Please read below our transcript and key Points of an excellent session conducted by Prabhakar Kudva (Samvitti capital) of how to generate an investment idea at https://indianinvestingconclave.com/ which in managed by another stalwart investor Jatin Khemani. (Emphasis Ours)
Mr. Kudva has been instrumental in providing a lot of insights on markets and teaches how to basically spot patterns in the markets. He not only manages a PMS but also has been writing a blog since quite some time.
He has been fascinated by the markets since a long time and he shares that it is important to take note of the patterns in order to succeed in markets in the longer run. He focuses on two very important questions throughout the presentation; one involves answering how does the market work and the other involves answering what factors trigger price moves.
He talks about how every kind of investor whether a growth investor, value investor or a momentum investor they all look for some favorable conditions which they have spotted in the market. He talks about how everyone looks at a certain pattern before making a decision and that pattern helps in the decision making.
He compares markets to science because in markets too we use terms like catalyst which is a scientific word and we sometimes knowledge from psychology too. Markets are a mirror to the complex human behavior and if we are able to decode the patterns that the market tells us than we will be able to perform well in markets relatively.
He talks about how the patterns that he will discuss are in a way denoting probabilities and not certainties. The pattern doesn’t necessarily have to work all the time. The pattern only increases the likelihood of the event to occur but doesn’t reduce the uncertainty component that the market brings.
He gives a metaphor of rain wherein the conditions like dark clouds might cause the rain to happen and it might happen quite often but it doesn’t tell that it will happen all the time.
He focuses on something very crucial; he says always follow patterns over ideology. When you label yourself as only a growth investor or a value investor or a momentum investor, your label in a way constrains you because it will limit the opportunity size that you will focus on. A value investor who is labelled as someone who only buys when the stock is cheap will forego the opportunity when the stock is expensive but the growth is still good. A growth investor might buy the growth but he won’t buy cheap stocks if he labels himself as a growth investor.
Focus on understanding the patterns whether it is related to price level or fundamentals.
Generating Investment Idea Source 1:
He starts with a pattern named as “Identify the sector of this cycle”. He says go back to any cycle and spot the sector which was performing well.
From 1996-2000 it was technology sector
From 2003-07 it was Infrastructure/real estate
From 2010-15 it was consumer sector
From 2015-20 it was NBFC
But basically how would you identify such sectors:
a) High sales growth
b) High profit growth
c) Margin expansion
d) PE > 2-3x the market
e) Earnings visibility for 2-3 years
f) Seems like growth can continue forever
g) Charts: Moves up step stair patterns, Consolidation followed by breakout- rinse and repeat
All the factors that he mentions have a common theme that growth is here to stay. When a particular sector becomes the darling of the market each and every company in that sector starts outperforming the index. It is important to be aware of the stocks which might run out of luck when the tide turns.
But as with life the good times don’t last so the factors which were contributing to the growth of the sector will now run opposite to it.
How will we basically come to know that the bull market is going to end?
a) Check how long the rally has been going on
b) What has been the extent of PE expansion from the start?
c) Margin trajectory
d) Thematic funds; how are the sector specific funds performing? Have they started to lose steam?
e) Late stage rallies
f) Parabolic moves
What mistakes do people make?
a) Buying late into the game
b) Participating on the way down
c) Averaging down
d) Not selling – sitting on their hands
Takeaways
Life changing set up if you get in early
This is a 2-3 year cycle- always remember that and bet accordingly
Generating Investment Idea Source 2:
POST EARNINGS ANNOUNCEMENT DRIFT (PEAD)
Most important event in the market- Earnings
Real estate is about location, location, location. The stock market is about earnings, earnings, earnings.
Earnings force the market to take a stand
The Key elements:
a) Surprise
b) Acceleration
c) Not crowded
Examples:
Divis: For this company the earnings were really unexpected as you can see in the image. When the markets reward something it rewards it handsomely. Markets do create such opportunities from time to time; that allows you to gain big and perform well relatively.
Angel Broking: As you can see here that there is a huge increase in the sales in the context of Angel broking. The market didn’t anticipate such sales and because of that the stock performed significantly well. If the earnings come as a big surprise and the sales has increased significantly than the markets will shoot up the stock price.
Generating Investment Idea Source 3:
Another indicator which is seen as a biggest positive in terms of the market is Debt reduction:
Meaningful debt reduction leads to a large increase in EPS especially in case of highly leveraged companies.
Given above, debt reduction adds much shareholder value as a high growth stock.
Debt reduction: Makes the business less prone to future risks and hence the PE expands along with the increased EPS and that gives us a move
Example: Radico Khaitan
As you can see the company started to reduce debt significantly; which led to the earnings of the company to improve significantly.
Generating Investment Idea Source 4:
52 week/ all time highs across the sectors
a) Several 100s of stocks hit 52 week/all-time highs during good markets
b) Look for new 52 week/ all-time highs
c) Look for multiple stocks in a given sector hitting new 52 week highs
d) This is an exploratory pattern – i.e. the pattern itself is not the cause unlike the earlier ones but it is the effect. Having seen the effect, we need to look at the cause.
Generating Investment Idea Source 5:
Spin offs
a) Demergers/Spin offs lead to opportunities for the retail investors
b) Institutions typically don’t want to keep the spun-off entity
c) Too small for their portfolio
d) Too dirty
e) Doesn’t fit with their theme
This leads to forced selling initially and then if the company turns around as it does in most cases-it typically gives you a Multibagger
You can also buy the parent and still do well as it has undergone a surgery and the tumour (spun-off entity) is removed
Examples: Borosil- Borosil Renewables de-merger and Orient Electric de-merger
Generating Investment Idea Source 6:
IPOs
Power set up because:
a) It’s under owned
b) There is very little float (Volume available to retail investors)- little buying leads to large moves
c) Better if it’s a new sector or is under-represented
When do you buy them?
a) Not on Day 1- that’s a different game
b) Powerful when combined with all time highs
c) More powerful when combined with PEAD (Post earnings announcement Drift)
d) Examples: Gland Pharma
Generating Investment Idea Source 7:
Low capacity Utilization/ General Pessimism
Typically found in industries which are out of favor having undergone an up-cycle where massive capacity was built and now there is capacity but very low demand.
Typical Zone of value investors
Needs industry knowledge and scuttlebutt; (talking with suppliers and other company stakeholders) to understand changes in demand cycle. When the demand cycle turns there is massive operating leverage, (fixed cost remains the same but because of the rise in prices, each rise in price would directly result in profits) that comes into play and earnings explode.
Massive rewards with low risk if you get it right and are early
See the jump in operating profit from 487 to 6111; this unanticipated and huge jump has the potential to give humongous amount of returns.
Generating Investment Idea Source 8:
52 week Lows with insider buying
a) There is truth in the markets
b) People may sell a stock for many reasons like genuine pessimism, need for cash-flow etc.
c) But people buy a stock for only one reason- they expect it to go up
d) When you see promoters buying a 52 week low stock aggressively for a meaningfully large value, you should get interested. Often we are very close to the stock bottoming out
Examples:
N Chandra buying TATA communications last year- almost exactly at the lows
Filatex promoters increasing stake from 60 to 65%
Generating Investment Idea Source 9:
Quality Businesses
a) These are sector leading compounding machines.
b) Endured multiple cycles
c) Proven management with a track record of excellence across business environments
d) Several examples we all know of- Nestle, Asian Paints, Kotak Mahindra Bank, Titan to name a few
e) The simplest way to make money for anyone starting out or new to markets:
Go out and accumulate them during market corrections with a view to hold on to them forever. The key word is general market correction.
f) Do not buy them if there is a specific company issue. For example, don’t buy Nestle during the maggi issue- that is a different ball game
g) This set up is to buy them when the fall in their stock prices is not directly linked to the business but a broader market fall in general across stocks.
Why does it work?
a) Strong businesses often thrive in difficult environments
b) Managements have seen multiple cycles and know how to deal with cyclicality
c) The concept of optionalities- good managements keep finding newer revenue sources.
Examples: Amazon web services
Generating Investment Idea Source 10:
Change in Management
a) This is a big one
b) He said earlier that the most important thing for a stock is its earnings
c) It is the management that makes the earnings happen. Hence it is one of the most important variables watched by the market participants.
d) A change to a well known and a proven management/manager can trigger a large rally in the stock even before the new management starts delivering tangible results.
Examples: Chandra and TATA group , CG power and Murugappa and More recently Aditya Puri and PNB HF
FEW GENERAL PRINCIPLES
Rule of thumb for Margin of safety
a) Can this stock be down 50% after three years?
b) Profits five years down the line equal to today’s market cap
c) These are heuristics which point to extreme cheapness and a potential for multibaggers
d) These situations won’t arise on a day to day basis
e) Especially useful during deep corrections as it gives you the confidence to buy during panics
Small Caps- Vehicle of choice
a) One of the best ways to play small caps is to play them as a market cycle play
b) Small cap moves are accentuated on both extremes
c) In bull markets they are over-valued to extremely undervalued, often priced for bankruptcy
d) Next time there is a deep bear market; just go out and buy a few small cap mutual funds- you won’t be too disappointed with the results after 3-5 years. If it’s a march 2020 like fall, which was sharp and swift; you will get your results much sooner.
The game of Margins
a) Margins tell the story of where the business is in its cycle
b) Tracking the margin trajectory often gives very pertinent clues and opportunities
c) The see-saw of the margins from the lower end to the higher end is essentially what the cyclical investors do best
d) However even in a non cyclical business; periods of very high margin are followed by months and months of stagnant prices as the EPS (Earnings per share) of the high margin years takes many quarters to be taken out again.
ROCE DELTA (Return on capital employed changes)
What is common to almost all multibaggers?
a) An improvement in ROCE from single digits to high double digits
b) Look at any multibagger and you will likely see this- Avanti feeds, GPIL.
c) This happens as a confluence of multiple patterns that we have discussed: Change in management, Demand coming back, Margin expansion, Understand what is driving the ROCE and these can be high conviction and very rewarding bets.