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The Golden Rules [REVISITED]

The Golden Rules [REVISITED]

The statutory minimum period for reporting financial results is three months.

Great investors shape portfolios to last for decades. But the statutory minimum period for reporting financial results is three months. Every quarter, numbers change. You should review investment decisions when numbers are updated. Also, the Budget offers a chance to fine-tune forecasts. It shows the macro shape of things to come.

Six months (two fiscal quarters) ago in October 2006, MONEY TODAY formulated nine golden rules that help investors design long-term portfolios. These commonsense principles hold through ups and downs. Higher sales, higher profits, better valuations, etc— only exceptional businesses meet all the set criteria.

The rules are inviolate. But we set specific benchmarks and it makes sense to review those. We also generated a portfolio that met our benchmarks and seemed likely to be great long-distance runners. There’s ample information to update six-month-old estimates and see if anything needs tweaking.

Our portfolio (see page 39) has lost around 6% while the Nifty is hovering at its October levels. Relax! We stick by our October recommendations. The losses are scarcely enough to trigger a panic attack. The stocks we picked continue to have marathon potential. More detailed projections are available on page 42. As for the rules and benchmarks, a refresher follows:

Higher sales is a must. Look for 30% growth per year
Because everything flows from the top line

Obviously sales growth is key to stockbuying decisions. And, if we look at the uniformly excellent October-December results, there’s no obvious reason to ease up on the 30% benchmark.

Our expectations suggest that on this parameter, TCS (81% growth projected for 2007-8) and Suzlon (222%) from our portfolio, will outshine the others. But most will comfortably meet this benchmark except for Varun Shipping and Kirloskar Brothers. In these two businesses however, we see huge growth prospects over the next three years, though 2007-8 may not be exciting. Our overall projections suggest that 2007-8 may see slowdowns across most sectors in terms of sales growth (see page 42). So, if you’re looking for new picks, perhaps you can ease turnover growth requirements down to 25%.

Profits should have outpaced sales
PAT should have grown at over 30% every year for the past three years

This is another obvious criterion along with sales growth. Not only should a business deliver on sales growth, it should also register rising profits.

Ideally, the PAT should outpace turnover growth—otherwise profit margins are either stagnant or dropping. Since our benchmark was 30% sales growth, we believe that PAT should grow at over 30%. A business that registers 30% sales grwoth and over 30% PAT growth is moving at a fast clip and maintaining high profitability. Our portfolio will by and large, meet this target in 2007-8 except for Kirloskar Brothers. Again, we reiterate our belief that KBL will be a big beneficiary from massive investments in the water sector and irrigation that the Budget announced. Ultratech could be the outperformer in PAT growth despite the government’s step-motherly treatment of the cement sector

Making your money sweat
Look for a return on net worth of 25% or more

Does a company use its funds efficiently? Or does it swallow huge amounts of capital?

One way to judge capital efficiency is to compare profits with net worth. Net worth is the sum of the equity capital and retained profits. The percentage of profict after tax (PAT) to net worth is return on net worth (RNW), or returns on equity (RoE). The Nifty has an average RNW of 22.75%. We suggested a premium to that benchmark in setting the RoE at 25%. One caveat is that a company with a small equity base and a high debt component may register a misleadingly high RoE.

The best ratio to check for debt is return on capital employed (RoCE) which is the percentage of PAT to net worth plus long-term debt. RoCE should be at least 15% if RoE is 25%. All the companies in our portfolio comfortably ease past these qualifiers.

Looking beyond price to find real value
Use price to earnings ratios and dividend yields to buy cheap

We want to buy when the share price is lower than the value of the business. The most common valuation measure in use is the PE ratio (see page 51). High-growth companies often have high PEs. Ideally, you should compare EPS growth to PE to see if a stock is fairly valued. A high PE can only be justified by high EPS growth projections.

The PE divided by the projected EPS growth rate is called the PEG ratio and this should be less than 1 for a company to look good on this account A more conservative measure is the dividend yield, which is dividend per share as a percentage of price. But dividend payouts will fall this year as corporates adjust for a higher tax on dividends. Our stocks are lower than PEG 1 except for Praj Industries and Kirloskar, which are only marginally over.

Cheap stocks can be very expensive
High-priced stocks may be better value

This is a follow up to the previous rule about the difference between value and price. A loss-making business may be very expensive at any price. You should buy a lossmaker only if you see prospects of a turnaround or takeover perhaps.

Here we didn’t set any benchmarks. But smaller businesses are more vulnerable to both price speculation by traders as well as to business risks. We believe that 2007-8 will see more volatility and somewhat lower EPS growth than 2006-7. Hence, we suspect that this makes small stocks more risky. The BSE Small Caps (0.4%) has underperformed the Nifty (11.6%) through the past 12 months. It doesn’t affect our chosen portfolio, which consists mainly of midcaps or even larger stocks. In general, we would advise investors to steer clear of small caps in 2007-8.

Heads you win...
Subscribe to IPOs only if you like betting on the toss of a coin

Is an IPO allotment really equivalent to winning a lottery as so many investors seem to believe? According to Prime Database and MONEY TODAY (see The IPO Treasure, 30 November 2006), it’s not quite that way. Prime Database’s research suggests that if you sell an allotment immediately upon listing you will usually make a profit. But this is not a method favoured by long-term investors—it’s much more akin to the mindset of a hard-core trader. If you hold an IPO for the longer term, returns are more uncertain. In a bull market IPOs are often over-priced while they dry up in bear markets. Out of the 79 IPOs launched since last April, 49 are now trading below issue price. Out of 68 IPOs in 2005-6, 21 are below issue price. If you buy an IPO for the long term, you may lose money quite often. It’s safer to target listed companies with a longer track record. You can be a successful investor while ignoring IPOs.

Learn to cut your losses
Don’t get emotionally invested. Set loss limits and stick to them

The worst losses occur when the investor gets stubborn about a decent business, in which he has invested in at too high a valuation and price. The IT boom of 1999-2000 threw up several classic cases. Wipro, Infosys, Satyam are great companies but they were trading at unrealistically high prices in early 2000. Investors at those levels lost money for the next seven years.

Always set a personal loss-limit and sell if that limit is hit. One trader’s trick that might help is to translate a loss limit into the terms of circuit filters. For example, a loss limit of 20% translates to five maximum loss sessions for a stock with a 5% circuit. But while we believe in the principle of stop-losses, we certainly haven’t hit the loss limit on our portfolio of 10 stocks as yet.

Don’t under or over diversify
Three stocks may be too few, and thirty, too many
If you hold too many stocks, you’ll get a return that very closely approximates the market return. If you don’t mind that, you may as well buy an index fund rather than go through all the trouble of picking stocks.

Conversely, if you hold too few stocks, your portfolio is subject to wild swings. A portfolio of somewhere between six and 15 stocks spread across several industries will give smoother returns and still offer chances of beating the index. For example, in our 10-stock portfolio, Praj Industries has gained 84% while Varun Shipping has lost 28%—that’s a big range of potential returns. But the overall portfolio return is just minus 5.9 %. We believe this portfolio is diversified enough to insulate us from wild swings.

All things come to she who waits
Returns rise if you hold for the long term

Once, you’ve selected a business, you must give it time to generate returns. Sure, set stop-losses based on the amount you are personally prepared to risk. Review your picks with reference to the balance sheet. But ignore the short-term price swings so long as your personal pain barrier is not breached. In the short-run prices can move very unpredictably. In a single year, the Sensex may swing anywhere between -54% and +268% if we go by its record since 1980. But over 27 years, the BSE Sensex has offered an average of 30% compounded to those investors who have stuck it out for five-year stretches. And there isn’t a single rolling 10-year stretch since 1980 ( counted as 1981- 1991, 1982-1992, etc) when the market has delivered negative returns!