AuthorRohit Chauhan

Real estate valuation – Inverting the problem

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 18, 2007
3 Min read
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R

As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

In the last post, I developed the basic logic that real estate valuation depends on the rentals. Lets say you are looking at a property valued at say 50 lacs (5 million) . Now the reason to invest in this property is that you expect to make more than fixed income. Lets say you expect 15% p.a.

So the property should be worth 1 Cr (10 million) in the next five years. Such a property to sell at 10 Million, should atleast yield a rent of 40000 Rs/ month (assuming a P/R of 20). For some one to pay a rent of 40000/month, that individual should be earning atleast 170000 rs / month pre-tax.

How did I come up with number? assume a 30% tax rate and that a person would not prefer to spend more than 30% of his net income on rent in the long run. So we are talking of a person making 20-22 lacs per annum.

I agree salaries in india are rising and will continue to do so, but think of it this way – How many people can earn 20-22 lacs per annum (or 50000 usd ). To give a comparison, 50000 usd income is around the median income in the US too. On the flip side, with dollar depreciation and margins of IT/BPO companies getting squezed do you think it is feasible for indian companies to keep increasing salaries at 15% for the next 5-6 years and still be competitive?
Going one step further, if the investor thinks he can sell the property for 10 million , the person buying it will have to do a similar math. If the next investor expects 15% p.a , then he may agree to buy the property for 10 Million at a P/R of 20. However the property should then be 20 million, 10 years from now and needs a tenant making 40 lacs p.a (100000 dollars) to support the rents.
At any point during the next 10 years, if the above assumptions break, due to drop in salaries or recesion, the P/R (like P/E of a stock) could fall and returns could drop. I would agree that in the above scenario there are a lot of assumptions and ifs and buts. However one should think hard before going ahead with a big investment decision.

Please note that I am not talking of local knowledge of real estate. If someone has special knowledge of an area and knows that the area would develop in the next few years, then that person has an information edge and can make high returns. My example is of a general case of an apartment in a city which is what most of the investors put their money in.
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Real estate valuation – I

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 13, 2007
4 Min read
1 comment
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If like me you believe the basic definition that the intrinsic worth of an asset is the sum total of all the cash flows one would receive out of an asset from now onwards, then real estate could be analysed using the same approach as stocks or bonds.

Using that logic, we can say that there are two components to the cash flow
1. Rent which is equivalent of dividends
2. Final sale price of the asset (real estate) which is the same as the sale price one would get from a stock or bond

Like stocks, it is easy to get the value of rent (or dividend), but difficult to get the final selling price. In case of real estate the final selling price would depend on the state of real estate market, interest rate, economic activity of that area and location of the real estate. This is similar to stocks where the final selling price depends on a large number of factors, most of which cannot be predicted.

Using the same analogy, if it is possible to value a stock roughly, if not with precision, then one should be able to get some idea whether the real estate asset is under valued, over valued or fairly priced.

I recently read an article in fortune on real estate valuation, current pricing and likely future of the same in the US
Real estate : Buy hold or Sell

I have included a few paras from the article which are very relevant for valuing real estate

Many factors determine the value of a house. A family would consider the quality of local schools, the number of bedrooms, the size of the yard. Economists assessing a region look at interest rates, employment, and population growth. But over time the most reliable guide to home values is rents.

In most markets people won’t lay out much more in monthly costs to own a house or condo than they would to rent a similar property unless they expect a huge profit when they sell. Indeed, speculators chasing quick profits did a lot to inflate the recent bubble.

But once the fervor fades, prices must fall to restore their normal, long-term relationship with rents. Rents exercise a kind of inevitable gravitational pull on prices. The ratio of prices to rents “behaves much like price/earnings ratios for stocks,” says Yale economist Robert Shiller. “Like P/Es, price-to-rent ratios are mean-reverting.” In other words, while prices soar from time to time, sending the ratio to exceptional heights, sooner or later the relationship is bound to return to its historical average.

The last para above is very important. Kaushik in his blog has posted several times on the rent for several properties in places like bangalore. Although this is anecdotal evidence, I would not discount it completely.

So based on this evidence if the rent is say 20000 per month, we are talking a valuation of 48 lacs for a 3 bedroom apartment ( 1 lac = 100000)
Rent = 20000/ month = 2.4 lacs p.a. For P/R ( price to rent like PE ratio) of 20, the valuation is 48 lacs.

The only variable in the above equation which can be debated is the P/R ratio. I will discuss about this in more detail in the next post, but think of it this way – the inverse of P/R is the yield on the real estate. For P/R of 20, the yield is around 5%. Globally, most investors demand a yield of 5-7% on an average. So a P/R ratio of 20 is around the average and may not be too low.

Net post : Looking real estate valuation using the ‘invert the problem’ approach.

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Financial institutions and risk

By Rohit Chauhan
In Finance and Banking, Uncategorized, Views on news
November 7, 2007
3 Min read
5 comments
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update: 09-Nov – A great post on the valuation of financial firms and the diffculty of doing so …see here

I have written on banking earlier. You can find my analysis of allahabad bank here. Most of you must be aware of the subprime crisis. I discussed it briefly here.

Banks and financial instutions by their very nature are highly leveraged organizations. So the risk of bankruptcy and losses is higher with banks. Citibank is one of the largest bank in the world and has seen its stock drop by 35% this year. The CEO has just resigned. You can read all about the crisis here.

So what does citibank and the subprime crisis have to do with banking in india. Well a lot … Let me digress and tell you a short story.

The year is 1996 or maybe 1997. I was starting to invest and saw an article on IFCI (I guess you must have already got the hint or must be thinking ….what a Bozo !). Well, the article said that IFCI is a good opportunity as it was near its 52 week low and had a dividend yield of almost 5-6 % (don’t remember the numbers exactly). So thinking that I had found a good opportunity I promptly bought some stock.

Fast forward: 1998-1999. IFCI is a government controlled institution. Politicians look at it as their piggy bank. So if you are a well connected businessman, launch a project, get funding from IFCI, take your money out and refer the company to BIFR. So by 1999, I think IFCI had more than 12% NPA and was bankrupt. There was hardly any dividend and the stock had tanked by more than 70%.

So the moral is …..

1. Don’t base your investments on someone else’s analysis
2. Investing based only on dividend yields is not a good idea. Investing in financial institution based only on dividend yields is a very bad idea unless the financial institution is sound and can maintain the dividend.

So what has happened with citibank is possible with Indian banks too. Banks have a lot of leeway in hiding bad loans. Indian public sector banks due to political interference can end up with even more and these bad loans or assets come out only later. It is difficult to judge asset quality just from the balance sheet

Added note: I have an NRI friend who had invested in citibank based on the dividend yield. Just out of curiosity I downloaded the AR of the bank and my head started spining. It is more than 100 pages, very complex and very difficult to understand (especially for me and may be the CEO too who got fired for not understanding or maybe underestimating the risks).

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A deep value stock

By Rohit Chauhan
In From other blogs, Uncategorized
November 6, 2007
2 Min read
10 comments
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Prof bakshi had posted a quiz to his students. You can find the answer to his question in the comments section. I have posted on the same company earlier.

In addition you may find my response in the comments section too. There are several other answers from others in the comments section such as VST, wyeth, divyashakti granite etc. Some of the ideas sound pretty interesting and I would be looking at them closely.

My suggestion – if you are interested in value investing, read prof bakshi’s posts ,articles and interviews. There is a lot you can learn from him.

As an aside – i am reading a book : seeking wisdom – from darwin to munger. This book has been recommended by charlie munger himself. I dont remember the exact comment, but it seems he liked the book so much he bought a copy of this book for all his friends and relatives. He also said that if there are more books like this, he could bankrupt gifting them. I am not sure of the authenticity of the comment. But after reading 60 odd pages, i can tell you that this is a great book, especially if you are looking at developing a latticework of mental models. For those you who may not know charlie munger, he is the vice chairman of berkshire hathaway and a long term partner of warren buffett.

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Sundaram Finance Spreadsheet

By Rohit Chauhan
In Company analysis, Finance and Banking, Uncategorized
November 2, 2007
1 Min read
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S

I have uploaded the spreadsheet for sundaram finance in valueinvestor india google group.

Please use link – http://groups.google.com/group/valueinvestorindia to download the file. Please also see the disclaimer, as I am not recommending this stock. The spreadsheet analysis (correct or wrong) is my personal analysis of the company.

You can find the sum of the part analysis of the company under the tab – sum of parts.

Please feel free to leave a comment if you find something wrong in the spreadsheet.

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Allahabad Bank

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
October 29, 2007
4 Min read
3 comments
A

My notes on Allahabad bank

About
Allahabad bank is one of the oldest banks in India with over 2000 branches. The bank’s branch network is predominant in UP, Bihar and other northern parts of the country. The bank also has 47 specialised branches for various business activities such as Industrial finance, Collection service, Treasury management etc. The Bank is a PSU bank
The bank was a basket case a few years back. I was reading a research report when the bank came out with an IPO in 2002. The bank had NPA of 10.5% which was actually a reduction from 15.1% in 1998. So technically the bank had a zero networth till 2002. The bank has improved its performance since then.

Financials
The Bank has improved its financials substantially in the last few years. The following Key parameters of the Bank have shown improvements from 2002 to 2007

ROE – 11.2 % to 22%
CAR – From 10.5% to 13%
Net NPA – from 10.5% to 0.9%
ROA – From 0.6% to 1.3%
Absolute Net NPA – from 1160 Cr to 315 Cr
Credit deposit ratio – from 48% to 65%

Income growth has been 15%+ for the last 5 years
Net profit has also grown by 20%+ per annum over the last 5 years

The following financial numbers have remained stable or not shown much of an improvement
Other income as a percentage of total assets
Provision ratio has dropped to 70%
Yield on asset – In line with fall in rates over the past few years.

Positives
– The key indicators such NPA, ROE, CAR, ROA, Credit deposit ratio, income and netprofit growth are good for the bank.
– The bank has been expanding its branch network and also getting into the international markets. In addition the bank has kept its NPA’s low in percentage terms and absolute level.
– The bank is also increasing the other income component. The other income which comprises of fee income, trading etc has grown at a much faster rate this year as compared to the Net interest income.
– Operating costs as a percentage of total income has dropped mainly due to reduction in manpower costs. The bank has thus become more efficient in the past few years.

Risks
The biggest risk for the bank is political interference. As the majority shareholder is our government, you can never be sure what hairbrained scheme they will come up with. In the past there have been loan melas, loan writeoff etc. This has reduced in the last few years, but you never know.
In addition the NPA are controlled. However the bank operates in UP, bihar etc. There is a small risk of the rise in the NPA.

Comparitive Valuation
The bank is currently selling at a PE of around 5 and a P/B of around 0.9. On a comparitive basis SBI sells for a PE of around 17 and P/B ratio of around 2.5. SBI is a bigger bank, but on Key parameters such as ROE (around 18% ) , Growth rates (net profit around 8% for last 5 years) etc is not much better than Allahabad bank.

The other top notch bank HDFC is priced at around 35 time PE and P/B of around 6.5. On certain parameters such NPA and growth the bank is ahead of Allahabad bank, however ROE is higher for Allahabad bank. Finally the market recognizes the qualilty of HDFC bank’s management and performance and has priced it accordingly

Conclusion
Allahabad bank is one those non-glamorous, dull stocks. However key to investing is not how sexy the stock is or how much sizzle it has, but whether you can buy a stock at a discount to intrinsic value.
Personally I feel the stock is a bit undervalued, however I have yet to make up my mind on it . I don’t see an immediate catalyst to unlock the value, however if management continue to perform as it has in the past 4-5 years, the returns should be decent.

Please see disclaimer

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The frustation with Value investing

By Rohit Chauhan
In General thoughts, Investment process, Uncategorized
October 23, 2007
5 Min read
8 comments
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I received the following comment from amit and can completely empathize with his frustation. Instead of replying via a comment, I thought of posting it as my reply is rather long winded. My reply is after amit’s comment.

Hello Rohit,
In 2005 i passed from my engineering course and joined a software MNC.As there was too much hype about stock markets i too got lured into it and had my Demat account.

Confused why i am writing this story,please read on.The next part was to do some investing and for that i wanted to earn big and fast.My first trade was buying Reliance pre split at 830/- a share.Many said it was overvalued and i wont gain from split.I had other thoughts,i have always had a fascination for reliance and i thought i was perfectly right.In fact i was and today that 830/- has zoomed to 5000/-.

The next thing i heard was value investing.And i hate the day i heard about this whole value investing funda.I started to read blogs of value investors and plz dont take otherwise they are so sick people that right from 8000 level of sensex they are saying that the market is overvalued and market will crash and only value investors will have the final say.Today market stands tall at 17500 and value investors are as usual worried.

And after devoting so much time to value investing i feel i have missed the bus from 8000 to 17500 in a big way.Guys who had simply invested in sensex (famous) stocks have made much much more than what i have made.

May be all this value investing will come handy when the market actually crashes and go in a bear phase.Seems that is not going to happen anytime sooner.

I m sorry for myself and for most value investors i guess.Most have lost…..agree or disagree i hold my view………

Amit agarwal.

My response

Amit

I can understand your frustation. I will not try to ‘sell’ you the concept of value investing or justify it. I think that is something one has to decide for himself.

Let me first try to clarify (per my understanding) what value investing is not. It is not a system of predicting the market. I am not sure if anyone could have forseen this rise in the stock market from 3000 to 18000 (the market was at 3000 in May 2003). One can guess that the market will do well in broad terms, but it is very difficult to predict whether the market will be at 20000 or 25000 next year.

In addition, one can only estimate (probabilistically) how over valued or undervalued is the market . See my post on the same topic here. So if someone is sure that the market will tank soon or take off, take it with a pinch of salt (value investor or otherwise)

One important point to remember is that value investing does not work all the times. Over a 8-10 year period you can do well ( I am saying can and not will), but there will be phases when you will underperform the market, especially during bull markets. This is not a new phenomenon. Value investor got killed during the 1999-2000 dotcom bubble in the US. Warren buffett who is recognized as ‘the’ investor was assumed to have lost it and the press was writing him off. So if you want to follow value investing , be prepared to look like a fool sometimes. Also if you recommend an out of favor, value stock, your friends may smile (if they are polite and don’t want to laugh at your face).

Finally value investing is buying something for less than what it is worth. What can be more rational than buying something for less than it is worth…we buy all other stuff that way …except maybe stocks. The approach is simple but it is not easy. On the contrary it is emotionally very taxing. I have gone through the same phase myself. I started off in 1999-2000. I did not have experience then and saw my portfolio bleed as the market tanked. The stocks which I though were cheap, became cheaper …can you believe that concor sold at 5 times PE in 2003, blue star at 5 times and so on.

I was not able to understand the reason why the undervalued stocks I was holding were not appreciating then and why no analyst was even analysing or recommending them. It took 2-3 years for the stocks to be recognized and the value to be realised.

I have not regretted being a value investor over the last 10 years. I chased IT stocks in 2000 and lost money on that. I have found value investing to be a rational approach and from personal experience, a profitable one too.

I agree the last 3-4 years have been tough for value investors, where you may have lagged the market. Will it end soon and then everyone will convert to value investing and value investors will have the last laugh? I don’t know and frankly not concerned about it. I just prefer to follow a logical and rational approach, which is what value investing is about.

I would also recommend you to read this article by micheal mauboussin on process v/s outcome . See the matrix closely and I hope you realize that even when you follow a good process, the outcome will not always be favourable (but over time favourable)

One last suggestion – try to invest some portion of your portfolio in an index fund or a good mutual fund while you experiment with various investing styles and pick one eventually. Maybe that will reduce the regret.

please feel free to leave your response to amit’s points in the comments


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How to look at the market swings – Time horizon

By Rohit Chauhan
In Investment process, Uncategorized
October 21, 2007
4 Min read
7 comments
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I have been re-thinking my time horizon for investments for some time and have made some changes to it. The corresponding impact on my investment decisions and how I look at the market swings has been dramatic. My earlier time horizon was on an average 2-3 years. However I have now increased my time horizon to 10 years for my SIP component. The active portfolio component still has a horizon of 2-3 years.

I cannot understate the impact of extending or changing time horizon has on how one looks at market volatility, current events, investment ideas etc. Let me illustrate

10 year or more horizon – If you are in you 20’s, 30’s or even 40’s this time horizon makes sense. For a time horizon of 10 years, short term market movements have no importance. Over a 10 year horizon, if you are looking at index funds or well managed mutual funds, a small amount of overvaluation does not matter. These overvaluations would even out as long as one has not bought extensively during the peak. At the same time if you are investing via SIP (systematic investment plan), then during a 10 year or more period, there will be periods of recessions, market bubbles and all kinds of fluctuations. However the portfolio should perform well (see my post on the power of SIP here)

If like me, you are investing a portion of your portfolio with the above horizon, the current circus on PN notes, subprime crisis in US, oil price etc etc will not hold too much importance. If you feel that Indian companies as a whole will do well in the next 10-15 years, then find an ETF, get into an SIP and get on with other things in life

2-5 years – This is my active portfolio horizon. I tend to look for undervalued companies selling at 50% discount to intrinsic value and if the gap closes in 2-3 years, I have a 20-25% return per annum. For this horizon, current market events make a difference in the sense they provide me opportunities to buy stocks which have been beaten down for no reason. The more the better. Beyond that, it doesn’t matter whether the market will open 1% up or 1% down.

1 year or less – This is the time horizon for the aribitrage component of my portfolio. I have written about a few likely opportunities earlier. Here some corporate action such as buy back, rights issue, spin offs create an opportunity. In this component, current market level or events should not matter. The company specific developments are more important. However I have seen that sometimes market events can suddenly throw off the entire calculations and result in a loss. I am still not heavily into arbitrage and would not have more than 10% of my portfolio in it in the future.

1 day – 1 month – I do not operate in this horizon. Profitable or not, it is not my cup of tea and I do not have the stomach for it. This where all financial websites, TV channels’ and several blogs focus. In this time horizon the current PN issue, subprime in US and whether the market will open higher or lower on Monday may matter. Question to ask yourself – are the returns you are making commensurate with the effort?

All I can say is that if you decide to play this game, have the stomach for it and don’t risk too much capital.

I have been reading on some websites and blogs, stories of people who got into the market near the top and are now suffering losses. I can empathise with them as I have gone through the same. The problem is that most of us think we can tolerate losses, but when they really happen it is gut wrenching. The worst thing to happen is that such people get scared from the market for ever and never return back. That is definitely not good in the long term if you want to build a decent nest egg.

I think it is important for us to understand our risk tolerance and see which time horizon we want to operate in and take investment decisions accordingly. That ofcourse is easier said than done.

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Banking

By Rohit Chauhan
In Finance and Banking, Industry analysis, Uncategorized
October 16, 2007
2 Min read
4 comments
B

I have written earlier on banks

On valuation approach of banks

More thoughts on valuation of banks

Various factors to evaluate banks

Margin of safety and Banks

I recently posted on a Financial services company ‘sundaram Finance’ which has a business model similar to banks.

I have been analysing banks as a group, trying to understand their business models better. I found the following articles useful to understand the working of a bank

Asset liability management function of banks

Various factors in evaluating banks

NPA and various factors in understanding Bank NPA’s

A few additional thoughts on the business model of banks

– The traditional lending business of banks is now becoming a smaller portion of the business. The ‘other income’ portion which comes from various activities such as distribution of financial products, cash management etc is now becoming more important as this income is not sensitive to interest rate changes and requires less capital
– The % of other income to total profit is higher for the newer private banks than the PSU banks. In addition lower NPA and more profitable growth has resulted in a higher valuation for private banks such as HDFC, ICICI etc
– Banks have been consistently increasing the proportion of their variable rate products. This enables the bank to reduce their Asset liability mismatch.
– Banks profits, especially of PSU banks were subdued last year due to the increase in deposit rates. However PSU bank assets tend to follow the higher rates with a lag. Private banks are able to manage these fluctuations better through various derivative products. I think PSU banks are still lagging in this field. As a result it is likely that several PSU banks will see an expansion of margins as deposit rates stabilize and the Asset yields improve
– NPA’s in most PSU banks though higher than Private banks are still better than a few years ago

I have done a preliminary analysis of the various banks and have found Private sector banks to be fairly or in some cases slightly over-valued. However there are some PSU banks such as Allahabad bank, which I feel are undervalued. I will be posting on Allahabad bank and a few other banks later.

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How to make 6.4 lacs by investing 1000 per month

By Rohit Chauhan
In Investment process, Uncategorized
October 13, 2007
2 Min read
7 comments
H

Is’nt the above title like a typical get rich quick scheme ? Frankly there is no magic in the above. The approach is very simple. The NSE or BSE index on an average has returned around 16-17% per annum for the last 10-15 years. So if one can invest via SIP (systematic investment plan) around 1000 Rs per month, it should amount to around 6.4 lacs after 10 years. This is with the assumption that the gain is evenly distributed ( @ 1.4 % per month) across the entire 120 month time period.

Ofcourse reality is not that convinient. However volatility generally helps in improving the overall returns in an SIP plan. So if one can maintain the discipline of investing 1000 per month irrespective of how the market is doing in the short term, it will work out in the long run.

Let me give a few scenarios (investing 1000/ month)


Anyone can follow this approach by regularly investing in an ETF or an index fund for the long term and come out well. Even better if you can find a mutual fund which can beat the market by 2-3% point.

So where’s the catch? well there is none really. The main problem is us. Think of it … where is the sex appeal or sizzle in this strategy. If you discuss this with your friend, do you think you will get anything more than a yawn? Who is going to be impressed with this approach ?

I know what comes to everyone’s mind (mine included), namely – I am a better investor. I can make 25% per annum and have beaten the daylights out of the market for last 2 years. Who wants this boring strategy, when I can do all kinds of fancy stuff, have fun at it and boast about it too. Maybe its true, but can you be sure?

So the question is – is it better to follow a known strategy and build a decent nest egg in the next 10-15 years, or try for the moon which may or may not happen.

I am not different than anyone else and tend to follow both approaches at the same time. I prefer not to discount a simple and effective approach. As a result a portion of my portfolio is always indexed and in SIP.

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