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The Pointlessness of Fretting Over 'Eighty Percent' - Views on News from Equitymaster
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  • Oct 3, 2017 - The Pointlessness of Fretting Over 'Eighty Percent'

The Pointlessness of Fretting Over 'Eighty Percent'
Oct 3, 2017

I was a student when I first heard of Pareto Principle. It states that for many events, roughly 80% of the effects come from 20% of the causes.

My colleague was quick to apply it to the life of engineering students, notorious for finishing 80% of the projects and syllabus in 20% of the time. Incidentally just before the deadline and exams.

Interestingly, the father of Pareto Principle is an engineer named Joseph Juran. The discovery goes back to Second World War. Juran worked for the government in Washington streamlining shipment processes. There, he noted that most defects in production are due to a small percentage of all the causes of defects. He classified these causes into 'the vital few' and 'the trivial many'.

He named this discovery after the economist Vilfredo Pareto, an Italian professor who found that 20% of the Italians owned 80% of the land in Italy. Pareto principle is loosely called as 80:20 rule.

The 80:20 rule laid the basis of Japan's quality-control systems- the best in the world. Its universal use makes it one of the most crucial concepts of today's management.

Think about it. The law is all pervasive. Be it life, business, economics or science...the results of any situation can be traced to a few vital causes.

'The Vital Few' Vs 'The Trivial Many'



Consider these.

Roughly 20% of all your activities that you engage in over life generate 80% of your income.

20% of the relationships bring you 80% of the happiness.

Microsoft once came up with observation that 80% of the crashes and errors are caused by 20% of the bugs. .

In business, 20% of the clients account for 80% of the sales. The same could be said for employees as well.

20% of the people account for 80% of the wealth in a nation.

Just 700 words make up two-thirds of our language. - Sir Isaac Pitman

The 20% could be 10% or 30% for some, but the message is clear.

Don't sweat the small stuff. Focus on few but vital aspects of a matter, and you could make a big positive difference.

Pareto Principle in Investing

Did you know that 90% of Warren Buffett's returns came from just ten investments ? (Source: "The Tao of Warren Buffet" by Mary Buffett and David Clark).

Look at the typical portfolio allocations. The high risk and high potential stocks (mostly small caps) ideally should not be more than 10%-20% of the portfolio. Further, look at your own portfolio. Chances are 80% of your profits stem from 20% of the investments. Or 20% of your investments could account for 80% of the losses. That's why legendary investors suggest letting the winners run and cutting losses early.

In this digital age of communication, indeed, you must cut 80% of the noise to get to the 20% information that really matters.

We certainly end up rejecting 90% of the stock ideas before finalizing one Phase one stock.

You see, there are quite a few areas in investing where Pareto principle plays out.

But the one I want to emphasize most is the stock price performance.

Phase one Investing - A Non-Linear Journey

Investment returns on stocks are mostly nonlinear. More so for less liquid stocks.

For one, the returns may not come in the time line you expected despite the good business performance. There could be a long period for Phase one stocks when the stock price refuses to budge (as very few investors know about the business in the initial stage). It may even correct due to low liquidity in the stock when market sentiments turn negative.

It is frustrating to see your investment stagnate or decline when the market is in a bull run. You may feel isolated, dejected, mocked at. And may end up selling a great business.

Let's consider a real-life example.

Last year, I shared with you the journey of Relaxo Footwear from Phase One to Phase Two Stage.

While the financial performance for Relaxo was quite volatile between 2001-06, its fundamentals were marching towards Phase One in FY07. By the end of FY08, the company was clearly in Phase One Stage. Its return on net worth and return on capital employed had improved from single digits in FY06 to 19% and 20% respectively in FY08.

So how did the stock perform?

Relaxo Footwear's Performance as it Enters Phase One Stage

After four years, there were hardly any stock returns to show despite the improvement in the fundamentals. Most investors would have quit in this period. It would indeed have taken a braveheart to hold on to the stock through this roller coaster ride.

To the one would have not given up then, the investment in subsequent months would like this.

Stock Price Surges in the Fifth Year

The stock price multiplied 15 times in five years (2005-10). But the actual gains came only in the final year of the five-year long period, i.e., in 20% of the period.

  • You only have to do a few things right in your life, so long as you don't do too many things wrong - Warren Buffett.

With a fifteen bagger in your portfolio, it would not have mattered much if a few investments would not have performed as expected (another instance of Pareto Principle : a few stocks drive the major gains in the portfolio).

Keep this example in mind through your entire Phase One Journey.

Updates on The Existing Recommendations

Last week, Arrow Textiles Ltd.'s AGM took me to Nasik.

With few in attendance, it was quite a nonevent. The entire affair was over in less than 15 minutes. Typical of AGMs of companies of small companies with low liquidity, this was expected.

However, I did get a chance to speak to Mr Chand Arora, the Managing Director, in person.

The financial performance of the company has been in line with expectations. I was curious about the status of plant expansion.

One must note that at the time of recommendation, the management was considering a capacity expansion for higher margin products (with gross margin as high as 80%). The expected time line to start another plant was 1.5 to 2 years. In our estimates, we had expected the incremental capacity to get reflected from 2019-2020.

However, things have slowed down on that front. Mr Arora stated that the company is facing some difficulty in getting land at reasonable rates in Nasik. Because of this, we expect a delay in capacity expansion.

On the positive side, with the formalization in the economy, the long-term story for the organized apparel industry is getting better. Arrow Textiles, with a strong balance sheet, is likely to be a key beneficiary. A case in point is Page Industries' upcoming expansion. Page Industries' plan to double its capacity in by 2020 is likely to benefit Arrow Textiles (Page Industries being one of the top five clients for the company). Further, Arrow is planning to shift the product mix to high margin labels.

Overall, the long-term scenario remains good. However, capacity expansion was one of the key reasons for recommendation. With the uncertainty and delay in the capex, we recommend subscribers to consider holding on to the investment and not buy further shares. We will track the developments on this aspect and will keep you updated.

Pokarna Ltd conducted a concall few weeks ago. Revenue for the quarter ended June 2017 declined 23.8% YoY while bottomline was down 70.5% YoY.

Don't be alarmed. The financial performance suffered as plants were shut down for 45 days for maintenance purpose. The operations have normalized in the second quarter.

The maintenance operations of this kind were undertaken after 7 years. Further, the management plans to take modernize plant in a way so that parallel production can be carried on and does not have to be stopped at the time of maintenance. As such, this disruption was one off event.

The management has maintained the growth guidance of 10%-12% for FY18. It expects to maintain the margins.

After a successful tie up with Ikea, the management recently participated in annual CREDAI (Confederation of Real Estate Developers' Association of India) event which is attended by all prominent builders from India. Such steps are likely to improve visibility and expand domestic market for Pokarna (around 80% revenues from exports). It is also directly marketing to builders and architectural community.

Update on Pokarna's Quartz Capacity Expansion

The greenfield capacity expansion plan worth Rs 3.25 billion in the quartz segment (by 130%) may witness some delay due to the delay in land allocation. While the state government had allotted a plant to the company initially, it was withdrawn as the government now wants to construct a government office complex in that area . And it does not want a manufacturing facility in its proximity.

The company is actively looking for public or private land. Once the land is finalized, it will take another 15 to 18 months for the plant to be ready. The initial estimated timeline for the plant to be operational was June 2018.

In the quartz segment, the company is differentiating itself through its exclusive high quality Bretonstone technology. It is exclusive in the sense that Bretonstone only picks one player in a country. It is worth noting that not a single player in China has access to this technology. Globally, only 25 players (60 odd lines) have access to this technology.

Regarding granite segment, while the competition remains strong, the company is differentiating by offering high value cut to size (customized) stone. Having own quarries in granite (and even quartz) also gives company a strong edge over other players.

Pokarna is yet to refinance its loan at lower rate. Once this happens, the interest rate is likely to come down from 14% to 6%-8%.

Overall, the fundamentals of the business remain strong. The US is witnessing good demand for quartz. The management is focusing on improving product mix, distribution network, brand visibility and customer connect to make the most of the strong demand. Apart from US, the company is focusing on other markets like Australia.

Here is the performance review table for the recommendations made in Phase One Alert so far.

Company Reco. Date View at the time of recommendation Reco. Price (Rs) Maximum Buy price (Rs) Price as on Oct 03rd, 2017 (Rs) Adjusted Change (%)** View as on 3-Oct-17
National Fittings Ltd 22-Sep-16 Buy 189 230 230 22% Buy
Arrow Textiles Ltd 2-Feb-17 Buy 43 NA 42 -2% Hold
Arman Financial Services Ltd 6-Feb-17 Buy 238 270 214 -10% Buy
Pokarna Ltd 4-Apr-17 Buy 1,232 1,400 1,046 -15% Buy
Captain Polyplast Ltd^ 8-Jul-17 Buy 50% of the sum intended to invest into the stock 174 165 165 3% Buy

^ The view on Captain Polyplast Ltd was changed to full buy after the price correction, at a price of Rs 147.5. The maximum buy price was revised to Rs 165. The adjusted change considers average buying price.

Moving on to a fresh opportunity we have come across....

Electric Vehicle Revolution - While Big Auto Companies Are Nervous, This Company is Gearing Up to benefit from The Trend

Last week, we took a 5:15 AM flight to a South Indian state. The pain of an early morning flight was dulled by the excitement to finally meet the management (we had been trying since last one year).

I can't disclose the name of the company at this stage. But will try my best to share what excites us about it and the meeting takeaways.

This is an auto ancillary firm with a market share of 30%. It's an owner operated business with a lot of growth potential.

While the company is small at this stage, it is highly respected for the quality of its products by both Indian and International auto OEMs (Original Equipment Manufacturers). Besides, the company is focused on profitability and cost control. All these aspects are reflected in the margins and return ratios of the company which are the best in the industry. The market leader in this segment is six times the company's size. Yet, less profitable. The most exciting part is its valuations (P/E ratio) - at 60% discount to the market leader.

We were eager to know how this company manages to command industry best margins, return rations and realizations. And whether these can be sustained and grown.

Before we had the chance to shoot queries, the management came up with this (to the best of my memory):

Well, before discussing the current business, let me tell you we have a sword on our heads. Even though auto industry will take some time in fully going electric, it's a big disruption.

The whole industry, including us could suffer. However, we have already started developing a product that will help us adapt to this change. We hope to be well ahead of the industry that way.

Disruption is a part and parcel of any economy and industry. But few have the foresight to take stock of such changes and adapt accordingly. Those who are aware and take timely action survive and prosper. Rest witness a 'Kodak' moment.

As far as electric vehicles are concerned, it's a disruptive force (or an opportunity depending upon a player's approach) for all the existing auto and auto ancillary players. We know some managements who would waive off this threat and rather bury their heads in sand. But this one was quite different.

We were impressed by the honesty of the management in admitting challenges in the business. Most importantly, by its proactive approach to develop a product that will help it turn a disruptive force into a business opportunity.

Well... the early signs look interesting. We are working on this idea in more detail to see if this can be the next recommendation for you. Stay Tuned.

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INTRODUCTION:
Equitymaster Agora Research Private Limited (hereinafter referred to as "Equitymaster"/"Company") was incorporated on October 25, 2007. Equitymaster is a joint venture between Quantum Information Services Private Limited (QIS) and Agora group. Equitymaster is a SEBI registered Research Analyst under the SEBI (Research Analysts) Regulations, 2014 with registration number INH000000537.

BUSINESS ACTIVITY:
An independent research initiative, Equitymaster is committed to providing honest and unbiased views, opinions and recommendations on various investment opportunities across asset classes.

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There are no outstanding litigations against the Company, it subsidiaries and its Directors.

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Details of Associates are available here.

DISCLOSURE WITH REGARDS TO OWNERSHIP AND MATERIAL CONFLICTS OF INTEREST:
  1. 'subject company' is a company on which a buy/sell/hold view or target price is given/changed in this Research Report.
  2. Equitymaster holds 1 share of Arrow Textiles as per the guidelines prescribed by the Board of Directors of the Company. The investment is made for research purposes only.
  3. Equitymaster has no other financial interest in Arrow Textiles.
  4. Equitymaster's Associates and Research Analyst or his/her relative doesn't have any financial interest in the subject company.
  5. Neither Equitymaster, it's Associates, Research Analyst or his/her relative have actual/beneficial ownership of one percent or more securities of the subject company at the end of the month immediately preceding the date of publication of the research report.
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