low risk investing

Consider this: Nifty was at 1480.45 on 30 December 1999. It was trading at a PE multiple of 24.09 and PB multiple of 4.30. The market was yielding dividends of 1.02%. Of course, it was trading at a very high price compared to value. In fact, it was looking at a bubble which was about to break; the market was at such a peak price that the implied equity risk premium was the lowest. Any sensible investor would not buy into these levels. 

And bubble break it was. By July 2001, Nifty was trading at 1053.40 with a PE multiple of 14.92 and PB multiple of 2.33. Frankly, for an investor there was value everywhere until 2003. The opportunity to make money was clearly visible. 

In October 2003, Nifty was trading back at December 1999 levels. That means, for someone who bought at the beginning of 2000 and held through until 2003, there was zilch. Just why would anyone buy the market at such high prices? It does not make any sense, does it? 

Well, it turns out that considering the opportunity costs it did make sense to buy the market at that time provided the investor held it through today. On 12 June 2015, Nifty closed at 7982.90. The annual return for the investor would have been close to 12%. This return is actually post-tax since long term capital gains are not taxed in India. I don't think any other alternative investment would have returned better than this. 

The moral of this story is that time in the market is more important than timing the market. Equity investment is actually a low risk, high return game, as opposed to the more conventional high risk, high return.  

Even buying in a high-priced market would have yielded superior returns if the buyer had the qualities to admit first and then correct the mistake by letting the time take its course.

If the investor does not understand or has no interest in the game, it is much better to keep buying the index over a long period of time, rather than believing that he can beat the market. If he had done just that, i.e. bought the index every month from January 2000, the annual return by now would have been close to 15%, rather than 12%. This return should be more than adequate for the time and effort put in. 

If the investor wanted better returns there was another way: A more sensible investor could have, and should have, bought the market in 2003 and earned close to 19% after-tax returns. That's the way this game should actually be played.

Just imagine, how easy it is to make money provided one behaves in a manner that is required; emotions have no place in this game. The markets supply enough opportunities for us to act, but these are not available on a routine basis. We should have the patience to wait for the right time before we strike. Alas, not many are equipped to do this simple, yet powerful act.

Eventually, market prices follow fundamentals of the business:

Of course, nothing like picking stocks: Individual stocks give much better returns if the investor is ready to put in efforts in analyzing the business, its price and value. Equities are actually low risk, high return investments. Unfortunately, not many understand this, and more evidently, not many have the right behavior that is required to play this game.

If investing was high risk, I would avoid it. Thank heavens, it is not, but speculating is.

did you buy nestle in 2004

Nestle has had a phenomenal success in India in the last many years is something everyone knows. But just how phenomenal for the shareholder?

It depends upon at what price you bought, obviously. If you bought at 2004 high price the annual return would be 18.54% by now; and if it was 2004 low price the return would be 22.19%. The market return during the period is 12.72%. 

I tried to go back to 2004 and find out the intrinsic value of Nestle stock at that time, just to check if there was any indication of a screaming buy. Then I compared my estimated numbers to the actual numbers. This is what I saw:

Actual revenues in 2014 were Rs.98.55 b compared to my estimate of Rs.68.82 b.

Usually, we estimate that operating margins would be linear across time; however, in reality it is never so.

I missed Rs.15.57 b capex that Nestle spent in 2011 on expansion. 

Again, linearity in estimation never seems to vanish; actual return on capital has been impressive.

Finally, I estimated that Nestle would generate free cash flows to firm of Rs.44.44 b during 2005-2014. However, it actually generated Rs.56 b.

From 2015, I assumed that Nestle would be in a stable growth period, and accordingly its growth rate, return on capital and reinvestment rate were adjusted. Nestle stock had a high of Rs.720 in 2004, and EPS was Rs.26.13, implying a PE multiple of 27.56. My valuation suggested a buy at its high price, but not a screaming one. Nestle also had a low of Rs.500 in 2014.

Nevertheless, when I tried to value Nestle in 2004 assuming that I had the knowledge of its actual free cash flows (Rs.56 b), the stock became a screaming buy.

To put it differently, at PE multiple of 27.56 Nestle was a buy in 2004. Today, Nestle is immersed in an interesting tangle where its future looks bleak, and its stock is trading at a PE multiple of 45.

Will you buy that stock now? Remember what I said earlier.

do you want to jump the gun on nestle

As I look for the stories currently developing on Nestle in India, I see this:

Well, as you can see there are too many stories to tell. There is a problem with Maggi now is an understatement. Perceptions have the power to cause much stronger impact, and consequently, can inflict real damages. They can take to very different levels irrespective of the facts. 

The debate should not be about whether the product is bad for health; of course, all packaged food items are bad for health. Colas are bad too. The quicker we deal with these issues, the better it is. The question is, will we ever?

People have been eating bad food for a long time. Because history has taught us something - they will forever remain the same - how can an investor, current or potential, in Nestle think now? Will consumers be smarter, wiser? 

Our favorite game has just begun, though: Can we buy Nestle stock now that it has fallen close to 15% from its previous levels? On 19 May 2015, Nestle closed at Rs.7,007.75 when this story broke out. Now it is selling at Rs.6,000 levels:

While we see a buying opportunity there are a number of questions remain to be asked.

Before the story became public, the stock was trading at a very high earnings multiple. While earnings multiple is just a proxy, the fact was that the stock was priced very high compared to its future earning power. In other words, at that price the present value of future cash flows of the business was much lower.

What has changed now is that the price has come down a bit, and might come down much more if the current perceptions continue. If we have to make an investment decision now, naturally we have to take a fresh call on the gap between price and value.

The question to ask is whether the long term earning power of Nestle has reduced significantly due to the dent on its powerful brand, or whether it is just a temporary problem that can be and will be fixed in due course. Maggie forms a significant portion of Nestle's revenues, and has been a very profitable product. The chances of diminishing brand power rubbing off on other packaged food items of Nestle cannot be ruled out. But then, it might not either.

As we gather our thoughts, we should ask what is going to be the impact on the following in the coming years?

And consequently on this?

If the developing story is not going to be good, as earnings go down, and business prospects deteriorate, so will the market price eventually. The gap between the current market price and the intrinsic value of the stock then should be very high. On the other hand, if the story is going to be as it was in Nestle's long past, well, we have an operation to make money.

Where do we stand now? We don't have crystal balls, and it is not easy to make those predictions. The answer is to play the wait and watch game. With the passage of time we will get to more stories, and hopefully, we should be in a position to take a decision.

Until then though, just don't jump the gun.

the story that ril has

Reliance Industries had a story to tell: its foray into telecom, and its declining returns. Now with the passage of time, the story seems to have changed, at least for the analysts. 

Reliance is yet to come near its historical high market valuation.

It had a high market capitalization of Rs.4,794 b in 2008 and Rs.3,705 b in 2015 (so far). At the current market value of Rs.2,835 b, it is about 41% lower than its all time high. There was a lot of optimism built into the high market prices in 2008 and 2009. 

Subsequently, it has had its share of issues to deal with, some external and some internal, due to which its return on equity and return on capital have been declining. 

Its investment in telecom has been significant, and it has a delayed return cycle. This itself is the biggest drag on its return on capital. Reliance has spent over Rs.2,000 b in capex since 2011 twice its previous 5-year capex spend. As of 31 March 2015 there were more than Rs.400 b of commitments outstanding. 

However, if we believe in the changed storyline there is potential for efficiency in capital allocation for the company as a whole. Its capital expenditure cycle is going to be completed soon. 

For a careful investor there were opportunities in 2012 and 2013 to buy the stock at much lower prices. I am not sure how many did though.

Yet, the next few years are going to be interesting for this business. 

when's the money amazon?

I like the business; I like the way it disrupted retail; I like the way Kindle revolutionized reading. For the year 2014, Amazon had revenues of $89 b. So far so good, and I thought about it as a firm with long term vision. But later I had to ask how long is this long term. 

Long term shareholders of this business have made money all along: In May 2010, it had a market cap of $56 b, and today it is $200 b. Just last year in Feb, it was selling for $159 b. Funnily enough, since it came out with its initial public offering in May 1997, it has never made any real money. 

Revenues increased 19% in 2014, and that's about it. Sure, Amazon is still in a disruptive growth mode, where you care about market share and then about making money. 

For its part, it presents the statement of cash flows first before statement of income and balance sheet. The reason appears to be obvious:

In claiming those free cash flows, it has conveniently forgotten that stock-based compensations are real expenses for the business.

Arguing that these costs are non-cash will be at their own peril. Otherwise, it would be much easier to pay every supplier with stocks and bring cash expenses to zero. This is for discussion another day.

It has also excluded acquisitions from calculating free cash flows, an error whether acquisitions are made through cash or by issuing stock.

At the moment, all I see is that Amazon as a business is yet to make real money. Usually, stock prices follow business profits in the long run. So far, the long run seems like too far away for Amazon because the stock prices are not reflecting business fundamentals.

There is another storyline for this business: Current earnings do not matter. What matters is the future earning power of the business. As long as Amazon is going to make disproportionately larger profits in later years, it is going to be fine. Market knows this, that's why it is factoring in the stock prices.

Which side of the story are you in? 

rate hike and markets

If the rate hike is appropriate this year and later, what should happen to the stock prices, and the market as a whole? Well, if cash flows are not going to change the prices should fall. At least, the intrinsic value of all cash flow generating assets should fall. If they don't, it would mean that prices are expensive for a buyer. 

While bond prices adjust pretty quickly to the changes in interest rates, it is not going to be as easy as it sounds for equities. This is because at least for individual firms the cash flows pattern and their growth rate could be different. There aren't fixed coupons to be paid out and the time line is perpetuity.

There would also be flow of capital from let's say emerging markets where interest rates are much higher back to the US. Since the rate hikes are going to be gradual, to come back to what we can call the normalized interest rate (and inflation) environment it could still take several years. In the meantime, currency-based investments may still not be the best option. So for investments in the US, equities should remain favorites.

Nevertheless, interest rate is an important factor in making decisions about allocating capital. It measures our opportunity costs in investment options.

are you a pe - squeezing the market

Value of a business is the present value of its future cash flows. For an investor it becomes difficult to predict cash flows and estimate the right discount rate. He struggles in that attempt all the time. What to expect of an investment, say, in a stock, is a pertinent question. 

While many analysts stick to the standard DCF model (of course, they do complicate it in the process is another matter), some loathe it citing reasons that it is difficult to predict cash flows. The latter take solace in applying multiples. And a few others use the combo - a mix of DCF and multiples. Really, there is no dearth of imagination when it comes to an analyst's emotions and his excel worksheet.

I can argue that it is possible to use DCF model in estimating an approximate (rather than precise) value of a business. I would rather keep that for another post.

The topic of this post is how venture capital and private equity firms earn their returns. They use different models to supply finance and acquire stake in the (often a private) business. The simplest form is usually the most sought after: Invest in equity of the business. Estimate the price (it isn't value) of the business 3-5 years hence. The pricing model usually is earnings-multiple, revenue multiple, or any other multiple. Have a minimum hurdle rate for the investment. Work back to calculate the price to be paid for the equity today.

If that means squeezing the present owners, so be it. In capitalism, it is fair. What is fancy in this investment model is that it is not fancy.

I want to argue that it is not difficult to use this pricing (not valuation) model for a small individual investor. It is actually a superior model to use for returns in excess of the market returns provided he is aware that pricing game is what is played here. The key to success with this model is of course the behavior of the investor.

Here's how it works:

The buy price depends upon the expected return:

As we can see for an investor who wants 30% return, the buy price has to be 47.40 which has an implied PE ratio of 13.54. This is about 52.60% down from the current price.

Is it possible to play this game in a publicly listed company? Of course it is possible because the market can be squeezed on occasion. For a patient investor there would be occasions to buy at his price. After all, the markets are inefficient, and a more-sensible investor can make money at the cost of the less-sensible one.

Two things hold out: Estimating future growth rate and PE ratio can be anybody's guess, and in addition, the emotions of the analyst can flow through to spoil the pricing game.

Nevertheless, thinking like a private equity investor is often useful. At least, it lets you to play the game on your terms.