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Dec 20 12

The Quest for Multi-Bagger

by Altais

‘‘Multi-bagger’’ is the dream of every investor in the stock market. So it’s pretty logical that it’s also the most abused word in the markets. Every stock is touted as a potential multi-bagger, though most turn out to be ‘multi-beggar’ !

Yet, the quest for finding multi-bagger continues…

Recently, there were couple of nice examples of some multi-baggers.

Rakesh Jhunjhunwala discussed his investment in Prime Focus.

“I bought Prime Focus stock at Rs 4 and held about 10 percent in the company. Goldman Sachs offered me  Rs 115 over a period of four years.”

http://www.moneycontrol.com/news/market-outlook/motherbull-markets-is-aheadus-jhunjhunwala_777078-2.html

From Rs. 4 to Rs. 115 – that’s 29 times in 4 years, CAGR of 132%! Something to definitely probe deeper!!!

First, some basic stock history:

Looking at the chart and IPO prospectus, RJ is talking about the period 2004 – 2007. He invested the money in Jun 2004 before IPO at Rs. 6.6 (all share price adjusted), and the company came out with IPO in Jun 2006 at Rs. 41.7. The stock listed at a discount at Rs. 37 and reached Rs. 140 during the frenzy of Nov 2007 – Jan 2008. The stock subsequently tumbled to Rs. 5 in Mar 2009 and is now at Rs. 45.

Now the more important analysis:

The company reported a PAT growth of 4 times between 2004 and 2008. Great! (including through acquisitions, but we are not analyzing the company as of now). But what really explains his return of near 20 times is that his initial forward P/E was 7, and the high he was offered was around P/E of 40!! By the way, the P/E is back to 7-8 times!!!

The second example is of Bhavook Tripathi value hunt in FAG Bearings in Outlook Business magazine.

http://business.outlookindia.com/article.aspx?282963

He bought FAG Bearings at Rs. 20 around the year 2000, and sold the bulk at Rs. 500 in year 2006. 25 times in 6 years – CAGR of 71% over 6 years!

Since we don’t have exact data points, I have tried to calculate the approximate timelines. Between Oct 2000 to Oct 2006, the company’s stock price rose from Rs. 33 to Rs. 590, CAGR of 62%. During the same period, sales growth was only 18% and PAT growth was 34%. Importantly, P/E grew from 4 times to 13 times.

In Prime Focus, the P/E expansion was 7 times, while PAT growth was 4 times. In FAG Bearings, the P/E expansion was 3 times, while PAT growth was 6 times.

For a multi-bagger, both P/E expansion and Earning growth are important. Buying a stock at 40 P/E is unlikely to yield a multi-bagger. However, a low P/E stock without Earning growth is also unlikely to get rerated to higher P/E.

Further, there is an interesting comparison between SKF India and FAG bearings (within industry comparison) in the same period. Look at the following chart:

SKF looks far better on every parameter in this period. But what about stock returns? Well, SKF India returned CAGR of 42% in this period. Great. How about FAG Bearings? 62%. What, how? FAG Bearings P/E moved from 4 times to 13 times, while SKF India’s moved from 25 times to 16 times, still justifiably higher than FAG Bearings.

So FAG Bearings outperformed SKF India by starting at much cheaper valuations, and showing good growth to deserve higher valuations.

To reiterate, for a multi-bagger, both P/E expansion and Earning growth are important. Buying a stock at 40 P/E is unlikely to yield a multi-bagger. However, a low P/E stock without Earning growth is also unlikely to get rerated to higher P/E.

What about the Test of Time? FAG Bearings stock is still 3.5 times up from 2006 levels and maintaining its P/E of 14 times, while Prime Focus stock is at a third of its 2007 peaks (and closer to 2006 IPO price), and has again fallen to single digit P/E. In this case at least, Bhavook has scored over RJ. His company has continued to perform, and his exit was not based on getting very high P/E to make a killing.

Dec 11 12

Buying AAA quality at BBB prices

by Altais

Donald Yacktman is one of the not so written about Investment Gurus, maybe because he is neither fully in typical value camp, nor in typical growth camp.

He, along with team, manages around USD 7 billion through the Yacktman Focused Fund and the Yacktman Fund. In the last five years (to 2011), his cumulative return is 47.2%, compared to -3.1% for the S&P 500. He has also beaten 99% of his peers in the last three, five, ten and fifteen-year periods. (source: gurufocus)

I had earlier also read his interviews, but could not fully appreciate the wisdom of his approach. My recent experiences in equities and vicarious learning from other investors I observe, led me to re-read his interviews. I have got fully hooked on, and have been reading all I can find on his approach. I would advise you to do the same!

I read the following:

http://www.gurufocus.com/news/187901/donald-yacktman-interview-with-gurufocus

http://www.gurufocus.com/news/171597/investing-great-donald-yacktman-answers-gurufocus-readers-questions

http://online.barrons.com/article/SB50001424052970204582404576214643228390606. html#articleTabs_article%3D0

http://www.yacktman.com/pdfs/flexiblevalueinvesting.pdf

http://www.yacktman.com/pdfs/value_investor_20091231.pdf

In the spirit of Lawrence Cunningham collating excerpts from various annual letters of Warren Buffett and neatly arranging them in relevant headings, I have attempted to do the same.

Investment Goals

Our process is basically is a function of our goals. The first one is, protect the clients’ capital over time. This is a portfolio level goal, and understand that not all investment ideas will work out. We have a significant amount of our personal net worth in our strategies and we manage them as though we were managing a client’s entire net worth.

The second goal is obtaining what we’d call equity-type returns, approximately double-digit annualized.

Our third goal is to beat the (S&P 500) index over a full peak-to-peak cycle. If you go back and study our results from the times when the market has peaked, I think you’ll find that the performance has been very, very good. More importantly, I think that our risk-adjusted returns are really excellent, and that’s what it’s all about.

(Most investors focus on 1st and 3rd goal, 2nd goal is equally important.)

Defining Quality of Business

We think quality is a combination of characteristics. We like to start with high return-on-asset businesses. We also like predictability. We prefer businesses that have fairly stable operating results in both good and challenging economic environments. Below is a simple chart we use to demonstrate characteristics we like.

We believe that companies that have low capital intensity and low cyclicality like Coke (KO), Pepsi (PEP), or Proctor & Gamble (PG) have the ability to earn some of the highest returns. What you’re looking for is both the low asset requirements and low cyclicality. It is at its best when a company sells a disposable product or a recurring service. We also like to see a large market share.

We’re not usually looking for the scruffy cyclical or turnaround story, but for businesses with high market shares in their principal product or service lines, with long product cycles but short customer – repurchase cycles, and with relatively low capital requirements that allow the company to generate high cash returns on tangible assets while growing. We’ve always considered businesses requiring enormous amounts of capital for fixed assets, especially when they’re economically sensitive, to be at a big disadvantage. That’s why something like the airline industry has been a growth business for most of the past 100 years but doesn’t make any money for shareholders.

Something we find that isn’t often fully recognized by the market is how incredible the returns on the marginal unit sold can be for low asset- intensity businesses with strong market positions. That’s why growing businesses can pay off so well – you get the one-time appreciation from a lower base to a higher base, but on top of that you get the compounding effect of significant operating leverage.

The Triangle

Basically, we are investors in businesses and we view the selection process as though we were buying a long-term bond. Our logo is a triangle.

1. The base of the triangle is a low purchase price. We look at businesses as if we were going to buy them and own them for a long period of time. We look at the rate of the return we would earn and the quality of those businesses. The higher the quality is, the lesser the required rate of return. It’s very much like a person buying a bond. But we don’t like to calculate returns to the fourth decimal; we try to make sure we have a lot of room for error.

Think of everything being priced against the long-term Treasury, and we want to see a large spread over what the long-term Treasury yield is.

Then we try to get as much as we can of the other two sides of the triangle, namely good businesses run by shareholder-oriented managers.

2. On the good business side, our sweet spot is businesses that have low capital intensity and low cyclicality. One of our largest holdings, for instance, is Coca-Cola (KO). It fits our criteria very well. We will also move away from those components if the rates of return are adequate for the additional unpredictability that comes with the business, whether it has more fixed assets or more economic sensitivity. We have moved in both directions, but we don’t typically invest in businesses that have both enormous amounts of fixed assets and cyclicality. The airline industry would be the classic example. Coca-Cola is the opposite side of the grid. If you think of it like a bond, we’re buying high coupon bonds.

3. The third part of the triangle is the management. The difference between a stock and a bond is with a bond, the investor reinvests the cash flow most of the time. In the case of an equity owner, a lot of the reinvestment is done by the manager, so we like to evaluate the manager on the basis of how well he has invested cash in the past. We look at five basic options the manager has. The first option is putting the money back into the business through R&D, marketing, cost reduction, distribution, etc. The second option is making acquisitions, but the acquisitions should be synergistic and the manager should not pay too high a price for them. The problem is, in a lot of cases, the egos of managers get in the way of doing a proper job. Another option is buying back stock, which is buying more of the same. The fourth is paying a dividend and the fifth option is paying down debt or letting it accumulate, which is pretty much the same thing.

(Thinking of equities as bonds is great, with accepting lower returns for high quality & predictable business, and swapping only when risk reward greatly in favour)

Forward Rate of Return

This number is a calculation of a normalized free cash flow yield plus real growth plus inflation. If the business is stable, this calculation is fairly straight forward.

<Nov 2009> The first thing we do is normalize what we think the company’s earnings power is. A lot goes into that, but it essentially means looking at what the business has traditionally been able to generate over time and adjusting for various factors that might make it more or less attractive going forward. We then estimate the percentage of those normal earnings that the company will keep after things like capital spending and investments in working capital, resulting in a free cash flow number we can divide by the current market value to get a freecash- flow yield. On top of that we’ll add inflation and the annual growth in free cash flow we expect in order to arrive at our estimated rate of return.

As an example, Coca-Cola [KO], whose free cash flow is a high percentage of net income, trades at a free-cash-flow yield on our normalized numbers of about 5.5%. Inflation adds another 3% and we assume another 2% in organic growth, so that gives us an estimated compound annual return of 10.5%.

Compare that to the S&P 500. We estimate normalized per share earnings for the S&P 500 of about $60, of which you keep maybe 45% as free cash flow. At 1,100 on the index, the resulting $27 in free cash flow gives you a 2.5% freecash yield. Add on 3% inflation and 1.5% for cash-flow growth, and we believe the average investor today on a cash basis is looking at a 7% annual return from the market.

Given our belief that Coca-Cola is a higher-quality business with lower risk than the average S&P 500 company, it should trade at a premium to the market, not a discount. When an excellent company like this trades at a solid annual rate of return and that kind of discount to the market, that’s attractive to us.

<Apr 2012> For instance, on the S&P 500 we would normalize earnings. We would then calculate what percentage of those earnings are not reinvested in the underlying businesses and are therefore free. Historically, for the S&P 500, this has been just under 50% of earnings. Currently, we expect the S&P to earn about 70 on a normalized basis, a number which is far below reported earnings due to our adjusting for record high profit margins. $70 X ½ / 1400 gives you a normalized free cash flow yield of approximately 2.5%.The historical real growth rate of the S&P 500 is about 1.5%.

Assuming an inflation rate of 2.5%, the forward rate of return on an investment in the S&P 500 is about 6.5% today (2.5% free cash flow yield plus 1.5% real growth plus 2.5% inflation).

One thing I would like to point out is, if we’re looking at a company and it has a forward rate of return of 12% and another one has a forward rate of return of 20% and we buy it, we don’t necessarily get that extra 8% a year right away. The market might not recognize what we see and the market may take a few years to play out. The good news though is that 8% a year of excess return is accruing in the background. Then it will just explode to the upside when the market finally realizes what we realize. We’re not really worried about whether or not the market recognizes it right away. The good thing is when the market does finally recognize it and also presents us with other opportunities, we are able to move rapidly from one to the other

(Look at current free cash flow yield and not 5 years in the future as the starting expectation – at 5% free cash flow yield, it will eliminate paying more than 20 P/E for any stock as FCF will be lower than Earnings)

Fascination with Consumer Stories

Most of the consumer businesses we own make disposable products with very little economic sensitivity. The consumer goods I’d still be somewhat concerned about in this economic environment are those that have long lives, like autos and appliances, where the replacement decision can be easily delayed.

This goes back again to what we said earlier about the virtue of companies without heavy reinvestment needs. The average company has to pour more than half its earnings every year back into the business to maintain itself. If you don’t have to do that – like most consumer products companies, for example – you have more to invest in new businesses, to give back to shareholders, or to keep on hand for a rainy day. That’s a huge advantage that we don’t think people are correctly evaluating.

Assessing Management

The most important aspect of analyzing management is how well they’ve invested cash in the past, not what they say they are going to do. Because we typically own companies generating a lot of free cash flow, we’re in trouble if management doesn’t allocate that cash wisely.

(See what I do, not what I say)

Swapping quality for valuations

There is no magic decision point, however when the potential rate of return becomes significantly higher on a less predictable security, we may be willing to trade quality for valuation. Each situation is unique to the security we appraise. In 2008-2009, we think we generally moved from high quality to slightly lower quality that was offering significantly better rates of return. We generally avoid low quality unless we expect that we can manage the downside and get paid extremely well compared to alternatives.

We generally demand an annual high single-digit or low double digit forward rate of return for a high quality business and more for one we think is lower quality.

Edge over Market

People often ask us what unique insight we have in buying something like Pepsi. It’s almost as if to be considered astute, you need to have some complex thesis that no one else comprehends. The fact of the matter is that there are times when quality businesses are undervalued and we just have to be smart enough to recognize when that is and own them. It doesn’t have to be more complicated than that.

There was an article in the 1930s, describing what a great growth story Coca-Cola was. It went on to say, though, that it was too late to benefit on the stock because the story was so well understood. Sometimes the market understands, and sometimes it doesn’t.

On Selling

Many people set a price target by saying, “Okay, I think it is worth $X.” Well, we don’t think that way. We look at what the forward rate of return is, stack it up against other investments and determine which one is the highest and which one is the lowest and what risk we are taking to get that rate of return. We account for things like leverage, cyclicality of earnings, and the quality of the business.

A sale is triggered by two things. If the rate of return is not sufficient or if there is a better opportunity elsewhere with a larger margin of safety to get a similar or higher rate of return, we’ll sell it.

On being in Cash

But in the present environment the dollar is being deflated and the Treasury rate of return is very low. At some point we say, “Hey, the rate of return of an investment is not acceptable to us.” We walk away. It’s the hardest thing to do because we have to wait for something else to come along. We can’t create something out of nothing.

Unfortunately, in an environment where everything goes up, is fewer of these returns are satisfactory and we end up more heavily in cash. It’s not that we’re trying to time the market; it’s just there’s nothing to buy.

But the reality is that in a typical year, the average large-cap stock fluctuates about 50% from its low to its high. If you’ve done your homework and you’re patient, more than enough opportunities will come along.

(Be patient, prices will come to your buy price)

On Diversification

We’d love to be widely diversified if everything had the same return characteristics, but they obviously don’t. There are some rules on diversification for mutual funds, but we basically rank the stocks that meet our minimum-return requirements and try to have as much of the portfolio as possible in the companies with the highest expected rates of return, adjusted subjectively for risk. Right now that leaves us with around 50 positions in the Yacktman Fund, with close to 60% of the portfolio in the top 10.

In our less-restricted accounts, we have 75% of the portfolio in the top 10 – we’d sleep well at night with that at 100%, but that doesn’t work for most clients. As a result, we spread the last 25% in names that are typically smaller and with very high potential, but with more expected variance in the outcome.

Risk Management

Ultimately, in our minds, risk is losing money. There are two ways to minimize risk. One is by making sure the forward rate of return is significantly higher than Treasuries or at least is high enough on a historical basis to justify making the purchase. The other thing is to take into account quality measures so the amount of risk taken as a business owner is warranted. We take into account things like cyclicality, leverage, management and other kinds of considerations that would influence the rate of return. We used to comment on the difference between Coca-Cola and Tyco as being like comparing a AAA bond with a single A bond. We basically come back to the grid of looking at the forward rate of return and level of quality.

To us, that’s risk management, looking at the individual security and making sure we were correct about our assumptions and know what we bought and have a high degree of confidence we are going to get our money back in the worst-case scenario.

(Valuations and Quality as cornerstone of risk management)

Avoiding Value Traps

I tend to favor “escalator”-type businesses over what I call “moving-sidewalk”-type businesses. Businesses that earn high returns on tangible assets and can grow their units have an edge over the other kind.

We think the best way to avoid a value trap is to have a company that produces durable free cash flow.

That doesn’t mean you can’t make money on the slower-growing or non-growing businesses, if you buy them cheaply enough. That’s the key. But what happens is, you get that one-time revaluation, you need to get it quickly, and once you get it you need to move on. A value trap, to me, is a grubby business not bought cheaply enough.

Time will tell.

(Quite in line with our earlier post http://altaisadvisors.com/blog/2012/04/11/hidden-value-or-value-traps/)

Macros

Another one is that our attitude has been… we should focus on things we can control. We believe you can find investments that could do well even if the economy is challenging or the market suffers. Even though the U.S. stock market has done poorly since 2000, we have achieved strong results because we focused on and invested in individual securities. We can set the sails, we can’t control the wind. It’s fun to talk about the economy, don’t get me wrong… I’ll be happy to answer your question directly. But when push comes to shove, it’s what you buy and what you pay for it.

We spend almost no time trying to forecast things like inflation, interest rates and the value of the dollar, but we do try to pay a lot of attention to cycles in how we normalize earnings. If margins are at a peak, for example, we don’t necessarily assume they’ll stay there forever. That alone kept us out of a lot of the financials that got hurt the most in the meltdown.

Overall Market Valuations

Ultimately, however, investing for us is about valuing individual businesses. If we find good investment opportunities we are not generally concerned if with think the overall market is overpriced.

Taking advantage of Blood on the Street in 2008

Going into this downturn, we had some cash, but we also had a lot of defensive stocks, the Cokes and the Pepsis (PEP) of the world, and these companies initially held up quite well.

We were able to take advantage of the downturn by using our cash to purchase bargains.

After the cash was gone, we were able to essentially rotate out of consumer staples, the Cokes and the Pepsis that had held up well, and rotate into consumer-based cyclical stocks. Some cyclical stocks were trading at extremely high cash yields. So we bought USG (USG), and the retailers Williams-Sonoma (WSM) and Abercrombie & Fitch (ANF). By the time it was all done, we were buying Bank of America (BAC) and Barclays (BCS). So we were able to take advantage of the pricing disparity. Since the market’s bounce off the bottom, those stocks have performed quite well. The other area we bought into heavily was media — companies like Viacom (VIA) and News Corp. (NWS). We’ve managed to outperform on both the downside and the upside.

Looking forward, we will objectively examine our options. If we are going to get the same return, we’d rather own Coke than a bank stock or a cyclical stock. At that point, we can move back into the Cokes and Pepsis of the world and be protected.

(Note the sequence – Consumer Staples, Consumer Cyclicals, Financials)

Avoiding reversion to mean for fund managers

We think continuity of the investment team is one of the keys to long-term success. All of the key members of our investment team today have been at the firm for more than a decade and are significant owners of the firm. We also think good investing is about being flexible. Many firms have experienced performance reversion because what is successful in one period often fails to sustain. We also think it is important to recognize that producing strong results over time does not mean that your investment style will work in every short period of time.

Motivation

I’m motivated just to try to be better. I see this world as imperfect people helping other imperfect people move toward perfection, and I just want to be better in all aspects of my life: investment; as a husband; as a father; as a grandpa; and as a member of the community.

Multiple Contraction at Walmart

Over time the multiple declined as investors slowly recognized the growth would be modest. The business executed fairly well during the period of multiple compression which is probably why the multiple came down slowly.

Thoughts on RIM (Blackberry)

Here’s the dilemma with it. It has a wide array of possible outcomes. We felt we had protection with the balance sheet and customer base, but given the history of dramatic leadership change in the cell phone industry, people are nervous. I think you have three pieces. You have the cash and excess working capital, you have the patents and you have the embedded customer base. The real problem has been delays in getting a new phone to market. The length of time without a viable product has caused the customer base to become an ice cube on a hot day.

(I like the phrase “ice cube on a hot day”)

Nov 6 12

The Liquid Oxygen Stocks

by Altais

There is a famous Ajit joke – “Dump this man in liquid oxygen. The liquid won’t let him survive, and the oxygen won’t let him die !!”

There are quite a few of these stocks in the Indian Markets today – which have high amount of net cash on the balance sheet, in comparison to the Market Cap of the company. The presence of cash acts both as a support for stock valuation as well as gravity to stock price increase, atleast till the time the cash is converted into a profitable business of some significance. In all these companies, the cash was gained by sale of substantial part of the business, at great valuation to MNCs in non distress business condition. We have taken 5 examples below, where the management seems credible, and have used the cash in a productive manner. The list is in order of current Market Cap:

Piramal Healthcare/ Piramal Enterprises

CMP: Rs. 490

Market Cap: Rs. 8500 cr

FY 2013 continuing business: Sales and PAT: Diversified Businesses

Likely Dividend Yield: 3.5-4%

Stock Return since deal (2.5 years): Flat

The largest cash bargain ever in the Indian Stock Market! Prof Bakshi has already put a detailed and wonderful analysis of the same.

(http://fundooprofessor.wordpress.com/2011/03/26/the-grand-strategy-of-ajay-piramal/)

The company sold its domestic formulations business to Abbott Labs for Rs. 17,140 cr and diagnostic business to Super Religare for Rs. 600 in mid 2010. The company paid taxes of Rs. 3700 cr, utilized Rs. 2500 in stock buyback and repaid debt of Rs. 793 cr.

The company is strengthening present business lines, entering into new business lines, and parking excess cash in likely profitable investments in the interim.

J B Chemicals & Pharmaceuticals

CMP: Rs. 73

Market Cap: Rs. 620 cr

Net Cash on Books: Rs. 450 cr

FY 2013 continuing business: Sales of Rs. 800 cr, PAT: 12%

Likely Dividend Yield: 3-4%

Stock Return since deal (1.5 years): Flat (adjusted for Rs. 40 dividend)

The company sold its Russian-CIS OTC product business to Johnson and Johnson for around Rs. 1200 cr in May 2011. The company has given Rs. 394 cr as a special dividend.

The company had also announced a deal with Dr. Reddy for sale of prescription product business in Russia – CIS countries, and later the deal was terminated.

Recently, there was also announcement about some dispute with Johnson and Johnson with the balance deal money in escrow account, which needs to be monitored.

The company plans to aggressively growing its domestic formulations and Rest of the World (ROW) business.

Force Motors

CMP: Rs. 470

Market Cap: Rs. 620 cr

Net Cash on Books: Rs. 400 cr

FY 2013 continuing business: Sales of Rs. 2400 cr, PAT: 2-3%

Likely Dividend Yield: 1-2%

Stock Return since deal (8 months): Flat

The company sold its shareholding in JV in Man Force Trucks for gain of Rs. 960 cr in Mar 2012. The company paid tax of Rs. 200 cr, repaid debt of Rs. 165 cr, and paid additional dividend of Rs. 6.5 cr, and capex of Rs. 140 cr, and reduced trade credit by Rs. 80 cr.

The company has announced targeting high revenue growth with high investment and new product launches.

Smartlink Network System

CMP: Rs. 50

Market Cap: Rs. 150 cr

Net Cash on Books: Rs. 350 cr

FY 2013 continuing business: Sales of Rs. 125 cr, PAT: Marginally Negative

Likely Dividend Yield: 4-5%

Stock Return since deal (1.5 years): 30% (adjusted for Rs. 30 special dividend)

The company sold DIGILINK brand product business to Schneider Electric in May 2011 for profit of Rs. 470 cr. The company paid around Rs. 95 cr as Tax and Rs. 90 cr as special dividend.

The company is now focused on building size in – DIGISOL for Active networking product lines, DIGILITE for Motherboards & peripherals and DIGICARE for Support services.

Numeric Power/ Swelect Energy System

CMP: Rs. 140

Market Cap: Rs. 144 cr

Net Cash on Books: Rs. 240 cr

FY 2013 continuing business: Sales and PAT: difficult to estimate

Likely Dividend Yield: 2%

Stock Return since deal (10 months): 30-40% (adjusted for Rs. 120 special dividend)

The company sold its UPS division to Legrand Group for Rs. 837 cr and a profit of Rs. 615 cr in Feb 2012. The company paid Rs. 132 cr as tax on this gain and declared additional dividend of Rs. 121 cr.

The company plans to aggressively get into generation of Solar/ Wind energy, manufacture of LED products, etc besides up scaling Foundry business.

Our view on these companies: At this point of the time, these companies look okay for investors who like to buy stocks at deep discount, and are willing to wait for medium -long period of time for potential returns. But these are worth tracking for most value investors, and evaluate when the business starts getting some traction.

Disclosure: No Investment as on date

Oct 9 12

Kelly Criterion

by Altais

Kelly Criterion (http://en.wikipedia.org/wiki/Kelly_criterion) is a useful idea (not necessarily a precise formula) that Investors should think about while deciding portfolio construction and position sizing. Various investors have been quoted about it, and Mohnish Pabrai has also written a chapter on it in his book “The Dhando Investor”.

I came across an intelligent view on it, in the interview of ‘The Cook and Bynum Fund’ by ‘The Manual of Ideas’ (http://www.manualofideas.com). The interview can be read here

http://www.scribd.com/doc/109389581/Manual-of-Ideas-Interview-With-Cook-Bynum-With-Disclaimers

To quote:

“Our key takeaway from Kelly is that a position’s size is a function of both the expected return of a position and its anticipated range of outcomes (hence this general formula construct: position size = expected return/ range of outcomes). The math implies two important points, with the first being more obvious than the second: (i) the larger the expected return, the bigger the position should be, and (ii) the larger the possible range of outcomes, the smaller the position should be. Because an investment in a less attractive business would generally have a larger range of outcomes, including a higher probability of permanent capital loss as opposed to slower-than-expected growth, this approach dictates that such a business would be a smaller position in the portfolio at a comparable expected return to a better business. Furthermore, the logic indicates that the expected return would have to be very high (i.e., as your question implies, extremely cheap would be at a very substantial margin of safety) for us even to consider building a meaningful position in a low-quality business or one with uncertain asset values. We believe the math from Kelly shows that both Ben Graham and Charlie Munger were operating optimally when the former owned two hundred cigar butt businesses and the latter owned three outstanding businesses (at one point in his career).”

Further, from the Apr 2007 Quarterly letter on the Fund website (http://www.cookandbynum.com), (available in link ‘Downloadable E-Book’)

“We have previously discussed in-depth the issues surrounding the purchase or sale of a given security, but there exists another equally important problem for the investor – how to allocate capital between competing qualifying ideas. It is not good enough to simply say, “This is an undervalued business with a high margin of safety.” How do you decide how much capital to commit to such an idea? The task is not simple because each choice will have slightly different risk vs. return characteristics. While we build a portfolio one security at a time, we must use a rational system to allocate our limited capital in the most-efficient way – that is to allocate it with the highest chance of outsized returns while minimizing real risk (business risk).

The goal of the investor, therefore, is to maximize the geometric mean of possible outcomes, as opposed to his arithmetic mean. The goal is such because the investor must always have all of his capital invested. The geometric mean is the nth root of the product of n numbers. The arithmetic mean is the sum of n numbers divided by n. For example, for the list of numbers {0.5, 2, 3, 1, 0.2}, the geometric mean is the 5th root of (0.5 x 2 x 3 x 1 x 0.2) or 0.90. For the same list, the arithmetic mean is (0.5 + 2 + 3 + 1 + 0.2) / 5 or 1.34. Maximizing the arithmetic mean is appropriate when you are playing games once, but in investing you are by nature playing games (investment opportunities) repeatedly. Therefore, the investor needs to pick the games that will maximize the long-run result of playing the games over and over again. The appropriate goal for the investor, then, is to maximize the geometric mean of his portfolio. The following example will explain this concept more clearly.

Let’s look at an example of a Wheel of Fortune with twenty-three spaces marked “$100” and one space marked “Bankrupt.” While the arithmetic mean of this wheel is $2,300 / 24, or $96, the geometric mean is $0 due to the presence of the “Bankrupt” space. While you might be very happy to play this game with part of your money, if you play this game with all of your money, you will go broke with 100% certainty in the long run. If you look at another Wheel of Fortune with twenty $50 spaces and four $10 spaces, the arithmetic mean will be $43 and the geometric mean would be $38. While the latter wheel will underperform the first wheel on 96% of spins, it is the only rational choice for one’s entire portfolio.

A special case formula for maximizing the geometric mean was developed by Bell Labs’ scientist John L. Kelly, Jr. He showed that the rational gambler should put a percentage of his bankroll in a given game based on the formula Edge/ Odds. This formula has been dubbed the “Kelly Criterion.” Edge is calculated at the expected profit of playing the game. Odds is the public odds of playing the game. Suppose you have the opportunity to get paid 2-1 Odds on a coin-flip. The Edge for this game would be 3 for heads plus 0 for tails divided by 2 for the number of outcomes minus 1 for the initial investment, or 0.5. The Odds of the game are 2, so you should bet 0.5/ 2 or 25% of your bankroll (portfolio) on each coin flip in order to maximize your geometric mean and the long-run value of your portfolio. In investing, one can obviously not know the Edge and Odds exactly, but understanding this concept is critical. Intuitively, as the expected profit (Edge) of the investment choice rises, the investor should put more of his portfolio to work in this investment. But note also that given a constant expected value, as the Odds rise (in other words as the degree of certainty in the idea falls), the percentage of the portfolio deployed should fall as well. So if the investor has two ideas with the same expected return, but one is in a highly-leveraged financial company and one is in a very stable consumer products company, the investor should allocate substantially more money to the consumer products company because the Odds will be smaller. When we talk about risk, we are always talking about business risk NOT volatility. So the mathematics of maximizing the geometric mean proves that you make much bigger bets on ideas where the range of possible outcomes is smaller even if the expected value of such options are slightly lower. It is, in short, the logic behind concentration of capital when certainty is high. This strategy leads to the highest long term returns.

A discussion of portfolio allocation is not complete without considering the nature of leverage (borrowed money). When the investor uses leverage, he will almost certainly raise the arithmetic mean of his portfolio returns, but he will be adding a bankruptcy space to his wheel.

As we have shown above, regardless of the arithmetic mean, this one bankruptcy space will make the geometric mean (long-term outcome) zero. Even if there are thousands of spaces on the wheel and only one bankruptcy space, the long term result of running a portfolio by simply trying to maximize the arithmetic mean with leverage will be losing all your money – whether it happens in one year, 10 years, 100 years, or 1,000 years. Our goal at Cook & Bynum will continue to be to maximize our long-run returns without the permanent loss of capital, and that goal will continue to preclude our using leverage.

The Kelly Criterion shows that a key to success in investing is to maximize the difference between the actual odds of an investment opportunity and the odds that the market is giving you. In other words, the greater the discount between the current price of a stock and its true underlying intrinsic value the better. Our job is to find places where we have superior insights to the other market participants. The other key is to accurately estimate how big our information advantage is. If we underestimate the informational advantage, we will underperform as an investor. If we overestimate the advantage, we will go broke.

Sep 12 12

Use Your Edge – Peter Lynch

by Altais

Its always a pleasure to read articles written by Investment Legends – they are insightful yet simple, and very actionable. Here’s one by Peter Lynch

(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/Lynchgrowthstocks.htm).

What’s the best way to invest $1 million? Tip one: Don’t buy stocks on tips alone. If your only reason for picking a stock is that an expert likes it, then what you really need is paid professional help. Mutual funds are a great idea (I ran one once) for folks who want this sort of assistance at a reasonable price.

Still, I’m not convinced that having 4,000 equity funds in this country is an entirely positive development. True, most of the cash flooding into these funds comes from retirement and pension contributions, where people can’t pick their own stocks. But some of it also has to be pouring in from former stock pickers who failed to invest wisely on their own account and have given up trying.

When people find a profitable activity — collecting stamps or rugs, buying old houses and fixing them up — they tend to keep doing it. Had more individuals succeeded at individual investing, my guess is they’d still be doing it. We wouldn’t see so many converts to managed investment care, especially not in the greatest bull market in U.S. history. Halley’s comet may return ten times before we get another market like this.

If I’m right, then large numbers of investors must have lost money outright or badly trailed a market that’s up eightfold since 1982. How did so many do so poorly? Maybe they traded a new stock every week. Maybe they bought stocks in companies they knew little about, companies with shaky prospects and bad balance sheets. Maybe they didn’t follow these companies closely enough to get out when the news got worse. Maybe they stuck with their losers through thin and thinner, without checking the story. Maybe they bought stock options. Whatever the case, they failed at navigating their own course.

Amateurs can beat the Street because, well, they’re amateurs.

At the risk of repeating myself, I’m convinced that this type of failure is unnecessary — that amateurs can not only succeed on their own but beat the Street by (a) taking advantage of the fact that they are amateurs and (b) taking advantage of their personal edge. Almost everyone has an edge. It’s just a matter of identifying it. While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there’s a decent chance one of them will turn out to be a 10-, a 20-, or even a 50-bagger, where you can make 10, 20, or 50 times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

One of the oldest sayings on Wall Street is “Let your winners run, and cut your losers.” It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds. Warren Buffett quoted me on this point in one of his famous annual reports (as thrilling to me as getting invited to the White House). If you’re lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it. Let’s say you have a portfolio of six stocks. Two of them are average, two of them are below average, and one is a real loser. But you also have one stellar performer. Your Coca-Cola, your Gillette. A stock that reminds you why you invested in the first place. In other words, you don’t have to be right all the time to do well in stocks. If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio.

Look around you for good stocks. Down the road, you won’t regret it.

A lot of people mistakenly think they must search far and wide to find a company with this sort of potential. In fact, many such companies are hard to ignore. They show up down the block or inside the house. They stare us in the face.

This is where it helps to have identified your personal investor’s edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber’s baby food, and Gerber’s stock was a 100-bagger. If you put your money where your baby’s mouth was, you turned $10,000 into $1 million. Fifty-baggers like Home Depot, Wal-Mart, and Dunkin’ Donuts were obvious success stories to large crowds of do-it-yourselfers, shoppers, and policemen. Mention any of these at a party, though, and you’re likely to get the predictable reaction: “Chances like that don’t come along anymore.”

Ah, but they do. Take Microsoft — I wish I had.

You didn’t need a Ph.D. to figure out that Microsoft was going to be powerful.

I avoided buying technology stocks if I didn’t understand the technology, but I’ve begun to rethink that rule. You didn’t need a Ph.D. in programming to recognize the way computers were becoming a bigger and bigger part of our lives, or to figure out that Microsoft owned the rights to MS-DOS, the operating system used in a vast majority of the world’s PCs.

It’s hard to believe the almighty Microsoft has been a public company for only 11 years. If you bought it during the initial public offering, at 78 cents a share (adjusted for splits), you’ve made 100 times your money. But Apple was the dominant company at the time, so maybe you waited until 1988, when Microsoft had had a chance to prove itself.

By then, you would have realized that IBM and all its clones were using Microsoft’s operating system, MS-DOS. IBM and the clones could fight it out for market share, but Microsoft would prosper regardless of who won. This is the old combat theory of investing: When there’s a war going on, don’t buy the companies that are doing the fighting; buy the companies that sell the bullets. In this case, Microsoft was selling the bullets. The stock has risen 25-fold since 1988.

The next time Microsoft might have got your attention was 1992, when Windows 3.1 made its debut. Three million copies were sold in six weeks. If you bought the stock on the strength of that product, you’ve quadrupled your money to date. Then, at the end of 1995, Windows 95 was released, with more than 7 million copies sold in three months and 40 million copies as of this writing. If you bought the stock on the Windows 95 debut, you’ve doubled your money.

If you missed the boat on Microsoft, there are still other technology stocks you can buy into.

Many parents with children in college or high school (I’m one of them) have had to step around the wiring crews as they installed the newfangled campus wide computer networks. Much of this work is being done by Cisco Systems, a company that recently wired two campuses my daughters have attended. Cisco is another opportunity a lot of people had a chance to notice. Its earnings have been growing at a rapid rate, and the stock is a 100-bagger already. No matter who ends up winning the battle of the Internet, Cisco is selling its bullets to various combatants.

Computer buyers who can’t tell a microchip from a potato chip still could have spotted the intel inside label on every machine being carried out of the computer stores. Not surprisingly, Intel has been a 25-bagger to date: The company makes the dominant product in the industry.

Early on, it was obvious Intel had a huge lead on its competitors. The Pentium scare of 1994 gave you a chance to pick up a bargain. If you bought at the low in 1994, you’ve more than quintupled your investment, and if you bought at the high, you’ve more than quadrupled it.

Physicians, nurses, candy stripers, patients with heart problems — a huge potential audience could have noticed the brisk business done by medical-device manufacturers Medtronics, a 20-bagger, and Saint Jude Medical, a 30-bagger.

There are ways you can keep yourself from gaining on the good growth companies.

There are two ways investors can fake themselves out of the big returns that come from great growth companies.

The first is waiting to buy the stock when it looks cheap. Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Wal-Mart never looked cheap compared with the overall market. Its price-to-earnings ratio rarely dropped below 20, but Wal-Mart’s earnings were growing at 25 to 30 percent a year. A key point to remember is that a p/e of 20 is not too much to pay for a company that’s growing at 25 percent. Any business that can manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace. In the 1970s I got interested in McDonald’s. A chorus of colleagues said golden arches were everywhere and McDonald’s had seen its best days. I checked for myself and found that even in California, where McDonald’s originated, there were fewer McDonald’s outlets than there were branches of the Bank of America. McDonald’s has been a 50-bagger since.

These “nowhere to grow” stories come up quite often and should be viewed skeptically. Don’t believe them until you check for yourself. Look carefully at where the company does business and at how much growing room is left. I can’t predict the future of Cisco Systems, but it doesn’t suffer from a lack of potential customers: Only 10 to 20 percent of the schools have been wired into networks, and don’t forget about office buildings, hospitals, and government agencies nationwide. Petsmart is hardly at the end of its rope — its 320 stores are in only 34 states.

Whether or not a company has growing room may have nothing to do with its age. A good example is Consolidated Products, the parent of the Steak & Shake chain that’s been flipping burgers since 1934. Steak & Shake has 210 outlets in only 12 states; 78 of the outlets are in St. Louis and Indianapolis. Obviously, the company has a lot of expansion ahead of it. With 160 continuous quarters of increased earnings over 40 years, Consolidated has been a steady grower and a terrific investment, even in a lousy market for fast food in general.

Sometimes depressed industries can produce high returns.

The best companies often thrive even as their competitors struggle to survive. Until recently, the airline sector has been a terrible place to put money, but if you had invested $1,000 in Southwest Airlines in 1973, you would have had $460,000 after 20 years. Big Steel has disappointed investors for years, but Nucor has generated terrific returns. Circuit City has done well as other electronics retailers have suffered. While the Baby Bells have toddled, a new competitor, WorldCom, has been a 20-bagger in seven years.

Depressed industries, such as broadcasting and cable television, telecommunications, retail, and restaurants, are likely places to start a research list of potential bargains. If business improves from lousy to mediocre, investors are often rewarded, and they’re rewarded again when mediocre turns to good and good turns to excellent. Oil drillers are in the middle of such a recovery, with some stocks delivering tenfold returns in the past 18 months. Yet it took a decade of lousy before they even got to mediocre. Readers of my column in Worth learned of the potential in this long-suffering sector in February 1995.

Retail and restaurants haven’t been performing well — but they’re two of Lynch’s favorite areas.

Retail and restaurants are two of the worst-performing industries in recent memory, and both are among my favorite research areas. I’ve taken a beating in a number of retail stocks (some of which I still like and have continued to buy), but the general decline hasn’t stopped Staples, Borders, Petsmart, Finish Line, and Pier 1 Imports from rewarding shareholders. Two of my daughters and my wife, Carolyn, have continued to shop at Pier 1, reminding me of its popularity. The stock has doubled in the past 18 months.

A glut in casual-dining outlets didn’t hurt Outback Steakhouse, and a surplus of pizza parlors didn’t bother Papa John’s, whose stock was a double last year. CKE Restaurants – whose operations include the Carl’s Jr. restaurants — has been a profitable turnaround play in California.

You can even find bargain stocks in this market that have been overlooked.

So far, we’ve been talking about growth companies on the move, but even in this so-called extravagant market, there are plenty of bargains among the laggards. Of the nearly 4,000 IPOs in the past five years, several hundred have missed the rally on Wall Street. From the class of 1995, 37 percent, or 202 companies, are selling below their IPO price. From the class of 1996, 33 percent, or 285, now trade below their offering price. So much for the average investor’s never having a chance to profit from an offering. In more than half the cases, you can wait a few months and buy these stocks cheaper than the institutions that were cut in on the original deals.

As the Dow has hit new records week after week, many small companies have been ignored. In 1995 and 1996, the Standard & Poor’s 500 Stock Index was up 69 percent, but the Russell 2000 index of smaller issues was up only 44 percent. And while the Nasdaq market rose 25 percent in 1996, a lot of this gain can be attributed to just three stocks: Intel, Microsoft, and Oracle.

Half the stocks on the Nasdaq were up less than 6.9 percent during 1996.

That’s not to say owning these laggards will protect you if the bottom drops out of the market. If that happens, the stocks that didn’t go up will go down just as hard and fast as the stocks that did. I learned that lesson in the 1971-73 bear market. Before the selling was over, companies that looked cheap by any measure got much cheaper. McDonald’s dropped from $15 a share to $4. I thought Kaiser Industries was a steal at $13, but it also fell to $4. At that point, this asset-rich conglomerate, with holdings in aluminum, steel, real estate, cement, fiberglass, and broadcasting, was trading at a market value equal to the price of four airplanes.

Wondering when you should exit the market? Use Lynch’s rule of thumb.

Should we all exit the market to avoid the correction? Some people did that when the Dow hit 3000, 4000, 5000, and 6000. A confirmed stock picker sticks with stocks until he or she can’t find a single issue worth buying. The only time I took a big position in bonds was in 1982, when inflation was running at double digits and long-term U.S. Treasury’s were yielding 13 to 14 percent. I didn’t buy bonds for defensive purposes. I bought them because 13 to 14 percent was a better return than the 10 to 11 percent stocks have returned historically. I have since followed this rule: When yields on long-term government bonds exceed the dividend yield on the S&P 500 by 6 percent or more, sell stocks and buy bonds. As I write this, the yield on the S&P is about 2 percent and long-term government bonds pay 6.8 percent, so we’re only 1.2 percent away from the danger zone. Stay tuned.

So, what advice would I give to someone with $1 million to invest? The same I’d give to any investor: Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play, or a value play? Stocks do well for a reason and do poorly for a reason. Make
sure you know the reasons.

Stocks do well for a reason, and poorly for a reason.

* Pay attention to facts, not forecasts.

* Ask yourself: What will I make if I’m right, and what could I lose if I’m wrong? Look for a risk-reward ratio of three to one or better.

* Before you invest, check the balance sheet to see if the company is financially sound.

* Don’t buy options, and don’t invest on margin. With options, time works against you, and if you’re on margin, a drop in the market can wipe you out.

* When several insiders are buying the company’s stock at the same time, it’s a positive.

* Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

* Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

* Enter early — but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.

* Don’t buy “cheap” stocks just because they’re cheap. Buy them because the fundamentals are improving.

* Buy small companies after they’ve had a chance to prove they can make a profit.

* Long shots usually backfire or become “no shots.”

* If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

* Investigate ten companies and you’re likely to find one with bright prospects that aren’t reflected in the price. Investigate 50 and you’re likely to find 5.

Peter Lynch owns shares in the following companies mentioned above: Outback Steakhouse, Pier 1 Imports, Consolidated Products, Staples, and WorldCom.

Read “How to Invest a Million” in its entirety in the March 1997 issue of Worth (on newsstands today), or in the Worth archives on this site.

Another good read: http://marketcruncher.com/2011/10/13/peter-lynchs-25-golden-rules-of-investing/

Aug 31 12

Some learnings/ observations…

by Altais

1. Mistakes are an inherent part of life, and investing is no different. What makes mistakes in investing different is that these get amplified in the market – people lose years of hard earned money in a matter of months. The best way to learn is to learn from the mistakes of others, though obviously one will still make mistakes. In the markets, as long as one can avoid making big losses and most of the mistakes are opportunity loss, and not capital loss, one should do well in the long term. As it is said, “To finish first, you have to first finish.” A common problem in the market is that people lose capital or courage (mostly both) to be able to successfully invest for long period of time – critical to compound money. The common reason is – high stake speculation, most probably at heights of bull markets.

2. The market is like an ocean with few islands of excellence. Investing in these great businesses at a fair price can lead to years of superior profits, while reducing the risks associated with seemingly cheap businesses and also the reinvestment risk, besides the costs related to transactions and taxes. As Buffett says “Time is the enemy of the poor business and the friend of the great business”.

3. There are very few businesses where one can bet for growth. Most are mediocre businesses lacking growth prospects/ moat/ intelligent & honest management.

4. A blend of growth and value could lead to optimal portfolio construction. Most value investors keep going down the quality curve to get value (speculative businesses), while most growth investors keep justifying any valuations just to chase growth (speculative valuations). Both approaches can lead to pretty nasty results!

5. Waiting for a fat pitch is way better than to just invest in a mediocre idea, just to “invest” your monthly paycheck. As Munger mentioned “I didn’t get where I did by going for average ideas”.

6. Over a period of time, I have realized right asset allocation at appropriate times is an important aspect of making and retaining gains in the market. It’s not about the timing the market, but pricing the market. Going into cash when markets are overheated is important to avoid paper profits turning into losses. Loading up when there is blood on the streets and everyone is avoiding markets like a plague is an almost-sure way to the riches.

7. People spend more time researching when buying a Rs. 20,000 TV than buying shares of Rs. 200,000. It seems losing Rs. 200,000 is less painful than spending 1 hour reading the annual report!

8. As Buffett often says “Investing is simple, but not easy.” The environment and our own attitude make profitable investing such a difficult task.

9. The easiest and most dangerous thing is to take recent success as evidence of superior intelligence/ skills. As Richard P. Feynman said “The first principle is that you must not fool yourself and you are the easiest person to fool”.

Jul 8 12

Cadbury India – Not a Stock Idea!

by Altais

Well, first a disclosure – I am really into chocolates since I first tasted one, and am just unable to refuse the temptation! So I have been a big customer of Cadbury since the time I can remember.

For the background, Cadbury India delisted in early 2003, offering Rs. 500 per share to shareholders. The company managed to buy over 90% of the shares, and delisted from the stock exchanges. Around 8,000 minority shareholders, holding 2.4% equity, rejected the price. At an Extra Ordinary General Meeting held in Nov 2009, the company passed a special resolution to reduce the Equity capital by extinguishing the share capital of only the minority shareholders, by paying them Rs. 1,340 per share. Court case is being fought between the company and minority shareholders over the final exit price.

I was studying various listed FMCG companies, and then thought it would be interesting to also analyze some unlisted ones, whose financials are available. So while the Court will take the final decision, it would be insightful to look at the leading chocolate maker in the country, especially since the consumption boom is the main story now days in the stock market.

(All Figures in Rs. Million, Dec Ending)
(RONW – Operational calculation after reducing estimated excess cash)

All the figures show an outstanding business managed well, with perhaps the exception of dividend policy. Given the nature of business, the company could have easily paid a very large part of the earning as dividend. But the dividend intention could have been governed by other considerations like tiring out the minority shareholders.

Looking at the valuations of FMCG currently, the company would be trading at substantial premium today. Various assumptions like trailing P/E between 25-45x, and P/S of 2-4x leads to fair valuation per share between Rs. 2400 – 4500.

The last price I read was Rs. 2,014, leading to a CAGR of 16.7% since delisting (dividend return would be meager). If the final price is Rs. 3,000 per share, it will work out to be CAGR of 22%.

1. It shows the advantage of investing money in great businesses for the long term.

2. 17-22% CAGR seems like an attractive return, but not perhaps in comparison to returns generated by other FMCG companies in the same period, especially with stock liquidity, absence of court battles and liberal re-investible dividends thrown in. Perhaps shows a marriage of reluctance may not be worth it. Choose your long term partner well!!

Jun 12 12

Analysis : HDFC

by Altais

Over the past few months, we have liked HDFC (Rs. 630) as an investment, and have invested in the same.

HDFC is India’s leading housing mortgage financier, having started operations in 1977, and incubated leading financial powerhouses like HDFC Bank, HDFC Insurance, HDFC Mutual Fund etc. HDFC has generated tremendous value for its shareholders over the past 2 decades, and is classic product of “Lollapalooza Effect”:

1. Strong tailwind of secular growth in business

2. Great Risk Management System

3. High degree of corporate governance

No wonder, the stock is up 15 times over the past 12 years, in addition to generous dividends!

Now, let’s look at the stock price over the past 4 years, for the period Jan 2008 – May 2012.

The stock price has been effectively stagnant over the period Jan 2008 – Mar 2012 at around Rs. 600 per share, as shown in the above chart. As the business has grown by around 20% a year, the business value has actually doubled over the past 4 years. Now, one can argue that since Sensex is down by 20% over the same period, the stock has outperformed. But that is only relative outperformance, what we as investors require is absolute outperformance over long term, beating inflation at the minimum.

What happened? If we look at the valuations in Jan 2008, they were way off the charts – it was trading at high 5x forward P/B (after adjusting for investments). So while the mortgage business continued to grow at CAGR of 20%, the valuations have fallen to more sensible 2.7x forward P/B (again after adjusting for investments).

So, while there has always been a debate about pros and cons about investing in quality vz. cheap, there are two key lessons in this:

1. Over long period of time, quality stocks outperform normal stocks (represented by Sensex in this case).

2. If you pay high initial price for quality, the subsequent returns can be quite mediocre, defeating the purpose/ risk reward equation of investing in equities.

Happy Investing !

May 27 12

The Third Rule of Investing

by Altais

Warren Buffett is famous for saying that Rule No. 1 in investing is “Don’t lose money” and Rule No. 2 is “Don’t forget rule No. 1.” The premise is that capital preservation takes precedence over capital growth, and if we are able to take care of the downside, the upside will take care of itself.

But what about making money? While Buffett doesn’t explicitly say it, Alice Schroeder, author of his biography, The Snowball, explains this brilliant yet simple nugget about Buffett’s investing strategy – Buffett doesn’t aim at making outsized returns – his aim is to make high probability 15% return on investment from day 1, and then take it from there. So while a lumpy 15% is better than smooth 12%, a certain 12% is better than uncertain 15%. This is a fine but very important distinction.

To reflect this on our portfolio, lot of times, we buy lottery ticket like stocks – high upside, seemingly low downside. Missing in the equation is what minimum return we can expect over medium term – say 3 years. If the threshold CAGR is at least high probability 15% (or 20% in Indian context), then only we should go ahead with the investment. Many times we think about investments with imbedded option value or stuff like UU (Unknown and Unknowable), while ignoring this basic element of investing. Mathematically also, investing in companies with certainty of making 20% a year is far better than those with a mere chance of making 100% if something happens.

So what are the investment situations which yield to analyzing the probability of making threshold returns?

1. Growing realizable intrinsic value of the business – earning/ book value per share with dividend payouts, with dividend yield becoming sizable to merit rerating of the stock

2. Management focused on creating shareholder returns (should not be too indifferent to market capitalization of the business though also should not be too interested in day to day stock price!)

3. Cheap enough entry buy price

Apr 11 12

Hidden Value or Value Traps

by Altais

I recently read a story about how Mr. Anil Agarwal, founder and Chairman of Vedanta Resources Plc, early in his career, bought a distress factory on sale with bank borrowing, and repaid the bank loan within a month by selling copper inventory in the company’s warehouse! Now this is classic value investing with a LBO spin – buying a company at a steep discount to conservatively calculated intrinsic value.

We as investors in the stock market try to do the same – buying companies at price lower than our estimate of fair price. Apart from the obvious difficulties in trying to foresee the future (estimating discounted cash flows), there are other challenges we face.

We don’t have any semblance of control over the assets or cash flows of the company. We are at the mercy of the management to take the right decisions or let a rising tide (bull market) bail us out.

The market is plenty of statistical cheap companies – from cash bargains to net current asset bargains to companies trading at low P/E or P/B. But we as investors make money when cheap companies stop being cheap companies or better become expensive companies!! As any bruised investor will tell, differentiating between companies which will remain cheap and which will become dear is a game – equally of skill and chance.

The problem with lot of these cheap companies is that due to poor moat/ growth/ RoE, any long term investing in these companies becomes a losing proposition. As Warren Buffett says “Time is the friend of the wonderful business, the enemy of the mediocre”. First, such businesses are very fragile to economic downturns. How profits suddenly turn to losses is very surprising reality to see. Second, low growth and low RoE means that longer than anticipated holding period could dramatically lower the annualized average return. Thirdly, management of many of these companies can always be counted to take stupid/ unethical/ sub-optimal businesses decisions, and any statistical value proves to be pure maya.

When investing in such companies, we have found following some rules to be quite valuable:

1. Giving primacy to normalized earning power and trough earnings, rather than asset value (especially hidden assets!)

2. Demanding a much higher margin of safety when investing in such companies (to compensate for longer holding period and lower growth)

3. Trying to investing in companies with sales/ profit growth and RoE of atleast 15% each.

3. Having a good starting dividend yield (of 4%+) – to reduce potential downside as well as getting paid for the waiting period

4. Capping allocation to certain percentage of portfolio (25%-30% in our case) so that dead stocks do not impact the overall portfolio returns

5. Increased diversification within this category of stocks (putting large allocation could be very profitable or very painful)

6. Limiting time frame to reasonable period (2-3 years in our case) so that money can be channeled in profitable manner

Of course, there is always lollapalooza effect which needs to be considered – how confluence of the above rules will impact investment decisions.