Investor's Carnival- Presentation- Evolution of an amateur value investor

@ankit1511,

Yes, you are right. I too feel that among the general investor community, power of operating leverage is underappreciated. However, I will say that “risk” of operating leverage is underappreciated too as operating leverage is a double edged sword and when the growth tapers off, decline in earning can be equally swift (as is the rise)

On your specific queries, the place where some operating leverage is built on the balance sheet side is fixed asset base. Typically, I look for fixed asset turns- if the fixed asset turn is much lower than industry average or the past asset turns- that is a good indicator of operating leverage existing in the business. However, one still needs to make judgement about, how well the new asset base created will be utilized to generate revenue.

On your second question, I am not sure I have an answer that works in all situation. Also the answer will vary from company to company. Hence, for a cyclical companies, one has to watch for how supply side is panning out. IF the supply side is shrinking (players getting out/getting bankrupt etc), then the likelihood of good times are nearer and hence the survivors will benefit from demand uptick as and when it happens. Most senior investors that I have interacted with, closely monitor supply and seldom predict demand. They think, it is very difficult to predict demand, but supply can be accurately measured. For companies that are not cyclical, one has to form an informed opinion based on facts/data on what is the likelihood of demand getting back or company returning to growth path. One can try to understand the lead indicators for demand growth and monitor them to see if the green shoots are there or not. However, as I said earlier, demand is much more difficult to predict.

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Thanks @desaidhwanil for sharing your thoughts and presentation. I have been following your threads for quite some time now and have learnt so much from your writings. Keep sharing.

Operating leverage is an interesting investing strategy. I am trying to take this discussion further with couple of examples purely from learning perspective.
(Discl: I do not have any positions in any of the below mentioned companies and also don’t have buy/sell view).

Operating leverage plays well in capital intensive companies where majority of the operating costs are fixed.

Look at the below example of Adlabs Entertainment Ltd. They set up a theme park Adlabs Imagica, which became fully operational from November 2013. There was an initial capital outlay of approx. Rs.1,470 cr. to set up this theme park. As majority of the capex is already incurred with huge capacity, there are very minimal expenses to be incurred to generate additional sales.

As can be seen, the OPM has increased from 3.34% in 2014 to 25.46% in 2017. This is clearly due to better capacity utilisation (footfalls in case of a theme park).

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For the year 2017, mere 2% change in sales has led to 52% change in Operating profit.

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There is no growth in footfalls in 2017 when compared with 2016, still OPM has increased by approx. 8% (from 17% to 25%). This is mainly due to increase in Gross realisation per visitor.

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Thus, increase in capacity utilisation / increase in sales price can lead to high OPM for companies with high fixed operating expenses.

As pointed out by Dhwanil, operating leverage is a double edged sword. Let’s look at the below example of MCX where Operating leverage has played negative role with sudden lower capacity utilisation.

Below table shows total contract values for different years. The value continuously kept increasing upto 2012 and then there was a sharp decline in the years 2013 and 2014. There were multiple factors for this sharp decline like imposition of Commodities Transaction Tax and stability in the prices of precious metals which constitutes major portion of MCX’s trading value. This coupled with NSEL scam (promoter group company) led to sharp correction in the stock price at that time. Understanding of operating leverage can help to value the company differently in such scenarios. Dhwanil has very well articulated his thoughts in MCX thread.

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Source: Historical Data

Below table shows that in the initial years, as the volume and value of the traded contracts on the exchange grew, operating leverage played a positive role (Positive disproportionate change in Operating profit compared to change in sales).

However, as the volumes and value of the traded contracts declined in the year 2013-2014, there was a negative disproportionate change in Operating profit. 35% reduction in sales led to 54% reduction in Operating profit.

MCX has built a platform which has handling capacity of 40,000,000 transactions (Orders and Trades put together) per day, which is well above the record volumes witnessed by the Exchange till date (As per AR 2017). This means that there is huge operating leverage and any change in sales (positive or negative) will have disproportionate impact on bottomline.

Dhwanil has pointed out in the presentation in slide 8 - “Typically, businesses with high gross margins may have high operating leverage”. Both the above companies have Gross margin of 75% and 95% respectively.

Requesting all members to please their thoughts.

Discl: Companies mentioned above are for learning purpose only. Both companies have very different capital structure. Adlabs has huge debt which is not able to generate sufficient operating cash flows to service interest payments and also need to incur high maintenance CAPEX. MCX on the other hand does not have any debt and generates surplus cash. Investment decision should be based on various such other factors.

No buy/sell recommendation. No holdings in any of the company.

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Dhwanil,

Thanks for sharing the presentation. Am yet to learn the ropes of value investing (started off about 6 months ago) and one of the key variables I was reading about was the P/E ratio. However , realised that in the end it was denominator dependent and any change would be impactful. On operating leverage can you share thoughts on how one can assess in the entertainment , media space , travel and hospitality space given that there is supposed to be an uptick in discretionary spending going forward.
Thanks

Thanks for sharing the presentation. Can you suggest some books/literature on Capital Allocation Framework and Behavioral Aspects of Investing.

Hi Dhwanil, thank you for sharing your insights. How do you track the supply side for cyclical Industries? This supply side would be the aggregate of all companies in the industry, right?

Hi @desaidhwanil,

Thank you — I will look at the asset turn trend in some historical cases to see if there is any pattern that can be established.

As regards the supply vs demand analysis, I completely agree with your view that looking at supply side is a much better indicator, especially for cyclicals. The way I look at it is that demand is predicted by analysts and investors, while capacity addition and consolidation is done by CEOs. And if the management has a track record of good capital allocation, then it’s a no brainier as to which one to trust more. This approach has high efficacy in cyclical industries where capex cycles are relatively well defined (e.g. the S-D equation is showing clear signs of inflection in the hospitality sector. Textile could also head that way in the near future as most companies are in the last leg of their Capex cycle).

The challenge to the SD analysis, however, comes in more secular sectors where the relationship is not very linear, and which is where I find no clear way of establishing operating leverage. E.g. the battery sector where leverage could be counter productive because of technology migration. On the flip side, the leverage in Internet based companies or software product companies can surprise even managements positively because of the non-linearity. But I guess as you said, there is no single approach for such sectors/companies — therefore, a combination of looking at demand trends/recovery (which means one could be late in entry) and company specific issues is probably still the best way to go about it. Thank you once again for sharing your thoughts.

Regards,
Ankit

@mohammedsaqib,

Yes, we should measure the aggregate supply.

@sko5prasad,

I am not too sure, if there is any one book that I have come across (for an individual investor) for capital allocation. There are bits and pieces in various books and it is left to us to stitch it together to make it a beautiful art piece! :grinning:

Totally agreed @desaidhwanil.
But to start with, what one should go for on this two topic will certainly help.

Very well explained! Interesting observation.

@desaidhwanil,

Really thoughtful and nicely articulated presentation. Can you share a sample checklist (as per slide 6)? I generally follow Peter Lynch’s approach of writing a one pager on the company. Would be nice to see what all one needs to check.

Rgds.

Dhwanil,
Good presentation. Well done.
I have a question on capital allocation.
In my portfolio, 50% is with 1 stock, (a small holding evolved over the years of bonus/rights) and continues to do well.
In such a situation, in your opinion, this winning horse should be allowed to run or chopped to make equal distribution?

@Advait_6270,

Sure. Here it is.

Investment_Checklist.xlsx (22.1 KB)

It is for a specific company, but you may tweak it based on your style/parameters.

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@ausking,

It is indeed a very tricky question and one which I too have struggled with. To be honest, I too am experimenting with similar situations and do not have a clue that my approach is optimal or not. I can only share my thought process which may (or may not!) help you.

  • If we continue to chop off your winners (and not let them run), we may definitely miss out on compounding it can generate for long period of time. On the other hand, with increasing allocation beyond a point (and limit can be different for different people), we carry significant risk in our portfolio where if one of the variables in industry/business going wrong can significantly impact the overall compounding of the portfolio. Thus, it will boil down to what is our conviction and level of understanding of the business/industry dynamics. My personal view is no matter how convinced you are of the understanding the business and its future potential…there will always be variables in business which either we have not factored in or are outside the control of the management…in short as Prof.Bakshi often mentions …Shit Happens! I lean on the side, where beyond a point, I am fine sacrificing returns…for the sake of managing risk. Thus, I do prune those positions that go beyond my comfort level. On the other hand, many great investors we know, have gained immensely by sticking to the winners. So, I do not think, there is either right/wrong approach. It will boil down to how much risk one can handle (which is a very personal trait) without losing the sleep.
  • I also feel, that it is also a function of the portfolio size (in terms of capital) and at what mindset you have as investor. If someone is in a phase…where wealth creation/accumulation is the idea…one may take additional risk for the sake of generating the return. On the other hand, once the portfolio reaches certain size, one may start thinking about capital preservation…and precisely at that point of time, managing risk starts to override generating returns.
  • Lastly, I feel, one must assess whether keeping the position will meet ultimate goal of compounding capital at desired rate from here on. If we can not build thesis around, compounding capital at desired rate, it may not make sense to keep that in portfolio, irrespective of quality.

As I said, my thinking around this is quite fluid at the moment and hence all over the place!!! But, I am using these 3 broad construct to decide when and how much to prune.

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Thanks Dhwanilbhai for sharing diligent hard work, (123) points of checklist
Really very helpful

Thanks
Ashit

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So far I have used net personal wealth criteria - Any holding not to exceed 10%, But it is difficult to do such assessment as frequently as looking at the demat statement!! I suspect this is what you mean by portfolio size in 2nd para.

Such criteria will work if wealth is distributed in more than one asset class.

If one knows who is going to compound at what rate, one can match portfolio expectations accordingly. Probably only God knows an apple seed if planted will deliver how many apples!

Thanks for your input Dhwanil.

Here is another perspective -

I guess, howsoever I like to believe that Indian residents are driving the market, I don’t. The flood of cheap US / European / Japanese money is a significant contributor in my opinion. They are all at zero percent interest. India offers arbitrage opportunity.

The Japanese market scenario described in this link is worth noting. Unlikely Indian market will face that situation. But the US and European markets can despite zero interest. What will be the trigger? Don’t know. When ? Don’t know.

All these get in the Risk Assessment bucket. Each one has to identify their own answer.

Another guideline people often use is - Your cash assets should equal to your physical age. As age advances, risk assets should reduce.

A wonderful presentation, @desaidhwanil! One question… what is the reason for the recommendation to sell when a specific stock becomes a disproportionately large part of your portfolio? As I understand, diversification helps in mitigating the risk that an individual stock assessment of yours can go completely wrong (Specific Risk). If a stock has already given wonderful returns (Thereby becoming a major part of your portfolio), you are clearly right. So why would you cut into your winner?

Thank you.

@dineshssairam,

There are two parts to my rationale. The first is RISK. My thought process is that no matter how confident we are about knowing the business or the variables involved in it, there will always be blind spots and/or uncontrollable factors that can spook the party. If one has disproportionately large allocation in one business, I see the vulnerability of the entire portfolio (in terms of generating desired returns) to one variable going wrong in one of the businesses. Considering my risk appetite, I would reduce risk even if it means trimming something that has worked in the past.

Secondly, I feel market is always forward looking and so should be investor. Hence, having the anchor of past performance/returns - to judge the future attractiveness of an investment may be too simplistic. Hence, it is better to reassess periodically, how the current investment in a business, will help us achieve our compounding goals from hereon. If it fits in and one is willing to take the portfolio level risk mentioned above, it may make sense to stay put

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Dhwanil,
I agree with you completely.

But when I see candidates in most of the major portfolios and recommendations in public domain, it becomes challenging to simply chop down personal holdings … Theory Vs Practice, Emotions Vs Rationale, Past Vs Analyst Projections of future…

And yes, I should reduce some holdings to rationalise risk distribution.

Thanks for sharing your thoughts.