Happy New Year - Some thoughts on personal investments

I was wondering what I have learnt in the past year… that I can share with you as a New Year’s gift… I came up with this… hope it helps…

I attended a conference where Marc Faber, an investment guru, was the lead speaker… The room was packed with atleast 1000 people… all shrewd fund managers and smart analysts… He asked us to raise our hands if we had more than 10% of our investable corpus invested in Gold… I was shocked to see that the number of people who raised their hands was Zero… Every one has been following Marc Faber for donkeys years and he has been advising Gold for as many years… But none did what he said… When he enquired as to how many of us were 5-10% invested in gold… six hands went up… thats 0.6% of the most astute investor community… the torch bearers of the investor community… This made me realize that the opinion about Indian investors investing in gold excessively is hyped up… The reality is the new age knowledgeable investor is under invested in Gold… So, the first tip for the year is to invest atleast 10% of corpus in Gold… The yellow metal is still glittering!... the macro scenario across the globe indicates that it is going to glitter for decades… Analyze any asset class against gold over the past decade and they have all under performed this precious metal...

At the cost of being a spoil sport of your zest, I am writing the next para… A few days back, a cousin of my close friend passed away in a freak accident at age 22… He was the sole earning member for the family of three – mother who is a house wife, father who is retired from a private job & has not saved for post retirement life and sister of marriageable age… How do you think the family will survive? I have no idea… I guess neither do you… My next request is that all of us should have a Term Policy… Thanks to online term policies like ICICI iProtect and Aegon Religare iTerm, you should stop wondering that you are getting nothing out of your ‘investment’… You get a piece of mind with yearly expense of Rs 11,000 for a 30 year old for sum assured of Rs 1 Crore taken for 30 years… It translates to about Rs 900 – lesser than the tab you pick for a two person dinner… Ten years down the lane, you pay the same premium for the same cover but will you pay the same amount of the same dinner??? I doubt… it will be four times the current bill…

Talking about prices… Inflation is here to stay… I remember paying a labourer 30 rupees for an honest day’s work during my IIT days in 2000… I was embarrassed when he touched my feet to thank… Today, I am willing to pay 600 rupees and I can get no one to do some low skill carpentry work at my house… high prices are a reality… the way to play hedge against inflation in by investing in Equities… counter intuitive but true… or real estate if you can afford it… You may know that I have been a proponent of IDFC Premier and HDFC Equity mutual funds for a long time and would continue to believe that they should do well going forward as well…

Finally, I will quote legendary Warren Buffet to invest in Self. "The most important investment you can make is in yourself. Very few people get anything like their potential horsepower translated into the actual horsepower of their output in life. Potential exceeds realization for many people. Just imagine you’re 16 and I was going to give you a car of your choice today, any car you wanted to pick. But there was one catch. It was the only car you were able to have for the rest of your life. You had to make it last. So how would you treat it?

Well, of course you’d read the owners’ manual about five times before you turn the key in the ignition. You would keep it garaged; any little rust would get taken care of immediately; you’d change the oil twice as often as you were supposed to – because you would know it had to last a lifetime.

Then I tell the students you get one body and one mind. And it’s going to have to last you a lifetime so you’d better treat it the same way. You’d better start doing it right now because it doesn’t do any good if you start working on it when you are 50 or 60 and the little speck of rust has turned into something big… The best asset is your own self. You can become to an enormous degree the person you want to be."

Wishing you a very happy and prosperous New Year 2011!

Are we in a slowdown or a double dip?

Are we in a slowdown or a double dip? This is the question the markets are dealing with. Being in an economy like India, it becomes especially difficult to answer this question. This is because of the dichotomy that exists between us and the rest of the world. While we are growing our GDP at 8-9% pace, the other economies are struggling to keep the numbers positive. If we as investors can answer whether US is going to slowdown or go into double dip recession, we have our strategy laid out. This is irrespective of India’s GDP growth as we are overly dependent on foreign capital for both equity market growth and corporate earnings growth.

I have an article by BCA titled “Gauging the risk of recession: slowdown or double-dip?”. I rate the research reports of BCA highly because of their depth of research due to availability of intellectual capital and resources. They believe that we are slowdown and not a double dip. The probability of double dip is zero.

Data point – Trend – Indicates warning of recession?
Avg. weekly initial claims for unemployment insurance – Falling - No
Unemployment Rate - Flattening - No
Credit Spreads - Falling - Nearing

Fed Funds Rate - Falling No
Inflation Expectations - Falling - No

Oil Prices - Rising No

Yield Curve - Rolling Over - No

Leading Economic Indicator - Rising - No
Money Supply, M2 - Falling ROC - No
Avg. weekly hours, manufacturing - Rising - No
Interest rate spread, 10-year treasury bonds less fed funds - Rolling Over - Yes
Manufacturers’ new orders, consumer goods and materials – Rising - No
Index of supplier deliveries - vendor performance - Flattening - No
Stock prices, 500 common stocks - Flattening - No
Index of consumer expectations - Rolling Over - No
Building permits, new private housing units - Rising - No
Manufacturers’ new orders, nondefense capital goods - Rising - No
Coincident Economic Indicator - Rising - No
Employees on nonagricultural payrolls - Picking Up - Yes
Personal income less transfer payments - Picking Up - No
Industrial production - Rising - No
Manufacturing and trade sales - Rising - No

Historical performance is the key!

Consider this: Out of the available 325 equity funds, there are only four funds that have beaten Nifty Index for the last six years continuously. These funds account for just 4% of industry equity assets – our money.

In the past five years, there are only five funds that have beaten the Nifty Index continuously. These funds manage only 7% of our equity corpus.

By reducing the time frame to three years, the numbers improve but far from desirable. In the last three years, there are 18 funds that have beaten the Nifty Index continuously. These funds manage 13% of our money allocated to equities.

This is where manager selection becomes important. One would rather be in that 4% or 7% figure and not figure among those who did not make money work for them.

While selecting funds from the existing basket is itself ominous task, but people still go for New Fund Offerings (NFOs). 15% of our money is with funds that have an history of less than 3 years. Analysis of the 17 funds launched in 2007, one would decipher that only eight funds have beaten Nifty Index in both 2008 & 2009. This is a hit rate of less than 50%. It is always better to wait for a fund to complete three years before deciding to jump on the band wagon.

Why gung-ho about Persistent Systems IPO?

Firstly, a strategic investor is different from a financial investor. If some has love for product development and cutting edge technologies and want to be invested in Persistent Systems (PS), it is ok. However, a financial investor is quite picky as to what he is getting into and at what price. This piece is for a financial investor.

The question is “Should one be gung-ho about Persistent Systems (PS)?” I am trying to rationalize such optimism.

“We are different”: How clichéd this has become? The company says: “No really! We are different from other listed players?” PS delivers IT services to R&D wings of product companies. At the end of the day, it provides services as do other IT players. More importantly, R&D is discretionary in nature. So, this is the company which would get affected more than diversified IT player.

Revenue per employee: If they are really in a niche space where only the crème de la crème is recruited, why is their revenue per employee low? Assuming they do Rs 580 crores topline with 4500 employees, their revenue for employee is 13 lakhs. Its low compared to its midcap peers like KPIT -15 lakhs, Mindtree -15 lakhs and Sasken – 19 lakhs. It is even lesser than a large cap company like Infosys – 21 lakhs (with an employee strength of 1.1 lakh). PS only fares better compared to Infotech Enterprises which generates 13.3 lakhs per employee. All figures are FY10E. What niche are we talking about?

“Revenue growth CAGR of 40% in 5 years”: I struggled to figure out which five years. It was from FY05 – FY09. What about the recent five years? From FY06-FY10E, PS’s revenue growth is 22% CAGR. A change in one year reduces the impressive figure by almost half. It does only better than Sasken which has a Revenue CAGR of 16%. All others have fared well. KPIT – 23%, Mindtree – 23% and Infotech Enterprises – 35%. Interesting to note that both PS and Infotech Enterprises did sales of Rs 216 cr FY05. While Infotech will clock Rs 960 cr this year, PS will languish at Rs 580 cr.

“Impressive EBITDA & PAT margins”: PS’s EBITDA margin would be at 23% while that of KPIT & Infotech Enterprises are about the same. Mindtree & Sasken are lower at 19%. PAT of PS stands at 19% which is better than KPIT & Infotech which is at 16% and Mindtree & Sasken which is at 12%. The margins are just passable and there’s more story in RoE.

RoE:
KPIT has RoE of 34% which is 7% more than that of Mindtree and 15% more than PS. PS’s RoE is 18.7% which is comparable to 17.8% of Infotech and better than 13.7% of Sasken. The large cap stocks have much better numbers. For instance, Infosys has RoE of 31%.

At upper band, PS is valued at 11.3x FY10E. KPIT and Mindtree which have better RoE are valued at 10.3x and 11.1x FY10E numbers. Infotech has RoE of 12.7x. On a relative valuation basis, PS could have an upside of 12% to catch up with Infotech Enterprises.

Fairly valued at EV/Sales:
On EV/Sales metric, PS is at 2.1x which is same has that of Infotech Enterprises. It is higher than KPIT - 1.4x and Mindtree – 1.8x

According to me the gameplan should be the following:
Due to the salability of the management and the investments bankers, the issue will get a good response for sure. In terms of growth, the diversified players have a better opportunity than PS. Though the grey market premium is to the tune of 40% above the upper band of Rs 310, I think it would list and trade above 20% to upper band at around Rs 370. Better would be to shift to Mindtree or Infotech Enterprises which have better metrics and opportunities among the IT midcap players.

Sip the Brazilian Samba…

When we speak about diversification to international funds, the question most people ask is “why should I when I am making money here in India”? Point noted. But could you not have made more money? For instance, Brazil Index gave a return of 136% in 2009 compared to 80% of Nifty. China also gave a return of 80%.

Consider this: What if there is an event that could shake the Indian markets more? I say “more” because any event that spooks India would shake the global markets. The event could be in the form of anything:
Our neighboring country pokes its nose in the form of a war
An issue causes dissent in ruling coalition and brings the government down
Some random calamity (God forbid!)
Government decides to borrow more which spikes interest rates

So, it’s a good idea to hedge our portfolio. I am not asking to hedge with a Japanese fund or a UK fund. Brazilian and Chinese ones could help. These countries are growing just like ours and have better Debt/GDP ratio and fiscal discipline. More than taking country bets, it is better to take stock bets if it compliments our portfolio. Why not an agri based company in Brazil? a semi conductor company in Taiwan? a bottling company in China? a green energy company in US? Of course, picking up a stock (globally) is a complicated process.

What is easy is choosing a country fund. I would like to high light the Latin America funds here. For a retail investor, ING Latin America fund can be a best bet as it feeds your investments into the Luxemburg based fund. As little as Rs 5000 can be invested in this fund.

If one were rich (super rich actually) and wants to choose the best Latin America funds, she could go for HSBC Brazil fund which is Brazil focused and Blackrock Latin America fund which covers the entire region of Latin America. These funds have a minimum limit of USD 5000 and will come under the USD 200k remittance limit.

The snapshot of the funds is given above.

Strategy for NMDC FPO

There are three mining companies in the world that come close to NMDC for comparisons. Thanks to a CLSA report, I could get the names and valuations of these companies. Add Sesa Goa to the list, we have four comparables.
To make things simple, let us only look at PE & EV/EBITDA multiples. The band of these four companies is so tight that the average of these would be the fair value for NMDC.

At CMP of 435: NMDC will be at 120% premium for both multiples
At 300, the price touted for the FPO: NMDC will be at 50% premium
At 275, the price touted for the FPO for retail: NMDC will be at 40% premium
At 200: NMDC will be at fair value

Looking at these valuation metrics, I would not go for it at Rs 300. Why would I pay 50% premium to the company when it has only 14% output of that of India. Moreover, its performance for FY10 is below average and the bet is for FY11 where we could see a substantial improvement in performance.

Even if I go for it, I would flip it immediately after listing. The retail investors should definitely make use of this opportunity as they would get substantial chunk stocks (due to $3bn issue size) at a 5% discount.

The listing would get done because of some of these factors. It is a Navratna company of India. Everyone, especially the foreign investors want to own it. It is supposed to have a superior ore compared to the others and at the lowest price in the world. It is cash flow positive company which is the most sought after in these markets.

Alternatively, investment in Sesa Goa could see a pop of about 10-15% testing the recent high of Rs. 460 as comparitive valuations with NMDC kicks in.

Even after listing, I would short NMDC and long Sesa Goa to play on relative valuations. I expect contraction of the premium going forward.

Happy Moment Personally

Three of the Five funds we are invested in have won the CRISIL-CNBC awards. The fourth fund – IDFC Premier won the 7 star award by ICRA. So, four of the five funds invested by us were recognized last week. Performance as of 10th Feb 10 is given above.

Can we reach the previous high made on 08th Jan 2008?

Sensex closed at 20,873 on 08th Jan 2008. During the time of my analysis on 22nd Jan 2010, Sensex is at 16700. It is down 20% over the last two years. To find the biggest beneficiaries of the period, it is better to look at market cap. Reason why? Because Sensex considers free float market cap of companies and there has been quite a bit of equity dilution for many Sensex companies.

No points for guessing who the winner is. Hero Honda (136%), M&M (56%) and Maruti (52%) from the Auto pack appear in top five. Inspite of its debt pain, Tata Motors has gained 32%. The big run up since H2 of 2009 brought IT among top gainers. Infosys (57%), TCS (54%) and Wipro (45%) made money for investors. Sun Pharma had been the darling with a return of 33% over the period under consideration. The Rahul Dravid of Sensex, HDFC Bank has gained 27% while its peers like SBI gained a mere 2% and ICICI Bank lost 37%.
(Refer to Figure 1)

HUL & ITC which are considered defensive bets were up only 6-7% each. RCom is the biggest loser. It is down 78%. Its peer Bharti Airtel is down 35%. Real estate major DLF is down 69%. Big brothers RIL & L&T are down 23% and 30% respectively.
(Refer to Figure 2)

During the period there has been quite a bit of equity dilution. Thanks to QIPs, conversion of FCCBs et al. Look at this stats:

The market cap of Hindalco is up 18% while the stock price is down 17%.
The market cap of Tata Motors is up 32% while the stock price is up 1%.
The market cap of HDFC Bank is up 27% while the stock price is down 3%.
The market cap of M&M is up 56% while the stock price is up 35%.
The market cap of Tata Steel is down 15% while the stock price is down 30%.
(Refer to Figure 3)

Can we reach the previous high?
The answer is in the questions:
Can Reliance Industries which has a weight of 13% go up 23% from here?
Can ICICI Bank which has a weight of 7% go up 37% from here?
Can L&T which has a weight of 6% go up 30% from here?
Can HDFC which has a weight of 5% go up 21% from here?
Can Infosys which has a weight of 10% sustain at these levels?
Can HDFC Bank which has a weight of 5% sustain at these levels?

With President still finding a solution to US's eternal problems, noises about Chinese asset bubble and our dependence of earnings on global economy the probability looks low! Well, these are markets and funny things happen!

Emergence of 'China' noise

The Chinese property sales jumped by 75.5% to $644bn in 2009. The prices in Dec'09 went up 7.8% officially. The private numbers suggest that this might have gone up by more than 20-30%. The country's cabinet has imposed has imposed a sales tax on homes sold before five years of their purchase. Banks are being asked not to lend more than 60% for second homes. Infact, some of the banks have stopped lending for rest of January.

Mr. Jim Chanos, the king of shorts and the person who got the calls on Enron & Sub Prime right has been holding a negative view on China for quite sometime. Though Mr. Jim Rogers says he doesn't know a thing about China, history is on Chanos's side. Chanos says that the numbers do not add up. The growth in car sales do not tie in with no increase in petrol consumption. He opines that the largest exporter of the world has grown its GDP by 9.6% when the world's trade collapsed in 2008.

It is not only Mr. Chanos who has been pointing out to China's doom but also Mr. Stephen Roach of Morgan Stanley. Mr. Roach points out that China is a supply driven economy more than demand led. The lacuna created by global downturn was lapped up by domestic consumption which is driven by government stimulus of about $900bn, 25% of its GDP.

Bill Gross is another famous personality that is sounding caution on China. Forbes carried a cover story about the Chinese Bubble. http://www.forbes.com/forbes/2009/1228/economy-ponzi-debt-peking-china-bubble.html

The solace is that China is sitting on $2.3 bn of cash. But if US does not fire its economic cylinders, China would have to put this pile to work. Well, leading to further inflation of assets probably.

Market Performance Vs GDP

I hear from people quite often that if India has to grow by 8-9% in terms of GDP, then the stock markets have to do well. This has to be taken with caution.

Let me draw you attention to China. In the years 2001 to 2005, China has lost 45% while the GDP grew by 7-10%. This is attributed to a reform called Guquanfenzhi which aimed at offloading government owned non tradable shares of government companies into the market. This lead to the fear that that the value of the tradable shares will be undermined by the release of non tradable shares. However, this reform was modified after the initial market collapse. There was a lock in of one year. In addition to it, a maximum conversion of 5% and 10% per year from second year was allowed. Inspite of these modifications, the Chinese markets continued to bleed. (The same reform was brought back in 2006 when the sentiments were high)

When our government talks about divesting 50 PSUs, it has to bear this in mind.

The Elements of Investing

One of the best articles I have read on investing

Burton G. Malkiel, Princeton economics professor and author of 'A Random Walk Down Wall Street,' and Charles D. Ellis, author of 'Winning the Loser's Game,' have teamed up to write 'The Elements of Investing.'

We're both in our seventies. So is Warren Buffett. The main difference between his spectacular results at Berkshire Hathaway and our good results is not the economy and not the market, but the man from Omaha. He is simply a better investor than just about any other in the world. Brilliant, consistently rational, and blessed with a superb mind for business, he has managed to avoid the mistakes that have crushed so many portfolios. Let's look at two examples.

In early 2000, Berkshire Hathaway's portfolio had underperformed funds that enjoyed spectacular returns by loading up on stocks of technology companies and Internet startups. Buffett avoided all tech stocks. He told his investors that he refused to invest in any company whose business he did not fully understand - and he didn't claim to understand the complicated, fast-changing technology business - or where he could not figure out how the business model would sustain a growing stream of earnings. Some said he was passé, a fuddy-duddy. Buffett had the last laugh when Internet-related stocks came crashing back to earth.

In 2005 and 2006, Buffett largely avoided the mortgage-backed securities and derivatives that found their way into many investment portfolios. Again, his view was that they were too complex and opaque. He called them "financial weapons of mass destruction." When they brought down many a financial institution (and ravaged our entire financial system), Berkshire Hathaway avoided the worst of the meltdown.

Avoiding mistakes - such as the mistake of incurring unnecessary risks - is one of the great secrets of investment success. Be alert to these common ones that can prevent you from realizing your goals.

Mistake #1: Overconfidence

At our two favorite universities, Yale and Princeton, psychologists are fond of giving students questionnaires asking how they compare with their classmates. For example, students are asked: "Are you a more skillful driver than your average classmate?" Invariably, the overwhelming majority answer that they are above-average drivers. Even when asked about their athletic ability, where one would think it more difficult to delude oneself, students generally say they're above average. They see themselves as above-average dancers, conservationists, friends, and so on.

And so it is with investing. In recent years, a group of behavioral psychologists and financial economists have created the important new field of behavioral finance. Their research shows that we are not always rational. We tend to be overconfident. If we do make a successful investment, we confuse luck with skill. It was easy in early 2000 to delude yourself that you were an investment genius when your Internet stock doubled and then doubled again.

To deal with the pernicious effects of overconfidence, think about amateur tennis. The player who steadily returns the ball, with no fancy shots, is usually the player who wins. And the prudent buy-and-hold investor who holds a diversified portfolio through thick and thin is the investor most likely to achieve his long-term goals

Mistake #2: Following the herd

People feel safety in numbers. Investors tend to get more and more optimistic, and unknowingly take greater and greater risks, during bull markets and periods of euphoria. That is why speculative bubbles feed on themselves.

But any investment that has become a widespread topic of conversation among friends or has been hyped by the media is very likely to be unsuccessful. Throughout history, some of the worst investment mistakes have been made by people who have been swept up in a speculative bubble. Whether with tulip bulbs in Holland during the 1630s, real estate in Japan during the 1980s, or Internet stocks in the United States during the late 1990s, following the herd - believing that "this time it's different" - has led people to make some of the worst investment mistakes.

Just as contagious euphoria leads investors to take greater and greater risks, the same self-destructive behavior leads many to sell at the market's bottom when pessimism is rampant.

More money went into equity mutual funds during the fourth quarter of 1999 and the first quarter of 2000 - the top of the market - than ever before. Most of that money went to high-tech and Internet investments, the ones that turned out to be the most overpriced and then declined the most during the subsequent bear market. And more money went out of the market during the third quarter of 2002 than ever before, as mutual funds were redeemed or liquidated - just at the market trough. Later, during the punishing bear market of 2007-09, new record withdrawals were made by investors who threw in the towel at record lows just before the first, and often best, part of a market recovery.

It's not today's price or even next year's price that matters; it's the price you'll get when you sell. For most investors, that's in retirement - and even at age 60, chances are you will live another 25 years and your spouse may live several years more. So don't let the crowd trick you into either exuberance or distress. Remember the ancient counsel, "This too shall pass."

Mistake #3: Timing the market

Does the timing penalty - the cost of second-guessing the market - make a big difference? You bet it does. The stock market as a whole has delivered an average rate of return of 9.6% over long periods of time.

But that return measures only what a buy-and-hold investor would earn by putting money in at the start of the period and keeping his money invested through thick and thin. The average investor's actual returns are at least two percentage points lower because the money tends to come in at or near the top and out at or near the bottom.

In addition to the timing penalty, there is also a selection penalty. When money poured into equity mutual funds in late 1999 and early 2000, most of it went to the riskier funds - those invested in high tech and Internet stocks. The staid "value" funds, which held stocks selling at low multiples of earnings and with high dividend yields, experienced large withdrawals. During the bear market that followed, these same value funds held up very well while the "growth" funds suffered large price declines. So the gap between overall market returns and an investor's actual returns is even larger than those two percentage points.

Mistake #4: Assuming more control than you have

Psychologists have identified a tendency in people to think they have control over events even when they have none. That can lead investors to overvalue a losing stock in their portfolio. It also can lead them to imagine trends when none exist or believe they can spot a pattern in a stock chart and thus predict the future. In fact, the changes in stock prices are very close to a "random walk": There is no dependable way to predict the future movements of a stock's price from its past wanderings.

The same holds true for supposed seasonal patterns, even if they appear to have worked for decades. Once everyone knows there is a Santa Claus rally in the stock market between Christmas and New Year's Day, the "pattern" will evaporate. Investors will buy one day before Christmas and sell one day before the end of the year to profit from the supposed regularity. But then investors will have to jump the gun even earlier, buying two days before Christmas and selling two days before the end of the year. Soon all the buying will be done well before Christmas and the selling will take place right around Christmas. Any apparent stock market pattern that can be discovered will not last as long as there are people around who will try to exploit it.

Mistake #5: Paying too much in fees

There is one piece of investment advice that, if you follow it, can dependably increase your returns: Minimize your investment costs. We have spent two lifetimes thinking about which mutual fund managers will have the best performance year in and year out. Here's what we now know: It was and is hopeless.

That's because past performance is not a good predictor of future returns. What does predict investment performance are the fees charged by the investment manager. The higher the fees you pay for advice, the lower your return. As our friend Jack Bogle, founder of mutual fund company the Vanguard Group, likes to say, "You get what you don't pay for."

We looked at all equity mutual funds over a 15-year period and measured the rate of return produced for their investors, as well as all the costs charged and the implicit costs of portfolio turnover - the cost of buying and selling portfolio holdings. We then divided the funds into quartiles. The lowest-cost-quartile funds produced the best returns.

If you want to own a mutual fund with top-quartile performance, buy a fund with low costs. If we measure after-tax returns, recognizing that high-turnover funds tend to be tax-inefficient, our conclusion holds with even greater force.

Mistake #6: Trusting stockbrokers

The stockbroker's real job is not to make money for you but to make money from you. Brokers tend to be friendly for one major reason: It gets them more business. The typical broker "talks to" about 75 customers who collectively invest about $40 million. (Think for a moment about how many friends you have and how much time it takes you to develop each of those friendships.) Depending on the deal he has with his firm, your broker gets about 40% of the commissions you pay.

So if he wants a $100,000 income, he needs to gross $250,000 in commissions charged to customers. Now do the math. If he needs to make $200,000, he'll need to gross $500,000. That means he needs to take that money from you and each of his other customers. Your money goes from your pocket to his pocket. That's why being "friends" with a stockbroker can be so expensive. A broker has one priority: getting you to take action, any action.

We urge you not to engage in "gin rummy" behavior. Don't jump from stock to stock or from fund to fund as if you were selecting and discarding cards in a game. You'll run up your commission costs - and probably add to your tax bill as well.