Stock Talk - Anomalies

This piece is dedicated to ‘Anomalies’. In a world that is seemingly dominated by ‘we-know-it-all’ stockbrokers & investment bankers, typical investors feel that they are powerless against the treacherous force called the stock market. But this piece will try & show how investors can benefit from the thoughtlessness of the market. It will also show how one needn’t be a genius to ‘identify’ opportunities…& benefit from it.

What is an Anomaly? Think about it this way. Last year you intended to buy a house. You zeroed in on a location, liked the house, & although it was not fully completed & you couldn’t find daily-need shops in the vicinity, it wasn’t exactly an outright reject candidate. However, you deferred your purchase, with your decisions being based on the factors enlisted above.

You come back a year later & discover to your joy that the house is not only completed but also beautifully painted. In addition to this there is a garden & a swimming pool in the locality. Lot of shops have mushroomed in the past year & the convenience factor has gone up manifold. Moreover, you figure that the area is still relatively unpopulated & reasonably feel that the land rates could be headed north in the coming years. You ask your agent the price of the flat & discover to your ecstasy that the price he quotes is at a neat discount to the price he quoted last year. The typical human being in you suspects that something is amiss & you do some background check. After doing this, you find that there is nothing wrong & the reason for the low prices is lack of demand. (There we go into Economics!)

What would you do in this situation?

I am sure one would have noticed the allusion to the stock market in the example. The same thing happens in the stock market from time to time. Companies get better fundamentally as compared to last year, & have better prospects, but still their stock prices plunge when temporary stupidity grips the stock market. This is where a rational investor can benefit, even if he doesn’t know a lot about Balance Sheets, Income Statements etc. What is required is a reasonably good sense of observation.

I will introduce a table here with some examples from the recent stock market crash. The table is self-explanatory. For this example, I have considered stock prices as on June 14, 2006 (the day the stock markets hit their low) compared to prices as on June 14, 2005. Let’s take a look.

Table 1

COMPANY	Year End EPS (Rs)		PRICE (Rs)		P/E (x)
	Mar-06	Mar-05	14-Jun-06	14-Jun-05	14-Jun-06	14-Jun-05
BANK OF INDIA	14	7	96	109	7	16
PNB	45	44	308	404	7	9
SYNDICATE BANK	10	8	50	59	5	7
CMC	28	15	340	511	12	35
TATA TEA	32	22	575	587	18	27

For the sake of brevity, I limit myself to these 5 issues.

All of the above companies, with the exception of Punjab National Bank, have increased their Earned Per Share significantly over last year. But what happened to their stock prices? Don’t ask me, because I don’t have the answer! But I am very happy that this thing occurs time & again.

If one is wondering why the list has (only) 3 banks, it’s because of brevity! If I expanded the list, one would see the list filled with banks. Why did this happen? Here is where a little bit of observation & judgment comes in handy.

The markets perceived the Interest Rate hikes instituted by the RBI to have a negative impact on most banks. The market reasoned that most banks would have to hike rates on their deposits & hence this would increase their ‘cost of funds’, & with ‘credit growth’ slowing, the middle rung banks would be choking soon…& hence we need to dump them. & So their prices fell. You & me were presented with a fantastic opportunity! Lets adopt a slightly different viewpoint as compared to the market & look at the same situation.

When banks take in Deposits from us at higher Interest Rates, they definitely will take a hit, as they have to ‘pay out’ more than they did before. But it will most likely be of a temporary nature. Because the Interest Rates on Corporate & Home loans also go up simultaneously. The effect of this will start showing up with a time lag. Think about it. A 1% increase on Home Loans doesn’t exactly result in sleepless nights. Take a look (Another table! All loans are for a 5 year term.)

Table 2

LOAN AMOUNT (Rs)	INTEREST RATE %	INSTALLMENTS	EMI (Rs)
100,000	8	60	2,028
100,000	10	60	2,125
100,000	12	60	2,224

Source: www.statebankofindia.com

Is the difference so big as to discourage prospective home loan buyers from taking on a fresh loan? I doubt. When people are earning more each year, shopping malls are witnessing increasing ‘footfalls’, car sales are healthy, is it unreasonable to expect home loans to grow too? Especially when a home occupies a higher position in an individual’s hierarchy of needs.

Corporate India cannot defer their expansion plans for too much longer as the current utilization levels are hovering around 100%. Indeed most will feel the pinch in a rising Interest Rate scenario, which in turn augurs well for banks. In my opinion, almost the entire banking sector, with a few exceptions (as always), came up as a ‘contrarian’ opportunity in the recent fall, but the markets were hell bent on dumping them.

So maybe the prices of these banks were beaten down far more than was warranted. For an observant investor, the opportunity was there for the taking. It is divergences such as these that help one make big money, & one needn’t be an investing Einstein to achieve this. One only needs observation.

Table 1 is also an instruction in human thinking (again, I just can’t seem to get enough of this!).

Investors were paying far more for a rupee of Earnings in 2005 than they were in 2006! (See the P/E column). This seems a little silly to me, especially given the fact that not only had the performances of these companies improved significantly, most were facing better prospects going forward. What should one do as a rational investor in this case?

One little secret: I bought into Syndicate bank at precisely the price shown in Table 1. The latest Year-end Book Value of the bank is Rs.50, so I ended up buying the stock at Book Value. When one does this, he/she is giving him/herself some downside cushion. The bank has got its act together & has been delivering on the promises made at the start of the year. Without delving too much into the nitty-gritty, the bank adopted prudent & conservative accounting this financial year, which resulted in the Net Profit figure being somewhat lower than ‘Street’ expectations. & This contributed to the share price fall. I distinctly remember asking a big shot (at one of India’s ‘best’ brokerage houses & which is anything but!) about his view on Syndicate Bank after it fell. & His answer filled my heart with joy! He said, “Dump it, the results have gone really bad! We have already sold out of it completely” How much luckier can one get than to have than an opponent who thinks that his sword is useless just because it looks a little ‘ugly’! A little polishing would have solved his problem, but he gleefully gifts you the sword, for almost next to nothing!

Running the risk of sounding repetitive, I strongly believe that normal investors have an advantage in the investing arena over the BIG guys. They are unbiased & can base their actions on what they ‘see’ & not on heresy.

Investing to me is the ultimate paradox. You need to keep your ears ‘closed’ & ‘open’ at the same time!

To round out this piece, I would like to add that doing this isn’t too difficult. What it does involve is a little bit of time, some basic ability in number crunching & the innate ability to be able to ‘see’ what others can’t. & Conviction. Most people have everything else but the last, but don’t want to ‘see’ what they can ‘see’. & Then blaming something else for lack of success is a not so brilliant idea.

By the way…I never wrote on what happened to the stock prices of the companies shown in Table 1, did I? So I will sign off with another table. I don’t think one would have done badly for oneself.

Table 3

COMPANY	PRICE (Rs)		% Change
	24-Aug-06	14-Jun-06
BANK OF INDIA	133	96	39
PNB	446	308	45
SYNDICATE BANK	71	50	42
CMC	517	340	52
TATA TEA	833	575	45
SENSEX	11,532	8,929	29

“Hope…can’t substitute Reason…”

Some follow on Comments

Since the June crash, the Banking Sector Index was one of the best performers in the stock markets. Also, within the sector, Syndicate Bank outperformed all its peers.

This is not meant to be a vindication of my apparent prescience or a See-I-Told-You-So, it just goes to show that at times the markets act in a super irrational fashion. Interestingly, lot of investors did not buy Banks when they were sitting ducks. They reasoned that more clarity was needed before risking capital. My point is, at the prices that most banks were then, the risk of Capital Loss was much lower than when the world decided to start investing!

Also the subsequent behavior of the markets just serves as a proof that simple observation & conviction are the ingredients that will help one become a good investor.

Stock Talk - Taking Stock of Stock Options

This piece comes after a rather long sabbatical. It's been somewhat due to lack of ideas & largely due to lethargy. I am very finicky about shareholder friendliness & admire corporations whose actions conform to this objective. In this piece, I will write on the subject of Employee Stock Options (ESO) & my views on it. Most employees love it, some corporations, I'll try to be a little euphemistic here, 'use' (mis?) it for their benefit. Rather than rewarding the exceptional performers proportionately to their performance, which is what should ideally happen, most Stock Options have a Socialistic feel about them. While there are lots of corporations that use ESOs judiciously, I will write on why I think they may not be very shareholder friendly in lot of cases. In fact, in some cases they are not 'employee friendly' as well!

The most common reasons corporations cite for issuing Employee Stock Options (ESO), is that it motivates the employees to strive towards a common goal, & that it aligns shareholder & employee interests etc. etc. Indeed, for a lot of them, ESO's are a way to attract & retain top talent. The Internet companies not so long ago used (misused?) it to rather good effect, seemingly achieving their objective in the process. But did they achieve the commonly ranted 'we are shareholder oriented' baritone as well?

Some of the abuses that strike me as utterly un-shareholder oriented, & in cases un-employee oriented, includes Backdating of ESOs, non-expensing of option grants, & finally the Pricing & Repricing of ESOs. Each demands some 'piece-space' here & so I'll dive directly into each of them. The shareholders perspective is mostly the same under all these cases.

BACKDATING

What is 'Backdating'? Simple. Assume today is 6th Aug 2006. A company's stock price as of today is Rs.120. It decides to grant ESOs dated 1st Jan 2006, although today's date is 6th Aug 2006. This is 'Backdating'. Why would someone do that? Assume that the price on 1st Jan 2006 was Rs.100. This act achieves the purpose of taking advantage of a lower stock price as on the previous date compared to the prevailing market price.

This gives the employees; including the Top Brass, an immediate paper profit (Rs.20 in this case)…& the poor shareholder is the one who is the sufferer. In hindsight, this may seem very profitable for the employees, but it's not always the case. This is why.

'Non Qualified' Stock Options as they are called, attract a tax treatment that is slightly different from 'Incentive Stock Options'. For employees, 'Non Qualified' Stock Options attract tax payment at the ordinary Income Tax Rate (which is about 30% under US Tax code), while the 'Incentive Stock Options' attract a lower Capital Gains Tax Rate (about 15%).

Now if the unfortunate employee was unaware whether the Options granted to him are 'Non Qualified' or 'Incentive based' he will get into a shit hole later when the taxman comes knocking on this doorstep. That's because he would have paid the lower Capital Gains Tax assuming the Options to be 'Incentive based', while in reality, he should have paid the full ordinary Income Tax Rate as the Options were 'Non Qualified'! Employee friendly?

EXPENSING (OR LACK OF IT)

This is a no-brainer. When Stock Options are included as Compensation when HR works out your package, I think it's pretty straightforward to record it as an Expense on the Financial Statements. But most don't do this! The US code has now made it mandatory to expense all granted Stock Options, but corporations continue to abuse this rule.

A recent example that springs in my mind is that or Brocade, which has been accused of regularly backdating options, without expensing them! Once this is taken as correct, a cascade of charges hit the company. Misrepresentations to auditors, botching books, misrepresentation by the CEO & CFO thereby violating the Sarbanes-Oxley Act & finally, the big one Misrepresentation of Financial Statements to Investors! Whew! I wonder who benefits from all this pain, for a rather small gain (in the form of paper profit)!!!! Certainly not the corporation & most certainly not the naïve Investor who commits his money oblivious of this hanky panky.

PRICING & RE-PRICING

This to me is one of the extreme examples of selfish human thinking!

When a corporation receives a take-over bid from a competitor, it quickly & vehemently points out how the price offered, which in most cases is slightly higher than the prevailing market price, is too low (Think Arcelor-Mittal). But when the same corporation grants Stock Options to itself, they are invariably at a juicy discount to the current market price! I don't see any further room for expanding selfishness & stupidity than this!

As an example of the latter case, the Indian Bauxite/Bentonite company Ashapura Minechem has an outstanding Employee Stock Option grant that is exercisable at Rs.65 / share. The Prevailing price is about Rs.200 / share. Why on earth should a company 'take' the right to buy an additional stake at 1/3rd the prevailing price?

I can't fathom & digest the fact that managers are unwilling to sell themselves to an 'outsider' at the prevailing market price, but gleefully sell to 'themselves' a stake in their company at a super discount to the same prevailing market price! Shareholder friendly or plain stupid? I think both.

When an unwitting pay-off occurs to employees due to extraneous factors & they have an option to exercise, one can't find anybody complaining, but if the same pay-off were to occur to an 'outsider' (including investors) you can rest assured there will be a huge hue & cry over it! Chrysler being a striking example.

When the US Government, which had an option on Chrysler during its near-bankruptcy days, got an unintended pay-off, Chrysler cried like hell over the 'injustice' but if the same pay-off had occurred to themselves, I wonder how many would have cried hoarse…

The subject of Pricing & Repricing of Stock Options seem inherently un-shareholder friendly. Ideally, the Exercise Price should be around the Fair Value of the company, but this is seldom the case. Employees can readily & at times at a substantial discount, exercise their Options, make a neat profit & dilute Equity.

Equity Dilution has the effect of reducing EPS (Earning Per Share) & who suffers? Shareholders. The scene goes on something like this.In the beginning I had mentioned that ESOs have a Socialistic feel about them. This is why. The Exercise Price is the same for all employees. So, the hard-working exceptionally talented guy receives the same reward as a one-foot-on-another guy who does mostly nothing! The ESOs, which are apparently constructed to reward employees don't seem to achieve their purpose!

This is not to say that ESOs are useless instruments but I think they need to be structured realistically, not only in terms of pricing but also in terms of the parameters that clearly differentiate exceptional performers from the duds. One of the ways out of this is to devise ESO systems that are directly connected to Person X's department's performance rather than the performance of the overall corporation. Unfortunately the latter is mostly prevalent & so mostly ESO tend to be instruments that turn out to be neither shareholder friendly nor employee friendly!

Who benefits from all this then, you may ask? Well, I don't know. Hardly few, with the prevailing ESO system at least!

Stock Talk - On Herd Mentality & Logic...or the lack of it...

In this piece I will revert back to my ‘no-mathematics’ stance & write on Herd Mentality & the beauties of Logic…it is indeed beautiful…


On Herd Mentality

The freefall experienced in the markets over the past two weeks gave me some more interesting insights into human thinking or the lack of it! The markets put on display, & stretched beyond any imagination, the meaning of the word ‘herd mentality’.

Picture this. A ‘BIG’ Foreign Institutional Investor (FII) gets out a report saying that the Indian market is ‘over-valued’ & warrants a bit of correction &…plunge! Down the market goes correcting almost 30%. Who are the losers? Naïve investors & late entrants into the rally who thought that the party would never end got a smack on their rears. Did these guys even wonder if the FII had already sold off his holdings before getting out the ‘intelligent’ report?

I always knew it’s against human nature to accept things as they are. The above event only gave more proof to that belief. Everyone from the neighbor, to the news channels, to the government was blamed for the downfall. I fail to understand these flip-flops by humans especially when they are put in a corner. Maybe that’s the reason why they have solitary cells in prison. Some wise guy understood that if cornered, humans would first blame everyone else & in that process itself the ‘real’ culprit would be given away! I laud him!

When the markets were rising & people were making money by the dozen, the government was the ‘best’ & the idiots squeaking on the news channels were the ‘smartest’ guys in the business who knew what they were talking. Markets drop. SWISSSSHH! All this talk evaporates in an instant. & Then only ‘bad’ guys everywhere! Flippant?

It amazes me even further how humans when running in the same direction, ‘choose’ to ignore the warning signs that the markets put up on their roads every now & then. They do it thinking its all an illusion…but at the end they discover that they have come up to a point where their roads are an illusion & all that awaits them at the next step is a cliff! & They still jump, thinking that some magic force will invent a cushion when they land on their backsides! Optimism?

I can see the concept of ‘Inertia’ flashing before my eyes. I can also see Newton’s Laws of Motion floating in my brain. How prophetic was he! He might not have had the slightest idea that his path breaking Law would have implications outside Physics too!

The bigger problem with our race is that we think the majority is always correct. & Behave in contradictory fashion when the need of the hour is rational behavior. Its like people running like hell when they hear ‘fire’. All logic is thrown to winds & the only desire is to save ones own ass. & invariably the ass gets burnt in the process.

The herd mentality is not restricted to individual investors alone, even the ‘big’ guys seem to suffer from the same disease. Three days of successive fall & all brokerages & institutions fall over one another in hooting that it’s a bear market & things have changed for the worse. Changed in a day? Beats all logic. I don’t understand this too. Suddenly, everybody focuses on Sell numbers, which investing celebrity has negative things to say about the stock market & valuations now ‘look’ stretched. Suddenly the ‘bottom’ searching is the most important question on everybody’s minds. I don’t understand how one can predict the ‘Top’ or the ‘Bottom’. It’s tantamount to predicting the behavior of a collection of people. I don’t know what word to use for describing this tendency. I am not a big fan of astrology but I think in this case astrology is better…as it tries to predict the effect of planets on us. & Trying to predict a planet’s motion is much more logical than trying to predict human behavior.


On Logic…or the lack of it…

The very same guys, who bought a stock at Rs.X a month back, on the premise that it’s under-priced, were the first ones to dump it when the markets took a U-turn. They were selling when, ideally, they should have been buying more! What happened to the confidence? Do fundamentals change with perception? Or market levels? They are independent events that should not influence an investor’s thought & decision making process.

I wonder what makes people behave the way they do. Its almost always contradictory to what is required on the occasion. I am no super human & I have committed errors too. But that hasn’t stopped me from trying to understand or question or marvel at human behavior. We are ‘straight’ when we should actually be taking a ‘U’ turn & take a ‘U’ turn when we should actually be ‘straight’!!!

All the happenings make me think that investing is not so much about fundamentals, technicals, ‘economicals’ or ‘statisticals’ (pardon those terms) as much as it is about your neighbor’s behavior. The R-Squared metric tells us how much of the variation of the dependent variable can be explained by the independent variable. Invariably, the independent variable is the market & we speak of ‘X% of a stock’s variation can be explained by the market.’

I wonder if we should have the ‘neighbor’ as the independent variable & the ‘individual’ as the dependent! If we expand this to the entire population, the result would be an intertwined web of human behavior…that would, in all probabilities, be a contradiction in itself! So, finally who influences whom? (Newton’s 3rd Law of Motion floats in my brain) Answer. Both…

Physics & the markets seem inextricably linked to me. Physics believes that all bodies in this universe are forever ‘exerting’ a force on another body & vice versa. This force is termed ‘gravity’. The same thing happens in the markets & market participants too. The US markets shoot up & the world markets follow suit. US investors buy & the world investors follow them. My neighbor sells & I follow him. & My neighbor follows me!

Only difference, I think, is that the ‘gravity’ should be replaced with ‘stupidity’…Most times at least. On those few occasions when ‘behavior’ is actually one with what is called for, I will term it ‘serendipity’!!!

My thoughts have led me to a place where I now am beginning to question the very utility of ‘fundamental’ analysis. If its just stupidity that influences behavior, most times, what is the point in digging deep in financial statements to unearth ‘value’?

…This I will leave for another piece!

Stock Talk - Math, Valuation...or Psychology?

I will devote this piece to the darling ‘number’ of most investors…the P/E Ratio. It is a pretty long one where I will write on what the Ratio means…to me, & how one may cautiously use it when looking at investing in a company. I love to get drunk on Mathematics & Human Psychology, & even today am trying to find an answer to the rather elusive question of whether the latter influences the former…or the former…the latter! Initially I thought I would try & keep as much of Mathematics out of my writings as possible, but the temptations are too strong to resist! I will directly dive into the Mathematics part first…so that if you are bored, you may leave this piece mid-way! We will also see how Human Psychology is a bundle of contradictions, as we go through the piece…


Not so long ago, when I went about buying my first stock, I noticed that the P/E (or Price/Earnings) Ratio for some companies/sectors were higher/lower than others. The answer to this called for a rudimentary understanding of stock prices, what they stood for & what moved stock prices in the long run.

The stock price at any particular time, as most people know, reflects the ‘expectation’ that investors have from the company in the coming period(s). What is the ‘Expectation’? The ‘Expectations’, broadly speaking, are in terms of the company’s ‘Earnings’ & ‘Dividends’. Most investors, & I stress the term; buy a company for its expected future Earnings & probable Dividends. (At this moment, if hear someone asking me, “What happens when there are no Earnings & Dividends”? That will come later!)

Most people associate Return with Capital Appreciation of a stock. While this is not all that wrong, the Capital Appreciation may/may not reflect the ‘true’ Growth Potential of a company. I will try & peer through the surface to see what ‘Return’ an investor can expect, given a company’s state at any point in time.

If I were to express the Total Return that I could expect from a stock, what would it be? When I invest in a company, I am looking at Growth, no doubt, but there is also a rather ‘silent’ friend in the name of Dividend Yield (mathematically this is Dividend Per Share / Price Paid Per Share expressed as a percentage). The Total Return I make from a stock is simply a sum of the Growth & the Dividend Yield.

Putting all the English I wrote in the last paragraph in one line, we have,

Total Return = Growth + Dividend Yield

This is what I love about Mathematics, one can lucidly & economically express ones thoughts without wasting ‘English’ & ‘Trees’!


Using Notations, I write the above as follows:

Ke = g + D1/P0 ------------ (A)

Where,

Ke; is the Required Return from the Investment
g; is the Sustainable Growth Rate (elaborated below)
D1/P0; is the Dividend Yield


WHAT IS ‘g’?

Suppose I earn Rs.100 as my Net Profit & decide to ‘Retain’ all of this & invest it back into my business.

Further assume that my Return on Equity (or ROE, which tells an investor how much Return a company is getting on the investor’s money) last year was 20%.

If I now invest the ‘Retained’ Rs.100 at last year’s ROE (20%), at the end of the next year I should end with Rs.20 (= 100 x 20/100)

By doing so, I have managed to ‘grow’ my Net Profit from Rs.100 to Rs.120 by ‘Retaining’ all the Profits & investing it into my business, to give me a Growth Rate of 20%.

Now, what happens if I decide to ‘Retain’ only 50% of my Net Profit & ‘Payout’ the rest to shareholders in the form of a dividend? Simple, I run through the earlier math again to find the ‘g’, but this time instead of the Rs.100 I will use Rs.50, which is what is ‘Retained’ after paying the Dividend. In this case, the ‘g’ works out to 10%.

So, we see that a company’s Sustainable Growth Rate ‘g’ depends on two factors: the Retention Ratio & the ROE. We will need more of this number a little later, when you will notice that everything starts making intuitive sense!


Now, if we will play around with (A) to see what we turn up with.


Ke = g + D1/P0

P0 = D1/ (Ke – g)


If I now divide both sides of (B) with E1 lets see what happens.

P0/E1 = (D1/E1) / (Ke – g) ------------- (B)


Bingo! What have we got here? If you closely observe the left side of the equation, you will see that it is the P/E Ratio!!!

The right side has the following:

D/E, which is the Dividend Payout Ratio, (or the portion of Earnings that is paid out as Dividends to common stock holders)

The denominator has already been seen earlier.


WHY DO PRICES RISE/DROP WHEN THERE IS AN INCREASE/CUT IN DIVIDEND?

You might have noticed most stocks running up, after the company announces that they will be raising their Dividend/Dividend Payout this year. Conversely, the market beats down a company’s stock that announces a cut in Dividend. Why does this happen? The equation provides the answer.

If the Numerator goes down, with the Denominator being constant, the Ratio also goes down. If the Dividend Payout goes down, the P/E also goes down, thereby pulling down the stock price!

A look at the equation also tells us why we see a fast growth company commanding a High P/E. In fast growing companies, the ‘g’ is High. Why? Fast Growth companies tend to have high ROE due to which the ‘g’ is high. (g = Retention Ratio x ROE)

Now, if the Numerator is held constant, we see that as ‘g’ rises, the Denominator shrinks. Result? The P/E Ratio rises, & with it the Stock Price!

The market is willing to pay a premium for the growth & hence the P/E tends to be high. You would have noticed that the Dividend Payout & the Retention Ratio couldn’t both go up at the same time! Most Growth companies tend to have Lower Payout Ratios than Retention Ratios. This can be attributed to the fact that they need the money & they have enough avenues to invest the money at a good rate of return.

The 1 subscript stands for the ‘Expected’ number ‘next’ year. So, the P/E in the equation gives us the ‘Expected’ P/E, given an expected Dividend Payout & Growth Rate. This is consistent with the view that stock prices reflect ‘Expectations’ rather than what’s happened in the past.

This write-up is by no means exhaustive! There are lots of other things that go into the P/E as well, but this model gives us an introduction to mathematically ‘see’ things. (I love mathematics!)

The equation also gives us an insight into why the P/E for Cyclicals fluctuate depending on where the cyclical is in the ‘cycle. When times are bad, the ‘g’ will be low & if the company is Cash-Rich, it might Up the Dividend Payout. However, the 3 terms on the right side of the equation adjust in a way, which keeps the P/E low…& hence the stock prices.

When times turn for the good, the ‘g’ moves up, & for the moment assuming the Ke is constant, the denominator shrinks again, thereby pushing up the P/E…& hence…well by now you know what!


WHAT IF THERE ARE NO EARNINGS…OR DIVIDENDS?

Simple. The model breaks down!

We now need to resort to other Valuation models like the Discounted Cash Flow Valuation to give us an idea of the ‘fair’ value. The same holds for companies that declare no Dividends. In this case, the equation gives us a 0, which is pretty much ridiculous. A Fast Growth company may pay no dividend in its early years, as it needs all the money for growth.

For companies that pay no dividend, the markets ‘expect’ them to pay a dividend ‘some day’ & that is what moves prices.

…Which brings me face-to-face with Psychology!


PREDICTBILITY?

We humans, by nature, put a premium on Predictability. Not only in life but also in the companies we want to buy! So, when we look at a company as a prospective buy, we try & look at the factors that we can ‘predict’ pretty well. Once we as a group manage to pretty much agree on our ‘prediction’ so that we have a ‘consensus’ figure, we are ready to pay a ‘premium’ for that company! That is one reason for the High P/Es of Software companies, which traditionally have followed a ‘this-is-our-next-year’s-guidance’ philosophy. Never mind if the ‘guidance’ is off the mark! If the guidance is good, the markets reward them by upping the prices. & The same market beats the prices down if, unfortunately, the ‘guidance’ is ‘guided’ down.

Things aren’t that simple always. People were buying like hell into Microsoft in the days it was paying no dividend. The prices went up. In such cases, the markets ‘expect’ them to pay a dividend ‘some day’ & that is what moves prices. Closer home, Bharti Tele-ventures is an example.

What is the ‘Right’ price is indeed debatable & it’s very seldom that two people agree on the price. It amazes me how different people can think when it comes to a stock price. In good times, people keep buying, thereby upping the P/E ratio. The prices up, market moves up, & most feel that the good times will last forever. This causes them to justify high P/E on some basis or another thereby taking pries to stratospheric levels.

People start looking at ‘Relative’ valuation & buy the company that figures on the lower end compared to the ‘Sector P/E’ & laud themselves for finding ‘a great buy’! Never mind if the entire sector is itself ‘over-valued’! Who is correct? Everyone! That’s what the markets believe in.


This finally brings me to my unanswered question of whether Mathematics influences Human behavior or vice versa.

As we saw, Mathematics beautifully & lucidly explains why prices move, given a set of ‘next year’ expectations, but how many people know about it? If I were to thrust the equation on somebody’s face & told him that Mathematics is capable of explaining his behavior, he will most probably balk at me! He would think, it’s a no-brainer. Dividend down, prices down etc. all this is logical, what’s the fuss all about?

Maybe. But it fills my heart with happiness that a simple equation is capable of explaining the madness among people in the markets…& to the smart ones, it teaches them how to control their own behavior!

Stock Talk - 'Airy' Dreams

In this piece, I will digress a bit from the normal flow & write on the Airline Industry & why I prefer staying as far away from it as possible. This topic caught my attention after the announcement of the Air Deccan IPO. As usual, most brokerages have/will have a Buy on it, including some newspapers & investor interest seems to be high.

I will take a look at the global market, most specifically the US to see how the Airlines there have fared & will try & reason why I would invest/not invest in them. As a sample space, I will look at Southwest Airlines Co. along with 2 of its competitors; AMR Corp. & JetBlue Airways Corp. Let’s take a look.



TTM: Trailing Twelve Months
All figures are in USD Billion; except Per Share data


The numbers are less than inspiring. I guess it’s the fascination with flying that gets a lot of investors pumping in more & more money into airlines worldwide. If I think of myself trying to run an airline well, the idea doesn’t exactly get me jumping out of my seat. The economics just don’t seem to be exciting enough to me.

Most of the business seems to be hinged on factors that I cannot predict with a reasonably good amount of accuracy. For example Fuel Costs, a major component is difficult to predict. If one were to look at the outlook on this front, it doesn’t really seem very rosy. I find it difficult to predict the Load Factor.


WHERE ARE THE EARNINGS…& DIVIDENDS?

I don’t really lay a lot of emphasis on last 1-Year numbers, nor do I focus too much on the what ‘next’ year numbers will be. This comes later. I prefer glancing through the last 5 Year numbers, because they give me a fair idea as to how the company has coped up in a changing business scenario. What I see doesn’t inspire me too much.

Although JetBlue has shown a very good 5 Year Sales Growth Rate, it is still Net Income negative. Also, the mechanics of the industry are such that the Return Ratios aren’t earth shattering. With Margins also not that high, partly due to the high cost component & partly due to increased competition, the combination is none too exciting.

Even in the case of Southwest, the 5 Year EPS Growth Rate is negative. Not a good sign. Just how long will these companies go on without showing a turnaround in terms of Bottomline is something I don’t know.

Whatever the business model, it doesn’t really seem so profitable that would get me running to start an airline. Or even think about owning an airline company in my portfolio.

No Earnings, so no Dividends! & Even if there is a Dividend, the Dividend Yield is not too compelling. The 5 Year Dividend Growth Rate for Southwest is also not very exciting. What concerns me even more is that the Payout Ratio in Southwest’s case is a paltry 2%, & looking at the ROE, it doesn’t seem to be investing the Retained Earnings in a very profitable way either. Why is it not upping the Dividend then? Simple. Lot of Capital is needed in running an airline & an airline will do anything to retain whatever it can. Never mind if it cannot invest it in a profitable manner.

Without going too much into the numbers, it is clear that the airline business, as I understand it is one that requires too much capital, very cost sensitive & price sensitive too, in case of an LCC.

These kinds are not for me.


WHAT ABOUT AIR DECCAN & ITS ‘FRIENDS’?

Well, lot of people talk about Spice Jet & cite FII buying into it as a positive sign. I don’t know when will these airlines show Consistent Earning Power. 5 Years? 10 Years? I don’t know. To me, an investment into any airline in India today is more speculation than anything else. All the talk about India being demographically well placed for these airline companies to take advantage of seems a little like astrology to me. If any of these are Debt heavy, & indeed many will be, they will be all the more sensitive to any downturn. Not a very exciting state I would like to find myself in.

Of course, Kingfisher is a damn good airline. I hear a lot of rave reviews about whoever has traveled in it. But will the pleasure of travel translate into pleasure of returns to me as an investor? I can’t predict. As far as I am concerned, I find it difficult to convince myself into owning an airline company. There are simply too many things left to factors that I have no control over & more importantly, I can’t predict with a good amount of accuracy. I don’t like shooting in the dark. There are far less exciting business that invest my money better & these are the ones that I prefer owning.

Whenever I am tempted into owning an airline company, I remind myself of the great Warren Buffet’s eventful rendezvous with the Airline Industry...& come back to earth from my 'airy' dreams!

Stock Talk - On 'Diversification' & 'How many should I own?'

In this piece, I will be putting my thoughts on the perennial questions of how many stocks make up a ‘Good’ portfolio & the much-misunderstood concept of ‘Diversification’. I will also write briefly about building a portfolio. All these are somewhat linked to one another, so I will address them in turns.


In my personal interactions with people & ‘ghost’ interactions with lot of Mutual Fund Managers, most of them seem to follow the Lynchian philosophy of owning as many stocks as possible. The more I think about this, the more I find my mind not being able to reconcile with this philosophy. But the returns generated by some of the Mutual Funds seem to make a very strong case for having ‘as-many-as-you-can-find’ thinking. Sundaram Select MidCap Fund immediately comes to mind. This fund has consistently had ~65-70 stocks in its portfolio & has managed to generate excellent returns over a period. But I try & counter this with a Fidelity Equity (~100 stocks) that has promised more to deceive than my liking. But, then again one can point out that it hasn’t a long record….

What can amateur investors do? Buy 50? Hmm…with the kind of corpus a typical investor has at his disposal, its unthinkable to own anything more than 20. Even this figure is a bit high for me. What then should be an ‘ideal’ number?


I strongly believe that one needs just 5 extremely good stock ideas to achieve market-beating returns consistently. Does this mean a portfolio should have only 5? Maybe not. Personally I find it within my ability to keep track of at most 10 stocks at a time.

The advantage that a 10 stock portfolio has for me is that it allows one particular stock to have a meaningful impact on the overall portfolio. There is no joy in buying a stock that makes up 1% of your portfolio & seeing it double. It’s a best-case scenario when most of your 10 are on their way to ‘bag’ with a couple proving to be a drag on your portfolio. What drives the selection of my 10 & how do I decide what should be my largest holding? Once I decide that how much of an exposure should I take in it?

This is where clearly setting out your objectives assumes a lot of importance. I believe that before one sets out buying stocks, one should clearly set out his objectives. Objectives in terms of Return Expectation, how much Risk one is willing to take to achieve that Return & ones Time Horizon.

Too often, I have seen investors buying on heresy, without having a clear picture of the Risk that they are taking to get that Return. & More often than not, they are caught on the wrong foot & then blame everyone & everything else but themselves for the fiasco.

The next thing that drives my selection is the confidence I have in the companies that I am thinking of buying. The company that I am most confident in & also believe is trading at a good Margin of Safety, becomes my largest holding. There is no fun in buying the best company in the world at an absurd price. History is replete with examples of investors losing their money in ‘great’ companies. Investors in Microsoft in the boom of 2000 have still lost more than 50% of their investment.

If I find ‘my’ company at a great price, I am willing to take a big bet on it. How ‘big’ is ‘big’? For me, it is 17.5% of my total portfolio value. For me, this is conservative but for a lot others this is too high. Where is the ‘Diversification’ they ask?

…Which brings me to the question that I am at pains to answer. Because whenever I try answering, I find myself going nowhere. People’s perception of Risk is very different. The most common retort that they give me is, “Its too risky investing 17.5% in one stock.” I ask why? & they go off tangentially speaking in a dialect that I don’t follow!

Although I agree with the fact that there is inherent uncertainty in terms of a company’s Business, I feel that the ‘Risk’ stems more out of our ignorance of what is truly happening in the company. There is ‘Risk’ when you don’t know where your company’s plants are maybe because they don’t publish it. There is ‘Risk’ when you have little information of your company’s competition, maybe because the industry is such that they are hardly any data available anywhere.

When I encounter such problems, the simplest (& to me the most effective) method is to ‘ask’ for a greater Margin of Safety than I would otherwise normally desire. For e.g., if I decide on buying companies that I believe have the potential to appreciate by 20% in a year’s time, I might buy company X (the one in the previous paragraph), only if I feel that its value could go up by 30% in a year’s time. If I am not comfortable with the number that I am ‘seeing’, I don’t buy. The pain of Loss of Capital is infinitely more than Loss of opportunity.

Think about it. Suppose you are thinking about buying a house. You find 2 locations, good in most respects & you are able to satisfactorily make a call that both have good scope for appreciation in the future. Would you not buy both? To me, the idea of buying 20 stocks in one’s portfolio just ‘to ensure diversification’ is like buying the 2 houses in our example & then buying another one (that I don’t know much about), just so to ensure ‘Diversification’. In fact, if you think about it, the ‘Risk’ actually increases on buying something that you don’t know much about.

I view ‘Risk’ as not knowing something reasonably well enough to control my behavior, in the event of the price not behaving in a way that I expect it to.

If I can’t predict something reasonably, I can’t control my actions & then I will get sucked into the herd mentality that pervades the investing community…& I will most definitely lose money.

Why don’t you Hedge? Use Futures & Options? I hear somebody asking me. I will reserve this for another piece later…

One of the ways of ensuring ‘Diversification’ is what I call ‘Buying-Opposites’. For e.g., suppose you feel that the Automobile Industry will do very well in the next couple of years. Moreover, you also manage to find a couple of companies that excite you. You buy both. What happens if Steel, Paints & Oil Prices go through the roof? You think, “Hell! My companies will get affected, as their Input Costs will increase. & Also, potential buyers will think twice before buying an automobile for they will have to pay higher prices for the fuel in their car.”

In such a scenario, it is wise to buy some Steel, Paints & Oil manufacturing companies that will benefit in a rising price scenario. This way, you are buying an entire ‘chain’ & your portfolio performance will then depend on your allocation to each stock in your portfolio. Simple?

Maybe yes, maybe no. But there is immense joy in seeing your ‘chosen ones’ doing well & behaving in a way you expected them to. The joy is even more when you see one company in our above example shitting, but another offsetting this. Of course, all this is contingent to you getting your allocation right.

How does one get that right…is something that I will leave for another piece!

Stock Talk - Building a Portfolio

After the initial goof-ups, I had learnt my early lessons & then went about building my portfolio. In this piece, I will dwell on the premises on which I built my portfolio & the tenets that I diligently stick to. I will also write briefly about the importance of making & sticking to your chosen strategy.


I started my portfolio in early March 2005 & at that time I was faced with the task of deciding how to actually go about investing my Million. Should I invest on 'Tips', 'Brokerage House Recommendations', 'My Own Homework'...& thankfully, I decided on the last. The reasons? Here goes...


‘TIPS’, I notice, has a tomblike chime with ‘PITS’…& that is where most investors end up trying to follow the former.

It’s my experience that most 'Tips' come from deluded souls who live under the perennial belief that they 'know' what they speak. It is very seldom that one comes across 'Tips' that are successful, & even if they do, their frequency is so low that one will lose patience & a lot of money acting on those 'Tips'. As far as I am concerned, I have always been a great friend of reason & logic. & Although I am the first to claim that Stock Picking is a scientific 'art', I firmly believe that the premise on which you base your decision should be a logically sound one.

In watching people running after every ‘Tip’ I have learnt a wonderful aspect of human behavior. We human beings, by nature, readily get drunk on anything that is intriguing, esoteric. The desire is all the more compelling when a friend drops in a ‘Tip’ & tells you to keep it under wraps. The next day, one can’t help notice that the entire world knows the ‘secret’ but nobody is ‘talking’!!! A ‘Tip’, for all its worth, is almost always based on speculation & if it comes from a Brokerage House, invariably it will be out of vested interest.

I didn’t want to end up in a pit.


BROKERAGE HOUSE RECOMMENDATIONS

I got a tight slap on my face once in real life, trying to follow this ‘gospel’. I bought into a dud called Ginni Filaments after reading a report from a reputed brokerage house. The report was elaborately decorated & had so many numbers I had to strain my eyes trying to read it. Moreover, it ran 25 pages, which led me to think that those guys really knew what they were speaking. Later I realized the truth, after burning a lot of money. They didn’t know zilch!

I learnt some interesting aspects of the brokerage business after losing money in this one. Most brokerages do not issue a ‘SELL’ recommendation on any company, for the simple reason that doing so strains the relationship that it ahs with the company. There is a vested interest on both sides at times too, with the company ‘sugar-coating’ its business to brokerage houses.

Typically, the brokerage meets the company, comes back to office, writes a research report, sends it out to clients, who buy BLINDLY, the stock appreciates, the company’s market value goes up, the company is happy, the clients are happy & the brokerages put on a ‘I-told-you-so’ show. Fools like me buy after the stock has run-up substantially, choosing to be completely oblivious of the time of the report &…WE lose money! The naïve clients who bought the moment the brokerage sent them out a report gladly sell to fools like me & they are happy. The only ones left in the dark & with less money than when we started off are people like me…I feel no sympathy for myself.

After this I decided never to act just on the basis of a brokerage house research report.


HOMEWORK

When I finally got enlightened & started following this gospel (actual!), I started beating the indices. & It happened consistently. As of this writing, my virtual portfolio has returned 30% (1-Year Period) versus 9% (1-Year Period) for the S&P 500 Index. I gather that a 20% annual return from the US market is a very good return. Of course, there are a lot many funds out there in the US market that are returning higher than my fund, but I will reserve this for a later piece.

The biggest advantage one has when one decides to do his homework is that one knows how to react when the stock price does not behave in a way one expects it to behave. This is seldom the case with ‘I-don’t-know’ investors who are extremely happy when their ‘investment’ makes them money. They have no idea why a price is moving up & they have no idea why the price is moving down. & My reasoning says that when you don’t know what’s happening, you have no control over your reactions. Which is unpardonable to me.

My reservations on ‘Tips’, ‘Brokerage Recommendations’ etc. do not stem out of any dislike or hatred at the way they do business. It’s just that I cannot digest the fact that I have no idea about what’s happening.