August 28, 2014

The costs of investing

Cost is an important, though poorly understood aspect of investing. It is important for the simple reason that costs reduce the overall return one makes from an investment option. It is also poorly managed as people focus too much on explicit costs (cost of brokerage or fees) and ignore the hidden ones (such as opportunity costs).

As an investor, you have the following few options
a.    Fixed deposit : cost 0, likely return : 8-9% (pre-tax)
b.    Index fund ETF: cost 0.6% to 1%. Likely return : 14-15% (pre-tax)
c.    Mutual funds (HDFC equity fund): cost 2%. Likely return : 20-21% (pre-tax)
d.    PMS: usually 2% of asset and % of gains.  Likely returns: Who knows?

The options
Fixed deposit and index funds are zero or low cost options with the FDs having no volatility, but much lower returns. IF you want to build wealth, an FD is not going to get you there. Index funds are a decent alternative, where the risk of active portfolio management is removed. You don’t have to worry if your portfolio manager is an idiot who will underperform or worse lose money over the long term.

The third option is a well managed, diversified mutual fund with a long operating history. We can quibble about which mutual fund to choose, but I prefer one which has been conservatively managed for a long time. HDFC equity has been around since 1995 (almost 20 yrs) and has delivered good performance over the years. I am not recommending HDFC equity fund, but using it as an example of a well managed fund which has returned above average returns over the long term.
The last option is private vehicles such as PMS (portfolio management schemes). These involve high costs, and in some cases deliver good returns. However they have a mixed record and are generally not a good option for most investors due to a high minimum investment.

The math
Let’s take a hypothetical case

Let’s say you have 9 lacs to invest. It is Jan 2011 and you are looking for some avenues. You decide to invest equally in the three choices I have discussed above (lets ignore PMS for the time being)
At the end of 3.5 years, you will have following sums with you
Fixed deposit (pre-tax): 4.05 Lacs (pre-tax) and 3.84 Post tax
Index fund (pre-tax and post tax): 4.18 Lacs (net 1% as cost)
Mutual fund (pre-tax and post tax): 4.62 lacs (net 2% management fee )

The last 3.5 years have not been really that great for the stock markets (around 10% CAGR). Inspite of that, the index fund was able to do better than the FD on a post tax basis. The same held true for a well managed mutual fund too.
The explicit costs
In order to make the higher returns, an investor had to contend with all the volatility and noise in the market. In addition to the emotional toll, there was an explicit cost of around 3% for the index fund and around 6% for the mutual fund.

Most investors tend to ignore these costs unless it is pointed out to them. If someone  told them upfront that a 3 lac investment in a mutual fund would cost them 18000 over three years, they would balk at it and run towards FDs , real estate or gold.
Inspite of these costs, if an investor could stomach the volatility, he or she came out ahead during one of the lousy periods in the stock market.

Implicit costs
If you think explicit costs are bad, I would say the hidden costs are even worse.

So what is the hidden cost for an FD? It’s the opportunity cost to create wealth. In the above example an FD would cost 20% more than a mutual fund over a 3-3.5 year period (difference between the amounts after 3.5 years between the two options).
This difference only increases over time and would be even wider once the market performs close its long term average (15-17%) and interest rates drop.

I am sure I will get a counter point – how about real estate or gold. Let’s look at each of them –
If you bought 3 lacs of gold in Jan 2011, you would have around 3.78 Lacs of gold now (at pre-tax). I don’t want to discuss taxes as paying taxes on gold is different issue altogether. So gold did barely as well as an FD. Keep in mind that gold over a 20 year or longer period has delivered 9-10% per annum despite the recent runup (excluding transaction and holding costs)

Let’s move onto the next darling – real estate. So what returns can one get here? Well all of us have stories about how person xyz made 10X the capital in 5 years. Well, that is the equivalent of saying some investors made 20X their capital in page industries.
The returns on a specific investment – a stock or a property is not same as the return of an entire investment class. If you want to look at the average returns, look at this table by NHB. The returns vary from -15% for a Kochi to 249% returns for Chennai over a 7 year period. So we are talking of -2% to 15% per annum for different locations. This does not even include taxes, brokerage, and maintenance fee (For property).

Now the final argument would be – I was able to find a property and invest in it for a 10X gain in the last 5 years !
Congrats – but then you are missing the final point. The final point is the cost of time and effort – if you are a full time or even a part time investor in RE, you are using knowledge/ skill/ time to dig out such deals and investment in them. As you do this, you are not using your time do XYZ (spend time working, with your kids, play – whatever you can think of)

Compare all costs
IF you truly want to compare multiple investment options, compare all the costs – implicit and explicit

The explicit costs are fees and taxes. These are generally obvious and laid out to an investor (though still ignored). The implicit costs are usually hidden and often bigger – they are the opportunity costs of money (not investing in equity) and of time (spending time on investing versus other pursuits)
It is foolish to look at some costs and declare a particular option as better. Maybe I value peace of mind and time with family more than returns – in that case an FD is better.  My own dad valued these attributes more than returns and spent his spare time with his kids and on his own hobbies (without ever depriving us of anything in life)

On the other hand, there are people like me who love the process of investing and enjoy the higher returns. In my case, the vehicle is stocks and some other cases, it is real estate. There is an implicit cost  (time and energy) involved in earning the higher returns, which we don’t mind incurring, but it is a cost all the same (my wife can vouch for it !)
In addition to these costs and corresponding returns, I would say there are emotional and bragging benefits to various options which will be the subject of the next post.

July 25, 2014

An update on selan exploration

I had written a note about Selan exploration here . I will not repeat the analysis as the main thesis laid out earlier, still holds true.

An update
The company is cheap from multiple perspectives – enterprise value per barrel of oil reserves, EV/EBDITA etc. However due to lack of timely clearances for drilling new wells, the production and profits have stagnated for the last few years. As a result, the stock price stagnated for a few years, before the recent run from the 200 levels to around 620 now.

The company has recently started receiving approvals and has been able to re-start the drilling program. As per the latest annual report, the company has been able to drill around 10 wells and is in the process of completing the same (connect the drilled well to pipelines or other modes of transport)
In addition to the above disclosure, there is another very key variable which is showing an upward trend – development of hydrocarbon properties. This is the cost incurred by an oil and gas company to prospect for locations for new wells and then drill the well and complete it. The company has spent close to 80 Crs in the last four years in prospecting for new drilling locations.

The more interesting bit is that the company has ramped up the actual drilling and completion expenses in the current fiscal which has jumped up from 6 crs to around 55 Crs. This is a very critical variable to track as oil and Gas Companies need to drill new wells to grow production (and hence profits and cash flows).
We cannot be sure how many of these wells will be successful and when exactly they will come online. At the same time, the typical lead time from start of drilling to production of oil and gas varies between 6-9 months. So we are in effect talking of about 3-6 months of time for the oil production to ramp up.

In addition to the above, the new government seems to be focused on improving the speed of clearances and get projects moving on the ground. Considering that approvals came to standstill in the last few years, any progress on this front will help the company tremendously.
This is not a core position
This is not a big position as i think it is risky for the reasons already detailed in my earlier post. Let me repeat the key ones

-          The company has inadequate level of disclosures for an Oil and gas exploration company
-          The management provides the minimum level of commentary on the performance and outlook for the company. There are no interviews, quarterly conference calls etc. In effect short of speaking to the management directly, there are no publicly available sources of information. One is driving through a foggy windshield and being forced to make inferences based on published data

In view of the above, I have around 2% of my portfolio allocated to this idea and may add more if I think the price is getting attractive.
Please do not consider this to be a stock recommendation and do you own homework. Please read the disclaimer if you still have some doubts

----------------
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

July 17, 2014

Model portfolio performance H1 2014

This is my ‘twice a year’ sales pitch where I try to convince you about my brilliance J. I recently shared this update with the subscribers of my paid service.
--------------------------------------------------------------------------------------------------------------------

We have achieved our stated goal of 3-5% outperformance relative to the indices. The model portfolio has now outperformed the indices by around 20% on an annualized basis (after considering dividends). This has been achieved while holding around 10-20% cash at various times.
If you wish to read further – please download the rest of the document from here

If you are interested in learning more about the paid subscription, please email : admin@rcfunds.com with subject line – Interested.
----------------
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

May 31, 2014

How to miss a 10 bagger

What is worse than losing 100% on a stock ? It’s missing a 10 bagger !

What’s worse than missing a 10 bagger ? It missing a 10 bagger which you identified and decided to take no action inspite of knowing about the company. Now you must be thinking – that’s quite dumb ! In a way it is, but as always the story is more nuanced than just being dumb.

So what’s the name of this mystery company ?
Let me give some more hints J ..I wrote about it in July 2010 when it was selling for around 80 Crs market cap. It now sells at around 1400 crores. That’s a 20 bagger excluding dividends during a period where the market has gone nowhere.

I won’t tease you any more ….the company name is Mayur uniquoters! See the post here .
Now I can assign this to bad luck and move on. However I have never operated this way – I want to dissect each failure – failure of losing money or failure missing out on a 10+ bagger.

How did I miss it?
I wrote about this company in July 2010 when it was a micro cap and started a small position in the company. I was comfortable with the financial performance of the company, but was concerned with a corporate governance issue – issue of warrants to the promoter at below market price, when the company did not really need the extra capital.

As the stock price rose, I lost interest in the company and sold my small position as I was not comfortable with the corporate governance issue. In hindsight, I do not fault myself for this decision – it was the right thing to do based on the facts known to me at that point

The downside of labeling
So where did I really go wrong? As I look back, I can attribute the failure to a label I attached to the company. I was not comfortable with the management and attached the label of ‘poor corporate governance’ to the company.

After I sold my position in 2010, I continued to track the company and could clearly see the good performance. Inspite of the facts, I refused to change the label and remain locked to an existing view although the management did not show any new governance issues.
First conclusion or confirmation bias

The other name for this locking is called the first conclusion bias (read here). Once I had reached a conclusion I refused to change it, inspite of evidence to the contrary. It is only after the evidence became too obvious to ignore that I have revisited my conclusion and realized the flaw in my thinking

The illusion of high valuation
If mayor uniquoters was an isolated example, it would have been comforting to ‘label’ it as an aberration and move on. However there are a few more examples (atleast ones which are obvious to me).

Let me give another example and the back story behind missing the multi-bagger
Hawkins cooker: This stock was pointed out to me in 2010 when the company was selling at a PE of around 15. The company was and is easy to understand, has great economics and a wonderful management. So if such a company was presented to me on a platter , why did I ignore it ? The single word for that is valuations – The Company was selling at a PE of 15+ which in my mind was expensive.

I started off my investing life with high quality companies such as asian paints and Pidilite selling at reasonable valuations (15-18 times earnings) and slowly graduated to graham style low PE stocks (the reverse of most people). Over time, I got locked into a mental model where I started equating a low PE with an attractively priced stock and a high PE with an expensive stock.
The above thought process holds true in isolation, but it is important to consider the PE ratio in context of business quality. A business with weak economics is a bad stock even if it has a low PE and an exceptional business with a moderately high PE can still be a great stock. I have been aware of this fact, but still had to relearn this important concept all over again

How to change your mind ?
It would be safe to assume that if you are presented ‘data’ which contradicts your assumptions, you will change your prior conclusions ? Atleast not in my case !

Let me point to two extreme example –
Ajanta pharma has been a multi-bagger since it was pointed out to me by a very smart investor – Hitesh. I still have the email in which he shared the idea with me in 2011. At that time, I was not comfortable with pharma companies and thought that I could not judge Ajanta’s future prospects accurately.

That’s a reasonable argument and can be a plausible reason, but for the fact that this idea was posted on the website – valuepickr by Hitesh and donald. This website is run by Donald Francis and it has a lot of good investors who write regularly on it. The good thing about this forum is that Donald, Hitesh and ayush have encouraged a long term investing mindset with a focus on the process of investing. I am not praising the website due to any vested interest (I don’t have any), but think that one should read through the analysis on some of the picks made by the team
I personally follow this site and occasionally post on it too. Ajanta pharma and Mayur uniquoters are two such ideas which were posted on this site and analyzed in a lot detail. I have been following these companies over the last few years and inspite of over whelming evidence did not take the plunge

So much for changing my mind based on evidence  !
How to change ?

The first step in fixing a blind spot is recognizing one. Now that I have recognized multiple biases in my case, I have started focusing on the following points in my investment process

-          Do not equate a high PE with expensive. Analyze the business in detail and determine if the company can still double in 3 years at current or slightly lower valuations
-          Focus on quality before valuations
-          Constantly question my own conclusions. I have started doing this after each quarterly result – does the company match the original thesis (positive or negative)? Do I have access to some new non-quantitative information which should prompt me to revise my original thesis ?

I have already made changes in my stock picks in the recent past and the initial results are good. In summary I think there is a lot of value in analyzing the success of other people  – not to be envious of them, but to reverse engineer it and improve your own process.
Ps: if you guys have some stock tips, do send it my way. I will have a more open mind on it now J
----------------
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.