April 25, 2013
Maintaining a Strict “Sell” Discipline
I continue to tell my subscribers that in sideways markets buy and hold for the long-term is a losing strategy. Before you get upset and start hurling Warren Buffet quotes at me, let me explain. In his book Active Value Investing, Vitaliy Katsenelson provides a blueprint for how to approach range bound markets. What he explicitly states is that “although principles of fundamental analysis are agnostic to the long-term direction of the market, stock analysis and investment strategy should be actively recalibrated to adapt to changing market environments.” What is he saying exactly? Essentially, he’s trying to get the point across that in a secular bear market investors need to maintain an active “sell” discipline. In bull markets investors are rewarded for “buying and forgetting to sell” as P/Es continue to expand. The shares of so-so companies continue to rise and the shares of great companies shoot to the stars. Warren Buffett generated the vast majority of his wealth in the late 20th century bull market in the US that began in 1982 and ended with the dotcom crash in 2000. He was essentially rewarded for buying and holding the shares of great companies. Most value investors know the list of companies by heart and includes names such as Coke, Wells Fargo and See’s Candies. However, during Buffett’s partnership years (1957 to 1969) nearly half of his profits were generated through special situation type investments such as merger arbitrage, liquidations and spin-offs. Interestingly, from 1966 – 1982 the Dow Jones Industrial Average was caught in a tight trading range. During this range bound market Buffett clearly chose alternative investment strategies rather than solely relying on a buy and hold approach. Thus, the view that he’s a buy and hold investor is an oversimplification. Katsenelson states the following in his book:
You need to become an active buy-and-sell investor. I cannot overemphasize the importance of the selling process. You need to sell when your stocks hit their predetermined sell valuations, which will be emotionally difficult, since it will happen when everybody else is buying and excited about the market again.
You need to become an active seller in range bound markets because P/Es continue to grind lower and the shares of average companies get crushed while the shares of great companies barely tread water. The next question you might have is how do you know we’re in a range bound market? Unfortunately, the answer to that is beyond the scope of this post. But I recommend that you read Katsenelson’s book. He dedicates the first half of the book to supporting his thesis that the US is in a range bound market. I’ve written a review of the book here. Additionally, I think the 2007/2008 market experience clearly violates the belief that the emerging markets such as India have somehow decoupled from the developed markets and in particular the US. The phrase “correlation goes to one in times of market stress” is a generalization but it does have a strong basis in reality. If you’re interested in my view on prospective returns over the next decade in the US market, you can read an article of mine titled “Scrambling for Returns” published by Mauldin Economics earlier this year. You can find the article here.
My call on Infosys
I’m writing this post to highlight that an active value approach can be utilized effectively and that it worked flawlessly with my Infosys recommendation. I originally recommended taking a position in Infosys to my subscribers on November 1, 2012 when the stock closed at 2,362.8 on the BSE. My original fundamentally driven price target was INR 2,762 based on my own DCF. After the Q3 results and huge move up, I recommended my subscribers to close the position on January 16, 2013 when the stock closed at INR 2,771.05. The total return for the trade was 17.3% (excluding commissions). If you want to know more about my investment thesis before I entered the position you can read it here.
I want to clarify that I didn’t base my sell decision on market timing, rather it was driven by the stock hitting my fundamentally driven price target. My price target was based on an absolute valuation framework vs. a relative valuation framework. Relative valuation tools such as P/E, P/S and P/B multiples are relatively simple to use and most investors make the false assumption that if a stock is cheap on a relative or historical basis it qualifies as being cheap on an absolute basis. Normally relative valuation tools are an adequate shortcut for gauging the value of equities but in a range bound market you have to utilize absolute valuation tools such as discounted cash flow models. Obviously, there are risks when using relative valuation tools. Infosys is a perfect example. The company is currently trading at 13.5x the Bloomberg FY14 consensus EPS estimate. On almost any historical time frame the current P/E valuation looks cheap. However, the company’s past sales and earnings growth profile are vastly different to it’s current growth profile. The lower P/E valuation doesn’t necessarily mean the stock is cheap because Infosys’ growth profile has changed. Growth will almost assuredly be slower in the future. It’s a function of the company’s size and industry growth trends.
On Friday, April 12, 2013 Infosys reportd Q4FY13 results, which were largely in-line with their prior guidance. However, investors were disappointed with the guidance for FY14 and the shares came under intense selling pressure and closed down by 21%. The main cause of the disappointment was that management provided full year FY14 revenue guidance between 6%-10%. The guidance was well below the Nasscom revenue growth forecast for the entire industry. Nasscom expects India’s IT industry to grow at 12-14% in the current fiscal year. In my view, the entire run-up and subsequent sell-off reflect the illogical behavior of your typical index hugging and performance chasing mutual fund manager. Most funds were heavily underweight the stock going into the Q3 results. After the better than expected results fund managers that missed the move piled into the stock without a second thought. The shares subsequently became fully valued at least based on my own earnings estimates and price target. Following worse than expected guidance in Q4, the same mutual fund managers who were simply chasing performance sold-off the stock. Both the upside and downside moves were overreactions.
However, I can’t simply dismiss the entire move in the stock as being momentum driven. EBIT margins have been on a declining trend. I would imagine that the chart below is what keeps Infosys’ CEO, Mr. Shibulal, up at night. The company hit its FY13 EBIT guidance of 26%, but the declining trend is a major concern.
Infosys historically was able to maintain both pricing power and revenue growth. The high returns the company generated on capital implied that they had some form of “moat” as defined by Buffett. The decline in margins and revenue growth imply the company no longer has a “wide” moat relative to peers. The company’s revenue mix has traditionally been more leveraged to discretionary IT spend such as consulting and package implementation. Approximately 32% of Infosys’ revenue is derived from higher margin discretionary IT spending. The upside is that this business is more profitable. The downside is that in depressed economic environments, by its very nature, discretionary IT spending is the first thing to be cut in terms of costs by businesses. Additionally, 21% of revenue comes from Europe and 65% from North America. Europe is in the throes of a minor depression and the US economy can’t get out of first gear. Even IBM (a Buffett holding) reported an earnings miss for Q1CY13 due to weaker than expected hardware sales. Thus, Infosys’ management team is not alone when they say the IT spending environment is uncertain. Before you can determine whether the shares are cheap and worth buying, you have to discern whether the current margin decline is a function of the demand environment or due to increased competition from the other Indian IT companies.
It’s possible that if the US rebounds in 2H13, overall IT spending will increase and we would expect positive revisions to earnings guidance as discretionary IT spending picks up. As an investor you need to be aware what you’re assuming when making an investment. In the case of Infosys a rebound in US economic growth would be sufficient for the stock to re-rate on a P/E basis from current levels. However, there are some mid-cap plays in the IT services space that have better profitability, cheaper valuations and have better upside potential if US economic growth were to pick-up. In the next issue of the Value Investing India Report, I’m going to highlight one such investment opportunity. If you’re expecting Infosys’ margins and revenue growth to rebound then the stock is definitely undervalued at current levels. The problem is that if you forecast the current margins forward and assume single digit revenue growth the shares are not really cheap at current price levels. I have my own view on Infosys’ future and will advise my subscribers to invest or avoid the shares accordingly. As an investor you need to make a call on the future profitability of a company, but avoid the mistake of simply assuming because a stock is trading below it’s historical P/E range that it’s a bargain and should be bought.