AuthorRohit Chauhan

Reading the Book – The Black swan

By Rohit Chauhan
In Book review, Uncategorized
January 2, 2008
2 Min read
3 comments
R

I am currently reading the book – The Black swan by N N Taleb. This is a great book on low probability, high impact events which are termed as black swans.

I am still in the middle of this book. One key point which I came across is ‘confirmation bias’ on which the author has devoted a complete chapter.

The basic idea behind confirmation bias is that once we make a decision, we tend to look for evidence to confirm it. As a result we tend to ignore any negative information which could refute our decision. As a corollary to this concept, any additional information is of no use as it would only re-inforce the decision and not add any more value to the decision making process.

Like others, I am equally susceptible to this bias. My approach to reduce its impact is to write a single page thesis on an investment idea and sometimes post it on my blog. I try to gather negative information and also prefer to get negative feedback on my idea. That helps me in wieghing all negative information and arrive at a better decision (hopefully).

I am not sure if I have been entirely successfull in it, but I have rejected a few ideas after selecting them, once I was pointed out some key information (which I had missed out). In a few other cases, the negative information, which I had missed earlier resulted in reducing my estimate of intrinsic value for the stock – for ex: I missed the impact of liabilities in the case of VST. As a result I ended up taking a smaller position

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And I am out !

By Rohit Chauhan
In Investment ideas, Uncategorized
December 28, 2007
2 Min read
5 comments
A

For sake of disclosure, let me say that I have started exiting my position in MRO-TEK. The stock is almost at 95 and has shown an 80% rise in the last one month. It is now above my calculation of intrinsic value for the stock.

I can see the thrill of momentum investing – instant gratification. In spite of the thrill, I am not planning on changing my approach which I understand well, and have become comfortable with, over the years. In general I have seen my picks rise and approach intrinsic value in 1-2 years. That allows me to analyse the company in detail and build a decent position. Sometime I have been able to even average down on the stock as the price went lower and I developed a better understanding of the company.

A case like MRO-TEK is not really suited to my style of investing. Too soon, too fast. If the stock moves up very fast, I lose interest if it crosses my buy levels as I cannot complete the analysis and would hate to create a big position without understanding the company in depth. This approach is ofcourse contrary to most investors. However I do not have such an approach for the sake of being contrary or just because it is a smarter approach. It is just that with my time constraints and risk aversion, I prefer to analyse a company in detail before I invest in it.

Will the stock go higher …? I have no clue and am not planning to play the stock on that.

As always, please read my disclaimer

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From Value to momentum – MRO TEK

By Rohit Chauhan
In Investment ideas, Uncategorized
December 24, 2007
4 Min read
11 comments
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I generally select and buy stocks where the general enthusiam for them is very low. None of my picks shoot up after I have bought them and so when a few did in the last few months, it was a new experience for me.

One such pick was MRO-TEK. I started looking at the Company a few weeks back when the stock was at around 52 per share. My analysis was as follows

About
The company is primarily into end-to-end solutions and hardware/products-provider in data communications, data access and networking fields, offering a wide range of sophisticated LAN/WAN products.
The company has a JV with RAD corporation and a few other technical collaborations. The company had a split of 30-70 of manufacturing v/s trading a few years back. In the recent years, the split has reversed to around 70-30 in terms of revenue

Performance
The company has had very erratic performance. The projections which the company made at the time of the IPO in 2000, were never met (by a huge margin). Since then the performance has been one step forward and one step back. The ROE has fluctuated between 5 and 15 %. Topline has also fluctuated and has grown by 9% per annum and the Net profit has also grown by roughly the same amount.

The margins have held steady at 9-10% and the asset turns have improved from 1.2 to 2.6

Positives
The company has maintained its margins and improved its efficiency ratios. Wcap ratio has improved from 1.5 to 6 due to improvement in inventory and recievable turns. The company has freed up cash and as a result has no debt and almost 40 Crs of cash on the balance sheet.
The company recently completed a buyback program using the surplus cash. The promoters have also been increasing their holding % in the last few years. The company has been paying a decent dividend with a DPS/EPS of around 30-40%.

Negatives
Although the management appears rational, pro-shareholder and is trying to create value, their performance has not been up to the mark. Reading the annual report reminds me of kids in school, who study hard and have the right work ethic, but still manage to flunk one or two subjects each year.
The company operates in a very competitive field with competition from likes of CISCO and LUCENT etc. This industry involves a lot of new technology, high R&D expenditure and high rates of obsolescence. MRO has only recently started investing in R&D and till recent past was mainly a distributor of networking products.

Conclusion
My personal estimate of intrinsic value was around Rs 90/ share. At 52 / share, the company was not a screaming buy, but worth creating an initial position.
I am not too optimistic on the long term economics of the company as this is a very small company in a fast paced and competitive industry. As a result it is diffcult for the company to operate at the top end of the product range and make good margins. Due to my lack of confidence on sustained good performance I conservatively estimated the intrinsic value at around 90 /share

Post script
Once I complete the analysis, I write a single page note detailing my investment thesis. This is more to record my thoughts at the time of the decision. It is useful to keep such notes as I can check them again later and check if my assumptions were true or not.


Well in this case, it never came to that. Almost from the next day the stock suddenly caught the fancy of the market. Somehow everyone has a very different opinion and as a result the stock is up almost 50-60% since then. In my case after creating an initial position, I stop buying it. Personally I buy at 40-50% of my estimate of intrinsic value and if the stock sells above that I don’t do anything. You may think I am leaving money on the table, but I prefer to follow a discplined approach. In my case I am not comfortable with trading and momentum plays and prefer to leave it to other who are better at it.

Valuation logic – 2008 EPS around 6-7 / share
PE ( will explain logic for this in a different post ) = 9-10
Cash / share = 40 Rs/ share
Total = 94 – 110 Rs/share

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It was difficult NOT to do well

By Rohit Chauhan
In Uncategorized
December 17, 2007
3 Min read
Add comment
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2007 has been one of those years where it was difficult NOT to make money in the stock market. At the risk of offending, let me say even a monkey would have made money. Don’t get me wrong, if you have done well this year, it does not make you a monkey 🙂 (by that measure I am a monkey too, not that I am complaining).

The monkey term is more to randomly picking stocks than to a monkey IQ. This was one of those years where almost all types of stocks did well. If you avoided some of the sectors such as IT, everything else was in a bull market. From Aug to Oct the large caps did well and since then the Mid caps have caught fire. I have seen some of the stocks almost double in the last 1-2 months. When I wrote earlier, on midcaps in may there were a decent number of opportunities available. However the valuation gaps have started closing since then and the number of opportunities have come down (although there are still a few around).

So whats in store for the next year? As if I know !! and so does no one else. I have long stopped bothering about market forecast and which sector is going to do well etc etc. The smart thing to do is to analyse companies and if you can find one selling below intrinsic value, buy it. Not all your picks will do well at the same time (unlike 2007!), but a few would.

If I started investing this year or during the current bull run (from 2003 onwards), I would want to re-analyse my approach to ensure that it was due to my own stock picking skills and not due to the rising tide. I do that every year in the following manner

– did my portfolio do better than the market index such as Sensex
– Which stocks did better than average and which did not
– What was the reason for the stocks which overperformed (luck?)
– What the reason for the stocks which underperformed and how to avoid the the cause of the underperformance

It is important to do the above analysis to ensure that the good performance was not due to luck and can be repeated again. Luck can make you money in the short run, but in the long run you will give it back. So it is critical to be brutually honest with yourself.

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Ashok leyland – Private market value

By Rohit Chauhan
In Investment ideas, Uncategorized
December 13, 2007
3 Min read
10 comments
A

I had written on Ashok leyland earlier.

My valuation was as follows
The company sells at a PE of 12. The current EPS is around 3.3 per share. The company can be expected to grow at 10-12% over the next few years. In addition the company has some competitive advantage such as a known brand name (especially in the south), long operating history and experience in the market, rational management and a decent distrubution/ service network.The company can be valued at around 16-18 times PE and given an intrinsic value of around 60 Rs/ share.

I recently got this email from Vishnu

I have been going through Eicher JV deal with VOLVO. It would be great if you can share your opinions.

Story:
Eicher is stepping down its Commercial Vehicle and Component business into a JV with VOLVO which is paying 275 million USD in CASH and 75 million USD in terms of VOLVO’s truck distribution business in the JV.

Valuations:
Cash(VOLVO) is paying 1045
VOLVO India Truck distribution 142
TOTAL VOLVO Share (45.6%) 1187
EICHER Share in JV (54.4%) 1416.070175
Eicher Market cap 1314
* All figures are in Crores (INR)

I have already shared my opinion on the above opportunity with him. What struck me was that the deal involved the Commercial vehicle business and the deal was valued at approximately 2000 crs. Eicher motor’s CV business had a PAT of roughly 62 crs (pretax – 82 Crs) and hence the private market value (the amount that a private investor would be willing to pay for the company, in its entirety, were it not public) seems to be around 25-30 times earnings

So Ashok leyland can be valued at 70-90 Rs/share by the above metric. My own conservative estimate was around 60/share.

Whats the point of this analysis ? well private market valuation is another approach to valuation. It may be more than your own estimate as it may include controlling premium. However if you can find the private market value to a business you are looking at, it helps in calculating the intrinsic value.

In case you are wondering if I really benifited from my research, I did not completely. I have this tendency to do detailed analysis and build my position over a period of a few months especially if the price drops reaches or drops below 50% of my estimate of intrinsic value. Ashok leyland is around 54 now, so basically the price went up before I could go beyond my initial position. That unfortunately has happened several times this year.

Why should a quick price increase be unfortunate? Well that’s another post for this wacky idea.

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Maintenance capex calculation

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
December 10, 2007
3 Min read
5 comments
M

I discussed about maintenance capex and its relation with Free cash flow. To recap

Free cash flow = Net earnings + depreciation – maintenance capex

And free cash flow is the money the owner of business can take out or re-invest in the business.

Maintenance capex however does not have a precise formulae. That does not mean you cannot calculate it. But as you can see, if valuation is based on free cash flow which itself is based on an imprecise measure such as maintenance capex, it cannot be precise in itself.

Valuation depends on free cash flow, project growth rates , terminal value and the discount rates. All these are estimates and hence valuation is itself an estimate. That is the reason I find it assuming when analysts give reports where they give precise valuation targets and on top of that even the duration (next one year !!) when the target would be met.

So, coming back to maintenance capex, how do I estimate it? let me warn you at the outset. My approach is self developed, imprecise and only roughly right.

I will use my valuation template to explain my approach

Worksheet – anal – In this worksheet I fill up the sales, depreciation, wcap etc. On line 26, I calculate the additional capex (additional fixed asset and Wcap for the year). Line 27 is capex as % of sales. This gives me a capex trend (total) for a period of time for the business. I then use this trend to estimate the maintenance capex.

For ex: if the business has an asset turn (on average) of 2, then I would assume capex as 2.5% of sales

Sales = 100
Asset = 50
Inflation increase in sales = 5
Corresponding asset required = 2.5 (2.5% of sales)

If the business is asset heavy (commodity industry) then the maintenance capex as % of sales is high.

If the asset turn is 1, then maintenance capex would be roughly 5% of sales. You can compare this % with depreciation as a % of sales to see if both are roughly equal.

You may find some errors in my worksheet and I plan to load an updated version soon. I don’t use these worksheet very frequently now. After using these worksheets for several years, I am now in a position where I can look at the numbers and estimate if the company looks roughly undervalued. A lot of companies don’t pass that test and are rejected outright. If a company passes that filter, I fill up the excel and go through the entire exercise (which is not very precise in itself)

I have loaded a few samples in the google groups. If you go through this exercise yourself several times, you will see patterns and it will be faster for you too.

In addition to the above excel, please have a look at the excel – Quantitative calculation – worksheet : Maintenance capex to see the relationship between Sales, Asset turns, Maintenance capex and ROC.

Ofcourse you can have a counter argument – who the hell wants to go through such an elaborate exercise to value a company? Don’t I have better things to do in life 🙂

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maintenance capex and FCF

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
December 3, 2007
4 Min read
10 comments
m

I received the following question from sanjay shetty via email. I will try to answer the question and have also simplified it via several assumptions

You mentioned you “use maintenance capex needed to support unit volumes or competitive position (maintenance capex).”
I downloaded your Excel sheets couldn’t figure out the basis for calculation of the same, especially as companies don’t give break ups of maintenance capex. If you could explain would be great.
Maybe my understanding is incorrect, however I feel that all Purchase of Fixed assets should be deducted from Free Cash Flow especially when the amount out there is a yearly spend by the company to grow it’s business.

Let me start with the following definition for free cash flow (paraphrased) as given by warren buffet

Free cash flow = Net earnings + depreciation – maintenance capex

Now you can take the above formulae as a given or debate whether it is correct. I think it is correct as free cash flow is basically discretionary cash which the owners (actually managers on their behalf) of the business can choose whichever way to invest. It is discretionary cash because the business is left with this cash after it has incurred the required capex to maintain its current position in terms of volume and competitive position. If it does not do that, then the business will start degrading and may eventually be wiped out.

Now the discretionary cash can be spent in the following ways

1. Invest in the buiness itself if the returns are good – most common approach. Value adding if the business earns more than cost of capital . for ex: ITC, asian paints, HLL etc. This investment is in fixed assets and working capital
2. Accquire other company – Eg. Marico
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing – Ex: Merck, Novartis etc

Now the question – How to calculate maintenance capex? There is no precise formulae for that. The best you can do is to arrive at a rough number as companies don’t give this number. Let take the definition above and let me give my approach

If the maintenance capex is to maintain unit volumes, then value sales would be growing at the rate of inflation. So lets take a hypothetical case (simplified)

Sales = 100
Return on equity = 20% ( debt = 0)
Net margin = 10%
Total asset / sales = 2
Total asset = 50
Depreciation = 5 % of asset

Now in year 2
Sales = 105 (5 % inflation)
ROE = 20%
Net margin = 10%
Total asset / sales = 2
Total asset = 52.5
FCF = 10.5+2.5-2.5 [ asset increase = 2.5 ]

So in the simple case above FCF is equal to Net profit. Ofcourse reality is not so simple. However once you get an idea of the basic concept, you can do a rough estimation of the maintenance capex and free cash flow.

Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.

Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.

So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.

The above post may appear fairly academic and boring, but I think the question asked by sanjay goes to the core of how to value a company.
Next post : I will try to explain how I calculate FCF using the excels I have uploaded

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Grindwell norton and Free cash flow

By Rohit Chauhan
In Investment ideas, Uncategorized
November 29, 2007
3 Min read
1 comment
G

I received the following email from sanjay shetty and decided to post it as he has asked a very important question on valuation. I have done some work on it on my own and have put the results in the worksheet – Quantitative calculations.xls

You can download is from here or use the download link in the side bar. Please see the tabs – Maintenance capex and FCF anal.

My responses are in italics. There is a follow up question from sanjay on maintenance capex. I will post on it in detail shortly with an example. If you have looked at my valuation templates, you may have noticed that I use FCF based on maintenance capex for valuation purposes

Hi Rohit,

I’ve been viewing your blog, after your comment on my blog (http://indiainvestor.wordpress.com).

I had a few questions for you.

What methodology are you using to value companies in India?

DCF, comparitive or relative valuation, sum of parts etc. I try to value a company based on multiple approaches and also depending on the nature of the company

Are you using a Discounted Cash Flow method to calculate Intrinsic value? If so, are you checking the Free Cash Flow, how are you calculating it?

yes, i use free cash flow. I however do not use capital expenditure directly. I use maintenance capex needed to support unit volumes or competitive position (maintenance capex). Difficult for me to explain in brief. i have a few excels uploaded in my google group explaining the calculation.

I’ve see most of the companies I’ve analyzed seem to be blowing enormous amounts of cash, with almost negative free cash flow which is worrying. –

I think the key point is whether the capex is maintenance or for growth / accquisition. Let’s take a short example. If a company earns 5% on capital , and has 10% margins (asset turn is 0.5). Then to grow by 5%, the company will use all its free cash flow. Also 5% growth is roughly inflation, so in this case the company is using all its free cash for maintenance capex
In case of a company growing by 20% and 10% margins (asset turns is 2), growth of 5% requires only 50% of the netprofit . The rest is cash flow which company can use to aqcuire other companies, give dividend or build assets. This is the case with grindwell norton. Grindwell has low FCF as it is investing the surplus cash in assets to increase volumes.

Hope the above clarifies .i have tried to provide a quick explaination and have left a few things out (like adding back depreciation)

Take for instance Grindwell Norton, which you’ve recently mentioned on your blog, Every thing seems rosy however Free Cash Flow is the concern.

I have taken out the detailed calculations by sanjay and put the final computations

 Free Cash Flow
Mar’ 02 29.178
Mar ’03 21.802
Mar ’04 17.149
Mar ’05 18.481
Mar ’06 3.121

The worrying fact about this company is the amount of cash it’s blowing, though currently it’s Sales, ROIC etc. are all healthy and growing.
Free Cash flow growth is actually going from bad to worse. I’m calculating Free Cash Flow as Net Cash from Operations minus Capital Expenditure which is Purchase of Fixed Assets.

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Real estate valuation – Random thoughts

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 23, 2007
3 Min read
1 comment
R

I have been reading the book ‘Seeking wisdom – From darwin to munger’ which talks of various mental models and applying them to a problem to analyse it in detail.

The book is itself inspired by charlie munger and his lecture on the same topic. I have attempted to apply some models to valuing and analysing real estate.

The first post was valuing the real estate as a financial asset like stocks and bonds

The second post was trying to invert the problem.

The third post was looking at psychological baises in valuation of real estate. I will follow up with more posts on the same topic with other models.

I would like to add a personal approach for a first time buyer (buying for personal use)

If you are buying a house to stay (not investment), the maximum value of the investment would be driven by two numbers – EMI and personal debt to equity.

Let me explain
Suppose I earn 40000 as net income. My current networth ( all stocks, bonds, cash etc) is 10 lacs (10 lacs = 1 million). To be on the safe side, I would look at a house where my EMI is around 16000 / month (40% of net income)
So based on the above EMI, I can afford a loan of around 16 lacs at an interest of 10% for a 20 year tenure.

Assuming I have to put up 20% of the value of the house, I would look at a maximum investment of 20 lacs (2 million).
For a 16 lacs loan, my personal debt to equity is around 1.6 (16/10). This is higher than what I am comfortable. However it is not too high if you are in your 20s or 30s and have a long career ahead.

The above is a very simplistic approach and may sound conservative. But I prefer to plan for adversity and for a situation where things can go wrong. Buying a house as a first time buyer is less of an investment for me and more of having a roof on my head (in worst possible situation).

Some bad reasons for buying real estate
– Because the price has risen a lot lately or because the broker is predicting a rise.
– Because one can never lose in real estate
– Because your friend is buying it
– Because you can get a loan to buy it
– FII / Institutional investors are investing money – This is really a strange reason. FII/ foreign investors may have a good reason or maybe they are just following the herd. Just because an investor is an FII does not mean they have extra brains. Sometimes they are worse than an ordinary investor

A few links to value real estate
http://en.wikipedia.org/wiki/Real_estate_appraisal
Real estate valuation and analysis – read on the Cap rate which is similar to the P/R ratio
Deepak shenoy’s real estate cash flow calculator – Excellent worksheet to value real estate. Please read his terms.

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Real estate valuation – Psychological biases

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 20, 2007
2 Min read
4 comments
R

I think there are several psychological baises working in case of real estate. The first is incentive caused bais. Typically real estate is sold via brokers or by sales agents of the builder. They have an incentive to sell the property and typically earn a commision based on sale price. It is quite obvious that the broker or sales agent would be motivated to sell at as high price as possible. In addition it is likely that he will give you a bullish outlook for the property prices.

The second strong bias is social- proof and deprival super reaction tendency. You see you friend buy a property and make easy money. At the same if you have not invested money and feel deprival super reaction tendency as everyone one else is making easy money.

So these two tendencies work together and motivate us to look for a property. Combine this with the incentive caused bias where the broker is constantly trying to create a scarcity (he will tell you that he has a lot of buyers and even you don’t buy now then the price will go up), lack of information and overoptimism on our part and this creates a combined effect. All these factors add up and can cause the buyer to become irrational.

I personally think the risk of bubbles are higher in real estate for the following reasons
– the common notion that real estate cannot lose value and represent something limited which is land
– High amount of leverage. Typically loans on a property is around 20%
– Lack of transparency and information in this market.
– All the above psychological factors

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