good investor

The long-term goal

Everyone's pursuit is to be a good investor; this is true whether that person's training or day's job is in the field of business and finance, or not. If earnings are not invested properly, financial security for the family will be at stake. That brings us to think about investing. 

There are certain things that I consider fundamental to investing and to becoming a good investor. It is imperative to be clear about those things before we start our efforts in building a secured financial future, i.e. by taking the right investing decisions.

Investment and speculation

The first thing is to understand the difference between investment and speculation. I see a lot of confusion, mostly subconscious, out there about this.  Investment looks at the downside first; speculation does not. Investment gives a reasonable comfort that the capital invested is protected, i.e. it will not be eroded, and the returns over the period will be more than the inflation rate. Thus, investment gives the consolation that purchasing power of capital is retained at a minimum. If analysis is done properly, investment can give higher returns, but that is only incidental. 

Speculation fails to do any of this. There are many activities which have the characteristics of speculation; one example is trading of stocks without business analysis. 

If one starts with a wrong footing, i.e. thinks investing when actually is speculating, or even vice versa, the results are not going to be pleasant. 

Price and value

As a corollary to the first one, this is another important aspect.  Price is what we pay and value is what we get, is a widely known phrase. This has to be taken literally when it comes to investing. Value is based on the fundamentals of a cash flow generating asset, such as a business. Value is mostly driven by changes in cash flows, growth and associated risk; any decision that does not impact these, does not change value of that asset. On the contrary, price is influenced by almost anything including the value drivers. Speculators get this concept wrong invariably; investors understand it well.

In the short term, the most common factor that changes prices, is the behavior of the market; fear and greed are the traits of the behavior that drives prices. Bad weather, headline news, political changes, stock splits, stock dividends, less-or-more--than-expected earnings, management's views, analysts' views, and you-name-it are examples that influence prices.

Most corporate acquisitions take place without understanding the difference; overpaying has become a habit the cost of which eventually is paid for by the providers of capital.

In the long term, however, prices usually catch up with the fundamentals, i.e. the value drivers. That is the presumption the investors hold on to in order to expect adequate returns on their investment; history is on their side to support this presumption.

If one is not able to understand the difference between price and value, the advise is to first grasp it before taking any investing decisions. 

Risk

The meaning of risk in business and finance is quite clear; risk is a downward movement in prices when long on securities, and upward movement in prices when short on securities. This is fine, we are all worried about downside risks, not upside risks. So far so good.

The problem starts when it comes to measuring risk. The common understanding of measuring risk is in terms of the volatility in the price of an asset. It is perceived that if the price swings too much, the asset is considered risky; if prices stay within range, it is considered stable, i.e. safer. Practically, this assumes that market prices are good enough to measure the value of the asset all the time. For someone who understands the difference between price and value, this is bull. 

For instance: The prices of the stock of a lousy business which has no takers could remain at stable, albeit lower, levels for quite some time, giving low volatility. A great business, having short-term problems, although nothing related to its long-term cash flows, growth and risk has changed, could trade at swings if markets do not factor its fundamentals, giving high volatility. A private business or a real property or a farm land may not have quoted prices, and hence have low volatility; yet, if analyzed based on their fundamentals, these may be independently viewed as risky or safer assets.

We can correct this mistake in measuring risk in an asset by knowing more about it. Like someone said, risk lies in not knowing what one is doing. This is apt; to measure risk, what one needs to do is to understand the asset more, i.e. to understand the factors driving its cash flows and growth. An asset is viewed safer, if its cash flows are more certain and growth is more reasonably visible. In other words, we need to look at the downside risk that is more likely to be permanent; short-term downside risks are temporary in nature, usually speculative, and therefore are not actually a risk in the investment.

The riskiness of a business depends upon - nature of the business, the products it sells and the regulation under which it prices it products, the managers running it, the corporate governance surrounding it, its operating and financial leverage, its capitalization, i.e. equity and debt proportion, and its competitive advantages - its long term prospects. The more we know about these aspects of the business, the less we feel uncertain about it, the less we speculate about it, and therefore, the less risky it appears to us if acquired at the right price.

Contrary to the common belief, risk cannot be measured in precise terms; it can only be perceived as a guide for the investor's analysis. It is possible that something that appears to be risky to one, may not be risky to another because of her knowledge on the value drivers.

Understanding the concept of risk is crucial for the long-term investment results.

Analyzing and valuing an asset

Analyzing value comes first; any asset is a buy or a sell only at the right price. Let's be clear that there is a business behind a stock or a bond. Consequently, when investing in stocks analyzing the business itself is important. Watching ticker prices is of no use; that is for the speculators. 

Accordingly, developing the skills for business analysis and valuation is vital to investing. Without this we will not know the real worth (intrinsic value) of the business. That said, it is not easy. The good news, though, is that it can be developed gradually. As the knowledge grows, so do the skills. Over the long period we should be better at understanding and valuing businesses than before.

However, it is important to understand that there is no such thing as a complete knowledge; it is a life-long learning process. 

The first step in this learning is to read about the business from the annual reports, quarterly reports, and manager press conferences. Annual reports of past years should supply enough information about the business, the managers, where investments were made, how these investments were financed, the quality of these investments in terms of return on capital, and what was done with excess cash, if any. As we read more about the business we should be able to understand more about it, and thus, feel less uncertain about its prospects, good or bad, to be able to value it. The numbers, i.e. financial statements, tell us the most part of the story we seek. Gradually, we will be able to gather which part of the annual report and other information is relevant to our analysis.

Then there is information related to the business, the industry, the economy, and other aspects of business and finance that should be read. Since accounting is the language of finance, it is advisable to have some knowledge related to accounting and financial reporting as well. Moreover, it is always good to read about the investment philosophy and methodology of investors we admire. It is amazing how interesting this process can be; accumulation of knowledge is a good stuff.

It is also important to know what not to read. Any views expressed by the analysts or even managers about the future prospects should be shunned. These are the personal opinions more often based on bias. So ignoring them is the correct thing to do.

Finally, it should be realized that value is only an estimate based on some analysis. For valuing a business, we need to estimate both cash flows until perpetuity and the right discount rate, which is never going to be precisely right. Therefore, it is prudent to keep the price paid for the asset fairly lower than the value estimated. This is to make up for the human error of judgment. Only hubris can come in its way; so it is better beware.

Behavior

In the meantime, we need to build the right behavior, not to be swayed by the whims of the markets. For that sticking to the basics is what is required. If the analysis is done right and an investment decision is taken, the short-term price movements, which are the doings of the speculators, should not change our decision. On the contrary, we can thrive on these price swings by taking advantage. It is clear that investors make money at the cost of speculators. 

Maintaining some discipline in investing is important. Fear, greed, and envy are to be avoided at all times; it pays to control that urge. 

Business of investing

There are no shortcuts to this process. If, let's say, we start a business today, we cannot reap rewards immediately. Any business, private or listed, has to operate for a fairly long period of time to give results. There are short-term investment strategies too where the price catches up with value sooner than usual. Usually, investing is a long-term process. We read, we analyze, we value and we buy; then we need to wait until our efforts fructify, which usually takes longer than we would like. It is best to view active investing as a business we operate.

There is no scope for part-time active investing. If we have no time or interest in this process, it is better to invest regularly in an index fund; over the long term, the return on investments should be fair. In the meantime, our time and efforts can be directed towards things we like, rather than being halfhearted or forceful on the business of investing. 

Limits to expectations

With all the time and efforts that we put in learning about business and investing, it is crucial to understand the limits to the expectations from our investments. There are no super-normal returns to be expected. Some exceptions could be there in the short term, however, over a long period of time, it is wise to have a limit to our expected returns.

Usually, the price paid becomes a key factor in determining the returns. Stating the obvious, the lesser the price paid the higher the returns. Nevertheless, super-normal returns over a long period of time are not only unsustainable, but also unreasonable. Both the long term macro economic conditions and the fundamentals of the business itself will ensure dilution of the competitive advantages attached to the business; at some stage, the competition, technology, or regulation will kick in such that the business will experience stable growth or even decline, rather than high growth.

Therefore, it is sensible to set the expectations to be normal; ideally, the rate higher than long term inflation rate plus a few points should be adequate to beat the broader index. Rest assured the amazing power of compounding should take care to create wealth. 

Humility
Finally, it will be good to have some humility in this whole affairs. If we attribute success only to our skills, it would be imprudent. For investment success, the market price should eventually catch up with our estimated value; if this does not happen, however good our analysis be, we will not be able to seek expected returns. For all the silliness, irrationality and inefficiency in the short term, we want the markets to become efficient at some point; and this requires both our efforts and a bit of luck. So let's shun that hubris, if there is any.

Plan for the coming years
Let us be the owner of the business of investing; let us put in our time and efforts to seek long-term financial security; And let us have loads of fun in the process, because it is actually a lot of fun.

Let's defy the markets.

decline of the firm

Declining revenue; no earnings; increasing losses; eroding equity; and increasing debt. If this is the story over the last five years, it should be reasonable to presume that either the business itself is lousy, or managers are not able to take the right decisions, or may be both. Such a situation should only result in destruction of value for the shareholders. 

And who are these shareholders? The government owns 56.25% and Life Insurance Corporation owns 18.81%, may be a forced buy for LIC. It is LIC's Fortune Plus Secure Funds that owns the shares of this firm; however, there is neither fortune nor secure in this investment.

What was selling for Rs.78 b in 2009 is now available at less than Rs.10 b.

While the broader market increased.

It is difficult to understand why the firm had to reinvest in its business; over the last five years, it has spent about Rs.87 b as net capex. It is not tough to realize that competition is killing its business.

The best thing to do in this situation is to gradually withdraw from the market or make an outright sale. The first claim on this value would go to the lenders; they cannot get their full Rs.115 b, though, unless the government decides to make payments out of the tax payers' money.

The current year to date performance is consistent with prior periods; it seems there are far too many problems for the firm. When the book value of debt is Rs.115 b and market value of equity is Rs.9.73 b, there isn't much left for the shareholders.

Yet, here's a buy recommendation for MTNL. By the way Sharekhan owns 1.19% of this business.

change in market value

How much can (intrinsic) value of a business change in a year? Unless, there have been significant changes to its cash flows, growth or risk factors, an analyst would say, not much. 

Now, how much can market value (price) of a business change in a year? The answer depends upon the extent of rationality prevailing in the market. If markets are efficient (are they?), the answer is not much. If there is too much fear or too much greed, the price would swing; then it becomes difficult to measure the madness.

Value of a business should change over the period; As it begins as a start-up firm, it is exposed to the growth period, then to the stable market period, and then eventually decline. At every stage, the fundamentals of the firm undergo changes, and so does its value. There could be exceptions, such as, a firm could see decline before it experiences the stable period, for instance. However, how soon a firm is exposed to these conditions depends upon both external macro economic factors and internal corporate finance decisions involving, investing, financing and dividend decisions taken by the managers. We can visit this subject some other time.

For the moment, check out the swing in the market value of equity of Havells India during the past five years:

I am amazed at the extent of swing each year, i.e. the difference between the high and low market value of equity in a year. I wonder if there were any significant decisions related to projects, financing or dividend payouts envisaged by the managers that were factored by the market; I doubt it. If we think rationally, we can figure out how crazy it is to view a business in that way.

I would like to find out the quality of investments made by managers, the financing arrangement (i.e. the way the firm is capitalized) and how the managers treat excess cash. These factors have direct impact on value drivers, i.e. cash flows, growth and risk.

Market behavior has nothing to do with the value of the firm, but influences price. Whereas, the business behavior impacts its value and eventually influences price. It is for us to decide where to invest our time and efforts.

valuing real property

I have posted on the property market in India before and have argued that prices appear to be too high to justify value. Well, some time has lapsed, and nothing much seems to have changed in the market. 

There are innumerable stories floating around how people have made money in the property market in India. This is one of them. Some of my friends have made a lot of money as well. While I have not been a party to it, they are amazed at that; they consider that I haven't been able to analyze the prospects of the real property. After all, typical Indians invest in two assets: real property and gold; they usually utilize black money for these purposes. Their argument that under current regulation they do not want to pay undue taxes on their hard earned money may appear to be a little far-fetched. 

That said, I have my views on both as investments: gold is a dead-investment; and it is difficult to find value in investment in real property. 

Let us come back to the real property. The investments could be in land or building; house or apartment; commercial or residential. I don't think that prevailing prices for these assets relate to their value. Valuing a real property is no different from valuing any other cash flow producing asset such as a business or a share in stock of a business. 

Thus, value of a real property is the present value of its cash flows over its life discounted at the right cost of capital. Rentals represent cash inflows; there are no other fundamental sources. Costs of maintenance, such as repairs, co-op society charges, municipal fees represent cash outflows. Estimating terminal value becomes a bit dodgy; nevertheless, it is imperative to estimate it based on perpetual rentals if there is a perpetual period; if there is a finite life, that issue is not there. However, the most bizarre thing to do is to use a terminal value multiple; it is like mixing coke with yogurt; yuck!

I find that prices are ridiculously far away from value. I can argue that either prices are far too high, or the rentals have not caught up with the present economic conditions, i.e. rentals are far too low. In the absence of any evidence, I would like to stick to the former argument. 

Why else would a sub-urban Mumbai apartment fetching annual rentals of Rs.300,000 should sell at Rs.12.5 m? Or the one with annual rentals of Rs.180,000 should sell at Rs.7.5 m? Remember, rentals are not free cash flows. A plot of land measuring about 1089 square feet in a remote small town currently sells at Rs.1 m; the price was about Rs.150,000 just about five years back; I don't see any significant improvement in economic conditions of that town or the residents to justify that price. The story is true in any part of India in the present times. 

The funny part is due to poor regulation and urge to accumulate black money, most transactions are registered at a price far lower than the actual transaction price. The result is lower rentals, lower taxes and further investment in real property with black money; a vicious cycle.

The property developers use high leverage and unidentified sources of capital to finance the projects, and play strange games to influence prices. No wonder the realty stocks have faltered; however, I don't think that the developers' personal wealth has. These developers, private or listed, are not monitored and regulated adequately.

The current news is that prices are under threat, and that inventories of unsold properties are piling up in major cities; yet, there are no signs of prices falling.

I haven't got any answer to the questions, yet. Despite that people have been buying, prices have been going up and people have been making money; Only that I have not been party to this party. 

Identifying the greater fool has been difficult so far. A bubble or a burst...you tell me.

coke's story 2012

I have posted about coke before; apart from its enormous brand power, I did not have much to appreciate about. As a continuation of the previous post, the following shows how coke has performed in terms of operations and market value.

The decade

Revenues increased by close to 11% p.a.; Operating profits by 8.25%; However, I have not noticed significant increase in free cash flows to firm. Of course, FCFF depends upon how we calculate it in the first place; I have used after-tax operating profits and past reinvestment in both capex and working capital. Acquisitions also represent reinvestment; in the last decade, coke has reinvested about $19 b in net capex and acquisitions.

Market value of equity is at $173 b now, trading at about 20 times earnings. Coke's high and low PE multiples have reduced over the years perhaps suggesting market's reluctance to accept coke like it did historically. If we compare high-to-high market values over five or ten year periods the return to the shareholders is pathetic. Even if we consider low-to-high market values the annual return over five-year period is about 11.51% and over ten-year period it is about 8%. Not great by any measure.

The most interesting aspect has been coke's deteriorating after-tax return on capital which stands at about 21% for 2012. Again, definition of return on capital is important here. If we consider only tangible operating assets return on capital is stupendous. I have considered both goodwill (about $12 b at 2012) and other intangible assets as part of operating capital. In 2010, coke acquired Coca-Cola Enterprise’s North American business, which resulted in additional goodwill of about $7.7 b. It depends upon how we look at these assets. Where a firm continues to overpay its acquisitions and recognizes large goodwill on a periodic basis, ignoring goodwill would be a mistake. Charging it to equity would increase return ratios; however, the damage would already be done. Coke may not be in that category. 

Over 60% of revenues come from North America, Latin America and Europe. May be there is scope for growth in the emerging markets.

All said, people still do recognize its brand instantaneously; I still wonder why, though.

markets on to something

The party
We have been seeing markets run-up all over. Dow is at 16020 and S&P-500 at 1805 now; BSE Sensex is at 21326 and CNX Nifty at 6364. All of these indices are on a high. What has changed to cause this effect is the sentiment. Emotions are flowing in such that an optimistic view is being painted all over. Fear is being folded for the moment and greed unfolded. In other words, the market behavior has changed. 

The right reason for indices to change should be based on the fundamentals, i.e. cash flows, growth and the related risk of the firms in the indices. In the long term that will take place, but in the meanwhile the behavior of the so-called players in the markets influences indices.

Instead of asking questions such as are businesses going to do well given the macro environment, efforts are being made to check out how soon prices can be moved upwards.

For an investor, though, such behavior is good news, for it will help him take the right decisions depending upon price and value. So cheers to pessimism and optimism, and cheers to fear and greed. Speculators and traders make decisions based on ticker prices; investors do that based on price and value. The more the speculation and trading taking place in the markets, the better the profits for investors with the right behavior. 

The past journey
The extraordinary extension for Dow and S&P-500:

However, over the five-year period the Indian markets haven't done that well.

Both Nifty and Sensex are back to where they were in 2008:

Mid-cap and Small-cap have been disasters:

So too have been capital goods and metals. Autos have done relatively well.

FMCG, Health care and IT have done well.

Oil and Gas, Power, Realty and PSU have faltered.

Not really a party
There are lessons to be learnt: when in a downturn go for the businesses that are stable in terms of demand for their products. Other things being equal, a business which sells less discretionary products is inherently less risky. Generally, a business which has lower operating and financial leverage is also less risky. 

Instead of seeking super-normal profits, it is wise to check the downside of an investment first, and then look for the upside. The magic of compounding does wonders for any investment if it is utilized well. Yet, it is not well understood by many; but then why do we care?

The right thing to do now

For the moment, it appears that buying time is beginning to get over for the investors. It is time to either hold on to good businesses, or sell those where prices have peaked.

The rest of the time is well spent just watching the fun of speculative trading from a fair distance, and more importantly, reading and learning about business, finance and investing.

Skills worth developing for an investor: to first understand the difference between investment and speculation, and price and value; second, to understand how to analyze and value a business; third, to have the right behavior, i.e. to try to conduct in a rational manner as much as possible. These skills are inculcated over a long period rather than abruptly.

It is a never-ending journey, but, surely an engaging and enjoyable one.

google, the third biggest

I have posted about Google before; some good, some not-so-good stories. The classes of shares and corporate responsibility were interesting, but its phenomenal growth has been more interesting. 

Since 2003, revenues have grown annually compounded at 48% and for the last five years they have grown at close to 25%. It had revenues of $50 b in 2012, book operating profit of $13 b and $48 b of cash; cool! Return on capital has been consistently high and there is negligible debt.

All this has translated into high market value of its equity of $350 b from $86 b in 2009.

It is only behind Apple and Exxon Mobil now in terms of market-cap. The run-up has been sharp if we compare the multiples over the period. However, we know that these multiples and market values are meaningless if we look from the point of view of investment (the intrinsic value). Business valuation is what matters then.

It has $10 b of goodwill sitting on its balance sheet which represents its faith that its past acquisitions are going to generate cash.

That brings us to question whether the current market value for Google is fair based on its future cash flows potential and risks.

Google claims to be a technology leader focused on improving the ways people connect with information; and aspires to build products and services that improve the lives of  billions of people globally. In this regard, it has significantly exceeded my expectations. Today, Google is an educational institution. Its search tool has been of great advantage as a lot of information and knowledge is gained through it by anyone sitting anywhere. With all the crap that is being taught at schools and colleges, formal education has become only a means to take up employment. Google has helped people pursue their areas of interest and passion; have fun in the process, and also make money. It is difficult to imagine life without the Internet and Google now. Everyone uses Google is an understatement.

Google's revenues comprise predominantly advertising, with marginal contribution from Motorola Mobile coming from 2012.

Google's value will depend upon how much of its online advertising market share it would have to cede to its competitors, more importantly to, Facebook, LinkedIn, Twitter and Yahoo, in future. As these firms become more prominent the obvious would be smaller pie for Google both in terms of revenues and margins.

It is anybody's guess, though, about the total market size and Google's share in future. Difficulty in estimating revenues and margins makes its valuation exercise futile. Nevertheless, I wanted to have some fun based on my estimates of revenues, margins and reinvestment needs to get its value. The value came far too lower than its current market value; I had a lot of fun, though.

Google will see significant reduction of, yet reasonably high, operating margins and return on capital in future. It is currently spending a large portion (13.5% of revenues) on research and development. We don't know what products are in the pipeline; but we do hope that they are as good as the other products have been and continue to be.