The simple rule that can turn good returns to great - The 5 Minute WrapUp by Equitymaster
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The simple rule that can turn good returns to great

Mar 5, 2015

In this issue:
» Do you have these most expensive stocks in your portfolio?
» Excerpts from Dr Rajan's Q&A with analysts post rate cut
» Can this change the fortunes of PSU banks?
» ...and more!

If there's one industry that moat-loving investors are more allergic to than any other it is indeed the airline industry. And not without reason. The track record of the industry in terms of creating wealth for shareholders is easily the worst of all industries.

In fact, the joke doing the rounds is that thank god capitalists were not around when the Wright brothers flew their first plane. For had they been there, they would have certainly shot the plane down! Indeed, had it not been for repeated cash infusions into these companies, the cumulative net worth of the industry right since its inception would have been hugely in the red today.

Criticism aside, why is this particular sector a favourite whipping boy of investors? For starters, the sector's dynamics fly in the face of the famous Warren Buffett advice of staying with simple propositions. Or for that matter the Peter Lynch mantra of never investing in any idea you can't illustrate with a crayon.

To be more specific, imagine you have taken fancy to an airline stock. And are considering making an investment in it. Now try making a list of things that need to go in your favour over the next 3-5 years for your investment to be successful. First up, you need the economy to be in good shape. This is because when times are bad, flying is one thing people may want to cut down on unless it's absolutely necessary. Secondly, you have to pray hard that the competitive intensity of the sector stays low. And also that there's no pricing war.

Thirdly, if you are buying planes, you would be up against a powerful duopoly of plane manufacturers in the form of Boeing and Airbus. Therefore, even here, you may not get your planes on the most favourable terms. And if demand is high, you will have to endure a long waiting period. Then there are factors like crude oil prices, availability of trained manpower, capacity utilisation, interest rates etc. Mind you each one of these is capable of running the company to ground on its own. Thus, all in all, a long list of independent variables that needs to go your way for your investment to be profitable.

If you are still not convinced, let us try and seal the deal using some basic math. Imagine that there are about 6 independent variables on which your airline stock is dependent on and each of them has a 90% chance of going your way. Any idea what the overall success probability comes to? Well, all you have to do is multiply 90% six times and the answer comes to a little over 50%. That's a poor odd isn't it? Increase the list to 10 and the overall success probability falls further to a mere 35%!

We hope it is now clear why Warren Buffett mentioned the idea of sticking with simple propositions. You see, it is all about how many variables need to go right for your investment to be successful. If there's just one variable on which the entire investment is dependent upon and it has a 90% success of probability, the chance for a successful outcome is obviously 90%. But as the number of variables increase, the success probability keeps going down even though each of the factors individually has 90% chance.

We are strongly of the view that internalising this one idea can save you from a lot of heartburn in the future. Therefore the next time you are itching to commit money to a stock, try making a list of variables that need to go right. If you see the list moving beyond a few variables, you would be better off forgetting about the stock we believe. In other words, why jump over a seven foot pole when there are several much lower placed poles available.

What do you think? Do you think staying with simple propositions is a much better strategy over the long term? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
We just saw how the idea of sticking with simple propositions can generate huge wealth for shareholders over the long term. However, ignoring this one factor can overweigh the simple proposition advantage that you may have. And that factor is valuations. Today's chart shows a list of stocks that are trading at abnormally high valuations. As can be seen, the P/E band is somewhere between 50-100x.

Such high multiples are a sign that lot of earnings expectations are built into the price. If the multiple sustains it indicates that the faith in earnings delivery is even higher. However, if the earnings growth does not materialize for such stocks then there could be a huge correction.

This is where an investor needs to be smart and judge the earnings sustainability factor of high P/E companies. For example, from the list, Page Industries and Asian Paints have business models such that their earnings can be forecasted with reasonable certainty. However, for other engineering companies that are cyclical in nature predicting earnings is difficult. High PEs of such stocks reflects markets are pricing in a huge recovery in earnings. And if that fails, correction could be on the cards.

Most expensive stocks on P/E benchmark
AP$ = Asian Paints

After surprising markets with a repo rate cut ahead of the monetary policy yesterday, Dr Rajan spoke on a range of issues right from inflation to fiscal consolidation in his interaction with the investing community later. With respect to further rate cuts, which the street was most interested in knowing about, Dr Rajan chose to maintain a diplomatic stance. Just few days prior to the monetary policy, he was misquoted by the media as being hawkish when he addressed a public gathering. As such, this time when asked about future stance he chose not give a direction or guidance.

He was also vocal on dangers of excessive rupee appreciation and consoled investors that RBI will step in if need be. On inflation targeting, he has given a timeline of 2 years with a mid-point range of 4% odd. He also praised the fiscal consolidation measures of the government which gave him headroom to cut rates.

His comments on inflation targeting and quality of fiscal consolidation are noteworthy. However, we reckon keeping inflation at sub 4% kind of range in the long term will prove to be a challenge. This is because currently RBI has natural advantage from falling crude prices and food inflation. If rain gods frown or for that matter the Gulf countries decide to cut oil production both food and fuel inflation shall rise. And RBI will be able to do very little then as monetary policies are inept to curb supply side inflation.

Also, it should be noted that the quality of fiscal consolidation is a matter of debate. Currently, there is a windfall from coal and spectrum auctions which is window dressing the actual deficit. Thus, it remains to be seen if government and RBI are actually able to deliver on their promises.

Let's move from a rate cut story to a PSU banking story. And when it comes to PSU banks, talent crunch and inefficiency are the centre points of discussion. However, it seems that the new government is determined to solve them. For one, it has now created a separate post of MD & CEO and is seeking applications to find suitable candidates. Also, the hiring criteria, which was opaque until now, is made more transparent. This is likely to invite more applications. What more, the government has also agreed to loosen its purse strings to hire talent.

Till now, the biggest disincentive to work for PSU banks was below par salary. As per reports, PSU chiefs generally get paid 1/5th of what their private counterparts draw! This is a huge gap by any means. So, government's willingness to bridge this gap is a welcome move.

But the question is will it invite chiefs of private banks to PSUs? Well, to be quite honest it may but with certain challenges. For one, PSU chiefs generally lack freedom to operate. And even best of the talent will not be able to perform if not given freedom.

So, if the government is indeed keen to change the fortunes of PSUs it must give a free hand to the incoming candidates. Only independent decision making can generate results and not piecemeal efforts. The latter, in fact, weaves bureaucratic webs and impedes growth. With Modi government banking on the theme of minimum government and maximum governance it remains to be seen if the new PSU crop will be given operational freedom or not. Else the entire exercise to hire talent from outside will go down the drain.

The Indian stock markets are trading weak today. At the time of writing, the BSE-Sensex was trading down by around 150 points, while the NSE-Nifty was down by 53 points. Losses were largely seen in capital goods and metal stocks. Most Asian markets were also trading in the red at the time of writing. European stock markets, however, opened in the green today.

 Today's investing mantra
"Nothing sedates rationality like large doses of effortless money" - Warren Buffett

Editor's Note: Please note that there will be no edition of The 5 Minute WrapUp on Friday and Saturday on account of Holi. We wish our readers a very happy and colourful Holi.

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

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2 Responses to "The simple rule that can turn good returns to great"


Mar 6, 2015



Dorairaj R

Mar 5, 2015

I completely agree with you; 2 stocks I hold with this view are Castrol and Pidilite. Request you take up these 2 as examples some other time and provide your views. Extremely difficult to resist the idea of booking profits whenever I think they have unreasonable excessive P/E values( I failed sometimes )

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