AuthorRohit Chauhan

Fortune’s formula

By Rohit Chauhan
In Book review, Market analysis, Uncategorized
December 18, 2006
2 Min read
5 comments
F

I have been reading this book : Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.

I have found this book quite good especially if one wants to learn about odds, betting etc.

I am just halfway through the book. The book discusses about the kelly’s formula.

F = edge/odds. I have written about this formulae earlier (see here).

I found the above formula intersting although I have yet to figure out, how to use it directly in investment management. The formulae works well for betting situations like blackjack, horse betting which have limited outcomes. Its diffcult to work out mathematically the value of edge and odds in a common stock situation.

I have also been doing some analysis on the NSE data and have the following data

The above is the distribution of PE ratio for the last 7 years. It clearly shows that the only for around 8% of the trading days has the PE ratio been higher than 22.

If we take the above numbers as proxy for probability of occurrence and multiply that with the gain/ loss ( current PE – PE of the particular day / current PE) for each day, the expected value is around –19%.

To cut a long story short, the market seems to be overvalued by historical measures (which may not mean that the market is overvalued if the future performance is better than expected). Overall, I am planning to be more cautious especially in investing in the index (via index funds or ETF)

update : 8-Jan : Found this interesting discussion thread on the Berkshire board on MSN on the same topic. For those interested in kelly formulae, i would recommend reading the thread

http://groups.msn.com/BerkshireHathawayShareholders/general.msnw?action=get_message&mview=0&ID_Message=26958&LastModified=4675605385636001835

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Classification of companies based on nature of competition

By Rohit Chauhan
In Competitive advantage, Industry analysis, Uncategorized
December 13, 2006
3 Min read
1 comment
C

I was reading a book on economics and found the following basic types of competition

– Perfect monopoly
– Oligopoly or duopoly
– Monopolisitic competition
– Perfect competition

I find the above types instructive and a good way to analyse the long term economics of an industry. Let me define the specifics of each type and add a few more subtypes under each

Perfect monoply – As the name suggest, there is just one firm and can charge any price it wants. Obviously this is more in theory than practise, although we have had several monopolies in india till date. Overall monoplies are very profitable (if private) for the investor and bad for the consumer. Several examples come to mind – BSNL, MTNL, Indian airlines (in the past) and now Indian railways. These were (or could have been) extremely profitable (excluding railways) even after all the mismanagement and waste. In a nutshell a perfect monopoly or a close one is extremely profitable for an investor. I would also define a company a monopoly if it has a huge market share in its specific segment and can hold on to it due to some competitive advantage.

Oligopoly or duopoly – A limited number or just two firms in the market. Although not as profitable as a monopoly, I would say these companies are quite profitable and extremely good investments for the long run. Several companies come to mind in this group. For ex : Crisil and other rating agencies, asian paints and other paint companies. One specific point worth noting is that the barrier to entry in this industry are high and hence new entrants cannot enter easily into the industry. As a result the incumbents can earn good profits.

Monopolistic competition – A large number of companies with limited profitability. Barriers to entry are not too high and as a result new companies can enter the industry more easily. I would say most of the commodity companies fall under this group. For ex: cement, steel, Auto, Telecom etc. Few companies in this kind of industry enjoy high profits and generally the lowest cost provider has some kind of competitive advantage. As an investor I would look at companies which have some kind of low cost advantage, some other local or national competitive advantage and a good management. Bad management in such an industry can kill the company.

Perfect competition – A ideal or theorotical construct more than a practical scenario. In such an industry there is no competitive advantage at all, all companies are price takers and they earn only the cost of capital. I would say very few industries would fall in this group. Brokerage firms come close to perfect competition, but still this is more theory than reality.

The way to classify an industry in anyone of the above groups is to look at the following variables
– no of companies in the industry controlling 60-70% of the sales in the industry
– Avg profitability of the companies
– Relative Market share changes between companies over a period of time

By doing the above analysis, one can figure out the level of competition and as a result have a rough idea of the long term economics of the industry.

The above analysis is just a rough guideline or a starting point of a more detailed analysis of the industry and individual companies. However by doing the above assesment, I am able to understand the intensity of competition in an industry over a period of time

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The mirage of holding companies

By Rohit Chauhan
In From other blogs, General thoughts, Investment ideas, Uncategorized
December 11, 2006
1 Min read
1 comment
T

I found these two investment ideas on the blog ‘Indian equity guru’.

http://equityguru.blogspot.com/2006/12/stock-idea-srf-polymers.html
http://equityguru.blogspot.com/2006/11/stock-idea-maharastra-scooters.html

Both the ideas are of holding companies. For ex: SRF polmers has a substaintial holdings of SRF. As a result if you add the value of the business to the value of holdings, the company is selling at a substantial discount to intrinsic value.

One can make a similar case for Balmer lawrie limited and BMIL. Actually I would not be surprised if there are several such stocks available. I find such ideas interesting and cannot argue against the basic logic. What I cannot get my arms around is how will the value get unlocked? There seems to be no catalyst in sight as the holding company is a means for the promoter to exercise control. As a result the holdings may never get sold. What will unlock the value then in such cases?

Somehow these ideas seem to have a mirage like quality. You can see the value out there, but may never gain from it (unless there is an underlying catalyst to unlock the value)

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Evaluating past performance

By Rohit Chauhan
In Investment process, Uncategorized
December 6, 2006
2 Min read
3 comments
E

I have been doing an analysis of my past stock picks and comparing my notes with how the stock picks have turned out over time.

I have been able to divide my picks into broadly three groups

Group A – The multibaggers. These were picks like concor, marico , asian paints, blue star etc. I had no inkling that these companies would do so well and the stock price would appreciate multiple times over the last few years when I first analysed and purchased the stocks. However on deeper analysis I found that the key reason the pick turned out well was due to a double dip I received. First the gap between the intrinsic value and the stock price closed. At the same time, these companies have been able to increase their intrinsic value through some great perfromance in the last couple of years. As a result of these two happy occurences, I have been able to get good profits

Group B – Good return stocks. These were picks like kothari products, macmillan, KVB bank etc. In case of these picks there was a narrowing of the gap between stock price and intrinsic value. As a result I was able to get decent returns as a whole. However in some cases where I was late in selling the stock, the eventual returns were lower.

Group C – The dogs. These were picks like Larsen and tubro (ouch !! see here), SSI, arvind mills etc. Each pick had its own reason for going wrong from over paying for the stock, poor performance of the business, sloppy analysis etc.

The above analysis is definitely not earth shattering and I have known it vauguely for some time. But after almost 8-9 years of buying, selling and analysing stocks, I thought of doing some analysis so as to improve my future performance.

Ofcourse the logical conclusion would be to always buy stocks in group A. However most of the stocks in that group seem to be fairly or over priced. I am finding more picks in group B. Not too exicted about it, but beats overpaying for quality stocks or picking dogs. Key point for me to remember would be to sell these stocks in time if they do not show promise of improvement in intrinsic value

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Postmortem of an arbitrage opportunity

By Rohit Chauhan
In Arbitrage, Uncategorized
December 5, 2006
2 Min read
5 comments
P

I was analysing a potential arbitrage for Infomedia Limited in april. I posted my analysis here and here.

At the time of analysis the stock was selling at 210. Based on a quick analysis, I felt the intrinsic value for the stock was around 180-190. As the terms of the buyback stated that for any holding greater than 50 shares, the acceptance ratio would be around 14%, I passed the opportunity as I felt that post the buyback, I may not be able to sell the stock at a price higher than the purchase price and I was not comfortable buying and holding the stock at 210.

So how did my thesis play out?

Well my thesis proved to be correct, but I still missed an opportunity as I did not track the stock subsequently. Let me explain,

If I had bought the stock at 210 and attempted to arbitrage, I would have suffered a loss of 16% on my investment (assuming a sale price of the stock at 170 after the close of the buyback on 8th August).

However had I continued to track the stock, there was a buying opportunity in june (see graph above, around 8 – 15th) when the stock traded briefly between 115- 140. A purchase at that price (and sale at 170 after buyback) would have given me an annualised return of 135 %.

So lesson for me is that I need to keep tracking an arbitrage stock till the end of the event to take advantage of any sudden opportunities which may come up.

Additional note: I read a few analysis from some brokerage houses of the above arbitrage and found that the analysis covered only the upside and had no mention of the risk or downside.
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More on Valuation of banks

By Rohit Chauhan
In Finance and Banking, Industry analysis, Uncategorized
November 26, 2006
3 Min read
2 comments
M

Got the following comments on my previous post from prem sagar. Thought they were very valid points and hence I am posting my reponse to it seperately in a post.

Hi Rohit,

nice analysis. But I get some thoughts here.

1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?

2. What would you pay for a bank/nbfc with a low leverage (Say IDFC with leverage of around 4 times)..that has potential to increase leverage and hence ROE in future…as per your ROE equation, IDFC wud get a low Price to book.
3. Why shouldnt we consider ROA (assets net of NPA) instead of ROE in ur calculation? THis will show if constantly increased leverage was the reason in maintaining ROE or not.

I agree with all the above points. The post on bank valuation is a simplistic approach to valuing a bank. I always consider leverage an important variable expecially for a financial institution, such as a bank. As a matter of fact I tend to avoid companies with high leverage unless they are well run. Businesses with high leverage are extremely dependent on the quality of management. A small error by management can hurt the business very badly (note the number of banks and FI which have failed and been bailed out by the government on tax payers money).

What I should have put in my previous post is that all of the following factors being in favour, ROE can be used as a good variable to value a bank.

Factors
1. Leverage – This is represented by CAR (capital adequacy ratio). Higher the CAR, better the quality of the business. As a personal note, I prefer to select banks with CAR of atleast 10-12%
2. Level of NPA and asset quality. A bank can have high ROE and still have a lot of problems loans which are hidden by a practise called as greening of loans (give loan to an existing account to prevent the loan from defaulting)
3. Level of operating expense / Net interest income. This reflects the operating efficiency of the bank
4. Level of non-interest, fee based income. Higher the better.
5. Brand name, retail network and management quality. All fuzzy factors, but fairly important ones for a bank

I tend not to overwiegh ROA. An ROA of 1.3% or more is good. Acutally a very high ROA may not be a good sign (possible that the bank is lending to high yield, high risk segment)

I also agree with prem’s point that if a bank has a low leverage, then earnings can expand more easily. To put it another way, the bank will have no need to access the capital market to raise equity to fund its growth (one of the problems being faced by several public sector banks).

All said, valuing and analysing a bank is far more diffcult (according to me) than other businesses. However the ROE approach can be taken as one approach to arrive at an estimate of intrinsic value. I acutally use this instrinsic value as a starting point and then adjust this number based on the other factors, after the bank meets the basic quality standards

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Valuation of Banks – some thoughts

By Rohit Chauhan
In Industry analysis, Investment process, Uncategorized, Valuation
November 22, 2006
3 Min read
3 comments
V

I have been reading the book – The warren buffett way (previous post here). There are several instances of valuations in the book on various companies such as Cap cities/ABC, American express etc. One point which caught my attention was the comparison of a company to a Long term bond investment. Buffett has mentioned several times that he uses the long term bond rates for discount in the DCF model.

Using the above comment, I have used the following thought process to look at another way of valuing a bank (earlier post on the same topic here).

The current long term rate for a 10 year bond is say 7 % (example purpose). So I would be ready to pay 100 Rs for this bond (face value). Now if I have a bond, say Bond B (of similar risk) which pays 14 % on face value, I would be ready to pay around Rs 188 for a face value of Rs 100 for the Bond B (A 7% bond would give 196 Rs in 10 years v/s 370 Rs for the 14 % Bond).

Taking the analogy to equity, lets consider a bank which has an ROE of 14%. Assume a 10 year period for which the bank can maintain this ROE ( This is the crucial part as this is the assestment an investor has to make on the competitive advantage of the Bank and its ability to maintain the high ROE). Beyond the 10 year period the bank’s ROE returns to 7% and so the bank in investment profile is similar to a Long bond.

In the above case, the Bank is similar in its return profile to Bond B. So everything else being equal I would value this bank at 1.88 times Book value.

Ofcourse the above is a very simple sceanrio. But we can add more complexity to the above case and make it more realisitic

Case 1: The ROE is 20 %. This ROE can be maintained for 10 years as in the above example. In such as case, I would value the bank at 3.14 times book value.

Case 2 : The ROE is 14%, but the Excess returns can be maintained for 20 years instead of 10. In such as case the valuation can be at 3.55 times book value

Case 3 : ROE is 20% and the period is 20 years. In that case the bank can be valued at 9.9 times book value.

So the simple conclusion is that higher the ROE and the longer the period for which it can be maintained, the higher is the instrinsic value of the bank (which is basic Discounted flow approach).

The above is a more shorthand approach of valuing a bank. I would look at the valuation in the following way now,

– What is the ROE for the bank
– What is the adjusted book value (net of NPA)
– What is the likely duration of excess return (select only a bank which is well run and hence the duration is atleast 10 years)

Based on the above factors I would prefer to invest at 1.5 – 2 times the adjusted book value (keeping a reasonable margin of safety).

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Value Traps

By Rohit Chauhan
In General thoughts, Notable value investors, Uncategorized
November 16, 2006
2 Min read
7 comments
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I think every value investor dreads a value trap which is basically a company, which seems cheap by historical standards and the gap between the price and the supposed intrinsic value does not close.

I found the following very useful comment from bill miller (he is a very famous money manager in the US whose fund has beaten the index for a straight 15 years)

“You never know for certain, but the nature of value traps is, they tend to have certain characteristics. Typically, one is that the valuation of the business or the industry is lower than its historical norms. The company or business normally has a fairly long history, so the historical normal valuations provide a lot of comfort. Therefore, when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there’s a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren’t working.”

The complete article is here

In addition found the following interesting quote from warren buffett

“Margin of Safety is the untapped pricing power in a business.”

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Further thoughts on pricing strength of a business

By Rohit Chauhan
In Competitive advantage, Investing Philosophy, Uncategorized
November 13, 2006
2 Min read
3 comments
F

The following question was posed to me by Prem sagar on my previous post. The question made me think and I am posting my thoughts on what I think is a fairly important issue in investing (earlier post on pricing )

But what would u say for an industry like say auto ancillaries or retail-proxies like Bartronics, control print, etc where the opportunity is huge, but they have little or no pricing power?

According to me, pricing is an important variable to evaluate the presence of a competitive advantage or strength. A company with strong pricing power, will be able to sustain high returns for a long time and can increase its intrinsic value over time too. So if one were to buy a company with strong pricing power (with other factors in favour), then it is likely that the investment would work out well with passage of time as the company increases its intrinsic value. So such companies can be long term holdings in a portfolio

That said, it does not mean that companies without pricing power would not be good investments. If one can find a company with low pricing power (commodity business), but with some kind of competitive advantage and selling below its intrinsic value, then such a company can be good investment. I would however not hold such an investment too long, once the stock price is close to the intrinsic value as the likelyhood of an increase in the intrinsic value is less.

I do not have much insight into retail-proxies. However as far as auto-ancillaries are concerned, I have done a bit of analysis ( see here, and here) and have not found too many companies to invest in (mainly due to valuation issues). By the very nature of the industry, these companies have poor pricing power (except for retail), have a few large buyers (OEM) and not many have achieved economies of scale in their operation (this industry is still fairly fragmented). However some auto-ancillaries do posses a few competitive advantages such as a low cost position due to focus on specific segment (fasteners for sundaram clayton?) and good growth opportunities. However as I have written earlier, I would invest in these companies only at a fair discount to intrinsic value and sell once the stock reaches the intrinsic value. I would really not hold the stock for a long term.

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Learnings from the Book: The warren buffett way

By Rohit Chauhan
In Book review, Uncategorized, Warren buffett
November 9, 2006
2 Min read
4 comments
L

I have been reading again the excellent Book ‘The warren buffett way’. This book was my first exposure to Warren buffett and his approach to Investing. I have followed and learnt from him since then. The following were the key re-learnings I have had over the past few days (I am yet to finish the book)

– ROE (Return on equity) is one the most important indicator of the economic performance of a company. A company can raise this measure through five different means
o Higher Asset turns (Sales / Total assets)
o Higher margins
o Higher leverage
o Cheaper leverage
o Lower taxes.

I have seen the above happen for several companies in the past few years and have seen the stock price follow the improvement in ROE

For ex: Bluestar (better asset turns), ICICI bank (cheaper leverage, higher margins).

– Inflation does not improve ROE and actually reduces the net return to an investor
– The best companies are the ones which have strong franchies like crisil. Over time some of them become weak franchises. Further weakning of the franchise leads to a good business and then finally to a commodity company.
– Pricing strength is a key attribute of Franchises. These companies can raise prices even when the demand is flat and can earn good returns.

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