Remembering my Investing Gurus !!!

On this occasion of Guru Purnima, I take this opportunity to thank all my Investment Gurus who taught me (and their is lot more yet to learn) and stood like a Light house in my Investment Journey.

In the investment world, some people think it is “cool” to say “I am a Value Investor”. But it is not so cool to follow it. Not at all. Infact it is a mindset that should be incorporated in the life style itself and not only in Investment related decisions.

One person who is the dean of Value Investing is “Ben Graham”.

1) Benjamin Graham:

There is nothing left to tell about this legend. His 2 books “Intelligent Investor” & “Security Analysis” are the greatest monuments of Investment world.

People may say some of this teachings like “Buy any company if it is available at two third of its working capital” can be irrelevant. But there is no doubt in saying all his investment philosophies are like the mother root of all other philosophies. His golden words like “Price is what you pay, Value is what you get”, “A Great Company is not a great investment, if you pay too much for the stock” and a beautiful concept called “Mr. Market” in the chapter 8th of Intelligent Investor. People who say his teachings are outdated, in my humble opinion are the ones who are retarded. His teachings are valid a century ago and will do the same a century later.

ben

2) Charlie Munger:

I may be nuts to place this little known guy before Warren Buffett. But to put in WB daughter’s own words “Charlie uncle is the most rational person I had ever seen, second being my father”. His book “Poor charlie’s almanack” is one of the few most influential books I had read. He himself is a walking library. His wits like “You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing”, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero” are few quotes which always will be there in my subconscious mind. I started reading Berkshire Hathaway’s and Wesco’s annual reports (will take months to complete and years to understand and follow) to know the wits of this legend and his favorite words “I have nothing to add” :)

charlie

3) Warren Buffett:

The one guy who made it BIG, REALLY BIG through the value investing ideas taken from his father, Ben Graham and his partner Charlie. Being the most successful business man living on the planet and on the other side he is a great philanthropist. He pledged 99% of his net worth for the society. A HUGE “GIVE BACK” !!!. His biography “The Snowball” is a must read for all investors not because he will share all his investment ideas, but because he will tell you “How to lead a successful life”.

wb

4) Peter Lynch:

I don’t think there will be any person in this Investment world who didn’t read “One upon wall street” as his second or third book. His successful career as a Fund manager of Magellan Fund at Fidelity Investments which delivered a CAGR of 29% from 1977 to 1990. An astonishing journey with a lots of learnings.

peterlynch

5) Philip Fisher:

His amazing book “Common stocks and uncommon profits” is another gem in the investment world. This book will have high influence on your investment style and many of his quotes like “Buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.” is like a golden rule for me.

fisher

6) Parag Parikh:

I got a privilege to meet this visionary in person. He can been termed as a dean of Value investing in India. I was astonished by his wisdom, his conviction. After reading his books “Value Investing And Behavioral Finance” & “Stocks to Riches”, I learnt about behavior side of Investing and how it is most powerful in day to day in stock markets.

parag

I once asked him a question “One of your darling stock Noida toll bridge which you started to accumulate at 40, is now trading at 12. Do you still continue to buy it?”. For which he answered “I Liked the stock at 40, at 12 I am LOVING it”.

This particular reply of him haunted me for several days. I was spellbounded by his conviction.

I was extremely happy to see him in the Forbes India list of top 20 investors and their philosophy

7) Prof Sanjay Bakshi:

bakshi

I got to know about this guy from a video of PPFAS in youtube. Then I searched about him. Then I realized myself “What should be my path?”. He has a unique way to analyze a company (which in turn he borrowed bits and pieces from Ben Graham, WB, Fisher). After reading his life struggle, I got huge respect on him (because, somewhere unknowingly I related to it. I worked as a Paper boy who delivered newspapers on cycle early in the morning to earn for my school fees in my high school days).

His journey inspired me and taught me “Dream BIG and find a way to achieve it. No matter how small you start, you can make still reach there with constant learning”. He was also listed in Forbes India list of top 20 investors and their philosophy along with Parag sir.

8) Aswath Damodaran:

ad

I am happy that I got visionary Bakshi sir holding my hand (through his articles & blogs) and teaching me how to analyze a company. But where to go for the Valuation side of it? Remember Ben Graham’s quote “A Great Company is not a great investment, if you pay too much for the stock”. Hence I took the help of Aswath Damodaran in this aspect. He is the authority of Equity valuation and corporate governance. His teachings are immense and are in-depth (they will also have in-depth impact in your mind). His writings will make you run and are like roller coaster rides.

9) Basant Maheswari:

BM

The “Oracle of Calcutta” through his Blue Bible “The Thoughtful Investor” taught many of new ways to look at stock prices. He incorporated a new style of investing and has been successful. His site “theequitydesk.com” itself is a khazana of amazing leanings.

 10) PV Subramanyam:

subra

Subra sir (as we normally address him) is one of most respected people in Indian financial markets. His blog “subramoney.com” touches every aspect of Investing (mostly in a sarcastic way, which he is famous for). He is an amazing critic. He terms himself as Investor, Trader and a speculator (sometimes). His book “Retire Rich Invest: Rs. 40 a Day” is a book which you MUST read immediately you received you first pay check (I did so).

Pattabiraman Murari:

pattu

I first got to know about him some 3 years back (at jagoinvestor.com) where he was an active participant. Then I visited his blog “www.freefincal.com” and was amazed to see some GREAT financial calculators and that too free for download. Any other person with his wisdom & knowledge would make money out of it (and I personally feel they are worth some thousands of rupees). I am privileged that we will be in contact with each other (in our amazing facebook group Asan Ideas for Wealth) and he is just a click away. There are enormous learnings from his writings and calculators.

Another amazing thing about Pattu sir is “He is double edged sword. He is having Ph.D. in Physics and an unmeasurable knowledge in the field of Investing”

 Ashal Juhari:

ashal

Ashal ji not only comes with enormous knowledge but also with extraordinary patience. He loves to answer every question. He thinks there will be a learning in every post or a query. During my days at Jagoinvestor (where I was very active, there wouldn’t been any query which was not answered by Ashal. No I am not exaggerating. One incident which I still remember was, He was on vacation and one of the reader posted nothing but “Where is Ashal?” nothing more, nothing less. That’s shows the importance of his knowledge. He is the admin of the group Asan Ideas for Wealth in facebook and extremely happy to be in touch with him on daily basis. His favorite quote “My dull and boring SIP’s will continue” is like a mantra in all market conditions.

 Manish Chauhan:

manish

He had done a great contribution to personal finance in India through his blog “Jagoinvestor.com”. This SHOULD be the starting point for every person who thinks in terms of managing their financial life. I have learnt a lot from his blog.

thank-you

Thanks a lot to all  who influenced me and many others through their teachings. They all walk their talk and I have immense respect for all of them.

 

 

My monkey’s portfolio experiment !!!

Few days back I read an article which says about an experiment conducted at City University London (view the report here), where a group of monkeys (not the original monkeys but computer programmed) were given the task to choose couple of stocks and built a portfolio. Then they back tracked them to check how they performed vis-a-vis the market.

Inspired by this idea, I had conducted the same experiment on Indian stock markets.

Following assumptions are made for this experiment:

1) I had chosen 5 monkeys and they have selected their own portfolios (using Random.org) consisting of 5 stocks each.

Random Portfolios

2) I tried to find the index composition of BSE 200 for previous years but couldn’t find it, hence used the same composition of current BSE 200 index. So if any of the selected company was not listed during (2003-2013), then the immediate next company has been picked. For example, Monkey 1 has selected Company 1 which is TCS, but TCS went public on July 2004, hence it was filled with Company 2 i.e ONGC. All the index companies are sorted by Market Capitalization.

(*) in the portfolio indicates that the actual selection company is not available and hence the next best market cap company has been selected.

3) A lump sum investment of 1, 00,000 has been made on 1st Jan 2003 on every stock (hence each portfolio had started with 5 lacs). Also equal amount (5 lacs) has been invested on S&P BSE 200 index.

4) In order to analyze correctly, our experiment is divided into 2 phases. 1st Jan 2003 to 31st Dec 2007 (Bull phase) & 1st Jan 2008 to 31st Dec 2013 (Bear Phase).

 

Let’s start!!!

Assume we are currently in 2003. India is in the beginning of the best Bull Run it had ever witnessed. Everyone is turning to stock market. New brokerage companies are emerging and want to make the best use of it. Every investor is thinking, Stock market is the place to make quick money and they don’t want to miss the opportunity. They heard that, his neighbor had made 40% returns on a stock in one month and he too wants the same. Greed everywhere on the streets of Dalal street. With the same greed our 5 monkeys also jumped, opened a demat account and started investing.

Portfolio of Monkey 1:

Port1-2003

Seems like this monkey wanted to ride this wave, hence it had chosen 2 banks, 2 PSU’s and a strong company ITC.

 Portfolio of Monkey 2:

port2-2003

This monkey is very much interested in mid-caps. He thinks what most of the investors think, “Today mid-caps are tomorrow’s large caps”. Hence chosen everything from mid-caps space, with enough diversification like Pharma, Banks, Transportation and Entertainment.

Portfolio of Monkey 3:

port3-2003

This monkey can be termed as a “Trend Monkey”. It goes with the trend. Like most of the investors out there, it also loves to pick up the current fancies in the market. Hence picked up L&T and Unitech from Infra and construction space, which was trending at 2003.

 Portfolio of Monkey 4:

port4-2003

This monkey is also no different. It had diversified well across sectors.

Portfolio of Monkey 5:

port5-2003

 

Now let’s see how our Benchmark had performed during the same period (2003-2007).

bse2003

 

Also let’s compare with the Top mutual fund of India, HDFC Top 200

hdfc2003

 

If you can see, “All the monkeys have outperformed its bench mark” and “4 out of 5 monkeys had outperformed HDFC Top 200 by huge margins.”

bull

All my monkeys are happy. Just like all the investors were happy during those days.

happymonkeys

Investor’s community at that time was thinking like:

1) In equities, you can NEVER lose money (Recency bias)

2) You are not into equity, Ohhh boy!!!

3) My portfolio had given 120% returns this year. Now I have become an “Individual stock picker”. I know how to choose the companies and beat the market.  I did it for 5 years in a row. I haven’t lost money till date in market. I am no less than Prasanth Jain and Siva Subramanian.

4) There is no RISK in equities. Take out your money from PPF and debt instruments and keep it in equity, you will earn a hell lot of returns here.

5) Leverage your positions using F&O’s. Make more and more money. Arey yaar it’s simple, ho jayega. Just go on!!!

 

Everything went fine. Let’s move on to the second phase.

 

Now we just entered into 2008. Financial shock waves have started in US. My monkeys were un-aware of it. They are just enjoying the ride. In the mid of the year, these waves hit the entire world. Every equity investor, every index and every country (well most of them) had been affected by this.

Now let’s see, what are our monkeys and their portfolios doing during these years.

port1-2008

port2-2008

port3-2008

port4-2008

port5-2008

At the end of 2013, only 3 monkeys made into Green zone and 2 monkeys were in red zone.

bear

Let’s also see how our benchmark and HDFC Top 200 is performing.

bse2008

Impressive!!! HDFC Top 200 maintained its way into Green zone, even though the benchmark is in red.

As a value investor, my first agenda is preservation of capital. Prashant Jain does it better.

 

Learnings from my Monkeys:

1) Monkey 1 is in safe zone, because it had selected strong companies like ITC and HDFC bank. No matter what the economic structure of India, world etc. etc., few companies do their job without any distraction. Monkey 1 won this experiment by choosing these kind of stocks.

2) Monkey 2 took the approach of Mid-caps and it is LUCKY enough to  win.

3) Our “Trend Monkey” took the trend. Chased the fancies (L&T, Unitech, NMDC), paid the fancies price to own them. Now sitting on fancy losses.

4) Monkey 4 just crossed the winning line with much difficulty.

5) Another disastrous portfolio created by monkey 5 purely chasing the fads like Petronet LNG, BHEL, Unitech.

 

Now the same people, who said above 5 points regarding stock market, are saying these statements now:

1) I had lost humongous amounts of money in stock market.

2) Everything is manipulated here. Only big heads make money in share market. This is not the place for Retail investors.

3) Equities are dead. Debt instruments, Gold and Real estate are the only ways left for us.

4) Yes, I agree that I was greedy at that time. But I just need my buy price for this stock that I am holding. I will sell it and will never be back to equities.

What is the point for us?

In the recent euphoria in the market:

1) Is your current portfolio is making new heights every week after week? Is every stock you pick is trading at new heights every session?

2) Do you think that you have become a good stock picker on you own and 5 out of your 6 stocks gave 20% return in the past 6 months and in no mood to slow down?

3) You are getting ready to ride this wave and mostly looking for fancies and fads (Power, Infra, RE etc.) companies in the market to make quick money?

Beware, “You may be just another monkey out there, but not an investor whom you think you are!!!”

Learn to move from a Monkey to an Informed investor yourself. DIY. Stick to the basic investment principles, irrespective of Bull or Bear ruling the market.

 Buy companies with:

a) Strong moat with high network or distribution channel.

b) Secular growth.

c) Management in which we can trust

d) Companies which has pricing power

e) Above all, they must be available at reasonable valuations.

Only the companies that have fulfilled these criteria’s have succeeded in the past and will do in the future. These companies will do the magic, even if they are picked up by the monkeys.

Outcome of this experiment:

full

If you see the performance graph of Individual companies, secular growth companies like ITC, HDFC bank, Lupin, Axis bank and Marico have outperformed all other fancies over long run. I am not considering Unitech and L&T, because of the HUGE standard deviation associated with it in the past 6 years. In my humble opinion they are lose makers.

NEVER chase fancies, Repeat NEVER EVER chase fancies. No matter how tempted you are. You may make money out of it initially, but you will end up just as a monkey sitting on huge losses when the party ends. There is no evidence in the past that a fancy or a fad of the market made wealth in long term. 

Finally,

To be honest, I was skeptical before writing this post. This post can be taken in wrong way, if not conveyed properly.

This post is NOT to say, every stock and every investor will make money in Bull Run.

Or this is NOT to say, pick any leader from any sector and you will make money.

Also NOT to stay that good companies will always outperform good diversified mutual funds.

This post is to say:

“Stay Informed & Know what and why you are doing so?”, especially during the times of Bull runs, where all the valuations goes for a toss and every Tom, Dick and Harry around you are making profits in stock markets and you also want to join them. Always keep it in mind, initially you will make money just as my monkeys did, but ultimately if you want to continue those profits, we have to Learn, Learn & Learn!!!

I am personally feeling happy to conduct this experiment on my own and this can be a triggering point for other posts to come.

Please let me know your learnings and views on this experiment. Many Thanks.

 

 

 

 

How little we know?

That was exactly my feeling after reading some of the facts in the past few days which I am going to discuss below.

The heading of this post have 2 meanings:

1) How much as an individual I know?

2) How much as a retail investor community WE know compared to big players out there?

Companies, Promoters, Brokers, Auditors, Institutional investors etc, all these people have only one thing in their mind apart from making profit. It is to use every opportunity to take the money out from Retail investors pockets. (Not all companies, but most of them). This greedy nature of companies combined with the pressure to stay top in the competition allows them to do such things. They make use of every option they have, to show us that their books are stronger than actual.

Let’s look at some of the examples in the past. Be ready to see some BIG names here in this section.

Before that just to have better understanding of what actually happened, let’s see some definitions. Don’t worry even if you don’t understand them in particular, just get the gist of them.

BIG BATH Accounting: The strategy of manipulating a company’s income statement to make poor results look even worse. The big bath is often implemented in a bad year to enhance artificially next year’s earnings.

Capitalize: An accounting method used to delay the recognition of expenses by recording the expense as long-term assets. It will do so inappropriately & most likely to artificially boost its operating cash flow and look like a more profitable company.

Write-Off: A reduction in the value of an asset or earnings by the amount of an expense or loss. Companies are able to write off certain expenses that are required to run the business, or have been incurred in the operation of the business and detract from retained revenues.

icici

1) In FY 2000-01, a giant in private banking sector had done Big Bath accounting. ICICI bank wrote off Rs 813 crore of bad loans against its profit and loss account, as a result profit fell by 55%. As against this, ICICI wrote-off only Rs 701crore in the three years 1997 to 1999 and that too against reserves.

Tata Motors Logo

2) Another example of such act comes from most respected corporate house in the world TATA.

TATA Motors, during the time of its Indica launch in the year 2001-02, it has spent Rs 1178 crore on the launch process. Later the company showed a net loss during 2001-02 of just Rs 53 crore as compared to a loss of Rs 500 crore in the previous year (2000-01). If this expenditure of Rs 1,178 crore was shown on the P&L Account, the net loss for 2001-02 would have been more than double of that in 2000-01.

rolta

3) Rolta India was accused off propping-up its sales in the late 1990s by adopting some creative method of accounting. The company has been accused of inflating its sales by asking one of its own divisions to sell capital equipment to another on much higher profit.

hdfc

4) Another example is from most respected firm and an example of wealth creating by its two twins (HDFC & HDFC bank).

During FY 2002, HDFC bank had shown the profits from sale of investments as part of operating profit. About 4% of such profits came from sale of securities.

(I have immense respect on HDFC and Deepak Parekh in person. He is truly a legend and some of these happenings must be restricted and tighten the auditing process)

And the list goes on and on…

“Krishna, to find this kind of fishy happening in the company, we need to read all the financial statements, foot notes, Annual reports etc. But we don’t have that much time.”

Agreed with you 100%, you need some time to find out this kind of book cookings. But what if I told you even after knowing “ALL SUCH COOKINGS”, people still invest in such companies.

Don’t believe me? Let’s take an example.

What if I told you “Bro, I am running a business X, which is not running well. Hence I want to start a new business Y in SAME SECTOR. Invest in my company”

You: What Same sector?

Me: Yes same sector.

You: But you said you already made losses in that sector, why to go again with it. Choose some other business.

Me: No I don’t. I want to go with same business.

You: Okay. How much is the value per share?

Me: 5 rupees, but I am selling it for 200 rupees.

You: Have you lost your mind? Firstly it is a loss running business and upon that you want to sell for 200 rupees. GO TO HELL GREEDY FELLOW.

This is exactly what happened in the India’s most scariest IPO till date Reliance Power.

Anil Ambani already had a company called Reliance Energy which is also into Power generating business, but because of the greed, he started another company Reliance Power and wanted to raise money for it. Each stock with a face value of 10, is reasonable to sell at Rs 100 or Rs 120 premium. But because of the greed, the issue went up to 450 per share. Promoters kept the share worth Rs 10 and for public sold it for Rs 450 (huge premium).

share holdings

Perfect

Every person who subscribed to this IPO knows the shareholder pattern (it should be published in every report according to SEBI guidelines), but many acted on it with “Known information” only.

Okay Krishna, everything is fine. All the examples you have shown above tells us that:

1) First the companies can cook the books. Hence we investors can take a hit, because the valuations which we have done based on those cooked books goes for a toss.

2) Second, because of our greed, most of the times we first value a company and later look for the reasons to justify the price

But I can happily value a business which is easy to understand and the books are tight and correct.

Really, lets see that scenario as well?

For example, the books of the below company are accurate and detail. They are the MOST trustful promoters in the world (just an example).

Now tell me, What is SBI ? What business is it into??

sbi final

(Luckily SBI has the correct Logo which I am talking about )  :)

Off course it is a Bank. Sure?

What if I told you it is not a bank, but a Real estate company who runs a side business of running largest bank in India.

The huge branch network of SBI (it typically has at least one branch in the most valuable part of every large Indian city and not most of the buildings are leased) is also one of the most valuable real estate portfolio in the country.

If we were to value, at current prices, the real estate portfolio of SBI, we would find that, perhaps, it is far more valuable than the market value of its all its outstanding shares and debt. Does that make SBI a bank, or a real estate company?

Suppose, one was to do a branch-by-branch valuation of SBI. It would not be a surprise to find that the market value of the land underneath several hundred of its branches turned out to be worth a lot more than the value of the banking business that these branches are doing. Does that mean that SBI will close these branches, sell them, and distribute the after-tax proceeds to its shareholders as tax-free dividends? Well, for all sorts of reasons, we know that the answer to that question is “no”, at least for now.

Does it mean we should include the land base in the valuation of its business? Or do we have to only look at future aspect of its main wing called Baking.

Well, the answer is debatable. But the question is what we needed for now.

Now tell me my friend, How little we know about the companies which we look on daily basis? We think we know about them. Do we??

We think we know the business of SBI. We think big names like Tata Motors, ICICI, and HDFC etc will never make any mistakes. We seriously take the real meaning of Reliance.

But actually we know little, very little about all the companies.

We are dealing with the least ethical financial sector and we have nothing left except to learn and doubt everything.

Always use pure mathematics in investing (as said by one of my favorites as a person my inspiration as a blogger Pattabiraman Murari Sir of www.freefincal.com)

This constant learning will take years in fact decades (for me at least) to get some understanding, after all who told It is an easy ride?

 

 

Source & References

Zenith international Journal for research

Sanjay Bakshi’s article on two values

Reliance IPO case study by IBS institute

What is the Piotroski score of your stock ?

In fundamental analysis, no single tool or ratio will give the complete picture of the stock. Let it be P/E, EPS, D/E etc, all these ratios must be considered together to get the overall financial health of the company. In today’s post let’s know about something called “Piotroski score” which gives a number using fundamental analysis. What is this number and how it must be used? Let’s see below:

Joseph Piotroski, an American professor of Accounting at Stanford University. He rose to fame by his most influential 2000 paper he wrote at University of Chicago titled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” (Click here link for the full report)

Image 1

His idea behind this was “Because value stocks are by definition often troubled companies, many will not possess the financial resources to recover. Consequently, if it was possible to improve the performance of a value stock portfolio by eliminating stocks that were the weakest financially. Then the returns will outperform the markets.”

What is Piotroski score ?

It is a simple nine point criteria (also called as Piotroski’s F-score) stock-scoring system for evaluating a stock’s financial strength that could be determined using data solely from financial statements.

Scores “one” point if a stock passes each test and “zero” if it doesn’t. The maximum score is 9.

a) Net Income: Bottom line. Score 1 if last year net income is positive.

b) Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.

c) Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.

d) Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.

e) Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets          are increasing, score 1 anyway.)

f) Current Ratio:  Measures increasing working capital. Score 1 if CR has increased from the prior year.

g) Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.

h) Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.

i) Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

He classed any stocks that scored eight or nine points as being the strongest stocks any stock with two or three being the weekest.

Piotroski’s strategy:

1) He looked for stocks with low price-to-book ratios. Often such stocks are “financially distressed”, they languish there because they deserve to be (Sanjay Bakshi’s report on Value or Value traps wonderfully explains how some stocks deserve to be at low valuations irrespective of strong books).  Click here for Prof Bakshi’s report.

But there are some with solid and improving financials that are probably neglected by the market. Small, thinly traded stocks are rarely followed by analysts. The flow of information is limited for these stocks and can lead to mispriced stocks.

2) Also financially distressed firms may be beaten down below their intrinsic value as investors await strong signs that a company has fixed its problems and the worst is behind. Poor prior performance often leads to overly pessimistic expectations of future performance.

Piotroski found either situation can create buying opportunities if checked thoroughly for solid and improving financials.

 Well, did he succeeded?

Yes. It worked very well. Buying those companies that passed the his rigorous test and shorting those that didn’t produced a 23% average annual return from 1976 through 1996. That’s more than double the S&P 500′s gain during that time period.

 Below is the Piotroski score of Indian companies:

Image 2

Incidentally none of the Sensex companies are qualifying for the score of his Best stock (8 or 9)  :)

Any pit falls?

Yes. This score typically compares this year’s financial reports against those of last year and could create come to conclusions. For example, it requires a positive divergence between cash flow from operations and net income before extraordinary items. It will be a fair assessment if the divergence between cash flow operations and net income is evaluated on a multi-year basis rather than just an year. Cash flow from operations could fall below net income in any single year as a result of the timing in recognition of net income.

Finally, this score should act like another metrics to analyze the stock but surely not the only one.

 P.S: Before completing the post. Can someone tell me, why do analysts doesn’t track or recommend Value Stocks? Why they only go with Growth / Fancy stocks all the time?

How to Value Financial services firms (Banks & NBFC’s) ?

With more than 50% of my direct equity portfolio holdings are being in NBFC’s (Gruh & Repco), I want to dig little deeper and wanted to learn, how differently Financial firms are valued?

But then, where to go? Stupid question right?  Who else can be the right person other than the Authority of Valuation himself “Aswath Damodaran”.

In this post I am going to take it with an Indian example and value most consistent wealth creator of Indian markets “HDFC”.

Before moving on I just want to quote my favorites on Banking system:

 “It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.” - Henry Ford, founder of the Ford Motor Company.

Financial Service firms – The Big Picture

Any firm that provides financial products and services to individuals or other firms can be categorized as a financial service firm.

Banks, Insurance companies, Security brokerages, Investment banks, Mortgage companies etc comes under this category.

In emerging markets like India, financial service firms tend to have a higher profile and account for a larger proportion of overall market (Financial firms in India have an total market cap of 1612633.67 Cr as of 20th June 2014)

With such huge base and are tightly associated with country’s economic condition, it is quite clear that no one template of method will value all financial service firms and hence we have to be flexible in how we valuation models to allow for all types of financial service firms.

 What is unique about financial service firms?

Financial service firms have much in common with non-financial service firms. They also try to be as profitable as they can, they also worry about competition and want to grow rapidly over time. They are also judged by the total return they make for their stockholders. But these following points make it different.

1) Debt: Raw Material or Source of Capital:

Any company can raise the capital by using 2 ways, Debt (bond holders) and Equity (shareholders). When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity. But when coming to a Financial Firm, debt seems to considered as a different aspect.

“Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material.”

In other words, debt is to a bank what steel is to Tata Motors (a Raw material). Treat is as a raw material that something to be molded into other products which can then be sold at a higher price and yield a profit. For example, should deposits made

by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between deposits and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

 2) The Regulatory Overlay:

Financial service firms are heavily regulated all over the world. In general, these regulations take these forms:

a) Banks and NBFC’s are required to maintain regulatory capital ratios like CRR, SLR, CAR etc

b) Repo rate, Reverse repo rate are decided by RBI based on Inflation and many other macro and micro factors. These have direct  impact on Banks.

c) Entry of new firms into the business is often controlled by the regulatory authorities

Why does this matter? From a valuation perspective, If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, which can have an effect on estimations and valuations.

3) Estimating cash flows is difficult:

For manufacturing firms like Asian Paints, L&T etc, Capex (Capital Expenditure) they invest in plant, equipment and other fixed assets. But here, Banks invest in intangible assets like brand, human capital etc.

Of course banks needs some space and offices to run the business, but most of them are taken on lease and are nothing when compared to other companies like ITC, HUL etc.

Since we cannot identify how much a company is reinvesting for future growth, we cannot identify cash flows.

So, is there any other way? Yes. Many analysts accept the reality that estimating cash flows for financial service firms is not feasible and fall back is only the observable cash flows, that is “Dividends”

Enough of theory. Now without any delay, let’s jump on to the numbers :)

In Dividends Discount Model (DDM), I am using 2 phase growth model which implies, HDFC will be in growth trajectory (which it has been in the past 25 years) for the next five years and constant growth for the next 5 years.

1

 HDFC under growth trajectory for the next 5 years:

2

HDFC as a stable growth company for the later 5 years:

3

HDFC under transition phase:

4

10% growth for perpetuity is impossible. But as you look closely at perpetuity formula and do the computations, the values after 10 years from perpetuity (that is 20 years from now), will be negligible or not considered. Hence, it can be said with surety that HDFC can grow at 10% from year 10 to year 20.

Final Valuation:

The final value per share for HDFC can be computed by adding the present values of the dividends during the high growth phase, the dividends during the transition period and the terminal price at the end of the transition period.

Value per share = PV of dividends: high growth + PV of dividends: transition phase + PV of terminal price

5

This value (Rs 607.857) looks very conservative and unrealistic. But Mr. Market will give us some situations where we can take the advantage of it.

During Aug 13 to Sep 13, HDFC traded at levels closer to its intrinsic value.

Important Note: We also have to consider other factors as well. For example NPA’s. It can be like a time bomb on the books of banks.

Even though we have great dividend history for some banks, we have to consider how clean its books without toxic materials are and should take a call.

 

Sources & References

Damodaran on Valuation

http://www.moneycontrol.com

http://www.screener.in

 

 

 

 

How to differentiate between Moats and Hawa Mahals ?

For most of us, it’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to command higher prices, because the higher up-front cost will be offset by a few more years of use. Hero Motor corp bikes costs more than TVS bikes, Asian paints costs more than Berger paints and so forth.

The same concept applies to the stock market. Durable companies that is, companies that have strong competitive advantages are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition.

What is an Economic moat?

“The idea of an economic moat refers to how likely a company is able to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors.”

castle

Moats Matter for Lots of Reasons:

Why else should moats be a core part of your stock-picking process?
Thinking about moats can protect your investment capital in a number of ways. High returns on capital will always be competed away eventually, and most companies must be ready to face the competition. Bargaining power with customers, Bargaining power with suppliers, Entry barriers, Rapid changes in business environment, Government policy etc are the factors that determine the economic moat.

Flipkart is currently facing huge competition from global online gaint Amazon.
Exide batteries had failed in this aspect and loosing it’s market share to Amaron batteries.
BSE also failed in this area and lost most of the market share to NSE.
Bharti Airtel v/s Tata Teleservices
L&T v/s Hindustan Constructions
HDFC bank v/s Central Bank
Prestige home appliances v/s Ganga home appliances

and the list goes on (some comapnies in the above list can also be considered as duopoly in the markets).

Moats give us a framework for separating the “Here-today-and-gone-tomorrow” stocks from the companies with real sticking power.

Finally in Buffet’s own words “I want a business with a moat around it. I want a very valuable castle in the middle. I want the Duke(management) who is in charge of that castle to be very honest and hard working and able”

All said, now the interesting part :)

How to identify Hawal Mahal companies and stay away from them?

These companies looks great from outside or at initial stage of their business, but in future they fails miserably leaving investors a huge pile of scary experiences.

Hawa-Mahal1

There is a jargon in investment community, “Shall we bet on Jockey or the horse?” (Infosys present situation is perfect example of it). Well no single answer for it. What happens if world’s fastest horse is given to a below average jockey. What if the world best Jockey is given a shetland pony. Nothing much can be done. No matter what, we have to emphasize on both Horse and Jockey (because we are poor retail investors)

Let’s take an example, Pantaloons was once a wealth generating machine (Basant Maheshwari sir made a forture of out it), but does it have a Moat around it. Absoultely NO. It failed to the competitors. Bajaj auto case was almost the same (but thanks to it’s Bajaj Pulsar) later back in the game. No matter what, even good the management (like Bajaj family & Kishore Biyani) cannot ride a business without economic moat for longer time.

Hence always look for:

1) The products or services that a company sells maybe hard for customers to give up, which createscustomer switching costs that give the firm pricing power.
2) Companies have cost advantages, stemming from process, location, scale, or access to a unique asset, which allow them to offer goods or services at a lower cost than competitors.
3) Sources of structural competitive advantage are intangible assets, high customer switching costs, and cost advantages. If you can find a company with solid returns on capital and one of these characteristics, you’ve likely found a company with a moat.

Use above given points to identify if your company have a moat or not. If yes, How strong? Answer yourself. This is another good reason to stay invested in secular growth companies.

Following are the companies which didn’t fit in the above characteristics and failed miserably. Needless to say about it’s investors.

Hawa Mahals of India:
Suzlon
Unitech
Relaince Capital
DLF
Reliance Power
and many more…

No moat or very week moat, added by herd menality lead to the disastrous happenings in the above stock.
These are few examples of the companies you should never look at even in the dreams.

“All I want to know is, where I am going to die, so that I will never go there” – Charlie Munger

Now you can ask, we have a rally happening in India now, and these companies are having a run up, can I enter now and sell later?

All I can say is “A pig with lipstick is still a pig”.  :)

What should be my first stock ?

Last Sunday, I met a friend and the conversation went some thing like this.

Friend: Krishna, last year when I asked you to suggest one good fund as my First equity mutual fund, you suggested me to go with balance fund and chosen HDFC Prudence. It is performing amazingly well. I am sitting on a return of nearly 29%. Thanks for it.

Me: Welcome. But actually, the major chunk of your credit must go to Modi mania, another major portion to Prasanth Jain’s conviction and only a decimal fraction of it should come to me.

Friend: Now I want to come to direct equities. Can you suggest me one good stock to buy right now ?

Me: NO. Believe me, this is the best suggestion I can give you (at least for now).

Friend: If we have a direct answer for Equity Mutual fund like newbies must start SIP in a balanced fund. Why can’t we have the same case with Direct Equities ?

This amazing question from my friend triggered me to write this post.

No, we can’t have a direct answer for this. If someone gave an instant answer to this question, run away from him after a punch on this face :)

Because, the thought process will be different for Mutual Funds and Direct equities. How ?

In mutual funds we select an already built-in portfolio managed by well skilled fund manager and his research team. Where as, in Direct equities you should select a company which you want to own (partially or fully should not make any difference) and you alone is the team (Scary isn’t ?).

Interestingly investors, if they wear the hat of “Debt fund”, there investment tenure increases to more than 7 years. And with “Mutual Fund” hat they say 5 years minimum. But with “Stocks”, they say Buy fast sell Faster !!!

Let’s take a scenario, you went for a coffee break in your office and have seen that the canteen is already full. You have to wait for 5 minutes, just to place the order of chai and samosa. No empty chairs even to sit. Then you might think of “He is running a profitable business, when ever I come here, it is full. Wish I had same kind of shop as my side income”. Did this ever happen to you ? Well it happened with me.

Now, do you see any LED screen above that shop that displays the value of the business second by second like the one below. Do you ? No.

imlRxw05w9S8

But when it comes to valuing Infosys, Tata Motors, HUL we do it second by second, minute by minute. Just that BSE and NSE provides it every second, we are not obliged to watch it or even consider it. (Chapter 8 of The Intelligent Investor)

The quote which I recently read ” The right thing for an investor to love is the process of investing, not the bet itself. The right process for an investor is to understand the value generated by the underlying business.”

But does that mean that we should never start investing in direct equities ? NO. There is a process associated to it (the process I believe in, may or may not be true)

Remember baby steps of your children, nephew or niece. And after few years they start walking with little help and finally will stand on there OWN.

That’s exactly should be the process.

1) Start small. Your equity portfolio in the initial year should not increase more than 5% of your entire portfolio. If your total portfolio is of worth one lakh, then allocate not be more than 5000 in the first year. This small amount you have invested is not to Earn but to Learn from the markets.
2) Choose your area of competence. If you work for a Pharma company, IT company or automobile company or your father works for a bank. Any business which you think that is easily understandable. Pick that up (Initially, prefer large caps).
3) Learn reading Financial statements yourself. Yes, it’s not a tough task as it looks from outside. We have many learning videos and books available online. Also keep a track of your stock.
4) Once quarterly results are out, try to look at it. Compare with previous quarters. List down what change in the numbers you observe ? What is the % increase in Sales, What is D/E ratio, What is current ROE, How much has the OPM increased etc etc. Answer it to yourself.
5) Continue the process of learning and reading the best books in the field of Investing.
6) Calculate the intrinsic value of the stock and make the first buy as close as it can be to that value (Remember 5% of portfolio should be the cap)
7) This is a long term process and needs patience.

Take ideas from others, but before acting on it do proper analysis and invest only if you are comfortable.

I will give you my own example, for the investors who already read “The Thoughtful Investor” knows that Page Industries is the darling stock of Basant Maheswari sir and without second thought we can say it has given stupendous returns in the past 6 years. BM said his last purchase was at 5600 and says still many more years of juice is left within it. With such golden words from a stock visionary like him, it shall be taken for granted and stocks should be bought without any delay of a second. But, I couldn’t act like that. Somewhere inside my mind another stock market gaint Parag Parikh sir came and asked me “What have you learnt from my books and videos ? This particular stock is contradicting all my teachings and my experience of 30 years in the market.”
Then, I re-read “Value Investing and Behavior Finance” (not all but few chapters), done some valuation analysis and took a call “This is NOT for me”.

That doesn’t mean I am right. I may be utterly wrong and the stock can go 50 times in future. But it is not fitting in my learning, so I didn’t acted on it.
I may look like a fool, but it is OK for me :)

Finally you need “passion” to own great businesses like ITC, Colgate, HUL, Asian Paints, Pidilite, Gruh Finance and many more for years together (money will just follow), and you need “Greed” to make more money in short term and loose it all in one bad trade. This will not happen if you “Learn yourself” (Quote from my favorite professor in IIIT-B)

” It is better to be a mile deep in understanding handful of companies than an inch deep on many more.”
“When someone confronted a stock without analysis, imagine him holding a megaphone at the circus and then think about what they are saying.”
“First Buy, Later know about the stock”, may work some times, but it fails most of the times without mercy.”

Hence the reason I didn’t answered you my friend :)

P:S Learning from others mistakes will be the best option as we can’t do all the mistakes on our own. Recently I came across an amazing thread in my favorite Facebook group “Asan Ideas for wealth“. Here is the link. I strongly suggest you to be a part of the group.