Wishes for the new year

A happy new year to all the readers and thank you for reading and visiting my blog.

A poll

I have added a poll on the sidebar with the following question

What do you expect to make from investing in stocks in the next 3-5 years ?

10-15% per annum
15-20% per annum
20-25% per annum
25-30% per annum
30%+ per annum

The question is not what you wish, but what you think you will be able to make based on your past experience. The distinction is important as in my own case i would wish to make 100%+, have a private jet etc etc, but i will never make those kind of returns no matter how much i wish for it.

Why should i respond ?
Based on the survey i plan to publish a post with my personal views (who else's ..its my blog :) ) on what it would take to make the returns in each segment (10-15, 15-20% etc).

It should take not more than 10 sec to participate in the post and you can use the results to compare your expectations with others and see what it would take to get these returns.

Annual portfolio review – 2009

I usually review my portfolio towards the end of the year and try to figure out what went right and where I goofed up. I disclosed my portfolio last year and the portfolio has remained more or less the same since then. I sold off some small positions such as India nippon, manugraph etc and have added to other ideas such as LMW, Ashok Leyland and other existing ideas, which I felt were cheap during the course of 2009. So how did it all turn out? well far better than I expected at the beginning of 2009. A summary of the results follows

Stock % change Gujarat gas 105% Novartis 105% Merck 91% Balmer lawrie 124% LMW 171% BEL 143% NIIT Tech 144% Patni 254% CRISIL 84% Maruti 185% Grindwell norton 80% Honda siel 68% Ashok Ley 222% asian pts 99% Concor 103% Sulzer india 45% ESAB india 111% HTMT global 228% Others 130% Index – nifty 71% nifty midcap 96%

I have compared the returns on the stocks with the nifty (large cap) index and the midcap index as several holdings in my portfolio are mid caps and hence it would appropriate to compare them with the midcap index.

The reason for comparing with the index is straightforward. If one has to pick stocks, then the picks in aggregate (not necessarily each) have to do better than then index, otherwise one is better off buying the index via index funds and not wasting time and energy on picking stocks.

So what grade do it get ?

I have given myself a B for picking stocks and a B+ for having the patience and confidence in buying and holding the picks during the terrible drop in the markets. The stock picks are not phenomenal picks in themselves. It was very easy to find undervalued stocks during the Oct 2008 – Mar 2009, but difficult to buy and hold them. As an analogy with cricket, my picks are like singles and doubles, occasional fours and a very rare six. I am unlikely to lose my wicket on a reckless shot, but watching me play would kill one with boredom :)

Reviewing the picks

A few picks standout in the above list – namely Merck, CRISIL, Grindwell Norton and Honda siel. ESAB india and sulzer don't count as they are fairly recent picks. These picks have done poorer than the index and hence are worthy of deeper attention.
I have written about merck earlier here. I still feel it is undervalued and plan to hold on to it. The main reason for the underperformance is that the fundamentals of the company have not improved as expected over the years and hence the stock market has not given it a decent valuation.

CRISIL has performed as expected. The company was not as undervalued as some other stocks last year and hence the gain has not been as high. Grindwell Norton and Honda siel have not perform as well as some of the other companies and hence the stock performance has not been as good as the index.

A few other picks such India Nippon, Manugraph were clear goofups bought during the bull market and exiting them was a necessary decision. I don't expect to have a 100% success rate in picking stocks and it should still work out fine as long as my mistakes are smaller than my successes. For the time being, that has been so.

Is an annual review sensible

I have continuously harped on the need to have a long term view. Is it sensible to evaluate a portfolio on an annual basis ?

I personally think that any outperformance or underperformance over a year is usually a matter of luck. However it still does not mean that one should not evaluate the picks atleast once a year and see what worked and what didn't

Conclusion

My conclusions for the year has been as follows

• Majority of the returns for the year have happened as the market corrected the undervaluation of midcaps. This is unlikely to happen in 2010 as there are not as many undervalued stocks out there.
  
• It is important to understand the difference between a cyclical drop in demand and permanent change in industry dynamics. 2008-2009 was a cyclical drop for several industries such as auto. The same is however not true for telecom which is undergoing a structural change.
  
• It is important to bet big when the odds are in favor (price is low). It is also important to ignore the chatter in the media which is as best a distraction.
  
• I was lucky in 2009. I don't expect to be as lucky in 2010 and will have to work harder to get decent returns.

So whats next ?

I really don't have a crystal ball for 2010. I have no clue whether the market will go up or down. My approach has remained the same for the last 10 years and will be the same in 2010 – buy when the stock is undervalued and sell at intrinsic value or higher – market forecasts be dammed.

That said, I expect it to be more difficult to generate good returns in 2010 and beat the market.

Final note : The above listing is not entirely indicative of my returns as all the holdings are not equal weighted in the portfolio. Some holdings such as LMW and ashok Leyland have a higher wieghtage than the others.

As I read somewhere – its better to be lucky than smart. Well, 2009 was a very lucky year.

Some corrections to the previous post

The thing about a blog is that if you make an error in your analysis, especially a dumb one, it gets caught very quickly. I did not notice that HDFC floater LT has a 3% exit load. As a result, one of my conclusion in the previous post is invalid, if one is looking for parking short term funds. If however, the time horizon is more than 1.5 years, I think HDFC floater LT should turn out to be a decent option.

In addition to the options posted in my previous post, it was pointed out that flexible deposits and sweep-in are good options for short term funds. I agree with those comments completely. There may be a difference of +/- 1% point in terms of return between these various options, but unless you plan to invest 10 crores, I don’t think it will make a huge difference.

My personal preference when investing short term funds is for liquidity and safety of principal. Returns are important, but I will not compromise on the safety of my capital. A few percentage points is not worth the risk at all. I am a very conservative and risk averse investor in terms of debt and have always given high priority to the safety of principal.

Personal finance
This brings me to the next topic – personal finance. My own personal finance is split between equities, a little bit of debt instruments and cash. It is an idiosyncratic split reflecting my personal needs. I will definitely not recommend it to others who may have different goals than mine.

I don’t consider real estate (primary home) as an investment. I find it completely stupid to think of my primary home as an investment. If my home appreciates by 50%, what will do with it ? sell it and go live in a forest ? A home is an expense and responsibility. A second or third home or apartment can be called as an investment, but that’s a different story.

I consider insurance as simply that – insurance. So I have never bought a ULIP or a hybrid policy which are instruments of fleecing the common man. I have bought term insurance to cover my liabilities and to secure my family.

Keeping it simple
I prefer to keep my personal finance structure simple and manageable. I prefer to low to non-existent risk on my debt and other investments. The only risk I like to carry is the one for which I am paid – equity risk.

Analysing floating rate funds

I wrote in my last post on my views on inflation and one venue of investing or hedging against it – floating rate funds. Two key points to keep in mind, when reading my views on inflation or any other macro fundamentals. They are views and guesses, nothing more and nothing less. Even paid economists get it wrong more than 50% of the time and it is their job to get it correct.

The second point – I look at floating rate funds as temporary place holders for cash. If I don't find attractive ideas, I invest the surplus cash in a floating rate fund till I find something interesting. That way, the cash is earning more than the paltry 1% in a savings account and I can liquidate with complete ease and within 1-2 days if I want to move the cash to an attractive idea.

Due to the second point, I don't agonize on finding the most attractive fund as the difference would at best 1-1.5% per annum which is not worth the effort for me.

A caveat – I am not a typical investor (that does not mean I am a super smart investor). I spend far more time looking for attractive ideas and as a result my focus and effort is directed towards higher return opportunities such as equities or arbitrage. If you do not fall in this category - investing being an area of extreme interest – then my suggestions on personal finance may not be entirely valid for you. If you really want to invest in a debt fund for the long turn, it makes sense to do more homework and invest intelligently

Floating rate funds are basically debt funds which invest in floating rate securities. So if the interest rates rise, the return on these securities and hence the fund rises and vice versa.

This is not the same in case of fixed rate funds. A fund which invests in fixed rate securities faces a different risk. When the interest rates rise, these debt instruments with fixed rates fall in value and so does the mutual fund. As a result these fixed rate funds show a higher return in falling rate scenario and poor returns in an increasing rate scenario

My views on mutual funds can be found here and on debt funds here.

Selection criteria

I had written the following in terms of debt funds

- Mutual funds – fixed income: This is my favored avenue during a falling rate scenario and I tend to invest with well know mutual fund houses such as franklin templeton, DSP etc. At the time of investing in a debt mutual fund, I tend to look at the following factors
o Asset under management – avoid investing in funds with low level of asset as the expense ratios could be high.
o Fund expense – lower the better. Although the indian mutual fund industry typically gouges its customers and charges too high compared to the returns.
o Duration of fund – This is the average duration of the fund. A fund with longer duration will rise or fall more when interest rates change
o Fund rating – 80-90% of the fund holding should be in p1+ or AAA / AA+ securities.
o Long term performance of the fund versus the benchmark

- Mutual funds – floating rate funds : This is my favored approach in a rising rate scenario. In addition to all the factors for the fixed income mutual funds, I also tend to favor floaters with shorter duration.

So based on the above criteria and in view of the possible rise in interest rates, I was able to find the following funds

Some selections

Templeton Floating rate retail growth – The fund has been around for 5+ years, has beaten the index by around .5% and has 425 crs under management. Majority of the fund holding is in AAA securities. The major downside is that it charges 1% as management fees.

Birla sunlife floating rate LT retail growth – This fund has been around for 6 odd years, beaten the index by around 1% and invests in AAA securities. An additional point is that the fund charges .44% as management fees which allows the fund to deliver better returns to the investor compared to other floating rate funds. The downside is that the fund does not have as much asset under management (around 150 crs)

HDFC floating rate income LT – This fund has been around for 7 years, has beaten the index by around 1%, and invests in AAA securities. In addition the fund charges only .25% as management fees and has fairly high asset under management (around 850 Crs). This fund clearly seems to be better among the lot.

ICICI prudential LT floating rate B – The fund has been around for 6 years, has barely beaten the index and charges 0.85%. In addition the fund is fairly small, less than 100 crs in asset.

Kotak Floater LT G – This is one of the largest funds with around 18000 crs in asset. The fund has beaten the index by around 0.6%. In spite of its large size, it charges around 0.5% as management fees.

The above list clearly shows that the variance in the performance between the funds is low as expected. As a result, it is critical to choose a low cost fund which is difficult as all the funds clearly charge too much compared to the value provided. If one nets out the cost, the return is almost same as the index for most of the funds.

Conclusion

The conclusions are obvious

• If you want flexibility and ease of transaction, select a low cost fund such as HDFC or kotak.
• If you have the time and can put the effort of going to a bank and don't need the liquidity, then it makes sense to buy short duration fixed deposits with good banks and keep rolling them. As a result when the interest rates rise, you will be able to take advantage of the higher rates.

What am I doing ?

I am using option 1 for myself and option 2 for my parents.

The inflation risk

I think the inflation risk is now obvious to most of us, even if we don’t read the papers everyday. Even if the government claims the inflation is 4% or so, buying a kg of potato or sugar gives a different view of reality. So what do we do in response or if we need to do anything at all.

As far as equities are concerned, I rarely do any top down analysis and so I frankly don’t have any specific plans for my current holdings based on the inflation risk. No logic of inflation resulting in an increase in interest rates, in turn driving down demand for cars and hence the sales of an auto company.

I personally plan to avoid investing in long term deposits or long dated debt funds. If the inflation risk persists and the RBI decides to raise the rates (I have no idea if it will or not), then buying long duration debt fund or a long term deposit (more than 1 yr) would lock you into lower interest rates.

I plan to put my surplus cash in short duration floating rate mutual funds such HDFC floater and others. I don’t have preference for any specific ones, as most are identical and there is not much difference between them. If the rates do rise, then these funds should cover the inflation risk on the cash.

Test of patience

The last one year has been a value investor’s dream. Analyze and find an undervalued stock, buy decent quantities of it and voila!, in a few months time the market has recognized the undervaluation and corrected it. As a result most of the stocks in my portfolio have corrected substantially and I am looking at decent gains.

This has been the experience across the board and I don’t think it is proof of my or anyone else’s special genius or abilities. Now, before we start considering this as a normal state of affairs, let me point out an experience I have had for the last few years. This experience is not unique and has happened to me several times, but I am giving this example as it is recent and ongoing.

I read and analyzed Merck in Aug-Sept 2006 and found it to be substantially undervalued. The company had a growth problem, where due to the limited portfolio of products, its topline was more or less stagnant. However the company was able to improve its bottom line by 50% during the same period by cutting costs. In addition the company had almost 350 Crs in excess cash and was thus selling at 4-5 times its earnings.

So here was a company with great ROE, moderate growth and high cash balance selling for a song. I decided to start building a position and started buying the stock slowly. I eventually built my position for 2 years with the stock dropping during that period. The net result of the position was a loss of around 15% by the end of 2008 including dividends.

Was it a bad pick?
Now a valid argument could be that the stock was bad pick in the first place. In investing, it is important to remember that decision need to be made looking forwards and not backwards. My approach to investing is to compute intrinsic value with conservative assumptions and buy at a discount to this number. This approach may not work everytime, but works surprisingly well most of the time.

The company had a decent performance in the past, was reasonably well managed and had quite a bit of cash. During the period 2006-2008, the company was able to grow the topline by 30% and the bottom line by 10%. Not exactly a blowout performance, but pretty decent. In addition, there were a few things happening below the surface. The company started investing heavily in sales and marketing during this period due to which the topline started accelerating at the cost of the net margins.

The turnaround
The turnaround in the price finally came in Q2-Q3 2009 as the topline growth started flowing through to the net profit in terms of growth. At the same, the market was also in a mood to correct undervaluations and price most stocks closer to their fair value.

Whats the point?
The point is that undervaluation and fundamental performance alone are not sufficient triggers. A lot of times it is the market mood which decides when the undervaluation will correct and you will make your returns.

Now, one can say that if it all depends on the moods, then one should wait for the mood to turn and buy the stock before the turn happens. Well, on that please leave me a comment if you know some logical approach of figuring that out without getting into mumbo jumbo.

The point of the post is that an investor cannot control when the market will correct the undervaluation, but he or she can look for sound companies selling below intrinsic value, buy them and hold a portfolio of such companies with patience. Some of the holdings may take time, but over the course of time the portfolio as a whole will do reasonably well to be worth your while.

Analysis – some cement companies

I have written about the cement industry in the past (see here, here and here). You can download a detailed analysis of the industry from here (see file - Business analysis_working_aug 2007.xls, column for cement industry).

I had the following in an earlier post

Considering the level of undervaluation in some sectors such as pharma, IT etc and the better economics enjoyed by those industries compared to Cement, I am personally not too keen on investing in the cement sector. If I had to pick up one cement company to put my money in for the long term, I would prefer ambuja cement.

When I wrote this comment, I did not realize that it would turn out to be this accurate. IT and pharma stocks (the don’t touch sectors of 2007-2008) have done much better than the cement industry stocks. Note the word stocks and not the industry. As I have said in the past, a good and well performing company or industry is not necessarily a good stock and vice versa.

I have been running various filters to come up with new ideas and it has been slim pickings. The filters recently threw up some cement companies, so I decided to an analysis of these companies again . A short review follows

Mangalam cement
This is a birla group company with a capacity of around 2MT and caters to the northern market. The company currently has a net margin of around 15% and an ROE of around 30%. The company also has surplus cash on its books
The company however has been a BIFR case in the past (2002-2003). The company has since then been able to turn around its performance by restructuring its debt, reducing its cost structure (by generating power internally) and was also aided by the rise in the demand and pricing for cement in the last 5 years.
The company now plans to expand capacity by around 1.5 MT at the cost of 750 crs. The company sells at around 300 crs, net of cash and at a PE of 2-3. In addition, the company is also selling at 25% of replacement cost.

Ambuja cement
This is one of the top companies in the industry with an installed capacity of around 22 MT.The company has generally maintained an ROE in excess of 20%, net margins in excess of 10% and fairly low debt equity ratios.
The company has one of the lowest cost of production in the industry and is a well managed company. The company sells at around 11-12 times PE and around 610 Crs/MT of capacity.

Additional thoughts
The cement industry is a commodity industry where the profitability of the players is driven by the demand supply situation and the resulting cement pricing. The demand growth is now at around 8-9% and picking up due to revival of the economy. However at the same time, a lot of additional capacity is scheduled to come online which may add to the pricing pressure.

To look at the same dynamics in a different way, the current profits per MT of cement is around 70 Crs. The average profitability is generally around 40-50 Crs per MT of sale. As a result the current profits are around 30-40% higher than average. Any increase in capacity or slowing down of demand could impact the margins and net profit for the industry.

The second tier companies such as mangalam, JK cement etc look attractive at current valuation. However such companies typically sport low PE ratios at the peaks of business cycles or peak pricing. As a result, I have yet to make up my mind if the above companies are truly undervalued. Maybe a good time to buy cement stocks was a year back, but then one could have bought almost anything then and made money by now.

Disclosure: no current holding, only extensive reading. As always if you buy based on my analysis, blame yourself :)

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Analysis - Tata sponge ltd

About
Tata sponge ltd is a 676 cr sponge iron manufacturer with an annual capacity of 3.42 Lac MT. The company uses iron ore and coal as the raw material, which is used to produce sponge iron. Sponge iron is an important raw material for the manufacture of steel and the price for sponge iron in turn depends on steel demand and pricing.

The company is a part of the Tata group, which holds a 40% stake in the company through Tata steel. Tata steel also supports the company, by supplying iron ore. In addition the company has purchased and is developing coal mines for captive use and to control input costs.

Financials
The company has revenue of 676 crs and has recorded an average growth of 15%+ in the last 10 years. The bottom line is around 105 Crs with a growth of 20%+ in the last 5 years. The key point to note in the performance is that quite a bit of growth in the topline and bottomline has happened in the last 5 years.
The net margin of the company is currently at 17%. However the net margin has fluctuated between 4% and 17% in the last 10 years. These fluctuation are closely linked to the steel demand and pricing and has generally fallen when the overall economy has slowed down.
The company has now become a debt free company and has a cash holding of around 115 crs on its balance sheet.

Positives
The company has a strong balance sheet with excess cash which can be used to fund additional capacity without taking on debt. In addition the company is a part of the Tata group which is known for good corporate governance.
The company also has access to ore supplied by Tata steel which provides some stability to raw material costs. In addition the company has acquired a coal mine and is in process of developing it. This would help the company to control its key inputs costs which is iron ore and coal.
The company has demonstrated good topline and bottom line performance and has a high ROE (15% or higher) at low to moderate levels of debt. Finally the company has always operated at a low or negative working capital.

Risks
The key risk for the company is the nature of the industry in which it operates. The industry is cyclical, with low barriers to entry. In addition, the product is a commodity and hence the profitability of the company is tied to steel prices and the demand supply situation of the same.
The industry and the company are also characterized by large swings in performance depending on the demand and pricing for its product.

Competitive analysis
The industry is characterized by low entry barriers and the only competitive edge a company can have in this industry would be from economies of scale. Companies do not have much control on raw material (coal and iron ore mainly) pricing and the pricing of the final product (sponge iron) is also driven by steel prices. Scrap steel is a substitute for sponge iron and hence the price and availability of scrap steel also has an impact on the price of sponge iron.
Finally the industry faces price based competition, atleast at the local level and most of the companies are price takers. I don’t think any company can demand a premium for their sponge iron.

Management quality checklist

- Management compensation: Management compensation is fairly low with the MD drawing a compensation in the region of 50-60 lacs
- Capital allocation record: The management has demonstrated a good capital allocation record. The company has maintained an ROE in excess of 15% even during downturns. The company has also demonstrated an ROE of around 25% on the incremental capital invested in the last 5 years. The only negative has been the low level of dividend payout. The low dividend payout is however understandable due to the lower levels of free cash flows (atleast 20-30% of the earnings is required as maintenance capex).
- Shareholder communication – Shareholder communication has been good and the management has been transparent about the performance.
- Accounting practice – looks conservative
- Conflict of interest - none
- Performance track record – good in comparison to the industry economics

Valuation
The intrinsic value of the company can be taken between 350-400 for a net profit margin of around 11-13% over a business cycle and for a topline growth of around 13-15%. The current margins of around 17% cannot be taken as a base line as the margins have fluctuated between 4 to 24% with an average of 11% for the last 10 yrs. The topline assumption is a bit conservative, but a higher rate of growth will not increase the intrinsic value as much, as a higher growth would require a higher level of re-investment and result in a lower free cash flow.

Scenario analysis
The current price discounts a net margin of 11% and topline growth of 9%. A topline growth of 15% would give an intrinsic value of around 360-400.

Conclusion
The company seems to be undervalued by around 30-35% at best. The company may look undervalued based on the PE, but the correct approach to value a company is to compute its intrinsic value based on a DCF (discounted cash flow) formulae using the free cash flow generated by the company.
A company such as Tata sponge is in a commodity business which requires a higher level of maintenance capex (for understanding maintenance capex, see here). As a result the earnings of such a business consistently overstates the free cash flow. In case of tata sponge, the free cash is around 70-80% of the earnings. Based on the above free cash flow, margin and growth estimates, I would conservatively put the intrinsic value between 350-400.
Finally, the industry and the company is in a commodity industry with low to non-existent competitive advantages. As a result, it would be sensible to take the intrinsic value on the conservative side

Disclosure: I don’t hold the stock as it is not cheap enough for me. However I may not disclose it on my blog, when I decide to initiate a position in the stock. As always, please read the disclaimer

What’s on my mind – Nov 09

I am planning to start a new monthly post with the topic – what's on my mind. It's more likely to be a brain dump of my thoughts – more for myself – to check back in future as to what I was thinking (or smoking J ) at a particular point of time. This should help me cross-reference some of the investing decision I took at the time.

It's a natural tendency to look at decision after they play out with a fair amount of hindsight bias. Like others, I too have a tendency to forget the key factors which played into my decision and color the history based on present information. Anyway, more on this bias in a later post.

Dollar depreciation

The US is now running a deficit of almost 1.4 trillion (that's 1000 billion and 1 billion = 100 crores). That's a lot of zeroes. The deficit is almost 10% of GDP and projected to continue for some time. A deficit of this proportion would land (and it did in 91) a country like India in serious trouble very quickly. If we had to borrow as much to fund our deficit, we would have a crisis (as we did in 1991).

Now the US dollar is a reserve currency and they get to print it and hence can monetize their debt. In addition, it's a rich country, so other countries are ready to lend to the US. However there is finally a limit to everything and something which cannot go on forever will stop some way or other. In the usual case, a country incurring such a deficit could see its currency depreciate, cost of debt and inflation shoot up and contraction of its economy if it went too far. The US has been able to avoid all this as it is still the largest economy and other countries do not really have too much of an alternative.

That said, it is appear likely (atleast in the long run), that the currency will keep depreciating. That does not mean, that we will not have episodes (as in 2008), where the currency strengthened. However in the long run a country with a large deficit and growing debt can fix it in 3 ways – inflate, raise taxes and cut expenses. Inflation (via currency depreciation) is easier politically and hence looks more likely to happen.

All of the above is a conjecture, but still a probable scenario. Now, you may ask, how does it impact us? A few points come to my mind

• Our currency is still a managed currency and everytime the dollar has depreciated, RBI attempts to control the appreciation of the rupee. This has in general resulted in high liquidity in the domestic markets which results in asset bubbles – spike in real estate and Stock markets etc.
  
• Higher inflation due to higher commodity prices as most of commodities are priced in dollar
  
• Reduction in margins for IT and export oriented companies due to stronger rupee and weaker growth in export market such as US
  

The problem with macroeconomics is that you may be right in the long run, but in the short run be completely off the mark. In addition, it is easy to guess, but difficult to arrive at specific investment decisions based on these macro-economic mumbo jumbo.

All said and done, I am worried about the implied (based on current valuations) bottom line growth for IT companies and the head winds faced by them.

Automotive sector

The growth for the current quarter is likely to be high due to the base effect (dec 2008 was bad) and hence the market may still react positively. However in view of the valuations, I have already started reducing my position in maruti. Need to make up my mind on Ashok Leyland, which has appreciated quite a bit

Overall market levels

I am not sure if the market are overvalued at 22 times earnings, but at the same time I have started reducing my Index ETF positions. I do not look at chart and any other technical indicators. As I have said in the past, when the market has fallen below 12 times earnings, it has generally been a good time to buy the index and a market level of 23 and above a decent time to sell. Its not a precise approach, but makes decent sense from a valuation perspective.

Fixed income investing

I would prefer to buy short dated debt (short term deposits) or floating rate funds. I think that inflation is likely to go up and hence it would better to buy floating rate funds than fixed rate ones. Again, no specific analysis as to why I think that inflation will go up – only reason is that the government has a stimulus package and low rates. Once the inflation starts creeping up, RBI may have to raise rates again.

New ideas

Not many attractive ones. So I am currently just studying some companies such as Tata sponge and others from a learning perspective. This should help me pull the trigger when the valuations are right. I need to avoid trying to be too clever for my own good.

Comments and reply to my options post

Aniruddha brought up a very good point in the comments and as a result, I decided to add it to the post as it captures the issue for a long term investor. My response follows the comment

Hi Rohit,
i also tried with options while ago. I realized that, i would never sell my portfolio. So even if it is hedged by options, it's waste of money. If market falls you would earn money through options but that time you will not sell your entire portfolio. Option Profits would be offset against your virtual loss. Same thing with advances. The gain in the portfolio is offset with the option premium you pay, which would expire worthless.I found it good tool to earn money in volatile market for traders.

hi anirudha
As i said, for a long term investor, options will not make sense unless one plans to sell in the short term. Here again it may make sense to just sell and not get too clever with options. so options is still an area i am trying to figure as part of my portfolio.

If however one is managing money professionally, options can help reduce short term volatility, which is critical for clients who may not have the emotional fortitude to bear huge swings in the portfolio and may pull their money out at the wrong time.

Options work well as disaster protection too...end of 2008 if you thought icici was going down the tube and had deposits, then puts would have helped. I bought those options to protect my deposits with the bank and it was more of an insurance, than a trading position.
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I recently wrote on my purchase of options for hedging purposes and received several comments and emails on it. I discussed about the ‘what’ of the transaction, but did get into the ‘why’ of it. So let me discuss about it a bit here and then try to give a response to the various comments on the previous post

The why of options purchase
As I stated my previous post, the only scenarios where options would make sense for me are
· The market appears considerably overvalued and options are underpriced due to low volatility: This is a valuation and not a timing decision. However it is not a decision based on deep fundamental analysis. As the market gets more overvalued, I can reduce my long positions and the put option acts as a backstop for me. So in this case I am paying a small premium to protect myself from the downside, as I reduce my holdings and benefit from the upside in the interim.
· I wish to hedge a specific stock position which I plan to sell in the next few months: In such a case, I would prefer to buy a put option on the stock to hedge my open position. This is a hedging position and has no element of speculation in it. I am basically paying a premium for an insurance (against the stock dropping below the strike price)

In both the cases, I am paying a small premium for ‘insuring’ my portfolio for the short term as I sell the overvalued position. If I were to do this multiple times, I would expect to lose money on my options with the benefit of protecting my portfolio from downside while I am reducing my holdings.

In the past one month, I was lucky to have sold my open positions and then have the market drop a bit, due to which I was able to close out my options at a decent profit. I was lucky and not smart in this case.

Aren’t you speculating ?
I cannot deny that there is an element of speculation here. However I did not create a position with that in mind. As I said earlier, if I were to do this multiple times, I expect to lose money on my options positions with the benefit of being able to hedge the downside. If the market does crash, then the options positions would reduce my losses and thus reduce volatility of my portfolio. Speculation depends on the objective of a position and not on the nature of the instrument.
The cost of short term options is around 12-13% (annualized) for a downside protection for 10%. It would stupid of me to hedge my portfolio using options on a regular basis. Yes, the market is efficient in this aspect.

Why not buy long dated options
For starters, I looked for long dated options and was not able to buy them. The second key point is that the price of long dated options is very high. There is no point in buying a 10% downside protection for 1 year and pay 15% or more premium for it. In such a case, I am better off selling the open position itself. I see option protection useful only if I wish to buy short term protection in an overvalued market with clear plans of selling the overvalued positions during the same period

Imperfect hedge
Some readers pointed out that I bought an index put where as my portfolio is mainly midcaps. Well, my disclosed portfolio is mid-caps, but not necessarily my entire portfolio. I do have mutual fund holding and Infosys stock and hence an index hedge is good enough for me. I have disclosed my portfolio in the past and the associated disclaimers.

Educational experience
I am in a learning and exploratory phase in terms of options. Options basics and pricing is easy to understand. The difficult part is to build a sensible strategy around these instruments and use it properly. My positions in the past have been miniscule (<0.5 %) and a gain or loss is more or less a non-event.

I will continue to read and learn and may dabble in these instruments a bit in the future. I see the utility of these instruments in arbitrage positions, but continue to be doubtful in terms of their utility for my core portfolio.

The other day, as I was discussing my options plan with my wife, she summarized it well – All boys have their toys, in my case they are options.

Moving to the dark side – bought options

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions in the instruments discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance

In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

• Strike price of the index put
  
• Duration of the put
  

The Strategy

At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it J ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result

After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion

Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios

• The market appears considerably overvalued and options are underpriced due to low volatility
  
• I wish to hedge a specific stock position which I plan to sell in the next few months.
  

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive J

Competitive analysis of IT companies

Warning: A long post on the competitive analysis of IT companies (low in entertainment value :) ). So please get a cup of coffee or tea before you continue further

I recently received a comment from madhav

The question I have on outsourcing kind of IT companies like NIIT, Infosys, TCS etc is, "where is the moat?".

Every company seems to be into everything that happened yesterday, today or will happen in the future. All companies are generally present in all geographies, across all industry sectors etc. To top up the challenge, the "asset" of such IT companies are their people, but the employees keep hopping between the competitors and there is hardly anything preventing them from doing so. So where is the moat or where is the long term advantage? This also leads to the question - how do you value such a company?

This is an interesting question and there are several ways to answer it. I will try to answer it, by first doing a porter's five factor model analysis on IT companies (for more on this model you will have read this book). I will then use the conclusions from this analysis to answer madhav's question and see if we can value these companies.

The porter's five factor model has the following five factors, on which the moat of a company can be analyzed (by the way, I do this analysis for every investment I do)

• Entry barrier : Level of entry barriers in the industry to a new entrant
  
• Level of rivalry : Level of competition within the existing companies
  
• Supplier power : bargaining power of suppliers
  
• Buyer power : bargaining power of buyers
  
• Substitute product : presence of substitute products

I have a spreadsheet uploaded in Google groups, wherein I had done a similar analysis some time back for multiple industries. It is dry reading, but I think a useful document (for me). I am reproducing some parts below for this post, for the IT industry with appropriate updates.

Entry barriers: This factor can be analyzed in detail based on multiple sub-factors. I have listed the analysis in the table below. The summary of the analysis is in the first row

ENTRY BARRIER - No. 1 Factor deciding industry profitability	Moderate to high switching costs Barriers due to economies of scale especially in the volume business Some barriers due to vertical based competency (BCM / Insurance )
Asset specificity	Low. Mainly buildings and facilities.
Economies of Scale	Economies of scale important in recruitment, training and staffing, especially for outsourcing
Proprietary Product difference	None - IPR / knowledge base for vertical is the only differentiator
Brand Identity	To a small extent for specific verticals. However not too critical
Switching cost	High
Capital Requirement	High now, especially for the mid-size and large deals
Distribution strength	NA
Cost Advantage	High - but available to all. Scale adds to this advantage
Government Policy	NA
Expected Retaliation	High
Production scale	NA
Anticipated payoff for new entrant	Moderate at the low end
Precommitted contracts	High
Learning curve barriers	Moderate
Network effect advantages of incumbents	None
No. of competitors - Monopoly / oligopoly or intense competition (concentration ratio )	Intense competition

The above analysis clearly shows 2-3 main sources of competitive advantage. Scale is critical in this business as the larger companies tend of have cost advantages due to economies of scale and can also provide the requisite resources for large engagements. In addition, these companies can afford to spend higher amounts on marketing and sales. The second source of advantage is customer relationships (long term contracts). This advantage is not set in stone, but it a very critical asset. For ex: After the scandal, the key value in satyam, was existing client relationships and Mahindra paid for that. Ofcourse this asset does not have as much life as fixed assets and can be lost much more easily.

Level of rivalry:

RIVALRY DETERMINANT	Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past
Industry growth	moderate
Fixed cost / value added	Low
Intermittent overcapacity	Low
Product difference	Low
Informational complexity	Medium to Low
Exit Barrier	Low
Demand variability	Low

The above analysis shows that the level of rivalry has been high, but not destructive till date. Most companies in the sector earn high return on capital and are fairly profitable. This has been mainly due to high growth in the industry and low fixed costs (they can cut our salary and bonus when the demand drops :)). Due to multiple companies in the industry, the long term returns in the industry are bound to trend lower (read that as profit margins).

Supplier power

SUPPLIER POWER	None - Input is manpower
Differentiation of input	None
Switching cost of supplier	None
Presence of substitute	None
Supplier Concentration	None
Imp of volume to supplier	None
Cost relative to total purchase	None
Threat of forward v/s Backward integration	None

If you work in the IT industry, you are the supplier. Supplier power – zip, nothing..doesn't exist. Yes, companies say employees are their asset etc etc. We all know the reality. Employees are the raw material for the industry like steel and copper (sorry if I hurt your feeling by comparing you to a commodity :)). Most companies pay for this commodity based on what the market prices it.

Buyer power

BUYER POWER	% Sales contributed by Top 5 account. High for smaller companies
Buyer conc. v/s firm concentration	Varies for companies. Tier II companies have higher Buyer conc.
Buyer volume	High for Tier II companies
Buyer switching cost	High for buyers
Buyer information	High
Ability to integrate backward	Low. The reverse is happening

Buyer power is clearly a bigger issue for smaller companies. The large IT companies have consciously tried to diversify their revenue to reduce dependence on any specific client. This is a key variable for a company. If the buyer concentration is high, the vendor can get squeezed and will not be able to make high returns.

Substitute product

Substitute product	Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable
Price sensitivity	High for low end work
Price / Total Purchase	High
Product difference	Low
Switching cost	Medium
Buyer propensity to Substitute	Medium to high

Substitution of one vendor with another is a key competitive threat for each company. Clients typically have multiple vendors to ensure that they can maintain competition and keep the prices low. Till date, the competition has not been destructive and most companies have made decent returns in the past.

Conclusion

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

• Switching cost due to customer relationships
  
• Economies of scale
  
• Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
  
• Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.
  

Inverting the question

Let's assume for argument sake that the industry does not have a competitive advantage and is similar to the steel or cement industry (which by the way has some competitive advantage). In such as case, the industry would be characterized by intense competition and low returns on capital (low ROE). This has not been the case for the last 15 odd years and most companies especially the larger ones have maintained fairly high returns on capital. This variable alone shows that the industry has some level of competitive advantage – especially the larger ones.

Valuation

The above analysis is clearly a backward looking exercise. Valuation on the contrary requires a forward looking estimate. Can we arrive at any conclusion from the above analysis?

It is difficult to arrive at how each company will evolve over the next 5-10 yrs (the typical duration required for a valuation). However we can arrive at some general conclusions

1. As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
   
2. The industry could split in two levels – the large SI (system integrators) such as Infosys, Accenture, Wipro, IBM etc and the niche players. Both these type of players should enjoy a decent level of profitability.
   
3. The industry is likely to diversify and expand into new geographies, but the future growth is unlikely to be as high for the big players.
   

The above conclusions are my educated guess and are as valid as anyone else's. However based on these conclusions I would propose the following

• The large SI like Infosys, WIPRO etc should continue to do well. However, these companies would see only moderate growth in profit. As a result I would be hesitant in giving a PE of more than 25 to these companies.
  
• The attractive returns in this sector are to be made with the small niche players. These companies, if they can be indentified early enough, are likely to have high growth and profit. However this is a specialized form of investing, requiring deep skills in the specific sub-segments.
  

Are you still reading? Wow!! ..If I have not put you to sleep, leave me a comment :)