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Mailbag: Why do you choose such simple criterias for shortlisting stocks?

We received a question in comment section of our last post on selecting 10 stocks to buy in next market crash. The question asked was very simple, but relevant…

 
“Why do you guys choose such simple filters for shortlisting stocks? There are more comprehensive and well proven methods of doing the same.”
We will first explain a little about these 5 filters and then answer the question –
 
Filter 1: Management (Atleast Decent)
 
The last two words of this filter, ‘atleast decent’, make this a completely subjective criteria. We believe that we are average investors. Hence, we are the last ones to receive company / promoter related news, leave alone insider information. Hence, in the event we do come to know that management is not trustworthy (read decent), then it means that there is more negative news which has not even come out in public domain. Isn’t it? Hence, we will prefer to stick with companies with ‘known decent’ promoters / management.
 
Filter 2: Not Highly Cyclical
 
Some experts say that one should buy cyclical business at high PEs. It is at these times, when things are about to turn around for better. They may be right. And sometimes, it seems logical on face value of the argument. But we are not sure. Frankly, we haven’t devoted adequate time to analyzing cyclical businesses. And hence, we don’t understand them too well. Also, highly cyclical businesses are highly uncertain. Such companies are at the mercy of the economic cycles. So it’s better that we avoid such companies.
 
Filter 3: Atleast Average Growth Potential
 
If the underlying business does not have any growth potential, then how can we expect the stock to move up? We should never forget how Kodak, a great company which did not embrace the advent of digital photography and how it paid the price with its bankruptcy.
 
Filter 4: God Dividend Record
 
We just love dividends. That is all we have to say. 🙂 But we have a reason for it. You can read it here.
 
Filter 5: Are we ready to hold the stock for 10 Years?
 
Mr Buffett once remarked, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”Being self-claimed long term investors, we ourselves would like to hold stocks of great businesses. We would love to act like owners of companies. And when a great company is going through tough times, the owners don’t sell and runaway. They stick with it. They know that when times will change, the company would be back. And in a much better shape.
 
So now, we are back to our original question…
 
Why do we use such simple filters??
 
The primary reason for using such simple filters is that these have worked for us. It is easier to evaluate stocks on these filters than more complex quantitative ones. Though we do use such quantitative metrics in our case studies of individual stocks, we always prefer to keep things simple. We try to stick with proven businesses. We try to find indicators of overall pessimism in the market, so that we can be a little sure that we are being greedy when others are fearful. We know that by following these filters, we are simply eliminating the possibility of finding those 50 and 100 baggers. We are restricting ourselves to a very small universe of 40 (or max 50) stocks. But we accept this tradeoff. We don’t want to lose money in stock markets by taking very risky bets. We know what we are good at and we will prefer sticking to our strengths. Over time, we will increase our expertise in other areas and may be, would be able to find the next multibagger. As of now, we are happy to lay a strong foundation for our long term portfolio.
 
We hope this post clarifies the doubt which our reader(s) had. 🙂
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Starbucks in India: Choose between a Coffee for Rs 150 or Rs 1.65 Lacs from SIP?

Starbucks has finally opened its first store in India. Being in Mumbai, we got an opportunity to check out the store on very first day. Lucky us… 🙂

 
Starbucks in India
From Starbucks (India) website
 Checking the menu, we found that a cup of coffee could cost anywhere between Rs 100 to Rs 200, depending on the type of drink. Though this does not seem much at first, if it does become a part of the routine for the young generation, then it could eventually turn out to be a bit costly. Assuming one makes a visit every week and shells our Rs 150 (in between Rs 80 and Rs 200) for a coffee, one would end up spending about Rs 600 a month on coffees.

Now, if this amount was invested on monthly basis (SIP) in a good mutual fund scheme, then assuming 15% pa growth, the amount would have become Rs 1.65 Lacs in 10 years. You can calculate the same yourself by using a SIP Calculator.

 
A Snapshot from SIP Calculator (Source: HDFC MF)
Now don’t think that we are against coffee or enjoyment. Instead of coffee, you can choose expenditures made on more unhealthy habits like cigarettes. And the result would be more or less same. All we want to convey is that if you are ready to invest systematically for the long term, you are bound to earn handsome returns.

Thoughts on starting a new portfolio – Part 1

In our post on changing Stable Investor’s approach, we mentioned that we plan abandoning our existing portfolio (Monk’s Portfolio). We also plan to start a new portfolio named Dead Monk’s Portfolio (DMP). Reason for choosing this name is given in next few lines.Why Dead?

We want our portfolio to be so easy to maintain that even a dead person is able to do it, i.e., without much thought and activity. 🙂

Why Monk?

For us, monks are ultimate symbols of calmness, serenity, stability and longevity. These are some of the terms which we want our portfolio to be associated with.

Note – The topic may seem a bit haywire as it documents a loud thinking session.

Here are some of our thoughts –

  • Dead Monk’s Portfolio (DMP) can follow a Core –Satellite approach in which core could account for 60-75% of portfolio and Satellite the rest 25-40%
 
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  • Core can be made up of high dividend yield large cap stocks OR low PE, average to good dividend yield large & mid cap stocks OR low to average PE, good to average dividend yield large and mid cap stocks, trading below their book values OR any other combination of parameters and concepts like Magic Formula.
  • We prefer companies which pay regular & increasing dividends as the proceeds can be used to buy more stocks or as a source of passive income. Also these stocks are stable and less risky. But according to experts, this stability comes at the price of lower returns. And as stable long term investors, we are ready to accept non-astronomical returns.
  • Satellite can be made up of companies which offer long term above average growth and which may not be doling out dividends. Such companies generally prefer to invest profits back into the company which may be growing at rates higher than company’s cost of capital OR for novices like us, higher than overall market growth rates.
  • But how do we find stocks which offer stability as well as good dividends? There are many ways of finding such stocks. One is to check the indices that track dividends. Another is to check lists of highest dividend yielding stocks. But such lists throw up names which we are not comfortable investing in : so it would be a good idea to take such lists and add a filter or two like market cap, profitable in last 5 years, etc).
  • Another approach can be to use stock screeners with conditions like large and mid caps, dividend yield of more than 3%, consistent & increasing dividend payouts in last 5 years, trading close to 52 week lows, low PEs  etc. 
  • We are compiling a list of good stock screeners for this purpose and would share them shortly.
  • Another question which has been raised is that does it even make sense to bother about capital appreciation of the Core portion of such a portfolio?
These are just some of our preliminary thoughts and we are still not done with our analysis. We are also exploring other ideas which have not found mention in this post. Let’s wait till the time we finalize the first version of our new portfolio approach (with blessings of the Dead Monk in the grave). 🙂

PE Ratio of Indian Markets – A Long Term Analysis

Price to Earnings ratio (P/E ratio) is a measure of price paid for a share relative to the profit earned by that share; i.e.


You can read more about P/E Ratios here & here.


They say that it is best to invest when valuations are low.

Sensex is currently (December 2011) trading at a P/E of 16.5. So is this the right time to invest? Is this what experts call a low valuation? We at Stable Investor have decided to answer these questions.

Analysis of Sensex’s last 12 years data (from 1stJan 1999 onwards) reveals a few interesting points –
  • Over any rolling period of 5 years in last 12 years, Sensex has not given negative returns! So if you are ready to stay invested (in this case, in an Indian Index Fund) for a period of 5 years, you won’t lose money. 
  • Returns earned during last 12 years, when segregated on basis of P/E ratios are –
Returns (Over 3 & 5 years) & P/E Ratios

This clearly indicates that at current P/E of 16.5, we have a chance of earning more than 15% per annum for next 3-5 years!

(Caution – This statement is made on basis of historical data. Past performance is no guarantee of future performance.)

So after analyzing this interesting relationship between P/E Ratio and Returns, what does a Stable Investor do?
  • Stable Investor is now in a better position to respond to people’s view that it is better to invest in markets of lower multiples (P/E). Our analysis clearly shows that if investor invests in markets of lower multiples, probability of earning high returns is very high. 
  • P/E Ratios are still relevant for judging overall valuations of markets, if not individual stocks. 
  • It is advisable to invest when markets are trading in early teens (i.e. 13<P/E<16). It has also been seen that Indian markets tend to stay between P/E Multiples of 12 and 24 (Read Indian Markets PE 12 to 24 for details) 
  • P/E Ratio is a beautiful indicator of market’s overall valuation. But before making any buy or sell decisions, an investor should also look at a lot of other information/data.
Update – You can check the latest PE-Ratio Analysis of Indian Markets in 2013 or 2012. For constant updates about Indian Markets’ PE, P/BV Ratios, please check the State of Indian Markets.

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Believe Us, You are not Warren Buffett!

Oracle of Omaha, Warren Buffett has been in news lately for tipping his son Howard Buffett to be the new chairman of Berkshire Hathaway (source). By profession, Howard is a farmer. Company’s investment strategy would still be governed by the CEO and Board of Directors. But Warren Buffett’s son would serve as a Custodian of Company values rather than take part in regular day to day affairs.

So what makes Warren Buffett so special? On very first page of his famous and revered Annual Letters to Shareholders (2011, 2012), it is mentioned that from 1965-2010 (a period of 45 years), Berkshire has had a CAGR of 20.2% i.e. your money doubles every 4 years!

Can average investors like you and me, who don’t know so many things beat that performance?

Can we earn 20% year on year for decades? I doubt that.

you are not warren buffett
You are not Warren Buffett. Period.
 

Such superlative performance can have have the effect that average investors try to become the next Warren Buffett. But in doing so, they would be making a grave mistake. That’s because-

  • Most profits made by Berkshire come from owning entire companies, which an average investor is incapable of doing.
  • Though Buffett gives independence to individual companies’ management, he always keeps a tab on them to see that they don’t deviate from Berkshire’s simple but sacred principles. As far as an average investor is concerned, he doesn’t even meet any member of the company’s management.
  • Buffett owns the perfect business of insurance. This is equivalent of having a constant source of interest-free loans given to buy shares of other companies. Now who among us can boast of ownership of such a business?
  • Inspite of being famous for having a holding period of forever, Buffett occasionally sells stocks. Unlike us, he doesn’t require money for his basic needs. He sells when he does not see value in his investments or wants to fund more lucrative investments.
  • Unlike average investors, he has access to loads of insider information and has an army of people who can do comprehensive number crunching for him. This augments his investment decision making process.
  • Buffett is a fast and voracious reader. We can’t imagine an average investor to read Forbes, Wall Street Journal, Financial Times, New York Times, USA Today and Omaha World-Herald every single day of the year, decade after decade. (For Indian Investors, replace above names with Indian financial newspapers and publications). Even if a person does read a few good publications, the question arises whether he will he be able to utilize and interpret this information to his advantage?
  • An average investor does not get deals which are skewed heavily in his favor. Buffett got one hell of a deal from Goldman Sachs, where he was earning $500 million every year for doing simply nothing!!! And when Goldman Sachs decided to redeem the preferred stocks, Warren was the unhappiest person in the world as any normal person would hate to lose a free cash flow of $500 Million an year. Very recently, he entered solar energy via Topaz. An interesting article shows once again that why and how he lands up such delicious deals.

Warren Buffett had once said – My wealth has come from a combination of living in America, some lucky genes, and compound interest”. Out of these three, only compound interest, is under our control.

Though compounding has a peculiar problem, it still works for those who are patient enough.

So an average investor should focus more on buying good stocks and allowing compounding to show its magic. But instead, what he does is that he is constatnly on a lookout for stock tips and is looking to find the next multibagger. As a sensible investor, one should be prepared for opportunities which markets throws up every now and then. And when that opportunity comes, be prepared to take advantage of them.