Note: This interview was originally published in the October 2016 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.
I recently interviewed Rohit Chauhan for our premium newsletter, Value Investing Almanack.
Rohit Chauhan is an Engineer / MBA with 20+ years of experience, working in different functions in large corporations in India and abroad. Rohit was introduced to the value investing philosophy in the mid 90s and has since then followed it in managing money for himself and others who have entrusted their capital to him.
Rohit has been writing on the topic of investing for the last 11 years through his blog.
In his interview with Safal Niveshak, Rohit shares his wide investment experience and how small investors can practice sensible investment decision making.
Safal Niveshak (SN): You’ve’ widely covered your journey on your blog, but let me still start with the customary question. How did you get into value investing, and how has your process evolved over the years?
Rohit Chauhan (RC): I got interested in investing as I had to manage my family’s finances after I finished my MBA. I started learning the basics by reading newspapers and books as this was the only way prior to the internet.
I came across a book The Warren Buffett Way in a public library and the book spoke about this billionaire in Omaha who had become rich by investing in stocks using some very common-sense principles. I was hooked.
Over the years, I read as much as I could find on Buffett, which lead me deeper into value investing and to the teachings of Benjamin Graham, Philip Fisher and other greats in this field. So you can say that I have learnt mainly through books and the internet just accelerated the process.
As I was exposed to Buffett at the start of my journey, his philosophy and teachings have formed the bedrock of my approach. Over the years, I have studied other great investors and have dabbled in deep value investments, arbitrage and other opportunities. However, my core philosophy of buying good companies at reasonable prices remains the same.
My process has evolved to become more qualitative and focused on aspects such as the competitive advantage of businesses, industry dynamics and management as these factors finally drive the numbers. This evolution has also happened due to the fact that markets have become much more competitive over the years and it is difficult to find obvious quantitative bargains now.
SN: That’s a very important point you mentioned about the markets getting competitive. So how does your qualitative process look like in terms of finding investment ideas? What are the necessary conditions that you would look at before you invest in a company and the additional conditions that that will just go about reinforcing your confidence in the company?
RC: I used to run screens in the past, but missed some very good opportunities as I was more focused on the numbers. I have changed my approach to focus more on the qualitative aspects now.
My search process is usually based on serendipity driven by general reading. I also maintain a list of companies I like and track, but have not added to my portfolio due to valuations or some other short term concern.
When I come across an idea, I am looking for possible 2-3X in 3-5 years. It takes me a long time to analyze and get comfortable with an idea, so a 20-30% upside is not worth the effort for me. This approach would work only if you are ready to work harder and churn through more ideas, but in my case it has only added to extra stress rather than returns in the past. As I hold most of my positions for the long term, I rarely need more than 1-2 ideas a year to make it a productive one.
When digging through an opportunity, I am looking for a company which has been mispriced by the market because the true earnings are obscured for temporary reasons or the market is under-estimating the company’s moat. So in effect I am trying to visualize if the company can earn in excess of 20% return on capital and maintain a high level of growth going forward, which is not recognized and priced accordingly by the market. The rest of the process is really digging into this question further and understanding the subjective factors which will lead to that outcome.
The quality of management in terms of capital allocation skills and their ability to take advantage of the opportunities in the concerned industry are the additional conditions which reinforce my confidence in the idea.
SN: How can investors trapped by irrelevant information make independent investment decisions? What are the few factors investors can use to improve the quality of their decision making?
RC: I don’t think it is possible to list a small list of factors which can help investors improve their quality of decisions. Inspite of the claims we read and hear, there is no silver bullet for this problem.
I think the first step in improving your investment decisions is to make fewer of them. The second step is to understand, with as much depth as possible, the economics of the business which you are considering. If you understand a business well, you will be able to identify the key drivers of its performance. Once you cross this stage, it is easy to ignore the irrelevant details and noise in the financial markets.
Finally, the behavioural aspects are important to convert this knowledge into action. One of the best ways to do this is to avoid watching financial news. It is not only useless, but quite toxic to making sensible decisions.
SN: What are your thoughts on position sizing? When you find a good bet with great risk-reward, at what level do you stop and how do you think about it, whether it should be 10, 20, or 30% of your portfolio?
RC: I think portfolio sizing is a fairly neglected aspect of portfolio management and I have been guilty on the same count. The main factor which should drive portfolio sizing is the level of confidence with which you can analyze a company. This makes it subjective, which I think is the right way to think about it.
In the above thought process, one needs to be careful about being over-confident and hence over sizing a position. The best way to calibrate this is to note down your decision making process at the time of making the investment and check it with how the whole thing plays out over time. Let me illustrate
At the start of my investing career, I was quite apprehensive about my skills and generally under-sized my positions at around 5% of the portfolio. In addition, my equity portfolio was a small size of my overall net worth. I did not want to blow up my portfolio by being over-confident. Over time, based on the results, I realized that I was too timid and hence started allocating a larger portion of my net worth to equity.
At the current juncture, I look at position sizing via the lens of overall risk for me. What is my percentage of net worth invested in equity? How stable are my sources of income? If I am comfortable on these two factors and find an attractive bet, I will go up to 10% of my portfolio at the time of purchase. However, I do this rarely and only after I have developed a high level of confidence on the company and its management.
Finally, I have something called the ‘sleep test’. If a position and its size is making me worry or lose sleep over it (metaphorically), then I will reduce the position size. Personally, I am fine getting rich very slowly, rather than facing even a small chance of ruin
SN: How I wish more investors laid importance on this point about their investments letting them sleep peacefully. Anyways, what are your thoughts on concentration vs diversification? Which of these styles do you follow?
RC: I think of concentration versus diversification along a spectrum. At one end of the spectrum is 100% diversification achieved by investing in an index funds/ ETF which would represent the entire market. At the other end, an extreme concentration would be investing your entire net worth in a single business, as many entrepreneurs do.
I like to combine the concept of diversification with the idea of knowledge and control over one’s investment. Let’s say you are a highly skilled doctor, then it makes sense to invest your time and capital in running a business which will leverage your skills. On the other hand, a know nothing investor with almost no control over his or her investments should invest via a highly diversified fund to reduce his risk.
In my own case, like most active investors, I lie somewhere in the middle of the spectrum in term of knowledge (a reasonable understanding of the companies in the portfolio), but with no control over them. If I consider these factors, I think it makes sense to diversify sensibly to reduce the overall risk.
In terms of number of positions, I have usually maintained between 15-20 position depending on the valuations and types of opportunities. At the same time, the top 10 positions generally account 60-70% of my portfolio. This level of concentration has also gone up with time as I have deepened my understanding of various businesses.
SN: Given your reasonably long career in the stock market, you have gone through several periods of uncertainties and turmoil. How have you learned to deal with such situations?
RC: I have been investing since mid-90s and have seen a few ups and downs in the market. I think in most cases, the markets and people over-react to short term events and miss out on great investment opportunities.
For example – In 2004, the UPA government came to power leading to a large drop in the indices, as the stock market expected the new government to be anti-business. I am sure almost no one remembers this event. However, investors who over-reacted to this event missed a great opportunity to compound their wealth over the next 4 years.
The same held true during one of the worst phases of the stock market: 2008-09 when the indices dropped more than 50%.
I think the best way to deal with the inevitable turmoil and uncertainty is know that such events will occur repeatedly over an investing lifetime. The best time to prepare is when everything is hunky-dory.
I usually ask myself this question when the outlook is very sunny – will I be comfortable holding, or even buying the current positions if they were to drop by 20%+ in event of a market correction? If yes, then I will continue to hold. However, if I am not sure of the answer, then that means I should reduce the position size and move some of my money to cash or other ideas.
If one cannot do the above, then the second best option is to get into passive investing as much as possible. Identify a few good mutual funds and set up a regular investment plan. Once this is done, stop watching the financial channels forever and pick up some hobbies outside of work. In time, this hands off approach works out much better than the hyper-active style of most active investors.
SN: That’s true, Rohit. I have seen this passive approach work wonders for a lot of people around me.
Anyways, let me talk a bit about the behavioural part of investing. Charlie Munger emphasizes about building a latticework of mental models in order to make better decisions in life and investing? Which models have served you the most over the years as far as investing is concerned, and how?
RC: I have a fairly poor memory and unlike Charlie Munger or other great investors, cannot really hold these models in my head. As a result, I have developed a process of noting down all the mental models in a spreadsheet as I have come across them. This spreadsheet was started in 2002 and has grown each year. My friends now call me a ‘spreadsheet king’.
I use this spreadsheet, running through all these mental models as a checklist, when I am working on a new idea. It takes a bit of time to do this work, but I think it is absolutely necessary for me to do it to ensure that I have considered the idea from all angles.
Some of the models I use are accounting and financial analysis models, competitive analysis and competitive advantage and its source. In addition to this, I will consider the behavioural models when making the decision.
Finally, I have recently added Bayesian models to think and make decisions probabilistically.
SN: What are your thoughts on investment cycles?
RC: I have ignored investment cycles in the past, but have realized that ignoring business cycles is not a good idea. The peak of investment cycles can usually be seen in elevated valuations and if one is disciplined about not over-paying or holding onto excessively priced stocks, then one can use these cycles in your favour.
Business cycles are a different matter. As an investor, I think it is important to understand the degree of cyclicality of a business as that informs the valuations one should pay and also the time one will have to hold onto a position before the earnings and the stock price will turn.
SN: How do you think about intrinsic values?
RC: I think intrinsic value is one those concepts which is simple to understand, but not easy to implement. I think one of the key points to keep in mind is that there is no objective and single intrinsic value number for a business.
One should think of intrinsic value as a range of numbers with their individual probabilities. As intrinsic value is based on future cash flows, it depends on the evaluation of an uncertain future and hence it is important to think of this concept probabilistically.
How does one estimate the numbers and the probabilities involved? I think it comes back to my earlier point that an investor needs to understand the economics of the business as well as possible and estimate the range of future cash flow estimates for it.
The evaluation of probabilities also requires understanding the long term economics of the business. Now there are some business which are relatively stable and predictable and thus an in-depth study will enable one to come up with a range of numbers with high level of confidence – for example a consumer goods company.
On the other hand, there are some industries such as oil and gas, metals etc. where the future cash flows depend on the price of a commodity which for the most part cannot be predicted over the long term with any degree of confidence. In such a scenario, any cash flow estimation and intrinsic value number is not very helpful and can actually mislead an investor into thinking that he or she is buying a bargain, whereas the individual is just betting on the price of a commodity.
SN: Most experienced investors say that volatility is your friend and the only real risk is permanent loss of capital. But we humans have a bad history of dealing with volatility. So if history has any significance, isn’t volatility the real risk? How do you deal with it?
RC: I think Warren Buffett has given us one of the best definitions of risk – Risk is not knowing what you are doing. Let’s look at this comment in more depth.
There are two elements to this – one is knowledge and the other is time horizon. An investor should know what the time horizon of his or her investment is and should understand the economics of the business or investment over this time horizon.
As an example, let’s say the investment horizon is ten years, then the main risk for the investor during this period is not volatility but the risk of business model disruption, change in competitive intensity etc. It is anything which will change the economics of the business for the worse during this period.
As a counter example, if an investor is acting as a trader and has a horizon of a few weeks to months, then none of the risks mentioned above matter. In such a case, the individual should be more concerned about volatility from various macro factors which may have nothing to do with the company in question.
So it boils down to knowing what your time horizon is and then evaluating the risks during that period. If you are ready to hold an investment for a long time period, then volatility is not a risk as long as the competitive dynamics do not change.
SN: Technology is disrupting every industry, be it services or manufacturing. The rules of game are changing very fast. Companies are getting into oblivion very fast, thereby making finding sustainable businesses and thus investing in them difficult. The old school rules of value investing may not sometime be very helpful. How does one deal with such a situation? What precautions need to be taken?
RC: I think disruption is both a threat and an opportunity. There is no silver bullet to manage it. I think the most important asset is to have a curious mind, with a drive for constant learning.
One needs to keep in mind that the half-life of knowledge (a term from radioactive decay) is reducing. As a result, an investor or any other professional cannot assume that what he or she has learned till date will last a lifetime.
As an investor it is important to understand your companies deeply in terms of competitive position and disruption risk. In addition to learning, one also needs to think probabilistically. One should not be 100% sure of any conclusions, but should constantly be reviewing the company and its competitive position based on current and emerging risks and make changes to your confidence level.
As an example, let’s say you are invested in a telecom company and had a high level of confidence on the performance of the company. Let’s say, for argument sake, you have a 70% confidence level on the fair value and competitive position of the company.
Now the launch of Reliance Jio should make you review your estimate of fair value and the confidence level too. The numerical estimate of the confidence level may sound too mathematical and un-realistic, but I think it forces one to think and really question one’s assumptions.
In summary, one needs to have a curious and open mind, a constant drive to learn and be ready to change your conclusions rapidly when the environment changes due to disruption or otherwise.
SN: Most people would rather die than change their beliefs and conclusions. Anyways, where have you made the most of your mistakes over the years – omission or commission? And what lessons have you learned out of these mistakes?
RC: I have had both types of mistakes, but I think the biggest mistake for me was a sort of commission. My biggest mistake has been selling a few companies such as Asian Paints, Pidilite etc. early based on some valuation threshold and not understanding the power of long term compounding in these ideas. So instead of selling, I should have been buying these stocks in my portfolio.
To add insult to injury, I did some calculations and realized that the opportunity cost was at least 50X of all the losses I have incurred till date in all my positions.
I highly recommend analyzing your mistakes in depth – the learning is invaluable and anyway at least something good should come out of a mistake. I think this mistake made me realize that if you have a winning hand, play it out fully. A few wining positions over a lifetime is all that is needed to have a good investment record with a lot less stress.
SN: Hypothetical Question: Let’s say that you knew you were going to lose all your memory the next morning. Briefly, what would you write in a letter to yourself, so that you could begin relearning everything starting the next day?
RC: I would ask myself to read the Bhagavad Gita starting next day. If one can metaphorically wipe the slate clean and start from reading the Bhagavad Gita, I think one would actually be in better place in life after this event.
Of course I will also list the names of my family members, close friends and a few people I admire so that I can talk to them and rebuild my life in the right manner.
SN: Which are some the books on investing, behavior, and multidisciplinary thinking that have inspired you the most over the years? If you were to give away all your books but one, which one would it be and why?
RC: Here are a few –
- The Intelligent Investor – Benjamin graham
- The Most Important Thing – Howard marks
- Common Stocks and Uncommon Profits – Philip Fisher
- Poor Charlie’s Almanack – Peter Kaufman
- Bhagavad Gita
I would keep the Bhagavad Gita. It is the source of all wisdom in life and I think one can never be wise enough.
SN: Who are some of the people – inside or outside the value investing circles – who have inspired you the most over the years, and why?
RC: Warren Buffett for his investing philosophy and approach to work, Charlie Munger for his multi-disciplinary thinking, Ekanath Easwaran for his spiritual teachings, my wife for her empathy for others, and my mother for her energy and drive.
SN: If you had just five-minutes to advise someone wanting to get into investing, what would your advice be? What are the pitfalls he/she must be aware of?
RC: I would first ask the person why he or she wants to get into investing? Does the individual want to learn the basics and thus make better decisions for his or her long term financial goals?
In such as case, I would ask the person to find a few good books on personal finance and understand the basics on savings, compound interest and the various options on passive investments such as mutual funds, real estate etc. This would enable the individual to make informed decisions about his or her savings over a life time. On the other hand, if the individual wants to get into this field as he thinks this is an easy way to make money and get rich, I would advise him to drop the whole idea and find something else to pursue.
One needs to be passionate about this topic and be ready to learn and pursue it for a long time even if the returns don’t materialize for an extended period of time. If you are fascinated by this field and ready to learn over your lifetime, then it can be quite a bit of fun and in the end rewarding too.
SN: That’s a wonderful thought, Rohit! Well, thank you so much for the insights you have shared!
RC: Thanks for the interview, Vishal! I really enjoyed it.
Note: This interview was originally published in the October 2016 issue of our premium newsletter – Value Investing Almanack (VIA). To read more such interviews and other deep thoughts on value investing, business analysis and behavioral finance, click here to subscribe to VIA.
http://www.safalniveshak.com/value-investor-interview-rohit-chauhan/
