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January 2015 - Investment Newsletter from Gokul Raj (Fund Manager)

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January 2015 - Investment Newsletter from Gokul Raj (Fund Manager)

  1. 1. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 Dear Members of "The Millionaire Portfolio (TMP)", Indian Markets have rallied strongly in the first month of this New Year. Last year’s drivers of Stock returns (Global Liquidity + Domestic Political Mandate) continued to drive markets higher in this month as well. The entire focus of the Market has now shifted to the Union Budget which is expected to present by the end of this Month. Global liquidity continues to be strong with the European Union adding much more firepower to the Quantitative easing. Investors would be happy to park capital in India, if the Government follows through with its reforms.
  2. 2. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 Current Market condition calls for differentiated Investment strategies. As we have been writing consistently for the past several months, we are extremely uncomfortable with adding incremental positions to secular growth ideas that are quoting at frothy valuations. At the same time, we believe that Indian Markets are well poised for a strong rally over the next 5 years. Hence, for Investors with low Equity allocations, there is no option but to find and deploy capital in good opportunities that can deliver strong risk-adjusted returns. We try to scout for the few attractive opportunities that still exist in this space. To highlight on the theme of frothy valuations - we are seeing a few businesses that have a decent growth visibility, trading at valuations which we believe are absurd. Investors are being bombarded with these “Special Quality stocks” and there is a prevalent mindset that has developed among Investors that “You can’t lose money in quality businesses if you stay Invested for long”. Investors with such mindsets needs to take into account the opportunity cost in some of these Investments compared with better alternatives and the valuation risk built into such stocks. While even investments in best of best businesses have underperformed over long period of time, if price paid is too high – the current Indian Market has several businesses that are paraded as “High Quality” while the reality is far from it. Let me give an example of the mindset of the crowd in a few of these stocks. I have been reading a few SELL side brokerage reports to check as to how they justify current valuations. There is a “Strong BUY” report on a stock in which the analyst has written “The stock trades at an attractive 2% FCF Yield on FY-17 (E)”. There was an another report on a different stock from a different brokerage that stated “We value the business at 35X P/E multiple on FY-17 (E)”. We are still unable to get an understanding of such valuation models. We believe that Investors are getting biased with the performance of the past few years and are trying to extrapolate these trends and then are justifying their assumptions with absurd logic. This has essentially led to bipolarity in markets - a set of stocks that are deeply undervalued and a set of stocks that are deeply overvalued in our perspective. While some of these fault lines exist because of real quality difference, there has been exaggeration of the same by Investors as is the usual. We believe that there are a few opportunities that lie in between these fault lines (Quality business but attractively valued) and our job is to find them.
  3. 3. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 As investor Akash Prakash of Amansa Capital had written in his recent note titled “It’s all about earnings”, there is still a lot of anchoring in financial projections. Analysts find it extremely difficult to accurately project earnings as the cycle turns and hence there are “Regular Upgrades” in estimates after a prolonged period of subdued earnings growth. This anchoring bias works both ways. While some of the sectors that have done well over the last few years have been provided with over optimistic projections, the case has been reverse for sectors that haven’t done well in the recent past. This has forced us to invest differently with an overweight on contrarian Tactical positions. We have always been comfortable with the concept of Multi-Dimensional Investing and have been ready to change strategies as per Market conditions. Some of our key belief’s such as importance of Bottom-Up stock picking rather than Macro forecasting has been reinforced during the past year. Importance of Multi-Dimensional Investing & Second - Level thinking in Markets : With the Market performance of the past few years, Investors are being sold onto a belief that, you will make money in Markets - if you buy good businesses irrespective of the price you pay for it. While we understand the concept of paying up for Quality, we believe that just like every other trend this is being taken too far for comfort. Let’s understand a few things from Second - Level thinking in Markets to understand the current Investing paradigm in Indian Small/ Mid caps. Second Level thinking:
  4. 4. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 We believe that successful Investing requires a second level thinking that can overlap your expectations against that of the Market and check if the spread of odds is in your favor to bet. Look at the examples of Second Level thinking in the words of Howard Marks, First-level thinking says, "It's a good company, let's buy the stock". Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell. First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy! We are forced to reiterate that no rule always works. An Investment approach may work for a while, but eventually the actions it calls for, will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness. We believe that too much focus on chasing the so-called quality businesses at absurd valuations is not a game that we would like to play. We believe that there are better ways to invest capital. Multi-Dimensional Investing: We believe that Investors must have a strong Investment process that allows them to evaluate each and every investment on a bottom-up basis and not get swayed by the current flavor of the market. We also believe that simplistic models of focusing only on a specific theme of stocks runs out of steam overtime. Investors should have a few Core investing principles that forms the framework for their research and those can be non negotiable but to take it to the point of focusing only on a
  5. 5. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 specific set of sectors/ themes is asking for trouble. Investors should have a flexible mind and not get fixated with things that have worked for them in the past. Our core Investment framework is built on Contrarian picks that offer Value. We are flexible enough to apply these principles across wide range of Ideas from secular growth businesses, Moat + Float businesses; Graham styled Net-Net’s, Cash Bargains, Turnarounds, BIG Outliers etc. We vary the ways in which we value opportunities across this spectrum from, providing additional premiums to quality to calculating the opportunity costs of an Investment. This enlarges our Investment pool while sticking with our core philosophy. One of the biggest winners for us last year was HSIL. First level thinking would have asked us to not look at the business, considering that it had a bad capital allocation track record and poor earnings. A one dimensional Investor would have suggested to stick with tried and tested quality businesses with secular growth opportunity instead of buying a stock that had several grey areas in its Investment Rationale. Anyone who would have done a bottom-up analysis on the stock, ignoring the biases, would have screamed at the attractiveness of the opportunity. The stock had a strong Market positioning in both of its business segments. These segments provided a long runway for growth. The business was cheap both on relative and absolute basis. The results are for all to see, the Stock is up almost 5X in the last year. Similarly over the period prior to 2014, we had several good businesses in the secular growth Small Cap/ Mid cap space that were available at attractive valuations. There were not many interested in these ideas and you were able to BUY them real cheap. Hence a lot of our recommendations were from this space from Astral Poly, Cera Sanitary ware, Ashiana Housing, Kewal Kiran, PVR to Atul Auto. This space has done fantastically well and today, Investors are crowding on to this trade. Existing Investments Vs Incremental Capital :
  6. 6. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 We believe that the Secular growth trade in the Small/ Mid-Cap space is crowded as most Investors are trying to discover businesses that have a 20 year growth opportunity and are willing to pay any price to accumulate those stocks. This is truer in the consumer oriented stocks. We have a little nuanced position on this trade. While we are not selling our existing secular growth Positions just because they are overvalued, we are also not incrementally buying the well discovered Mid/ Small Cap stocks at the current frothy valuations. We believe that Markets always use the trick of slight overvaluations to dislodge Investors, who try to time the market, from making a Fortune. Hence, we are not trying to SELL our portfolio ideas now so that we can buy back later at better valuations. We have bought good businesses at attractive prices and we would like to continue riding with them unless we feel they have become ridiculously expensive or we find extremely attractive long term alternate Investing opportunities. As they say, Bubbles provide the biggest wealth creating opportunities for investors. We will not exit our winners unless we see extremely clear reasons to BOOK Profits. While the secular growth businesses have not entered bubble valuations still, I think we are heading there in quiet a lot of stocks. There is a fad currently among Investors that Quality stocks will deliver returns over long term irrespective of valuations. I believe that this trend is dangerous. History’s verdict is clear on this subject. From the Nifty-Fifty underperformance for the succeeding 20 years to the recent time corrections in quality businesses such as HUL (10 years of no returns), Coca Cola (16 years of no returns), Colgate India (8 Years of no returns) only says to us that Valuations do matter even for Quality businesses that are growing. Second Level thinking does work in Markets. We would be happy to sit out with Cash if such irrational valuations appear on the stocks that we HOLD in our portfolios too. As of now, most of them are overvalued but not to a point where we are speculating about exiting them. The bigger challenge for us has been as to how we should incrementally deploy capital. We are neither interested in buying the well discovered stocks that are quoting at >30X earnings nor the high beta stocks that have poor balance sheets, questionable
  7. 7. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 governance practices etc that are available at throwaway valuations. We believe that a bottom-up stock picker will be able to find a few quality cyclical businesses that are available at attractive opportunities. We are happy to deploy incremental capital in some of these opportunities. Our Investment Research under the current circumstances : We are finding good stocks in businesses that have volatile/ lumpy earnings. There are good businesses that don’t have a smooth earnings profile but can deliver strong average returns on equity across a full economic cycle. Currently, markets are giving too much premium for predictable earnings and a huge discount for businesses where there are few uncertainties. Similar to Mohnish Pabrai, we like stocks in which there is high uncertainty but low risk. We feel there are a few good opportunities in Indian equities that offer this combination. We are also actively looking at good quality businesses that have high operational leverage that can magnify returns in an economic upturn. All our recent Investments such as TV Today Network, City Union Bank, DB Corp etc fall under this category. This is not exactly a Beta strategy but one of the versions of our regular Alpha strategy that delivers superior returns compared to risk (in the way we measure - "Probability of permanent loss of Capital"). We would continue to scout for ideas that provide better Risk-adjusted returns and Invest in them. Learning’s for this Month: "Arguing about how to estimate draw-downs is no substitute for knowing how to live through them" - Ed Sekyota.
  8. 8. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 “Rather than sticking to smaller cap companies or growth companies or special situations or for that matter any other theme, stick to the principle of buying what’s being thrown away” - Peter Lynch. “The good hunting season is just after several years of deep depression, or just before a major war, or at a time when stock prices generally are at the lowest level for many years. It follows perhaps that the key to finding maximum capital gains potential now may be patience. It may be best to set aside a large amount of money now in high grade bonds or savings banks and then wait patiently until one or more of these three factors can be found, either in this country or in some other country. Patience may be the most profitable policy in the long run; but it does not have much public appeal”. - John Templeton. “You can make more money being passively active than actively passive.” – Robert G Kirby. “Great investing requires a lot of delayed gratification.” – Charlie Munger. “Avoid business & financial risk, but embrace market risk.” - Amit Wadhwaney. Templeton Approach – Snippets: It’s necessary to analyze his approach to investing under four distinct headings: (1) the bargain-hunting principle; (2) “broad business principles”—those corporate, social, and political principles that guide his decision making on national and global levels; (3) some very personal principles that are extremely important to his success but not always easy to define; and (4) a set of intuitive or spiritual factors that are perhaps most influential of all in giving the Templeton Touch its distinctive character.
  9. 9. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 Mark Mobius on Sir John Templeton: He would say: “Oh no, we don’t want to look at what the P/E is today. We want to look at what the P/E will be in five years. Let’s look at the future, not at the past.” His approach was really growth and value. I would say that that is one of the things he had added to Graham and Dodd. He also believed in flexibility. There is a tendency for people to become rigid, which is not a good idea. FLEXIBILITY: “If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past.” —John M. Templeton By “inflexible” he means that these investors tend to gravitate consistently toward one type of investment or another— such as small companies, Japanese companies, or some other definite group. When that particular group is doing well, then those investors do well. But when that group is doing poorly, those investors don’t have the necessary flexibility to shift to another, more profitable group of stocks. To remain flexible, “always try to examine seriously what area has done well for you for several years. Then you say, ‘Well, now, maybe that’s not the place for us to be in the future.’ ‘Well, what is it today that is depressed in price?’ Those things that helped you so much in the last two or three years can’t be the bargains they were when you first bought them. So instead of staying in those things that have treated you well in the past, you should be looking for those things that performed worst in the past—and consider buying those now.”Personal discipline and self-confidence to stay with an investment decision until the price rises or until the facts prove him wrong”. “But then we look at their price patterns: If two out of those twelve have already started to move up, then we buy those, because they’re just as good bargains as those that aren’t moving. So we may not have to hold them for long before they rise in price and provide a good profit.” “If 10 civil engineers tell you to build a bridge a particular way, then that is how you should build the bridge. If 10 doctors provide the same diagnosis then you should follow their recommended treatment. However, if 10 investment advisers tell you that a particular stock is cheap, then the last thing you should do is invest in it.”
  10. 10. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 “Some students then, as now, become immobilized by the pros and cons involved in the wide variety of such choices they must make. All of life is a gamble. No one can ever see every ramification of a given decision beforehand, no matter how thoroughly he or she plans and prepares. It is far better to make a relatively fast decision—a fast “roll of the dice”—and keep moving than to postpone the answering of important questions and allow random events to make those decisions for you.” – John Templeton [The Templeton Touch] The prudent and conservative policy is to follow a long-range program designed to profit from stock market cycles without the need for predicting either the timing or extent of such cycles. [i.e 60% invested in equities when market are at normal level and adjust the proportion as valuation gets cheaper or steep] His focus is always to increase holding of bonds whenever he felt valuation are excessive. Whenever he saw overvaluation, he increased his holding of bonds by up to 40% of portfolio. This is pretty large number for an equity mutual fund. “Travel and study of stocks and bonds in other nations,” he observed in one letter, “serves two purposes. Firstly it leads to discovery of attractive opportunities in the securities of those nations. More importantly, a study of the exotic conditions and investment trends in other lands helps us to understand more clearly what can happen in our own nation. It teaches us to question the economic theories and fads popular here. It gives us deeper respect for the fact that the most unexpected things can happen and often do “Prices fluctuate more than values—so therein lies opportunity. Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it. We could sit there and figure it all out, but I like to keep it simple. It happens; it continues to happen; the opportunities are there. I just want to take advantage of prices away from value.. If you do good
  11. 11. [HBJ CAPITAL - THE MILLIONAIRE PORTFOLIO] January 1, 2015 valuation work and you are right, Mr. Market will pay you back. In the short term, one to two years, the market is inefficient. But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—.. Mr. Market will pay you.” “Looking forward to a good 2015 !!” Regards, GokulRaj. P, [Principal Fund Manager, HBJ Capital] Date: January 31st 2015, Place: Bangalore, India.