Unfair Value

ICICI Bank's profit shoots up by 21%.. Wow!!

2009-07-26T00:48:00.000-07:00

A classic example of how the headlines of corporate results can be misleading. ICICI bank reported 21% jump in profits which would make a good impression on an untrained eye but the reality is quite different.

If you go to the following link, you would find 3 documents http://www.icicibank.com/pfsuser/aboutus/resultsann/webcast.htm

The first Performance Review gives the management's version of story. It talks about growth in profits, strong net interest margins, falling cost of deposits due to higher portion of CASA deposits. It paints a rosy picture,

If you just ignore the text and read the numbers in second document, audited financial results you would see this very clearly in last 1 year
• Deposits fell by 11%
• Advances fell by 11.6%.
• NPAs rise to 4.63% at gross level and 2.33% at net level

It's not surprising that if you search 'NPA' in the 'Performance Review', you won't find any mention of it. You won't find mention of falling deposits and advances.
Now another statement copied verbatim from 'Performance Review'..along with its font size and style!! Current and savings account (CASA) ratio increased to 30.4% at June 30, 2009 from 27.6% at June 30, 2008.

Banking is all about gathering low cost funds and generating good returns by managing a portfolio of good quality advances. The Current and savings accounts give lower interests compares to fixed term deposits which helps a bank keep its cost of funds low. It's a key variable tracked by analysts.

In June 2008, the bank had deposits of 234,461 crores out of which 27.6% was CASA. This means they had 64,711 crores of CASA deposits and 169,749 crores of term deposits. In June 2009, the total deposits fell to 210,236 crores and percentage of CASA deposits rose to 30.4%. This means the CASA deposits in June 2009 were 63,911 crores and term deposits were 146234 crores.

This implies, CASA deposits fell by 1.24% and term deposits fell by whopping 13.8% in one year. This is a fact we know because last year when the rumors about health of the bank were spreading, people shifted their fixed deposits from ICICI to PSU banks.
Hence ratio of CASA deposits didn't rise because of good performance of the bank but due to drastic fall in the term deposits with the bank.

Management's attempt to highlight it as an achievement is tantamount to assuming that the people can't do this simple math.

The bank reported 21% increase in standalone profit after tax to Rs. 878 crore for the quarter ended June 30, 2009 from Rs. 728 crore for the quarter ended June 30, 2008 . Look out the details in the document. The net interest income fell by 5%, fee based income fell by 32.6%. The treasury operations showed a profit of 714 crores compared to loss of 594 crores in the same quarter last year. This shows that the rise in Profit after Tax was mostly due to treasury gains which are highly volatile. A small rise in interest rates can result in huge treasury losses due to fall in prices of govt securities held by bank in 'available for sale' category.

The bank also reported 68% increase in consolidated profit after tax. But they haven't filed their consolidated results with stock exchanges. The result document gives no details!

The results clearly show that ICICI Bank's honeymoon period is over. It has to do serious efforts to get bank on growth track. The performance review by the management reflects at best an ostrich like mentality to deny the obvious and at worst, it's a attempt to mislead investors.

The investors can take a lesson from this. The numbers reported in the corporate results can be misleading. They have to look at foot notes, analyze the details, slice and dice the documents to find the true picture. If you have to find oil, don't scratch the surface. You got to dig deep.

A prudent portfolio

2009-07-19T09:34:00.000-07:00

[Many people told me that they are "kind of getting the hang of things" that matter in investing but they don't know where to start and how to start. They are afraid of losing their capital in their maiden attempt. While sharing the knowledge, data and analysis helps people, sharing real life examples is a real morale booster. That's why I'm sharing with you a story of a small portfolio]

Four months ago, I created a portfolio for Seema partly as a token gift to her for her excellent work as editor of Unfair Value and partly to prove to her that value investing works, even during slowdown. Women are a difficult lot. They need proof. They need constant reinforcement even for the things they keep in a jar labeled "Truth". So you can guess that the odds were stacked against me.

As I have said in the past, the investor is a key variable in the equation of investing. It is impossible to give a specific advice without knowing whom you are advising. After discussion with her, I listed down the things that were important to her. (1) Capital Protection (2) Regular Income (3) Investments in domains within her circle of competence (4) Scope of long term appreciation (5) Low volatility

The investment characteristics you would look for in candidate companies for such a portfolio will include companies which are financially strong and entrenched in their respective industry segments. They have a healthy cash flow and low capital requirement enabling them to pay liberal dividends. For capital protection, they should be quoting at discount to their real support levels like book value and discounted cash flow value. Volatility is something that is beyond an investor's control and the only thing you can do is to diversify. At the same time, I wanted to keep the portfolio limited to things she knew about, i.e., regular day to day use products and services.

The interesting aspect was that the list of her objectives was different from mine. Low volatility and regular income don't rank high in my personal list. Also, I can choose from a much broader field due to my understanding of various industries based on the knowledge accumulated over many years. Then the size of the portfolio was small which meant that I could invest in much smaller companies than I usually do. (I limit myself to only large companies, typically top 200, because I don't feel comfortable putting large sums into small companies and I want to limit the number of companies in my portfolio to less than 20).

During the editing of previous issues, we have had discussions about Castrol and Gujarat Gas, which made her comfortable with the sectors these companies operated in. I chose Indraprastha Gas for her due to her familiarity with the company and the dividend payout being higher. At that time, banks were selling at really dismal valuations with doubts about solvency of some large private banks. So I chose a PSU bank, Oriental Bank of Commerce, with high dividend yield, low NPAs and low price to book value. Then I added 3 small companies, Mahindra Finance, Venky's and Hawkins. These 3 companies were interesting in their own ways and met the criteria I had set forth.

Hawkins is a 50-year-old brand of pressure cookers which has sold 3.59 crore pressure cookers since its inception. It is very well entrenched in the market. They sold 20.6 lakh pressure cookers last year. The company earned a return on networth of a whopping 56.33% in 2008 (which rose to 81.8% in 2009). Its dividend payout ratio (dividend/EPS) had been in the range of 47% to 66% which showed that the company needed very little additional cash for growth. It was easy to analyze the company. If you have ever bought a Hawkins pressure cooker, you know the company. Interestingly, a pressure cooker as a product is immense value for money. It can pay for its cost within months by saving fuel. Not surprisingly, it is usually the first big ticket purchase for a very poor family when their lot improves (a cycle comes next).

Venky's is a company I got interested in during the times of the bird flu. Contrarian that I am, I was happily relishing roasted chicken when flu fear stricken denizens of the mortal world chickened out. I wanted to buy Venky's below cash but I failed. In the process I read about hatcheries, broilers, production of eggs and emerging trends in packaged meat. Their pathetic looking website (worse than Berkshire Hathaway's) had loads of interesting facts if you can find tem (like nine of every ten eggs consumed in India are laid by BV 300, a layer developed by Venky's. A layer is a hen, bred specially for laying eggs). The company pays good dividends and it was selling at a discount to book value.

Mahindra Finance is an NBFC which is quite strong in rural finance. The workings of rural finance are very different and banks lack the infrastructure and will to tap the opportunities. A Mahindra Finance employee has to ride his bicycle for miles before he reaches a village to collect EMI. At times the EMI is paid in one rupee coins. Defaulting on the loans is a matter of losing pride in the village and that keeps the NPAs low. The company also piggybacks on the growth in vehicle sales of its parent, providing financing of tractors, jeeps, autos and yes, Scorpios and Xylos.

Now the results of the portfolio. The outcome is quite satisfactory so far. The portfolio gave her a dividend yield of 6.06% which is the same as the after tax yield available on fixed deposits. The only source of volatility for the portfolio has been its rapid advance. It never went below the invested capital.

Company	Price Paid	Dividend (Rs)	Div. Yield	Current Price	Gain
Hawkins	163	20.0	12.3%	345	111.6%
Oriental Bank of Commerce	99	7.3	7.4%	167	69.4%
Castrol Ltd	295	15.0	5.1%	385	30.4%
Indraprastha Gas Ltd	96	4.0	4.2%	138	43.8%
Venkey’s Ltd	88	3.5	4.0%	117	32.6%
Mahindra Finance	205	5.5	2.7%	262	27.5%

Aggregate			6.06%		53.86%

For the long term analysis, the short term capital gain can be safely ignored. The 53.86% gain in four months was a result of excessively depressed prices and is unlikely to be repeated. What is certain is that her portfolio will give a yield better that 6% in the coming years. As the years pass the prices of these companies will keep pace with growth in business and that in the long run will yield a return in excess of 15%.

I have strong reasons to believe that investors can get good results by sticking to conservative investing principles and by focusing on things which are real like dividends, networth, strength of brand, familiarity with the company's products and services. You don't need to be able to predict the future. If you can trace the history of a company on how it reached to its present strength, you are better off than those using fancy algorithmic models

P.S.: If the approach seems too simplistic to your intelligent brain, there are enough ways in the world to get lousy returns using sophisticated methods. For one such example, you can read about Religare's Agile fund. Agile stands for Alpha Generated from Industry Leaders.

Show me the dividend!

2009-07-19T06:57:00.000-07:00

In the years before the 1950s, all the texts about equity investment laid a clear emphasis on dividend. Benjamin Graham said that a conservative investor should consider only those companies that have been paying uninterrupted dividends for the last 20 years. The emphasis was evident not only on the presence of dividends. The quantum was considered important too. The Dividend Discount Model^[1] was based upon the theory that a stock is worth the discounted sum of all of its future dividend payments.

Then came the era of growth companies. Companies like IBM and Xerox funneled all the returns from business back to it to fuel growth and paid little or no dividends. The only returns from such companies were from capital gains. It is important to note that this trend was a result of change in the mindset of investors, not the cause of it. The perception of investors has a bearing upon dividend policies of companies. The promoters want the price of their listed company to be higher than its value. A higher price enables them to raise extra capital when needed, raises a bulwark against hostile takeovers and gives a stronger currency to trade in during acquisitions. So what caused this shift in perception towards dividends?

If a company can earn higher returns on incremental capital addition than the rates investors can get in fixed income instruments, then lower dividends are better for investors. For example, Castrol generates 55.82% return on networth. If it pays dividends to me and I invest them in Fixed Deposits, I can get only 7%. Why should Castrol pay dividends and taxes upon it instead of deploying the cash into its highly profitable business? The answer depends on whether Castrol needs more capital or not. If it doesn't need more capital for business, even the company can't get high returns on idle cash. So it makes sense to pay out dividends.

At the same time, all the classic arguments in favor of dividends remain in force. As a matter of practice, companies maintain or increase dividend rates over the years. The declaration of dividend is an indication that the company expects the future earning per share to exceed the dividend per share. Dividends are harder to fake. Dividends also avoid bloated corporate structures with unprofitable diversification into non core areas. Dividends give the right to a shareholder to decide whether he wants to put the returns from capital into the same business or invest elsewhere (or consume). Finally, dividends remove the risk that the retained earnings will be blown away by some future act of foolishness (Citi Bank) or mischief by the management (Satyam). A bird in hand is worth two in the bush.

For a shareholder friendly board (!), it should be pretty easy to decide upon dividend. They know about the current capital requirements of business and available resources. They know about the future plans. If they have funds left after taking into account the capital required to handle contingencies and growth requirements they should release the money. If the company has high cost debt in its books, the debt should be paid first before paying out dividends. The earnings should not be retained unless there is a reason to do so.

Reality is very different, though. At least in India, I can see a whole lot of companies following dividend policies which are detrimental to the interests of shareholders. A few examples: Infosys Ltd, cash more than 2 billion dollars, produces 250 million dollars every quarter in free cash flow, zero debt, EPS 101.65 and dividend?? A paltry Rs 23.5 per share. They have no plans to invest this cash profitably and hence no reason to hoard but they do. Moser Baer, at the other extreme, is nose deep in debt with debt to equity ratio 1.32, interest cost 273 crores, loss per share Rs 21.6 and yet dividend Rs 0.6 per share. How much more stupid could one get?`The bottom line is this. The investors should analyze the company's profitability in conjunction with growth plans and outstanding debt to decide what percentage of profits they should get as dividend. If they get significantly more or significantly less than that percentage, the attractiveness of the company as a long term investment is questionable.

References

1. Dividend Discount Model
http://www.investopedia.com/articles/fundamental/04/041404.asp

To hell with liquidity

2009-07-19T06:07:00.000-07:00

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. ^[1]

These words of John Maynard Keynes ring in my ears every time I hear the term 'liquidity'. Yes, fetish is the right word. To someone uninitiated to finance, the persistent talk of terms like volumes, flows, depth and liquidity will make him feel as if he is sitting in a fluid dynamics class.

Had I been an MBA, I would have been fluent with these fluid terms, but the engineer in me revolts against pseudo scientific talk which uses terms that can't be defined or measured. Liquidity is one such term. Keynes made an important assertion that "there is no such thing as liquidity of investment for the community as a whole". He meant that the capital already deployed in production of goods and services can't be pulled back at will. A new steel plant cannot be liquidated just because the steel prices have gone down. The investor of that steel company may liquidate his investment and turn it into cash but for that, there must be other investor who is willing to part with his cash and invest it into the steel company.

Keynes correctly questions the rationale behind organizing the markets to promote liquidity.
When I say that the investors should think like the owner of a business, what should be their view to liquidity? Before I build my argument further, let's see when do you need liquidity. You need liquidity at the time of sale and only to the extent of the stocks owned by you. If I to sell hundred stocks, does it matter if there are thousand stocks traded a day of a million? If I'm not planning to sell, does it matter if the stock is traded at all?

Liquidity drives down the spread between bid and ask price of a stock which reduces the transaction cost. That's a definite virtue. And then there are other questionable virtues. A liquid stock attracts more participation from institutional investors. It is also said that the liquid stocks are less volatile. The participation from institutional investors is a virtue if they act like long term investors. It's a virtue if they stand up against any actions of management which are detrimental to the interests of minority shareholders. Both these aspects are questionable. The volatility of the highly liquid stocks raises doubts on the credibility of the notion that liquidity reduces volatility.

The long term investors do not share the high opinion about liquidity with the rest of the investing community. Charlie Munger said, "I think the notion that liquidity of a tradable common stock is a great contributor to capitalism is mostly twaddle". Warren Buffett's Berkshire Hathaway is one of the most illiquid stocks in the US. At a price of $90,000 per share, it's out of the reach of most investors. Once when he was asked about splitting the stock to increase liquidity, Buffett quipped, "Over my dead body". In the letter to shareholders in 1983^[2], he has described the reasons behind the no- split policy.

Now let me speak from my personal experience. I've never rated liquidity as a virtue in my investment decisions. In fact, about 20% of my equity portfolio consists of stocks which have been delisted and a further 20% is bordering on illiquid. This is not by design but it so happens that the investor apathy which is the reason behind low volumes, sometimes brings the prices down to the bargain basement levels which they find me waiting. It is also true that value I can see so clearly in those stocks, won't go unnoticed by the promoters. The net result is that promoters have either raised the stake so high that the stock has become illiquid or they have delisted the companies. Pretty scary state to be in! Right??

Well not quite. Here are the records from 3 such illiquid companies where I chose to invest a significant portion of my portfolio.

Company	MALCO	Eicher Ltd	Novaritis Ltd
Avg. Purchase price	21.32	79.85	289.45
Purchase Dates	July-04 to Sep-04	Aug-05 to June-06	Mar-08
Exit Offer 1 Price	48	265	351
Exit Offer 1 Date	Mar-05	Dec-06	Mar-09
Exit Offer 2 Price	115	354.37	450
Exit Offer 2 Date	Mar-09	Jul-09	May-09
Current Status	Holding on	Exited	Holding on

Returns(No. of times)	5.39	4.44	1.55
CAGR	45.43%	53.08%	42.33%

As you can see, I have been rewarded handsomely for foregoing the liquidity. In case of Eicher Ltd, I opted to remain a private shareholder when they delisted the company. Later, I exercised the option to convert into preferred stock, which I redeemed at a price 33% above the delisting price. In case of MALCO, I not only refused to exit at a price of 115 but invested more money before delisting. In case of Novartis, I did not participate in their two open offers and bought more.

These seemingly counter- intuitive actions can be explained by a simple principle that when I own a stock, I own a part of a business. Whether someone else is willing to buy out doesn't matter to me as long as my business grows. If you own something valuable, rest assured, you will find buyers. You can't say so about a piece of junk that's a regular entrant in the list of highly traded stock.

None of this will impress those who offer daily prayers to the Goddess of liquidity. Nor will they pay heed to Charlie Munger's advice to study carefully the example of the English economy which continued to do well despite the ban on trading of stocks after the South Sea Bubble in 1720.

For those who invest on leverage, liquidity assumes paramount importance. The same can be said about the institutions that attract hot capital by promises of high short term returns. They have a sword hanging over their neck. Liquidity is important to them but all the long term investors can safely say, "To hell with liquidity".

References

The General Theory of Employment, Interest, and Money
John Maynard Keynes
Chaptor 12 'THE STATE OF LONG-TERM EXPECTATION'
http://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/chapter12.html
Stock Splits and Stock Activity
Warren Buffett, Letter to Shareholders
http://www.berkshirehathaway.com/letters/1983.html