AuthorRohit Chauhan

I often get a comment or email, which goes along the following lines – I have been analyzing this company and the company seems undervalued to me. Should I wait for a lower price before I start my buying?

My usual response to this question is – Do you want to delay an informed decision based on an uninformed guess?

Lets think through this dilemma further. Lets assume you have been analyzing a company for some time and feel that the company is easily worth 100, but selling at 50. Now the company is a great buy, but due to the sentiments of pundits, your friends and your milkman, you ‘feel’ that the stock could go lower. As a result you are thinking of holding on a bit longer so that you can buy the stock at 40.

Now this is a very tempting thought. Who doesn’t want to buy a stock at the cheapest possible price? I can bet a lot of us have engaged in this mental gymnastic (I definitely have!).

The only problem with this approach is that it is a waste of time and energy and muddles up the decision making process.

Is it possible to predict stock prices?
The key underlying assumption behind the above thought process is that somehow we know the direction of the stock price. Let assume for a moment that is true. If that is the case, then why bother buying the stock? Go ahead and buy calls or puts on the stock and you will be rich.

It is quite possible that in extreme markets such as seen in the last quarter, the market is on a sustained downward trend and you strongly believe it will continue to do so. However this kind of sustained movement happens only a few times and market can turn around abruptly (There were no sirens in the first week of march when the market started turning and has jumped 50% from the lows).

If however you still have a very strong reason to believe that the stock price will keep dropping, is it not smarter to buy in small lots and average your cost down, rather than wait for the absolute bottom.

Combine technical analysis?
A lot of chartist and technical analyst claim to know the short-term direction and I have heard of people wanting to combine the two approaches. I personally don’t subscribe to it.

It is not due to the fact that technical analysis or charting does not work (I don’t have the skill or knowledge to evaluate that), but due to the fact that for a long term investor like me a 10 or 20% difference in the purchase price will not make as much difference to my end result as being accurate on the analysis of the stock.

If my thesis is right, I will make good returns and a 10-20% price difference will not make a huge difference. However if I am wrong on my analysis, a 10% discount will not save me. As a result, I would rather focus on analyzing the company in depth rather than try to time the stock precisely.

Am I perfect?
Now all this talk could give this false impression that I never get swayed by price and never try to time the stock. Far from it!! I have been guilty of trying to average down my cost several times and have missed the boat in that process.

As I have noted in the past, I typically build a 50-60% position in the beginning and then keep buying till I hit 100% of my position size. This works well in a falling market, but leaves me with a smaller position if the stock turns around quickly. I faced this with maruti suzuki recently. I started buying at around 500 levels and was able to build a 70% position. However the stock turned around suddenly and I remained ‘anchored’ to the 500 level and did not build a complete position. Luckily I did not repeat this mistake in the case of CRISIL.

So what should we do?
Simplify the process. I personally avoid looking a charts, tea leaves, pundit speak and blogger recommendations before making a final decision. I would try to seek out the facts, analyze the company in detail, and if I am confident that I am getting a bargain, I will go ahead and buy the stock. How does it matter if the stock gets 20% cheaper if my analysis is correct and the company is doing fine?

How about trading?
The above thought process does not hold true for trading. If you are chasing 10-20% returns over the short term then you may want to get the absolute bottom on a stock. Of course if your basic analysis is wrong then an unsuccessful trade can always become a long-term investment 🙂

Final question: How many of us are still waiting for our favourite stock to hit the feb-march lows before we go ahead and start buying?

About
Gujarat gas is a gas distribution company with a distribution network in south gujarat in cities such as surat, vapi, ankleshwar etc.

Gujarat gas supplies natural gas to Industrial, commerical and domestic customer in the above areas and has been expanding into CNG distribution in the same cities.

I have written on gujarat gas earlier here and uploaded a detailed analysis here

Performance 2008
The company reported a topline growth of around 7% and bottom line growth of around 5% inspite of volume de-growth due to supply shortage of gas.

The profitability numbers such as net profit margin has been maintained at 11.9%, ROE at 20%+ and the company continues to hold almost 360 Crs of cash on its books.

Q109 performance
The company had drop of around 20% in profit due to serious shortages of Gas again. It seems GAIL (their main supplier) has not been supplying as per earlier contract due to certain ‘Force majeure event’ (unforseen event). Due to the drop in volumes supplied, the company had a drop in topline and bottom line.

The company is now working to contract additional sources of gas to meet the expanding demand.

Attractive business model
As I have noted earlier on my blog, Gujarat gas has a very attractive business model. The company on account of its distribution network has a kind of monopoly in the areas it operates (Not a true monopoly as other companies can come in, but are not likely to). As a result the company, within the constraints of its contracts, can pass cost increases to its customers.

In addition, gujarat gas has free cash flow which greater than the net profits. This is due to the fact that the company can charge a deposit from a customer and gets to retain this money as long as it keeps the customer. In a growing business, this is an additional source of cash (interest free loan) which the company can use to expand the business.

In addition the company has a negative working capital position which continues to expand with the growth in the buisness. Companies like Lakshmi machine works (LMW) are able to generate cash from customer deposits and FMCG companies like levers etc have operated with negative working capital. Gujarat gas has a unique business model where is it able to generate additional cash flows from these two sources in addition to its own profit stream.

As a result of the above cash flow, the company can fund its own growth based on the money received from customers and suppliers

Looking forward
Gas is a supply constrained commodity and compares well with alternative sources of fuel. With the new gas finds coming online, gujarat gas should benefit and should be able to meet the demand of its customers.

In addition the company is expanding into new areas such dahej, hojiwala etc. These new markets and the growth in the existing markets should drive the topline and bottom line of the company.

Management
I have been following the company since 2003 and have found the management to be shareholder friendly. The management compensation seems to be fair. Although Gujarat gas is a subsidiary of BG (british gas), I have not seen any attempts till date on part of BG to cheat the minority shareholders (although one can never be 100% sure).

The management has executed extremely well in the last few years. They have transitioned well from a controlled gas pricing model (GAIL was the supplier and the price was below market rate) to an open market pricing model. In addition, the company has also been able to reduce the impact of the loss of transmission income and expand into new areas such as CNG distribution.

The management has been a good allocator of capital in the past as it invested in the business at high rates of seturn and been able to expand the business while maintaining the profitability levels.
Disclosure : I hold the stock.

I recently came across this article which highlighted some stocks which have jumped more than 100% in the last one month. Out of curiosity, I decided to do a quick analysis of some of these stocks to see if I may have picked any of these stocks based on the fundamentals and valuation. The analysis which follows has not been done in depth and is usually the quick check I do to reject or continue further research on the stock.

Essar Oil
The statement I check first is usually the balance sheet. Essar oil has a debt of almost 10000 Crores with a debt equity ratio of 1:5. In addition, the company has had losses in the last 3 of 5 years. The management also does not inspire confidence in this company. In a nutshell, the company and its fundamentals are too speculative for me.

Jai corp
The company has a very low debt level and seems to have raised considerable equity, to the tune of 2000 odd crs to fund the SEZ and real estate initiatives . Due to this high level of liquid cash, the company has considerable other income too. The income statement, net of this non core income, shows a profit margin of 6-7% (fy 2009).
Based on an expected turnover of around 400 Crs, the core operating profit after tax could be in the range of 25-30 Crs. Based on the above numbers, the company seems to be selling at a PE of around 40 (after netting cash from market cap and considering only the operating income).
The market is clearly pricing some of the new initiatives in the current price. It is quite possible the new initiative would do well and the current price could be a bargain. However evaluating SEZ and real estate initiatives is beyond my circle of competence and hence I avoid such types of ideas.

KLG systel
The company looks very cheap based on fundamentals selling at around 3-4 PE (based on Enterprise value). However I started with the analysis of the balance sheet and saw warrants being issued to promoters and some strategic investors at a price of around 351 when the market price was in excess of 400. The dilution was around 10-11% due to the warrants. In addition the company has also raised some usd 22 million through Foreign Currency Convertible Bonds.

My analysis of this company ends here. I am not interested in companies where the minority shareholder is diluted by preferentail allotment of warrants at prices lower than market price. If you think warrants in themselves are free, then by that logic call options which are similar to warrants should be free too. Have you seen any call options available for free in the stock market (especially with a strike price below current price?)

If the company needs capital, when why not have rights issue where all the existing shareholders get an equal opportunity ?

Selection criteria too strict ?
Should it be otherwise ? I typically hold 12-15 stocks in my core portfolio. A new idea should be of equal quality and better valuation for me to replace an existing one.

The above analysis was done in matter of a few hours. Unfortunately (or maybe fortunately) for me all the stars and planets and the rest of the stuff has to line up for me to start investigating the stock further. Even with all due diligence, I manage to get it wrong several times. I am definitely not stepping into those ideas where there are red flags or the company itself is out of my circle of competence.

I typically review the annual reports of my holdings to get a sense of how the business is doing and to recalculate changes in the intrinsic value.
Asian paints is a long term holding for me. I have not looked at the asian paints annual report for quite some time and hence decided to review the 2007-2008 report for the time being and to also compare it with the 9 month results (ending dec 2008).

Background
I have had a long and personal association with this company. I started my career with this company in mid 90s as a sales manager. I have held the stock of this company for almost 8-9 years now. Why the personal background ? – Consider it as additional information to discount my analysis as it is likely to be more baised than that for other companies.

I have worked with several other companies since then, and have also analysed a long list of companies . However my admiration for asian paints remains intact. The reasons for the admiration go beyond the mere fact that my work experience with them was great and have also been rewarded as a shareholder

A few key points (not apparent from the annual report)
– The company enjoys enormous competitive advantage in its business. It has a big mind share of the consumer, strong brands, great distribution network and finally good management.
– The company has a high amount of lockin at the dealer and painter level. I have personally witnessed how this works. Once the company achieves a high market share in a local market, it is difficult for any other company to move into that market. In addition, the dealer coloring machines add to this lockin (once the dealer invests in the coloring machine, he is unlikely to sell too much of competitor products)
– The company management has always been rational, focussed and shareholder friendly. Their compensation structure is rational, there is low related party transactions and the management has made good capital allocation decisions in the past (The ROE is now at 50%).

Annual report points
– The company has doubled the topline in the last 5 years and almost tripled its net profits during the same period.
– The ROE has gone up from 29% to around 50%, where as the debt: equity ratio has improved during this period too.
– The dividend levels have doubled in the last 5 years .
– The company continues to do well in the domestic market and continues to have a leading position in the decorative paints segment (which is almost 70% of the indian paints market). 2008 has however not been as good due to the slowdown in the economy and increase in the RM prices
– The international business had a turnaround in 2008 and has continued to grow well in 2009. The profitability of the international business has also improved susbtantially and was the reason why the company was able to reduce the drop in net profits in the current year.

Valuation – My personal estimate of intrinsic value is around 1200-1300 per share. The stock is available at a discount of 25-30% to its intrinsic value.

Q&A
– The company has done badly in 2008 due to the bad economy and 2009 looks bad too
True. The company’s business is cyclical to a small extent and the company’s revenue and profits have suffered in the past (to a small extent) during slow downs in the economy. However the competitive advantage of the company has always grown and now with the international business, the cyclicality of the company’s performance is also lower. If one is a long term investor and not too concerned with short term swings, then these ups and downs should not be much of a problem

– The company’s stock hasn’t done too well ?
It depends on the time period you are looking at. If one is looking at the last 6 months or 6 days then that may very well be the case. For the long term investor the company has returned almost 18% per annum (in the last 10 years) excluding dividends (which add to another 2-3%).

– This is such a dull company and dull business. They just have this 15-20% profit growth year after year …. I cannot double my money in a few months !!!
I personally love such dull businesses which give me good returns year after year. I don’t speak for others, but I personally think 18% returns per annum for a long period (10 years +) are extremely good returns and can make a person fairly well off in due course of time.

As always please read my disclaimer

I wrote about the nano launch and its impact on maruti suzuki recently. Interestingly, there were several comments on Tata motors and a few personal emails asking me about what I thought about the company.

I have cursorily looked at the company in the past and avoided it as it was too complex for me.

A few questions on my mind

– How will the nano do ? Will it be success or a millstone for the company ?
– How will Tata motors manage the JLR accquistion ? how successful will the integration be ?
– How will Tata motors manage its debt ? Will I face an equity dilution in the future ?
– How will the HCV/MCV and other products perform for the company ?

There may be more questions, but I can think of the above questions as of now. Now some of you may have answers for all of them, but for me these are diffcult questions and add to quite a bit of complexity to this investment idea.

In enginering exams (or any other exams), the tougher questions have more marks assigned to them. So if you want to do well, you have study and crack (or copy 🙂 ) these questions. Fortunately, investing is not like engineering exams. I will not make more money if I solve a diffcult problem. If I can find a simple to understand company, which is undervalued, with a few or maybe a single tough question to answer, I will make good money through that idea too.

A Buffett Quote
I am highly influenced on this point by the following quote by warren buffett

Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.

Whats my point ?
Why bother with a complex and diffcult to analyse company when there are simpler, easy ideas out there ?

Ofcourse, easy and diffcult is very subjective. A few of you may have an indepth understanding of Tata motors and may find it to be an easy problem to crack. In that case, you have an edge over the market and could make well-deserved gains on the stock.

Other topics
I was recently forwarded a link to this site – magicformulaindia.com by Jaishankar Panchapakesan . It is a good resource for investors. I have done the magic formulae calculation in the past manually using spreasheets and found it time consuming. So if he maintains the site on a regular basis, it should be a good tool

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The flavor of the month has been the launch of Nano by Tata motors. The Nano launch got an extremely wide coverage in media, which is something only Apple’s products are able to get.

My interest around the launch of Nano has been more in terms of the impact on Maruti suzuki. Maruti suzuki is a holding for me and I have analysed the company in the past ( see here and here ).

The percieved threat to Maruti from Nano has been known for quite sometime now. The reason I use the word percieved is due to the fact that I don’t consider this as an immediate threat, but a long term one. Let me explain

The product which is supposed to be impact by Nano is Maruti 800. However this model has been in a state of decline for the company for the last couple of years. In the year 2007, even before the launch, the product had volume decline of 10%+ and now accounts to barely 10% of the sales volume and must account for less than that in terms of profits (I don’t have the profit contribution for Maruti 800, but we can safely assume that the margins for this model are less than the higher end products). As a result, Maruti suzuki seems to be consciously moving out of the lower end of the market and the launch of nano could accelerate the process. Any further loss of volumes in Maruti 800 should not hurt the company much.

So much for the short term. What about the long term ? That is different story. For reference, let me point out the book – The innovators dilemma by Clayton M. Christensen, which talks in detail about disruptive technologies. I cannot explain the key concepts in a short post and would recommend reading the book or using this link.

The key point is that some companies introduce disruptive products at the low end of the market which meet only a subset of the requirements and cannot meet the requirements of majority of the users. These disruptive products or technologies are ignored by incumbents, as they are cheap, low margin and a threat to the current business model and products. However with the time the disruptive companies keep improving these cheap, disruptive products which then become good enough to threaten the mainstream products. A well know example – Personal computers.

Tata’s nano can be a disruptive product in the long term. As of now, this product will not threaten Maruti suzuki and other companies or their profits. But if Tata motors gets it strategy right and keeps improving the product, then they could be a major threat to the other companies.

It is however not a given that the above will happen. It will depend on how the other car companies react. However irrespective of the response, if the Nano is successful, it will affect the profitability of most of the car companies in the long run. I would recommend reading – Clayton M. Christensen’s books to understand how this has typically played out in other industries and you will appreciate how the same could happen in the car industry.

All of the above is still in the future. For the time being, everything is bright and sunny and investors like me in maruti suzuki are not complaining. However, due to the above market dynamics I do not plan to hold the stock for more than a few years (yes my concept of long term is more than a few months 🙂 ).

I recently read the news on suspending AS11 accounting standards for the next 2 years in view of the dramatic changes in international markets. In the last one year, the rupee has suddenly depreciated from 40s level to 50s declining by more than 20% during this period. Most of the companies were caught by surprise as they did not expect the rupee to depreciate so sharply and hence are facing MTM (mark to market) losses for the current year.

AS11 is a standard for recognizing impact of forex changes on the company’s accounts. I have the discussed impact of forex changes in my discussion of NIIT tech. I have said the following in the past

The current quarter results show a bottom line drop of around 50%, mainly due to forex losses. I do not consider them as core losses (just as forex gains are not permanent gains). I have seen a lot of people get all worked up about forex losses, which does not make sense to me.
Unless the company is speculating on forex (via non effective hedges), I think the forex gains and losses should even out over the period of few years and hence one should be concentrating on the core profits to value the company.
As an example look at the results of the airlines such as southwest (in the US). Southwest airlines has been consistently profitable for the last 20+ years. They have had 2-3 quarters of hedging related losses due to oil price volatility. Do you think they have a problem in their core operations?

So if I have considered these losses to be temporary, akin to a bad bet, then why am I not applauding this temporary suspension of the standards?

The reason is simple – I want my companies to give me the true picture. Don’t fudge, whitewash or hide information from me (as an investor). Please tell me the whole truth and leave it to me to judge the impact of it. As investors we are smart enough (as a group) to judge the impact of forex changes on the long term economics of the companies and don’t need the companies to whitewash this information for me.

Now that we are in the territory of fantasy accounting, I have a few more proposals

– Ignore cost increases of raw material when they become too high. When steel prices increase sharply, all auto and other companies should be allowed to ignore price increases
– Ignore manpower costs and salary hikes. Allow all IT companies to ignore salary hikes in excess of 5%.
– Ignore depreciation after a huge capex. Whenever the company puts up a new plant or makes a big accquisition, allow it to ignore depreciation and amortization expenses

I could go on and on. The above change is self serving and will only muddy up the numbers. It allows the companies to present the numbers in a good light and ignore reality. Is it a given that the rupee will appreciate to 40s level in 2 years and all will be great in the fantasy land?

I personally don’t care what companies report by suspending AR 11 for 2 years. I will personally adjust the numbers of the companies I have invested in or plan to, based on the forex changes.

I really wish I had this flexibility when I was studying !! I would have asked the examiners to ignore all the question I got wrong and I would have always got 100% in all my exams 🙂 . Life would have been good !!

I am mad ! very very mad. See this news item on novartis india.

Novartis AG has announced an open offer for Rs 351 per share with the aim of taking their shareholding to 90%. Although they have not stated any plans for delisting, I think once the shareholding reaches 90%, delisting norms could kick in and the rest of the shareholders will be forced to exit the company.

Why am I mad ? See my analysis of novartis here. My conservative estimate of the intrinsic value is around 600-650 (company has a cash of almost 150 rs/ share). Look at it this way – Net of cash, the buy back offer is valuing the company at 800 crs. This is for a company making almost 100 Crs of profit on a capital base of around 30-40 Crs !!

Another view point – The buyback offer will cost the company around 440 Crs. The company has cash and equivalents of around 435 Crs as of december 2008. So the Parent company will be able to increase its holding to 90% without spending a penny from their pocket !!

Should I feel cheated ? May be not. I have known this modus operandi for some time. A lot of MNC’s have cheated their minority shareholders this way. The steps are as follows

– Allow the performance of the company to stagnate for a few years by avoiding product launches and anything else which enhances value
– Hold all the surplus cash during this time period.
– Wait for a bear market to drive your price down to very low levels.
– Announce an open offer at premium to current price, utilising the cash holding
– Try to mask this operation as a shareholder friendly operation by pointing out that the price is at premium to the current price (which is way below intrinsic value).

I have known and written the above earlier on my blog. I have however chosen to ignore my own advice though and would now be paying for it. At the current price, net of dividends, I have made modest returns. However that is not the point – The point is being treated fairly by the management of your company.

Another case – Ingersoll rand : They have announced their intention of coming out with an open offer too. I am not holding my breath on that as they have tried a similar tatic in the past, but were not successful in completing the buyback.

Lesson for me : Management matters more than i would like to accept. A good business with bad management will translate to poor returns.

What next ?
I am going to wait and watch how this open offer will play out. However even if the minority shareholders reject it, don’t expect the management to change or mend their ways. They will continue to ignore the minority shareholder, give poor dividends and will continue to accumulate cash. The best startegy in such a case would be to exit the stock and deploy the capital somewhere else.