Prime Focus - - 28 56 31 Radico Khaitan - - - - 29 Sterling Holiday Resorts 70 57 50 42 24 DB Realty - - 18 20 15 Spicejet - - - 19 14 McNally Bharat Engineering Company - - 14 15 10 Viceroy Hotels 11 11 13 15 10 Bilcare 13 9 14 18 10 Hindustan Oil Exploration - - - - 9 Autoline Industries 9 9 12 12 9 Ion Exchange 23 22 18 16 8 A2Z Maintenance & Engineering Services 5 5 7 5 8 Prozone Capital Shopping Centers 11 10 5 7 6 Adinath Exim resources 0 0 0 0 0 MCX 175 169 161 45 - Edelweiss Capital 70 54 47 62 - Orient Cement 46 38 33 24 - Prakash Industries 21 23 23 44 -

Other companies that he was involved in but no longer seems to be invested in are:

Pantaloons Fashion Retail Orchid Chemicals & Pharma Zen Technologies Provogue Subex Future Retail B-DVR Alphageo Reliance Broadcast Network Aptech HT Media

I will try to cover a few of these names over time.

If there are companies I have missed from news stories or the BSE website please post them on the blog comments.

#rakesh jhunjhunwala #cloning

Institutional (short term) performance derby

I got this phrase from the Seth Klarman book on value investing - "Margin of safety". My attempt here is to put this into context of the Indian markets.

Market participants

Overall a large percentage of the Indian markets are owned by FIIs. The number has been steadily rising since 1992 making the markets more and more linked with the global financial system. The percentage of volume on the exchanges is now over 22%. So the gyrations of the market are similar to the global system. Mutual fund penetration in India seems low at 9% of urban households versus 46% in the US. But that is probably because of much lower investment money available to most households and lower banking penetration. The FII volume in India as of Jan 2015 is about 3 times the DII (Domestic Institutional investor) volume which basically means that the institutional activity is driven by FIIs. Overall FII + DII constitute about 80% of the total volume. This 80% of market activity drives the institutional performance derby.

Short term index beating performance rat race

What makes an asset management company successful? NO the answer is not returns. The answer is assets under management. Given that around 80% of the market trade is in with institutional investors it is not necessary for the largest institutional investor to be the one with the best returns. Returns are the marketing key for each institutional investor. This is why most asset management companies (AMCs) have several funds. The idea is that some fund or the other will be outperforming and that will be used by the sales force to market the product. This means that all fund managers working for the AMC will be given a key result area to deliver better than market returns year on year, quarter on quarter, month and month - and YES day on day. The most rational way to do that is for the fund manager to play the momentum trades - buy the fad of the day. So instead of investing the manager has pressure to become a fad picker. The investors also have a choice to go in and out of the funds (with a fee ofcourse) which makes capital highly mobile thus increasing the pressure to be ahead of the fads.

Roadblocks for sound institutional money management

Too much information is available and with the advent of the internet it is not possible for a money manager to know everything about even 10% of their portfolio. Most fund houses own several stocks making the task even harder. Research is typically provided by brokerage firms which also have investment banking arms. The research team, although is supposed to be walled off from the investment banking team, has incentive to write reports that favor their clients over others' clients. This makes research highly biased from brokers and should always be taken with a pinch of salt. Given high liquidity requirements of investors - illiquid but high quality assets often get ignored. Most funds are under pressure to be fully invested at all times. This is because there is a fear of under performance if the market rallies. So even when stocks are trading at absurd prices funds are forced to buy. Secondly many managers believe that market timing is the job of the investor putting money into the fund - and their job is to pick companies/stocks. All these factors lead to managers ignoring the fundamentals.

Indexing - invest without thinking

Many a financial literature has recommended investing in index funds as the cost is low and because the average performance of the mutual fund industry is index return minus fees. While this is true if too many people participate in indexing (which they probably are) the stock picking job becomes that of the index maker. Now most index companies will invariable carry a premium to ones outside the indices when there is a bull market and a discount when there is a bear market.

Why is this good for value investing?

This institutional short term performance derby is responsible for an overreaction of the markets in both directions creating opportunities for the astute value investor sharply focused on fundamental value. The pitfall is that several value investors start feeling the pinch when they are sitting on cash and the market is rallying. There is a strong urge to follow the fad and get out before the peak - this is a very dangerous urge and needs to be avoided at all costs.

#value traps #value investing concepts #value #strategy

Greenply Industries: Good quality but overvalued

21 Jan 2015 I have to start this one by saying that Greenply Industries definitely makes beautiful looking annual reports. I know this brand from furniture shopping trips and ads for the last 2 decades but little did I know that it is the largest interior company in india, Largest laminate manufacturer in Asia and the 3rd largest laminate manufacturer globally. The laminates business is in the process of being de-merged and the stock is trading ex-record date.

1. How good is the moat?

Grade: B

Brand: Replication cost and timeline are both massive. This is a household name in India and chances are if you are telling your furniture store to use something it will be greenply or greenlam. Plywood manufacturing licenses are also hard to come by.

Technology: nothing great. MDF has some edge. Its pretax margins are high.

Performance during recessions - this is the opposite of recession proof. The good news is that construction and housing is likely to grow rapidly over the next few years owing to the positive outlook on infrastructure by the government.

Pricing power - The industry has low pricing power but when it comes to commercial establishments and housing - most professionals would like a brand. Here branding will play a similar role to branding in the cement industry.

Very high market share - 32% in plywood, 28% in laminates and 30% in MDF. In MDF Greenply is 40% of the installed capacity so overcapacity maybe a problem. Overall India's consumption of MDF is low at 0.5 mil m3 versus China at 30 mil m3.

The Laminates business has been demerged and today you cannot buy stock of the laminates business as it has not been listed yet - but the stock is trading ex-record date of 27 Nov 2014.

Overall being the market leader and good prospects I would say the moat is good.

2. Risks

Biggest risk I see is the employees - there are too many of them and thus average compensation is low at 4.2L/employee per year. Also sales/head is not going up which is a matter of huge concern as over time this can lead to lower increments leading to resentment and tough situations for manufacturing companies.

Low margin business - Over time if the brand can be made stronger maybe this company can expand margins but for now its a bit dicey.

Myanmar is the single largest source of raw materials for the company. Myanmar government is banning timber exports and thus the company is planning to setup a plant in Myanmar.

3. Financials

Debtors % of sales is decent at 16% - it is a bit high for my liking but nevertheless decent.

ROIC is decent at 14.9% and ROE at 20% or so.

Inventory % of sales stands at 19% or so which is a bit high but seems to be the norm in the business

Cash flow from operations exceeds Net income which is a good sign

Exports are around 15% of the sales and growing rapidly but the imports section is about 1.5 times of the exports.

Dividend % of earnings is low at 7.2% but that can be justified by the massive room to grow.

One has to adjust the earnings stated by the amount that the laminates business makes. Now the interesting thing is that in the demerged entity the plyboard and MDF board business has higher returns on capital than the laminates business so it is a better quality company than the financials show but the EPS of the stock you can buy today is lower than what might show up on websites.

4. Soft factors

A great advantage is that the company is aggressive and has clear global ambitions. It has the wherewith-all to understand that installing a plant in Myanmar might be an excellent investment as well a secure source of raw materials. I like that.

Presentation as I already said is wonderful. This can be a bad thing because a company trying to woo investors could be doing that but the marketing material seems to be good.

One the companies reporting late financial results on 5th Feb 2015 for the 31st Dec 2014 quarter. I always feel late reporting companies are not as smart as the ones who report sooner. In fact this is one of the new companies whose December 2014 shareholding patter is also not out yet.

Volume - Total trading volume daily is average at 50L but there are days of 1.2L of trading as well. This makes the stock susceptible to larger mis-pricing up or down factors. The are also days of 19Cr+ of trading.

Price on BSE and NSE sometime varies as well. I don't understand why.

5. Pricing

One has to be careful with the pricing as the stock is trading ex-record date of the demerger. So a buyer today would NOT get the Greenlam demerged entity

Stock is trading at around 20 times TTM earnings. Now the real estate sector is in the doldrums and this stock is going to be affected by that kind of activity but going forward I think the next 5 years more housing and commercial establishments are going to be established than the last 10.

Unfortunately I think today the margin of safety is absent and the stock is trading around or over what the company is worth.

The demerged financials are also a source of concern - While it is probably possible to create the exact financials of the demerged entity in a spreadsheet - I would put this in the too hard bucket as the valuation on the face of it is high.

#plywood #plyboard #MDF #infrastructure #housing #GDP #commercial real estate

Nucleus Software Exports

This is my review of Nucleus software exports from earlier in Jan. --- Nucleus software is a financial software provider to the banks with a geographically diversified customer base. Currently cash on the balance sheet is worth about 50% of market cap and the stock seems quite cheap. The question really is whether the earnings can be grown.

1. How big is the moat?

Grade: B-

Brand replication cost: Brand is decent and the chances of banks hiring a new firm to do their financial software are very low. Customers in this case are likely to be sticky just because of the fear of switching

Brand replication timeline: For a new company it will take very long to establish the kind of trust and track record that this company has

Ease of product/technology replication: A large software company may be able to replicate this fairly easily but not necessarily make it bug free and something that lots of financial institutions will jump it

Sales and distribution replication: This will be highly challenging.

Vendor relationships: Nothing really special. Creditor % of sales is fairly large at 19%+.

Employee relationships: This is a good area. Average compensation is ~12L/year which is higher than even some of the larger companies. 24L sales per employee which is excellent as well. Not as good as RS software but somewhat better than TCS. Even top management remuneration is only 0.5% of sales which is an excellent sign.

Performance during recessions - Will not be great but banks will have to use software as the regulatory environment is forcing them to be highly compliant with esoteric laws - the kind of compliance only a computer can do.

Pricing power - Once a long standing customer is established pricing power should be good. Entry level pricing power will be weak.

2. Risks

Growth sources - Compliance at banks will be a good driver of growth. Also overall in the developing world banking penetration should rise. In the developed world smaller banks who have not discovered financial software from cheaper and reliable sources like India will be a growth driver. Middle east and Africa business is growing rapidly.

Obsolescence risk - Fairly low. Banking transaction and compliance is not likely to become simpler for a long long time.

Debt/financial risk - little. There is cash on on the balance sheet which could be squandered away but that is unlikely too.

Transparency - Doesnt seem to be a big issue. Reporting is fairly rigorous.

Customer creditworthiness - Debtor % of sales is at 11% or so which makes this a fairly moot point. Even so creditworthiness should be decent.

Parent company risk - none

Long research/product development cycle - not really.

3. Financials

FX exposure - Net foreign exchange earner. Given the high inflationary environment in India typically net foreign exchange earner is a good thing. Given that oil is down and the current government is making a massive push for development, FDI, FII and other capital inflows might reverse the decline of the rupee so I am a bit concerned.

Options dilution - options were last issued in 2005 and 2006. There are none outstanding at the end of 2014.

CFO % of PAT is 78% which is a bummer. Some part can be explained by subsidiary company dividends. Rest of it is from financial instruments that are on the balance sheet.

Exceptional items - financial instrument income which contributes 20 Cr to the PBT and 14 to the PAT.

Inventories - nothing to talk about.

Margins - Minimum in the last 5 years has been 9.4%. Average margins have been 13% but latest margins are 17% which could be a flash in the pan. Latest Q margins are 14.8%

Lots of overseas subsidiaries.

ROE and ROIC are high at 16% and 65%+ respectively. The ROE is not higher as there is cash on the balance sheet.

4. Soft factors

The stock is a Dolly Khanna holding. She bought and declared in the Mar 2013 filings.At that time the stock was trading between 75 and 80 per share. Which was extremely cheap for this as there was a fair amount of cash on the balance sheet.

In the latest quarter ICICI Prudential mutual fund has sold 84K shares or 7% of their stake.

Deloitte is the auditor.

5. Pricing

After backing out the cash and the return from the non-business related investments the stock is trading at 6.5 times earnings at 200 INR/share. I think around 10% a year of earnings growth can be expected which should generate a decent return over 5 years.

There is about 95 INR/share or so of cash & non-business related investments. This could be a good and a bad thing. The company could squander the money or may not be finding opportunities to grow.

BSE: 531209

NSE: NUCLEUS

ISIN: INE096B01018

#IT services #financial software #dolly khanna

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