Checklist for a Falling Market

Equity markets have fallen rather sharply over the last 6 weeks or so. When 4,800 on Nifty was breached on previous occasions, market “experts” were saying we’re near the bottom but this time they’re not saying so which gives an impression that price bottom may not be too far. But nobody knows. Either way, yours truly has always professed stock-specific approach which keeps you more focused in a bear market.

What’s that you should do in a falling market?

1. Do your home-work and keep ready your Buy-list of stocks with total quantity that you’d like to accumulate depending on your portfolio composition alongwith staggered price points. We are presuming that one’s already in 30-50% cash to capitalize on the fall or may be fresh position coming in.
2. In the Buy-list, avoid any highly leveraged companies or those with management/governance issues and where more than 40% of promoters’ holding is pledged.
3. Next is make a note of the price points at which you’d be willing to buy each of those stocks in small lots of say 20%, 25%, 25% and 30% of the target quantity in a falling market. To give an example, suppose you want to accumulate 100 shares of RIL and price points begin with 20 no.s at Rs 780 going to 25 at Rs 740, 25 at Rs 705 and 30 at Rs 670. If it goes below 670 you don’t do anything. If it rebounds from 700 you hold only 70 and live for another day. There may be some change in your pricing depending on actual situation at that time, cash flow etc but a broad plan has to be ready upfront as to what you want to do to your portfolio both on buy and sell side. Example of RIL was just an illustration, I have no interest in the stock.
4. Investors should be able to distinguish between a stock falling due to weakness in broader market and a stock falling due to fundamental damage. Out of the two, it’s only the former that should be bought into provided the stock was in your Buy-list in the first place.
5. Be flexible to identify good opportunities. Having a starting list does not prevent you from being open. Very often, price falls make some stocks more attractive than they originally were. What happens is that a vertical fall is generally irrational and new opportunities are unraveled very fast in the slide. Having said that, basic conviction in the stock should be there and no short-cuts in the diligence process.
6. Watch out for people advocating seemingly good stories and often enhancing them to suit their own biases while ignoring the hard facts.
7. Even after the fall is over (first gets over in index and large cap stocks), the small caps languish at beaten down levels for some more time making easy picking, but please remember #4.
8. Staying power is a must. One should be prepared for a flat to bearish phase of 12-18 months, if not longer. Oct-2008 to Mar-2009 was a very short fall time-wise and it can certainly get longer than that, and much will depend on actual signs of reversal in interest rate cycle.
9. Make sure the cash deployed does not come in the way of any personal/family goals coming up in next 2 years.

Big money can be made in falling markets amidst despondency and pessimistic news flow, and that’s one of the reasons that equity investing is so tricky.

Happy hunting!

Bajaj Electricals Ltd – An update

We discussed the stock of Bajaj Electricals Ltd (BjEL) in April 2011 here.

CMP is Rs 194 and the stock price has corrected by about 28% since April 2011.

Coming to its Q2-FY2012 results, revenue at Rs 700.80 crore increased by 19% on the back of a strong growth in lighting and consumer durables which grew by 25% and 21% respectively. E&P growth was lower at 10%.

Earnings increased slower at 7% as interest costs jumped up significantly.

Let us evaluate the key risks to our investment case:

1. Large number of unorganized and small players operating in the electrical appliances business.
2. Increasing competition from branded players including some new entrants will squeeze operating margins of BjEL.
3. Excessive dependence on certain vendors for key supplies or production.
4. Performance of E&P segment is a concern, and this could lock higher working capital debt resulting in more interest outgo.

Now we look at some of the mitigants and comforts:

1. Lighting division has some pricing power despite competition.
2. Morphy Richards brand products in the premium segment are growing well ahead of the industry average.
3. BjEL has taken steps to stop bleeding in the E&P division and cut down the number of projects handled to around 50 to improve project execution.
4. Commodity prices have softened which will benefit BjEL margins.
5. Consumer durable division will maintain its momentum given the market positioning of BjEL products.

We expect BjEL to close fiscal FY12E with topline of about Rs 3,000 crore and EPS of Rs 14. In less than 6 months from now, markets would start discounting FY13 estimates. At about 9-10 times FY13E earnings, EV/EBIDTA of 6, MCap/Sales of 0.6, ROE of 25% and decent Free Cash Flow expected in FY2013, BjEL looks quite attractively placed.

Representativeness: Does this heuristic affect your Stock-picking?

Very often, we see in investing world that a person categorizes a situation based on his/her previous experiences or notion or belief about it rather than any objective assessment. In simple terms this is how we can explain Representative Heuristic which is a cognitive bias. Well, if one makes a short-cut decision, something like a rule of thumb strategy, this can sometimes be useful when faced with uncertainty. But as a process, representative heuristic can be limiting and almost suffering from close-mindedness when we talk about stock-picking.

The Next….

Cut back to 2002, we had so many software companies claiming to be the next Infosys. A few growth years or financial parameters, and pat came the declaration from the investing community of The Next... It was representativeness without any thorough understanding of their business or management attributes. We know most of them do not exist today, and others failed to make it big.

Cut back to 2007, we had so many engineering and infrastructure companies claimed to be the next L&T. Hefty order books and growing construction work all around and even professional analysts declared arrival of The Next... Again, it was mainly representative heuristic without any objective assessment. I don’t want to name any companies in this league but those who follow the markets would have understood which ones I’m alluding to, and look how they are struggling to keep their head above the water.

Now in 2011, you’ve a urban consumption branded stock that is highly successful in something - shoes, undergarments, pizza, coffee or whatever. Here I’m talking about success of the stock, not necessarily success of the company (my saying so can put off few but I defer that discussion for some other time). Then comes another stock in similar space, through an IPO, re-listing, analyst’s discovery or restructuring. And the analysts declare it as The Next…

The Gambler's Fallacy…

This basically means that if a fair coin is tossed repeatedly and say heads comes up 6 out of 6 times, a gambler may incorrectly believe that in 7th toss the coin is “due” for a tails and the outcome of heads is less likely. When in reality, the probability remains the same 50% no matter how many times the coin is flipped. Likewise, there is a reverse gambler's fallacy where a person may instead decide that heads are more likely since run of events or fate has all this time allowed heads consistently so why change the odds. Either way, memory of past results does not statistically influence future outcome.

To some extent, this fallacy happens in investing while extrapolating the stock trends and performance. When we look at a stock which has historically traded at high PE of 20 times and due to “turn of events” came down to say 10, Investor A will buy thinking how cheap it is, without regard to change in its business dynamics. Investor B will bet that it has now lost favour of the market and sell it.

The Reversion to Mean…

Will returns generated by that evergreen stock over the next 5 years outpace the industry average the way it has done in the last 5 years? This is the moot question. Can it be taken for granted if you do a Rip Van Winkle and come back after many years? Well, mean reversion works until it doesn’t. There have got to be good reasons that it has worked or they did something better than the pack. What needs to be investigated from investment perspective is can this competitive advantage be sustained over a longer period?  Stocks that have risen too fast like flash in a pan or beaten the normal trajectory for a short while can revert to the mean faster than one expects.

Most of the Polyfilm stocks gave such an opportunity in 2010 where decent money was made given the disproportionate market demand and fewer players (yours truly also utilized the run and sold out in time), but to have expected that this would last forever was a fallacy.

Sum up

Representative heuristics affect our stock decisions all the time. Sentiment is an integral part of the market psychology. Not very long ago, you heard your friend saying that 52-week high for this stock is so and so and now it’s available at such a lucrative price. Besides the stock and its underlying, we need to track the real drivers that decide its performance - the competition catching up, the moat melting away, the size becoming an enemy, the macro policy shifting, the hitherto tight cost structures giving away and the customer preferences changing.

We need to be sure that we are looking at the right metrics. I conclude with quote from Peter Bernstein “The fundamental law of investing is the uncertainty of the future”.