buyer beware

Heard on the street: 
There are the money managers who think they take cash only from the like­-minded people. They are the eternal academic corporate finance bashers and the contrarian strategy embracers. They tell you how you can make money with low risk and beat every other guy. They write books, give presentations, create blogposts and websites, all to seek money from you with the premise of making you richer. 

Why do they want others to make money? Do they want to change the lifestyle of the general public by telling them how simple it is to make money? What is their ultimate goal? They start their value investing fund, but seek money from others. Why? If they really believe in their abilities to identify good stocks and bonds using a low risk strategy, why do they need other people's money in the first place? We find their actions quite ironical, and that is why, quite tricky. Our guess is that they want to make money for themselves first, and if investors get wealthier, it is incidental; or worse is that they get their fees irrespective of their performance. We don't find that charitable. 

There are others who similar to value investing money managers follow their philosophy. They are good storytellers. They try to connect with you with their so­-called simplicity, contrarian ideas, corporate finance bashing, trashing news channels, and other tactics. They make their case through blogposts, podcasts, presentations, and their own websites. A lot of stuff that they give is free, at least initially, and then after they feel that they have won over a reasonable number of the gullible, they slowly change their strategy to make it fee­ based subscriptions. Some of them develop their own private money management office and seek to manage money for the select individuals. 

Aren't they a bit unethical? Doesn't their conscience hurt them when they make up those goodly stories about life and finance, borrowing quotes from others and repackaging them to public, and all that for money? The fact that they seek subscription means that they are probably pretty bad at what they preach. Most likely, they take advantage of those men and women who are ever dipped in their problems of life, and are always in the lookout of someone who can tell them nice little bedtime stories. They reckon, those lullabies would take them to somewhere else. Perhaps they are good at lullabies and babysitting. But, it does not make what they are doing is any good. Clearly, they are asking money for their stories. 

Naturally, they also have a life. They cannot beat the market, how else can they clear their bills other than by seeking others' money?

These self-proclaimed experts are akin to shills. What can people do to safeguard their thoughts and cash? Better beware of them: caveat emptor.

where's the buying opportunity

On 29 Jan 2015, Nifty closed at 8952.35. Although it had implied values of higher return on equity and a reasonable growth rate, I concluded that based on the fundamentals, it was quoting high. On 3 March 2015, it was at 8996.25. Since then, Nifty has been on a downward trend, and this has given the talking heads ample opportunity to talk. As of 25 Feb 2016, it closed at 6970.60. 

Some have been saying that this is a buying opportunity since India has all the requirements of a high-growth economy. Some have been advising to wait because there will be buying opportunities further ahead. Some others are recommending to buy in small proportions and increase as we see better opportunities. Probably, most of them are looking at Nifty and talking about individual stocks. If so, what they are missing is that selective stock picking can be done at any time of the market; you only have to figure out the gap between price and value. Buying the index itself at one go is usually a bad idea; index investing requires periodic investments over a long period of time; call it dollar-cost averaging or systematic investment plan. 

Coming to the current market, the stocks that appear to be cheap are actually commodities, cyclicals, realties, infrastructure and banks. I wouldn't want to buy any of them now, except may be banks. Yet, that is a tough game. It is far easy to fool ourselves with the delusion of apparent value. Those stocks that have better fundamentals, aren't available at prices that I want. So for me, there is no selective buying as of now. I am watching though. 

What about the market itself? If find that the market fundamentals are not pretty at all. Let's start from Jan 2015. Both return on equity and growth rate have been steadily deteriorating. Although, this month has been better in terms of index value, it is not an index buying month either. For direct lump sum investment in the index, I would like to see higher growth rate in earnings and efficiency in that growth rate, i.e. higher return on equity, in the coming months. It is far better to stick to periodic investments in the index than attempting something stupid. 

In investing, I like to look at the downside first, and then the upside. The market is not cheap at the moment. 

capm and margin of safety two sides of a coin

The question that confronts me: are CAPM and margin of safety two sides of the same coin? Let's explore.

In chapter 20 of The Intelligent Investor Benjamin Graham wrote thus: Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety. He propagated margin of safety as the central concept of investment, and noted that this concept renders an accurate estimate of the future unnecessary. While it is applicable to all securities, for a common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. The risk of paying too much for a good quality stock is a real one, and overpaying for a low quality stock is much real. Therefore, margin of safety becomes necessary and evident when there is a favorable difference between the market price and the intrinsic value. This is very well written indeed, and there is no dispute there. 

His number one disciple, Warren Buffett embraced it instantly and has been applying it in all of his investment decisions. He may have modified the concept a bit to include high quality businesses, consistently earning excess returns, managed by honest, ethical and capable managers. For him, such businesses inherently possess certain margin of safety, and when price paid is reasonable, the investment becomes more than ordinary. This too is a very sensible idea, and I don't have any arguments. 

Both Buffett and his partner Charlie Munger have been very critical of the understanding of risk and business valuation by business schools. This is very true, and I too endorse their views.

The margin of safety concept can be extended to businesses having superior brands or unregulated franchise businesses. However, it is heavily dependent upon the price paid. The larger the gap between price and value, the larger the margin of safety, and the safer the investment.

If we understand that there is a fundamental difference between price (what we pay) and value (the intrinsic worth), it should be adequate. We can call it the margin of safety or the comfort level or simply the gap, or whatever else.

What bothers me, though, is the interpretation of their community, - oh, I have to use that word now - value investors. For them, anything that others do is worth some bashing. 

Their favorite topic for attack is the concept of risk. As much as value investors like to talk about futility of risk and return models, they tend to do the same implicitly.

For business schools, academicians, and the majority of analysts, return sought is directly proportional to the risk assumed. The higher the risk, the higher the expected return. Their best proxy for risk is the volatility (measured by beta) in stock prices, which can be of any period: daily, weekly, monthly, quarterly or yearly. This is utter nonsense because short term fluctuations in prices have no bearing on long term investment returns. 

This is again beautifully laid down by Graham: The rate of return sought should be dependent, rather, upon the intelligent effort the investor is willing and able to bring to bear on his task. For Buffett, is quite clear: If you buy a dollar bill for 60 cents, it is riskier than if you buy it for 40 cents, but the expectation of reward is greater in the latter case.

My experience has been that higher risk does not merit expectation of higher returns. In fact, it should be quite the opposite. In investing, one should look for low risk opportunities which have potential for higher returns. If there is no value in an investment, it is a speculation. I do not hold all those, who use higher risk higher return model and measure risk by short term volatility in prices, in the category of investors.

Risk should mean returns lower than alternative investment returns. It includes permanent loss of capital. It also includes, for instance, actual returns realized on a stock which are far lower than say, government (or any other AAA rated) bonds. The logic is simple: If we could get 8% on a government security which is (almost) riskfree in terms of nominal capital and has (almost) no default risk, why should we settle for a bond or a stock that yields lower than that?

However, the catch is that the return should be based on the actual realized return rather than daily, monthly, quarterly, or yearly (notional) returns. If we are not forced to sell our investment, any volatility during the period is only academic. Moreover, an investor does not sell based on short term fluctuations in prices; his rationale for sale is purely based on the gap between price and value, and alternative opportunities available. Therefore, if we chuck short term events, it becomes clear that risk lies in lower returns realized during the investment period.

The real risk actually lies in not able to retain the purchasing power of cash flows. If you are not able to do that it is not worth investing. Alas, no many realize that even AAA rated bonds erode in value due to inflation. Those government bonds may not even be riskfree in real terms.

Having laid down my thoughts on price and value, investment and speculation, and risk and reward, I would like to note how value investors and others use the discount rate to value stocks.

Buffett supposedly uses the same discount rate (usually the treasury bond rate) to value all businesses. However, Munger recently mentioned, again supposedly, that different businesses need different rates. We don't know what exactly they do for they have never come up with their valuation methodology, and this has led people to assume based on their own interpretation.

Value investors use a discount rate that is not based on beta and CAPM. They may use treasury bond rates, AAA bond rates, or some higher (implicitly due to risky cash flows) rates for valuing businesses. They like to say lower risk higher return, yet they are willing to increase the discount rate when cash flows are difficult to estimate. Then they like to apply a margin of safety depending upon how they feel about cash flows.

Now, the others, use a discount rate that is based on beta and CAPM. They like to use higher discount rate for risky cash flows, and lower discount rate for less risky cash flows. In fact, they use treasury rates for certain cash flows, which can only be in text books.

One can posit that there is not much difference between how value investors and others value a business. Let us consider an example of a business which has perpetual free cash flows of $120 m.

The value of that business for a value investor could be:



Value of the business is estimated to be $1,200 m. However, since the value investor is not sure of his valuation (but does not like to call cash flows risky), he applies a margin of safety of say, 20%, to arrive at a buy price of $960 m.

The value of that business for the other investor could be:



Since the other investor is not sure of his cash flows (and likes to call it risky), he uses a higher discount rate calculated based on beta and CAPM, and estimates the value of the business at $960 m, which is also his buy price.

We notice that both the value investor's and the other investor's buy price is the same at $960 m. While one has applied a margin of safety due to uncertainty of value, the other has used higher discount rate due to riskiness of cash flows. How wonderful it is that both values are the same.

Now, how the heck an investor like me is going to interpret it? We can also conclude that the value investor's buy price has an implied discount rate of 12.50%, and the other investor's buy price has an implied margin of safety of 20%.

I really don't care what people call it, margin of safety or risk-adjusted discount rate. I am neither a value investor nor a growth investor; I don't want any tag to my investing philosophy. I would like to believe that I am an investor and not a speculator. I try not to operate based on hope, greed, fear or envy. For me, there are certain fundamental philosophies on investing:

1) Value of a business is the present value of its cash flows over its life discounted at an appropriate rate.
2) The rate of return is not dependent upon the riskiness of cash flows.
3) Higher rate for higher risk is for schmucks.
4) The margin of safety has to be used in the context of the extent of gap between price and value.
5) You cannot use cash flows that are difficult to estimate (i.e. risky cash flows), and then apply a margin of safety. That is schmuck too.
6) There are three variables in valuing a business: cash flows, growth rate and discount rate.
7) The cash flows have to be as near certain as possible. If this can't be you have to let it pass.
8) The growth rate should be as reasonable as possible. On a perpetual basis, the growth rate has to be less than the economy's growth rate.
9) The discount rate should be based on an expectation of purchasing power and alternative opportunities available.

There are some value investors who try to be smarter, and use both higher discount rate and apply a margin of safety. I call them double whammies, and precisely schmucks.

I have another philosophy too: We cannot value a business at all because neither our estimates of cash flows are certain to occur nor the discount rate used is going to be appropriate. As a corollary, we can set a buy price based on our expected return, and play the equity game. I will keep that for another post.

Now back to the original question: are CAPM and margin of safety two sides of the same coin? I don't know. You tell me.

public sector banks into the abyss

Banking is a tough business; we know that. However, it is not such a bad business that a good manager cannot take advantage of its economics. Yet, a bad manager can surely keep the reputation intact while running a bank. Here's the proof.

The public sector banks in India have the reputation for being run poorly. The evidence is more prominent now. 

As of 10 February 2016, the market capitalization of the major public sector banks was as below:

The stock prices of these banks have reached the deep bottom; and it should take a while before they are restored to more reasonable levels.

State Bank of India is currently quoting at September 2007 prices. 

Punjab National Bank is at February 2005 prices. 

Bank of Baroda is at February 2010 prices.

IDBI bank is at October 2003 prices.



Canara bank is at December 2004 prices.



Syndicate bank is at February 2005 prices.



Such is the state of these banks that these pictures say much more than they are required to; and I haven't got anything to say now other than into the abyss.

banks hammered

We have been witnessing bank stocks getting hammered by the day. In fact, the bank Nifty is quoting at its lowest point for sometime. 

The public sector bank stocks are quoting at 52-week low points.

There is a good reason for this to happen. Banking is a tough business; and this is not well understood by many. We can be cautious about investing in highly leveraged firms, and choose to invest only in businesses that have low debt or capacity to service debt comfortably. Yet, this comfort is limited when we deal with banks. 

Banks are inherently risky because they have no option but to be highly leveraged. They have to raise debt which is disproportionate (in size compared to any other business) to their equity. Their investments are actually loans that they make to the borrowers, both retail and corporate. Because their assets are largely funded by debt, a small percentage loss on loans becomes a large portion of equity. 

If equity is not adequate, the bank can possibly go under; if not, the equity erosion can be stressful enough. The option then is to either raise more equity capital or lower growth. Both can become double-edged swords. Stressed assets lead to lower equity and returns, which lead to lower stock prices. Low stock prices hamper efforts in raising new equity. Lower growth also suppresses the already low stock prices. The vicious cycle for banks is painful. 

It is always better to be prudent when dealing with loans. A loan that is not recoverable is actually not worth making in the first place. Furthermore, if for some reason a loan becomes difficult to recover, it makes sense to acknowledge it and provide for it. Don't surprise markets at the wrong time. However, most banks do not follow this policy for the fear of lower stock prices. Little do they know that eventually what has to happen shows up. 

I have noted earlier how HDFC bank is treated by the market the way it is. Not much has changed. Markets continue to treat it well. Of course, it is managed much better than its peers. Yet, its pricing has always been at large premiums. 

For the investor, it is: for low long this premium will continue?

Another private sector bank, ICICI bank has been treated pretty badly. Its stock price is at a year low, and has been like that for sometime. 

It was trading at Rs.242 in May 2013 and at Rs.393 in January 2015. As of 10 February 2016, it is at Rs.207. Considering it was priced at Rs.192 in February 2014, one can still argue for a short call. 

HDFC bank is worth more than twice ICICI bank now. For the investor it is: for low long this discount will continue?

ICICI bank has not had good numbers in its operations. Its non-performing assets are increasing, which only tells how they were initiated. We cannot put the blame on commodity prices and commodity businesses. There must be something wrong in the process out there. 

Yet when we want to make an investment decision, both HDFC bank and ICICI bank pose different perspectives: The large premium and large discount. Which is true?

As of December 2015, ICICI bank had equity of Rs.896 b and loan book of Rs.4,348 b. It had Tier 1 capital of Rs.700 b, which is adequate. Its risk-weighted assets were Rs.5,934 b. About 79% of its loans were financed by debt. Its gross and net NPAs were Rs.213 b and Rs.100 b respectively. Provision for NPA has been increasing each quarter which is worrying the market. The bank has said it would continue in the coming quarter too. The equation is: every 1% loss in loans erodes 4.85% of its equity. How long will this continue, and does the bank have the capability to bring it down?

Markets may not strengthen its stock price significantly in the next three months at least. Well, that's not the point right? We don't care what markets think in the short term. My question is: given the hammered down prices for ICICI bank, or the stretched prices for HDFC bank, how large is the gap between their value and price?

When I think about HDFC bank and ICICI bank, I think that if one is long, the other is short. Heck, which one is it?

I know that markets can remain irrational longer than investors can remain solvent. I also know that markets have the tendency to force investors to be irrational.