Wednesday, May 25, 2011

How a small investor can beat fund managers

About a year ago, I helped a friend make a portfolio when he wanted to invest a small amount in stocks. It comprised of only 4 stocks. As always we were seeing a lot of head wind arising from global uncertainties, high inflation and RBI efforts to tame it. Most businesses were fairly valued and sitting tight for a correction is easier said than done. As some one said, all problems arise because humans can not sit tight in a room without doing something. We actively seek action. And in that lies the root of all problems. So I set out to identify companies that have a consumer monopoly and continue to generate earnings over long periods of time. Those that are not impacted by economic crisis in a global environment. I am a fan of warren Buffet's teachings. It was very easy to identify them. Those that show continuous growth in EPS, High ROE, over say a 10 year period. These are front indicators to a company that has a moat. A consumer monopoly as Warren calls it. They have a strong brand, or an authority like a toll way. Today with the advent of information highway, getting data is not a challenge. Its about being able to decipher meanings. Its about how to segregate wheat from the chaff. The markets have oscillated in the last 1 year between 15,960 - 21,108. That was technically a huge spread to make returns. But my personal money which is invested with a well known fund manager is yet to make any semblance out of this band. The reason being, it is virtually impossible to predict a top or a bottom. Strong businesses continue to make money irrespective of where stock markets are headed.

My friend went ahead and invested in 3M & 3 other companies. Jut to give a perspective of why these were selected, it was based on pure common sense and by checking for the Warren filters. Lets take the case of 3M. I was attracted first to a product they make called Scoth-Brite & Post it. It was easy to understand their business. Scotch-Brite is a cleaning material such as scrubbers and mops. Post-it is the ubiquitous yellow pasting slips seen in every office & home. 3M makes over 50,000 products. They differentiate from competitors by producing products of innovation. They have labs that research on products to solve very common problem and make life easy. Who would not have used the scoth-brite cleaning scrubber. Use their cloth mop and see how they suck water and make it easy to use. Each product is first of its kind. And their earnings expand as they grow their markets in both unorganized and organized space. Look at the traffic dividers, they are illuminated with 3M reflectors. or anti corrosive paints for cars. Half the world's population today enjoys experiencing at least one of 3M's 50,000 products. This is common sense research of a business which is simple to understand

Coming to warren's filters, they have grown their EPS by 24% CAGR over last 10 years (Rs 9 to Rs 82). Their average ROE is 21%. It Carries no Debt, a rare occurrence. I will agree now that the valuations are very unfavorable. There is no margin of safety. Frankly there wasn't when I had recommended this to my friend. It has returned 67% in last 1 year. I have tried calculating the valuations for these stocks and have always found them expensive. The portfolio of 4 stocks has returned 47% in a year. And they were all very expensive then too. No fund manager in his sense would recommend to invest in these stocks as they lack a margin of safety. All of them had high P/Es. That, to me is a referendum of their sound business. I am now increasing the portfolio by another 2 names. It is easy to beat a professional fund manager. Investing knowledge does not come from dalal street fund managers. Instead they come from our circle of comfort. We can better them by investing in companies , industries we understand well. You have so much going in favour that a fund manager does not have. To start with he is a victim of regulations. He cant hold cash, he cant sell all or buy beyond a certain corpus portion. He cant invest in small companies. As an individual, you are free to have all your money lying in only 4 stocks. You can flee to cash at will. You don’t have to justify high valuation. You need not out do your counterparts on a quarterly basis.

Warren emphasizes strong fundamentals which can be measured by a strong growth in per share earnings (EPS). He likes companies whose return on equity is above average. And those that are conservatively financed with little or no debt. 3M fits into all these filters and more, but is not fairly valued at current price. Markets go up on rumors and correct on results or facts. Lets await good-times. Like another great company, SBI corrected recently on results of higher provision. The fundamental net interest income and profits have only grown. Markets can' differentiate risk from uncertainty. When a company faces uncertainty, markets punish them by beating down their prices. Investors must avoid risk but be-friend uncertainty which provides good buying opportunities. Lets use such times to accumulate great gems. Wealth is made during extreme pessimism but researching & identifying can be done at all times.

Best Wishes,


Disclaimer: I may hold positions in companies and businesses being discussed. However this is not a solicitation to invest in those stocks . The name of companies are discussed only to illustrate ideas, thoughts and learn. Please do not invest with out thorough knowledge. It can cause potentially heart attacks.


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