Friday, March 22, 2019

Value v/s Growth Investing

In the business world, the rearview mirror is always clearer than the windshield.



Warren Buffett
Successful stock market investors are often bracketed in one of two categories depending on their investment style i.e. Value Investor or Growth Investor. Both these styles can generate handsome returns for investors, yet they take diametrically different approaches to stock picking. Knowing the difference between these two styles is important in building an investment strategy and a diversified portfolio. So let us first understand the key differences between these two highly popular styles of investing, which I have tabulated below for ease of understanding


Value
Growth
Focus
Distressed companies
Companies with growth potential
Type of Company
Well established
Young
Approach
Buy low, sell high
Buy high, sell higher
Timeframe
Long-term
Short-term
P/E ratio
Low
High
Investing basis
Ratio of current share price to intrinsic value
Inter-firm and industry-firm comparisons
Risks
Wrongly assessed value
Wrongly projected earnings
Tendency to outperform
During high GDP Growth and high inflation periods
During low GDP Growth and low inflation periods
Entry pricing
Undervalued
Fair to overvalued
Volatility
Less volatile than the broader market
More volatile than the broader market

Value investing is about finding diamonds in the rough. Value investors seek to invest in businesses that are trading at a price much lower than their intrinsic value. Hence such shares are available at a bargain. They bet that markets will discover the correct value of such shares over a period of time and the price will rise. The businesses underlying such stocks are established businesses with strong cash flows and a history of consistent dividend payouts. Hence even when the price of such stocks is not appreciating much, dividend distribution may still satisfy investor’s return appetite for a while. Such stocks can become undervalued for many reasons, such as if a promoter of the company is involved in a personal scandal or if the company is caught doing something unethical. Stocks markets generally punish the occurrence of such incidents by pushing down the stock price steeply. At this point value investors step in, betting that such incidents will soon fade from public memory and the stock price will be restored to its original value. Legends of investing including Benjamin Graham and his disciple Warren Buffett, have long championed the cause of value investing

Growth investors on the other hand seek to find stocks that have the potential to outperform either the overall markets or a specific sub-segment of the market for a period of time. Growth stocks are associated with high-quality businesses whose earnings are expected to continue growing at an above-average rate relative to the market. Such stocks are generally costlier compared to their intrinsic value, but investor expectations of continued growth keeps pushing their price even higher. Such businesses often re-invest their earnings into their own growth and hence do not generally pay dividends. Investors therefore look for capital appreciation in such stocks as the only means to justify their investing decision.

Which style is better?
The answer to this question depends on the investor’s own risk profile, investing time horizon and current state of the economy. Conservative to low risk investors will prefer value stocks over growth stocks. Passive investors with a long time horizon will also prefer value stocks over growth stocks. If the economy is growing steadily then value stocks may do better than growth stocks. On the contrary, investors with moderate to high risk profile will find resonance with growth stocks. Active investors with a short to medium term time horizon will find growth stocks attractive. Finally growth stocks will certainly find more favor with investors when the economic growth itself is low.

What to Do?
First of all assess and understand your own risk profile. This will give you a good idea of how you should be investing the stock markets. Secondly assess the current economic climate on just two parameters – GDP growth rate and inflation rate. This will tell you what type of stocks to invest in. As you do this keep in mind that it is difficult to determine exactly when economic shifts will occur. Therefore if you want to err on the side of profits, you should combine elements of both value and growth investing with occasional rebalancing of your portfolio. This approach will allow you to benefit from each strategy regardless of the prevailing economic climate. This is also the approach that we follow when we pick stocks for our Client’s portfolio using our icAdvisor service. Do browse the stocks from the icTracker database that are used for delivering this service and feel free to revert with queries, if any.

Sunday, February 24, 2019

Berkshire loses $25bn for the qtr. Buffett soothes the pain with words of wisdom.

If you call a dog’s tail a leg, how many legs does it have? Four, because calling a tail a leg doesn’t make it one.


Abraham Lincoln, re-quoted by Warren Buffett

Omaha-based financial conglomerate Berkshire Hathaway (NYSE: BRK.B) reported a staggering loss of $25.1bn for the December 2018 quarter largely due to its 27% holdings in Kraft Heinz (NYSE: KHC), which itself reported a $12.6bn loss in the fourth quarter. Kraft Heinz also wrote down the value of its iconic brands by $15.4bn and disclosed an SEC investigation into its accounting policies, procedures and procurement related internal controls. This news spooked the stock markets which wiped out more than $12bn in the stock’s market cap last Thursday and left its shares trading at its lowest value in the past 4 years. All of this had a cascading effect on Berkshire which had to mark-to-market its losses in KHC as expenses as per new regulatory changes that are part of GAAP. Despite this huge loss for the quarter, Berkshire reported annual profits of $4bn for the entire calendar year of 2018. In his letter that accompanies the annual results, Warren Buffet - chairman of Berkshire - warned shareholders that they should get used to such huge swings in quarterly profits because they own a huge equity portfolio worth $173bn which can fluctuate by up to $2bn in a single day! For the benefit of investors, here are nuggets of wisdom that I could glean from his letter this year.

  • Focus on operating earnings (EBITDA) rather than Net Profits. Berkshire goes one step further than EBITDA and includes manager compensation and restructuring expenses (if any) when calculating operating earnings. This conservative approach is in stark contrast to the frequent Wall Street practice of excluding a variety of real costs when computing operating earnings. For the record, Berkshire’s operating earnings soared 71 percent from a year ago.
  • Book Value has lost its relevance it once had. Despite the volatility of stock markets, market price provides the best measure of business performance.
  • Succession planning at Berkshire has been executed beautifully and is working like a charm.
  • Berkshire’s business goal remains unchanged over the years i.e. to buy well-managed businesses that have durable economic attributes at reasonable prices.
  • Buffet favors buyback decisions by investee companies. His reasoning is that when earnings of investee companies increase and their shares outstanding decrease (due to buybacks), then the investor’s pie increases without any additional cash outflow to the investor.
  • Berkshire is a financial fortress and is sitting on more than $112bn in cash and cash-equivalents. At least $20bn of this cash is untouchable as a safeguard to protect the insurance business from losses resulting from external calamities. The remaining cash is not getting deployed because in the current market, prices are sky-high for businesses that have decent long term prospects. Berkshire has been holding more than $100bn in cash for six straight quarters now!
  • Buffet does not focus on quarterly results and neither does the company give out any earnings estimate. His reasoning is that focusing on quarterly numbers encourages bad corporate behavior and induces managers to start ‘fudging’ earnings in order to meet their targets.
  • The reduction in US corporate tax rate from 35% to 21% greatly boosted the earnings of Berkshire starting last year. Consequently it also boosted the intrinsic value of Berkshire stock.
  • Berkshire’s insurance business is the engine that has been propelling its growth since 1967. It has operated at an underwriting profit for 15 of the last 16 years, except 2017.
  • Berkshire uses debt sparingly for financing its operations, except for its asset heavy businesses like railroad and energy. Berkshire does not need to use debt because it has amassed a net worth of $349bn over the years and also leverages the float provided by the insurance business.
  • Buffet attributes much of Berkshire’s success to the American tailwind – a reference to the steady growth in the American economy over the past decades. In the future he hopes to invest significant capital across American borders as well.

The subtext

Reading between the lines of Buffet’s letter, here are some points that I noted for myself.

  • The world’s greatest investor is not infallible and his investment in Kraft Heinz is proof that even he can make mistakes – big mistakes!
  • Buy and Hold as an investment strategy does not work, again as proved by the huge loss reported by Kraft Heinz. It is therefore prudent to always watch for warning signs of trouble and exit a troubled holding before disaster strikes. Could Buffet have seen this one coming? Sure he could, you could too. Take a look at the page for Kraft Heinz from our icTracker database. You will observe that Economic Value Added (EVA) for this stock was continuously negative until March 18 when it went slightly positive for the first time. Thereafter it turned negative once again in June 18 and September 18. That was two quarters of warning and enough time for Buffet to exit his holding in Kraft Heinz during that period.
  • Does Buy and Hold strategy encourage emotional bias towards a stock? It possibly does, again as shown by the Kraft Heinz episode. If as an investor you ignore the warning signs of trouble despite obvious indications then you are definitely afflicted by emotional affection towards the stock, which is never a good thing for any long term investor.
  • Do tailwinds exist in economies other than the American economy? Sure they do. Buffet himself admits so and is in fact preparing for investing significantly in other emerging economies (such as India IMHO). Berkshire’s recent investment of $300mn in Paytm is proof and is just the beginning. Therefore we can expect more action from him in the future in the sub-continent.
  • Despite the extra-ordinarily big loss for the quarter, Berkshire stock price has compounded at an annual rate of 20.5% from 1965 until 2018, in contrast to the S&P500 which has compounded at only 9.7% during the same period. In other words, a dollar invested in the S&P500 in 1965 would have appreciated to $150.19 by the end of 2018. The same dollar invested in Berkshire however, would have appreciated to a whopping $24,726.27 in the same period! In the process, it would have outperformed the S&P500 by a multiple of 164! The question naturally arises - should you invest in Berkshire at this time? Let me put it this way – the $25bn loss is too big even for Berkshire to digest quickly. If you are already invested in Berkshire, then you can ride out the storm along with Buffet. If on the other hand you are planning to make a fresh investment today in the stock markets today, there are many more attractive options available at this time.

Happy Investing!

Monday, February 18, 2019

Why are fund managers unable to outperform the Nifty?

The most important quality for an investor is temperament, not intellect.
Warren Buffet
In the past one year we have observed a very strange and perhaps unique phenomenon in the Indian stock markets. Out of the 289 equity mutual funds (regular) which invest in the Indian stock markets and for which performance data for the past one year is available (source: amfiindia.com, annual performance data from 16 Feb 2018 until 15 Feb 2019), only 63 funds managed to outperform their corresponding benchmarks. In other words only 21.8% of such funds could deliver alpha returns when compared to their benchmarks. This data is shown in summary format below:


Fund Category
Outperformers
Total Funds in category
Outperformer Percentage
Smallcap
14
17
82.4%
Midcap
17
25
68.0%
Contra
1
3
33.3%
Sectoral
17
76
22.4%
Multicap
6
35
17.1%
ELSS
4
42
9.5%
LargeMidcap
2
23
8.7%
Largecap
2
33
6.1%
Value
0
12
0.0%
Focused
0
18
0.0%
DivYield
0
5
0.0%
All
63
289
21.8%
Table 1 : Funds outperforming their benchmark, by category


We can see from the above table that except for Smallcap and Midcap funds, all other equity funds failed to beat their corresponding benchmarks in the past one year. Almost 4 of 5 funds underperformed their own benchmarks. How is it possible that so many experienced, skilled and highly paid fund managers failed to read the markets correctly in the past one year? Granted that the stock markets faced spells of high volatility in the past year, but the benchmarks would have been as volatile as the fund itself. Does this mean that most fund managers panicked during times of volatility and experienced a double whammy thereby getting hit on the way down as well as back on the way up?

Dismal as this picture is, it becomes even more depressing when we change the goalpost slightly and compare each fund’s performance against the Nifty, instead of against its own benchmark. Here is how that picture looks like:

Fund Category
Outperformers
Total Funds in category
Outperformer Percentage
Sectoral
9
76
11.8%
Multicap
2
35
5.7%
Midcap
1
25
4.0%
Largecap
1
33
3.0%
Value
0
12
0.0%
Smallcap
0
17
0.0%
LargeMidcap
0
23
0.0%
Focused
0
18
0.0%
ELSS
0
42
0.0%
DivYield
0
5
0.0%
Contra
0
3
0.0%
All
13
289
4.5%
Table 2 : Funds outperforming the Nifty, by category

This table shows that in the past one year only 13 of the total 289 equity funds outperformed the Nifty. And of those thirteeen, 9 were sectoral funds which were primarily oriented towards the Information Technology sector. The question arises at this point, what was the Nifty return in the past one year. It was a meager 3.14% mind you. And yet more than 95% of skilled, qualified, experienced and highly paid fund managers failed to make more than 3.14% from the stock markets in the past one year! What can we attribute such huge underperformance to? Is there some superior intelligence that is more insightful than the collective intellect of more than 95% of the fund managers in this country? On the face of it, that is what it looks like. The other explanation could be that fund managers in general have a herd mentality and panic collectively during times of high volatility. 

Let’s dig deeper and look at the performance of the Nifty components themselves. Here is a summary of their performance in the past one year:

Performance range
Total stocks
-15% and below
19
-15% to 3.14%
12
3.14% to 15%
5
15% to 30%
8
30% and more
6
Total
50
Table 3 : Performance of Nifty components in past one year

As shown in the above table, of the 50 stocks in the Nifty only 19 outperformed the Nifty during the year. In other words less than 2 in 5 of the Nifty stocks outperformed the Nifty during the year. What this implies is that all fund managers had to do was to have a few of these 19 stocks in their folios in order to compete with the Nifty. Yet a vast majority of them (more than 95%) failed to do exactly this. Was it so difficult to identify at least a few of these 19 stocks at the start of the year? Seemingly it was. It shows that nobody is infallible, regardless of what the mutual fund commercials will have you believe day in and day out with their ‘Sahi Hai’ campaign. 

What to Do

If you are a Mutual fund investor you have to realize that fund managers are not as smart as you wish them to be. The data clearly confirms this fact and it is indisputable. This logic can perhaps be extended to portfolio managers who run Portfolio Management (PMS) schemes as well, but I do not have the data to support that argument at the moment. If you are a PMS investor, your own experience in the past one year with the performance of your fund may confirm my point of view. Either way, in such difficult times it is handy and especially useful to have an open line of communication with your investment advisor. Ask incisive questions about the non-performance of specific stocks in your portfolio to your advisor, understand the reasons for the same and then convince yourself about the way forward. Nobody is infallible including your advisor, but at least a direct conversation between you and your advisor will make both of you aware of the situation and then make him/her work out ways to deal with it going forward. Hopefully both of you will emerge as better investors in the process.