timing market is futile

Someone said it long before that markets will fluctuate. And they do, always. It is difficult to predict what will happen to them in the short term. However, it should be possible for any of us to say that markets will be marching ahead in the long future. And they have been, always. Of course there are aberrations: 

Dow Jones did not move from end of 1964 to 1981; S&P-500 did move, but only a little. Without dividends, you got nothing from the Dow, and less than 2.50% from the S&P-500. The long term treasuries gave you over 13% by the end of 1981. In May 2007, S&P-500 was at 1511.14, and by February 2013, it was still at 1512.31. During the period, the financial crisis took a toll on the markets and investor returns. 

Yet, when you play a long game, you are usually better off. Playing the timing game is futile since we do not possess crystal balls. If you stick to index investing, you are more likely to come out a winner. Your costs will be averaged out, and returns you get will be market returns. 

If you are willing to spend time, you can play the long game, but with stocks rather than the index. Here, you are faced with three challenges: Information, Analytical ability, and Behavior. You need to have the behavioral edge, coupled with at least one of the other. The information edge is more difficult these days because most of the information required is already there in the public domain, and that too in real time. The only edge here is the ability to separate wheat from chaff. Knowing what counts is an important tool in your kit. There is no point in spending time on what does not count. 

It is much better to possess the analytical edge, though. If you are able to check the numbers with the story told by the market, you are on to something, especially when combined with the right behavior. There are times when stories and numbers do not match, and that is where opportunities lie for the investors. Such opportunities are available for a curious investor most of the time. As long as the expected returns are a few points higher than the alternative opportunities, you could pick that story for investment. 

Here's an old story that did not go well with the underlying numbers, and a sensible investor could have profited. Ford Motor Company had a tough time in dealing with its Edsel experiments.

From a low price of $40 per share in 1958, the stock moved to a high of $90 by 1959. The time lag was just a couple of years, but dividends were rich enough for the investor who believed in both the business and the ability of the management. 

The story is an old one; but history often rhymes and repeats. For a stock picker with the analytical and behavioral edge, opportunities are enormous, and the long game need not be always a very long one. I reckon there can be 3 strategies based upon just one philosophy, i.e. gap between price and value.

The first is a very long one: Pick businesses with the long term competitive advantages, and stay with them for a long, long time.

The second is a long one: Find businesses with decent quality that are undergoing genuine, but temporary, hiccups and consequently priced much lower than their underlying intrinsic value. Then wait for the gap to fill. This could take any time from several months to a few years.

The third one is not that long, but long enough: For the most market participants, long term is less than a quarter. Because of this, markets tend be inefficient. This means for a sensible investor, there will be stocks available where stories and numbers invite scrutiny. The stocks need not necessarily be of very high quality. But it is wise to reject all poor quality businesses; the idea is to reduce risk in investments, not increase it. The opportunities could last from a few months to a couple of years. 

So stop timing the markets. Go pick your game, and play it well. 

money managers, gimme reasons

I have noted how I think about money managers. Before I begin though, I have to say I admire Mohnish Pabrai; he is a great guy doing stuff for the underprivileged on a scale that probably I cannot do. So more power to him, always. 

Yet, I wonder why he had to manage money for others; there was no need since he is such a good investor. He has set goals to make investment returns of 26% annually over a very long period. Let's analyze. 

Based on his talks I gather that he had cash of $1 m in 1994. It became $10 m by 1999, and $160 m by 2007. By his own admission, its market value came down by 65% in 2009, and later recouped. Apparently as of now, the initial cash is worth $170 m. This can be corroborated: Let's start with $1 m in 1994. Based on his target rate of return, his investments value should double every 3 years. This means by 2017, it should be worth about $170 m. This is one side of the story. 

Apparently, he sold his IT consulting business, TransTech, in 2000 for $20 m. Let's do the math again. If he had invested $20 m of his own cash in 2000, by his own standards the market value would be $890 m by now. That's annual compounded returns of 25% over 17 years. So, he could have had a total of $1 b if he had invested with his own money.

I am not sure of his actual current net worth, but, $1 b is a lot of cash, and is enough cash to fund his philanthropic interests. Instead, he chose to manage money for others and thus, pick fee income. I have no business to interfere; yet, what the heck is this lure for other people's money?. Of course, Mohnish is a huge Buffett fan; and so am I. Nevertheless, I have not stopped questioning Buffett.

On another note, Pabrai funds bought 6.4 m shares of KRBL at Rs.594 per share.

KRBL has been a great business. In the last 5 years, revenues grew by 14% annually, operating income by 26%, and net income by 40%. Earnings per share grew by 41% during the period. It carried out stock buybacks twice in 2013 and 2014; the highest market value in 2013 was Rs.7 b, and Rs.11.8 b in 2014. As of now, the market value of its equity is Rs.135 b. Of course those buybacks made sense. The upside of the business has been tremendous: The lowest market value in 2007 was Rs.1.6 b, and Rs.3 b in 2012. From 2015 onwards, the markets took fancy to the stock, and accorded double digit earnings multiples. As of now, the multiple is over 30 times earnings.

The stock is priced at Rs.575 per share as of now. Pabrai bought it at Rs.594. Is it really worth it? While I cannot predict its prospects, here are some facts. For 2017, the business clocked negative growth in revenues, down 6%; never mind one year. Operating margins increased from 10.77% (2010) to 18.49% (2017). Net margin improved from 7.89% to 12.68%. Return on equity for 2017 was 26.66%, and aftertax return on capital was 16.47%. KRBL has about Rs.10.9 b of debt. I have not made adjustments for its advertisement costs and leases, which in my view don't make much of an impact.

Its working capital requirements have been quite erratic moving back and forth from positive to negative over the years. KRBL spent Rs.8.7 b on capital expenditure in the last 5 years. There have not been much of free cash flows. In fact, 5-year cumulative FCFF was negative Rs.1.5 b. When you have capex plans and large working capital requirements, that's what happens.

Let's do some math. In 2017, KRBL had revenues of Rs.31.5 b. If they grew by 20% each year (which they never did in the past 3 years), they would be Rs.78 b in 2022. Let's hope that its net margin stands at 15% (which it never did in the past) by that time; the net income then would be Rs.11.7 b. If we assume that markets give KRBL a multiple of 30, its market value would be Rs.352 b. Assuming further that there are no equity dilutions, the annual rate of return for the investor would be 21% over 5 years. With similar assumptions over a 10-year period, the rate of return would be similar too. Now, 21% is not a bad return even if it is falling short of Pabrai's target rates.

The key question is whether our assumptions and hopes are realistic. Can KRBL do what was never done before? That's a question Pabrai probably has answers for.

savings rate hype

Most people do not like to work for money, and would rather like their money work for them. Then they can choose to take up work they like for the rest of their time. That is a powerful way to spend life, and is called being financially independent. No matter who the person is being in that life situation lets one to be out of the grind, and concentrate on things that matter the most. But it is not easy. That's why most people end up working for money all their life.

I have noted how it is possible for anyone to achieve financial independence within a reasonable period of time. I have also highlighted that increasing income is great; but lowering expenses is a much easier path for the average person. That means, increasing savings and investing over time should lead to the road desired. There is no question that savings are important. In fact, it is great to pay oneself first, and then spend what is available. 

But savings rate concept is one hyped concept that many of those who have achieved or aspire to achieve the financial nirvana propagate. What they say is that as you increase your savings rate, the years to retire early reduce. While it is obviously true, there are limits to what you can say. Most of these people make reference to this, and go about making precise calculations on savings rate and years required to retire. That isn't always right. 

Take a rather extreme instance, where they say if your savings rate is 100%, the years to retire is zero. Isn't there a limit? Suppose that your annual aftertax income is $100,000, and suppose you were sheltered and fed by some gracious soul for one full year. Now your annual savings rate is 100%. Great, but does that mean you can retire now? Note that being retired is used rather loosely; what it means is that you can choose to retire if you want to. With $100,000 in assets, can someone retire? Assumption inherent in this is, you find that gracious soul for your lifetime; remember your annual costs are zero. Yet, people accept it and talk about it. 

Here are the assumptions behind the math on savings rate and years to retire.

I am not taking away the fact that savings are important; and the more you save, the easier and faster it becomes to be financially independent. Heck, that is way different from saying that if you save 64% a year, you can retire in 10.9 years.

I am also not taking away the basic assumption behind these calculations, which is that you require financial assets of about 25 times your annual expenses in order to retire well. This is again based upon the Trinity study, which says a 4% withdrawal is safe enough for a retirement portfolio to last.

Nevertheless, if we over simplify these basic assumptions, we will be doing it at our own peril. Consider this: With an annual income of $170,000 and savings rate of 90%, the calculations say that one can retire in 2.7 years. 

Of course with the built-in assumptions, the portfolio increases to $494,000 within that period, which is roughly 25 times annual expenses of $17,000. Yet, one has to ask this question: are $17,000 sustainable annual expenses? What if someone, for the heck of it, started saving at 90% rate just to create a quicker and larger portfolio? The person might want to increase spending after the desired level of assets is built.

While there is no sure-fire way to calculate exact cash required to remain financially independent for life, my view is to remain as conservative as possible. One way is to assume zero real rate of return over the life period. Then the math becomes simpler: Your normalized, sustainable annual costs times the number of years required. For instance, if annual costs are say, $50,000 and expected number of years to remain financially independent is 30, then cash required is $1.5 m. For a 40-year time, cash is $2 m, and for 20 years, it is $1 m. That it is possible to earn some real rate of return is more comforting.

Let's make it more concrete. For someone aspiring to be financially independent at age 35 and expecting to live until 85, the timeline is 50 years. The required cash then is $1.25 m when annual costs are limited to $25,000 in today's dollars; and $2.50 m with costs of $50,000. It might appear to be daunting to make over $1 m by age 35, but there are ways to go towards it. I come back again to say that trying to increase income and reduce expenses over the years should help. There is no need to stick to the savings rate as such, as long as one chooses to vehemently save as much as possible. 

I have shown how it is possible for the average people to become financially independent both in the US and in India. It is meaningless if you choose to work for money for too long. Go get a meaningful life instead.

capital gains tax changes

In the new budget, the government made impactful changes to the way capital gains on equity are taxed in India. 

The past

Until now all short term capital gains (held for less than a year) were taxed at a flat rate of 15%. All long term capital gains (held over a year) were fully exempted from tax; Security transactions tax was being paid on each transaction. All dividend income up to Rs.1 m was exempt at the hands of the investors. Dividend distributions tax was being paid by the corporates announcing dividend payouts. 

What's new

Long term capital gains are going to be taxed at a flat rate of 10% on all investments made with effect from 1 February 2018; all gains up to Rs.100,000 are exempt. All gains made up to 31 January 2018 continue to be tax exempt. This means to calculate gains in future, the cost basis is considered as the higher of the actual price paid and the highest market price as of 31 January 2018. These nuances apart, what it means to the new investors is that they will have to pay long term capital gains at 10%. 

What doesn't make sense

There are a few things I find don't make sense especially when you want to look at direct taxes as progressive which they should be. I see at least five problems with the new rules:

Short term capital gains: are being taxed at a 15% flat rate. For those who are in the marginal tax rates of less than 15%, this does not make sense. Someone with marginal rate of say, 10%, will have to pay 5% more just because of equity transactions. Yet, someone with marginal tax rate of say, 25%, is going to have fun playing short term with equities. This is absurd when you want to take care of the small, retail investors. The ideal rule should be to add the short term capital gains on equity to the ordinary income, and tax at the marginal rates. 

Long term capital gains: up to Rs.100,000 are made tax exempt. And the logic is that the government will have to take care of the retail investors. This defies logic though, for Rs.100,000 in today's times is not a meaningful amount for those coming to the equity markets. To make any impact on small, retail investors, the exemption limit should be say, Rs.500,000 to Rs.600,000. Gains made in excess of this value are usually by the bigger investors, and tax there should be fine. 

Another problem with the flat rate of 10% on long term gains is that there is no regard for the inflation component. Equities are considered to be hedges against long term inflation. That's the primary reason for equity investments. By not allowing for some sort of indexation benefits, long term investors are left out. There isn't any reward for the truly long term investors.

Security transactions tax was introduced in lieu of the long term capital gains tax. Now both taxes are being retained at the cost of investors. 

Finally, investors do not find any major advantages of long term taxes (10%) over short term taxes (15%). As I noted there isn't any reward for the truly long term investors. If you do the math, it is still better to play the long term game, rather than the short term, but the distinct advantages which were there earlier are gone. For all I can see, the new rules encourage short term trading as opposed to long term savings and investments. 

A better way forward

Of course, the joyride on the long term capital gains should be over. After all, all income earned should be appropriately taxed. Here are my suggestions though:

1. Add short term capital gains to the ordinary income, and tax at the marginal rates.
2. Increase exemption limit to Rs.500,000 on all long term equity capital gains.
3. Remove security transactions tax. 
4. Bring in indexation benefits to deal with inflation on long term gains.

An investor-friendly market is in the best interest of both the investors and the government.

amazon, the year that was

Amazon is worth $695 b now. It was available at $364 b in the first quarter of 2017. That's a massive jump. What caused it? Well, the same factors that caused it to increase from $15 b in 2007 to $78 b in 2012. Markets have been very forgiving for Bezos for all his long term stories. Every year I look at Amazon, and say, too much. Now it is a little $695 b, and much. 

Revenues for the year grew 30% to $177 b; they were $14 b in 2007. 

Revenues have been growing each year in double digits; the lowest growth rate was 19% in 2014. The 5-year compounded annual growth is over 23% and the 10-year is over 28%.

In 2017, it earned $6.27 in earnings per share, which is its best recorded number. Yet, the market is willing to price it over 230 times earnings. That is one way to look at it. 

Leases

If you capitalize its non-cancellable leases, the per share earnings for 2017 drops to $5.62. But then its debt increases by the present value of its lease commitments of $19 b. Lease asset is created, and depreciation and finance charges are taken to the income statement.

Advertisements

Amazon spends over 3% of its revenues on advertisement and promotions, after all it is a retail business. In the last 10 years, the total spend has been $26 b; for 2017, it was $6.3 b. If you consider that the benefits of these costs should accrue over a period of say, 3 years, you should capitalize these costs. Capital asset is created, and depreciation is taken to the income statement instead of the actual advertisement spend each year. 

The combined effect of leases and advertisement costs adjustments increases the earnings per share for 2017 to $10.31.

Research and development 

Amazon is in retail business alright. But at its core it is a technology company, which has disproportionate spends on technology and content.

It spent $22.6 b in 2017, which is over 12% of its revenues. In the last 10 years, Amazon spent over $78 b on technology and content. Naturally, the benefits of these costs should accrue over a period of time in future rather than in a single year. If you capitalize these costs, which you should, you create a capital asset again, and depreciate it over the period of its life, say 3 years. Consequently, depreciation is taken to the income statement instead of the actual spend.

We have made three adjustments to the books now: leases, advertisement, and research costs. The combined effect of these increases the earnings per share for 2017 to $30,94; much better than the book values. 

This is how the adjusted earnings per share look over the years compared to the book values.

Even operating margins look better.

Return on equity and capital are respectable.

Now the adjusted PE multiple is 46 times rather than 230 times book earnings. Will this make Amazon a better buy? That depends upon how much free cash flows the business is able to throw out each year. 

In 2017, there weren't much of free cash flows because of Amazon's acquisition of Whole Foods for $13.2 b. Even if we consider $15 b of free cash flows to firm, which it has never earned till date, Amazon is priced at more than 46 times. 

When I do a DCF with 15% revenue growth rate until it reaches sort of a mature state, I find the current price of $1442.82 too much even when I use an expected rate of return of 8%. The price is too high when I do a simple FCFF projection over the next 10 years, and apply a multiple at year 10. 

The 8% path

However, there is one way which can give Amazon investors a return of 8% over the next decade. That is when it earns an adjusted EPS of $125 compared to $30 now, and trades at 25 times those earnings at year 10. For that to happen, the revenues should grow to $719 b and net margins should be 8.42%, and there should not be any dilution in equity. The math is simple, but the path to that? There is a consolation that Walmart had revenues of $485 b in 2017. 

If you want returns more than 8%, you should seriously hope that the markets remain more patient than ever even after a decade from now, hoping that Jeff Bezos vision of long term value is yet to come, and boy will it come.

The operations

Amazon has a mix of operations.

Its AWS business has been growing faster than its retail business. And its contribution to the operating profits is predominant.

As always, its international business has been losing money primarily because of advertisement and research spends. 

Interestingly, assets employed on its segments reveal much.

On $18.6 b assets, AWS earned operating profits of $4.3 b; whereas, its international operations lost money on similar assets employed. Of course, these are accounting numbers prior to lease, advertisements, and research adjustments.

AWS is not retail
In fact, I wonder what AWS is doing inside a retail business. It would be far better if Bezos spun off AWS business as a separate entity which is basically into cloud computing. Instead of Amazon owning it, let Bezos and other shareholders own it separately so that AWS is not consolidated as a subsidiary of Amazon. We will then know the water levels Amazon retail is treading upon.

Capital employed
Amazon's capital adjusted for leases, advertisement, and research costs is estimated at $76 b equity and $64 b debt. From $140 b capital, we can back out excess cash of $31 b and arrive at operating capital of $109 b.

This will not give us total capital employed by Amazon to date. My estimate for that is: $27 b book equity; $44 b book debt; $19 b lease debt. Add to this $90 b, accumulated depreciation on its assets of $50 b, and we get $140 b. With a cumulative advertising costs of $30 b and research costs of $90 b, we have a total estimated capital employed by Bezos amounting to $270 b to date. Backing out debt, equity contribution is $207 b. Of course these are estimates, but give us a fair idea.

So then it is $207 b historical equity compared to $695 b current market prices.