Some Risk Management Lessons From Guru Warren

The blindness to risk in the buoyant environment of 2003-07 and the subsequent fall in 2008 (67% down for the year) taught me a lot of useful lessons. Some of those were captured in my earlier blog on Risk Management here. Those lessons still serve as guiding principles to me. From time to time, reading books like "Black Swan" and "Fooled by Randomness" also helps in emphasizing the importance of risk management in investing. But, there is a continuous need for improvement, esp. in an environment where stocks are becoming costlier by the day. Reading the latest letter from Warren Buffet to Berkshire's shareholders gives some good insights into the risk management strategies practiced at BH. Interestingly, whatever is applicable to one of the biggest corporations in the world is also applicable to small investors. Here is what Guru has to say.

Financial staying power requires a company to maintain three strengths under all circumstances: 
(1) a large and reliable stream of earnings; 
(2) massive liquid assets and 
(3) no significant near-term cash requirements. 

If one pays attention, it is not difficult to understand that individual investors must practice these mantras as well.

A large and reliable stream of earnings -  This statement simply means that we should own many sources of earnings(diversify) and the companies that we own should have reliable earnings(Consistent). At some other place in the letter, he mentions the criteria that Berkshire applies before purchasing a company.  One of the important ones is as follows.

Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations).

Above mentioned criteria clearly tells us what kind of companies we should own and what kinds we should avoid.

As far as diversification goes, everyone has their own criteria and comfort level. Too much diversification leads to leniency in stock selection, while too less diversification exposes one to black swans. One needs to find his comfortable mean and stick to his principles. But definitely owning one or two stocks is ruled out.

(Massive) liquid assets - Many individual investors utilize leverage. It really works well in early stages of a bull market. I myself used 10% leverage for generating higher returns in 2014. But, as the market matures, we should definitely move towards liquid assets. Remaining invested only to the level of 75-80% and keeping 20-25% as cash in a matured bull market should be considered by every serious investor. In challenging times like 2008, it helps us in keeping nerves calm and allows us to invest in some really good businesses at reasonable prices. After all, longevity in investing is far more important than a great performance in the short run. In Guru's words:

At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.

No significant near-term cash requirements - This is directly related to the liquid assets. If you are debt laden elsewhere and you have obligations to pay, then your liquid assets will be of no use in bad times. All the lenders will want you to pay in the bad times. And, liquid assets are useful only when the times are really bad. So, if you have an obligation to pay in near term, please don't count on your liquid assets as they might get utilized for near-term cash requirements. Actually, to reduce risk, we should try to remain debt/obligation free at all the times.

There are many important nuggets of wisdom in the letter and I would recommend all of us to read it. But, if one could only take this risk management part and practice it, his investing life would be much more satisfying and fruitful.

Relativity

Einstien's famous theory of relativity states that "Measurements of various quantities are relative to the velocity of observers." Even though the theory is related to the field of physics, it is extremely relevant to the stock markets. The satisfaction and sense of achievement that a market participant derives from performance of his portfolio is relative to the performance of portfolios of other market participants. To a general investor, it does not matter whether he has done well in absolute terms, what matters more is how others have performed.

Sample this- last year my portfolio was up 110%  and I was so gung ho about it. I wrote this rather boastful article here. This year my portfolio returns have surpassed last years' returns in 8 months. But, I am not that excited this year. The reason being, last year I was not coming across people whose portfolios have done better than mine. This year every serious investor is claiming returns in triple digits. Even some of the mutual funds have given that kind of return.

Is 110% a bad return for 8 months? Of course not. Anyone should be extremely happy with that kind of performance. But then why I still believe that I have not done as well as I wanted to. I understand that there is theory of relativity that applies to stock markets as well. But that is just one part of the puzzle. The other part is even more interesting. Many stocks which were rejected as investment candidates by me are up by 300 to 400% YTD. I keep thinking that it was possible to construct a concentrated portfolio of following stocks to improve my performance by at least another 100%.

Stock	YTD Performance
Avanti Feeds	459.01%
Kitex Garments	309.92%
Granules India	307.51%
Symphony	227.64%
Shakti Pumps	218.62%
RS Software	211.86%
Acrysil India	204.88%

One would think that these stocks are picked on the basis of  "survivorship bias". But the truth is that I have considered all these stocks at some point of time in last one year and rejected all of them except RS Software for investment. These are very popular stocks among small investors and they exist in many portfolios. Actually, one can argue that these stocks were ignored because of "ownership bias" of existing stocks. Performance of "Ajanta Pharma" - up 70% for the year and "PI Industries"- up 80% for the year pales in comparison to these stocks. A "HCL Technologies" which is up by 35% for the year appears like an absolute dud.

Is this situation telling me something about the market conditions and an imminent market crash? I still believe that a significant market crash is far off as current PE of Sensex is only 18. Markets don't crash considerably from 18 PE. The other interesting fact is the growth of EPS of Sensex, which is more than 20% y-o-y for last 2 quarters. This is exactly what happened in 2003. The only difference being the Sensex PE, which was 11 then. Considering both these facts, it appears that a serious crash is far away.

If markets are not poised for a serious crash then the above discussion points me to a lacunae in my stock picking process. There are two clues about what can be improved. If one looks closely at the stocks mentioned above, all the stocks except for Symphony were trading at a single digit PE on trailing basis at the start of the year. Symphony itself was growing its profits by more than 200% per annum. These are probably two lead points that need to be kept in mind while selecting next set of stocks. If a stock matches these criteria, then it can be provided some leeway on management and business quality or on valuation front. That seems to be the only way to perform relatively better. Of course, one should not give so much leeway on quality front that instead of relative out performance one gets relative under performance. After all "Ati Sarvatr Varjayet".

Template for analyzing a stock story

There are many ways to analyze a stock story. But, at the core, one needs to pay attention to the following.

• Business model
• Sources and Quality of growth
• Risk/Bear Case
• Management
• Profitability 
• Financial Health 
• Valuation
• Moat
• Opportunity Size
  

Some of these are subjective, while others are more objective and they can be derived easily from financial statements. In any case, one needs to go through annual reports of many years to get these details right.  One should also be aware of the various happenings in the company and keep a track of all the news available about the company. One important aspect is not to miss any of these details while analyzing the stock story. For that, one needs to keep a template and try to fill it for every business that one is analyzing. The template listed below is the one that I use. It has been created based on Pat Dorsey's "The Five Rules for successful stock investing".

What does the company do aka Business

Sources of Growth

• Selling more goods or services?
• Raising prices?
• Selling new goods or services?
• Buying another company? 

Quality Of Growth 

• Is there a big difference between growth rate of net income, operating income and cash flow from operations? 
• What is the tax Rate? Has it changed recently? Why has it changed? 
• Are there one time gains? 
• What is the equity Dilution over a period of time?   

The Bear Case

• List all the potential negatives
• What could go wrong with my investment thesis?
• Why will someone sell this company?

Management 

• Does the management have a reputation of cheating minority shareholders?
•  Does the management have a political connection or involved in political deal making?
• Is management conservative in its guidance and projection or over aggressive?
• Has management been candid in telling about impending slowdown earlier? 
• How is management compensation relative to company profit? 
• Were executives given loans that were subsequently forgiven?
• Does the company rank and file get the stock options or it is given only to top management?
• What percent of company's equity is given as stock option every year?
• What percentage and kind of transactions are related party transactions?
• What is the attrition rate in the company?

Profitability

• ROE
• Free Cash Flow = Cash From Operations-Capital Expenditure

Financial Health

• D/E Ratio 
• Number of years of Net Profit(FCF) needed to pay off complete debt

Moat

• Does the company have superior technology or provides better features?
• Does the company have a trusted brand?
• Does the company run its operation far better than others(superior process)?  
• Does the company have locked in customers?
• Can the company lock out competitors by creating creating high entry barriers?
• How long will the moat last? Short, Long, Very Long?
• Does the industry generally have companies with high ROE or is the company unique? If industry itself has high ROE, Moat is more sustainable.

Valuation

• P/E
• PEG
• P/B
• P/S
• IV

Opportunity Size

• What is the overall size of opportunity? How long the company can continue growing with high rate?

What To Buy From "Common Stocks And Uncommon Profits"

"Common Stocks And Uncommon Profits" remains one of the best books ever written on stock market investing. It has a very important chapter on what stocks to buy. Ideas mentioned there would add to the arsenal of any serious investor. One can also add these to the investing checklist to make better choices in future. Below is a short summary for future reference:

a. Size of Opportunity - Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? E.g., Large number of Indian homes do not have toilets. As the economic status of people improve, they will install more and more toilets at home. That represents a huge size of opportunity for a company like Cera Sanitaryware.

b. Innovation/Related Products - Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potentials of currently attractive product lines have largely been exploited. E.g. Cera Sanitaryware is trying to enter related areas like Faucet ware, Mirrors, Tiles and Air Fresheners. If any of these areas click, they can substantially increase their sale.

c. Effectiveness of R&D - How effective are the company's research and development efforts in relation to its size? Ajanta Pharma is the best example of such effectiveness. Company puts a lot of money on research and the kind of products it is producing is helping them grow their businesses tremendously.

d. Sales Strength - Does the company have an above-average sales organization? This should be directly visible in the kind of sale growth the company is showing.

e. Profit Margin - Does the company have a worthwhile profit margin? this data can directly be tracked from profit and loss account.

f. Profit Margin Improvement - What is the company doing to maintain or improve profit margins? This can be traced by looking at profit and loss account for several years.

g. Labor Relations - Does the company have outstanding labor and personnel relations? New tools like glassdoor may help us in extracting this information.

h. Executive Relations - Does the company have outstanding executive relations? Glassdoor should help us in getting this information.

I. Depth of Management - Does the company have depth to its management?

J. Accounting Standard - How good are the company's cost analysis and accounting controls?

k. Leadership Position - Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

l. Long range outlook on profit - Does the company have a short range or long-range outlook in regards to profits?

m. Equity Dilution - In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?

n. Candidness of Management - Does the management talk freely to investors about its affairs when things are going well but "calm up" when troubles and disappointments occur?

o. Candidness of Management - Does the company have a management of unquestionable integrity?

Himmat-e-Marda Toh Madad-e-Khuda

"Fortune favors the brave" is a popular saying. This proverb describes my stock market performance for the last year very aptly (though I prefer more rustic and local "Himmat-e-Marda toh Madad-e-Khuda"). After almost 10 years of active stock market investing, this year turned out to be the most fruitful for my investing career not only in terms of the percentage returns but also in terms of the absolute performance. I don't know any investor that have come close to my performance for the year. This year, I achieved returns in triple digits(110%).  It is important to note that these returns have come at a time when 110% of my net worth was invested in the markets. The importance of the last line increases in view of  an interesting tweet by venerable Samir Arora.

Interestingly, this tweet came exactly a day after I disclosed my portfolio performance on one of the equity forums while responding to a query. Is this too much of a co-incidence or the online equity world is really too small :). Anyways, we need to get back to the contributors of such a performance which is more important.

The biggest contributor to this performance has been the lesser number of mistakes made during the year. Actually, only one trade was a loss making trade this calendar year. AmaraRaja was purchased around 296-297 in Jan this year and it was sold around 260-270 in the march, causing a loss of close to 10-12%. The reason for selling at a loss was more pledging by the owners. I still don't consider selling this stock as a bad decision even though the share has bounced back to 325 levels. Staying with the stock would have given me a 20% return from the march time till now, but the opportunity cost would have been higher as my other picks have done much better.

Now with the bad news out of the window, let us discuss some brilliant decisions, which in hindsight appear almost divine.(P.S.- I was told by a friend that 2013 was my year because my birthday is on 13th).

a. Ajanta Pharma was suffering from taxation related issues at the start of the year. Most of the investors shunned the counter after receiving this news. My decision to stick with this scrip proved almost divine as the share went up by 250%  this year.

b. I was bullish on Bajaj Corp and have been buying this share from August 2012. I started buying this share from 165 levels and kept on buying till Feb 2013 when the price was almost 247. Towards the end of May 2013, the stock touched 275 levels for the first time and I sold all of the Bajaj Corp at that level. The decision hit the bulls eye as the stock never crossed that level and is trading currently at 214.

c. Last quarter Cera Sanitryware did not post good quarterly results. Its bottom line was almost flat. Many investors sold their shares seeing the results. I stuck with my position and Cera jumped from 550 to 700 in a quarter. Not a bad outcome for sticking with a company with bad results. Now, everybody and their cook are recommending this share.

d. My call on the Rupee that it will not fall below 65 turned out to be extremely correct (Please read the old blog for the thought process and analysis of the same here). From the stock market perspective, I switched from HCL Tech(exporter) to Astral(Importer) based on that call. Astral is up by 40% since then compared to a 20-25% jump in HCL Tech. Recently, I made a reentry into HCL Tech based on the better fortunes of USA and European economies and hoping to make money in that counter as well.

e. My firm belief on improvement in rural economy despite huge media outcry of sinking Indian economy fetched huge dividends with Kaveri Seeds up almost 40% and PI Industries up almost 90% for the year.

f. Some brilliant decisions were taken at the start of the calendar year 2013 to sell RS Software, Zensar Tech and PC Jwellers at a huge profit. These companies have struggled through out the year at best. RS Software has recovered itself to come closer to my sell price of 175 after an years' hiatus. PC Jwellers is in dumps and is trading at less than half of the price at which I sold it around a year back. The only decent performer is Zensar Tech which is trading 40% higher than my sell price. But most of the gains in this counter has been achieved in the last quarter only. This company has almost doubled in the last quarter and looks like a lot of froth is built into the price.

Now that this stupendous year is over, hoping to do good in current year as well. The ground is still fertile, but the terrain is becoming difficult with most of the under priced opportunities getting recognized by the market. These are the times when people tend to make stupid decisions and all the good performance of last year gets lost. Let us see how much I have learnt from my previous mistakes and can I avoid becoming dud this year after such a good run.

Happy New Year !!!

Disclaimer:
a. Above discussion is not an invitation to invest in the stocks mentioned.
b. One needs to put a lot of effort and energy to get buy/sell decisions right. Please do your own due diligence before making any investment decisions.
c. I sleep, eat, drink and watch only stock markets and hence I can exit or enter any stock in a jiffy and I may not inform anyone about my decisions before or after the trade.
d. The stocks mentioned above are small caps and they represent a minefield to navigate for any passive investor.

The Power Of Compounding

The Power of compounding keeps surprising me every now and then, even though I am familiar with it for quite a long time. Today, while calculating the returns made by Page Industries (The franchise owners of Jockey in India) in last 4 years, I realized that it has gone up by more than 5 times (from 800+ to 4300+). What intrigued me most was the fact that this share was a costly share even four years back. It used to trade at 25+ pe even in 2009. Of course, 25 pe is much lesser than the 40 pe at which it trades now, but the valuation expansion because of pe re-rating is just about 50%. The remaining 4x expansion in the valuation has actually come through profit growth.

As I have been tracking this stock from 2009 onwards, I knew that this stock was never one of those high fliers who grow their profits by 70-80%. It was much more of a compounding story. So, I decided to look back at the compounded annual growth rate (CAGR) in the profit of this company. For the last 3 years the profit CAGR of this company is 42%, while for the last 5 years it stands at 37%. I realized that the company might have grown its profit by an average CAGR of 40% for last 4 years. This 40% profit growth is definitely not a very high flier number, but done for 4 years consistently can take the profit to 4x in 4 years. And, that is what explains the rise in the price of Page Industries share.

Sometimes, when a lot of hype is created around a stock, we pay attention only to the hype and consider that to be the only reason for the rise. But, a little careful analysis can throw such insights like "A company growing its profit by 40% for 4 years can rise by 4x without any hype attached to it". Whether the market discovers such stocks or not, by sheer power of compounding and consistency they can be multi-baggers.

The implication of such insights for our portfolio of stocks is quite profound. If we can find a stock that can consistently grow its profit by 40% CAGR, we have a 4 bagger in 4 years without any pe rerating. This means that such shares should not be sold even if they become slightly costly in the near term. This also reaffirms my belief in shares like Ajanta Pharma (49% profit CAGR in the last three years), Kaveri Seeds (67% profit CAGR in the last three years), and Cera Sanitryware (34% profit CAGR in the last 3 years). These are horses for quite a long run and should not be sold even if they become slightly costly in the near term (they are far from being costly at current valuations). Of course, past performance is no guarantee of the future performance, but if they continue to perform like they have been doing till now, investing in them could be quite satisfying.

Risk Management and Diversification in Stock Markets

My opinion on risk management and diversification in stock markets have kept on changing with time. But, the recent thought process has stayed with me for the past couple of years, and I think the time has come to write it down. Here is what I think about diversification and risk management.

a. A diversified portfolio in itself does not ensure that you don't suffer large losses. I learnt this lesson in 2008, when my portfolio of more than 20 stocks went down by 67% in a year. For that matter, go and look at the history of most of the mutual funds for 2008. All of them made similar losses in NAV for that year, even those which had 100s of stocks in them.

b. The natural question that comes to mind is how to protect one's portfolio. In my opinion, there is no option other than having a stop loss to prevent the losses. You must define a threshold level, beyond which you will eject yourself out of the market, however painful that might be and however attractive the scrip may appear. Think about it from the reverse perspective: if the stock was so attractive, it would not have fallen by that much percentage in the first place.

c. Point b above clearly demolishes "buy and hold" strategy, which should be applied only by people who can't exit certain stocks at a time of panic, as their holdings in the scrip are too large to be disposed of. It is very good for Warren Buffet to preach "Buy and Hold", as his holdings in most of the companies is so high that he can't exit in a panic scenario. Individual investors should not get fooled into following something, which is a limitation for large investors.

d. Point c limits the amount and the scrips in which individual investors can invest. The natural conclusion is not to invest in companies with low volumes, unless your own investment is very low. E.g., if a company trades on an average 100 shares daily and its price is 50 Rs, and you have invested five lakhs in it, you may have to wait for 100 days ( around 5 months) to exit this share, if only your shares were executed. That means with only five lakh Rs., you become Warren Buffet of the stock. You can sink and raise prices of this stock at your whim. As a rule of thumb, I don't buy more shares than daily traded average volume of the last three months in a company. If you have to pass a company because its daily traded volume is so meaningless that it won't make an impact to your portfolio, please do so.

e. Following b, c and d above provides the best chances for an individual investor to protect his portfolio. Besides this, one should keep an eye on Nifty/BSE PE levels and when they trade in historically top quadrants of PE (23-28), one should move a substantial percentage in cash, debt and other instruments, and wait patiently for markets to self correct and give an opportunity. Similarly, if the Sensex is in the bottom quadrant of PE (10-14), one should become aggressive and even may use leverage. (Personally, I have not gotten a chance to implement this point, but whenever I get an opportunity next time, I will definitely follow this).

f. Once you have your risk management in place by implementing above points, one should only look for the best stocks, which have a very high probability of giving high returns. In my opinion, it's difficult to find even ten such stocks at any point of time in the market. The more comfortable number is around five.

g. One final point, the companies that you invest in, themselves should not be cyclical, leveraged, negative operating cash flow companies, high promoter pledged or struggling companies that are waiting for turnaround as that might not happen soon enough. If you do that, it is more likely that even with a reasonable stop loss, you will not have to churn your portfolio often enough. One more caveat is that you have to give wider stop losses for the companies that have risen sharply in recent time, so the stop loss percentage can't be a hard and fast rule and it might have to change with time. But, not having one is suicidal.

And finally, risk management and diversification are clearly two different things, which people generally mix, while there is no anecdotal evidence to suggest that a diversified portfolio is more protected.