AuthorRohit Chauhan

Correction to the post : valuation – reverse engineering the stock price

By Rohit Chauhan
In Uncategorized
February 20, 2008
3 Min read
4 comments
C

There was an error in the analysis of crisil in the post . I had looked at the standalone numbers only and not the consolidated numbers (as an anonymous reader has pointed out in the comments)

So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.

That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.

The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock

Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.

I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).

Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him 🙂

Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post

“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.

I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book – dhandho investor.

Following article from mohnish explains the key point of the post – A good company may not be a good stock and vice versa in a great (and much better) way.

Valuation by intrinsic value.

In addition you can find the links for a lot of mohnish’s articles here. I strongly recommend reading each article

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Some Interesting ideas

By Rohit Chauhan
In Investment ideas, Uncategorized
February 14, 2008
1 Min read
45 comments
S

I am analysing some of the following stocks in detail as these stock have passed my initial filters

Concor
Balmer Lawrie
GSK Smithline consumer

Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.

In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.

In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books

More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman

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Using puts to reduce cost basis

By Rohit Chauhan
In Portfolio management, Uncategorized
February 11, 2008
2 Min read
6 comments
U

A thought experiment –
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.

If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).

The key objections to this strategy could be

· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases

A few other cases

· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)

I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.

Please feel free to comment on the above strategy or any better ones you may have tried.

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Futures, Options and hedging

By Rohit Chauhan
In Portfolio management, Uncategorized
February 6, 2008
4 Min read
9 comments
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If your first thought is – Options and value investing …what a combination? You are not alone. You will rarely find discussions on options and derivatives in books and articles on value investing. But then just because most value investors don’t talk about options, does not mean one should not even try to understand them.

That said, let me clarify – I am not an expert, heck not even a novice on options. I have read a few books on options and derivatives, bought a few here and there. However I am planning to read up more on options and understand them better – it would improve my understanding of probability.

Most of the discussions I have seen on options is around the strike price. A lot of investors look at options as leveraged bets on the stock price. It goes like this – Lets assume I am bullish on L&T (who isn’t 🙂 !).

The current price is around 2500 (for argument sake). I expect it to rise by 20% in the next 6 months. So instead of investing 250000 and making 20% on that, I can invest buy 2500 contracts (for argument sake each contract is 100 Rs) and if the prices increases by 20%, then each contract is worth 500 Rs ( 2500*1.2- 2500). So I have made 5 times my investment. So I have leveraged my bet. The downside is that if price drops, I am out of the entire 250000

The above math is not accurate, but depicts the basic argument. The problem is that short of having a crystal ball, it is difficult to know what the future price would be. In addition to getting the price right, I need to get the timing right. If the contract expires in 6 months and the rise increases after that, I may be right but still lose money. Finally I am not sure how profitable this strategy is in the long term (net of all profits and losses) as one keeps losing money often and makes money in chunks a few times.

I think value investing principles, not in its traditional sense, are still relevant when investing in futures and options. Let me explain –

Options pricing is generally dependent on the following variables
– strike price
– time for expiration
– Interest rates
– Volatility

Value investing is about find undervalued securities which can include options. That would mean figuring out the option pricing based on the above variables and comparing it with the market prices. If the market prices are lower than the actual price, then it makes sense to buy the options. I have read about it, but have never tried it myself. In addition I think the options pricing is far more efficient and hence it is not easy to make money this way.

The second approach would be to look at options to help in hedging my portfolio. For example if I plan to sell part of my portfolio in the next couple of months as they seem to overvalued, I would like to buy put options to hedge those specific stocks. This however works only for specific stocks and is not useful as a general strategy.

The last approach is to buy long term call/put options on stocks which I think are undervalued. That would be equivalent of making a leveraged long term bet on a stock. However it suffers from the same, time related disadvantage I discussed earlier and also from the lack of such options in the Indian market (not sure if we have these options at all)

In summary I see options currently as an insurance against market crashes. However due the cost factor I need to still figure out if it is profitable to protect the portfolio against such crashes in the long term.

Ps: I would appreciate if anyone can suggest some good books on options and option pricing etc.

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Seesaw markets,my plans, a good book and market crisis

By Rohit Chauhan
In Uncategorized
February 1, 2008
3 Min read
4 comments
S

The month of jan was a complete rollcoaster. Initially the market shotup, then crashed and now seems to go one step forward and one step backward.

One could have made a killing shorting the market or by buying puts. I however did none of that. I personally need to do more homework in that area to venture into it. However I do see puts as a decent option to hedge the portfolio. The part I still need to work out is this –

Most options expire worthless. The reason is that the options market is fairly efficient, definitely more than straight equity. So is it possible to buy puts over the long term, make money a few times only and still have a decent return after all the costs ?

Some of my own holdings, some of which I have discussed (and some not), have declined below 50% of intrinsic value. Earlier I would get mixed feeling – pained by the decline and excited by the opportunity to buy more. Now I get more excited than pained. I however try to re-analyse the position and check if I have missed something which the market is discounting. In the past my key mistake was not putting more money into such ideas – Blue star, concor, Pidilite etc.

I just finished reading the book – A demon of our own design. I am not going ga ga over it. However it is a good book. This book came out 6-8 months back and is fairly presceint of the current subprime crisis. The book discusses the past crises like the 1987 US market crash and the LTCM collapse. One key point the author makes is that the main cause of the market crises is tight coupling and complexity.

Complexity in the markets is mainly due to the complex instruments such as CDO, derivatives etc which very few understand. In addition these instruments are non linear and it is diffcult to model them. That’s why a lot of the companies holding these instruments are not able to compute their value and appear clueless. By tight coupling the author means is refering to the linkages between companies and markets. That is easy to see even in India. 10 years back a subprime crisis would not have affected the Indian markets. However inspite of no direct exposure, indirect linkages via hedge funds and FII are causing these wild swings in the market. All in all a decent book.

I am a big fan of warren buffett and have read his annual reports several times. He purchased a company called GenRe in 1999 and wound down their derivative operations over 3-4 years. This was done during normal times and by one of the smartest investors around. Inspite of that the company took 400Mn or higher writedowns. Buffett noted in his letter then (2002 I think) that inspite of such orderly and planned unwinding, they faced such losses for such a small derivative operation. The larger banks (read citi, JP morgan and others) may face much higher losses if they have to unwind their derivatives during a market crisis (now).

So personally I think market problems are far from over and we may get more buying opportunities in the future. Will the market crash or will it be a bear market?? ..i don’t know. Either way I think it would be good to keep some cash around to take advantage of opportunities as they come up.

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Valuation – some more thoughts

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
January 28, 2008
2 Min read
3 comments
V

I covered my approach to estimating the appropriate PE for a stock and reverse engineering the current valuations in the previous posts. This is ofcourse not the approach taken by analysts. The typical approach is to look at the past history and decide on the likely earnings (and not even free cash flow). If the analyst is optimisitic he slaps on a high PE and voila ..we have the price target. To support the argument, the analyst does a comparison with other companies in the sector and tries to justify the PE. So we may have an optimisitic earnings estimate and on top of that a high PE attached to it, which would amount to double counting.

That is an incomplete approach. If the sector is in a bull run or has very high valuation then you are committing the same mistake twice. First assuming an optimistic estimate of earnings and then applying a high PE. Don’t believe me ? …well several IT companies sold for a PE of 100 in 2000 and real estate and capital goods companies sell for similar high valuations. Average PE for IT companies is now below 20 and mid caps in IT sometimes sell for less than 10 times.

This brings me to some interesting observations which you can derieve from this table below

For a company to justify a PE of 30+ the following has to happen – The company has to grow a more than 15-18% per annum for 9-10 years and maintain a ROE or ROC of 15% or higher. That would justify the PE of 30. If a company sells for that PE, then for you to make money the company has to do better than that. PE ratios of higher than 40, require higher growth, higher ROC and much longer CAPs.

Is that likely ? well it can happen …but don’t bet on that. Industries which have high growths and high ROC tend to attract a lot of competiton which drives the returns down. That’s a given rule of economics.

As a result I am wary of companies having a high PE. To justify an investment, the company has do better than the implied value (which you can get from the table above).

Final point – I have put comments on the right of the table with color schemes. Red means stay away for me !

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Valuation – reverse engineering the stock price

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
January 23, 2008
3 Min read
4 comments
V

I discussed my approach on evaluating PE ratios (see here). In addition based on the table shown in the previous post, we can work out the assumptions built into the stock price in terms of the ROC, CAP and growth rates. These variables can be compared with the actual and expected results of the company to decide if the stock is undervalued or not. Sounds easy in concept, and it is if you understand the company and the industry well. This approach is also called as expectations investing and I learnt about it in the book -.expectationsinvesting. I would recommend reading this book to understand DCF and the previous post better.

The above approach is a very useful tool in analysing a company. Let me give two examples.

Example A – CRISIL . This company sells for a PE of almost 60+. The embedded expectations are
ROC – 25% (current value)
Profit growth ( Net profit = Free cash flow) – 18% p.a for last 6 years
CAP – 20 years

Basically the company needs to grow at 18% per annum for the next 20 years and maintain the ROC. The company would be earning a net profit of almost 1000 odd crores by then. To make money on the stock in long run, one has to believe that the company will do better than what is implied by the stock price. Will the company do as good or better than implied above? I don’t know and certainly not comfortable or confident of a company to do this well for such a long period of time.

Example B – Novartis. The company sells for an adjusted PE (take cash out from mcap) of around 7.
ROC – 50% +
Profit growth – around 10% per annum for last 6 years
CAP (implied) – 0 years (if you assume terminal value at 10-12 times cash flow).

Basically the company sells for 7 times earnings. Current earnings are around 90 crores on a very low capital base. In addition the company has strong competitive advantage. So with a mcap of around 600 odd crores, the company will earn the current investment back in 5 years. The market is current pricing novartis with an assumption that the company will be out of business in 4-5 years.

I have given the two examples for illustrative purposes only. It does not mean that the stock will do well for novartis in the next few months or do badly for Crisil. But the above analysis is useful in making investment decisions.

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Valuation – How to evaluate the PE ratio

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
January 17, 2008
3 Min read
16 comments
V

I had done a quick valuation exercise of MRO-TEK earlier (see here). I used a certain PE ratio in the post and said that I would explain my approach later. So here it goes …

To understand my approach, you have to look at the file Quantitative calculation and worksheets – cap analysis and ROC and PE. You download this file from the google groups
The worksheet ‘ROC and PE’ has DCF (discounted cash flow model) scenarios for various businesses such as Low growth, high ROC (return on capital ). For ex: Like Merck or high growth and high ROC like infosys etc.

As you can see in excel screenshot, I have put a growth of around 10% in Free cash flow, ROC of 40% and calculated the Intrinsic value (or Net present value). The ratio of the NPV/current earnings gives a rough value of PE for the above assumptions

Now I have used various assumptions of growth, ROC etc and created the matrix below (CAP analysis worksheet in the same file)

The above is for a matrix of ROC (return of capital = 15%). I have varied the growth and CAP (Competitive advantage period).

As you would expect, if growth increases, so does the intrinsic value and the PE. If the ROC increases the same happens. This is however ignored by most analysts and sometimes the market too. This is where opportunity lies sometimes. The third variable – CAP also behaves the same. Higher the period for which the company can maintain the CAP, higher the intrinsic value and higher the PE. CAP or competitive advantage period is not available from any annual report or data. It is the period for which the company can maintain an ROC above the cost of capital. For a better understanding of CAP, read this article – measuringthemoat from google groups. It’s a great article and a must read if you want to deepen your understanding of CAP and DCF based valuation approach.

As I was saying, CAP is diffcult to estimate as it depends on various factors such as the nature of industry, competitive threats etc. I usually assume a CAP of 5-8 years in my valuations. If it turns out to be more than that, then it serves as a margin of safety.

Now when I look at the company, I use the worksheet ‘ROC and PE’ and my thought process (simplified) is as follows

1. Look at ROC – does the company have an ROE or ROC of greater than 13-14% ? If yes, is it sustainable (this is subjective).
2. Use the above worksheet to select a specific ROC sceanrio.
3. What has been the growth for the company in the last 8-10 years. What is the likely growth (again subjective estimates).
4. What is the likely CAP? This is a very subjective exercise and requires studying the company and industry in detail. If the company checks out, I usually take a CAP of 5-6 years.
5. Plug the ROC, growth, CAP and current EPS numbers in the appropriate sceanrio and check the PE. That is the rough PE for the instrinsic estimate.
6. Check if the current price is 50% of the instrinsic value
7. Cross check valuation via comparitive valuations and other approaches.

If all the above checkout, it is time to pull the trigger.

In case the above has not bored you to tears, 🙂

Next posts: Some conclusions from table for CAP v/s PE v/s Growth (CAP analysis worksheet), pointers on DCF etc etc.
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The black swan – unpredictability, futility of forecasting etc

By Rohit Chauhan
In Book review, Uncategorized
January 11, 2008
4 Min read
6 comments
T

I have just finished this book. I wrote about this book earlier here. I have also read N N Taleb’s earlier book – fooled by randomness and liked it a lot.

I will not be doing a detailed review of the book as that can be found on amazon and a lot of other website. I will however highlight some of the points, which struck me as important and how they impact me as an investor.

One of the key points, which the author makes, is about the complexity of the real world and lack of predictability. For ex: No one predicted the rise and the importance of the internet. The Internet has become one of the major forces shaping our world. It can be termed as a positive black swan. As a result all complex systems such as the economy, financial markets, which get impacted by such black swans, cannot be predicted. But that does not stop analysts and all the talking heads on TV from making predictions (predictions for 2008 etc etc)

Now one can argue that some prediction do come through. Well, you don’t have to be a guru for that. Just take some events, toss a coin and make a prediction based on the toss. You will be right 50% of the time. Analysts and TV gurus are worse than that in terms of their success rate. There are numerous studies supporting it, so you don’t have to take my word for it. Try this on your own – write down some predictions you hear this year and check back a year later.

Why are we suckers for this? because we want to resolve uncertainity and anyone who can or claims to provide visibility to the future is sought out (we do have astrologers !) . The author terms this as the narrative fallacy.

Personally, I stopped looking at predictions, analyst estimates, top picks/ hot picks etc etc long time back. If I want to be entertained I would rather watch a movie or a cricket match!

A logical question is how to invest if you do not predict. Does developing a DCF not amount to forecasting a company’s cash flow? Well it does. The difference is between a macro and a micro forecast. Forecasting a company’s cash flow is much easier than forecasting the direction of the stock market. If you know the company well, it is in your circle of competence, and you can figure out the few key variables driving the cash flow of the company then it is possible to arrive at a reasonable estimate. Will it be accurate? I don’t think so. However if you are conservative in your assumptions (don’t assume 50% growth rates) then the impact of the negative surprises would be minimal. I would not worry about positive errors (cash flow more than forecast) as I will gain from it. In addition, if you buy at a discount to the estimate of the intrinsic value (margin of safety concept), then you are protected further from errors in the forecast.

Compare this approach with macro, top down forecast. If some one says – infrastructure stocks will do well because infrastructure spending is to increase by 50%. In addition to all the stock specific factors, you thesis is also dependent on the increase in the spending which in turn depends on multiple factors. The more variables in the investment idea, the more there is a chance of something going wrong. In addition, you will also pay more for such an optimistic scenario. So if the macro forecast or something else with the company goes wrong, the losses can be severe.

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HPCL – a quick review

By Rohit Chauhan
In Investment ideas, Uncategorized
January 6, 2008
2 Min read
Add comment
H

I had written about HPCL earlier (see here). To recap, my main thesis was as follows.

HPCL now sells at around 9000 crores. The EV is around 10000-11000 crores at best. The replacement value of the assets is around 25000-30000 crs. The company is selling at 25-30% of replacement value, which can reduce due to the following reasons

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

So what is the situation now ? Well the company is selling at around 400 Rs/ share and the gap has now reduced to around 40% of replacement value. It is easy to declare that the original thesis has been validated. However although I think that the above reasons are still valid, they are not responsible for the reduction in the gap. I expected these reasons to play out over 1-2 years. However in the current bull run, each and every listed stock is rising almost every other day. HPCL is no different. That said, I am not complaining if I have been lucky.

These are interesting times in the market. The market is now at a PE of almost 27. Almost 1000+ stocks are now at a 52 week high and any stock which one could have picked in the last 6 months has risen. I cannot speak for others, but for me it is time to be cautious. Frankly I am having diffculty finding good ideas. It has almost become like searching for a needle in a haystack. However for me doing nothing is better than doing something stupid.

Disclosure: I have a position in the stock. As always please see the disclaimer too.

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