2017 - Letter to Clients

2017 has been a good year for Indian long term investors. The Nifty started the year at 8179 and ended it at 10,531, recording an impressive annual gain of 28.8% in the process. Equity remained the preferred asset class for investors this year, partly due to the continuing subdued mood in the real estate and bullion markets. 2017 has also been an impressive year for me and for all our Clients at Attainix Consulting. The average annual return of client portfolios under our advice clocked in at 53.6% this year. This is almost twice as much as the benchmark itself and is admirable by any yardstick. More importantly, all our client advised portfolios beat the benchmark Nifty by a significant margin. This is a matter of immense satisfaction for me, because it implies that our stock picking methodology generated healthy alpha (excess return above and beyond the benchmark) for the benefit of all our Clients, justifying our advisory fees! Further, it endorses our investment thesis that businesses with high degree of knowledge assets will always outperform the competition and continue to find favor with investors. The fact that we are the first and only firm that has quantified this investment thesis into programming logic that enables us to pick stocks free of human bias, only gives us an added edge!.

Which begs the question - what is the basis for our investment thesis anyway? Why do we believe in businesses with high Knowledge assets? And what are Knowledge assets? Why do businesses with high degree of Knowledge assets

have a competitive advantage in the marketplace? We will have to go back in time to answer these questions. Take a look at the graphic alongside. It shows that for the longest time in our history and until the turn of the last century agriculture was the main source of income for a majority of the population. Scale was achieved during this era simply by expanding into additional land. But land is a limited commodity and businesses had to find a way to get more from the land under their control. The invention of the steam engine and electricity enabled this need, ushering in the Industrial era. This era led to the creation of scale enabling businesses that achieved scale simply by replacing human and animal labor with machines. In this era the focus shifted from the production of agricultural produce to industrial products. This era lasted for the next 150 years or so which is when the Information era kicked in, with the invention of the computer. Just as machines in the Industrial era fastened the production of goods, computers in the Information era hastened the processing of Information. Thus in this era the focus shifted from the production of industrial goods to the processing of Information. Those businesses that could process Information quickly, efficiently and continuously were able to convert this information into Knowledge. And Knowledge is Power. This Knowledge gave such businesses a leg up over their rivals. It also gave them pricing power and enhanced their profitability beyond bounds. But it also attracted competitors who tried to replicate this process. Businesses that are able to encapsulate and institutionalize their information processing and knowledge generation process and shield it from their competitors have effectively developed an asset, which we classify as a Knowledge asset. Knowledge assets are intangible in nature – they are formed from a fluid combination of human knowledge and skills, business processes, databases, brands and supplier/customer relationships. Such is their beauty that Knowledge assets are hard to develop, maintain and replicate, but their impact is eminently visible and measurable! 

Having understood the nature of Knowledge assets, the only question left now is how do we discover such assets? That is where our icTracker software comes in – it calculates and reports the Knowledge assets (a.k.a. Intellectual Capital) of leading Indian and US businesses continuously. It provides us the basis for our simple three step stock picking process which, although described on our website, is worth repeating here.

STEP 1 – EVA check: We start by first checking whether the business is generating more money than its cost of capital. This is done by calculating the EVA (Economic Value Added) of the business. Ideally, we want to select businesses that have a positive EVA. The rationale for this check is that if the business is not able to generate at the least even its cost of capital, then it is actually eroding shareholder value. Alternately, if the business is generating more than its cost of capital, it will be in a position to fund its future expansion from internal resources, which will further decrease its cost of capital. Note that, this check will eliminate startup and fledgling businesses by design. It does not mean that such businesses are not good investments. It only means that these businesses have to prove their business model before they can be considered worthy of investing for retail investors.

STEP 2 – Knowledge assets check: This is the asset quality test. Here, we check whether the business is generating profits from traditional assets (such as land, building, machinery, cash) or from Knowledge assets. We look for businesses that have at least 50% of their total assets in the form of Knowledge assets. The rationale for this check is our belief that businesses that are generating profits from traditional assets will come under competitive pressure sooner or later, simply because such assets are not defensible. Anyone with sufficient cash can buy land and machinery. Knowledge assets on the other hand take years to build and develop and once in place, they provide sustainable competitive advantage to the business. In other words, such businesses develop a moat, which is difficult to surmount.

STEP 3 – Affordability check: In the above two steps, we have shortlisted businesses that are generating value through the use of Knowledge assets. As investors, these are highly desirable businesses because in all probability they will continue to generate sustainable profits for years to come. All that remains to do now is to find whether the stock underlying the business is affordable. For that we compare the market value of the stock to the intrinsic value of the business. Those stocks that have a low ratio of market value to intrinsic value are the ones that have not yet been recognized by the stock markets and hence worthy of our attention as investors.

This simple three step stock pricking process has not only proved its mettle during our back-testing but also provided above-benchmark returns to real Clients. Our icAdvisor service uses this exact stock picking process. In addition, when designing Client portfolios using the icAdvisor service we strive to reduce risk for our Clients by the following three actions: 

• Taking risk profile of the Client into consideration. This ensures that the stocks that we recommend match the risk taking ability of our Client. For instance, a Client who has low risk appetite and interested primarily in capital preservation will benefit from investing in established mature businesses that have a high dividend yield than from investing in emerging smaller sized businesses, which are considerably riskier.
• Selecting stocks from different sectors. This ensures that we do not put all our eggs in one basket. Rather, we divest the portfolio into multiple sectors, picking no more than one or two stocks from each sector. Sectoral impact on the portfolio, if any, is thus limited to the specific stock.
• Striving to build a perfectly diversified portfolio. All our Client portfolios are designed at the efficient frontier – it means that the quantum of each stock in the portfolio is such that it has minimum correlation with any other stock in the portfolio. This gives each stock the chance to perform independently of each other in the portfolio.

Despite all the above steps, sometimes one or two stocks in the portfolio fail to perform due to the vagaries of the market. This is the reason why we provide a free rebalance option in our icAdvisor service. Many of our Clients opted for the free rebalance this year and saw the benefit of doing so. Others chose to skip it because of satisfactory performance of their portfolios. Remember, even though the rebalance is free from our side, there is still a cost that you have to incur in terms of brokerage fees, transaction fees and government taxes.

In passing, I want to take this opportunity to thank you for putting your faith in our investment thesis and in our icAdvisor service for generating above average returns for your hard earned money. Your continued trust makes us stay committed to the vision encapsulated in our tagline – ‘Growth through Knowledge’. I believe that we can grow only when you see value in our service and growth in your own portfolios. I am available to address client queries at all times and am approachable via email or whatsapp. I am also open to feedback and suggestions and welcome you to provide the same. I also hope that if you have benefitted from our service, you will spread the word to your own friends, family and colleagues and have them share the benefit as well. 

Finally, let me wish you and your family a very happy and prosperous Happy New Year and hope that the relationship that we have built this year will continue to grow for many years to come!

Abhijit Talukdar
Founder, Attainix Consulting
SEBI Registered Investment Adviser

Invest in Stocks as per your risk profile

Risk comes from not knowing what you are doing.

Warren Buffet

Investing in the stock markets requires a study of stocks no doubt, but more importantly it requires an understanding of your own self – your expectations and objectives for investing in stock markets in the first place. Stock market investments are inherently risky and therefore the first thing to do is to understand your own attitude towards risk. Some questions that you need to ask yourself in this regard are:

• Your investment objectives – Capital preservation, Regular Income, Capital Appreciation, or a combination of these.
• The amount of time you are willing to stay invested in the markets and forget about the invested money
• Your inclination to learn more about the underlying business, the competition, the economic environment, etc.
• The frequency with which you tend to follow your stock investments – by the hour, daily, weekly, etc.
• Your mental make-up in the face of a steep market correction – ranging from sell and get out asap to buy more since stocks are much cheaper now

A professional investment adviser can understand your risk profile using a standard multi-choice questionnaire within minutes. This can range from conservative to balanced to very aggressive. At Attainix Consulting we use a five step risk profile classification and use that to advise Clients about the right stocks for their portfolio. This is not only in the best interest of the Client himself but it is also mandated by SEBI as the standard approach to be followed by all SEBI Registered Investment Advisers. This approach aligns the client’s expectations and investments objectives with his stock portfolio and thus minimizes the chances of future discontent.

Managing the risk of investing in stock markets has many elements, but the first step is to know your own attitude towards risk. As Warren Buffet likes to put it – Risk comes from NOT knowing what you are doing.

Ideal number of stocks to hold in a Portfolio

Individual Investors who manage their own portfolios often grapple with the question of the ideal number of stocks that they should hold in their portfolio. This question is very relevant since a low number of stocks can significantly increase portfolio risk while a high number of stocks can considerably dilute portfolio returns and also increase transaction costs. This question is particularly relevant to those investors who are prone to buying stocks from ‘stock tips’ that come their way via various channels, and who therefore have to decide at some point of time whether enough is enough.

It is pertinent to note that when determining the number of stocks to be held in the portfolio, investors implicitly deal with two types of risk – systematic and unsystematic risk. Unsystematic risk is the risk associated with a particular company or Industry. It can be reduced to near zero levels by holding a portfolio of well diversified stocks.  Systematic risk on the other hand, is the risk associated with the entire stock market. No amount of diversification in your portfolio can reduce it.

Hence the exercise behind trying to understand the ideal number of stocks to hold in a portfolio is one of striking the right balance between minimizing unsystematic risk and maximizing portfolio returns. While there is no right answer to this question, the factors that will influence the answer are

• The Portfolio corpus
• Stock market that you are investing in (US, India, etc.)
• Your Investment time horizon
• Your Risk tolerance

In this context, the celebrated economist John Maynard Keynes proposed in 1938 that investors should hold concentrated investment portfolios. He believed that skilled investors can maximize their long-term returns through a deliberate selection of well researched and diversified stocks. This concept has stood the test of time to this day as confirmed by the fact that fund managers of most diversified equity mutual funds hold no more than 30 stocks in their portfolios. While such funds have access to considerable research resources from a variety of sources, individual investors generally lack these resources. Researching quality stocks with the potential for generating above average returns in the long runs takes considerable amount of time and resources.

Hence at Attainix Consulting, we believe that as a thumb rule individual investors should hold no more than 15 stocks in their portfolio at a given time, which is half that held by most equity mutual funds. We also practice this philosophy when advising our Clients for the icAdvisor service, wherein depending on the four factors enumerated above, we recommend between a minimum of 5 and a maximum of 15 well diversified stocks. Even the back-testing of the icTracker software has been performed using a maximum holding of 15 stocks at any point in time and the results published on the website only confirm the superior returns that can be had from a concentrated portfolio, with the minimum of risk!

Sources:

1.   concentrated-stock-portfolios.html. (n.d.). Retrieved Feb 24, 2017, from www.maynardkeynes.org: https://www.maynardkeynes.org/concentrated-stock-portfolios.html

2.   optimalportfoliosize.asp. (2005, July). Retrieved Feb 24, 2017, from www.investopedia.com: http://www.investopedia.com/ask/answers/05/optimalportfoliosize.asp

Why do so many Indian Companies delay their quarterly results?

In my ten years of tracking Indian stocks, the one thing that has intrigued me the most is the delay with which most Indian companies report their quarterly earnings. Let me illustrate this point with a delay summary for the current quarter, i.e. quarter ended Dec 2016. In the chart below, the x-axis shows the lag in reporting earnings in days from the end of the quarter and the y-axis shows the percentage of companies that have reported their quarterly earnings within that lag. This data comes from the icTracker database which tracks more than 400 of the largest Indian companies. 

Data from the chart lead us to the following conclusions

• Less than 10% companies reported their quarterly earnings within 20 days of the end of the quarter
• Despite a spurt of reporting activity in the next 10 days, less than 30% companies reported their quarterly earnings within 30 days of the end of the quarter
• At the end of 35 days of delay, less than 50% of companies had reported their quarterly earning
• At the time of writing this article, it is exactly 39 days of delay and yet less than 60% of companies have reported their quarterly results as of now.
• More than 40% of companies will be reporting their results with a delay between 40 and 45 days – which is the SEBI mandate for maximum delay.
• More than 20% of companies will be reporting their results on the last 2 days before the mandated reporting period end.

Isn’t this situation very appalling? This kind of lackadaisical attitude in reporting quarterly earnings by Indian companies not only smacks of apathy towards the capital markets but also betrays the trust with which investors have invested their hard earned money in such companies. More importantly it also raises questions in the mind of the investor about the (lack of) prevailing Corporate Governance within the Company. Management credibility is surely eroded in every company that this happens on a regular basis.

Why then do managements delay results so much at the risk of seriously eroding their own credibility? Here are some plausible answers and my own responses to them.

We have many locations and subsidiaries and have to collect and collate data from all of them - If large companies such as Infosys, TCS and Reliance Industries which have multiple locations and subsidiaries – and many of them overseas subsidiaries - can report their quarterly results within 15 days of the end of quarter, so can you.

We are ready, but our auditors are not available - Appoint an auditor who will be available.

A complete audit takes a lot of time - Investigate and fix the reasons for the delay in the audit. Consider reporting unaudited results with only a limited review by the auditors in the meantime.

Our auditors have submitted audit findings which we need to rectify - Do it quickly. This should not warrant delays of weeks.

And to those companies that delay results with the intent of delaying bad news, remember that the Internet is a great leveler. Capital Markets have an uncanny knack for sniffing out news about bad results much before the company reports them. Hence, discovery of such malicious intent only ends up denting the credibility of the management. On the other hand, the few companies that have made investments and efforts in reporting their earnings as quickly as possible not only find favor with analysts, but also with investors in the long run.

Stocks provide the best return in the long term

When we buy a business, we try to look out and estimate the cash it will generate and compare it to the purchase price. We have to feel pretty good about our projections and then have a purchase price that makes sense. Over time, we have had more pleasant surprises than we would have expected.

Warren Buffet

Long term investing requires an understanding of the performance of various asset classes over an extended period of time. Traditionally, only two asset classes have existed – debt and equity. However, as investment options have extended beyond the capital markets, other options such as real estate, currency and gold have opened up and found favor with investors. 

Real estate is a practical investment option only for those investors who can afford a large ticket size, high transaction and switching costs, long holding periods and the risk of illiquidity. 

Currency markets are not meant for long term investors at all – rather they are meant as a means of hedging the exchange rate risk of businesses having income in foreign currency. 

Gold is a defensive asset class, since its primary objective is to serve as a hedge against inflation. Nonetheless, since Indians have an insatiable appetite for holding gold assets, we will consider it as an asset class for the purpose of this article. 

The following table shows the return from PPF (proxy for debt), Gold and the Nifty (proxy for equity) over 5 different time periods – ranging from 1 year to 15 years.

Date	PPF rate	Gold rate	NSE Nifty
1-Jan-02	9.50%	4274	1058.85
1-Jan-03	9.00%	5320	1093.6
1-Jan-04	8.00%	5989	1880.35
1-Jan-05	8.00%	6128	2080
1-Jan-06	8.00%	8400	2836.8
1-Jan-07	8.00%	10800	3128.2
1-Jan-08	8.00%	12500	6136.75
1-Jan-09	8.00%	13670	2963.3
1-Jan-10	8.00%	16665	5200.9
1-Jan-11	8.00%	20688	6177.45
1-Jan-12	8.60%	27322	4640.2
1-Jan-13	8.80%	30893	5937.65
1-Jan-14	8.70%	28430	6323.8
1-Jan-15	8.70%	26699	8272.8
1-Jan-16	8.70%	24966	7938.45
1-Jan-17	8.10%	27445	8210.1
Annual Return
1 year	8.10%	9.93%	3.42%
3 years	8.50%	-1.17%	9.09%
5 years	8.60%	0.09%	12.09%
10 years	8.36%	9.78%	10.13%
15 years	8.31%	13.20%	14.63%

As can be seen from the above data, debt returns are consistently above 8% over the long term and appear to be a good option, especially for risk averse investors. However, if we factor in inflation even at a modest rate of 6%, the real rate of returns from the debt market shrinks to a meager 2%. Clearly this is not enough of a reward for long term investors.

Turning next to Gold, we see that it has offered double digit returns over the long run. However, this is primarily due to price appreciation during the years 2006-2012 when inflation in India was quite high. As inflation has moderated in recent years, returns from Gold have stagnated, as proved by the 3 year and 5 year gold return data above. 

Finally, turning to equity we see that the Nifty has returned close to 15% over the long term. This is the expected long term return from Indian equities and it has also been established by numerous studies. At this level of return, the investor is left with a real rate of return of 9% after budgeting for inflation at 6%, which is a decent return for any long term investor. However, the Nifty is an index of the top 50 large-cap stocks in India – which by definition do NOT provide the most capital appreciation. That comes from mid-cap and small-cap stocks. Investing in equities can be very rewarding, but the challenge lies in picking stocks with a high return potential. That is where an Investment Advisor can help.

At Attainix Consulting, we have developed the icTracker software that assesses the Knowledge Assets (aka Intellectual Capital) of the underlying business every quarter. The reason for doing this is simple - Knowledge Assets provide long term competitive advantage to a business. These are the businesses with the most return potential especially if they have not yet been noticed by the capital markets. Back-testing of the icTracker shows that returns from such stocks can be easily more than twice the expected returns from the Nifty! Now, wouldn’t you consider that as an icing on your cake?