It has been close to 50 minutes, DS and I not only recognized each other, but it also looked like we were back to our old days when we would just go on and on about stock market ideas. In my last post, I stopped at when DS mentioned how he attempted to maintain two different types of portfolio, one for trading and one for long term portfolio. So the conversation continues….

I said, “DS, I have been fascinated, and quietly toyed with the idea of having such different portfolios”, “But wait before you get any ideas”.

You see folks, I wanted to add my disclaimer like we do in all walks of life, so I add, “I have not used it, but I am fascinated by this thought”. Before I say anything else, he jumps in.

“You had to add your disclaimer, you know, when people add that what it really means?” he said.

“what does it mean?” I ask him.

“It means chor ki daddi mai tinka”, he said with a raised eyebrows and smirked smile.

I try to show that I am ignoring this chor ki daddi mai tinka comment, and I continue, “well….”

He retorts again, “Yes or no”, “did you toy with it or did you not’. It looks like DS was not ready to leave this opportunity to pull my leg.

“No man! I have never tried it”, I take a pause. We look at each other, he is still smiling at me thinking, he got me now. But I continue, “and I will tell you why”, “because I just do not have that much time, I have thought about to trade on value opportunities”,

I go on, “But I just do know how to manage time with a full time job and my family”.

He says, “yeah, ok, ok, I get it”.

I ask him, “what was your experience like, of having two portfolios, what are your thoughts, teach me something”.

He says, “there are two big issues with having different types of the portfolios”, “this is all from my own perspective, or you may say for my situation with full time job that as moderate travel and wife”.

I nod and say, “that’s perfect, like me, but I have to travel less”.

He continues, “number one issue is related to personal trading discipline”, “examples are lack of clarity, confusion, focus, etc”.

“can you give some examples”, I ask him.

“when I buy a shares for trading, I follow all the principles, stop loss, yadi yada yada…..right?”. I keep nodding, like I know what he is talking about. He continues, “it is a blind shot, no logic behind it. Right?”

“Right”, I said.

He continues, “So after spending some time, I started focusing of swing, momentum, or moving averages based trading, most of the time, swing based on moving averages”, “and I think I became somewhat good at it”.

I interrupt and ask, “good at it, means?”

“Good means, overall I started getting positive returns, more than 65% of the trades I made gave me positive returns”, he says.

“OK, I would certainly agree, you were becoming good at it”, I tell him.

He adds, “That’s where the second problem starts”, “stock pick alone is not good, you also need to get good at when to take loss, or when to book profits”

“for example, since it is moving average based trading, I take a position in a given stock. But I do not have stop loss points, or take profit sell points”,

I interrupt and ask him, “so when do you decide to sell”

He retorts, “you are very impatient my friend, let me finish”.

“OK, OK sorry, go on”, what else could I have said.

So he continues, “in my case, sell was based on certain profit level or acceptable loss point”.

“my profit range was 2% to 5% and same range was acceptable loss”, he adds and then takes pause. May be he was expected me to say something. But I look at him as if I am telling him to go on, I am listening.

He continues, “in the beginning it was good. It was working, I started to become more confident in my stock picking”.

“At one point, I earned almost half of my yearly salary in one year”; he takes a sigh and then pauses.

That is pretty damm good earnings for someone who does it part time. I said, “wow that is certainly a very good success”,

“And that’s when we exchanged emails, where you mentioned you were planning to go full time” I tell him.

He nods in agreement.

“As I mentioned, the first problem is discipline”, he adds and then continues, “every week I use to take one or two trade positions”, “so yearly it us about 50 to 120ish total trades”.

“Now, week after week, what happens is you start losing discipline”, he adds, “I did not realize, I had starting cashing out or booking profits at 2% and many times even less”, “the scare of losing money, the urge to book whatever profits I could get”,

I nod and say, “Interesting”.

“That’s not it”, he says with a concerned voice, but continues, “two years down the line, I realized, all the failures got accumulated in my so called long term portfolio”.

“I did not have guts to sell my trading positions at loss, thinking it will recover, but quite opposite, it kept sinking”. At this point, I can see a sense of disappointment on his face.

But he goes on, “my long term portfolio became a hodge podge”, “can you guess how many company shares I had in my so called long term portfolio?” he ask me.

“You tell me”, I said.

“61 to be precise, in two years, give and take few more months”, “can you believe that”, and he continues, “the worst part, I only had 12 or 13 good companies that I believed I wanted to hold of many many years”.

He goes on, “somewhere during this, I lost track that I had to maintain two portfolios”, “I had to think from two different perspectives”.

He adds, “I lost track to make sure that picking a stock for long term has different requirements, while stock picking for short term trading needs a different mindset”,

“On few occasions, I sold stocks that I could have held longer; I could not resist and sold pre-maturely”

“I think I made a mess of my investments, if you call them investments”, he says in a dejected voice.

“the only good part is when all said and done, I was still positive by few percentages, may be somewhere around 5% to 8%, may be, I can’t recall exact numbers” he continues, “but it was less than 10%”, he takes a pause.

There is awkward silence. Each of thinking the other person will say something.

I break the silence and said, “let me put this way, if you had discipline, and had more time, would you be able to do a better job at this”

Before answering my questions, he asks me, “by better job you mean?”

I clarify to him and said, “assume you did this full time, that you could focus more, you could think and execute better”, “the key is executing”.

He looks at me somewhat puzzled. It gives me a message that he is trying to understand my question

I continue, “full time….”

He interrupts me, “I understand full time and hence better focus, I am trying to figure out what you mean my better job”.

I again try to clarify, “you do not have to think of anything else, its your full time job to make these buy, sell, hold decisions”, “in that case, you can execute your process better” “you getting what I am saying, I am talking about execute your trading process”.

He is still looking at me baffled, and asks, “executing a trading process?” “that’s online by the website, what have I to do with it”

“No no no, that’s not what I mean”, I show my frustration. I take a pause.

I am thinking, am I such a bad communicator? How to explain him in very simple language?

I tell him, “Ok, you are fan of TIPBlog, right?”.

He nods.

“Have you read his investment process?” I ask him.

He says nodding, “yeah”.

I think he saw the enthusiasm in me, and I continue my attempt to explain him, “similarly, if you were full time, you can come up with such a process for your swing or momentum trading”,

“Oh that’s what you mean”, he says and continues, “I equate that to discipline, clarity, focus, etc etc, you know”.

He continues, “this TIP Guy calls it a process, I call it discipline, focus, and very much objective”, he takes a pause. And then adds, “now I get it”.

“Yeah, doing it full time, will definitely help to get into discipline” he said.

He continues, “And I believe I was going that path, that was the point in time, I thought of going full time”.

I ask him, “so why didn’t you, you were becoming good at stock picking, 65% of your picks were getting positive returns, all you needed was discipline?”

He looks at me with a smile on his face, “my friend, its simple”, “I did not have guts”, “I did not have guts to leave my well-paid job, established job, good growth prospects, and other stuff that comes with full time job”.

He continues, “that’s one thing, and second thing it was during those days we came to know, we are having a baby in eight months time”.

“you combine these two, and odds tilt against leaving an established full time job”. he adds.

He says, “let me clarify, I did not expect to become really great at stock picking, I would still continue to have only 65% success, its only that, full time would have helped me reduce my losses”,

He continues, “you know what I mean”, “that would automatically increase my total returns”, “but again I would be fool to expect my total return of more than 20 or 30”.

I give him a smiley face look.

He adds, “that level of total returns is just unrealistic”,

“what would be a realistic returns with the risk an individual like us can take”, I ask him.

He says, “in swing or positional or MA based trading, with 65% success rates, I would expect to do around 15% give or take few”.

“with transactions and tax considerations?” I ask him.

“yeah including that, 15% should be net expectation, and I will tell even this, you could do anywhere between 30 to 40 trades for that” he adds his disclaimer, I suppose?.

He continues, “this TIP Guy has a great chart that shows returns from trading when you have different timescales, swing and momentum fits nicely into weekly or monthly time scale”, “have you seen that?”, he ask me with an inquisitive voice.

I tell him, “yeah I have seen it”,

At this point, I am trying to hide my happiness and joy, I am telling myself, “DS is using this as a reference in our discussion”. Somebody using your article as a reference is true appreciation.

I had to say something, so I said, “but that chart is for index, how can you use that for individual stock picks”

He retorts immediately, “it is not an exact science, you would be [expletive] idiot to dream of something with direct correlation”, “its just a guideline to get an overall perspective, nothing more”.

I nod in agreement, “you have to [expletive] swear on every damn small thing, don’t you?”

We both start laughing.

I look at DS and continue the conversation, “so, to sum up, your experience as a trader was good, because you were getting good at it with pretty good success level”,

He nods in agreement.

“But for some reason, you could not execute with discipline”,

He continues to nod saying “yeah, yeah”.

I keep adding, “may be if you had time, you could better focus”, “because of lack of discipline, overall your portfolio became hodge podge, you started transferring losing positions to long term portfolio, never to recover back”.

He is still nodding and saying “yeah yeah”.

I continue, “Your experience of maintaining two portfolios is that, it is very difficult for an individual to have two distinctly different focus and still do good”.

He says in between, “not good, I want to do great, what’s the point of being good, I can do good without any effort”, “I strive to be above average”.

“OK OK, great, above average”, I tell him with a sarcastic tone.

He got that, and says “what the [expletive] do you mean”?

I retort, “yeah, we all [expletive] want to be great like Buffett, in 2 years, right?”, I continue, “we do not understand that Buffett’s greatness was established on the back of consistency over 40 years, and not just few years”.

I am still continuing, “by the time we will 65+ years, we realize we were not even good enough, forget greatness”, “In our quest for greatness, we will realize we were not even good”, “and by that time, we would have lost enthusiasm”.

We start laughing, he says, “[expletives], you are already talking like [expletive] old man”

I tell him, “[expletive] you think its old thinking, but isn’t that the reality?”

He jumps in and says, “I get it, I get it”, “lets not go there”.

“Ok getting back to your experience”, I am trying to get back to our line of conversation.

“so you think maintaining two portfolios is not a good idea”, I ask him.

He gives me curious look and say, “hmmmm, not a good idea for a person like me who cannot devote time”, “I wasted few years, to realize it does not fit my situation”.

He takes a pause, and adds, “after about 14 years of trying my hand at every damn thing, I realized, I need to stick to one approach”, “this hodge podge does not work”.

As usual, I keep nodding in agreement.

He says to me, “you cannot ask Shewag to bat like Gavaskar, all he knows is slam bang, let him do that”, “you can’t ask Dravid to slam bang, he is just too logical”, he is still not stopping and goes on, “don’t we say let them play to their strength”.

‘Stock market trading or investing is the same”, “work around your strength and know your weakness”, he stops with an awkward pause like he expects me to say something.

“But by the time we know our strength, we are already in our mid to late 30s”, I add to his thoughts.

He says, “yeah, I guess, that’s the learning curve all of us go through”, “Let me also tell you, if not all, then most of us normal people like you and me, by late 30s we all end up in buy and hold category”

“you know it seems very natural, we look for stability and unknowingly, end up in that box”, “we lose that excitement and rush for that flair”

I am still nodding in agreement, “yeah, you are right”.

I am sensing some boredom on DS’ body language. So far, he was looking directly at me and his body language showed enthusiasm. Now, he is looking around all over the place, and I feel he wants to take a walk. I sense the urgency to get up and do something. But he does not tell me what he is looking for. So I try to end this conversation.

“So if you had to sum up your experience in two lines, what it would be?” I ask him.

He takes a moment to think and is still looking around, “simple, don’t jump on everything that you think is available out there, become good at one thing, and do it. Don’t try to become jack of all trades, become master of one”, he now gets up and starts stretching, but he continues talking, “people like you and me who work full time and have a family, it’s a mirage to think that you can manage multiple approaches like trading, investing, swing, technicals, etc, etc”.

“you know, keep it simple”, he then stops and says, “I want to drink something cold”.

I tell him, “sure, why not!”

While walking, he asks him, “I have been doing the all the talking, what about you?”

Feeling uneasy, I ask him back, “what about me?”

“what are you doing in stock market, I know you said you earlier you don’t play, you ditched Harshad Mehta cart and have joined the Buffett bandwagon? Didn’t you” he asks me.

He takes a simple vanilla smoothie. I take lemon juice. After taking the first sip, I realize, I am not on roadside dhabba or a typical Indian juice stand. These flashy looking juice stands really don’t have real fruit juice, its some kind of artificially flavored something. Anyways, I think I only took few sips, that too because it was really chill to the core. DS seemed to be have satisfied his cravings for something cold with his vanilla smoothie. I think he knew what he exactly wanted, and he got it.

I tell him, “believe it or not, I have made less than 20 trades in last 10 years, may be?”.

“that seems right for a somebody who talks like a reading buffett-nomics”, he says to me with sarcastic bent to his voice.

By this time, its almost two hours and 15 minutes. I think I still had three hours to kill before my flight. Well, I will stop at this point. I will cover this part “what about me” sometime later in other post. This part of the conversation will be cliché for readers of this blog.

To me this was a very interesting conversation. I got what I wanted, an honest opinion about maintaining two portfolios. When I said, I toyed with the idea, I really meant it in a sense that I have had this desire to do something additional than my dividends/value investing. But readers to this blog should know by now, I am conservative stickler. I will not do it just for the heck of it. I need to understand the full chain, before I jump on something else. I know for sure, I do not have sufficient time to give to my investments, but another aspect that always bugged me was execution process, the discipline that DS talks about. A small conversation with DS solidified my concerns. My suspicions are real. Trying to do two completely different things will mess up my overall portfolio.

You may read about my investment buckets article. I have a significant portion dedicated to index (30%) and opportunity (20%) investments. I have been contemplating about opportunity aspects for a while now, but have not been able to devote sufficient time. In my case, I have unknowingly re-deployed my allocation from index/opportunity to my long term dividend/value portfolio. Early in 2009, when markets were down, I thought they are opportunity and bought same stocks that I already had.

In case of index, I only have one starter position. There is not much choice except NIFTY BeES. In case of opportunity, I have had only 2 trades in last two years, in which there is nothing much to talk about.

My thoughts fully resonates with DS, when he says, over time, we drift towards something that we do not want. Knowingly or unknowingly, we create this mess. Sometimes we just get lucky that it works out. But luck will not be on your side for through out your investing career. If you keep repeating the same mistakes, then you will never become wealthy.

I have summed up the message I got from conversation with DS. What message did you get, what are your thoughts and experience about running different distinct type of portfolios? Can you share?

(Photo Credit)

I am sitting at Singapore’s Changi International Airport. It is middle of the night, and I come to know my flight is delayed by four hours for technical reasons. I was contemplating what should I do. Made few personal calls and then I decide to munch on unhealthy burger and some fries. I was getting bored, so I started browsing the internet. I log into my blog’s wordpress interface and opened another tab with my blog. I was hoping to answer my emails and blog comments. That just remained a hope.

While I was reading comments, an Indian gentleman came and said, “may I sit here” pointing a chair just across me. I said, “sure, be my guest”. We exchanged few more pleasantries, and then each of us continued doing our own stuff. He started playing with his blackberry, and I turned my eyes to my computer. At the same time, I am thinking, there is no one around in this cafeteria, tons of empty chairs, so why this guy came just next to me. Usually, we just go and sit in an empty space.

I said to myself, “hmm, forget it, why bother”. I went back to reading comments and emails.

Few minutes later, he stops playing with his blackberry. He is looking around. I can sense he wants to talk to me. The moment I raise my head, he says, “The blog you are reading is awesome. Isn’t it?”

I give him a blank look for few seconds, trying to figure out what hit me. How did this guy know it’s my blog. I blur out, “yeah, I like it too”.

He says, “I just wish I had such discipline and patience”. He continues, “sometimes I doubt if what he say is really true, and does he really mean it”, “it seems too good to be true”.

By this time, I recollect my thoughts and become little more composed. I ask him, “what makes you doubt it”, “any particular reason that makes you not believe it”.

He says, “nahh, no particular reason, and that’s the whole point”, “what do you think?, do you believe his posts?”

It was natural for me to say yes. I blabbered little bit and said, “yeah, I tend to believe it”.

He says, “you seem to be interested in stock market”, “how do you play it?”, “do you trade?”.

With a surprised tone, I asked, “play the market!”, “no, no”, “my philosophy is to look for good business and try to buy them at cheap”, I continued, “I try not to sell”

“you are part of those clichéd value investor brigade who ape Buffet or Graham”, he says.

I nod to agree.

He continues, “who most of the time are negative about markets and keep cribbing about overvaluations”.

“I do not understand what you mean”, I interrupted with a smirked smile.

He continues, “at 15000, these value investors say it is overvalued, it still keeps going up”, “at 17000, they still say it is overvalued and markets will crash”

I am looking at him with raised eyebrows but I keep nodding.

He goes on, “how different are these value investors than brokers and agents,” “they are wrong as often as the brokers are,” “aren’t they?”

Sensing a level of hostility towards value investors, I ask, “You probably had some bad experience”. I am thinking what makes a stranger talk like this, frank, opinionated, tending to be brutish, with an argumentative bent to the discussion, “Do I know him? Probably I do? Who is he?”

“Bad experience, yes, but it’s not about my bad experience” he said. “Ok you seem to be value investor, what’s your philosophy”, he takes a pause hoping I will respond.

“hmmm, well….” Before I can say anything else, he starts again.

“great opportunity if the stock is less than 12 PE, heard from some business pundit about growth, mix the two, woila, I recommend the stock because its value”, “isn’t that what value investing means to all these pseudo – Buffett followers”

I am listening to him, and at the same time thinking, there was no way a stranger sitting at an international airport, in the middle of night, engage in such an argumentative discussion. By this time, I am almost sure. I tell myself, “I probably know this guy”, “He knows me too!”

He just does not want to stop, he goes again, “I would like to ask these pseudo Buffeters, have you forgotten what Buffet says”, “Buffett says, buy it never to sell”, “individual investors should just buy the index fund and….”

I interrupt him, “wow hold a minute”, I take my glasses off and pretending to clean it, “do I know you?”

He retorts, “what do you mean [expletive]”. At this point, I am sure, I know him.

Few more expletives latter, I knew who he was. He was one of my ex-colleague from a company I used to work 13 years ago. This is a guy who 13 years ago was tall lanky guy with glass, always wore formal trousers and shirts. I think I worked in that company for two years, and never saw him in T-shirts or jeans. And now, he is still tall, but without glasses, wearing a t-shirt, jeans, and had put on lot of weight. This was the justification I was giving him for not recognizing him.

Let me give you little background.

Thirteen years ago internet access was not readily available. We paid Rs 20 for one hour access in a cybercafé, a far cry from today’s easy accessibility. I used to bring newspaper, i.e. Economic Times, to my work place and we used look for stock prices. In a nutshell, discuss what to buy next, what to sell next, mostly focusing on newspaper stories and recommendations of gurus. My friend (his initials are DS) was fanatic about stock market investing (a.k.a. trading). DS was very passionate about analyzing stock related stories in newspaper and then trying to correlate it with somebody else or read another business newspaper. We both were completely naïve about stock markets. Long term was alien to us or rather I should say limited to 3 months! Understanding business was not part of our vocabulary. It was my first year of working full time after my under graduation, and I think second year for DS. We both stayed with working parents and hence no responsibilities. Salary was basically free money for us. We did not know the difference between investing and trading. Graham and Buffett were non existent for us. Two years down the line, I went back to school. DS stayed back for one more year and then went to top class B-school. In terms of returns from stock market, after two years, I was under the impression I came out with positive returns. DS also had same thinking that his returns were positive in three years. Now when I look back for those two years, I actually was negative considering transaction tax, brokerage, and taxes (not including inflation). Brokerage was very high in those days and concept of Demat was still being implemented.

I recall sometime in early 2005 we had exchanged couple of emails and he was actively trading and was very ecstatic that his trades were making him good money. At one point he mentioned he made almost half of his yearly salary in one year. Even after taking his education from good B-school, he was thinking of leaving his full time job and do a full time trading. I vividly recall I had written to him that I do not trade anymore. I have become a very cautious, risk averse, investor. And he pulled my leg on the concept of long term investing, and stock market being risk averse. I never responded to his this email and ignored it. Now, coming back to the DS at Changi International Airport…

After reminiscing few old stories, he asks me, “are you still in the market?” “Did you learn new styles like technical analysis or swing or positional trading?”

“wow, you trade and not invest”, I said. I take a little pause, and then continue, “what happened to investing that we used to do 13 years ago”.

“Nahi yaar, I am sick of trading and losing money”, he takes a pause, and then continues, “the constant pressure of timing it properly was stressful”, “with a full time job I could not manage”, “I do not trade anymore”.

I interrupt him, “so you are out of the market”, “last time when we exchanged email you were planning for a full time trading profession”, “you wanted to leave your well-paid full time job”

“I do not know how to answer”, he says, “after breaking my head for 10 to 12 years in trading, I realized I have not much to show”

“What do you mean by not much to show?” I ask in a subdued voice.

He says, “when I say not much, I mean, less than 10%”, “I am still positive overall”, he takes a pause, “but is 10% really good for all that effort?” “hmm, nah, not worth it”, “what a waste of time and effort”

I could sense that DS is still passionate about investing in stock market. Both of us did not make any special effort to talk on this subject, it just naturally flowed into the conversation. But does it make sense to talk about investing when you meet after such a long time? And this was one sided conversation which was going no where. I was waiting for him to pause, so I can break this conversation.

I interrupt DS, and ask, “hey, do you want to have a coffee?”

He agreed.

I pick up my trash from the table. I still had my plate with little bit of left over burger. The fries have become soft and soggy. My coffee became cold and I wanted to throw that too.

I close my computer, put in my carry on bag and ready to go.

DS noticed the coffee cup and asks me, “you just had a coffee”, “you are up for it again!”

He did not know my motives for a coffee break. I wanted to break the conversation. Coffee was just an excuse. So I said, “No, this one has become cold and does not taste good anyway”, “this time, I will have some other type”. While walking towards the coffee shop I ask him, “how about you?”

“I will skip coffee, it will make me hyper active” he said and continued, “but I will take hot chocolate to give you company”.

We buy coffee and hot chocolate. This time we go back to different place with soft chairs. The table and chair kind of setup was not required for our conversation.

DS asks me, “hey, what about you?”

“What about me”, I ask with little surprise.

He says, “Do you still have that zeal and passion like old days”, “do you still keep track of markets”, “what’s your style”.

All this time, I am thinking, walk for a coffee would break this conversation. But I was wrong. This was the DS of old days who is like a chatter box when it comes to stock market.

I said, “look DS, as we age, we mellow down, you learn more, I do not trade like we used to do 13 years ago”, I take a pause.

DS interrupts me, “wait a minute, don’t tell me you have joined the bandwagon of clichéd value investors”, “I did get an inkling based on the blog you were reading”

I am looking at him; literally give him a stare to show my anger. DS is a guy, I can tell him to F’off and he would laugh it off without taking any offence.

I say to him, “I don’t know what my style is”, I continue, “But what I do now-a-days is focus on dividend paying companies, I look for buying at fair values, I look for sustainability”.

“now I buy stock to hold it forever”, It is his turn look directly into my face. I continue “off course the stock should continue to perform”

He says, “I am trying to do something very similar, like, buy at low price and holding it forever”, “hmmmm, but not dividend or classic value investing”.

I nod to show him that I am getting what he is saying.

He adds, “it is really difficult to figure out what would be the value based on classic principles of net-net, intrinsic, etc, etc.”, “you know what I mean, right?”

I nod in agreement, and say, “yeah, it’s the same dilemma I have”

I ask him, “what happened to your trading?”

He says, “whatever I made in last 10 years or so, I made similar on percentage basis in one year in 2009”, “when you are into this daily business or short term focus, you get stressed out, you will get winners, but you get more losers” “overall it is a negative preposition”.

“more so, if you are working full time and have a family” he continues, “this concept of buy and hold seems to work” “but I still need to figure out when to buy”.

At this time, my phone rings. It was my wife. Before DS met me, I had tried to call her to inform about my flight being late. I could not reach her. So she was returning my call. I think I talked to her for three minutes or so.

He says, “Isn’t it strange, we both were crazy young idiots who thought they knew what they were doing”, “13 years down the road, we both drift towards something very similar”, “mind you, both independently, not knowing what each other is doing!”

I nod in agreement. What else could I have said; it was true what he was saying. We thought we knew everything. We thought we could cook up some crazy trading strategy and it would be the only way to get more money. At that time, we did not realize how dumb and wrong we were.

DS starts again, did I say he is a chatter box?, “You know for few years in middle, hmmm, I think 2003 to 2005, I had tried my hand at having two portfolios”.

I interrupt and blur out, “don’t tell me, one for trading, and one for long term”

“you got it”, he said.

At this point, I couldn’t stop myself. For quite sometime, I have wanted to talk to somebody and get some honest opinion about how this works. I have been wondering if I can find somebody with some level of experience who has used this approach and has done it for few years. It has been my experience that people always tell you successes, never negative aspects. Over the years, all my conversations with people have lacked true reflection to admit they failed. Almost always, it is about ideas and strategies. When I ask how they practiced it, do they follow their own advice; I never get a good experiential aspect. Why? Because our ideas are for others to execute, we are scared to practice our own ideas. We are not convinced enough to execute our own ideas. We need someone else’s approval. Knowing DS, I was sure to have an honest opinion.

By this time, it was almost 50min we have been talking. I still had few more hours to kill, and DS also had few more hours to kill. But when DS is around few hours are nothing for him, particularly when it is about stock market. We went on to talk for three more hours. I will continue this in future posts. In future posts I will present:

1. DS’ experience of maintaining two portfolios. He shares with me his experience about getting confused. There is this tendency to buy and sell at slightest hint for profit, and difficulty to remain objective. He mentions how the failed stocks ultimately end up in buy and hold portfolio (never returning to profits), and winners get traded out due to quest for booking profits.
2. DS took TIP Guy to task. While he does not question TIP Guy’s integrity, but wishes that somehow there is a way to validate it. In his own words, “why is he hiding behind pseudo character?” It was natural for me to provide my supporting arguments, although, I did not feel he agreed to my arguments. He also had some very constructive suggestions to grow TIPBlog. At that time, he did not know who he was really talking to. But after reading this story, I am sure; he would be looking for that first opportunity to kick my rear end.

(Photo Credit)

Praj Industies (PRAJIND) provides turnkey plants and equipments for fermentation and distillation systems used in bio fuels processing (primarily ethanol related). It sells it products domestic Indian markets (about 70% market share), South East Asia (about 50% market share), and Europe (about 30% market share). It has been attempting to diversify in Brazilian and North American market but is still in very early investment/growth phase.

In addition to geographic diversification, it has also attempting at product diversification. It has begun working in other areas like Brewers, Agro Chemicals, Bio Chemicals, and Health and Wellness Products,

Praj Industries is small cap company. My objective here is to understand, if it will fit in my long term buy and hold portfolio. I like it because of very low debt.

Trend Analysis

The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends. All the data below is from 2000 to 2009.

• Revenue: Increasing trend since 2000 with average growth of 43% (SDev. 48%). Based on first nine months, I expect this to reduce for year 2010.  Neutral Observation.
• Earnings per share: Overall acceptable increasing trend. Average growth of 41% (SDev. 104%). Extremely high variability and has possibility of negative growth. Not a good observation.
• Net cash flow from operations: Overall an increasing. Has been above net profit. However, has dropped below reported profits. Not a good observation.
• Profit/Loss from operations: Overall increasing trends in profits from its operations since 2001. Good observation.
• Reported net profit: Overall an increasing trend since. Good observation.
• Gross margins: Current GM of 22.2% is higher than historical average of 15.4% (SDev. 3.8%). Good observation.
• Operating margins: Current OM of 23.2% is higher than historical average of 15% (SDev. 4.4%) and increasing trend. Good observation.

Praj Industries Trend Analysis

Quality of Dividends

In this part of my analysis, I am trying to understand dividend growth rate, consistency, and ability of the corporation to demonstrate sustainability. In is also an indirect way to gauging management’s policy vis-à-vis sharing of profits with common shareholders.

• Dividend per share: Chart 3 shows dividend growth from 2004 onwards. Neutral observation.
• Payout factor: This has been less than 30%. The most recent annual report, management mentioned they will restrict dividends to maximum of 30% of profits. This shows intention to share profits but not all of them. Good observation.
• Dividend growth rate: The dividends have not grown at sustained year-on-year basis. i.e. there has been a high level of variability. Overall, on the basis of last five years, the dividends have grown at an average of 37% (SDev. 57%) which is a tad less than overall EPS growth rate of 41% (SDev 104%). Neutral observation.
• Ratio of cash from operations to reported net profit: It has been more than 1.0 until 2007. Dropped below in 2008 and 2009. Not a good observation. However, when you include cash flow from sundry debtors, this ratio is more than 1.0.
• Ratio of profits from operations to reported net profit: This ratio is more than one. Good observation.  
• Ratio of Cash from operations to total debt: Practically a zero debt company. Good observation.

Dividend Cash Flow vs. Risk Free Savings Cash Flow

Why should I take risk if I can get a same or more cash flow by putting my capital into any risk free savings, fixed deposits, or any such risk free accounts? Therefore, I try to understand how dividends will affect my cash flow in 10 years of time period. The baseline assumptions are (1) the stock’s dividend yield is 2.2% at current price of Rs 83.00; and (2) savings interest rate is 7%.

• Best case scenario: considering average dividend growth rate of 57% for last five years, the dividend cash flow will be 9.96 times the cash flow from savings interest at the end of 10 years.
• Worst case scenario: considering low end of the expected dividend growth of 12%, the dividend cash follow will be 0.5 times the cash flow from savings interest at the end of 10 years. Note: this includes only dividends and not capital appreciation.
• For dividend cash flow to be equal to savings cash flow the stocks buy price should be Rs 39 (or 4.9% yield). This assumes conservative average dividend growth rate of 12% for next 10 years.

Expected Beta-based Volatility

I measured Beta for this stock’s risk (or price movement) relative to the S&P CNX NIFTY (or index movement). Here, I am trying to understand how a stock price behaves relative to the market.

• The stocks three year Beta value is 1.05, while it is 1.38 for last one year. This means this stock has high volatility w.r.t. S&P CNX NIFTY index.
• If I buy this stock, I should expect high degree of volatility.
• Note: I am not calculating beta-based expected return. This is because; it gives an impression to readers that I am using this parameter to calculate my potential capital appreciation. In true sense, the only reason I use this parameter is to understand volatility. This helps me set an expected on fluctuations. It helps me gauge how it behaves relatively to my objectives of 12% to 18% target. I have made a note of this, and I will discuss in the future post.

Fair Value Calculation

The next step is to estimate the fair value so that we can understand return characteristics for this investment.

• NPV price based on 15 year DCF: Rs 72.1
• Average high yield price calculated based on past 9 years: Rs 68.2
• Pricing relative to 9 year average PE ratio: Rs 57.0
• Pricing based on PE ratio of 12: Rs 83.3
• Graham number: Rs 61.4

The range of fair value is calculated as Rs 63 to Rs 68.

Qualitative Analysis

• In the recent past, Praj Industries has remained focused only on ethanol end market segment. It has achieved leading market position in India and South East Asia, and to a certain extent in Europe. It rode the ethanol craze of 2000s. One of the biggest growth driver has been regulatory diktat of using upto 10% of ethanol in automobile fuels in different countries.
• While I believe there will be more and more countries to join this bandwagon, the growth for Praj Industries will slow down.
• I am intrigued by its decision to invest in Brazilian market. I believe the barrier to entry is very high for it to make any meaningful returns. E.g. I would not go to China to open a manufacturing shop, or oil refinery in Middle East. One of the primary reason Praj wants international diversification is improvement in profit margins, which it could achieve in developed markets (but not in emerging economy). US and Europe can provide improved margins. Again, exchange rate driven growth? If yes, I do not expect long term sustainable growth.
• It’s margins have improved, but I believe it will get capped very soon. When and how much, I do not know.
• Instead, I like the company’s recent moves to diversify its product base. This is likely to provide long term growth potential. It still remains to be seen, when these efforts will bear fruits. In my viewpoint, this is a very positive move.
• Contrarily, I like Praj’s financial position. It has an enviable zero debt, good cash flow (including sundry debtors), and managements profit sharing ideology.
• One the great positives about the company is, I like management’s ability to use capital very cautiously.

Summary

Praj Industries has a good management that focuses on capital usage and control growth. It has remained focused in its core area, and has not gone on the growth binge beyond its expertise. I have very positive opinion about its product diversification efforts. Furthermore, the zero debt and good cash flow makes be want to buy shares for this company. I expect (1) intermediate term challenge of maintaining its earnings and dividends; and (2) high volatility. At present, it is trading at 21% premium to my fair value buy range. I will wait for price to be in buy range, until then it remains on my watch list.

Disclosures: No position at the time of this writing.

Disclaimer: This analysis is in the context of my long term buy and hold investment philosophy. It is in accordance with my investment objectives and my personal risk profile. If you intent to use this analysis for your own investment decision, then please make sure it meets your own objectives and your own risk profile.

In my last post, I discussed about my fair valuation for buying and how it would be likely different than selling value. I tried to make a case that I would like to minimize my cost basis and maximize my sell price. Buying is easy because minimizing cost basis is under my control. Nobody can force me to buy high unless I want to do it, right? However, when it comes to selling I do not have any control. Like everybody else, I would like to sell high, but there has to be somebody willing to pay for it? And hence, it is little bit of subjective.

Furthermore, I identified three companies viz. HDFC Bank, Pidilite, and ABB, as stocks that I would consider as fairly valued for selling. OR likely to be tad over valued. I do not consider them to be extremely overvalued. In this post, I do not intend to discuss (or present an argument) what would I consider over priced or extreme overvaluation. No two people will come up with same conclusion.

For this discussion, I will consider them over valued and hence I will sell. These are around 30PE ratio (assuming 20PE being fair value). Selling them fully will give me a cash position. Selling all three of these will give me close to 40% cash position in my overall portfolio.

Following is the performance metric as of today. YOC is yield on cost, and RofC is return of capital by means of dividends

• HDFC Bank: 4.19% (YOC), 15.5% (RofC)
• Pidilite: 10.5% (YOC), 56.0% (RofC)
• ABB: 3.76% (YOC), 16.2% (RofC)
• Cumulative weighted YOC for all three is 4.23%

When I sell these positions, I will incur long term capital gains tax on HDFC Bank and Pidilite (and not on ABB). Let us say, the total capital I receive from sale of all three positions is 100. The total tax comes to 13% based on weighted contribution. Thus my capital is now at 87 after taxation.

• To get back to my 100 value, I will need 14.5% appreciation, just to get back to my original value. So I will need to find companies that will give me 14.5% return. That is the typical return I expect in one year. So I am already one year behind. If I hold on to cash longer, it will take longer to recover. I am not even considering growth aspect yet.

• Considering the risk profile I have, I will not be putting all 87 that I receive into just one stock. I would like to diversify them into at a minimum three different stocks. This adds to my challenge of finding at least three opportunities that will give me 14.5% return.

• I do not expect to get more than 1.2% dividends on my new investments. The cumulative dividends at 1% is still much lower (about 35% lower) than actual dividends I receive on YOC of 4.23%. So my dividend reinvestment slows down. Total dividends per year is at that critical mass where I buy one stock every year from dividends.

Challenge from me….

It is my desire to buy three to four new stock positions every year based on the new cash that I allocate every month. This adds up to opportunities I need to look for. I will need eight to nine new positions.

• It is highly likely that I will end of holding more cash. I already hold high percentage of new allocated cash. I do not want to add to this cash from portfolio. It will reduce my overall returns in long term.

• I expect that all these existing three companies (HDFC/Pidilite/ABB) will show 14.5% per year average EPS growth over next 5 years or so. So what would I achieve by selling these position? Sell this position (which I expect 14.5% returns) and buy something else with the same expected returns? To refresh, when I buy a new stock, I expect XIRR in the range of 12% to 18%.

• One could argue that the capital base will be higher. So baseline is higher. But wait a minute! The average growth expectation from existing companies is also y-o-y, and not lower capital base of 5 or 10 years back? So what would be the difference?

• I cannot base my decision only on probability of higher returns; one has to look at the downside too. Hence, there is a 50/50 probability that existing stocks or new stocks would give me either higher or lower returns.

• In next four years, I expect YOC from these existing positions will exceed 8.5%. The cumulative dividends that I receive from this 8.5% YOC would be much higher than YOC of new investments in 4 years time. Keep in mind all dividends are tax free.

How much higher capital base?

30PE gives me 100 value (effective 87 cash after taxes)

20PE gives me 83 value (effective 72 cash after taxes)

In short, I will get 15 (=87-72) extra cash which I could use for new stocks or compounding. Now, I already expect that these three existing companies will provide me similar level of growth in next few years. So why would I want to take added risk of looking for new opportunities?

After looking into the extra capital base selling would give me, challenges for me to deploy that extra capital, my risk profile, and my investment strategy, I find it more advantages in continuing to hold these three stocks. I ignored black swan scenarios.

This discussion becomes mute in following cases:

1. Belief that 30PE is extreme or insane valuations. I consider it extreme if future growth expectations are in single digits. But not extreme for growth expectations of up to mid double digits.
2. Belief that existing three companies will grow in single digits. Belief that 14.5% growth is too high for these companies.
3. Belief and high level of confidence that one can deploy cash at expected return of 18%+ with sustainability. Any such higher return expectations should also consider down side risk. My investment process does not capture or identify such opportunities.
4. PE of 40+, or 35+ ?

Epilogue

I consider selling a difficult process. I always had a feel (or mental map) of why it makes sense for me to what I am doing. But I had never put it down on paper. The questions/comments/conversation on this blog forced me to. I was surprised by the fact that it comes close to my abstract thought process. This has been one of the most enriching experiences from this blog. I have had few takeaways from writing these articles on selling. They are significant outcome which helped me tweak my investment process and hence, it deserves a separate post.

The key message to take is; look in the context of what makes sense for you, weigh it in from your own risk profile, your own capabilities, etc. Go for it when you have confidence that higher capital base gives you potential for higher overall appreciation. Just be cognizant of downside risk. It is my belief that if I manage downside risk, then upside potential will automatically take care of itself.

In today’s post, I am continuing my discussion on selling aspects for my long term buy and hold portfolio. To me, buying is always a very easy decision. Easy in a sense that I have few quantitative metrics and qualitative aspect that help me decide whether I should buy a given stock. However, I do not have such fixed metrics that tells me, hey buddy, its time to sell. For me selling is a very subjective process. I touched upon few guidelines that help me make a sell decision.

Discussing and presenting my thoughts on this blogs helps this subjective process. The comments and conversations I have with readers of this blog helps (or influences?) this subjective process. When I say influences, I mean influencing the thought process, and not directly sell a stock because my blog reader says so.

Sachin8778 and Aurnsg are two readers who have presented some thought provoking arguments. The common theme is why not sell when it is overpriced. I have summed up their questions are follows:

• Why not sell when market is gives extreme valuation? Use your knowledge of fair value and sell if valuations are higher
• Selling will give higher basis for next capital allocation. i.e. why not think from the viewpoint of maximizing the efficiency of capital allocation (or overall returns from the same capital base).

To Sachin8778: your observations and interpretation are correct. Current market valuation alone is not trigger for me. However, current market valuation does affect timing of executing the sell. E.g. I would have not sold GE Shipping or Reliance Infra in March 2009.

To Arugnsg: your observation is also correct. It is inward looking, completely based on “what is in it for me”.

To me, the notion of being overpriced is very subjective. It depends upon an individual how he/she looks at pricing. Comparing current market pricing with my fair valuations (during buying) is not truly a comparative metric. If you ask different people, all of them will come up with different valuations.

The fair value in my buying process is what I am willing to pay to buy the stock. That’s it. I come up with that fair value by using few different parameters. In general (if not always), this fair value comes around +/-15% of graham’s number. In other words, many times this fair valuation is around 8 to 13 PE ratio. This is not exactly a classical value investing based on intrinsic value, but on similar lines. In this fair value pricing, the margin of safety is in-built. Sometimes, this margin of safety is higher, some times it is lower. So now you know, why I cannot compare current market pricing to my fair valuation. Let me give a simple example.

• I want to buy a house. I will be looking for lowest possible cost. I will try to minimize my cost basis. This is where I say fair valuation I am willing to pay to buy a house. Some other person can say, well, he/she is willing to pay 15% higher to buy the same house, because he/she would have some another advantage like closer to work place, or closer to family, or something else.
• However, when I want to sell this house I will be looking for highest possible cost. I will try to maximize my sell price. At the time of selling, I will not use my buy price as my cost basis. I will not say, hmmm, I bought at 100, let me sell at 130, I am still making money. If it is my primary home, then forget it, I have lots of intangibles which would make it difficult to determine the sell price. BUT if it is an investment property, then my thinking would be different.
• In one scenario, my rental income is still positive. It is improving. The place where this house is located still upcoming and growing. In this case, I would value my sell price at much higher multiples. I would need to believe that valuation is extremely higher. I would not sell at 130. I would not sell at 150. But may be if it is 160 or more.
• In second scenario, my rental income is barely positive, lots of maintenance headache, the place is slowly rotting, or rental incomes are falling due to bad area, or slowly becoming low income region, etc etc. In this scenario, I would be willing to sell at 130 and get out when I am still positive. But probably not at 110, I will spend some time to atleast attempt to get higher price.

So you see, determining a sell valuation is very subjective. This applies to stock positions also. In recent past, I have based my decision to sell/reduce depending upon how it affects my portfolio (inward looking). There are two steps (1) The downside risk to my portfolio triggers what I should do next (2) After indentifying the stock, the next is when to execute the sell.

At this point in time, from the perspective of my thought process, the stocks that I believe could be considered as fairly valued for selling are HDFC Bank, Pidilite, and ABB. I would tend not to consider them extremely overvalued.

So why did I not sell them, and instead chose Reliance Infra? Simply because, I tend to believe that these companies do not pose significant downside risk to my portfolio. Even if I decide to reduce my position (i.e. selling partially), then I would most likely keep cash position. I would have to wait for a while before I fully deploy that cash. Why not keep cash? I have been saying many times, I would be happy to keep cash, haven’t I? Since the post has become long, I will continue this discussion in next post.