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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