AuthorRohit Chauhan

Have you been hoping for a quick rebound and a re-start of the bull market? I would not hold my breath on that. No one knows when the market will rebound. Those who claim to know are guessing. If you need a forecast fix on when the rebound will start, let me give you one – 11:22 am, 22 April 2009.

If the above forecast comes out to be false, I will just keep mum and issue a new forecast.

If the above guess turns to be correct, expect a banner on the blog proclaiming my brilliance and infinite wisdom (hail rohit !!). I will start issuing regular forecasts after that and will charge you for it.

Now this would be an easy way to make money, as long as I can find enough suckers …sorry ‘investors’ for it.

So are you willing to sign up for my hourly, daily, weekly, quarterly and annual forecasts? If you sign up today, I will give you a special 20% discount and throw in two extra forecasts, absolutely free !!!.

Moving the feed account

The feed to this blog is on feed burner (see here to understand what is a feed). Google (which owns feedburner) is moving all feedburner accounts to google accounts.

I am planning to move my account to google too. Hopefully it should be a non event. However in the event, there is some technical glitch and you do not receive an update in 3-4 days, I would request you to check the blog and leave a comment for me. Being a super duper tech whiz, I will immediately get down to fixing it :).

In case you are new to the blog or have not subscribed to the blog, you can use this link to subscribe to my blog. you could all the juicy forecasts in your mailbox 🙂

I was recently referred to an article by Prof. Bakshi (read here). Prof bakshi has written about a few companies which seems to be cash bargains (selling less than cash on the books), but are suspect due to their accounting and corporate governance.

Readers of this blog would be aware that I have a bias for companies with low debt and high cash on books. I do not get excited by growth as high growth companies are usually fairly valued or overvalued. However slow to moderately growing companies with a solid business model are frequently undervalued. Excess cash on the book only adds to the attractiveness of these companies.

Low debt and cash on books is usually a good thing, but excess cash holdings for long periods of time are not good for shareholders. It usually signifies that the management is allocating capital poorly and in absence of high return opportunities is letting the cash idle. This is ofcourse better than spending the cash on stupid acquisitions. However a shareholder friendly management should return the cash through dividends or buybacks.

The above holds true if the cash is actually present. After the satyam episode, one cannot be completely sure of that. I have always looked at the management quality and corporate governance of a company in the past, before committing my money to it. It is easy to identify cases of bad (see aftek here, which the prof has also referred to in his article) or good governance. The problem is identifying managements which are not good, but not overtly bad. The bigger problem is identifying complete frauds, where the !@## (put your choice of expletive) auditors are hand in glove with the management.

There are books, which discuss this topic (of financial fraud) in detail (see here). There are no clear-cut formulae to identify aggressive or fraudulent accounting. A deep understanding of accounting and experience, will throw up red flags when one is reading and analyzing the annual report of a company. A single red flag may not be a cause for concern, but several of them together should alert you. I will be covering some of these red flags in a future post.

Let me come back to another example in the article – HTMT global. I have discussed about the company in the past and have a small holding in the company (it is part of my diversified graham styled portfolio). The key reasons for my investment are – cash on books higher than the market cap, decent topline and bottom line growth and ultra cheap valuation. However the negative on the stock is corporate governance. As indicated in the article, the cash is held in a subsidiary in Mauritius.

The CFO indicated in the analyst meet that the cash is being held to avoid the 30% tax and for acquisitions. During the analysis of the company, I read this explanation (I was searching for it) and found it plausible. However on reading, prof bakshi’s article I was disappointed to read this

HTMT has deposited cash in Mauritius. When asked about keeping its money outside India, Anand Vora, CFO, said: “We have been getting a lot of queries, because PwC is our auditors and have a considerable amount of cash on our books. We don’t want to comment till we get a clearance from our legal team. So, while your questions (on overseas accounts and account balance and cash on books) may not be very sensitive issues, we will still like our legal team to go through it.”

There are two red flags in the above statement : PWC and the reluctance of the CFO to give a straight response. If you have cash on the books, why do you need the legal team to go through it?

Does the above mean that the cash does not exist? Should one exit the stock? To be honest, I don’t have an answer for that. If one cannot trust the management and the auditors to tell the truth, then it is not possible to invest in a company. The entire financial system depends on this trust. No one will invest, if the management and auditors cannot be trusted to tell you the truth.

So where do we go from here? For starters I am reviewing all my holding to check their cash holdings closely and tie it with the interest income. I have checked these numbers in the past, but with only a passing interest. I will however be looking at these numbers far more closely now.

In addition, though I have focused on corporate governance in the past and rejected several ideas for my core portfolio, I have been more tolerant in my graham styled portfolio. I plan to give more wieghtage to this factor in my stock picks in the future. I have purchased companies, which are statistically cheap, even if they are not upto the mark in corporate governance. I plan to put more wieghtage on this factor going forward.

I am still thinking about HTMT and have not decided yet. However my comfort levels have dropped a lot with this company and my gut feel is not good (yes, I listen to my gut feeling ..ignoring it in the past has been costly). I may decide to exit the company even if I have to take a small loss. This may be an over-reaction to the satyam episode as there is still no factual basis to distrust the company. However there should be no tolerance on corporate governance and transparency. In the end i would rather err on the side of caution than repent later.

Added note : I just glanced at Satyam’s annual report. The company reported 3300+ crs of cash with scheduled banks and an interest income of 270 Crs. The scheduled banks seem to be bank of baroda, BNP, citibank, HDFC, HSBC and ICICI bank. How the hell did the auditors certify the cash if the management says all this cash was fictitious ? If this news report is true, then one could derive comfort that the statements were not fraudulent and the cash was actually siphoned out.

About
Ingersoll Rand (india) is a subsidiary of Ingersoll rand (US) with a 75% holding of the parent company. The main business (after all the disposals) of the company is air solutions – mainly compressors and other instruments such as air dryers, filters, after-coolers, receivers, water separators, etc.

Financials
The company has been disposed off three businesses in the last 3 years. This includes the road development, utility equipment, Bobcat business and climate control business. The company has realised a pre-tax profit of almost 217 crs in the last 3 years.
Due to the above developments, the topline of the company is not comparable across the years. The remaining business – airsolutions seems to be growing at double digits for the last few years. The net margins of the company has improved to almost 10% (which could be cylical high) and the ROE has leaped from a good 20%+ to 70%+ number (net of surplus cash on the balance sheet).
The improvement in the ROE has come via improvement in margins and asset turns (both inventory and recievables ratios have shown improvements in the last 4 years).

Positives
The company’s balance sheet looks extremely good. Almost 80% of the balance is cash and equivalents. Part of this cash is from the sale of the various businesses and rest has come from the free cash flow of the business. The core business of the company is throwing off a good amount of cash with low Capex requirements.
The company has become more efficient via a combination of improvement in margins (which may drop) and improvement in various ratios (due to improvement of efficiencies).
The air solutions business has been showing decent growth in the last few years. This growth may slow down in the short to medium term, but should remain good over the long term. In addition the valuations of the company are very attractive. The business is selling for 1-2 times the current years earnings (excluding cash).

Risks
The business risk seem to be low. There are 3-4 competitors in this business like Elgi equipment, Atlas copco etc. However the level of competition has not been intense. However with such high growth rates and returns, foreign competition is being expected. This may result in lower returns and low growth in the future. The valuation however discounts this and more currently.

There are several risks for the minority shareholders. The key risk in my opinion is that the company is a 75% subsidairy of an MNC. The parent company has an unlisted company in india and there is a clear conflict of interest. My personal experience with such type of situations has been bad. The minority shareholders in such cases have suffered from poor governance, poor utilization of excess cash (cash continues to lie in the balance sheet with no clear plans) and no special focus from the parent company. In some cases the parent has bought out the minority holders at an unfair price.

In addition, the Annual report is sketchy in terms of the future plans for the business and how the excess capital will be utilized.

Competitive analysis
The main competitors of Ingersoll Rand are Atlas Copco and Elgi equipment. Atlas Copco is twice the size of Ingersoll rand and Elgi equipment is roughly the same size as Ingersoll rand. The various financial parameters such as Net margins, ROE, Sales etc are similar for Elgi and Ingersoll rand. Ingersoll rand is slightly cheaper than Elgi equipment. However the elgi management seems more focussed on the growth of the business (as atleast they are more articulate about it) and have aggressive growth plans for the domestic and international markets, so that may explain the difference in the valuations.
By various measures even Elgi equipment seems to be cheap and it can be preferred over Ingersoll on qualitative parameters
Atlas copco has similar margins (10%), higher turnover (twice) and lower efficiency ratios (ROE of around 20%) . The valuation for Atlas is however much higher than the other two companies and can be used as a reference point for comparitive valuation

Valuation
The company net of cash is selling at 1-2 times of the free cash flow. At the current rate, the business would be a cash bargain in the next 1-2 years. From a pure, numbers point of view, the stock is undervalued by a decent margin.

Conclusion
The company looks cheap and undervalued by quantitative measures. The core business is growing and should pick up steam once the economy recovers. However there are quite a few small things, which make me uncomfortable from a subjective standpoint. The management has no interest in communicating with minority shareholders (who are less than 25%) on the future plans for the business, the cash holding etc.

In addition the parent has an unlisted subsidiary, which is generally not a good thing for the indian shareholder. If I were to consider this company, it would be part of my graham style portfolio and not the core due to above issues.

Additional point: I did this analysis before the satyam issue. There is no change in my analysis due to the above incident. Having cash on the balance is not a red flag for fraud. One cannot invest based on the assumption that all companies are committing a fraud, unless proven otherwise.

Please read disclaimer

update 9-Jan
When it rains, it pours ! for satyam it is pouring bad news.
I am reminded of buffett’s comment – There is never a single cockroach in the kitchen.

There are no suitors coming up. Who wants to be associated with a tainted brand ! The value of an IT company comes from three sources – its brand/ reputation, customer relationship and employees. The brand/ reputation is the foremost and a damage to this asset can destroy the other two.

Satyam, with a new board may be able to rebuild the company (though not to its former glory) partly. However the company is facing a cash crunch and if it is not able to get cash for operations, then it could be in serious trouble. Getting a loan is not going to be easy, if the books have been cooked and the banks cannot trust your accounts.

Once clients feel there is a risk, they may press the panic button too. It is not easy to change a vendor, but i will not be surprised if clients have not started working out a contigency plan.

Finally, this episode will impact Indian IT in the long run. Do you think clients will trust other companies as easily as they have in the past ? With Indian companies vying with IBM and the likes for billion dollar deals, trust and faith is far more important. This episode is going to make life diffcult for all the vendors.

——————————————————————————————————–

A few days back, I wrote about corporate governance in Indian companies. I hardly expected this – a full fledged fraud at satyam. I was shocked to say the least. Satyam is not a fly by night operator. There were some concerns on the coporate governance (forget the peacock or whatever ‘bird’ award), but what has come out is not some corporate governance lapse, but outright cooking of the books.

Bad intentions
I personally have no idea of the intentions of the management. However from the letter and from what I have seen in the past on such incidents, is that the start of such a fraud is small and not with malice. The management typically is not able to meet the numbers and fudges the numbers a bit to meet the targets with the hope that they will be able to cover the gap in subsequent quarters. However the gap does not get covered and the management resorts to even more manipulation to meet the numbers till finally they hole is too big to cover. This happened with Enron, worldcom and several other companies during the dotcom bubble in the US.

Bankruptcy
Is satyam headed for bankruptcy ? I don’t think so. This is not a bank where there could be a run on the company. That said, there is more pain ahead and the critical thing to watch over the next few quarters would be how the company manages its customer relationships and employees, which are the bigger assets than the cash on the balance sheet.

Possible to know before hand ?
I received a comment on how to calculate the value of the company if the numbers cannot be trusted ? My response is – you cannot. The entire basis of investing is ‘trust’. When you invest your money in a company, you trust that the management is honest and presenting the true picture. You trust the auditors to be doing their job when they certify the accounts. Clearly both the management and the auditors blew it at satyam.

You can expect articles to come out on how it was evident that something was wrong at satyam. I would say that is complete bullshit. I have not analysed the satyam annual reports till date and plan to do so now to see if it was possible to know the fraud before hand. Most of the times there are red flags on aggressive accounting which would give you a clue that something is not right. You can use these red flags to stay away from the company. However it is very difficult to detect fraud from the public filings such as annual and quarterly reports.

What now?
Such incidents are not unique to India. They have happened in other countries around the world. What is different is the kind of punishment for such a fraud. In the US, the CEO of Enron was sentenced to 24 years in jail. The US law is very strict with white collar crime and gives out harsh punishment for such crime.

In india, I doubt much will happen. We treat white collar crime as no crime. This incident is going to cast a major shadow on all indian companies. If satyam could fudge cash of 5000 crs+, what about all the smaller mid and micro cap companies which have some unknown auditors and a weak to non-existent board.

I hope investors now demand tranparency from companies and vote with their feet (sell !) if the management is not transparent.

Lesson for us
As an investor I can think of two ways to handle such an eventuality – avoid companies where corporate governance is suspect and diversify.

This is a complete tragedy, especially for the 53000+ employees who have worked for years with the company and now face this for no fault of theirs.

I think most of you must be aware of what has been happening with satyam lately. I will not go over the details as you can find it on the net easily.

The key events seem to be
– Satyam decided to buy out Maytas infra using the surplus cash on it balance sheet. The logic provided was that the company was trying to de-risk its IT business and diversify
– The market did not like the deal due to the conflict of interest (Maytas is owned by the same management)
– The stock price of Satyam crashed even after the deal was cancelled
– The Rajus (promoters) had pledged their shares against loans taken by them. Due to the price drop, they got into a margin situation and some of their holdings were sold off.
– This drop in the holding has created an interesting situation as the Promoters held around 8% of the stock earlier which may have dropped further. This has put the company into play and there seem to be several other IT companies/ PE players, which are interested in satyam now.

I have been surprised by the above turn of events. However, i am not a bit surprised by the corporate governance fiasco. Does anyone think that this incident was an exception?

I have been reading and analyzing companies for the last 9 years. I can safely bet that almost 90% of the Indian companies have corporate governance issue. One has to search for companies, which are shareholder friendly. There are issues like huge cross holdings, excessive compensation, poor disclosure, diversion of surplus cash to other promoter firms and in some cases pure apathy where the management just sits on the cash and does nothing with it.

These problems are not limited to Indian managements. MNC’s are worse than Indian companies in this respect. Most MNCs have unlisted subsidiaries which are used to launch new products, whereas the listed subsidiary is allowed to just stagnate. Some of these listed subs have huge cash holdings with no clear plans for the cash. In several cases after allowing the listed sub to stagnate, the parent has come out with a buy back offer at a price which is above the quoted price (but way lower than the intrinsic value). I think that is daylight robbery.

The annual reports of most MNC subs and Indian companies are a joke. There is minimal management discussion and analysis of performance. The disclosures are limited to whatever is mandatory. In some cases the companies don’t even care to post their Annual reports and quarterly statements on their website.

I could go on and on, but the key point is that corporate governance in India is very poor. It reflects our overall psyche. People in power, be it politicians or promoters care two hoots about others. The typical promoters thinks that the company is their personal fiefdom and they treat it as such.

The difference this time around has been that Satyam was listed in the US and has large FII and foreign holdings. These investors are not as apathetic as Indian shareholders and reacted negatively to this incident.

Such corporate governance issues happen in foreign markets too. However these markets have more active investors and thriving M&A market. If the market reacts negatively to the company’s performance or its governance practices, the company is put in play. An undervalued company then becomes a target for buyout or takeover. This threat keeps the management in check.

I personally don’t expect much to change after this incident. Our security laws are weak and managements can get away with anything. There is very weak market for hostile takeovers in India and as a result even if the company is undervalued, you will not find too many takeover bids.

There are a lot of undervalued companies in India (i hold several of them). In the US, a value investor can count on a hostile takeover to eliminate the undervaluation, if the management does nothing about it. I don’t expect it to happen in India.

As an investor my approach is to identify companies, which are undervalued and are a bit shareholder friendly (or atleast are not bent on stiffing the minority shareholder). I have given less wieghtage to corporate governance and management quality in the past. Although quality of management is a subjective issue and cannot be analysed with precision, I plan to pay more attention to this factor in the future.

Now this is one cheerful post to start the new year 🙂

Wish you all a very happy and prosperous new year. Thank you all for visiting and reading this blog.

Let me tell you a short story : There was once a smart young guy who like all of us was a charming, intelligent and hard working fellow (please replace guy with gal – for the ladies reading this blog). Now this guy, like others knew that the stock market is the place to invest your money if you want to get a good return. So he would occasionally dabble in the stock market and would make a few bucks here and there, nothing serious though.

One day our friend was relaxing at home, watching CNBC, where a smart confident looking analyst recommended the stock of a hot upcoming company (lets call the company longshot). The analyst was extremely bullish and was going ga-ga over the prospects of the company. This was a hot company in a hot sector (hot – hot !!). The company had increased its profits by 5 times in the last 3 years and was growing rapidly. The promoters were confident that sky was the limit and they would be the next infosys of their industry.

Our friend on hearing this tip was intrigued. He decided to call his friends and his broker to find out more (research !). His broker was ofcourse estactic about the company and his friend (who was a budding investor himself ) was also very positive. So having received two solid recommendations, our friend decided to invest 100000 (20% of his networth) in the company.

Fast forward 2 months : The company’s stock rose 4 times during this period. Our friend was completely delerious. He felt like a winner now. Ever since he bought this stock, he was following it closely. He would read every article on the company, every interview by the CEO. He was even participating on various stock forums where are almost everyone was more than 100% sure that the company would do very well. There were a few morons, who kept pointing to the high valuations, but then what would they know !.

The company had been reporting rising profits for the last 10 quarters and the next quarter was expected to be great. Our friend was giddy with excitement. He dreamt of the stock going up still further (everyone believed that !).

Fast forward 6 months : No one saw it coming. The company report good profits, slightly below expectations, but still good profits. The market reacted strangely to this news. The stock dropped 20% !!. Our friend was surprised. However he was re-assured by his friends and fellow investors on the stock forum that this was just a temporary reaction and the management and other analysts believed the same thing.

A few morons again pointed out that the valuation was too high, but they were abused and kicked out of the stock forum (sheesh !! what spoilsports ..our friend thought).

Fast forward 3 months : The company reported profits below forecast. They still reported a good growth, but below forecast. They however reduced the outlook for the next year as recessionary conditions had reduced the order inflow. Once this news came out the stock tanked by 50%.

Our friend was still up by 60%. However he was surprised by the sudden drop in the stock. How could the stock drop so rapidly ? He felt regret that he had not sold when the stock was at its peak. Now the stock had dropped almost 60% from that level. There was no point selling now …so he held on

Present day : The bad news kept flowing in. The stock dropped another 50% and was now below his cost. Our friend was angry with the analysts and the management who misled him. He was feeling cheated. He still visits the stock forum and is now looking for the next PRIL or L&T or infosys (or whatever you can think of)

End of story

I am currently reading a book ‘your money and your brain – the science of neuroeconomics’. It is a great book on the behavioural aspects of investing. I have not written much on emotions and behavioural aspects of investing on my blog. However I think these aspects of investing are equally if not more important than the analytical aspects.

The above story is something which a few of us have gone through or seen others go through. Some will learn the right lessons from it, whereas others will keep their head in the sand and blame others for their losses.

There are several behavioural baises in the above story which I will discuss in the rest of the post.

tendency to consider gain, but ignore the probability of gain
social proof bias
hindsight bais
commitment and consistency tendency bias
predicition bias
pattern seeking bias

Let me go through each of the above now

tendency to consider gain, but ignore the probability of gain : The book mentioned above discusses this bias in detail. I have know about this bais, but when I read about it in the book, it was like a light bulb going on. Humans have a tendency to over wiegh the gain, but tend to underwiegh the probability of gain. This tendency explains why people buy lotteries. The odds of winning the lottery are very low, but the likely gain is very high. An odd of 1 in 10 million cannot be ‘felt’. However a gain of 10 million is vivid. You can imagine all the stuff you can buy with it.

This bias explains why people go for long shots in investing even if the valuation (or odds) is high. The gain appears tangible, but the low probability does not register. This is also the reason why people are looking for the next infosys or the next L&T or PRIL etc. What most people forget is that the odds of finding one is low (would you have predicted that infosys would do as well in 1993 ? the promoters could not !). This bias explains why our friend is still looking for the next longshot.

social proof bias : If others are recommending the stock, then I must be correct. As the above book and countless other books on the same topic have stated – Humans are social creatures and like to stay with the crowd. You don’t want to stand away from the crowd and be proven wrong. Easier to buy a hot stock and be proven wrong, than buy a beaten up stock that no one likes.This bias explains why our friend felt comfortable with the company when others were recommending it.

Hindsight bais : This is the tendency to believe that you always knew the outcome after it has occurred. The book explains this bias very well. You will find a lot of pundits saying that the stock was bound to drop (or rise) after it has done so. What they don’t tell you is that they did not have this insight before the event happened. One of the key reasons for writing an investment thesis and publishing on this blog is to avoid this bais. I am no different than others and could easily fool myself that I always knew what was bound to happen.

Commitment and consistency bias : Once you make a commitment (especially public), you have tendency to be consistent with it. No one likes a person who changes his mind and is not ‘faithful’. Our friend bought the stock, committed to it and hence could not bring himself to selling it when the fundamentals turned bad. I personally try to avoid this bias by publicly not committing to buying or selling a stock on the blog. I prefer to publish the analysis and leave it to the readers to take their decision

Predicition bias – The book explains this bias in a lot of detail. Humans have a bias to predict events. If you toss coins in front them, there is an automatic tendency to predict the next toss even if they know it is random. There is a deep biological basis behind it (too lengthy for me to go into). All of us suffer from it and it seems to be a sub-conscious tendency. This bias explains why people are continously tryind predict price movements in the stock market even though they are random. This bias also explains the attraction for technical analysis.

Pattern seeking bais – This bais also has a biological basis and closely linked to the previous bais. All humans try to find patterns, even in random data. It is an inbuilt tendency and an automatic one. The book (your money and your brain) goes into detail and explains it fairly well. This bias explains why people on seeing 4 quarter of rising earnings or 3 weeks of rising prices seem to find a pattern in it and predict that the next quarter or price will be higher than the previous one. Our friend with others was suffering from the same bias and assumed blindly that the earnings and the stock price will continue to rise.

There are several other such biases which I will cover in future posts. I personally think all of us suffer from these biases (less or more) and the difference between a successful and average investor is that the successful ones are able to reduce or compensate for these baises.

These biases are not weakness. These tendencies come from the human evolution and served us well in the past and continue to do so. If some one yelled fire and everyone started running away from it, would it be smart to be a contrarian to run towards it ? The worst that can happen if you follow the crowd (social proof) is that everyone will look foolish if there was no fire. But if everyone is correct and you go against the crowd, you may pay with your life.

These biases however work against us in the financial markets. They cannot be compensated easily. I have been reading on them (see this article by charlie munger on it) for the last few years and know several times that I am operating under their influence, but can still not avoid acting otherwise. The bigger problem is when you don’t even know that you are operating under their influence and they are hurting you.

Now if believe you are above all these influences and it is others who suffer from them, then you are suffering from another bias – where almost all individuals think that they are better than the average. The book gives example of several experiments which were done to demonstarte this bias. Most investors, drivers etc feel that their skills are superior than the average (even if the evidence is to the contrary).

I personally operate with the assumption that I am influenced by all these biases and instead of ignoring them, I should be focussing my effort on reducing their impact.