Investment Checklist I.I - Filtering your ideas

Once you have a hunting ground for ideas, the next task is to filter them and put them in different buckets. Charlie Munger does this quite simply. He has only three buckets - in, out, too tough. But how to filter?

Circle of Competence

Working inside your circle of competence is crucial. It's not so much that you can never make money outside your circle of competence, but mistakes made here will take a toll on your portfolio and consequently your mental well-being. Also with investments failures outside your circle of competence, you are unlikely to learn anything from a post-mortem. 

Try to widen your circle of competence. Don't be despondent if you're unable to do so. You will find opportunities if you're patient enough. For example, till recently Buffett did not invest in technology stocks. He was ridiculed prior the tech bubble, but in hindsight his obstinacy saved him. 

Once you have identified that an idea is within your circle of competence, you may proceed to detailed questions based on past performance.

Criteria is a filter

Shaern points to a number of questions which can be used to filter investment ideas. More than anything else, I like to boil it down to some very basic things. Motivated from an interview with the Big Bull, I like to look for five things during my initial search - 

• Opportunity - This is a measure of how long the runway is for the industry and consequently the business. 
• Scalability - Is the business scalable? Can additional plants/manufacturing units be put up with increased return on incremental capital?
• Management integrity -  Probably the most important facet to avoid sour grapes in the Indian context. Does the management have a clear vision? Does it communicate this is a transparent way to stakeholders? Are minority shareholders given an equal opportunity to reap benefits from the underlying business?
• Competitive ability - This covers aspects related to Porter's five forces and moats.
• Valuation - "Price is what you pay; value is what you get" - always remember this. Without a reasonable estimate of value, you're only gambling.

Valuation is a criteria

There are numerous ways to arrive at valuations - DCF, relative or residual. Each has its own pros and cons. What one may use is highly dependent on the situation at hand. [post forthcoming]

For instance, Shearn quotes the example of Brad Leonard who uses enterprise value (EV) to EBITDA as a qualifying valuation criteria. In his words - 

"When you are paying one or two times EV to EBITDA, not much needs to go right. If the business survives, you win. As long as the business does not end, you don’t need to make a lot of great assumptions in your analysis. If instead I were paying a 5 percent earnings yield (earnings divided by market capitalization) on depressed earnings, it would not really be that cheap."

Valuation lies in the eye of the beholder. Subject to inherent assumptions, two people can come up with varied notions of intrinsic value. They may be both right (or wrong) at the start, but in the long run, the one to gain profitably from investing is likely the one who's honest and conservative in his assumptions and bets with good margin of safety.

Using a tracking sheet

A tracking sheet is a wonderful way to monitor businesses. More often than not, you'll encounter businesses which look strong fundamentally but do not offer any margin of safety. A tracking list gives you a number of advantages in making rational decisions:

• The sheet keeps our favourite businesses on the radar. An alert system can be incorporated to notify us about stocks that offer good price-value propositions in the future.
• Putting a business on the tracking sheet helps wear off the novelty of a new idea. We are conditioned to act impulsively and the sheet instills the discipline to think holistically before a buy decision.
• Ignoring other businesses in the sheet is the opportunity cost of making a new stock purchase. One is likely to make the best choices amongst a list of relatively good stocks. Over time, this is likely to deliver handsomely to the overall portfolio.

I've touched base with the most rudimentary ideas here - in further posts, I'll delve deeper into each of the matters listed here.

Investment Checklist I: Hunting for ideas

This is the first in a series of posts inspired by Michael Shearn's work The Investment Checklist. I'll be following a chapter-wise format as provided in the book. I will also follow up points made in the book with my own commentary of my understanding so far. For any examples provided in the book, I will use Indian examples for my own benefit (and hopefully for yours too).

This post deals with generation of investment ideas. Quite frankly, I am boggled with the multitude of options illustrated in investing literature on how to make money. The answer perhaps lies in developing your own strengths, learning about your biases and making informed and rational decisions with a long term perspective. Investment ideas can be qualitative or quantitative or both. Let's start with hunting grounds for investment ideas.

At the outset, Shearn warns his readers quite prophetically -

"You need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime."

Are we indulging in intellectual masturbation here? What is the point of this all, if you're not going to get rich. No, no. I didn't say it. If you're a Munger fan and practice second-level thinking, you've probably already figured it out - most of your money will be made in just a handful of investments. So pull no punches when opportunity presents itself. But how many punches - if you're listening to Buffett, no more than 20!

Some places to seek new ideas:

1. Times of crisis undoubtedly present exceptional opportunities. Take for example the Asian crisis of 1997-98, the tech bubble of 2000 or the mortgage crisis of 2008. Most of the these opportunities arise out of forced selling. This happens when institutions must make good on large-scale client redemptions. Even though fund managers may have some inclining that the stocks they're dumping are intrinsically undervalued, they have no choice but to meet their mandates.
   
2. Other examples of forced selling include selling after a stock is dropped out of an index. This usually happens because stocks are ousted as index constituents based on some mathematical computation (such as market cap). Spin-offs may also present If such stocks are fundamentally sound, they may present good opportunities.
   
   Comment: In the Indian context, I am unaware of any academic study which checks the stock performance of stocks which dropped out of indices. But the exercise may be worthwhile. With regard to spin-offs too, I am not very well informed. In recent times, Syngene IPO and the run up in both its stock and that of its parent Biocon may be a worthwhile consideration [post forthcoming].
   
   

   

   Syngene and Biocon (after listing of Syngene)

3. Broad market sell-offs: look for sectors which are in greatest distress. In other words why is capital scarce in such sectors and why are investors fleeing? Invert and ask yourself, when the
   cycle reverses - which companies will stand to gain the most.
   
   Inversely, which sectors seem to have an abundance of capital? Which sectors have highly leveraged balance sheets and appear to be heading into bubble territory? These may the ones to avoid.
   
   Comment: As an illustration I compared the BSE Metal Index with the Sensex. Metals unde-performed the broader market for three years from 2012 to 2015, but staged an impressive comeback in 2016 during which time Sensex has been almost flat [post forthcoming].
   
   

   

   Sensex v/s Metals (2013-15)



Sensex v/s Metals (2016)

4. Stock-specific sell-off: When bad news hits a particular business, investors dump the stock quickly. This can be good hunting ground if you can make the distinction between permanent and temporary distress. Take for example, Buffett's investment into American Express after the Salad Oil Scandal.
   
   Comment: In the Indian context, think of the Maggi fiasco. Or more recently, the Welspun cotton-issue or promoters at VRL saying they will get into airlines. Are these investment bets for the future? I don't know. But if you do your homework and find the distress temporary and inconsequential to long term profitability for the companies, these may present good buying opportunities. [posts forthcoming]
   
5. Stock screens: Tools like screener.in are indispensable to retail investors. They help us quickly sort through a multitude of companies using financial indicators which are most important to us. But perhaps, screens are too simplistic. When the devil lies in the detail, some caution is warranted. A principal concern can be in the nature of accounting itself. One needs to look at real earnings [post forthcoming]. Also, if you're looking at earning multiples, a temporary loss can throw a company out of the screen. Most importantly, without the necessary tools build into a screen, it's difficult to investigate the qualitative aspects on an investment thesis such as management integrity.
   
   Comment: For example, Lycos Internet is always thrown up on my screen whenever I use return metrics for screening. But it's trading at PE of 0.88 currently! Surely something must be wrong here? Could this be a case of creative accounting? [post forthcoming].
   
6. Low lifes: It maybe worthwhile to investigate companies which are hitting 52 week lows. Some companies may be deservedly in the list, but some may be going through temporary distress. If you can connect the dots with point 4 related to stock specific sell-off, you may find good bargains.
   
   Comment: For example, look at Speciality Restaurants. The company has been hitting lows since its IPO. But they have no debt on their books and whenever I've been to Mainland China, I've always been pleasantly surprised with the quality of their service. A turnaround could augur well for shareholders. [post forthcoming]
   
7. Coat-tailing: Following investments of renowned investors and betting with them is called coat-tailing. It can be incredibly useful to hunt for investment bets. A word of caution is warranted here. Without an investment thesis, betting your money is akin to gambling. So while coat-tailing may be a good idea to discover companies, without independent research you cannot build conviction.
   
   Comment: Investments above a certain percentage of shareholding of the company or monetary value must be disclosed as Bulk/Block deals to the exchanges. These can be the mostly timely indicators of interest by seasoned investors. Annual reports also carry names of top ten shareholders besides promoters and management.
   
   
8.  Buying shares to track a business: Sometimes you need motivation to get things going. This involves buying small quantities of some companies which look interesting but where you've not completely formed your investment thesis. These holdings generally don't affect your overall portfolio (consequently, you can't expect to gain enormously if these do well too). Paul Sonkin of Hummingbird Value Fund calls this the grab bag. This idea maybe seem to be at odds with Warren Buffett's 20-punch rule, but examples like American Express come very infrequently. In most cases, conviction builds over time. The idea is to keep these holdings in your mind space and research in greater detail (even if valuations aren't very rosy). In the long run, when the iron is hot, you'll know where to strike.
   
   Comment: I've been guilty of indulging in some investments with this point of view. Consumer discretionary businesses like Wonderla Holidays and Mahindra Holidays present some examples.
   
9. Looking inside: Sometimes you already own the best ideas and don't need to go looking around. When valuations are favourable and your original investment thesis is still at play, you can buy more stocks of business you already own. Think in terms of opportunity costs.
   
10. Researching IPOs: Shaern points to something important - while researching IPOs, you don't have any prices to disrupt your valuation process. Without availability bias, you're likely to form an independent opinion of the company. Soon after listing, you can validate your valuation against the market quoted price. IPOs are inherently cyclical in nature (just look at the money raised in 2016 compared to previous years). In a bull market, valuations can be exaggerated. Having an independent opinion can save you from losses. Moreover, many IPOs are likely to be those of new-economy firms. Tracking changing industry trends in the market can serve in the long haul.

This list is obviously not exhaustive. To an amateur whose just starting off though, this list can be handy. To cut it short, ideas can be discovered anywhere. If you're a Peter Lynch follower you'd keep an eye for brands in the supermarket too.

Please note: I'm not a SEBI registered investment advisor and my discussion of stocks is not a recommendation to buy/sell/hold or transact in any way on the stock exchange. Please do your due diligence and make informed decisions. 

Are you ticking the boxes?

Numerous investors [here and here] have highlighted the use of investment checklists in screening potential investments. Mohnish Pabrai likens the investment process to surgeries and flying airplanes and is inspired by Atual Gawande's book Checklist Manifesto. Bottom line - seemingly complex tasks can be broken down to simple ground rules. Breaking decisions over smaller bites consumes lesser mind space and avoids biases.

Smart investors make their own checklists and I was educated on this quite early on. Still, you only appreciate the process till the rubber meets the road. For example, I discovered Michael Shearn's book The Investment Checklist even before I started building my portfolio. When I read the book initially, I was able to go only so far. Most of what was written seemed obvious and mundane. There were some aha! moments, but without practice, I felt like I was indulging in intellectual stagnation.

In my own journey so far, only six months old mind you, I've already bought some stocks. Although I've tried to stick to the basics (such as reading annual reports in detail, performing independent valuations and buying with a margin of safety), I now feel the need for well-grounded rules. Most of purchases have come without any record of investment thesis. I know I will regret this later and let biases ruin my rational decision making if I don't indulge in making a checklist now.

I already feel animal spirits taking over me. The markets are on a downward trend following the Trump election and the demonetisation wave. The 'buy low, sell high' mentality drives me to jump into the market impulsively and buy more. However, without a sound understanding of my present holdings and almost no understanding of other businesses in the market, I feel intellectually incapable to act. Therefore, I am wary to make any more purchases till I build strong investment thesis for my present holdings. Making a checklist will not only screen my present holdings for possible errors, but serve as a template for future purchases. I think this exercise is well deserved and will serve me well in the long run!

For starters, I've decided to back to 'The Investment Checklist'. The next couple of posts will look at Michael's checklist in greater detail.

Getting started: How to think about potential investments?

Everything that needs to be said has already been said. But since no one was listening, everything must be said again.

- Andre Gide 

The best ideas are already out there. So there's no need to reinvent the wheel. Save yourself the trouble of thinking you're truly special to come up with innovative solutions every time. Some of the world's most successful value investors are cloners, and there is no shame in it.

With reference to thinking about potential investments and tracking them on an ongoing basis, the following are useful:

1. The four-quadrant approach is an effective way to think about your potential investments. It avoids the clutter and neatly organizes companies into four buckets as per business and valuation. Going ahead it makes sense to have rules about how much you will be willing to bet into these buckets.

2. Vishal (founder to Safal Niveshak) has done a great favour by teaching amateur investors how to keep track of their investments using Google Finance and Excel. It's a very handy tool and serves as a ready reckoner of potential investments. 

Most often good businesses are not available at cheap valuations. If you're not completed convinced about growth, you may not invest in such companies. It's important to keep them on your radar though so that when the iron is hot (good business; good valuation), you can strike them! This is where the excel sheet is most useful.

Cheers, and happy investing!

Why I was not a value investor

As an introduction to value investing, the course on Safal Niveshak recommends keeping an investment diary to note down learnings from value investing. These may be instructions of some sort, like a checklist before making investment decisions or just notes on companies. The idea is simple. As Neeraj Marathe elegantly put it, you cannot hide from your own written words. By maintaining a diary, you keep checks and balances on yourself and ensure that your theoretical understanding of concepts in enforced in practice. It's also an excellent way to rejig your memory about past decisions and alter future course of action if need be.

One of the first things to increase self awareness as a value investor includes the understanding of why you have not used value investing principles to make decisions yet. I wrote the following down as I mulled over this issue:

I have not been a value investor because...

I am fairly new to investing in general (less than a year). I was not introduced to value investing directly. Initially I started with William O' Neil's CANSLIM methodology of stock picking. I dabbled in some stocks. I remember my first bet - Symphony Ltd. It was nearing the end of it's meteoric rise and was trading at 40x PE around April 2015. Without a sound background in accounting, I took CANSLIM to heart and dived headlong in. In hindsight, I was a victim to availability bias. Without sufficient reading and exposure, I naturally assumed CANSLIM to be the definitive method for successful investing. The methodology did not talk about valuations at all and I mistook 'good companies' as 'good investments'.

Despite my losses, I was not demotivated. Even though CANSLIM is largely a momentum based approach, at its heart it looks for stocks with proven track records of long term profitability and performance. The other aspect of it is based on technicals which are largely driven by institutional forces. While William O' Neil gives numerous examples in his book and his methodology is considered successful in US market, I wondered if it was truly replicable in the Indian context. A quantitative study of this methodology in the Indian context remains unfinished and I will be very glad to discuss the experiences of Indian investors who may have tried such an approach. Coming from a coding background, I've always been excited about using algorithms to help make investing decisions. From an academic point of view, this is work in progress.

I apologise for digressing from value investing. But I feel my losses have been instrumental in understanding the importance of valuations and consequently 'margin of safety'. I think investing is inherently risky. Whether you consider risk in the academic sense of volatility or permanent loss of capital, risk comes from uncertainty about the future of any business. Value investing trumps other investing methodologies because it minimises speculative value and focuses on intrinsic value arising from an existing business in its existing competitive environment. Focusing on intrinsic value and applying a margin of safety minimises the chance of 'permanent' loss of capital. However, 'short term' loss of capital in terms of paper losses (affected by volatility in prices) cannot be eliminated. This proves for longer time horizons in value investing. I now understand the importance of taking rational decisions for long term wealth creation and am very excited about training myself to be a value investor.

Qualitative v/s Quantitative

Quantitative Value talks about how you can use numbers directly and run them through a sieve to separate good and bad companies. The authors have gone to great lengths to prove how a purely Buffett style of value investing can be combined with an Ed Thorp inspired quantitative model to gain advantage in stock picking. In the American context, they've used Enron and WorldCom as examples to show the power of their models. What is likable about the book is that they've not laid claim to these methods and only tried to enhance them by bringing various tools together. But the question really is whether it's so simple. Surely algorithm based accounting methodologies cannot give the best answers always. Even if the book tries to argue its case for US market, I am not aware of any case studies in the Indian context.

Then again you have Mr. Greenblatt who professes that Magic Formula beats the market and that his methodology has worked year on year without market timing. The authors of Quantitative Value have also used it for their case study in their book. At the heart of it, Magic Formula boils down to very simple value investing principles - i.e. buying companies with good returns on capital at cheap prices. In that sense there is much merit in keeping things simple and boiling it down to a few simple ideas in the end.

Einstein said, "Make things as simple as possible but not simpler". So losing out essential details by focusing far too much on simplicity can be harmful. With respect to Indian markets especially corporate governance is probably one key variable which cannot be measured through numbers directly. Rahul Saraogi makes this point very clearly in the video below (for a general sense of how professional investment managers invest with a value investing perspective in India, this is a wonderful interview). With this perspective in mind, qualitative assessment is probably as crucial as quantitative valuation.

To boil it down, I think there's merit in both qualitative and quantitative methods. In the Indian context, I'm unaware of any methodological study of Magic formula investing or the other quantitative methods extolled by foreign investors. Without access to a database of past financial accounting information on Indian firms, testing would be not be possible for the layman investor. Nonetheless, I would definitely suggest the book Quantitative Value to fellow investors. Even without being able to test methods, the ideas behind financial metrics explained in the book have merit and can be key to making sound investment decisions.

P.S. For Indian investors who would like to use quantitative filters to search for stocks, I recommend screener.in. We'll be ever grateful to Ayush Mittal for this. :)

Musings about social media and validity bias

The craving for action is always high; especially when you tune into any of the business channels. The hulabaloo surrounding corporate stories and constant chatter by market experts makes you feel uneasy during both bull and bear markets. In the first case you're scared that the ship might sail off without you and in the latter you're scared the ship will sink taking you down with it. Independent analysis based on rationality can take a serious hit in such cases.

I want to take this further and recount from my experience with social media. Recently, I decided to follow some 'value investors' from India on my twitter page. Needless to say I was hooked onto their tweets and looked forward to their pearls of wisdom. Initially, I did well to chant their mantras (and make mental notes for the future). However, in any discipline there are only a few main ideas. I like this quote I heard somewhere - "Everything that has to be said has already been said." Usually people are only giving their own twists and turns to old ideas. This is not without merit of course, for different people respond differently to different story tellings and most often the most lasting impact of a moral story is when you fail to learn from the core message and it happens to yourself. Experience is the best teacher. But Munger also says that it's better to learn from the history of other people and that this can speed up your learning curve exponentially. This was the sole aim of joining twitter.

But my point in outlining the role of the twitterati is also to suggest that because some people have a lot to say, it can make you feel unaccomplished. This is especially true for twitter. Most people I know make twitter accounts and find it extremely difficult to come up with intelligent things to say in 140 words. More often than not, most of their accounts remain dummies for most periods of time. So taking to twitter with the single minded goal of following people with similar interests and contributing to that circle of interest can be daunting if you don't have much to say yourself, especially when you'd like to grow to become like some of the people you are following.

My feed, for example, is often abuzz with stock ideas from some 'value investors' and although I have no reason to doubt their skill in picking good stock picks (until now at least), I usually feel rather unaccomplished seeing the multitude of companies on which they have things to say. This makes me question my own capacity to evaluate companies on my own.

I think this bias is close to the kind you face when you view business channels. The goal is then to focus more on your own study of annual reports; even if you're a newbie and it takes you more than a couple of days to try and understand a single company. Surely the gurus out there were not nearly as good as they are now. There is value in focusing on your own strengths and waiting for your own 'aha' moment. That's when you must strike with all your might.