I am thrilled to announce the launch of the https://fundamentalanalysisscore.in website, dedicated to simplifying fundamental analysis for stock market investing.

Previously, I delved into the concept of fragility in a series of posts, which you can find here

The Fragility series explores the four fundamental pillars of fragility which an investor needs to be aware of to eliminate fragility in their portfolio:

1. Pillar 1 - Avoid investing in Fragile Companies

2. Pillar 2 - Avoid investing in Overvalued Companies

3. Pillar 3 - Avoid investing in Companies with Management having a fragile mindset

4. Pillar 4 - Avoiding Shorter Timeframes

By adhering to these four pillars, we can minimize the impact of negative news and allow positive news to work its magic on our portfolio.

It's crucial to note that Pillar 4 is more about the investor than the company itself. Investors are required to give sufficient time to each of their investments for them to grow. On the other hand, the first three Pillars are what need to be evaluated while making an investment decision.

Based on these principles, I have conceptualized a company fundamental score, which is the core focus of the https://fundamentalanalysisscore.in website. The details are as follows:

The platform aims to simplify fundamental analysis using the approach based on the first three core pillars discussed in the fragility series.

1. Pillar 1 - Financial Strength: This is derived from the Fragility score card explained in the fragility series. The Financial Score in the website quantifies a company's financial strength/robustness, assigning a value between 0 and 10. It is derived from a combination of four key financial ratios based on the latest available audited/unaudited financial statements. The Financial Score is dynamic and subject to change every quarter or year, depending on a company's financial performance.

2. Pillar 2 - Valuation: The Valuation Score in the website quantifies the valuation of a company, assigning a value between 0 to 10. It is derived from a combination of historical 3-year, 5-year & 10-year price-to-earnings ratios, present price-to-earnings ratio, price-to-earnings-to-growth (PEG) ratios based on the last 5 years of earnings growth, and PEG ratios based on the last 10 years of earnings growth.

3. Pillar 3 - Management: This aspect is currently under development. While the website does not provide a Management score at this juncture, users should note that the Management score is a crucial factor in investment decision-making.

Company Fundamental Score: The platform calculates the company's fundamental score by combining the Financial Score and Valuation Score (i.e., Pillar 1 and Pillar 2), assigning a value between 0 to 10. This score simplifies risk assessment, with lower scores indicating lower risk and higher scores suggesting increased risk. It is imperative to consider this score before making any investment decisions. Presently, the company fundamental score does not include the Management Score, which users need to assess separately.

The fundamental analysis scores focus on companies with a market capitalization of over Rs 100 Crs, as smaller firms often operate in localized markets and inherently tend to be more fundamentally weak.

Visit https://fundamentalanalysisscore.in now to explore the simplification of fundamental analysis. If you found the website valuable, please share it with your friends and colleagues who might also benefit from it.

Introduction:

In my previous posts in the fragility series which can be found here Fragility Series, we explore building an Antifragile Portfolio, focusing on vital aspects of investment fragility. By following these guidelines, investors can safeguard their equity portfolios from negative impacts and maximize gains from positive news. The series covers four key fragility pillars for eliminating fragility and reducing downside risk. The goal is to create a portfolio that not only withstands adverse events but also leverages positive events for unlimited growth. Antifragility involves capitalizing on both negative and positive events, achieved by removing fragility through the discussed pillars. This approach unlocks a few "Antifragile Powers" that when utilized amplify positive impacts on returns.

I discussed two such Antifragile Powers - Power of Population Explosion & Power of Saying No in my previous posts. In this post, we will delve into another such Antifragile power - Power of Experimentation. 

Experimentation

One of the ways of achieving upside potential is through “Experimentation”. Experimentation is the act of exploring new ideas, approaches, and methods in order to achieve a desired goal. It involves stepping out of one's comfort zone, taking calculated risks, and venturing into uncharted territory. This approach stands in stark contrast to conventional thinking, which often discourages deviation from tried-and-true methods.

Incorporating experimentation into one's pursuits opens the door to a multitude of possibilities. It encourages individuals and organizations to break free from the constraints of routine and to push boundaries in search of novel solutions.

Experimentation like other Antifragile Powers, unlocks upside potential.

Companies can experiment by way of launching new products, acquisition, capacity expansion, R&D, etc.

An investor can experiment by finding new companies to invest in.

However, experimentation is like the act of launching arrows into the darkness – outcome can be either success or failure. Whether we hit our target (keep aside bullseye) is uncertain. 

Risk of Ruin

The maxim "Failure is the stepping stone to success" underscores the necessity of continually releasing arrows into the darkness, hopeful that we will eventually find its mark. Each miss (failure to hit the target) serves as a lesson that the target lies elsewhere.

We can also endup in total failure by exhausting all our arrows in our arsenal and not being able to hit the target. This is called risk of ruin. We should avoid the risk of ruin at all costs.

How can we navigate experimentation without succumbing to risk of ruin? Three core principles can guide us in avoiding the risk of ruin while embracing experimentation.

Maintaining a Sufficient Arsenal of Arrows: Engaging in experimentation necessitates a stockpile of arrows in our arsenal. Fragile companies often grapple with constrained cash flows, rendering experimentation unfeasible – effectively depleting their arsenal of arrows. Notably, such fragile companies can fall even without engaging in experimentation, due to the weight of their mounting debt.

Prudent Allocation of Arrows: Unlike a single massive launch of all arrows at once, which can render even a robust company fragile, it's wiser to release smaller, targeted new bets in proportion to the size of the portfolio and future SIPs. This approach safeguards against the risk of ruin, offering a buffer against substantial losses.

Continual Pursuit of Experimentation: To sidestep stagnation, one must consistently unleash arrows into the dark, symbolizing a commitment to ongoing experimentation. This practice is far more advantageous than hoarding arrows in the arsenal. Exploring uncharted territories and embracing calculated risks fuels growth.

Maintaining a Sufficient Arsenal of Arrows

We can throw arrows into the dark (experiment) only if we have arrows in our arsenal. Fragile companies have limited cash flows to afford Experimentation. In other words they do not have arrows in their arsenal. Further, fragile companies can fail even without experimentation to begin with.

Some of the large Indian fragile companies which failed are:

• Bhushan Power and Steel: This was a steel manufacturing company that was one of the 12 large defaulters identified by the Reserve Bank of India in 2017. It had a debt of US$6.9 billion and was admitted to insolvency in July 2017.

• Essar Steel: This was another steel manufacturing company that was also among the 12 large defaulters identified by the RBI in 2017. It had a debt of US$6.9 billion and was admitted to insolvency in June 2017.

• Lanco Infra: This was an infrastructure development company that had interests in power, roads, railways, and mining. It had a debt of US$6.3 billion and was admitted to insolvency in August 2017.

• Bhushan Steel: This was yet another steel manufacturing company that was also among the 12 large defaulters identified by the RBI in 2017. It had a debt of US$6.2 billion and was admitted to insolvency in July 2017.

• Reliance Communications: This was a telecommunications company that was part of the Reliance Anil Dhirubhai Ambani Group. It had a debt of US$4.6 billion and was admitted to insolvency in May 2018.

• Alok Industries: This was a textile manufacturing company that had a debt of US$4.1 billion and was admitted to insolvency in July 2017.

• Jet Airways: This was an airline company that had a debt of US$2 billion and was admitted to insolvency in June 2019.

These companies before getting admitted to insolvency had limited cash flows to experiment. They were fragile and succumbed due to their mounting debt.

For investors, future SIPs act as a tool to keep replenishing arrows in our arsenal. We can experiment with future SIPs i.e. we can always invest in new companies from future SIPs instead of existing companies in our portfolio. Alternatively, we can also replenish arrows in our arsenal whenever there is Population Explosion in our portfolio. We can partially exit stocks which experience Population Explosion and invest such money in new companies.

Prudent Allocation of Arrows

A robust company can become fragile by taking one large leveraged bet (launching all arrows including borrowed arrows at once). This can lead to Risk of Ruin. It should avoid throwing all arrows at once. One such classic example is Tata Steel acquiring Corus which is explained in following articles:

Tata Corus: 7 Lessons from a Deal from Hell | Founding Fuel

BACKSTORY: Tata Steel’s high-octane battle to acquire Corus (cnbctv18.com)

Tata Steel in 2007 acquired Corus which is 4 times its size through debt (it threw all arrows and once, it even borrowed few of the arrows). 

Look at its share price after that. It never reached its peak of Rs 88 per share in 2008 up until 2021. It could remain afloat only because of its strong Tata Parentage. 

For investors, we should avoid allocating entire money in one single company. We should also avoid taking debt to invest. This should not be confused with Power of Population Explosion. While we should encourage our investments to explode after we invest in them, we at the same time should avoid taking large bets when we invest to begin with. 

We should experiment within our means or limits.

Continual Pursuit of Experimentation

Robust companies keep generating surplus cash flows every year from existing businesses. They keep replenishing their arsenal with arrows. They can choose not to experiment by either building cash reserves from these surplus cash flows or sharing these cash flows as dividends or share buyback to investors. Such companies are not utilizing their Antifragile Power i.e. Power of Experimentation. However, these companies can become antifragile by using surplus cash flows to experiment i.e. by way of launching new products, acquisition, capacity expansion, R&D, etc.They need to keep taking multiple small bets instead of one large bet. They also need to avoid taking debt while taking new bets. Who knows, they might end up hitting bullseye like Infoedge’s investment in Zomato which led to windfall gains at the time of Zomato’s IPO or Eicher’s experiment with 2 wheelers which led to its dominance in the premium segment.

As investors too, we need to remain invested in the market through experimentation instead of keeping our savings in the form of Cash and trying to time the market.

Conclusion

In conclusion, the Antifragile Power of Experimentation offers a pathway to unlocking upside potential, reliant on a balance of resources, prudent allocation, and sustained commitment to venturing into the unknown. By wielding this power, we empower ourselves to navigate the realm of uncertainty, bolstering our portfolios against fragility and embracing the promise of unlimited upside potential.

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Introduction:

In my previous posts in the fragility series which can be found here Fragility Series, we have explored the four fundamental pillars of fragility which an investor needs to be aware of to eliminate fragility in their portfolio:

1. Pillar 1 - Avoid investing in Fragile Companies

2. Pillar 2 - Avoid investing in Overvalued Companies

3. Pillar 3 - Avoid investing in Companies having Management with fragile mindset

4. Pillar 4 - Avoiding Shorter timeframes

By diligently implementing the above pillars, we can reduce the severity of adverse events and allow favorable news to substantially enhance our portfolio. 

While the four pillars mainly focus on eliminating fragility and reducing downside risk, we also need to create a portfolio that not only withstands adverse events but also capitalizes on positive events with unlimited upside potential.

Antifragility entails surviving adverse events and minimizing their impacts, enabling us to take advantage of positive events with non-linear impacts and unlimited upside potential. To achieve this, we must harness certain "Antifragile Powers" that will enhance the impact of positive events and make our returns non-linear. We acquire these “Antifragile Powers” only if we remove fragility from our investments which we can do by following the four pillars of fragility. I discussed one such Antifragile Power - Power of Population Explosion in my previous post. In this post, we will delve into another such Antifragile power - Power of Saying No. 

Saying No

The significance of “Saying No" is showcased in the iconic movie "Rocky," recounting the journey of Rocky Balboa, a humble boxer from Philadelphia. The crux of Rocky's life narrative unfolds when an unforeseen opportunity arises to challenge Apollo Creed, the reigning heavyweight champion, subsequent to Creed's original opponent's withdrawal due to injury. Despite overwhelming odds, Rocky perceives this chance as a platform to prove his mettle and carve a distinctive identity in the realm of boxing.

Here’s the exact quote from the movie when Rocky confides in Adrian, his love interest, the night before his big fight with Apollo Creed, the world champion boxer:

"All I wanna do is go the distance. Nobody’s ever gone the distance with Creed, and if I can go that distance, you see, and that bell rings and I’m still standin’, I’m gonna know for the first time in my life, see, that I weren’t just another bum from the neighborhood."

The significance lies in the fact that Rocky's career teetered on the brink of collapse prior to the opportune encounter with Apollo Creed. His circumstances were inherently fragile, with limited avenues to propel his boxing career forward. Rocky lacked the luxury of the "Power of Saying No" to the match with Apollo Creed. Beyond merely Saying Yes to the bout, he was also required to prove his competence.

On the other hand, Apollo Creed is not fragile. As an established champion, Creed held the privilege of handpicking his opponents, opting for the relatively obscure Rocky as his adversary.

Moreover, it is worth noting that Creed possessed the power of “Saying No". Following a near defeat in the initial match against Rocky, Creed could have declined a rematch – a choice he opted against. Creed's actions underscore the notion that while the power of Saying No existed, it remained underutilized. In contrast, Rocky was devoid of such power, a predicament that dictated his inability to decline the original match or the subsequent rematch against Creed.

This concept extends beyond the realm of cinema. Consider two employees with comparable job roles. One (Employee X) carries lots of obligations, such as EMIs and children's education, leaving minimal room for financial flexibility. The other (Employee Y) boasts a substantial retirement fund and fewer obligations. Employee X's cannot afford to say no and always has the fear of losing his job. Employee Y, conversely, can confidently refuse tasks that do not align with preferences, embracing a stress-free work environment.

Similarly, companies which are not fragile can wield the Power of Saying No when encountering business propositions lacking favorable terms. Few examples are:

Reliance, Aramco call off $15 billion deal amid valuation differences: Sources - The Economic Times (indiatimes.com) Reliance did not go ahead with the deal as the valuation is not to their expectation. They used the Power of Saying No for the deal. 

Why did Bajaj Auto/KTM pull out of Ducati?: Rajiv Bajaj, Auto News, ET Auto (indiatimes.com) Rajiv Bajaj said they called off the Ducati Deal

“For two good reasons: too much overlap with KTM and a valuation that is beyond our limited comprehensions”. 

In Q2-FY2020 earnings call,, Wonderla Management informed the following with regard to Chennai Park:

The Government of Tamil Nadu has given the permission to exempt our park from the LBT (Local Body Tax) for five years from November 1, 2019. As per the Order, the Project execution period is also included in the exemption period of 5 years. This is an anomaly.

In a subsequent update in June 2023, company informed the following:

The Government of Tamil Nadu has granted waiver of Local Body Tax (LBT) of 10% for a period of 10 years from the commencement of commercial operations subject to the condition that the commercial operation shall be commenced within a period of 2 years from 2nd June 2023,, after persistent efforts by the Company

Wonderla already incurred a cost to the tune of Rs 109 Crs towards land acquisition for Chennai Project by the time the company started pursuing with the government. The company utilized its Power of Saying No in the form of not commencing the project and keeping the land idle till it could negotiate favorable terms.

Similarly as an investor, we also have the Power of Saying No in the following forms:

1. We only need to choose 10 to 20 companies out of 5000 companies to invest

2. We can say no to overvaluations

3. We need not invest incase of no good investment opportunities

Power of Saying No is acquired

Fragile companies do not have this power of Saying No.

Deal or Exit? Etihad to take final call on Jet Airways on 31 March | Mint (livemint.com) In the talks with Etihad, Etihad had the deciding power and not Jet Airways. 

Like the Power of Population explosion, it is imperative to recognize that the Power of Saying No is a power acquired through the elimination of fragility. A company cultivates this power by fortifying its core resilience, thereby wielding the ability to negotiate favorable business terms, mirroring the principle elucidated in the example of the movie "Rocky." 

As an investor, we acquire this Power of Saying No by investing only long term capital i.e. money which we don’t need for next 5 to 10 years and also maintaining a contingency fund. By doing this, we are not forced to exit during bear markets and need not be in a hurry to invest when we cannot find any good opportunities to invest. 

While following the four pillars of Fragility helps reduce the impact of adverse events, enhancing the impact of positive events requires us to leverage various Antifragile Powers like Power of Population Explosion and the Power of Saying No.

However, failing to utilize these Antifragile Powers would limit our upside potential. Similarly, there are other Antifragile Powers that we "acquire" by removing fragility from our investments. In my subsequent posts, I will explore these various "Antifragile Powers" that will enable positive events to thrive in our portfolio.

If you found this post valuable, please share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM. You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.

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Introduction:

In my previous posts in the fragility series which can be found here Fragility Series, we have explored the four fundamental pillars of fragility which an investor needs to be aware of to eliminate fragility in their portfolio:

1. Pillar 1 - Avoid investing in Fragile Companies

2. Pillar 2 - Avoid investing in Overvalued Companies

3. Pillar 3 - Avoid investing in Companies having Management with fragile mindset

4. Pillar 4 - Avoiding Shorter timeframes

By diligently implementing the above pillars, we can reduce the severity of adverse events and allow favorable news to substantially enhance our portfolio. I have also provided a consolidated checklist encompassing all these pillars, aimed at guiding investors towards effectively eliminating investment fragility.

However, it's essential to understand that 'robust' is not the true opposite of 'fragile.' The real opposite of fragility is 'antifragility.' We have previously explored this concept in the post titled "How to build an Antifragile Portfolio." While the four pillars mainly focus on eliminating fragility and reducing downside risk, we must now shift our focus to transforming our portfolio into an antifragile one. In other words, how can we create a portfolio that not only withstands adverse events but also capitalizes on positive events with unlimited upside potential? This will be the focus of our forthcoming posts in the Fragility Series.

Antifragility entails surviving adverse events and minimizing their impacts, enabling us to take advantage of positive events with non-linear impacts and unlimited upside potential. To achieve this, we must harness certain "Antifragile Powers" that will enhance the impact of positive events and make our returns non-linear. We acquire these “Antifragile Powers” only if we remove fragility from our investments which we can do by following the four pillars of fragility. In this post, we will delve into one such power - the Power of Population Explosion. 

Population Control

Mother Nature maintains a delicate balance between populations of various organisms, exemplified by the symbiotic relationship between zebras and lions on the African savannah. The abundance of vegetation supports a thriving zebra population, which, in turn, attracts the vigilant attention of the lion population that benefits from the availability of prey. This cycle of life depends on the existence of both species, each playing a crucial role in maintaining ecological equilibrium.

Similarly, the world of finance emphasizes the importance of diversification in an equity portfolio. Just as the population of zebras and lions are interlinked, acting as checkpoints for each other's populations, we too rebalance our portfolios regularly to ensure proper diversification and avoid concentration risk. For example, if a stock starts appreciating and starts contributing a significant share of our portfolio, we try to exit a portion of the same and invest in other stocks to avoid concentration risk.

Even SEBI has stipulated a Risk capping of maximum allocation of 10% in a particular stock for mutual funds. When HDFC and HDFC Bank merged, few mutual funds had to exit a portion of their allocation towards HDFC twins to comply with the 10% allocation. 40 equity mutual funds have more than 10% in HDFC twins - The Economic Times (indiatimes.com)

However, imposing too many restrictions on portfolio allocation can hinder our upside potential. By regular rebalancing and restricting maximum capping in a single stock in a portfolio to say 10%, aren't we limiting our upside potential? This works against the concept of Antifragility. Remember Antifragility means having as limited restrictions as possible for Upside Potential when positive events occur. By capping % allocation in the portfolio for a single stock, we are not letting positive events do their work. 

Power of Population Explosion

While following the four pillars of Fragility helps reduce the impact of adverse events, enhancing the impact of positive events requires us to leverage the Power of Population Explosion unlike Mother Nature which tries to control Population of various organisms. This means removing the restrictions we place on upside potential and allowing our winners to grow substantially within our portfolio. By doing so, we can maximize our returns when positive events occur.

To illustrate, let's consider an example: If we invest in ten stocks with equal 10% allocation in our portfolio, there is no guarantee that positive events will occur evenly across all ten stocks. What if all ten positive events happen in a single stock, and the others experience none? By strictly adhering to rebalancing practices, we might unintentionally limit our upside potential.

In the initial 5 years of my investing journey, I earned FD like returns of 7% per year or so as there were no major positive events in any of my portfolio stocks. However, things changed drastically in the 6th year when one particular stock became 10 bagger and started contributing 80% of my portfolio!! I let this stock grow till 10 bagger and then exited a portion of the same to diversify into other stocks. This enabled me to earn higher than market returns subsequently. If I had exited/rebalanced when it reached 10% or 15% of portfolio allocation, then I would have restricted the upside potential of positive events happening in this particular stock. 

Legendary investors like Rakesh Jhunjhunwala and Radhakishan Damani have experienced remarkable wealth creation by unleashing the Power of Population Explosion. Allowing their winners to grow significantly within their portfolios contributed to their outstanding success. Late Rakesh Jhunjhunwala bought 6 Crore shares of Titan at Rs 3 each in 2002-2003 i.e. a Rs 18 Crs investment. The share price of Titan has since become ~1000X. While he exited partially during the years, he (i.e. now his wife) continues to still hold ~4.5 Cores shares of Titan which is still contributing 40% of his wealth. Titan is a significant contributor towards his wealth creation journey. Similarly Avenue Supermarts (DMart) significantly contributed  towards the wealth creation journey of Radhakishan Damani.

Power of Population Explosion is “Acquired” 

The concept of not putting all our eggs in one basket is often emphasized in investment advice, promoting the idea of diversification. This strategy aims to mitigate risks associated with fragile investments, much like delicate eggs. However, what if each of our investments were more akin to rubber balls—resilient and even antifragile? In that case, we could confidently place all these rubber balls in one basket without fear. In other words, we could embrace concentration risk if our individual investments lacked fragility and exhibited robustness or antifragility.

By diligently following the four pillars of fragility, we "acquire" the Power of Population Explosion, which grants us the ability to take on concentration risk. This means that we can allow certain investments to grow significantly within our portfolio, maximizing their potential when positive events occur.

However, failing to utilize this acquired power of population explosion would limit our returns. Similarly, there are other Antifragile Powers that we "acquire" by removing fragility from our investments. In my subsequent posts, I will explore these various "Antifragile Powers" that will enable positive events to thrive in our portfolio.

To unleash the true potential of positive events, we must tap into these Antifragile Powers and cultivate an antifragile portfolio. By removing fragility from our investments and acquiring these powers, we can create a resilient investment strategy that thrives on the opportunities presented by positive events.

If you found this post valuable, please share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM. You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.

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As I have informed in my previous post, I had to take 4 to 6 weeks of break in my weekly posts due to personal obligations that required my full attention. I'll try to start posting on a weekly basis again, every Sunday at 8 AM, as I used to do earlier.

I'm back with a new post in the Fragility Series. In my previous posts in the series, I explained about the four pillars of investing. In this post, I would like to give a live example with regard to the fourth pillar of investing, i.e. Time. I gave a detailed explanation about this pillar in my post "Fourth Pillar of Investing: Time – Let’s make it our friend rather than a foe," wherein I explained how fragility reduces with Time; the longer the time horizon of our investments, the lesser the fragility.

Technical Glitch by Zerodha caused losses for a few traders on July 7th, 2023

You can find details of the Technical glitch in the below 2 news articles.

1. Zerodha glitch: Traders say unable to exit Sensex option trades, brokerage says 'issue with the ISPs' - BusinessToday

2. Netizens angry after losing money as Zerodha suffers tech glitch again | Mint (livemint.com)

Before we get into the details, we need to understand Equity Options, which is required for better understanding the issue.

Imagine you're planning to buy a new video game console, but you're not sure if you'll have enough money when it's released in three months. You really want to secure the option to buy it at the current price, just in case the price goes up later. So, you decide to pay a small fee to the store owner to lock in that option.

Now, let's translate this concept to the world of finance:

Equity options are like these "price-locking" agreements but for stocks (shares of a company). They give you the right, but not the obligation, to buy or sell a certain number of shares of a company's stock at a set price (called the "strike price") before a specific date (the "expiration date").

There are two types of equity options:

1. Call Option: This is like the price-locking agreement for buying shares. If you buy a call option, you pay a small fee (called the premium) to secure the option to buy the shares at the strike price before the expiration date. If the stock price goes up, you can buy the shares at the lower strike price and sell them at the higher market price, making a profit.

2. Put Option: This is like the price-locking agreement for selling shares. If you buy a put option, you pay a premium to secure the option to sell the shares at the strike price before the expiration date. If the stock price goes down, you can sell the shares at the higher strike price and then buy them back at the lower market price, again making a profit.

Keep in mind that options are time-sensitive, meaning they have an expiration date. If the stock price doesn't move in your favor before the expiration, the option may expire worthless, and you lose the premium you paid for it.

Apart from Options for shares of a company, there are also Index Options, i.e. call/put options for NIFTY or SENSEX.

Now there are few trading strategies that deal with trading Options on their expiry date. As I explained above, Options will become worthless if the price of a company or Index does not move in our favor at the time of expiration, i.e. at 3:30 PM on the expiration date.

A few traders were trading on BSE Options on July 7th, 2023, on the expiry date through Zerodha. They were unable to post their traders on the platform in the last 20 minutes of expiry, i.e. between 3:10 to 3:30 PM, due to which a few of the traders incurred huge losses, which eroded a significant % of their capital.

While it is regrettable that these traders incurred losses due to external factors and not due to their own doing. However, if we think about it, incurring huge losses in our portfolio due to a small technical glitch of a few minutes means the investment strategy is fragile. Fragility means getting significantly impacted by adverse events and antifragility means having minimal impact due to adverse events and taking advantage of positive events. Here, the technical glitch by Zerodha for a few minutes is an adverse event, and this event caused huge losses for a few traders, which implies that the strategy is very fragile. The strategy is overly dependent on the last few minutes of expiry of Options. Those few minutes are very critical for the strategy to work.

This is one of the reasons I prefer a long-term strategy as fragility reduces with time. As I explained in the four pillars of investing in my fragility series, we can eliminate fragility by following the first three pillars of investing, i.e. investing in companies with robust financials, are undervalued, and have management who does not have a fragile mindset. However, the fourth pillar, i.e. Time is equally important. Let me explain this using another example.

Another example with a technical glitch of 2 years!!

Wonderla Holidays is into Amusement Parks. I wrote a detailed post about the company here. The Amusement Parks of the company had to remain closed/ negligible footfalls for 2 full years due to COVID. Try to digest that information, Negligible revenue for 2 full years!!

Look at their quarterly results for that period. They had to incur a loss for 6 quarters due to COVID, which is an external adverse event and not because of their own doing. However, they came back strong with lifetime high profits in FY23 after the COVID effect was reduced.

Look at their share price during this period. While the share price fell from Rs 291 in Oct'19 to Rs 110 in May'20, it bounced back and reached an all-time high price of Rs 575 last month.

While COVID is an adverse event, lifetime high profits are partly due to a positive event called revenge tourism. Wonderla was able to absorb a 2-year adverse event and took advantage of a positive event. If this is not antifragile, then what is?

Wonderla was able to survive a technical glitch (COVID lockdown) of 2 full years vs. the traders who could not withstand a technical glitch of a few minutes!!

By looking at the above 2 examples, can’t we safely conclude that Wonderla is antifragile, whereas the trading strategy with regard to Options expiry is fragile?

Our strategy should be such that we can survive adverse events so that we live another day to take advantage of positive events. For this, we need to let the fourth pillar i.e. Time do its work. As they say, Time heals most wounds.

If you found this post valuable, please share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM. You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.

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Introduction:

In my previous posts in the fragility series which can be found here Fragility Analysis | Budget Tiger (budgetiger.in), we have explored the four fundamental pillars of fragility which an investor needs to be aware of to eliminate fragility in their portfolio:

1. Avoid investing in Fragile Companies

   1. How to measure fragility in a company using financial statement analysis 

   2. Introducing the Fragility Score Card: Financial Statement Analysis made easy

2. Avoid investing in Overvalued Companies

   1. Overvaluation increases fragility of our investment & Stock Market is not always right

   2. The Power of PEG: A More Comprehensive Valuation Metric Than PE Ratio

3. Avoid investing in Companies having Management with fragile mindset

   1. A Step-by-Step Approach to Management Analysis for Companies

4. Avoiding Shorter timeframes

   1. Time – Let’s make it our friend rather than a foe

By following the above four pillars, we can reduce the impact of bad news and let good news do its magic for our portfolio.

In this post I have provided a consolidated checklist covering various aspects of all the above four pillars for enabling an investor to eliminate fragility in their investments. 

Understanding the Role of Checklists

In the world of investing, as in many aspects of life, the power of simplicity should never be underestimated. This is where a checklist comes into play. A checklist is a curated list of essential tasks, designed to ensure that we do not overlook crucial steps. It helps to turn broad, overarching principles into tangible, actionable steps.

Checklists have gained popularity in a wide array of fields, from aviation to medicine to investing, due to their ability to streamline complex processes and minimize errors. They act as a valuable tool to keep us focused and structured in our approach, ensuring that we follow consistent, disciplined steps in decision making.

Importance of a Checklist in Investing

In investing, a checklist plays an indispensable role. The investing landscape is vast and often filled with noise - countless companies to evaluate, numerous financial metrics to consider, and a constant stream of market news and events. A well-crafted checklist helps investors navigate this landscape with ease, breaking down complex investment decision-making into a series of structured, manageable steps.

Moreover, a checklist acts as a guard against potential pitfalls such as emotional decisions, biases, and impulsive behavior. It encourages a systematic, rational approach that aligns with one's investment principles and objectives, serving as a compass during both calm and stormy market conditions.

Utilizing the Checklist Effectively

Every time you consider a potential investment, go through each item on your checklist. Take your time, perform due diligence, and make sure you are comfortable with each aspect. If a potential investment doesn't satisfy all items, it may not align with your investing principles, and it might be wise to consider other opportunities.

In short, a checklist should not be seen as a shortcut or a strict set of rules. Instead, it should be considered a tool to facilitate disciplined and well-informed investment decisions. It fosters an environment of systematic analysis, reducing the chances of missed or hasty decisions that could lead to potentially unsound investments.

Remember, the ultimate goal of investing is not merely to chase returns, but to build a portfolio that aligns with your principles, risk tolerance, and long-term financial goals. A well-structured checklist can be your trusted ally in this rewarding journey.

In our exploration of the investing landscape, let's distil the four fundamental pillars of fragility into a practical checklist.

Checklist

Pillar 1: Avoid Investing in Fragile Companies

• Is Equity as a % of Balance sheet size more than 65%? (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates the company’s balance sheet is healthy as the company has limited obligations

• Is Breakeven sales as a % of Actual Sales less than 28%? (indicates the percentile is in top 60 percentiles of all listed companies) -  Lower percentage indicates the company’s Profit & Loss statement is healthy as the company has flexibility to experiment

• Is ROCE more than 13%? (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates that there is some inherent strength in the business model of the company

• Is Cash Flow from Operations as a Multiple of Yearly Debt Obligations Plus Depreciation more than 1.1x?  (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates the company’s cash flows are healthy as the company is generated adequate surplus cash flows which will enable it to experiment or share it with shareholders

• Is the company in a growing/ mature industry and not in a declining industry?

• Have the company’s sales and profits grown in the past 5 to 10 years? (decline in sales and profits for a brief period of say 1 or 2 years is forgivable considering the same may be attributable to randomness/luck/cyclicity or whatever we call it)

Pillar 2: Avoid Investing in Overvalued Companies

• Examine the valuation metric Price-to-Earnings (P/E) and get convinced that it is not too high? (higher P/E implies that the  company is assumed to deliver high growth rates which makes our investment fragile as valuations get corrected if the company does not meet the required growth expectations. Achieving lower growth rates are always easier than higher growth rates )

• Have I examined the PEG ratio based on the last 5 years growth rate in earnings? (ratio of less than 1 is considered favourable)

• Have I examined the PEG ratio based on the last 20 years growth rate in earnings? (ratio of less than 1 is considered favourable)

• Have I examined the PEG ratio based on the future 5 to 10 years growth rate in earnings? (ratio of less than 1 is considered favourable)

• Is the company PEG -ve? (-ve PEG indicates that the earnings of the company are declining. It is suggestable to avoid such companies unless the decline in earnings is temporary)

Pillar 3: Avoid Investing in Management with Fragile Mindset

• Whether Management used external funding like equity instead of Debt for growth in the past? (same can be analyzed through cash flow statements) 

• Whether Management built/maintained adequate cash reserves for rainy days with surplus cash flows generated from operations? 

• Whether management after maintaining adequate cash reserves distributed/shared surplus cash generated from operations with shareholders in the form of dividends or buyback?

• In investor concalls, annual reports and media interviews, management should not be giving any importance to share price? (If managements focus is on long term growth rather than short term stock price valuations, then it indicates that management has long term perspective)

• Whether Management has a frugal mindset? (Management should not be spending in swanky offices or unnecessary expenses which may not be required for business. Spending Patterns in personal life of Management can also be observed)

• Management should not have inclination for taking Debt

• Shares of Promoters should not be pledged (Borrowing against pledge of shares is the extreme case of borrowing and generally used as a last resort for borrowing when all other options are closed)

• Salary paid to promoters as a % of Sales should not be high

• No major related party transactions

• Promoters have not issued warrants for themselves at much lower price than market price

• Company should not be paying royalty to group companies/ related parties

• Google search with Management and/or company name along with keywords like fraud, legal disputes, SEBI, etc should not reveal any adverse findings

• Promoters having skin in the game is desirable (A Promoter who has majority shareholding in a company and the shareholding contributes to the majority portion of networth of the Promoter has lot of skin in the game as compared to a promoter who has less than 50% holding in a company and also the shareholding contributes to only a small portion of net worth. A Promoter who has more skin in the game has more incentive to ensure that the company performs well)

Pillar 4: Giving Time for Our Investments

• Have I invested funds that I won't need in the short-term, allowing my investments to weather market volatility?

• Am I prepared to remain patient during market downturns, understanding that drawdowns are temporary and can potentially be followed by recoveries?

• Am I committed to staying invested for an extended period (5 to 10 years or more), giving my investments the time they need to potentially reap benefits?

• Do I have adequate contingency funds so that I need not dip in my equity investments in the time of need - (This is to avoid dipping into equity investments during bear market phase)

This checklist is more than a mere list of to-dos. It's a blueprint for investing style wherein we reduce the impact of bad news on our portfolio and let good news do its work for our portfolio. This is an approach to creating a portfolio that eliminates fragility and is as antifragile as it is rewarding. Remember, the key to success in investing lies in our approach, not in the whims and fluctuations of the market. Let's craft our investing strategy with a commitment to these four pillars, and navigate the investing journey with confidence and serenity.

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Introduction:

In my previous posts in the fragility series which can be found here Fragility Analysis | Budget Tiger (budgetiger.in), we have explored the three fundamental pillars of investing: avoiding investing in fragile companies, steering clear of overvalued companies, and avoiding investing in firms led by management with a fragile mindset. While these principles lay a strong foundation for eliminating fragility in our investments thereby making our portfolio robust/antifragile, let me introduce to the indispensable fourth pillar of investing: Time. 

Pillar 4: Time - The Essence of Long-term Investments:

Time plays an undeniably crucial role in investing. It is the secret ingredient that converts our prudent investments into a flourishing portfolio. The longer we allow our investment to stay in the market, the greater the chances for it to grow and flourish. Hence, the adage 'time in the market is better than timing the market' holds truer than ever.

Often, investors are tempted to make quick profits by entering and exiting the market based on short-term trends or speculation. This can increase the fragility of our investments due to volatility, turning the investment game into a gamble. However, true wealth creation requires maturity to allow our investment to marinate in the market for an extended period, often 5 to 10 years, or even longer.

A Statistician's Perspective:

Now, let me try to explain the importance of Time and how it can help reduce fragility by wearing my statistician's hat and dive into some numbers. I have analyzed daily closing index values of NIFTY50 since 1995 i.e. past 28 years data of NIFTY50.

Volatility introduces fragility in our investments. Longer the time frame of our investments lower the volatility. Here is the volatility vs timeframe graph for NIFTY50 index.

As you can observe, volatility of NIFTY50 becomes negligible with longer timeframes like more than 5 years to 10 years.

I have plotted % rolling returns of NIFTY50 index of the past 28 years in a histogram for various time frames.

Daily % rolling returns of NIFTY50

Weekly % rolling returns of NIFTY50

Monthly % rolling returns of NIFTY50

Yearly % rolling returns of NIFTY50

2 Yearly % rolling returns of NIFTY50

5 Yearly  % rolling returns of NIFTY50

10 Yearly % rolling returns of NIFTY50

As you can observe, when we look at daily returns of NIFTY50, nearly half of the days, NIFTY50 is in losses, whereas NIFTY50 is hardly in losses for a timeframe of 10 years. The histogram moves towards the right side with increasing time frame i.e. the chances of losses reduces with increase in timeframe.  

What we can observe from the NIFTY50 data is that volatility is lower for longer timeframes. Further, chances of losses also greatly reduces with longer time frames. Hence, more time we remain invested implies that there is lesser fragility in our investments.

Embracing Windfall gains:

No company, no matter how robust or antifragile, is immune to occasional bouts of bad news. During such times, investments can experience drawdowns, potentially causing momentary panic. However, if we adhere to the first three pillars as explained in my previous posts, our investments will likely be resilient enough to weather these temporary storms of bad news/adverse events without falling into a precipitous decline.

Just as bad news can cause temporary setbacks, good news can bring windfall gains. However, for these windfall gains to blossom and enrich our portfolio, our investments need the fourth Pillar i.e. Time. Staying invested for longer periods allows these positive surprises to compound and significantly boost our returns.

The Value of Contingency Fund:

As you might have understood by now, the longer we remain invested in the stock market, the lesser is the fragility of our investments. Now how do we ensure that our investments stay for a longer period? We ensure this by investing only long term capital in the stock market i.e. we invest money which we don't need in the near/medium term. 

This is where the contingency fund helps. Planning ahead for contingencies can make a significant difference in our investment journey. If a financial crunch hits, having a separate contingency fund helps ensure that we do not have to liquidate our long-term equity investments prematurely, especially during a bear market phase. This further underscores the importance of remaining patient and letting time work its magic.

Conclusion:

Ultimately, investing isn't a sprint; it's a marathon. It requires not just smart decision-making but also the patience to stick with those decisions for an extended period. Time, therefore, forms the fourth pillar of investing, supplementing and enhancing the other three pillars. 

Just as a sapling requires time to grow into a tall and sturdy tree, our investments need time to transform into a substantial wealth corpus. So, planning our investments wisely, preparing for contingencies, and allowing time to play its magic for financial growth. 

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I have written a series of posts on Fragility Analysis. You can find the posts here Fragility Analysis | Budget Tiger (budgetiger.in)

By eliminating fragility in our investments, we can avoid steep drawdowns upon an adverse news/event. While analysing a company from a fragility perspective, we need to look at three important pillars. 

• Pillar 1 : Avoid investing in fragile companies. We can measure the fragility of a company through financial statement analysis. 

• Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile

• Pillar 3: Avoid investing in companies whose Management has fragile mindset 

Each of the three pillars are important. In this post, I would like to explain more on Pillar 2 i.e. Avoid investing in overvalued companies.

The most commonly used valuation metrics are the Price to Earnings (PE) ratio and the Price to Earnings Growth (PEG) ratio. However, while the PE ratio has been a popular go-to for investors for years, the PEG ratio offers a more nuanced, holistic perspective.

The Limitations of the PE Ratio

The PE ratio, which is calculated by dividing a company's market price per share by its earnings per share (EPS), is a simplistic measure of a company's value. It essentially tells us how much investors are willing to pay for each Rupee of earnings generated by the company. However, the PE ratio has a significant drawback: it doesn't account for the company's growth prospects.

In other words, the PE ratio can mislead investors into overvaluing stagnant companies with high earnings or undervaluing high-growth companies with currently low earnings. For example, a company growing at 30% y-o-y and trading at a PE of 20 is undervalued as compared to a company growing at 10% y-o-y and trading at a PE of 10. 

This leads us to the concept of the PEG ratio.

PEG Ratio

The PEG ratio, on the other hand, takes the PE ratio and adjusts it for the company's earnings growth rate. It's computed by dividing the PE ratio by the earnings growth rate.

By incorporating growth into the equation, the PEG ratio provides a more balanced view of a company's valuation, offering insight into whether its stock is overpriced or underpriced given its earnings growth trajectory. Essentially, it allows investors to compare the relative trade-offs between the price of a stock, the earnings generated per share, and the company's growth.

Understanding Earnings Growth Rate in PEG Ratio

Earnings growth rate is a crucial component of the PEG ratio, providing the denominator that adjusts the PE ratio to account for the company's growth prospects. This rate can be determined based on past performance, future projections, or a combination of both.

When using historical earnings growth rate, we can look at the past 5 or 10 years. This approach provides insight into the company's demonstrated ability to grow its earnings over time. So we can arrive at PEG by dividing PE with past 5 years earnings growth or dividing PE by past 10 years earnings growth. 

However, it's worth noting that past performance is not always indicative of future results. For example, earnings of most companies were impacted during COVID-19 years i.e. FY2021 and FY2022. Arriving at historical growth rate based on FY2022 with earlier years is not a right indication.  Economic conditions, industry trends, and company-specific factors can all impact a company's future earnings growth, making the past growth rate only as a guidance factor.

On the other hand, using projected earnings growth for the next 5 or 10 years offers a forward-looking perspective. However, they also introduce an element of uncertainty, as they rely on assumptions about future conditions.

Ultimately, the choice of earnings growth rate period (past vs. future, 5 years vs. 10 years) depends on our risk tolerance, and belief in the company's prospects. Some investors may prefer to use a blend of historical and projected growth rates to balance the stability of past performance with the potential of future growth.

Why a PEG of 1 or Below is Considered Favorable

In terms of interpretation, a PEG ratio of 1 suggests that the company is fairly valued given its growth rate. A PEG ratio below 1 typically indicates that the stock may be undervalued – that is, investors may be underestimating the company's ability to grow its earnings in the future. This could potentially lead to higher than 15% Compound Annual Growth Rate (CAGR), making these companies attractive for investment.

The Unsustainability of High Growth

While a low PEG ratio may signal an undervalued high-growth company, it's crucial to understand that high growth rates are often not sustainable over extended periods. 

For example a company with PEG of 1 and PE ratio of 300 implies the company is required to grow its earnings at 300%!!! y–o-y for the stock to justify appreciation of just 15% CAGR.

Companies, especially those in their growth phase, may experience extraordinary growth rates. However, as they mature, their growth rates typically taper off, settling closer to the average growth rate of the economy. Furthermore, market saturation, increased competition, regulatory hurdles, and other factors can also slow down a company's growth over time.

So it is very very difficult to sustain hyper growth rates. 

Wipro Limited was trading at PE of ~500 in Feb 2000. However, it took 15 years to again reach the same price in March 2015. Whether the company did not grow during this period? No, actually profits grew from Rs 112 Crs in FY1999 to Rs 7991 Crs in FY2014 at a scorching pace of 33% CAGR during this period. Still investors who invested at PE of 500 did not earn any return for 15 years. Because to even justify a return of 15% for the investor  at PE 500, a company is required to grow its earnings at 500% per year i.e. the company is required to multiply its profits by 6 times every year!! Which is next to impossible just like light escaping a black hole due to its gravity.

Conclusion

In conclusion, while both PE and PEG ratios have their place in valuation analysis, the PEG ratio's incorporation of growth offers a more comprehensive view of a company's value. However, investors should be mindful of the fact that high growth rates are often not sustainable over the long run. Therefore, as with all investment decisions, it's essential to combine these.

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While analysing a company from an investment perspective, we need to look at three important pillars. 

Pillar 1 : Avoid investing in fragile companies -

We can measure fragility of a company through financial statement analysis. I explained the same in my post How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

Pillar 2: 

Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile -

I explained about overvaluation in my post Overvaluation increases fragility of our investment & Stock Market is not always right (budgetiger.in)

Pillar 3: Avoid investing in companies whose Management has fragile mindset -

I explained about management analysis in my post A Step-by-Step Approach to Management Analysis for Companies (budgetiger.in)

Each of the three pillars are important. In this post, I would like to explain more on Pillar 1 i.e. Avoid investing in fragile companies. 

Fragility of a company can be measured through financial statement analysis. There are four key financial ratios to measure a company's fragility. 

The Four Key Financial Ratios:

1. Equity as a Percentage of Balance Sheet: This ratio measures a company's financial leverage by comparing its equity to its total assets. A higher percentage indicates that the company relies less on debt financing and has a stronger financial position and accordingly a higher equity percentage indicates the company is less fragile. 

2. Break-Even Sales as a Percentage of Actual Sales: This ratio reveals the proportion of sales required to cover a company's fixed and variable costs. A lower percentage means that the company can generate profits more easily, indicating financial robustness.

3. Return on Capital Employed (ROCE): ROCE is a profitability ratio that measures how efficiently a company is using its capital to generate returns. A higher ROCE suggests that the company is using its resources more effectively, which is a positive indicator of financial health. Further a higher ROCE indicates that there is some inherent strength in the business model of the company due to which the company is able to generate higher returns on its capital employed. 

4. Cash Flow from Operations as a Multiple of Yearly Debt Obligations Plus Depreciation: This ratio measures a company's ability to generate sufficient cash flow to meet its debt obligations and cover depreciation expenses. A higher multiple indicates that the company has a better cash flow position, which is essential for its long-term financial robustness

I prepared a Fragility Score Card, a tool that uses the above four key financial ratios to measure a company's fragility. In this post, I will explain how the Fragility Score Card works and how you can use it to easily analyze financial statements of a company using this fragility score card.

The Fragility Score Card:

I shortlisted companies listed on NSE/BSE with more than Rs 100 Crs market cap. There are more than 2100 such companies. I then calculated the 10th, 20th, 30th, 40th, 50th, 60th, 70th, 80th, and 90th percentiles of each of the above four key  financial ratios to create a Fragility Score Card. By comparing a company's financial ratios to these percentiles, we can easily determine its fragility and overall financial health.

Below are the values of each ratio at respective percentiles

I believe that a picture explains more than words. That's why, I tried displaying the fragility score card in a plot. 

Using the Fragility Score Card:

To use the Fragility Score Card, follow these steps:

1. Calculate the four key financial ratios for the company you're analyzing.

2. Plot the company’s ratios in the above fragility score card plot. 

3. If the company's ratios appear in the right side of the plot, then the company is robust. If the ratios appear on the left side of the plot, then company is fragile. 

4. Alternatively, if you are more comfortable dealing with tables, then compare the company's ratios to the respective percentiles on the Fragility Score Card table. If the company’s ratio are at a higher percentile, then the company is robust. If the ratios are at a lower percentile, then the company is fragile. 

Few Examples:

Asian Paints

Asian Paints has moderate Equity as a % of balance sheet ratio. Further, its Cash Flow multiple is also moderate. However, it has very good Breakeven % and ROCE. Cash Flow multiple is low in FY2022 partly due to increased inventory and receivable levels in that year. However, the multiple is higher historically for the company. As per the above, company appears to be more robust.

Bharti Airtel

Bharti Airtel appears to be more fragile based on these four key ratios. This is understandable considering the regulatory constraints in the industry and also intense competition in the form of Jio. 

Larsen & Turbo 

L&T appears to be more fragile based on all the four ratios. However, if I compare the ratios of L&T with earlier three years, then ratios of L&T are improving year on year. 

Infosys

Infosys financials appear to be robust based on the four key ratios. 

Conclusion:

The Fragility Score Card is an invaluable tool for investors looking to ease the financial statement analysis. By using this scorecard and plotting the ratios of a company, you can easily measure the fragility of a company’s financials. 

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Introduction

There are three key pillars of fundamental analysis in stock market investing.

Pillar 1: Avoiding Investing in fragile companies

We need to try to avoid investing in fragile companies. I explained about the concept of fragility in my previous posts. A fragile company is like a flower vase. We dont know when the flower vase will break or will it even break. We only know that a flower vase is fragile and will break as soon as it falls. By investing in Robust/ Antifragile companies, we avoid this risk. A robust/Antifragile company is like a rubber ball which does not easily break upon a mere fall. I explained about how to measure fragility of a company in my post How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile

We need to avoid investing in companies when they are overvalued. Valuation of a company is like a balloon which can burst if there is too much air and on the other hand there is a lot of scope to grow if there is too little air.Valuation is an additional fragility parameter which is relevant for an investor but is irrelevant for a company. Investing in a robust company at overvaluation makes our investment fragile. I explained about overvaluation in my post Overvaluation increases fragility of our investment & Stock Market is not always right (budgetiger.in)

Pillar 3: Avoid investing in companies whose Management has fragile mindset

We can measure the fragility of a company as explained in Pillar 1 by analyzing past financial performance. We can also measure whether a company is overvalued or not as explained in Pillar 2 by conservatively estimating future performance. However, a management with a fragile mindset can hamper future performance of a company. We need to avoid investing in companies whose Management has a fragile mindset. In this post, Ill try to explain how we can analyze whether management of a company has a fragile mindset or not.

Five key qualities of a management with robust/antifragile mindset

If you are into reading books, then The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William N. Thorndike Jr. | Goodreads is an excellent book which explains five key qualities of a management with robust/antifragile mindset through eight unconventional CEOs.

Here are are five key skills that the eight unconventional CEOs in the book had:

- They focused on capital allocation as their primary role, rather than operational management or strategic vision. They were able to allocate capital efficiently and effectively among various options such as acquisitions, dividends, share buybacks, debt repayments, or internal investments.

- They had a long-term perspective and did not care about short-term fluctuations in earnings or stock prices. They ignored Wall Street analysts and the media, and did not follow the latest management fads or trends. They were willing to be contrarian and unconventional in their decisions, even if they faced criticism or skepticism from others.

- They had a disciplined approach to valuation and did not overpay for acquisitions or investments. They used simple metrics such as cash flow and return on invested capital to evaluate opportunities, rather than accounting earnings or sales growth. They also avoided diluting their shareholders by issuing new shares or taking on excessive debt.

- They had a decentralized organizational structure and delegated operational authority to their managers. They hired talented and trustworthy people and gave them autonomy and incentives to run their businesses. They did not micromanage or interfere with their managers' decisions, but held them accountable for results.

- They had a frugal mindset and avoided wasteful spending on perks, headquarters, or bureaucracy. They kept their overhead costs low and reinvested their profits into their businesses. They also paid themselves modestly and aligned their interests with their shareholders.

How do we identify if Management of a company has the above qualities? I use the following approach for the same. 

Capital Allocation and Disciplines approach

Capital allocation and disciplined approach can be analyzed through the cash flow statement of a company.  I explained about Cash Flow Statements in my earlier post Company Analysis - Cash Flow Analysis and their trickle-down effect (budgetiger.in).

Here, lets instead focus on decision making of management through cash flow statement analysis. Below is the summary total of cash flows of TCS for the period FY2019 till FY2023.

Cash flow from Operations indicates the cash generated by the company from its operations. It also includes any cash deployed by company for incremental working capital (WC) requirements i.e. for growth. TCS generated Profits from operations of Rs 2.76,870 Crs in the past 5 years. Out of the same, the company paid taxes of ~Rs 57000 Crs and deployed cash of ~Rs 13000 Crs in WC requirements which is hardly 5% of profits from operations. It is possible that Management is very conservative in investing capital for future growth. This is one of the indicators that Management does not have a fragile mindset. Management with a fragile mindset could have possibly aggressively deployed capital for new projects or acquisitions and could have even taken Debt for the same. For example Meta has burned $15 billion trying to build the metaverse — and nobody's saying exactly where the money went | Business Insider India. This is kind of a fragile mindset. Look what happened after that Meta cuts 11,000 jobs as it sinks more money into the metaverse | Reuters. Let's further go deeper into the Cash flow statements to see what TCS Management did with this surplus cash flow from operations of ~Rs 2,06,000 Crs. 

Cash flow from Investing activities indicate whether the company purchased any fixed assets or made any investments. Infact, TCS generated cash of Rs 5,500 Crs from Investing activities. It did not deploy any cash there. TCS purchased Fixed assets worth ~Rs 16,000 Crs which is hardly 7.7% of Cash flow from operations.The same is understandable considering TCS is a services company and would require very little Fixed Assets in commensurate to its operations.  TCS invested Rs 6000 Crs in Investments which are mainly Government bonds and Fixed Deposits.  IT infact earned Interest of Rs 17000 Crs in past five years on these investments aggregating to ~Rs 50000 Crs. So, where did it deploy the cash generated from business?

Cash Flow from Financing activities is the final item in cash flow statement which indicates how the company raised long term capital if any i.e. through debt or fresh issuance of shares. TCS instead of raising capital, there is outflow of capital to the tune of ~Rs 2,09,000 Crs from financing activities. TCS paid dividends of ~Rs 1,75,000 Crs and Brought back shares of ~Rs 75000 Crs which is nearly Rs 2,00,000 Crs. Management shared the entire cash generated from business operations to shareholders through Dividends or Buyback of shares as it could not find any other growth opportunities. It may be noted that TCS doubled its Sales during this time without requirement for deploying any cash in the business. It also continued to maintain a cash buffer of Rs 50000 Crs in its books. 

This indicates that the mindset of TCS management is not fragile. Cash Flow statement analysis helps us analyze capital allocation decisions and whether management has a disciplined approach.

Lets look at another company, Johnson Controls-Hitachi Air Condition India Ltd which is primarily engaged in the business of manufacturing, selling and trading of air conditioners, refrigerators, chillers and VRS systems.

Johnson Control generated profits from operations of Rs 778 Crs and paid taxes of Rs 163 Crs. The company also deployed cash of Rs 226 Crs in incremental WC requirements which is nearly 30% of profit from operations which is slightly bending towards a fragile mindset. Net cash flow from operations is Rs 422 Crs. 

The company purchased fixed assets of Rs 336 Crs which is 76% of cash flow from operations. Even if we assume it is difficult to avoid incremental working capital requirements, the management has a choice not to purchase fixed assets except for replacement capex. Infact, the company invested in capacity expansion plans. The company had net fixed assets of only Rs 244 Crs in FY2018 and management invested Rs 336 Crs in Fixed Assets in the next five years. While investing in Capacity expansion plan is not wrong, investing in the same in commensurate with the cash flows generated from operations tells us whether management’s mindset is fragile or not. I feel the mindset of the management in this company is bending towards fragile. 

If we look at Cash flow from financing activities, the company raised fresh debt of Rs 220 Crs and paid debt of Rs 236 Cr and it also paid interest on this debt of Rs 29 Crs. The company had debt of only Rs 13 Crs in FY2018. That means, the company raised fresh debt of Rs 220 Crs in the past 5 years and also paid a significant portion of this debt as the company had debt of Rs 112 Crs at the end of March 2022. This shows that the mindset of management is slightly inclined towards fragile.

As we have seen, Cash flow from Investing activities and Financing activities are choices of a management and the way capital is deployed in these activities gives an indication of Management decision making.

Long Term Perspective

Whether Management has a long term perspective or not, we can take cues from the following:

1. In investor concalls, annual reports and media interviews, we can observe whether management is giving any importance to share price. If managements focus is on long term growth rather than short term stock price valuations, then it indicates that management has long term perspective

2. For example, ITC’s management did not demerge its various businesses despite a lot of discussions happening by the investors community on the same since the past few years. 

3. MRF Promoters did not split their shares or issue bonus shares despite the share price reaching near Rs 90000 per share. Split of shares or issuance of bonus shares would have decreased the share price, thereby increasing liquidity of the shares in the market. But the Management never thought about the same and instead only focussed on long term growth.They also did not budge despite criticism from the investor community that dividend is only Rs 3 per share on a share price of Rs 90000 per share. The share price of MRF multipled 7.5 times in the last 10 years and turned out to be a wealth creator for the past few decades. 

Frugal Mindset

We can take cues from the following on whether Management has Frugal Mindset or not:

1. Pledge of promoter shares: Borrowing against pledge of shares is the extreme case of borrowing and generally used as a last resort for borrowing when all other options are closed. Pledge of shares by Promoters is a red flag.

2. No inclination for taking debt

3. Not investing in swanky offices and spending pattern in personal life

4. Investing Majority of the profits in business or sharing part the profits with shareholders in the form of dividends or share buyback

5. Keeping cash buffer in the balance sheet

Alignment of Management's interest with that of minority shareholders

A Management whose interests are not aligned with that of minority shareholders is a red flag. For this red flag. we need to find out if a Management is trying to take out money without sharing with other shareholders. We can take cues from the following for the same:

1. Salary paid to Promoters/ Management as a % of sales. Ideal scenario is Promoters not taking any salary as they can earn income through dividends. Hence, Salary of promoters as a % of sales is an indication of whether their interests are aligned with that of other shareholders.

2. Setting up subsidiaries/group companies for backward/forward integration when such businesses can be executed in the same company without forming a new company. We can look at related party transactions for the same in annual report

3. Issuing warrants to Promoters at a much lower value than the ongoing share price.

4. Paying royalty to Promoters or related companies.  Hindustan Unilever's royalty hike move hits investor mood, stock dips 4% (business-standard.com)

5. Google search with Management and/or company name along with keywords like fraud, legal disputes, SEBI, etc might reveal something about the management

Skin in the Game

A Promoter who has majority shareholding in a company and the shareholding contributes to the majority portion of networth of the Promoter has lot of skin in the game as compared to a promoter who has less than 50% holding in a company and also the shareholding contributes to only a small portion of net worth. A Promoter who has more skin in the game has more incentive to ensure that the company performs well. 

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I try  to invest in companies which are robust or antifragile and try to avoid companies which are fragile. I explained how to measure fragility of a company through my earlier post How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

All the fragility parameters I explained in the said post are from the point of view of a company. However, valuation of a company is an additional fragility parameter which is relevant from the point of view of an investor and irrelevant from the point of view of a company. In this post, I will try to explain about the valuation of a company which is also an equally important fragility parameter for an investor. 

Stock Market is not always right

Does the stock market know everything and can it rightly value the company?

The answer is No. Valuation given by the stock market is like a balloon. A Balloon can have too little air and there is still a lot of scope for infusing more air into the balloon or a balloon can have too much air in which case, it can burst at any moment. Similarly, sometimes a company is undervalued and sometimes it is overvalued by the stock market. Our goal is to invest in a company when it is undervalued and exit when it is overvalued. Let me explain this using stock markets favorite meme stock ITC as an example.

As we can observe, the stock price of ITC Limited dropped from Rs 320 per share in Aug 2018 to Rs 165 per share in May 2020 and again increased to present level of Rs 396 per share in April 2023.

Now lets look at the P/E of the company during this period. P/E is one of the valuation parameters. It is nothing but Market Capitalisation of a company by Profit earned by the company. Market capitalization of a company is the valuation given by the Stock Market to a company. Profit earned by a company is like an interest earned on a Fixed Deposit. Hence, P/E ratio gives an indication of how many times the market capitalisation of a company is as compared to profit earned by a company. It does not makes sense to compare PE of one company to another company as PE should ideally be higher for high growth companies as compared to PE of a company with moderate growth.

For example, Both company A and company B earned a profit of Rs 100 Crs in FY2022. If company A is expected to grow at 15% yoy for next 10 years and company B is expected to grow 10% yoy for next 10 years, then projected profits for company A in year FY2032 will be Rs 404 Crs as compared to projected profit for company B in year FY2032 of Rs 259 Crs. While both companies earned the same profits in FY2022, their profits are projected to be different in FY2032. Accordingly, company A should ideally have higher market capitalisation as compared to company B to factor in higher growth. Accordingly, the PE of company A should ideally be higher than PE of company B.  

Can PE of the same company change over a period of time, if it is growing at the same rate yoy? I dont think so. Lets look at PE of ITC Limited in the last 5 years. 

It dropped from 35.4 in Aug 2018 to 12.9 in May 2019 and then increased to present PE of 26.9.

Look at the fluctuation of PE of ITC in the past 5 years. It is interesting to note that at a share price of Rs 320 per share in Aug 2018, the PE is 35.4 which is higher than PE of 26.9 in April 2023 at a much higher share price of Rs 396 per share. This is mainly due to increase in Profit earned by the company in March 2018 of Rs 11493 Crs to Rs 18500 Crs in the last 4 quarters i.e. from March 2022 to Dec 2022. 

Is the drop in PE to 12.9 in May 2020 justified? Look at the financial performance of the company in the last 10 years.

ITCs sales and profits have been growing yoy at a constant pace except for slight dip in profits in FY2021 which was temporary in nature due to COVID-19 related lockdowns. I believe the dip in PE in May 2020 is not at all justified looking at the strong performance of the company during the past several years. This is proof enough that the valuation given by the stock market is not always right. The company was clearly undervalued in May 2020. 

How to identify if a company is overvalued or not?

One easy way to reduce fragility in our investment due to overvaluation is by simply investing in a company through SIP mode in which way we will be investing in the company at various points of time i.e. when it is overvalued and when it is undervalued. This way, over a period of time, our investment will be average valuation and thereby avoiding overvaluation.

However, if we are not comfortable with this strategy and would like to avoid overvaluation altogether, then let me try to explain how I identify whether a company is overvalued or not.

I try to project the profits likely to be earned by a company 10 years down the line. We need to make lot of assumptions for the same like:

1. Whether the industry is growing or at a mature stage. For example, FMCG is a mature industry in India as the Total addressable Market has already been captured. Whereas Healthcare is a growing industry as a very small population is able to get access to adequate healthcare in India.  If the industry is growing, then I give a higher growth rate for the company as compared to a mature industry.

2. Growth of industry can be limited to domestic, that is within India or can be global. For example, the IT services industry and Pharmaceutical industry grew at an impressive pace in the past few years and most of this growth is attributable to exports. On the other hand, there are companies which grew domestically without relying on exports like Bajaj Finance.

3. We can even find pockets of growth in mature industries primarily due to 2 factors, inflation and premunisation. Sale price of the product keeps increasing every year due to inflation. This inturn increases sales of the company. Premunisation is another factor with which a company can grow, for example, sales of SUVs in India are growing at a faster pace than hatchbacks. Similarly, people shifted from buying surf excel soap, to powder to liquid.

4. Another factor of growth is a company increasing its market share yoy within the industry. One example is Patanjali which clocked a turnover of Rs 30000 Crs in FY2021 as compared to negligible turnover 10 years ago whereas all other companies in FMCG segment grew at a constant pace of ~11% yoy and multiplied their sales by 3X in 10 years. 

After analyzing growth potential, industry growth, etc, we need to conservatively arrive at projected Profits after 10 years from now for a company. We need to assume a conservative terminal PE 10 years from now, like say 20 for a growing company and PE of 10 for a moderately growing company. We need to multiply the terminal PE by projected profits 10 years from now to arrive at projected market capitalisation 10 years from now. We already know the present market capitalization given by the stock market.  Projected market capitalisation 10 years from now divided by present market capitalisation gives us a multiplier from which we can arrive at the projected CAGR of our investment by investing in the company for the next 10 years. Below is the comparison table. 

Let me explain this using ITC as an example. Profits of ITC grew from Rs 7704 Crs in FY2013 to Rs 18500 Crs in current FY i.e. profits multiplied by 2.4 times. Majority of profits of ITC are from its Cigarettes division which always has the regulatory risk. To factor in the same, if we conservatively assume profits of ITC will only multiply by 2 times in next 10 years as compared to 2.4 times in past 10 years, then profits in FY2033 will be Rs 37000 Crs. If terminal PE is assumed as 15, then market cap in FY2032 should be Rs 5,55,000 Crs. Present market cap is Rs 4,91,000 Crs. Projected Mrkt Cap by present Mrkt Cap is 1.13 times which implies a CAGR of hardly 1.5% on our investment. At present market capitalisation, dividend yield is around 3%. Even if we include dividends paid by the company, the returns we can earn is 4.5%. Remember market capitalisation in May 2020 of ITC was only Rs 1,90,000 Crs. Projected Market Cap of Rs 5,55,000 Crs divided by Market Capitalisation in May 2020 of Rs 1,90,000 Crs gives us a multiplier of 2.92 times which implies a CAGR of 12%. Dividend yield was 8% in May 2020. If we include dividends also, then projected CAGR in our investment would work out to 20% CAGR for next 10 years which is a decent return. 

ITC was definitely undervalued in May 2020 as compared to present levels. I invested in ITC at Rs 180 levels in 2020 and exited at Rs 388 levels recently due to the above calculations. I may turnout to be wrong in my calculations and ITC share price can give handsome returns in the next 10 years. But, remember, error of commission is unforgivable as compared to error of omission. 

Its like we need not try to hit a sixer with each and every ball. We can choose which ball to go for a sixer.I prefer to pick easy balls for trying to hit a sixer rather than a difficult ball. At present share price, ITC is like a difficult ball to try for a sixer. 

Disclaimer: This is not a Buy/sell recommendation. I am not a SEBI registered advisor. I only tried to explain the concept of valuation in this post.

Summary

Even if we identify a fundamentally strong company which is either robust or antifragile, investing in the company when it is overvalued introduces fragility in our investment. Hence, entry valuation is an equally important parameter while making an investment decision. And finally, No, the Market is not always Right. 

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Introduction: 

Fragility is a term that describes how vulnerable a system or an asset is to external shocks or stressors. A fragile company is one that suffers large losses when market conditions change unexpectedly or unfavorably as against Robust/Antifragile companies which can withstand such changes/shocks. Similarly there is scope for large drawdowns if a portfolio comprises fragile companies.

I explained about concept of Fragility in detail and how to measure the same through my following posts

Adani & Alphabet & the concept of Fragility - Two Groups which lost $100 billion in market value in the same month (budgetiger.in)

How to build an Antifragile Portfolio (budgetiger.in)

How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

Methodology:

I shortlisted companies with market capitalisation of more than Rs 100 Crs and there are 2168 such listed companies in India. Smaller companies are a different segment as they are mostly localized companies wherein they generally have one or two customers. They generally have limited options due to which by default they are more fragile. Due to this, I excluded companies with market capitalisation of less than Rs 100 Crs. 

I use the method of optionality for measuring fragility as explained in my various posts. As per the methodology, a company with more obligations and fewer options is more fragile as against a company with fewer obligations and more options. Less fragile companies are either Robust or Antifragile companies. 

I measured fragility of each company based on following four parameters and using method of optionality:

• Equity as a % of Balance Sheet Total - Higher the percentage indicates lower the obligations of a company

• Break Even Sales as a % of Actual Sales - Lower the percentage indicates more the options available to a company

• Return of Capital Employed - Higher the percentage indicates more the options available to a company

• Cash Flow from operations / (Replacement Capex plus Yearly Debt Obligations) - Higher the ratio indicates lower the obligations of a company

Based on the above parameters, I arrived at a fragility score on a scale of 0 to 10 for each company wherein a score of 0 indicates least fragile company i.e. robust/ antifragile and a score of 10 indicates most fragile company.

I used the financials of FY22 for measuring the fragility of each company. FY22 is part of the disruptive 2 years COVID period wherein few industries were more impacted than others due to COVID. Accordingly, fragility scores for few companies/ industries are likely to change based on FY23 financials. A fragility score is dynamic and will change every quarter/year based on financials of a company. For example, if a debt free company takes a huge loan for a greenfield project, then fragility of the company will increase. Similarly a major dip in sales of a company will increase the fragility score of a company. 

The universe of 2168 companies are further subdivided into 106 industries and I arrived at the average fragility score of each industry based on the fragility score of each company in the Industry.

The fragility score as calculated above only measures the fragility of a company without considering the entry valuation of an investor. Entry valuation for an investor is an added variable and if an investor invests in a robust/antifragile company at high entry valuation, then fragility at portfolio level increases. 

Learnings

Low fragility scores indicate robust or antifragile companies/ industries. Higher the fragility score on a scale of 0 to 10 higher the fragility.

Least Fragile Industries

Following are the top 20 Industries with least fragility scores i.e. these industries are Robust or Antifragile.

Pharmaceuticals - Multinational companies panned out to be the  least fragile industry with a fragility score of 1.73 i.e. the industry is very Robust/ Antifragile in nature. The industry comprises companies like Abbott India, Astrazenca Pharma, GSK, Novartis India, P&G Healthcare, Pifzer and Sanofi India each of which individually have very low fragility scores. 

The other industries in top 5 i.e. least fragile are (in order of ranking):

• Cigarettes - Godfrey Philips, VST, ITC;; 

• Personal Care - Mutlinational - Colgate-Palmolive, Gilette India, Hindustan Unilever; P&G Hygiene

• Petrochemicals - A surprising entry in top 5 with small cap companies like Bhansali Engineering Polymers , Panama Petrochem Limited, Supreme Petrochemicals Limited, etc. Most of these companies had a very good performance during FY21 and FY22 which is possibly due to COVID disruption. We need to see how the scores of these companies will change with FY23 and later financials. 

• Pesticides / Agrochemicals - Multinational - There is only one company in this industry i.e. Bayer CropScience Limited. The Bayer group launched its Indian operations in 1958 by setting up an agrochemical manufacturing unit under BCSL. BCSL manufactures and markets crop protection solutions, and trades in seeds on behalf of Bayer Bioscience Pvt Ltd.

Most Fragile Industries

Following are the top 20 Industries with highest fragility scores i.e. these industries are more fragile than other industries.

I expected Banks and NBFCs to be the most fragile industries due to the nature of their business model. I explained this in detail in my post The Fall of SVB Bank, Signature Bank - What Makes Banks Fail? (budgetiger.in)

Accordingly top 6 Industries include Banks - Public Sector; Banks - Private Sector & Finance - Term Lending Institutions.

It is surprising that the most fragile Industry panned out to be Automobiles - LCVs/ HCVs with a fragility score of 7.74. The industry includes companies like Ashok Leyland, Force Motors, Tata Motors, SML Isuzu, Olectra Greentac. Most of these companies incurred losses during 2 years of COVID i.e. FY21 & FY22. These companies also are leveraged due to which the fragility score of these companies is high based on FY22 financials indicating that these companies are highly fragile. We need to see if the fragility score decreases based on FY23 financials for these companies.

The other 2 industries in top 6 are Telecommunications - Service Provider & Cables - Telephone.

Cables - Telephone comprises Sterlite Technologies; Birla Cables & Aksh Optifibre. All three companies are into manufacturing of Optical Fibre cables. I could not find any correlation of high fragility score with COVID. The high scores may be due to the capital intensive nature of the industry wherein the companies had to raise debt for capex outlay.  It may also have to do with the fact that most of the projects executed by these companies are floated by Central and State Governments due to which these companies have limited pricing flexibility. 

Telecommunications - Service Provider comprises Bharti-Airtel, MTNL, Reliance Communications, Tata Teleservices Maharashtra Limited, Netflinx, Onmoblie Global, Tata Communications, Tejas Networks, Vodafone Idea & Railtel Corporation. The high fragility scores may have to do with high regulatory intervention in the Industry and also intense competition in the Industry. Railtel Corporation & Tejas Networks are the least fragile companies within this industry with scores of 4.9 and 4.6 respectively. Railet Corporation is a PSU company and classified as Miniratna”. Tejas Networks Ltd is a global R&D-driven telecom equipment company headquartered in India. It designs, develops and manufactures high-performance optical and data networking products that are used by telecom service providers, utilities, government and defense networks. Ken had done detailed analysis of the company in its post The Tata wind beneath Tejas Networks’ wings carries investors away (the-ken.com)

Other Learnings:

• There is scope for change in fragility scores for few industries as the analysis is done based on FY22 financials which is a COVID disruptive year. 

• Few industries have companies with a wide range of fragility scores. For example,  Recreation/ Amusement Parks Industry has Imagica Entertainment with a fragility score of 8.6 vs Wonderla Holidays with a score of 2.92 and Nicco Parks with a score of 1.48. Imagica Entertainment alone increased the industry score due to which the Industry got a score of 4.35.

• There is no correlation between valuation and fragility scores. I used P/E as a valuation parameter for this analysis. Below is the scatter plot between P/E and Fragility Scores

As we can observe, there are both low and high P/E companies with various fragility scores. 

• The fragility score of all 5 new age tech stocks is more than 7 indicating they are in the top 20% percentile of most fragile companies in the universe of 2168 stocks. All the 5 companies scored high fragility on ROCE, CFO/ (Replacement Capex + Yearly Debt Obligations and Breakeven sales as % of Actual Sales which is not surprising as all these companies are yet to turn cash flow positive. However all these companies scored very low fragility in terms of Equity as % of Balance Sheet Total as all these companies had very low Borrowings/ Debt and other liabilities. 

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Annual reports of a company are the primary source where we can get access to financial statements of the company. Screener.in is a very good website which gives a summary of key financials of each and every listed company for the past 10 years. Apart from annual reports, we can also easily download latest rating rationales, announcements of the company, shareholding pattern, etc from the website. We can also create custom ratios, variables and also customize display as per our preferences. 

Ill use the method of optionality which I introduced in my previous post for measuring fragility. That method says that more the obligations and lesser the options will increase the fragility of a company.

Financial Statement Analysis

Some of the key ratios which I look at for measuring fragility of a company are:

Equity as a % of Total Liabilities

Equity comprises Equity share capital and Reserves and Surplus. Equity is a liability which a company need not pay. There is no defined timeline for payment of the same. There are stipulated timelines for payment of all other liabilities in a balance sheet except equity. Hence company is not obligated to pay equity. Accordingly, more the Equity as % of Total liabilities, less the obligations of the company to pay and less the fragility of a company. 

Lets take the example of Castrol Limited and its balance sheet snapshot from screener.in 

Castol’s Equity as a % of total liabilities is consistently above 60%

A company can be considered as not fragile if Equity as a % of Total liabilities is high.  As per this ratio, Castrol has very limited obligations to take care off as its Equity as % of Total liabilities has consistently been about 60 to 65%. Accordingly, Castrol does not appear to be fragile as per this ratio 

Breakeven Sales as a % of Actual Sales of a company

Break Even sales is the sales at which a company just turns profit. If actual sales turn out to be below breakeven sales, then a company incurs loss. If actual sales turn out to be more than breakeven sales, then the company generates profit. 

If actual sales of a company are much higher than breakeven sales, then the company has enough flexibility to experiment wherein the company can afford for a dip in sales without leading to losses. If actual sales are nearly the same as break even sales, then the company has very limited options to experiment as even slight dip in sales will lead to losses. Hence, lower the % of breakeven sales vs Actual Sales, lower the fragility.

If we look at a typical P/L statement, take for example Castrol Limited

Expenses of a company can be bifurcated into Fixed and Variable Expenses. Variable expenses are incurred only if an actual sale is made. Whereas Fixed expenses are incurred whether a company makes a sale or not. Accordingly, fixed expenses are like obligations of a company. More the fixed expenses, more the obligations and more the fragility in the company. 

Fixed Expenses by Variable margin gives us breakeven sales. Crude method for arriving at breakeven sales from Screener snapshot is (Interest + Depreciation) by Operating profit margin. Here the assumption is that Fixed expenses of the company comprises only Interest and Depreciation and variable margin is the same as operating margin. However, for deeper analysis, screener snapshot will not suffice as there are other semi fixed expenses like Electricity, Salaries, etc which also needs to be factored in for arriving at Breakeven Sales. You may refer to my detailed post on the same. However, for prima facie analysis screener snapshot will suffice. 

Below is the breakeven sales as a % of actual sales of Castrol Limited.  

Breakeven sales as a % of actual sales of Castrol Limited is consistently very low in the range of 4 to 11% for the past 10 years indicating that Castrol has very high flexibility to experiment and very limited obligations (fixed expenses). Accordingly, Castrol Limited is not fragile as per this ratio as well.

Return on Capital Employed (ROCE) 

I have written a detailed post on ROCE here. ROCE tells us the return a company generated from its capital employed in business. Its like the rate of interest of a Fixed Deposit. Higher ROCE indicates that there is some inherent strength in the business model of a company. Accordingly, high ROCE indicates that a company is not fragile. For example below is ROCE of Castrol Limited from Screener. 

ROCE of Castrol Limited has been consistently above 100% except for the past three years in which case it dipped to 60%. The same may be because of COVID or threat from Electric Vehicles. However, we can come to know of the same only upon deeper analysis of the business model. However, even 60% ROCE is very high as compared to ongoing Fixed Deposit rates of ~7%. Accordingly, we can conclude that the business model of Castrol Limited is nowhere near fragile as of now. However, dip in ROCE in recent years needs to be analyzed further to understand whether there is scope for further dip of ROCE in the future years. 

Yearly Debt obligations plus Replacement Capex as a % of Cash Flow from operations

Yearly debt obligations consist of Interest plus Installments. While interest is easily available from P/L statement, one crude way to arrive at Installments is 20% of Borrowings. 20% is based on the assumption that a Debt (Borrowing) needs to be paid in 5 years. One proxy for replacement capex is Depreciation. 

Yearly debt obligations and replacement capex are obligations of a company. More the obligations, more the fragility. Accordingly, if obligations as a % of cash flows generated by a company are very low, then we can conclude that the company is not fragile. Further, Cash Flow from operations minus Obligations are surplus cash flows available with the company. Hence very low obligations also imply that the company has surplus cash flows available to utilise for other purposes. This increases the optionality of the company. 

Based on these assumptions, following are the calculations for Castrol Limited. 

Debt Obligations plus replacement capex as % of Cash Flow from operations for Castrol Limited is consistently in the range of 6 to 11% implying that Castrol Limited is not fragile. Further, it implies that 90% of cash flows generated by Castrol are surplus cash flows. Company is free to utilise these cash flows anywhere it wants like say capacity expansion, Research and Development, New product launches, etc. 

In the case of Castrol, the company choose to pay dividends from the majority of the surplus cash flows it generates. 

If Castrol had utilized these surplus cash flows for experimentation like capacity expansion, Research and Development, New product launches, etc, it would have turned itself Antifragile. Since, it has been paying back the majority of these cash flows as dividends, it remained as a Robust company.  A company can turn from Robust to Antifragile by deploying certain surplus cash flows for experimentation. Few such examples are Reliance Industries which used its surplus cash flows from Oil business for setting up Jio. Another example is Info Edge which uses its surplus cash flows from Naukri to deploy in multiple businesses like Zomato, 99Acres, etc.

Valuation

While above ratios measure fragility of a company, Entry valuation by an investor is an additional variable which increases fragility specific to an investor but does not in any way impact the fragility of a company. 

If an investor invests in a Robust or Antifragile company at a very high entry valuation, then the investment becomes fragile even if the company is not fragile as any small bad news will correct the valuations.

Hence, low entry valuation reduces fragility. 

One proxy for valuation is P/E (Price to Earnings). However, PEG is a better indicator for valuation as it also incorporates further growth potential of a company into the ratio. In case of Castrol Limited, it is very difficult to gauge the future growth/ cash flows on account of changing industry scenario due to Electric Vehicles. The present PE of Castrol Limited is 13 which indicates that the company will not grow in the future as per present PE. While Castrol's existing business is robust and valuations are reasonable considering healthy dividends from the same, the uncertainties involved are adaptability of Castrol in EV scenario which will have an impact on future earnings. If we assume that EV may not materialize at least for the next 10 years, then the existing entry valuation looks reasonable as we will be able to get 50% payback for our investments in the next 10 years in the form of dividends. Further, if Castrol is able to adopt for EVs, then it will be like an upside. 

Disclaimer: This is not a recommendation for investment in Castrol Limited. I gave this example only to explain the concept. You will need to do your own due diligence before investing.

Crisis creates opportunities

On the other hand, bad news for a company creates opportunities for an investor to enter at low valuations. One example is Maggi crisis faced by Nestle in June 2015.

During the Maggi crisis in June 2015, share price of Nestle Limited fell by 20% from Rs 7000 per share to Rs 5500 per share. It further fell to Rs 5000 per share in the year. Maggi contributes only 15% of total sales of the company. However, share price fell 20% indicating that the market assumes the company will no longer be able to sell maggi and also other products of the company will also get impacted. While Nestle recalled its Maggi packets from various dealers and incurred a one time loss of Rs 500 Crs that year. It reintroduced its Maggi product after obtaining required approvals from the government and then the rest is history. Its share price zoomed to present Rs 18000 levels in the next 7 years. 

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Raktabija is a Asura in Hindu Mythology. He acquired a boon from Shiva that whenever a drop of his blood fell on the ground, various Raktabījas would emerge from the spot, equivalent to his strength, form, and weapons. Raktabija can be considered as Antifragile due to this boon,

We can use this concept to categorize various businesses into Fragile, Robust and Antifragile. However, categorizing a business into these three categories is not a straightforward task, as there is no universally accepted definition or metric for it. One approach we can use is:

Based on optionality:

This approach proposes to measure antifragility by using the concept of optionality, which is the ability to choose among different alternatives in an uncertain situation. A system is antifragile if it has more options than obligations, fragile if it has more obligations than options, and robust if it has equal options and obligations.

Optionality can be estimated by factors such as cash flow, liquidity, leverage, diversification and growth opportunities. These factors show how well a business manages its risks and capitalizes on its opportunities.

Fragile Business:

A fragile business has more obligations than options. An example of a fragile business is an Airline business.

There is very limited flexibility in pricing an airline ticket due to intense competition in the sector. If a company tries to price its tickets slightly higher, then there is a risk that the flight might have to take off empty. There is also limited flexibility when it comes to expenses. The company has to take off the flight even if very few passengers booked tickets. Hence, majority of the expenses of the company like Fuel, employees, parking charges, etc are fixed irrespective of whether there are passengers or not. As setting up an airline is a costly affair, company will likely have to resort to external sources of capital like Debt for funding which further reduces its financial flexibility. An airline business is also highly regulated.  Hence, based on optionality, an airline business is a fragile business.It is not surprising that a lot of Airlines in India failed despite the overall growth in the sector.

Robust Business:

Colgate -Palmolive (India) Ltd can be considered a Robust business as it is in the business of selling Toothpaste. People wont stop brushing their teeth whether there is a financial crisis or during COVID or during demonetisation.Its revenue is robust. At the same time as the market is saturated wherein it is present in the entire addressable market, there is little scope for growth in revenue apart from premiumisation of toothpaste. While Colgate’s obligations are limited (Zero Debt and nil expansion cost), its options for growth are also limited. That is also the reason why it paid majority of its cash flows as a dividend. Against cash flow from operations of Rs 5017 Crs in the last five years, it paid dividends of Rs 3654 Crs. 

Antifragile business:

A business which has very few obligations and multiple options is an antifragile business.Some characteristics of antifragile businesses are:

• The business has a strong brand or proprietary technology that gives it a competitive edge and allows it to adapt to changing customer needs and preferences.

• The business has a diverse portfolio of products, services, markets and customers that reduces its dependence on any single source of revenue or demand.

• The business has a culture of innovation and experimentation that encourages learning from failures and mistakes and fosters continuous improvement and creativity.

• The business has a flexible and agile organizational structure that enables fast decision making and execution and empowers employees to take initiative and responsibility.

• The business has a high degree of optionality that allows it to exploit opportunities and avoid risks by having multiple choices and alternatives available at any given time.

These are some characteristics of antifragile businesses that help them thrive in uncertainty and change.

It is very rare to identify an antifragile business with all the above qualities. Few examples are:

Insurance: Insurance coverage increases immediately after a crisis. Further, an insurance company takes premium in advance and is required to compensate if any at a later date. During this interim period, it can invest this money in various assets and thereby earn income. An insurance company is also scalable as it can increase its revenue through online/offline modes without incurring major expansion costs. This makes the business model of an insurance company antifragile as it has very limited obligations and multiple options for expansion.. 

Reliance Industries: The company used its cash flows from its robust Oil business to setup Jio and Reliance Retail. These new businesses turned out to be market leaders in their respective segments. The company converted itself from Robust business into an Antifragile business.

Scalability as an alternative

While it is difficult to identify an Antifragile business, we can instead easily identify scalable businesses. Scalability means the ability of a system to handle increasing amounts of work or demand without compromising performance or quality. Scalable systems can grow in size and complexity without losing efficiency or functionality.

Therefore, scalability can be one of the factors that contribute to antifragility, but it is not sufficient by itself. A business can be scalable but still fragile if it cannot adapt to changing environments or customer needs.

New industries like Electric vehicles can be considered scalable as there is a long runway for growth. Sometimes even in old industries, we can identify companies with long runway for growth due to premiumisation of the product. .For example luxury cars or SUV segments in India. With increase in disposable incomes, the demand for these cars is increasing faster than the entire segment. Online businesses can also be considered as scalable. 

A scalable business can also be fragile as the sales can fall abruptly with disruption. Facebook blames Apple after a historically bad quarter, saying iPhone privacy changes will cost it $10 billion.

Netflix used to boast that its biggest competitor is sleep. However, it recently declared that Netflix password sharing is costing the company billions.

While a scalable business has features of antifragility, it also has some features of fragility. Hence scalability is not a fool proof method for antifragility. 

Antifragile Portfolio Strategy

One strategy proposed by N N Taleb is using the barbell strategy. A barbell strategy is an investment approach that involves allocating a large portion of funds (such as 80-90%) to safe and stable assets and a small portion of funds (such as 10-20%) to risky and volatile assets.

The idea behind this strategy is to protect the portfolio from negative black swan events (unexpected and extreme events that have a large negative impact) while exposing it to positive black swan events (unexpected and extreme events that have a large positive impact). The safe assets provide a buffer against losses and preserve capital, while the risky assets provide a chance for high returns and growth.

The barbell strategy also aims to exploit the nonlinearity of returns, meaning that some assets have more upside potential than downside risk. For example, an option contract might lose its entire value if it expires out of the money, but it might increase exponentially if it expires in the money. Similarly, a start-up company might go bankrupt or be acquired for a huge premium.

The barbell strategy can be seen as an antifragile approach because it benefits from uncertainty and volatility rather than suffering from them. It also avoids the middle ground of moderately risky assets that offer neither safety nor opportunity. By diversifying across two extremes, the barbell strategy can achieve better risk-adjusted returns than a conventional portfolio.

We can use this strategy by building a portfolio with a mix of Robust businesses (80 to 90% allocation) and a small portion of funds (such as 10-20%) to highly scalable businesses.

One precaution we need to take for building a robust businesses portfolio (80 to 90% allocation) is that our entry valuation should not be overvalued, as overvaluation introduces fragility. 

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Since January 24, 2023 the market-cap of seven listed Adani Group companies has fallen by nearly $100 billion. The group shares have been in a free fall since the Hindenburg Research report came to light. The report has made some serious allegations on Adani Group regarding overvaluation, over leverage, artificially inflating share price, etc which caused the free fall. The shares of some of the companies continue to fall even after 1 month since the report was released. 

Google - Bard Launch

Open AI’s Chatgpt is a AI generative chatbot that has gone viral and achieved 100 million users within 2 months of being made public in Nov 2022. Microsoft was quick to capitalise on this popularity and immediately invested USD 10 billion. It also integrated the chatgpt into Bing search engine. Bing is the second most popular search engine with 15% market share. Google which is the most popular search engine with 85% market share to counter Chatgpt/ Bing, introduced its own AI chatbot Bard. Bard gave a wrong answer on its launch event which led to loss of $100 billion in market value of Alphabet which is parent of Google.

Spot the Difference: 

While prima-facie both the events look similar wherein both the Business groups lost $100 billion market value due to adverse news, yet they are actually very different from an investors point of view.

To understand the difference, we need to first understand the concept of Fragility. Fragility is a term that describes how vulnerable a system or an asset is to external shocks or stressors. A fragile portfolio is one that suffers large losses when market conditions change unexpectedly or unfavorably. A fragile portfolio can also be prone to volatility and drawdowns, which can erode investor confidence and wealth.

To explain the concept, let me take the example of a flower vase (courtesy N N Taleb). We know a flower vase is fragile. If it falls, it’ll break and can never be used again. But what we don’t know and can never guess is when it will fall or under which exact circumstances it will fall. Flower Vase may never fall as well. On the other hand, a rubber ball is not fragile and will not break by a mere fall. A Rubber ball is less fragile than a flower vase.

From an investors point of view, we can only measure fragility in our portfolio. We can never guess when an adverse event will occur. We can only ensure that fragility in our portfolio is low such that even if an adverse event occurs, it will have minimal impact in the portfolio.

The valuations of Adani Group companies from P/E point of view is overvalued as some of the companies are in the range of P/E of 300 to 800. To justify this P/E, Adani needs to grow fast. Fast growth can only be achieved with external capital. That is also the reason why Adani is leveraged too. Leverage and Overvaluation are two factors which increase fragility.

Alphabet on the other hand has zero debt and hold cash in hand of $120 billion as on 2022. The valuation from P/E perspective is also 18. 

Hence, Alphabet is less fragile as compared to Adani Group. 

Any adverse news will likely have larger impact on Adani as compared to Alphabet. In fact Adani had to withdraw FPO. It also had to prepay Debt to instill confidence. This further will likely slow down growth as access to external capital is impacted. 

Alphabet on the other hand is working towards improving Bard without worrying about market value or external capital. 

I never got worried about recession or COVID or any other adverse news events as my only focus was having a low fragile portfolio. My focus on reducing fragility in my portfolio gave me courage to remain invested in equity markets in the past ~10 years without cutting down my portfolio at any point of time. Low Fragility apart from giving me courage also gave me peaceful nights without worrying about adverse news.

The Solution:

Here are some steps to follow for reducing fragility in equity portfolio:

1. Investing only long term capital i.e. money which we dont need in next 10 years. While there might drawdowns due to adverse news events, most of the drawdowns will be only short term in nature and may last maximum upto 3 to 5 years. Hence, time is a weapon which we can use against short term volatility. Time heals most of the wounds and hence will also reduce fragility. 

2. Investing in companies which do not have Debt. Leverage increases fragility. Lack of leverage/Debt reduces fragility.

3. Getting associated with companies whose Management does not like taking Debt. There are Two types of Management. Type 1 - If given Rs 100 Crs capital, they invest in 5 different projects of Rs 20 Crs each without taking any Debt. Type 2 - If given Rs 100 Crs capital, they take Debt of Rs 900 Crs and invest in as single project of Rs 1000 Crs. Style of Type 2 Management increases fragility of the company. IF they succeed, they will have multiplier growth effect. But the chances of failure is high due to high fragility. On the other hand, in Type 1 style, while the growth prospects may be at a slower pace, the chances of failure is low. 

4. No to BAAP (Buy at any Price). We should not enter in a company when it is overvalued. Overvaluation increases fragility as any adverse news will correct the valuations.

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