Thinking independently

There is generally no shortage of recommendations, tips, or get rich - schemes which are pedelled to the general public. You will notice that the number of such ‘schemes’ (for want of better word) increase almost proportionately with the rise in the corresponding asset or the market. So if there is bull market in gold, you will find more of such tips for the gold market. If the stock market is up, then you will get such schemes for the stock market.

Just think about it, how many recommendations or tips did you see for gold in 1999 (gold was 3900 at that time) or for the stock market in 2003.

And now gold is being touted as an investment and so are a lot of low grade stocks. Mutual funds who are supposed to be for the small investors are no better. Try to check on the number on new launches in the last one year versus 2003. I don’t blame the industry for more launches now, because the subscription would be low if the fund gets launched during the bear market. What irritates me that these funds play on your greed. Now you can argue that if one is greedy then one deserves to be punished for it (well , I definitely was for all the IT funds I bought in 2000). But is the behaviour of the mutual funds not that of a drug dealer who supplies the drug to an addict (rather than a doctor or counseller who prevents it)

So what is the antidote to all of the above. The starting point of this post was this comment from abhijeet . If you know that there are people trying to part you from your money, either by preying on your greed or fear or through fraud, how does one protect himself? Here is what I think

No. 1 protection is knowledge. Learn how to invest. I have mad
e it a point never to invest money in any opportunity if I don’t know what are the risks in it (rewards will take care of itself). Now, I have lost a number of opportunities by that, but have also avoided severe losses.

In my case, I tend to remember the losses far more (I think my pain for loss is far more than average) than an average person. It is not the loss of money which has hurt (that hurts too) as much as loss of faith on my own skills. In cases where I have made a bad decision, I tend to remember that very long, even if I may not have lost as much.

As a result, I am extremely cautious in making my investment. That is not same as avoiding it though. The difference is that I try to do as much homework as possible on an opportunity. I try not to make a decision immediately if I find a good opportunity. I make my notes and wait for a couple of days. Then when the intial excitement of finding an undervalued stock is gone, I tend to be more rational.

Finally, I never go any one recommendation. I read a lot of broker reports, blogs etc. but never accept any recommendations on face value. So if I find a recommendation, I try to analyse it on my own and reach my own conclusions.

In some areas which are out of my circle of competence or interest, I don’t even bother. They include gold, commodities etc. Does not mean that one cannot make money on them, just that I am not competent to do it.

Finally, my thinking is derieved from this quote from warren buffett

‘Risk is not knowing what you are doing’

ps: by the same logic, please do not base your decision on stocks which I post here.

Thinking independently

There is generally no shortage of recommendations, tips, or get rich - schemes which are pedelled to the general public. You will notice that the number of such ‘schemes’ (for want of better word) increase almost proportionately with the rise in the corresponding asset or the market. So if there is bull market in gold, you will find more of such tips for the gold market. If the stock market is up, then you will get such schemes for the stock market.

Just think about it, how many recommendations or tips did you see for gold in 1999 (gold was 3900 at that time) or for the stock market in 2003.

And now gold is being touted as an investment and so are a lot of low grade stocks. Mutual funds who are supposed to be for the small investors are no better. Try to check on the number on new launches in the last one year versus 2003. I don’t blame the industry for more launches now, because the subscription would be low if the fund gets launched during the bear market. What irritates me that these funds play on your greed. Now you can argue that if one is greedy then one deserves to be punished for it (well , I definitely was for all the IT funds I bought in 2000). But is the behaviour of the mutual funds not that of a drug dealer who supplies the drug to an addict (rather than a doctor or counseller who prevents it)

So what is the antidote to all of the above. The starting point of this post was this comment from abhijeet . If you know that there are people trying to part you from your money, either by preying on your greed or fear or through fraud, how does one protect himself? Here is what I think

No. 1 protection is knowledge. Learn how to invest. I have mad
e it a point never to invest money in any opportunity if I don’t know what are the risks in it (rewards will take care of itself). Now, I have lost a number of opportunities by that, but have also avoided severe losses.

In my case, I tend to remember the losses far more (I think my pain for loss is far more than average) than an average person. It is not the loss of money which has hurt (that hurts too) as much as loss of faith on my own skills. In cases where I have made a bad decision, I tend to remember that very long, even if I may not have lost as much.

As a result, I am extremely cautious in making my investment. That is not same as avoiding it though. The difference is that I try to do as much homework as possible on an opportunity. I try not to make a decision immediately if I find a good opportunity. I make my notes and wait for a couple of days. Then when the intial excitement of finding an undervalued stock is gone, I tend to be more rational.

Finally, I never go any one recommendation. I read a lot of broker reports, blogs etc. but never accept any recommendations on face value. So if I find a recommendation, I try to analyse it on my own and reach my own conclusions.

In some areas which are out of my circle of competence or interest, I don’t even bother. They include gold, commodities etc. Does not mean that one cannot make money on them, just that I am not competent to do it.

Finally, my thinking is derieved from this quote from warren buffett

‘Risk is not knowing what you are doing’

ps: by the same logic, please do not base your decision on stocks which I post here.

My thoughts on sundaram clayton

I came across this post on sundaram clayton which got me interested in the checking on the company. On reading the annual report, this is what is found

• sundaram clayton is in the business of auto-components – namely brakes and into aluminium castings
• The company has a revenue of 5360 million rupees, NP of 534 million rupees
• An average of ROCE of 20%+ with average Debt/equity ratio below 50 % (except current year where ratio is close to 50%)
• Healthy NPM of 8-10% consistently across the years
• Sundaram clayton is also know for its six sigma initiatives and has received several prefered supplier awards over the year

The company has several subsidiaries with a few associate companies too. The rough back of envelope calculation is as follows

The biggest holding is TVS motor company at 57%. A rough valuation is 16000 million (current year NP*12). The value of the holding is conservatively at 9120 million.
All the other subsidiaries are small with combined net profit of roughy 130 million. I would value is not more than 2000 million with Sundaram clayton value not exceeding 1500 million ( a very rough valuation).

So the total value of all the holding seems to be around 10620 million. With around 1090 million as debt and 25 million as cash , I would put the net value of these investment as 9600 million. The stock sells at 885 per share and with 18.9 million outstanding shares, the equity value is 16726 million. Back off the value of this investments and the company is valued at around 7100 million.

So with current EPS of 28, the PE comes to around 12-13.

Now all the above calculations are very rough. But it seems to be that the company is undervalued.
Although my initial analysis has not turned up anything negative, I would still not commit money to the stock as I still have figure out the following

• The catalyst which could unlock the above value.
• A more detailed analysis of the industry dynamics as there seems to be new competition coming up in the same segment as the company (there is mention of this in the management discussion)

My thoughts on sundaram clayton

I came across this post on sundaram clayton which got me interested in the checking on the company. On reading the annual report, this is what is found

• sundaram clayton is in the business of auto-components – namely brakes and into aluminium castings
• The company has a revenue of 5360 million rupees, NP of 534 million rupees
• An average of ROCE of 20%+ with average Debt/equity ratio below 50 % (except current year where ratio is close to 50%)
• Healthy NPM of 8-10% consistently across the years
• Sundaram clayton is also know for its six sigma initiatives and has received several prefered supplier awards over the year

The company has several subsidiaries with a few associate companies too. The rough back of envelope calculation is as follows

The biggest holding is TVS motor company at 57%. A rough valuation is 16000 million (current year NP*12). The value of the holding is conservatively at 9120 million.
All the other subsidiaries are small with combined net profit of roughy 130 million. I would value is not more than 2000 million with Sundaram clayton value not exceeding 1500 million ( a very rough valuation).

So the total value of all the holding seems to be around 10620 million. With around 1090 million as debt and 25 million as cash , I would put the net value of these investment as 9600 million. The stock sells at 885 per share and with 18.9 million outstanding shares, the equity value is 16726 million. Back off the value of this investments and the company is valued at around 7100 million.

So with current EPS of 28, the PE comes to around 12-13.

Now all the above calculations are very rough. But it seems to be that the company is undervalued.
Although my initial analysis has not turned up anything negative, I would still not commit money to the stock as I still have figure out the following

• The catalyst which could unlock the above value.
• A more detailed analysis of the industry dynamics as there seems to be new competition coming up in the same segment as the company (there is mention of this in the management discussion)

Portfolio size matters!

The above may sound strange. Ofcourse, warren buffett has famously said that large amounts of capital act as an anchor on investment results, but then it is more so for the professional investor and certainly not for individual investors like us.

But I have different viewpoint and it goes like this. For me investing is more of risk than return. Before I look at the likely returns, I tend to look at what I could lose under the worst case scenario. Now the worst case scenario for an individual stock is ofcourse 100%. But it likely that during a market downturn, the portfolio can drop by 25% or more (even for a conservative investor)

It is under these conditions that the portfolio size becomes important. How much is the portfolio as a % of your networth? If it is 20-25 %, I can rationally handle a loss of upto 50%. But if the portfolio is 100% of my networth, I think I would not be rational if the portfolio drops by 50% or more. I could very likely panic and sell at the bottom. Now you may feel that you would not react in that fashion and it is quite likely. But believe me, if you are one of those who started investing seriously in 1998-99 and saw your portfolio go down right upto 2003, you would have wondered when it would end.

Ofcourse looking back at 2003 now, feels like april/ may 2003 (the lowest point of the indian market) was a wonderful time to start investing as the great bull market was ahead of you. But if history was any guide at that time, the market has gone nowhere in the last 10+ years and one had to have the conviction to hold onto and better add to your portfolio at that time (with a negative performance to boot!). It is precisely for this reason that I am conservative in my approach and once I have a few years of experience and have gone through atleast one bear and bull market will I increase my equity portfolio as % of my networth.

So next time when you hear some one brag that he had fanatastic return last year on his portfolio, ask him what % of his networth has he put into equity and has he gone through a bear market with that percentage. If he/she has a high % of networth in the stock market, has had a fanatastic run in the last 2-3 years and is feeling that he/she is the next warren buffett, smile and better, pray for him that he pulls out before the next bear market.

So what if one is levearged and has more than 100% in the market and has seen only the bull market. Unfortunately these are the people who hit the headlines when the market tanks.

Portfolio size matters!

The above may sound strange. Ofcourse, warren buffett has famously said that large amounts of capital act as an anchor on investment results, but then it is more so for the professional investor and certainly not for individual investors like us.

But I have different viewpoint and it goes like this. For me investing is more of risk than return. Before I look at the likely returns, I tend to look at what I could lose under the worst case scenario. Now the worst case scenario for an individual stock is ofcourse 100%. But it likely that during a market downturn, the portfolio can drop by 25% or more (even for a conservative investor)

It is under these conditions that the portfolio size becomes important. How much is the portfolio as a % of your networth? If it is 20-25 %, I can rationally handle a loss of upto 50%. But if the portfolio is 100% of my networth, I think I would not be rational if the portfolio drops by 50% or more. I could very likely panic and sell at the bottom. Now you may feel that you would not react in that fashion and it is quite likely. But believe me, if you are one of those who started investing seriously in 1998-99 and saw your portfolio go down right upto 2003, you would have wondered when it would end.

Ofcourse looking back at 2003 now, feels like april/ may 2003 (the lowest point of the indian market) was a wonderful time to start investing as the great bull market was ahead of you. But if history was any guide at that time, the market has gone nowhere in the last 10+ years and one had to have the conviction to hold onto and better add to your portfolio at that time (with a negative performance to boot!). It is precisely for this reason that I am conservative in my approach and once I have a few years of experience and have gone through atleast one bear and bull market will I increase my equity portfolio as % of my networth.

So next time when you hear some one brag that he had fanatastic return last year on his portfolio, ask him what % of his networth has he put into equity and has he gone through a bear market with that percentage. If he/she has a high % of networth in the stock market, has had a fanatastic run in the last 2-3 years and is feeling that he/she is the next warren buffett, smile and better, pray for him that he pulls out before the next bear market.

So what if one is levearged and has more than 100% in the market and has seen only the bull market. Unfortunately these are the people who hit the headlines when the market tanks.

My Worst invesment decision till date

My decision to sell L&T in 2003 (after holding for 4 years) has been my worst investment decision till date. Although my cost basis was 190 odd (pre-divesture) and I sold at 230 odd (again pre-divesture) and did not lose money on it, I consider it to be one of my worst decisions because of the following reasons

1. The stock has since then become a 10 bagger (sells at around 2250 without considering the value of cemex)
2. I sold off because I became exasparated with the management. Between 2001 and 2003, they would constantly pay lip service to divesting the cement division and would then drag their feet on it. What I failed to realise at that time was that the Kumarmangalam birla group would be able to force the management to divest the business eventually.
3. Did not appreciate the importance of the business cycle. The E&C sector was in doldrums at that time and as a result L&T (E&C) division profits were depressed. The E&C sector turned around big time after 2003 and every E&C company has benefited since then
4. Did not do the sum of parts analysis – basically that the sum of value of the various L&T divisions was more than the complete entity.

In the end, my regret is not that I missed a 10 bagger. What clearly pricks me is that my analysis was sloppy and I did not evaluate all the factors clearly. I was looking at the company with a rear mirror view (the Margins and the ROE were poor then and I expected it to continue).

However, I have tried to learn something from this disaster. So here goes

• understand the sector dynamics when investing in a stock.
• Appreciate the importance of business cycle. Although predicting it is not critical, but a basic understanding is a must.
• Focus on sum of parts versus looking at a company as a whole, especially if the company has various different businesses.
• Have patience
• Try to avoid a rear mirror view.

Have you had such an experience?

My Worst invesment decision till date

My decision to sell L&T in 2003 (after holding for 4 years) has been my worst investment decision till date. Although my cost basis was 190 odd (pre-divesture) and I sold at 230 odd (again pre-divesture) and did not lose money on it, I consider it to be one of my worst decisions because of the following reasons

1. The stock has since then become a 10 bagger (sells at around 2250 without considering the value of cemex)
2. I sold off because I became exasparated with the management. Between 2001 and 2003, they would constantly pay lip service to divesting the cement division and would then drag their feet on it. What I failed to realise at that time was that the Kumarmangalam birla group would be able to force the management to divest the business eventually.
3. Did not appreciate the importance of the business cycle. The E&C sector was in doldrums at that time and as a result L&T (E&C) division profits were depressed. The E&C sector turned around big time after 2003 and every E&C company has benefited since then
4. Did not do the sum of parts analysis – basically that the sum of value of the various L&T divisions was more than the complete entity.

In the end, my regret is not that I missed a 10 bagger. What clearly pricks me is that my analysis was sloppy and I did not evaluate all the factors clearly. I was looking at the company with a rear mirror view (the Margins and the ROE were poor then and I expected it to continue).

However, I have tried to learn something from this disaster. So here goes

• understand the sector dynamics when investing in a stock.
• Appreciate the importance of business cycle. Although predicting it is not critical, but a basic understanding is a must.
• Focus on sum of parts versus looking at a company as a whole, especially if the company has various different businesses.
• Have patience
• Try to avoid a rear mirror view.

Have you had such an experience?

The sensex at 10000 ...a historical perspective

It’s difficult to miss that the sensex is at 10K. Frankly, I personally think that 10K is no different than 9900 (ofcourse it is 1% higher). Fundamentally nothing much has changed when the sensex rose from 9500+ to 10K. But at the same time with the index at these levels, I updated my worksheets and generated the graphs above. What does the data tell (and everyone will have their own interpretation)

- ROE is 20% +, highest in the last 15 years. This clearly shows that the cost cutting and restructuring that indian companies went through, has paid off.
- Earnings which were roughly flat between 1997 and 2003, have exploded since then. The reason is not diffcult to see. Good economic growth, higher efficiency due to the restructuring, low interest rates etc etc.
- P/E ratios do not appear very high, but have to be seen with reference to the ROE which is above the past averages and the earnings growth has been very high.

So does the data give me an insight into what is likely to happen in the future?

ROE appears high and may come down a bit in the future to the average levels. But on the other variables like PE (which is dependent on market psychology) and earnings I frankly don’t have any special insight. My guess is as good as anyone else’s. For now, I am not doing much in terms of buying or selling.

But the price levels on some of the individual securities which I own, are now in the ‘alert’ range. What I mean by alert is that once the price crosses my upper estimate of intrinsic value, I relook at the scrip and start selling slowly (around 5% for every 2-3 % price increase). Why 5 % for every 2-3% increase. Nothing scientific or smart about it. I have developed this approach so that if the price keeps increasing I am able to sell at a higher average price and don’t feel regret of losing out on the gain. Conversely if the price starts dropping, then I end up doing nothing (as the scrip is now below my estimate of intrinsic value).

The sensex at 10000 ...a historical perspective

It’s difficult to miss that the sensex is at 10K. Frankly, I personally think that 10K is no different than 9900 (ofcourse it is 1% higher). Fundamentally nothing much has changed when the sensex rose from 9500+ to 10K. But at the same time with the index at these levels, I updated my worksheets and generated the graphs above. What does the data tell (and everyone will have their own interpretation)

- ROE is 20% +, highest in the last 15 years. This clearly shows that the cost cutting and restructuring that indian companies went through, has paid off.
- Earnings which were roughly flat between 1997 and 2003, have exploded since then. The reason is not diffcult to see. Good economic growth, higher efficiency due to the restructuring, low interest rates etc etc.
- P/E ratios do not appear very high, but have to be seen with reference to the ROE which is above the past averages and the earnings growth has been very high.

So does the data give me an insight into what is likely to happen in the future?

ROE appears high and may come down a bit in the future to the average levels. But on the other variables like PE (which is dependent on market psychology) and earnings I frankly don’t have any special insight. My guess is as good as anyone else’s. For now, I am not doing much in terms of buying or selling.

But the price levels on some of the individual securities which I own, are now in the ‘alert’ range. What I mean by alert is that once the price crosses my upper estimate of intrinsic value, I relook at the scrip and start selling slowly (around 5% for every 2-3 % price increase). Why 5 % for every 2-3% increase. Nothing scientific or smart about it. I have developed this approach so that if the price keeps increasing I am able to sell at a higher average price and don’t feel regret of losing out on the gain. Conversely if the price starts dropping, then I end up doing nothing (as the scrip is now below my estimate of intrinsic value).

Kelly’s betting system and portfolio configuration

Michael J. Mauboussin recently published a paper on the legg mason website called ‘size matters’ on the Kelly criterion and importance of money management.

The paper is slightly technical on probability and an extremely good read. The key point of the paper is that investors should use the kelly criteria of defining the optimum bet size based on the edge or information advantage one has over the market. The formulae is very simple, namely

F = edge/odds

Where F is the percentage of portfolio one should bet. Edge being the expected value of the opportunity and odds being gain expected from the opportunity.

So if one has a meaningful variant perception or edge over the market (translating into a positive expected value) and expects to win big, then the above formulae helps in deciding the size of the bet as a percentage of the portfolio.

In simple terms, if one’s expected value (probability of gain*gain+probability of loss*loss) is high and the gain is also high, then one should bet heavily.

Conceptually I find the above approach very compelling. My own approach has been the similar. For example, if I am confident of a stock (after all the necessary analysis), I tend to allocate a higher amount of money. My definition of low, medium and high is around 2 % , 5% and 10 % of portfolio for a single stock.

Ofcourse the above approach is sub-optimal and would not lead to highest returns over a long period of time. It is not that I have a problem with the formulae. My problem is how do I know that my ‘edge’ is really an edge. Ofcourse whenever I have put money into a stock, the unstated assumption is that I have an edge. but then i invested in tech stocks in 2000 thinking i had an edge. Although I have a quantitative approach of going for a high expected value with a 3:1 odd, I cannot be sure.
So to safeguard myself (against my own ignorance, risk aversion or stupidity or whatever you can call it), I tend to adopt a suboptimal approach which gives me lower returns, but lets me have sound sleep (I have sleep test for risk, if I lose sleep on something, then it is too risky)

But irrespective of how one executes the above concept, it is a very sound one and should be followed to manage risk prudently

Kelly’s betting system and portfolio configuration

Michael J. Mauboussin recently published a paper on the legg mason website called ‘size matters’ on the Kelly criterion and importance of money management.

The paper is slightly technical on probability and an extremely good read. The key point of the paper is that investors should use the kelly criteria of defining the optimum bet size based on the edge or information advantage one has over the market. The formulae is very simple, namely

F = edge/odds

Where F is the percentage of portfolio one should bet. Edge being the expected value of the opportunity and odds being gain expected from the opportunity.

So if one has a meaningful variant perception or edge over the market (translating into a positive expected value) and expects to win big, then the above formulae helps in deciding the size of the bet as a percentage of the portfolio.

In simple terms, if one’s expected value (probability of gain*gain+probability of loss*loss) is high and the gain is also high, then one should bet heavily.

Conceptually I find the above approach very compelling. My own approach has been the similar. For example, if I am confident of a stock (after all the necessary analysis), I tend to allocate a higher amount of money. My definition of low, medium and high is around 2 % , 5% and 10 % of portfolio for a single stock.

Ofcourse the above approach is sub-optimal and would not lead to highest returns over a long period of time. It is not that I have a problem with the formulae. My problem is how do I know that my ‘edge’ is really an edge. Ofcourse whenever I have put money into a stock, the unstated assumption is that I have an edge. but then i invested in tech stocks in 2000 thinking i had an edge. Although I have a quantitative approach of going for a high expected value with a 3:1 odd, I cannot be sure.
So to safeguard myself (against my own ignorance, risk aversion or stupidity or whatever you can call it), I tend to adopt a suboptimal approach which gives me lower returns, but lets me have sound sleep (I have sleep test for risk, if I lose sleep on something, then it is too risky)

But irrespective of how one executes the above concept, it is a very sound one and should be followed to manage risk prudently

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Value investing and the role of catalyst

As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.

Value investing and the role of catalyst

As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.