InvestRationale: My 2006 approach and rules for investing

1st of my 5-series post on how I have been looking at investing in equity since Dec 2006, when I decided to put my money where my mouth was and start learning investment with real $$$. In Dec 2006, on a flight back to India, I created this note for my wife on how we need to put our money to work. Since then, I have tweaked the approach. Now, I have decided to put my experience and changes made to my investment outlook in this very public forum in keeping with the title of my blog "Nothing Held Back". In 2006, focused on a quick country and quick sector view, moved to a very ETF centric investment approach and evolved 13 rules of investing for our equity holdings. Here is how I laid it out then: Country/region specific view – Dec 2006 US o Pros: Most innovative economy, largest economy, huge company profitability of late, inventory exhausting, potential investment in capital by cash rich companies, developed financial markets o Cons: High deficit, high debt, currency fall risk, housing price collapse, consumer confidence may get hit Western Europe (non UK) o Pros: 2nd largest economy, good governance of companies, developed financial markets, Government will step in to prevent run-away losses, excellent infrastructure, European stock markets already moving up and economy getting better o Cons: Ageing population, slow growth, stagnant policies, Euro costly (currency risk big), general sense of unhappiness will impact growth, extensive social protection, high tax wedge on labour income reducing the incentive to work, high non-wage labour costs, rigid employment protection and persistently weak domestic demand depressed the demand for labour Japan o Pros: 3rd largest economy, excellent companies in some sectors, banks re-structured, its Government efforts to directly boost economy, currency will not go down but likely up, brilliant technical capability, hard working quality conscious people, huge trade surplus o Cons: Ageing population, slow growth, China/US/Taiwan/Korea taking away its existing areas of dominance, oil dependent economy, resource starved, immigration low therefore wage impact, bad relations with neighbours India o Pros: fast growing economy, IT and service driven economy, young population, driving hard, optimism, realization that infrastructure needs to be focus area, entrepreneurial, scientific man-power, highly educated manpower coming in droves, significant expansion in the production of durable consumer goods including cars, scooters, consumer electronics, computer systems and white goods, Services, including airlines, banks, construction and small-scale private traders, as well as the public sector, accounted for 49.4% of GDP in 2001/02; Indian companies gaining confidence and striding globally o Cons: Oil dependent economy, political wrangling with left, slow reforms, lop-sided growth, endemic poverty, pathetic industrial infrastructure, India’s trade deficit rising. Although exports performed strongly, rising by 31.3% to US$78bn, imports soared by 42% to US$97bn, Two-thirds of India’s labour force works in agriculture which, with forestry and fishing, accounts for around 25% of GDP and most are on subsistent basis, agriculture monsoon dependent; service sector wages rising very fast; hubris of corporate chieftains Latin America o Mexico still a commodities driven country, could not capitalize on US relations, excellent literate population, endemically weak? o Brazil is a commodities story again; but seems the seeds of economic growth are growing deeper; market friendly socialist government o Peru/Chile : tourism, commodities driven – difficult to find vehicles to invest in South Africa o South Africa, best known for its precious metals, fruit, and wine, has in fact moved from an economy historically dominated by mining and agriculture to one where manufacturing and financial services contributes the larger share of GDP. o Mining, nevertheless, remains an important foreign-exchange earner: gold accounts for over one-third of exports. The main mined products include manganese, chrome, platinum, gold, coal and diamonds. o Agriculture, together with mining, continues to be an important provider of both direct and indirect employment. o Manufacturing accounts for around one-fifth of total GDP, but has faced significant challenges since the opening up of the economy to global competition. o Metals and engineering, especially steel-related products, drive the sector. o Services is the most important contributor to GDP, ranging from an advanced financial sector to a developing tourism sector, which has significant employment potential, and an active retail sector. o Unemployment is a worrying structural feature of the economy. With the official unemployment rate at 29.4%, creating sufficient jobs for the estimated 4.7m currently without jobs remains the most critical economic challenge in South Africa. The high unemployment rate has contributed to South Africa’s ranking as one of the most unequal countries in the world judged by distribution of income. Canada o Pros: leading G8 economy, excellent infrastructure, commodity rich, services sector accounting for over two-thirds of the country's output and providing employment for nearly three-quarters of the working population, NAFTA, good peaceful relations with almost all, taxes (personal and company) should go down or worse case remain at the current levels; water can be next “white gold” o Cons: US dependent, highly taxed, greying population, weakening manufacturing prowess, socialist tendencies, Quebec separatism moves can result in pressures on costs, minority Government can be unstable and not good for economy, lack of ambition Industry/sectoral perspective - 2006 1) Bullish: alternative energy, refining, infrastructure builder, gas and petrol tech, engineering consulting, defence, biometrics, security equipment, ports, high end containers, US religion, US sports at good price, genetics, staples, high end retail, metals, materials, pilot training and simulators, manpower consultants in 3rd world, video & wireless equipment, aerospace, mid end hotels 2) Neutral/watch/confused: communication service, internet infrastructure, health, brokers (or banks), transportation, Web 2.0 3) Bearish: Airlines, auto, ancillaries, building, building supplies Our rules to be in the game 1. Be humble when making gains – they may be fleeting 2. We must always remember rationality and economics are just some factors in driving equity; fear, paranoia, herd mentality, psychology, mass hysteria, politics drive these markets, albeit in short to mid term, long term fundamentals will triumph 3. Shall not pay management fees to the greatest extent possible – look for lowest cost of investment 4. Investments will be made with a mid to long term perspectives, not short 5. Money will be lying in easy float in e-Trade to capture any panics (e.g. temporary fall) in markets or shares we believe in 6. We may go along with advice from pundits but we will always take a few contra or unique bets 7. We will not over-diversify our portfolio i.e. we will not spread across all sectors – we may rotate choice of investments in accordance with business cycles and sentiments and bulk of our investments will be in 5 to 7 industries or plays (sector, region, segment) with a maximum of 20 individual buys (shares plus ETFs plus indexes) 8. For ETFs, the general rule would be to buy from: o Vanguard for US exposure and global generic o iShares for different countries o Powershares for exotic global and US sector offerings o Claymore for exotic bets no one else wants to take 9. For individual company buys, we will buy o Check industry – bear or bull o Company must be profitable for the past 2 years o If operating cash-flows are regularly rising o It has uniqueness in market o We understand the market, customer needs and general direction of the company o There are no major know litigation challenges? o After P/E and PEG checks o For Hi-tech unproven companies (additional criteria): Uniqueness of model, Mgmt background - Israel, IIT, MIT, Entrepreneurial hunger, Makes life or business easy 10. Quantitative factors to consider while buying stocks o Price to cash flow (income – depreciation + amortization) very well rewarded in the market o Large caps with low Price to Sales do well o Dividend yielding large caps do well o Low price to book rewarded, not Price to earnings o Is there price momentum for a year or 2 o Conservative ratios: debt to equity <= 1.55, CR >= 2, QR >= 1 ; o Safety net asset value = (CA – CAL – LTD) / Number of shares below 1/3 is a steal o Long term earnings over 5 years; average over 5 years versus current earnings 11. Smart advice to consider from others o EPS, EPG Growth > inflation, payroll/ revenue o Qualitative (ugly duckling, spin-off with low attention, Porter analysis, defensive, lower analyst coverage, faster growth in dull industry) 12. When to sell o Sees too much upside – market has embraced the scrip – take off and then come back when pull back o Valuation has changed completely o Perspective for buying initially has changed to the negative o Too many analysts covering a “hot tip” 13. Low cost players are attractive when o Scale o Location advantage o Regulation specific advantage