Investment - Key Metric

Posting an email response that I sent out recently(italicised phrase are for clarification) for a question on my previous post on TDYT:-
As an investor, I am interested in what I term "Real RONW". I define it as the Return on Net Worth (RONW) I get by investing at the current price. Let's say you have a business earning 30% RONW currently and it trades at 3 times book value, as an investor my real RONW will be 10% (30%/3). This is an indirect way of coming up with an accounting goodwill calculation. Usually I compare the real RONW to the expected yield on stocks/bonds to decide whether to do further research on the business. Let's say I am buying a significant stake in this business, the way I would pay (assume market price USD 30 per share), USD 20 as goodwill and USD 10 would be the net equity in the books on consolidation. At the end of a year, the business (assuming the business earned at the same rate) earns the same return, I would increase the net equity by USD 3 (30% of USD 10 Net Worth or 10% of USD 30, the price). As a result, even though the business earned 30% on its networth, I earn only 10% because I paid 3 times the book value.
For TDYT, I didn't have to go into this whole exercise. It was a screaming buy, just because of the P/E and the fact that management reported in 10k that their true value was somewhere close to USD 2.50. The more than 40% calculation was just the inverse of P/E (P/E was a little over 2, if I remember correctly). I also realised that the business was facing strong headwinds because of its presence in the housing market. This was one of the reasons I was looking at it as a short-term trade than a long-term buy.

Indian Markets

Mr.Market after 70 plus years of being called manic-depressive still continues to be so. What a drastic change in one week? Everything is so great one fine day. Suddenly, there is a sign put up that says discount sale - top tier IT companies going for 16 times earnings, FMCG even better, already discounted pharma - even cheaper. Earlier, in December, I had recommended a put option to a friend who was willing and able to take the risk. He was worried about the possibility that he would have to roll it over to the next month at a not so cheap time premium (interest, for the uninitiated). He was ecstatic that he sold his put at 75% profit one day and the next week, worried that he sold too early because the put was trading at what would have been a 300% profit.
I am in the Indian market for long-term. This might seem a contradiction to my sell statement from few weeks ago. Different times call for different strategies. When I see businesses selling for 30 times earnings, no matter how good it may be - it is underpricing of risk. If anything is certain, it is that this is an uncertain world. The overpricing of cash flows is a sign to me that it is time to sell. Why? Protection of Capital is my first priority. I would rather sell now and wait for another year or so to re-invest than count ephemeral book profit. Going by the larger trends prevailing, I would most probably not have to wait a full year before opportunities spring up.

The year that was 2007

As 2007 came to a close, the annualized return so far remains at 36.6% (35.7% - 2006), whereas Nifty is trying to play catch-up reaching 28.2% (2006 - 24.1%) and Sensex at 29.2% (2006- 26.3%).My return inclusive of dividends is 40.2% (2006 - 36.6%). I don't have a definite percentage target in my mind. As long as I am able to double the investment every 5 years, I should be satisfied.

In the first week of January, I have sold off majority of my holdings – most of which were trading at high PEs. It has been a good performance so far. However, it doesn’t guarantee future performance. There are companies trading at 30 times TTM earnings. At that multiple, comparing to an investment of 8% Fixed Deposit (taxable at 25%), it would take 9 years for the cumulative earnings yield of the stock to catch-up with the compound interest of the fixed deposit. So if you see the multiple re-rating downwards soon to 20, you need only wait 3 years, and 15 (anything less than 16.67, for that matter) would give instant excess returns.

Arguably, you could buy at 30 PE and sell soon at 31 PE. However, it is a game of musical chairs with liquidity replacing the handbell/music. I had a strong dislike for that game even as a kid. I haven’t found a compelling reason to like it in the last quarter century, either. Interestingly, Chuck Prince of Citi made a now infamous statement of 2007 that they are paid to dance, before booking the losses.

It doesn’t mean that my view on Indian economy has changed. I believe it will be more like the Nifty go-go era in the US Market for the high priced stocks. The economy is very strong and should continue to be strong. There are sectoral opportunities due to over-pricing of risk, on the other extreme. I will post the specifics as and when they play out with my positions, in accordance with my policy of no tips.

Indian Markets Developing

Two new proposals this month.

• Permission for Short Selling with Securities Lending and Borrowing


• New F&O Products.

In the Indian markets, it was difficult to take a short position so far. Some time ago, ICICI Bank came out with an FPO where they virtually guaranteed allotment of shares to retail investors for Rs.900 when the shares were trading around Rs.930 in the market. I was evaluating whether I could apply for the maximum shares under retail segment and then short the equivalent in secondary market and capture the Rs.30 per share almost risk-free. That is when I found out that short positions could not be carried for more than one day. It would be interesting to see if the market progress at a more normal levels than what it is doing now after the proposal goes into effect.

The new F&O products bring LEAP type longer term options, volatility index similar to VIX, exchange traded products for strategies, exchange traded currency F&O, Bond index F&O etc.

Cost of Capital

IFRS 3 requires allocation of goodwill among intangible assets. Click here for details on the IFRS . All is well when you read the IFRS. In practice, it means having to reconcile between WARA (Weighted Average Return on Assets) and WACC (Weighted Average Cost of Capital). What is the WACC?

One additional thought though, thinking in parallels of Ricardo's theory of comparative advantage, does it mean that assets will move from the hands of the investors with a high cost of capital to the ones with a low cost of capital? Comments invited.

I am reminded of the Charlie Munger discussion (source: http://articles.wallstraits.net/articles/1361) which I am copying here:-

"Charlie Munger often quotes the late Nobel laureate physicist Richard Feynman, who said the first rule is to not fool yourself, and you are the easiest person to fool. Munger can be merciless if he believes he has caught someone in the act of silly self-deception.

Pitty the poor professor who gets caught up in a debate with Munger on the academic treatment of investment policy. Such was the case at The Benjamin Cardozo School of Law in New York City in 1996 when, due to the death of a close friend, the scheduled moderator was unable to attend. Charlie Munger was asked to step in.

Charlie told the audience: "The accidents of mortality have given you a Baptist bumpkin suddenly put in charge of a bunch of Catholic archbishops who are going to debate revisions of the Catholic mass, in Latin. But I figure I could moderate such a convention."

It was the panel's assignment to discuss the research of Professor William Bratton of the Rutgers-Newark School of Law, which dealth with the corporate decision to pay dividends to shareholders rather than reinvest profits. Munger soon nailed Bratton with what he considered a flawed assumption in the research.

Munger: I take it that you believe that there is no one-size-fits-all dividend policy and that you're with the professor (Jill E. Fisch of Fordham University School of Law) who said yesterday that there wasn't any one-size-fits-all scheme for corporate governance?

Bratton: On that simple proposition I am entirely in concord with Professor Fisch.

Munger: But you say there is some vaguely established view in economics as to what is an optimal dividend policy or an optimal investment?

Bratton: I think we all know what an optimal investment is.

Munger: No, I do not. At least not as these people use the term.

Bratton: I don't know it when I see it... but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett. (Laughter from the audience)

Munger: What is the break point where a business becomes suboptimal in an ordinary corporation or when an investment becomes suboptimal?

Bratton: When the return on the investment is lower than the cost of capital.

Munger: And what is the cost of capital?

Bratton: Well, that's a nice one (Laughter) and I would...

Munger: Well, it's only fair, if you're going to use the cost of capital, to say what it is.

Bratton: I would be interested in knowing, we're talking theoretically.

Munger: No, I want to know what the cost of capital is in the model.

Bratton: In the model? It will just be stated.

Munger: Where? Out of the forehead of Job or something?

Bratton: That is correct. (Laughter)

Munger: Well, some of us don't find this too satisfactory. (Laughter)

Bratton: I said, you'd be a fool to use it as a template for real world investment decision making. (Laughter) They're only trying to use a particular perspective on human behavior to try to explain things.

Munger: But if you explain things in terms of unexplainable subconcepts, what kind of an explanation is that? (Laughter)

Bratton: It's a social science explanation. You take for what it's worth.

Munger: Do you consider it understandable for some people to regard this as gibberish? (Laughter)

Bratton: Perfectly understandable, although I do my best to teach it. (Laughter)

Munger: Why? Why do you do this? (Laughter)

Bratton: It's in my job description. (Laughter)

Munger: Because other people are teaching it, is what you're telling me. (Laughter)

The audience laughter points are essential in this exchange, lest it sound like a food fight at a junior high school cafeteria. The bantering was done in a good-natured tone, but the point of the exchange was quite serious. Later, to make sure his comments were not misunderstood, Munger made amends:

I don't want my remark about the cost of capital to be interpreted as meaning that I think the great bulk of Professor Bratton's paper is wrong. I think it's profoundly right. When he talks about agency costs in corporations and the discipline caused by levels of debt and the discipline caused by dividend conventions, I think he is profoundly right. And to the extent that those are the conventional academic explanations, I think it's wisdom he's giving. It's just the cost of capital thing that always makes me go into orbit. (Laughter)

Although he did not say so then, Munger has his own idea of how the cost of capital should be measured. Buffett has explained that at Berkshire, the cost of capital is measured by the company's ability to create more than $1 of value for every $1 of earnings retained. "If we're keeping $1 bills that would be worth more in your hands than in ours, then we've failed to exceed our cost of capital," Buffett said.

Sage@wallstraits.com

Credits: Much of this article is extracted from Damn Right by Janet Lowe, 2000.
Posted on 20 Feb 2006."

Gujarat Industries Power Company

Here were the key stats when I came across this company:-

RONW - 16%
P/BV - 0.92
which meant that I would get more than 17% if I just hold on to the shares. I wasn't expecting to write so soon about this particular company.

The reason for the discount was obvious. GIPCL was going for an expansion of their capacities and was taking on new debt. The new project is expected to go online by 2008-09. It would almost double their capacity. The expansion is for their lignite based power plant and GIPCL has captive lignite mines which implies that the cost of extraction will remain pretty much unchanged over the next years.
As per the projections by the government, power supply is going to remain behind peak demand for the coming years.
Considering this scenario, it is a great investment, though I have concerns about the pricing power of the company.

The share price almost doubled in the last few months. I booked the profits over the course of last few weeks. GIPCL will still be on my watch list for any future buying opportunities.

Shivering with Greed

I had a busy August. I started looking in India after a while for fresh investments with the pre-conceived notion that opportunities would be hard to find in a market that has gone up 40% and upwards in the last 5 years. Surprise, Surprise!!!!
Here's what I am looking at:-
Company A trades at 0.92 times book value, earns c.16% RONW in a industry facing lot of regulatory tailwind.
Company B trades at c.8 times earnings from multiple industries and impeccable management.
Company C trades at 2.5 times earnings and pending a few value unlocking trigger events in the coming two years.
I hope to find similar "disappointments" in the future and hope to write about these three companies in the near future.

Against the Gods: The Remarkable Story of Risk

Peter Bernstein examines the historic evolution of the concept of risk in about 268 pages of this 337 dedicated to the writing. He takes the reader through a journey from the Greeks through the days of Luca Paccioli, Pascal, Bernoulli, Leibiniz, Bayes, Gauss, Galton, Keynes, Kenneth Arrow, Frank Knight, John von Neumann to Markowitz, Kahneman, Tversky, Sharpe, Merton, and Scholes.

I plan to re-read the book at least a couple of times and search for the books listed in its bibliography.

Some of my favorite quotes:-

"The idea of risk management emerges only when people believe that they are to some degree free agents." - This simple statement to some extent answered my question as to why despite all the writings in other subjects ranging from weaponry to logic, didn't ancient Indians (East Asian Indians) talk about risk. I guess it meant going against the wills of the Gods for them.

Quoting Pascal's idea from Port-Royal Logic "Fear of harm ought to be proportional not merely to the gravity of the harm, but also to the probability of the event."

"...Only the pathologically risk-averse make choices based on the consequences without regard to the probability involved.....only the foolhardy make choices based on the probability of an outcome without regard to its consequences."

"..people with a phobia about being struck by lightning place such a heavy weight on the consequences of that outcome that they tremble even though they know that the odds on being hit are tiny."

"..this does not mean that numbers are useless in real life. The trick is to develop a sense of when they are relevant and when they are not."

"...coined the term "Quetelismus" to describe the growing popularity of discovering normal distribution in places where they did not exist or that failed to meet the conditions that identify genuine normal distributions."

"..it is easier to assume that the future will resemble the present than to admit that it may bring some unknown change."

On regression to mean "..never depend upon it to come into play without constantly questioning the relevance of the assumptions that support the procedure." This statement has a new meaning to me after reading "When Genius Failed" recently.

"The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us"

Quoting Poincare' "..what is chance for the ignorant is not chance for the scientist. Chance is only the measure of our ignorance"

"The information you have is not the information you want.
The information you want is not the information you need.
The information you need is not the information you can obtain.
The information you can obtain costs more than you want to pay."

Quoting Arrow "The possession of actual money lulls our disquietude; and the premium we require to make us part with money is the measure of our disquietude"

Quoting Knight "Uncertainity must be taken in a sense radically distinct from the familiar notion of Risk,......a measurable uncertainity or "risk" proper...is so far different from an unmeasurable one that is not in effect an uncertainity at all."