Understanding and applying value investing principles

The advantages of part time investing

2012-01-22T05:50:00.001+05:30

Does the professional investor, FII or the institutional investor have a big advantage over the small, part time investor?

Fact 1: The professional investor has access to in-depth research on a large number of companies. They also have access to the management and other industry professionals which allows them to cover an industry in depth and finally they do this on a full time basis. How can you beat that?

Fact 2: Very few mutual funds and institutional investors are able to beat the market over the long term (5+ years). In case of developed market such as the US where the performance numbers are more readily available (including those of hedge funds), only a handful can beat the market by a few % points.

How does one explain these two contradictory facts?

There are several reasons for this contradiction and I will explore some to highlight how a small investor like you and me can still score over the big boys.

The over emphasis on industry knowledge

The number one advantage cited is that the professional has access to in-depth analysis of an industry and can thus make better decisions. I think this advantage is overrated.

As an individual investor, if one really wants to learn about an industry, a good starting point is to read the annual reports of the top 3-4 companies in the industry. In addition there is a wealth of information available on the internet which one can Google to explore an industry in depth.

In the pre-internet days, the professional investor had substantial advantage over the part time investor but now a lot of information is available at the click of a button.

The other point cited by those trying to sell you funds and other such products is they have access to the latest data on the industry. I don’t think this is a big advantage to a long term investor. If your time horizon is 3-4 years, then getting the monthly sales figures before everyone else is hardly of any advantage unless you want to trade on that information.

Professional behavior

The other advantage of the professional investors is assumed to be their experience and ability to act more rationally than the small investor. I have not seen any evidence which shows that the professionals are more rational than the rest of the market.

Several fund managers and FIIs have portfolio turnovers in excess of 100%, which means that these professionals have an average holding period of less than 1 year. In addition if you look at the FII behavior, they demonstrate the classic herd behavior – exit the market when everyone is doing so and re-enter when the market starts picking up or has already risen substantially.

The net effect of constant turnover and herd behavior is higher cost (transaction costs) and lower returns over the long term.

As an individual investor, I do not have the pressure to follow others or excessively churn my portfolio. I can afford to hold a stock for 5 years, if the long term outlook for the company is bright even if the short term price performance is expected to be terrible

The institutional pressures

The point which is never highlighted by brokers and professionals is the problem of institutional pressures. Professional managers live by the quarter – though they ask their customers (investors) to think long term.

Any fund manager who under performs the market for a few quarters is at the risk of losing his or her job as the fund management company faces the risk of losing the assets due to redemptions. In addition, even if the fund manager is rational and long term oriented, they cannot afford to take unpopular decisions such as buying capital goods or financial stocks now as any underperformance due to such stocks will result in a career suicide.

This institutional pressure more or less forces the fund manager to buy the popular stocks and mimic the index with minor variations in the long run.

The small investor like you and me has none of these compulsions. In my case, other than the risk of looking foolish (sometimes publicly or worse in front of my wife) in the short term, I don’t face the risk of losing my job or ruining my career due to any unconventional decisions. This is a big advantage over the big boys

Is there any disadvantage?

The key assumption in my arguments till now is that the small investor is willing and able to devote a reasonable amount of time in researching companies and following up on them. There is no short cut for that.

Can you think of any time in college where you did not attend any classes or even study a new subject on your own and still managed to do very well in the final exam (without cheating of course )?

I personally think that if you are interested in investing and willing to devote 5-6 hours a week consistently on it for a long time, there is no disadvantage of information or insight versus the professional. On the contrary as a small investor, one does not face the institutional pressure and thus has an advantage over the professional.

One stock, three viewpoints

2012-01-08T09:50:00.001+05:30

Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company. In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj marathe ( and a few more ).

We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias.

The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.

Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions. I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here . We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.

Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones :)

About

NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.

The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land

Financials

The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.

The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.

The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.

The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).

Positives

The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).

The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.

The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.

Risks

The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.

I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).

The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.

Management quality checklist

Management compensation: The management compensation is around 3% of net profits which seems reasonable.

Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.

Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.

Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.

Conflict of interest: None as yet

Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation

The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.

The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).

Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.

Conclusion

The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

Happy new year

2012-01-01T23:19:00.000+05:30

Wish you all a very happy new year

What's on my mind - Dec 2011

2011-12-30T04:09:00.000+05:30

I want to close the year by discussing a few things which are on my mind and do not warrant individual posts for each topic.

Buy or hold for a crash

The market has dropped by 22% in the case of large caps and more than 30% in case of mid caps or small caps. That’s painful to say the least and has driven a lot of investors (should we call them that?) out of the market.

The most common view (including of some smart fellow investors I personally know) is that we have a lot of pain to follow in the coming quarters and hence it would be smart to wait for the prices to correct further, before diving in.

I agree with everyone that power, infrastructure, real estate and as a result banking are in for rough times over the next few quarters. Where I diverge from almost everyone is that, prices in some cases reflect the pessimism and more. As a result, the valuations are quite attractive and as it not possible to predict stock prices (at least in my case), I would rather buy based on what I think I know (cheap valuations) than what I would like to guess (prices in the short to medium term)

This is a risky stand to take and I am standing completely away from the crowd. I can’t think of any analyst or newspaper (not that I care about them) that is encouraging the investors to get into the market. On the contrary, almost everyone is exercising caution.

My reason for deploying my capital on a consistent basis is that the short to medium term may be bad, but the economy should recover in the next 1-2 years and as a result some of the companies which are hated now, should do fine.

I may end looking like a complete moron or a hero in a year’s time. I am hoping for my sake, that I am at best early and not wrong.

The story stocks

I come to the next point – my allergy with story stocks. If you have been around, you will remember that IT companies were the story stocks of early 2000, infra and real state in 2006-07 and consumption or consumer stocks since 2009.

I find it quite amusing when others expound the virtues of the current favorites. The typical argument is that the Indian middle class is growing, so it will buy more of X and hence the future of these companies is bright. I don’t disagree with this thesis at all.

What I find amusing is that this is hardly new. This has been the case for the last 15 years and it is only now that the market has taken a fancy to this concept and bid the valuations up. I have a mind block due to the fact that the market generally tends to overdo a good thing. In its enthusiasm for IT or infrastructure stocks, the valuations went way up and when the mood turned, the results were not pretty.

Just in case you are thinking that this is a case of sour grapes in my case ,I would like to add that I started my professional career with a consumption company (asian paints) and my initial investments were all such companies (pidilite, asian paints, GSK consumer, P&G etc) as they were much easier for me to understand .

One another point – If you think these companies and the stocks will continue to do well, then how can the rest of the industry (power, infrastructure, banking etc) continue to do badly as implied by the current valuations. If the current dichotomy were to continue for 5 or more years, we may have a very weird economic outcome in the country.

I personally like a lot these ‘consumption’ companies, but not the valuations.

What mutual funds to buy?

I recently received the following comment (slightly edited) on mutual funds.

One thing i need to ask about your mutual fund portfolio is diversification..i am commenting about 5 funds u have selected ( may be possible that u don’t have any positions in them now )
1. Are all your funds are large caps and multicaps..why?
2. Don’t u believe in core and satellite approach which many magazines, papers are advocating these days
3. you are an aggressive investor and your mutual portfolio doesn’t reflect that?
4. u have invested in growth style funds only..not in any value fund why? don’t u think diversification in investment style is also necessary

The above comment raises good questions and as it was not possible to do justice via a comment, I have decided to take it up in this post

First a disclosure – I do not hold any mutual funds now. It is true that I have held mutual funds in the past (for almost 8-9yrs) as I elaborated in this post. I also elaborated on why I followed this strategy inspite of investing in stocks (see here).

In addition to the reasons in the post, I have always had this question in my mind – Are my return due to luck or skill? One needs to look at performance over a long period of time to be sure that the results are mainly due to stock picking skills and not a fluke. After picking stocks for 10+ years and outperforming most of the mutual funds I held during this period, I am inclined to believe that it must be due to skill and hopefully not luck (though one can never be sure).

My mutual fund selection process has never been based on market cap, investment style or any core/ satellite approach. You can find my approach in selecting equity funds here.

Frankly, I find the entire market cap, value versus growth or any other approach of selecting mutual funds downright self serving on part of financial advisors, mutual fund companies and personal finance magazines. How will they make money if they give you a simple, though equally effective plan ?

I have never quite understood the market cap or sector approach to fund selection till date. It is like asking Sachin tendulkar to score a hundred while playing only 3 balls in each over. Why would you want to invest in a fund where you restrict the manager in his or her stock picks? I would rather go with a diversified fund where an intelligent manager can picks attractive stocks with no restrictions.

I would personally prefer to invest regularly in index funds or widely diversified equity funds with a long term track record . My suggestion may appear as odd and opposite of what almost everyone has to say. I would rather keep investing in mutual funds simple and focused on the basics and not get carried away with all the fancy marketing which is used to sell garbage to investors.

On the last point of being an aggressive investor? I actually consider myself quite risk averse (to the point of being chicken) and am constantly obsessing with the downside of my stock picks. The upside on the other hand usually takes care of itself.

Finding diamond in a coal mine

2011-12-19T02:25:00.000+05:30

I have nothing against the airline industry, other than the fact that it is injurious to investor wealth. There are other industries such as sugar which fall in the same group, where most of the players are not even able to meet their cost of capital over a business cycle.

I got several comments, where it was noted that there are some companies such as spice jet in the airline industry could turn out to be successful. A comparable example is bharti airtel which has done well in a fairly competitive industry with poor profitability (telecom)

I do not deny the fact that it is possible to find a profitable company which manages to buck the trend. There are often profitable companies in terrible industries and poor performers even in profitable ones (such as FMCG)

A probabilistic exercise

Let play a game of chance. Suppose I give you two dices and say that if you roll a 1,1 or 6,6 (both dices turn up one or six), I will pay you 5 for every one rupee you wager. Will you play this game?

If you understand the concept of expected value, you will decline it (read here about it and I will strongly recommend you to understand this concept thoroughly). You may get lucky once a while (roughly 5% of the times) but over a long period of time you will lose money by playing this game (you will lose 1 rupee 95% of the times and gain 5 rupees, 5 % of the times giving a net loss of .7 for the game)

So what does this game have anything to do with investing in an airline? Let me explain –

If you read through the previous post closely, you would have noticed that roughly around 16 or more airlines have failed till date and all the current ones are also losing money (some of these could fail too –at least for their shareholders). So even if spice jet or some other airline succeeds, you are talking of a 6-7% success rate in the industry.

Will you play a game where the probability of success is less than 10%? If yes what should be the payoff?

Well, venture capitalists who make such investments (low probability of success) typically expect a payoff of 20 or more for every rupee invested, to earn a respectable return on capital. Can you expect the same from spicejet or Jet airways?

But I am not putting all my money on airlines

You can make an argument that one is not really putting all his money in the airline industry and hence the above probabilities don’t apply. That is really not the case, as the said probabilities do apply to the specific idea, if not to the entire portfolio.

At the same time think of it – If you put a certain portion of your portfolio in industries with poor economics and high levels of failure, are you not setting yourself up for failure? The ex-ante probability of success in all such cases is quite low. If you are really a smart investor, does it not make sense to invest in industries where the chance of success is high to begin with and then on top of that you can apply your considerable skills to improve the eventual outcome.

The counter argument

I can think of two counter arguments to my logic

The first one is that if one has some special skills or insight into the industry and thus an edge over the market, it makes sense to invest in that industry inspite of the problems. Even in such as case, I cannot think of a scenario where most of the investors would have a considerable edge in a wide range of industries (including the lousy ones).

The second counter argument is the graham style of investing – pick a lousy company so cheap, that when the industry turns a bit, this company goes from a bargain price to just about cheap. I have done this several times in the past and made some money from it. This is however a 1-2 year game of cycling through such stocks on a regular basis, and constantly looking for the next one. There is nothing wrong with it except, that it requires wide diversification and constant effort to look for new ideas.

Ignoring industries with poor economics or governance?

Does the above post mean that one should just ignore and never try to learn about an industry which is known for poor economics? I think that would be silly. It is not like one will get some kind of infection or loose money just by reading about such an industry. One should practice safe investing, but that does not mean one should not learn about these companies.

Let me give an example – I am quite allergic to real estate companies. The industry has extremely poor governance, unethical practices and is a cesspool of corruption. At the same time, it does not mean that one should never study or look at real estate companies.

I am actually reading the annual reports of several real estate companies and find some of them interesting and surprisingly clean! The question I am now grappling with is how do you value a realesate company? That will most probably be the next post

Look for diamonds in a diamond mine

I think one should be intellectually honest with oneself. If you genuinely think that you have considerable insight into some industry and can do well inspite of the poor economics of the industry – then more power to you.

In my own case, inspite of understanding the poor economics of the sugar or metals industry, I have invested some money in the past and learned an expensive lesson.

I think it is far more profitable for investors to look for diamonds in a diamond mine, than go searching for one in a coal mine.

Why I will never buy an airline stock ?

2011-12-10T05:50:00.000+05:30

The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air, Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes. In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze behavior. It is generally a race to the bottom as airlines compete on the basis of price. The majority of an airline’s costs are fixed - cost of an airplane, fuel and salaries do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees. I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

<start rant > Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools) healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by jet or kingfisher the flight is good and the airhostesses are pretty J . That is money well spent !

Why do stocks go up?

2011-11-28T03:19:00.000+05:30

This is an odd post to write when markets are dropping by the day. However I think that at times like these, it is important to remind ourselves of the basics so that one does not get overwhelmed by the negativity and fear around us.

So coming back to the question – Why do stocks go up? Well it depends on who you ask.

If you ask a day trader, he or she is likely to say that it is due to volumes, the day’s news and finally due to sentiments. If you ask a technical analyst, the reason could range from the ordinary (volumes, patterns etc) to the esoteric (Elliot wave theory, Fibonacci sequence etc). If you ask the lay person, they would usually have no answer for it (as most consider the stock market to be nothing more than a casino).

As a long term investor, I prefer to ask the question in a different way. I am not concerned directly with the stock price, which merely reflects the business value over the long run. I am more concerned with what causes the business value to rise. If the intrinsic value of the business rises, the stock price is bound to follow sooner or later.

What is the difference?

If you agree with my argument that the key question to ask is what increases the intrinsic value, then the focus of analysis changes completely. One is no longer concerned with the market price (which will follow intrinsic value in time), but more concerned with the fundamentals of the business.

A focus on business value means that one is now concerned with the economics of the business, the competitive dynamics of the industry and finally the actions of the management.

The time horizon also changes from the short (price action) to the long term (business value). The reason for this change is also due to the fact that business value does not change much from day to day and usually takes anything from a few quarters to years to change.

What causes the business value to increase?

So let’s come back to the original question and restate it as – what causes the business value to increase?

Let me put a simple hypothesis – The value of a business usually increases if the management is able to invest, incremental capital at high rates of return.

Let me explain – Let’s say a company is earning around 15% on invested capital. If the management can re-invest the profits or borrowed money (incremental capital) at 20-25% on a sustained basis (say 5-8 yrs), intrinsic value is bound to increase and the stock price will follow in due course of time.

In the above example, if the management can re-invest at these high rates through new or existing businesses, then growth (which is what almost everyone is focused on) will follow automatically. Growth thus becomes a derivative of high rates of re-investment.

Examples of the value creators

Let try to understand the implication of the above hypothesis for various types of companies and see if it matches with reality.

Let’s look at the case of a few highly successful companies such as Hero Honda motors (10 yr CAGR = 34%) and HDFC (10 yr CAGR = 29.1%).

HDFC bank has maintained an average ROE in excess of 16% during the last 10 years and has grown its book value (which is a good proxy for intrinsic value) at the rate of 23% during the same period. The overall stock returns have followed this growth in book value, with a small delta coming through an increase in valuations (PE ratio).

The company has re-invested almost 75% of the profits (dividend payout is 25%) at high rates of return and thus increased the intrinsic value of the business

Hero Honda has an effective Return on capital of 100% or higher in its core business. It is very very difficult to re-invest all the profits back into the business at such high rates of return. The company has paid out a dividend of around 65% of its profits and re-invested the rest into the business or held it as cash equivalents on its books.

Any business which can earn such stupendous rates of return on capital and re-invest even part of it at such high rates is likely to increase the intrinsic value of the business.

The value destroyers

The second group of companies are those which have a high return on capital, are not able to re-invest the profits at high returns but have chosen to retain this capital and invest it into low yielding deposits or mutual funds. These type of companies are actually destroying value as they are retaining the excess capital and ‘re-investing’ it at low rates.

The market clearly dislikes these type of companies and tends to give them a low valuation. An example which come to mind is a company like Cheviot Company. These type of companies have above average rates of return in their core business, but choose to hold back majority of the profits on their balance sheet in low yielding deposits. These companies are value traps (in which yours truly has invested in the past)

The final group of companies are those which earn a low rate of return and tend to re- invest all the incremental capital at these low rates of return. This would include most of the commodity companies in sectors such as cement, steel, sugar etc. These companies destroy value as they grow and hence never get decent valuations in the stock market. For example, pickup any sugar company and look at their 5 and 10 year returns. Investors have lost money over a 5 to 10 year period in these companies.

Does the hypothesis help in picking stocks?

The above proposition does not help one in picking the next multi-bagger. Although it is easy to see which company performed well in hindsight, returns come from being able to identify which company will do well in the future and then buy it at a reasonable price.

Inspite of this limitation, the above thought process helps one to avoid a certain set of companies. Not losing money is half the battle in the stock market.

If one has a 3-5 year time horizon, then it is important to avoid companies which are likely to destroy value by re-investing at low rates of return – in the core business or by just holding the cash.

Applying models to real life

2011-11-16T15:58:00.000+05:30

As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.

I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business

- The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.

- The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.

- He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.

- The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.

- The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.

I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model

a. Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)

b. Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.

c. Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.

d. Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators

e. Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital

It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.

One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.

At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.

In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett

‘When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’

Learning from failure

2011-10-27T18:20:00.000+05:30

I often torture myself by looking at my past mistakes, every now and then. It may not be fun, but it is a very useful exercise

The idea of doing these exercises is not to beat myself up , but to identify patterns of incorrect thinking, and avoid repeating them in the future.

So why analyze mistakes

The human mind has a tendency to ascribe failure to bad luck and success to one’s own brilliance. In addition to this bias, there is also the problem of social disapproval. In school, did you ever get a pat on your back when you came back home with a bad report card?

In spite of all the disadvantages, I think there is substantial value in analyzing and learning from your own and other’s mistakes. The first and more difficult step is to acknowledge to yourself, that you goofed up. A more fool hardy step, is to do it publicly like me and make a fool out of yourself J

A recent example

Let’s look at a recent example. I had posted about facor alloys recently. I wrote about it here, here and here.

The key points of the thesis were

- The company had turned around its fundamentals and was now operating profitability. The balance sheet was sound with plenty of excess cash

- The company would continue to do reasonably well if the industry economics did not collapse (i.e steel demand did not collapse)

- Finally and one of the key reasons driving my purchase, was that the company appeared to very cheap.

As I said in the earlier posts, this was a small position with the intention of exploring the small/midcap space in the commodity sector. I was not able to convince myself to carry a big position (call it gut feel or whatever)

The transaction history

I wrote about the company around March 2010 and started buying around that time. I built a small position over the next few months at an average price of around 6.6 Rs per share. I sold around 30% of the position, when the price rose to around 8 / share and booked some profit (I usually never do that – which shows my conviction levels).

I read the annual report of facor alloys later in the year and posted the following

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

As you can see, the above was posted in Nov 2010, but I finally exited the position in June 2011. Why did I wait? Good question! The answer is that I was slow to accept my own conclusions and was ‘hoping’ the position would work out. In the end, hope is a dangerous strategy in the stock market

Learnings

I lost around 12% on the position after including dividend. So what I learn from this expensive tuition?

- Hope is a very bad strategy. If your original thesis turns out to incorrect, then exit the position. In this case, it turned out that the cash was never to going to come back to the investor. The management has their own plans, with which i am not comfortable. In such a situation, one cannot have the conviction to hold on to the stock.

- Accepting mistakes is painful. At the same time, the earlier one does it, the better it is for the overall portfolio (there are opportunity costs involved)

- The market rewards companies which are able to re-invest capital in their own business at high rates of return. If the company cannot do that, then the expectation is that the cash would be returned to the shareholders via dividend or buyback. If the management decides to diversify without appropriate transparency, the market is likely to take a dim view of it (read poor valuations)

- Small and midcap commodity stocks are possibly good trading stocks. You buy at specific time of the commodity cycle and exit before just before the cycle turns. It is not a coincidence that companies like facor alloys are the most touted stocks on the various tip services. These kinds of stocks are a bad idea for me as I cannot play this game at all.

Why do this to yourself?

You may ask – why invest in such stocks in the first place. I personally think, it is not possible to become a good investor without committing a few mistakes along the way. The more important thing is to keep the mistakes small, acknowledge them quickly, close them out and finally learn from them. Easy to say, difficult to do

A side project

I am doing an analysis of stocks which have dropped by more than 50% in the last 5 yrs. The reason for this analysis is to understand the cause of failure and hopefully use the learnings to make better decisions. If you are aware of any such stocks, please leave it in the comments. I would greatly appreciate it.

By the way, in case you are wondering, I don’t always lose money on my stocks picks J. Quite a few do well too, but then what is the fun in boasting when every other guy is anyway doing that.

A happy diwali to all the readers. Hope all of you have a prosperous new year.

A case of ignored liabilities

2011-10-20T05:12:00.000+05:30

There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again, recently with tata steel.

I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J

I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.

The story behind tata steel

Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.

Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.

The Corus acquisition

Tata steel acquired Corus in 2007. You can read about it here. Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company. You can read about Corus here.

Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.

Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.

I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).

Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.

So what interested me ?

As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.

The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years

The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.

So what scares me?

As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .

I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.

Look at the above number and ponder on it for a minute.

Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.

I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.

The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.

As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.

In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.

The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot get away from such liabilities at all (short of bankruptcy)

Where’s the risk

The assets under the pension plan cover the liabilities for now. However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.

I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders

So why is no one talking about it?

I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J

If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this – I have uploaded a sum of the parts valuation for tata steel here (pls have a look and leave me any feedback you may have)

Controlling my testosterone

As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.

In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and weak European operations . All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !

Stock for the long run

2011-10-10T20:14:00.002+05:30

I am married to some stocks, which in these times of hyperactive trading, is quite shocking to a lot of people.

I have held some of these stocks for five to ten years. I have discussed most these companies on my blog in the past. A partial list follows

Balmer lawrie – Held since early 2005: compounded return of around 26% per annum including dividends. You can read the analysis here, here and here
Asian paints – Held since 2001: Compounded return around 31% per annum including dividends. You can read the analysis here and here
Gujarat gas – Held since early 2005: Compounded return of around 38% per annum including dividends. You can read the analysis here and here
Crisil – Held since late 2008: Compounded return of around 42% per annum including dividends. You can read the analysis here and here
Lakshmi machine works – Held since late 2008: Compounded return of around 50% per annum including dividends. You can read the analysis here and here.

Buy and hold philosophy?

The most common reaction to such an approach is to call it the buy and hold philosophy. I personally don’t follow any dogma in investing. At the time of investing in any stock, my approach is to buy stock in a company which has a sustainable competitive advantage (ability to maintain above average return on capital over a long period) and at a discount to fair value. I will hold the stock as long as the company continues to do well (maintains its competitive advantage) and is not too overpriced.

As you would notice in my approach above, there are no quantitative measures. Competitive advantage, though a well defined concept, is fuzzy in practice and not clear cut always. In addition, though some analysts like to give a specific number for fair value, it is usually an approximate number. As a result overvaluation also depends on your specific point of view (what you think about the company’s future prospects).

Due to the above subjectivity, I do not have a specific holding period in mind when I take a position in a stock. I generally evaluate the performance of the company annually, update the fair value and will hold till the market price does not exceed this fair value by 20-30%.

The above approach has led to a holding period of 5-10 yrs in case of some stocks.

Do I ever sell?

I will not hold the stock of a company, no matter how I feel about it, if I think the stock is overpriced. For example, I have reduced my position in asian paints in the last 2 years as the stock became overpriced.

I have exited Gujarat gas in the past when I thought it was overpriced and re-entered the stock when I felt it was undervalued again.

So in way, it is truly not a marriage, but more of a long term steady relationship :)

Why do most investors hold for shorter periods?

I have a theory or hypothesis on this. There is some research to support this theory too. Let me call this the ‘macho effect’. Most men, me included, want to look macho or ‘manly’ in almost all the activities they do. This testorone display is useful in a lot of activities (though one can doubt that too), but it is completely disastrous as far as investing is concerned.

What is the macho effect? Simply put, most men think that they are highly skilled in investing and the way to show it off is to aim for the highest possible returns. Any returns less than 40% per annum is for sissies. So in order to get these super high returns, they trade in and out of stocks and in the end are not even able to match market returns. The means becomes more important than the end itself.

If you don’t agree with my hypothesis, try discussing about a stock which can give you 20% per annum for the next 5 years with a high probability. Most of the guys will dismiss such a stock as useless and point to you a hot idea which can double in 3 months.

The same research (Barber and Odean (2000) study), also points out that women are much better investors than men. I think that would be true if they were more involved in the financial decisions of the family.

What are the downsides of long term holdings?

One downside is that such ideas will not make you look smart in front of your friends. These ideas will also not satisfy that ‘macho’ urge in you :). If you really have that itch to scratch, keep around 10% of your portfolio for entertainment.

In addition, it is not always possible to know such ideas in advance. Some stocks develop into long term holdings as the company in question continues to perform well and as a result there is no reason to sell the stock. One can only look for good quality companies and hope that they will continue to perform well into the future.

How should one buy?

In times of market distress, several high quality companies are available at cheap valuation. One can look at creating a position in these stocks at such times. The advantage of buying the stock on the cheap is that one gets a double kicker – one from the reversion of the valuations to more normalized levels and the other from a steady increase in fair value of the stock.

I am quite comfortable with stocks listed in the post. In addition, I will add to them if the market continues to drop and they get cheaper.There are no guarantees that each of these companies will continue to do well, but as a group I would expect them to do well. Of course one has to be careful about the valuations at which you buy any stock.

Fasten your seatbelts

2011-09-26T01:38:00.001+05:30

A swing of 1% up or down is a decent move in the stock market during normal times. In the US and European markets a 3%+ swing is now becoming the norm. If you have been looking at these markets, you will realize that the volatility of these markets has gone up.

The European debt crisis and other issues are causing a surge in the volatility . The Indian market, though not yet impacted to the same extent, is beginning to feel the effects. It is easy to feel dizzy and disoriented by such large daily swings.

The most common reaction to such swings is to look for explanations and the common source for it is usually the news channels. We have the talking heads trying to make sense of it on a daily basis and giving us one silly reason after another after each up or down in the market.

What if there is no explanation

It is quite likely that we do not have any specific reason to explain these wild swings on a daily basis. Almost everyone in the market is equally confused and just reacting to the news flow on a day by day basis.

One option for all of us have is to ignore the daily chatter and get on with our daily lives. I am trying to follow this option. It is not easy, but I am definitely trying hard to ignore the noise as it is easy to get overwhelmed by it and do something silly as a result

Head in the sand?

Does that mean one buries his or her head in the sand and just ignores what is happening around us. I don’t think that’s a smart option either. The line between keeping your eyes open and getting swamped by the noise is however very fine

There are a few scenarios which look more probable every day. It is now an accepted fact that Greece is close to bankruptcy (if not already so) and sooner or later will have to restructure its debt in some shape or form.

It is difficult to figure out the chain of events that will follow from this event.

Will this lead to defaults in other European countries and consequent failure of banks? Will this be a repeat of 2008 and more? There are many opinions, each supported by its own logic and each sounding as plausible as the other

My thought process

I will not add more noise to the mix. My thoughts are good as anyone’ else’s or maybe worse as I don’t have any special macroeconomic skills. As I cannot forecast what is going to happen, the prudent approach is to position myself for the possible storm.

The usual recommendation is to go into cash, hunker down and avoid all equities till it all sorts out. If you have been reading this blog for sometime, you know I will hardly recommend that and will not follow that course of action J

I actually have a very simple plan which I can break it down into a few points

- Keep 25-30% or more cash as part of the portfolio to take advantage of a collapse in the market, if it happens. Ofcourse the market could rise and my returns could suffer.

- Keep analyzing companies and identify some attractive ideas before hand. If the market drops, these companies could be available at cheap prices and I need to only pull the trigger. Ofcourse one needs ample amounts of courage at such times

- Keep 6-9 months surplus cash in form of expenses at hand. If there is a contagion and a loss of job, the last thing one should do is to liquidate your investments to pay the bills.

- Have some popcorn and coca cola ready for the entertainment on CNBC and other channels – need to have a sense of humor during such dark times !

Isn’t it déjà vu ?

It is tempting to think that this is a repeat of 2008 again. The market could collapse and the brave would go riding in with their cash. They may have to wait for 6-9 months and then we would see a sudden turnaround as we saw in 2009. It may turn out that way and then maybe not !

As the saying goes – History does not repeat, but rhymes. We may have a similar crash, but it also quite likely the rebound may not be as quick. The last time around, the central banks and governments released a flood of liquidity which did the trick. This time around the lenders of last resort – the governments are themselves the problem. There is no superman around this time to save the day. As an equity investor one needs to be prepared for the long haul.

One thing which will not change is the reaction of people around us. A lot of people will be shell-shocked and scared. One advantage of writing for 6 odd years is that I can go back to my earlier posts and look at the comments and see the thought process of a lot of people.

You may find some of these posts interesting. Do read the comments (some may be yours too) to see how we looked at the crisis as it was unfolding

Time to get busy – this was after the Lehman bros collapse and markets started dropping. I started getting excited way before the bottom (as always)

Buying in bear market –As I spoke about buying into the bear market, a lot of people and their friends were advising otherwise. See – nothing changes !

Analysis: Lakshmi machine works – this is one of my favorite posts. The company sold for close to cash during this period. This is the no.1 textile machinery manufacturer in India. I just could not see this company going bankrupt. Still, a lot of people had doubts. I still hold the stock and will add if the stock drops 15% from current levels ( stock tip J)

My portfolio details in 2008 – Needless to say it got hammered during the drop as I kept buying.

Don’t catch a falling knife – As prices dropped, everyone felt that it was dangerous to invest till the bottom was reached. There is no bell when the bottom is reached. One knows about the bottom only in hindsight. Another similar post here on NIIT.

Hoping for a quick rebound and Bear market to end soon – These posts were meant to be jokes, when I predicted that the bear market will end by April 22^nd 2009. Interestingly it did rebound in April – though I was off by a few days. If I have such a flash of inspiration this time too, I will let all of you know when this bear market will end J

Are you feeling excited – With perfect hindsight, March 2009 turned out to be the bottom.

It was quite a rollercoaster ride then and i expect it be a similar one, this time around too.

Analysis: Maharastra seamless - conclusion

2011-09-18T02:54:00.000+05:30

I wrote about maharastra seamless a few weeks back. The initial part of the analysis is here. The rest of the analysis follows

Competitive analysis

There are several companies in the steel tubes and pipes space. Some of the key companies in this space are Welspun corp, PSL, APL Apollo tubes etc.

Welspun corp is one the biggest companies in this space with a total capacity of around 1.5 MMT (3 times Maharastra seamless) which is slated to rise to around 2 MMT. The company is into LSAW, MSAW (higher dia pipes), ERW and seamless pipes. The company has maintained its ROE numbers at around the 20% levels. The company has also maintained its net margin levels at around 6-8% levels which is much lesser than MSL (at around 9-10%).

PSL is one of the largest HSAW pipe makers with a installed capacity of around 1.8 MMT. The company is expanding capacity by 75000 MT in 2012. The company also has a presence in the middle east (UAE) and US. The company has maintained an ROE of around 15% with a net margin of around 3% in the last few years. The company however has a high debt equity ratio of around 1.6.

MSL seems to have better financials than the other companies in the same sector. The company has an operating margin which is higher than the other companies in the sector by atleast 4-5% which has led to a better ROC and higher cash flows. This higher operating margin seems to be the result of better pricing and lower overheads.

Management quality checklist

- Management compensation: Management compensation seems to be reasonable. The MD made less than 0.5% of net profit in 2011 which is on the lower side for promoter led companies

- Capital allocation record: The capital allocation record is a mixed bag. The company has consistently maintained a high gross margin on its product and thus been able to generate a high return on capital and good cash flows. These cash flows have been used to pay off debt and is also being used for capacity expansion (horizontal and vertical). At the same time the company raised money through an FCCB offer in 2005, which was not utilized by the company. I would give some benefit of doubt to the company on this point as they have been trying to expand into a billet plant (Which is the RM for ERW pipes) and have not been able to make progress due to land acquisition issues.

- Shareholder communication: Seems adequate. The management provides adequate information about the business and has quarterly presentations about the same on its website. In addition the company conducts quarterly conference calls and shares the transcripts on its website

- Accounting practice: Seems adequate and in line with the standards. Nothing stands out

- Conflict of interest: There were no related party transactions which seem to be out of line. However the management has lent out around 177 Crs to a company (highlighted by the auditors) in 2011 which is a point of concern.

Valuation

The company sells at around 7-8 times core earnings. One needs to exclude the impact of excess cash and non –core income (income from deposits and other sources) to arrive at the core earnings which were around 300 Crs last year. A normalized margin of around 14 % (rough average of last 5-6 years excluding impact of non core icome) gives an approximate net profit of around 270-290 Crs.

If you exclude the excess cash on the books, the company is selling at around 7-8 times earnings.

The other companies in the same sector sell at around the same valuation. If one considers that maharastra seamless has superior financials, then one can make a case for a premium. The company is also selling on the lower side of its historical valuations, which has ranged between 5 to 20 times earnings.

In summary the company appears to be undervalued on various measures. At the same time, I still have doubts on the sustainability of the margins. In view of the capacity expansion in the industry and higher level of competition (due to dumping from china), it is quite likely the margins would trend downwards.

Conclusion

This is an industry with a limited number of players in india and with low levels of competitive advantage. The main competitive advantage comes from economies of scale and client relationships (takes time to become an approved supplier for the major O&G companies). In addition, there is a lot of competition from the Chinese companies in the same space and this has led to price pressure in india.

At the same time, the user companies of oil and gas, power utilities and water supplies are growing and is likely to result in robust demand over the medium and long term. We thus have two opposing trends (growth in topline and pressure on margins) and it is difficult (for me) to understand how this will impact profits eventually.

I have the company on a watch list for the time being and 10% drop in the price would be a good point for me to start a small position.

On being patient

2011-09-12T19:31:00.000+05:30

One of the most common advice on investing is to be patient. I read this early on and always wondered what it meant? In my early days of investing, I thought I was missing something profound and did not get what the writer had to say. Overtime I have come to realize that a lot of people, who write that investors should be patient, are completely clueless about it themselves.

What does being patient mean? Should I wait 1 day, 1month, 1 year or 10 years before I buy or sell the stock?

Does it mean I should be patient for the results? Is 1 year being patient enough?

There is no universal definition

I personally think that there is no universal definition of patience. This is something, one has to figure out for oneself. It depends on your investing philosophy, temperament and goals.

A day trader is being patient when he waits for more than a couple of hours, whereas for an investor like me that is the blink of an eye. There is nothing wrong with what the day trader is doing as it works for him.

I would say that being patient has two components – time one should be able wait before buying a stock and the second piece is the time before selling the stock or getting the expected returns.

Patience in buying

Why should one wait before pulling the trigger ? If you are a long term investor and the company has a bright future, then should you not just buy the stock as a small difference in valuation will work itself out over the long term.

The above statement would be true if you knew the future of the company perfectly. As most of us don’t know the future precisely, it makes sense to have a margin of safety built into the purchase price. There are no hard and fast rules here, but I generally prefer to buy a stock at a 50% discount to fair value. If I have a high level of conviction, then I may drop the discount a bit , but I will never buy it close to fair value.

A lot of times, the company may be selling at or above its fair value. The future would be bright and everyone one and his milkman would be buying the stock. In such times, it makes sense to wait .

As it usually happens, something in the environment changes such as a slowdown in the industry and the market will abandon the stock. It is during such times that one has to have the courage of his or her convictions to buy the stock. The wait is sometimes short, but usually is long, often extending into years

Patience in selling

Let’s say you have been patient in buying the stock. Once you have purchased the stock, you want the stock to rise rapidly to validate your brilliance. I don’t know about you, but I get this urge all the time. However the world does not owe me anything ! If the industry is going through some short term pain, then it likely to take time for things to work out and the stock to realize its fair value.

I have found that 2-3 years is a good time for things to work out and if the market still does not see the light, then there is a strong possibility that you are wrong in your assessment.

So have you perfected it ?

The tone of the post would suggest that I am the perfect investor, who is supremely patient and is able to buy and sell with complete rationality. I wish I was!

I go through the same emotions as everyone else. If I find an attractive idea, I have to really hold myself back from rushing into it. To satisfy this urge, I create a small position and ensure that the itch is scratched.

I think I am far more patient on the sell side. This is usually a plus, but it has been curse too. I have been patient to the point of being stubborn in changing my view of the company. I have often persisted with a company for far too long and ignored the lack of performance. This flaw has usually resulted in an opportunity loss (where my capital was tied up in a low return idea).

How about now ?

So we come to point of the current market situation. In view of the high inflation, issues in Europe, US debt, corruption, my dog’s constipation (ok I don’t have a dog !) and all other issues, does it not make sense to be patient ?

As one of my friends was saying the other day – should you not wait till all this uncertainty clears up ? If you have been reading my blog for sometime, you know my answer - The future is never clear !!! It is clear only in hindsight. I personally do not believe on waiting for a specific level of the market, before buying specific stocks.

I am being patient on the price of specific stocks. I am currently 30-35% in cash and tracking and analyzing companies everyday. If the price falls below my target price, I start buying the stock.

If the market crashes for some reason and I get a lot of bargains, then I will get aggressive. If nothing happens, I will keep waiting and hopefully be patient.

Two differing ideas – Akzo nobel and Techno fab engineering

2011-09-02T03:03:00.000+05:30

I have a constant struggle in my mind – Do I pay for quality (overpay?) or do I buy cheap stuff, which may turn out to be a value trap.

The ideal situation would be to get a high quality stock at a cheap price. But then if wishes were horses!, I would be a good looking billionaire with my own private island J.

So let’s look at my current dilemma

Akzo nobel

Akzo nobel is a global company in the business of decorative and auto paints and other industrial chemicals. The company acquired ICI plc a few years back and thus got the Indian business of ICI with the acquisition.

ICI paints (atleast in the late 90s) was a company with good brands and was fairly aggressive in the paints business. At one point, they even tried to acquire asian paints by buying out the stake of one of the promoters.

ICI paints is one of the oldest paint companies in India and is fairly strong in geographical pockets (West Bengal) and in specific products (premium paints). The company has however not been able to capitalize on its strength in the past and did not seem to have a focused strategy. The new management however seems to be developing a focused strategy of introducing new products, expanding distribution and spending on brand building.

The paints business is a very profitable business with very high entry barrier (I saw this first hand when I was working in the industry). As a result, most of the companies in this business have enjoyed above average growth and high returns on capital

Akzo nobel india has a Return on capital of 100%+ (excluding excess cash on the books) and has been able to grow the topline and profit by 30% in the last 5 years . In addition the company has been shedding the non-core businesses and freeing up capital. The company is also investing in manpower, its brands and expanding its distribution.

My hesitation in investing is the valuation. If one excludes cash, the company is selling at around 18-19 times earnings. On a comparative basis, the company is cheaper than other paint companies such as asian paints (around 30 times earnings). However I don’t believe much in comparative valuations and find the current valuation a bit high compared to the prospects.

Techno fab engineering

Technofab engineering is in the EPC space and is involved in various turnkey engineering projects in industries such as power, industrial and oil & gas.

The company came out with an IPO in 2010 at a price of around 235 per share. The stock currently sells at around 142 / share (selling below the IPO price does not mean it is a bargain!)

The company has been in this business from 1970s. The company has grown its topline and profit by more than 30% per annum in the last five years (which means that in the past the business barely grew). The company clocked a turnover of around 290 Cr in 2011 and has around 900 Crs open order book (almost 3 yr visibility)

In addition to the above, the company has around 100 Crs of cash on the books (some of it due to the IPO) which will be invested in expanding capacity to manage the higher order volumes. The company is thus selling at around 2 times earnings, has shown 30% growth in the recent past and delivered a 30%+ return on capital during this period.

The company looks like a complete bargain?

I am not so sure. The EPC industry is characterized by moderate to low entry barriers, high levels of competition (from the likes of L&T and others) and high working capital needs. In addition it is also a very cyclical industry with drop in margins and cash flows during the down cycle.

The dilemma

So the dilemma is whether to invest in an above average business which may be fully priced or in an average business which is very attractively priced.

There is no obvious answer in the above case and it depends on each individual’s mindset. I have invested in technofab types of businesses in the past with decent, though unspectacular results. In contrast if I am able to invest in a good business at decent prices , then the returns are fantastic

I have not made up my mind yet and have no position in either stock. I plan to dig deeper into Technofab engineering to get a better picture of the industry.

It is quite likely that I will just file away these companies and watch them till either the price is better (in case of akzo noble) or the business quality improves (in case of technofab engineering).

Time to open up the wallet?

2011-08-21T04:12:00.002+05:30

26-Aug : A clarification
In the post below, i spoke about investing in the index either via a systematic investment plan or through some simple rule set ( such as buy below a PE of 12 and sell above 20).
I did not imply that one should be investing in the index now !. I am surely not investing in the index now as it is not as cheap as i would like it to be.

However if you want to avoid all this mumbo jumbo, the best option is to use a systematic investment plan and invest in a mutual fund or index fund on a regular basis.

Finally, remember to switch off the finance channels on TV to avoid derailing a sensible long term plan.
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I have a little extra spring in my steps these days!

Let me share a small personal story. As a kid growing up, diwali was a great time for me. Being a north Indian, sweets are a big part of diwali. We would visit our grandparents during diwali, and I had complete freedom to eat as much sweets or mithai as I wanted to. I have always had a sweet tooth and I still recall a month of pure bliss during diwali. Barfi, gulab jamun, pedas …mmmmm!

I feel like it is diwali or almost diwali these days. I don’t mean in the literal sense, but everyday I look at the market and find my favorite barfis and pedas available for less and less J

But it is such a bad time!

I think all of us know the million reasons why one should not invest money and stay away from market. US is in a mess, Europe is a disaster waiting to happen, India is overheating …blah blah blah.

One cannot open the papers or watch a channel without someone trying to predict a disaster sometime soon. Where were these idiots in the beginning of the year when the index was at 20000 levels? If they could not see six months out then, how are they able to see six months out now?

The truth is that, it is never a good time to invest. There always is some problem somewhere. It could be macro problems such as now or industry/ company specific issues such as in the infrastructure or IT industry. By the way, the right time to sell would be before the market realizes that there is a problem in the industry and not after it has been priced in.

If risk avoidance is the goal, then the only way to invest is in bank deposits. Even in the case of bank deposits, one faces the inflation risk. So in effect, one cannot escape risk. The only thing an investor can do is take intelligent risks for which one is compensated (much like an insurance company)

What is an intelligent risk?

An intelligent risk is one for which one gets the appropriate return adjusted for the risk. The main component for intelligent risk taking is diversification and pricing. You do not overpay for it and you diversify. This is much like an insurance company.

The unsaid part in the above is that one knows what one is doing. No amount of diversification or price can save you from ignorance.

Why not wait till it all clears up

Unless you have some crystal ball to look into the future, it is futile to try to predict the turning point (if you do have a crystal ball, why waste it on the stock market anyway).

Majority of the investors are typically late in knowing when the tide has turned and then there is a mad rush into stocks (remember April 2009 when the index jumped by 10%+ in a day !)

If like me you cannot predict the turning or don’t care to, then a good time to buy is when the prices are low. It is quite possible that things could turn worse before they get better and you may get a better opportunity. However trying to pick the bottom or the top is a fool’s game and I would prefer to pick up stocks which are cheap enough and then just stick with them.

So what to buy?

The first question to ask yourself is this – Do I have the stomach to withstand large swings in the stock prices and considerable paper losses for sometime? It is quite possible that all this may take some time to clear up and could test your patience.

The second critical point is whether you need the money in the medium term. If you need the money in the next five years, then don’t put that money into the stock market. A large drop will scare you and you may exit the market at the wrong time.

The perceived risk in the stock market is high during bear markets, but the actual risk is lower. Everyone was scared in March 2009 – so the perceived risk was high. But if you invested during that period, you made good returns.

If you are short on time and cannot do the research, then you can do what I have done in the past – Invest in an index fund. As I have said in the past, investing in an index is a good option for a lot of investors, especially if you not have the time and interest in analyzing stocks. You can use a simple rule set like mine or do some fancy math to figure the right time to buy.

I was short on time during the first quarter of 2009 and felt the market was fairly cheap. To take advantage of the undervaluation, I invested quite a bit in index funds to take advantage of the low valuations.

If however you have the time and inclination to analyze stocks, then beaten up sectors which do not have a structural issue is a good place to start. I think infrastructure and capital good is a place to search for bargains. The IT industry on the other hand has structural issue and I will not invest in any company unless it is really really cheap.

My mouth has started watering these days and if the market continues to drop, it would be an early diwali feast for me J

We will all run our TVs without power

2011-08-09T01:16:00.003+05:30

The Indian middle class is on the cusp of a fantastic change. The economy is growing by leaps and bound and so is the per-capita income. With all this money in our hands, we are and will continue to buy fridges, TVs, pressure cookers and all other comforts of life.

The white good companies have not even scratched the surface ! We have one of the lowest penetration for all these white goods and consumer goods in the world. It is silly not to believe in a glorious future. Companies like Hawkins, nestle, marico and all other FMCG and consumer companies deserve even higher valuation, because they will all grow at phenomenal rates.

In contrast, the infrastructure companies deserve the kind of lousy valuations we are seeing in the market now. Power companies, power equipment producers and all kind of companies engaged in building the infrastructure deserve the sub par valuation because the environment is hostile. The government will never fix the policy issues and we will continue to have poor quality roads, blackouts and lack of other amenties.

If the market and a lot of investors are correct, I can visualize a scene where I will be sitting in my house without power, gas and connecting roads but with the best plasma TV and all kinds of soaps, detergents and packaged goods.

I think I need to figure out a way to run my 100 inch TV without power and use my fancy shampoo without water :)

Is it not obvious that this scenario is not consistent? If consumer goods are to grow, then the rest of the economy has to grow and hence the valuations of all kinds of infrastructure related companies have to be higher. If the power, water and infra companies are doomed, do you think any of the other consumer companies will do well ?

A personal story

I hear this logic often – India has 50 Cr middle class. The global average is around X per million of population. In india, even if we double the consumption levels from here, we are looking at a huge opportunity. In view of this logic , the consumer companies deserve a higher valuation

Where have we heard this logic before? Remember the dotcoms and IT stocks in 2000, infrastructure and real estate in 2007-2008?

Let me give a personal story. I used to work in the consumer goods industry in the 90s in sales. Among the many products, we used to sell soaps . The logic would go like this – A family of 4 can use around 2-3 soaps per month. In a town of 100000, there should be a consumption of around 2-3 lacs per month. We currently sell around 10000 bars per month. So even if I can increase the penetration levels by 1%, we can easily double the volumes.

The above argument is very plausible and so easy to follow. Except reality does not work that way.

An armchair investor like me sitting comfortably in a chair at home and sipping masala chai can come up nice projections on a spreadsheet and justify any price for the stock. But if you have worked in sales, let me tell you that it takes a lot of effort and time to grow sales. The reasons can be varied - such as poor ROI at the micro level due to which production penetration cannot be increased, or high competition - but the end result is that growth is not an easy linear process.

Company specific growth depends on a lot of factors beyond the basic macro opportunity and it is rarely a simple, linear process. If you make simplistic assumptions and pay top valuations for it, then the experience can be bad if those expectations do not materialize.

I have been investing in consumer good companies for some time now and my preference is to look for companies which can tap into a large macro opportunity and have the management capability to do so. At the same time, I don’t want to pay too much for it. Although’ too much’ is a subjective term and any number would be arbitrary, I would rarely pay more than 15-18 times earnings

Survivorship bias

The worst counter argument against the above logic is to give an example of a titan or a nestle. For every titan or such high valuation company which subsequently did well, I can give 2 examples of companies with high valuations which disappointed investors as the business reality did not match the expectations.

One should pay for quality, but not take the logic too far. Even if it is arbitrary and one risks missing some good companies, I would still prefer to have some cutoff to avoid buying an over priced stock which disappoints me in the future.

Analysis : Maharashtra seamless

2011-08-01T03:50:00.002+05:30

About
Maharashtra seamless is in the business of seamless and ERW steel pipes. These steel pipes are made from steel billets and HR coils respectively.

Seamless pipes are used mainly in the oil and gas and other such industries where there is a need to carry fluid under high pressure application. ERW pipes which have a higher diameter are also used in the same industry, in water distribution and other applications in airports, malls and other civic locations.

The company now has a capacity of around 550000 MT in seamless pipes and produced around 220000 MT. In addition the company has a capacity of around 200000 MT of ERW pipes and produced around 115000 MT.

The company is a certified supplier to several prominent O&G companies such as ONGC, Oil india and GAIL and other companies such as SAIL, NTPC etc. In addition the company is also an approved supplier to several global O&G companies such as Chevron, Saudi aramco and occidental oman etc. The company has benefited from the imposition of anti-dumping duties on seamless pipes from china, due to which its products have become competitive in various foreign markets.

Financials
The company has increased its revenue from around 383 Crs in 2003 to 1760 Crs in 2011 with an annual growth of around 18% per annum. The topline growth has however slowed from 2007 onwards. The net profit has grown at a CAGR of around 20% from around 62 Crs in 2003 to around 346 Crs in 2011 (excluding other income).

The net profits have grown at a higher rate than the topline due to improvement in margins. The net margins have mainly improved due to reduction in overhead expenses as % of sales.

The company has paid off its debt completely and now has a surplus of around 700 Crs on the balance sheet. The company raised around 300 Crs of capital via FCCB in 2005 for expansion which was converted to equity in 2006. This capital has however not been utilized as the company has been able to generate sufficient capital from operations to fund its capex, pay off debt and maintain its dividend.

Positives
The company has been able to maintain an ROE in excess of 25% for the last 8-9%. To get the true picture of the core business ROE, one needs to adjust for the excess cash and revaluation of fixed assets. The ROE numbers have dropped in 2011 mainly due to revaluation of fixed assets which caused the networth numbers to go up by almost 67% in one year.

The company has been able to maintain a reasonable growth in topline which has however slowed down in the recent past. In addition the company has been able to improve its margins from 12-13% levels to around 16% levels. It remains to be seen if this level of margin will be maintained.

The company has been able to pay off its entire debt and has close to 700 Crs excess capital on the balance sheet. The company has imported a plant from Romania for seamless pipes which it is installing near its current facility. This new plant will take the capacity up from 350000 to 550000 MT. In addition the company is also going in for backward expansion in steel billets which is a key RM for the seamless pipe (remains to be seen if the expansion is a good move). The company can easily meet all its expansion plans with the excess capital on the books.

Risks
The company sells a product which is a commodity product. The company has been able to maintain its gross margins inspite of fluctuation in steel prices which account for more than 60% of the total cost. It remains to be seen if the company will be able to maintain these margins in a slower growth/ higher competition environment (where other companies are expanding capacity too).

The company has managed the liability side of the balance sheet quite poorly. The company raised around 300+ crs in FCCB in 2005-06 which been idle since then. This is expensive capital which has been lying on the books and earning low rates of return. This excess capital has depressed the return numbers for the company.

Next post: Competitive analysis of the company, management review, valuation and final conclusion.

Paying more for quality

2011-07-14T00:53:00.024+05:30

As part of my paid subscription, I recently added a stock in the portfolio. I bought this company at around 16 times earnings and as I am constantly preaching about buying stocks on the cheap, it must have surprised a few subscribers.

A good friend of mine wrote to me and we exchanged a few emails where I shared my thinking behind this pick. I have lightly edited the conversation and added some additional commentary to detail out my thought process. Think of this post as a continuation of the previous post on value traps.

Hi Rohit,
What is the reasoning behind buying XXX? The stock already is trading at P/E of 23+. Also they don’t seem to be in a market where they have monopoly.

Bye,
Kedar

Hi kedar
Because i like the company :) and it will look good in the portfolio

Jokes apart, the company on a consolidated basis is selling for around 16-17 times earnings and earns 60%+ return on capital. In addition the company has been growing at 15%+ (slowed down lately a bit) and expanding globally and in India too.

The company is also making small acquisitions to add to the product/ technology portfolio and is planning to spend 3%+ on R&D in the future. Finally the company has an associate company at book value for 250 crs on the balance sheet, which is worth much more than that.

All in all a good business with good competitive advantage, but it is not cheap.

Hi Rohit,
The business may be good but if the market price is close to fair value, why will you buy it. I have not seen you buying stocks unless the market value is at least at 40% discount to fair value.

regards
Kedar

Hi kedar
It is not really selling at fair value ...still a 25-30% discount. There is a key difference in the approach here. I am paying up for quality here.

One approach is to buy at a 50% discount for a decent business and wait for the gap to close...like seamec which is cheap and the returns will come when the PE re-rating happens. As the fair value is increasing slowly, the stock price will rise slowly after that. In all such cases we have the re-investment risk - what to do with the money once the company sells at fair value?

The other approach is to buy a good business which is selling at a smaller discount, but at the same time is also growing its intrinsic value - think LMW, gujarat gas, crisil etc. These are high quality businesses which will increase fair value at a decent rate - call these steady compounders.

In such cases you can get a step jump due to re-rating of the PE as the market recognizes the quality of the business. At the same time as the fair value is growing at a fair clip, one can hold onto the stock and get above average returns from the rise in fair value. This increase will not happen in a nice smooth upward trend, but over time it works out pretty well.

The best situation will be to buy these companies at a discount ..isnt it ? but that is not likely to happen very often ..unless there is a crisis in the market like 2008, but then we have to wait forever for that.

I have been thinking on these lines for some time and have always invested this way (Crisil, LMW etc are in that bucket) , just now doing more explicitly with the new picks.

A personal experiment
My drift towards higher quality companies has not been a sudden one. I still cannot resist a cheap stock :).

I have maintained a dual portfolio for sometime now. The main portfolio has carried my high conviction bets with sizeable positions in each of the idea. At the same time, i have maintained a smaller portfolio of cheap, unloved stocks such as ultramarine pigments, Denso india etc.

The results, as expected have been mixed. A few companies such as Denso india gave high returns, but others such as ultramine pigments have dissapointed. In the final analysis, the main portfolio has beaten the cheap , graham style portfolio by a wide margin.

I will continue to opportunistically pick the cheap and unloved stocks, but at the same time i am more comfortable now with quality stocks and paying up for it. It is one thing to read about it and something else to arrive at a conclusion based on personal experiences. The latter remains with you much longer.

The anatomy of value traps

2011-06-23T06:21:00.001+05:30

The number one problem faced by value investors is not a big permanent loss of capital, due to overpayment for growth, but the weak and anemic return from an average business bought at a cheap price.

Let me explain further –

A typical value investor (who are far and few anyway) generally tend to be conservative in paying up for a business. The deep value types go for the really cheap stocks (as measured by low PE or P/B ratios), whereas the others would pay up a bit for the quality of the stock and growth, but not too much.

A deep value investor typically looks for a company which is selling in low single digit PE ratios and in some cases if you back out the cash or other assets on the balance sheet, the core business could be available for almost nothing.

What is a value trap?
The problem with most of these investments is that the underlying business is stagnant with a comatose management who is not interested in either growing the business or ready to return the excess cash to the shareholder. In such cases, the market discounts this cash heavily and refuses to bid up the stock price.

Let me a give a personal example – Kothari products. You can read my earlier posts on this company here and here

Let’s look at the price history for the company below

As you can see, that the stock has gone nowhere in the last 5 years. If one includes dividends then, the return comes to around 15% for the entire 5 year duration. The index during this period has more than doubled.

Even a savings account would have done better!!

What are the key causes?
There are several causes for such value traps. The primary cause is a stagnant or declining business with a management which keeps pouring capital into the sinkhole. If on the other hand, the business is generating excess cash, the management keeps hoarding it and refuses to return it to the shareholder.

The second reason is that the underlying economics of the business has deteriorated and the market realizes it with a lag. Case in point – the telecom industry. The economics of this industry has gone into a tailspin for the last few years, with almost everyone bleeding money (except probably bharti airtel). In such cases, if you keep looking at the past data and do not understand how the economics of the industry has changed, you can get stuck in a no-win situation

The last category of value traps are the low return, second and third tier commodity players. These companies have a low return on capital over the entire business cycle, and unless you can dance in and out of the stock in time, you can get stuck with very low returns.

How to indentify value traps before hand ?
That’s the tough bit.

For starters, investors like me need to get out of the low PE, cheap stock mindset. A really cheap stock is often cheap for a reason. It makes sense to dig deep and understand the business in detail to figure out why the market is valuing the company at such low valuations ?

If a company has been cheap for the last 5 years, why should it suddenly get re-rated just because smart lil me bought the stock?

One needs to understand the economics of the business in depth and also confirm that the management is creating value for the shareholder and not just twiddling their thumbs. Only if you have a strong belief that that business is doing well and will continue to do so and the management is also good, then should you think of making a commitment to the stock

What if you are caught in value trap?
There are no easy answers. For starters, swallow your pride and sell the stock. That’s easier said than done – ask me!. The unfortunate bit is that people like me take 10 years to realize it :). Luckily for me these mistakes have not been big enough to damage my long term returns.

The risk of holding onto such investments is that although you do not lose money on paper, in reality you are losing the benefits of compounding by not investing the same money in other opportunities. It would be silly to compound your money at 10% in a value trap, when the index itself can give you 15% without any effort.

If you have invested in one of those low return commodity stocks, hope that the commodity cycle turns and market in its temporary fits of insanity, re-prices the stocks. As soon as this happens, sell the stock and never look back !

It is always a constant struggle to avoid value traps, as they come in various shapes and forms. One has to be vigilant and learn to exit them, once you have realized that you are stuck in one

Evaluating banks – Putting a picture together

2011-06-14T05:46:00.001+05:30

I have discussed about the various factors or parameters in analyzing a bank in some earlier posts (see here and here). In this post, I will use these parameters to evaluate a real example.

A warning before I proceed – The wieghtage given to each factor and conclusions derived depend heavily on the temperament and biases of an individual. If you are an investor who likes growth and are ready to take some risks to get a multi-bagger, you may overweight the topline and bottom line growth and pick a bank which is growing rapidly.

On the other hand if you are conservative in nature, you may overweigh the CAR ratio and may actually get nervous if the bank is growing too rapidly. I personally prefer a middle path – I would prefer a conservatively managed bank which is growing at 1.5-2 times the GDP growth rate and hence is likely to give a 15-20% growth rate.

In my world a 15-20% growth rate is adequate, if it can be sustained for 5-10 years. I am not looking for shooting stars.

I am taking the example of Axis bank for this post to demonstrate the process I go through when evaluating a bank. I do not have any position in the stock.

Profitability and its source
The first factor I would look at for in any company is the Return on capital (ROE in case of banks). Any company earning below the cost of capital (over the business cycle) is out of contention. The bank or the company should have an average ROE in excess of 15% over the last 10 years. Axis bank has had an ROE of around 23% over the last 10 years. The ROE has dropped from 32% in 2001 to around 20%, but has generally been maintained above 18% during the entire time period.

I am also interested in understanding the source of the above average returns. In case of a bank, the ROA (return on asset) is an important number. A number in excess of 1.3% is considered good. Axis bank has improved its ROA from 0.8% in 2001 to around 1.6% in 2011.

The improvement in ROA was driven by higher net interest margins and better other income, resulting in higher net profit margins which have gone up from around 1.8% to around 3.7% . So in effect the bank has improved the profitability, both from lending and fee based sources.

Asset Quality
A bank may be very profitable and showing great results, but may have very risky loans on its books. Asset quality is an important factor in evaluating the quality of the earnings of the bank. Unfortunately there is no easy and direct way of doing it.

I typically look at the NPA number, the level of provisioning of the NPA and profile of the assets. It helps to review the distribution of credit risk by industry in the notes to account, to confirm that there is not too much concentration of lending to any specific industry or borrower.

The truth of the matter is that one cannot get a perfect read of the asset quality and has to trust the management. This is the main reason why a long term track record and culture of the bank is important. If the bank has a past history of conservative lending over the business cycle, then one can expect the same to continue.

I am a bit concerned on this count with Axis bank. The bank has been expanding rapidly, especially on the home loans and other retail assets. One cannot be sure if the bank has been conservative in lending.

Safety
The next factor I would look at is the safety or capital cushion of the bank. The ratio to look for is the CAR (Capital adequacy ratio). The bank has on average maintained a CAR of 12.5% and may need to raise more capital to fund future growth.

The next factor to evaluate the sustainability of the earnings is the gross/ Net NPA and level of provisioning. The bank has a gross NPA of around 1% and net NPA of around .26%. The bank was provisioned around 68% in 2010, which means that 32% of the NPA have not been provided for (and could hurt the profitability if these loans cannot be fixed).

The NPA number is very crucial for the banks. It is difficult to be sure about the true NPA of the bank as a bank can play a lot of games to modify this number and thus come up with a desired profit number. One has to just trust the numbers, based on the overall feel of the management.

Growth
If I am satisfied with the profitability and safety of the bank, I would move on to the growth in topline and net profit for the bank. In case of Axis bank, both the numbers have increased in excess of 30%. Clearly the bank is in a lot of hurry to grow.

In addition to the income and profit, the bank has grown its branch network from 139 to 1390 in 2011 and the ATM network from 490 in 2002 to around 6270 in 2011. The bank is thus expanding the retail network which is healthy growth as it helps the bank on the liability side (gather low cost deposit) and also lend to the retail segment (in the form of home loans, personal loans etc).

Cost analysis
Cost is an important factor in the analysis of any industry and more so in the case of the bank. The two crucial cost elements are the cost of funds and the overhead costs.

The cost of funds in case of axis bank has dropped from around 7.5% to around 5%, due to the increasing current and savings deposits. This is a good trend and has enabled the bank to earn a decent net margin (3.7% currently).

The cost to income (or overhead) ratio has gone up from 30% to around 40% level mainly due to the cost of new branches and other such investments. If this ratio is up due to expansion of the branch network, then I am all for it. Axis bank is clearly investing in expanding the branch and ATM network and is benefiting from this expansion too

Competitive advantage
It is also crucial to evaluate the strength of the bank’s competitive advantage and if the bank is working on enhancing it. The competitive advantage comes from the following factors

- Brand : Axis bank is now a well know brand, especially in the urban areas and is constantly being strengthened through advertising and promotion

- Customer Lockin : The bank is improving the lockin by increasing the number of branches, ATM and by providing a wide range of products. The bank can keep increasing the customer lockin by constantly improving the service levels and adding new products.

- Production side advantage : The bank has been able to expand the branch network and increase the number of customers. This provide the bank, economies of scale in gathering deposits (and lower cost of funds) and reduce the per customer cost of servicing them.

- Entry barrier: There is certain level of entry barrier as RBI does not issue new licenses easily (which may change now). As a result the private banks have been shielded from relentless competition and have been able to grow rapidly and achieve scale. Any new banks will to incur years of investment to achieve the same scale.

Management quality
This is the most important and the most difficult factor to evaluate. In the case of axis bank, I can offer a few view points, but these are just that – views or impressions. Each one of us will come up with their own impressions.

I find the management quite aggressive in expanding growing the bank. In some ways, the bank looks like a version of ICICI bank when it was in the growth phase. Some of you may find that comparison unfair as ICICI grew too rapidly and then had to fix the asset quality issues. I am not implying that axis bank has the same issues, but one cannot sure in cases where the growth has been rapid.

The disclosure levels of the bank are quite adequate and the bank provides a lot of detail about asset profile and distribution.

Overall the management is definitely doing the right things and has strengthened the balance sheet and increased its competitive advantage over the years.

Conclusion
I have covered how I would evaluate a bank based on the various factors. As you can see, there is no checklist or points system where if the bank scores well on most of the factors, then at the end of the exercise you would have neat conclusion to buy or sell.

I find the bank passes most of the checkpoints in terms of fundamental analysis, except for my concern on asset quality. The key reason for not pulling the trigger is price – I find the price higher than what I would like to pay.

Ingredients and recipes

2011-05-31T21:59:00.001+05:30

The idea for this post came from a question from a reader –

Rohit – you gave us the ingredients in the last two posts on banking (see here and here for various factors on analyzing banks), but these ingredients or factors alone are not sufficient. Where is the recipe? How do i combine the various factors to come up with a final decision or idea?

This is a very interesting question, and I plan to publish a post on how I would combine these factors to arrive at a decision.

The analogy with cooking
Most of us have watched cooking shows or would have seen recipes in a book or a magazine. These cookbooks list out the various ingredients with the precise amounts and then they guide you through the steps of putting these ingredients together to come up with a final dish.

Personally, I am an atrocious cook – I can even burn water :). There have been times when my wife has given the list of ingredients and the exact steps and yet I have managed to mess up the dish completely. Even if you are not as horrible a cook as I am, you must have had the experience that inspite of the following the recipe to the T, the final dish does not come out as good as you thought it would.

There is an art to cooking and after all the instructions and teaching, there is no substitute to practice and experimenting. One tends to get better at it over time and there are subtle nuances that cannot be written in a cookbook (which is why old grannies can cook great food, without any formal training).

If you think of it, there is a lot of similarity with investing. I can tell you all the factors and maybe some kind of recipe , but in the end there is no substitute for actually doing it. You may mess it up once a while, but over time if you are interested in the craft of investing, it will work out for sure.

The case for fund managers or chefs
Now that I have decided to bring in the analogy of cooking, let’s take it a step further. Even if you can cook, you still prefer to go to a restaurant to eat once in a while. The reasons are many – variety, better food, less effort etc.

The case for mutual funds or PMS can be similar too. You may be able to invest well if you worked hard at it, but a lot of times you have other priorities in life and would like to hand over the job of investing to a professional (hopefully a good one) who does this full time.

The same logic applies to almost everything else – otherwise we would be growing our own food, milking our cows and doing most of the other basic work too.

The need for oversight
If you decide to outsource some aspect of life, it does not mean that you should ignore it completely. Do you hire a carpenter or a plumber for some job, pay him cash and ask him to do whatever he wants with no oversight from anyone ?

Why should it be different for a mutual fund or a PMS ?

On the other extreme, do you instruct or monitor every nail that you carpenter hits ? Evaluating weekly or monthly portfolio performance is akin to that.

Irrationality in money
The reason the above points raised by me sound funny or absurd is due to the irrational relationship we have with money. A lot of people either ignore it completely (and hope things will work out) or think it is a form of entertainment to invest money / trade in the market.

I can think of only one rational reason for investing – wealth creation. You invest money so that you are able to build an adequate amount of wealth over time which will help you to realize your goals such as retirement, healthcare or children’s education etc. All of the rest – whether you beat the market by X % or find a hot stock is fluff.

By the way – Although I invest my own money, I will never eat my own cooking unless I want to torture myself :)

Evaluating banks - More factors

2011-05-23T21:32:00.000+05:30

In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.

I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)

Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.

In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.

Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.

However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.

The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.

Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.

The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.

The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.

Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins

In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.

Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.

So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.

Let’s now look at additional factors which are not commonly followed

Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?

Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.

For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.

So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).

The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.

If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.

The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.

Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.

If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think

Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).

I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.

No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)

Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?

Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.

Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)

Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.

For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.

Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)

Are you exhausted :) ?

We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.

Evaluating banks - Key factors

2011-05-11T19:49:00.002+05:30

I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.

In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.

Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.

An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.

CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.

The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)

Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA

This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.

Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.

The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.

Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.

An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.

Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .

NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.

This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)

NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.

There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.

Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.

You don’t have to be smart often

2011-04-25T04:26:00.000+05:30

Lets say you have a portfolio of around 15 stocks, which I think is sufficient diversification for most of us. Now let’s say, you are one of those odd guys who for some inexplicable reason, believes in long term investing – that is buying high quality companies at decent prices and then holding the stock for the long term.

Let’s assume, for argument sake that the average holding period is around 3 years. In such a scenario, you are buying/ selling 5 stocks per year. Now let’s say, you are able to spend around 5-6 hrs each week on searching for decent ideas and are able to analyze 1-2 companies each week. At this rate, you can analyze 50-60 companies each year.

If you look at the above math, you need to smart or lucky around 10% of the time. I don’t consider that as a high threshold.

What wrong with the above logic?
For starters, the above reasoning assumes that you will be able to find attractive ideas on a regular basis – one every 2-3 months. As most of us who have been investing in the market for sometime know that, these things don’t work on such a smooth schedule. Investing ideas tend to come in clusters and in short periods of time – especially when the short term outlook is clouded.

The other assumption is that one will spend a 5-6 hours a week, diligently looking for stock ideas. Unfortunately, I don’t know of any shortcut to make money in the market. A lot of cheats claim to know ‘techniques’ to make money with minimal effort and are able to find enough fools to sell their techniques.

The logic actually works even better
The above logic works even better than what i claim in the post. Let’s say you are able to indentify some high quality companies such as a titan or crisil and make a purchase at decent valuations. Once you purchase such a company, I don’t see any reason to sell the stock unless the valuations go beyond all reason. In such a case, the portfolio turnover drops still further and the number of new ideas required each year is even lesser.

A 60-70% success rate of your ideas, where 3-4 ideas will either make no money or lose a bit for you is quite reasonable. At this success rate, one will still do well on an aggregate portfolio basis.

If you put it all together, I think one needs to pick a successful idea 5-10% of the time or around 1 in 10 ideas evaluated.

The only downside in the above approach is that you cannot share any exciting stories of your stock market coups with your buddies over a drink.

The comparison with trading
I genuinely believe that trading is much tougher game than long term investing. Even if one leaves aside what is required to be a successful trader, the basic math tends to work against you.

Even if you are a moderately active trader and buy/sell 10-15 stocks a year (1-2 per month), the success rate (no. of ideas invested/no. of ideas looked at) required is much higher than a long term investor. I think one has to be much smarter to be a successful trader than a successful long term investor.

Is that what you do?
Short answer to this question is – Yes. I typically evaluate 2-3 ideas each week in some depth and may end up picking just one idea every few months. In most of the cases, it is either some fundamental issue which turns me off or it may just be that the valuation is not attractive enough.

If the idea is good, but the price is not right, then it goes into my tracking list. I tend to review the tracking list once a month to see if Mr Market is offering some bargain on a decent idea.