AuthorRohit Chauhan

Why do stocks go up?

By Rohit Chauhan
In Uncategorized
November 27, 2011
6 Min read
26 comments
W
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.
Read on26 comments

Applying models to real life

By Rohit Chauhan
In Uncategorized
November 16, 2011
5 Min read
9 comments
A
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’
Read on9 comments

Learning from failure

By Rohit Chauhan
In Uncategorized
October 27, 2011
5 Min read
31 comments
L
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.
Read on31 comments

A case of ignored liabilities

By Rohit Chauhan
In Industry analysis, Uncategorized
October 19, 2011
8 Min read
20 comments
A
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 !
Read on20 comments

Stock for the long run

By Rohit Chauhan
In Uncategorized
October 10, 2011
5 Min read
13 comments
S
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
  1. Balmer lawrie – Held since early 2005: compounded return of around 26% per annum including dividends. You can read the analysis here, here and here
  2. Asian paints – Held since 2001: Compounded return around 31% per annum including dividends. You can read the analysis here and here
  3. Gujarat gas – Held since early 2005: Compounded return of around 38% per annum including dividends. You can read the analysis here and here
  4. Crisil – Held since late 2008: Compounded return of around 42% per annum including dividends.  You can read the analysis here and here
  5. 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.
Read on13 comments

Fasten your seatbelts

By Rohit Chauhan
In Uncategorized
September 25, 2011
6 Min read
14 comments
F
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 22nd 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.
Read on14 comments

Analysis: Maharastra seamless – conclusion

By Rohit Chauhan
In Company analysis
September 17, 2011
5 Min read
4 comments
A

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.

Read on4 comments

On being patient

By Rohit Chauhan
In Uncategorized
September 12, 2011
5 Min read
12 comments
O
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.
Read on12 comments

Two differing ideas – Akzo nobel and Techno fab engineering

By Rohit Chauhan
In Company analysis, Uncategorized
September 1, 2011
4 Min read
19 comments
T
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).
Read on19 comments

Time to open up the wallet?

By Rohit Chauhan
In Uncategorized
August 20, 2011
6 Min read
27 comments
T
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.
—————————————————————————————————————————-
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
Read on27 comments

Subscription

Enter your email address if you would like to be notified when a new post is posted:

I agree to be emailed to confirm my subscription to this list

Recent Posts

Select category to filter posts

Archives