Wish you all a happy new year

Wish you all a very happy and prosperous new year. Thank you all for visiting and reading this blog.

Wish you all a happy new year

Wish you all a very happy and prosperous new year. Thank you all for visiting and reading this blog.

Lure of the long shot

Let me tell you a short story : There was once a smart young guy who like all of us was a charming, intelligent and hard working fellow (please replace guy with gal – for the ladies reading this blog). Now this guy, like others knew that the stock market is the place to invest your money if you want to get a good return. So he would occasionally dabble in the stock market and would make a few bucks here and there, nothing serious though.

One day our friend was relaxing at home, watching CNBC, where a smart confident looking analyst recommended the stock of a hot upcoming company (lets call the company longshot). The analyst was extremely bullish and was going ga-ga over the prospects of the company. This was a hot company in a hot sector (hot – hot !!). The company had increased its profits by 5 times in the last 3 years and was growing rapidly. The promoters were confident that sky was the limit and they would be the next infosys of their industry.

Our friend on hearing this tip was intrigued. He decided to call his friends and his broker to find out more (research !). His broker was ofcourse estactic about the company and his friend (who was a budding investor himself ) was also very positive. So having received two solid recommendations, our friend decided to invest 100000 (20% of his networth) in the company.

Fast forward 2 months : The company’s stock rose 4 times during this period. Our friend was completely delerious. He felt like a winner now. Ever since he bought this stock, he was following it closely. He would read every article on the company, every interview by the CEO. He was even participating on various stock forums where are almost everyone was more than 100% sure that the company would do very well. There were a few morons, who kept pointing to the high valuations, but then what would they know !.

The company had been reporting rising profits for the last 10 quarters and the next quarter was expected to be great. Our friend was giddy with excitement. He dreamt of the stock going up still further (everyone believed that !).

Fast forward 6 months : No one saw it coming. The company report good profits, slightly below expectations, but still good profits. The market reacted strangely to this news. The stock dropped 20% !!. Our friend was surprised. However he was re-assured by his friends and fellow investors on the stock forum that this was just a temporary reaction and the management and other analysts believed the same thing.

A few morons again pointed out that the valuation was too high, but they were abused and kicked out of the stock forum (sheesh !! what spoilsports ..our friend thought).

Fast forward 3 months : The company reported profits below forecast. They still reported a good growth, but below forecast. They however reduced the outlook for the next year as recessionary conditions had reduced the order inflow. Once this news came out the stock tanked by 50%.

Our friend was still up by 60%. However he was surprised by the sudden drop in the stock. How could the stock drop so rapidly ? He felt regret that he had not sold when the stock was at its peak. Now the stock had dropped almost 60% from that level. There was no point selling now …so he held on

Present day : The bad news kept flowing in. The stock dropped another 50% and was now below his cost. Our friend was angry with the analysts and the management who misled him. He was feeling cheated. He still visits the stock forum and is now looking for the next PRIL or L&T or infosys (or whatever you can think of)

End of story

I am currently reading a book ‘your money and your brain – the science of neuroeconomics’. It is a great book on the behavioural aspects of investing. I have not written much on emotions and behavioural aspects of investing on my blog. However I think these aspects of investing are equally if not more important than the analytical aspects.

The above story is something which a few of us have gone through or seen others go through. Some will learn the right lessons from it, whereas others will keep their head in the sand and blame others for their losses.

There are several behavioural baises in the above story which I will discuss in the rest of the post.

tendency to consider gain, but ignore the probability of gain
social proof bias
hindsight bais
commitment and consistency tendency bias
predicition bias
pattern seeking bias

Let me go through each of the above now

tendency to consider gain, but ignore the probability of gain : The book mentioned above discusses this bias in detail. I have know about this bais, but when I read about it in the book, it was like a light bulb going on. Humans have a tendency to over wiegh the gain, but tend to underwiegh the probability of gain. This tendency explains why people buy lotteries. The odds of winning the lottery are very low, but the likely gain is very high. An odd of 1 in 10 million cannot be ‘felt’. However a gain of 10 million is vivid. You can imagine all the stuff you can buy with it.

This bias explains why people go for long shots in investing even if the valuation (or odds) is high. The gain appears tangible, but the low probability does not register. This is also the reason why people are looking for the next infosys or the next L&T or PRIL etc. What most people forget is that the odds of finding one is low (would you have predicted that infosys would do as well in 1993 ? the promoters could not !). This bias explains why our friend is still looking for the next longshot.

social proof bias : If others are recommending the stock, then I must be correct. As the above book and countless other books on the same topic have stated – Humans are social creatures and like to stay with the crowd. You don’t want to stand away from the crowd and be proven wrong. Easier to buy a hot stock and be proven wrong, than buy a beaten up stock that no one likes.This bias explains why our friend felt comfortable with the company when others were recommending it.

Hindsight bais : This is the tendency to believe that you always knew the outcome after it has occurred. The book explains this bias very well. You will find a lot of pundits saying that the stock was bound to drop (or rise) after it has done so. What they don’t tell you is that they did not have this insight before the event happened. One of the key reasons for writing an investment thesis and publishing on this blog is to avoid this bais. I am no different than others and could easily fool myself that I always knew what was bound to happen.

Commitment and consistency bias : Once you make a commitment (especially public), you have tendency to be consistent with it. No one likes a person who changes his mind and is not ‘faithful’. Our friend bought the stock, committed to it and hence could not bring himself to selling it when the fundamentals turned bad. I personally try to avoid this bias by publicly not committing to buying or selling a stock on the blog. I prefer to publish the analysis and leave it to the readers to take their decision

Predicition bias – The book explains this bias in a lot of detail. Humans have a bias to predict events. If you toss coins in front them, there is an automatic tendency to predict the next toss even if they know it is random. There is a deep biological basis behind it (too lengthy for me to go into). All of us suffer from it and it seems to be a sub-conscious tendency. This bias explains why people are continously tryind predict price movements in the stock market even though they are random. This bias also explains the attraction for technical analysis.

Pattern seeking bais – This bais also has a biological basis and closely linked to the previous bais. All humans try to find patterns, even in random data. It is an inbuilt tendency and an automatic one. The book (your money and your brain) goes into detail and explains it fairly well. This bias explains why people on seeing 4 quarter of rising earnings or 3 weeks of rising prices seem to find a pattern in it and predict that the next quarter or price will be higher than the previous one. Our friend with others was suffering from the same bias and assumed blindly that the earnings and the stock price will continue to rise.

There are several other such biases which I will cover in future posts. I personally think all of us suffer from these biases (less or more) and the difference between a successful and average investor is that the successful ones are able to reduce or compensate for these baises.

These biases are not weakness. These tendencies come from the human evolution and served us well in the past and continue to do so. If some one yelled fire and everyone started running away from it, would it be smart to be a contrarian to run towards it ? The worst that can happen if you follow the crowd (social proof) is that everyone will look foolish if there was no fire. But if everyone is correct and you go against the crowd, you may pay with your life.

These biases however work against us in the financial markets. They cannot be compensated easily. I have been reading on them (see this article by charlie munger on it) for the last few years and know several times that I am operating under their influence, but can still not avoid acting otherwise. The bigger problem is when you don’t even know that you are operating under their influence and they are hurting you.

Now if believe you are above all these influences and it is others who suffer from them, then you are suffering from another bias – where almost all individuals think that they are better than the average. The book gives example of several experiments which were done to demonstarte this bias. Most investors, drivers etc feel that their skills are superior than the average (even if the evidence is to the contrary).

I personally operate with the assumption that I am influenced by all these biases and instead of ignoring them, I should be focussing my effort on reducing their impact.

Lure of the long shot

Let me tell you a short story : There was once a smart young guy who like all of us was a charming, intelligent and hard working fellow (please replace guy with gal – for the ladies reading this blog). Now this guy, like others knew that the stock market is the place to invest your money if you want to get a good return. So he would occasionally dabble in the stock market and would make a few bucks here and there, nothing serious though.

One day our friend was relaxing at home, watching CNBC, where a smart confident looking analyst recommended the stock of a hot upcoming company (lets call the company longshot). The analyst was extremely bullish and was going ga-ga over the prospects of the company. This was a hot company in a hot sector (hot – hot !!). The company had increased its profits by 5 times in the last 3 years and was growing rapidly. The promoters were confident that sky was the limit and they would be the next infosys of their industry.

Our friend on hearing this tip was intrigued. He decided to call his friends and his broker to find out more (research !). His broker was ofcourse estactic about the company and his friend (who was a budding investor himself ) was also very positive. So having received two solid recommendations, our friend decided to invest 100000 (20% of his networth) in the company.

Fast forward 2 months : The company’s stock rose 4 times during this period. Our friend was completely delerious. He felt like a winner now. Ever since he bought this stock, he was following it closely. He would read every article on the company, every interview by the CEO. He was even participating on various stock forums where are almost everyone was more than 100% sure that the company would do very well. There were a few morons, who kept pointing to the high valuations, but then what would they know !.

The company had been reporting rising profits for the last 10 quarters and the next quarter was expected to be great. Our friend was giddy with excitement. He dreamt of the stock going up still further (everyone believed that !).

Fast forward 6 months : No one saw it coming. The company report good profits, slightly below expectations, but still good profits. The market reacted strangely to this news. The stock dropped 20% !!. Our friend was surprised. However he was re-assured by his friends and fellow investors on the stock forum that this was just a temporary reaction and the management and other analysts believed the same thing.

A few morons again pointed out that the valuation was too high, but they were abused and kicked out of the stock forum (sheesh !! what spoilsports ..our friend thought).

Fast forward 3 months : The company reported profits below forecast. They still reported a good growth, but below forecast. They however reduced the outlook for the next year as recessionary conditions had reduced the order inflow. Once this news came out the stock tanked by 50%.

Our friend was still up by 60%. However he was surprised by the sudden drop in the stock. How could the stock drop so rapidly ? He felt regret that he had not sold when the stock was at its peak. Now the stock had dropped almost 60% from that level. There was no point selling now …so he held on

Present day : The bad news kept flowing in. The stock dropped another 50% and was now below his cost. Our friend was angry with the analysts and the management who misled him. He was feeling cheated. He still visits the stock forum and is now looking for the next PRIL or L&T or infosys (or whatever you can think of)

End of story

I am currently reading a book ‘your money and your brain – the science of neuroeconomics’. It is a great book on the behavioural aspects of investing. I have not written much on emotions and behavioural aspects of investing on my blog. However I think these aspects of investing are equally if not more important than the analytical aspects.

The above story is something which a few of us have gone through or seen others go through. Some will learn the right lessons from it, whereas others will keep their head in the sand and blame others for their losses.

There are several behavioural baises in the above story which I will discuss in the rest of the post.

tendency to consider gain, but ignore the probability of gain
social proof bias
hindsight bais
commitment and consistency tendency bias
predicition bias
pattern seeking bias

Let me go through each of the above now

tendency to consider gain, but ignore the probability of gain : The book mentioned above discusses this bias in detail. I have know about this bais, but when I read about it in the book, it was like a light bulb going on. Humans have a tendency to over wiegh the gain, but tend to underwiegh the probability of gain. This tendency explains why people buy lotteries. The odds of winning the lottery are very low, but the likely gain is very high. An odd of 1 in 10 million cannot be ‘felt’. However a gain of 10 million is vivid. You can imagine all the stuff you can buy with it.

This bias explains why people go for long shots in investing even if the valuation (or odds) is high. The gain appears tangible, but the low probability does not register. This is also the reason why people are looking for the next infosys or the next L&T or PRIL etc. What most people forget is that the odds of finding one is low (would you have predicted that infosys would do as well in 1993 ? the promoters could not !). This bias explains why our friend is still looking for the next longshot.

social proof bias : If others are recommending the stock, then I must be correct. As the above book and countless other books on the same topic have stated – Humans are social creatures and like to stay with the crowd. You don’t want to stand away from the crowd and be proven wrong. Easier to buy a hot stock and be proven wrong, than buy a beaten up stock that no one likes.This bias explains why our friend felt comfortable with the company when others were recommending it.

Hindsight bais : This is the tendency to believe that you always knew the outcome after it has occurred. The book explains this bias very well. You will find a lot of pundits saying that the stock was bound to drop (or rise) after it has done so. What they don’t tell you is that they did not have this insight before the event happened. One of the key reasons for writing an investment thesis and publishing on this blog is to avoid this bais. I am no different than others and could easily fool myself that I always knew what was bound to happen.

Commitment and consistency bias : Once you make a commitment (especially public), you have tendency to be consistent with it. No one likes a person who changes his mind and is not ‘faithful’. Our friend bought the stock, committed to it and hence could not bring himself to selling it when the fundamentals turned bad. I personally try to avoid this bias by publicly not committing to buying or selling a stock on the blog. I prefer to publish the analysis and leave it to the readers to take their decision

Predicition bias – The book explains this bias in a lot of detail. Humans have a bias to predict events. If you toss coins in front them, there is an automatic tendency to predict the next toss even if they know it is random. There is a deep biological basis behind it (too lengthy for me to go into). All of us suffer from it and it seems to be a sub-conscious tendency. This bias explains why people are continously tryind predict price movements in the stock market even though they are random. This bias also explains the attraction for technical analysis.

Pattern seeking bais – This bais also has a biological basis and closely linked to the previous bais. All humans try to find patterns, even in random data. It is an inbuilt tendency and an automatic one. The book (your money and your brain) goes into detail and explains it fairly well. This bias explains why people on seeing 4 quarter of rising earnings or 3 weeks of rising prices seem to find a pattern in it and predict that the next quarter or price will be higher than the previous one. Our friend with others was suffering from the same bias and assumed blindly that the earnings and the stock price will continue to rise.

There are several other such biases which I will cover in future posts. I personally think all of us suffer from these biases (less or more) and the difference between a successful and average investor is that the successful ones are able to reduce or compensate for these baises.

These biases are not weakness. These tendencies come from the human evolution and served us well in the past and continue to do so. If some one yelled fire and everyone started running away from it, would it be smart to be a contrarian to run towards it ? The worst that can happen if you follow the crowd (social proof) is that everyone will look foolish if there was no fire. But if everyone is correct and you go against the crowd, you may pay with your life.

These biases however work against us in the financial markets. They cannot be compensated easily. I have been reading on them (see this article by charlie munger on it) for the last few years and know several times that I am operating under their influence, but can still not avoid acting otherwise. The bigger problem is when you don’t even know that you are operating under their influence and they are hurting you.

Now if believe you are above all these influences and it is others who suffer from them, then you are suffering from another bias – where almost all individuals think that they are better than the average. The book gives example of several experiments which were done to demonstarte this bias. Most investors, drivers etc feel that their skills are superior than the average (even if the evidence is to the contrary).

I personally operate with the assumption that I am influenced by all these biases and instead of ignoring them, I should be focussing my effort on reducing their impact.

A Graham style deep value stock portfolio

Benjamin graham is considered as the dean of value investing. Warren buffet was graham’s student and considers him as his mentor. Buffett’s followed graham’s approach to value investing in the early part of his career. However later, he expanded on graham’s approach and started focussing on the quality of the business too.

Graham’s approach is basically picking stocks which are statistically cheap. What that means is that the stock is cheap based on various quantitative measures such as mcap being less than Net current assets, or the stock is selling for less than cash on books. The disadvantage of this approach is that you may end up buying some complete dogs which are cheap for a reason. The underlying business would be going downhill and so the value is just an illusion.

Graham understood this and he circumvented it by diversifying. So the key point in building a portfolio of cheap graham style stocks is to diversify the holding. It makes sense to hold 15-20 stocks at a time and to keep selling the stocks when they reach 80-90% of intrinsic value and to replace them with other cheap issues.

With the current drop, I can see more of such opportunities coming up. The last time I saw such an opportunity was in 2002-2003 time frame.

The initial filter criteria I am using is as follows

Mcap less than 500 crs
Debt / equity ratio less than 0.5
No loss in the preceeding 5-6 years
PE less than 7
ROE atleast 8-10%

I have been developing a list of such ideas and have loaded a list of possible ideas in google groups (stock screen graham). I have holdings in HTMT global, LMW and Denso india. I am still analysing the other stocks in the list and have yet to make up my mind on them.

The key point, and I repeat, is to hold a large portfolio of these stocks via diversification. Some will turn out to be clunkers, but on an aggregate the portfolio should do well.

Now you may have a valid counterpoint – why buy this stuff when there are good companies getting cheap by the day. That is true ..but if like me you also take a long time to analyse each company, then the above mechanical approach is a quick way to assemble a decent portfolio. If you have the cash and the nerve (I could use a stronger word here :) ) to invest when everyone is pessimistic, then the mechanical graham style of investing can be used to quickly assemble a decent portfolio while the opportunity lasts.

Please keep in mind that this list is just raw analysis and not a final list of stocks from which I plan to build my graham style portfolio. I will keep adding and dropping stocks and will upload the revised list when I do so.

A Graham style deep value stock portfolio

Benjamin graham is considered as the dean of value investing. Warren buffet was graham’s student and considers him as his mentor. Buffett’s followed graham’s approach to value investing in the early part of his career. However later, he expanded on graham’s approach and started focussing on the quality of the business too.

Graham’s approach is basically picking stocks which are statistically cheap. What that means is that the stock is cheap based on various quantitative measures such as mcap being less than Net current assets, or the stock is selling for less than cash on books. The disadvantage of this approach is that you may end up buying some complete dogs which are cheap for a reason. The underlying business would be going downhill and so the value is just an illusion.

Graham understood this and he circumvented it by diversifying. So the key point in building a portfolio of cheap graham style stocks is to diversify the holding. It makes sense to hold 15-20 stocks at a time and to keep selling the stocks when they reach 80-90% of intrinsic value and to replace them with other cheap issues.

With the current drop, I can see more of such opportunities coming up. The last time I saw such an opportunity was in 2002-2003 time frame.

The initial filter criteria I am using is as follows

Mcap less than 500 crs
Debt / equity ratio less than 0.5
No loss in the preceeding 5-6 years
PE less than 7
ROE atleast 8-10%

I have been developing a list of such ideas and have loaded a list of possible ideas in google groups (stock screen graham). I have holdings in HTMT global, LMW and Denso india. I am still analysing the other stocks in the list and have yet to make up my mind on them.

The key point, and I repeat, is to hold a large portfolio of these stocks via diversification. Some will turn out to be clunkers, but on an aggregate the portfolio should do well.

Now you may have a valid counterpoint – why buy this stuff when there are good companies getting cheap by the day. That is true ..but if like me you also take a long time to analyse each company, then the above mechanical approach is a quick way to assemble a decent portfolio. If you have the cash and the nerve (I could use a stronger word here :) ) to invest when everyone is pessimistic, then the mechanical graham style of investing can be used to quickly assemble a decent portfolio while the opportunity lasts.

Please keep in mind that this list is just raw analysis and not a final list of stocks from which I plan to build my graham style portfolio. I will keep adding and dropping stocks and will upload the revised list when I do so.

Real estate – current reality and some thoughts

I had written about real estate and its valuation a year back. I would suggest reading the earlier post before proceeding on this one.

The usual approach to valuing real estate is to look at the rental yields.

Rental yield = net rental after all expenses / capital value.

Investors expect yields to be in the range of 4-6%. This equates the capital value to around 16-25 times the rentals being received on a property.

Ancedotal evidence
I have a few friends who have trying to rent out their apartments in bangalore. They are finding it diffcult to get a rent of 11000 per month on a 2 bedroom, 1200 sqft apartment. Supposedly the apartment is worth between 40-45 lacs (atleast, depending on who you ask).

So based on the valuation thumb rule, either they should get a gross rental (excluding expenses) of around 16000-20000 at a minimum or the property value should be around 25-30 lacs.

Now I can consider my 2 bedroom dinghy, a tajmahal and value it at 50 lacs, but the value has to be backed by rentals. I personally think the litmus test of property values is the rentals one can receive on it. Property values are like stock prices. They have an element of underlying value (cash flows in stocks and rentals in case of property), but at the same time there is a speculative element too. The speculative element appears as a part of the quoted price – stock price or property value.

When investors are optimistic, stock prices are bid up and when they are pessimistic they bid them down. Simple isnt it ? well almost everyone forgot this basic idea for real estate. Property prices rose 2-10 times across the country depending on the location and type of property

Is the valuation approach correct ?
Now you can say that this valuation approach is incorrect. Consider this – if I have to invest in an illiquid asset, will it not expect 14-15% returns over the long term ? So if I am getting 2-2.5% via rentals, then my property should appreciate by 12-13% p.a over the long term to get decent returns.

Well, globally over a range of markets, real estate is known to return 2-3% returns over inflation ( so around 7-8 % in case on india) over the long run.

You may argue, as several of my friends have – this time it is different. India is doing well, incomes are rising, there is limited land and huge demand etc etc. Well, to that I can say, please read the history of the real estate boom and bust in japan in late 90s, in california and florida in 80s and check what is happening in the US, dubai and other markets. Similar faulty logic was given to justify the inflated prices, till the bubble burst and prices returned to reality.

Hope and belief does not count
Investing in any asset, stock or real estate cannot be based on borrowed wisdom. If you want to make money, use common sense and read about it before taking a plunge.

Unfortunately a lot investors in the US and maybe in india got greedy and speculated in stocks, real estate and other assets in the last 2-3 years.

Real estate like any other asset is known to get overpriced from time to time. I strongly felt that the huge surge in global liquidity from 2003 drove the interest rates down in india and pushed the stock and real estate prices up.

All talk ?
You may be thinking – everyone is smart after the fact. If you were so smart, what did you do about it ?
For starters, I was not smart about it. I avoided being greedy and tried to use common sense. I personally like to run my finanical affairs with a margin of safety. For example, when buying an apartment, my primary considerations were the following

- can I afford the EMI – I tried to keep the EMI at 40% of my current gross income (not future income)
- would I be able to keep the house if the worst case scenario happened, such losing my job or loss of income.
- What would my debt equity ratio after buying the property (see this post for more details of my logic)

2003-2004 was a great time to take housing loan. Banks and HFC were giving variable rate loans at around 7.5% and fixed term loans at 7.75%. I had no idea whether the real estate prices would boom or go down. However what was obvious then, was that banks were underpricing debt. Let me explain my logic for the same

A loan by a bank is basically a product which has a cost and a profit margin for the bank.

So interest charged = bank’s profit margin + cost

Cost = interest paid by the bank + loan losses due to bad loans (typically around 1-1.2 %) + overheads (typically around 0.5%)

The interest rates paid by the bank is dependent on the inflation.

So for a 7.75% charge, the bank was assuming a cost of fund of 6% (7.75 – 1.2-0.5 %). This was too low. This is the cost at which the Indian government is barely able to borrow, much less the banks.

The subsequent events have borne out the above logic. The loan losses were underestimated by the banks and the cost of funds was underestimated too. As a result, bank have now repriced their loans and are not likely to underprice them as low as 2003-2004 time frame.

During the 2003-2004 time frame, I strongly felt that the loan rates were too low. In response to that, I refinanced my loans and increased the duration from 15 to 20 years (see an earlier post on the same). The key was to focus on what I know (loan rates were low) and avoid speculating on what I could not know (real estate prices would rise or fall)

Have I gloated enough?
The above thought process turned out to be too conservative. Others who took higher risks in 2003-2004, were rewarded handsomely. So, my decision was not some unqualified success. However I am still very happy with decision as my conservative approach has helped me in avoiding losses in the past.

Being rational and avoiding greed is like virginity. Either you have it or you don’t.

Collateral damage
Not everyone who is suffering in the US or india was greedy or speculated in real estate. Some of the buyers in the US were first time buyers who bought property as their first home at speculative prices. These people are now facing ruin due to drop in home prices. One feels sorry for them.

What does the future hold ?
I don’t know :) ..what one can do is to look at history and try to learn from it. History does not always repeat, but it is good starting point. In most of the real estate bubbles, the market takes upto a decade to recover the earlier peaks.

One should also remember that real estate typically gives a few percentage points over inflation. If you speculate in an illiquid asset, by buying it on debt, you are asking for trouble.

Real estate – current reality and some thoughts

I had written about real estate and its valuation a year back. I would suggest reading the earlier post before proceeding on this one.

The usual approach to valuing real estate is to look at the rental yields.

Rental yield = net rental after all expenses / capital value.

Investors expect yields to be in the range of 4-6%. This equates the capital value to around 16-25 times the rentals being received on a property.

Ancedotal evidence
I have a few friends who have trying to rent out their apartments in bangalore. They are finding it diffcult to get a rent of 11000 per month on a 2 bedroom, 1200 sqft apartment. Supposedly the apartment is worth between 40-45 lacs (atleast, depending on who you ask).

So based on the valuation thumb rule, either they should get a gross rental (excluding expenses) of around 16000-20000 at a minimum or the property value should be around 25-30 lacs.

Now I can consider my 2 bedroom dinghy, a tajmahal and value it at 50 lacs, but the value has to be backed by rentals. I personally think the litmus test of property values is the rentals one can receive on it. Property values are like stock prices. They have an element of underlying value (cash flows in stocks and rentals in case of property), but at the same time there is a speculative element too. The speculative element appears as a part of the quoted price – stock price or property value.

When investors are optimistic, stock prices are bid up and when they are pessimistic they bid them down. Simple isnt it ? well almost everyone forgot this basic idea for real estate. Property prices rose 2-10 times across the country depending on the location and type of property

Is the valuation approach correct ?
Now you can say that this valuation approach is incorrect. Consider this – if I have to invest in an illiquid asset, will it not expect 14-15% returns over the long term ? So if I am getting 2-2.5% via rentals, then my property should appreciate by 12-13% p.a over the long term to get decent returns.

Well, globally over a range of markets, real estate is known to return 2-3% returns over inflation ( so around 7-8 % in case on india) over the long run.

You may argue, as several of my friends have – this time it is different. India is doing well, incomes are rising, there is limited land and huge demand etc etc. Well, to that I can say, please read the history of the real estate boom and bust in japan in late 90s, in california and florida in 80s and check what is happening in the US, dubai and other markets. Similar faulty logic was given to justify the inflated prices, till the bubble burst and prices returned to reality.

Hope and belief does not count
Investing in any asset, stock or real estate cannot be based on borrowed wisdom. If you want to make money, use common sense and read about it before taking a plunge.

Unfortunately a lot investors in the US and maybe in india got greedy and speculated in stocks, real estate and other assets in the last 2-3 years.

Real estate like any other asset is known to get overpriced from time to time. I strongly felt that the huge surge in global liquidity from 2003 drove the interest rates down in india and pushed the stock and real estate prices up.

All talk ?
You may be thinking – everyone is smart after the fact. If you were so smart, what did you do about it ?
For starters, I was not smart about it. I avoided being greedy and tried to use common sense. I personally like to run my finanical affairs with a margin of safety. For example, when buying an apartment, my primary considerations were the following

- can I afford the EMI – I tried to keep the EMI at 40% of my current gross income (not future income)
- would I be able to keep the house if the worst case scenario happened, such losing my job or loss of income.
- What would my debt equity ratio after buying the property (see this post for more details of my logic)

2003-2004 was a great time to take housing loan. Banks and HFC were giving variable rate loans at around 7.5% and fixed term loans at 7.75%. I had no idea whether the real estate prices would boom or go down. However what was obvious then, was that banks were underpricing debt. Let me explain my logic for the same

A loan by a bank is basically a product which has a cost and a profit margin for the bank.

So interest charged = bank’s profit margin + cost

Cost = interest paid by the bank + loan losses due to bad loans (typically around 1-1.2 %) + overheads (typically around 0.5%)

The interest rates paid by the bank is dependent on the inflation.

So for a 7.75% charge, the bank was assuming a cost of fund of 6% (7.75 – 1.2-0.5 %). This was too low. This is the cost at which the Indian government is barely able to borrow, much less the banks.

The subsequent events have borne out the above logic. The loan losses were underestimated by the banks and the cost of funds was underestimated too. As a result, bank have now repriced their loans and are not likely to underprice them as low as 2003-2004 time frame.

During the 2003-2004 time frame, I strongly felt that the loan rates were too low. In response to that, I refinanced my loans and increased the duration from 15 to 20 years (see an earlier post on the same). The key was to focus on what I know (loan rates were low) and avoid speculating on what I could not know (real estate prices would rise or fall)

Have I gloated enough?
The above thought process turned out to be too conservative. Others who took higher risks in 2003-2004, were rewarded handsomely. So, my decision was not some unqualified success. However I am still very happy with decision as my conservative approach has helped me in avoiding losses in the past.

Being rational and avoiding greed is like virginity. Either you have it or you don’t.

Collateral damage
Not everyone who is suffering in the US or india was greedy or speculated in real estate. Some of the buyers in the US were first time buyers who bought property as their first home at speculative prices. These people are now facing ruin due to drop in home prices. One feels sorry for them.

What does the future hold ?
I don’t know :) ..what one can do is to look at history and try to learn from it. History does not always repeat, but it is good starting point. In most of the real estate bubbles, the market takes upto a decade to recover the earlier peaks.

One should also remember that real estate typically gives a few percentage points over inflation. If you speculate in an illiquid asset, by buying it on debt, you are asking for trouble.

A simple idea

I have written about the overall market a few times in the past (see here). The problem with market analysis is that it is fuzzy and not actionable. For example, if someone were to say that the market is undervalued, what does that mean and what should one do about it?

Most of the times, market analysis is just noise. Good to hear and entertain yourself, but not really actionable. That said, there are a few times when the overvall market levels can be analysed and some buy or sell decisions can be taken.

I have generally invested in the overall market via an ETF (exchange traded funds). An ETF can be bought or sold like a stock and esentially represents an underlying index (see here for more details).

I bought heavily (by my standards) in 2003-2004 and held the ETFs for 2-3 years. I started moving out by 2006 and was completely out by mid 2007. As I have written in the past, I have followed a very simplistic approach on investing in ETF’s : Buy when the PE is below 12 and start selling once it crosses 17-18.

There are several valid drawbacks of using this approach, such as
- PE data is based on historical data. However the market is not stationary (which means that the index of year 2000 is not same as index of 2008), and hence the data is not comparable across time horizons
- PE data is backward looking, whereas the returns will depend on what happens going forward.
- There is no hard and fast rule that the market is undervalued below a PE of 12 and overvalued above 18. If the economy is going into a recession then a PE of 12 is not low as the earnings are about to fall off.

In spite of all the above drawbacks, I have found that buying below a PE of 11-12 and selling above 17-18 works well over a 2-3 year time frame. The returns are not fantastic, maybe a 40-50% returns over a 2-3 year time frame. However as it involves a minimal effort, I think it is worth it. The above approach may not give big returns, but it definitely gives better returns than a fixed deposit.

I have also uploaded an analysis of the market data – PE, P/B etc for the last 9 years (see file history data.xls in google groups). The data is downloaded from the nse website. As you can see from the data, the market has been below the current PE (11.9) only 2% of the days. I personally think that the odds are decent at the current market levels.

A simple idea

I have written about the overall market a few times in the past (see here). The problem with market analysis is that it is fuzzy and not actionable. For example, if someone were to say that the market is undervalued, what does that mean and what should one do about it?

Most of the times, market analysis is just noise. Good to hear and entertain yourself, but not really actionable. That said, there are a few times when the overvall market levels can be analysed and some buy or sell decisions can be taken.

I have generally invested in the overall market via an ETF (exchange traded funds). An ETF can be bought or sold like a stock and esentially represents an underlying index (see here for more details).

I bought heavily (by my standards) in 2003-2004 and held the ETFs for 2-3 years. I started moving out by 2006 and was completely out by mid 2007. As I have written in the past, I have followed a very simplistic approach on investing in ETF’s : Buy when the PE is below 12 and start selling once it crosses 17-18.

There are several valid drawbacks of using this approach, such as
- PE data is based on historical data. However the market is not stationary (which means that the index of year 2000 is not same as index of 2008), and hence the data is not comparable across time horizons
- PE data is backward looking, whereas the returns will depend on what happens going forward.
- There is no hard and fast rule that the market is undervalued below a PE of 12 and overvalued above 18. If the economy is going into a recession then a PE of 12 is not low as the earnings are about to fall off.

In spite of all the above drawbacks, I have found that buying below a PE of 11-12 and selling above 17-18 works well over a 2-3 year time frame. The returns are not fantastic, maybe a 40-50% returns over a 2-3 year time frame. However as it involves a minimal effort, I think it is worth it. The above approach may not give big returns, but it definitely gives better returns than a fixed deposit.

I have also uploaded an analysis of the market data – PE, P/B etc for the last 9 years (see file history data.xls in google groups). The data is downloaded from the nse website. As you can see from the data, the market has been below the current PE (11.9) only 2% of the days. I personally think that the odds are decent at the current market levels.

Overseas investing

I was recently chatting with sandesh and he asked me a question – Why don’t you invest in US based companies? Is it due to the fact that you consider them outside your circle of competence or some other reason ?

My response was – As an indian resident, I cannot invest out of india and that is the main reason for not looking at US companies.

So much for due diligence ! It seems one can invest abroad through ICICI direct and this facility has been available for some time. I do not know if there are some restrictions on the type of stocks one can buy and so would appreciate if some one can leave a comment on it.

I have been following a few companies in the US, mainly out of curiosity and as a learning experience. The one company I would like to own is Berkshire hathaway. This company is run by warren buffett and as most of the readers of this blog would know, I am a Buffett fan.

Warren buffett has been the chairman and CEO of this company since 1967 or 68 (don’t have the exact date). The company stock price and intrsinic value has grown by 20%+ since he took over the management of the company (you do the math of what 1000$ invested then would be worth now after almost 40 years of compounding at 20%+ per annum).

The core business of the company is insurance. In addition Buffett has invested capital by accquiring a collection of good companies or by investing in stocks. The company is a major shareholder in companies such as Cocacola, Amex, washington post etc and a 100% owner of companies such as See’s candies, DQ, GIECO etc.

It is diffcult to analyse the company in a short post and I will do a detailed post later if I can confirm that an Indian investor can invest in this company. However irrespective of the outcome, I would recommend everyone to read Buffett’s letter to shareholders (download here) and analyse the company. I have read these letters multiple times and I can tell you from personal experience that these letters are the best education in economics, finance and investing.

I have analysed the company to understand the economics of an insurance business and also to see the disclosure a shareholder friendly management (Buffett is known for his shareholder orientation and ‘really’ considers them as partners).

I am uploading the valuation of the company (BRK valuation.xls) in google groups (see here). The company is undervalued from my perspective. I would encourage you to download the annual report and read through it. It is a big report and takes effort to understand it, but it is worth it.

Caution: The company is undervalued, but the stock is not cheap. The ‘A’ stock is worth around 100000 usd (50 lacs per share) and the ‘B’ stock (which is 1/30 of A stock) is worth around 3200 usd (1.6-1.7 lacs per share). The reason for this high price is that buffett has not split the stock for the last 40 years (read the owners manual in the Annual report for the reason).

Overseas investing

I was recently chatting with sandesh and he asked me a question – Why don’t you invest in US based companies? Is it due to the fact that you consider them outside your circle of competence or some other reason ?

My response was – As an indian resident, I cannot invest out of india and that is the main reason for not looking at US companies.

So much for due diligence ! It seems one can invest abroad through ICICI direct and this facility has been available for some time. I do not know if there are some restrictions on the type of stocks one can buy and so would appreciate if some one can leave a comment on it.

I have been following a few companies in the US, mainly out of curiosity and as a learning experience. The one company I would like to own is Berkshire hathaway. This company is run by warren buffett and as most of the readers of this blog would know, I am a Buffett fan.

Warren buffett has been the chairman and CEO of this company since 1967 or 68 (don’t have the exact date). The company stock price and intrsinic value has grown by 20%+ since he took over the management of the company (you do the math of what 1000$ invested then would be worth now after almost 40 years of compounding at 20%+ per annum).

The core business of the company is insurance. In addition Buffett has invested capital by accquiring a collection of good companies or by investing in stocks. The company is a major shareholder in companies such as Cocacola, Amex, washington post etc and a 100% owner of companies such as See’s candies, DQ, GIECO etc.

It is diffcult to analyse the company in a short post and I will do a detailed post later if I can confirm that an Indian investor can invest in this company. However irrespective of the outcome, I would recommend everyone to read Buffett’s letter to shareholders (download here) and analyse the company. I have read these letters multiple times and I can tell you from personal experience that these letters are the best education in economics, finance and investing.

I have analysed the company to understand the economics of an insurance business and also to see the disclosure a shareholder friendly management (Buffett is known for his shareholder orientation and ‘really’ considers them as partners).

I am uploading the valuation of the company (BRK valuation.xls) in google groups (see here). The company is undervalued from my perspective. I would encourage you to download the annual report and read through it. It is a big report and takes effort to understand it, but it is worth it.

Caution: The company is undervalued, but the stock is not cheap. The ‘A’ stock is worth around 100000 usd (50 lacs per share) and the ‘B’ stock (which is 1/30 of A stock) is worth around 3200 usd (1.6-1.7 lacs per share). The reason for this high price is that buffett has not split the stock for the last 40 years (read the owners manual in the Annual report for the reason).

Anger and frustation

I was planning to publish the post below today, but then these attacks happened in mumbai. I am extremely angry and frustated, partly due to the fact that I have lived a considerable part of my life in mumbai and still have a lot of friends in the city. I wish I could write more. My only hope is that if you belong to mumbai, you and your family members are safe.

To buy or hold ?
Almost all markets, worldwide are dropping almost on a daily basis. Just as it was a no brainer last year to buy some stock and watch it go up, the reverse is happening now. I have received comments and emails asking if the right strategy in such circumstances is to wait for the bottom ?

Most of you, who have made any purchases in the last few months, would have seen the prices drop further. A common reaction is to regret the purchase and to think that holding out would be much better. I used to be prone to this ‘hindsight’ bias too. It is very common to see ‘hindsight bias’ in both bear and bull markets. After the event, you will feel or others will tell you that it would have been good to hold out (in a bear market) or to have bought (in the bull market).

Hindsight bias
This is faulty thinking. Although Hindsight is 20/20 , you cannot invest based on hindsight. Does anyone know how the market will do in the next few days or months or a year ?
If you do then you should buying options and betting on the direction ( I have done that a few times in the past). However when investing for the long term, based on underlying business value, timing cannot be perfect. As I have said in the past, if the stock looks undervalued by a large margin, create a 20-25% position. You can later add to this position as the price changes.

I typically create a 20-25% position and then start buying more if the price drops. If the price increases, then I will just hold and do nothing. The problem with this strategy is that it works well in bear markets, but fails in bull markets. During bull markets, such opportunities are quickly discovered and the price adjusts accordingly. This strategy could save you money in bear markets, but cost you in a bull market.

I am currently looking at CRISIL closely. I have written about it in the past and will publish some analysis in a subsequent post.

Anger and frustation

I was planning to publish the post below today, but then these attacks happened in mumbai. I am extremely angry and frustated, partly due to the fact that I have lived a considerable part of my life in mumbai and still have a lot of friends in the city. I wish I could write more. My only hope is that if you belong to mumbai, you and your family members are safe.

To buy or hold ?
Almost all markets, worldwide are dropping almost on a daily basis. Just as it was a no brainer last year to buy some stock and watch it go up, the reverse is happening now. I have received comments and emails asking if the right strategy in such circumstances is to wait for the bottom ?

Most of you, who have made any purchases in the last few months, would have seen the prices drop further. A common reaction is to regret the purchase and to think that holding out would be much better. I used to be prone to this ‘hindsight’ bias too. It is very common to see ‘hindsight bias’ in both bear and bull markets. After the event, you will feel or others will tell you that it would have been good to hold out (in a bear market) or to have bought (in the bull market).

Hindsight bias
This is faulty thinking. Although Hindsight is 20/20 , you cannot invest based on hindsight. Does anyone know how the market will do in the next few days or months or a year ?
If you do then you should buying options and betting on the direction ( I have done that a few times in the past). However when investing for the long term, based on underlying business value, timing cannot be perfect. As I have said in the past, if the stock looks undervalued by a large margin, create a 20-25% position. You can later add to this position as the price changes.

I typically create a 20-25% position and then start buying more if the price drops. If the price increases, then I will just hold and do nothing. The problem with this strategy is that it works well in bear markets, but fails in bull markets. During bull markets, such opportunities are quickly discovered and the price adjusts accordingly. This strategy could save you money in bear markets, but cost you in a bull market.

I am currently looking at CRISIL closely. I have written about it in the past and will publish some analysis in a subsequent post.

Don’t catch a falling knife

This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

- The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
- There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
- There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.

Don’t catch a falling knife

This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

- The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
- There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
- There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.

Some questions on value investing

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?


In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?


If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
And
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing - security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.


You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her :)

Some questions on value investing

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?


In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?


If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
And
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing - security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.


You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her :)

The infatuation with growth

If you were to ask someone about his favorite stock, the odds are that the idea would be a company with high growth prospects. This extreme bias in favor of growth is quite pervasive. You will it in analyst reports, on TV and on discussion boards too.

The flip side is that if you mention a company with low or poor growth prospects, the other person is completely surprised. It is like you have belched in a social gathering!!

The problem is that almost everyone favors growth without really thinking about it. It is almost a herd like behavior where we have been conditioned to prefer companies with high growth prospects.

Is growth always good?
Growth in a company is usually a good thing, though not always. It is not written in stone that if you buy a high growth company, you will make good returns. There is more to investing than just growth. The value of a company depends on the following factors

- Does the company earn more than the cost of capital? More the better
- How long will the company earn more than the cost of capital? This is known as the competitive advantage period. Longer the better
- If the company earns more than the cost of capital, growth is good and adds value.

Mental checklist
So anytime you look at a company with high growth prospects, think of the following points

- Is the company earning more than the cost of capital and how sustainable is it? remember that companies earning high returns with high growth rates attract a lot of competition. Competition in turn drives down growth and return on capital
- How sustainable is the growth of the company?
- Does the valuation discount the growth already? I have seen a lot of people miss this point completely and overpay for growth most of the times.

The above factors are quite subjective and not really quantifiable. As a result high growth investing is not easy, requires more experience and judgment and there is a bigger chance of getting it wrong

Missing other opportunities
The flip side of focusing on growth alone results in missing opportunities where the growth of company is low or non-existent. Low growth industries are characterized by a lower competition, moderate competition and fewer companies with some enjoying a dominant position in the industry.

It is far easier to find a mispriced company in such situations as there are fewer investors following these companies.

The infatuation with growth

If you were to ask someone about his favorite stock, the odds are that the idea would be a company with high growth prospects. This extreme bias in favor of growth is quite pervasive. You will it in analyst reports, on TV and on discussion boards too.

The flip side is that if you mention a company with low or poor growth prospects, the other person is completely surprised. It is like you have belched in a social gathering!!

The problem is that almost everyone favors growth without really thinking about it. It is almost a herd like behavior where we have been conditioned to prefer companies with high growth prospects.

Is growth always good?
Growth in a company is usually a good thing, though not always. It is not written in stone that if you buy a high growth company, you will make good returns. There is more to investing than just growth. The value of a company depends on the following factors

- Does the company earn more than the cost of capital? More the better
- How long will the company earn more than the cost of capital? This is known as the competitive advantage period. Longer the better
- If the company earns more than the cost of capital, growth is good and adds value.

Mental checklist
So anytime you look at a company with high growth prospects, think of the following points

- Is the company earning more than the cost of capital and how sustainable is it? remember that companies earning high returns with high growth rates attract a lot of competition. Competition in turn drives down growth and return on capital
- How sustainable is the growth of the company?
- Does the valuation discount the growth already? I have seen a lot of people miss this point completely and overpay for growth most of the times.

The above factors are quite subjective and not really quantifiable. As a result high growth investing is not easy, requires more experience and judgment and there is a bigger chance of getting it wrong

Missing other opportunities
The flip side of focusing on growth alone results in missing opportunities where the growth of company is low or non-existent. Low growth industries are characterized by a lower competition, moderate competition and fewer companies with some enjoying a dominant position in the industry.

It is far easier to find a mispriced company in such situations as there are fewer investors following these companies.

A question on skill

I recently got a comment which raised the following points

- You seem to have done badly when the market went down and well when the market went up. I don’t see any special skill in that.
- The picks you have shared have not convinced me that these picks will do better than what I can achieve via indexing
- A lot of people seem to agree with your analysis. However if the stocks you have analysed do badly then the market is right and not you or the entire group, which agrees with you.

I have responded to the comment, but wanted to discuss these points via a post.

Special skills or not ?
The first and most important point for the readers of this blog is this – This blog is about ‘learning and applying value investing principles’. This blog is not about my performance or how good or bad an investor I am. Value investing is a commonly used approach to investing and my attempt has been to learn and share my learnings with everyone. My own performance (good or bad) do not change the principles.

My personal focus always has been to take publicly available data, analyse it and present the conclusions. It is not a sermon I am preaching from mount olympus. I am providing my viewpoint and analysis and opening it up for discussion – for and against it. If you are expecting stock tips or some kind of portfolio management, then you will be dissapointed.

I have never disclosed my performance on this blog and will not be doing it via this blog. My personal objective is to beat the index by 3-5% on a rolling 3 year basis. I have done that by a decent margin with low risk. I try to lose less than the index during bear markets and match the index during the uptrend. Till date, I have been able to achieve that.

You may have a different risk reward objective and may find this level of outperformance poor. Well, to each his own. Remember the following fact – A 3-5% outperformance is an annual return of 16-18% which is not easy to achieve. Over long term, this kind of annual return can add up to a decent amount. However over the last 3-4 years (till 2007), a lot of investors came to expect a return of 40% as a minimum.

How will the picks do?
How do you react when the price drops, but the company continues to perform well ? Do you think that you are doing badly?

If yes, then your approach is different from mine. My yardstick for performance is business performance. If the company does well, it is only a matter of time when the stock price will catch up with the underlying value. Sometimes it takes a few months and sometimes a few years.

A valid counterpoint can be – how are you sure that the price will converge to value ? It is based on my personal experience and based on what I have read about the experience of other value investors.

The other way of analysing performance is to compare the returns of your portfolio with the index on a long term basis ( I use rolling 3 years as 1 year is too short and more than 3 years is a bit too long). If you cannot beat the index, then you should look at passive indexing and not pick stocks. I have always maintained a mutual fund and index portfolio as benchmark to see how I am doing. Till date the results are good.

Finally, I am not trying to convince anyone with my analysis. I am presenting my analysis and opinions. It is upto to the reader to agree or dis-agree with the analysis.

Group think
I have never derieved satisfaction with how many people agree with me or not. The success of my picks will depend on the quality of my analysis and not how many people agree or disagree with me. I personally prefer counterpoints to my thesis as it helps me in improving the quality of the analysis.

I evaluate the success based on a single criteria : Is the business performing as expected or better ? If the business is performing well, I will hold the stock even if the price has not followed the business performance in tandem as price eventually follows value. I don’t judge my ideas based on short term swings in price. However if my assumptions or analysis are wrong, I have exited the position irrespective of the price in the past

A question on skill

I recently got a comment which raised the following points

- You seem to have done badly when the market went down and well when the market went up. I don’t see any special skill in that.
- The picks you have shared have not convinced me that these picks will do better than what I can achieve via indexing
- A lot of people seem to agree with your analysis. However if the stocks you have analysed do badly then the market is right and not you or the entire group, which agrees with you.

I have responded to the comment, but wanted to discuss these points via a post.

Special skills or not ?
The first and most important point for the readers of this blog is this – This blog is about ‘learning and applying value investing principles’. This blog is not about my performance or how good or bad an investor I am. Value investing is a commonly used approach to investing and my attempt has been to learn and share my learnings with everyone. My own performance (good or bad) do not change the principles.

My personal focus always has been to take publicly available data, analyse it and present the conclusions. It is not a sermon I am preaching from mount olympus. I am providing my viewpoint and analysis and opening it up for discussion – for and against it. If you are expecting stock tips or some kind of portfolio management, then you will be dissapointed.

I have never disclosed my performance on this blog and will not be doing it via this blog. My personal objective is to beat the index by 3-5% on a rolling 3 year basis. I have done that by a decent margin with low risk. I try to lose less than the index during bear markets and match the index during the uptrend. Till date, I have been able to achieve that.

You may have a different risk reward objective and may find this level of outperformance poor. Well, to each his own. Remember the following fact – A 3-5% outperformance is an annual return of 16-18% which is not easy to achieve. Over long term, this kind of annual return can add up to a decent amount. However over the last 3-4 years (till 2007), a lot of investors came to expect a return of 40% as a minimum.

How will the picks do?
How do you react when the price drops, but the company continues to perform well ? Do you think that you are doing badly?

If yes, then your approach is different from mine. My yardstick for performance is business performance. If the company does well, it is only a matter of time when the stock price will catch up with the underlying value. Sometimes it takes a few months and sometimes a few years.

A valid counterpoint can be – how are you sure that the price will converge to value ? It is based on my personal experience and based on what I have read about the experience of other value investors.

The other way of analysing performance is to compare the returns of your portfolio with the index on a long term basis ( I use rolling 3 years as 1 year is too short and more than 3 years is a bit too long). If you cannot beat the index, then you should look at passive indexing and not pick stocks. I have always maintained a mutual fund and index portfolio as benchmark to see how I am doing. Till date the results are good.

Finally, I am not trying to convince anyone with my analysis. I am presenting my analysis and opinions. It is upto to the reader to agree or dis-agree with the analysis.

Group think
I have never derieved satisfaction with how many people agree with me or not. The success of my picks will depend on the quality of my analysis and not how many people agree or disagree with me. I personally prefer counterpoints to my thesis as it helps me in improving the quality of the analysis.

I evaluate the success based on a single criteria : Is the business performing as expected or better ? If the business is performing well, I will hold the stock even if the price has not followed the business performance in tandem as price eventually follows value. I don’t judge my ideas based on short term swings in price. However if my assumptions or analysis are wrong, I have exited the position irrespective of the price in the past