Probability and Investing : A dynamic duo !!

 

I believe "Probability" is one of the most sensible mathematical techniques after "Compound Interest" formula. If one has a good command over these two, and simultaneously apply them while investing, once can do wonders and is bound to become wealthy in long term. To support my views, I have examples of some great investors who are applying both the principles while investing and they are not only rich but extremely wealthy. List of such investing extraordinaire includes WARREN BUFFET, Mohnish Parbai etc.

Charlie Munger, in one of his speech highlighted the way Warren buffet thinks. He mentioned that Warren buffet is so much rational in thinking that he uses Decision tree Analysis in almost every decision making. Similarly, Mohnish parbai too in his book "Dhandho investor" has mentioned about probability as one of the effective tool and suggested "Kelly Criterion" for portfolio construction.

Why Probability Works ??

In my sense, Probability is such a powerful tool, coz it reduces the effect of uncertain event on the decison's outcome. The reason for it might be, that it incorporates the possibility of unfavourable events before hand and hence normalise the decision, making it future proof to a great extent.

In investing paralance,we can take it as "margin of safety" of decision making. If we see the underlying effect of "margin of safety", it is meant to reduce the effect of uncertain event of future that can have effect on stock price. As, one cannot ascertain the future unfavaourable event correctly, incorporating "Margin of safety" in an investing decision is suggested over and over again by each and every Value investor ranging from Father of Value investing "Ben Graham" to Warren buffet, Charlie Munger to Walter Schloss, Seth Klarman (Even wrote a whole book on the topic) to Mohnish Parbai.

Probability and Investing : Application of thoughts

We usually start our investing through our hard earned money and after finding a next possible mulitbagger, we are inclined to bet on it heavily. But, a scrip will be multibagger in future and we as investor, can't and never will be able to ascertain future correctly. So, making an investing decision based on the optimism that everything will turn out as presumed, will be nothing short of utter foolishness.

So, this is where we can plug in probability and take its advantage in portfolio construction. One such method is "Kelly Criterion" as highlighted by Mr. Mohinsh Parbai in "Dhandho Investor". The Kelly Criterion formula is simple :

Capital to be committed : Probability of winning – (Probability of losing / Edge)

                              (where, Edge = Win ratio i.e. Winning Amount/ losing amount)

 

The other probability method to be deployed is "Margin of Safety".

Example :

Suppose you analysed the stock with CMP of Rs.120 and its near its 52 Week Low (Rs. 118/-). Now as per your analysis, the stock price may go upto 130/- on account of some triggers (say some value accretive product launch, some buy back indications from management etc.).

As per kelly criterion, the weightage of this scrip in your portfolio should be ascertained as under :

Probability of Winning : Say 60 %

Hence, Probability of Losing : 1- 60% = 40%

Expected Win Amount = Rs. 10/- (130 -120)

Expected Loss Amount = Rs. 5/- (120-115)

Hence Edge = 2

Kelly Criterion = .6 – (0.4/2) = 0.4 i.e. 40 %

Hence as per Kelly's Criterion, one can bet upto 40% of its capital on this particular investing bet.

Conclusion:

As rightly mentioned by Prof. Sanjay Bakshi "A chain is as strong as its weakest link", one should apply the mathematical models with due caution and only after acquiring proper knowledge. As half knowledge is extremely dangerous,especially for investing decisions,

So, wish u a happy new year and all the luck for your future investing decisions.

--

Tony Stark

CEO- Stark Capital

Fluidomat limited | BSE : 522017

Name : Fluidomat Limited

M.Cap : Rs. 27 Cr || CMP : Rs. 55.10/-

ABOUT THE COMPANY :

The company manufactures Fluidic coupling, having its application in varied industries ranging from Thermal Power Plants, Cement Plants, Coal, Lignite & Ore Mining, Chemical, Fertilizer, Paper & Oil Extraction, Steel Plants, Copper, Zinc & Aluminum Plants, Harbour handling, an other miscellaneous Indsutries

LIST OF CUSTOMERS :

a) Plant & Machinery Manufacturers :

ABB, BHEL, Braithwaite, Burn Standard, CIMMCO, Chemical Construction, DEMACH, DCIPS, ELECON, EPIL, FFE, Fuller KCP, Flakt, Flender, HEC, HDOL, HSML, INDURE, Krupp, Kirloskar, Kraft Engg., L&T, MAMC, MBE, Metso, MECON, Naveen, Oilex, Penwalt, Promac, Reitz, Sayaji Iron, Techpro,Thermax, TLT, TRF, Walchandnagar Industries, Warman etc.

b) Approvals from the Consultants :

Fluidomat Fluid Couplings are approved by all leading industries and consultants in the country. The consultants include ACC, BHEL, Birla Tech Services, DCPL, Desin, HOWE India, Holtech, Jacobs, MECON, MN Dastur, NTPC, Tata Consultants,Tata Projects, Samsung, Doosan (Korea), Hyundai (Korea), Alstom (France), Sulzer (Germany) etc.

KEY FINANCIAL FIGURES :

BUSINESS MOAT :

The company manufactures fluid coupling, which is one of the key components in Industries. Hence the future of the company is dependent on Infrastructure sector and growth plans of other industries. Globally, only limited numbers of companies are in the manufacturing of fluidic coupling, making it a niche market.(Source : Balance sheet)

The company is manufacturing the products since 1971 on the basis of its own engineered products and it also has an in house Non Ferrous and Cast Iron Foundries for producing high quality intricate castings required for Fluid Couplings. In a way, the compnay has undertaken backward integration and thus enjoying the low cost benefit, which is evident from the improving Operating profit Margins (OPM) and Return on Equity (ROE). Moreover, despite of the fact that the customers being the big brand organisations, the company has been able to pass on its increasing cost of raw material, with sales price per unit increasing from Rs. 61116.79/- in FY 2005-06 to 97865.10/- in FY 2010-11.

A point to be noted is that the company went into Debt Restructuring in 2002-03, and has successfully came out of it in 2009-10. The testament to the above fact are the figures posted by the compnay on an year-on-year basis. And it seems like the company learned the lesson from restructuring and has not raised any debt after repayment of restructured debt from its internal accruals. Currently the company is debt free and has only working capital limits with Central Bank of India

As per the website, the company also has orders from likes of Adani Power Plant, Mundra Port, BHEL etc . There is a need to dwell more on this front.

RISK AND CONCERN :

1. There has been no major increase in capacity in recent times. Instead the company is over utillising its capacity.In year FY 08-09 and 2010-11, the company was able to produce 1704 and 1776 units respectively with installed capacity being only 1500 units. This leads to over utillisation of the capacity by 20-25%. If the product is having so much demand, why the management is not augmenting the capacity ?

2. The future of the company is dependent on the Infrastructure and other allied sectors which in turn depends on the spending activities of government. Considering the current scenario and India's slowing economy, the growth aspect needs to be reconsider

3. Being a small cap scrip, not much data available about the management. Though the management seems to be investor friendly considering the fact that the company has started distributing dividends from last 2 years and also the capital allocation has been good (indicated by improving ROE), but still lot needs to be find out rather than just relying on numbers.

4. The Auditor is not a recognised entity and the details in balance sheet (such as MD&A) are not up to the mark. Management is not sharing much details about the industry and the company in MD&A. Also, details of order book are mentioned in Balance sheet on a regular basis.

5. The Revenue Recognition policy of the company is a bit aggressive, as it recognises the revenue at the point of dispatch of goods. Though, I am not a good judge of accounting policies, but considering the AS-9 for revenue recognition, the revenue should be recognised when all the material risk are transferred to the buyer. In this case, company is recognising revenue at dispatch itself, even when the risk related to sales are not transferred in favour of buyer. Need to check further on the accouting policy

6. The compnay purchased a flat in Leelam Vatika, Indore in FY 2007-08 for Rs.16.20 lacs. The purpose stated was for stay of Executives of compnay. However, the same is removed from the the list of assets in FY 2008-09. The loss on sale of fixed assets is shown at Rs. 61,000/-, which I believe doesn't reflect the transaction of the property. The only deduction I am able to make out of this transaction is that the promoter used the company's money to buy the property for self.

7. No details of R&D mentioned in Balance sheet, which makes me skeptical of the future growth prospects. Since,the company is in a high tech sector, R&D is the key to prolonged success.

8. No details of Order book mentioned in the current year. As per the balance sheet of 2010-11, the pending order book was Rs. 31.73 Cr, but no mention of the same in current year. This restricts the revenue visibility.
9. The analysis mentioned above might be suffering from the various behaviourial bias such as "confirmation bias", "Self- deception bias" "Selective thinking bias". Such biases can distort the analysis and reduce the effectiveness.

VALUATION :

Valuation as per Debt Capacity Valuation : Rs.46.31/-

Valuation as per EPV Valuation : Rs. 42.10/-

Valuation as per Relative Valuation : Rs. 56.39/-

Valuation as per 12M P/E Fwd : Rs. 58.93/-

Average Valuation : Rs. 50.93

Considering the current market price of Rs. 55/-, the stock seems to be fairly valued and the position can be initiated at levels of around Rs. Rs. 50/-. Though this stock doesn't seem to be turning multibagger, but can give decent return in coming years. So stay tuned for further action.

Views and discussions invited !!

--

Tony Stark

CEO - Stark Capital LLP

Usual Startup Post !!

To keep it short and succinct, this is yet another blog from a novice and utterly confused value investor !!

Reason for starting : Get some of my confusion solved through mutual discussion (Expectation of some comments on posts !!)

What to expect : Lots of confused thoughts, which might be camoflouged as Stock Analysis based on value Investing principle. Please carry on at your own risk.

What not to expect : Some “TIPS” on stocks, next “CRISIL” or “Infosys”, some good gyaan on “Value Investing”, some high fundaa valuation methods, and last but not the least any technical anlaysis gyaan (like Resistance / Support etc.) … but let me assure you that nothing of sort will be available going ahead, as yours truly is no where close to such esoteric knowledge.

Statutory Warning : All the post on this blog are wierd thoughts and imagination of author and it has no relation what so ever with the life and death, profit and loss, or any sort of mishappening of any follower. Readers are requested to enjoy the posts merely for fun and in no way the post should be taken seriously !! 

Lastly, I don’t recommend any of the stock on this blog, and recommend self reliance to readers in investing process.