Monday, March 26, 2012

What do you price an overpriced

This story is about a company that is celebrating 100 years of business in India and whose EPS has crossed just over 100. Nestle started its India operations in 1912 by importing and trading milk products and chocolates. The net profits of the company compounded at 17.5% every year over the previous years. The stock price catapulted from Rs 285 in the year 2000 to Rs 4500 in 2012 (not withstanding the 160% average 18 dividend payments) with laser focus to deliver Strong operating cash flows. Nestle’s net profit grew at a CAGR of 21% per year from Rs 118 crore in 2000 to Rs 961 crores in FY 2011. The eps also grew from Rs 12.30 on year 2000 to Rs 100 in 2011, again a CAGR 21% (per year). This is too good to be true. It’s heartbreaking to miss being part such a company that is a true wealth generator through innovation, unparalleled distribution and invaluable brands. How many companies can we recall that have survived for 100 years? Hardly any. NestlĂ©’s recall has been painstakingly built over 100 years. This is a feat that is not easily replicable by simply making large investments. Hence one can safely expect that this growth of Nestle will far continue into the future on the back of the strength of its brands and popularity of its products.

But look beyond and we will learn some lessons. When nestle has grown at a compounding rate of 21 % over the past 12 years and if it is guaranteed to continue its growth engine for many more years into the future, investors will quite naturally overpay for the stock and make it expensive. The markets will overprice such businesses having demand and with a moat. Nestle's intrinsic value is around Rs 25,000 crore when I last calculated while it is quoting now at Rs 43,000 Crore making it highly overpriced. When such growth engines like Nestle are overpriced, how can future returns be possible? The returns on our investments are proportional to the price we pay to buy them. We can't over pay a growth story and expect to make great returns. In the recently held IPL Auctions, Ravindra Jadeja was bought by CSK for Rs 9.72 crores plus a secret tie breaker amount. Would CSK have been ready to bid 10 times more than that as tie breaker amount? Would it have made business sense? Jadeja has a finite value to the CSK’s IPL business and would be bought at a commensurate value that makes business sense. If the price paid for an investment is high, it would diminish the returns on the investment. Investors must factor this Margin of safety which tells us how cheap is the going rate over the actual valuations. A 25% margin of safety ensures we never over pay.

Like many paradox in life, we are very optimistic about a stock generally when it is overpriced and are pessimistic when they are undervalued. The capital goods, infrastructure and power stocks trade at very low p/e multiples today because the market considers future prospects of this industry very bleak. Just yesterday they were poster boys of the stock markets.

No one can make an accurate forecast of the future of the market in general or an industry or stock in particular. Future as ever shall continue to surprise the one who is absolutely sure about it. As an investment expert said “The worst the financial market’s future look, the better they will turn out to be". Keep investing in little, over time and stay invested.

Wednesday, March 07, 2012

Iowa Gambling Task

Why do people invest differently? Why do some always lose money in markets and why is it some people refuse to lose money by not investing or postponing their decisions? Yet there are people, who are remotely connected to markets, inherit huge holdings and never do anything about it but they grow their wealth many times? Yet there are people who invest to lose money and never return?

It’s about how the brain is made and how we make different decisions to same situations. Recently I tried Iowa Gambling Task online to better understand my investing behavior. It tells you if are a carefree risk taker, or fear losing money in market, or are you the one who will take money away when the market tanks. Such investing behavior potentially inhibits your success. The task also reveals if your brain responds to low risk bets and limits downside, such behavior helps build reasonable portfolio returns. The wiring of your brain will manifest in investing decisions. If you are low on wiring as you can make out in the Iowa Gambling Task, it would be better for you leave your wealth management to professionals or invest through a market or index fund.

The investing part of the brain can't at times handle prolonged period of low return. We either kick ourselves for a poor decision or exit early causing irreparable investing damage. I had the opportunity to understand this recently when I met up with a well known Fund manager. He was legendary at one time for his multi-bagger picks like Sintex and Pantaloon. His funds were number 1 for years in a row. A bull by nature, he can't retain a negative opinion for long. He remembered investing in Pantaloon in the year 2002 and then the stock never moved for almost 3 years since. During that period it was stagnant hovering around Rs 10 per stock. But by 2005 or so the stock went up to Rs 300 per share. Now in retrospect would you say it was the right pick or not? Most funds could not ride the wave as they exited the stock owing to long stagnation at early levels. In the fund industry, if the fund manager does not deliver returns better than the index and peer funds for 2 quarters in a row, he will be axed. So it becomes difficult for him to stick to stocks like Pantaloon for 3 years without his investments delivering. As an individual investor, we are under no such pressure and hence can better an average fund-manager.

However as small investors with limited power to influence businesses, one key factor in investing is to look for companies with strong management you trust. As warren buffet said "I'm hunting for companies that have some kind of a sustainable competitive advantage, that have the kind of management I trust and that I can buy at a price that makes sense". The management who are transparent, have rewarded shareholders over periods of time, are trust worthy and those who know their businesses very well. They merit attention especially when they have done some mistakes or are going through unfavorable markets conditions as that is when you get the businesses at price that makes sense. I looked at 2 companies that are in such situations. Pantaloon moved on to reach dizzying height of 800 at the peak of the retail revolution and euphoria in late 2007 and early 2008. The company made so much profits that they wondered what to do with so all the money. Pantaloon attempted at multiple diversification which weekend the business and towards Jan 2012 hit a low of 125 per share. Pantaloon is run by management who know their business very well and they quickly got out of all thinly diversified businesses and are back to focus on core area of retailing. Recently when the FDI in retail bill was getting passed the stock shot up to 240 in one week and later lost steam as the FDI bill was shelved. The stock is back to 150 levels and is a potent stock run by well qualified management and when FDI in retail becomes a reality at some time, will benefit from it coupled with prospects of earnings & business growth. There are other great businesses run by management who know their business very well but have been battered by the markets due to short-term challenges that will pass by. Varadaman Textiles which was around 6000 crore in market cap is now 1200 crore, and is available at half its book value. Their fundamentals have not changed, nor have their management.

The secret of financial success is within us. If we invest with Patience and confidence coming from knowledge, we can take advantage of many situations around us and by refusing to let optimism or pessimism dictate our destiny. As Jason Zweig said, how our investments behave is much less important than how we behave.