The Making of a Value Investor

Introduction

The genesis of this book lies in the response to a tweet of mine:²

I found the suggestion very helpful and interesting. Shortly thereafter, I started work on this book.

I spent ten dollars on a journal in late 2014, and I consider it to be one of the best value investments I ever made. Since that day, I have been keeping track of my investing decisions and subsequent developments in a journal. This habit has helped me a lot in learning about myself and improving as both an investor and an individual. I receive a lot of valuable feedback and use it to correct my biases. I also have maintained a personal archive of the media commentary and investor behaviour during various episodes of market panic … I find that it is highly beneficial to refer to this information whenever the market undergoes its periodic steep corrections. Human behaviour in the markets has not really changed much over time.

—The Joys of Compounding

My writing frequency in the journal witnessed a sharp rise from 2018. I experienced a brutal bear market in India from January 2018 to February 2020, followed by a pandemic-induced market crash in March 2020. By the time the bear market ended, I had evolved from being a highly concentrated portfolio investor focused on statistically cheap securities, to one focused on quality and prudent diversification. The entire experience ingrained in my mind the significance of resilience and longevity—the key to compounding. This book covers the journey of my evolution as an investor during a bear market, and my reflections and learnings along the way.

A bear market teaches one the reality of the harsh math behind compounding in reverse, with fraudulent management teams or weak business models. This is when we realize the deep wisdom, in Andy Grove’s words, that ‘bad companies are destroyed by crises; good companies survive them; great companies are improved by them’. And this is the catalyst for the transformational phase when investors can take huge strides and begin to rebuild their portfolios to include strong high-quality businesses. The key, then, is to not succumb to greed in future bull markets.

—The Joys of Compounding

My learning curve as an investor began accelerating from June 2018, as the bear market in India gained steam. I started taking copious notes in my journal, and there was an important reason for it.

The greatest learnings always come from a bear market, and these lessons bear fruits for an entire lifetime. Never let a bear market go to waste.

—The Joys of Compounding

Readers of The Joys of Compounding will recall the following important graph from the beginning of that book, along with my message in its footnote.³ This is compounding in action. This illustrates what I experienced in 2018, after many years of determined efforts amid repeated setbacks. Resilience is a superpower.

Having equipped themselves with the fundamental principles of investing through my previous book, those readers are now about to step on the exponential part of the J-curve, and experience the power of compounding knowledge in action, just like I did from mid-2018. While most of the stock names and case studies are from the Indian market (where my personal portfolio is primarily invested), the bulk of the learnings and investing principles are universal, timeless and applicable globally.

I wish all my readers great success in their lives and investing journeys.

The Bear Market

(1 January 2018–24 March 2020)

After the roaring bull run in mid-caps and small-caps in India between 2014 and 2017, investors were in for a nasty shock. The gut-wrenching bear market that began in mid-cap and small-cap stocks from January 2018 lasted an agonizing twenty-seven months, and concluded with the COVID-19 market crash of March 2020 (see Figures 1 and 2).⁴

Figure 1: Huge price erosion in mid-cap stocks

Figure 2: Decimation of stock prices in small-caps

By the time the bear market ended, there was a widespread sense of utter hopelessness among most investors as the mid-cap and small-cap indices had collapsed more than 45 per cent and 55 per cent respectively from their January 2018 highs. Thousands of listed stocks in India crashed more than 60–80 per cent during this period. Panic in the market started being witnessed from June 2018. That’s where we begin.

3 June 2018

•As cheap keeps getting cheaper in this market, there is an increasing perception among investors that a stock that is cheap isn’t ‘quality’.

•I am noticing that the frustration index has shot up everywhere, and people are becoming very aggressive on social media. We need to stay calm and keep progressing in this journey, and social media is not helping many, as I can see.

•Apex Frozen Foods looks interesting. Manufacturing capacity will rise from 15,000 tonnes to 35,000 tonnes, of which 5,000 tonnes will be in the higher margin value added (ready to eat) category. This should lead to profit growth outpacing revenue growth. Shrimp export prices in India have fallen by about 14 per cent in May. But Indian rupee (INR) depreciation should support revenues and help the company absorb some of this realization fall. Unfavourable base effect of high realizations of last year should last till the end of this month, so Q1 may be impacted slightly, but Q2 onwards, it should be back to business as usual.

Author’s Note

In India, the financial year for most companies is from 1 April to 31 March. Q1 thus refers to the April–June quarter; Q2 refers to July–September, and so on.

•Initial Public Offerings (IPOs) of some good companies in the shrimp processing sector are expected in future, so the scarcity premium enjoyed by the currently listed players like Apex Frozen Foods and Avanti Feeds should come down over time.

•It’s very difficult for me to understand the financial reporting of infrastructure companies in India. I have always tried to avoid such stocks to the maximum extent possible.

Author’s Note

If you do invest in infrastructure stocks in India, try to avoid them ahead of an upcoming national elections year. In 2018, infrastructure stocks should have been completely avoided since 2019 was expected to witness a tightly contested national election. In most cases, one should avoid politically sensitive stocks as they are not conducive for long-term investing.

•Read a very informative thread on ValuePickr Forum ⁵ about the current bear market in mid-cap and small-cap stocks. There are many great insights in it. Essential reading for all investors.

•Hearing bullish commentary from a textile company which I have studied in the past. I would be cautious. Their goalposts keep shifting a lot. Previously, the company’s 2020 vision got shifted to 2022, and now, it’s been moved to 2023. It’s very important to be aware of the history of individual companies. This company just keeps making capex announcements and piling on debt at a time when competition is intensifying in its industry.

4 June

•Fall in indices from January highs:

•Nifty—3.9 per cent

•Mid-cap—14 per cent

•Small-cap—20 per cent

•Broader market is in real pain. Sentiment is pretty bearish among most investors. Many stocks that were retail investor favourites have lost more than 50 per cent in the past four months, and include HDIL, HCC, Kwality, Strides, Manpasand Beverages and Punjab National Bank (PNB), among many others.

•Meanwhile, the expensive blue-chip stocks continue to do well amid a flight to safety. In the last four months:

•Bajaj Finance—up 21 per cent

•Mahindra & Mahindra (M&M)—up 18 per cent

•Kotak Bank—up 18 per cent

•Tech Mahindra—up 16 per cent

•Hindustan Unilever—up 14 per cent

•Asian Paints—up 12 per cent

•Some analysts are recommending the stock of Munjal Showa by stating its low trailing price-to-earnings (P/E) ratio of 9x and debt-free balance sheet without considering the fact that nearly 75 per cent of this company’s sales come from one single customer (Hero MotoCorp). Markets don’t give good valuation multiple to single-client companies.

•The fancied micro-cap stocks of 2017 are now being termed by investors as ‘operated stocks’.

•In this bearish environment, it is best to stay with stocks having earnings growth visibility. When the market sentiment improves in future, these stocks will be the ones to recover the fastest.

•During a bear market, even if you buy good stocks cheap, you need to be mentally prepared for further drawdowns.

•Sudden crash in the broader market. What a bloodbath in small-cap stocks! So many of them are hitting lower circuits—Rain Industries, HEG, Graphite India, Himadri Speciality Chemicals, Goa Carbon, Butterfly Gandhimathi, Venky’s, NELCO, Associated Alcohols, IOL Chemicals, Future Consumer, JBF Industries, GVK Power, Prakash Industries, Bhushan Steel, Tinplate, India Glycols and many others. The list is endless.

•Market ‘experts’ are saying a further 10–15 per cent fall is possible in mid-cap and small-cap stocks. They have been saying the same since February with each passing fall. Best to focus on individual stocks and ignore the noise.

5 June

•There is complete panic going on in small-caps. Bhansali Engineering, HEG, Graphite India, Prakash Industries, Rain Industries and Goa Carbon have hit lower circuits.

•Sreeleathers is down from Rs 340 to Rs 240. There is serious damage to share prices. Even KEI Industries is down sharply today.

•For the first time this year, I am getting a feeling that mindless selling is taking place, irrespective of valuations. This small-cap carnage has been triggered by rising US interest rates. It’s sucking liquidity like no tomorrow. If the US Federal Reserve (Fed) doesn’t slow down, it may lead to a continued free fall in emerging market stocks.

•Now it’s the turn of mid-caps to crash. Capitulation is happening fast and furious. I didn’t expect it to occur so quickly. I thought stocks in the broader market will consolidate after their recent sharp fall until the state elections in December are over. But rising crude oil and US interest rates have hastened the collapse.

Author’s Note

India imports nearly 80 per cent of its crude oil requirements. History has shown that mid-cap and small-cap companies in India are highly vulnerable to an oil price shock (and the resultant surge in interest rates), and their stocks tend to do poorly in such times.

•Many retail investors who entered the markets late are now running for cover. A painful phase of vicious selling is going on, where people think any rumour must be true, so they try to exit at any price they can get.

•I am waiting for quality large-caps like Bajaj Finance and DMart to capitulate. The blue-chip stocks need to crash for a durable market bottom to take place.

•It was a day of mayhem on Dalal Street with more than 400 stocks hitting a lower circuit, primarily triggered by the recent Additional Surveillance Measure (ASM) rules put in place by the stock exchange. Massive margin selling was witnessed in mid-cap and small-cap stocks. I had not studied the implications of the ASM before today’s crash. In hindsight, I should have.

•The stock exchange introduced the ASM mainly for controlling speculation (intra-day trading) in individual stocks. The ASM has two key points—a daily circuit filter of 5 per cent and a 100 per cent margin on open positions of the stock (it is like how trade-to-trade or T2T stocks ⁶ work in the Indian market). You cannot do intra-day trade in the stock. The rules mean that you have to pay full amount when you buy the stock, and you can sell it only if you have it in your demat account. No speculation is allowed in the stock. Some brokers used to give credit facilities to their client by keeping 35–40 per cent margin. Now, it is compulsory to keep 100 per cent margin. If you have paid the full amount for your purchase of the stock, then no margin is required. This 100 per cent margin concept is most relevant for speculative traders who do not pay full amount for the stock, and avail credit facilities from their brokers. The stock exchange has introduced ASM to control this speculation. Market participants are confused about the rules because they are new, and this is leading to the panic sell-off. A big regulatory change is usually disruptive in the short term. In future, ASM will become familiar like T2T.

•All major falls (greater than 20 per cent) in the history of Bombay Stock Exchange (BSE) small-cap index:

•2005—24.09 per cent

•2006—43.51 per cent

•2007—22.59 per cent

•2008—79.92 per cent

•2010—55.24 per cent

•2016—22.13 per cent

•2018 (till date)—24.5 per cent

Author’s Note

As investors, many of us are hopeful optimists by nature. The period between 2003 and 2007 saw a big bull market in India, so we attempt to reassure ourselves by looking at such statistics during a bear market to give us hope that the fall may just be a routine sharp small-cap correction within a larger bull market.

•Fall in indices from January highs:

•Nifty—5 per cent

•Mid-cap—17 per cent

•Small-cap—24.5 per cent

•The worrying aspect of the current market is that panic-selling has not even begun yet among institutions. The Nifty is still only 5 per cent from its highs. Investors are very nervous about what a 10 per cent cut in the Nifty from here would do to mid-cap and small-cap stocks.

•One important lesson for me over the last decade is that if you want to make it big as an investor in the stock market, you need to be detached from stock price fluctuations. In bad times, it gets extremely tough for one to endure such severe notional losses. Market cycles will come and go, but good-quality businesses bought at reasonable prices will eventually make you money, sooner or later. India will grow at a healthy rate; Nifty stocks could have earnings growth of low double digits; but there will be a few mid-cap and small-cap stocks which will grow earnings at 25–30 per cent compound annual growth rate (CAGR) for next three to five years. They are bound to create wealth in the longer run. You just need to have the confidence and the conviction to back them. In the long run, what ultimately counts are earnings. Sanity will eventually prevail, like it always does.

6 June

•Some investors are advocating Asian Granito on the basis of its much lower P/E compared to its peer Kajaria Ceramics. They are overlooking the higher working capital intensity and high debt levels of the former.

Author’s Note

The P/E ratio in isolation tells us nothing about a business’s capital intensity, cash flow generation, management quality or balance sheet strength, or about the expected duration of its competitive advantage period. There is a lot more to making money in the stock market than just looking at P/E ratios in isolation.

•The Miglani family, promoters of Uttam Galva Steels, has agreed to repay the entire dues of the company and its subsidiaries to lenders, thus saving it from going into auction in the National Company Law Tribunal under the Insolvency and Bankruptcy Code (IBC). ⁷ The IBC has truly been a huge reform for the banking system in India.

Author’s Note

The ownership structure in Indian companies is characterized by ‘promoters’ and ‘non-promoters’. In principle, promoters refer to founders or controlling shareholders, while non-promoters refer to other shareholders, including minority shareholders.

•A micro-cap Non-Banking Financial Company (NBFC), which recently completed a preferential issue to some marquee investors, is giving hypergrowth guidance for the next five years. I am wary of such lenders; they tend to eventually blow up in their pursuit of market cap maximization.

7 June

•A big learning for me this year—be very conscious of the quality of companies entering your portfolio during a period of euphoria in small-cap stocks. It is very difficult to exercise discipline at such times, but those phases are the most important in our long-term investing journey.

•Ten-year bond yield in India is at the highest level since May 2015, at 7.96 per cent. Many investors thought higher interest rates would sound the death knell for NBFCs, and today, the stock of Bajaj Finance has hit a new high. One needs to be cautious, though. Small NBFCs may not do as well amid rising interest rates as their large established peers with pricing power.

Author’s Note

Bajaj Finance is regarded as the gold standard among NBFCs in India.

•In the long run, markets rise, then fall, then rise again, then fall. Meanwhile, individual stocks become 10x–100x along the way.

14 June

•Analysts are now applying a 10x P/E multiple to Avanti Feeds in their research reports, stating that it is a commodity business. Six months ago, they were justifying multiples of 25x for the same business by highlighting its negative working capital and sector leadership. Price drives perception in markets.

•Some red flags to take note of while analysing stocks—low tax payout, large number of overseas subsidiaries, revenues of Indian entity that has previously raised money are shrinking rapidly, debt has not reduced, receivables are up sharply, cash flows are weak, all money is routed to overseas subsidiaries, and dilution after dilution takes place. One small-cap information technology (IT) stock that has been catching favour with investors of late has all the above characteristics.

•One thing has clearly come to light in this bear market—not many investors understand the difference between accrued net profit and operating cash flow. If you want to identify ‘inflated sales’, they show up in debtor days. Whenever you find receivables of more than six months with negligible creditors, be very careful. Ricoh India is a good case study. Over the last decade, it had Rs 400 crore cumulative net profit, but Rs 500 crore negative operating cash flow, and debt ballooned 3x funding its stretched working capital. Once you understand the concept of cash conversion cycle, that’s half the battle won as an investor.

15 June

•Finding an ethical promoter is a necessary but not sufficient condition for wealth creation. One needs to take opportunity cost into account. There have been several good companies in India before investing in whom I waited a long time. The potential was always there, but with opportunity cost attached. I would rather buy on some development and materialization than do hope-based investing. The next time you hear someone saying ‘buy this stock because X is going to happen or Y is going to happen’, you should simply respond by saying, ‘I will buy it when X or Y does actually happen’.

•In the market, every stock has its own set of investors who find it attractive to buy; P/E is not the only measure. A low-quality steel producer at 10x P/E may be thought of as expensive, while a high-quality discount retailer (such as DMart) at 100x