Investing Mistake and a List of Value Investors

a)

Q1. What is the first rule that every value investor needs to adhere to?

A1. Invest in stocks which the investor understands and is comfortable with.

Q2. What is the second rule that every value investor follows as a habit?

A2. Run some numbers and see if it is undervalued.

Q3. What happens if a value investor doesn’t adhere to A1 and A2?

A3. He commits an investing mistake – if not in terms of magnitude, but in terms of principle. The act of omission is ok, but the act of commission, in this case, mis-commission is pathetic.

And I am guilty of Q3/A3. The stock was PI Industries. I neither understood the industry nor did I value the stock. But I invested in it. Why? Because a few other investors were extremely bullish on the stock. I got heavily influenced and invested in the stock without checking on valuations (well, I checked P/E, if I want to be generous with myself and it was 12 P/E). I invested around Rs.560/-.

The stock went on to hit Rs. 590/- and then Rs. 620/- within 15 days. I was extremely happy with my investment and congratulated myself on finding a multibagger for the long run without putting in any effort.

And then it dropped. It kept dropping every single day. And with the bear market in 2011, it dropped as far as Rs. 420/-. I had no clue why it was dropping nor did I understand whether I should buy more or sell my position at a loss. I was asking myself a peculiar question – ‘If I put in more money into this stock at Rs.420-430 levels, am I averaging my investment or am I averaging my hope?’. I had not valued the stock and by not understanding the industry, I had no clue of the intrinsic value in the stock. There was no way I could justify that I was averaging my investment. If I put in more money, I was only ‘hoping’ that the stock would bounce back to Rs.500/- levels and then I would get out with a breakeven. But it could drop further (there was no way of knowing) and I would be stuck with a bigger loss. I refrained from putting in more money. I didn’t sell either.

Thankfully, the bull (or whatever) market came along and I sold my position recently at Rs.557/-, a price very close to breakeven (and this is inspite of management not meeting guidance nor having a strong order book). I heaved a sigh of relief. And probably some lessons learnt.

a) I got caught in the wave of ‘influence’ by other investing peers. In fact, most of these peers have made money in this stock by virtue of getting in at a lower price. I didn’t value the stock nor did I understand the industry. What was a ‘low’ or ‘high’ price for me really? Even if it had doubled to Rs.1200/-, I had no clue if I had to sell or hold or buy more.

b) I was definitely caught in the ‘mystique of multibagger’. You know, its a good story for your grandkids. ‘You know kids, there was this stock which I didn’t understand that I invested in and now that one stock paid for all your luxuries. Talk about luck, eh?’. ‘Building castles in the air’ is being too nice here.

c) Loss aversion. I strongly believe in the process/outcome matrix (2×2 matrix). I honestly believe that I was lucky with a bad process and good outcome on this occasion. Most times, that won’t happen (as in, most times, bad outcome results). Even if I was caught in a) and b) traps, a good process would have ensured that I sell at a loss and invest the remaining money in a stock that I understood. But I never did. Resulted in an opportunity loss, considering how my other investments have run up in this market.

d) Laziness. What else can explain the logic of not picking myself up to run some numbers even after I invested in the stock? Nope. It was ‘too hard’ since I couldn’t plug in any decent numbers without understanding the company/industry and that would have taken way too much time and effort. A good process would have ensured ‘boss, if it’s ‘too hard’ then sell the stock and invest in what you understand’. Nope. I thrived on laziness.

Anyway, I am very glad that I sold the stock at very close to break even. This stock might run away from these levels and maybe go 10 times from here, but I don’t care. Somehow, I have never taken fancy to the concept of ‘oh, you should invest in this one – this one is a multibagger’ concept. I have always felt comfortable taking the side of omission rather than commission. PI was the first stock that I deviated from my principles. Thankfully, I haven’t paid heavily. But a lesson learnt strongly. I never want to repeat this mistake again (and boy, this behavioral stuff is hard, very hard).

b) Over the past 1.5 years since I started writing this blog, I have observed that my learning curve has been pretty steep in terms of investing. Through this blog and then Twitter, I have met some super investors and learnt a ton from them. My investing process is much better than what it was 1.5 yrs ago and its all thanks to these investors who have shared/keep sharing their investing ideas, wisdom and investing process with me (and the world in general). If you are new to this blog/value investing in India in general, these investors are pretty much a must-follow (in no particular order, except the first one).

i) Prof. Sanjay Bakshi. Top of the list. Biggest jump in my investing learning due to him. The Guru. Enough said.

ii) Ayush Mittal – Fantastic investor. His blog is ardently followed by many and rightly so. Whatever little I have read about John Neff and little I know about Ayush’s investing picks, their investing styles match very closely. An amazing sense (and art) of picking some great stocks.

iii) Neeraj Marathe – Amazing sense and analytical ability to tell you what’s wrong with some stocks. His mindmap on the Sugar industry had gone viral and so have quite a few posts from his blog. It’s almost like he is teaching you the ABC’s of investing in each of his blogs.

iv) Donald Francis – His investing forum has been golden with a lot of quality investors pitching investing ideas and discussing them. Extremely enthusiastic and thorough in his investing picks and process.

v) Abhishek Basumallick – Crystal clear thought process is what I would term Abhishek’s blog as. Somehow I get the feeling (might be wrong) but this blog’s quite low profile and probably intended that way. But quality of writing, investing process, ideas, thought process – all top-notch.

vi) Amit Arora – His ideas and discussions go viral almost every single time he mentions a stock 🙂 And his blog indicates his focus area – multibaggers. Fantastic stuff on his blog.

vii) Rohit Chauhan – I recollect reading through Rohit’s blog way back in 2006 and dismissing it as yet another blog. Blogging and bull markets were very common then. I was fresh out of college and I was in a bull market. Who cared about value investing, right? Horribly wrong. One of the first investor-blogger, terrific and thorough investing process, widely followed and respected. Need I say anything more?

viii) Ninad Kunder – Special situation investing expert. Again, much like Rohit, starting a investing blog way back. His blogs have helped me develop a special situation framework and checklist. Some of his archives are worth their weight in gold.

ix) Devesh Kayal – A value investor who is gung-ho on consumption stocks and is very good at it. Also follows multiple PE/VC firms focused on the Indian markets (and he keeps you updated on it). He had stopped blogging for a while. He is just coming out of the woods again 🙂

x) Ankur Jain – Ankur, along with Arpit Ranka (who unfortunately doesn’t blog anymore) were one of the first investor-bloggers that I started following actively. What I love about Ankur’s blogs (he started blogging recently again) is the step-jump in thoughts, ideas and conclusions he takes you through as a reader. I am sure there is a ton of research behind each of his blogposts, but the sheer simplicity, learning and insight you get from reading his blogs is wonderful.

xi) Chinmay – Doesn’t blog as frequently as he used to or should have. A hardcore value investor. He will take you through some Graham/Buffett principles through some practical examples. Terrific stuff (do read the archives).

xii) Prabhakar Kudva – If there was ever a hardcore growth investor, Prabhakar Kudva is one. His passion for strong concentration in equities (maybe 3-5 stocks max) and a superior research and mental model process, he is a true Fisher disciple.

xiii) Deepak Shenoy – As much as he wants to convince the world that he is a technical trader, I personally think he has got a great grounding and sense of fundamentals to invest or not invest in a stock 🙂 His charts are legendary as is his ability to simplify and explain complex things in English.

One of the objectives of this blog along with sharing my learnings (successes and failures) was to connect with as many quality investors as possible. I have connected with all of the investors above either through my blog or my twitter handle (@_kirand) and hope to continue to interact with them fruitfully. I hope to connect to many more in the future. Do drop in a line.

Undervalued Companies – An Approach

a) I am experimenting with the approach stated below (which I am pretty sure I’ve read somewhere but can’t recollect where). Let me know your views.

The interest rate offered on a AAA bond in India is around 9.75% (SBI AAA, issued in Feb 2011). Now that we have all that interest increase jazz, let’s assume that if any firm would issue a AAA bond today, the interest rate would be around 10.7%. Post-tax, the return would be 7.5%.

Imagine there is some company somewhere in the Indian stock market which delivers around 30% post tax return. That is, its Return on Capital Employed is 30%. Since this company has utilised the capital 4 times better than a AAA bond (4*7.5), it should ideally command a price 4 times the price of a AAA bond.

In summary,

Post-tax return of AAA bond = 7.5%

Post-tax return on some company = 30% (4 times AAA)

Therefore, the fair value of this company will be around 4 times P/B.

I usually don’t invest in companies with RoCE < 20%. For experimental purposes, I am trying to find companies with RoCE >= 30% with P/B < 4. Since a company can deliver very high returns in any single year, I have taken an average (rather, a median) over the past 7 years (10 yrs would be even better,but I don’t have the data). Extra caution has been exercised to list out only those companies where there has been a continous increase in Book value per share. (Devesh did point to me that this would work only for non-cyclical companies. Also, credit to Moneysights and Valuepickr for the data and tools provided). Here’s a initial list – Thoughts are invited.

S.No	Company	CMP	Median RoCE 7 yrs	Current P/B	Fair Value P/B
1	Sesa Goa	223.5	58.88	1.65	7.85
2	Voltamp Transformers	510	27.78	1.38	3.70
4	NESCO	594	45.47	3.67	6.06
5	Mangalam Cement	101	31.22	0.69	4.16
6	Goodyear India	313	31.21	2.51	4.16
8	Facor Alloys	3.75	33.3	0.53	4.44
9	DISA India	1453	36.5	3.8	4.87
10	Bharat Bijlee	718	33.58	1.44	4.48

Of the above list, I like Sesa Goa, NESCO, Goodyear, DISA and Bharat Bijlee. Sesa Goa especially seems highly undervalued according to this parameter (economic conditions, shipping downturn and all that – but is this entry price alright?).

b) This one is for momentum investors. And maybe I am the last person in the universe to realize this trick. Whenever a company declares a stock split or a bonus issue, the share price rises considerably (in cases I have seen, atleast by 20%). So maybe there is a theme here (or probably I am plagued by availability bias – not sure yet). Buy stock of any company (not any company literally – some basic checks on revenue, EPS, RoCE etc. are required) which declares a stock split or bonus (If you think about it, it doesn’t matter whether the company’s face value is Rs. 10/- or Rs. 5/- (2:1 split or bonus) or Rs. 2/- (5:1 split or bonus). The company earnings are not going to change. The only change would be increased liquidity in the market which has nothing to do with the company (but this is after the split, and not before the split) and yet the stock price shoots up. Maybe irrationality. Maybe its a corporate signal that dividends/earnings are going to increase in the future (how?).) No idea. Titan Industries, HDFC Bank are some of the prime examples. Alternately, NESCO share price rose on the split announcement and fell considerably once the split announcement got cancelled.

c) Wonderful read from Prof. Sanjay Bakshi, written way back in 1997 –

http://www.sanjaybakshi.net/Sanjay_Bakshi/Articles_files/The_Relatively_Unpopular_Large_Company.HTM

Name some companies in the current environment which fall in this ‘relatively unpopular large company’?

 

Disc: Invested in NESCO. Kindly do your due diligence before investing in any of these companies and all that.

Indian Stock Market – Cash Bargains

Alright – even in this market (with Nifty P/E above 20, well above its historical average of 17.5), there are some cash bargains. What are cash bargains? Prof. Sanjay Bakshi defines them as “A cash bargain arises when the market value of a company goes below the amount of cash and other liquid assets in its possession, net of all current liabilities and debt.”

I found some companies satisfying this criteria and I have listed them below.

Company	Cash per                   Share	Debt per             Share	Cash-Debt	Current                  Price	Discount
Aftek	28	9.73	18.27	13.11	39.36%
Amrapali Industries	19.81	0	19.81	6.9	187.10%
Eldeco Housing	187.97	31.75	156.22	138	13.20%
MPIL Corp	93	5	88	63.5	38.58%
Rajesh Exports	250	78	172	131.8	30.50%
Teesta Agro	63.37	3.58	59.79	10.75	456.19%

I have excluded companies which are burning cash. For example, ‘Punjab Communications’ was one such stock which was on my radar for a cash bargain, but I realised that they were having negative Operating cash flows (and Operating margins) for the past 5 years. Any cash on the balance sheet would soon be burnt. Hence, I have excluded such companies.

I have also excluded companies like MTNL which satisfied Cash Bargains criteria, but is a value trap (as Neeraj puts it very elegantly here and here).

I have also excluded companies with very high debt like JVL Agro (in this rising interest rate environment, its very dangerous to bet on any company with high debt!)

All the 6 companies in the list have low margins, low operating profit and may not have any competitive advantages at all (there are some reasons why these companies have been beaten down by the market). But they have been beaten down so much so that they are quoting below cash

I have not researched extensively on any of these companies except for the fact that each of these company financials are in decent order (i.e., they are not burning cash, and have most of the time generating positive operating cash flow). (I doubt though, that something is seriously wrong with ‘Teesta Agro’ and/or ‘Amrapali Industries’ (mgmt problems?), else why would they be quoting as such a tremendous cash discount?). (Aftek, I think is one of K-10 stocks, and hence quoting at a discount?)

Do any of you have any idea why these companies are quoting at cash discounts? Do you have a position in any of these companies?

As usual, the disclaimer applies. Please do your due diligence before you invest.

Disclosure: I have starter positions in Eldeco Housing and Rajesh Exports.

Indian Stock Market–Debt Capacity Bargains

As I stated in the blog yesterday, this talk by Prof. Sanjay Bakshi throws up multiple value investing themes. One other theme is ‘Debt Capacity Bargains’.

This theme was originally propounded by Benjamin Graham in ‘Security Analysis’. He didn’t call it a Debt Capacity Bargain. Rather, he called it ‘The rule of minimum valuation’. The ‘rule of minimum valuation’ states that –

“An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part thereof.”

He explained this rule with the help of an example (American Laundry Machinery). An excerpt –

“The purpose of this analysis is to show that at $7 per share for American Laundry Machinery stock in early 1933- equivalent to only $4,300,000 for the entire business- the purchaser was getting as much safety of principal as would be required of a good bond, and in addition he was obtaining all the profit opportunities attaching to common stock ownership.
Our contention is that if American Laundry Machinery had happened to have outstanding a $4,500,000 bond issue, this issue would have been considered adequately secured by the standards of fixed-value investment.
There would have been no question about the continuance of interest payments, in view of the powerful cash position revealed by balance sheet. Nor could the investor fail to be impressed by the fact that the net current assets alone were nearly five times the amount of the bond issue.
If a $4,500,000 bond issue of American Laundry Machinery would have been safe, then the purchase of the entire company for $4,300,000 would also have been safe. For a bondholder can enjoy no right or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, the owner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”

To get a more layman understanding of this debt capacity bargain/minimum valuation, we take the help of ‘The Intelligent Investor’ where Graham states –

“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”

All this Graham-gyaan is fine, but what does it mean in really really layman term? (the basic logic is – hidden inside every stock of a debt-free company is a high-grade bond which can easily be valued).

Let’s break it down further, into discrete steps for clearer understanding –

1. Search for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the same in the future.
2. Average the past earning power, say for the past 5 years (Approaches differ here. You can either use EBIT or Buffett’s Owner’s Earnings (Cash flow from Operations – Capex +/- Changes in Working Capital) Both will result in different results though. Safer to go the Buffet way!)
3. Use a desired interest coverage ratio of 3x-5x (Prof. Sanjay Bakshi recommends 3x for highly stable businesses, 5x for cyclical businesses). I use 5x for all, just to be extremely safe.
4. We can use steps 2 and 3 to find out what is the interest expense that the company can service (EBIT/Interest coverage ratio or Owner’s Earnings/Interest coverage ratio)
5. Divide the interest expense arrived at in Step 4. into the current interest rate to determine debt-capacity of the company; SBI’s AAA bonds were issued recently at 9.5%. Let us be conservative and take an interest rate of 12.5% (a 15% would be even more conservative)
6. Compare this debt-capacity with the current market cap, and if the Market Cap is less than Debt-Capacity, we can consider buying the stock.

I have seen another approach (I can’t recollect where) where the author follows the steps below in addition to the steps above –

7. The value of equity would be 75% of this debt capacity.

8. Add back the value of cash on the balance sheet.

9. Add the debt capacity, equity value obtained in Step 7 and add cash on the balance sheet. This would be the enterprise value of the company. If this Enterprise value is less than Market cap, we can consider buying the stock.

(I would personally stop at Step 6, although in my analysis, I have hardly found any company which does not fulfill Step 6, but fulfills Step 9.)

Note: This approach works beautifully in bear (more likely, severe bear markets) than any bull market. We might find shady companies fulfilling the criteria above in a bull market.

Let us look at what companies fulfill this criteria in the current market (I consider the valuations of the current market are on the higher side; you can call it a bull market/dead cat bounce in a bear market or whatever!)

 

No.	Company	MarketCap
1	Monnet Sugar	16.85
2	Simplex Realty	46.37
3	Suditi Industries	8.09

Of the three, Suditi Industries looks slightly better. But then again, as I said, in times of valuations like these, it is difficult to find debt capacity bargains. File this methodology away for bear markets. Diligently followed, it can make money.

Your thoughts on this methodology?

Indian Stock Market– Value+Momentum Strategy

As I have stated before, I have been more than inspired by Prof. Sanjay Bakshi’s work and talks. I am researching on a couple of methodologies suggested by Prof. Bakshi in this talk (a must must read, if you haven’t already taken a print out and penciled important points!). In this post, I will try to elaborate on the Value+Momentum strategy from that talk.

Value+Momentum – The theme of this approach rests on a hypothesis which states that the Market realises the value of a stock in a relatively short period of time. For example, if Stock A is quoting at say Rs. 50/-, but its intrinsic value is Rs. 150/-; the Market might ignore Stock A for 6 months, 1 year, 2 years but when it does realise the price of the stock is quoting far below its intrinsic value, the approach to intrinsic value from Rs. 50/- to Rs. 150/- happens in a relatively short time. This approach can be broken down into two parts:

a) Value Stock which can defined as per Graham parameters (low P/B, low P/E, sufficient Margin of Safety etc). However, if we monitor the momentum for this stock (say, by returns or volume), we can put in more money into the stock once the momentum starts increasing so that the absolute gain increases within a short period of time.

For example, if we have a Stock B which we think is a Grahamian stock and is languishing at Rs. 50/- for about 18 months now, although its intrinsic value is Rs. 200/-. If we were to monitor the momentum of this stock (in terms of increasing volume/sustained uptick in the stock), we can put in more money behind Stock B say at Rs. 75/- and/or Rs. 100/- and/or Rs. 125/- and achieve more absolute returns with a higher probability in a relatively short period of time.

b) An approach from ‘What works at Wall Street’ as well as Prof. Bakshi’s talk. Prof Bakshi says “We have a low PSR, we have a highly leveraged balance sheet, we have a low absolute stock price and there are multiple triggers out there”. In ‘What works on Wall Street’, the theme is Low PSR (as Value) + Highest One year returns (Momentum). Prof. Bakshi goes on to say, if there is any kind of corporate debt restructuring announcement on such stocks, and if the management is trustworthy enough, such stocks can generate very good returns in the medium to long term.

What are some of the stocks that we can look at for this strategy (I illustrate with strategy b)) I turn to the ValuePickr screener to come up with stocks which have a PSR < 1, D/E > 3, exclude Financial Stocks and look at decreasing debt y-o-y for the last couple of years  (the stock list is only indicative – lots of other research needs to be done before even thinking of investing in these stocks) –

No	Company	Debt2Equity_LFY	Industry	P2Sales
1	Beeyu Overseas	3.96	Trading	0.59
2	India Steel Works	21.93	Steel	0.66
3	Rama Phosphates	3.18	Fertilisers	0.08
4	Saurashtra Cement	16.88	Construction Materials	0.11
5	Spentex Industries	5.82	Cotton & Blended Yarn	0.18
6	Suryalata Spinning Mills	6.1	Cotton & Blended Yarn	0.32
7	Venus Sugar	3.26	Food & Beverages	0.18

Comments? Suggestions on the approach? Any nuances that we can add?

My Initial Hypothesis

My initial hypotheis includes one fundamental idea – I will have two portfolios. One, a diversified portfolio (based on Graham valuation) and the second, a concentrated portfolio (based on comprehensive valuation). Some of the stocks of Graham might (and probably will) flow to the concentrated portfolio.

The idea behind having two portfolios is again a learning from the Masters.

1) Diversified portfolio – Graham, in his infinite wisdom, focused just on the output (numbers). He didn’t care what the company produced, how the management was, where the company was located etc. He just concentrated on the price at which he would like to buy a share. He espoused certain principles via this theme. My diversified portfolio will follow Graham’s theme, in conjunction with the Magic Formula (evangelized by Joel Greenblatt) and which is not too different from what Graham said.

2) Concentrated portfolio – This is an idea which has been a confluence of two masters. Prof Sanjay Bakshi says that Grahamian diversification is fine, if you just want to beat the market by a certain percentage of points. However, to create wealth, one needs to put in serious money behind only a few stocks which might be multi-baggers. Even Buffett espouses the same principle (he says ‘you only need to make about 10 investing decisions throughout your life, and you’d be rich’). Shankar also follows the same principle of having a diversified portfolio and concentrated portfolio.

We’ll come to discussions on concentrated portfolio a little later. Let’s set the stage for the Diversified portfolio in the next post.

An Introduction

Over the past few years of my investing, I have done reasonably well. The shocking part though is I have done well just by knowing which sector to invest in. For example, I was bullish on the Banking sector and by sheer luck (and nothing else!), I was able to generate decent returns. Again, in a bull market, who doesn’t make money? I’d say, I have been part of the tide which lifted all boats.

Now that the thrill of just playing on the stock market like a monkey has subsided, I want to learn about the nitty-gritty of value investing. I probably know a miniscule part of value investing (as miniscule as an electron I guess) right now, and this blog is an endeavor to experiment and learn about value investing.

I am a huge fan of Prof Sanjay Bakshi, who teaches at MDI, India. Although I have never met him, he has had an enormous influence on my thought process in investing. He talks about 10 value investing themes (here) and I only hope to learn atleast 3-4 themes in a comprehensive fashion.

The second person who has had an influence is Shankar. Again, I have not met him but his thought process has had a fantastic influence. He has stopped writing for quite a while now, but you can still find gems of his writing here.

I’d be lying if I say that I have not been influenced by Magic Formula of investing, promoted by Joel Greenblatt. It can be a starting point for anyone to start on the path of investing and I kicked myself for some time not to have know this earlier. Magic Formula investing makes investing look very easy (atleast for starters!) and once curiosity is aroused, the complexities of value investing would look like a healthy challenge to overcome.

I have linked to almost all financial/value investing websites I follow in the blogroll. I hope to spread the enormous wisdom each of these guys have written over the years through this attempt.

Again, I strongly recommend you not to follow anything I say on this blog as my reading on a particular situation might be drastically different from reality. Please invest on my ideas at your own risk.

Happy Investing.