Value Investing - Part 5

Value Investing - Part 4

Value Investing - Part 3

Value Investing - Part 2

Value Investing - Part 1

SIPs or Value Averaging

Do you wish to build an equity portfolio in a mutual fund? If so, you can now choose between lump investments and the popular systematic investment plan (SIP).

A recent addition to the menu is the value averaging investment plan (VIP). For investors having a one-time surplus on their hands, their obvious choice will be the lump sum investment. However, for salaried individuals, who are likely to retain some amount of surplus every month, the option to build the wealth is naturally to invest through monthly instalments either by way of the SIP or VIP, where investment is made based on their financial goals or the target they wish to achieve.

Now let us consider a case where an individual plans to build a portfolio. By investing a monthly sum of Rs 10,000, he wishes to invest for 36 months in an index fund to reach a target of Rs 4.5 lakh.

We have assumed index funds to avoid any fund-specific risks. The assumed equity returns we consider here is 15 per cent. Here we take a look at whether SIPs or VIPs would have more beneficial for such an individual, in terms of maturity value and how much money he needs to meet the target.

First an overview of how the two options will work.

Systematic investment plan (SIP): Under this option, one invests the same sum without worrying about market movements. By investing regularly over a period of time, market volatility will be evened out. As units are acquired at different NAVs, more units are bought when markets are down.

At the time of selling, an investor sells all the units at the prevailing NAV and takes out his profits.

Under systematic investment plan, one optimises the returns rather than maximising them.

For instance, if you start an SIP close to the market peak, you will continue to buy units at higher levels all the way down to the bottom.

Value averaging investment plan (VIP): Under the VIP the sum invested (and not the number of units) varies based on market levels. The investor sets a target return from the portfolio at the outset, say 15 per cent per annum. The VIP then ensures that you invest a larger monthly sum when the market falls and a lower sum when the market is high.

Assuming you can spare a minimum monthly amount of Rs 10,000. At the start of the investment assume the NAV of the scheme is quoting at Rs 35. If the NAV shoots up to Rs 39 next month, your portfolio value will be Rs 11,142. The plan will measure this against your target portfolio value. If it falls short, the fund will deduct only the remaining sum from your account and buy a lesser number of units.

How VIP compares to SIP

Let's take an example here. Suppose you have started an SIP in December 2006 and are contributing a monthly sum of Rs 10,000 to be invested in a CNX 500 index fund for the past 36 months. Currently your investment of Rs 3,60,000 stands at Rs 4,40,000.The annualised return on your cash flows works out to 12.7 per cent. Assume you made the same investment in a VIP for 36 months. In VIP, because your monthly instalment will tend to vary, you need to mention both the minimum monthly commitment as well as the maximum that you can set aside. If you have opted for maximum of 10 times of the monthly commitment, calculations show that the actual deduction could have varied very widely from Rs 10,000 to as high as Rs 84,700 a month.

In periods where your portfolio value was higher than you targeted, the fund would have not debited any sum from your account. But in all you have paid Rs 4.8 lakh towards the investment but your current value stands at Rs 6.8 lakh.

That works out to an annual return of about 22.5 per cent (based on a monthly return of 1.87 per cent), much higher than the SIP returns.

Conclusion

The VIP may be a good method to invest for the long term because it ensures that you commit large sums to equity funds when markets are at a low. It also automatically “rebalances” your portfolio when its value rises or falls.

However, the key disadvantage of the VIP is that the sum you invest each much will be highly unpredictable.

A salaried individual whose income is constant may find it difficult to commit to a VIP knowing that the sums debited to his account may vary so widely. This may prompt him to commit to a low monthly investment. Therefore, investors who have the flexibility to overshoot their investment targets significantly can consider the VIP.

The second factor is that investing through a VIP is most effective when the market is not moving in one direction.

If on starting the VIP the market is in a steady decline for many months, investors in a VIP would find themselves committing larger and larger sums to the equity fund, even while the investment loses value. Such a course may be difficult to stick to, as the absolute loss to the investor can be very high.

This suggests that even in a VIP, investors need to set a portfolio target on which they will book profits.

via BL

How to find the right stock price

Just about a year ago, the rumour mills were working overtime, leading to speculation about the survival of ICICI Bank. This was soon after the global economic crisis hit the Indian shores and ICICI Bank owned up to subprime losses. After it announced the extent of the losses, the bank's share price went into a tailspin as panicky investors started offloading their holdings. Within two months, the share price crashed from Rs 650-700 to Rs 310. The fall may have seemed scary, but not to analysts and brokerages, who upgraded their rating of the bank from 'underperformer' to 'buy' in October 2008.

What prompted the upgrade in the midst of a downturn? The answer lies in the value of the stock. As the stock corrected to Rs 310, analysts found that the price was lower than the market value of the bank's investments, or the book value per stock. "If we factor in the worst case scenario and erode the entire non-government foreign investments from our target price, our rock bottom valuations are at Rs 445, say Prabhudas Lilladher's banking analysts, Abhijit Majumder and Bharat Gorasiya. On an average, analysts valued the bank at Rs 440 per share (book value).

Given the fact that bank shares usually trade at two times their book value, ICICI Bank soon became the most favoured stock. The stream of upgrade calls were not wrong. Since then, the stock price has more than doubled to Rs 755 and is currently around 1.5 times its estimated 2009-10 book value.

This case offers an important lesson for equity investors - get the price right. No matter which stock you invest in, the cardinal rule is not to overpay.

Yardsticks to Value Stocks in Different Sectors
Industry	Best measure of value
Auto	Price to Earnings (PE) multiple
Banking	PE and Price to Book Value (PBV) or Adjusted PBV multiple
Cement	PE, Enterprise Value to Earnings before interest, tax, depreciation & amp; amortisation (EV/EBITDA), EV/tonne
Engineering	Forward PE, which reflects the order book position of the company
FMCG	PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratios
Real Estate	Net asset value (NAV), which is book value at market prices. Also look at debt levels
Telecom*	PE and DCF, because there is a future stream of cash flows for upfront heavy investment
Oil & amp; Gas	Residual reserves of energy assets
Technology	Trailing PE and its growth
* Includes utilities

Unlike fixed income options, such as bank deposits, where the returns are guaranteed, the performance of equity investments is determined by the purchase price as well. Once the stock is bought, there is very little that retail investors can do apart from buying more or selling them. So, if they invest at the right price range (or low valuations), the probability of earning greater returns is higher.

Valuation tools
How do you know you are paying the right price for a stock? The answer is to check the target investment using a couple of financial parameters. "Depending on the nature of the business and the sector's growth prospects, an appropriate tool must be used to value the company, says Hitesh Agrawal, head of research, Angel Broking. This tool is the ratio or financial metric that determines the value of a stock.

Unfortunately, there is no single tool for all industries and stocks. "One ratio cannot be applied blindly to value stocks across sectors, says Manish Shah, associate director, Motilal Oswal Financial Services. This is due to the inherently different nature of businesses. Broadly, there are two valuation metrics: PBV (price to book value) and PE (price to earnings). The former calculates the value of assets and the latter determines the price investors are paying for the company's earnings per share. A high growth, low capital-intensive company must be valued on PE, whereas the PBV or the replacement value is the appropriate tool to value capital-intensive businesses.

Another ratio that takes care of the debt leveraging aspect across companies is the EV/EBITDA (enterprise value/ earnings before interest, tax, depreciation and amortisation), or the enterprise multiple. But, as Agrawal says, it is always advisable to consider two or three valuation tools before taking an investment decision.

The tools that apply to different sectors and industries vary. Cement manufacturers are best valued using EV/EBITDA, real estate firms using NAV, while engineering companies can be valued using forward PE (see graphic). The PBV is used for capital-intensive businesses like banks and power companies.

Public sector bank stocks are attractive when they are trading below their book values. For a private bank, depending on its size, the ideal PBV ratio is around 2. In case of FMCG companies, the PE multiple is a better yardstick because these companies invest upfront in building brands and facilities and derive the earnings in subsequent periods.

What Impacts Stock Valuations in Sectors
Industry	Best measure of value
Auto	Volume growth, realisations, operating profit margins, new product launches
Banking	Loan growth, non-performing assets, net interest margins, CASA ratio
Cement	Dispatches, operating costs, regional demandsupply equation
Engineering	Order book inflows, execution skills, margins
FMCG	RoE, RoCE, margins, volume growth, new products, marketshare
Real Estate	Debt levels, liquid assets, inventory levels, promoters' ability to raise funds
Utilities/Power	Project costs, plant load factors, raw material costs, debtequity ratios
Telecom	Revenue per user, growth in usage, new subscribers, non-wireless revenues, EBITDA
Oil & amp; Gas	Reserves, efficiency ratios, free cash flow generation
Technology	Order inflow, ability to contain costs, service verticals, profitability, client attrition

Comparing with peers
After deriving the book value, a peer group comparison is needed. "Always conduct a peer analysis. Consider the sector's potential and see how the company compares with its peers, says Sonam Udasi, vice-president, Brics Securities.

However, peer group valuation has its own limitations. The target company's valuations might be lower than the benchmark or industry average due to constraints regarding market share or economies of scale, and it might continue trading at a discount. Infosys, which is considered to have superior margins and a high-yielding business portfolio, has always traded at a premium to Wipro, Tata Consultancy Services and the information technology industry as a whole.

"One also has to look at the reasons for the valuation discount versus the benchmarks. Most likely, there is a good reason for the discount. For instance, if a company can address adverse issues going forward, the discount will narrow and the stock valuation will improve. If it fails to do so, then the stock will continue to trade at a discount to its peers, says Udasi.

To refine the research process further, comparing the efficiency and return ratios of the stock with the industry or benchmark would help investors take informed decisions. In case of banks, the loan growth, net interest margins and the rise in bad loans can help find the right stock. Likewise, FMCG stocks can be sorted on the basis of return ratios like the return on equity (RoE), return on capital employed (RoCE) and the company's operating margins.

How does an investor find out if a particular valuation method is a good parameter? According to Macquarie Research, the valuation parameter is considered good "if the sector consistently shows increasingly strong returns from progressively lower levels of the valuation metric, and increasingly weak or negative returns from progressively higher levels of the valuation metric.

Sustainable growth
The sustainability of the earnings momentum is crucial because all the financial parameters or metrics are based on this presumption. "The valuation of the financial parameters needs to be done on expected or estimated earnings potential and growth. This is the most difficult and critical part for any analysis, says D.D. Sharma, senior vice-president, research, Anand Rathi Financial Services.

Apart from comparisons with benchmarks, the management quality, transparency, earnings growth and earnings volatility are key factors for driving the valuations of a stock. "Any change in these factors will re-rate or de-rate a stock. So, a standalone comparison of a stock with its peers or benchmark indices will not help much. Look for a change in the earnings potential, growth or management for a re-rating trigger, says Sharma. Hence, a company that is currently not earning profits cannot be valued at zero or close to zero.

A typical example is dishtv. The direct-to-home cable service provider is still in the investment process and is not making a profit now. The loss-making company is currently trading at Rs 42. "This is because it is developing a business, which will earn significant profits in the next few years, says Sharma.

The bottom line
Clearly, valuations are not static, but dynamic. Depending on broader factors, such as market sentiment and sectoral preference, these change with time. A stock that trades at a discount to benchmark valuations, but shows superior earnings growth rates and scores better on operational efficiencies, can be a good investment pick. Investors should use the valuation methods mentioned above to zero in on the stocks that have value, while avoiding the ones that trap them by appearing to offer value.

via Money Today/Indiainfoline

Picking Stocks

“I have a full year’s savings with me and equity investments look attractive at this stage. Tell me, what stocks to buy?” I was surprised when my friend shot this question at me. But my friend isn’t the only one eyeing the equity plunge.

With markets beginning to look up again, such enquiries are on the rise. So, how do you decide which stocks to buy, that too in a market that has already run up considerably?

Granted, picking stocks is not as easy as shopping for a pair of jeans. But then, certain basic aspects of making a choice hold good for both. For instance, the value-for-money proposition or the “would-it-fit-me” question still remains the same.

Broadly, there are two ways of selecting a stock — top-down approach and bottom-up approach. The top-down style involves identifying sectors first and then getting down to stock specifics — akin to getting the ‘big picture’ first.

The bottom-up approach, on the other hand, entails a stock-specific approach to investments, giving higher weightage to a thorough analysis of the company, while remaining relatively uninfluenced by macro-economic trends or concerns relating to that sector. Whichever of the two you opt for, note that there are some basic tests that the stock you eye should clear before it becomes a part of your portfolio.
Financial filters

Compounded growth

The compounded annual growth rate (CAGR) in sales and profits of a company would give you a picture of the historic performance of that company over a longer time frame.

This becomes more relevant as the CAGR also irons out the lumpiness in the growth numbers of a company during that time.

For instance, while the year-on-year sales or profit growth would tell you how the company has performed in that particular fiscal year, the yearly performance, however, may be prone to seasonality.

So, to that extent, it could be misleading. CAGR, on the other hand, may help give a perspective on the average sustainable growth rates.

For instance, take the case of Hindustan Unilever and Marico. While for the last fiscal year, Marico grew its sales by 25 per cent, HUL reported a sales growth of about 46 per cent.

This growth picture, however, would change considerably if we consider the compounded growth rates over the last five years. While HUL reported a sales growth of 14.11 per cent, Marico expand its sales by 21.87 per cent during the period.

Operating profit margin

Operating profit margin denotes the sales margin left with a company after meeting all its operating expenses. This is different from operating profit.

For example, Hero Honda posted an operating profit of Rs 692.60 crore for the quarter ended June 2009 while Bajaj Auto, for the same period, posted an operating profit of Rs 454.54 crore. While on the face of it, it may seem that Hero Honda made more money from its operations, the story changes if you consider operating margins for comparison. Despite a lower operating profit, Bajaj Auto has a higher OPM (21.12 per cent), while that of Hero Honda stood lower at 18.17 per cent.

Price earnings ratio

Price to earnings multiple of a company indicates the price the stock market is willing to pay for every rupee of earnings generated by a share of the company.

Typically, stocks with high PE ratios indicate that their stock price is at a premium to their earnings, whereas ones with lower multiples are believed to be a discount.

On the whole, the general perception is that stocks with low PE offer better growth potential. For example, between Maruti Suzuki and Mahindra and Mahindra, while Maruti Suzuki trades its trailing four quarters earnings at a PE ratio of 33 times its peer M&M trades lower at about 24 times.

But even as the general idea is to spot stocks that are trading at a discount to their intrinsic value, note that a lower PE doesn’t necessarily mean that the stock has a potential to appreciate. In some cases, the market accords a lower multiple to certain stocks in keeping with the overall business dynamics of those companies. On a similar line, a higher PE also doesn’t necessarily mean premium valuations.
More to go

While these filters will help you line up a list of suitable stock candidates, know that these tools by themselves aren’t enough to spot the right stock.

You may need to employ other filters and take a closer look at the company-specific financials, its balance sheet strength, cash flows and management bandwidth before making an investment.

via Business Line

Ten Commandments of Successful Equity Investing

By Jiten Parmar via Another Forum

Ten Commandments of Successful Equity Investing :


1. Discipline : The first thing an investor must learn while investing in the markets is discipline. The investor needs to be disciplined as to when to buy the stock and when to sell. If there is euphoria all around and tips are flying around, investor needs to be disciplined enough to not invest at this time. That is generally the best time to book profits in existing portfolio. At the same time, if investor finds market very undervalued, but there is pessimism all over, he needs to go ahead and buy. These may turn out to be his best buys. Investor needs to be greedy when everyone is fearful and fearful when
everyone is greedy. Do not go with the HERD MENTALITY. Exercise CAUTION during euphoric periods. The best mantra for making money in the stock market is “BUY when CHEAP and SELL when EXPENSIVE”.

2. LEARN before you EARN : One of the most important thing an investor needs to do is READ, READ, and READ. Before you invest your hard- earned money, read everything about the stock. Learn to read quarterly results, annual reports, read about peer companies, read about that particular industry in general. Make sure that the stock being bought is undervalued or reasonably valued. Do not chase a stock on the way up.

3. Conviction : If you have purchased a stock after thorough study, have conviction in the stock. Keep buying the stock at every fall and average your stock. When tide turns, this can give you super profits. Conviction in the stock is important.

4. Everything has a Price : Every stock has a right price. Many investors typically make the mistake of holding onto a stock for decades. But if you do make a close analysis you will generally find that the stocks had done very well when the companies were mid-caps and were growing at breathtaking speed. After becoming large-caps growth slows and there will be periods of massive overvaluation. These are the times when investor needs to book profits and rotate to less expensive stocks or wait for reasonable valuations to re-enter the stock. There are a number of stocks which have done anything for the investor’s portfolio for almost a decade.

5. Portfolio Allocation : Everyone should do a portfolio allocation according to their risk appetite/age and other factors. What is typically observed is that there will be periods when portfolio weightage completely changes without investor actively changing anything. If stock market is in an extremely bullish phase than equity pie becomes large. One should bring it back to its original allocation. That would mean booking profits when valuations are very high. Conversely, in a bearish phase the equity pie shrinks and investor needs to shift from debt to bring his equity pie to the
original one. This would mean buying into equity at very low valuations. This approach really works and one needs to be disciplined in following this.

6. Diversify : Do not put all you eggs in one basket. Diversify your portfolio over different stocks/industries. Ideally no stock in your portfolio should be more than 10-15% of your holdings.

7. Give Equity Some Time : Do not invest in the stock market with a short-term perspective. Invest only surplus funds, which you will not need for a long time. Often investors are forced to sell their stocks when it is the worst time to sell, because they are leveraged. Give your stocks time. Markets will have swings and can stay bearish for long periods of time and do not accord stocks the valuations they deserve. If you have conviction, these are great times to buy.
Typically, I ask people to invest with a 5-year+ horizon. This does not mean that you will be stuck with the stocks for 5 years. If during this period, stock runs ahead of fundamentals, book profits.

8. SIP : SIPping is the best way to invest in stocks. As is the nature of the markets, it gives corrections and many opportunities to buy stocks at lower prices then your previous purchases. If there is no drastic change in the prospects of the industry and the stock, have the conviction to add more quantity. SIPping brings down your average price and can help in giving stupendous returns.

9. Continuous Monitoring : Continuously monitor the health of the stock and the industry it operates in. Monitor quarterly results, announcements, etc. If something fundamentally changes with the stock or the industry take a fresh call.

10. Reward Winners : Do not try to offset your losses in losers with punishing your winners. Typically investors hold onto duds in hope of getting their price and sell their winners. This should be avoided. Don’t be afraid to admit mistake on the losers.

Stocks Below Book Value

Stocks Below Book Value

Value Stocks

Value Stocks

Pick stocks with potential

The last few weeks have been quite good for the markets in general. There has been a positive trend in the markets thanks to a push from the companies' results (many large companies have declared a good set of numbers) as well as the Reserve Bank of India's (RBI) Credit Policy.

The market volumes are good and advance-decline ratio is in favour of advances. Foreign institutional investors (FII) numbers shows that they are buying in the market but their buying is limited to certain selected counters only.

The inflation rate is above seven percent from the last one month. Both the RBI and the government have made some key announcements last week to control the soaring inflation rate.

These are the highlights of this week's announcement made by the government and RBI:

Cash reserve ratio

The RBI raised the cash reserve ratio (CRR) by 25 basis points to 8.25 percent with effect from May 24. This 25 basis point hike is in addition to the 50 basis points CRR hike announced a couple of weeks ago, which is to be implemented in two 25 bps installments on April 26 and May 10. The RBI has left the repo and reverse repo rates unchanged at 7.75 percent and six percent respectively

GDP target

The RBI revised the GDP growth target downwards to 8-8 .5 percent.

Inflation range

The RBI has revised the Wholesale Price Index (WPI) based inflation range upwards from 4.5-5 percent to 5-5 .5 percent.

Duty on steel

The government has imposed an export duty on steel exports. This will impact exporters operating in steel sector negatively.

IT tax holiday

The government has extended the tax exemption for IT and BPO companies under the Software Technology Parks of India (STPI) upto March 2010. This is an extension for one more year from the earlier deadline of March 2009.

The markets and analysts were pleasantly surprised by these announcements by the RBI and government. With the inflation rate hovering above seven percent and showing no signs of cooling off, many analysts and market participants were expecting the RBI to take harsh steps.

They expected the central bank to increase the repo rate by at least 25 basis points. But the RBI left the reverse repo and repo rates unchanged, surprising many in the market. Raising the CRR in steps (0.5 percent earlier followed by 0.25 percent) clearly suggests that the RBI was thinking of a larger CRR hike earlier and decided to spread out the impact on the markets.

Analysts believe the inflation rate will continue to remain high for a few weeks due to the base effect from last year and rising commodity prices (especially crude oil) in global markets. Many analysts are not comparing the WPI index from their last year levels but are looking at week over week tick movement in the WPI index.

The current inflation level of seven percent is factored in by the market. Analysts believe that the markets will not fall much if we get a couple of weeks with a seven percent plus inflation numbers but the market may inch up a bit if the rate of inflation goes below the seven percent level.

Currently, markets have factored in most of the positive news. Since the results season has almost come to an end and not many news bits are expected to be coming out in the next couple of weeks, there could be some correction or consolidation in the markets. It would be a good time to look at your portfolio and pick some stocks which have potential in the current market conditions.

Via Economic Times

Investing mistakes you should not make ...

Overconfidence - Don't be unrealistically optimistic

A bull market makes retail investors believe that they are geniuses - after all, anything they put money into goes up. This overconfidence in their own abilities leads to a complete disregard of the risks involved. Every new generation that invests in the market ignores past experience. These new investors wrongly believe that stock prices only go up.

Don't be overconfident and don't start believing that you have superior skills compared to the market. Recognise that in a bull market you are benefiting because the whole market is going up. If those around you are getting unrealistically optimistic, start managing your risk accordingly. Remember that sometimes markets do come crashing down.

Over enthusiasm to trade - Not every ball should be hit

Good batsmen realise that some balls outside the off-stump should be left alone. Similarly, professional investors realise that sometimes its better to just stand still than to rush into a stock. Retail investors often make the mistake of "flashing outside the off-stump" because they cannot resist the temptation to trade in every opportunity. And, like an inexperienced batsman, they suffer the same fate.

Too much trading will lead to a lot of churn, extra commissions to your broker and huge tax implications for you. Some of the world's best investors follow a buy and hold strategy - you should too.

Missing the benefits of compounding of capital - Learn from Einstein

Albert Einstein is reputed to have said that compounding of capital is the 8th wonder of the world because it allows for the systematic accumulation of wealth. Even though any one in class 5 could tell you how compounding works, retail investors ignore this basic concept.

Compounding of capital can benefit you only if you leave your money uninterrupted for a long period of time. The sooner you start investing, the bigger the pool of capital you will end up with for your middle-aged and retirement years.

Don't wait to start investing only when you have a large amount of money to put to work. Start early, even if it's with a small amount. Watch this grow to a very large amount with the passage of time.


Worrying about the market - But there is no answer to your favourite question

Smart investors don't worry about the direction of the market - they worry about the business prospects of the companies whose stocks they own. Retail investors are obsessed with the question "Where do you think the market will go?" This is a wrong question to ask. In fact, no one knows the answer.

The right question to ask is whether the company, whose stock you are buying, is going to be a much bigger business 10 years from now or not? Don't take a view on the market, take a view on long-term industry trends and how your chosen companies can create value by exploiting these trends.

Timing the market - Around 99% of investors will fail in this strategy

Its very difficult to time the market, i.e, be smart enough to buy at the absolute bottom and sell at the absolute top. Professionals understand that timing the market is a wasted exercise.

Retail investors always wait for that elusive best opportunity to get in or to get out. But by waiting they let great investment opportunities go by. You should use systematic or regular investment plans to make investments. You'll have to make fewer decisions and yet can accumulate substantial wealth over time.

Selling in times of panic - You should be doing the opposite

The best opportunity to buy is when the markets are falling and there is fear in the minds of investors. Yet, many retail investors do exactly the opposite. They sell when the markets are falling and buy only when the markets are high. This way they end up losing twice - by selling low and buying high, when they should be doing exactly the opposite.

If nothing has changed about the long-term outlook for the company that you own, then you should not sell this company's stock. Use this opportunity to buy more of the same stock in falling markets. Some of the world's biggest fortunes were made by buying when others were selling in panic.

Focusing on past performance - Its like driving forward while looking backwards

It is a very common perception that because a stock has done well in the past one year, it's the best stock to invest in. Retail investors do not realise that often the best performers will underperform the market in the future because their optimistic outlook has already been priced into the stock.

Don't go after hot sectors that are currently producing high returns. Don't let greed drive your investment decisions. Look forward to see whether the gains produced in the past can get repeated or not. Short-term trends of the past might not get repeated in the future.

Diversifying too much will kill you - Investing is all about staying alive

Beyond a point, having too many names in a portfolio can be counterproductive. You might end up duplicating, or end up taking too much exposure to a sector. Over-diversification can upset your portfolio, especially when you have not done enough research on all the companies you have invested in.

If you are an active investor in the stock market, maintain a manageable portfolio of 15-25 names. Instead of adding new names to this portfolio, recognise ideal ones. Then back them with more capital. In the long-run, this will produce better returns for you than adding another 20 names to your portfolio. Investing is all is about patience and discipline. By avoiding mistakes you can improve the long-term performance of your portfolio, whatever the economic conditions prevailing in the market.

Via iTrust

Monkeys, Goats and Markets

So there was this village where one day a man appeared and said that he wanted to buy monkeys. He said that he would pay a hundred rupees per monkey. The villagers caught all the monkeys in the neighbourhood and sold them to him for a hundred rupees each. Soon another man appeared and said that he would pay two hundred rupees for each monkey. But there weren't any more monkeys around. They were all owned by the first man. So the villagers went to him and said that they were willing to take the monkeys back and return his money. But the monkey owner was unwilling to sell. The villagers raised the offer price to Rs 150 per monkey, then Rs 175 and finally to Rs 199 but the man just didn't want to sell, even though he clearly didn't have any use for the monkeys. Eventually, just to see whether he would sell, they offered him Rs 200 but he still refused.

The villagers were puzzled by this. Finally, one of them figured out that there must be someone else who was going to come to the village and offer even more money for the monkeys. Convinced that this was the real explanation, they went and offered the man Rs 300 for each monkey and sure enough the man accepted. Joyous at having landed such a good deal, they quickly paid him off before he changed his mind and took possession of the monkeys. The man went away with his money and presumably lived happily ever after. The villagers waited for the next buyer. And waited. And waited. But no one ever appeared who wanted to buy a monkey.

But wait. If you think you've guessed the moral of the story, you are wrong because the story isn't over yet. This story isn't quite the same as the monkey story you may have got in one of those chain-fowarded emails. In my version, there was another village nearby. In this village a man appeared one day and offered a thousand rupees each for a goat. Now goats were valuable, but not as much as a thousand rupees so the villagers sold the goats to this man. A similar thing happened here too. A second man appeared, offered two thousand for each goat, the first man refused and eventually the villagers ended up buying the goats back for Rs 3,000 each. Here too, the two men disappeared and no one ever came and offered so much money for a goat again. But there was a difference. Goats aren't monkeys. They could be milked every day and the milk was good and healthy. In fact I've heard that Gandhiji preferred goat milk. Even the goat droppings could be used as fuel, though I'm not sure of that. When the goats eventually grew too old to be milked, the villagers could kill them for mutton. All in all, it wasn't a complete disaster.

But the monkey-owners were not so lucky. Since these weren't demat monkeys, they actually had to be kept in one's house. The monkeys ate too much, shouted and shrieked all day and sometimes bit people. Eventually, when it became clear that the monkeys were worthless, their owners abandoned them and tried to forget about their losses. And that's the moral of the story. In the stock markets today, there are good companies that are overpriced and there are worthless companies that are overpriced. If you are going to be a fool and pay absurd prices because you think that a greater fool will appear in the future, make sure you buy a goat and not a monkey.

Dhirendra Kumar

Events to drive the markets rather than earnings?

At various points in this four-year bull run investors have wondered where and when a bubble situation would arise. Last week showed the first clear signs of irrational exuberance. While the Sensex level of 17,000 was itself a bit stretched, the rise thereafter has been crazy. Fundamentals would hardly explain the kind of frenzied rise.

At these levels, the Sensex is trading at a trailing PE ratio of around 25x. Once again, this is not sustainable, since earnings of Indian corporates cannot rise at 25x over a sustained period. Over the past five-year period, beginning FY03, earnings have risen by around 35% annually. This performance is getting increasingly difficult to continue. The first quarter of FY08 saw a net profit growth of only 8%, if you stripped out other income.

Investors, and even broking firms, seem to have missed this altogether. The second-quarter results, many of which will come this week onwards, will finally set the tone for FY08, but drastic improvements are unlikely.

The reasons for a likelihood of earnings growth slowdown in FY08 aren’t hard to see. Interest rates are now 20-40% higher than three years ago when corporates weren’t borrowing anyway. Earlier, an average corporate could borrow at 7-8%, now they need to pay over 10%. While this looks like only 200-300 basis points, investors should look at it in proper context. A 3 divided by 7 is 43%.

So if interest rates go up from 7% to 10% for a corporate (or a home loan), cost of borrowing is up 43% and not 3%. Higher interest costs are affecting profitability and causing demand slowdown. It is visible in two-wheelers, and will now become visible in housing and cars if interest costs remain high.

With this background, lets pose two key issues:

Why did the market run up so fast, and from here, how do we spot outperformance? In both the cases, deals or rumours play a key role. The market’s run, post-Sensex level of 17,000, appears partly speculative, and partly deal news driven. Most of the scrips that have led the rally seem driven more by deal news, rather than the changing perception of earnings growth. Both Bharti Airtel and Reliance Communications seem to have benefited from tower business hive off.

There is something brewing in R Comm’s subsidiary Flag Telecom as well. Reliance Energy (REL) has gone from around Rs 600 to Rs 1,700 levels in maybe a month. This surge seems driven by the listing plans of Reliance Power, where REL holds 50%.

While there’s been no specific news in Reliance Industries, rumours abounded last week. One such was a possible large float from the retail business. The same pattern may persist if the market stays around these levels. With little hope of earnings driving outperformance, new triggers can best come from news flow.

Saturday’s newspapers, for example, had an announcement of a massive $9-billion investment plan from Reliance Industries. Reliance Industries chairman and managing director Mukesh Ambani said the company will invest $8-9 billion in the next three to four years at its Jamnagar ‘super site’.

It was not clear whether this is a new announcement or a reiteration of an earlier plan. Mr Ambani also talked about plans for ‘acquisition mode of growth’ and ‘forging new partnerships’. In other words, organic growth alone would not suffice for Reliance going forward.

Investors may take a cue from this line of thinking as well. Organic growth will rarely lead to earnings growth beyond 25%. In sectors that are growing faster than this, like telecom, growth is anyway priced in. Bharti Airtel is quoting at 43x trailing P/E, for example. Corporate action, either an acquisition/divestiture, or entering a new area, may be necessary to generate market excitement from hereon.

The reverse of this logic also appears visible. Scrips that lagged last month or so are perhaps the ones that haven’t made any great announcement to catch shareholders’ attention. ICICI Bank, another index biggie, for example, has lagged in this recent surge.

A lot of corporate activity happened in this stock around the time of its follow-on issue in June. Since then, things have been quiet on this counter. The bottomline for investors: absolute returns maybe hard to get for sometime, unless they are event driven.

Options for retail investors

If you sail a small boat, what do you do in choppy seas complete with high tidal waves? You could dive deep to stay off turbulence on the surface and spare being thrown around. Apply the strategy to the volatile stock markets, and you may still have an opportunity to weather the storm. Consider this. Since July, the benchmark sensex shot up 22%, while the index for medium-sized companies represented by BSE midcap index rose only by 11.7%. The index for BSE smallcap stocks rose 13.6%. Fund managers see an opportunity here.

Says Samir Rachh, fund manager, Emkay PMS: “As the trading gets more institutionalised, the focus is on the top 100 stocks. Investors should look for good stocks below the radar of large fund managers.’’ Think of FIIs as large whales, who have a big appetite. In the last couple of days, as they poured big money, they lapped up frontline stocks making some of them look expensive.

Their logic was simple. Should there be any shock in the system, the more liquid large stocks will allow them a quick exit. With action diverted, medium and small cap stocks seemed lost for attention. Says another fund manager in one India’s largest mutual fund: “After a while, the action is bound to trickle down the smaller companies. After all, it is some of these companies that will eventually become large cap stocks.’’

How do investors pick these businesses? Rachh says today there is a premium for growth and size, rather traditional value based investing . For example, though oil companies like BPCL and HPCL may be valuable based on their assets, investors aren’t buying these stocks as they can’t see a growth story for these companies. Instead, smaller businesses like Educomp and Elecon Engineering have risen faster, on the basis of growth plans and healthy order books respectively.

Says Bharat Shah, CEO and managing director of ASK Investment Managers, who manages over $600 million: “Today, growth is an important subset of value. There is value only if there is real growth.’’

Shah, one of India’s earliest fund managers, says that to make money, investors should have the stomach for quotational losses. He also advises that the popular price-to-earnings ratio is an inefficient metric to value stocks.

He would rather prefer to arrive at the value of a business based on the life time earnings potential of a company. “In a market of 6,000 stocks, not everything is expensive. There are enough stocks available at reasonable prices to fill a portfolio.’’

Via ET

Investing in the bull market

The stock markets are brimming with optimism. Money is pouring into the market like never before. The index has embraced unimaginably new highs. For now, it appears that the bull-run is at the horizon. For a true bull market, at least 20-25 per cent of the stocks must be on an increase and that too for a sustained period say two years. An upswing market is considered a good time for the investor.

What sort of a strategy must investors adopt to make it rich in a bull run? It is not unusual to find some stocks faring poorly in a bull market and some doing exceptionally well in a bear market. A bull run implies a booming economy, low unemployment rate, high production of goods, and low inflation.
The market ups and downs follow cyclic patterns.

For now, it is the time of rising index and increasing volatility. In a bull run, investors follow the formula 'buy low and sell high'. It is now time for investors to sell their stocks and book profits. Investors need to make well-educated and investigated investments in the markets.

Mere speculation can prove costly. Suppose in a bear market one stock fares poorly. An investor who has done enough research will know the reason for its fall. There may be something fundamentally wrong with the stock and the company policies.

Or the slide in the stock's price will be a reflection of general pessimism pervading a bear market. If an investor knows that it is the latter, he will stay calm and may be even add more stocks of the company to his portfolio. On the other hand, if he believes that something is fundamentally wrong with the stock, he may decide to sell it and stop further loss.

The scenario holds much the same in a bull market. Some stocks may become highly overpriced. An overpriced stock in a heated market is sure to burst when the bull run ends. Some investors prefer to sell all their shares and make profits. Another strategy is to sell some of the shares and buy back the stock when the price falls back to reasonably low levels.

The value of equities tends to rise fast in a bull run. Predictably, the equity investments in your portfolio will become disproportionately higher. Depending upon your age, objectives and financial obligations, you would have arrived at an asset allocation plan.

In order to stick to the asset allocation, make a judicious down-sizing of the equity component. This will provide ample cushion in case the bubble bursts and markets fall. In a bull run, investigate the real value or worth of the stocks. Do not invest in overpriced stocks. It is advisable to sell overvalued stocks. Exit immediately if you feel the prices have gone up adequately.

Invest regularly. The power of compounding and systematic investment plans goes a long way in wealth accumulation. Finally, bear in mind that there are no permanent bull and bear markets. Disciplined investing and avoiding speculation will help investors.

Cash flow investing - Chetan Parikh

In a great book “The Market Masters”, there is an insightful interview of value investor Andy Pilara.

“Like most young boys, Andy Pilara once dreamed of becoming a profes­sional baseball player. In fact, his love of sports is what originally sparked his interest in stocks. As a youth, he'd devour the sports pages of his home­town newspaper, the San Francisco Chronicle. Back then, the stock tables were part of the sports section, and all those funny-looking numbers fasci­nated him. Before long, Pilara found himself taking an investment class and developing a friendship with the instructor that eventually would pave the way to his future in the business.

After almost two decades of running his own value-oriented one-man boutique, Pilara joined RS Investments in 1993. While the firm has long been known as a growth-oriented shop, Pilara has made a strong name for himself as head of the RS Investments value group. Pilara, 63, runs three funds, all of which have been top performers in their respective categories, including the RS Partners, Global Natural Resources, and Value (formerly known as Contrarian) funds.

In describing his strategy, Pilara says he's a low-expectation investor who focuses on bottom-up analysis and cash flows. He follows small- and mid-cap stocks and has found some of his biggest winners over the years in some rather unusual places.

Kazanjian: Is it true that a friend took you to an investment course when you were in junior high school?

Pilara: It is. When I was 12 or 13, the mother of the catcher of my baseball team brought me to an investment class taught by Claude Rosenberg, who was the head of research at the time for J. Barth and Company. I really en­joyed it. In the summer, I would go down and walk along Montgomery Street in San Francisco, sit inside the brokerage houses, and learn as much as I could about this fascinating thing called the stock market. I made an investment a year or two later in a company called Yuba Consolidated. The stock went from $4 to $16 and I got hooked. My dad was a printer for 40­some years and I watched him sweat and toil with his hands. As I made four times my money in Yuba, I saw that you could make money investing without using your hands. During the class, I told Rosenberg I'd like to work for him someday. We kept in contact, and when I graduated from St. Mary's College, I called him and said I'd like to work for him, but had other things I needed to learn. Instead, I took a job with the Federal Re­serve Bank of San Francisco.

Kazanjian: What did you do there?

Pilara: I was a bank examiner. That job lasted about 13 months. I then went back to Rosenberg and said I'd like to work for him. He hired me to be a runner in the research department. It was a great experience. It was my first exposure to my most important lesson: the value of grassroots re­search. Getting out there and seeing companies, walking through the stores and factories, talking to customers, vendors, and competitors. After work­ing in the research department at J. Barth and Company, I became the first candidate for the firm's registered rep program in training to become a re­ tail salesman. I spent three years doing the things salespeople do. I then moved into an institutional sales position. J. Barth and Company special­ized in West Coast research. As institutional salespeople, we sold this re­search to investment management firms throughout the country. Among my accounts at the time were Capital Research (managers of the American Funds) and several hedge funds in New York. That job was really my MBA. I probably spent more time asking these managers questions than I did ser­vicing the accounts. It was especially insightful to be exposed to the Capi­tal Research process. One of my New York accounts was Steinhart, Fine and Berkowitz. Michael Steinhart was the guru of trading, and I learned a lot just watching him at work. I also learned a great deal about research from Jerry Fine.

At that time I knew I wanted to manage money. I started to get in­volved in trading and research at J. Barth and Company. I would try to go on research visits with our analysts. Salespeople don't do that any more. I also would sit on the trading desk.

Kazanjian: When did you make the move from selling to managing money?

Pilara: In 1974 I created a value investment management boutique called Pilara Associates. It was a one-man shop. Part of my education was picking up accounting books that I knew some of the Harvard MBAs used when they were in school. I educated myself in accounting and read some of the popular investment books of that era, including Phil Fisher's Common Stocks and Uncommon Profits. I would make notes about how Fisher ap­proached analyzing a company and work that into my own template. When I went out to visit a company, I had one sheet for all my production questions, one sheet for all my marketing questions, and one for all my fi­nancial questions. It helped me to organize and pattern myself after a very successful investor.

Kazanjian: When you started your own shop, why did you decide to focus on the value style and study value managers? Was it deliberate?

Pilara: I kind of grew up in the business in the era of companies like Am­pex and Memorex. When times were good, you made a lot of money. When times were bad, you lost a lot. That didn't fit my personality well. I'm a poor loser. I found the pain of losing far outweighed the pleasure of the gain, and became a value investor very quickly after some losing expe­riences. I really became a value investor two or three years before starting my own operation. I was a security analyst in the mold of Ben Graham, doing deep book-value work. It worked well, and 1974 was a great time to be a value investor and small-cap stock picker.

Kazanjian: So you originally were led to the value style because of your desire to lower the risk of investing in stocks?

Pilara: Yes. Emotionally I was trying to remove that pain of loss. As I say to my analysts, tell me about your serious money ideas. Tell me where we can invest big money. Don't tell me the latest fancy stocks. That's not what we're about. I really invested in plain-vanilla companies.

Kazanjian: Have you always been value-oriented in life as well, like many of the other value managers I've interviewed over the years, including several of those in this book?

Pilara: I'd say so. I grew up in an Italian-Catholic household that was both economically and religiously conservative. Marrying that background with my growth stock investing experiences made the transition to value easy.

I also made a transition in my "value process" from deep value to a focus on returns. At a point, I looked at my portfolios and while they were doing well, I asked myself if there was a common denominator to my losers. The stocks were cheap for a reason: They were poor businesses. I then started to investigate how I could improve my process. I still spend a lot of time on process. I went to Northwestern University, which in those days had something called Merger Week at the business school. It focused on cash flow return and how to create shareholder value. This really turned my head. I realized I could look at and evaluate businesses with this tool, using a discounted cash flow methodology. I moved from a process driven by PE and book value to a cash flow return methodology designed to im­prove results by avoiding poor businesses.

Kazanjian: What made you leave your own firm to join RS Investments?

Pilara: I met Paul Stephens in the early 1970s. He was one of the princi­pals at Robertson Stephens, an investment banking firm that also had a money management arm. He was building a very successful money man­agement business and I really liked the people at the firm. I talked to Paul in 1993 about joining the firm, and ultimately did in September 1993.

Kazanjian: You must have been a bit like a fish out of water, because Robertson Stephens was very much a growth shop at that time.

Pilara: Yes, and it still is. What interested me is Paul ran what was called the Contrarian Fund. Paul has always been a growth stock investor, but he has valuation disciplines and I felt comfortable bringing him my ideas. In 1995, I started the Partners Fund, which is our small-cap value product. A year later I launched the Natural Resources Fund. And in 1999 I became portfolio manager of the Contrarian Fund.

Kazanjian: Why did you start a natural resources fund?

Pilara: I've always been drawn to the natural resources area because I like putting my hands on a product. Unlike a technology company or retailer, once you have your mine in the ground, all you have to worry about is be­ing a low-cost producer. This area of the market lends itself to financial analysis. You can easily run discounted cash flow models with different commodity price assumptions. The natural resources sector has become a good diversifier to technology. Natural resources stocks are negatively co­variant to technology stocks and this makes them a good addition to one's portfolio. Plus, I think we're in a new area for commodities. Natural re­sources look like an even more attractive asset class today than when we started the fund.

Kazanjian: Why?

Pilara: I think if I were to ask a company one question, it would be how much capacity have you built in the last three years and how much do you plan to build in the next three years? Had investors asked that question in technology a few years ago, they would have saved themselves a lot of pain. There's been very little capacity added in most major commodities in the last three years. Commodity prices are primarily driven by supply, not by demand. We have major structural events going on, in which the two largest populations in the world-China and India-are moving toward a more middle-class society. When you move toward middle class, your con­sumption of basic materials increases dramatically. Commodities are the basic building blocks of a middle-class economy. I've not seen resource companies generating as much free cash flow as they are today. When I vis­ited all the paper companies in Canada four or five years ago, I started hearing talk about return on investment rather than the next big paper machine they were going to build. All of a sudden the energy companies are starting to talk about return on investment and so are the mining com­panies. The mindset and fundamentals of the resource business have changed. These companies are now terrific cash flow generators. Some of them realize they can get good stock performance if they can get their rates of return above their cost of capital.

Kazanjian: The natural resources group has done well in recent years. Is the sector still fertile ground for value investors?

Pilara: Yes, assuming you pick and choose your spots. We think that the re­sources sector has favorable supply/demand fundamentals for the next three to five years. China will certainly be a major factor on the demand side. Keep in mind that commodity stocks will always be more cyclical than the general stock market.

Kazanjian: Because of your affinity for this sector, do you keep large weightings in natural resources in all of the funds you manage?

Pilara: No, we are generalists. We do not have an affinity for any particular sector. We don't make big sector bets in the Partners and Contrarian funds. We try to have a diversified portfolio where we can get appropriate nega­tive covariance. That negative covariance is sometimes presented by the natural resources investments. But it's strictly a bottom-up process with an affinity for good business models available at a cheap price.

Kazanjian: You look for stocks with market capitalizations from $100 million to around $16 billion. That's a pretty wide universe to choose from. How do you find your investment ideas?

Pilara: We try to work with a focused list of 150 to 200 companies. This includes the 50 to 70 stocks in our typical portfolio. Our ideas come from various sources. Grassroots research generates ideas. We like to turn over as many rocks as possible. These company meetings also generate candidates for our portfolio.

Over the last 30 years I've had contact with a number of good compa­nies and executives that I want us to always follow. I call this our farm team. It wasn't created from a screen, but from my experiences observing these executives allocate capital.

In addition, because the market today is so short-term oriented, when companies miss earnings in one quarter it creates opportunities for us. I look for companies with good business models experiencing short-term problems. We take a three-year view, so we think of ourselves more as busi­ness analysts than stock market analysts. Nobody analyzing a business would get too concerned about one bum quarter.

Kazanjian: What's more of the company-specific analysis you do when deciding whether to buy a stock?

Pilara: Above all, what we're doing is trying to assess the business model. It's all about unit economics and returns on capital. If we're looking at a retail concept, we'll go look at the store model. How much capital does it take to open one store? If the company is leasing this store, we will capitalize the lease. Then we'll look at the store model in terms of cash flow returns. If it looks like a company has an ability to earn above the cost of capital, we'll do additional due diligence. This includes looking at 10-Q's and 10-K's.We also look at the annual meeting proxy letter. This tells you how management is compensated. We always pay attention to the difference in pay between the CEO and the executive vice president or the CFO, whoever is next in line. If the CEO is making $1,000,000 and the executive VP is making $250,000 a year, you're wasting your time talking to anybody but the CEO.

We read annual reports backwards. The first thing that's usually inside the back cover is the board of directors. All of this has become much more important in our post-Enron world. We want to read the footnotes. It's sort of like being a detective. The best compliment I received was when a CEO said to me, "I feel like I'm talking to Detective Columbo." Columbo asked the apparently inane questions, but at the end of the day he solved the murder. That's what we're trying to do: ask simple questions that will lead us to an understanding of the business.

The first financial statement you come to by reading the annual report backwards is the flow of funds statement. I want to marry that with the balance sheet. Residually we look at the profit and loss (P and L) state­ment, because earnings result from capital deployment. That's why it's fool­ish to concentrate on quarterly earnings. The quarterly outcome has been decided a year or two before by the capital deployed to drive those earn­ings. When we visit with a company, we spend most of the time on our first visit discussing capital deployment.

One of the other ways we'll make a judgment about whether we want to continue with the analysis is by looking at the company's enter­prise value and capital account. I define the capital account of a com­pany as the total assets less non-interest-bearing current liabilities minus cash. We also look at it on a gross basis. By that I mean we add back the accumulated depreciation on the property account. What I'm really trying to do is see what we are paying versus the company's imbedded capital. The other things we'll take a look at are EBITDA (earnings be­fore interest, taxes, depreciation, and amortization) and estimated free cash flow.

Kazanjian: It sounds like a fairly complicated process, especially for those without an accounting background.

Pilara: It's really not. It's not high math. What's noticeable is there's not a focus on the income statement. If I look at one thing on the P and L it is gross margins. We want to know whether this is a commodity business, or one in which the company has a proprietary advantage. If somebody tells me he's got a proprietary product and I see gross margins of 17 percent, he's fooling himself. As far as we're concerned, a proprietary product has growth margins north of 30 percent. But the key point for us is cash flow returns.

Kazanjian: You do all of this research before talking to management. Is having a discussion with company executives required before you'll buy the stock?

Pilara: Yes, and we can't do a management visit without doing our home­work first because we want to be prepared.

Kazanjian: Perhaps it would help if you gave us an example of a company you bought and the analysis that led you to this decision.

Pilara: Several years back we bought a company called Fresh Del Monte. It's a fresh produce company that sells Del Monte bananas and pineapples. I first met the company when it went public. Management came into our offices. I liked the fundamentals of the business, and I admired the way they managed their capital allocation process. This was all confirmed when I went down to see the company shortly after the IPO. I sat down with the chief operating officer and asked him about the capital allocation process. He had a stack of papers on his desk and pulled out a paper with numbers on the acquisition of a motorcycle. He had the capital they spent and the rationale for spending it. I was impressed. Also, this was a company with new management and I saw there would soon be a material improvement in the balance sheet. They were using free cash flow to payoff debt. The returns on capital were above the costs of capital and it met our criteria at that time on our cash flow model.

Kazanjian: What happened to the stock?

Pilara: Subsequent to the IPO it eventually went down to $4 a share.

Kazanjian: Did you buy in at the IPO?

Pilara: We made an investment on the IPO. The stock price declined after the company went public.

Kazanjian: Were you buying more as the stock went down?

Pilara: We purchased more as the stock declined and substantially in­creased our position when shares were trading below $6. It was obvious that banana pricing was deteriorating, but while this part of the business had the largest revenues, it made the smallest contribution to cash flows. All the while, the higher gross margin pineapple business continued to im­prove. At $4 a share the company had a market cap of $200 million and an enterprise value of approximately $500 million, with cash flows in the $150-$200 million range. At that level, I figured I was buying a good brand name for cash flow multiple under 3. Within the next three years, the company's earnings per share were almost as much as the lowest price I bought the stock at. It went from $400 million in debt to zero in two and a half years. The stock went from $4 to $28.

Kazanjian: When did you sell out?

Pilara: I sold the stock in the $20s. Our target price was reduced after fun­damentals in the pineapple business changed and it became a more com­petitive business.

Kazanjian: Do you have specific rules for when you sell a stock?

Pilara: We have a couple of sell disciplines. If a stock reaches our war­ranted value and there's been no change in the fundamentals, we sell. If the returns of the business start to deteriorate, we make a call to management. We mayor may not sell, but it raises a red flag. If returns are deteriorating and we become uncomfortable, as at Fresh Del Monte, we sell. If the com­pany makes a large capital acquisition, we discuss it with management. If we don't believe it's creating value, we will sell.

Kazanjian: Fresh Del Monte turned out okay for you, but my guess is the average investor wouldn't have held on as the stock went from $16 to $4. They probably would have sold out sooner, to keep a cap on losses. Weren't you tempted to get out?

Pilara: This was an unusual example. I would say that 90 percent of the time if a stock goes down 15 percent and the fundamentals haven't changed, we'll add to our position. I think the reason for our good perfor­mance is not because we've had a lot of home runs, but rather because we haven't had a lot of big losers in the portfolio.

Kazanjian: Does that mean that if the price drops 15 percent and something has changed for the worse you'll get out?

Pilara: If the fundamentals have changed, we get out. Part of our philoso­phy here is that we're low-expectation investors. I tell my guys, "If you fall out of a window, fall out the basement window. Don't fall out the top-­floor window." Most times we go into stocks with low expectations. We're all about losing less, not making more. For the most part, when one of our companies misses its earnings, nobody cares because it's not a high-­expectation stock.

Kazanjian: 'True, although you mentioned that most of the names you buy are hav­ing some short-term problems. I suppose there~ an investment risk that these prob­lems will get even worse

.

Pilara: No. Most of our companies do not have short-term problems. Oc­casionally we look at companies going through some short-term problem, but we're trying to buy after the short-term problem has been worked out. We're not playing turnarounds. We still want a company with a good busi­ness model.

Kazanjian: One of your huge home runs over the last few years was China Yuchai. What led you to that unusual company?

Pilara: When I took over the Contrarian Fund in 1999, China Yuchai was in the portfolio. This was the second largest diesel motor company in China. Unit volumes were increasing at a dramatic rate. The fundamentals looked very good, and the stock was under $2. Within 18 months, the company would almost earn our inherited cost basis.Yuchai was a "10-bagger." Home runs like that don't come along that often. I certainly don't expect them. I'm just trying to hit singles and doubles without striking out along the way.

Kazanjian: Do you pay any attention to PE ratios at all?

Pilara: Sure, we look at the PE, but we don't think it's robust enough to give us the information we need as a primary assessment of whether this is a business we want to own. The reason is that when you look at the price-­to-earnings, you don't solve for how much capital it took to generate the earnings, which is really important. Nor will it tell us about free cash flow.

Kazanjian: Given that, let’s say you're looking at a company selling at what you deem to be 50 percent below what it’s worth, yet it has a PE of 30 or 40. Would you still buy the stock?

Pilara: That really doesn't happen very often. But there are instances where a company is currently losing money, there is no PE, and it is selling below its business value.

Kazanjian: How diversified do you keep your portfolios, in terms of the number of holdings?

Pilara: In the small- cap portfolio, we own around 60 names, and approximately 50 names in the mid- cap portfolio. Our core position is 2 to 4 percent at cost.

Kazanjian: When looking at the mistakes you've made over the years when it comes to picking stocks, do the losers tend to have any common themes?

Pilara: The common theme is that we made a mistake in evaluating the business model and its sustainability. Sometimes you make people mistakes, but more often it's not properly assessing the business model.

Kazanjian: Carrying that further, what would you say is the biggest mistake indi­vidual investors make?

Pilara: Not understanding the business and unreal return expectations.

Kazanjian: What are some realistic expectations over the next 5 to 10 years, in your opinion?

Pilara: Less than a 10 percent annualized total return from the market. I say that because when you look back at market history, a significant part of total returns have come from the dividend yield. Dividend yields today are only 1.7 percent. If you look at the last 20 years, you had a period of de­clining interest rates and declining inflation. It's been the best of times for stocks. I do not expect interest rates and inflation to exert such a positive influence on equities in the next few years. I believe we're in a low return environment for most asset classes.

While Pilara still loves sports, and emphasizes that just about everyone else on his investment team does as well, golf is about the only game he ac­tively plays these days. In his spare time, Pilara collects photography, espe­cially post-World War I social documentary photographs, but maintains his real passion in life is the investment business. "I'm one of those guys who says, 'Thank God it's Monday,' " he adds.”

Invest wisely in the subprime chaos

While the world equity market was reeling under the subprime chaos, there was a small news item, which probably slipped attention of many. Investment guru Warren Buffett was quoted as saying “worsening credit and housing markets may provide some real investment opportunities.” Generally speaking, when there's a certain amount of chaos in certain sections, it is unpredictable where the fallout will be, but the fallout offers some real opportunity. It may surprise many but investing in the end seems all about conviction and lateral thinking.

Mr Buffett with his successful investment track record has created a cult of investment followers. In fact, some days back S&P's came with finding that Infosys , Wipro and Satyam would have fulfiled his investment criteria. His investing picking style is unique, in that he uses a blend of value and growth investment philosophies. He once said “ I am half Benjamin Graham and half Philip Fischer” . While the former is a thorough value based stock picker, the latter has dabbled with growth strategies . Worldwide equity investors seem to be divided into these two distinct styles of stock picking - Value and Growth. Both are quite popular stockpicking strategies so let's first understand who's who.

Value Investing - 'Offer till stocks last'

Don't we rush to pick things on sale thinking that its real worth is more than the offer price. This is what value investing simplistically put means. Investors that follow this style specifically target companies with strong fundamentals in terms of earnings, dividends, cash flow, etc but are trading below their actual worth (technically it's called intrinsic value). Investors believe that a value stock is created due to over reaction to particular news affecting the industry only in the short term. Benjamin Graham pioneered this method of investment. His investing style was invented from his bad experience in the 1929 stock market crash in US and therefore one could see that his investment principles are more defensive in nature.

He insists on 'margin of safety' , which is nothing but the discount to the intrinsic value that the stock price is currently quoting at. Wider the discount , more is the margin of safety. The parameters he uses to pick stocks are low price-to-earnings ratio, price-to-book ratio or price-to-sales ratio. Some of these stocks may no longer be the flavour of current investors but again, the fundamentals make a strong case that the stock will bounce back and 'show its true colour' . Value stocks are not sector-specific as an attractive bargain can almost be found anywhere, but the probability of locating them today is more in energy, financial service or healthcare sectors.

A word of caution here - a value stock available at a bargain does not mean that any stock that has taken a plunge will qualify as a candidate in this category. A company that has hit 12-month low may not necessarily be a value stock. A stock's sudden fall may be the market's reaction to some fundamental problem of the company and thus refuting the basic criteria for categorising a stock as a value stock.

Before qualifying a stock as value pick one must ensure that the debt of company does not exceed its equity and it has shown a healthy earnings growth over the past few years. One might also get into 'value trap' in which the low stock price never recovers in one's holding period and hence may not get expected returns.

Growth Investing - 'Mining Diamonds'

Unlike a value investor, a growth investor is concerned with the future potential of a company, and less interested in its current trading price - quite like mining diamonds knowing that it will give good returns once it is 'cut and polished' . Growth investing is based on figuring out companies that have the competitive edge to become the next Reliance, Infosys, ITC or Hero Honda. A typical growth company has expanding business model and reinvests its profit for extending operations.

They are represented by high price-to-earnings ratio and price-to-book ratio. As a thumb rule, they generally show considerably high return on net worth/ equity (RONW or ROE). This indicates that its shareholders are current enjoying its growth story in the form of higher ROE. A company that has shown robust growth in profits and is expected to do even better in future is a good candidate for classification as growth stock. Investors are ready to pay a premium for such stocks factoring in the future growth potential which leads to its high P/E ratio. They believe that increasing top line and bottom lines will automatically translate into higher stock price and hence will take care of the return. At current juncture, companies in the infrastructure and IT sector would be good examples of growth stocks.
The risk involved here is actual growth falling short of expectations, for which you have already paid a premium. This may be due to poor revenues and earnings and may lead to a slump in the stock price.

To pick or to mix

Now this is an on going debate. It is difficult to predict which strategy will outperform the other. If there are cases showing that value investors have outperformed growth over a period of time, the support on the growth investor side may be no less.

In fact, both these stock-picking strategies compliment each other well. So, instead of sticking to one strategy , an investor may strive for decent returns with low risk by combining growth and value investing - quite like diversifying one's portfolio across sectors to minimise risk and add up returns.

Common parameters used by fund managers:

P/E below 16 or P/B value below 1

Debt to equity ratio below 1

Dividend yield of 5% or more

Companies showing consistent growth in sales and profits

High return on equity (16% plus)

Firms with higher earnings margin